Mathematical Methods

AMATH 460: Mathematical Methods for
Quantitative Finance
1. Limits and Derivatives
Kjell Konis
Acting Assistant Professor, Applied Mathematics
University of Washington
Kjell Konis (Copyright 2013)
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Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Continuity and Asymptotes
Differentiation
Product Rule and Chain Rule
Higher Derivatives
Bond Duration
10
lHopitals Rule
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Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
3 / 68
Course Information
Instructors:
Lecturer: Kjell Konis <kjellk@uw.edu>
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Recommended Texts
5 / 68
Recommended Texts
Calculus, Early Transcendentals

James Stewart
Any Edition
(Or equivalent big, fat calculus textbook)
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Quarter Overview
Topics
1
Limits and Derivatives
Integration
3/4
Multivariable Calculus
5/6
Vectors, Matrices, Linear Algebra
Lagranges Method, Taylor Series
Numerical Methods
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Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
8 / 68
Simple and Compound Interest Rules

Simple Interest
Money accumulates interest proportional to the total time of the
investment.
V = (1 + rn) A0
Compound Interest
Interest is paid regularly.
V = [. . . (1 + r )[(1 + r ) A0 ]] = [. . . (1 + r )A1 ] = (1 + r )n A0
Compounding at Various Intervals
Interest rate r is yearly but interest is paid more often (e.g., monthly).
V = [1 + (r /m)]k A0
A0 = Principal, r = rate, n = # years, m = periods/year, k = # periods
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Present and Future Value

Suppose the interest rate r = 4%.
In one years time, the future value (FV) of $100 will be $104.
Conversely, the present value (PV) of a $104 payment in one years
time is $100.
Since
FV = (1 + r ) PV,
an expression for the present value is
PV =
1
FV = d1 FV
1+r
where d1 is the 1-year discount factor.

More generally,
1
dk =
[1 + (r /m)]k
the present value of a payment Ak received after k periods is dk Ak .
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Annuities
An annuity is a contract that pays money regularly over a period of
time.
Question: suppose we would like to buy an annuity that pays $100 at
the end of the year for each of the next 10 years. At an interest rate
of 4%, how much should we expect to pay?
Solution: appropriately discount each of the 10 future payments and
take the sum.
The present value of the k th payment is
PVk = dk Ak =
100
(1 + 0.04)k
The value of the annuity is then

V = PV1 + PV2 + + PV10 =
10
X
100
(1 + 0.04)k
k=1
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Annuities (continued)
Recall: V =
10
X
100
(1 + 0.04)k
k=1
(1 + 0.04) V
0.04V
100 +
9
X
100
(1 + 0.04)k
k=1
9
X
100
100
+
k
(1
+
0.04)
(1
+
0.04)10
k=1
100
100
(1 + 0.04)10
1
100
100
0.04
(1 + 0.04)10

=
V =
= 811.09
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Perpetual Annuities
A perpetual annuity or perpetuity pays a fixed amount periodically
forever.
Actually exist: instruments exist in the UK called consols.
(1 + 0.04) V
100 +
100
(1 + 0.04)k
k=1
100
(1 + 0.04)k
k=1
0.04V
100
V =
100
= 2500
0.04
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Summary: Present Value

Discount factor dk for a payment received after k periods, annual
interest rate r , interest paid m times per year.
dk =
1
[1 + (r /m)]k
Value V of an annuity that pays an amount A annually, annual

interest rate r , n total payments.
A
1
1
r
(1 + r )n

V =
Value V of a perpetual annuity that pays an amount A annually,

annual interest rate r .
A
V =
r
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Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
15 / 68
A Diverging Example
Calculate
V = 1 1 + 1 1 + 1...
Rewrite as
?
V =
(+1 1) =
k=1
0=0
k=1
Also could rewrite as

?
V =
k=1
But
k=1 1
=1+1+1+
?
V =
X
k=1
k=4 1
1=0
k=1
=1+1+1+
1=1+1+1+
k=1
X
j=1
j=1 1
X
?
1=3
k=1
Can make V any integer value.

