Professional Documents
Culture Documents
• However I was badly hospitalized in Summer 2012 and did not get to
correct the many typos that semester
• I didn’t fully recover from the anemia I had till Dec 2014
• So I went through the book this semester and published this version
2-1
• I believe this version relatively free from errors with correct worked
out solutions and good verbal proofs
• http://www.iiisci.org/journal/sci/FullText.asp?var=&id=SA135EN14
0.11 Modularization
• Throughout the text we emphasize breaking big problems into smaller
component parts
0.12 Rule of 6
• Every concept in the course should be approached from 6 points of
view
• Some problems are difficult because students are looking for the for-
mula
• When instead the hard part of the problem are the English conventions
or its classification
• Studies have shown that when people read web pages they do not read
it as prose
• They read down the page skimming the first few words of each line
• The special symbols are however defined but their formulae are not
necessary to solve verbal problems
• The building blocks can then mechanically be unified for a final table
• http://www.soa.org/education/exam-req/syllabus-study-materials/edu-
multiple-choice-exam.aspx
0.24 Abbeviations
• e.g. M01#3 means Question 3 on the May 2001 exam
• Q-IT: http://www.soa.org/files/edu/2015/edu-2015-exam-fm-ques-theory.pdf
• S-IT: http://www.soa.org/files/edu/2015/edu-2015-exam-fm-sol-theory.pdf
• D-SQ: http://www.soa.org/files/edu/edu-2014-10-exam-fm-ques.pdf
• D-SA: http://www.soa.org/files/edu/edu-2014-10-exam-fm-sol.pdf
x
Chapter 1
Calculators
• III) A) Formatting
• X) D) Mentally checking
1
2 CHAPTER 1. CALCULATORS
• On SOA and CAS exams they allow: BA 35, TI-30XA, TI-30X II,
TI-30X
• B) Order of operations
• Two other special calculator items will be covered later when dis-
cussing their specific content
• G) Amortization Worksheet
• Example: Consider 2 + 3 × 4.
• In the above example, the Chain method does addition 1st, multipli-
cation 2nd
• 1) Do Exponentation 1st
• 2) Do Multiplication/Divisions 2nd
• multiplication 1st
• addition 2nd
• (2 + 12 = 14)
• Quit, 2(1,1)
• Answer: 2.9410
• 1 − 1.01yx 3± = STO7
• 0.01 = STO 4
• RCL 7 / RCL 4 =
• i) The exponentiation
• The division is done last because the fraction symbol is like parenthesis
• ±+1=
• / .01=
10 CHAPTER 1. CALCULATORS
• Why check?
• Bernoulli’s law is a required part of the syllabus for one course topic
.03
• Step #3) Calculate denominator: .01 =3
• Suppose the bank agrees to give you 10 percent of your account value
each year
• Then at the end of the year the bank pays 10% × $1, 000 = $100 in
your account
• Now that we understand this basic setup let us look more deeply
12 CHAPTER 1. CALCULATORS
• A similar calculation would apply if one left the money for a 3rd year
• At the end of the 3rd year you would have 1.1 × (1.12 × 1000) =
1.13 × 1000.
• t is the number of years the money lies in for example the bank
• Timeline
• The other row indicates the balance in the account at that time
• So for example the account has 1000 at time 0 and 1100 at time 1.
1
2
A(2) A(2)
• Find i : Solution: A(0) = (1 + i)t ; 1 +i= A(0)
A(t) A(t)
• Find t : Solution: A(0) = (1 + i)t ; t log(1 + i) = log A(0)
1.39 TV Timeline
• Basic idea. Enter any 3 of 4 numbers; then compute 4th number.
• Find A(0)
• Solution.
2 10 CPT 0 1210
N I/Y PV PMT FV
• 2 (3,1)
1.40 TV Signs +, −
• How do you determine +, −.
• At t = 0 you give me, the bank, 1000, and hence, you lose, 1000.
• Find t
• Solution
CPT 10 − 1000 0 1210
N I/Y PV PMT FV
1.43 Summary
• TV allows you to press 3 buttons to solve for a 4th unknown amount
• TV is faster than algebra!
• Using the TV worksheet is a basic skill
• The Timeline is a basic geometric aid
• Use CLEAR when you want to correct a typo and not start over
• (3) On-off Clears typos/starts over, but does not clear memory cells!
Chapter 2
Money Growth
• X) Discount factor, v
• XII) Rule of 6
17
18 CHAPTER 2. MONEY GROWTH
• Interest rate i : The bank agrees to pay you 10% per year for your
money
• Interest Period: The interest period - the time interval to which the
10% applies - is the year
• Payment Period: The bank will pay you the interest at the end of
each year.
• Note that in our example, the interest period and payment period are
the same.
•
A(s) − A(s − 1) = Is = is × A(s − 1) (2.1)
• Simple interest: When you withdraw the interest from the bank and
leave the principle
• The compound interest rate is also called the effective annual rate
• We use the English phrase Present Value to refer to A(0) = $1, 000
20 CHAPTER 2. MONEY GROWTH
• In every interest method three things remain the same and two things
change
• #4) In all methods there is some symbol describing the rate of growh.
• Some typical symbols are i for interest, d for discount and δ for force.
• #5) In each problem, the algebraic formula relating A(t) with A(0), t
and i, d, or δ changes.
•
I = A(1) − A(0), the interest amount (2.6)
•
I
i= , the interest rate (2.7)
A(0)
•
I
d= , the discount rate (2.8)
A(1)
• Interest and discount are two ways to describe the same situation
A(1) A(0)
• A(2) = 1−d = (1−d)2
.
• ..
•
A(0)
A(n) = (2.9)
(1 − d)n
•
A(0)
A(n) = (2.10)
d(p) pn
(1 − p )
24 CHAPTER 2. MONEY GROWTH
• What is A(n)? How much total money will I have accrued at time
t = n.
• Simple discount
A(0) A(0)
A(0) A(1) = ... A(n) =
1−d 1 − dn
0 1 ... n
•
A(0)
A(n) = (2.12)
(1 − dn)
•
mIt,t+ 1
A(t + 1
− A(t)
1
− A(t) A0 (t)
m m) 1 A(t + m)
δt ≈ =m = 1 −→
A(t) A(t) A(t) m
A(t)
(2.13)
1 i(m)
• But A(t + m) − A(t) = m A(t)
δt ≈ i(m) (2.14)
δt ≈ d(p) (2.15)
• As an exercise one should check the following identity, using the chain
rule, (??)
d A0 (t)
log A(t) = = δt (2.16)
dt A(t)
A(E) RE
= e B δt dt (2.17)
A(B)
•
A(t) = A(0)eδt = A(0)(1 + i)t (2.18)
26 CHAPTER 2. MONEY GROWTH
•
eδ = 1 + i (2.19)
A(B) δt A(E)
B E
• All you need to know are the seven formulae in the last two slides
(which also contain perspectives)
A(0) A(n)
0 n
• Why are they equivalent? In both cases I = $100, A(0) = 1000, A(1) =
1100
100 100
• But 1000 = 10% while 1100 = 9.09%
• The same timeline has two different but equivalent descriptions.
• So Actuarial Equivalence is a way of saying that two different descrip-
tions are the same
1
• Solving, we obtain, v = 1+i (Why?)
• 2 year timeline.
v2 v1 1
0 1 2
• n years
vn 1
0 n
•
If A(0) = v n X −→ A(n) = X. (2.21)
• Although the same word is used, the meanings are totally different
2.23. USEFUL FORMULAE FOR V, D I AND D 29
• If you only apply theory to simple problems you are not learning, not
practicing enough
• Such problems are higher cognitive since they require executive brain
function
• There are several public URLs where these problem sources may be
freely downloaded
• Q-IT https://www.soa.org/Files/Edu/2015/edu-2015-Exam-FM-ques-
theory.pdf
• S-IT https://www.soa.org/Files/Edu/2015/edu-2015-Exam-FM-sol-theory.pdf
• D-SQ https://www.soa.org/Files/Edu/edu-2014-10-Exam-FM-ques.pdf
• D-SA https://www.soa.org/Files/Edu/edu-2014-10-Exam-FM-sol.pdf
• The interest theory exams are sometimes called Course 2 and some-
times Course FM
• From a theory point of view, each of these 7 types are equally on the
syllabus
2.30 Rule of 6
• In Interest theory each course concept and example is approached in
6 ways .
• Timeline:
A(0) i A(n)
0 n
• Calculator:
• Note the subtlety that each timeline has an equation relating its be-
ginning and terminal value
• This is different than the EOV which relates several different timelines
34 CHAPTER 2. MONEY GROWTH
• #5) Identify and algebraically solve each timeline and TV line sepa-
rately
• Notice how the formatting of the problem hints at the timelines needed
• Determine k
• X
t2
A(0) = 1 δt = AX (5)
k
0 n
• Y
•
AX (5) = AY (5).
• Answer: I gave you seven equations for force. Review all seven and
pick the right one
• Note: Selecting the right equation from seven equations is harder than
just plugging into one equation
t2
R5
dt
• e 0 k = AX (5)
36 CHAPTER 2. MONEY GROWTH
• k = 102.07
37
38 CHAPTER 3. IRR - INTERNAL RATE OF RETURN
• English
• TV Sheet
• i = 1.84%
• Note: TV method faster, more versatile, and less prone to error than
the formula method.
• Examples could be your college expenses (and assets) for the semester
or a collection of stocks
3.5. EOV - EQUATION OF VALUE 39
• Any particular item may be worth alot or cost alot; we are interested
in the overall portfolio performance
• Here, C stands for Cash Flow, D stands for Deposits, and W stands for
Withdrawals
• Timeline
C1 C2 C3 ... Cm
t1 t2 t3 ... tm
• EOV N P V = C1 v t1 + C2 v t2 + . . . + Cm v tm
• Alternate version: X X
Dk v tk = Wj v tj (3.1)
+1000 −600 −P
0 1 2
• Calculator
• FV = 50
• Timeline
+50
1000 −600 −600
0 1 2
• To clear the CF worksheet: 2(-1,1) 2(1,1). 2nd CLR WORK, 2nd QUIT
• To scroll to the time 0,1,2,3 rows: Use and ; (1,3) and (1,4)
• To enter amounts in a cell: Type number, sign and hit ENTER, (1,2)
• Throughout the course: ENTER and = have similar functions but are
not interchangable
• After spreadsheet is filled, to compute yield: type IRR CPT (2,4), (1,1).
• Scroll to CFo.
