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Exam FM/2 Interest Theory Formulas: by (/iropracy
Exam FM/2 Interest Theory Formulas: by (/iropracy
by (/iropracy
This is a collaboration of formulas for the interest theory section of the SOA Exam FM / CAS Exam 2.
This study sheet is a free non-copyrighted document for students taking Exam FM/2.
The author of this study sheet is using some notation that is unique so that no designation will repeat. Each
designation has only one meaning throughout the sheet.
i
(1 + i )
1
v=
(1 + i )
d=
a (t )
A(t )
PV =
FV
(1 + i )n
d = 1 v
i d = id
v =1 d
d = iv
= ln(1 + i )
a(t ) = e t
v n = (1 + i ) = e n
n
(t ) =
a(t )
a(t )
e 0
(u ) du
A(0 ) e 0
= a(t )
(u ) du
= A(t )
i (m )
1
i = 1 +
m
d ( p)
1 d = 1
p
i (m )
d ( p)
1
1
= 1
1+ i = e = =
= 1 +
v 1 d
m
p
amount earned
a(t ) a(t 1) A(t ) A(t 1)
=
=
beginning amount
a(t 1)
A(t 1)
Note that the t-th year is given by the time period [t 1,t ]
Therefore, the interest earned during the t-th year is given by:
A(t 1) i = A(t ) A(t 1)
<<
Annuities
Annuity Immediate payments are made at the end of the period
Annuity Due payments are made at the beginning of the period
Annuity Immediate
an | i = v + v +
2
1 vn
+v =
i
n
n 1
n2
sn | i = (1 + i ) + (1 + i ) +
sn | i = (1 + i ) an | i
n
an | i = v n s n | i
Annuity Due
an | i = 1 + v +
n
(
1 + i) 1
+1 =
+v
n 1
1 vn
=
d
s n | i = (1 + i ) + (1 + i )
n
n 1
n
(
1 + i) 1
+ (1 + i ) =
sn | i = (1 + i ) an | i
n
an | i = v n sn | i
i
a = (1 + i ) an |
d n|
sn | =
i
s = (1 + i ) sn |
d n|
a n | = 1 + a n 1|
sn | = sn+1| 1
Perpetuity
a | i = lim an | i = v + v 2 + v 3 +
1
i
a | i = lim an | i =
n
1
d
Continuous Annuities
an | i
1 vn i
=
= an | i
sn | i
n
(
1 + i) 1
=
=
(u ) du
PV = e 0
p(t ) dt
FV = e t
( u ) du
i
s
n|i
p ( t ) dt
a n | i = v t dt
0
(Ia )n | i =
an | nv n
(Ia )n | i
(Is )n | i = (1 + i )n (Ia )n | i =
(Ia ) | i = lim
(Ia )n | i =
n
sn | n
an | nv n
i
= (Ia )n | i = (1 + i )(Ia )n | i =
d
d
(Ia ) | i = lim
(Ia )n | i =
n
1 1 1
= +
di i i 2
sn | n
d
1
d2
(Da )n | i =
n an | i
(Ds )n | i = (1 + i ) (Da )n | i =
n
n(1 + i ) sn | i
n
(Ds )n | i = (1 + i )n (Da )n | i
X an | i + Y
X Y
+
i i2
n an | i
d
n 1
Present Value is V (0 ) = 1 v + (1 + q ) v 2 + (1 + q ) v 3 +
+ (1 + q )
n 1
1 (1 + q ) v n
iq
n
vn =
Useful Identities
an+ k | = an | + v n ak |
v n v m = i am | an |
a2 n |
1 = v n + i an |
an |
a2 n |
an |
1 v 2n
= 1 + vn
1 vn
(Da )n | + (Ia )n | = (n + 1) an |
s2 n |
sn |
s2n |
sn |
(1 + i )2 n 1 = (1 + i )n + 1
(1 + i )n 1
1
1
+
+
a (1) a(2)
1
a (n )
sn | =
a(n ) a(n )
+
+
a(1) a(2 )
a(n )
a(n )
If the compounding frequency of the interest exceeds the payment frequency of k years
Use an equivalent interest rate over k years: j = (1 + i ) 1
k
an(m| ) =
(m )
an |
sn(m| ) =
(m )
sn |
an(m| ) =
d
a
d (m ) n |
sn(m| ) =
d
s
d (m ) n |
(2) Use an equivalent interest rate effective over the payment period: j = (1 + i )
