Financial Mathematics I

Math3142, MTU

by Tezamed Asfetsami

April 10, 2023

(version 1.0)
Contents

1 Basic Finance 5
1.1 Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3 Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.4 Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.5 Internal Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.6 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

2 Revisions on Probability Spaces and Random Variables 17

2.1 Sample Spaces and Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.2 Discrete Probability Spaces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.3 Conditional Probability and Independence . . . . . . . . . . . . . . . . . . . . . . 20
2.4 General Properties of Random Variables . . . . . . . . . . . . . . . . . . . . . . . 20
2.5 Discrete Random Variables and Continuous Random Variables . . . . . . . . . . . 20
2.6 Distributions of Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.7 Independent Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.8 Identically Distributed Random Variables . . . . . . . . . . . . . . . . . . . . . . 20
2.9 Sums of Independent Random Variables . . . . . . . . . . . . . . . . . . . . . . . 20

3 Options and Arbitrage 21

3.1 The Price Process of an Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.2 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3.3 Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3.4 Currency Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.5 Futures and Equality of Forward and Future Prices . . . . . . . . . . . . . . . . . 23
3.6 Call and Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.7 Properties of Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.8 Dividend-Paying Stocks and Exotic Options . . . . . . . . . . . . . . . . . . . . . 24
3.9 Portfolios and Payoff Diagrams . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

4 Discrete-Time Portfolio Processes 25

4.1 Discrete Time Stochastic Processes . . . . . . . . . . . . . . . . . . . . . . . . . . 25
4.2 Portfolio Processes and the Value Process . . . . . . . . . . . . . . . . . . . . . . 25
4.3 Self-Financing Trading Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . 25
4.4 Equivalent Characterizations of Self-Financing . . . . . . . . . . . . . . . . . . . 25
4 CONTENTS

4.5 Option Valuation by Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

5 Expectation 27
5.1 Expectation of a Discrete Random Variable . . . . . . . . . . . . . . . . . . . . . 27
5.2 Expectation of a Continuous Random Variable . . . . . . . . . . . . . . . . . . . . 27
5.3 Basic Properties of Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
5.4 Variance of a Random Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
5.5 Moment Generating Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
5.6 The Strong Law of Large Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . 27
5.7 The Central Limit Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

Further Reading 29
Chapter 1

Basic Finance

1.1 Interest
Interes is a fee paid by one party for the use of assets of another.
• In exchange for the use of a depositor’s money, banks pay a fraction of the account balance back
to the depositor this fractional payment is known as interest.
• The amount of interest is generally time dependent; the longer the outstanding balance, the more
interest is accrued.
• Annual/nominal interest rate, denoted by r , is used to calculate interest.
Notation used:
A0 : Initial deposit or Present Value (PV) or discounted value of the account
At : Future Value (FV) or comound amount or accrued amount at time t.
r : annual interest rate.
m : compounding period per annum.
i : interest rate per compounding period i := r/m.

Simple Interest
Consider an account that pays simple interest at an annual rate of r%. If A0 is the initial deposit
made at time zero, then after t years the account has values:

At = A0 (1 + tr) or FV = PV (1 + tr) (1.1)

which is the so-called simple interest formula.

NB: In simple interest, interest is paid only on the initial deposit.
Example 1.1.1: Suppose an account earns a simple interest rate of 12% annually. If the principal
amount is $800 then after two years the compound amount will be

A2 = A0 (1 + 2r) = 800(1 + 2(0.12)) = 800(1.24) = $992.00

6 CHAPTER 1. BASIC FINANCE

Discrete-Time Compound Interest

Now consider the same account that pays an annual rate of r% but with interest compounded m
times per year, for example, semi-annually m = 2, quarterly m = 4, monthly (m = 12) or daily
(m = 365). In this case the interest rate per period is i := r/m.
Definition 1.1.2 (Compound Interest). The value of the account after t years is then:
At = A0 (1 + r/m)mt or An = A0 (1 + i)n n := m × t (1.2)
which is the compound interest formula.
NB: In Compound interest, interest is paid not just on the principal A0 but on the accrued amounts
in the account.
Example 1.1.3: Suppose an account earns 12% annually compounded monthly. If the principal
amount is $800 then after two years the compound amount will be
0.12 12(2)
 
