Numerical Techniques in Finance by

Simon Benninga: A Solution and Study

Manual
R.E. Salvino

4329 Thistlewood Terrace

Burtonsville MD 20866
1995 - reformatted: 2 Apr 2013
Abstract
This study guide and solution manual is incomplete and oered in
an as is condition. It was written nearly 20 years ago when I began
a self-study program in nance in anticipation of a career shift. This
career shift never happened and is one of two reasons this guide and
manual was not completed. While writing solutions to the problems,
it occurred to me that the publisher, MIT Press, might be interested
in a solution manual to Professor Benningas book. While MIT Press
was interested in such a solution manual, Professor Benninga felt his
book was near the end of its life cycle and, consequently, a solution
manual would not be particularly helpful. This was the second reason
the study guide and solution manual was abandoned.
Keywords: nance, numerical techniques in nance, numerical nance,
nancial simulations
Table of Contents
I CORPORATE FINANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
1 Simulating Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2 Analyzing Mergers and Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3 Debt Capacity and Riskless Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4 Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Current address: 9 Thomson Lane, 15-06 Sky@Eleven, Singapore 297726.

1
5 Financial Analysis of Leveraged Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
II PORTFOLIO PROBLEMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
6 Portfolio Models - An Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
7 Calculating the Variance-Covariance Matrix . . . . . . . . . . . . . . . . . . . . . . . . . 23
8 Calculating Ecient Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
9 Estimating Betas and the Security-Market Line . . . . . . . . . . . . . . . . . . . . . 23
10 Entering Portfolio Information - A Macro . . . . . . . . . . . . . . . . . . . . . . . . . . 25
11 References for Portfolio Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
III OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
12 The Normal Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
13 The Lognormal Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
14 Simulating the Normal and the Lognormal Distributions . . . . . . . . . . . 31
15 Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
16 Portfolio Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
IV DURATION AND IMMUNIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
17 Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
18 Immunization Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
V THE TECHNICAL BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
19 The Gauss-Seidel Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
20 The Newton-Raphson Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
21 Matrices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
22 Random Number Generators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
23 Lotus Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
24 Macros in Lotus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
25 Data Table Commands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2
PART I: CORPORATE FINANCE
1 Simulating Financial Statements
1.1 Introduction.
We begin with a summary of the main points in the chapter together with
a recasting of the discussion into basic algebraic terms. Financial statement
models may be considered as belonging to one of two main classes:
(a) Models which assume the rm wishes to maintain a given ratio of debt
to equity in its balance sheet (Warren & Shelton, 1971)
(b) Models which assume the rm wishes to maximize its value subject to
a set of nancing constraints (Myers & Pogue, 1974)
Models of type (b) are preferable to models of type (a), but type (a) models
are more widespread.
The Warren & Shelton model assumes that most balance sheet items are
directly or indirectly related to sales and that the rms primary nancing
concern is to maintain an appropriate balance between the value of debt and
the value of equity in its balance sheet.
1.2 How Financial Models Work: Theory and Examples.
To set up such a model, we begin by dening a set of ratios of various quan-
tities to sales: (1) current assets to sales, (2) current liabilities to sales, (3)
net xed assets to sales, (4) expenses (excluding interest and depreciation)
to sales, and (5) debt to equity ratio,
R
ca
(n) =
A
c
(n)
S(n)
(1.1)
R
cl
(n) =
L
c
(n)
S(n)
(1.2)
R
nfa
(n) =
A
nf
(n)
S(n)
(1.3)
3
R
ex
(n) =
E
ex
(n)
S(n)
(1.4)
R
DE
(n) =
D
LT
(n)
E
eq
(n)
(1.5)
where A
c
(n) are current assets, S(n) are sales, L
c
(n) are current liabilities,
A
nf
(n) are net xed assets, E
ex
(n) are expenses excluding interest and de-
preciation, D
LT
(n) is long term debt, E
eq
(n) = E
s
(n) +E
r
(n) is the equity,
E
s
(n) is the stock component of equity, and E
r
(n) is the retained earnings
component of equity, all for the n
th
year.
We must distinguish between (1) those nancial statement items that are
functional relationships of sales and of other nancial statement items and
(2) those that involve policy decisions. The asset side of the balance sheet
is usually assumed to be dependent on functional relationships; current li-
abilities may also be taken as functional relationships only; and the major
policy decision is the target ratio of long-term debt to equity for each year.
To handle the troublesome modeling of xed assets and depreciation, we
assume (1) a depreciation policy that depreciates all xed assets over a
specied life span (T
d
, e.g., 10 years) using straight line depreciation and
(2) that new assets are purchased at the end of year (so that items acquired
in year n are rst depreciated in year n+1). The accumulated depreciation
is given by
D
acc
(n) = D
acc
(n 1) +
A
fac
(n 1)
T
d
(1.6)
where D
acc
(m) is the accumulated depreciation for year m, A
ac
(m) are the
assets at cost for year m, and T
d
is the average depreciable life span of the
assets.
The index value m = 0 corresponds to the current year; the value for sales for
the current year, S(0), is given; the sales growth rate, G
S
, the growth of sales
per year, is given; nally, the nancial statement relations contained in the
above ratios are anticipated, that is, they are assumed given. The nancial
statement can then be summarized by the following set of equations:
Assets
A
c
(n) = S(n)R
ca
(n) (1.7)
4
A
fac
(n) = A
nf
(n) +D
acc
(n) (1.8)
D
acc
(n) = D
acc
(n 1) +
A
fac
(n 1)
T
d
(1.9)
A
nf
(n) = S(n)R
nfa
(n) (1.10)
A
Tot
(n) = A
c
(n) +A
nf
(n) (1.11)
where A
fac
(n) are xed assets at cost and A
Tot
(n) are the total assets for
year n.
Liabilities
L
c
(n) = S(n)R
cl
(n) (1.12)
D
LT
(n) = R
DE
(n)(E
s
(n) +E
r
(n)) (1.13)
E
s
(n) = E
s
(n 1) + E
s
(n) (1.14)
E
r
(n) = E
r
(n 1) + E
r
(n) (1.15)
L
Tot
(n) = L
c
(n) +D
LT
(n) +E
s
(n) +E
r
(n) (1.16)
where the sales for year n is S(n) = S(0)(1 + G
s
)
n
, the addition to stock
equity is E
s
(n), the addition to retained earnings is E
r
(n), and L
Tot
(n)
are the total liabilities for year n.
Unknowns
The unknowns in the balance sheet, considered as the primary unknowns,
are the increase in stock equity, total new debt, and the new debt (the
addition to total new debt),
E
s
(n) = A
Tot
(n) L
c
(n) D
LT
(n) E
s
(n 1) E
r
(n) (1.17)
5
D
TN
(n) = D
LT
(n) D
LT
(0)(1 P
d
n) (1.18)
D
TN
(n) = D
TN
(n) D
TN
(n 1) (1.19)
D
TN
(0) = 0 by denition for the case where new debt is raised at the
beginning of the year.
Income Statement
The remaining part of the nancial statement, the prot and loss or income
statement, can be summarized by the following equations:
E
ex
(n) = R
ex
(n)S(n) (1.20)
I(n) = D
LT
(0)(1 P
d
n)r
c
+D
TN
(n)r
new
(1.21)
E
depr
(n) = D
acc
(n) D
acc
(n 1) =
A
fac
(n 1)
T
d
(1.22)
P
BT
(n) = S(n) E
ex
(n) I(n) E
depr
(n) (1.23)
P
AT
(n) = P
BT
(n)(1 T
r
) (1.24)
P
Div
(n) = P
AT
(n)P
o
(1.25)
E
r
(n) = P
AT
(n) P
Div
(n) = P
AT
(1 P
o
) (1.26)
where I(n) is the interest paid in year n, r
c
is the current interest rate on
debt, r
new
is the new interest rate on newly generated debt, P
d
is the fraction
of old debt to be paid in each year, E
Depr
(n) is the yearly depreciation,
P
BT
(n) are the prots before taxes, P
AT
(n) are the after tax prots, T
r
, is
the rms tax rate, P
Div
(n) are the stockholder dividends, P
o
is the dividend
payout ratio, and E
r
(n) is the addition to retained earnings for year n.
Policy decisions are related to stipulated values for ratios such as R
DE
(n),
that is, the values these ratios should have over the periods of interest are
constraints on the model. For example, in the model presented in the chap-
ter, the policy decision is related to the behavior of R
DE
(n) over a 5 year
period: it is assumed that R
DE
(n + 1) = R
DE
(n) 0.02 for n 5 so that
R
DE
(0) is reduced to R
DE
(5) = R
DE
(0) 0.1.
6
1.3 Setting Up and Solving the Model.
This set of equations for the nancial statement model may be solved alge-
braically by the substitution method. This will give a closed form solution
which can be used as a check on purely numerical methods to generate ac-
curate solutions. First, in the equation for new stock, we can substitute the
expression for stock and solve for new stock,
E
s
(n + 1) =
A
Tot
(n + 1) L
c
(n + 1)
1 +R
DE
(n + 1)
E
s
(n) E
r
(n + 1) (1.27)
The only quantity on the right hand side which is unknown at this level of
the indexing is the retained earnings, E
r
(n + 1). Since
E
r
(n + 1) = E
r
(n) + E
r
(n + 1) (1.28)
This means that the additional retained earnings part of the statement must
be found. If we dene the temporary variable,
F(n + 1) =
A
Tot
(n + 1) L
c
(n + 1)
1 +R
DE
(n + 1)
(E
s
(n) +E
r
(n)) (1.29)
F(n + 1) =
A
Tot
(n + 1) L
c
(n + 1)
1 +R
DE
(n + 1)

