1 MATHEMATICAL METHODS

1.1 SERIES

Exponential function

x2 x3
exp(x)=ex =1+x+-+-+'"
2! 3!

Natural log function

x2 x3
log(l +x) = In(l +x) x- - +-- . . · (-1< x:::; 1)
2
=

Binomial expansion

where n is a positive integer

- l)( p 2) 3 ...
(l + x)p = 1 + px + pCP -1) x2 + pCP -
x +
2! 3!

(-I<x<l)

2
1.2 CALCULUS

Taylor series (one variable)

2
h
fex+h) = f( x) + hf'(x)+- f"(x) +
2!
...
Taylor series (two variables)

f( x+h,y + k) = f( x,y) + hf:(x,y)+kf;( x,y)

+ � ! (h2 f�(x,y)+ 2hk f;;' (x,y) + k2 f;(x,y»)+ .. .

Integration by parts

f b u-m=[uv]
dv b f b du
- v-m a
a m a m

Double integrals (changing the order of integration)

The domain of integration here is the set of values ( x,y) for which
a<.:;.y<,:;,x<':;'b.

Differentiating an integral

bey)
d
d f f(x,y)m=b'(y)f[b(y),y] -a'(y)f[a(y),y]
Ya(y)
bey)
a
+ f a f( x,y)dx
aCyl Y

3
1.3 SOLVING EQUATIONS

Newton-Raphson method

If x is a sufficiently good approximation to a root of the equation

lex) = 0 then (provided convergence occurs) a better approximation
IS

lex)
x* =x- --
{'(x)
.

Integrating factors

The integrating factor for solving the differential equation

dy .
-+ P(x)y = Q(x) IS:
dx

exp (J P(x)dx )
Second-order difference equations

The general solution of the difference equation

axll+2+bXn+1 + cXn = 0 is:

if b2 - 4ac > 0: Xn = AAJI + BA�

(distinct real roots, Al "* 11. )
2
n
if b2 -4ac =0: xil = (A+ Bn)A
(equal real roots, Al = 11.2 = A)

if b2- 4ac < 0: xn = rll(Acosn8+ Bsinn8)

(complex roots, Al = � = rei6)

2

Al and 11.
where are the roots of the quadratic equation
2
2
aA +bA+C=O.

4
1.4 GAMMA FUNCTION

Definition

r(x) = ftX-le-tdt, x >O

o

Properties

rex)= (x -l)rex -1)

ren) = (n -I)!, n = 1,2,3, ...

1.5 BAYES' FORMULA

Let AI> A2, ... , An be a collection of mutually exclusive and exhaustive

events with P( Ai ) 7: 0, i 1,2, ... , n.
=

For any event B such that PCB) 7: 0:

P )P
P(AiIB)= n (BIAi (AJ , i=I,2, ...,n.
L,P(BIAj)P(Aj)
j=l

5
2 STATISTICAL DISTRIBUTIONS

Notation

PF = Probability function, p(x)

PDF = Probability density function, f(x)
DF = Distribution function, F(x)
PGF = Probability generating function,G(s)
MGF = Moment generating function, M(t)

Note. Where formulae have been omitted below, this indicates that
(a) there is no simple formula or (b) the function does not have a
finite value or (c) the function equals zero.

2.1 DISCRETE DISTRIBUTIONS

Binomial distribution

Parameters: n, p (n=positive integer, 0 < p <1 with q =1- p)

PF:
n
x
)
p(x)= (l px q n-x , x=O,I,2,... ,n

DF: The distribution function is tabulated in the statistical

tables section.

P GF :
n
G(s) = (q + ps )

MGF:

Moments: E(X) = np, var(X) = npq

Coefficient
q- p
of skewness:
Jnpq

6
BernouHi distribution

The Bernoulli distribution is the same as the binomial distribution

with parameter n = I.

Poisson distribution

Parameter: fl (fl > 0)

e -�flx
PF: p(x)= , x==O,I,2, ...
x!
--

DF: The distribution function is tabulated in the statistical

tables section.

