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Exam FM/2
Spring 2010
Alvin Soh
Outline
I. Theory of Interest
A) Measurement of Interest
B) Valuation of Annuities
C) Yield Rates
D) Amortization and Sinking Funds
E) Pricing Common Stocks
F) Bonds
G) Advanced Financial Analysis
II. Derivatives Markets
A) Introduction to Derivatives and Risk
B) Forward Contract
C) Options
D) Contracts and Positions
E) Insurance and other Option Strategies
F) Risk Management
G) Financial Forwards and Futures
H) Swap
Theory of Interest- Measurement of Interest
Accumulation Function
Theory of Interest- Measurement of Interest
where
a (t ) a (t 1)
i
a (t 1)
Theory of Interest- Measurement of Interest
a t 1 it
Theory of Interest- Measurement of Interest
This is the reason that the effective rate of interest is decreasing as the time
of accumulation increases.
Theory of Interest- Advanced Financial Analysis
1 st
t
1 st 1 1 f t 1 1 st 2 1 f t 2 1 f t 1
t 1 t 2
where
1 i
1 i '
1 r
where
Macaulay Duration
Theory of Interest- Advanced Financial Analysis
tv CF t
t
d t 1
n
v CF
t 1
t
t
Theory of Interest- Advanced Financial Analysis
Modified Duration
Theory of Interest- Advanced Financial Analysis
d n t n
n t
d
di
P v CFt
di t 1
t 1
tv CFt tv CFt
v n n
t 1
v t n1 vd
v CFt
P
vt CFt vt CFt t
t 1 t 1 t 1
Theory of Interest- Advanced Financial Analysis
Convexity
Theory of Interest- Advanced Financial Analysis
d2 d n t 1 n
2
P
di
tv CFt t t 1 v t 2
CFt
c di tn1 t 1
n
v CFt v CF
P t t
t
t 1 t 1
Theory of Interest- Advanced Financial Analysis
1. PAssets i PLiabilities i
2. d Assets i d Liabilities i OR v Assets i v Liabilities i
3. c Assets i c Liabilities i
Derivatives Markets- Introductions
1. Speculation
2. Portfolio Replication
3. Arbitrage
4. Risk Management
Derivatives Markets- Introductions
Long position
When a trader buys an option contract that he has not already
written (i.e. sold), he is said to be opening a long position.
When a trader sells an option contract that he already owns, he is
said to be closing a long position.
When a trader is 'long', he/she wins when the price increases, and
loses when the price decreases.
Short position
When a trader writes (i.e. sells) an option contract that he does not
already own, he is said to be opening a short position.
When a trader buys an option contract that he has written (i.e. sold),
he is said to be closing a short position.
When a trader is 'short', he/she wins when the price decreases, and
loses when the price increases.
Derivatives Markets- Contracts and Positions
Long positions using forward contract, call option and put option
Derivatives Markets- Contracts and Positions
Profit
FV(P)
0
K Asset Price
K-FV(P)
-(K- FV(P))
Short positions using forward contract, call option and put option
Derivatives Markets- Contracts and Positions
Profit
FV(C)
K+FV(C)
0 K Asset Price
Comparisons of long positions using forward contract, call option and put
option in terms of:
1. Maximum loss
2. Maximum profit
3. Range of underlying asset price such that the profit is positive
Derivatives Markets- Contracts and Positions