A cash ow is a series of payments over a period of time. A cash ow model projects the payments.
Cash ows depends on nature (inow /outow ), amount, timing and probability.
Cash ows can only be compared if their values are calculated for the same point of time.
Interest embodies time preference of agents (impatience), risk (risk premium) and ination.
The accumulation function a (t) is the accumulated value at time t for $1 at time 0.
The function represents the way money accumulates with the passage the time. I.e.
a (t + k)
A (t + k) = A (t) .
a (t)
A (t + k) A (t)
it,k =
A (t)
Homogeneity in time is when the eective rate of interest is the same for all t.
In this case it,k = a (k) 1, i.e. it is irrespective of t.
We have dierent ways of expressing interest rates, each way with a dierent set of assumptions.
Simple interest: no interest is ever earnt on interest. Interest only depends on initial principal.
It is NOT homogeneous in time, with:
a (t) = 1 + it
Here, eective rate of interest is decreasing (A (t) is increasing in the above formula).
Compound interest: interest is continuously earnt on interest.
It IS homogeneous in time, with:
a (t) = (1 + i)t
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The normal rate of interest i applies to principal now for interest calculated at t = 1.
The discount rate d applies to principal at the end of period for interest calculated at t = 0. In
other words, we consider the end-of-period amount to nd the current amount.
ia (0) = da (1)
1
1+i=
1d
d = iv
v =1d
t
1 1
For simple interest: a (t) = a (0) . For compound interest: a (t) = a (0) .
1 dt 1d
Nominal interest rates, i(m) , have several (m) compounding periods per year.
m
i(m)
1+i= 1+
m
Nominal discount rates, d(m) , similarly, has m compounding periods per year.
m
d(m)
1d= 1
m
This is a nominal interest rate, where the compounding frequency is increased to innity.
()
Similarly, we have a force of discount, d() , where 1 d = ed .
But force of interest = force of discount, i.e. i() = d() = , so:
= ln (1 + j) = ln (1 d)
Recall j is the equivalent annual eective interest rate and d is the discount rate.
d
(t) = ln a (t)
dt
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1+i
1+r =
1+
f (in )
in+1 = in
f (in )
where f (i) is the equation relating present values and cash ows.
1.3 Annuities
(p)
m| ax:n i
1.3.1 PERPETUITY
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Simon Stevin, a Dutch mathematician, developed the rst compound interest tables.
Blaise Pascal, a French mathematician and philosopher, gives birth to probability calculus.
Edmund Halley, a British mathematician and astronomer, builds the rst mortality table.
James Dodson, a British mathematician, was the rst to put all components together. In a 1756
lecture, he showed how:
a life insurance plan should be set up;
premium rates should be calculated;
reserves would build up.
Let Z be a continuous random variable that denotes the age-at-death, and (x) a life aged x.
The CDF of Z is FZ (x) = Pr (Z x) . That is, probability of the life dying before or at age x.
The survival function for a new-born is denoted as S (x) = Pr (Z > x) = 1 FZ (x). That is, the
probability that the new-born will survive until at least age x.
Future lifetime of a life aged x is denoted by T (x) = Z x. Its CDF is:
S (x) S (x + t) S (x + t)
FT (t) = t qx = =1
S (x) S (x)
t|u qx = Pr ((x) surviving next t years, and then dying in the next u years) = Pr (t < T (x) t + u)
S (x + t) S (x + t + u)
= = t+u qx t qx
S (x)
The hazard rate is also known as the failure rate function or force of mortality. It represents
the likelihood for the individual (x) to die in the next instant, and is dened as:
S (x) fZ (x)
(x) = =
S (x) 1 FZ (x)
x+t
d s (x + t)
Note we can rewrite (y) = ln s (y). By integrating we obtain (y) dy = ln ,
dy x s (x)
so:
x+t
S (x + t)
= t px = exp (y) dy
S (x) x
x
S (x) = exp (y) dy
0
x
FX (x) = 1 exp (y) dy
0
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As mentioned, the force of mortality represents the likelihood for the individual (x) to die in the
next instant, thus we obtain the probability of dying:
x
fX (x) = (x) exp (y) dy = (x) S (x)
0
x+t
fT (x) (t) = (x + t) exp (y) dy = (x + t) t px
x
Laws of mortality are models proposed for the hazard rate for human lives.
De Moivres law: assuming the number alive decreased in an arithmetical progression, so that
x 1
s (x) = 1 = (x) = .
x
Makehams Law: Gompertz Law with a constant, that is, (x) = A + Bcx where A > B.
