MATHEMATICAL FINANCE CHEAT SHEET

In other words, W (t ) is a drifting Q-Brownian motion with drift (t ) at time t .

Normal Random Variables

A random variable X is Normal N(, 2 ) (aka. Gaussian) under a measure P if and
only if


1 2 2
EP e X = e + 2 , for all real .
A standard normal Z N(0, 1) under a measure P has density
Z x
1
2
(z ) d z .
(x ) = p e x /2 .
P[Z x ] = (x ) :=
2

Let X = (X 1 , X 2 , . . . , X n )0 with X i N(i , qi i ) and Cov[X i , X j ] = qi j for i , j = 1, . . . , n.

We call := (1 , . . . , n )0 the mean and Q := (qi j )ni, j =1 the covariance matrix of X .
Assume detQ > 0, then X has a multivariate normal distribution if it has the density

1
1
(x ) = p
exp (x )0Q 1 (x ) , x Rn .
2
(2)n detQ
We write X N(,Q ) if this is the case. Alternatively, X N(,Q ) under P if and
only if

1
0
EP [e X ] = exp 0 + 0Q , for all Rn .
2
If Z N(0,Q ) and c Rn then X = c 0 Z N(0, c 0Q c ). If C Rmn (i.e., m n matrix)
0
0
then X = C Z N(0, C Q C ) and C Q C is a m m covariance matrix.
Gaussian Shifts
If Z N(0, 1) under a measure P, h is an integrable function, and c is a constant
then
2
EP [e c Z h (Z )] = e c /2 EP [h (Z + c )].
Let X N(0,Q ), h be a integrable function of x Rn , and c Rn . Then
EP [e c

h (X )] = e

1
2

c 0Q c

Cameron-Martin-Girsanov Converse
If (W (t ))t 0 is a P-Brownian motion, and Q is a measure equivalent to P, then there
exists a F -previsible process ((t ))t 0 such that
Z t
f(t ) := W (t ) +
(s ) d s
W
0

is a Q-Brownian motion. That is, W (t ) plus drift (t ) is a Q-Brownian motion. Additionally,

Z t

ZT
dQ
1
(t ) d W (t )
= exp
(t )2 d t .
dP
2 0
0
Martingale Representation Theorem

Suppose (M (t ))t 0 is a Q-martingale process whose volatility EQ [M (t )2 ] = (t )

satisfies (t ) 6= 0 for all t (with Q-probability one). Then if (N (t ))t 0 is any other QRT
martingale, there exists an F -previsible process ((t ))t 0 such that 0 (t )2 (t )2 d t <
(with Q-prob. one), and N can be written as
Z t
N (t ) = N (0) +

or in differential form, d N (t ) = (t ) d M (s ). Further, is (essentially) unique.

Multidimensional Diffusions, Quadratic Covariation, and Its Formula
If X := (X 1 , X 2 , . . . , X n )0 is a n -dimensional diffusion process with form
Z t
Z t
X (t ) = X (0) +

EP [h (X + c )].

Correlating Brownian Motions

f(t ))t 0 be independent Brownian motions. Given a correlaLet (W (t ))t 0 and (W
tion coefficient [1, 1], define
p
c(t ) := W (t ) + 1 2 W
f(t ),
W
c(t ))t 0 is a Brownian motion and E[W (t )W
c(t )] = t .
then (W
Identifying Martingales
If X t = X (t ) is a diffusion process satisfying
d X (t ) = (t , X t ) d t + (t , X t )d W (t )
RT
and EP [( 0 (s , X s )2 d s )1/2 ] < (or, (t , x ) c |x | as |x | ), then
X is a martingale X is driftless (i.e., (t ) 0 with P-prob. 1).
Novikovs Condition
In the case d X (t ) = (t )X (t ) d W (t ) for some F -previsible process ((t ))t 0 , then
we have the simpler condition

