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I.

Interest Rate Measurement:



Accumulation Function, a(t): Accumulated value @ time (t) of an original investment of $1
Amount Function, A(t): Accumulated value @ time (t) of an original investment of $K
A(t) = K o(t)
Effective Rate of Interest, i
t
=
a(t)- a(t-1)
a(t-1)

Effective Rate of Discount, J
t
=
a(t)- a(t-1)
a(t)

1 J
t
=:
t
=
u(t-1)
u(t)

1+i
t
=
1
1-d
t

For simple interest, o(t) = 1+t i
For compound interest, o(t) = (1+i)
t


Nominal Rates:
o i
(m)
=Nominol onnuol rotc o intcrcst compounJcJ (m) timcs pcr ycor
o

(m)
m
=Eccti:c rotc o intcrcst pcr m
th
o o ycor
o J
(n)
=Nominol onnuol rotc o Jiscount compounJcJ (n) timcs pcr ycor
o
d
(n)
n
=Eccti:c rotc o Jiscount pcr n
th
o o ycor
o To convert between nominal rates, use the equivalence of rates:
(1+

(m)
m
)
m
=(1+

(n)
n
)
n


(1
d
(m)
m
)
m
=(1
d
(n)
n
)
n


[1+

(m)
m

m
=
1
_1-
d
(n)
n
]
n

Force of Interest:
o Measure of interest @ individual moments of time
o Interest payable continuously
o o
t
=
A
|
(t)
A(t)
=
u
|
(t)
u(t)

For Simple Interest:
o
t
=
i
1+i t

For Compound interest:
o
t
=ln(1+i)


Real rate of interest:
o The real rate of interest takes into account the rate of inflation =r
o i
cuI
=
-
1+


II. Valuation of Annuities:

Annuity Immediate:
o Prcscnt Ioluc,o
n
=
1-
n


o AccumulotcJ Ioluc, S
n
=o
n
(1+i)
n


Annuity Due:
o Prcscnt Ioluc,o
n
=
1-
n
d

o AccumulotcJ Ioluc,S

n
=o
n
(1+i)
n
=
(1+)
n
-1
d


Relationship between immediate & due:
o Note that an annuity due is equivalent to an annuity immediate evaluated one period later
o
n
(1+i) =o
n

S
n
(1+i) =S

n

o
n
=o
n-1
+1
S
n
=S

n-1
+1

Deferred Annuities: (n payments deferred for m periods)
o m|o
n
=:
m
o
n
=o
m+n
o
m


Accumulated Value of (n) payments (m) periods after last payment:
o (1+i)
m
S
n
=S
n+m
S
m


Perpetuity Immediate:
o o

=
1



Perpetuity Due:
o o

=
1
d



Annuities Payable m
thly
:
o Each period has (m) payments of
1
m
each
o o
n
(m)
=
1-
n

(m)

o This can be also attempted as an ordinary annuity with (mn) payments

Arithmetically Increasing Annuities:
o Io
n
=
u
n
-n
n


Using BAII Plus:
Set mode to BGN
N=n
PMT=1
FV=-n
CPT, PV
Divide by (i)
o IS
n
=
S

n
-n


o Io
n
=
u
n
-n
n
d

o IS

n
=
S

n
-n
d


Increasing Perpetuity:
o Io

=
1+

2

o Io

=(
1+

)
2


Decreasing Annuities:
o o
n
=
n-u
n


o o
n
=(1+i)o
n
=
n-u
n
d

o S
n
=
n(1+)
n
-S
n


o S

n
=(1+i)S
n

Using BAII Plus:
Set mode to END
N=n
PMT=-1
PV=-n
CPT, FV
Divide by (i)


Geometrically Varying Annuities:
o PI
ucomctc
Immcdutc
=
1-(
1+r
1+i
)
n
-

o PI
ucmomctc
uc
=PI
ucomctc
Immcdutc
:
o If r =i PI
ucomctc
Immcdutc
=n:
o If r =i FI
ucomctc
Immcdutc
=n(1+i)
n-1


