Introduction to Financial Mathematics

Zhenjie Ren1

October 8, 2017

1
Universite Paris-Dauphine, PSL Research University, CNRS, UMR [7534], Cere-
made, 75016 Paris, France, [email protected].
2
Chapter 1

Basic Notions

In this course, we assume an investors portfolio is composed of the following

three parts:

characteristics operations knowledge

Bank account period of time, interest rate borrow/lend interest rates market
Assets price long/short stochastic models
Derivatives maturity, payoff long/short calculus based on models

Remark 0.1 Taking a short position of assets (or derivatives) is equivalent to

borrowing & selling the assets (or derivatives).

No arbitrage principle is a basic notion in financial mathematics. It rules out

the possibility that an investor can start with a portfolio with 0 value, and end
up with a positive wealth in all possible scenarios of the future. A more precise
definition will be given in the following chapters. We can study how to use
a no-arbitrage argument for pricing through the following example of forward
contracts.
Forward is a derivative which allows a long-position holder to purchase the
underlying asset at a forward price K at a future time T . Note that at initial
time 0 forward contracts are with cash prices 0. The payoff of a forward (long
position) is ST K.
Proposition 0.2 Assume r is the interest rate (continuously compounded) for
the time period [0, T ]. Then the forward price K = S0 erT , where the process S
is the price of the underlying asset and S0 is the price at time 0.
Proof If K > S0 erT (in other word, the forward is overpriced), one may
construct the following portfolio with 0 initial value:
Foward Asset Bank account
Operations at Time 0 short 1 unit buy 1 unit borrow S0
Values at Time T K ST ST S0 erT

3
4 CHAPTER 1. BASIC NOTIONS

The value of this portfolio at time T is K ST + ST S0 erT = K S0 erT > 0.

Therefore, we construct an arbitrage and we should have K S0 erT .
Otherwise, if K < S0 erT (in other word, the forward is underpriced), one
may construct another portfolio with 0 initial value:
Foward Asset Bank account
Operations at Time 0 long 1 unit short 1 unit save S0
Values at Time T ST K ST S0 erT

The value of this portfolio at time T is ST K ST + S0 erT = S0 erT K > 0.

Again, we have an arbitrage, and thus K S0 erT . Finally, we conclude K =
S0 erT .

Remark 0.3 Strictly speaking, we did not show in the previous proof that K =
S0 erT is a non-arbitrage price (we only excluded all other possiblities). For the
sake of the simplicity of the course, we keep this incomplete proof.
Chapter 2

Interest Rates Market

1 Types of rates
In this course, we mainly talk about two types of rates:

Treasury Rates Treasury rates are the interest rates applicable to bor-
rowing by a government in its own currency. We usually assume that there
is no chance that a government will default on an obligation denominated
in its own currency, because it can always meet the obligation by printing
money. That is why the Treasury rates are considered as risk-free rates.

LIBOR Rates (London Interbank Offer Rates) The rates are deter-
mined in trading between banks and change as economic conditions change.
LIBOR rates are generally higher than the corresponding Treasury rates,
because there is always a chance that a bank could default. However,
when evaluating derivatives transactions, banks and other large financial
institutions tend to use LIBOR rates as the risk-free rates, because they
invest surplus funds in the LIBOR rates market and borrow to meet their
short-term funding requirement in this market.

2 Different Compoundings
When referring to an interest rate, one need to specify how the rate is com-
pounded (e.g. the rate is with annual compounding, semiannual compounding,
or continuous compounding, etc.).
For example, suppose that an amount A is invested for n years at an interest
rate of R with annual compounding. Then the terminal value of the investment
is
A(1 + R)n .

If the same rate is compounded m times per year, the terminal value of the

5
6 CHAPTER 2. INTEREST RATES MARKET

investment is  R mn
A 1+ .
m
If the rate is with continuous compounding, then the terminal value of the
investment is  R mn
lim A 1 + = AeRn .
m m
In this course, interest rates will be measured with continuous compounding
except where otherwise stated, because it is generally more computing-friendly.

