ACST2001: Financial Modelling

ACST2001
Financial Modelling
Unit Convenor: Sachi Purcal
(c) Macquarie University 2021 1

Workshop presenters:
Sachi Purcal
Common email address for queries:

acst2001@mq.edu.au

ACST2001
Financial Modelling
Week 01: Introduction

• Where are we starting from?
• Where are we going?
Where are we starting
from?
… from what you learned

in ACST1001

Where are we going?
… towards a deeper
understanding of some basic
financial concepts (and a better
understanding of learning)
USING FINANCIAL MATHS
TO UNDERSTAND …...
…… SOME BASIC
PRINCIPLES OF FINANCE

BASICS OF FINANCIAL
MATHS FROM ACST101 …...
…… applied to prices, yields,

reinvestment risk, contingent
payments, insurance pricing,
forwards & futures, options
Most people learn …
10% of what they read
20% of what they hear
30% of what they see
50% of what they see and hear
70% of what they talk over with others
80% of what they use and apply in real life
95% of what they teach someone else

Workshop Week 1
➢ SIMPLE INTEREST AND

SIMPLE DISCOUNT
➢ PRICES AND YIELDS OF
SHORT TERM FINANCIAL
INSTRUMENTS
Workshop Week 1
- things you’ve already seen in

ACST101, but from a different
perspective.

Note that …
Sample solutions for all

these problems are
available from Friday
evening on iLearn.

PROBLEM 1.
Explain in words (without

using any formulae or
numbers) the difference
between a rate of simple
interest and a rate of
simple discount.
PROBLEM... 1
A rate of simple interest expresses the
interest amount as a proportion of the
amount originally invested or borrowed
at the beginning of the investment or
loan.
On the other hand:
A rate of simple discount expresses the
interest amount as a proportion of the
future amount to be received or paid
back when the investment or loan
matures.
Simple interest and simple
discount rates are
expressed as a rate per
annum.
When the time period
involved is less than a year
the interest amount or the
discount amount is
pro-rated on a proportional
basis. (c) Macquarie University 2021 14
The number of days in a year is taken as:
365 days in Australia and UK

360 days in the US and
Euromarkets.
We will use 365 days in this
course (unless specified
otherwise).

REVISION: COUNTING
THE NUMBER OF DAYS
When counting the number
of days between two dates,
we use this rule:
Count either the starting
day or the ending day, but
not both
PROBLEM 2
Find the present value of a

payment of $100,000 due
in 6 months’ time at:
a) 6% pa simple interest;
b) 6% pa simple discount.
PROBLEM ... 2
Call the present value PV.
PV + Interest = Future amount
The present value of a future
sum of money is the amount
that needs to be invested now,
at a given rate of interest, in
order to accumulate that future
sum.
PROBLEM ... 2
(a) At simple interest:
PV + PV  0.06  (6/12) = 100,000
PV  (1 + 0.06  ½) = 100,000
PV = 100,000 / (1.03) = $97,087.38

PROBLEM... 2
(b) At simple discount:
PV + 100,000  0.06  (6/12) = 100,000
PV = 100,000 – 100,000  0.06  (6/12)
PV = 100,000  (1 – 0.06  ½)
PV = 100,000  0.97 = $97,000

PROBLEM…2…extension
A friend looks at these answers and
comments that the PV at simple
interest is more than the PV at
simple discount and asks whether
the calculations are correct.
Explain what rough checks you can
do on your result and explain why
the PV at simple interest is more
than the PV at simple discount.
PROBLEM…2
Do these answers look correct?
Future amount: $100,000

PV at simple interest : $ 97,087.38
PV at simple discount: $ 97,000.00
Do some rough checks:
PV < Future amount
The interest charged is 6%pa which is
equivalent to 3% per half-year.

PROBLEM … 2
Future amount: $100,000
PV at simple interest : $ 97,087.38
PV at simple discount: $ 97,000.00
For simple discount the interest charged is

3% of $100,000 or $3,000.
For simple interest the interest charged is
3% of PV where PV< $100,000 so interest
charged is a bit less than <$3,000
As PV = Future amount - Interest ,
the PV at simple discount will be slightly
less than PV at simple interest.
Pricing Short Term
Financial Instruments
In Australia
Short term financial instruments
are priced
➢ using a rate of simple interest
➢ and assuming a 365-day year.

