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FM Formulas PDF
FM Formulas PDF
by (/iropracy
This is a collaboration of formulas for the interest theory section of the SOA Exam FM / CAS Exam 2.
This study sheet is a free non-copyrighted document for students taking Exam FM/2.
The author of this study sheet is using some notation that is unique so that no designation will repeat. Each
designation has only one meaning throughout the sheet.
Fundamentals of Interest Theory and Time Value of Money
FV
FV = PV (1 + i )
n
PV =
(1 + i )n
i
d= d = 1− v i − d = id
(1 + i )
1
v= v =1− d d = iv
(1 + i )
v n = (1 + i ) = e − δn
−n
a′(t )
t t
δ (u ) du δ (u ) du
δ (t ) = e ∫0 = a(t ) A(0 ) e ∫0 = A(t )
a(t )
m
⎛ i (m ) ⎞
i = ⎜⎜1 + ⎟⎟ − 1
⎝ m ⎠
p
⎛ d ( p) ⎞
1 − d = ⎜⎜1 − ⎟⎟
⎝ p ⎠
m −p
1 1 ⎛ i (m ) ⎞ ⎛ d ( p) ⎞
1+ i = e = =
δ
= ⎜⎜1 + ⎟⎟ = ⎜⎜1 − ⎟
v 1− d ⎝ m ⎠ ⎝ p ⎟⎠
Effective annual rate it during the t-th year is given by:
Note that the t-th year is given by the time period [t − 1,t ]
Therefore, the interest earned during the t-th year is given by:
Annuities
Annuity Immediate— payments are made at the end of the period
Annuity Due— payments are made at the beginning of the period
Annuity Immediate
an | i = v + v + 2
+v =
1 − vn
n
sn | i = (1 + i ) + (1 + i ) +
n −1 n−2
+1 =
(1 + i) − 1
n
i i
sn | i = (1 + i ) ⋅ an | i
n
an | i = v n ⋅ s n | i
Annuity Due
an | i = 1 + v + +v n −1
=
1 − vn
s n | i = (1 + i ) + (1 + i )
n n −1
+ + (1 + i ) =
(1 + i) −1
n
d d
sn | i = (1 + i ) ⋅ an | i
n
an | i = v n ⋅ sn | i
i i
an | = a = (1 + i ) an | sn | = s = (1 + i ) sn | a n | = 1 + a n −1| sn | = sn+1| − 1
d n| d n|
Perpetuity
1 1
a∞ | i = lim an | i = v + v 2 + v 3 + = a∞ | i = lim an | i =
n→∞ i n→∞ d
Continuous Annuities
an | i =
1 − vn i
= an | i sn | i =
(1 + i) − 1
n
=
i
s
n
a n | i = ∫ v t dt
δ δ δ δ n|i 0
n t n n
− δ (u ) du
PV = ∫ e ∫0 FV = ∫ e ∫t
δ ( u ) du
p(t ) dt p ( t ) dt where p (t ) = payment function
0 0
an | − nv n i an | − nv n
(Ia )n | i = (Ia )n | i = (Ia )n | i = (1 + i )(Ia )n | i =
i d d
sn | − n sn | − n
(Is )n | i = (1 + i )n (Ia )n | i = (Is )n | i = i (Is )n | i = (1 + i )n (Ia )n | i =
i d d
n − an | i n − an | i
(Da )n | i = (Da )n | i = i (Da )n | i = (1 + i )(Da )n | i =
i d d
n(1 + i ) − sn | i
n
(Ds )n | i = (1 + i ) (Da )n | i =
n
(Ds )n | i = (1 + i )n (Da )n | i
i
X Y
+
i i2
Annuities with Terms in Geometric Progression— 1, (1 + q ), (1 + q ) , … , (1 + q )
2 n −1
1 − (1 + q ) v n
n
Present Value is V (0 ) = 1 ⋅ v + (1 + q ) ⋅ v 2 + (1 + q ) ⋅ v 3 + + (1 + q )
n −1
⋅ vn =
2
i−q
Useful Identities
an+ k | = an | + v n ak | (
v n − v m = i am | − an | ) (Da )n | + (Ia )n | = (n + 1) an |
1 = v n + i an |
a2 n |
=
a2 n |
=
1 − v 2n
= 1 + vn
s2 n |
=
s2n |
=
(1 + i )2 n − 1 = (1 + i )n + 1
an | an | 1 − vn sn | sn | (1 + i )n − 1
If the compounding frequency of the interest exceeds the payment frequency of k years—
i i d d
an(m| ) = an | sn(m| ) = (m ) sn | an(m| ) = a sn(m| ) = s
i (m )
i d (m ) n | d (m ) n |
(2) Use an equivalent interest rate effective over the payment period: j = (1 + i )
1m
−1
n an | i − nv n
If the payments are , ,… , , then the present value is (Ia )n | i =
1 2 (m )
m m m i (m )
an(m| i) − nv n
If the payments are 2 , 2 ,… , 2 , then the present value is (I a )n | i =
1 2 n (m ) (m )
m m m i (m )
Loan Repayment— Amortization
Amortization Method— when a payment is made, it must be first applied to pay interest
due and then any remaining part of the payment is applied to pay principle
Notation
L
L = PA ⋅ an | i PA =
an | i
Bk +t = Bk (1 + i ) and Pk +t = Pk (1 + i )
t t
PA = Pk + I k (
I k = i ⋅ Bk −1 = PA 1 − v n−k +1 ) Pk = PA − I k = PA ⋅ v n−k +1
I k = i ⋅ Bk −1 Pk = P(k ) − I k = Bk −1 − Bk
Loan Repayment— Sinking Fund
Sinking Fund Loan (SFL)— accumulate money in a separate fund by making a payment,
in addition to the regular interest payment, every period.
