Ch 1: Bond Pricing/Arbitrage Want to hold bond for more time than maturity. 1. Only portfolios on efficient frontier.

 YTM and bond price are inversely related. Liquidity premium to induce to hold shorter = 2. Choose CAL with steepest slope.
P = FV (C = YTM) = par higher yields for short bonds = downward 3. Optimal risky portfolio where tangent CAL
P > FV (C > YTM) = premium sloping term structure. from rf touches frontier.
P < FV (C < YTM) = discount sft = E(syt) + L
Bond pricing Forward rates determined by expectations +
𝑐1 𝑐𝑡 + 𝐹𝑉 liquidity premium/discount.
𝑃= 1
+ ⋯+ L – positive for liquidity risk.
(1 + 𝑦1 ) (1 + 𝑦𝑇 )𝑇
Annuity L – negative for reinvestment risk.
𝑐 1
𝑃 = [1 − 𝑇 ] (i.e. just coupon payments.
𝑟 (1+𝑟) Ch 4: Markowitz Theory
Add PV of FV on end for bond). Minimise risk, maximise wealth.
Preferable if positive first derivative (positive CAL is new EF as every investor will choose on
slope) and negative second derivative (concave this line (all other choices are dominated).
up, increasing at decreasing rate). Separation Theorem
Utility 1. Choose P* and implicitly CAL.
1 Sharpe Ratio / CAL slope
𝑈 = 𝐸(𝑟𝑝 ) − 𝐴𝜎 2 ∆𝑦 𝐸(𝑟𝑃 ) − 𝐸(𝑟𝑓 )
2
Risk-free portfolio: variance = 0 𝑆𝑃 = =
∆𝑥 𝜎𝑃
YTM = the IR that makes the PV of the bond’s Indifference curves  Choose highest Sharpe ratio.
payments equal to its price. (i.e. average return). Connect points of equal utility (all combinations
Current Yield of E(rp) and variance). Never intersect. 2. Choose how much to invest in risky asset
𝐶𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 Portfolio formulae
𝐶𝑌 = Expected return:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 𝑟𝑝 = 𝑤1 𝑟1 + 𝑤2 𝑟2 + ⋯ + 𝑤𝑁 𝑟𝑁 𝐸(𝑟𝑐 ) = 𝑟𝑓 + 𝑦[𝐸(𝑟𝑃∗ ) − 𝑟𝑓 ]
Gross Return
𝐸(𝑟) = ∑ 𝑝𝑠 𝑟 𝑠 Volatility:
e.g. 2-year, c=$10, FV=$100, can reinvest at
𝑠 𝜎𝐶 = 𝑦𝜎𝑃∗
r=0.10
𝜎𝐶2 = 𝑦 2 𝜎𝑃2 Utility:
Aggregate CF at t=2 = 100+10+10(1.1) = 121 1
Gross return = 1+R = 121/96.62 = 1.25 𝑈 = 𝑟𝑓 + 𝑦[𝐸(𝑟𝑃∗ ) − 𝑟𝑓 ] − 𝐴𝑦 2 𝜎𝑃∗ 2
Realised compound yield 2
1 To find max utility, solve for y*:
(1 + 𝑅)𝑇 − 1 1 𝐸(𝑟𝑃∗ ) − 𝑟𝑓
e.g. 1.250.5 -1 = 11.9% 𝑦∗ = ×
𝐴 𝜎𝑃∗ 2
Quadratic formula How much to invest in optimal risky portfolio =
−𝑏 ± √𝑏 2 − 4𝑎𝑐 y*. e.g. if y*=1.5, 1-y*=-0.5 therefore borrow
𝑥= 50% of wealth, invest 150% in optimal risky
2𝑎
Use when needing to calculate YTM in bond portfolio.
pricing equation. Let x = 1/(1+YTM). x > 0. Everyone invests in P*, the only thing that
Holding period return changes with risk aversion is how much (i.e. y*).
𝑃0 (1 + 𝐻𝑃𝑅) Domination
𝜎𝑃2 = 𝑤𝐴2 𝜎𝐴2 + 𝑤𝐵2 𝜎𝐵2 + 𝑤𝐶2 𝜎𝐶2
= 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝐶𝐹 𝑓𝑟𝑜𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 Say we have asset X, asset Z, and a risk-free
+ 2𝑤𝐴 𝑤𝐵 𝜌𝐴,𝐵 𝜎𝐴 𝜎𝐵
P0 = initial investment. asset. A portfolio of asset Z and the risk-free asset
+ 2𝑤𝐵 𝑤𝐶 𝜌𝐵,𝐶 𝜎𝐵 𝜎𝐶 dominates asset X in 2 scenarios:
If you sell at t=1, then the powers reset for next
holder i.e. what was CF t=2 for you will be t=1 + 2𝑤𝐴 𝑤𝐶 𝜌𝐴,𝐶 𝜎𝐴 𝜎𝐶 E(portfolio) > E(X) AND 𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝜎𝑋 ;
and only put to power of 1. Useful rules OR
If YTM changes, use that as IR for calculation of E(X + Y) = E(X) + E(Y) E(portfolio) = E(X) AND 𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 > 𝜎𝑋
price at the time you are selling. E(aX) = aE(X)
Solve for the weights and then show how the
Var(X) = Cov(X,X)
expected return differs.
