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Subject 102: Mathematics of Finance.

Indicative Solutions

Q1. For a given amount of loan (principal), simple interest is a charge on the principal per specified period

and no charge is made on the interest charged on the principal. In case of compound interest, interest is a

charge not only on principal but also on the interest accrued (which is treated as principal).

In simple interest calculations, amount of interest for the period n is determined using the formula:-

= P x n x i ; where P is the principal, n is the period of loan during which interest is charged at the rate of

interest i per specified period (usually per annum)

In compound interest calculations, amount of interest for the period n is determined using the formula:-

= A - P; Where A = P x ( 1 + i)n

and P is the principal, n is the period of loan during which interest is charged at the rate of interest i per

specified period (usually per annum) (called effective rate of interest).

Q 1. Changed Question:

(a) Arbitrage in the continuous buying and selling of two economically equivalent but differently

priced portfolios of assets so as to make risk free profit. This is possible if

(i) an investor can make a deal that would give him an immediate profit with no risk of future

loss,

(ii) he can make a deal that has zero initial cost, no risk of future loss and a non-zero

probability of a future profit.

(b) A put option gives the right, not the obligation to sell a specified asset on a set date in future or a

specified price.

1.1.97 600x105/100=630

1.1.98 600x108/100=648

1.1.99 (11000+600) x 113/100 = 13108

2 2

Approximately : d=0.065 - 0.065 =6.08%; δ = 0.065 - 0.5 x 0.065 = 6.29%

Q4.

(a) â7= (i /δ) ; (i= .075, δ = 0.72 ; â7 = 5.297) ( @ 7.5% p.a.) = 5.518

5

( @ 10% p.a.)

(4) (.25)

(c) ä

(4) (4)

= (i/d ) x a 15 ; (i = .10, d = .09091; d = 4 x [1-(I-d)

15 ] = .09418) a15 = 7.606)

= 8.076 ( @10% p.a.)

1

½)

(d) S( 15 = [(1.10) 15 - 1] / .5 x [(1.10)2 - 1 ] = 3.177 / .105 = 30.257

**** [ The answer is wrong . Hence, i=0.10 in the question i=.01) ]**** ???

½ ½ ½

5,000 = 100(ν + 1.04 ν + 1.04 ν …..)

ie. 100ν½

5,000 =

1-1.04ν

½

Rearranging and simplifying leads to a quadratic equation in ν

52 ν + ν ½ - 50 = 0

Q.6.(i) Mortgage Loans can be a repayment mortgage where the initial capital is repaid during the term of

the loan; repayments being greater than the amount of interest due; and the remainder of the payment is

used to repay part of the principal. Or they can be endowment mortgages where the repayments represent

interest payments only; and the borrower will need to repay the capital using money from elsewhere.

1 2 n-t

(ii) L t = X (ν + ν + ………ν ) = X a n-t

= L a n-t

L

Total Loan = L = X an ⇒

X=

at

• Net present value and accumulated profit

• Internal rate of return

• Payback period

• Discounted payback period

(4)

NVPX ( i) = 10,000 + 1000 a

15

2

(4)

and the yield is found by solving the equation NVPX (i) =0, or a =10, which gives ix 5.88%

15

(4)

This is easily checked by calculating a @ 5.88%:

15

They are usually unsecured loan stocks or preference shares that convert into ordinary shares of the issuing

company. They have a stated annual interest payment. The date of conversion might be a single date or, at

the option of the holder, one of a series of specified dates.

As the likely date of conversion (or not) gets nearer, it becomes clearer whether the convertible will stay as

loan stock or become ordinary shares. As this happens, its behavior becomes closer to that of the security

into which it converts.

They provide higher income than ordinary shares and lower income than conventional loan stock or

preference shares.

They will be less volatile in the price when compared with the company's share price.

For example,(Example is a must), 6% convertible unsecured loan stock 2010. The stock will be converted

in 2010 into ordinary shares at the specified price. The investor might have a choice to convert or not, at

that date.

(b) Derivatives.

A derivative is a financial instrument with a value dependent on the value of some other, underlying asset.

Common types are: futures, options and swaps. For example, futures on commodities such as crude oil,

sugar, cotton.