D
LT
(n)
R
DE
(n)
(1.30)
then the equation for new stock may be written simply as
E
s
(n + 1) = F(n + 1) E
r
(n + 1) (1.31)
Furthermore, if we dene the auxiliary variables,
A(n+1) (S(n+1)E
ex
(n)E
depr
(n+1)D
LT
(0)(1P
d
(n+1)) (1.32)
B(n + 1) R
DE
(n + 1)(E
s
(n) +E
r
(n)) (1.33)
7
G(n+1) =

(A(n + 1)(r
c
r
new
) B(n + 1)
(1 +R
DE
(n + 1)r
new
(1 T
r
)(1 P
o
))

(1T
r
)(1P
o
)) (1.34)
then the equation for the additional retained earnings, obtained from the
income statement, can be written as
E
r
(n+1) = G(n+1)
R
DE
(n + 1)r
new
(1 T
r
)(1 P
o
)
[1 +R
DE
(n + 1)r
new
(1 T
r
)(1 P
o
)]
E
s
(n+1)
(1.35)
These equations for the additional retained earnings and new stock can be
solved in closed form to obtain
E
s
(n + 1) = (1 +R
DE
(n + 1)r
new
(1 T
r
)(1 P
o
))
(F(n + 1) G(n + 1)) (1.36)
E
r
(n + 1) = G(n + 1) R
DE
(n + 1)r
new
(1 T
r
)(1 P
o
)
(F(n + 1) G(n + 1)) (1.37)
Now that we have these quantities, everything else in the nancial statement
can be obtained. Thus we have a closed form algebraic solution that can
be investigated in detail and used as a benchmark for purely numerical
solutions.
1.4 Where Do We Go From Here?
This is the basic type (a) model. Such a model requires considerable knowl-
edge of how the rm works and it may be too simple: these are its major
drawbacks. On the other hand, as more complexity is incorporated, more
guessing is required which generates more opportunities for mistakes, and a
simple model will have known faults and inaccuracies that render the simple
model transparent compared to a more complex model: these are the major
advantages of the simple model.
There are a number of more realistic elements that we may wish to consider
as modications to the basic algebraic model. Among these are the following
ideas:
8
(1) If a rm cant raise new equity, all new nancing must come from
additional debt, that is, no additional stock is generated E
s
(n) = 0.
This can actually simplify the implementation of the model.
(2) Break down current liabilities into payables (which bear no explicit
interest, although interest is implicit in extension of trade credit) and
bank loans (which bear explicit interest charges). The present model
pays no interest on current liabilities, only on long term debt.
(3) Break down current assets into various items: (1) accounts receivable
which are directly and linearly related to sales (some xed percent-
age of sales), (2) inventories (the optimal inventories increase with
the square root of sales according to operations research models: in-
ventories =

