Financial Math Test

Applied Financial Mathematics [v1.
2]
[-] Power and logarithm functions
[-] Power function
x Showing that a^m * a^n = a^(m+n)
x Showing that a^m / a^n = a^(m-n)
x Showing that x^0 = 1 for all x not zero
x Showing that a^(-m) = 1/(a^m)
x Showing that (a^m)^n = a^(m*n)
x Used in annual compounding
x Determining interest rate to double investment in ten years
x Compounding value vs compounding frequency
[-] Log function
x Showing that log(a^n) = n*log(a)
x Showing that log (a * b) = log (a) + log(b)
x Showing that log (a / b) = log (a) - log(b)
x Time to compound annually to a given value
x Time to compound semi-annually to a given value
[-] Exponential and ln functions
[-] Exponential function
x Exponential function - Used with continuously compounding interest rate.
x Exponential function - Converting continuous rate to quarterly compounding.
x Exponential function - Showing e^x is approximately 1+x if x is small.
[-] Ln function
x Ln function - Converting from periodic interest rate to continuous compounding
[-] Measures of growth
[-] Growth
x Calculating arithmetic and compound average growth rate - when growth is constant
x Calculating arithmetic and compound average growth rate - when growth varies
x Calculating quarterly, semi and p.a. growth given monthly growth
x Calculating effective growth rate given the nominal growth rate
x Calculating yearly effective growth rate given nominal continuously compounding rate
x Calculating nominal growth rate given the effective growth rate
x Calculating nominal compounding rate given yearly effective rate.
x Converting from "M" compounding periods per year to "N" periods.
x Showing that 10% growth followed by -10% growth has a different result than has zero growth.
[-] Present and future value; interest rates: simple, compounding, continuous; compounding conversion.
[-] Simple interest
x Future value of an investment earning simple interest.
x Present value of an investment earning simple interest.
x Simple interest rate as a function of present value, future value and investment term.
x Investment term as a function of present value, future value and interest rate.
[-] Compound interest
x Future value of an investment earning compound interest.
x Present value of an investment earning compound interest.
x Compound interest rate as a function of present value, future value and investment term.
[-] Continuous interest
x Future value of an investment earning continuous interest
x Present value of an investment earning continuous interest
x Continuous interest rate as a function of present value, future value and investment term.
[-] Nominal and effective rates
x Effective annual rate of an investment with given nominal rate and compounding semi-annually
x Nominal p.a.rate of an investment given an effective p.a. rate and compounding frequency
[-] Yield / Zero-Coupon curve, discount factors, forward interest rates
[-] Yield curves Discount factors
x Calculating discount factors from points on a yield curve
x Using discount factors to calculate the value of a series of future cash flows.
x Generating a yield curve equivalent to a set of discount factors.
[-] Forward interest rates
x Calculating forward interest rate implied by zero coupon yield curve
x Calculating implied forward curve from yield curve.
x Calculating zero curve from forward curve
x Rolling forward yield curve
[-] Forward pricing of yield and non-yield-bearing assets
[-] Forward pricing
x Calculating forward sale price of non-yield bearing asset.
x Calculating forward purchase price of a non-yield bearing asset.
x Calculating forward sale price of yield-bearing asset.
x Calculating forward purchase price of a yield-bearing asset.
[-] Bond fundamentals and sensitivities
[-] Annuities
x Value of a growing annuity
[-] Bond fundamentals
x Present value of a bond - calculating from future cash flows and a discount rate.
x Using present value and yield to generate future cash flows.
x Calculating yield to maturity of a bond.
x Calculating yield to maturity of an annuity
[-] Bond sensitivities
x Bond value as function of coupon rate.
x Present value of a 1 basis point increase in coupon rate.
x Number of coupon basis points needed to add 1% to bond value.
x Bond value as function of yield.
x Bond value as function of time to maturity.
x Calculating accrued interest and capital price
x Bond price sensitivity - to 1bps increase in yield
x Relationship between duration and yield sensitivity
x Duration as a function of number of coupons and discount rate.
[-] Floating rate notes
x Valuing a floating rate note from first principles.
x Determining interest rate sensitivity of a floating rate note.
x Determining floating rate note value as a function of settlement date
x Determining floating rate note interest rate sensitivity as a function of settlement date
[-] Swap fundamentals
[-] Swap fundamentals
x Valuing the fixed and floating legs of a fixed-to-float interest rate swap
x Calculating fixed coupon rate that makes swap value zero.
[-] IRR and inflation
[-] IRR
x Calculate IRR of a yearly series of cash flows.
x Calculate nominal yearly IRR for a semi-annual series of cash flows
x Demonstration that certain cash flows can have more than one IRR
x Demonstration that a set of cash flows can have an undefined IRR
x Calculating IRR when cash flows grow at a constant rate in perpetuity
x Demonstration that differing growth rates can give different NPV's but the same IRR's
x Calculating NPV as a function of IRR for a given growth rate.
[-] Inflation
x Calculating present value on nominal and inflation-adjusted bases
x Calculating IRR on nominal and inflation-adjusted bases
[-] Sensitivity, rate of change, curvature
[-] Sensitivity
x Calculating sensitivity of fixed-interest investment's value to time
x Calculating sensitivity of forward price to its drivers.
x Calculating sensitivity of annuity to its drivers
[-] Gradient and curvature
x Gradient of e^(ax)
x Gradient of x^n
x Gradient of a^x
x Gradient of ln(x)
x Calculating gradient of the product of two functions
x Calculating the gradient of a function of a function
x Calculating gradient of a piecewise-linear curve.
x Calculating curvature
x Using gradient and curvature in interpolating and extrapolating
[-] Mean, standard deviation, distributions
[-] Frequency distribution
x Calculating a frequency distribution from a sample set
x Calculating a mean from a frequency distribution.
x Calculating a mode from a frequency distribution.
x Calculating a cumulative frequency distribution.
x Calculating lowest return in upper quartile.
x Calculating standard deviation.
x Generating a normal distribution
x Calculating percentage of outcomes less than N standard deviations above mean
x Calculating percentage of outcomes within N standard deviations of the mean
x Calculating number of standard deviations above mean below which a given percentage of samples occur
x Generating samples from a normal distribution.
[-] Variance and correlation
x Calculating sample variance
x Calculating population variance
x Calculating population covariance
x Calculating population correlation
x Calculating correlation matrix from covariance matrix
x Calculating covariance matrix from correlation matrix and standard deviation
x Calculating volatility
x Calculating correlation of log returns
[-] Interpolation, extrapolation and curve fitting
[-] Interpolation and extrapolation
x Linear interpolation
x Cubic spline interpolation
x TREND function to perform linear interpolation / extrapolation
x GROWTH function to perform linear interpolation / extrapolation
x Fitting to a logarithmic curve
x Fitting to a square-root curve
[-] Asset evolution
[-] Asset evolution
x Calculating asset price distribution in one period's time.
x Calculating asset price distribution in two period's time.
x Calculating asset price distribution "N" periods into the future.
x Calculating probability distribution of long-term return.
x Calculating probability distribution of logarithm of asset price in "N" period's time.
x Calculating distribution of compound average growth rates over "N" periods.
x Matching volatility and growth rate when evolving an asset's price.
x Calculating asset price distribution by using continuous log-normal distribution.
x Calculating confidence intervals on an asset's future price.
x Calculating confidence intervals on an asset's future price (alternate formula)
[-] Multi asset
x Calculating return of a portfolio of assets
x Calculating volatility of a portfolio of assets
[-] Option fundamentals
[-] Options
x Portfolio of put / call options to achieve this expiry payoff profile: \/
x Portfolio of put / call options to achieve this expiry payoff profile: \_/
x Portfolio of put / call options to achieve this expiry payoff profile: /-/
x Portfolio of put / call options to achieve this expiry payoff profile: __/'''''''
x P/L of unhedged put option held to expiry
x P/L of unhedged put spread held to expiry
x Intrinsic, time and total value of an option - as a function of strike
x Intrinsic, time and total value of an option - as a function of time to expiry
x Rate of time decay of an option as a function of time to expiry.
[-] Applications of arbitrage
[-] Arbitrage
x Determining arbitrage in a foreign exchange market
x Determining arbitrage in a fixed interest market.
x Determining arbitrage in a forward market on a yield-bearing asset.
x Determining arbitrage in an options market.
[-] Revision questions
[-] Revision
x Tailored profile to achieve a future goal.
x Calculating value at risk on a portfolio of assets.
x Interpolation using cubic spline.
x Attributing profit/loss drivers on an option position
x Using matrices to solve a problem with several constraints
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Answers to the questions in this spreadsheet
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ancial mathematics skills.
ematics topics. To answer questions you
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left will turn yellow:
swered correctly. On that page markers

marker that looks like "-" means all parts of
s like "x" means the answer isn't complete.
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cs and sections you can expand or contact
"[+]" icon to expand it. For this feature to
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s how your answers should look. The .PDF

It also shows how your charts should look.
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(folder) that you have will put this
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. All rights reserved.

Click here to see what your answer should look like.
1 Showing that a^m * a^n = a^(m+n)
h Calculate 1.2 to the power of 3.4 [=1.2^3.4] <- "A"

h Calculate 1.2 to the power of 5.6 <- "B"
h Calculate "A" * "B" <- "C"
h Calculate 1.2 to the power of (3.4+5.6) <- "D"
"C" and "D" should be the same i.e. 1.23.4 * 1.25.6 = 1.2(3.4+5.6)
2 Showing that a^m / a^n = a^(m-n)
h Calculate 3.4 to the power of 5.6 <- "A"

h Calculate 3.4 to the power of 1.2 <- "B"
h Calculate "A" / "B" <- "C"
h Calculate 3.4 to the power of (5.6 - 1.2) <- "D"
"C" and "D" should be the same i.e. 3.45.6 / 3.41.2 = 3.4(5.6-1.2)
3 Showing that x^0 = 1 for all x not zero
Calculate "x" to the power of 0
x x^0
e 4
e 2
e 1
e 0.5
e -8
4 Showing that a^(-m) = 1/(a^m)

h Calculate 2.3 to the power of -1.5 <- "B"
h Calculate 1/A <- "C"
"B" and "C" should be the same i.e. 2.3-1.5 = 1/2.31.5
5 Showing that (a^m)^n = a^(m*n)

h Calculate A to the power of 5.6 <- "B"
h Calculate 1.2 to the power of (3.4 * 5.6) <- "C"
"B" and "C" should be the same i.e. (1.23.4)5.6 = 1.2(3.4*5.6)
6 Used in annual compounding
$100 earns 5% interest compounding annually. How much is the compounded value in
four years?
i Compounded value in four years:

How much is the compounded value in four and a half years?
i Compounded value in four and a half years:
7 Determining interest rate to double investment in ten years
What interest rate (semi-annual compounding) is required to double an investment in ten

years?
h Rate required:
8 Compounding value vs compounding frequency
Continuous compounding formulae usually contain "e" - which is approximately 2.71828.

This example shows that when the compounding frequency is increased the result
converges to "e".
An investment of $1 earns a nominal annual interest rate of 100%. The investment is for a
term of one year. Interest compounds "n" times per year. The value of the investment at
the end of one year is "v". Complete the following table showing v as a function of n.
n v
e 1
e 2
e 4
e 12
e 365
e 10000
e 1000000
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1 Showing that log(a^n) = n*log(a)
g Calculate 1.2^3.4 <- "A"

g Calculate log(A) <- "B"
g Calculate log(1.2) <- "C"
g Calculate 3.4 * C <- "D"
B and D should be the same i.e. log(1.23.4) = 3.4 * log(1.2)

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2 Showing that log (a * b) = log (a) + log(b)
g Calculate log (1.3 * 2.4) <- "A"

g Calculate log (1.3) <- "B"
g Calculate log (2.4) <- "C"
g Calculate B + C <- "D"
A and D should be the same i.e. log(1.3 * 2.4) = log(1.3) + log(2.4)

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3 Showing that log (a / b) = log (a) - log(b)
g Calculate log (1.3 / 2.4) <- "A"

g Calculate log (1.3) <- "B"
g Calculate log (2.4) <- "C"
g Calculate B - C <- "D"
A and D should be the same i.e. log(1.3 / 2.4) = log(1.3) - log(2.4)

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4 Time to compound annually to a given value
$100 compounds at 6%. How long will it take to compound to a

value of $120?
g Time to compound (years):

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5 Time to compound semi-annually to a given value
$100 compounds at a nominal annual rate of 6%. Compounding is

semi-annually. How long will it take to compound to a value of
$120?
g Time to compound (years):
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1 Exponential function - Used with continuously compounding interest rate.
What would $100 compound to if the nominal annual continuously compounding rate is
6% and the term is one year?
g Value in one year:
What is the annual effective compounding rate?
g Annual effective rate:

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2 Exponential function - Converting continuous rate to quarterly compounding.
What quarterly compounding rate is equivalent to a nominal annual continuously

compounding rate of 7%?
g Quarterly rate:
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3 Exponential function - Showing e^x is approximately 1+x if x is small.
Complete the following table
x ex 1+x
f g 0.1
f g 0.01
f g 0
f g 0
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1 Ln function - Converting from periodic interest rate to continuous compounding
What continuously compounding rate is equivalent to an annually

compounding rate of 6%?
f Continuous rate:
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Growth may seem a simple term but it encompasses some important and subtle concepts - For
example, a +10% growth followed by -10% growth leads to a different outcome than does zero
growth. In this section we review and apply various measures of growth and show how these
measures relate to each other.
1 Calculating arithmetic and compound average growth rate - when growth is constant
Consider the investment shown below. The value of the investment at the end of each year is listed.
Find the per annum (p.a.) growth rate in each year.
Growth
Year Value p.a.
0 50.00
f 1 51.25
f 2 52.53
f 3 53.84
f 4 55.19
f 5 56.57
f 6 57.98
Determine the average (mean) yearly growth rate.
f Mean growth rate:
Calculate the compound average growth (CAGR) rate.
f CAGR
2 Calculating arithmetic and compound average growth rate - when growth varies
Consider the investment shown below. The value of the investment at the end of each year is listed.
Find the p.a. growth rate in each year.
Growth
Year Value p.a.
0 50.00
f 1 50.00
f 2 49.00
f 3 52.00
f 4 51.00
f 5 53.00
f 6 55.00
Determine the average (mean) yearly growth rate.
f Mean growth rate:
Calculate the compound average growth (CAGR) rate.
f CAGR
Note the difference between the average short term growth rate in cell F47 and the long term growth
rate (CAGR) in cell F51. In this example you should find that the CAGR is less than the average
arithmetic growth rate. Can CAGR ever be greater?
3 Calculating quarterly, semi and p.a. growth given monthly growth
Monthly growth is 1%. What is the growth in one quarter? Six months? One year?
Period Growth
One
f quarter [%]
Six
f months [%]
f One year [%]
4 Calculating effective growth rate given the nominal growth rate
The nominal rate of growth p.a. is 10%. Every six months the underlying increases by half of 10%
(i.e. by 5%). What is the effective yearly growth rate? Calculate the answer with a formula.
Effective
f rate [%]
Calculate the answer using the =EFFECT function
Effective
f rate [%]
5 Calculating yearly effective growth rate given nominal continuously compounding rate
The nominal continuously compounding rate is 10%. What is the effective yearly growth rate?
Effective
f rate [%]
6 Calculating nominal growth rate given the effective growth rate
The nominal rate of growth p.a. is N (%). Every quarter the underlying increases by one quarter of N.
In one year the underlying grows by 12%. What is the nominal rate of growth on a quarterly basis (i.e,
what is N). Calculate the answer by using a formula.
Nominal
f rate [%]
Calculate the answer using the =NOMINAL function
Nominal
f rate [%]
7 Calculating nominal compounding rate given yearly effective rate.
The yearly effective rate is 10%. What is the equivalent continuously compounding nominal rate?
Nominal
f rate [%]
8 Converting from "M" compounding periods per year to "N" periods.
Growth on a nominal basis when compounding is quarterly is 11%. What nominal rate is that
equivalent to on a monthly basis?
g Nominal rate on quarterly basis

g Effective rate
g Nominal rate on monthly basis
9 Showing that 10% growth followed by -10% growth has a different result than has zero growth.
An investment has an initial value of 100. In the first year its value changes by +10% and in the
second year by -10%. What is the final value of the investment?
f Final value
What compound average growth rate (CAGR) is this equivalent to?
f CAGR
The CAGR you obtain above should be approximately equal to -(10%2)/2. Confirm that is so.
f -(10%)2/2
If we think of the +10% and -10% growths as exhibiting volatility then we can see that volatility can
"feed through" into growth by a factor of -σ2/2. That is why many formulae relating to the evolution of
asset prices and formulae relating to option pricing contain that term in the "growth" part of the
formula.
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e concepts - For
e than does zero
how how these
of each year is listed.
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of each year is listed.

