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Sussex Mathematics Lecture Notes

Year 2009

Monetary Theory Analysis (G5078–MTA)

taught by Omar Lakkis

Contents

 What’s this? 5 Disclaimer 5 Course synopsis 5 Chapter 1. Theory of interest rate 1 1.1. Discrete interest rate 1 1.2. From discrete time to continuous time 2 1.3. Present value 6 1.4. Valuing cash ﬂows, equation of value and yield 8 1.5. Interest income 10 1.6. Compound Interest Functions 11 1.7. Annuities-certain: present values and accumulation 12 1.8. The general loan or mortgage schedule 14 1.9. Cash ﬂow 15 Exercises and problems on Theory of Interest Rate 16 Chapter 2. Nominal rate of interest and fractionally convertible annuities 19 2.1. Interest payable fractionally 19 2.2. Annuity payable fractionally 22 2.3. Annuities payable at time r > 1 25 2.4. The loan schedule for a fractional annuity 26 Exercises and problems on Rates convertible p-thly 26 Chapter 3. Applications of Interest Rate Theory 29 3.1. The valuation of some securities 29 3.2. Price and yield relation 31 3.3. Perpetuity 34 3.4. Makeham’s formula 35 3.5. The eﬀect of the term to redemption on the yield 38 3.6. Real returns, inﬂation and index-linked stocks 40 Exercises and problems on Application of interest rate 42 Chapter 4. Simple market model 45 4.1. Building a simple market model 45 4.2. Basic assumptions 47 4.3. No-Arbitrage Principle (NAP) 48 4.4. One-step binomial model 49 Exercises and problems on Simple market model 51 Chapter 5. Arbitrage and pricing 53 5.1. Terminology and notation 53 5.2. Redundant Assets 55 5.3. Contingent Claims and Derivative Assets 56 5.4. Insurable portfolios and states 56

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MTA (G5078) Autumn 2009 Complete course

 5.6. Pricing under NAP 60 5.7. Riskless Issues 62 5.8. Applications 64 Exercises and problems on Arbitrage and portfolios 67 Appendix A. A review of optimisation 69 1.1. Homotheticity and homogeneity 69 1.2. General optimisation (also known as nonlinear programming) 69 1.3. Linear programming (LP) and duality 72 Appendix B. Brush-up of Probability Theory 77 2.1. Probability space and measure 77 2.2. Random variables 78 2.3. Distribution and density 80 2.4. Moments and characteristic functions 86 2.5. Normal distribution 89 2.6. Limit Theorems 89 2.7. Central limit-theorem 90 2.8. Examples of random variables 90 2.9. Stochastic Processes 92 2.10. Regression and analysis of variance 93 Appendix C. Common indices in Economics and the Housing Market 95 3.1. FTSE 100 Index (also known as Footsie) 95 3.2. Halifax House Price Index 95 3.3. Nationwide House price Index 97 3.4. Calculating the price of a typical house 99 3.5. Pooled Property Fund Indices 100 Appendix. Bibliography 101 Appendix. Index 103

MTA (G5078) Autumn 2009 0. Contents

5

What’s this?

This booklet bears the essential contents of the course Monetary Theory Analysis (MTA), code G5078, as taught at the University of Sussex by Omar Lakkis in 2009.

It contains the (most of) the material covered in class as well as the exercises and

their solutions. If you are a University of Sussex maths student, or prospective stu- dent, you are allowed to use this document only after you have taken the Monetary Theory Analysis course with me. Otherwise you must have explicit permission from the tutor o.lakkis@sussex.ac.uk to use it.

Disclaimer

A part from a couple of places, these notes are largely the result of summarising

the reading from published sources [CZ03, MCS86, mainly]. I therefore have no pretense at originality, except for the errors that you may ﬁnd in the manuscript. If you do ﬁnd what you think is an error/typo/mistake, I will be grateful if you sent me an email about it (subject: “MTA G5078 notes typo”) so that things can be ﬁxed for future releases of these notes. Much of the material in the notes is copyrighted by the authors of the aforementioned sources. If you publish or broadcast this material, or otherwise use it for purposes not directly related to this particular course you may be acting illegaly at your own risk.

Course synopsis

This course focuses on the basic mathematical aspects of money dynamics.

Interest rate theory and manipulations are at the base of the course, there we learn about mathematical (and where necessary computational) methods in ﬁnance such

as cash ﬂows, the equation of value and the methods for calculating mortgages.

