Financial Mathematics: The Basics

by Annamaria Olivieri

E XERCISES

E.1 Mr X invests 5 000 euro for 4 years, simple interest, annual interest rate 3%.

(a) Calculate the value accumulated after 2 years (i.e., at time 2) and at matu-
rity (i.e., at time 4).
(b) For each year, calculate the annual interest per unit of value accumulated
at the beginning of the year.

E.2 Perform again the assessments described in Exercise E.1, but assuming com-
pound interest (instead of simple interest) and compare the relevant findings.

E.3 Plot in the same graph the simple interest and the compound interest accumu-
lation factors defined in Exercises E.1 and E.2.

E.4 Mr X invests 8 000 euro for 3 years, compound interest. The interest rate is
floating: in the first two years the annual interest rate is 2%, then it moves to
2.5%.

(a) Calculate the accumulated amount at maturity (time 3).

(b) For each year, calculate the annual interest per unit of value accumulated
at the beginning of the year.
(c) Assess the annual average return (or yield) to maturity. Why the value of
such a return is lower than 2%+22.5% = 2.25%?

E.5 Mr X pays today 2 400 euro and will cash back 2 500 euro after 12 months.

(a) Calculate the annual yield to maturity, adopting (alternatively) a linear and
an exponential law.
(b) Plot in the same graph the relevant linear and the exponential accumula-
tion factor.

E.6 Mr X pays today 2 350 euro and will cash back 2 500 euro after 18 months.

(a) Calculate the annual yield to maturity, adopting (alternatively) a linear and
an exponential law.
(b) Plot in the same graph the relevant linear and the exponential accumula-
tion factor.

E.7 At time t0 = 0, Mrs X invests the amount S at simple interest, annual inter-
est rate i = 0.10. Take the following as possible (alternative) durations of the
investment: 3 months, 6 months, 1 year. Calculate for each alternative duration:

(a) the accumulation factor f (t);

1
 (b) the discount factor v(t).

E.8 Perform again the assessments described in Exercise E.7, but assuming com-
pound interest and compare the relevant findings.

E.9 A bill, final value 5 000 euro and maturity 1 year, is sold to a bank. The price
paid by the bank is 4 800 euro.

(a) Adopt the simple interest discount factor, and calculate the annual interest
rate used by the bank to set the price.
(b) Adopt now the compound interest discount factor, and calculate the an-
nual interest rate used by the bank to set the price.
(c) Adopt now the commercial discount factor, and calculate the annual dis-
count rate used by the bank to set the price.
(d) Plot in the same graph the three discount factors.

E.10 In a bank deposit, interest are compounded every 3-months (i.e.: on 31/3, 30/6,
30/9, 31/12). The following transactions have been recorded:

1/2/2018 Issue of the deposit, 1 000 euro are deposited;

1/6/2018 500 euro are deposited.

Calculate the balance of the deposit on 31/8/2018, annual interest rate 1.5%.

E.11 Given the annual nominal interest rate i (k) = 0.05 (payable k times in a year)

(a) Set k = 2 and calculate the 6-months interest rate i1/2 and the equivalent
annual effective interest rate i;
(b) take k = 4 and calculate the 3-months interest rate i1/4 and the equivalent
annual effective interest rate i;
(c) Set k = 12 and calculate the monthly interest rate i1/12 and the equivalent
annual effective interest rate i;
(d) Set k = 360 and calculate the daily interest rate i1/360 and the equivalent
annual effective interest rate i;
(e) Assume continuous compounding (i.e., k → ∞), identify the short rate r
and calculate the equivalent annual effective interest rate i.

E.12 Assume: t0 = 0, t1 = 2, t2 = 3 and i = 0.05, and check that the linear law does
not meet the consistency property, whilst the exponential law does.

E.13 A ZCB face value 1 000 euro and maturity at time 2 is currently priced 942.60
euro. A forward transaction has face value 1 000 euro, price 966.18 euro to be
paid at time 1, maturity at time 2. A ZCB with maturity at time 1 and face value
966.18 euro is currently priced 938.04 euro. In all cases, time is measured in
years.

(a) Assuming that the risk of default can be disregarded, short sales are ad-
mitted and there is no transaction cost, construct an arbitrage portfolio.

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 (b) Assume now that transaction costs amount to 2.50 euro for each transac-
tion. Is it still possible to gain from the arbitrage?

E.14 Mr X wants to cash 1 000 euro at the end of each year for the next 5 years,
annual interest rate 3%. Calculate the price Mr X has to pay today to enter into
the transaction.

