MATH 360 (Mathematics of Investment)

MATH 360: Theory of Investment and Credit
Albert Cohen
Actuarial Sciences Program
Department of Mathematics
Department of Statistics and Probability
C336 Wells Hall
Michigan State University
East Lansing MI
48823
albert@math.msu.edu
acohen@stt.msu.edu
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Logistics
All course materials available on class page (www.math.msu.edu)

Syllabus too
Course textbook is S.A. Brovermans Mathematics of Investment
and Credit, 5th edition or later
Some questions on these slides, and on in class exam preparation
slides, are taken from the third edition of Brovermans book. Please
note that Actex owns the copyright for that material. No portion of
the ACTEX textbook material may be reproduced in any part or by
any means without the permission of the publisher. We are very
thankful to the publisher for allowing posting of these notes on our
class website.
Supplementary book is Finan, available online
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Introduction
The value of money is a function of the time that passes while it is stuffed
under a mattress, deposited in a bank account, or invested in an asset.
Just what that function is depends on many circumstances, and we will
spend our time investigating many real-world examples
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Main Tools
Calculus, and the study of Geometric Series, provides
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Main Tools
Calculus, and the study of Geometric Series, provides

the machinery necessary for solving for the final value of an
investment
the optimal time to switch accounts
the interest rate needed to plan fixed income investments
among other wonderful things
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Main Tools
Calculus (1-d only!)
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Main Tools

Can you take a derivative?
Can you find the maximum of a function?
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Main Tools

Sequences and Series
Do you know what a geometric series is? What happens as n ?
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Main Tools

Sequences and Series
Do you know what a geometric series is? What happens as n ?
n
X
k=0
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k =
1 n+1
1
(1)
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Interest Accumulation and Effective Rates of Interest (Ex

1.1)
Begin by investing 1000 at 9% per annum. Compound annually for 3

years. End up with...
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Interest Compounded Monthly
Sometimes, interest rate is quoted per annum, but compounded monthly.

For previous example, assume again 9% but compounded monthly. Then
"
FV = 1000
0.09
1+
12
12 #3
(2)
= 1000 (1.0938)3
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Sometimes, interest rate is quoted per annum, but compounded monthly.

For previous example, assume again 9% but compounded monthly. Then
"
FV = 1000
0.09
1+
12
12 #3
(2)
= 1000 (1.0938)3
In other words, the equivalent or effective annual rate is 9.38%
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Fluctuating Interest Rates
It may be that over a longer period of time, the rate of return on an initial
investment A(0) may fluctuate. At time n, the value of the investment is
now A(n).
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Fluctuating Interest Rates
Guess: A(n) = A(0) (1 + r )n

Reality: A(n) = A(0) (1 + r1 ) ... (1 + rn )
In a bank account or bond, the interest rate, ri is guaranteed to be small
but positive. For a general investment, there is no guarantee that an
investment will not shrink in value over a period of time.
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Arithmetic vs Geometric Means

n
. The
One other possible guess for an average rate of return is r = r1 +...r
n
question of ordering, ie which average rate is bigger, reduces to the
question:

r1 + ...rn n
> (1 + r1 ) ... (1 + rn )?
(3)
Is 1 +
n
To answer this, define for k {1, 2, .., n},
xk = 1 + rk .
(4)
Then, our question is reframed as:

x + ...x n
1
n
Is
> (x1 ) ... (xn )?
n
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The answer is yes, and there are many proofs. One of them is by
induction. Another is to apply Jensens Inequality:
For
a concave function f , for example if f 00 (x) 0 for all x in our domain
P
real numbers ak such that nk=1 ak 6= 0,
real numbers xk ,
it follows that
f
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! P
Pn
n
ak xk
a f (x )
k=1
Pn
Pn k k .
k=1
k=1 ak
k=1 ak
(6)
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By Jensens Inequality, if we define f (x) = ln (x) and each ak = n1 , then

we retain
ln
n

x + ... + x 1 X

1
n
ln (xk ) = ln n x1 ... xn
n
n
(7)
k=1
and so by taking exponentials of both sides we are done.

The inequality can be shown to be strict if the {xk }nk=1 are not all the
same. In other words, if even one interest rate is different between periods,
the the arithmetic average rate is strictly greater than the geometic rate.
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Example 1.2
Table: Average vs. Annual Rate of Return
Year
Annual Rate
Average Rate
2002
6.9%
6.9%
2001
6.4%
6.65%
2000
9.4%
7.56%
1999
3.0%
4.82%
1998
7.8%
5.41%
We can calculate the average interest rate iav via

(1 + iav )n = (1 + r1 ) (1 + r2 ) ... (1 + rn )
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Example 1.3
A very nice example is the following: On Jan 1, 2000, Smith deposits 1000
into an account with 5% annual interest. The interest is paid on every Dec
31. Smith withdraws 200 on Jan 1, 2002, deposits 100 on Jan 1 2003 and
again withdraws from the account on Jan 1 2005, this time 250. What is
the balance in the account just after the interest is paid on Dec 31, 2006?
Hint: Think of a deposit as a loan to the bank, a withdrawal as a loan to
Smith, and at the end of the term (7 years,) both bank and Smith settle
up accounts.
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Example 1.3
We can replicate the cash flows of this example by stating that Smith has
invested both positive and negative amounts of money over the period of
time:
Table: Example 1.3
Year
1000
200
100
250
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Period
7 years
5 years
4 years
2 years
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Example 1.3
We can replicate the cash flows of this example by stating that Smith has
invested both positive and negative amounts of money over the period of
time:
Table: Example 1.3
Year
1000
200
100
250
Period
7 years
5 years
4 years
2 years
Hence,
A(7) = 1000 (1.05)7 + (200) (1.05)5
+ 100 (1.05)4 + (250) (1.05)2 = 997.77
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Example 1.3
Another way of computing A(7) is to do so recursively:
A(0) = 1000
A(1) = A(0) 1.05 = 1000 (1.05)
A(2) = A(1) (1.05) 200
= 1000 (1.05)2 200
A(3) = A(2) (1.05) + 100
= 1000 (1.05)3 200 (1.05) + 100
(10)
A(4) = A(3) (1.05)

A(5) = A(4) (1.05) 250
A(6) = A(5) (1.05)
A(7) = A(6) (1.05)
= 1000 (1.05)7 + (200) (1.05)5
+ 100 (1.05)4 + (250) (1.05)2 = 997.77
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Linear Interest
Another way interest can be designed to accrue is linearly Symbolically, if

A(0) is the initial value of our investment, then the final value is
Alinear (t) = A(0) (1 + i t)
(11)
Notice that at any time k t = n,

Acompound (n) = A(k) (1 + i)nk
= A(0) (1 + i)k (1 + i)nk
(12)
Alinear (n) = A(0) (1 + i n)

6= A(k) (1 + i (n k))
= A(0) (1 + i k) (1 + i (n k))
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Bonus Question
Assume you can select

from two interest rates j, i where 0 < i < j < 1 and
time t [0, 1]
where you can decide to switch from a bank paying j for a time of length t
to one paying i for the remaining time 1 t .
At what time t would this be optimal to do, if at all?
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Bonus Question
In general, if we switch at, then it must be that
1 + j < (1 + jt)(1 + (i(1 t))
1 + j < 1 + jt + i(1 t) + ijt(1 t)
(13)
(j i)(1 t) < ijt(1 t)

j i
< t.
ij
It follows that if 0 <
ji
ij
< 1, we are able to justify such a switch!
The inequality linking i to j is now

i <j <
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i
.
1i
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Bonus Question
The optimal time to switch is when f (t) := (1 + jt)(1 + i(1 t)) is
maximized:
i
dh
(1 + jt)(1 + i(1 t))
dt
= (j i) + ij(1 2t).
1 1 j i
= +
.
2 2
ij
0 = f 0 (t) =
toptimal
Of course, toptimal < 1 as i < j <

bank account is
i
1i
and so the optimal value of the
1 1 j i i
h
1 1 j i ih
+
1+i

.
f (toptimal ) = 1 + j
2 2
ij
2 2
ij
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Accumulated Amount Function
A(t) is also known as the A.A.F., and

A (t2 ) = A (t1 ) (1 + it2 )
A (t2 ) A (t1 )
it2 :=
A (t1 )
(17)
it2 is known as the effective rate for our investment from t1 to t2 .
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Present Value
A dollar today is certainly more valuable than a dollar tomorrow, and even
more valuable than a dollar next year. To reflect this idea, we say that the
present value of a unit of currency one year from now is , where
1
.
(18)
1+i
is also known as the discount factor. This factor works as the inverse of
the interest gained on an investment of a unit of currency for one year.
For example, the present value of 25, 000 at a rate of 5% per annum, 25
25000
years from now, is (1.05)
25
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Equation of Value
In calculating the present value of an investment, we are working

backwards from a fixed outcome to calculate its value to us today.
But, there may be more than one payment expected in the future, such as
when planning for retirement. They may also be balanced by further
investment made in the future.
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Example 1.5
Loan Shark pays you 1000 every week, starting today. There are 4
payments in total, at 8% weekly interest. Starting the week after the last
1000, you are to repay the loan in 3 consecutive weekly installments of
1100 at 8% weekly interest, plus a fourth payment X at 8% weekly
interest. What is X ?
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Example 1.5
Table: Example 1.5: Payments In
Week
Payment in
0
1000
1
1000
2
1000
3
1000
Table: Example 1.5: Payments Out
Week
Payment out
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4
1100
5
1100
6
1100
7
X
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Example 1.5
PV0 (in) = PV0 (out)
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Example 1.5
PV0 (in) = PV0 (out)

1000
1000
1000
+
PV0 (in) = 1000 +
+
2
1.08
1.08
1.083
1100
1100
1100
X
PV0 (out) =
+
+
+
4
5
6
1.08
1.08
1.08
1.087
X = 2273.79
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Nominal Interest Rates
When a credit card has a 24% nominal annual interest rate, you do not
only pay 24% on the balance. Rather, that 24% is broken down into 12
monthly interest charges on the average balance over a 30 day billing
cycle. So, one pays an effective annual rate of

0.24 12
1 = 0.2682.
1+
12
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Example 1.9
Which is better:
(A) 15.25% compounded semi-annually, or
(B) 15% compounded monthly ?
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Example 1.9
Which is better:
(A) 15.25% compounded semi-annually, or
(B) 15% compounded monthly ?

0.1525 2
1 = 0.1583
2

0.15 12
iB (eff ) = 1 +
1 = 0.1608
12

iA (eff ) =
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Notation
Actuaries reserve i for effective annual rate and i (m) for the nominal rate
compounded m times annually. The link between the two is
!m
i (m)
i = 1+
1
m
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Notation
!m
i (m)
i = 1+
1
m

1
i (m) = m (1 + i) m 1
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Notation
!m
i (m)
i = 1+
1
m

1
i (m) = m (1 + i) m 1
i () = lim i (m) = ln (1 + i)
m
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Notation
!m
i (m)
i = 1+
1
m

1
i (m) = m (1 + i) m 1
(22)
i () = lim i (m) = ln (1 + i)
m
(m)
<i
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Example 1.10
Assume i = 0.12. Then

Table: Example 1.10
m
1
2
6
52
365
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1
m (1 + i) m 1
0.12
0.1166
0.1144
0.1135
0.113346
0.113329
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Comparison of continuous to compound interest earned
Assume that we are promised 12% annual interest, and we wish to

calculate the daily interest gained on 10, 000, 000:
1
= 3287.67
interestovernight = 10, 000, 000 0.12
1 365
interestcontinuous = 10, 000, 000 e 365 1 = 3288.21,
(23)
a difference of 0.54 on a principle of 10 million
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Discount Rates
Sometimes, interest paid up front: Receive A(0) up front, pay back
A(1) > A(0).
Consider the example
A(0) = 900
A(1) = 1000
A(1) A(0)
d=
A(1)
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Discount Rates
Sometimes, interest paid up front: Receive A(0) up front, pay back
A(1) > A(0).
Consider the example
A(0) = 900
A(1) = 1000
A(1) A(0)
d=
A(1)
1
= =1d
1+i
(24)
Essentially, the discount is the forward price of a dollar (or any other unit
of currency) in the interest market with no carrying cost or dividends
(coupons) paid out.
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Example 1.11
A T-bill represents the forward value today of 100 delivered at time T .
The price is calculated via simple discount:

T
P(0) = P(T ) (1 d t) = 100 1 d
365
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Example 1.11

T
P(0) = P(T ) (1 d t) = 100 1 d
365

(25)
T
100 = P(T ) = P(0) (1 + i t) = P(0) 1 + i
365
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Example 1.11

T
P(0) = P(T ) (1 d t) = 100 1 d
365

(25)
T
100 = P(T ) = P(0) (1 + i t) = P(0) 1 + i
365
Table: Example 1.11
Term
12day
28day
91day
128day
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Discount (%)
0.965
0.9940
1.130
1.400
Investment (%)
0.974
0.952
1.150
1.430
Price per 100

99.680
99.927
99.174
99.292
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Nominal Annual Discount Rate
d (m) is the quoted annual discount rate that is applied m times over the
(m)
year, with the effective discount rate as dm for the period of m1 years.
Also, d is the effective discount rate :
!m
d (m)
1d = 1
m

1
(26)
d (m) = m 1 (1 d) m

1
d () = lim d (m) = ln
= i ()
m
1d
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Force of Interest
From time t1 to t2 , an investment grows by a rate of
it1 t2 :=
A(t2 ) A(t1 )
A(t1 )
(27)
Now, fix a time t1 = t and correspondingly, let t2 = t + m1 . It follows that

the nominal rate that gives the same annual growth from t to t + m1 is
i (m) = m
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A t+
1
m
A t+
A(t)
1
=
A(t)
A(t)
1
m
1
m
A(t)
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Force of Interest
it1 t2 :=
A(t2 ) A(t1 )
A(t1 )
(27)

i (m) = m
lim i (m) =
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1
A(t)
1
m
A t+
A(t)
1
=
A(t)
A(t)

1
A t + m A(t)
lim
1
A t+
1
m
1
m
A(t)
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Force of Interest
it1 t2 :=
A(t2 ) A(t1 )
A(t1 )
(27)

i (m) = m
1
A(t) m
1 dA
=
A(t) dt
lim i (m) =
1
m
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A t+
A(t)
1
=
A(t)
A(t)

1
A t + m A(t)
lim
1
A t+
1
m
1
m
A(t)
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Force of Interest
it1 t2 :=
A(t2 ) A(t1 )
A(t1 )
(27)

i (m) = m
1
A(t) m
1 dA
=
=: (t)
A(t) dt
lim i (m) =
1
m
A t+
A(t)
1
=
A(t)
A(t)

1
A t + m A(t)
lim
1
A t+
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1
m
1
m
A(t)
(28)
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Force of Interest
Since (t) =
Z t
0
1 dA
A(t) dt
d
= dt
[ln (A(t))], it follows that
Z t
d
[ln (A(s))] ds = ln (A(t)) ln (A(0))
(s)ds =
0 ds
(29)
and so
A(t) = A(0)e
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Rt
0
(s)ds
(30)
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Some Examples...
Calculate (t) for

