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Original Title: Financial Mathematics Lecture Notes Using the SOA/CAS FM Syllabus and Problems

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You are on page 1of 320

Problems

Version 2-2

(c) Fall 2015

Table of Contents

0 - Preface (includes, goals, features of the book,

abbreviations, approach to pedagogy)

1 – Calculators

2 - Money Growth

3 – (IRR) – Internal Rate of Return

4 – Time and Dollar Weighted Methods

5 - Periodic Payments

6 – Increasing Decreasing Annuity

7 - Inflation

8 – Miscellaneous Annuities

9 – Amortization

10 – Amortization Problems

11 – Bonds

12 - Reinvestment

13 - Stocks, Margin, Spot, Forward, Term Structure

14 – Callable Bonds

15 – Duration Convexity

16 –Full Immunization

17 – Insurance, Puts, Calls, Forwards

18 – Introduction to Derivatives

19 – Derivatives - Graphing Methods

20 – Call Put Parity

21 –Arbitrage

22 – Swaps

23 – Appendix (two dozen derivatives)

Solutions to Selected Problems

0.1. PREFACE TO VERSION 2-1 i

• This preface has 5 goals. To present:

typos and sharpening of proofs

• I published the first version of my book in Spring 2012

remove all typos

• However I was badly hospitalized in Summer 2012 and did not get to

correct the many typos that semester

• I didn’t fully recover from the anemia I had till Dec 2014

• So I went through the book this semester and published this version

2-1

• I believe this version relatively free from errors with correct worked

out solutions and good verbal proofs

provements

• This version

ii

• I plan to update this book every semester

all improvements

home page

• The following feautures of this book cannot be found in other current

books:

utive brain function

Calculator, Name/Classification, English Conventions

internet rule of F

0.6. II: GOOD FEATURES OF THIS BOOK (FOUND IN OTHER BOOKS)iii

books)

• Emphasis on live SOA problems

• This book can be used for a 15 week, 2-day a week course

• We now describe in more details the unique features mentioned above

• Executive function refers to the brain’s ability to solve a problem with

two or more cognitive areas

iv

tion

• The following paper of mine outlines my views on executive function

and pedagogy

• http://www.iiisci.org/journal/sci/FullText.asp?var=&id=SA135EN14

0.11 Modularization

• Throughout the text we emphasize breaking big problems into smaller

component parts

timelines

and TSP

0.12 Rule of 6

• Every concept in the course should be approached from 6 points of

view

verbal problems associated with this concept

0.13. USE OF VERBAL DERIVATIONS v

• Some problems are difficult because students are looking for the for-

mula

• When instead the hard part of the problem are the English conventions

or its classification

• We derive many important formulae verbally

math

• The book has 22 chapters

course)

• This book is not written in prose; rather it is written in a bulleted

fashion

vi

• Studies have shown that when people read web pages they do not read

it as prose

• They read down the page skimming the first few words of each line

tent specific items

• We next describe features of this book addressing actuarial content

• In some books problems are too easy, for example, plug ins

integrated

slides 4.16, 5.32, 9.19

0.18. CALCULATOR - REVIEW OF NEEDED SKILLS vii

• Several books have review of needed calculator skills

quently seen arithmetic functions

Value, IRR, and Amortization

riod are different

• Traditional interest theory knows of monthly payments

monthly rate

• The special symbols are however defined but their formulae are not

necessary to solve verbal problems

• We cover all course material without ever mentioning geometric series

at the adjusted inflation rate

viii

tives

• Many derivative problems can be solved without profit tables

is sufficient

require profit tables

equations

• All derivative problems can be broken into 3 building blocks

• The building blocks can then mechanically be unified for a final table

joins

• Throughout this book we use abbrevitations

0.24. ABBEVIATIONS ix

• http://www.soa.org/education/exam-req/syllabus-study-materials/edu-

multiple-choice-exam.aspx

0.24 Abbeviations

• e.g. M01#3 means Question 3 on the May 2001 exam

• In addition to past exams

• Q-IT: http://www.soa.org/files/edu/2015/edu-2015-exam-fm-ques-theory.pdf

• S-IT: http://www.soa.org/files/edu/2015/edu-2015-exam-fm-sol-theory.pdf

• D-SQ: http://www.soa.org/files/edu/edu-2014-10-exam-fm-ques.pdf

• D-SA: http://www.soa.org/files/edu/edu-2014-10-exam-fm-sol.pdf

x

Chapter 1

Calculators

• I) Calculator Importance

• III) A) Formatting

• X) D) Mentally checking

1

2 CHAPTER 1. CALCULATORS

• Course goals include both

• Each decade has different technologies available

edge

challenging

it is no longer challenging

• BA II Plus is preferred

• On SOA and CAS exams they allow: BA 35, TI-30XA, TI-30X II,

TI-30X

req/exam-day-info/edu-calculators.aspx

1.5. MINIMUM CALCULATOR KNOWLEDGE 3

• Do we have to be calculator experts?

• A) Formatting

• B) Order of operations

ory, iii) Order of Operations

item The above five items - A - E - will be used throughout the course

• Two other special calculator items will be covered later when dis-

cussing their specific content

Value

• G) Amortization Worksheet

• Calculator has 9 rows and 5 columns

first

4 CHAPTER 1. CALCULATORS

• Examples in this section follow the BA II Plus/Professional Keyboard

• Those with other keyboards should adjust their notes

• Some important buttons are: on-off, clear, 2nd function key, ex-

ponential, logarithm, power

• You should know where the buttons for each of these functions is

• On-off at (1,5); clear at (-1,1)

• 2nd Function key at (2,1);

• So (-4,1) gives logarithm; 2(-4,1) gives exponential function

(5,4) gives powers

• Goal: Readability, rounding, accuracy (Discussion: Why?)

• Wrong: 1/3 = .33

• Wrong: 1/3=.33333333333

• Preferred: 1/3 = 0.3333

• A course requirement on exams and homework for a perfect score is

4-place accuracy.

• To Enter Format window: 2(-1,3)

• To Navigate with Control Arrows: (1,3), (1,4)

• Use arrows until DEC appears

• Hit keys: 4 ENTER (1,2)

• This sets all computations to 4 decimal places.

• To leave formatting window: QUIT 2(1,1)

1.11. IV) B) ORDER OF OPERATIONS - (REVIEW) 5

• Goal: Make calculator usage consistent with the way we think

• Example: Consider 2 + 3 × 4.

• There are two methods to compute 2 + 3 × 4.

• CHN: Chain method refers to sequential operations

• In the above example, the Chain method does addition 1st, multipli-

cation 2nd

• AOS is Based on 5 principles

• 1) Do Exponentation 1st

• 2) Do Multiplication/Divisions 2nd

tially left to right

left

6 CHAPTER 1. CALCULATORS

• multiplication 1st

• addition 2nd

• (2 + 12 = 14)

• Enter FORMAT, 2(-1,3)

• Quit, 2(1,1)

• Example: Calculate 1

1.013

= 1.01−3

1.17. THE THREE METHODS - A,B,C 7

• a) 1.01yx 3± =

• The keystrokes are 1.01 (5,4) (-2,4) (-1,4) (-1,5)

• yx is found at (5,4)

• b) 1.01yx 3=; 1/x

• 1/x is found at (4,4)

• Note: You do not have to enter = after 1/x

• c) 1/1.01yx 3=

• Note the different locations of = in methods (a) and (b)

• There are 3 primary calculation methods

• a) Natural-Parenthesis. This method is a frequent source of error

on calculators

• b) Memory. This is an alternative to Parenthesis

• c) Order of Operations This is another alternative to Parenthesis

• Best practice is to select a method and develop habits now

1−1.01−3

• Example: 0.01

• Answer: 2.9410

tion Method

• Correct: (1 − 1.01yx 3±)/.01=

• Common Parenthesis error. 1 − 1.01yx 3±/.01= − 96.0590

8 CHAPTER 1. CALCULATORS

• The key to the Memory method is use of the STO, RCL keys (store,

recall )

• 1 − 1.01yx 3± = STO7

• 0.01 = STO 4

• RCL 7 / RCL 4 =

• Some students use this method but do not use the STO keys

• See the last section, section XIV, in this chapter for advanced memory

methods

1.24. IX) DC) OPERATION-ORDER CALCULATION METHOD 9

• To use the operation-order calculation method one has to enumerate

operations

1−1.01−3

• The example 0.01 uses 3 operations . . .

• i) The exponentiation

• The order of operations is as listed in the last slide

• The division is done last because the fraction symbol is like parenthesis

• After performing an analysis of order of operations, we sequentially

perform them

in the display window?

• ±+1=

• / .01=

10 CHAPTER 1. CALCULATORS

• Mentally checking is not part of the syllabus

a good actuary.

• Why check?

• Bernoulli’s law is a required part of the syllabus for one course topic

• Theorem: For small values of x, y,(1 + y)x ≈ 1 + yx

x(x−1) 2

• (1 + y)x = 1 + xy + 2 y ...

• Example 1. 1.015 ≈ 1.05

√ 1

1

• Example 2. .9 = (1 − .1) 2 ≈ 1 − 2 × 0.1 = 0.95.

• How would we check the following

1−1.01−3

• Example: .01 = 2.9410.

1.31. XI) TIMELINE - COMPOUND INTEREST 11

.03

• Step #3) Calculate denominator: .01 =3

• The Timeline is a powerful geometric aid

• Sample question: How much is 1,000 worth in 2 years in a 10 percent

account?

• Suppose the bank agrees to give you 10 percent of your account value

each year

• Then at the end of the year the bank pays 10% × $1, 000 = $100 in

your account

• Now that we understand this basic setup let us look more deeply

12 CHAPTER 1. CALCULATORS

• Year 1. 1000 + 10%1000 = 1.1 × 1000 = 1100

• A similar calculation would apply if one left the money for a 3rd year

• At the end of the 3rd year you would have 1.1 × (1.12 × 1000) =

1.13 × 1000.

years.

•

A(t) = A(0)(1 + i)t (1.1)

• t is the number of years the money lies in for example the bank

• A(1) = 1000(1 + .1)1

1.36. THE GEOMETRIC DIAGRAM 13

• The following diagram summarizes all calculations

• Timeline

0 1 2

• The other row indicates the balance in the account at that time

• So for example the account has 1000 at time 0 and 1100 at time 1.

• The Time Value Worksheet is found on Row 3 of your calculator

• All four problems come from one basic situation

A(2) 1210

• Find A(0) : Solution: (1+i)2

= 1.21

14 CHAPTER 1. CALCULATORS

1

2

A(2) A(2)

• Find i : Solution: A(0) = (1 + i)t ; 1 +i= A(0)

A(t) A(t)

• Find t : Solution: A(0) = (1 + i)t ; t log(1 + i) = log A(0)

1.39 TV Timeline

• Basic idea. Enter any 3 of 4 numbers; then compute 4th number.

• Find A(0)

• Solution.

2 10 CPT 0 1210

N I/Y PV PMT FV

keystrokes:

• 2 (3,1)

1.40 TV Signs +, −

• How do you determine +, −.

• At t = 0 you give me, the bank, 1000, and hence, you lose, 1000.

1.41. TV KEYSTROKES - FURTHER EXAMPLES 15

• Find i

• Solution.

2 CPT − 1000 0 1210

N I/Y PV PMT FV

• Find t

• Solution

CPT 10 − 1000 0 1210

N I/Y PV PMT FV

• Suppose I wanted to check what I entered

• You use the RCL button

• For example RCL N places 2 in the display window since N = 2 years

• It is always good to check your entries.

1.43 Summary

• TV allows you to press 3 buttons to solve for a 4th unknown amount

• TV is faster than algebra!

• Using the TV worksheet is a basic skill

• The Timeline is a basic geometric aid

• MEMORY 2(-1,2)

• Use ARROWS (1,3) (1,4)

• You can see values in all 10 memory locations

16 CHAPTER 1. CALCULATORS

• Three types of clearing

• Use CLEAR when you want to correct a typo and not start over

• (3) On-off Clears typos/starts over, but does not clear memory cells!

Chapter 2

Money Growth

• We have 13 sub-goals to meet in this chapter

• X) Discount factor, v

• XII) Rule of 6

17

18 CHAPTER 2. MONEY GROWTH

ogy

• Principle A(0) : You go into a bank and deposit $1,000

• Interest rate i : The bank agrees to pay you 10% per year for your

money

t = s − 1 to t = s.

• Interest Period: The interest period - the time interval to which the

10% applies - is the year

• Payment Period: The bank will pay you the interest at the end of

each year.

period.

• Note that in our example, the interest period and payment period are

the same.

$1000 × 10% = $100

earned from time t = s − 1 to time t = s.

•

A(s) − A(s − 1) = Is = is × A(s − 1) (2.1)

indicated by Is,t , with

you have accumulated A(1) = $1, 100.

2.2. I) DEFINITINS, BANK BACKGROUND AND TERMINOLOGY 19

accumulation function, a(t).

A(t)

• a(t) is defined by a(t) = A(0) .

further deposits, becomes the $1,100 at time t = 1.

values at two different times

• Simple interest: When you withdraw the interest from the bank and

leave the principle

• The compound interest rate is also called the effective annual rate

Current Value(CV):

• We use the English phrase Present Value to refer to A(0) = $1, 000

20 CHAPTER 2. MONEY GROWTH

t to refer to A(t).

at time t = 2.

1+i

rates

What changes?

• There are seven methods to describe interest or money growth

• In every interest method three things remain the same and two things

change

time t

lated from s to t.

• #4) In all methods there is some symbol describing the rate of growh.

• Some typical symbols are i for interest, d for discount and δ for force.

2.4. 7 INTEREST METHODS 21

• #5) In each problem, the algebraic formula relating A(t) with A(0), t

and i, d, or δ changes.

relating A(0), A(n)

• In this chapter, we will explore the following 7 methods:

ple discount, nominal interest, nominal discount, force.

• This is a review of Chapter 1.

interest rate i,

22 CHAPTER 2. MONEY GROWTH

• Suppose the bank pays 10% per year payable twice a year.

• By convention, this means that you earn 5% each six months

• We call this 10% interest in name or nominal interest

• Why is it called interest in name?

• Because you never use 10% in any calculations. Rather you use 5%.

• So the 10% is in name only.

• So A(0) = $1, 000, A(0.5) = 1.05 × $1, 000 = $1, 050, . . .

• . . . A(1) = 1.05 × $1, 050 = $1, 102.50, etc.

• We use the symbol i(2) = 10% to indicate nominal interest payable

twice a year.

•

i(m)

rate of i(m) payable m times a year ←→ interest rate of every m-th of a year

m

(2.4)

• So the accumulation formula becomes

i(m) mn

A(n) = A(0) 1 + (2.5)

m

• payable twice a year, nominal rate payable twice a year, compounded

twice a year, convertible twice a year, i(2) .

count method

• Timeline.

A(0) A(1)

0 1

2.8. FORMULA FOR A(N ) 23

•

I = A(1) − A(0), the interest amount (2.6)

•

I

i= , the interest rate (2.7)

A(0)

•

I

d= , the discount rate (2.8)

A(1)

• Interest and discount are two ways to describe the same situation

A(0)

• A(1) = A(0) + I = A(0) + dA(1) −→ A(1) = 1−d

A(1) A(0)

• A(2) = 1−d = (1−d)2

.

• ..

•

A(0)

A(n) = (2.9)

(1 − d)n

• This is analogous to nominal compound

•

A(0)

A(n) = (2.10)

d(p) pn

(1 − p )

24 CHAPTER 2. MONEY GROWTH

• Here is a basic question:

• What is A(n)? How much total money will I have accrued at time

t = n.

• Simple interest

0 1 ... n

• Simple discount

A(0) A(0)

A(0) A(1) = ... A(n) =

1−d 1 − dn

0 1 ... n

•

A(n) = A(0)(1 + in) (2.11)

•

A(0)

A(n) = (2.12)

(1 − dn)

• Compound: Interest rate, i, is constant each year

2.14. VIII) METHOD G: FORCE 25

• Here is motivation for the concept of force, instantaneous rate of in-

terest

in calculus courses.

•

mIt,t+ 1

A(t + 1

− A(t)

1

− A(t) A0 (t)

m m) 1 A(t + m)

δt ≈ =m = 1 −→

A(t) A(t) A(t) m

A(t)

(2.13)

1 i(m)

• But A(t + m) − A(t) = m A(t)

δt ≈ i(m) (2.14)

ing the sister approximation

δt ≈ d(p) (2.15)

• As an exercise one should check the following identity, using the chain

rule, (??)

d A0 (t)

log A(t) = = δt (2.16)

dt A(t)

• Integrate both sides of (??) from Beginning time, B, to End time, E

A(E) RE

= e B δt dt (2.17)

A(B)

•

A(t) = A(0)eδt = A(0)(1 + i)t (2.18)

26 CHAPTER 2. MONEY GROWTH

•

eδ = 1 + i (2.19)

• Force Timeline

A(B) δt A(E)

B E

• All you need to know are the seven formulae in the last two slides

(which also contain perspectives)

• Timeline.

A(0) A(n)

0 n

equal.

• The following two are equivalent

rate of 9.09%

2.19. BASIC I − D FORMULAE 27

• Why are they equivalent? In both cases I = $100, A(0) = 1000, A(1) =

1100

100 100

• But 1000 = 10% while 1100 = 9.09%

• The same timeline has two different but equivalent descriptions.

• So Actuarial Equivalence is a way of saying that two different descrip-

tions are the same

• If I deposit $1 for n years, payable m times a year, (discounted p times

a year), how much do I have at t = n?

m −p

i(m) 1 d(p)

• 1+ m = 1 + i = 1−d = 1 − p

i(m) mn d(p) −pn

A(n) = A(0) 1 + = A(0) 1 − = A(n) (2.20)

m p

in parenthesis

• i(m) is called the nominal rate of interest payable or compounded m

times a year

• d(p) is called the nominal rate of discount payable or compounded p

times a year

• In any problem you may want A(0), A(n), i, d, or n.

• You simply use the basic formula relating A(0), A(n).

• Timeline.

v 1

0 1

28 CHAPTER 2. MONEY GROWTH

1

• Solving, we obtain, v = 1+i (Why?)

• 2 year timeline.

v2 v1 1

0 1 2

• n years

vn 1

0 n

•

If A(0) = v n X −→ A(n) = X. (2.21)

• v n is the present value of 1 at n.

is v n .

• Discount factor refers to v

• Although the same word is used, the meanings are totally different

2.23. USEFUL FORMULAE FOR V, D I AND D 29

•

I iA(0) i

d= = = = iv (2.22)

A(1) (1 + i)A(0) 1+i

•

i 1

1−d=1− = =v (2.23)

1+i 1+i

• Most texts explain theory well

• If you only apply theory to simple problems you are not learning, not

practicing enough

quality

• Such problems are higher cognitive since they require executive brain

function

problems, iii) comparisons

conversions required

• We shall use live problems from the public SOA/CAS exams as a

source of problems

• There are several public URLs where these problem sources may be

freely downloaded

are as follows:

30 CHAPTER 2. MONEY GROWTH

• Q-IT https://www.soa.org/Files/Edu/2015/edu-2015-Exam-FM-ques-

theory.pdf

• S-IT https://www.soa.org/Files/Edu/2015/edu-2015-Exam-FM-sol-theory.pdf

• D-SQ https://www.soa.org/Files/Edu/edu-2014-10-Exam-FM-ques.pdf

• D-SA https://www.soa.org/Files/Edu/edu-2014-10-Exam-FM-sol.pdf

Interest Theory

req/syllabus-study-materials/edu-multiple-choice-exam.aspx

• The interest theory exams are sometimes called Course 2 and some-

times Course FM

• Chapters 1 and 2 presented the theory of 7 types of interest:

discount, (constant) force

• From a theory point of view, each of these 7 types are equally on the

syllabus

involve force

and discount problems are too easy

ory

2.27. GOOD SOA/CAS EXAM PROBLEMS ON THE SEVEN INTEREST METHODS31

Interest Methods

• N00#53 - Force - compound (Comparison / Algebra)

• M01#45 - Force - nominal discount (Good comparison problem)

• M03#1 - Force - nominal (Good comparison problem)

• M01#49 -Force-nominal-simple (Comparison problem/Abstract)

• M00#37 - Force-nominal - Piecewise functions

• N01#1 - Force - Interest Amount (Algebra)

• M03#12 - Nominal - Simple Interest - Interest Amount

• Q-IT#1 - Same as M03#1

• Q-IT#21 Same as N01#28

• Q-IT#3 Same as M03#12

• N01#28 - Payment - Deposit are continuous function of t

• Q-IT#61 - Force - Substitution

• Q-IT#77 - Nominal-Nominal (Good conversion problem)

• Q-IT#79 - Force-Compound

• The Rule of 6 is an approach to learning and teaching

• The Rule of 6 applies to the entire term and all concepts and examples

in the course

• The concept of Rule of X was first articulated by Prof. Hughes-Hallet

• She made many advances in Calculus pedagogy

• She formulated the rule of 4

• Each course example is approached using i) formalism (algebra), ii)

graphs, iii) numerics iv)verbal

32 CHAPTER 2. MONEY GROWTH

• In interest theory, we will use algebraic formulas for formalism (Func-

tions are used in calculus)

tions/naming

2.30 Rule of 6

• In Interest theory each course concept and example is approached in

6 ways .

