Brian Lam 09/06/2016

ACTL2111: Financial Mathematics

1 TIME VALUE OF MONEY AND VALUATION OF CASH FLOWS

1.1 Cash Flow Mo dels

A cash ow is a series of payments over a period of time. A cash ow model projects the payments.
Cash ows depends on nature (inow /outow ), amount, timing and probability.
Cash ows can only be compared if their values are calculated for the same point of time.

1.2 A Mathematical Mo del of Interest

Interest embodies time preference of agents (impatience), risk (risk premium) and ination.
The accumulation function a (t) is the accumulated value at time t for $1 at time 0.
The function represents the way money accumulates with the passage the time. I.e.
a (t + k)
A (t + k) = A (t) .
a (t)

1.2.1 HOMOGENEITY IN TIME AND EFFECTIVE RATE OF INTEREST

The eective rate of interest is given by:

A (t + k) A (t)
it,k =
A (t)

Homogeneity in time is when the eective rate of interest is the same for all t.
In this case it,k = a (k) 1, i.e. it is irrespective of t.
We have dierent ways of expressing interest rates, each way with a dierent set of assumptions.

1.2.2 SIMPLE AND COMPOUND INTEREST

Simple interest: no interest is ever earnt on interest. Interest only depends on initial principal.
It is NOT homogeneous in time, with:

a (t) = 1 + it

Here, eective rate of interest is decreasing (A (t) is increasing in the above formula).
Compound interest: interest is continuously earnt on interest.
It IS homogeneous in time, with:

a (t) = (1 + i)t

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1.2.3 DISCOUNT INTEREST

The normal rate of interest i applies to principal now for interest calculated at t = 1.
The discount rate d applies to principal at the end of period for interest calculated at t = 0. In
other words, we consider the end-of-period amount to nd the current amount.

ia (0) = da (1)

1
1+i=
1d

d = iv

v =1d
 t
1 1
For simple interest: a (t) = a (0) . For compound interest: a (t) = a (0) .
1 dt 1d

1.2.4 NOMINAL INTEREST

Nominal interest rates, i(m) , have several (m) compounding periods per year.
 m
i(m)
1+i= 1+
m

Nominal discount rates, d(m) , similarly, has m compounding periods per year.
 m
d(m)
1d= 1
m

1.2.5 FORCE OF INTEREST

The continuously compounded interest rate or force of interest is = lim j (m) .

m

This is a nominal interest rate, where the compounding frequency is increased to innity.
()
Similarly, we have a force of discount, d() , where 1 d = ed .
But force of interest = force of discount, i.e. i() = d() = , so:

= ln (1 + j) = ln (1 d)

Recall j is the equivalent annual eective interest rate and d is the discount rate.

For non-constant force of interest (non-homogeneous):

 t 
a (t) = exp (s) ds
0

d
(t) = ln a (t)
dt

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1.2.6 REAL AND MONEY INTEREST

Ination/Deation is characterised by rising/falling prices or value of money.

Commonly measured by change in Consumer Price Index (CPI) annual rate of change in a
specied basket of consumer items.
Let i be money interest rate, r be real interest rate and be the ination rate:

1+i
1+r =
1+

Note: this holds only for eective rates!

To include ination in calculations, we either:

Consider the nominal value and discount with the money interest rate, or;
Consider the real value, and discount with the real interest rate.

1.2.7 SOLVING FOR INTEREST: NEWTON-RAPHSON METHOD

f (in )
in+1 = in
f  (in )

where f (i) is the equation relating present values and cash ows.

1.3 Annuities

We have symbol for annuities:

(p)
m| ax:n i

where a represents present value (where an s in place represents accumulated value);

n| represents the length of annuity in time unit;
(p) represents the number of payments per time unit;
Double dots represents in advance, whereas a bar represents continuously, otherwise
(nothing) represents in arrears;
m| represents that the annuity is deferred by m time units;
x represents contingency (the age of life at time 0 );
i represents interest rate.

1.3.1 PERPETUITY

A perpetuity has present value:

1
a =
i
i
Note: replace i with d for a perpetuity due. Recall d = .
1+i
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1.3.2 TERM ANNUITIES

A term annuity (immediate) has present value:

1
an = (1 v n )
i
Similarly, replace i with d for annuity due.
The accumulated value for a term annuity is:
(1 + i)n (1 + i)n 1
sn = (1 v n ) =
i i
For an annuity deferred by m years, the present value would be m| an = v m an .
1
For annuities with p payments of within a time unit, then replace i by i(p) :
p
(p) 1
an = (p)
(1 v n )
i

1.3.3 NON-LEVEL ANNUITIES

For annuities increasing in an arithmetic progression:

an nv n
(Ia)n = an a v n na =
i
Similarly, replace i with d for payments in advance; or i(p) for p (constant) payments per time unit.
For annuities increasing in an geometric progression, growing at rate g:
   
1 1+g n
1
ig 1+i

For annuities decreasing in an arithmetic progression:

n an
(Da)n = na an a =
i
Similarly, replace i with d for payments in advance; or i(p) for p (constant) payments per time unit.

1.3.4 CONTINUOUS ANNUITY

  t 
Recall that v (t) = exp (s) ds . Present value for a continuous annuity (starting at t-0 ):
0
 n   t 
an = exp (s) ds dt
0 0

For an increasing continuous annuity (with discrete increments), starting at t-0 :

an nen
(Ia)n = an a v n na =

That is, replace i by . Also note that v n = en .
For an increasing continuous annuity (that is continuously increasing ), starting at t-0 :
 n

an nen

Ia n = tet dt = an a v n na =
0

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2 VALUATION OF CONTINGENT CASH FLOWS

2.1 History of Life Insurance Mathematics

Simon Stevin, a Dutch mathematician, developed the rst compound interest tables.
Blaise Pascal, a French mathematician and philosopher, gives birth to probability calculus.
Edmund Halley, a British mathematician and astronomer, builds the rst mortality table.
James Dodson, a British mathematician, was the rst to put all components together. In a 1756
lecture, he showed how:
a life insurance plan should be set up;
premium rates should be calculated;
reserves would build up.

