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MATH 360: Theory of Investment and Credit
Albert Cohen
Actuarial Sciences ProgramDepartment of Mathematics
Department of Statistics and ProbabilityC336 Wells Hall
Michigan State UniversityEast Lansing MI
48823albert@math.msu.eduacohen@stt.msu.edu
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 1 / 223
Logistics
All course materials available on class page (www.math.msu.edu)
Syllabus too
Course textbook is S.A. Broverman’s ”Mathematics of Investmentand Credit”, 5th edition or later
Some questions on these slides, and on in class exam preparationslides, are taken from the third edition of Broverman’s book. Pleasenote that Actex owns the copyright for that material. No portion ofthe ACTEX textbook material may be reproduced in any part or byany means without the permission of the publisher. We are verythankful to the publisher for allowing posting of these notes on ourclass website.
Supplementary book is Finan, available online
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 2 / 223
Introduction
The value of money is a function of the time that passes while it is stuffedunder a mattress, deposited in a bank account, or invested in an asset.Just what that function is depends on many circumstances, and we willspend our time investigating many real-world examples
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 3 / 223
Main Tools
Calculus, and the study of Geometric Series, provides
the machinery necessary for solving for the final value of aninvestment
the optimal time to switch accounts
the interest rate needed to plan fixed income investments
among other wonderful things
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 4 / 223
Main Tools
Calculus, and the study of Geometric Series, provides
the machinery necessary for solving for the final value of aninvestment
the optimal time to switch accounts
the interest rate needed to plan fixed income investments
among other wonderful things
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 4 / 223
Main Tools
Calculus (1-d only!)
Can you take a derivative?
Can you find the maximum of a function?
Sequences and Series
Do you know what a geometric series is? What happens as n→∞ ?
n∑k=0
λk =1− λn+1
1− λ(1)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 5 / 223
Main Tools
Calculus (1-d only!)
Can you take a derivative?
Can you find the maximum of a function?
Sequences and Series
Do you know what a geometric series is? What happens as n→∞ ?
n∑k=0
λk =1− λn+1
1− λ(1)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 5 / 223
Main Tools
Calculus (1-d only!)
Can you take a derivative?
Can you find the maximum of a function?
Sequences and Series
Do you know what a geometric series is? What happens as n→∞ ?
n∑k=0
λk =1− λn+1
1− λ(1)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 5 / 223
Main Tools
Calculus (1-d only!)
Can you take a derivative?
Can you find the maximum of a function?
Sequences and Series
Do you know what a geometric series is? What happens as n→∞ ?
n∑k=0
λk =1− λn+1
1− λ(1)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 5 / 223
Interest Accumulation and Effective Rates of Interest (Ex1.1)
Begin by investing 1000 at 9% per annum. Compound annually for 3years. End up with...
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 6 / 223
Interest Compounded Monthly
Sometimes, interest rate is quoted per annum, but compounded monthly.
For previous example, assume again 9% but compounded monthly. Then
FV = 1000 ·
[(1 +
0.09
12
)12]3
= 1000 · (1.0938)3
(2)
In other words, the equivalent or effective annual rate is 9.38%
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 7 / 223
Interest Compounded Monthly
Sometimes, interest rate is quoted per annum, but compounded monthly.
For previous example, assume again 9% but compounded monthly. Then
FV = 1000 ·
[(1 +
0.09
12
)12]3
= 1000 · (1.0938)3
(2)
In other words, the equivalent or effective annual rate is 9.38%
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 7 / 223
Fluctuating Interest Rates
It may be that over a longer period of time, the rate of return on an initialinvestment A(0) may fluctuate. At time n, the value of the investment isnow A(n).
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 8 / 223
Fluctuating Interest Rates
Guess: A(n) = A(0) · (1 + r)n
Reality: A(n) = A(0) · (1 + r1) · ... · (1 + rn)
In a bank account or bond, the interest rate, ri is guaranteed to be smallbut positive. For a general investment, there is no guarantee that aninvestment will not shrink in value over a period of time.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 9 / 223
Arithmetic vs Geometric Means
One other possible guess for an average rate of return is r = r1+...rnn . The
question of ordering, ie which average rate is bigger, reduces to thequestion:
Is(
1 +r1 + ...rn
n
)n> (1 + r1) · ... · (1 + rn)? (3)
To answer this, define for k ∈ 1, 2, .., n,
xk = 1 + rk . (4)
Then, our question is reframed as:
Is(x1 + ...xn
n
)n> (x1) · ... · (xn)? (5)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 10 / 223
Arithmetic vs Geometric Means
The answer is yes, and there are many proofs. One of them is byinduction. Another is to apply Jensen’s Inequality:
For
a concave function f , for example if f ′′(x) ≤ 0 for all x in our domain
real numbers ak such that∑n
k=1 ak 6= 0,
real numbers xk ,
it follows that
f
(∑nk=1 akxk∑nk=1 ak
)≥∑n
k=1 ak f (xk)∑nk=1 ak
. (6)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 11 / 223
Arithmetic vs Geometric Means
By Jensen’s Inequality, if we define f (x) = ln (x) and each ak = 1n , then
we retain
ln(x1 + ...+ xn
n
)≥ 1
n
n∑k=1
ln (xk) = ln(
n√
x1 · ... · xn)
(7)
and so by taking exponentials of both sides we are done.
The inequality can be shown to be strict if the xknk=1 are not all thesame. In other words, if even one interest rate is different between periods,the the arithmetic average rate is strictly greater than the geometic rate.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 12 / 223
Example 1.2
Table: Average vs. Annual Rate of Return
Year 2002 2001 2000 1999 1998
Annual Rate 6.9% 6.4% 9.4% −3.0% 7.8%Average Rate 6.9% 6.65% 7.56% 4.82% 5.41%
We can calculate the average interest rate iav via
(1 + iav )n = (1 + r1) · (1 + r2) · ... · (1 + rn) (8)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 13 / 223
Example 1.3
A very nice example is the following: On Jan 1, 2000, Smith deposits 1000into an account with 5% annual interest. The interest is paid on every Dec31. Smith withdraws 200 on Jan 1, 2002, deposits 100 on Jan 1 2003 andagain withdraws from the account on Jan 1 2005, this time 250. What isthe balance in the account just after the interest is paid on Dec 31, 2006?
Hint: Think of a deposit as a loan to the bank, a withdrawal as a loan toSmith, and at the end of the term (7 years,) both bank and Smith settleup accounts.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 14 / 223
Example 1.3
We can replicate the cash flows of this example by stating that Smith hasinvested both positive and negative amounts of money over the period oftime:
Table: Example 1.3
Year Period
1000 7 years
−200 5 years
100 4 years
−250 2 years
Hence,
A(7) = 1000 · (1.05)7 + (−200) · (1.05)5
+ 100 · (1.05)4 + (−250) · (1.05)2 = 997.77(9)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 15 / 223
Example 1.3
We can replicate the cash flows of this example by stating that Smith hasinvested both positive and negative amounts of money over the period oftime:
Table: Example 1.3
Year Period
1000 7 years
−200 5 years
100 4 years
−250 2 years
Hence,
A(7) = 1000 · (1.05)7 + (−200) · (1.05)5
+ 100 · (1.05)4 + (−250) · (1.05)2 = 997.77(9)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 15 / 223
Example 1.3
Another way of computing A(7) is to do so recursively:
A(0) = 1000
A(1) = A(0) · 1.05 = 1000 · (1.05)
A(2) = A(1) · (1.05)− 200
= 1000 · (1.05)2 − 200
A(3) = A(2) · (1.05) + 100
= 1000 · (1.05)3 − 200 · (1.05) + 100
A(4) = A(3) · (1.05)
A(5) = A(4) · (1.05)− 250
A(6) = A(5) · (1.05)
A(7) = A(6) · (1.05)
= 1000 · (1.05)7 + (−200) · (1.05)5
+ 100 · (1.05)4 + (−250) · (1.05)2 = 997.77
(10)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 16 / 223
Linear Interest
Another way interest can be designed to accrue is linearly Symbolically, ifA(0) is the initial value of our investment, then the final value is
Alinear (t) = A(0) · (1 + i · t) (11)
Notice that at any time k ≤ t = n,
Acompound(n) = A(k) · (1 + i)n−k
= A(0) · (1 + i)k · (1 + i)n−k
Alinear (n) = A(0) · (1 + i · n)
6= A(k) · (1 + i · (n − k))
= A(0) · (1 + i · k) · (1 + i · (n − k))
(12)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 17 / 223
Bonus Question
Assume you can select
from two interest rates j , i where 0 < i < j < 1 and
time t ∈ [0, 1]
where you can decide to switch from a bank paying j for a time of length tto one paying i for the remaining time 1− t .
At what time t would this be optimal to do, if at all?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 18 / 223
Bonus Question
In general, if we switch at, then it must be that
1 + j < (1 + jt)(1 + (i(1− t))
⇒ 1 + j < 1 + jt + i(1− t) + ijt(1− t)
⇒ (j − i)(1− t) < ijt(1− t)
⇒ j − i
ij< t.
(13)
It follows that if 0 < j−iij < 1, we are able to justify such a switch!
The inequality linking i to j is now
i < j <i
1− i. (14)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 19 / 223
Bonus Question
The optimal time to switch is when f (t) := (1 + jt)(1 + i(1− t)) ismaximized:
0 = f ′(t) =d
dt
[(1 + jt)(1 + i(1− t))
]= (j − i) + ij(1− 2t).
⇒ toptimal =1
2+
1
2· j − i
ij.
(15)
Of course, toptimal < 1 as i < j < i1−i and so the optimal value of the
bank account is
f (toptimal) =[1 + j ·
(1
2+
1
2· j − i
ij
)][1 + i ·
(1
2− 1
2· j − i
ij
)]. (16)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 20 / 223
Accumulated Amount Function
A(t) is also known as the A.A.F., and
A (t2) = A (t1) (1 + it2)
it2 :=A (t2)− A (t1)
A (t1)
(17)
it2 is known as the effective rate for our investment from t1 to t2.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 21 / 223
Present Value
A dollar today is certainly more valuable than a dollar tomorrow, and evenmore valuable than a dollar next year. To reflect this idea, we say that thepresent value of a unit of currency one year from now is ν, where
ν ≡ 1
1 + i. (18)
ν is also known as the discount factor. This factor works as the inverse ofthe interest gained on an investment of a unit of currency for one year.For example, the present value of 25, 000 at a rate of 5% per annum, 25years from now, is 25000
(1.05)25
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 22 / 223
Equation of Value
In calculating the present value of an investment, we are workingbackwards from a fixed outcome to calculate it’s value to us today.
But, there may be more than one payment expected in the future, such aswhen planning for retirement. They may also be balanced by furtherinvestment made in the future.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 23 / 223
Example 1.5
Loan Shark pays you 1000 every week, starting today. There are 4payments in total, at 8% weekly interest. Starting the week after the last1000, you are to repay the loan in 3 consecutive weekly installments of1100 at 8% weekly interest, plus a fourth payment X at 8% weeklyinterest. What is X ?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 24 / 223
Example 1.5
Table: Example 1.5: Payments In
Week 0 1 2 3
Payment in 1000 1000 1000 1000
Table: Example 1.5: Payments Out
Week 4 5 6 7
Payment out 1100 1100 1100 X
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 25 / 223
Example 1.5
PV0(in) = PV0(out)
PV0(in) = 1000 +1000
1.08+
1000
1.082+
1000
1.083
PV0(out) =1100
1.084+
1100
1.085+
1100
1.086+
X
1.087
X = 2273.79
(19)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 26 / 223
Example 1.5
PV0(in) = PV0(out)
PV0(in) = 1000 +1000
1.08+
1000
1.082+
1000
1.083
PV0(out) =1100
1.084+
1100
1.085+
1100
1.086+
X
1.087
X = 2273.79
(19)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 26 / 223
Nominal Interest Rates
When a credit card has a 24% nominal annual interest rate, you do notonly pay 24% on the balance. Rather, that 24% is broken down into 12monthly interest charges on the average balance over a 30 day billingcycle. So, one pays an effective annual rate of(
1 +0.24
12
)12
− 1 = 0.2682. (20)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 27 / 223
Example 1.9
Which is better:
(A) 15.25% compounded semi-annually, or
(B) 15% compounded monthly ?
iA(eff ) =
(1 +
0.1525
2
)2
− 1 = 0.1583
iB(eff ) =
(1 +
0.15
12
)12
− 1 = 0.1608
(21)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 28 / 223
Example 1.9
Which is better:
(A) 15.25% compounded semi-annually, or
(B) 15% compounded monthly ?
iA(eff ) =
(1 +
0.1525
2
)2
− 1 = 0.1583
iB(eff ) =
(1 +
0.15
12
)12
− 1 = 0.1608
(21)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 28 / 223
Notation
Actuaries reserve i for effective annual rate and i (m) for the nominal ratecompounded m times annually. The link between the two is
i =
(1 +
i (m)
m
)m
− 1
i (m) = m ·(
(1 + i)1m − 1
)i (∞) = lim
m→∞i (m) = ln (1 + i)
< i (m) ∀m
(22)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 29 / 223
Notation
Actuaries reserve i for effective annual rate and i (m) for the nominal ratecompounded m times annually. The link between the two is
i =
(1 +
i (m)
m
)m
− 1
i (m) = m ·(
(1 + i)1m − 1
)
i (∞) = limm→∞
i (m) = ln (1 + i)
< i (m) ∀m
(22)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 29 / 223
Notation
Actuaries reserve i for effective annual rate and i (m) for the nominal ratecompounded m times annually. The link between the two is
i =
(1 +
i (m)
m
)m
− 1
i (m) = m ·(
(1 + i)1m − 1
)i (∞) = lim
m→∞i (m) = ln (1 + i)
< i (m) ∀m
(22)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 29 / 223
Notation
Actuaries reserve i for effective annual rate and i (m) for the nominal ratecompounded m times annually. The link between the two is
i =
(1 +
i (m)
m
)m
− 1
i (m) = m ·(
(1 + i)1m − 1
)i (∞) = lim
m→∞i (m) = ln (1 + i)
< i (m) ∀m
(22)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 29 / 223
Example 1.10
Assume i = 0.12. Then
Table: Example 1.10
m m ·(
(1 + i)1m − 1
)1 0.12
2 0.1166
6 0.1144
52 0.1135
365 0.113346
∞ 0.113329
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 30 / 223
Comparison of continuous to compound interest earned
Assume that we are promised 12% annual interest, and we wish tocalculate the daily interest gained on 10, 000, 000:
interestovernight = 10, 000, 000 · 0.12 · 1
365= 3287.67
interestcontinuous = 10, 000, 000 ·(
e1
365 − 1)
= 3288.21,(23)
a difference of 0.54 on a principle of 10 million
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 31 / 223
Discount Rates
Sometimes, interest paid up front: Receive A(0) up front, pay backA(1) > A(0).Consider the example
A(0) = 900
A(1) = 1000
d =A(1)− A(0)
A(1)
1
1 + i= ν = 1− d
(24)
Essentially, the discount is the forward price of a dollar (or any other unitof currency) in the interest market with no carrying cost or dividends(coupons) paid out.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 32 / 223
Discount Rates
Sometimes, interest paid up front: Receive A(0) up front, pay backA(1) > A(0).Consider the example
A(0) = 900
A(1) = 1000
d =A(1)− A(0)
A(1)
1
1 + i= ν = 1− d
(24)
Essentially, the discount is the forward price of a dollar (or any other unitof currency) in the interest market with no carrying cost or dividends(coupons) paid out.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 32 / 223
Example 1.11
A T-bill represents the forward value today of 100 delivered at time T .The price is calculated via simple discount:
P(0) = P(T ) · (1− d · t) = 100 ·(
1− d · T
365
)
100 = P(T ) = P(0) · (1 + i · t) = P(0) ·(
1 + i · T
365
) (25)
Table: Example 1.11
Term Discount (%) Investment (%) Price per 100
12−day 0.965 0.974 99.680
28−day 0.9940 0.952 99.927
91−day 1.130 1.150 99.174
128−day 1.400 1.430 99.292
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 33 / 223
Example 1.11
A T-bill represents the forward value today of 100 delivered at time T .The price is calculated via simple discount:
P(0) = P(T ) · (1− d · t) = 100 ·(
1− d · T
365
)100 = P(T ) = P(0) · (1 + i · t) = P(0) ·
(1 + i · T
365
) (25)
Table: Example 1.11
Term Discount (%) Investment (%) Price per 100
12−day 0.965 0.974 99.680
28−day 0.9940 0.952 99.927
91−day 1.130 1.150 99.174
128−day 1.400 1.430 99.292
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 33 / 223
Example 1.11
A T-bill represents the forward value today of 100 delivered at time T .The price is calculated via simple discount:
P(0) = P(T ) · (1− d · t) = 100 ·(
1− d · T
365
)100 = P(T ) = P(0) · (1 + i · t) = P(0) ·
(1 + i · T
365
) (25)
Table: Example 1.11
Term Discount (%) Investment (%) Price per 100
12−day 0.965 0.974 99.680
28−day 0.9940 0.952 99.927
91−day 1.130 1.150 99.174
128−day 1.400 1.430 99.292
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 33 / 223
Nominal Annual Discount Rate
d (m) is the quoted annual discount rate that is applied m times over the
year, with the effective discount rate as d (m)
m for the period of 1m years.
Also, d is the effective discount rate :
1− d =
(1− d (m)
m
)m
d (m) = m ·(
1− (1− d)1m
)d (∞) = lim
m→∞d (m) = ln
(1
1− d
)= i (∞)
(26)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 34 / 223
Force of Interest
From time t1 to t2, an investment grows by a rate of
it1→t2 :=A(t2)− A(t1)
A(t1)(27)
Now, fix a time t1 = t and correspondingly, let t2 = t + 1m . It follows that
the nominal rate that gives the same annual growth from t to t + 1m is
i (m) = m ·A(t + 1
m
)− A(t)
A(t)=
1
A(t)·
A(t + 1
m
)− A(t)
1m
limm→∞
i (m) =1
A(t)· limm→∞
A(t + 1
m
)− A(t)
1m
=1
A(t)
dA
dt=: δ(t)
(28)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 35 / 223
Force of Interest
From time t1 to t2, an investment grows by a rate of
it1→t2 :=A(t2)− A(t1)
A(t1)(27)
Now, fix a time t1 = t and correspondingly, let t2 = t + 1m . It follows that
the nominal rate that gives the same annual growth from t to t + 1m is
i (m) = m ·A(t + 1
m
)− A(t)
A(t)=
1
A(t)·
A(t + 1
m
)− A(t)
1m
limm→∞
i (m) =1
A(t)· limm→∞
A(t + 1
m
)− A(t)
1m
=1
A(t)
dA
dt=: δ(t)
(28)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 35 / 223
Force of Interest
From time t1 to t2, an investment grows by a rate of
it1→t2 :=A(t2)− A(t1)
A(t1)(27)
Now, fix a time t1 = t and correspondingly, let t2 = t + 1m . It follows that
the nominal rate that gives the same annual growth from t to t + 1m is
i (m) = m ·A(t + 1
m
)− A(t)
A(t)=
1
A(t)·
A(t + 1
m
)− A(t)
1m
limm→∞
i (m) =1
A(t)· limm→∞
A(t + 1
m
)− A(t)
1m
=1
A(t)
dA
dt
=: δ(t)
(28)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 35 / 223
Force of Interest
From time t1 to t2, an investment grows by a rate of
it1→t2 :=A(t2)− A(t1)
A(t1)(27)
Now, fix a time t1 = t and correspondingly, let t2 = t + 1m . It follows that
the nominal rate that gives the same annual growth from t to t + 1m is
i (m) = m ·A(t + 1
m
)− A(t)
A(t)=
1
A(t)·
A(t + 1
m
)− A(t)
1m
limm→∞
i (m) =1
A(t)· limm→∞
A(t + 1
m
)− A(t)
1m
=1
A(t)
dA
dt=: δ(t)
(28)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 35 / 223
Force of Interest
Since δ(t) = 1A(t)
dAdt = d
dt [ln (A(t))], it follows that∫ t
0δ(s)ds =
∫ t
0
d
ds[ln (A(s))] ds = ln (A(t))− ln (A(0)) (29)
and so
A(t) = A(0)e∫ t0 δ(s)ds (30)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 36 / 223
Some Examples...
Calculate δ(t) for
A(t) = e−t2
A(t) = t · e−t
A(t) = (t − 1)2
A(t) = A(0) · (1 + i · t)
A(t) = A(0) · (1 + i)t
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 37 / 223
Example 1.14
Assume δ(t) = 0.08 + 0.005t and your asset’s initial value is A(0) = 1000.Then
A(t) = A(0)e∫ t0 (0.08+0.005s)ds = 1000e0.08t+0.0025t2
A(5) = 1000e0.08·5+0.0025·52 = 1588.04(31)
But, if we were give A(2) = 1000, then
A(7) = A(2)e∫ 72 δ(s)ds = 1000e0.08·5+0.0025·(72−22) = 1669.46 (32)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 38 / 223
Some thoughts...