A(t) = e t
A(t) = t e t
A(t) = (t 1)2
A(t) = A(0) (1 + i t)
A(t) = A(0) (1 + i)t
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Example 1.14
Assume (t) = 0.08 + 0.005t and your assets initial value is A(0) = 1000.
Then
A(t) = A(0)e
Rt
0 (0.08+0.005s)ds
= 1000e 0.08t+0.0025t
A(5) = 1000e 0.085+0.00255 = 1588.04
(31)
But, if we were give A(2) = 1000, then

A(7) = A(2)e
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R7
2
(s)ds
2 22 )
= 1000e 0.085+0.0025(7
= 1669.46
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Some thoughts...
This limiting term, known as the force of interest represents the

theoretical upper limit for interest gained on this asset. However, In the
derivation above, there is no randomness involved in obtaining the ordinary
differential equation
dA(t) = (t)A(t)dt
(33)
To handle this lack of stochasticity, one common asset model (Geometric

Brownian Motion) is defined by the stochastic differential equation
dA(t) = (t)A(t)dt + (A(t)) dW (t),
(34)
where W (.) is the Wiener process.
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Introduction and Geometric Series
An annuity is a series of periodic payments.
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An annuity is a series of periodic payments. In this class, they are not

event-contingent, but rather only depend on the passage of time.
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event-contingent, but rather only depend on the passage of time. To
compute the value of the most foundational annuity, we must recall the
following fact:
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following fact: If x R : x 6= 1, then
Xn := 1 + x + ... + x n
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Xn := 1 + x + ... + x n
(1 x) Xn = 1 x n+1
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Xn := 1 + x + ... + x n
(1 x) Xn = 1 x n+1
(35)
1 x n+1
Xn =
1x
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Example 2.1
The federal government sends Smith a family allowance of 30 every month

for Smiths child. Smith deposits the payments in bank account on the
last day of each month. The account earns interest at the annual rate of
9% compounded monthly and payable on the last day of each month, on
the minimum monthly balance. If the first payment is deposited on May
31, 1998, what is the account balance on December 31,2009, including the
payment just made?
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Example 2.1
There are 140 total payments
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Example 2.1

imonthly =
i
12
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= 0.0075
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Example 2.1

imonthly =
i
12
= 0.0075
TotalValue = 30 + 30 (1.0075)1 + ... + 30 (1.0075)139

= 30
139
X
k=0
1.0075k = 30
1 1.0075140
1 1.0075
(36)
= 7385.91
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Level Payment Annuities
Number of payments in a series of payments is called the term of the

annuity
Time between the successive payments is called the payment period,
or frequency
A series of payments whose value is found at the time of the final
payment is known as accumulated annuity immediate
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annuity
or frequency
sn i :=
n1
X
k=0
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(1 + i)k =
(1 + i)n 1
i
(37)
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annuity
or frequency
sn i :=
n1
X
(1 + i)k =
k=0
(1 + i)n 1
i
(37)
Equivalently, (1 + i)n = 1 + i sn i .
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Ex 2.2
What level amount must be deposited on May 1 and Nov 1 each year from
1998 to 2005, inclusive, to accumulate to 7000 on November 1, 2005 if
the nominal annual interest rate, compounded semi-annually, is 9% ?
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16 total deposits
i (2) = 0.09
X denotes the level amount deposited per period
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16 total deposits
i (2) = 0.09
X denotes the level amount deposited per period
7000 = X 1 + (1.045)1 + ... + (1.045)15
= X s16 0.045
(38)
X = 308.11
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Example 2.3
Suppose that in Example 2.1, Smiths child is born in April 1998 and the
first payment is received in May (and deposited at the end of May.) The
payments continue and the deposits are made at the end of the month
until, and including the month of, the childs 16th birthday. The payments
stop after the 16th birthday, but the balance continues to accumulate with
interest until the end of the month of the childs 21st birthday. What is
the balance X in the account at that time ?
Albert Cohen (MSU)
MSU Spring 2014
46 / 223
Example 2.3
Suppose that in Example 2.1, Smiths child is born in April 1998 and the
first payment is received in May (and deposited at the end of May.) The
payments continue and the deposits are made at the end of the month
until, and including the month of, the childs 16th birthday. The payments
stop after the 16th birthday, but the balance continues to accumulate with
interest until the end of the month of the childs 21st birthday. What is
the balance X in the account at that time ?
X = 1.007560 30 s192 0.0075 = 20, 028.68
Albert Cohen (MSU)
MSU Spring 2014
(39)
46 / 223
Some Arithmetic
After accumulating cash via a series of payments at rate i until time n, we

allow this amount to grow until time n + k :
(1 + i)n 1
(1 + i)k
i
(1 + i)k
Value(n + k) = sn i (1 + i)k =
=
(1 + i)n+k
i
(1 + i)n+k 1 (1 + i)k 1
=
i
i
= sn+k i sk i
Albert Cohen (MSU)
MSU Spring 2014
47 / 223
Some Arithmetic
After accumulating cash via a series of payments at rate i until time n, we

allow this amount to grow until time n + k :
(1 + i)n 1
(1 + i)k
i
(1 + i)k
Value(n + k) = sn i (1 + i)k =
=
(1 + i)n+k
i
(1 + i)n+k 1 (1 + i)k 1
=
i
i
= sn+k i sk i
(40)
sn+k i = sk i + sn i (1 + i)k
Albert Cohen (MSU)
MSU Spring 2014
47 / 223
Example 2.4
Suppose that in Example 2.1, the nominal annual interest rate earned on
the account changes to 7.5%, still compounded monthly, as of January
2004. What is the accumulated value of the account on December 31
2009 ?
Albert Cohen (MSU)
MSU Spring 2014
48 / 223
Example 2.4
Suppose that in Example 2.1, the nominal annual interest rate earned on
the account changes to 7.5%, still compounded monthly, as of January
2004. What is the accumulated value of the account on December 31
2009 ?

Value = 30 s68 0.0075 1.0062572 + s72 0.00625 = 6865.22
Albert Cohen (MSU)
MSU Spring 2014
(41)
48 / 223
Example 2.5
Suppose 10 monthly payments of 50 each are followed by 14 monthly

payments of 75 each. If interest is at an effective monthly rate of 1%, what
is the accumulated value of the series at the time of the final payment ?
Albert Cohen (MSU)
MSU Spring 2014
49 / 223
Example 2.5
Suppose 10 monthly payments of 50 each are followed by 14 monthly

payments of 75 each. If interest is at an effective monthly rate of 1%, what
is the accumulated value of the series at the time of the final payment ?
Value = 50 s24 0.01 + 25 s14 0.01
Albert Cohen (MSU)
(42)
MSU Spring 2014
49 / 223
Present Value of an Annuity

Make a lump sum payment X now to receive periodic payments C ,
starting one period from today. If the market bears a constant interest of
i, the the the Present Value of this Annuity Immediate is calculated as
C
C
C
+
+ ... +
2
1+i
(1 + i)
(1 + i)n
n
n1
X
X
=C
k = C
k
X =
k=1
k=0
(43)
1 n
=C
1
1 n
1 (1 + i)n
=C
=C
i
i
C an i
Albert Cohen (MSU)
MSU Spring 2014
50 / 223
Example 2.7
Brown has bought a new car and requires a loan of 12000 to pay for it.
The car dealer offers Brown two alternatives on the loan:
A : Monthly payments for 3 years, starting one month after purchase,
with an annual interest rate of 12% compounded monthly
B : Monthly payments for 4 years, also starting one month after
purchase, with an annual interest rate of 15% compounded monthly.
Find Browns monthly payment and the total amount paid over the course
of the repayment period under each of the two options.
Albert Cohen (MSU)
MSU Spring 2014
51 / 223
Example 2.7
12000 = PA a36 0.01 PA = 398.57

12000 = PB a48 0.0125 PB = 333.97
TotalValue(A) = 36 PA = 14348.52
(44)
TotalValue(B) = 48 PB = 16030.56
Albert Cohen (MSU)
MSU Spring 2014
52 / 223
Example 2.8
Suppose that in Example 2.7, Brown can repay the loan, still with 36
payments under option A or 48 payments under option B, with the first
payment made 9 months after the car is purchased in either case.
Assuming interest accrues from the time of the car purchase, find the
payments required under options A and B. This is known as a deferred
annuity
Albert Cohen (MSU)
MSU Spring 2014
53 / 223
Example 2.8
12000 = PA0 1.019 + 1.0110 + ... + 1.0144
= PA0 A8 a36 0.01

PA0 = 431.60
12000 = PB0 1.01259 + 1.012510 + ... + 1.012556
(45)
= PB0 B8 a48 0.0125

PB0 = 368.86
Albert Cohen (MSU)
MSU Spring 2014
54 / 223
Some Facts About Annuities
There is a duality between an i and sn i :

sn i = (1 + i)n an i
(46)
an i = n s n i
As n , we have
a i = lim an i
n
(47)
1 n
1
=
n
i
i
= lim
Albert Cohen (MSU)
MSU Spring 2014
55 / 223
Example 2.9
A perpetuity immediate pays X per year. Brian receives the first n

payments, Colleen receives the next n payments, and Jeff receives the
remaining payments. Brians share of the present value of the original
perpetuity is 40%, and Jeffs share is K . Calculate K .
Albert Cohen (MSU)
MSU Spring 2014
56 / 223
Example 2.9
1 n
i
X
= 0.4 X a i = 0.4
i
1 n = 0.4
PV (Brian) = X an i = X
PV (Colleen) = n X an i = 0.4 0.6
Albert Cohen (MSU)
X
X
= 0.24
i
i
MSU Spring 2014
57 / 223
Example 2.9
1 n
i
X
= 0.4 X a i = 0.4
i
1 n = 0.4
PV (Brian) = X an i = X
PV (Colleen) = n X an i = 0.4 0.6
X
X
= 0.24
i
i
(48)
X
= PV = PV (Brian) + PV (Jeff ) + PV (Colleen)
i
X
X
= 0.4 + K + 0.24
i
i
X
K = 0.36
i
Albert Cohen (MSU)
MSU Spring 2014
57 / 223
Recall...
sn i = 1 + (1 + i) + (1 + i)2 + ... + (1 + i)n1 =

an i
1 n
= + = ... + =
i
2
(1 + i)n 1
i
(49)
Of course, sn i is the accumulation of all the payments at the final time,

whereas an i is the present value of all the paymenst, one period before the
first payment. Now, define
sn i := (1 + i) + (1 + i)2 + ... + (1 + i)n = (1 + i)sn i
= annuity due
= accummulated value one-period after final payment
(50)
an i := (1 + i)an i
= present value at time of first payment
Albert Cohen (MSU)
MSU Spring 2014
58 / 223
Level Payment Annuities: Some Generalizations.
What happens when compounding interest period and annuity payment

period dont coincide? For example: Consider 4 deposits made per year,
over 16 years, of 1000 each. What is the balance after the last payment if
interest is quoted at 9% nominal annual interest rate, compounded
monthly?
Albert Cohen (MSU)
MSU Spring 2014
59 / 223
Level Payment Annuities: Some Generalizations.
What happens when compounding interest period and annuity payment

period dont coincide? For example: Consider 4 deposits made per year,
over 16 years, of 1000 each. What is the balance after the last payment if
interest is quoted at 9% nominal annual interest rate, compounded
monthly?
In this case, the equivalent rate j for the 3month periods satisfies
3
1 + j = 1 + 0.09
. It follows that
12
Value = 1000s64 j = 141, 076
Albert Cohen (MSU)
(51)
MSU Spring 2014
59 / 223
mthly payable annuities: Some Generalizations.

Imagine that for each of n periods in the term of an annuity, 1 is paid out
over m payments of m1 each. Then the present value is computed using
(m)
j = i m , where
(m)
1
1
1
sm j + 2 sm j + ... + n sm j
m
m
m

m
i (m)
1+ m
1

1
= + 2 + ... + n
i (m)
m
m

m
(m)
1 + im
1
i
= an i
= an i (m)
(m)
i
i
an i =
Albert Cohen (MSU)
MSU Spring 2014
60 / 223

Imagine that for each of n periods in the term of an annuity, 1 is paid out
over m payments of m1 each. Then the present value is computed using
(m)
j = i m , where
(m)
1
1
1
sm j + 2 sm j + ... + n sm j
m
m
m

m
i (m)
1+ m
1

1
= + 2 + ... + n
i (m)
m
m

m
(m)
1 + im
1
i
= an i
= an i (m)
(m)
i
i
i
= sn i (m)
i
an i =
(m)
sn i
Albert Cohen (MSU)
MSU Spring 2014
(52)
60 / 223
As m , we have i (m) ln (1 + i), and so it follows that

(m)
i
ln (1 + i)
i
ln (1 + i)
an i an i
(m)
sn i sn i
(53)
Lets analyze this using calculus!
Albert Cohen (MSU)
MSU Spring 2014
61 / 223
Take t2 t1 = m1 , and assume that 1 is paid out at a continuous rate.

Then, from t to t + dt, the amount paid out is dt. At time n, the value of
dt accumulated from t to n is dt (1 + i)nt .
Albert Cohen (MSU)
MSU Spring 2014
62 / 223
Take t2 t1 = m1 , and assume that 1 is paid out at a continuous rate.

