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CMF-F1-Unit1

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Course in Mathematical Finance 2009-10 Finance I Unit 1: Basic Concepts Mathematical Sciences Foundation New Delhi www.

msfonline.in
Copyright c 2009 Mathematical Sciences Foundation. This handout forms part of a Mathematical Sciences Foundation programme. Further details of this and other MSF programmes can be obtained from the MSF website (www.mathscifound.org). You can also call MSF at 01129230401 and 65182616, or email courses@mathscifound.org. All rights reserved; no part of this publication may be reproduced, stored, transmitted or utilised in any form or by any means, without written permission from the Mathematical Sciences Foundation.

Contents
1 Introduction to Finance 2 Arbitrage 3 Return and Interest 4 The Time Value of Money 5 Bonds, Shares and Indices A Solutions to Exercises 1 3 8 10 17 19 22

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Mathematical Sciences Foundation: Course in Mathematical Finance

Unit 1: Basic Concepts
In this unit, we shall explore basic features of finance such as the notions of risk and profit, interest rates, present and future value, inflation, bonds, shares, and indices. We shall also encounter a fundamental principle – known as the No Arbitrage Principle – that will underlie much of our subsequent work. Some standard references for Finance are listed at the end of this Unit, and we encourage you to refer to them for additional details and insights. For example, relevant sections for the material in this Unit are §1.2, 1.3, 2.1 and 2.2 of Luenberger [1]. We emphasize that this unit gives a brief introduction to concepts and products that form the basis of finance. We shall revisit all of these repeatedly and in much greater detail as the course progresses.

Study Plan
You should aim to finish this unit in a week, at an average of roughly one hour of study a day, including time spent in solving the exercises. Solutions to most exercises are provided at the end of the unit, but do try to solve them yourself first! Mathematically, you will need to be familiar with the exponential function e , limits, and derivatives. You should also review basic Probability: the concept of a random variable and its expectation and standard deviation. What is needed here is an intuitive idea of what these concepts represent. Soon, however, you will need their precise definitions and you may as well start reviewing them now.
x

During this week you should also complete the first Excel worksheet titled “Practical 1: Excel Basics”.

1

Introduction to Finance

The aim of Finance is to explore how money should be invested. Imagine that you have inherited a large sum of money from a rich uncle. The sum is so large that even when you have satisfied your immediate needs and desires,

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you still have a considerable amount left over. What can you do with it? We list some typical responses below: 1. Put it in a savings account. 2. Put it in a fixed deposit. 3. Buy bonds. 4. Buy shares. 5. Invest in a Mutual Fund. 6. Buy gold. 7. Buy real estate. Of course, there are many other possibilities, but let us start with just these. The question which arises is – in which of these should we put our money? This naturally depends on how the nature of these investments matches with our requirements. Fixed Deposits For example, the advantage of a fixed deposit as opposed to a savings account is that the former pays a higher rate of interest. The savings account, on the other hand, allows you constant access to your money while a fixed deposit requires the money to be with the bank for a set time such as three months or a year. Bonds A bond provides regular payments over a set time period in return for an initial payment, and is thus rather like a fixed deposit. Many bonds can be traded during their lifetime, and thus provide additional flexibility to the investor. Bonds are also issued by companies, not only banks, and typically offer higher gains than fixed deposits. But there is a downside - if the company hits sufficiently bad times it may not be able to meet its obligations and the investor may not receive the promised payments or even get the initial payment back. In other words, the investor faces default risk, though

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Mathematical Sciences Foundation: Course in Mathematical Finance

only in exceptional circumstances. Risk also enters the picture if the investor wishes to sell the bond before its expiry, since the price would be affected by prevailing market conditions. Shares Risk comes even more into prominence when we consider the remaining possibilities for investing. Share prices, for instance, vary greatly from day to day. Even if we invest in a company with an excellent record, there is no guarantee that we will gain by owning its shares over the next few months. On the other hand, if we hold on to the shares for many years we have a good chance of making a handsome profit. Mutual Funds It used to be thought that bonds provide the optimal way to do well in the long run – say over 20 or 30 years. Current opinion, however, is in the favour of shares, provided one invests in a diverse collection of stable companies and thus reduces the possible loss due to one or more of them doing badly. Mutual funds, which distribute the investor’s money over such a collection, cater to the investor who wants steady long-term growth. The investor who wishes to make money quickly would invest in just a few shares that he believes are going to do exceptionally well in the immediate future. Such an investor would naturally be exposed to high levels of risk.