This limiting term, known as the force of interest represents thetheoretical upper limit for interest gained on this asset. However, In thederivation above, there is no randomness involved in obtaining the ordinarydifferential equation
dA(t) = δ(t)A(t)dt (33)
To handle this lack of stochasticity, one common asset model (GeometricBrownian Motion) is defined by the stochastic differential equation
dA(t) = δ(t)A(t)dt + σ (A(t)) dW (t), (34)
where W (.) is the Wiener process.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 39 / 223
Introduction and Geometric Series
An annuity is a series of periodic payments.
In this class, they are notevent-contingent, but rather only depend on the passage of time. Tocompute the value of the most foundational annuity, we must recall thefollowing fact: If x ∈ R : x 6= 1, then
Xn := 1 + x + ...+ xn
(1− x) · Xn = 1− xn+1
⇒ Xn =1− xn+1
1− x
(35)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 40 / 223
Introduction and Geometric Series
An annuity is a series of periodic payments. In this class, they are notevent-contingent, but rather only depend on the passage of time.
Tocompute the value of the most foundational annuity, we must recall thefollowing fact: If x ∈ R : x 6= 1, then
Xn := 1 + x + ...+ xn
(1− x) · Xn = 1− xn+1
⇒ Xn =1− xn+1
1− x
(35)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 40 / 223
Introduction and Geometric Series
An annuity is a series of periodic payments. In this class, they are notevent-contingent, but rather only depend on the passage of time. Tocompute the value of the most foundational annuity, we must recall thefollowing fact:
If x ∈ R : x 6= 1, then
Xn := 1 + x + ...+ xn
(1− x) · Xn = 1− xn+1
⇒ Xn =1− xn+1
1− x
(35)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 40 / 223
Introduction and Geometric Series
An annuity is a series of periodic payments. In this class, they are notevent-contingent, but rather only depend on the passage of time. Tocompute the value of the most foundational annuity, we must recall thefollowing fact: If x ∈ R : x 6= 1, then
Xn := 1 + x + ...+ xn
(1− x) · Xn = 1− xn+1
⇒ Xn =1− xn+1
1− x
(35)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 40 / 223
Introduction and Geometric Series
An annuity is a series of periodic payments. In this class, they are notevent-contingent, but rather only depend on the passage of time. Tocompute the value of the most foundational annuity, we must recall thefollowing fact: If x ∈ R : x 6= 1, then
Xn := 1 + x + ...+ xn
(1− x) · Xn = 1− xn+1
⇒ Xn =1− xn+1
1− x
(35)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 40 / 223
Introduction and Geometric Series
An annuity is a series of periodic payments. In this class, they are notevent-contingent, but rather only depend on the passage of time. Tocompute the value of the most foundational annuity, we must recall thefollowing fact: If x ∈ R : x 6= 1, then
Xn := 1 + x + ...+ xn
(1− x) · Xn = 1− xn+1
⇒ Xn =1− xn+1
1− x
(35)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 40 / 223
Example 2.1
The federal government sends Smith a family allowance of 30 every monthfor Smith’s child. Smith deposits the payments in bank account on thelast day of each month. The account earns interest at the annual rate of9% compounded monthly and payable on the last day of each month, onthe minimum monthly balance. If the first payment is deposited on May31, 1998, what is the account balance on December 31,2009, including thepayment just made?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 41 / 223
Example 2.1
There are 140 total payments
imonthly = i12 = 0.0075
TotalValue = 30 + 30 · (1.0075)1 + ...+ 30 · (1.0075)139
= 30 ·139∑k=0
1.0075k = 30 · 1− 1.0075140
1− 1.0075
= 7385.91
(36)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 42 / 223
Example 2.1
There are 140 total payments
imonthly = i12 = 0.0075
TotalValue = 30 + 30 · (1.0075)1 + ...+ 30 · (1.0075)139
= 30 ·139∑k=0
1.0075k = 30 · 1− 1.0075140
1− 1.0075
= 7385.91
(36)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 42 / 223
Example 2.1
There are 140 total payments
imonthly = i12 = 0.0075
TotalValue = 30 + 30 · (1.0075)1 + ...+ 30 · (1.0075)139
= 30 ·139∑k=0
1.0075k = 30 · 1− 1.0075140
1− 1.0075
= 7385.91
(36)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 42 / 223
Level Payment Annuities
Number of payments in a series of payments is called the term of theannuity
Time between the successive payments is called the payment period,or frequency
A series of payments whose value is found at the time of the finalpayment is known as accumulated annuity immediate
sn i :=n−1∑k=0
(1 + i)k =(1 + i)n − 1
i(37)
Equivalently, (1 + i)n = 1 + i · sn i .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 43 / 223
Level Payment Annuities
Number of payments in a series of payments is called the term of theannuity
Time between the successive payments is called the payment period,or frequency
A series of payments whose value is found at the time of the finalpayment is known as accumulated annuity immediate
sn i :=n−1∑k=0
(1 + i)k =(1 + i)n − 1
i(37)
Equivalently, (1 + i)n = 1 + i · sn i .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 43 / 223
Level Payment Annuities
Number of payments in a series of payments is called the term of theannuity
Time between the successive payments is called the payment period,or frequency
A series of payments whose value is found at the time of the finalpayment is known as accumulated annuity immediate
sn i :=n−1∑k=0
(1 + i)k =(1 + i)n − 1
i(37)
Equivalently, (1 + i)n = 1 + i · sn i .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 43 / 223
Ex 2.2
What level amount must be deposited on May 1 and Nov 1 each year from1998 to 2005, inclusive, to accumulate to 7000 on November 1, 2005 ifthe nominal annual interest rate, compounded semi-annually, is 9% ?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 44 / 223
Interest Compounded Monthly
16 total deposits
i (2) = 0.09
X denotes the level amount deposited per period
7000 = X ·(1 + (1.045)1 + ...+ (1.045)15
)= X · s16 0.045
⇒ X = 308.11
(38)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 45 / 223
Interest Compounded Monthly
16 total deposits
i (2) = 0.09
X denotes the level amount deposited per period
7000 = X ·(1 + (1.045)1 + ...+ (1.045)15
)= X · s16 0.045
⇒ X = 308.11
(38)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 45 / 223
Example 2.3
Suppose that in Example 2.1, Smith’s child is born in April 1998 and thefirst payment is received in May (and deposited at the end of May.) Thepayments continue and the deposits are made at the end of the monthuntil, and including the month of, the child’s 16th birthday. The paymentsstop after the 16th birthday, but the balance continues to accumulate withinterest until the end of the month of the child’s 21st birthday. What isthe balance X in the account at that time ?
X = 1.007560 · 30 · s192 0.0075 = 20, 028.68 (39)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 46 / 223
Example 2.3
Suppose that in Example 2.1, Smith’s child is born in April 1998 and thefirst payment is received in May (and deposited at the end of May.) Thepayments continue and the deposits are made at the end of the monthuntil, and including the month of, the child’s 16th birthday. The paymentsstop after the 16th birthday, but the balance continues to accumulate withinterest until the end of the month of the child’s 21st birthday. What isthe balance X in the account at that time ?
X = 1.007560 · 30 · s192 0.0075 = 20, 028.68 (39)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 46 / 223
Some Arithmetic
After accumulating cash via a series of payments at rate i until time n, weallow this amount to grow until time n + k :
Value(n + k) = sn i · (1 + i)k =(1 + i)n − 1
i· (1 + i)k
=(1 + i)n+k − (1 + i)k
i
=(1 + i)n+k − 1
i− (1 + i)k − 1
i= sn+k i − sk i
sn+k i = sk i + sn i · (1 + i)k
(40)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 47 / 223
Some Arithmetic
After accumulating cash via a series of payments at rate i until time n, weallow this amount to grow until time n + k :
Value(n + k) = sn i · (1 + i)k =(1 + i)n − 1
i· (1 + i)k
=(1 + i)n+k − (1 + i)k
i
=(1 + i)n+k − 1
i− (1 + i)k − 1
i= sn+k i − sk i
sn+k i = sk i + sn i · (1 + i)k
(40)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 47 / 223
Example 2.4
Suppose that in Example 2.1, the nominal annual interest rate earned onthe account changes to 7.5%, still compounded monthly, as of January2004. What is the accumulated value of the account on December 312009 ?
Value = 30 ·(s68 0.0075 · 1.0062572 + s72 0.00625
)= 6865.22 (41)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 48 / 223
Example 2.4
Suppose that in Example 2.1, the nominal annual interest rate earned onthe account changes to 7.5%, still compounded monthly, as of January2004. What is the accumulated value of the account on December 312009 ?
Value = 30 ·(s68 0.0075 · 1.0062572 + s72 0.00625
)= 6865.22 (41)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 48 / 223
Example 2.5
Suppose 10 monthly payments of 50 each are followed by 14 monthlypayments of 75 each. If interest is at an effective monthly rate of 1%, whatis the accumulated value of the series at the time of the final payment ?
Value = 50 · s24 0.01 + 25 · s14 0.01 (42)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 49 / 223
Example 2.5
Suppose 10 monthly payments of 50 each are followed by 14 monthlypayments of 75 each. If interest is at an effective monthly rate of 1%, whatis the accumulated value of the series at the time of the final payment ?
Value = 50 · s24 0.01 + 25 · s14 0.01 (42)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 49 / 223
Present Value of an Annuity
Make a lump sum payment X now to receive periodic payments C ,starting one period from today. If the market bears a constant interest ofi , the the the Present Value of this Annuity Immediate is calculated as
X =C
1 + i+
C
(1 + i)2+ ...+
C
(1 + i)n
= C ·n∑
k=1
νk = C · ν ·n−1∑k=0
νk
= C · ν · 1− νn
1− ν
= C · 1− νn
i= C · 1− (1 + i)−n
i≡ C · an i
(43)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 50 / 223
Example 2.7
Brown has bought a new car and requires a loan of 12000 to pay for it.The car dealer offers Brown two alternatives on the loan:
A : Monthly payments for 3 years, starting one month after purchase,with an annual interest rate of 12% compounded monthly
B : Monthly payments for 4 years, also starting one month afterpurchase, with an annual interest rate of 15% compounded monthly.
Find Brown’s monthly payment and the total amount paid over the courseof the repayment period under each of the two options.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 51 / 223
Example 2.7
12000 = PA · a36 0.01 ⇒ PA = 398.57
12000 = PB · a48 0.0125 ⇒ PB = 333.97
TotalValue(A) = 36 · PA = 14348.52
TotalValue(B) = 48 · PB = 16030.56
(44)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 52 / 223
Example 2.8
Suppose that in Example 2.7, Brown can repay the loan, still with 36payments under option A or 48 payments under option B, with the firstpayment made 9 months after the car is purchased in either case.Assuming interest accrues from the time of the car purchase, find thepayments required under options A and B. This is known as a deferredannuity
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 53 / 223
Example 2.8
12000 = P ′A ·(1.01−9 + 1.01−10 + ...+ 1.01−44
)= P ′A · ν8A · a36 0.01⇒ P ′A = 431.60
12000 = P ′B ·(1.0125−9 + 1.0125−10 + ...+ 1.0125−56
)= P ′B · ν8B · a48 0.0125⇒ P ′B = 368.86
(45)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 54 / 223
Some Facts About Annuities
There is a duality between an i and sn i :
sn i = (1 + i)nan i
an i = νnsn i(46)
As n→∞, we have
a∞ i = limn→∞
an i
= limn→∞
1− νn
i=
1
i
(47)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 55 / 223
Example 2.9
A perpetuity immediate pays X per year. Brian receives the first npayments, Colleen receives the next n payments, and Jeff receives theremaining payments. Brian’s share of the present value of the originalperpetuity is 40%, and Jeff’s share is K . Calculate K .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 56 / 223
Example 2.9
PV (Brian) = X · an i = X · 1− νn
i
= 0.4 · X · a∞ i = 0.4X
i⇒ 1− νn = 0.4
PV (Colleen) = νn · X · an i = 0.4 · 0.6X
i= 0.24
X
i
X
i= PV = PV (Brian) + PV (Jeff ) + PV (Colleen)
= 0.4X
i+ K + 0.24
X
i
⇒ K = 0.36X
i
(48)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 57 / 223
Example 2.9
PV (Brian) = X · an i = X · 1− νn
i
= 0.4 · X · a∞ i = 0.4X
i⇒ 1− νn = 0.4
PV (Colleen) = νn · X · an i = 0.4 · 0.6X
i= 0.24
X
iX
i= PV = PV (Brian) + PV (Jeff ) + PV (Colleen)
= 0.4X
i+ K + 0.24
X
i
⇒ K = 0.36X
i
(48)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 57 / 223
Recall...
sn i = 1 + (1 + i) + (1 + i)2 + ...+ (1 + i)n−1 =(1 + i)n − 1
i
an i = ν + ν2 = ...+ νn =1− νn
i
(49)
Of course, sn i is the accumulation of all the payments at the final time,whereas an i is the present value of all the paymenst, one period before thefirst payment. Now, define
sn i := (1 + i) + (1 + i)2 + ...+ (1 + i)n = (1 + i)sn i
= annuity due
= accummulated value one-period after final payment
an i := (1 + i)an i
= present value at time of first payment
(50)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 58 / 223
Level Payment Annuities: Some Generalizations.
What happens when compounding interest period and annuity paymentperiod don’t coincide? For example: Consider 4 deposits made per year,over 16 years, of 1000 each. What is the balance after the last payment ifinterest is quoted at 9% nominal annual interest rate, compoundedmonthly?
In this case, the equivalent rate j for the 3−month periods satisfies
1 + j =(1 + 0.09
12
)3. It follows that
Value = 1000s64 j = 141, 076 (51)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 59 / 223
Level Payment Annuities: Some Generalizations.
What happens when compounding interest period and annuity paymentperiod don’t coincide? For example: Consider 4 deposits made per year,over 16 years, of 1000 each. What is the balance after the last payment ifinterest is quoted at 9% nominal annual interest rate, compoundedmonthly?In this case, the equivalent rate j for the 3−month periods satisfies
1 + j =(1 + 0.09
12
)3. It follows that
Value = 1000s64 j = 141, 076 (51)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 59 / 223
mthly payable annuities: Some Generalizations.
Imagine that for each of n periods in the term of an annuity, 1 is paid outover m payments of 1
m each. Then the present value is computed using
j = i (m)
m , where
a(m)n i = ν · 1
msm j + ν2 · 1
msm j + ...+ νn · 1
msm j
=(ν + ν2 + ...+ νn
)· 1
m·
(1 + i (m)
m
)m− 1
i (m)
m
= an i ·
(1 + i (m)
m
)m− 1
i (m)= an i ·
i
i (m)
s(m)n i = sn i ·
i
i (m)
(52)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 60 / 223
mthly payable annuities: Some Generalizations.
Imagine that for each of n periods in the term of an annuity, 1 is paid outover m payments of 1
m each. Then the present value is computed using
j = i (m)
m , where
a(m)n i = ν · 1
msm j + ν2 · 1
msm j + ...+ νn · 1
msm j
=(ν + ν2 + ...+ νn
)· 1
m·
(1 + i (m)
m
)m− 1
i (m)
m
= an i ·
(1 + i (m)
m
)m− 1
i (m)= an i ·
i
i (m)
s(m)n i = sn i ·
i
i (m)
(52)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 60 / 223
mthly payable annuities: Some Generalizations.
As m→∞, we have i (m) → ln (1 + i), and so it follows that
a(m)n i → an i ·
i
ln (1 + i)
s(m)n i → sn i ·
i
ln (1 + i)
(53)
Let’s analyze this using calculus!
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 61 / 223
mthly payable annuities: Some Generalizations.
Take t2 − t1 = 1m , and assume that 1 is paid out at a continuous rate.
Then, from t to t + dt, the amount paid out is dt. At time n, the value ofdt accumulated from t to n is dt · (1 + i)n−t .
Add up all of these bits andwe obtain
sn i =
∫ n
0(1 + i)n−tdt =
∫ n
0e ln (1+i)(n−t)dt
= e ln (1+i)n ·
[e− ln (1+i)t
− ln (1 + i)
]n0
=(1 + i)n − 1
ln (1 + i)= sn i ·
i
ln (1 + i)= lim
m→∞s(m)n i
(54)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 62 / 223
mthly payable annuities: Some Generalizations.
Take t2 − t1 = 1m , and assume that 1 is paid out at a continuous rate.
Then, from t to t + dt, the amount paid out is dt. At time n, the value ofdt accumulated from t to n is dt · (1 + i)n−t . Add up all of these bits andwe obtain
sn i =
∫ n
0(1 + i)n−tdt =
∫ n
0e ln (1+i)(n−t)dt
= e ln (1+i)n ·
[e− ln (1+i)t
− ln (1 + i)
]n0
=(1 + i)n − 1
ln (1 + i)= sn i ·
i
ln (1 + i)= lim
m→∞s(m)n i
(54)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 62 / 223
An Example: Daily vs Continuous deposits
Consider depositing 12 per day in 2004 and 2005 and 15 per day in 2006.The earned interest in 2004-05 is i1 = 9% effective per year, and i2 = 12%effective per year in 2006. Compute the total accumulated amount at theend of 2006 if computed via (a) daily deposits and (b) continuousdeposits. Assume no leap years!
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 63 / 223
An Example: Daily vs Continuous deposits
For daily deposits, we compute the equivalent daily interest rates j1 for2004-05 and j2 for 2006 by
j1 = (1.09)1
365 − 1 = 0.00023631
j2 = (1.12)1
365 − 1 = 0.00031054(55)
So,
AccValue = 12 · s730 j1 · (1 + i2) + 15 · s365 j2= 12 · s730 0.00023631 · (1.12) + 15 · s365 0.00031054= 16502.59
(56)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 64 / 223
An Example: Daily vs Continuous deposits
For continuous deposits, we compute that 12 · 365 = 4380 is invested peryearfor the period 2004-05 and 15 · 365 = 5475 for 2006.So,
AccValue = 4380 · s2 0.09 · (1.12) + 5475 · s1 0.12
= 4380 · 1.092 − 1
ln (1.09)· (1.12) + 5475 · 1.12− 1
ln (1.12)
= 16504.75
(57)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 65 / 223
Continuous Annuities in General
Define a(t1, t2) as the accumulated value at t2 of an amount 1 invested att1.
Hence, ∫ t2
t1
a(t, t2)dt (58)
is the accumulated value at t2 of a continuous annuity paying 1 perunit time over the interval (t1, t2),and ∫ t2
t1
1
a(t, t2)dt (59)
is the present value at t1 of a continuous annuity paying 1 per unit timeover the interval (t1, t2),
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 66 / 223
Continuous Annuities in General
Define a(t1, t2) as the accumulated value at t2 of an amount 1 invested att1. Hence, ∫ t2
t1
a(t, t2)dt (58)
is the accumulated value at t2 of a continuous annuity paying 1 perunit time over the interval (t1, t2),and ∫ t2
t1
1
a(t, t2)dt (59)
is the present value at t1 of a continuous annuity paying 1 per unit timeover the interval (t1, t2),
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 66 / 223
Continuous Annuities in General
If δs is the force of interest at time s, then
a(t1, t2) = e∫ t2t1δsds
an δs =
∫ n
0e−
∫ t0 δsdsdt
sn δs =
∫ n
0e∫ nt δsdsdt
(60)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 67 / 223
Unknown Number of Payments in an Annuity
Assuming n level payments of J each at interest rate i , the accumulatedvalue is
M = J[(1 + i)n−1 + ...+ (1 + i) + 1
]= J · (1 + i)n − 1
i= J · sn i
⇒ (1 + i)n = 1 + i · M
J
⇒ n =ln(1 + i · MJ
)ln 1 + i
(61)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 68 / 223
Unknown Number of Payments in an Annuity
Assuming n level payments of J each at interest rate i , the accumulatedvalue is
M = J[(1 + i)n−1 + ...+ (1 + i) + 1
]= J · (1 + i)n − 1
i= J · sn i
⇒ (1 + i)n = 1 + i · M
J
⇒ n =ln(1 + i · MJ
)ln 1 + i
(61)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 68 / 223
Unknown Number of Payments in an Annuity
Assuming n level payments of J each at interest rate i , the accumulatedvalue is
M = J[(1 + i)n−1 + ...+ (1 + i) + 1
]= J · (1 + i)n − 1
i= J · sn i
⇒ (1 + i)n = 1 + i · M
J
⇒ n =ln(1 + i · MJ
)ln 1 + i
(61)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 68 / 223
Example 2.13
Smith wishes to accumulate 1000 by means of semi-annual depositsearning interest at nominal rate i (2) = 0.08, with interest creditiedsemi-annually. Regular deposits of 50 are made. Find the number ofperiods and regular deposits needed, along with any additional fractionaldeposits if such a fractional deposit is made at the time of the last regulardeposit or the very next period (i.e. last regular deposit can be 0.)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 69 / 223
Example 2.13
Here, the parameters are M = 1000, J = 50, i = 0.04. It follows that
n =ln(1 + i · MJ
)ln 1 + i
= 14.9866 (62)
Rounding down to n = 14, we obtain 50s14 0.04 = 914.60.. However, 50 isnot enough to carry over to get a final amount of 1000, so let the 914.60accrue for 1 period to 914.60 · (1.04) = 951.18 , and then add thefractional payment of 48.82. Hence 15 periods are needed
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 70 / 223
Example 2.13
Here, the parameters are M = 1000, J = 50, i = 0.04. It follows that
n =ln(1 + i · MJ
)ln 1 + i
= 14.9866 (62)
Rounding down to n = 14, we obtain 50s14 0.04 = 914.60..