Ch 2: Term structure of IR Cov(X,Y) = 𝜌𝜎𝑋 𝜎𝑌
Borrowing constraints
Generally upward sloping. Cov(𝛼𝑋, 𝛽𝑌) = 𝛼𝛽𝐶𝑜𝑣(𝑋, 𝑌) If have to borrow at higher rate than lend, put this
Inferring spot rates using bond pricing equation: Var(𝛼𝑋) = 𝛼 2 𝑉𝑎𝑟(𝑋) rate instead of rf in the max. utility equation when
Find y1, sub to find y2, repeat for all y. Solve Var(X+Y) = Var(X) + Var(Y) + 2Cov(X,Y) determining how much to invest.
simultaneously for zero-coupon bonds. Picking portfolios Ch 6: CAPM
Arbitrage & term structure Optimal portfolio – where efficient frontier For a portfolio of risky assets, Port M:
Construct synthetic bond to mimic CFs of touches highest indifference curve (tangent).
Indifference curve = investor preferences, 𝑟𝑀 = ∑ 𝑤𝑗 𝑟𝑗
over/underpriced bond.
𝐶𝐹1𝑆 = 𝑋𝐴 𝐶𝐹1𝐴 + 𝑋𝐵 𝐶𝐹1𝐵 = 𝐶𝐹1𝐶 efficient frontier = un-dominated portfolios. 𝑗
Ch 5: Optimal Portfolios – consider RFA 𝑉𝑎𝑙𝑢𝑒𝑗
𝐶𝐹2𝑆 = 𝑋𝐴 𝐶𝐹2𝐴 + 𝑋𝐵 𝐶𝐹2𝐵 = 𝐶𝐹2𝐶 𝑤𝑗 =
Market value of synthetic bond: Risk-free portfolio: 0 variance, E(rf) = rf. ∑𝑗 𝑉𝑎𝑙𝑢𝑒𝑗
𝑃𝐶𝑆 = 𝑋𝐴 𝑃𝐴 + 𝑋𝐵 𝑃𝐵 𝐸(𝑟𝑀 ) = ∑ 𝑤𝑗 𝐸(𝑟𝑗 )
Future rate in forward period 𝑗
t s 1/(t-s)
sft = [(1+yt) / (1+ys) ] –1
If things are certain: e.g. 𝑉𝑎𝑟(𝑟𝑀 ) = 𝐶𝑜𝑣(𝑟𝑀 , 𝑟𝑀 ) = ∑ 𝑤𝑗 𝐶𝑜𝑣(𝑟𝑗 , 𝑟𝑀 )
𝑗
(1+yn)n = (1+r1)(1+f2)(1+f3)…(1+fn)
(1+yn)n(1+fn+1) = (1+yn+1)n+1 CAPM Capital Asset Pricing Model
Note: to calculate bond pricing, you need y1, y2, 𝐸(𝑟𝑗 ) − 𝑟𝑓 = 𝛽𝑗 ∗ (𝐸(𝑟𝑀 ) − 𝑟𝑓 )
𝑟𝑐 = (1 − 𝑦)𝑟𝑓 + 𝑦𝑟𝑃 𝐶𝑜𝑣(𝑟𝑗 ,𝑟𝑀 )
etc. Do not use forward rates (e.g. 1f2) – have to Where 𝛽 = 2 (measures risk contibu).
convert from forward rate to y1 using formula. Where y = weight invested in risky asset. 𝜎𝑀
Formulae: complete portfolio (c) Beta>1-more risk than average asset.
Then price.
Expectation hypothesis 𝐸(𝑟𝑐 ) = 𝑟𝑓 + 𝑦[𝐸(𝑟𝑃 ) − 𝑟𝑓 ] Security Market Line
sft = E(syt)
𝑉𝑎𝑟(𝑟𝑐 ) = 𝑦 2 𝑉𝑎𝑟(𝑟𝑃 ) = 𝑦 2 𝜎𝑃2
Market expectations determine future rates – 𝜎𝑐 = √𝑦 2 𝜎𝑃2 = 𝑦𝜎𝑃
typically upward sloping.