2aQK where a is the xed cost of reordering, k is the

unit carrying cost of inventory, and Q is the level of sales), and (3)
cash and market securities which are needed to complete day to day
transactions associated with the business: cash may be a complicated
function of sales (see Brealey and Myers) and marketable securites are
used to park excess cash and should not be directly related to sales.
(4) Break down xed assets, detail the classes of assets, their relation to
sales, and their depreciation schedules.
(5) Break down current liabilities into component liabilities.
(6) Improve the modeling of xed asset accounts.
Modeling Fixed Assets. Item (6), however, is a dicult improvement to
achieve. The present xed assets model assumes that assets do not die and
must be removed from the depreciable base. This is troublesome to model.
Once accumulated depreciation fully deprciates old assets, the old assets
should be removed from the books: they are dead. This may be termed the
actual xed assets account, but it should be remembered that depreciation
is not commonly accepted as reecting the actual economic use of assets.
However, the actual xed assets model may be considered a better version
of the present xed assets model. If the ages of all assets were known and
depreciation schedules were known, the actual xed assets model could be
implemented into a more accurate model: but this is unrealistic and negates
the purpose of nancial statement modeling, that is, obtaining a simplied
but realistic snapshot of a rm at dierent stages in the future. Thus, the
options for modeling xed assets are:
9
(a) Stick with the old model as long as it is not stretched too far into the
future and the initial asset base is not too old.
(b) If assets have a constant, depreciable life, in the long run the xed
assets at cost can be modeled by A
fac
= A
nf
/(1
1
T
d
).
1.5 Exercises
1. Generate the model described in the chapter. Assume that current lia-
bilities bear no interest.
The policy decisions or anticipations are summarized by the ratio
statements,
R
ca
(n) = R
ca
(0) = 0.15 (1.38)
R
cl
(n) = R
cl
(0) = 0.08 (1.39)
R
nfa
(n) = R
nfa
(0) = 0.77 (1.40)
R
ex
(n) = R
ex
(0) = 0.80 (1.41)
R
DE
(n) = R
DE
(0) 0.02n (1.42)
where R
DE
(0) = 0.5 and n 5. We may consider assigned values to any
of these ratios, either to remain xed in time or to decrease in time by a
specied amount, as policy decisions. Since these ratios are now considered
known, a method for solving the model can be chosen. In addition, the
initial sales are set at S(0) = 1000, the sales growth is set at G
S
= 0.10,
the initial long term debt is D
LT
(0) = 280, the current interest rate is
r
c
= 0.105, and this debt is to be repaid in annual equal installments over
5 years (P
d
= 1/5 = 0.2). The estimated new interest rate on any new debt
is r
new
= 0.095. The initial common stock balance is E
s
(0) = 450, and the
initial value of retained earnings is E
r
(0) = 110. The tax rate for the rm
is T
r
= 0.47.
These equations can not be solved yet until some further information
is obtained: for the current year, the quantitites A
fac
(0), D
acc
(0), and
E
Depr
(0) must be dened or additional previous history of the rm must
10
be available in order to calculate these quantities. Actually, since the net
xed assets A
nf
(0) is known, only one of A
fac
(0) or D
acc
(0) is needed in
addition to E
Depr
(0). In the text, it would appear that the following assign-
ments were made:
A
fac
(0) = 1100 (1.43)
E
Depr
(0) = 110 (1.44)
Consquently, D
acc
(0) = 330. The numerical results, rounded to the nearest
integer, are compiled in the table:
Balance Sheet
+ 0 1 2 3 4 5
+ A
c
(n) 150 165 182 200 220 242
+ A
fac
(n) 1100 1287 1500 1744 2020 2355
+ D
acc
(n) 330 440 569 719 893 1095
+ A
nf
(n) 770 847 932 1025 1127 1240
+ A
Tot
(n) 920 1012 1113 1225 1347 1482
+ L
c
(n) 80 88 97 106 117 129
+ D
LT
(n) 280 300 320 342 364 387
+ E
s
(n) 450 502 561 628 704 791
+ E
r
(n) 110 123 136 149 162 175
+ L
Tot
(n) 920 1012 1113 1225 1347 1482
Unknowns
+ E
s
(n) - 52 59 67 76 87
+ D
TN
(n) - 76 77 77 78 79
+ D
TN
(n) 0 76 152 230 308 387
Debt/Equity Ratio
+ R
DE
(n) 0.50 0.48 0.46 0.44 0.42 0.40
11
Prot and Loss Statement
+ S(n) 1000 1100 1210 1331 1464 1611
+ E
ex
(n) 800 880 968 1065 1171 1288
+ I(n) 29 31 32 34 35 37
+ E
Depr
(n) 110 110 129 150 174 202
+ P
BT
(n) 61 79 81 83 83 83
+ P
AT
(n) 32 42 43 44 44 44
+ P
Div
(n) 22 29 30 31 31 31
+ E
r
(n) 10 13 13 13 13 13
The calculation for new stock and new debt for the current year (E
s
(0)
and D
TN
(0)) either require knowledge for the previous year, since E
s
(1)
and E
r
(1) are needed for E
s
(0) and D
TN
(1) is needed for D
TN
(0),
or they must be assigned a value based on an assumption for the model,
such as D
TN
(0) = 0 for the present model that assumes new debt is raised
at the beginning of the year.
2. Now consider a dierent problem. The rm feels that it will not be able
to sell any new stock in the next ve years.
(a) If it pays no dividends, what will happen to its debt/equity ratio? As-
sume the same growth rate of sales as in the previous problem.
(b) What is the maximum annual growth rate of sales so that the rms
debt/equity ratio will not exceed 0.6?
(a) For this problem, the quantity E
s
(n) is known and equal to 0; the
debt/equity ratio R
DE
(n) is no longer determined by policy but is now an
unknown that takes the place of E
s
(n) in the algebra. Since E
s
(n) = 0,
E
r
(n) = F(n) (1.45)
E
r
(n) = G(n) (1.46)
where F(n) and G(n) are dened above. Eliminating E
r
(n) from these
equations determines R
DE
(n) in terms of known quantities. If we dene
auxiliary functions by
12
H(n) = [S(n) E
ex
(n) D
LT
(0)(1 P
d
n)(r
c
r
new
)]
(1 T
r
)(1 P
o
) (1.47)
H(n) = H(n) r
new
(1 T
r
)(1 P
o
)(A
Tot
(n) L
c
(n))+
E
s
(0) +E
r
(n 1) (1.48)
then the solution for the debt/equity ratio can be written as
R
DE
(n) =
A
Tot
(n) L
c
(n) E
s
(0) E
r
(n 1) H(n)
H(n)
(1.49)
This value of the debt/equity ratio is then used in the function F(n) to
determine E
r
(n),
E
r
(n) =
A
Tot
(n) L
c
(n)
1 +R
DE
(n)
(E
s
(0) +E
r
(n 1)) (1.50)
The only quantities which change for this problem, relative to the previous
problem, are on the liability side of the balance sheet (D
LT
(n), E
s
(n), and
E
r
(n)) and on the prot and loss statement (I(n), P
BT
(n), P
AT
(n), P
Div
(n),
and E
r
(n)). The numerical values are tabulated below:
Balance Sheet
+ 0 1 2 3 4 5
+ A
c
(n) 150 165 182 200 220 242
+ A
fac
(n) 1100 1287 1500 1744 2020 2355
+ D
acc
(n) 330 440 569 719 893 1095
+ A
nf
(n) 770 847 932 1025 1127 1240
+ A
Tot
(n) 920 1012 1113 1225 1347 1482
+ L
c
(n) 80 88 97 106 117 129
+ D
LT
(n) 280 325 372 442 516 601
+ E
s
(n) 450 450 450 450 450 450
+ E
r
(n) 110 151 191 230 267 301
+ L
Tot
(n) 920 1014 1110 1228 1350 1481
13
Unknowns
+ E
s
(n) - 0 0 0 0 0
+ D
TN
(n) - 101 103 126 130 141
+ D
TN
(n) 0 101 204 330 460 601
Debt/Equity Ratio
+ R
DE
(n) 0.50 0.54 0.58 0.65 0.72 0.80
Prot and Loss Statement
+ S(n) 1000 1100 1210 1331 1464 1611
+ E
ex
(n) 800 880 968 1065 1171 1288
+ I(n) 29 33 37 43 50 57
+ E
Depr
(n) 110 110 129 150 174 202
+ P
BT
(n) 61 77 76 73 69 64
+ P
AT
(n) 32 41 40 39 37 34
+ P
Div
(n) 0 0 0 0 0 0
+ E
r
(n) 32 41 40 39 37 34
There may be some propagation in rounding errors that can be eliminated
with more care in the computations.
(b) The requirement that the debt/equity ratio go no higher than 0.60,
that is, R
DE
(n) 0.6, places a constraint on the sales growth for a specied
maximum value of n (in this case, taken to be 5). The inequality produces
the condition that
[A
Tot
(n) L
c
(n)](1 0.6r
new
(1 T
r
)(1 P
o
)) 1.6H(n)
1.6(E
s
(0) +E
r
(n 1)) 0 (1.51)
If we dene the two auxiliary variables T
1
(n) and T
2
(n) by
T
1
(n) = [R
ac
(0) +R
nfa
(0) R
cl
(0)](1 0.6r
new
(1 T
r
)(1 P
o
))
1.6(1 R
ex
(0))(1 T
r
)(1 P
o
) (1.52)
T
2
(n) = 1.6[D
LT
(0)(1 P
d
n)(r
c
r
new
) +E
Depr
(n)](1 T
r
)(1 P
o
)
+ 1.6(E
s
(0) +E
r
(n 1)) (1.53)
14
then, upon substitution, eq. (1.51) may be written as
S(n)T
1
(n) T
2
(n) 0 (Ex2.9)
Consequently, sales must satisfy the inequality,
S(n)
T
2
(n)
T
1
(n)
(Ex2.10)
Since S(n) = S(0)(1 + G
s
)
n
, this may be taken to be a condition on the
sales growth G
s
. However, this requires knowledge of E
r
(n1) which is not
readily available unless the calculation is redone with G
s
an unknown.
A less computationally intensive approach is to note that a debt/equity
ratio of 0.6 lies between the results for years 2 and 3, R
DE
(2) = 0.58 and
R
DE
(3) = 0.65. If we consider sales as a function of the debt/equity ratio,
a simple linear interpolation gives S = S(2) + 1729(R
DE
0.58) and for
R
DE
= 0.6 this gives S = 1245. Thus, taking this value of sales as that cor-
responding to the ratio R
DE
= 0.6, then S(n) 1245 or G
s
(1.245)
1/n
1
since S(0) = 1000. Taking n = 5 as the maximum time into the future, the
sales growth must satisfy G
s
0.045 if the debt/equity ratio is to satisfy
R
DE
(n) 0.6 for n 5.
3. The model described in the chapter assumes that all new debt is raised
at the beginning of the year and that repayments od the old debt are made
at the beginning of the year. Somewhat inconsistently, it assumes that
new assets are acquired only at the end of each year - this is a didactic
compromise. Set out a model in which debt repayment is made at the end
of the year and in which new debt is likewise raised at the end of the year.
As stated, the model in the chapter assumes all new debt is raised at the
beginning of the year (n = 1, 2, 3, 4, 5) and repayment of old debt is also
made at the beginning of the year (n = 1, 2, 3, 4, 5). This can be inferred
from the fact that the interest payments on new debt and old debt are
I
new
(n) = D
TN
(n)r
new
(1.54)
I
c
(n) = D
LT
(0)(1 P
d
n)r
c
(1.55)
and the total long term debt is
15
D
LT
(n) = D
LT
(0)(1 P
d
n) +D
TN
(n) (1.56)
Interest paid on the new debt is calculated for the entire year, showing
the debt for year n was raised at the beginning of year n: year 0 shows
no new debt, so new debt for year 1 can not be raised at end of year 0.
Similarly, interest paid on the original debt is also calculated for the entire
year, showing the debt repayment for year n was made at the beginning
of year n: year 0 shows no principal repayment was made, so principal
repayment applied to year 1 can not be made at end of year 0.
To make debt repayments at the end of the year (n = 1, 2, 3, 4, 5)
requires no alteration of D
LT
(n) since new debt raised at the end of the
year n and repayment of the original debt at the end of the year n are still
applied to year n. However, interest on new debt raised in year n does not
accrue until year n + 1 and interest on the original debt is not reduced by
the principal repayment at the beginning of the year,
I
new
(n) = D
TN
(n 1)r
new
(1.57)
I
c
(n) = D
LT
(0)(1 P
d
(n 1))r
c
(1.58)
Again, the new debt, D
TN
(m), is raised at the end of year m and the
repayment of principal of the original debt, P
d
D
LT
(0), is also made at the
end of the year m. Consequently, the only required model statement change
is
I(n) = D
LT
(0)(1 P
d
(n 1))r
c
+D
TN
(n 1)r
new
(1.59)
Eq. (1.59) should be used in place of the equation for interest given above
in the summary, eq. (1.21). All other model statements remain the same.
4. Consider the following variation of the model of exercise 2: Let current
assets denote only current assets needed to support sales, and add another
current account called cash. Make the following additional assumptions:
the rm does not repay any debt, the interest on old debt and new debt is
the same (9.5 %), the ratio of net xed assets to sales is 0.65, the rm puts
retained earnings not needed to support sales into its cash accounts, and
cash earns 8.7 % interest. Build an appropriate model.
16
5. Find a rm whose nancial statements are available for the past 10
years. Go back to the last 5 years and try to gure out how the various
nancial statement items are related to the sales of the rm. Then build
a nancial statement model for the rm based on what you have learned.
Finally, compare the output of your model with the actual results for the
last 5 years.
2 Analyzing Mergers and Acquisitions
3 Debt Capacity and Riskless Cash Flows
4 Leasing
5 Financial Analysis of Leveraged Leases
17
PART II: PORTFOLIO PROBLEMS
6 Portfolio Models - An Introduction
6.1 Example.
We begin by dening the relevant quantities: E(R
i
) is the expected return
on asset i, Var(R
i
) is the variance of asset is return, Cov(R
i
, R
j
) is the
covariance between the returns of asset i and asset j, and the asset index i
runs from 1 to N
A
where N
A
is the total number of assets.
The closing price at the end of month t=0,1,2,... is denoted by P
A
(t)
with P
A
(0) denoting the initial price of the asset. The price return of an
asset earned by an investor who bought the asset at the end of month t 1
and sold it at the end of month t is dened as R
A
(t) = (P
A
(t) P
A
(t 1) +
Div(t))/P
A
(t 1) where Div(t) is the dividend payment made by the asset.
The heroic assumption that is made is that the average of historic data
represents the expected monthly return from the investment:
E(R
A
) =
1
N
t
Nt