Lee-Carter: x,t = ex +x t + x,t = Ax Bxt + x,t , where force of mortality depends on both age
Curtate Future Lifetime, K (x) T (x), is the random number of completed years lived by (x).
Pr (K (x) = k) = k px qx+k
1
ex = E [K (x)] ex
2
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2.4 Exp ected Present Value of Basic Life Insurance Pro ducts
The expected present value is also called the net single premium, or actuarial present value,
or risk premium.
In life insurance, benet payments are contingent on the death and/or survival of the insured.
Whole life insurance (for the whole duration of life): single payment on death:
Ax = E v K(x)+1 = v k+1 k px qx+k
k=0
It has variance 2 Ax (Ax )2 where 2 Ax = E v 2(K(x)+1) = E v 2
K(x)+1
.
Term insurance: single payment if death within n years.
n1 n
1 1
Ax:n = v k+1 k px qx+k and Ax:n = v t t px x+t dt
k=0 0
Ax:n1 = v n n px
Whole life annuity due: annuity due paid as long as (x) is alive:
k
ax = v k px = ak+1 k px qx+k
k=0 k=0
1 Ax
dax + Ax = 1 ax = (similar for insurance/endowment)
d
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It+1 = i OBt
P Rt = K t I t
n n n
Total repayment KT = 1 Kt , total interest IT = 1 It = KT L , and L = KT IT = 1 P Rt .
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A loan schedule provides all information for each period on payments, interest due, principal repayments,
principal outstanding and other important details.
The principal outstanding can be calculated through:
The prospective method: forward looking. It calculates the loan balance as the present value
n
of all future payments to be made: OBt = Ks v st , or if payments are equal, Kant i .
s=t+1
The retrospective method: backward looking. It calculates the loan balance as the accumu-
lated value of the loan at the time of evaluation minus the accumulated value of all instalments
t
paid up to the time of evaluation. OBt = L (1 + i)t Ks (1 + i)ts .
s=0
A sinking fund is a fund established by setting up payments over a period of time to fund repayment
of a long-term debt.
The loan is repaid as a lump sum at the end of the term.
I.e. the fund will accumulate to the loan amount (L) at time n to ensure the reimbursement.
L
So, the level payment must be .
sn j
The company needs to also pay interest at rate i each year to the lender.
L
Thus, the total payment (including interest) at each time unit will be iL + .
sn j
The fund usually earns an interest rate of j, which is usually less than i.
If j < i, then one needs to pay more overall since more money needs to be put aside.
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The price of a bond is essentially the present value of its future cash ows.
The rate is at which cash ows are discounted called yield.
The yield is usually quoted along with the price of the bond (equivalent ways of quoting the price).
The yield usually depends on the current structure of interest, as well as the risk associated to the bond
as perceived by the market.
The price of a bond is (given face value equals redemption; i.e. R = 1):
P = F c anp i + F vinp
1 vn
Or equivalently, using an = :
i
P = F + F (c i) anp i
If c = i, the bond is selling at par; if c > i, the bond is trading at premium; otherwise discount.
The seller will require the interest accumulated since the last coupon date to be paid by the buyer.
If the sale is too close to the next coupon payment (in Australia, 7 days or less), the bond becomes
ex-interest, which means that the next coupon payment will still be paid to the seller. So this coupon
will not be included in the valuation of the bond.
The general pricing approach is to discount the bond cash ows to the next coupon payment date
(including the coupon payment at that date, unless ex-interest), and then further discount this present
value to the sale date (by the number of days). Count the days!
That is, the RBA formula:
f /d
P = vi [Cnext + Gan i + F v n ]
where f is the number of days until the next payment; d is the number of days in the current period.
Two bonds with the same cash ows and the same yield will have a dierent purchase price if
coupons payment dates are dierent. Hence, bonds are usually quoted at a market price.
Price-plus-accrued: the purchase price (or dirty price, full price, at price)
the price with accrued interest (coupon).
The price goes up exponentially until the next coupon, upon which the price falls instantly.
Market price: the quoted price (smoothed price, clean price)
accrued interest is removed. Market price = dirty price accrued interest = P tF c.
The graph of the price is a slightly curved line, joining the prices at which coupons are paid.
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Yield: eective average rate of interest over the whole length of investment.
accumulated value 1/length of investment
Yield = 1
investment cost
Net present value (NPV): present value of inows minus outows (net cash ows).
Calculated using a relevant interest rate that reects risk and cost of capital.
