Financial Mathematics

December 16, 2013

1 The Measurement of Interest

1.1 Accumulation function

a(t) − a(t − 1)
it =
a(t − 1)
A(t) − A(t − 1)
it =
A(t − 1)
A(t) = k · a(t)

Under simple interest

a(t) = 1 + it
i
it =
1 + i(t − 1)

Under compound interest

a(t) = (1 + i)t
1
PV =
a(t)

1.2 Effective Rate of Discount

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

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

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

1.3 Force of Interest

1 d
δt = a(t)
a(t) dt
1 d
= A(t)
A(t) dt
Rt
δs ds
a(t) = e 0

Constant force of interest: eδ = 1 + i

1.4 Power Series

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

1.5 Variable Force of Interest

a(t1 ) R t2
PV = = e− t1 δt dt
a(t2 )

2 Solutions of Problems in Interest

No formulas

2
3 Basic Annuities

[1 − (ratio)N ]
S = (f irst term)
1 − ratio

3.1 Annuities

1 − vn
an =
i
1 − vn
än =
d
än = (1 + i)an = an−1 + 1

3.2 Accumulated values

(1 + i)n − 1
sn =
i
(1 + i)n − 1
s̈n =
d
s̈n = (1 + i)sn = sn+1 − 1

3.3 Deferred annuities/perpetuities

m| an = v m an = am+n − am
1
a∞ =
i
1
än =
d
1 1
− =1
d i

3.4 Annuity tricks

a2n
= 1 + vn
an

a2n = an + v n an
= (1 + v n )an

a3n = an + v n an + v 2n an
= (1 + v n + v 2n )an

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4 More General Annuities
4.1 m-thly annuities

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

(m) 1
a∞ =
i(m)
(m) (m) 1
a∞ − ä∞ =
m

1 − vn
ān =
δ

4.2 Payments in arithmetic progression

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

Increasing annuities
än − nv n
(Ia)n =
i
s̈n − n
(Is)n =
i
s̈n−1 − (n + 1)
=
i
Decreasing annuities
n − an
(Da)n =
i
n(1 + i)n − sn
(Ds)n =
i
(Ia)n + (Da)n = (n + 1)an
Increasing perpetuities
1 1 1
(Ia)∞ = = + 2
id i i
1
(Iä)∞ = 2
d

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Increasing payment up to n and level payments of n afterwards
än
P V (1, 2, 3, . . . , n, n, n, . . .) =
i

4.3 May God Have Mercy On Your Soul

(m) än − nv n
(Ia)n =
i(m)
 
1 1 2 2 3
= PV ,..., , ,..., , ,...
m m m m m
 (m) ä(m) − nv n
I (m)
a = n (m)
n i 
1 2 3
= PV , , ,...
m2 m2 m2

¯

ān − nv n
Iā n
=
δ

4.4 Payments in geometric progression

 n
1+k
1− 1+i
P V (1, (1 + k), (1 + k)2 , . . .) =
i−k
= v · än i0
1+i
with 1 + i0 =
1+k
Annual payment f (t) (and variable force of interest δt )
Z n
PV = f (t)v t dt
Z0 n Rt
PV = f (t)e− 0 δr dr dt
0

Palindromic annuity

P V (1, 2, 3, . . . , n − 1, n, n − 1, . . . , 3, 2, 1) = an · än
P V (1, 2, 3, . . . , n − 1, n, n, n − 1, . . . , 3, 2, 1) = an+1 · än

5
5 Yield Rates
5.1 Reinvestment rates
Option 1: Deposit of 1, into fund earning i, interest is reinvested at i0 .

AV = 1 + i · sn i0

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

AV = n + i · (Is)n i0

5.2 Interest measurement of a fund

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

5.3 Dollar-weighted and time-weighted rates

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

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

- Time-weighted
A+x C
· =1+i
A A+x+B

5.4 Portfolio methods and investment year methods

- Portfolio method:

All members of the club, regardless of when they began to invest, get the
same yield rate.

- Investment year method (IYM):

Interest is credited in a way that recognizes when a member joined the club.

