Index

Note: Page numbers with f denote gures; t tables; and b boxes.

A
absolutely matched business, 193
acceptance-rejection method, 293
accrued interest, 124
accumulation, 5, 12, 20e21, 25, 46
of annual payable pthly, 66e70
factors, 15e16, 30
American options, 239e241, 267
annual payable pthly
accumulation of, 66e70
for non-integer value of n, 72e74
present value of, 66e70
annual percentage rate of charge (APR), 85e87, 89
annual rates of return
dependent, 297e299
independent, 280e285
annuity(ies), 8, 35
annuity-certain, 44e49
accumulated value of, 46
immediate, 44e45
present value of, 44e46
annuity-due, 45e46
continuously payable, 50e51
deferred, 49e50, 49f
increasing, 52e53
level annuity, loan repayment schedule for,
81e83, 82t
payable at intervals of time R, where R > 1, 70e71
pthly annuity, loan repayment schedule for,
83e85

valuation through equivalent payments, 70f

varying, 52e56
APR. See annual percentage rate of charge
arbitrage, 217e219, 253, 397
opportunity, 217
arbitrageurs, 217e218
asset(s)
asset-proceeds, 193
matching of, 192e194
price volatility, 250e251
related, 126e128
ordinary shares, 126
preference shares, 126e128
property investment, 128
at-the-money, 242

B
bear markets, 256
bear spread, 257, 259f, 402
ratio, 258
Bermudan option, 239e240
binominal model, 251e252
bisection method, 314
BlackeScholes equation, 251e252
BlackeScholes model, 249e253, 268
bond(s), 125
futures, 212e213
borrower, 1, 9
borrowing, interest rates for, 101e102
BoxeMuller algorithm, 293e294

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box spreads, 259e263

Brownian motion, 301e303, 302f
geometric, 302
bull market, 258
bull spread, 258, 260f
ratio, 258
buttery spreads, 266, 402
buyer, 211e212

C
call option, 239, 242, 245e246, 267
call spread. See bull spread
Canary options, 239e240
capital, 1, 9
asset pricing model, 251e252
dened, 1
gain, 29e30
gains tax, 122, 161e176
loan with allowance for, valuing, 161e164
offsetting capital losses against, 171
optional redemption dates, 169e170
tax rate variation, impact of, 166e167
varying redemption price, impact of, 166e167
yield of, 167
loss, 29e30
See also principal
cash ow, 11
convexity of, 197
of deferred annuities, 49f
net, 38e39
present values of, 22e24
continuously payable cash ows, 22e24
discrete cash ows, 22, 23f
valuing, 25e27, 31
certicates of deposit, 125
clearinghouse, 214, 231
collars, 255e256, 257f
commodity futures, 212
common stocks. See ordinary shares
compound interest, 4e6, 9
functions, 35e78
compound options, 239e240
consistency principle, 16, 30, 179
consumer credit legislation, 85e88

annual percentage rate of charge, 85e87

at rates of interest, 87e88
continuously compounded spot rate, 181
continuously payable annuities, 50e51
continuously payable cash ows, 22e24
continuous rate of dividend payment, 252, 268
continuous time forward rates, 181
continuous time spot rates, 181
contract
forward, 217
future, 211e213, 216
convexity of cash ow, 197
coupon rate, 121
credit risk, 214, 231, 238e239
cum dividend, 127
cumulative preference shares, 126e127
currency futures, 213
currency swap, 237e239, 267

D
debentures, 125
deep-in-the-money, 242
deep-out-of-the-money, 242
deferred annuities, 49e50, 49f
dependent annual rates of return, 297e299
deposit, certicates of, 125
derivatives, 211e276, 397
discounted cash ow, 223
of ordinary shares, 126, 127b
discounted mean term of project, 184e185, 204
discounted payback period (DPP), 102e103, 111
discounted present value, 20e21, 25, 30
discounting period, 177
discrete cash ows, 22, 23f
discrete time forward rates, 181
discrete time spot, 181
dividend, 126
cum, 127
ex, 127
payment, continuous rate of, 252, 268
yield, 222
security with known, forward price calculation
for, 224e226
DPP. See discounted payback period

