CHAPTER 2

Pricing of Financial Instruments

1. Introduction
In this chapter, we will introduce and explain the use of financial instruments
involved in investing, lending, and borrowing money. In particular, we will focus
on government and corporate bonds, interest, future and present value of financial
instruments, mortgages, and stocks.
Marketable financial securities are contracts that are bought and sold by the
general public in various venues. The two main examples of such securities are stocks
and bonds. Securities are initially sold by investment banks such as Goldman Sachs.
They can be bought and sold after the initial offering in organized exchanges, such as
the New York Stock Exchange (NYSE), where stocks are traded. These instruments
are also traded through associations like the National Association of Security Dealers
(NASDAQ).

2. Bond pricing
The most basic tradable asset is a bond. When corporations, governments, or
other entities would like to spend more money than they currently have, they issue
bonds to raise capital. A purchaser of a bond is loaning the issuing institution money
for a period of time to finance civil projects, corporate expansions, or other activities.
To compensate the bond holder or creditor, the issuer or debtor will end up paying
back more than was originally invested - through coupons or offering the bond at
a discount. Coupon payments are periodic interest payments, paid to the bond
holder, determined by the interest rate on the date of purchase. Large companies
prefer bonds over bank loans since it is often a cheaper, more efficient, and easier
alternative.
More specifically, a bond is a marketable financial security that gives the owner
the right to a fixed payment at a predetermined date, called the maturity date. The
amount loaned at time t = 0, or the amount the bond trades for, is the principal
or the present value of the bond and is denoted P V (0). On the other hand, the
amount the bond trades for at a later time t > 0, P V (t) or F V , is called the future
33
34 2. PRICING OF FINANCIAL INSTRUMENTS

value of the bond. Notice that, in the case of the bond, the future value of the bond
on the maturity date is predetermined when the bond is purchased.
There are several types of bonds classified by the borrowers of funds and the
terms of maturity. The main two types of bonds we will consider are US government
bonds and corporate bonds. The government issues bonds when their expenditures
are greater than tax revenue. Government bonds include bills, notes, and bonds.
Treasury bills, or T-Bills, have a time to maturity T of less than a year, T < 1, and
do not issue coupon payments. Investors instead turn a profit by buying these bonds
at a discount; that is, P V (0) < P V (T ). Notes and bonds, however, issue coupon
payments every 6 months, where the last payment includes the coupon (interest) and
the principal. Notes have a time to maturity between one and ten years 1 T 10,
whereas bonds are more long term with T > 10 years.

Bills
Government Notes
Bonds
Bonds
Commercial
Corporate Paper
Direct Financial Bonds

Instruments
Preferred
Stocks
Common

Figure 1. Direct financial instruments

Corporations issue bonds to pay for large investments and large short term pay-
ments. They issue two basic kinds of bonds - commercial paper and bonds. Com-
mercial paper is a short term bond, T < 1, which is sold for immediate investments
by companies and are sold at a discount from the principal price listed. Corporate
bonds typically have time to maturity greater than a year T 1. Corporate bonds
have higher interest rates and generally shorter terms for maturity than government
bonds because they are riskier investments. Obviously, smaller firms generally are
more likely to go bankrupt than larger, more established firms, but there is always
a chance that any firm, even seemingly more stable ones, can unexpectedly go bank-
rupt. A higher likelihood of bankruptcy means a firms bonds are sold with a higher
interest rate. Because the government is much less likely to default on its bond pay-
ments, government bonds are considered less risky and have lower interest rates and
longer maturity terms.
 3. FIXED INTEREST RATES 35

3. Fixed interest rates

In this section, we introduce the fundamental concepts of interest rates, present
value, and future value of an investment. Let P V denote the initial value of the
investment and F V denote the terminal value. We define the annual interest, or
annual return, r of the investment to be
. FV PV
r= . (3.1)
PV
Therefore, the terminal value F V of an initial investment P V after 1 year is the value
of the investment plus interest: F V = P V + rP V . Equivalently,
FV
F V = (1 + r)P V or P V = . (3.2)
1+r
The interest earned after the first year will be added to the principal and henceforth
will also earn interest. As a result, how often the interest is paid affects the amount
the investor earns. The more often interest is added, or compounded, the more money
the investor makes.
Annual Compounding for t years:

