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S.A. Ross, R.W. Westerfield, and J. Jaffe (2010),

Corporate Finance, 9th ed., McGraw-Hill.

FIN3073: Financial Mathematics

---- Course Intended Learning Objectives (CILOs)

finance and portfolio optimization, return forecasting models,

CILO 1

regression techniques in finance and CAPM, event studies and

capital market anomalies.

CILO 3

financial data.

Financial Mathematice 2

Course Outline

Lecture 1: Time Value of Money (basic interest theory)

Lecture 2: Derivatives (futures, options, swaps, etc.)

Lecture 3: Interest Rates (advanced interest theory)

Assignment 1 (due in one week)

Lecture 4: Capital Asset Pricing Model (CAPM)

Lecture 5: Binomial Trees (for pricing financial instruments)

Midterm Review/Exam (2 hours, close-book)

Lecture 6: Winner Process and Itos Lemma

Lecture 7: The Black-Scholes-Merton (BSM) Model

Assignment 2 (due in one week)

Financial Mathematice 3

Textbook & References

John C. Hull, Options, Futures & Other Derivatives, 9th/8th

ed., Prentice Hall, 2014/2012.

D. Jordan. Corporate Finance, 11th/9th ed., McGraw-Hill, 2015/2010.

2. Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan.

Fundamentals of Corporate Finance, 11th ed., McGraw-Hill, 2015.

3. Marek Capinski and Tomasz Zastawniak, Mathematics for Finance: An

Introduction to Financial Engineering, Springer, 2003.

4. Steven E. Shreve, Stochastic Calculus for Finance I, Springer, 2004.

5. Steven E. Shreve, Stochastic Calculus for Finance II, Springer, 2004.

Financial Mathematice 4

Useful Information

Lecturer: Dr. Ming-Lu Wu

Office: B-106 Email: MLWu@uic.edu.hk

Phone: 3620647 / 15819444601

Teaching Assistant: Ms. Sunny Ouyang

Office: C119A Email: OuyangSunny@uic.edu.hk

Phone: 3620295 / 15992638275

Course Assessments:

Class Attendance & Discussions 10%

Two (2) Assignments 20%

Midterm Test (Week 8 or 9) 20%

Final Exam 50%

Total 100%

Financial Mathematice 5

Time Value of Money

Time Value of Money

The relationship between present value and future value of money:

A dollar today is worth more than a dollar tomorrow.

comparing values. Three rules govern these processes:

Financial Mathematice 6

Basic Definitions

Present value todays money on a time line.

Future value money in later periods on a time line.

Interest rate exchange rate between earlier money and later

money.

Other names for interest rate

Discount rate

Cost of capital

Opportunity cost of capital

Required return

Financial Mathematice 7

Cash Flows over a Time Line

To help make things clear, drawing a time line could be a

useful step.

Cash flow at period 2

discounting compounding

C0 C1 C2

t=0 1 2 .

Convention:

Discounting and compounding

are done with interest rate (r). Positive cash inflow

Negative cash outflow

Financial Mathematice 8

Future Values: General Formula

FV

PV

(1 r ) n This is the relationship

where between PV and FV,

FV = future value

PV = present value

n = number of periods

1

Present value interest factor =

(1 r) n

Financial Mathematice 9

Annual Percentage Rate (APR)

This is the annual interest rate that is often stated in practice.

By definition APR = period rate times the number of periods per year.

Examples:

What is the APR if the monthly rate is 0.5%?

0.5% 12 = 6%

0.5% 2 = 1%

compounding?

12% / 12 = 1%.

Financial Mathematice 10

Effective Annual Rate (EAR)

This is the actual rate paid (or received) after accounting

for compounding that occurs during the year.

different compounding periods, you need to compute the

EAR and use that for comparison.

number (m) of periods per year it will NOT give you

the period rate.

Financial Mathematice 11

Effective Annual Rates and Compounding Periods

Effective annual rate (EAR) formula:

m

APR

EAR 1 1

m

where m = compounding frequency (number of periods) per year.