E.15 Mr X wants to accumulate 100 000 euro in 5 years, through monthly constant
payments (at the end of each month), annual effective interest rate 3%. Calcu-
late the amount of each monthly payment.

E.16 A real estate provides an annual income of 10 000 euro (at the end of the year).
Taking a 4% annual interest rate, assess the value of the estate as the present
value of all future incomes.

E.17 Mr X underwrites a loan, principal amount 100 000 euro, to be repaid in 8 years,
with monthly constant payments (at the end of each month). The annual nom-
inal interest rate (payable 12 times in a year) is 12%. Calculate the amount of
each monthly payment.

E.18 Mr X underwrites a loan, principal amount 100 000 euro, to be repaid in 8 years,
with monthly payments (at the end of each month), each amounting to 1 500
euro. Check whether the annual nominal interest rate which is applied by the
bank is i(12) = 9.6%. Check whether the annual effective interest rate applied
by the bank is i = 10%.

E.19 Mr X deposits 150 000 euro in an investment fund. He will withdraw 900 euro
at the end of each month, as long as money is available. The interest rate gained
on the investment is 3% each year. Check whether Mr X can withdraw money
from the fund for 17 years.

E.20 A worker now aged 50 plans to retire at age 65 (i.e., after 15 years from now).
His/her target is to hold 300 000 euro at retirement time, in order to be able
to fund a satisfactory post-retirement income. In order to reach such a tar-
get, he/she underwrites a savings product, planning to make constant monthly
payments at the end of each month for the next 15 years. At time 0, the current
(and forecasted) annual return on investments is 3% (effective).

(a) Assess the amount of the monthly payment.

(b) Assume that the return on investments keeps 3% up to time 5 (time is mea-
sured in years). Calculate the amount already accumulated at that time.
(c) Soon after time 5, the worker is informed that the current (and forecasted)
annual return on investments is now 4%. The worker then decides to re-
duce the amount of the future payments, so that they are constant and
allow to reach the target of 300 000 euro accumulated at retirement time.
Calculate the amount required for the future payments.

E.21 A loan must be repaid in 10 years, with annual payments (at the end of each
year). The principal amount is 300 000 euro; the interest rate is floating. At

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 issue and then at any change of the interest rate, it is assumed that the future
payments are constant at the current interest rate.

(a) Assume that the annual interest rate at issue is 6%. Calculate the annual
payment.
(b) Fill-in the amortization table up to time 2.
(c) Assume that at time 2 (right after the payment at that time) the annual
interest rate moves to 6.5%. Calculate the new amount required for the
annual payment.

E.22 A loan must be repaid in 10 years, with annual constant payments, annual in-
terest rate 10%. The principal amount is 200 000 euro.

(a) Calculate the annual payment. Fill-in the amortization table up to time 2.
(b) Due to financial difficulties, the borrower obtains not to pay the 3rd and
4th installments. Calculate the amount of thenoutstanding balance at time
4.
(c) At time 4, the amount of future payments is reassessed so that they are
constant and the loan turns out to be fully repaid at time 10 (note that the
first payment will be made at time 5).

E.23 An investment transaction consists of an outflow of 100 000 euro at time 0, fol-
lowed by an income of 20 000 euro at time 1, an income of 40 000 euro at time 2
and an income of 60 000 euro at time 3.

(a) Calculate the NPV, discount rate 8%, and guess a reasonable value for the
IRR of the transaction.
(b) Note that the total cash amount of incomes is 120 000 euro. Assume that
such total amount is uniformly spread over three annual incomes (i.e. the
incomes will be 40 000 euro at the end of each of the next three years),
whilst the initial outgo is still 100 000 euro. Calculate the NPV of this new
transaction. Why the NPV is higher than for the previous transaction?

E.24 An investment transaction consists of an outgo of 100 000 euro at time 0, fol-
lowed by annual incomes each amounting to 25 000 euro. Annual incomes will
be received at the end of each of the next 5 years.

(a) Calculate the NPV, discount rate 7%.

(b) Assume that only 50 000 euro are available at time 0. It is possible to under-
write a loan for the missing 50 000 euro; the loan must be repaid in 5 years,
through constant annual payments, inclusive of interest at the annual in-
terest rate 8%. Calculate the NPV on the net cashflows of the transaction
(i.e., the Adjusted Present Value). Why is it lower than the NPV calculated
previously?

E.25 In a market, ZCB with face value 1 euro and maturities 1, 2, 3 years are available;
the spot prices are (respectively): 0.97847, 0.95181, 0.91514 euro.