They are securities (also called equities) issued by companies and other bodies which entitle their holders

to receive all the net profits of the company after interest on loans and fixed interest stocks has been paid.

They are the principal way in which companies are financed. They offer higher returns. Dividends are not a

legal obligation of the company but are paid at the discretion of the directors.

For examples, Company A has 1 al kh ordinary shares of Rs. 10 each. Ordinary shareholders of the

Company A might receive dividend if it makes profits. on winding up the company, they get whatever is

left, and their liability is limited to the extent of unpaid portion of the ordinary share, if any.

3

They are similar to unsecured fixed interest stock, but they are entitled to fixed dividend after net profits

but before anything is paid to ordinary shareholders. They get rights when their dividends are unpaid or

when their interests are effected (eg issue of any further preference stock)

Example: 5% preference Stock. The holder is entitled to 5% on the nominal value of each preference share,

when the company makes profits. If the preference dividend is not paid in a financial year, it has to be paid

in the next financial year, such that the dividends become cumulative.

• Short term

• Issued at discount, redeemed at par

• No coupons

• Very marketable and secure

• Yield quoted as simple rate of discount.

• Investors receive coupons (usually half-yearly) plus redemption payment (usually at par)

• Some redemption date are variable and some stocks are undated

• Very secure, liquid and marketable in developed countries)

• Low expected return

• Low dealing costs

• Real returns are uncertain unless index-linked bond

Q.9 Consider the present value at the outset of the payment that will be made at time

1.06t

0.05 x 30,000 =

1.08t

2nd yr = 30,000(1.00)

ACC Value

15 15

= 1.05 - 30,000 [ (1.08) + (1.08) (1.0)]

ä15 2%

15

= 1.05 x 30,000 (1.08)

This expression contains a 6% factor on the top and an 8% factor on the bottom ie the payments are being

discounted at a net rate of 2% per annum. So we can find the approximate total present value of all the

payments by using an annuity factor based on 2% interest:

@ 2%

PV = 1,500 ä15

4

The accumulated value at the end of the 15 years can then be calculated as:

@ 2%

ACC V 1,500 ä15

15

x 1.08 X 13.1062 X 3.1722 = Rs.62,363.

In this example, the other factor involved was salary inflation, rather than price inflation.

(If you've used the "exact" formula you should get Rs. 62,825- but the question did ask you to find the

approximate amount.)

Q 10. (i) Yield curve is a curve of spot rates (y:) [where Y: is a spot rate. It need not be spot rate, it can be

redemption yield or forward rates]

The x-axis represents term and y axis represents spot rate. (We should except a graphic representation

from the candidate)

Advantages:

• The shape of the curve is useful to predict the fall/rise in interest rates, and therefore, appropriate

decision can be taken for a given stock.

• It is also useful for switching to take the opportunity of price differential and therefore the profit.

• Volatility of stocks can be assessed.

Q.10 (ii) Using the formula P = 3a n + 100 ν with n=5 and n=25, we find that:

n

• The price of the 5 year stock would fall from £83.60 to £ 80.04 ie a fall of 4.3%.

• The price of the 25 year stock would fall from £ 53.39 to £ 46.63 ie a fall of 12.7%.

The change in interest rate has a greater effect on the longer 2; year stock, which has a DMT of 14.9 years

(based on 7% interest), than it has on the shorter 5 year stock, which has DMT of 4.7 years.

Q.11 (i) For Project B, the investor will need to take out the loan for £ 100,000. which requires interest

payments of £ 7,000 each year and repayment of the £ 100,000 on 31 December 2006. In order to pay the

interest payments, the investor will have to take out 8 extra loans for £ 7,000 each (Note that for the extra

loans all the interest is paid at the end of the term, rather than in the form of annual payments.)

On 31 December 2006 the investor will need to repay the £ 100,000 from the original loan and the

accumulated value of £ 7,000 from each of the 8 extra loans required, making a total of:

There will be no surplus funds to invest. The project will provide a payment of £ 197,750 on 31 December

2006. So the accumulated profit will be:

For Project A, the investor will again need to take out the loan for £100,000, which will require interest

payments of £ 7,000 each year and repayment of the £ 100,000 on 31 December 2006. The income from

the project increases by 5%(compound) each year.