2.2 A Continuous Mo del for Survival Analysis

Let Z be a continuous random variable that denotes the age-at-death, and (x) a life aged x.
The CDF of Z is FZ (x) = Pr (Z x) . That is, probability of the life dying before or at age x.
The survival function for a new-born is denoted as S (x) = Pr (Z > x) = 1 FZ (x). That is, the
probability that the new-born will survive until at least age x.
Future lifetime of a life aged x is denoted by T (x) = Z x. Its CDF is:

S (x) S (x + t) S (x + t)
FT (t) = t qx = =1
S (x) S (x)

t|u qx = Pr ((x) surviving next t years, and then dying in the next u years) = Pr (t < T (x) t + u)
S (x + t) S (x + t + u)
= = t+u qx t qx
S (x)

2.2.1 FORCE OF MORTALITY

The hazard rate is also known as the failure rate function or force of mortality. It represents
the likelihood for the individual (x) to die in the next instant, and is dened as:

S  (x) fZ (x)
(x) = =
S (x) 1 FZ (x)
 x+t  
d s (x + t)
Note we can rewrite (y) = ln s (y). By integrating we obtain (y) dy = ln ,
dy x s (x)
so:
  x+t 
S (x + t)
= t px = exp (y) dy
S (x) x
  x 
S (x) = exp (y) dy
0
  x 
FX (x) = 1 exp (y) dy
0

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As mentioned, the force of mortality represents the likelihood for the individual (x) to die in the
next instant, thus we obtain the probability of dying:
  x 
fX (x) = (x) exp (y) dy = (x) S (x)
0
  x+t 
fT (x) (t) = (x + t) exp (y) dy = (x + t) t px
x

The expected future lifetime:


ex = E [T (x)] = t t px (x + t) dt
0

2.2.2 LAWS OF MORTALITY

Laws of mortality are models proposed for the hazard rate for human lives.
De Moivres law: assuming the number alive decreased in an arithmetical progression, so that
x 1
s (x) = 1 = (x) = .
x

(some can be found on page 32 in the Orange Book)

Gompertz Law: assuming that the force of mortality increases with age in a geometric progression,
so (x) = Bcx , where B > 0, c > 1, x 0.
 
B x
This would give s (x) = exp (c 1) .
ln c

Makehams Law: Gompertz Law with a constant, that is, (x) = A + Bcx where A > B.

Lee-Carter: x,t = ex +x t + x,t = Ax Bxt + x,t , where force of mortality depends on both age

and time, and x,t are iid N 0, 2 random variables.

This is the continuous model for longitudinal or generation life tables, that relate to the
generation of persons born at time t x.

2.3 A Discrete Mo del for Survival Analysis

Curtate Future Lifetime, K (x) T (x), is the random number of completed years lived by (x).

Pr (K (x) = k) = k px qx+k

The expected future lifetime in discrete time:



ex = k k px qx+k = k px
k=1 k=1

1
ex = E [K (x)] ex
2

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2.4 Exp ected Present Value of Basic Life Insurance Pro ducts

The expected present value is also called the net single premium, or actuarial present value,
or risk premium.
In life insurance, benet payments are contingent on the death and/or survival of the insured.

2.4.1 LIFE INSURANCE: INSURANCE IN CASE OF DEATH

Whole life insurance (for the whole duration of life): single payment on death:
 
Ax = E v K(x)+1 = v k+1 k px qx+k
k=0
  

It has variance 2 Ax (Ax )2 where 2 Ax = E v 2(K(x)+1) = E v 2
K(x)+1
.
Term insurance: single payment if death within n years.

n1  n
1 1
Ax:n = v k+1 k px qx+k and Ax:n = v t t px x+t dt
k=0 0

2.4.2 INSURANCE IN CASE OF SURVIVAL

Pure endowment: payment if survive n years:

Ax:n1 = v n n px

Whole life annuity due: annuity due paid as long as (x) is alive:



k
ax = v k px = ak+1 k px qx+k
k=0 k=0

Whole life annuity immediate: ax = ax 1.

Temporary life annuity-due for n years: annuity due paid as long as (x) is alive for n years:

n1 
n1
ax:n = v k k px = ak+1 k px qx+k + an n px
k=0 k=0

2.4.3 INSURANCE IN CASE OF SURVIVAL AND DEATH

Endowment: payment if death before n years OR survive n years:


n1
1
Ax:n = Ax:n + Ax:n1 = v k+1 k px qx+k + v n n px
k=0

2.4.4 IMPORTANT RELATIONS

1 Ax
dax + Ax = 1 ax = (similar for insurance/endowment)
d

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3 LOAN VALUATION AND PROJECT APPRAISAL TECHNIQUES

The aim of project appraisals is to value and compare projects and make recommendations.
Need to determine net cash ows. Gains and sales? Costs, expenses and taxes? Etc.
A project can be nanced through:
For an individual: personal wealth and/or personal loan.
For a company: equity (shares) and/or debt (loans and bonds).
For a government: taxes and/or debt (treasury bonds).

3.1 Allowing for Tax

When analysing cash ow, tax inuences through:

When and how much tax is paid? There is usually a lag.
Tax rates depend on type of cash ow (e.g. income, capital gains).
Tax rates also depend the individual considered (person or company? )
Income and capital losses can oset against gains (tax benets).
Tax payments are simply additional negative cash ows.
Or positive cash ow for tax benets.
Depreciation of capital equipment, for taxation purposes, is done either through prime cost (level
over life) or diminishing value (constant percentage of written down value/WDV ).
Taxable income is income minus expenses.
Net cash ow is the cash payments less taxation expense.

