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Financial Mathematics

Financial Mathematics
Jonathan Ziveyi1
1 University of New South Wales
Risk and Actuarial Studies, Australian School of Business
j.ziveyi@unsw.edu.au

Module 1 Topic Notes

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Financial Mathematics

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
2/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
3/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models

Cash flow models A cash flow is a series of payments (inflows or


outflows) over a period of time.
A mathematical projection of the payments involved in a financial
transaction is referred to as a cash flow model.
Cash flows are characterised by their:

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nature: inflow or outflow

amount

timing

probability (if contingent)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models

Comparing cash flows We want to compare different sets of cash


flows:
why?

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compare 2 securities or investments


compare scenarii for a given product (product development,
profit testing, solvency)
compare potential new products (product development)
etc. . .

how?

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models

Procedure:

make the cash flow clear; draw a time diagram


choose any point in time

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now: present value, sometimes NPV (Net Present Value)


in the future: accumulated value
in the middle...
should be convenient: all are equivalent!

"bring back or forth" all cash flows to the point of time you
have chosen

add them up

compare!

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models

You want to buy a television from Bling Bees on 31/12/2009 that


is worth $3000. The super mega deal (yeahh) is that you can take
the television now and need only to pay $1000 on 31/12/2011 and
$2000 on 31/12/2012. Their advertisement campaign is "No
interest, no deposit until 2011!".
But you are smart (of course, you are an actuary), and you know
that if Bling Bee invests $1000 now, this investment will be worth
$1100 in one year, $1210 in two years and $1331 in three years.
Taking this information into account, what discount can you
reasonably get from Bling Bee?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
8/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest

Time value of money How much would you pay to buy a security
that is guaranteed to give you $100 in 1 years time?

What if there was a chance of default?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest

Time is money!
Interest is a mathematical tool to embody

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the time preference of agents in the economy


usually, agents are impatient (interest is positive)

risk (interest is raised to include a risk premium)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest

Mathematical model
Consider an amount of money invested for a period of time.

A(0): principal = the amount of money initially invested

t: the length of time for which the amount has been invested
A(t): amount function or accumulated amount function

this is the accumulated amount of money at time t


corresponding to A(0)

Assuming these are two equivalent cash flows at two different point
in time, how can we link them using interest?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest

Accumulation function Let a(t) be the accumulation function:

a(t) the accumulated value at time t of an original investment


of 1 made at time 0

it is a scaled version of A(t) with a(0) = 1 and can thus be


studied independently of the amounts that are invested

it represents the way in which money accumulates with the


passage of time

We have

A(t + k)
a(t + k)
=
,
A(t)
a(t)

which means
A(t + k) = A(t)

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a(t + k)
.
a(t)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest

Effective Interest In mathematical terms, the effective interest It,k


accumulated between t and t + k (for a period k from t) is
It,k = A(t + k) A(t),
and then the effective rate of interest it,k for this same period is
it,k =

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A(t + k) A(t)
a(t + k) a(t)
=
.
A(t)
a(t)

(1.1)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest

Homogeneity in time When the effective rate of interest is the same


for all t, then we have
a(t + k)
a(k)
=
= a(k)
a(t)
a(0)
A(t + k) = A(t)a(k)

it,k

=
=

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A(t + k)
A(t + k) A(t)
=
1
A(t)
A(t)
a(t + k) a(t)
= a(k) 1.
a(t)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest

Forms of interest

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a(t) is modeled with the help of interest

effective interest is always defined as in (1.1)

however, interest can be expressed in many different ways,


depending on the situation (mainly conventions)

each way has a different set of assumption

each definition may lead to different forms for a(t)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
A Mathematical Model of Interest

Assumptions about interest


1. how much interest is paid?

usually expressed as a percentage per year (per annum, p.a.)


amount can depends on the time period (inhomogeneity)
term structure of interest, see module 4
non-constant force of interest
amount is sometimes stochastic
deterministic vs stochastic interest, see module 6

2. how often is interest paid?

as a rule, once per compounding period, whose number per


time unit needs to be determined (usually once a year)
simple vs compound interest (time horizon)
nominal vs effective interest (several times a year)
force of interest (continuously)

3. when is interest paid?