We then introduce various applications of interest theory by looking at examples

where “surrounding” interest rates and inﬂation may inﬂuence investments. We

learn how to calculate return and introduce the concept of yield, for ﬁxed and variable income securities.

A learning outcome of the course is “to know how to evaluate, analyse and dissem-

inate a real world investment project by writing an easy to understand ﬁnancial report”, which implies that the assessment comes in the form of an Essay covering a particular aspect of the course. For the Essay, you will need to be:

comfortable mathematics methods to solve ﬁnancial problems; preparted to do autonomous reading in the ﬁeld; able to communicate mathematical ideas to an audience.

CHAPTER 1

Theory of interest rate

1.1. Discrete interest rate

1.1.1. Simple interest. If an amount C is deposited in an account which pays

simple interest at the rate of i × 100% per annum and the account is closed after

n years - there being no intervening payments to or from the account - then the

amount paid to the investor when the account is closed will be C(1 + ni) This payment consists of a return of the initial deposit C, together with interest of amount niC.

1.1.2. Exercise. An investor puts £1, 000 in a savings account that pays 10%

simple interest at the end of each year. Compare how much the investor would have after 2 years if the money was:

 (i) invested continuously for 2 years (ii) invested for 1 year, then immediately reinvested for a further year.

1.1.3. Compound interest. The essential feature of compound interest is that

interest itself earns interest. Assuming that the annual interest is i × 100% per annum and the account is closed after n years, then the amount paid to the investor when the account is closed will be C(1 + i) n . This payment consists of a return of the initial deposit, C, together with accumulated interest (i.e., interest which, if n > 1, has itself earned further interest) of amount:

C((1 + i) n 1) .

The compound interest rate in this case is i.

This can be extended to variable interest rate case: let the interest rate for year k

to be i(k), k = 0, 1, 2,

accumulation of investment C from year 0 to year n is

n 1. If an investment has been held for n years, then the

C(1 + i(0))(1 + i(1))

(1 + i(n 1)).

In general, let an investment of 1 for a time period of 1 time unit commencing at time t is returned 1 + i(t) at time t + 1, we call i(t) the rate of interest for the period t to t + 1. i(t) is also referred to as the eﬀective rate of interest for the period.

1.1.4. Deﬁnition (nominal and eﬀective rates of interest). Consider transactions

for a term of length h times units where h > 0 is a real number. Although not necessary, it is useful to think h < 1. Deﬁne i h (t) as the nominal rate of interest per unit time on transaction of term h

beginning at time t. The eﬀective rate of interest over this period is thus deﬁned as

hi h (t). Thus if the amount C is invested at time t for a term of length h, the sum

to be received at time t + h is

C(1 + hi h (t)). If h = 1, then i 1 (t) = i(t). When i h (t) does not depend on t we write it simply as i h and we speak of a constant interest rate. The typical choice for h is 1/p with p a positive integer (e.g., 12 for the number of months in a year, or 4 for the number of quarters/trimesters in a year). If h = 1/p

2

MTA (G5078) Autumn 2009 Lecture Notes

and p integer, we write i h = i (p) , which also means i 1/p = i (p) . According to this deﬁnition, an investment of 1 for a period of length 1/p produces a return of 1+i (p) /p.

1.1.5. Example (nominal rates).

Problem. Working in time units of years, we will let the nominal rate of interest per year on monthly transactions over the next year be 12. If £100 is invested at time 0, how much is it worth at the end of the ﬁrst month and at the end of the third month? Solution. We have deﬁned: i 1/12 = 12% and so the eﬀective monthly interest rate

is i 1/12 /12 = 1%.

At the end of the ﬁrst month we have 100(1 + 0.01) = £101. At the end of the third month we have 100 × 1.01 3 = £103.03

1.1.6. Example.

Problem. The nominal interest rate of interest per annum quoted in the ﬁnancial press for local authority deposits on a particular day are as follows:

 Term Nominal rate of interest (%) 1 day 11.75 1 week 11.5 1 month 11.375 1 quarter 11.25

Find the accumulation of an investment at this time of £100 for

 (a) for 2 days, (b) for 3 weeks, (c) for 1 month,
 (d) for 7 days, and compare with 1 week, (e) for 90 days, and compare with 1 quarter.

Draw conclusions.

