Financial Mathematics Exercises Actuarial Studies UNSW

Australian School of Business
School of Actuarial Studies

Financial Mathematics
Exercises
S1, 2010
22 February 2010
Contents
1 Time Value of Money and Cash Flow Valuation 2
1.1 Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exercise 1.1 [int1] . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exercise 1.2 [int2] . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exercise 1.3 [int3] . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exercise 1.4 [int4] . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exercise 1.5 [int5] . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exercise 1.6 [int7] . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exercise 1.7 [int8] . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exercise 1.8 [int9] . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exercise 1.9 [int10] . . . . . . . . . . . . . . . . . . . . . . . . 3
Exercise 1.10 [int11] . . . . . . . . . . . . . . . . . . . . . . . 3
Exercise 1.11 [int12] . . . . . . . . . . . . . . . . . . . . . . . 3
Exercise 1.12 [int13] . . . . . . . . . . . . . . . . . . . . . . . 3
Exercise 1.13 [int15] . . . . . . . . . . . . . . . . . . . . . . . 3
Exercise 1.14 [int19] . . . . . . . . . . . . . . . . . . . . . . . 4
Exercise 1.15 [int18] . . . . . . . . . . . . . . . . . . . . . . . 4
Exercise 1.16 [int20] . . . . . . . . . . . . . . . . . . . . . . . 5
Exercise 1.17 [int6] . . . . . . . . . . . . . . . . . . . . . . . . 5
Exercise 1.18 [int14] . . . . . . . . . . . . . . . . . . . . . . . 5
Exercise 1.19 [int24] . . . . . . . . . . . . . . . . . . . . . . . 5
Exercise 1.20 [int25] . . . . . . . . . . . . . . . . . . . . . . . 5
Exercise 1.21 [int21] . . . . . . . . . . . . . . . . . . . . . . . 5
Exercise 1.22 [int22] . . . . . . . . . . . . . . . . . . . . . . . 6
Exercise 1.23 [int23] . . . . . . . . . . . . . . . . . . . . . . . 6
Exercise 1.24 [new10] . . . . . . . . . . . . . . . . . . . . . . . 6
i
Financial Mathematics Exercises Actuarial Studies UNSW
1.2 Level Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Exercise 1.25 [ann1] . . . . . . . . . . . . . . . . . . . . . . . . 6
Exercise 1.26 [ann2] . . . . . . . . . . . . . . . . . . . . . . . . 6
Exercise 1.27 [ann3] . . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.28 [annB1] . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.29 [annB2] . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.30 [annB3] . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.31 [annB4] . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.32 [annB5] . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.33 [annB6] . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.34 [annB7] . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.35 [ann4] . . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.36 [ann5] . . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.37 [ann6] . . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.38 [ann7] . . . . . . . . . . . . . . . . . . . . . . . . 7
Exercise 1.39 [annB8] . . . . . . . . . . . . . . . . . . . . . . . 8
Exercise 1.40 [annB9] . . . . . . . . . . . . . . . . . . . . . . . 8
Exercise 1.41 [ann13] . . . . . . . . . . . . . . . . . . . . . . . 8
1.3 Non-Level and Continuous Annuities . . . . . . . . . . . . . . . . . . 8
Exercise 1.42 [ann8] . . . . . . . . . . . . . . . . . . . . . . . . 8
Exercise 1.43 [ann9] . . . . . . . . . . . . . . . . . . . . . . . . 8
Exercise 1.44 [ann12] . . . . . . . . . . . . . . . . . . . . . . . 8
Exercise 1.45 [new8] . . . . . . . . . . . . . . . . . . . . . . . 8
Exercise 1.46 [ann14] . . . . . . . . . . . . . . . . . . . . . . . 8
Exercise 1.47 [ann15] . . . . . . . . . . . . . . . . . . . . . . . 8
Exercise 1.48 [new4] . . . . . . . . . . . . . . . . . . . . . . . 9
Exercise 1.49 [new1] . . . . . . . . . . . . . . . . . . . . . . . 9
Exercise 1.50 [annB10] . . . . . . . . . . . . . . . . . . . . . . 9
Exercise 1.51 [loaB2] . . . . . . . . . . . . . . . . . . . . . . . 9
Exercise 1.52 [annB11] . . . . . . . . . . . . . . . . . . . . . . 9
Exercise 1.53 [loaB1] . . . . . . . . . . . . . . . . . . . . . . . 9
Exercise 1.54 [annB12] . . . . . . . . . . . . . . . . . . . . . . 9
Exercise 1.55 [annB13] . . . . . . . . . . . . . . . . . . . . . . 9
Exercise 1.56 [annB14] . . . . . . . . . . . . . . . . . . . . . . 10
ii
Exercise 1.57 [annB15] . . . . . . . . . . . . . . . . . . . . . . 10
Exercise 1.58 [new2] . . . . . . . . . . . . . . . . . . . . . . . 10
Exercise 1.59 [ann11] . . . . . . . . . . . . . . . . . . . . . . . 10
2 Life Contingencies 11
Exercise 2.1 [lif1] . . . . . . . . . . . . . . . . . . . . . . . . . 11
Exercise 2.2 [lif2] . . . . . . . . . . . . . . . . . . . . . . . . . 11
Exercise 2.3 [lif3] . . . . . . . . . . . . . . . . . . . . . . . . . 11
Exercise 2.4 [lif4] . . . . . . . . . . . . . . . . . . . . . . . . . 11
Exercise 2.5 [lif5] . . . . . . . . . . . . . . . . . . . . . . . . . 12
Exercise 2.6 [new7] . . . . . . . . . . . . . . . . . . . . . . . . 12
3 Loans and Investments 13
3.1 Loan Repayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Exercise 3.1 [loa1] . . . . . . . . . . . . . . . . . . . . . . . . . 13
Exercise 3.2 [loa2] . . . . . . . . . . . . . . . . . . . . . . . . . 13
Exercise 3.3 [loa3] . . . . . . . . . . . . . . . . . . . . . . . . . 14
Exercise 3.4 [loaB3] . . . . . . . . . . . . . . . . . . . . . . . . 14
Exercise 3.5 [loaB4] . . . . . . . . . . . . . . . . . . . . . . . . 14
Exercise 3.6 [loaB5] . . . . . . . . . . . . . . . . . . . . . . . . 14
Exercise 3.7 [loa5] . . . . . . . . . . . . . . . . . . . . . . . . . 14
Exercise 3.8 [loa6] . . . . . . . . . . . . . . . . . . . . . . . . . 14
Exercise 3.9 [loa7] . . . . . . . . . . . . . . . . . . . . . . . . . 15
Exercise 3.10 [loa8] . . . . . . . . . . . . . . . . . . . . . . . . 15
3.2 Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Exercise 3.11 [loa4] . . . . . . . . . . . . . . . . . . . . . . . . 15
Exercise 3.12 [loa9] . . . . . . . . . . . . . . . . . . . . . . . . 15
Exercise 3.13 [new13] . . . . . . . . . . . . . . . . . . . . . . . 16
Exercise 3.14 [loa10] . . . . . . . . . . . . . . . . . . . . . . . 16
Exercise 3.15 [loaB6] . . . . . . . . . . . . . . . . . . . . . . . 16
Exercise 3.16 [loaB7] . . . . . . . . . . . . . . . . . . . . . . . 16
Exercise 3.17 [loa11] . . . . . . . . . . . . . . . . . . . . . . . 16
Exercise 3.18 [ann16] . . . . . . . . . . . . . . . . . . . . . . . 17
Exercise 3.19 [loa12] . . . . . . . . . . . . . . . . . . . . . . . 17
Exercise 3.20 [loa13] . . . . . . . . . . . . . . . . . . . . . . . 17
iii
Exercise 3.21 [loa14] . . . . . . . . . . . . . . . . . . . . . . . 17
4 Interest Rate Risk 18
4.1 Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . 18
Exercise 4.1 [irr1] . . . . . . . . . . . . . . . . . . . . . . . . . 18
Exercise 4.2 [irr2] . . . . . . . . . . . . . . . . . . . . . . . . . 18
Exercise 4.3 [irr3] . . . . . . . . . . . . . . . . . . . . . . . . . 18
Exercise 4.4 [irr4] . . . . . . . . . . . . . . . . . . . . . . . . . 19
Exercise 4.5 [irr5] . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.2 Price Sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Exercise 4.6 [irr6] . . . . . . . . . . . . . . . . . . . . . . . . . 19
Exercise 4.7 [irr7] . . . . . . . . . . . . . . . . . . . . . . . . . 19
Exercise 4.8 [new11] . . . . . . . . . . . . . . . . . . . . . . . 20
Exercise 4.9 [lif6] . . . . . . . . . . . . . . . . . . . . . . . . . 20
4.3 Immunisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Exercise 4.10 [irr8] . . . . . . . . . . . . . . . . . . . . . . . . 20
Exercise 4.11 [irr9] . . . . . . . . . . . . . . . . . . . . . . . . 21
Exercise 4.12 [irr10] . . . . . . . . . . . . . . . . . . . . . . . . 21
Exercise 4.13 [new12] . . . . . . . . . . . . . . . . . . . . . . . 22
Exercise 4.14 [irr11] . . . . . . . . . . . . . . . . . . . . . . . . 22
Exercise 4.15 [irr12] . . . . . . . . . . . . . . . . . . . . . . . . 23
5 Derivatives 24
5.1 Forwards, Futures and Swaps . . . . . . . . . . . . . . . . . . . . . . 24
Exercise 5.1 [der1] . . . . . . . . . . . . . . . . . . . . . . . . 24
Exercise 5.2 [der2] . . . . . . . . . . . . . . . . . . . . . . . . 24
Exercise 5.3 [der3] . . . . . . . . . . . . . . . . . . . . . . . . 24
Exercise 5.4 [der4] . . . . . . . . . . . . . . . . . . . . . . . . 24
Exercise 5.5 [der5] . . . . . . . . . . . . . . . . . . . . . . . . 24
Exercise 5.6 [der6] . . . . . . . . . . . . . . . . . . . . . . . . 25
Exercise 5.7 [der7] . . . . . . . . . . . . . . . . . . . . . . . . 25
Exercise 5.8 [der8] . . . . . . . . . . . . . . . . . . . . . . . . 25
Exercise 5.9 [der9] . . . . . . . . . . . . . . . . . . . . . . . . 25
Exercise 5.10 [der10] . . . . . . . . . . . . . . . . . . . . . . . 25
5.2 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
iv
Exercise 5.11 [der11] . . . . . . . . . . . . . . . . . . . . . . . 25
Exercise 5.12 [der12] . . . . . . . . . . . . . . . . . . . . . . . 25
Exercise 5.13 [der13] . . . . . . . . . . . . . . . . . . . . . . . 26
Exercise 5.14 [der14] . . . . . . . . . . . . . . . . . . . . . . . 26
Exercise 5.15 [der15] . . . . . . . . . . . . . . . . . . . . . . . 26
Exercise 5.16 [der16] . . . . . . . . . . . . . . . . . . . . . . . 26
Exercise 5.17 [der17] . . . . . . . . . . . . . . . . . . . . . . . 26
6 Stochastic Interest Rates 27
6.1 IID Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Exercise 6.1 [sto1] . . . . . . . . . . . . . . . . . . . . . . . . . 27
Exercise 6.2 [sto2] . . . . . . . . . . . . . . . . . . . . . . . . . 27
Exercise 6.3 [sto3] . . . . . . . . . . . . . . . . . . . . . . . . . 27
Exercise 6.4 [sto4] . . . . . . . . . . . . . . . . . . . . . . . . . 28
Exercise 6.5 [sto5] . . . . . . . . . . . . . . . . . . . . . . . . . 28
6.2 Lognormal Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Exercise 6.6 [sto6] . . . . . . . . . . . . . . . . . . . . . . . . . 28
Exercise 6.7 [sto7] . . . . . . . . . . . . . . . . . . . . . . . . . 29
Exercise 6.8 [sto8] . . . . . . . . . . . . . . . . . . . . . . . . . 29
Exercise 6.9 [sto9] . . . . . . . . . . . . . . . . . . . . . . . . . 29
Exercise 6.10 [sto10] . . . . . . . . . . . . . . . . . . . . . . . 29
6.3 Dependence and Further Concepts . . . . . . . . . . . . . . . . . . . 30
Exercise 6.11 [new3] . . . . . . . . . . . . . . . . . . . . . . . 30
Exercise 6.12 [new5] . . . . . . . . . . . . . . . . . . . . . . . 30
Exercise 6.13 [new6] . . . . . . . . . . . . . . . . . . . . . . . 30
Exercise 6.14 [new9] . . . . . . . . . . . . . . . . . . . . . . . 31
7 Solutions to Exercises 32
7.1 Module 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
7.2 Module 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
7.3 Module 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
7.4 Module 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
7.5 Module 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
7.6 Module 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
1
Module 1
Time Value of Money and Cash Flow
Valuation
1.1 Time Value of Money
Exercise 1.1: [int1] Determine the interest earned during the 5
th
year by $100
invested today under compound interest with i = 0.05, and under simple interest
with i = 0.05. Perform the calculations both by hand and using R.