However, 50 isnot enough to carry over to get a final amount of 1000, so let the 914.60accrue for 1 period to 914.60 · (1.04) = 951.18 , and then add thefractional payment of 48.82. Hence 15 periods are needed
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 70 / 223
Example 2.13
Here, the parameters are M = 1000, J = 50, i = 0.04. It follows that
n =ln(1 + i · MJ
)ln 1 + i
= 14.9866 (62)
Rounding down to n = 14, we obtain 50s14 0.04 = 914.60.. However, 50 isnot enough to carry over to get a final amount of 1000, so let the 914.60accrue for 1 period to 914.60 · (1.04) = 951.18 , and then add thefractional payment of 48.82. Hence 15 periods are needed
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 70 / 223
Example 2.13
Smith pays 100 per month to a fund earning i (12) = 0.09, with interestcredited on the last day of each month. At the time of each deposit, 10 isdeducted from the deposit for expenses and administration fees. The firstdeposit is made on the last day of Jan 2000. In which month does theaccumulated value become greater than the total gross contribution tothat point?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 71 / 223
Example 2.13
We wish to solve for the time when the Value of the account exceeds thetotal amount invested, i.e. the value n that satisfies
90 ·[1 + 1.0075 + ...+ 1.0075n−1
]≥ 100n
sn i ≥100
90n
1.0075n ≥ 1 + 0.00833n
(63)
Essentially, we are solving a fixed point equation for f (x) = 0, where
f (x) = ekx − 1− 0.00833x
k = ln (1.0075)(64)
In this case, plotting the above function of x gives an intercept ofapproximately 28.6. Hence, n = 29.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 72 / 223
Example 2.13
We wish to solve for the time when the Value of the account exceeds thetotal amount invested, i.e. the value n that satisfies
90 ·[1 + 1.0075 + ...+ 1.0075n−1
]≥ 100n
sn i ≥100
90n
1.0075n ≥ 1 + 0.00833n
(63)
Essentially, we are solving a fixed point equation for f (x) = 0, where
f (x) = ekx − 1− 0.00833x
k = ln (1.0075)(64)
In this case, plotting the above function of x gives an intercept ofapproximately 28.6. Hence, n = 29.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 72 / 223
Example 2.13
We wish to solve for the time when the Value of the account exceeds thetotal amount invested, i.e. the value n that satisfies
90 ·[1 + 1.0075 + ...+ 1.0075n−1
]≥ 100n
sn i ≥100
90n
1.0075n ≥ 1 + 0.00833n
(63)
Essentially, we are solving a fixed point equation for f (x) = 0, where
f (x) = ekx − 1− 0.00833x
k = ln (1.0075)(64)
In this case, plotting the above function of x gives an intercept ofapproximately 28.6. Hence, n = 29.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 72 / 223
Example 2.13
We wish to solve for the time when the Value of the account exceeds thetotal amount invested, i.e. the value n that satisfies
90 ·[1 + 1.0075 + ...+ 1.0075n−1
]≥ 100n
sn i ≥100
90n
1.0075n ≥ 1 + 0.00833n
(63)
Essentially, we are solving a fixed point equation for f (x) = 0, where
f (x) = ekx − 1− 0.00833x
k = ln (1.0075)(64)
In this case, plotting the above function of x gives an intercept ofapproximately 28.6. Hence, n = 29.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 72 / 223
Example 2.13
We wish to solve for the time when the Value of the account exceeds thetotal amount invested, i.e. the value n that satisfies
90 ·[1 + 1.0075 + ...+ 1.0075n−1
]≥ 100n
sn i ≥100
90n
1.0075n ≥ 1 + 0.00833n
(63)
Essentially, we are solving a fixed point equation for f (x) = 0, where
f (x) = ekx − 1− 0.00833x
k = ln (1.0075)(64)
In this case, plotting the above function of x gives an intercept ofapproximately 28.6. Hence, n = 29.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 72 / 223
Example 2.13
We wish to solve for the time when the Value of the account exceeds thetotal amount invested, i.e. the value n that satisfies
90 ·[1 + 1.0075 + ...+ 1.0075n−1
]≥ 100n
sn i ≥100
90n
1.0075n ≥ 1 + 0.00833n
(63)
Essentially, we are solving a fixed point equation for f (x) = 0, where
f (x) = ekx − 1− 0.00833x
k = ln (1.0075)(64)
In this case, plotting the above function of x gives an intercept ofapproximately 28.6. Hence, n = 29.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 72 / 223
Dividend Discount Model for Stock Shares
We now have a philosophy for pricing assets that bring a future stream ofpayments. Simply put, the value today of the asset is simply the NetPresent Value, opr NPV, of that stream of payments, when adjusted forinflation or (compound) growth, if applicable.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 73 / 223
Dividend Discount Model for Stock Shares
If a table, or number line of future payments looks like
Table: Example 1.5: Payments In
Week 0 1 2 ...n
Payment in 0 K K · (1 + r) K · (1 + r)n−1
then the NPV, valued with rate i , is
NPV =K
1 + i+
K · (1 + r)
(1 + i)2+ ...+
K · (1 + r)n−1
(1 + i)n
=K
1 + i·n−1∑j=0
(1 + r
1 + i
)j
=K
1 + i·
1−(1+r1+i
)n1− 1+r
1+i
(65)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 74 / 223
Dividend Discount Model for Stock Shares
As n→∞, we approach a perpetuity, and
NPV → K
1 + i· 1
1− 1+r1+i
=K
i − r(66)
In words, we have a perpetuity that is adjusted for the growth rate r . Weuse this formula to price a stock or any other asset as a perpetuity withpossible compound growth at rate r .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 75 / 223
Example 2.13
Stock X pays dividend 50 per year with growth of 5% after the first year.John purchases X at the theoretical price corresponding to an effectiveyield of 10%. After receiving the the 10th dividend, John sells the stock forprice P. If annual yield for John was 8%, what is the fair price for P ?
The equation of value is
50
0.10− 0.05= 1000 =
50
1.08·
9∑j=0
(1.05
1.08
)j
+P
1.0810
⇒ P = 1000(1.08)10 − 50(1.08)9 ·9∑
j=0
(1.05
1.08
)j
= 1000(1.08)10 − 50(1.08)9
(1−
(1.051.08
)101−
(1.051.08
)1)
= 1275.54.
(67)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 76 / 223
Example 2.13
Stock X pays dividend 50 per year with growth of 5% after the first year.John purchases X at the theoretical price corresponding to an effectiveyield of 10%. After receiving the the 10th dividend, John sells the stock forprice P. If annual yield for John was 8%, what is the fair price for P ?
The equation of value is
50
0.10− 0.05= 1000 =
50
1.08·
9∑j=0
(1.05
1.08
)j
+P
1.0810
⇒ P = 1000(1.08)10 − 50(1.08)9 ·9∑
j=0
(1.05
1.08
)j
= 1000(1.08)10 − 50(1.08)9
(1−
(1.051.08
)101−
(1.051.08
)1)
= 1275.54.
(67)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 76 / 223
Example 2.13
Stock X pays dividend 50 per year with growth of 5% after the first year.John purchases X at the theoretical price corresponding to an effectiveyield of 10%. After receiving the the 10th dividend, John sells the stock forprice P. If annual yield for John was 8%, what is the fair price for P ?
The equation of value is
50
0.10− 0.05= 1000 =
50
1.08·
9∑j=0
(1.05
1.08
)j
+P
1.0810
⇒ P = 1000(1.08)10 − 50(1.08)9 ·9∑
j=0
(1.05
1.08
)j
= 1000(1.08)10 − 50(1.08)9
(1−
(1.051.08
)101−
(1.051.08
)1)
= 1275.54.
(67)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 76 / 223
Increasing Annuities
Consider now a payment schedule where the payment, at time k , wasKm = m .
Now, the net present value is
X =n∑
m=1
Kmνm =
n∑m=1
mνm =n∑
m=1
m
(1 + i)m(68)
Then
(1 + i) · X =n∑
m=1
mνm−1 =n∑
m=1
m
(1 + i)m−1
i · X = 1 + ν + ν2 + ...+ νn−1 − nνn
=1− νn
1− ν− nνn
X =an i − nνn
i=: (Ia)n i
(69)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 77 / 223
Increasing Annuities
Consider now a payment schedule where the payment, at time k , wasKm = m .Now, the net present value is
X =n∑
m=1
Kmνm =
n∑m=1
mνm =n∑
m=1
m
(1 + i)m(68)
Then
(1 + i) · X =n∑
m=1
mνm−1 =n∑
m=1
m
(1 + i)m−1
i · X = 1 + ν + ν2 + ...+ νn−1 − nνn
=1− νn
1− ν− nνn
X =an i − nνn
i=: (Ia)n i
(69)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 77 / 223
Increasing Annuities
Consider now a payment schedule where the payment, at time k , wasKm = m .Now, the net present value is
X =n∑
m=1
Kmνm =
n∑m=1
mνm =n∑
m=1
m
(1 + i)m(68)
Then
(1 + i) · X =n∑
m=1
mνm−1 =n∑
m=1
m
(1 + i)m−1
i · X = 1 + ν + ν2 + ...+ νn−1 − nνn
=1− νn
1− ν− nνn
X =an i − nνn
i=: (Ia)n i
(69)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 77 / 223
Increasing Annuities
An increasing perpetuity is defined as
limn→∞
(Ia)n i = limn→∞
1−νn1−ν − nνn
i
=1 + i
i2
(70)
Notice that the level payment perpetuity of Kl ≡ 1 has present value ofonly 1
i . Since i ≈ 0, we have 1i2>> 1
i .
HW: apply same analysis for decreasing annuities, with Km = n −m + 1,where m ∈ 1, 2, .., n
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 78 / 223
Increasing Annuities
An increasing perpetuity is defined as
limn→∞
(Ia)n i = limn→∞
1−νn1−ν − nνn
i
=1 + i
i2
(70)
Notice that the level payment perpetuity of Kl ≡ 1 has present value ofonly 1
i . Since i ≈ 0, we have 1i2>> 1
i .
HW: apply same analysis for decreasing annuities, with Km = n −m + 1,where m ∈ 1, 2, .., n
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 78 / 223
Example 2.22
Consider perpetuities X and Y with payment
Table: Example 2.22: Payments Schedule X
Week 1 2 3 ..n..
Payment in 1 2 3 ..n..
Table: Example 2.22: Payments Schedule Y
Week 1 2 3 4 ..2k − 1 2k ..
Payment in q q 2q 2q ..kq kq..
at the end of each year. It is known that NPV (X ) = NPV (Y ) whenvalued at annual interest rate i = 0.10. Solve for q.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 79 / 223
Example 2.22
If we take νeq := ν2 =(
11.1
)2= 1
1.21 , and so ieq = 0.21. It follows that
NPV (X ) =1 + i
i2=
1.1
0.01= 110
NPV (Y ) = qν + qν2 + 2qν3 + 2qν4 + 3qν5 + 3qν6 + ...
= q ·(ν + 2ν3 + 3ν5 + ..
)+ q ·
(ν2 + 2ν4 + 3ν6 + ..
)=(
q +q
ν
)·(ν2 + 2ν4 + 3ν6 + ..
)=(
q +q
ν
)·(νeq + 2ν2eq + 3ν3eq + ..
)= 2.1 · q · 1 + ieq
i2eq= 2.1 · q · 1.21
0.212= 57.62q
q = 1.91
(71)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 80 / 223
Example 2.22
If we take νeq := ν2 =(
11.1
)2= 1
1.21 , and so ieq = 0.21. It follows that
NPV (X ) =1 + i
i2=
1.1
0.01= 110
NPV (Y ) = qν + qν2 + 2qν3 + 2qν4 + 3qν5 + 3qν6 + ...
= q ·(ν + 2ν3 + 3ν5 + ..
)+ q ·
(ν2 + 2ν4 + 3ν6 + ..
)=(
q +q
ν
)·(ν2 + 2ν4 + 3ν6 + ..
)=(
q +q
ν
)·(νeq + 2ν2eq + 3ν3eq + ..
)= 2.1 · q · 1 + ieq
i2eq= 2.1 · q · 1.21
0.212= 57.62q
q = 1.91
(71)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 80 / 223
Continuous Payment Schemes
What if the payments Km were just discrete samples at time tm of acontinuous payment scheme? For example, the payment at time t = t1was Ki = h(ti )dt.
Then all payments must be summed to obtain the NPV and AccValue:
NPV =
∫ n
0
1
(1 + i)th(t)dt
AccVal =
∫ n
0(1 + i)n−th(t)dt
(72)
A special case is when h(t) = t. Then
(I a)n i
=
∫ n
0
1
(1 + i)ttdt
(I s)n i
=
∫ n
0(1 + i)n−ttdt
(73)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 81 / 223
Continuous Payment Schemes
What if the payments Km were just discrete samples at time tm of acontinuous payment scheme? For example, the payment at time t = t1was Ki = h(ti )dt.
Then all payments must be summed to obtain the NPV and AccValue:
NPV =
∫ n
0
1
(1 + i)th(t)dt
AccVal =
∫ n
0(1 + i)n−th(t)dt
(72)
A special case is when h(t) = t. Then
(I a)n i
=
∫ n
0
1
(1 + i)ttdt
(I s)n i
=
∫ n
0(1 + i)n−ttdt
(73)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 81 / 223
Continuous Payment Schemes
Integration by parts allows us to obtain
(I a)n i
=
∫ n
0
1
(1 + i)ttdt =
an i − nνn
δ(I s)n i
=
∫ n
0(1 + i)n−ttdt =
sn i − n
δ
δ := ln (1 + i)
(74)
where δ is the constant force of interest.
If the force of interest varies, then
(I a)n δ∗
=
∫ n
0e−
∫ t0 δsdstdt(
I s)n δ∗
=
∫ n
0e∫ nt δsdstdt
(75)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 82 / 223
Continuous Payment Schemes
Integration by parts allows us to obtain
(I a)n i
=
∫ n
0
1
(1 + i)ttdt =
an i − nνn
δ(I s)n i
=
∫ n
0(1 + i)n−ttdt =
sn i − n
δ
δ := ln (1 + i)
(74)
where δ is the constant force of interest.If the force of interest varies, then
(I a)n δ∗
=
∫ n
0e−
∫ t0 δsdstdt(
I s)n δ∗
=
∫ n
0e∫ nt δsdstdt
(75)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 82 / 223
Unique Interest Rates for Annuity Valuation: Anapplication of the Intermediate Value Theorem
Returning to the discrete setting, consider the following important theorem
Theorem
Assume that an annuity X pays amount Kj > 0 at time tj for all times0 < t1 < t2.. < tn. Suppose that you are given L > 0. Then there exists aunique i > −1 such that NPV (X )(i) :=
∑nl=1
Kl
(1+i)tl= L under rate i .
Without this theorem, we would not be able to uniquely price returns onassets.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 83 / 223
Unique Interest Rates for Annuity Valuation: Anapplication of the Intermediate Value Theorem
Proof.
It follows that since (Kl , tl)nl=1 ⊂ R2+, we have NPV (X )′(i) < 0. This
also follows from financial reasoning as a higher rate i would demand alower up front payment L. Since
limi→∞
NPV (X )(i) = 0
limi→−1
NPV (X )(i) =∞(76)
it follows from the IVT that there exists a unique i (due to strictdecreasing nature of NPV (X )(i)) such that NPV (X )(i) = L
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 84 / 223
Yield and Reinvestment Rates
Assume a loan amount L for a term of n years, and a total value M of allpayments after the n years. Then it must be that for level payments K theyield rate i satisfies
L =M
(1 + i)n=
K
1 + i+
K
(1 + i)2+ ..+
K
(1 + i)n= K · an i (77)
On a loan, the Internal Rate of Return, or IRR, is the rate of interest forwhich the loan amount upront is equal in value to the NPV of all loanpayments. Also known as the loan rate. Sometimes, the entity that loansL can reinvest these loan repayments at a higher rate.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 85 / 223
Ex. 2.25
Smith owns a 10000 savings bond that pays i(12)Bond = 0.06. Upon receipt of
an interest payment, he immediately deposits it into an account earning
interest, payable monthly, at a rate of i(12)X = 0.12. Find the accumulated
value of this account just after the 12th, 24th, and 36th deposit. In each
case, find the average annual yield i(12)avg based on his initial investment of
10000. Assume that the savings bond may be cashed in any time for10000.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 86 / 223
Ex. 2.25
The interest paid each month is at a rate of i (12)
12 = 0.0612 = 0.5%. On an
investment of 10000, this means payments of 50 each month. The valueof his reinvestment of these payments at rate 0.01 is
Table: Example 2.25: Accumulated Value of Reinvestment
Month 12 24 36
Acc Val 50 · s12 0.01 50 · s24 0.01 50 · s36 0.01= 634.13 1348.67 2153.84
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 87 / 223
Ex. 2.25
After 12 months, the equivalent rate j needed to accumulate10000 + 50 · s12 0.01 = 10634.13 satisfies
10000(
1 +i(12)avg
12
)12= 10634.13
⇒ i(12)avg = 0.0616
(78)
Do this for the other cases.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 88 / 223
Ex. 2.25
In general, we have
10000(
1 +i(12)avg (n)
12
)n= 10000[1 + 0.005sn 0.01]
= 10000[1 + 0.005
(1.01)n − 1
0.01
]⇒ i
(12)avg (n) = 12
[(1
2+
1
2(1.01)n
) 1n − 1
] (79)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 89 / 223
Sinking Fund Method of Valuation
It often happens that interest payments returned to an investor at rate ican only be reinvested at ”market” rate j . If j 6= i , then the yield rate tovalue the investment is also 6= i and we consider another way to determinethe value. Instead of using the present value method, we now consider thevalue at the end of the term n of the investment.
When an investment is made, it can be considered a loan (principal) to theperson receiving the money up front. By the end of the term, the entireprincipal has been repaid and the investor has enjoyed (consumed) periodicinterest payments for making the initial investment.
Consider, for example, the fair purchase price P of an annuity with levelpayments K over n periods.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 90 / 223
Sinking Fund Method of Valuation
Receive periodic payments K in return for initial investment P.
The interest payment is P · i , received every unit of time over intervalof length n.
These interest payments are consumed, and the excess K − P · i everyperiod is reinvested at a rate j into a sinking fund.
The fair value P is now determined via the recursive equation thatsays investor recovers P at end of term, and this is equivalent to theamount accumulated by reinvesting the excess K − P · i per period:
P = (K − P · i) sn j
P =Ksn j
1 + i · sn j=
Ksn j
1 + ij · ((1 + j)n − 1)
limj→i
P =Ksn i
1 + (1 + i)n − 1= Kan i
(80)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 91 / 223
Sinking Fund Method of Valuation
Receive periodic payments K in return for initial investment P.
The interest payment is P · i , received every unit of time over intervalof length n.
These interest payments are consumed, and the excess K − P · i everyperiod is reinvested at a rate j into a sinking fund.
The fair value P is now determined via the recursive equation thatsays investor recovers P at end of term, and this is equivalent to theamount accumulated by reinvesting the excess K − P · i per period:
P = (K − P · i) sn j
P =Ksn j
1 + i · sn j
=Ksn j
1 + ij · ((1 + j)n − 1)
limj→i
P =Ksn i
1 + (1 + i)n − 1= Kan i
(80)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 91 / 223
Sinking Fund Method of Valuation
Receive periodic payments K in return for initial investment P.
The interest payment is P · i , received every unit of time over intervalof length n.
These interest payments are consumed, and the excess K − P · i everyperiod is reinvested at a rate j into a sinking fund.
The fair value P is now determined via the recursive equation thatsays investor recovers P at end of term, and this is equivalent to theamount accumulated by reinvesting the excess K − P · i per period:
P = (K − P · i) sn j
P =Ksn j
1 + i · sn j=
Ksn j
1 + ij · ((1 + j)n − 1)
limj→i
P =Ksn i
1 + (1 + i)n − 1= Kan i
(80)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 91 / 223
Sinking Fund Method of Valuation
Receive periodic payments K in return for initial investment P.
The interest payment is P · i , received every unit of time over intervalof length n.
These interest payments are consumed, and the excess K − P · i everyperiod is reinvested at a rate j into a sinking fund.
