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Financial Maths Notes PDF
Financial Maths Notes PDF
Financial Maths Notes PDF
Financial Mathematics
Jonathan Ziveyi1
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Financial Mathematics
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
Procedure:
make the cash flow clear; draw a time diagram
choose any point in time
now: present value, sometimes NPV (Net Present Value)
in the future: accumulated value
in the middle...
should be convenient: all are equivalent!
"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
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest
Time value of money How much would you pay to buy a security
that is guaranteed to give you $100 in 1 years time?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest
Time is money!
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest
Mathematical model
Consider an amount of money invested for a period of time.
A(0): principal = the amount of money initially invested
t: the length of time for which the amount has been invested
A(t): amount function or accumulated amount function
this is the accumulated amount of money at time t
corresponding to A(0)
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
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest
and then the effective rate of interest it,k for this same period is
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest
A(t + k) = A(t)a(k)
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest
Forms of interest
a(t) is modeled with the help of interest
effective interest is always defined as in (1.1)
however, interest can be expressed in many different ways,
depending on the situation (mainly conventions)
each way has a different set of assumption
each definition may lead to different forms for a(t)
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest
01/01/2011
30/06/2011
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest
a(t) = 1 + it,
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest
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
Simple and Compound Interest
Numerical Example
A Bank accepts deposits for terms up to 3 years and pays interest
on maturity. How much interest would it pay on a deposit of
$20,000 for a term of 1 year and 33 days if the interest rate is 5%
p.a. effective?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest
General questions
1. What happens to the accumulation if i ? i ?
2. What is the amount of interest earned during each unit period
under compound interest? simple interest?
3. What is the effective rate of interest during each unit period
under compound interest? simple interest?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
a(1) a(0)
Remember: i =
a(0)
A(1) A(0)
= = a(1) = (1 + i)
A(0)
a(1) a(0)
Now: d =
a(1)
A(1) A(0) 1
= = a(1) =
A(1) 1d
Financial reasoning:
At rate of compound interest of i% p.a. the discounted value
of an instrument is known. Is the compound rate of discount
that produces an equivalent discounted value higher or lower?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
1
1+i = .
1d
For simple interest:
1
a(t) = a(0)
1 dt
and for compound interest:
t
1
a(t) = a(0)
1d
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
Numerical Example
In the US Treasury Bills are quoted using simple discount on the
basis of a 360 day year.
Consider a US T-Bill with a face value of 500,000 and maturity in
180 days time. Suppose that this is sold to yield 6%p.a (simple
discount). What are the proceeds of the sale?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
d
i =
1d
i
d =
1+i
d = iv
d = 1v
i d = id
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
Intuition behind d = 1 v ?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest
Intuition behind i d = id ?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest
i (m)
m
is an effective rate of interest for a period of 1/m years.
Reminder:
the effective rate of interest for a period is the ratio between
1. the effective (actual amount of) interest earned and
2. the principal at the beginning of the period (for interest) or at
the end of the period (for discount).
i (m) , m > 1, is not an effective rate of interest
i is the effective rate of interest for a year, equivalent to i (m)
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest
<
i (m) >i ??
Can you use your financial reasoning to convince yourself which is
correct?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest
1
Exercise Show that d (m) = i (m) vi m
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest
We have
() ()
1 d = e d and 1 + i = e i .
Now
1
1d =v = .
1+i
Thus,
i () = d ()
and, in general,
d < . . . < d (m) < . . . < d () = = i () < . . . < i (m) < . . . < i.
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest
and thus
A(t + t) A(t)
(t) .
A(t)t
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest
A(t + t) A(t)
(t) = lim
t0 A(t) t
1 d
= A(t)
A(t) dt
A (t)
=
A(t)
d
= ln A(t).
dt
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest
Zt
(s)ds = ln A(s)|t0
s=0
= ln A(t) ln A(0)
A(t)
= ln .
A(0)
Thus we have Z t
A(t) = A(0) exp (s)ds
0
and Z t
a(t) = exp (s)ds .
0
a(t + k) k
= e 2 [(t)+(t+k)]
a(t)
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest
Notation Let
i% p.a. be the money interest rate
r % p.a. be the real interest rate
p(t) be the price index (with P(0) = 1)
% p.a. be the inflation rate
What relationships can be established among i, r , P(t) and ?
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest
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
1+i i
1+r = r = .
1+ 1+
Caution: this holds only for effective rates!
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest
.09/4 .05/4
= 0.9876543%
1 + .05/4
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest
Asset 1 Method 1:
100, 000
PV = 40
1 + .09
4
= 41, 064.58
Method 2:
100, 000
Real value = 40 = 60, 841.33
1 + .05
4
60, 841.33
PV = = 41, 064.57
(1.00987654)40
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest
Asset 2 Method 1:
40
100 000 1 + .054
PV =
.09 40
1+ 4
= 67 494.53
Method 2:
100, 000
PV =
(1.00987654)40
= 67, 494.54
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
Practical examples
Find the price of a security: determine an initial cash flow such
that the NPV is 0, given interest and a set of cash flows
Find the yield of a security or a project: determine the rate of
interest such that the NPV is 0 (IRR), given a set of cash flows
Find the minimum return on the reserves that is necessary to
ensure all current life annuities can be paid until the end, given
the current level of mortality (pensions)
...
Note
If the NPV is 0, we have then an equation of value
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
A(t)
A(t) = PV a(t) PV = .
a(t)
Powers of the discount factor can be used to discount all cash flows
if interest is homogeneous with time
(which is the usual assumption)
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
f (in ) f (in )
f (in ) = in+1 = in
in in+1 f (in )
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction
Notation
(p)
m|
ax:n i
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction
Numerical example
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
Deferred annuity
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities
Numerical example
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
Plan
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
Decreasing annuity
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities
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