Q2 Financial Mathematics

1) XYZ Property development Ltd is offered a choice of loan funds at the following
nominal interest rates. Which of these nominal interest rates provides the lowest
cost of finance in terms of the corresponding effective annual interest rates?
j nom
m

Formula: i = (1 +

)m 1

(1) 14.00% payable annually

jnom = 0.14; m = 365
i = (1 +

0.14
365

)365 1

= 0.1502
15.02%
(2) 13.50% payable semi annually
jnom = 0.135; m = 2
i = (1 +

0.135
2

)2 1

= 0.1396
13.96%
(3) 13.00% payable quarterly
jnom = 0.13; m = 4
i = (1 +

0.13
4

)4 1

= 0.1365
13.65%
(4) 12.50% payable monthly
jnom = 0.125; m = 12
i = (1 +
= 0.1324

0.125
12

)12 1

 13.24%
The nominal interest rate with 12.50% payable monthly has the lowest cost of finance in
terms of the corresponding effective annual interest rates.

2) Jane deposited $2,500 today in a bank account that pays interest annually at a
rate of 5.5 per cent. She then makes ten (10) more deposits of $2,500 each at
annual intervals. What is the value of the investment at the date of the last
deposit?
Given: C = 2,500; i = 5.5%; n = 10
Present value of an ordinary annuity:
P=C+

c
i

= 2,500 +

[1

1
]
n
(1+i)

2,500
0.055

[1

1
]
10
(1+0.055)

= 2,500 + 45,454.54(0.415)
= $21,344.06
S = P (1+i) n
= 21,344.06(1 + 0.055)10
= $36,458.74
The value of the investment at the date of the last deposit is $36,458.74.

3) Juan borrowed home loan of $500,000 from a bank. He agreed to pay a fixed

interest of 6.45 per cent per year compounded monthly, over 25 years. Calculate
the monthly repayment.
Given: P = $500,000; i = 0.0645/12 = 0.0054; n = 25*12 = 300

Effective Interest Rate:

j nom m
i=(1+
) 1
m

= (1 +

0.0645
12

)12 1

= 0.0664/year
= 0.0055/month

Present Value (P) of an ordinary annuity:

P=

500,000 =

C
1
[1
]
i
( 1+ i )n
C
1
[1
]
0.0055
( 1+0.0055 )300

500,000 =

C
0.0055

619,517.36 =

C
0.0055

(0.8071)

C = $3,407.35
The monthly repayment is $3,407.35.

4) ABC Ltd pays annual dividends on its ordinary shares. The latest dividend of 60
cents per share was paid yesterday. The dividends are expected to grow at 7.5 per
cent for the next two years, after which a growth rate of 5 per cent is expected to
be maintained indefinitely. Estimate the value of one share if the required rate of
return is 15 per cent.
Required rate of return (ke) = 0.15
Current dividend per share (D0) = $0.60
Current dividend growth (g) = 0.075 per year
Expected dividend falling rate (g) = 0.05 per year
P0=

D 0 ( 1+ g )1 D 0 ( 1+ g )2
D0 (1+ g )2 ( 1+ g' )
1
+
+
1
2
2
( 1+ k e )
( 1+ k e ) ( 1+ k e )
( k e g' )

0.6 ( 1+0.075 )1 0.6 ( 1+0.075 )2

0.6 ( 1+ 0.075 )2 ( 1+0.05 )
1
P 0=
+
+
( 0.150.05 )
( 1+0.15 )1
( 1+0.15 )2
( 1+0.15 )2

P0= 0.5609 + 0.5243 + 5.5047

P0=$ 6.59
The value of one share would be $6.59 if the required rate is 15 per cent.

