© G.S.

Questa, TN 1- Basic Pre-calculus [2016-08-31] Page 1 of 11

TN 1
Basic Pre-calculus
1 Power Function, Discount Factors, Value Relatives, and Yields
2 The Summation Operator ( ∑) . Arithmetic Series
3 Geometric Series. Pricing Coupon Bonds
4 Linear Equations
5 Non-linear Equations and Polynomials
6 IRR and Bond Yield to Maturity (YTM)
Glossary
Using some Excel Functions

Acronyms
FV Future Value
IRR Internal Rate of Return
PV Present Value
SY Spot Yield, Zero coupon Yield (Y)
YTM Yield to Maturity (y)
Notation
B Bond or bill price
d (T ) Discount factor for a tenor (T )
E[ ] Expected value
K Face value (principal), usually set at K = 100
r Spot simple yield rate (annualized)
T Tenor, Maturity, in years, of a single payment
v (T ) Spot value relative, for a tenor (T )
Y Spot zero coupon compounded yield (annualized)
YTM Yield to maturity (y)
Z(K, T) Zero coupon bond spot price for a tenor (T )

Excel Functions Referred to in This TN

IRR
POWER
PV
SUMPRODUCT

Foreword
In these notes we will often use the words real number and real line. The set of real
numbers (denoted by R ) includes:
 Integers (set denoted with Z )

 Rational numbers, that is fractions of two integers, such as 3/2 (set denoted by Q )
 Irrational numbers (such as Ö2, π, e, etc.) that cannot be expressed as fractions.
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All of the above sets have an infinite number of elements. However, real numbers are
of a higher order of infinity than rational numbers.
Complex numbers (set denoted by C ), which we will not cover in these induction notes,
represent the solution of equations that do not have a real solution, for example −n .
In fact there is no real number that multiplied by itself equals (-n).

§1 Power Function, Discount Factors, Value Relatives,

and Yields
In order to anchor these notes to finance applications, we begin by introducing some
basic and widely used finance-related concepts.

Yields
When dealing with zero coupon debt securities, which promise a single payment at some
contractually defined future date (T ) , we denote their compounded yield with (Y ) and
refer to it as zero coupon yield or spot yield. When dealing with coupon bonds (or
swaps) that promise more than one fixed future payments, we use the yield to maturity
(YTM) metric that we denote with ( y ) .
YTM is the bond-speak equivalent of the much-used corporate finance yield metric
(IRR – internal rate of return). This is the single compounded yield that will equate the
present value of a stream of payments to their present value (PV). Note that IRR can be
easily calculated using the IRR Excel worksheet function.
NOTE: yields are usually quoted as annualized values, irrespective of the maturity
of the financial instrument. This entails that the time-to-maturity (also known as tenor)
must be included in present value (PV) and future value (FV) calculations.

The Power Function

The power function (PF) can be written as follows, denoting the independent variable
with ( x ) and the fixed power coefficient with (T ) :
y = xT
Values can be calculated in Excel either using the POWER spreadsheet function or the
( y = x ^ a ) syntax. The PF has a number of applications in finance. Suffice to note that
the ubiquitous discount factors are PFs, when (T ) is the fixed exponent (see eq. 1.1).

Discount Factors
A discount factor, denoted by d (T ) , is the present value (PV) of a unit payment due at
time-T. NOTE: in finance time is usually indicated in years. Discount factors don’t have a
currency dimension: they are pure numbers. In this TN we shall not examine the details
of the possible relationships between discount factors and different yield metrics. We
shall use only compounded yield, a concept, with which we are all likely to be familiar.
1.1 Discount Factor Equation
d (T )= f (Y | T )= (1 + Y ) −T
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The PV of a non-unit amount is calculated multiplying the discount factor by the given
amount. For example:
1.2 Present Value Example
= =
K $100, =
Y 4%, T 5
K 1.04 −5 × $100
d (5) ×= = $82.1927

Value Relatives
Value relatives, demoted by v (T ) , are the future value of a unit investment at time-0.
Thus, they are the inverse of discount factors.
1.3 Value Relative Example
1 1
v=
(T ) = = 1.2167
d (T ) 0.821927