PGF: G(s) == e�(s-l)

MGF: M(t) == e�(e' -1)

Moments: E(X) = fl, var(X) = fl

Coefficient
1
of skewness:
�

7
 Negative binomial distribution - Type 1

Parameters: k, p (k =posi tive integer, 0 < p < 1 with q = 1- p)

PF: p{X) =
[ -I) k x-k
X
P q x=k,k+l,k + 2,...
k- I
,

PGF: G( s)= ( � )lk

l l - qs

MGF: M(t) =
[ )k
pet
I- qe
I

Moments: E(X)=!, var(X) = p2

kq
p

Coefficient
2-p
of skewness: fkq

8
Negative binomial distribution - Type 2

Parameters: k, p (k > 0, 0 < p < I with q = 1 p )-

r(k+x)
PF: p(x)
k x
p q , x= 0,1,2, ...
r(x+l)r(k)
=

PGF : G(S)= � ( r
l-qs

MGF: M (I) : (---",r

l-qe

Moments : E(X) =
kq
p
, var(X)= �
P

Coefficient
2-p
of skewness:
jkq
Geometric distribution

The geometric distribution is the same as the negative binomial

distribution with parameter k = 1.

9
 Uniform distribution (discrete)

Parameters: a, b, h (a < b, h> 0, b - a is a multiple of h )

h
PF: p(x)= , x=a,a+h,a+2h, ... ,b-h, b
b-a+h

[b+h 1 a
h s -s
PGF: G(s) =
b-a+h sh-l
MGF :
h
M(t) = ---
[eCb+h)t -eat 1
----,---
b-a+h eht -1

1 I
Moments: E(X)=- (a+b), var(X)= -(b-a )(b- a+ 2h)
2 12

2.2 CONTINUOUS DISTRIBUTIONS

Standard normal distribution - N(O,I)

Parameters: none

PDF:

DF: The distribution function is tabulated in the statistical

tables section.

MGF:

Moments: E(X)=0, var(X)=1

r
E(X ) =

2
1
r!2 ( )
reI + r)

r 1+-
r
' r=2,4,6, ...

10
No rmal (Gauss ian) distribution - N(I-l,a2)

Parameters: I-l, a2 (a> 0)

-- -- ) 2

1 (
1 1 x- I-l
00
PDF: f(x) = exp --
2
,- 00 <x<
a5 a

1 2 2
MGF: M(t)=ellt+2cr t

Moments: E(X)= I-l, var(X) = a2

Exponential distribution

Parameter: A (A>O)

PDF: f(x) = Ae-Ax, x>O

DF: F(x) = l-e-Ax

1
MGF: M(t)= 1 ( fT- , t<A

1
Moments: I
E(X)= ' var(X)=2
A

r r(1 + r )
E(X ) = , r = 1 2,3 ...
, ,
Ar

Coefficient
of skewness: 2

11
 Gamma distribution

Parameters: a, A (a>O, A>O)

a
PDF'. f() A
x =--x
a-I -Ax
e , x>°
n a)

DF: When 2 a is an integer, probabilities for the gamma

distribution can bc found using the relationship:

MGF:

Moments: E(X) = I ' var(X) = �

r f'(a+r)
E(X ) = , r 1,2,3, ...
na)Ar
=

Coefficient
2
of skewness:
Ja

Chi-square distribution - X�
The chi-square distribution with '\) degrees of freedom is the same as

the gamma distribution with parameters a � and A = .!.. .

2 2
=

The distribution function for the chi-square distribution is tabulated in

the statistical tables section.

12
Uniform distribution (continuous) - U(a, b)

Parameters: a,b ( a <b )

1
PDF: f(x) = , a<x<b
b-a
--

x-a
DF: F(x)
b-a
=

MGF:

Moments: E(X)=.l(a+b), var(X)=J.-(b-a)2

2 12

E(Xr) _1 1_Cbr+1 _ ar+1), r= 1,2,3,

(b-a)r+l
= _
_ . . .