42 CHAPTER 3. IRR - INTERNAL RATE OF RETURN
• +1000, ENTER
3.13 Timeline
• TimeLine
• Why did I use 14000 for FV? Why didn’t I use 11000?
• TimeLine
i(2)
• Nominal: 2 = 5% −→ Anominal (.5) = 1.05
3.22 Why
i(2)
• Nominal rate, i(2) by convention means 2 every half year
• But compound rate has no special meaning for half year periods
i(m)
1
Anominal = A(0) 1 + (3.2)
m m
1
1 m
Acompound = A(0) 1 + i . (3.3)
m
• The yield need not be unique (There might be two solutions to EOV.)
.72
• It takes (approximately) i time to double your money
• Now, instead of asking what IRR will make the NPV 0, we reverse the
question.
• Scroll using the up and down arrows to the NPV display and hit CPT
(1,1)
3.26. VIII) MODEL EXAM PROBLEMS 47
• Now scroll to the I display and ENTER 4 and then scroll to NPV and
hit CPT
• Here and throughout the book Q-IT problems may duplicate exam
problems
• Q-IT#20 Comparison
• Q-IT#23 Comparison
3.27 Q-IT#20
• We sketch the solution
• TimeLine
• EOV: 1 + 2v n + 3v 2n = 6v 10 .
4.1 Overview
• In this lecture we will go over non-exact methods
49
50 CHAPTER 4. TIME AND DOLLAR WEIGHTED METHODS
• You may want the yield for the entire period of investment or
• Time weighted
• Timeline
4.7 Approximate
• Bernoulli (1 + i)f ≈ 1 + f i
• Apply Bernoulli to the above
• 10210(1 + i) + 4000(1 + 56 i) − 3000(1 + 7
12 i) + 1000(1 + 1
12 i) = 12982.
• Warning: You must apply Bernoulli to the last equation with i.
• Applying Bernoulli to the equation with present values (v) will give a
different approximation.
• Although this different answer is a correct approximation it is not the
officially recognized dollar weighted approximation
• The approximation we are using, based on i is an industry standard.
= 12982
52 CHAPTER 4. TIME AND DOLLAR WEIGHTED METHODS
!
5 7 1
• Exposure: 10210 + 6 4000 − 12 3000 + 12 1000 = 11876
• Timeline
4.15 Subtleties
• The diagrams really help you memorize the formulae
• ---------------------
• ---------------------
4.16. V) EXAM PROBLEMS 55
• ---------------------
• Q-IT#19 = N01-20
• Q-IT#45 = M01-31
• Q-IT#5 = M03-17
• Q-IT#8 = M03-30
56 CHAPTER 4. TIME AND DOLLAR WEIGHTED METHODS
Chapter 5
Periodic Payments
5.1 Overview
• We have 9 subgoals to meet in this chapter
• I) Annuity Immediate
• V) Annuity-Perpetuity
0 1 1 1 ... 1 (5.1)
0 1 2 3 ... n (5.2)
57
58 CHAPTER 5. PERIODIC PAYMENTS
5.3 Rule of 6
• Symbol
• Name
• Timeline
• Formula
• Calculator
• English Description
5.4 Timeline
• Done above. See (??)
5.5 Name
• The name is level annuity certain immediate
• Underneath the 4 words of this name we place the implications and
nuances
• Name
5.6 Calculator
• Calculator:
n 100i CPT −1 0
N I/Y PV PMT FV
5.7. ENGLISH DESCRIPTION 59
• My point of view
1 −1
0 n
my 1 ...
0 i i ... i
0 1 2 ... n
• Timeline
0 1 1 1 ... 1 (5.7)
0 1 2 3 ... n (5.8)
•
1 − vn
v + v 2 + v 3 + . . . + v n = an = (5.9)
i
• Applying the formula for geometric series to the left side will give the
right side
5.13 Notation
• Given above. an
• Periodic Payment
• Constant Amount
• Deferral
0 2 2 2 ... 2
0 1 2 3 ... n
5.16 Deferral
• Timeline
0 ... 1 1 ... 1
0 1 2 ... 10 11 12 ... 30
• P V = v 10 a20
0 ... 5 5 ... 5
0 1 2 ... 10 11 12 ... 30
• P V = 5v 10 a20
• s version e.g. sn
• Perpetuity e.g. a∞
0 1 1 1 ... 1
0 1 2 3 ... n
5.20 Formula-a-s
• Timeline
a s
0 n
5.21 Calculator-a-s
• Calculator a:
n 100i CPT −1 0
N I/Y PV PMT CPT
• Calculator s:
n 100i 0 −1 CPT
N I/Y PV PMT FV
• Timeline
än
1 1 1 ... 1 0
0 1 2 ... n−1 n
• Timeline#1 = 1+Timeline#2
5.24. PROOF 2 - TIMELINE METHODS 65
• Timeline#1
1 1 1 ... 1 0
0 1 2 ... n−1 n
• Timeline#2
0 1 1 ... 1 0
0 1 2 ... n−1 n
• =⇒
• än = 1 + an−1
• Emphasize: Derived without any algebra.
• än
v v v ... v 0
0 1 2 ... n−1 n
• vän = an
• Here we use, v, the discount factor, from chapter 2.
• än
n 100i CPT −1 0
N I/Y PV PMT FV
• If you found you made such an error, get out of BGN mode
• You need not enter the numbers again after changing BGN mode.
• You can continue to compute whatever you were doing without reen-
tering the numbers.
5.28 V) Annuity-Perpetuity
• Timeline
0 1 1 1 ...
0 1 2 3 ...
• Symbol a∞
1−v n 1
• ä∞ = limn→∞ än = limn→∞ d = d
5.31 s, s̈, a, ä
• Timeline
0 1 1 1 ... 1
0 1 2 3 ... n
an sn
• Timeline
1 1 1 1 ... 1
0 1 2 3 ... n−1 n
än s̈n
• Symbols: I,Increasing,Decreasing
P,Perpetuity
Inf,Inflation
C,Conversion
A,Algebraic Manipulation
• Most duplicate problems in QIT have been caught but not all.
• M00#14 P/C
• N00#20 P/I
• N01#05 P/Inf
• N05#12 P/I
• N05#09 P/Inf
• QIT#25 P/A
• QIT#14 P/Inf
• M05#24 A
• N00#44 I/I
• QIT#6 I/P/A
• M05#14 I - 2 pieces
• QIT#29 P/C
• QIT#18 I/C
• N01#16 P/I/C
• QIT#86 I/A
• This module is one of the hard parts of the course since we must . . .
• Timeline
32 ...
10 10 10 ...
0 1 2 3 ...
• EOV: 32 = 10a∞ |j
X ...
1 1 1 ...
0 1 2 3 ...
• EOV:X = a∞ |k
• (1 + k)3 = 1 + i
• (1 + i)3 = 1 + j ⇒
• (1 + k)9 = 1 + j
10
• So j = 32
1
• X = a∞ |k = k
• =⇒
• X=
72 CHAPTER 5. PERIODIC PAYMENTS
Chapter 6
Increasing Decreasing
Annuity
6.1 Overview
• We have 9 subgoals to meet in this chapter.
• VI) N05#12 Illustrates Use of Variables and the Initial Offset Tech-
nique
73
74 CHAPTER 6. INCREASING DECREASING ANNUITY
1 2 3 ... n
0 1 2 3 ... n
• The notational symbol for the Present Value for an increasing annuity
immediate is: (Ia)n
• The symbol for the Present Value for an increasing annuity due is:
(Iä)n
• The symbol for the Future Value (t = n) for an increasing annuity due
is: (I s̈)n
• The symbol for the Present Value for a decreasing annuity immediate
is: (Da)n
• Timeline
• X = 100 × (Da)25
• Problem is way too easy. Good problems have two parts. This one
has one part!
6.10. IV) N01#16 ILLUSTRATES CONVERSION METHOD FOR DIFFERING PAYMENT/INTEREST
• Timeline
2 4 6 ...
2×1 2×2 2×3 ...
0 1 2 3 ...
• 5 years = 5 × 12 = 60 months
• =⇒ X = 2 × (Ia)60 |k
6.11 Who is k?
• k is the interest rate per month. (The problem says so!)
• Timeline
0 1 2 3 4 ...
• Remember: There are only 3 basic patterns; go over them; see which
ones fit best in this problem.
• Timeline
• Timeline
P P + 15 P + 30 P + 45 ... =
15 15 × 2 15 × 3 15 × 4 ... +
P − 15 P − 15 P − 15 P − 15 ...
0 1 2 3 4 ...
• Two timelines
• Timeline #1
X = (Da)10 ...
10 9 8 ...
0 1 2 3 ...
1 2 3 ... 10 11 11 ...
0 1 2 3 ... 10 11 12 ...
• Approach A
1 2 3 ... 10 | 11 11 ...
0 1 2 3 ... 10 | 11 12 ...
1 2 3 ... 10 11 11 ...
0 1 2 3 ... 10 11 12 ...
• Approach B
1 2 3 ... 10 11 | 11 ...
0 1 2 3 ... 10 11 | 12 ...
• Which approach right? Both! Use the approach where the algebra
simplifies!
• I deposit n at time t = 0
• Timeline
n − an
n n−1 n−2 n−3 ... 1
0 1 2 3 ... n−1
• Timeline
i(Da)n
ni (n − 1)i (n − 2)i ... i
0 1 2 3 ... n−1
•
i(Da)n = n − an (6.1)
•
n − an
=⇒ (Da)n = (6.2)
i
6.23 Calculator
n−an
• Suppose we want to compute (Da)n = i
• #1: Compute an .
• #2: Hit ±
6.24. IX) INCREASING ANNUITY FORMULA (BROVENDER’S TRICK) 83
• #3: Hit +n =.
• #4 Hit ÷ RCL i =
• #5 Hit × 100 =
1 2 3 ... n +
n n−1 n−2 ... 1 =
0 n+1 n+1 n+1 ... n+1
•
än − nv n
(Ia)n = (6.3)
i
•
än − nv n än 1
(Ia)∞ = lim = lim = (6.4)
n→∞ i n→∞ i id
84 CHAPTER 6. INCREASING DECREASING ANNUITY
• Similarly
1
(Iä)∞ = (6.5)
d2
• http://www.soa.org/files/pdf/FM-23-05.pdf page 29
• Calculator:
n 100i CPT −1 n
N I/Y PV PMT FV
• #4: ÷ RCL i =
• #5: × 100 =
Chapter 7
Inflation
7.1 Overview
• This chapter is about inflation
• I) Inflation definition
85
86 CHAPTER 7. INFLATION
• Define
1 1+g
0
= (7.1)
1+i 1+i
• Notice that the deferral factor uses i not i0 since inflation is not yet
present.
