General concepts/tools of

Mathematics, Statistics & Cash Flow

1
 General Cash Flow Concepts – Present Value Analysis

Assumptions for future cash flows:

1 Cash flow amount from last period ($) C
2 Constant growth rate per period (%) g
3 Long-term required return/yield per period (%) k
4 Number of periods n
5 Future cash flows expected to occur each period at the constant growth rate

C (1+g)n
Let S be the sum of present values of all future cash flows: S=S (1+k)n

C(1+g) C(1+g)2 C(1+g)3 C(1+g)n-1 C(1+g)n

Therefore, S= + + + ….. + + Equation (a)
(1+k) (1+k)2 (1+k)3 (1+k)n-1 (1+k)n

Multiplying both sides by (1+g)/(1+k), we get;

S (1+g) = C(1+g)2 C(1+g)3 C(1+g)4 C(1+g)n C(1+g)n+1

+ + + ….. + + Equation (b)
(1+k) (1+k)2 (1+k)3 (1+k)4 (1+k)n (1+k)n+1

If we subtract (b) from (a), we get;

n+1 n+1 n+1

S - S (1+g) = C(1+g) C(1+g) (S + Sk) - (S + Sg) = C(1+g) C(1+g) C(1+g)
- n+1 OR - n+1 OR S(k-g) = C(1+g) - n Equation (c)
(1+k) (1+k) (1+k) (1+k) (1+k) (1+k) (1+k)

Further factoring and cross multiplying of (c), we get;

C(1+g) (1+g)n
S=
(k-g)
[1- (1+k)n
] Equation (d)

2
 General Cash Flow Concepts – Present Value Analysis

C1 Using equation (d) to model fixed rate loan (or bond) payments

For a level payment fixed rate loan, S = Principal Amount, growth rate = 0%, C = coupon payment, k = interest rate, n = number of installment payments.

1 1
Therefore, S= C (1- ) ; where (1- ) is also know as the present value factor of an annuity Equation (e)
(1+k)n (1+k)n
k k

Accordingly, equation (e) can also be used to determine the present values of fixed rate bond interest payments.

Exercise: The formula above assumes cash flows occur at period end. Show that when cash flows occur at beginning of period the formula below is true:
1
1 + ( 1 - (1+k)n-1 )
k

C2 Using equation (d) to model stock valuation

S = Common Stock Price or Value, C = stable after tax earnings, g = constant growth rate, k = required rate ofreturn, n => approaches infinity since common stocks do not have maturity dates.
(1+g)n
Let us assume that g less than k, then (1+g)/(1+k) < 1. Accordingly, as n => infinity, approaches zero.
(1+k)n

(1+g)
Therefore, S= C also known as the Gordon-Growth Model Equation (f)
(k-g)

3
 General Cash Flow Concepts – Present Value Analysis

Assumptions for future cash flows:

1 Cash flow investment amount at each period ($) C
2 Number of periods n
3 Constant period return of each cash investment (%) r
4 1st cash flow starts NOW

Let S be the lump sum future value of cash flows: S=S C (1+r)
n-x
where C = fixed cash flow amount at period x

n n-1 n-2 2
Therefore, S = C (1+r) + C (1+r) + C (1+r) + ….. + C (1+r) + C (1+r) Equation (a)

Multiplying both sides of equation (a) by (1+r);

n+1 n n-1 3 2
We get S(1+r) = C (1+r) + C (1+r) + C (1+r) + ….. + C (1+r) + C (1+r) Equation (b)

Subtracting equation (a) from (b), we get;

Sr = C (1+r)n+1 - C (1+r) Equation (c)

1 Therefore, when 1st cash flow starts NOW, then;

(1+r)n - 1 (1+r)n - 1
S = C(1+r) [ r ] where
r
is also know as the future value factor of an annuity Equation (d)

2 If 1st cash flow starts at the END of the period, then;

(1+r)n - 1 (1+r)n - 1
S = C [ r ] where
r
is also know as the future value factor of an annuity Equation (e)

4
 General Cash Flow Concepts – Duration and Convexity of a fixed rate bond
Taylor's Series of approximation C (1/2 yr) 3.00%
y (1/2 yr) 2.75%
i n
P (x) = S n=0n n
f (a)*(x-a) /n!n n 20
f(a) + f'(a)(x-a) + f''(a)(x-a) 2/2! + f'''(a)(x-a) 3/3! + f''''(a)(x-a) 4/4! + …. + f n(a)(x-a) n/n! x -0.50%
where "a" = now, "x" = change from "a" RV 100.00

ii Let a = 0 ==> spot (now), the P n(x) then, we get ==> f(0) + f1(0)(x) + f2(0)(x) 2/2! + f3(0)(x) 3/3! + f4(0)(x) 4/4! + …..

