AS 2553a Mathematics of nance

Formula sheet
November 29, 2010
This document contains some of the most frequently used formulae that are discussed in the course.
As a general rule, students are responsible for all denitions and results appearing in propositions in
the lecture notes.
1 Interest rate measurement
To convert from one type of compound interest/discount rate to another, one may use the relationships
1 +i =
_
1 +
i
(m)
m
_
m
=(1 d)
1
=
_
1
d
(m)
m
_
m
=e

.
As a result, we have
d =
i
1 +i
v =
1
1 +i
=ln(1 +i).
For a general force of interest
t
,

t
=
S

(t)
S(0)
=
d
dt
S(t).
When ination is taken into account, the ination-adjusted rate of interest is i r and the real
rate of interest is (i r)/(1 +r), where r is the ination rate.
1
2 Valuation of annuities
Present value Future value
Level annuity-immediate a
n i
=
1 v
n
i
s
n i
=
(1 +i)
n
1
i
Level annuity-due a
n i
=
1 v
n
d
=
i
d
a
n i
s
n i
=
(1 +i)
n
1
d
=
i
d
s
n i
Level continuous annuity a
n i
=
1 v
n

=
i

a
n i
s
n i
=
(1 +i)
n
1

=
i

s
n i
m-thly payable a
(m)
n i
=
1 v
n
i
(m)
=
i
i
(m)
a
n i
s
(m)
n i
=
(1 +i)
n
1
i
(m)
=
i
i
(m)
s
n i
annuity-immediate
m-thly payable a
(m)
n i
=
1 v
n
d
(m)
=
i
d
(m)
a
n i
s
(m)
n i
=
(1 +i)
n
1
d
(m)
=
i
d
(m)
s
n i
annuity-due
k-period deferred annuity
k|
a
n i
= v
k
a
n i
Perpetuity(-immediate)
1
i
Perpetuity-due
1
d
Increasing annuity-immediate (Ia)
n i
=
a
n i
nv
n
i
(Is)
n i
=
s
n i
n
i
Increasing annuity-due (I a)
n i
=
a
n i
nv
n
d
=
i
d
(Ia)
n i
(I s)
n i
=
s
n i
n
d
=
i
d
(Is)
n i
Continuously increasing (

I a)
n i
=
a
n i
nv
n

I s)
n i
=
s
n i
n

continuous annuity
Decreasing annuity-immediate (Da)
n i
=
n a
n i
i
(Ds)
n i
=
n(1 +i)
n
s
n i
i
Decreasing annuity-due (D a)
n i
=
n a
n i
d
=
i
d
(Da)
n i
(D s)
n i
=
n(1 +i)
n
s
n i
d
=
i
d
(Ds)
n i
Continuously decreasing (

D a)
n i
=
n a
n i

(

D s)
n i
=
n(1 +i)
n
s
n i

continuous annuity
If the force of interest varies in time, then the present and future values of a continuous annuity
paying h(t) at time t are respectively
a
n u
=
_
n
0
h(t)e

R
t
0
udu
dt,
2
and
s
n u
=
_
n
0
h(t)e
R
n
t
udu
dt,
and they are related by
s
n u
= e
R
n
0
udu
a
n u
.
We also have the following relationships by placing the relevant payments on the time line. (Stu-
dents are not expected to memorize the next set of formulae but to be able to derive them when
needed.)
v
k
a
n
=a
n+k
a
k
=
k|
a
n i
s
n
(1 +i)
k
=s
n+k
s
k
a
n i
=(1 +i)a
n i
s
n i
=(1 +i)s
n i
a
n i
=1 +a
n1 i
s
n i
=s
n+1 i
1
(Da)
n i
+ (Ia)
n i
=(n + 1)a
n i
(

D a)
n i
+ (

I a)
n i
=n a
n i
3 Loan repayment
Under the amortization method of a loan repayment, we have for t = 1, 2, . . . , n where n is the term
of a loan of amount L
I
t
=iOB
t1
,
PR
t
=K
t
I
t
,
and
OB
t
=OB
t1
PR
t
=(1 +i)OB
t1
K
t
.
Once the loan is completely payed o, OB
n
= 0. Thus, the total principal repaid is
n

t=1
PR
t
=
n

t=1
(K
t
I
t
) = L,
and the total interest paid is
n

t=1
I
t
=
n

t=1
K
t
L.
The retrospective form of the outstanding balance is
OB
t
= (1 +i)
t
L
t