• Original Timeline
P i P (1 + g) P (1 + g)2 ...
m rate m+1 m+2 ...
• Modified Timeline
P i0 P P ...
m rate m+1 m+2 ...
• g = 0.50. i = 0.75.
1+g 1.50
• Compute 1+i = 1.75 = 0.857
1 1
• Now solve 1+i0 = 0.857 (Hint: Use x key.)
PV i = 0.75 1.50
P V = 0.857
0 1
7.11. IV) INFLATION ALGORITHM 89
• Modified Timeline
PV i0 = 0.16666 1.00
P V = 0.857
0 1
• The method works because you hide the inflation in the modified in-
terest rate
• i = 0.092
• Calculate K
• Review: A timeline is correct if it contains all information in English
version of problem.
• Timeline #2
10 (1 + g)10 (1 + g)2 10 (1 + g)3 10 ...
5 6 7 8 ...
• Second: Compute i0 :
1 1+K
• 1+i0 = 1+.092
• Year 5
10 10 10 ...
5 6 7 ...
• ä∞ i0
• Amount is . . .
• . . . 10.
• Deferral factor is . . .
5
• . . . v0.092
• Timeline #1
n
• ä∞ i0 = limn→∞ än i0 = lim 1−v
d0 =
1
d0
1 1+i0
• d0 = i0
1+i0
• 167.50 = 10 × 3.2255 + 0.6440 × 10 × i0
• Solve. i0 = 1
20 (5 percent)
1+K 1
• 1.092 = 1.05
• =⇒ K = 0.04
Miscellaneous Annuities
8.1 Topics
• Today we cover miscellaneous examples
95
96 CHAPTER 8. MISCELLANEOUS ANNUITIES
• Principle #2: If you have some rate j and need the corresponding d
(1 + iP )n = 1 + iQ . (8.1)
• Then we will use the approach with quarterly annuity symbols (interest
per year and payments per quarter)
• Calculator:
• j But what is j
98 CHAPTER 8. MISCELLANEOUS ANNUITIES
• I call this approach the conversion method and advocate its use.
• Timeline
1 1 1 1
...
m m m m
1 2 3
0 ... y years
m m m
1−viy
• Formula i(m)
• Solution to Problem
(4)
• Accumulated value at end of 10 years = 1000s10 .04
• Yes: It is an approximation
• But the approximation will usually agree on the penny with the exact
answer
100 CHAPTER 8. MISCELLANEOUS ANNUITIES
ln(1.04)
• Note that 1.04 = eδ so that δ = 365
• Formula
n
1 − e−δn
Z
an = e−δt dt = . (8.2)
t=0 δ
• Similarly
eδn − 1
sn = . (8.3)
δ
• As can be seen, the daily approximation differs from the exact answer
by less than 1 dollar.
• At instant of time ∆t
• Note: Requires integration by parts but you can just memorize formula
• Adding
R n −δt up all these present values and taking the limit we obtain
0 te dt
• Timeline
1 2 3 nm
...
m2 m2 m2 m2
1 2 3
0 ... n years
m m m
(m)
än i −nv n
• Formula i(m)
• You can also derive the formula for the associated perpetuities
• We will solve this problem without using the monthly increasing an-
nuity symbol and formula
• As an exercise you may want to check and redo the problem that way
• Timeline
25 30 35 ... 20 + 120 × 5
0 1 2 3 ... 120
• Timeline
20 20 20 ... 20 +
5 10 15 ... 120 × 5
0 1 2 3 ... 120
• P V = 20a120 j + 5 Ia , (1 + j)12 = 1.04.
120 j
• This problem has the unusual feature of level monthly payments but
increasing annual payments.
• Timeline
1 1 1 2 2 2 n
... ... ...
m m m m m m m
1 2 12 13 2 24
0 ... ... ... n years
m m m m m m
• Timeline
• The top and 3rd row are easily describable. The 4th row requires a
new technique.
• Timeline Trick
• So
Timeline 100 row = 100s12 j Ia
25
• So (1 + j)12 = 1 + i = 1.04
8.29. PUTTING IT ALL TOGETHER 107
• So,
2900a25×12 j + 100s12 j Ia = Xa25×12 j
25 i
108 CHAPTER 8. MISCELLANEOUS ANNUITIES
Chapter 9
Amortization
• I) Amortization Table
109
110 CHAPTER 9. AMORTIZATION
• Calculator:
• I, Interest amount
• P, Principle amount
• t, time t = 0, 1, 2 . . .
• You owe 7679.88. You can pay that off at t = 1 and owe nothing more
• The other 500 is interest you paid for the right to loan
(OLB)0 = L (9.1)
(OLB)n = 0 (9.2)
It = i × (OLB)t−1 (9.3)
Rt = It + Pt (9.4)
(OLB)t = (OLB)t−1 − Pt (9.5)
112 CHAPTER 9. AMORTIZATION
• Calculator:
9.13 Row 2
• Simply set P 1 = 2, P 2 = 2.
• The name sinking fund refers to the fact that I sink money into the
bank until L is accumulated
• Also notice that there are two payees: The lender and the bank into
which I sink money
9.17 Set up
• L = 10000, iL = 0.10, iSF = 0.05
SF D SF I SF B OLB t
10000 0
D = 2320.12 0 = 0.05 × 0 2320.12 + 0 = 2320.12 = Ds1 10000 − 2320.12 = 7679.88 1
D = 2320.12 116 = 0.05 × 2320.12 2320.12 + 116 + 2320.12 = 4756.24 = Ds2 10000 − 4756.24 = 5243.76 2
.. .. .. .. ..
. . . . .
2320.12 ... 10000 0 4
116 CHAPTER 9. AMORTIZATION
• M05#8 Refinance
• N00#34 Refinance
• Q-IT#75 Refinance
• Q-IT#88 Refinance
• M00#39 Reinvest
• Q-IT#80
• Q-IT#15 Duplicate
• Q-IT#16 Duplicate
• Q-IT#24 Duplicate
• Q-IT#26 Duplicate
• Q-IT#28 Duplicate
• Q-IT#46 Duplciate
118 CHAPTER 9. AMORTIZATION
Chapter 10
Amortization Problems
10.1 Overview
• Today we review problems
• We have 3 goals
119
120 CHAPTER 10. AMORTIZATION PROBLEMS
t R I P OLB
0 0 0 0 1000
1 150 100 50 950
2 142.5 95 47.5 902.5
3 135.38 90.25 45.12 857.38
4 128.61 85.74 42.87 814.51
5 122.18 81.45 40.73 773.78
6 116.07 77.38 38.69 735.09
7 110.26 73.51 36.75 698.34
8 104.75 69.83 34.92 663.42
9 99.51 66.34 33.17 630.25
10 94.54 63.02 31.51 598.74
• In the next few slides we will see how this problem solving strategy is
implemented.
• A) 20 year loan −→ n = 20
• Use C on last slide to fill in row 1: −→ Fill the row in this order,
I1 , R1 , P1 , OLB1 (Use 13 basic formulae)
• I1 = 10%L
• OLB2 = 95%2 L
• You could still solve the problem but it would take longer
T V Calculator 0 0 97.44 0
10 10 OLB10 CP T 0
N I PV PMT FV
• This can be solved using the TV calculator timeline (See table 10.3)
• Please read it
10.11 Lori
• Lori repays her loan with 10 level payments at the end of every six-
month period.
• Solve, using TV
10.14 Janice
• Janice pays interest due every period
• It = I × OLBt−1
• So R1 = I1 + P1 = I1 = 300
• I2 = 6% × 5000 = 300
• P2 = 0 (Why?)
• R2 = I2
10.20 Seth
• Seth lets interset accumulate over 5 years
10.21 Chapter 2
• How do you do this
• Think chapter 2
10.22. CHAPTER 2 - INTEREST 127
Bonds
11.1 Overview
• We have 8 subgoals to meet in this chapter
• III) Conversions
129
130 CHAPTER 11. BONDS
• Once the business is started the profits will sustain the business
• You pay me $1,000 now and the IOU says I pay you back $1,000 in 5
or 10 years
• The symbol C indicates how much the bond is called for at maturity.
11.6 C vs F vs P
• P is what you pay me at time t = 0.
• Fr, the coupon amount is what I pay you at the end of each period.
• If the problem gives you P,F,C then they are all different
• If the bond is called a par value bond and nothing else is said then
C = F.
• In such a case F is called the par value of the bond; C is the redemption
value.
C
−P Fr Fr ... Fr
0 1 2 ... n
• To apply the TV line we need to use all 5 calculator keys since there is
a balloon payment
• Calculator TV Line:
n 100i −P Fr C
N I/Y PV PMT FV
132 CHAPTER 11. BONDS
•
P = F ran i + Cvin . (11.1)
• M00#29 Refinancing
• M01#41 Reinvestment
• N05#11 Reinvestment
• N05#16 Reinvestment
11.9. IV) SOA EXAM PROBLEMS 133
• M03#42 8 Formulae
• QIT#62 8 Formulae
• N01#31 Comparison
• M05#5 Comparison
• QIT#74 Comparison
• QIT#76 Comparison
• N05#19 Trivia
• N05#22 Callable
• M05#11 Callable
• QIT#54 Callable
• QIT#55 Callable
• QIT#56 Callable
• QIT#57 Callable
134 CHAPTER 11. BONDS
• QIT#91 Callable
• QIT#10 Duplicate
• QIT#22 Duplicate
• QIT#47 Duplicate
• Problem Statement: A ten year 100 par value bond pays 8% coupons
seminannually. The bond is priced at 118.20 to yield an annual nom-
inal rate of 6% convertible semiannually. Calculate the redemption
value of the bond.
• semiannually → n = 2 × 10 = 20.
.08
• semiannually → r = 2 = 0.04.
• P = 118.20
11.13. N05#4 SOLUTION STEP 2: TIMELINE 135
.06
• i= 2 = 0.03.