4
 (a) Calculate the spot rates for each maturity.
(b) Calculate the forward prices and the forward rates for each maturity. Jus-
tify why i0|1 (1) > i0 (2).
(c) Assume that a coupon-bearing bond is available, time to maturity 3 years,
face value 1 000 euro, annual coupon, coupon rate 3.5%. Calculate the no-
arbitrage price and give an approximate value for the yield to maturity.
Why the bond is quoted above par? Why we can say that the yield to
maturity is lower than its coupon rate?
(d) Calculate the mean duration of the coupon-bearing bond. The yield to
maturity of the bond is 2.98%; calculate the flat-yield mean duration of the
bond, using its yield to maturity. Why its value is not the same as the mean
duration assessed before?
(e) Assume now that the coupon-bearing bond is traded at par on the market.
Arrange an arbitrage deal.

E.26 In a market, the following spot prices are taken from ZCB’s: v0 (1) = 0.97561;
v0 (2) = 0.95181. A coupon-bearing bond is traded, time to maturity 3 years,
annual coupon 40 euro each, face value 1 000 euro, current price 1 037.21 euro.
Calculate the spot price for maturity 3 years consistent with the price of the
bond.

E.27 Consider the following bond: time to maturity 5 years, annual coupon, coupon
rate 5%, face value 100 euro, yield to maturity 5%. Assume that the term struc-
ture does not change, so that the yield to maturity never changes.

(a) Calculate the price and the mean duration of the bond at time 0.
8
(b) Calculate the price and the mean duration of the bond at time 12 (i.e., af-
ter 8 months). Check that the mean duration is simply the initial mean
duration reduced by 8 months. Why the bond is no longer priced at par?
(c) Calculate the price and the mean duration of the bond at time 1 (i.e., 1 year
after time 0). Check that the mean duration is not the mean duration at
time 0 reduced by 1 year. Why do we find this different result (in respect
of the assessment at time 8 months)? And why the bond is now priced
again at par?

E.28 In a market, the following securities are traded: ZCB maturity 1 year, face value
2 000 euro, current price 1 941.75 euro; ZCB maturity 2 years, face value 1 000
euro, current price 938.04 euro; ZCB maturity 3 years, face value 500 euro, cur-
rent price 450.98 euro.

(a) Calculate the spot rates for all maturities.

(b) Calculate the mean duration of a portfolio consisting of 10 units of 1-year
ZCB, 20 units of 2-years ZCB and 10 units of 3-years ZCB. To increase the
mean duration of the portfolio, which security should we underwrite in
higher quantity?

5
E.29 The following securities are traded: ZCB, time to maturity 3.73 years, face value
1 000 euro; coupon-bearing bond, time to maturity 4 years, face value 100 euro,
annual coupon, coupon rate 5%. The term structure is flat and the annual inter-
est rate (for all maturities) is 3%.

(a) Calculate the price and the mean duration of the ZCB and the coupon-
bearing bond.
(b) Which is the security whose price (in relative terms) is more sensible to
interest rate movements? Explain why.
(c) Assume that the interest rate falls down to 2.5%. Calculate the new prices
of the ZCB and of the coupon-bearing bond. Check whether the answer
to the previous question is correct, by calculating the rate of change of the
price of each security (i.e., the change of the price as a percentage of the
initial price).
(d) Set again the interest rate to 3%. Calculate the second order mean duration.
With this further piece of information, what can you tell about the price
volatility of the two securities?

E.30 We invest 20 000 euro, underwriting ZCBs with face value 1 euro and maturity
respectively after 1 and 3 years. The annual market interest rate (for all the
maturities) is 2%.

(a) Check that if we underwrite 15 300 units of ZCB with maturity 1 year and
5 306.04 units of ZCB with maturity after 3 years, the investment is immu-
nized over a time-horizon of 1.5 years.
(b) Check that if we underwrite 10 200 units of ZCB with maturity 1 year and
10 612.08 units of ZCB with maturity after 3 years, the investment is im-
munized over a time-horizon of 2 years. Why the number of units of ZCB
with maturity 3 years is higher than in the previous case, while the number
of units of ZCB with maturity 1 year is lower?

E.31 We purchase 9.804 units of ZCB with maturity after 2 years, face value 1 000
euro, and 10.2 units of ZCB with maturities 4 years, face value 1 000 euro. This
serves to guarantee that 20 000 euro will be available at time 3. The current
annual interest rate is 2%, for all the maturities.

(a) Check that the investment is immunized over the time-horizon of 3 years.
(b) Assume that there is no change in the interest rate. Check whether the
investment is still immunized after 1 year.
(c) Assume that at time 1 there is a change in the interest rate, which rises to
2.5% per year, for all the maturities. Check whether the investment is still
immunized.