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Notation
R the set of real numbers
Z the set of integers
in: indicator of set membership
for all
there exists
goes to
g : R R a real-valued function with a real argument
b x c floor: the largest integer less than or equal to x
d x e ceiling: the smallest integer greater than or equal to x
6
not (e.g. not in would be x 6 Z)
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Definition of limit
Let g : R R.
The limit of g(x ) as x x0 exists and is finite and equal to l if and
only if for any > 0 there exists > 0 such that |g(x ) l| < for all
x (x0 , x0 + ).
Alternatively,
lim g(x ) = l iff > 0, > 0 s.t. |g(x ) l| < , |x x0 | <
x x0
Similarly,
lim g(x ) = iff C > 0, > 0 s.t. g(x ) > C ,
x x0
|x x0 | <
lim g(x ) = iff C < 0, > 0 s.t. g(x ) < C ,
x x0
|x x0 | <
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Modification for x
How to make sense of |x | < ?
lim g(x ) = l iff > 0, b s.t. |g(x ) l| < , x > b
Example, recall pricing formulas:

A
1
1
Annuity:
Vn =
r
(1 + r )n
Perpetuity:
V =
A
r
Question: is lim Vn equal to V ?

n
Strategy: given > 0, find N such that |Vn V | < for n > N.
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Example
Given > 0, find N such that |Vn V | < for n > N
|Vn V | =
=
=

A
1
A

r 1 (1 + r )n r

A
A
A

r
r (1 + r )n
r
A
r (1 + r )n
Next, solve for N such that

A
r (1 + r )n

2
for n > N.
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Example (continued)
A
r (1 + r )n
(1 + r )n =

2
2A
r
2A
n log(1 + r ) = log
r

n =
log(2A) log(r )
log(1 + r )
log(2A) log(r )
Choose N =
then for n > N
log(1 + r )

|Vn V |
A

<
n
r (1 + r )
2
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Summary: Limits
Given > 0, can find N such that |Vn V | < for n > N, thus
lim Vn = V
Definition of a limit
lim g(x ) = l iff > 0, > 0 s.t. |g(x ) l| < , |x x0 | <
x x0
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Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
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Evaluating Limits
Observation: working with the definition = not fun!
Suppose that c is a real constant and the limits
lim f (x )
x a
and
lim g(x )
x a
exist. Then
(i)
(ii)
(iii)
(iv)
lim [f (x ) + g(x )] = lim f (x ) + lim g(x )
x a
x a
x a
lim cf (x ) = c lim f (x )
x a
x a
lim [f (x )g(x )] = lim f (x ) lim g(x )
x a
x a
x a
lim f (x )
f (x )
= x a
x a g(x )
lim g(x )
if lim g(x ) 6= 0
lim
x a
x a
(v)
lim
x a
p
n
f (x ) =
q
n
lim f (x )
x a
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Evaluating Limits
If P(x ) and Q(x ) are polynomials and c > 1 is a real constant then
(a)
(b)
lim
P(x )
= lim P(x ) c x = 0
x
cx
lim
log |Q(x )|
=0
P(x )
Examples
(a)
(b)
lim x 2 e x = 0
log(x 3 )
=0
x
x
lim
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Evaluating Limits
Notation: x & 0 means x 0 with x > 0; k! = k (k 1) 2 1
Let c > 0 be a positive constant, then
(a)
(b)
(c)
lim c x = 1
lim x x = 1
lim x x = 1
x &0
If k is a positive integer and if c > 0 is a positive constant, then

(a)
(b)
(c)
lim k k = 1
lim c k = 1
ck
=0
k k!
lim
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Example
1
4x + 1 x
x 2 4x + 1 + x
1
= lim
x
x 2 4x + 1 x
x 2 4x + 1 + x
x 2 4x + 1 + x
= lim 2
x x 4x + 1 x 2
x 2 4x + 1 + x x1
= lim
1
x
1 4x
x
lim
x2
lim
limx
4
1
x + x2
1
x 4
4
x
1
x
=
limx
+1
1
x2
+1
=
1+1
1
=
4
2
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Example
lim
x2
1
4x + 1 x + 2
1
x 2 4x + 1 + (x 2)
lim
x
x 2 4x + 1 (x 2)
x 2 4x + 1 + (x 2)
x 2 4x + 1 + x 2
lim 2
x x 4x + 1 (x 2)2
x 2 4x + 1 + x 2
lim 2
x x 4x + 1 [x 2 4x + 4]
x 2 4x + 1 + x 2
lim
x
3