• C is unknown
C
−118.20 100 × 0.04 = 4 4 ... 4
0 1 2 ... 20
Cg = F r. (11.2)
Gi = F r. (11.3)
• So
P = C(g − i)an i + C (11.5)
• Try and use the first formula, called the basic formula whenever pos-
sible
• The five formulae for non-level payments are almost the same
• #1) Rt = F r is the coupon rate (This belongs in the next section, the
formulae for level coupon rates)
• Refinancing and reinvestment follow the same rules for Loan amorti-
zations
• BVt is the price on the books; what someone would pay at t for the
bond
• The BVt is present value at t of all future coupons and the redemption
value
• v) The formula for It is derived from the formula for Pt (just given)
and the relation It + Pt = Rt = F r = Cg
• Since this is complicated we omit it also (So there are only 3 formulae
for the level case)
• So there are a total of 8 Bond formulae (5 for any case and 3 for the
level case)
138 CHAPTER 11. BONDS
• n = 10, no conversions!
• r = .08
• i = 0.06
• P, price is unknown
11.22 8-Bond-Formulae
• We present two solutions, both based on the 8 Bond Formulae
• Aha! I7 = i × OLB6
• The rest is computation since all variables on the right side are known.
• Aha! Rt = It + Pt
• Note that F r = Cg → r = g
Reinvestment
12.1 Overview
• We have one main goal for today: Reinvestment problems
141
142 CHAPTER 12. REINVESTMENT
• At the end of 10 years, immediately after Bill receives the final coupon
payment and the redemption value of the bond, Bill has earned an
annual effective yield of 7% on his investment in the bond.
• Calculate i
12.5. SOLUTION - COUNT BANKS / INTEREST RATES 143
12.6 Timeline #1
• Timeline #1
1000
−P 3% × 1000 = 30 30 ... 30
0 1 2 ... 20
• EOV: P = 30a20 20 .
+ 1000v3%
3%
• Calculator Timeline #1
N I PV PMT FV
020 3 CPT 30 1000
• P V = 1000.
12.7 When r = i
• In the last slide we saw an example where
• C=F
• r=i
144 CHAPTER 12. REINVESTMENT
• P =C
• If r = i then P = C
12.8 Timeline #2
• Timeline #2
A(20)
3% × 1000 = 30 30 ... 30
0 1 2 ... 20
• Note: i is rate per year; but we need j, rate per half year
• The calculator timeline approach does not work because there are too
many unknowns
• Calculator Timeline #2
N I PV PMT FV
20 CPT 0 −30 A(20)
12.9 Timeline #3
• Remember: This is a chapter 2 problem
• Bond Timeline
C = 1000
A(20)
P
0 1 2 ... 20
N I PV PMT FV
20 CPT 0 −30 1000(1.07)10 − 1000
• So j = 4.7597
• She uses the amount borrowed to purchase a 1000 par value 10-year
bond with 8% semiannual coupons bought to yield 6% convertible
semiannually.
• Calculate the net gain to the investor at the end of 10 years after the
loan is repaid.
146 CHAPTER 12. REINVESTMENT
... C = 1000
4% × 1000 40 ... 40
p
0 1 2 ... 20
4% × 1000 40 ... 40
A(20)
0 1 2 ... 20
12.15. THE FINAL SUMMARY LINE 147
• That is: The problem does not want the annual effective percentage
rate,
• Why? Because the person loaned P and then spent P on the bond
• All we care about is the overall gain at time t = n; What was spent
and earned?
12.19 Hints
• How many distinct investment rates / banks are there?
13.1 Overview
• We have 8 brief subgoals in todays chapter
• VI) Good exam problems on spot and forward rates, yield, and term
structure
149
150CHAPTER 13. STOCKS, MARGIN, SPOT, FORWARD, TERM STRUCTURE
• You can work any new expenses or gains into the basic formula above
• M01#27 Margin
• M03#36 Margin
• N00#24 Margin
• M05#22 Margin
13.10. M01#27 153
13.10 M01#27
• Jose and Chris each sell a different stock short for the same price.
• Each investor buys back his stock one year later at a price of 760 .
• The stock owned by Jose stock paid a dividend of 32 at the end of the
year while the stock owned by Chris paid no dividends.
• During the 1-year period, the return of Chris on the short sale is i,
which is twice the return earned by Jose.
• Calculate i
P −760+6%×50%×P −32
• Yield is iJ = 50%P
P −760+6%×50%×P
• So yield is iC = 50%P
154CHAPTER 13. STOCKS, MARGIN, SPOT, FORWARD, TERM STRUCTURE
•
1
1 (13.3)
(1 + rn )n
0 n (13.4)
• In words The price (PV) of an n-year zero coupon bond with redemp-
tion amount 1 is (1+r1n )n .
13.15 Strips
• Given any bond you can sell the coupons and redemption separately
• You have stripped the bond of its coupons and are selling them sepa-
rately
• The graph with the x-axis giving interest rates and the y-axis giving
spot rates is called the yield curve
• QIT#33
• QIT#34
13.18 Q-IT#34
• You are given the following information with respect to a bond:
Calculate the annual effective yield rate for the bond if the bond is
sold at a price equal to its [present] value.
156CHAPTER 13. STOCKS, MARGIN, SPOT, FORWARD, TERM STRUCTURE
13.19 Solution
• Coupon amount equals 1000 × 6% = 60
60
• Present value of 1-year strip of 60 equals 1.07
60
• Present value of 2-year strip of 60 equals 1.082
60
• Present value of 3-year strip of 60 equals 1.093
1000
• Present value of redemption strip of 1000 equals 1.093
60 60 1060
• Present value, price, of bond: 1.07 + 1.082
+ 1.093
=P
• Yield of bond: P = 60a3 i + 1000vi3 .
• SOA solutions suggest using TV Calculator Timeline
• Important: Notice how spot rates and yield are different.
13.23 Solution
• Use the one formula (??)
• (1 + ri )i (1 + fi,j )j−i = (1 + rj )j .
• So let i = 1, j = 2. Then
• (1 + r1 )(1 + f1,2 ) = (1 + r2 )2 .
•
1.085 × (1 + f1,2 ) = 1.0952 −→ 1 + f1,2 = 1.105.
158CHAPTER 13. STOCKS, MARGIN, SPOT, FORWARD, TERM STRUCTURE
Chapter 14
Callable Bonds
14.1 Overview
• We cover one topic today, Callable bonds
• VI) QIT#54
159
160 CHAPTER 14. CALLABLE BONDS
• The decision on when to redeem the bond is the seller’s not the buyer’s
14.8 P − C vs. g − i
• The definition was formulated in terms of P, C or g, i
• So P > C ↔ g > i.
• P >C
• 3) the redemption price C was the same for each redemption date
• Brute Force approach: You can also compute the yield for each
possible t and compare them
• Timeline #1
C
−P Cg Cg ... Cg
0 1 2 ... t
• Timeline #2
C
−P Cg Cg ... Cg Cg
0 1 2 ... t t+1
• The point is that the buyer has already paid for the bond
• As the yield goes to infinity the present value of the timeline goes down
to 0
• As the yield goes to 0 the present value of the timeline goes up to the
sum of all amounts (since interest is 0)
• So as yield goes up, PV goes down and as yield goes down, PV goes
up
166 CHAPTER 14. CALLABLE BONDS
• In other words, proving yt+1 > yt ⇔ P V2 > P V1 = P, if both tinelines are evaluated at yt
• But the two timelines have identical amounts except at the end
• So
• This last inequality is the theorem assumption that the bond is bought
at a premium, that is, P > C or equivalently g > i.
• QIT#55 Have to 1st find price at several dates and for each price find
minimal yield
• QIT#56 Have to 1st find redemption price at several dates and for
each price find minimal yield
• Simply check the earliest and latest coupon date and take the minimum
Duration, Convexity
15.1 Overview
• In this chapter we have the following 10 subgoals
• VII) M05#3
• X) Convexity formulae
169
170 CHAPTER 15. DURATION, CONVEXITY
• Timeline
C1 C2 ... Cj ...
t1 t2 ... tj ...
•
j=n
t
X
P V (i) = Cj v i j (15.1)
j=1
6%−5%
• You might say 5% = 20%
• Rather than 6%
• Suppose
• 1) P V 0 (i0 ) = 0
• 2) P V (i0 ) = 0
• We only need the first two terms of the Taylor series to develop the
definitions and theorems
dCvit dCeδt
• Note: dt = dt = tCeδt = tCvit . Hence,
X Cj vitj
!
0
tj (15.4)
P (i0 )
allj
• Duration Relationships:
• Where Dj is the duration of the j-th portfolio and P Vj (0) is the pur-
chase price (See problem M 05#6 for an example)
15.10 In Practice
• Modified duration is what you theoretically need to measure changes
in PV
• This allows you to estimate how changes in interest rates affect changes
in profits
15.12 Formulae
• It is confusing to memorize three similar formulae and their uses
•
P (i) ≈ P (i0 ) + P 0 (i0 )(i − i0 ) (15.6)
• Consequently,
• We obtain the following (almost linear) graph of the price of the bond
at t = 3 as a function i interest yield
• −−−−−−−−−
• −−−−−−−−−
• How good are your approximations for the absolute price change
• 3)What is exact price change Answer Exact New price − exact Price
• 7) What is the slope of the relative price change Answer Multiply the
last answer by minus 1
• What is the approximate new price Answer Add exact price to the
last answer
• How good are your approximations for the absolute price change An-
swer Divide the approximate answer by the exact answer and subtract
1
15.16 Project I
• I will post individual Project I-s for each student
• Note the following: To calculate the approximate new price you must
sequentially calculate
• N05#21 Immunization
• QIT#59 Immunization
• QIT#70 Immunization
• QIT#71 Immunization
• QIT#72 Immunization
• QIT#73 Immunization
15.19 Solution
• Step 1: Timeline
1000
100 100 100
0 1 2 3
• Step 3: TV line
789.35
3 20 CP T −100 −1000
N I PV PMT FV
X Ct v t
• Step 4a: EOV Duration t
P
100v 2 3
• Step 4b: EOV Duration Numerics: P × 1 + 100v 100v
P ×2+ P ×
3
3 + 1000v
P × 3 = 2.7
15.20. VIII) QIT#36 - GOOD QUIZ PROBLEM 179
• If you can do quiz with hints but not without them then you must
memorize
• Hints #2) Take the derivative of P (i) with respect to i (Piece of cake)
P0
• Hints #3) Take ratio P (Piece of cake)
P0
• Hints. Fill in #4) P gives Duration of fill in amount.
• In the process you have derived a useful formula for stock duration
without inflated dividends
• The SOA recently remedied this by adopting a new book with a great
new handout
• Hint: If you wanted to test someone on new material where would you
go?