6
A NSWERS

E.1 (a) Accumulated value after t years since issue: V (t) = S · (1 + it).
Accumulated value after 2 years since issue:
V (2) = 5 000 · (1 + 0.03 · 2) = 5 300 euro.
Accumulated value at maturity: V (4) = 5 000 · (1 + 0.03 · 4) = 5 600 euro.
(b) Interest per unit of accumulated value (and per unit of time)
V (1)−V (0) ·0.03
1st year: i1 = V (0)
= 5 000
5 000 = 0.03;
V (2)−V (1) 000·0.03
2nd year: i2 = V (1)
= 55 000 ·1.03 = 0.02913;
V (3)−V (2) ·0.03
3rd year: i3 = V (2)
= 5 0005 000
·(1+0.03·2)
= 0.02830;
V (4)−V (3) ·0.03
4th year: i4 = V (3)
= 5 0005 000
·(1+0.03·3)
= 0.02752.
Such interest rates are decreasing, given that the linear law is used (and
the simple interest rate is constant). In each year, the interest amount is
proportional to the initial amount, and then as a percentage of the accu-
mulated value it decreases.
E.2 (a) Accumulated value after t years since issue: V (t) = S · (1 + i )t .
Accumulated value after 2 years since issue:
V (2) = 5 000 · 1.032 = 5 304.50 euro.
Accumulated value at maturity: V (4) = 5 000 · 1.034 = 5 627.54 euro.
[In Excel, you can use the function FV.]
(b) Interest per unit of accumulated value (and per unit of time)
V (1)−V (0) ·0.03
1st year: i1 = V (0)
= 5 000
5 000 = 0.03;
V (2)−V (1) ·1.03·0.03
2nd year: i2 = V (1)
= 5 000
5 000·1.03 = 0.03;
V (3)−V (2) ·1.032 ·0.03
3rd year: i3 = V (2)
= 5 000
5 000·1.032
= 0.03;
V (4)−V (3) ·1.033 ·0.03
4th year: i4 = V (3)
= 5 000 = 0.03.
5 000·1.033
[In Excel, you can use the function RATE.]
Such interest rates are constant, given that the exponential law is used (and
the interest rate is constant). In each year, the interest amount is propor-
tional to the current accumulated value, and then as a percentage of the
accumulated value it stays constant.
E.3

1.03t
1 + 0.03t
1.03

1 t

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 Remark: The two functions intersect at time 1 (and at time 0). The accumulation
factors f (t) = 1.03t and f (t) = 1 + 0.03t are equivalent for t = 1. This is why in
Exercise E.2 the accumulated value at time 2 an 4 is higher than what found in
Exercise E.1.

E.4 (a) Accumulated value at maturity: V (3) = 8 000 · 1.022 · 1.025 = 8 531.28
euro.
(b) Interest per unit of accumulated value
·0.02
1st year: i1 = 8 000
8 000 = 0.02;
8 000·1.02·0.02
2nd year: i2 = 8 000·1.02 = 0.02 (thus: i2 = 2%, i.e. i2 = compound
interest rate of the 2nd year);
·1.022 ·0.025
3rd year: i3 = 8 0008 000·1.022
= 0.025 (thus: i3 = 2.5%, i.e. i3 = compound
interest rate of the 3rd year).
(c) Average return to maturity: interest rate iave such that
1.022 · 1.025 = (1 + iave )3 . We find: iave = (1.022 · 1.025)(1/3) − 1 = 2.1664%.
Such a rate is a weighted average of 2% and 2.5%, where most of the time
the 2% has been gained. This is why it takes a value lower than the simple
(arithmetic) average of the two rates.

E.5 (a) Yield to maturity under the linear law:

rate iS such that 2 500 = 2 400 · (1 + iS ). It turns out: iS = 0.04167.
Yield to maturity under the exponential law:
rate iC such that 2 500 = 2 400 · (1 + iC ). It turns out: iC = 0.04167, i.e.
iC = iS [to calculate iC , you can use the function RATE in Excel].
(b)

1.04167t
1 + 0.04167t
1.04167

1 t

Remark: Taking the year as the time-unit, the two functions intersect at
time 1 (and at time 0). The accumulation factors f (t) = 1.04167t and f (t) =
1 + 0.04167t are equivalent for t = 1.