which is ===> Spot price + (f'(0)*Dyield) + (f''(0)*Dyield2)/2 + (f'''(0)*Dyield3)/6 + (f''''(0)*Dyield4)/24 + …

where "a" = spot, "x" = yield change (Dyield)

Spot price = C*(1 - (1/(1+y) n))/y + RV/(1+y)n , where C = coupon payment, y = yield-to-maturity, n = number of coupon payments, RV = maturity or redemption value

Spot price = $103.81

2 2
f'(0)*x = {C* [ -1/y + 1/(y *(1+y) ) + n/(y*(1+y)n n+1
)) ] - RV*n/(1+y) n+1 *
} x f'(0)*x = $7.79 change due to duration [ C * Duration * Dyield ]
f''(0)*x2 /2 = {C * [ 2/y3 - n/(y2 *(1+y)n+1 ) - 2/(y3 *(1+y)n) - n*(n+1)/(y*(1+y)n+2 ) - n/(y2 *(1+y)n+1 ) ] + RV*n*(n+1)/(1+y)n+2 } * x2 / 2 f''(0)*x2 /2 = $0.36 change due to convexity [ C * Convexity * 0.5 * Dyield2 ]
Change $8.15 due to duration & convexity
New Price $111.96 1st & 2nd terms of Taylor Series ONLY
Actual New Price = $111.97
Difference (Error term) = ($0.01) Error term can be further reduced by
3 3 4 3 n+1 2 n+2 4 n 3 n+1 2 n+2 n+3
f (0)*x /6 = {C * [ -6/y + 2n/(y (1+y) ) + n(n+1)/(y (1+y) ) +6/(y (1+y) ) +2n/(y (1+y) ) + n(n+1)/(y (1+y) ) + n(n+1)(n+2)/(y(1+y) )
f3 (0)*x3 /6 = $0.01 3rd term of Taylor Series
+2n/(y3 (1+y)n+1 ) +n(n+1)/(y2 (1+y)n+2 ) ] - 100n(n+1)(n+2)/(1+y)n+3 } * x3 / 6
Remaining Error term (after 3rd Taylor Series term) = ($0.00)

NOTE: The formuli above calculate semi-annual duration and convexity. To convert to annual duration and convexity divided the semi-annual duration and convexity by 2 and 4 respectively.

Assume a parallel shift in yield change D% 5

 General Math Concepts/Techniques

To find the base value of an exponential expression, take the root of the resulting expression;
i.e. Xa = b. To find X, we take the root of b, that is, the root of b is b1/a.
e.g. if X3 = 27, then X = 271/3 = 3.

To find the exponential value of an expression, we convert the expression into the logarithmic version;
i.e. Xa = b.  a*ln(X) = ln(b)
e.g. if 4a = 64, then a*ln(4) = ln(64)
a = ln(64)/ln(4) = ln(43)/ln(4) = 3*ln(4)/ln(4) = 3

Summing a series of numbers from the first expression in the series f(1) to the final expression f(N);
SNi=1 [ a*f(i) + b ]; where a, b are constants and f(i) is a variable
SNi=1 = (a*f(1) + b) + (a*f(2) + b) + (a*f(3) + b) + … + (a*f(1) + b)
e.g. Find the sum of 3*f(i) + 7 where f(i) = 2i for i = 1 to 5; then
SN=5i=1 [ 3*(2i) + 7 ] = (3*2)+7 + (3*22)+7 + (3*23)+7 + (3*24)+7 + (3*25)+7 = 13+19+31+55+103 = 221

6
 General Statistics – Law of Probability, Portfolios & Expectations

Law of expectation - E(X) where E(X) is the expected value:

E(X) = SNi=1 Probability(i) * Xi
e.g. if bad weather, then X = $10. if good weather, then X = $50.
probability of bad weather is 40% and good weather is 60%.
Then E(X) = Prob(bad)*Xbad + Prob(good)*Xgood = (0.4*10) + (0.6*50) = $34

Variance: Var(X) = SNi=1 Probability(i) * (Xi – E(X))2, E(X) = SNi=1 Probability(i) * Xi

e.g. if bad weather, then X = $10. if good weather, then X = $50.
probability of bad weather is 40% and good weather is 60%.
Then E(X) = Prob(bad)*Xbad + Prob(good)*Xgood = (0.4*10) + (0.6*50) = $34
Var(X) = Prob(bad)*(Xbad – E(X))2 + Prob(good)*(Xgood – E(X))2
= (0.4*(10-34)2) + (0.6*(50-34)2) = 230.40 + 153.60 = 384

Standard deviation: Stdev(X) = Var(X)1/2

7
 General Statistics – Law of Probability, Portfolios & Expectations

We used the example of a single variable, X, to describe its expected value, variance and standard
deviation. If X represents an investment’s rate of return, then the earlier statistics are valid.

However, when we combine several variables into a group the dynamics become complicated and we
need a more generic set of formuli to describe their group expected value, variance and standard
deviation.

