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10 FM 1 TN 4pp
10 FM 1 TN 4pp
Financial Mathematics
Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
Continuous Annuities
Relations and Recursive Formulas between Annuities
Financial Mathematics
Benjamin Avanzi1
1 University of New South Wales
Actuarial Studies, Australian School of Business
b.avanzi@unsw.edu.au
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Financial Mathematics
Financial Mathematics
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amount
timing
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how?
Financial Mathematics
Financial Mathematics
Procedure:
I
I
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"bring back or forth" all cash flows to the point of time you
have chosen
add them up
compare!
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Financial Mathematics
Financial Mathematics
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Financial Mathematics
Financial Mathematics
Mathematical model
Consider an amount of money invested for a period of time.
Time is money!
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t: the length of time for which the amount has been invested
A(t): amount function or accumulated amount function
Assuming these are two equivalent cash flows at two different point
in time, how can we link them using interest?
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Financial Mathematics
Financial Mathematics
Accumulation function
Effective Interest
We have
a(t + k)
A(t + k)
=
,
A(t)
a(t)
which means
A(t + k) = A(t)
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it,k =
a(t + k)
.
a(t)
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A(t + k) A(t)
a(t + k) a(t)
=
.
A(t)
a(t)
(1)
Financial Mathematics
Financial Mathematics
Homogeneity in time
Forms of interest
When the effective rate of interest is the same for all t, then we
have
a(t + k)
a(k)
=
= a(k)
a(t)
a(0)
A(t + k) = A(t)a(k)
it,k
=
=
A(t + k) A(t)
A(t + k)
=
1
A(t)
A(t)
a(t + k) a(t)
= a(k) 1.
a(t)
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
30/06/2010
01/01/2011
30/06/2011
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple Interest
Main difference:
I
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6=
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Numerical Example
Compound Interest
Accumulation function: for compound interest i,
a(t) = (1 + i)t ,
and the accumulated amount function after a period t is given by
A(t) = A(0) a(t) = A(0) (1 + i)t .
In this case, effective interest is homogeneous:
a(t + k) = (1 + i)t+k
or alternatively
a(t + k)
= (1 + i)k = a(k), t, k 0.
a(t)
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Numerical Example
General questions
1. What happens to the accumulation if i ?
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i ?
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Financial Mathematics
Financial Mathematics
Discount Interest
Discount Interest
Rate of Discount
I
I
I
and for d :
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Financial Mathematics
Financial Mathematics
Discount Interest
Discount Interest
=
=
Now: d
=
=
a(1) a(0)
a(0)
A(1) A(0)
= a(1) = (1 + i)
A(0)
a(1) a(0)
a(1)
A(1) A(0)
1
= a(1) =
A(1)
1d
Financial reasoning:
I
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
Numerical Example
Discount Interest
d
1d
i
=
1+i
= iv
= 1v
i
d
i d
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= id
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
Discount Interest
Intuition behind d = 1 v ?
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Intuition behind i d = id ?
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Financial Mathematics
Financial Mathematics
Nominal Interest
Nominal Interest
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Financial Mathematics
Financial Mathematics
Nominal Interest
Nominal Interest
i (m)
m
!m
i (m)
(1 + i) =
1+
m
h
i
i (m) = m (1 + i)1/m 1
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<
i (m) >i
??
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Financial Mathematics
Financial Mathematics
Nominal Interest
Nominal Interest
Numerical Example
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Financial Mathematics
Financial Mathematics
Nominal Interest
Nominal Interest
Exercise
Show that d (m) = i (m) vi
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Numerical Example
1
m
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Financial Mathematics
Financial Mathematics
Force of Interest
Force of Interest
Force of Interest
Consider
lim
I
I
I
!m
lim 1 + m
i (m)
m
i ()
= 1+i
+
2!
i ()
= e
or e ,
2
()
i (m)
1+
m
m (m 1)
2!
i ()
+
3!
i (m)
!2
+ ...
3
+ ...
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Financial Mathematics
Financial Mathematics
Force of Interest
Force of Interest
Force of Discount
We have
Similarly, consider
1
lim
d (m)
m
lim 1 m
= 1d
= e
1 d = e d
!m
()
d ()
and 1 + i = e i
Now
1d =v =
d (m)
m
d ()
+
2!
2
m (m 1)
2!
d ()
3!
d (m)
m
!2
()
1
.
1+i
Thus,
...
i () = d ()
and, in general,
3
+ ...
d < . . . < d (m) < . . . < d () = = i () < . . . < i (m) < . . . < i.
()
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Financial Mathematics
Financial Mathematics
Force of Interest
Force of Interest
Let
I
(t) =
4t0
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Financial Mathematics
Financial Mathematics
Force of Interest
Force of Interest
Numerical Example
Force of interest at time 0 is 0.04, and increases uniformly to 0.06
after 5 years. Find the amount after 5 years of an investment of $1.
ln A(s)|t0
s=0
= ln A(t) ln A(0)
A(t)
.