d the long term growth
than the average
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year?
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ases by half of 10%

th a formula.
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es by one quarter of N.
on a quarterly basis (i.e,
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1 Future value of an investment earning simple interest.
A $100 investment earns simple interest at the rate of 5% per annum (p.a.)
What is the investment's value after six months?
h Investment value at six months [$]

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2 Present value of an investment earning simple interest.
An investment earning 6% per annum simple interest will have a value of $150 in three
months. What is the inverstment's current value?
h Investment's current value [$]

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3 Simple interest rate as a function of present value, future value and investment term.
An investment of $150 will have a value of $163 in one and a half years. The
investment earns simple interest. What is the per annum interest rate?
g Interest rate [%]

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4 Investment term as a function of present value, future value and interest rate.
An investment of $175 earns simple interest of 5.5%. In how many years

will the investment be worth $185?
e Years:
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1 Future value of an investment earning compound interest.
A $100 investment earns compound interest at the rate of 5% per annum (p.a.) What is
the investment's value after six months?

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2 Present value of an investment earning compound interest.
An investment earning 6% per annum compound interest will have a value of $150 in
three months. What is the inverstment's current value?

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3 Compound interest rate as a function of present value, future value and investment term.
An investment of $150 will have a value of $163 in one and a half years. The investment
earns compound interest. What is the per annum interest rate?
g Interest rate [%]

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An investment of $175 earns compound interest of 5.5% p.a. In how many years will the
investment be worth $185?
e Years:
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1 Future value of an investment earning continuous interest
An investment of $100 earns a continuous interest rate of 5%. What will the
investment compound to after nine months?

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2 Present value of an investment earning continuous interest
An investment earning 6% per annum continuous interest will have a value of $150 in
three months. What is the inverstment's current value?

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3 Continuous interest rate as a function of present value, future value and investment term.
An investment of $150 will have a value of $163 in one and a half years. The
investment earns continuous interest. What is the per annum interest rate?
h Continuous interest rate [%]

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An investment of $175 earns continuous interest of 5.5%. In how many

years will the investment be worth $185?
e Years:
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1 Effective annual rate of an investment with given nominal rate and compounding semi-annually
An investment of $100 earns 8% p.a. nominal interest compounding semi-annually.

What is the investment's value in one year's time?
g Investment value [$]
What is the effective annual rate of the investment?
g Effective annual rate [%]

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2 Nominal p.a.rate of an investment given an effective p.a. rate and compounding frequency
An investment of $100 earns an effective p.a. rate of 6.5%. Interest compounds

quarterly. What is the nominal p.a. rate?
g Nominal p.a. rate [%]
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1 Calculating discount factors from points on a yield curve
Consider the spot / zero-coupon yield curve shown below. Yields are annual effective.
Calculate discount factors corresponding to each point on the curve.
Time [yrs] 0.25 0.5 0.75 1 1.25

Yield p.a. [%] 5.50% 5.70% 5.75% 5.80% 5.81%
k l m n o Discount factor [#]
2 Using discount factors to calculate the value of a series of future cash flows.
Use the discount factors above to value a security that has cash flows as shown below.
Time [yrs] 0.25 0.5 0.75 1 1.25

Cash flows [$'000] 5 5 5 5 105
k l m n o Present value [$'000]
k Total value [$'000]
3 Generating a yield curve equivalent to a set of discount factors.
Consider the discount factors shown below. Calculate the equivalent spot / zero-coupon
yields on an annual effective basis.
Time [yrs] 0.25 0.5 0.75 1 1.25

Discount factor [#] 0.0000 0.0000 0.0000 0.0000 0.0000
k l m n o Yield - annual effective) [%]
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Index
Index
Index
1 Calculating forward interest rate implied by zero coupon yield curve
Consider the zero coupon yield curve shown below.
Time [yrs] 1 2 3 4
Yield p.a. [%] 5.00% 6.00% 6.50% 6.75%
$100 is invested at time 0 for one year. Call this investment "A". How much
will the investment be worth at the end of the year?
l Investment in one year [$]
$100 is invested at time 0 for two years. Call this investment "B". How much
will the investment be worth in two years?
l Investment in two years [$]
Investment A is re-invested in one year for an additional year. If, at maturity, the
investment is worth the same as investment "B" then at what rate would the re-investment
have been made?
k Reinvestment rate [%]
The rate you have obtained is the current implied forward rate from 1 year to 2 years.
2 Calculating implied forward curve from yield curve.
In a similar way to that used above calculate the complete one-year-ahead forward curve.
Time t [yrs] 1 2 3 4
Value of $100
k l m n o invested for t [$]
From 0 1 2 3
Forward
rate
To: 1 2 3 4
l m n o Value: 5.00%
Zero coupon (spot) yield and implied forward curves

8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%Row 7
0 37 1
Row 2 2 3 3 4 4 5 5 6
3.00%
2.00%
1.00%
0.00%Row 7
0 37 1
Row 2 2 3 3 4 4 5 5 6
3 Calculating zero curve from forward curve
Term [yrs] 1 2 3
Fwd rate [%] 5.00% 0.00% 0.00%
l m n o Discount factor [#] 1.0000
l m n o Zero rate [%]
Forward and implied zero coupon curves

0.06
0.05
0.04
0.03
0.02
0.01
0 Row 61
0 Row 631 2 2 3 3 4 4 5
4 Rolling forward yield curve
Term [yrs] 1 2 3
Fwd rate [%] 0.00% 0.00% 0.00%
l m n Discount factor [#] 1.0000
l m n Zero rate [%]
Implied zero curve in one year compared with today's zero curve advanced by one year
12
10
0Row 89
Row
0 63 1 2 3 4
4
0Row 89
Row
0 63 1 2 3 4
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5
6.88%
maturity, the
would the re-investment
1 year to 2 years.
Index
r-ahead forward curve.
4
5
curves
5 6
5 6
Index
4
0.00%
Index
e advanced by one year
4
4
Index
1 Calculating forward sale price of non-yield bearing asset.
A non-yield-bearing asset is currently trading at $50. You contract to deliver (sell) the
asset in one year's time for $53. To hedge your exposure to the forward price of the asset
you enter into the following transactions:
You arrange to borrow $50 now, buy the asset, hold the asset for year, then sell it at the
agreed price and pay back your borrowing. You can borrow at a rate of 5% (continuously
compounding) for a year. What is the present value of this arrangement?
Time [yrs] 0 0 1 1 1
Borrow Pay back
$50 Buy asset Sell asset loan
l m n o p Cash on hand [$]
Loan balance
l m n o p (negative) [$]
l m n o p Asset position [#]
l Present value: [$]
What is the minimum price you would agree to sell the asset for in one year's time?
[Assume you make a profit of zero.]
l Minimum sale price [$]
2 Calculating forward purchase price of a non-yield bearing asset.
A non-yield-bearing asset is currently trading at $50. You contract to purchase the asset
in one year's time for $51. To hedge your exposure to the forward price of the asset you
enter into the following transactions:
You will arrange to borrow the asset now, sell it on-market for $50 and invest the $50 for
one year at 5% (continuously compounding).
At the end of the year you will buy the asset for the agreed price of $51, return the asset to
the borrower and receive the proceeds of the $50 investment.
What is the present value of this arrangement?
Time [yrs] 0 0 1 1 1
Borrow Sell asset Invest sale Redeem

Asset on-market proceeds investment Buy asset
l m n o p q Cash on hand [$]
l m n o p q Investment balance [$]
l m n o p q Asset position [#]
l Present value: [$]

What is the maximum price you would agree to buy the asset for in one year's time?
m Maximum purchase price [$]
3 Calculating forward sale price of yield-bearing asset.
A yield-bearing asset is currently trading at $50. The asset provides a yield of 3%

(continuously compounding). You contract to deliver (sell) the asset in one year's time for
$52. To hedge your exposure to the forward price of the asset you enter into the following
transactions:
You arrange to borrow $50 now, buy the asset, hold the asset for year, then sell it at the
agreed price and pay back your borrowing. You can borrow at a rate of 5% (continuously
compounding) for a year. [Note that your borrowing cost of 5% is offset by the 3% yield
the asset provides.] What is the present value of this arrangement?
Time [yrs] 0 0 1 1 1
Borrow Pay back
$50 Buy asset Sell asset loan
l m n o p Cash on hand
Loan balance [$]
l m n o p (negative) [$]
l m n o p Asset position [#]
l Present value of profit: [$]
What is the minimum price you would agree to sell the asset for in one year's time?
l Minimum sale price [$]
4 Calculating forward purchase price of a yield-bearing asset.
A yield-bearing asset is currently trading at $50. The asset provides a yield of 3%. You
contract to purchase the asset in one year's time for $50.50. To hedge your exposure to
the forward price of the asset you enter into the following transactions:
You will arrange to borrow the asset now, sell it on-market for $50 and invest the $50 for
one year at 5% (continuously compounding).
Note that your investment account will face a continuous drain of 3% - This is the
compensation you need to make to the asset lender who has forgone the 3% yield the
asset would otherwise have provided them.
At the end of the year you will buy the asset for the agreed price of $50.50, return the
asset to the lender and receive the proceeds of the $50 investment.
What is the present value of this arrangement?
Time [yrs] 0 0 1 1 1
Borrow Sell asset Invest sale Redeem
Asset on-market proceeds investment Buy asset
l m n o p q Cash on hand [$]
l m n o p q Investment balance [$]
l m n o p q Asset position [#]
l Present value of profit: [$]
What is the maximum price you would agree to buy the asset for in one year's time?
m Maximum purchase price [$]
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Index
Return
asset
Index
Index
1
Return
asset
Index
1 Value of a growing annuity
An annuity of $100 will be received in one year's time. Thereafter the annuity will grow at 2.0% per
year. The discount rate r (annual effective) is 4.5% per year. Calculate the future and present values
of the annuities and the total present value.
g [%] 2.0%
r [%] 4.5%
C [$] 100
Time [yrs] 1 2 3 4 5
m n o p q Annuity [$] 100.00
l m n o p q PV [$]
k Total PV [$]
Use an annuity formula in cell K21 below to calculate the annuity present value.
Using
annuity
k formula [$]
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will grow at 2.0% per
re and present values
Index
1 Present value of a bond - calculating from future cash flows and a discount rate.
This exercise illustrates the fundamentals of bond valuation: Taking the future coupon and
principal payments and present-valuing them. This method gives the total bond value
(including accrued interest).
A bond has cash flows as shown below. The bond has a coupon rate of 6%.
Time of cash flow [yrs] 1 2 3 4

Amount of cash flow [$ 000's] 6 6 6 106
Determine the present value of the invidual cashflows assuming the bond's yield is 4%.
k l m n Discounted value [$ 000's]

k Total present value [$ 000's]
If we buy the above bond for the amount calculated in cell K16 then the implied yield is
4%.
2 Using present value and yield to generate future cash flows.
The bond yield relates the present value of the bond to its future payments. The yield is
the fixed/constant discount rate that - applied to the future cash flows - gives the present
value. Another way of thinking about the yield is illustrated in this exercise: If you sell a
bond, deposit the funds into an account earning the yield, then you can exactly reproduce
the coupon and principal payments the bond holder requires.
If we earn 4% on investments and we start with the amount calculated in cell K16 above
then we can reproduce the cash flows shown in cells K10:N11.
k l m n Opening balance [$ 000's]

k l m n Interest earned [$ 000's]
Coupon / principal
paid [$ 000's] -6 -6 -6 -106
k l m n Closing balance [$ 000's]
So if we can lend funds at a rate of 4% we can sell a bond for the amount calculated
in cell K16 and can deliver to the bond holder the coupon and principal cashflows they
require.
3 Calculating yield to maturity of a bond.
Term [yrs] 1 2 3 4
Zero rate [%] 5.00% 6.00% 6.50% 6.75%
l m n o Fwd rate [%]
l m n o Discount factor [#] 1
Cashflow [ 000's] 3 3 3 103
l m n o Present value [ 000's]

l Total PV [ 000's]
l YTM [%] <- Use RATE function
Check of PV using YTM
l m n o Discount factor using YTM [#]

l Total PV [ 000's]
The PV's in cell L50 and L59 should match.
Forward and YTM curves

8.00%
7.00%
YTM 0.00% 0.00% 0.00% 0.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
Row 45
0.00% Row 44
0.5Row 671 1.5 2 2.5 3 3.5 4 4.5
4 Calculating yield to maturity of an annuity
Find individual and total PV's of annuities
Term [yrs] 1 2 3 4
Cashflow [ 000's] 1 1 1 1
l Total PV [ 000's]
Assemble a cash flow that IRR can be used with. First value is minus of PV in cell L90.
Subsequent values are the cash flows in row 88.
k l m n o IRR cash flows [ 000's]

k YTM [IRR of [%]
cashflows in row 95].
Check that discounting cash flows in row 88 at YTM in cell K96 gives the same PV as in
cell L90.
Check that discounting cash flows in row 88 at YTM in cell K96 gives the same PV as in
cell L90.
l m n o Cashflow in row 88 [ 000's]

discounted at YTM.
k Total PV
Bond and annuity yields to maturity

8.00% YTM 0.00% 0.00% 0.00% 0.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00% Row 45
Row 44
0.00% Row 67
0Row 1081 2 2 3 3 4 4 5
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Index
Index
Index
1 Bond value as function of coupon rate.
Two interest rates influence the value of a bond: 1) The coupon interest rate, 2) The yield. The bond
value increases linearly with interest rate and decreases non-linearly with yield. It can be useful to
know the bond's sensitivity to the coupon rate - for example when setting the fixed side of a swap or in
setting a fixed margin on the floating leg of a swap.
A bond has four annual coupons remaining. When the last coupon is paid the principal of $100 is also
paid. Show the bond cash flows as a function of coupon rate. The coupon rate is given in cell K13.
Don't 'hard-code' the coupon rate but rather refer to cell K13.
Coupon rate: [%] 5%
Time of cash flow [years] 1 2 3

k l m n Amount of cash flow [$ 000's]
Yield (annual effective): [%] 6%
Find the discounted and total values of the cash flows using the yield above.
k l m n Discounted value [$ 000's]

k Total value [$ 000's]
The table below shows the bond value as a function of coupon rate.
Coupon Bond Bond value as function of coupon rate

rate value
130
0.0% 0.00
125
1.0% 0.00
2.0% 0.00 120
3.0% 0.00 115
4.0% 0.00 110
5.0% 0.00 105
6.0% 0.00 100
7.0% 0.00 95
8.0% 0.00 90
9.0% 0.00 85
10.0% 0.00 80
4%
6%
8%
0%
2%
10%
Is the line on the chart straight or curved?
Why?
2 Present value of a 1 basis point increase in coupon rate.
Assume the coupon rate is one basis point higher than that given in cell K13.
k Coupon rate + 1bps [%]
k l m n Amount of cash flow [$ 000's]

