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.

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