Study Manual For Exam FM/Exam 2 Financial Mathematics & Financial Economics Ninth Edition by Harold Cherry, FSA, MAAA, EA and Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D. Note: NO RETURN IF OPENEDTO OUR READERS: Please check A.S.M.’s web site at www.studymanuals.com for errata and updates. If you have any comments or reports of errata, please e-mail us at [email protected]. ©Copyright 2008 by Actuarial Study Materials, 276 Roosevelt Way, Westbury, NY 11590, All rights reserved. Reproduction in whole or in part without express written permission from the publisher is strictly prohibited.Contents Introduction 1 part I FINANCIAL MATHEMATICS 7 sec. 1 ‘The Measurement of Interest 9 $a Basie Concepts 9 CaleulatorNotes 13 Calculator Notes #1: Formatting; Present Values and Future Values 14 ‘Summary of Concepts and Formulas in Sections Ja(i) to La(v) 20 Past Exam Questions on Seetions Ia()(0 Lav) 21 Calculator Notes #2: Discount Rates; Nominal Rates 31 Summary of Concepts and Formulas in Sections la(vi)to la(ix) 33 Past Exam Questions on Sections la(vi) to Iatix) 34 §1b_ Why Do We Need a Force of Interest? 39 §le Defining the Force of Interest 39 §ld_ Finding the Fund in Terms of the Force of Interest 41 Sle The Simplest Case: A Constant Force of Interest 43, §If Power Series 44 Calculator Notes #3:Foree of Interest 46 ‘Summary of Concepts and Formulas in Sections 1b 0 1f 47 Past Exam Questions on Sections Ibto If 48 Sg The Variable Force of Interest Trap 60 ‘Summary of Concepts and Formulas in Seetion Ig 62 Past Exam Questions on Section 1g 63 §1h Equivalent Rates 70 Caleulator Notes #4; Equivatent Rates 72 ‘Summary of Concepis and Formulas in Section Ih 75 Past Exam Questions on Section 1h 75 SEC. 2 Solution of Problems in Interest 19 §2a Equations of Value, Time Value of Money, and Time Diagrams 79 §2b Unknown Time and Unknown Interest Rate 84 ‘Summary of Concepts and Formulas in Sections 2a and 2b 87 Past Exam Questions on Sections 2a and 2b 88 Copyright © 2009 ASM, th editionSEC. 3 SEC. 4 iv Contents Basic Annuities 95, §3a The Geometric Series Trap 95 $36 Annuity-Immediate and Annuity-Due 96 $3c The Deceptively Simple sq Function 100 530 $e 93 8g §3h $31 Calculator Notes #5: Basic Annuities 103 ‘Summary of Concepts and Formulas in Sections 3a to 3c 108 Past Exam Questions on Sections 3a to 3e 109 ‘Annuity Values on Any Date (or Playing “Now youseeit...") 116 ‘A Short-Cut Method for Annuities with “Block” Payments 117 Perpetities 119 ‘Summary of Concepts and Formulas in Sections 3d to 3f 122 Past Exam Questions on Sections 3d 0 3f 123 ‘The azq/ aq Trick (and Variations) 133 ‘Summary of Concepts and Formulas in Section 3135 Past Exam Questions on Section 3g 136 Unknown Time 140 Unknown Rate of Interest 141 ‘Summary of Concepts and Formulas in Sections 3h and 31 143 Past Exam Questions on Sections 3h and 3i 144 Varying Interest 151 ‘Summary of Concepts and Formulas in Sections 3} 152 Past Exam Questions on Section 3} 153 More General Annuities 155 Sa sb He sa ae SMe sh Si si Annuities with “Off-Payments"—Part 1135 Annuities with “Off Payments’"—Part 157 Avoiding the mY Annuity Trap 163 Summary of Concepts and Formulas in Sections 4a tode 164 Past Exam Questions on Sections 4atode 165 Continuous Annuities 180 “Double-dots Cancel” (and so do “upper m’s") 181 ‘A Short Note on Remembering Annuity Formulas 182 ‘The sq Trap When Interest Varies 183 ‘Summary of Concepts and Formulas in Sections 4d 04g. 185 Past Exam Questions on Sections dd to 4g 186 Payments in Arithmetic Progression 191 Calculator Notes #6: Annuities in Arithmetic Progression 198 Remembering Increasing Annuity Formulas 201 ‘Summary of Concepts and Formulas in Sections 4 to-4i 203 Past Exam Questions on Sections 4h and 4i 205 Payments in Geometric Progression 225, Summary of Concepts and Formulas in Sections 4j 227 Past Exam Questions on Section 4j ‘Copyright © 2009 ASM, 9th editionSEC. 5 SEC. 6 SEC. 7 Contents §4k The Amazing Expanding Money Machine (Or Continuous Varying Annuities) 238 ‘Summary of Concepts and Formulas in Sections 4k 241 Past Exam Questions on Section 4k 242 $41 A Short-Cut Method for the Palindromic Annuity 245, ‘Summary of Concepts and Formulas in Sections 41 247 Past Exam Questions on Section 41 248, §4m The 0% Test: A Quick Check of Symbolic Answers 250 Yield Rates 253 §5a Discounted Cash Flow Analysis 253 §5d Uniqueness of the Yield Rate 255 §5c Reinvestment Rates 256 ‘Summary of Concepts and Formulas in Sections Sato Se 258 Past Exam Questions on Sections Sato Se 259 §5d_ Interest Measurement of aFund 268 §5e Dollar-Weighted and Time-Weighted