k=1
R
A
(k) (6.1)
Var(R
A
) =
1
N
t
Nt

k=1
(R
A
(k) E(R
A
))
2
(6.2)

A
=

Var(R
A
) (6.3)
Cov(R
A
, R
B
) =
1
N
t
Nt

k=1
(R
A
(k) E(R
A
))(R
B
(k) E(R
B
)) (6.4)

A,B
=
Cov(R
A
, R
B
)

B
(6.5)
E(R
A
) is the expected return, Var(R
A
) is the variance of the return,
A
is the
standard deviation of the return, Cov(R
A
, R
B
) is the covariance of the return
of asset A with the return of asset B, and
A,B
is the correlation coecient.
18
The correlation coecient satises the inequalities 1
A,B
1 and
measures the degree of a linear relationship that may exist between the
returns of asset A and asset B. If
A,B
= 1 then R
A
(t) = a +bR
B
(t) where
b > 0; if
A,B
= 1, the R
A
(t) = a bR
B
(t) where b > 0. If R
A
(t) and
R
B
(t) are independent, then
A,B
= 0; however,
A,B
= 0 does not imply
that R
A
(t) and R
B
(t) are independent (its a necessary condition, but not
a sucient condition).
6.2 Calculating Portfolio Means and Variances.
For a two asset portfolio, the fraction of the portfolio in asset A will be
denoted by and consequently the fraction of the portfolio in asset B is
1 . The expected return, the variance, and the standard deviation of the
two asset portfolio are
E(R
p
) = E(R
A
) + (1 )E(R
B
) (6.6)
Var(R
p
) =
2
Var(R
A
) + (1 )
2
Var(R
B
) + 2(1 )Cov(R
A
, R
B
) (6.7)

2
p
=
2

2
A
+ (1 )
2

2
B
+ 2(1 )
A,B

B
(6.8)
The standard exercise is to plot E(R
p
) as a function of
p
for ranging
from zero to one.
6.3 Portfolio Means and Variances - General Case
The general case for mean and variance considers N
A
assets with
i
the
proportion of asset i in the portfolio so that

N
A
i=1

i
= 1. The asset weights

i
are used to construct a column and row vector:
=

2
.
.
.

N
A

(6.9)

T
= (
1
,
2
, . . . ,
N
A
) (6.10)
19
and corresponding column and row vectors are constructed from the ex-
pected returns of the N
A
assets
(R) =

E(R
1
)
E(R
2
)
.
.
.
E(R
N
A

(6.11)

T
(R) = (E(R
1
), E(R
2
), . . . , E(R
N
A
) (6.12)
Consequently, the expected return of the portfolio
E(R
p
) =

i
E(R
i
) (6.13)
can be written in matrix notation as
E(R
p
) =
T
(R) =
T
(R) (6.14)
The construction of the portfolio variance in matrix notation requires a little
more work. First we note that the portfolio variance is
Var(R
p
) =
N
A

i=1

2
i
Var(R
i
) +
N
A

i=1
N
A

j=1

j
Cov(R
i
, R
j
) (6.15)
where the double sum excludes the i = j term. Since Var(R
i
) = Cov(R
i
, R
i
),
this can be written as
Var(R
p
) =
N
A

i=1
N
A

j=1

j
Cov(R
i
, R
j
) (6.16)
where the double sum includes the i = j term. Another way to write the
portfolio variance is by restricting one of the double sum indices:
Var(R
p
) =
N
A

i=1

2
i
Var(R
i
) +
N
A

i=j+1
N
A

j=1

j
Cov(R
i
, R
j
) (6.17)
20
Now we construct a covariance matrix, S
ij
= Cov(R
i
, R
j
), S
ii
= Var(R
i
) =
Cov(R
i
, R
i
) so that the portfolio variance may be written as
Var(R
p
) =
N
A

i=1
N
A

j=1

j
S
ij
(6.18)
Since the matrix elements for S are
S =

S
11
S
12
... S
1N
A
S
21
S
22
... S
2N
A
.... .... ... ....
S
N
A
1
S
N
A
2
... S
N
A
N
A

(6.19)
the portfolio variance can be written very compactly in matrix notation as
Var(R
p
) =
T
S (6.20)
Now, suppose that two portfolios consist of the same assets with the same
expected returns, variances, etc. but the portfolios are assembled with dier-
ent proportions for each asset. In other words, portfolio 1 has asset weights

i
while portfolio 2 has asset weights
i
. Then the covariance between the
two portfolios is given by
Cov(p
1
, p
2
) = S
T
= Cov(p
2
, p
1
) = S
T
(6.21)
where is the column vector dened above and is the column vector
formed from the
i
.
6.4 Ecient Portfolios.
An ecient portfolio is a portfolio of risky assets that gives the lowest vari-
ance of return of all portfolios having the same expected return. Alterna-
tively, an ecient portfolio is a portfolio of risky assets that gives the highest
expected return of all portfolios having the same variance. Mathematically,
an ecient portfolio minimizes the variance Var(R
p
) =

j

i

j
S
ij
sub-
ject to the constraints

i

i
E(R
i
) = E(R
p
) and

i

i
= 1.
The ecient frontier is the set of all ecient portfolios. It is the locus of
all convex combinations of any two ecient portfolios. This means that if
21
and are ecient portfolios, then so is any linear combination +(1)
where is some constant. Thus, we can nd the entire ecient frontier if
we can nd any two ecient portfolios.
The minimization process subject to the specied constraints leads to
the following equations:
E(R
k
) C =