1m
an(m| i) = an | j
sn(m| i) = sn | j
an(m| i) = an | j
sn(m| i ) = sn | j
an | i nv n
1 2
n
(m )
If the payments are , , , , then the present value is (Ia )n | i =
i (m )
m m
m
an(m| i) nv n
1 2
n
(m ) (m )
If the payments are 2 , 2 , , 2 , then the present value is (I a )n | i =
i (m )
m m
m
PA
P(k )
Bk
Pk
Ik
Note that B0 = L
L = PA an | i
PA =
Prospective Method
Bk = PA ank | i
Retrospective Method
Bk = L(1 + i ) PA s k | i
k
Bk +t = Bk (1 + i ) and Pk +t = Pk (1 + i )
t
PA = Pk + I k
I k = i Bk 1 = PA 1 v nk +1
Pk = PA I k = PA v nk +1
I k = i Bk 1
+ P(n )v n
Pk = P(k ) I k = Bk 1 Bk
+ P(n )v nk = Bk 1 (1 + i ) P(k )
Notation
effective interest rate per payment period by the borrower to the lender
DS
PS
Sk
Lk
Useful Equations
L = DS s n | j
S k = DS s k | j = L
DS =
sk | j
sn | j
L
sn | j
PS = Li + DS = Li +
L
sn | j
Lk = L DS sk | j
S k S k 1 = DS sk | j DS sk 1| j = DS (1 + j )
Li jS k 1 = Li jDS sk 1| j
k 1
Notes on Loans
Amortized Loan over time interest paid decreases and principal paid increases
SFL for each outlay interest paid to lender is constant
Installment Loan over time interest paid decreases while the principal paid is constant
Bonds
Bonds interest bearing securities; basically loans from lenders perspective
Callable Bond a bond that can be paid off (called) before maturity
Notation
F
par value
Fr
BVk
book value of the bond (bond amortized balance after k-th payment)
vi =
1
1+ i
K = Cvin
g=
Fr
C
Premium If i > r then the bond is priced at a premium. P > C , and P C is the
amount of the premium.
Premium P C = (Fr iC ) an | i
P C = Pk v k 1 + v k 2 +
+ v + 1 + (1 + i ) +
+ (1 + i )
nk
) = P (a
k
k 1 | i
+ s nk +1| i
Discount If i < r then the bond is priced at a discount. P < C , and C P is the
amount of the discount
Discount C P = (iC Fr ) an | i
Par If i = r the bond is selling at the price P = C we say that it sells at par.
P = C 1 + (g i ) an | i
if F = C , then P = F 1 + (r i ) an | i
BVk = BVm (1 + i )
Fr = I k + Pk
Bond Amortized
k m
I k = i BVk 1 = Fr 1 v nk +1 + iC v nk +1
If F = C , then
Fr sk m | i
Pk = Fr v nk +1 iC v nk +1
Pk +t
t
= (1 + i )
Pk
Makehams Formula
g
P = K + (C K )
i
WU k = ( iC Fr ) v n k +1
if F = C , then P = K +
r
(F K )
i
Take N using
Earliest Possible Redemption Date
Latest Possible Redemption Date
Cn
C1
C2
+
++
=0
2
(1 + i ) (1 + i )
(1 + i )n
or
C0 + C1v + C2 v 2 + + Cn v n = 0
Contribution at time t k
Bk
jk
1 + jk =
Bk
Bk 1 + C k 1
TWR
1 + i = (1 + j1 )(1 + j2 )
Interest earned
Ct
C Net
Net contribution
C Net = Ct
DWR
B = A + C Net + I
i=
I
A + Ct (1 t )
I = B A C Net
(1 + jm )
P(1)
P( 2)
(1 + s1 ) (1 + s2 )2
P( n )
(1 + sn )
P(1)
P( 2)
(1 + f1 ) (1 + f1 )(1 + f 2 )
P( n )
n
(1 + f )
i =1
(3) Once we have found the price of a bond using the yield curve we can find the
yield to maturity as the constant yield on the bond at that price.