Internal rate of return (IRR): sets NPV to zero.
There will be multiple IRRs if the cash ows are non-conventional.
NPV and IRR assumes a homogeneous/same rate of interest for all cash ow.
I.e. accumulated value at IRR is (Investment cost) (1 + IRR)time .
If the reinvestment rate (i.e. the rate at which the inows are accumulated ) is dierent from the
IRR, then the yield is not equal to the IRR.
We have modied IRR (MIRR) such that the accumulated value at the reinvestment rate is
equal to (Investment cost) (1 + MIRR)time .
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Interest rates change regularly (e.g. RBA cash rate) rst Tuesday of each month.
Interest rates depend on the term (maturity or tenor) of an investment, bond or loan.
Longer terms usually have higher interest rates.
Yield curves can be increasing, decreasing or humped.
Forward rate, ft1 ,t2 , is the eective annual rate of interest during the period (t1 , t2 ) as of today.
1
A (t2 ) t2 t1
ft1 ,t2 = 1
A (t1 )
Spot rate is a forward rate with t1 = 0. I.e. st = f0,t . Spot rates are determined:
By observing the market.
By zero coupon bonds: E.g. PZCB of 1 with maturity 1 (1 + s1 ) = 1.
Forward rates follow from spot rates (or vice versa). The relationship between spot/forward rates:
(1 + st )t
ft1,t = 1
(1 + st1 )t1
We can use spot rates (alternatively, prices of ZCB ) to determine coupon bonds.
Recall yield to maturity is the eective average rate of interest over the whole term.
Process of bootstrapping using prices of coupon bonds is used to nd the spot yield curve.
Noting that the coupon/payments are discounted using relevant spot rates!
In practice, coupon months/maturing dates are not evenly spaced. So it is not possible to solve for
evenly spaced spot rates.
Instead, t a yield curve to the market data, then extract spot rates from the tted curve.
To calculate spot rates, we assume bonds are par yield, i.e. yield equals to coupon rate (c).
1 v (n) 1
Using each c we use the formula c = n to calculate each v (t), where v (t) = .
t=1 v (t) (1 + st )t
The formula comes from the equation for the price of a coupon bond.
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We can calculate an equivalent forward force of interest t,t+dt = ln (1 + ft,t+dt ), ...and we are back to:
t
v (t) = exp (s) ds
0
Dene spot force of interest for maturity t, t = 0,t , such that (1 + st )t = e0,t t , then this spot force
is simply the constant force of interest equivalent to (t) over [0, t].
Note that the price of a security can be stated as a function of yield i, i.e. P (i). Using Taylors
expansion on P (i + i), we can examine the change in price due to a small change in yield :
(i)2
P (i + i) P (i) i P (i) + P (i)
2
P (i) P (i)
We denote as modied duration and as convexity; equivalently the formula
P (i) P (i)
P (i + i) P (i) (i)2
becomes i (M D) + C.
P (i) 2
P (i) (1 + i)t
The dollar modied duration is = Ct (i.e. without the division) and thus
i i
t>0
P (i)
$M D = = tCt (1 + i)t1 = t Ct vit+1
i
t>0 t>0
Ct vit Ct vit
where wt = t = . Note wt = 1.
t>0 Ct vi P (i)
This standardisation allows comparison between dierent sets of cash ows.
The MD has the form of a weighted sum.
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The (Macaulay) duration D is the weighted average/mean term to receipt of the cash ows:
t Ct vit
D = t>0 t = t wt (in years)
t>0 Ct vi t>0
The longer the duration, the more sensitive the price is to interest changes.
Duration (mean term) and modied duration (price sensitivity) are related ( M D = v D ).
In continuous time, D = M D.
Duration decreases to 0 almost like a straight line as time increases except that duration increases
suddenly at coupon payment dates.
4.5.3 M-SQUARED
M-squared:
M2 = (t D)2 wt
t>0
The spread of the maturities of the cash ows around their mean D.
A weighted variance of the time to receipt of the cash ows around the duration.
Higher values of M 2 for the same duration will indicate higher price sensitivity.
(p)
In practice, bond yields i(p) are quoted on a nominal basis. So P i = (p)
Ct 1 + .
p
t>0
1 tp
i(p) i(p)
(p)
Then the dollar modied duration is P i = 1+ t Ct 1 + . So:
p p
t>0
1
i (p)
M D(p) = 1 + t wt
p
t>0
(p) tp
Ct 1 + i p
where wt = tp .
i(p)
t>0 Ct 1 + p
i(p)
Consequently, D = D(p) = 1+ M D(p) . Note D(p) = M D(p) as p .
p
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For complicated cash ows, we decompose them into a portfolio of ZCBs. We rst calculate each of
their individual dollar modied duration and dollar convexity.
