A Mathematician's Take on FM

Part I

Interest Theory (65 80%)

1

Interest Rates and Time Value of Money

1. Easy formulas (most of these are denitions/easy to derive):

d=

i
,
1+i

v=

1
,
1+i

v + d = 1,
i d = id,
d = iv,
and

d < d(m) < < i(m) < i.

2. When given nominal rates, instead of calculating the eective interest rate using ICONV and then calculate
where

nm
(m)

is the number of years, it is much much easier to use the nominal rate directly, i.e.,

1+

(1
+ i)
nm

(m)

or

3. It is important to understand these three formulas,

i(m)
m

d(m)
m


1d=
and


1+

i(m)
m

m

1+


1+i=

m


=

,
m

d(m)
m

,
m
.

Use intuition, not brute force.

4. Continuous interest:

= ln (1 + i).

can also understand it as a

5% compounded continuously means

nominal

rate of

5%

= 0.05,

is always a constant, for example,

0.05

i = 0.05!

Equivalently, we

convertible continuously/innitely. Formula to memorize:

a (t) = a (0) et .
Here

not

(1)

mentioned above. It is not to be confused with the instantaneous

force of interest below:

5. Force of interest:

(t) =

a0 (t)
a(t) is a function of t, and

astart amount e

end time
start time (u)du

= aend amount .

(2)

Some

a (t)

are easy to get given

integers). Also, when

a (t)

(t),

for example, when

is of the form (1), then

(t)

(t) =

m
t+n ,

t).

(m and

are positive

happens to be a constantso the previous bullet point is

really just a special case where the force of interest is always a number, for example,
function (of

a (t) = (t + n)

0.05,

it is basically a constant

Annuities
1. Make the best out of STO and RCL features! Trust me, this is the dierence maker! I am surprised that ACTEX
doesn't mention this at all. Practice with your calculator! You calculator is your best friend!
2. Make sure you know how to use the calculator to solve the CF-related questions.
3. Always remember to CLR TVM. CPT N if you are not sure if you did, if Error 1, then you are good to go. Or just
simply CLR TVM again. CLR TVM does not clear CF data, you need to CLR WORK within the CF interface to
do that.
4. For problems that do not have both present and future values involved, there is no need to worry about plus/minus
signs if you are not calculating the interest. When the payment is plus (minus), then the present value or future
value is minus (plus). Edit: after a while, especially after later chapters, it becomes a second nature to get the signs
right, so I guess it does not hurt to train yourself early.
5. Check if it's beginning or end on calculator. Default is end (does not show BGN). My friend, who is an accountant,
said that I should never bother switching between beginning and end, just do everything as if it is end, then multiply

(1 + i)

the result by

if it is beginning.

anq =

1 vn
i

(3)

3 is all you need to memorize for level payments, here is why

Immediate = end = denominator is

= normal: 3.

Due = beginning = denominator is

= two dots:

Continuous = denominator

= bar:

anq =

a
nq =

1v n
.

1v n
d .

Again, given the same amount of payment, then the present value of due =
because

x=

x
1+i

(1 + i),

(1 + i)

present value of immediate,

think about it.

6. For future values, just multiply dierent versions of 3 by

(1 + i)

accordingly.

7. All you need for arithmetic payment problems is this all-inclusive formula:


P anq + Q

anq nv n
i

Write it down on scrap paper at the beginning of the exam.

P = n, Q = 1.

When

Q 6= 1,

make sure you multiply the

nv


.

Remember, when it is

term with

Ia, P = Q = 1,

when it is

Da,

too when you break the bracket.

8. We will show that it is intuitively easy to understand

1+g
1+i

n

ig

(4)

But you need to rst memorize the perpetuity formula (which is easy to memorize)

1
.
ig
Since 5 is positive and has

ig

at the bottom, we assume that

(5)

i>g

(actually when

g > i,

the perpetuity diverges

and therefore the formula is meaningless). In order for the fraction part of the numerator of 4,
to zero when

goes to innity, its numerator should be smaller than the denominator, thus

1+g

See 11 for a complete short list of important formulas that you should write down at the beginning of the exam.

1+g
1+i

n

, to go

is on top, and

therefore,

1 + i is at the bottom.

n also makes sense because before the rst payment,

The power is

i.e., when

n = 0,

the numerator should zero, so it checks out.

9. Just to emphasize, 5 and etc. is for immediates, it calculates the present value of the total payments

period

before

the rst payment. Also keep in mind that the nal result is

1
rst payment

where the rst payment could be of the form

10. The future value of
value today) of
the time

at time

t1

x (1 + g)

B.

1+g
1+i

n

ig

already.

is twice the future value of

is twice the current value of

at time

t2

does not mean the current value (present

It is extremely important that you are always crystal clear about

when you talk about present values and/or future values.

11. ALWAYS distinguish between the interest rate and the actual interest value, do NOT confuse between
the calculator uses

for

5%,

make sure you use

12. If money is deposited constantly at

0.05

K%

and

K,

when you do calculations!

c (t), and force of interest is (t) compounded continuously, then the nal amount

is

end
begin

c (t) e

end
t

(u)du

dt.

(6)

6 is pretty complicated on the surface, yet it is actually a straight forward formula. It tests your understanding of
1 and 2 greatly. (Courtesy of question 8)
13. If you need

retirement income and you are told that every thousand in the fund will generate

each period, then

x
you need
k 1000 in the fund. (Courtesy of question 12)
14. Keep in mind that the end of the

10

th

10th

year is the beginning of the

11th

year. Don't just stop at the beginning of the

year! When you are drawing a cash ow chart, always go one extra year at the end, just in case. Also, keep in

mind that, on the time axis,

always indicates the end of the

nth

year, because you start with

0!

15. When a geometrically increasing payment decreases by the same percentage, you have to calculate the new payment

10% increase and decrease, we have 100, 110, 110 0.9 = 99, not 100, 110, 100. In general
n+1
n
n+1
n
x (1 + i)
, x (1 + i)
(1 i), not x (1 + i) , x (1 + i)
, x (1 + i) ! (Courtesy of question 24)

manually, for example, at

it is

x (1 + i)

n+1

Loan Repayment

k : Pk .

1. Loan payment at time

2. Balance after
3. Loan amount:

Pk

is made:

B0 .

4. Interest paid in

Notation.

Bk .

Notation.

Obvious since

payment has been made.

Pk+1 : Ik+1 = i (Bk ).

Your new payment always pays the interest of the old balance o rst. Key

concept!
5. Principal paid in
6. Balance after

Pk+1 : Rk+1 = Pk+1 Ik+1 .

Pk+1

Obvious!

is made:

Bk+1 = Bk Rk+1 = Bk (1 + i) Pk+1

There are two ways to look at the balance after

Pk+1

(7)

is made:

(a) Old balance subtract the new principal paid, this is straight forward.
(b) The second is a mathematical result, it is counter-intuitive but let us rst look at an example: say we borrow

10

today and we repay

repayment is

year from now, we obviously need to repay

regardless if we calculate

10 10

(rst way) or

10 (1 + i).