Solution. To express the above information in terms of our notation, we draw up the following table, our time unit is one year and the particular time is t 0 :

 Term h 1/365 1/52 1/12 1/4 i h (t 0 ) The accumulations are: 0.117 5 0.115 0.113 75 0.112 5
 (a) for 2 days, 100(1 + 0.117 5/365) 2 = 100.064 394, (b) for 3 weeks, 100(1 + 0.115/52) 3 = 100.663 104, (c) for 1 month, 100(1 + 0.113 75/12) = 100.947 917 (d) for seven days, 100(1 + 0.117 5/365) 7 = 100.225 560, and for a week, 100(1 + 0.115/52) = 100.221 154. (e) for 90 days, 102.939 159 and, for a quarter, 102.812 500.

It is apparent that the rates have been rounded up a bit too much. An enterprising

bank clerk could take advantage of this situation to perform some salami slicing:

she invests the money for 90 days for the customer wanting it for a quarter. She then shaves oﬀ the a “salami slice” of 102.939 159 102.812 500 = 0.13£, on each such customer.

1.2. From discrete time to continuous time

A continuous time model is useful as it allows us to use the many rules of calculus

that are available. In this section we relate our discrete-time vision, described above, to one where time is continuous. In mathematical words, we want to see how to express interest phenomena when h 0.

MTA (G5078) Autumn 2009 1.2. From discrete time to continuous time3

1.2.1. Accumulation factors. Let time be measured in suitable units (e.g. years).

For t 1 t 2 we deﬁne A(t 1 , t 2 ) to be the accumulation at time t 2 of an investment of 1 at time t 1 for a term of t 2 t 1. Thus A(t 1 , t 2 ) is the amount which will be repaid at time t 2 in return for an investment of 1 at time t 1 . Expressing this in terms of capital, suppose our capital at time t 1 was C(t 1 ) and at time t 2 , C(t 2 ), then the accumulation factor is given by

A(t 1 , t 2 ) = C(t C(t 2 1 ) ) .

(1.2.1)

Since hi h (t) is the eﬀective rate for the period of length h beginning at time t and so, by the deﬁnition of i h (t), for all t and for all h > 0,

A(t, t + h) = 1 + hi h (t)

and hence that

(1.2.2)

i h (t) = (A(t, t + h) 1)/h for

h > 0

(1.2.3)

We also deﬁne A(t, t) = 1 for all t. The number A(t 1 , t 2 ) is often called the accumu- lation factor, since the accumulation at time t 2 of an investment of C at time t 1 is, by proportion,

CA(t 1 , t 2 ).

1.2.2. Theorem (Principle of Consistency). If t 1 t 2

(1.2.4)

t n, then

A(t 1 , t n ) = A(t 1 , t 2 )A(t 2 , t 3 ) .

A(t n1 , t n ).

Proof The proof is easily achieved by induction on n and observing that

C(t n ) = C(t n1 )A(t n1 , t n ).

The details are left to the student as an exercise.

1.2.3. Example. For integer times, £50 are invested at time 2 and the accumulated

amount at time 7 is £100. Find i 5 (2) and i(2).

Solution.

have i 5 (2) = (2 1)/5 = 0.2 = 20%.

1.2.4. Exercise. Calculate the equivalent eﬀective annual rate of interest (assumed

to be a constant over the period) for the investment in the above example, assuming that time is in years.

1.2.5. Exercise. £5000 is invested at time 0 and the proceeds at time 10 are £9000.

Calculate A(6, 10) if A(0, 9) = 1.8, A(2, 4) = 1.1, A(2, 6) = 1.32, A(4, 9) = 1.45.

1.2.6. Force of interests. We consider the case where the interest is paid continu-

ously throughout the time period: a nominal interest rate convertible very frequently (e.g., every second), then this fund steadily accumulates over the period as interest is earned and added. In the limiting case, i.e., as h 0, the amount of the fund can be considered to be subject to a constant “force” causing it to grow. This leads us to the concept of a force of interest per unit time at time t: δ(t). It is mathematically deﬁned as

The accumulation factor is A(2, 7) = 100/50 = 2 and, using (1.2.3), we

(1.2.5)

lim + i h (t) = lim h 0 + (A(t, t + h) 1)/h = δ(t).

h0

δ(t) is also know as the nominal rate of interest per unit time at time t convertible momently.

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MTA (G5078) Autumn 2009 Lecture Notes

1.2.7. Continuous accumulation. The relationship of the force of interest to accumulation is intimately related to the properties of the exponential.