Risk and Profit
Our discussion has brought forth some aspects of risk and profit. In this course we shall investigate these in greater detail. The main task is to quantify the relationship between risk and profit, so we can make well-informed and precise decisions. The initial problem is to figure out the “correct” price for a product, by which we mean a price that satisfies both buyer and seller. We will refer to it as the value of the product. The products, by the way, could be anything from commodities like cars or wheat, to bonds and shares, or even contracts about future transactions. We will use the generic term asset for the products being traded. A collection of assets will be called a portfolio.

Finance I, Unit 1: Basic Concepts Asset Choice

5

Beyond pricing, the main decision is what assets to invest in. Naturally, we would like to invest in ones whose value seems likely to increase at a faster rate. It is almost a law of Nature, however, that bigger promises are also less reliable. In fact, less reliable promises must be bigger, if they are to have any takers. Thus there is a trade-off between expected profit and risk: to aim for higher profit, the investor must undertake greater risk. The Meaning of Risk The word risk is used in Finance in a special way. It refers to uncertainty, and does not necessarily have a negative connotation. Thus, consider the choice between putting money in a bank account or using it to buy shares in a company. The second investment is riskier because it has more uncertainty, but it is not obvious how its worth compares to that of the the first one. Lotteries provide an extreme instance of high-risk investments which are nevertheless popular.

Probability
This discussion leads us to the role of Probability in Finance. The relative worth of an investment depends on the probabilities of the possible payoffs. If higher pay-offs are perceived as more likely, its value will increase. For example, if we can model the fluctuations in prices of a stock, we can assign probabilities to the possible pay-offs from this investment, and thus estimate its value to the investor.1 Specifically, we treat the future profit as a random variable. Its expectation then represents the expected profit, while its standard deviation represents fluctuations and hence risk. (See Figure 1)2
We shall look at specific stock price models later in this course. You can ignore this discussion for now if you are unfamiliar with the terms random variable, expectation, and standard deviation. However, you should start your study of basic Probability and familiarize yourself with these concepts as they will soon become essential.
2 1

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Mathematical Sciences Foundation: Course in Mathematical Finance

0.02

0.015

0.01

0.005

0.02 -0.005

0.04

0.06

0.08

Figure 1: This diagram considers the 65 stocks making up the Dow Jones Composite Index, and their weekly profits over the one year period ending November 6, 2006. The mean profit (per dollar invested) is plotted on the vertical axis, and the standard deviation of the profits (representing risks) is plotted on the horizontal axis. The curve has been drawn to emphasize that higher mean profit requires greater risk.

Risk-Free Assets
Some assets can be viewed as free of risk. For instance, deposits in banks and bonds bought from governments are typically treated as risk-free. Of course, both banks and governments can collapse, but such instances are rare. We shall soon see that there is good reason to expect that all risk-free assets will gain in value at the same rate, and we may therefore talk of the risk-free rate of growth. This rate is not universally fixed, but varies with market and time.

Portfolios
So far, we have considered individual assets. To create a portfolio, we need to consider not only the individual characteristics (regarding profit and risk) of the assets, but also their relationships with each other. Two assets could be linked together in certain ways – for instance, they may show a tendency

Finance I, Unit 1: Basic Concepts

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to rise or fall in value together. Alternately, one may tend to move in the opposite direction to the other. In the latter case, a rise in one would be offset by the fall in the other, and a portfolio consisting of both these assets would be less risky than a portfolio consisting of only one of them! By combining assets in various ways, one can tailor a portfolio to satisfy the risk preferences of any investor.

Hedging
The process of reducing risk by combining assets appropriately is called hedging. By hedging, we reduce risk, and therefore also lower our expected profit. One of the goals we will pursue in this text is to see how to hedge against specific risks to which a portfolio is exposed, for instance fluctuations in the prices of stocks or in interest rates. If the hedging is complete, no risk will remain, and the portfolio will grow slowly at the risk-free rate. Therefore, we will also consider how to hedge to the right extent, so that the remaining risk just falls within acceptable levels and the portfolio is able to grow at a faster rate.