The fair value P is now determined via the recursive equation thatsays investor recovers P at end of term, and this is equivalent to theamount accumulated by reinvesting the excess K − P · i per period:
P = (K − P · i) sn j
P =Ksn j
1 + i · sn j=
Ksn j
1 + ij · ((1 + j)n − 1)
limj→i
P =Ksn i
1 + (1 + i)n − 1= Kan i
(80)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 91 / 223
Amortization
When repaying a loan L with periodic payments Km at time m, we havethe equation of value
L =n∑
m=1
Km
(1 + i)m(81)
In this method, we track the outstanding balance on a loan, denoted byOB(i) or sometimes OBi .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 92 / 223
Amortization
OB0 = L
OB1 = L · (1 + i)− K1
OB2 = OB1 · (1 + i)− K2
OBt+1 = OBt · (1 + i)− Kt+1 = OBt − PRt+1
PRt+1 = Kt+1 − i · OBt
It+1 = i · OBt
OBn = 0 = OBn−1 · (1 + i)− Kn
(82)
Also note that the total interest and cash paid out are, respectively,∑nt=1 It and
∑nt=1 Kt −
∑nt=1 It .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 93 / 223
Amortization
OB0 = L
OB1 = L · (1 + i)− K1
OB2 = OB1 · (1 + i)− K2
OBt+1 = OBt · (1 + i)− Kt+1 = OBt − PRt+1
PRt+1 = Kt+1 − i · OBt
It+1 = i · OBt
OBn = 0 = OBn−1 · (1 + i)− Kn
(82)
Also note that the total interest and cash paid out are, respectively,∑nt=1 It and
∑nt=1 Kt −
∑nt=1 It .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 93 / 223
Amortization
OB0 = L
OB1 = L · (1 + i)− K1
OB2 = OB1 · (1 + i)− K2
OBt+1 = OBt · (1 + i)− Kt+1 = OBt − PRt+1
PRt+1 = Kt+1 − i · OBt
It+1 = i · OBt
OBn = 0 = OBn−1 · (1 + i)− Kn
(82)
Also note that the total interest and cash paid out are, respectively,∑nt=1 It and
∑nt=1 Kt −
∑nt=1 It .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 93 / 223
Amortization
OB0 = L
OB1 = L · (1 + i)− K1
OB2 = OB1 · (1 + i)− K2
OBt+1 = OBt · (1 + i)− Kt+1 = OBt − PRt+1
PRt+1 = Kt+1 − i · OBt
It+1 = i · OBt
OBn = 0 = OBn−1 · (1 + i)− Kn
(82)
Also note that the total interest and cash paid out are, respectively,∑nt=1 It and
∑nt=1 Kt −
∑nt=1 It .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 93 / 223
Amortization
OB0 = L
OB1 = L · (1 + i)− K1
OB2 = OB1 · (1 + i)− K2
OBt+1 = OBt · (1 + i)− Kt+1 = OBt − PRt+1
PRt+1 = Kt+1 − i · OBt
It+1 = i · OBt
OBn = 0 = OBn−1 · (1 + i)− Kn
(82)
Also note that the total interest and cash paid out are, respectively,∑nt=1 It and
∑nt=1 Kt −
∑nt=1 It .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 93 / 223
Retrospective and Prospective Forms
At time t, if we look backwards to balance out how the original loanamount has grown and subtract form that our total payments, then
OBt = L · (1 + i)t −t∑
m=1
Km · (1 + i)t−m (83)
If we take the NPV viewpoint, then the outstanding balance today issimply the present value of all future payments until the the loan is paidoff:
OBt =n∑
m=t+1
Km
(1 + i)m−t(84)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 94 / 223
Example 3.2
A loan of 3000 at an effective quarterly rate of j = 0.02 is amortized bymeans of 12 quarterly payments, beginning one quarter after the loan ismade. Each payment consists of a principal repayment of 250 plus interestdue on the previous quarters outstanding balance. Construct theamortization schedule.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 95 / 223
Example 3.2
In this case, we have level princiapl repayments, and so PRt = 250 for all0 ≤ t ≤ 12. Since It+1 = 0.02 · OBt , it follows that
OBt+1 = OBt − 250
⇒ OBt = 3000− 250t
It = 0.02 · (3000− 250 · (t − 1)) = 65− 5t
Kt = It + PRt = 250 + 65− 5t = 315− 5t
(85)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 96 / 223
Amortization of a Loan with Level Repayments
In this case, which is common, the payments are held constant, say atK, but the proportion of interest paid versus principal paid varies withtime.
Examples such as mortgages, car payments, etc..
Can use retrospective method to value outstanding balance at time t.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 97 / 223
Amortization of a Loan with Level Repayments
Here, the outstanding balance is of course OBt = K · an−t i , and the totalcash paid out by time t is
∑tm=1 Kt = K · t. It follows that, with
δ = ln (1 + i)
It = i · OBt−1 = i · K · an−t+1 i = K ·(1− (1 + i)t−n−1
)PRt = Kt − It =
K
(1 + i)n+1−t
OBt =K
i·(
1− e−δ·(n−t)) (86)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 98 / 223
Sinking Fund Method of Valuation Revisited
Even though the outstanding balance is paid off only at the end of theterm of the loan, we can still interpolate and say that the outstandingbalance decreases as
OBt = L− L
sn j· st j (87)
where the balance decreases by the amount paid into the account earningat a rate j.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 99 / 223
Sinking Fund Method of Valuation Revisited
Note that we can also calculate the net interest payment each month via
Kt = L · i +L
sn j
PRt = OBt−1 − OBt = L ·(
st j − st−1 jsn j
)It = Kt − PRt = L ·
(i − j ·
st−1 jsn j
) (88)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 100 / 223
Sinking Fund Example from previous SOA Exam FM/1
Ronaldo borrows L for 10 years at an annual effective interest rate of100 · i%. At the end of each year, he pays the interest on the loan anddeposits the level amount necessary to repay the principal to a sinkingfund earning an annual effective interest rate of 100 · j%. The totalpayments made by Ronaldo over the 10-year period is X. Calculate X .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 101 / 223
Sinking Fund Example from previous SOA Exam FM/1
Answer:
Annual interest payment = L · iAnnual sinking fund deposit is L
s10|j
Total annual payment = L · i + Ls10|j
Total of all payments = 10 ·(
L · i + Ls10|j
)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 102 / 223
Makeham’s Formula
Consider the following scenario: An investor makes a loan at interest ratei, with only interest payments for the term of the loan, and then a lumpsum L at the end of term. The investor then sells the loan to a speculator,who values the expected cash flows at a rate j. Then the value thespeculator puts on the investment is
A =L
(1 + j)n+ L · i · an j =
L
(1 + j)n+
i
j·(
L− L
(1 + j)n
)(89)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 103 / 223
Makeham’s Formula
This idea generalizes to the case where the principal L is paid over a seriesof lump sum payments L =
∑nm=1 Lm and periodic repayments
K =∑n
m=1 Km.
Each of these lump sum payments can be viewed as corresponding to anindividual loan:
As =Ls
(1 + j)ts+ Ls · i · ats j =
Ls
(1 + j)ts+
i
j·(
Ls −Ls
(1 + j)ts
)(90)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 104 / 223
Makeham’s Formula
This idea generalizes to the case where the principal L is paid over a seriesof lump sum payments L =
∑nm=1 Lm and periodic repayments
K =∑n
m=1 Km.
Each of these lump sum payments can be viewed as corresponding to anindividual loan:
As =Ls
(1 + j)ts+ Ls · i · ats j =
Ls
(1 + j)ts+
i
j·(
Ls −Ls
(1 + j)ts
)(90)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 104 / 223
Makeham’s Formula
We can find the total value now by summing up the individual loan values
A =n∑
s=1
As =n∑
s=1
Ls
(1 + j)ts+
i
j·(
Ls −Ls
(1 + j)ts
)
=n∑
s=1
Ls
(1 + j)ts+
i
j·
(n∑
s=1
Ls −n∑
s=1
Ls
(1 + j)ts
)
= K +i
j· (L− K )
(91)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 105 / 223
Mortgage Repayment from previous SOA Exam FM/1
A loan L is being repaid with n annual level payments of K each. With themth payment, m < n, the borrower pays an extra amount A, and thenagrees to repay the remaining balance over l years with a revised annualpayment. The effective rate of interest is 100 · i%. . Calculate the amountof the revised annual payment.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 106 / 223
Mortgage Repayment from previous SOA Exam FM/1
With n −m yealy payments left right before the extra repayment, theremaining balance is K · a(n−m)|i . Right after the extra payment A, theremaining balance is K · a(n−m)|i − A. Hence, the new payment over thenew 10−year schedule is
Knew =K · a(n−m)|i − A
al |i(92)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 107 / 223
Bonds
A Bond is a financial contract where an up front payment is exchanged forcoupon payments (periodic interest paid to the debt-holder) plus a faceamount the maturity date (end of term). The Bond is valued using a yieldrate used to value future cash flows. The notation used with bondvaluation is
j = the Yield rate per period
F = the Face amount
r = the Coupon rate
C = the redemption amount, usually equal to the face value
N = the number of coupon payments until maturity
P = the price of the bond, where
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 108 / 223
Bonds
The bond can now be valued as
P =F
(1 + j)n+ F · r ·
(1
1 + j+ ..+
1
(1 + j)n
)= Fνn + F · r · an j
= F + F · (r − j) · an j
= Fνn +r
j· (F − Fνn)
(93)
Note that Bond prices are usually listed, and the investor determines yieldrate from listed price. To do so, must invert our Bond pricing formula.This requires some calculation.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 109 / 223
Example 4.1
Price the following bond with face 100:
Issue Date: March 1,2004
Maturity Date: Feb 28, 2006
r = 1.625%
j = 1.675%
Term is 2 years (4 six month periods)
P = 100 · 0.5 · 0.01625 ·(
1
1.008375+ ...+
1
1.0083754
)+
100
1.0083754= 99.02
(94)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 110 / 223
Example 4.1
Price the following bond with face 100:
Issue Date: March 1,2004
Maturity Date: Feb 28, 2006
r = 1.625%
j = 1.675%
Term is 2 years (4 six month periods)
P = 100 · 0.5 · 0.01625 ·(
1
1.008375+ ...+
1
1.0083754
)+
100
1.0083754= 99.02
(94)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 110 / 223
Bonds
At time t, we define Pt to be the price of the bond, just after the couponpayment. This is equal to the NPV of the remainin payments:
Pt =F
(1 + j)n−t+ F · r · an−t j (95)
Now, since the initial price P satisfies the relation P − F = F · (r − j)an j ,we say that a bond is bought at premium if r > j , at par if r = j , and at adiscount if r < j .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 111 / 223
Bond Pricing Between Coupon Dates
Let
u :=the number of days since last coupon payment
number of days in coupon period(96)
Then Pt = Pm · (1 + j)u − u · F · r , where m is the number of couponpayments left and Pm · (1 + j)u is known as the price plus accrued.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 112 / 223
Amortization of Bond
Sometimes need to determine the Book Value of a bond for tax or investorpurposes. The Book Value at time t is the outstanding balance at time tright after the coupon payment. This is the present value of the remainingcash payments of that the bond holder is entitled to receive:
Pt = OBt = F + F · (r − j) · an−t j (97)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 113 / 223
Amortization of Bond
We can use the idea that we are loaning money to bond-issuer, and thatwe price this as a mortgage. So,
Pt = OBt = F + F · (r − j) · an−t jKt = F · r for t ∈ 1, 2, 3, .., n − 1Kn = F · r + F
It = Kt − PRt
PRt = Kt − (OBt−1 − OBt)
= F · (r − j) · νn−t+1
(98)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 114 / 223
Bond Pricing Lemma
Lemma
Consider a bond with face F , coupon rate r , and term T = 2n, n ∈ N,purchased by A for a price PA. Just after the nth coupon, A sells the bondto B who desires a yield j and correspondingly pays PB . If PB > PA and
j < r or
j > r and PB >F+PA
2
then i > j , where i is the non-zero yield rate calculated on A′s investment.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 115 / 223
Bond Pricing Lemma: Proof 1
Proof.
We prove each case separately, both of which reveal something about thesituation described above.Case 1 First, if j < r
PA = F · r · an i +PB
(1 + i)n
>Fr
i·(
1− 1
(1 + i)n
)+
PA
(1 + i)n
PB = F + F · (r − j) · an j
(99)
We can see that this implies
Fr
i< PA < PB = F + F · (r − j) · an j < F + F · r − j
j=
Fr
j(100)
and so i > j
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 116 / 223
Bond Pricing Lemma: Proof 2
Proof.
Case 2 If j > r then by Makeham’s formula F > PB > PA and
PA = F · ran i +PB
(1 + i)n
= F · ran i +F
(1 + i)n+
[PB − F
(1 + i)n
]PB = F · ran j +
F
(1 + j)n
(101)
For the sake of contradiction, assume i ≤ j . Then it follows by ourassumptions that
F − PB < PB − PA ≤F − PB
(1 + i)n(102)
which is impossible.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 117 / 223
Exotic Bonds
Callable Bonds: Bond can be recalled by issuer over a window ofredemption dates. Price investor pays is the minimum of these possibleprices. So, if the bond was purchased at a premium, then price at earliestpossible date. If purchased at a discount, price at latest possibleredemption date
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 118 / 223
Exotic Bonds
Serial Bonds: Face amount F is redeemed over a collection of datest1, .., tn with staggered payments F1 + ..+ Fn = F , coupon ratesr1, .., rn, tailored to yield rates j1, .., jn. One can view this as the sum of mbonds with the corresponding payments, and can use Makehams formulato price this
P =n∑
m=1
Pm
Pt =Ft
(1 + j)nt+
rtjt·(
Ft −Ft
(1 + jt)nt
) (103)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 119 / 223
Measuring The Rate of Return Of An Investment
Yield rate can be derived from cash-flows from an investment
When presented with more than one investment opportunity, wouldlike to be able to quantitatively measure their value to the investor
There are many ways to do this some work in situations that othersdont
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 120 / 223
Internal Rate of Return
In an investment, at any time may have cash flows out and in saypayments to buy a license for a taxicab, with monthly maintenance feesversus fare payments in.
Notation is such that Ak is a payment received and Bk is a payment madeout, each at the same time tk . The net payment is thus Ck .
f (j) :=n∑
k=1
Ck
(1 + j)tk(104)
The Internal Rate of Return j is one that balances out all net payments sothat their net present value is 0.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 121 / 223
Example 5.1
Smith buys 1000 shares of stock at 5.00 per share and pays a commissionof 2%. Six months later he receives a cash-dividend of 0.20 per share,which he immediately reinvests commission free in shares at a price of 4.00per share. Six months after that he buys another 500 shares at a price4.50 per share, along with a commission of 2%. Six months after that hereceives another cash dividend of 0.25 per share and sells his existingshares at 5.00 per share, again paying a 2% commission. Find Smithsinternal rate of return for the entire transaction in the form i (2)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 122 / 223
Example 5.1
Let 0 represent the time of the original share purchase, t = 1 at 6 months,t = 2 at 12 months and t = 3 at 18 months after the original purchase.Then
(A0,B0) = (0, 5000 + [0.02× 5000]) = (0, 5100)
(A1,B1) = (200, 200)
(A2,B2) = (0, [1.02× 4.50× 500]) = (0, 2295)
(A3,B3) = ([0.25 + 0.98× 5]× 1550, 0)
= (7982.50, 0)
∴ (C0,C1,C2,C3) = (−5100, 0,−2295, 7982.5)
⇒ 0 = −5100 + 0 · ν − 2295ν2 + 7982.50ν3
(105)
Solving this polynomial, we obtain
ν =1
1 + j⇒ i (2) = 2j = 0.0649 (106)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 123 / 223
Uniqueness? Guaranteed Solution?
If C0 < 0 and Cj > 0 for all j ∈ 1, 2, ..n, then by the IntermediateValue theorem and simple calculus, we have a unique solution for theinternal return rate j . (i.e. Mortgages or other loans paid off byperiodic payments)
BUT, we can have situations where the above isnt satisfied, and wecompute more than solution for j , or worse, no real solution.
What can we use to measure the value of an investment in this case?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 124 / 223
Net Present Value
Assume that among all possible investment alternatives, all have samemeasure of risk and fixed interest rate i that investor proposes(Utility theory!)
In this incomplete case, use i , also known as cost of capital, to findpresent value of cash flows of each investment on the table
The one with the largest present value, given investors rate i, is mostpreferable. In symbols, for investments a, b, c , with NPVfa(i), fb(i), fc(i), choose the biggest
HW: Can NPV curves ever intersect for different values of i ?
Of course, if i = j =yield rate, then NPV = 0
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 125 / 223
Profitability Index
Again, if the investor proposes his own interest rate i , then we can useanother measure, the Profitability Index:
I =PV [ Cash Flows In]
PV [ Cash Flows Out ](107)
Note that if i = j = IRR, then I = 1 by design,as yield rate is what we useto balance out flows with in flows.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 126 / 223
Profitability Index: Example
Compare
(a) lending 1000 and being repaid 250 per year for 5 years withi = 0.05 and
(b) lending 1000 and being repaid 140 per year for 10 years withi = 0.05
We compute
Ia =250a5 0.05
1000= 1.0824
Ib =140a10 0.05
1000= 1.0810
(108)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 127 / 223
Profitability Index: Example
Compare
(a) lending 1000 and being repaid 250 per year for 5 years withi = 0.05 and
(b) lending 1000 and being repaid 140 per year for 10 years withi = 0.05
We compute
Ia =250a5 0.05
1000= 1.0824
Ib =140a10 0.05
1000= 1.0810
(108)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 127 / 223
MIRR
Goal: Find j such that Accumulated Value at end of project of paymentsout at rate j matches Accumulated Value of payments received atinvestor’s cost of capital i .
Notation:
Ak is the payment in at time k
Bk is the payment out at time k
Then j solves the equation
N∑n=0
An · (1 + i)n =N∑
m=0
Bm · (1 + j)m (109)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 128 / 223
MIRR
Goal: Find j such that Accumulated Value at end of project of paymentsout at rate j matches Accumulated Value of payments received atinvestor’s cost of capital i .
Notation:
Ak is the payment in at time k
Bk is the payment out at time k
Then j solves the equation
N∑n=0
An · (1 + i)n =N∑
m=0
Bm · (1 + j)m (109)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 128 / 223
MIRR: Example
Compare
(a) lending 1000 and being repaid 250 per year for 5 years withi = 0.05 and
(b) lending 1000 and being repaid 140 per year for 10 years withi = 0.05
We compute
1000(1 + ja)5 = 250s5 0.05 = 1381.41
⇒ ja = 0.0668
1000(1 + jb)10 = 140s10 0.05 = 1760.90
⇒ jb = 0.0582
(110)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 129 / 223
MIRR: Example
Compare
(a) lending 1000 and being repaid 250 per year for 5 years withi = 0.05 and
(b) lending 1000 and being repaid 140 per year for 10 years withi = 0.05
We compute
1000(1 + ja)5 = 250s5 0.05 = 1381.41
⇒ ja = 0.0668
1000(1 + jb)10 = 140s10 0.05 = 1760.90
⇒ jb = 0.0582
(110)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 129 / 223
Project Return Rate
There are times during a project where investor is borrower and timeswhen she is lender. Cost of financing at rate i , and project return rate is jwhen she is net lender. Solving j in terms of i would give minimum returnrate needed for project to break even if set NPV to 0 at end of project.
Goal: Set up an equation of value such that Net Project Value = 0 whent = N. If the value at t = n is > 0, then earn at rate j . If balance < 0,then ”earn” (pay) at rate i (cost of capital). As an example, consider
S0 = 1→ S1− = (1 + j)
S1 = 1 + j − 2.3→ S2− = (1 + j − 2.3)(1 + i)
S2 = (1 + j − 2.3)(1 + i) + 1.33 = 0
⇒ j = 1.3− 1.33
1 + i
(111)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 130 / 223
Dollar Weighted Rate of Return
Goal: Calculate measure of return over 1 year.
