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Wolfgang Marty

Fixed
Income
Analytics
Bonds in High and Low Interest Rate
Environments
Fixed Income Analytics
Wolfgang Marty

Fixed Income Analytics

Bonds in High and Low Interest Rate
Environments
Wolfgang Marty
AgaNola AG
Pfaeffikon
Switzerland

ISBN 978-3-319-48540-9 ISBN 978-3-319-48541-6 (eBook)

DOI 10.1007/978-3-319-48541-6

Library of Congress Control Number: 2017952064

# Springer International Publishing AG 2017

This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of
the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations,
recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission
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The use of general descriptive names, registered names, trademarks, service marks, etc. in this
publication does not imply, even in the absence of a specific statement, that such names are exempt
from the relevant protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and information in this
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Foreword

In light of an investment environment characterized by low yields and new regu-

latory capital regimes, it has become increasingly demanding for investors to
achieve sustainable returns. Particularly, fixed income investments are called into
question. There is a solution.
Since the foundation of AgaNola a decade ago, we have put our interest into
convertibles, and at this point we want to thank our clients for having supported us
also in challenging times—particularly when convertible bonds were considered at
most a niche investment. Unjustly!
For being a hybrid, convertible bonds offer the “best of both worlds,” the
benefits of an equity with the advantages of a corporate bond. AgaNola is consid-
ered a leading provider in this asset class, and to date convertible bonds remain the
core competence of us as a specialized asset manager.
As we consider increasingly popular convertible bonds a living and dynamic
universe, we are placing a great importance on research and the exploration of the
nature of this asset class. As an internationally renowned expert in the fixed income
and bond field, Dr. Wolfgang Marty has contributed valuable insights to our
work—making the bridge from theory to portfolio management. AgaNola is
committed to continue to support his fundamental research.
We wish Wolfgang Marty lots of success with his latest book.

Chairman and Founder AgaNola AG Stefan Hiestand

v
Foreword

Compared to other asset classes, fixed income investments are routinely considered
as a relatively well-understood, transparent, and (above all) safe investment. The
notions of yield, duration, and convexity are referred to confidently and resolutely
in the context of single bonds as well as bond portfolios, and the effects of interest
rates are generally believed to be well-understood.
At the same time, we live in a world where the amount of private, corporate, and
sovereign debt is steadily increasing and where postcrisis stimuli continue to affect
and distort investor behavior and markets in an unprecedented way. And that is
even before we start contemplating the enormous uncertainties introduced by
negative interest rates.
In his book, Dr. Wolfgang Marty covers and expands on classic fixed income
theory and terminology with a clarity and transparency that is rare to be found in a
world where computerization of accepted facts often is the norm. Wolfgang
highlights obvious but commonly unknown conflicts that can be observed, for
example, when applying standard theory outside its default setting or when migrat-
ing from single to multiple bond portfolios. He also includes the effects of negative
interest rates into standard theory.
Wolfgang’s book makes highly informative reading for anyone exposed to fixed
income concepts, be it as a portfolio manager or as an investor, and it shows that
often we understand less than we think when studying bond or bond portfolio
holdings purely based on their commonly accepted key metrics; Wolfgang
encourages to ask questions. Anyone building automated software would benefit
from familiarity with the model discrepancies highlighted as it is to everyone’s
disadvantage if we find these too deeply rooted in commonly and widely applied
tools.
In summary, Wolfgang’s book makes interesting reading for the fixed income
novice as well as the seasoned practitioner.

