The Theory of Interest

Third Edition

Stephen G. Kellison
University of Central Florida

I McGraw-Hill
I Irwln
Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis
Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City
Mijan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

ement of interest
iction, 1
cumulation and amount functions, 2
fective rate of interest, 5
: interest, 7
>und interest, 8
t value, 13
fective rate of discountv 15
al rates of interest and discount, 22
of interest and discount, 28
g interest, 35
iry of results, 38
19
interest for fractional periods, 39
lund interest for fractional periods, 40

iroblems in interest

.49

iction, 49
sic problem, 50
MIS of value, 52
wn time, 55
wn rate of interest, 58
lining time periods, 60
al examples, 62

6
tion involving method of equated time, 66

XI

xii Contents

Basic annuities

73

3.1
Introduction, 73
3.2
Annuity-immediate, 74
3.3
Annuity-due, 79
3.4
Annuity values on any date, 83
3.5
Perpetuities, 86
3.6
Unknown time, 89
3.7
Unknown rate of interest, 93
3.8
Varying interest, 95
3.9
Annuities not involving compound interest, 98
Appendix 3, 106
Approximate formula for unknown rate of interest, 106
Exercises, 107
4

More general annuities

.r.
114
4.1
Introduction, 114
4.2
Differing payment and interest conversion periods, 114
4.3
Annuities payable less frequently than interest is convertible, 117
4.4
Annuities payable more frequently than interest is convertible, 121
4.5
Continuous annuities, 125
4.6
Payments varying in arithmetic progression, 127
4.7
Payments varying in geometric progression, 133
4.8
More general varying annuities, 137
4.9
Continuous varying annuities, 140
4.10 Summary of results, 142
Appendix 4, 143
Other formulas for annuities payable more frequently than interest is
convertible, 143
Alternative approach for payments varying in arithmetic progression, 144
Exercises, 146

Amortization schedules and sinking funds

5.1 Introduction, 152
5.2 Finding the outstanding loan balance, 153
5.3 Amortization schedules, 156
5.4 Sinking funds, 164
5.5 Differing payment periods and interest conversion periods, 170

152

Contents

5.6

Varying series of payments, 172

5.7

Amortization with continuous payments, 178

5.8

Step-rate amounts of principal, 181

xiii

Exercises, 185
Bonds and other securities
6.1

Introduction, 194

6.2

Types of securities, 194

6.3

Price of a bond, 200

6.4

Premium and discount, 206

6.5

Valuation between coupon payment dates, 213

6.6

Determination of yield rates, 219

6.7

Callable and putable bonds, 222

6.8

Serial bonds, 226

6.9

Some generalizations, 228

6.10

Other securities, 231

6.11

Valuation of securities, 234

194

->

Appendix 6, 238
?

Derivation of the bond salesman's formula, 238

Exercises, 240
Yield rates
7.1

Introduction, 248

7.2

Discounted cash flow analysis, 249

7.3

Uniqueness of the yield rate, 255

7.4

Reinvestment rates, 258

7.5

Interest measurement of a fund, 264

7.6

Time-weighted rates of interest, 269

7.7

Portfolio methods and investment year methods, 274

7.8

Short sales, 277

7.9

Capital budgeting - basic techniques, 281

7.10

Capital budgeting - other techniques, 286

Appendix 7, 295
Uniqueness of the yield rate, 295
Further analysis of the simple interest assumption in Section 7.5, 296
Interest measurement using continuous functions, 297
Exercises, 299

248

xiv Contents

Practical applications
8.1
Introduction, 309
8.2
Truth in lending, 310
8.3
Automobile financing, 316
8.4
Real estate mortgages, 326
8.5
Approximate methods, 333
8.6
Depreciation methods, 344
8.7
Capitalized cost, 352
8.8
Modern financial instruments, 355
Exercises, 364

15

10

309

More advanced financial analysis

9.1
Introduction, 373
9.2
An economic rationale for interest, 374
9.3
Determinants of the level of interest rates, 376
9.4
Recognition of inflation, 379
9.5
Consideration of expenses, 385
9.6
Effect of taxes, 391
9.7
Currency exchange rates, 397
9.8
Reflecting risk and uncertainty, 400
9.9
Interest rate assumptions, 408
Exercises, 411

373

The term structure of interest rates

10.1 Introduction, 419
10.2 Yield curves, 420

419

10.3 Spot rates, 424

10.4 Relationship with bond yields, 426
10.5 Forward rates, 431
10.6 Arbitrage, 437
10.7 A continuous model, 440
Exercises, 444

11

Duration, convexity and immunization

11.1
11.2
11.3

Introduction, 450
Duration, 451
Convexity, 458

450

Contents

11.4

Interest sensitive cash flows, 467

11.5

Analysis of portfolios, 470

11.6

Matching assets and liabilities, 476

11.7

Immunization, 480

11.8

Full immunization, 486

11.9

A more general model, 488

xv

Appendix 11, 491

Further analysis of varying annuities, 491
Exercises, 492

12

Stochastic approaches to interest

12.1

Introduction, 500

12.2

Independent rates of interest, 501

12.3

The lognormal model, 509

12.4

Time series models, 515

12.5

Binomial lattices, 520

12.6

Continuous stochastic models, 527

12.7

Scenario testing, 535

12!.8

More advanced models, 540

500

Appendix 12, 542

Derivation of the variance of annuity, 542
Exercises, 545
13

Options and other derivatives

13.1

Introduction, 551

13.2

Definitions and concepts, 552 "^

13.3

Position and profit diagrams, 556

13.4

Determinants of option value, 559

13.5

Combination positions, 563

13.6

Binomial lattices, 566

13.7

Black-Scholes formula, 574

13.8

Some extensions, 576

Appendix 13, 579

Derivation of the Black-Scholes formula, 579
Exercises, 582

551

xvi

Contents

Appendix A

Table numbering the days of the year

587

Appendix B

Illustrative mortgage loan amortization schedule

588

Appendix C

Basic mathematical review

592

Appendix D

Statistical background

595

Appendix E

Iteration methods

599

Answers to the exercises

'.

Glossary of notation
Index.

601
625

.'..

635