# The Theory of Interest - Solutions Manual

Chapter 12
−1 ⎤
⎡n
1. E [ a −1 ( n )] = E ⎢Π (1 + it ) ⎥
⎣ t =1

n

= Π E [1 + it ]

−1

t =1

from independence

−n

= (1 + i ) .
−1 ⎤
⎡n t
2. E ⎡⎣ an ⎤⎦ = E ⎢ Σ Π (1 + is ) ⎥
⎣ t =1 s =1

n

t

= Σ Π E [1 + is ]

−1

t =1 s =1
n

from independence

= Σ (1 + i ) = an i .
−t

t =1

3. (a) Year 1: 8% given.
Year 2: .5 (.07 + .09 ) = .08, or 8%.
Year 3: .25 [.06 + 2 (.08 ) + .10] = .08, or 8%.

(b) Year 1: σ = 0, no variance.
2
2
Year 2: σ 2 = .5 ⎡⎣(.07 − .08 ) + (.09 − .08 ) ⎤⎦ = .0001

σ = .0001 = .01.
2
2
2
Year 3: σ 2 = .25 ⎡⎣(.06 − .08 ) + 2 (.08 − .08 ) + (.10 − .08 ) ⎤⎦
= .0002

σ = .0002 = .01 2
(c) 1000 (1.08 )(1.09 )(1.10 ) = \$1294.92.
(d) 1000 (1.08 )(1.07 )(1.06 ) = \$1224.94.
(e) 1000 (1.08 ) = \$1259.71.
3

(f) .25 (1000 ) [(1.08 )(1.09 )(1.10 ) + (1.08 )(1.09 )(1.08 )

+ (1.08 )(1.07 )(1.08 ) + (1.08 )(1.07 )(1.06 )]
= .25 [1294.92 + 1271.38 + 1248.05 + 1224.94]
= \$1259.82

141

79 σ = 2720.857412 − .82 ) + (1271. 5.925952 .92 − 1259. 1 −2 (c) E ⎡⎣(1 + it ) ⎤⎦ = .82 ) ⎤⎦ = 2720. 1 −1 4.07 1 + t ⎥⎦.925952 ( 2.16630.09 = 1 ⎤ ln (1 + t ) ⎥ = .07997 ) = .09 − . we have E ⎡⎣ a3 ⎤⎦ = a3 i = a3 .82 ) 2 2 + (1248.857412 − .925952.925952 = .25 ⎡⎣(1294.00735. 142 . (a) E ⎡⎣(1 + it ) ⎤⎦ = .07997.09 − .857412 ) − (. we have m2a + m1a 2m2a 2 a − a − ( a3 i ) a a 3 k a a 3 i m2 − m1 m2 − m1 ( 2 ) (.925952 ) = . .09 Then set (1 + k ) = .82 ) + (1224.0000549 3 and the standard deviation is 6 .07 1 dt .0000549 = .14).16. (b) Applying formula (12.The Theory of Interest Chapter 12 2 2 (g) σ 2 = . (d) Applying formula (12.38 − 1259. ⎣ .07997 = 2.857412 and solve k = .07 ⎦.925952 and solve i = .07 Then set (1 + i ) = .005444 Var ⎡⎣ a3 ⎤⎦ = and the standard deviation is . −1 (d) Applying formula (12.09 − .0735.09 .07 1 + t ∫ .857412 + .857412. −1 −3 (b) We have a −1 ( 3) = (1.05 − 1259.07 (1 + t )2 ∫ dt 1 ⎤ ⎡ −1 =⎢ ⋅ = .5772.2229 ) − ( 2.005444 = .79 = 52.5772 )2 = .79390.10).857412 ) .5772 ) − ( 2.09 1 . we have Var [ a −1 ( 3)] = (.09 − .07 .94 − 1259.11).07 .