Index

duration
effective, 187, 204
Macauley, 184, 204

E
effective duration, 187, 204
efcient market, 250
equation of value, 35e36, 38e44, 40b, 41f, 97,
310e311
equivalent payments, 63f
annuity valuation through, 70f
Eurobonds, 125
European options, 239e241, 244e249, 267
call options, 245e246
put-call parity, 247e249, 268
put options, 246e247
theoretical bounds on, 245e249
ex dividend, 127
expectations theory, 183
expiry date, 219, 239e240, 267

nal redemption date, 142

Finance Act 1965, 161
nancial futures, 212
nancial leverage, 253
xed-interest, 8e9
government bonds, 124
securities, 121e125, 222
certicates of deposit, 125
debentures, 125
dened, 121
Eurobonds, 125
xed-interest government bonds, 124
government bills, 124
issued by local authorities, 124
issued by nationalized industries, 124
issued by public boards, 124
municipalities, loans issued by, 124
overseas governments, loans issued by, 124
overseas provinces, loans issued by, 124
unsecured loan stocks, 125
volatility of, 188e192, 189f
at rates of interest, 11, 87e89

at redemption yield, 130

force of interest, 17e20, 30, 39
forward contracts, 217, 231
payoff function for, 220f
prior to maturity, calculation of, 226e230
forward(s)
force of interest, 182
position
long, 211e212, 219e220, 231
short, 211e212, 220, 230e231
price calculation, 219e226, 231
for non-income-paying security, 221e222
for security with xed cash income, 222e223
for security with known dividend yield,
224e226
rate, 177e182
continuous time, 181
discrete time, 181
instantaneous, 182
relationship with spot rate, 181e182
synthetic, 255
full immunization, 200e204, 201f
futures contracts, 211e213, 231
bond futures, 212e213
commodity futures, 212
currency futures, 213
nancial futures, 212
short interest rate futures, 213
stock index futures, 213
uses of, 216

G
Garman-Kolhagen pricing formulae, 252
geometric Brownian motion, 302
gilt-edged stocks. See xed-interest government
bonds
government bills, 124
gross redemption yield, 129e130

H
hedging, 216, 230, 253, 397
dynamic, 231
static, 231
holder option, 239, 243, 267

445

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Index

I
immunization, 177e210
full, 200e204, 201f
Redingtons theory of, 194e200
income tax, 122
increasing annuity, 52e53
independent annual rates of return, 280e285
series of annual investments, moment of,
283e285
single investment, moment of, 281e282
independent uniform model, 298e299
index-linked stocks, 124, 149e155
ination
dened, 149
effects on project appraisal, 105e108
instantaneous forward rate, 182
interest, 1e2, 9
accumulated, 5
compound, 4e6, 9
dened, 1
income, 27e29, 28f
payable pthly, 61e66
practical illustrations of, 6e9
rate quantities, 35e38
rate swap, 235e237, 267
simple, 2e4, 9
internal rate of return (IRR), 97e98, 111
in-the-money, 242
intrinsic value of option, 245
inverse transform method, 291e293, 292f,
294f
investment performance measurement,
108e111
IRR. See internal rate of return
issue price, 121

L
law of one price, 218, 231
lender, 1, 9
lending, interest rates for, 101e102
level annuity, loan repayment schedule for, 81e83,
82t
liabilities, matching of, 192e194
linked internal rate of return, 109, 111

liquidity preference theory, 183

loan(s)
with allowance for capital gains tax, valuing,
161e164
issued by municipalities, 124
issued by overseas governments, 124
issued by overseas provinces, 124
mortgage, 8
perpetual, 132
stocks, unsecured, 125
loan repayment schedules, 79e94
consumer credit legislation, 85e88
annual percentage rate of charge, 85e87
at rates of interest, 87e88
general, 79e81
for level annuity, 81e83, 82t
prospective approach of, 80e81, 89
for pthly annuity, 83e85
retrospective approach of, 80, 89
local authorities, securities issued by, 124
log-normal distribution, 285, 304
long forward position, 211e212, 219e220,
231

M
Macauley duration, 184, 204
maintenance margin, 214e215
Makehams formula, 132e135, 144e146, 155,
163e164, 172
margin(s), 214e215
call, 214e215
initial, 214e215
maintenance, 214e215
payments, 231
risk, 214, 231, 238e239
variation, 214e215
markets
bear, 256
bull, 258
marking to, 214e215
segmentation theory, 184
marking to market, 214e215
Martingale approach, 251e252
matching of assets and liabilities, 192e194