Then, from t to t + dt, the amount paid out is dt. At time n, the value of
dt accumulated from t to n is dt (1 + i)nt . Add up all of these bits and
we obtain
Z n
Z n
sn i =
(1 + i)nt dt =
e ln (1+i)(nt) dt
0
0
#n
"
ln
(1+i)t
e
= e ln (1+i)n
(54)
ln (1 + i)
0
(1 + i)n 1
i
(m)
=
= sn i
= lim s
ln (1 + i)
ln (1 + i) m n i
Albert Cohen (MSU)
MSU Spring 2014
62 / 223
An Example: Daily vs Continuous deposits
Consider depositing 12 per day in 2004 and 2005 and 15 per day in 2006.
The earned interest in 2004-05 is i1 = 9% effective per year, and i2 = 12%
effective per year in 2006. Compute the total accumulated amount at the
end of 2006 if computed via (a) daily deposits and (b) continuous
deposits. Assume no leap years!
Albert Cohen (MSU)
MSU Spring 2014
63 / 223
For daily deposits, we compute the equivalent daily interest rates j1 for
2004-05 and j2 for 2006 by
1
j1 = (1.09) 365 1 = 0.00023631
(55)
j2 = (1.12) 365 1 = 0.00031054

So,
AccValue = 12 s730 j1 (1 + i2 ) + 15 s365 j2
= 12 s730 0.00023631 (1.12) + 15 s365 0.00031054
(56)
= 16502.59
Albert Cohen (MSU)
MSU Spring 2014
64 / 223
For continuous deposits, we compute that 12 365 = 4380 is invested per

yearfor the period 2004-05 and 15 365 = 5475 for 2006.
So,
AccValue = 4380 s2 0.09 (1.12) + 5475 s1 0.12
1.092 1
1.12 1
(1.12) + 5475
ln (1.09)
ln (1.12)
= 16504.75
= 4380
Albert Cohen (MSU)
MSU Spring 2014
(57)
65 / 223
Continuous Annuities in General

Define a(t1 , t2 ) as the accumulated value at t2 of an amount 1 invested at
t1 .
Albert Cohen (MSU)
MSU Spring 2014
66 / 223

Define a(t1 , t2 ) as the accumulated value at t2 of an amount 1 invested at
t1 . Hence,
Z t2
a(t, t2 )dt
(58)
t1
is the accumulated value at t2 of a continuous annuity paying 1 per

unit time over the interval (t1 , t2 ),
and
Z t2
1
dt
(59)
t1 a(t, t2 )
is the present value at t1 of a continuous annuity paying 1 per unit time
over the interval (t1 , t2 ),
Albert Cohen (MSU)
MSU Spring 2014
66 / 223
If s is the force of interest at time s, then

Rt
ds
a(t1 , t2 ) = e t1 s
Z n R
t
e 0 s ds dt
an s =
Z0 n R
n
sn s =
e t s ds dt
(60)
Albert Cohen (MSU)
MSU Spring 2014
67 / 223
Unknown Number of Payments in an Annuity
Assuming n level payments of J each at interest rate i, the accumulated

value is
Albert Cohen (MSU)
MSU Spring 2014
68 / 223

value is

M = J (1 + i)n1 + ... + (1 + i) + 1
(1 + i)n 1
=J
= J sn i
i
Albert Cohen (MSU)
MSU Spring 2014
68 / 223

value is

M = J (1 + i)n1 + ... + (1 + i) + 1
(1 + i)n 1
=J
= J sn i
i
(61)
M
(1 + i)n = 1 + i
J

ln 1 + i M
J
n=
ln 1 + i
Albert Cohen (MSU)
MSU Spring 2014
68 / 223
Example 2.13
Smith wishes to accumulate 1000 by means of semi-annual deposits

earning interest at nominal rate i (2) = 0.08, with interest creditied
semi-annually. Regular deposits of 50 are made. Find the number of
periods and regular deposits needed, along with any additional fractional
deposits if such a fractional deposit is made at the time of the last regular
deposit or the very next period (i.e. last regular deposit can be 0.)
Albert Cohen (MSU)
MSU Spring 2014
69 / 223
Example 2.13
Here, the parameters are M = 1000, J = 50, i = 0.04. It follows that

ln 1 + i M
J
= 14.9866
(62)
n=
ln 1 + i
Albert Cohen (MSU)
MSU Spring 2014
70 / 223
Example 2.13

ln 1 + i M
J
= 14.9866
(62)
n=
ln 1 + i
Rounding down to n = 14, we obtain 50s14 0.04 = 914.60..
Albert Cohen (MSU)
MSU Spring 2014
70 / 223
Example 2.13

ln 1 + i M
J
= 14.9866
(62)
n=
ln 1 + i
Rounding down to n = 14, we obtain 50s14 0.04 = 914.60.. However, 50 is
not enough to carry over to get a final amount of 1000, so let the 914.60
accrue for 1 period to 914.60 (1.04) = 951.18 , and then add the
fractional payment of 48.82. Hence 15 periods are needed
Albert Cohen (MSU)
MSU Spring 2014
70 / 223
Example 2.13
Smith pays 100 per month to a fund earning i (12) = 0.09, with interest
credited on the last day of each month. At the time of each deposit, 10 is
deducted from the deposit for expenses and administration fees. The first
deposit is made on the last day of Jan 2000. In which month does the
accumulated value become greater than the total gross contribution to
that point?
Albert Cohen (MSU)
MSU Spring 2014
71 / 223
Example 2.13
We wish to solve for the time when the Value of the account exceeds the
total amount invested, i.e. the value n that satisfies

90 1 + 1.0075 + ... + 1.0075n1 100n
Albert Cohen (MSU)
MSU Spring 2014
72 / 223
Example 2.13

90 1 + 1.0075 + ... + 1.0075n1 100n
100
n
sn i
90
Albert Cohen (MSU)
MSU Spring 2014
72 / 223
Example 2.13

90 1 + 1.0075 + ... + 1.0075n1 100n
100
(63)
n
sn i
90
1.0075n 1 + 0.00833n
Albert Cohen (MSU)
MSU Spring 2014
72 / 223
Example 2.13

90 1 + 1.0075 + ... + 1.0075n1 100n
100
(63)
n
sn i
90
1.0075n 1 + 0.00833n
Essentially, we are solving a fixed point equation for f (x) = 0, where
f (x) = e kx 1 0.00833x
Albert Cohen (MSU)
MSU Spring 2014
72 / 223
Example 2.13

90 1 + 1.0075 + ... + 1.0075n1 100n
100
(63)
n
sn i
90
1.0075n 1 + 0.00833n
f (x) = e kx 1 0.00833x
(64)
k = ln (1.0075)
Albert Cohen (MSU)
MSU Spring 2014
72 / 223
Example 2.13

90 1 + 1.0075 + ... + 1.0075n1 100n
100
(63)
n
sn i
90
1.0075n 1 + 0.00833n
f (x) = e kx 1 0.00833x
(64)
k = ln (1.0075)
In this case, plotting the above function of x gives an intercept of
approximately 28.6. Hence, n = 29.
Albert Cohen (MSU)
MSU Spring 2014
72 / 223
Dividend Discount Model for Stock Shares
We now have a philosophy for pricing assets that bring a future stream of
payments. Simply put, the value today of the asset is simply the Net
Present Value, opr NPV, of that stream of payments, when adjusted for
inflation or (compound) growth, if applicable.
Albert Cohen (MSU)
MSU Spring 2014
73 / 223

If a table, or number line of future payments looks like
Table: Example 1.5: Payments In
Week
Payment in
0
0
1
K
2
K (1 + r )
...n
K (1 + r )n1
then the NPV, valued with rate i, is

K
K (1 + r )
K
+
+ ... +
1+i
(1 + i)2

n1
X
K
K
1+r j
=
=
1+i
1+i
1+i
NPV =
j=0
Albert Cohen (MSU)
(1 + r )n1
(1 + i)n

n
1 1+r
1+i
1 1+r
1+i
MSU Spring 2014
(65)
74 / 223
As n , we approach a perpetuity, and

NPV
K
1
K
=
1+r
1 + i 1 1+i
i r
(66)
In words, we have a perpetuity that is adjusted for the growth rate r . We

use this formula to price a stock or any other asset as a perpetuity with
possible compound growth at rate r .
Albert Cohen (MSU)
MSU Spring 2014
75 / 223
Example 2.13
Stock X pays dividend 50 per year with growth of 5% after the first year.
John purchases X at the theoretical price corresponding to an effective
yield of 10%. After receiving the the 10th dividend, John sells the stock for
price P. If annual yield for John was 8%, what is the fair price for P ?
Albert Cohen (MSU)
MSU Spring 2014
76 / 223
Example 2.13
The equation of value is
9
50 X
50
= 1000 =
0.10 0.05
1.08
j=0
Albert Cohen (MSU)
1.05
1.08
j
P
1.0810
MSU Spring 2014
76 / 223
Example 2.13
The equation of value is
9
50 X
50
= 1000 =
0.10 0.05
1.08
j=0
P = 1000(1.08)
10
1.05
1.08
j
50(1.08)
P
1.0810

9
X
1.05 j
j=0
= 1000(1.08)10 50(1.08)9
1
1
1.08
!
1.05 10
(67)
1.08

1.05 1
1.08
= 1275.54.
Albert Cohen (MSU)
MSU Spring 2014
76 / 223
Increasing Annuities
Consider now a payment schedule where the payment, at time k, was
Km = m .
Albert Cohen (MSU)
MSU Spring 2014
77 / 223
Km = m .
Now, the net present value is
X =
n
X
Km
m=1
n
X
m=1
n
X
m=1
m
(1 + i)m
(68)
Then
Albert Cohen (MSU)
MSU Spring 2014
77 / 223
Km = m .
Now, the net present value is
X =
n
X
Km
m=1
n
X
m=1
n
X
m=1
m
(1 + i)m
(68)
Then
(1 + i) X =
n
X
m m1 =
m=1
n
X
m=1
m
(1 + i)m1
i X = 1 + + + ... + n1 n n
1 n
=
n n
1
an i n n
X =
=: (Ia)n i
i
Albert Cohen (MSU)
MSU Spring 2014
(69)
77 / 223
An increasing perpetuity is defined as

lim (Ia)n i = lim
1 n
1
n n
i
(70)
1+i
= 2
i
Notice that the level payment perpetuity of Kl 1 has present value of
only 1i . Since i 0, we have i12 >> 1i .
Albert Cohen (MSU)
MSU Spring 2014
78 / 223
An increasing perpetuity is defined as

lim (Ia)n i = lim
1 n
1
n n
i
(70)
1+i
= 2
i
Notice that the level payment perpetuity of Kl 1 has present value of
only 1i . Since i 0, we have i12 >> 1i .
HW: apply same analysis for decreasing annuities, with Km = n m + 1,
where m {1, 2, .., n}
Albert Cohen (MSU)
MSU Spring 2014
78 / 223
Example 2.22
Consider perpetuities X and Y with payment
Table: Example 2.22: Payments Schedule X
Week
Payment in
1
1
2
2
3
3
..n..
..n..
Table: Example 2.22: Payments Schedule Y
Week
Payment in
1
q
2
q
3
2q
4
2q
..2k 1
..kq
2k..
kq..
at the end of each year. It is known that NPV (X ) = NPV (Y ) when

valued at annual interest rate i = 0.10. Solve for q.
Albert Cohen (MSU)
MSU Spring 2014
79 / 223
Example 2.22
If we take eq := 2 =

1 2
1.1
1
1.21 ,
and so ieq = 0.21. It follows that
1+i
1.1
=
= 110
2
i
0.01
NPV (Y ) = q + q 2 + 2q 3 + 2q 4 + 3q 5 + 3q 6 + ...

= q + 2 3 + 3 5 + .. + q 2 + 2 4 + 3 6 + ..

q
= q+
2 + 2 4 + 3 6 + ..

q
2
3
= q+
+ 3eq
+ ..
eq + 2eq
1 + ieq
1.21
= 2.1 q
= 2.1 q
= 57.62q
2
ieq
0.212
NPV (X ) =
Albert Cohen (MSU)
MSU Spring 2014
80 / 223
Example 2.22
If we take eq := 2 =

1 2
1.1
1
1.21 ,
and so ieq = 0.21. It follows that
1+i
1.1
=
= 110
2
i
0.01
NPV (Y ) = q + q 2 + 2q 3 + 2q 4 + 3q 5 + 3q 6 + ...

= q + 2 3 + 3 5 + .. + q 2 + 2 4 + 3 6 + ..

q
= q+
2 + 2 4 + 3 6 + ..

q
2
3
= q+
+ 3eq
+ ..
eq + 2eq
1 + ieq
1.21
= 2.1 q
= 2.1 q
= 57.62q
2
ieq
0.212
NPV (X ) =
(71)
q = 1.91
Albert Cohen (MSU)
MSU Spring 2014
80 / 223
Continuous Payment Schemes

What if the payments Km were just discrete samples at time tm of a
continuous payment scheme? For example, the payment at time t = t1
was Ki = h(ti )dt.
Albert Cohen (MSU)
MSU Spring 2014
81 / 223

What if the payments Km were just discrete samples at time tm of a
continuous payment scheme? For example, the payment at time t = t1
was Ki = h(ti )dt.
Then all payments must be summed to obtain the NPV and AccValue:
Z n
1
NPV =
h(t)dt
(1
+
i)t
Z0 n
(72)
nt
AccVal =
(1 + i) h(t)dt
0
A special case is when h(t) = t. Then

Z n

1
I a
=
tdt
ni
(1 + i)t
Z0 n

I s
=
(1 + i)nt tdt
ni
(73)
Albert Cohen (MSU)
MSU Spring 2014
81 / 223

Integration by parts allows us to obtain
Z n

1
an i n n
I a
=
tdt
=
ni
(1 + i)t
Z0 n

sn i n
I s
=
(1 + i)nt tdt =
ni
0
:= ln (1 + i)
(74)
where is the constant force of interest.
Albert Cohen (MSU)
MSU Spring 2014
82 / 223

Integration by parts allows us to obtain
Z n

1
an i n n
I a
=
tdt
=
ni
(1 + i)t
Z0 n

sn i n
I s
=
(1 + i)nt tdt =
ni
0
:= ln (1 + i)
(74)
where is the constant force of interest.

If the force of interest varies, then
Z n R

t
I a
=
e 0 s ds tdt
n
Z0 n R

n
I s
=
e t s ds tdt
n
(75)
Albert Cohen (MSU)
MSU Spring 2014
82 / 223
Unique Interest Rates for Annuity Valuation: An

application of the Intermediate Value Theorem
Returning to the discrete setting, consider the following important theorem

Theorem
Assume that an annuity X pays amount Kj > 0 at time tj for all times
0 < t1 < t2 .. < tn . Suppose that you are P
given L > 0. Then there exists a
Kl
unique i > 1 such that NPV (X )(i) := nl=1 (1+i)
tl = L under rate i.
Without this theorem, we would not be able to uniquely price returns on
assets.
Albert Cohen (MSU)
MSU Spring 2014
83 / 223
Unique Interest Rates for Annuity Valuation: An

application of the Intermediate Value Theorem
Proof.
It follows that since {(Kl , tl )}nl=1 R2+ , we have NPV (X )0 (i) < 0. This
also follows from financial reasoning as a higher rate i would demand a
lower up front payment L. Since
lim NPV (X )(i) = 0
(76)
lim NPV (X )(i) =
i1
it follows from the IVT that there exists a unique i (due to strict
decreasing nature of NPV (X )(i)) such that NPV (X )(i) = L
Albert Cohen (MSU)
MSU Spring 2014
84 / 223
Yield and Reinvestment Rates
Assume a loan amount L for a term of n years, and a total value M of all
payments after the n years. Then it must be that for level payments K the
yield rate i satisfies
L=
K
K
K
M
=
+
+ .. +
= K an i
n
2
(1 + i)
1+i
(1 + i)
(1 + i)n
(77)
On a loan, the Internal Rate of Return, or IRR, is the rate of interest for
which the loan amount upront is equal in value to the NPV of all loan
payments. Also known as the loan rate. Sometimes, the entity that loans
L can reinvest these loan repayments at a higher rate.
Albert Cohen (MSU)
MSU Spring 2014
85 / 223
Ex. 2.25
(12)
Smith owns a 10000 savings bond that pays iBond = 0.06. Upon receipt of
an interest payment, he immediately deposits it into an account earning
(12)
interest, payable monthly, at a rate of iX = 0.12. Find the accumulated
value of this account just after the 12th , 24th , and 36th deposit. In each
(12)
case, find the average annual yield iavg based on his initial investment of
10000. Assume that the savings bond may be cashed in any time for
10000.
Albert Cohen (MSU)
MSU Spring 2014
86 / 223
Ex. 2.25
(12)
The interest paid each month is at a rate of i 12 = 0.06