If an initial amount PV is invested for t years at an interest rate r compounded

annually, then applying formula (3.2) repeatedly we get
FV
F V = P V (1 + r)t or P V = . (3.3)
(1 + r)t
Semiannual Compounding for t years:
Semiannual compounding means that every 6 months, the investment P V earns in-
terest P V (r/2) which is reinvested, where r is the annual
interest rate. Therefore,
r
after one period of 6 months, we have F V = P V 1 + 2 , and after two periods, or
one year, we have the terminal value
 r  r  r 2
FV = PV 1 + 1+ = PV 1 + ,
2 2 2
which at the end of 2 years (four periods) becomes
 r 2  r 2  r 22
FV = PV 1 + 1+ = PV 1 + .
2 2 2
Similarly, we find that at the end of 3 years, this investment becomes
 r 23
FV = PV 1 + .
2
36 2. PRICING OF FINANCIAL INSTRUMENTS

After t years of semiannual compounding, we obtain the terminal value:

 r 2t
FV = PV 1 + .
2
Quarterly Compounding for t years:

Quarterly compounding means that every 3 months an investment P V earns in-

terest P V (r/4), which is reinvested. Following a similar process to the case of semi-
annual compounding argument, we find that after t years of quarterly compounding
we obtain the terminal value:
 r 4t
FV = PV 1 + .
4
Furthermore, we obtain the similar formulas for monthly, weekly and daily compound-
ing.

Compounding Frequency Future Value

Annual F V = P V (1 + r)t
Semiannual F V = P V (1 + 2r )2t
Quarterly F V = P V (1 + 4r )4t
r 12t
Monthly F V = P V (1 + 12
)
r 52t
Weekly F V = P V (1 + 52 )
r 365t
Daily F V = P V (1 + 365 )

Table 1. Formulas for interest compounded for t years at an annual

rate r

The formulas in Table 1 are special cases of the following general case when the
compounding frequency m takes the values: m = 1, 2, 4, 12, 52, 365.
Compounding with Frequency m times per year for t years:

This means that every 1/m portion of the year, an investment P V earns interest
P V (r/m), which is reinvested. Therefore, after t years of such compounding, an
initial investment P V reaches the terminal value F V given by
 r mt  r mt
FV = PV 1 + or P V = F V 1 + . (3.4)
m m
 3. FIXED INTEREST RATES 37

Solving for P V , as we have done, gives the companion discounting formula. Given
a F V , it yields its present discounted worth of the future payment. The formulas
in Table 1 are special cases of the general formula (3.4) when the compounding
frequency m takes the values: m = 1, 2, 4, 12, 52, 365.
Example 1. The following table lists the value of $100 after 1 year of compound-
ing with frequency m and annual interest rate r = 0.1.

m 100(1 + 0.1/m)m
(Compounding frequency) (Value of $100 in 1 year)
1 110.00
2 110.25
4 110.38129
12 110.47131
52 110.50648
365 110.51558
10,000 110.51704
1,000,000 110.51709
Exercise 1. Find the amount you need to deposit now into an account paying
the annual interest rate of 5% compounded monthly so that it becomes $100,000 in
10 years.
Effective annual rate. If interest is reinvested with frequency m for t years at
annual rate r, then the effective annual rate rm is the equivalent rate (the one that
gives the same terminal value) with compounding frequency 1. Thus, rm is found by
solving the equation
 r mt
P V (1 + rm )t = P V 1 + ,
m
to get
 r m
rm = 1 + 1. (3.5)
m
Example 2. If the compounding frequency m = 365 and the annual interest rate
r = 10% = 0.1, then the effective annual interest r365 is equal to:
 r 365
r365 = 1 + 1 0.10516.
365
Exercise 2. Given an annual interest rate (nominal interest rate) of 0.04, find
the effective annual rate when interest is compounded every minute.
38 2. PRICING OF FINANCIAL INSTRUMENTS

3.1. Finding the ask & bid price of a T-Bill. Here we illustrate how the
formulas in the section above are used in a T-Bill situation.

Example 3 (Finding the Ask & Bid Price of a T-Bill). Dealers or market makers
set a bid and ask price on financial securities. The bid price Pbid is what a dealer pays
when a customer wants to sell her security, while the ask price Pask is the price the
customer pays when they are buying the security from the dealer. The dealer makes
a profit when you buy and then sell a security. The dealers profit is
Profit = Pask Pbid .
The table provides a summary of who gets what from a trade.
Customer Dealer
Bid Price Receive Payment Pay
Ask Price Pay Receive Payment

