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(Useful formulas from Marcel Finans FM/2 Book) Compiled by Charles Lee 8/19/2010

Interest

Interest Simple Compound a(t) Period when greater The Rule of 72 The time it takes an investment of 1 to double is given by Discount Simple Compound The Method of Equated Time

Interest Formulas

Force of Interest

Date Conventions Recall knuckle memory device. (February has 28/29 days) Exact o actual/actual o Uses exact days o 365 days in a nonleap year o 366 days in a leap year (divisible by 4) Ordinary o 30/360 o All months have 30 days o Every year has 360 days o Bankers Rule o actual/360 o Uses exact days o Every year has 360 days Basic Formulas

Annuities

Basic Equations Immediate Due Perpetuity

Annuities Payable More Frequently than Interest is Convertible Let = the number of payments per interest conversion period Let = total number of conversion periods Hence the total number of annuity payments is

Coefficient of is the total amount paid during on interest conversion period Perpetuity Immediate Due

Annuities Payable Less Frequently than Interest is Convertible Let = number of interest conversion periods in one payment period Let = total number of conversion periods Hence the total number of annuity payments is Immediate Due Perpetuity

Continuous Annuities Geometric a=1 r = 1+k ki If k = i a=1 r = 1-k ki If k=i Varying Annuities Arithmetic Immediate General P, P+Q,, P+(n-1)Q Increasing P=Q=1 Continuously Varying Annuities Consider an annuity for n interest conversion periods in which payments are being made continuously at the rate and the interest rate is variable with force of interest . Perpetuity Due

Decreasing P=n Q = -1

Perpetuity

Rate of Return of an Investment Yield rate, or IRR, is the interest rate at which Hence yield rates are solutions to NPV(i)=0 Interest Reinvested at a Different Rate Invest 1 for n periods at rate i, with interest reinvested at rate j Invest 1 at the end of each period for n periods at rate i, with interest reinvested at rate j Invest 1 at the beginning of each period for n periods at rate i, with interest reinvested at rate j

Uniqueness of IRR Theorem 1 Theorem 2 Let Bt be the outstanding balance at time t, i.e. o o Then o o

Dollar-Weighted Interest Rate A = the amount in the fund at the beginning of the period, i.e. t=0 B = the amount in the fund at the end of the period, i.e. t=1 I = the amount of interest earned during the period ct = the net amount of principal contributed at time t C = ct = total net amount of principal contributed during the period i = the dollar-weighted rate of interest Note: B = A+C+I Exact Equation Simple Interest Approximation Summation Approximation The summation term is tedious. Define

Time-Weighted Interest Rate Does not depend on the size or timing of cash flows. Suppose n-1 transactions are made during a year at times t1,t2,,tn-1. Let jk = the yield rate over the kth subinterval Ct = the net contribution at exact time t Bt = the value of the fund before the contribution at time t Then

Bonds

Notation P = the price paid for a bond F = the par value or face value C = the redemption value r = the coupon rate Fr = the amount of a coupon payment g = the modified coupon rate, defined by Fr/C i = the yield rate n = the number of coupons payment periods K = the present value, compute at the yield rate, of the redemption value at maturity, i.e. K=Cvn G = the base amount of a bond, defined as G=Fr/i. Thus, G is the amount which, if invested at the yield rate i, would produce periodic interest payments equal to the coupons on the bond Quoted yields associated with a bond 1) Nominal Yield a. Ratio of annualized coupon rate to par value 2) Current Yield a. Ratio of annualized coupon rate to original price of the bond 3) Yield to maturity a. Actual annualized yield rate, or IRR Pricing Formulas Basic Formula o Premium/Discount Formula o Base Amount Formula o Makeham Formula o Yield rate and Coupon rate of Different Frequencies Let n be the total number of yield rate conversion periods. Case 1: Each coupon period contains k yield rate periods o Case 2: Each yield period contains m coupon periods o

Amortization of Premium or Discount Let Bt be the book value after the tth coupon has just been paid, then Let It denote the interest earned after the tth coupon has been made Let Pt denote the corresponding principal adjustment portion

Coupon

Interest earned

Book Value

Approximation Methods of Bonds Yield Rates Exact Approximation Bond Salesmans Method

Where

Equivalently

Valuation of Bonds between Coupon Payment Dates The purchase price for the bond is called the flat price and is denoted by The price for the bond is the book value, or market price, and is denoted by The part of the coupon the current holder would expect to receive as interest for the period is called the accrued interest or accrued coupon and is denoted by From the above definitions, it is clear that