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Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
29 / 68
Continuity
Most of the time:
lim f (x ) = f (a)
x a
y
f(x)
f(a)
a
x
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Continuity Definitions
A function f is continuous at a if
lim f (x ) = f (a)
x a
A function is right-continuous at a if
lim f (x ) = f (a)
x &a
A function is left-continuous at a if
lim f (x ) = f (a)
x %a
A function is continuous on an interval (c, d) if it is continuous at

every number a (c, d).
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(Dis)continuity
f(x)
Is f (x ) continuous at a?
Is f (x ) right-continuous at a?
Is f (x ) left-continuous at a?
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Continuity Theorems
Let f and g be continuous at a and c be a real-valued constant. Then
1.
4.
f +g
fg
2.
5.
f g
f
g (g(a) 6= 0)
3.
cf
are continuous at a.
Any polynomial is continuous on R.
The following functions are continuous on their domains:
polynomials
rational functions
root functions
logarithmic functions
trigonometric functions
inverse trigonometric functions
exponential functions
If g is continuous at a, and f is continuous at g(a), then

f g(x ) = f g(x ) is continuous at a.
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Example
Where is the following function continuous?
f (x ) =
log(x ) + tan1 (x )
x2 1
tan1 (x ) means arctan(x ), not
1
tan(x )
cos(x )
sin(x )
= cot(x )
log(x ) is continuous for x > 0 and arctan(x ) for x R

thus log(x ) + arctan(x ) is continuous for x (0, )
x 2 1 is a polynomial = continuous everywhere

f (x ) is continuous on (0, ) except where x 2 1 = 0
= f (x ) is continuous on the intervals (0, 1) and (1, )
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Horizontal Asymptotes
What happens to f (x ) =
x2 1
as x becomes large?
x2 + 1
The line y = L is called a horizontal asymptote if

lim f (x ) = L
x
or
lim f (x ) = L
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Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
36 / 68
Tangent Line
Goal: find the slope of the line tangent to y = f (x ) at a point a.
f(a)
f(x)
A line y = l(x ) is tangent to the curve y = f (x ) at a point a if there

is > 0 such that
f (x ) > l(x ) on (a , a) and (a, a + ) or
f (x ) < l(x ) on (a , a) and (a, a + )
and f (a) = l(a).

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Strategy
f(x + h)
rise
f(x)
f(x)
run
x+h
Use the slope of a line connecting a nearby point as an estimate of

the slope of the tangent line.
slope =
rise
f (x + h) f (x )
=
run
h
Get successively better estimates by letting h 0

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Definition of Derivative
A function f : R R is differentiable at a point x R if
lim
h0
f (x + h) f (x )
h
exists.
When this limit exists, the derivative of f (x ), denoted by f 0 (x ), is
defined as
f (x + h) f (x )
h0
h
f 0 (x ) = lim
A function f (x ) is differentiable on an open interval (a, b) if it is

differentiable at every point x (a, b).
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Example
Compute the derivative of f (x ) = 3x 2 + 5x + 1
f 0 (x ) =
f (x + h) f (x )
h0
h
lim
3(x + h)2 + 5(x + h) + 1 [3x 2 + 5x + 1]

h0
h
3x 2 + 6xh + 3h2 + 5x + 5h + 1 3x 2 5x 1
h0
h
6xh + 3h2 + 5h
h0
h
lim 6x + 3h + 5
lim
lim
lim
h0
= 6x + 5
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Properties of Derivatives
The derivative of a constant is 0.
Linearity: let f (x ) and g(x ) be differentiable functions and let a and
b be real-valued constants. The derivative of
l(x ) = a f (x ) + b g(x )
is
l 0 (x ) = a f 0 (x ) + b g 0 (x )
Power Rule: Let n be a real-valued constant. The derivative of
f (x ) = x n
is
f 0 (x ) = n x n1
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Section Summary: Differentiation

Summary
f (x + h) f (x )
h0
h
Definition: f 0 (x ) = lim
Derivative of a constant: if f (x ) = c then f 0 (x ) = 0.

0
Linearity: a f (x ) + b g(x ) = a f 0 (x ) + b g 0 (x )
Power Rule: (x c )0 = c x c1
for c 6= 0.
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Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
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Product Rule
Suppose f (x ) and g(x ) are differentiable functions.
Let p(x ) = f (x ) g(x )
Then p(x ) is differentiable, and
0
p 0 (x ) = f (x ) g(x ) = f 0 (x ) g(x ) + f (x ) g 0 (x )
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Examples
0
Recall: p 0 (x ) = f (x ) g(x ) = f 0 (x ) g(x ) + f (x ) g 0 (x )

p(x ) = x e x
f (x ) = x ,
g(x ) = e x
p 0 (x ) = 1 e x + x e x
= (x + 1)e x
t(1 t)
1
f (t) =
t = t2,
p(t) =
p 0 (x ) =
=
g(t) = (1 t)
1
1 1
t 2 (1 t) + t 2 (1)
2
(1 t)
1 3t
t=
2 t
2 t
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Chain Rule
Suppose f (x ) and g(x ) are differentiable functions.
The composite function (g f )(x ) = g(f (x )) is differentiable, and
0
(g f )(x ) = g 0 (f (x )) f 0 (x )
Alternative notation: let u = f (x ) and g = g(u) = g(f (x )), then