Pricing Short Term
Financial Instruments
In the USA and UK Short term
financial instruments are priced
using a rate of simple discount:
(a) and assuming a 360-day year,
in the USA;
(b) and assuming a 365-day year,
in the UK
PROBLEM 3
A promissory note for
$500,000 will mature ninety
(90) days from 11 February,
2012. Find its price on
1 March, 2012 at:
a) 5.2% pa simple interest;
b) 5.2% pa simple discount.
PROBLEM... 3
11 February to 1 March (in 2012, which IS
a leap year) is (29-11)+1 = 19 days.
So on 1 March the bill has (90-19) = 71
days to run to maturity.
The price is the present value (PV) of the
maturity amount of the bill, where the
PV is calculated at the rate of interest
the investor wishes to earn (or the rate
currently available in the market).

PROBLEM... 3
Price + Interest = Maturity value
(a) At simple interest:

Price + Price  0.052  (71/365) = 500,000
Price  {1 + 0.052  (71/365)} = 500,000
Price = 500,000 / {1 + 0.052  (71/365)}
Price = $494,993.11
PROBLEM... 3
Price + Interest = Maturity value
(b) At simple discount:
Price + 500,000  0.052  (71/365) = 500,000
Price = 500,000 – 500,000  0.052  (71/365)
Price = 500,000  {1 – 0.052  (71/365)}
Price = $494,942.47

PROBLEM... 3
Some rough checks:
Maturity value: $500,000
Price at simple interest: $494,993.11
Price at simple discount: $494,942.47
Price < Maturity value
Price at simple discount < Price at
simple interest
See solutions on iLearn for some other
rough checks
FUNDAMENTAL PRINCIPLE
OF PRICING A FINANCIAL
INSTRUMENT …..
PRICE = Present value of all

the future cash flows to be
received by the holder of the
financial instrument …….
FUNDAMENTAL PRINCIPLE
OF PRICING A FINANCIAL
INSTRUMENT …..
The interest rate (used to calculate
the present value of cash flows) is
the investor’s required yield (ie the
rate of return the investor wishes
to earn, by holding the financial
instrument until it matures)
PRICE: SHORT TERM FINANCIAL INSTRUMENTS
Purchase Maturity
date date
$P $M
Period : up to (about) 12 months
P is the purchase price;

M is the maturity value;
P is calculated as the present value of M

Comparison: Short Term and Long
Term Financial Instruments
Feature Short term Long term
instruments instruments
Period to Up to (say) One year or
maturity 12 months more
Pattern of Just one One or more
cash flows cash flow cash flows
Type of Simple Compound
interest rate interest (or interest
used for simple
pricing discount)
PROBLEM 4
How long (in months, to
one decimal place) will it
take for $10,000 to
accumulate to $11,000 if
it is invested at 5.8% pa
simple interest?
PROBLEM …4
Starting Finishing
date date
$10,000 $11,000
How long (in months)?
Amount invested is $10,000;

Maturity value is $11,000;
Simple interest rate is 5.8% pa

Problem ... 4
Need to earn interest of:

(11,000 – 10,000) = $1,000
One month’s interest would be:
10,000×0.058×(1/12) = $48.333333
At simple interest , the amount of
interest earned each month is the
same.
Problem ... 4
One month’s interest would be

$48.333333
So, number of months required to
earn $1,000 interest would be:
1,000 ÷ 48.333333 = 20.7 months

PROBLEM 5
If an investor buys a
$100,000 120-day bank
bill for $98,144.66, what
simple interest yield pa
will she earn?
PROBLEM …5
Purchase Maturity
date date
$98,144.66 $100,000
Period : 120 days
Purchase price is $98,144.66;

What yield pa does investor earn?