Full Immunization
16.1 Overview
• We have five subgoals in todays chapter
• V) Asset Matching
183
184 CHAPTER 16. FULL IMMUNIZATION
t
X
• A(i) = Cj v i j
Cj >0
t
X
• L(i) = |Cj |vi j
Cj <0
• Note: Theorem assumption: You have one liability with two assets
• Timeline
• Assets: Buy zero coupon bonds before and after the liability date:
Say t = 3, t = 10.
16.9 Strategy
• We have two unknowns −→ We need two equations
• We obtain one equation for P (i0 ) = 0
• We obtain one equation for P 0 (i0 ) = 0
• We then solve the two equations in two unknowns
• And find the value of x and y
• Let us do A0 first
• But what is t1 , t2
• P (i) = 0 =⇒ x + y = 100000(1.02)−7
• Need to solve
• You now have a linear equation in one variable which is easy to solve
• So x = 37309.72, y = 49746.30
16.19 M05-#15
• An insurance company accepts an obligation
• To pay 10,000 at the end of each year for 2 years.
• The insurance company purchases a combination of the following two
bonds
• At a total cost of X in order
• To exactly match its obligation:
• (i) 1-year 4% annual coupon bond with a yield rate of 5%
• (ii) 2-year 6% annual coupon bond with a yield rate of 5%
190 CHAPTER 16. FULL IMMUNIZATION
t 0 1 2
Liability 10000 10000
F 1.04F 0
G 0.06G 1.06G
16.21 Equations
• The basic EOV is Assets = Liabilities
• Why? Because you will have one equation in one unknown and you
can solve
• 1.06G = 10000
• Next go to t = 1
• Two equations in two unknowns; piece of cake; solve for G; then solve
for F
• Final answer is PF + PG
Chapter 17
17.1 Overview
• We have the following 9 subgoals in this chapter.
• I) Insurance, Derivatives
• V) Short sale
• For Homework I want you to think how you would solve DS-Q#3
191
192 CHAPTER 17. INSURANCE, PUTS, CALLS, FORWARDS
• When you buy insurance: You buy the right to buy a car if your
current car is destroyed
• Insurance typifies not buying objects but buying rights to buying ob-
jects
17.4 Goals
• We will discuss puts,call,forwards-futures-buys-sales
• If your car is fine −→ you don’t exercise the insurace −→ you lose
your insurance premium
17.6. DERIVATIVE OVERVIEW - PROFIT DIAGRAMS/GRAPHS 193
• If the new car is worth more than your old car you profit
• They depend on possible future values of the underlying asset (in this
case the car)
• The money you give me for the asset is call the Price
• We call a buy/sale long if the Asset and price are both exchanged at
time t = 0
• You lose 30 at t = 0;
• Again this is all rough since we must take into account interest
• This means
• I receive the 30 at t = 0
• Notice that the asset has gone up but I, the seller, have lost 10
• Although the asset has gone up, you, the buyer, have gained 10
• I only need to pay 20 to cover my short and obtain a watch for which
I received 30
• So long and short are opposites (one profits when the other loses)
• But it is confusing because the same word can be used in two ways
17.19. STRATEGIES 197
17.19 Strategies
• Items like watches don’t fluctuate that much in price
• If you think a stock will go up you buy long and expect to profit
• If you think a stock will go down you sell short and expect to profit
• We say that your position in the foward is short (You make money if
asset goes down)
• In a future lecture we will discuss the fair price of forwards and how
to adjust for dividends
• Exchanges have rules which affect futures; forwards have less rules
• There are other differences but they are consequences of the daily
settlement.
• If the price of wheat or alfafa fluctuates I pay more for alfafa, eating
up my profits
17.32 Example
• Premium: 93.81
• Interest rate for 6 months: 2%
• Strike Price: $1000
202 CHAPTER 17. INSURANCE, PUTS, CALLS, FORWARDS
Actual Price-X Agreed Price Buy? Reason Payoff Premium Premium Profit-Y
t=6 t=6 t=6 t=6 t=0 t=6 t=6
900 1000 No No buy for more − −93.81 −95.68 −95.68
1000 1000 − − − −93.81 −95.68 −95.68
1100 1000 Y es Buy cheap 100 −93.81 −95.68 4.32
• The Call Payoff Diagram/graph looks like the clock position TIME 9:10
• We can also use letter notation: HU, a horizontal line (slope 0) followed by an upwards slanting line
• Call Profit Diagram Same shape but lower (The two graphs are translations)
• Note the horizontal line of graph =⇒ no exercise of options; the slanting line =⇒ exercise of option
• You might also benefit from using the following 3 more columns
• Furthermore, label each column with two header rows, the second row
indicating t = 0 or t = expiration date
17.35. IX) OPTIONS - PUT 203
• (Possibility #1)
• (Possibility #2)
• Long Put diagram looks like TIME 2:50 (Slanting downwards line,
followed by horizontal line)
• Important point: Short call and short put diagrams are x-axis re-
flections of the corresponding long positions
Introduction to Derivatives
18.1 Overview
• We have one goal today: Coverage of DS-Q#3
• X) Application to DS-Q#3
205
206 CHAPTER 18. INTRODUCTION TO DERIVATIVES
• Remember: For both puts and calls, the slanting part of graph corre-
sponds to exercise of option
• We have two ways to do table: Strike price equals i) 12 cents ii) 1200
dollars
• Put graphs look like time position 2:50; exercising of option occurs
on slanting part of graph
18.11 Forward at t = 1
•
Jalapeno Sale P rof it at 1
M arket price − X Cost to me P ayof f to me P rof it to me − Y
T =1 T =1 T =1 t=1
0.1 −1000 1000 0
0.11 −1000 1100 100
0.12 −1000 1200 200
0.13 −1000 1300 300
0.14 −1000 1400 400
0.15 −1000 1500 500
• We will examine this in more detail after introducing the graph method
18.18 Examples
• A long call graph is abbreviated HU corresponding to a 9:10 clock
position
• This unit slope of 1 or -1 is valid for long and short calls and puts as
well as buys and sales
• For example, in a call or put there are 2 regions (one H and the
2nd either U,D)
• If you want the actual graph vs. its form you have to identify the
y-intercept
• This rule follows from the way we have defined U,D,H for basic com-
ponents
• Piece of Cake!
• A Short call is HD
• A long put is DH
• A purchase is U
• Look over the basic 6 components and find the basic component with
a downward slanting line
• The premiums of the sold call and long put almost cancel
• You cut your profits (Downward short call line + upward forward line)
• Let us study part (A) Buy a 90-put, buy a 110 put, sell two 100 puts
Derivatives - Graphing
Methods
19.1 Overview
• This chapter deals with Derivatives
• I) Derivative Definition
• V) Illustrative Examples
217
218 CHAPTER 19. DERIVATIVES - GRAPHING METHODS
• You must know how to infer their properties from their Graphs
• The properties you must know are summarized in the following terms:
• You make a Profit at a given market (x) value if the y value is positive
(above x-axis)
19.6 Superiority
• Derivative I is superior to Derivative II at market value x, if yI (x) >
yII (x)
• Profits, caps and limits can typically be done without tables, compu-
tation of numerical values, by general graph methods
19.7 Volatility
• Volatility refers to changes in market value x
• A volatile stock’s market values will typically move away (left or right)
from the strike price
• A non-volatile stock’s market values will stay near the strike price
• The typical phrase to describe volatility is more volatile than the mar-
ket
• This emphasizes that although the market is volatile you expect higher
volatility in a given stock
220 CHAPTER 19. DERIVATIVES - GRAPHING METHODS
19.8 Moneyness
• Every option can be classified in one of three ways
• If selling the option at the current market price would bring a profit,
the option is ITM
• Note that ITM is different for calls and puts (Since their profit regions
are different)
• If the current market price would motivate not exercising the option,
the option is OTM
• This call premium compensated for the loss of premium in buying the
put
• This combo: Buying one option and selling another to offset premium
costs is common
• ITM options have higher premiums (Because you can make money if
the price persists)
• OTM options have lower premiums (Because you can’t make money if
the price persists)
19.11. III) GOOD DERIVATIVE PROBLEMS 221
• D-SQ#9
• D-SQ#15
• D-SQ#17
• D-SQ#26
• D-SQ#11
• D-SQ#13
• D-SQ#14
• D-SQ#16
• Note: This method is also a good start even when numerical tables
are necessary
• To make the table, you can break the derivative into component build-
ing blocks
• Since you know the slope of each graph segment you can quickly
compute any point
• So if you are away from the strike price the graph is horizontal
• That means you would not make a profit if market is very volatile
• This would not give you a profit if market values were away from strike
price
19.20 D-SQ#15
• The current price of a non-dividend paying stock is 40 and the con-
tinuously compounded risk-free rate of return is 8%. You enter into
a short position on 3 call options, each with 3 months to maturity, a
strike price of 35, and an option premium of 6.13. Simultaneously,
you enter into a long position on 5 call options, each with 3 months to
maturity, a strike price of 40, and an option premium of 2.78. Assum-
ing all 8 options are held until maturity, what is the maximum possible
profit and loss for the entire option portfolio?
P rof it Loss
A. 3.42 4.58
B. 4.58 10.42
C. U nlimited 10.42
D. 4.58 U nlimited
E. U nlimited U nlimited
• The first step is to analyze the graph using the graphing method
• We also show how to combine the graphical method with one computed
point at 0 to get the table
Join Graph H 3D 2U
• So one can see that the graph minimum occurs at the point y(40) =
−10.42
19.28. METHOD #3: FAST TABLES BY COMPUTING ONLY ONE POINT PLUS GRAPH227
• For the long call there is also no exercise at 0, again, because the graph
is flat
19.31 D-SQ#17
• Assume the current price for a stock index is 1,000, and the following
premiums exist for various options to buy or sell the stock index 6
months from now: Strike Price Call Premium Put Premium
Strategy I is to buy the 1,050-strike call and to sell the 950-strike call.
Strategy II is to buy the 1,050-strike put and to sell the 950-strike put.
Strategy III is to buy the 950-strike call, sell the 1,000-strike call, sell
the 950-strike put, and buy the 1,000-strike put.
Assume that the price of the stock index in 6 months will be between
950 and 1,050. In 6 months, which of the three strategies will have
greater payoffs for lower prices of the stock index than for relatively
higher prices?
