Te Thee of Interest STEPHEN G. KELLISON j McGRAW-HILL INTERNATIONAL EDITION pr TEInternational Edition 2000 Exclusive rights by McGraw-Hill Education (Asia) for manufacture and export. This book cannot be reexported from the country to which it is sold by MeGraw-Hill. Ths International Edition is not to be sold or purchased in North America and contains content that is ferent from its Non American version, Published by McGraw Hilldwin, a business unit of The McGraw-Hill Companies, Inc.. 1221 Avenue of the Americas, New York, NY 10020, Copyright © 2009, 1991, 190 by ‘The McGratv-Hill Companies, Ine. Al rights reserved. No pat of this publication may be reproduced ‘or distributed in any form or by any means, or stored in a database or retrieval system, without the prior writen consent of The McGraw-Hill Companies, In including, but not lied to, “any network or other electronic storage or transmission, or broadeas! for distance learning. Some ancillaries, including electronic and print components, may not be available 10 ‘customers outside the United States, 10 09 08 07 06 05 04 03 02 20 8 CTF ANE ‘When ordering this ttle, use ISBN: 978.007-127627-6 or MHID: 007-127627-0 Printed in Singapore ‘wow mibhe-com ‘To my family: Toni, Mat, and LexiPreface ‘This third edition is a substantially revised and expanded treatment of the theory of interest from that contained in the second edition. With » few minor exceptions, all the material in the second edition has been retained and updated. In addition, a significant amount of new material has been added. ‘The first seven chapters cover the basic mathematical theory of interest as traditionally developed. ‘These seven chapters match the first seven chapters in the second edition. However, the material on yield rates was moved from ‘Chapter 5 to Chapter 7 and the other two chapters were renumbered accordingly. ‘The coverage of topics in these seven chapters largely tracks the second edition. The consideration of annuities varying in geometric progression has been expanded into a separate section reflecting the increasing importance of indexed annuities in various types of applicstions. The material on capital ‘budgeting in Chapter 7 has been significantly expanded with the introduction of several techniques not covered in the second edition. Finally, the discussion of short sales has been expanded and repositioned into Chapter 7 ‘Chapter 8 covers practical applications of material presented in the first seven chapters. It is organized into largely independent sections, so that it can readily be used as a reference for the topics covered. One new topic that has ‘been added in Chapter 8 is leasing as an alternative to traditional loan financing, ‘with particular emphasis on automobile leasing. Also, the section introducing the reader to modem financial instruments has been expanded to include additional financial instruments. Chapters 9 through 13 introduce the reader to the economic and financial theory of interest, in additional to the mathematical theory of interest. Much of this material was covered in the second edition, but the extent and depth of coverage has been significantly expanded in the third edition. For example, Chapter 9 has separate sections devoted to reflecting the effects of inflation, expenses, taxes, currency exchange rates, and risk and uncertainty in calculations involving interest. Chapters 10 and 11 are two new chapters representing a significantly ‘expanded treatment of two important topics covered in Chapter 9 of the second edition. Chapter 10 covers the term structure of interest rates with expanded consideration of spot rates, forward rates, relationship with bond yrelds, and &Preface viii section with a detailed discussion of arbitrage. Chapter 11 covers important techniques in the management of assets and liabilities, such as duration, convexity, and immunization. The analysis of interest sensitive cash flows is considered more explicitly and in more gepth. Also, the material on the full ‘immunization technique has been moved from an appendix and expanded into @ separate section. With a couple of notable exceptions, the first eleven chapters largely utilize a deterministic approach to the subject of interest. The final two chapters explicitly address stochastic approaches to interest theory. Chapter 12 contains a number of different models for doing this and consists of an expanded ‘treatment of material from Chapter 10 in the second edition. The use of binomial lattices for interest rate modeling and the development of several ‘continuous stochastic models are new to the third edition. Chapter 13 addresses options and other derivatives and has been expanded into an entire chapter. Significant non-mathematical introductory material has been added in the carly part of the