3(1). 000 ⎡⎣(1 + 2 i + i 2 + s 2 ) − (1 + i ) ⎤⎦ 4 2 8 = 10.01. and the standard deviation is sn +1 − 1⎤⎦ =  sn +1 i − 1.25%.03) + (. We know that 1 + i is lognormal with μ = .828 and the standard deviation is 119. (b) Var ⎡⎣ sn ⎤⎦ = Var ⎡⎣  (c) E ⎡⎣ an ⎤⎦ = E ⎡⎣1 + an −1 ⎤⎦ = 1 + an −1 i . 4 Applying formula (12.67549 ) − 2 1.03 ⎣1.0634 2 and ( )( ) ⎡1.3). 8.74.03) + (. we have E [100a ( 4 )] = 100 (1. 000 ⎡⎣{1 + ( 2 ) (.13 ( e. (b) Applying formula (12.0634 − 1.03 m2s = 1 + 2 (.03) + .91.1).8).3091) − ( 4.03) + .01 − 1) 2 ( 2 ) = e.0025 = 1.The Theory of Interest Chapter 12 ( ) 6. we have 4 8 Var ⎣⎡100a4 ⎦⎤ = 10.929 944. From the solution to Example 12.0634 + 1. (a) E ⎡⎣ sn ⎤⎦ = E ⎡⎣  sn +1 − 1⎤⎦ = Var ⎡⎣  sn +1 ⎤⎦ .0634 ( 4. we have E ⎡⎣100 s4 ⎤⎦ = 100 s4 .03) ⎤⎦ = 119. we have i = . we have m1s = 1.3091)2 ⎤⎥ Var [100 s4 ] = 10.0025} − (1.06 +.0634 − 1.01 − 1) = . Applying formula (12.828 = 10.01 ( e.03 ⎦ = 944. (d) Var ⎡⎣ an ⎤⎦ = Var ⎡⎣1 + an −1 ⎤⎦ = Var ⎡⎣ an −1 ⎤⎦ .03) = 112.929 = 30.011445.55.03 = 430. 143 .5).067159 and then s 2 = e 2 μ +σ ( eσ − 1) = e 2 .95 . The random variable it 2 / 2 will be normal with μ = 3% and σ = .03 ( 4. 000 ⎢ 1. 7.06 and σ 2 = . (a) Applying formula (12.

5) with i = e μ +σ 2 − 1. Mean = E ⎡⎣ a10 ⎤⎦ = a10 .549 Var [ a −1 (10 )] = e −1.134.058 .067159 ) + .941812 10 mean = E [ a −1 (10 )] = (.06178 = 7.06189 = 14.13) and (12.121 s.001 − 1) = .11) with i = e μ −σ 2 − 1.d.09821 and the standard deviation = . 10 Var [ a (10 )] = e 2 ( )(10 )(.06178 −1 and (1 + k ) = e −. −1 (c) E ⎡⎣(1 + it ) ⎤⎦ = e −.0001e.3134 agreeing with the other approach. 2 (d) Formulas (12.The Theory of Interest Chapter 12 We then apply formula (12. (a) Formula (12.d.003325 = .201 ( e. 9.06 ) + (10 )(.067159 ) 2 10 = .2+.0001/ 2 = .0001 = e−.12+.000302 = .06189 ) = 1. 144 .06+.12).067159 ) + (.297. using formula (12.823. (a) E [1 + it ] = e.0001/ 2 = 1. (b) Mean = E ⎡⎣ s10 ⎤⎦ =  s10 .7) and (12. (12.001 − 1) = .14) = . = .8) with j = e 2 μ + 2σ . = .d.6).06189 mean = E [ a (10 )] = (1.4a) to obtain Var [ a ( n )] = (1 + 2 i + i 2 + s 2 ) − (1 + i ) n 2n 5 = ⎡⎣1 + 2 (.941812 ) = .941812 or i = . 2 (b) Formulas (12.0001) − 1) = e1.14) with k = e −2 μ + 2σ . s.000302 and s.298.09821 = .001 ( e.003325 and s.1198 −1 = . using formula (12. 2 10. (12. (d) We have (1 + i ) = .12727.d.011445⎤⎦ − (1.8) = .06+.0001) ( e(10)(.887098 or k = . (c) Formula (12.017 .

