FM

Updated 03/23/22

INTEREST MEASUREMENT ANNUITIES MORE GENERAL ANNUITIES

Interest Measurement Annuities More General Annuities
Effective Rate of Interest Annuity-Immediate j-effective method is used when payments
𝐴𝐴(𝑡𝑡) − 𝐴𝐴(𝑡𝑡 − 1) 𝑃𝑃𝑃𝑃 = 𝑎𝑎+| are more or less frequent than the
𝑖𝑖! =
𝐴𝐴(𝑡𝑡 − 1) = 𝑣𝑣 + 𝑣𝑣 ) + ⋯ + 𝑣𝑣 + interest period.
1 − 𝑣𝑣 +
Effective Rate of Discount = “j-effective” Method
𝑖𝑖
𝐴𝐴(𝑡𝑡) − 𝐴𝐴(𝑡𝑡 − 1) 𝐴𝐴𝐴𝐴 = 𝑠𝑠+| Convert the given interest rate to the
𝑑𝑑! =
𝐴𝐴(𝑡𝑡) equivalent effective interest rate for the
= 1 + (1 + 𝑖𝑖) + ⋯ + (1 + 𝑖𝑖)+%(
(1 + 𝑖𝑖)+ − 1 period between each payment.
Accumulation Function and =
𝑖𝑖
Amount Function Example: To find the present value of 𝑛𝑛
𝐴𝐴(𝑡𝑡) = 𝐴𝐴(0) ∙ 𝑎𝑎(𝑡𝑡) a s monthly payments given annual effective
n n rate of 𝑖𝑖, define 𝑗𝑗 as the monthly effective
$1 1 … 1 1
All-in-One Relationship Formula rate where 𝑗𝑗 = (1 + 𝑖𝑖)(⁄() − 1.
#! 1 2 … n–1 n Then apply 𝑃𝑃𝑃𝑃 = 𝑎𝑎+| using 𝑗𝑗.
𝑖𝑖 (#)
(1 + 𝑖𝑖)! = .1 + 0 = (1 − 𝑑𝑑)%!
𝑚𝑚
%#! Annuity-Due Payments in Arithmetic Progression
𝑑𝑑(#)
= .1 − 0 = 𝑒𝑒 &! 𝑃𝑃𝑃𝑃 = 𝑎𝑎̈ +| • PV of n-year annuity-immediate with
𝑚𝑚
= 1 + 𝑣𝑣 + 𝑣𝑣 ) + ⋯ + 𝑣𝑣 +%( payments of
1 − 𝑣𝑣 + 𝑃𝑃, 𝑃𝑃 + 𝑄𝑄, 𝑃𝑃 + 2𝑄𝑄, … , 𝑃𝑃 + (𝑛𝑛 − 1)𝑄𝑄
Simple Interest = +
𝑑𝑑 111 − 𝑛𝑛𝑣𝑣
𝑎𝑎+|
𝑎𝑎(𝑡𝑡) = 1 + 𝑖𝑖𝑖𝑖 𝑃𝑃𝑃𝑃 = 𝑃𝑃𝑎𝑎+| + 𝑄𝑄
𝐴𝐴𝐴𝐴 = 𝑠𝑠̈ +| 𝑖𝑖
= (1 + 𝑖𝑖) + (1 + 𝑖𝑖)) + ⋯ + (1 + 𝑖𝑖)+ Calculator-friendly version:
Variable Force of Interest 𝑄𝑄 𝑄𝑄𝑄𝑄 +
𝑎𝑎' (𝑡𝑡) (1 + 𝑖𝑖)+ − 1 𝑃𝑃𝑃𝑃 = G𝑃𝑃 + H 𝑎𝑎+| 111 + G− H 𝑣𝑣
𝛿𝛿! = = 𝑖𝑖 𝑖𝑖
𝑎𝑎(𝑡𝑡) 𝑑𝑑
𝑁𝑁 = 𝑛𝑛, 𝐼𝐼⁄𝑌𝑌 = 𝑖𝑖 (in %),
Accumulate 1 from time 𝑡𝑡( 𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡) : 𝑄𝑄 𝑄𝑄𝑄𝑄
!! a!! s
!! 𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑃𝑃 + , 𝐹𝐹𝐹𝐹 = −
n n 𝑖𝑖 𝑖𝑖
𝐴𝐴𝐴𝐴 = exp .9 𝛿𝛿* 𝑑𝑑𝑑𝑑0
!" $1 1 1 … 1
• PV of n-year annuity-immediate with
1 2 … n–1 n payments of 1, 2, 3, … , 𝑛𝑛
Discount Factor
𝑎𝑎̈ +| − 𝑛𝑛𝑣𝑣 +
1 Unit increasing: (𝐼𝐼𝐼𝐼)+| =
𝑣𝑣 = = 1 − 𝑑𝑑 Immediate vs. Due 𝑖𝑖
1 + 𝑖𝑖
𝑎𝑎̈ +| = 𝑎𝑎+| (1 + 𝑖𝑖) = 1 + 𝑎𝑎+%(| P&Q version: 𝑃𝑃 = 1, 𝑄𝑄 = 1, 𝑁𝑁 = 𝑛𝑛
𝑖𝑖
𝑑𝑑 = = 𝑖𝑖𝑖𝑖 𝑠𝑠̈ +| = 𝑠𝑠+| (1 + 𝑖𝑖) = 𝑠𝑠+-(| − 1
1 + 𝑖𝑖 • PV of n-year annuity-immediate with
payments of 𝑛𝑛, 𝑛𝑛 − 1, 𝑛𝑛 − 2, … , 1
Deferred Annuity 𝑛𝑛 − 𝑎𝑎+|
m-year deferred n-year annuity-immediate: Unit decreasing: (𝐷𝐷𝐷𝐷)+| =
𝑖𝑖
𝑃𝑃𝑃𝑃 = #|𝑎𝑎+| = 𝑣𝑣 # ⋅ 𝑎𝑎+| = 𝑎𝑎#-+| − 𝑎𝑎#| P&Q version: 𝑃𝑃 = 𝑛𝑛, 𝑄𝑄 = −1, 𝑁𝑁 = 𝑛𝑛