Beta distribution

Parameters: a, � ( a>O, �>O)

PDF:

a a
Moments: E(X) = __, var(X) -,-�
a +� (a+�)2(a+�+1)
= ___ ___

a+�)l(a+r), =1,
E(Xr) = l( r 2,3, ...
l(a)r(a+l3+r)

Coefficient

of skewness:
2(� - a) � a +� + 1
(a+�+2) a�

13
 Lognormal distribution

Parameters:

I ))
1 1 1 ( 1ogx-1l
PDF: f(x)= �-exp -- ,x>O
(5.,,; 21t x 2 (5

11 + "21 {j
2
2 2 ( 2
-1
Moments: E(X) = e , var(X)= e �+O" eO"
)

Coefficient

of skewness: (e0"
2
+2 )� e0"
2
-1

Pareto distribution (two parameter version)

Parameters: ex. , A ( ex.>0, 1.>0)

PDF:

DF: F(x) == 1- (_A A+x

2
Moments: E(X)= -
-
ex.
A
1
(ex.>l), var(X)=
ex.A
2
(ex. -1) (ex. - 2) (a>2)
E(Xr)= r(ex. - )r(l
r + r ) 'I r
II. ,r= " 21 3 , ... ,r<ex.
r(ex.)

Coefficient
2(ex. + 1) ) ex.-2
of skewness: (ex.> 3)
(ex.- 3) ex.

14
Pareto distribution (three parameter version)

Parameters: a, A, k (a>O, A>O, k>O)

PDF:

2
k(k+a-l) A (a> 2 )
Moments: E(X)= � (a>1 ) , var(X)=
a-I (a-I) 2(a- 2 )

Weibull distribution

Parameters: c, Y (c>O, Y>O)

PDF:

DF: -cxY
F(x) = l-e

Moments: E(Xr) = r l ( +..c)�/

Y cr y

Burr distribution

Parameters: a, A, Y (a > 0, A> 0, Y > 0 )

PDF:

DF: F(x) = 1 - (_A+A_XY Ja

Moments: ( )( )
r r A r/y
£(X r ) =r a-- r 1+- -- , r=1,2,3, . . . ,r<ay
y y r(a)

15
2.3 COMPOUND DISTRIBUTIONS

Conditional expectation and variance

E(Y) = E[E(Y I XI]

var(Y) = var[E(Y I X)] + E[var(Y I X)]

Moments of a compound distribution

If X1, X2, ... are lID random variables with MGF MxCt)

an independent nonnegative integer-valued random variable, then

S = X1 + ... + XlV (with S = 0 when N = 0) has the following
properties:

Mean: E(S) = E(N)E(X)

1
Variance: var(S) = E(N) var(X) + var(N)[E(X)]�

MGF:

Compound Poisson distribution

Mean: Am1

Variance: Am2

Third centra

where A = E(N) and mr = E(Xr)

16
Recursive formulae for integer-valued distributions

(a ,b,O) cla

Let gr = peS r), r

= = 0,1,2,... and Ij P(X = j), j = 1,2,3,....
=

If Pr = peN = ( )
r) , w here p,. = a +� Pr-I,r=1,2,3,... , then

r ( ·
go=Po
j=!
b
r
)
and gr =Ll a +1 ijgr-J,r=1,2,3,...

Compound Poissondistribution

If N has a Poisson distribution with mean A., then a = ° and b = A. ,

and

A. r
go=e-'· and gr=-LjIig,.-j' r=I,2,3,...
r =1 .
1

17
2.4 TRUNCATED MOMENTS

Normal distribution

2
If f(x) is the PDF of the N(�,(J ) distribution, then

J� x f(x)dx = �[<p(U') - <p(L')] - (J[<\l(U') <\l(L')]

