CLs Handy

Formula Sheet
(Useful formulas from Marcel Finans FM/2 Book)
Compiled by Charles Lee
8/19/2010
 Interest
Interest Discount The Method of Equated Time
Simple Compound Simple Compound
a(t)

Period The Rule of 72

when The time it takes an investment of 1 to double is given by
greater

Date Conventions
Recall knuckle memory device. (February has 28/29 days)
Interest Formulas Exact
o actual/actual
o Uses exact days
o 365 days in a nonleap year
o 366 days in a leap year (divisible by 4)
Ordinary
o 30/360
o All months have 30 days
o Every year has 360 days
Force of Interest
o
Bankers Rule
o actual/360
o Uses exact days
o Every year has 360 days

Basic Formulas
Basic Equations
Annuities
Immediate Due Perpetuity

Annuities Payable More Frequently than Interest is Convertible

Let = the number of payments per interest conversion period
Let = total number of conversion periods
Hence the total number of annuity payments is

Coefficient of is the total amount paid during on interest

conversion period
Perpetuity
Immediate Due

Annuities Payable Less Frequently than Interest is Convertible

Let = number of interest conversion periods in one payment period
Let = total number of conversion periods
Hence the total number of annuity payments is

Immediate Due

Perpetuity
Continuous Annuities
Geometric
a=1
r = 1+k
ki
If k = i
a=1
r = 1-k
ki

If k=i
Varying Annuities
Perpetuity
Arithmetic
Immediate Due
General
P, P+Q,,
P+(n-1)Q

Increasing
Continuously Varying Annuities
P=Q=1
Consider an annuity for n interest conversion periods in which
payments are being made continuously at the rate and the interest
rate is variable with force of interest .
Decreasing
P=n
Q = -1
Under compound interest, i.e. , the above becomes

Perpetuity
 Rate of Return of an Investment
Rate of Return of an Investment Interest Reinvested at a Different Rate
Yield rate, or IRR, is the interest rate at which Invest 1 for n periods at rate i, with interest reinvested at rate j

Hence yield rates are solutions to NPV(i)=0 Invest 1 at the end of each period for n periods at rate i, with interest
reinvested at rate j

Discounted Cash Flow Technique Invest 1 at the beginning of each period for n periods at rate i, with
interest reinvested at rate j

Uniqueness of IRR
Theorem 1

Theorem 2
Let Bt be the outstanding balance at time t, i.e.
o
o
Then
o
o
Dollar-Weighted Interest Rate

A = the amount in the fund at the beginning of the period, i.e. t=0
B = the amount in the fund at the end of the period, i.e. t=1
I = the amount of interest earned during the period
ct = the net amount of principal contributed at time t
C = ct = total net amount of principal contributed during the period
i = the dollar-weighted rate of interest

Note: B = A+C+I
Exact Equation Simple Interest Approximation Summation Approximation
The summation term is tedious.

Define

Exposure associated with i"= A+ct(1-t) If we assume uniform cash

flow, then

Time-Weighted Interest Rate

Does not depend on the size or timing of cash flows.
Suppose n-1 transactions are made during a year at times t1,t2,,tn-1.
Let jk = the yield rate over the kth subinterval
Ct = the net contribution at exact time t
Bt = the value of the fund before the contribution at time t
Then

The overall yield rate i for the entire year is given by

 Bonds
Notation Yield rate and Coupon rate of Different Frequencies
P = the price paid for a bond Let n be the total number of yield rate conversion periods.
F = the par value or face value Case 1: Each coupon period contains k yield rate periods
C = the redemption value o
r = the coupon rate
Fr = the amount of a coupon payment Case 2: Each yield period contains m coupon periods
g = the modified coupon rate, defined by Fr/C o
i = the yield rate
n = the number of coupons payment periods
K = the present value, compute at the yield rate, of the Amortization of Premium or Discount
redemption value at maturity, i.e. K=Cvn Let Bt be the book value after the tth coupon has just been paid, then
G = the base amount of a bond, defined as G=Fr/i. Thus, G is
the amount which, if invested at the yield rate i, would produce Let It denote the interest earned after the tth coupon has been made
periodic interest payments equal to the coupons on the bond
Let Pt denote the corresponding principal adjustment portion
Quoted yields associated with a bond
1) Nominal Yield
a. Ratio of annualized coupon rate to par value
Amount for
2) Current Yield Interest
Date Coupon Amortization Book Value
a. Ratio of annualized coupon rate to original price of the earned
of Premium
bond
June 1, 1996
3) Yield to maturity
a. Actual annualized yield rate, or IRR Dec 1, 1996
June 1, 1997
Pricing Formulas
Basic Formula
o Approximation Methods of Bonds Yield Rates
Premium/Discount Formula
o Exact Approximation Bond Salesmans Method
Base Amount Formula
o
Makeham Formula
o Power series Equivalently
Where
expansion
Valuation of Bonds between Coupon Payment Dates Premium or Discount between Coupon Payment Dates