Notation
i ≡ effective interest rate per payment period by the borrower to the lender
Useful Equations
L L
L = DS ⋅ s n | j DS = PS = Li + DS = Li +
sn | j sn | j
sk | j
S k = DS ⋅ s k | j = L Lk = L − DS ⋅ sk | j
sn | j
S k − S k −1 = DS ⋅ sk | j − DS ⋅ sk −1| j = DS (1 + j )
k −1
Net Principal Paid
Notes on Loans
Amortized Loan— over time interest paid decreases and principal paid increases
Installment Loan— over time interest paid decreases while the principal paid is constant
Bonds
Bonds— interest bearing securities; basically loans from lenders perspective
Callable Bond— a bond that can be paid off (called) before maturity
Notation
F ≡ par value
BVk ≡ book value of the bond (bond amortized balance after k-th payment)
1
vi =
1+ i
Fr
g= ≡ modified coupon rate
C
Premium— If i > r then the bond is priced at a premium. P > C , and P − C is the
amount of the premium.
Premium ≡ P − C = (Fr − iC ) an | i
(
P − C = Pk v k −1 + v k −2 + + v + 1 + (1 + i ) + + (1 + i )
n−k
) = P (a
k k −1 | i
+ s n−k +1| i )
Discount— If i < r then the bond is priced at a discount. P < C , and C − P is the
amount of the discount
Discount ≡ C − P = (iC − Fr ) an | i
Par— If i = r the bond is selling at the price P = C we say that it sells at par.
Price and Premium-Discount Formula
P = Fran | i + K
(
P = C 1 + (g − i ) an | i ) (
if F = C , then P = F 1 + (r − i ) an | i )
Bond Amortized
BVk = BVm (1 + i )
k −m
BVk = Fran−k | i + Cvin−k − Fr ⋅ sk −m | i Fr = I k + Pk
( )
I k = i ⋅ BVk −1 = Fr 1 − v n−k +1 + iC v n−k +1 Pk = Fr v n−k +1 − iC v n−k +1
Pk +t
= (1 + i )
t
If F = C , then
Pk
Makeham’s Formula
g r
P = K + (C − K ) if F = C , then P = K + (F − K )
i i
Given investment cash flows C0 , C1 , C2 , … , Cn , the IRR is a solution for i of the equation
C1 C2 Cn
C0 + + +…+ =0 or C0 + C1v + C2 v 2 + … + Cn v n = 0
(1 + i ) (1 + i )2
(1 + i )n
Bk′
1 + jk = TWR → 1 + i = (1 + j1 )(1 + j2 ) ⋅ (1 + jm )
Bk′ −1 + C k′ −1
I ≡ Interest earned
I
DWR → i=
A + ∑ Ct (1 − t )
Term Structure of Interest Rates
Spot Rates
(1) The annual interest rate on the n-year Treasury STRIP is called the n-year
spot rate, and the series of spot rates over time is called the yield curve.
(2) To value a bond, take the present value of each payment at the appropriate
yield curve rate and sum the present values.
P(1) P( 2) P( n ) P(1) P( 2) P( n )
P= + + + = + + +
(1 + s1 ) (1 + s2 )2 (1 + sn )
n
(1 + f1 ) (1 + f1 )(1 + f 2 ) n
∏ (1 + f )
i =1
i
(3) Once we have found the price of a bond using the yield curve we can find the
yield to maturity as the constant yield on the bond at that price.
