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# AS 2553a — Mathematics of ﬁnance

Formula sheet

November 29, 2010

This document contains some of the most frequently used formulae that are discussed in the course.

As a general rule, students are responsible for all deﬁnitions and results appearing in propositions in

the lecture notes.

1 Interest rate measurement

To convert from one type of compound interest/discount rate to another, one may use the relationships

1 +i =

_

1 +

i

(m)

m

_

m

=(1 −d)

−1

=

_

1 −

d

(m)

m

_

−m

=e

δ

.

As a result, we have

d =

i

1 +i

v =

1

1 +i

δ =ln(1 +i).

For a general force of interest δ

t

,

δ

t

=

S

(t)

S(0)

=

d

dt

S(t).

When inﬂation is taken into account, the inﬂation-adjusted rate of interest is i − r and the real

rate of interest is (i −r)/(1 +r), where r is the inﬂation rate.

1

2 Valuation of annuities

Present value Future value

Level annuity-immediate a

n i

=

1 −v

n

i

s

n i

=

(1 +i)

n

− 1

i

Level annuity-due ¨ a

n i

=

1 −v

n

d

=

i

d

a

n i

¨ s

n i

=

(1 +i)

n

− 1

d

=

i

d

s

n i

Level continuous annuity ¯ a

n i

=

1 −v

n

δ

=

i

δ

a

n i

¯ s

n i

=

(1 +i)

n

− 1

δ

=

i

δ

s

n i

m-thly payable a

(m)

n i

=

1 −v

n

i

(m)

=

i

i

(m)

a

n i

s

(m)

n i

=

(1 +i)

n

− 1

i

(m)

=

i

i

(m)

s

n i

annuity-immediate

m-thly payable ¨ a

(m)

n i

=

1 −v

n

d

(m)

=

i

d

(m)

a

n i

¨ s

(m)

n i

=

(1 +i)

n

− 1

d

(m)

=

i

d

(m)

s

n i

annuity-due

k-period deferred annuity

k|

a

n i

= v

k

a

n i

Perpetuity(-immediate)

1

i

Perpetuity-due

1

d

Increasing annuity-immediate (Ia)

n i

=

¨ a

n i

−nv

n

i

(Is)

n i

=

¨ s

n i

−n

i

Increasing annuity-due (I¨ a)

n i

=

¨ a

n i

−nv

n

d

=

i

d

(Ia)

n i

(I¨ s)

n i

=

¨ s

n i

−n

d

=

i

d

(Is)

n i

Continuously increasing (

¯

I¯ a)

n i

=

¯ a

n i

−nv

n

δ

(

¯

I¯ s)

n i

=

¯ s

n i

−n

δ

continuous annuity

Decreasing annuity-immediate (Da)

n i

=

n −a

n i

i

(Ds)

n i

=

n(1 +i)

n

−s

n i

i

Decreasing annuity-due (D¨ a)

n i

=

n −a

n i

d

=

i

d

(Da)

n i

(D¨ s)

n i

=

n(1 +i)

n

−s

n i

d

=

i

d

(Ds)

n i

Continuously decreasing (

¯

D¯ a)

n i

=

n − ¯ a

n i

δ

(

¯

D¯ s)

n i

=

n(1 +i)

n

− ¯ s

n i

δ

continuous annuity

If the force of interest varies in time, then the present and future values of a continuous annuity

paying h(t) at time t are respectively

¯ a

n δu

=

_

n

0

h(t)e

−

R

t

0

δudu

dt,

2

and

¯ s

n δu

=

_

n

0

h(t)e

R

n

t

δudu

dt,

and they are related by

¯ s

n δu

= e

R

n

0

δudu

¯ a

n δu

.

We also have the following relationships by placing the relevant payments on the time line. (Stu-

dents are not expected to memorize the next set of formulae but to be able to derive them when

needed.)

v

k

a

n

=a

n+k

−a

k

=

k|

a

n i

s

n

(1 +i)

k

=s

n+k

−s

k

¨ a

n i

=(1 +i)a

n i

¨ s

n i

=(1 +i)s

n i

¨ a

n i

=1 +a

n−1 i

¨ s

n i

=s

n+1 i

− 1

(Da)

n i

+ (Ia)

n i

=(n + 1)a

n i

(

¯

D¯ a)

n i

+ (

¯

I¯ a)

n i

=n¯ a

n i

3 Loan repayment

Under the amortization method of a loan repayment, we have for t = 1, 2, . . . , n where n is the term

of a loan of amount L

I

t

=iOB

t−1

,

PR

t

=K

t

−I

t

,

and

OB

t

=OB

t−1

−PR

t

=(1 +i)OB

t−1

−K

t

.

