Monday 25 August 2014

The Ghost Behind The Formulas


Staying up all night just to memorize formulas for finance is not a good solution. Because the set of formulas you memorize today will be forgotten by tomorrow. Remembering the logic behind the formula helps a lot.



For instance, Money market yield (rMM) is simply annualized version of Holding period yield (HPY). (considering 360 days a year)

So, rMM = (HPY) (360/t) ........................ (i)

On the other hand the difference between Bank discount yield and Money market yield is one is based on Face value (F) and the other is based on purchase price (P0). So, we just take the bank discount yield (rBD) and convert the ratio as if it was calculated by taking purchase price. So another formula for money market yield becomes

rMM = (rBD) (F/P0)  .................................(ii)

However, the most commonly used formula for Money market yield is derived in the following way

     rBD = (D/F) (360/t)
or, rBD = ((F-P0)/F)*(360/t)
or, F/P0 = 360 / (360 - (rBD * t)) ..............(iii)

Now replacing (ii) with (iii)

rMM = (rBD) (F/P0)
rMM = 360 * (rBD) / (360 - (rBD) (t)) .......(iv)

The formula number (iv) is the most used formula for Money Market Yield, however, it comes from certain financial and mathematical logic.

So the hush-hush is understand the logic.

Cheers!

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