2

Arbitrage

Arbitrage is the making of profit without undertaking risk. It can be earned, for instance, when a product is being sold at different prices in different markets. Then risk free profit can be made by buying it where it is cheaper and selling it where it is costlier. A variation is when the different prices are at different times, so that it is possible to buy today at a low price and sell some days later at a higher price. For this profit to qualify as arbitrage, however, you must be certain beforehand that the price will go up. Deciding whether a profit has in fact been made can be tricky. If we invest Re 1 and after a while it becomes Rs 2, we may feel we have made a profit of Re 1. Suppose however, that we are based in the US and therefore count our gains in dollars. In the given time period, if the value of the rupee in terms of dollars falls sufficiently far we will perceive a loss rather than a gain. Yet again, suppose that in the same period a rupee put in a savings account would have more than doubled. Then it would be difficult to see the first investment as truly representing a profit. A simple way to resolve these ambiguities is to demand that arbitrage must

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Mathematical Sciences Foundation: Course in Mathematical Finance

be carried out without investing your own money (essentially, this means you start by borrowing some money and pay off the loan by the end). If you start with zero and end up with something, you have definitely made a profit. A basic principle is that arbitrage opportunities are short-lived: Prices evolve in such a way as to eliminate them. For as soon as it is realized that a product is under-valued and is creating an arbitrage opportunity, investors will rush to buy it. This will drive up its price, reducing and ultimately eliminating the arbitrage opportunity. Similarly, if the opportunity arises from an over-priced product, there will be a rush to sell it and this will drive its price down. Reflecting on this process, we are led to the formal definition of arbitrage. We start by noting that the amount of profit does not have to be known beforehand: it is enough to know that it cannot be negative and has a chance of being positive. This will suffice to attract investors and initiate the stabilization process described above. Therefore, an investment strategy is said to lead to arbitrage if: 1. It does not involve an initial investment of the investor’s own money. 2. It is known that at some future time the investment will have a value which is definitely non-negative and additionally has a non-zero probability of being strictly positive. Exercise 2.1 Which of the following situations provides an arbitrage opportunity? 1. A guarantee that in return for Rs 10 paid now, Rs 20 will be returned after ten years. 2. A guarantee that in return for Rs 10 paid now, Rs 20 will be returned tomorrow. 3. A lottery ticket. 4. A free lottery ticket. 5. Bank A loans money at an annual interest rate of 10%, while Bank B pays 15% interest annually on deposits. 6. Bank A loans money at an annual interest rate of 15%, while Bank B pays 10% interest annually on deposits.

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How long an arbitrage opportunity lasts depends on the communication within the market. The better it is, the faster investors will react to the situation and eliminate the opportunity. Thus, in the idealized situation of an efficient market, in which communication is instantaneous and complete, arbitrage opportunities will die immediately: No Arbitrage Principle: In an efficient market, there are no arbitrage possibilities. The No Arbitrage Principle is a surprisingly powerful tool for establishing the “correct” price of a product and underlies every important result in this course. It seems to have been first mentioned by Louis Bachelier in 1900 when he described “operations in which one of the traders would profit regardless of eventual prices” and also noted that these are “never found in practice.”3 Its systematic use in modern Finance, however, was initiated by Franco Modigliani and Merton Miller in the 1950’s.4

3

Return and Interest

Consider an asset whose value evolves from V0 at an initial time t = 0 to VT at a later time t = T . Then the return from this asset over the time interval [0, T ] is defined to be Return = VT − V0 . The rate of return is defined by Rate of Return = VT − V0 . V0

Commonly, one also writes “return” for “rate of return”. Confusion is avoided by noting that return has a currency as unit, while the rate of return is unit-free. We will further express rate of return in percentages. Thus the phrase “The return was Rs 10” refers to the first definition, while “The return was 10%” refers to the second and conveys that the rate of return was 0.1.
Bachelier worked on the Paris stock exchange before doing his PhD on modeling the price fluctuations of various securities. His work led to striking innovations in both mathematics and economics, and he is now considered the father of modern Finance. 4 Modigliani was awarded the Nobel Prize in Economics in 1985, Miller in 1990.
3