Exercise 1.2: [int2] At what rate of compound interest will $200 grow to $275 in
5 years? Use R to nd your answer.
Exercise 1.3: [int3] How many years does it take $200 to accumulate to $275 at
an eective annual rate of 5%?
Exercise 1.4: [int4] With compound interest at i = 0.05, what is the present value
now of $275 in 5 years? Use R to nd your answer.
Exercise 1.5: [int5] If $150 grows to $240 in n years, what will $1000 grow to over
the same period?
Exercise 1.6: [int7] If funds invested today will earn 8% for the next 10 years and
at least 5% for the following 10 years, what is the most one must invest today to
accumulate $1 million in 20 years?
Exercise 1.7: [int8] What level rate of interest is equivalent to 8% for the next 10
years followed by 5% for the following 10 years?
Exercise 1.8: [int9] Assuming an eective rate of i = 0.10, nd the value of the
cash ows below at times t = 0 and t = 3.
2
Exercise 1.9: [int10] The following cash ows have a value of 7.7217 at time t = 0
(assuming i = 0.05):
Find the value of the following cash ows at time 0:
Exercise 1.10: [int11] If $100 is deposited at time t = 0 into an account earning
10% interest and $20 is withdrawn at t = 1 and 2, then how much can be withdrawn
at t = 3?
Exercise 1.11: [int12] At what rate of interest will $100 accumulate to $200 in 6
years?
Exercise 1.12: [int13] (SOA Course 2 May 2000, Question 1) Joe deposits $10
today and another $30 in ve years into a fund paying simple interest of 11% per
year. Tina will make the same two deposits, but the $10 will be deposited n years
from today and the $30 will be deposited 2n years from today. Tinas deposits earn
an annual eective rate of 9.15%. At the end of 10 years, the accumulated amount
of Tinas deposits equals the accumulated amount of Joes deposits. What is the
value of n? Perform the calculations both by hand and using R. You may nd the
function uniroot useful.
Exercise 1.13: [int15] (SOA Course 2 Nov 2000, Question 2) The following table
3
shows the annual eective interest rates being credited by an investment account,
by calendar year of investment. The investment year method is applicable for the
rst 3 years, after which a portfolio rate is used.
Calendar Year of
Investment
Investment
Year Rates
Calendar Year of
Portfolio Rates
Portfolio
Rate
i
1
i
2
i
3
1990 10% 10% x% 1993 8%
1991 12% 5% 10% 1994 (x 1)%
1992 8% (x 2)% 12% 1995 6%
1993 9% 11% 6% 1996 9%
1994 7% 7% 10% 1997 10%
An investment of $100 is made at the beginning of years 1990, 1991, and 1992. The
total amount of interest credited by the fund during the year 1993 is equal to 28.40.
What is the value of x?
Exercise 1.14: [int19] You wish to buy a new home theatre system and have two
potential payment options.
Option A. You pay $610 down (at t = 0), $475 next year (at t = 1) and $340 the
following year (at t = 2).
Option B. You pay $560 down (at t = 0), $580 next year (at t = 1) and $274 the
following year (at t = 2).
Assuming a compound interest accumulation function, determine the values of the
rate of interest r for which Option A is preferred to Option B.
Exercise 1.15: [int18] In return for a single payment of $1000, an investment bank
oers the following alternatives:
A. A lump sum of $1330 after three years
B. A lump sum of $1550 after ve years
C. Four annual payments, each of amount $425, the rst payment being made
after ve years
You wish to decide what alternative is the best.
(a) Write down an equation of value for each alternative and nd the yield for
each.
(b) Assume that an investor selects alternative A and that after three years she
invests the proceeds for a further two years at a xed rate of interest. How
large must this rate of interest be in order for her to receive at least $1550 at
the end of 5 years?
Why do we ask this question?
4
(c) Assume that an investor selects alternative B and that after ve years he wants
to compare his proceeds with the value of alternative C. Determine the value
of alternative C in 5 years time. What interest rate should you use?
Exercise 1.16: [int20] Use an equation of value to determine the level annual pay-
ment (in arrears) equal in value to $1,000,000 (at time t = 0) at an interest rate of
13% p.a. eective, allowing for 5 payments.
Exercise 1.17: [int6] If v = 0.94, what are d and i?
Exercise 1.18: [int14] (SOA Course 2 May 2001, Question 12) Bruce and Robbie
each open up new bank accounts at time 0. Bruce deposits $100 into his bank
account and Robbie deposits $50 into his. Each account earns an annual eective
discount rate of d. The amount of interest earned in Bruces account during the
11th year is equal to X. The amount of interest earned in Robbies account during
the 17th year is also equal to X. What is the value of X?
Exercise 1.19: [int24] Tina issues a 2-year promissory note for a face value of
$6000 and receives $4843.30 in return (ie. she borrows $4843.30 and promises to
repay $6000 after 2 years). At the end of 6 months, 1 year, and 18 months, she
deposits $1000, $1000, and $2000 into her bank account and earns the same interest
rate as the implied rate on the promissory note. Assuming interest is compounded
semi-annually, determine how much extra money (in addition to the amount in her
bank account) she will need to redeem (repay) the note for its face value in 2 years
time.
Exercise 1.20: [int25] A trust account quotes a nominal annual interest rate of 6%.
Interest is credited quarterly, on the last day of each March, June, September and
December. Simple interest is paid for amounts on deposit for less than a quarter of
a year. In 2001, Maria made 4 deposits of $1000 into her trust account every 1st day
of March, June, September, December. By 31 December 2005, how much interest
will Maria have earned from these deposits?
Exercise 1.21: [int21] You are given the following interest options:
A. an eective rate of discount of 5% per annum
B. a nominal rate of interest of 5% per annum convertible semi-annually
C. a nominal rate of interest of 5% per annum convertible monthly
D. a nominal rate of discount of 5% per annum converted semi-annually
E. a nominal rate of discount of 5% per annum converted monthly
F. a force of interest of 5%
5
(a) Discuss dierences between the above interest rates by expressing each option
as eective rates of interest.
(b) How much will an investment of $10,000 accumulate to in 4
1
2
years based on
each of the above interest options?
Perform all computations both by hand and using R.
Exercise 1.22: [int22] Assume that the force of interest is (t) = 0.04(1 + t)
1
,
with t measured in years. Using an accumulation function a(t):
(a) Calculate the equivalent eective rate of interest for the period t = 1 to t = 2.
(b) Calculate the equivalent eective rate of interest for the period t = 2 to t = 3.
(c) Find the value at time t = 2 of an investment that accumulates to $200,000
at time t = 4.
Exercise 1.23: [int23] A fund credits simple interest with i = 10% from time zero
to time k. After time k, the fund accumulates at a constant force of interest of 8%.
(a) Find the value of k that maximises a(4).
(b) Using the value of k from (a), nd the force of interest as function of time t
(for 0 t 4).
Exercise 1.24: [new10] Suppose the force of interest is = 0.05. Using R, plot (on
the same graph) (i) i
(m)
against m and (ii) d
(m)
against m, for 0.5 < m < 50
1.2 Level Annuities
Exercise 1.25: [ann1] You are given a combined annuity-immediate payable monthly
such that payments are $1000 p.a. for the rst 6 years and $400 p.a. for the next
4 years together with a lump sum of $2000 at the end of the 10 years. An interest
rate of 12% p.a convertible monthly is assumed.
(a) Write a function in R that calculates the value a
n i
given inputs of n and i.
(b) Find the present value of this annuity.
(c) Calculate the amount of the level annuity-immediate payable for 10 years
having the same present value as the payments in (a).