A. I only
B. I and II only
C. I and III only
D. II and III only
E. I, II, and III
19.32. D-SQ#17-ANALYSIS 229
19.32 D-SQ#17-Analysis
• (Sketch) We analyze each derivative - I,II,III - using the graphical
methods
20.1 Overview
• We do a variety of short topics today
• I) Call-Put Parity
• IV) Hedging
231
232 CHAPTER 20. CALL PUT PARITY
•
C(K, T ) − P (K, T ) = S(0) − P V (K) (20.1)
• C(K, T ) is the premium for a long call, with strike price K and expi-
ration date T
• −P (K, T ) is the premium for a short put, with strike price K and
expiration date T
• Short Put: Buyer (of short) will sell stock and receive K, at time T
- if price at T is less than K
• Short Put: Equivalently, Seller of short (me) will buy stock and pay
K, at T - if price at T less than K
20.5 Proof-Equality
• So right side and left side describe the following identical situation
• I own stock and pay K at time T
• −→ Consequently, the cost of the two sides of the equation must be
equal
• The right side deals with stock; the left side deals with options
• This is called the call-put parity principle
• It is a single principle that enables you to solve any situation relating
the following
• premiums of call and put options with the same strike price and
expiration, and the underyling stock, provided no dividends are paid
• Let us now look at some examples.
20.6 D-SQ#2
• You are given the following information:
• The current price to buy one share of XYZ stock is 500.
• The stock does not pay dividends.
• The risk-free interest rate, compounded continuously, is 6%.
• For both the call and put:
• Strike price is K; expiration date is one year; option is European
• Put premium is 18.64
• Call premium is 66.59
• Using put-call parity, determine the strike price, K.
234 CHAPTER 20. CALL PUT PARITY
20.8 Solution
• We solve this equation for K
• We obtain K = 480
20.9 D-SQ#5
• You are given the following information:
• You want to buy this index in one year for a price of 1,025.
• You do this with put and call options with a strike price of 1,025.
20.11 Interpretation
• Tricky question. Published SOA solutions do not solve this using put-
call parity
• But remember: Put-call parity is all you need when dealing with op-
tions/stocks at same strike price and expiration date
• I should buy the call (long) and sell the put (Short)
• This is an English convention: You for example say that the cost of a
pen is 10, not -10.
• If stocks have been going down for a while you may want to sell short
• When people speak about the market trend they may be speaking
about the DOW
20.14 D-SQ#14
• The current price of a non-dividend paying stock is 40 and the con-
tinuously compounded risk-free rate of return is 8%. You are given
that the price of a 35-strike call option is 3.35 higher than the price
of a 40-strike call option, where both options expire in 3 months. How
much does the price of an otherwise equivalent 40-strike put option
exceed the price of an otherwise equivalent 35-strike put option?
20.17 Algebra
• We have left to solve
• Rather we are solving for the algebraic expressions, C(35) − C(40) and
P (35) − P (40)
• We start with the first two equations presented two slides ago
N ame W hen you pay W hen you receive security P rice F ormula
P urchase 0 0 S0
Leveraged P urchase T 0 S0 ert
P
P repaid F orward 0 T S0 = F0,T
F orward T T S0 ert = F0,T
238 CHAPTER 20. CALL PUT PARITY
20.19 D-SQ#29
• Good problem.
• It is a straightforward plug in
• You should complete the lecture, especially the part about Dividends
prior to attempting this problem
• Why? Because you bought stock and hence are a co-owner in the
corporation
• If the stock goes up you get more dividends; if the stock goes down
you get less
• Traditionally the rate of monetary growth is called the risk free rate
20.27. FAIRNESS ISSUES 241
• The Dividends are part of the stock deal, for example, there might be
automatic reinvestment
• Otherwise, the seller would receive the value of the dividends twice.
• The stock price grows by the risk free interest rate, r, governing money
growth
• But we subtract from the stock the dividends because the buyer al-
ready received them
• The sum is taken over all times t when dividends are given
20.30 D-SQ#20
• The current price of a stock is 200, and the continuously compounded
interest rate is 4%. A dividend will be paid every quarter for the next
3 years, with the first dividend occurring 3 months from now. The
amount of the first dividend is 1.50, but each subsequent dividend will
be 1% higher than the one previously paid. What is the fair price of a
3-year forward contract on this stock?
20.31 Solution
• Break up the price into two parts
• i) Growth of stock
• Note this gives the value of the stock without consideration of divi-
dends
20.36 Numbers
• i0 = 0.004967%
• 200e.04×3 = 225.50
20.38 Hedging-Options
• One type of hedging is insurance hedging
20.40 D-SQ#19
• You are a producer of gold, and have expenses of 800 per ounce of gold
produced. Assume that the cost of all other production-related expenses
is negligible, and that you will be able to sell all gold produced at the
market price. In 1 year, the market price of gold will be in 1 of 3
possible prices, corresponding to the following probability table: Gold
will either be 750 an ounce with probability 20%, 850 an ounce with
probability 50% or 950 an ounce with probability 30%. You hedge the
price of gold by buying a 1-year put option with an exercise price of 900
per ounce. The option costs 100 per ounce now, and the continuously
compounded interest rate is 6%. Which of the following is closest to
your expected 1-year profit per ounce of gold produced?
Arbitrage
21.1 Overview
• We are covering one topic today, Arbitrage
• IV) Stock Arbitrage - Fair Forward Price less than Actual Market
Price
• V) Terminology
• VI) Stock Arbitrage - Fair Forward Price more than Actual Market
Price
• VIII) Exercises
249
250 CHAPTER 21. ARBITRAGE
• The same object, pens, are being sold for two prices
• How?
• Here r is the risk free continuous rate currently offered by the Market
• Recall we subtract dividend worth since the seller owned the stock till
t
•
F0,t = S0 ert e−δt (21.1)
• If r and δ are the current market rates we call the resulting forward
price,Fair
• But the market may offer a forward price different than the fair forward
price
• So you have two prices for the same object: actual market vs. fair
21.11. STOCK ARBITRAGE - FAIR FORWARD PRICE LESS THAN MARKET FORWARD PRICE253
• T = 0.5
T =0 T =0 T =0 T = 0.5 T = 0.5
Action Have/P rof it N eed/Owe P rof it/Have N eed/owe
• Profit: At t = 0.5, I profitted F0,T −S0 e−δT erT = Actual M arket F orward−
Synthetic F air F orward = 965 − 960.79 = 4.21
21.15 V) Terminology
• We call this arbitrage a cash and carry arbitrage
• The first two rows of the tableau are called a synthetic long forward
• You can check that the two rows together have the characteristics
of an actual long forward
• That is, at T = 0.5 you have 1 share of stock and must pay the
forward price S0 e−δT erT
• In the pen example, we shorted a pen high and longed a pen low
and profited on the difference
• In each case the profit is the difference between the high short
and the long low.
21.16. SYNTHETIC FORWARDS 255
• Actual market forward price is lower than the fair forward price
• Indeed: At T = 0.5 in rows 1,2 I have received money and owe one
share stock
• But you cannot do rows 1 and 2 in one step you need two rows
• Why? Because no one would pay me 970.45 for 1 share when they can
buy this share in the market for 965
T =0 T =0 T =0 T = 0.5 T = 0.5
Action Have/P rof it N eed/Owe P rof it/Have N eed/owe
Short Stock +S0 e−δ T $ −e−δ T shares See next row −1 Share
Lend NA −S0 e−δ T $ +S0 e−δ T erT $ NA
Long F orward NA NA +1 Share −F0,T $
• You could still arbitrage based on F Actual M arket and F Synthetic F air
Swaps
22.1 Overview
• Today we cover swaps
259
260 CHAPTER 22. SWAPS
• Given: You are also given a collection of spot rates (n-year interest
rates from t = 0, today)
• Suppose that interest rates are determined from the following table:
• r1 = 5%, r2 = 5.5%, r3 = 6%
• If the farmer uses a commodity swap to hedge the price for selling
pork bellies,
• what is the level amount he would receive each year (i.e. the swap
price)
X X X
0 1 2 3
r1 = 5% r2 = 5.5% 53 = 6%
•
1
vii = = Price of a 1 dollar n-year zero coupon bond (22.1)
(1 + ri )i
• The following terms are also relevant: prepaid swap, back-to-back trans-
action, swap term, swap tenor, asset swap, swap spread, deferred swap,
accretizing swap, amortizing swap, swaption
• Instead of wanting 50 tons per year for all years we suppose we want
• Since we wanted 50 tons for each year, we multiplied the amount per
ton by 50
• We still use the relation between present value, vi and spot rates ri
X × 10 X × 20 X × 30
0 1 2 3
r1 = 5% r2 = 5.5% 53 = 6%
• Convert spot rates to present values and solve for the basic amount X
22.19 A subtltety
• D-SQ#4 presents an interesting problem
• This is true
• One can also apply the concept of swap - actuarially equivalent level
payments,
266 CHAPTER 22. SWAPS
• It is instructive to work out why use of the factor vs. rate is eqiuvalent
• You enter into a 5-year interest rate swap (with a notional amount of
100,000)
22.24. LIBOR 267
• to pay a fixed rate and to receive a floating rate based on future 1-year
LIBOR rates.
• If the swap has annual payments, what is the fixed rate you should
pay?
22.24 LIBOR
• LIBOR is an acronym for London Interbank Offered Rate
• The Libor rate is the average interest rate that leading banks in Lon-
don charge when lending to other banks.