3.2 Analysis of Loan Schedules and Repayments

Let L be loan amount made at time 0, with repayments Ki at times i.

So L = K1 v + K2 v 2 + + Kn v n .
Each repayment K consists of a principal component and an interest component the interest due
since last repayment. Outstanding balance is the amount that still need to be reimbursed after a
payment.
It is the interest component of the tth payment. It = i OBt1 .
P Rt is the principal repaid in the tth payment. P Rt = Kt It .
OBt is the outstanding balance immediately after the tth payment.
Calculating recursively we obtain:

It+1 = i OBt

P Rt = K t I t

OBt+1 = OBt (1 + i) Kt+1 = OBt P Rt+1

n n n
Total repayment KT = 1 Kt , total interest IT = 1 It = KT L , and L = KT IT = 1 P Rt .
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3.3 Loan Schedule: Calculating Principal Outstanding

A loan schedule provides all information for each period on payments, interest due, principal repayments,
principal outstanding and other important details.
The principal outstanding can be calculated through:
The prospective method: forward looking. It calculates the loan balance as the present value

n
of all future payments to be made: OBt = Ks v st , or if payments are equal, Kant i .
s=t+1

The retrospective method: backward looking. It calculates the loan balance as the accumu-
lated value of the loan at the time of evaluation minus the accumulated value of all instalments

t
paid up to the time of evaluation. OBt = L (1 + i)t Ks (1 + i)ts .
s=0

Be careful when interest rates changes.

Make sure interest is only calculated on principal outstanding!

3.4 Sinking Funds

A sinking fund is a fund established by setting up payments over a period of time to fund repayment
of a long-term debt.
The loan is repaid as a lump sum at the end of the term.
I.e. the fund will accumulate to the loan amount (L) at time n to ensure the reimbursement.
L
 So, the level payment must be .
sn j
The company needs to also pay interest at rate i each year to the lender.
L
 Thus, the total payment (including interest) at each time unit will be iL + .
sn j
The fund usually earns an interest rate of j, which is usually less than i.
If j < i, then one needs to pay more overall since more money needs to be put aside.

3.5 Loans at a Flat Rate of Interest

Interest = Loan amount at rate of interest duration of loan.

Loan amount + Interest
Loan repayments = .
number of payments
Eective rate of interest: consider an annuity solve for the interest rate!
Problems of using at rate interests:
The real/eective rate of interest is usually much higher than what the at rate suggests.
Flat rate loans do not encourage earlier payment.
Flat rates of interest are not used everywhere (mainly developing countries).

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3.6 Mo delling with Tax on Interest and Capital Gain Tax

CGT depends on price, and price depends on CGT.

 
face value reimbursedt
CGTt = % actual paymentt Price (if positive check!).
L
Net cash ow: Actual payment + Interest Tax on interest CGT.
We can nd the price on a spreadsheet by setting a dummy price, and then use Solver to nd the
actual price such that Price = PV of net cash ows.

3.7 Fixed Income Securities and Bonds

3.7.1 SECURITIES WITH FIXED INCOME

Bonds (or notes, or debentures), issued by the government or private companies.

Types of bonds:
short term (e.g. Australian Treasury note, or promissory note) vs long term (e.g. Australian
Treasury bond)
virtually risk free to very risky (junk bonds)
coupon bonds or zero-coupon bonds (ZCB)
indexed bonds, or real return bonds
but also, certicates of deposit (tradable or not), ...

3.7.2 GOVERNMENT BONDS

Borrow money from investors to fund spending plans.

Provide low risk securities (liquidity on the market, and determination of the structure of interest).
Both short and long term (in Australia: Treasury Notes and Treasury Bonds).
Consist of both coupon and capital payments (in Australia: usually interest only until maturity).
For (Commonwealth) Government Bonds in Australia
usually semi-annual coupons
coupons are paid on the 15th of each relevant month.
yields are quoted as nominal p.a. with the same frequency as the coupon payments.

3.7.3 BOND BASICS

Fc
Coupons of are paid p times per year. (F = face value and c = coupon rate).
p
Maturity is the date when the bond is redeemed (reimbursed).
The redemption amount F R at maturity is not always equal to the face value.
At par, below par, or above par.
Dierence in face value and redemption is capital gain/loss (above/below par reimbursements).

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3.8 Pricing Bonds

The price of a bond is essentially the present value of its future cash ows.
The rate is at which cash ows are discounted called yield.
The yield is usually quoted along with the price of the bond (equivalent ways of quoting the price).
The yield usually depends on the current structure of interest, as well as the risk associated to the bond
as perceived by the market.

The price of a bond is (given face value equals redemption; i.e. R = 1):

P = F c anp i + F vinp

1 vn
Or equivalently, using an = :
i

P = F + F (c i) anp i

If c = i, the bond is selling at par; if c > i, the bond is trading at premium; otherwise discount.

3.8.1 SELLING BETWEEN COUPON DATES

The seller will require the interest accumulated since the last coupon date to be paid by the buyer.
If the sale is too close to the next coupon payment (in Australia, 7 days or less), the bond becomes
ex-interest, which means that the next coupon payment will still be paid to the seller. So this coupon
will not be included in the valuation of the bond.
The general pricing approach is to discount the bond cash ows to the next coupon payment date
(including the coupon payment at that date, unless ex-interest), and then further discount this present
value to the sale date (by the number of days). Count the days!
That is, the RBA formula:

f /d
P = vi [Cnext + Gan i + F v n ]

where f is the number of days until the next payment; d is the number of days in the current period.