Additional cash flow due to extra
k l m n 1bps coupon [$ 000's]
Discounted value of additional
k l m n cash flow [$ 000's]
k Present value of increase [$ 000's]
3 Number of coupon basis points needed to add 1% to bond value.
For the bond above how many basis points would need to be added to the coupons to increase the
present value of the bond by 1%? [Calculations like these may need to be made in setting swap rates
and margins prior to the inception of a swap.]
k Number basis points [#]
4 Bond value as function of yield.
A bond has cash flows as shown below. The bond has a coupon rate of 6%.
Time of cash flow [years] 1 2 3 4

Amount of cash flow [$ 000's] 6 6 6 106
A yield is given in cell J77. Using the given yield calculate the discounted values of the individual cash
flows and their combined present value. Make sure your discounting formulae don't "hard-code" the
yield but instead refer to cell J77.
j k l m Discounted value [$ 000's]
j Total present value [$ 000's]
The table below shows the bond value as a function of yield.
Bond Bond value as function of yield

Yield value Change
130
0.0% 0.00
125
i 1.0% 0.00 6% 95 5% 100
i 2.0% 0.00 120 6% 100 6% 100
i 3.0% 0.00 115 6% 105 7% 100
i 4.0% 0.00 110
i 5.0% 0.00 105
i 6.0% 0.00 100
i 7.0% 0.00 95
i 8.0% 0.00 90
i 9.0% 0.00 85
i 10.0% 0.00 80
i 11.0% 0.00
4%
6%
8%
10%
0%
2%
100
95
90
85
80
4%
6%
8%
0%
2%
10%
Is the line in the chart straight or curved?
Why?
Why is the bond value 100 when the coupon rate is 6%?
Suppose the yield can change from 6.0% to either 5.95% or to 6.05%. Would the bond holder lose
more on the change to 6.05% than they'd gain on the change to 5.95%?
Why?
5 Bond value as function of time to maturity.
A bond has coupon and principal payments as shown below in cells L116:N117. The yield is 6.0%.
Date of payment [Date] 15-Dec-13 15-Dec-14

Coupon / Principal [$ 000's] 5 5
Settlement date [Date] 30-Dec-13
Coupon is yet to be received [0/1] [0/1] 0 1

Years to this coupon [#] -0.04 0.96
In cells L129:N124 below calculate the discounted values of the coupon and principal payments.
Multiply each answer by the 'coupon is yet to be received' flag on row 123.
l m n Value as on settlement date: [$ 000's]
l Total value:: [$ 000's]
Valuation Present Bond price as function of valuation date and yield

date value
1.00
15-Jun-13 0.00
11-Aug-13 0.00 0.90 3% 3
7-Oct-13 0.00 0.80 5%
3-Dec-13 0.00 0.70 6%
29-Jan-14 0.00 0.60 9% 6.00%
27-Mar-14 0.00 0.50
23-May-14 0.00 0.40 30-Dec-13 1
19-Jul-14 0.00 0.30 30-Dec-14 30-Dec-13
14-Sep-14 0.00 0.20 30-Dec-15
10-Nov-14 0.00 0.10
6-Jan-15 0.00 0.00
6-May-13
22-Nov-13
10-Jun-14
27-Dec-14
31-Jan-16
18-Oct-12
15-Jul-15
4-Mar-15 0.00
30-Apr-15 0.00
26-Jun-15 0.00
0.20
0.10
0.00
6-May-13
10-Jun-14
31-Jan-16
18-Oct-12
22-Nov-13
27-Dec-14
15-Jul-15
22-Aug-15 0.00
18-Oct-15 0.00
14-Dec-15 0.00
6 Calculating accrued interest and capital price
Accrued interest is calculated on a pro-rata basis by taking into account the proportion of a full coupon
period that has elapsed in the current coupon period and the value of the next coupon. So, if the
time since the last coupon is one quarter of the time between the last coupon and the next coupon
then the interest accrued is one quarter of the next coupon.
The capital price is the total price less accrued interest.
Calculate the accrued interest and capital price for the bond above.
Settlement date 15-Dec-13

Total price 0.00
i Accrued Interest
i Capital price
TotalAccrued
price and capital price as function of valuation date and yield
Total price interest Capital price
1.00 0.00 0.00 0.00
0.90
15-Dec-13 0.00 0.00 0.00 Generalised accrued interest
29-Jan-14
0.80 0.00 0.00 0.00 Index 1
16-Mar-14 0.00 0.00 0.00 Next date 15/12/14
0.70
30-Apr-14 0.00 0.00 0.00 Prev date 15/12/13
0.60
15-Jun-14 0.00 0.00 0.00 Acc int 0.00
31-Jul-14
0.50 0.00 0.00 0.00 Cap price 0.00
14-Sep-14
0.40 0.00 0.00 0.00
30-Oct-14 0.00 0.00 0.00
0.30
15-Dec-14 0.00 0.00 0.00
0.20
29-Jan-15 0.00 0.00 0.00
16-Mar-15
0.10 0.00 0.00 0.00
30-Apr-15 0.00 0.00 0.00
0.00
15-Jun-15 0.00 0.00 0.00
14-Aug-13
22-Nov-13
10-Jun-14
18-Sep-14
27-Dec-14
15-Jul-15
2-Mar-14
6-Apr-15
23-Oct-15
31-Jan-16
31-Jul-15 0.00 0.00 0.00
14-Sep-15 0.00 Column 0.00
H 0.00
30-Oct-15 0.00 Column 0.00
J 0.00
14-Dec-15 0.00 0.00 0.00
Set the yield of the bond (in cell J119) to be the same as the coupon rate. In the chart above is the
line showing the capital price exactly horizontal? If so why? If not why not?
7 Bond price sensitivity - to 1bps increase in yield
In this question you need to determine the sensitivity of a bond's price to changes in its yield-to-
maturity. You need to do that valuing the bind at two different yields: 1) The current yield, and 2) the
yield shifted up by 1bps (.01%).
Date of payment [Date] 15-Dec-13 15-Dec-14
Coupon / Principal [$ 000's] 5 5

Settlement date [Date] 15-Jun-13
Coupon is yet to be received [0/1] [0/1] 1 1

Years to this coupon [#] 0.5014 1.5014
l m n Discounted value [as at settlement date] [$ 000's]
l m n Discounted value if yield is 1bps higher [$ 000's]
l Total present value (as on settlement date):

l Total present value at higher yield:
Calculate the percentage decrease in bond value that results from a 1bp increase in YTM.
l % decrease in present value
Valuation Bond interest rate sensitivity as function of settlement date

date Sensitivity
15-Jun-13 0.000% 18-Oct-12 22-Nov-13 27-Dec-14 31-Jan-16 6-Mar-
11-Aug-13 0.000% 0.000% 15-Jun-13 1
7-Oct-13 0.000% 10.000% 15-Jun-14 15-Jun-13
3-Dec-13 0.000% 15-Jun-15
20.000%
29-Jan-14 0.000%
27-Mar-14 0.000% 30.000%
23-May-14 0.000% 40.000%
19-Jul-14 0.000%
14-Sep-14 0.000% 50.000%
10-Nov-14 0.000% 60.000%
6-Jan-15 0.000%
70.000%
4-Mar-15 0.000%
30-Apr-15 0.000% 80.000%
26-Jun-15 0.000% 90.000%
22-Aug-15 0.000%
18-Oct-15 0.000% 100.000%
14-Dec-15 0.000%
Why does the line in the chart above have kinks in it?
8 Relationship between duration and yield sensitivity
For a fixed rate bond there is a simple relationship between its sensitivity to changes in yield to
maturity and its time-weighted cash flows (duration). In this section we show how the two are related.
Yield [%] 4%
The present values of a bond's cashflows are shown below. Also shown are the times at which those
cashflows will be received.
Present value of coupon (PV) [$ 000's] 4.90 4.71
Years to coupon (t) [years] 0.5014 1.5014
Calculate the time-weighted present values.
l m n PV * t [$ 000's]
l Sum of (PV * t) [$ 000's]
Calculate the total present value of the bond's cash flows.
l Sum of PVs [$ 000's]
Divide the sum of the time-weighted present values by the sum of the present values. This gives the
"Macauley duration".
l Sum of (PV * t) / Sum of (PV)
l Multiply the Macauley duration in [%]

cell L264 by minus the increase in
yield (0.0001).
l Divide the result in cell L266 by 1 [%]

plus the yield.
The result in cell L270 above - derived by considering the time-weighted cashflows is exactly the
same as the interest rate sensitivity calcuated in cell L214 earlier. This illustrates the connection
between duration and interest rate sensitivity.
Valuation Bond interest rate sensitivity and duration as function of date

date Sensitivity
15-Jun-13 0.000% 18-Oct-12 27-Dec-14 6-Mar-17
22-Nov-13 31-Jan-16
11-Aug-13 0.000%
0.000%
7-Oct-13 0.000%
3-Dec-13 0.000% 10.000%
29-Jan-14 0.000% 20.000%
27-Mar-14 0.000%
30.000%
23-May-14 0.000%
19-Jul-14 0.000% 40.000%
14-Sep-14 0.000% 50.000%
10-Nov-14 0.000% 60.000%
6-Jan-15 0.000%
70.000%
4-Mar-15 0.000%
30-Apr-15 0.000% 80.000%
26-Jun-15 0.000% 90.000%
22-Aug-15 0.000% Column H
100.000% Column H
18-Oct-15 0.000%
14-Dec-15 0.000%
9 Duration as a function of number of coupons and discount rate.

In certain cases a bond's duration can increase as the time to maturity decreases. The following is
an example of this. In this example the discount rate is very high. One coupon is paid per year.
Coupon rate [%] 10%

Discount rate [%] 20%
Number of coupons [#] 3
Face value [$] 100
Per-period discount
k factor [#]
Present value of time-weighted
k coupons [$]
k principal [$]
k principal + coupons [$]
Present value of principal +
k coupons [$]
k Duration [#]
Duration in years of bond as a function of years to maturity

0
1 1 0
0.9 4 0
7 0
0.8
10 0
0.7 13 0
0.6 16 0
19 0
0.5 22 0
0.4 25 0
28 0
0.3
31 0
0.2
0.1
0
1 2 3 4 5 6 7 8 9 10 11
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, 2) The yield. The bond
d. It can be useful to
fixed side of a swap or in
e principal of $100 is also

e is given in cell K13.
on of coupon rate
8%
10%
12%
Index
Index
upons to increase the

ade in setting swap rates
Index
es of the individual cash

e don't "hard-code" the
ction of yield
8%
10%
12%
8%
10%
12%
the bond holder lose
Index
17. The yield is 6.0%.
15-Dec-15
105
1
1.96
principal payments.
aluation date and yield

27-Dec-14
31-Jan-16
18-Aug-16
15-Jul-15
31-Jan-16
27-Dec-14
15-Jul-15
18-Aug-16
Index
roportion of a full coupon

xt coupon. So, if the
and the next coupon
date and yield
accrued interest
23-Oct-15
31-Jan-16
the chart above is the
Index
nges in its yield-to-

current yield, and 2) the
15-Dec-15
105
1
2.5014
ease in YTM.
function of settlement date

Dec-14 31-Jan-16 6-Mar-17
Index
hanges in yield to
how the two are related.
he times at which those

95.19
2.5014
values. This gives the
flows is exactly the

ates the connection
duration as function of date

6-Mar-17
1-Jan-16
Index
ases. The following is
on is paid per year.
to maturity
9 10 11
eserved. Index
1 Valuing a floating rate note from first principles.
Value a floating rate note immediately after a coupon has been paid. The next coupon to be paid will have
been rateset to the value shown in cell J14. Following coupons (i.e. at times 0.5, 0.75 and 1.0 years) will
'float'.
Notional [$] 100

Payments per year [#] 4
Nominal interest [%] 1.00% <- Need to add this to fwd rate when calculating FRN
margin p.a. payment.
Nominal traded margin [%] 10.00% <- Need to add this to fwd rate when discounting to present
p.a. value.
Next coupon rate [%] 4.10%
Term [yrs] 0.00 0.25 0.50 0.75 1.00

Fwd rate p.a. [%] 4.00% 4.50% 5.00% 5.50%
Discount factor [#] 1.0000 0.9662 0.9324 0.8987 0.8652
k l m n FRN payment [$]
Present value of
k l m n payment [$]
j FRN value = Total PV [$]
2 Determining interest rate sensitivity of a floating rate note.
The analysis above should be repeated but with forward rates 1 basis point (.01%) greater than the forward
rates above. Note that the first payment has been rateset and won't change.
Term [yrs] 0.00 0.25 0.50 0.75 1.00

k l m n Fwd rate p.a. [%]
k l m n Discount factor [#] 1.0000
k l m n Payment [$]
Present value of
k l m n payment [$]
j FRN value = Total PV [$]
Interest rate sensitivity

j [$/%]
The following chart shows the interest rate sensitivty as a function of traded margin.
Interest rate sensitivity as a function of traded margin

0.00
-15
0% 0
-17 1% 0
2% 0
-19 3% 0
-21 4% 0
-23
-25
-27
-29
-15
-17
-19
-21
5% 0
-23 6% 0
-25 7% 0
8% 0
-27 9% 0
-29 10% 0
11% 0
-31 12% 0
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
3 Determining floating rate note value as a function of settlement date
Consider the FRN described below. The FRN pays quarterly coupons.
Nominal [$] 100

Settlement date [date] 14-Sep-12
Maturity date [date] 15-Jun-13
Nominal interest [%] 1.0% <- Need to add this to fwd rate when calculating FRN
margin p.a. payment.
Nominal traded margin [%] 5.0% <- Need to add this to fwd rate when discounting to present
p.a. value.
Assume that the yield curve is flat and all forward rates are 4.0%.
Fwd rates [%] 4.0%

Rateset rate [%] 4.0%
The section below calculates payments from the settlement date to the maturity date. Calculate the present
values of the individual payments.
Payment dates [date] 15-Sep-12 15-Dec-12 15-Mar-13 15-Jun-13