For a zero coupon bond (ZCB):
Price: B (0, t) = (1 + i)t ;
Dollar modied duration: B (0, t) = t (1 + i)t1 ;
Dollar convexity: B (0, t) = t (t + 1) (1 + i)t2 .
Then we aggregate them:
Aggregated price: P (i) = CFt B (0, t) = CFt (1 + i)t ;
Aggregated dollar modied duration: P (i) = CFt B (0, t) = CFt t (1 + i)t1 ;
Aggregated dollar convexity: P (i) = CFt B (0, t) = CFt t (t + 1) (1 + i)t2 .
To nd the aggregated modied duration and convexity, divide the above by the price.
MD
Recall duration is .
v
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When the interest rate changes, both PV of liabilities L (i) and assets A (i) change.
Net asset (or surplus) is dened as S (i) = A (i) L (i).
How do we select assets such that the eect of changes in interest rate is minimised?
How do we ensure that assets are always enough to payout the claims?
One way is to match the cash ows of liabilities: dedication (very hard, often impossible).
Assets might not have exact maturities as cash ows; etc.
Immunisation is based on matching present values and duration to control interest rate risk.
Using the Taylor series we have S (i + i) S (i) + i S (i) , we select:
A (i) = L (i) (match PV) and A (i) = L (i) i.e. S (i) = 0 (match duration).
So for any small change in i we have S (i + i) S (i).
(i)2
We can also include convexity so S (i + i) S (i) + i S (i) + S (i) . (Note S (i) = 0.)
2
So the change in surplus will be positive if S (i) = A (i) L (i) > 0. That is, CA > CL .
So, we would choose:
At v t = Lt v t (match PV)
t At v t+1 = t Lt v t+1 (match durations)
t (t + 1) At v t+2 > t (t + 1) Lt v t+2 (CA > CL )
(i)2
Then S (i + i) S (i) S (i) 0.
2
We have assumed that all cash ows are xed, and do not depend on interest rates, and the yield curve
is at (all spot rates are i).
Now we further assume that the spot rate curve moves in a parallel fashion (note it is still at).
As interest rate changes, we need to change portfolios to match durations again.
We have full immunisation: i.e. S (i + i) 0 is always true, irrespective of i.
An increase in convexity of A will increase S however also more risk.
Note: these assumptions are unrealistic but are necessary to achieve full immunisation.
Issue medium-term liabilities, and invest the money in long- and short-term bonds so that S (i) = 0.
Here S (i) = 0 and S (i + i) 0 positive prot without risk! Arbitrage opportunity.
But there is a severe mismatch of the assets and liabilities (high convexity risky!), and assumptions
are unrealistic (interest rate moves are random! ).
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5 DERIVATIVES
A derivative is a security/contract with payments at specied times in the future, the amounts of
which are contingent on the value of an underlying nancial variable.
Derivatives include forwards, swaps and options and are actively traded over the counter (privately
between two parties) and on organised exchanges.
The underlying nancial variable could be a stock/share or a bond, a market index, an interest rate, a
currency, or gold, wheat, or other commodities.
Derivatives have high leverages (big outcomes for small investments). They are used for:
speculation: increase volatility of investments (dangerous! )
hedging: decrease volatility of investments (useful! )
Hedging is a strategy to reduce the risk borne by an agent. Reducing risk reduces expected prot.
The law of one price: in an ecient market, two securities with the same cash ows have the same
price. Otherwise:
There will be an arbitrage opportunity: prot without risk.
When pricing derivatives, we assume:
a risk-free rate of return can be obtained by any investor (government bonds).
any amount of money will be invested or borrowed at the risk-free rate.
short selling is allowed: sell a security without having bought it (yet), by borrowing it or not (if
not, naked short sale).
a long (buying) or short position (selling) can be taken in any asset in any fractional quantity.
markets are ecient and there are no arbitrage opportunities.
Purchasing forward/futures contracts can help insure or hedge against price uctuations:
eliminate uncertainty of the price level at sale (delivery) date;
taking a position in forward contracts that osets/mitigates some of the risk associated with a
given market commitment.