-

L-I! U-I!
where L'= -- and U'= -- .
(J cr

Lognormal distribution

If f(x) is the PDF of the lognormal distribution with parameters /..l

2
and (J , then

logL-� logU-� k
whereLk= - k(J and Uk= cr.
cr (J

18
N
o RELATIONSHIPS BETWEEN STATISTICAL DISTRIBUTIONS

DISCRETE CO�TINUOUS
L")gJ1on
�'(
a2
!J .
LX, (samep)
eX f logX' X -/1
/1=np
n= I '1
ri- � np(l- p) ,-----, y->�
�'ffiou\li � Binotrua
. � ..-!.
P -----.-. n.p
..
11 --} 00
... , �
' I
I � " ' /1 (JX �
cp
LX,
� -�
+
\ .. ' 2
I '
(s.mep) , /1=np LX2 • xllr 4 r= I
n->� � L(a +b·X) , Xli, VI •X a=1.v
2 z
t
' " -
j
' V;
ri- = /1 k=l.v\ k".,J
=
X 21
po:son /1-> F I 2 Pareto
LX,
LXi a Par eto
, - "'-
1 �. /1= -­
.... v], v2 r� a.l.,k .. ,
a A
I
VjX.,V2-:l>OO A=-...l.
a.,.p I .
I
kg
<.�
ap (( = 1.. v, I VI
/1= ri-
V= 2 � .� ,A.=
t;tJ
minXi
A. - 2 2A.X
--;. (a+fl)2(a+P+I)+
' ". I/r
-�tt " .
a -» 00, a=1 X

LX, /3->=
LX, , ...� WcM
(sameA.)'. � ...... . " c,y
(samep)
.-� &�,�em: � ..."-,1·-1
/ /' IXj "./,// \\ ' y=l
A. = I /' (sameA.) ·./
� .-- III III x,
/
�, � /'
XI+X,
� /,,'

a=jJ=1
-�InX
+ A

X -0
b- a
•
[3fJ .

I I� - Unifonn
..
a, b
I �.r h->O
 EXPLANATION OF TliE DISTRlBUTION DIAGRAM

The distribution diagram shows the main interrelationships between the distributions in the statistics section. The relationships shown are of four
types:

Special cases
For example, the arrow marked" n = I " connecting the binomial distribution to the Bernoulli distribution mcans:
In the special case where n = I, the binomial distribution is equivalent to a Bernoulli distribution.

TransjiJrmalions
For example, the arrow marked" eX" connecting the normal distribution to the lognormal distribution means:

If X has a normal distribution, the function eX will have a lognormal distribution.

Note that the parameters of the transformed distributions may differ from those of the basic distributions shown.

Sums, products and minimum values

For example, the arrow marked" 1: Xj (same p)" connecting the binomial distribution to itself means:
The sum of a fixcd number of independent random variables, cach having a binomial distribution with the same value for the parameter
p , also has a binomial distribution.

Similarly, "n Xi " and" min Xi " denote the product and the minimum of a fixed set of independent random variables. Where a sum or product

includes" ai " or "bi ", these denote arbitrary constants.

Limiting cases (indicated by dotted lines)

For example, the arrow marked "�= np, n � <x> " connecting the binomial distribution to the Poisson distribution means:
For large values of n, the binomial distribution with parameters n and p will approximate to the Poisson distribution with parameter � ,
where �=np.

IV
3 STATISTICAL METHODS

3.1 SAMPLE MEAN AND VARIANCE

The random sample (x!,x2, . . . ,xn) has the following sample

moments:

Sample mean:

Sample variance: s2 = -1-

n 1 -
{i xf - nx2 }
i=1

3.2 PARAMETRIC INFERENCE (NORMAL MODEL)

One sample

For a single sample of size n under the normal model X � N(Il,cr2):

x -!l (n -1)S2 2
!
S/Fn �tn-
-- and
cr 2
�Xn-l

Two samples

For two independent samples of sizes m and n under the normal

models X �N(!lx,cr�) and Y -N(IlY,cr�):

sl/cr�
�
Sy2/·cry2 Fm-l,n-l

22
 Under the additional assumption that O' � = O' � :

(X -

S
�lY)

p
-

�+-
(Il x -Ily)
-lm+n-2
m n

where S� = m+n-2
1 {(m -1)S1 +(n -l)Sf} is the pooled sample
variance.