Head of Quantitative Research Dr. Jan Hendrik Witte

Record Currency Management

vii
Preface

Computers have become more and more powerful and often are an invaluable aid.
But there is a considerable disadvantage: often, the output of a computer program is
difficult to understand, and the end user may be swamped by data. In addition,
computers solve problems in many dimensions, and, as human beings, we struggle
thinking in more than a few dimensions. To provide a sound background of
understanding to anyone working in fixed income, we intend to illustrate here the
essential basic calculations, followed by easy to understand examples.
The reporting of return and risk figure is paramount in the asset management
industry, and the portfolio manager is often rewarded on performance figures. The
first motivation for the here presented material were the findings of a working group
of the Swiss Bond Commission (OKS), where we compared the yield for a fixed
income benchmark portfolio calculated by different software providers: we found
different yields for the same portfolio and the same underlying time periods. The
following questions are obvious: How can a regulating body accept ambiguous
figures? Should there not be a standard?
An additional complication is linearization, often the first step in analyzing a
bond portfolio. The yield of the bonds in a bond portfolio is routinely added to
report the yield of the total bond portfolio, and different durations of bonds in the
portfolio are simply added to indicate the duration of a bond portfolio. We found
that linearization works well for a flat yield curve, but the more the yield deviates
from a flat curve, the more the resulting figures become questionable.
Also, historically, interest rates have been positive. In the present market
conditions, however, interest rates are close to zero or even slightly negative. We
find ourselves confronted with several questions: Does the notion of duration still
make sense in this new environment? And which formulae can be applied for
interest rates equal or very close to zero? How do discount factors behave? In the
following, we attempt to include negative interest in our considerations. For
instance, in the world of convertibles, yield to maturities can easily be negative
and is not problematic.

ix
x Preface

We describe the here presented material in three ways. Firstly, we use words and
sentences, in order to give an introduction into in the notions, definitions, ideas, and
concepts. Secondly, we introduce equations. Thirdly, we also use tables and figures
in order to make the outputs of our numerical calculations accessible.

Pfaeffikon SZ, Switzerland Wolfgang Marty

July 18, 2017
Acknowledgments

This book is based on several presentations, courses, and seminars held in Europe
and the Middle East. The here presented material is based on a compilation of notes
and presentations. Presenting fixed income is a unique experiment and I am grateful
for the many feedbacks from the audience. The initial motivation for the book was a
seminar held at the education center of the SIX Swiss Exchange. I became aware
that many issues in fixed income need to be restudied and revised; moreover, I did
not find satisfying answers to my questions in the pertinent literature. The SIX
Swiss Exchange Bond Advisory Group was an excellent platform for analyzing
open issues.
Furthermore, the working group “Portfolio Analytics” of the Swiss Bond Com-
mission was instrumental for the research activities. In particular my thanks go to
Geraldine Haldi, Dominik Studer, and Jan Witte. They revised part of the manu-
script and provided helpful comments.
The European Bond Commission (EBC) was very important for my professional
development. The members of the EBC Executive Committee Chris Golden and
Christian Schelling gave me continuing support for my activities, and the EBC
sessions throughout Europe yielded important ideas for the book.
At the moment I am focusing on convertibles. My thanks go to Marco Turinello
and Lukas Buxtorf for introducing me into the analytics of convertibles. The last
chapter of the book is dedicated to convertibles.
The book was written over several years, and I am grateful to my present
employer AgaNola for the opportunity to complete this book.

xi
Conventions

This book consists of eight chapters. The chapters are divided into sections. (1.2.3)
denotes formula (3) in Sect. 1.2. If we refer to formula (2) in Sect. 1.2, we only write
(2); otherwise we use the full reference (1.2.2). Within the chapters, definitions,
assumptions, theorems, and examples are numerated continually, e.g., Theorem 2.1
refers to Theorem 1 in Chapter 2.
Square brackets [ ] contain references. The details of the references are given at
the end of each chapter.

xiii
Contents

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2 The Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1 The Return Over a Time Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 Discount Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.3 Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3 The Flat Yield Curve Concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.1 The Description of a Straight Bond . . . . . . . . . . . . . . . . . . . . . . . 17
3.2 Yield Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.3 Duration and Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.4 The Approximation of the Internal Rate of Return . . . . . . . . . . . . 55
3.4.1 The Direct Yield of a Portfolio . . . . . . . . . . . . . . . . . . . . . 57
3.4.2 Different Approximation Scheme for the Internal
Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
3.4.3 Macaulay Duration Approximation Versus Modified
Duration Approximation . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.4.4 Calculating the Macaulay Duration . . . . . . . . . . . . . . . . . . 89
3.4.5 Numerical Illustrations . . . . . . . . . . . . . . . . . . . . . . . . . . 93
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
4 The Term Structure of Interest Rate . . . . . . . . . . . . . . . . . . . . . . . . 103
4.1 Spot Rate and the Forward Rate . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.2 Discrete Forward Rate and the Instantaneous Forward Curve . . . . 107
4.3 Spot Rate and Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
4.4 The Effective Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
5 Spread Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
5.1 Interest Rate Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
5.2 Rating Scales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
5.3 Composite Rating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
5.4 Optionality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