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Mathematical Sciences Foundation: Course in Mathematical Finance

Interest
We will call the income from an investment interest if it is earned regularly and in a predetermined manner, without risk. Interest can be calculated according to different conventions. Consider a starting amount P (called the principal ) on which interest is earned over a time period T . The amount of interest earned is given by the rate of interest, denoted r, in accordance with the adopted convention. The rate r is given relative to some time interval, called its period. The most commonly used period is one year, in which case the rate is called annual. If the period is a half-year (six months) the rate is called semi-annual. Other periods used are monthly, weekly and daily. Interest rates are commonly given as percentages, which have to be converted to fractions for calculations. Now we shall consider the various ways of computing interest.

Simple Interest
In simple interest, the interest earned over one period is not added to the principal (e.g., it may be returned to the investor), and further interest is again earned on the principal alone. Thus, if P is invested at a rate of interest r, the amount after one period is A = P + P r = P (1 + r). During the second period, interest is again earned on P alone, so that the amount after two periods is A = P (1 + r) + P r = P (1 + 2r). In general, the final amount after earning simple interest over n periods is: A = P (1 + nr) Example 3.1 A common example of simple interest is the provision of fixed deposits by banks. The interest earned on the money in a fixed deposit account is returned to the investor, so that future interest is earned on the original amount alone. 2

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Discrete Compound Interest
In compound interest, interest earned over one period is added to the principal, and earns interest in subsequent periods. If an amount P is invested at a rate r, then the amount after one period is A = P (1 + r), just as for simple interest. However, in the second period P (1 + r) serves as the principal, so that the amount after two periods is A = P (1 + r)(1 + r) = P (1 + r)2 . After n periods, the final amount is: A = P (1 + r)n Sometimes the period for which the rate is quoted is not the same as the interval at which interest is compounded. For instance, the rate may be given as an annual one, while the interest is calculated every 6 months. In this situation, the rate is adjusted linearly. If interest is compounded m times during the period of the rate, then the rate per compounding interval is set to r/m and so the final amount over n periods is calculated by: A=P 1+ r m
mn

Example 3.2 Savings accounts in banks provide an example of compound interest, since the interest earned on the amount in the account is fed back into the account. 2 Exercise 3.3 Suppose you take a loan of Rs 1000, and have to pay it back in two equal and equally spaced instalments over a year. The annual rate of interest applied to this loan is 15% and the interest is compounded semiannually. (a) What will be the size of each instalment? (b) How much of each instalment will go toward the principal and how much toward the interest? (Assume that each payment has to pay off the outstanding interest at the time.)

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Mathematical Sciences Foundation: Course in Mathematical Finance

Continuous Compound Interest
Consider a bank offering interest compounded annually at a rate r. Suppose it allows an investor who withdraws his money at a time t before one year to earn interest at a linearly adjusted rate of rt. For example, an investor can withdraw his investment of P after 6 months, together with the interest earned. It would total P (1 + r/2). He can then immediately reinvest it for another 6 months. This strategy nets him a final amount of A = P (1 + r/2)(1 + r/2) = P (1 + r + r 2 /4), which is slightly better than the P (1 + r) he would have had if he had just let the money sit in the bank for the whole year. An investor who can create this strategy, will certainly think of pushing it further by using smaller and smaller investment periods. In general, if he withdraws and reinvests m times, he will end up with A=P 1+ r m
m

.

The larger the value of m, the greater is his profit. This naturally leads to considering the limit m → ∞. If we recall that limh→0+ (1 + h)1/h equals Euler’s Number e ∼ 2.71, we can easily calculate: lim P 1 + r m
m

m→∞

= P lim

m→∞

1+

r m

(m/r)r

= P lim (1 + h)(1/h)r = P er .
h→0+

This suggests creating a new kind of interest, calculated by A = P er for a single period. Over n periods, the growth is given by A = P enr Interest calculated according to this formula is said to have been continuously compounded, and r is called the continuously compounded rate of interest.