Let Z represents a collection (“portfolio”) of different stock investments (Xi); where N represents the
number of Xi stocks Then;

E(Z) = Si=1N (wi * ri); where wi = %age weight of Xi, ri = expected return of Xi stock
Var(Z) = Si=1N { Sj=1N [wi * wj * cov(ri,rj) ] }; where cov(ri,rj) = covariance of ri & rj
Stdev(Z) = Var(Z)1/2

Covariance is the expected (ri – E(ri)) * (rj – E(rj)). In the special case where i = j, then cov(ri,rj) = var(ri)

8
 General Statistics – Law of Probability, Portfolios & Expectations
RETURN AND RISK ANALYSIS (DOLLAR AND SCENARIO PROBABLITY WEIGHTED)

Invest S1 S2 S3 S4 Weighted S1 S2 S3 S4 Weighted

Option Asset Portfolio Port% 25% 25% 25% 25% 100% 25.0% 25.0% 25.0% 25.0% 100.000%
1 M Return (M) $100.00 100.0% $97.00 $103.00 $105.00 $111.00 $104.00 -3.0% 3.0% 5.0% 11.0% 4.000%
Deviation (M) a ($7.00) ($1.00) $1.00 $7.00 $0.00 -7.0% -1.0% 1.0% 7.0% #DIV/0!
Variance (M) b $49.00 $1.00 $1.00 $49.00 $25.00 0.5% 0.0% 0.0% 0.5% 0.250%
Std Dev (M) $5.00 5.000%

Invest S1 S2 S3 S4 Weighted S1 S2 S3 S4 Weighted

Option Portfolio Port% 25% 25% 25% 25% 100% 25.0% 25.0% 25.0% 25.0% 100.000%
2 A Return (A) $100.00 100.0% $103.00 $111.00 $97.00 $105.00 $104.00 3.0% 11.0% -3.0% 5.0% 4.000%
Deviation (A) c ($1.00) $7.00 ($7.00) $1.00 $0.00 -1.0% 7.0% -7.0% 1.0% #DIV/0!
Variance (A) d $1.00 $49.00 $49.00 $1.00 $25.00 0.0% 0.5% 0.5% 0.0% 0.250%
Std Dev (A) $5.00 5.000%

Invest S1 S2 S3 S4 Weighted S1 S2 S3 S4 Weighted

Option Portfolio Port% 25% 25% 25% 25% 100% 25.0% 25.0% 25.0% 25.0% 100.000%
3 B Return (B) $100.00 100.0% $105.00 $99.00 $107.00 $113.00 $106.00 5.0% -1.0% 7.0% 13.0% 6.000%
Deviation (B) e ($1.00) ($7.00) $1.00 $7.00 ($0.00) -1.0% -7.0% 1.0% 7.0% #DIV/0!
Variance (B) f $1.00 $49.00 $1.00 $49.00 $25.00 0.0% 0.5% 0.0% 0.5% 0.250%
Std Dev (B) $5.00 5.000%

Invest S1 S2 S3 S4 Weighted S1 S2 S3 S4 Weighted

Option Portfolio Port% 25% 25% 25% 25% 100% 25.0% 25.0% 25.0% 25.0% 100.000%
4 C Return (C) $100.00 100.0% $117.00 $103.00 $111.00 $93.00 $106.00 17.0% 3.0% 11.0% -7.0% 6.000%
Deviation (C) g $11.00 ($3.00) $5.00 ($13.00) $0.00 11.0% -3.0% 5.0% -13.0% #DIV/0!
Variance (C) h $121.00 $9.00 $25.00 $169.00 $81.00 1.2% 0.1% 0.3% 1.7% 0.810%
Std Dev (C) $9.00 9.000%

Invest S1 S2 S3 S4 Weighted S1 S2 S3 S4 Weighted

Option Portfolio Port% 25% 25% 25% 25% 100% 25.0% 25.0% 25.0% 25.0% 100.000%
5 F Return (F) $100.00 100.0% $101.00 $101.00 $101.00 $101.00 $101.00 1.0% 1.0% 1.0% 1.0% 1.000%
Deviation (F) i $0.00 $0.00 $0.00 $0.00 $0.00 0.0% 0.0% 0.0% 0.0% #DIV/0!
Variance (F) j $0.00 $0.00 $0.00 $0.00 $0.00 0.0% 0.0% 0.0% 0.0% 0.000%
Std Dev (F) $0.00 0.000%