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We ensure that there is no arbitrage opportunity in this contract, so the delivery price F0,T should
equal to the accumulated value of all previous cash ows. So:
T
F0,T = S0 (1 + r)T CFt (1 + t)T t
t=0
where S0 is the cost to buy the asset now (spot price), and CF are cash ows related to the asset (e.g.
storage, coupons).
A futures contract is similar to a forward in that it sets the price of a trade to take place in the future,
but it is dierent in other respects:
futures are highly standardised with regard to maturity, size, and underlying asset or index,
whereas forwards are usually customised to the needs of each party (thus not very liquid );
some futures contracts are settled in cash (the asset is not exchanged);
futures are used for both hedging and speculation;
for futures, brokers (third party) require a margin account based on the underlying assets spot
price, whereas the loss (or prot) is entirely realised at maturity for forwards.
An interest rate swap involves two counterparties who exchange interest payments based on a notional
principal amount F (the principal amount does not change hands).
Interest rates swaps can be from xed to oating rate (coupon swap) or from one oating rate to
another (basis swap).
Cash ows are xed in the contract such that the present value of the two interest streams is equal.
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First the present value of both interest payment streams must be equal;
Calculate interest from oating rate using forward rates for that period. Each payment
(1+sn )n
(1+sn1 )n1
1 1
can be expressed as F , which the sum can be simplied to F 1 .
(1 + sn )n (1 + sn )n
Use the PV of these payments with forward rates to determine the xed rate. So:
1
1 (1+sn )n
c = n 1
t=1 (1+st )t
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5.5 Options
An option is a contract that gives its holder the option (but not the obligation):
to buy (call) or sell (put) an underlying asset;
at time T (for European option) or any time before T (an American option);
for a strike price K.
The payo will always be positive or null (option! No one will exercise a negative payo.)
Pricing American options is very dicult (involves stochastic processes).
Pricing European options is easier (but can also involve stochastic processes, e.g. binomial model).
The payo of a European call (buy) is (ST K)+ at time T . The call option is:
Out-of-the-money if ST < K;
At-the-money if ST = K;
In-the-money if ST > K.
The payo of a European put (sell) is (K ST )+ at time T . The put option is:
Out-of-the-money if ST > K;
At-the-money if ST = K;
In-the-money if ST < K.
Note: there could also be a cost associated with the call/put.
5.5.2 PRICING OPTIONS: THE PUT-CALL PARITY THEOREM (ORANGE BOOK P.47 )
Put-call parity is a principle that denes the relationship between the price of European put options
and European call options of the same class, that is, with the same underlying asset, strike price and
expiration date.
Call option with price c and an initial cash deposit of Kert , PV of strike price;
Pull option with price p and one unit of the underlying asset.
Both portfolios have a payo of max{K, ST } at expiry. They must also have equal value, so:
c + Kert = p + S0
The price of the underlying at time T (ST ) is a random variable. Thus the payo is also random.
We can price the option by expected value. But it requires knowledge of probability distribution. It is
also likely to create arbitrage opportunity with respect to current market prices.
Or we can use the prices of a portfolio of assets that replicates the options payo at T .
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There exists, over any period, a one period bond investment that accumulates 1 to ert where r
is the risk-free (force of) interest rate.
The underlying asset has thus a binomial distribution for its price at time T .
Consider
a call option expiring at the end of the period. It will have payo:
c = (u s K)+ , with probability p;
t,u t
Ct+t =
ct,d = (d st K)+ , with probability 1 p.
We can construct a portfolio of ht of the underlying asset and bonds Bt , with initial value Vt = ht st + Bt ,
such that the payo of the call is replicated.
This portfolio with have value Vt+t = ht st+t + Bt ert .
We equate this valuewith the payo of the call. So we have
c = h u s + B ert , with probability p;
t,u t t t
Ct+t = Vt+t
ct,d = ht d st + Bt ert , with probability 1 p.
ct,u ct,d rt u ct,d d ct,u
We solve for unknowns to get ht = and Bt = e .
(u d) st ud
This portfolio has the same payo as the call, and so the EPV/price of the call must equal to
the price of the portfolio, i.e. E ert Ct+t = Vt = ht st + Bt .
Using the put-call parity theorem, we can nd the price of a put.
Note that we can express Vt (after substitution) as Vt = ert [qct,u + (1 q) ct,d ] , which is a discounted
expected value with special probabilities, called the risk free probabilities, where q:
ert d
q=
ud
For multiple periods, the binomial model is implemented by recursive computation starting at the
nal time period for the model and working backwards period by period for each time step.