The new balance after our

10 (1 + i) 10 (1 + i)

(second way). The new

balance is the future value of the loan one period from now, so if we do not pay anything one period from now,
the new balance would simply be

Bk (1 + i),

but we are going to pay

n, k ,

Some usual ways to understand equations involving indices

Pk+1 ,

thus

Bk (1 + i) Pk+1 .

etc.:

(a) Look at simple examples.

(b) Consider extreme cases like when the index is
7. Prospective method: the loan balance after

Pk

or

is the present value of the rest payments at the time of

Pk .

If we

calculated the present value of all the future payments at the time we borrow the money, it would have to equal to
the loan amount, otherwise it's not a fair trade! So then it is simple: consider the new loan balance after payment

Pk

brand new

loan that you borrow right after payment

Pk !

8. Retrospective balance:

Bk = B0 (1 + i)

k
X

kj

Pj (1 + i)

(8)

1
ACTEX does a good job explaining this one: if we do not pay anything until payment
grow to

B0 (1 + i)

, so to calculate the balance after

Pk ,

it would be

P1 (1 + i)

P1 (1 + i)

k1

21

, because the rst payment grows to

= P1 (1 + i),

not

P1 (1 + i)

then the loan would

when we know that we in fact did make payments, we

would calculate the present value of all the payments at time when
summation is

Pk ,

Pk

is made, so at time

k1

P1 (1 + i)

at time

k.

! The last term of the summation is

is obviously true, the current value (present value today) of

$1

paid today is simply

$1.

k.

The rst term of the

k = 2,

For example, when

Pk (1 + i)

kk

= Pk

which

If you accept this analogy,

then the second part of 7 also becomes intuitively true because it would simply be a special case.
9. For Level Payment

x,

the principal paid in payment

is:

xv nt+1 .

(9)

Remember, with each payment you make, you pay more and more principal. So clearly, there should be an
somewhere in the power of
payment that is

100%

in the last payment.

v,

now to remember the extra

+1,

(n t)

you just have to realize that you NEVER make a

principal, so if it was not there, you would be paying

xv nn = x

principal, so

100%

principal,

10. For Level Payment

x, the interest paid in payment t is: x xv nt+1 = x 1 v nt+1

. You do not need to memorize

this one, it is trivial given 9!

11. For Level Payment
new loan with

x,

nk

12. For Level Payment

the prospective balance at time

payments of

x,

i,

13. Sinking Fund Loan, Loan interest rate:

Bk = B0 (1 + i) xskq .

15. Term interest payable to the lender:

17. Balance in the fund after payment

is

brute force, keep in mind the

19. Net interest in payment

y = Li.

z =x+y =

16. Total sinking fund payment:

18. Principal paid in payment

Sinking fund deposit rate:

L
snqj . Simple, because you want

x=

Same as above, look at it this way: you have a

left, what is the loan amount?

the retrospective balance is

14. Sinking Fund Deposit:

k , xankq .

is based on

t: z xvj1t .

This can usually be done with a calculator.

not

1
snqj

. Trivial.

Trivial, but notice that when

= xvj1t .
j

xsnqj = L.


+ Li = L i +

k : Bk = xskqj .
t1

j.

Trivial.

L
snqj

x (1 + j)

It is nothing but a special case of 8.

i,

k = n,

you get

This is similar to 9, except, there is no

because

L which is expected.

n.

So memorize it by

is only related to the interest!

Obvious, you take the whole payment, subtract the principal (which we

memorized by brute force), and you are left with the interest.
20. Another way to calculate net interest in payment

t: y Bt1 j .

This is actually easy to understand:

itself is

interest, but you make some interest back from your fund in this period too, the interest that you make is

100%

Bt1 j ,

so

subtract and ta-da!

21. Do not confuse between the

n+1

nth

year and the

nth

payment! If the rst payment is made at time

is actually made at the spot where you write

0,

then payment

in the time axis.

22. When it is monthly payment but the question asks in

years, make sure you input

as

12k ,

I made this silly

mistake!
23. Just to emphasize, the loan balance at the end of one year is the present value of all future payments at the end of
one year, not today! Again, present value does not necessarily mean today!
24. APR means annual percentage rate, it is the true interest rate. You calculate the payment with the original loan,
then CPT PMT, then change the original loan to the actual amount (usually something like original
CPT I/Y.

(1 2.5%)),

Bonds
1. A bond is basically a series of
payment,

x + R,

xed

level payments (returns), to the investor

x,

called coupons, with a huge last

coupon + redemption.

2. The price of a bond,

P,

is the present value of all of those

P = xanq + Rv n .
3.

r=

x
F is called the coupon rate, where

F,

(10)

xed, is called the face value, since

and

are both xed,

4. Sometimes the interest rate demanded by investors go up (or down), compared to the xed
with a higher (or lower)

yield per period rate i, which is the interest rate used in 10.

while 10 remains equal is by increasing (decreasing)

or decreasing (increasing)

does not change, so we are left with one option: decrease (increase)

P.

P.

each year for the next

10

years and

$5

a higher yield per period rate, so paying

than paying

$5)

than paying

$6

at the end of

$4

10

is xed too.

i.e., they will settle

The only way to achieve those

Usually

is the same as

and

Do not worry if you feel lost here, we will

show that this makes sense intuitively. For example, there is a bond with a face value

$1

r,

$5,

the buyer of the bond gets

years. If you want to impress your boss, then you need

to get the package would be much better (higher yield per period rate

to get the exact same package (lower yield per period rate than paying

5. The previous bullet point also makes sense mathematically: under the assumption that

R = F,

$5).

10 is of the form

P = xanq + Rv n

n
1

n
1 1+i
1
=x
+F
i
1+i
n
n


1
1
1 1+i
1+i
=x
+ Fi
i
ni


1
1 1+i
+F
= (x F i)
i

n

1
1 1+i
+F
= (F r F i)
i
= F (r i) anq + F.
(a) If

i = r,

(b) If

i > r,

the new
(c) If

i < r,

then

stays the same,

P = F.

i.e., when the demanded yield per period rate goes up (you want to impress your boss, remember?),

is the sum of

and a negative number, so

goes down,

P < F.

i.e., when the demanded yield per period rate goes down (there is another person that wants to buy it,

so you are willing to settle for less), the new

F (r i) anq

(11)

is the sum of

and a positive number, so

goes up,

P > F.

is called the premium (if positive) or discount (if negative). It is worth mentioning that, in real life,

premium bonds usually come with a higher coupon rate than discount bounds, so people are willing to pay for more
than face value just for the big coupons.
6.

