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Contents
Preface xi
0 An introduction to the Texas Instruments BA II Plus 1
0.1 Choosing a calculator . . . . . . . . . . . . . . . . . . . . . . . 1
0.2 Font convention . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
0.3 BA II Plus basics . . . . . . . . . . . . . . . . . . . . . . . . . . 2
0.4 Problems, Chapter 0 . . . . . . . . . . . . . . . . . . . . . . . . 7
1 The growth of money 9
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.2 What is interest ? . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.3 Accumulation and amount functions . . . . . . . . . . . . . . . 11
1.4 Simple interest / Linear accumulation functions . . . . . . . . . 15
1.5 Compound interest (The usual case!) . . . . . . . . . . . . . . . 20
1.6 Interest in advance / The effective discount rate . . . . . . . . 25
1.7 Discount functions / The time value of money . . . . . . . . . . 29
1.8 Simple discount . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
1.9 Compound discount . . . . . . . . . . . . . . . . . . . . . . . . 42
1.10 Nominal rates of interest and discount . . . . . . . . . . . . . . 47
1.11 A friendly competition (Constant force of interest) . . . . . . . .
55
1.12 Force of interest . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
1.13 Note for those who skipped Sections (1.11) and (1.12) . . . . .
60
1.14 Quoted rates for Treasury bills . . . . . . . . . . . . . . . . . . 61
1.15 Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
1.16 Choice of quotation base for interest rates . . . . . . . . . . . . 68
1.17 Problems, Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . 70
2 Equations of value and yield rates 83
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
2.2 Equations of value for investments involving a
single deposit made under compound interest . . . . . . . . . . 84
2.3 Equations of value for investments with multiple
contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
2.4 Investment return . . . . . . . . . . . . . . . . . . . . . . . . . 94
2.5 Reinvestment considerations . . . . . . . . . . . . . . . . . . . . 100
2.6 Dollar-weighted yield rates . . . . . . . . . . . . . . . . . . . . . 102
2.7 Fund performance . . . . . . . . . . . . . . . . . . . . . . . . . 108
2.8 Problems, Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . 11
3 Annuities (annuities certain) 121
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
3.2 Annuities - immediate . . . . . . . . . . . . . . . . . . . . . . . . 123
3.3 Annuities - due . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
3.4 Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
3.5 Deferred annuities and values on any date . . . . . . . . . . . . 143
3.6 Outstanding loan balances . . . . . . . . . . . . . . . . . . . . . 147
3.7 Nonlevel annuities . . . . . . . . . . . . . . . . . . . . . . . . . 153
3.8 Annuities with payments in geometric progression . . . . . . .
155
3.9 Annuities with payments in arithmetic progression . . . . . . .
158
3.10 Yield rate examples involving annuities . . . . . . . . . . . . . 164
3.11 Annuity symbols for nonintegral terms . . . . . . . . . . . . . . 170
3.12 Annuities governed by general accumulation
functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
3.13 The investment year method . . . . . . . . . . . . . . . . . . . 177
3.14 Problems, Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . 180
4 Annuities with different payment and conversion periods 195
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
4.2 Level annuities with payments less frequent than each interest
period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
4.3 Level annuities with payments more frequent than each
interest
period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
4.4 Annuities with payments less frequent than each interest
period
and payments in arithmetic progression . . . . . . . . . . . . . 207
4.5 Annuities with payments more frequent than each interest
period and payments in arithmetic progression . . . . . . . . . . . 209
4.6 Continuously paying annuities . . . . . . . . . . . . . . . . . . . 214
4.7 A yield rate example . . . . . . . . . . . . . . . . . . . . . . . . 219
4.8 Problems, Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . 221
5 Loan repayment 229
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
5.2 Amortized loans and amortization schedules . . . . . . . . . . .
229
5.3 The Sinking Fund method . . . . . . . . . . . . . . . . . . . . . 238
5.4 Amortized loans with other repayment patterns . . . . . . . . .
245
5.5 Yield rate examples and replacement of capital . . . . . . . . .
247
5.6 Problems, Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . 255
6 Bonds 265
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