3.3 MAXIMUM LIKELIHOOD ESTIMATORS

Asymptotic distribution

If e is the maximum likelihood estimator of a parameter e based on

a sample X , then e is asymptotically normally distributed with mean
e and variance equal to the Cramer-Rao lower bound

Likelihood ratio test

approximately (under Ho)

where ep = max 10gL is the maximum log-likelihood for the

Ho
model under Ho (in which there are
p free parameters)

and e p+q = max 10gL is the maximum log-likelihood for the

HOuHj
model under H0 u HI (in which there
are p+q free parameters).

23
3.4 LINEAR REGRESSION MODEL WITH NORMAL ERRORS

Model

Intermediate calculations

n n

sx-t:
�
xi -)2 �
= £.,; ( - £.,; Xj2 - nx-2
X =

i=l ;=1
n n
�
Syy = £.,; ( Yi - Y)
-2 � 2 -2
== £";Yj - ny
;=1 i=1
n n

Sxy = L(X; - X)(Yi - y) == LXiYi - nxy

i=1 i=1
Parameter estimates

Distribution of �

24
Variance of predicted mean response

An additional cr2
must be added to obtain the variance of the
predicted individual response.

Testing the correlation coefficient

sxy
r=
�SXXSyy

Ifp=O,then
r�
�
�1- r�
- In - 2 .

Fisher Z transformation

z,. - N(Zp,_l_) n-3

approximately

where z,. = r =�IOg(ll-r+r)

tanh-
I
and zp =
I
tanh- p =-!-IO/ll-p+p ): .
1

Sum of squares relationship

n n n
L,(Yi - y)2 L(Yi - .v;)2 + LeY;
=
_ y)2
i=1 ;=1 i=1

25
3.5 ANALYSIS OF VARIANCE

Single factor normal model

Yij � N(1l + 'ti,O"2 ) , i = 1,2,... ,k, j = 1,2, ... ,n;

k k
where n = � >i' with I, n;'t; = 0
;=1 ;=1

Intermediate calculations (sums of squares)

k ni k ni
Y
2
SST =I, I, (Yij - y .)
2
Total: •
= I, I, yJ - n
••

i=lj=1 i=lj=1
k k
Y
2 2
- -2 � i·
Y••
Between treatments: SSB k" ni ( Y;. - Y .. )
� k,, ---
i=1 ;=1 n; n
=
=

Residual: SSR = SST - SSB

Variance estimate

Statistical test

Under the appropriate null hypothesis:

SSB /.§SR Fk-1 . n-k

k-l n-k
�

26
3.6 GENERALISED LINEAR MODELS

Exponential family

For a random variable Y from the exponential family, with natural

parameter S and scale parameter <\>:

Probability (density) function: fy(y;S,<\» = exp [ YO - b(S)

a(<I»
+ C(Y,<I»]
Mean: E(Y) = b'(S)

Variance: var(Y) = a(

Canonical link functions

�
Binomial: g(ll) = log
1-11

Poisson: g(

Normal: g(ll) = 11

1
Gamma: g(ll) = -
11

27
3.7 BAYESIAN METHODS

Relationship between posterior and prior distributions

Posterior oc Prior X Likelihood

The posterior distribution fee I.!) for the parameter e is related to

the prior distribution fee) via the likelihood function f( .!

fee I.!) DC fee) x f(:i I e)

Normal /normal model

2
is a random sample of size n from a N(!l,cr ) distribution,
If .!

where cr is known, and the prior distribution for the parameter !l is

2

N(!lo,cr5 ), then the posterior distribution for !l is:

28
3.8 EMPIRICAL BAYES CREDIBILITY - MODEL 1
Data requirements

{Xii,i = 1,2, ... ,N,j = 1,2, ... ,n}

Xii represents the aggregate claims in the j th year from the i th risk.