Verbal conventions

• Let us illustrate the rule of 6 using compound interest.

interest theory

glish phrase has a specific algebraic correlate

(t = 2) years in a 5% (= i) account

interest

2.32. XIII) A TYPICAL COMPARISON PROBLEM AND SOLUTION APPROACH 33

• Timeline:

A(0) i A(n)

0 n

• Calculator:

N I/Y PV PMT FV

lution approach

• We solve M01#45 in this section

equivalence)

form.

an equation whose solution solves the original problem; this equation

is called the Equation of Value or EOV

• Note the subtlety that each timeline has an equation relating its be-

ginning and terminal value

• This is different than the EOV which relates several different timelines

34 CHAPTER 2. MONEY GROWTH

• #5) Identify and algebraically solve each timeline and TV line sepa-

rately

to the end

• Since this is our first problem I will give the full text

• Notice how the formatting of the problem hints at the timelines needed

t2

• Fund X accumulates at a force of interest δt = k.

convertible semiannually.

value of Fund Y

• Determine k

• The general procedure mentioned above calls for identifying the sub-

problems first

lines as the second step

2.35. M01#45 - EQUATIONS Y 35

• X

t2

A(0) = 1 δt = AX (5)

k

0 n

• Y

0 n

•

AX (5) = AY (5).

• How do I get an equation for Y?

−2×5

d(2) =.08

• Use (??). AY (5) = 1 − 2

• How do I get an equation for X?

• Answer: I gave you seven equations for force. Review all seven and

pick the right one

• Note: Selecting the right equation from seven equations is harder than

just plugging into one equation

t2

R5

dt

• e 0 k = AX (5)

36 CHAPTER 2. MONEY GROWTH

• I have equations for Y and X - what do I do next?

−2×5

t2

R5

dt d(2) =.08

• e 0 k = AX (5) = AY (5) = 1 − 2

53

• Solve e 3k = (.96)−10

• k = 102.07

Chapter 3

Return

• We have 8 sub-goals to meet in this chapter

• I) Review of Chapter 1 - single investments under compound interest

• II) Portfolios - Multiple investments - Equation of Value - Equivalence

Principle

• III) IRR: Internal Rate of Return, calculator worksheet

• IV) Comparison of methods: Algebra, TV, IRR

• V) Compound vs. nominal accumulated value

• VI) Trivia on equations of value

• VII) The NPV worksheet

• VIII) Model Exam Problems

under compound interest

• Typical Problem Abe deposits $500 in an account which accumu-

lates to $600 after 10 years. Assume there is a constant, annual,

37

38 CHAPTER 3. IRR - INTERNAL RATE OF RETURN

rate

• English

same each year payment period=1 year compound not discount rate

• Rule of 6 states that we should approach the problem solution in mul-

tiple ways

• TV Sheet

N I/Y PV PMT FV

• i = 1.84%

• Note: TV method faster, more versatile, and less prone to error than

the formula method.

tion of Value - Equivalence Principle

• A portfolio refers to a collection of deposits and withdrawals

• Examples could be your college expenses (and assets) for the semester

or a collection of stocks

3.5. EOV - EQUATION OF VALUE 39

• Any particular item may be worth alot or cost alot; we are interested

in the overall portfolio performance

• Here, C stands for Cash Flow, D stands for Deposits, and W stands for

Withdrawals

• An important actuarial principle

• Timeline

C1 C2 C3 ... Cm

t1 t2 t3 ... tm

• EOV N P V = C1 v t1 + C2 v t2 + . . . + Cm v tm

Why?)

• Sometimes we are interested in the rate for which the N P V (i) = 0.

is called either the yield, the rate of return or IRR, the internal rate

of return.

money flows (Why? Discussion)

40 CHAPTER 3. IRR - INTERNAL RATE OF RETURN

• Alternate version: X X

Dk v tk = Wj v tj (3.1)

values of withdrawals

• Bonnie borrows 1000 and agrees to pay back 600 at time t = 1 and an

unknown payment, P at time t = 2. The current interest rate is 10%.

Compute P

4. No extra EOV, 5. TV Sheet, 6. Numerical Answer

• Timeline

+1000 −600 −P

0 1 2

• Calculator

N I/Y PV PMT FV

• FV = 50

• We have not yet explained the difference between the PMT key and the

FV key

3.10. III) IRR INTERNAL RATE OF RETURN, CALCULATOR WORKSHEET41

including the last

• Timeline

+50

1000 −600 −600

0 1 2

worksheet

• You use the Cash Flow Worksheet for one purpose:

• To clear the CF worksheet: 2(-1,1) 2(1,1). 2nd CLR WORK, 2nd QUIT

• To scroll to the time 0,1,2,3 rows: Use and ; (1,3) and (1,4)

• To enter amounts in a cell: Type number, sign and hit ENTER, (1,2)

• Throughout the course: ENTER and = have similar functions but are

not interchangable

• After spreadsheet is filled, to compute yield: type IRR CPT (2,4), (1,1).

• CF, 2nd CLR WORK, 2nd QUIT, CF

• Scroll to CFo.

42 CHAPTER 3. IRR - INTERNAL RATE OF RETURN

• +1000, ENTER

IRR

• We use the following problem

3.13 Timeline

• TimeLine

0 1 2 3

• 4000 at t = 0 has present value of 4000 at t = 0

3.15. TV WORKSHEET APPROACH 43

• TV Worksheet

N I/Y PV PMT FV

• Why did I use 14000 for FV? Why didn’t I use 11000?

• TimeLine

−−−−− − − −− − − −− − − −−

14000

−4000 −3000 −3000 −3000

0 1 2 3

• 2nd CF CLR WORK, 2nd QUIT, CF

44 CHAPTER 3. IRR - INTERNAL RATE OF RETURN

• If F0# = 1, then

• Still using the same example we have been studying

• F01 = 2 means use this value on two consecutive times

3.20. V) COMPOUND VS. NOMINAL ACCUMULATED VALUE 45

• The most frequent error I see among students is the answer to the

following:

• In each case we use the formulae from Chapter 2 with that particular

money growth

i(2)

• Nominal: 2 = 5% −→ Anominal (.5) = 1.05

√

• So Acompound (.5) = 1.10 = 1.0488.

1

• Discount: Adiscount (.5) = (1−0.10). 5 = 1.0541

3.22 Why

i(2)

• Nominal rate, i(2) by convention means 2 every half year

• But compound rate has no special meaning for half year periods

value formulae

46 CHAPTER 3. IRR - INTERNAL RATE OF RETURN

• Given i = i(m)

i(m)

1

Anominal = A(0) 1 + (3.2)

m m

1

1 m

Acompound = A(0) 1 + i . (3.3)

m

• The following are facts which are consequences of the definitions and

methods

• The yield need not be unique (There might be two solutions to EOV.)

.72

• It takes (approximately) i time to double your money

• We return to the example above with cash flows of -4000, -3000 -3000,

11000 at t = 0, 1, 2, 3

• Now, instead of asking what IRR will make the NPV 0, we reverse the

question.

• Scroll using the up and down arrows to the NPV display and hit CPT

(1,1)

3.26. VIII) MODEL EXAM PROBLEMS 47

• Now scroll to the I display and ENTER 4 and then scroll to NPV and

hit CPT

you will lose more money

• We list useful exam problems on multiple non-periodic investments

• Here and throughout the book Q-IT problems may duplicate exam

problems

• Q-IT#20 Comparison

• Q-IT#23 Comparison

3.27 Q-IT#20

• We sketch the solution

48 CHAPTER 3. IRR - INTERNAL RATE OF RETURN

• TimeLine

0 n 2n 10

• EOV: 1 + 2v n + 3v 2n = 6v 10 .

1

• If you have v you can solve for i since v = 1+i .

Chapter 4

Methods

4.1 Overview

• In this lecture we will go over non-exact methods

ognized

• These 2 methods apply to yield problems

49

50 CHAPTER 4. TIME AND DOLLAR WEIGHTED METHODS

• You may want the yield for the entire period of investment or

• Dollar weighted (also called Money weighted)

• Time weighted

• Here is a typical problem

• Timeline

1 - 1 - 90 5 - 1 - 90 11 - 1 - 90 11 - 1 - 91 12 - 31 - 91

1 5 11

t=0 t= t= t= t=1

6 12 12

period

11

• 22 months is 12 of the entire 24 month period from 1-1-90 to 12-31-91

• Typical Question #1. What is the yield for the entire period?

4.6. EXACT APPROACH 51

• First: Ask for the interest rate for the entire period.

• In other words, entire period is one unit of time

1 5 11

• EOV: 10210 + 4000v 6 − 3000v 12 + 1000v 12 = 12982v

• Multiply through by 1 + i

5 7 1

• 10210(1 + i) + 4000(1 + i) 6 − 3000(1 + i) 12 + 1000(1 + i) 12 = 12982.

• What is the meaning of i?

• i is the interest rate per period, that is for the entire 2 years!

4.7 Approximate

• Bernoulli (1 + i)f ≈ 1 + f i

• Apply Bernoulli to the above

• 10210(1 + i) + 4000(1 + 56 i) − 3000(1 + 7

12 i) + 1000(1 + 1

12 i) = 12982.

• Warning: You must apply Bernoulli to the last equation with i.

• Applying Bernoulli to the equation with present values (v) will give a

different approximation.

• Although this different answer is a correct approximation it is not the

officially recognized dollar weighted approximation

• The approximation we are using, based on i is an industry standard.

• Let us now solve the equation obtained by using Bernoulli.

• 10210(1 + i) + 4000(1 + 65 i) − 3000(1 + 7

12 i) + 1000(1 + 1

12 i) = 12982.

!

• 10210 + 4000 − 3000 + 1000 +

!

i 10210 + 56 4000 − 7

12 3000 + 1

12 1000

= 12982

52 CHAPTER 4. TIME AND DOLLAR WEIGHTED METHODS

!

• Interest Amount, I : 12982− 10210 + 4000 − 3000 + 1000 = 772

!

5 7 1

• Exposure: 10210 + 6 4000 − 12 3000 + 12 1000 = 11876

I 772

• Interest rate: i = Exposure = 11876 = 0.065.

• 0.065 is the appoximate (dollar weighted) yield per period

• Let j be the interest rate per year.

• How do you solve for j?

• You use the equation (1 + j)2 = 1.065. (Why?)

• Fundamental Technique: This last equation in j illustrates the

EOV for conversions of interest rates for different periods

• We will cover conversions more thoroughly in a later chapter

• Too many formulae in course to memorize all of them

• For example, in the next few chapters we introduce 50 symbols

• Each symbol has a time line, formula, English, etc.

• The best approach is to memorize a few formulae and then under-

stand/derive the rest.

• We have approached dollar weighted as a Bernoulli approximation to

the exact solution of the equation of value using accumulated values at

t = 1!

4.12. DOLLAR WEIGHTED - METHOD SUMMARY 53

• Method Summary:

Timeline has deposit and withdrawal amounts and times,

Compute exact EOV,

multiply by 1 + i,

Apply Bernoulli,

Solve linear for i,

solve annual yield vs. i

• For the timeline below we ask what is the yield for the period?

• Timeline

DATE 1 - 1 3 - 1 5 - 1 12 - 31

DEP / WITH 0 −50000 50000

NEW BALANCE 100000 55000 110000

105000 60000 115000

• Solution: 100000 × 55000 × 110000 = 1.1975.

• Method Summary:

Fill in deposit/withdrawal,

Fill in end-balance;

Compute interest-factor between each two transactions;

Multiple all interest-factors to obtain period interest factor

54 CHAPTER 4. TIME AND DOLLAR WEIGHTED METHODS

4.15 Subtleties

• The diagrams really help you memorize the formulae

matter

annual yield

• Approximation problems are popular. Almost 1 per exam.

• ---------------------

• ---------------------

4.16. V) EXAM PROBLEMS 55

• ---------------------

• Q-IT#19 = N01-20

• Q-IT#45 = M01-31

• Q-IT#5 = M03-17

• Q-IT#8 = M03-30

56 CHAPTER 4. TIME AND DOLLAR WEIGHTED METHODS

Chapter 5

Periodic Payments

5.1 Overview

• We have 9 subgoals to meet in this chapter

• I) Annuity Immediate

• V) Annuity-Perpetuity

• Timeline

0 1 1 1 ... 1 (5.1)

0 1 2 3 ... n (5.2)

57

58 CHAPTER 5. PERIODIC PAYMENTS

(at time t = 0) of a stream of periodic payments of 1 at the end of the

next n years.

• Symbol. an

5.3 Rule of 6

• Symbol

• Name

• Timeline

• Formula

• Calculator

• English Description

5.4 Timeline

• Done above. See (??)

5.5 Name

• The name is level annuity certain immediate

• Underneath the 4 words of this name we place the implications and

nuances

• Name

same amount periodic payments not dependent on survival payment at year end

5.6 Calculator

• Calculator:

n 100i CPT −1 0

N I/Y PV PMT FV

5.7. ENGLISH DESCRIPTION 59

• Given above. A level annuity certain immediate is the present value

at time t = 0 of a stream of n payments of 1 at the end of each of the

next n years.

• Warning. Proofs in Interest Theory are unlike proofs in calculus.

• Situation I deposit 1 at t = 0, in a bank account giving i per year,

and withdraw the 1 at time t = n.

• My point of view

1 −1

0 n

60 CHAPTER 5. PERIODIC PAYMENTS

• Bank gives i at end of each year (interest on my deposit of 1 at time

t = 0)

my 1 ...

0 i i ... i

0 1 2 ... n

• We use, as usual, PV to stand for Present Value

• Derivation

(5.3)

English PV my investment = PV of bank’s investment

(5.4)

Formulae 1 − vn = ian

(5.5)

1 − vn

Annuity formula = an

i

(5.6)

• Recall the timeline for an annuity immediate

• Timeline

0 1 1 1 ... 1 (5.7)

0 1 2 3 ... n (5.8)

5.13. NOTATION 61

from 1 to n

•

1 − vn

v + v 2 + v 3 + . . . + v n = an = (5.9)

i

• Applying the formula for geometric series to the left side will give the

right side

5.13 Notation

• Given above. an

• Use of the following three attributes is called the Rule of 3

• Periodic Payment

• Constant Amount

• Deferral

• Timeline

0 2 2 2 ... 2

0 1 2 3 ... n

62 CHAPTER 5. PERIODIC PAYMENTS

5.16 Deferral

• Timeline

0 ... 1 1 ... 1

0 1 2 ... 10 11 12 ... 30

• P V = v 10 a20

t = 10.

• Timeline

0 ... 5 5 ... 5

0 1 2 ... 10 11 12 ... 30

• P V = 5v 10 a20

5.18. III) RELATED SYMBOLS: A-S 63

• For each symbol taught such as an we can generate 4-6 more symbols

as follows:

• s version e.g. sn

• Perpetuity e.g. a∞

• Timeline

0 1 1 1 ... 1

0 1 2 3 ... n

5.20 Formula-a-s

• Timeline

a s

0 n

1−v n

• But an = i

n n (1+i)n −1

• ⇒ sn = (1 + i)n 1−v

i = (1 + i)n 1−v

i = i

64 CHAPTER 5. PERIODIC PAYMENTS

5.21 Calculator-a-s

• Calculator a:

n 100i CPT −1 0

N I/Y PV PMT CPT

• Calculator s:

n 100i 0 −1 CPT

N I/Y PV PMT FV

• Symbol än

• Timeline

än

1 1 1 ... 1 0

0 1 2 ... n−1 n

the beginning of each of n periods.

year:begin of year

• Use methods of Equation of timelines

• Timeline#1 = 1+Timeline#2

5.24. PROOF 2 - TIMELINE METHODS 65

• Timeline#1

1 1 1 ... 1 0

0 1 2 ... n−1 n

• Timeline#2

0 1 1 ... 1 0

0 1 2 ... n−1 n

• =⇒

• än = 1 + an−1

• Emphasize: Derived without any algebra.

• an

0 1 1 ... 1 1

0 1 2 ... n−1 n

• än

v v v ... v 0

0 1 2 ... n−1 n

• vän = an

• Here we use, v, the discount factor, from chapter 2.

•

än =(1 + i)an

1 − vn

=(1 + i)

i

1 − vn 1 − vn

= =

iv d

• Exercise: Produce verbal proof, presented in slides 5.8 - 5.11, for

value of än

66 CHAPTER 5. PERIODIC PAYMENTS

• BEGIN-END mode

corner of display window

• än

n 100i CPT −1 0

N I/Y PV PMT FV

• Warning: If you were in BGN mode a few weeks ago and forget to get

out of it, the calculator remembers and computes due

• If you found you made such an error, get out of BGN mode

• You need not enter the numbers again after changing BGN mode.

• You can continue to compute whatever you were doing without reen-

tering the numbers.

5.28 V) Annuity-Perpetuity

• Timeline

0 1 1 1 ...

0 1 2 3 ...

• Symbol a∞

payments of 1 at the end of each year forever.

5.29. PERPETUITY FORMULAE 67

1−v n 1

• a∞ = limn→∞ an = limn→∞ i = i

1−v n 1

• ä∞ = limn→∞ än = limn→∞ d = d

• Derive perpetuity by taking limits

5.31 s, s̈, a, ä

• Timeline

0 1 1 1 ... 1

0 1 2 3 ... n

an sn

• Timeline

1 1 1 1 ... 1

0 1 2 3 ... n−1 n

än s̈n

• We classify exam problems using the following 5 symbols

68 CHAPTER 5. PERIODIC PAYMENTS

• Symbols: I,Increasing,Decreasing

P,Perpetuity

Inf,Inflation

C,Conversion

A,Algebraic Manipulation

• Most duplicate problems in QIT have been caught but not all.

• M00#14 P/C

• N00#20 P/I

• N01#05 P/Inf

• N05#12 P/I

• N05#09 P/Inf

• QIT#25 P/A

• QIT#14 P/Inf

ecutive function)

• M05#24 A

• N00#44 I/I

• QIT#6 I/P/A

• M05#14 I - 2 pieces

• QIT#29 P/C

• QIT#18 I/C

5.33. VIII) OVERVIEW OF NEXT LECTURES 69

• N01#16 P/I/C

• QIT#86 I/A

• Today we learned 6 symbols

• This module is one of the hard parts of the course since we must . . .

• Please read problem Q-IT#29 to get the most of these next few slides

interest period

70 CHAPTER 5. PERIODIC PAYMENTS

• Timeline

32 ...

10 10 10 ...

0 1 2 3 ...

• EOV: 32 = 10a∞ |j

• Timeline

X ...

1 1 1 ...

0 1 2 3 ...

• EOV:X = a∞ |k

• i, rate per year.

• (1 + k)3 = 1 + i

• (1 + i)3 = 1 + j ⇒

• (1 + k)9 = 1 + j

• 32 = 10a∞ |j

1

• a∞ |j = j

5.38. QIT#29 - HIGHSCHOOL ALGEBRA 71

10

• So j = 32

1

• X = a∞ |k = k

• (1 + k)9 = 1 + j.

10

• j= 32

1

• X= k

• =⇒

• X=

72 CHAPTER 5. PERIODIC PAYMENTS

Chapter 6

Increasing Decreasing

Annuity

6.1 Overview

• We have 9 subgoals to meet in this chapter.

Periods

• VI) N05#12 Illustrates Use of Variables and the Initial Offset Tech-

nique

73

74 CHAPTER 6. INCREASING DECREASING ANNUITY

• Timeline

1 2 3 ... n

0 1 2 3 ... n

• The notational symbol for the Present Value for an increasing annuity

immediate is: (Ia)n

annuity immediate is: (Is)n

• For an increasing annuity due . . .

• The symbol for the Present Value for an increasing annuity due is:

(Iä)n

• The symbol for the Future Value (t = n) for an increasing annuity due

is: (I s̈)n

• Timeline

0 1 2 3 ... n

• The symbol for the Present Value for a decreasing annuity immediate

is: (Da)n

immediate is: (Ds)n

6.5. OTHER DECREASING ANNUITIES 75

• For a Decreasing annuity due . . .

• start with a payment of n at t = 0 . . . and

• end with a payment of 1 at t = n − 1.

• The symbol for the Present Value for a decreasing annuity due is:

(Dä)n

• The symbol for the Future Value (t = n) for a decreasing annuity due

is: (Ds̈)n

• Due starts at 0 while immediate starts at 1

• Both Due and immediate are for n payments

• The a symbol corresponds to the present value at t = 0

• The s symbol corresponds to the accumulated future value at t = n.

• WARNING: For s and due: The last payment is at t = n − 1 but

the accumulated value is at t = n

Block Approach

• The above is all the theory you need!

• We first solve problems in terms of symbols

• We will do a few calculator/formula explanations after we do problems!

• This is the proper approach to problem solving thinking.

• Each problem presented below introduces a basic problem solving tech-

nique.

• See the first slide, 6.1, of this lecture for a summary

• Note: A complete list of annuity problems was given in slide 5.32

76 CHAPTER 6. INCREASING DECREASING ANNUITY

• 1. Only 3 Building Blocks level, increasing, decreasing

numerics!

Rule of 3

• Problem The present value of a 25-year annuity-immediate with a

first payment of 2500 and decreasing by 100 each year thereafter is X.

Assuming an annual effective interest rate of 10 percent, calculate X.

• Timeline

25 × 100 24 × 100 23 × 100 ...

0 1 2 3 ...

• X = 100 × (Da)25

• Problem is way too easy. Good problems have two parts. This one

has one part!

6.10. IV) N01#16 ILLUSTRATES CONVERSION METHOD FOR DIFFERING PAYMENT/INTEREST

for Differing Payment/Interest Periods

• Olga buys a 5-year increasing annuity for X. Olga will receive 2 at the

end of the first month, 4 at the end of the second month, and for each

month thereafter the payment increases by 2. The nominal interst rate

is 9 percent convertible quarterly. Calculate X.

• Timeline

2 4 6 ...

2×1 2×2 2×3 ...

0 1 2 3 ...

• 5 years = 5 × 12 = 60 months

• =⇒ X = 2 × (Ia)60 |k

6.11 Who is k?

• k is the interest rate per month. (The problem says so!)

4

12 i(4)

• =⇒ (1 + k) = 1 + i = 1 + 4

line Approach

• At an annual effective interest rate of i the present value of a perpetuity-

immediate starting with a payment of 200 in the first year and increas-

ing by 50 each year thereafter is 46,530. Calculate i.