2.40

2.00 vT dT

1.60

1.20

0.80

0.40

0.00
0 5 10 15 20

Exhibit 1.1 – Value relatives and discount factors using a 4% YTM

§2 – The Summation Operator (Σ). Arithmetic Series

The SUMMATION OPERATOR is widely used both in finance and statistics. In the simplest
case, ( ∑) it is merely a compact way to denote a sum. In the following equation we use
a summation index, usually an integer denoted with: (i, j, k ). The lowest value of the
index is indicated below the ( ∑) sign, while the highest value is indicated above it.
10
∑aj =
a1 + a2  + a10
j =1
The summation operator can be used to indicate a sum of products. Excel has a
spreadsheet function, appropriately named SUMPRODUCT that will calculate it (See TN
4, §1).
2.1 Sum of Products
n
∑ (a j × b j ) = a1 × b1 +  + an × bn
j =1
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One further use of the ( ∑) operator, which we are likely to come across in finance, is to
indicate a product of polynomials:
2.2 Product of Polynomials
m n
∑ ∑ a jbk = (a1 +  + am ) (b1 +  + bn ) = a1b1 +  + ambn
=j 1 =
k 1

A very useful feature of the ( ∑) operator is that we can use the index both as a counter
and as a parameter of the quantities we are adding up. The simplest example is:
10
∑ j =1 + 2 +  + 10 = 55
j =1

A finance-specific use of the summation index is to denote the present value (PV) of an
annuity, which, in the example, is simply a fixed amount (C ) paid in arrears at regular
yearly intervals. The annual compounded yield ( y ) is assumed to be fixed throughout
the time-horizon of the annuity.

2.3 Present Value of a Constant Annuity

T
 C ∑ (1 + y ) − j
PV= C (1 + y ) −1 +  + (1 + y ) −T =
 
j =1
T
)] C ∑ d ( j )
= C [ d (1) +  + d (T=
j =1

Arithmetic Progression
These are ordered sequence of numbers such that the difference between successive
terms ( d ) is a constant. (This is known as the common difference.) An arithmetic series
is simply the sum of an arithmetic progression. An arithmetic series comprising of (n)
terms can be written as follows:
2.4 Arithmetic Series
Sa = d + 2d +  + nd

In the following numerical example, we set (d = 2) and (n = 10).

Sa = 2 + 4 +  + 20 = 110
The numerical value of an arithmetic series can be easily calculated in Excel with the
SUM function. However, the following equation (proof in mathematical appendix)
makes things easy also with a handheld calculator.
2.5 Equation for the Arithmetic Series
n( n + 1)d 10 × 11 × 2
=Sa = = 110
2 2
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§3 Geometric Series. Pricing Coupon Bonds

A geometric progression, is an ordered sequence in which the ratio of any two
successive terms, known as common ratio, is a constant. For example, in the following
progression the common ratio equals (x):
3.1 Geometric Progression
x1, x 2 , x 3 , , x n −1, x n
A geometric series is simply the sum of a geometric progression. The equation is:
3.2 Geometric Series
x − x ( n +1)
S g =x + x 2 +  + x n =
1− x
With a simple algebraic manipulation (proof in the mathematical appendix) we can use
the above equation to find the price of a plain-vanilla bond (B), with an integer number
of years to maturity, priced to yield ( y ) and paying:
 Constant coupons (C ) at regular intervals (usually yearly or semiannually)
 A principal ( K ) , reimbursed at the same time of the last coupon.

3.3 Coupon Bond Pricing Equation

= C (1 + y ) −1 +  + (1 + y ) −T  + K (1 + y ) −T
B
 
C
= 1 − (1 + y ) −T  + K (1 + y ) −T
y 

In the numerical example, the calculation was done using the PV Excel function. The
coupon bond is quoted below par because the YTM rate is higher than the coupon rate
Numerical Example
=
C €4, = y 5.00%, = T 5,= K €100

B=
€4
0.05
( )
1 − 1.05−5 + €100 × 1.05−5 = €95.6705

§4 Linear Equations
Linear equations (and systems of linear equations) are relatively simple to deal with, and
this explains their widespread use in economics, finance and management. In this
section we’ll also discuss systems of two linear equations in two unknowns. This will
allow us to develop an intuitive understanding of the conditions under which a system
of linear equations will have a solution.

Measuring the Slope of a Function

The slope of a function is a widely used tool in mathematics. Hence it makes sense to
examine it, albeit concisely.
 Slopes can be measured in more than one way. The preferred approach in calculus

is to define slope as the height (positive or negative) of a unit-base rectangular

 © G.S. Questa, TN 1- Basic Pre-calculus [2016-08-31] Page 6 of 11

tringle. This allows to use the slope to calculate by how much the dependent variable
will change, given a unit change in the independent variable. (See Exhibit 4.1.)
 The term slope can be used to indicate a change in ( y ) due to a unit change in ( x )
also when the variables are measured in different units (for example yield an $ price
of a bond)
 Slope can be measured at a single point of a non-linear function, as we shall see in
Chapter 2 (§2, Derivatives.)