Consider the situation where money accumulates at the force of interest δ on an interval [t, s]. Subdivide this interval into n equal-length intervals [t k1 , t k ], for

k = 1,

, n, where

 t k = t + kh, for k = 0, , n. (1.2.6) By the Principle of Consistency (1.2.4), we have A(t, s) = A(t 0 , t 1 )A(t 1 , t 2 ) ··· A(t n−1 , t n ). (1.2.7) Recalling the deﬁnition of i h this implies A(t, s) = (1 + hi h (t 0 ))(1 + hi h (t 1 )) · · ·(1 + hi h (t n−1 )) , (1.2.8)

which is a long product. A very useful property of exp (and of its inverse log) is that it transforms sums into products (and viceversa). Using these properties we may write the above as

A(t, s) = exp(log(1 + hi h (t 0 )) + log(1 + hi h (t 1 )) + · · · + log(1 + hi h (t n1 ))) .

 (1.2.9) Now, recalling Taylor’s formula of order 2 we know that log(1 + ξ) = ξ + θ(ξ), for − 1/2 < ξ < 1/2, (1.2.10) where the remainder function θ satisﬁes |θ(ξ)| ≤ c 0 ξ 2 ∀ ξ ∈ (−1/2, 1/2) . (1.2.11) Supposing then that there is a uniform bound on i h , i.e., i h (τ) ≤ i ∗ ∀ τ, h > 0, (1.2.12)

it follows that, for h < 1/2i , we can apply the Taylor formula and regroup terms to get

A(t, s) =

exp hi h (t 0 ) + · · · + hi h (t n1 ) + θ(hi h (t 0 )) + · · · + θ(hi h (t n1 ))

where

= exp

n1

k=0

 hi h (t k ) + Θ(h), (1.2.13) Θ(h) := θ(hi h (t 0 )) + · · · + θ(hi h (t n−1 )). (1.2.14)

Note that identity (1.2.13) is true for all h > 0 and h < 1/2i . Taking h 0 (and using uniform convergence of step functions) we have

h0

lim

n1

k=0

hi h (t k ) = s δ(τ ) dτ.

t

(1.2.15)

To see what happens to the second term on the right-hand side of (1.2.13), we use the properties of the remainders in Taylor’s formula (1.2.11) and the uniform bound (1.2.12), we get

0 ≤ |Θ(h)| ≤

n1

k=0

|θ(hi h (t k ))| ≤ c 0 hi 2

n1

k=0

h = c 0 i 2 (s t)h 0, as h 0.

(1.2.16)

Thus Θ(h) 0 and, modulo minor technical points, we have shown that

A(t, s) = exp s δ(τ ) dτ.

t

(1.2.17)

MTA (G5078) Autumn 2009 1.2. From discrete time to continuous time5

1.2.8. Theorem (accumulation factor and force of interest relation). Given an accumulation factor (t, s) A(t, s), then

A(t, s) = exp s δ(τ) dτ ,

t

for all t s.

Proof 1 Fix t and let s be variable. Deﬁne

R(s) := log(A(t, s)) and

L(s) := s δ(τ ) dτ.

t

(1.2.18)

(1.2.19)

We want to show that R(s) = L(s) for all s t. For starters we have

R(t) = 0 = L(t)

(t is frozen) .

(1.2.20)

Then for s t, we have (by the Chain Rule and the deﬁnition of A and δ) that

R (s) =

=

=

d

ds R(s) =

1

A(t, s)

1

A(t, s)

lim

h0

lim

h0

1

A(t, s)

d

ds A(t, s)

A(t, s + h) A(t, s)

h

A(t, s)(A(s, s + h) 1)

h

A(s, s + h) 1

h

= lim

h0

= δ(s).

(1.2.21)

On the other hand, by the Fundamental Theorem of Calculus, we have that

(1.2.22)

Thus R (s) = L (s), for all s t and L(t) = R(t), so by the integrating both sides over [t, s] we obtain

L (s) = δ(s).

L(s) = L(t) + s L = R(t) + s R = R(s), s t.

t

t

(1.2.23)

1.2.9. Example. Assume (a) δ(t) = δ, or (b) δ(t) = a + bt. Find the formulas for the accumulation of 1 unit from t 1 to t 2 in each case.

