CLs Handy

Formula Sheet
(Useful formulas from Marcel Finans FM/2 Book)
Compiled by Charles Lee
8/19/2010

Interest
Interest
Simple
Compound

Discount
Simple
Compound

The Method of Equated Time

a(t)
Period
when
greater

Interest Formulas

Force of Interest

The Rule of 72
The time it takes an investment of 1 to double is given by

Date Conventions
Recall knuckle memory device. (February has 28/29 days)
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
o
Bankers Rule
o actual/360
o Uses exact days
o Every year has 360 days
Basic Formulas

Annuities
Basic Equations
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
Arithmetic
Immediate

Perpetuity
Due

General
P, P+Q,,
P+(n-1)Q
Increasing
P=Q=1

Continuously Varying Annuities

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.

Perpetuity

, the above becomes

Rate of Return of an Investment

Rate of Return of an Investment
Yield rate, or IRR, is the interest rate at which

Interest Reinvested at a Different Rate

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)

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

If we assume uniform cash

flow, then

Bonds
Notation
P = the price paid for a bond
F = the par value or face value
C = the redemption value
r = the coupon rate
Fr = the amount of a coupon payment
g = the modified coupon rate, defined by Fr/C
i = the yield rate
n = the number of coupons payment periods
K = the present value, compute at the yield rate, of the
redemption value at maturity, i.e. K=Cvn
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
periodic interest payments equal to the coupons on the bond
Quoted yields associated with a bond
1) Nominal Yield
a. Ratio of annualized coupon rate to par value
2) Current Yield
a. Ratio of annualized coupon rate to original price of the
bond
3) Yield to maturity
a. Actual annualized yield rate, or IRR
Pricing Formulas
Basic Formula
o
Premium/Discount Formula
o
Base Amount Formula
o
Makeham Formula
o

Yield rate and Coupon rate of Different Frequencies

Let n be the total number of yield rate conversion periods.
Case 1: Each coupon period contains k yield rate periods
o

Case 2: Each yield period contains m coupon periods

o

Amortization of Premium or Discount

Let Bt be the book value after the tth coupon has just been paid, then
Let It denote the interest earned after the tth coupon has been made
Let Pt denote the corresponding principal adjustment portion

Date

Coupon

Interest
earned

Amount for
Amortization
of Premium

Book Value

June 1, 1996
Dec 1, 1996
June 1, 1997
Approximation Methods of Bonds Yield Rates
Exact

Where

Approximation

Power series
expansion

Bond Salesmans Method

Equivalently

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
The part of the coupon the current holder would expect to
receive as interest for the period is called the accrued interest
or accrued coupon and is denoted by
From the above definitions, it is clear that
$

Flat price

Book value

Theoretical Method
1
The flat price should be the book value Bt
after the preceding coupon accumulated by (1+i)k

Callable Bonds
The investor should assume that the issuer will redeem the bond to the
disadvantage of the investor.
If the redemption value is the same at any call date, including the
maturity date, then the following general principle will hold:
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
smaller than the coupon rate (issuer would like to stop repaying
the premium via the coupon payments as soon as possible)
2) The call date will be at the latest date possible if the bond was
sold at a discount, which occurs when the yield rate is larger
than the coupon rate (issuer is in no rush to pay out the
redemption value)

Practical Method
Uses the linear approximation

Semi-theoretical Method
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.

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

Loan Repayment Methods

Amortization Method

Prospective Method
o The outstanding loan balance at any time is equal to the
present value at that time of the remaining payments
Retrospective Method
o The outstanding loan balance at any time is equal to the
original amount of the loan accumulated to that time
less the accumulated value at that time of all payments
previously made

Consider a loan of
at interest rate i per period being repaid with
payments of 1 at the end of each period for n periods.
Period Payment
amount

Interest paid

Principal
repaid

Outstanding loan
balance

Total

Sinking Fund Method

Whereas with the amortization method the payment at the end of each
period is , in the sinking fund method, the borrower both deposits
into the sinking fund and pays interest i per period to the lender.
Example
Create a sinking fund schedule for a loan of $1000 repaid over four
years with i = 8%.
If R is the sinking fund deposit, then
Period

0
1
2
3
4

Interest
paid

80
80
80
80

Sinking
fund
deposit

221.92
221.92
221.92
221.92

Interest
earned
on
sinking
fund
0
17.75
36.93
57.64

Amount
in
sinking
fund

221.92
461.59
720.44
1000

Net
amount
of loan

1000
778.08
538.41
279.56
0

Measures of Interest Rate Sensitivity

Stock
Preferred Stock
o Provides a fixed rate of return
o Price is the present value of future dividends of a
perpetuity
o
Common Stock
o Does not earn a fixed dividend rate
o Dividend Discount Model
o Value of a share is the present value of all future
dividends

Duration
Method of Equated Time (average term-to-maturity)
o
where R1,R2,,Rn are a series of payments

made at times 1,2,,n

Macaulay Duration
o

, where

o
is a decreasing function of i
Volatility (modified duration)
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
following notation:
M = Margin deposit at t=0
S0 = Proceeds from short sale
St = Cost to repurchase stock at time t
dt = Dividend at time t
i = Periodic interest rate of margin account
j = Periodic yield rate of short sale

Convexity
o

Modified Duration and Convexity of a Portfolio

Consider a portfolio consisting of n bonds. Let bond K have a current
price
, modified duration
, and convexity
. Then the
current value of the portfolio is
The modified duration

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

Fischer Equation
A common approximation for the real interest rate:

of the portfolio is

Similarly, the convexity of the portfolio is

Thus, the modified duration and convexity of a portfolio is the
weighted average of the bonds modified durations and convexities
respectively, using the market values of the bonds as weights.