j=1
(1 +i)
tj
K
j
,
and its prospective form is
OB
t
=
n

j=t+1
v
jt
K
j
.
3
When payments are level,
I
t
=K
_
1 v
nt+1
_
,
PR
t
=Kv
nt+1
,
and
OB
t
= Ka
nt i
.
Under the sinking-fund method,
I
t
=iL jSF
t1
= iL jL
s
t1 j
s
n j
,
PR
t
=
L
s
n j
(1 +j)
t1
,
and
OB
t
= L SF
t
= L
_
1
s
t j
s
n j
_
.
If a loan is repaid under the sinking-fund method and there are n remaining payments, the present
value of the loan may be calculated through Makehams fomula
A = M +
i
j
(L M)
where M = Lv
n
j
.
4 Bond valuation
The present value of a bond that has face value F, redemption amount C, eective yield to maturity
j per coupon period, coupon rate r, and term to maturity n is
P = Fra
n j
+Cv
n
j
.
When F = C, we also have
P = F +F(r j)a
n j
.
Letting M = Fv
n
j
, Makehams formula may be obtained
P = M +
r
j
(F M).
The price-plus-accrued at time t = k +s is
P
t
= (1 +j)
s
P
k
= v
1s
(Fr +P
k+1
),
where
s =
# of days since last coupon paid
# of days between coupon payments
.
The respective price quoted in the newspapers is dened by
Price
t
= P
t
sFr.
4
When amortizing a bond, we have
OB
t
=(Book value)
t
=Cv
nt
j
+Fra
nt j
, t = 1, 2, . . . , n 1,
I
t
=jOB
t1
, t = 1, 2, . . . , n
and
PR
t
=
_
Fr I
t
, t = 1, 2, . . . , n 1
Fr +C I
t
, t = n
.
Using Makehams formula, the price of a serial bond is calculated by
P = M +
r
j
(F M),
where M =

m
k=1
M
k
and F =

m
k=1
F
k
.
5 Measuring the rate of return of an investment
The following are three ways of determining the rate of return on an investment yielding cashows
(positive or negative) C
0
, C
1
, . . . , C
n
occurring at times t
0
, t
1
, . . . , t
n
:
1. the internal rate of return i = v
1
1 > 1 is such that v is a positive real root to the
equation
n

k=0
v
t
k
C
k
= 0;
2. if A is the initial amount of the portfolio, B is its nal amount, and 0 < t
0
< t
1
< < t
n
< 1,
then the net interest earned in the fund is I = B[A +

n
k=1
C
t
k
] and the dollar-weighted
rate of return is
i =
I
A +

n
k=1
C
t
k
(1 t
k
)
;
3. if V
t
k
is the value of the portfolio at time t
k
just after interest has been credited but before
contributions or withdrawals have been made, then the time-weighted rate of return is
i =
_
n

k=1
V
t
k
V
t
k1
+C
t
k1
_
1/(tnt
0
)
1.
6 Term structure of interest rates
Let the term structure of zero-coupon bonds be {s
[0,t]
}
t0
, then the one-year forward rate of
interest for n 1 years from now is
i
[n1,n]
=
(1 +s
[0,n]
)
n
(1 +s
[0,n1]
)
n1
1.
5
7 Cashow duration and immunization
If a series of n payments K
1
, K
2
, . . . , K
n
occurring at times 1, 2, . . . , n, respectively, is evaluated at
price P at time 0, then the Macaulay duration (also called just duration) is calculated through
the formula
D =
dP
dj
P
1+j
=

n
t=1
tK
t
v
t
j
P
,
and the modified duration is found by
MD =
dP
dj
P
=

n
t=1
tK
t
v
t+1
j
P
.
As a result, the Macaulay and the modied durations of a coupon bond are respectively
D =
Fr(Ia)
n j
+nCv
n
j
Fr a
n j
+Cv
n
j
and
MD =
Frv
j
(Ia)
n j
+nCv
n+1
j
Fr a
n j
+Cv
n
j
.
(Remembering the last two formulae is optional for this course.)
If the current term structure {s
[0,t]
}
t0
is used to evaluate the modied duration of cashows
K
1
, K
2
, . . . , K
n
occurring at times 1, 2, . . . , n, respectively, then we have
P =
n

t=1
K
t
(1 +s
[0,t]
)
t
.
and
MD =
dP
dj
P
=

n
t=1
tK
t
(1 +s
[0,t]
)
(t+1)

n
t=1
K
t
(1 +s
[0,t]
)
t
.
Redington immunization is in place, if
1. PV
A
(i
0
) = PV
L
(i
0
);
2.
d
di
PV
A
(i)

i=i
0
=
d
di
PV
L
(i)

i=i
0
;
3.
d
2
di
2
PV
A
(i)

i=i
0
>
d
2
di
2
PV
L
(i)

i=i
0
.]
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