78 CHAPTER 6. INCREASING DECREASING ANNUITY

• Timeline

50 × 1 50 × 2 50 × 3 50 × 4 ...

0 1 2 3 4 ...

• This is a typical problem of pattern recognition:

• Remember: There are only 3 basic patterns; go over them; see which

ones fit best in this problem.

the Initial Offset Technique

• Megan purchases a perpetuity-immediate for 3250 with annual pay-

ments of 130. At the same price and interest rate, Chris purchases an

annuity-immediate with 20 annual payments that begin at amount P

and increase by 15 each year thereafter. Calculate P.

• Timeline

0 1 2 3 4 ...

6.15. VII) N00#44 ILLUSTRATES MULTIPLE APPROACHES TO THE SAME PROBLEM 79

• Timeline

P P + 15 P + 30 P + 45 ... =

15 15 × 2 15 × 3 15 × 4 ... +

P − 15 P − 15 P − 15 P − 15 ...

0 1 2 3 4 ...

Makes formulae smoother.

• Two timelines

to the Same Problem

• Joe can purchase one of two annuities: Annuity 1: A 10-year decreas-

ing annuity-immediate, with annual payments of 10, 9, 8, . . . , 1.

Annuity 2: A perpetuity-immediate with annual payments. The perpe-

tuity pays 1 in year 1, 2 in year 2, 3 in year 3, . . . , and 11 in year

11 . After year 11, the payments remain constant at 11. At an annual

effective interest rate of i, the present value of Annuity 2 is twice the

present value of Annuity 1 . Calculate the value of Annuity 1.

• Timeline #1

X = (Da)10 ...

10 9 8 ...

0 1 2 3 ...

80 CHAPTER 6. INCREASING DECREASING ANNUITY

• Timeline #2

1 2 3 ... 10 11 11 ...

0 1 2 3 ... 10 11 12 ...

• Approach A

1 2 3 ... 10 | 11 11 ...

0 1 2 3 ... 10 | 11 12 ...

• Timeline #2

1 2 3 ... 10 11 11 ...

0 1 2 3 ... 10 11 12 ...

• Approach B

1 2 3 ... 10 11 | 11 ...

0 1 2 3 ... 10 11 | 12 ...

• First: Recall that the present value of annuity two is twice that of

Annuity one

6.19. VIII) DECREASING ANNUITY FORMULA 81

• Which approach right? Both! Use the approach where the algebra

simplifies!

timelines

• We again emphasize the verbal derivation approach

• I deposit n at time t = 0

• Timeline

n − an

n n−1 n−2 n−3 ... 1

0 1 2 3 ... n−1

82 CHAPTER 6. INCREASING DECREASING ANNUITY

piont

• At time t = 1 bank gives me ni because of n at time t = 0.

t = 1.

• Timeline

i(Da)n

ni (n − 1)i (n − 2)i ... i

0 1 2 3 ... n−1

• Equivalence principle: My total payments = Banks total payments.

•

i(Da)n = n − an (6.1)

•

n − an

=⇒ (Da)n = (6.2)

i

• For (Dä)n replace i by d

6.23 Calculator

n−an

• Suppose we want to compute (Da)n = i

• #1: Compute an .

• #2: Hit ±

6.24. IX) INCREASING ANNUITY FORMULA (BROVENDER’S TRICK) 83

• #3: Hit +n =.

• #4 Hit ÷ RCL i =

• #5 Hit × 100 =

trick)

• Timeline

1 2 3 ... n +

n n−1 n−2 ... 1 =

0 n+1 n+1 n+1 ... n+1

•

än − nv n

(Ia)n = (6.3)

i

• For the due version replace i in denominator by d

•

än − nv n än 1

(Ia)∞ = lim = lim = (6.4)

n→∞ i n→∞ i id

84 CHAPTER 6. INCREASING DECREASING ANNUITY

• Similarly

1

(Iä)∞ = (6.5)

d2

• We follow Brovendor’s free calculator e-book,

• http://www.soa.org/files/pdf/FM-23-05.pdf page 29

Increasing annuity formula

• Calculator:

n 100i CPT −1 n

N I/Y PV PMT FV

afterwards). Why?

• #4: ÷ RCL i =

• #5: × 100 =

Chapter 7

Inflation

7.1 Overview

• This chapter is about inflation

• I) Inflation definition

• Suppose Milk/OJ/Beer costs 1 at t = 0

85

86 CHAPTER 7. INFLATION

• Assume interest is 0.75

• Timeline

PV .75 interest 1.50

1.50

PV = = .857

1.75

0 1

• Suppose I have .857 at t = 0.

milk/oj/beer

7.6. II) INFLATION ALGEBRA 87

• Let i be the interest rate

• Define

1 1+g

0

= (7.1)

1+i 1+i

• If you are given a problem with an inflation rate g and interest i

to anything in the real world

• Notice that the deferral factor uses i not i0 since inflation is not yet

present.

• We can compactly summarize this approach by using two equivalent

timelines

88 CHAPTER 7. INFLATION

• Original Timeline

P i P (1 + g) P (1 + g)2 ...

m rate m+1 m+2 ...

• Modified Timeline

P i0 P P ...

m rate m+1 m+2 ...

• Let us use the example from the beginning of this chapter

• g = 0.50. i = 0.75.

1+g 1.50

• Compute 1+i = 1.75 = 0.857

1 1

• Now solve 1+i0 = 0.857 (Hint: Use x key.)

• Original Timeline

PV i = 0.75 1.50

P V = 0.857

0 1

7.11. IV) INFLATION ALGORITHM 89

• Modified Timeline

PV i0 = 0.16666 1.00

P V = 0.857

0 1

• The method works because you hide the inflation in the modified in-

terest rate

•

compute (??), i0

Set up timeline with i0 and level payments, P

P is the begin-year payment in the first year of inflation

(7.2)

Compute PV as you ordinarily would with an annuity due

The deferral factor would be vim

where (m, m + 1) is the first year of inflation

The deferral factor uses i not i0 (7.3)

pute present values and then multiply by (1 + i)n (Use i not i0 )

90 CHAPTER 7. INFLATION

• The rule of 6 states that certain parts of the course deal with English

• The next two descriptions both involve the English word increasing

• See if you can find the difference

• An increasing annuity of 1 per year pays 1 at t = 0, 2 at t = 1, 3 at

t = 2, . . .

• Inflation of 10 percent per year increases from 1 at t = 0 to 1.1 at

t = 1, . . .

• Both of these use the word increasing

• However an Increasing Annuity increases arithmetically; inflation in-

creases geometrically

• You can recognize an Increasing annuity because the amount increases

• Contrastively, inflation has an increasing percent

• Q-IT#14 N01#5 is illustrative

• We approach this problem with the Example method for Timeline

constructions

• This method is very useful in problems when you don’t know how to

begin

• The idea is simple

•

Make sure the timeline has 2-3 sample values corresponding to each English phrase

(7.4)

• Please read the problem in the course resources

• Then see if you can come up with the payment values at t = 6, 7, 8.

7.15. EXAMPLE: Q-IT#14 N01#5 91

• Timeline

10 10 10 10 10 (1 + K)10 (1 + K)2 10 (1 + K)3 10 . . .

0 1 2 3 4 5 6 7 8 ...

• i = 0.092

• Calculate K

• Review: A timeline is correct if it contains all information in English

version of problem.

• Problem speaks about increasing by K percent

• So use Inflation rather than Increasing Annuity approach

• Timeline #1

10 10 10 10

0 1 2 3 4

• Timeline #2

10 (1 + g)10 (1 + g)2 10 (1 + g)3 10 ...

5 6 7 8 ...

• I emphasize many times - draw each time line separately

• Timeline #1

10 10 10 10

0 1 2 3 4

92 CHAPTER 7. INFLATION

• Timeline #2

5 6 7 8 ...

• First: Find first year with inflation:

5 6 7 ...

• Second: Compute i0 :

1 1+K

• 1+i0 = 1+.092

• Year 5

10 10 10 ...

5 6 7 ...

rule of 3.

7.21. APPLICATION OF RULE OF 3 93

• Annuity symbol is

• ä∞ i0

• Amount is . . .

• . . . 10.

• Deferral factor is . . .

5

• . . . v0.092

• The EOV Timeline #2 is modeled with

5 1 1+K

• v0.092 10ä∞ i0 , 1+i0 = 1+.092

5 1 1+K

• 167.50 = 10a4 0.092 + v0.092 10ä∞ i0 , 1+i0 = 1+.092

pect (like inflation)

• 10a4 0.092

• Timeline #1

N I PV PMT FV

94 CHAPTER 7. INFLATION

n

• ä∞ i0 = limn→∞ än i0 = lim 1−v

d0 =

1

d0

1 1+i0

• d0 = i0

1+i0

• 167.50 = 10 × 3.2255 + 0.6440 × 10 × i0

• Solve. i0 = 1

20 (5 percent)

1+g 1

• 1+i = 1+i0

1+K 1

• 1.092 = 1.05

• =⇒ K = 0.04

• Refer to the list in Chapter 5.32

Chapter 8

Miscellaneous Annuities

8.1 Topics

• Today we cover miscellaneous examples

• We have already learned how to solve problems using interest conver-

sion methods

95

96 CHAPTER 8. MISCELLANEOUS ANNUITIES

and payment periods

• The phrase annual payment of P payable m times a year...

P 1

• ...by convention means: That you pay m each m th of a year

• But what is interest rate, j?

i(m)

• If given rate is nominal i(m) then use m

j

• Principle #1: Never use i(m) .

i(m)

• Always immediately replace i(m) with j = m

• Principle #2: If you have some rate j and need the corresponding d

j

• Of course d(j) = 1+j .

8.6. II) DISCRETE EXAMPLE - INTEREST CONVERSION METHOD97

(1 + iP )n = 1 + iQ . (8.1)

method

• Find the accumulated value at the end of 10 years if 1000 is invested

annually payable at the end of each quarter at an annual rate of 0.04

rates

• Then we will use the approach with quarterly annuity symbols (interest

per year and payments per quarter)

• annual payment of 1000 payable quarterly ←→ 250 payable quarterly

• Calculator:

N I/Y PV PMT FV

• j But what is j

98 CHAPTER 8. MISCELLANEOUS ANNUITIES

0.04

• If i = 0.04 is nominal rate per year =⇒ j = 4 is rate per quarter

1

• If i = 0.04 is effective rate per year =⇒ 1 + j = (1 + .04) 4 is rate per

quarter

• In this problem annual rate is 0.04.

1

• So 1 + j = 1.04 4 =⇒ j = 0.009853

• I call this approach the conversion method and advocate its use.

bol

• We now present the actuarial symbol and formulae when payment

period 6= interest period

above and not use symbols

(m)

• Symbol ay i

ments m times a year.

8.12. IV) CONTINUOUS ANNUITIES - DAILY APPROXIMATION 99

• Timeline

1 1 1 1

...

m m m m

1 2 3

0 ... y years

m m m

1−viy

• Formula i(m)

• Solution to Problem

(4)

• Accumulated value at end of 10 years = 1000s10 .04

1

• Answer: Because monthly annuity pays m not 1 each payment period

conversion method

tion

• We now deal with continuous annuities

1000

• An Annual payment of 1000 payable continuously ←→ 365 every day

1000

or 365×24 every hour

1000

• Is using 365 an approximation?

• Yes: It is an approximation

• But the approximation will usually agree on the penny with the exact

answer

100 CHAPTER 8. MISCELLANEOUS ANNUITIES

tice

• To show how good the approximation is we solve the following problem

in three ways

• Find the accumulated value in 10 years of an annual payment of 1000

payable continuously at an annual effective rate of 0.04

• We will solve this problem 1) Exactly 2) By a daily approximation and

3) compare to the quarterly problem done previously

• All three answers are very close

P

• So P per year payable continuously can be approximated by 365 as

daily rate

• What about the interest rate?

δ

• We can use 365 as daily force

• If the problem gives you the annual effective rate, i

• Then first convert i to δ using the equation 1 + i = eδ .

δ

• Then use 365 as daily force

tion

• Calculator:

ln(1.04) 1000

365 × 10 100 0 − CPT

365 365

N I/Y PV PMT FV

ln(1.04)

• Note that 1.04 = eδ so that δ = 365

we obtained above for the quarterly payments.

8.16. V) CONTINUOUS ANNUITIES - EXACT METHOD 101

• Symbol an

tive rate i, (at constant force of interest δ)

• Formula

n

1 − e−δn

Z

an = e−δt dt = . (8.2)

t=0 δ

• Similarly

eδn − 1

sn = . (8.3)

δ

eln(1.04)×10 −1

ln(1.04) = 12244.66.

continuously - we see

• As can be seen, the daily approximation differs from the exact answer

by less than 1 dollar.

Rn

• Let us prove that an i = 0 e−δt dt.

• At instant of time ∆t

Rn −δt dt

• The limiting sum of all these present values is t=0 e

102 CHAPTER 8. MISCELLANEOUS ANNUITIES

• Symbol Ia

n δ

ible continually at force δ

Rn an i −nv n

• Formula 0 te−δt dt = δ

• Note: Requires integration by parts but you can just memorize formula

You

perpetuity Ia

∞ δ

• At instant of time ∆t

• Adding

R n −δt up all these present values and taking the limit we obtain

0 te dt

(m)

(m)

• Symbol I a

n i

ments increasing m times a year.

8.21. ILLUSTRATIVE EXAMPLE - ANNUITIES INCREASING MONTHLY103

• Timeline

1 2 3 nm

...

m2 m2 m2 m2

1 2 3

0 ... n years

m m m

(m)

än i −nv n

• Formula i(m)

(m)

• You can derive corresponding formulae for the the following: I (m) s ,

n i

(m) (m)

(m)

I ä (m)

, I s̈

n i n i

• You can also derive the formula for the associated perpetuities

• Compute the present value of an increasing annuity immediate for

10 years with monthly payments that pays 25 at t = 1 and increases

payments by 5 each month. The annual effective rate is 0.04.

• We will solve this problem without using the monthly increasing an-

nuity symbol and formula

• As an exercise you may want to check and redo the problem that way

first payment 25, i = 0.04; increasing monthly by 5

• Timeline

25 30 35 ... 20 + 120 × 5

0 1 2 3 ... 120

104 CHAPTER 8. MISCELLANEOUS ANNUITIES

• Timeline

20 20 20 ... 20 +

5 10 15 ... 120 × 5

0 1 2 3 ... 120

• P V = 20a120 j + 5 Ia , (1 + j)12 = 1.04.

120 j

a numerical answer.

• John starts working at age 30 at an annual salary of 36000 payable

monthly. John’s salaary increases 1200 per year payable monthly with

level payments every month. John works until age 55 at which time

he retires. Compute an equivalent level monthly payment X such that

25 years of monthly payments, X, have the same present value of what

John gets paid.

• This problem has the unusual feature of level monthly payments but

increasing annual payments.

increasing per year

(m)

• Symbol Ia

n i

each month; payments increase each year

8.24. ILLUSTRATIVE PROBLEM ANALYZED 105

• Timeline

1 1 1 2 2 2 n

... ... ...

m m m m m m m

1 2 12 13 2 24

0 ... ... ... n years

m m m m m m

formula.

• Let us analyze this as a sum of timelines.

• Timeline

3000 3000 . . . 3000 3100 3100 . . . 3100 . . . 2900 + 25 × 100 =

2900 2900 . . . 2900 2900 2900 . . . 2900 . . . 2900 +

100 100 . . . 100 200 200 . . . 200 . . . 25 × 100

0 1 2 ... 12 13 14 . . . 24 . . . 25 × 12

• The top and 3rd row are easily describable. The 4th row requires a

new technique.

• Timeline of top row = Xa25×12 j

106 CHAPTER 8. MISCELLANEOUS ANNUITIES

• Timeline 2900 row = 2900a25×12 j

• Timeline Trick

... 100s12 j

0 1 2 3 ... 12

• Timeline Trick

... 200s12 j

0 1 2 3 ... 12

100s12 j

value of 2 × 100s12 j

value of 3 × 100s12 j

• So

Timeline 100 row = 100s12 j Ia

25

• j is interest rate per month

• So (1 + j)12 = 1 + i = 1.04

8.29. PUTTING IT ALL TOGETHER 107

• Recall Equation of Value

• So,

2900a25×12 j + 100s12 j Ia = Xa25×12 j

25 i

108 CHAPTER 8. MISCELLANEOUS ANNUITIES

Chapter 9

Amortization

• In this chapter 9 we introduce and cover the following 5 major topics

• I) Amortization Table

• In chapters 10-12 we do problems

109

110 CHAPTER 9. AMORTIZATION

• Let us begin with an example

2820.12 at the end of each year for 4 years

• Calculator:

N I/Y PV PMT FV

• R, periodic payment

• I, Interest amount

• P, Principle amount

• t, time t = 0, 1, 2 . . .

• Amortization Table:

R It = i × OLBt−1 P t = R t − It OLBt = OLBt−1 − Pt t

10000 0

R = 2820.12 500 = 0.05 × 10000 2820.12 − 500 = 2320.12 10000 − 2320.12 = 7679.88 1

R = 2820.12 383.99 = 0.05 × 7679.88 2820.12 − 383.99 = 2436.12 7679.88 − 2436.12 = 5243.76 2

.. .. .. .. ..

. . . . .

2820.12 ... ... 0 4

• Idea: Separation of interest and principle

9.7. II) THE 14 PAYMENT FORMULAE - 5 GENERAL, 5 LEVEL, 4 TOTAL 111

• You owe 7679.88. You can pay that off at t = 1 and owe nothing more

• The other 500 is interest you paid for the right to loan

level, 4 total

• Every amortization question can be solved using 14 formulae

constant

constant or not

• The following formulae are general formulae whether R is constant or

not

(OLB)0 = L (9.1)

(OLB)n = 0 (9.2)

It = i × (OLB)t−1 (9.3)

Rt = It + Pt (9.4)

(OLB)t = (OLB)t−1 − Pt (9.5)

112 CHAPTER 9. AMORTIZATION

•

(OLB)t =Ran−t , (9.6)

(OLB)0 =Ran =L ,

(OLB)1 =Ran−1 , . . .

It =R(1 − v n−(t−1) ), (9.7)

1− vn

I1 =i(OLB)0 = iRan = iR = R(1 − v n )

i

Pt =Rv n+1−t , (9.8)

R = I1 + P1 =⇒ P1 = R − R(1 − v n ) = Rv n

(OLB)t = Ran−t , Prospective method, for level payments only

(9.9)

(OLB)t = L(1 + i)t − Rst , Retrospective method, for level paymen

(9.10)

Important: For level payments,Pt forms a geometric series

•

Total payments: nR (9.11)

Total principle paid: Rv n + Rv n−1 + . . . + Rv 1 = Ran

(9.12)

n n−1 n−(m−1)

Total principle t = 1 . . . m: Rv + Rv + . . . + Rv = R an − an−m

(9.13)

Total interest paid: nR − Ran = nR − L (9.14)

without discount factors

• Throughout course: Total means total present value

• But by amortization: total means total raw sum

• Discussion on why.

9.11. III) CALCULATOR AMORTIZATION SPREADSHEET 113

• The Calculator Worksheet is actually a spreadsheet

• Calculator:

N I/Y PV PMT FV

• The Amortization worksheet presents the Amortization table presented

above in slide 9.5

9.13 Row 2

• Simply set P 1 = 2, P 2 = 2.

114 CHAPTER 9. AMORTIZATION

• Suppose I ENTER P 1 = 1, P 2 = 1.

• Idea: At time t = 0 I lend L from lender

to the lender

• The name sinking fund refers to the fact that I sink money into the

bank until L is accumulated

• Also notice that there are two payees: The lender and the bank into

which I sink money

trate amortization

9.16. TERMS USED 115

• Interest on Loan iL × L

9.17 Set up

• L = 10000, iL = 0.10, iSF = 0.05

end of each year.

D + iL × L = 3320.12

• Sinking Fund Table:

SF D SF I SF B OLB t

10000 0

D = 2320.12 0 = 0.05 × 0 2320.12 + 0 = 2320.12 = Ds1 10000 − 2320.12 = 7679.88 1

D = 2320.12 116 = 0.05 × 2320.12 2320.12 + 116 + 2320.12 = 4756.24 = Ds2 10000 − 4756.24 = 5243.76 2

.. .. .. .. ..

. . . . .

2320.12 ... 10000 0 4

116 CHAPTER 9. AMORTIZATION

• M00#26 Refinance

• M05#8 Refinance

• N00#34 Refinance

• Q-IT#75 Refinance

• Q-IT#88 Refinance

• M00#39 Reinvest

• Q-IT#80

9.19. V) SOA EXAM PROBLEMS 117

• Q-IT#15 Duplicate

• Q-IT#16 Duplicate

• Q-IT#24 Duplicate

• Q-IT#26 Duplicate

• Q-IT#28 Duplicate

• Q-IT#46 Duplciate

118 CHAPTER 9. AMORTIZATION

Chapter 10

Amortization Problems

10.1 Overview

• Today we review problems

• We have 3 goals

methods

• #1) a) Read problem and identify the b) variables and the c) cells,

that is the column and row

important

119

120 CHAPTER 10. AMORTIZATION PROBLEMS

t R I P OLB

0 0 0 0 1000

1 150 100 50 950

2 142.5 95 47.5 902.5

3 135.38 90.25 45.12 857.38

4 128.61 85.74 42.87 814.51

5 122.18 81.45 40.73 773.78

6 116.07 77.38 38.69 735.09

7 110.26 73.51 36.75 698.34

8 104.75 69.83 34.92 663.42

9 99.51 66.34 33.17 630.25

10 94.54 63.02 31.51 598.74

• In the next few slides we will see how this problem solving strategy is

implemented.

level payments

• Please read QIT#9 in the problem resources

• Step #1 in slide 10.2 says to a) read problem, identify b) variables,

and c) cells.