E.6 (a) Yield to maturity under the linear law:

rate iS such that 2 500 = 2 350 · (1 + iS · 1.5) (remark: having to calculate
the annual rate, time is measured in years). It turns out: iS = 0.04255.
Yield to maturity under the exponential law:
rate iC such that 2 500 = 2 350 · (1 + iC )1.5 . It turns out: iC = 0.04211.

8
 (b)

1.04211t

1.06383 1 + 0.04255t

1.5 t

Remark: Taking the year as the time-unit, the two functions intersect at
time 1.5 (and at time 0). The accumulation factors f (t) = 1.04211t and
f (t) = 1 + 0.04255t are equivalent for t = 1.5. Note that since the equiva-
lence falls at a time t > 1, we have iC < iS .

E.7 Since the interest rate is annual, time must be measured in years.

(a) Accumulation factors: f (0.25) = 1 + 0.10 · 0.25 = 1.025;

f (0.5) = 1 + 0.10 · 0.5 = 1.05; f (1) = 1 + 0.10 = 1.10.
1 1
(b) Discount factors: v(0.25) = 1.025 = 0.97561; v(0.5) = 1.05 = 0.95238;
1
v(1) = 1.10 = 0.90909.
E.8 Since the interest rate is annual, time must be measured in years.

(a) Accumulation factors: f (0.25) = 1.100.25 = 1.02411;

f (0.5) = 1.100.5 = 1.04881; f (1) = 1.10.
(b) Discount factors: v(0.25) = 1.10−0.25 = 0.97645;
v(0.5) = 1.10−0.5 = 0.95346; v(1) = 1.10−1 = 0.90909.

Given that the interest rate is the same for the two laws, for t < 1, the simple
interest accumulation factor (discount factor) is lower (higher) than the expo-
nential accumulation factor.
1
E.9 (a) Equation defining the price: 4 800 = 5 000 · 1+ iS ;
thus: iS = 45 800
000
− 1 = 0.04167.
(b) Equation defining the price: 4 800 = 5 000 · (1 + iC )−1 ;
thus: iC = 45 800
000
− 1 = 0.04167.
(c) Equation defining the price: 4 800 = 5 000 · (1 − d);
thus: d = 1 − 54 000
800
= 0.04.

9
 (d)

1
1
0.96 1+0.04167t
1.04167−t
1−0.04t

1 t

Remark: The three functions intersect at time 1 (and time 0). The discount
1
factors v(t) = 1+0.04167t , v(t) = 1.04167−t and v(t) = 1 − 0.04t are equiva-
iC
lent for t = 1. It turns out: d = 1+ iC and iS = iC .
E.10

1 000 500
| | | | | |
Date: 1/1 1/2 31/3 1/6 30/6 31/8
1 5 8
Time: 0 12 0.25 12 0.5 12 Years

Balance on 31/8/2018:
V (8/12) = 1 000 · (1 + 0.015 · 122 ) · (1 + 0.015 · 123 ) · (1 + 0.015 · 2
12 )
+ 500 · (1 + 0.015 · 121 ) · (1 + 0.015 · 122 )
= 1 510.65 euro

E.11 (a) 6-months interest rate: i1/2 = 0.052 = 0.025;

annual effective interest rate: i = 1.0252 − 1 = 0.05062.
(b) 3-months interest rate: i1/4 = 0.054 = 0.0125;
annual effective interest rate: i = 1.01254 − 1 = 0.05095.
(c) Monthly interest rate: i1/12 = 0.05
12 = 0.00417;
annual effective interest rate: i = 1.0041712 − 1 = 0.05116.
(d) Daily interest rate: i1/360 = 0.05
360 = 0.00014;
annual effective interest rate: i = 1.00014360 − 1 = 0.05127.
(e) If k → ∞, i(k) represents the short rate (r);
annual effective interest rate: i = er − 1 = 0.05127.
[In Excel, to calculate the annual effective interest rate you can use the
function EFFECTIVE.]
E.12 We can refer, for example, to the accumulation factor.
Simple interest: f (3) = 1 + 0.05 · 3 = 1.15;
f (2) · f (1) = (1 + 0.05 · 2) · 1.05 = 1.155.
Thus: f (3) 6= f (2) · f (1).
Compound interest: f (3) = 1.053 = 1.15763;
f (2) · f (1) = 1.052 · 1.05 = 1.053 = f (3) = 1.15763.