• In other words each bank borrowing money from another bank pays
the lending bank interest
• The LIBOR is the average of these rates among major banks and is
published
• Many financial entities use the LIBOR rates as a benchmark for their
own rates (which may be higher)
• The maturity value can be 30 days, 90 days, and several other values
up to 10 years
• The loans with smaller maturity, such as 30 and 90 days, are call
T-bills
• Why? It is not varying and gets cancelled from both sides of the
equation
• (1 + f0,1 ) = (1 + r1 ) −→ f0,1 = r1
(1+r2 )2
• (1 + r1 )1 (1 + f1,2 ) = (1 + r2 )2 −→ 1 + f1,2 = 1+r1 = 1.050024 −→
f1,2 = 5%
X X X X X
0 1 2 3 4 5
r1 = 4% r2 = 4.5% r3 = 5.25% r4 = 6.25% r5 = 7.50%
22.30 EOV
• P V1 = 4%v1 +5.002%v22 +6.766%v33 +9.307%v44 +12.649%v55 , vii =
1
(1+ri )i
1
• P V2 = Xv1 + Xv22 + Xv33 + Xv44 + Xv55 , vii = (1+ri )i
• P V1 = P V2 −→ X = 7.20%
• 2) Let Pi denote the price of an i-year zero coupon bond with a re-
demption of 1 dollar
Appendix
271
272 CHAPTER 23. APPENDIX
23.3 Notation
• Graph Column: H = Horizontal, U = U P, D = DOW N, (Line seg-
ments left to right)
• ATM means AT THE MONEY; OTM means out of the money; ITM
means In the Money
• Its graph is HUDH but the UD part is not symmetric (hence the name)
• K2 is a weighted average: K2 = L × K1 + (1 − L) × K3
Please find on the next page a table of contents. To illustrate use of the table: We see that
problem M00#26, is illustrative of Loan problems. It particularly illustrates the technique of
writing down examples of the first few rows and detecting a pattern (in contrast to other
problems where you plug in a formula)
The reader must look up the problem prior to reading the solution
The abbreviations used follow the abbreviations listed in the introduction
The problems themselves are copyright SOA and are reprinted with
permission
The SOA also has copyrighted solutions
My solutions reflect my methods; sometimes all I have added to the SOA
solutions are timelines and calculator TV lines; sometimes (as in inflation
problems) my approach is totally different
My own solutions are copyright (like the rest of these notes; that simply
means that anyone using the notes should retain identification of the
author (me) and not use them for monetary gain)
The solutions are not direct to the answer; rather they illustrate the
thinking process that a student must go through to arrive at an answer.
This includes choosing between competing methods. It also includes
fundamental items that must be memorized.
Area Problem Topic-Subtopic
Time Value of Money M01#49 Force – Nominal –
Discount
QIT#1 Force – Nominal –
Comparison
QIT#9 Amortization – 13
Formulae – Examples /
Patterns – English
Conventions
Time 0 1 2 3 5
A(t) X X(1.05)2t
Express as
function of t=5
Fabio Timeline
Time 0 1 2 3… 5
A(t) 1000 1000(1+ti) = Z
We have
However you can’t use that formula unless you express A(t) as a function of t. Why? Because if you use
t=5, you have a constant and can’t differentiate.
The problem is testing your capacity to do abstraction. Now let us do the differentiation (Which you are
suppose to know!!!)
But then
Note that this is the traditional formula for force of compound interest
But now, and only now, we plug in t=5. We can multiply both sides by the denominator and obtain a
linear equation and solve
The problem asks to solve for Z. We however had to solve for i first. We obtain
Summary of tips:
Use timelines
Use unknowns for what you don’t know
Express in variable form if you have to differentiate (This is a key reason this is a level 7
problem)
Express EOV up front
Know your formulas (Have you memorized chapter 2 yet! All formulas in Chapter 2 of my
notes are very important and will appear on exams)
Sample Problems Question #1 ( c ) Sp 2015 Dr Hendel;
Solution reflects Dr Hendel’s approach
Force-Nominal-Comparison
Time 0 1 2… 14.5
Payment 100 A1(14.5)
Timeline 1: Bruce. Period=half year. Interest / period =2 %
Time 0 1 2 .. 7.25
Payment 100 0 0 … A2(7.25)
Timeline 2: Peter. Period = one year. Force of interest δ
Timeline equations:
A1(14.5) = 100(1.02)14.5= 133.26
Date 1/1 2/1 3/1 4/1 5/1 6/1 7/1 8/1 9/1 10/1 10/15 11/1 12/1 1/1
Deposit 75 10 10- 10 10 10 10- 10 10 10 -80 10- 10 60
5 25 35
Step 3: Bernoullie:
Using the Bernoulli approximation we have
75(1+12/12 i) + 10 (1+ 11/12 i) + 5(1+ 10/12 i) + 10(1+9/12 i) + 10(1+ 8/12 i) + 10(1+7/12 i) - 15 (1+6/12
i) + 10(1+5/12 i) + 10(1+4/12 i) + 10(1+3/12 i) -80(1+2.5/12 i)-25(1+2/12 i)+10(1+1/12 i)=70
TIMELINES
t 0 4 8 12... 20 40
t 0 1 2 3… 5 10
Payment 100 100 100 … 100… 100
Accumulated X/5=A(20) X=A(40)
Value
General Timelines @ rate i per year; broken up into two timelines till 5 and 10
t 0 4 8… 16 20
t 0 1 2… 4 5
Payment 100 100 100… 100 A(5)
Timeline 2: @ i per year.
t 0 4 8… 36 20
t 0 1 2… 9 10
Payment 100 100 100… 100 A(10) =X
Timeline 3: @ i per year.
CONVERSION BOX
i is rate per year
j is rate per 4 years
(1+i)4 = 1+j
TIP: We do not need i. We only need vj. This will save you
time
EOV
Next we observe several possible EOV based on the cut off points
How do you decide which EOV to use? Or, perhaps both of them are OK?
The basic idea is to take the EOV where the manipulations are most straightforward
After studying the two EOV we can see that EOV with cutoff at $n$ allows cancellation. We have
TV LINE
We can solve this last equation with a TV calculator line as shown below
N I PV PMT FV
CPT 10.5 -77.1 x 10.5\% -1 0
= 8.0955
N=19
FM – M03#45 Annuities Inflation Refinancing
( c ) 3/24/2015 Dr Hendel – Solution reflects Dr Hendel’s approach to these problems
TIMELINE 1
0----100 (t=1)----100(t=2) ----…
An exchange is made at t = 5. So we need the the outstanding balance (OB) at t=5. This
outstanding balance (OB) is the present value at t=5 of all future payments!
To envision all timelines I use a trick of absolute dates and relative dates. The difference
between the absolute and relative dates on any timeline is constant. Here is an outline for this
problem
TIMELINE II
Remember the trick of reinvestment: We are standing at 2005 so that is 0.
This timeline is equivalent to TIMELINE III evaluated at the modified rate of i’ where 1/(1+i’)
= 1.08/1.08=1 i’=0%.
TIMELINE III
0----------------X(t=1)--------------X(t=2)-------------X(t=3)…..X(t=24)
We now have to find the outstanding balance of TIMELINE II at t=10. We also need the
payments at t=10 and t=11. For this we use the pattern technique.
Notice that we use Timeline II to compute the outstanding balance. If we used TIMELINE III
to compute the outstanding balance we would use a level payment of X which is incorrect
TIMELINE IV
t=0-------------t=1, X(1.08)10----------t=2, X(1.08)11….t=15, X(1.08)24
We still use the same i’. Why? Because inflation and interest rate are the same so modified rate
is same.
TIMELINE VI
Remember: We are now standing in 2015. The 1619.19 is exchanged for a perpetuity. We have
the following timeline
1619.19-----------Y(t=1)-------------Y(t=2)…
QIT#93
Solutions ( c ) Dr Hendel, Spring 2015
Solutions Reflect Dr Hendel’s Approach
Annuity – Increasing Yearly/Level Monthly
TIMELINE #1
0—2000(t=1)--2000(t=2)---2000(t=12)---2000(1.02)(t=13)….2000(1.02)(t=24)----2000(1.02)24(t=275-300)
TIMELINE #2
Fundamental technique: The first 12 payments of 2000 have a value of at t=0. Similarly the next 12
payments of 2000(1.02) have a present value at t=12 of
Tip: In computing i’ remember to use j not i. Why? Because i is the rate per month while j is the rate per year.
TIMELINE 4
1(t=0)-----------------1(t=1)---------------1(t=2)----------------------------------------------------1(t=24) @ i’=1.040861
The way you recognize refinancing problems is by a recalculation of PVs at a time different than 0. The
recalculation may involve different i,n. It may also involve conversions.
This problem has 3 timelines and 5 equations. So it affords us an opportunity to review how to approach
solving several equations in several variables
Timeline 1:
Notice how I converted immediately. Neither year nor the nominal 8% interest rate are mentioned. This
is the best way to avoid accidental errors.
Timeline 2:
Notice the problem. Timeline 2 begins at the old t=12 but is a new timeline so t=0. The best way to avoid
confusion is to use two sets of labels. I have found this very helpful.
OLBI12-------------R2----------R2----------------------------i=1.5%/quarter-------------------------40-12=28 periods
12-------------------13----------14---------------------20-------------------------------------------------------40
0---------------------1------------2----------------------8------------------------------------------------------28
The symbol refers to what is already in memory. (Recall we entered 2% when calculating R. So I and
PMT are retained. Also note that when computing the OLB at t =12 we use N=28 (40-12) since we use a
prospective approach, with 28 periods left.
These 2 equations are the essense of refinancing, computing PV at two different 0 points. It is not
conceptually difficult. But you have to have a system to avoid error.
Timeline 3:
Second, we have an extra payment of X at t=20 of first timeline, which is t=8 of second timeline. How do
we deal with this. We have two issues.
Is it OLB120 or OLBII8. One of the tricks of refinancing is forgetting previous timelines. In this case
we are on timeline II, so we have forgotten timeline I. So we use OLBII8
How do we deal with X. To answer this recall the meaning of OLBII8: It is what is owed at time 8.
If you like it is the new loan at time 8. If I owe OLBII8 and I immediately pay back X at the time of
the loan then my loan is really OLBII8 – X. This is the fundamental method of dealing with paying
off. Simply subtract from the OLB.
We need OLBII8.
Solution Time:
We have 3 EOVs. So we have 3 equations. But we have 5 unknowns: R1, R2, X, OLBI12, OLBII8. We have
two more equations for OLBI12, OLBII8. But even then we have five equations in 5 unknowns. How do you
solve them.
Trick for solving 5 equations in 5 unknowns: If some equations have one unknown solve them first. Then
you have 4 equations in 4 unknowns. Repeat the process (find the equation with one unknown). This has
been done throughout the document. We could have waited to the end to solve OR we could solve as
each equation comes up. That is a matter of taste. But an important principle of solving many equations
in many unknowns is when each equation gives one more unknown.
Summary: Go back through the document. Make sure you understand the basic characteristic of
refinancing, a recalculation at a different 0 point.