Intermediate calculations

1
n N
I
Xi LXii' X= NLX;
n j=l i=1
_ =- _ _

Parameter estimation

Quantity Estimator

E[m(8)] X

)
E[s -(8 )]

var[m(8)]
1 � -
--.-,.JX
N -1 i
=1
i
-
-X) 2 - -I
L..,
Nn i=l
�{ 1 �
L.., ( Xij
n - 1 j=1
- -
-
Xi ) 2
}
Credibility factor

z ___
n--;:--_
=

E[ i (8 )]
n+
a [ m(8)]
---'-=--
---"-----'

v r

29
3.9 EMPIRICAL BAYES CREDIBILITY - MODEL 2

Data requirements

{i'ij,i= 1,2, ... , N,} =1,2, ... ,n}, {Pij,i= 1,2, ... , N,} = 1,2, ... ,n}

Yij represents the aggregate claims in the } th year from the i th risk;

�i is the corresponding risk volume.

Intermediate calculations

n
l1=2,�j' J5=2,�, p*=_ 1_2,11 1-!j
N N ( -j
j=l i=1 Nn - 1 =1 P
i

x.. = Yij XI' = £..,

� �j� ij , X = � � �j�ij
IJ p.' j=1 pi
£.., £..,
i=1 j=1 P
IJ

Parameter estimation

Quantity Estimator
E[m(8)]

var[m(8)] - -
1 (- 1 N
"' ''' P(Xi) -X) 2
n

Nn -I £... £... I)
_
I
--
N
I -Iplj(xlj
{ I II

- XI )
_

2})
P* 1=1 J=I
N 1=1 n 1.J=I _

Credibility factor

2,Pij
ZI· =
j=1
n
E[s 2 (8)]
2, p + ------
--"-- '-=-
--'----
j=1 IJ var[m(8)]

30
4 COMPOUND INTEREST

Increasing/decreasing annuity functions

.. n
(fa);;] G;;] � nv (Da);;]
n -.G;;]
1 I
= , =

Accumulation factor for variable interest rates

31
5 SURVIVAL MODELS

5.1 MORTALITY "LAWS"

Survival probabilities

Gompertz' Law

Makeham's Law

X t
x tgc (c -l) -A
!lx = A+Bc , (Px-s where s =e
_

Gompertz-Makeham formula

The Gompertz-Makeham graduation formula, denoted by GM(r,s),

states that

where t is a linear function of x and polYl (I) and polY2 (t) are

polynomials of degree rand s respectively.

32
5.2 EMPIRICAL ESTIMAnON

Greenwood's formula for the variance of the Kaplan-Meie r

estimator

- [ , (t 2 " dj
F )J
.
var[ F(t)] = \-
1 501 nj (nj -dj )
,

Variance of the Nelson-Aalen estimate of the integrated hazard

5.3 MORTALITY ASSUMPTIONS

Balducci assumption

1-/ qx+1 = (1- t)qx (x is an integer, 0 ::; t::; 1)

5.4 GENERAL MARKOV MODEL

Kolmogorov forward differential equ ation

a "
gh
at I Px
-_ L.J ( I Px Ilx+1
gj jh .
- t
gh hj
Px Ilx+1
)
rich

33
5.5 GRADUAnON TESTS

Grouping of signs test

If there are n, positive signs and n2 negative signs and G denotes the
observed number of positive runs , then :

Critical values for the grouping of signs test are tabulated in the
statistical tables section for small values of n, and n2' For larger
values of nl and n2 the normal approximation can be used.

Serial correlation test

I m-j
--. L (zi -:2)(Zi+j -:2)
r.) ""
m- } _, I-
where z =
1 m
-L Zi
1 m
-L(Zi _:2)2
mi=!
mi=l

r X rm � N(O,l) approximately.
j

Variance adjustment factor

.2
�
4-.1 1ti
r =_i
x
__

Li1ti

where 1ti is the proportion of lives at age x who have exactly i

policies.

34
5.6 MULTIPLE DECREMENT TABLES

For a multiple decrement table with three decrements a, � and y,

each uniform over the year of age (x,x + 1) in its single decrement

table, then

5.7 POPULATION PROJECTION MODELS

Logistic model

1 dP(t) p kP(t) has general solution pet) =

_
p
pet) dt Cpe-Pi + k
__ =

where C is a constant.