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E.13 (a) The 1-year ZCB joint to the forward transaction provide the same inflows
than the 2-years ZCB, but at a different price. It is convenient to short-sale
the 2-years ZCB (whose price is higher than the replicating strategy).
Arbitrage portfolio
Transaction Cashflow at time 0 Cashflow at time 1 Cashflow at time 2
Short-sale of the 2-years ZCB 942.60 –1 000
Purchase of the forward transaction –966.18 1 000
Purchase of the 1-year ZCB –938.04 966.18
balance 4.56 0 0

(b) The arbitrage portfolio involves three transactions; thus, expenses amount
to 7.50 euro in total. Transaction costs are higher than the profit, and hence
it is not convenient to exploit the arbitrage opportunity.

E.14 Price: V (0) = 1 000 · a 5 0.03 = 4 579.71 euro

[Function PV in Excel].

E.15 We must have: 100 000 = b · s 60 i

1/12
, with i1/12 = 1.031/12 − 1 = 0.00247. It turns
out: b = 1 548.44 euro.
[Use the function PMT for calculating b; you can use the function NOMINAL to
calculate i(12) and then, dividing by 12, you obtain the monthly interest rate
i1/12 ].
1
E.16 Value: V (0) = 10 000 · 0.04 = 250 000 euro.

E.17 We must have: 100 000 = b · a 96 i , with i1/12 = 0.12

12 = 0.01. It turns out:
1/12
b = 1 625.28 euro.

E.18 We must have: 100 000 = 1 500 · a 96 i . If i(12) = 9.6%, then i1/12 = 0.096
1/12 12 =
0.8%. We find: 1 500 · a 96 0.008 = 100 245.03 > 100 000 euro. Thus, the annual
nominal interest rate applied by the bank is not i(12) = 9.6%, but higher. If i =
10%, then i1/12 = 1.11/12 − 1 = 0.797%. Considering the result obtained with
i1/12 = 0.8%, we can conclude that the annual effective interest rate applied by
the bank is higher than 10%.

E.19 We must have: 150 000 = 900 · a m i1/12 , with i1/12 = 1.031/12 − 1 = 0.00247. It
turns out: 900 · a 204 0.00247 = 144 088.41 < 150 000 euro, where 204 = 17 · 12 is
the duration in months. After 17 years, there will still be money available for
further withdrawals.

E.20 (a) Monthly payments: from 300 000 = b · s 180 i

1/12
(where i1/12 = 1.031/12 − 1 =
0.00247), we find b = 1 326.03 euro.
(b) Amount accumulated at time 5 (years): F5 = 1 326.03 · s 60 0.00247 = 85 636.22
euro.
0
(c) New monthly interest rate from time 5: i1/12 = 1.041/12 − 1 = 0.00327.
Updated monthly payments: from 300 000 = 85 636.22 · 1.0410 + b0 · s 120 0.00327 ,
we find: b0 = 1 180.93.

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E.21 (a) Annual payment: from 300 000 = b · a 10 0.06 , we find b = 40 760.39 euro.
(b) Amortization table:

t Ct It bt Dt it
0 − − − 300 000 −
1 22 760.39 18 000.00 40 760.39 277 239.61 6%
2 24 126.01 16 634.38 40 760.39 253 113.60 6%

(c) Updated amount of the annual payment: from 253 113.60 = b0 · a 8 0.065 , we
find b0 = 41 570.69 euro.

E.22 (a) Annual payment: from 200 000 = b · a 10 0.10 , we find b = 32 549.08 euro.
Amortization table:

t Ct It bt Dt
0 − − − 200 000
1 12 549.08 20 000.00 32 549.08 187 450.92
2 13 803.99 18 745.09 32 549.08 173 646.93
3 −17 364.69 17 364.69 0.00 191 011.63
4 −19 101.16 19 101.16 0.00 210 112.79

(c) Outstanding balance at time 4: D4 = D2 · 1.12 = 210 112.79 euro (alterna-

tively, you can obtain this amount from the amortization table, by inserting 0
for b3 and b4 , as shown above).
(d) Updated annual payment: from D4 = b0 · a 6 0.10 , we obtain b0 = 48 243.45
euro.

E.23 (a) NPV: NPV (0.08) = −100 000 + 20 000 · 1.08−1 + 40 000 · 1.08−2 + 60 000 ·
1.08−3 = 442.01 euro. Since NPV (0.08) > 0, then IRR> 8%. Since NPV (0.08) is
small in respect of the cash value of the transaction (which is NPV (0) = 20 000
euro), a reasonable guess for the IRR could be 8.5% (the actual value of the IRR
is 8.208%).
(b) NPV: NPV (0.08) = −100 000 + 40 000 · a 3 0.08 = 3 083.88 euro. The value is
higher because money is cashed earlier (on average).