Callable bonds are bonds that can be redeemed early by THE BOND ISSUER (no more coupons chaps, here is
your redemption and get out of here ). It is intuitively true that a callable premium bond gives the minimum yield
to the investor when called at the earliest possible date, because of an early capital lossyou did pay more than
the face value. Would you be happy if I sell you a

$10-par

bond for

$11

(therefore a premium bond) and call it

immediately? No, because you just lost a dollar in one second. Another intuitive way to see it is, remember what

in real life, you buy premium bonds for the big coupons, so the more coupons you get, the better.
Although this is not the case in FMwe often see premium and discount bonds that oer the same couponsthis

we said earlier,

is because you are only learning the concepts so it is convenient for the books/guides to use the same numbers
(especially coupon rate) over and over. Just think: if things were like this in real life, then who on earth would buy
a premium coupon when they can buy a discount coupon that oer the exact same amount of returns (dollar-wise)?
Similarly, a callable discount bond gives the minimum yield to the investor when called at the latest possible date,
because of a late capital gainyou did pay less than the face value. Would you be happy if I sell you a
bond for

$9

$10-par

(therefore a discount bond) and call it immediately? Yes, because you just made a dollar in one second.

7. Callable bonds are priced as

low

as possible, because investors are all

prudent they are afraid that the bond issuer

might call the bond at the worst time (minimum yield rate to the investor), so they want to pay the smallest
A callable premium bond is priced as if it will be redeemed at the earliest possible time (if
then the premium, a positive number, gets

less positive, and so P

is priced as if it will be redeemed at the latest possible time. (if

number, gets

more negative, and so P

P!

gets smaller in 11,

gets smaller). Similarly, a callable discount bond

gets bigger in 11, then the discount, a negative

gets smaller). If they are not priced in this way, prudent investors will simply

not buy these bonds.

8. The original formula 10 and the premium-discount formula 11 are two ways to calculate the price of a bond. There
is a third formula, the Makeham's Formula, it is in a way similar to 11instead of the dierence between
we use the ratio of
also that

R=F

and i. Here is the derivation, keep in mind that all of our

and

anq

are based on i,

and

i,

not r, and

is assumed as usual:

P = xanq + Rv n
n

1
1 1+i
=x
+K
i
n
1
1 1+i
= Fr
+K
i 

n 
1
r
F F
+K
=
i
1+i
r
= (F K) + K
i
where

K = F vn = F

1
1+i

n

. Also, note that this formula is basically 10 except we write

xanq

in a fancy way.

So you do not really have to memorize this formula, you can just derive it during the exam, assuming you are
comfortable with calculations. But I personally nd this formula cute and decided to memorize it.
9. Assuming

R = F , principal of premium or discount paid in period t is F (r i) v nt+1 .

just like 9, except we use

F (r i), which is a small number.

But it makes sense, because the premium or discount is

a (relatively speaking) small number to begin with! Also, notice that, when
premium is positive, and when

r < i, F (r i)

check out! Lastly, just like 9 and many other

can calculate a dierent

F (r i) v

nt2 +1

by

But wait a minute, this looks

r > i, F (r i)

is positive, because the

is negative, because the discount is negative! It is nice when things

t-in-the-power
F (r i) v

formulas, when given the value of

nt2 +1

= F (r i) v

nt1 +1

t1 t2

F (r i) v nt1 +1 ,

we

10. Make sure you know how to use calculator to calculate date dierence. Price of a bond sold between two coupons:

P0 (1 + i) tx,
where

datelast coupon date

t = settlement
# of days in this period

and

P0

is the price immediately after the last coupon date. If you sell the

bond to another person immediately after the last coupon date, it would be a brand new bond to that person, the

price would be

P0

which is easy to compute. However, when the settlement date is in between two coupon dates,

we have two problems:

simple interest ), because

some time has passed since the bond was worth exactly P0 . This part is called the dirty price.

(a) The bond price (P0 ) has increased to

P0 (1 + i)

(or

P0 (1 + ti)

if you are asked to use

(b) The dirty price uctuates too much, so for appearance purposes, all quote prices take away

clean price P0 (1 + i)t tx,

price to obtain the

tx

from the dirty

the clean price is what we use for FM, it is NOT the actual

trading price.
Make sure you know how to use the BOND worksheet on your calculator!

The BOND worksheet gives you the

clean price (not using the simple interest), so when the question asks you to nd the

purchase

price, make sure you

add the accrued interest back on. Also, when the question asks you to use simple interest specically, you have to
calculate

P0 (1 + ti)

manually and not rely on the BOND worksheet.

11. I am surprised that these did not came up in the rst few chapters, but when the question gives you the value of

vn ,

say

vn = k,

yet the bond has semi-annual coupons, make sure you use

k2

when you calculate things, because I

am pretty sure that is what you actually need! Also, when the question asks you for the number of yeas a coupon
is held for, always divide your

Tricky bastards !

from the calculator, most likely half years or quarters, by

or 4, respectively.

My friend says always write down Question #: annually/semi-annually/quarterly(4)/monthly on

the scrap paper and circle it. So something like this,

Question 21, quarterly (4) , should keep those pesky bastards

from stealing points from you.

12. (2005 Exam FM Sample Questions #30) As of 12/31/03, an insurance company has a known obligation to pay

1, 000, 000

on 12/31/2007.

bonds totaling

5%

$822, 703

through 12/31/07.

To fund this liability, the company immediately purchases

4-year 5%

annual coupon

of par value. The company anticipates reinvestment interest rates to remain constant at

The maturity value of the bond equals the par value.

Under the following reinvestment

interest rate movement scenarios eective 1/1/2004, what best describes the insurance company's prot or (loss) as
of 12/31/2007 after the liability is paid?
Insight from this question:
(a)

4-year 5%

annual coupon bonds totaling $822, 703 of par value means the coupon is an annual coupon that pays

822703 0.05 = $41135.15

per year for

years, this sentence does not tell you about the redemption value yet.

Them fancy words!

(b) When you reinvest the coupon payments at the same rate as your bond, and when the redemption rate is par,
then your money is petty much growing at
mathematically true, because

i,

like here,

822703 (1.05) = 1, 000, 000

The

the coupons that you get do not magically grow according

xsnq + F = xanq (1 + i) + F = (xanq + F v ) (1 + i) = F (1 + i)

(c) But then you might ask, why do I have to reinvest?

reinvestthe

which is desired. This is

you get from the rst coupon will still be

yield per period rate i is already at 5%! Because

to the bond's yield per period rate i if you do not

at the time of redemption if you just let it sit on

your desk!
i. Andrew reinvests at the bond's yield per period rate i, so his original investment is growing at i, so he ends
up with an even over-all yield per period

iA = i

by reinvesting at

i.

ii. Bill reinvests at a rate higher than the bond's yield per period rate

, he ends up with more money than

Andrew in the end, so he achieves a higher over-all yield per period rate
iii. Chris reinvests at a lower rate than the bond's yield per period rate

iB > iA = i.