Treasury bill, or T-Bill, security dealers quote a bid and ask yield on a discount
basis rather than on a price basis for historical reasons. These discount quotes dictate
the terms of the contractual agreement, and the ask yield gives the investor the literal
annual yield from the bill. To determine the T-Bills bid and ask price, you can
calculate it from the discounted yields. Suppose we have a T-Bill with the following
information:
Time to Maturity: 34 days
Bid yield on discount basis: rdbid = 0.080%
Ask yield on discount basis: rdask = 0.060%
Ask yield: rask = 0.061%,
and we would like to determine how much we would pay (Pask ) for a T-Bill with
future value F V = $1 million. Using the formula for P V (3.3), the actual ask yield
on an annual basis for the T-Bill is defined by1

365 F V Pask 365 1 Pask

rask = = .
d Pask d Pask
To simplify calculations in the old days, the convention of multiplying by 360 rather
than 365 was adopted to simplify computations. The same is true for the division

1Fabozzi and Mann (2010) refer to this as the bond equivalent yield when d 182. This yield
is more complicated for d > 182 because the bond has semi-annual coupon rates. See Fabozzi and
Mann (2010, p. 133).
 3. FIXED INTEREST RATES 39

by 1 (FV) instead of Pask . This inspired the definition of the ask yield on a discount
basis rdask , an annual interest rate:
. 360 F V Pask 360 1 Pask
rdask = = .
d FV d 1
Now, to find the ask price of our T-Bill, we apply this formula with d = 34 days
360 1 Pask
0.00060 =
34 1
to get Pask = 0.9999433333. Therefore, you pay $999,943.33 for a $1 million T-Bill
which expires in 34 days. Similarly, to find the bid price of the bill, we use the formula
for the bid yield on a discount basis:
. 360 F V Pbid 360 1 Pbid
rdbid = = .
d FV d 1
Exercise 3. What is the brokers profit in Example 3?
Example 4. The following is screenshot of a T-Bill quote from Wall Street
Journals website. From this quote, we can read off all of the necessary informa-

Figure 2. Quote for a T-Bill purchased on January 29, 2012

tion needed to find the T-Bills price. The bond matures 4 days after its purchase
date, and it has a discounted bid and ask yield of rdbid = 0.04% = 0.0004 and
rdask = 0.03% = 0.0003, respectively. The actual ask yield, or return, of this treasury
bill is rask = 0.03% = 0.0003. Using the formula for rdask , we can solve to find that
the price of a $1 million T-Bill is Pask = $999, 996.67.
Exercise 4. Find a T-Bill quote for today, and determine the bid and ask price
of the bill.
Exercise 5. Find the ask and bid price for a $1 million T-Bill with the quote in
Table 2.
This Table can be read as:
Purchase Date: January 20, 2012
Maturity Date: March 1, 2012
Bid yield on discount basis, rdbid = 0.03%
Ask yield on discount basis, rdask = 0.02%
Ask yield, r = 0.02%.
40 2. PRICING OF FINANCIAL INSTRUMENTS

Date Maturity Bid Asked Chg Asked Yield

1/20/2012 3/1/2012 0.030 0.020 0.01 0.0200

Table 2.

How much would you pay a dealer for this $1 million T-Bill? What is the dealers
revenue if he buys and immediately sells this T-Bill?
Exercise 6. Find the ask and bid price for a $1 million T-Bill with the quote in
Table 3.

Date Maturity Bid Asked Chg Asked Yield

1/20/2012 1/10/2013 0.11 0.090 0.01 0.0910

Table 3.

How much would a dealer pay you for this $1 million T-Bill? What is the dealers
revenue if he buys and immediately sells this T-Bill?
Remark 3.1. T-Bill quotes can be found at http://online.wsj.com/ by clicking
on Markets Market Data Center Bonds Bonds, Rates, & Credit Markets
Treasury Quotes, or simply typing T-Bill Quote WSJ into Google and choosing
the first link. To determine the number of days to maturity, you may use the website
http://www.timeanddate.com/date/duration.html.
Alternatively, one can use the Excel function = DATEVALUE(10 Jan 2013)
to find the excel number for the maturity date and subtract off the purchase date =
DATEVALUE(20 Jan 2012).

4. Discrete income streams

In this section, we will consider two examples of discrete income streams: coupon
bonds and mortgages. Using the simple notions of present value, future value, and
interest rates, we will learn how to read coupon bond quotes and calculate mortgage
payments.
4.1. Finding the yield of a coupon bond. A holder of a coupon bond receives
scheduled payments Ct at the end of each period t (typically every 6 months). The
coupon rate is set at the time of the bonds purchase. Using the formulas for present
 4. DISCRETE INCOME STREAMS 41