Payment [$] 1.2500 1.2500 1.2500 101.2500
Number quarterly
periods to this payment [#]
0.0110 1.0082 1.9945 3.0027
j k l m Present value [$]
j FRN value [$]
### 0
FRN value as function of settlement date
### 0 14-Sep-12 1
1 ### 0 1-Nov-12 14-Sep-12
0.9 ### 0 14-Jan-13
### 0 14-Apr-13
0.8
### 0
0.7 ### 0
0.6 ### 0
### 0
0.5 ### 0
0.4 ### 0
### 0
0.3
0.2
0.1
0
-12
-12
-12
-13
-13
-13
-13
t-12
-13
-13
0.7
0.6
0.5
0.4
0.3
### 0
0.2 ### 0
0.1 ### 0
### 0
0 ### 0
15-Sep-12
14-Nov-12
14-Dec-12
13-Jan-13
12-Feb-13
14-Mar-13
12-Jun-13
15-Oct-12
13-Apr-13
13-May-13
### 0
### 0
### 0
### 0
4 Determining floating rate note interest rate sensitivity as a function of settlement date
Assume forward rates are shifted up by 0.01% (as shown in cell J109. [Note, however, that the first coupon
after the settlement date is rateset and isn't shifted.]
Shifted fwd rates [%] 4.01%
Recalculate the present values of the FRN payments.
Payment dates 15-Sep-12 15-Dec-12 15-Mar-13 15-Jun-13

Payment 1.2500 1.2525 1.2525 101.2525
Number quarterly
periods to this payment [#]
0.0110 1.0082 1.9945 3.0027
j k l m Present value
j FRN value [$]
j Interest rate sensitivity [$/%]
### 0.0000
FRN interest rate sensitivity as function of settlement date
### 0.0000
1 ### 0.0000
1 ### 0.0000
### 0.0000
1
### 0.0000
1 ### 0.0000
1 ### 0.0000
### 0.0000
0 ### 0.0000
0 ### 0.0000
0 ### 0.0000
### 0.0000
0 ### 0.0000
0 ### 0.0000
### 0.0000
0
### 0.0000
2/12/2013
9/15/2012
10/15/2012
12/14/2012
1/13/2013
3/14/2013
4/13/2013
5/13/2013
6/12/2013
11/14/2012
### 0.0000
### 0.0000
### 0.0000
### 0.0000
0
9/15/2012
10/15/2012
11/14/2012
12/14/2012
1/13/2013
2/12/2013
www.tykoh.com
3/14/2013
4/13/2013
5/13/2013
6/12/2013
on to be paid will have
75 and 1.0 years) will
calculating FRN
discounting to present
Index
reater than the forward
argin
10% 11% 12%
Index
calculating FRN
discounting to present
. Calculate the present

-13
-13
te
5/13/2013 13-May-13
6/12/2013 12-Jun-13
er, that the first coupon

Index
5/13/2013
Index 6/12/2013
1 Valuing the fixed and floating legs of a fixed-to-float interest rate swap
Receive fixed, pay float, semi-annual payments
Notional [$ 000's] 1,000

Fixed rate coupons [%] 8.0000%
Term [yrs] 0 0.5 1.0 1.5

Fwd rate [%] 7.00% 7.20% 7.10%
m n o p Discount factor [#] 1.00000
l m n o p Floating payment [$ 000's]
l m n o p Fixed payment [$ 000's]
Present value of fixed
l m n o p q payment [$ 000's]
Present value of
l m n o p q floating payment [$ 000's]
l m n o p q PVBP [$ 000's]
The present value of the floating leg should be zero. Why is this so?
2 Calculating fixed coupon rate that makes swap value zero.
Continuing on from the preceding question: What fixed coupon rate is required in order to set the
overall value of the swap (i.e. fixed leg + floating leg) to zero?
n Fixed coupon rate to make swap zero value [%]
Using the coupon rate calculated above in cell N26:
l m n o p Fixed payment [$ 000's]

Present value of fixed
l m n o p q payment [$ 000's]
l m n o p Net cash flow
l m n o p q PV of net cash flow
Fixed rate coupons required to give swap zero net value

8.00% 0.0000% 0.0000% 0.0000% 0.0000%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00% Row 37
0.4 0.6 Row0.8
10 1.0 1.2 1.4 1.6 1.8 2.0 2.2
4.00%
3.00%
2.00%
1.00%
0.00% Row 37
0.4 0.6 Row0.8
10 1.0 1.2 1.4 1.6 1.8 2.0 2.2
Swap net cash flows

12
10
0
0 0.5 1.0 1.5 2.0
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2.0
6.90%
Total
[$ 000's]
Index
s required in order to set the
Total
ero net value
1.8 2.0 2.2

1.8 2.0 2.2
1.5 2.0
s reserved. Index
1 Calculate IRR of a yearly series of cash flows.
Period [yr] 0 1 2 3
Cash flow [$ 000's] -100 20 40 60
k IRR [%]
2 Calculate nominal yearly IRR for a semi-annual series of cash flows
Period [yr] 0 0.5 1.0 1.5

Cash flow [$ 000's] -100 20 40 60
k IRR [%]
3 Demonstration that certain cash flows can have more than one IRR
Period [yr] 0 1 2
Cashflow [$ 000's] 699.3 -1678.32 1000
Discount NPV[$ NPV as a function of discount rate

rate [%] 000's]
12
j 0%
j 5% 10
j 10%
8
j 15%
j 20% 6
j 25%
j 30% 4
j 35%
j 40% 2
30%
5%
10%
15%
20%
25%
35%
0%
Generate the IRR for the cash flow in row 19 using 0% as the second (optional, guess)
parameter.
k IRR with 0% guess:
Generate the IRR for the cash flow in row 19 using 50% as the second (optional, guess)
parameter.
k IRR with 50% guess:
4 Demonstration that a set of cash flows can have an undefined IRR
A project, as initially structured, has the cash flow profile shown below in Profile A.
Calculate the IRR of profile A.
Profile A
Year [yr] 1 2 3 4
Cash flow [$ 000's] (200) 80 80 90
l IRR [%]
The project is restructured so that the initial $200 investment is amortised and paid in four
$70 installments beginning in year 2. The restructured profile is shown in Profile B.
Calculate the net cash flow of profile B.
Profile B
Year [yr] 1 2 3 4
Original cash flow [$ 000's] (200) 80 80 90
Amortising cash flow [$ 000's] 200 -70 -70 -70
l m n o p q Net cash flow [$ 000's]
IRR [%] Err:523
Why is the IRR of profile B undefined?
A. One of the cash flows is zero.

B. All cash flows are zero or have the same sign.
C. Each successive cash flow is greater than its predecessor
j Answer:
5 Calculating IRR when cash flows grow at a constant rate in perpetuity
An investment of $6m is made. The investment will generate a yield of $1.25m in the first year and
yields threreafter increase at 5% forever. What is the IRR of this investment?
k IRR [%]
6 Demonstration that differing growth rates can give different NPV's but the same IRR's
An investment generates a yield of $1.2m in its first year. The yield grows by a fixed percentage eac
year. Yields are discounted to present value at 12%. The IRR is 20.0%. What is the present value
the investment as a function of growth rate?
Growth NPV as a function of growth rate

rate [%] NPV [$m]
25
j 4.0% 20
j 4.5% 20 20
j 5.0% 20
j 5.5% 15 20
j 6.0% 20
j 6.5% 10 20
j 7.0% 20
j 7.5% 5 20
j 8.0% 20
j 8.5% 0 20
j 9.0% 20
4.0%
4.5%
5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
Column J
j 9.5% 20 Column L
7 Calculating NPV as a function of IRR for a given growth rate.
In the preceding example what is the present value as a function of IRR if the growth rate is 5.0%?
NPV as a function of IRR

12
10
8
IRR [%] NPV [$m] NPV as a function of IRR
j 15.0% 12
j 17.5%
j 20.0% 10
j 22.5% 8
j 25.0%
j 27.5% 6
j 30.0% 4
j 32.5%
j 35.0% 2
j 37.5%
0
j 40.0%
17.5%
22.5%
25.0%
30.0%
32.5%
37.5%
40.0%
42.5%
45.0%
47.5%
15.0%
20.0%
27.5%
35.0%
j 42.5%
j 45.0%
j 47.5%
j 50.0%
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Index
Index
n of discount rate
30%
20%
25%
35%
40%
nd (optional, guess)
ond (optional, guess)
Index
ow in Profile A.
5 6
90 95
ortised and paid in four
own in Profile B.
5 6
90 95
-70 0
Index
d of $1.25m in the first year and

vestment?
Index
but the same IRR's
grows by a fixed percentage each

0.0%. What is the present value of
on of growth rate
7.5%
8.0%
8.5%
9.0%
9.5%
Index
IRR if the growth rate is 5.0%?
nction of IRR
32.5%
35.0%
hts reserved.
37.5%
nction of IRR
40.0%
42.5%
45.0%
47.5%
50.0%
Index
1 Calculating present value on nominal and inflation-adjusted bases
Calculating NPV on a nominal basis
Nominal discount rate [%] 4.50%
Time [yrs] 1 2 3 4
Nominal cash flow [$ 000's] -360 110 140 150
NPV using nominal
k values [$ 000's]
Calculating NPV on a real (inflation-adjusted) basis
Inflation rate [%] 1.20%

k Real discount rate [%] <- Note - the exact value of this is not simply the
nominal discount rate less the inflation rate.
Time [yrs] 1 2 3 4
l m n o p Inflation index [#] 1.000
l m n o p Real cash flow [$ 000's]
k NPV using real values [$ 000's]
Note that the NPV on a nominal basis is the same as the NPV on a real (inflation-
adjusted) basis. This is because NPV is relative to "today" and inflation has no effect
relative to today.
2 Calculating IRR on nominal and inflation-adjusted bases
IRR of nominal cash

k flows [%]
k IRR of real cash flows [%]

Difference between
k IRR on nominal and [%]
real bases
k Inflation rate [%]
Note that the IRR on a real basis does not equal the IRR on a nominal basis less inflation.
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5
150
s not simply the
Index
ss inflation.
Index
The sensitivity of an "output" to its "inputs" is often measured by varying the input by a small amount,
determining the resultant change in output and then dividing the change in output by the change in
input. "Inputs" could be: Time elapsed, time to maturity, asset price, volatility, interest rate, yield,
correlation, inflation rate, fx rate, default rate and so on. "Outputs" could be value, rate of return,
frequency, probability, duration and so on.
1 Calculating sensitivity of fixed-interest investment's value to time
An investment of $100 earns 6% interest compounding semi-annually. At what rate is the investment
growing in value at time t = 1.5 years?
m Investment value at time 1.5 years: [$]

m Investment value at time 1.51 years: [$]
m Rate of increase at time 1.5 years: [$ / yr]
What continuously compounding rate is equivalent to the semi-annual rate given above?
m Continuously compounding rate: [%]
From your knowledge of the slope of the exponential function what is the exact answer to the question
above (whose approximate answer was calculated in cell M16?
m Rate of increase at time 1.5 years: [$ / yr]
2 Calculating sensitivity of forward price to its drivers.
An asset has a spot price of S and yields a continuous return of d. The interest rate (continuously
compounding) is r. The forward price, F, of the asset at time t is given by the following equation:
F = S * exp((r-d)*t)
The current values of S, d, r and t are as shown below:
Spot [$] 100

r [%] 4.30%
d [%[ 1.20%
t [yrs] 1.5
Find the sensitivity of the forward price to S, r, d and t.
Forward
Spot r d t price
o Original values: 100 4.30% 1.20% 1.5
k l m n o Increase original spot by 1%:
k l m n o Add 1% to original r:
k l m n o Add 1% to original d:
k l m n o Add 0.01 to original t:
k Sensitivity to spot: [#]
k Sensitivity to r: [1/%]
k Sensitivity to d: [1/%]
k Sensitivity to t: [1/yrs]
3 Calculating sensitivity of annuity to its drivers
An investment generates a dividend that grows by g% per year in perpetuity. The first dividend is D and is
received in one year's time. Future dividends are discounted back to present value at a discount rate of r. T
present value, P, of the dividends generated by the investment is given by the formula P = D/(r-g)
The current values of D, r and g are as shown below:
D 1
r 4.5%
g 1.5%
Find the sensitivity of the present value, P, to D, r and g.
D r g P
n Original values: 1 4.50% 1.50%
k l m n Increase D by 1%
k l m n Add 1% to original r
k l m n Add 1% to original g
k l m n Add 1 to n
l Sensitivity to D [#]
l Sensitivity to r [1/%]
l Sensitivity to g [1/%]
33.33 of next annuity

Annuity value as function
0.5 16.67
60
0.6 20
50 0.7 23.33
0.8 26.67
40 0.9 30
1 33.33
30 1.1 36.67
1.2 40
20 1.3 43.33
1.4 46.67
10 1.5 50
0
1
1.5
0.5
0.6
0.7
0.8
0.9
1.1
1.2
1.3
1.4
33.333 of discount rate

2.25% 133.333
140
r 2.70% 83.333
120
100
80
60
Annuity value as function of discount rate
140
120 3.15% 60.606
100 3.60% 47.619
4.05% 39.216
80 4.50% 33.333
60 4.95% 28.986
5.40% 25.641
40
5.85% 22.989
20 6.30% 20.833
6.75% 19.048
0
3.15%
3.60%
4.95%
5.40%
6.75%
2.25%
2.70%
4.05%
4.50%
5.85%
6.30%
g 33.33 of growth rate
0.75% 26.67
50
0.90% 27.78
45
1.05% 28.99
40
1.20% 30.3
35
1.35% 31.75
30
1.50% 33.33
25
1.65% 35.09
20
1.80% 37.04
15
1.95% 39.22
10
2.10% 41.67
5
2.25% 44.44
0
1.95%
2.25%
0.75%
0.90%
1.05%
1.20%
1.35%
1.50%
1.65%
1.80%
2.10%
www.tykoh.com
put by a small amount,
put by the change in
nterest rate, yield,
ue, rate of return,
rate is the investment
answer to the question
Index
t rate (continuously
ollowing equation:
Index
he first dividend is D and is

alue at a discount rate of r. The
ormula P = D/(r-g)
1.5
1.4
2.10% 6.30%
2.25% 6.75%
hts reserved.
Index
Gradient is a similar concept to sensitivity. If Y is a function of X then the gradient of Y is the change
in Y divided by the change in X.
1 Gradient of e^(ax)
Some common financial functions have gradients that can be expressed as formulae. In this and
following questions we look at some of those functions.
Calculate the gradient of e2x when x is 1.5. Show that the gradient is equal to 2.e2x. We can
conclude that, in general, the gradient of eax is a.eax.
x e2x gradient 2.e2x

g h i 1.5 Gradient is =(G15-G14)/(F15-F14)
g 1.5
2 Gradient of x^n
Calculate the gradient of x3 when x is 2. Show that the gradient is equal to 3.x2. We can conclude
that, in general, the gradient of xn is n.x(n-1).
x x3 gradient 3.x2
g h i 2
g 2
3 Gradient of a^x
Calculate the gradient of 2x when x is 3. Show that the gradient is equal to ln(2).2x. We can conclude
that, in general, the gradient of ax is ln(a).ax.
x 2x gradient ln(2).2x
g h i 3
g 3
4 Gradient of ln(x)
Calculating the gradient of ln(x) when x is 2. Show the gradient is equal to 1/2. We can conclude
that, in general, the gradient of ln(x) is 1/x.
x ln(x) gradient 1/x

g h i 2
g 2
5 Calculating gradient of the product of two functions
Suppose f and g are functions of x. Then the gradient of f x g is given by the following formula;
Gradient of f(x).g(x) = f ' (x).g(x) + f(x).g ' (x), where ..