$ Flat price

Callable Bonds The investor should assume that the issuer will redeem the bond to the disadvantage of the investor. If the redemption value is the same at any call date, including the maturity date, then the following general principle will hold: 1) The call date will be at the earliest date possible if the bond was sold at a premium, which occurs when the yield rate is smaller than the coupon rate (issuer would like to stop repaying the premium via the coupon payments as soon as possible) 2) The call date will be at the latest date possible if the bond was sold at a discount, which occurs when the yield rate is larger than the coupon rate (issuer is in no rush to pay out the redemption value)

Book value

Theoretical Method 1 The flat price should be the book value Bt after the preceding coupon accumulated by (1+i)k Practical Method Uses the linear approximation

Serial Bonds Serial bonds are bonds issued at the same time but with different maturity dates. Consider an issue of serial bonds with m different redemption dates. By Makehams formula, where

Semi-theoretical Method Standard method of calculation by the securities industry. The flat price is determined as in the theoretical method, and the accrued coupon is determined as in the practical method.

Amortization Method Prospective Method o The outstanding loan balance at any time is equal to the present value at that time of the remaining payments Retrospective Method o The outstanding loan balance at any time is equal to the original amount of the loan accumulated to that time less the accumulated value at that time of all payments previously made Sinking Fund Method Whereas with the amortization method the payment at the end of each period is , in the sinking fund method, the borrower both deposits into the sinking fund and pays interest i per period to the lender. Example Create a sinking fund schedule for a loan of $1000 repaid over four years with i = 8%. If R is the sinking fund deposit, then Period Interest paid Sinking fund deposit Interest earned on sinking fund 0 17.75 36.93 57.64 Amount in sinking fund Net amount of loan

Consider a loan of at interest rate i per period being repaid with payments of 1 at the end of each period for n periods. Period Payment amount Interest paid Principal repaid Outstanding loan balance

0 1 2 3 4

80 80 80 80

Total

Stock Preferred Stock o Provides a fixed rate of return o Price is the present value of future dividends of a perpetuity o Common Stock o Does not earn a fixed dividend rate o Dividend Discount Model o Value of a share is the present value of all future dividends o Short Sales In order to find the yield rate on a short sale, we introduce the following notation: M = Margin deposit at t=0 S0 = Proceeds from short sale St = Cost to repurchase stock at time t dt = Dividend at time t i = Periodic interest rate of margin account j = Periodic yield rate of short sale Duration Method of Equated Time (average term-to-maturity) o where R1,R2,,Rn are a series of payments made at times 1,2,,n Macaulay Duration o , where o is a decreasing function of i Volatility (modified duration) o o o if P(i) is the current price of a bond, then Convexity o

Modified Duration and Convexity of a Portfolio Consider a portfolio consisting of n bonds. Let bond K have a current price , modified duration , and convexity . Then the current value of the portfolio is The modified duration of the portfolio is

Similarly, the convexity of the portfolio is Thus, the modified duration and convexity of a portfolio is the weighted average of the bonds modified durations and convexities respectively, using the market values of the bonds as weights.

Redington Immunization Effective for small changes in interest rate i Consider cash inflows A1,A2,,An and cash outflows L1,L2,,Ln. Then the net cash flow at time t is Immunization conditions We need a local minimum at i o The present value of cash inflows (assets) should be equal to the present value of cash outflows (liabilities) o The modified duration of the assets is equal to the modified duration of the liabilities o The convexity of PV(Assets) should be greater than the convexity of PV(Liabilities), i.e. asset growth > liability growth

Interest Yield Curves The k-year forward n years from now satisfied where it is the t-year spot rate

Full Immunization Effective for all changes in interest rate i A portfolio is fully immunized if Full immunization conditions for a single liability cash flow 1) 2) 3) Conditions (1) and (2) lead to the system

Dedication Also called absolute matching In this approach, a company structures an asset portfolio so that the cash inflow generated from assets will exactly match the cash outflow from liabilities.