The binomial model for many time periods is referred to as a Binomial Lattice.
The important concept is to construct the portfolio to reproduce (or replicate) the derivative
payments at the end of each time period consisting of the underlying asset and the one period investment
(or borrowing).
The value of the derivative is the value of this portfolio based on the price of the underlying asset and
the investment at the beginning of the period and the number of units in the replicating portfolio.
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Again, due to the premium of the call, one will lose a bit more for ST > K + P .
Covered call: short call with long underlying. Payo capped at K. Due to the purchase of the
underlying the graph shifts down.
Prot if the underlying is performing well. (Else prot)
Covered put: short put with short underlying. Overall payout graph is shifted up due to sale of put
and underlying.
Prot if underlying is not performing well. (Else loss)
Bull spread: either:
long call with a lower strike price than a short call; again there is a premium related to the long
call. Overall, there is a small prot when underlying is performing well.
long put with a lower strike price than a short put. There is a prot that shifts the graph up.
Overall there is a prot when underlying is performing well.
Bear spread: similar to bull spread, but long call has a higher strike price than the short call. Overall,
there is a small prot when underlying is not performing well.
Box spread: replicated a risk free deposit with calls and puts. One short put and one long call (with
strike price K1 ) and one long put and one short call (with strike price K2 > K1 ). End result is a
constant payo of K2 K1 throughout. Supported by put-call parity.
Straddle: Long put and long call with same strike price. End result is similar to an absolute value graph.
Graph is shifted down due to the purchases. Prot if underlying price changes signicant from strike
price.
Buttery spread: Short put and short call with same strike price (K). End result is the opposite to
straddle. This is combined with a strangle (long put with K1 and long call with K2 ). End result is an
absolute value graph at K, with constant values for less than K1 (constant K1 K) and greater than
K2 (constant K K2 ). This graph is shifted up. Prot if underlying price is about K.
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6 STOCHASTIC RETURNS
In practices, returns on an investment and interest rates will uctuate randomly (not known! ).
Stochastic Models explicitly allow for this randomness by introducing probability into models.
An assumption is required for the probability distribution of returns based on the historical data and its
main features.
Discrete: Binomial model.
Continuous: Log-Normal model.
We have a stochastic process: a collection of random variables ({yt , y = 1, 2, . . . , n} in discrete case)
representing the evolution of some system of random values over time.
We now consider a function, not single values.
An increment (change over a period) can be either:
totally independent of the past (stationary process); or
depend only on the starting value (e.g. yt1 ) (still stationary); or
depend on some other events in the past (non-stationary).
The increment itself is a single value and is a random variable.
n
The accumulated value of $1 after n periods is Sn = (1 + yt ), where {yt } are random variables.
t=1
The distribution of Sn can be derived under simple assumptions, or use simulation techniques.
So we dene yt as the random return over year t. We assume these returns are:
independent of each other (do not depend on any previous return); and
are identically distributed.
We denote expected value and variance: E [yt ] = j and Var (yt ) = s2 .
n
The k-th moment is E Snk = E (1 + yt )k .
t=1
n
In particular, E [Sn ] = (1 + j)n and variance Var (Sn ) = 1 + 2j + s2 + j 2 (1 + j)2n .
as (1 + yn ) sn1 +1 with s0 = 0. We use this to derive this recursive formula to derive its moments.
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The log-normal model is continuous and we consider a continuously compounded return (force of
interest) for a period.
1 year: r1 N , 2 ;
1 1 2
0.5 year: r1/2 N , ;
2 2
Intuitively, it makes sense to consider that the next value of the interest rate will depend on the current
one. (Note: good thing is it is still a stationary process! )
One (simple) assumption is to consider returns that are random, but whose next value will depend on
the current and tend to revert back to the long-term (average) return (mean reversion).
This leads to an autoregressive or mean reverting model.
We express the mean reverting model as:
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This model can also be expressed as yn+1 = yn + (1 ) ( yn ) + n+1 .
The conditional expectation of yn+1 given yn is:
E [yn+1 | yn ] = + (yn )
Assume that the interest rate for investing over the rst time period will be i0 which is xed and known
today and is referred to as the one period spot interest rate.
i , with probability p;
u
The interest rate in the second period can be
id , with probability 1 p.
An amount of $1 invested today will have value $ (1 + i0 ) with certainty at the end of one period.
$ (1 + i ) (1 + i ) , with probability p;
0 u
At the end of two periods, then it would be
$ (1 + i0 ) (1 + id ) , with probability 1 p.
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