Use Simple Interest forfraction of years. Define interest gained as the difference between the totalamount paid out during year to term and the total amount paid in duringyear to term.
idollar weigted =Total Interest Gained
Average Amount on deposit during year(112)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 131 / 223
Dollar Weighted Rate of Return
Goal: Calculate measure of return over 1 year. Use Simple Interest forfraction of years. Define interest gained as the difference between the totalamount paid out during year to term and the total amount paid in duringyear to term.
idollar weigted =Total Interest Gained
Average Amount on deposit during year(112)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 131 / 223
Example 5.3
A Pension fund receives contributions and pays benefits from time to time.The fund began the year 2005 with a balance of 1, 000, 000. There werecontributions to the fund of 200, 000 at the end of February and again atthe end of August. There was a benefit of 500, 000 paid out of the fund atthe end of October. The balance remaining at the start of the year 2006was 1, 100, 000. Find the dollar weighted return on the fund, assumingeach month is 1
12 of a year
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 132 / 223
Example 5.3
1, 100, 000 = 1, 000, 000(1 + i) + 200, 000 ·(
1 +10
12i
)+ 200, 000 ·
(1 +
4
12i
)− 500, 000 ·
(1 +
2
12i
)T .I .G . = 1, 100, 000 + 500, 000− 1, 000, 000
− 200, 000− 200, 000 = 200, 000
A.A.o.d .d .y = 1, 000, 000 + 200, 000 · 10
12
+ 200, 000 · 4
12− 500, 000 · 2
12= 1, 150, 000
⇒ i =200, 000
1, 150, 000= 0.1739
(113)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 133 / 223
Even More Methods of Valuation
Time Weighted Rate of Return: Compound over fraction of years, butthe time length doesnt matter
Portfolio Method: Contributions to a fund, once opened, aresegregated from initial investment and accrue interest at a differentrate for a fixed term
Interest Preference Rates for Borrowing and Lending: If accumulatedamount falls below zero, pay interest at a different rate than interestcredited on a positive balance. This is useful to compare twoalternatives when one may have a negative balance for some time
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 134 / 223
Continuous Withdrawal and Investment
Begin with the equation for accumulated value
F (t2) = F (t1)·(1+i)t2−t1+n∑
k=1
ct∗k (1+i)t2−t∗k +
∫ t2
t1
c(t)(1+i)t2−tdt (114)
As an example, consider t1 = 0, t2 = 1, t∗k = kn , ct∗k = 1, c(t) = N − n.
Then
F (1) = F (0) · (1 + i) +n∑
k=1
(1 + i)1−kn + (N − n) ·
∫ 1
0(1 + i)1−tdt
= F (0) · (1 + i) +i
(1 + i)1n − 1
+(N − n) · iln (1 + i)
(115)
Now, given F (0),F (1), n,N, solve for i .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 135 / 223
Continuous Withdrawal and Investment
Begin with the equation for accumulated value
F (t2) = F (t1)·(1+i)t2−t1+n∑
k=1
ct∗k (1+i)t2−t∗k +
∫ t2
t1
c(t)(1+i)t2−tdt (114)
As an example, consider t1 = 0, t2 = 1, t∗k = kn , ct∗k = 1, c(t) = N − n.
Then
F (1) = F (0) · (1 + i) +n∑
k=1
(1 + i)1−kn + (N − n) ·
∫ 1
0(1 + i)1−tdt
= F (0) · (1 + i) +i
(1 + i)1n − 1
+(N − n) · iln (1 + i)
(115)
Now, given F (0),F (1), n,N, solve for i .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 135 / 223
Continuous Withdrawal and Investment
Begin with the equation for accumulated value
F (t2) = F (t1)·(1+i)t2−t1+n∑
k=1
ct∗k (1+i)t2−t∗k +
∫ t2
t1
c(t)(1+i)t2−tdt (114)
As an example, consider t1 = 0, t2 = 1, t∗k = kn , ct∗k = 1, c(t) = N − n.
Then
F (1) = F (0) · (1 + i) +n∑
k=1
(1 + i)1−kn + (N − n) ·
∫ 1
0(1 + i)1−tdt
= F (0) · (1 + i) +i
(1 + i)1n − 1
+(N − n) · iln (1 + i)
(115)
Now, given F (0),F (1), n,N, solve for i .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 135 / 223
Term Structure of Interest Rates
The relationship of the yield of a bond (or other fixed incomeproduct) to its time to maturity is the Term Structure
The graph of this relationship is the Yield Curve
Term Structure is dynamic ; reflects new information gained asmarkets evolve
A yield curve that corresponds to Normal Term Structure is one thatsees yield increase when the time to maturity increases. When theyield decreases as term increases, we say the yield curve is Inverted,and if it is roughly constant, we say it is a Flat curve.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 136 / 223
Law of One Price
Bond Prices are linear. If we have a coupon paying bond, it musthave the same value as the sum of the prices of each coupon as anindividual zero coupon bond, as well as the lump sum paid atmaturity.
If this does not hold, then we have observed a case of arbirtrage. Thismeans one could construct a portfolio that consists of purchasingindividual pieces of a coupon bond while selling the equivalent wholebond, making a net profit with no risk involved.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 137 / 223
Example 6.1
Suppose that the current term structure has the following yields onzero-coupon bonds, where all yields are nominal annual rates of interestcompounded semi-annually
Table: Example 6.1: Term Structure
Term (Years) 0.5 1 1.5 2
Zero Coupon Bond Rate 8% 9% 10% 11%
Find the price per 100 face amount and yield to maturity of each of thefollowing 2-year bonds (with semi-annual coupons)
a.) Zero coupon bond
b.) 5% annual coupon rate
c .) 10% annual coupon rate
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 138 / 223
Example 6.1
a.) PV = 100
(1+ 0.112 )
4 = 80.72, which implies j (2) = 0.11
b.)
PV =2.5
1.04+
2.5
1.0452+
2.5
1.053+
102.5
1.0554= 89.59
=2.5
1 + j(2)
2
+2.5(
1 + j(2)
2
)2 +2.5(
1 + j(2)
2
)3 +102.5(
1 + j(2)
2
)4⇒ j (2) = 0.109354
(116)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 139 / 223
Example 6.1
c .) Similarly,
PV =5
1.04+
5
1.0452+
5
1.053+
105
1.0554
= 98.46
=5
1 + j(2)
2
+5(
1 + j(2)
2
)2 +5(
1 + j(2)
2
)3 +105(
1 + j(2)
2
)4 (117)
and so j (2) = 0.108775
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 140 / 223
Spot Rates
The Spot Rate st is the effective annual interest rate for a zerocoupon bond maturing t years from now.
There is a relationship between the spot rate and the yield tomaturity of a bond.
If term structure of spot rates is increasing, then yield for bonds withsame maturity decreases as coupons increase
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 141 / 223
Spot Rates and Yield Rates
The general equation of value here to determine the yield rate yr on abond with face 1 is
PV = r ·(
1
1 + s1+
1
(1 + s2)2+ ..+
1
(1 + sn)n
)+
1
(1 + sn)n
= r ·(
1
1 + yr+
1
(1 + yr )2+ ..+
1
(1 + yr )n
)+
1
(1 + yr )n
(118)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 142 / 223
Spot Rates and Yield Rates
Solving for r , we obtain
r = −1
(1+yr )n− 1
(1+sn)n∑nk=1
1(1+yr )k
−∑n
k=11
(1+sk )k
(119)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 143 / 223
Spot Rates and Yield Rates
Q: Is there anything we can say about dyrdr given a normal term structure?
A: Implicit differentiation leads to
dyrdr
=1
r·
1(1+sn)n
− 1(1+yr )n
r∑n
k=1k
(1+yr )k+1 + n(1+yr )n+1
< 0
(120)
if we have a normal term structure as we expect sn > yr and so1
(1+sn)n< 1
(1+yr )n.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 144 / 223
Spot Rates and Yield Rates
Q: Is there anything we can say about dyrdr given a normal term structure?
A: Implicit differentiation leads to
dyrdr
=1
r·
1(1+sn)n
− 1(1+yr )n
r∑n
k=1k
(1+yr )k+1 + n(1+yr )n+1
< 0
(120)
if we have a normal term structure as we expect sn > yr and so1
(1+sn)n< 1
(1+yr )n.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 144 / 223
Forward Rates
In keeping with Law of One Price (No Arbitrage), can set up therelationship between spot rates and forward rates
Forward Rate is the interest rate to be charged starting at time t for afixed period
We will talk about 1−year Forward Rates, i.e. interest rate chargedfrom to t + 1
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 145 / 223
Exact Form
If we set up a deal such that 1 is to be invested at time 0, and the 1−yearspot rate s1 = 0.08 , and the 2−year spot rate is s2 = 0.09, then at t = 1,if the rate to borrow and lend is the same, the rate from year 1 to year 2,i1,2 , should be defined via
1.092 = (1 + i1,2) · 1.08
i1,2 = 0.1001(121)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 146 / 223
General Relationship between Spot Rates and ForwardRates
1 + s1 = 1 + i0,1
(1 + s2)2 = (1 + i0,1)(1 + i1,2)
... =...
(1 + sn)n = Πnk=1(1 + ik−1,k)
(122)
Inverting this relationship, we obtain
ik−1,k =(1 + sk)k
(1 + sk−1)k−1− 1 (123)
Q: For a normal term structure where sk > sk−1, what can we say aboutthe relationship between sk and ik−1,k ?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 147 / 223
General Relationship between Spot Rates and ForwardRates
1 + s1 = 1 + i0,1
(1 + s2)2 = (1 + i0,1)(1 + i1,2)
... =...
(1 + sn)n = Πnk=1(1 + ik−1,k)
(122)
Inverting this relationship, we obtain
ik−1,k =(1 + sk)k
(1 + sk−1)k−1− 1 (123)
Q: For a normal term structure where sk > sk−1, what can we say aboutthe relationship between sk and ik−1,k ?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 147 / 223
General Relationship between Spot Rates and ForwardRates
From the previous slide, we can compute the following table:
Table: Example 6.3: Term Structure
Spot Rate s1 = 0.05 s2 = 0.1 s3 = 0.15
Forward Rate i0,1 = 0.05 i1,2 = 0.1524 i2,3 = 0.2596
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 148 / 223
Force of Interest vs YTM
Define αt as the continuously compounded yield rate. Then
PV (t = 0) = Fe−tαt
= Fe−∫ t0 δsds
⇒ tαt =
∫ t
0δsds
⇒ αt + tdαt
dt= δt
(124)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 149 / 223
Force of Interest vs YTM
Summarizing, we have the dual relationship
αt =1
t
∫ t
0δsds
δt = αt + tdαt
dt
(125)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 150 / 223
Force of Interest vs YTM
Recall that in the discrete case,
1 + sn = [(i + i0,1) · (1 + i1,2) · ... · (1 + in−1,n)]1n (126)
Hence, 1 + sn is the geometric mean of the forward rates.
In the continuous case, the YTM αt is the arithmetic mean of the force ofinterest over the interval [0, t]. It follows that δt can be seen as a forwardrate in the continuous case.
Q: Again, if the term structure is increasing, ie. if dαtdt > 0, then how does
αt relate to δt ?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 151 / 223
Force of Interest vs YTM
Recall that in the discrete case,
1 + sn = [(i + i0,1) · (1 + i1,2) · ... · (1 + in−1,n)]1n (126)
Hence, 1 + sn is the geometric mean of the forward rates.
In the continuous case, the YTM αt is the arithmetic mean of the force ofinterest over the interval [0, t]. It follows that δt can be seen as a forwardrate in the continuous case.
Q: Again, if the term structure is increasing, ie. if dαtdt > 0, then how does
αt relate to δt ?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 151 / 223
Force of Interest vs YTM
Recall that in the discrete case,
1 + sn = [(i + i0,1) · (1 + i1,2) · ... · (1 + in−1,n)]1n (126)
Hence, 1 + sn is the geometric mean of the forward rates.
In the continuous case, the YTM αt is the arithmetic mean of the force ofinterest over the interval [0, t]. It follows that δt can be seen as a forwardrate in the continuous case.
Q: Again, if the term structure is increasing, ie. if dαtdt > 0, then how does
αt relate to δt ?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 151 / 223
Force of Interest vs YTM
Recall that in the discrete case,
1 + sn = [(i + i0,1) · (1 + i1,2) · ... · (1 + in−1,n)]1n (126)
Hence, 1 + sn is the geometric mean of the forward rates.
In the continuous case, the YTM αt is the arithmetic mean of the force ofinterest over the interval [0, t]. It follows that δt can be seen as a forwardrate in the continuous case.
Q: Again, if the term structure is increasing, ie. if dαtdt > 0, then how does
αt relate to δt ?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 151 / 223
Example 6.5
Suppose that the yield to maturity for a zero-coupon bond maturing attime t is αt = 0.09− 0.08 · 0.94t , a continuously compounded rate.Forward Rate is the interest rate to be charged starting at time t for afixed period
(a) Find the related forward rate
(b) A borrower plans to borrow 1000 in one year and repay the loanwith a single payment at the end of the second year. Determine theamount that will have to be paid back based on the stated termstructure
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 152 / 223
Example 6.5
a.) We find that
δt = αt + tdαt
dt= 0.09− 0.08 · 0.94t − 0.08 · 0.94t · ln (0.94) · t (127)
b.) We find that
Value = 1000e∫ 21 δtdt = 1024.11
= 1000e2α2−α1 (128)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 153 / 223
Example 6.5
a.) We find that
δt = αt + tdαt
dt= 0.09− 0.08 · 0.94t − 0.08 · 0.94t · ln (0.94) · t (127)
b.) We find that
Value = 1000e∫ 21 δtdt = 1024.11 = 1000e2α2−α1 (128)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 153 / 223
At Par Yield
Measure of Bond Yield: Find the Coupon rate rt such that the BondYield is also rt .
In this case, the Bond price is at par.
For an n−year bond,
1 = rn ·
(n∑
k=1
(1 + sk)−k
)+
1
(1 + sn)n
⇒ rn =1− 1
(1+sn)n∑nk=1
1(1+sk )k
(129)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 154 / 223
At Par Yield
Measure of Bond Yield: Find the Coupon rate rt such that the BondYield is also rt .
In this case, the Bond price is at par.
For an n−year bond,
1 = rn ·
(n∑
k=1
(1 + sk)−k
)+
1
(1 + sn)n
⇒ rn =1− 1
(1+sn)n∑nk=1
1(1+sk )k
(129)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 154 / 223
Interest Rate Swaps
Used to convert Floating Rate Liability to Fixed Rate Liability
Used between two borrowers that have access to different interestmarkets
Example
(FixedRate(A),FloatingRate(A)) = (0.08,Prime + 0.01)
(FixedRate(B),FloatingRate(B)) = (0.09,Prime + 0.015)(130)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 155 / 223
Interest Rate Swaps
Swap: A borrows at FixedRate(A), and loans to B at rate 0.085. Bborrows at FloatingRate(B), and loans to A at rate prime + 0.0125.
Net effect:
A pays (0.08− 0.085 + prime + 0.0125) = prime + 0.0075
B pays (prime + 0.015− (prime + 0.0125) + 0.085) = 0.0875
Notice both of these are smaller than what they could have gotten on theirown. Usually, there is a question of default risk, so an intermediary can bebrought in, for a small fee, depending on the spread between availablerates for A and B
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 156 / 223
Interest Rate Swaps
In general, a swap is a series of coupons exchanged upon delivery.
Imagine a bond with face value F , and term structure (impliedforward rates) for period k − 1 to k : ik−1,knk=1.
Then the implied swap rate Rn for term n is the rate that equatesthe present value all the coupon exchanges, forward rate to constantRn, to 0:
0 =n∑
k=1
(Rn − ik−1,k)F
(1 + sk)k(131)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 157 / 223
Interest Rate Swaps
We can interpret Rn in two ways. The first is to look at Rn as an averageforward rate:
Rn =n∑
j=1
pj × ij−1,j
pj =(1 + sj)
−j∑nm=1(1 + sm)−m
(132)
Note that 0 < pj < 1 and∑m
j=1 pj = 1 for positive spot rates.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 158 / 223
Interest Rate Swaps
The second way to interpret Rn is to look at Rn as an at par yield rate :
Rn =n∑
j=1
( (1 + sj)−j∑n
m=1(1 + sm)−m
)×
((1 + sj)
j
(1 + sj−1)j−1− 1
)
=
∑nj=1
(1
(1+sj−1)j−1 − 1(1+sj )j
)∑n
m=1(1 + sm)−m=
1− (1 + sn)−n∑nm=1(1 + sm)−m
= rn
(133)
as the numerator above is a telescoping series.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 159 / 223
Deferred and Non-Level Notional Interest Rate Swaps
Keeping with the analysis above, we have a Deferred Swap beginning ink periods with value
R(k)n =
n∑j=k
p(k)j × ij−1,j
p(k)j =
(1 + sj)−j∑n
m=k(1 + sm)−m.
(134)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 160 / 223
Deferred and Non-Level Notional Interest Rate Swaps
Similarly, if the notional used to calculate the coupon varies with time, andis defined as Fj at time j , then
0 =n∑
k=1
(Rn − ik−1,k)Fk
(1 + sk)k(135)
then
Rn =n∑
j=k
qj × ij−1,j
qj =Fj × (1 + sj)
−j∑nm=k Fm × (1 + sm)−m
.
(136)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 161 / 223
Example: Calculating the Swap Curve
Recall the table from Example 6.3:
Table: Example 6.3: Term Structure
Spot Rate s1 = 0.05 s2 = 0.1 s3 = 0.15
Forward Rate i0,1 = 0.05 i1,2 = 0.1524 i2,3 = 0.2596
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 162 / 223
Example: Calculating the Swap Curve
We can now add to this table:
Table: Example 6.3: Term Structure
Spot s1 = 0.05 s2 = 0.1 s3 = 0.15
Fwd i0,1 = 0.05 i1,2 = 0.1524 i2,3 = 0.2596
Prob p1 =1
1.051
1.05+ 1
1.102+ 1
1.153
p2 =1
1.1021
1.05+ 1
1.102+ 1
1.153
p3 =1
1.1531
1.05+ 1
1.102+ 1
1.153
∴ r3 =1
1.05 × 0.051
1.05 + 11.102
+ 11.153
+1
1.102× 0.1524
11.05 + 1
1.102+ 1
1.153
+1
1.153× 0.2596
11.05 + 1
1.102+ 1
1.153
= 0.1413.(137)
HW: Compute r1, r2. Can you set up a spreadsheet to do this?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 163 / 223
Susceptibility: Single Factor Model
How does the PV of the cashflow change as the yield rate (termstructure) changes? (1st order changes)
Once quantified, this can be used as a measure of risk associated withinvesting in this cashflow.
Consider the case where we have continuous compounding with a force ofinterest δ. For a stream of payments, we have the present value, or upfront price, determined by P(δ). The only risk factor that could changethe value then is δ. If we were to equate this value with a zero-couponbond of unknown Duration D, then
P(δ) = P(0)e−δD
D = − 1
P
dP
dδ
(138)
This of course implies that dPdδ < 0.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 164 / 223
Susceptibility: Single Factor Model
How does the PV of the cashflow change as the yield rate (termstructure) changes? (1st order changes)
Once quantified, this can be used as a measure of risk associated withinvesting in this cashflow.
Consider the case where we have continuous compounding with a force ofinterest δ. For a stream of payments, we have the present value, or upfront price, determined by P(δ). The only risk factor that could changethe value then is δ. If we were to equate this value with a zero-couponbond of unknown Duration D, then
P(δ) = P(0)e−δD
D = − 1
P
dP
dδ
(138)
This of course implies that dPdδ < 0.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 164 / 223
Susceptibility: Single Factor Model
How does the PV of the cashflow change as the yield rate (termstructure) changes? (1st order changes)
Once quantified, this can be used as a measure of risk associated withinvesting in this cashflow.
Consider the case where we have continuous compounding with a force ofinterest δ. For a stream of payments, we have the present value, or upfront price, determined by P(δ). The only risk factor that could changethe value then is δ. If we were to equate this value with a zero-couponbond of unknown Duration D, then
P(δ) = P(0)e−δD
D = − 1
P
dP
dδ
(138)
This of course implies that dPdδ < 0.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 164 / 223
Susceptibility: Single Factor Model
How does the PV of the cashflow change as the yield rate (termstructure) changes? (1st order changes)
Once quantified, this can be used as a measure of risk associated withinvesting in this cashflow.
Consider the case where we have continuous compounding with a force ofinterest δ. For a stream of payments, we have the present value, or upfront price, determined by P(δ). The only risk factor that could changethe value then is δ. If we were to equate this value with a zero-couponbond of unknown Duration D, then
P(δ) = P(0)e−δD
D = − 1
P
dP
dδ
(138)
This of course implies that dPdδ < 0.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 164 / 223
Susceptibility and Sensitivity to Market Changes: SingleFactor Model
If the environment is one of annual compounding, then δ = ln (1 + i) andwe define
DM := limh→0
1
h· P(i)− P(i + h)
P(i)
= − d
diln (P(i))
D := (1 + i) · DM
(139)
For P(i) = (1 + i)−n, we obtain
DM =n
1 + i
D = n(140)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 165 / 223
Intuition
Increasing yield decreases present value. Thus, we take the negativeof derivative w.r.t yield.
The Modified Duration DM measures the ratio of rate of change of Pwrt i to the actual value P.