Invest Multi-Asset S1 S2 S3 S4 Scenario S1 S2 S3 S4 Scenario

Option Portfolio Port% 25% 25% 25% 25% 100% 25.0% 25.0% 25.0% 25.0% 100.000%
Return (M) $20.00 20.0% $19.40 $20.60 $21.00 $22.20 $20.80 -3.000% 3.000% 5.000% 11.000% 4.000%
Return (A) $20.00 20.0% $20.60 $22.20 $19.40 $21.00 $20.80 3.000% 11.000% -3.000% 5.000% 4.000%
Return (B) $20.00 20.0% $21.00 $19.80 $21.40 $22.60 $21.20 5.000% -1.000% 7.000% 13.000% 6.000%
Return (C) $20.00 20.0% $23.40 $20.60 $22.20 $18.60 $21.20 17.000% 3.000% 11.000% -7.000% 6.000%
Return (F) $20.00 20.0% $20.20 $20.20 $20.20 $20.20 $20.20 1.000% 1.000% 1.000% 1.000% 1.000%

P Portfolio $100.00 100.0% $104.60 $103.40 $104.20 $104.60 $104.20 4.600% 3.400% 4.200% 4.600% 4.200%
Deviation pd $0.40 ($0.80) $0.00 $0.40 $0.00 0.400% -0.800% 0.000% 0.400% #DIV/0!
Variance pvr $0.16 $0.64 $0.00 $0.16 $0.24 0.002% 0.006% 0.000% 0.002% 0.002%
Variance weighted $0.04 $0.16 $0.00 $0.04 $0.24 0.000% 0.002% 0.000% 0.000% 0.002%
Std Dev $0.49 0.490%

9
 General Statistics – Law of Probability, Portfolios & Expectations
Portfolio Var: Sum of weighted average asset variance + 2*weighted average covariance
M Deviation (M) Unweighted a ($7.00) ($1.00) $1.00 $7.00 $0.00 -7.000% -1.000% 1.000% 7.000% 0.000%
A Deviation (A) Unweighted c ($1.00) $7.00 ($7.00) $1.00 $0.00 -1.000% 7.000% -7.000% 1.000% 0.000%
B Deviation (B) Unweighted e ($1.00) ($7.00) $1.00 $7.00 ($0.00) -1.000% -7.000% 1.000% 7.000% 0.000%
C Deviation (C) Unweighted g $11.00 ($3.00) $5.00 ($13.00) $0.00 11.000% -3.000% 5.000% -13.000% 0.000%
F Deviation (F) Unweighted i $0.00 $0.00 $0.00 $0.00 $0.00 0.000% 0.000% 0.000% 0.000% 0.000%
5X5= 25 Permutation: Matrix of Portfolio Covariances (25 units)
1 var(1) Variance (M) Unweighted b $49.00 $1.00 $1.00 $49.00 $25.00 0.490% 0.010% 0.010% 0.490% 0.250%
2 var(2) Variance (A) Unweighted d $1.00 $49.00 $49.00 $1.00 $25.00 0.010% 0.490% 0.490% 0.010% 0.250%
3 var(3) Variance (B) Unweighted f $1.00 $49.00 $1.00 $49.00 $25.00 0.010% 0.490% 0.010% 0.490% 0.250%
4 var(4) Variance (C) Unweighted h $121.00 $9.00 $25.00 $169.00 $81.00 1.210% 0.090% 0.250% 1.690% 0.810%
5 var(5) Variance (F) Unweighted j $0.00 $0.00 $0.00 $0.00 $0.00 0.000% 0.000% 0.000% 0.000% 0.000%
6 Covar(1) Covar (M*A) Unweighted a *c $7.00 ($7.00) ($7.00) $7.00 $0.00 0.070% -0.070% -0.070% 0.070% 0.000%
7 Covar(2) Covar (M*B) Unweighted a *e $7.00 $7.00 $1.00 $49.00 $16.00 0.070% 0.070% 0.010% 0.490% 0.160%
8 Covar(3) Covar (M*C) Unweighted a *g ($77.00) $3.00 $5.00 ($91.00) ($40.00) -0.770% 0.030% 0.050% -0.910% -0.400%
9 Covar(4) Covar (M*F) Unweighted a *i $0.00 $0.00 $0.00 $0.00 $0.00 0.000% 0.000% 0.000% 0.000% 0.000%
10 Covar(5) Covar (A*B) Unweighted c*e $1.00 ($49.00) ($7.00) $7.00 ($12.00) 0.0100% -0.4900% -0.0700% 0.0700% -0.120%
11 Covar(6) Covar (A*C) Unweighted c*g ($11.00) ($21.00) ($35.00) ($13.00) ($20.00) -0.1100% -0.2100% -0.3500% -0.1300% -0.200%
12 Covar(7) Covar (A*F) Unweighted c*i $0.00 $0.00 $0.00 $0.00 $0.00 0.0000% 0.0000% 0.0000% 0.0000% 0.000%
13 Covar(8) Covar (B*C) Unweighted e*g ($11.00) $21.00 $5.00 ($91.00) ($19.00) -0.1100% 0.2100% 0.0500% -0.9100% -0.190%
14 Covar(9) Covar (B*F) Unweighted e*i $0.00 $0.00 $0.00 $0.00 $0.00 0.0000% 0.0000% 0.0000% 0.0000% 0.000%
15 Covar(10) Covar (C*F) Unweighted g *i $0.00 $0.00 $0.00 $0.00 $0.00 0.0000% 0.0000% 0.0000% 0.0000% 0.000%
MU Count Weights% 25% 25% 25% 25% 100% 25.0% 25.0% 25.0% 25.0% 100.000%
1 WA Va ri a nce (M) weighted 4.00% $0.49 $0.01 $0.01 $0.49 $1.00 0.005% 0.000% 0.000% 0.005% 0.010%
1 WA Va ri a nce (A) weighted 4.00% $0.01 $0.49 $0.49 $0.01 $1.00 0.000% 0.005% 0.005% 0.000% 0.010%
1 WA Va ri a nce (B) weighted 4.00% $0.01 $0.49 $0.01 $0.49 $1.00 0.000% 0.005% 0.000% 0.005% 0.010%
1 WA Va ri a nce (C) weighted 4.00% $1.21 $0.09 $0.25 $1.69 $3.24 0.012% 0.001% 0.003% 0.017% 0.032%
1 WA Va ri a nce (F) weighted 4.00% $0.00 $0.00 $0.00 $0.00 $0.00 0.000% 0.000% 0.000% 0.000% 0.000%
2 2*WA Cova r (M*A) weighted 8.00% $0.14 ($0.14) ($0.14) $0.14 $0.00 0.001% -0.001% -0.001% 0.001% 0.000%
2 2*WA Cova r (M*B) weighted 8.00% $0.14 $0.14 $0.02 $0.98 $1.28 0.001% 0.001% 0.000% 0.010% 0.013%
2 2*WA Cova r (M*C) weighted 8.00% ($1.54) $0.06 $0.10 ($1.82) ($3.20) -0.015% 0.001% 0.001% -0.018% -0.032%
2 2*WA Cova r (M*F) weighted 8.00% $0.00 $0.00 $0.00 $0.00 $0.00 0.000% 0.000% 0.000% 0.000% 0.000%
2 2*WA Cova r (A*B) weighted 8.00% $0.02 ($0.98) ($0.14) $0.14 ($0.96) 0.000% -0.010% -0.001% 0.001% -0.010%
2 2*WA Cova r (A*C) weighted 8.00% ($0.22) ($0.42) ($0.70) ($0.26) ($1.60) -0.002% -0.004% -0.007% -0.003% -0.016%
2 2*WA Cova r (A*F) weighted 8.00% $0.00 $0.00 $0.00 $0.00 $0.00 0.000% 0.000% 0.000% 0.000% 0.000%
2 2*WA Cova r (B*C) weighted 8.00% ($0.22) $0.42 $0.10 ($1.82) ($1.52) -0.002% 0.004% 0.001% -0.018% -0.015%
2 2*WA Cova r (B*F) weighted 8.00% $0.00 $0.00 $0.00 $0.00 $0.00 0.000% 0.000% 0.000% 0.000% 0.000%
2 2*WA Cova r (C*F) weighted 8.00% $0.00 $0.00 $0.00 $0.00 $0.00 0.000% 0.000% 0.000% 0.000% 0.000%
25 Variance weighted 100.0% $0.04 $0.16 ($0.00) $0.04 $0.24 0.000% 0.002% 0.000% 0.000% 0.002%
Std Dev $0.49 0.490%