j
S
kj
z
j
(6.22)

j
=
z
j

k
z
k
(6.23)
or, in matrix notation,
(R) CI = SZ (6.24)
where I is the identity matrix. Solving this equation for Z gives
Z = S
1
[(R) CI] (6.25)
Substituting two dierent values for the constant C gives two dierent vec-
tors and corresponding to two dierent ecienct portfolios. If corre-
sponds to portfolio 1 and corresponds to portfolio 2, then the covariance
between the two ecient portfolios is Cov(p
1
, p
2
) = S
T
. From these two
ecient portfolios, the entire ecient frontier can be obtained by
+ (1 ) (6.26)
where 0 1. If R
1
is the expected return for portfolio 1 () and R
2
is
the expected return for portfolio 2 (), then
R
1
= (R) (6.27)
R
2
= (R) (6.28)
E(R
p
) = R
1
+ (1 )R
2
(6.29)
Var(R
p
) =
2
Var(R
1
) + (1 )
2
Var(R
2
) + 2(1 )Cov(p
1
, p
2
) (6.30)
22
Exercises
7 Calculating the Variance-Covariance Matrix
Exercises
8 Calculating Ecient Portfolios
Exercises
9 Estimating Betas and the Security Market Line
9.1 Introduction.
The Capital Asset Pricing Model (CAPM) is an equilibrium model of capital
markets. Its main conclusion is the equilibrium relation between risk and
return given by the Security Market Line (SML):
E(R
i
) = R
f
+
i
[E(R
m
) R
f
] (9.1)
where E(R
i
) is the expected return on asset i, E(R
m
) is the expected return
on the market portfolio m, R
f
is the return on a risk-free asset, and
i
is
a measure of the riskiness of asset i. Formally, is a linear regression
coecient (slope) tting the expected returns of an asset to the expected
returns of the market as a whole. Formally,

i
=
Cov(R
i
, R
m
)
Var(R
m
)
(9.2)
An alternative version (Black, 1972) eliminates the assumption of the exis-
tence of a risk-free asset with the assumption of the existence of a zero-beta
asset:
E(R
i
) = E(R
z
) +
i
[E(R
m
) E(R
z
)] (9.3)
where E(R
z
) is the expected return of an asset whose beta is zero,
z
= 0.
It should be noted that the SML should hold when the market portfolio m
is replaced by any ecient portfolio.
23
Thus, there are really two types of tests relating to CAPM. The rst
is a statistical test that determines whether we have an ecient portfolio
on which to run regressions. The second is an economic test to determine
whether the portfolio we picked is really the market portfolio. The steps
of the test are: (1) determine a candidate for the market portfolio m, such
as the S&P 500 Index, (2) for each asset in question, determine the assets
beta, and (3) regress the mean returns of the assets on their respective betas
to give the SML.
9.2 Testing the CAPM
The simple test of the CAPM consists of calculating s for a set of assets and
then determining the equation of the SML (this also requires the denition
of the market portfolio, such as the S&P 500). There exists an enormous
literature discussing the statistical and methodological pitfalls of this test:
the classic reference is Miller & Scholes (1972); Elton & Gruber (1984) and
Levy & Sarnat (1984) provide surveys.
9.3 Setting Up the Spreadsheet
9.4 An Alternative Method for Calculating Beta
As an alternative to the covariance approach for obtaining
i
, one may
regress the returns of asset i on the returns of the market, however the
market is dened (in this case, the S&P 500 is chosen as the candidate for
the market portfolio m).
i
is the slope of the linear regression line - the
two methods had better give the same result. But it seems to me that
the covariance approach is simply the formula for the linear regression that
yields the slope.
9.5 Estimating the Securities Market Line
Once all the
i
s have been determined, a second regression is then per-
formed. Dene the
i
s of the assets as the independent variables and the
mean returns of the assets as the dependent variables. A straight line is
then tted to these data pairs to yield the SML: Predicted Mean Return
on Asset i is C
1
+ C
2

i
where the constants C
1
and C
2
have been obtained
from this second regression.
24
9.6 Is Our Market Portfolio Merely Ecient?
Take an ecient portfolio as the market portfolio, compute the s and
mean returns for each of a number of other ecient portfolios and nd
excellent linear behavior, that is, a very good linear regression t. This
merely indicates that the market portfolio is an ecient portfolio, and any
other ecient portfolio would work as well (e.g., use the data on page 85
and on page 100).
Exercises
10 Entering Portfolio Information - A Macro
11 References for Portfolio Theory
Appendix: SML Minimization
As in statistical mechanics, we dene a function that is a linear combina-
tion of the function we wish to minimize and constraints with Lagrange
multipliers:
F =

i,j

j
S
ij
+
0

i
E(R
i
) +
0

i
(A.1)

0
and
0
are arbitrary constants in this minimization process. In particular,

0
has nothing to do with the beta of an asset, it is simply a Lagrange
multiplier here. Taking the derivative of F with respect to the portfolio
weights
k
gives
F

k
= 2

j
S
kj
+
0
E(R
k
) +
0
(A.2)
The symmetry of S
ij
has been used in obtaining this equation. The second
derivative of F is

2
F

l
= 2S
kl
(A.3)
25
The minimization process requires setting the rst derivative to zero,
E(R
k
) +

0

0
=
2

j
S
kj

j
(A.4)
Dening C =
0
/
0
and 2/
0
= 1 gives the equation we seek,
E(R
k
) C =

j
S
kj

j
(A.5)
26
PART III: OPTIONS
12 The Normal Distribution
12.1 Background
The cumulative normal probability or distribution function is the integral
of the normal probability or distribution density:
F(x) =

f(y)dy (12.1)
f(y) =
e
(y)
2
/2
2

2
2
(12.2)
The random variable x is normally distributed with a mean and variance

2
or standard deviation . The standard normal distribution is dened as
the normal distribution with zero mean and unit variance:
N(x) =

g(y)dy (12.3)
g(y) =
e
y
2
/2

2
(12.4)
This is simply obtained from the normal distribution by setting = 0 and
= 1.
A convenient and apparently widely used approximation to the standard
cumulative normal distribution is
N(x) = 1 h(x)t
4

i=0
b
i
t
i
+ (12.5)
h(x) =
e
x
2
/2

2
(12.6)
t =
1
1 +px
(12.7)
27
p = 0.2316419 (12.8)
< 7.5 10
8
(12.9)
and where the b
i
are given on page 114 of the text or in Handbook of Math-
ematical Functions by Abramowitz and Stegun. This is form of the ap-
proximation is valid for x > 0; for x < 0 the properties of the distribution
function show that N(x) = 1 N(x).
12.2 A Long Exercise
12.3 How To Prevent Your Spreadsheet From Thinking
Exercises
13 The Lognormal Distribution
13.1 A Crude Introduction
The price of any risky asset is uncertain. The question should not be what
is its price, but what is the probability distribution of its price. We may list
some reasonable properties: (1) the stock price is uncertain, (2) the stock
price is never zero, that is, we exclude dead companies, (3) the return from
holding a stock tends to increase over time, (4) changes in stock prices are
continuous: over short periods of time, changes in the stock price are very
small, tending to zero as t 0 (although it is possible to build occasional
and discontinuous random jumps into the model), and (5) the uncertainty
associated with the return from holding a stock also tends to increase over
time: given the stock price today, the variance of the stock price tomorrow
is small but increases as time goes on.
We will denote the stock price at time t by S(t). We will assume that
the price S(t + t) is comprised of two parts, one certain or deterministic
and the other uncertain or stochastic:
S(t + t) = S(t)e
(t+

tZ)
(13.1)
where is the average rate of growth (assumed constant over time), t is
the elapsed time interval, is the standard deviation of the stock price,
28
and Z is a standard random variable, that is, a random number drawn from
a normal distribution with zero mean and unit variance. The