Geometric Perpetuity Immediate:
o Present value is only defined for r <i
1
-


Continuous Annuities:
o o
n
= :
t
Jt
n
0
=
1-
n
6
=

6
o
n

o S

n
=
(1+)
n
-1
6
=

6
S
n


Continuous Varying Annuities:
o Io

n
=
u
n
-n
n
6

o IS

n
=
S

n
-n
6

o If the payment @ time (t) =(t) and the force of interest is o
t
:
o PI = (t)c
- 6
r
d
t
0
Jt
n
0



III. Project Appraisals & Loans:
Net Present Value:
o NPI =
(Nct CP)
t
(1+)
t
n
t=0


Internal Rate of Return:
o IRR is the interest rate at which NPV =0

Dollar-weighted rate of return:
o Measures the success of the investor
o Internal balances do not matter

Time-weighted rate of return:
o Measures the success if the broker
o Lengths of internal intervals do not matter

Portfolio Rate of Return:
o i =
Nct Inccusc
Lxposuc to Rsk


Amortization: (Level payments)
o I
t
=R(1:
n-t+1
)
o P
t
=R:
n-t+1

o P
t+k
=P
t
(1+i)
k

o I =P
1
S
n


IV. Bond Valuation:
Notation:
o P Pricc o o BonJ
o F Focc Amount,Por Ioluc
o r Coupon Rotc
o C RcJcmption Ioluc
o g HoJiicJ Coupon Rotc
g =
P
C

o i iclJ Rotc o o BonJ, cilJ to Hoturity
o K PI,compounJcJ ot tc yiclJ rotc,o tc rcJcmption :oluc
K =C:
n



Yields:
o Nominal Yield: Annualized Coupon Rate
N =
AnnuuIzcd Coupon
Pu vuIuc


o Current Yield: Ratio of annualized coupon to price
C =
AnnuuIzcd Coupon
0gnuI Pcc


o Yield-to-Maturity: Actual annualized yield rate.

Price of a bond:
o P =Fro
n
+K (Frank)

Amortizing a Bond:
o I P >C(g >i)
BonJ is bougt ot o prcmium,writtcn Jown o:cr tc lic o tc bonJ.
Amount or omortizotion o prcmium =P
t
=Coupon I
t
=(Fr Ci):
n-t+1

Book Ioluc =BI
t-1
P
t


o I P <C(g <i) BonJ is bougt ot o Jiscount,writtcn up o:cr tc lic o tc bonJ.
Amount or occumulotion o Jiscount =P
t
=I
t
Coupon
Book Ioluc =BI
t-1
+P
t


o IMPORTANT NOTE ABOUT AMORTIZING A BOND: The book value at any point in time is equal
to a hypothetical redemption value had the bond been redeemed at that time. It also equals a
hypothetical price at which the bond is bought at that point in time.

Callable Bonds:
o For a fixed redemption value:
Prcmium colculotc tc pricc ot tc corlicst colling Jotc.
iscount colculotc tc pricc ot moturity.
o For different calling prices:
Colculotc tc lowcst pricc.


V. Cashflow Duration:
Price as a function of yield:
o P = CF
t
(1+

m
)
-mt
t>0


Modified Duration:
o HoJ =
P
|
()
P()
=
tA
t
(A
t
)(1+
Y
m
)


Macaulay Duration:
o Hoc =
P
|
(6)
P(6)
=
tA
t
P

o I tc bonJ is priccJ ot por,Hoc =o
n

o urotion o o gcomctricolly incrcosing pcrpctuity =
1+
-K


Relationship between Mod D & Mac D:
o Hoc =lim
m
HoJ
o HoJ =
Muc
(1+
Y
m
)


Redington Immunization:
o PI
A
=PI
L
0R P
A
=P
L

o urotion
A
=urotion
L
0R P
A
i
=P
L
i

o Con:cxity
A
>Con:cxity
L
0R P
A
ii
>P
L
ii


Full Immunization:
o PI
A
=PI
L

o urotion
A
=urotion
L

o Assct cos lows must occur bcorc & otcr coc liobility cos low

Stock Valuation:
o Pricc o stock =PI o uturc Ji:iJcnJs
o For geometrically increasing dividends:
Pricc =
d
1
-g

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