Examples

$1,000 invested for one year at 12% p.a. (per annum):

1,000 (1 + 0.12) = 1,120 EAR = 12%

$1,000 invested for one year at 12% p.a. compounded monthly:

1,000 (1 + 0.12/12)12 = 1,126.83 EAR = 12.683%

$1,000 invested for one year at 12% p.a. compounded daily:

1,000 (1 + 0.12/365)365 = 1,127.47 EAR = 12.747%

Financial Mathematice 12

PV Example

You are considering an investment that will pay you C1 = $1,000

in one year, C2 = $2,000 in two years, and C3 = $3,000 in three

years. If you want to earn r = 10% annually on your money, how

much (P0) would you like to make investment today?

PV1 = C1 / (1 + r)1 = 1,000 / (1.1)1 = 909.09.

PV2 = C2 / (1 + r)2 = 2,000 / (1.1)2 = 1,652.89.

PV3 = C3 / (1 + r)3 = 3,000 / (1.1)3 = 2,253.94.

P0 = 909.09 + 1,652.89 + 2,253.94 = $4,815.92.

With initial investment P0 = $4,815.92 and an annual interest rate r = 10%,

you can get the mentioned three future payments ---- no more, no less.

With another initial investment (at another rate), you will get more or less

than the mentioned three future payments.

The difference is called net present value (NPV) of the investment.

Financial Mathematice 13

NPV of an Investment

Suppose an investment (or a project) can be acquired now

(time 0) at price or cost P0 > 0, which can produce non-

negative cash flows C1, ..., Cn at future times 1, , n.

The appropriate discount (or return, interest) rate is r (per period).

Then the net present value (NPV) of the investment is the

present value of its future cash flows C1, ..., Cn minus its

initial price or cost: NPV = k=1~n Ck/(1+r)k P0.

If NPV is positive, you should make the investment (with an initial cash

amount P0 to receive the future cash flows of C1, ..., Cn).

In the previous Example, if you can acquire the investment at a

lower price, say $4,500, you should do it since it has a

positive NPV of 4,815.92 4,500 = $815.92.

Financial Mathematice 14

Simplifications

Applying the PV equation all the time could be

troublesome. We want to find some simplifications.

When the cash flows follow certain patterns, we

may be able to use formulas to calculate the

present values.

Perpetuity

Cash Flow

1. Constant cash flow. Growing Perpetuity

2. Cash flow growing at a constant rate g.

Time Frame Annuity

1. Goes to infinity.

Growing Annuity

2. Stop after T periods.

Financial Mathematice 15

Simplifications

After understanding the concept of Present Value, we could have

some simplifications if some assumptions are met.

Perpetuity

A constant stream of cash flows that lasts forever.

Growing perpetuity

A stream of cash flows that grows at a constant rate forever.

(Ordinary) Annuity

A stream of constant cash flows that lasts for a fixed number

of periods.

Growing annuity

A stream of cash flows that grows at a constant rate for a

fixed number of periods.

Financial Mathematice 16

Perpetuity

A constant stream of cash flows that lasts forever.

Cash flows are the same in every period.

C C C

0 1 2 3

C C C C

PV 0

(1 r ) (1 r ) 2

(1 r ) 3

r

Financial Mathematice 17

Proof of Perpetuity Formula

Sum of geometric series (of n terms):

Sumn = a + aq + aq2 + + aqn-1 = a(1 qn)/(1 q).

If | q | < 1, then qn 0 when n .

So sum of infinite geometric series: Sum = a/(1 q).

For our perpetuity,

a = C/(1 + r) and q = 1/(1 + r) < 1.

So: PV0 = C/(1 + r) + C/(1 + r)2 + C/(1 + r)3 +

= a + aq + aq2 +

= a/(1 q) = [C/(1 + r)][1 1/(1 + r)] = C/r.

Financial Mathematice 18

Perpetuity: Example

to pay 15 every year for ever?

The interest rate is 10% annually.

15 15 15

0 1 2 3

15

PV 0 150

0 .10

Financial Mathematice 19

Growing Perpetuity

A stream of cash flows that grows at a constant rate and lasts forever.

C C(1+g) C(1+g)2

0 1 2 3

C C (1 g ) C (1 g ) C 2

PV 0

(1 r ) (1 r ) 2

(1 r ) 3

rg

Need to assume: g < r !

Financial Mathematice 20

Growing Perpetuity: Example

The expected dividend next year is $1.30, and dividends are

expected to grow at 5% forever.