35
6 ANNUITIES AND ASSURANCES

6.1 APPROXIMATIONS FOR NON ANNUAL ANNUITIES

.. (m)
ax
..
""0 -
x
--
m-l
2m

(j(m) "" (j
x:;;] x:;;]
_ m- 1
2m
[1 _
Dx+n
Dx
)
6.2 MOMENTS OF ANNUITIES AND ASSURANCES

Let Kx and T, denote thc curtate and complete future lifetimes

(respectively) of a lifc aged cxactly x.

Whole life assurances

E[ v Kx+I]= 4x' .[ Kt+l]=2A _(A)2

val v x
x
,

wme
...x:;;])
Similar relationships hold for endo nt assurances (with status
, pure endowments (with status �)
x: , term assurances (with

status !:;;]) and deferred whole life assurances (with status mi··· x ) .

Whole life annuities

Similar relationships hold for temporary annuities (with status·· ·x:;;]) .

36
6.3 PREMIUMS AND RESERVES

Premium conversion relationship between annuities and

assurances

Similar relationships hold for endowment assurance policies (with

status··· X:nI
,) .

Net premium reserve

ax +t ax +t
v
t X
1- v
t x
1- -
a� a
= =

x
•• �

Similar formulae hold for endowment assurance policies (with

statuses ... X:nI
, and···
+t:n�t I
)
x
- .

6.4 THIELE'S DIFFERENTIAL EQUATION

Whole life assurance

Similar formulae hold for other types of policies.

Multiple state model

37
7 STOCHASTIC PROCESSES

7.1 MARKOV "JUMP" PROCESSES

Kolmogorov differential equations

Forward equation :

Backward equation: � P (s t)
o ij
, -L= (Jik(S)Pkj(s,t)
s kES

where (Jij (t) is the transition rate from state i to state j (j -j:. i) at
time t, and (Ju = - L (Jij 0

f#i

Expected time to reach a subsequent state k

7.2 BROWNIAN MOTION AND RELATED PROCESSES

Martingales for standard Brownian motion

If {Bt,t 2:: O} is a standard Brownian motion, then the following

processes are martingales:

Distribution of the maximum value

[
p maX (Bs +�) >
OSsSt
yJ ( Ii IoU)
= <I> - Y
+
+ e2J.1Y<I> -Y( Ii-1.Lt) , Y
> 0

38
 Hitting times

If 't y = min {s : Bs +� = y} where 11 > ° and y < 0, then

s;:,;o

Ornstein-Uhlenbeck process

7.3 MONTE CARLO METHODS

Box-Muller formulae

If UI and U2 are independent random variables from the U(O,l)

distribution then

are independent standard normal variables.

Polar method

If JII and V2 are independent random variables from the U(-l,l)

distribution and S = J112 + vl then, conditional on ° <S � 1,

are independent standard normal variables.

Pseudorandom values from the U(O,l) distribution and the N(O,l)

distribution are included in the statistical tables section.

39
 8 TIME SERIES

8.1 TIME SERIES - TIME DOMAIN

Sample autocovariance and autocorrelation function

I n 1 n
Autocovariance: .
Yk=- �
£." ( xt - ,
1l )( xl k
-
,
_
� �
-11)' where �=- LXI
n l=k+1 n 1=1

, Yk
Autocorrelation: Pk=-,
Yo

Autocorrelation function for ARMA(l,l)

For the process Xt = axl_1 + el + � el_l:

Partial autocorrelation function

*
detPk
<ilk ---, k-2,3,
_ _

. . . ,
det/k

PI P2 Pk-I
PI 1 PI Pk-2
where Pk= P2 PI 1 Pk-3

Pk-I Pk-2 Pk-3

and P; equals Pk , but with the last column replaced with

T
(PI,P2,P3"",Pk) .

40

...
 Partial autocorrelation function for MA(1)

For the process XI = 11 + el + �el_1 :

<ilk = (_l)k+!
(1
l-�
- �;1�� ,
+
k= I,2,3, ...