, he ends up with less money than

Andrew in the end, so he achieves a lower over-all yield per period rate

iC < iA = i.

Yield Rate of an Investment

1. The internal rate of return formula is just a special case of the net present value formula:

NPV

When you calculate the net present value,

= C0 + C1 v + C2 v 2 + Cn v n

i is given so that the left hand side can be calculated.

the internal rate of return, the left hand side of 12 is

equation holds. It is nothing but an

to

because

v=

1
1+i is close to

1.

th

(12)

When you calculate

to begin with, you are required to nd

such that the

degree polynomial. We are however, only interested in roots that are close

Once we solve for

v,

we can solve for

i.

The

nth

degree polynomial that you are

going to get will be an easy one, it helps to know the quadratic formula and some other simple techniques. But at
the end of the day, you could always nd the answer by trial and error, not recommended but can be a last resort.
2. Know how to use the CF worksheet. When the money at time

0,

but the

Ct2 entry

This is very important, you should NEVER keep the

3.

Eective

t1

is reinvested until time

t2 ,

the

Ct1

entry becomes

now increases by whatever the total amount of the total payo of the reinvestment is at time

(means actual interest rate

Ct1

entry and just add the earned interest to

Ct2 .

t2 .

For example,

+1) rate of time weighted rate of interest is simply the product of eective rate

of interest from equal-length sub-periods,

1 + i = (1 + i1 ) (1 + i1 ) (1 + in ) .

(13)

Notice that in actual exam questions, it may tell you the balance at the end of January
December

31st

31st ,

November

30th ,

only, the sub-periods might seem unequal at rst glance, but you can just assume the monthly

interest rate from February

1st

to October

30th

to be

0,

then calculate

(1 + i1 ) 1 1 (1 + i11 ) (1 + i12 ).

Basically, unless you have negative interest periods and positive interest periods that multiply out to be exactly
like when

0.80 1.25 = 1,

the time weighted rate of interest is rarely

1,

0.

4. Dollar weighted Rate of Interest is a little bit more tricky. First, we give the formula for net cashow. Here we do
not care about interest/time value of money at all, it is just elementary addition and subtraction,

Net cashow

= End

balance

Initial

balance

Net

contribution.

Remember contributions are only deposits (positive contributions) and withdraws (negative contributions) , when
the fund simply drops or increases on its own, we do not count that towards the contribution.
Then, we give the formula for weighted contributions, notice how this is dierent from net contribution because now
we actually care about when these contributions are made,

Weighted contribution

where

Ct

is the contribution at time

when the total period is

Ct (1 t) ,

t (for example, when the rst contribution is made at the end of the rst month,

year, then

t=

1
12 ). Finally, dollar weighted rate of interest given by
Net cashow

Initial balance

+ Weighted

contributions

(14)

Keep in mind that in the numerator you subtract the (net) contributions, in the denominator you add the (weighted)
contributions. Do lots of practice because it is very easy to mess up the signs. Word of advice: it is easier to keep
the contributions in a bracket of its own, that way, you do not have to worry about signs too much.
5. Keep in mind that, 13 gives the eective interest rate

(1 + i),

but 14 gives the actual interest rate.

6. Portfolio method and investment year method are pretty straight forward. Just practice with a table until you are
absolutely comfortable with it.

Term Structure of Interest Rates

1. A zero coupon bond is a bond that does not give any coupons. The
zero-coupon bond is the spot rate

sn .

So

nyear

dollar today would be worth,

maturity quote of a Treasury STRIP

years from now,

(1 + sn )

2. Let us look at one simple example,

The price of a four year

Year

Spot Rate

s1 = 2%

s2 = 3%

s3 = 3.5%

s4 = 4%

s5 = 4.5%

$1000 par bond with 3% coupon rate, based on the above table, is

30
30
1.02 + 1.032

30
1030
+ 1.035
3 + 1.044 =

965.20.
3. Eective forward rate from time

to time

n + 1 (in, n+1

is called the

1 + in, n+1 =

(1 + sn+1 )
n
(1 + sn )

n-year

forward rate) is

n+1

The index and power in the numerator are both

n + 1,

(15)

the index and power in the denominator are both

n,

so this

should be an easy to remember formula. Notice that a direct result of 15 is

(1 + sn ) = (1 + i0, 1 ) (1 + i1, 2 ) (1 + in2, n1 ) (1 + in1, n )

where

i0, 1

is dened to be

realize that the

4.

16 makes perfect sense intuitively if you stare at it long enough. It also helps to

forward rate today is simply the

One year forward rate for year two

calculating

5.

n-year

s1 .

i2, 3

(16)

means

instead. Remember the

One year eective rate during year n

i1, 2 .

n-year

is simply

The

1year

spot rate in year

for year two

part is redundant and meant to trick you into

forward rate is simply

in1, n .

n!

in, n+1 .

This is just a dierent way of saying

(n 1)-year

forward

rate.
6. (Nov 05 #15) You are given the following term structure of spot interest rates:

Term (in years)

Spot Rate

s1 = 5%

s2 = 5.75%

s3 = 6.25%

s4 = 6.5%

A three-year annuity-immediate will be issued a year from now with annual payments of

5000.

Using the forward

rates, calculate the present value of this annuity a year from now.
Insight from this question:
(a)

A three-annuity-immediate issued one year from now means the rst of the three payments do not come in until
2

on the time axis.

(b) The question itself is easy to solve, we can simply calculate the current value of the payments and then multiply
by

1.05:

5000
1.05752

5000
1.6253

5000
1.0654

1.05

(c) However, this question and its solution provided by ACTEX raises an interesting issue: how do we calculate
spot rate and forward rate at a future time?

The

1-year

spot rate

year from now,

s (n)1

is simply the

n-year

forward rate today,

(1+sn+1 )n+1
(1+sn )n . The 2-year spot rate n year from now, s (n)2 , must satisfy
n+2
n+1
3
(1+sn+2 )n+2
n+2 )
n+1 )
= (1+s
in+1, n+2 ) = (1+s
(1+sn )n
(1+sn )n . Similarly, (1 + s (n)3 ) =
(1+sn+1 )n+1

in, n+1 =

(1 + s (n)2 ) = (1 + in, n+1 ) (1 +

(1+sn+3 )n+3
(1+sn )n . So in general, we have, the

k -year

spot rate

year from now is

n+k

(1 + s (n)k ) =

(1 + sn+k )
n
(1 + sn )

(17)

17 makes perfect sense if we move the denominator to the left hand side and obtain

n+k

(1 + s (n)k ) (1 + sn ) = (1 + sn+k )
Also notice that, when
trivially true!

n = 0,

that is, when we talk about today, 17 gives

(1 + sk ) = (1 + sk )

which is

Term Structure of Interest Rates

1. Macaulay duration,

D (i) = D,

is a function of

i.2

This is an important concept, you have to remember that you

are dealing with a very complicated function here, not just a number.