chapter to provide a more complete introduction into the basics of options. The two primary approaches for option valuation, binomial lattices and the Black-Scholes formula, have been updated and expanded, Finally, the reader is briefly introduced to some extensions of ‘option valuation techniques for more complex types of options. ‘The computational approaches in the third edition have been modernized to reflect the widespread availability of calculators with exponential and logarithmic capability, including those with built-in financial functions. Techniques for solving certain key types of problems, e.g. the determination of aan unknown yield rate given a set of cash flows, are illustrated. However, the presentation is generic and not tied to any one particular financial calculator. ‘The coverage of calculator techniques is targeted and is not widespread throughout the book, The importance of the mastery of basic concepts and techniques is stressed throughout and is not sacrificed in those areas in which calculator techniques are illustrated. ‘The interest tables have been eliminated from the third edition as obsolete. Alls, iteration techniques are greatly deemphasized from the presentation in the second edition. An appendix on iteration methods is retained for those reader interested in pursuing this subject in more detail. ‘The pedagogical approach in the second edition has been retained in the third edition. The textbook narrative emphasizes both the importance of conceptual understanding and the ability to apply die techniques to practical problems. Verbal interpretations of key results are emphasized throughout. Key formulas are numbered for ease of reference. Illustrative examples are provided Preface ix at the ends of most sections. The number of exercises at the ends of the chapters, has been significantly expanded to 545. Each exercise is intended to illustrate a somewhat different point to keep the number of repetitious exercises to a ‘minimum. Answers to the exercises are provided at the back of the book. ‘A new feature in the third edition is the addition of chapter appendices, ‘These appendices contain such items as the more complex derivations, extended results of interest but not fundamental, and additional formulas and techniques. ‘The purpose is for the primary textbook narrative to be “tighter” and focused on, the fundamental material. In addition to these chapter appendices, the book also contains five yeneral appendices at the cnd of the book. These latter five appendices are lettered rather than numbered to avoid ambiguity. ‘A working knowledge of calculus is required, since the continuous nature of interest is recognized throughout the book. Also, the last two chapters of the book dealing with stochastic approaches assume knowledge of basic probability and statistics ‘The book is designed to be appropriate for both classroom use with an instructor and for self-study by those Jeaming the subject without the aid of an instructor. The amount of material probebly excecds that which can be covered in a one-semester university course. ‘The author is indebted to a number of students who have used the textbook and a number of other correspondents who have written over the years in connection with the second edition. As a result of this input and correspondence, a number of improvements have been incorporated into the third edition. ‘The author wishes to express his appreciation to the Society of Actuaries ‘and to the Casualty Actuarial Society for using the second edition as a syllabus reference on the actuarial examination covering financial mathematics for many years. A number of the exercises appearing in this book have been obtained from published examinations of these two actuarial organizations. The author also wishes to give special recognition and appreciation to two individuals at the University of Central Florida. Kellie Tabor spent uncountable hours typing the manuscript for the book. Since final copy was produced by ‘word processing, this was a very painstaking process. Dandan Xu, a graduate student, used special software to develop the figures in the book and also contributed extensively to the exercises. Finally, the author wishes to recognize the patience and understanding of hhie wife Toni for her unfailing support. Without her dedication and support this ‘book could not have been completed. October 2007 ‘STEPHEN G. KELLISONContents . | LL Inroduetion, 1 1.2 The accumulation and amount functions, 2 13. The effective rte of interest, 5 14 Simple interes, 7 1.5 Compound interest, 8 .6 Present value, 13, 1.7 The effective rte of discount, 15 1.8 Nominal rates of interest and discount, 22 19 Forces of interest and discount, 28 110 Varying interest, 35 LIL Summary of results, 38 Appendix 1, 39 ‘Simple interest for factional periods, 39 (Compound interest for fractional periods, 40, Bxerciss, 42 2. Solution of problems tn Inter €Stwwnnneenenenenrsnnennsnen 2.1 kntroduction, 49 22. Thebesic problem, 50 23. Equations of value, 52 24 Unknown time, $5 25 Unknown rte of interest, $8 26 Determining time periods, 60 2.7 Practical examples, 62 Appendix 2, 66 ‘Derivation involving method of equated time, 66 Exercises, 67xii Contents: Basic annuities enn 3.1 Introduction, 73 3.2 Annuity-immediate, 74 , 33° Annuity-due, 79 3.4 Annuity values on any date, £3 35 Perperites, 86 3.6 Unknown time, 89 3.7 Unknown rate of interest 93. 