Once the loan is completely payed oﬀ, OB

n

= 0. Thus, the total principal repaid is

n

t=1

PR

t

=

n

t=1

(K

t

−I

t

) = L,

and the total interest paid is

n

t=1

I

t

=

n

t=1

K

t

−L.

The retrospective form of the outstanding balance is

OB

t

= (1 +i)

t

L −

t

j=1

(1 +i)

t−j

K

j

,

and its prospective form is

OB

t

=

n

j=t+1

v

j−t

K

j

.

3

When payments are level,

I

t

=K

_

1 −v

n−t+1

_

,

PR

t

=Kv

n−t+1

,

and

OB

t

= Ka

n−t i

.

Under the sinking-fund method,

I

t

=iL −jSF

t−1

= iL −jL

s

t−1 j

s

n j

,

PR

t

=

L

s

n j

(1 +j)

t−1

,

and

OB

t

= L −SF

t

= L

_

1 −

s

t j

s

n j

_

.

If a loan is repaid under the sinking-fund method and there are n remaining payments, the present

value of the loan may be calculated through Makeham’s fomula

A = M +

i

j

(L −M)

where M = Lv

n

j

.

4 Bond valuation

The present value of a bond that has face value F, redemption amount C, eﬀective yield to maturity

j per coupon period, coupon rate r, and term to maturity n is

P = Fra

n j

+Cv

n

j

.

When F = C, we also have

P = F +F(r −j)a

n j

.

Letting M = Fv

n

j

, Makeham’s formula may be obtained

P = M +

r

j

(F −M).

The price-plus-accrued at time t = k +s is

P

t

= (1 +j)

s

P

k

= v

1−s

(Fr +P

k+1

),

where

s =

# of days since last coupon paid

# of days between coupon payments

.

The respective price quoted in the newspapers is deﬁned by

Price

t

= P

t

−sFr.

4

When amortizing a bond, we have

OB

t

=(Book value)

t

=Cv

n−t

j

+Fra

n−t j

, t = 1, 2, . . . , n − 1,

I

t

=jOB

t−1

, t = 1, 2, . . . , n

and

PR

t

=

_

Fr −I

t

, t = 1, 2, . . . , n − 1

Fr +C −I

t

, t = n

.

Using Makeham’s formula, the price of a serial bond is calculated by

P = M +

r

j

(F −M),

where M =

m

k=1

M

k

and F =

m

k=1

F

k

.

5 Measuring the rate of return of an investment

The following are three ways of determining the rate of return on an investment yielding cashﬂows

(positive or negative) C

0

, C

1

, . . . , C

n

occurring at times t

0

, t

1

, . . . , t

n

:

1. the internal rate of return i = v

−1

− 1 > −1 is such that v is a positive real root to the

equation

n

k=0

v

t

k

C

k

= 0;

2. if A is the initial amount of the portfolio, B is its ﬁnal amount, and 0 < t

0

< t

1

< · · · < t

n

< 1,

then the net interest earned in the fund is I = B−[A +

n

k=1

C

t

k

] and the dollar-weighted

rate of return is

i =

I

A +

n

k=1

C

t

k

(1 −t

k

)

;

3. if V

t

k

is the value of the portfolio at time t

k

just after interest has been credited but before

contributions or withdrawals have been made, then the time-weighted rate of return is

i =

_

n

k=1

V

t

k

V

t

k−1

+C

t

k−1

_

1/(tn−t

0

)

− 1.

6 Term structure of interest rates

Let the term structure of zero-coupon bonds be {s

[0,t]

}

t≥0

, then the one-year forward rate of

interest for n − 1 years from now is

i

[n−1,n]

=

(1 +s

[0,n]

)

n

(1 +s

[0,n−1]

)

n−1

− 1.

5

7 Cashﬂow duration and immunization

If a series of n payments K

1

, K

2

, . . . , K

n

occurring at times 1, 2, . . . , n, respectively, is evaluated at

price P at time 0, then the Macaulay duration (also called just duration) is calculated through

the formula

D = −

dP

dj

P

1+j

=

n

t=1

tK

t

v

t

j

P

,

and the modified duration is found by

MD = −

dP

dj

P

=

n

t=1

tK

t

v

t+1

j

P

.