5

31 December Interest due on original loan Income from project

1990 7,000 5,000.00

1991 7,000 5,350.00

1992 7,000 5,724.50

1993 7,000 6,125.50

1994 7,000 6,553.98

1995 7,000 7,012.75

1996 7,000 7.503.64

1997 7,000 8,028.90

During the first 5 years, the income will not be sufficient to pay the interest on the original loan. So extra

loans will be required, which will need to be repaid on 31 December 2006. The Accumulated amount of the

debt can be calculated as:

5,000 8

( 7,000 a5 @ 7% - a5 ) x 1.07

1.07

8

1.07

(Since the interest rate equals the accumulation rate here, the starred annuity factor is calculated at 0%.)

(i) The IRR for Project B is the interest rates that satisfies the equation of value:

8

-100,000 + 197,750ν =0

Rearranging gives:

i= 1.977501/8 - 1 = 0.08897

So the IRR for Project B ( correct to the nearest 0.1%) is 8.9%

The IRR for Project A is the interest rates that satisfies the equation of value:

8

- 100,000 + 5,000 a8 + 130,662ν =0

1.07

1.07

Trying 9% (assuming that the IRRs for the two projects are similar) gives:

@1.8692% 8@9%

LHS = -100,000 + 5,000 a8 + 130,662ν =0

1.07

= -100,000 + 5,000 a8 + 7.3670 + 130,662 x 0.50187 = £ 1

1.07

A small change in the interest rate would make a significant difference to this value. So the IRR for Project

A (correct to the nearest 0.1%) is 9%.

6

In the Last 3 years there will be surplus' funds to invest, which will accumulate (at 4%) to:

2

12.75 x 1.04 + 503.64 x 1.04 + 1.02890 = £1,566

So the overall accumulated profit will be:

Advantages

* Monetary amounts of interest and capital known at outset

* High marketability

* Low dealing costs

* Very secure investment

Disadvantages

* Low expected returns

* Income volatile in real terms

* Reinvestment terms for coupons and sale price before redemption not known

The answer to part (i) would not change very much. The main differences between the two are:

• Corporate bonds are usually less secured than government bonds. The level of security depends on

the type of bond, the company which has issued it, and the term.

• Corporate bonds are usually less marketable than government bonds, mainly because the sizes of

issues are mu ch smaller.

• Investors expect to receive a higher investment return to compensate for the lower security and

marketability.

(iii)

5

PV = 2 x 1.200 x 0.8 x a5 (2) + 25,000ν

= 1,920 x 4.2124 x 1.014782 + 25,000 x 0.74726

= £ 26,889

(a) δ = loge(1+ i )

Hence if δ follows a normal profit, then (1+ i ) follows a log-normal p. d. f, then

2

E(1+ i ) = exp(µ +½ σ2 )

Var (1+ i ) = exp(2µ+σ ) [ exp(σ -1)]

2 2

7

= e2 µ + σ2 (eσ2 - 1)

We have two ways of obtaining the solution ( any one will be ok)

E [loge (1+ i )10 ] = 10E(s) = 1.00

Var[loge(1+ i )10 ] = -100 var(s) = 100 x .0004 =.04

⇒ E(1+ i )10 e1 = 2.671

E(1+ i )n = enµ +½ n2σ2

where n=10, µ=.10, σ=.02

= e1.02 ~ 2.856

The rate of interest (i) follows a uniform probability distribution function. Mean of (1+ i )2 is given as

follows:

.09

E(1+ i ) =2 1

∫

.07 (1+ i ) 2 dx

.02

= _1_ [ ( 1.09 )3 - (1.07) 3 ]

.06

= 0.07 = 1.167

.06

= .25(a5 + a10 ) + .50 a20 + 4 a 40 + 105 ν40

= 83.1861 + 18.0526 = 101.239

= 4.25 a40 + 5a20 + 98ν40

= 84.7107 + 16.8492 = 101.560

Since the value at 4.5% of the payments under the three options is the greatest under the option (c), this one

should be accepted.

8

9

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