A2 = A0 (1 + r/m) m(2)
= 800 1 + = 800(1.01)24 = $1, 015.79
12

Continuous-Time Compound Interest

Now consider what happens when the number m of compounding periods per year increases without
bound. Write (1.2) as
At = A0 [(1 + 1/x)x ]rt ; where x = m/r.
As m → ∞, the term in brackets tends to e, the base of the natural logarithm. This leads to the
formula: At = A0 ert
Definition 1.1.4 (Continuously Compounded interest). The value of an account after t years under
continuously compounded interest is given by:
At = A0 ert . (1.3)
Example 1.1.5: Suppose an account earns 12% annually compounded continuously. If the principal
amount is $800 then after two years the compound amount will be
A2 = 800e12(2) = $1, 016.99

Comparison of the Methods

Comparison of the previous 3 examples.

A B C
3 Initial Deposit Year Annual Rate
4 800 2 12%
6 Interest Method computation Future Value
7 simple 800(1 + 2(0.12)) 992.00
0.12 12(2)
 
8 monthly(m = 12) 800 1 + 1,015.79
12
12(2)
9 continuous 800e 1,016.99
1.1. INTEREST 7

Exercise 1.1.1: Suppose that $1000 is deposited in an account which earns 3.5% interest annually. What is
the future value after 5.4 years if the interest method is
(a) simple
(b) compounded monthly
(c) compounded daily
(d) compounded continuously

Solution: Input/output for Future Value

A B C
3 Initial Deposit Year Annual Rate
4 100 5.4 3.5%
6 Interest Method computation Future Value
7 simple 1189.00
8 12 1207.71
9 365 1208.03
10 continuous 1208.04

Note that compounding continuously instead of daily adds only $.01 to the future value.

Effective Rate
In view of the various ways one can compute interest, it is useful to have a method to compare
investment strategies. One such device is the effective interest rate.
Effective Interest Rate re : is the simple interest rate that produces the same yield in one year as
compound interest.
Thus if interest is compounded m times a year, then the effective rate must satisfy the equation

A0 (1 + r/m)m(1) = A0 (1 + 1re ) =⇒ re = (1 + r/m)m − 1.

Similarly, if interest is compounded continuously, then

A0 er(1) = A0 (1 + 1re ) =⇒ re = er − 1.

for Compound Interest: re = (1 + r/m)m − 1.

for Continuously Compounded interest: re = er − 1

Example 1.1.6: You just inherited $10,000, which you decide to deposit in one of three banks, A,
B, or C. Bank A pays 11% compounded semiannually, Bank B pays 10.76% compounded monthly,
and Bank C pays 10.72% compounded continuously. Which bank should you choose?

Solution: We compute the effective rate re for each given interest rate.
8 CHAPTER 1. BASIC FINANCE

Bank Annual Rate Compoundng Method Effective Rate

A .1100 2 (semi-annually) re = (1 + r/m)m − 1 = (1 + 0.11 2
2 ) − 1 = 0.11302500
B .1076 12 (monthly) re = (1 + r/m)m − 1 = (1 + 0.1076 12
12 ) − 1 = 0.11306832
C .1072 continuous re = er − 1 = e0.1072 − 1 = 0.315686

Bank C has the highest effective rate and is therefore the best choice.

1.2 Inflation
Inflation is defined as an increase over time of the general level of prices of goods and services,
resulting in a decrease of purchasing power.
For a mathematical model, assume that inflation is running at an annual rate of r f . If the price of
an item now is A0 , then the price after 1 year is A1 = A0 (1 + r f ), after 2 years is A2 = A0 (1 + r f )2
and so on. In general, the price after t years is:

At = A0 (1 + r f )t .

Thus inflation is governed by a compound interest formula.