Q3 Option Pricing Model

Calculate the value of a six-month call option assuming the current price is $70, the
strike price is $60, the risk-free interest rate is 6.5% per annum (continuously
compounding interest rate), and the volatility (
Current share price, S = $70
Strike price, X = $60
Risk-free rate, r = 0.065 p.a.
Variance (Volatility),

= 0.225

Standard deviation, = 0.4743

Maturity, T = 0.5

[
d 1=

d1 =

S
1
]+ r + 2 T
X
2
T

[ ][

70
1
+ 0.065+ ( 0.225 ) 0.5
60
2
0.4743 0.5

0.1542+ 0.0888
0.3354

= 0.7245

d 2=d 1 T
d 2=0.72450.3354
d 2=0.3891

) is 22.5% per annum.

Using Normal Distribution Table,

N ( d 1 )=N ( 0.72 )=

0.7642

N ( d 2 )=N ( 0.39 )= 0.6517

erT =e0.065 (0.5 )
rT

0.0325

=e

erT =0.9680

(rT)

C=SN ( d1 ) X e

N (d2)

C=(70) ( 0.7642 )(60)( 0.9680) ( 0.6517 )

C=53.4937.85

C=$ 15.64
The Black-Scholes call price is therefore approximately $15.64.

Q4 Binomial Option Pricing

One of the bank current share price is $50, and it will be worth either $55 or 45 in two
months. The risk free rate of interest is 6% (continuously compounding interest rate).
What is the value of call option with an exercise of $49. Find the hedge ratio and
explain.
Current price, f

= $50

Stock price (move up), S 0 u = $55,

Stock price (move down), S 0 d

= $45

Call option with exercise price, C = $49

Time, t = 2 months
Risk-free rate, rT

u=1+

=1+

= 6%

S0 uf
f
5550
50

= 1.1 > 1
Pay off from the option,
f u = S0 u - C
= $55 - $49
= $6
d=1+

=1+

S 0 df
f
$ 45$ 50
$ 50

= 0.9 < 1

Pay off from the option,

fd =0

A generalization option price

e rT d
P=
ud
0.06

2
12

0.9
1.10.9

0.1101
0.2

= 0.5503

Option price,
rT

f =e

[ p f u + ( 1 p ) f d ]

0.06

2
12

[0.5503 ( 6 ) + ( 10.5503 ) 0]

= 0.99 3.3018
= $3.27

Hedge Ratio,
=

f uf d
S 0 uS 0 d

60
5545

= 0.6

Comment:
Hedge ratio shows how exposed an investment to risk. A hedge ratio of 0.6 means that 60%
of the investment is being protected from risk while 40% remains exposed.

Q5
Year
2008
2009
2010
2011
2012

ABC
Returns

XYZ
Returns

0.0163
0.1465
0.0740
-0.0119

-0.0292
0.0164
0.0511
-0.0121

Returns Formula:
Rt = [Pt-(Pt-1)]/Pt-1
i.e: Returns for year 2009, R2009 = (P2009 P2008)/P2008
= (68.38-67.28)/67.28
= 0.0163
(a) 1: Average Return:
n

ABC:

rt

t =1

n
0.0163+ 0.1465+0.0740+(0.0119 )
4

0.2249
4

= 0.0562
5.62%

XYZ:

0.0292+0.0164 +0.0511+(0.0121)
4

0.0262
4

= 0.0066
0.66%
Comment:
ABC stock indicates a higher return of 5.62% compare to XYZ stock with a return of
0.66%. It also means that ABC stock will have a higher risk compare to XYZ stock as
higher return always comes with a higher risk.
2: Risk:

ABC:

t
( Rt R)
t =1

n1

(0.01630.0562)2 +(0.14650.0562)2+(0.07400.0562)2 +(0.01190.0562)2

41

0.0016+ 0.0082+ 0.0003+0.0046

3

= 0.0049
= 0.07
7%
XYZ:

(0.02920.0066)2+(0.01640.0066)2 +( 0.05110.0066)2 +(0.01210.0066)2

41

0.0012

0.0013+ 0.0001+ 0.0020+ 0.0003

3

= 0.0351

3.51%

Comment:
A high standard deviation indicates that the data are spread out over a large range of
values. In this case, ABC Stock has a higher standard deviation of 0.07 compared to ABC
Stock with only 0.0351. Thus, ABC Stock is more spread out over a large range of values
than XYZ Stock.

