MINISTRY OF EDUCATION AND SCIENCE OF THE RUSSIAN FEDERATION Federal State-Funded Educational Institution of Higher Vocational Education «National Research Tomsk Polytechnic University» Department of Higher Mathematics and Mathematical Physics BASICS OF FINANCIAL MATHEMATICS A study guide 2012 BASICS OF FINANCIAL MATHEMATICS Author A. A. Mitsel. The study guide describes the basic notions of the quantitative analysis of financial transactions and methods of evaluating the yield of commercial contracts, investment projects, risk-free securities and optimal portfolio of risk-laden securities. The study guide is designed for students with the major 231300 Applied Mathematics, 230700 Application Informatics, and master’s program students with the major 140400 Power Engineering and Electrical Engineering. CONTENTS Introduction Chapter 1. Accumulation and discounting 1.1. Time factor in quantitative analysis of financial transactions 1.2. Interest and interest rates 1.3. Accumulation with simple ınterest 1.4. Compound interest 1.5. Nominal and effective interest rates 1.6. Determining the loan duration and interest rates 1.7. The notion of discounting 1.8. Inflation accounting at interest accumulation 1.9. Continuous accumulation and discounting (continuous interest) 1.10. Simple and compound interest rate equivalency 1.11. Change of contract terms 1.12. Discounting and accumulation at a discount rate 1.13. Comparison of accumulation methods 1.14. Comparing discounting methods Questions for self-test Chapter 2. Payment, annuity streams 2.1. Basic definitions 2.2. The accumulated sum of the annual annuity 2.3. Accumulated sum of annual annuity with interest calculation m times a year 2.4. Accumulated sum of p – due annuity 2.5. Accumulated sum of – due annuity with p m,1 m 2.6. The present value of the ordinary annuity 2.7. The present value of the annual annuity with interest calculation times a year 2.8. The present value of the – due annuity ( m 1) 2.9. The present value of the – due annuity with m1, p m 2.10. The relation between the accumulated and present values of annuity 2.11. Determining annuity parameters 2.12. Annuity conversion Questions for self-test Chapter 3. Financial transaction yield 3.1. The absolute and average annual transaction yield 3.2. Tax and inflation accounting 3.3. Payment stream and its yield 3.4. Instant profit Questions for self-test Chapter 4. Credit calculations 4.1. Total yield index of a financial and credit transaction 4.2. The balance of a financial and credit transaction 4.3. Determining the total yield of loan operations with commission 4.4. Method of comparing and analyzing commercial contracts 4.5. Planning long-term debt repayment Questions for self-test Chapter 5. Analysis of real investments 5.1. Introduction 5.2. Net present value 5.3 internal rate of return 5.4. Payback period 5.5. Profitability index 5.6. Model of human capital investment Questions for self-test Chapter 6. Quantitative financial analysis of fixed income securities 6.1. Introductioon 6.2. Determining the total yield of bonds 6.3. Bond portfolio return 6.4. Bond evaluation 6.5. The evaluation of the intrinsic value of bonds 6.6. Valuation of risk connected with investments in bonds Questions for self-test Chapter 7. Bond duration 7.1. The notion of duration 7.2. Connection of duration with bond price change 7.3. Properties of the duration and factor of bond convexity 7.4. Time dependence of the value of investment in the bond. Immunization property of bond duration 7.5. Properties of the planned and actual value of investments Questions for self-test Chapter 8. Securities portfolio optimization 8.1. Problem of choosing the investment portfolio 8.2. Optimization of the wildcat security portfolio 8.3. Optimization of the portfolio with risk-free investment possibility 8.4. Valuating security contribution to the total expected portfolio return 8.5. A pricing model on the competitive financial market 8.6. The statistical analysis of the financial market Questions for self-test Bibliography Part 1. Lecture Course Introduction The main goal of the science of finances consists in studying how the financial agents (persons and institutions) distribute the resources limited in time. The accent exactly on the time, but not other distribution types studied in economics (in regions, industries, enterprises), is a distinguishing feature of the financial science. The solutions made by the persons with regard to the time distribution of resources are financial decisions. From the point of view of the person(s) taking the such decisions, the resources distributed refer to either expenses (expenditures) or earnings (inflows). The financial decisions are based on commensuration of the values of expenses and profit streams. In the term payment the temporal character of resource distribution is reflected. The problems concerning the time distribution of resources (in the most general sense), are financial problems. Since the solution of financial