xv
xvi Contents

6 Different Fixed Income Instruments . . . . . . . . . . . . . . . . . . . . . . . . . 149

6.1 Segmentation of the Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . 149
6.2 Floating Rate Note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
6.3 Interest Rate Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
6.4 Asset Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
7 Fixed-Income Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
7.1 Definition and Fundamental Properties . . . . . . . . . . . . . . . . . . . . 159
7.2 Constructing a Fixed-Income Benchmark . . . . . . . . . . . . . . . . . . 160
7.3 Recent Developments in the Benchmark Industry . . . . . . . . . . . . . 162
7.4 Fixed Income as Asset Class . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
7.4.1 Equity Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
7.4.2 Fixed-Income Indices . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
7.4.3 Hedged Fixed-Income Indices . . . . . . . . . . . . . . . . . . . . . 167
7.4.4 Commodity Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
8 Convertible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
8.1 Basics Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
8.2 The Stock Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
8.3 The Bond Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
8.4 The Embedded Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
About the Author

Wolfgang Marty is senior investment strategist at AgaNola, Pfaeffikon SZ,

Switzerland. Between 1998 and 2015, he was working with Credit Suisse. He joined
Credit Suisse Asset Management in 1998 as head product engineer. He specializes
in performance attribution, portfolio optimization, and fixed income in general.
Prior to joining Credit Suisse Asset Management, Marty worked for UBS AG in
London, Chicago, and Zurich. He started his career as an assistant for applied
mathematics at the Swiss Federal Institute of Technology.
Marty holds a university degree in mathematics from the Swiss Federal Institute
of Technology in Zurich and a doctorate from the University of Zurich. He chairs
the method and measure subcommittee of the European Bond Commission (EBC)
and is president of the Swiss Bond Commission (OKS). Furthermore, he is a
member of the Fixed Income Index Commission at the SIX Swiss Exchange and
a member of the Index Team that monitors the Liquid Swiss Index (LSI).

xvii
Introduction
1

A fixed-income security is a financial obligation of an entity that promises to pay a

specified sum of money at specified future dates. The entity can be a government, a
company, or an individual and is called an issuer. The investor lends a specified
amount of money to the issuer. A bond is a legal engagement between the issuer and
an investor.
A bond is a fixed-income instrument and has usually a finite live. Periodic future
cash flows from the issuer to the investor are called the coupon of the bond.
Coupons are unaffected by market movements for the live of the bond and reflect
the notion “fixed income.” As depicted in Fig. 1.1, a straight bond or a coupon
paying bond is a bond that pays a coupon periodically and pays back at the end of its
live the money that was originally invested. For precise definitions and analytics,
we refer to Chap. 3.
The bond markets have grown tremendously, and today there is a large universe
of organizations that issues bonds. Together with equities, bonds are the two major
traditional asset classes in financial markets. There are much different bonds than
equities. For instance, there were 5447 shares traded and admitted to trading on the
EU regulated market (mifiddatabase.esma.europa.eu), and TRAX has data for
300,000 government bonds, corporate bonds, medium-term notes, and private
derivative issues (xtrakter.com).
The time to maturity and the coupon are fixed at the issuance of a bond and are
thus called static data or reference data, whereas the market price is determined by
the trading activity and is thus called market data.
Unlike equities, every bond has potentially special and unique features. A
company has one or two kinds of equities but many different bonds. Bond markets
are very fragmented. Figure 1.2 (see www.sifma.org/research/statistics.aspx) shows
the development of the four most important segments of the US Bond Market. Ever
since interest rates began to climb in the late 1960s, the appeal for fixed-income
instrument has increased. This is due to the fact that interest levels were competitive
with other instruments, and at the same time, the market rates began to fluctuate
widely, providing investors with attractive capital gain opportunities emphasizing

# Springer International Publishing AG 2017 1

W. Marty, Fixed Income Analytics, DOI 10.1007/978-3-319-48541-6_1
2 1 Introduction

cash
flows

Original
investment

coupon coupon coupon coupon Original time

Investment +
coupon

Fig. 1.1 Straight bonds

Outstanding U.S. Bond Market Debt

14,000.0

12,000.0

10,000.0
Municipal
8,000.0
Treasury
6,000.0 Mortgage Related

4,000.0 Corporate

2,000.0

0.0
1980 1985 1990 1995 2000 2005 2010

Fig. 1.2 The development of the US bond market

that fixed income is not necessarily fixed income. Only for the buy and hold
investor, i.e., the investor who keeps the bond till maturity, cash flows are fixed.
The here presented material gives a comprehensive introduction to fixed-income
analytics. Some of the topics are:

• The transition from a single bond to portfolio of bonds is examined. We

investigate the nonlinearity of income since just adding characteristics of indi-
vidual bonds yields in general wrong results for the overall portfolio.
• We consider market-relevant values for interest rates and examine different
shape of the yield curve. In particular, we discuss negative interest rates.
• We introduce the main ideas for assessing the credit quality of a bond. We
compile different definitions of the default of a bond.
• We describe the construction of an income benchmark and give an overview of
different benchmark providers.
1 Introduction 3

We now provide more detail about the different chapters of this book.
Chapter 2 describes the time value of money. This chapter contains the building
blocks of a fixed-income instrument. We introduce the concept of an interest rate.
We stress specifically that throughout this book and all its results, we treat negative
and positive interest rates with generality (rather than favoring positive interest
rates as has been so common in the literature until now).
In Chap. 3, the flat yield curve concept is explained, i.e., every cash flow is
discounted by the same interest rate. This does not mean that the yield curve is flat.
If all bonds have the same yield, the yield curve is said to be flat. We discuss
deviation of the flat yield curve.
The yield to maturity is a well-established measurement for indicating a bond’s
future yield. It is derived from the coupon, the nominal value, and the term to
maturity of the bond.
Portfolio analysis frequently refers to the “yield.” The question is which yield?
In the following, we will not focus on a single bond. Rather, we will examine the ex
ante yield of an entire bond portfolio, i.e., exclusively future cash flows are factored
into the calculation. The equation for yield to maturity will be generalized to derive
an equation for the bond portfolio (internal rate of return). This equation is not
solved exactly by the programs offered by most software providers; instead, it is
considered in combination with the yields to maturity of the individual bonds.
In Chap. 4, we speak about the transition from yield curve to spot curves and spot
curves to forward curves (see Fig. 1.3). Figure 1.3 refers to a specific time and does
not say anything about the dynamic of the curve. Actual prices are measured in the
marketplace, and yield, spot, and forward curve are in general calculated or
computed. Duration is a risk measure of bonds and bond portfolios. Here, we assess
the durations in the context of a bond and a portfolio of bonds. Effective duration
versus durations based on the flat yield concept is discussed. Modified duration is

Fig. 1.3 Different interest

rate term structures
forward rate

spot rate

yield to maturies
4 1 Introduction

used for a sensitivity analysis of a bond portfolio. The different durations we

introduced tackle the interest risk and the yield curve risk. The duration is the
fulcrum of a bond and can be compared to an equilibrium in physics.
In Chap. 5, we depart from the assumption that a straight bond is riskless. We
consider credit markets. The credit quality of a bond is described by different
spreads. We introduce the normal spread and the Z-spread and give the definition
of default of a bond from S&P, Moodys, and Fitch. More recent developments of
credit markets are described. We illustrate some figures from a transition matrix and
discuss composition ratings followed by the description of call and put features of
a bond.
In Chap. 6, we start with float rate notes. Unlike fixed coupons, floating rates are
tied to the short end of the yield curve. We give an introduction in the analytics of
floating rate notes. We then proceed with the interest rate swap, which exchanges
the liability of two counterparties. Interest swap markets are important for steering
the duration of a bond portfolio. In the last section of the chapter, asset swaps are
described.
Starting point in Chap. 7 are the basic characteristics of a benchmark. An
overview of different benchmark providers is given. We describe benchmarks
from different asset classes and discuss benchmarks for a balanced portfolio. We
give more recent developments in the benchmark industry.
In Chap. 8, we give an introduction into convertible bonds. Convertible is
corporate bond with an option on the stock of the issuing company. Convertibles
can behave like a bond as well as a stock. We compile the most important notions
describing a convertible. Difficulties of pricing a convertible are discussed.
The Time Value of Money
2

In this chapter, we introduce the basic notions and methods for assessing fixed-
income instruments. The subject of this chapter is the connection between time and
the value of money.

2.1 The Return Over a Time Unit

Return measurement always relates to a time span, i.e., it matters whether you earn
a specific amount of money over a day or a month. Therefore, return measurement
has to be relative to a unit time period. In finance, the most prominent examples are
a day, a month, or a year. In Fig. 2.1 we see a unit time period and a partition into
four time spans of the same length.
With a beginning value BV and a yearly or annular interest r, we write

EV1 ¼ BVð1 þ rÞ ð2:1:1Þ

for the ending value EV1. The underlying assumptions of (1) are that:

• We hold the beginning value over one year.