f ' (x) is the gradient of f(x) and g ' (x) is the gradient of g(x)
Calculate the gradient of 2x.x3 when x is 2. Show that the gradient is the same as would be predicted
by using the rule above. The rule predicts the gradient should be 2x.x2(3+ln(2).x)
x 2x.x3 gradient x2.2x(3+ln(2).x)

g h i 2
g 2
6 Calculating the gradient of a function of a function
g(x) is a function of x. f is a function of g(X). Then the gradient of f(g(x)) is given by a "chain rule":
Gradient of f(g(x)) = f ' (g(x)).g ' (x)
Calculate the gradient of 3ln(x) when x is 2. Show that the gradient is the same as would be predicted
by using the chain rule. The rule predicts the gradient should be 3ln(x).ln(3)/x
x 3ln(x) gradient 3ln(x).ln(3)/x

g h i 2
g 2
7 Calculating gradient of a piecewise-linear curve.
y x y as a function of x
60 0.00
50
70 0.04 x y
80 0.43 40 90 2.12 110 12.79
90 2.12 100 2.12 130 12.79
100 6.19 30
110 12.79 100 2.12 130 30.60
20
120 21.22 100 6.19 130 12.79
130 30.60 10
140 40.37
0
60 70 80 90 100 110 120 130 140
The table and chart above show a piecewise-linear "curve". Using that table calculate the gradients
at the x values given in the table below.
x gradient gradient of y as a function of x

g 65
12
g 75
g 85 10
g 95 8
g 105
g 115 6
g 125 4
2
0
60 70 80 90 100 110 120 130 140
10
8
6
4
g 135
2
0
60 70 80 90 100 110 120 130 140
8 Calculating curvature
Curvature is a second-order measure: It is the gradient of the gradient. In other words curvature
measures how quickly the gradient of y changes as a function of x.
Continuing with the above example - calculate the curvature of y(x) in the table below.
x Curvature curvature of y as a function of x

g 70 12
g 80
g 90 10
g 100 8
g 110
g 120 6
g 130 4
2
0
60 70 80 90 100 110 120 130 140
9 Using gradient and curvature in interpolating and extrapolating
Gradient and curvature can be used in interpolating and extrapolating. Consider a function V(x).
Suppose the value of the function V(x), its gradient V'(x) and curvature V''(x) are all known at a
particular value of x, say x1. Then the value of V at a slightly different value of x - say x1+dx is given
approximately by the following formula: V(x1+dx) = V(x) + V'(x).dx + 0.5 V''(x).dx2/2
Calculate the approximate value of V(x) when x is 2.1 by using the value of V(x) and its gradient and
curvature at x = 2.0
value gradient curvature

x V(x) V'(x) V''(x)
2.0 2.23 0.89 0.36
g 2.1
www.tykoh.com
ent of Y is the change
mulae. In this and
2.e2x. We can
4)/(F15-F14)
Index
2
. We can conclude
Index
2).2x. We can conclude
Index
We can conclude
Index
ollowing formula;
as would be predicted
.x)
Index
en by a "chain rule":
as would be predicted
Index
120 130 140
alculate the gradients
on of x
120 130 140

120 130 140
Index
er words curvature
below.
on of x
120 130 140
Index
er a function V(x).
e all known at a
x - say x1+dx is given
x2/2
x) and its gradient and
Index
1 Calculating a frequency distribution from a sample set
This question and the following ones relate to frequency distributions, mean and mode. All o
ways of reducing large data sets to represent them in a more concise but still useful form.
The table below shows the number of times a particular security has yielded a given return. C
the frequency distribution of the returns. The frequency distribtion is the list of the percentag
each return has occurred.
Number of Frequency Frequency distributio

Return times [%]
9.6
8.8
o -5% 1 8
o -4% 0 7.2
o -3% 3 6.4
o -2% 5 5.6
o -1% 10 4.8
o 0% 8 4
o 1% 12 3.2
o 2% 8 2.4
1.6
o 3% 13
0.8
o 4% 9 0
o 5% 3
-5%
-4%
-3%
-2%
-1%
0%
o 6% 2
2 Calculating a mean from a frequency distribution.
Calculate the mean return.
n Mean
3 Calculating a mode from a frequency distribution.
Calculate the modal return (the return that occurred the most often)
r Number of times most frequent return has occurred:

r Corresponding return:
4 Calculating a cumulative frequency distribution.
In cells O49:O60 show the number of times returns have been less than or equal to the retur
For example, the number in cell O51 should show the number of times returns were less than
to -3%. In cells P49:P60 show the cumulative frequency as a percentage.
Cumulative Cumulative Cumulative frequency distr

Number of frequency frequency
1
Return times [number] [%]
o p -5% 1 0.8
0.6
0.4
0.2
Cumulative frequency distr
1
0.8
o p -4% 0
o p -3% 3 0.6
o p -2% 5
o p -1% 10 0.4
o p 0% 8
0.2
o p 1% 12
o p 2% 8 0
o p 3% 13
o p 4% 9 -0.2
o p 5% 3
-4%
-2%
-1%
-5%
-3%
0%
o p 6% 2
5 Calculating lowest return in upper quartile.
What is the lowest return in the upper quartile?
p Lowest return in upper quartile:
6 Calculating standard deviation.
Both standard deviation and variance are measures of the "spread" of a distribution. Standa
is the square root of variance. Both standard deviation and variance can be calculated on "s
"population" terms. "Population" means that the data you're working with comprises all the d
"sample" means that there is more data and you're working with the sampled subset.
Calculate the sample standard deviation of the frequency distribution described in cells M81:
Number of
times x
Number of Return - (Return - (Return -
Number of times x mean mean mean
Return times return return return)2 return)2
o p q r -5% 1
o p q r -4% 0
o p q r -3% 3
o p q r -2% 5
o p q r -1% 10
o p q r 0% 8
o p q r 1% 12
o p q r 2% 8
o p q r 3% 13
o p q r 4% 9
o p q r 5% 3
o p q r 6% 2
n r Total
o Mean return
t Standard deviation = Square root of [total in column R / (total in column N - 1)]
7 Generating a normal distribution
We can generate a normal distribution by using the NORMDIST function. In the question bel
the NORMDIST function to superimpose a normal curve on our actual frequency distribution.
shows visually the extent to which the data set is "Normal".
Cells N114:N127 calculate the cumulative normal distribution using the mean and standard d
calculated in cells O97 and T99 respectively. In cells O115:O126 calculate the increments in
cumulative distribution. Scale these by the total number of samples in cell N95 to give the pr
number of normal samples in cells P115:P126.
Cumulativ Change in Frequency of actual and

e normal Cumulative
Return dist normal dist Frequency 14
-6% #DIV/0! 12
o p -5% #DIV/0!
o p -4% #DIV/0! 10
o p -3% #DIV/0!
o p -2% #DIV/0! 8
o p -1% #DIV/0!
o p 0% #DIV/0! 6
o p 1% #DIV/0!
4
o p 2% #DIV/0!
o p 3% #DIV/0!
2
o p 4% #DIV/0!
o p 5% #DIV/0! 0
o p 6% #DIV/0! Column N
-3%
-2%
2%
3%
-5%
-4%
-1%
0%
1%
7% #DIV/0! Column P
8 Calculating percentage of outcomes less than N standard deviations above mean
We can use the NORMSDIST function to give the proportion of values less than a given num
standard deviations above the mean.
An investment has normal returns. What percentage of returns will be less than one standar
(σ) above the mean?
q % returns < (mean + σ):
Complete the table below showing the percentage of returns less than N standard deviations
mean.
N % returns % returns less than N standard deviatio

n -3.5 100%
n -3.0
n -2.5 80%
60%
40%
20%
% returns less than N standard deviatio
100%
80%
n -2.0
n -1.5 60%
n -1.0 40%
n -0.5
n 0.0 20%
n 0.5
n 1.0 0%
n 1.5
-20%
n 2.0
-3.5 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5
n 2.5
n 3.0 N
9 Calculating percentage of outcomes within N standard deviations of the mean
Complete the table below showing the percentage of returns within N standard deviations fro
mean.
Percentag % returns within N standard devia

N e
1
n 0.00
0.8
n 0.30
n 0.60 0.6
n 0.90 0.4
n 1.20
n 1.50 0.2
n 1.80 0
n 2.10
n 2.40 -0.2
n 2.70 0.00 0.30 0.60 0.90 1.20 1.50 1.80
n 3.00 N
10 Calculating number of standard deviations above mean below which a given percentage of s
We can use the NORNMSINV function to give the number of standard deviations above the m
which a certain proportion of outcomes will occur.
85% of returns occur less than N standard deviations above the mean. What is N?
n N
Complete the following table which shows the number of standard deviations above the mea
which X% of samples occur.
Number Number of standard deviations above mean below wh

X Sd's
12.00
n 50.00% 10.00
n 54.00% 8.00
6.00
4.00
2.00
0.00
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Number of standard deviations above mean below wh
12.00
10.00
8.00
n 58.00%
6.00
n 62.00%
4.00
n 66.00%
n 70.00% 2.00
n 74.00% 0.00
50.00%
54.00%
58.00%
62.00%
66.00%
70.00%
74.00%
78.00%
82.00%
86.00%
n 78.00%
n 82.00%
n 86.00%
n 90.00% X
n 94.00%
n 98.00%
n 99.99%
11 Generating samples from a normal distribution.
The RAND function can be used to generate samples drawn from a rectangular distribution.
distribution can be "mapped" to another distribution. For example, to generate samples draw
normal distribution you can pass the numbers generated by RAND to the NORMSINV functio
NORMSINV function will then generate samples drawn from a normal distribution that has a m
zero and standard deviation of 1.
The samples below have been generated by using the =RAND() function. That function gene
numbers that are equally likely to fall anywhere in the range from 0 to 1. In other words, the
have a "rectangular" distribution.
0.2216 0.3150 0.5566 0.6857 0.7798 0.6219

0.3908 0.3954 0.0936 0.6733 0.9432 0.2704
0.1079 0.1321 0.1018 0.0828 0.2485 0.4235
0.0238 0.2703 0.7686 0.1145 0.1044 0.0064
0.5004 0.4223 0.6263 0.3240 0.9859 0.6059
Use the numbers above to generate normally distributed numbers.
m n o p q r s t u v
m n o p q r s t u v
m n o p q r s t u v
m n o p q r s t u v
m n o p q r s t u v
Chart the frequency distribution of the normally distributed numbers. Use the FREQUENCY
Min number: 0.0000 Rounded min:

Max number: 0.0000 Rounded max:
Interval Number Frequency distribution of normally di

n 0.00 12
n 0.00
n 0.00 10
n 0.00 8
n 0.00
6
0
Frequency distribution of normally di
12
10
n 0.00 6
n 0.00
n 0.00 4
n 0.00 2
n 0.00
n 0.00 0
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
n 0.00
n 0.00
n 0.00 Interval
www.tykoh.com
stributions, mean and mode. All of these are
ore concise but still useful form.
curity has yielded a given return. Calculate

stribtion is the list of the percentage of times
Frequency distribution of returns

9.6
8.8
8
7.2
6.4
5.6
4.8
4
3.2
2.4
1.6
0.8
0
1%
4%
6%
-5%
-4%
-3%
-2%
-1%
0%
2%
3%
5%
Index
Index
Index
een less than or equal to the return specified.

mber of times returns were less than or equal
s a percentage.
Cumulative frequency distribution of returns

1
0.8 75%
0.6
0.4
0.2
Cumulative frequency distribution of returns
1
0.8
75%
0.6 75%
75%
0.4 75%
75%
0.2
75%
75%
0
75%
-0.2 75%
75%
-4%
-2%
-1%
1%
3%
6%
-5%
-3%
0%
2%
4%
5%
75%
Index
Index
"spread" of a distribution. Standard deviation

d variance can be calculated on "sample" or
re working with comprises all the data,
g with the sampled subset.
distribution described in cells M81:N92 below.

tal in column N - 1)]
Index
MDIST function. In the question below we use

n our actual frequency distribution. This
.
on using the mean and standard deviation we

5:O126 calculate the increments in the
f samples in cell N95 to give the predicted
Frequency of actual and normal returns

14
12
10
0
Column N
-3%
-2%
2%
3%
4%
-5%
-4%
-1%
0%
1%
5%
6%
Column P
Index
deviations above mean
on of values less than a given number of
turns will be less than one standard deviation
ns less than N standard deviations above the
ns less than N standard deviations above the mean

ns less than N standard deviations above the mean
5 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0
N
Index
viations of the mean
ns within N standard deviations from the
returns within N standard deviations of mean
0.30 0.60 0.90 1.20 1.50 1.80 2.10 2.40 2.70 3.00
N
Index
elow which a given percentage of samples occur.
of standard deviations above the mean below
ve the mean. What is N?
tandard deviations above the mean below
viations above mean below which X% of samples occur

0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
9%
viations above mean below which X% of samples occur
94.00%
98.00%
54.00%
58.00%
62.00%
66.00%
70.00%
74.00%
78.00%
82.00%
86.00%
90.00%
99.99%
X
Index
wn from a rectangular distribution. The

xample, to generate samples drawn from a
y RAND to the NORMSINV function. The
m a normal distribution that has a mean of
AND() function. That function generates

e from 0 to 1. In other words, the samples
0.2636 0.6221 0.0389 0.2515

0.5687 0.5744 0.4195 0.1504
0.9109 0.2288 0.9881 0.4921
0.6685 0.9453 0.7188 0.2208
0.7956 0.7289 0.9280 0.2045
umbers.
numbers. Use the FREQUENCY function.
0.0000 Step size: 0.000

0.0000
ency distribution of normally distributed numbers

ency distribution of normally distributed numbers
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
Interval
Ltd. All rights reserved. Index

m
1 Calculating sample variance
Variance is the square of the standard deviation. One method of calculating standard deviation is
shown in an earlier tab in this topic. Another way - which can be used if you have individual samples -
is to use the spreadsheet function STDEV.
Calculate the standard deviation and variance of the following set of samples:
0% -2% -5% -1% -3% -2% 1% 1%