• A) 20 year loan −→ n = 20

10.5. USE OF 13 BASIC FORMULAE 121

0 0 0 0 0 598.74

1 11 97.44 59.87 37.57 561.17

2 12 97.44 56.12 41.32 519.84

3 13 97.44 51.98 45.46 474.39

4 14 97.44 47.44 50 424.38

5 15 97.44 42.44 55 369.38

6 16 97.44 36.94 60.5 308.88

7 17 97.44 30.89 66.55 242.32

8 18 97.44 24.23 73.21 169.11

9 19 97.44 16.91 80.53 88.58

10 20 97.44 8.86 88.58 0

• Step #2,#3 of slide 10.2: Fill in cells; if necesssary do 3-4 examples

first.

• Use C on last slide to fill in row 1: −→ Fill the row in this order,

I1 , R1 , P1 , OLB1 (Use 13 basic formulae)

Fill the row in in this order, I2 , R2 , P2 , OLB2 (Fill using the 14 basic

formulae)

Fill the row this order, I3 , R3 , P3 , OLB3 (Use 14 basic formulae)

122 CHAPTER 10. AMORTIZATION PROBLEMS

• Step #4 in slide 10.2

• I1 = 10%L

• Same argument (write it out!) gives

• OLB2 = 95%2 L

• Do you see the pattern?

• You could still solve the problem but it would take longer

• Step #5:

Original Times

• OLB10 = New Loan Amount = OLB0New Times in new count-

ing

10.10. III) QIT#26 ILLUSTRATING THE SUBGOAL OF TOTAL PAYMENTS123

T V Calculator 0 0 97.44 0

10 10 OLB10 CP T 0

N I PV PMT FV

• This can be solved using the TV calculator timeline (See table 10.3)

payments

• We now do QIT#26

• Please read it

10.11 Lori

• Lori repays her loan with 10 level payments at the end of every six-

month period.

• Solve, using TV

• But how do you compute total interest

124 CHAPTER 10. AMORTIZATION PROBLEMS

P ERSON t R I P OLB

Lori 0 0 0 0 5000

Lori 1 679.34 300 379.34 4620.66

Lori 2 679.34 277.24 402.1 4218.56

Lori 3 679.34 253.11 426.23 3792.33

Lori 4 679.34 227.54 451.8 3340.53

Lori 5 679.34 200.43 478.91 2861.63

Lori 6 679.34 171.7 507.64 2353.98

Lori 7 679.34 141.24 538.1 1815.88

Lori 8 679.34 108.95 570.39 1245.5

Lori 9 679.34 74.73 604.61 640.89

Lori 10 679.34 38.45 640.89 0

0 0 0 0 0 0

0 0 6793.4 1793.4 5000 0

Solution 0 0 T OT AL Int 0 0

• Method #2: Level payments −→ Use level payment formulae

10.14 Janice

• Janice pays interest due every period

10.15. 5 GENERAL FORMULAE 125

• But what is interest due

• It = I × OLBt−1

• I1 = 6% × 5000 = 300

• So R1 = I1 + P1 = I1 = 300

• So

• I2 = 6% × 5000 = 300

• P2 = 0 (Why?)

• R2 = I2

• Do you see the pattern?

126 CHAPTER 10. AMORTIZATION PROBLEMS

P ERSON t R I P OLB

Janice 0 0 0 0 5000

Janice 1 300 300 0 5000

Janice 2 300 300 0 5000

Janice 3 300 300 0 5000

Janice 4 300 300 0 5000

Janice 5 300 300 0 5000

Janice 6 300 300 0 5000

Janice 7 300 300 0 5000

Janice 8 300 300 0 5000

Janice 9 300 300 0 5000

Janice 10 5300 300 5000 0

0 0 0 0 0 0

T otalInterest 0 0 3000 0 0

• So total interest (in this special case)

10.20 Seth

• Seth lets interset accumulate over 5 years

10.21 Chapter 2

• How do you do this

• Think chapter 2

10.22. CHAPTER 2 - INTEREST 127

P ERSON t R I P OLB

Seth 0 0 0 0 5000

Seth 1 0 0 0 5300

Seth 2 0 0 0 5618

Seth 3 0 0 0 5955.08

Seth 4 0 0 0 6312.38

Seth 5 0 0 0 6691.13

Seth 6 0 0 0 7092.6

Seth 7 0 0 0 7518.15

Seth 8 0 0 0 7969.24

Seth 9 0 0 0 8447.39

Seth 10 0 0 0 8954.24

0 0 0 0 0 0

8954.24 - 5000 3954.24 0 0

A(n) - A(0) T otalInt 0 0

• But what is total interest

128 CHAPTER 10. AMORTIZATION PROBLEMS

Chapter 11

Bonds

11.1 Overview

• We have 8 subgoals to meet in this chapter

• III) Conversions

• Suppose I want to start, for example, a pen business

ment, etc.

129

130 CHAPTER 11. BONDS

• Once the business is started the profits will sustain the business

• A bond is basically an IOU

• You pay me $1,000 now and the IOU says I pay you back $1,000 in 5

or 10 years

• The $1000 you pay me is called the Price, P

maturity date

• The symbol C indicates how much the bond is called for at maturity.

• In the last slide I have described a 0-coupon bond: P, C

ically

(Spooky!)

11.6. C VS F VS P 131

11.6 C vs F vs P

• P is what you pay me at time t = 0.

• Fr, the coupon amount is what I pay you at the end of each period.

• If the problem gives you P,F,C then they are all different

• If the bond is called a par value bond and nothing else is said then

C = F.

• In such a case F is called the par value of the bond; C is the redemption

value.

• Bond Timeline

C

−P Fr Fr ... Fr

0 1 2 ... n

• To apply the TV line we need to use all 5 calculator keys since there is

a balloon payment

ment goes to PMT

• Calculator TV Line:

n 100i −P Fr C

N I/Y PV PMT FV

132 CHAPTER 11. BONDS

•

P = F ran i + Cvin . (11.1)

• A final word about payment periods vs. interest periods

r

• you replace r with 2

1 + j = (1 + i)2 .

• N05#4 Plug in (Basic Formula)

• M00#29 Refinancing

• M01#41 Reinvestment

• N05#11 Reinvestment

• N05#16 Reinvestment

11.9. IV) SOA EXAM PROBLEMS 133

• M03#42 8 Formulae

• QIT#62 8 Formulae

• N01#31 Comparison

• M05#5 Comparison

• QIT#74 Comparison

• QIT#76 Comparison

• N05#19 Trivia

• N05#22 Callable

• M05#11 Callable

• QIT#54 Callable

• QIT#55 Callable

• QIT#56 Callable

• QIT#57 Callable

134 CHAPTER 11. BONDS

• QIT#91 Callable

• QIT#10 Duplicate

• QIT#22 Duplicate

• QIT#47 Duplicate

• This is a plug in problem and in my opinion way to easy. But it did

occur on an exam.

• Problem Statement: A ten year 100 par value bond pays 8% coupons

seminannually. The bond is priced at 118.20 to yield an annual nom-

inal rate of 6% convertible semiannually. Calculate the redemption

value of the bond.

• 1) We use the English to identify P, i, r, n, F, C.

• 100 par value → F = 100.

• semiannually → n = 2 × 10 = 20.

.08

• semiannually → r = 2 = 0.04.

• P = 118.20

11.13. N05#4 SOLUTION STEP 2: TIMELINE 135

.06

• i= 2 = 0.03.

• C is unknown

and C are different

• Timeline

C

−118.20 100 × 0.04 = 4 4 ... 4

0 1 2 ... 20

• Equation of Value, EOV 118.20 = 0.04 × 100a20 20 .

+ Cv.03

.03

line

• Calculator:

N I/Y PV PMT FV

136 CHAPTER 11. BONDS

• Modified coupon rate, g is defined by

Cg = F r. (11.2)

Gi = F r. (11.3)

•

P = F ran i + Cvin (11.4)

• So

P = C(g − i)an i + C (11.5)

• Try and use the first formula, called the basic formula whenever pos-

sible

• The Bond amortization schedule is almost identical to the Loan Amor-

tization Schedule

• The five formulae for non-level payments are almost the same

OLBt , v)OLBn = C

11.19. THE 5 BASIC BOND FORMULAE WHEN COUPONS ARE LEVEL 137

• #1) Rt = F r is the coupon rate (This belongs in the next section, the

formulae for level coupon rates)

• Refinancing and reinvestment follow the same rules for Loan amorti-

zations

• BVt is the price on the books; what someone would pay at t for the

bond

• The BVt is present value at t of all future coupons and the redemption

value

are level

• i)coupons = F r = Cg

i)an−t i

fore omitted

• v) The formula for It is derived from the formula for Pt (just given)

and the relation It + Pt = Rt = F r = Cg

• Since this is complicated we omit it also (So there are only 3 formulae

for the level case)

• So there are a total of 8 Bond formulae (5 for any case and 3 for the

level case)

138 CHAPTER 11. BONDS

• Problem Statement A 10,000 par value 10-year bond with 8% an-

nual coupons is bought at a premium to yield an annual effective rate

of 6%. Calculate the interest portion in the 7th coupon.

• par value → C = F = 10000.

• n = 10, no conversions!

• r = .08

• i = 0.06

• P, price is unknown

11.22 8-Bond-Formulae

• We present two solutions, both based on the 8 Bond Formulae

• Aha! I7 = i × OLB6

+ Cv.06

0.06

• The rest is computation since all variables on the right side are known.

11.23. THE SECOND SOLUTION 139

• In this slide we present the 2nd solution

• Aha! Rt = It + Pt

4 = 158.42

• Note that F r = Cg → r = g

140 CHAPTER 11. BONDS

Chapter 12

Reinvestment

12.1 Overview

• We have one main goal for today: Reinvestment problems

SOA syllabus

141

142 CHAPTER 12. REINVESTMENT

• Typical problem - a) loan with pay back or b) buy bond and get

redemption

each interest rate

• Each investment rate component gets its own timeline, its own EOV

i)n = A(n).

• Bill buys a 10-year 1000 par value 6% bond with semi-annual coupons.

The price assumes a nominal yield of 6%, compounded semi-annually.

into an account earning interest at an annual effective rate of i .

• At the end of 10 years, immediately after Bill receives the final coupon

payment and the redemption value of the bond, Bill has earned an

annual effective yield of 7% on his investment in the bond.

• Calculate i

12.5. SOLUTION - COUNT BANKS / INTEREST RATES 143

• (Timeline #1) 10 year bond is at a 3% rate

7% rate

12.6 Timeline #1

• Timeline #1

1000

−P 3% × 1000 = 30 30 ... 30

0 1 2 ... 20

• EOV: P = 30a20 20 .

+ 1000v3%

3%

• Calculator Timeline #1

N I PV PMT FV

020 3 CPT 30 1000

• P V = 1000.

12.7 When r = i

• In the last slide we saw an example where

• C=F

• r=i

144 CHAPTER 12. REINVESTMENT

• P =C

• If r = i then P = C

12.8 Timeline #2

• Timeline #2

A(20)

3% × 1000 = 30 30 ... 30

0 1 2 ... 20

• Note: i is rate per year; but we need j, rate per half year

• The calculator timeline approach does not work because there are too

many unknowns

• Calculator Timeline #2

N I PV PMT FV

20 CPT 0 −30 A(20)

12.9 Timeline #3

• Remember: This is a chapter 2 problem

12.10. IV) MODEL PROBLEM: N05#11 145

• Bond Timeline

C = 1000

A(20)

P

0 1 2 ... 20

N I PV PMT FV

20 CPT 0 −30 1000(1.07)10 − 1000

• So j = 4.7597

• An investor borrows an amount at an annual effective interest rate of

5% and will repay all interest and principal in a lump sum at the end

of 10 years.

• She uses the amount borrowed to purchase a 1000 par value 10-year

bond with 8% semiannual coupons bought to yield 6% convertible

semiannually.

semiannually.

• Calculate the net gain to the investor at the end of 10 years after the

loan is repaid.

146 CHAPTER 12. REINVESTMENT

• The 5% loan

rates

• A(0) = P − − − − − − − − − − − − − −A(10) = P (1.05)10

• Bond Timeline

... C = 1000

4% × 1000 40 ... 40

p

0 1 2 ... 20

+ 1000v3%

3%

year)

year)

• Bond Timeline

4% × 1000 40 ... 40

A(20)

0 1 2 ... 20

12.15. THE FINAL SUMMARY LINE 147

year)

• Normally, investment problems ask for the overall yield

• That is: The problem does not want the annual effective percentage

rate,

• How do we compute gain

• Why? Because the person loaned P and then spent P on the bond

• All we care about is the overall gain at time t = n; What was spent

and earned?

• We separately tally the loan, the bond and the coupon timelines

1000.

148 CHAPTER 12. REINVESTMENT

• Dan purchases a 1000 par value 10-year bond with 9% semiannual

coupons for 925.

convertible semiannually.

the ten-year period.

12.19 Hints

• How many distinct investment rates / banks are there?

if appropriate?

Chapter 13

Forward, Term Structure

13.1 Overview

• We have 8 brief subgoals in todays chapter

• VI) Good exam problems on spot and forward rates, yield, and term

structure

• Say I want to create the Dr. Hendel Pen company

149

150CHAPTER 13. STOCKS, MARGIN, SPOT, FORWARD, TERM STRUCTURE

• Then I would sell many pens and earn money

• Bonds - loaning money - are one approach to obtaining million dollars

• Stocks are another approach

• #1) Each share of stock represents co-ownership in the company

• Stock are different than bonds since stock holders co-own the

company.

• If a stock holder owns enough shares (s)he can determine policy

• #2) Also share-owners (stock holders) may get percentages of

profits

• These period profit payments are called dividends

• I could not find any problems in the exams on the Dividend Discount

model

• The issue is how to price stocks

• In the real world many factors influence price - for example what other

investors think the stock will do

• The Dividend Discount model says that the value of the stock is the

PV of all dividends, D

•

P = Da∞ i% (13.1)

• This formula can also be modified to reflect non-level dividend amounts

13.5. III) SHORT SALES OF STOCKS AND MARGIN REQUIREMENTS151

quirements

• When you sell long the buyer

• pays P at t = 0

• receives the stock bought at t = 0

• When you sell short you

• receive P at t = 0 for a stock you don’t own!

• but you agree to give the buyer the stock say at t = 1

• Alternate formulation: You receive P at t = 0

• You fictitiously borrow the stock you were suppose to sell

• and agree to pay back the stock say at t = 1

• Why sell short? Because you expect the stock to go down. You make

P at t = 0 but lose only the lower value of the stock at t = 1.

• You receive P at t = 0

• You buy back the stock - that is you cover the short - at t = 1 for C

• You also have to give the buyer at t = 1 any dividends, D, earned

between t = 0 and t = 1.

• So your profit amount is P − C − D while the amount you spent is 0.

• If you spend 0 and roughly earn P − C − D, your yield is infinite.

• This is not good: if people can earn money without spending

• This was the cause of the great depression

• Why? Suppose C > P

• Then you can’t cover the short sale - so you go bankrupt

152CHAPTER 13. STOCKS, MARGIN, SPOT, FORWARD, TERM STRUCTURE

• To protect the economy we require depositing margin, M at t = 0

i= = . (13.2)

M M

to do sales and buys

• You can work any new expenses or gains into the basic formula above

• One formula - all problems are the same

• M01#27 Margin

• M03#36 Margin

• N00#24 Margin

• M05#22 Margin

13.10. M01#27 153

13.10 M01#27

• Jose and Chris each sell a different stock short for the same price.

• Each investor buys back his stock one year later at a price of 760 .

• The stock owned by Jose stock paid a dividend of 32 at the end of the

year while the stock owned by Chris paid no dividends.

• During the 1-year period, the return of Chris on the short sale is i,

which is twice the return earned by Jose.

• Calculate i

• At t = 0, Jose spends 50% × P = 50%P

P −760+6%×50%×P −32

• Yield is iJ = 50%P

• Only difference between Yose and Chris is no dividend

P −760+6%×50%×P

• So yield is iC = 50%P

154CHAPTER 13. STOCKS, MARGIN, SPOT, FORWARD, TERM STRUCTURE

• iC = 2iJ

• Spot rates rn describe annual yields for n year bonds

•

1

1 (13.3)

(1 + rn )n

0 n (13.4)

• In words The price (PV) of an n-year zero coupon bond with redemp-

tion amount 1 is (1+r1n )n .

giving spot rates

13.15 Strips

• Given any bond you can sell the coupons and redemption separately

• You have stripped the bond of its coupons and are selling them sepa-

rately

• Let us suppose I have different spot rates for different years

13.17. VI) GOOD EXAM PROBLEMS ON SPOT AND FORWARD RATES, YIELD, AND TERM STRUCT

• The graph with the x-axis giving interest rates and the y-axis giving

spot rates is called the yield curve

yield curve is 0.

ward rates, yield, and term structure

• One formula - all problems are the same

• QIT#33

• QIT#34

13.18 Q-IT#34

• You are given the following information with respect to a bond:

1 7%

2 8%

3 9%

Calculate the annual effective yield rate for the bond if the bond is

sold at a price equal to its [present] value.

156CHAPTER 13. STOCKS, MARGIN, SPOT, FORWARD, TERM STRUCTURE

13.19 Solution

• Coupon amount equals 1000 × 6% = 60

60

• Present value of 1-year strip of 60 equals 1.07

60

• Present value of 2-year strip of 60 equals 1.082

60

• Present value of 3-year strip of 60 equals 1.093

1000

• Present value of redemption strip of 1000 equals 1.093

60 60 1060

• Present value, price, of bond: 1.07 + 1.082

+ 1.093

=P

• Yield of bond: P = 60a3 i + 1000vi3 .

• SOA solutions suggest using TV Calculator Timeline

• Important: Notice how spot rates and yield are different.

• Suppose spot rates for two different periods are different

• We say the spot rates imply corresponding forward rates

• The forward rate fi,j is the annual rate from t = i to t = j

• There is only one formula

• One formula - all problems are the same

• N05#15

• M05#10

• N05#19 (Problem illustrates English terms yield rates, risk-free yield

curve (term structure), forward rates,spot rates,strips)

13.22. VIII) M05-#10,A GOOD EXAM PROBLEM ON FORWARD RATES157

forward rates

• Yield rates to maturity for zero coupon bonds are currently quoted at

8.5% for one-year maturity, 9.5% for two-year maturity, and 10.5%

for three-year maturity. Let i be the one-year forward rate for year

two implied by current yields of these bonds. Calculate i.

13.23 Solution

• Use the one formula (??)

• (1 + ri )i (1 + fi,j )j−i = (1 + rj )j .

• So let i = 1, j = 2. Then

• (1 + r1 )(1 + f1,2 ) = (1 + r2 )2 .

•

1.085 × (1 + f1,2 ) = 1.0952 −→ 1 + f1,2 = 1.105.

158CHAPTER 13. STOCKS, MARGIN, SPOT, FORWARD, TERM STRUCTURE

Chapter 14

Callable Bonds

14.1 Overview

• We cover one topic today, Callable bonds

• VI) QIT#54

• An ordinary bond is called or redeemed at t = n for the maturity value,

C

159

160 CHAPTER 14. CALLABLE BONDS

• Contastively, a callable bond may be called earlier than t = n

• The decision on when to redeem the bond is the seller’s not the buyer’s

t=n

different

• A callable bond can be done in 3 ways:

extra date besides t = n : Say t = n1 < n.

set of dates, t = n1 , n2 , . . . , n

paid

• What is the yield?

14.6. II) THE DIFFERENCE BETWEEN PREMIUM VS. DISCOUNT 161

count

• In solving the callable bond problem we introduce one more concept

• A bond is bought at a premium if either P > C or g > i

14.8 P − C vs. g − i

• The definition was formulated in terms of P, C or g, i

• So P > C ↔ g > i.

Cg = F r), and g > i is equivalent to r > i.

Discount

• The following English conventions are associated with the term Pre-

mium

• P >C

P −C

162 CHAPTER 14. CALLABLE BONDS

t-th coupon is Pt

• The amount of write down in the t-th coupon is Pt

• The following English conventions are associated with the term Dis-

count

• C>P

• The bond is bought at a discount

• The amount of discount in the purchase price of the bond is C −P

• The amount of (amortization / accumulation of) discount in the

t-th coupon is −Pt

• The amount of write up in the t-th coupon is −Pt

• Consider a 2 year bond with redemption value 5 and coupons of 1

yielding 10%.

• If the bond is not callable then the price is 5.8678

• In other words 5.8678 = 1 × a2 10% + 5v 2

• This is solved in a traditional manner with calculator

• Suppose the seller had the option to redeem the bond at par value at

t=1

• What is the yield on the transaction

• Notice that the investor (buyer) has already paid the 5.8678

• Well the EOV is 5.8678 = 1 × v + 5 × v −→ i = 2.25%

• This can be calculated using a TV line on 5.8678 = 1 × a1 i% + 5vi

1+5

• Alternatively, you can directly calculate 5.8678 = 1.0225

14.12. MOTIVATING EXAMPLE - SO WHAT IS YIELD 163

• Let us summarize

• In this example we satisfy the following three assumptions:

on coupon dates

• 3) the redemption price C was the same for each redemption date

164 CHAPTER 14. CALLABLE BONDS

• 1) Suppose the bond is bought at a discount

• 1) Suppose the bond can only be redeemed on coupon dates

over the range of coupon dates for which C is the same

• Theorem approach: You can use the theorems provided the criteria

are met

• Brute Force approach: You can also compute the yield for each

possible t and compare them

sion

• Let timeline #1 have redemption at time t, have yield yt and present

value, P

14.18. A HEURISTIC RESULT 165

• Timeline #1

C

−P Cg Cg ... Cg

0 1 2 ... t

present value, P

• Timeline #2

C

−P Cg Cg ... Cg Cg

0 1 2 ... t t+1

• The point is that the buyer has already paid for the bond

• We need a preliminary heuristic result

• As the yield goes to infinity the present value of the timeline goes down

to 0

• As the yield goes to 0 the present value of the timeline goes up to the

sum of all amounts (since interest is 0)

• So as yield goes up, PV goes down and as yield goes down, PV goes

up

166 CHAPTER 14. CALLABLE BONDS

• When timeline #2 uses P it has yield yt+1

• In other words, proving yt+1 > yt ⇔ P V2 > P V1 = P, if both tinelines are evaluated at yt

• But the two timelines have identical amounts except at the end

• So

• This last inequality is the theorem assumption that the bond is bought

at a premium, that is, P > C or equivalently g > i.

