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A&J Flashcards for

Exam FM/2
Spring 2010

Alvin Soh
Outline
I. Theory of Interest
A) Measurement of Interest
B) Valuation of Annuities
C) Yield Rates
D) Amortization and Sinking Funds
E) Pricing Common Stocks
F) Bonds
G) Advanced Financial Analysis
II. Derivatives Markets
A) Introduction to Derivatives and Risk
B) Forward Contract
C) Options
D) Contracts and Positions
E) Insurance and other Option Strategies
F) Risk Management
G) Financial Forwards and Futures
H) Swap
Theory of Interest- Measurement of Interest

Accumulation Function
Theory of Interest- Measurement of Interest

a(t )  a t 11  i  or A(t )  A t 11  i 

where

At   ka t  , k is the principal .


Theory of Interest- Measurement of Interest

Effective Rate of interest for period t  1 to t


Theory of Interest- Measurement of Interest

a (t )  a (t  1)
i
a (t  1)
Theory of Interest- Measurement of Interest

The accumulation function for simple interest.


Theory of Interest- Measurement of Interest

a t   1  it
Theory of Interest- Measurement of Interest

Effective rate of interest for Simple Interest from period t  1 to t


Theory of Interest- Measurement of Interest

a(t )  a(t  1) (1  it )  (1  i(t  1)) i


it   
a(t  1) 1  i(t  1) 1  i(t  1)

This is the reason that the effective rate of interest is decreasing as the time
of accumulation increases.
Theory of Interest- Advanced Financial Analysis

The relationship between spot rate and forward rate.


Theory of Interest- Advanced Financial Analysis

1  st 
t

 1  st 1  1  f t 1   1  st  2  1  f t  2 1  f t 1 
t 1 t 2

 1  s1 1  f1  ... 1  f t  2 1  f t 1 

where

1. st is the spot rate at at time t ;


2. f t is the t –year forward rate.
Theory of Interest- Advanced Financial Analysis

The real interest rate after inflation


Theory of Interest- Advanced Financial Analysis

1 i
1 i ' 
1 r
where

1. i is the nominal interest rate;


2. r is the inflation rate.
Theory of Interest- Advanced Financial Analysis

Macaulay Duration
Theory of Interest- Advanced Financial Analysis

 tv CF t
t
d t 1
n

 v CF
t 1
t
t
Theory of Interest- Advanced Financial Analysis

Modified Duration
Theory of Interest- Advanced Financial Analysis

d n t n
 n t 
d
di
P  v CFt 
di t 1
t 1
tv CFt   tv CFt 
v  n  n
t 1
 v  t n1   vd
 
    v CFt
P
vt CFt vt CFt t

t 1 t 1  t 1 
Theory of Interest- Advanced Financial Analysis

Convexity
Theory of Interest- Advanced Financial Analysis

d2 d n t 1 n

2
P
di
 tv CFt  t  t  1 v t 2
CFt
c  di   tn1  t 1
n

 v CFt  v CF
P t t
t
t 1 t 1
Theory of Interest- Advanced Financial Analysis

The conditions for Redington Immunization


Theory of Interest- Advanced Financial Analysis

1. PAssets  i   PLiabilities  i 
2. d Assets  i   d Liabilities  i  OR v Assets  i   v Liabilities  i 
3. c Assets  i   c Liabilities  i 
Derivatives Markets- Introductions

The purposes of Derivatives


Derivatives Markets- Introductions

1. Speculation
2. Portfolio Replication
3. Arbitrage
4. Risk Management
Derivatives Markets- Introductions

Buying Price by end users =

Selling Price by end users =


Derivatives Markets- Introductions

Buying Price by end users = Ask Price

Selling Price by end users = Bid Price

(Bank Buy : Bid Price)


Derivatives Markets- Contracts and Positions

The meaning of Long and Short positions


Derivatives Markets- Contracts and Positions

Long position
 When a trader buys an option contract that he has not already
written (i.e. sold), he is said to be opening a long position.
 When a trader sells an option contract that he already owns, he is
said to be closing a long position.
 When a trader is 'long', he/she wins when the price increases, and
loses when the price decreases.

Short position
 When a trader writes (i.e. sells) an option contract that he does not
already own, he is said to be opening a short position.
 When a trader buys an option contract that he has written (i.e. sold),
he is said to be closing a short position.
 When a trader is 'short', he/she wins when the price decreases, and
loses when the price increases.
Derivatives Markets- Contracts and Positions

Long positions using forward contract, call option and put option
Derivatives Markets- Contracts and Positions

1. Long forward contract


2. Purchased call
3. Written put
Derivatives Markets- Contracts and Positions

The profit of written put


Derivatives Markets- Contracts and Positions
Written Put Profit  PerT  max 0, K  ST 

Profit

FV(P)
0
K Asset Price
K-FV(P)

-(K- FV(P))

Written Put Profit vs. Asset Price


Derivatives Markets- Contracts and Positions

Short positions using forward contract, call option and put option
Derivatives Markets- Contracts and Positions

1. Short forward contract


2. Purchased put
3. Written call
Derivatives Markets- Contracts and Positions

The profit of written call


Derivatives Markets- Contracts and Positions
Written Call Profit  CerT  max 0, ST  K 

Profit

FV(C)
K+FV(C)
0 K Asset Price

Written Call Profit vs. Asset Price


Derivatives Markets- Contracts and Positions

Comparisons of long positions using forward contract, call option and put
option in terms of:

1. Maximum loss
2. Maximum profit
3. Range of underlying asset price such that the profit is positive
Derivatives Markets- Contracts and Positions

Method Maximum Loss Maximum Profit Positive Profit

Long forward Forward Price Unlimited ST > F

Purchased Call Future value of Unlimited ST > K+FV(C)


call premium

Written Put K – FV(P) Future value of ST > K-FV(P)


put premium