Interest at Arbitrary Times
We have been considering the interest earned when money is invested for a full time period, or for n full time periods. Now we look at what happens when an investor withdraws his money at some intermediate time. In particular,

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250

200

150

100 Simple 50 Discrete Compounding Continuous Compounding 2 4 6 8 10

Figure 2: This diagram shows the growth of Rs 100 according to the different
interest rates, each with r = 10%, over a period of 10 years.

let the investor withdraw his money after a time T which consists of n full time periods and a final fraction t of a time period (so 0 ≤ t < 1). The convention is that during the fractional period, the rate of interest is adjusted linearly to rt. (Note that this is consistent with the convention used when the period for the quoted rate differs from the compounding period.) Then, over the time T , the invested amount becomes Simple Interest: A = P (1 + nr) + P rt = P (1 + rT ) Discretely Compounded Interest: A = P (1 + r)n (1 + rt) Continuously Compounded Interest: A = P enr ert = erT The formulas for simple and continuously compounded interest are mathematically simple, while that for discrete compounding is slightly more complicated. If we plot A versus T , then for simple interest we get a straight line, for discretely compounded interest a broken line, and for continuously compounded interest an exponential curve. (See Figure 2) Exercise 3.4 Consider a bank that offers to double your investment in 10 years. What is the corresponding annual rate of interest if we assume the interest is

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Mathematical Sciences Foundation: Course in Mathematical Finance

(a) simple (b) compounded annually (c) compounded continuously Continuous compounding is mathematically pleasant in another way. Withdrawing and reinvesting becomes just the same as making a single long investment, since erT1 erT2 = er(T1 +T2 ) . Moreover, if continuous compounding is used, the same r can be used for borrowing and lending without creating arbitrage opportunities. This is not the case with discrete compounding. Exercise 3.5 Suppose a bank has fixed an annual 5% discretely compounded interest rate for both deposits and loans. Show that this creates an arbitrage opportunity. Exercise 3.6 Given that continuous compounding has nicer behaviour than discrete compounding, can you explain why financial institutions use the latter? Let us now consider the possibility of different interest rates being available in the market. The differences could be of various types: 1. Use of different types of interest. 2. Different rates offered by different financial institutions. 3. Different rates for deposits and loans. 4. Different rates for investments of different time durations. Typically, institutions use discretely compounded interest. The difference would be in the frequency of compounding. The same value of r, but with more frequent compounding, leads to more interest being earned. Thus institutions doing more frequent compounding would also use slightly lower values of r. Continuous compounding is used more in mathematical modelling, and these models would use a value of r that is essentially equivalent to that being used for discrete compounding in the real world.

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Effective Rate of Interest
One way to reduce the confusion from different kinds of interest, is to calculate for each the amount of interest it earns over one year. This is called its effective rate. Thus, suppose that a principal P has grown to an amount A by earning interest over a year. Then the interest earned is A − P . The effective rate of interest is defined to be the interest earned per unit invested: reff = A−P . P

We can expect that the effective rates of different available interest earning schemes would be the same. Example 3.7 Consider an r of 10% annually. If this is used with annual compounding, then the corresponding effective rate is again 10%. If the compounding is semi-annual (every 6 months), the effective rate becomes (1 + 0.1/2)2 − 1 = 0.1025, i.e. 10.25%. Finally, if continuous compounding is used, the effective rate is e0.1 − 1 = 0.1052 or 10.52%. 2 Exercise 3.8 A credit card offers a cash withdrawal facility at a “low” monthly rate of 2%. What is the corresponding effective annual rate? Exercise 3.9 Consider two investments A and B of the same amount, and at the same effective annual interest rate. Suppose A earns semi-annually compounded interest and B earns continuously compounded interest. (a) Which one earns more interest if the period of the investment is: 6 months, 9 months, 1 year? (b) Suppose the invested amount is Rs 1000, and the common effective rate is 10%. What is the maximum difference in the interests earned by A and B at any point during the first 6 months? (The answer is quite small so use a good number of decimal places in your calculations.) The second kind of variation can be expected to be negligible due to competition. A bank offering lower interest on deposits than its competitors would soon start losing customers, and would have to raise its rates. The third kind certainly exists: thus, a bank will offer lower interest on deposits than it will exact on loans. However, it should be noted that only the first rate can be reasonably seen as risk-free. The second rate involves a risk taken by the bank, which explains why it is higher.