SOLUTION M00#24 ( c ) 2015 Dr Hendel, AMORTIZATION – REFINANCING Reflects my approach to these problems
Notice how the two loan timelines are straightforward. The hard part of the problem? The connection between the two
loans. Here are some of the issues
Before proceeding further make sure you understand why you are confused by the above
To solve this dilemma you need a 3rd timeline for the 6 months between the 8th and 9th payment
t=4 years 4 years 1 month 4 years 2 months 4 years 3 months 4 years 4 months 4 years 5 months 4 years 6 months
th
8 payment 0 point of 1st payment
1st loan new loan (0 new loan
point is one
period
before 1st
payment-
deep)
Interest rate 0.9902% 0.9902% 0.9902% ¾% Why? ¾% ¾%
(1+j)6 Because loan
=1.0609 is refinanced
3 months
before 9th
payment is
due
OLB8I 1.0099 OLB8I 1.00992 1.00993 1.00993
1.00993
OLB8I OLB8I 1.0075 OLB8I
1.00752
OLB8I=L2
To understand what is going on I made a timeline with 4 rows of labels. Notice how Chapter 2 is the hard part of the
problem not amortization as you might expect. Here are the calculations
Notice how I left the numbers in expression form rather than simplifying to one number.
The purpose of doing this is to facilitate seeing patterns. Also notice how I don’t care about R which of
course equals I + P. Now let us look at row 2
We do not yet see all patterns. The rule of thumb is to do 3-4 examples. If you don’t see anything by
then, give up. So let us do row 3.
At t = 16, Bank X sells to Bank Y all i) future interest and ii) principal payments at a new interest rate.
The reason that the sales price is not OLB16 is because the interest has changed.
The new interest rate is j with (1+j)6 = 1+ 14%/2, o r j = 1.1340%. Notice the two conversions: You have
to convert both the nominal and the compound rates.
1) The current value at t =16 of principal is a level stream of 20 payments (from t=17 to t=36) of
550.
3)
Adding (1) and (2) but subtracting (3), we get 9792.39 + 3525.26 - 2460.38 = 10857.27.
The published SOA solutions noticed a further pattern. They noticed that 198 = 36 x 5.5. So
But then I17 – I35 is simply 20*5.5 to 1*5.5. So they subtract 5.5 (Da)20
The reason I did it without this extra pattern is in order to emphasize that you can solve a problem
without noticing every pattern. You do have to notice some basic patterns; but once you notice the
minimum patterns you can solve. You may, as in this example, have to combine annuities and use
discount or accumulation factors.
M03#49 Dr Hendel ( c ) Sp 2015
Solutions reflect Dr Hendel’s approach
This problem requires pattern recognition. That is the hard part
because you can’t use the formulas till you find the pattern.
The only way to find patterns is to do examples and that takes
time which you have to spend
TIP: Use variables not numbers since it helps you see the
pattern.
T R I P OLB
0 1000 = L
1 10% L 10% L 0 1000
2 10% L 10% L 0 1000
…
10 10% L 10% L 0 1000= L
N I PV PMT FV
10 10 -(95%)10 CPT=97.44 0
1000
Reinvestment N05,#16, ( c ) Dr Hendel Spring 2015; Solutions reflect Dr Hendel’s approach
TIMELINE 1
925 45 45 … 1045
0 1 2 … 10 x 2
TIMELINE 2
45 45 …
0 1 2 … 20
These 3 steps need not be done simultaneously. You can simply state A(20) and later identify its value
SUMMARY TIMELINE
0 1 2 20
TLine 1 925 1000
TLine 2 1272.59
Summary 925 2272.59
QIT#7 ( c ) Dr Hendel Sp 2015; Solutions Illustrate Dr
Hendel’s Approach
Reinvestment – Decreasing - Examples
TIMELINE
Fund X Timeline 6%
1
T 0 1 2 3 4… 8 9 10
Deposits 1000 1060 954 848 …
900 800 700 … 100 0
Fund Y Timeline 9%
2
Deposits 160 154 148
Timeline 2: This timeline has the interest and principle withdrawn from timeline 1
Timeline 3: This is a standard trick for decreasing cashflow. (1) First raise the first amount by the
constant decrease.
So the 160 becomes 166. Make the 166 a level annuity and the decreased amount becomes an increasing
annuity times 6
EOV
TV LINE
N I PV PMT FV
10 9 CPT=1065.33 -166 0
BGN
Retain Retain CPT=2.7711 -1 10 Brovender
Divide .09=30.79
X 6 =184.74
Subtract 880.59
10
X 1.09 2084.67
NOTE: Why did I use PV and then multiply by 1.0910? Couldn’t I have just used future value?
Answer: By using PV, I can use Brovender’s trick simplifying calculations.
QIT#9 ( c ) Sp 2015 Dr Hendel, Solution Reflects Dr
Hendel’s Approach
Amotization – Examples – 13 Basic Formulae – English
Conventions
English-Algebraic Derivations
Text Of Problem with Key Phrases Underlined
A 20-year loan of 1000 is repaid with payments at the end of each year.
Each of the first ten payments equals 150% of the amount of interest due. Each of the
last ten payments is X. The lender charges interest at an annual effective rate of 10%.
Calculate X.
Figure 1: Text of QIT#9. Problem is ( c ) SOA and reprinted from their website with permission.
English Algebra
20 year loan N=20
1000 L=1000
Payments equals 150% of amount of interest do Rt = 150% It, t=1,2,3,…
Last 10 payments is X Rt = X, t=11,12,13,…
Interest at an annual effective rate of 10% i=10%
AMORTIZATION TABLES
We now look at examples and explore patterns using a standard table and formulae
T R I P OLB
0 1000 = L
1 150% I 10% L 150% x 10% L L-5% L =95% L
– 10% L = 5%
L
2 150% I 10% 95% L 150% x 10% (95%)2 L Exponent 2 = t=2
95% L – 10%
95% L = 5%
95% L
3 150% I 10%(95%)2 L 5% (95%)2 L (95%)3 L Exponent 3= t=3
… … … … … …
10
(95%)10 L Justified
by Pattern
of
examples
11 X
12 X
13 …
14-19 …
20 X
Table 2: We break the problem into two amortization tables. The first 10 rows correspondes to
one amortization table.
The 2nd 10 rows corresponds to the 2nd amortization table. Notice how we have to use
examples and patterns in the
first 10 rows in order to see the pattern. The purpose of this is to derive a formula for the OLB10
EOV: There are two EOV; one for the first 10 rows and one for the 2 nd
10 rows.
TV LINE
N I PV PMT FV
10 10 -598.74 CPT=97.44 0
QIT#10 / M03#42 ( c ) Sp 2015, Dr Hendel, Solutions
Reflect Dr Hendel’s Approach
Bonds – 13 Formulae – Plug in – English Conventions
Text of Problem
A 10,000 par value 10-year bond with 8% annual coupons is bought at a premium
to yield an annual effective rate of 6%.
Calculate the interest portion of the 7th coupon.
Figure 1: Text of QIT#10. Text is copyright SOA and reprinted with permission
Although not necessary for the problem we explain the terms “bought at a premium” and related terms
EOV: Approach #2
I7 = I OLB6 = 6% OLB6
TV LINE
N I PV PMT FV
4 6% CPT=10693.02 8% x 10000 = 800 10000
Sample Problems, #74 Bond Comparison
( c ) Dr Hendel Spring 2015;
Solutions reflect Dr Hendel’s approach
Bonds – Pricing - Comparison
Note: This problem can be done using either the Fr or C(g-i) formulae.
TIPS:
Do all conversions up front
Write EOV up front
Conversions
Phrase in problem Conversion
10 years n = 20
Coupon rate of i+4% i/2 + 2%
Coupon rate of i-4% i/2 – 2%
Yield …nominal rate of i convertible i/2
N I PV PMT FV
20 CPT =4.2 -5341.12/400 1 0
So i/2 = 4.2% i = 8.4%
QIT#55
Solutions © Sp 2015, Dr Hendel
Solutions Reflect Dr Hendel’s Approach
Bonds - Callable
Tip: As I indicated in class, these problems can be confusing since there are so many things to
check. I present in this solution an organizational technique. The organization is based on
roman numerals I,II,III and upper case letters A,B,C.
N I PV PMT FV
40 3 CPT=1261.80 40 1100
1B: Check yield of part (A) with other possible call dates and call values.
Remember, the coupons remain the same. Peeking through the problem we see that we must
check 2 x 15 = 30 through 39. Since the premium will be the same on these dates, 1200, we
only have to calculate 1 or 2 points. (Thoughout the solution I am checking 2 points but
indicating which one I didn’t have to do if applicable)
N I PV PMT FV
40 3 CPT=-1261.80 40 1100
NOTE: Since the bond is (bought) at a premium C=1200 <1261.80=P, the earliest yield, t = 30,
is the lowest, lower than 39. But a safe approach is to always check two points.
IIA: Calculate the bond price using the alternate call premium.
N I PV PMT FV
30 3 CPT=1278.40 40 1200
IIB: Check yield of part (A) with other possible call dates and call values.
Peeking through the problem we see that we must check N=39, C=1200 and N=40, C=1100.
Since the bond is bought at a premium we need not check N=39, C=1200 but do so anyway
N I PV PMT FV
30 3 CPT=-1278.40 40 1200
N I PV PMT FV
39 3 CPT = -1291.23 40 1200
Answer to question: Look over all the (B) parts. Remember, the buyer does not know which
call date will be used. The buyer wants at least a 3% yield. Only one of the B tables gives a 3%
yield for all redemption values and prices. Hence we use table IA: The maximum, indeed only
price, is 1261.80. Why? By Table IB, the buyer may get either 3%, 3.07% or 3.10% depending
on when the seller calls. So indeed the buyer gets at least 3% as required.
Quick Method for Solving Interest Swap Problems , Problem 23 Sample Derivative problems
(c ) Dr Hendel Sp 2015; Solution reflects Dr Hendel’s approach
t 1 2 3 4 5
1+f0,1 1+f1,2 1+f2,3 1+f3,4 1+f4,5
Timeline I: Timeline of 1-year forward rate factors
t 1 2 3 4 5
1+i 1+i 1+i 1+i 1+i
Timeline II: Timeline of level one year swap rate factors
t 1 2 3 4 5
1 1 1 1 1
Timeline III: Timeline of level ones (Warning: This is not calculable on TV line; why?)
t 1 2 3 4 5
i i i i i
Timeline IV: Timeline of level swap rates (Warning: This is not calculable on TV line; why?)
t 0 1 2 … 5
1 0 0 0 -1
Timeline V: Deposit 1 in bank at time 0 and withdraw that 1 at time 5 (Withdraw all interest)
Note: (1+ri-1)i-1 (1+fi-1,i) = (1+ri)i 1+fi-1,i = (1+ri)i / (1+ri-1)i-1 (1+fi-1,i)/ (1+ri)I = 1/(1+ri-1)i-1
Hence TLI = 1 +1/1.04 + 1/1.0452 +1/1.0553 + 1/1.06254 = 4.5135