value, see Table 1, we can determine the current value of the discrete income stream
produced by the coupons.
Example 5 (Finding the Yield of a Coupon Bond). Consider a $100 coupon bond
which pays coupons every 6 months with the following information:
Time Elapsed in Period: 92 (out of 184) days
Time to Maturity: 2.5 periods or 1 yr 92 days
Ask Price: $106.00
Bid Price: $105.97
Annual Coupon Rate: 6%
To determine the profitability of this investment, as compared with others, we would
like to find the average annual rate of return, or the yield to maturity, of this coupon
note. The yield to maturity is the interest rate, y, which makes the present value of
the bonds income stream, P V (y), equal the amount paid.
First, we notice that since the bond was purchased in the middle of a payment
period, the buyer will owe the notes seller the unpaid accrued interest in addition to
the price of the bond. Since half of the period has elapsed, the buyer will pay
1 6
Ask Price + Accrued Interest = 106 + $107.50.
2 2
From the time line in Figure 3, we see that 2.5 six month periods remain. At the end
of each period, the bond holder will be paid $3.00, and at the end of the last period,
she will also be paid the principal.

92
Time t=0 t =1- 180 t=1 t=2 t=3
(in 6 mo periods)

Payments $3.00
$3.. $3.00 $103.00

Figure 3. Payment timeline for a coupon note

Using the formulas for present value, see Table 1, we have that the present value
of this income stream is
$3.00 $3.00 $3.00 + $100
P V (y) = 92 +
1+ 92 + 92 . (4.6)
(1 + y/2) 184 (1 + y/2) 184 (1 + y/2)2+ 184
Thus, to find the yield y, we must solve
$3.25 $3.25 $3.25 + $100
92 + 92 + 92 = $107.5.
1+ 180
(1 + y/2) 180 (1 + y/2) (1 + y/2)2+ 180
for y.
42 2. PRICING OF FINANCIAL INSTRUMENTS

119
109.00
102

85 As we can see in Figure 4, the function P V (y) is

PV(y)

68 $109.00 when y = 0 and goes to 0 as y . By

51
the Intermediate Value Theorem, since 0 < 108.06 <
109.00, there must exist a solution y such that
34
P V (y) = 107.5. We use Maples fsolve command
17 to find that the average annual yield of this bond is
y 0.01351 or 1.351%.
0 1 2 3 y 4 5 6

Figure 4. P V (y)

Example 6. Table 4 contains the information for a U. S. Treasury coupon note

quote from Wall Street Journals website. This quote is for the purchase of the bond
on July 23, 2012. From this quote, we can read off all of the pertinent information
about the note. This note matures 22 days after its purchase date and for a $100
note, the bid and ask price
are $104.2891 and $104.3047, respectively. The accrued
$4.25 22
interest is 2 1 182 = $1.868. 182 days are used for the length of the period
from February 15, 2012 to August 15, 2012. Using the present value calculations as
in (4.6), the asked yield of the bond is y = 0.0018288 = 0.183%.

Purchase Date Maturity Coupon Bid Asked Chg Asked Yield

7/23/2012 8/15/2013 4.25 104.2891 104.3047 -0.0156 0.185

Table 4.

Remark 4.1. Notice that this result is different from the ask yield in the Table
4. Based on the yield in this Table P V (y) = $106.224376 rather than $104.3047 +
$1.861 = $106.1728. You may think that 5 pennies on $100 is not that important but
if you are trading $1 million at a time the difference is $515.76. The reason for this
difference is an arbritrage opportunity, which investment banks like Goldman Sachs
take advantage of. The arbitrage opportunity arises because the coupon bonds can
be broken up into individual zero coupon bonds. In the case of Example 5 there are
three separate payments which can be used to create three bonds. These three zero
coupon bonds are called Treasury Strips. These bonds would have a different terms
to maturity for example the first bond would have a term to maturity of 92 days.
 4. DISCRETE INCOME STREAMS 43

Thus, you would use the ask yield to maturity on a 3 month T-Bill, while the second
payment as a yield to maturity of 9 months. It turns out that the yield changes as the
yield to maturity changes.2 In most cases, the yield increases as the maturity date
increases. Thus, one can make money by buying the cheaper PV and selling short
the more expensive PV.
Exercise 7. Find a US government note sold today, and determine its yield to
maturity as in Example 5.
www.online.wsj.com: Home Personal Finance Investment Data Center
Bond Rates Treasury Quotes.
Exercise 8. Find the average annual rate of return, or yield to maturity, for the
US government coupon note with a principal of $100 in Table 5.

Purchase Date Maturity Coupon Bid Asked Chg Asked Yield

1/16/2013 8/15/2013 0.750 100.3516 100.3594 0.0 0.129

Table 5.