38 Varying interest, 95 3.9 Annuities not involving compound interest, 98 Appendix 3, 106 “Approximate formula for unknown rate of interest, 106 Exercises, 107 More general anauitiesinncsnns 4.1 Introduction, 114 42 Differing payment and interest conversion periods, 114 43° Annuities payable less frequently than interest is convertible, 117 44 Annuities payable more frequently than interest is convertible, 121 45° Continoous annuities, 125 4.6 Payments varying in arithmetic progression, 127 47 Payments varying in geometric progression, 133, 48 More general varying annuities, 137 49° Continuous varying annuities. 140 410 Summary of results, 142 Appendix 4, 143 (Other formulas for annuities payable reore frequently then intrest is convertible, 143 Alternative approach for payments varying in arithmetic progression, 144 Enercises, 146, Amortization schedules and sinking funds....... S.A Introduetion, 152 5.2 Finding the outstanding loan balance, 153 53. Amortization schedules, 155 54. Sinking funds, 164 ‘5.5 Differing payment periods and interest conversion periods, 170 seamen 2 Contents xiii 3.6 Varying series of payments, 172 5.7 Amortization with continuous payments, 178 5.8 Step-rate amounts of principal, 181 Exercises, 185 Bonds and other securities... 6.1 Introduction, 194 62 Types of securities. 194 63 Price of a bond, 200 64° Premium and discount, 206 65 Valuation between coupon payment dates, 213, 66 Determination of yield rates, 219 6.7 Callable and putable bonds, 222, 68 Serial bonds, 226 69 Some generalizations, 228 6.20 Other securities, 231 6.11 Valuation of securities, 234 Appendix 6, 238 Derivation ofthe bond salesman's formula, 238 Exercises, 240, Yield rates... 7.1 Introduction, 248 72 Discounted cash flow analysis, 249 73 Uniqueness of the yield rate, 255 74 Reinvestment rates, 258 75 Interest measurement ofa fund, 264 76 Time-weighted ates of interest, 269 7.7. Portfolio methods and investment year methods, 274 78 Shor sales, 277 79 Capital budgeting -basic techniques, 281 7.10 Capital budgeting - other techniques, 286 ‘Appendix 7, 295 ‘Uniqueness ofthe yield rate, 29S, Further analysis ofthe simple interest assumption in Section 7.5, 296 Interest measurement using continuous functions, 297 Exercises, 299u Practical appliCtth015venreneremnenenenenenneenonnrnnren 30D 8.1 Introduction, 309 82 Truth in lending, 310 83 Automobile financing, 316 8.4 Real estate mortgages, 326 8.5 Approximate methods, 333 86 Depreciation methods, 344 8.7 Capitalized cost, 352 88 Modem financial instrument, 355 Exercises, 364 More advanced financial analysts. 9.1 Introduction, 373 9.2. Ameconomic rationale for irtrest, 374 9.3 Determinants ofthe level of interest rates, 376 9.4 — Recognition of inflaton, 379 9.5 Considertion of expenses. 285 9.6 Effectof mes, 391 9.7 Currency exchange rates, 397 98 Reflecting risk and unceristy 400 9.9 Interest rate assumptions, 408 Exercises, 411 ‘The term structure of interest rates..-nennininnennnenennnane 9 10.1 Introduction, 419 102 Yield curves, 420 103 Spotrates, 424 10.4 Relationship with bond yielés, 426 10.5 Forward rates, 431 10.6 Arbitrage, 437 10.7 A continuous model, 440 Exercises, 444 Duration, converity and immunization nsnwsnon TA Introduction. 450 1.2 Duration, 451 113 Convexity, 458 2 13 ne ns 116 a7 ns ng Contents xv Interest sensitive cash flows, 467 ‘Analysis of portfolios, 470 Matching assets and liabilities, 476 [mmonization, 480, Full immunization, 486 ‘A more general model, 488 Appendix 11, 491 Further analysis of varying annuities, 491 Exercises, 492 ‘Stochastic approaches to interest... Ra R2 23 14 25 126 27 Rs Introduction, $00 Independent rates of interest, SOL ‘The lognormal mode!, S09 Time series models, 515, Binomial lattices, 520 ‘Continuous stochastic models, 527 Scenario testing, 535, More advanced models, $40 ‘Appendix 12, 542 Derivation of the variance of annuity, $42 Exercises, 545 (Options and other derivatives... BI 132 133 Ba BS 136 137 138 senna Introduction, $51 Definitions and concepts, 552 Position and profit diagrams, 556 Determinants of option value, 559 Combination postions, 563 Binomial latices, 566 Black-Scholes formula, 574 ‘Some extensions, 576 Appendix 