Index

maturity date. See expiry date

modied market price, 226
modied regula falsi method. See secant method
moneyness, 241e242
money-weighted rate of return, 109e111
mortgage loans, 8
municipalities, loans issued by, 124

N
nationalized industries, securities issued by,
124
net cash ow, 38e39, 95e96
net liability-outgo, 192e193
net present value (NPV), 24e25
dened, 97
of project, 97e99, 111
NewtoneRaphson method, 315, 316f
no-arbitrage assumption, 217e218, 231, 245
nominal amount, 121
nominal rate of discount converted pthly,
63, 74
nominal rate of interest, 11, 13e15
convertible pthly, 13e14, 30, 63, 74
payable pthly, 13e14
with pthly rests, 13e14
non-income-paying security, forward price
calculation for, 221e222
non-linear equations, solution of, 313
notional stock, 212e213
NPV. See net present value
n-year par yield, 179e181, 204
n-year spot rate, 177, 204

O
offsetting capital losses against capital gains,
171
optional redemption dates, 122, 141e144
capital gains tax, 169e170
options, 239e240
American, 239e241, 267
Bermudan, 239e240
call, 239, 242, 267
Canary, 239e240
compound, 239e240

European, 239e241, 244e249, 267

call options, 245e246
put-call parity, 247e249, 268
put options, 246e247
theoretical bounds on, 245e249
holder, 239, 243, 267
intrinsic value of, 245
payoff, 240e244, 241f, 242f
premium, 245
pricing, 244e249, 268
prot, 240e244
put, 239, 246e247, 253, 267
shout, 239e240
time value of, 245
vanilla, 239e240
written, 239, 267
ordinary shares, 126
out-of-the-money, 242
overseas governments, loans issued by, 124
overseas provinces, loans issued by, 124
over the counter, 217, 231, 235e236

P
payback periods, 102e105, 111
discounted, 102e103, 111
paylater strategy, 248
payoff
function for forward contracts, 220f
options, 240e244, 241f, 242f, 268
perpetuities, 47, 132
payable pthly, 69
perpetuity-due, 69
polar algorithm, 293, 295e297
portfolio management, 398
position diagram, 243e244, 243f
for bear spread, 259f
for bull spread, 260f
for collars, 257f
for long buttery spread, 266f
for long/short straddles, 265f
for long/short strangles, 266f
for ratio call spread, 263f
preference shares, 126e128
cumulative, 126e127

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Index

present value, 20e21

of annuity-certain, 44e45
of annual payable pthly, 66e70
of cash ows, 22e24
continuously payable cash ows, 22e24
discrete cash ows, 22, 23f
discounted, 20e21, 25, 30
expected, 56e57
net, 24e25, 97e99, 111
n-year annuity paid in arrears, 45e46
principal, 1, 9
See also capital
prot diagram. See position diagram
project appraisal, 95e120
borrowing, interest rates for, 101e102
ination effects on, 105e108
investment performance measurement,
108e111
lending, interest rates for, 101e102
net cash ows, 95e96
net present value, 97e99
payback periods, 102e105
two investment projects, comparison of, 99e100,
100f
yields, 97e99
property investment, 128
protective put strategy, 253, 256
pseudo-random numbers, 285e288, 304
pthly annuity, loan repayment schedule for,
83e85
public boards, securities issued by, 124
put-call parity, 247e249, 268
put option, 239, 246e247, 253, 267
put spread. See bear spread
puttable swap, 239