The purchase price for the bond is called the flat price and is
denoted by
The price for the bond is the book value, or market price, and is
denoted by
Callable Bonds
The part of the coupon the current holder would expect to
receive as interest for the period is called the accrued interest The investor should assume that the issuer will redeem the bond to the
disadvantage of the investor.
or accrued coupon and is denoted by
From the above definitions, it is clear that
If the redemption value is the same at any call date, including the
$ maturity date, then the following general principle will hold:
Flat price
1) The call date will be at the earliest date possible if the bond
was sold at a premium, which occurs when the yield rate is
Book value smaller than the coupon rate (issuer would like to stop repaying
the premium via the coupon payments as soon as possible)
Theoretical Method 2) The call date will be at the latest date possible if the bond was
1 2 3 4
The flat price should be the book value Bt sold at a discount, which occurs when the yield rate is larger
after the preceding coupon accumulated by (1+i)k than the coupon rate (issuer is in no rush to pay out the
redemption value)


Serial Bonds
Practical Method Serial bonds are bonds issued at the same time but with different
Uses the linear approximation maturity dates.
Consider an issue of serial bonds with m different redemption dates.
By Makehams formula,

Semi-theoretical Method where

Standard method of calculation by the securities industry. The flat
price is determined as in the theoretical method, and the accrued
coupon is determined as in the practical method.



 Loan Repayment Methods
Amortization Method

Prospective Method Sinking Fund Method

o The outstanding loan balance at any time is equal to the Whereas with the amortization method the payment at the end of each
present value at that time of the remaining payments period is , in the sinking fund method, the borrower both deposits
Retrospective Method
o The outstanding loan balance at any time is equal to the into the sinking fund and pays interest i per period to the lender.
original amount of the loan accumulated to that time
less the accumulated value at that time of all payments Example
previously made Create a sinking fund schedule for a loan of $1000 repaid over four
years with i = 8%.
Consider a loan of at interest rate i per period being repaid with If R is the sinking fund deposit, then
payments of 1 at the end of each period for n periods.
Period Interest Sinking Interest Amount Net
Period Payment Interest paid Principal Outstanding loan paid fund earned in amount
amount repaid balance deposit on sinking of loan
sinking fund
fund
0 1000
1 80 221.92 0 221.92 778.08
2 80 221.92 17.75 461.59 538.41

3 80 221.92 36.93 720.44 279.56
4 80 221.92 57.64 1000 0

Total
Measures of Interest Rate Sensitivity
Stock Duration
Preferred Stock Method of Equated Time (average term-to-maturity)
o Provides a fixed rate of return o where R1,R2,,Rn are a series of payments
o Price is the present value of future dividends of a
perpetuity made at times 1,2,,n
Macaulay Duration
o
Common Stock o , where
o Does not earn a fixed dividend rate o is a decreasing function of i
o Dividend Discount Model Volatility (modified duration)
o Value of a share is the present value of all future
o
dividends
o
o o if P(i) is the current price of a bond, then

Short Sales
In order to find the yield rate on a short sale, we introduce the Convexity
following notation: o
M = Margin deposit at t=0
S0 = Proceeds from short sale
St = Cost to repurchase stock at time t Modified Duration and Convexity of a Portfolio
dt = Dividend at time t Consider a portfolio consisting of n bonds. Let bond K have a current
i = Periodic interest rate of margin account price , modified duration , and convexity . Then the
j = Periodic yield rate of short sale current value of the portfolio is

The modified duration of the portfolio is

Inflation Similarly, the convexity of the portfolio is

Given i' = real rate, i = nominal rate, r = inflation rate,

Thus, the modified duration and convexity of a portfolio is the

Fischer Equation weighted average of the bonds modified durations and convexities
A common approximation for the real interest rate: respectively, using the market values of the bonds as weights.
Redington Immunization Interest Yield Curves
Effective for small changes in interest rate i The k-year forward n years from now satisfied
Consider cash inflows A1,A2,,An and cash outflows L1,L2,,Ln.
Then the net cash flow at time t is where it is the t-year spot rate

Immunization conditions
We need a local minimum at i

o The present value of cash inflows (assets) should be
equal to the present value of cash outflows (liabilities)

o The modified duration of the assets is equal to the
modified duration of the liabilities

o The convexity of PV(Assets) should be greater than the
convexity of PV(Liabilities), i.e. asset growth > liability
growth

Full Immunization
Effective for all changes in interest rate i
A portfolio is fully immunized if

Full immunization conditions for a single liability cash flow

1)
2)
3)
Conditions (1) and (2) lead to the system

where =ln(1+i) and k=time of liability

Dedication
Also called absolute matching
In this approach, a company structures an asset portfolio so that the
cash inflow generated from assets will exactly match the cash outflow
from liabilities.
Option Styles
European option Holder can exercise the option only on the Long Forward Short Forward
expiration date
American option Holder can exercise the option anytime during the
life of the option
Bermuda option Holder can exercise the option during certain pre-
specified dates before or at the expiration date