3.8.2 MARKET PRICE

Two bonds with the same cash ows and the same yield will have a dierent purchase price if
coupons payment dates are dierent. Hence, bonds are usually quoted at a market price.
Price-plus-accrued: the purchase price (or dirty price, full price, at price)
the price with accrued interest (coupon).
The price goes up exponentially until the next coupon, upon which the price falls instantly.
Market price: the quoted price (smoothed price, clean price)
accrued interest is removed. Market price = dirty price accrued interest = P tF c.
The graph of the price is a slightly curved line, joining the prices at which coupons are paid.
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3.8.3 OPTIONAL REDEMPTION DATES

Redemption date may be xed, or vary at either borrowers or lenders option.

It could be on or after certain date, undated, or between two dates.
In such case yields cannot be easily determined at the purchase date. Yet, they can still determine:
a maximum price, for a given yield; or
a minimum yield, for a given price.

3.9 Yield, IRR and MIRR

Yield: eective average rate of interest over the whole length of investment.
 
accumulated value 1/length of investment
Yield = 1
investment cost

Net present value (NPV): present value of inows minus outows (net cash ows).
Calculated using a relevant interest rate that reects risk and cost of capital.
Internal rate of return (IRR): sets NPV to zero.
There will be multiple IRRs if the cash ows are non-conventional.
NPV and IRR assumes a homogeneous/same rate of interest for all cash ow.
I.e. accumulated value at IRR is (Investment cost) (1 + IRR)time .
If the reinvestment rate (i.e. the rate at which the inows are accumulated ) is dierent from the
IRR, then the yield is not equal to the IRR.
We have modied IRR (MIRR) such that the accumulated value at the reinvestment rate is
equal to (Investment cost) (1 + MIRR)time .

3.10 Investment Decision Criteria

Payback period: choose the lower option.

The amount of time until repayments accumulate (without interest) to initial investment.
Discounted payback period: choose the lower option.
The amount of time until discounted repayments have a higher PV than initial investment.
NPV: choose the higher option. Depends on interest rate.
IRR or MIRR: choose the higher option.
Protability index: the ratio (PV of repayments)/(initial investment)
Dollar-weighted rate of return: simple rate of interest such that the NPV is 0 (similar to IRR).
Time-weighted rate of return
Returns over subsequent periods are compounded to yield an average return.
Particularly used by investment funds to transform monthly returns into longer term returns.

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4 INTEREST RATE RISK

4.1 Term Structure of Interest and Interest Rate Risk

Interest rates change regularly (e.g. RBA cash rate) rst Tuesday of each month.
Interest rates depend on the term (maturity or tenor) of an investment, bond or loan.
Longer terms usually have higher interest rates.
Yield curves can be increasing, decreasing or humped.

Interest rate risk is the risk associated to interest rates.

Interest rates are used to discount cash ows to determine price.
Securities might have cash ows that directly depend on current structure of interest.

4.2 Sp ot and Forward Rates (Non-homogeneous Interest)

Forward rate, ft1 ,t2 , is the eective annual rate of interest during the period (t1 , t2 ) as of today.
  1
A (t2 ) t2 t1
ft1 ,t2 = 1
A (t1 )

Spot rate is a forward rate with t1 = 0. I.e. st = f0,t . Spot rates are determined:
By observing the market.
By zero coupon bonds: E.g. PZCB of 1 with maturity 1 (1 + s1 ) = 1.
Forward rates follow from spot rates (or vice versa). The relationship between spot/forward rates:

(1 + sn )n = (1 + f0,1 ) (1 + f1,2 ) (1 + fn1,n )

(1 + sn )n = (1 + sn1 )n1 (1 + fn1,n )

(1 + st )t
ft1,t = 1
(1 + st1 )t1

We can use spot rates (alternatively, prices of ZCB ) to determine coupon bonds.
Recall yield to maturity is the eective average rate of interest over the whole term.
Process of bootstrapping using prices of coupon bonds is used to nd the spot yield curve.
Noting that the coupon/payments are discounted using relevant spot rates!

In practice, coupon months/maturing dates are not evenly spaced. So it is not possible to solve for
evenly spaced spot rates.
Instead, t a yield curve to the market data, then extract spot rates from the tted curve.
To calculate spot rates, we assume bonds are par yield, i.e. yield equals to coupon rate (c).
1 v (n) 1
Using each c we use the formula c = n to calculate each v (t), where v (t) = .
t=1 v (t) (1 + st )t
The formula comes from the equation for the price of a coupon bond.
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4.3 Continuous Time Forward Rates

We can calculate an equivalent forward force of interest t,t+dt = ln (1 + ft,t+dt ), ...and we are back to:
  t 
v (t) = exp (s) ds
0

Dene spot force of interest for maturity t, t = 0,t , such that (1 + st )t = e0,t t , then this spot force
is simply the constant force of interest equivalent to (t) over [0, t].

4.4 Sensitivity of Price to Interest

Note that the price of a security can be stated as a function of yield i, i.e. P (i). Using Taylors
expansion on P (i + i), we can examine the change in price due to a small change in yield :

(i)2 
P (i + i) P (i) i P (i) + P (i)
2

Alternatively, the change in percentage is:

P (i + i) P (i) P  (i) (i)2 P  (i)

i +
P (i) P (i) 2 P (i)

P  (i) P  (i)
We denote as modied duration and as convexity; equivalently the formula
P (i) P (i)
P (i + i) P (i) (i)2
becomes i (M D) + C.
P (i) 2

4.5 Measures of Interest Sensitivity

4.5.1 MODIFIED DURATION


Consider the general case P (i) = Ct vit , assuming that the yield curve is at/constant at i.
t>0

P (i)  (1 + i)t
The dollar modied duration is = Ct (i.e. without the division) and thus
i i
t>0

P (i)  
$M D = = tCt (1 + i)t1 = t Ct vit+1
i
t>0 t>0

So for modied duration (standardised ), we divide by the price:

 t+1 
t>0 t Ct vi
MD =  t = vi t wt
t>0 Ct vi t>0

Ct vit Ct vit 
where wt =  t = . Note wt = 1.
t>0 Ct vi P (i)
This standardisation allows comparison between dierent sets of cash ows.
The MD has the form of a weighted sum.