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at the beginning or end of the compounding period


discount interest (beginning)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
16/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

Assumptions about interest


1. how much interest is paid?

usually expressed as a percentage per year (per annum, p.a.)


amount can depends on the time period (inhomogeneity)
term structure of interest, see module 4
non-constant force of interest
amount is sometimes stochastic
deterministic vs stochastic interest, see module 6

2. how often is interest paid?

as a rule, once per compounding period, whose number per


time unit needs to be determined (usually once a year)
simple vs compound interest (time horizon)
nominal vs effective interest (several times a year)
force of interest (continuously)

3. when is interest paid?

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at the beginning or end of the compounding period


discount interest (beginning)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

Simple and Compound Interest Example: Assume John deposits


$1000 on his bank account on 01/01/2010 at an effective rate of
interest of 5% p.a. At the following dates:
1. what is the balance of his account?
2. how much would he get if he closed his account?
3. how much interest has he earnt?
4. how much interest has been credited on the account?

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30/06/2010

01/01/2011

30/06/2011

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

18/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

Simple and Compound Interest Main difference:

with simple interest: no interest is ever earnt on


interestinterest is not compounded

with compound interest: interest is continuously earnt on


interestinterest is compounded

When to use one or the other?

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What happens within a year (compounding period) is usually


simple interest (short term securities, T-bills, . . . )

However, simple interest is not homogeneous in time

For cash flows spanning over periods of more than


a year, compound interest is generally used (easier..!)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

Simple Interest Accumulation function: for simple interest i,


a(t) = 1 + it,
and the accumulated amount function after a period t is given by
A(t) = A(0) a(t) = A(0) (1 + it).
Usually, t < 1 (days/360 or 365, or months/12).
Effective rate of interest is not constant in this case (decreasing):
a(t + k) = (1 + i(t + k))

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6=

(1 + it)(1 + ik) = a(t)a(k)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

Numerical Example A Bank accepts deposits for terms up to 3


years and pays interest on maturity. How much interest would it
pay on a deposit of $20,000 for a term of 1 year and 33 days if the
interest rate is 5% p.a. simple?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

Compound Interest Accumulation function: for compound interest


i,
a(t) = (1 + i)t ,
and the accumulated amount function after a period t is given by
A(t) = A(0) a(t) = A(0) (1 + i)t .
In this case, effective interest is homogeneous:
a(t + k) = (1 + i)t+k

(1 + i)t (1 + i)k = a(t)a(k)

or alternatively
a(t + k)
= (1 + i)k = a(k),
a(t)
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t, k 0.

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

Numerical Example
A Bank accepts deposits for terms up to 3 years and pays interest
on maturity. How much interest would it pay on a deposit of
$20,000 for a term of 1 year and 33 days if the interest rate is 5%
p.a. effective?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Simple and Compound Interest

General questions
1. What happens to the accumulation if i ?

i ?

2. What is the amount of interest earned during each unit period


under compound interest? simple interest?
3. What is the effective rate of interest during each unit period
under compound interest? simple interest?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
25/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest

Assumptions about interest


1. how much interest is paid?

usually expressed as a percentage per year (per annum, p.a.)


amount can depends on the time period (inhomogeneity)
term structure of interest, see module 4
non-constant force of interest
amount is sometimes stochastic
deterministic vs stochastic interest, see module 6

2. how often is interest paid?

as a rule, once per compounding period, whose number per


time unit needs to be determined (usually once a year)
simple vs compound interest (time horizon)
nominal vs effective interest (several times a year)
force of interest (continuously)

3. when is interest paid?