10
 Z-Table
Table of Cumulative Probability for Standard Normal Distribution Table of Cumulative Probability for Standard Normal Distribution
Area Under the standard "bell" curve (Left-Side) Area Under the standard "bell" curve (Right-Side)
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
-3.00 0.0013 0.0014 0.0014 0.0015 0.0015 0.0016 0.0016 0.0017 0.0018 0.0018 0.00 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
-2.90 0.0019 0.0019 0.0020 0.0021 0.0021 0.0022 0.0023 0.0023 0.0024 0.0025 0.10 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
-2.80 0.0026 0.0026 0.0027 0.0028 0.0029 0.0030 0.0031 0.0032 0.0033 0.0034 0.20 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
-2.70 0.0035 0.0036 0.0037 0.0038 0.0039 0.0040 0.0041 0.0043 0.0044 0.0045 0.30 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
-2.60 0.0047 0.0048 0.0049 0.0051 0.0052 0.0054 0.0055 0.0057 0.0059 0.0060 0.40 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
-2.50 0.0062 0.0064 0.0066 0.0068 0.0069 0.0071 0.0073 0.0075 0.0078 0.0080 0.50 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
-2.40 0.0082 0.0084 0.0087 0.0089 0.0091 0.0094 0.0096 0.0099 0.0102 0.0104 0.60 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
-2.30 0.0107 0.0110 0.0113 0.0116 0.0119 0.0122 0.0125 0.0129 0.0132 0.0136 0.70 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
-2.20 0.0139 0.0143 0.0146 0.0150 0.0154 0.0158 0.0162 0.0166 0.0170 0.0174 0.80 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
-2.10 0.0179 0.0183 0.0188 0.0192 0.0197 0.0202 0.0207 0.0212 0.0217 0.0222 0.90 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
-2.00 0.0228 0.0233 0.0239 0.0244 0.0250 0.0256 0.0262 0.0268 0.0274 0.0281 1.00 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
-1.90 0.0287 0.0294 0.0301 0.0307 0.0314 0.0322 0.0329 0.0336 0.0344 0.0351 1.10 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
-1.80 0.0359 0.0367 0.0375 0.0384 0.0392 0.0401 0.0409 0.0418 0.0427 0.0436 1.20 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
-1.70 0.0446 0.0455 0.0465 0.0475 0.0485 0.0495 0.0505 0.0516 0.0526 0.0537 1.30 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
-1.60 0.0548 0.0559 0.0571 0.0582 0.0594 0.0606 0.0618 0.0630 0.0643 0.0655 1.40 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
-1.50 0.0668 0.0681 0.0694 0.0708 0.0721 0.0735 0.0749 0.0764 0.0778 0.0793 1.50 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
-1.40 0.0808 0.0823 0.0838 0.0853 0.0869 0.0885 0.0901 0.0918 0.0934 0.0951 1.60 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
-1.30 0.0968 0.0985 0.1003 0.1020 0.1038 0.1056 0.1075 0.1093 0.1112 0.1131 1.70 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
-1.20 0.1151 0.1170 0.1190 0.1210 0.1230 0.1251 0.1271 0.1292 0.1314 0.1335 1.80 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
-1.10 0.1357 0.1379 0.1401 0.1423 0.1446 0.1469 0.1492 0.1515 0.1539 0.1562 1.90 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
-1.00 0.1587 0.1611 0.1635 0.1660 0.1685 0.1711 0.1736 0.1762 0.1788 0.1814 2.00 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
-0.90 0.1841 0.1867 0.1894 0.1922 0.1949 0.1977 0.2005 0.2033 0.2061 0.2090 2.10 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
-0.80 0.2119 0.2148 0.2177 0.2206 0.2236 0.2266 0.2296 0.2327 0.2358 0.2389 2.20 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
-0.70 0.2420 0.2451 0.2483 0.2514 0.2546 0.2578 0.2611 0.2643 0.2676 0.2709 2.30 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
-0.60 0.2743 0.2776 0.2810 0.2843 0.2877 0.2912 0.2946 0.2981 0.3015 0.3050 2.40 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
-0.50 0.3085 0.3121 0.3156 0.3192 0.3228 0.3264 0.3300 0.3336 0.3372 0.3409 2.50 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
-0.40 0.3446 0.3483 0.3520 0.3557 0.3594 0.3632 0.3669 0.3707 0.3745 0.3783 2.60 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
-0.30 0.3821 0.3859 0.3897 0.3936 0.3974 0.4013 0.4052 0.4090 0.4129 0.4168 2.70 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
-0.20 0.4207 0.4247 0.4286 0.4325 0.4364 0.4404 0.4443 0.4483 0.4522 0.4562 2.80 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
-0.10 0.4602 0.4641 0.4681 0.4721 0.4761 0.4801 0.4840 0.4880 0.4920 0.4960 2.90 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
0.00 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359 3.00 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990