ZT

1
EP exp
(s )2 d s < X is a martingale.
2 0
Its Formula

Given X (t ) and Y (t ) adapted to the same Brownian motion (W (t ))t 0 ,

d X (t ) = (t )d t + (t )d W (t ), d Y (t ) = (t ) d t + (t ) d W (t ).
Then d (X (t )Y (t )) = X (t ) d Y (t ) + Y (t ) d X (t ) + d X , Y (t ).
| {z }

f(t ).
d X (t ) = (t ) d t + (t ) d W (t ), d Y (t ) = (t ) d t + (t ) d W
Then d (X (t )Y (t )) = X (t ) d Y (t ) + Y (t ) d X (t ) as d X , Y (t ) = 0.
Radon-Nikodm Derivative
Given P and Q equivalent measures and a time horizon T , we can define a random
variable dd QP defined on P-possible paths, taking positive real values, such that

dQ
EQ [X T ] = EP
X T , for all claims X T knowable by time T ,
dP
[t X t |Fs ], for s t T ,
EQ [X t |Fs ] = 1
s EP
where t is the process EP [ dd QP |Ft ].
Cameron-Martin-Girsanov Theorem
If (W (t ))t 0 is a P-Brownian motion and
((t

R))Tt 0 is an F
-previsible process satisfying the boundedness condition EP exp 12 0 (t )2 d t < , then there exists a
measure Q such that:
Q is equivalent
P,

Z to
ZT
T
dQ
1

= exp
(t ) d W (t )
(t )2 d t ,
dP
2 0
0
R
f(t ) := W (t ) + t (s ) d s is a Q-Brownian motion.
W
0

i (s )0 j (s ) d s ,

X i , X j (t ) =

or in differential form d X i , X j (t ) = i (t )0 j (t ) d t , where i (t ) is the i th column

Rt
of (t ). The quadratic variation of X i (t ) is X i (t ) = 0 i (s )0 i (s ) d s .
The multi-dimensional It formula for Y (t ) = f (t , X 1 (t ), . . . , X n (t )) is
n
X
f
f
d Y (t ) =
(t , X 1 (t ), . . . , X n (t ))d t +
(t , X 1 (t ), . . . , X n (t ))d X i (t )
t

xi
i =1
+

n
1 X 2f
(t , X 1 (t ), . . . , X n (t ))d X i , X j (t ).
2 i , j =1 xi x j

The (vector-valued) multi-dimensional It formula for

Y (t ) = f (t , X (t )) = (f1 (t , X (t )), . . . , fn (t , X (t )))0
where fk (t , X ) = fk (t , X 1 , . . . , X n ) and Y (t ) = (Y1 (t ), Y2 (t ), . . . , Yn (t ))0 is given componentwise (for k = 1, . . . , n ) as
n
X
fk (t , X (t ))
fk (t , X (t ))
d Yk (t ) =
dt +
d X i (t )
t
xi
i =1
+

n
1 X 2 fk (t , X (t ))
d X i , X j (t ).
2 i , j =1 xi x j

Stochastic Exponential
The stochastic exponential of X is Et (X ) = exp(X (t ) 21 X (t )). It satisfies
E (0) = 1, E (X )E (Y ) = E (X + Y )e X ,Y , E (X )1 = E (X )e X ,X .
The process Z = E (X ) is a positive process and solves the SDE
Z (0) = e X (0) .

dZ =Z dX ,

(t )(t ) d t

In the other case, if X (t ) and Y (t ) are adapted to two different and independent
f(t ))t 0 ,
Brownian motions (W (t ))t 0 and (W

(s ) d W (s ),

where (t ) Rn m and W is a m -dimensional Brownian motion. The quadration

covariation of the components X i and X j is
Z t

g
g
1
2g
(t , X t ) d t +
(t , X t ) d X t + (t )2
(t , X t )d t .
t
x
2
x2
The Product Rule

(s ) d s +

For X t = X (t ) given by d X (t ) = (t ) d t + (t ) d W (t ) and a function g (t , x ) that is

twice differentiable in x and once in t . Then for Y (t ) = g (t , X t ), we have
d Y (t ) =

(s ) d M (s ),

Solving Linear ODEs

The linear ordinary differential equation
d z (t )
= m (t ) + (t )z (t ),
dt
for a t b has solution given by
Z t
t 1
u m (u) d u ,

z (t ) = t +

z (a ) = ,

t := exp

= exp

(u ) d u ,
a

Z

(u) d u +
a

m (u ) exp

(r ) d r d u .
u

Solving Linear SDEs

The linear stochastic differential equation
d Z (t ) = [m (t ) + (t )Z (t )]d t + [q (t ) + (t )Z (t )] d W (t ),
for a t b has solution given by
Z t
Z t
Et Eu1 [m (u) q (u)(u)] d u +