Interest Rates 269 ‘Summary of Concepts and Formulas in Sections Sd and Se 272, Past Exam Questions on Section Sd and Se 273 §5¢ Portfolio Methods and Investment Year Methods 280, ‘Summary of Concepts and Formulas in Sections Sf 283, Past Exam Questions on Section Sf 284 Amortization Schedules and Sinking Funds 287 $61 Amortizing a Loan 287 Caleulator Notes #7: Amortization Schedules 294 ‘Summary of Concepts and Formulas in Section 6 297 Past Exam Questions on Section 61 298 $6 Don’t be Sunk by Sinking Funds 3. §6c General Approach to SF Problems 323 ‘Summary of Concepts and Formulas in Sections 6b and 6e 326 Past Exam Questions on Sections 6b and 6¢ 327 §6d Outstanding Balance, Interest Paid and Principal Repaid under the inking Fund Method 336 ‘Summary of Concepts and Formulas in Section 6d 338 Past Exam Questions on Section 6d 339 §6c Varying Series of Payments 341 ‘Summary of Concepts and Formulas in Section 6c 34 Past Exam Questions on Section 6e 345 §6f Equal Principal Repayments (A Special Case of Varying Payments) 352 ‘Summary of Concepts and Formulas in Section 6f 354 Past Exam Questions on Section 6f 355 Bonds 359 §7a Bonds and Other Investments 359 §7 Finding the Price ofa Bond 359 Copyright © 2009 ASM, Sth edition vSEC. 8 SEC. 9 Contents §7e sd 7 Calculator Notes #8: Bonds 364 ‘Summary of Concepts and Formulas in Sections 7a and 7b 365 Past Exam Questions on Sections 7a and 7b 366 Premium and Discount 380 ‘Summary of Concepts and Formulas in Section 7¢ 384 Past Exam Questions on Section 7e 385 Price Between Coupon Dates 391 Determination of Yield Rates 396 ‘Summary of Concepts and Formulas in Sections 7d and 7e 398 Past Exam Questions on Sections Td and 7e 399 §7f Callable Bonds 401 ‘Summary of Concepts and Formulas in Section 7f 405 Past Exam Questions on Section 7f 406 Financial Instruments §81 Bonds, Preferred Stock, and Common Stack 409 §8b Price of a Share of Stock 410 ‘Summary of Concepts and Formulas in Sections 8a and 8 412 Past Exam Questions on Section 8a and 8b 413. $8¢ Other Financial Instruments 418 More Advanced Financial Analysis §9 99 §9c 598 §9e §or 8 §9h $91 $95 89k. §91 59m 99m Recognition of Inflation 421 ‘Yield Curves, Spot Rates and Forward Rates 423, ‘Summary of Concepts and Formulas in Sections 9a and 9b 432 Past Exam Questions on Sections 9a and 9b 433 Duration of a Single Cash Flow 439 Macaulay Duration 441 ‘Macaulay Duration as a Measure of Price Sensitivity 445 Modified Duration 447 Duration of a Portfolio 449 Change in Duration As Time Goes By 450 Summary of Concepts and Formulas in Sections 9¢ to 9h 451 Past Exam Questions on Sections Seto 452 Convexity 456 Redington Immunization 458 Full Immunization 463 ANote on Rebalancing 465, Immunization by Exact Matching (“Dedication”) 465 Interest-Sensitive Cash Flows: Effective Duration and Convexity 468 ‘Summary of Concepts and Formulas in Sections 9ito9n 471 Past Exam Questions on Sections 9ito9n 472 409 421 Copyright © 2009 ASM, 9th editionContents part II FINANCIAL ECONOMICS 475 SEC. 10 _ Introduction to Derivatives 477 §10a What isa Derivative? 477 §10b Development and Use of Derivatives 478 106 Buying and Selling Assets 480 §10d Short-Selling Assets 481 ‘Tho Lease Rate of an Asset 484 Summary of Concepts and Formulas in Section 10 485 Practice Problems on Section 10 486 sec. 11 Forward Contracts 493 §11a What isa Forward Contract? 493, §L1b The Long and Short of It 493 §Llc The Payoff 494 §11d A Forward Contract ws. Immediate Purchase 496 §lle Cash Settlement 499 ‘Summary of Concepts and Formulas in Section 11500 Practice Problems on Section 11 S01 sec. 12 Call Options 505 §12a First, a Cautionary Note 505 §12b The Basics of Call Options 506 ‘Summary of Concepts and Formulas in Section 12.511 Practice Problems on Section 12 512 sec. 13 Put Options 517 §13a The Basics of Put Options 517 §13b A Mnemonic for Put Options 520 §13¢ A Put Option is Insurance; Insurance is a Put Option 520 ‘Summary of Concepts and Formulas in Section 13.523 Practice Problems on Section 13. 524 sec. 14 Comparing Contracts 529 §lda “In-the-Money” or “Outof-the-Money” 529 §14b Comparison of Contracts by Position 530 §14¢ Comparison of Contracts by Maximum Profit and Loss 531 §14d Comparison by “Asset Price Contingency” 533 §1de Comparing Contacts by Strategy 534 {§14¢ Practica Issues in Buying or Selling Options 536 §14g Contracts as Building Blocks 537 Summary of Concepts and Formulas in Seetion I4 541 Practice Problems on Section 14 542 sec. 15 Insuring Your Position 547 §15a Insuring a Long Position S47 §15b Insuring a Short Position 552 Copyright © 2009 ASM, Sth edition vil