= ln
A(0)
Thus we have
Z
A(t) = A(0) exp
(s)ds
and
Z
a(t) = exp
(s)ds .
k
a(t + k)
= e 2 [(t)+(t+k)]
a(t)
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Financial Mathematics
Financial Mathematics
Inflation
Notation
Let
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Financial Mathematics
Financial Mathematics
Main relations
We have
and
p(0) = 1 and p(1) = 1 +
Thus, the value of accumulation at todays prices is given by
a(1)
1+i
=
.
p(1)
1+
Now, define
A(t)
A(0) =
(1 + )t
1+i
i
r =
.
1+
1+
Caution: this holds only for effective rates!
1+r =
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1
1+r
t
Financial Mathematics
Financial Mathematics
Example
To determine the price, we must be consistent. Either we work with
An investor will receive an asset in 10 years time with face value
$100,000. Given a nominal (money) interest rate of 9% p.a.,
quarterly compounding, and an expected inflation rate of 5% p.a.,
(also quarterly compounding), what should you pay now:
Method 2: the real value, and discount with the real interest
rate.
Asset 1 if the payment on the asset will not change, failing to increase
in line with inflation
.09/4 .05/4
= 0.9876543%
1 + .05/4
Asset 2 if the asset maintains its real value (an inflation indexed bond)
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Financial Mathematics
Financial Mathematics
Asset 1
Asset 2
Method 1:
Method 1:
PV
100, 000
=
40
1 + .09
4
= 41, 064.58
PV
40
Method 2:
Method 2:
100, 000
Real value =
40 = 60, 841.33
1 + .05
4
PV =
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60, 841.33
(1.00987654)40
PV
= 41, 064.57
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100, 000
(1.00987654)40
= 67, 494.54
Financial Mathematics
Financial Mathematics
Practical examples
...
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Note
I
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Financial Mathematics
Financial Mathematics
v=
1
1+i
= 1d
=
= d /i
Powers of the discount factor can be used to discount all cash flows
if interest is homogeneous with time
(which is the usual assumption)
See Broverman and Sherris for the main definitions and examples.
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1
a(1)
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Financial Mathematics
Financial Mathematics
Numerical Examples
Numerical Examples
Example 1
Consider a Coupon bond which pays $6 at times 1 and 2, and an
additional $100 at time 2. Find the Present Value of this bond at
8% p.a. effective interest.
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Example 2
In Australia, Short term Government securities such as Treasury
Notes and Treasury Bonds (less than 6 months to maturity) are
priced using simple interest and a 365 day convention.
Consider a Treasury-note with a face value of 500,000 and maturity
in 180 days time. Suppose that this is sold at a yield (interest rate)
of 6%p.a. What are the proceeds of the sale?
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Financial Mathematics
Financial Mathematics
f 0 (in ) =
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f (in )
f (in )
in+1 = in 0
in in+1
f (in )
2. determine f 0 (i)
3. choose initial value i0
4. perform recursions
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Numerical Example
Annuities: Introduction
Notation
(p)
ax:n i
m|
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction
Annuities: Introduction
Numerical example
A foundation has $100,000,000. Assuming a long term net return
on investments of 5% p.a., how much money can it use every year
without decreasing the capital?
Determine the annual payment if it is made in arrears or in
advance, and in the two situations:
1. the capital should not decrease in nominal terms
2. the capital should not decrease in real terms
Assume a long term inflation rate of 3% p.a.
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction
Numerical example
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Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
Numerical example
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
Numerical example
Term Annuities
Deferred annuity
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
Numerical example
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
Term Annuities
Alternative method
an i =
1
anp j
p
where j = (1 + i)1/p 1.
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
Numerical example
Term Annuities
Numerical example
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i (p)
.
p
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
Non-Level Annuities
Numerical example
Value the following set of cashflows at 10% p.a.: A payment of$10
at time 1, $20 at time 2, $30 at time 3, $40 at time 4. What is the
present value at time t = 0?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
Non-Level Annuities
Numerical example
Value the following series of payments at 10% p.a.:
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
Non-Level Annuities
Numerical example
You can invest in a bond that pays coupons that grow with
inflation. The coupon received at the end of the first year is
$25,000, and each annual payment will increase, with inflation, at
rate 2.5% p.a. There are 10 annual payments and the bond
matures in 10 years with a face value of $400,000 (not indexed to
inflation). What is the price of the bond at a valuation interest rate
of 8%p.a.?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
Non-Level Annuities
Numerical example
Determine the present value of a 10 year annuity with half-yearly
payments in arrears at rate 2 p.a. in the first year, 4 p.a. in the
second year, . . . , 20 p.a. in the 10th year. Use a 10% p.a.
convertible half-yearly compound interest rate.
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Financial Mathematics
Financial Mathematics
Non-Level Annuities
Non-Level Annuities
Decreasing annuity
Numerical example
Value the following set of payments at 10% p.a: $40 at time 1, $30
at time 2, $20 at time 3, $10 at time 4.
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Financial Mathematics
Financial Mathematics
Continuous Annuities
Continuous Annuities
Continuous annuity
Remember: a(t) = e
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Rt
0
(s)ds
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Financial Mathematics
Financial Mathematics
Continuous Annuities
Continuous Annuities
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Financial Mathematics
Financial Mathematics
an+k = ak + v k an
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sn+k = sk (1 + i)n + sn
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Financial Mathematics
Financial Mathematics
an+1 = v (1 + an )
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relations and Recursive Formulas between Annuities
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sn+1 = 1 + (1 + i)sn