Example 1.2.1: If inflation is running at 5% per year, then prices will increase by 5% each year, so
an item costing $100 now will cost 100(1.05)2 = $110.25 in 2 years.
To see the combined effects of inflation and interest, suppose we make an investment whose
(nominal) rate of return is r, compounded yearly.
What is the actual annual rate of return ra if inflation is taken into account?
A 1 birr investment now will have future value (1 + r) in one year. In purchasing power this
is equivalent to the amount (1 + r)/(1 + r f ) now. Thus, in terms of constant purchasing units, the
investment transforms 1 birr of purchasing units into the amount (1 + r)/(1 + r f ).
Definition 1.2.2. The annual interest rate ra that produces the same return is called the inflation-
adjusted rate of return. Thus
1+r 1+r r −rf
1 + ra = ⇐⇒ ra = −1 =
1+rf 1+rf 1+rf

For small r f we have the approximation

ra ≈ r − r f

which is frequently taken as the definition of ra .

1.3. ANNUITIES 9

In view of this, if inflation is taken into account the compound interest formula 1.2 becomes:

An = A0 (1 + i − i f )n where i = r/12 and i f = r f /12.

In general suppose you are to receive a payment of Q Birr in n months. If the investment pays
interest at an annual rate of r% compounded monthly, then the present value of this payment, taking
monthly inflation into account, is

Q
A0 = .
(1 + i − i f )n

This is the same as the present value formula for an annual rate of r − r f spread over 12 months.

1.3 Annuities

An annuity is a sequence of periodic payments of a fixed amount P.

The payments may be deposits into an account such as a pension fund or a layaway plan, or
withdrawals from an account, as in a trust fund or retirement account.

Types of Annuities

Annuities typically offer payments at either the start or the end of each period.
Annuity-Immediate: An annuity in which payments are made at the end of each period.
For example, Retirement account, Mortgage payments., Salary(contract)
Annuity-Due: An annuity in which payments are made at the beginning of each period.
For example, rents

Present and Future Value of Annuity Immediate

Assume the account pays interest at an annual rate r% compounded m times per year
The Future value An is the sum of the time-n values of payments 1 to n.
10 CHAPTER 1. BASIC FINANCE

Figure 1.1: An annuity of deposits.

Since payment j accrues interest over n − j compounding periods, its time-n value is
r
P(1 + i)n− j , i :=
m
. Hence

An = P(1 + i)n−1 + P(1 + i)n−2 + · · · + P(1 + i) + P

= P 1 + (1 + i) + (1 + i)2 + · · · + (1 + i)n−1

(1 + i)n − 1
 
=P
(1 + i) − 1
(1 + i)n − 1
 
=P
i

The FV of an Annuity-Immediate of n Payments of $P at Interest Rate i just after the last

payment is made:
(1 + i)n − 1
 
r
An = P i := . (1.4)
i m
More generally, if a deposit of A0 is made at time 0, then the time-n value of the account is

(1 + i)n − 1
 
n
An = A0 (1 + i) + P . (1.5)
i
Using this equation, one may easily calculate the number n of monthly deposits required to reach a
goal of A. Indeed, setting A = An , solving for (1 + i)n , and then taking logarithms we see that the
desired value n is the quantity
ln (iA + P) − ln (iA0 + P)
(1.6)
ln (1 + i)
rounded up to the nearest integer. This is the smallest integer n for which An ≥ A.
1.3. ANNUITIES 11

We use the formula we developed earlier

An
An = A0 (1 + i)n ⇐⇒ A0 =
(1 + i)n
together with 1.4 to easily compute the Present Value of an annuity-Immediate.
n
h i
P (1+i)i −1 
1 − (1 + i)−n