• There is no interest payment and no cash flow during the year.

Example 2.1 We consider for BV a Coupon C of an annual paying bond. Then

(1) expresses the ending value EV1 after 1 year. In the European bond market,
coupons are usually paid yearly.
The index 1 in EV1 says that there is no cash flow during the year and EV1.
Next, we assume that one half of the interest is pay out in the middle of the year,
which gives

# Springer International Publishing AG 2017 5

W. Marty, Fixed Income Analytics, DOI 10.1007/978-3-319-48541-6_2
6 2 The Time Value of Money

Fig. 2.1 The time unit t1 = 0.25 t3 = 0.75

t0 = 0 t2 = 0.5 t4 = 1 t

h

 
r i
r r2
EV2 ¼ BV  1 þ : 1þ ¼ BV 1 þ r þ :
2 2 4

Here, we have a reinvestment assumption about the middle of the year: we

assume that the money received is reinvested with the same interest rate r. We
observe that EV2 > EV1, and we proceed by iterating and taking the limit:
 
1 n
EV ¼ BV lim 1þ , n ¼ 1, 2, 3, . . .
n!1 n

The question is whether the sequence EVn is bounded or unbounded. The answer
is that the sequence is convergent since from calculus we know that
 
1 n
lim 1 þ ¼e
n!1 n

with

e ¼ 2:71828 18284 5905:

From calculus we also have

    r
r n 1 nr 1 n
lim 1 þ ¼ lim 1 þ ¼ lim 1þ ¼ er :
n!1 n n!1 n n!1 n

Hence, when compounding with an infinitely small compounding interval, the

continuous compounding expression becomes

EV1 ¼ BVer :

Example 2.2 For r ¼ 0.05 (¼5% annually) and BV ¼ $100 we get in decimals

EV2 ¼ $105.06250 (semi-annual).

EV4 ¼ $105.09453 (quarterly).
EV100 ¼ $105.1257960.
EV1000 ¼ $105.1269782.
EV10000 ¼ $105.1270965.
2.2 Discount Factors 7

EV100000 ¼ $105.1271083.
EV1 ¼ $105.1271109 (continuous).

Definition 2.1 The return

EVn  BV
AERðnÞ ¼ , n ¼ 1, 2, 3, . . .
BV
is called the annual effective rate.

Remark 2.1 For discrete compounding, we have

EVn  BV EVn
r n
AERðnÞ ¼ ¼ 1¼ 1 þ  1, n ¼ 1, 2, . . . :
BV BV n
and for continuous compounding, we have with n!1

AER ¼ er  1:

Example 2.3 We consider a semiannual bond with face value F 1 year before
maturing. Furthermore, we assume there are two coupons, i.e., we get C/2 in the
middle of the year and C/2 at the end of the year. By using continuous compounding
and prevailing interest r1 and r2, we find
 
C r1 C r2
P¼ e þ Fþ
2 e :
2 2

2.2 Discount Factors

The time value of money concept is concerned with the relationship between cash
flow C occurring on different dates. If C > 0 or C < 0, the investor has an inflow or
outflow, resp., in his or her portfolio. The cash flow can occur at arbitrary different
dates. A simple time pattern is depicted in Fig. 2.1. In Fig. 2.2, we introduce N time
knots between the time knot t0 and tN, where the time t is the independent variable.
We specify N (not necessarily equidistant) knots on the time axis with
corresponding times tk and denote them by

tk , 0  k  N: ð2:2:1Þ

By assuming t0 ¼ 0, t0 is the present or for short t0 is now. However, in principle,

t0 can be in the past (t0 < 0) or in the future (t0 > 0). For illustration purposes, we
use years as units. Then, for equidistant knots of annual cash flows between t0 and
tN, we have
8 2 The Time Value of Money

equidistant knots

t
t0 = 0 t1 t2 tk tN tN = T
1

Fig. 2.2 The time axis

tk ¼ k, 0  k  N: ð2:2:2Þ

For two equidistant knots over 1 year, we have N ¼ 2, and the time knots are
marked by

1
t1 ¼ ,
2
t2 ¼ 1:

Definition 2.1 The discount factor function or for short the discount factor
d(r(t  tk), t, tk) with an annual discount rate function r(t  tk) > 1,
k ¼ 0,. . ., N, at arbitrary time tk ∈ R1 for arbitrary t ∈ R1, is defined by

1
dðrðt  tk Þ; t; tk Þ ¼ , ð2:2:3aÞ
ð1 þ rðt  tk ÞÞðttk Þ

and for equidistant knots tj ¼ j with rj ¼ r(tj) and tk ¼ 0, the abbreviation

     1
dj rj ¼ d r tj ; tj ; 0 ¼  tj ð2:2:3bÞ
1 þ rj

is often used.
We see that in (3), $1 is discounted by the discount factor d(r, t, tk). We consider
in the following the more general form by considering a cash flow C and a
beginning value BV:

BVðC; rðt  tk Þ; t; tk Þ ¼
Cdðr; t; tk Þ 
C
 : ð2:2:4Þ
1 þ r t  tk ðttk Þ

Example 2.4 We choose N ¼ 4 in (1, 2) with a cash flow $3 in t ¼ tN ¼ 4. With

t0 ¼ 0 and r(t) ¼ r ¼ 5% in (3), we have for the beginning value BV with (4)
2.2 Discount Factors 9

3.00

2.50

2.00
r = 0.5
r =0
1.50
r = -0.5

1.00

0.50
-6.00 -4.00 -2.00 0.00 2.00 4.00 6.00

Fig. 2.3 Discount factor ex post and ex ante

$2 $2
BVð$3; 2%; 2; 0Þ ¼ ¼ ¼ $1:567052:
ð1 þ rÞ4 ð1 þ 0:05Þ4

In Fig. 2.3, we assume N ¼ 10 and show the discount factor for the interest rates
r ¼ 0.05, r ¼ 0, and r ¼ 0.05 between the times t0 ¼ 5 (ex post) and t10 ¼ 5
(ex ante). We see that the behavior of the discount factors is different for positive
and negative discount factors.

Remark 2.2 From Eq. (2.1.1), we have with C ¼ EV after one time unit

C ¼ BV ð1 þ rÞ:

On the interval r ∈ (1, 0), we see that value is destroyed, i.e., C < BV, and for
r ¼ 1, we have complete loss, i.e., C ¼ 0.
The following lemma summarizes some fundamental properties about discount
factors:

Lemma 2.1 In (4) we have under the assumption C > 0:

(a) For fixed r ∈ R1 with r > 1 and t ∈ R1 with t > 0, BV(C, r, t, tk) is a
monotonically increasing linear function of C, i.e.,

BVðλC; r; t; tk Þ
ð2:2:5Þ
¼ λBVðC; r; t; tk Þ, λ ∈ R1 :

(5) says that by changing the cash flow by a fixed factor, the value at present is
multiplied by the same factor.
10 2 The Time Value of Money

(b) For fixed C ∈ R1 and t ∈ R1 with t > 0, BV(C, r, t, tk) is a monotonically

decreasing function of r. The higher the interest, the less worth is the money at
present.
(c) For C ∈ R1 and for t ∈ R1, BV(C, r, t, tk) is for a fixed r ∈ R1:
• With r > 0 monotonically decreasing
• With r ¼ 0 constant
• With 1 < r < 0 monotonically increasing function of t
(d) The series of the discount factor

C
dn ¼ , n ¼ 1, 2, 3, . . .
ð1 þ rÞn

are:

• For r > 0, monotonically decreasing and converging with limit 0.

• For r ¼ 1, the series is constant with dn ¼ 1, n ¼ 1, 2, 3, . . .,
• For 1 < r < 0, the series dn is diverging for n! 1 .

Proof From (4), we have

1 1 1
¼ ,
ð1 þ rÞðttk Þ ð1 þ rÞt ð1 þ rÞtk

and by assuming r > 1, we have

1
> 0,
ð1 þ rÞtk

i.e., in order to show monotonicity, it is enough to consider

C
BVðC; r; t; 0Þ ¼ :
ð1 þ r Þt

The assertions a and b follow from the partial derivatives

∂BV 1
¼ > 0,
∂C ð1 þ r Þt

∂BV
¼ Ct ð1 þ rÞτ1 < 0:
∂r
The assertion c follows also from the partial derivative and the hypothesis that
the coupon is positive. We have to distinguish the following cases:
2.2 Discount Factors 11

• For r > 0,

∂BV
¼ Cet ln ð1þrÞ
ð ln ð1 þ rÞÞ < 0:
∂t
• For r ¼ 0,

∂BV
¼ 0,
∂t
• For 1 < r < 0,

∂BV
¼ C et ln ð1þrÞ
ð ln ð1 þ rÞÞ > 0:
∂t

The assertion d follows from induction with respect to n. □

Lemma 2.1 discusses the monotonicity of the discount factors. We assumed
three independent variables, C, r, and t. In the following lemma, we change the
three variables simultaneously, and we see that there is no monotonicity.