0.4
y = 0.3x
0.2
y = 0.1x
0

-0.2 y = −0.2 x

-0.4 y = −0.4 x
0 0.2 0.4 0.6 0.8 1

Exhibit 4.1 – Measuring the slope of linear functions

Linear Functions
A linear function (its graph is a straight line) is written in terms of two parameters (a, b),
where (a) determines where the straight line will intersect the y-axis (for x = 0) while (b)
is the slope of the function
4.1 Linear Function
y= a + bx
2
y = 1.2
1
y = 0.6 x
0

-1
y =−1 − 0.6 x
-2
-3 -2 -1 0 1 2 3
Exhibit 4.2 – Three linear functions

One Linear Equation in One Variable

If a linear function is defined over the whole real line (x-axis) it will always have a real
solution, provided that the slope is not zero (see exhibit 4.2, where the dotted line does
not intersect the x-axis). Solving one linear equation in one variable means finding the
value of (x) for which the following linear function intersects the x-axis. This is a
straightforward exercise as shown in equation 4.2:
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4.2 Univariate Linear Equation

y =a + bx =0
bx = −a
x =−a ÷ b
Example 4.1 - Consider the following spot (zero-coupon) yield curve and associated
discount factors (exhibit 4.3).
t Y (t ) d (t )
1 4.60% 0.9560
2 5.10% 0.9053
3 5.50% 0.8516
4 5.80% 0.7981
5 6.00% 0.7473
∑ 4.2583
Exhibit 4.3 – Five-year spot yield curve
Assume that we want to calculate the annual payment (C ) that will have a (PV = $50).
Using discount factors the calculation becomes a straightforward linear equation in one
variable where (C ) is the unknown.
4.3 Annuity Coupon Equation
$50= C ∑ t =1 d (t )= C × 4.2583
5

= =
C $50 / 4.2583 $11.74

Two Linear Equations in Two Variables

Let us consider the following system of two linear equations.
4.4 Two Linear Equations
a1,1x1 + a1,2 x2 =
c1
a2,1x1 + a2,2 x2 =
c2
There are several methods to solve simple systems of linear equations. However, the
most efficient approach is to use matrix algebra, and this can be easily done using Excel
(see TN 4).
4.5 Two Linear Equations Example
2 x1 + 0.8 x2 =
0.8

3x1 − 1.2 x2 =
−1.2
4.6 Solution of the Example
 x1 = 0
x = 1
 2
The solution of the two equations system has been calculated in Excel with the matrix
approach. If we substitute these values in the linear equations (eq. 4.5) we verity that
the solution is in fact correct, as shown in Exhibit 4.4.
 © G.S. Questa, TN 1- Basic Pre-calculus [2016-08-31] Page 8 of 11

2.00 x1
x1  0.4  0.4x 2
1.00

0.00

-1.00
x1  0.4  0.4x 2
-2.00 x2
-3 -2 -1 0 1 2 3

Exhibit 4.4 – Verifying the solution of a two linear equations system

We should keep in mind that a system of linear equations will have a real solution if the
number of independent equations (in our two equations example this means that the
linear functions are not parallel) equals the number of unknowns (see mathematical
appendix
 If the number of equations is less that the number of unknowns, the system will have
infinitely many solutions
 When equations outnumber unknowns, the system will almost certainly not have a
solution

§5 Non-Linear Equations and Polynomials

Linear equations and systems of linear equations are relatively simple to solve. This is
not the case with non-linear equations, as we shall see in this section with reference to
polynomials. This topic has a clear relevance for finance as we shall see in §6, discussing
IRR, YTM, and the possibility of multiple IRRs.

Simple Non-linear Equations

Some non-linear equations are very simple. Take for example the pricing equation of a
zero coupon bond. Finding the price ( Z ) is straightforward and the numerical calculation
can be performed using Excel of a handheld calculator.
5.1 Pricing a Zero Coupon Bond
=
K $100,=
T 5,=
Y 4%
Z =K (1 + Y ) −T =$100 × 1.04 −5 =$82.1927
We could also consider (Z = £82.1927) as given and calculate the yield. This requires a
very simple manipulation of the pricing equation.
5.2 Calculating Y
K (1 + Y ) −T =
82.1927
(1 + Y ) −T =
0.821927
−1/ T
= =
Y 0.821927 − 1 0.04
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Polynomials
They have the following structure, where the highest exponent (n ) is known as the
degree of the polynomial. A root of the polynomial is a value of ( x ) for which ( y = 0) .
5.3 Polynomial of Degree (n)
y = ao + a1x + a2 x 2 +  + an x n
Consider exhibit 5.1 that shows three simple quadratic functions:
y=
a + bx 2 {a =
4,0, − 2}
These equations have the following roots:
 For a > 0 there is no real root
 For a = 0 there is one real root, namely ( x = 0)
 For a < 0 there are two real roots