0% 3% 4% -2% 3% 2% -1% 2%
5% 4% 3% -3% -1% 0% -1% 4%
1% -2% 5% -2% 0% 1% 1% 0%
2% -1% -1% -1% 0% -1% 6% 3%
3% 4% 3% 4% -1% -3% 3% 4%
1% 3% 1% 0% 1% 6% 3% 2%
1% 2% 1% 0% 5% 2% 4% 1%
2% 3% 4% 3% 2% 3% 4% 3%
-1% 1%
j Standard deviation: [%]

j Variance (square of cell J21). [%]
j Variance (using VAR function)
2 Calculating population variance
If your data encompasses the entire population you should use the STDEVP or VARP functions to
calculate the population standard deviation and variance respectively.
j Standard deviation: [%]

j Variance (square of cell J30). [%]
j Variance (using VARP function)
3 Calculating population covariance
Consider the data for three series (X,Y & Z) below. Calculate the (population) covariances between
the series by using the COVAR function.
X Y Z
1.2 3 5
1.7 3.2 4.9
2.1 3.1 5.5
2.2 3.4 7
Covariance matrix
X Y Z
g h i X
g h i Y
g h i Z
Determine the (population) standard deviations of the X, Y and Z series.
Standard deviations
X Y Z
g h i
4 Calculating population correlation
Determine the correlations between the X, Y and Z series by using the CORREL function.
Correlation matrix
X Y Z
g h i X
g h i Y
g h i Z
5 Calculating correlation matrix from covariance matrix
The correlation between x and y - correl(x,y) - is equal to covar(x,y)/(sd(x)*sd(y)) where covar(x,y) is

the covariance between x and y, and sd(x) and sd(y) are the standard deviations of x and y
respectively.
Calculate the correlation matrix below by using the covariance and standard deviation matrices above.
Correlation matrix
X Y Z
g h i X
g h i Y
g h i Z
6 Calculating covariance matrix from correlation matrix and standard deviation
The covariance between x and y - covar(x,y) - is equal to correl(x,y)*sd(x)*sd(y) where correl(x,y) is the
correlation between x and y, and sd(x) and sd(y) are the standard deviations of x and y respectively.
Calculate the covariance matrix below by using the correlation and standard deviation matrices above.
Covariance matrix
X Y Z
g h i X
g h i Y
g h i Z
7 Calculating volatility
Volatility is the standard deviation of the "log-returns" of an asset. The "log-return" r is given by r =
ln(at+1/at) where at+1 is the price of the asset at time t+1 and at is the price at time t.
Calculate the volatility of the asset whose daily prices are shown below.
Day Price Log return

1 100.0
h 2 100.7
h 3 101.2
h 4 101.1
h 5 100.5
h 6 99.9
h 7 99.9
h 8 98.7
h 9 99.5
h 10 99.1
h 11 97.9
h 12 98.8
h 13 100.1
h 14 99.4
h 15 100.4
h 16 101.2
h 17 102.4
h 18 103.1
h 19 103.4
j Standard deviation of log return: [%] <- Use STDEV
The volatility above is the daily volatility. To convert to a yearly volatility multiply by the square root of
the number of trading days in a year.
Number of trading days in year: [#] 252
j Yearly volatility [%]
8 Calculating correlation of log returns
Calculate the correlation between the log returns of the two assets below.
Asset 1 Asset 2 Asset 1 Asset 2

Day price price log return log return
1 1.1789 1.9100 Asset 1 vs Asset 2 log ret
i j 2 1.1790 1.8944
1200%
i j 3 1.1743 1.8820
i j 4 1.1632 1.8474
1000%
i j 5 1.1659 1.8406
i j 6 1.1569 1.8134 800%
i j 7 1.1520 1.8090
i j 8 1.1744 1.8620 600%
i j 9 1.1653 1.8353
i j 10 1.1626 1.8388 400%
i j 11 1.1612 1.8292
i j 12 1.1616 1.8295 200%
i j 13 1.1575 1.8064
i j 14 1.1572 1.8171 0%
i j 15 1.1567 1.8225 0% 500% 1000
i j 16 1.1584 1.8317
i j 17 1.1582 1.8391
i j 18 1.1529 1.8313
i j 19 1.1410 1.8262
i j 20 1.1384 1.8087
h Correlation: [%]
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andard deviation is
ve individual samples -
Index
VARP functions to
Index
ovariances between
Index
L function.
Index
) where covar(x,y) is
s of x and y
viation matrices above.
Index
where correl(x,y) is the

x and y respectively.
viation matrices above.
Index
urn" r is given by r =
e t.
by the square root of
Index
Asset 1 vs Asset 2 log returns
% 500% 1000% 1500%

hts reserved. Index
Interpolation involves "filling in the gaps" between discrete data points. In this section we review and
interpolation methods including two of the most used: Linear and cubic spline interpolation. We also
fitting" and at extrapolation.
1 Linear interpolation
Consider the two (x,y) data points defined in cells J12:J15. Calculate by using linear interpolation the
corresponds to the x value in cell J17. Also calculate the x value that correponds to the y value in ce
x1 1.5 Linear interpolation

x2 6
12
y1 2
y2 10 10 3 3 0
0 0 3
x value to 8
interpolate 3
6
j y at that x Y 0 0 0
4 0 7 0
y value to
interpolate 7 2
j x at that y
0
0 1 2 3 4 5 6
X
2 Cubic spline interpolation
Cubic spline interpolation fits a curve (cubic) between data points. In the method described below th
rightmost curve segments have zero curvature at the leftmost and rightmost points respectively.
Consider the table of (x,y) values shown below in cells J38:K45. Use cubic spline interpolation to fin
corresponding to the x value in cell K47.
Discrete points which will be cubic spli

1.2
Table to interpolate
i (interval) xi yi 1
1 1.00 1.00
2 1.50 0.00 0.8
3 2.00 0.50 3.25 0
4 2.50 0.80 0.6 3.25 1
5 3.00 0.50 Y
6 3.50 0.40 0.4
7 4.00 1.00
8 4.50 0.50 0.2
x value to interpolate 3.25 0

0.5 1 1.5 2 2.5 3 3.5 4
Column K
Column O X
Step 1 - Calculate "hh" - the interval between successive x values. [x values are spaced evenly - so
calculate the difference any two successive intrervals.]
Step 1 - Calculate "hh" - the interval between successive x values. [x values are spaced evenly - so
calculate the difference any two successive intrervals.]
j hh
Step 2 - Calculate which interval the interpolated x value is in
i #DIV/0! <- =FLOOR((x_to_interpolate-first_x)/hh,1)+1
Step 3 - Calculate x's offset within the interval it is in
dX #DIV/0! <- =x_to_interpolate-first_x-(i-1)*hh
Step 4 - Calculate a vector of curvatures of yi
i yi Curvaturei
1 1
2 0 #DIV/0! <- Copy and paste this formula down
k 3 0.5
k 4 0.8
k 5 0.5
k 6 0.4
k 7 1
8 0.5
Step 5 - Generate an "M" matrix.
i "M" matrix
1
2 4 1 0 0 0 0
3 1 4 1 0 0 0
4 0 1 4 0 0 0
5 0 0 1 4 0 0
j k l m n o 6
j k l m n o 7
8
Step 6 - Generate an 'M' vector in cells K95:K100 by multiplying the inverse of the 'M' matrix in J82:O
by the y curvatures in cells K69:K74.
i yi Mi
1 1 0
k 2 0
k 3 0.5
k 4 0.8
k 5 0.5
k 6 0.4
k 7 1
8 0.5
Step 7 - Calculate the interpolated y values within each interval (in the step following we will choose
only one of the intervals)
i xi yi Mi ai bi ci
1 1.0 1 0 #DIV/0! 0 #DIV/0!
m n o p 2 1.5 0 0
m n o p 3 2.0 0.5 0
m n o p 4 2.5 0.8 0
m n o p 5 3.0 0.5 0
m n o p 6 3.5 0.4 0
m n o p 7 4.0 1 0
8 4.5 0.5 0
Step 8 - Choose the interpolated y value in the interval we calculated in step 2.
Interpolated y value: #DIV/0!
Cubic spline interpolation

1.2 #DIV/0!
1 #DIV/0!
1 1.25 #DIV/0!
1.5 #DIV/0! 3.25 0
0.8 1.75 #DIV/0! 3.25 #DIV/0!
2 #DIV/0! 0 #DIV/0!
2.25 #DIV/0!
0.6
2.5 #DIV/0!
2.75 #DIV/0!
0.4 3 #DIV/0!
3.25 #DIV/0!
0.2 3.5 #DIV/0!
3.75 #DIV/0!
0 4 Column K
#DIV/0!
Column J
0 4.25 0.5 #DIV/0!
1 1.5 2 2.5 3 3.5 4 4.5 5
4.5 Column O
#DIV/0!
3 TREND function to perform linear interpolation / extrapolation
The TREND function performs a "least-squares" straight-line fit to a set of data points. Another such
function is the GROWTH function - that function performs a fit to an exponential or growth curve. Ot
types of curve can be fitted to by transforming them into straight lines, using TREND and then revers
the transformation. Examples of these techniques are covered in this and the following questions.
Consider the table of (x,y) values shown below in cells I155:J163. Use the TREND function to perfor
a straight-line fit to those points and to calculate the y values corresponding to the x values in cells I1
to I166.
x y Interpolate Linear interpolation / extrapol

k 0
k 1 1.6
k 2
k 3 0.80
k 4 0.85 1.2
k 5 0.95
k 6 1.05
k 7 1.10 0.8
0.4
Column J
1.2
0.8
k 8 1.08
k 9 1.20
k 10 1.44 0.4
k 11 1.40
k 12
k 13 Column J
0.0
k 14
0 2 4Column6K 8 10 12
4 GROWTH function to perform linear interpolation / extrapolation
The GROWTH function assumes the data points to be fitted are on an exponentially growing curve.
this question we use the same data points as in the preceding question but now we assume the
underlying function is exponential rather than linear.
Use the GROWTH function to fit an exponential curve to the (x,y) data points listed below.
Exponential interpolation / extra

x y Interpolate
k 0 1.6
k 1
k 2
k 3 0.80 1.2
k 4 0.85
k 5 0.95
k 6 1.05
0.8
k 7 1.10
k 8 1.08
k 9 1.20
k 10 1.44 0.4
k 11 1.40
k 12
k 13 0.0 Column J
k 14 0 2 4Column6K 8 10 12
5 Fitting to a logarithmic curve
You can fit points to an arbitrary underlying function by first transforming the function to a straight line
straight line interpolation function TREND and then reversing the original transformation. The questi
illustrate that technique.
Fit a natural log curve to the (x,y) data points defined in the table below.
ln(Interpol Logarithmic interpolation /

x y exp(y) Interpolate ate)
l m 0 1.6
l m 1
l m 2
k l m 3 0.80 1.2
k l m 4 0.85
k l m 5 0.95
k l m 6 1.05
0.8
k l m 7 1.10
0.4
0 Column J
1.2
0.8
k l m 8 1.08
k l m 9 1.20
k l m 10 1.44 0.4
k l m 11 1.40
l m 12
l m 13 0 Column J
l m 14 0 2 Column
4 6M 8 10 12
6 Fitting to a square-root curve
Fit a square root curve to the (x,y) data points defined in the table below.
(Interpolat Square root interpolation /

x y y2 Interpolate e)1/2
1.6
l m 0
l m 1
l m 2
k l m 3 0.80 1.2
k l m 4 0.85
k l m 5 0.95
k l m 6 1.05
0.8
k l m 7 1.10
k l m 8 1.08
k l m 9 1.20
k l m 10 1.44 0.4
k l m 11 1.40
l m 12
l m 13 0 Column J
l m 14 Column
0 2 4 6M 8 10 12
www.tykoh.com
s. In this section we review and apply various
bic spline interpolation. We also look at "curve
e by using linear interpolation the y value that

t correponds to the y value in cell J20.
ear interpolation
0
0
7
7
3 4 5 6 7 8
X
Index
the method described below the leftmost and

htmost points respectively.
e cubic spline interpolation to find the y value
oints which will be cubic spline interpolated
5 2 2.5 3 3.5 4 4.5 5

X
x values are spaced evenly - so you can

<- Continue the pattern on the
two rows below.
nverse of the 'M' matrix in J82:O87
e step following we will choose

y
#DIV/0! <- Copy and paste
these formulae down
in step 2.
4 4.5 5
Index
et of data points. Another such

exponential or growth curve. Other
s, using TREND and then reversing
s and the following questions.
se the TREND function to perform

onding to the x values in cells I152
inear interpolation / extrapolation
olumn J
olumn J
olumn6K 8 10 12 14 16
Index
n exponentially growing curve. In

on but now we assume the
a points listed below.
onential interpolation / extrapolation
olumn J
olumn6K 8 10 12 14 16
Index
ming the function to a straight line, using the

ginal transformation. The questions below
ow.
Logarithmic interpolation / extrapolation
Column J
Column J
2 Column
4 6M 8 10 12 14 16
Index
low.
Square root interpolation / extrapolation
Column J
2 Column
4 6M 8 10 12 14 16
y Ltd. All rights reserved. Index