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Mathematical Sciences Foundation: Course in Mathematical Finance

Exercise 3.10 Show that the No Arbitrage Principle rules out a bank offering higher interest on deposits as compared to loans. The fourth kind of difference is quite important, and we will consider it in detail later. As a general rule, investments for longer time durations are granted higher interest rates. The idea is that such an investment is exposed to more risk over its life and, to compensate, it must promise a higher profit. Example 3.11 In April 2005, 6 month investments in Reserve Bank of India bonds were earning 5.4% interest, while 12 month investments were earning 5.6%. 2 In sum, we can expect the same interest rates for investments of the same duration. Thus, we may (and do) talk of a common risk-free rate that applies to all risk-free investments over the same time period.

4

The Time Value of Money

Consider two offers: the first promises you one rupee right away, and the other after a month. Assuming both the offers are from trustworthy sources, do you have any reason to prefer one to the other? The simple answer is that it is better to get the money early, as you can put it in a bank and start earning interest on it. This example illustrates the important idea that the value of a transaction involves not only an amount of money but also the time at which it is undertaken.

Present and Future Value
We have observed that holding a rupee now is not the same as holding it a year from now. Well then, what is the precise difference between the two? It depends on how much the rupee could have earned in a year by means of interest. Example 4.1 Suppose a rupee can be invested at a simple annual rate of 5%. Then, after a year, it has become 1.05 rupees. In this situation, earning a rupee now is equivalent to earning 1.05 rupees after a year. 2

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In the above example, Rs 1.05 is the future value of Re 1. Conversely, Re 1 is the present value of Rs 1.05. In general, consider two amounts P and F that exist at times t1 and t2 respectively, with t1 < t2 . Let the risk-free rate of return over the interval [t1 , t2 ] be r. Then we call P the present value of F (at t1 ) if P = F . 1+r

Conversely, F is the future value of P (at t2 ). The factor C = 1/(1 + r) is called the discount factor for this time interval. If the risk-free rate is given in terms of interest, then the corresponding discount factor can be calculated as follows: 1. Suppose the annual interest rate is r, with compounding m times a year (after equal periods of time). Then the discount factor over n periods is 1 . C= (1 + (r/m))n 2. If the interest is compounded continuously, the discount factor over T years is C = e−rT . It cannot be over-emphasized that amounts of money existing at different times must not be compared or combined without taking into account the relevant discount factors.

Inflation
Another way that the value of money changes through time is with respect to its purchasing power. Typically, the same amount of money can buy less and less as time progresses – this phenomenon is known as inflation. Inflation shows up as a general increase in prices. By averaging the rise in prices over various commodities, one can arrive at a single number – the rate of inflation f – which represents the annual decrease in purchasing power of a unit of currency: Purchasing Power after 1 year = Original Purchasing Power . 1+f

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Mathematical Sciences Foundation: Course in Mathematical Finance

If an amount A is invested at the risk-free rate r for a year, then the effective amount one has after a year is 1+r A, 1+f and so we may talk of the real risk-free rate r ′ defined by 1 + r′ = 1+r , 1+f or r ′ = r−f . 1+f

Exercise 4.2 If continuous rates are used for inflation as well as risk-free growth, show that the real risk-free rate is given by r ′ = r − f . Exercise 4.3 The table below shows estimates of annual inflation rates in India during 2001-2004. Year Inflation Rate 2001 3.8 2002 4.3 2003 3.8 2004 3.8 If an investment earned an annually compounded 8% interest throughout this period, what would be the return from it in real terms (i.e., in terms of purchasing power)? In this course, we will not worry about inflation. The above discussion shows that, if necessary, inflation can be taken into account by a suitable modification of the risk-free rate.