dg
dg du
=
dx
du dx
(Leibniz notation)
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Examples
0
Recall: (g f )(x ) = g 0 (f (x )) f 0 (x )
(g f )(x ) =
x 2 + 1 = (x 2 + 1) 2
(g f )(x )
0
=
=
1
1 2
(x + 1) 2 2x
2
x
2
x +1
(g f )(x ) = (x 3 1)100
(g f )(x )
0
= 100(x 3 1)99 3x 2
= 300x 2 (x 3 1)99
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Substitution Method
Recall Leibniz notation:
Compute
d
dx
dg du
dg
=
dx
du dx
sin(x 2 ); let u = x 2 , g(u) = sin(u) and
d
sin(u) =
dx
du
dx
= 2x
d
du
sin(u)
du
dx
= cos(u) 2x
= 2x cos(x 2 )
Compute
d sin()
;
d e
d sin()
e
=
dx
let u = sin(), g(u) = e u and
du
d
= cos()
d u du
e
du
d
= e u cos()
= cos() e sin()
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Derivative of the Inverse Function

The inverse function of f (x ) is the function such that f 1 (f (x )) = x
Let f : [a, b] [c, d] be a differentiable function
Let f 1 : [c, d] [a, b] be the inverse function of f (x )
f 1 (x ) is differentiable for x [c, d] where f 0 (f 1 (x )) 6= 0 and
0
f 1 (x ) =
1
f 0 (f 1 (x ))
Example
log(e x ) = x
f (x ) = e x , f 0 (x ) = e x , and f 1 (x ) = log(x )
0
0
log(x ) = f 1 (x ) =
1
e log(x )
1
x
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Summary: Product Rule and Chain Rule
Product Rule
0
f (x ) g(x ) = f 0 (x ) g(x ) + f (x ) g 0 (x )
Chain Rule
0
(g f )(x ) = g 0 (f (x )) f 0 (x )
dg
dg du
=
dx
du dx
50 / 68
Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
51 / 68
Utility Functions
A utility function is a real-valued function U(x ) defined on the real
numbers.
Used to compare wealth levels: if U(x ) > U(y ) then U(x ) is
preferred.
U(x)
Exponential U(x ) = e ax
(a > 0)
Logarithmic
Power
Logarithmic
U(x ) = log(x )
Quadratic
Power U(x ) = bx b
b (0, 1]
x
Exponential
Quadratic U(x ) = x bx 2
(b > 0)
What is the derivative telling us?
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Critical Points
A critical point of a function f (x ) is a number a in the domain of
f (x ) where either f 0 (a) = 0 or f 0 (a) does not exist.
If f has a local min or max at a, then a is a critical point.
f(x)
U(x)
U'(x)
f'(x)
local max if f 0 (x ) decreasing at a, local min if increasing

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Higher Derivatives
If f (x ) is a differentiable function, f 0 (x ) is also a function.
If f 0 (x ) is also differentiable, its derivative is denoted by
f 00 (x ) = f 0 (x )
0
f 00 (x ) is called the second derivative of f (x )

In Leibniz notation:
d d
d2
d 2f
f (x ) = 2 f (x ) = 2
dx dx
dx
dx

Alternative notation: f 00 (x ) = D 2 f (x )
No reason to stop at 2:
f (n) (x ) =
dn
d nf
f
(x
)
=
= D n f (x )
dx n
dx n
provided f (n1) (x ) differentiable

54 / 68
First and Second Order Conditions
f''(x)
U(x)
f(x)
U'(x)
f'(x)
U''(x)
f 0 (x ) = 0 and f 00 (x ) < 0 = local maximum

f 0 (x ) = 0 and f 00 (x ) > 0 = local minimum
55 / 68
Absolute Minimum and Maximum Values

Want to invest a fixed sum in 2 assets to maximize expected return.
Find the absolute maximum value of f (x ) on the interval [0, 1]
More generally, on a closed interval [a, b]
Evaluate f (x ) at the critical
points in (a, b)
Evaluate f (x ) at a and b
The global max is the max of

the values in steps 1 & 2.
The global min is the min of the

values in steps 1 & 2.
Expected Return
56 / 68
Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
57 / 68
Bond Pricing Formula

400
Price
300
200
100
0
0
5%
10%
15%
20%
The price P of a bond is

P =
where:
n
X
F
C
+
n
[1 + ]
1 + k
k=1
C = coupon payment
F = face value
n = # coupon periods remaining

= yield to maturity
F
C
1
+
1
n
[1 + ]
[1 + ]n

58 / 68
Duration and Sensitivity

Let PVk =
ck
,
[1 + ]k
P=
n
X
PVk =
k=1
n
X
ck
[1
+
]k
k=1
The duration of a bond is a weighted average of times that payments

are made.
D=
n
X
PVk
k=1
or
DP =
n
X
k PVk
k=1
Sensitivity: how is price affected by a change in yield?