As a result, the Macaulay and the modiﬁed durations of a coupon bond are respectively

D =

Fr(Ia)

n j

+nCv

n

j

Fr a

n j

+Cv

n

j

and

MD =

Frv

j

(Ia)

n j

+nCv

n+1

j

Fr a

n j

+Cv

n

j

.

(Remembering the last two formulae is optional for this course.)

If the current term structure {s

[0,t]

}

t≥0

is used to evaluate the modiﬁed duration of cashﬂows

K

1

, K

2

, . . . , K

n

occurring at times 1, 2, . . . , n, respectively, then we have

P =

n

t=1

K

t

(1 +s

[0,t]

)

−t

.

and

MD = −

dP

dj

P

=

n

t=1

tK

t

(1 +s

[0,t]

)

−(t+1)

n

t=1

K

t

(1 +s

[0,t]

)

−t

.

Redington immunization is in place, if

1. PV

A

(i

0

) = PV

L

(i

0

);

2.

d

di

PV

A

(i)

¸

¸

¸

i=i

0

=

d

di

PV

L

(i)

¸

¸

¸

i=i

0

;

3.

d

2

di

2

PV

A

(i)

¸

¸

¸

i=i

0

>

d

2

di

2

PV

L

(i)

¸

¸

¸

i=i

0

.]

6

then the present and future values of a continuous annuity paying h(t) at time t are respectively n an δ u = ¯ 0 h(t)e− Rt 0 δu du dt. 2 .2 Valuation of annuities Present value Future value sn i = sn i ¨ (1 + i)n − 1 i (1 + i)n − 1 i = = sn i d d i (1 + i)n − 1 = sn i δ δ (1 + i)n − 1 i = = (m) sn i i(m) i (1 + i)n − 1 i = (m) sn i (m) d d Level annuity-immediate Level annuity-due Level continuous annuity m-thly payable annuity-immediate m-thly payable annuity-due k-period deferred annuity Perpetuity(-immediate) Perpetuity-due Increasing annuity-immediate Increasing annuity-due Continuously increasing continuous annuity Decreasing annuity-immediate Decreasing annuity-due Continuously decreasing continuous annuity an i = an i ¨ 1 − vn i 1 − vn i = = an i d d i 1 − vn = an i δ δ 1 − vn i = (m) = (m) an i i i 1 − vn i = (m) an i (m) d d an i = ¯ an i (m) sn i = ¯ sn i (m) an i = ¨ (m) sn i = ¨ (m) k| an i = v k an i 1 i 1 d (Ia)n i = (I¨)n i a ¯a (I¯)n i an i − nv n ¨ i an i − nv n ¨ i = = (Ia)n i d d an i − nv n ¯ = δ n − an i i n − an i i = = (Da)n i d d n − an i ¯ = δ (Is)n i = (I s)n i ¨ ¯¯ (I s)n i sn i − n ¨ i sn i − n ¨ i = = (Is)n i d d sn i − n ¯ = δ n(1 + i)n − sn i i n(1 + i)n − sn i i = = (Ds)n i d d n n(1 + i) − sn i ¯ = δ (Da)n i = (D¨)n i a ¯a (D¯)n i (Ds)n i = (D¨)n i s ¯s (D¯)n i If the force of interest varies in time.

3 . P Rt =Kt − It . the total principal repaid is n n P Rt = t=1 t=1 (Kt − It ) = L. we have for t = 1. Thus. . and its prospective form is n OBt = j=t+1 v j−t Kj . and they are related by sn δu = e ¯ δu du an δ u . 2. Once the loan is completely payed oﬀ. and the total interest paid is n n It = t=1 t=1 Kt − L.) v k an =an+k − ak =k| an i an i =(1 + i)an i ¨ an i =1 + an−1 i ¨ (Da)n i + (Ia)n i =(n + 1)an i ¯a ¯a (D¯)n i + (I¯)n i =n¯n i a sn (1 + i)k =sn+k − sk sn i =(1 + i)sn i ¨ sn i =sn+1 i − 1 ¨ 3 Loan repayment Under the amortization method of a loan repayment. .and sn δu = ¯ 0 n h(t)e Rn 0 Rn t δu du dt. n where n is the term of a loan of amount L It =iOBt−1 . . OBn = 0. The retrospective form of the outstanding balance is t OBt = (1 + i)t L − j=1 (1 + i)t−j Kj . and OBt =OBt−1 − P Rt =(1 + i)OBt−1 − Kt . ¯ We also have the following relationships by placing the relevant payments on the time line. . (Students are not expected to memorize the next set of formulae but to be able to derive them when needed.