12 = 0.5%. On an
investment of 10000, this means payments of 50 each month. The value
of his reinvestment of these payments at rate 0.01 is
Table: Example 2.25: Accumulated Value of Reinvestment
Month
Acc Val
=
Albert Cohen (MSU)
12
50 s12 0.01
634.13
24
50 s24 0.01
1348.67
36
50 s36 0.01
2153.84
MSU Spring 2014
87 / 223
Ex. 2.25
After 12 months, the equivalent rate j needed to accumulate

10000 + 50 s12 0.01 = 10634.13 satisfies
(12)

iavg 12
10000 1 +
= 10634.13
12
(12)
iavg = 0.0616
(78)
Do this for the other cases.
Albert Cohen (MSU)
MSU Spring 2014
88 / 223
Ex. 2.25
In general, we have
(12)

iavg (n) n
= 10000[1 + 0.005sn 0.01 ]
10000 1 +
12
h
(1.01)n 1 i
= 10000 1 + 0.005
0.01
1
h 1 1
i
n
(12)
iavg (n) = 12
+ (1.01)n 1
2 2
Albert Cohen (MSU)
MSU Spring 2014
(79)
89 / 223
Sinking Fund Method of Valuation
It often happens that interest payments returned to an investor at rate i

can only be reinvested at market rate j. If j 6= i, then the yield rate to
value the investment is also 6= i and we consider another way to determine
the value. Instead of using the present value method, we now consider the
value at the end of the term n of the investment.
When an investment is made, it can be considered a loan (principal) to the
person receiving the money up front. By the end of the term, the entire
principal has been repaid and the investor has enjoyed (consumed) periodic
interest payments for making the initial investment.
Consider, for example, the fair purchase price P of an annuity with level
payments K over n periods.
Albert Cohen (MSU)
MSU Spring 2014
90 / 223

Receive periodic payments K in return for initial investment P.
The interest payment is P i, received every unit of time over interval
of length n.
These interest payments are consumed, and the excess K P i every
period is reinvested at a rate j into a sinking fund.
The fair value P is now determined via the recursive equation that
says investor recovers P at end of term, and this is equivalent to the
amount accumulated by reinvesting the excess K P i per period:
P = (K P i) sn j
Albert Cohen (MSU)
MSU Spring 2014
91 / 223

of length n.
P = (K P i) sn j
Ksn j
P=
1 + i sn j
Albert Cohen (MSU)
MSU Spring 2014
91 / 223

of length n.
P = (K P i) sn j
Ksn j
Ksn j
P=
=
i
1 + i sn j
1 + j ((1 + j)n 1)
Albert Cohen (MSU)
MSU Spring 2014
91 / 223

of length n.
P = (K P i) sn j
Ksn j
Ksn j
P=
=
i
1 + i sn j
1 + j ((1 + j)n 1)
lim P =
ji
Albert Cohen (MSU)
(80)
Ksn i
= Kan i
1 + (1 + i)n 1
MSU Spring 2014
91 / 223
Amortization
When repaying a loan L with periodic payments Km at time m, we have

the equation of value
L=
n
X
m=1
Km
(1 + i)m
(81)
In this method, we track the outstanding balance on a loan, denoted by

OB(i) or sometimes OBi .
Albert Cohen (MSU)
MSU Spring 2014
92 / 223
Amortization
OB0 = L
Albert Cohen (MSU)
MSU Spring 2014
93 / 223
Amortization
OB0 = L
OB1 = L (1 + i) K1
Albert Cohen (MSU)
MSU Spring 2014
93 / 223
Amortization
OB0 = L
OB1 = L (1 + i) K1
OB2 = OB1 (1 + i) K2
Albert Cohen (MSU)
MSU Spring 2014
93 / 223
Amortization
OB0 = L
OB1 = L (1 + i) K1
OB2 = OB1 (1 + i) K2
OBt+1 = OBt (1 + i) Kt+1 = OBt PRt+1
PRt+1 = Kt+1 i OBt
It+1 = i OBt
Albert Cohen (MSU)
MSU Spring 2014
93 / 223
Amortization
OB0 = L
OB1 = L (1 + i) K1
OB2 = OB1 (1 + i) K2
OBt+1 = OBt (1 + i) Kt+1 = OBt PRt+1
(82)
PRt+1 = Kt+1 i OBt

It+1 = i OBt
OBn = 0 = OBn1 (1 + i) Kn
Also
total interest
and cash paid out are, respectively,
Pn note that
Pthe
Pn
n
I
and
K
I
.
t=1 t
t=1 t
t=1 t
Albert Cohen (MSU)
MSU Spring 2014
93 / 223
Retrospective and Prospective Forms
At time t, if we look backwards to balance out how the original loan

amount has grown and subtract form that our total payments, then
OBt = L (1 + i)t
t
X
Km (1 + i)tm
(83)
m=1
If we take the NPV viewpoint, then the outstanding balance today is

simply the present value of all future payments until the the loan is paid
off:
OBt =
n
X
m=t+1
Albert Cohen (MSU)
Km
(1 + i)mt
(84)
MSU Spring 2014
94 / 223
Example 3.2
A loan of 3000 at an effective quarterly rate of j = 0.02 is amortized by

means of 12 quarterly payments, beginning one quarter after the loan is
made. Each payment consists of a principal repayment of 250 plus interest
due on the previous quarters outstanding balance. Construct the
amortization schedule.
Albert Cohen (MSU)
MSU Spring 2014
95 / 223
Example 3.2
In this case, we have level princiapl repayments, and so PRt = 250 for all
0 t 12. Since It+1 = 0.02 OBt , it follows that
OBt+1 = OBt 250
OBt = 3000 250t
It = 0.02 (3000 250 (t 1)) = 65 5t
(85)
Kt = It + PRt = 250 + 65 5t = 315 5t
Albert Cohen (MSU)
MSU Spring 2014
96 / 223
Amortization of a Loan with Level Repayments
In this case, which is common, the payments are held constant, say at
K, but the proportion of interest paid versus principal paid varies with
time.
Examples such as mortgages, car payments, etc..
Can use retrospective method to value outstanding balance at time t.
Albert Cohen (MSU)
MSU Spring 2014
97 / 223
Amortization of a Loan with Level Repayments
Here, the outstanding balance

Pt is of course OBt = K ant i , and the total
cash paid out by time t is m=1 Kt = K t. It follows that, with
= ln (1 + i)

It = i OBt1 = i K ant+1 i = K 1 (1 + i)tn1
K
PRt = Kt It =
(86)
(1 + i)n+1t

K
OBt =
1 e (nt)
i
Albert Cohen (MSU)
MSU Spring 2014
98 / 223
Sinking Fund Method of Valuation Revisited
Even though the outstanding balance is paid off only at the end of the
term of the loan, we can still interpolate and say that the outstanding
balance decreases as
OBt = L
L
s
sn j t j
(87)
where the balance decreases by the amount paid into the account earning
at a rate j.
Albert Cohen (MSU)
MSU Spring 2014
99 / 223
Sinking Fund Method of Valuation Revisited
Note that we can also calculate the net interest payment each month via
Kt = L i +
L
sn j

st j st1 j
PRt = OBt1 OBt = L
sn j

st1 j
It = Kt PRt = L i j
sn j
Albert Cohen (MSU)
MSU Spring 2014
(88)
100 / 223
Sinking Fund Example from previous SOA Exam FM/1
Ronaldo borrows L for 10 years at an annual effective interest rate of

100 i%. At the end of each year, he pays the interest on the loan and
deposits the level amount necessary to repay the principal to a sinking
fund earning an annual effective interest rate of 100 j%. The total
payments made by Ronaldo over the 10-year period is X. Calculate X .
Albert Cohen (MSU)
MSU Spring 2014
101 / 223
Sinking Fund Example from previous SOA Exam FM/1
Answer:
Annual interest payment = L i
Annual sinking fund deposit is
L
s10|j
Total annual payment = L i + s L

10|j

Total of all payments = 10 L i +
Albert Cohen (MSU)
s10|j
MSU Spring 2014
102 / 223
Makehams Formula
Consider the following scenario: An investor makes a loan at interest rate

i, with only interest payments for the term of the loan, and then a lump
sum L at the end of term. The investor then sells the loan to a speculator,
who values the expected cash flows at a rate j. Then the value the
speculator puts on the investment is

i
L
L
L
+ L i an j =
+ L
(89)
A=
(1 + j)n
(1 + j)n j
(1 + j)n
Albert Cohen (MSU)
MSU Spring 2014
103 / 223
Makehams Formula
This idea generalizes to the P

case where the principal L is paid over a series
n
of lump
sum
payments
L
=
m=1 Lm and periodic repayments
Pn
K = m=1 Km .
Albert Cohen (MSU)
MSU Spring 2014
104 / 223
Makehams Formula
This idea generalizes to the P

case where the principal L is paid over a series
n
of lump
sum
payments
L
=
m=1 Lm and periodic repayments
Pn
K = m=1 Km .
Each of these lump sum payments can be viewed as corresponding to an
individual loan:

Ls
Ls
i
Ls
+ Ls i ats j =
+ Ls
As =
(1 + j)ts
(1 + j)ts
j
(1 + j)ts
Albert Cohen (MSU)
MSU Spring 2014
(90)
104 / 223
Makehams Formula
We can find the total value now by summing up the individual loan values
n
X
n
X

Ls
i
Ls
+
s
(1 + j)ts
j
(1 + j)ts
s=1
s=1
!
n
n
n
X
X
X
Ls
Ls
i
Ls
=
+
(1 + j)ts
j
(1 + j)ts
A=
As =
s=1
s=1
(91)
s=1
i
= K + (L K )
j
Albert Cohen (MSU)
MSU Spring 2014
105 / 223
Mortgage Repayment from previous SOA Exam FM/1
A loan L is being repaid with n annual level payments of K each. With the
mth payment, m < n, the borrower pays an extra amount A, and then
agrees to repay the remaining balance over l years with a revised annual
payment. The effective rate of interest is 100 i%. . Calculate the amount
of the revised annual payment.
Albert Cohen (MSU)
MSU Spring 2014
106 / 223
Mortgage Repayment from previous SOA Exam FM/1
With n m yealy payments left right before the extra repayment, the
remaining balance is K a(nm)|i . Right after the extra payment A, the
remaining balance is K a(nm)|i A. Hence, the new payment over the
new 10year schedule is
Knew =
Albert Cohen (MSU)
K a(nm)|i A
al|i
(92)
MSU Spring 2014
107 / 223
Bonds
A Bond is a financial contract where an up front payment is exchanged for

coupon payments (periodic interest paid to the debt-holder) plus a face
amount the maturity date (end of term). The Bond is valued using a yield
rate used to value future cash flows. The notation used with bond
valuation is
j = the Yield rate per period
F = the Face amount
r = the Coupon rate
C = the redemption amount, usually equal to the face value
N = the number of coupon payments until maturity
P = the price of the bond, where
Albert Cohen (MSU)
MSU Spring 2014
108 / 223
Bonds
The bond can now be valued as

F
+F r
P=
(1 + j)n
= F n + F r an j
1
1
+ .. +
1+j
(1 + j)n
(93)
= F + F (r j) an j
r
= F n + (F F n )
j
Note that Bond prices are usually listed, and the investor determines yield
rate from listed price. To do so, must invert our Bond pricing formula.
This requires some calculation.
Albert Cohen (MSU)
MSU Spring 2014
109 / 223
Example 4.1
Price the following bond with face 100:

Issue Date: March 1,2004
Maturity Date: Feb 28, 2006
r = 1.625%
j = 1.675%
Term is 2 years (4 six month periods)
Albert Cohen (MSU)
MSU Spring 2014
110 / 223
Example 4.1
Price the following bond with face 100:

Issue Date: March 1,2004
Maturity Date: Feb 28, 2006
r = 1.625%
j = 1.675%
Term is 2 years (4 six month periods)

P = 100 0.5 0.01625
1
1
+ ... +
1.008375
1.0083754
100
+
= 99.02
1.0083754
Albert Cohen (MSU)
MSU Spring 2014
(94)
110 / 223
Bonds
At time t, we define Pt to be the price of the bond, just after the coupon
payment. This is equal to the NPV of the remainin payments:
Pt =
F
+ F r ant j
(1 + j)nt
(95)
Now, since the initial price P satisfies the relation P F = F (r j)an j ,

we say that a bond is bought at premium if r > j, at par if r = j, and at a
discount if r < j.
Albert Cohen (MSU)
MSU Spring 2014
111 / 223
Bond Pricing Between Coupon Dates
Let
u :=
the number of days since last coupon payment

number of days in coupon period
(96)
Then Pt = Pm (1 + j)u u F r , where m is the number of coupon

payments left and Pm (1 + j)u is known as the price plus accrued.
Albert Cohen (MSU)
MSU Spring 2014
112 / 223
Amortization of Bond
Sometimes need to determine the Book Value of a bond for tax or investor
purposes. The Book Value at time t is the outstanding balance at time t
right after the coupon payment. This is the present value of the remaining
cash payments of that the bond holder is entitled to receive:
Pt = OBt = F + F (r j) ant j
Albert Cohen (MSU)
(97)
MSU Spring 2014
113 / 223
Amortization of Bond
We can use the idea that we are loaning money to bond-issuer, and that
we price this as a mortgage. So,
Pt = OBt = F + F (r j) ant j
Kt = F r for t {1, 2, 3, .., n 1}
Kn = F r + F
(98)
It = Kt PRt
PRt = Kt (OBt1 OBt )
= F (r j) nt+1
Albert Cohen (MSU)
MSU Spring 2014
114 / 223
Bond Pricing Lemma
Lemma
Consider a bond with face F , coupon rate r , and term T = 2n, n N,
purchased by A for a price PA . Just after the nth coupon, A sells the bond
to B who desires a yield j and correspondingly pays PB . If PB > PA and
j < r or
j > r and PB >
F +PA
2
then i > j, where i is the non-zero yield rate calculated on A0 s investment.
Albert Cohen (MSU)
MSU Spring 2014
115 / 223
Bond Pricing Lemma: Proof 1

Proof.
We prove each case separately, both of which reveal something about the
situation described above.
Case 1 First, if j < r
PB
PA = F r an i +
(1 + i)n

Fr
1
PA
>
1
+
n
i
(1 + i)
(1 + i)n
PB = F + F (r j) an j
(99)
We can see that this implies

Fr
r j
Fr
< PA < PB = F + F (r j) an j < F + F
=
i
j
j
(100)
and so i > j
Albert Cohen (MSU)
MSU Spring 2014
116 / 223
Bond Pricing Lemma: Proof 2

Proof.
Case 2 If j > r then by Makehams formula F > PB > PA and
PB
(1 + i)n

PB F
F
+
+
(1 + i)n
(1 + i)n
F
+
(1 + j)n
PA = F ran i +
= F ran i
PB = F ran j
(101)
For the sake of contradiction, assume i j. Then it follows by our

assumptions that
F PB < PB PA
F PB
(1 + i)n
(102)
which is impossible.
Albert Cohen (MSU)
MSU Spring 2014
117 / 223
Exotic Bonds
Callable Bonds: Bond can be recalled by issuer over a window of

redemption dates. Price investor pays is the minimum of these possible
prices. So, if the bond was purchased at a premium, then price at earliest
possible date. If purchased at a discount, price at latest possible
redemption date
Albert Cohen (MSU)
MSU Spring 2014
118 / 223
Exotic Bonds
Serial Bonds: Face amount F is redeemed over a collection of dates