problems implies the commensuration of values of expenses (expenditures) and the results (earnings), the existence of some common measure to evaluate the cost (value) of the distributed resources is supposed. In practice, the cost of the resources (assets) is measured in these or those currency units. However, it is only one aspect of the problem. The other one concerns the consideration of time factor. If the problem of time distribution of resources is an identifying characteristic of financial problems, then the financial theory must give means for commensuration of values referring to different time moments. This aspect of the problem has an aphoristic expression time is money. The ruble, dollar, etc. have different values today and tomorrow. Besides, there is one more crucially important aspect. In all the real financial problems which one must face in practice, there is an uncertainty referring to both the value of the future expenses and income, and the time points which they refer to. This very fact that the financial problems are connected with time stipulates the uncertainty characteristic of them. Talking of uncertainty, we imply, of course, the uncertainty of the future, but not past. The uncertainty of the past is usually connected (at least in financial problems) with the lack of information and in this sense, in principle, it is removable along with the accumulation and refinement of the data; whereas, the uncertainty of the future is not removable in principle. This uncertainty is that is characteristic of financial problems leads to the risk situation at their solution. Due to uncertainty, any solution on the financial problems may lead to the results different from the expected ones, however thorough and thoughtful the solution may be. The financial theory develops the concepts and methods for financial problem solution. As any other theory, it builds the models of real financial processes. Since such basic elements as time, value, risk, and criteria for choosing the desired distribution of resources obtain a quantitative expression, these models bear the character of mathematical models, if necessary. The majority of the models studied in the modern financial theory, have a strongly marked mathematical character. Along with that, the mathematical means used to build and analyze the financial models, vary from the elementary algebra to the fairly complicated divisions of random processes, optimal management, etc. Although, as it was mentioned, the uncertainty and risk are inseparable characteristics of financial problems, in a number of cases it is possible to neglect them either due to the stability of conditions in which the decision is made, or in idealized situations, when the model considered ignores the existence of these or those risk types due to its specificity. Financial models of this type are called the models with total information, deterministic models, etc. The study of such models is important because of two factors. First, in a number of cases, these models are fairly applicable for a direct use. This refers to, tor instance, the majority of models of the classical and financial mathematics devoted to models of the simplest financial transactions, such as bank deposit, deal on the promissory note, etc. Second, one of the ways for studying the models in the uncertainty conditions is modeling, i.e. the analysis of possible future situations or scenarios. Each scenario corresponds to a certain, fairly determined, future course of events. The analysis of this scenario is made, naturally, within the deterministic model. Then, on the basis of the carried out analysis of different variants of event development, a common solution is made. Chapter 1 Accumulation and Discounting 1.1. Time Factor in Quantitative Analysis of Financial Transactions The basic elements of financial models are time and money. In essence, financial models re- flect to one extent or another the quantitative relations between sums of money referring to vari- ous time points. The fact that with time the cost or, better to say, the value of money changes now due to constant inflation, is obvious to everyone. The ruble today and the ruble tomorrow, in a week, month or year – are different things. Perhaps, it is less obvious, at least not for an economist, that even without inflation, the time factor nevertheless influences the value of money. Let us assume that possessing a ―free‖ sum you decide to place it for a time deposit in a bank at a certain interest. In time, the sum on your bank account increases, and at the term end, under favorable conditions, you will get a higher amount of money than you placed initially. Instead of the deposit, you could buy shares or bonds of a company that can also bring you a certain profit after some time. Thus, also in this case, the sum invested initially turns into a larger amount after some time period. Of course, you may choose to not undertake anything and simply keep the money at home or at a bank safe.