6.2 Bond alphabet soup and the basic price formula . . . . . . . . .
267
6.3 The premium-discount formula . . . . . . . . . . . . . . . . . . 272
6.4 Other pricing formulas for bonds . . . . . . . . . . . . . . . . . 274
6.5 Bond amortization schedules . . . . . . . . . . . . . . . . . . . 276
6.6 Valuing a bond after its date of issue . . . . . . . . . . . . . . . 286
6.7 Selling a bond after its date of issue . . . . . . . . . . . . . . . 292
6.8 Yield rate examples . . . . . . . . . . . . . . . . . . . . . . . . 301
6.9 Callable bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
6.10 Floating-rate bonds . . . . . . . . . . . . . . . . . . . . . . . . . 310
6.11 The BA II Plus calculator Bond worksheet . . . . . . . . . . . 312
6.12 Problems, Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . 317
7 Stocks and financial markets 327
7.1 Common and preferred stock . . . . . . . . . . . . . . . . . . . 327
7.2 Brokerage accounts . . . . . . . . . . . . . . . . . . . . . . . . . 331
7.3 Going long: buying stock with borrowed money . . . . . . . . .
337
7.4 Selling short: selling borrowed stocks . . . . . . . . . . . . . . . 340
7.5 Problems, Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . 345
8 Arbitrage, term structure of interest rates, and derivatives 351
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
8.2 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
8.3 The term structure of interest rates . . . . . . . . . . . . . . . . 355
8.4 Loans with floating rate of interest . . . . . . . . . . . . . . . . 366
8.5 Interest rate swaps: the basics . . . . . . . . . . . . . . . . . . . 369
8.6 Formulas for interest rate swaps . . . . . . . . . . . . . . . . . . 381
8.7 Market value of an interest rate swap . . . . . . . . . . . . . . . 385
8.8 More swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
8.9 Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . 391
8.10 Commodity futures held until delivery . . . . . . . . . . . . . . 394
8.11 Offsetting positions and liquidity of futures contracts . . . . . .
401
8.12 Price discovery and more kinds of futures . . . . . . . . . . . . 405
8.13 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
8.14 Using replicating portfolios to price options . . . . . . . . . . . 413
8.15 Using weighted averages to price options . . . . . . . . . . . . .
426
8.16 Problems, Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . 433
9 Interest rate sensitivity 449
9.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449
9.2 Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454
9.3 Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467
9.4 Using duration to approximate price . . . . . . . . . . . . . . . 475
9.5 Using duration and convexity to approximate price . . . . . . .
480
9.6 Immunization . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
9.7 Other types of duration . . . . . . . . . . . . . . . . . . . . . . 491
9.8 Problems, Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . 495
10 Determinants of interest rates 503
10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
10.2 Supply and demand of loans . . . . . . . . . . . . . . . . . . . . 503
10.3 Default risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
10.4 Inflation risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
10.5 Banks and other financial intermediaries in the retail
sector . . 516
10.6 Savings and lending interest rates in the retail sector . . . . . .
518
10.7 Bonds issued by governments and corporations . . . . . . . . .
521
10.8 The role of central banks . . . . . . . . . . . . . . . . . . . . . 526
10.9 Problems, Chapter 10 . . . . . . . . . . . . . . . . . . . . . . . 529
APPENDICES
A Some useful formulas 533
B Answers to end of chapter problems 541
Bibliography 567
Index 569
About the Authors 580

An introduction to the Texas Instruments BA II Plus

0.1 CHOOSING A CALCULATOR
0.2 FONT CONVENTION
0.3 BA II PLUS BASICS
0.4 PROBLEMS, CHAPTER 0

0.1 CHOOSING A CALCULATOR

There are many modestly priced financial calculators
on the market today. Among these is the Texas
Instruments BA II Plus, and we have chosen to
integrate instructions regarding its effective use for
solving problems. Our choice of calculator for the
illustrations is based on the fact that the BA II Plus
calculator is very well suited for the tasks we pose, is
among the calculators allowed for the SOA/CAS
examinations including Financial Mathematics (SOA
Exam FM, CAS Exam 2), and Texas Instruments
representatives have informed us that they expect to
continue selling the BA II Plus calculator for some
time to come. You may also follow the instructions
using the BA II Plus Professional calculator that was
released in 2004. This is an enhanced version of the
BA II Plus calculator, and has the same keys.
