ESCP Business School - MF31: Mathematical Finance --- Page 1 of 8

ESCP Business School

APPENDIX for the

EXAM of
MF31: Mathematical Finance

Instructions: A copy of this Appendix is given to the students at the beginning

of the exam. The students are allowed to read this Appendix during the exam
and in fact it’s expected that they have access to any information contained in
it. However, at the end of the exam this Appendix will be collected by the
invigilators.
 ESCP Business School - MF31: Mathematical Finance --- Page 2 of 8

Chapter 1: Introductory concepts of mathematical finance

• The future value (FV) in 𝑡 years of amount 𝐴 invested with a yearly interest of 𝑟 is: 𝑨𝒆𝒓𝒕 .
• The present value (PV) of amount 𝐴 discounted by 𝑡 years with a yearly interest of 𝑟 is: 𝑨𝒆−𝒓𝒕 .
• The expected value of a discrete variable 𝑋 can be calculated as: 𝐸(𝑋) = ∑𝑎𝑙𝑙 𝑥 𝑥 ∙ 𝑃(𝑋 = 𝑥) .
• The expected value of the product of two discrete variables 𝑋 and 𝑌 can be calculated as:
𝐸(𝑋𝑌) = ∑𝑎𝑙𝑙 𝑥𝑦 𝑥𝑦 ∙ 𝑃(𝑋𝑌 = 𝑥𝑦) .
• The variance of a discrete variable 𝑋 can be calculated as: 𝑉(𝑋) = 𝐸(𝑋 2 ) − (𝐸(𝑋))2, where
obviously: 𝐸(𝑋) = ∑𝑎𝑙𝑙 𝑥 𝑥 ∙ 𝑃(𝑋 = 𝑥), and 𝐸(𝑋 2 ) = ∑𝑎𝑙𝑙 𝑥 𝑥 2 ∙ 𝑃(𝑋 = 𝑥) .
• The standard deviation is equal to the square root of the variance.

Chapter 2: The mathematics of Bonds and forward rates

Coupon′ s annual interest rate ×Face value

• 𝑪𝐨𝐮𝐩𝐨𝐧 𝐩𝐚𝐲𝐦𝐞𝐧𝐭 = Number of coupon payments per year
• The non-arbitrage price 𝐷 of a zero-coupon bond which has a face value of 1 unit of money and
matures in 𝑡 years (and 𝑟 is the annual interest rate over the same period of time) is: 𝑫 = 𝒆−𝒓𝒕 .
• A discount curve is a function of time, 𝐷(𝑡), whose value at 𝑡 (where 𝑡≥0) is the present value of 1
unit of money paid in 𝑡 years from now.
• A yield curve (or “spot rate”) is a function of time, Y(𝑡), whose value at 𝑡 (where 𝑡≥0) is the interest
rate paid on 𝑡-years deposits.
−𝒍𝒏[𝑫(𝒕)]
• 𝒀(𝒕) = .
𝒕
• The non-arbitrage pre-agreed interest rate 𝑟12 for a forward rate agreement whose time period
starts in 𝑡1 years and ends in 𝑡2 years (and the spot interest rates for 𝑡1 and 𝑡2 years deposits are 𝑟1
𝑟2 𝑡2 −𝑟1 𝑡1
and 𝑟2 in respect) is: 𝑟12 = .
𝑡2 −𝑡1

Chapter 3: The mathematics of Forward and Futures contracts

• A forward/futures contract is an agreement to deliver an asset at a pre-specified price F, i.e. the