t in the
random part guarantees that the variance of the stocks log return is linear
in t.
Note that if = 0, then the stock price grows at an exponential rate
with certainty, similar to a riskless bond that bears an interest rate and is
compounded continuously. For > 0, there is still a tendency for the stock
price to increase, but there is a normally distributed uncertain element that
must be taken into account.
13.2 Some Properties of Equation (13.1)
A simple manipulation of eq. (13.1) yields the log return of the stock:
ln(S(t + t)/S(t)) = t +

tZ (13.2)
If we now take the expected value of this equation, we nd that
E(ln(S(t + t)/S(t))) = t (13.3)
since the E(Z) = 0, that is, Z is drawn from a distribution with a zero
mean. Calculating the variance yields linear growth in t,
Var(ln(S(t + t)/S(t))) =
2
t (13.4)
since Var(Z) = 1, that is, Z is drawn from a distribution with unit vari-
ance. In other words, the logarithm of the stock price returns is normally
distributed with mean and variance
2
: this is termed the lognormal
distribution.
13.3 Calculating a Lognormal Distribution
We may calculate the density function of a lognormally distributed random
variable. First, we calculate the densities for the standard normal distri-
bution, for instance using the approximation described in Chapter 12. If
F
prob
(Z
0
) is the probability density that the standard normal random vari-
able Z will have the value Z
0
, then F
prob
(Z
0
) is the probability density that
29
the lognormal distribution will have the value exp(t +
2

tZ
0
). For
example, if Z
0
= 2.975, then F
prob
(Z
0
) = N(Z + Z
0
/2) N(Z Z
0
/2) =
0.000239. In other words, our approximation is to attach the probability of
an interval to its midpoint If = 0.2, = 0.5, and t = 1, then the value of
the lognormal density function is exp(0.2+0.5(2.975)) = 0.275959 occuring
with probability F
prob
(Z
0
) = 0.000239.
13.4 From Price Data to Distributional Parameters
Suppose we are given a set of data in the following form:
+ Month Closing Price 1+R log(1+R)
+ 0 25
+ 1 24.69219 0.987687 -0.01238
+ 2 23.68760 0.959315 -0.04153
+ 3 22.88975 0.966317 -0.03426
+ 4
+ 5
+ 6
+ 7
+ 8
+ 9
+ 10
+ 11
+ 12
The monthly mean is then =

i
log(1+R
i
) and the annualized mean is
simply 12 = 0.072874. The monthly standard deviation is calculated in the
usual way as the square root of the monthly variance, and the annualized
standard deviation is then

12 = 0.099871. In other words, we write

S(t + t) = S(t)e
R
(13.5)
which is actually provides the denition of the variable R:
ln R = ln(S(t + t)/S(t)) = t +

tZ (13.6)
In other words, ln R has mean and standard deviation since the monthly
time increments are t = 1:
30
E(ln R) = (13.7)
Var(ln R) =
2
(13.8)
(ln R) = (13.9)
This means that the end of the year price can be written as
S(12) = S(0)e
(R
1
+R
2
+R
3
+R
4
+R
5
+R
6
+R
7
+R
8
+R
9
+R
10
+R
11
+R
12
)
(13.10)
where S(0) is the beginning of the year price. If the log rates of return R
k
are independent, the then annual log return ln(S(12)/S(0)) has an expected
value of 12 and expected variance of 12
2
where and are the monthly
mean and standard deviation obtained from the monthly data.
13.5 Exercises
14 Simulating the Normal and Lognormal Distributions
14.1 Introduction
14.2 Simulating the Normal Distribution: A General
Description
The algorithm can be described in the following manner:
(1) Choose two random numbers, r
1
and r
2
, uniformly distributed between
-1 and +1
(2) Form the quantity S
1
= r
2
1
+ r
2
2
. If S
1
1 go back to step (1); for
S
1
< 1 go to step (3)
(3) From S
1
form the quantity S
2
= (2 ln S
1
/S
1
)
1/2
(4) Finally construct two independent random variables by x
1
= r
1
S
1
and
x
2
= r
2
S
2
: these random variables are from a normal distribution with
zero mean and unit variance.
31
14.3 The Macro Program
14.4 Some Output
14.5 Simulating the Lognormal Distribution
Since S(t + t) = S(t) exp(t + Z