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4.5.2 (MACAULAY) DURATION

The (Macaulay) duration D is the weighted average/mean term to receipt of the cash ows:

t Ct vit 
D = t>0 t = t wt (in years)
t>0 Ct vi t>0

The longer the duration, the more sensitive the price is to interest changes.
Duration (mean term) and modied duration (price sensitivity) are related ( M D = v D ).
In continuous time, D = M D.
Duration decreases to 0 almost like a straight line as time increases except that duration increases
suddenly at coupon payment dates.

4.5.3 M-SQUARED

M-squared:

M2 = (t D)2 wt
t>0

The spread of the maturities of the cash ows around their mean D.
A weighted variance of the time to receipt of the cash ows around the duration.
Higher values of M 2 for the same duration will indicate higher price sensitivity.

4.6 Practical Considerations

4.6.1 NOMINAL RATES OF INTEREST

tp
i

(p) 
In practice, bond yields i(p) are quoted on a nominal basis. So P i = (p)
Ct 1 + .
p
t>0
 1  tp
  i(p)  i(p)
 (p)
Then the dollar modied duration is P i = 1+ t Ct 1 + . So:
p p
t>0
 1
i (p) 
M D(p) = 1 + t wt
p
t>0
 
(p) tp
Ct 1 + i p
where wt =   tp .
i(p)
t>0 Ct 1 + p
 
i(p)
Consequently, D = D(p) = 1+ M D(p) . Note D(p) = M D(p) as p .
p

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4.6.2 COMPLICATED CASH FLOWS

For complicated cash ows, we decompose them into a portfolio of ZCBs. We rst calculate each of
their individual dollar modied duration and dollar convexity.
For a zero coupon bond (ZCB):
Price: B (0, t) = (1 + i)t ;
Dollar modied duration: B  (0, t) = t (1 + i)t1 ;
Dollar convexity: B  (0, t) = t (t + 1) (1 + i)t2 .
Then we aggregate them:
 
Aggregated price: P (i) = CFt B (0, t) = CFt (1 + i)t ;
 
Aggregated dollar modied duration: P  (i) = CFt B  (0, t) = CFt t (1 + i)t1 ;
 
Aggregated dollar convexity: P  (i) = CFt B  (0, t) = CFt t (t + 1) (1 + i)t2 .

To nd the aggregated modied duration and convexity, divide the above by the price.
MD
Recall duration is .
v

4.6.3 NUMERICAL APPROXIMATION

The modied duration can be approximated numerically by (estimating the derivative):

P (ih)P (i+h)
2h
MD
P (i)

Convexity can also be approximated by:

P (i+h)2P (i)+P (ih)
h2
C
P (i)

4.6.4 FISHER-WEIL DURATION AND CONVEXITY

Now we consider non-homogeneous interest (non-constant spot rates).

The Fisher-Weil Duration and Convexity:
  t
t>0 t Ct B (0, t) t>0 t Ct (1 + st )
Duration: DF W =  =  t ;
t>0 Ct B (0, t) t>0 Ct (1 + st )
 
2
t>0 t Ct B (0, t) t2 Ct (1 + st )t
Convexity: CF W =  = t>0 t .
t>0 Ct B (0, t) t>0 Ct (1 + st )
Recall the denominator is the price.
Note usually when asked for duration or modied duration, use yield to maturity. Only use spot
rates if specically asked for Fisher-Weil duration.

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4.7 Asset Liability Management (ALM) Issues: Immunisation

When the interest rate changes, both PV of liabilities L (i) and assets A (i) change.
Net asset (or surplus) is dened as S (i) = A (i) L (i).
How do we select assets such that the eect of changes in interest rate is minimised?
How do we ensure that assets are always enough to payout the claims?
One way is to match the cash ows of liabilities: dedication (very hard, often impossible).
Assets might not have exact maturities as cash ows; etc.

4.7.1 REDINGTON IMMUNISATION

Immunisation is based on matching present values and duration to control interest rate risk.
Using the Taylor series we have S (i + i) S (i) + i S  (i) , we select:
A (i) = L (i) (match PV) and A (i) = L (i) i.e. S  (i) = 0 (match duration).
So for any small change in i we have S (i + i) S (i).

(i)2 
We can also include convexity so S (i + i) S (i) + i S  (i) + S (i) . (Note S  (i) = 0.)
2
So the change in surplus will be positive if S  (i) = A (i) L (i) > 0. That is, CA > CL .
So, we would choose:
 
At v t = Lt v t (match PV)
 
t At v t+1 = t Lt v t+1 (match durations)
 
t (t + 1) At v t+2 > t (t + 1) Lt v t+2 (CA > CL )

(i)2 
Then S (i + i) S (i) S (i) 0.
2

4.7.2 FULL IMMUNISATION

We have assumed that all cash ows are xed, and do not depend on interest rates, and the yield curve
is at (all spot rates are i).
Now we further assume that the spot rate curve moves in a parallel fashion (note it is still at).
As interest rate changes, we need to change portfolios to match durations again.
We have full immunisation: i.e. S (i + i) 0 is always true, irrespective of i.
An increase in convexity of A will increase S however also more risk.
Note: these assumptions are unrealistic but are necessary to achieve full immunisation.

