A&J Study Manual For SOA Exam FM/ CAS Exam 2

Study Manual for
Exam FM/2, 3rd Edition
Electronic Product/ No Returns

Contents SOA Exam FM/ CAS Exam 2
Table of Contents
Part A - Theory of Interest ......................................................................................................... 10
Chapter 1 .................................................................................................................................... 10
Measurement of Interest............................................................................................................ 10
1.1 Accumulation Function and Effective Rate of Interest ......................................................... 10
1.2 Simple Interest ................................................................................................................... 15
1.3 Compound Interest ............................................................................................................. 17
1.4 Present Value ..................................................................................................................... 19
1.5 Nominal Rate of Interest ..................................................................................................... 23
1.6 Discount Rate ..................................................................................................................... 27
1.7 Force of Interest ................................................................................................................. 30
Calculator Guides (BA II PLUS/ BA II PLUS PROFESSIONAL) ............................................... 37
Practice Questions ................................................................................................................... 40
Solutions .................................................................................................................................. 46
Chapter 2 .................................................................................................................................... 51
Valuation of Annuities ............................................................................................................... 51
2.1 Annuity Immediate, Annuity Due & Deferred Annuity .......................................................... 51
2.2 Future Value of Annuity ...................................................................................................... 59
2.3 Relationships between present value and future value of annuity ....................................... 63
2.4 Perpetuity ........................................................................................................................... 68
2.5 Annuities payable at a different frequency than interest is convertible ................................ 71
2.6 Miscellaneous topics and techniques in annuity valuation .................................................. 75
2.7 Arithmetic increasing and decreasing annuity ..................................................................... 81
2.8 Geometric increasing and decreasing annuity .................................................................... 90
2.9 Continuous annuity ............................................................................................................. 93
Calculator Guides (BA II PLUS/ BA II PLUS PROFESSIONAL) ............................................... 95
Practice Questions ................................................................................................................... 97
Solutions .................................................................................................................................109
Chapter 3 ...................................................................................................................................119
Yield Rates ................................................................................................................................119
3.1 Net Present Value and Internal Rate of Return ..................................................................119
3.2 Reinvestment ....................................................................................................................123
3.3 Dollar-Weighted Yield and Time-Weighted Yield ...............................................................127
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Calculator Guides (BA II PLUS/BA II PLUS PROFESSIONAL) ...............................................131

