Quantitative Techniques

and
Financial Mathematics
CAIIB-Financial Management
Module A
C.S.BALAKRISHNAN
Faculty Member
S.P.B.T.COLLEGE

Concept Of Time Value Of

Money,
Net Present Value,
Discounted Cash Flow

Present value is a concept which

shows that money has time value.
Dealing with cash flows at different
points of time can be made easier
using a time line that shows both the
value and timing of cash flows.
Cash inflows are called positive cash
flows and cash outflows are called
negative negative cash flows.
Discount rate is a rate at which
present and future cash flows are
traded off.

The process of discounting future cash

flows converts them into cash flows in
present value terms.
The process of compounding converts
present cash flows into future cash flows.
The present value of Rs.1,00,000 a year
from now must be less thanRs.1,00,000
today.
Present value(pv)=Discount factor x C1
c1=cash flow at time t.
PV= CFt/(1+r)
Discount factor=1/(1+r)

Suppose you have two options of

investment
Option a-Investing in a property worth
Rs.4lac today and your investment is
expected to go upto Rs.5lac.
Option b-Invest in PPF to receive Rs.5 lac
after a year say @9%.One has to invest
Rs.5lac/1.09 which is Rs.4,58,715.59.
Thus one can infer that option a is better
than option b in the above case.

To calculate the present value,we discount

the expected payoff by the rate of return
offered by equivalent investment
alternatives in the capital or financial
markets.This rate of return is often called
as discount rate,hurdle rate or oppurtunity
cost of capital.
It is referred to as oppurtunity cost since it
is the return forgone by investing in the
project rather than investing in the
securities.In our example the oppurtunity
cost was 9%.Present value was obtained
by dividing Rs.5lac by 1.09.

PV=Discount Factor x C1=1/(1+r) x C1

=5LAC/1.09=Rs.4,58,715.59
Net Present Value=PV-Required Investment
NPV=Rs.4,58,715.59-Rs.4,00,00=Rs.58,715.59
NPV=C0+C1/(1+r).Where C0 is cash flow today
which will be negative.
Relation of risk to present value-We do not use
the same discount factor while comparing
alternative investment avenues.
The discount rate for PPF may be 9%,or 0.09
but discount rate for the building property may
be 11% or0.11.Only after present values are
calculated using two different discount rates is
the best investment avenue or project decided.

Return=Profit/Investment
=(Rs.5 lac-Rs.4.30lac)/Rs.4.30 lac.
=Rs.70,000/Rs.4.30lac
=0.163 about 16%
This cost of capital is once again the return
foregone by not investing in securities.If
the office building is as risky as investing in
stock market securities where the expected
return is 14% then the return forgone is
14%.Since the 16% return on the office
building exceeds the 14% oppurtunity
cost,one should go ahead with the project.

Net Present Value Rule-Accept

investments that have positive net
present values.
Rate of Return Rule-Accept investments
that offer rates of return in excess of their
oppurtunity cost of capital.
Discounting a cash flow converts it into
present value rupees and enables the
user to aggregate and compare.other
things remaining equal,the present value
of a cash flow will decrease as the
discount rate increases and continues to
decrease further into future cash flows.

Rule of 72-It is a shortcut to estimating the

compounding effect.A cash flow growing at
6% will double in value in approximately 12
years,while a cash flow at 9% will double in
value in approximately 8 years.
Effective Interest Rate=
(1+Stated Annual Interest Rate) -1
N
Where N=no.ofcompounding periods
eg:10%annual int.rate,if there is semi
annual compounding works out to an
effective rate of
=(1.05^2-1)=(1.1.025-1.0)=10.25%

Effect of compounding frequency on effective

interest rate
Frequency Rate(%) T Formula Effective
Annual Rate
(%)
Annual
10
1
10
10
Semi-annual10
2 (1+10/2)^2-1=10.25
Monthly
10
12(1+10/12)^12-1=10.47
Daily
10
365(1+10/365)^365=10.5156
Continous 10
continous e^10-1= 10.5171