Exercise 1.26: [ann2] Bill leaves an inheritance to four charities, Faith Foundation
(F), Hope Institution (H), Love Trust (L) and Peace, Inc. (P). The total inheritance
is a series of level payments at the end of each year forever. During the rst 20 years,
6
F, H, and L share each payment equally. All payments after 20 years revert to P.
The present values of the shares of the four charities are known to be all equal.
What is the implied eective rate of interest?
Exercise 1.27: [ann3] Cathy must pay o a loan with ve annual payments of
$15,000 each. The rst loan payment is due 10 years from now. In order to accumu-
late the funds, she plans on making ten annual deposits of C into an account paying
eective annual interest of 6%. Having computed the least possible amount C (and
assuming she succeeded in her nancial mathematics course and thus it took her a
negligible amount of time), she immediately makes the rst deposit. Calculate C.
Exercise 1.28: [annB1] Exercise 2.1.11 from Broverman 4th Ed (2.1.14 in 3rd Ed).
Exercise 1.35: [ann4] To settle a $100,000 death benet, Tim, the primary ben-
eciary, opted to take an annuity-immediate payable monthly for 25 years. The
monthly payment was calculated using an eective annual interest rate of 3%. Af-
ter making payments for 10 years, the insurance company decides to increase the
monthly payments for the remaining 15 years by changing the eective annual in-
terest rate to 5%. By how much will the monthly payment increase?
Exercise 1.36: [ann5] Find the present value of a set of cash ows which pay $100
at the end of year 1, $200 at the end of year 2, $100 at end of year 3, $200 at the end
of year 4, and so on ($100 at odd years, $200 at even), with the nal payment being
at the end of the 20th year. The interest rate is 5% p.a. semi-annual compounding.
Exercise 1.37: [ann6] Bob has inherited an annuity-due on which there remain 12
payments of $18,000 per year at an eective discount rate of 10%; the rst payment
is due immediately. He wishes to convert this to a 20-year annuity-immediate at
the same eective rate of discount. What will be the size of the payments under the
new annuity?
Exercise 1.38: [ann7] Broverman 4th ed: 2.2.13 (2.2.14 in 3rd ed). Also solve for
the case if Smith repays the loan over 5 years (monthly payments).
7
Exercise 1.41: [ann13] Given that (t) =
1
20t
, t 0, nd s
10
.
1.3 Non-Level and Continuous Annuities
Exercise 1.42: [ann8] A loan of $4000 is being repaid by a 30-year increasing
annuity-immediate where payments increase each year and payments are in arrears.
The initial payment is P, each subsequent payment is P larger than the preceding
payment. The annual eective interest rate is 4%. Calculate the value of the future
payments (ie. the loan principal outstanding) after the ninth payment. Compare
your result with the initial loan amount and explain it. Is such a payment pattern
likely to exist in reality? Why?
Exercise 1.43: [ann9] Nicole, a UNSW Business part-time student, expects an
increasing amount of income as she advances through her program but will need to
borrow to cover her university costs. Accordingly, she plans to borrow a decreasing
annual amount from a student credit loan during her 5 years at university, and to
repay the loan with increasing amounts for 15 years after graduation. She borrows
amounts 5X, 4X, 3X, 2X and X at the beginning of each of 5 years, where the last
payment is paid at the beginning of her nal year. At the end of the rst year after
graduation she pays $500, then increases the amount by $200 each year until a nal
payment of $3300. If the eective annual interest rate assumed is 5%, determine X.
Exercise 1.44: [ann12] Paulo is saving madly to buy his rst home ten years from
now. He deposits to a fund each January 1 and July 1 for the years 2004 through
2014. The deposit he makes on each July 1 will be 10.25% greater than the one on
the immediately preceding January 1. The amount he deposits on each January 1
(except for January 1, 2004) will be the same amount as the deposit made on the
immediately preceding July 1. The fund will be credited with interest at a nominal
annual rate of 10%, compounded quarterly. On December 31, 2014, the fund will
have a balance of $110,000, an amount Paulo considers is enough for a home deposit
and other miscellaneous expenses. Determine Paulos initial deposit to the fund.
Exercise 1.45: [new8] Using R, nd the present value of a 30-year annuity imme-
diate which pays t
3
+ln(10t +12) at the end of year t, assuming an eective interest
rate of 5%.
Exercise 1.46: [ann14] Value the following set of cashows at a rate of 10% p.a.:
$10 at time
1
3
, $20 at times
2
3
and time 1
1
3
, $30 at times 1,1
2
3
and 2
1
3
, $40 at times
2, 2
2
3
and 3
1
3
, $50 at times 3 and 3
2
3
, and $60 at time 4.
8
Exercise 1.47: [ann15] Mary purchases an increasing annuity-immediate for $50,000
that makes twenty annual payments as follows:
(i) P, 2P, . . . , 10P in years 1 through 10; and
(ii) 10(1.05)P, 10(1.05)
2
P, . . . , 10(1.05)
10
P in years 11 through 20.
The annual eective interest rate is 7% for the rst 10 years and 5% thereafter.
Calculate P.
Exercise 1.48: [new4] Suppose the interest rate is a constant 5% p.a. eective, and
the ination rate is a constant 3% p.a. Determine the (initial) annual payment from
a 20 year annuity-immediate which is purchased at the fair price with $10,000 in
the case of:
(a) a xed annuity (level payments)
(b) an ination-indexed annuity
(c) Show that (a) and (b) are equally fair. Explain your calculations.
Find the solution (i) analytically and (ii) using R by considering the present value
of each of the 20 payments directly.
Exercise 1.49: [new1] A perpetuity has annual payments (in arrears) of 1, 3, 6,
10, 15, etc. For a constant force of interest of = 0.05:
(a) Find the present value of the perpetuity analytically.
(b) Verify your answer by nding the approximate present value using R by con-
sidering the 500 payments only. Plot the present value of each payment against
time t. Does this shape remind you of something?
Exercise 1.51: [loaB2] Exercise 2.3.8 from Broverman 4th Ed (2.3.7 in 3rd Ed).
Exercise 1.52: [annB11] Exercise 2.3.15 from Broverman 4th Ed (2.3.15 in 3rd
Ed).
Ed).
Ed).
9
Ed).
Ed).
Exercise 1.58: [new2] Find the present value of a 10-year increasing annuity that
pays at an annual rate of 100, 200, . . . , 1000, given that the annual eective interest
rate is 5% and:
(a) payments are made annually in arrears
(b) payments are made monthly in arrears
(c) payments are made continuously
Exercise 1.59: [ann11] A one-year deferred continuous varying annuity is payable
for 13 years. The rate of payment at time t is t
2
1 per annum, and the force of
interest at time t is
1
1+t
. Find the present value of the annuity.
10
Module 2
Life Contingencies
Exercise 2.1: [lif1] Z is the present value random variable for a special continuous
whole life insurance issued to (x), paying b
t
at death at x +t where:
b
t
= e
0.05t
For all t, it is given that
x+t
= 0.01 and
t
= 0.06. Determine the expected value
and variance of Z.
Exercise 2.2: [lif2] Show that the following two denitions of the life annuity a
x
are equivalent:
k=0
a
k+1
k
p
x
q
x+k
=
k=0
v
k
k
p
x
Interpret both sides of the equation and explain why it has to be true.
Exercise 2.3: [lif3] Prove the following identity:
d a
x
+A
x
= 1
Exercise 2.4: [lif4] You are given the following probabilities of death:
x q
x
0 0.10
1 0.05
2 0.10
3 0.20
4 0.40
5 0.70
6 1.00
Given a technical rate of interest of 5%, calculate by hand and using R:
Pr[K(0) = k], e
0
, Pr[K(2) = k], e
2
, A
2
,
2
A
2
, A
1
2:3
, A
1
2:3
, A
2:3
, a
2
, a
2
, a
2:3
11
Exercise 2.5: [lif5] (Gerber (1997), Exercise 17, p. 1356) Consider two independent
lives which are identical except that one is a smoker and the other is a non-smoker.
It is known that:
1.
x
is the force of mortality for non-smokers for 0 x < , and
2. c
x
is the force of mortality for smokers for 0 x < , where c is a constant
and c > 1
Calculate the probability that the remaining lifetime of the smoker exceeds that of
the non-smoker.
Check for the reasonableness of your answer.
Exercise 2.6: [new7] Benjamin is currently 65 years old, and has just purchased
a life annuity (at a fair price) using his superannuation lump sum of $1,000,000 to
pay for his retirement. The annuity will pay X at the end of each year as long as
the policyholder is alive. The interest rate is assumed a constant 5%. Furthermore,
the force of mortality is assumed to follow the Gompertz-Makeham law:
x
= A +Bc
x
It is known that A = 0.0003225, B = 0.000031, and c = 1.0966413. Using R:
(a) Find and plot the survival probabilities for a 65-year old, S
65
(t), t > 0.
(b) What annual payment does Benjamin receive each year?
(c) Suppose instead that the annuity pays X(1 + f)
t
at the end of year t, where
f = 0.03 is the annual ination rate (assumed to be constant). Find the new
value of X under this arrangement.
You may assume that no individual will survive beyond age 120.
12
Module 3
Loans and Investments
3.1 Loan Repayments
Exercise 3.1: [loa1] A bank decides to lend a company $15000 at a rate of interest
of 5% p.a. to be repaid by annual instalments over 5 years (in arrears).
(a) Calculate the annual payment.
(b) Calculate the loan outstanding at the end of the second payment using the
retrospective method.
(c) Calculate the loan outstanding at the end of the second payment using the
prospective method.
(d) At the end of the second year the bank tells you that from that time onwards
the rate of interest charged is going to be increased to 7.5% p.a. If you still
want to payo the loan by the end of the fth year what must your annual
payment change to?
(e) Having reviewed your companys free cash ows you decide that the amount
calculated in (d) is not aordable. You renegotiate with the bank and they
oer to extend your loan so that you can pay o the loan in an additional 4
years (instead of 3 years), at 7.6% p.a. What is the new annual repayment?
(f) Setup a loan schedule for part (e) above.
Exercise 3.2: [loa2] A loan of $20000 is to be repaid by 6 annual payments begin-
ning one year after the loan is made. The lender wants annual payments of interest
only at a rate of 7% and repayments of the principal in a single lump sum at the
end of 6 years. The borrower can accumulate the principal in a sinking fund earning
an annual interest rate of 5%, and decides to do this by means of 6 level deposits
starting one year after the loan is made.