Liquidity risk If y>1: borrowing at RFR (instead of investing
Want to hold bond for less time than maturity. in RFA) to invest in risky asset.
Liquidity premium to induce to hold for longer CAL - finding optimal complete portfolio
= higher yields for long bonds = upward sloping A line formed by plotting volatility against E(r)
term structure. for any complete portfolio, which joins the rf
𝑟𝑗 = 𝑟𝑓 + 𝛽𝑗 ∗ ( 𝑟𝑀 − 𝑟𝑓 ) + 𝜀
Reinvestment risk and the P.
Error term should be random/unpredictable. 3. 𝑆𝑃2 = 𝑆𝑀
2 2
+ 𝐼𝑅𝐴𝑃 = 𝑆𝑀2
+ ∑𝑗 𝐼𝑅𝑗2 Bet on high volatility – net premiums are
𝜎𝑖2 = 𝛽𝑖2 𝜎𝑀2 + 𝜎𝜀2 CAPM tells us to diversify. positive. 1xlong call, 1xlong put strike P= X.
Total risk = systematic risk + unsystematic risk General factor models Butterfly Spread
𝜎𝑖2 = 𝛽𝑖2 𝜎𝑀2 + 𝜎𝜀2 Bet on low volatility (U price within narrow X
Covariance = product of betas x market-index range). 1xlong call (SP= X – 𝛼), 1xlongcall (SP
risk =X+ 𝛼), 2xshortcalls (SP=X). Net premiums
𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑗 ) = 𝛽𝑖 𝛽𝑗 𝜎𝑀2 Asset’s E(r) should equal: positive.
Correlation = product of correlations with the
market index
2
𝛽𝑖 𝛽𝑗 𝜎𝑀
𝐶𝑜𝑟𝑟(𝑟𝑖 , 𝑟𝑗 ) =
𝜎𝑖 𝜎𝑗
= 𝐶𝑜𝑟𝑟(𝑟𝑖 , 𝑟𝑀 ) Fama-French-Carhart 4 Factor Model
× 𝐶𝑜𝑟𝑟(𝑟𝑗 , 𝑟𝑀 ) Four portfolio returns as factors:
System. = 𝛽𝑖2 𝜎𝑀2 =cannot be diversified. Implies
only system. Risk is priced.
Portfolio beta Each new factor is self-financing
𝐶𝑜𝑣(𝑟𝑃 , 𝑟𝑀 )
𝛽𝑃 =
𝜎𝑀2 PQ Answer:
𝛽𝑃 = 𝑤1 𝛽1 + 𝑤2 𝛽2 Long1put45;Short1put50;Long1call55;Short1ca
Market portfolio consists of all assets, 𝛽 = 1. ll50. Bond $5 part (b).
Ch 7: SIM and factor models Replicating covered call
CAPM relies on assumptions which can result in 1xshort put, 1x0couponbond
mispricing of assets.
Jensen’s Alpha
𝑟𝑖𝑡 − 𝑟𝑓𝑡 = 𝛼𝑖 + 𝛽𝑖 [𝑟𝑀𝑡 − 𝑟𝑓𝑡 ] + 𝜀𝑖𝑡
According to CAPM, alpha should = 0.
If not 0, there is mispricing – alpha measures.
If correctly priced, should lie on SML. Ch 10: Option strategies
Exploiting Mispricing Call = right to buy.
1. Calculate alpha (“the benefit”) Put = right to sell.
𝐸(𝑟𝐴 ) − 𝑟𝑓 = 𝛼𝐴 + 𝛽[𝐸(𝑟𝑀 ) − 𝑟𝑓 ] Put call parity
Call: IV: max(0, St – X)=discount. The covered call and its replication must be worth
Negative alpha = overvalued Put: IV: max(0, X – St) =premium. same (no-arbitrage).
Positive alpha = undervalued Moneyness 𝑆𝑡 − 𝑐𝑡 = 𝑃𝑉(𝑋) − 𝑝𝑡
2. Calculate unsystematic risk (“the cost”) In the money: Call X<St; Put St<X. ct = price of call, pt = price of put, PV(X)=value
𝜎𝜀2 = 𝜎𝐴2 − 𝛽2 𝜎𝑀2 At the money: X = St. of bond.