4.7.3 BARBELL STRATEGY

Issue medium-term liabilities, and invest the money in long- and short-term bonds so that S  (i) = 0.
Here S (i) = 0 and S (i + i) 0 positive prot without risk! Arbitrage opportunity.
But there is a severe mismatch of the assets and liabilities (high convexity risky!), and assumptions
are unrealistic (interest rate moves are random! ).
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5 DERIVATIVES
A derivative is a security/contract with payments at specied times in the future, the amounts of
which are contingent on the value of an underlying nancial variable.
Derivatives include forwards, swaps and options and are actively traded over the counter (privately
between two parties) and on organised exchanges.
The underlying nancial variable could be a stock/share or a bond, a market index, an interest rate, a
currency, or gold, wheat, or other commodities.
Derivatives have high leverages (big outcomes for small investments). They are used for:
speculation: increase volatility of investments (dangerous! )
hedging: decrease volatility of investments (useful! )
Hedging is a strategy to reduce the risk borne by an agent. Reducing risk reduces expected prot.

5.1 Non-Arbitrage Pricing

The law of one price: in an ecient market, two securities with the same cash ows have the same
price. Otherwise:
There will be an arbitrage opportunity: prot without risk.
When pricing derivatives, we assume:
a risk-free rate of return can be obtained by any investor (government bonds).
 any amount of money will be invested or borrowed at the risk-free rate.
short selling is allowed: sell a security without having bought it (yet), by borrowing it or not (if
not, naked short sale).
a long (buying) or short position (selling) can be taken in any asset in any fractional quantity.
markets are ecient and there are no arbitrage opportunities.

5.2 Forward and Futures Contracts

A forward contract between two parties:

Party 1 agrees at time 0 to buy a certain asset at a specic future date T for a certain delivery
price F0,T . Party 1 has a long position.
Party 2 sells the asset at these conditions. Party 2 has a short position.
P = vT F
The delivery payment can also occur at time 0 for F0,T 0,T .

Purchasing forward/futures contracts can help insure or hedge against price uctuations:
eliminate uncertainty of the price level at sale (delivery) date;
taking a position in forward contracts that osets/mitigates some of the risk associated with a
given market commitment.

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5.2.1 PRICING A FORWARD CONTRACT

We ensure that there is no arbitrage opportunity in this contract, so the delivery price F0,T should
equal to the accumulated value of all previous cash ows. So:

T
F0,T = S0 (1 + r)T CFt (1 + t)T t
t=0

where S0 is the cost to buy the asset now (spot price), and CF are cash ows related to the asset (e.g.
storage, coupons).

5.2.2 COST OF CARRY FORMULA

Forward price = Spot price

+ Costs (storage, ...)
Income (dividends, coupons, ...)
Value of a long position in the contract

accumulated to the right point in time.

5.2.3 PRICING A FORWARD CONTRACT BETWEEN 0 t T

The value of the long position at time T is ST F0,T .

Using the cost of carry formula in a similar way, the value of a long position at time t is:

T
St CFs v st F0,T v T t
s=t

5.2.4 FUTURES CONTRACTS

A futures contract is similar to a forward in that it sets the price of a trade to take place in the future,
but it is dierent in other respects:
futures are highly standardised with regard to maturity, size, and underlying asset or index,
whereas forwards are usually customised to the needs of each party (thus not very liquid );
some futures contracts are settled in cash (the asset is not exchanged);
futures are used for both hedging and speculation;
for futures, brokers (third party) require a margin account based on the underlying assets spot
price, whereas the loss (or prot) is entirely realised at maturity for forwards.

5.3 Interest Rate Swaps

An interest rate swap involves two counterparties who exchange interest payments based on a notional
principal amount F (the principal amount does not change hands).
Interest rates swaps can be from xed to oating rate (coupon swap) or from one oating rate to
another (basis swap).
Cash ows are xed in the contract such that the present value of the two interest streams is equal.
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5.3.1 COUPON SWAPS

Coupon swaps (xed rate to oating rate):

Party 1 (xed rate) pays a specied xed rate to party 2;
Party 2 pays a oating rate to the xed rate payer.
Interest payments for the xed rate will generally be annual or semi-annual.
The oating rate will be based on a market rate such as LIBOR or Bank Bill rate plus or minus a
margin. The frequency will be determined by the oating rate used (e.g. 180 day rate frequency).
The days in the year convention used to determine the payment amounts will also be determined by
the index. Swaps based on six month LIBOR will determine a oating rate payment based on actual
days over 360.

5.3.2 PRICING COUPON SWAPS

First the present value of both interest payment streams must be equal;
Calculate interest from oating rate using forward rates for that period. Each payment
(1+sn )n  
(1+sn1 )n1
1 1
can be expressed as F , which the sum can be simplied to F 1 .
(1 + sn )n (1 + sn )n
Use the PV of these payments with forward rates to determine the xed rate. So:
1
1 (1+sn )n
c = n 1
t=1 (1+st )t

The margin is added/subtracted at the end to the xed rate c.

5.4 Foreign Currencies Swap

Spot exchange rates for immediate conversion are quoted:

directly: cost in domestic currency of 1 unit of foreign currency;
indirectly: the amount of foreign currency that 1 unit of domestic currency can buy. A/B
stands for the amount of B that one unit of A can buy.
A foreign currency swap (or deposit swap) implies the simultaneous promise to purchase (take) a
currency:
either at time 0 (spot against forward swap) or at a future t1 (forward/forward swap);
and selling it (give it back) at t2 > t1 .
The price is quoted in terms of the forward margin (in points) and takes into account the dierence of
interest rates in both currencies.
A forward premium is when the spot futures exchange rate is trading at a higher spot exchange rate
than it is currently. I.e. currency more expensive in the future.
The forward margin is the dierence between the rates.
A cross currency swap: we swap two currencies at t = 0; interest payments are swapped during the
period the one currently with currency A will pay in A; the two currencies are swapped back at t = T ,
usually at the same spot rate as at t = 0.