• PV of perpetuity-immediate and
Perpetuity
perpetuity-due with payments of 1, 2, 3, …
• Perpetuity-immediate: 1 1 1
1 (𝐼𝐼𝐼𝐼)/| = = + )
𝑃𝑃𝑃𝑃 = 𝑎𝑎/| = 𝑣𝑣 + 𝑣𝑣 ) + ⋯ = 𝑖𝑖𝑖𝑖 𝑖𝑖 𝑖𝑖
𝑖𝑖 1
• Perpetuity-due: (𝐼𝐼𝑎𝑎̈ )/| = )
𝑑𝑑
1
𝑃𝑃𝑃𝑃 = 𝑎𝑎̈ /| = 1 + 𝑣𝑣 + 𝑣𝑣 ) + ⋯ =
𝑑𝑑
𝑎𝑎̈ /| = 1 + 𝑎𝑎/|

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 Payments in Geometric Progression Loan Amortization General Formulas for Bond Amortization
PV of an n-year annuity-immediate with For a loan of 𝑎𝑎+| repaid with n payments • Book value:
payments of of 1: 𝐵𝐵! = 𝐹𝐹𝐹𝐹𝑎𝑎+%!|4 + 𝐶𝐶𝑣𝑣 +%!
1, (1 + 𝑘𝑘), (1 + 𝑘𝑘)) , … , (1 + 𝑘𝑘)+%( = 𝐶𝐶 + (𝐹𝐹𝐹𝐹 − 𝐶𝐶𝐶𝐶)𝑎𝑎+%!|4
Period 𝑡𝑡
1 + 𝑘𝑘 +
1 − _ 1 + 𝑖𝑖 ` • Interest earned = 𝑖𝑖𝐵𝐵!%(
𝑃𝑃𝑃𝑃 = , 𝑖𝑖 ≠ 𝑘𝑘 Interest (𝐼𝐼! ) 1 − 𝑣𝑣 +%!-(
𝑖𝑖 − 𝑘𝑘
Principal repaid (𝑃𝑃! ) 𝑣𝑣 +%!-( Callable Bonds
Level and Increasing Continuous Annuity Total 1 Calculate the lowest price for all possible
+
1 − 𝑣𝑣 + 𝑖𝑖 redemption dates at a certain yield rate.
𝑎𝑎b+| = 9 𝑣𝑣 ! 𝑑𝑑𝑑𝑑 = = 𝑎𝑎+|
2 𝛿𝛿 𝛿𝛿 This is the highest price that guarantees this
General Formulas for Amortized Loan with
+ 𝑎𝑎b − 𝑛𝑛𝑣𝑣 + yield rate.
̅ b) = 9 𝑡𝑡𝑡𝑡 ! 𝑑𝑑𝑑𝑑 = +|
(𝐼𝐼𝑎𝑎 Level/Non-Level Payments
+| 𝛿𝛿
2 • Premium bond – call the bond on the
𝐼𝐼! = 𝑖𝑖 ⋅ 𝐵𝐵!%(
FIRST possible date.
𝐵𝐵! = 𝐵𝐵!%( (1 + 𝑖𝑖) − 𝑅𝑅! = 𝐵𝐵!%( − 𝑃𝑃!
𝑃𝑃! = 𝑅𝑅! − 𝐼𝐼! • Discount bond – call the bond on the
YIELD RATES LAST possible date.
Yield Rates 𝑃𝑃!-3 = 𝑃𝑃! (1 + 𝑖𝑖)3 (only for Level Payments)

Two methods for comparing investments:

• Net Present Value (NPV): Sum the BONDS SPOT RATES AND