8.2 TIME SERIES - FREQUENCY DOMAIN

Spectral density function

j'( )
. co-
_
1 � e- ikw Yk, -1t<co<n
2 1t """
�
k=

Inversion formula

Spectral density function for ARMA(p,q)

The spectral density function of the process <j>(B)(Xt - 11) 8(B)e"

=

where yareel ) = 0'2 , is

Linear filters

For the linear filter � = L QkXt-k:

k=�

A(co) = L e -i w Qk is the transfer function for the filter.

k
where
k=�

41
8.3 TIME SERIES - BOX-JENKINS METHODOLOGY

Ljung and Box "portmanteau" test of the residuals for an

ARMA(p,q) model

m 2
rk
n(n + 2) '"
2
L,, -- � Xm-(p+q)
k=! n-k

where rk (k ==1,2, . ,m) is the estimated value of the kth

. .

autocorrelation coefficient of the residuals and n is the number of

data values used in the ARMA(p,q) series.

Turning point test

In a sequence of n indep endent random variables the number of

turning points T is such that:

ar(T)=16n-29
E(T)=1.3(n-2) and v
90

42
9 ECONOMIC MODELS

9.1 UTILITY THEORY

Utility functions

Exponential: U(w) = -e -aw , a> 0

Logarithmic: U(w)= logw

Power:

Quadratic:

Measures of risk aversion

= _ U"(w)
Absolute risk a vers i on: A(w)
U'(W)

Relative risk aversion: R(w) = wA(w)

9.2 CAPITAL ASSET PRICING MODEL (CAPM)

Security market line

Capital market line (for efficient portfolios)

(Jp
Ep-r=(EM-r)­
(JM

43
9.3 INTEREST RATE MODELS

Spot rates and forward rates for zero-coupon bonds

Let PCt) be the price at time 0 of a zero-coupon bond that pays 1 unit

at time 1:.

Let s(1:) be the spot rate for the period (0,1:).

Let f(1:) be the instantaneous forward rate at time 0 for time 1:.

Spot rate

Instantaneousforward rate

d
P(1:) = exp ( -J; f(S)dS ) or f(1:) = --logP(1:)
d1:

Vasicek model

Instantaneous forward rate

Price ofa zero-coupon b ond

where D(1:) = l_e-a't

--­

ex

44
10 FINANCIAL DERIVATIVES

Note. (continuously-payable) dividend

rate.

10.1 PRICE OF A FORWARD OR FUTURES CONTRACT

For an asset with fixed income ofpresent value I:

T
F = (So - J)er

For an asset with dividends:

F - So e(r-q)T

10.2 BINOMIAL PRICING ("TREE") MODEL

Risk-neutral probabilities

t
erl1 -d
Up-step probability = ,
u-d

45
10.3 STOCHASTIC DIFFERENTIAL EQUATIONS

Generalised Wiener process

dx=adt+bdz

where a and b are constant and dz is the increment for a Wiener

process (standard Brownian motion).

Ito process

dx= a(x,t )dt+ b(x,t)dz

( ]
Ito's lemma for a function G(x, t)

dG 1 2cPG aG dt+b-dz
aG
ax 2 ax2 at
dG= a-+-b -+-
ax

Models for the short rate rt

Ho-Lee: dr = 8(t)d t + (Jdz

Hull-White: dr= [OCt) - ar ]dt + (Jdz

Vasicek: dr = a ( b - r )dt+ adz

Cox-Ingersoll-Ross: dr = a(b - r)dt+ a .Jrdz

10.4 BLACK-SCHOLES FORMULAE FOR EUROPEAN OPTIONS

Geometric Brownian motion model for a stock price St

Black-Scholes partial differential equation

- -
af +(r
at
a f 1 2 2 a 2f
q)S -+-(J St -=tj
last 2 as?

46
 Garman-Kohlhagen formulae for the price of call and put options

2
h d iog(St/K)+(r-q+IhO' )(T-/)
w ere 1 =
r;:;;--:
O'",T -/

.
d - iog(St! K)+ (r-q-IhO' d
2
)(T - t) Tr;:;;--:
2- -
_
and r;:;;--:
1 -0'",1 -I
O' \/T- I

10.5 PUT-CALL PARITY RELATIONSHIP

Ct + Ke r(T t) -
- -

- Pt + Ste
-q(T-t)

47