Mathematical Interest Theory (3rd Edition) Vaaler
AMS / MAA TEXTBOOKS VOL 57
Mathematical Interest Theory
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Third Edition
Leslie Jane Federer Vaaler, Shinko Kojima Harper, and James W. Daniel
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Mathematical
Interest Theory
Third Edition
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Mathematical Interest Theory (3rd Edition) Vaaler
AMS / MAA TEXTBOOKS
VOL 57
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Mathematical
Interest Theory
Third Edition
Leslie Jane Federer Vaaler
Shinko Kojima Harper
James W. Daniel
Providence, Rhode Island
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Mathematical Interest Theory (3rd Edition) Vaaler
Committee on Books
Susan G. Staples, Chair
MAA Textbooks Editorial Board
Stanley E. Seltzer, Editor
Matthias Beck Suzanne Lynne Larson Jeffrey L. Stuart
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Debra Susan Carney Michael J. McAsey Ron D. Taylor, Jr.
Heather Ann Dye Virginia A. Noonburg Elizabeth Thoren
William Robert Green Thomas C. Ratliff Ruth Vanderpool
2010 Mathematics Subject Classification. Primary 62P05, 97M30.
For additional information and updates on this book, visit
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Library of Congress Cataloging-in-Publication Data
Names: Vaaler, Leslie Jane Federer, author. | Harper, Shinko Kojima, 1967- author. | Daniel,
James W., author.
Title: Mathematical interest theory / Leslie Jane Federer Vaaler, Shinko Kojima Harper, James
W. Daniel.
Description: Third edition. | Providence, Rhode Island : MAA Press, [2019] | Series: AMS/MAA
textbooks ; volume 57 | Includes bibliographical references and index.
Identifiers: LCCN 2019018629 | ISBN 9781470443931 (alk. paper)
Subjects: LCSH: Interest rates–Mathematical models. | Interest rate futures–Mathematical mod-
els. | Risk management–Mathematical models.
Classification: LCC HB539 .D33 2019 | DDC 332.801/513–dc23
LC record available at https://lccn.loc.gov/2019018629
Softcover ISBN: 978-1-4704-6568-1
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Investors receive interest.
To Abigail Louise Vaaler and Douglas Quinn Vaaler,
the best interest ever.
To Jeffrey David Vaaler, my co-investor.
– Leslie Jane Federer Vaaler
To Kevin and Keiji.
– Shinko Kojima Harper
To my wife, Ann Daniel; my teacher, Paul Mielke;
and my actuarial guide, Gene Wisdom.
– James W. Daniel
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Mathematical Interest Theory (3rd Edition) Vaaler
Contents
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Preface xi
0 An introduction to the Texas Instruments BA II Plus 1
0.1 Choosing a calculator . . . . . . . . . . . . . . . . . . . . . . . 1
0.2 Font convention . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
0.3 BA II Plus basics . . . . . . . . . . . . . . . . . . . . . . . . . . 2
0.4 Problems, Chapter 0 . . . . . . . . . . . . . . . . . . . . . . . . 7
1 The growth of money 9
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.2 What is interest ? . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.3 Accumulation and amount functions . . . . . . . . . . . . . . . 11
1.4 Simple interest / Linear accumulation functions . . . . . . . . . 15
1.5 Compound interest (The usual case!) . . . . . . . . . . . . . . . 20
1.6 Interest in advance / The effective discount rate . . . . . . . . 25
1.7 Discount functions / The time value of money . . . . . . . . . . 29
1.8 Simple discount . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
1.9 Compound discount . . . . . . . . . . . . . . . . . . . . . . . . 42
1.10 Nominal rates of interest and discount . . . . . . . . . . . . . . 47
1.11 A friendly competition (Constant force of interest) . . . . . . . . 55
1.12 Force of interest . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
1.13 Note for those who skipped Sections (1.11) and (1.12) . . . . . 60
1.14 Quoted rates for Treasury bills . . . . . . . . . . . . . . . . . . 61
1.15 Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
1.16 Choice of quotation base for interest rates . . . . . . . . . . . . 68
1.17 Problems, Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . 70
2 Equations of value and yield rates 83
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
2.2 Equations of value for investments involving a
single deposit made under compound interest . . . . . . . . . . 84
2.3 Equations of value for investments with multiple
contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
2.4 Investment return . . . . . . . . . . . . . . . . . . . . . . . . . 94
2.5 Reinvestment considerations . . . . . . . . . . . . . . . . . . . . 100
2.6 Dollar-weighted yield rates . . . . . . . . . . . . . . . . . . . . . 102
2.7 Fund performance . . . . . . . . . . . . . . . . . . . . . . . . . 108
2.8 Problems, Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . 111
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Mathematical Interest Theory (3rd Edition) Vaaler
viii Contents
3Annuities (annuities certain) 121
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
3.2 Annuities - immediate . . . . . . . . . . . . . . . . . . . . . . . . 123
3.3 Annuities - due . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