PVk
ck
= ck [1 + ]k
[1 + ]k
d PVk
d
k ck [1 + ]k1 =
k ck
k
=
PVk
k+1
[1 + ]
1+
59 / 68
Duration and Sensitivity

P =
n
X
PVk
k=1
d
P =
d
n
n
X
d X
d PVk
PVk =
d k=1
d
k=1
n
X
k
PVk
1+
k=1
n
1 X
k PVk
1 + k=1
1
D P DM P
1+
DM is called the modified duration

60 / 68
Duration
Price Sensitivity Formula
dP
= DM P
d
Since
DM
1 dP
= DM
P d
measures the relative change in price as changes.
Duration measures interest rate sensitivity.
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Linear Approximation
400
Price
300
200
100
0
0
5%
10%
15%
20%
The tangent line can be used to approximate the price.

The approximation can be improved by adding a quadratic term
based on the convexity of the price-yield curve.
More on this later
62 / 68
Summary: Bond Duration

Duration
D=
n
X
PVk
k=1
or
DP =
n
X
k PVk
k=1
Modified Duration
DM =
1
D
1+
Price Sensitivity Formula

dP
= DM P
d
63 / 68
Outline
1
Course Organization
Present Value
Limits
Evaluating Limits
Differentiation
Higher Derivatives
Bond Duration
10
lHopitals Rule
64 / 68
lHopitals Rule
Problem: how to evaluate
lim
x 0
sin(x )
?
x
lim sin(x )
sin(x )
0
= x 0
=
x 0
x
lim x
0
lim
x 0
Not allowed since lim denominator = 0

x 0
65 / 68
lHopitals Rule
Let x0 be a real number (including ) and let f (x ) and g(x ) be
differentiable functions.
(i)
)
Suppose limx x0 f (x ) = 0 and limx x0 g(x ) = 0. If limx x0 gf 0(x
(x ) exists
and there is an interval (a, b) containing x0 such that g 0 (x ) 6= 0 for all
f (x )
x (a, b) \ 0, then limx x0 g(x
) exists and
lim
x x0
(ii)
f (x )
f 0 (x )
= lim 0
g(x ) x x0 g (x )
0
)
Suppose limx x0 f (x ) = and limx x0 g(x ) = . If limx x0 gf 0(x
(x )
exists and there is an interval (a, b) containing x0 such that g 0 (x ) 6= 0
f (x )
for all x (a, b) \ 0, then limx x0 g(x
) exists and
lim
x x0
f (x )
f 0 (x )
= lim 0
g(x ) x x0 g (x )
When x0 = , intervals are of the form (, b) and (a, ).

66 / 68
Examples
lim
x 0
sin(x )
x
since lim sin(x ) = 0 and lim x = 0

x 0
x 0
sin(x )
= lim
x 0
x 0
x
lim
x2 1
x x 2 + 1
d
dx
sin(x )
d
dx x
= lim
x 0
cos x
=1
1
since lim x 2 1 = and lim x 2 + 1 =
lim
x2 1
= lim
x x 2 + 1
x
lim
d 2
dx x
d 2
dx x
1
+1
2x
=?
x 2x
= lim
Since lim 2x = have to use lH

opitals rule again:
x
x2 1
= lim
x x 2 + 1
x
lim
d 2
dx x
d 2
dx x
1
+1
2x
= lim
x 2x
x
= lim
d
dx 2x
d
dx 2x
= lim
2
=1
2
67 / 68
http://computational-finance.uw.edu
68 / 68

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AMATH 460: Mathematical Methods for

1. Limits and Derivatives

Continuity and Asymptotes

Product Rule and Chain Rule

1. Limits and Derivatives

Continuity and Asymptotes

Product Rule and Chain Rule

1. Limits and Derivatives

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not (e.g. not in would be x 6 Z)

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1. Limits and Derivatives

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Example, recall pricing formulas:

Question: is lim Vn equal to V ?

1. Limits and Derivatives

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If k is a positive integer and if c > 0 is a positive constant, then