If a dealer buys and sells this note, what will her revenue be per million dollars
of this bond?
Exercise 9. Find the average annual rate of return, or yield to maturity, for the
following US government coupon note with a principal of $100 in Table 6. If a dealer
buys and sells this note, what will her revenue be per million dollars of this bond?

Purchase Date Maturity Coupon Bid Asked Chg Asked Yield

1/20/2012 12/15/2012 1.125 100.8594 100.9297 -0.0313 0.085

Table 6.

Remark 4.2. Such bond quotes can be found at http://online.wsj.com/ by click-

ing on Markets Market Data Center Bonds Bonds, Rates, & Credit Markets
Treasury Quotes, or simply typing Coupon Bond Quote WSJ into Google and
choosing the first link. To determine the number of days to maturity, you may use
the website http://www.timeanddate.com/date/duration.html.
2You can find these rates on the same website under Treasury Stips. For detailed description of
the process see Fabozzi and Mann (2010).
44 2. PRICING OF FINANCIAL INSTRUMENTS

4.2. Finding mortgage payments. The second example of a discrete income

stream is a mortgage. Annuities, or mortgages, are used when an individual would
like to borrow money and repay it over time in fixed payments. Each payment period,
the borrower must pay a fixed amount C. If a loan of $P V is issued for a duration
of n periods, then using the formulas for present value, we find that
n
C C C X 1
PV = + 2
+ + n
= C ,
1 + r (1 + r) (1 + r) k=1
(1 + r)k

where r is the interest rate per period and C is the payment per period. Using the
n
formula for a geometric series 1 + x + + xn1 = 1x
1x
, we can solve to find that
  n 
C 1
PV = 1 . (4.7)
r 1+r

This formula also allows us to find the monthly payment C for an amount of money
borrowed P V :

Example 7. Suppose you take out a 30 year mortgage for $200, 000 at an (annual)
interest rate of 6%. What is your monthly payment?
Using (4.7), we can solve for the monthly payment. Here the monthly interest
rate is r = 0.06
12
, the number of time periods is n = 12 30 = 360 months, and the
principal is P V = 200, 000. The monthly payment for this mortgage is
0.06


rP V 12
200, 000
C= 1 n = 360 = $1, 199.10.
1 ( 1+r )

1
1 1+ 0.06
12

Exercise 10. Look up the average mortgage rate on a 30 year loan and determine
the amount you can borrow given that you can afford $1,500 per month.

5. Continuous compounding
In the previous sections, we have considered the value of investments for which
interest is compounded yearly, monthly, or daily. Now we ask what happens as we
continue this trend and compound all of the time or continuously. If we let the
compounding frequency m go to infinity, we obtain what is known as continuous
compounding. From the formula for compounding frequency m (3.4), the future
 5. CONTINUOUS COMPOUNDING 45

value of an investment of P V at an annual interest rate r is

 r mt  1  mr rt
F V = lim P V 1 + = P V lim 1 + m
m m m
r
 1  nrt h  1 n irt
= P V lim 1 + = P V lim 1 + .
n n n n
Now, using the well-known definition of e:
 n
1
e= lim 1 + , (5.8)
n n
we obtain the continuous compounding formula and the companion discounted value
formula:
F V = P V ert and P V = F V ert , (5.9)
respectively. The following table lists the terminal values of $1 after one year earning
the annual interest rate of 100% with compounding frequency n = 1, 2, 3, . . . :

n (1 + 1/n)n
(Compounding frequency) (Value of $1 in 1 year)
1 2
2 2.25
4 2.44141
12 2.61304
24 2.66373
52 2.69260
365 2.71457
1,000 2.71692
10,000 2.71815
100,000 2.71827
1,000,000 2.71828

In mathematical terms, the sequence in the second column of the table is a se-
quence which converges to e. This sequence converges since it increases and is bounded
from above. The table suggests that the upper bound is a little above 2.718. Indeed,
1 n


it can be shown that 1 + n < 3 for all n. The limit is an important irrational num-
ber, which is denoted by the letter e in honor of the great mathematician Leonhard
Euler (1707-1783). Its approximation to 40 decimal places is:
e 2.718281828459045235360287471352662497757.
46 2. PRICING OF FINANCIAL INSTRUMENTS

Example 8. Suppose you invest $10,000 in an account paying 4% annual interest,

and you dont make any further deposits or withdrawals. How much will you have at
the end of 3 years if the interest is compounded continuously?