Z (t ) = Et +

Z (a ) = ,

Et Eu1 q (u) d W (u ),

where Et := Et (X ) and X (t ) =
Z t

Rt
a

(u ) d u +
Z t

(u) d u +

Et = exp

Rt

(u )d W (u ). In other words,
Z t

1
(u) d W (u)
(u)2 d u .
2 a
a

Fundamental Theorem of Asset Pricing

AJD option pricing

Let X be some FT -measurable claim, payable at time T . The arbitrage-free price

V of X at time t is

ZT


r (s ) d s X Ft ,
V (t ) = EQ exp

Define the Fourier transform inversion of the conditional expectation

ZT

Market Price Of Risk

(t ) :=

t f 0 (X t ) + 12 2t f 00 (X t ) r f (X t )

,
t f 0 (X t )
and the behaviour of X t under the risk-neutral measure Q is given by
f(t ) +
d X (t ) = (t )d W

r f (X t ) 12 2t f 00 (X t )
f

0 (X

t)

Consider a European option with strike price K on a asset with value VT at maturity time T . Let FT be the forward price of VT , F0 the current forward price. If
log VT N(F0 , 2 T ) then the Call and Put prices are given by
C = P (0, T )(F0 (d 1 ) K (d 2 )), P = P (0, T )(K (d 2 ) F0 (d 1 )),

The forward rate at time t that applies between times T and S is defined as
P (t , T )
1
log
.
F (t , T,S ) =
S T
P (t ,S )
The instantaneous forward rate at time t is f (t , T ) = limS T F (t , T,S ). The instantaneous risk-free rate or short rate is r (t ) = limT t f (t , T ). The cash account is
given by
Z t

r (s ) d s ,

and satisfies d B (t ) = r (t )B (t ) d t with B (0) = 1. The instantaneous forward rates

and the yield can be written in terms of the bond prices as
log P (t , T )

log P (t , T ), R (t , T ) =
.
f (t , T ) =
T
T t
Conversely,
ZT

f (t , u) d u

and

1b X

((a + i v b , X 0 , T )e i v y )
dv
v

The i th entry in X is the log asset price and k = l o g (K ), the log strike. d is a vector
whose i th element is 1, else zero. The corresponding call option price is
C = G (d , d , k ) K G (0, d , k )
The Heath-Jarrow-Morton Framework
Given a initial forward curve T 7 f (0, T ) then, for every maturity T and under the
real-world probability measure P, the forward rate process t 7 f (t , T ) follows
Z t
Z t
(s , T )0 d W (s ),

(s , T ) d s +

f (t , T ) = f (0, T ) +

t T,

r (t ) = f (t , t ) = f (0, t ) +

(s , t ) d s +

(s , t ) d W (s ),

so the cash account and zero coupon T -bond prices are well-defined and obtained
through
ZT

Z t

r (s ) d s ,

P (t , T ) = exp

P (t , T ) = exp((T t )R (t , T )).

f (t , u) d u .

Forward Rates, Short Rates, Yields, and Bond Prices

P (t , T ) = exp

(a , X 0 , T ) 1

B (t ) = exp

p
log(EQ (VT )/K ) + 2 T /2
and d 2 = d 1 T .
p
T

B (t ) = exp

XT

where (t , T ) R and (t , T ) := (1 (t , T ), . . . , n (t , T )) satisfy the technical condiRT RT

tions: (1) and are previsible and adapted to Ft ; (2) 0 0 |(s , t )| d s d t <
for all T ; (3) sups ,t T k(s , t )k < for all T . The short-rate process is given by
Z t
Z t

dt.

Blacks Model

where d 1 =

where Q is the risk-neutral measure.

Let X t = X (t ) be the price of a non-tradable asset with dynamics d X (t ) = (t ) d t +

(t )d W (t ) where ((t ))t 0 and ((t ))t 0 are previsible processes and (W (t ))t 0 is
a P-Brownian motion. Let Y (t ) := f (X t ) be the price of a tradable asset where
f : R R is a deterministic function. Then the market price of risk is