{t1 , .., tn } with staggered payments F1 + .. + Fn = F , coupon rates
r1 , .., rn , tailored to yield rates j1 , .., jn . One can view this as the sum of m
bonds with the corresponding payments, and can use Makehams formula
to price this
P=
n
X
Pm
m=1
(103)

rt
Ft
Ft
+ Ft
Pt =
(1 + j)nt
jt
(1 + jt )nt
Albert Cohen (MSU)
MSU Spring 2014
119 / 223
Measuring The Rate of Return Of An Investment
Yield rate can be derived from cash-flows from an investment

When presented with more than one investment opportunity, would
like to be able to quantitatively measure their value to the investor
There are many ways to do this some work in situations that others
dont
Albert Cohen (MSU)
MSU Spring 2014
120 / 223
Internal Rate of Return
In an investment, at any time may have cash flows out and in say
payments to buy a license for a taxicab, with monthly maintenance fees
versus fare payments in.
Notation is such that Ak is a payment received and Bk is a payment made
out, each at the same time tk . The net payment is thus Ck .
f (j) :=
n
X
k=1
Ck
(1 + j)tk
(104)
The Internal Rate of Return j is one that balances out all net payments so
that their net present value is 0.
Albert Cohen (MSU)
MSU Spring 2014
121 / 223
Example 5.1
Smith buys 1000 shares of stock at 5.00 per share and pays a commission
of 2%. Six months later he receives a cash-dividend of 0.20 per share,
which he immediately reinvests commission free in shares at a price of 4.00
per share. Six months after that he buys another 500 shares at a price
4.50 per share, along with a commission of 2%. Six months after that he
receives another cash dividend of 0.25 per share and sells his existing
shares at 5.00 per share, again paying a 2% commission. Find Smiths
internal rate of return for the entire transaction in the form i (2)
Albert Cohen (MSU)
MSU Spring 2014
122 / 223
Example 5.1
Let 0 represent the time of the original share purchase, t = 1 at 6 months,
t = 2 at 12 months and t = 3 at 18 months after the original purchase.
Then
(A0 , B0 ) = (0, 5000 + [0.02 5000]) = (0, 5100)
(A1 , B1 ) = (200, 200)
(A2 , B2 ) = (0, [1.02 4.50 500]) = (0, 2295)
(A3 , B3 ) = ([0.25 + 0.98 5] 1550, 0)
(105)
= (7982.50, 0)
(C0 , C1 , C2 , C3 ) = (5100, 0, 2295, 7982.5)
0 = 5100 + 0 2295 2 + 7982.50 3
Solving this polynomial, we obtain
=
Albert Cohen (MSU)
1
i (2) = 2j = 0.0649
1+j
(106)
MSU Spring 2014
123 / 223
Uniqueness? Guaranteed Solution?
If C0 < 0 and Cj > 0 for all j {1, 2, ..n}, then by the Intermediate
Value theorem and simple calculus, we have a unique solution for the
internal return rate j. (i.e. Mortgages or other loans paid off by
periodic payments)
BUT, we can have situations where the above isnt satisfied, and we
compute more than solution for j, or worse, no real solution.
What can we use to measure the value of an investment in this case?
Albert Cohen (MSU)
MSU Spring 2014
124 / 223
Net Present Value
Assume that among all possible investment alternatives, all have same
measure of risk and fixed interest rate i that investor proposes
(Utility theory!)
In this incomplete case, use i, also known as cost of capital, to find
present value of cash flows of each investment on the table
The one with the largest present value, given investors rate i, is most
preferable. In symbols, for investments a, b, c, with NPV
fa (i), fb (i), fc (i), choose the biggest
HW: Can NPV curves ever intersect for different values of i ?
Of course, if i = j =yield rate, then NPV = 0
Albert Cohen (MSU)
MSU Spring 2014
125 / 223
Profitability Index
Again, if the investor proposes his own interest rate i, then we can use
another measure, the Profitability Index:
I =
PV [ Cash Flows In]

PV [ Cash Flows Out ]
(107)
Note that if i = j = IRR, then I = 1 by design,as yield rate is what we use

to balance out flows with in flows.
Albert Cohen (MSU)
MSU Spring 2014
126 / 223
Profitability Index: Example
Compare
(a) lending 1000 and being repaid 250 per year for 5 years with
i = 0.05 and
(b) lending 1000 and being repaid 140 per year for 10 years with
i = 0.05
Albert Cohen (MSU)
MSU Spring 2014
127 / 223
Profitability Index: Example
Compare
i = 0.05 and
i = 0.05
We compute
250a5 0.05
= 1.0824
1000
140a10 0.05
Ib =
= 1.0810
1000
Ia =
Albert Cohen (MSU)
(108)
MSU Spring 2014
127 / 223
MIRR
Goal: Find j such that Accumulated Value at end of project of payments

out at rate j matches Accumulated Value of payments received at
investors cost of capital i.
Notation:
Ak is the payment in at time k
Bk is the payment out at time k
Albert Cohen (MSU)
MSU Spring 2014
128 / 223
MIRR
Goal: Find j such that Accumulated Value at end of project of payments

out at rate j matches Accumulated Value of payments received at
investors cost of capital i.
Notation:
Ak is the payment in at time k
Bk is the payment out at time k
Then j solves the equation
N
X
n=0
Albert Cohen (MSU)
An (1 + i) =
N
X
Bm (1 + j)m
(109)
m=0
MSU Spring 2014
128 / 223
MIRR: Example
Compare
i = 0.05 and
i = 0.05
Albert Cohen (MSU)
MSU Spring 2014
129 / 223
MIRR: Example
Compare
i = 0.05 and
i = 0.05
We compute
1000(1 + ja )5 = 250s5 0.05 = 1381.41
ja = 0.0668
1000(1 + jb )10 = 140s10 0.05 = 1760.90
(110)
jb = 0.0582
Albert Cohen (MSU)
MSU Spring 2014
129 / 223
Project Return Rate

There are times during a project where investor is borrower and times
when she is lender. Cost of financing at rate i, and project return rate is j
when she is net lender. Solving j in terms of i would give minimum return
rate needed for project to break even if set NPV to 0 at end of project.
Goal: Set up an equation of value such that Net Project Value = 0 when
t = N. If the value at t = n is > 0, then earn at rate j. If balance < 0,
then earn (pay) at rate i (cost of capital). As an example, consider
S0 = 1 S1 = (1 + j)
S1 = 1 + j 2.3 S2 = (1 + j 2.3)(1 + i)
(111)
S2 = (1 + j 2.3)(1 + i) + 1.33 = 0
1.33
j = 1.3
1+i
Albert Cohen (MSU)
MSU Spring 2014
130 / 223
Dollar Weighted Rate of Return
Goal: Calculate measure of return over 1 year.
Albert Cohen (MSU)
MSU Spring 2014
131 / 223
Dollar Weighted Rate of Return
Goal: Calculate measure of return over 1 year. Use Simple Interest for
fraction of years. Define interest gained as the difference between the total
amount paid out during year to term and the total amount paid in during
year to term.
idollar weigted =
Albert Cohen (MSU)
Total Interest Gained

Average Amount on deposit during year
MSU Spring 2014
(112)
131 / 223
Example 5.3
A Pension fund receives contributions and pays benefits from time to time.
The fund began the year 2005 with a balance of 1, 000, 000. There were
contributions to the fund of 200, 000 at the end of February and again at
the end of August. There was a benefit of 500, 000 paid out of the fund at
the end of October. The balance remaining at the start of the year 2006
was 1, 100, 000. Find the dollar weighted return on the fund, assuming
1
each month is 12
of a year
Albert Cohen (MSU)
MSU Spring 2014
132 / 223
Example 5.3

10
1, 100, 000 = 1, 000, 000(1 + i) + 200, 000 1 + i
12

2
4
+ 200, 000 1 + i 500, 000 1 + i
12
12
T .I .G . = 1, 100, 000 + 500, 000 1, 000, 000
200, 000 200, 000 = 200, 000
10
A.A.o.d.d.y = 1, 000, 000 + 200, 000
12
4
2
+ 200, 000
500, 000
= 1, 150, 000
12
12
200, 000
i =
= 0.1739
1, 150, 000
Albert Cohen (MSU)
MSU Spring 2014
(113)
133 / 223
Even More Methods of Valuation
Time Weighted Rate of Return: Compound over fraction of years, but

the time length doesnt matter
Portfolio Method: Contributions to a fund, once opened, are
segregated from initial investment and accrue interest at a different
rate for a fixed term
Interest Preference Rates for Borrowing and Lending: If accumulated
amount falls below zero, pay interest at a different rate than interest
credited on a positive balance. This is useful to compare two
alternatives when one may have a negative balance for some time
Albert Cohen (MSU)
MSU Spring 2014
134 / 223
Continuous Withdrawal and Investment

Begin with the equation for accumulated value
F (t2 ) = F (t1 )(1+i)t2 t1 +
n
X
k=1
Albert Cohen (MSU)
ctk (1+i)t2 tk +
t2
c(t)(1+i)t2 t dt (114)
t1
MSU Spring 2014
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F (t2 ) = F (t1 )(1+i)t2 t1 +
n
X
ctk (1+i)t2 tk +
k=1
t2
c(t)(1+i)t2 t dt (114)
t1
As an example, consider t1 = 0, t2 = 1, tk = kn , ctk = 1, c(t) = N n.

Then
Z 1
n
X
1 kn
F (1) = F (0) (1 + i) +
(1 + i)
+ (N n)
(1 + i)1t dt
0
k=1
(115)
(N n) i
= F (0) (1 + i) +
+
1
ln (1 + i)
(1 + i) n 1
i
Albert Cohen (MSU)
MSU Spring 2014
135 / 223

F (t2 ) = F (t1 )(1+i)t2 t1 +
n
X
ctk (1+i)t2 tk +
k=1
t2
c(t)(1+i)t2 t dt (114)
t1
As an example, consider t1 = 0, t2 = 1, tk = kn , ctk = 1, c(t) = N n.

Then
Z 1
n
X
1 kn
F (1) = F (0) (1 + i) +
(1 + i)
+ (N n)
(1 + i)1t dt
0
k=1
(115)
(N n) i
= F (0) (1 + i) +
+
1
ln (1 + i)
(1 + i) n 1
i
Now, given F (0), F (1), n, N, solve for i.

Albert Cohen (MSU)
MSU Spring 2014
135 / 223
Term Structure of Interest Rates
The relationship of the yield of a bond (or other fixed income

product) to its time to maturity is the Term Structure
The graph of this relationship is the Yield Curve
Term Structure is dynamic ; reflects new information gained as
markets evolve
A yield curve that corresponds to Normal Term Structure is one that
sees yield increase when the time to maturity increases. When the
yield decreases as term increases, we say the yield curve is Inverted,
and if it is roughly constant, we say it is a Flat curve.
Albert Cohen (MSU)
MSU Spring 2014
136 / 223
Law of One Price
Bond Prices are linear. If we have a coupon paying bond, it must

have the same value as the sum of the prices of each coupon as an
individual zero coupon bond, as well as the lump sum paid at
maturity.
If this does not hold, then we have observed a case of arbirtrage. This
means one could construct a portfolio that consists of purchasing
individual pieces of a coupon bond while selling the equivalent whole
bond, making a net profit with no risk involved.
Albert Cohen (MSU)
MSU Spring 2014
137 / 223
Example 6.1
Suppose that the current term structure has the following yields on
zero-coupon bonds, where all yields are nominal annual rates of interest
compounded semi-annually
Table: Example 6.1: Term Structure
Term (Years)
Zero Coupon Bond Rate
0.5
8%
1
9%
1.5
10%
2
11%
Find the price per 100 face amount and yield to maturity of each of the
following 2-year bonds (with semi-annual coupons)
a.) Zero coupon bond
b.) 5% annual coupon rate
c.) 10% annual coupon rate
Albert Cohen (MSU)
MSU Spring 2014
138 / 223
Example 6.1
a.) PV =
100
(1+ 0.11
2 )
= 80.72, which implies j (2) = 0.11
b.)
2.5
2.5
2.5
102.5
+
+
+
= 89.59
2
3
1.04 1.045
1.05
1.0554
2.5
2.5
2.5
102.5
=
+
2 +
3 +
(116)
j (2)
(2)
(2)
(2) 4
1+ 2
1 + j2
1 + j2
1 + j2
PV =
j (2) = 0.109354
Albert Cohen (MSU)
MSU Spring 2014
139 / 223
Example 6.1
c.) Similarly,
5
5
5
105
+
+
+
2
3
1.04 1.045
1.05
1.0554
= 98.46
5
5
105
5
+
=
2 +
3 +

j (2)
(2)
(2)
(2) 4
1+ 2
1 + j2
1 + j2
1 + j2
PV =
(117)
and so j (2) = 0.108775
Albert Cohen (MSU)
MSU Spring 2014
140 / 223
Spot Rates
The Spot Rate st is the effective annual interest rate for a zero
coupon bond maturing t years from now.
There is a relationship between the spot rate and the yield to
maturity of a bond.
If term structure of spot rates is increasing, then yield for bonds with
same maturity decreases as coupons increase
Albert Cohen (MSU)
MSU Spring 2014
141 / 223
Spot Rates and Yield Rates
The general equation of value here to determine the yield rate yr on a

bond with face 1 is

1
1
1
1
+
+ .. +
+
PV = r
2
n
1 + s1 (1 + s2 )
(1 + sn )
(1 + sn )n

1
1
1
1
=r
+
+ .. +
+
2
n
1 + yr
(1 + yr )
(1 + yr )
(1 + yr )n

Albert Cohen (MSU)
MSU Spring 2014
(118)
142 / 223
Solving for r , we obtain

1
(1+yr )n
1
k=1 (1+yr )k
r = Pn
Albert Cohen (MSU)
1
(1+s )n
Pn n
(119)
1
k=1 (1+sk )k
MSU Spring 2014
143 / 223
Q: Is there anything we can say about
Albert Cohen (MSU)
dyr
dr
given a normal term structure?
MSU Spring 2014
144 / 223
Q: Is there anything we can say about

A: Implicit differentiation leads to
dyr
dr
given a normal term structure?
1
1
dyr
1
(1+sn )n (1+yr )n
= Pn
k
dr
r r k=1
+ (1+ynr )n+1
(1+yr )k+1
(120)
<0
if we have a normal term structure as we expect sn > yr and so
1
1
(1+sn )n < (1+yr )n .
Albert Cohen (MSU)
MSU Spring 2014
144 / 223
Forward Rates
In keeping with Law of One Price (No Arbitrage), can set up the
relationship between spot rates and forward rates
Forward Rate is the interest rate to be charged starting at time t for a
fixed period
We will talk about 1year Forward Rates, i.e. interest rate charged
from to t + 1
Albert Cohen (MSU)
MSU Spring 2014
145 / 223
Exact Form
If we set up a deal such that 1 is to be invested at time 0, and the 1year

spot rate s1 = 0.08 , and the 2year spot rate is s2 = 0.09, then at t = 1,
if the rate to borrow and lend is the same, the rate from year 1 to year 2,
i1,2 , should be defined via
1.092 = (1 + i1,2 ) 1.08
(121)
i1,2 = 0.1001
Albert Cohen (MSU)
MSU Spring 2014
146 / 223
General Relationship between Spot Rates and Forward