forward/futures price, on an agreed date, i.e. the maturity date (or delivery/expiry date). The party
which receives the asset has a long position. The party which delivers the asset has a short position.
• Consider a forward contract on an asset with no income: Let 𝑆 be the spot price of the asset, i.e.
the price of the asset at 𝑡 = 0. Then, the non-arbitrage forward price is 𝑭 = 𝑺𝒆𝒓∙𝑻 , where 𝑇 is the
time to maturity and 𝑟 = 𝑌(𝑇) is the 𝑇-years spot interest rate.
• However, if the asset generates income, then, the non-arbitrage forward price is 𝑭 = (𝑺 − 𝑰)𝒆𝒓∙𝑻,
where 𝐼 is the present value of all the income generated by the asset during the entire period until
time point 𝑇.
• The non-arbitrage forward exchange rate 𝐹 for a foreign exchange forward contract on 1 unit of
foreign currency, which matures 𝑇 in years is: 𝑭 = 𝑺𝒅𝒇 ∙ 𝒆 (𝒓−𝒓𝒇 ) 𝑻 , where 𝑆𝑑𝑓 is the foreign
exchange spot rate, 𝑟 = 𝑌(𝑇) be the domestic spot rate paid on 𝑇 -years deposits, 𝑟𝑓 = 𝑌𝑓 (𝑇) be
the spot rate paid on 𝑇 -years deposits of foreign currency. In 𝑇 years from now, the party taking
the short position in the agreement must deliver 1 unit of foreign currency (to the party taking the
long position), and receive 𝐹 units of domestic currency by the other party.
 ESCP Business School - MF31: Mathematical Finance --- Page 3 of 8

Chapter 4: The mathematics of Options

• A European/American call option gives its owner the right to buy its underlying asset at a certain
price on/by a certain date. The certain price at which an option is exercised is called the “strike
price” 𝐾.

• A European/American put option gives its owner the right to sell its underlying asset at a certain
price on/by a certain date. The certain price at which an option is exercised is called the “strike
price” 𝐾.

• The pay-off at expiration 𝑇 for the owner (i.e. the party taking a long position) of a European call
option (on an asset whose spot price at expiration is 𝑆𝑇 ) is 𝐦𝐚𝐱⁡(𝑺𝑻 − 𝑲, 𝟎) .

• The pay-off at expiration 𝑇 for the owner (i.e. the party taking a long position) of a European put
option (on an asset whose spot price at expiration is 𝑆𝑇 ) is 𝐦𝐚𝐱⁡(𝑲 − 𝑺𝑻 , 𝟎) .

• The following are some basic inequalities which are satisfied by option prices, assuming that all of
the options have a particular stock (which doesn’t pay dividends) as their underlying asset; the
stock’s spot price is 𝑆, all of the options expire in 𝑇 years and have a strike price of 𝐾. Furthermore,
𝑐 and 𝑝 the current prices of European call and put options, whereas 𝐶 and 𝑃 are the current prices
of American call and put options. Finally, 𝑟 is the 𝑇–years spot interest rate.

𝑐, 𝐶, 𝑝, 𝑃 ≥ 0

𝑐≤𝐶≤𝑆

𝑝≤𝑃≤𝐾

𝑐 > 𝑆 − 𝐾𝑒 −𝑟𝑇

𝑝 > 𝐾𝑒 −𝑟𝑇 − 𝑆

𝑐 + 𝐾𝑒 −𝑟𝑇 = 𝑝 + 𝑆

𝑐=𝐶

𝑆 − 𝐾 < 𝐶 − 𝑃 < 𝑆 − 𝐾𝑒 −𝑟𝑇

• Here is a summary of the typical results about the prices of options when increasing some factors:

An increase in … … results in ….

𝑆𝑇 • an increase for the price of a call option

• a decrease for the price of a put option
𝐾 • a decrease for the price of a call option
• an increase for the price of a put option
stock’s volatility an increase for the price of a call/put option
𝑇 an increase for the price of a call/put option
 ESCP Business School - MF31: Mathematical Finance --- Page 4 of 8

Chapter 5: Binomial trees and risk-neutral valuation

We consider a European option on a non-dividend stock whose current spot price is 𝑆 and at the end of
time period 𝛥𝑡, the stock’s price will either go up to 𝑆𝑢 or go down to 𝑆𝑑 . The option expires at the end of
the same time period. Let the pay-off of the option be 𝑌𝑢 and 𝑌𝑑 when the price of the stock goes up and
down in respect. Furthermore, let 𝑟 be the interest rate (which is constant for any time period).