R
random number generation, 291e297
BoxeMuller algorithm, 294
inverse transform method, 291e293, 292f,
294f
polar algorithm, 293, 295e297
rate of commercial discount, 3e4
rate of interest, 11e34, 36

effective, 11, 30
at, 11
nominal rate of, 11, 13e15, 63, 74
rate of return
annual
dependent, 297e299
independent, 280e285
internal, 97e98, 111
linked, 109, 111
money-weighted, 109e111
time-weighted, 109e111
ratio spreads, 258e259, 263f
real investment returns, 149e155
redeemable above par (redeemable at a premium),
122e123
redeemable at par, 122e123
redeemable below par (redeemable at a discount),
122e123
redemption, 278
date, 122
nal, 142
optional, 122, 141e144, 169e170
price, 122e123
single-premium capital redemption policies,
278
yield, 130
curve, 177
term effects on, 139e141
Redingtons theory of immunization,
194e200
related assets, 126e128
ordinary shares, 126
preference shares, 126e128
property investment, 128
replicating portfolios, 218, 231, 245
risk-free force of interest, 219
risk-free trading prot, 217
risk premium, 1, 57
running redemption yield. See at redemption
yield

S
secant method, 315, 315
securities

Index

with xed cash income, forward price calculation

for, 222e223
xed-interest, 121e125, 222
certicates of deposit, 125
debentures, 125
dened, 121
Eurobonds, 125
xed-interest government bonds, 124
government bills, 124
issued by local authorities, 124
issued by nationalized industries, 124
issued by public boards, 124
municipalities, loans issued by, 124
overseas governments, loans issued by, 124
overseas provinces, loans issued by, 124
unsecured loan stocks, 125
volatility of, 188e192,
189f
with known dividend yield, forward price
calculation for, 224e226
Makehams formula, 132e135
non-income-paying security, forward price
calculation for, 221e222
optional redemption dates, 141e144
perpetuities, 132
prices and yields, 129e131
related assets, 126e128
ordinary shares, 126
preference shares, 126e128
property investment, 128
two interest dates, valuation between, 144e146
valuation of, 121e160
yield to redemption, term effects on, 130,
139e141
seller, 211e212
shares
ordinary, 126
preference, 126e128
cumulative, 126e127
short forward position, 211e212, 220, 231
eliminating risk of, 230e231
short interest rate futures, 213
short selling, 230
shout options, 239e240

simple discount, 3e4

simple interest, 2e4, 9, 12
simulation technique, 252e253, 278, 285e291,
304
single-premium capital redemption policies,
278
speculation, 216
speculation, 253, 397
spot rate, 177e182
continuously compounded, 181
continuous time, 181
discrete time, 181
relationship with forward rate, 181e182
spreads, 257e258
bear, 257, 259f, 402
box, 259e263
bull, 258, 260f
buttery, 402
ratio, 258e259
stochastic interest rate model, 277e308
Brownian motion, applications of, 301e303,
302f
examples of, 277e279
independent annual rates of return, 280e285
series of annual investments, moment of,
283e285
single investment, moment of, 281e282
log-normal distribution, 285
random number generation, 291e297
BoxeMuller algorithm,
294
inverse transform method, 291e293, 292f,
294f
polar algorithm, 295e297
simulation technique, 285e291
stocks
common, 126
index-linked, 124
notional, 212e213
stock index futures, 213
unsecured loan, 125
straddles, 263e264, 265f, 402
long, 263e264
short, 263e264

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Index

strangles, 264e265, 266f

long, 264
short, 265
swaps, 235e239, 267
currency, 237e239, 267
dened, 235
interest rate, 235, 267
puttable, 239
synthetic forwards, 255

T
taxation, 29e30
term structure of interest rates,
15, 177e210
expectations theory, 183
liquidity preference theory, 183
market segmentation theory, 184
theory of, 183e184
term to redemption, 177
time value of option, 245
time-weighted rate of return, 109e111
trading strategies, 253e266
buttery spreads, 266
collars, 255e256, 257f
simple option trades, 253
spreads, 257e263
straddles, 263e264
strangles, 264e265
synthetic forwards, 255
two interest dates, valuation between, 144e146
two investment projects, comparison of, 99e100,
100f

U
uncertain payments, 35, 56e57
uncertainty, 277
undated, 122, 142
unsecured loan stocks, 125

V
vanilla options, 239e240
variation margin, 214e215
varying annuities, 52e56
volatility, 186e187, 204
asset price, 250e251
of xed-interest securities, 188e192, 189f

W
written option, 239, 267

Y
yield(s), 8, 97e99
of capital gains tax, 167
dividend, 222
equation, 39
at/running, 128, 130
gross, 129e130
to redemption, 97e98, 130, 139e141
of securities, 129e131

Z
zero-coupon bond, 177e178