Agenda

Differentiation
Taylor's approximation
Application of Derivatives in Finance
Partial Differentiation
Integral calculus
Optimization
Modified Duration of Bonds

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Agenda

Differentiation
Taylor's approximation
Application of Derivatives in Finance
Partial Differentiation
Integral calculus
Optimization
Modified Duration of Bonds

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(Confidential)

Differential and Integral calculus

Differentiation
Measure of how a function changes, with respect to its input
Applications
Calculation of marginal utility
Measuring the rate of change of the price of a bond as a result of a change in the yield
on that bond
In structuring of a portfolio of risky assets in order to maximize the portfolio return for a
given level of portfolio risk. i.e. optimization

Integration
Known as summation/ anti-derivative, finds area under the curve or surface
Applications
Finding the expected value of a European option at expiry
Finding the probability in a given range of outcomes by finding the area under a
probability density function.

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Differentiation
First derivative
Measures how fast the dependent variable is changing with respect to independent
variable
dy

Denoted by dx or f'(x)

For a line Y=mX + c, m represents the slope of the line :change of vertical coordinate
with respect to horizontal coordinate and is given by

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dy
dx

Differentiation (Cont)
Let a, b, c be the constants then
d (c )
0
dx

d (ax b)
a
dx
d (xn )
nx n 1
dx

Example: Differentiate x 5

d ( x5 )
5x 4
dx
Example : Differentiate x

d ( x 5 ) 1 ( 6 5 )

x
dx
5

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Differentiation (Cont)
Product of two function
If y = u.v, then dy v du u dv
dx

dx

dx

Examples: Differentiate the following

a) 3x 4 x 2 5x3
Using summation rule of differentiation we get,
dy d (3x) d (4 x 2 ) d (5 x 3 )

3 8 x 15 x 2
dx
dx
dx
dx

b) u 3x

v (4 x 2)
dv
du
4x
3
dx
dx
dy
3x(4) (4 x 2)3 24 x 6
dx

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Differentiation (Cont)

Rules

d ( f ( x)) c
c( f ( x)) c 1 ( f ' ( x))
dx

Example

Chain rule

d (3x 4) 6
6(3x 4)5 (3) 18(3x 4)5
dx

If y = f(u) and u = f(x), then

dy
dy du

*
dx
du dx

Differentiate

(3x 4) 4

4
u 3x 4 y u
dy
du
4u 3
3
du
dx
dy
12u 3 12(3x 4)3
dx

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Differentiation (Cont)

Rules

de x
ex
dx
d ln x 1

dx
x

Example :Differentiate

e5 x ln(3x 2 )

u e 5 x , v ln(3 x 2 )
du
5e 5 x
dx
dv
1
2

f
'
(
3
x
)
dx
3x 2
2

x
dy
2
hence ,
5e 5 x
dx
x

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Higher order derivatives

Second order derivative
Derivative of a derivative
Rate of change of slope

Denoted by f " ( x) or

dy
)
dx
dx

d(

d2y
dx 2

d d2y
Third order derivative = ( 2 )
dx dx
Further higher order derivatives are also calculated in the similar way
Example: Find 2nd order and 3rd order derivatives of (3x 4)

y (3x 4) 3
dy
9(3x 4) 2
dx
d2y
18(3x 4) * f ' (3x 4) 54(3x 4)
dx 2
d3y
162 x
dx 3

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