om
A B C E F G H I J K L M N O P
1 Click here to see what your answer should look like.
2 1 Calculating asset price distribution in one period's time.
3
4 Assume that over a certain period an asset's value can change by +10% or by -10% and that each of these
5 possibilities are equally likely. The asset's current price is $100. Calculate the probability distribution of the asset's
6 price in one period's time. The table below should be ranked in decreasing order of price.
7
8 Price in
one period Probability Return
9 f g h
10 f g h
11
12 Calculate the expected or mean return over the period.
13
14 i Expected / mean return
15
16 Calculate the volatility. [Use the STDEVP function.]
17
18 i Volatility
19 Index
20 2 Calculating asset price distribution in two period's time.
21
22 With the same asset as in the preceding question - what is its price probability distribution in two period's time?
23
24 Price in
two weeks Probability
25 f g
26 f g
27 f g
28
29 What is the expected (mean, average) price in two period's time?
30
31 h Expected price
32
33 What is the modal (most likely, highest probability) price in two period's time?
34
35 h Modal price
36 Index
37 3 Calculating asset price distribution "N" periods into the future.
38
39 Consider the same asset as in the preceding question. What is its price distribution in 20 period's time? [ Use the
40 BINOMDIST function to calculate the probabilities]
41
Number of
42 "up"
moves in Price in 20
20 periods periods Probability
43
44 g h 20
Probability distribution of asset price in 20 period's time
45 g h 19
46 g h 18 12
47 g h 17
48 g h 16
10
49 g h 15
50 g h 14
51 g h 13 8
52 g h 12
53 g h 11
54 g h 10 6
55 g h 9
56 g h 8
4
57 g h 7
58 g h 6
59 g h 5 2
60 g h 4
61 g h 3
62 g h 2 0
63 g h 1 0 50 100 150 200 250 300 350 400
64 g h 0
65
66
67 What is the expected (mean, average) price in twenty period's time?
68
69 h Expected price
70
71 What is the modal (most likely, highest probability) price in two period's time?
72
73 h Modal price
74
75 What is the approximate probability that the asset's value in 20 period's time will be less than its current value? [Add
76 up the probabilities in the table above that correspond to an asset price of less than 100.]
77
78
79 h Probability:
80 Index
81 4 Calculating probability distribution of long-term return.
82
83 Define the long-term return over "N" periods as being the percentage change in asset price over that interval.
84 Calculate the probability distribution of the long-term return of the asset above.
85
Number of
86 "up"
moves in Price in 20 Long-term
20 periods periods return [%] Probability
87
88 g h i 20
Probability distribution of long-term return
89 g h i 19
90 g h i 18 12
91 g h i 17
92 g h i 16
10
93 g h i 15
94 g h i 14
95 g h i 13 8
96 g h i 12
97 g h i 11
98 g h i 10 6
99 g h i 9
100 g h i 8 4
101 g h i 7
102 g h i 6
103 g h i 5 2
104 g h i 4
105 g h i 3
106 g h i 2 0
107 g h i 1 -0.9 -0.4 0.1 0.6 1.1 1.6 2.1 2.6
108 g h i 0
109
110
111 What is the expected long-term return?
112
113 i Expected long-term return:
114 Index
115 5 Calculating probability distribution of logarithm of asset price in "N" period's time.
116
117 The distribution above is log-normal (as long as time intervals are relatively short). We can confirm the log-normal
118 nature of the distribution by charting the distribution of the logarithm of the asset price: It should be normal.
119
120 In the table below calculate the natural log of the asset price and the probability of that occuring.
121
Number of
122 "up" Ln of price
moves in in 20
20 periods periods Probability
123
124 g h 20
Probability distribution of natural log of asset price in 20 period's time
125 g h 19
126 g h 18 12
127 g h 17
128 g h 16
10
129 g h 15
130 g h 14
131 g h 13 8
132 g h 12
133 g h 11
134 g h 10 6
135 g h 9
136 g h 8
4
137 g h 7
138 g h 6
139 g h 5 2
140 g h 4
141 g h 3
142 g h 2 0
143 g h 1 2.4 2.9 3.4 3.9 4.4 4.9 5.4 5.9 6.4
144 g h 0
145
146 Index
147 6 Calculating distribution of compound average growth rates over "N" periods.
148
Number of
149 "up"
moves in Price in 20 Weekly CAGR
20 periods periods Probability [%]
150
151 g h i 20
Probability distribution of CAGR over 20 periods
152 g h i 19
153 g h i 18 975%
910%
845%
780%
715%
650%
585%
520%
455%
390%
Probability distribution of CAGR over 20 periods
A B C E F G H I 975%J K L M N O P
154 g h i 17 910%
155 g h i 16 845%
156 g h i 15 780%
157 g h i 14 715%
158 g h i 13 650%
159 g h i 12 585%
160 g h i 11 520%
161 g h i 10 455%
162 g h i 9 390%
163 g h i 8 325%
164 g h i 7
260%
165 g h i 6
195%
166 g h i 5
130%
167 g h i 4
g h i 3 65%
168
169 g h i 2 0%
170 g h i 1 -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
171 g h i 0
172
173
174 i Expected / mean CAGR
175
176 Why, when the expected weekly return is zero, is the expected compound average growth rate less than zero?
177
178
179 A. Because the analysis above is only approximate and needs more time steps to be accurate.
180 B. Because the expected weekly return is an arithmetic mean and the CAGR is geometric.
181 C. Because the 50% up / 50% down probability assumption is unrealistic.
182 D. Because the CAGR assumes a normal distribution of asset prices.
183
184 g Answer:
185 Index
186 7 Matching volatility and growth rate when evolving an asset's price.
187
188 Up till now we have assumed the asset's up and down moves in each time step are +/- 10%. If we want to match a
189 particular growth rate and volatility then we need to calculate the up and down moves. There are various ways of
190 doing this. One is illustrated below.
191
192 An asset has a yearly return volatility of 30%. Its growth rate is 20% p.a. (continuously compounding). Its current
193 price is 100. What is its expected price in one month's time?
194
195 i Expected price in one month:
196
197 Assume that in each month the asset can change in price from S to S*u or to S*d. Each possibility is equally likely.
198 u and d are defined this way:
199
200 u = egt + σ(δt)1/2

201 d = egt - σ(δt)1/2
202
203 g is the growth rate, δt is the time interval (one month i.e. 1/12 years) and σ is the volatility.
204
205 Calculate the "u" (up) and "d" (down) factors.
206
207 g u factor
208 g d factor
209
210 Determine the asset price in one month if the current asset price (100) is multiplied by the u (up) or d (down) factors.
211
212
213 Price in one

month. Probability
214 h i "up" price
215 h i "down" price
216
217 Find the expected price (i.e. the mean or average) in one month's time.
218
219 k Expected price (mean of "up" and "down" prices):
220
221 Find the growth rate (p.a.) that is implied by having an asset price now of 100 and an asset price in one month of
222 that shown in cell K219.
223
224 k Growth rate implied by expected price:
225
226 You should find that the implied growth rate in cell K224 matches the asset's assumed growth rate of 20%.
227
228
229 Find the one-month returns implied by the asset prices in cells H214:H215.
230
231 k One-month return implied by asset's "up" price in one month.
232 k One-month return implied by asset's "down" price in one month.
233
234 Find the yearly volatility implied by the returns in cells K231:K232.
235
Yearly volatiliy implied by the one month returns in cells
236
k K231:K232.
237
238 You should find that the volatility in cell K236 matches the asset's known volatility of 30%.
239
240 We have confirmed that our "up" and "down" factors generate an expected return and volatility that matches the
241 asset's assumed values.
242
243 Calculate the probability distribution of the asset's price in one year.
244
Number of
245 "up"
moves in Price in one
one year. year. Probability
246
247 g h 12 Probability distribution of asset price in one year.
248 g h 11
249 g h 10 950%
250 g h 9 855%
251 g h 8 760%
252 g h 7 665%
253 g h 6 570%
254 g h 5 475%
255 g h 4 380%
256 g h 3 285%
257 g h 2 190%
258 g h 1 95%
259 g h 0 0%
260 0 2 4 6 8 10 12
261
262 Index
263 8 Calculating asset price distribution by using continuous log-normal distribution.
264
265 We can save ourselves some work in calculating the future asset price if we know or assume that short-term asset
266 returns are normally distributed (as they have been on this worksheet). In this case the log of the future asset price
267 is normally distributed. The mean and standard deviation of the natural logarithm of the future asset price is given by
268 the following formulae:
269
270 µ = ln(S) + (g-σ2/2)T

271 sd = σ * T1/2
272
273
where µ is the mean of the log distribution, sd is its standard deviation, g is the continuously compounding short-
274
275 term growth rate of the asset, σ is the asset's yearly return volatility and T is the time (in years) at which we are
276 calcuating the asset price distribution.
277
278 We'll calculate the distribution of asset prices for the case we considered above.
279
280 Calculate the mean µ and standard deviation sd of the log of future asset prices using the two formulae above.
281
282 g Mean
283 g sd
284
285 In the table below the asset price column contains asset prices that are "evenly" spaced: Each asset price is a fixed
286 multiple of the asset price below it. [In this case the "even" spacing is in a geometrical rather than arithmetic sense.]
287
288
289 i) In cells G300:G313 calculate the natural logs of the asset prices that are in the column to the left.
290 ii) Cells H300:H313 are the same as the cells to the left except they are 'shifted' by half a division. So, for example,
291 cell H300 contains a number that is midway between the numbers in cells G300 and G301.
292 iii) In cells I300:I313 calculate the probability that the log of the asset price in one year's time will be less than or
293 equal to the log of the asset price in column H. To do this you will need to use a function that calculates cumulative
294 normal distributions.
295 iv) In cells J300:J313 calculate the difference between successive cumulative normal probabilities. This will
296 determine the probability that a future asset price will fall into the corresponding interval.
297
Difference Probability distribution of asset price in one year.
between 990%
298 successive 945%
Cumulative cumulative 900%
Asset ln(Asset Shifted by normal normal 855%
810%
price price) 1/2 division probability probabilities
765%
299 720%
300 g i 386.36 -0.08538 675%
301 g i j 325.71 -0.08538 630%
585%
302 g i j 274.59 -0.08538 540%
303 g i j 231.48 -0.08538 495%
304 g i j 195.15 -0.08538 450%
405%
305 g i j 164.51 -0.08538 360%
306 g i j 138.69 -0.08538 315%
307 g i j 116.92 -0.08538 270%
225%
180%
135%
90%
45%
Column H
0%
Column
0 J50 100 150 200 250 300 350
810%
765%
720%
675%
630%
585%
540%
495%
450%
405%
360%
315%
A B C E F G H I J 270% K L M N O P
225%
308 g i j 98.57 -0.08538 180%
309 g i j 83.09 -0.08538 135%
310 g i j 70.05 -0.08538 90%
45%
311 g i j 59.05 -0.08538 Column H
0%
312 g i j 49.78 -0.08538 Column
0 J50 100 150 200 250 300 350
313 g i j 41.97 -0.08538
314
315 Index
316 9 Calculating confidence intervals on an asset's future price.
317
318 An asset has a spot price of $80, an expected yearly return of 8%, and a volatility of 25%. Within a confidence level
319 of 99.0% - what is the lowest value the asset's price be in 0.5 years.?
320
321 Spot price [S] [$] 80
322 Expected return [µ] [%] 8%
323 Volatility [σ] [%] 25%
324
325 Future time [T] [yrs] 0.5
326 Confidence level [p] [%] 99.0%
327
328 j Mean of ln(ST) = ln(S) + (µ - σ2/2)*T
329 j Standard deviation of ln(ST) = σ*T1/2
330
331 k 99.0% confidence limit on lowest value of ln(ST)
332 k 99.0% confidence limit on lowest value of ST
333
334 Continuing with the example above: Within a confidence level of 99% - below what value will the asset be in 0.5
335 years?
336
337 j With 99.0% confidence asset will be below:
338
339 Continuing with the example above: Within a confidence level of 99% - between which values will the asset be in 0.5
340 years? [Assume that the 1.0% of values ourside the 99.0% limit are equally distributed above the upper confidence
341 value and below the lower confidence value.]
342
343 j Between this upper value:
344 j And this lower value:
345 Index
346 10 Calculating confidence intervals on an asset's future price (alternate formula)
347
348 Spot price [S] [$] 80
349 Expected return [µ] [%] 8%
350 Volatility [σ] [%] 25%
351
352 Future time [T] [yrs] 0.5
353 Number sd's [#] 2.576
354 Confidence level [p] [%] 99.0%
355
356 h Upper limit
357 h Lower limit
358
359
360 Copyright (c) 2010 Tykoh Group Pty Ltd. All rights reserved. Index
361 www.tykoh.com
1 Calculating return of a portfolio of assets
A set of assets comprises a portfolio. The returns of each asset together with their portfolio weights
are shown below. Find the portfolio return.
Portfolio
Asset Return weight
#1 6% 20%
#2 10% 25%
#3 11% 55%
f Portfolio return
2 Calculating volatility of a portfolio of assets
A set of assets comprises a portfolio. The asset covariance matrix is shown below together with each
asset's portfolio weights. Find the portfolio volatility.
Variance / covariance matrix

Portfolio
Asset #1 #2 #3 weight
#1 0.010 0.006 0.006 20%
#2 0.006 0.090 0.024 25%
#3 0.006 0.024 0.040 55%
f Portfolio volatility
www.tykoh.com
Index
Index
1 Portfolio of put / call options to achieve this expiry payoff profile: \/
The expiry payoff profile is a chart showing the value of an option at expiry as a function of spot. How many put a
call options are needed to achieve the following expiry payoff profile?
Expiry payoff as a function of spot

12
10
8
6
4
Spot Payoff
2 90 10
100 0
0 110 10
90 95 100 105 110
You can use the option analyser below to answer this and other questions. To generate an option's expiry profile
the option analyser set the expiry (which is in years) to a low number like 0.001.
Number of put and/or call options needed:
Number Type Strike

h i j
h i j
Option analyser
Spot 100 Interest rate 5.0%
Type Strike Barrier Rebate Expiry Num. Prem.

Put [1] ,strike = 110,
Putexpiry = 1 110 1 1.00 14.66
Call [0.66] ,strike =
Call
100, expiry = 1 100 1 0.66 9.39
, barrierCall
= 150,
up rebate
and out=[5]Call
,strike
up and
= 80,out
barrier = 150,
80 rebate
150 = , expiry = 1 1 5.00 69.75
n/a Call 120 1 0.00 0.00
n/a Total 93.80
Premium .. as a function of .. Spot
90.00
80.00 TRUE
TRUE 100 1
70.00
TRUE
60.00 FALSE
Spot
50.00 FALSE Volatility
Time
40.00
30.00
expiry = 1
20.00
Call [0.66] ,strike = 100,
expiry = 1
10.00
Call up and out [5] ,strike
= 80, barrier = 150,
70.00
60.00
50.00
40.00
30.00
expiry = 1
20.00
Call [0.66] ,strike = 100,
expiry = 1
10.00
Call up and out [5] ,strike
= 80, barrier = 150,
0.00
rebate = , expiry = 1
0 20 40 60 80 100 120 140 160 180 200
n/a
n/a Spot
2 Portfolio of put / call options to achieve this expiry payoff profile: \_/
How many put and/or call options are needed to achieve the following expiry payoff profile?

12
Spot Payoff
10 90 10
100 0
8
110 0
6 120 10
4
2
0
90 95 100 105 110 115 120
Number Type Strike

h i j
h i j
3 Portfolio of put / call options to achieve this expiry payoff profile: /-/

90 -20
30
100 0
20 110 0
120 20
10
0
-10
-20
-30
90 95 100 105 110 115 120
0
-10
-20
-30
90 95 100 105 110 115 120
Number Type Strike

h i j
h i j
4 Portfolio of put / call options to achieve this expiry payoff profile: __/'''''''

90 0
12
100 0
10 110 10
120 10
8
6
4
2
0
90 95 100 105 110 115 120
Number Type Strike

h i j
h i j
6 P/L of unhedged put option held to expiry
For this and the following questions assume the interest rate and asset yield are both zero. Assume volatility is 3
and that the spot price one year prior to expiry is 100.
A put option with strike 100 is purchased one year before expiry. The option is held to expiry. Calculate the expi
payoff and overall profit / loss as a function of the spot price at expiry.
Spot price at Profit /

expiry Payoff Loss
i j 80
i j 90
i j 100
i j 110
Expiry payoff and P/L as function of spot at expiry

12
10
8
6
4
2
0 Column I
12
10
8
6
4
2
0 Column I
80 85 J
Column 90 95 100 105 110
7 P/L of unhedged put spread held to expiry
A put spread is constructed by purchasing a put option with strike 100 and selling a put option with strike 110. Th
options are held to expiry. Calculate the expiry payoff and overall profit / loss as a function of the spot price at ex
Spot price at Profit /

expiry Payoff Loss
i j 75
i j 85
i j 95
i j 105
i j 115

12
10
8
6
4
2
0 Column I
75 Column
80 J
85 90 95 100 105 110 115
8 Intrinsic, time and total value of an option - as a function of strike
The intrinsic value of an option is the option's payoff if exercised. The time value of the option is the difference
between the intrinsic value and the total value. Find the intrinsic, time and total values for the options listed below
this and the following questions assume the spot price is 100, volatility is 30% and the interest rate and asset yie
zero.
Time to
expiry Time Total
Option type Strike [yrs] Intrinsic value value value
k m n Call 90 1
k m n Call 95 1
k m n Call 100 1
k m n Call 105 1
k m n Call 110 1
Which option has the greatest time value? ITM (in-the-money), ATM (at-the-money), O
(out-of-the-money)?
l Option with greatest time value is:
Call option - time value and intrinsic value as function of strike