A0 = =P
(1 + i)n i
The Present Value of an Annuity-Immediate of n Payments (made at the end of each period) of
$P at Interest Rate i :
1 − (1 + i)−n
A0 = P . (1.7)
i
Solving for P in (1.7) we obtain the formula
i
P = A0 . (1.8)
1 − (1 + i)−n
which may be used, for example, to calculate the mortgage payment for a mortgage of size A0 (see
below).
Example 1.3.1: Calculate the present value of an annuity-immediate of amount $100 paid annually
for 5 years at the rate of interest of 9% per annum using formula (1.7). Also calculate its future
value at the end of 5 years.
Solution: Here P = $100, i = 0.09 and n = 5.
From (1.7), the present value of the annuity is
1 − (1 + i)−n 1 − (1.09)−5
A0 = P = 100 = $388.97
i 0.9
The future value of the annuity is
(1 + i)n − 1 (1.09)5 − 1
   
An = P = 100 = $598.47.
i 0.09

Example 1.3.2: Calculate the present value of an annuity-immediate of amount $100 payable
quarterly for 10 years at the annual rate of interest of 8% convertible quarterly. Also calculate its
future value at the end of 10 years.
Solution: Note that the rate of interest per payment period (quarter) is 84 % = 2%, and there are
4 × 10 = 40 payments.
Thus, from (1.7) the present value of the annuity-immediate is
1 − (1.02)−40
A0 = 100 = $2, 735.55,
0.2
and the future value of the annuity-immediate is
(1.02)40 − 1
 
An = 100 = $6, 040.20.
0.02
12 CHAPTER 1. BASIC FINANCE

Application: Amortization
Example 1.3.3: Suppose you take out a 20-year, $200, 000 mortgage at an annual rate of 8%
compounded monthly. Determine your monthly mortgage payment P?

Solution. Your monthly mortgage payments P constitute an annuity with

A0 = $200, 000, i = .08/12 = .0067 and N = 240

Using formula (1.8), the monthly mortgage payment is

i
P = A0
1 − (1 + i)−n
.0067
= 200, 000 = $1, 677.8
1 − (1.0067)−240

Application: Retirement
Suppose you make monthly deposits of size P into a retirement account with an annual rate r,
compounded monthly. After t years you wish to make monthly withdrawals of size Q from the
account for s years, drawing down the account to zero.
This plan requires that the future value, An , of the first account (deposit) is the present (initial)
value, A0 , of the second (withdrawal).

Figure 1.2: Retirement plan

Thus, by formula (1.4) and (1.7), setting An = A0 we have

(1 + i)12t − 1 1 − (1 + i)−12s r
P =Q , i :=
i i 12

Solving for P we obtain the formula

1 − (1 + i)−12s
P= Q
(1 + i)12t − 1
1.4. BONDS 13

For a numerical example, suppose that t = 40, s = 30, and r = 0.06. Then

P 1 − (1.005)−360
= ≈ 0.084,
Q (1.005)480 − 1

so that the withdrawal of, say, Q = $5000 during retirement would require monthly deposit of

P = (0.84)5000 ≈ $419.

Table 1.1: Input/Output for RetirementPlan

A B C D
4 Deposit years 40 Withdrawl years 30
5 Deposit annual rate 6% Withdrawl interest rate 6%
6 Number of deposits 480 Number of withdrawals 360
7 Desired withdrawal Q 5000 Required deposit P 419

This seems like a small amount to invest, but such is the power of compound interest and starting
a savings plan for retirement early.

1.4 Bonds
A bond is a financial contract issued by governments, corporations, or other institutions.
Common Types of Bonds:
1. Zero-Coupon bond, are the simplest type of bond. Bond for Abay Dam, U.S.Treasury bills and
U.S. savings bonds are common examples.
2. Coupon Bonds. Lottery, PLC company shares(AXIONS) are examples of coupon bond.
The purchaser of a bond pays an amount B0 (present value) and receives a prescribed amount F,
the face value/future value of the bond, at a prescribed time T , the maturity date.
The purchase amount(present value) of a bond may be expressed in terms of a continuously
compounded interest rate r:
B0 = F e−rT
where, F := Face value(FV) of the bond and T := Maturity date(payment day).
The value Bt of the bond at any time t is then the face value of the bond discounted to time t:

Bt = Fe−r(T −t) = Fe−rT × Fert = B0 ert , 0 ≤ t ≤ T.