• N05#22

• QIT#55 Have to 1st find price at several dates and for each price find

minimal yield

• QIT#56 Have to 1st find redemption price at several dates and for

each price find minimal yield

14.21. VI) QIT#54 167

• Matt purchased a 20-year par value bond with semiannual coupons at

a nominal annual rate of 8% convertible semiannually at a price of

1722.25. The bond can be called at par value X on any coupon date

starting at the end of year 15 after the coupon is paid. The price

guarantees that Matt will receive a nominal annual rate of interest

convertible semiannually of at least 6%. Calculate X.

• r = 4% per half year

• i = 3% per half year

• So i = 3% < 4% = r −→ Bond bought at a Premium

• Apply theorem: Check assumption #1: Bond bought at a Premium

• Check assumption #2: Redemption price the same

• Check assumption #3: Can be redeemed on coupon dates (Notice

problem only cares about t ≥ 15.)

• Conclusion: y1 < y2 < . . . < y30

• Minimal yield to buyer is earliest yield on which redemption can take

place

• So minimal yield occurs at t = 15.

• t = 15 is really n = 30 because we count half years

• r = 4%, i = 3%

30

• EOV 1722.25 = 4%Xa30 3% + Xv3%

1722.25 30 .

• So X = 4%a30 3% + v3%

1722.25

• Can use calculator to solve for the expression X

168 CHAPTER 14. CALLABLE BONDS

•

—– —– —– —– —–

Premium Bermuda Always C y1 < y2 < . . . < yn Earliest date

Discount Bermuda Always C y1 > y2 > . . . > yn Latest date

with the same redemption value

• Simply check the earliest and latest coupon date and take the minimum

Chapter 15

Duration, Convexity

15.1 Overview

• In this chapter we have the following 10 subgoals

• VII) M05#3

• X) Convexity formulae

tion

• Sequence of investments/debts that is deposits and withdrawals

169

170 CHAPTER 15. DURATION, CONVEXITY

• Timeline

C1 C2 ... Cj ...

t1 t2 ... tj ...

•

j=n

t

X

P V (i) = Cj v i j (15.1)

j=1

• If P V (i) > 0 then you make a profit

• The problem is that you don’t know how interest rates, i, will fluctuate

i fluctuates a little bit.

loss even if i fluctuates alot

• First we introduce a problem of language

15.6. BASIS POINTS - SOLUTION 171

6%−5%

• You might say 5% = 20%

• Rather than 6%

• We introduce Basis points

• Solution approach to problem of obtaining profit uses calculus to iden-

tify minima

• Suppose

• 1) P V 0 (i0 ) = 0

• 2) P V (i0 ) = 0

172 CHAPTER 15. DURATION, CONVEXITY

• Warning: Taylor series approach not usually emphasized alot in cal-

culus courses

2

• Taylor Series: P (i) = P V (i) = P (i0 )+P 0 (i0 )(i−i0 )+P ”(i0 ) (i−i20 ) . . .

• We only need the first two terms of the Taylor series to develop the

definitions and theorems

2

P 00 (i0 ) (i−i20 )

Duration

• Linear Approximation: P (i) ≈ P (i0 ) + P 0 (i0 )(i − i0 )

P (i)−P (i0 ) P 0 (i0 )

• Normalized P (i0 ) ≈ P (i0 ) (i − i0 ) ≡ −D(i0 , 1)(i − i0 )

P 0 (i0 ) d

D(i0 , 1) = − = − log P (i0 ) (15.2)

P (i0 ) di

dP

dδ0

(15.3)

P (i0 )

dCvit dCeδt

• Note: dt = dt = tCeδt = tCvit . Hence,

X Cj vitj

!

0

tj (15.4)

P (i0 )

allj

15.10. IN PRACTICE 173

• Duration Relationships:

of durations

n

P V (0)

Pn j

X

• DAll = Dj ,

j=1 i=1 P Vj (0)

• Where Dj is the duration of the j-th portfolio and P Vj (0) is the pur-

chase price (See problem M 05#6 for an example)

15.10 In Practice

• Modified duration is what you theoretically need to measure changes

in PV

pute (weighted average)

minus sign in the definition of duration

duration, (Macaulay) duration and slope of price

• Recall that negative modified duration measures first derivative or

slope of relative price change function

• This allows you to estimate how changes in interest rates affect changes

in profits

ear slope line.

174 CHAPTER 15. DURATION, CONVEXITY

15.12 Formulae

• It is confusing to memorize three similar formulae and their uses

•

P (i) ≈ P (i0 ) + P 0 (i0 )(i − i0 ) (15.6)

• Consequently,

P 0 (i0 )

• The approximate relative price change is P (i0 ) = −D(i0 , 1),

volatility

• Suppose P is the price of a 10-year, zero-coupon bond, with a current

yield of 10%

• We obtain the following (almost linear) graph of the price of the bond

at t = 3 as a function i interest yield

P (i) 529.79 521.40 513.16 505.07 497.12

P (i) − P (10%)

3.24% 1.61% 0% −1.58% −3.13%

P (10%)

basis points

15.14. THE TEN PROJECT QUESTIONS 175

• 1) What is the exact price

• −−−−−−−−−

• −−−−−−−−−

• How good are your approximations for the absolute price change

• We assume the yield, i, increases 100 basis points (from 10% to 11%)

7

• 1)What is the exact price Answer 1000v10%

7

• 2)What is the exact new price Answer1000v11%

• 3)What is exact price change Answer Exact New price − exact Price

exact price

7

7×1000v10%

• 5) What is the duration Answer 7

1000v10%

1.10

176 CHAPTER 15. DURATION, CONVEXITY

• 7) What is the slope of the relative price change Answer Multiply the

last answer by minus 1

answer by the exact price

• What is the approximate new price Answer Add exact price to the

last answer

• How good are your approximations for the absolute price change An-

swer Divide the approximate answer by the exact answer and subtract

1

15.16 Project I

• I will post individual Project I-s for each student

points in the change

point change

• Note the following: To calculate the approximate new price you must

sequentially calculate

approximate new price

may get simple problems like this wrong

15.17. VI) GOOD SOA EXAM PROBLEMS 177

• M05#3 Duration - Bond

• N05#21 Immunization

• QIT#59 Immunization

• QIT#70 Immunization

• QIT#71 Immunization

• QIT#72 Immunization

• QIT#73 Immunization

178 CHAPTER 15. DURATION, CONVEXITY

many challenging problems

• A bond will pay a coupon of 100 at the end of each of the next three

years and will pay the face value of 1000 at the end of the three-year

period. The bonds duration (Macaulay duration) when valued using an

annual effective interest rate of 20% is X. Calculate X.

15.19 Solution

• Step 1: Timeline

1000

100 100 100

0 1 2 3

+ 1000v20%

20%

• Step 3: TV line

789.35

3 20 CP T −100 −1000

N I PV PMT FV

X Ct v t

• Step 4a: EOV Duration t

P

100v 2 3

• Step 4b: EOV Duration Numerics: P × 1 + 100v 100v

P ×2+ P ×

3

3 + 1000v

P × 3 = 2.7

15.20. VIII) QIT#36 - GOOD QUIZ PROBLEM 179

• Please read problem in SOA resources

1

id

• If you can do quiz with hints but not without them then you must

memorize

Why?

• Hints #2) Take the derivative of P (i) with respect to i (Piece of cake)

P0

• Hints #3) Take ratio P (Piece of cake)

P0

• Hints. Fill in #4) P gives Duration of fill in amount.

• In the process you have derived a useful formula for stock duration

without inflated dividends

• Duration approximates the tangent line to the present value curve P (i)

180 CHAPTER 15. DURATION, CONVEXITY

• If locally you look like y = x2 −→ local minima −→

• We start with 2 term Taylor

2

• P (i) ≈ P V (i) = P (i0 ) + P 0 (i0 )(i − i0 ) + P 00 (i0 ) (i−i20 )

P (i)−P (i0 ) P 0 (i0 ) 1 P 00 (i0 )

• P (i0 ) = P (i0 (i − i0 ) + 2 P (i0 (i − i0 )2

definitions

• Macaulay Duration ×v = Modified Duration

P 0 (i0 ) P 00 (i0 )

M odif ied D(i, 1) = − C(i, 1) =

P (i0 ) P (i0 )

dP d2 P

dδ dδ 2

(M acaulay)

P (i) P (i)

t t

! !

X Cj v j X Cj v j

F ormula (M acaulay) i

tj i

t2j

P (i) P (i)

all j all j

duration given above.

15.25. GOOD EXAM PROBLEMS 181

ified convexity

• There are no exam problems on convexity!!!

• The SOA recently remedied this by adopting a new book with a great

new handout

• Hint: If you wanted to test someone on new material where would you

go?

by convexity.

182 CHAPTER 15. DURATION, CONVEXITY

Chapter 16

Full Immunization

16.1 Overview

• We have five subgoals in todays chapter

• V) Asset Matching

ities,

• Immunization means you are immunized or protected against lost

fluctuations in i

in i

(Why?)

183

184 CHAPTER 16. FULL IMMUNIZATION

• Theorem Suppose P (i0 ) ≥ 0, P 0 (i0 ) = 0, P 00 (i0 ) ≥ 0

t

X

• Recall P (i) = Cj v i j

allj

t

X

• A(i) = Cj v i j

Cj >0

t

X

• L(i) = |Cj |vi j

Cj <0

lated

• Theorem If A(i) ≥ L(i), A0 (i) = L0 (i), and A00 (i) ≥ L00 (i)

16.6. II) FULL IMMUNIZATION THEOREM 185

• Rather exciting. Mathematics assures you that you can’t lose

• Note: Theorem assumption: You have one liability with two assets

• Timeline

A1 −L1 A2

0 t1 t t2

munization)

• We present some numbers and then show how to fully immunize

• Assets: Buy zero coupon bonds before and after the liability date:

Say t = 3, t = 10.

purchased to guarantee payment?

matching

P V (Assets); and P V 0 (Liability) = P V 0 (Assets).

186 CHAPTER 16. FULL IMMUNIZATION

• Unknowns: Buy $x worth of three year zero coupon bonds

• Unknowns: Buy $y worth of 10 year zero coupon bonds

• Note: x and y are prices at time t = 0, and therefore are present

values.

• An alternate approach lets x and y be the number of bonds of each

type

• But if you approach that way you must separately compute Present

Value

• The way I have approached, the present values are already computed

x, y, and x + y

• Still another alternate approach lets x, y be the values at maturity of

the total redemption

• When solving problems it is important to carefully select variables:

PV, number, FV

16.9 Strategy

• We have two unknowns −→ We need two equations

• We obtain one equation for P (i0 ) = 0

• We obtain one equation for P 0 (i0 ) = 0

• We then solve the two equations in two unknowns

• And find the value of x and y

• Recall P (i0 ) = 0 =⇒ A(i0 ) = L(i0 ).

• But A(i0 ) = x + y (Why?)

7 = 87056.02 (Why?)

• L(i0 ) = 100, 000v2%

7 .

• So first equation is x + y = 100, 000v2%

16.11. EQUATION 2: ASSETS: NUMERATOR, DENOMINATOR 187

nator

• Second equation is P 0 = 0 or A0 = L0

• Let us do A0 first

0

• But a slick trick is to compute the Macaulay Duration which is − AA

C1 v t 1 C2 v t2

• Duration is P t1 + P t2

• But what is t1 , t2

bonds

0.

are prices

x y

• Putting it all together: Duration = x+y ×3+ x+y × 10.

• What is the Macaulay duration of the liability

188 CHAPTER 16. FULL IMMUNIZATION

10y

• P 0 (i) = 0 =⇒ 3x

x+y + x+y = 7.

• P (i) = 0 =⇒ x + y = 100000(1.02)−7

• Need to solve

• We have two linear equations in two unknowns

the other

• You now have a linear equation in one variable which is easy to solve

• So x = 37309.72, y = 49746.30

• We only used two equations corresponding to P and P 0 but are fully

immunized

37309 49746

• Convexity of assets is 87056 × 32 + 87056 × 102 = 61 > 49

like a parabola)

16.17. IV) PROJECT 2 IMMUNIZATION PROJECT 189

• For Project 2 each of you will do your own personal project

• You will be given a) Liability b) liability date c) two dates for assets

d) interest rate

• You will then recommend purchase of zero coupon bonds to fully im-

munize liability

• There are asset matching problems that don’t require immunization

• What do they require?

• They require buying assets to pay off a liability

• In symbols we want A(i) = L(i)

• We just want to match the liability

• We are not concerned about fluctuations in interest rates

• We assume the interest rate is constant and just want to match assets

to liabilities

• Very often this type of problem is called exact asset-liability matching

16.19 M05-#15

• An insurance company accepts an obligation

• To pay 10,000 at the end of each year for 2 years.

• The insurance company purchases a combination of the following two

bonds

• At a total cost of X in order

• To exactly match its obligation:

• (i) 1-year 4% annual coupon bond with a yield rate of 5%

• (ii) 2-year 6% annual coupon bond with a yield rate of 5%

190 CHAPTER 16. FULL IMMUNIZATION

• We must adjust our strategies

t 0 1 2

Liability 10000 10000

F 1.04F 0

G 0.06G 1.06G

16.21 Equations

• The basic EOV is Assets = Liabilities

• Why? Because you will have one equation in one unknown and you

can solve

• 1.06G = 10000

• Next go to t = 1

• Two equations in two unknowns; piece of cake; solve for G; then solve

for F

• Final answer is PF + PG

Chapter 17

Forwards

17.1 Overview

• We have the following 9 subgoals in this chapter.

• I) Insurance, Derivatives

• V) Short sale

• For Homework I want you to think how you would solve DS-Q#3

191

192 CHAPTER 17. INSURANCE, PUTS, CALLS, FORWARDS

• What is the difference: Buy insurance vs. Buy a car

• When you buy insurance: You buy the right to buy a car if your

current car is destroyed

• Insurance typifies not buying objects but buying rights to buying ob-

jects

• What are the types of derivatives

17.4 Goals

• We will discuss puts,call,forwards-futures-buys-sales

• Think of buying insurance for your car

• If your car is fine −→ you don’t exercise the insurace −→ you lose

your insurance premium

17.6. DERIVATIVE OVERVIEW - PROFIT DIAGRAMS/GRAPHS 193

a new car

• If the new car is worth more than your old car you profit

• The example in the last slide illustrates what profits depend on

• They depend on possible future values of the underlying asset (in this

case the car)

• Possible Actions: Buy/Sell Long/Short

Calls / puts

• As in other parts of the course we emphasize a building block approach

(level, increasing, decreasing)

eral, level, total)

194 CHAPTER 17. INSURANCE, PUTS, CALLS, FORWARDS

• There are 6 basic Derivative building blocks

call or iii) put

forward-future-buy-sale/call/put

• We will cover the 6 building blocks today

• Standard Example: I sell you my watch

• The money you give me for the asset is call the Price

• We call a buy/sale long if the Asset and price are both exchanged at

time t = 0

17.12. PROFIT ON LONG SALE 195

• Suppose the Asset goes up: t = 0, P rice(0) = 30; t = 1, P rice(1) =

40

• You lose 30 at t = 0;

• If the asset price goes up −→

• Again this is all rough since we must take into account interest

• I sell my 30 dollar watch short

• This means

• I receive the 30 at t = 0

it.

196 CHAPTER 17. INSURANCE, PUTS, CALLS, FORWARDS

• Suppose watches are worth 40 at t = 1

• Notice that the asset has gone up but I, the seller, have lost 10

• Although the asset has gone up, you, the buyer, have gained 10

• Suppose watches are worth 20 at t = 1

• I only need to pay 20 to cover my short and obtain a watch for which

I received 30

• Long buyer makes money if asset price goes up

• So long and short are opposites (one profits when the other loses)

• Here the word Short refers to the transaction

• But it is confusing because the same word can be used in two ways

17.19. STRATEGIES 197

17.19 Strategies

• Items like watches don’t fluctuate that much in price

• If you think a stock will go up you buy long and expect to profit

• If you think a stock will go down you sell short and expect to profit

• What is a forward?

• Again: The stock is the underlying asset

goes up)

• We say that your position in the foward is short (You make money if

asset goes down)

contract

198 CHAPTER 17. INSURANCE, PUTS, CALLS, FORWARDS

• We have covered forwards and ordinary sales

• In all 4 cases I give money and you give me stock

Outright purchase t=0 t=0

F orward t=1 t=1

P repaid f orward t=0 t=1

F ully leveraged purchase t=1 t=0 (17.1)

• In a future lecture we will discuss the fair price of forwards and how

to adjust for dividends

• Future and Forwards are almost the same thing

17.25. WHY USE FORWARDS / FUTURES 199

• Exchanges have rules which affect futures; forwards have less rules

• There are other differences but they are consequences of the daily

settlement.

• Typical Example: I raise hogs, cattle, sheep, etc.

• If the price of wheat or alfafa fluctuates I pay more for alfafa, eating

up my profits

• Let us deal with a forward with expiration date at t = 1

t=1 t=1

1000 900 −100

1000 1000 0

1000 1100 100

200 CHAPTER 17. INSURANCE, PUTS, CALLS, FORWARDS

asset is worth 900 (at t = 1) then I have lost 100

• To make a profit table you can use excel and make many rows

• However you only need three points: Below, at, above agreed price

• Note: Payoff is what you get at t = 1; profit is payoff − expenses.

• But there are no expenses (Premium) for a forward or future.

• So for a forward / future, P rof it = P ayof f

• X axis: The price of the underlying asset at t = 1

• Y axis: The payoff or profit from the transaction at t = 1

• Description of Graph: Line slanting upwards

• I use clock positions to describe graphs

• a line slanting upwards resembles the clock position of 7:05

• I also use letters: U indicates a slanting upwards line

• The slope is 1; Can you justify this from the above table?

• What does it mean for me to buy a Call on stock X

• It means I buy the right or option to do one of two things

• (Possibility #1)

• Buy the underlying asset, X,

• At the future expiration date,

• At the agreed strike price,

• (Possibility #2)

• I have the right to do nothing (no buy; no sale)

17.29. WHY USE A CALL 201

• Think of the hog and alfafa example mentioned above

• A call would give me the option of buying alfafa at P if the price goes

up

• But if the price goes down I buy at the lower price

• So my future expenses for alfafa are capped at P

• Calls are therefore a sort of insurance - I can’t spend more than P

• Like an insurance policy I have to pay for the right to have this option

• The payment price is called the premium

• If I decide to buy the asset at expiration date we say I exercise the

option

• The other terms - price, underlying asset, premium, expiration

date - are mentioned above

• These are the same three styles we discussed for callable bonds

• An American style allows me to exercise the call at any time

• A Bermuda style allows me to exercise the call at certain times

• An European style allows me to exercise the call only at the expira-

tion date

• For the most part we will deal with European styles.

17.32 Example

• Premium: 93.81

• Interest rate for 6 months: 2%

• Strike Price: $1000

202 CHAPTER 17. INSURANCE, PUTS, CALLS, FORWARDS

• Payoff-Profit Table Long Call

Actual Price-X Agreed Price Buy? Reason Payoff Premium Premium Profit-Y

t=6 t=6 t=6 t=6 t=0 t=6 t=6

900 1000 No No buy for more − −93.81 −95.68 −95.68

1000 1000 − − − −93.81 −95.68 −95.68

1100 1000 Y es Buy cheap 100 −93.81 −95.68 4.32

• The Call Payoff Diagram/graph looks like the clock position TIME 9:10

• We can also use letter notation: HU, a horizontal line (slope 0) followed by an upwards slanting line

• Call Profit Diagram Same shape but lower (The two graphs are translations)

• Note the horizontal line of graph =⇒ no exercise of options; the slanting line =⇒ exercise of option

• The following slide gives important advice on how to create a table for

a call graph

t = expiration date 4) Profit (Y -axis)

• You might also benefit from using the following 3 more columns

t = 0 and t = expiration date

• Furthermore, label each column with two header rows, the second row

indicating t = 0 or t = expiration date

17.35. IX) OPTIONS - PUT 203

• What does it mean for me to buy a Put on stock X

• (Possibility #1)

• (Possibility #2)

• Long Call Diagram/Graph looks like TIME 9:10 (horizontal line,

followed by slanting upwards line)

• Long Put diagram looks like TIME 2:50 (Slanting downwards line,

followed by horizontal line)

• Important point: Short call and short put diagrams are x-axis re-

flections of the corresponding long positions

(x, −y) in short diagram.