Practice Questions ..................................................................................................................132
Solutions .................................................................................................................................137
Chapter 4 ...................................................................................................................................142
Amortization and Sinking Funds .............................................................................................142
4.1 Amortization Schedule and Prospective Method ................................................................142
4.2 Retrospective Method ........................................................................................................148
4.3 Sinking Fund .....................................................................................................................150
4.4 Outstanding balance, Interest payment and Principal repaid under Sinking Fund Method .154
Solutions .................................................................................................................................163
Chapter 5 ...................................................................................................................................168
Pricing Common Stock.............................................................................................................168
5.1 Common Stock ..................................................................................................................168
5.2 Discounted Dividend Model ...............................................................................................170
5.3 Types of Bond ...................................................................................................................172
Solutions .................................................................................................................................175
Chapter 6 ...................................................................................................................................178
Bonds ........................................................................................................................................178
6.1 Pricing Bond ......................................................................................................................178
6.2 Price at Premium and Discount .........................................................................................181
6.3 Amortization of Premium and Discount ..............................................................................185
6.4 Price between Coupon Dates ............................................................................................189
6.5 Callable Bonds ..................................................................................................................191
Solutions .................................................................................................................................201
Chapter 7 ...................................................................................................................................207
Advanced Financial Analysis ...................................................................................................207
7.1 Yield Curves, Spot Rates, Forward Rates .........................................................................207
7.2 Inflation Rate .....................................................................................................................213
7.3 Portfolio Methods and Investment Year Method ................................................................215
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7.4 Duration.............................................................................................................................217
7.5 Convexity ..........................................................................................................................222
7.6 Immunization .....................................................................................................................224
7.7 Cash Flow Matching ..........................................................................................................229
Solutions .................................................................................................................................239
Part B - Derivatives Market .......................................................................................................244
Chapter 1 ...................................................................................................................................244
Introduction to Derivatives and Risk .......................................................................................244
1.1 What is Derivative?............................................................................................................244
1.2 Purpose of Derivatives ......................................................................................................245
1.4 Risk and risk sharing .........................................................................................................247
1.5 Buying and selling financial assets ....................................................................................249
Chapter 2 ...................................................................................................................................253
Forward Contract ......................................................................................................................253
2.1 Forward Contract ...............................................................................................................253
2.2 Mathematics of Forward Contract ......................................................................................255
2.3 Replicating Forward Contract with Zero-coupon Bond and Stock ......................................258
Chapter 3 ...................................................................................................................................262
Options ......................................................................................................................................262
3.1 Call option .........................................................................................................................262
3.2 Mathematics of Call Options ..............................................................................................264
3.3 Put Option .........................................................................................................................268
3.4 Mathematics of Put Option ................................................................................................269
Chapter 4 ...................................................................................................................................276
Contracts and Positions ...........................................................................................................276
4.1 Introduction to “Position” ....................................................................................................276
Long position .....................................................................................................................276
Short position ....................................................................................................................276
4.2 Long Position.....................................................................................................................277
4.3 Short Position ....................................................................................................................281
4.4 Equity-Linked Certificate of Deposit ...................................................................................284
Chapter 5 ...................................................................................................................................289
Insurance and Other Option Strategies ...................................................................................289
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5.1 Insuring a long Position- Floor ...........................................................................................289

5.2 Insuring a short position- Cap ............................................................................................292
5.3 Naked Writings, Covered Call, Covered Put ......................................................................294
5.4 Synthetic Forward and Put-Call Parity ...............................................................................297
5.5 Bull and Bear Spreads .......................................................................................................300
5.6 Box Spread and Ratio Spread ...........................................................................................304
5.7 Collar .................................................................................................................................306
5.8 Straddles, Strangles and Butterfly Spread .........................................................................308
Chapter 6 ...................................................................................................................................316
Applications of Derivatives – Risk Management ....................................................................316
6.1 Introduction to Risk Management ......................................................................................316
6.2 The Seller’s perspective- Hedging with forward contract....................................................317
6.3 The Seller’s Perspective- Hedging with put option .............................................................319
6.4 The Seller’s Perspective- Insuring with call option .............................................................321
6.5 The Seller’s Perspective-Hedging using purchased collar .................................................323
6.6 The Buyer’s Perspective- Hedging with a Forward Contract ..............................................326
6.7 The Buyer’s Perspective- Hedging with a call option .........................................................328
6.8 Hedging and Taxation .......................................................................................................330
6.9 Paylater Strategy ...............................................................................................................331
Chapter 7 ...................................................................................................................................333
Financial Forwards and Futures ..............................................................................................333
7.1 Four ways to purchase a stock ..........................................................................................333
7.2 Pricing Prepaid Forward ....................................................................................................334
7.3 Forward contracts on stock................................................................................................338
7.4 More about synthetic forward and Cash-and-carry arbitrage .............................................339
7.5 Future Contract .................................................................................................................342
Chapter 8 ...................................................................................................................................345
Swap ..........................................................................................................................................345
8.1 Introduction to swap ..........................................................................................................345
8.2 Swap counterparty and hedging swap using forward contract ...........................................347
8.3 Market value of swaps .......................................................................................................349
8.4 Introduction to interest rate swaps .....................................................................................351
8.5 Setting the fixed rate of interest rate swap .........................................................................352
8.6 Swap curve, deferred swap, and amortizing/ accreting swap .............................................355
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Mock Exam 1 .............................................................................................................................357