3. Get optimal weight of active portfolio Out of: Call St<X; Put X<St. Profit diagram – long = -, short = +.
𝛼𝐴 𝐸(𝑟𝑀 ) − 𝑟𝑓 Time Value
𝑤𝐴0 = 2 /
𝜎𝜀(𝐴) 𝜎𝑀2 Increases with TTM and volatility of UA price Continuous Compounding
Use result to compute: 𝑟𝑛−𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑛
(1 + 𝑟𝑎𝑛𝑛𝑢𝑎𝑙 ) = (1 + )
𝑤𝐴0 𝑛
𝑤𝐴∗ = 𝑟𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠 = ln(1 + 𝑟𝑎𝑛𝑛𝑢𝑎𝑙 )
1 + 𝑤𝐴0 (1 − 𝛽𝐴 )
𝑔𝑟𝑜𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 = (1 + 𝑟𝑎𝑛𝑛𝑢𝑎𝑙 )𝑇 = 𝑒 𝑟𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠 𝑇
𝑤𝐴∗ = how much of risky investment to invest in
^^ If you are shorting these diagrams, flip them r=continuously compounded rate from here.
mispriced asset. Rest goes in market portf.
4. Calculate amount to invest in risky P and how upside down. Betting for volatility = buy options, PV(X)=𝑋𝑒 −𝑟(𝑇−𝑡)
much in RFA. betting against volatility = sell option X = 𝑋𝑒 −𝑟𝑇
𝛼 Protective Put 𝑆𝑡 − 𝑐𝑡 = 𝑋𝑒 −𝑟(𝑇−𝑡) − 𝑝𝑡
𝐼𝑅 = Invest in stock, unwilling to bear potential losses: 𝑋
𝜎𝜀 𝑐 = 𝑃 + 𝑆0 −
𝛼 guaranteed payoff of at least put price. (1 + 𝑟𝑓 )𝑇
𝑆𝑃2 = 𝑆𝑀 2
+ ( )2
𝜎𝜀 1x stock, 1x long put Ch 11: Option valuation
Squared Sharpe ratio of P after incorporating Risk neutral valuation of options (1 period)
mispriced assets. S = price of UA, at time t either S0u/S0d
Exploiting multiple mispriced assets Option = f, fu(high) or fd(low)
1. Combine to form active portfolio, then treat as 1. Create portfolio of delta stocks and one short
single mispriced asset and follow above. option.
Weight of mispriced asset in active P: 𝑓𝑢 −𝑓𝑑
𝛼𝑖 ∆=
𝑆0 𝑢 − 𝑆0 𝑑
𝜎𝜀𝑖2 Covered Call ∆𝑆0 𝑢 − 𝑓𝑢 = ∆𝑆0 𝑑 − 𝑓𝑑
𝑤𝑖 = 𝛼𝑗 Buy stock, short call option. Gain premium, lose This makes portfolio RF (earn RFR – no arb)
∑𝑁𝑗=1 2
𝜎𝜀𝑗 risk of upside from stock. Price derivative at t=0 as,
Calculating 𝜎𝜀𝑖2 : 1 x stock, 1x short call 𝑓0 = 𝑒 −𝑟𝑇 [𝑝𝑓𝑢 + (1 − 𝑝)𝑓𝑑 ] where
𝜎𝑖2 = 𝛽𝑖2 𝜎𝑀2 + 𝜎𝜀𝑖2 𝑒 −𝑟𝑇−𝑑
𝛼 𝑝= (risk neutral p that value of stock
Then calculate 2𝑖 for each asset. 𝑢−𝑑
𝜎𝜀𝑖 increases).
Calculate beta for of the active portfolio (sum Interpreting p as prob, 𝑓0 = 𝑒 −𝑟𝑇 𝐸(𝑓𝑇 )
of: weight of asset x beta). expected value discounted by RFR.
Calculate the return of the active portfolio (sum Extending one-period valuation formulae
of: weight of asset x expected return of asset). 𝑢 = 𝑒 𝜎√∆𝑡 (delta t is time interval for each step),
Calculate the alpha of the asset using 𝐸(𝑟𝐴 ) − 𝜎 is stock volatility (est. historically).
𝑟𝑓 = 𝛼𝐴 + 𝛽[𝐸(𝑟𝑀 ) − 𝑟𝑓 ] substituting the beta Straddle  Price backwards using 1-step formula.
and expected return just calculated above. Then To remove dependence on St let ∆𝑆𝑇𝑢 − max =
do step 3 as above. ∆𝑆𝑡𝑑 − 𝑚𝑎𝑥 e.g. ∆125-25=∆80 − 0
2
2. 𝐼𝑅𝐴𝑃 = ∑𝑗 𝐼𝑅𝑗2 To find certain value PT sub delta back into one
side of this equation.
Arbitrage-free price: P0 = PTe-r
PT = ∆ST – CT (same if sub T=0).
S0er = E(ST)