Use formula (5.9) with P V =10,000, r = 0.04 and t = 3 to get the amount
F V = 10, 000e0.043 $11, 274.97.
Exercise 11. How much money must be put into a continuously compounded
account paying 5% annual interest in order to have $10,000 at the end of 4 years?
Effective annual rate for continuous compounding If r is a continuously com-
pounded interest rate, then the effective annual rate re is found by solving the equation
P V (1 + re )t = P V ert ;
i.e.,
re = er 1. (5.10)
More generally, to find the relation between an interest rate rc with continuous
compounding and an interest rate rm with compounding frequency m, we must solve
the equation
 rm mt
PV 1 + = P V erc t
m
or  rm m
1+ = erc . (5.11)
m
Example 9. Given a nominal interest rate of 0.04, find the effective annual rate
if interest is compounded continuously.
Using formula (5.10), we find
re = e0.04 1 = 0.0408107742.
Exercise 12. Assume that a bank offers you a savings account with the annual
interest rate of 5% compounded daily. What is the equivalent rate with continuous
compounding?

6. Variable interest rates

What if the interest rate is not fixed? Next, we discuss continuous compounding
when the annual interest rate is variable, that is r = r(t). For this, let us assume that
at t = 0 we are investing an amount A0 , which at any subsequent time t is earning
annual interest rate r(t) compounded continuously. If we denote by A(t) the amount
 7. CONTINUOUS INCOME STREAMS 47

of our investment at time t and by A(t + t) the amount of our investment at time
t + t, then we have
A(t + t) A(t) r(t) A(t) t,
assuming that r(t) is continuous. Next, dividing by t gives
A(t + t) A(t)
r(t) A(t).
t
Finally, letting t go to zero yields the first order differential equation (DE)
dA
= r(t)A(t). (6.12)
dt
Solving it with initial data A(0) = A0 , we obtain the formula
Rt
r(s)ds
A(t) = A0 e 0 ,
which in the present/future value notation reads as follows:
Rt
r(s)ds
FV = PV e 0 . (6.13)
Exercise 13. Solve DE (6.12) to produce formula (6.13).

7. Continuous income streams

Suppose that at t = 0, we open an investment account with an initial amount
A0 , and thereafter, we make continuous deposits at the rate of S(t) per year. If the
account pays an interest rate of r, compounded continuously, then we want to find
the amount A(t) in the account at any subsequent time t.
We begin by modeling this situation with a differential equation. After we have
a model, we will solve it to find the amount A(t). Observe that A(t) grows in two
ways: by deposits and interest. The deposits increase the amount of money at a rate
of A(t) per year, and the interest increases the amount at the interest rate r of the
current balance.
To translate this information into the form of a differential equation, we let t
denote a very small amount of time, and we compare the balance at time t with the
balance at time t + t. During that time interval, the interest paid is approximately
rA(t)t (which represents money growing at a rate of r of the current balance A(t)
for a period of length t). The new money added is approximately S(t)t (which
represents money being added at a constant rate of S(t) for a period of length t).
Therefore, the approximate change in the balance is given by the formula

A(t + t) A(t) rA(t)t + S(t)t,

48 2. PRICING OF FINANCIAL INSTRUMENTS

and we can make the approximation as good as we want by taking t small enough.
Dividing both sides by t, we get
A(t + t) A(t)
rA(t) + S(t).
t
Letting t 0, we obtain the first order linear differential equation
dA
= rA(t) + S(t). (7.14)
dt
Our continuous stream investment problem has now been modeled by equation (7.14)
and the initial condition
A(0) = A0 . (7.15)
Solving initial value problem (7.14)(7.15) gives the formula:
Z t
rt
A(t) = A0 e + S( )er(t ) d (7.16)
0

Exercise 14. Solve initial value problem (7.14) (7.15) to derive formula (7.16).

Exercise 15. Verify that initial value problem (7.14) (7.15) models continuous
income streams even in the case that r = r(t) (variable) and solve it.

Exercise 16. Suppose you open a retirement account at age 30 with an initial
amount of $5,000 and thereafter make continuous deposits at the rate of $10,000 per
year. If the account pays an interest rate of 7%, compounded continuously, what is
the balance in the account at any given time? In particular, what is the balance at
the retirement age of 65?