E.24 (a) NPV: NPV (0.07) = −100 000 + 25 000 · a 5 0.07 = 2 504.94 euro.
(b) APV: APV (0.07) = −50 000 + (25 000 − b) · a 5 0.07 = NPV (0.07) + 50 000 −
b · a 5 0.07 = 1 158.89 euro (where b = 50
a
000
= −12 522.82 euro). The value is
5 0.08
lower because the cost of the loan is higher than the opportunity cost of capital.

E.25 (a) Spot rates: i0 (1) = v0 (1)−1 − 1 = 2.2%; i0 (2) = v0 (2)−1/2 − 1 = 2.5%;
i0 (3) = v0 (3)−1/3 − 1 = 3%.
v0 (2) v0 (3)
(b) Forward prices: v0|1 (1) = v0 (1)
= 0.97275; v0|1 (2) = v0 (1)
= 0.93528;
v0 (3)
v 0|2 (1 ) = v0 (2)
= 0.96147.
Forward rates: i0|1 (1) = v0|1 (1)−1 − 1 = 2.80%; i0|1 (2) = v0|1 (2)−1/2 − 1 =

12
 3.4%; i0|2 (1) = v0|2 (1)−1 − 1 = 4.01%.
The term structure is increasing; due to the no-arbitrage condition:
(1 + i0 (2))2 = (1 + i0 (1)) · (1 + i0|1 (1)). Since i0 (1) < i0 (2), then we find
i 0|1 (1 ) > i 0 (2 ).
(c) No-arbitrage price: V (0) = 35 · v0 (1) + 35 · v0 (2) + 1 035 · v0 (3) = 1 014.73
euro. Yield to maturity: rate i such that 1 014.73 = 35 · (1 + i )−1 + 35 · (1 +
i )−2 + 1 035 · (1 + i )−3 . The yield to maturity is a weighted average of the
market rates, so that 2.2% < i < 3%. The yield to maturity should be close
to 3%, given the magnitude of the last cashflow in respect of the previous
ones. The bond is quoted above par because its coupon rate is higher than
the market rates. For the same reason, its yield to maturity is lower than
its coupon rate.
1·35·v0 (1)+2·35·v0 (2)+3·1 035·v0 (3)
(d) Mean duration: D = 1 014.73 = 2.9 years.
− 1 − 2 +3·1 035·1.0298−3
Flat-yield duration: D = 1·35·1.0298 +2·35·11.0298
014.732.9 years; =
the approximation is not apparent (an approximation is present, given that
in the numerator the spot prices are replaced by the discount factors based
on the yield to maturity).
(e) If the actual price of the bond is 1 000 euro, it is underpriced. It is conve-
nient to buy it, short-selling the replicating portfolio. Arbitrage deal:

Transaction Cashflows in t = 0 Cashflows in t = 1 Cashflows in t = 2 Cashflows in t = 3

Purchase 1 unit bond –1 000 35 35 1 035
Short-sale of 35 units 1-year ZCB 35 · 0.97847 –35
Short-sale of 35 units 2-years ZCB 35 · 0.95181 –35
Short-sale of 1 035 units 3-years ZCB 1 035 · 0.91514 –1 035
balance 14.73 0 0 0

E.26 From the no-arbitrage condition: 1 037.21 = 40 · v0 (1) + 40 · v0 (2) + 1 040 · v0 (3),
1 037.21−40·v0 (1)−40·v0 (2)
we find: v0 (3) = 1 040 = 0.92318.
E.27 (a) Price: V (0) = 100 euro; the bond is priced at par, given that the yield to
maturity is the same as the coupon rate.
−1 +5·105·1.05−5
Mean duration: D0 = 1·5·1.05 +...100 = 4.546 years.
8
(b) Price: V ( 12 ) = 5 · 1.05−4/12 + . . . + 105 · 1.05−5+8/12 = 100 · 1.058/12 =
103.31 euro; the bond is no longer priced at par because if we buy the
8
bond at time 12 we must pay the share of the first coupon that we have not
earned.
8
Mean duration: D 8 = D0 − 12 = 3.879, given that nothing has changed in
12
the structure of the transaction (and the interest rate has not changed).
(c) Price: V (1) = 100 euro; the bond is priced at par, given that the yield to
maturity is the same as the coupon rate (and we must await one whole
year before the next annual coupon payment).
−1 ... +4·1.05−4
Mean duration: D1 = 1·1.05 +100 = 3.723 years. The structure of the
transaction has changed, as now we are facing just four inflows (instead
of five; the first coupon has been cashed). At time 1, there is a jump in the
time-profile of the mean duration; thus, D1 > D0 − 1.