Occasionally we will make notes specific to the BA II
Plus Professional. Although the less expensive Texas
Instruments BA-35 calculator performs well for many
of the problems addressed, there are some problems
(notably those relating to uneven cashflows) where it
is deficient. We caution you not to follow our
calculator instructions with the BA-35 calculator,
since the correct operation is not always what you
might guess. For example, the sign with which certain
payments need to be entered is not always the same
as it would be for the BA II Plus. For those readers who
choose to follow along using a calculator other than
the BA II Plus calculator, for instance one of the
Hewlett Packard financial calculators, perhaps our
instructions will still be of some service.
0.2 FONT CONVENTION Those parts of the text that
are aimed at readers using the BA II Plus calculator
will be given in sans serif (or boldface sans serif) type.
The sans serif font is illustrated in Figure (0.1.1). Focus
on the third row of buttons on the BA II Plus
Calculator. From left to right, the symbols are N , I/Y ,
PV , PMT , and FV . FIGURE (0.1.1) Readers who wish
to concentrate on the theoretical flow, and not worry
about how to perform calculations on the BA II Plus
calculator, may ignore all discussion given in the sans
serif font just displayed in Figure (0.1.1). 0.3 BA II PLUS
BASICS We will introduce you to the basic features of
the BA II Plus calculator only to the extent necessary
in order that our directions are clear. For instance, we
presume familiarity with standard arithmetic
operations of the calculator and how to change a
newly entered number on the display if you have
entered it incorrectly. It is important that we explain to
you the “calculation methods” available on the BA II
Plus and BA II Plus Professional calculators; that is,
how the calculator interprets a string of keystrokes.
The default setting for the calculation method is the
so-called chain method; arithmetic operations are
done in the order you enter them, unless parentheses
indicate instructions to the contrary. So, if you key 4 +
2 × 5 = the calculator will compute (4 + 2) × 5 = 30, and
if you press 2 × 5 yx 3 = the calculator will compute (2
× 5)3 = 1,000. If instead, you need to compute 2×53 =
250, this may be accomplished by pressing the
sequence of keys 2 × ( 5 yx 3 ) = or 5 yx 3 × 2 = . The
chain calculation method (Chn) is commonly used on
financial calculators, and our calculator instructions
assume that you have your calculator set for the chain
calculation method. Remember, the chain calculation
method is the default setting, and you must take
action if you prefer your calculator to use the algebraic
operating system (AOS) implemented by many
scientific calculators. To change the calculation
method, you press 2ND FORMAT ↑ 2ND SET 2ND
QUIT . Section 0.3 BA II Plus basics 3 If your calculator
is set for AOS, keying 4 + 2 × 5 = results in the
calculator computing 4+(2×5) = 14, while pushing the
sequence 2 × 5 yx 3 = causes the calculator to find 2 ×
53 = 250. Warning: If your calculator is set with the
algebraic operating system, adjustments to our key-
by-key instructions are needed in some cases. Even if
you are accustomed to using a scientific calculator,
we encourage you to have your calculator set for the
chain calculation method and to use parentheses to
achieve the order of operation you desire. There are
many times when you need to raise a number to a
rational power. For example, you might wish to
calculate (.96) 4 3 . This can be done efficiently by
pushing the nine-key sequence • 9 6 yx 4 yx 3 1/x = , or
by pressing the nine-key sequence • 9 6 yx ( 4 ÷ 3 ) = .
