The Theory of Interest Second Edition Stephen G. Kellson Georgia Siawe University ‘The McGraw-Hill Companies, Inc. us Boston, Burr Ridge I, Dubuque LA, Madison WI, New York San Francie, St Louis lero Bangkok. Bogota, Caacs, Kula Lumpur Lishoo, London Madi, Meco City, Min, Motes, New Deli, aniago, Seoul, Singapore, Syey, Tape, TorontoTrwin/McGraw-Hill A Division of The McGraw-Hill Companies The Theory of Interest, Second Edition 3 2000 International Edi Exclusive rights by McGraw-Hill Book Co, - Singapore for manufacture and export. This ‘cannot be re-exported from the country to which itis consigned by MeGraw-Hill Copyright ©1991 by the McGraw-Hill Companies, Ine. All rights reserved, Printed in the Un States of America. Except as permitted under the United States Copyright © Act of 1976, no of this publication may be reproduced or distributed in any form or by any means, or stored database or retrieval system, without the prior written permission of the publisher. 98765432 2098765432 PuW Liorary of Congress Cataloyogto-Pullcation Data Kelso, Stephen 6. ‘The theory of intrest / Stephen G. Kelison—2ad ed coe Includes bibbogrphical former and index ISBN 0-256-09150-1 1. Interest 2 Interest—Prblems, exercises tI, Tie 1539.28. 1991 332840 9116494 ‘When ordering this title, use ISBN 0-07-118480-5 Printed in Taiwan To Toni, Matt and LexiPreface This second edition is a substantially revised and expanded treatment of the theory of interest from that contained in the first edition. With a few minor exceptions, all the material in the first edition has been retained and updated In addition, a significant amount of new material has been added, In addition to a thorough treatment of the mathematical theory of interest, the second edition also introduces the reader to the economic and financial theory of interest. The effect of such factors as inflation, risk and uncertainty, and yield curves is examined. In addition, material has been added to introduce ‘a number of modern financial instruments that have become important since the first edition The interrelationship between assets and liabilities has received increased attention in recent years. The second edition provides the reader with an introduction to the tools available to quantify and manage this relationship. The techniques of duration analysis, immunization, dedication, and scenario testing are considered at a level commensurate with the rest of the book. The first edition adopted a largely deterministic approach to the subject of interest. The second edition retains this approach in the earlier chapters, but introduces a number of stochastic approaches toward the end. Models in which suocessive rates of interest are independent and dependent random variables are is followed with a discussion of the Capital Asset Pricing including an important extension of the model to liabilities which is often not considered in other literature, Finally, two contemporary approaches to valuing options are presented; namely, the Black-Scholes formula and binomial lattices. ‘The material on yield rates in the first edition has been significantly expanded, New topics added include time-weighted rates of interest and the distinction between portfolio and investment year methods of calculating interest. Calculation reflecting reinvestment rates have been expanded and