Then, we have the following:

𝒆𝒓∙𝚫𝐭 −𝒅
• The risk-neutral probability 𝒒 is: 𝒒= 𝒖−𝒅

• “Risk-neutral valuation” says that the current price 𝑥 of the option is:
𝒙 = 𝒆−𝒓∙𝚫𝐭 (𝒒𝒀𝒖 + (𝟏 − 𝒒)𝒀𝒅 )
 ESCP Business School - MF31: Mathematical Finance --- Page 5 of 8

Chapter 6: Statistics with Brownian motion and the Black-Scholes pricing formulas

• Consider the price of a stock 𝑆, whose current price is 𝑆0 , its expected annual return is 𝜇, and its
annual price volatility (i.e. standard deviation) is 𝜎. Furthermore, suppose that the stock price
follows a Geometric Brownian motion (GBM): 𝒅𝑺 = 𝝁 𝑺 𝒅𝒕 + 𝛔 𝐒 𝐝𝐁 .
Then, for any time 𝑇 in the future, the price of the stock at time 𝑇 satisfies:

𝜎2
𝑙𝑛(𝑆𝑇 )~𝑁 ( 𝑙𝑛(𝑆0 ) + (𝜇 − )Τ , 𝜎 2 Τ)
2

• Hence, a 90% Confidence Interval for 𝒍𝒏(𝑺𝑻 ) at time point 𝑇 is:

𝝈𝟐 𝝈𝟐
[𝒍𝒏(𝑺𝟎 ) + (𝝁 − ) 𝚻 − 𝟏. 𝟔𝟒𝟓𝝈√𝑻; 𝒍𝒏(𝑺𝟎 ) + (𝝁 − ) 𝚻 + 𝟏. 𝟔𝟒𝟓𝝈√𝑻]
𝟐 𝟐

• Similarly, we could also construct 95% and 99% Confidence Intervals for 𝑙𝑛(𝑆𝑇 ). However, in such a
case we have to replace 1.645 by another number. Specifically, in the case of 95% and 99%
Confidence Intervals for 𝑙𝑛(𝑆𝑇 ), the aforementioned number changes to 1.96 and 2.58 in respect.

𝜗𝑓 𝜗𝑓 1 𝜗2𝑓
• The Black-Scholes differential equation (BSDE) is: + 𝑟𝑆 𝜗𝑆 + 2 𝜎 2 𝑆 2 𝜗𝑆2 = 𝑟𝑓 ,
𝜗𝑡
where: 𝑆 is the price of the underlying stock, 𝜎 is its volatility, 𝑡 is time, 𝑟 is the risk-free interest.
Furthermore, 𝑓 is a function: it is equal to the value at time 𝑡 of a financial derivative on stock 𝑆.

• THE BLACK-SCHOLES PRICING FORMULAS:

Consider a European option at time 𝑡 on a stock with spot price 𝑆; the strike price of the option is 𝐾 and
the option expires at time 𝑇. Furthermore, 𝜎 is the annual volatility of the stock, and 𝑟 is the 𝑇-years
interest rate. We have:

𝑺 𝝈𝟐
𝒍𝒏 (𝑲) + (𝒓 + 𝟐 ) (𝑻 − 𝒕)
𝒅𝟏 =
𝝈√𝑻 − 𝒕

𝒅𝟐 = 𝒅𝟏 − 𝝈√𝚻 − 𝒕

Then, the price of the call option 𝑐 and the price of the put option 𝑝, at time point 𝑡 are:

𝒄 = 𝑺 𝚽(𝒅𝟏 ) − 𝑲𝒆−𝒓(𝑻−𝒕) 𝚽(𝒅𝟐 )

𝒑 = 𝑲𝒆−𝒓(𝑻−𝒕) 𝚽(−𝒅𝟐 ) − 𝑺 𝚽(−𝒅𝟏 )

where Φ is the standard normal distribution function.

 ESCP Business School - MF31: Mathematical Finance --- Page 6 of 8

Chapter 7: The mathematics of Portfolio theory

Consider portfolio Π𝑤 . We have 𝑋 units of money it total and we want to invest a portion of it, namely 𝑤,
in the risk-free investment 𝐵 (e.g. bank deposit), and the rest of the money, 𝑋 − 𝑤, in the market portfolio.
Let: 𝑟𝐵 be the expected return of the risk-free investment, 𝑟𝑀 be the expected return of the market
portfolio 𝑀, and 𝜎𝑀 be the standard deviation of the expected return of the market portfolio 𝑀. Then:

• The expected return of portfolio Π𝑤 is:

𝒘𝒓𝑩 + (𝑿 − 𝒘)𝒓𝑴 .