By either method, you should obtain that (.96) 4 3
≈ .947025437. The keys on the BA II Plus have their
primary function printed on the key. Most of the keys
also have a secondary function and it is printed above
the key, in pale yellow on the BA II Plus calculator and
in charcoal gray on the BA II Plus Professional
calculator. To access a given secondary function, you
first press the key 2ND and then the key whose
secondary function you desire. For example, if you
wish to reset your calculator to the factory default
settings (as is required of candidates on the SOA/CAS
exams), you will need to begin by pushing 2ND
followed by the key +/− . Even though RESET is the
second function on the key +/− , our directions to the
reader will be to push 2ND RESET ENTER 2ND QUIT .
Our intention is to provide instructions that focus on
the function we desire to access rather than the
function written directly on the key pushed. To reset
your calculator, use 2ND RESET ENTER 2ND QUIT . If
you reset the BA II Plus calculator you clear all ten
memories and all worksheet data. The default settings
include using angles measured in degrees rather than
radians as the arguments of trigonometric functions.1
More importantly, the default format setting is 2-
formatting. The BA II Plus calculator can
1Trigonometric functions and their inverses are rarely
used in this subject, but see Problems (0.3.2) and
(1.12.10). The inverse of a trigonometric function is
called by keying INV prior to pressing the key
sequence for the function; for example INV 2ND TAN
accesses tan−1. display at most ten digits (although it
stores thirteen-digit numbers), and for α in {0, 1, 2,...,
9}, we say that we have α-formatting if, while not
exceeding the ten digit limit, the calculator attempts
to display up to α digits to the right of the decimal
point. (So with 4-formatting the ten digit number
12345.54321 is displayed as 12345.5432 if it is the
result of a calculation, while the twelve-digit number
123456789.543 is displayed as 123456789.5.
Rounding is used, so with 4-formatting the ten digit
number 12345.56786 is displayed as 12345.5679 if it
is the result of a calculation, as is 12345.56785; but a
resulting 12345.5678499 will be displayed as
12345.5678.) The authors most often prefer to keep
their calculators with 9-formatting so that an answer
is displayed with maximal possible accuracy. To
obtain α-formatting, use 2ND FORMAT α ENTER 2ND
QUIT . Note that you enter α when the calculator
screen reads “DEC = ” as it awaits your numerical
input.Allowable inputs are in the interval (-.5,9.5), but
you might as well enter an integer from {0, 1, 2,..., 9} as
the calculator rounds the entered number to an
integer. One situation in which you may not want to
have 9-formatting is if you are calculating a number of
dollars to change hands, particularly if you then use
that dollar amount for further computation. To find the
correct number of cents and have it stored in the
calculator for further calculation, you may use both
the FORMAT key and the ROUND key. This technique
is demonstrated in the solution to our first (and very
elementary) example. EXAMPLE 0.3.1 Problem: Mrs.
Juanitez is a savvy shopper. At a drugstore, she finds a
binder on sale for $14.97 plus 8.25% sales tax. She
has a mail-in coupon for a $7.00 rebate on the binder,
and she charges it on her credit card that refunds 5%
of the charged amount to her. The store advertises
that the binder is “$7.97 after mail-in rebate.”
Calculate how much the binder will actually cost her
assuming that it costs 42 cents to mail in the rebate
request (postage and the cost of the envelope).
Solution The drugstore purchase generates a credit
card charge of $16.21, since 1.0825 × $14.97 =
$16.205025. As stated, Mrs. Juanitez spends $.42 to
mail her $7.00 rebate request. She receives the $7.00
rebate and Mrs. Juanitez’s credit card company gives
her a rebate of $.81 since .05 × $16.21 = $.8105.
Therefore, Mrs. Juanitez’s total cost for the binder is
$16.21+$.42−$7.00−$.81 = $8.82.