Redington Immunization
Effective for small changes in interest rate i
Consider cash inflows A1,A2,,An and cash outflows L1,L2,,Ln.
Then the net cash flow at time t is
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.

Interest Yield Curves

The k-year forward n years from now satisfied
where it is the t-year spot rate

Option Styles
European option Holder can exercise the option only on the
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 prespecified dates before or at the expiration date

Call
Put

Buy

Write

Long Forward

Short Forward

Long Call

Short Call

Payoff

Floor own + buy put

Cap short + buy call
Covered Call stock + write call = write put
Covered Put short +write put = write call

Profit
Price at Maturity

Cash-and-Carry buy asset + short forward contract

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

Long Put

Short Put

Fo,T = no arbitrage forward price

Call(K,T) = premium of call
Put-Call Parity

Derivative
Position
Long
Forward
Short
Forward
Long Call
Short Call
Long Put
Short Put

Maximum Loss

Maximum Gain

Strategy

Payoff

Unlimited

Position wrt
Underlying Asset
Long(buy)

-Forward Price

Guaranteed price

PT-K

Unlimited

Forward Price

Short(sell)

Guaranteed price

K-PT

-FV(Premium)
Unlimited
-FV(Premium)
FV(Premium) Strike Price

Unlimited
FV(Premium)
Strike Price FV(Premium)
FV(Premium)

Long(buy)
Short(sell)
Short(sell)
Long(buy)

Insures against high price

Sells insurance against high price
Insures against low price
Sells insurance against low price

max{0,PT-K}
-max{0,PT-K}
max{0,K-PT}
-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
Creating a position consisting of only calls or only puts, in which some
options are purchased and some are sold
Bull Spread
o Investor speculates stock price will increase
o Bull Call
Buy call with strike price K1, sell call with strike
price K2>K1 and same expiration date
o Bull Put
Buy put with strike price K1, sell put with strike
price K2>K1 and same expiration date
o Two profits are equivalent (Buy K1 call) + (Sell K2
call) = (Buy K1 put) + (Sell K2 put)
o Profit function

Bear Spread
o Investor speculates stock price will decrease
o Exact opposite of a bull spread
o Bear Call
Sell K1 call, buy K2 call, where 0<K1<K2
o Bear Put
Sell K1 put, buy K2 put, where 1<K1<K2

Long Box Spread

Bull Call Spread Bear Put Spread
Synthetic Long Forward
Buy call at K1
Sell put at K1
Synthetic Short Forward
Sell call at K2
Buy put at K2
Regardless of spot price at expiration, the box spread guarantees a cash
flow of K2-K1 in the future.
Net premium of acquiring this position is PV(K2-K1)
If K1<K2, then lending money
Invest PV(K2-K1), get K2-K1
If K1>K2, then borrow money
Get PV(K1-K2), pay K1-K2
Butterfly Spread
An insured written straddle
Let K1<K2<K3
o Written straddle
Sell K2 call, sell K2 put
o Long strangle
Buy K1 call, buy K3 put
Profit
o Let F
o

Profit

Payoff
K2-K1

K2-K1-FV[
PT
PT
K1

K2

-FV[

Asymmetric Butterfly Spread

Collar
Used to speculate on the decrease of the price of an asset
Buy K1-strike at-the-money put
Sell K2-strike out-of-the-money call
K2>K1
K2-K1 = collar width

Profit Function

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

Profit Function

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

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

Strangle
A straddle with lower premium cost
Buy K1-strike call
Buy K2 strike put
K1<K2

Profit Function

Profit Function

Equity-linked CD (ELCD)

Can financially engineer an equivalent by

Buy zero-coupon bond at discount
Use the difference to pay for an at-the-money call option

Prepaid Forward Contracts on Stock

Let FP0,T denote the prepaid forward price for an asset bought
at time 0 and delivered at time T
If no dividends, then FP0,T = S0, otherwise arbitrage
opportunities exist
If discrete dividends, then
o
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-

Financial Engineering of Synthetics

(Forward) = (Stock) (Zero-coupon bond)
o Buy e-T shares of stock
o Borrow S0e-T to pay for stock
o Payoff = PT F0,T
(Stock) = (Forward) + (Zero-coupon bond)
o Buy forward with price F0,T = S0e(r-)T
o Lend S0e-T
o Payoff = PT
(Zero-coupon bond) = (Stock) (Forward)
o Buy e-T shares
o Short one forward contract with price F0,T
o Payoff = F0,T
o If the rate of return on the synthetic bond is i, then
S0e(i-)T = F0,T or
Implied repo rate