Solution for Mock Exam 1 ........................................................................................................367
Mock Exam 2 .............................................................................................................................376
Solutions for Mock Exam 2 ......................................................................................................385
Author’s Biography ..................................................................................................................393
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TOI Chapter 1- Measurement of Interest SOA Exam FM/ CAS Exam 2
Part A - Theory of Interest

Chapter 1. Measurement of Interest
This chapter discusses about:
1. The concept of accumulation function and effective rate of interest
2. How to calculate simple interest
3. How to calculate compound interest
4. The concept of present value (time value of money)
5. The relationship between nominal rate of interest and effective interest rate
6. Discount rate
7. Force of interest
1.1 Accumulation Function and Effective Rate of Interest
Let me begin by asking you one question: Assume that everything is constant, do you want me to
give you $1000 now, or $1000 after 10 years?
Of course you will choose to receive it now. Why? This is because you can make use of the
money now, to buy your favorite study manual for exam FM, and to register for the exam, and then
you might use the remaining for exam M. Compare this to 10 years later. If you only have $1000
ten years from now, you do not have money to spend for the manuals, exams etc. You will have to
wait for 10 years with no extra $1000.
This shows that my offer was definitely not fair. Time is gold; it is the coin of our life. To make it
fair, I should offer an additional amount of money after 10 years to compensate for the time that
you have to wait. Perhaps, I should offer $1000 now and $1250 after 10 years. This concept is
called time value of money.
The additional amount of $250 in this case is called interest.
Now, let say you have just got your salary of $5000, (You may change the figure if you think that it
is too low), and after cutting off the income tax, daily expenses, savings, etc, you are left with
$1000. You want to invest this $1000 somewhere, so that after t years this amount of money
grows.
At this moment, assume that your best friend, Alvin is in an urgent need of money, and he wants to
borrow $1000 from you. He promises that he will return $1045 to you after 1 year. While you are
negotiating the amount to be returned to you, XXX, a guy who used to bully you during your
childhood comes to you to borrow money as well. He needs $1000, and he promises to pay you
back $1100 after one year. To whom will you lend your $1000?
Caring ones might lend the money to Alvin. Let’s see which decision gives more profit (interest):
Lending $1000 to Alvin

The profit (interest) that you earn is 1045-1000= $45. In percentage, the interest that you earn in
one year time is:
1045 − 1000
i= = 0.045
1000
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Lending $1000 to XXX

The interest that you earn is 1100-1000= $100. The effective interest that you earn in one year will
be:
1100 − 1000
i= = 0.1
1000
This shows that lending money to XXX earns more interest. In terms of accumulation, lending
money to Alvin will earn 104.5% of the initial amount whereas XXX will give 110%. In
mathematical expression, Alvin and XXX give the accumulation factors of 1.045 and 1.1
respectively.
Now, let us generalize the idea. Let us define A(t) to be the amount function. A(t) is the amount
accumulated after t years. In the above illustration, A(0) is simply 1000, the money to be invested,
the principal. For Alvin’s offer, the A(1) is 1045, and for XXX’s, 1100.
In mathematical symbols, it is intuitive that the effective interest is:
A(t − 1)* (1 + i ) = A(t )