• We use the terms write a call, sell a call, sell a put, or write a

put to indicate short sales

204 CHAPTER 17. INSURANCE, PUTS, CALLS, FORWARDS

I buy a Call TIME 9 : 10 HU buy asset (17.3)

I buy a P ut TIME 2 : 50 DH sell asset (17.4)

I write a Call TIME 9 : 20 HD f orce me to sell (17.5)

I write a put TIME 2 : 40 UH f orce me to buy (17.6)

• Find in the following question, the basic building blocks: puts, calls,

buy-sell-forwards-future. Describe each transaction - who is buyer and

seller, when will transfers take place etc.

ply jalapeno peppers to the organizers of the annual jalapeno eating

contest. The contract states that the contest organizers will take de-

livery of 10,000 jalapenos in one year at the market price. It will cost

Happy Jalapenos 1,000 to provide 10,000 jalapenos and todays market

price is 0.12 for one jalapeno. The continuously compounded risk-free

interest rate is 6%. Happy Jalapenos has decided to hedge as follows

(both options are one-year, European): Buy 10,000 0.12-strike put op-

tions for 84.30 and sell 10,000 0.14-stike call options for 74.80. Happy

Jalapenos believes the market price in one year will be somewhere be-

tween 0.10 and 0.15 per pepper. Which interval represents the range

of possible profit one year from now for Happy Jalapenos?

Chapter 18

Introduction to Derivatives

18.1 Overview

• We have one goal today: Coverage of DS-Q#3

the building blocks

• X) Application to DS-Q#3

205

206 CHAPTER 18. INTRODUCTION TO DERIVATIVES

graphing

• Currently this topic can not be found in any other textbook

• It is however a very useful technique.

forward-future-buy-sale

• We learned the six basic building blocks in Chapter 17

• puts, calls, forward-purchases

• long,short

• You must know their profit diagrams and graphs

• Everything else in Chapter 18 and 19 is built from them

• This is a great multi-part problem

• We presented it last time

• We state it here and then analyze its components

• DS-Q#3. Happy Jalapenos, LLC has an exclusive contract to supply

jalapeno peppers to the organizers of the annual jalapeno eating con-

test. The contract states that the contest organizers will take delivery

of 10,000 jalapenos in one year at the market price. It will cost Happy

Jalapenos 1,000 to provide 10,000 jalapenos and todays market price

is 0.12 for one jalapeno. The continuously compounded risk-free in-

terest rate is 6%. Happy Jalapenos has decided to hedge as follows

(both options are one-year, European): Buy 10,000 0.12-strike put op-

tions for 84.30 and sell 10,000 0.14-stike call options for 74.80. Happy

Jalapenos believes the market price in one year will be somewhere be-

tween 0.10 and 0.15 per pepper. Which interval represents the range

of possible profit one year from now for Happy Jalapenos?

18.4. III) SOLUTION APPROACH: I) FIND/LIST ALL BUILDING BLOCKS IN THE PROBLEM207

ing blocks in the problem

• Sell call - so we take a short position

• Buy put - so we take a long position

• Happy Jalapenos is seller; Eating Contest is buyer

from profit

• δ = 6%

208 CHAPTER 18. INTRODUCTION TO DERIVATIVES

ing block

•

SHORT CALL Should other P ayof f on 1 P ayof f on all COST COST P ROF IT − Y

M arket price − X Strike price buy to me to me P remium P remium at

T =1 t=0 t=1 t=1 t=0 t=1 t=1

0.1 0.14 No 0 0 74.8 79.43 79.43

0.11 0.14 No 0 0 74.8 79.43 79.43

0.12 0.14 No 0 0 74.8 79.43 79.43

0.13 0.14 No 0 0 74.8 79.43 79.43

0.14 0.14 No 0 0 74.8 79.43 79.43

0.15 0.14 Y es −0.01 −100 74.8 79.43 −20.57

• Position is short. I sell call. Other person is buyer

• Remember: For both puts and calls, the slanting part of graph corre-

sponds to exercise of option

time position 9 : 10

• We have two ways to do table: Strike price equals i) 12 cents ii) 1200

dollars

10000 peppers

18.10. LONG PUT 209

•

Long put Should I P ayof f on 1 P ayof f on all P remium P remium P rof it − Y

M arket price − X Strike price sell to me to me At At at

T =1 t=1 t=1 t=0 t=1 t=1

0.1 0.12 Y es 0.02 200 −84.3 −89.51 110.49

0.11 0.12 Y es 0.01 100 −84.3 −89.51 10.49

0.12 0.12 Y es 0 0 −84.3 −89.51 −89.51

0.13 0.12 No 0 0 −84.3 −89.51 −89.51

0.14 0.12 No 0 0 −84.3 −89.51 −89.51

0.15 0.12 No 0 0 −84.3 −89.51 −89.51

• Put graphs look like time position 2:50; exercising of option occurs

on slanting part of graph

18.11 Forward at t = 1

•

Jalapeno Sale P rof it at 1

M arket price − X Cost to me P ayof f to me P rof it to me − Y

T =1 T =1 T =1 t=1

0.1 −1000 1000 0

0.11 −1000 1100 100

0.12 −1000 1200 200

0.13 −1000 1300 300

0.14 −1000 1400 400

0.15 −1000 1500 500

• How do you join together the above tables

210 CHAPTER 18. INTRODUCTION TO DERIVATIVES

• The results are shown in the next slide

of this book

• Join Table

T =1 Call P ut Jalapenos P rof it

T = 1 T = 1 T = 1 T = 1 T = 1

0.1 79.43 110.49 0 189.91

0.11 79.43 10.49 100 189.91

0.12 79.43 −89.51 200 189.91

0.13 79.43 −89.51 300 289.91

0.14 79.43 −89.51 400 389.91

0.15 −20.57 −89.51 500 389.91

18.15. COMPLETION OF PROBLEM 211

• We can draw graph directly

cents

• We will examine this in more detail after introducing the graph method

approach

• We can draw graph directly without ANY computation!

tation

• The graphs of puts,calls,buy-sell-forward-future have 3 components

212 CHAPTER 18. INTRODUCTION TO DERIVATIVES

18.18 Examples

• A long call graph is abbreviated HU corresponding to a 9:10 clock

position

position

position

position

• Consider a U of a graph

assets results in a 1 dollar increase in profit

is 0

• This unit slope of 1 or -1 is valid for long and short calls and puts as

well as buys and sales

• Suppose you have a combination of puts, calls and forwards

18.21. X) APPLICATION TO DS-Q#3 213

• For example, in a call or put there are 2 regions (one H and the

2nd either U,D)

• If you want the actual graph vs. its form you have to identify the

y-intercept

(18.1)

• This rule follows from the way we have defined U,D,H for basic com-

ponents

• Piece of Cake!

• A Short call is HD

• A long put is DH

• A purchase is U

214 CHAPTER 18. INTRODUCTION TO DERIVATIVES

•

Short Call H H D

Long P ut D H H

F orward U U U

Sum H +D+U H +H +U D+H +U

Join Graph H U H

10000 units 10000H 10000U 10000H

We would find Y (0) = 189.91

∆X

• But slope = 10000 = ∆Y and hence ∆Y = 10000 × 0.01 = 100

• We can now discuss DS-Q#3 more thoroughly

• The loss is indicated by the Upward line below the x axis

18.25. WHY SELL A CALL 215

• Look over the basic 6 components and find the basic component with

a downward slanting line

• But buying the put costs money and that is loss

• The premiums of the sold call and long put almost cancel

• You cut your profits (Downward short call line + upward forward line)

graphing: DS-Q#9

• Please read DS-Q#9 in the class resources.

• Let us study part (A) Buy a 90-put, buy a 110 put, sell two 100 puts

computations.

216 CHAPTER 18. INTRODUCTION TO DERIVATIVES

•

M arket P rice Below 90 Between 90 100 Between 100 110 Above 110

Buy 90 call H U U U

Buy 110 call H H H U

sell two 100 calls H H D D

2nd 100 call H H D D

Symbolic sum H+H+H+H U +H+H+H U +H+D+D U +U +D+D

Join Graph H U D H

Chapter 19

Derivatives - Graphing

Methods

19.1 Overview

• This chapter deals with Derivatives

• I) Derivative Definition

• V) Illustrative Examples

• A derivative is a simultaneous purchase/sale of several puts/calls

other details

217

218 CHAPTER 19. DERIVATIVES - GRAPHING METHODS

• A typical row of the Appendix gives various attributes of each deriva-

tive

you use to obtain this derivative

to know

• In addition to knowing the Names, Definitions, Graphs . . . of

derivatives,

• You must know how to infer their properties from their Graphs

• The properties you must know are summarized in the following terms:

• Let us now go over each derivative property and explain it

• You make a Profit at a given market (x) value if the y value is positive

(above x-axis)

infinity

slope) at the end of the graph

19.6. SUPERIORITY 219

itive

a (nU) at the end of the graph for some integer n

the graph description as x goes to infinity

cap losses.

19.6 Superiority

• Derivative I is superior to Derivative II at market value x, if yI (x) >

yII (x)

• Profits, caps and limits can typically be done without tables, compu-

tation of numerical values, by general graph methods

values)

19.7 Volatility

• Volatility refers to changes in market value x

• A volatile stock’s market values will typically move away (left or right)

from the strike price

• A non-volatile stock’s market values will stay near the strike price

• The typical phrase to describe volatility is more volatile than the mar-

ket

• This emphasizes that although the market is volatile you expect higher

volatility in a given stock

220 CHAPTER 19. DERIVATIVES - GRAPHING METHODS

19.8 Moneyness

• Every option can be classified in one of three ways

• To classify an option we compare the current market value and strike

price

• If selling the option at the current market price would bring a profit,

the option is ITM

• Note that ITM is different for calls and puts (Since their profit regions

are different)

• If the current market price would motivate not exercising the option,

the option is OTM

• Remember in lecture 18 how we used a put for insurance in the Happy

Jalapeno example

• This call premium compensated for the loss of premium in buying the

put

• This combo: Buying one option and selling another to offset premium

costs is common

• ITM options have higher premiums (Because you can make money if

the price persists)

• OTM options have lower premiums (Because you can’t make money if

the price persists)

19.11. III) GOOD DERIVATIVE PROBLEMS 221

• Some derivative problems can be done solely by graphs without com-

putational tables

• D-SQ#8

• D-SQ#9

• D-SQ#15

• D-SQ#17

• D-SQ#26

• D-SQ#3

• D-SQ#11

• D-SQ#13

• D-SQ#14

• D-SQ#16

lems

• First, we discuss how to graph a derivative without computation

222 CHAPTER 19. DERIVATIVES - GRAPHING METHODS

• Note: This method is also a good start even when numerical tables

are necessary

lems

• After using the graphical approach mentioned in the last slide,

• To make the table, you can break the derivative into component build-

ing blocks

graph method

• The fastest computational method does the following

• Since you know the slope of each graph segment you can quickly

compute any point

• We do the five graphical problems listed above in order. We start with

D-SQ#8

19.18. D-SQ#8 - SOLUTION 223

market prices for options on that stock. You want to speculate on that

belief by buying or selling at-themoney options. What should you do?

A. Buy a strangle

B. Buy a straddle

C. Sell a straddle

D. Buy a butterfly spread

E. Sell a butterfly spread

• Volatile means you expect stock market values to go away from the

strike price

ical form HDUH.

• So if you are away from the strike price the graph is horizontal

• That means you would not make a profit if market is very volatile

• This would not give you a profit if market values were away from strike

price

from the market price

correct answer is buying a straddle, B

• This pretty problem was done in lecture 18

ful

224 CHAPTER 19. DERIVATIVES - GRAPHING METHODS

19.20 D-SQ#15

• The current price of a non-dividend paying stock is 40 and the con-

tinuously compounded risk-free rate of return is 8%. You enter into

a short position on 3 call options, each with 3 months to maturity, a

strike price of 35, and an option premium of 6.13. Simultaneously,

you enter into a long position on 5 call options, each with 3 months to

maturity, a strike price of 40, and an option premium of 2.78. Assum-

ing all 8 options are held until maturity, what is the maximum possible

profit and loss for the entire option portfolio?

P rof it Loss

A. 3.42 4.58

B. 4.58 10.42

C. U nlimited 10.42

D. 4.58 U nlimited

E. U nlimited U nlimited

• This is another problem that unexpectedly can be done soley by graphs

• The first step is to analyze the graph using the graphing method

methods

• We also show how to combine the graphical method with one computed

point at 0 to get the table

• The graph is HDU

19.23. GRAPHICAL ANALYSIS 225

• The terminal U indicates a potential for unlimited profit as x goes to

infinity

• The vertex of the DU segment is the minimum of the graph

• It represents the maximum loss

• Remarkably only answer C allows maximum profit and capped losses

•

Short Call H D D

Short Call H D D

Short Call H D D

Long Call H H U

Long Call H H U

Long Call H H U

Long Call H H U

Long Call H H U

Join Graph H 3D 2U

• Although we don’t need to, it is good to review table creation

• The techniques were illustrated in the solution to D-SQ#3, Chapter

18

• Step 1: Create two building blocks, the Short call, Long call

• Step 2: Each building block uses the columns in our standard set up

• Step 3: Create the Join table

• Be sure and multiply the short and long calls by 3 and 5

226 CHAPTER 19. DERIVATIVES - GRAPHING METHODS

•

V alue P rice Exercise? t=1 t=0 t=1 t=1

0 35 No 0 6.13 6.25 6.25

35 35 No 0 6.13 6.25 6.25

40 35 Y es −5 6.13 6.25 1.25

100 35 Y es −65 6.13 6.25 −58.75

•

V alue P rice Exercise? t=1 t=0 t=1 t=1

0 40 No 0 −2.78 −2.84 −2.84

35 40 No 0 −2.78 −2.84 −2.84

40 40 No 0 −2.78 −2.84 −2.84

100 40 Y es 60 −2.78 −2.84 57.16

•

V alue Call Calls Call Calls

0 6.25 18.76 −2.84 −14.18 4.58

35 6.25 18.76 −2.84 −14.18 4.58

40 1.25 3.76 −2.84 −14.18 −10.42

100 −58.75 −176.24 57.16 285.82 109.58

• So one can see that the graph minimum occurs at the point y(40) =

−10.42

19.28. METHOD #3: FAST TABLES BY COMPUTING ONLY ONE POINT PLUS GRAPH227

one point plus Graph

• We already have the graph shape and all relevant slopes

• Well there are only 2 basic items: Short call and Long call

• For the long call there is also no exercise at 0, again, because the graph

is flat

• How do we compute the minimum

228 CHAPTER 19. DERIVATIVES - GRAPHING METHODS

5 × 3 = −10.42

derivatives:

19.31 D-SQ#17

• Assume the current price for a stock index is 1,000, and the following

premiums exist for various options to buy or sell the stock index 6

months from now: Strike Price Call Premium Put Premium

950 120.41 51.78

1, 000 93.81 74.20

1, 050 71.80 101.21

Strategy I is to buy the 1,050-strike call and to sell the 950-strike call.

Strategy II is to buy the 1,050-strike put and to sell the 950-strike put.

Strategy III is to buy the 950-strike call, sell the 1,000-strike call, sell

the 950-strike put, and buy the 1,000-strike put.

Assume that the price of the stock index in 6 months will be between

950 and 1,050. In 6 months, which of the three strategies will have

greater payoffs for lower prices of the stock index than for relatively

higher prices?

A. I only

B. I and II only

C. I and III only

D. II and III only

E. I, II, and III

19.32. D-SQ#17-ANALYSIS 229

19.32 D-SQ#17-Analysis

• (Sketch) We analyze each derivative - I,II,III - using the graphical

methods

goes down then when up

230 CHAPTER 19. DERIVATIVES - GRAPHING METHODS

Chapter 20

20.1 Overview

• We do a variety of short topics today

• I) Call-Put Parity

• IV) Hedging

231

232 CHAPTER 20. CALL PUT PARITY

• This is a very important principle. The equation is as follows.

•

C(K, T ) − P (K, T ) = S(0) − P V (K) (20.1)

• C(K, T ) is the premium for a long call, with strike price K and expi-

ration date T

• −P (K, T ) is the premium for a short put, with strike price K and

expiration date T

stock has no dividends

• We now verbally prove the important call-put parity formula.

t=0

• Long Call: I will buy stock and pay K, at time T - if price at T

exceeds K

• Short Put: Buyer (of short) will sell stock and receive K, at time T

- if price at T is less than K

• Short Put: Equivalently, Seller of short (me) will buy stock and pay

K, at T - if price at T less than K

20.5. PROOF-EQUALITY 233

• In all cases, at time t = T, I buy/own the stock and pay K

20.5 Proof-Equality

• So right side and left side describe the following identical situation

• I own stock and pay K at time T

• −→ Consequently, the cost of the two sides of the equation must be

equal

• The right side deals with stock; the left side deals with options

• This is called the call-put parity principle

• It is a single principle that enables you to solve any situation relating

the following

• premiums of call and put options with the same strike price and

expiration, and the underyling stock, provided no dividends are paid

• Let us now look at some examples.

20.6 D-SQ#2

• You are given the following information:

• The current price to buy one share of XYZ stock is 500.

• The stock does not pay dividends.

• The risk-free interest rate, compounded continuously, is 6%.

• For both the call and put:

• Strike price is K; expiration date is one year; option is European

• Put premium is 18.64

• Call premium is 66.59

• Using put-call parity, determine the strike price, K.

234 CHAPTER 20. CALL PUT PARITY

•

66.59 −18.65 = 500 −Ke−0.06

20.8 Solution

• We solve this equation for K

• We obtain K = 480

20.9 D-SQ#5

• You are given the following information:

• You want to buy this index in one year for a price of 1,025.

• You do this with put and call options with a strike price of 1,025.

•

1025

Buy the call Sell the put = 1000 −

1.05

20.11. INTERPRETATION 235

20.11 Interpretation

• Tricky question. Published SOA solutions do not solve this using put-

call parity

• But remember: Put-call parity is all you need when dealing with op-

tions/stocks at same strike price and expiration date

• I should buy the call (long) and sell the put (Short)

1025

• The premium cost is 1000 − 1.05 = 23.81

premium

• This is an English convention: You for example say that the cost of a

pen is 10, not -10.

• DS-Q#5 mentions the index

• If stocks have been going down for a while you may want to sell short

236 CHAPTER 20. CALL PUT PARITY

• When people speak about the market trend they may be speaking

about the DOW

20.14 D-SQ#14

• The current price of a non-dividend paying stock is 40 and the con-

tinuously compounded risk-free rate of return is 8%. You are given

that the price of a 35-strike call option is 3.35 higher than the price

of a 40-strike call option, where both options expire in 3 months. How

much does the price of an otherwise equivalent 40-strike put option

exceed the price of an otherwise equivalent 35-strike put option?

•

C(35, T ) −P (35, T ) = 40 −35e−.02

C(40, T ) −P (40, T ) = 40 −40e−.02

• To solve this problem we need algebraic expressions for two more En-

glish phrases.

20.17. ALGEBRA 237

40-strike put option exceed the price of an otherwise equivalent 35-

strike put option?

20.17 Algebra

• We have left to solve

• Rather we are solving for the algebraic expressions, C(35) − C(40) and

P (35) − P (40)

• We start with the first two equations presented two slides ago

• C(35, T ) − C(40, T ) − P (35, T ) − P (40, T ) = 5e−.02

• −→ P (40, T ) − P (35, T ) = 5e−.02 − 3.35 = 1.55

0.08

• So the continuous interest rate for 3 months is 4 .

•

N ame W hen you pay W hen you receive security P rice F ormula

P urchase 0 0 S0

Leveraged P urchase T 0 S0 ert

P

P repaid F orward 0 T S0 = F0,T

F orward T T S0 ert = F0,T

238 CHAPTER 20. CALL PUT PARITY

20.19 D-SQ#29

• Good problem.

• It is a straightforward plug in

• You should complete the lecture, especially the part about Dividends

prior to attempting this problem

• In this slide we present the definition of dividend

• Why? Because you bought stock and hence are a co-owner in the

corporation

• Dividends are frequently paid quarterly (at end of quarter)

20.22. DIVIDEND REINVESTMENT 239

• Many stocks allow automatic reinvestment of monetary dividends

• Here is an example of how this works

• Suppose the stock is worth 100 and pays a dividend of 10 every year

• Then you have the option of automatically converting this 10 into new

stock

• So in our example you would own 1.1 shares of stock (worth 110)

• The (dis)advantage of owning stock versus money is that the stock

may go up/down

• A further consequence of automatic reinvestment is that you automat-

ically acquire the stock

• Normally, to acquire or sell a stock you have to pay the stock broker

a commision

• Commision is an expense

• The commission is the payment to the broker for his work in buying

or selling the stock for you

• When you automatically reinvest you don’t have to pay any commi-

sions

• Not paying commisions saves you money.

• Let us use the example just given

• The stock is worth 100 and pays one dividend of 10 every year

• We could say that the dividend rate is 10%

• This would imply that the dividend in year 2 is 11, not 10 (Why?)

• If the dividend rate is continuous then we would use the continuous

rate 9.53% (Why?)

• We will present an example below using discrete quarterly dividends

240 CHAPTER 20. CALL PUT PARITY

• When dealing with stocks and derivatives the symbol traditionally

used to indicate interest is r, not i

portion of course

• In the interest theory portion of this course

pound rates respectively

dend interest

• We have two interest rates

• If the stock goes up you get more dividends; if the stock goes down

you get less

risk

• Traditionally the rate of monetary growth is called the risk free rate

20.27. FAIRNESS ISSUES 241

• In a Forward contract I receive the stock at time T

• The Dividends are part of the stock deal, for example, there might be

automatic reinvestment

relates Dividends to the Stock Price

from the forward price

• Otherwise, the seller would receive the value of the dividends twice.

• We now compute, using the above discussion, the fair price for a for-

ward contract at time T, F0,T

• The stock price grows by the risk free interest rate, r, governing money

growth

• Now suppose there are dividends

• But we subtract from the stock the dividends because the buyer al-

ready received them

242 CHAPTER 20. CALL PUT PARITY

P

• The sum is taken over all times t when dividends are given

P

• This sum

20.30 D-SQ#20

• The current price of a stock is 200, and the continuously compounded

interest rate is 4%. A dividend will be paid every quarter for the next

3 years, with the first dividend occurring 3 months from now. The

amount of the first dividend is 1.50, but each subsequent dividend will

be 1% higher than the one previously paid. What is the fair price of a

3-year forward contract on this stock?