For example—
Purchasing a bond with coupons has cash flows given by − P, P(1) , P(2 ) , … , P(n )
Forward Rates
The rate agreed upon today for a one-year loan to be made n years in the future
(1 + sn )
n
(1 + sn ) = (1 + f n )(1 + sn −1 )
n n −1
1 + fn = ⇒
(1 + sn−1 )
n −1
Duration
Duration— a measure of sensitivity of a financial asset to changes in interest rates
v t Ct v t Ct v t Ct
Weights for Macaulay Duration wt = = =
P (i ) vC1 + v 2 C 2 + + v nCn ∑ v t Ct
t >0
∑ tv C t
t
Macaulay Duration DM = 1 ⋅ w1 + 2 ⋅ w2 + + n ⋅ wn = t >0
∑v C
t >0
t
t
d
P(i ) =
1
Modified Duration D=− DM
di 1+ i
(Ia )n | i
Duration of a Level Payment Investment D=
an | i
Macaulay Duration of a coupon bond with face value F and coupon Fr for n periods and
redemption value C
Fr (Ia )n | i + nCv n
DM =
Fran | i + Cv n
Change in Price
P′(i )
ΔP = P(i + Δi ) − P(i ) ≈ P′(i )Δi = P (i )Δi = − D ⋅ P(i )Δi
P(i )
P′′(i ) 2 P(i ) 2
ΔP ≈ P′(i )Δi + Δi = − D ⋅ P(i )Δi +C ⋅ Δi
2 2
Immunization
Notation
S (i ) ≡ Surplus
S (i ) = A(i ) − L(i )
d d
(2) Duration Matching A(i ) = L(i )
di i0 di i0
d 2
d 2
(3) Greater Convexity for Assets A(i ) > L(i )
di 2 i0
di 2 i0
(1) PV Matching ∑ Av
t >0
t
t i0 = ∑ Lt vit0
t >0
Notation
General Case—
Suppose you make an initial investment of C0 . The yield rate y is the actual rate
of return you are receiving on the investment. AV is the accumulated value of your
investment.
C0 (1 + y ) = AV
n
• Suppose you are investing payments into a fund X at the end of each k period
• …and reinvesting the interest accrued each k period into fund Y
an y (1 + y ) = sn y = k + i ( Is )k j
n
C0 (1 + y ) = C0 + k ( iX C0 ) + iY iX C0 ( Is )k −1 i
n
Z
(1 + y ) = 1 + kiX + iY iX ( Is )k −1 i
n
⇒
Z
Bond Reinvestments
This refers to the case where we have bought a bond for a price of P = Fran | i + K and we
reinvest the coupon payments Fr into a separate account at the time they are received.
Notation
m⋅n
⎛ y (m ) ⎞ Frs k | i + C
P (1 + y ) = P ⎜⎜1 + ⎟ (1 + y )n =
n
= Frsk | i + C ⇒
⎝ m ⎟⎠ Frak | i + K
Of course we can have more than one bond involved. If that is the case we just need to
combine prices and coupon payments accordingly.
We are going to cover the case that liability frequency matches the coupon frequency.
(e.g. We would not have a liabilities at year 1 and year 2 with coupons semiannually).
Let F1 , r1 and C1 denote the par value, coupon rate and redemption value, respectively,
for the bond with the longest duration. Denote F2 , r2 and C2 for the bond with the next
longest duration, and so on.
C1
Step1- Purchase of the bond. This is a percentage.
F1r1 + C1
C1
Step2- This gives F1r1 ⋅ , a fractional amount of the coupon the period before.
F1r1 + C1
C1
Step 3- Determine the amount left we need to match. C 2 − F1r1 ⋅
F1r1 + C1
C1
C 2 − F1r1 ⋅
F1r1 + C1
Step 4- Purchase of the bond.
F2 r2 + C 2
C1
C2 − F1r1 ⋅
F1r1 + C1 C1
Price of the bond to match liabilities is: P2 + P1 . This matches
F2 r2 + C2 F1r1 + C1
liabilities at time 1 and time 2.
(2) To value a bond, take the present value of each payment at the appropriate yield
curve rate and sum the present values.
P(1) P( 2) P( n ) P(1) P( 2) P( n )
P= + + + = + + +
(1 + s1 ) (1 + s2 )2 (1 + sn )
n
(1 + f1 ) (1 + f1 )(1 + f 2 ) n
∏ (1 + f )
i =1
i