1.2.10. Solution. Using (1.2.18) we have

(a)

A(t 1 , t 2 ) = exp(δ(t 2 t 1 )), and

(b)

1.2.11. Exercise. A bank credits interest on deposit using accumulation factors

based on a variable force of interest. On 1 July 1999, a customer deposited £100, 000 pounds with the bank. On 1 July 2001, his deposit has grown to £120, 000. As- suming that the force of interest per annum was bt (1 July 1999 = 0, unit = year) during the period, ﬁnd the force of interest per annum on 1 July 2000.

1

A(t 1 , t 2 ) = exp(a(t 2 t 1 ) + 2 b(t 2 2 t 2 )).

1

This proof, as presented, is a more rigorous, but perhaps less insightful,

alternative to the one in §1.2.7. Also this proof will work only for diﬀerentiable accumulation functions A. The argument in §1.2.7 can be made perfectly rigorous for δ that is Lebesgue- integrable, so it may even have jumps. See [MCS86, Appendix 1] for another proof.

1 Technical note.

6

MTA (G5078) Autumn 2009 Lecture Notes

1.2.12. Solution. Using Theorem 1.2.8 we have

A(t 1 , t 2 ) = exp 1 2 b(t 2

2 t 2 ) = 120 000/100 000 = 1.2

1

(1.2.24)

Since we have t 1 = 0 for year 1999, and thus t 2 = 2 for year 2001, we get

1

exp(2b) = 1.2, hence b = 2 ln(1.2).

(1.2.25)

The force of interest per annum at t = 1 (year 2000) is ln(1.2)/2.

1.2.13. Exercise. If a large pension fund with a value of £2000m is assumed to

grow steadily subject to a constant force of interest of 10% per annum, how much interest is earned every second? (Assume that there are 365 days in a year.)

1.2.14. Exercise. A bank credits interest on deposit using accumulation factors

based on a variable force of interest. On 1 July 1999, a customer deposited £100, 000 pounds with the bank. On 1 July 2001, his deposit has grown to £120, 000. Assum- ing that the force of interest per annum was a + bt (1 July 1999 = 0, unit = year) during the period, ﬁnd the force of interest per annum on 1 July 2000 and the force of interest per annum on 1 Jan 2001.

1.3. Present value

1.3.1. Example (discounted present value). Due to interest rate eﬀect cash ﬂows

have diﬀerent real meanings at diﬀerent times. A payment of 100 pounds to us now means 100 pounds now. Does it have the same value if the 100 pounds is promised to us but in fact paid one year later? Let us assume that an interest rate of 7% per annum is available to us. If someone promises to pay us 100£ in a year that includes 7% of some initial quantity X, which they can invest, at the beginning of the year.

X(1.07) = 100 and thus X = 100/1.07 = 93.46£.

That is, that 100£ to be paid in a year means only about 93.50£ now. We say that 93.50£ is the discounted present value of 100£ in a year, at a 7% interest rate.

1.3.2. Deﬁnition (discounted present value and past accumulation). Let t 1 < t 2 ,

it follows that an investment of C/A(t 1 , t 2 ) = C exp

δ(t) dt at time t 1 will

produce a return of C at time t 2 . We say that the discounted value at time t 1 of value C due at time t 2 is

t 2

t

1

t 2

C/A(t 1 , t 2 ) = C exp

t

1

δ(t) dt

When t 1 = 0 (the present time) and t 2 = t 0, the discounted value of C due at t, is called its discounted present value (or more brieﬂy, its present value). The present value of C is thus equal to

t

C exp

t

1

2

δ(t)dt

(1.3.1)

Normalize (by getting rid of C) and deﬁne the function of time

v(t) := exp t δ(t)dt .

0

(1.3.2)

When t 0, v(t) is the discounted present value of 1 due at time t.

MTA (G5078) Autumn 2009 1.3. Present value

7

When t < 0, v(t) is the accumulation of 1 from (negative) time t to time 0. Hence the discounted present value of C due at a (non-negative) time t 0 is Cv(t). Under a constant force of interest assumption, i.e.,

 δ(t) = δ, ∀ t ∈ , (1.3.3) for some ﬁxed value δ ∈ , we have v(t) = v t , ∀t ∈ (1.3.4) where v = v(1) = exp(−δ). (1.3.5) 1.3.3. Example.

Problem. Measuring time in years from present, suppose that δ(t) = 0.06(0.9) t for all t 0. Find a simple expression for v(t) and ﬁnd the discounted present value of £100 due in 3.5 year’s time.