20.31 Solution

• Break up the price into two parts

• i) Growth of stock

• δ = 0.04, n = 3 −→ 200e0.04×3 = value of stock at t = 3

• Note this gives the value of the stock without consideration of divi-

dends

20.33. TIMELINE - ANNUITY 243

•

0 1 2 3 4 ...

• The above is equivalent to the following timeline at the modified (in-

flation adjusted) rate i0

0 1 2 3 4 ...

1 1.01

1+i0 = e0.01

• The annuity gives us the present value

244 CHAPTER 20. CALL PUT PARITY

20.36 Numbers

• i0 = 0.004967%

• 200e.04×3 = 225.50

• What is a Hedge

20.38 Hedging-Options

• One type of hedging is insurance hedging

• There are hedges based on probability distributions

20.40. D-SQ#19 245

loss/profit

20.40 D-SQ#19

• You are a producer of gold, and have expenses of 800 per ounce of gold

produced. Assume that the cost of all other production-related expenses

is negligible, and that you will be able to sell all gold produced at the

market price. In 1 year, the market price of gold will be in 1 of 3

possible prices, corresponding to the following probability table: Gold

will either be 750 an ounce with probability 20%, 850 an ounce with

probability 50% or 950 an ounce with probability 30%. You hedge the

price of gold by buying a 1-year put option with an exercise price of 900

per ounce. The option costs 100 per ounce now, and the continuously

compounded interest rate is 6%. Which of the following is closest to

your expected 1-year profit per ounce of gold produced?

• We will make 3 tables

• One new column is added to the tables: Probability

246 CHAPTER 20. CALL PUT PARITY

•

T =1 T =1 T =1 T =1

750 0.2 −800 750 −50

850 0.5 −800 850 50

950 0.3 −800 950 150

•

T =1 T =1 T =1 T =1

750 Y es 900 150 −106.18 43.82

850 Y es 900 50 −106.18 −56.18

950 No 0 0 −106.18 −106.18

•

Gold P rice P robability of P rice P rof it on Gold P rice P ut P rof it P rof it T ot P rof it ∗ P rob

T =1 T =1 T =1

750 0.2 −50 43.82 −6.18 −1.24

850 0.5 50 −56.18 −6.18 −3.09

950 0.3 150 −106.18 43.82 13.14

• We go to the combined table

20.47. GOOD HW EXERCISE 247

• D-SQ#18 resembles D-SQ#19

248 CHAPTER 20. CALL PUT PARITY

Chapter 21

Arbitrage

21.1 Overview

• We are covering one topic today, Arbitrage

• IV) Stock Arbitrage - Fair Forward Price less than Actual Market

Price

• V) Terminology

• VI) Stock Arbitrage - Fair Forward Price more than Actual Market

Price

• VIII) Exercises

249

250 CHAPTER 21. ARBITRAGE

• Suppose

• The same object, pens, are being sold for two prices

• How?

•

t = 0 Short A, 1 pen Receive 10 N eed pen to cover short

t=0 Long B, 1 pen Receive pen, pay 7 N one

t=1 N one (10 − 7)(1 + i) prof it Cover short, Give A pen

• Arbitrage is a guaranteed profit without any money expenditure

• The table in slide 21.3 is called an arbitrage Tableau

21.6. II) REVU OF STOCK DIVIDENDS 251

• Lets revu stocks, futures and dividends

• Here r is the risk free continuous rate currently offered by the Market

• Now suppose the stock issues dividends

• Recall we subtract dividend worth since the seller owned the stock till

t

•

F0,t = S0 ert e−δt (21.1)

• If r and δ are the current market rates we call the resulting forward

price,Fair

252 CHAPTER 21. ARBITRAGE

• Suppose S0 = 100, dividends are discrete, with discrete rate 10%

paying commissions

• Why would I choose reinvestment of dividends?

• In the real world you typically do not find stocks sold at two different

prices

• But the market may offer a forward price different than the fair forward

price

• So you have two prices for the same object: actual market vs. fair

21.11. STOCK ARBITRAGE - FAIR FORWARD PRICE LESS THAN MARKET FORWARD PRICE253

than Market Forward Price

• Step I: We deal with the following hypothetical problem.

• T = 0.5

• Actual market forward price: 965

•

T =0 T =0 T =0 T = 0.5 T = 0.5

Action Have/P rof it N eed/Owe P rof it/Have N eed/owe

Borrow S0 e−δ T $ −S0 e−δ T $ N A −S0 e−δ T erT $

Short F orward NA NA F0,T $ −1 Share

254 CHAPTER 21. ARBITRAGE

• Cost: I spent nothing at t = 0

• Profit: At t = 0.5, I profitted F0,T −S0 e−δT erT = Actual M arket F orward−

Synthetic F air F orward = 965 − 960.79 = 4.21

21.15 V) Terminology

• We call this arbitrage a cash and carry arbitrage

forward

• The first two rows of the tableau are called a synthetic long forward

• You can check that the two rows together have the characteristics

of an actual long forward

• That is, at T = 0.5 you have 1 share of stock and must pay the

forward price S0 e−δT erT

the cash and carry arbitrage

• In the pen example, we shorted a pen high and longed a pen low

and profited on the difference

fair forward, low, and shorted the actual market forward, high

• In each case the profit is the difference between the high short

and the long low.

21.16. SYNTHETIC FORWARDS 255

• At T = 0.5 I have 1 share and paid S0 erT e−δT = 960.79

• This is just like a forward where I buy one share at T = 0.5

• We call this a synthetic forward, because it is made up of two sep-

arate transactions

• You cannot however do this in one step. Why?

• Because no one would sell you one share for 960.79 when they can get

the higher actual market price of 965

• So you need to do it in two steps - that is, you need to synthetically

create a forward

• Cash and Carry Arbitrage: by definition means an arbitrage that

buys the underlying asset and sells/shorts a forward

• You use a cash and carry when Actual market f orward price >

Synthetic F air F orward price

• The next example is a reverse cash and carry

• You use a reverse cash and carry when Actual market f orward price <

Synthetic F air F orward price

than Actual Forward Price

• We use the following information

• Current Stock Price 1000

• Market Forward Price 965

• Market risk free rate is r = 2%

• T = 0.5

• Market dividend rate is δ = 8%

256 CHAPTER 21. ARBITRAGE

ward Price

• Forward Formula: F0,T = S0 erT e−δT

• Actual market forward price: 965

• Actual market forward price is lower than the fair forward price

forward price > Fair forward price

• See the tableau at the bottom of the slide

• Indeed: At T = 0.5 in rows 1,2 I have received money and owe one

share stock

• But you cannot do rows 1 and 2 in one step you need two rows

• Why? Because no one would pay me 970.45 for 1 share when they can

buy this share in the market for 965

21.22. STEP 4: PROFIT-COST ANALYSIS 257

T =0 T =0 T =0 T = 0.5 T = 0.5

Action Have/P rof it N eed/Owe P rof it/Have N eed/owe

Short Stock +S0 e−δ T $ −e−δ T shares See next row −1 Share

Lend NA −S0 e−δ T $ +S0 e−δ T erT $ NA

Long F orward NA NA +1 Share −F0,T $

• Cost: I spent nothing at t = 0

Actual M arket F orward = 970.45 − 965 = 5.45

• Notice the oppositeness of corresponding rows in the two stock arbi-

trage tableaus

• Suppose I had not given dividends

258 CHAPTER 21. ARBITRAGE

• You could still arbitrage based on F Actual M arket and F Synthetic F air

0,1

would you arbitrage

Chapter 22

Swaps

22.1 Overview

• Today we cover swaps

• A swap refers to an actuarially equivalent payment scheme

259

260 CHAPTER 22. SWAPS

• Given: You are given a series of market forward payments for a com-

modity at a future time

• Given: You are also given a collection of spot rates (n-year interest

rates from t = 0, today)

• A farmer expects to sell 50 tons of pork bellies at the end of each of

the next 3 years.

• Suppose that interest rates are determined from the following table:

• r1 = 5%, r2 = 5.5%, r3 = 6%

• If the farmer uses a commodity swap to hedge the price for selling

pork bellies,

• what is the level amount he would receive each year (i.e. the swap

price)

22.5. SOLUTION - TIMELINE #1 261

• We use an Equation of Timeline method

0 1 2 3

r1 = 5% r2 = 5.5% r3 = 6%

• The second timeline is the timeline for the actuarially equivalent level

price

X X X

0 1 2 3

r1 = 5% r2 = 5.5% 53 = 6%

• X represents the unknown level swap value sought

tion of Value

• But the EOV for Timeline #1 is: P V1 = 1600v1 + 1700v22 + 1800v33

262 CHAPTER 22. SWAPS

equation

•

1

vii = = Price of a 1 dollar n-year zero coupon bond (22.1)

(1 + ri )i

• Plugging in and solving we obtain X = 1695.81

84790.38.

• In the above I have simply numerically solved the problem

be traded,

• The following terms are also relevant: prepaid swap, back-to-back trans-

action, swap term, swap tenor, asset swap, swap spread, deferred swap,

accretizing swap, amortizing swap, swaption

in this chapter

22.11. III) ILLUSTRATIVE EXAMPLE MODIFIED D-SQ#22 263

• To illustrate the importance of notional amounts we modify the above

problem

• Instead of wanting 50 tons per year for all years we suppose we want

• In the unmodified D-SQ#22 we first solved for the amount per ton

• Since we wanted 50 tons for each year, we multiplied the amount per

ton by 50

• We still use an equation of two timelines

• We still use the relation between present value, vi and spot rates ri

as follows

•

0 1 2 3

r1 = 5% r2 = 5.5% r3 = 6%

264 CHAPTER 22. SWAPS

•

X × 10 X × 20 X × 30

0 1 2 3

r1 = 5% r2 = 5.5% 53 = 6%

tion of Value

• We now modify the EOV to reflect the amounts

1800 × 30v33

1729.73

• In the unmodified D-SQ#22,

22.18. IV) SWAP SUMMARY - FULL METHOD 265

• A swap is an attempt to find an actuarially equivalent (level) value

• Convert spot rates to present values and solve for the basic amount X

rates

22.19 A subtltety

• D-SQ#4 presents an interesting problem

equivalent sequence of payments

• This is true

of level payments

• In the previous example the concept of swap - actuarially equivalent

level payments,

• One can also apply the concept of swap - actuarially equivalent level

payments,

266 CHAPTER 22. SWAPS

• In a commodity swap the t = i value is the expected cost of the

commodity at t = i, the forward rate for the commodity

rate fi−1,i

rate factor 1 + fi−1,i

• It is instructive to work out why use of the factor vs. rate is eqiuvalent

• Here we have an unusual feature: The spot rates are used for two

purposes

i

i 1

• 1) They are used to calculate present values: vi = 1+ri

(1 + ri )i

• You are given the following spot rates from the latest upward-sloping

yield curve:

• You enter into a 5-year interest rate swap (with a notional amount of

100,000)

22.24. LIBOR 267

• to pay a fixed rate and to receive a floating rate based on future 1-year

LIBOR rates.

• If the swap has annual payments, what is the fixed rate you should

pay?

22.24 LIBOR

• LIBOR is an acronym for London Interbank Offered Rate

• The Libor rate is the average interest rate that leading banks in Lon-

don charge when lending to other banks.

• In other words each bank borrowing money from another bank pays

the lending bank interest

• The LIBOR is the average of these rates among major banks and is

published

• Many financial entities use the LIBOR rates as a benchmark for their

own rates (which may be higher)

• We often in this course, speak about the interest rate

(T-Bills)

• The maturity value can be 30 days, 90 days, and several other values

up to 10 years

• The loans with smaller maturity, such as 30 and 90 days, are call

T-bills

268 CHAPTER 22. SWAPS

rates

these rates are respected as the current market rates

• The notional amount of 100,000 does not matter

• Why? It is not varying and gets cancelled from both sides of the

equation

• We need to compute the forward rates

• (1 + f0,1 ) = (1 + r1 ) −→ f0,1 = r1

(1+r2 )2

• (1 + r1 )1 (1 + f1,2 ) = (1 + r2 )2 −→ 1 + f1,2 = 1+r1 = 1.050024 −→

f1,2 = 5%

•

0 1 2 3 4 5

r1 = 4% r2 = 4.5% r3 = 5.25% r4 = 6.25% r5 = 7.50%

22.29. SOLUTION - TIMELINE #2 269

•

X X X X X

0 1 2 3 4 5

r1 = 4% r2 = 4.5% r3 = 5.25% r4 = 6.25% r5 = 7.50%

22.30 EOV

• P V1 = 4%v1 +5.002%v22 +6.766%v33 +9.307%v44 +12.649%v55 , vii =

1

(1+ri )i

1

• P V2 = Xv1 + Xv22 + Xv33 + Xv44 + Xv55 , vii = (1+ri )i

• P V1 = P V2 −→ X = 7.20%

my goal was to emphasize the underlying concepts; but if you are

studying for an SOA exam where time matters you should master this

shortcut for this problem

• Computations require present values vii

1

• 1) vii = (1+ri )i

• 2) Let Pi denote the price of an i-year zero coupon bond with a re-

demption of 1 dollar

270 CHAPTER 22. SWAPS

of values with vii and then convert as appropriate

Chapter 23

Appendix

• A derivative is a combination of calls,puts,buys, shorts and forwards

• The derivative characteristics can always be derived from the graph

271

272 CHAPTER 23. APPENDIX

F loor HU K1 Asset P (K)AT M ?

Cap DH K1 AssetShort C(K)AT M ?

CoveredCall UH K1 Asset -C(K) ATM?

Coveredput HD K1 Assetshort -P(K) ATM?

Collar DHD K1 < K2 +P(K1) -C(K2)

W rittenCollar U HU K1 < K2 -P(K1) +C(K2)

Collaredstock HU H K1 < K2 Asset(K1???) +P(K1) ATM? -C(K2)

0-Cost Collar DHD K1 < K2 +P(K1) -C(K2)

Iron Butterf ly HU DH K1 < K2 < K3 +P(K1) OTM -P(K2) ATM -C(2) ATM +C(K3) OTM

Long Call butterf ly HU DH K1 < K2 < K3 +C(K1) -2C(K2) ?K2 ATM +C(K3)

Short Call butterf ly HDU H K1 < K2 < K3 -C(K1) +2C(K2) ?K2 ATM -C(K3)

Long P ut Butterf ly HU DH K1 < K2 < K3 +P(K1) -2P(K2) ?K2 ATM +P(K3)

Short P ut Butterf ly HDU H K1 < K2 < K3 -P(K1) +2P(K2) ?K2 ATM -P(K3)

Collaredstock K1 < K2 Asset(K1???) +P(K1) ATM? -C(K2)

0-Cost Collar K1 < K2 +P(K1) -C(K2)

23.3 Notation

• Graph Column: H = Horizontal, U = U P, D = DOW N, (Line seg-

ments left to right)

• ATM means AT THE MONEY; OTM means out of the money; ITM

means In the Money

common expiration dates

• We omitted the long Asymmetric butterfly from the Butterfly table

23.4. LONG ASYMMETRIC BUTTERFLY 273

Long Bull CallSP READ HU H K1 < K2 +C(K1) -C(K2)

Long Bull P utSP READ HU H K1 < K2 +P(K1) -P(K2)

Long Bear CallSP READ HDH K1 < K2 -C(K1) +C(K2)

Long Bear P utSP READ HDH K1 < K2 -P(K1) +P(K2)

Box Spread HHH K1 < K2 +C(K1) -C(K2) -P(K1) +P(K2)

Ratio Spread K1 <?K2 Buy m + C(K1) Sell n − C(K2)

Straddle DU K1?AT M ?? +C(K1) +P(K1)

W rittenStraddle UD K1?AT M ?? -C(K1) -P(K1)

Strangle DHU K1, K2 +P(K1) OTM +C(K2) OTM

• Its graph is HUDH but the UD part is not symmetric (hence the name)

• K2 is a weighted average: K2 = L × K1 + (1 − L) × K3

274 CHAPTER 23. APPENDIX

SOLULTIONS TO SELECTED PROBLEMS

The following pages contain worked out solutions to SOA problems using the methods in the

lecture notes. I plan to have a complete set of solutions using a uniform notation for version 3 by

the end of the summer or year.

Please find on the next page a table of contents. To illustrate use of the table: We see that

problem M00#26, is illustrative of Loan problems. It particularly illustrates the technique of

writing down examples of the first few rows and detecting a pattern (in contrast to other

problems where you plug in a formula)

The reader must look up the problem prior to reading the solution

The abbreviations used follow the abbreviations listed in the introduction

The problems themselves are copyright SOA and are reprinted with

permission

The SOA also has copyrighted solutions

My solutions reflect my methods; sometimes all I have added to the SOA

solutions are timelines and calculator TV lines; sometimes (as in inflation

problems) my approach is totally different

My own solutions are copyright (like the rest of these notes; that simply

means that anyone using the notes should retain identification of the

author (me) and not use them for monetary gain)

The solutions are not direct to the answer; rather they illustrate the

thinking process that a student must go through to arrive at an answer.

This includes choosing between competing methods. It also includes

fundamental items that must be memorized.

Area Problem Topic-Subtopic

Time Value of Money M01#49 Force – Nominal –

Discount

QIT#1 Force – Nominal –

Comparison

Difference of Squares

QIT#6 Annuity-Perpetuity-

Increasing-Algebra

M03#45 Annuities-Refinancing-

Inflation

increasing monthly

M00#24 Refinancing – Deferral

Pattern Seeking

M03#49 Loans – Examples /

Pattern Seeking

QIT#7 Loans – Reinvestment

(Decreasing)

QIT#9 Amortization – 13

Formulae – Examples /

Patterns – English

Conventions

Emglish Conventions

QIT#74 Bond Comparison

Solution to M01#49,

Tawny Timeline

Time 0 1 2 3 5

A(t) X X(1.05)2t

Express as

function of t=5

Fabio Timeline

Time 0 1 2 3… 5

A(t) 1000 1000(1+ti) = Z

We have

However you can’t use that formula unless you express A(t) as a function of t. Why? Because if you use

t=5, you have a constant and can’t differentiate.

The problem is testing your capacity to do abstraction. Now let us do the differentiation (Which you are

suppose to know!!!)

But then

Note that this is the traditional formula for force of compound interest

Plugging into the EOV (which is why you state it first), we have

But now, and only now, we plug in t=5. We can multiply both sides by the denominator and obtain a

linear equation and solve

The problem asks to solve for Z. We however had to solve for i first. We obtain

Summary of tips:

Use timelines

Use unknowns for what you don’t know

Express in variable form if you have to differentiate (This is a key reason this is a level 7

problem)

Express EOV up front

Know your formulas (Have you memorized chapter 2 yet! All formulas in Chapter 2 of my

notes are very important and will appear on exams)

Sample Problems Question #1 ( c ) Sp 2015 Dr Hendel;

Solution reflects Dr Hendel’s approach

Force-Nominal-Comparison

Time 0 1 2… 14.5

Payment 100 A1(14.5)

Timeline 1: Bruce. Period=half year. Interest / period =2 %

Time 0 1 2 .. 7.25

Payment 100 0 0 … A2(7.25)

Timeline 2: Peter. Period = one year. Force of interest δ

Timeline equations:

A1(14.5) = 100(1.02)14.5= 133.26

QIT#5

Solutions ( c ) Spring 2015, Dr Hendel

Solutions reflect Dr Hendel’s approach

Time/Dollar Weighted

This solution uses the 5-6 steps in my notes.

Date 1/1 2/1 3/1 4/1 5/1 6/1 7/1 8/1 9/1 10/1 10/15 11/1 12/1 1/1

Deposit 75 10 10- 10 10 10 10- 10 10 10 -80 10- 10 60

5 25 35

EOV: 75(1+i)12/12 +10(1+i)11/12+5(1+i)10/12+10(1+i)9/12+10(1+i)8/12+10(1+i)7/12-

15(1+i)6/12+10(1+i)5/12+10(1+i)4/12 +10(1+i)3/12-80(1+i)2.5/12-25(1+i)2/12+10(1+i)1/12=70

Step 3: Bernoullie:

Using the Bernoulli approximation we have

75(1+12/12 i) + 10 (1+ 11/12 i) + 5(1+ 10/12 i) + 10(1+9/12 i) + 10(1+ 8/12 i) + 10(1+7/12 i) - 15 (1+6/12

i) + 10(1+5/12 i) + 10(1+4/12 i) + 10(1+3/12 i) -80(1+2.5/12 i)-25(1+2/12 i)+10(1+1/12 i)=70

(75+10+5+10+10+10-15+10+10+10-80-25+10) + i/12(75*12+10*11+5*10+10*9+10*8+10*7-

15*6+10*5+10*4 +10*3 -80*2.5-25*2+10*1) = 60

Sample Problems Question #2

Solution ( c ) Sp 2015 Dr Hendel;

Solution reflects Dr Hendel’s approach

Money Growth – (a/s) – Conversions – Difference of Squares

TIMELINES

t 0 4 8 12... 20 40

t 0 1 2 3… 5 10

Payment 100 100 100 … 100… 100

Accumulated X/5=A(20) X=A(40)

Value

General Timelines @ rate i per year; broken up into two timelines till 5 and 10

t 0 4 8… 16 20

t 0 1 2… 4 5

Payment 100 100 100… 100 A(5)

Timeline 2: @ i per year.

t 0 4 8… 36 20

t 0 1 2… 9 10

Payment 100 100 100… 100 A(10) =X

Timeline 3: @ i per year.