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at the beginning or end of the compounding period


discount interest (beginning)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest

Rate of Discount The rate of interest i applies to the principal now,


for interest calculated at t = 1, whereas the rate of discount d
applies to the principal at the end of the period, for interest
calculated at t = 0.
In other words, for i:

we focus on the principal now

we correct this figure by adding interest at the end of the


period

and for d :

we focus on the principal at the end of the period

we correct this figure by subtracting interest now

Both methods are equivalent, and use of one or the other is


dictated by the situation for convenience.
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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest

Remember: i

=
=

Now:

=
=

a(1) a(0)
a(0)
A(1) A(0)
= a(1) = (1 + i)
A(0)
a(1) a(0)
a(1)
A(1) A(0)
1
= a(1) =
A(1)
1d

Financial reasoning:

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At rate of compound interest of i% p.a. the discounted value


of an instrument is known. Is the compound rate of discount
that produces an equivalent discounted value higher or lower?

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest

Simple vs compound discount interest Since we want d and i to be


equivalent (they are just formulated differently), we have
1+i =

1
.
1d

For simple interest:


a(t) = a(0)

1
1 dt

and for compound interest:


a(t) = a(0)

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1
1d

t

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest

Numerical Example
In the US Treasury Bills are quoted using simple discount on the
basis of a 360 day year.
Consider a US T-Bill with a face value of 500,000 and maturity in
180 days time. Suppose that this is sold to yield 6%p.a (simple
discount). What are the proceeds of the sale?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest

Relations between Interest and Discount i is the effective rate of


interest, d is the effective rate of discount and v = 1/a(1) is the
discount factor.
Show these are correct as an exercise and use financial reasoning.

d
1d
i
=
1+i
= iv

= 1v

i
d

i d

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= id

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest

Intuition behind d = 1 v ?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Discount Interest

Intuition behind i d = id ?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
33/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest

Assumptions about interest


1. how much interest is paid?

usually expressed as a percentage per year (per annum, p.a.)


amount can depends on the time period (inhomogeneity)
term structure of interest, see module 4
non-constant force of interest
amount is sometimes stochastic
deterministic vs stochastic interest, see module 6

2. how often is interest paid?

as a rule, once per compounding period, whose number per


time unit needs to be determined (usually once a year)
simple vs compound interest (time horizon)
nominal vs effective interest (several times a year)
force of interest (continuously)

3. when is interest paid?

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at the beginning or end of the compounding period


discount interest (beginning)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest

Nominal Interest Rate

usually the compounding period is one year


nominal interest rates are interest rates

Example of securities for which nominal rates are relevant:

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that are still expressed as % p.a.


but that have several (m) compounding periods per year
Some bonds pay interest yearly, some semi-annually and some
quarterly
Home loans usually charge interest monthly
Some bank accounts pay interest daily

Notation: i (m) nominal interest rate, payable mthly

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest

Nominal vs effective rates With nominal interest rates, the rate


i (m)
m
is an effective rate of interest for a period of 1/m years.
Reminder:
the effective rate of interest for a period is the ratio between
1. the effective (actual amount of) interest earned and
2. the principal at the beginning of the period (for interest) or at
the end of the period (for discount).

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i (m) , m > 1, is not an effective rate of interest

i is the effective rate of interest for a year, equivalent to i (m)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest

Relationship to i, the effective interest rate In general, for rate i per


annum
!m
i (m)
(1 + i) =
1+
m
h
i
i (m) = m (1 + i)1/m 1
<

i (m) >i

??

Can you use your financial reasoning to convince yourself which is


correct?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest

Numerical Example A product offers interest at 8% p.a., payable


quarterly. What is the effective annual rate of interest implied?

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest

Nominal Discount Rates

Interest is converted m times per year (period)

Notation: d (m) nominal discount rate converted mthly

Relationship to d the effective rate of discount


!m
d (m)
1
= (1 d ) = 1
a(1)
m

Note that the nominal discount rate increases as the frequency


of conversion increases.
d < d (2) < d (4) . . .

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest
1

Exercise Show that d (m) = i (m) vi m

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Nominal Interest

Numerical Example Find the accumulated amount of $100 invested


for 15 years if i (4) = .08 for the first 5 years, d = .07 for the second
5 years and d (2) = .06 for the last five years.