3 Cash flow and its value

A cash flow is a sequence of payments one will obtain along the time in the
future. It is composed of two parts, the dates of the payments {t1 , t2 , , tn }
and the amounts of the the investors can manage to borrow and lend money
with the rates ri during the time period [0, ti ] for 1 i n, then an asset
providing the corresponding cash flow has the following theoretical price
n
X
P0 = ci eri ti .
i=1

This price isPimplied by the non-arbitrage principal.

n
If P0 > i=1 ci eri ti , that is, the asset is over-priced, the investor with 0
initial wealth would short (borrow and sell) one piece of the asset at the price
P0 and lend ci eri ti amount of money for the period [0, ti ] for all 1 i n.
By doing this, the investor will get the principal and the interest ci at time ti ,
meanwhile shePneed to pay ci to the buyer of the asset. After all, the investor
n
still has P0 i=1 ci er i ti
Pn > 0 at the end. This is an arbitrage.
Otherwise, if P0 < i=1 ci eri ti , the investor could manage an arbitrage,
by borrowing ci eri ti amount of money for the period [0, ti ] for 1 i n and
using it to purchase one piece of the asset.

4 Zero(-Coupon) Rates and Bond Pricing

The n-year zero rate is the rate of interest earned on an investment that stars
today and lasts for n years. All the interest and principal is realized at the end
of n years. There are no intermediate payments. We denote the rate by

R(0, n).

Using the zero rates as the discounting rates we can calculate the current value
of a cash flow.
Most bonds provides coupons (of value C) periodically. The owner also
receives the principal or (face value F ) of the bond at maturity. Suppose a
5. ACCRUED INTERESTS AND QUOTATIONS 7

bond lasts for n years and bears annual coupon C. Given the zero rates, we can
theoretically calculate the price of the bond at the initial time:
n
X
P0 = CeR(0,i)i + F eR(0,n)n .
i=1

The yield (y) on a coupon-bearing bond is the constant discount rate that
equates the cash flows on the bond to its market value. Still take the previous
bond as an example. The corresponding yield y must satisfy
n
X
P0 = Ceyi + F eyn =: g(y). (4.1)
i=1

Obviously, the function g is a strictly decreasing function such that

lim g(y) = + and lim g(y) = 0.

y y+

Therefore, there is an unique y making (4.1) hold true. Although there is no

explicite solution to (4.1), we may easily find the solution numerically by bi-
section algorithm, thanks to the monotonicity of g. Indeed, the function g is also
convex, and thus the Newton method is more efficient to calculate the solution
to (4.1).
Slightly differently from the yield, the par yield on a bond is the constant
discount rate that equates the cash flows on the bond to its face value. In the
previous example, the par yield y must satisfy
n
X
F = Ceyi + F eyn = g(y). (4.2)
i=1

Unlike the yield, the par yield can generally be computed explicitly. Here, (4.2)
leads to
  C 
1 eyn F = 0.
ey 1
 
The only solution to the equation above is y = ln 1 + CF , so is the par yield
on this bond.

5 Accrued Interests and Quotations

First, we need to introduce the day count conventions. There are mainly
three types:

Actual/actual

30/360 (i.e. 30 days for each month, and 360 days for a year)
8 CHAPTER 2. INTEREST RATES MARKET

Actual/360
Actual/actual is used for U.S. Treasury bonds, 30/360 is used for U.S. corporate
and municipal bonds, and actual/360 is used for U.S. Treasury bills and other
money market instruments.
Choosing the right day count convention, we may calculate the accrued
interest (A):
Number of days since the last coupon date
A=C .
Number of days between the two coupon dates
It is noteworthy that the price quoted (clean price) for a bond is often not
the same as the cash price (dirty price) you would pay if you purchased it. In
fact, we have
Dirty Price = Clean Price + Accrued Interest.
The theoretical price mentioned in the previous section is logically the cash price
(dirty price).

6 Determining Zero Rates

In practice, one can calculate the zero rates for different periods of time from
the prices of instruments of trade (e.g. bonds). For short terms, one can use
the bonds paying no more coupons (and treat them as zero-coupon bonds) in
order to compute the zero rates. With the zero rates (of short terms) calculated,
one can further use other bonds with further maturities (probably still paying
coupons) to compute the zero rates of longer terms. Finally, we apply the
bootstrap method (linear interpolation) to obtain the zero rates curve. For
more details, we refer to the examples in Section 5.4 in [1].