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 Calculus Fundamentals

1. Binomial Expansion

(P + PQ)m/n = P m/n + (m/n)AQ + ((m-n)/2n)BQ + ((m-2n)/3n)CQ + ((m-3n)/4n)DQ + etc., etc. such that A,B,C,D represents the preceding term [ 1.1 ]

Factoring the left-side and expanding the right-side, we get;

m/n m/n m/n m/n m/n 2 m/n 3 m/n 4

P (1+Q) =P + (m/n)(P )Q + ((m-n)/2n)*(m/n)(P )Q + ((m-2n)/3n)*((m-n)/2n)*(m/n)(P )Q + ((m-3n)/4n)*((m-2n)/3n)*((m-n)/2n)*(m/n)(P )Q + etc., etc.

Dividing both sides by Pm/n, we get;

(1+Q)m/n = 1 + (m/n)Q + (1/2)(m/n)(m/n – 1)Q2 + (1/(3*2))(m/n)(m/n – 1)(m/n – 2)Q3 + (1/(4*3*2))*(m/n)(m/n – 1)(m/n – 2)(m/n – 3)Q4 + etc., etc.

= 1 + (m/n)Q + (m/n)( m/n – 1)Q2 + (m/n)( m/n – 1)( m/n – 2)Q3 + (m/n)( m/n – 1)( m/n – 2)( m/n – 3)Q4 + etc., etc. [ 1.2 ]
2! 3! 4!

Note: 2x1 = 2! 3x2x1 = 3! 4x3x2x1 = 4! etc….