A(t )
⇒ 1+ i =
A(t − 1)
A(t ) A(t ) − A(t − 1)
⇒i= −1 =
A(t − 1) A(t − 1)
Now, in order to make the calculation easier, we do not want to include the initial amount in the
amount function. Let us define a(t), accumulation function, such that:
A(t ) = ka (t ) , where k is the initial amount invested, which is also called principal
Hence, applying this formula to the above illustration, we have k=$1000, and a(t) offered by Alvin
and XXX are a(t)= 1.045 and 1.1 respectively. In the coming section, we shall go into the details
for some commonly used accumulation functions.
Obviously, if given a(t), we can also obtain the interest rate by the same reasoning:
a (t − 1) *(1 + i ) = a (t )
a (t )
⇒ 1+ i =
a (t − 1)
a (t ) a (t ) − a (t − 1)
⇒i= −1 =
a (t − 1) a (t − 1)
Well, you might wonder, what is an effective interest rate? Why is it so important?
An effective interest rate is the proportion that you earn when you invest your money into a fund
for ONE period of time. The period can be a day, a month, a year, 4 years or anything else. For
example, “The bank offers an effective rate of interest of 50% over 5 years”, it means, if you invest
$1 into the bank, after 5 years, you will get $1*1.5= $1.50.
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However, an effective interest rate is usually measured monthly or annually. For example, “The
bank offers effective interest rate of 5% annually”, this means investing $1 in the bank you will get
accumulated value of $1.05 at the end of one year, and $1*1.056= $1.34 after 6 years. In other
words, for this bank, it offers an annual effective interest rate of 5%, or equivalently, an effective
interest rate of 34% for 6 years. Don’t worry if you still can’t get it. We shall go into the details of it
later on.
Example 1.1
You have $15000 cash and you would like to invest this amount of money for 8 years to earn
interest. Bank A offers the accumulation function of a(t)=1 + 0.07t for the first 5 years. After 5 years,
the bank will return the interest accumulated and change the accumulation function to a(t)=
1+0.005t² for the years after year 5. Assume that you keep the interest after 5 years under your
pillow.
At the same time, Bank B offers a(t)=1.07t for all t.
Decide which bank to invest in for the maximum profit.
Solution 1.1
To determine which bank offers the better return, we simply find the final accumulated amount,
and the larger of the two is the better choice.
For Bank A after 5 years,
A(5) = 15000 a (5) = 15000[1 + 0.07(5)] = 20250
Since bank returns the interest earned, you get back $5250 and you earn no further income or
interest for it. (Why?)
After 8 years,
A(8) = 15000a (3) = 15000[1 + 0.005(3) 2 ] = 15675
Hence, the total interest earned is 5250+ 675 = $5935
For Bank B at the end of 8 years,
A(8) = 15000a (8) = 15000[1.078 ] = 25772.79
The total interested earned is 25772.79- 15000= 10772.79

No doubt, you should go for Bank B.
#1
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Example 1.2
Jessica invests $3400 into Fund A whose accumulation function is a(t)= 1.05t. At the same time,
Ron would like to invest $4200 into Fund B, which allows the money to be accumulated at a(t)=
1.04t.
(a) Find t at which the accumulated amount of Jessica and Ron is the same.
(b) Manager of Fund B would like to exploit arbitrage (take advantage of different interest rate and
make free lunch) by investing Ron’s $4200 into Fund A. Find the profit made by the manager after
10 years, assuming that Ron doesn’t withdraw the money throughout the years.
Solution 1.2
(a) We want to find t at which AJessica(t)= ARon(t). Hence,
3400(1.05t ) = 4200(1.04t )
t
3400  1.04 
⇒ = 
4200  1.05 
⇒ 0.8095 = 0.99047t
⇒ t = 22.07
At the end of year 22, the accumulated value of Jessica and Ron will be the same.
(b) First, we need to determine the revenue of the manager. Subtracting the liability then will give
us the profit.
Revenue: Liability
4200(1.05)10 = 6841.36 4200(1.04)10 = 6217.03
Hence, the profit is 6841.36- 6217.03= $624.33
Example 1.3
Fund ABC offers an effective interest of 5.5% reinvested each year from 1 Jan 2000 until 31 Dec
2007. Fund XYZ offers product XYZ whose accumulation function is a(t)= 1+0.06t from 1 Jan 2000
until 31 Dec 2004. From 1 Jan 2005 onwards, the product returns the interest earned and reinvest
the principal amount at a(t)= 1.035t. If you are the manager of Fund XYZ, how much the free lunch
will you get if Mr. Ignorant purchases your product at $1680 and will not withdraw the money until
year 2009?
Solution 1.3
Notice that Fund ABC offers an effective annual interest rate of 5.5% for 8 years. This is actually a
compound interest (compound, as the question says “reinvested each year”), which will be
covered soon and will be greatly tested in exam FM. This means that the interest earned in the
first year will not be returned, but is reinvested into the fund for another year, and so on.
For Fund ABC, the accumulated amount after 8 years is:
A(8) = 1680a (8) = 1680(1.055)8 = 2578.27
The interest earned is 2578.27- 1680= 898.27
For Fund XYZ, after 5 years the product gives:
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A(5) = 1680a (5) = 1680[1 + 0.06(5)] = 2184
Since the product gives back the interest earned (2184-1680= $504) in the first 5 years, the
principal goes back to $1680 and is invested at a(t)= 1.035t.
A(3) = 1680a (3) = 1680[1.035]3 = 1862.65
The interest earned from 1 Jan 2005 until 31 Dec 2007 is 1862.65-1680= $182.65
After solving these, you can get the free lunch by investing the $1680 into Fund ABC, and gain an
arbitrage of 898.27- 504- 182.65= $211.62
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TOI Chapter 6- Bonds SOA Exam FM/ CAS Exam 2
Chapter 6. Bonds
1. Bond pricing
2. Price at premium and discount
3. Amortization of premium and discount
4. Value of bonds between coupon dates
5. Callable bond
6.1 Pricing Bond
A bond is a kind of loan. Bonds are usually used by federal government, corporations, and banks
and so forth to raise fund. If you buy a bond, it means you lend money to the bond seller. Since it
is a kind of borrowing, the borrower is supposed to pay back an amount more than the principal.
That is the concept of time value of money which we have been dealing with.
Every game has its own rule. This is the same for trading bonds and pricing them. Below are the
terms that you need to know to play the game:
1. Face Value/ Par Value, F

