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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
( )( )
( ) 1 1 a t a t i = ÷ + or
( )( )
( ) 1 1 A t A t i = ÷ +
where
( ) ( )
, A t ka t k is the principal = .
Theory of Interest Measurement of Interest
Effective Rate of interest for period 1 t ÷ to t
Theory of Interest Measurement of Interest
( ) ( 1)
( 1)
a t a t
i
a t
÷ ÷
=
÷
Theory of Interest Measurement of Interest
The accumulation function for simple interest.
Theory of Interest Measurement of Interest
( )
1 a t it = +
Theory of Interest Measurement of Interest
Effective rate of interest for Simple Interest from period 1 t ÷ to t
Theory of Interest Measurement of Interest
( ) ( 1) (1 ) (1 ( 1))
( 1) 1 ( 1) 1 ( 1)
t
a t a t it i t i
i
a t i t i t
÷ ÷ + ÷ + ÷
= = =
÷ + ÷ + ÷
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
where
1.
t
s is the spot rate at at time t ;
2.
t
f is the t –year forward rate.
( )
( ) ( ) ( ) ( )( )
( )( ) ( )( )
1 2
1 1 2 2 1
1 1 2 1
1
1 1 1 1 1
1 1 ... 1 1
t
t
t t
t t t t t
t t
s
s f s f f
s f f f
÷ ÷
÷ ÷ ÷ ÷ ÷
÷ ÷
+
= + + = + + +
= + + + +
Theory of Interest Advanced Financial Analysis
The real interest rate after inflation
Theory of Interest Advanced Financial Analysis
1
1 '
1
i
i
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
1
1
n
t
t
t
n
t
t
t
tv CF
d
v CF
=
=
=
¯
¯
Theory of Interest Advanced Financial Analysis
Modified Duration
Theory of Interest Advanced Financial Analysis
1
1 1 1
1 1 1
n n n
t t t
t t t
t t t
n n n
t t t
t t t
t t t
d
d
v CF tv CF tv CF
P
di
di
v v vd
P
v CF v CF v CF
+
= = =
= = =
 


= ÷ = ÷ = = =


\ .
¯ ¯ ¯
¯ ¯ ¯
Theory of Interest Advanced Financial Analysis
Convexity
Theory of Interest Advanced Financial Analysis
( )
2
1 2
2
1 1
1 1
1
n n
t t
t t
t t
n n
t t
t t
t t
d
d
tv CF t t v CF
P
di
di
c
P
v CF v CF
+ +
= =
= =
+
= = ÷ =
¯ ¯
¯ ¯
Theory of Interest Advanced Financial Analysis
The conditions for Redington Immunization
Theory of Interest Advanced Financial Analysis
( ) ( )
( ) ( ) ( ) ( )
( ) ( )
1.
2. OR
3.
Assets Liabilities
Assets Liabilities Assets Liabilities
Assets Liabilities
P i P i
d i d i v i v i
c i c 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
 
max 0,
rT
T
Written Put Profit Pe K S = ÷ ÷
Written Put Profit vs. Asset Price
Profit
Asset Price
0
K
KFV(P)
(K FV(P))
FV(P)
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
 
max 0,
rT
T
WrittenCall Profit Ce S K = ÷ ÷
Written Call Profit vs. Asset Price
Profit
Asset Price 0
K
K+FV(C)
FV(C)
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 S
T
> F
Purchased Call Future value of
call premium
Unlimited S
T
> K+FV(C)
Written Put K – FV(P) Future value of
put premium
S
T
> KFV(P)