5

Bonds, Shares and Indices

Bonds and shares are the principal means by which institutions raise money for their operations, and hence they provide the chief avenues for investment. A bond is a contract written by a company or government (called its issuer). The purchaser of the bond makes an immediate payment to the issuer and, in return, is entitled to a certain number of regular payments in the future. Thus, a bond is essentially a loan. Institutions use bonds to raise money

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when the amount needed is too large to be obtained from a single source. Investors use bonds as relatively safe investments providing a higher rate of return than a simple deposit in a bank. Judiciously used, they can provide insulation from interest rate changes as well. A share represents part of the capital of a company. Its holder is thus a part-owner of the company and takes part in its fortunes. The share may offer him certain voting rights in the affairs of the company. Most companies also release regular payments, called dividends, to their shareholders out of their profits. The term stock is also used for a share. Another usage of the word stock is the total capital represented by the shares — or the total market capitalization (TMC) of the company. A stock index is a hypothetical portfolio which is used to keep track of general trends in the market. Suppose a stock index has stocks labelled 1, 2, . . . , n and it has ai shares of the stock labelled i. Also, let Si be the price of one share of the stock i. Then the total value of the index is n ai Si . i=1 The weight of a stock is the proportion invested in it: wi = ai Si n j=1 aj Sj

Indices change with time. If the composition (the collection of ai ’s) is fixed then the weights will vary. If the weights are fixed, the composition will vary. Exercise 5.1 In an index with fixed composition, weight rises with a rise in the corresponding stock price. Exercise 5.2 In an index with fixed weights, a rise in the price of a stock leads to a fall in its amount in the index. Some examples from India5 : 1. BSE Sensex, is based on 30 stocks forming a sample of large, liquid and representative companies listed on the Bombay Stock Exchange (BSE). 2. S&P CNX Nifty, consists of the 50 best stocks (in terms of TMC) on the National Stock Exchange of India (NSE). It represents about 60% of the TMC on the NSE.
For more information, consult the websites of the National Stock Exchange of India (www.nse-india.com) and the Bombay Stock Exchange (www.bseindia.com).
5

20

Mathematical Sciences Foundation: Course in Mathematical Finance 3. S&P CNX 500, consists of 500 stocks and covers 98% of the total turnover on NSE and 94% of TMC. 4. CNX Midcap 200, covers 77% of the TMC of the “midcap universe” (TMC of Rs 75 to 750 Cr).

Some examples from the US: 1. Standard and Poor’s 500 Index (S&P 500), is based on 500 stocks distributed as follows: 400 industrials, 40 utilities, 20 transport, 40 financial institutions. S&P500 covers about 70% of the total TMC and 78% of the total traded value. 2. Dow Jones Industrial Average (DJIA) consists of 30 of the largest public companies in the US. It was created in 1896, when it consisted of 12 companies. 3. NASDAQ 100 consists of 100 of the largest companies (including nonUS ones) listed on the NASDAQ exchange. It is relatively heavy in IT companies. Infosys is one of the current components of this index. 4. NASDAQ Composite (or just “the NASDAQ”) includes every company listed on the NASDAQ exchange – currently more than 3000. 5. NYSE Composite includes each of the over 2000 stocks listed on the New York Stock Exchange. Other international examples: 1. FTSE 100 consists of the top 100 companies, in terms of TMC, on the London Stock Exchange. It represents about 80% of the TMC on the London Stock Exchange. 2. Nikkei 225 is based on the Tokyo Stock Exchange. 3. Hang Seng Index consists of 39 companies listed on the Hong Kong Stock Exchange and comprising 65% of its TMC. Of these various stock indices, the smaller ones (with 30-50 constituents) give a summary of some particular aspect of the economy – perhaps of its largest companies, or of those belonging to a particular sector. Larger ones attempt to portray the national economy as a whole. Recently, stock indices have been created that track entire continents or the whole world.

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A

Solutions to Exercises

Exercise 2.1 Let us compare the given situations with the requirements of an arbitrage opportunity: zero initial investment and zero probability of loss together with a positive probability of profit. The first two situations can be arbitrage if interest rates are low enough. For we can start by borrowing Rs 10, thus avoiding an initial investment of our own money. This will earn us Rs 20 by the end of the set time (ten years or one day), which we can use to pay off the loan. If the interest on the loan is low enough, we will still have money left over and this will constitute our risk-free profit. In the second situation, this is almost certain to happen. The lottery ticket does not constitute arbitrage since there is no guarantee of profit (indeed, a loss is almost certain). The free lottery ticket does provide an arbitrage opportunity. There is no possibility of loss, and a very small one of success. In the fifth situation, we can loan some amount from Bank A and deposit it in Bank B for a year. At the end we will earn 15% interest on it, which can be used to pay off the 10% interest on the loan. The remaining 5% is our arbitrage profit. The last situation does not, by itself, provide an arbitrage opportunity. Exercise 3.3 Let each instalment be of an amount I. (a) After 6 months, the debt is 10, 000 × 1.075 = 10, 750, since the interest rate for 6 months is 15/2=7.5%. On payment of the first instalment, a debt of 10, 750−I remains. Over the final 6 months, this becomes (10, 750−I)×1.075. For the debt to be paid off, this amount must equal the last instalment and we get the equation I = (10, 750 − I) × 1.075. The solution is I = 5569.28. (b) Of the first instalment, Rs 750 goes towards the interest and Rs 4819.28 towards the principal. The last instalment pays off the remaining principal amount of Rs 5180.72 as well as interest amounting to Rs 5569.28−5180.72 = 388.56. Exercise 3.4 Let us base our calculations on an investment of Rs 1. Let the