2. Coupon Rate, r
3. Yield Rate, i
4. Redemption value, C
5. Price of the Bond, P
6. Special Coupon Rate, g
7. Number of remaining payments, n
Suppose you lend $900 to a corporation. The loan contract says that you will be paid $10 per
annum for 10 years, at the end of each year. At the end of 10 years, the corporation will repay you
$1000. As we know, the relationship between these figures is:
900 = 10a10 i + 1000v10
This is so because the present value of the loan is $900. Assuming i being the interest rate
charged, it should be equated to the discounted value of the coming next 10 payments of $10 and
$1000 at the end of year 10.
This is basically how a bond works. The “general” pricing equation of a bond is as followed:
P = Fran i + Cv n
Let us look at an example:
Example 6.1
A bond with semiannual coupons at coupon rate of 16% payable semiannually has a face amount
of $1000, and it is redeemable at par. The bond will pay 40 payments, and the yield to maturity is
9% per year. Find the price of the bond.
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Solution 6.1
The first item we look at is the face amount/ par value. It is $1000. This amount has an indirect
relationship with the price of the bond, yet it is not the price itself. The question might express the
par value of a bond in this way: $1000 bond. This means that the par value is $1000. It is used
together with the following two items.
The next item is coupon rate of 16% payable semiannually. Since it is mentions that the coupon
payment is paid per 6 months, it means that the bond pays a coupon of (0.16/2)($1000)=
(0.08)($1000)= $80 every 6 months.
Let us go on to the redemption value. The question says that the bond is redeemable at par. If the
question does not say anything about redemption value, it is ASSUMED that the bond is
redeemable at par. This means that the bondholder will be paid the par value at maturity. (Maturity
is the date until which the bond is still valid). In this case, the redemption value is $1000.
Have a try before looking at the solution.
Did you get any of the following?
1000 1000 1000