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
41/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest

Assumptions about interest


1. how much interest is paid?

usually expressed as a percentage per year (per annum, p.a.)


amount can depends on the time period (inhomogeneity)
term structure of interest, see module 4
non-constant force of interest
amount is sometimes stochastic
deterministic vs stochastic interest, see module 6

2. how often is interest paid?

as a rule, once per compounding period, whose number per


time unit needs to be determined (usually once a year)
simple vs compound interest (time horizon)
nominal vs effective interest (several times a year)
force of interest (continuously)

3. when is interest paid?

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at the beginning or end of the compounding period


discount interest (beginning)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest

Force of Interest Consider


!m
i (m)
lim 1 +
m
m

i (m) m (m 1)
= lim 1 + m
+
m
m
2!

i ()
= 1+i
+
2!
i ()

= e
or e ,
()

2

i ()
+
3!

3

i (m)
m

!2

+ ...

+ ...

where is called the force of interest, or continuously compounding


rate of interest.
42/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest

Force of Discount Similarly, consider


!m
d (m)
lim 1
m
m

d (m) m (m 1)
= lim 1 m
+
m
m
2!
= 1d
= e d

()

()

d ()
+
2!

2

d ()

3!

where d () is the force of discount.


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3

d (m)

+ ...

!2

...

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest

We have
1 d = e d

()

and 1 + i = e i

Now
1d =v =

()

1
.
1+i

Thus,
i () = d ()
and, in general,
d < . . . < d (m) < . . . < d () = = i () < . . . < i (m) < . . . < i.

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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest

Force of interest that varies with time Let

A(0) be the principal invested at time 0

interest be paid continuously at a rate (t) at time t

We seek an expression for A(t).


Interest paid over a small interval t is
A(t + t) A(t) A(t)(t)t
and thus
(t)

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A(t + t) A(t)
.
A(t)t

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest

Taking the limit, as t 0,


A(t + t) A(t)
t0
A(t) t
1
d
A(t)
=
A(t) dt
A (t)
=
A(t)
d
=
ln A(t).
dt

(t) =

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lim

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest

Integrating both sides over [0, t],


Zt

(s)ds

ln A(s)|t0

s=0

= ln A(t) ln A(0)
A(t)
= ln
.
A(0)
Thus we have
A(t) = A(0) exp

Z

(s)ds

and
a(t) = exp

Z

(s)ds .

Note that interest is homogeneous iif (t) , t 0.


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Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Force of Interest

Numerical Example Force of interest at time 0 is 0.04, and


increases uniformly to 0.06 after 5 years. Find the amount after 5
years of an investment of $1.

For affine (t), the integral in exponential can be simplified:


k
a(t + k)
= e 2 [(t)+(t+k)]
a(t)

48/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
49/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest

Inflation When comparing cash flows, time has to be accounted


1. because of the time preference of agents in the economy (risk
free interest)
2. because there is a risk of default (risk premium)
3. because the value of money changes over time:
inflation/deflation
Inflation:

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Inflation (deflation) is characterized by rising (falling) prices, or


by falling (rising) value of money.

A common way of measuring inflation is the change in


Consumer Price Index (CPI) which itself measures the annual
rate of change in a specified "basket" of consumer items.

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest

Notation Let

i% p.a. be the money interest rate

r % p.a. be the real interest rate

p(t) be the price index (with P(0) = 1)

% p.a. be the inflation rate

What relationships can be established among i, r , P(t) and ?

50/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest

Main relations We have


a(0) = 1 and a(1) = 1 + i.
and
p(0) = 1 and p(1) = 1 +
Thus, the value of accumulation at todays prices is given by
a(1)
1+i
=
.
p(1)
1+
Now, define
1+r =

1+i
i
r =
.
1+
1+

Caution: this holds only for effective rates!