(a) What should the annual payment be?
13
(b) What if the sinking fund interest rate was 7%?
(c) Suppose you can decide whether you can setup a sinking fund arrangement
or to have a standard loan arrangement (ie. repay both capital and interest
with each payment) to repay the loan. If the sinking fund rate was 5% which
method would you prefer?
(Hint: you should not need to do any extra calculations to decide this al-
though you can use it to check your answer if you wish)
(d) Model the cash ows of this sinking fund arrangement in a spreadsheet (for
the 5% case).
Exercise 3.3: [loa3] An individual borrows $5000 to buy a plasma TV. The sum
borrowed is repayable by 24 monthly instalments in arrears, which are calculated
on the basis of a at rate of interest of 10% p.a.
(a) Calculate the monthly repayment and the true (eective) annual rate of inter-
est being charged. Do this by hand using Newton-Raphson with 5 iterations
(starting at 10%), then using R with 10 iterations.
(b) Just after making the 12th repayment, the outstanding loan is to be repaid.
What is the outstanding balance which must be repaid at this time?
Exercise 3.7: [loa5] A loan of $20000 is being repaid by monthly instalments of
principal and interest (18% p.a. nominal) over 8
1
3
years. Provide a schedule in both
Excel and R showing the principal and interest contained in each of the last four
monthly instalments.
Exercise 3.8: [loa6] A householder is paying o four debts by monthly payments
all at an eective rate of 1% per month (12% p.a. nominal). The monthly payments
and respective terms to run are:
Monthly Payment ($) Terms to Run (Months)
4.36 11
17.20 15
35.00 12
20.24 18
The householder arranges a consolidation of these debts, with the total (sum) pay-
ments under the consolidated loan being equal to the total remaining payments
under the existing loans.
14
Calculate the monthly instalment and the term to run of the consolidated loan so
that the eective rate of interest involved will be unchanged. Note that a nal
repayment may be required to ensure the loan is fully repaid. For this exercise, this
nal repayment is assumed to be made one month after the last monthly instalment.
You may nd R helpful in speeding up algebraic computation.
Exercise 3.9: [loa7] Paul takes out a loan of $47,500 to purchase a new car. The
interest applicable is 12% p.a. (monthly compounding). Instead of paying o the
loan using level instalments, he decides to pay it o using monthly payments over
3 years. The payments within each year is the same, but the payments in the 2nd
year are 10% higher than the payments in the 1st year, and the payments in the 3rd
year are 10% higher than the payments in the 2nd year. Set out the loan schedule
for this loan in both Excel and R.
Exercise 3.10: [loa8] A recently married couple have decided to buy a new house
in Sydney. After an investigation of their nancial situation they nd that they will
need to borrow $600,000 from the bank. The rate of interest charged is 6.75% p.a
eective.
(a) If they want to pay o the loan in 10 years using annual payments, how much
would they have to pay in total over the 10 years?
(b) If they want to pay o the loan in 10 years using monthly payments, how much
would they have to pay in total over the 10 years?
(c) Suppose they choose to follow (a). At the end of year 5 (just after the payment
at time 5), interest rates increase to 7.25% p.a. eective. How much do they
need to pay to settle the loan at that time?
3.2 Investments
Exercise 3.11: [loa4] (McCutcheon & Scott, 1986, p. 158) A loan of $75,000 is to
be issued bearing interest at the rate of 8% per annum payable quarterly in arrears.
The loan will be repaid at par (ie. 100 per 100 face value) in 15 equal annual
instalments, with the rst instalment being repaid ve years after the issue date.
Find the price to be paid on the issue date by a purchaser of the whole loan who
wishes to realise a yield of (a) 10% per annum eective, and (b) 10% per annum
convertible half-yearly.
Exercise 3.12: [loa9] (McCutcheon & Scott, 1986, p. 197) A loan of nominal
amount $500,000 was issued bearing interest of 8% per annum payable quarterly in
arrears. The loan principal will be repaid at $105% by 20 annual instalments, each
of nominal amount $25,000, the rst repayment being ten years after the issue date.
An investor, liable to both income tax and capital gains tax, purchased the entire
loan on the issue date at a price to obtain a net eective annual yield of 6%. Assume
15
that capital losses cannot oset capital gains for tax purposes. Find the price paid,
given that his rates of taxation for income and capital gains are:
(a) 40% and 30% respectively
(b) 20% and 30% respectively
Do this question in both Excel and R.
Exercise 3.13: [new13] Consider a 10-year bond of face value $100 and annual
coupons at a rate of 6%.
(a) Write down an equation of value given the price of the bond is $80.
(b) Write a function newton in R which takes an expression (in terms of x), a preci-
sion (percentage change since last estimate), and an initial estimate as inputs,
and outputs the estimated root using Newton-Raphson where the number of
iterations is chosen to obtain the desired precision.
(c) Hence nd the yield to maturity of the bond using a precision of 0.01%. Use
any appropriate initial estimate.
Exercise 3.14: [loa10] (McCutcheon & Scott, 1986, p. 206) Two bonds (100 face
value) each have an outstanding term of four years. Redemption will be at par for
both bonds. Interest is payable annually in arrears at the annual rate of 15% for
the rst bond and 8% for the second bond. Interest payments have just been made
and the prices of the bonds are $105.80 and $85.34 respectively.
(a) Verify that an investor, liable for income tax at the rate of 35% and capital
gains tax at the rate of 50% who purchases either of these bonds (but not
both) will obtain a net yield on his transaction of 8% per annum.
(b) Assume now that the investor is allowed to oset capital gains by capital
losses. Show that, if the proportion of his available funds invested in the 8%
bond is such that the overall capital gain is zero, he will achieve a net yield of
combined transaction of 8.46% per annum.
Exercise 3.17: [loa11] An investor purchased an Australian Government bond on
11 June 2006 paying a coupon 5.75% p.a with a maturity of 15 June 2011. The bond
is ex-interest within 7 days prior to the coupon payment. Explain what is meant
by ex-interest for an Australian government bond and describe the payments that
the buyer will receive on an ex-interest Australian government bond. Determine
the price paid for the Australian Government bond at a yield of 4.75% p.a on 11
June 2006.
16
Exercise 3.18: [ann16] Outline the payments made on ination indexed bonds and
give an example of an investor who would invest in these nancial instruments.
Exercise 3.19: [loa12] A loan of nominal amount $500,000 was issued bearing in-
terest of 8% per annum payable quarterly in arrears. The loan will be repaid at
$110% by 10 annual instalments, each of nominal amount $50,000, the rst repay-
ment being ten years after the issue date. An investor, liable to both income tax and
capital gains tax, purchased the entire loan on the issue date at a price to obtain a
net eective annual yield of 7%. Find the price paid, given that his rates of taxation
for income and capital gains are both 15%. Do this question in both Excel and R.
Exercise 3.20: [loa13] A loan, on which interest is payable half-yearly, was issued
on 1 January 1974. The loan was to be redeemed with deferred annual payments
(always on 1 January) in accordance with the following schedule:
Amount redeemed Redemption
in each year rate
1 Jan 1984 to 1 Jan 1992 (inclusive) $150 000 105%
1 Jan 1993 to 1 Jan 2003 (inclusive) $250 000 110%
1 Jan 2004 $300 000 112%
Interest is payable at the rate of 7% p.a. until the payment on 1 July 2000 has been
made and thereafter at 8% p.a. What was the issue price if a purchaser of the whole
loan secured a yield of 6.5% p.a. eective on his or her investment? Do this question
using both Excel and R.
Exercise 3.21: [loa14] A loan of nominal amount $1,200 was issued bearing interest
of 10% per annum payable annually in arrears. The loan will be repaid by 3 annual
nominal payments of equal value, the rst repayment being two years after the issue
date. The actual repayment will be at $100% for the rst two instalments, and
$120% for the nal instalment. An investor, liable to both income tax and capital
gains tax at 20%, purchased the entire loan on the issue date at a price to obtain a
net eective annual yield of 8%. Find the price paid, given that it is greater than
$1,200.
17
Module 4
Interest Rate Risk
4.1 Term Structure of Interest Rates
Exercise 4.1: [irr1]
Consider the following spot interest rates that are quoted on a nominal p.a. basis
assuming interest compounds semi-annually (ie. they are i
(2)
interest rates).
Term (Years) % p.a.
0.5 4.875180
1.0 5.031182
1.5 5.234408
2.0 5.448436
(a) Use these spot rates to calculate the value of a 6.75% bond paying semi-annual
coupons maturing in two years time with a face value of $100.
(b) Calculate the yield to maturity on this bond for the price calculated above.
(c) Determine the par yield, as a semi-annual compounding yield, for one year
and two year maturity bonds corresponding to the above rates. Interpret your
result.
(d) Determine the 6 month forward rates corresponding to these spot rates.
Exercise 4.2: [irr2] Consider two 5 year bonds. One has a 9% coupon and sells for
101.00; the other has a 7% coupon and sells for 93.20. Find the price of a 5 year
zero coupon bond.
Exercise 4.3: [irr3] Let s(t), 0 t denote a spot rate curve, that is, the
present value of a dollar to be received at time t is e
s(t)t
. Show explicitly that if the
spot rate curve is at and that s(t) = r, then all forward rates must be the same.
18
Exercise 4.4: [irr4] The half year forward rates are as follows (semi-annual com-
pounding):
Time Period % p.a
0 0.5 5.00
0.5 1 5.50
1 1.5 6.00
1.5 2 6.10
2 2.5 6.25
2.5 3 7.00
Calculate the 1 year forward rates for time periods 0 1, 0.5 1.5, 1 2, 1.5 2.5,
2 3.
Exercise 4.5: [irr5]
Consider the following spot rates (semi-annual compounding):
Term (Years) % p.a.
0.5 4.5000
1.0 5.2500
and forward rates:
Time Period % p.a.
1-1.5 7.5082
1.5-2 2.0290
Calculate the value of a bond paying semi-annual coupons of 8% p.a., maturing in
2 years time.
4.2 Price Sensitivity
Exercise 4.6: [irr6] Let D() be the duration, at a constant force of interest (con-
tinuous compounding) p.a., of a xed-interest security with interest payable con-
tinuously at the annual rate D per unit nominal and redeemable at R per unit
nominal in n years time. Let g = D/R. Show that:
D() =
g(
I a)
n
+ nv
n
g a
n
+ v
n
Exercise 4.7: [irr7] Consider a xed-interest security bearing interest of 5% p.a.
payable continuously and redeemable at par in n years time, where n is not neces-
sarily an integer. Assuming a constant continuously compounding force of interest
of 7% p.a:
19
(a) Determine the duration of the security for n = 20 and n = 60.