Buy Write
Call Long Call Short Call
Put
Payoff
Floor own + buy put
Profit
Cap short + buy call
Covered Call stock + write call = write put
Covered Put short +write put = write call Price at Maturity

Cash-and-Carry buy asset + short forward contract

Synthetic Forward a combination of a long call and a short put with Long Put Short Put
the same expiration date and strike price

Fo,T = no arbitrage forward price

Call(K,T) = premium of call

Put-Call Parity

Derivative Maximum Loss Maximum Gain Position wrt Strategy Payoff

Position Underlying Asset
Long -Forward Price Unlimited Long(buy) Guaranteed price PT-K
Forward
Short Unlimited Forward Price Short(sell) Guaranteed price K-PT
Forward
Long Call -FV(Premium) Unlimited Long(buy) Insures against high price max{0,PT-K}
Short Call Unlimited FV(Premium) Short(sell) Sells insurance against high price -max{0,PT-K}
Long Put -FV(Premium) Strike Price FV(Premium) Short(sell) Insures against low price max{0,K-PT}
Short Put FV(Premium) Strike Price FV(Premium) Long(buy) Sells insurance against low price -max{0,K-PT}
(Buy index) + (Buy put option with strike K) = (Buy call option with strike K) + (Buy zero-coupon bond with par value K)
(Short index) + (Buy call option with strike K) = (Buy put option with strike K) + (Take loan with maturity of K)

Spread Strategy Long Box Spread

Creating a position consisting of only calls or only puts, in which some Bull Call Spread Bear Put Spread
options are purchased and some are sold Synthetic Long Forward Buy call at K1 Sell put at K1
Bull Spread Synthetic Short Forward Sell call at K2 Buy put at K2
o Investor speculates stock price will increase Regardless of spot price at expiration, the box spread guarantees a cash
o Bull Call flow of K2-K1 in the future.
Buy call with strike price K1, sell call with strike Net premium of acquiring this position is PV(K2-K1)
price K2>K1 and same expiration date If K1<K2, then lending money
o Bull Put Invest PV(K2-K1), get K2-K1
Buy put with strike price K1, sell put with strike If K1>K2, then borrow money
price K2>K1 and same expiration date Get PV(K1-K2), pay K1-K2
o Two profits are equivalent (Buy K1 call) + (Sell K2
call) = (Buy K1 put) + (Sell K2 put)
o Profit function Butterfly Spread
An insured written straddle
Let K1<K2<K3
o Written straddle
Bear Spread Sell K2 call, sell K2 put
o Investor speculates stock price will decrease o Long strangle
o Exact opposite of a bull spread Buy K1 call, buy K3 put
o Bear Call Profit
Sell K1 call, buy K2 call, where 0<K1<K2 o Let F
o Bear Put
Sell K1 put, buy K2 put, where 1<K1<K2
o

Payoff Profit
K2-K1 K2-K1-FV[
PT Asymmetric Butterfly Spread
PT
-FV[
K1 K2
Collar
Used to speculate on the decrease of the price of an asset Profit Function
Buy K1-strike at-the-money put
Sell K2-strike out-of-the-money call
K2>K1
K2-K1 = collar width

Collared Stock
Collars can be used to insure assets we own Profit Function
Buy index
Buy at-the-money K1 put
Buy out-of-the-money K2 call
K1<K2

Zero-cost Collar
A collar with zero cost at time 0, i.e. zero net premium

Profit Function
Straddle
A bet on market volatility
Buy K-strike call
Buy K-strike put

Strangle
Profit Function
A straddle with lower premium cost
Buy K1-strike call
Buy K2 strike put
K1<K2
Equity-linked CD (ELCD) Financial Engineering of Synthetics
(Forward) = (Stock) (Zero-coupon bond)
o Buy e-T shares of stock
Can financially engineer an equivalent by o Borrow S0e-T to pay for stock
Buy zero-coupon bond at discount o Payoff = PT F0,T
Use the difference to pay for an at-the-money call option (Stock) = (Forward) + (Zero-coupon bond)
o Buy forward with price F0,T = S0e(r-)T
o Lend S0e-T
o Payoff = PT
Prepaid Forward Contracts on Stock (Zero-coupon bond) = (Stock) (Forward)
Let FP0,T denote the prepaid forward price for an asset bought o Buy e-T shares
at time 0 and delivered at time T o Short one forward contract with price F0,T
If no dividends, then FP0,T = S0, otherwise arbitrage o Payoff = F0,T
opportunities exist o If the rate of return on the synthetic bond is i, then
If discrete dividends, then S0e(i-)T = F0,T or
o Implied repo rate
If continuous dividends, then
o Let =yield rate, then the
and 1 share at time 0 grows to eT shares at
time T

Forward Contracts
Discrete dividends
o
Continuous dividends
o
Forward premium = F0,T / S0
The annualized forward premium satisfies
o
If no dividends, then =r
If continuous dividends, then =r-