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==The Capital Asset Pricing Model==  
===The Capital Asset Pricing Model===  


The rate of return, r,  from an equity asset is given by  
The rate of return, r,  from an equity asset is given by  


::::::'''r&nbsp;=&nbsp;''r''<sub>f&nbsp;</sub>&nbsp;β(''r''<sub>m&nbsp;</sub>&nbsp;-&nbsp;''r''<sub>f</sub>)
'''<math>r=r_f\beta(r_m-r_f)</math>'''
''''


where
where
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(for a proof of this theorem see David Blake ''Financial Market Analysis''  page 297 McGraw Hill 1990)
(for a proof of this theorem see David Blake ''Financial Market Analysis''  page 297 McGraw Hill 1990)


==The Arbitrage Pricing Model==
===The Arbitrage Pricing Model===


The rate of return on the ith asset in a portfolio of n assets, subject to the influences of factors j=1 to k is given by
The rate of return on the ith asset in a portfolio of n assets, subject to the influences of factors j=1 to k is given by
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:::<math>Var(d_j)</math> is the variance of the jth factor
:::<math>Var(d_j)</math> is the variance of the jth factor


==Gambler's ruin==
===Black-Scholes option pricing model===
 
The fair price,P, of a call option on a security is given by:
 
:<math> P = CN(d_1) - Xe^{-rt}N(d_2) \, </math>
 
where:
:C is the current price of the security;
:<math>N(d_1)</math> is the cumulative probability distribution  for the standard normal variate from -∞ to <math> d_1 </math>;
:X is the exercise price (see ''options'' definition);
:r is the risk-free interest rate;
:t is the time to expiry of the option;
:<math> d_1 </math> and <math> d_2 </math> are given by the equations:
 
 
:<math> d_1 = \frac{\ln(C/X) + (r + \sigma^2/2)t}{\sigma\sqrt{t}} </math>;
:<math> d_2 = d_1 - \sigma\sqrt{t}</math>;
 
and
:<math>\sigma</math> is the ''standard deviation (or volatility) of the price of the asset.
 
The first expression,&nbsp;<math> CN(d_1)</math>, &nbsp; of the equation is the expected benefit from acquiring a stock outright, obtained by multiplying the asset price  by the change in the call premium with respect to a change in the underlying asset price. The second expression,&nbsp; <math> Xe^{-rt}N(d_2)</math>,&nbsp;is the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts
 
 
The underlying  assumptions include:
 
:* Dividend payments are not included; 
:*    Options cannot be exercise before the stipulated date;
:* Markets are efficient;
:* No commissions are paid;
:* Volatility is constant;
:* The interest rate is constant; and,
:* Returns are log-normally distributed.
 
===Gambler's ruin===




If q is the  risk of losing one  throw in a win-or-lose winner-takes-all game in which an amount c is repeatedly staked, and k is the amount with which the gambler starts, then the risk, r,  of losing it all is given by:
If q is the  risk of losing one  throw in a win-or-lose winner-takes-all game in which an amount c is repeatedly staked, and k is the amount with which the gambler starts, then the risk, r,  of losing it all is given by:


:::: r&nbsp;  =&nbsp; ''(q/p)''<sup>(k/c)</sup>
:::: '''r&nbsp;  =&nbsp; ''(q/p)''<sup>(k/c)</sup>'''


where p&nbsp;  =&nbsp;  (1&nbsp;-&nbsp;q),&nbsp; and q&nbsp;  ≠&nbsp;  1/2  
where p&nbsp;  =&nbsp;  (1&nbsp;-&nbsp;q),&nbsp; and q&nbsp;  ≠&nbsp;  1/2  

Latest revision as of 11:02, 7 December 2009

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Tutorials relating to the topic of Financial economics.

The Capital Asset Pricing Model

The rate of return, r,  from an equity asset is given by

where

rf  is the risk-free rate of return

rm  is the equity market rate of return

(and rrf is known as the equity risk premium)

and β is the covariance of the asset's return with market's return divided by the variance of the market's return.


(for a proof of this theorem see David Blake Financial Market Analysis page 297 McGraw Hill 1990)

The Arbitrage Pricing Model

The rate of return on the ith asset in a portfolio of n assets, subject to the influences of factors j=1 to k is given by


where


and

is the weighting multiple for factor
is the covariance between the return on the ith asset and the jth factor,
is the variance of the jth factor

Black-Scholes option pricing model

The fair price,P, of a call option on a security is given by:

where:

C is the current price of the security;
is the cumulative probability distribution for the standard normal variate from -∞ to ;
X is the exercise price (see options definition);
r is the risk-free interest rate;
t is the time to expiry of the option;
and are given by the equations:


;
;

and

is the standard deviation (or volatility) of the price of the asset.

The first expression, ,   of the equation is the expected benefit from acquiring a stock outright, obtained by multiplying the asset price by the change in the call premium with respect to a change in the underlying asset price. The second expression,  , is the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts


The underlying assumptions include:

  • Dividend payments are not included;
  • Options cannot be exercise before the stipulated date;
  • Markets are efficient;
  • No commissions are paid;
  • Volatility is constant;
  • The interest rate is constant; and,
  • Returns are log-normally distributed.

Gambler's ruin

If q is the risk of losing one throw in a win-or-lose winner-takes-all game in which an amount c is repeatedly staked, and k is the amount with which the gambler starts, then the risk, r, of losing it all is given by:

r  =  (q/p)(k/c)

where p  =  (1 - q),  and q  ≠  1/2


(for a fuller exposition, see Miller & Starr Executive Decisions and Operations Research Chapter 12, Prentice Hall 1960)