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3.4 Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
3.5 Deferred annuities and values on any date . . . . . . . . . . . . 143
3.6 Outstanding loan balances . . . . . . . . . . . . . . . . . . . . . 147
3.7 Nonlevel annuities . . . . . . . . . . . . . . . . . . . . . . . . . 153
3.8 Annuities with payments in geometric progression . . . . . . . 155
3.9 Annuities with payments in arithmetic progression . . . . . . . 158
3.10 Yield rate examples involving annuities . . . . . . . . . . . . . 164
3.11 Annuity symbols for nonintegral terms . . . . . . . . . . . . . . 170
3.12 Annuities governed by general accumulation
functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
3.13 The investment year method . . . . . . . . . . . . . . . . . . . 177
3.14 Problems, Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . 180
4 Annuities with different payment and conversion periods 195
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
4.2 Level annuities with payments less frequent than each interest
period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
4.3 Level annuities with payments more frequent than each interest
period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
4.4 Annuities with payments less frequent than each interest period
and payments in arithmetic progression . . . . . . . . . . . . . 207
4.5 Annuities with payments more frequent than each interest pe-
riod and payments in arithmetic progression . . . . . . . . . . . 209
4.6 Continuously paying annuities . . . . . . . . . . . . . . . . . . . 214
4.7 A yield rate example . . . . . . . . . . . . . . . . . . . . . . . . 219
4.8 Problems, Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . 221
5 Loan repayment 229
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
5.2 Amortized loans and amortization schedules . . . . . . . . . . . 229
5.3 The Sinking Fund method . . . . . . . . . . . . . . . . . . . . . 238
5.4 Amortized loans with other repayment patterns . . . . . . . . . 245
5.5 Yield rate examples and replacement of capital . . . . . . . . . 247
5.6 Problems, Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . 255
6 Bonds 265
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
6.2 Bond alphabet soup and the basic price formula . . . . . . . . . 267
6.3 The premium-discount formula . . . . . . . . . . . . . . . . . . 272
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Contents ix
6.4 Other pricing formulas for bonds . . . . . . . . . . . . . . . . . 274
6.5 Bond amortization schedules . . . . . . . . . . . . . . . . . . . 276
6.6 Valuing a bond after its date of issue . . . . . . . . . . . . . . . 286
6.7 Selling a bond after its date of issue . . . . . . . . . . . . . . . 292
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6.8 Yield rate examples . . . . . . . . . . . . . . . . . . . . . . . . 301
6.9 Callable bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
6.10 Floating-rate bonds . . . . . . . . . . . . . . . . . . . . . . . . . 310
6.11 The BA II Plus calculator Bond worksheet . . . . . . . . . . . 312
6.12 Problems, Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . 317
7 Stocks and financial markets 327
7.1 Common and preferred stock . . . . . . . . . . . . . . . . . . . 327
7.2 Brokerage accounts . . . . . . . . . . . . . . . . . . . . . . . . . 331
7.3 Going long: buying stock with borrowed money . . . . . . . . . 337
7.4 Selling short: selling borrowed stocks . . . . . . . . . . . . . . . 340
7.5 Problems, Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . 345
8 Arbitrage, term structure of interest rates, and derivatives 351
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
8.2 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
8.3 The term structure of interest rates . . . . . . . . . . . . . . . . 355
8.4 Loans with floating rate of interest . . . . . . . . . . . . . . . . 366
8.5 Interest rate swaps: the basics . . . . . . . . . . . . . . . . . . . 369
8.6 Formulas for interest rate swaps . . . . . . . . . . . . . . . . . . 381
8.7 Market value of an interest rate swap . . . . . . . . . . . . . . . 385
8.8 More swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
8.9 Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . 391
8.10 Commodity futures held until delivery . . . . . . . . . . . . . . 394
8.11 Offsetting positions and liquidity of futures contracts . . . . . . 401
8.12 Price discovery and more kinds of futures . . . . . . . . . . . . 405
8.13 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
8.14 Using replicating portfolios to price options . . . . . . . . . . . 413
8.15 Using weighted averages to price options . . . . . . . . . . . . . 426
8.16 Problems, Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . 433
9 Interest rate sensitivity 449
9.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449
9.2 Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454
9.3 Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467
9.4 Using duration to approximate price . . . . . . . . . . . . . . . 475
9.5 Using duration and convexity to approximate price . . . . . . . 480
9.6 Immunization . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
9.7 Other types of duration . . . . . . . . . . . . . . . . . . . . . . 491
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