7 Forward Rates
The forward rates are the rates of interest implied by current zero rates for
periods of time in the future. It will be in partiuclar useful for the pricing of
the forward rate agreements (FRA) in the next section. Suppose we have
L as the principal and consider the time period [t, T ]. Then the cash flow of a
saving with the forward rate is:
lending L amount of money at time t
obtaining LeRf (T t) at time T .
Assume the investors can borrow/lend money at the zero rate R(0, t) for the
period [0, t] and at R(0, T ) for the period [0, T ]. Then the forward rate will be
locked as
R(0, T ) T R(0, t) t
Rf = .
T t
8. FORWARD RATE AGREEMENTS 9

One can deduce this result by the mentioned cash flow through no-arbitrage
argument.

8 Forward Rate Agreements

A forward rate agreement is an agreement that a certain interest rate will apply
to a certain principal during a specified future period of time. For the simplicity
of the formula, in this section, we use the rates only compounded once at the
end of the terms. Denote by RK the rate and L the principal in the FRA and
by [t, T ] the considered time period. The FRA is an agreement to the following
cash flow:
Time t: L
Time T : L(1 + RK (T t))
Comparing to the cash flow using the forward rate in the previous section, one
can easily determine the current value of the FRA as

V0 = L(RK RF )(T t)eR(0,T )T ,

where RF is the forward rate compounded once at T , and thus different from
Rf in the previous section. More precisely, we have

eRf (T t) 1
RF = .
T t
Exercise: What is the yield of the underlying cash flow of the FRA ?
There is an alternative characterization of FRAs. Review the cash flow of
the FRA. In fact, one may borrow L amount of money at time t with the rate
R (compounded only at T ). As a result, the investor does not need to pay L at
time t, instead she need to pay L(1 + R(T t)). Therefore, the new cash flow
is:
Time t: 0
Time T : L(RK R)(T t)

Remark 8.1 At time 0, the rate R is unknown (as a random variable), and it
is only determined at time t. In many cases, R is closely related to the zero rate
R(0, t), and they are only different in the respect of compoundings, i.e.

eR(t,T )(T t) 1
R= .
T t
The new cash flow shows that an FRA is equivalent to an agreement where
interest at a fixed rate RK is exchanged for interest at the market rate R. This
interpretation will be useful when we consider interest rate swaps in the next
chapter.
10 CHAPTER 2. INTEREST RATES MARKET

9 Duration
In Section 4, we introduced yield of a bond. Indeed, yield can be defined to any
cash flow in the same way, that is, the price P and the yield y of a cash flow
must satisfy:
n
X
P = ci eyti
i=1

The duration D is a measurement for how long on average the holder of the
corresponding asset has to wait before receiving the payments. It is defined as
Pn yti n
i=1 ti ci e
X ci eyti
D := = ti ,
P i=1
P

ci eyti
that is, D is the average of {ti }1in with the weight P on ti for each
1 i n.
It is easy to note that
P
= P D. (9.1)
y
Therefore, the duration is clearly a measurement of sensitivity of asset prices to
the change of yields.
The proceeding analysis is based on the assumption that the yield y is ex-
pressed with continuous compounding. Slightly different to the current case, if
y is expressed with the compounding frequency of m times per year, the cash
price of the cash flow will (approximately) be
n
X  y mti
P = ci 1 + .
i=1
m

We define the modified duration D :

 mti 1
n c 1+ y
X i m
D := ti ,
i=1
P

and (9.1) still holds true. Note that as y is a small number and thus
 y mti
1+ eyti ,
m
we have approximately

D
D =
1 + y/m
10. CONVEXITY 11

10 Convexity
From (9.1) we learn that the duration can provide the first order approxima-
tion to the asset price, if a slight change on the yield y happens. In some
circumstances, we urge a higher order approximation. That leads to the notion
convexity, C:
n
X ci eyti
1 2P
C := = t2i .
P y 2 i=1
P