3: Chances of obtaining negative return

The chance of obtaining negative return of ABC stock:
P (RABC<0) = P (Z<

00.0562
)
0.07

= P (Z<-0.8029)
= 1 P (Z>0.8029)
= 1 0.7881
= 0.2119
21.19%

The chance of obtaining negative return of XYZ stock:

P (RXYZ<0) = P (Z<

00.0066
0.0351 )

= P (Z<-0.1880)
= 1 P (Z>0.1880)
= 1 0.5714
= 0.4286

 42.86%

Comment:
In this case, XYZ stock has a higher probability of obtaining a negative return as it has a
higher figure, 42.86% compared to ABC stock with a probability of 21.19%.

Year
2008
2009
2010
2011
2012

Relative Return
ABC
XYZ
1.0163
1.1465
1.0740
0.9881

0.9708
1.0164
1.0511
0.9879

Relative Return Formula:

RR = 1 + Rt

(b)

Calculate the geometric mean of both XYZ and ABC stocks. Comment on these
values.

Geometric Mean:
G = [(RR1)(RR2)(RR3)(RRn)]1/n 1
ABC: G = [(1.0163)(1.1465)(1.0740)(0.9881)]1/4 1
= 1.0545-1
= 0.0545
5.45%
XYZ: G = [(0.9708)(1.0164)(1.0511)(0.9879)]1/4 1
= 1.0061-1
= 0.0061
0.61%

Comment:
Geometric mean indicates the spread between the two dependants in the dispersion of the
distribution. The larger the dispersion, the larger the spread between the two means. In this
case, ABC stock has the highest geometric mean, therefore it has a larger spread since it has
the largest dispersion.
(c) Calculate the cumulative wealth index of both stocks. Comment on those values.
Cummulative Wealth Index:
CWIn = WI0(RR1)(RR2)(RR3)(RRn)
ABC: CWI2012 = 1.00(1.0163)(1.1465)(1.0740)(0.9881)
= 1.2365
XYZ: CWI2012 = 1.00(0.9708)(1.0164)(1.0511)(0.9879)
= 1.0246
Comment:
In the case of ABC stock, if $10,000 is invested at the end of 2008 (the beginning of 2009), it
would have been worth $12,365 by the end of 2012. As for XYZ stock, $10,000 invested at
the end of 2008 would have been worth $10,246 by the end of 2012. Comparing the 2 stocks
cumulative wealth index, ABC stock worth more than XYZ stock by the end of 2012.

Standard Deviation
Mean Return

ABC (1)
0.0700
0.0562

XYZ (2)
0.0351
0.0066

(d) Suppose that 10 million is invested in ABC stock and 10 million is invested in XYZ
stock and calculate the VaR 5% level of an equally weighted portfolio and compare
the result with the individuals assets VaR values. Correlation between ABC return
and XYZ return is 0.593.
ABC stock value = 10 million
Confidence level at 95%
VaRABC = 1.645 * * stock value
= 1.645 * 0.0700 * 10,000,000

= $1,151,500
XYZ stock value = 10 million
Confidence level at 95%
VaRXYZ = 1.645 * * stock value
= 1.645 * 0.0351 * 10,000,000
= $577,395
Risk of portfolio,
= W12 12 + W22 22 + 2 W1 W2 1,2 1 2
= (0.5)2(0.0700)2+(0.5)2(0.0351)2+ 2(0.5)(0.5)(0.593)(0.0700)(0.0351)
=0.0012+0.0003+0.0007
=0.0022
=0.0469

Portfolio value = 20 million

Confidence level at 95%
VaRportfolio = 1.645 * * portfolio value
= 1.645 * 0.0469 * 20,000,000
= $1,543,010

Comment:
The total value at risk at 5% level of the individual assets is $1,728,895 ($ 1,151,500 + $
577,395). After diversification by pooling the risk of ABC and XYZ stock into a portfolio, the
value at risk at 5% level has decreased to $1,543,010. This shows that the VaR at 5% of
portfolio is significantly lower compared to individual assets. Furthermore, this also indicates

that the portfolio has a 5% tendency to experience a loss of greater than $1,543,010 whereas
the individual assets have a 5% tendency to experience a loss of greater than $1,728,895. This
has proven that diversification is able to decrease risk within an investment.