t), it follows that S(t) is given

by S(0) exp(t +Z

t) so that
S(nt) = S(0)e
n(t+Z

t)
(14.1)
The quantities that are needed are todays price S(0), the annual log mean
return , the annual log standard deviation , and the time interval of
interest t. For instance, if the daily price behavior is wanted, then t =
1/250 since there are about 250 business days per year. Z is a random
variable obtained from the standard normal distribution with zero mean
and unit variance.
14.6 The Simulation
14.7 Technical Analysis
Security analysts are broadly divided into two groups. The fundamentalists
believe the value of a stock is ultimately determined by underlying economic
variables such as earnings, debt/equity ratio, markets, and so on. The tech-
nicians or technical analysts believe that stock prices are determined by
patterns and that they can predict future prices based on the patterns of
past behavior. The orthodox, ivory tower view of technical analysis is that it
is worthless. The ecient market hypothesis, that markets eciently incor-
porate information known about securities that are traded on the markets, is
a basic tenet of nancial theory. In its weakest form, the weak ecient mar-
kets hypothesis states that all information about past prices is incorporated
into the current price. If this hypothesis is correct, it immediately implies
that technical analysis can not make predictions of future prices since it is
based solely on past price information which is already incorporated in the
current price.
32
Exercises
3. Let e(t) = ln X(t) where X(t) is the exchange rate between two cur-
rencies. Then e(t) is normally distributed with an expectation value and
variance given by
E(e(t)) = (e(0) E)e
t
+E (14.2)
Var(e(t)) =
(e
2t
1)
2
2
(14.3)
where < 0 and E is the log og the purchasing power parity rate, that is, E
is the log of the exchange rate that equilibrates the cost of baskets of goods
in the two countries, E = ln X
eq
.
15 Option Pricing
15.1 Introduction
An option on a stock is a security that gives the holder the right to buy or
sell shares of the underlying stock on or before a predetermined date for
a predetermined price. A call is an option giving the holder the right to buy
shares of the stock. A put is an option giving the holder the right to sell
shares of the stock. The exercise price K is the price at which the holder of
the option can buy or sell the underlying stock. The expiration date T is the
date on or before which the holder can buy or sell the underlying stock. The
stock price S(t) is the price at which the underlying stock is selling at date
t. The option price is the price at which the option is bought or sold: C(t)
is the price of a call on date t and P(t) is the price of a put on date t. The
actual variable dependence of the options may be written as C(t, S(t), K, T)
and P(t, S(t), K, T).
There are two main types of options: American options and European
options. American options can be exercised on or before the expiration date
T, while European options can only be exercised on the expiration date T.
However, the options sold on both American and European options markets
are usually American options. A theorem relating to calls states that
early exercise is optimal only if the underlying stock pays dividends before
the expiration date; even then, early exercise is optimal only at the moment
33
before the dividend payment. In other words, most American call options
can be analyzed as if they were European call options.
For every buyer of an option there corresponds the writer of the option.
In other words, the purchaser of a call acquires the right to buy shares
of stock for a given price and pays for this right at the time of purchase.
Initially, there is a negative cash ow (the price of the option); the future
cash ow is at worst zero (if the option is not worth exercising) and otherwise
positive (if the option is worth exercising). The writer of the call sells the
right to buy shares of stock and collects the price of the option in return for
the obligation to deliver the shares of stock in the future at the exercise price
if the purchaser of the call exercises the option. Initially, the cash ow is
positive (the price of the option); the future cash ow is at best zero (if the
option is not exercised) and otherwise negative (if the option is exercised).
For example, GP Sept 50 call option is a security giving the holder
the right to buy shares of GP on or before a specied date in September for
$50. In most American markets, the date is the 3
rd
Friday in the month. If
the price of the GP Sept 50 call option today is $4, the buyer pays this
price for the privilege of purchasing shares of GP at $50 between now and
the specied date in September, no matter what price GP shares are selling
for at the time the option is exercised.
The purchaser of a put acquires the right to sell shares of stock for a
given price and pays for this right at the time of purchase. Initially, there
is a negative cash ow (the price of the option); the future cash ow is at
worst negative (if shares are not owned and the option is exercised), zero
if the option is not exercised, and at best positive (if shares are owned and
the option is exercised). The writer of the put sells the right to sell shares
of stock and collects the price of the option in return for the obligation to
buy the shares of stock in the future for the exercise price if the purchaser
of the put option wishes to exercise the option. Initially, the cash ow is
positive (the price of the option); the future cash ow is at best zero (if the
option is not exercised) and otherwise negative (if the option is exercised).
In contrast to calls, early exercise of American puts may be optimal even in
the absence of dividend payments.
For example, GP Sept 50 put option is a security giving the holder
the right to sell shares of GP in September (on or before the same day in
the month as the call) for $50. If the price of the GP Sept 50 put option
today is $2, the buyer pays this price for the privilege of selling shares of
GP for $ 50 between now and September, no matter what the market price
34
of GP shares are selling for at the time the option is exercised. The option
will be exercised only if the market price is less than $50, that is, less than
the exercise price.
In the payo patterns at expiration, the word prot is used loosely,
since it ignores costs associated with buying an asset: however, this is the
standard and traditional usage. The quantity S(0) denotes the price of stock
at date t = 0 and S(T) denotes the price of the stock at date t = T. The
prot from the stock is simply P
S
= S(T) S(0) while the prot from a call
is
P
call
= Max(0, S(T) K) C(0) (15.1)
where C(0) is the price of the call option and K is the strike price, and the
prot from a put is
P
put
= Max(0, K S(T)) P(0) (15.2)
where P(0) is the price of the put option and K is again the strike price.
In addition, for the case of the put, it is assumed that the holder of the put
has shares of the stock to sell, that is, that it is a covered put.
For example, suppose S(0) = $50, C(0) = $4, and P(0) = $2. Then the
payo patterns are given by
P
S
= S(T) 50 (15.3)
P
call
= 4(50 S(T)) + (S(T) 54)(S(T) 50) (15.4)
P
put
= (48 S(T))(50 S(T)) 2(S(T) 50) (15.5)
P
put
= (48 2S(T))(50 S(T)) 2(S(T) 50) (15.6)
where (x) is the unit step function ((x) = 1 for x > 0, (x) = 0 for
x < 0), the rst put payo is for a covered put, and the second is for an
uncovered put. The payo for a protective put or portfolio insurance
is the payo from the purchase of the stock at price S(0) and a put on the
same stock with a strike price set at the present price K = S(0),
35
P
pp
= (S(T) S(0)) + Max(S(0) S(T), 0) P(0) (15.7)
where the rst component is the stock payo P
S
and the last component
is the put payo P
put
for strike price S(0). This is an insurance policy
in that it limits the maximum loss to the put price P(0). As an example,
suppose that S(0) = K = $50 and P(0) = $2. Then the payo pattern is
simply
P
pp
= 2(50 S(T)) + (S(T) 52)(S(T) 50) (15.8)
This is an example of a combination of an option market position with a
spot market position. Combinations of option market positions with other
option market positions are commonly termed spreads.
A bullish spread consists of buying a call with a given exercise price and
writing a call on the same security but with a higher exercise price. The
payo pattern is
P
bull
= Max(S(T) K
L
, 0) C
L
+C
H
Max(S(T) K
H
, 0) (15.9)
where the subscripts L and H refer to low and high, respectively. The
rst component is the payo for the purchased call (low) and the second
component is the payo for written call (high). As an example, suppose
C
L
= $4, K
L
= $50, C
H
= $2, and K
H
= $55. Then the payo is
P
bull
= 2(50 S(T)) + (S(T) 52)
(S(T) 50)(55 S(T)) + 3(S(T) 55) (15.10)
Another combination is a bearish spread. This consists of buying a call with
a given exercise price and writing a call on the same security but with a
lower exercise price. The payo pattern is
P
bear
= Max(S(T) K
H
, 0) C
H
+C
L
Max(S(T) K
L
, 0) (15.11)
where,again, the subscripts L and H refer to low and high, respectively. The
rst component is the payo for the purchased call (high) and the second
36
component is the payo for the written call (low). For example, if we use
the same numerical values that were used to illustrate the bullish spread,
then the payo is
P
bear
= 2(50 S(T)) + (52 S(T))
(S(T) 50)(55 S(T)) 3(S(T) 55) (15.12)
A third common combination is known as a buttery spread. This consists of
buying two calls each with the same exercise price K
B
and selling two calls,
one with an exercise price K
1
and the other with an exercise price K
2
such
that K
1
+K
2
= 2K
B
. For concreteness, we will assume that K
1
< K
B
< K
2
.
The payo pattern is given by
P
butter
= 2(Max(S(T) K
B
, 0) C
B
) +C
1
Max(S(T) K
1
, 0)+
C
2
Max(S(T) K
2
, 0) (15.13)
The rst component is the payo for the two purchased calls, the second
component is the payo for the rst written call, and the last component
is the payo for the second written call. As a nal illustration of the types
of spreads that are possible, we consider a straddle. This consists of buying
both a put and a call on the same stock with the same exercise price and
the same expiration date. The payo pattern is
P
straddle
= Max(S(T) K, 0) C(0) + Max(K S(T), 0) P(0) (15.14)
where the rst component is the payo for the call and the second is the
payo for the put.
The factors that inuence the price of a call option are the exercise price
K, the expiration date T, and the behavior of the stock price S(t) on which
the option is written. The dependence of a call option on these factors can
be described in the following terms: (a) the higher the exercise price, the
less worthwhile to exercise the option and thus the lower the value of the
call option; (b) the higher the current price S(t), the more the option is
worth, the greater the probability that the option will be exercised; (c) the
37
more time left to exercise the option, T t, the greater the probability it
will be worth exercising and thus the higher the value of the option; and (d)
as the variability of the stock price S(t) increases, the probability that the
option can be exercised protably increases: usually we think of variability
as implying the risk of obtaining lower values, but the call option protects
the holder against downward movements of the stock price so that the holder
only cares about upward movements.
15.2 The Black-Scholes Equation for Option Pricing
The Black-Scholes equation for option pricing makes two major assumptions:
(1) it assumes the call option is an European option, written on a stock that
pays dividends and (2) it assumes the stocks price is lognormally distributed
with a lognormal standard deviation of . The equation depends upon the
standard deviation of the returns but not on the expected value of these
returns. If we dene S(t) as the stock price at time t, K as the exercise price,
T as the expiration date, = T t as the time remaining until expiration, r
as the risk-free interest rate, assumed to be continuously compounded and
expressed in terms compatible with (for example, both in annual terms),
and C(t) as the value of the call option, then the Black-Scholes pricing
equation for call options is
C(t) = S(t)N(d
1
) Ke
r
N(d
2
) (15.15)
d
1
=
ln(S(t)/K) + (r +
2
/2)

(15.16)
d
2
=
ln(S(t)/K) + (r
2
/2)

(15.17)
where N(x) is the cumulative standard normal distribution function. Note
that d
1
and d
2
are related by d
2
= d
2