vC1 + 2v 2 C2 + . . . + nv n Cn
vC1 + v 2 C2 + . . . + v n Cn



2
n

1
1
1
C2 + . . . + n 1+i
Cn
1+i C1 + 2 1+i
= 
,


2

n
1
1
1
C
+
C
+
.
.
.
+
C
1
2
n
1+i
1+i
1+i

D (i) =

(18)

Ck 's are investment cash ows at time k . It is worth mentioning that, when Ck 's are non-negative, 1 D n

k
1
shown below, let
Ck = ak . Since ak 's are positive, we have
1+i

where
as

1=
Usually we write

a1 + a2 + . . . + an
a1 + 2a2 + . . . + nan
na1 + na2 + . . . + nan

=D
= n.
a1 + a2 + . . . + an
a1 + a2 + . . . + an
a1 + a2 + . . . + an

vC1 + v 2 C2 + . . . + v n Cn = P (i) = P

because it is the net present value (the price) of the

investments.
2. Modied Duration,

M (i) = M = vD =
This is how I remember

M = vD,

P0
.
P

(19)

like in sports they have MVPmost valuable player, MVDmost valuable

duration.
3. If you clearly understand 18, then you do NOT need to memorize any of the level payment/bond/zero-coupon bond
duration formulas. They are all easily followed if you write out 18. I will do it for you here, but make sure you do
it on your own.
(a) Level payments with payments

D=

x,

the duration is

(Ia)nq
vC1 + 2v 2 C2 + . . . + nv n Cn
v + 2v 2 + . . . + nv n
vx + 2v 2 x + . . . + nv n x
=
=
=
.
2
n
2
n
vC1 + v C2 + . . . + v Cn
vx + v x + . . . + v x
v + v2 + . . . + vn
anq

It helps that you remember the denominator of

is the price/net present value of the cashow, so the above

formula makes perfect sense.

(b) Bonds with payments

and redemption payment

D=

R,

the duration is

x (Ia)nq + nv n R
vx + 2v 2 x + . . . + nv n (R + x)
=
.
vx + v 2 x + . . . + v n (R + x)
xanq + v n R

Again, it helps that you remember the denominator of

is the price/net present value of the cashow, so the

denominator is just the price of the bond! It is very important that during the exam, you must not forget to
multiply

with

n.

(c) Bonds with payments

2 We

x and redemption payment

x
i , notice that the most common bond satisfying this condition

write D (i) = D to mean that we will use D for Macaulay duration sometimes for convenience, even though it is a function of i really.

is just an

r=i

par bond, the duration is

D=

x (Ia)nq + nv n xi
xanq + v n xi
n

(Ia)nq + nvi
=
n
anq + vi



n
n
anq + anq nv
+ nvi
i
=
n
1v n
+ vi
i




anq + anq
1
i
=
= anq 1 +
i
1
i
i
= anq (1 + i) = a
nq .
(d) Zero-coupon bonds

D=

vC1 + 2v 2 C2 + . . . + nv n Cn
nv n R
=
= n.
vC1 + v 2 C2 + . . . + v n Cn
vn C

Notice that is is also the maximum of the Macaulay duration function, it is achieved precisely when there is
only

nal payment. Can you spot when the minimum is achieved?

4. When you write FM, many duration questions can be solved by simply calculating
what

is (do NOT plug in

yet),

is usually a nice function because

simplify beautifully. Then once you have

point here is you do NOT plug in

M,

plug in the given

and

M = PP

once you gure out

often have common factors and

to get a number, then do

D = M (1 + i).

The key

in the early steps.

5. It helps to know the Taylor series, it is such a widely-used formula, you might as well memorize it.

f (x) = f (a) +
So we let

x = x + x

and let

a=x

f 00 (a)
f (3) (a)
f 0 (a)
2
3
(x a) +
(x a) +
(x a) + .
1!
2!
3!

(20)

in 20, we obtain

f (x + x) f (x) =

f 0 (x)
f 00 (x)
f (3) (x)
2
3
x +
(x) +
(x) + .
1!
2!
3!

(21)

And luckily, for FM, we only need the rst two terms of the right hand side of 21

f (x + x) f (x) = f 0 (x) x + f 00 (x)

22 makes sense intuitively, the change of the value of

after shifting

(x)
.
2
by a tiny

(22)

is directly aected by two

things:
(a) The change in

x (

means change), but we need to multiply the change in

x, x,

by the rst derivative, which

is a measure of how a function changes as its input changes.

(b) Half of the square of the change in

x,

that is,

(x)2
2 , but we also need to multiply that by something, seeing it

has a second power, we need to multiply it by the second derivative.

Sometimes, we only need one term.

f (x + x) f (x) = f 0 (x) x.
Now to apply the above knowledge. Recall that

M = PP

, so

P 0 = M P .

(23)
Using 19 and 23, we have,

P (i + i) P (i) = P = M P i = vDP i.
3 The

minimum is also achieved precisely when there is only 1 nal payment that arrives at time 1, that is, when n = 1.

(24)

Next, the convexity of a

is dened to be

=
So

P 00 = P .

P 00
.
P

(25)

Using 19 and 22, we have,

P (i + i) P (i) = P = M P i + P

(i)
(i)
= vDP i + P
.
2
2

(26)

I understand that 24 and 26 are both hard to memorize, but if you go through the derivation above a few times,
and memorize the small formulas (they are the building blocks of the big formulas!) like 19, 22 and 25, it becomes
a lot easier.
6. The duration of a portfolio, in which

all investments have the same interest rate shift, is the weighted average of the

durations of the investments. You really do not have the need to memorize this formula, but here it is anyways,

D=

wk Dk

k
and

M=

wk Mk ,

k
where the

wk 's

are the weights based on the investment amount, so bigger investment = bigger weight, smaller

investment = smaller weight.

wk =

Pk
P

7. Immunization is where you have to keep reminding yourself that

f = f (x),

P = P (i).

Take any random function of

as long as it is not too complicated, you should be able to dierentiate it with respect to

f 0 = f 0 (x),

f 00 = f 00 (x).

and then dierentiate it again to obtain

stand for asset and

L stand for liability, i0

x,

to obtain

Immunization is pretty much just this. Let

some interest, in order to achieve immunity near i0 , we need three criteria,

PA (i0 ) = PL (i0 ) ,
PA0 (i0 ) = PL0 (i0 ) ,
and

PA00 (i0 ) > PL00 (i0 ) .