Rates
1 + s1 = 1 + i0,1
(1 + s2 )2 = (1 + i0,1 )(1 + i1,2 )
.. ..
.=.
(122)
(1 + sn )n = nk=1 (1 + ik1,k )
Inverting this relationship, we obtain
ik1,k =
Albert Cohen (MSU)
(1 + sk )k
1
(1 + sk1 )k1
(123)
MSU Spring 2014
147 / 223

Rates
1 + s1 = 1 + i0,1
(1 + s2 )2 = (1 + i0,1 )(1 + i1,2 )
.. ..
.=.
(122)
(1 + sn )n = nk=1 (1 + ik1,k )
Inverting this relationship, we obtain
ik1,k =
(1 + sk )k
1
(1 + sk1 )k1
(123)
Q: For a normal term structure where sk > sk1 , what can we say about
the relationship between sk and ik1,k ?
Albert Cohen (MSU)
MSU Spring 2014
147 / 223

Rates
From the previous slide, we can compute the following table:

Spot Rate
Forward Rate
Albert Cohen (MSU)
s1 = 0.05
i0,1 = 0.05
s2 = 0.1
i1,2 = 0.1524
s3 = 0.15
i2,3 = 0.2596
MSU Spring 2014
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Force of Interest vs YTM
Define t as the continuously compounded yield rate. Then

PV (t = 0) = Fe tt
Rt
= Fe 0 s ds
Z t
tt =
s ds
(124)
dt
= t
t + t
dt
Albert Cohen (MSU)
MSU Spring 2014
149 / 223
Summarizing, we have the dual relationship

Z
1 t
s ds
t =
t 0
dt
t = t + t
dt
Albert Cohen (MSU)
(125)
MSU Spring 2014
150 / 223
Recall that in the discrete case,

1
1 + sn = [(i + i0,1 ) (1 + i1,2 ) ... (1 + in1,n )] n
Albert Cohen (MSU)
MSU Spring 2014
(126)
151 / 223

1
1 + sn = [(i + i0,1 ) (1 + i1,2 ) ... (1 + in1,n )] n
(126)
Hence, 1 + sn is the geometric mean of the forward rates.
Albert Cohen (MSU)
MSU Spring 2014
151 / 223

1
1 + sn = [(i + i0,1 ) (1 + i1,2 ) ... (1 + in1,n )] n
(126)

In the continuous case, the YTM t is the arithmetic mean of the force of
interest over the interval [0, t]. It follows that t can be seen as a forward
rate in the continuous case.
Albert Cohen (MSU)
MSU Spring 2014
151 / 223

1
1 + sn = [(i + i0,1 ) (1 + i1,2 ) ... (1 + in1,n )] n
(126)

In the continuous case, the YTM t is the arithmetic mean of the force of
interest over the interval [0, t]. It follows that t can be seen as a forward
rate in the continuous case.
Q: Again, if the term structure is increasing, ie. if
t relate to t ?
Albert Cohen (MSU)
dt
dt
> 0, then how does
MSU Spring 2014
151 / 223
Example 6.5
Suppose that the yield to maturity for a zero-coupon bond maturing at

time t is t = 0.09 0.08 0.94t , a continuously compounded rate.
Forward Rate is the interest rate to be charged starting at time t for a
fixed period
(a) Find the related forward rate
(b) A borrower plans to borrow 1000 in one year and repay the loan
with a single payment at the end of the second year. Determine the
amount that will have to be paid back based on the stated term
structure
Albert Cohen (MSU)
MSU Spring 2014
152 / 223
Example 6.5
a.) We find that

t = t + t
dt
= 0.09 0.08 0.94t 0.08 0.94t ln (0.94) t (127)
dt
b.) We find that

Value = 1000e
Albert Cohen (MSU)
R2
1
t dt
= 1024.11
MSU Spring 2014
153 / 223
Example 6.5
a.) We find that

t = t + t
dt
= 0.09 0.08 0.94t 0.08 0.94t ln (0.94) t (127)
dt
b.) We find that

Value = 1000e
Albert Cohen (MSU)
R2
1
t dt
= 1024.11 = 1000e 22 1
MSU Spring 2014
(128)
153 / 223
At Par Yield
Measure of Bond Yield: Find the Coupon rate rt such that the Bond
Yield is also rt .
In this case, the Bond price is at par.
Albert Cohen (MSU)
MSU Spring 2014
154 / 223
At Par Yield
Measure of Bond Yield: Find the Coupon rate rt such that the Bond
Yield is also rt .
In this case, the Bond price is at par.
For an nyear bond,
1 = rn
rn =
Albert Cohen (MSU)
n
X
(1 + sk )k
!
+
k=1
1 (1+s1 n )n
Pn
1
k=1 (1+sk )k
1
(1 + sn )n
(129)
MSU Spring 2014
154 / 223
Interest Rate Swaps
Used to convert Floating Rate Liability to Fixed Rate Liability

Used between two borrowers that have access to different interest
markets
Example
(FixedRate(A), FloatingRate(A)) = (0.08, Prime + 0.01)
(FixedRate(B), FloatingRate(B)) = (0.09, Prime + 0.015)
Albert Cohen (MSU)
MSU Spring 2014
(130)
155 / 223
Interest Rate Swaps
Swap: A borrows at FixedRate(A), and loans to B at rate 0.085. B

borrows at FloatingRate(B), and loans to A at rate prime + 0.0125.
Net effect:
A pays (0.08 0.085 + prime + 0.0125) = prime + 0.0075
B pays (prime + 0.015 (prime + 0.0125) + 0.085) = 0.0875
Notice both of these are smaller than what they could have gotten on their
own. Usually, there is a question of default risk, so an intermediary can be
brought in, for a small fee, depending on the spread between available
rates for A and B
Albert Cohen (MSU)
MSU Spring 2014
156 / 223
Interest Rate Swaps
In general, a swap is a series of coupons exchanged upon delivery.

Imagine a bond with face value F , and term structure (implied
forward rates) for period k 1 to k: {ik1,k }nk=1 .
Then the implied swap rate Rn for term n is the rate that equates
the present value all the coupon exchanges, forward rate to constant
Rn , to 0:
0=
n
X
(Rn ik1,k )F
k=1
Albert Cohen (MSU)
(131)
(1 + sk )k
MSU Spring 2014
157 / 223
Interest Rate Swaps
We can interpret Rn in two ways. The first is to look at Rn as an average

forward rate:
Rn =
n
X
pj ij1,j
j=1
(1 + sj )j
pj = Pn
m
m=1 (1 + sm )
Pm
Note that 0 < pj < 1 and j=1 pj = 1 for positive spot rates.
Albert Cohen (MSU)
MSU Spring 2014
(132)
158 / 223
Interest Rate Swaps
The second way to interpret Rn is to look at Rn as an at par yield rate :

!
n

X
(1 + sj )j
(1 + sj )j
Pn
Rn =
1
m
(1 + sj1 )j1
m=1 (1 + sm )
j=1
!
Pn
1
1
(133)
(1+s
j
j=1
(1+sj1 )j1
j)
1 (1 + sn )n
Pn
=
= Pn
m
m
m=1 (1 + sm )
m=1 (1 + sm )
= rn
as the numerator above is a telescoping series.
Albert Cohen (MSU)
MSU Spring 2014
159 / 223
Deferred and Non-Level Notional Interest Rate Swaps
Keeping with the analysis above, we have a Deferred Swap beginning in

k periods with value
(k)
Rn
n
X
(k)
pj
ij1,j
j=k
(k)
pj
Albert Cohen (MSU)
(134)
(1 + sj )j
= Pn
.
m
m=k (1 + sm )
MSU Spring 2014
160 / 223
Deferred and Non-Level Notional Interest Rate Swaps
Similarly, if the notional used to calculate the coupon varies with time, and
is defined as Fj at time j, then
0=
n
X
(Rn ik1,k )Fk
k=1
(135)
(1 + sk )k
then
n =
R
n
X
qj ij1,j
j=k
(136)
Fj (1 + sj )j
qj = Pn
.
m
m=k Fm (1 + sm )
Albert Cohen (MSU)
MSU Spring 2014
161 / 223
Example: Calculating the Swap Curve
Recall the table from Example 6.3:

Spot Rate
Forward Rate
Albert Cohen (MSU)
s1 = 0.05
i0,1 = 0.05
s2 = 0.1
i1,2 = 0.1524
s3 = 0.15
i2,3 = 0.2596
MSU Spring 2014
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Example: Calculating the Swap Curve

We can now add to this table:
Spot
Fwd
s1 = 0.05
i0,1 = 0.05
Prob
p1 =
r3 =
1
1.05
1
1
+
+ 13
1.05
1.102
1.15
1
1.05
1
1.05
s2 = 0.1
i1,2 = 0.1524
0.05
+
1
1
+ 1.10
2 + 1.153
p2 =
1
1.102
1
1
+
+ 13
1.05
1.102
1.15
1
1.102
1
1.05
s3 = 0.15
i2,3 = 0.2596
0.1524
1
1.102
1
1.153
p3 =
1
1.153
1
1
+
+ 13
1.05
1.102
1.15
1
1.153
1
1.05
0.2596
1
1.102
1
1.153
= 0.1413.
(137)
HW: Compute r1 , r2 . Can you set up a spreadsheet to do this?
Albert Cohen (MSU)
MSU Spring 2014
163 / 223
Susceptibility: Single Factor Model

How does the PV of the cashflow change as the yield rate (term
structure) changes? (1st order changes)
Once quantified, this can be used as a measure of risk associated with
investing in this cashflow.
Albert Cohen (MSU)
MSU Spring 2014
164 / 223

Consider the case where we have continuous compounding with a force of
interest . For a stream of payments, we have the present value, or up
front price, determined by P(). The only risk factor that could change
the value then is . If we were to equate this value with a zero-coupon
bond of unknown Duration D, then
P() = P(0)e D
Albert Cohen (MSU)
MSU Spring 2014
164 / 223

P() = P(0)e D
1 dP
D=
P d
Albert Cohen (MSU)
(138)
MSU Spring 2014
164 / 223

P() = P(0)e D
1 dP
D=
P d
This of course implies that
Albert Cohen (MSU)
dP
d
(138)
< 0.
MSU Spring 2014
164 / 223
Susceptibility and Sensitivity to Market Changes: Single

Factor Model
If the environment is one of annual compounding, then = ln (1 + i) and
we define
1 P(i) P(i + h)
h0 h
P(i)
d
= ln (P(i))
di
D := (1 + i) DM
DM := lim
(139)
For P(i) = (1 + i)n , we obtain

n
1+i
D=n
DM =
Albert Cohen (MSU)
(140)
MSU Spring 2014
165 / 223
Intuition
Increasing yield decreases present value. Thus, we take the negative

of derivative w.r.t yield.
The Modified Duration DM measures the ratio of rate of change of P
wrt i to the actual value P.
The Macaulay Duration D := (1 + i) DM says that the longer the
time maturity n, the more susceptible it is to yield change. For an
nyear zero coupon bond, D = n. Hence, the name duration
Can apply the linearization formula from calculus:
P(i + h) P(i) + P 0 (i) h = P(i) DM P(i) h
D
= P(i)
P(i) h
1+i
Albert Cohen (MSU)
MSU Spring 2014
(141)
166 / 223
Duration of General Cashflows
P=
n
X
m=1
Km
(1 + i)m
Pn
mKm
d
1 dP
m=1 (1+i)m+1
DM = ln (P(i)) =
= Pn
Km
di
P di
m=1 (1+i)m
D = (1 + i) DM =
n
X
(142)
m pm = E[m]
m=1
pm =
Albert Cohen (MSU)
Km
(1+i)m
Pn
Kl
l=1 (1+i)l
MSU Spring 2014
167 / 223
Note also that
Km
n
m
dD
d X
(1+i)
=
m Pn
Kl
di
di
l
l=1
m=1
Albert Cohen (MSU)
(1+i)
MSU Spring 2014
168 / 223
Note also that
Km
n
m
dD
d X
(1+i)
=
m Pn
Kl
di
di
l=1 (1+i)l
m=1
!2
n
n
X
1 X 2
m pm
m pm
=
1+i
m=1
Albert Cohen (MSU)
(143)
m=1
Var [m]
<0
1+i
MSU Spring 2014
168 / 223
Duration of a Perpetuity
Even though it has no finite term, we can still find the duration of a
perpetuity. In this case
1 dP
P di

1 d 1
= (1 + i) 1
di i
i
1
=1+
i
D = (1 + i)
Albert Cohen (MSU)
(144)
MSU Spring 2014
169 / 223
Duration of a Perpetuity
Even though it has no finite term, we can still find the duration of a
perpetuity. In this case
1 dP
P di

1 d 1
= (1 + i) 1
di i
i
1
=1+
i
An equivalent way to calculate this is to see that
P
k
(Ia) i
k=1 (1+i)k
D = P
=
1
a i
k=1 (1+i)k
D = (1 + i)
=
Albert Cohen (MSU)
1+i
i2
1
i
(144)
(145)
1
=1+
i
MSU Spring 2014
169 / 223
Example 7.3 Duration of a Coupon Bond
In the case of a coupon bond, we have K1 = K2 = .. = Kn1 = F r , and

Kn = F + F r , and so
Pn
nF
mF r
m=1 (1+i)m + (1+i)n
D = Pn
F r
F
m=1 (1+i)m + (1+i)n

n
(1+i)an i (1+i)
n
n
(146)
r
+ (1+i)
n
i
=
1
r an i + (1+i)
n
Albert Cohen (MSU)
MSU Spring 2014
170 / 223
Bonds and Macaulay Duration: Example from previous

SOA Exam FM
A bond with Face F will pay a coupon of F r at the end of each of the
next three years. It wil also pay the face value of F at the end of the
three-year period. The bonds duration (Macaulay duration) when valued
using an annual effective interest rate of 20% is X. Calculate X .
Albert Cohen (MSU)
MSU Spring 2014
171 / 223
Bonds and Macaulay Duration: Example from previous

SOA Exam FM
Recall that the Macaulay Duration over n time periods is defined as an
expection of sorts:
Pn
ti PV (i)
D = Pi=1
(147)
n
j=1 PV (j)
where the PV (i) are the present values of the revenue received at time ti .
For our present case, we have
1
D=
Albert Cohen (MSU)
r
1.2
F (1+r )
(1.2)3
F (1+r )
F r
+ (1.2)3
(1.2)2
(1+r )
r
(1.2)
2 + 3 (1.2)3
)
r
+ (1+r
(1.2)2
(1.2)3
+2
F r
1.2
1
=
F r
1.2
+2
r
1.2
F r
(1.2)2
+3
(148)
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Portfolio Duration
ImagineP
that P(i) is the price of a portfolio of income streams:
P(i) = nk=1 Pk (i). Then
Pn
P 0 (i)
P 0 (i)
= (1 + i) k=1 k
D = (1 + i)
P(i)
P(i)
n
n
0
X P (i)
X
Pk (i) Pk0 (i)
k
= (1 + i)
= (1 + i)
P(i)
P(i) Pk (i)
k=1
n
X
k=1
(149)
Dk qk
k=1