As compounding becomes more frequent,the

effective rate increases,and the present
value of future cash flows decreases.
Under rule 72,how long will it take for an
investment to quadruple in value,if the
interest rate is 12%?
a)10 years b)15 years c)12 years d)17
years
In order to avoid taxes,my grandfather,starts
giving me gifts of Rs1lac for the next 10
years.If the interest rate is 6%,how much will
I get at the end of 10 years?
a)10 lac b)15 lac c)12 lac d)18 lac

A quarterly repayments of a loan carry an

interest rate of 8% per annum.What is the
effective annual rate of interest?
a)7.24% b)6.25% c)8.24% d)9.24%
Find the interest rate?Present value is
Rs100.Future value becomes Rs.115.76 in
3 years.
a)7% b)6%
c)8%
d)9%
If I take a loan of Rs8,000 and repay
Rs225 per month,for 4 years,what is the
effective annual rate on the loan?
a)15.25% b)15.35% c)15.58%
d)15.45%

Sampling Methods-Presentation of data

analysis and interpretation of dataHypothesis testing

Sampling is the integral tool of the

quantitative methods we use.
To take a sample from an entire population
and use it to describe a population.
To make sure the samples you take are an
accurate representation of the population
they come from.
To introduce the concepts of sampling
distribution.
To understand the trade offs between
costs of larger samples and accuracy.
To introduce experimental designSampling procedures-more information at
least cost.

Estimation-Data analysis and interpretation.

Testing of hypotheses- sample data.
Four methods of sampling
-Simple Random Sampling
-Systematic Sampling
-Stratified Sampling
-Cluster Sampling
Central Limit Theorem
The relationship between the shape of the
population distribution and the shape of the
sampling distribution of the mean is called The
Central Limit Theorem.

The central limit theorem is perhaps

the most important theorem in all of
statistical inference.It assures that
the sampling distribution of mean
approaches normal as the sample
size increases.
Which of the following is a method of
selecting samples from a population?
a)Judgement sampling b)Random
sampling c)Probability sampling d)All
of the above

In random sampling,we can describe

mathematically how objective our estimates
are.Why is this?
a)We always know the chance that any
population element will be included in the
sample.
b)Every sample always has an equal chance
of being selected.
c)All the samples are exactly the same size
and can be counted.
d)a and b but not c

Suppose you are performing stratified

sampling on a particular population and have
divided it into strata of different sizes.How
can you now make your sample selection?
a)Select at random an equal number of
elements.
b)Draw equal numbers of elements from
each
stratum and weigh the results.
c)Draw numbers of elements from each
stratum proportional to their weights in the
population.
d)(b) & (c) only.

The dispersionamong sample means is

less than the dispersion among the
sampled items themselves because
a)Each sample is smaller than the
population from which it is drawn.
b)Very large values are averaged down
and very small values are averaged
up.
c) The sampled items are all drawn
from
the same population.
d)None of these.

Suppose that a population with N=144 has

=24.What is the mean of the sampling
distribution of the mean for samples of size
25?
a)24
b)2
c)4.8 d)Cannot be
determined from the available information.
The central limit theorem assures us that
the sampling distribution of the mean is
a)Always normal b)Always normal for
large sample size c)Approaches normality
as sample size increases d) Appears normal
only when N is greater than 1,000

broader patrol checkpoint that

stops every passenger van is using
a)Simple Random Sampling
b)Systematic sampling
c)Stratified sampling
d)Complete enumeration

portion of the elements in a population

chosen for direct examination or
measurement
is a --------.(sample)

The proportion of population contained in

a sample is the ---------(sampling fraction)
------- sample should be used when each
group considered has small variation
within itself but there is wide variation
between different groups.(stratified).
--------is the degree of accuracy with
which the sample mean can estimate the
population.(precision)
Within a population,groups that are
similar to each other are called as-------(clusters)

Determine the sample size if standard

deviation is 6,population mean is 25 and
sample mean is 23.The desired degree of
precision is 99%.
a)60
b) 75
c) 90
d) 45
A sample size of 90 values has a mean 55
and standard deviation 3.A second sample
of 110 values has mean 60 and standard
deviation 2.Find the mean and standard
deviation of the combined sample of 200
values.
a)54.5;2.812 b)62;4.345 c)57.75;3.526
d)61.90;3.89

REGRESSION CORRELATION-TIME
SERIES

Regression is the measure of the

average relationship between two or
more variables.Regression analysis
refers to the methods by which
estimates are made of the values of a
variable from a knowledge of the
values of one or more variables.The
study of the functional relationship
between variables provides a
mechanism for prediction,estimating.