The Macaulay Duration D := (1 + i) · DM says that the longer thetime maturity n, the more susceptible it is to yield change. For ann−year zero coupon bond, D = n. Hence, the name duration
Can apply the linearization formula from calculus:
P(i + h) ≈ P(i) + P ′(i) · h = P(i)− DM · P(i) · h
= P(i)− D
1 + i· P(i) · h
(141)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 166 / 223
Duration of General Cashflows
P =n∑
m=1
Km
(1 + i)m
DM =− d
diln (P(i)) = − 1
P
dP
di=
∑nm=1
m·Km(1+i)m+1∑n
m=1Km
(1+i)m
D = (1 + i) · DM =n∑
m=1
m · pm = E[m]
pm =
Km(1+i)m∑nl=1
Kl
(1+i)l
(142)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 167 / 223
Duration of General Cashflows
Note also that
dD
di=
d
di
n∑m=1
m ·Km
(1+i)m∑nl=1
Kl
(1+i)l
= − 1
1 + i
n∑m=1
m2 · pm −
(n∑
m=1
m · pm
)2
= −Var [m]
1 + i< 0
(143)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 168 / 223
Duration of General Cashflows
Note also that
dD
di=
d
di
n∑m=1
m ·Km
(1+i)m∑nl=1
Kl
(1+i)l
= − 1
1 + i
n∑m=1
m2 · pm −
(n∑
m=1
m · pm
)2
= −Var [m]
1 + i< 0
(143)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 168 / 223
Duration of a Perpetuity
Even though it has no finite term, we can still find the duration of aperpetuity. In this case
D = −(1 + i)1
P
dP
di
= −(1 + i) · 11i
· d
di
(1
i
)= 1 +
1
i
(144)
An equivalent way to calculate this is to see that
D =
∑∞k=1
k(1+i)k∑∞
k=11
(1+i)k
=(Ia)∞ i
a∞ i
=1+ii2
1i
= 1 +1
i
(145)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 169 / 223
Duration of a Perpetuity
Even though it has no finite term, we can still find the duration of aperpetuity. In this case
D = −(1 + i)1
P
dP
di
= −(1 + i) · 11i
· d
di
(1
i
)= 1 +
1
i
(144)
An equivalent way to calculate this is to see that
D =
∑∞k=1
k(1+i)k∑∞
k=11
(1+i)k
=(Ia)∞ i
a∞ i
=1+ii2
1i
= 1 +1
i
(145)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 169 / 223
Example 7.3 Duration of a Coupon Bond
In the case of a coupon bond, we have K1 = K2 = .. = Kn−1 = F · r , andKn = F + F · r , and so
D =
∑nm=1
m·F ·r(1+i)m + n·F
(1+i)n∑nm=1
F ·r(1+i)m + F
(1+i)n
=
r ·(
(1+i)an i−n
(1+i)n
i
)+ n
(1+i)n
r · an i + 1(1+i)n
(146)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 170 / 223
Bonds and Macaulay Duration: Example from previousSOA Exam FM
A bond with Face F will pay a coupon of F · r at the end of each of thenext three years. It wil also pay the face value of F at the end of thethree-year period. The bond’s duration (Macaulay duration) when valuedusing an annual effective interest rate of 20% is X. Calculate X .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 171 / 223
Bonds and Macaulay Duration: Example from previousSOA Exam FM
Recall that the Macaulay Duration over n time periods is defined as anexpection of sorts:
D =
∑ni=1 tiPV (i)∑nj=1 PV (j)
(147)
where the PV (i) are the present values of the revenue received at time ti .
For our present case, we have
D =1 · F ·r1.2 + 2 · F ·r
(1.2)2+ 3 · F ·(1+r)
(1.2)3
F ·r1.2 + F ·r
(1.2)2+ F ·(1+r)
(1.2)3
=1 · r
1.2 + 2 · r(1.2)2
+ 3 · (1+r)(1.2)3
r1.2 + r
(1.2)2+ (1+r)
(1.2)3
(148)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 172 / 223
Portfolio Duration
Imagine that P(i) is the price of a portfolio of income streams:P(i) =
∑nk=1 Pk(i). Then
D = −(1 + i) · P ′(i)
P(i)= −(1 + i) ·
∑nk=1 P ′k(i)
P(i)
= −(1 + i) ·n∑
k=1
P ′k(i)
P(i)= −(1 + i) ·
n∑k=1
Pk(i)
P(i)·
P ′k(i)
Pk(i)
=n∑
k=1
Dk · qk
(Dk , qk) =
(−(1 + i) ·
P ′k(i)
Pk(i),
Pk(i)
P(i)
)(149)
and so the portfolio duration is the weighted average of the individualdurations.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 173 / 223
Portfolio Duration
Smith holds a portfolio of a 20− year 100 bond bought at par and withduration of 8, a stock purchased for 50 with duration 7 and an 30− yearannuity purchased for 50 with duration 5. What is the portfolio duration?
D = 8 · 100
200+ 7 · 50
200+ 5
50
200= 7 (150)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 174 / 223
Portfolio Duration
Smith holds a portfolio of a 20− year 100 bond bought at par and withduration of 8, a stock purchased for 50 with duration 7 and an 30− yearannuity purchased for 50 with duration 5. What is the portfolio duration?
D = 8 · 100
200+ 7 · 50
200+ 5
50
200= 7 (150)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 174 / 223
Cashflow Immunization and Convexity
An institution such as a bank or insurance company will have both assetsand liabilities which may come due at different times. These may bestructured so that the net present value of the institution is zero. Hence,for a given i ,
P(i) ≈ 0 (151)
If the rate i is perturbed slightly, the institution may find itself with anegative NPV. To counter this risk, the institution may structure its assetsand liabilities such that P is a local minimum at i .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 175 / 223
Cashflow Immunization and Convexity
To explain this further, define the Convexity
Γ :=P ′′(i)
P(i)(152)
and so
P(i + h)− P(i)
P(i)≈ −DM · h + Γ · h2 (153)
If P ′(i) = 0 and Γ(i) > 0, then DM = 0 and we have a local minimum
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 176 / 223
Cashflow Immunization Example
Suppose a bank has promised its investors a one-year 5% return ondeposits of 100. The bank has 50 per investor on hand, is able to purchaseperpetuities that pay one per year and one year zero-coupon bonds thatyield 10%. How should the bank structure it’s assets so they areimmunized from interest rate risk?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 177 / 223
Cashflow Immunization Example
At rate i , we have the NPV of x units perpetuity and y units of bondminus the NPV of the liability of the one-year withdrawal as
P(i) = 50 +x
i+
1.1 · y1 + i
− 105
1 + i
P ′(i) = − x
i2− 1.1 · y − 105
(1 + i)2
P ′′(i) = 2 · x
i3+ 2 · 1.1 · y − 105
(1 + i)3
(154)
For whatever rate i we fix, if we set
x = 50i2
y =105− 50 · (1 + i)2
1.1
(155)
then P(i) = P ′(i) = 0 and P ′′(i) = 100i ·(1+i) > 0 so we have a local
minimum.Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 178 / 223
Some Comments
Book, or Amortized, value is calculated using fixed rate
Market value determined via market term structure
The spot rate used in this term structure varies with time
This leads to difference between Book and Market value of cashflow
These values converge as time approaches maturity; investor can holdon to his investment to realize original yield rate
Before maturity, however, the cashflow is valued at market rate
Previous analysis is for flat term structure. To generalize to normal orinverted term structure, require new definitions and multivariablecalculus
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 179 / 223
Basic Ideas and Beyond
As we have seen, interest rate fluctuation can lead to possibleshortfalls that banks may wish to immunize their portfolio against.Currency fluctuation also leads to operational risk, and shouldfactor into planning. For example, should a band tour Europe orAmerica this summer ? Click here for an insightful article by NeilShah in the Wall Street Journal TM, with comment from themanager of a very prominent rock band
Interest rates are only one risk factor. Another very real factor isknown as longevity risk, which is due to the possibility that apensioner may live longer than expected. Hedging against such apossibility is extremely important, and a topic we hope to cover inSTT 455− 456. In the meantime, please consult the paper by Tsai,Tzeng, and Wang on Hedging Longevity Risk When Interest RatesAre Uncertain
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 180 / 223
Probability Space
Let us define an event as a point ω in the set of all possible outcomes Ω.This includes the events ”The stock doubled in price over two tradingperiods” or ”the average stock price over ten years was 10 dollars”.
In our initial case, we will consider the simple binary spaceΩ = H,T for a one-period asset evolution. So, given an initialvalue S0, we have the final value S1(ω), with
S1(H) = uS0,S1(T ) = dS0 (156)
with d < 1 < u. Hence, a stock increases or decreases in price,according to the flip of a coin.
Let P be the probability measure associated with these events:
P[H] = p = 1− P[T ] (157)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 181 / 223
Probability Space
Let us define an event as a point ω in the set of all possible outcomes Ω.This includes the events ”The stock doubled in price over two tradingperiods” or ”the average stock price over ten years was 10 dollars”.
In our initial case, we will consider the simple binary spaceΩ = H,T for a one-period asset evolution. So, given an initialvalue S0, we have the final value S1(ω), with
S1(H) = uS0,S1(T ) = dS0 (156)
with d < 1 < u. Hence, a stock increases or decreases in price,according to the flip of a coin.
Let P be the probability measure associated with these events:
P[H] = p = 1− P[T ] (157)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 181 / 223
Probability Space
Let us define an event as a point ω in the set of all possible outcomes Ω.This includes the events ”The stock doubled in price over two tradingperiods” or ”the average stock price over ten years was 10 dollars”.
In our initial case, we will consider the simple binary spaceΩ = H,T for a one-period asset evolution. So, given an initialvalue S0, we have the final value S1(ω), with
S1(H) = uS0,S1(T ) = dS0 (156)
with d < 1 < u. Hence, a stock increases or decreases in price,according to the flip of a coin.
Let P be the probability measure associated with these events:
P[H] = p = 1− P[T ] (157)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 181 / 223
Probability Space
Let us define an event as a point ω in the set of all possible outcomes Ω.This includes the events ”The stock doubled in price over two tradingperiods” or ”the average stock price over ten years was 10 dollars”.
In our initial case, we will consider the simple binary spaceΩ = H,T for a one-period asset evolution. So, given an initialvalue S0, we have the final value S1(ω), with
S1(H) = uS0,S1(T ) = dS0 (156)
with d < 1 < u. Hence, a stock increases or decreases in price,according to the flip of a coin.
Let P be the probability measure associated with these events:
P[H] = p = 1− P[T ] (157)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 181 / 223
Probability Space
Let us define an event as a point ω in the set of all possible outcomes Ω.This includes the events ”The stock doubled in price over two tradingperiods” or ”the average stock price over ten years was 10 dollars”.
In our initial case, we will consider the simple binary spaceΩ = H,T for a one-period asset evolution. So, given an initialvalue S0, we have the final value S1(ω), with
S1(H) = uS0,S1(T ) = dS0 (156)
with d < 1 < u. Hence, a stock increases or decreases in price,according to the flip of a coin.
Let P be the probability measure associated with these events:
P[H] = p = 1− P[T ] (157)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 181 / 223
Arbitrage
Assume that S0(1 + r) > uS0
Where is the risk involved with investing in the asset S ?
Assume that S0(1 + r) < dS0
Why would anyone hold a bank account (zero-coupon bond)?
Lemma Arbitrage free ⇒ d < 1 + r < u
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 182 / 223
Arbitrage
Assume that S0(1 + r) > uS0
Where is the risk involved with investing in the asset S ?
Assume that S0(1 + r) < dS0
Why would anyone hold a bank account (zero-coupon bond)?
Lemma Arbitrage free ⇒ d < 1 + r < u
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 182 / 223
Arbitrage
Assume that S0(1 + r) > uS0
Where is the risk involved with investing in the asset S ?
Assume that S0(1 + r) < dS0
Why would anyone hold a bank account (zero-coupon bond)?
Lemma Arbitrage free ⇒ d < 1 + r < u
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 182 / 223
Arbitrage
Assume that S0(1 + r) > uS0
Where is the risk involved with investing in the asset S ?
Assume that S0(1 + r) < dS0
Why would anyone hold a bank account (zero-coupon bond)?
Lemma Arbitrage free ⇒ d < 1 + r < u
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 182 / 223
Arbitrage
Assume that S0(1 + r) > uS0
Where is the risk involved with investing in the asset S ?
Assume that S0(1 + r) < dS0
Why would anyone hold a bank account (zero-coupon bond)?
Lemma Arbitrage free ⇒ d < 1 + r < u
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 182 / 223
Derivative Pricing
Let S1(ω) be the price of an underlying asset at time 1. Define thefollowing instruments:
Zero-Coupon Bond : V B0 = 1
1+r ,VB1 (ω) = 1
Forward Contract : V F0 = 0,V F
1 = S1(ω)− F
Call Option : V C1 (ω) = max(S1(ω)− K , 0)
Put Option : V P1 (ω) = max(K − S1(ω), 0)
In both the Call and Put option, K is known as the Strike.Once again, a Forward Contract is a deal that is locked in at time 0 forinitial price 0, but requires at time 1 the buyer to purchase the asset forprice F .
What is the value V0 of the above put and call options?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 183 / 223
Derivative Pricing
Let S1(ω) be the price of an underlying asset at time 1. Define thefollowing instruments:
Zero-Coupon Bond : V B0 = 1
1+r ,VB1 (ω) = 1
Forward Contract : V F0 = 0,V F
1 = S1(ω)− F
Call Option : V C1 (ω) = max(S1(ω)− K , 0)
Put Option : V P1 (ω) = max(K − S1(ω), 0)
In both the Call and Put option, K is known as the Strike.Once again, a Forward Contract is a deal that is locked in at time 0 forinitial price 0, but requires at time 1 the buyer to purchase the asset forprice F .
What is the value V0 of the above put and call options?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 183 / 223
Derivative Pricing
Let S1(ω) be the price of an underlying asset at time 1. Define thefollowing instruments:
Zero-Coupon Bond : V B0 = 1
1+r ,VB1 (ω) = 1
Forward Contract : V F0 = 0,V F
1 = S1(ω)− F
Call Option : V C1 (ω) = max(S1(ω)− K , 0)
Put Option : V P1 (ω) = max(K − S1(ω), 0)
In both the Call and Put option, K is known as the Strike.
Once again, a Forward Contract is a deal that is locked in at time 0 forinitial price 0, but requires at time 1 the buyer to purchase the asset forprice F .
What is the value V0 of the above put and call options?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 183 / 223
Derivative Pricing
Let S1(ω) be the price of an underlying asset at time 1. Define thefollowing instruments:
Zero-Coupon Bond : V B0 = 1
1+r ,VB1 (ω) = 1
Forward Contract : V F0 = 0,V F
1 = S1(ω)− F
Call Option : V C1 (ω) = max(S1(ω)− K , 0)
Put Option : V P1 (ω) = max(K − S1(ω), 0)
In both the Call and Put option, K is known as the Strike.Once again, a Forward Contract is a deal that is locked in at time 0 forinitial price 0, but requires at time 1 the buyer to purchase the asset forprice F .
What is the value V0 of the above put and call options?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 183 / 223
Derivative Pricing
Let S1(ω) be the price of an underlying asset at time 1. Define thefollowing instruments:
Zero-Coupon Bond : V B0 = 1
1+r ,VB1 (ω) = 1
Forward Contract : V F0 = 0,V F
1 = S1(ω)− F
Call Option : V C1 (ω) = max(S1(ω)− K , 0)
Put Option : V P1 (ω) = max(K − S1(ω), 0)
In both the Call and Put option, K is known as the Strike.Once again, a Forward Contract is a deal that is locked in at time 0 forinitial price 0, but requires at time 1 the buyer to purchase the asset forprice F .
What is the value V0 of the above put and call options?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 183 / 223
Put-Call Parity
Can we replicate a forward contract using zero coupon bonds and put andcall options?
Yes: The final value of a replicating strategy X has value
V C1 − V P
1 + (K − F ) = S1 − F = X1(ω) (158)
This is achieved (replicated) by
Purchasing one call option
Selling one put option
Purchasing K − F zero coupon bonds
all at time 0.Since this strategy must have zero initial value, we obtain
V C0 − V P
0 =F − K
1 + r(159)
Question: How would this change in a multi-period model?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 184 / 223
Put-Call Parity
Can we replicate a forward contract using zero coupon bonds and put andcall options?Yes: The final value of a replicating strategy X has value
V C1 − V P
1 + (K − F ) = S1 − F = X1(ω) (158)
This is achieved (replicated) by
Purchasing one call option
Selling one put option
Purchasing K − F zero coupon bonds
all at time 0.Since this strategy must have zero initial value, we obtain
V C0 − V P
0 =F − K
1 + r(159)
Question: How would this change in a multi-period model?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 184 / 223
Put-Call Parity
Can we replicate a forward contract using zero coupon bonds and put andcall options?Yes: The final value of a replicating strategy X has value
V C1 − V P
1 + (K − F ) = S1 − F = X1(ω) (158)
This is achieved (replicated) by
Purchasing one call option
Selling one put option
Purchasing K − F zero coupon bonds
all at time 0.Since this strategy must have zero initial value, we obtain
V C0 − V P
0 =F − K
1 + r(159)
Question: How would this change in a multi-period model?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 184 / 223
Put-Call Parity
Can we replicate a forward contract using zero coupon bonds and put andcall options?Yes: The final value of a replicating strategy X has value
V C1 − V P
1 + (K − F ) = S1 − F = X1(ω) (158)
This is achieved (replicated) by
Purchasing one call option
Selling one put option
Purchasing K − F zero coupon bonds
all at time 0.
Since this strategy must have zero initial value, we obtain
V C0 − V P
0 =F − K
1 + r(159)
Question: How would this change in a multi-period model?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 184 / 223
Put-Call Parity
Can we replicate a forward contract using zero coupon bonds and put andcall options?Yes: The final value of a replicating strategy X has value
V C1 − V P
1 + (K − F ) = S1 − F = X1(ω) (158)
This is achieved (replicated) by
Purchasing one call option
Selling one put option
Purchasing K − F zero coupon bonds
all at time 0.Since this strategy must have zero initial value, we obtain
V C0 − V P
0 =F − K
1 + r(159)
Question: How would this change in a multi-period model?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 184 / 223
Put-Call Parity
Can we replicate a forward contract using zero coupon bonds and put andcall options?Yes: The final value of a replicating strategy X has value
V C1 − V P
1 + (K − F ) = S1 − F = X1(ω) (158)
This is achieved (replicated) by
Purchasing one call option
Selling one put option
Purchasing K − F zero coupon bonds
all at time 0.Since this strategy must have zero initial value, we obtain
V C0 − V P
0 =F − K
1 + r(159)
Question: How would this change in a multi-period model?Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 184 / 223
General Derivative Pricing -One period model
If we begin with some initial capital X0, then we end with X1(ω). To pricea derivative, we need to match
X1(ω) = V1(ω) ∀ ω ∈ Ω (160)
to have X0 = V0, the price of the derivative we seek.
A strategy by the pair (X0,∆0) wherein
X0 is the initial capital
∆0 is the initial number of shares (units of underlying asset.)
What does the sign of ∆0 indicate?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 185 / 223
Replicating Strategy
Initial holding in bond (bank account) is X0 −∆0S0
Value of portfolio at maturity is
X1(ω) = (X0 −∆0S0)(1 + r) + ∆0S1(ω) (161)
Pathwise, we compute
V1(H) = (X0 −∆0S0)(1 + r) + ∆0uS0
V1(T ) = (X0 −∆0S0)(1 + r) + ∆0dS0
Algebra yields
∆0 =V1(H)− V1(T )
(u − d)S0(162)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 186 / 223
Replicating Strategy
Initial holding in bond (bank account) is X0 −∆0S0
Value of portfolio at maturity is
X1(ω) = (X0 −∆0S0)(1 + r) + ∆0S1(ω) (161)
Pathwise, we compute
V1(H) = (X0 −∆0S0)(1 + r) + ∆0uS0
V1(T ) = (X0 −∆0S0)(1 + r) + ∆0dS0
Algebra yields
∆0 =V1(H)− V1(T )
(u − d)S0(162)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 186 / 223
Replicating Strategy
Initial holding in bond (bank account) is X0 −∆0S0
Value of portfolio at maturity is
X1(ω) = (X0 −∆0S0)(1 + r) + ∆0S1(ω) (161)
Pathwise, we compute
V1(H) = (X0 −∆0S0)(1 + r) + ∆0uS0
V1(T ) = (X0 −∆0S0)(1 + r) + ∆0dS0
Algebra yields
∆0 =V1(H)− V1(T )
(u − d)S0(162)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 186 / 223
Replicating Strategy
Initial holding in bond (bank account) is X0 −∆0S0
Value of portfolio at maturity is
X1(ω) = (X0 −∆0S0)(1 + r) + ∆0S1(ω) (161)
Pathwise, we compute
V1(H) = (X0 −∆0S0)(1 + r) + ∆0uS0
V1(T ) = (X0 −∆0S0)(1 + r) + ∆0dS0
Algebra yields
∆0 =V1(H)− V1(T )
(u − d)S0(162)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 186 / 223
Risk Neutral Probability
Let us assume the existence of a pair (p, q) of positive numbers, and usethese to multiply our pricing equation(s):
pV1(H) = p(X0 −∆0S0)(1 + r) + p∆0uS0
qV1(T ) = q(X0 −∆0S0)(1 + r) + q∆0dS0
Addition yields
X0(1 + r) + ∆0S0(pu + qd − (1 + r)) = pV1(H) + qV1(T ) (163)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 187 / 223
Risk Neutral Probability
Let us assume the existence of a pair (p, q) of positive numbers, and usethese to multiply our pricing equation(s):
pV1(H) = p(X0 −∆0S0)(1 + r) + p∆0uS0
qV1(T ) = q(X0 −∆0S0)(1 + r) + q∆0dS0
Addition yields
X0(1 + r) + ∆0S0(pu + qd − (1 + r)) = pV1(H) + qV1(T ) (163)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 187 / 223
If we constrain
0 = pu + qd − (1 + r)
1 = p + q
0 ≤ p
0 ≤ q
then we have a risk neutral probability P where
V0 = X0 =1
1 + rE[V1] =
pV1(H) + qV1(T )
1 + r(164)
with
p =1 + r − d
u − d
q =u − (1 + r)
u − d
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 188 / 223
If we constrain
0 = pu + qd − (1 + r)
1 = p + q
0 ≤ p
0 ≤ q
then we have a risk neutral probability P where
V0 = X0 =1
1 + rE[V1] =
pV1(H) + qV1(T )
1 + r(164)
with
p =1 + r − d
u − d
q =u − (1 + r)
u − dAlbert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 188 / 223
Example: Pricing a forward contract
Consider the case of a stock with
S0 = 100
u = 1.2
d = 0.8
r = 0.05
Then the forward price is computed via
0 =1
1 + rE[S1 − F ]⇒ F = E[S1] (165)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 189 / 223
Example: Pricing a forward contract
Consider the case of a stock with
S0 = 100
u = 1.2
d = 0.8
r = 0.05
Then the forward price is computed via
0 =1
1 + rE[S1 − F ]⇒ F = E[S1] (165)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 189 / 223
This leads to the explicit price
F = puS0 + qdS0
= (0.625)(1.2)(100) + (0.375)(0.8)(100) = 105
Homework Question: What is the price of a call option in the caseabove,with strike K = 95?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 190 / 223
This leads to the explicit price
F = puS0 + qdS0
= (0.625)(1.2)(100) + (0.375)(0.8)(100) = 105
Homework Question: What is the price of a call option in the caseabove,with strike K = 95?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 190 / 223
General one period risk neutral measure
We define a finite set of outcomes Ω ≡ ω1, ω2, ..., ωn and anysubcollection of outcomes A ⊂ Ω an event.