The series above can also be described as S k=0(m/n) (m/n)!/(k!(m/n - k)!) Qk

Some of us are more familiar with the (a + b) n form, the formula can be written as: S k=0n (n!/(k!(n - k)!) an-kbk

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2. Fundamental Theorem of Calculus ( Differentiation, power rule)

n
Let the function f(X) = Y = aX where “X” is a variable of the continuous function and “a” = constant.
n
If “X” changes by a small amount “x”, then the new value of the function = f(X+x) = Y+y = a(X+x) .

The change in value is: f(X+x) – f(X) = Y+y-Y = a(X+x) n - aXn , and, the average rate of change is:
n n n n
(change in Y/small change in X) = y/x = (a(X+x) – aX )/x = (a/x) [ (X+x) – X ]
= (a/x) [ Xn(1+(x/X))n – Xn ] ; using 1.2 above, we expand and get:
n 2 3 4 n
=(a/x) [ X (1+ n(x/X) + (1/2)(n)(n-1)(x/X) + (1/6)(n)(n-1)(n-2)(x/X) + (1/24)(n)(n-1)(n-2)(n-3)(x/X) + etc., etc. …. – X ]
= (a/x) [ Xn + n(xXn-1) + (1/2)(n)(n-1)(x2Xn-2) + (1/6)(n)(n-1)(n-2)(x3Xn-3) + (1/24)(n)(n-1)(n-2)(n-3)(x4Xn-4) + etc., etc. …. – Xn ]; simplifying further, we get:
n-1 n-2 2 n-3 3 n-4
= a [ nX + (1/2)(n)(n-1)(xX ) + (1/6)(n)(n-1)(n-2)(x X ) + (1/24)(n)(n-1)(n-2)(n-3)(x X ) + etc., etc. ]

Now, if we keep making “x” smaller and smaller, the average rate of change actually converges into a limit (an amount certain in value) such that
as “x” approaches zero, the average rate of change becomes the instantaneous rate of change!

Substituting zero for “x”, the limit or instantaneous rate of change becomes
= a [ nXn-1 + (1/2)(n)(n-1)(xXn-2) + (1/6)(n)(n-1)(n-2)(x2Xn-3) + (1/24)(n)(n-1)(n-2)(n-3)(x 3Xn-4) + etc., etc. ]
n-1 n-2 2 -3 3 n-4
= a [ nX + (1/2)(n)(n-1)(0*X ) + (1/6)(n)(n-1)(n-2)(0 *Xn ) + (1/24)(n)(n-1)(n-2)(n-3)(0 *X ) + 0., 0. ]
= anXn-1

If Y = aXn, we proved that the differentiation of Y, Y’ = anXn-1 [ 2.1, aka power rule ]
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 Calculus Fundamentals

Dif erentiation of Sums:

n p n p
Suppose f(X) = aX + bX , then f(X+x) = a(X+x) + b(X+x) .
n n p p
Accordingly, f(X+x) – f(X) = [ a(X+x) – aX ] + [b(X+x) – bX ], and,
n-1 p-1
f’(X) = anX + bpX {the dif erentiation of a sum function is the sum of their dif erentiations}
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 Calculus Fundamentals

3. Product Rule of Differentiation

If Y = U*V, and f(X) = Y, g(X) = U and h(X) = V, then Y+y = (U+u)(V+v) = UV + uV + vU + uv for a small change in X. Y+y – Y = y = UV + uV + vU + uv – UV.
y = uV + vU + uv; by the theorem of differentiation in 2.1, the instantaneous rate of change;
Y’ = U’V + V’U + U’V’ [ i.e. y/x = (u/x)V + (v/x)U + (uv/x) ; as x approaches zero ]
The product U’V is clear i.e. it is the instantaneous rate of change U’ times the original value V.
The product V’U is clear i.e. it is the instantaneous rate of change V’ times the original value U.
Now U’V’ is a problematic. It is NOT the product of (u/x) and (v/x) as x approaches zero. It is either (u/x)*v or (v/x)*u as x approaches zero.
Let us first look at (u/x)*v. As x approaches zero, (u/x) approaches the limit or instantaneous rate of change of U and v approaches zero. Therefore, (u/x)*v = zero as x approaches zero.
Therefore, (u/x)*v = zero as x approaches zero. Similarly, by the same argument, (v/x)*u = zero as x approaches zero. Accordingly, the product rule of differentiation is given by:

If Y = UV, then Y’ = U’V + V’U [ 3.1 ]