Bonds Spot Rates and
present value of cash inflows and cash FORWARD RATES
Forward Rates
outflows. Choose investment with Bond Pricing Formulas
greatest positive NPV. 𝑃𝑃 Price of bond 𝑠𝑠! is the 𝑡𝑡-year spot rate.
• Internal Rate of Return (IRR): The rate 𝐹𝐹 Par value (face amount) of bond 𝑓𝑓[!",!! ] is the forward rate from time 𝑡𝑡(
such that the present value of cash (not a cash flow) to time 𝑡𝑡) , expressed annually.
inflows is equal to the present value of 𝑟𝑟 Coupon rate per payment period
cash outflows. Choose investment with #
𝐹𝐹𝐹𝐹 Amount of each coupon payment (1 + 𝑠𝑠+ )+ ⋅ m1 + 𝑓𝑓[+,+-#] n
greatest IRR. 𝐶𝐶 Redemption value of bond = (1 + 𝑠𝑠+-# )+-#
(𝐹𝐹 = 𝐶𝐶 unless otherwise stated)
𝑖𝑖 Interest rate per payment period
(1+sn+m)n+m
LOANS 𝑛𝑛 Number of coupon payments
Loans
Basic Formula
0 n n+m
Outstanding Balance Calculation 𝑃𝑃 = 𝐹𝐹𝐹𝐹𝑎𝑎+|4 + 𝐶𝐶𝑣𝑣 +
• Prospective: 𝐵𝐵! = 𝑅𝑅𝑎𝑎+%!| , Premium/Discount Formula: (1+sn)n (1+f[n,n+m])m
Present value of future level payments 𝑃𝑃 = 𝐶𝐶 + (𝐹𝐹𝐹𝐹 − 𝐶𝐶𝐶𝐶)𝑎𝑎+|4
(1 + 𝑠𝑠+ )+ = m1 + 𝑓𝑓[2,(] n ⋅ m1 + 𝑓𝑓[(,)] n ⋯
of 𝑅𝑅.
• Retrospective: 𝐵𝐵! = 𝐿𝐿(1 + 𝑖𝑖)! − 𝑅𝑅𝑠𝑠!| m1 + 𝑓𝑓[+%(,+] n
Premium vs. Discount
Accumulated value of original loan Premium Discount
amount L minus accumulated value of all (1+sn)n
𝑃𝑃 > 𝐶𝐶 𝑃𝑃 < 𝐶𝐶
past payments.
Condition or or
0 1 2 … n–1 n
𝐹𝐹𝐹𝐹 > 𝐶𝐶𝐶𝐶 𝐹𝐹𝐹𝐹 < 𝐶𝐶𝐶𝐶
Retrospective Prospective (1+f[0,1]) (1+f[1,2]) … (1+f[n–1,n])
Accumulating Discounting Amortization Write-
Past Payments Future Payments Write-Up
Bt Process Down

