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Financial Mathematics

December 16, 2013

1
1.1

The Measurement of Interest


Accumulation function
a(t) a(t 1)
a(t 1)
A(t) A(t 1)
it =
A(t 1)
A(t) = k a(t)
it =

Under simple interest


a(t) = 1 + it
i
it =
1 + i(t 1)
Under compound interest
a(t) = (1 + i)t
1
PV =
a(t)

1.2

Effective Rate of Discount


a(t) a(t 1)
a(t)
d
i=
1d
i
d=
= iv
1+i
1d=v
dt =

i(m)
1+
m

1+i=

!m

i(m) = m[(1 + i)1/m 1]

d(m)
1
m

1d=

!m

d(m) = m[1 (1 d)1/m ]

1.3

Force of Interest
1 d
a(t)
a(t) dt
1 d
=
A(t)
A(t) dt

t =

Rt

a(t) = e

s ds

Constant force of interest: e = 1 + i

1.4

Power Series
x2 x3
+
+ ...
2
3
x2 x3
+
...
ln(1 + x) = x
2
3
ex = 1 + x +

1.5

Variable Force of Interest


PV =

R t2
a(t1 )
= e t1 t dt
a(t2 )

Solutions of Problems in Interest

No formulas

Basic Annuities
S = (f irst term)

3.1

[1 (ratio)N ]
1 ratio

Annuities
1 vn
i
1 vn
a
n =
d
a
n = (1 + i)an = an1 + 1
an =

3.2

Accumulated values
(1 + i)n 1
i
(1 + i)n 1
sn =
d
sn = (1 + i)sn = sn+1 1
sn =

3.3

Deferred annuities/perpetuities
= v m an = am+n am
1
a =
i
1
a
n =
d
1 1
=1
d
i
m| an

3.4

Annuity tricks
a2n
= 1 + vn
an
a2n = an + v n an
= (1 + v n )an
a3n = an + v n an + v 2n an
= (1 + v n + v 2n )an

4
4.1

More General Annuities


m-thly annuities
(m)

an

(m)

sn

1 vn
i
(m)
= (m) an = s1 an
(m)
i
i
(1 + i)n 1
=
i(m)
=

(m)

a =
(m)

(m)

a a
=

a
n =

4.2

i(m)
1
m
1 vn

Payments in arithmetic progression


an nv n
i
with P =first payment, Q=common difference
sn n
S = P sn + Q
i

A = P an + Q

Increasing annuities
a
n nv n
i
sn n
(Is)n =
i
sn1 (n + 1)
=
i

(Ia)n =

Decreasing annuities
n an
i
n(1 + i)n sn
(Ds)n =
i
(Ia)n + (Da)n = (n + 1)an
(Da)n =

Increasing perpetuities
1
1
1
= + 2
id
i
i
1
= 2
d

(Ia) =
(I
a)

Increasing payment up to n and level payments of n afterwards


P V (1, 2, 3, . . . , n, n, n, . . .) =

4.3

a
n
i

May God Have Mercy On Your Soul


(m)

(Ia)n

(m)

a
n nv n
i(m)


1
1 2
2 3
= PV
,..., , ,..., , ,...
m
m m
m m
=

(m)
(m) a
n nv n
=
a
(m)
n
i

1 2 3
,
,
,...
= PV
m2 m2 m2


n nv n
a = a
I
n

4.4

Payments in geometric progression

P V (1, (1 + k), (1 + k)2 , . . .) =

1+k
1+i

n

ik
=va
n i0

with 1 + i0 =

1+i
1+k

Annual payment f (t) (and variable force of interest t )


Z n
PV =
f (t)v t dt
Z0 n
Rt
PV =
f (t)e 0 r dr dt
0

Palindromic annuity
n
P V (1, 2, 3, . . . , n 1, n, n 1, . . . , 3, 2, 1) = an a
P V (1, 2, 3, . . . , n 1, n, n, n 1, . . . , 3, 2, 1) = an+1 a
n

5
5.1

Yield Rates
Reinvestment rates

Option 1: Deposit of 1, into fund earning i, interest is reinvested at i0 .


AV = 1 + i sn

i0

Option 2: Yearly deposits of 1, into fund earning i, interest reinvested at i0 .