If the discount rate is 10% annually, what is the value of this

promised dividend stream?

0 1 2 3

$ 1 .30

PV 0 $ 26 .00

0 .10 0 .05

Financial Mathematice 21

(Ordinary) Annuity

for a fixed number of periods.

Simplification: PV0 = C[1 1/(1 + r)n]/r = CAr,n,

FVn = C[(1 + r)n 1]/r = C(1 + r)nAr,n,

where Ar,n = [1 1/(1 + r)n]/r is the (unit) annuity factor.

Example: $100 $100 $100 (r = 10%)

0 1 2 3

PV0 = 100[1 1/(1 + 10%)3] / 10% = 249,

FV3 = 100[(1 + 10%)3 1] / 10% = 331 [= 249(1.1)3].

Financial Mathematice 22

Annuity Present Value Formula

Annuity cash flow line:

C C C C

0 1 2 3 n

C C C C

PV 0

(1 r ) (1 r ) 2

(1 r ) 3

(1 r ) n

{ denoting: a = C/(1 + r) and q = 1/(1 + r) }

= a + aq + aq2 + + aqn-1 = a(1 qn)/(1 q).

= [C/(1 + r)] [1 1/(1 + r)n] / [1 1/(1 + r)]

C 1

= C[1 1/(1 + r)n]/r = CAr,n 1

n

r 1 r

Financial Mathematice 23

Annuity PV Example: assume monthly compounding

If you can afford a $400 monthly car payment-by-

installments (), how much is the car you can

afford if stated annual interest rate, called annual

percentage rate (APR), is 7% on a 36-month loan?

0 1 2 3 36

$ 400 1

PV 0 1 36

$ 12 ,954 .59

0 .07 / 12 (1 0 .07 12 )

Financial Mathematice 24

Ordinary Annuity Another Example

Your mother bought an annuity from Rock Solid Insurance

Company for $200,000 when she retired. In exchange for the

$200,000, Rock Solid will pay her $25,000 per year until she

dies. The interest rate is 5%. How long must she live after she

retired to get more in value than what she paid in?

200,000 < PV of annuity = 25,000[1 1/(1 + 5%)n] / 5%.

8 < (1 1/1.05n) / 0.05 0.4 < 1 1/1.05n.

1/1.05n < 0.6 1/0.6 < 1.05n.

ln(1/0.6) < n ln(1.05) n > ln(1/0.6) / ln(1.05) = 10.47.

Financial Mathematice 25

Annuity: Future Value Formula

FV n PV 0 (1 r )

n C

r

1 r 1

n

Example: To provide for college education, you are

going to deposit $2,000 at the end of each year for

the next five years in a bank account where you will

earn 10% annual interest. Then how much will you

have at the end of five years?

FV5 = C[(1 + r)n 1]/r

= 2,000[(1 + 0.1)5 1] / 0.1

= 2,000(6.1051) = $12,210.2.

Financial Mathematice 26

Annuity Due

An annuity due is a stream of constant cash flows, paid at the

beginning of each period, that lasts for a fixed number of periods.

(for ordinary annuity, cash flows come at the end of periods.)

$100 $100 $100 $100 $100 $100

|---------|---------|--------|---------| (r = 10%) |---------|--------|---------|

-1 0 1 2 3 0 1 2 3

annuity due ordinary annuity

Method 1: Annuity due value = ordinary annuity value (1+r)

PV-1

PV0 = C 1 (1 + r) CAr,n (1 + r),

1

r 1 r n

PV0 = 100A10%,3 (1.1) = 100(1/1.1 + 1/1.12 + 1/1.12) 1.1 = 273.55.

Method 2: PV0 = C + CAr,n-1.

PV0 = 100 + 100A10%,2 = 100 + 100(1/1.1 + 1/1.12) = 273.55.

Financial Mathematice 27

Annuity Due Example

You want to buy a new sports car from Muscle Motors for

$65,000. The contract is in the form of a 48-month annuity due

at a 6.45% APR. What will your monthly payment be?

PV-1 = CAr,n = C[1 1/(1 + r)n]/r.

PV0 = PV-1 (1 + r) = CAr,n (1 + r) = 65,000.

C = 65,000 / [Ar,n (1 + r)].

r = 6.45% / 12 = 0.005375, n = 48,

Ar,n = (1 1/1.00537548)/0.005375 = 42.2085204.