sn j st j sn j st−1 j . the present value of the loan may be calculated through Makeham’s fomula i A = M + (L − M ) j n where M = Lvj . Makeham’s formula may be obtained r P = M + (F − M ). sn j . n Letting M = F vj . redemption amount C. It =K 1 − v n−t+1 . coupon rate r. and term to maturity n is n P = F ran j + Cvj . where # of days since last coupon paid . j The price-plus-accrued at time t = k + s is Pt = (1 + j)s Pk = v 1−s (F r + Pk+1 ). Under the sinking-fund method. 4 Bond valuation The present value of a bond that has face value F. P Rt =Kv n−t+1 . It =iL − jSFt−1 = iL − jL P Rt = and OBt = L − SFt = L 1 − L (1 + j)t−1 . eﬀective yield to maturity j per coupon period. 4 . and OBt = Kan−t i .When payments are level. If a loan is repaid under the sinking-fund method and there are n remaining payments. When F = C. # of days between coupon payments The respective price quoted in the newspapers is deﬁned by s= Pricet = Pt − sF r. we also have P = F + F (r − j)an j .

n − 1. . . n Using Makeham’s formula. then the time-weighted rate of return is i= Vtk Vtk−1 + Ctk−1 k=1 n 1/(tn −t0 ) − 1. . . B is its ﬁnal amount. . . .n] = (1 + s[0. the price of a serial bond is calculated by r P = M + (F − M ). . and P Rt = F r − It .t] }t≥0 . . then the net interest earned in the fund is I = B − [A + n Ctk ] and the dollar-weighted k=1 rate of return is I i= . . . . It =jOBt−1 . 5 Measuring the rate of return of an investment The following are three ways of determining the rate of return on an investment yielding cashﬂows (positive or negative) C0 . . C1 .n] )n − 1. . if Vtk is the value of the portfolio at time tk just after interest has been credited but before contributions or withdrawals have been made. Cn occurring at times t0 . k=0 2. j where M = m k=1 Mk and F = m k=1 Fk . then the one-year forward rate of interest for n − 1 years from now is i[n−1. F r + C − It . n − 1 . and 0 < t0 < t1 < · · · < tn < 1. . tn : 1. (1 + s[0. we have OBt =(Book value)t n−t =Cvj + F ran−t j . 2. . if A is the initial amount of the portfolio. t = n t = 1. 6 Term structure of interest rates Let the term structure of zero-coupon bonds be {s[0. . . t1 . n A + k=1 Ctk (1 − tk ) 3.When amortizing a bond. the internal rate of return i = v −1 − 1 > −1 is such that v is a positive real root to the equation n v tk Ck = 0.n−1] )n−1 5 . t = 1. 2. 2. . t = 1. .

. d P VA (i) di = i=i0 d P VL (i) di . is evaluated at price P at time 0. D = − P = t=1 P 1+j and the modified duration is found by MD = − dP dj P = n t=1 t+1 tKt vj . Kn occurring at times 1. .t] ) Redington immunization is in place. n. the Macaulay and the modiﬁed durations of a coupon bond are respectively n F r(Ia)n j + nCvj D= n F r an j + Cvj and MD = n+1 F rvj (Ia)n j + nCvj .] i=i0 6 . then the Macaulay duration (also called just duration) is calculated through the formula dP n t tKt vj dj .) If the current term structure {s[0. n −t t=1 Kt (1 + s[0. 2. 2. . Kn occurring at times 1. P As a result. .t] )−t . n. K2 . .7 Cashﬂow duration and immunization If a series of n payments K1 . . . 2. n F r an j + Cvj (Remembering the last two formulae is optional for this course. . 3. respectively. . .t] }t≥0 is used to evaluate the modiﬁed duration of cashﬂows K1 . i=i0 d2 P VA (i) di2 > i=i0 d2 P VL (i) di2 . . . . . if 1. . . P VA (i0 ) = P VL (i0 ).t] ) . respectively. K2 . and MD = − dP dj P = n −(t+1) t=1 tKt (1 + s[0. then we have n P = t=1 Kt (1 + s[0.