To perform this simple calculation on the BA II Plus
calculator, first format to two decimal places (if
necessary) by pressing 2ND FORMAT 2 ENTER 2ND
QUIT . Then press 1 • 0 8 2 5 × 1 4 • 9 7 = 2ND ROUND
STO 0 + • 4 2 = − 7 = − ( RCL 0 × • 0 5 ) = . Your display
should now read 8.82, so Mrs. Juanitez’s cost was
$8.82. Note that had you pressed the above sequence
of keys except that you omitted 2ND ROUND , your
answer would have been $8.81. This is because stored
information carries more decimal values than those in
the display. The use of 2-formatting and the ROUND
key was appropriate in Example (0.1.2) because all
rounding was to the nearest integral number of cents.
However, you should be careful because sometimes a
problem requires you to round up or round down. Note
0.3.2 on rounding: Usually, you wait until the end of
the problem to round. The exception is that if money
changes hand (for instance, you close a savings
account or make a mortgage payment), you must
round to an integral number of cents. Whether you
should round to the nearest penny, round up, or round
down depends on the particular situation. For
instance, if you are asked for the smallest deposit you
can make today at 3% so as to be able to withdraw
$243.25 one year from now and $K deposited today
will grow to $K(1.03), you round up $243.25 1.03 ≈
$236.1650485 to $236.17. We have used the notation
≈ to mean “approximately equal to,” and this will be
used throughout the text. On the other hand, if you are
asked how much you may withdraw in one year if you
deposit $236.17 now to your new account, you
compute $236.17(1.03) = $243.2551, and since the
balance to the nearest penny is $243.26, you may
withdraw $243.26 unless you have a particularly stingy
bank that makes you round down to $243.25. (To
determine whether the bank can round down, you
might have to read the fine print or look at applicable
state law, but we will not concern ourselves with this.)
As was the case in Example (0.1.2), our calculator
instructions will sometimes include storing a partial
result in one of the BA II Plus calculator’s ten
memories. It is a matter of taste (and habit) which
memory is selected. Therefore, although in Example
(0.1.2) we specified storage in memory 0, in our
directions specific memory numbers will not be given.
It is helpful to develop routines as to where you store
certain types of intermediate results, but it would be
presumptuous of us to impose a particular pattern. To
store a number displayed on your calculator in
memory m use STO m . To recall a number stored in
memory m use RCL m . A useful feature of the BA II
Plus calculator is that you may replace the number
stored in register m by its sum with the displayed
value by pushing STO + m . Likewise, you may replace
the entry in register m by its value minus the displayed
value by pushing STO − m , by its value multiplied by
the displayed value by pushing STO × m , and by its
value divided by the displayed value by pushing STO ÷
m . Pressing STO yx m will result in the value in
memory m being raised to the number that was just
displayed. If you wish to view the entries in all ten
memory registers, it is most efficient to open the
Memory worksheet by pressing 2ND MEM . The
calculator display will then show “M0 = ”. The number
following the equal sign gives the number stored in
memory register 0, or as many digits of it as the
formatting requires. Go ahead and push ↓ , and the
display will include “M1 = ” and the number stored in
memory register 1, again as dictated by formatting.
Repeatedly pushing ↓ allows you to cycle through the
memory registers. Should you wish to reverse the
direction of your cycling, push ↑ rather than ↓ . The
memory worksheet is one of twelve “worksheets”
included in the BA II Plus calculator. Five of these we
discuss in detail and three others receive at least
passing treatment. In general, a worksheet contains
registers for storing a set of variables, and the
worksheets each have a set of built-in formulas
relating how the entries in the worksheet’s registers
should be related (although in the case of the memory
worksheet, the set of relationships is empty). For
instance, the Interest Conversion worksheet has
variables NOM, EFF, and C/Y, and if j, i, and m are their
respective entries, the formula 1 + i = (1 + j m ) m
should hold. The TVM worksheet [discussed in Section
(3.2)] has registers that may be filled using the keys N ,
I/Y , PV , PMT , and FV highlighted in Figure (0.1.1), but
usually worksheet registers are accessed using the
2ND key. For instance, the Interest Conversion
worksheet is accessed by keying 2ND ICONV .
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