(b) Note that the duration of the security, on the basis of a specied constant
force of interest per annum , may be considered as a function of n. Assuming
= 0.07, show that the duration is maximised when the following equation is
satised:
0.07 a
n
+ 0.05(n a
n
) =
0.07
0.07 0.05
Hence (or otherwise) nd the maximum duration and the corresponding value
of n at which the duration is maximised.
Exercise 4.8: [new11] Consider a level n-year annuity-immediate paying $1 at the
end of each year.
(a) Write down the expressions which relate the modied duration and convexity
with derivatives of the price (present value).
(b) Write R functions to nd (analytically) the modied duration and convexity
of the annuity. You may nd the functions D, expression, and eval useful.
(c) Write R functions to nd the approximate modied duration and convexity
(using a Taylor approximation).
(d) Use your functions to nd the modied duration and convexity of a 10-year
annuity.
Exercise 4.9: [lif6] Show that the Macaulay Duration of a
x
is equal to:
D
x
=
k=0
w
k
k
where w
k
is given by:
w
k
=
v
k
k
p
x
l=0
v
l
l
p
x
4.3 Immunisation
Exercise 4.10: [irr8] (Boyle, 1992) Suppose the term structure of spot rates is level
for all maturities and equal to 8% p.a. Suppose that in the next instant, the term
structure of interest rates will be either 9% p.a. for all maturities or 7% p.a. for all
maturities. Consider the following strategy. An investor goes short a zero coupon
bond with a 10-year maturity and a face value of 1000. Simultaneously, she uses
the proceeds to purchase a 5-year zero coupon bond with maturity value M
5
and a
15-year maturity bond with maturity value M
15
.
(a) Give expressions for the value of assets V
A
(i) and the value of liabilities V
L
(i).
20
(b) What is meant by an arbitrage opportunity?
(c) By suitable choice of M
5
and M
15
such that V
A
(.08) V
L
(.08) is zero, demon-
strate that arbitrage prots are possible with parallel shifts to a at yield
curve.
Exercise 4.11: [irr9] Consider 3 coupon paying bonds x, y and z. You have
calculated their Price to be (P
x
, P
y
, P
z
), and their duration and convexity to be
(D
x
, D
y
, D
z
) and (C
x
, C
y
, C
z
) respectively. Consider a portfolio by buying 1 unit
of each bond. Derive a formula for the duration and convexity for the portfolio in
terms of the price, duration, and convexity of the individual bonds.
Exercise 4.12: [irr10] Consider a portfolio of insurance liabilities. Your best esti-
mate of the future outgoes (claims) are as follows
Time Outgo
1 3m
2 4m
3 3m
4 2m
Assume that the spot rate term structure is at and equal to 4.5%. Assume that
the insurer can only invest in 2 ZCBs. One matures in 0.5 years while the other
matures in 5 years. Find an immunisation strategy using the two bonds.
(a) Using R, write a function s which outputs the surplus when given an input of
i, where i is a function itself that outputs the t-year spot rate when given t.
(b) What happens to the surplus if the yield shifts in a parallel fashion to 6.5%?
(c) What happens to the surplus if the yield shifts in a parallel fashion to 2.5%?
(d) What happens to the surplus if the yield curve twists and you are faced with
the following spot rate curve?
Time Rate
0.5 3%
1 3.5%
1.5 4%
2 4.5%
2.5 5%
3 5.5%
3.5 6%
4 6.5%
4.5 7%
5 7.5%
21
(e) Determine the surplus if we are faced with a term structure where the t-year
spot rate is given by:
s
t
= +
_
1 e
t
t
_
+
_
1 e
t
t
e
t
_
where = 0.06, = 0.01, = 0.08, and = 0.6 are known parameters.
Exercise 4.13: [new12] The Nelson-Siegel class of term structure models are com-
monly used in practice to model the yield curve through time. One example is the
model used in Exercise 4.12(e). Another simple example is the following yield curve,
which describes the zero coupon yield of maturity (ie. -year spot rate) as:
s
= +
t
_
1 e
_
where and are constant parameters and
t
is a time-varying parameter. It is
assumed that = 0.06 and = 0.6, while the values of
t
for each time t are
independent and identically distributed with
t
N(0.01, 0.002
2
).
(a) Write an R function which outputs the spot rate s
when given the parameters

,
t
, and the term to maturity . Plot the spot curve (for maturities 0 <
< 20) for the given parameters and when
t
is equal to its mean of -0.01.
(b) Why is the use of Fisher-Weil duration more realistic?
(c) Consider the portfolio of insurance liabilities in Exercise 4.12, and again as-
sume that the insurer can only invest in 2 ZCBs of maturity 0.5 and 5 years
respectively. Find an immunisation strategy if the current value of
t
is 0.01.
(d) Simulate 1000 outcomes for the yield curve in the next moment and determine
the surplus in each case. Also plot a histogram for the surplus and estimate
the probability of a negative surplus. Is your portfolio fully immunised? Why?
Exercise 4.14: [irr11] Consider a portfolio of insurance liabilities. Your best esti-
mate of the future outgoes (claims) are as follows
Time Outgo
1 3m
2 4m
3 3m
4 2m
Assume that the spot rate is at and is equal to 4%. Suppose the insurer has
available for investment two coupon bonds. One is a 4% coupon bond with 0.75
years till maturity. The second bond is a 8% coupon bond with 8 years till maturity.
Find an immunisation strategy using the two bonds. (Derive your solutions without
using Excel.)
22
Exercise 4.15: [irr12] Suppose you have a liability of $2 million due at time 3. As-
sume that the spot rate is at and is equal to 6%. You have available for investment
ve ZCBs, with maturities at 1, 2, 3, 4 and 5 respectively.
(a) Suppose you wish to use an immunisation strategy using 2 bonds. Derive the
portfolio.
(b) Explain the term cash ow matching. Derive the portfolio (using 1, 2, 3, 4 or
all 5 bonds) that corresponds to a cash ow matching strategy.
(c) Suppose the spot rate moves to 7% at. What happens to your surplus for
the strategies in (a) and (b)?
(d) Suppose the spot rate curve such that the spot rate for maturity T is equal to
(3 + T)%. What happens to your surplus for the strategies in (a) and (b)?
23
Module 5
Derivatives
5.1 Forwards, Futures and Swaps
Exercise 5.1: [der1] On 12 May 1987, the closing value of the S&P 500 Index was
293.3 and the December 1987 S&P 500 futures closing index, with delivery in 210
days, was 299.0. Calculate the theoretical futures index assuming transactions and
storage costs are negligible, a constant annual continuously compounding interest
rate of 7%, and that the S&P 500 portfolio pays dividends continuously at an annual
rate of 3.5% of its market value on 12 May 1987. You may also assume that interest
rates are deterministic so that the futures price is equal to the theoretical forward
price.
Exercise 5.2: [der2] Consider a forward contract to buy 6.5% coupon 6 year Trea-
sury bonds in 2 years time (immediately after the coupon then due has been paid).
These bonds are assumed to be currently available as 6.5% 8 year Treasury bonds
at a yield of 6.96% p.a. (semi-annual). Funding costs for the rst year are 6.5% p.a.
(monthly compounding) and 7% p.a. (monthly compounding) for the second year.
Determine the forward price and forward yield in two years time.
Exercise 5.3: [der3] An investor holds a short position in a forward contract on
gold for delivery in 90 days at $450 an ounce. The current spot price of gold is $420
an ounce and insurance and storage cost for gold are 2.5% p.a of the spot price paid
on delivery. Ninety day (simple) interest rates are 9.75% p.a. What is the value of
this forward contract?
Exercise 5.4: [der4] Consider a forward contract on 10000 shares, deliverable in 6
months time. The share is currently trading at $10.00. Assume that there will be a
dividend payment of 0.40 per share in 3 months time. Funding costs for 6 months
are 6% p.a. (monthly compounding). Transaction costs are 2% of the value of the
shares purchased. Determine the forward price for sale of the shares in 6 months at
which all net funding and other costs will be covered.
24
Exercise 5.5: [der5] Explain the cost of carry formula:
F
t,T
= S
t
e
r(Tt)
de
r(Tt
1
)
There are no storage costs but there is a payment to the holder of the spot asset
(eg. dividend) of d at time t
1
.
Exercise 5.6: [der6] Suppose the current spot and forward rates are as given in
Table 6.4 of Sherris (1996, p. 109). Calculate the implied repo rate (the risk-
free rate implied by current spot and forward prices) associated with each forward
contract. Also, for each forward contract, outline an arbitrage strategy you could
use to realise your arbitrage prot now. Give the amount of the prot in both
instances. Use simple interest as the contracts are for terms less than one year.
Exercise 5.7: [der7] Review Example 7.1 of Sherris (p. 133)
Exercise 5.10: [der10] Consider an agreement where party A receives the spot
price for N units of a commodity each period while paying a xed amount X per
unit for N units. If the agreement is made for M periods (ie. at times t
1
, t
2
, .., t
M
),
derive a formula that can be used to determine the swap price X on inception of the
swap contract. Assume that no storage costs or dividends occur during the period,
and the risk free interest rate is r (continuous compounding).
5.2 Options
Exercise 5.11: [der11] In a one-period binomial model, it is assumed that the
current share price of 260 will either increase to 285 or decrease to 250 at the end
of one year. The annual risk-free interest rate is 5% compounded continuously and
assume that this share pays no dividends.
(a) Calculate the price of a one-year European call option with a strike price of
275 by replicating the payo with a portfolio of shares and bonds.
(b) Calculate the price of a one-year European put option with a strike price of
275 by replicating the payo with a portfolio of shares and bonds.
(c) Verify numerically that the put-call parity relationship holds in this case.
Exercise 5.12: [der12] Assume that the stock price is currently $50, and will in-
crease or decrease by 10% at the end of the month. The interest rate is 5% p.a.
(simple). Find the price of a call option with a strike price of $50.
25
Exercise 5.13: [der13] In the pricing of forwards, futures, swaps and options, the
expected value of the underlying asset for these contracts has not appeared in the
valuation. Explain why this is the case. (Do you nd it surprising?)
