Contents

The measurement of interest

................ ........ 1

1.1 Introduction, 1 1.2 The accumulation and amount functions, 1 1.3 The effective rate of interest, 4 1.4 Simple interest, 5 1.5 Compound interest, 7 1.6 Present value, 10 1.7 The effective rate of discount, 12 1.8 Nominal rates of interest and discount, 17 1.9 Forces of interest and discount, 22 1.10 Varying interest, 28 1.11 Summary of results, 29

Solution of problems in interest

2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8

... . . . .... .. . .. . .....

35

Introduction, 35 Obtaining numerical results, 35 Determining time periods, 38 The basic problem, 40 Equations of value, 42 Unknown time, 44 Unknown rate of interest, 48 Practical examples, 51

Basicannuities
3.1 3.2 3.3 3.4 3.5 3.6

. . . . . ... .. . . . . ... ... ... .. .. . . . ..

58

Introduction, 58 Annuity-immediate, 59 Annuity-due, 62 Annuity values on any date, 65 Perpetuities, 69 Nonstandard terms and interest rates, 71
xi

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Contents

3.7 3.8 3.9 3.10

4

Unknown time, 72 Unknown rate of interest, 75 Varying interest, 80 Annuities not involving compound interest, 82

More general annuities

4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9

. . . ... . . . . . ... . . . .. . . . . . . .

95

Introduction, 95 Annuities payable at a different frequency than interest is convertible, 95 Further analysis of annuities payable less frequently than interest is convertible, 97 Further analysis of annuities payable more frequently than interest is convertible, 102 Continuous annuities, 107 Basic varying annuities, 109 More general varying annuities, 117 Continuous varying annuities, 1 19 Summary of results, 121

Yieldrates 5.1 Introduction, 128 5.2 Discounted cash flow analysis, 129 5.3 Uniqueness of the yield rate, 133 5.4 Reinvestment rates, 136 5.5 Interest measurement of a fund, 140 5.6 Time-weighted rates of interest, 145 5.7 Portfolio methods and investment year methods, 149 5.8 Capital budgeting, 152 5.9 More general borrowingAending models, 156 Amortization schedules and sinking funds
6.1 6.2 6.3 6.4

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128

. . .. .. .. . ..

166

6.5
6.6 6.7 6.8

Introduction, 166 Finding the outstanding loan balance, 167 Amortization schedules, 169 Sinking funds, 175 Differing payment periods and interest conversion periods, 181 Varying series of payments, 185 Amortization with continuous payments, 189 Step-rate amounts of principal, 192

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Bonds and other securities 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11

. . .. . . . .

204

Introduction, 204 Types of securities, 204 Price of a bond, 208 Premium and discount, 213 Valuation between coupon payment dates, 220 Determination of yield rates, 225 Callable bonds, 230 Serial bonds, 232 Some generalizations, 234 Other securities, 236 Valuation of securities, 238

Practical applications 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8

.. ... ..... ..... . .. .

248

Introduction, 248 Truth in lending, 248 Real estate mortgages, 255 Approximate methods, 260 Depreciation methods, 270 Capitalized cost, 277 Short sales, 279 Modern financial instruments, 282

More advanced financial analysis 9.1 9.2 9.3 9.4 9.5 9.6 9.7 O9.8 9.9 9.10

... ....

294

Introduction, 294 An economic rationale for interest, 295 Determinants of the level of interest rates, 296 Recognition of inflation, 298 Reflecting risk and uncertainty, 302 Yield curves, 309 Interest rate assumptions, 313 Duration, 315 Immunization, 320 Matching assets and liabilities, 326

10

Stochastic approaches to interest

. ..... .. ..

336

10.1 Introduction, 336 10.2 Independent rates of interest, 337 10.3 Dependent rates of interest, 345

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10.4 An asset pricing model, 349 10.5 An option pricing model, 355 10.6 A random walk model, 361 10.7 Scenario testing, 365 10.8 A review of the literature, 370

Appendix I Appendix I1 Appendix I11 Appendix IV Appendix V Appendix VI Appendix VII Appendix VIII

Table of compound interest functions

... . .... . . Table numbering the days of the year . . . . . . . . . Basic mathematical review . . . . . . . . . . . . . . . . Statistical background . . . . . . . . . . . . . . . . . . . Iteration methods . . . . . . . . . . . . . . . . . . Further analysis of varying annuities . . . . . . . . . .
Illustrative mortgage loan amortization schedule Full immunization

376 393 394 396 399 401 402 406 408 410 412 415 431

..

. . ........ . . . . . . . . Appendix IX Derivation of the variance of an annuity . . . . . . . . Appendix X Derivation of the Black-Scholes formula . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Answers to the exercises . . . . . . . . . . .. . . ...... . Glossaryofnotation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . * * o . * . * . D * . 439 *.