13
   −1  −1/2
1 941.75 938.04
E.28 (a) Spot rates: i0 (1) = 2 000 − 1 = 3%; i0 (2) = 1 000 −1 =
 −1/3
3.25%; i0 (3) = 450.98
500 − 1 = 3.499%.
(b) Mean duration: D = 1·1010·1·1941.75 +2·20·938.04+3·10·450.98
941.75+20·938.04+10·450.98 = 1.651 years. To in-
crease the mean duration, securities with a mean duration higher than
1.651 must be purchased in higher quantity, thus 2-years or 3-years ZCB.
E.29 (a) Price of the ZCB: VZCB (0; 3%) = 1 000 · 1.03−3.73 = 895.61 euro.
Mean duration of the ZCB: DZCB = 3.73.
Price of the bond: Vbond (0; 3%) = 5 · a 4 0.03 + 100 · 1.03−4 = 107.43 euro.
1·5·1.03−1 +...+4·105·1.03−4
Mean duration of the bond: Dbond = 107.43 = 3.73 years.
(b) If we just consider the mean duration, the volatility of the price of the two
securities is the same. However, considering also the time to maturity, we
should expect that for the bond the volatility is stronger.
(c) New price of the ZCB: VZCB (0; 2.5%) = 1 000 · 1.025−3.73 = 912.01 euro.
New price of the bond: Vbond (0; 2.5%) = 5 · a 4 0.025 + 100 · 1.025−4 = 109.40
VZCB (0;2.5%)
euro. Rate of change of the price of the ZCB: VZCB (0;3%)
− 1 = 1.832%; rate
Vbond (0;2.5%)
of change of the price of the bond: −1 =
1.834%. The mag-
Vbond (0;3%)
nitude of the rate of change of the price of the two securities is similar (as
witnessed by the value of the mean duration); however, there is a (slightly)
stronger change for the price of the bond.
(2)
(d) Second order mean duration of the ZCB: DZCB = 3.732 = 13.91. Second or-
(2) 2 −1 2 −4
der mean duration of the bond: Dbond = 1 ·5·1.03 +107.43...+4 ·105·1.03
= 14.50.
The higher value of the second order mean duration of the bond suggests
a stronger convexity of the price of the bond in respect of the ZCB; thus,
the volatility of the price of the bond is higher than for the ZCB, as we have
checked in the previous calculation.
E.30 (a) We must check that the following equalities hold:
• Current value: 15 300 · 1.02−1 + 5 306.04 · 1.02−3 = 20 000 euro;
−1 3·5 306.04·1.02−3
• Mean duration: 1·15 300·1.02 20+000 = 1.5 years.
It is not necessary to investigate the second-order mean duration, as the
liability consists of only one cashflow.
(b) We must check that the following equalities hold:
• Current value: 10 200 · 1.02−1 + 10 612.08 · 1.02−3 = 20 000 euro;
−1 +3·10 612.08·1.02−3
• Mean duration: 1·10 200·1.02 20 000 = 2 years.
The number of units of ZCB with maturity 3 years is higher because the
required mean duration is higher than in the previous case.
E.31 (a) We must check that the following equalities hold:
• Current value: 9.804 · 1 000 · 1.02−2 + 10.2 · 1 000 · 1.02−4 = 20 000 ·
1.02−3 euro;

14
 2·9.804·1 000·1.02−2 +4·10.2·1 000·1.02−4
• Mean duration: 20 000·1.02−3
= 3 years.
It is not necessary to investigate the second-order mean duration, as the
liability consists of only one cashflow.
(b) • Current value of the assets: 9.804 · 1 000 · 1.02−1 + 10.2 · 1 000 · 1.02−3 =
19 223.38 euro;
• Current value of the liabilities: 20 000 · 1.02−2 = 19 223.38 euro;
• Asset mean duration: 3 − 1 = 2 years, as no change has occurred since
time 0;
• Liability mean duration: 2 years.
Thus, the investment is still immunized, given that both the value and the
mean duration of assets coincide with those of the liabilities.
(c) • Current value of the assets: 9.804 · 1 000 · 1.025−1 + 10.2 · 1 000 · 1.025−3 =
19 036.52 euro;
• Current value of the liabilities: 20 000 · 1.025−2 = 19 036.29 euro;
−1 −3
• Asset mean duration: 1·9.804·1 000·1.025 +3·10.2·1 000·1.025
20 000·1.025−3
= 1.995 years.
• Liability mean duration: 2 years.
The investment is no longer immunized, as the asset value is slightly higher
than the liability value, and its mean duration is lower. The portfolio re-
quires to be rebalanced.

15