E [1 + it ] = e μ +σ 2 = 1. 13.0004762 = . E [1 + it ] = 1.20.00011665. 12.34798 = \$9556. 2 3 −1 E [ ln a ( 30 )] = −30 μ = −30 (. Var = 65. 2 2 Solving two equations in two unknowns gives μ = . Thus. .0001 Var ⎡⎣ln (1 + it ) ⎤⎦ = = = σ 2. 14. Var ⎡⎣ s3 ⎤⎦ = Var ⎡⎣  s4 − 1⎤⎦ = Var ⎡⎣  s4 ⎤⎦ .06 σ 2 = .08 ) = −2.09 − .25971 ± 1.08 ) + (.d.07 + .0001 − 1) = .00011665⎤⎦ − (1. = .067.08 ) 3 = . 100.08 = μ .06 and var = .08 − 1 = s3 . ⎝ 3 ⎠ The 95th percentile of ln a −1 ( 30 ) is −2.4.25971.08 ) = 1.08 = e μ +σ 2 = e μ +.34798.001.011445.The Theory of Interest Chapter 12 11.4 + 1.96 (.08 ) ( e.01 Therefore δ [t ] follows a normal distribution with mean = . 2 2 Var [1 + it ] = e 2 μ +σ ( eσ − 1) = (1. 3 2 6 Var [ a ( 3)] = ⎡⎣1 + 2 (.01.02182.1. E ⎡⎣ s3 ⎤⎦ = E ⎡⎣ s4 − 1⎤⎦ =  s4 .08 = 3.08 ) + . 2 2 E [ a ( 3)] = (1.30247 ) .62 using formula (12. 2 (.07691.001 = −2.645 .0001 ⎞ Var [ ln a −1 ( 30 )] = 30σ 2 = 30 ⎜ ⎟ = .0004762 and s. E ⎡⎣ln (1 + it ) ⎤⎦ = ⎛ . 000e −2. 145 . The 95% confidence interval is 1.21693.09 = .07 )2 .246 = mean.8).02182 ) or (1. 2 Var [1 + it ] = e 2 μ +σ ( eσ − 1) = .0001/ 2 so that μ = .

δ [t ] ⎤⎦ = 2 1 1− k 1 which is formula (12.08 + .6 and k2 = .6 (.2 (. (12.2 (1 − .08 ) + .0002 ⋅ = .31) with k1 = k . 146 .08 ) = .0880 δ [8] = . 1 + .08 ) + .2 )2 − (.08 + .34) Cov ⎡⎣δ [ s ] .0004762.0880 − . Cov ⎡⎣δ [ s ] .095 − .091 − .091 − . δ [t ] ⎤⎦ = Var ⎡⎣δ [t ] ⎤⎦ ⎡⎣τ g1t − s + (1 − τ ) g 2t − s ⎤⎦ .0896 − . Continuing Example 12.33) 1 − k2 σ2 Var ⎡⎣δ [t ] ⎤⎦ = ⋅ 1 + k2 (1 − k2 )2 k12 = σ2 1 − k1 if k2 = 0 which is formula (12.35). This will result in one equation in one unknown that can be solved for σ 2 . (b) Formula (12. Use formula (12.08 ) + .08 ) = .The Theory of Interest Chapter 12 15.08 ) = . σ2 k t −s Thus.36) with k1 = . Find the empirical estimate for Var ⎣⎡δ [t ] ⎦⎤ based upon the sample data for δ [t ] given in Example 12.7: δ [6] = .35) and (12. so that τ =1 g1 = k1 g2 = 0 from formula (12.2 (. 18.34). (a) Formula (12. We set k2 = 0.33) with k1 = . (a) Applying formula (12.6 and k2 = . We also substitute the result from part (a).0867.08 + .6.6 (.6 )2 (b) Applying formulas (12.0896 δ [7] = .2 (.2 and with t − s = 2 gives the answer .33) 1 − k2 σ2 Var ⎡⎣δ [t ] ⎤⎦ = ⋅ 1 + k2 (1 − k2 )2 − k12 = 1 − .2 .6 (.0896 − .0001300.2 . 16.30) with k1 = k . 17.