CONVERSION BOX

i is rate per year

j is rate per 4 years

(1+i)4 = 1+j

TIP: We do not need i. We only need vj. This will save you

time

Timeline equations:

Combining the EOV with the timeline equations

The problem could be worded better. It would be better to say “ Accumulated value at 20 just

before the 100 payment at 20” vs. the current text which states “the accumulated value at 20”

By adding the underlined phrase the problem statement would provide greater clarity

Many students try to use one timeline, timeline 1. By using 3 timelines, I have a leisurely pace

and avoid possible errors.

Notice the use of the difference of squares: (1-x2) = (1+x)/(1-x) or (x2-1)/(x-1)=x+1. This shocks

students but it is common on many exams. Quotients of annuity symbols with indexes 2n and n

have this property

Notice how we didn’t have to compute i. We wanted X and for that j was sufficient.

Finally, notice how this problem is naturally formulated in terms of s rather than a. You have to

be prepared to use both approaches.

QIT#6 Solution reflects Dr Hendel’s approach ( c ) Dr

Hendel Sp 2015

Annuity-Perpetuity-Increasing-Algebra

TIMELINE First we make a timeline

T 0 1 2 3 4 … n n+1 n+2 n+3

Payment 77.1 0 1 2 3 … n-1 n n N

Cut off Cutoff

here here

EOV

Next we observe several possible EOV based on the cut off points

How do you decide which EOV to use? Or, perhaps both of them are OK?

The basic idea is to take the EOV where the manipulations are most straightforward

After studying the two EOV we can see that EOV with cutoff at $n$ allows cancellation. We have

TV LINE

We can solve this last equation with a TV calculator line as shown below

N I PV PMT FV

CPT 10.5 -77.1 x 10.5\% -1 0

= 8.0955

N=19

FM – M03#45 Annuities Inflation Refinancing

( c ) 3/24/2015 Dr Hendel – Solution reflects Dr Hendel’s approach to these problems

TIMELINE 1

0----100 (t=1)----100(t=2) ----…

An exchange is made at t = 5. So we need the the outstanding balance (OB) at t=5. This

outstanding balance (OB) is the present value at t=5 of all future payments!

To envision all timelines I use a trick of absolute dates and relative dates. The difference

between the absolute and relative dates on any timeline is constant. Here is an outline for this

problem

I 0 1 5 6 15 16 29 30

II 0 1 10 11 24 25

VI 0 1 14 15

TIMELINE II

Remember the trick of reinvestment: We are standing at 2005 so that is 0.

This timeline is equivalent to TIMELINE III evaluated at the modified rate of i’ where 1/(1+i’)

= 1.08/1.08=1 i’=0%.

TIMELINE III

0----------------X(t=1)--------------X(t=2)-------------X(t=3)…..X(t=24)

We now have to find the outstanding balance of TIMELINE II at t=10. We also need the

payments at t=10 and t=11. For this we use the pattern technique.

Payment at t=2, X (1.08)1

Payment at t=3, X (1.08)2 Pattern of X(1.08)t-1 at time t.

Payment at t=11 X(1.08)10

Payment at t=12 X(1.08)11

Notice that we use Timeline II to compute the outstanding balance. If we used TIMELINE III

to compute the outstanding balance we would use a level payment of X which is incorrect

However the level timeline(III) is a fiction that allows us to compute PVs

TIMELINE IV

t=0-------------t=1, X(1.08)10----------t=2, X(1.08)11….t=15, X(1.08)24

We still use the same i’. Why? Because inflation and interest rate are the same so modified rate

is same.

t=0-------------t=1, X(1.08)10----------t=2, X(1.08)10….t=15, X(1.08)10

TIMELINE VI

Remember: We are now standing in 2015. The 1619.19 is exchanged for a perpetuity. We have

the following timeline

1619.19-----------Y(t=1)-------------Y(t=2)…

QIT#93

Solutions ( c ) Dr Hendel, Spring 2015

Solutions Reflect Dr Hendel’s Approach

Annuity – Increasing Yearly/Level Monthly

TIMELINE #1

0—2000(t=1)--2000(t=2)---2000(t=12)---2000(1.02)(t=13)….2000(1.02)(t=24)----2000(1.02)24(t=275-300)

2000(1.02)1 2nd year (2-1=1)

2000(1.02)2 3rd year (3-2=1)

TIMELINE #2

Fundamental technique: The first 12 payments of 2000 have a value of at t=0. Similarly the next 12

payments of 2000(1.02) have a present value at t=12 of

1 (t=0)-------------1.02 (t=1)--------------------1.022(t=2)--------------------1.023(t=3)-------…-------1.0224(t=24)

Tip: In computing i’ remember to use j not i. Why? Because i is the rate per month while j is the rate per year.

TIMELINE 4

1(t=0)-----------------1(t=1)---------------1(t=2)----------------------------------------------------1(t=24) @ i’=1.040861

N00#34 Solution Dr. Hendel ( c ) Mar 15 2015, Lecture I – Solutions reflect Dr Hendel’s approach

The way you recognize refinancing problems is by a recalculation of PVs at a time different than 0. The

recalculation may involve different i,n. It may also involve conversions.

This problem has 3 timelines and 5 equations. So it affords us an opportunity to review how to approach

solving several equations in several variables

Timeline 1:

Notice how I converted immediately. Neither year nor the nominal 8% interest rate are mentioned. This

is the best way to avoid accidental errors.

Timeline 2:

Notice the problem. Timeline 2 begins at the old t=12 but is a new timeline so t=0. The best way to avoid

confusion is to use two sets of labels. I have found this very helpful.

OLBI12-------------R2----------R2----------------------------i=1.5%/quarter-------------------------40-12=28 periods

12-------------------13----------14---------------------20-------------------------------------------------------40

0---------------------1------------2----------------------8------------------------------------------------------28

The symbol refers to what is already in memory. (Recall we entered 2% when calculating R. So I and

PMT are retained. Also note that when computing the OLB at t =12 we use N=28 (40-12) since we use a

prospective approach, with 28 periods left.

These 2 equations are the essense of refinancing, computing PV at two different 0 points. It is not

conceptually difficult. But you have to have a system to avoid error.

Timeline 3:

Second, we have an extra payment of X at t=20 of first timeline, which is t=8 of second timeline. How do

we deal with this. We have two issues.

Is it OLB120 or OLBII8. One of the tricks of refinancing is forgetting previous timelines. In this case

we are on timeline II, so we have forgotten timeline I. So we use OLBII8

How do we deal with X. To answer this recall the meaning of OLBII8: It is what is owed at time 8.

If you like it is the new loan at time 8. If I owe OLBII8 and I immediately pay back X at the time of

the loan then my loan is really OLBII8 – X. This is the fundamental method of dealing with paying

off. Simply subtract from the OLB.

We need OLBII8.

Solution Time:

We have 3 EOVs. So we have 3 equations. But we have 5 unknowns: R1, R2, X, OLBI12, OLBII8. We have

two more equations for OLBI12, OLBII8. But even then we have five equations in 5 unknowns. How do you

solve them.

Trick for solving 5 equations in 5 unknowns: If some equations have one unknown solve them first. Then

you have 4 equations in 4 unknowns. Repeat the process (find the equation with one unknown). This has

been done throughout the document. We could have waited to the end to solve OR we could solve as

each equation comes up. That is a matter of taste. But an important principle of solving many equations

in many unknowns is when each equation gives one more unknown.

Summary: Go back through the document. Make sure you understand the basic characteristic of

refinancing, a recalculation at a different 0 point.

SOLUTION M00#24 ( c ) 2015 Dr Hendel, AMORTIZATION – REFINANCING Reflects my approach to these problems

1.032 = 1+j j=6.09% Conversion

Notice how the two loan timelines are straightforward. The hard part of the problem? The connection between the two

loans. Here are some of the issues

The first payment of the new loan is at the time of the 9th payment of the old loan

The original loan is in half years while the refinanced loan is in months

The first loan is at 6.09% per half year; the 2nd load is at ¾% per month

What does it mean that the refinancing happens 3 months before the 1st payment

Before proceeding further make sure you understand why you are confused by the above

To solve this dilemma you need a 3rd timeline for the 6 months between the 8th and 9th payment

t=4 years 4 years 1 month 4 years 2 months 4 years 3 months 4 years 4 months 4 years 5 months 4 years 6 months

th

8 payment 0 point of 1st payment

1st loan new loan (0 new loan

point is one

period

before 1st

payment-

deep)

Interest rate 0.9902% 0.9902% 0.9902% ¾% Why? ¾% ¾%

(1+j)6 Because loan

=1.0609 is refinanced

3 months

before 9th

payment is

due

OLB8I 1.0099 OLB8I 1.00992 1.00993 1.00993

1.00993

OLB8I OLB8I 1.0075 OLB8I

1.00752

OLB8I=L2

To understand what is going on I made a timeline with 4 rows of labels. Notice how Chapter 2 is the hard part of the

problem not amortization as you might expect. Here are the calculations

Solution M00#26, Dr Hendel, ( c ) Mar 14 2015, Lec J

Loans – Amortization Table - Examples

L = 19,800

Notice how I left the numbers in expression form rather than simplifying to one number.

The purpose of doing this is to facilitate seeing patterns. Also notice how I don’t care about R which of

course equals I + P. Now let us look at row 2

We do not yet see all patterns. The rule of thumb is to do 3-4 examples. If you don’t see anything by

then, give up. So let us do row 3.

At t = 16, Bank X sells to Bank Y all i) future interest and ii) principal payments at a new interest rate.

The reason that the sales price is not OLB16 is because the interest has changed.

The new interest rate is j with (1+j)6 = 1+ 14%/2, o r j = 1.1340%. Notice the two conversions: You have

to convert both the nominal and the compound rates.

1) The current value at t =16 of principal is a level stream of 20 payments (from t=17 to t=36) of

550.

We have to subtract the PV of 16 x 5.5, 17 x 5.5, 18 x 5.5, …, 35 x 5.5. This almost looks like an increasing

annuity. In fact it seems to be the difference of 1,2,3,…,35 (times 5.5) minus 1,2,3…,15 (times 5.5).

However the difference of 1,2,3,…,35 minus 1,2,3…15 is the value of 16,17,18,…,35, 16 periods from

now. So we need a discount factor, actually an accumulation factor.

3)

Adding (1) and (2) but subtracting (3), we get 9792.39 + 3525.26 - 2460.38 = 10857.27.

The published SOA solutions noticed a further pattern. They noticed that 198 = 36 x 5.5. So

But then I17 – I35 is simply 20*5.5 to 1*5.5. So they subtract 5.5 (Da)20

The reason I did it without this extra pattern is in order to emphasize that you can solve a problem

without noticing every pattern. You do have to notice some basic patterns; but once you notice the

minimum patterns you can solve. You may, as in this example, have to combine annuities and use

discount or accumulation factors.

M03#49 Dr Hendel ( c ) Sp 2015

Solutions reflect Dr Hendel’s approach

This problem requires pattern recognition. That is the hard part

because you can’t use the formulas till you find the pattern.

The only way to find patterns is to do examples and that takes

time which you have to spend

TIP: Use variables not numbers since it helps you see the

pattern.

T R I P OLB

0 1000 = L

1 10% L 10% L 0 1000

2 10% L 10% L 0 1000

…

10 10% L 10% L 0 1000= L

12 15% 95%L 10% 95%L 5% 95% L (95%)2 L

13 15% (95%)2 L 10% (95%)2 L 5% (95%)2 L (95%)3 L

…

20 15% (95%)9 L 10% (95%)9 L 5% (95%)9 L (95%)10 L

N I PV PMT FV

10 10 -(95%)10 CPT=97.44 0

1000

Reinvestment N05,#16, ( c ) Dr Hendel Spring 2015; Solutions reflect Dr Hendel’s approach

Separate timeline and EOV for each investment (each bank)

Summary timeline with A(0), A(n) and A(n)=A(0)(1+i)n; chapter 2 problem

Use high level symbols (e.g. A(n) with subscripts) to describe timelines

TIMELINE 1

925 45 45 … 1045

0 1 2 … 10 x 2

TIMELINE 2

45 45 …

0 1 2 … 20

Using actuarial notation (s)

Using calculator (1844.80)

These 3 steps need not be done simultaneously. You can simply state A(20) and later identify its value

SUMMARY TIMELINE

0 1 2 20

TLine 1 925 1000

TLine 2 1272.59

Summary 925 2272.59

QIT#7 ( c ) Dr Hendel Sp 2015; Solutions Illustrate Dr

Hendel’s Approach

Reinvestment – Decreasing - Examples

TIMELINE

Fund X Timeline 6%

1

T 0 1 2 3 4… 8 9 10

Deposits 1000 1060 954 848 …

900 800 700 … 100 0

Fund Y Timeline 9%

2

Deposits 160 154 148

to Fund Y 3

Minus 6x1 6x2 6x3 6x4 6 x 10

Timeline 1: The 1000 accumulates 6% x 1000 = 60 so we have 1060 at time t=1. We withdraw the 60 and

an additional 100,

so we have left 900. The900 at t=1 accumulates to 6% x 900 = 54 at time t=2. We withdraw the 54 and

an additional 100

Notice the important of using examples to see the pattern of cash flows.

Timeline 2: This timeline has the interest and principle withdrawn from timeline 1

Timeline 3: This is a standard trick for decreasing cashflow. (1) First raise the first amount by the

constant decrease.

So the 160 becomes 166. Make the 166 a level annuity and the decreased amount becomes an increasing

annuity times 6

EOV

TV LINE

N I PV PMT FV

10 9 CPT=1065.33 -166 0

BGN

Retain Retain CPT=2.7711 -1 10 Brovender

Divide .09=30.79

X 6 =184.74

Subtract 880.59

10

X 1.09 2084.67

NOTE: Why did I use PV and then multiply by 1.0910? Couldn’t I have just used future value?

Answer: By using PV, I can use Brovender’s trick simplifying calculations.

QIT#9 ( c ) Sp 2015 Dr Hendel, Solution Reflects Dr

Hendel’s Approach

Amotization – Examples – 13 Basic Formulae – English

Conventions

English-Algebraic Derivations

Text Of Problem with Key Phrases Underlined

A 20-year loan of 1000 is repaid with payments at the end of each year.

Each of the first ten payments equals 150% of the amount of interest due. Each of the

last ten payments is X. The lender charges interest at an annual effective rate of 10%.

Calculate X.

Figure 1: Text of QIT#9. Problem is ( c ) SOA and reprinted from their website with permission.

English Algebra

20 year loan N=20

1000 L=1000

Payments equals 150% of amount of interest do Rt = 150% It, t=1,2,3,…

Last 10 payments is X Rt = X, t=11,12,13,…

Interest at an annual effective rate of 10% i=10%

AMORTIZATION TABLES

We now look at examples and explore patterns using a standard table and formulae

T R I P OLB

0 1000 = L

1 150% I 10% L 150% x 10% L L-5% L =95% L

– 10% L = 5%

L

2 150% I 10% 95% L 150% x 10% (95%)2 L Exponent 2 = t=2

95% L – 10%

95% L = 5%

95% L

3 150% I 10%(95%)2 L 5% (95%)2 L (95%)3 L Exponent 3= t=3

… … … … … …

10

(95%)10 L Justified

by Pattern

of

examples

11 X

12 X

13 …

14-19 …

20 X

Table 2: We break the problem into two amortization tables. The first 10 rows correspondes to

one amortization table.

The 2nd 10 rows corresponds to the 2nd amortization table. Notice how we have to use

examples and patterns in the

first 10 rows in order to see the pattern. The purpose of this is to derive a formula for the OLB10

EOV: There are two EOV; one for the first 10 rows and one for the 2 nd

10 rows.

TV LINE

N I PV PMT FV

10 10 -598.74 CPT=97.44 0

QIT#10 / M03#42 ( c ) Sp 2015, Dr Hendel, Solutions

Reflect Dr Hendel’s Approach

Bonds – 13 Formulae – Plug in – English Conventions

Text of Problem

A 10,000 par value 10-year bond with 8% annual coupons is bought at a premium

to yield an annual effective rate of 6%.

Calculate the interest portion of the 7th coupon.

Figure 1: Text of QIT#10. Text is copyright SOA and reprinted with permission

English Algebra

10000 F = 10000

Par value C=F

10 year bond N=10

8% annual coupons r=8%

Yield …6% i=6%

Interest portion of 7th coupon I7

Table 1: Correspondence between underlined English phrases in Figure 1 and algebraic equations

Although not necessary for the problem we explain the terms “bought at a premium” and related terms

Bond bought at premium/discount in premium/discount in

bought at premium bond1 t-th coupon

or discount

Premium P>C |P–C| Pt

Discount C>P |P–C| -Pt

NOTES: (1) Absolute amount of premium in t-th coupon is called write down; Absolute amount

of discount in t-th coupon is called write-up.

Fr = I7 + P7

Fr = 8% x 10000 = 800

P7 = (Cg – Fr) vn+1-7 = (Cg-Fr) v4 = C(i-r) v4 = 10000 (8%-6%) 1.06-4 = 158.42

I7 = Fr – P7 = 800 – 158.42 = 641.58

EOV: Approach #2

I7 = I OLB6 = 6% OLB6

TV LINE

N I PV PMT FV

4 6% CPT=10693.02 8% x 10000 = 800 10000

Sample Problems, #74 Bond Comparison

( c ) Dr Hendel Spring 2015;

Solutions reflect Dr Hendel’s approach

Bonds – Pricing - Comparison

Note: This problem can be done using either the Fr or C(g-i) formulae.

TIPS:

Do all conversions up front

Write EOV up front

Conversions

Phrase in problem Conversion

10 years n = 20

Coupon rate of i+4% i/2 + 2%

Coupon rate of i-4% i/2 – 2%

Yield …nominal rate of i convertible i/2

Subtract or divide

N I PV PMT FV

20 CPT =4.2 -5341.12/400 1 0

So i/2 = 4.2% i = 8.4%

QIT#55

Solutions © Sp 2015, Dr Hendel

Solutions Reflect Dr Hendel’s Approach

Bonds - Callable

Tip: As I indicated in class, these problems can be confusing since there are so many things to

check. I present in this solution an organizational technique. The organization is based on

roman numerals I,II,III and upper case letters A,B,C.

Remember, when the bond is bought, the buyer does not know when the seller will call it. So

the price of the bond is based on t=0. The investor wants a minimum yield (over all prices and

redemption values) of 3% so that is what we use. But we have to check the yield at other prices.

This is done in B.

N I PV PMT FV

40 3 CPT=1261.80 40 1100

1B: Check yield of part (A) with other possible call dates and call values.

Remember, the coupons remain the same. Peeking through the problem we see that we must

check 2 x 15 = 30 through 39. Since the premium will be the same on these dates, 1200, we

only have to calculate 1 or 2 points. (Thoughout the solution I am checking 2 points but

indicating which one I didn’t have to do if applicable)

N I PV PMT FV

40 3 CPT=-1261.80 40 1100

39 CPT =3.10 Retain Retain 1200

NOTE: Since the bond is (bought) at a premium C=1200 <1261.80=P, the earliest yield, t = 30,

is the lowest, lower than 39. But a safe approach is to always check two points.

IIA: Calculate the bond price using the alternate call premium.

N I PV PMT FV

30 3 CPT=1278.40 40 1200

IIB: Check yield of part (A) with other possible call dates and call values.

Peeking through the problem we see that we must check N=39, C=1200 and N=40, C=1100.

Since the bond is bought at a premium we need not check N=39, C=1200 but do so anyway

N I PV PMT FV

30 3 CPT=-1278.40 40 1200

40 CPT =2.94 Retain Retain 1100

N I PV PMT FV

39 3 CPT = - 40 1200

1291.23

IIIB: Check yield of part (A) with other possible call dates and call values.

Peeking through problem we must check N=30, C=1200 and N=40,C=1100. Note: Since bond

is (bought) at premium (1291.23=P>1200=C) we need not check N=30 but do so anyway.

N I PV PMT FV

39 3 CPT = -1291.23 40 1200

40 CPT=2.90 Retain Retain 1100

Answer to question: Look over all the (B) parts. Remember, the buyer does not know which

call date will be used. The buyer wants at least a 3% yield. Only one of the B tables gives a 3%

yield for all redemption values and prices. Hence we use table IA: The maximum, indeed only

price, is 1261.80. Why? By Table IB, the buyer may get either 3%, 3.07% or 3.10% depending

on when the seller calls. So indeed the buyer gets at least 3% as required.

Quick Method for Solving Interest Swap Problems , Problem 23 Sample Derivative problems

(c ) Dr Hendel Sp 2015; Solution reflects Dr Hendel’s approach

t 1 2 3 4 5

rt 4% 4.5% 5.5% 6.25% 7.5%

Find a level swap rate for one year interest rates

Solution

We want an equation of the following timelines

t 1 2 3 4 5

1+f0,1 1+f1,2 1+f2,3 1+f3,4 1+f4,5

Timeline I: Timeline of 1-year forward rate factors

t 1 2 3 4 5

1+i 1+i 1+i 1+i 1+i

Timeline II: Timeline of level one year swap rate factors

t 1 2 3 4 5

1 1 1 1 1

Timeline III: Timeline of level ones (Warning: This is not calculable on TV line; why?)

t 1 2 3 4 5

i i i i i

Timeline IV: Timeline of level swap rates (Warning: This is not calculable on TV line; why?)

t 0 1 2 … 5

1 0 0 0 -1

Timeline V: Deposit 1 in bank at time 0 and withdraw that 1 at time 5 (Withdraw all interest)

with the symbol TLx indicating Present values of Timeline x using implied forward rates.

TLIII = TLIV/i

Note: (1+ri-1)i-1 (1+fi-1,i) = (1+ri)i 1+fi-1,i = (1+ri)i / (1+ri-1)i-1 (1+fi-1,i)/ (1+ri)I = 1/(1+ri-1)i-1

Hence TLI = 1 +1/1.04 + 1/1.0452 +1/1.0553 + 1/1.06254 = 4.5135

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