10
y= 4 + x 2
8

2 y = x2
y =−2 + x 2
0

-2
-4 -3 -2 -1 0 1 2 3 4
Exhibit 5.1 – Three simple quadratic functions
The quadratic function in exhibit 5.1 is no anomaly, as we can see in exhibit (5.2), which
shows one cubic function ( ya ) with three real roots. The other two cubic functions,
obtained by shifting ( ya ) upwards, have respectively two and one roots.
5.4 Roots of a Cubic Polynomial
ya = ( x + 3) x ( x − 3) = 0.16( x 3 − 9 x )
y=
b ya + 1.62
y=
c ya + 4.00

In fact, it has been proved that every polynomial has a number of roots that equals the
degree of the polynomial (3 in the case of the cubic function). The problem is that some
of these roots can be complex numbers while others can be coincident (that is to say
more than one root for one value of ( x ) .
 © G.S. Questa, TN 1- Basic Pre-calculus [2016-08-31] Page 10 of 11

-2 =ya 0.16( x3 − 9 x)
-4

-6
-6 -4 -2 0 2 4 6

Exhibit 5.2 – Three roots of three cubic polynomials

Furthermore, there are non-linear equations that do have a real solution/s that must be
calculated with numerical methods (they have no closed-form solution). A well-known
case is that of general polynomials of 5-th degree or higher.
Eq. 5.5 – Fifth degree Polynomial
ao + a1x + a2 x 2 + a3 x 3 + a4 x 4 + a5 x 5
Fortunately, computers allow us to implement numerical methods, and some of the
necessary software is also available in Excel.

§6 IRR and Bond Yield to Maturity (YTM)

Bond Yield to Maturity (y)
Let us consider the case in which we know the price of a bullet bond, its notional
amount, coupons, and maturity. If we want to determine the bond’s YTM we must use
numerical methods to find the level of (y) that will satisfy the following equation.
B = PV ( K , y , C , T )
In this case the numerical calculation is done using the Excel IRR function. In exhibit 6.1,
we consider a 20 year 2% annual coupon bond, priced at $110. The numerical solution,
obtained using the IRR Excel spreadsheet function, is (y = 1.42%). Note that the bond
price as a function of (y), which can be calculated with the Excel PV function, appears to
be almost linear but in fact it is slightly convex (see TN 2).

$140

$120

$100

$80

$60
0. 0% 1. 0% 2. 0% 3. 0% 4. 0% 5. 0%
 © G.S. Questa, TN 1- Basic Pre-calculus [2016-08-31] Page 11 of 11

Exhibit 6.1 – Visualizing the YTM calculation

Multiple IRRs
We have seen that the YTM of a bond and the IRR of an investment project are the root
of a polynomial. Thus, we might have more than one real root. In reality this is not a very
likely event. Without getting stuck in very advanced algebra we may state that to have
a double root:
A necessary, but not sufficient, condition is that the cash flow must have two changes
of sign. More in general, Descartes rule of signs establishes that the maximum number
of real roots of a polynomial is equal to the number of changes of signs of its coefficients.
Typically we must have a large negative cash flow at the end of the project. We can think
of: a nuclear power plant that may entail very large decommissioning costs, a strip mine
that has to be closed, etc.

t=1 t=2 t=3 … t = 10 t = 11 t = 12

-100.0 25.5 24.74 … 19.39 18.80 -145.0
Exhibit 6.2 – Cash flow that will result in the two real, non-
coincident, IRRs shown in exhibit 6.3

$6
NPV
$4

$2

$0

-$2
YTM
-$4
0% 2% 4% 6% 8% 10% 12%

Exhibit 6.3 – Visualizing an example of two IRRs

Key Terms
Annuity Face Value Spot Yields
Arithmetic Progression Geometric Progression Summation Operator
Arithmetic Series Geometric Series Time-intensity of Returns
Commercial Paper Holding Period Time-series Aggregation
Common Difference Imaginary Nunber Time-to-maturity
Common Ratio Intensity of Return Treasury Bills (T-bills)
Complex Number LIBOR Treasury Notes (T-notes)
Convexity Power Function Value Relatives
Degree of a Polynomial Present Value Yield to Maturity (YTM)
Descartes Rule of Signs Proportional Growth Zero Coupon Bonds
Discount Factors Root of an Equation Zero Coupon Yield