Q6 Volatility Forecasting
(a) Calculate the volatility (

) of ABC and XYZ shares. The parameter

in the exponential weighted moving average (EWMA) n2 = n-12 + (1- )u n-12

model is 0.96. Forecast the 2013 volatility of ABC and XYZ shares using the
2011 and 2012 prices with the aid of estimated volatility (

) and EWMA

model?
Estimating Volatility of Shares:
m

1
2
n =
(un 1 u)

m1 i=1
2

Volatility of ABC shares:

0.0163+0.1465+ 0.0740+ (0.0119 )
u =
4
= 0.0562
2=
=

1
[ ( 0.01630.0562 )2 + ( 0.14650.0562 )2+ ( 0.07400.0562 )2 + (0.01190.0562 )2 ]
41
1
( 0.0016+0.0082+0.0003+ 0.0046 )
3

=0.0049
0.49%
Volatility of XYZ shares:
0.0292+0.0164+0.0511 + (0.0121 )
u =
4
= 0.0066
2

=
=

1
[ (0.02920.0066 )2 + ( 0.01640.0066 )2 + ( 0.05110.0066 )2 +(0.01210.0066 )2 ]
41
1
( 0.0013+0.0001+0.0020+0.0003 )
3

=0.0012
0.12%

Forecasting Volatility using EWMA Model:

 n2 = n-12 + (1- )u n-12

Given, = 0.96
2
ABC, 2013 = (0.96)(0.0049) + (1-0.96)(-0.0119)2

= 0.004704 + 0.0000057
= 0.0047097
0.47%
2
XYZ, 2013 = (0.96)(0.0012) + (1-0.96)(-0.0121)2

= 0.001152 + 0.0000059
= 0.0011579
0.12%

(b) Write the GARCH (1,1) model. Forecast the 2013 Volatility of ABC and XYZ
shares using the 2011 and 2012 prices, estimated volatility and the given
parameters of a GARCH (1,1) model
=0.82 and =0.000002, =0.05 and

=0.000003,

=0.04 and

=0.82 respectively.

GARCH(1, 1) model:
n2 = + u n-1 2 + n-1 2
Volatility of ABC shares:
Given, =0.000003; =0.04;

=0.82; u n-1 2= (-0.0119)2=0.000142; n-1

=0.0049
22013 = 0.000003 + (0.04)(0.000142) + (0.82)(0.0049)
= 0.00403
0.40%

Volatility of XYZ shares:

Given, =0.000002; =0.05;

=0.82; u n-1 2= (-0.0121)2=0.000146; n-1

=0.0012

2
2013

= 0.000002 + (0.05)(0.000146) + (0.82)(0.0012)

= 0.00099

 0.10%

(c) Estimate the long-run average volatility of ABC and XYZ and comment on
these values.
Long-term Variance:

V = where =1

Long-run average volatility of ABC:

Given, =0.000003, =0.04, =0.82
=10.040.82
= 0.14
V=

0.000003
0.14

= 0.000021
Volatility =

0.000021

= 0.0046
0.46%

Long-run average volatility of XYZ:

Given, =0.000002, =0.05 and
=10.050.82

= 0.13
V=

0.000002
0.13

= 0.000015
Volatility = 0.000015
= 0.0039
0.39%

Comment:

=0.82

The average volatility of ABC in the long run is 0.46%, which is higher than
XYZ stock which has an average volatility of 0.39% in the long run.