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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

where

Theory of Interest- Measurement of Interest

Theory of Interest- Measurement of Interest

a (t ) a (t 1)

i

a (t 1)

Theory of Interest- Measurement of Interest

Theory of Interest- Measurement of Interest

a t 1 it

Theory of Interest- Measurement of Interest

Theory of Interest- Measurement of Interest

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

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

where

2. f t is the t –year forward rate.

Theory of Interest- Advanced Financial Analysis

Theory of Interest- Advanced Financial Analysis

1 i

1 i '

1 r

where

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 tn1 t 1

n

v CFt v CF

P t t

t

t 1 t 1

Theory of Interest- Advanced Financial Analysis

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

Derivatives Markets- Introductions

1. Speculation

2. Portfolio Replication

3. Arbitrage

4. Risk Management

Derivatives Markets- Introductions

Derivatives Markets- Introductions

Derivatives Markets- Contracts and 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

2. Purchased call

3. Written put

Derivatives Markets- Contracts and Positions

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))

Derivatives Markets- Contracts and Positions

Short positions using forward contract, call option and put option

Derivatives Markets- Contracts and Positions

2. Purchased put

3. Written call

Derivatives Markets- Contracts and Positions

Derivatives Markets- Contracts and Positions

Written Call Profit CerT max 0, ST K

Profit

FV(C)

K+FV(C)

0 K 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

call premium

put premium

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