By Taylors expansion, we approximately have the following relation between

the change of the asset price and that of the yield
 1 
P P Dy + Cy 2 .
2

11 Hedge based on duration

Suppose that an investor holding a portfolio of bonds with yield y and duration
D want to hedge the risk of the portfolio (namely P ) caused by the possible
perturbation of the yield y. Also assume that one may find a bond in the
market such that the change of the yield y 0 is parallel to that of y (namely
y = y 0 ). The duration of the bond is denoted by D0 and its price is denoted
by P 0 .
The investor can short M amount of this bond. If the yield y, y 0 change both
for y an instant later, then the short operation wins the following profit for
the investor:

M P 0 M P 0 D0 y.

Together with the original portfolio that the investor holds, the change of the
total wealth will be

P M P 0 P Dy + M P 0 D0 y.

Therefore, if M = PP0 DD
0 , then the change of wealth will be almost 0, that is, the

investor successfully avoid most of the risk (brought by the original portfolio),
by shorting PP0 D
D
0 bonds.
12 CHAPTER 2. INTEREST RATES MARKET
Chapter 3

Swap

1 Definition and Pricing

The most common type of swap is a plain vanilla interest rate swap. In this
swap a company agrees to pay (or receive) cash flows equal to interest at a
predetermined fixed rate on a notional principal for a predetermined number
of years. In return, it receives (respectively, pay) interest at a floating rate on
the same notional principal for the same period of time. In this course, we
always assume the payments are periodic, and the floating rates used in the
swap contracts are the zero rates.
The discounted value of the payments with the fixed rate r is
n
X
V0f ix = LrteR(0,ti )ti ,
i=1

where L is the amount of principal, ti are the payment dates (of fixed-rate
interests) and t = ti+1 ti .
Next we study the cash flow of the floating-rate payments. Let {sj }1jm
be the payment dates. Denote by R(sj , sj+1 ) the zero rate on the time period
[sj , sj+1 ]. Then the interest of the floating rate on date sj+1 will be
Ij+1 = L(eR(sj ,sj+1 )s 1).
In order to study the discounted value of the cash flow, we recall the pricing of
the FRA contracts. Take an FRA considering the time period [sj , sj+1 ] and of
RK = 0. We know from Remark 8.1 that the cash flow of the FRA is one single
payment equal to Ij+1 (one can calculate it using the formulas in Section 8
Chapter 2) on the date sj+1 , and thus the cash price of the FRA on time 0 is
V0j+1 = L eR(0,sj+1 )sj+1 eR(0,sj )sj .

Therefore, the value of the cash flow of the floating-rate interests is equal to
m
X
V0f loat = (V0j ) = L 1 eR(0,T )T .


j=1

13
14 CHAPTER 3. SWAP

Finally, the cash price of the swap from which the holder receives the fixed-rate
interests and pays the floating-rate ones is equal to
n
X
P0swap = V0f ix V0f loat = LrteR(0,ti )ti + LeR(0,T )T L. (1.1)
i=1

2 Why and how to make a swap

There are two main motivations for two companies to reach a swap:
Using swap to transform a liability.
Using swap to transform an asset.

In practice, the financial institutes, for example the banks, play the intermediate
roles between the companies. See examples in Section 7.1 in [1].

3 Hedge using swaps

Review the formula for the swaps price (1.1). If we ignore the constant term L,
then the rest of the formula represents the price of a bond which has maturity
T , face value L, coupon value Lrt, and pays coupons on the dates {ti }1in .
Since the difference between the price of the swap and that of the bond is a
constant, the two financial contracts face the exactly the same risk if the interest
rates change. In the previous chapter, we have learnt the notions concerning the
risk of a bond contract, namely, yield, duration, convexity. Now we naturally
define those notions for the swap contract using those of the corresponding bond.
In particular, once we have defined the duration for the swap, we can do the
same hedge based on duration (see Section 11 Chapter 2) using swaps.
Chapter 4

Discrete Time Models

15
16 CHAPTER 4. DISCRETE TIME MODELS
Bibliography

[1] J. Hull, Options, Futures, and Other Dervatives, fifth edition, Pearson Edu-
cation, 2003.

17