It is important to realize that all

P, P0

and

P 00

are functions of i, so with the bracket

to evaluate these functions at i0 . Just like if we have

can evaluate these functions of
and

00

00

f (x0 ) = f (3) = 2.

at some point, say

Again, these

P, P

f (x) = f = x

, then

(i0 ) attached to them, it means

0

f (x) = f = 2x

and

f 00 (x) = f 00 = 2,

we

x0 = 3, f (x0 ) = f (3) = 3 = 9, f (x0 ) = f (3) = 2 3 = 6

and

P 00

are NOT functions of

v,

we simply use

because it is

convenientthese functions are functions of i. So remember, always dierentiate rst, then evaluate, because if you
evaluate rst, then you get a xed number and the derivative is automatically
8. We can dierentiate with respect to

f = v

k 0

d
=
di

and

00

f = v
4 Pronounced

k 00

"

1
1+i

but keep the result in

k #

v.

In fact, if

0!

f = vk =

i
d h
k
k1
=
(1 + i)
= k (1 + i)
= k
di

1
1+i

1
1+i

k

, then

k+1

= kv k+1







d
d k+1

k+1
=
kv
= k
v
= k (k + 1) v (k+1)+1 = k (k + 1) v k+2 .
di
di

Gamma, it is the standard letter for convexity.

(27)

(28)

notice how these useful results are completely dierent from

f 0 = kv k1 and f 00 = k (k 1) v k2 which are completely

wrong and probably what you would have expected. This can be explained by realizing that

d
di

(f ) =

d dv
dv di

d
dv

(f ) =

(f )

dv
di

d
dv

(f ) v

is a function of

i,

so

which utilizes the chain rule.

9. If we are given

PA =

At v t

PL =

Lt v t ,

and

then to achieve immunity, we need

(a) Present value matching:

PA (i0 ) = PL (i0 )

Given

At v t (i0 ) =

Lt v t (i0 )

Denition of v


At

1
1+i

t

(i0 ) =


Lt

1
1+i

t
(i0 )

We evaluate these functions of i at i0 and "match" them


At

1
i0 + 1

t
=


Lt

1
i0 + 1

t
.

We dene a new vi0 for easier notation

At vit0 =

Lt vit0

(29)

You do not need to memorize 29 as it is intuitively true and easy to set up.
of these make sense only because we are given an interest rate
an input. We can only match two

f (x) = x

and

g (x) = x2

x = x0 = 0.1,

we have

evaluated

i0 .

Again, just to emphasize, all

We cannot match two

functions

without

functions. We will look another example. We cannot compare

in general. We can only compare them if we know what input we are using. When

0.1 = f (x0 ) = f (0.1) > g (0.1) = g (x0 ) = 0.01.

1 = f (x0 ) = f (1) = g (1) = g (x0 ) = 1.

When

x = x0 = 2,

we have

When

x = x0 = 1,

we have

2 = f (x0 ) = f (2) < g (2) = g (x0 ) = 4.

(b) Duration matching:

MA (i0 ) = ML (i0 )

Denition of M

To evaluate

P0
PA0
(i0 ) = L (i0 )
PA
PL

f
g

(x0 )

is (usually, so here) the same as evaluating

f (x0 )
g(x0 )

PA0 (i0 )
P 0 (i0 )
= L
PA (i0 )
PL (i0 )

Because we are already matching present value, so PA (i0 )=PL (i0 )

PA0 (i0 ) = PL0 (i0 )

See 27

At tv

t+1

(i0 ) =

AL tv t+1 (i0 )

Multiply both sides by v1 , we can do this because t starts at 1

tAt v t (i0 ) =

tAL v t (i0 )

Denition of v


tAt

1
1+i

t
(i0 ) =


tAL

1
1+i

t
(i0 )

We nally get to evaluate and "match"


tAt

1
1 + i0

t
=


tAL

1
1 + i0

t

Easier notation

tAt vit0 =

tAL vit0

(30)

30 is similar to 29 except with an extra t, you need to memorize it. Also try to understand the reasoning behind
each

(c) Greater convexity for assets:

A (i0 ) > L (i0 )

Denition of

P 00
PA00
(i0 ) > L (i0 )
PA
PL

Same as above

PA00 (i0 ) > PL00 (i0 )

See 28

At t (t + 1) v

t+2

Multiply both sides by

(i0 ) >

AL t (t + 1) v t+2 (i0 )

, we can do this because t starts at 1

1
v2

X




At t (t + 1) v t (i0 ) >
AL t (t + 1) v t (i0 )

We are simply breaking the bracket on both sides

t2 At v t (i0 ) +

At v t (i0 ) >

t2 Lt v t (i0 ) +

Lt v t (i0 )

Denition of P

t2 At v t (i0 ) + PA (i0 ) >

t2 Lt v t (i0 ) + PL (i0 )

Again, because PA (i0 )=PL (i0 )

t2 At v t (i0 ) >

t2 Lt v t (i0 )

Denition of v

t2 At

1
1+i

t
(i0 ) >

t2 Lt

1
1+i

t
(i0 )

We nally get to evaluate and "match"

t At

1
1 + i0

t
>

t Lt

1
1 + i0

t

Easier notation

t2 At vit0 >

31 is also similar to 30 except with yet another

reasoning behind each

t,

t2 Lt vit0

(31)

you need to memorize it. But again, try to understand the

10. The price formula for a equal-dividend stock is pretty trivial, it is just the rst dividend,

x,

multiplied by 5,

x
ig

(32)

Notice that,
(a) When

g = 0,

it means that the dividend is not increasing and stays

(b) When

g > i,

32 is meaningless and useless because the stock price diverges.

forever.

11. For the simple liability matching questions, always calculate the longest investment rst because the earlier coupons
of it can go towards the earlier liabilities. Never try to calculate the bond price on paper, use your calculator. The
less calculation you do with pen and paper, the less chance of making stupid arithmetic mistakes.

12. Because 29 and 30 are both equalities, sometimes you are asked to solve an immunity question using those two. Two
equations means they can only give you two unknowns. What you need to solve is probably something like this

a = bx + cy
d = ex + f y
where

22

and

matrix

are unknowns and represent money put into two investments. If you know that the determinant of a

is

ad cb.

It is then easy to solve a system of equation like this using Cramer's rule:

x=

a
det

b
det

y=

b
det

det

c
f

af dc
bf ec

bdea
bf ec

c
f

a
d

c
f

The denominator is always the determinant of the coecient matrix

!
, and the numerator is the determinant

of the coecient matrix where the corresponding unknown's coecients replaced by the column vector
this if you did not get

!
a
d

. Ignore

in linear algebra.

13. This really belongs somewhere in the beginning, but again, make sure you calculate the eective/nominal rate as
requested, do not calculate one when the question is asking for the other.
14. The full immunization technique is designed to work for any change in the interest rate. I previously thought for
only small changes. I was wrong.

Part II

Financial Economics (20 35%)

8

General Derivatives
1. A

stock index

2. The
3.

is an average of the prices of stock in a specic group.

spot price

Payo

is the current price of an asset at any time.

is the value of the nancial result at expiration.