Problem ... 5
We want the yield

expressed as a rate of
simple interest. A rate of
simple interest expresses
the interest earned as a
proportion of the amount
originally invested
Problem 5 - Solution
Amount of interest earned is:
(100,000 – 98,144.66) = $1,855.34
Original amount invested (price) is:
$98,144.66
Rate of simple interest is:
1,855.34 ÷ 98,144.66 = 0.018904
per 120-day period (not per annum)
So, rate of simple interest pa is:
0.018904 × (365 / 120) = 0.0575 or 5.75%
Problem ... 5
We want the rate per annum (ie per

year). If we divide the rate per 120-
day period by 120, we will have the
rate per day. If we then multiply this
by 365, we have the rate per annum.
So, rate of simple interest pa is:
0.018904 × (365 / 120) = 0.0575 or
5.75%
Short term financial
instruments … types
Commercial (bank) bills
Promissory notes (P-notes)
Treasury notes (T-notes)
Certificates of Deposit (CD’s)
Bonds (when less than six
months from maturity)
Treasury Bonds
Pay
half-yearly (semi-annual)
interest coupons and
the face value on Maturity.

T-bond with less than 6 months to run
to maturity
When a T-bond has less than 6
months to run to maturity:
it is priced as if it were short term
instrument.
Note that in this case it has the
features of a short term instrument:
➢ its term is less than 12 months and
➢ its holder will receive just one
future cash flow

What is the amount
payable at maturity ($M)?
When a Treasury bond matures,
the holder of the bond receives
a payment equal to …..
the maturity amount …..
plus …..
the final interest coupon!
Problem 6
Find the price of a 13.5%
Treasury bond, 107 days
before maturity, to give a
yield of 8.3% pa simple
interest
Problem 6
Find the price of a 13.5%
Treasury bond, 107 days
before maturity, to give a
Coupon rate pa,
payable half-yearly
interest

Problem 6: Price of T-bond
Purchase Maturity
date date
$P $M
Period : 107 days
• Purchase price is $P (unknown)

• Amount payable at maturity is $M
• Simple interest yield is 8.3% pa
• Assume face value of bond is $100
When a Treasury bond
matures
the holder of the bond receives a
payment equal to …..
the maturity amount …..
plus …..
the final interest coupon!

Assume the T-bond has face value
$100.
Treasury bonds pay half-yearly
(semi-annual) interest coupons, so
this bond pays half-yearly (semi-
annual) interest coupons at the rate
of 6.75% (half of 13.5%) per half-
year.
Half-yearly coupon = 100  0.0675
= $6.75 (per $100 face value)

Amount payable to bond holder
at maturity
= Face value of bond + Final
interest coupon
= 100 + 6.75 = $106.75

Price + Interest = Maturity amount
Maturity Amount = 106.75
Price + Price  0.083  (107 / 365) =
106.75
Price{1 + 0.083  (107 / 365)}= 106.75
Price = 106.75 /{1 + 0.083 (107 / 365)}
Price = $104.214 (per $100 face
value)

T-bond
These facts are assumed to be implicit for
T-bonds, unless otherwise stated:
coupons are payable half-yearly (on
15th of month)
stated coupon rate is nominal
annual rate (payable half-yearly)
T-bond redeemable at par
(ie maturity payment = face value)
if actual face value not stated, find
price per $100 FV (to 3 dec places)
Problem 7
A $100,000 bank bill, 20 days
before maturity, is quoted at a
interest
(a) Find the bill’s price
(b) Find the equivalent
simple discount rate
Problem 7 : Price of a bill
Purchase Maturity
date date
$P $100,000
Period : 20 days
Purchase price is P (unknown);

Simple interest yield is 5.85% pa

Problem 7
(a) Price + Interest = Maturity amount
Price + Price  0.0585  (20 / 365) = 100,000
Price  {1 + 0.0585  (20 / 365)} = 100,000
Price = 100,000 / {1 + 0.0585  (20 / 365)}
Price = $99,680.48