Thus, during the time interval [0, T ], the bond acts like a saving account with continuously com-
pounded interest.
With a coupon bond, one receives not only the amount F at time T but also a sequence of
payments during the life of the bond. Thus, at prescribed times t1 ,t2 , · · · ,tN , the bond pays an
14 CHAPTER 1. BASIC FINANCE

amount Cn , called a coupon, and at maturity T one receives the face value F. The price of the bond
is the total present value
N
B0 = ∑ e−rtnCn + Fe−rT . (1.9)
n=1
Note that this is the initial value of a portfolio consisting of N + 1 zero-coupon bonds maturing at
times t1 ,t2 , · · · ,tN , and T .

1.5 Internal Rate of Return

Internal rate of return is a measure used to evaluate a sequence of financial events. It is typically
used to rank projects that involve future cash flows: the higher the rate of return the more desirable
the project.
Consider an investment that returns, for an initial payment of P > 0, an amount An > 0 at the
end of periods n = 1, 2, · · · , N.

Internal Rate of Return (IRR) of the investment P is defined to be that periodic interest rate i for
which the present value of the sequence of returns (under that rate) equals the initial payment P.
Thus i satisfies the equation
N
An
P= ∑ (1 + i)n (1.10)
n=1
Examples of such investments are annuities and coupon bonds.
NB: A rate of return i may be positive, zero, or negative.
N An
To see Equation (1.10) has a unique solution i > −1, let f (i) = ∑ n
and note that f is
n=1 (1 + i)
continuous on the interval (−1, ∞) and satisfies

lim f (i) = 0 and lim f (i) = ∞.

i→∞ i→−1+

Since P > 0, the Intermediate Value Theorem implies that the equation f (i) = P has a solution
i > −1. Because f is strictly decreasing, the solution is unique.
If i > 0 : The sum of the payoffs is greater than the initial investment. In this case the investment
is considered profitable.
 1.6. EXERCISES 15

If i < 0 : The sum of the payoffs is less than the initial investment. In this case the investment is
not profitable should be terminated.

Example 1.5.1: Suppose you loan a friend $100 with the agreement that they will pay you at the
end of the next five years amounts {21, 22, 23, 24, 25}. The sum of the payoffs is greater than 100,
so the equation
21 22 23 24 25
+ 2
+ 3
+ 4
+ = 100
1 + i (1 + i) (1 + i) (1 + i) (1 + i)5
has a unique positive solution i. One can use Newton’s method to determine i, or one can simply
solve the equation by trial and error using a spreadsheet. The latter approach gives i ≈ 0.047, that
is, an annual rate of about 4.7%.

1.6 Exercises
1. Suppose that $3659 is deposited in a savings account which earns 6.5% simple interest. What is
the compound amount after five years?
2. Suppose that $3993 is deposited in an account which earns 4.3% interest. What is the compound
amount after two years if the interest is compounded:
(a.) monthly?
(b.) weekly?
(c.) daily?
(d.) continuously?
3. Find the effective annual simple interest rate which is equivalent to 8% interest compounded
quarterly.
4. Suppose for an investment of $10, 000 you will receive payments at the end of each of the next
four years in the amounts {2000, 3000, 4000, 3000}. What is the rate of return per year?
5. What annual interest rate r would allow you to double your initial deposit in 6 years if interest is
compounded quarterly? Continuously?
6. If you receive 6% interest compounded monthly, about how many years will it take for a deposit
at time-0 to triple?
7. If you deposit $400 at the end of each month into an account earning 8% interest compounded
monthly, what is the value of the account at the end of 5 years? 10 years?
8. You deposit $700 at the end of each month into an account earning interest at an annual rate of r
compounded monthly. Find the value of r that produces an account value of $50, 000 in 5 years.
9. An account pays an annual rate of 8% percent compounded monthly. What lump sum must you
deposit into the account now so that in 10 years you can begin to withdraw $4000 each month
for the next 20 years, drawing down the account to zero?
10. How large a loan can you take out at an annual rate of 15% if you can afford to pay back $1000
at the end of each month and you want to retire the loan in 5 years?