Lemma 2.2 For 100C ¼ t (1  t  10) and C ¼ r, the function defined in (4) has a
global maximum for C ¼ 7.259173%, and we have

BVðC; C; C=100Þ ¼ 4:364739:

Proof By assumption, we have:

C C
BVðC; r; tÞ ¼ t ¼ :
ð1 þ rÞ ð1 þ CÞ100C

We use the product rule for the derivative

1
d
dBV 1 ð1 þ CÞ100C 1 dexpð100C ln ð1þCÞÞ
¼ 100C
þC ¼ 100C
þC
dC ð1 þ C Þ dC ð1 þ C Þ dC
1 d ð100C ln ð 1 þ C Þ Þ
¼ þ Cexpð100C ln ð1þCÞÞ
ð1 þ CÞ100C  
dC

1 100C
¼ 1 þ C 100 ln ð1 þ C Þ þ :
ð1 þ CÞ100C 1þC

The condition
12 2 The Time Value of Money

function values
2
first Derivative
BV

second derivative
1

0
1 2 3 4 5 6 7 8 9 10 11

-1
C

Fig. 2.4 Global maximum

∂BV
¼0
∂C
is the same as
 
1 C 100C
 100 ln 1þ  ¼ 0:
C 100 1þC

Figure 2.4 shows this function, and a numerical method calculates the values
stated in the lemma, which completes the proof. □
We investigate the behavior of the discount factors in more detail in Example 4.7
(Chap. 4).

2.3 Annuities

In this section, we consider multiple cash flows. We start with the following
definition:

Definition 2.2 An annuity is a finite set of level sequential cash flows at equidis-
tant knots (2.2.2). An ordinary annuity has a first cash flow one period from the
present, i.e., in the time point t1 ¼ 1. An annuity due has a first cash flow
immediately, i.e., at t0 ¼ 0. A perpetuity or a perpetual annuity is a set of level
never-ending sequential cash flows.
2.3 Annuities 13

Lemma 2.2 A closed formula for the beginning value BVor of an ordinary annuity
in the time span between t0 ¼ 0 and tN is, for 1 < r < 0 or r > 0,
!
C 1
BVor ¼ 1 , ð2:3:1aÞ
r ð1 þ rÞN

and for the ending value EVor we find

C

EVor ¼ ð1 þ rÞN  1 : ð2:3:1bÞ
r
For r ¼ 0, we have

BVor ¼ EVo ¼ N:

A closed formula for an annuity due for the beginning value BVdue in the time
span t0 ¼ 0 and tN is, for 1 < r < 0 or r > 0,
!
C 1
BVdue ¼ 1þr , ð2:3:2aÞ
r ð1 þ r ÞN

and for the ending value EVdue, we find

C

EVdue ¼ ð1 þ rÞNþ1  1 : ð2:3:2bÞ
r
For r ¼ 0, we have

BVdue ¼ N þ 1:

A closed formula for the value PBVor of perpetual ordinary annuity in t0 ¼ 0 is,
for 1 < r < 0 or r > 0,

C
PBVor ¼ : ð2:3:3aÞ
r
A closed formula for the value PBVdue of an perpetual annuity due in t0, t0 ¼ 0,
denoted by PBVdue, is, for 1 < r < 0 or r > 0,

Cð1 þ rÞ
PBVdue ¼ : ð2:3:3bÞ
r

Proof We use the closed formula of a geometric series. For details see
Appendix A. □
14 2 The Time Value of Money

Remark 2.3 EV and BV are related by

BV
EV ¼ , ð2:3:4Þ
ð1 þ rÞN

and for N!1 and r > 0, we have

EV ¼ 0:

Example 2.5 For N ¼ 1 in (1a), we have

   
C 1 C 1þr1 C
BVor ¼ 1 ¼ ¼ :
r 1þr r 1þr 1þr

For N ¼ 1 in (2a), we have


  C ð1 þ r Þ2  1
C 1 Cð2r þ r2 Þ C
BVdue ¼ 1þr ¼ ¼ ¼Cþ :
r 1þr rð1 þ rÞ rð1 þ rÞ 1þr

Example 2.6 With C ¼ $150,000 and r ¼ 3%, we have by (3a)

$150, 000
¼ $5, 000, 000,
3%
i.e., for an annual income of $150,000, the capital of $5,000,000 is needed.
The following lemmas decompose the balance at each point of time of a cash
flow into the cash flow and the accumulated interest rate.