Pk0 (i) Pk (i)
(Dk , qk ) = (1 + i)
,
Pk (i) P(i)
and so the portfolio duration is the weighted average of the individual
durations.
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Portfolio Duration
Smith holds a portfolio of a 20 year 100 bond bought at par and with
duration of 8, a stock purchased for 50 with duration 7 and an 30 year
annuity purchased for 50 with duration 5. What is the portfolio duration?
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Portfolio Duration
Smith holds a portfolio of a 20 year 100 bond bought at par and with
duration of 8, a stock purchased for 50 with duration 7 and an 30 year
annuity purchased for 50 with duration 5. What is the portfolio duration?
D =8
Albert Cohen (MSU)
100
50
50
+7
+5
=7
200
200
200
(150)
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Cashflow Immunization and Convexity
An institution such as a bank or insurance company will have both assets

and liabilities which may come due at different times. These may be
structured so that the net present value of the institution is zero. Hence,
for a given i,
P(i) 0
(151)
If the rate i is perturbed slightly, the institution may find itself with a
negative NPV. To counter this risk, the institution may structure its assets
and liabilities such that P is a local minimum at i.
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Cashflow Immunization and Convexity
To explain this further, define the Convexity

:=
P 00 (i)
P(i)
(152)
and so
P(i + h) P(i)
DM h + h2
P(i)
(153)
If P 0 (i) = 0 and (i) > 0, then DM = 0 and we have a local minimum
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Cashflow Immunization Example
Suppose a bank has promised its investors a one-year 5% return on

deposits of 100. The bank has 50 per investor on hand, is able to purchase
perpetuities that pay one per year and one year zero-coupon bonds that
yield 10%. How should the bank structure its assets so they are
immunized from interest rate risk?
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Cashflow Immunization Example

At rate i, we have the NPV of x units perpetuity and y units of bond
minus the NPV of the liability of the one-year withdrawal as
1.1 y
105
x
+
i
1+i
1+i
x
1.1 y 105
0
P (i) = 2
i
(1 + i)2
1.1 y 105
x
P 00 (i) = 2 3 + 2
i
(1 + i)3
P(i) = 50 +
(154)
For whatever rate i we fix, if we set

x = 50i 2
y=
then P(i) = P 0 (i) = 0 and P 00 (i) =

minimum.
Albert Cohen (MSU)
(155)
105 50 (1 + i)2
1.1
100
i(1+i)
> 0 so we have a local
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Some Comments
Book, or Amortized, value is calculated using fixed rate

Market value determined via market term structure
The spot rate used in this term structure varies with time
This leads to difference between Book and Market value of cashflow
These values converge as time approaches maturity; investor can hold
on to his investment to realize original yield rate
Before maturity, however, the cashflow is valued at market rate
Previous analysis is for flat term structure. To generalize to normal or
inverted term structure, require new definitions and multivariable
calculus
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Basic Ideas and Beyond

As we have seen, interest rate fluctuation can lead to possible
shortfalls that banks may wish to immunize their portfolio against.
Currency fluctuation also leads to operational risk, and should
factor into planning. For example, should a band tour Europe or
America this summer ? Click here for an insightful article by Neil
Shah in the Wall Street Journal TM , with comment from the
manager of a very prominent rock band
Interest rates are only one risk factor. Another very real factor is
known as longevity risk, which is due to the possibility that a
pensioner may live longer than expected. Hedging against such a
possibility is extremely important, and a topic we hope to cover in
STT 455 456. In the meantime, please consult the paper by Tsai,
Tzeng, and Wang on Hedging Longevity Risk When Interest Rates
Are Uncertain
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Probability Space
Let us define an event as a point in the set of all possible outcomes .
This includes the events The stock doubled in price over two trading
periods or the average stock price over ten years was 10 dollars.
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Probability Space
In our initial case, we will consider the simple binary space
= {H, T } for a one-period asset evolution. So, given an initial
value S0 , we have the final value S1 (), with
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Probability Space
S1 (H) = uS0 , S1 (T ) = dS0
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(156)
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Probability Space
S1 (H) = uS0 , S1 (T ) = dS0
(156)
with d < 1 < u. Hence, a stock increases or decreases in price,

according to the flip of a coin.
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Probability Space
S1 (H) = uS0 , S1 (T ) = dS0
(156)
with d < 1 < u. Hence, a stock increases or decreases in price,

according to the flip of a coin.
Let P be the probability measure associated with these events:
P[H] = p = 1 P[T ]
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(157)
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Arbitrage
Assume that S0 (1 + r ) > uS0
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Arbitrage

Where is the risk involved with investing in the asset S ?
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Arbitrage

Assume that S0 (1 + r ) < dS0
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Arbitrage

Why would anyone hold a bank account (zero-coupon bond)?
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Arbitrage

Why would anyone hold a bank account (zero-coupon bond)?
Lemma Arbitrage free d < 1 + r < u
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Derivative Pricing
Let S1 () be the price of an underlying asset at time 1. Define the
following instruments:
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Derivative Pricing
1
B
1+r , V1 () = 1
0, V1F = S1 () F
Zero-Coupon Bond : V0B =

Forward Contract : V0F =
Call Option : V1C () = max(S1 () K , 0)

Put Option : V1P () = max(K S1 (), 0)
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Derivative Pricing
1
B
1+r , V1 () = 1
0, V1F = S1 () F


In both the Call and Put option, K is known as the Strike.
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Derivative Pricing
1
B
1+r , V1 () = 1
0, V1F = S1 () F


Once again, a Forward Contract is a deal that is locked in at time 0 for
initial price 0, but requires at time 1 the buyer to purchase the asset for
price F .
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Derivative Pricing
1
B
1+r , V1 () = 1
0, V1F = S1 () F


Once again, a Forward Contract is a deal that is locked in at time 0 for
initial price 0, but requires at time 1 the buyer to purchase the asset for
price F .
What is the value V0 of the above put and call options?
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Put-Call Parity
Can we replicate a forward contract using zero coupon bonds and put and
call options?
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Put-Call Parity
call options?
Yes: The final value of a replicating strategy X has value
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Put-Call Parity
call options?
V1C V1P + (K F ) = S1 F = X1 ()
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(158)
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Put-Call Parity
call options?
V1C V1P + (K F ) = S1 F = X1 ()
(158)
This is achieved (replicated) by

Purchasing one call option
Selling one put option
Purchasing K F zero coupon bonds
all at time 0.
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Put-Call Parity
call options?
V1C V1P + (K F ) = S1 F = X1 ()
(158)

all at time 0.
Since this strategy must have zero initial value, we obtain
V0C V0P =
Albert Cohen (MSU)
F K
1+r
(159)
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Put-Call Parity
call options?
V1C V1P + (K F ) = S1 F = X1 ()
(158)

all at time 0.
Since this strategy must have zero initial value, we obtain
F K
1+r
Question: How would this change in a multi-period model?
V0C V0P =
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(159)
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General Derivative Pricing -One period model
If we begin with some initial capital X0 , then we end with X1 (). To price
a derivative, we need to match
X1 () = V1 ()
(160)
to have X0 = V0 , the price of the derivative we seek.

A strategy by the pair (X0 , 0 ) wherein
X0 is the initial capital
0 is the initial number of shares (units of underlying asset.)
What does the sign of 0 indicate?
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Replicating Strategy
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Initial holding in bond (bank account) is X0 0 S0
Value of portfolio at maturity is
X1 () = (X0 0 S0 )(1 + r ) + 0 S1 ()
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(161)
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X1 () = (X0 0 S0 )(1 + r ) + 0 S1 ()
(161)
Pathwise, we compute
V1 (H) = (X0 0 S0 )(1 + r ) + 0 uS0

V1 (T ) = (X0 0 S0 )(1 + r ) + 0 dS0
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X1 () = (X0 0 S0 )(1 + r ) + 0 S1 ()
(161)
Pathwise, we compute
V1 (H) = (X0 0 S0 )(1 + r ) + 0 uS0

V1 (T ) = (X0 0 S0 )(1 + r ) + 0 dS0
Algebra yields
0 =
Albert Cohen (MSU)
V1 (H) V1 (T )
(u d)S0
(162)
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Risk Neutral Probability
Let us assume the existence of a pair (

p , q) of positive numbers, and use
these to multiply our pricing equation(s):
pV1 (H) = p(X0 0 S0 )(1 + r ) + p0 uS0

qV1 (T ) = q(X0 0 S0 )(1 + r ) + q0 dS0
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Risk Neutral Probability
Let us assume the existence of a pair (

p , q) of positive numbers, and use
these to multiply our pricing equation(s):
pV1 (H) = p(X0 0 S0 )(1 + r ) + p0 uS0

qV1 (T ) = q(X0 0 S0 )(1 + r ) + q0 dS0
Addition yields
X0 (1 + r ) + 0 S0 (
p u + qd (1 + r )) = pV1 (H) + qV1 (T )
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(163)
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If we constrain
0 = pu + qd (1 + r )
1 = p + q
0 p
0 q
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If we constrain
0 = pu + qd (1 + r )
1 = p + q
0 p
0 q
where
then we have a risk neutral probability P
V0 = X0 =
1
pV1 (H) + qV1 (T )
E[V1 ] =
1+r
1+r
(164)
with
1+r d
ud
u
(1 + r )
p =
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Example: Pricing a forward contract
Consider the case of a stock with

S0 = 100
u = 1.2
d = 0.8
r = 0.05
Then the forward price is computed via
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Example: Pricing a forward contract
Consider the case of a stock with

S0 = 100
u = 1.2
d = 0.8
r = 0.05
Then the forward price is computed via
0=
Albert Cohen (MSU)
1
1]
E[S1 F ] F = E[S
1+r
(165)
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This leads to the explicit price
F = puS0 + qdS0
= (0.625)(1.2)(100) + (0.375)(0.8)(100) = 105
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This leads to the explicit price
F = puS0 + qdS0
= (0.625)(1.2)(100) + (0.375)(0.8)(100) = 105
Homework Question: What is the price of a call option in the case

above,with strike K = 95?
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General one period risk neutral measure
We define a finite set of outcomes {1 , 2 , ..., n } and any

subcollection of outcomes A an event.
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We define a finite set of outcomes {1 , 2 , ..., n } and any

subcollection of outcomes A an event.
not necessarily the
Furthermore, we define a probability measure P,
physical measure P to be risk neutral if
P[]
>0
1]
X0 = 1 E[X
1+r
for all strategies X .
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The measure is indifferent to investing in a zero-coupon bond, or a

risky asset X
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risky asset X
The same initial capital X0 in both cases produces the same
average return after one period.
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risky asset X
Not the physical measure attached by observation, experts, etc..
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risky asset X
Not the physical measure attached by observation, experts, etc..
In fact, physical measure has no impact on pricing
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Example: Risk Neutral measure for trinomial case

Assume that = {1 , 2 , 3 } with
S1 (1 ) = uS0
S1 (2 ) = S0
S1 (3 ) = dS0
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S1 (1 ) = uS0
S1 (2 ) = S0
S1 (3 ) = dS0
Given a payoff V1 () to replicate, are we assured that a replicating
strategy exists?
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S1 (1 ) = uS0
S1 (2 ) = S0
S1 (3 ) = dS0
Given a payoff V1 () to replicate, are we assured that a replicating
strategy exists?
Homework: Try our first example with
S0 = 100
r = 0.05, u = 1.2, d = 0.8
V1 () = (S1 () > 90)
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Existence of Risk Neutral measure
be a probability measure on a finite space . The following are

Let P
equivalent:
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Let P
equivalent:
is a risk neutral measure
P
Albert Cohen (MSU)
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Let P
equivalent:
P
For all traded securities S i , S0i =
Albert Cohen (MSU)
1
1+r E
i
S1
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Let P
equivalent:
P
For all traded securities S i , S0i =
1
1+r E
i
S1
Proof: Homework (Hint: One direction is much easier than others. Also,
strategies are linear in the underlying asset.)
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Complete Markets
A market is complete if it is arbitrage free and every non-traded asset can

be replicated.
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Complete Markets
A market is complete if it is arbitrage free and every non-traded asset can

be replicated.
Fundamental Theorem of Asset Pricing 1: A market is arbitrage free
iff there exists a risk neutral measure
Fundamental Theorem of Asset Pricing 2: A market is complete iff
there exists exactly one risk neutral measure
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2-period pricing
Consider the case
r = 0.05, S0 = 100
S1 (H) = 1.2S0
S1 (T ) = 0.8S0
S2 (HH) = 1.2S1 (H)
S2 (HT ) = 0.8S1 (H)
S2 (TH) = 1.2S1 (T )
S2 (TT ) = 0.8S1 (T )
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2-period pricing
Consider the case
r = 0.05, S0 = 100
S1 (H) = 1.2S0
S1 (T ) = 0.8S0
S2 (HH) = 1.2S1 (H)
S2 (HT ) = 0.8S1 (H)
S2 (TH) = 1.2S1 (T )
S2 (TT ) = 0.8S1 (T )
Now price a digital option that has payoff V2 := (S2 100)

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We can do this for 2-period problems
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Case by Case, or..
by developing a general theory for multi-period asset pricing
Albert Cohen (MSU)
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Case by Case, or..
by developing a general theory for multi-period asset pricing
In the latter method, we need a general framework to carry out our
computations
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Multi-Period Pricing - Introduction
Again, we define the finite set of outcomes and any subcollection of

outcomes A an event.
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How does this relate to the case of 2 consecutive coin flips
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{HH, HT , TH, TT }
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{HH, HT , TH, TT }
Set of events includes statements like at least one head
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{HH, HT , TH, TT }
Set of events includes statements like at least one head
= {HH, HT , TH}
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algebras
Given a non-empty set of outcomes, a algebra F is a collection of

subsets of that satisfies
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algebras

F
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algebras

F
A F Ac F
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algebras

F
A F Ac F
A1 , A2 , A3 , .... F
n=1 An F
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algebras

F
A F Ac F
A1 , A2 , A3 , .... F
n=1 An F
Some Examples
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algebras

F
A F Ac F
A1 , A2 , A3 , .... F
n=1 An F
Some Examples
F0 = {, }
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algebras

F
A F Ac F
A1 , A2 , A3 , .... F
n=1 An F
Some Examples
F0 = {, }
F1 = {, , {HH, HT }, {TT , TH}}
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algebras

F
A F Ac F
A1 , A2 , A3 , .... F
n=1 An F
Some Examples
F0 = {, }
F1 = {, , {HH, HT }, {TT , TH}}
F2 = {, , {HH}, {HT }, {TT }, {TH}, ....}
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algebras