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 Calculus Fundamentals

4. Quotient Rule of Differentiation

If Y = U/V, and f(X) = Y, g(X) = U and h(X) = V, then Y+y = (U+u)/(V+v) = for a small change in X.
2
Y+y – Y = y = (U+u)/(V+v) – U/V = (UV +uV – UV – Uv)/(V(V+v)) = (uV – Uv)/(V +vV)
By the theorem of differentiation in 2.1, the instantaneous rate of change;
2 2
Y’ = (U’V + V’U)/(V +V’V) [ i.e. y/x = ((u/x)V – (v/x)U)/(V + v*V) ]. As x approaches zero, v =0, and, v*V = 0). Accordingly, the quotient rule of differentiation is given by:

-2
If Y = U/V, then Y’ = (VU’ – UV’)V [ 4.1 ]
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 Calculus Fundamentals

5. Chain Rule of Differentiation

mn m n n-1
If Y = a(X ) , let U = X , then Y = aU , then (y/x) = anU * (u/x)
m n-1 m-1 mn –m+m-1 mn-1
= an(X ) * mX = amnX = amnX

mn mn mn-1
Proof: Y = a(X ) = aX . Y’ = amnX
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 Calculus Fundamentals
Le t us s ta rt wi th a n a mount of pri nci pa l , "S", a nd a n a nnua l i nte re s t ra te of "r".

A Solving for the continuous compounding factor for a Year:

I f i nte re s t i s ca l cul a te d once a ye a r, the n, the ne w a mount a t the e nd of the ye a r i s :

S(1) = S(1+r)^1 e .g. if r = 5% the n 1+r = 1.04500

Suppos e we wa nt to do more fre que nt compoundi ng of thi s one ye a r s ce na ri o:

I f we compound e ve ry month, the n the ne w a mount woul d be :

S(1) = S(1+r/12)^12 e .g. if r = 5% the n (1 + r/12)^12 = 1.04594

I f we wa nt to i ncre a s e the fre que ncy of compoundi ng to "n" ti me s , the n the ne w a mount woul d be :

S(1) = S(1+r/n)^n i f we wa nt to compound e ve ry i ns ta nt, the n "n" ==> i nfi ni ty

For conti nuous compoundi ng, "n" a pproa che s i nfi ni ty a nd:

We s ol ve for Li mi t: (1+r/n)^n a s n ==> i nfi ni ty

Le t r/n = h, the re fore a s n ==> i nfi ni ty, h ==> ze ro.

We ca n re -wri te the Li mi t: (1+h)^r/h a s h ==> 0 OR ((1+h)^(1/h))^r a s h ==> 0

Ne xt, we wa nt to re -a rra nge the e xpre s s i on by l e tti ng h = 1/w, gi vi ng us ((1+(1/w))^w)^r
The n, for conti nuous compoundi ng, the Li mi t: ((1+(1/w)))^w)^r a s w ==> i nfi ni ty

Now, thi s l ooks fa mi l i a r…. (1 + (1/w))^w ==> tha t's the formul a for the na tura l "e " PROOF: Le t "w" a pproa ch i nfi ni ty, s a y 1,000,000,000
The n, (1 + 1/w)^w woul d be = 2.718282030815
The re fore , the s i mpl i fi e d e xpre s s i on of conti nuous compoundi ng for a ye a r i s : na tura l "e " {a pprox.}
e^r

Accordi ngl y, the ne w a mount wi th conti nuous compoundi ng for a ye a r i s :

S(1) = S*(e^r) For e xa mpl e , i f "r" = 4.50% "S" = $ 100.00 $ 104.60
S*(e ^r)

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 Calculus Fundamentals

B What if you wish to have continuous compounding for other than one year (i.e. 1/4 of a year or 10 years)?

If it's for 10 years, the expression is = S*(e^r)*(e^r)…(e^r); where (e^r) is done 10 times = S*(e^(10r))

If it's for 3 months, the expression is = S*(e^(r/4)), where (e^(r/4)) is for partial year

Therefore, for "n" years of continuous compounding, the general expression is:
e^(rt)

CONCLUSION:

In our option pricing formula, the present value for an instrument that expires in time "t": Note: FV = PV*(e^(rt)), therefore, PV = FV*(e^-(rt))

SA (adjusted for expected dividend yield) = SU (spot or unadjusted price) * (e^-(dividendrate*time))

C SA = S*(e^-(dt)), where S = spot price, d = dividend yield, e=natural "e", t = time in years

X0 (PV of expiration Strike Price) = X (Strike Price at expiration) * (e^-(riskfreerate*time))

D X0 = X*(e^-(rt)), where X = strike/exercise price at expiration, r = risk-free interest rate, e=natural "e", t = time in years

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 Calculus Fundamentals

E How do you convert a discrete compounding factor to its stochastic equivalent?

A discrete compounding factor can be shown as: (1 + d)t where d = compounding rate at fixed intervals, t = total time interval

rt
A continuous compounding factor is shown earlier as: e where r = continuous compounding rate

t
Accordingly, to find r (the continuous equivalent of d); (1 + d) = ert

Therefore, r = ln(1+d)

e.g. If the annual rate d = 5.0% then r = ln(1+5%) = 4.9%

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