R (X s )d s e a

G (a , b , y ) = EQ exp

The discounted asset price Z (t , T ) = P (t , T )/B (t ) satisfies

ZT
1

d Z (t , T ) = Z (t , T )
(t , u) d u d t + S (t , T )0 d W (t ) ,
S 2 (t , T )
2
t
|
{z
}
b (t ,T )

where S (s , T ) :=

RT
s

(s , u) d u . The HJM drift condition states that

Q is EMM (i.e., no arbitrage for bonds) b (t , T ) = S (t , T )(t )0 ,

R
f(t ) := W (t ) t (s ) d s is a Q-Brownian motion. If this holds, then under
where W
0
Q, the forward rate process follows
Z t
Z t
ZT

f(s ),
f (t , T ) = f (0, T ) +
(s , T ) d W
(s , T )
(s , u)0 d u d s +
s

{z

HJM drift

and the discounted asset Z (t , T ) satisfies d Z (t , T ) = Z (0, T )Et (X ) with

Z t
f(s ).
X (t ) =
S (s , T )0 d W
0

The LIBOR Market Model

For a tenor > 0, the LIBOR rate L (T, T, T + ) is the rate such that an investment
of 1 at time T will grow to 1+L (T, T, T +) at time T +. The forward LIBOR rate
(i.e., a contract made at time t under which we pay 1 at time T and receive back
The state vector X t follows a Markov process solving the SDE
1 + L (t , T, T + ) at time T + ) is defined as
d X t = (X t )d t + (X t )d Wt + d Z t

P (t , T )
1
where W is an adapted Brownian, and Z is a pure jump process with intensity .
L (t , T ) := L (t , T, T + ) =
1 ,
P (t , T + )
The moment generating function of the jump sizes is (c ) = EQ (exp(c J )). Impose
an affine structure on , T , and the discount rate R , possibly time dependent: and satisfies L (T, T ) = L (T, T, T + ).
Under the real-world probability measure P, The LMM assumes that each LIBOR
(x ) = K 0 +K 1 x ((x )(x )T )i j = (H0 )i j +(H1 )i j x (x ) = L 0 +L 1 x R (x ) = R0 +R1 x process (L (t , Tm ))0t T satisfies
m


Given X 0 , the risk neutral coefficients (K , H , L , , R ) completely determine the disd L (t , Tm ) = L (t , Tm ) (t , L (t , Tm )) d t + m (t , L (t , Tm ))0 d W (t ) ,
counted risk neutral distribution of X . Introduce the transform function


ZT

where W = (W 1 , . . . , W d ) is a d -dimensional Brownian motion with instantaneous


T
T

correlations
(u, X 0 , T ) = EQ exp
R (X s )d s e u X T  F0 = e (0,u)+ (0,u) x0

d W i , W j (t ) = i , j (t ) d t , i , j = 1, 2, . . . , d .
0
Affine Jump Diffusion (AJD) Models

where and solve the Ricatti ODEs subject to (T, u) = 0, (T, u) = u:

(t , u) =K T (t , u) + 1 (t , u)T H1 (t , u) + L 1 ( ( (t , u)) 1) R1
1

, u) =K 0T (t , u) + 21 (t , u)T H0 (t , u) + L 0 ( ( (t , u)) 1) R0
(t
AJD bond pricing

r =m +1

In , set L i = R0 = u = 0, R1 = 1 to obtain the zero coupon bond with maturity

T t via the Ricatti ODEs:
Short rate model
Merton
Dothan
Vasicek
CIR
Pearson-Sun
Ho & Lee
Hull & White
Extended Vasicek
Black-Karasinski

K0

(t )
(t )
(t )(t )
)
(t )(t

K1

(t )
(t )

The function (t , L ) : [0, Tj ] R RN d is the volatility, and (t ) : [0, Tj ] R is the

drift.
Let 0 m , n N 1. Then the dynamics of L (t , Tm ) under the forward measure
PTn+1 is for m < n given by

n
X
d L (t , Tm ) = L (t , Tm ) (t , Tm )
Tr ,Tr +1 (t )0 d t + (t , Tm )d W m (t )

H0
2
2
2
2
2
(t )2
(t )2

H1
2
2
2

P?MR?
NN
YN
NY
YY
YY
NN
NY
NY
YY

P means the process stays positive, MR means rt is mean-reverting. Closed form solutions for bond prices and European options exist for all models except for , which
describes the evolution of d log(rt ) instead of d rt .

For m = n,
and for m > n we have

d L (t , Tm ) = L (t , Tm )(t , Tm )d Wt m

d L (t , Tm ) = L (t , Tm ) (t , Tm )

m
X
r =n+1

Tr ,Tr +1 (t )0 d t + (t , Tm )d Wt m

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