|(𝐹𝐹𝐹𝐹 − 𝐶𝐶𝐶𝐶) ⋅ 𝑣𝑣 +%!-( |

Amount
0 n = |𝐵𝐵!%( − 𝐵𝐵! | = |𝐹𝐹𝐹𝐹 − 𝐼𝐼! |
t
L

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 DURATION ANDand
Duration CONVEXITY
Convexity IMMUNIZATION
Immunization Time Value of Money (TVM)
Good for handling annuities, loans and bonds.
Duration Redington and Full Immunization Note: Be careful with signs of cash flows.
𝑃𝑃' (𝛿𝛿) ∑+!82 𝑡𝑡 ⋅ 𝑣𝑣 ! ⋅ 𝐶𝐶𝐶𝐶! N : Number of periods
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = − = Redington Full
𝑃𝑃(𝛿𝛿) ∑+!82 𝑣𝑣! ⋅ 𝐶𝐶𝐶𝐶! I/Y : Effective interest rate per period
𝑃𝑃' (𝑖𝑖) ∑+!82 𝑡𝑡 ⋅ 𝑣𝑣 !-( ⋅ 𝐶𝐶𝐶𝐶! 𝑃𝑃𝑉𝑉?@@A!@ = 𝑃𝑃𝑉𝑉B4;C4D4!4A@ (in %)
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = − =
𝑃𝑃(𝑖𝑖) ∑+!82 𝑣𝑣 ! ⋅ 𝐶𝐶𝐶𝐶! PV : Present value
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀? = 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀B or 𝑃𝑃?' = 𝑃𝑃B'
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 ⋅ 𝑣𝑣 PMT : Amount of each payment of
There has to be asset an annuity
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐶𝐶? > 𝐶𝐶B
cash flows before FV : Future value
𝑛𝑛-year zero-coupon or CPT + (one of above): Solve for unknown
𝑛𝑛 and after each
bond 𝑃𝑃? > 𝑃𝑃B''
''
liability cash flow. 2ND + BGN , 2ND + SET , 2ND + QUIT
Geometrically 1 + 𝑖𝑖 : Switch between annuity immediate and
increasing perpetuity 𝑖𝑖 − 𝑘𝑘 Immunizes annuity due
Immunizes against 2ND + P/Y : Please keep P/Y and C/Y as 1
against small
𝑛𝑛-year par bond 𝑎𝑎̈ +| any changes in 𝑖𝑖
changes in 𝑖𝑖 2ND + CLR TVM : Clear TVM worksheet
2ND + AMORT : Amortization (See Below)