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5.5 Options

An option is a contract that gives its holder the option (but not the obligation):
to buy (call) or sell (put) an underlying asset;
at time T (for European option) or any time before T (an American option);
for a strike price K.
The payo will always be positive or null (option! No one will exercise a negative payo.)
Pricing American options is very dicult (involves stochastic processes).
Pricing European options is easier (but can also involve stochastic processes, e.g. binomial model).

5.5.1 EUROPEAN OPTIONS

The payo of a European call (buy) is (ST K)+ at time T . The call option is:
Out-of-the-money if ST < K;
At-the-money if ST = K;
In-the-money if ST > K.
The payo of a European put (sell) is (K ST )+ at time T . The put option is:
Out-of-the-money if ST > K;
At-the-money if ST = K;
In-the-money if ST < K.
Note: there could also be a cost associated with the call/put.

5.5.2 PRICING OPTIONS: THE PUT-CALL PARITY THEOREM (ORANGE BOOK P.47 )

Put-call parity is a principle that denes the relationship between the price of European put options
and European call options of the same class, that is, with the same underlying asset, strike price and
expiration date.
Call option with price c and an initial cash deposit of Kert , PV of strike price;
Pull option with price p and one unit of the underlying asset.
Both portfolios have a payo of max{K, ST } at expiry. They must also have equal value, so:

c + Kert = p + S0

5.5.3 PRICING OPTIONS: THE BINOMIAL MODEL

The price of the underlying at time T (ST ) is a random variable. Thus the payo is also random.
We can price the option by expected value. But it requires knowledge of probability distribution. It is
also likely to create arbitrage opportunity with respect to current market prices.
Or we can use the prices of a portfolio of assets that replicates the options payo at T .

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The binomial model has the following specications:

The period (0, T ) is cut into n periods of length t, so n t = T ;
Over theperiod (t, t + t), the price of the underlying asset can either go up or down:
u s , with probability p;
t
st+t =
d st , with probability 1 p.

There exists, over any period, a one period bond investment that accumulates 1 to ert where r
is the risk-free (force of) interest rate.
The underlying asset has thus a binomial distribution for its price at time T .
Consider
a call option expiring at the end of the period. It will have payo:
c = (u s K)+ , with probability p;
t,u t
Ct+t =
ct,d = (d st K)+ , with probability 1 p.

We can construct a portfolio of ht of the underlying asset and bonds Bt , with initial value Vt = ht st + Bt ,
such that the payo of the call is replicated.
This portfolio with have value Vt+t = ht st+t + Bt ert .
We equate this valuewith the payo of the call. So we have
c = h u s + B ert , with probability p;
t,u t t t
Ct+t = Vt+t
ct,d = ht d st + Bt ert , with probability 1 p.
 
ct,u ct,d rt u ct,d d ct,u
We solve for unknowns to get ht = and Bt = e .
(u d) st ud
This portfolio has the same payo as the call, and so the EPV/price of the call must equal to
 
the price of the portfolio, i.e. E ert Ct+t = Vt = ht st + Bt .
Using the put-call parity theorem, we can nd the price of a put.

Note that we can express Vt (after substitution) as Vt = ert [qct,u + (1 q) ct,d ] , which is a discounted

expected value with special probabilities, called the risk free probabilities, where q:
ert d
q=
ud

(Orange Book p.45 )

For multiple periods, the binomial model is implemented by recursive computation starting at the
nal time period for the model and working backwards period by period for each time step.
The binomial model for many time periods is referred to as a Binomial Lattice.
The important concept is to construct the portfolio to reproduce (or replicate) the derivative
payments at the end of each time period consisting of the underlying asset and the one period investment
(or borrowing).
The value of the derivative is the value of this portfolio based on the price of the underlying asset and
the investment at the beginning of the period and the number of units in the replicating portfolio.

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5.6 Hedging Strategies with Options

One would buy a call if one thinks the price of the

underlying will go up.

For the writer (who sells/short position), he/she only

earns the prot from the premium when the buyer decides
not to exercise the option.

We have these strategies to limit the potential loss.

Protective put/Floor: Buying a put for the long un-

derlying. Add the two graphs! For ST < K you will
have a payo of K, and otherwise you simply have the
payo of the underlying itself.
However, because of the premium of the put, one
loses slightly when ST > K P as compared to
without having the long put.

Cap position: short underlying with buy call. The

amount of money needed to be pay is capped at K for
ST > K.

Again, due to the premium of the call, one will lose a bit more for ST > K + P .
Covered call: short call with long underlying. Payo capped at K. Due to the purchase of the
underlying the graph shifts down.
Prot if the underlying is performing well. (Else prot)
Covered put: short put with short underlying. Overall payout graph is shifted up due to sale of put
and underlying.
Prot if underlying is not performing well. (Else loss)
Bull spread: either:
long call with a lower strike price than a short call; again there is a premium related to the long
call. Overall, there is a small prot when underlying is performing well.
long put with a lower strike price than a short put. There is a prot that shifts the graph up.
Overall there is a prot when underlying is performing well.
Bear spread: similar to bull spread, but long call has a higher strike price than the short call. Overall,
there is a small prot when underlying is not performing well.
Box spread: replicated a risk free deposit with calls and puts. One short put and one long call (with
strike price K1 ) and one long put and one short call (with strike price K2 > K1 ). End result is a
constant payo of K2 K1 throughout. Supported by put-call parity.
Straddle: Long put and long call with same strike price. End result is similar to an absolute value graph.
Graph is shifted down due to the purchases. Prot if underlying price changes signicant from strike
price.
Buttery spread: Short put and short call with same strike price (K). End result is the opposite to
straddle. This is combined with a strangle (long put with K1 and long call with K2 ). End result is an
absolute value graph at K, with constant values for less than K1 (constant K1 K) and greater than
K2 (constant K K2 ). This graph is shifted up. Prot if underlying price is about K.