Furthermore, we define a probability measure P, not necessarily thephysical measure P to be risk neutral if
P[ω] > 0 ∀ ω ∈ Ω
X0 = 11+r E[X1]
for all strategies X .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 191 / 223
General one period risk neutral measure
We define a finite set of outcomes Ω ≡ ω1, ω2, ..., ωn and anysubcollection of outcomes A ⊂ Ω an event.Furthermore, we define a probability measure P, not necessarily thephysical measure P to be risk neutral if
P[ω] > 0 ∀ ω ∈ Ω
X0 = 11+r E[X1]
for all strategies X .
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 191 / 223
General one period risk neutral measure
The measure is indifferent to investing in a zero-coupon bond, or arisky asset X
The same initial capital X0 in both cases produces the same”‘average”’ return after one period.
Not the physical measure attached by observation, experts, etc..
In fact, physical measure has no impact on pricing
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 192 / 223
General one period risk neutral measure
The measure is indifferent to investing in a zero-coupon bond, or arisky asset X
The same initial capital X0 in both cases produces the same”‘average”’ return after one period.
Not the physical measure attached by observation, experts, etc..
In fact, physical measure has no impact on pricing
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 192 / 223
General one period risk neutral measure
The measure is indifferent to investing in a zero-coupon bond, or arisky asset X
The same initial capital X0 in both cases produces the same”‘average”’ return after one period.
Not the physical measure attached by observation, experts, etc..
In fact, physical measure has no impact on pricing
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 192 / 223
General one period risk neutral measure
The measure is indifferent to investing in a zero-coupon bond, or arisky asset X
The same initial capital X0 in both cases produces the same”‘average”’ return after one period.
Not the physical measure attached by observation, experts, etc..
In fact, physical measure has no impact on pricing
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 192 / 223
Example: Risk Neutral measure for trinomial case
Assume that Ω = ω1, ω2, ω3 with
S1(ω1) = uS0
S1(ω2) = S0
S1(ω3) = dS0
Given a payoff V1(ω) to replicate, are we assured that a replicatingstrategy exists?Homework: Try our first example with
S0 = 100
r = 0.05, u = 1.2, d = 0.8
V1(ω) = χ (S1(ω) > 90)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 193 / 223
Example: Risk Neutral measure for trinomial case
Assume that Ω = ω1, ω2, ω3 with
S1(ω1) = uS0
S1(ω2) = S0
S1(ω3) = dS0
Given a payoff V1(ω) to replicate, are we assured that a replicatingstrategy exists?
Homework: Try our first example with
S0 = 100
r = 0.05, u = 1.2, d = 0.8
V1(ω) = χ (S1(ω) > 90)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 193 / 223
Example: Risk Neutral measure for trinomial case
Assume that Ω = ω1, ω2, ω3 with
S1(ω1) = uS0
S1(ω2) = S0
S1(ω3) = dS0
Given a payoff V1(ω) to replicate, are we assured that a replicatingstrategy exists?Homework: Try our first example with
S0 = 100
r = 0.05, u = 1.2, d = 0.8
V1(ω) = χ (S1(ω) > 90)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 193 / 223
Existence of Risk Neutral measure
Let P be a probability measure on a finite space Ω. The following areequivalent:
P is a risk neutral measure
For all traded securities S i , S i0 = 1
1+r E[S i1
]Proof: Homework (Hint: One direction is much easier than others. Also,strategies are linear in the underlying asset.)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 194 / 223
Existence of Risk Neutral measure
Let P be a probability measure on a finite space Ω. The following areequivalent:
P is a risk neutral measure
For all traded securities S i , S i0 = 1
1+r E[S i1
]Proof: Homework (Hint: One direction is much easier than others. Also,strategies are linear in the underlying asset.)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 194 / 223
Existence of Risk Neutral measure
Let P be a probability measure on a finite space Ω. The following areequivalent:
P is a risk neutral measure
For all traded securities S i , S i0 = 1
1+r E[S i1
]
Proof: Homework (Hint: One direction is much easier than others. Also,strategies are linear in the underlying asset.)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 194 / 223
Existence of Risk Neutral measure
Let P be a probability measure on a finite space Ω. The following areequivalent:
P is a risk neutral measure
For all traded securities S i , S i0 = 1
1+r E[S i1
]Proof: Homework (Hint: One direction is much easier than others. Also,strategies are linear in the underlying asset.)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 194 / 223
Complete Markets
A market is complete if it is arbitrage free and every non-traded asset canbe replicated.
Fundamental Theorem of Asset Pricing 1: A market is arbitrage freeiff there exists a risk neutral measure
Fundamental Theorem of Asset Pricing 2: A market is complete iffthere exists exactly one risk neutral measure
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 195 / 223
Complete Markets
A market is complete if it is arbitrage free and every non-traded asset canbe replicated.
Fundamental Theorem of Asset Pricing 1: A market is arbitrage freeiff there exists a risk neutral measure
Fundamental Theorem of Asset Pricing 2: A market is complete iffthere exists exactly one risk neutral measure
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 195 / 223
2-period pricing
Consider the case
r = 0.05,S0 = 100
S1(H) = 1.2S0
S1(T ) = 0.8S0
S2(HH) = 1.2S1(H)
S2(HT ) = 0.8S1(H)
S2(TH) = 1.2S1(T )
S2(TT ) = 0.8S1(T )
Now price a digital option that has payoff V2 := χ(S2 ≥ 100)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 196 / 223
2-period pricing
Consider the case
r = 0.05,S0 = 100
S1(H) = 1.2S0
S1(T ) = 0.8S0
S2(HH) = 1.2S1(H)
S2(HT ) = 0.8S1(H)
S2(TH) = 1.2S1(T )
S2(TT ) = 0.8S1(T )
Now price a digital option that has payoff V2 := χ(S2 ≥ 100)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 196 / 223
We can do this for 2-period problems
Case by Case, or..
by developing a general theory for multi-period asset pricing
In the latter method, we need a general framework to carry out ourcomputations
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 197 / 223
We can do this for 2-period problems
Case by Case, or..
by developing a general theory for multi-period asset pricing
In the latter method, we need a general framework to carry out ourcomputations
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 197 / 223
We can do this for 2-period problems
Case by Case, or..
by developing a general theory for multi-period asset pricing
In the latter method, we need a general framework to carry out ourcomputations
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 197 / 223
Multi-Period Pricing - Introduction
Again, we define the finite set of outcomes Ω and any subcollection ofoutcomes A ⊂ Ω an event.
How does this relate to the case of 2 consecutive coin flips
Ω ≡ HH,HT ,TH,TTSet of events includes statements like at least one head
= HH,HT ,TH
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 198 / 223
Multi-Period Pricing - Introduction
Again, we define the finite set of outcomes Ω and any subcollection ofoutcomes A ⊂ Ω an event.
How does this relate to the case of 2 consecutive coin flips
Ω ≡ HH,HT ,TH,TTSet of events includes statements like at least one head
= HH,HT ,TH
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 198 / 223
Multi-Period Pricing - Introduction
Again, we define the finite set of outcomes Ω and any subcollection ofoutcomes A ⊂ Ω an event.
How does this relate to the case of 2 consecutive coin flips
Ω ≡ HH,HT ,TH,TT
Set of events includes statements like at least one head
= HH,HT ,TH
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 198 / 223
Multi-Period Pricing - Introduction
Again, we define the finite set of outcomes Ω and any subcollection ofoutcomes A ⊂ Ω an event.
How does this relate to the case of 2 consecutive coin flips
Ω ≡ HH,HT ,TH,TTSet of events includes statements like at least one head
= HH,HT ,TH
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 198 / 223
Multi-Period Pricing - Introduction
Again, we define the finite set of outcomes Ω and any subcollection ofoutcomes A ⊂ Ω an event.
How does this relate to the case of 2 consecutive coin flips
Ω ≡ HH,HT ,TH,TTSet of events includes statements like at least one head
= HH,HT ,TH
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 198 / 223
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection ofsubsets of Ω that satisfies
∅ ∈ FA ∈ F ⇒ Ac ∈ FA1,A2,A3, .... ∈ F ⇒ ∪∞n=1An ∈ F
Some Examples
F0 = ∅,ΩF1 = ∅,Ω, HH,HT, TT ,THF2 = ∅,Ω, HH, HT, TT, TH, ....
F2 is completed by taking all unions of ∅,Ω, HH, HT, TT, TH.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 199 / 223
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection ofsubsets of Ω that satisfies
∅ ∈ F
A ∈ F ⇒ Ac ∈ FA1,A2,A3, .... ∈ F ⇒ ∪∞n=1An ∈ F
Some Examples
F0 = ∅,ΩF1 = ∅,Ω, HH,HT, TT ,THF2 = ∅,Ω, HH, HT, TT, TH, ....
F2 is completed by taking all unions of ∅,Ω, HH, HT, TT, TH.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 199 / 223
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection ofsubsets of Ω that satisfies
∅ ∈ FA ∈ F ⇒ Ac ∈ F
A1,A2,A3, .... ∈ F ⇒ ∪∞n=1An ∈ F
Some Examples
F0 = ∅,ΩF1 = ∅,Ω, HH,HT, TT ,THF2 = ∅,Ω, HH, HT, TT, TH, ....
F2 is completed by taking all unions of ∅,Ω, HH, HT, TT, TH.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 199 / 223
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection ofsubsets of Ω that satisfies
∅ ∈ FA ∈ F ⇒ Ac ∈ FA1,A2,A3, .... ∈ F ⇒ ∪∞n=1An ∈ F
Some Examples
F0 = ∅,ΩF1 = ∅,Ω, HH,HT, TT ,THF2 = ∅,Ω, HH, HT, TT, TH, ....
F2 is completed by taking all unions of ∅,Ω, HH, HT, TT, TH.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 199 / 223
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection ofsubsets of Ω that satisfies
∅ ∈ FA ∈ F ⇒ Ac ∈ FA1,A2,A3, .... ∈ F ⇒ ∪∞n=1An ∈ F
Some Examples
F0 = ∅,ΩF1 = ∅,Ω, HH,HT, TT ,THF2 = ∅,Ω, HH, HT, TT, TH, ....
F2 is completed by taking all unions of ∅,Ω, HH, HT, TT, TH.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 199 / 223
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection ofsubsets of Ω that satisfies
∅ ∈ FA ∈ F ⇒ Ac ∈ FA1,A2,A3, .... ∈ F ⇒ ∪∞n=1An ∈ F
Some Examples
F0 = ∅,Ω
F1 = ∅,Ω, HH,HT, TT ,THF2 = ∅,Ω, HH, HT, TT, TH, ....
F2 is completed by taking all unions of ∅,Ω, HH, HT, TT, TH.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 199 / 223
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection ofsubsets of Ω that satisfies
∅ ∈ FA ∈ F ⇒ Ac ∈ FA1,A2,A3, .... ∈ F ⇒ ∪∞n=1An ∈ F
Some Examples
F0 = ∅,ΩF1 = ∅,Ω, HH,HT, TT ,TH
F2 = ∅,Ω, HH, HT, TT, TH, ....
F2 is completed by taking all unions of ∅,Ω, HH, HT, TT, TH.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 199 / 223
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection ofsubsets of Ω that satisfies
∅ ∈ FA ∈ F ⇒ Ac ∈ FA1,A2,A3, .... ∈ F ⇒ ∪∞n=1An ∈ F
Some Examples
F0 = ∅,ΩF1 = ∅,Ω, HH,HT, TT ,THF2 = ∅,Ω, HH, HT, TT, TH, ....
F2 is completed by taking all unions of ∅,Ω, HH, HT, TT, TH.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 199 / 223
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection ofsubsets of Ω that satisfies
∅ ∈ FA ∈ F ⇒ Ac ∈ FA1,A2,A3, .... ∈ F ⇒ ∪∞n=1An ∈ F
Some Examples
F0 = ∅,ΩF1 = ∅,Ω, HH,HT, TT ,THF2 = ∅,Ω, HH, HT, TT, TH, ....
F2 is completed by taking all unions of ∅,Ω, HH, HT, TT, TH.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 199 / 223
Notice that F0 ⊂ F1 ⊂ F2.
Correspondingly, given an Ω, we define a
Filtration as ..
a sequence of σ−algebras F0,F1,F2, ...,Fn, ... such that
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...and F = σ(Ω) as the σ−algebra of all subsets of Ω.
Given a pair (Ω,F), we define a Random Variable X (ω) as a mappingX : Ω→ R
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 200 / 223
Notice that F0 ⊂ F1 ⊂ F2.
Correspondingly, given an Ω, we define a
Filtration as ..
a sequence of σ−algebras F0,F1,F2, ...,Fn, ... such that
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...and F = σ(Ω) as the σ−algebra of all subsets of Ω.
Given a pair (Ω,F), we define a Random Variable X (ω) as a mappingX : Ω→ R
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 200 / 223
Notice that F0 ⊂ F1 ⊂ F2.
Correspondingly, given an Ω, we define a
Filtration as ..
a sequence of σ−algebras F0,F1,F2, ...,Fn, ... such that
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...and F = σ(Ω) as the σ−algebra of all subsets of Ω.
Given a pair (Ω,F), we define a Random Variable X (ω) as a mappingX : Ω→ R
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 200 / 223
Notice that F0 ⊂ F1 ⊂ F2.
Correspondingly, given an Ω, we define a
Filtration as ..
a sequence of σ−algebras F0,F1,F2, ...,Fn, ... such that
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...
and F = σ(Ω) as the σ−algebra of all subsets of Ω.
Given a pair (Ω,F), we define a Random Variable X (ω) as a mappingX : Ω→ R
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 200 / 223
Notice that F0 ⊂ F1 ⊂ F2.
Correspondingly, given an Ω, we define a
Filtration as ..
a sequence of σ−algebras F0,F1,F2, ...,Fn, ... such that
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...and F = σ(Ω) as the σ−algebra of all subsets of Ω.
Given a pair (Ω,F), we define a Random Variable X (ω) as a mappingX : Ω→ R
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 200 / 223
Notice that F0 ⊂ F1 ⊂ F2.
Correspondingly, given an Ω, we define a
Filtration as ..
a sequence of σ−algebras F0,F1,F2, ...,Fn, ... such that
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...and F = σ(Ω) as the σ−algebra of all subsets of Ω.
Given a pair (Ω,F), we define a Random Variable X (ω) as a mappingX : Ω→ R
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 200 / 223
Given a pair (Ω,F) and random variable X ,
σ(X ) = the collection of all sets ω ∈ Ω | X (ω) ∈ A ⊂ R
Given a G ⊂ F , we say that X is G−measurable if
A ∈ σ(X )⇒ A ∈ G
A Probability Space for us will be the triple (Ω,F ,P), where
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 201 / 223
Given a pair (Ω,F) and random variable X ,
σ(X ) = the collection of all sets ω ∈ Ω | X (ω) ∈ A ⊂ RGiven a G ⊂ F , we say that X is G−measurable if
A ∈ σ(X )⇒ A ∈ G
A Probability Space for us will be the triple (Ω,F ,P), where
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 201 / 223
Given a pair (Ω,F) and random variable X ,
σ(X ) = the collection of all sets ω ∈ Ω | X (ω) ∈ A ⊂ RGiven a G ⊂ F , we say that X is G−measurable if
A ∈ σ(X )⇒ A ∈ G
A Probability Space for us will be the triple (Ω,F ,P), where
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 201 / 223
Given a pair (Ω,F) and random variable X ,
σ(X ) = the collection of all sets ω ∈ Ω | X (ω) ∈ A ⊂ RGiven a G ⊂ F , we say that X is G−measurable if
A ∈ σ(X )⇒ A ∈ G
A Probability Space for us will be the triple (Ω,F ,P), where
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 201 / 223
P : F → [0, 1]
P[∅] = 0
For any countable disjoint sets A1,A2, ... ∈ FP [∪∞n=1An] =
∑∞n=1 P[An]
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 202 / 223
And so
P[A] :=∑
ω∈A P[ω]
E[X ] :=∑
ω X (ω)P[ω] =∑n
k=1 xkP[X (ω) = xk]
with Variance := E[(X − E[X ])2
]
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 203 / 223
Conditional Expectation
Let us return to the two flip model.
If we are give a probability measure P, and know the value S1, can weestimate the value S2 given (conditional on) this information?
An Example:
S0 = 100,S1(H) = 120,S1(T ) = 80
p = 0.4, q = 0.6 for each flip
ω = (ω1, ω2) - each flip is independent, and a path ω is the total pathgenerated by both flips
Given this set-up, compute
E [S2 | S1] (ω1) (166)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 204 / 223
Conditional Expectation
Let us return to the two flip model.
If we are give a probability measure P, and know the value S1, can weestimate the value S2 given (conditional on) this information?
An Example:
S0 = 100,S1(H) = 120,S1(T ) = 80
p = 0.4, q = 0.6 for each flip
ω = (ω1, ω2) - each flip is independent, and a path ω is the total pathgenerated by both flips
Given this set-up, compute
E [S2 | S1] (ω1) (166)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 204 / 223
Conditional Expectation
Let us return to the two flip model.
If we are give a probability measure P, and know the value S1, can weestimate the value S2 given (conditional on) this information?
An Example:
S0 = 100,S1(H) = 120,S1(T ) = 80
p = 0.4, q = 0.6 for each flip
ω = (ω1, ω2) - each flip is independent, and a path ω is the total pathgenerated by both flips
Given this set-up, compute
E [S2 | S1] (ω1) (166)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 204 / 223
Conditional Expectation
Let us return to the two flip model.
If we are give a probability measure P, and know the value S1, can weestimate the value S2 given (conditional on) this information?
An Example:
S0 = 100, S1(H) = 120,S1(T ) = 80
p = 0.4, q = 0.6 for each flip
ω = (ω1, ω2) - each flip is independent, and a path ω is the total pathgenerated by both flips
Given this set-up, compute
E [S2 | S1] (ω1) (166)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 204 / 223
Conditional Expectation
Let us return to the two flip model.
If we are give a probability measure P, and know the value S1, can weestimate the value S2 given (conditional on) this information?
An Example:
S0 = 100, S1(H) = 120,S1(T ) = 80
p = 0.4, q = 0.6 for each flip
ω = (ω1, ω2) - each flip is independent, and a path ω is the total pathgenerated by both flips
Given this set-up, compute
E [S2 | S1] (ω1) (166)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 204 / 223
Conditional Expectation
Let us return to the two flip model.
If we are give a probability measure P, and know the value S1, can weestimate the value S2 given (conditional on) this information?