F
A F Ac F
A1 , A2 , A3 , .... F
n=1 An F
Some Examples
F0 = {, }
F1 = {, , {HH, HT }, {TT , TH}}
F2 = {, , {HH}, {HT }, {TT }, {TH}, ....}
F2 is completed by taking all unions of , , {HH}, {HT }, {TT }, {TH}.
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Notice that F0 F1 F2 .
Correspondingly, given an , we define a
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Filtration as ..
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Filtration as ..
a sequence of algebras F0 , F1 , F2 , ..., Fn , ... such that
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Filtration as ..
F0 F1 F2 ... Fn ...
Albert Cohen (MSU)
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Filtration as ..
F0 F1 F2 ... Fn ...
and F = () as the algebra of all subsets of .
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Filtration as ..
F0 F1 F2 ... Fn ...
and F = () as the algebra of all subsets of .
Given a pair (, F), we define a Random Variable X () as a mapping
X :R
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Given a pair (, F) and random variable X ,

(X ) = the collection of all sets { | X () A R}
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Given a G F, we say that X is G measurable if
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A (X ) A G
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A (X ) A G
A Probability Space for us will be the triple (, F, P), where
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P : F [0, 1]
P[] = 0
For any countable disjoint sets A1 , A2 , ... F
P [
n=1 An ] =
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n=1
P[An ]
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And so
P[A] :=
P[]
PA
P
E[X ] := X ()P[] = nk=1 xk P[{X () = xk }]
h
i
with Variance := E (X E[X ])2
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Conditional Expectation
Let us return to the two flip model.
Albert Cohen (MSU)
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and know the value S1 , can we
If we are give a probability measure P,
estimate the value S2 given (conditional on) this information?
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An Example:
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An Example:
S0 = 100, S1 (H) = 120, S1 (T ) = 80
p = 0.4, q = 0.6 for each flip
= (1 , 2 ) - each flip is independent, and a path is the total path
generated by both flips
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An Example:
S0 = 100, S1 (H) = 120, S1 (T ) = 80
Given this set-up, compute
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An Example:
S0 = 100, S1 (H) = 120, S1 (T ) = 80
Given this set-up, compute
[S2 | S1 ] (1 )
E
Albert Cohen (MSU)
(166)
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This means if we take X = S1 , for any A (S1 )

X
A
S2 ()P[]
=
[S2 | S1 ] ()P[]
(167)
Can extend this to any sub algebra of (S2 )
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Assume X F and G F
Tower Property: If G1 G2 , then
h
i
[X | G1 ] = E
E
[X | G2 ] | G1
E
(168)
[X | G ] = X
If X is G measurable, then E
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[| X |] < , then
Jensens Inequality: If f : R R is convex, and E

[f (X ) | G ] f E
[X | G ]
E
(169)
[X | G ] 0
If P[{X
0}] = 1, then E
Linearity
Independence: If X does not depend on the information contained in
G , then
E [X | G ] = E [X ]
(170)
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Taking out what is known: If X is dependent only on the information

contained in G , then
[XY | G ] = X E
[Y | G ]
E
(171)
Example: If G = F1 , and X = S1 (1 ), Y = S2 , then

[S1 (1 )S2 | F1 ] = S1 (1 )E
[S2 | F1 ]
E
Albert Cohen (MSU)
MSU Spring 2014
(172)
208 / 223

[XY | G ] = X E
[Y | G ]
E
(171)

[S1 (1 )S2 | F1 ] = S1 (1 )E
[S2 | F1 ]
E
(172)
2 | S0 ] ?
Example: What is E[S
Albert Cohen (MSU)
MSU Spring 2014
208 / 223

[XY | G ] = X E
[Y | G ]
E
(171)

[S1 (1 )S2 | F1 ] = S1 (1 )E
[S2 | F1 ]
E
(172)
2 | S0 ] ?
Example: What is E[S
Definition: When conditioning on the algebra Fn , we take the
notation
E [X | Fn ] = En [X ]
(173)
This is true, of course, for any measure we use.

Albert Cohen (MSU)
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208 / 223
Martingales
Observe a random process Mn that depends only on the first n coin flips.
The history of the random variable is encapsulated in the filtration Fn it
generates.
Albert Cohen (MSU)
MSU Spring 2014
209 / 223
Martingales
generates.
If Mn = En [Mn+1 ] then Mn is called a Martingale
Albert Cohen (MSU)
MSU Spring 2014
209 / 223
Martingales
generates.
If Mn En [Mn+1 ] then Mn is called a Submartingale
Albert Cohen (MSU)
MSU Spring 2014
209 / 223
Martingales
generates.
If Mn En [Mn+1 ] then Mn is called a Supermartingale
Albert Cohen (MSU)
MSU Spring 2014
209 / 223
Martingales
generates.
By the definition and the Tower property above, we have for all k 0
Albert Cohen (MSU)
MSU Spring 2014
209 / 223
Martingales
generates.
By the definition and the Tower property above, we have for all k 0
Mn = En [Mn+k ]
(174)
if Mn is a Martingale
Albert Cohen (MSU)
MSU Spring 2014
209 / 223
Martingale Pricing Theorem Under our model with risk neutral

d
probabilities p = 1+r
= u1r
ud , q
ud , the process
Albert Cohen (MSU)
MSU Spring 2014
210 / 223

d
= u1r
ud , q
ud , the process
Mn :=
Sn
(1 + r )n
(175)
is a martingale
Albert Cohen (MSU)
MSU Spring 2014
210 / 223

d
= u1r
ud , q
ud , the process
Mn :=
Sn
(1 + r )n
(175)
is a martingale
Proof
Albert Cohen (MSU)
MSU Spring 2014
210 / 223

d
= u1r
ud , q
ud , the process
Mn :=
Sn
(1 + r )n
is a martingale
Proof
We use the Tower property again:

Sn+1
Sn
1 Sn+1
En
= En
(1 + r )n+1
(1 + r )n 1 + r Sn

Sn
1 Sn+1
=
En
(1 + r )n
1 + r Sn
Sn pu + qd
=
(1 + r )n 1 + r
Sn
=
(1 + r )n
MSU Spring 2014
QEDAlbert Cohen (MSU)
(175)
210 / 223
Let us return to the multiperiod model. For each time n, we will

dynamically redistribute our wealth Xn by deciding to hold n shares of Sn
and invest the rest in the bank account at rate r . At time n + 1, this
means we have the value
Albert Cohen (MSU)
MSU Spring 2014
211 / 223

Xn+1 = (Xn n Sn ) (1 + r ) + n Sn+1
Albert Cohen (MSU)
MSU Spring 2014
(176)
211 / 223

Xn+1 = (Xn n Sn ) (1 + r ) + n Sn+1
(176)
If we discount this recursive process to form
Albert Cohen (MSU)
MSU Spring 2014
211 / 223

Xn+1 = (Xn n Sn ) (1 + r ) + n Sn+1
(176)

Mn :=
Albert Cohen (MSU)
Xn
(1 + r )n
(177)
MSU Spring 2014
211 / 223

Xn+1 = (Xn n Sn ) (1 + r ) + n Sn+1
(176)

Mn :=
Xn
(1 + r )n
(177)
then Mn is a martingale
Albert Cohen (MSU)
MSU Spring 2014
211 / 223
Risk Neutral Pricing Formula
Assume now that we have the regular assumptions on our coin flip space,
and that at time N we are asked to deliver a path dependent derivative
value VN . Then for times 0 n N, the value of this derivative is
computed via
Albert Cohen (MSU)
MSU Spring 2014
212 / 223
computed via

Vn+1
Vn = En
(178)
1+r
Albert Cohen (MSU)
MSU Spring 2014
212 / 223
computed via

Vn+1
Vn = En
(178)
1+r
and so
Albert Cohen (MSU)
MSU Spring 2014
212 / 223
computed via

Vn+1
Vn = En
(178)
1+r
and so
0
V0 = E
Albert Cohen (MSU)
VN
(1 + r )N
(179)
MSU Spring 2014
212 / 223
Markov Processes
If we use the above approach for a more exotic option, say a lookback
option that pays the maximum over the term of a stock, then we find this
approach lacking. There is not enough information in the tree or the
distinct values for S3 as stated. We need more. Consider our general
multi-period binomial model under P

Definition We say that a process X is adapted if it depends only on the
flips 1 , ..., n
Definition We say that an adapted process X is Markov if for every
0 n N 1 and every function f (x) there exists another function g (x)
such that
n [f (Xn+1 )] = g (Xn )
E
Albert Cohen (MSU)
(180)
MSU Spring 2014
213 / 223
This notion of Markovity is essential to our state-dependent pricing

algorithm. Indeed, since our stock process evolves from time n to time
n + 1, using only the information in Sn , we can in fact say that for every
f (s) there exists a g (s) such that
n [f (Sn+1 ) | Sn = s]
g (s) = E
pf (2s) + qf (0.5s)
g (s) =
1+r
(181)
So, for any f (s) := VN (s), we can work our recursive algorithm backwards
to find the gn (s) := Vn (s) for all 0 n N 1
Albert Cohen (MSU)
MSU Spring 2014
214 / 223
Returning to our example of a lookback option, we see that the problem

was that Mn := max0in Si is not Markov by itself, but the pair (Mn , Sn )
is. Why?
Lets generate the tree!
Homework Can you think of any other processes that are not Markov?
That are Martingales, but not Markov?
Albert Cohen (MSU)
MSU Spring 2014
215 / 223
The Interview Process
Consider the following scenario: After graduating, you go on the job

market, and have 4 possible job interviews with 4 different companies. So
sure of your prospects that you know that each company will make an
offer, with an identically, independently distributed probability attached to
the 4 possible salary offers -
Albert Cohen (MSU)
MSU Spring 2014
216 / 223
Consider the following scenario: After graduating, you go on the job

market, and have 4 possible job interviews with 4 different companies. So
sure of your prospects that you know that each company will make an
offer, with an identically, independently distributed probability attached to
the 4 possible salary offers P [Salary Offer=x1 ] = p1
P [Salary Offer=x2 ] = p2
(182)
p1 + p2 + p3 + p4 = 1
Albert Cohen (MSU)
MSU Spring 2014
216 / 223
How should you interview?
Albert Cohen (MSU)
MSU Spring 2014
217 / 223

Specifically, when should you accept an offer and cancel the
remaining interviews?
Albert Cohen (MSU)
MSU Spring 2014
217 / 223

Specifically, when should you accept an offer and cancel the
remaining interviews?
How does your strategy change if you can interview as many times as
you like, but the distribution of offers remains the same as above?
Albert Cohen (MSU)
MSU Spring 2014
217 / 223
Lets review the basic contracts we can write:
Albert Cohen (MSU)
MSU Spring 2014
218 / 223

Forward Contract Initial Value is 0, because both buyer and seller
may have to pay a balance at maturity
Albert Cohen (MSU)
MSU Spring 2014
218 / 223

(European) Put/Call Option Initial Value is > 0, because both only
seller must pay balance at maturity.
Albert Cohen (MSU)
MSU Spring 2014
218 / 223

(European) Exotic Option Initial Value is > 0, because both only
Albert Cohen (MSU)
MSU Spring 2014
218 / 223

During the term of the contract, can the value of the contract ever fall
below the intrinsic value of the payoff? Symbolically, does it ever occur
that
Albert Cohen (MSU)
MSU Spring 2014
218 / 223

that
vn (s) < g (s)
Albert Cohen (MSU)
(183)
MSU Spring 2014
218 / 223

that
vn (s) < g (s)
(183)
where g (s) is of the form of g (S) := max {S K , 0}, in the case of a Call
option, for example.
Albert Cohen (MSU)
MSU Spring 2014
218 / 223
For Freedom! (we must charge extra...)
What happens if we write a contract that allows the purchaser to exercise

the contract whenever she feels it to be in her advantage? By allowing this
extra freedom, we must
Albert Cohen (MSU)
MSU Spring 2014
219 / 223

Charge more than we would for a European contract that is exercised
only at the term N
Albert Cohen (MSU)
MSU Spring 2014
219 / 223

only at the term N
Hedge our replicating strategy X differently, to allow for the
possibility of early exercise
Albert Cohen (MSU)
MSU Spring 2014
219 / 223

only at the term N
Hedge our replicating strategy X differently, to allow for the
possibility of early exercise
Extend the notion of the replicating strategy as a Martingale, when
properly discounted
Albert Cohen (MSU)
MSU Spring 2014
219 / 223
Some examples:
American Bond: g (s) = 1
American Digital Option: g (s) = 1{6s10} and
1
= q
2
1
r=
4
p =
S0 = 4, u = 2, d =
Albert Cohen (MSU)
(184)
1
2
MSU Spring 2014
220 / 223
Using the state-variable version of our Risk-Neutral pricing algorithm, we

were able to compute the fair price of the European option as V0 .
Albert Cohen (MSU)
MSU Spring 2014
221 / 223

How would we compute this V0 for the corresponding American
option?
What would our tree look like?
What would our strategy be?
Albert Cohen (MSU)
MSU Spring 2014
221 / 223

How would we compute this V0 for the corresponding American
option?
What would our tree look like?
What would our strategy be?
Certainly, for any strategy X we enact, we must have
Xn max {K Sn , 0}
(185)
to reflect the early payoff the option holder can take.
Albert Cohen (MSU)
MSU Spring 2014
221 / 223
Stopping Times
The question of when exactly an investor will choose to prune the tree
and take her payoff must be asked. In precise language, we define a
Stopping Time as an adapted random variable on our discrete
probability space (, F, P) with filtration {Fk }N
k=0
: {0, 1, 2, ...N}
{ | () = k} Fk k = 0, 1, 2, .., N
Albert Cohen (MSU)
MSU Spring 2014
(186)
222 / 223
Stopping Times:Example
Consider the case of
1
= q
2
1
r=
4
p =
(187)
1
S0 = 4, u = 2, d = , N = 2
2
V2 := max {K S2 , 0}
Then for := min {m | vm (Sm ) = {K Sm , 0}}, we have
{ | () = 0} = F0
{ | () = 1} = {TH, TT } F1
(188)
{ | () = 2} = {HH, HT } F2
and so is a stopping time. Can you come up with a random time that is
not a stopping time?
Albert Cohen (MSU)
MSU Spring 2014
223 / 223

MATH 360 (Mathematics of Investment)

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MATH 360 (Mathematics of Investment)

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MATH 360: Theory of Investment and Credit

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

All course materials available on class page (www.math.msu.edu)

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Calculus, and the study of Geometric Series, provides

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Calculus, and the study of Geometric Series, provides

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Calculus (1-d only!)

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Calculus (1-d only!)

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Calculus (1-d only!)

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Calculus (1-d only!)

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Interest Accumulation and Effective Rates of Interest (Ex

Begin by investing 1000 at 9% per annum. Compound annually for 3

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Interest Compounded Monthly

Sometimes, interest rate is quoted per annum, but compounded monthly.

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Interest Compounded Monthly

Sometimes, interest rate is quoted per annum, but compounded monthly.

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Fluctuating Interest Rates

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Fluctuating Interest Rates

Guess: A(n) = A(0) (1 + r )n

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014

Arithmetic vs Geometric Means

Then, our question is reframed as:

Albert Cohen (MSU)

MATH 360: Theory of Investment and Credit

MSU Spring 2014