15
10
0
90 M
Column 95 100 105 110
Column K Strike
9 Intrinsic, time and total value of an option - as a function of time to expiry
Find the intrinsic, time and total values for the options listed below.
Time to
expiry Time Total
Option type Strike [yrs] Intrinsic value value value
k m n Call 95 0.01
k m n Call 95 0.21
k m n Call 95 0.41
k m n Call 95 0.61
k m n Call 95 0.81
Call option - time value and intrinsic value as function of time to expiry
15
10
0
15
10
0
0.81 0.61 0.41 0.21 0.01
Column M
Column K Years to expiry
10 Rate of time decay of an option as a function of time to expiry.
The theta of an option measures how quickly the option's value changes as time passes. The value of the option
above diminishes as the option approaches expiry. Using linear interpolation calculate the rate at which the optio
value is decreasing at the following time-to-expiries. (The thetas you calculate should be negative numbers.)
Daily theta: Rate at

Time to expiry which option value
[yrs] reduces [$/day].
j 0.1
j 0.3
j 0.5
j 0.7
Daily theta of option as a function of years to expiry

12
10
8
6
4
2
0
0.7 0.5 0.3 0.1
www.tykoh.com
function of spot. How many put and/or
ot
05 110
generate an option's expiry profile in
analyser
Asset yield 0.0% Volatility 30.0%
Delta Gamma Theta Vega Rho Show

-0.50 0.01 -2.75 39.89 -64.70 yes
0.41 0.01 -5.35 25.04 31.81 yes
0.48 -0.10 45.29 -311.16 28.45 yes
0.00 0.00 0.00 0.00 0.00 no
0.39 -0.08 37.20 -246.22 -4.44 no
Call
Put
2 3 4 Asset
Cash
Call Digital
Put Digital
Call up and out
Put up and out
Call up and in
Put up and in
Call down and out
Put down and out
Call down and in
Put down and in
20 140 160 180 200
ot
115 120
Index
ot
115 120
115 120
Index
ot
115 120
Index
both zero. Assume volatility is 30%
held to expiry. Calculate the expiry
t at expiry
t at expiry
110
Index
g a put option with strike 110. The

a function of the spot price at expiry.
t at expiry
115
Index
e of the option is the difference

values for the options listed below. For
nd the interest rate and asset yield are
-money), ATM (at-the-money), OTM
unction of strike
Index
ion of time to expiry

15
10
0
15
10
Index
e passes. The value of the option

culate the rate at which the option's
hould be negative numbers.)
s to expiry
12
10
8
6
4
2
0
0.1
up Pty Ltd. All rights reserved. Index

koh.com
1 Determining arbitrage in a foreign exchange market
Consider the following foreign exchange rates
Bid Ask
AUD/USD 0.91 0.91
GBP/USD 1.53 1.54
AUD/GBP 0.59 0.59
You start with $1m AUD. Determine whether a set of fx transactions can deliver an immediate arbitrage
profit in this market. If so, how much is the profit?
Net profit /
Start with Convert to Convert to Convert to (loss)
AUD GBP USD AUD
j k l m 1,000,000
AUD USD GBP AUD

j k l m 1,000,000
l Is there an arbitrage opportunity?
l If so, how much is the profit?
2 Determining arbitrage in a fixed interest market.
Consider the following interest rates.

Bid Ask
30 day bank bill rate: 4.350% 4.390%
60 day bank bill rate: 4.360% 4.400%
Forward 1mth to 2mth rate: 4.254% 4.294%
All of the rates above are simple interest rates. Use 30 / 365 day count convention (i.e. each month is 3
days and a year has 365 days).
Determine the profit or loss in carrying out the following transactions
Opening Cash flow

Time Transaction cash [$] [$]
o p Now Sell 60 day bill for $1m 0
n o p Now Buy 30 day bill for $1m
Enter into fwd agreement to buy
Now 30 day bill in 30 days time @ fwd
bid rate. Purchase price will be
n o p face value of 30 day bill.
Receive face value of matured 30
n o p 30 days day bill
n o p 30 days Buy 30 day bill at agreed fwd rate
Receive face value of matured 30
n o p 60 days day bill
n o p 60 days Pay face value of 60 day bill
Determine the profit or loss in carrying out the following transactions
Opening Cash flow

o p Now Buy 60 day bill for $1m 0

n o p Now Sell 30 day bill for $1m
Enter into fwd agreement to sell
Now 30 day bill in 30 days time @ fwd
ask rate. Sale price will be face
n o p value of 30 day bill.
Pay face value of matured 30 day
n o p 30 days bill
n o p 30 days Sell 30 day bill at agreed fwd rate
Pay face value of matured 30 day
n o p 60 days bill
n o p 60 days Receive face value of 60 day bill
l If so, what is its present value?
3 Determining arbitrage in a forward market on a yield-bearing asset.
A asset's spot price is $50. The asset provides a yield of 2%. You can enter into a forward
agreement today at zero cost to purchase the asset in six month's time for $50.5. Alternatively
you can enter into a forward agreement today at zero cost to sell the asset in six month's time for
$50.5.You can borrow or lend for six months at 5%. Determine whether an arbitrage exists and,
if so, its present value.
Make the following assumptions: You can take a $1m position in the asset. Interest rates and
yields are continuously compounding. If you hold the asset and borrow funds the asset yield is
deposited into the loan account. If you sell the asset short and lend funds the interest you earn
on the loan is reduced by the yield the asset must pay its holder.
Opening Cash flow

o p q Now Borrow $1m 0
Buy assets and offset loan interest

n o p q Now with asset's yield for next 6 mnths
Enter into forward agreement to
Now sell asset at $51 in six month's
n o p q time.
Six
n o p q months Pay back loan.
Six
n o p q months Sell asset at agreed forward price
n Present value of profit / (loss)
Opening Cash flow

o p q Now Borrow assets 0

n o p q Now Sell assets short
Lend proceeds from asset sale for
Now six months & pay yield to asset
n o p q lender over next 6 mnths
Enter into forward agreement to
Now buy asset at $51 in six month's
n o p q time.
Six Loan matures. Receive principal
n o p q months + interest
Six
n o p q months Buy asset at agreed forward price
n Present value of profit / (loss)
4 Determining arbitrage in an options market.
A European call option with strike 100 is trading at $9.60. A European put option with the same
strike is trading at $3.56. Both options expire in three months. The underlying asset's spot price
is $105. The asset pays no yield. The interest rate to expiry is 4.0%. The interest rate and yield
are continuously compounding.
Determine if an arbitrage opportunity exists and, if so, what is its present value?
Opening Cash flow Closing Put options

Time Transaction cash [$] [$] cash [$] held [#]
l m n o p q Now Buy put option

l m n o p q Now Sell call option
l m n o p q Now Buy underlying asset
Take out loan to set
l m n o p q Now closing cash to zero
Case a) - Call option is ITM at expiry
Call option holder pays

l m n o p q At expiry us strike
l m n o p q At expiry We deliver asset
l m n o p q At expiry Pay back loan
Case a) - Put option is ITM at expiry
Exercise put and sell

At expiry
l m n o p q asset at strike
l m n o p q At expiry Pay back loan
www.tykoh.com
n deliver an immediate arbitrage
Index
convention (i.e. each month is 30
Closing
cash [$]
Closing
cash [$]
Index
nter into a forward

or $50.5. Alternatively
set in six month's time for
an arbitrage exists and,
et. Interest rates and

funds the asset yield is
ds the interest you earn
Closing Assets
cash [$] held [#]
Closing Assets
cash [$] held [#]
Index
ut option with the same

erlying asset's spot price
he interest rate and yield
Call options Assets

held [#] held [#]
s reserved. Index
1 Tailored profile to achieve a future goal.
An account earns 7% interest p.a. Interest is paid yearly and is based on the account balance at the
start of the year. Interest is paid on the last day of the year. Deposits are made yearly into the
account. The account balance is initially zero. At the end of four years the account balance is
required to be 1,000,000.
Let "D" represent the total amount deposited into the account over the four years. In the first year
10% of D is to be deposited, in the second year 20%, in the third 30% and in the last 40%. Find "D"
and show the yearly deposits, account balances and interest earnings.
Interest rate [%] 7%

Final balance [$ 000's] 1,000
Year [yr] 1 2 3 4
Deposit profile [%] 10% 20% 30% 40%
Year [yr] 1 2 3 4
j k l m Opening balance [$ 000's]
j k l m Deposit [$ 000's]
j k l m Interest earned [$ 000's]
j k l m Closing balance [$ 000's]
j "D" [$ 000's]
2 Calculating value at risk on a portfolio of assets.
Consider the portfolio of three assets described below. To the confidence level specified in cell J51
find the value at risk over the term specified in cell J52.
Asset number
#1 #2 #3
Mean return [%] 12% 8% 16%
Portfolio weight [%] 20% 30% 50%
Volatility [%] 15% 30% 20%
Asset correlations
#1 #2 #3
#1 100% 30% 40%
#2 30% 100% 50%
#3 40% 50% 100%
Portfolio value [$ 000's] 1,000

Confidence level [%] 99%
Term [yrs] 0.5
j Value at risk [$ 000's]

0.00 of correlation b
Value at risk as a function
1 -40% 0
0.9-30.0% 0
0.8-20.0% 0
0.7-10.0% 0
0.6 0.0% 0
0.5 10.0% 0
0.4
20.0% 0
0.3
0.2 30.0% 0
0.1 40.0% 0
0 50.0% 0
60.0%
-30.0% -10.0%0 10.0% 30.0%
-40%
70.0%-20.0% 0.0%
0 20.0% 4
0.00
Value at risk as a function of asset #3 volatility Value at risk as a function of a
5% 0.0
1.0 1.00
10% 0.0
0.9 0.90
0.8 15% 0.0 0.80
0.7 20% 0.0 0.70
0.6 25% 0.0 0.60
0.5 30% 0.0 0.50
0.4 35% 0.0 0.40
0.3 40% 0.0 0.30
0.2 45% 0.0 0.20
0.1 50% 0.0 0.10
0.0 55% 0.0 0.00
10% 20% 60% 30% 0.0 40% 50% 60% -15% -5% 5% 15%
5% 15% 65%25% 35% 0.0 45% 55% 65% -20% -10% 0% 10%
3 Interpolation using cubic spline.
Consider the table of interest rates below. Use both cubic spline and linear interpolation to calculate the in
rate for 1.75 years. Also calculate the number of basis points between the cubic spline and linear interpola
values.
Table to interpolate
i (interval) xi yi Interest rate as function of time (years)
0 0.5 4.41% 1.75
4.90% 4.30% 0 0.00%
1 1 4.67% 1.75 0.00% 1.75 0.00%
2 1.5 4.80% 4.80%
3 2 4.83% 0.00%
4.70% 0.5 #NAME?
x value to interpolate 1.75 0.7 #NAME?
4.60% 0.9 #NAME?
i y value (Cubic spline) 1.1 #NAME?
i y value (linear) 4.50% 1.3 #NAME?
1.5 #NAME?
i Number basis pts 4.40% 1.7 #NAME?
1.9 #NAME?
4.30% 2 #NAME?
0 0.5 1 1.5 2
4 Attributing profit/loss drivers on an option position
At time T1 a European call option's parameters (spot, volatility, etc) are initially as shown in cells J129:N12
below. At a later time T2 the option's parameters have changed to those shown in cells J130:N130. The o
value at T2 will be different to its value at T1.
Part of the change in value will be because the spot price has changed, part because volatility has change
so on. Calculate the contributions of the individual parameter changes to the overall change in option valu
Strike 100
Time to
Spot Vol Rfr Yield expiry [yrs]
Parameter number 1 2 3 4 5
Value at T1 100 30.0% 4.50% 1.50% 1
Value at T2 100.5 29.7% 4.60% 1.40% 0.98
Index Spot Vol Rfr Yield Time

o Original 0 100 30.0% 4.50% 1.50% 1
o Spot changes [1] 1 100.5 30.0% 4.50% 1.50% 1
o Vol changes [2] 2 100.5 29.7% 4.50% 1.50% 1
o Rfr changes [3] 3 100.5 29.7% 4.60% 1.50% 1
o Yield changes [4] 4 100.5 29.7% 4.60% 1.40% 1
o Time changes [5] 5 100.5 29.7% 4.60% 1.40% 0.98
Final
Chart data
Attribution of change in option value to option's
Base Height
0.000 0 23.5
0.000 0.000
0.000 0.000 21.5
0.000 0.000
0.000 0.000 19.5
0.000 0.000
0.000 0 17.5
15.5
13.5
11.5
Original
Rfr changes [3]

Spot changes [1]
Vol changes [2]
Yield changes [4]

11.5
Original
Vol changes [2]
Rfr changes [3]

Spot changes [1]
Yield changes [4]

5 Using matrices to solve a problem with several constraints
Options A, B and C have deltas and thetas as shown in the table below:
Option Delta Theta

A -0.50 -2.75
B 0.62 -8.10
C 0.10 9.06
You hold one option A contract. How many contracts of options B and C should you hold so that the overa
and theta is zero? Assume you can hold fractional contracts.
Option Number
h A
h B
h C
www.tykoh.com
ccount balance at the
e yearly into the
count balance is
ars. In the first year

he last 40%. Find "D"
Index
l specified in cell J51

0.00 asset #1 and #3
s a function of correlation between
-20% 0.00
-15% 0.00
-10% 0.00
-5% 0.00
0% 0.00
5% 0.00
10% 0.00
15% 0.00
20% 0.00
25% 0.00
0% -10.0% 10.0%30%30.0% 0.00
50.0% 70.0%
-20.0% 0.0% 20.0%
35% 40.0%0.00 60.0%
at risk as a function of asset #3 return
15% -5% 5% 15% 25% 35%

-10% 0% 10% 20% 30%
Index
erpolation to calculate the interest

c spline and linear interpolated
ction of time (years)
1.5 2 2.5
Index
as shown in cells J129:N129

n in cells J130:N130. The option's
ecause volatility has changed, and

verall change in option value.
Option
value
option value to option's parameters

Final
Rfr changes [3]
Vol changes [2]
Yield changes [4]
Time changes [5]

Vol changes [2]
Rfr changes [3]
Yield changes [4]
Time changes [5]
d you hold so that the overall delta

Final
Index

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Applied Financial Mathematics [v1.

an has zero growth.

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swered correctly. On that page markers

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h Calculate 1.2 to the power of 3.4 [=1.2^3.4] <- "A"

2 Showing that a^m / a^n = a^(m-n)

h Calculate 3.4 to the power of 5.6 <- "A"

3 Showing that x^0 = 1 for all x not zero

Calculate "x" to the power of 0

4 Showing that a^(-m) = 1/(a^m)

h Calculate 2.3 to the power of 1.5 <- "A"

"B" and "C" should be the same i.e. 2.3-1.5 = 1/2.31.5

5 Showing that (a^m)^n = a^(m*n)

h Calculate 1.2 to the power of 3.4 <- "A"

"B" and "C" should be the same i.e. (1.23.4)5.6 = 1.2(3.4*5.6)

6 Used in annual compounding

i Compounded value in four years:

i Compounded value in four and a half years:

7 Determining interest rate to double investment in ten years

What interest rate (semi-annual compounding) is required to double an investment in ten

8 Compounding value vs compounding frequency

Continuous compounding formulae usually contain "e" - which is approximately 2.71828.

g Calculate 1.2^3.4 <- "A"