Option Styles European option Holder can exercise the option only on the expiration date American option Holder can exercise the option anytime during the life of the option Bermuda option Holder can exercise the option during certain prespecified dates before or at the expiration date Buy Write

Long Forward

Short Forward

Call Put

Long Call

Payoff Profit Price at Maturity

Short Call

Floor own + buy put Cap short + buy call Covered Call stock + write call = write put Covered Put short +write put = write call Cash-and-Carry buy asset + short forward contract Synthetic Forward a combination of a long call and a short put with the same expiration date and strike price Fo,T = no arbitrage forward price Call(K,T) = premium of call Put-Call Parity

Long Put

Short Put

Derivative Position Long Forward Short Forward Long Call Short Call Long Put Short Put

Maximum Loss -Forward Price Unlimited -FV(Premium) Unlimited -FV(Premium) FV(Premium) Strike Price

Maximum Gain Unlimited Forward Price Unlimited FV(Premium) Strike Price FV(Premium) FV(Premium)

Position wrt Underlying Asset Long(buy) Short(sell) Long(buy) Short(sell) Short(sell) Long(buy)

Strategy Guaranteed price Guaranteed price Insures against high price Sells insurance against high price Insures against low price Sells insurance against low price

(Buy index) + (Buy put option with strike K) = (Buy call option with strike K) + (Buy zero-coupon bond with par value K) (Short index) + (Buy call option with strike K) = (Buy put option with strike K) + (Take loan with maturity of K)

Spread Strategy Creating a position consisting of only calls or only puts, in which some options are purchased and some are sold Bull Spread o Investor speculates stock price will increase o Bull Call Buy call with strike price K1, sell call with strike price K2>K1 and same expiration date o Bull Put Buy put with strike price K1, sell put with strike price K2>K1 and same expiration date o Two profits are equivalent (Buy K1 call) + (Sell K2 call) = (Buy K1 put) + (Sell K2 put) o Profit function

Long Box Spread Bull Call Spread Bear Put Spread Synthetic Long Forward Buy call at K1 Sell put at K1 Synthetic Short Forward Sell call at K2 Buy put at K2 Regardless of spot price at expiration, the box spread guarantees a cash flow of K2-K1 in the future. Net premium of acquiring this position is PV(K2-K1) If K1<K2, then lending money Invest PV(K2-K1), get K2-K1 If K1>K2, then borrow money Get PV(K1-K2), pay K1-K2 Butterfly Spread An insured written straddle Let K1<K2<K3 o Written straddle Sell K2 call, sell K2 put o Long strangle Buy K1 call, buy K3 put Profit o Let F o

Bear Spread o Investor speculates stock price will decrease o Exact opposite of a bull spread o Bear Call Sell K1 call, buy K2 call, where 0<K1<K2 o Bear Put Sell K1 put, buy K2 put, where 1<K1<K2 Payoff Profit K2-K1-FV[ PT PT K1 K2 -FV[

K2-K1

Collar Used to speculate on the decrease of the price of an asset Buy K1-strike at-the-money put Sell K2-strike out-of-the-money call K2>K1 K2-K1 = collar width

Profit Function

Collared Stock Collars can be used to insure assets we own Buy index Buy at-the-money K1 put Buy out-of-the-money K2 call K1<K2 Zero-cost Collar A collar with zero cost at time 0, i.e. zero net premium

Profit Function

Straddle A bet on market volatility Buy K-strike call Buy K-strike put

Profit Function

Strangle A straddle with lower premium cost Buy K1-strike call Buy K2 strike put K1<K2

Profit Function

Equity-linked CD (ELCD)

Can financially engineer an equivalent by Buy zero-coupon bond at discount Use the difference to pay for an at-the-money call option

Prepaid Forward Contracts on Stock Let FP0,T denote the prepaid forward price for an asset bought at time 0 and delivered at time T If no dividends, then FP0,T = S0, otherwise arbitrage opportunities exist If discrete dividends, then o If continuous dividends, then o Let =yield rate, then the and 1 share at time 0 grows to eT shares at time T Forward Contracts Discrete dividends o Continuous dividends o Forward premium = F0,T / S0 The annualized forward premium satisfies o If no dividends, then =r If continuous dividends, then =r-

Financial Engineering of Synthetics (Forward) = (Stock) (Zero-coupon bond) o Buy e-T shares of stock o Borrow S0e-T to pay for stock o Payoff = PT F0,T (Stock) = (Forward) + (Zero-coupon bond) o Buy forward with price F0,T = S0e(r-)T o Lend S0e-T o Payoff = PT (Zero-coupon bond) = (Stock) (Forward) o Buy e-T shares o Short one forward contract with price F0,T o Payoff = F0,T o If the rate of return on the synthetic bond is i, then S0e(i-)T = F0,T or Implied repo rate

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