Prot

or

net payo

is payo less the future value (at

expiration) of any expenses incurred in setting up the nancial structure involved. A zero coupon bond's payo is
the redemption value, its prot or net payo is
4. A

derivative

0.

is an agreement between two people that has a value determined by the price of the

underlying asset

(stock, corn, wine, etc.).

5. Derivatives are used to
(a) Reduce risk (at a cost of reduced prot), called
(b) Increase risk (in an attempt to prot), called

hedging.

speculation.

(c) Capitalize on loopholes in regulatory systems in order to circumvent unfavorable regulation, called

arbitrage.
6.

Bid-ask spread

regulatory

is the amount by which the ask price exceeds the bid price of the same asset at the same time.

Bid-ask spread is easy if you remember that the investors (who enter into derivative contracts for the three reasons
listed in (5)) are always screwed by the market makersintermediaries or traders who will buy/sell derivatives from
customers who wish to sell/buy: the investors have to buy high at ask price and sell low at bid price.
7.

Over-the-counter market

is where buyers and sellers transact with banks and dealers rather than on an exchange.

So it is dicult to obtain statistics for its volume.

8. The typical, easy to understand buy-today&sell-tomorrow is called

lending you pay cash to receive the underlying

asset and late sell it to receive (hopefully more) cash. You are said to have a long position.
9.

Short-selling

is the exact opposite of lendingyou borrow the asset, sell it for cash, then later buy back the asset

and return it. You will most likely have to pay lease rate, which does not get returned to you, to short sell. You are
said to have a short position.
10. Short-sell can happen for at least three reasons that are not mutually exclusive,
(a)

Speculation, you aim to sell high and then buy low to make a prot.

(b)

Financing, it is a common way to borrow money.

(c)

Hedging, you can oset the risk of owning the stock or a derivative on the stock.

Usually done by market-makers.

11. Short-sell has two major issues,

(a)

Credit risk, as the short seller, you have an obligation to return the asset.

The lender may hold onto your proceed

you received from selling the asset, and also require you to hand over an extra amount, called a haircut. When
you return the asset, say after one period,

Collateral

(1 + Repo

rate)

(where Collateral is basically Proceed+Haircut.

Repo rate is also called Short rebate) is returned to you.

Obviously, repo rate/short rebate is lower than the market rate of interest, or even zero when the asset borrowed
is scarce and hard to replace.
(b)
12.

Scarcity risk, again, it might be hard to nd someone willing to lend you the asset.

Mark to Market

13. The

margin

is a measure of the fair value of assets or liabilities that can change over time.

is a performance bond that can earn interest, NOT a premium. Both buyers and sellers are required

to post a margin with the broker to protect the counterparty against your failure to meet your obligations. If a loss
occurs, you can choose to pay it directly; or allow it to be taken out of the margin balance.
14. Participants are required to maintain the margin at a minimum level, called the

maintenance margin.

This is often

set at 70% to 80% of the initial margin level.

15. When the margin balance drops below the maintenance margin, the broker would make a

margin call,

requesting

additional margin. Failing to post additional margin would cause the broker to close the position, and return to the
investor the remaining margin.

Options
1. Stockholders are typically paid a share of the company's prots called
2. A

forward contract

dividends.

is a contract to buy or sell a specied asset at a designated future time. The forward contract

should specify
(a)

Underlying asset.

(b)

Expiration date.

(c)

The sale price.

The type and quantity of the asset to deliver.

Time, place and date of delivery.

3. The buyer in the forward contact assumes a

long

position and the seller assumes a

short

position. Remember, the

long position holder always benets if the price of the asset goes up, just like in (8), in fact they have the same
prot function. Similarly, the short position holder always benets if the price of the asset goes down, just like in
(9), they have the same prot function.
4. At

future exchanges,

forward contract can be written for

cash settlement

in which a net payment is made for the

dierence between the spot price at expiration and the forward price.
5. Let

t=0

and

asset prices at
Let

t=T
t=0

denote the beginning and the expiration of the forward contract. Let

and

t = T.

Let

F0, T

denote the forward price at

t=0

S0

and

ST

denote the

for a forward contract expiring at

t = T.

denote the continuously compounded interest rate for the forward buyer and seller. We then have

F0, T = S0 erT
and
Prot of long forward

= ST S0 erT = Prot

of short forward.

6. Options:
(a)

European :

can be exercised only on the expiration date.

(b)

American :

can be exercised any time.

(c)

Bermudan :

can be exercised only during specied periods.

7. The price of an option is called the

8.

Strike

price or

exercise

premium, it is, of course, what the option buyer gives to the option seller.

price is the agreed settlement price.

9. The option buyer is also called the option purchaser. The option seller is also called the option writer. I just use
buy and sell so I do not confuse myself.

Call, can buy if protable

With respect to option

Buyer

Seller

With respect to asset

Buyer

Seller

Prot/Position

Long

Short

This is how I remember this chart: on the left, we have

B B B

(long means big), on the right, we have

(33)

S S S.

Put, can sell if protable

With respect to option

Seller

Buyer

With respect to asset

Buyer

Seller

Prot/Position

Long

Short

(34)

This is how I remember this chart: rst row (with respect to option) is the opposite of the previous chart, the rest
stay the same. When you take the exam, you will write down (33) and (34) on your scrap paper right after the exam
begins.

10. Regarding the payo and prot graph of options. Since the horizontal axis is the price of the asset at expiration, all
you need to remember is,

left

part of the payo

right

part of the payo

(a) When the price of the asset at expiration is low, nothing will happen with a call, so the
graph should be horizontal for both call buyers and call sellers.
(b) When the price of the asset at expiration is high, nothing will happen with a put, so the
graph should be horizontal for both put buyers and put sellers.
(c) It remains to see that, the

right

part of the call payo graph and the

left

part of the put payo graph go up

or down for long or short positions respectively because as we mentioned multiple times already: long position
makes money when the price goes up, and short position makes money when the price goes down.
Once you have the payo graph, the prot graph is obtained by a simple vertical shift of the pemium amount, it
shifts up for the option seller (who gets the premium) and down for the option buyer (who pays the premium).
11. An option is in/at/out of the money if the payo would be positive/0/negative if the option were exercised immediately.
12. To see how homeowner's insurance can be viewed as an option.
(a) First realize that it is a put option as no one is trying to buy the underlying asset, the house.
(b) Next realize that, if the value of the house goes down (for example, a re), then the home owner makes money
by selling it, so he is in the short position, so he is the put buyer.
(c) Lastly, the strike price is of course the house price

subtract

the deductible.

It is subtraction, not addition

because in the case that the house suers a small damage, the house owner does not get to claim it, which
means he does not exercise the put, which means the strike price should be lower than the house price.
13.

Covered writing, option overwriting, or selling a covered call is the opposite of a cap. Covered put is
of a oor. We rst use a pair of charts to summarize these four and memorize them with brute force.

the opposite
It is not too

hard, I will explain.