Exercise 5.14: [der14] In a one-period binomial model, it is assumed that the
current share price of 260 will either increase to 285 or decrease to 250 at the end
of one year. The annual risk-free interest rate is 4% compounded continuously and
assume that this share pays no dividends. Calculate the price of an option that pays
the cash dierence between the square of the share price at the end of the year and
70225, provided that the dierence is positive (ie. otherwise it pays nothing).
Exercise 5.15: [der15] The current stock price is $20, and the risk free rate (simple)
is 5% p.a. One year call and put options with strike price $22 are priced at $1.2245
and $2.5000 respectively. Verify that there is an arbitrage opportunity, and identify
the transactions required.
Exercise 5.16: [der16] Suppose we want to price a call option on a share using
a binomial model of the share price. Consider a portfolio of the share and bond.
Suppose however that the stock pays a xed dividend of $D on the maturity date
of the option (ie at time T) and that the owner of the option will not receive the
share dividend. Derive a formula for the number of stocks and bond that need to
be held to replicate this option payo.
Exercise 5.17: [der17] Consider call and put (European) options (with the same
strike price) on gold. The spot price of gold is G(0) at time 0, and the maturity of
the option is at time T. Storage costs of $c per unit of gold are payable at time T.
By equating the cost at time 0 of two portfolios that have the same payo at time
T, nd an updated version of the put-call parity that takes into account the storage
costs.
26
Module 6
Stochastic Interest Rates
6.1 IID Returns
Exercise 6.1: [sto1] (Institute of Actuaries Examination April 2003) $1000 is in-
vested for 10 years. In any year, the yield on the investment will be 4% with prob-
ability 0.4, 6% with probability 0.2, 8% with probability 0.4, and is independent of
the yield in any other year.
(a) Calculate the mean accumulation at the end of 10 years.
(b) Calculate the standard deviation of the accumulation at the end of 10 years.
(c) Without carrying out any further calculations, explain how your answers to
(a) and (b) would change (if at all) if:
(i) the yields had been 5%, 6% and 7% instead of 4%, 6%, and 8% p.a.
respectively.
(ii) the investment had been made for 12 years instead of 10 years.
Exercise 6.2: [sto2] (Institute of Actuaries Examination September 2003) In any
year t, the yield on a fund of investments has mean j
t
and standard deviation s
t
. In
any year, the yield is independent of the yield in any other year. The accumulated
value, after n years, of a unit sum of money invested at time 0 is S
n
.
(a) Derive formulae for the mean and variance of S
n
if j
t
= j and s
t
= s for all
years t.
(b) Calculate the expected value of S
8
if j = 0.06.
(c) Calculate the standard deviation of S
8
if j = 0.06 and s = 0.08.
Exercise 6.3: [sto3] (Institute of Actuaries Examination September 2002) $10,000
is invested in a bank account which pays interest at the end of each year. The rate
of interest is xed randomly at the beginning of each year and remains unchanged
27
until the beginning of the next year. The rate of interest applicable in any one year
is independent of the rate applicable in any other year.
During the rst year, the rate of interest per annum eective will be one of 3%,
4% or 6% with equal probability. During the second year, the rate of interest per
annum eective will be either 5% with probability 0.7, or 4% with probability 0.3.
(a) Assuming that interest is always reinvested in the account, calculate the ex-
pected accumulated amount in the bank account at the end of two years.
(b) Calculate the variance of the accumulated account in the bank account at the
end of two years.
Exercise 6.4: [sto4] (Institute of Actuaries Examination April 2005) In any year,
the interest rate per annum eective on monies invested with a given bank is equally
likely to be i
1
or i
2
(i
1
> i
2
), and is independent of the interest rates in all previous
years.
(a) Express the mean and variance of the eective rate in a particular year in
terms of i
1
and i
2
.
(b) The accumulated value at time t = 25 years of $1 million invested with the
bank at time t = 0 has expected value $5.5 million and standard deviation
$0.5 million. Find i
1
and i
2
.
Exercise 6.5: [sto5] (Institute of Actuaries Examination September 2000) An in-
surance company calculates the single premium for a contract paying $10,000 in ten
years time as the present value of the benet payable at the expected rate of interest
it will earn on its funds. The annual eective rate of interest over the whole of the
next ten years will be 7%, 8% or 10% with probabilities 0.3, 0.5 and 0.2 respectively.
(a) Calculate the single premium.
(b) Calculate the expected prot at the end of the term of the contract.
6.2 Lognormal Model
surance company has just written contracts that require it to make payments to
policyholders of $1,000,000 in ve years time. The total premiums paid by policy-
holders amounted to $850,000. The insurance company is to invest half the premium
income in xed interest securities that provide a return of 3% per annum eective.
The other half of the premium income is to be invested in assets that have an uncer-
tain return. The return from these assets in year t, i
t
, has a mean value of 3.5% per
annum eective and a standard deviation of 3% per annum eective. The random
variables (1 + i
t
) (for t = 1, 2, . . .) are independent and lognormally distributed.
28
(a) Deriving all necessary formulae, calculate the mean and standard deviation of
the accumulation of the premiums over the ve-year period.
(b) A director of the company suggests that investing all the premiums in the
assets with an uncertain return would be preferable because the expected
accumulation of the premiums would be greater than the payments due to the
policyholders.
Explain why this still may be a more risky investment policy.
Exercise 6.7: [sto7] (Institute of Actuaries Examination April 2002) A company
is adopting a particular investment strategy such that the expected annual eective
rate of return from investments is 7% and the standard deviation of annual returns
is 9%. Annual returns are independent and (1+i
t
) is lognormally distributed where
i
t
is the return in the tth year. The company has received a premium of $1,000 and
will pay the policyholder $1,400 after 10 years.
(a) Calculate the expected value and standard deviation of an investment of $1,000
over 10 years, deriving all formulae that you use.
(b) Calculate the probability that the accumulation of the investment will be less
than 50% of its expected value in ten years time.
(c) The company has invested $1,200 to meet its liability in 10 years time. Cal-
culate the probability that it will have insucient funds to meet its liability.
Exercise 6.8: [sto8] (Institute of Actuaries Examination September 2007) The ex-
pected eective annual rate of return from a banks investment portfolio is 6% and
the standard deviation of annual eective returns is 8%. The annual eective re-
turns are independent and (1 +i
t
) is lognormally distributed, where i
t
is the return
in year t.
Deriving any necessary formulae:
(a) Calculate the expected value of an investment of $2 million after ten years.
(b) Calculate the probability that the accumulation of the investment will be less
than 80% of the expected value.
vestment bank models the expected performance of its assets over a ve-day period.
Over that period, the return on the banks portfolio, i, has a mean value of 0.1%
and standard deviation of 0.2%. (1 + i) is lognormally distributed.
Calculate the value of j such that the probability that i is less than or equal to j is
0.05.
Exercise 6.10: [sto10] (Institute of Actuaries Examination September 2004) The
expected annual eective rate of return from an insurance companys investments is
29
6% and the standard deviation of annual returns is 8%. The annual eective returns
are independent and (1 +i
t
) is lognormally distributed, where i
t
is the return in the
tth year.
(a) Calculate the expected value of an investment of $1 million after ten years.
(b) Calculate the probability that the accumulated of the investment will be less
than 90% of the expected value.
6.3 Dependence and Further Concepts
Exercise 6.11: [new3] Company A and Company B currently have a swap contract
where A pays (annually) a oating interest rate on a principal of $1 million to B
in exchange for a xed rate of 5% from B to A. The oating rate i
t
in year t is
assumed to be independent for each year, and (1 + i
t
) is lognormally distributed
with i
t
having mean 4% and standard deviation 2%.
(a) Find the expected value of the accumulated value after 10 years of the net
receipts (from the perspective of A) from the swap.
(b) Using R, simulate (1000 times) the interest rate for the next 10 years and verify
your answer in (a). In addition, nd the variance and plot the distribution of
the accumulated value.
(c) In what situation may a company wish to enter into a xed-for-oating swap?
Exercise 6.12: [new5] Suppose that the interest rate y
t
(for year t) follows a mean
reverting process dened by:
y
t
= +(y
t1
) +
t
where
t
N(0, 1) iid for each time t = 0, 1, . . ..
It is also known that = 0.05, = 0.4, and = 0.01. Denote the accumulated
value of $1 in one years time as S
1
. Find:
(a) E(S
1
)
(b) Var(S
1
)
(c) Pr(S
1
< 1.04)
if the interest rate last year was (i) 4% and (ii) 6%.
Exercise 6.13: [new6] Suppose that the interest rate y
t
(for year t) follows a mean
reverting process dened by:
y
t
= +(y
t1
) +
t
It is also known that = 0.05, = 0.4, and = 0.01. Denote the accumulated
value of $1 in ten years time as S
10
. Using 1000 simulations in R, estimate:
30
(a) E(S
10
)
(b) Var(S
10
)
(c) Pr(S
10
< 1.55)
(d) Plot the histogram of S
10
.
if the interest rate last year was (i) 4% and (ii) 6%.
Exercise 6.14: [new9] Suppose that the interest rates in each year are independent
and identically distributed, with (1 + i
t
) LN(,
2
) and i
t
having mean 4% and
standard deviation 2%. Denote as s
30
the expected value and variance of the 30
year accumulated value of an annual payment of $1 in advance.
(a) Derive recursive formulae which can be used to nd E( s
30
) and Var( s
30
).
(b) Using R and the formulae in (a), nd E( s
30
) and Var( s
30
).
(c) Estimate E( s
30
) and Var( s
30
) using simulation in R, and compare your answers
with those in (b). Also plot the simulated density of s
30
and provide the
quartiles of the distribution.