22

Mathematical Sciences Foundation: Course in Mathematical Finance

rate of interest be r. Then the three cases yield the following equations: (a) (b) (c) 2 = 1 + 10r 2 = (1 + r)10 2 = e10r

The respective solutions are r = 0.1, 0.072 and 0.069, or 10%, 7.2% and 6.9%. Exercise 3.5 The arbitrage strategy is to borrow an amount X for a year and deposit it in the same bank. Withdraw it after 6 months and immediately reinvest it in that bank. After 1 year, the invested amount becomes 1.0252 X = 1.050625X. We use 1.05X to pay off the loan and are left with a risk-free profit of 0.000625X. Exercise 3.8 The annual growth factor is 1.0212 = 1.268, so the effective annual rate is 26.8%. Exercise 3.9 (a) Let the invested amount be Rs 1, the discrete rate be rd , and the continuous rate be rc . Since the interest earned over 1 year is the same for both A and B, we find that 1+ Hence rd 2
2

= erc .

rd = erc /2 , 2 which shows that the interest earned over 6 months is also the same for both A and B. If we graph the interest earnings against time, we get the following diagram. 1+

Finance I, Unit 1: Basic Concepts

23

6

9

12

In particular, at the 9 month mark, A has earned more interest than B. (b) Since the effective rate is 10%, we obtain the following equations: 1+ rd 2
2

= erc = 1.1.

This yields rd = 0.098 and rc = 0.095. Over the first 6 months, using years as units, the difference between the interests earned by A and B is f (t) = 1000(1 + 0.098t − e0.095t ), 0 ≤ t ≤ 0.5.

To locate the maximum we use the first derivative test: 0 = f ′ (t) = 1000(0.098 − 0.095e0.095t ), which gives t = 0.33. Hence the maximum gap is f (0.33) = 0.49, or a mere 49 paise! Exercise 4.2 When continuous rates are used, the relationship between the original and final purchasing power is Purchasing Power after 1 year = Original Purchasing Power . ef

24

Mathematical Sciences Foundation: Course in Mathematical Finance

If an amount A is invested at the risk-free rate r for a year, at the end we have the effective amount (in terms of purchasing power): er A = er−f A. ef Therefore the real risk-free rate is r − f . Exercise 4.3 The growth in purchasing power is 1.084 = 1.166. 1.0383 × 1.043 Therefore the return in real terms is 16.6%. Exercise 5.1 Let us verify the statement for the first stock. We have the relation a1 S1 . (1) w1 = n i=1 ai Si Differentiate with respect to S1 : ∂w1 a1 n ai Si − a2 S1 a1 1 i=1 = = n ∂S1 ( i=1 ai Si )2 ( Hence a rise in S1 causes a rise in w1 . Exercise 5.2 Equation (1) can be rearranged into a1 = w1 1 − w1
n n i=1 n i=2

ai Si > 0. ai Si )2

ai Si
i=2

1 . S1

Therefore an increase in S1 (with everything else untouched) causes a decrease in a1 .

References
[1] David G. Luenberger. Investment Science. Oxford University Press India. [2] Zvi Bodie, Alex Kane, Alan J. Marcus and P. Mohanty. Investments. 6th Edition. Tata McGraw-Hill. [3] William F. Sharpe, Gordon J. Alexander and Jeffery V. Bailey. Investments. 6th Edition. Prentice-Hall India.

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