P = 80a20 9% + OR P = 80a40 9% + OR P = 80a40 4.4031% + ?
1.0920 1.0940 1.04403120
If you do so, then you are a bit careless. Watch out! The correct equation should be:
1000 1000
P = 80a40 4.4031% + 20
or P = 80a40 4.4031% +
1.09 1.04403140
⇒ P = 80 (18.658933) + 178.43
⇒ P = 1671.14
It is quite common for us to make simple mistakes. Be cautious in finding the yield rate per
payment of coupon, the discount rate of redemption value, as well as the number of payments of
coupon.
Hence, the price of the bond is $1671.14.
#1
At this juncture, the only term we have not discussed is g, the special coupon rate. It is defined in a
way that Fr= Cg. Hence, when the redemption value is at par, r= g.
You might wonder what the purpose of the existence of this special coupon rate is. As we shall
see later, it is useful in writing bond formulas and of course, to answer exam questions. We will go
into the details of it in the coming section.
Example 6.2
A $1000 par value 15-year bond with annual coupons is redeemable at maturity at $1080 and is
purchased for $P to yield an annual effective rate of 9%. The first coupon is $80. The amount of
coupon is increasing at 3% each year. Find P.
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Solution 6.2
From the question we have the redemption value of $1080. Since the annual effective rate is 9%,
1080
we discount $1080 for 15 years: = 296.50 .
1.0915
Let us tackle the coupon rate. It is increasing at rate of 3% each year. This is to say that the
coupon payments are increasing geometrically at the ratio of 1.03. Hence, we have coupon
payments:
80  1.03  1.03   1.03  
2 2 14
 1.03 
1 + +  +  + ... +   
1.09  1.09  1.09   1.09   1.09  
= 73.39 (1 + 0.944954 + 0.944954 2 + ... + 0.94495414 )
 (1 − 0.94495415 ) 
= 73.39  
 1 − 0.944954 
 
= 762.99
Hence, adding the coupon payments and the redemption value gives the fair price of $762.99+
$296.50= $1059.49.
Example 6.3
A bond priced at $875 pays coupon X at the end of every 6 months for 30 times. The redemption
value is $980 and the par value is $1000. Find the coupon rate payable semiannually if the annual
effective rate is 7%.
Solution 6.3
From the formula we have:
980
857 = 1000ra30 3.4408% +
1.0715
⇒ r = 0.027082
Hence, the coupon rate payable semiannually is 2.7083% (2)= 5.4163%.
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DM Chapter 8- Swap SOA Exam FM/ CAS Exam 2
Chapter 8. Swap
1. Introduction to Swap
2. Swap counterparty and hedging swap using forward contract
3. Market value of swaps
4. Introduction to interest rate swaps
5. Setting the fixed rate of interest rate swaps
6. Swap curve, implicit lending of swap, and deferred swap
8.1 Introduction to swap
It is advisable that you study Theory of Interest Chapter 7 before entering this chapter. Throughout
this chapter, for the sake of consistency for better illustrations, the following information will be
used.
Years to Spot rate, st t-years Forward Force of interest, r Zero-coupon