Lemma 2.3 (Repayment of Mortgage) We assume that a BV and an interest r > 0

are given. The periodic payment of ordinary annuity is

r
Cor ¼ BV , ð2:3:5aÞ
1  ð1þr
1
ÞN

and for an annuity due, we have

r
Cdue ¼ BV : ð2:3:5bÞ
ð1 þ rÞ  ð1þr1ÞNþ1

Starting with an initial value BV, we consider the iteration

C
Bnþ1 ¼ Bn þ : ð2:3:6Þ
ð1 þ rÞnþ1
2.3 Annuities 15

With B1 ¼ 1þr
C
and (6) with n ¼ 2,. . .,N, we have for an ordinary annuity
(1a)

BN ¼ Bord ¼ BV: ð2:3:7aÞ

With B0 ¼ C and (6) with n ¼ 1,. . .,N, we have for an annuity due (2a)

BN ¼ Bdue ¼ BV: ð2:3:7bÞ

We decompose the annuity by the part that is due to the interest rate in the last
period and the part which is due to the amortizing part

C ¼ r Bn þ ðC  r Bn Þ:

Proof We consider the partial sum

X
n
C
Bn ¼ k
:
k¼1 ð1 þ rÞ

Then, for n ¼ N, we have (7a) based on (5) and Lemma 2.2. We consider the
partial sum

X
n
C
Bn ¼
k¼0 ð1 þ rÞk

with B0 ¼ C, and the proof (7b) follows like for the proof for (7a). □

Lemma 2.4 (Accumulation of Capital) We assume that an EV and an interest rate

r > 0 are given. The periodic payment of ordinary annuity is

r
Cor ¼ EV , ð2:3:8aÞ
ð1 þ r ÞN  1

and for an annuity due, we have

r
Cdue ¼ EV ð2:3:8bÞ
ð1 þ rÞNþ1  1þr
1
:

We consider the iteration

Enþ1 ¼ ð1 þ rÞnþ1 C þ En : ð2:3:9Þ

With E1 ¼ (1+r) C and (9) with n ¼ 2,. . .,N, we have for an ordinary annuity
(1b)
16 2 The Time Value of Money

Table 2.1 Amortization schedule

Scheduled End of month
Beginning of month Mortgage principal mortgage
Month mortgage balance payment Interest repayment balance
1 100,000 742.50 677.08 65.41 99,934.59
2 99,934 742.50 676.64 65.86 99,868.73
⋮ ⋮ ⋮ ⋮ ⋮ ⋮
359 1470.05 742.50 14.88 727.54 737.50
360 737.50 742.50 4.99 737.50 0.000

Eor ¼ EN ¼ EV: ð2:3:10aÞ

With E0 ¼ C and (9) with n ¼ 1,. . .,N, we have for an annuity due in (2b)

Edue ¼ EN ¼ EV: ð2:3:10bÞ

We decompose the annuity by the part which is due to increase of the balance
minus the interest rate payment in last period:

C ¼ ð C þ r En Þ  r En :

Proof We consider the partial sum

X
n
En ¼ ð1 þ rÞk C:
k¼1

Then, for n ¼ N, we have (10a) based on (5) Lemma 2.2. We consider the partial sum

X
n
En ¼ ð1 þ rÞk C:
k¼0

with E0 ¼ C. The proof (10b) follows like the proof for (10a). □

Example 2.7 We consider a fixed-rate mortgage such that the payments are equal.
We consider a mortgage of $100,000 with a mortgage rate of 8.125% over 10 years
with monthly payments. The investor pays off the mortgage completely in equal
installments. We have

rð1 þ rÞN
C ¼ BV ¼ ¼ $742:50:
ð1 þ rÞN  1

The amortization schedule is in Table 2.1.

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