Problem 7
(b) We want the yield

expressed as a rate of simple
discount. A rate of simple
discount expresses the
interest earned as a
proportion of the amount
received at maturity.
Problem 7
Amount of interest earned
= 100,000 – 99,680.48
= $319.52
At maturity receive face value of
bank bill) = 100,000
Rate of simple discount
= 319.52 / 100,000
= 0.00031952; or 0.031952%
Problem 7
This is the rate of simple discount
per 20-day period (because the
period of the investment was 20
days). We want the rate per
annum (ie per year).
Rate of simple discount per annum
= (0.031952 / 20)  365
= 5.83% pa
Problem 7
Check: Rate of simple discount
(5.83% in this case) should be
lower than the rate of simple
interest (5.85% in this case) for the
same transaction, because rate of
simple discount relates the
amount of interest to the amount
received at maturity ($100,000
here), which is larger than the
price ($99,680.48 here).
Problem 8
A 90-day bank bill is bought
to yield 7.4% pa. After 40
days it is sold at a yield of
6.8% pa. What yield did the
original purchaser obtain on
the investment?

Problem 8 : Yield on purchase/sale
Purchase Sale Maturity

date date date
$P1 $P2 $M
40 days
Period : 90 days
Purchase price is $P1; Sale price is $P2;

Maturity value is $M;
Yield (from purchase to sale) is …. ?

Problem 8
Assume the bank bill has face

value $100.
Let the purchase price be $P1, and
the sale price $P2.
P1 = 100 / {1 + 0.074  (90 / 365)}
= $98.208 (per $100 face value)
P2 = 100 / {1 + 0.068  (50 / 365)}
= $99.077 (per $100 face value)
Problem 8
So, the investor outlays $98.208 at
purchase, then receives $99.077 at
sale (40 days later). This means the
investor’s yield (as a rate of simple
interest per annum) is:
(99.077 – 98.208) 365

----------------------- × ----- × 100 = 8.07% pa
98.208 40
SUMMARY : Week 1
How simple interest and simple
discount work
Concept of price as PV of future cash

flows to be received
Yields on short term instruments
Pricing short term financial instruments

SUMMARY : Week 1
Value of cash flow diagrams
We can do rough checks on results
We can solve financial maths problems

without relying on formulas

ACST2001: Financial Modelling

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ACST2001

Unit Convenor: Sachi Purcal

(c) Macquarie University 2021 1

Common email address for queries:

(c) Macquarie University 2021 2

Week 01: Introduction

… from what you learned

(c) Macquarie University 2021 4

(c) Macquarie University 2021 6

…… applied to prices, yields,

(c) Macquarie University 2021 8

➢ SIMPLE INTEREST AND

- things you’ve already seen in

(c) Macquarie University 2021 10

Sample solutions for all

(c) Macquarie University 2021 11

Explain in words (without

365 days in Australia and UK

(c) Macquarie University 2021 15

Find the present value of a

PV + Interest = Future amount

(a) At simple interest:

PV + PV  0.06  (6/12) = 100,000

PV = 100,000 / (1.03) = $97,087.38

(c) Macquarie University 2021 19

PV + Interest = Future amount

(b) At simple discount:

PV + 100,000  0.06  (6/12) = 100,000

PV = 100,000 – 100,000  0.06  (6/12)

PV = 100,000  0.97 = $97,000

Future amount: $100,000

(c) Macquarie University 2021 22

For simple discount the interest charged is

➢ and assuming a 365-day year.

(c) Macquarie University 2021 24

(c) Macquarie University 2021 27

Price + Interest = Maturity value

(a) At simple interest:

Price  {1 + 0.052  (71/365)} = 500,000

Price = 500,000 / {1 + 0.052  (71/365)}

Price = 500,000 – 500,000  0.052  (71/365)

Price = 500,000  {1 – 0.052  (71/365)}

(c) Macquarie University 2021 29

PRICE = Present value of all

Period : up to (about) 12 months

P is the purchase price;

(c) Macquarie University 2021 33

How long (in months)?

Amount invested is $10,000;

(c) Macquarie University 2021 36

Need to earn interest of:

One month’s interest would be

(c) Macquarie University 2021 38

Period : 120 days

Purchase price is $98,144.66;

(c) Macquarie University 2021 40

We want the yield

We want the rate per annum (ie per

(c) Macquarie University 2021 45

(c) Macquarie University 2021 46

(c) Macquarie University 2021 49

Period : 107 days