First-order Modified Approximation Immunization Shortcut

For bonds _𝑃𝑃 = 𝐹𝐹𝐹𝐹𝑎𝑎+|4 + 𝐶𝐶𝑣𝑣 + `:
𝑃𝑃(𝑖𝑖+ ) ≈ 𝑃𝑃(𝑖𝑖9 ) ⋅ [1 − (𝑖𝑖+ − 𝑖𝑖9 )(𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀)] (works for immunization questions that have
asset cash flows before and after the liability N = 𝑛𝑛; I/Y = 𝑖𝑖; PV = −𝑃𝑃;
First-order Macaulay Approximation cash flow) PMT = 𝐹𝐹𝐹𝐹; FV = 𝐶𝐶.
:;<=
1 + 𝑖𝑖9
𝑃𝑃(𝑖𝑖+ ) ≈ 𝑃𝑃(𝑖𝑖9 ) ⋅ G H 1. Identify the asset allocation at the time Cash Flow Worksheet
1 + 𝑖𝑖+
the liability occurs by equating face ( CF , NPV , IRR )
amounts (prices) and durations.
Passage of Time Good for non-level series of payments.
𝑡𝑡) − 𝑡𝑡B
Given that the future cash flows are the 𝑤𝑤 = Input ( CF )
𝑡𝑡) − 𝑡𝑡(
same at time 𝑡𝑡( and time 𝑡𝑡) : CF0: Cash flow at time 0
𝑀𝑀𝑀𝑀𝑀𝑀𝐷𝐷!! = 𝑀𝑀𝑀𝑀𝑀𝑀𝐷𝐷!" − (𝑡𝑡) − 𝑡𝑡( ) 𝑡𝑡( Shorter bond duration Cn: nth cash flow
𝑀𝑀𝑀𝑀𝑀𝑀𝐷𝐷!! = 𝑀𝑀𝑀𝑀𝑀𝑀𝐷𝐷!" − 𝑣𝑣(𝑡𝑡) − 𝑡𝑡( ) 𝑡𝑡) Longer bond duration Fn: Frequency of the cash flow
𝑡𝑡B Liability duration
Duration of a portfolio 𝑤𝑤 Shorter bond's weight Output ( NPV , IRR )
For a portfolio of m securities where 1 − 𝑤𝑤 Longer bond's weight I: Effective interest rate (in %)
invested amount 𝑃𝑃 = 𝑃𝑃( + 𝑃𝑃) + ⋯ + 𝑃𝑃# at NPV + CPT : Solve for net present value
2. Adjust for interest to the asset
time 0: IRR + CPT : Solve for internal rate
maturity date.
𝑃𝑃( 𝑃𝑃# of return
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀> = 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀( + ⋯ + 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀#
𝑃𝑃 𝑃𝑃
Amortization Schedule
Convexity BA-II Plus
BA-II PLUS CALCULATOR
GUIDELINE ( 2ND + AMORT )
𝑃𝑃'' (𝑖𝑖) ∑+!82 𝑡𝑡 ⋅ (𝑡𝑡 + 1) ⋅ 𝑣𝑣 !-) ⋅ 𝐶𝐶𝐶𝐶! Calculator Guideline Good for finding outstanding balance of the
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = =
𝑃𝑃(𝑖𝑖) ∑+!82 𝑣𝑣 ! ⋅ 𝐶𝐶𝐶𝐶!
Basic Operations loan and interest/principal portion of
𝑃𝑃'' (𝛿𝛿) ∑+!82 𝑡𝑡 ) ⋅ 𝑣𝑣 ! ⋅ 𝐶𝐶𝐶𝐶!
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = = ENTER (SET) : Send value to a certain payments.
𝑃𝑃(𝛿𝛿) ∑+!82 𝑣𝑣 ! ⋅ 𝐶𝐶𝐶𝐶!
variable (option) Note: BA-II Plus requires computing the
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑣𝑣 ) (𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 + 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀)
↑ ↓ : Navigate through variables unknown TVM variable before entering into
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀(𝑛𝑛-year zero-coupon bond) = 𝑛𝑛) 2ND : Access secondary functions (yellow) AMORT function.
STO + 0~9 : Send on-screen value P1: Starting period
P2: Ending period
into memory
BAL: Remaining balance of the loan after P2
RCL + 0~9 : Recall value from a memory
PRN: Sum of the principal repaid from
P1 to P2
INT: Sum of the interest paid from P1 to P2

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