Solution.

v(t) = exp t 0.06(0.9) s ds = exp 0.06(0.9 ln(0.9) t 1)

0

.

Hence the present value of £100 due in 3.5 years is

100 exp[0.06(0.9 3.5 1)/ ln(0.9)] = 83.89£.

1.3.4. Exercise. Calculate the present value on 1 September 2002 of payments of

£280 due on 1 September 2004 and £360 due on 1 March 2005. Interest is 10% per annum eﬀective.

1.3.5. Exercise. Write a 1000-2000 words essay on the activity of house purchasing

with a mortgage and explain the value of a house.

1.3.6. Present Values of Discrete Cash Flows. The present values of the

amounts c 1 ,

sum of each single present value, relative to its time and amount,

c 1 v(t 1 ) + ··· + c n v(t n ).

This is called the summation principle.

1.3.7. Present Values of Continuously Payable Cash Flows. Let M (t) de- note the total payment made between time 0 and time t, then the rate of payment at time t is,

< t n , respectively, is given by the

(1.3.6)

, c n , due at times 0 < t 1 <

 ρ(t) = M (t), (1.3.7) i.e., the derivative of M at time t. During the inﬁnitesimal time period (t, t + dt), the amount of repayment is ρ(t)dt. (1.3.8) Its inﬁnitesimal discounted value at time t is then v(t)ρ(t) dt. (1.3.9)

Following the summation principle (and taking the limit, were we to make a fully rigorous argument) we obtain the following expression for the discounted value be- tween 0 and t given by

(1.3.10)

t

0

v(τ )ρ(τ ) dτ.

8

MTA (G5078) Autumn 2009 Lecture Notes

1.3.8. Present Values of Discrete and Continuously Payable Cash Flows.

When we have both types of payments: discrete ones coming at “bursts” in time and continuous one, which ﬂow with a certain rate ρ then we use the following continuous-discrete description of present value:

c 1 v(t 1 ) + ··· + c n v(t n ) + ··· + t v(τ) ρ(τ) dτ.

0

1.4. Valuing cash ﬂows, equation of value and yield

1.4.1. Discrete time description. Consider the following transaction, in return

, a n at times t 1 < t 2 < ··· < t n , an investor will , b n at these times respectively. (In most situations

only one of a j and b j will be non-zero for each j = 1,

, n.) At what force or rate

for outlays of amount a 1 , a 2 , receive payments of b 1 , b 2 ,

of interest does the series of outlays have the same value as the series of receipts? At force of interest δ the two series are of equal value if and only if:

n

r=1

a r exp t r δ(τ) dτ =

0

n

r=1

b r exp t r δ(τ) dτ .

0

(1.4.1)

Note that in spite of using a discrete description for the process we are using a continuous time description for the interest rate, i.e., in terms of the force of interest function δ. This equation may be written as:

n

r=1

c r exp t r δ = 0

0

(1.4.2)

where c r = b r a r is the amount of the net cash ﬂow at time t r . (We adopt the convention that a negative cash ﬂow corresponds to a payment by the investor and a positive cash ﬂow represents a payment to the investor.) Recalling that

v(t) = exp

t δ we may rewrite (1.4.2) as

0

n

r=1

c r v(t r ) = 0.

(1.4.3)

Equation (1.4.2), which expresses algebraically the condition that, at force of interest δ, the total value of the net cash ﬂows is 0, is called the equation of value for the force of interest implied by the transaction. Under the constant force of interest assumption we have

e δ = 1 + i =

1

v

and v(t) = v t ,

(1.4.4)

and the equation of value (1.4.3) may be then written as

n

r=1

c r (1 + i) t r or

n

r=1

c r v t r = 0.

(1.4.5)

1.4.2. Continuous time description. In relation to continuous payment streams,

if we let ρ 1 (t) and ρ 2 (t) be the rates of paying and receiving money at time t respec- tively, we call ρ(t) = ρ 2 (t) ρ 1 (t) the net rate of cash ﬂow at time t. The equation of value for the force of interest is:

0

ρ(t) exp(δt) dt = 0.

MTA (G5078) Autumn 2009 1.5. Valuing cash ﬂows, equation of value and yield

9

1.4.3. Hybrid description. If the cash ﬂows involve both discrete and continuous

transactions, we simply add the two contibutions.