C = 65,000/(42.20852041.005375)

= $1,531.74.

Financial Mathematice 28

Growing Annuity

A stream of cash flows that grows at a constant rate (g)

over a fixed number of periods.

C C(1+g) C(1+g)2 C(1+g)n-1

0 1 2 3 n

C C (1 g ) C (1 g ) 2 C (1 g ) n 1

PV 0

(1 r ) (1 r ) 2

(1 r ) 3

(1 r ) n

The formula for the present value of a growing annuity:

C 1 g n

PV 0 1

rg 1 r

Financial Mathematice 29

Growing Annuity: Example

A defined-benefit retirement plan offers to pay you annually for

40 years. The first payment is $20,000 at the end of your first

retirement year. Later payments will increase by 3% each year.

What is the present value at retirement of these payments, if the

appropriate discount rate is 10%?

0 1 2 40

$ 20 ,000 1 .03

40

0 .10 0 .03 1 .10

Financial Mathematice 30

Formula Review

Cn

Single Payment: P V0 F Vn C 0 1 r

n

(1 r ) n

Multi-Payments:

C

Perpetuity PV0

r

C 1

Annuity PV 0 1

r 1 r n r

FV n 1 r 1

C n

C

Growing Perpetuity PV 0

rg

C 1 g

n

Growing Annuity PV 0 1

rg 1 r

Financial Mathematice 31

Exercise Question 1

Mark has been working on an advanced technology in laser

eyes surgery. His technology will be available in the near term.

He anticipates his first annual cash flow from the technology

to be $215,000, received two years from today. Subsequent

annual cash flows will grow at 4% in perpetuity.

What is the present value of the technology if the discount rate

is 10%?

Solution:

PV1 = C/(r g) = 215,000/(10% 4%) = 3,583,333.33.

PV0 = PV1 /(1 + r) = 3,583,333.33/(1 + 10%) = 3,257,575.76.

Financial Mathematice 32

Exercise Question 2

Your job pays you only once a year for all the work you did

over the previous 12 months.

Today, December 31, you just received your salary of $60,000,

for the past year, and you plan to spend all of it.

However, you want to start saving for retirement beginning

next year.

You have decided that one year from today you will begin

depositing 5% of your annual salary in a retirement account

that will earn 9% per year.

Your salary will increase at 4% per year throughout your

career.

How much money will you have on the date of your retirement

40 years from today?

Financial Mathematice 33

Exercise Question 2: Solution

Since your salary grows at 4% per year, your salary next year

will be: $60,000 (1 + 0.04) = $62,400.

This means your first deposit into the account next year will be:

$62,400(0.05) = $3,120.

Since your salary grows at 4% annually, you deposit will also

grow at 4% annually. We can use the present value formula of a

growing annuity to find the value of your deposits today:

C 1 g

n

3,120 1 0 .04

40

PV 0 1 1 = 52,861.98

rg 1 r 0 .09 0 .04 1 0 . 09

Now, we can find the future value of this lump sum in 40 years:

FV40 = PV0 (1 + r)40 = $52,861.98(1.09)40 = $1,660,364.12.

Financial Mathematice 34

Exercise Question 3: Buying a House

You are ready to buy a house and you have $20,000 for a

down (first) payment and closing (administrative) costs.

Closing costs are estimated to be 4% of the loan value.

You have an annual salary of $36,000 and the bank is willing to

allow your monthly mortgage payment to be equal to 28% of your

monthly income.

The interest rate on the loan is 6% per year with monthly

compounding (0.5% per month) for a 30-year fixed rate loan.

How much money will the bank loan you per month?

How much can you offer for the house?

Financial Mathematice 35

Exercise Question 3: Solution

Bank loan

Monthly income = 36,000 / 12 = $3,000

Maximum monthly mortgage payment = 0.28(3,000) = $840

Loan value = present value of all (360) mortgage payments:

PV0 = 840[1 1/1.005360] / 0.005 = $140,105

Total Price

1. Closing costs = 0.04(140,105) = $5,604

2. Down payment = 20,000 5,604 = $14,396

3. Total (House) Price = 140,105 + 14,396 = $154,501

Financial Mathematice 36

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