maturity, t rate, ft bond price
1 6% 7.0023585% 5.8268908% 0.943396
2 6.5% 8.0070533% 6.2974799% 0.881659
3 7% 9.0140624% 6.7658648% 0.816298
4 7.5% 10.0233642% 7.2320661% 0.748801
5 8% 7.6961041% 0.680583
You should know how to verify all these numbers.
Swap
A swap is simply a combination of forward contracts with different expiration dates. For example, if
you enter into a long forward contract expiring after 1 year from now and another long forward
contract expiring after 2 years from now, you are replicating a 2-payment swap contract.
Formally, a swap is a contract that calls for an exchange of payments over time. A party of the
contract pays to or receives from the other party, depending upon the spot price of the underlying
asset whether it is greater or less than a pre-specified price, which is called swap price.
Let say Alvin being the oil seller wants to lock the series of revenue by selling oil per barrel over
the next 2 years at $70 and $75. To do this, he can enter into a short 1-year forward contract and
a short 2-year forward contract with forward prices of $70 and $75. By doing so, he is entitled to
receive $70 at the end of the first year and $75 at the end of second year. The present value of
these payments is:
70 75
PV = + = 132.16
1.06 1.0652
Hence, to receive the supply of 1 barrel of oil at the end of 1 year and 2 years, the oil buyer can
opt to pay Alvin $132.16 now or $70 at the end of first year and $75 at the end of 2 years. Paying a
single lump sum today for a single delivery of oil is called a prepaid forward, whereas paying a
single lump sum today for multiple deliveries of oil is called a prepaid swap.
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Notice that for this case, any amount of the 2 payments is acceptable, provided that the present
value of these 2 payments is $132.16. For example, the buyer may choose to pay $149.90 at the
end of 2 years or choose to pay $50 at the end of first year and $96.40 at the end of year 2; both
of them are acceptable.
In practice, a swap contract always calls for fixed payments over the life of the swap contract. In
this case, the fixed payment is x such that the present value is $132.16:
x x
132.16 = +
1.06 1.0652
⇒ x = 72.41
This amount $72.41 is called the swap price, the pre-specified price that we mentioned just now.
The purpose of swap price is similar to forward price. It is used to determine the payoff of the swap,
considering the spot price of the underlying asset.
Similar to a forward contract, a swap has physical settlement and financial settlement. Both of
them make no difference in quantity.
Example 8.1
A swap option can be replicated using 3 forward contracts expiring at the end of 1st, 2nd and 3rd
year. The seller would like to hedge the revenue at $120, $120, $140 after 1, 2 and 3 years
respectively.
Find the payoffs of the swap contract to the seller at the end of each year, if the spot prices at the
end 1, 2 and 3 years are $135, $100, and $130 respectively.
Solution 8.1
To find the payoffs of the swap contract, we firstly need to determine the swap price. To find the
swap price, we need to find the value of the swap contract.
The present value swap contract is:

120 120 140
PV = + + = 333.29
1.06 1.065 1.073
2
The next step is to find the swap price. Let the swap price be x, we have:
x x x
333.29 = + +
1.06 1.065 1.073
2
⇒ x = 126.18
Now we reach the final step. Since the question asks us to find the payment to the seller, it means
that positive payments will be made when the spot price is less than the swap price, and negative
payment will be made when the spot price is greater than the swap price. Hence, the payments
are $126.18- $135= -$8.82, $126.18- $100= $26.18, and $126.18- $130= -$3.82 respectively
at the end of 1, 2 and 3 years.
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8.2 Swap counterparty and hedging swap using forward contract
In the previous section we assume that the oil seller deals directly with the buyer in swap options.
Practically this is not the case. Usually it is the dealer who deals with the sellers and the buyers in
a swap contract. The situation where the dealer matches the seller and the buyer is called a back-
to-back transaction. The dealer makes a profit from the bid-ask spread and commission, yet the
dealer bears the credit risks of both parties.
The following diagram describes simple mechanism of:
1. How physical settlement is carried out between the oil buyer and seller;
2. How financial settlement is carried out between the oil buyer, oil seller and dealer;
3. How back-to-back transaction is carried out
Pay $72.41
Oil Buyer Oil Seller
Supply Oil
Physical Settlement between Buyer and seller of oil
Pay (Spot Price - $72.41) Dealer
Oil Buyer
Spot Price
Oil Seller
Supply Oil
Financial Settlement among Buyer, seller of oil and dealer
the authors. |
347
Dealer
Spot Price - $72.41 (Swap Spot Price - $72.41
Counterparty)
Oil Buyer Oil Seller