31
Module 7
Solutions to Exercises
7.1 Module 1
Exercise 1.1 [int1]
Under compound interest:
Accumulated amount at t = 4: 100(1.05)
4
= 121.5506
Accumulated amount at t = 5: 100(1.05)
5
= 127.6282
Interest earned = 6.08
Under simple interest:
Accumulated amount at t = 4: 100(1 + 4 0.05) = 120
Accumulated amount at t = 5: 100(1 + 5 0.05) = 125
Interest earned = 5.00
R code:
100*(1.05^5-1.04^5)
100*0.05
Exercise 1.2 [int2]
200(1 + i)
5
= 275 i =
_
275
200
_
1/5
1 = 0.06576
R Code:
(275/200)^(1/5) - 1
Exercise 1.3 [int3]
200(1.05)
t
= 275 t =
ln(275/200)
ln 1.05
= 6.527 years
Exercise 1.4 [int4]
275v
5
= 215.47, where v =
1
1+i
R Code:
32
v = 1/1.05
275*v^5
Exercise 1.5 [int5]
150(1 + i)
n
= 240
1000(1 + i)
n
=
1000
150
150(1 + i)
n
=
1000
150
240 = 1600
Exercise 1.6 [int7]
The most one requires will be the amount X which is sucient even when the
interest rate is always at its minimum of 5% in the latter 10 years (as this minimises
the interest earned). Therefore:
X(1.08)
10
(1.05)
10
= 1000000
X = 284360
Exercise 1.7 [int8]
The accumulation of $1 under the eective rate and the 8% and 5% rates should be
equivalent:
(1 + i)
20
= (1.08)
10
(1.05)
10
i = 0.06489
Exercise 1.8 [int9]
Value at time t = 0:
5 + 3v
2
+ v
3
= 8.2307
Value at time t = 3:
8.2307(1 + i)
3
= 10.9550
Alternatively: 5(1 + i)
3
+ 3(1 + i) + 2 = 10.9550
Exercise 1.9 [int10]
The 2nd set of cash ows contains two of the 1st set, one starting at t = 0 and
another starting at t = 1. Thus, the value is given by:
7.7217 + v7.7217 = 15.0757
100 (1.10)
3
20 (1.10)
2
20 (1.10) = 86.90
100(1 + i)
6
= 200
i = 0.12246
(SOA Course 2 May 2000, Question 1)
33
Accumulated value of 1st account after 10 years:
10(1 + 0.11 10) + 30(1 + 0.11 5) = 67.50
Therefore, accumulated value of 2nd account after 10 years must also be 67.50:
10(1.0915)
10n
+ 30(1.0915)
102n
= 67.50
30(1.0915)
10
v
2n
+ 10(1.0915)
10
v
n
67.50 = 0
v
n
=
10(1.0915)
10
_
100(1.0915)
20
+ 120(1.0915)
10
67.50
60(1.0915)
10
= 0.8158 or 1.1491
Since v
n
> 0, we have v
n
= 0.8158 n =
ln 0.8158
ln v
= 2.325
R code:
a = 30*1.0915^10
b = 10*1.0915^10
c = -67.5
v = 1/1.0915
f = function(x) { a*x^2 + b*x + c }
vn = uniroot(f) # find the root
vn = vn$root # extract the root only
n = log(vn)/log(v)
(SOA Course 2 Nov 2000, Question 2)
For the rst investment (the $100 at beginning of 1990), the interest credited in
1993 is 8% of the accumulated value at the beginning of 1993 (ie. after 3 years):
100(1.10)(1.10)(1 + 0.01x)(0.08) = 9.68 + 0.0968x
Similarly, for the second investment, the interest credited is:
100(1.12)(1.05)(0.10) = 11.76
and for the third investment:
100(1.08)(0.01(x 2)) = 1.08x 2.16
Therefore, the total interest credited in 1993 is:
19.28 + 1.1768x = 28.40
x = 7.7498
34
Using v =
1
1+r
, we have the following present values for the two payment options:
PV
A
= 610 + 475v + 340v
2
PV
B
= 560 + 580v + 274v
2
Option A is preferred when PV
B
PV
A
= 50 + 105v 66v
2
> 0. Note that the
quadratic 50 + 105v 66v
2
= 0 has no real roots. The quadratic is negative at
v = 1, since 50 +105 66 = 11 < 0. This implies that PV
B
< PV
A
for all values
of r, so Option B is always preferred to A.
(a) The equation of value for each of the alternative is given as follows with the
corresponding yield (rate of interest) r:
Alternative A:
1000(1 + r)
3
= 1330
r = 9.9724%
Alternative B:
1000(1 + r)
5
= 1550
r = 9.1607%
Alternative C:
1000(1 + r)
5
= 425
_
1 +
1
1 + r
+
_
1
1 + r
_
2
+
_
1
1 + r
_
3
_
r = 8.5761%
Note: for C, the yield must be found numerically (eg. using uniroot in R)
R Code:
f = function(v) {
1000*(1/v)^5 - 425*(1+v+v^2+v^3)
}
v = uniroot(f,c(0,1)) # solve f = 0
v = v$root # keep only the numerical value
r = 1/v-1
(b) We need the accumulated value of $1330 at a rate r to be at least $1550:
1330(1 + r)
2
1550
1330r
2
+ 2660r 220 0
35
For equality, we have:
r =
2660
2660
2
+ 4 1330 220
2660
= 0.079543 or 2.0795
r 7.9543%
We ask this question to compare A and B. If we chose A, then after 3 years, we
would need to invest the $1330 at some interest rate (eg. by putting the money in
the bank) for 2 years, after which it can be compared with the $1550 from B (at 5
years). Thus, we must be able to earn at least 7.95% during this 2 year period for
A to be a better choice than B.
(c) The value of alternative C is:
425
_
1 +
1
1 + r
+
_
1
1 + r
_
2
+
_
1
1 + r
_
3
_
= 1508.97
which is less than the value of B ($1550). Note that we have used the interest rate
from alternative C.
Equation of value:
P(v + v
2
+v
3
+ v
4
+v
5
) = 1000000
where v =
1
1.13
. Therefore, we obtain P = 284314.54.
d = 1 v = 0.06
v =
1
1+i
i =
1
v
1 = 0.06383
Also: i = d/v = 0.06383
(SOA Course 2 May 2001, Question 12)
Note the relationship between accumulating using eective interest and discount
rates:
1 + i = (1 d)
1
Thus:
X = 100[(1 d)
11
(1 d)
10
] = 50[(1 d)
17
(1 d)
16
]
For clarity, denote R = (1 d)
1
.
100R
10
(R 1) = 50R
16
(R 1)
2R
10
= R
16
R
6
= 2
R = 2
1/6
X = 100(R
11
R
10
) = 38.8793
36
An equation of value to solve for the eective semi-annual interest rate i is
4843.30(1 + i)
4
= 6000
whose only positive solution is i = 0.055. The total value of the three payments at
the time the note matures is
1000(1.055)
3
+ 1000(1.055)
2
+ 2000(1.055) = 4397.27
so she will need a top up of $1602.73 to redeem the note for $6000.
Each deposit accumulates under simple interest for 1 month, then under compound
interest for the remaining quarters. Therefore, by the end of December 2005:
March deposit accumulates to:
1000
_
1 + 0.06
1
12
__
1 +
0.06
4
_
19
= 1333.59
June deposit accumulates to:
1000
_
1 + 0.06
1
12
__
1 +
0.06
4
_
18
= 1313.88
September deposit accumulates to
1000
_
1 + 0.06
1
12
__
1 +
0.06
4
_
17
= 1294.46
December deposit accumulates to
1000
_
1 + 0.06
1
12
__
1 +
0.06
4
_
16
= 1275.33
Therefore, the total interest would be:
1333.59 + 1313.88 + 1294.46 + 1275.33 4000 = 1217.25
Using the relations for equivalent rates
1 + i =
_
1 +
i
(m)
m
_
m
= (1 d)
1
=
_
1
d
(m)
m
_
m
= e
we have:
37
Given rate Equivalent eective rate i A(4.5) = 10000(1 +i)
4.5
d = 0.05 0.0526316 12596.32
i
(2)
= 0.05 0.0506250 12488.63
i
(12)
= 0.05 0.0511619 12517.38
d
(2)
= 0.05 0.0519395 12559.10
d
(12)
= 0.05 0.0513809 12529.11
= 0.05 0.0512711 12523.23
R code:
i = c() # initialise vector
i[1] = (1-0.05)^(-1) - 1
i[2] = (1+0.05/2)^2 - 1
i[3] = (1+0.05/12)^12 - 1
i[4] = (1-0.05/2)^(-2) - 1
i[5] = (1-0.05/12)^(-12) - 1
i[6] = exp(0.05) - 1
rows = c("A","B","C","D","E","F") # row names
cols = c("i","A(4.5)") # column names
names = list(rows,cols) # create list of row/col names
matrix(c(i,10000*(1+i)^4.5),ncol=2,dimnames=names)
Note that the accumulation function is given by:
a(t) = exp
__
t
0
(s)ds
_
= exp
__
t
0
0.04
1 + s
ds
_
= (1 +t)
0.04
(a)
a(2) a(1)
a(1)
=
(3)
0.04
(2)
0.04
(2)
0.04
= 0.01635084
(b)
a(3) a(2)
a(2)
=
(4)
0.04
(3)
0.04
(3)
0.04
= 0.01157375
(c) Since A(t) = A(0)(1 + t)
0.04
, then A(0) =
200000
(5)
0.04
= 187530.19. Therefore:
A(2) =
200000
(5)
0.04
(3)
0.04
= 195954.86
We have
a(t) =
_
1 + 0.1t t k
(1 + 0.1k) exp [0.08(t k)] t > k
38
Hence
a(4) =
_
(1 + 0.1k) exp [0.08(4 k)] k < 4
1.4 k 4
(a) To maximize a(4), dierentiate w.r.t. k (assuming a(4) = (1 + 0.1k)e
0.08(4k)
,
ie. k < 4; will need to check this)
d
dk
a(4) = 0.1 exp [0.08(4 k)] 0.08 (1 + 0.1k) exp [0.08(4 k)]
and set to be zero. Solving for k (and noting that the exponential is positive) we
have:
0.1 = 0.08 (1 + 0.1k)
k = 2.5
Check: at k = 2.5, a(4) > 1.4, so assumption of k < 4 is OK. Note that if the as-
sumption of k < 4 was violated, then a(4) = 1.4 as opposed to our earlier expression
of (1 + 0.1k)e
0.08(4k)
, and a(4) will have a maximum of 1.4 (at any k 4).