Variable which is used to predict the variable of interest is called independent variableand the variable we are trying to predict is called dependent variable.Generally,independent variable is
denoted by x and the dependent variable is denoted by y.
Simple linear regression analysis -Only one independent variable is used.We assume linear relationship between variables,this is a linear analysis.Linear means that the equation is in a straight line
form,like Y=ax+b

Uses of regression analysis-To estimate the relationship between

economic variable like price,demand, etc.
-Estimating errors in prediction of the
dependent variable.
-We can calculate the coefficient of
coorelation.
Coefficient of determination is the square
of coefficient of correlation.This measures
the degree of correlation exists between
two variables.

Assume the principal of a college wants

to find out whether there is a
relationship between the entrance
examination score to a college and final
graduation GPA score of a student.
Student
A B C D E F G
H
Entrance
Exam
74 69 85 63 82 60 79 91
Cumulative
GPA
2.6 2.2 3.4 2.3 3.1 2.1 3.2
3.8

When we view these points

together,we see that we can fit a
line through these scattered
points.We try to draw the line in such
a way,that an equal number of points
lie on either side of line.As X
increases (independent variableentrance score),Y also
increases(dependent variablecumulative GPA score).We can say
that there is a direct linear
relationship.

Curvilinear Relationship
In many industries we have heard of
curvilinear relationship.The principle
is that as the employees produce
more and more of a new product ,the
time required to produce one unit
decreases by some fixed proportion
as the total number of unit doubles.
No.of planes produced 5
10 20
40
No.of hours per plane 1000 800 640
512

TIME SERIES

The first step in making the estimates

for future consists of gathering
information from the past.Data is
collected,and recorded at successive
intervals of time.Such data are called
time series.
Time series helps in understanding
past behaviour.It also helps in
planning future operations as well as
current operations.The actuals can be
compared with expected results and
cause of variation can be analysed.

It is customary to classify the fluctuations

of a time series into four basic types of
variations.
a)Secular trend b)Seasonal variation
c)Cyclical variation d)Irregular variation.
Methods of trend analysis
-Free hand graphic method.
-Semi-average method.
-Moving average method.
-Method of least squares.

Light bulbs are manufactured in a

factory and have a mean life of 540
hours and std.deviation of 50
hours.Calculate the fraction of bulbs
that have less than 500 hours.
a)0.54
b)0.2119 c)0.4234 d)0.3555
The fraction of bulbs having life
between
500 to 600 hours.
a)0.6730 b)0.5478 c)0.7734 d)0.3487

The mean and standard deviation of

marks of students of a class are 55 and
8 respectively.Within what interval
centred around the mean do at least
90% of marks lie?
a)40 and 65 b)39 and 61 c)42 and 68
d)30 and 72
A binomial distribution has n=20 and
p=0.3.Find the mean and the variance
of the distribution.
a)8 and 3.4 b)4 and 2.6 c)6 and 4.2
d)12
and 4.4

Customer accounts at a certain cooperative

bank have an average balance of Rs 4,800
and a Standard Deviation of
Rs.1,600.Assume the account balances are
normally distributed.Calculate
a)What proportion of the accounts is over
Rs.6,000?
a)32% b)20% c)15.44%
d)22.67%
b)What proportion of the accounts are
between Rs4,000 and Rs.6,000?
a)46.49% b)52.34% c)62.33% d)34.65%

C)What proportion of the accounts is

between Rs.2,400 and Rs.3,600 ?
a)32.45% b)15.98% c)22.50% d)10.44%.
State whether true or false
Secular trend refers to long term of data.
Regular variations include only seasonal
variations.
Yearly data are independent of the effect
of seasonal variations.
The period of seasonal variations is always
one year.