. As a numerical example,
suppose S(t) = $50, k = $50, = 0.35, r = 0.08, and = 0.25 years.
In this case, d
1
= 0.20178, d
2
= 0.02678, and the cumulative functions
are N(d
1
) = 0.5800 and N(d
2
) = 0.5107. Since the exponential factor is
exp(r) = 0.9802, the call price is C(t) = $3.9693.
38
15.3 Pricing Puts
The put-call parity theorem strictly applies to European options. A Eu-
ropean put on a stock with an exercise price of K and expiration date of
T is equivalent to a portfolio in which four asset positions are combined:
(1) the purchase of a call on the stock with an exercise price of K and
expiration date of T (an initial cash ow of C(t) and terminal payo of
Max(S(T) K, 0); (2) the purchase of K exp(r) of riskless assets (having
payo of K at time T); (3) selling short of shares of the stock (having cash
ow of S(t) at time t and cash ow of S(t) at time T); and (4) writing
a European put on the stock (having positive cash ow P(t) at time t and
cash ow Max(K S(T), 0) at time T). The terminal cash ow of the
entire portfolio (elements (1), (2), (3), and (4)) is zero: (a) if S(T) K
then C(T) = 0, the riskless asset has value K, the stock has value S(T),
and the put has value (K S(T) which totals to zero; (b) if S(T) K,
then C(T) = S(T) K, the riskless asset has value K, the stock has value
S(T), and P(T) = 0 which also totals to zero. Arbitrage considerations
require that the total initial cash ow of the portfolio must also be zero,
C(t) K exp r +S(t) +P(t) = 0 which then yields the value of the put,
P(t) = C(t) S(t) +Ke
r
(15.18)
This is known as the put-call parity theorem. If we use the Black-Scholes
result for C(t) and the fact that 1 N(x) = N(x), this may be written as
P(t) = S(t)N(d
1
) +Ke
r
N(d
2
) (15.19)
where d
1
and d
2
are dened above.
15.4 Calculating the Implied Variance
Of all the variables in the Black-Scholes option pricing equation and analysis,
the most dicult to estimate is the volatility . A common exercise is to
perform the following calculation: given C(t), S(t), , and r, calculate the
implied that makes the pricing equation valid. There is no closed form
solution, and two numerical methods are typically pursued. The problem
can be simply stated in this way: rst, dene the function f() by
39
f() = S(t)N(d
1
) Ke
r
N(d
2
) (15.20)
and nd such that f() = C(t).
The rst method proceeds in the following way. Note that f() is mono-
tonic in , so that (f())
min
= f(0) where
f(0) = Max(0, S(t) Ke
r
) (15.21)
The algorithm is:
Step 1: choose a
1
and a
2
such that f(
1
) < C < f(
2
)
Step 2: compute = (
1
+
2
)/2. Clearly,
1
< <
2
Step 3: if f() < C, let
1
= ; if f() > C, let
2
=
Step 4: repeat step 2 until |f() C| is suciently small.
The second method uses the Newton-Raphson technique to nd the root of
the equation C f() = 0. This is an iterative procedure that takes the
form
(i + 1) = (i)
f((i) C
f

((i))
(15.22)
where i is the iteration index and the prime refers to the derivative with
respect to . It has been shown (Manaster & Koehler, 1982) that the initial
value

2
(0) =

ln(S(t)/K) +r

(15.23)
will always lead to convergence. The nal quantity needed to complete the
iterative procedure is the derivative f

() which, after some manipulation,

is given by
f

() =
df()
d
= S(t)

(d
1
) (15.24)
N

(x) =
e
x
2
/2

2
(15.25)
Exercises
40
PART IV: DURATION AND IMMUNIZATION
17 Duration
17.1 Introduction
Duration is a measure of how long, on the average, a holder of a bond has
to wait before receiving cash payments. From another point of view, it is
a measure of the sensitivity of a bonds price to changes in interest rates.
An immunization strategy is an outgrowth of the duration concept. Such a
strategy is one in which a portfolio of bonds is managed so that its value is
always as close as possible to the value of another asset, that is, it remains
xed.
We dene the bond payments C(t) for t = 1, 2, 3, ..., N as composed of
interest payments C(t) for t = 1, 2, 3, ..., N 1 and the nal payment C(N)
as the last interest payment plus the repayment of the principal. We can
then construct a time-weighted average of payments
< C >=
N

t=1
tC(t)
(1 + r)
t
(17.1)
The duration is dened as this time-weighted average of bond payments
expressed as a fraction of the bond price
D =
< C >
P
=
1
P
N

t=1
tC(t)
(1 + r)
t
(17.2)
P =
N

t=1
C(t)
(1 + r)
t
(17.3)
where r is the current market interest rate at the time the bond is purchased.
17.2 Two Examples
17.3 Using Duration to Measure Price Volatility
If we begin with the expression given above for the bond price,
41
P =
N

t=1
C(t)
(1 + r)
t
(17.4)
and take the derivative of the price with respect to the interest rate r, we
nd that
dP
dr
=
N

t=1
tC(t)
(1 + r)
t+1
=
DP
(1 + r)
(17.5)
It should be remembered that the meaning of dP/dr is the rate of change
of the bond price P with interest rate r. This equation gives rise to two
interpretations of duration: (1) the discount rate elasticity of bond price
D =
dP/P
dr/(1 + r)
(17.6)
and (2) the measure of price volatility of a bond
dP
P
= D
dr
(1 + r)
(17.7)
As an approximation, P DPr is typically used, but P DPln(1+
r) and ln P Dln(1+r) are better approximations over wider ranges
of the variables P and r. In the highly exceptional case that D may be
treated as independent of r, then the above equation may be integrated to
give
ln P = Dln(1 + r) + K (17.8)
P =
e
K
(1 + r)
D
(17.9)
where K is a constant of integration. These two equations can be used to
provide the basis of the better approximations given above.
42
17.4 Closed-form Formulas for Duration
For the case of a bond with unchanging coupon payments over time, C(t) =
C for all t, there are two closed-form formulas for duration. If we denote the
face value of the bond by F so that C(N) = C + F, then Chuas formula
for duration is
D =
1
P
_
C
_
(1 + r)
N+1
(1 + r) rN

r
2
(1 + r)
N
+
NF
(1 + r)
N
_
(17.10)
If we further dene the present value interest factor (PVIF) of an N period
annuity of $ 1 per period, discounted at the interest rate r as
PVIF(r, N) =
N

t=1
1
(1 + r)
t
=
(1 + r)
N
1
r(1 + r)
N
(17.11)
and note that the current yield of the bond is dened as y = C/P, then
Babcocks formula for duration is
D = N
_
1
y
r
_
+
y
r
PVIF(r, N)
_
1 + r
_
(17.12)
There are two so-called insights from Babcocks formula. The rst states
that duration is the weighted average of the bond and (1 + r) times the
PVIF associated with the bond. The second states that, in many cases, the
current yield y of the bond is not greatly dierent from the yield to maturity
r (y r) so that D (1 + r)PVIF(r, N).
17.5 Duration and the Yield to Maturity
Chuas formula for duration can be used to calculate the eect of changes
in the yield to maturity r on the duration D. In other words, plot D as a
function of r.
17.6 Calculating the IRR for Uneven Periods
A problem often encountered is to calculate the yield to maturity r of a
bond when payments are not evenly spaced.
43
Exercises
6. A sequence of bonds indexed by i = 1, 2, 3, ... all have the same maturity,
N, and the same yield to maturity r, but each bond has a dierent coupon,
C
i
. Show (using Babcocks formula) that the duration of these bonds may
be written as D
i
= N KC
i
where K = N (1 + r)PVIF(r, N). Produce
a graph of this curve for dierent values of C
i
(see Morrisey and Huang,
1987).
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PART V: THE TECHNICAL BACKGROUND
Chapter 19: The Gauss-Seidel Method
Exercises
Chapter 20: The Newton-Raphson Method
20.1 Introduction
20.2 Theory
20.3 Finding Minima and Maxima
20.4 Using Lotus to Set Up the Newton-Raphson Method
Exercises
Chapter 21: Matrices
21.1 Introduction
21.2 Matrix Operations
21.3 Matrix Inverses
21.4 Solving Systems of Simultaneous Linear Equations
21.5 Lotus and Matrices
Exercises
Chapter 22: Random Number Generators
22.1 Introduction
22.2 Testing the Lotus Random Number Generator
Exercises
Chapter 23: Lotus Functions
23.1 Introduction
23.2 @NPV
23.3 @IRR
23.4 @PV
23.5 @VLOOKUP
23.6 @INT
23.7 @MOD(A,B)
23.8 @PI
23.9 @ABS(x)
23.10 @SUM(range), @STD(range), @VAR(range), @COUNT(range)
23.11 @NOW
Chapter 24: Macros in Lotus
24.1 Introduction
24.2 A Simple Example
24.3 Some Basic Macro Rules
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24.4 An Advanced Macro
24.5 Macro Keywords
24.6 Examples
24.7 Minimizing Macro Execution Time
Exercises
Chapter 25: Data Table Commands
25.1 Introduction
25.2 An Example
25.3 Setting Up /Data Table 1
25.4 Using /Data Table 2
25.5 An Aesthetic Note: Hiding Unnecessary Cells
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