AV = n + i (Is)n

5.2

i0

Interest measurement of a fund

2I
A+BI
with A = amount at beginning, B = amount at end and I = interest earned.
i=

5.3

Dollar-weighted and time-weighted rates

E.g. Invest A at start (grows to A+x halfway) and B halfway


- Dollar-weighted


i
A(1 + i) + B 1 +
=C
2
- Time-weighted
C
A+x

=1+i
A
A+x+B

5.4

Portfolio methods and investment year methods


- Portfolio method:

All members of the club, regardless of when they began to invest, get the
same yield rate.
- Investment year method (IYM):
Interest is credited in a way that recognizes when a member joined the club.

Amortization Schedules and Sinking Funds

6.1

Amortizing a loan

Duration
t

Payment
R

Interest Paid
It = iBt1

Principal Repaid
Pt = R It

Oustanding Principal
Bt = Bt1 Tt

an

ian = 1 v n

vn

an v n = an1

2
..
.

1
..
.

ian1 = 1 v n1
..
.

v n1
..
.

an1 v n1 = an2
..
.

t
..
.

1
..
.

iant+1 = 1 v nt+1
..
.

v nt+1
..
.

ant+1 v nt+1 = ant


..
.

ia1 = 1 v

a1 v = 0

Total

n an

an

With payments of

L
an

, the amounts in year t can be expressed as:



L
1 v nt+1
an
L nt+1
Pt =
v
an
L
Bt =
a
an nt
It =

6.2

Sinking funds
- Interest rate on loan = i
Interest rate on sinking fund = j
- Periodic interest payment on loan = It = i B0
- Periodic sinking fund deposit SF D =
- Total periodic payment R = i B0 +

B0
sn j

B0
sn j

- Total loan amount B0 = (R i B0 ) sn

- Principal repaid Pt = (1 + i)Pt1 + (Rt Rt1 )

7
7.1

Bonds
Price of a Bond

If C is the redemption value, F the face amount and r the coupon rate,
then:
P = F r an i + Cv n
If F r = Cg (usefull when n is unknown),
P = C + (F r Ci)an
and
P =

7.2

g
(C Cv n ) + Cv n
i

Premium and discount


- If g > i: Premium = P C
call at earliest date
- If g < i: Discount = C P
call at latest date

Amortization of premium Pt = (F r Ci)v nt+1

7.3

Price between coupon dates


- Price actually paid on date of purchase
Bt+k = Bt (1 + i)k
= (Bt+1 + F r)v 1k
- Quoted price (excl. accrued interest)
P = Bt+k kF r
= Bt (1 + i)k kF r
- Actual/Actual method for government bonds
30/360 method for corporate bonds
- Bond salemans method
Total interest = n Cg + C P
n Cg + C P
Average interest =
n
1
Average investment = (P + C)
2
Approximate yield rate per period i =

n Cg + C P
n
2 (P + C)

Financial Instruments

Price of a share of stock



P V D, D(1 + k), D(1 + k)2 , . . . =
Price of a U.S. T-Bill

9
9.1

D
ik


n 
P = 100 1
d
360

More Advanced Financial Analysis


Inflation, spot and forward rate

If i0 is the real interest rate and r the inflation rate,


1 + i0 =

1+i
1+r

If st is the spot rate up to year t and ft is the forward rate between year t
and t + 1,
(1 + st+1 )t+1 = (1 + st )t (1 + ft )
X CFt
P =
(1 + st )t
t

9.2

Duration
- Macaulay duration
P
t
t t v CFt
D= P
t
t v CFt
- Modified duration
D
P 0 (i)
=
P (i)
1+i
P (i + i) P (i) M odD P i
M odD =

- Portfolio duration
D=

9.3

P1 D1 + P2 D2 + P3 D3
P1 + P2 + P3

Convexity
P
C=

tt

(t + 1) v t+2 CFt
P t
t v CFt

P (i + i) P (i) M odD P i +

1
C P i2
2

9.4

Immunization

Redington immunization
- P V (assets) = P V (liabilities)
- PA0 = PL0
- PA00 = PL00
Full immunization
- P V (assets) = P V (liabilities)
- PA0 = PL0
- One asset CF before and one after liability CF
Interest-sensitive cash flows
P (i h) P (i + h)
2hP (i)
P (i + h) + P (i h) 2P (i)
Ef f ective convexity =
h2 P (i)
Ef f ective duration =

10

Introduction to Derivatives

No formulas

11

Forward Contracts
F orward = ST K

12

Options
- Call options
P ayof f (Call) = (ST K)+
P rof it(Call) = (ST K)+ F V [C(K, T )]
- Put options
P ayof f (P ut) = (K ST )+
P rof it(P ut) = (K ST )+ F V [P (K, T )]
- Put-Call Parity
C(K, T ) P (K, T ) = S0 eT KerT

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