An Example:
S0 = 100, S1(H) = 120,S1(T ) = 80
p = 0.4, q = 0.6 for each flip
ω = (ω1, ω2) - each flip is independent, and a path ω is the total pathgenerated by both flips
Given this set-up, compute
E [S2 | S1] (ω1) (166)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 204 / 223
This means if we take X = S1, for any A ∈ σ(S1)∑ω∈A
S2(ω)P[ω] =∑ω∈A
E [S2 | S1] (ω)P[ω] (167)
Can extend this to any sub σ−algebra of σ(S2)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 205 / 223
Assume X ∈ F and G ⊂ F
Tower Property: If G1 ⊂ G2, then
E [X | G1] = E[E [X | G2] | G1
](168)
If X is G−measurable, then E [X | G ] = X
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 206 / 223
Jensen’s Inequality: If f : R→ R is convex, and E [| X |] <∞ , then
E [f (X ) | G ] ≥ f(E [X | G ]
)(169)
If P[X ≥ 0] = 1, then E [X | G ] ≥ 0
Linearity
Independence: If X does not depend on the information contained inG , then
E [X | G ] = E [X ] (170)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 207 / 223
Taking out what is known: If X is dependent only on the informationcontained in G , then
E [XY | G ] = X E [Y | G ] (171)
Example: If G = F1, and X = S1(ω1), Y = S2, then
E [S1(ω1)S2 | F1] = S1(ω1)E [S2 | F1] (172)
Example: What is E[S2 | S0] ?
Definition: When conditioning on the σ−algebra Fn, we take thenotation
E [X | Fn] = En [X ] (173)
This is true, of course, for any measure we use.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 208 / 223
Taking out what is known: If X is dependent only on the informationcontained in G , then
E [XY | G ] = X E [Y | G ] (171)
Example: If G = F1, and X = S1(ω1), Y = S2, then
E [S1(ω1)S2 | F1] = S1(ω1)E [S2 | F1] (172)
Example: What is E[S2 | S0] ?
Definition: When conditioning on the σ−algebra Fn, we take thenotation
E [X | Fn] = En [X ] (173)
This is true, of course, for any measure we use.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 208 / 223
Taking out what is known: If X is dependent only on the informationcontained in G , then
E [XY | G ] = X E [Y | G ] (171)
Example: If G = F1, and X = S1(ω1), Y = S2, then
E [S1(ω1)S2 | F1] = S1(ω1)E [S2 | F1] (172)
Example: What is E[S2 | S0] ?
Definition: When conditioning on the σ−algebra Fn, we take thenotation
E [X | Fn] = En [X ] (173)
This is true, of course, for any measure we use.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 208 / 223
Martingales
Observe a random process Mn that depends only on the first n coin flips.The history of the random variable is encapsulated in the filtration Fn itgenerates.
If Mn = En [Mn+1] then Mn is called a Martingale
If Mn ≤ En [Mn+1] then Mn is called a Submartingale
If Mn ≥ En [Mn+1] then Mn is called a Supermartingale
By the definition and the Tower property above, we have for all k ≥ 0
Mn = En [Mn+k ] (174)
if Mn is a Martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 209 / 223
Martingales
Observe a random process Mn that depends only on the first n coin flips.The history of the random variable is encapsulated in the filtration Fn itgenerates.
If Mn = En [Mn+1] then Mn is called a Martingale
If Mn ≤ En [Mn+1] then Mn is called a Submartingale
If Mn ≥ En [Mn+1] then Mn is called a Supermartingale
By the definition and the Tower property above, we have for all k ≥ 0
Mn = En [Mn+k ] (174)
if Mn is a Martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 209 / 223
Martingales
Observe a random process Mn that depends only on the first n coin flips.The history of the random variable is encapsulated in the filtration Fn itgenerates.
If Mn = En [Mn+1] then Mn is called a Martingale
If Mn ≤ En [Mn+1] then Mn is called a Submartingale
If Mn ≥ En [Mn+1] then Mn is called a Supermartingale
By the definition and the Tower property above, we have for all k ≥ 0
Mn = En [Mn+k ] (174)
if Mn is a Martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 209 / 223
Martingales
Observe a random process Mn that depends only on the first n coin flips.The history of the random variable is encapsulated in the filtration Fn itgenerates.
If Mn = En [Mn+1] then Mn is called a Martingale
If Mn ≤ En [Mn+1] then Mn is called a Submartingale
If Mn ≥ En [Mn+1] then Mn is called a Supermartingale
By the definition and the Tower property above, we have for all k ≥ 0
Mn = En [Mn+k ] (174)
if Mn is a Martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 209 / 223
Martingales
Observe a random process Mn that depends only on the first n coin flips.The history of the random variable is encapsulated in the filtration Fn itgenerates.
If Mn = En [Mn+1] then Mn is called a Martingale
If Mn ≤ En [Mn+1] then Mn is called a Submartingale
If Mn ≥ En [Mn+1] then Mn is called a Supermartingale
By the definition and the Tower property above, we have for all k ≥ 0
Mn = En [Mn+k ] (174)
if Mn is a Martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 209 / 223
Martingales
Observe a random process Mn that depends only on the first n coin flips.The history of the random variable is encapsulated in the filtration Fn itgenerates.
If Mn = En [Mn+1] then Mn is called a Martingale
If Mn ≤ En [Mn+1] then Mn is called a Submartingale
If Mn ≥ En [Mn+1] then Mn is called a Supermartingale
By the definition and the Tower property above, we have for all k ≥ 0
Mn = En [Mn+k ] (174)
if Mn is a Martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 209 / 223
Martingale Pricing Theorem Under our model with risk neutralprobabilities p = 1+r−d
u−d , q = u−1−ru−d , the process
Mn :=Sn
(1 + r)n(175)
is a martingaleProofWe use the Tower property again:
En
[Sn+1
(1 + r)n+1
]= En
[Sn
(1 + r)n1
1 + r
Sn+1
Sn
]=
Sn
(1 + r)nEn
[1
1 + r
Sn+1
Sn
]=
Sn
(1 + r)npu + qd
1 + r
=Sn
(1 + r)n
QED
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 210 / 223
Martingale Pricing Theorem Under our model with risk neutralprobabilities p = 1+r−d
u−d , q = u−1−ru−d , the process
Mn :=Sn
(1 + r)n(175)
is a martingale
ProofWe use the Tower property again:
En
[Sn+1
(1 + r)n+1
]= En
[Sn
(1 + r)n1
1 + r
Sn+1
Sn
]=
Sn
(1 + r)nEn
[1
1 + r
Sn+1
Sn
]=
Sn
(1 + r)npu + qd
1 + r
=Sn
(1 + r)n
QED
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 210 / 223
Martingale Pricing Theorem Under our model with risk neutralprobabilities p = 1+r−d
u−d , q = u−1−ru−d , the process
Mn :=Sn
(1 + r)n(175)
is a martingaleProof
We use the Tower property again:
En
[Sn+1
(1 + r)n+1
]= En
[Sn
(1 + r)n1
1 + r
Sn+1
Sn
]=
Sn
(1 + r)nEn
[1
1 + r
Sn+1
Sn
]=
Sn
(1 + r)npu + qd
1 + r
=Sn
(1 + r)n
QED
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 210 / 223
Martingale Pricing Theorem Under our model with risk neutralprobabilities p = 1+r−d
u−d , q = u−1−ru−d , the process
Mn :=Sn
(1 + r)n(175)
is a martingaleProofWe use the Tower property again:
En
[Sn+1
(1 + r)n+1
]= En
[Sn
(1 + r)n1
1 + r
Sn+1
Sn
]=
Sn
(1 + r)nEn
[1
1 + r
Sn+1
Sn
]=
Sn
(1 + r)npu + qd
1 + r
=Sn
(1 + r)n
QEDAlbert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 210 / 223
Let us return to the multiperiod model. For each time n, we willdynamically redistribute our wealth Xn by deciding to hold ∆n shares of Sn
and invest the rest in the bank account at rate r . At time n + 1, thismeans we have the value
Xn+1 = (Xn −∆nSn) (1 + r) + ∆nSn+1 (176)
If we discount this recursive process to form
Mn :=Xn
(1 + r)n(177)
then Mn is a martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 211 / 223
Let us return to the multiperiod model. For each time n, we willdynamically redistribute our wealth Xn by deciding to hold ∆n shares of Sn
and invest the rest in the bank account at rate r . At time n + 1, thismeans we have the value
Xn+1 = (Xn −∆nSn) (1 + r) + ∆nSn+1 (176)
If we discount this recursive process to form
Mn :=Xn
(1 + r)n(177)
then Mn is a martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 211 / 223
Let us return to the multiperiod model. For each time n, we willdynamically redistribute our wealth Xn by deciding to hold ∆n shares of Sn
and invest the rest in the bank account at rate r . At time n + 1, thismeans we have the value
Xn+1 = (Xn −∆nSn) (1 + r) + ∆nSn+1 (176)
If we discount this recursive process to form
Mn :=Xn
(1 + r)n(177)
then Mn is a martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 211 / 223
Let us return to the multiperiod model. For each time n, we willdynamically redistribute our wealth Xn by deciding to hold ∆n shares of Sn
and invest the rest in the bank account at rate r . At time n + 1, thismeans we have the value
Xn+1 = (Xn −∆nSn) (1 + r) + ∆nSn+1 (176)
If we discount this recursive process to form
Mn :=Xn
(1 + r)n(177)
then Mn is a martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 211 / 223
Let us return to the multiperiod model. For each time n, we willdynamically redistribute our wealth Xn by deciding to hold ∆n shares of Sn
and invest the rest in the bank account at rate r . At time n + 1, thismeans we have the value
Xn+1 = (Xn −∆nSn) (1 + r) + ∆nSn+1 (176)
If we discount this recursive process to form
Mn :=Xn
(1 + r)n(177)
then Mn is a martingale
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 211 / 223
Risk Neutral Pricing Formula
Assume now that we have the regular assumptions on our coin flip space,and that at time N we are asked to deliver a path dependent derivativevalue VN . Then for times 0 ≤ n ≤ N, the value of this derivative iscomputed via
Vn = En
[Vn+1
1 + r
](178)
and so
V0 = E0
[VN
(1 + r)N
](179)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 212 / 223
Risk Neutral Pricing Formula
Assume now that we have the regular assumptions on our coin flip space,and that at time N we are asked to deliver a path dependent derivativevalue VN . Then for times 0 ≤ n ≤ N, the value of this derivative iscomputed via
Vn = En
[Vn+1
1 + r
](178)
and so
V0 = E0
[VN
(1 + r)N
](179)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 212 / 223
Risk Neutral Pricing Formula
Assume now that we have the regular assumptions on our coin flip space,and that at time N we are asked to deliver a path dependent derivativevalue VN . Then for times 0 ≤ n ≤ N, the value of this derivative iscomputed via
Vn = En
[Vn+1
1 + r
](178)
and so
V0 = E0
[VN
(1 + r)N
](179)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 212 / 223
Risk Neutral Pricing Formula
Assume now that we have the regular assumptions on our coin flip space,and that at time N we are asked to deliver a path dependent derivativevalue VN . Then for times 0 ≤ n ≤ N, the value of this derivative iscomputed via
Vn = En
[Vn+1
1 + r
](178)
and so
V0 = E0
[VN
(1 + r)N
](179)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 212 / 223
Markov Processes
If we use the above approach for a more exotic option, say a lookbackoption that pays the maximum over the term of a stock, then we find thisapproach lacking. There is not enough information in the tree or thedistinct values for S3 as stated. We need more. Consider our generalmulti-period binomial model under P
Definition We say that a process X is adapted if it depends only on theflips ω1, ..., ωn
Definition We say that an adapted process X is Markov if for every0 ≤ n ≤ N − 1 and every function f (x) there exists another function g(x)such that
En [f (Xn+1)] = g(Xn) (180)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 213 / 223
This notion of Markovity is essential to our state-dependent pricingalgorithm. Indeed, since our stock process evolves from time n to timen + 1, using only the information in Sn, we can in fact say that for everyf (s) there exists a g(s) such that
g(s) = En [f (Sn+1) | Sn = s]
g(s) =pf (2s) + qf (0.5s)
1 + r
(181)
So, for any f (s) := VN(s), we can work our recursive algorithm backwardsto find the gn(s) := Vn(s) for all 0 ≤ n ≤ N − 1
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 214 / 223
Returning to our example of a lookback option, we see that the problemwas that Mn := max0≤i≤nSi is not Markov by itself, but the pair (Mn,Sn)is. Why?
Let’s generate the tree!
Homework Can you think of any other processes that are not Markov?That are Martingales, but not Markov?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 215 / 223
The Interview Process
Consider the following scenario: After graduating, you go on the jobmarket, and have 4 possible job interviews with 4 different companies. Sosure of your prospects that you know that each company will make anoffer, with an identically, independently distributed probability attached tothe 4 possible salary offers -
P [Salary Offer=x1] = p1
P [Salary Offer=x2] = p2
P [Salary Offer=x3] = p3
P [Salary Offer=x4] = p4
p1 + p2 + p3 + p4 = 1
(182)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 216 / 223
The Interview Process
Consider the following scenario: After graduating, you go on the jobmarket, and have 4 possible job interviews with 4 different companies. Sosure of your prospects that you know that each company will make anoffer, with an identically, independently distributed probability attached tothe 4 possible salary offers -
P [Salary Offer=x1] = p1
P [Salary Offer=x2] = p2
P [Salary Offer=x3] = p3
P [Salary Offer=x4] = p4
p1 + p2 + p3 + p4 = 1
(182)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 216 / 223
The Interview Process
How should you interview?
Specifically, when should you accept an offer and cancel theremaining interviews?
How does your strategy change if you can interview as many times asyou like, but the distribution of offers remains the same as above?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 217 / 223
The Interview Process
How should you interview?
Specifically, when should you accept an offer and cancel theremaining interviews?
How does your strategy change if you can interview as many times asyou like, but the distribution of offers remains the same as above?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 217 / 223
The Interview Process
How should you interview?
Specifically, when should you accept an offer and cancel theremaining interviews?
How does your strategy change if you can interview as many times asyou like, but the distribution of offers remains the same as above?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 217 / 223
Let’s review the basic contracts we can write:
Forward Contract Initial Value is 0, because both buyer and sellermay have to pay a balance at maturity
(European) Put/Call Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
(European) ”Exotic” Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
During the term of the contract, can the value of the contract ever fallbelow the intrinsic value of the payoff? Symbolically, does it ever occurthat
vn(s) < g(s) (183)
where g(s) is of the form of g(S) := max S − K , 0, in the case of a Calloption, for example.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 218 / 223
Let’s review the basic contracts we can write:
Forward Contract Initial Value is 0, because both buyer and sellermay have to pay a balance at maturity
(European) Put/Call Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
(European) ”Exotic” Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
During the term of the contract, can the value of the contract ever fallbelow the intrinsic value of the payoff? Symbolically, does it ever occurthat
vn(s) < g(s) (183)
where g(s) is of the form of g(S) := max S − K , 0, in the case of a Calloption, for example.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 218 / 223
Let’s review the basic contracts we can write:
Forward Contract Initial Value is 0, because both buyer and sellermay have to pay a balance at maturity
(European) Put/Call Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
(European) ”Exotic” Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
During the term of the contract, can the value of the contract ever fallbelow the intrinsic value of the payoff? Symbolically, does it ever occurthat
vn(s) < g(s) (183)
where g(s) is of the form of g(S) := max S − K , 0, in the case of a Calloption, for example.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 218 / 223
Let’s review the basic contracts we can write:
Forward Contract Initial Value is 0, because both buyer and sellermay have to pay a balance at maturity
(European) Put/Call Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
(European) ”Exotic” Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
During the term of the contract, can the value of the contract ever fallbelow the intrinsic value of the payoff? Symbolically, does it ever occurthat
vn(s) < g(s) (183)
where g(s) is of the form of g(S) := max S − K , 0, in the case of a Calloption, for example.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 218 / 223
Let’s review the basic contracts we can write:
Forward Contract Initial Value is 0, because both buyer and sellermay have to pay a balance at maturity
(European) Put/Call Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
(European) ”Exotic” Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
During the term of the contract, can the value of the contract ever fallbelow the intrinsic value of the payoff? Symbolically, does it ever occurthat
vn(s) < g(s) (183)
where g(s) is of the form of g(S) := max S − K , 0, in the case of a Calloption, for example.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 218 / 223
Let’s review the basic contracts we can write:
Forward Contract Initial Value is 0, because both buyer and sellermay have to pay a balance at maturity
(European) Put/Call Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
(European) ”Exotic” Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
During the term of the contract, can the value of the contract ever fallbelow the intrinsic value of the payoff? Symbolically, does it ever occurthat
vn(s) < g(s) (183)
where g(s) is of the form of g(S) := max S − K , 0, in the case of a Calloption, for example.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 218 / 223
Let’s review the basic contracts we can write:
Forward Contract Initial Value is 0, because both buyer and sellermay have to pay a balance at maturity
(European) Put/Call Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
(European) ”Exotic” Option Initial Value is > 0, because both onlyseller must pay balance at maturity.
During the term of the contract, can the value of the contract ever fallbelow the intrinsic value of the payoff? Symbolically, does it ever occurthat
vn(s) < g(s) (183)
where g(s) is of the form of g(S) := max S − K , 0, in the case of a Calloption, for example.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 218 / 223
For Freedom! (we must charge extra...)
What happens if we write a contract that allows the purchaser to exercisethe contract whenever she feels it to be in her advantage? By allowing thisextra freedom, we must
Charge more than we would for a European contract that is exercisedonly at the term N
Hedge our replicating strategy X differently, to allow for thepossibility of early exercise
Extend the notion of the replicating strategy as a Martingale, whenproperly discounted
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 219 / 223
For Freedom! (we must charge extra...)
What happens if we write a contract that allows the purchaser to exercisethe contract whenever she feels it to be in her advantage? By allowing thisextra freedom, we must
Charge more than we would for a European contract that is exercisedonly at the term N
Hedge our replicating strategy X differently, to allow for thepossibility of early exercise
Extend the notion of the replicating strategy as a Martingale, whenproperly discounted
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 219 / 223
For Freedom! (we must charge extra...)
What happens if we write a contract that allows the purchaser to exercisethe contract whenever she feels it to be in her advantage? By allowing thisextra freedom, we must
Charge more than we would for a European contract that is exercisedonly at the term N
Hedge our replicating strategy X differently, to allow for thepossibility of early exercise
Extend the notion of the replicating strategy as a Martingale, whenproperly discounted
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 219 / 223
For Freedom! (we must charge extra...)
What happens if we write a contract that allows the purchaser to exercisethe contract whenever she feels it to be in her advantage? By allowing thisextra freedom, we must
Charge more than we would for a European contract that is exercisedonly at the term N
Hedge our replicating strategy X differently, to allow for thepossibility of early exercise
Extend the notion of the replicating strategy as a Martingale, whenproperly discounted
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 219 / 223
Some examples:
”American Bond:” g(s) = 1
”American Digital Option:” g(s) = 16≤s≤10 and
p =1
2= q
r =1
4
S0 = 4, u = 2, d =1
2
(184)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 220 / 223
Using the state-variable version of our Risk-Neutral pricing algorithm, wewere able to compute the fair price of the European option as V0.
How would we compute this V0 for the corresponding Americanoption?
What would our tree look like?
What would our strategy be?
Certainly, for any strategy X we enact, we must have
Xn ≥ max K − Sn, 0 (185)
to reflect the early payoff the option holder can take.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 221 / 223
Using the state-variable version of our Risk-Neutral pricing algorithm, wewere able to compute the fair price of the European option as V0.
How would we compute this V0 for the corresponding Americanoption?
What would our tree look like?
What would our strategy be?
Certainly, for any strategy X we enact, we must have
Xn ≥ max K − Sn, 0 (185)
to reflect the early payoff the option holder can take.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 221 / 223
Using the state-variable version of our Risk-Neutral pricing algorithm, wewere able to compute the fair price of the European option as V0.
How would we compute this V0 for the corresponding Americanoption?
What would our tree look like?
What would our strategy be?
Certainly, for any strategy X we enact, we must have
Xn ≥ max K − Sn, 0 (185)
to reflect the early payoff the option holder can take.
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 221 / 223
Stopping Times
The question of when exactly an investor will choose to ”prune the tree”and take her payoff must be asked. In precise language, we define aStopping Time τ as an adapted random variable on our discreteprobability space (Ω,F ,P) with filtration FkNk=0
τ : Ω→ 0, 1, 2, ...Nω ∈ Ω | τ(ω) = k ∈ Fk ∀k = 0, 1, 2, ..,N
(186)
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 222 / 223
Stopping Times:Example
Consider the case of
p =1
2= q
r =1
4
S0 = 4, u = 2, d =1
2,N = 2
V2 := max K − S2, 0
(187)
Then for τ := min m | vm(Sm) = K − Sm, 0, we have
ω | τ(ω) = 0 = φ ∈ F0
ω | τ(ω) = 1 = TH,TT ∈ F1
ω | τ(ω) = 2 = HH,HT ∈ F2
(188)
and so τ is a stopping time. Can you come up with a random time that isnot a stopping time?
Albert Cohen (MSU) MATH 360: Theory of Investment and Credit MSU Spring 2014 223 / 223