51/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest

How to deal with inflation Inflation is introduced in calculations


either by
1. considering the cash flow at its dates $ (nominal value) and
use money interest rates:

t
1
A(0) = A(t)
1+i
2. or adapting the amounts of cash flows to todays dollars (real
value) and use a (modified) real interest rate:
A(t)
A(0) =

(1 + )t
Both methods are equivalent.
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1
1+r

t

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest

Example An investor will receive an asset in 10 years time with face


value $100,000. Given a nominal (money) interest rate of 9% p.a.,
quarterly compounding, and an expected inflation rate of 5% p.a.,
(also quarterly compounding), what should you pay now:
Asset 1 if the payment on the asset will not change, failing to increase
in line with inflation
Asset 2 if the asset maintains its real value (an inflation indexed bond)

53/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest

To determine the price, we must be consistent. Either we work with

Method 1: the nominal value, and discount with the money


interest rate, or

Method 2: the real value, and discount with the real interest
rate.

The effective real quarterly rate is


.09/4 .05/4
= 0.9876543%
1 + .05/4
Thus, r (4) = 3.9506% and r = 4.0095%.

54/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest

Asset 1 Method 1:
PV

100, 000
40
1 + .09
4
= 41, 064.58
=

Method 2:
Real value =
PV =

55/90

100, 000
40 = 60, 841.33
1 + .05
4

60, 841.33

(1.00987654)40

= 41, 064.57

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Real and Money Interest

Asset 2 Method 1:
PV

100 000 1 + .05


4
=

.09 40
1+ 4
= 67 494.53

40

Method 2:
PV

56/90

100, 000

(1.00987654)40
= 67, 494.54

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
57/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Our fundamental problem Three inter-related (sets) of values:

a set of cash flows (inflows and outflows, timing, probability)

interest and its assumptions

a present value / accumulated value


(for a security: the price / value at maturity)

Learning outcome A3:


Understand the relation between a present value, a set of
cash flows and interest, be able to determine one in
function of the others in a variety of situations, as well as
understand the interest rate risk (duration, immunisation)

57/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Practical examples

Find the price of a security: determine an initial cash flow such


that the NPV is 0, given interest and a set of cash flows

Find the yield of a security or a project: determine the rate of


interest such that the NPV is 0 (IRR), given a set of cash flows

Find the minimum return on the reserves that is necessary to


ensure all current life annuities can be paid until the end, given
the current level of mortality (pensions)

...

Note

58/90

If the NPV is 0, we have then an equation of value

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Examples of Common Financial Instruments

Cash on deposit - term deposits, cash management trusts

Notes: Treasury notes, promissory notes, bank bills

Equities - also known as shares, equity shares or common stock

Bonds: Coupon Bonds, Zero Coupon Bonds (ZCB),


Government bonds

Annuities: annuities-certain, life annuities

Insurance applications: Term life insurance, Endowment


insurance

See Broverman and Sherris for the main definitions and examples.

59/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Determine a PV in function of cash flows and interest The present


value PV of an amount A(t) accumulated at time t is given by
A(t) = PV a(t) PV =

A(t)
.
a(t)

The present value or discount factor is then


v=

1
a(1)

1
1+i
= 1d
=

= d /i
Powers of the discount factor can be used to discount all cash flows
if interest is homogeneous with time
(which is the usual assumption)
60/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Numerical Examples Example 1


Consider a Coupon bond which pays $6 at times 1 and 2, and an
additional $100 at time 2. Find the Present Value of this bond at
8% p.a. effective interest.

61/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Numerical Examples Example 2


In Australia, Short term Government securities such as Treasury
Notes and Treasury Bonds (less than 6 months to maturity) are
priced using simple interest and a 365 day convention.
Consider a Treasury-note with a face value of 500,000 and maturity
in 180 days time. Suppose that this is sold at a yield (interest rate)
of 6%p.a. What are the proceeds of the sale?

62/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Determine interest in function of a PV and cash flows If there are


more than 2 cash flows, it is generally impossible to solve for
interest analytically.