02 )2 1⎡ 2 2 2 ⎤ ( ) ( ) ( ) (.06 / . 9 147 .04k .08 .02 / .06 / .04k ) + 7 more terms ⎤⎦ 9 (1.04k 1 [(1.06 / .06 / .04k .0001)(.02 − .105 − δ ) .06 − .02 − .06 + 1.10 .02157312k + .095 − . (b) Applying formula (12.04k .02 .06 / .10 / .04k .092.100 = δ + k (.06 − .096 = δ + k (. we have Cov ⎣⎡δ [ s ] .02 − .02 )(1.29) twice.0016 ) k 2 ⎥ + 3 ⎦ 1 = (11. 20.The Theory of Interest Chapter 12 19.383876 + .02 )(1.100 − δ ) .10 − .06 ) k = ⎣ 1.02 + 1.06 / .06 / .04k . (a) Applying formula (12.08 and δ = .10 )2 + (1. There are 9 paths each with probability 1/9: .04k ) + (1.04314624k + .10 + .08 ) = .02158336 + .02 )(1.06 / .01079168k 2 ) .8 ) 6 −3 = .01080192k 2 ) 9 and 2 2 Var [ a ( 2 )] = E ⎡⎣ a ( 2 ) ⎤⎦ − E [ a ( 2 )] 1 = (.10 )(1.06 / .02 / . Therefore δ [E4] = .06 ) + (.04k ) ⎤⎦ 3 1 2 = (1. Solving these two equations in two unknowns.0000512.02 / .06 ) + (1.04k ) + (1. we have .0032 ) k .10 )2 − (1.02 ) (1. we have k = .10 ⎦ + 9 3 ⎤ (1.06 / .06 − .31).02 ) (1.10 / .06 .06 / .06 / . 3 (a) E [ a ( 2 )] = 1 2 2 2 2 2 (b) E ⎡⎣ a ( 2 ) ⎤⎦ = ⎡⎣(1.06 + .10 / .08 )(1.04k ) + (1.8 (.06 − .08 + .04k ) + 7 more terms] 9 1 2 = ⎡⎣(1.02 )2 (. δ [t ] ⎦⎤ = σ2 1 − k2 k t − s = (.06 − .02 + .

55435 .73125 + .08333 i = .069 ) i = .d.08333 V = = 851.25 PV .3)(1045 ) + (.73125 .5 )( 851.7 )(1045 ) V= = 1004. 22.5 )( 935.06944 i = .10 ( ) i 2 = . (a) At time t = 1 : 2 ( ) i 2 = .57488 + .091 1.57488 .1 (.5664 2 and the s.1) = 751.53473 . 1.5 )(1000 ) + (.75821 . −3 (c) The mean interest rate is i = .10 V = (.53473 + . (a) Path 10/11/12 10/11/10 10/9/10 10/9/8 Probability .25 .5 )( 796.25 . (b) Var = (1000 ) (.74 1.74455 + .238 1.08 (.5664 = 15.7 )(1045 ) = 995.59637 ] = 232.75821 + .05 (.25 ) [.77225] = 751.31.126 1. = 232.079 1.153) = 748.10 V= = 909.5 )(1000 ) i = .25 .1 obtaining the same answer as obtained with the other method.091) + (.5 )( 909.57.04 V= 148 .5 )(1000 ) = 874.06944 V = = 935.144 (.3)(1045 ) + (.079 ) + (. At time t = 2 : (.25 ) [.126 ) + (.55435 + .77225 PV2 .12 V= At time t = 0 : i = .069 1.5 )(1000 ) i = .25 .74455 .5 )( 874.12 (.5 )(1000 ) + (.808.144 V= At time t = 1: (.59637 Value of the bond is 1000 (.091) = 796.5 )(1000 ) + (.The Theory of Interest Chapter 12 21.153 1.10 so the value is 1000 (1.5 )( 909. 23.