Exercise 17. Suppose that a home buyer plans to take a 15-year mortgage at
an interest rate of 5% and cannot spend more than $2,000 per month on payments.
(a) What is the maximum amount that she can afford to borrow?
(b) If the buyer borrows this maximum amount, how much total interest will she
pay?
For simplicity, assume that the interest is compounded continuously and that the
payments are made continuously at the rate of $24,000 per year. In practice, these
assumptions may not be precisely satisfied, but they greatly simplify the problem and
give close approximations to the actual solution.
 8. STOCK PRICING 49

8. Stock pricing
A stock is a certificate of ownership of a company. A share is a unit of stock.
At t = 0, the stock value, S0 , is given by
Market value of company
S0 = .
Number of shares of company
Example 10. If a company today has 40 million shares and the value of each
share is $50, then the market value of the company is $50 40 million or $2 billion.
Stocks do not come with the predictability or security of bonds:
(1) Dividends are unknown until payment.
(2) There is no maturity date for a stock.
(3) In the case of bankruptcy, bond holders are paid off before the shareholders.
The residual of the companys assets after meeting all other liabilities are
divided among the shareholders.
Corporate stock offers a share of ownership in a company. There are two types of
stocks: common and preferred. Common stock provides a dividend payment each
quarter. Dividends, denoted Dt , are the share of the companys profits that each
shareholder is entitled to. The companys profits are divided so that dividends per
share equal reported profits divided by number of shares. Common shareholders have
the right to vote in corporate elections. Preferred stock, on the other hand, pays
a specified dividend before the common shareholders receive dividends but after the
bondholders are paid. Unlike common stock holders, preferred shareholders do not
have voting rights.
The value of a stock is considered the sum of the dividends paid for a particular
stock before the company goes bankrupt. The value or price of the stock is denoted
S0 :
N
X Dt
S0 = t
.
t=1
(1 + rt )
Exercise 18. Consider a simple world where a stock gives the same dividend
D = $10 at the end of each year. If the annual interest is 2% and compounded
annually, what is the price of this stock?
The time N at which the company goes bankrupt, the dividends at each time of
payment Dt , and the interest rate rt and any time t are all unknown. Therefore, the
price of a stock is based on the expectation of its future activity:
" N #
X Dt
S0 = E .
t=1
(1 + rt )t
50 2. PRICING OF FINANCIAL INSTRUMENTS

The E [] denotes the expected value.

The return on a stock is the profit a stockholder makes from selling the stock
relative to the price at which it was purchased. The return R(t) is given by:
St S0 Dt
R(t) = Capital Gain + Dividend Yield = + .
S0 S0
Note: The return on a stock R(t) is different from the interest rate rt although each
are dependent on the specific time t.
People make decisions regarding the trading of stocks in advance of knowing the
outcome of the stock based on expected returns:
 
St S0 Dt
E [R(t)] = E + .
S0 S0
There is a risk involved in purchasing stocks that is not present while purchasing
bonds. For a bond, the expected value of the bond is merely the bonds face value
plus interest - there is no uncertainty about the future value. The stock, however,
might go up or down in the next period, so its future value is not determined. For
this reason, we can only consider the average or expected future value of a stock.
For instance, if the up value of the stock S1 (H) = uS0 occurs with probability
p and the down value S1 (T ) = dS0 occurs with probability 1 p, then the expected
payoff of a stock is p(uS0 ) + (1 p)(dS0 ). Later, we shall go into more detail about
the risks involved in purchasing stocks compared to purchasing bonds.

Example 11. Suppose we have a S0 = $50 stock which can attain the value
S1 (H) = 100 with probability p = 0.5 and the value S1 (T ) = 25 with probability
1 p = 0.5. If the stock dividends are 2% of S0 , then what are the possible rates of
return for the stock?
For the higher stock price, the return is:
S1 (H) S0 Dt 100 50
R(H) = + = + 0.02 = 1.02 or 102%.
S0 S0 50
For the lower stock price, the return is:
S1 (T ) S0 Dt 25 50
R(T ) = + = + 0.02 = 0.48 or 48%.
S0 S0 50
The expected return is:

E [R(t)] = 0.5R(H) + 0.5R(T ) = 0.5(1.02) + 0.5(0.48) = 0.27.

 10. CHAPTER EXERCISES 51

9. Short selling
If an investor is confident that a stocks price is going to decrease, he can make
a profit by short selling the stock. The ideal scenario for someone engaging in this
activity is as follows. The investor borrows the stock from a broker at time t = 0
under the agreement that the stock will be returned at t = T . He then sells the stock
immediately for S0 . After the price drops, the investor buys the stock at ST and
returns it, making a profit of
Profit = S(0) S(T ) Transaction Fees to Broker for Stock.
Naturally, if the price goes up, the investor will lose money.
Example 12. Suppose you consider the stock price in Example 11, and you decide
to short this stock since you think the probability of the low price is 1 p = 0.9.
How much would you gain when the price goes up and down? What is your expected
gain?
If the price is high, your loss is
S0 S1 (H) = 50 100 = 50.
If the price is low, your gain is
S0 S1 (T ) = 50 25 = 25.
Your expected gain is
0.1(50) + 0.9(25) = 5 + 22.5 = 17.5.
Exercise 19. Explain why you would have shorted Lehman Brothers stock in
July 2007. What would have been the most beneficial term to maturity for you?