• The standard deviation (of the return) of portfolio Π𝑤 is:

|𝑿 − 𝒘| 𝝈𝑴 .

The following are true for constants 𝑎 and 𝑏 and random variables 𝑌 and Z (where COV(Y, Z) is their
covariance, and 𝑉(𝑌) and 𝑉(𝑍) are the variances of variables Y and Z in respect):

• 𝑉(𝑎𝑌) = 𝑎2 𝑉(𝑌)

• 𝐶𝑂𝑉(𝑌 + 𝑍) = 𝑉(𝑌) + 2𝐶𝑂𝑉(𝑌, 𝑍) + 𝑉(𝑍)

• 𝐶𝑂𝑉(𝑎𝑌, 𝑏𝑍) = 𝑎 ∙ 𝑏 ∙ 𝐶𝑂𝑉(𝑌, 𝑍)

Chapter 8: The Mathematics of The Capital Asset Pricing Model (CAPM)

Suppose that 𝑟 is the expected return of an efficient investment and 𝜎 is the investment’s standard
deviation of return; 𝑟𝐵 is the expected return of a risk-free investment; rM is the expected return of the
market portfolio and 𝜎𝑀 is the market portfolio’s standard deviation; rA is the expected return of a
portfolio A and 𝜎A is the portfolio’s standard deviation of return, whereas 𝜌(A, M) is the correlation
between portfolio and the market portfolio; β is the beta coefficient. Then:

• We have the following CAPM formulas:

𝒓𝑴 − 𝒓𝑩
𝒓 − 𝒓𝑩 = 𝝈
𝝈𝑴

𝝆(𝐀, 𝐌) ∙ 𝝈𝐀
𝜷=
𝝈𝑴

𝐫𝐀 = 𝐫𝐁 + (𝐫𝐌 − 𝐫𝐁 )𝛃

• The “market risk of 𝐴” (or “systematic risk”) is defined as: 𝜷𝝈𝑴 .

• The “unique risk of 𝐴” (or “idiosyncratic risk”) is defined as: √(𝝈𝑨 )𝟐 − 𝜷𝟐 (𝝈𝑴 )𝟐 .
𝐂𝐎𝐕(𝐘,𝐙)
• The correlation of two random variables Y and Z is: 𝝆(𝐘, 𝐙) = , where COV(Y, Z) is
√𝑽(𝒀)∙𝑽(𝒁)
their covariance, and 𝑉(𝑌) and 𝑉(𝑍) are the variances of variables Y and Z in respect

• 𝐶𝑂𝑉(𝑌, 𝑍) = 𝐸(𝑌𝑍) − 𝐸(𝑌) ∙ 𝐸(𝑍)

 ESCP Business School - MF31: Mathematical Finance --- Page 7 of 8

Table for the calculation of Standard Normal probabilities (Z~N(0,1); 1 of 2; negative z-scores).