Series of figures arranged in a

chronological
Order are called
a) Time series b)Trend c)Linear d)Best
Which is an irreversible movement and
continues in the same direction for
considerable period of time
a) Trend b)Time series c)Best d)Linear.
The trend equation fitted by the method
of least squares is known as the equation
of-----fit.a)Linear b)Best c)Trend d)Time
series

In the case of a -------trend,successive

observations differ by a constant number.
a)Time series b)Trend c)Best d)Linear
If in a year 20,000 boats are rented
out,average per quarter should be
Rs.5,000.If the index for spring quarter is
142,then we estimate the number of
boats rented out during the summer will
be 5,000X(142/100)
=7,100.

Probability distribution-confidence
interval analysis-Estimating parameters
of distribution

A point estimate is a single number that is

used to estimate an unknown population
An interval estimate is a range of values
used to estimate a population parameter.
Any sample statistic that is used to
estimate a population parameter is called
an estimator which is a sample statistic
used to estimate a population parameter.
An interval estimate describes a range of
values within which a population
parameter is likely to lie.

Bond Valuation

Bond prices vary inversely to change in

interest rates.
When the interest rate increases,and
goes higher than the coupon rate,then
the bond value decreases.This is because
the present value of payments received
decrease,leading to a fall in bond prices.
When the interest rate decreases,and
becomes lower than the coupon
rate,then the present value of payments
increases and the bonds market price
increases.

When the interest rate is equal to the

coupon rate,the market price of the bond
is equal to face value.In this case,the
bond is selling at par.
When the market price of bond is greater
than its face value,it is said that the bond
is selling at a premium.
RBI issues a bond with a par value of
Rs.1000,coupon rate 10% and the
maturity period is 10years.What will
happen when interest rate increases?
The price of the bond will fall.Coupon rate

Will not change .Yield to maturity

increases.The interest payment received
each year is only Rs.100 (no change).
What is interest rate risk?
A fall in interest rates will result in
increase in
bond prices.A rise in interest rates will
result in
decrease in bond prices.

A Rs.100 par value bond,bearing a

coupon rate of 12% will mature in 8
years.the required rate of return on this
bond is 14%.What is the value of this
bond?
a)92.87 b)90.77 c)102.76 d)78.89

A Rs.1000 par value bond has a coupon

rate of 14% will mature after 5 years.The
required rate of return on this bond is
13%.What is the value of this bond?
a)1035.4 b)1200.5 c)945.88 d)1060

LINEAR PROGRAMMING
DECISION MAKING

Linear programming is concerned with

efficient allocation of limited sources to
known activities,with the objective of
meeting desired goals such as
maximizing profits or minimizing cost.
Objective function is one in which we
mention the objective quantitatively and
express it as a linear function of the
variables.It can be for maximizing profits
or minimizing costs.
Optimal solution satisfies all the given
constraints.

Sensitivity analysis-It refers to the

study of effect of changes in various
parameters
(constraints)on the optimal solution.
State whether following statements are
true or false
a)The distinctive characteristic of linear
programming models is that the
functions
representing the objective and the
constraints are linear.

Non negativity constraints means the

products are not produced.
Inequality means that the capacity of
each operation should not be
exceeded.
For finding out the optimal mix and the
corresponding profit,linear
programming method is not useful.

SIMULATION

Simulation is an imitation of reality.A

number of experiments is performed on
simulated models to determine the
behaviour of the real system.Example:
Testing of aircraft models in wind tunnel,
Planetarium shows represent a simulation
of the planet system.
Advantages of simulation:
-We can foresee difficulties and
bottlenecks
which may come up in real system.
-This eliminates costly and risky trials

This allows experimenting with a model

of the system without interfering with
real system.
Simulation models are comparatively
flexible and can be modified to
accommodate the changing environment.
Monte Carlo method is a technique that
involves using random numbers and
probability to solve problems.The term
Monte Carlo Method was coined by
S.Ulam and Nicholas Metropolis in
reference to games of chance,a popular
attraction in Monte Carlo,Monaco.

State true or false

-Simulation is a replica of real life.
-Random numbers are not necessary for
inputs in a simulation model.
-Simulation is used when the problem is
not
complex,and there is a linear relationship
between the variables.
-Simulation involves many iterations,and
computers are useful in solving them.

objective questions