10. Chapter exercises

Exercise 20. If you would like to make a return of $10,000 on an investment in
one year with a simple interest rate of r = 0.05, how much money should you plan to
invest initially?
Exercise 21. If you would like to make a return of $10,000 on an investment in
one year that grows by a compounded quarterly interest rate of rQ = 0.05, how much
should you plan to invest initially?
Exercise 22. Calculate the ask price Pask on a FV = $1,000,000 T-bill maturing
in 40 days with an actual ask yield of rask = 0.05%.
Exercise 23. Given a nominal interest rate of 0.05, find the effective annual rate
given that the interest rate is compounded (a) daily, (b) hourly, and (c) continuously.
52 2. PRICING OF FINANCIAL INSTRUMENTS

Exercise 24. Find the present value of a bond B0 with a continuous cash flow
B(t) = $5 and interest rate r = 0.05 held for 6 years.
Exercise 25. The holder of a coupon bond receives semi-annual coupon payments
of $10 for 5 years while holding the bond at an interest rate of r = 0.05. At the time
of the bonds purchase, what is the present value of those coupon payments?
Exercise 26. In order to purchase a new house, someone would like to borrow
$400,000 at an interest rate of r = 5% annually and make constant monthly payments
to repay the mortgage. What is the value of the monthly payments on a 30-year
mortgage?
11. Glossary of terms
Definitions come from Bodie, Kane, and Marcus (2008), and Wikipedia.
Bankruptcy A legally declared inability or impairment of ability of an in-
dividual or organization to pay their creditors.

Bond Marketable financial security that gives the owner the right to a fixed
payment, at a predetermined future date.

Borrower An individual or organization who spends more than her current

income.

Corporate Bond A bond issued by a corporation. The term is usually ap-

plied to longer-term debt instruments, generally with a maturity date falling
at least a year after their issue date. (The term commercial paper is some-
times used for instruments with a shorter maturity.)

Corporate Stock A share, also referred to as equity, of stock means a share

of ownership in a corporation (company).

Common Pays a dividend payment each quarter. The companys

profits are divided so that dividends per share equal reported profits divided
by number of shares. Common shareholders have the right to vote in corpo-
rate elections.

Preferred Pays a specified dividend before the common shareholders

receive dividends but after the bondholders are paid. Preferred shareholders
do not have voting rights.
 11. GLOSSARY OF TERMS 53

Coupon Payment A periodic interest payment that the bondholder receives

during the time between when the bond is issued and when it matures.

Creditor An entity that is promised a payment in the future.

Debtor An entity that owes a debt to someone else; the entity could be an
individual, a firm, a government, or an organization. The counterparty of
this arrangement is called a creditor.

Direct Financial Instrument Contract between initial saver and borrower.

Dividends Payments made by a corporation to its shareholder members.

When a corporation earns a profit or surplus, that money can be put to two
uses: it can either be re-invested in the business (called retained earnings),
or it can be paid to the shareholders as a dividend.

Future Value The nominal future sum of money that a given sum of money
is worth at a specified time in the future assuming a certain interest rate,
or more generally, rate of return.

Liquidity An assets ability to be easily converted through an act of buy-

ing or selling without causing a significant movement in the price and with
minimum loss of value.

Maturity The future date at which a bond is repaid.

Present Value The value on a given date of a future payment or series of

future payments, discounted to reflect the time value of money and other
factors such as investment risk.

Principal Payment promised on a bond at its maturity.

Saver An individual or organization who spends less than her current in-
come.

Security A contract between a borrower and a saver, which specifies the

terms of the deal.
54 2. PRICING OF FINANCIAL INSTRUMENTS

Short Selling or shorting The practice of selling a financial instrument

that the seller does not own at the time of the sale. Short selling is done
with intent of later purchasing the financial instrument at a lower price.
12. References
Bodie, Zvi, Kane, Alex, and Marcus, Alan J. Essentials of Investments edition 6
or 7, McGraw-Hill, New York, NY 2006 or 2008.
Cvitanic, Jaksa, and Fernando Zapatero Introduction to the Economics and Math-
ematics of Financial Markets , MIT press (2004).
Himonas, Alex, and Howard, Alan Calculus: Ideas & Applications, John Wiley &
Sons , NJ 2003.
Wikipedia, The Free Encyclopedia.