In that case, several approaches are possible:

63/90

use a financial calculator

use a computer (R, Goal Seek in Excel, etc. . . )

use a numerical method (e.g. Newton-Raphson)


(the method to be used in quizzes and in the final exam)

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Newton-Raphson method (a recursive numerical method) (see, e.g.


http://en.wikipedia.org/wiki/Newtons_method)
f (in ) =

f (in )
f (in )
in+1 = in
in in+1
f (in )

1. determine f (i) such that f (i ) = 0


2. determine f (i)
3. choose initial value i0
4. perform recursions

64/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Relation between Cash Flow, Interest and Present Value

Numerical Example A Bond pays $100 in 1.5 years. Coupon


payments of $5 are payable times 0.5, 1, and 1.5
1. Find the Price of the Bond if the yield is i (2) = 6%.
2. Suppose the Price of the Bond is 107.14. Find the Yield
implied by this price.

65/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
66/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction

Notation

66/90

(p)
ax:n i
m|

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction

Our main tool to value annuities-certain: the perpetuity

67/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction

Numerical example A foundation has $100,000,000. Assuming a


long term net return on investments of 5% p.a., how much money
can it use every year without decreasing the capital?
Determine the annual payment if it is made in arrears or in
advance, and in the two situations:
1. the capital should not decrease in nominal terms
2. the capital should not decrease in real terms
Assume a long term inflation rate of 3% p.a.

68/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Annuities: Introduction

Numerical example

69/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
70/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Annuity-immediate (paid in arrears)

70/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Numerical example A Bond pays $100 at time 3. Coupon payments


of $5 are payable at times 1, 2, and 3
1. Find the Price of the Bond if the effective yield is i = 5%.
2. What is the Price if the effective yield is 6%?

71/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Annuity-due (paid in advance)

72/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Numerical example A Bond pays $100 at time 2. Coupon payments


of $5 are payable times 0, 1, and 2. (i.e. the first payment occurs
immediately after purchase).
1. Find the Price of the Bond if the effective yield is i = 6%.
2. What is the Price if the effective yield is 5%?

73/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Deferred annuity

74/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Numerical example Consider a Bond pays $100 at time 6. Coupon


payments of $5 are payable times 4, 5, and 6. How much would
you be willing to pay to purchase the bond today? Assume i = 6%.

75/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Payments more frequent than a year

76/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

77/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Alternative method Alternatively, find the effective pthly rate of


interest,
i (p)
.
j = (1 + i)1/p 1 =
p
Then
(p)

an i =
where j = (1 + i)1/p 1.

78/90

1
anp
p

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Numerical example Payments of 10 made at end of each month for


next 5 years. Calculate their present value at (i) 8% p.a. effective,
and (ii) 8% p.a. convertible half-yearly.
There are at least two ways to do these questions:
1. work according to cash flows and change i
2. work according to i (p) and change cash flows

79/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Term Annuities

Numerical example

80/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
81/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Increasing annuity (arithmetic progression)

81/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Numerical example Value the following set of cashflows at 10%


p.a.: A payment of$10 at time 1, $20 at time 2, $30 at time 3, $40
at time 4. What is the present value at time t = 0?

What is the present value at time t = 1?

82/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Increasing annuity (arithmetic progression): general case

83/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Numerical example Value the following series of payments at 10%


p.a.:

84/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Increasing annuity (geometric progression)

85/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Numerical example You can invest in a bond that pays coupons


that grow with inflation. The coupon received at the end of the
first year is $25,000, and each annual payment will increase, with
inflation, at rate 2.5% p.a. There are 10 annual payments and the
bond matures in 10 years with a face value of $400,000 (not
indexed to inflation). What is the price of the bond at a valuation
interest rate of 8%p.a.?

86/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Increasing annuity with p payments per annum

87/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Numerical example Determine the present value of a 10 year


annuity with half-yearly payments in arrears at rate 2 p.a. in the
first year, 4 p.a. in the second year, . . . , 20 p.a. in the 10th year.
Use a 10% p.a. convertible half-yearly compound interest rate.

88/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Decreasing annuity

89/90

Financial Mathematics
Module 1: Time Value of Money and Valuation of Cash Flows
Non-Level Annuities

Numerical example Value the following set of payments at 10% p.a:


$40 at time 1, $30 at time 2, $20 at time 3, $10 at time 4.

90/90

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