Spot Price Spot Price
Spot Oil
Supply Oil Supply Oil
Market
Back-to-back transaction or “matched book” transaction
Hedging using Forward Contract
One of the ways for the dealer to hedge the transaction is by using forward market.
Let say a dealer enters into a 2- year swap contract with Alvin, the oil seller. The swap price is
$72.41. The way to hedge this position is by entering an opposite position of the forward contract.
The dealer enters into a short forward position to offset the payoff of the swap contract.
Year Payment to Alvin, the Oil Payment from Short Net Payment
Seller due to swap contract forward
1 $72.41- Year 1 Spot Price $70- Year 1 Spot Price -$2.41
2 $72.41- Year 2 Spot Price $75- Year 2 Spot Price $2.59
The fact the net payments are non-zero numbers, it means that hedging the oil price in that way
does not fully hedge the position. In addition to this, the dealer is exposed to interest rate risk as
well. In short, swap cannot be fully hedged using forward contracts.
the authors. |
348
Author’s Biography SOA Exam FM/ CAS Exam 2
Author’s Biography
Alvin Soh was born in Penang, Malaysia. He has been keen in sharing and helping his peers in
actuarial exams. His strong passion in mathematics and actuarial career is reflected in his fast
progress in actuarial exams. He has passed all the preliminary exams in the mere 1.5 years and
he is more than willing to share his study methods and experience to every actuarial student
striving to progress in exams. He has also passed an advanced level exam and is pursuing his
CERA and FSA in Finance and Enterprise Risk Management. He is now working as an actuarial
analyst in Prudential Financial Inc.
The following is the progress of his exams:
Exam Passed Sitting

P/1- Probability Spring 2007
FM/2- Financial Mathematics Fall 2007
MLC- Models for Life Contingencies Spring 2008
MFE/3F- Models for Financial Economics Fall 2008
C/4- Construction and Evaluation of Actuarial Models Fall 2008
AFE- Advanced Finance and Enterprise Risk Management Spring 2009
the authors. |
393

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A&J Study Manual For SOA Exam FM/ CAS Exam 2

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Study Manual for

Exam FM/2, 3rd Edition

Electronic Product/ No Returns

Calculator Guides (BA II PLUS/BA II PLUS PROFESSIONAL) ...............................................131

5.1 Insuring a long Position- Floor ...........................................................................................289

Mock Exam 1 .............................................................................................................................357

Part A - Theory of Interest

1.1 Accumulation Function and Effective Rate of Interest

The additional amount of $250 in this case is called interest.

Lending $1000 to Alvin

Lending $1000 to XXX

In mathematical symbols, it is intuitive that the effective interest is:

A(t − 1)* (1 + i ) = A(t )

At the same time, Bank B offers a(t)=1.07t for all t.

Decide which bank to invest in for the maximum profit.

For Bank A after 5 years,

A(5) = 15000 a (5) = 15000[1 + 0.07(5)] = 20250

A(8) = 15000a (3) = 15000[1 + 0.005(3) 2 ] = 15675

Hence, the total interest earned is 5250+ 675 = $5935

For Bank B at the end of 8 years,

A(8) = 15000a (8) = 15000[1.078 ] = 25772.79

The total interested earned is 25772.79- 15000= 10772.79

Hence, the profit is 6841.36- 6217.03= $624.33

For Fund ABC, the accumulated amount after 8 years is:

A(8) = 1680a (8) = 1680(1.055)8 = 2578.27

The interest earned is 2578.27- 1680= 898.27

For Fund XYZ, after 5 years the product gives:

A(5) = 1680a (5) = 1680[1 + 0.06(5)] = 2184

A(3) = 1680a (3) = 1680[1.035]3 = 1862.65

6.1 Pricing Bond

1. Face Value/ Par Value, F

900 = 10a10 i + 1000v10

Let us look at an example:

Have a try before looking at the solution.

Did you get any of the following?

1000 1000 1000

Hence, the price of the bond is $1671.14.

Hence, the coupon rate payable semiannually is 2.7083% (2)= 5.4163%.

8.1 Introduction to swap

Years to Spot rate, st t-years Forward Force of interest, r Zero-coupon

You should know how to verify all these numbers.

The present value swap contract is:

8.2 Swap counterparty and hedging swap using forward contract

The following diagram describes simple mechanism of:

Physical Settlement between Buyer and seller of oil

Pay (Spot Price - $72.41) Dealer

Financial Settlement among Buyer, seller of oil and dealer

Oil Buyer Oil Seller

Back-to-back transaction or “matched book” transaction

Hedging using Forward Contract

The following is the progress of his exams:

Exam Passed Sitting

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