Financial Exam Help 123

Category: Level I

  • Equivalence of Derivatives (Swaps, FRAs, and Interest Rate Options)

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    Bill Campbell
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    Various interest rate derivatives are, in fact, equivalent to each other; i.e., they can be structured to generate equivalent (though not necessarily identical) cash flows.  This article will explain how these derivatives can be structured to be equivalent to each other. First note that you will not be asked on an exam to create equivalent…

  • Swap Diagrams

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    Bill Campbell
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    This article’s going to turn out to be fairly short, but, I hope, quite useful.  It has pictures. Floating-Rate Inflow: Rates are Expected to Decrease Here’s the situation: you own a portfolio of investments (floating-rate bonds) paying 6-month USD LIBOR + 100bp; payments are every 6 months for the next three years.  You’re concerned that interest…

  • Utility Theory: Indifference Curves (Economics)

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    Bill Campbell
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    When I was an undergraduate student in university, I was fortunate enough to have to have written only two term papers.  One was in the capstone business management class I took my last semester, and the other was in a class in mathematical modeling.  The term paper I wrote for the latter class was on…

  • Substitution Effect vs. Income Effect

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    Bill Campbell
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    When the price of a good changes, there are two effects on the demand for that good: The substitution effect, which is a relative effect (i.e., how the demand for that good, by itself, changes relative to the demand for other goods) The income effect, which is an absolute effect (i.e., how the demand for…

  • Linear Interpolation/Extrapolation

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    Bill Campbell
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    After reading a number of posts on AnalystForum in which candidates have had difficulty with linear interpolation or extrapolation, I figured it was time to write an article on the subject.  At Level I it applies to binomial trees for calculating the weights for equity options, and for combining risky portfolios with the risk-free asset…

  • Equity Indices

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    Bill Campbell
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    An equity index is nothing more nor less than a hypothetical stock portfolio.  The index pretends to invest in a bunch of stocks, and tracks their performance over time.  It’s the sort of thing that you may have done in a high school economics or history class.  I did, at least. I don’t intend to…

  • Equilibria: Stable and Unstable

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    Bill Campbell
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    In economics, as in physics, an equilibrium is a point at which all opposing forces net to zero: once you’re there, there’s nothing that will drive you away. Do not assume that this means that all equilibria are created equal.  Far from it.  What matters is not what the forces do when you’re at an…

  • Binomial Pricing Trees (for Options)

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    Bill Campbell
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    Binomial trees are used in a variety of contexts in finance: Calculating probabilities for Bayes’ Formula type problems Calculating the value of options on stocks, commodities, and so on (you are here) Calculating the option-adjusted spread (OAS) for bonds Calculating the value of bonds with embedded options Calculating the value of floating-rate bonds Calculating the…

  • Yield Spreads

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    Bill Campbell
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    A yield spread is an amount of interest that is added to another interest rate (or rates) to achieve some specific goal.  For example, a yield spread might be added to the yield to maturity (YTM) of a risk-free bond to arrive at the YTM for a given risky bond of the same maturity.  Or…

  • p vs. α

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    Bill Campbell
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    Candidates galore have problems (nightmares, really . . . but let’s not rub it in) with p-values.  I’m here to tell you that understanding p-values is easy.  Seriously: easy. A p-value is nothing more nor less than a level of significance, just like α.  The best description I’ve heard is that α is the chosen…