Example: Φ(-3.14)=0.0008

z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
-3.4 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0002
-3.3 0.0005 0.0005 0.0005 0.0004 0.0004 0.0004 0.0004 0.0004 0.0004 0.0003
-3.2 0.0007 0.0007 0.0006 0.0006 0.0006 0.0006 0.0006 0.0005 0.0005 0.0005
-3.1 0.0010 0.0009 0.0009 0.0009 0.0008 0.0008 0.0008 0.0008 0.0007 0.0007
-3.0 0.0013 0.0013 0.0013 0.0012 0.0012 0.0011 0.0011 0.0011 0.0010 0.0010
-2.9 0.0019 0.0018 0.0018 0.0017 0.0016 0.0016 0.0015 0.0015 0.0014 0.0014
-2.8 0.0026 0.0025 0.0024 0.0023 0.0023 0.0022 0.0021 0.0021 0.0020 0.0019
-2.7 0.0035 0.0034 0.0033 0.0032 0.0031 0.0030 0.0029 0.0028 0.0027 0.0026
-2.6 0.0047 0.0045 0.0044 0.0043 0.0041 0.0040 0.0039 0.0038 0.0037 0.0036
-2.5 0.0062 0.0060 0.0059 0.0057 0.0055 0.0054 0.0052 0.0051 0.0049 0.0048
-2.4 0.0082 0.0080 0.0078 0.0075 0.0073 0.0071 0.0069 0.0068 0.0066 0.0064
-2.3 0.0107 0.0104 0.0102 0.0099 0.0096 0.0094 0.0091 0.0089 0.0087 0.0084
-2.2 0.0139 0.0136 0.0132 0.0129 0.0125 0.0122 0.0119 0.0116 0.0113 0.0110
-2.1 0.0179 0.0174 0.0170 0.0166 0.0162 0.0158 0.0154 0.0150 0.0146 0.0143
-2.0 0.0228 0.0222 0.0217 0.0212 0.0207 0.0202 0.0197 0.0192 0.0188 0.0183
-1.9 0.0287 0.0281 0.0274 0.0268 0.0262 0.0256 0.0250 0.0244 0.0239 0.0233
-1.8 0.0359 0.0351 0.0344 0.0336 0.0329 0.0322 0.0314 0.0307 0.0301 0.0294
-1.7 0.0446 0.0436 0.0427 0.0418 0.0409 0.0401 0.0392 0.0384 0.0375 0.0367
-1.6 0.0548 0.0537 0.0526 0.0516 0.0505 0.0495 0.0485 0.0475 0.0465 0.0455
-1.5 0.0668 0.0655 0.0643 0.0630 0.0618 0.0606 0.0594 0.0582 0.0571 0.0559
-1.4 0.0808 0.0793 0.0778 0.0764 0.0749 0.0735 0.0721 0.0708 0.0694 0.0681
-1.3 0.0968 0.0951 0.0934 0.0918 0.0901 0.0885 0.0869 0.0853 0.0838 0.0823
-1.2 0.1151 0.1131 0.1112 0.1093 0.1075 0.1056 0.1038 0.1020 0.1003 0.0985
-1.1 0.1357 0.1335 0.1314 0.1292 0.1271 0.1251 0.1230 0.1210 0.1190 0.1170
-1.0 0.1587 0.1562 0.1539 0.1515 0.1492 0.1469 0.1446 0.1423 0.1401 0.1379
-0.9 0.1841 0.1814 0.1788 0.1762 0.1736 0.1711 0.1685 0.1660 0.1635 0.1611
-0.8 0.2119 0.2090 0.2061 0.2033 0.2005 0.1977 0.1949 0.1922 0.1894 0.1867
-0.7 0.2420 0.2389 0.2358 0.2327 0.2296 0.2266 0.2236 0.2206 0.2177 0.2148
-0.6 0.2743 0.2709 0.2676 0.2643 0.2611 0.2578 0.2546 0.2514 0.2483 0.2451
-0.5 0.3085 0.3050 0.3015 0.2981 0.2946 0.2912 0.2877 0.2843 0.2810 0.2776
-0.4 0.3446 0.3409 0.3372 0.3336 0.3300 0.3264 0.3228 0.3192 0.3156 0.3121
-0.3 0.3821 0.3783 0.3745 0.3707 0.3669 0.3632 0.3594 0.3557 0.3520 0.3483
-0.2 0.4207 0.4168 0.4129 0.4090 0.4052 0.4013 0.3974 0.3936 0.3897 0.3859
-0.1 0.4602 0.4562 0.4522 0.4483 0.4443 0.4404 0.4364 0.4325 0.4286 0.4247
-0.0 0.5000 0.4960 0.4920 0.4880 0.4840 0.4801 0.4761 0.4721 0.4681 0.4641
 ESCP Business School - MF31: Mathematical Finance --- Page 8 of 8

Table for the calculation of Standard Normal probabilities (Z~N(0,1); 2 of 2; positive z-scores).

Example: Φ(0.31)=0.6217

z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.0 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
3.1 0.9990 0.9991 0.9991 0.9991 0.9992 0.9992 0.9992 0.9992 0.9993 0.9993
3.2 0.9993 0.9993 0.9994 0.9994 0.9994 0.9994 0.9994 0.9995 0.9995 0.9995
3.3 0.9995 0.9995 0.9995 0.9996 0.9996 0.9996 0.9996 0.9996 0.9996 0.9997
3.4 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9998