STRATHMORE UNIVERSITY

SCHOOL OF FINANCE AND APPLIED ECONOMICS

Bachelor of Business Science – Actuarial Science, Finance & Financial Economics
BSA 2204: FINANCIAL MATHEMATICS II

Course Outline and Delivery plan

Lecturer: Dr Elphas Okango
Office: MSB Basement staffroom
Email: [email protected]
Office Hours: Monday 10am to 12pm
Pre-requisite: Financial Mathematics I
Eligible students
Bachelor of Business Science-Actuarial Science
Bachelor of Business Science-Finance
Bachelor of Science-Financial Economics
Course Description
At the core of the discipline, Financial Mathematics is the study of time value of money measured with using
an interest rate ‘і’ In the pre-requisite we made the business case for time value of money and demonstrated the
different forms of measures and simple products within an imaginary world where amount and timing of cash
flows was known with certainty and the interest rate was constant. In the real [dynamic] world, however, either
the amount, or timing of cash flows, or both are unknown. Further the rate of interest (cost of capital) is
constantly changing by the day, hour, minute.
In this course, the key assumption that we shall no longer enforce is that there are “constant interest rates”. We
shall also add another dimension of reality by introducing inflation and variation of desired rate of return given
over time of investment. Once we advance to this level we are in a position to analyze financial products that
are sophisticated and reflect the uncertainty in the market as well as the needs of the players in the financial
markets (e.g. borrowers and lenders of assets). The concept of arbitrage pricing is also introduced. This is a
more advanced technique of pricing shares and derivatives (e.g. forwards, futures and options).
This course assumes a solid knowledge of basic calculus and probability distribution functions. Further, as this
course builds on the concepts in Financial Mathematics I, the student is advised to refer to the knowledge from
that course as needed since that is the foundation on which this course is built. The concepts learnt will be
further advanced in BSA 3106 Financial Modeling I, BSA 3217 Financial Modeling II, and BSA 4121
Derivatives Securities and Derivative Markets.
Important Semester Dates:

1
Week Topic Learning Outcomes Mode of Delivery Reading list
1-2 Index-Linked Bonds The student should be able to recall: Lecture Notes
1. Solve the equation of value for the real rate of Lectures
return implied by the equation in the presence of Tutorials
inflation Worked out class practice
2. Calculate the PV and the real yield of an inflation questions
indexed bond

3-4 Arbitrage and Forward The student should be able to: Lecture Notes
contracts Lectures
1. Define arbitrage and explain why arbitrage may be Tutorials
Worked out class practice
considered impossible in many markets
questions

2. Calculate the delivery price and value of a forward

contract using no-arbitrage principle, assuming:

-no income or expenditure associated with the

underlying asset during the term of the contract a
-fixed income from the underlying asset during
the term of the contract

-a fixed dividend yield from the underlying asset

during the term of the contract

3. Calculate the value of a forward contract at any time

during the term of the contract in the absence of

2
4-6 Stochastic Models for The student should be able to: Lectures Lecture Notes
interest rates 1. describe the concept of a stochastic interest rate Tutorials
model and the fundamental distinction between Worked out class practice
this and a deterministic model. Derive questions
algebraically, for the model in which the annual
rates of return are independently and identically
distributed and for other simple models,
expressions for the mean value and the variance
of the accumulated amount of a single premium.
2. Derive algebraically, for the model in which the
annual rates of return are independently and
identically distributed, recursive relationships
which permit the evaluation of the mean value
and the variance of the accumulated amount of an
annual premium.
3. Derive analytically, for the model in which each
year the random variable has an independent log-
normal distribution, the distribution functions for
the accumulated amount of a single premium and
for the present value of a sum due at a given
specified future time.
4. Apply the above results to the calculation of the
probability that a simple sequence of payments
will accumulate to a given amount at a specific
future time.

CAT ONE 10%

3
 7-8 Term-structure of The student should be able to: Lectures Lecture Notes
interest rates Tutorials
1. Describe the theories of term structure of interest Worked out class practice
rates. questions
2. Explain what is meant by the par yield to maturity

3. Explain what is meant by spot and forward

interest rates, derive the relationships between and
evaluate spot rates and forward rates
4. Define and evaluate Duration and Convexity of
cashflow sequence.
5. Explain how duration and convexity are used in
the (Redington) immunisation of a portfolio of
liabilities.

CAT TWO 10%

9-12 Investment Products The student should be able to: Lectures Lecture Notes
1. Describe the investment and risk characteristics of Tutorials
the following types of asset available for Worked out class practice
investment purposes: questions
-fixed interest government borrowings and fixed -
-interest borrowing by other bodies
–index-linked government borrowings
–shares and other equity-type finance
-derivatives

4
13-15 Project Appraisal The student should be able to: Lectures Lecture Notes
1. Calculate the net present value and accumulated Tutorials
profit of the receipts and payments from an Worked out class practice
investment project at given rates of interest. questions
2. Calculate the internal rate of return implied by the
receipts and payments from an investment project.

3. Describe payback period and discounted payback

period and discuss their suitability for assessing
the suitability of an investment project.
4. Determine the payback period and discounted
payback period implied by the receipts and
payments from an investment project.
5. Calculate the money-weighted rate of return, the
time-weighted rate of return and the linked
internal rate of return on an investment or a fund.

CAT THREE 10%

5
 Academic Assessment

TYPE Weighting

CAT I 10%

CAT II 10%

CAT III 10%

EXAMS 70%

TOTAL 100%

Course Materials

1. Samuel A. Broverman, Mathematics of Investment and Credit, 4th ed., ACTEX Publications,
2008. ISBN 978-1-56698-657-1.
2. The Faculty of Actuaries and Institute of Actuaries, Subject CT1: Financial Mathematics,
Core Technical. Core reading for the 2013 examinations.
3. Stephen G. Kellison, The Theory of Interest, 3rd ed., McGraw-Hill, 2009. ISBN 978-007-
127627-6.
4. John McCutcheon and William F. Scott, An Introduction to the Mathematics of Finance,
Elsevier Butterworth-Heinemann, 1986. ISBN 07506-0092-6.
5. Petr Zima and Robert L. Brown, Mathematics of Finance, 2nd ed., Schaum's Outline Series,
McGraw-Hill, 1996. ISBN 0-07-008203.
6. Daniel, J.W., and Vaaler, L.J.F., Mathematical Interest Theory (Second Edition), 2009, The
Mathematical Association of America
7. McDonald, R.L., Derivatives Markets (Third Edition), 2013, Pearson
8. Chan, Wai-Sum, and Tse, Yiu-Kuen, Financial Mathematics for Actuaries, Updated Edition,
2013, McGraw-Hill Education (Asia)