13, 579 Derivation ofthe Black-Scholes formula, 579 Exercises, 582,xvi Contems Appendix A, Appendix B ‘Appendix C ‘Appendix D Appendix E eration methods.. —ntinneeennS 9D Answers to the exerclseS.mneun, Glossary of notation... LT The measurement of interest 1.1 INTRODUCTION Interest may be defined as the compensation that @ borrower of capital pays to a lender of capital for its use. Thus, interest can be viewed as a form of rent that the borrower pays to the lender to compensate for the loss of use of the capital by the lender while it is loaned to the borrower. In theory, capital and interest need not be expressed in terms of the same commodity. For example, Farmer A may lend a tractor to Farmer B for use in harvesting B's wheat crop return for a percentage of the wheat harvested. In this example, the tractor is capital and the portion of wheat that B gives to A is interest. However, for almost all applications, both capital and interest are expressed in terms of money. In Chapter 1 the various quantitative measures of interest are analyzed. This ‘chapter includes most of the basic principles involved in the measurement of interest. Chapters 2 through 8 elaborate and extend these basic principles to more ‘complex financial transactions. “These chapters explore the various methods by which interest is calculated and by which capital and interest are repaid by the borrower to the lender. Chapters 1-8 in essence are concemed with the mathematical theory of interest on a deterministic basis. Chapters 9-13 introduce the reader to a number of more advanced topics. Among these topics are the following: the economic and financial theory of interest, the term structure of interest rates, techniques relating assets and liabilities, stochastic approaches to interest, and more advanced financial instruments such as options and other derivatives.2 The theory of interest 1.2 THE ACCUMULATION AND AMOUNT FUNCTIONS, ‘A common financial transaction is she investment of an amount of money at interest. For example, a person may invest in a savings account at a bank. The initial amount of money (capital) invested is called the principal and the total amount received after a period of time is called the accumulated value. The difference between the accumulated value and the principal is the amount of interest, oF just interest, earned during the period of investment. For the moment, assume that given the original principal invested, the accumulated value at any point in time can be determined, We will assume that no principal is added or withdrawn during the period of investment, ic. that any change in the fund is due strictly to the effect of interest. Later we will relax this assumption and allow for contributions and withdrawals during the period of investment. Let measure time from the date of investment. In theory, time may be measured in many different units, ¢g.. days, months, decades, ete. The unit in ‘which time is measured is called the measurement period. or just period. The ‘most common measurement period is one year, and this will be assumed unless stated otherwise. “_ Consider the investment of one unit of principal. We can define an ‘accumulation function a(t) which gives the accumulated value at time £2 0 of an ‘original investment of 1 ‘What properties does this function possess? 1. Wis clear that a(0) = t. 2. aft) is generally an increasing function, A decrease in the functional values for increasing 1 would imply negative interest. Although negative interest is possible mathematically, it is not relevant to most situations encountered in practice. However, there are situations in which negative interest does appear. eg. an investment fund that loses money over a certain period of time. Constant functional values would imply zero interest, a situation occurring occasionally. 3. I interest acerues continuously, as is usually the case, the function will be ‘continuous. However, there are situations in which interest dues wot accrue continuously between interest payment dates, in which case alt) possesses discontinuities, ‘The measurement of interest 3 In general, the original principal invested will not be one unit but will be some amount k > 0, We now define an amount function A(t) which gives the accumulated value at time 12 O of an original investment of &. Then we have At) a(t) a) A(O} “ ke ‘The second and third properties of alt listed above clearly also hold for A). We will denote the amount of interest earned during the nth period from the date of investment by J,.. Then we have 1, = Ala)~ n=l) for n= 1,23,...- 2) 1r should be noted that /, involves the effect of interest over an interval of time, whereas A(n} is an amount at a specific point in time. Au) au) [ae e soe ' o co at) Ag) wi ry Figure 1.1 Four ilustrative amount functions