6
6 Amortization Schedules and Sinking Funds
6.1 Amortizing a loan

Duration Payment Interest Paid Principal Repaid Oustanding Principal

t R It = iBt−1 Pt = R − It Bt = Bt−1 − Tt
0 an
1 1 ian = 1 − v n vn an − v n = an−1
2 1 ian−1 = 1 − v n−1 v n−1 an−1 − v n−1 = an−2
.. .. .. .. ..
. . . . .
t 1 ian−t+1 = 1 − v n−t+1 v n−t+1 an−t+1 − v n−t+1 = an−t
.. .. .. .. ..
. . . . .
n 1 ia1 = 1 − v v a1 − v = 0
Total n n − an an

L
With payments of an , the amounts in year t can be expressed as:

L
1 − v n−t+1


It =
an
L n−t+1
Pt = v
an
L
Bt = a
an n−t

6.2 Sinking funds

- Interest rate on loan = i
Interest rate on sinking fund = j

- Periodic interest payment on loan = It = i · B0

B0
- Periodic sinking fund deposit SF D = sn j

B0
- Total periodic payment R = i · B0 + sn j

- Total loan amount B0 = (R − i · B0 ) sn j

- Principal repaid Pt = (1 + i)Pt−1 + (Rt − Rt−1 )

7
7 Bonds
7.1 Price of a Bond
If C is the redemption value, F the face amount and r the coupon rate,
then:
P = F r an i + Cv n
If F r = Cg (usefull when n is unknown),
P = C + (F r − Ci)an i

and
g
P = (C − Cv n ) + Cv n
i

7.2 Premium and discount

- If g > i: Premium = P − C
call at earliest date
- If g < i: Discount = C − P
call at latest date
Amortization of premium Pt = (F r − Ci)v n−t+1

7.3 Price between coupon dates

- Price actually paid on date of purchase
Bt+k = Bt (1 + i)k
= (Bt+1 + F r)v 1−k

- Quoted price (excl. accrued interest)

P = Bt+k − kF r
= Bt (1 + i)k − kF r

- Actual/Actual method for government bonds

30/360 method for corporate bonds
- Bond saleman’s method
Total interest = n · Cg + C − P
n · Cg + C − P
Average interest =
n
1
Average investment = (P + C)
2
n · Cg + C − P
Approximate yield rate per period i = n
2 (P + C)

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8 Financial Instruments
Price of a share of stock
D
P V D, D(1 + k), D(1 + k)2 , . . . =


i−k
Price of a U.S. T-Bill  n 
P = 100 1 − d
360

9 More Advanced Financial Analysis

9.1 Inflation, spot and forward rate
If i0 is the real interest rate and r the inflation rate,
1+i
1 + i0 =
1+r
If st is the spot rate up to year t and ft is the forward rate between year t
and t + 1,
(1 + st+1 )t+1 = (1 + st )t (1 + ft )
X CFt
P =
t
(1 + st )t

9.2 Duration
- Macaulay duration
t
P
t t · v · CFt
D= P t
t v · CFt

- Modified duration
P 0 (i) D
M odD = − =
P (i) 1+i
P (i + ∆i) ≈ P (i) − M odD · P · ∆i

- Portfolio duration
P1 D1 + P2 D2 + P3 D3
D=
P1 + P2 + P3

9.3 Convexity

· (t + 1) · v t+2 · CFt
P
tt
C= P t
t v · CFt
1
P (i + ∆i) ≈ P (i) − M odD · P · ∆i + · C · P · ∆i2
2

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

10 Introduction to Derivatives
No formulas

11 Forward Contracts
F orward = ST − K

12 Options
- Call options
P ayof f (Call) = (ST − K)+
P rof it(Call) = (ST − K)+ − F V [C(K, T )]

- Put options
P ayof f (P ut) = (K − ST )+
P rof it(P ut) = (K − ST )+ − F V [P (K, T )]

- Put-Call Parity
C(K, T ) − P (K, T ) = S0 e−δT − Ke−rT

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