Prot Equivalent
Cap

Short Index & Long Call

Short Put

Covered Call

Long Index & Short Call

Long Put

and
Prot Equivalent
Covered Put

Short Index & Long Put

Short Call

Floor

Long Index & Short Put

Long Call

Notice that in these charts, the terms long/short with respect to options refer back to (33) and (34). So for example,
long call would be the equivalent of

buy call, similarly, long put would the equivalent of sell put.

(a) First Notice how the position with respect to the index (we use stock index instead of the usual word asset here,
you will see why) is always the opposite of the position with respect to the option? So even without knowing
anything, you can recreate the middle column of the two charts:

Prot Equivalent
Short Index & Long Call
Long Index & Short Call

See 11 for a complete short list of important formulas that you should write down at the beginning of the exam.

and
Prot Equivalent
Short Index & Long Put
Long Index & Short Put
(b) Next, the equivalent option in the last column is always the opposite of the option in the middle, with the
position opposite of the position with respect to the option in the middle (this sentence is long, but it is really
simple and staight forward). So you can ll in some more blanks without knowing a lot:

Prot Equivalent
Short Index & Long Call

Short Put

Long Index & Short Call

Long Put

and
Prot Equivalent
Short Index & Long Put

Short Call

Long Index & Short Put

Long Call

(c) Next, cap, is a hat, so it is made by silc (silk). Therefore cap goes into the row with

Short Index & Long Call.

The other one is then covered call.

Prot Equivalent
Cap

Short Index & Long Call

Short Put

Covered Call

Long Index & Short Call

Long Put

(35)

literal meaning, not mathematical ) prot equivalent of that of capequivalent

(d) Lastly, oor, has the exact opposite (

to short put, so it goes into the row with long call as prot equivlant. The other one is then covered put.

Prot Equivalent
Covered Put

Short Asset & Long Put

Short Call

Floor

Long Asset & Short Put

Long Call

(36)

This may seem long because I wrote out the entire thinking process one step at a time. When you take the exam,
you will write down (35) and (36) on your scrap paper right after the exam begins.

14. Now I will try my best to explain the two charts.

(a) A covered call is the opposite of a

naked call,

which is when you sell a call without owning the actual asset,

you can easily see why this would be dangerousif the price of the asset gets too high, you would be broke
because you cannot provide the asset when the call buyer excersise the option. So to avoid naked call, when
you sell a call, you also buy the asset, then you have a covered call.
(b) A cap is when you short an asset, but you are afraid that when the price of the asset gets too high, you would
be broke because you cannot return the asset when it is time to do so. So to avoid paying too much for the
asset in the future, you buy a call to cover your behind.
(c) Covered put is when you sell a put, but you are afraid that when the price of the asset gets too low, you
will end up spending a lot of money on something that is not worth a lot. So to make the (potential) pain
more bearable, you short the asset. This way, when the asset gets too low, at least you made money from the
short-sale of it.
(d) Floor is just like insurance. You buy an asset, but you are afraid that it will depreciate, so you buy a put to
cover your behind.

See 11 for a complete short list of important formulas that you should write down at the beginning of the exam.

15.

Synthetic forward

mimics a long (again, long means the party that makes money when the price of the asset goes

up) forward position on an asset by buying a call and selling a put, with each option having the same strike price
and time to expiration. Net income from the premiums of a synthetic forward is Put (K, T )
of synthetic forward is the opposite, Call (K, T )

Call (K, T ).

Net cost

Put (K, T ).

16. Put-call parity is

Put (K, T )

Call (K, T ) = P V (K F0, T )

(37)

(37) makes pefect sense because if you create a synthetic forward with strike price
dierence between

K,

then the present value of the

and the forward value of the asset should be the same as the dierence between your income

from selling the put and expense from buying the call. When

gets smaller than

F0, T , the right hand side becomes

negative. But at the same time, the more you have to pay for the call because it would seem like a really good deal
to you (bad to the call seller), so the left hand side becomes negative too. When

gets bigger than

F0, T ,

the right

hand side becomes positive. But at the same time, the more you get from selling the put because it would seem like
a really good deal to the put buyer (bad to you), so the left hand side becomes positive too.

10
1.

Hedging and Investment Strategies

Diversiable

risk is unrelated to other risks, such as a lightning strike.

a stock market cash. There exist risk-sharing mechanisms that benet

2.

Catastrophe bonds

Undiversiable
everyone.

risk is the opposite, such as

are bonds that the issuer need not repay if there is a specied event, such as a large earth quake.

Here is an example of tiered risk-sharing.

Policyholder

Insurer Reinsurer Catastrophe

bond

Note that, an insurer that purchases reinsurance is also called the "ceding company" or "cedant".
3.

Arbitrage

is the simultaneous purchase and sale of an asset in order to prot from a dierence in the price. It is a

trade that prots by exploiting price dierences of identical or similar nancial instruments, on dierent markets or
in dierent forms. Arbitrage exists as a result of market ineciencies; it provides a mechanism to ensure prices do
not deviate substantially from fair value for long periods of time.
4. An option
(a)

Bull

spread

is a position consisting of only calls or only puts.

spread is what you do when you expect the market value of an asset to increase. Remember it by realizing

that you simply buy low and sell high (which in a way agrees with the word increase, just remember that buy
comes before sell). You can do it with both call and put.
(b)

Bear

spread is what you do when you expect the market value of an asset to decrease. Remember it by realizing

that you simply buy high and sell low (which in a way agrees with the word decrease). You can do it with
both call and put.
5. A

box

6. Buy

spread is simply two synthetic forwards. It builds a zero coupon bond. Done in an attempt to lower taxes.

collar

is buy low put and sell high call. Sell

collar

is buy high call and sell low put.

(a) Remember this by noting that the sum of the two options is always the opposite of the position with respect
to the collar. It is always the
i. buy

low

ii. buy

low

high

sell

high

sell

sell

opposite

of what you would expect.

high, you expect the result to be sell because there is more sell, but it is actually buy

high = buy collar.

sell

low, you expect the result to be buy because there is more buy, but it is actually buy

low = sell collar.

(b) The high one is always the call because call sounds similar to collar.
(c) The collar can be used to hedge the price of a purchased asset.

Part III

Appendix
11

List of Formulas to Write Down at the Beginning of FM

(t) =
astart amount e

a0 (t)
a (t)

end time
start time (u)du


P anq + Q
anq =

= aend amount

anq nv n
i

1 vn
i

Call, can buy if protable

With respect to option

Buyer

Seller

With respect to asset

Buyer

Seller

Prot/Position

Long

Short

With respect to option

Seller

Buyer

With respect to asset

Buyer

Seller

Prot/Position

Long

Short

Put, can sell if protable

Prot Equivalent
Cap

Short Index & Long Call

Short Put

Covered Call

Long Index & Short Call

Long Put
Prot Equivalent

Covered Put

Short Asset & Long Put

Short Call

Floor

Long Asset & Short Put

Long Call