1.4.4. Example.

Problem. A businessman is owed the following amounts: £1000 on 1 January 1986, £2500 on 1 January 1987 and £3000 on 1 July 1987. Assume a constant force of interest of 0.06 per annum, ﬁnd the value of these payments:

 (a) on 1 January 1984, (b) on 1 March 1985.

Solution.

debts at that date is

Let time be measured in years from 1 January 1984. The value of the

1000v(2) + 2500v(3) + 3000v(3.5)

= 1000 exp(0.12) + 2500 exp(0.18) + 3000 exp(0.21) = £5406.85.

(1.4.6)

The value at 1 March 1985 of the same debts is

5406.85 exp(0.06(14/12)) = £5798.89.

1.4.5. Example.

(1.4.7)

Problem. Suppose that time is measured in years and that δ, the force of interest per unit time, is given by:

δ(t) = 0.076 961 +

0.121 890

1 + 0.5 exp(0.121 890 t)

(1.4.8)

(a) Find the single payment which, if invested at time 10, will accumulate to

£30 000 at time 20.

(b) Find the accumulated amount after ten years of ten annual payments each of

£1 000, the ﬁrst payment being made at time 0.

 Solution. (a) Hence Now

This is simply

30, 000 v(20) = xv(10)

x = 30, 000 v(20)

v(10)

.

v(20) = exp 20 δ(t) dt =

0

2

3 (1.22) 20 + 3 (0.08) 20 ,

1

v(10) =

2

3 (1.22) 10 + 3 (0.08) 10

1

and thus x = £10, 259.

(b) We have

1000(v(0) + v(1) +

+ v(9)) = xv(10)

Hence x = £22, 822.

1.4.6. Exercise. An investor owns a block of shares which are expected to pay a

dividend of amount D in one year’s time and dividends in each future year that are 100j % higher than in the previous year. Suppose that the bank deposit interest rate is i, Show that the present value of the proceeds from this investment is D/(i j) assuming the shares will be held indeﬁnitely. (Hint: bank interest rate will reduce the money value.)

10

MTA (G5078) Autumn 2009 Lecture Notes

1.5. Interest income

1.5.1. A lazy son of a rich. Keep capital at C and receive interest as income.

This is achieved by withdrawing continuously money from the account as to keep

it at C. Note that there is no inﬂation involved in this model, and money does not

lose value in time. Fix a time t > t 0 . The interest received at times

(1.5.1)

where h = (tt 0 )/n and n is a positive integer, can be calculated as follows. Interest payable at time t 0 + (j + 1)h for the period (t 0 + jh, t 0 + (j + 1)h) is

Chi h (t 0 + jh),

and the total of all payments is

t 0 + h, t 0 + 2h,

, t 0 + nh = t,

n1

C

j=1

hi h (t 0 + jh).

As n → ∞, we know that i h (t) δ(t), and we obtain the continuous version

n1

C

j=1

hi h (t 0 + jh) C

t

t 0

δ(s)ds =: I(t).

(Here I and δ play the role of M and ρ, respectively, in §1.4.2.)

If we invest at t 0 = 0, and ﬁx T as a ﬁnal time to base our calculation on, the present

δ(t)v(t)dt

and the ﬁnal capital’s present value is Cv(T ). On the other hand the present value

is C , therefore we obtain the relation

value of our income that we will receive from time 0 up to time T is C

T

0

C T δ(t)v(t) dt +

0

pr.val. of income

Cv(T)

pr.val. of capital

= C.

(1.5.2)

A mathematical description of this fact can be retrieved by integrating

T

0

δ(t)v(t) dt = T δ(t) exp t δ(s) ds dt

0

0

= T dt exp t δ dt

0

d

0

= exp t

0 δ t=T

t=0

= exp T δ 1

0

= 1 v(T).

Multiplying by C we recover

C = C T δ(t)v(t) dt + Cv(T)

0

as we expected from our earlier reasoning.

1.5.2. Exercise. What happens in (1.5.1) when T → ∞?

MTA (G5078) Autumn 2009 1.6. Interest income

11

1.5.3. Remark (Capital gains and losses). So far, we have described the diﬀerence

between money returned at the end of the term and the cash originally invested as “interest”. In practice, this quantity may be divided into interest income and capital gains. A capital loss is used for negative capital gain.

1.5.4. Exercise. Use “buy-to-let” concept to explain the concept of interest income

and capital gain.