For example
Purchasing a bond with coupons has cash flows given by P, P(1) , P(2 ) , , P(n )
If payments P(1) , P(2 ) , , P(n1) are not level
Using the BA-II Plus
1. CF Worksheet Set CFo = P, C01 = P(1) , C02 = P(2 ) , , CN = P(n )
2. IRR
CPT
CPT
Forward Rates
Denoted by f n the n year forward rate
The rate agreed upon today for a one-year loan to be made n years in the future
(1 + sn )
1 + fn =
n 1
(1 + sn1 )
n
(1 + sn )
= (1 + f n )(1 + sn 1 )
n 1
Duration
Duration a measure of sensitivity of a financial asset to changes in interest rates
Investment Cash Flows
C1 , C2 , , Cn
Investment Price
wt =
+ v n C n = v t Ct
v t Ct
v t Ct
=
P (i ) vC1 + v 2 C 2 +
t >0
+ v nCn
v t Ct
v t Ct
t >0
tv C
=
v C
t
DM = 1 w1 + 2 w2 +
Macaulay Duration
+ n wn
t >0
t >0
Modified Duration
D=
D=
d
1
P(i ) =
DM
di
1+ i
(Ia )n | i
an | i
Macaulay Duration of a coupon bond with face value F and coupon Fr for n periods and
redemption value C
Fr (Ia )n | i + nCv n
DM =
Fran | i + Cv n
The Duration of a Zero-Coupon Bond payable in n periods is n
Modified Duration of a Portfolio with Investments X k
DTot = W1 D1 + W2 D2 +
+ Wn Dn
where
Wk =
Xk
X1 + X 2 +
+ Xn
C=
1 d 2 P (i )
P(i i ) 2 P(i ) + P(i + i )
2
2
P (i ) di
P(i ) (i )
P(i )
P (i )i = D P(i )i
P(i )
P(i ) 2
P(i ) 2
i
P P(i )i +
i = D P(i )i +C
2
2
Immunization
Notation
A(i )
At
L(i )
Lt
S (i )
Surplus
S (i ) = A(i ) L(i )
A(io ) = L(io )
d
A(i )
di
d
A(i )
di 2
=
i0
d
L(i )
di
>
i0
i0
d
L(i )
di 2
2
Av
= Lt vit0
tA v
= tLt vit0
t >0
t
t i0
t
t i0
t >0
t
t >0
t >0
t >0
At vit0 = t 2 Lt vit0
t >0
i0
Special Cases
Yield Rate Reinvestments
Notation
y
n
k
i
j
General Case
Suppose you make an initial investment of C0 . The yield rate y is the actual rate
of return you are receiving on the investment. AV is the accumulated value of your
investment.
n
C0 (1 + y ) = AV
Suppose you are investing payments into a fund X at the end of each k period
and reinvesting the interest accrued each k period into fund Y
an y (1 + y )
= sn y = k + i ( Is )k j
AV of initial investment
AV of reinvestment
(1 + y )
= 1 + kiX + iY iX ( Is )k 1 i
Bond Reinvestments
This refers to the case where we have bought a bond for a price of P = Fran | i + K and we
reinvest the coupon payments Fr into a separate account at the time they are received.
Notation
y
n
k
Frsk | i + C is the AV of the account and the price P is the initial investment.
P (1 + y )
y (m )
= P 1 +
m
mn
= Frsk | i + C
(1 + y )n =
Frs k | i + C
Frak | i + K
Of course we can have more than one bond involved. If that is the case we just need to
combine prices and coupon payments accordingly.
Step1- Purchase
C1
, a fractional amount of the coupon the period before.
F1r1 + C1
C1
F1r1 + C1
C1
F1r1 + C1
of the bond.
F2 r2 + C 2
C 2 F1r1
Step 4- Purchase
C1
F1r1 + C1
C1
P1 . This matches
P2 +
F2 r2 + C2
F1r1 + C1
C2 F1r1
Price of the bond to match liabilities is:
liabilities at time 1 and time 2.
Stupid Yield Curve Stuff
(2) To value a bond, take the present value of each payment at the appropriate yield
curve rate and sum the present values.
P=
P(1)
P( 2)
(1 + s1 ) (1 + s2 )2
P( n )
(1 + sn )
P(1)
P( 2)
(1 + f1 ) (1 + f1 )(1 + f 2 )
P( n )
n
(1 + f )
i =1