83.95789 = e −.3552 1.6 )(1010.95789.36 PV .4 )( 981.4 )(1038 /1.28128 1.024 ) + (.1536 ) = \$997.036 1.23200 1.1536.7 )(1004.024 ) = 981.4 )(1038 /1.24 ) + (.4 )(1038 /1.095 + 38 ) + (.273 1. Path Probability 10/12/14.15860 .6 )(1038 /1.02 V = (.01667 ) j = .4094 1.0861.6 )(1026.01667 j = .24 10/8. which gives V= (.01389 V = = 1010.036 + 38 ) j = . then call the bond.02 26.024 (. Then we have v = .095 1. 1.944 . If the interest rate moves down.3)( 995.24 1.24 10/8.0288 (.3108 1.61%. 1.The Theory of Interest Chapter 12 At time t = 0 : (.045 25.4 )(1005.0288 V= At time t = 1 4 : (.095 + 38 ) = 1005.6 )( 998.03458 ) + (.7379 .63. ( ) i 2 = .4 )( 998.4 .02 (.024 V= At time t = 0 : j = .3)( 995.854 = 45v + 1045v 2 and solving the quadratic v = .01389 j = .238 + 45 ) + (.7095 .6 )(1038 /1.09 V = (b) The equation of value is 1001. At time t = 1 2 : (.01667 V = = 1026.808 + 45 ) 1.273 + 38 ) + (. 1.16 10/12/10 .85. or 8.6 )(1038 /1.2744 CV from time 1 1.02 V= = 998.333/6.01667 ) + (.238 + 45 ) + (.7629 .19170 1. 24.011575 ) j = .333/10 .7 )(1000 + 45 ) = \$998.7847 149 CV 1.5δ and δ = .045 = \$1001.

24 )(1.4094 ) + (.6 )(1. (c) E [ a ( 3)] = E [ a −1 ( 3)] + E [ a −1 ( 2 )] + E [ a −1 (1)] −1 −1 −1 −1 −1 = .3552 ) + (. Rendleman – Bartter: mean E [δ t ] = E [δ t − δ 0 + δ 0 ] = E [ Δδ 0 ] + E [δ 0 ] = aδ 0t + δ 0 = δ 0 (1 + at ) variance Var [δ t ] = a 2δ 2t Vasicek: mean E [δ t ] = E [ Δδ 0 ] + E [δ 0 ] = c ( b − δ 0 ) + δ 0 = cb + (1 − c ) δ 0 variance Var [δ t ] = σ 2t Cox – Ingersoll – Ross: mean E [δ t ] = cb + (1 − c ) δ 0 variance Var [δ t ] = σ 2δ 0t .749 .1) = 2.486.24 )(1.16 )(1. (b) E [ a −1 ( 3)] = . (d) E ⎡⎣ s3 ⎤⎦ = 1.The Theory of Interest Chapter 12 (a) E [ a ( 3)] = (.2744 ) = 1. 27.2038 + 1.1) + (. 150 δ which .626.1) ⎤⎦ + (1.08333) (1.326.4 )(1. 28. (a) We have d δ = c ( b − δ ) dt + σ dz = 0 + δ dz if c = 0 = adt + σ dz where a = 0 which is the process for a random walk. since the process error is proportional to squares in computing variances.749 + ⎡⎣(.3108 ) + (.326 + 1.096 = 3.12 ) (1.36 )(1.