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6 STOCHASTIC RETURNS
In practices, returns on an investment and interest rates will uctuate randomly (not known! ).
Stochastic Models explicitly allow for this randomness by introducing probability into models.
An assumption is required for the probability distribution of returns based on the historical data and its
main features.
Discrete: Binomial model.
Continuous: Log-Normal model.
We have a stochastic process: a collection of random variables ({yt , y = 1, 2, . . . , n} in discrete case)
representing the evolution of some system of random values over time.
We now consider a function, not single values.
An increment (change over a period) can be either:
totally independent of the past (stationary process); or
depend only on the starting value (e.g. yt1 ) (still stationary); or
depend on some other events in the past (non-stationary).
The increment itself is a single value and is a random variable.

6.1 Accumualted Value of One Dollar


n
The accumulated value of $1 after n periods is Sn = (1 + yt ), where {yt } are random variables.
t=1
The distribution of Sn can be derived under simple assumptions, or use simulation techniques.
So we dene yt as the random return over year t. We assume these returns are:
independent of each other (do not depend on any previous return); and
are identically distributed.
We denote expected value and variance: E [yt ] = j and Var (yt ) = s2 .
   n 
The k-th moment is E Snk = E (1 + yt )k .
t=1

n
In particular, E [Sn ] = (1 + j)n and variance Var (Sn ) = 1 + 2j + s2 + j 2 (1 + j)2n .

6.2 Accumulated Value of a Sto chastic Annuity

Recall sn = [(1 + y1 ) (1 + y2 ) (1 + yn )] + [(1 + y2 ) (1 + yn )] + + (1 + yn ), which can be written

as (1 + yn ) sn1 +1 with s0 = 0. We use this to derive this recursive formula to derive its moments.

E [sn ] = (1 + j)n + (1 + j)n1 + + (1 + j) = sn j .

 
   

E sn 2 = 1 + 2j + s2 + j 2 E sn1 2 + 2E sn1 + 1 (note recursive).

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6.3 Continuous: The Log-Normal Mo del

The log-normal model is continuous and we consider a continuously compounded return (force of
interest) for a period.

This is assumed to be normally distributed: rt N , 2 .

Recall (1 + yt ) = ert , this means (1 + yt ) is log-normally distributed, and will always take positive
values.
Normal distributions are innitely divisible, so the rates are moving all the time, or:

1 year: r1 N , 2 ;
 
1 1 2
0.5 year: r1/2 N , ;
2 2

For dt: rdt N dt, 2 dt .

6.3.1 ACCUMULATED VALUE UNDER I.I.D. LOG-NORMAL DISTRIBUTION


n
Recall for $1, its accumulated value is Sn = (1 + yt ), which implies:
  t=1

n
ln (Sn ) = ln (1 + yt ) = ln (1 + y1 ) + ln (1 + y2 ) + + ln (1 + yn ) .
t=1

Recall ln (1 + yt ) = rt N , 2 . With the assumption of i.i.d. r.v.s, then ln (Sn ) N n, n 2 .

Note the expected value and variance of log-normal distributions (Orange Book p.14 ):
 
1 2

E [X] = exp + and Var (X) = exp 2 + 2 exp 2 1 .

2

6.4 Mean Reversion

Intuitively, it makes sense to consider that the next value of the interest rate will depend on the current
one. (Note: good thing is it is still a stationary process! )
One (simple) assumption is to consider returns that are random, but whose next value will depend on
the current and tend to revert back to the long-term (average) return (mean reversion).
This leads to an autoregressive or mean reverting model.
We express the mean reverting model as:

yn+1 = + (yn ) + n+1

where is the long run mean;

is the standard deviation of the uncertain or unexpected change;

is the speed of mean reversion, 0 < < 1;

n+1 is a N (0, 1) random variable (a shock or unexpected change).

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This model can also be expressed as yn+1 = yn + (1 ) ( yn ) + n+1 .
The conditional expectation of yn+1 given yn is:

E [yn+1 | yn ] = + (yn )

Long run behaviour as n :

E [y] = by taking expected values of both sides;
2
Var (y) = by taking variances of both sides.
1 2

6.5 The Binomial Lattice Mo del

Assume that the interest rate for investing over the rst time period will be i0 which is xed and known
today and is referred to as the one period spot interest rate.

i , with probability p;
u
The interest rate in the second period can be
id , with probability 1 p.

The rate can go up or down in an additive or multiplicative way:

Additive model: iu = i0 + ku and id = i0 kd .
 However problem: over several periods, the interest rate can become negative.
Multiplicative model: iu = i0 ku and id = i0 kd with 0 < kd < 1.
 In the limit (for very small periods), this is the log-normal model.
 Over several periods, if the order of the ups and downs does not matter, we have a path
independent binomial lattice.
The second time period interest rate is a random variable taking a value of either iu or id . So,
Expected value: E [i] = piu + (1 p) id ; and
Variance: Var (i) = p (1 p) (iu id )2 .
In this model the distribution of an amount invested today will be related to future one period interest
rates.

6.6 Accumulated Value

An amount of $1 invested today will have value $ (1 + i0 ) with certainty at the end of one period.

$ (1 + i ) (1 + i ) , with probability p;
0 u
At the end of two periods, then it would be
$ (1 + i0 ) (1 + id ) , with probability 1 p.

It is easy to calculate the interest rates since it is path independent.

Count the number of ups and downs! Use binomial and permutations.
Note for accumulated value, it is not path independent. Calculate accumulated value with the
interest rates.
For distribution include probability.

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