1.6. Compound Interest Functions

In the following, we will work under the constant force of interest assumption. We

We review in

this short section the main properties of compound interest with constant force of interest.

assume, thus that δ(t) is a constant, which we denote also by δ. 2

1.6.1. Eﬀective discount rates. The value at time s of 1 due at time s + t is

exp

s+t

s

δ(r) dr   = exp(δt),

which is independent of s. Hence

v(t) = e δt = v t = (1 d) t ,

where the discount rate is deﬁned as d := 1 v. The number d is the eﬀective discount rate per time unit. This is a loan of 1 at which interest d is deducted in advance. Similarly, the accumulated amount at time s + t of 1 invested at time s is

exp

s+t

s

δ(r) dr

= exp(δt) = (1 + i) t

which is independent of s.

1.6.2. Exercise. Find all the relationship between δ, v, i and d.

Solution.

v =

1

1 + i = 1 d = e δ .

(1.6.1)

1.6.3. Remark (interest, discount and the (wrong) law of universal linearity).

The interest rate i and the discount rate d have an interesting “dual” relationship, summarised by

(1 + i)(1 d) = 1.

One way to remember this relation is to think i as the percentage gain that com- pensates for the percentage loss d.

= i. This is a common mistake (known

as the “law of universal linearity”) whereby, for instance, many people think that if the FTSE goes down by 5% one day and by 5% up then it has recovered. What is your guess?

It should be clear to the reader by now that d

(1.6.2)

2 We trust the reader will not be confused when reading expressions like δ (t s)

12

MTA (G5078) Autumn 2009 Lecture Notes

Figure 1.

1

1

Series of equal payments from time 1 to time n. payments

1

1

1

1

···

0

1

a n

a¨ n

2

3

···

n 2

annuity value at various times

n 1

n

n + 1

s n

s¨

n

time

The reason why many people commit this mistake (and the reason behind the mis- take’s nickname) is the Neumann series expansion (which is just another name of the Taylor expansion)

1

1 + x = 1 x + x 2 x 3 + · · · .

(1.6.3)

Using x = i we obtain

1 d = 1 i + i 2 i 3 + · · · ,

and hence

d = i i 2 + i 3 + · · · .

For very small i, say of the order of 1%, the remainder term (nonlinear part of the expansion) is negligible, and one may assume, for all practical purposes that d = i. But as soon as i becomes bigger, one should be more careful.

1.6.4. Problem. A lender bases his short-term transactions on a rate of commercial discount D, where 0 < D < 1. For 0 < t 1, in return for a repayment of X after a period t, he will lend X(1 Dt) at the start of the period. For such a transaction over an interval of length t, (0 < t 1) derive an expression in terms of D and t for d, the eﬀective rate of discount per unit time. Hence show that, regarded as a function of t, d is increasing on the interval 0 < t 1.

(1.6.4)

(1.6.5)

1.7. Annuities-certain: present values and accumulation

1.7.1. Annuity-certain, annuity-due, perpetuity. Consider a series of n pay- ments, each of amount 1, made at time interval of 1 unit, the 1 st payment is made at time t 0 + 1. We sketch the situation in Figure 1. The value of this series of payments at time t 0 (which is the present value if t 0 = 0) is denoted by a n , hence v = 1/(1 + i), and, for n 1, we get

a n = v + v 2 +

+ v n =

1 v n 1/v

1 = 1 v n

i

.

(1.7.1)

If n = 0 (no payment ever done) then we deﬁne a n := 0. We refer the quantity a n the present value of an immediate annuity-certain (annuity paid in arrear). By contrast, the value of this series of payment at the time the ﬁrst payment is made is denoted by a¨ n . Thus

a¨ n = 1 + v + v 2 + ··· + v n1 = 1 1 v v n

= 1 v n

d

.

The name of a¨ n is called the present value of an (annuity paid in advance).

MTA (G5078) Autumn 2009 1.8. Annuities-certain: present values and

accumulation

13

The value of the series of payments at the time of the last payment is denoted by, s n and therefore

s n = (1 + i) n1 + (1 + i) n2 + · · · + 1 = (1 + i) n a n] = (1 + i) i n 1 The value of the series of payment one unit time after the last payment is made is denoted by s¨ n and we have

.

s¨ n = (1 + i) n + (1 + i) n1 + · · · + (1 + i) = (1 + i) n a¨ n] = (1 + i</