The Theory of Interest Chapter 12 (b) We have d δ = c ( b − δ ) dt + σ dz = ( b − δ ) dt + σ dz if c = 1 which is the process for a normal distribution with μ = b.06030 Δδ . 29.1212.0055 Δδ1.5 = −.0075 Δδ1 = −.006 (.46. For the random walk model Δδ = aΔt + σΔz and for the Rendleman-Bartter model Δδ = aδΔt + σδΔz Random walk δ 0 = .06018 ) δ1.06045 ) δ1 = . (c) We have δ .0675 δ1 = .06018 δ 2 = .5 = .5 = .5 ) .063 δ 2 = .5 ) + (.083)(.0606 so that i 2 = .06045 Δδ . (b) We have 995.5) −(.06051 30. (a) We have δ 0 = .5) = \$995.065 δ1.Bartter δ 0 = .5 = .08 )(.151 = 39v + 1039v 2 and solving the quadratic ( ) ( ) i 2 / 2 = .08 )(.5) 151 = \$993.0075 )(.5 = (.06 δ .08 E [δ .08 )(.06 δ .08 + .5 = ( −.5 ) ( + 1039e − .0055 )(.06030 ) Δδ 2 = (.5) −(.5 = .0025 Δδ1.006 )(.5 = .08654 )(.5 ) = .08654 and ( P = 39e − .083 and ( P = 39e − .15.5 = .0685 Rendleman .08 + (.0025 )(.5) ( + 1039e − .06 ) Δδ1 = ( −.002 )(.01)(.08 )( .5 = .0020 Δδ 2 = .5 ] = δ 0 + at = . .

75%.79%.14 using ± 2 standard deviations.75 = .25 = .50 = .2461 using the binomial distribution.25 = .0790 δ . ⎛ 10 ⎞ 10 (e) ⎜ ⎟ (.25 = .9 ) = 99% of the starting value.029 Cox-Ingersoll-Ross Max δ .50 = .0880 δ .75 = .0386 δ1 = .61%.1007 δ1 = .0761.1017 δ1 = .0486 δ .114 Min δ .08 )(1.0590 δ . Rework Examples 12.50 = .0970 δ1 = .75 = .08 )(.026 Rendleman – Bartter Max δ .0876 δ .25 = .103 Min δ .75 = .0892 δ .034 10 32. ⎝5 ⎠ 152 .25 = .0480 δ .11-12.50 = .50 = .75 = .25 = .1)(.0497 δ .75 = .111 Min δ .0790 δ .75 = .The Theory of Interest Chapter 12 31.0410 δ1 = .1) (. The following results are obtained: Random walk Max δ .50 = . or 2.0590 δ . (d) A 10% increase followed by a 10% decrease results in a result that is (1. or 20.106 Min δ .0957 δ1 = . (a) (.25 = .9 ) = .5 ) = .0790 δ .9 ) = .0279.1) = .0590 δ .0419 δ1 = .0790 δ .0923 δ .75 = .0494 δ .0590 δ .035 Vasicek Max δ .50 = . 10 (b) (.2075.0370 δ1 = . or 7.08 )(1. 5 5 (c) (.25 = .50 = .

17 .08 )(1.080439e .73 .1) (.1 = .05 = .086880 i2 = .73%. One year spot rates s1 : i0 = . The yield curve became invested.65 .73 .080000 ( ) ( ) ( ) ( ) i1 = .080000e1.082558 ( ) i2 = .088946e1.1 = .05) = .086880e −.08 )(1. 153 .5 ) = 11(.05 = .98(.05 = .097270 ( ) i5 = .1 = . since 10. or 9.98 .086530 ( ) i4 = .0990.1 = .1 = .080439 ( ) i3 = .086530e1.070000 ( ) i1 = .094304 i5 = . Five year spot rates s5 : i0 = .085758e .1) = .1698 10 ⎡⎛10 ⎞ ⎛10 ⎞ ⎤ 10 10 Probability = ⎢⎜ ⎟ + ⎜ ⎟ ⎥ (.26 .088946 i4 = .9 ) = .070000e1. ⎣⎝10 ⎠ ⎝ 9 ⎠ ⎦ 33.097270e .90%.05 = .65 .90%.2075 9 9 increases (.73% > 9.26 .094304e .1073. or 10.082558e −.5 ) = .0107.085758 i3 = .17 .The Theory of Interest Chapter 12 (f) 10 increases (.

Sign up to vote on this title