(b)
a(t) =
_
1 + 0.1t t 2.5
1.25e
0.08(t2.5)
t > 2.5
ln a(t) =
_
ln(1 + 0.1t) t 2.5
ln 1.25 + 0.08(t 2.5) t > 2.5
(t) =
d
dt
ln a(t) =
_
0.1
1+0.1t
t 2.5
0.08 t > 2.5
Exercise 1.24 [new10]
We use the result:
1 + i =
_
1 +
i
(m)
m
_
m
= (1 d)
1
=
_
1
d
(m)
m
_
m
= e
Therefore:
i
(m)
= m
_
e
/m
1
_
d
(m)
= m
_
e
/m
1
_
R code:
delta = 0.05
m = seq(0.5,50,length.out=1000)
im = m*(exp(delta/m)-1)
dm = -m*(exp(-delta/m)-1)
plot(m,im,type="l",ylim=c(0.045,0.055),
39
main="Nominal Interest/Discount Rates",
xlab="Compounding Frequency",ylab="Nominal Rate")
lines(m,dm,col=2)
legend(50,0.055,c("i(m)","d(m)"),lty=c(1,1),col=c(1,2),xjust=1)
0 10 20 30 40 50
0
.
0
4
6
0
.
0
4
8
0
.
0
5
0
0
.
0
5
2
0
.
0
5
4
Nominal Interest/Discount Rates
Compounding Frequency
N
o
m
i
n
a
l

R
a
t
e
i(m)
d(m)
Note that = 0.05 and all the points on this plot yield the same eective rate of
interest!
Exercise 1.25 [ann1]
(a) R code:
a = function(n,i) (1-(1/(1+i))^n)/i
(b) Each monthly payment is
1
12
of the nominal amount. The eective monthly
rate i is given by:
i =
0.12
12
= 0.01
Therefore:
PV =
1000
12
a
72 0.01
+
_
1
1.01
_
72
400
12
a
48 0.01
+
_
1
1.01
_
120
2000
=
1000
12
_
1 (
1
1.01
)
72
0.01
_
+
_
1
1.01
_
72
400
12
_
1 (
1
1.01
)
48
0.01
_
+
_
1
1.01
_
120
2000
= 4262.50 + 618.34 + 605.99
= 5486.80
40
R code (contd):
PV = 1000/12*a(72,0.01) + 400/12*a(48,0.01)/1.01^72 + 2000/1.01^120
Alternatively, we can obtain the annual eective rate j:
j = 1.01
12
1 = 0.1268
Then, using annuities payable monthly:
PV = 1000a
(12)
6
+
_
1
1 + j
_
6
400a
(12)
4
+
_
1
1 + j
_
10
2000
= 1000
_
1 v
6
j
0.12
_
+
_
1
1 + j
_
6
400
_
1 v
4
j
0.12
_
+
_
1
1 + j
_
10
2000
= 5486.80
(c) Assume level annuity payments payable monthly, then
X
_
1 (
1
1.01
)
120
0.01
_
= 5486.80
X = 78.720
The quoted annual payment is then 78.720 12 = 944.64.
R code (contd):
X = PV/a(120,0.01)
12*X
The equation of value is based on the present value of the amount received by each
charity (which are known to be equal):
P
3
a
20
= v
20
Pa
P
3
_
1 v
20
i
_
= v
20
P
i
1 v
20
= 3v
20
v
20
= 0.25
i = (0.25)
1/20
1 = 0.07177
41
The accumulated value of the deposits 10 years after the rst deposit is:
AV = C s
10 0.06
= C(1.06)
10
_
1
_
1
1.06
_
10
0.06
_
= 13.1808C
The present value of the loan payments as at the end of 10 years is:
PV = 15000 a
5 0.06
= 15000
_
1
_
1
1.06
_
5
0.06
_
= 63185.4568
where we have used a rate of 6% because that is the amount paid by the account
(so the remaining funds in the bank will be earning 6% between years 10 and 15).
Equating these values and solving for C, we obtain C = 4793.75.
Exercises 1.281.34
[annB1annB7] See the Mathematics of Investment and Credit solutions manual.
The original and nal monthly eective interest rates i and j are given by:
(1 + i)
12
= 1.03 i = 0.00246627
(1 + j)
12
= 1.05 j = 0.00407412
The original monthly payment P is given by:
Pa
300 i
= 100000 P =
100000
a
300 i
= 472.1087
After 10 years, the remaining value of the annuity is:
Pa
180 i
This will also be the present value of the new annuity (with annual payments of P
),
which is valued at the new interest rate j:
Pa
180 i
= P
a
180 j
Therefore, the new payment is:
P
= P
a
180 i
a
180 j
= 538.1869
Thus, the payment increase is:
P
P = 66.08
42
The 1-year eective rate i and 2-year eective rate j are given by:
i = 1.025
2
1 = 0.050625
j = 1.025
4
1 = 0.103813
By drawing a cash ow diagram, it can be seen that the cash ow stream is a 20-year
annuity with annual payments of $100, plus an additional $100 every 2nd year (ie.
an additional 20-year annuity with biannual payments of $100). Thus:
PV = 100a
20 i
+ 100a
10 j
= 1844.16
A discount rate of 10% p.a. is equivalent to an interest rate of i = 11.11% p.a.
Therefore, the current cash ows are worth:
18000 a
12 i
= 18000 (1 +a
11 i
) = 129162.10
We want annual payments of X where:
129162.10 = Xa
20 i
X = 16337.69
See solutions manual. For 5 years, monthly payment required is 296.94.
Exercises 1.391.40
[annB8annB9] See the solutions in the Broverman text and solutions manuals.
s
10
is the accumulated value (at time 10) of $1 paid at each time t = 1, . . . , 10. The
accumulated value (at time 10) of a single $1 paid at time n is given by:
exp
__
10
n
1
20 t
dt
_
= exp [ln(20 10) + ln(20 n)]
= exp
_
ln
_
20 n
10
__
=
20 n
10
Therefore:
s
10
=
10
n=1
20 n
10
=
19 + 18 +. . . + 10
10
= 20
1
10
10(10 + 1)
2
= 14.5
43
The loan repayments are an increasing annuity with payments of P, 2P, . . . , 30P at
times t = 1, 2, . . . , 30. To determine the value of P, we use an equation of value (at
time t = 0):
4000 = P(Ia)
30 0.04
=
_
a
30 0.04
30v
30
0.04
_
P = 18.32
Immediately after the ninth payment, the outstanding loan is found by decomposing
the remaining payments into a level annuity and an increasing annuity:
10Pv + 11Pv
2
+ 12Pv
3
+... + 30Pv
21
= 9Pa
21 0.04
+P(Ia)
21 0.04
= 4774.80
This is greater than the original loan amount, and is because the earlier payments
are (very) small relative to the latter payments. Therefore, the earlier payments are
insucient to pay o the interest, let alone pay o part of the principal. Hence, this
is also unlikely to exist in reality.
The borrowings are a decreasing annuity, whereas the repayments can be decom-
posed into a level annuity of $300 and an increasing annuity starting at $200. An
equation of value (at the end of year when nal loan amount is received) is:
X(Ds)
5 0.05
(1 + i) = 300a
15 0.05
+ 200(Ia)
15 0.05
Noting that:
a
15 0.05
= 10.379658
(Ia)
15 0.05
=
a
15 0.05
15v
15
0.05
= 73.667689
(Ds)
5 0.05
= (1 +i)
5
(Da)
5 0.05
= (1 +i)
5
[6a
5 0.05
(Ia)
5 0.05
]
= (1 +i)
5
_
6a
5 0.05
a
5 0.05
5v
5
0.05
_
= 17.115531
We obtain:
X =
300a
15 0.05
+ 200(Ia)
15 0.05
(Ds)
5 0.05
(1 + i)
= 993.11
The annual eective rate i is given by:
1 + i = 1.025
4
i = 0.103813
44
For convenience, we will determine the initial deposit by discounting all cash ows
to time t = 0 (1/1/2004).
The entire series of deposits can be decomposed into two series:
A. Deposits of X, 1.1025X, . . . , (1.1025)
10
X at times t = 0, 1, . . . , 10
B. Deposits of 1.1025X, (1.1025)
2
X, . . . , (1.1025)
11
X at times t =
1
2
, 1
1
2
, . . . , 10
1
2
where time t is measured in years.
These two series are (geometrically) increasing annuities, and can be present valued
as geometric progressions:
PV
A
= X + 1.1025Xv +. . . + (1.1025)
10
Xv
10
= X
_
1 (1.1025v)
11
1 1.1025v
_
= 10.934815X
PV
B
= v
1/2
(1.1025)
_
X + 1.1025Xv +. . . + (1.1025)
10
Xv
10
= v
1/2
(1.1025) PV
A
= 11.474726X
Therefore, the initial deposit X is found as follows:
PV
A
+ PV
B
= 110000v
11
X = 1656.19
The present value is $3311.51.
R code:
i = 0.05
v = 1/(1+i)
t = 1:30
X = t^3 + log(10*t+12)
sum(X*v^t)
There are a number of ways to decompose the payments into annuity streams, which
allow the present value to be determined more easily.
A simple method is to consider 3 cash ow streams, each containing payments 1
year apart (which also means we will use the annual eective rate of 0.10):
A. 10, 20, 30, 40 at times t =
1
3
, 1
1
3
, 2
1
3
, 3
1
3
45
B. 20, 30, 40, 50 at times t =
2
3
, 1
2
3
, 2
2
3
, 3
2
3
C. 30, 40, 50, 60 at times t = 1, 2, 3, 4
Each of these streams is the combination of an increasing annuity and a level annuity.
Therefore:
PV
A
= 10v
1/3
(I a)
4
PV
B
= 10v
2/3
(I a)
4
+ 10v
2/3
a
4
PV
C
= 10v(I a)
4
+ 20v a
4
The annuity factors are given by:
(I a)
4
= v + 2v
2
+ 3v
3
+ 4v
4
= 8.302780
a
4
= (1.1)
_
1 v
4
0.1
_
= 3.486852
Therefore, we obtain the present value:
PV
A
+ PV
B
+PV
C
= 329.95
A more elegant method involves decomposing the original payments into:
X. 10,20,30,. . . ,10,20,30 at all times (t =
1
3
,
2
3
, 1, . . . , 4)
Y. 0,0,0,10,10,10,. . . ,30,30,30 at all times (t =
1
3
,
2
3
, 1, . . . , 4)
The payments of X can be grouped by year, resulting in four payments of (10,20,30).
Thus, X is a 4-year level annuity-due, with each payment being an increasing annu-
ity:
PV
X
= 10(Ia)
3 j
a
4 i
= 194.3179
where i = 0.1 is the annual eective rate, and j = (1.1)
1/3
1 is the
1
3
-year eective
rate.
Conversely, the payments of Y can are a 3-year increasing annuity, with each pay-
ment being a level annuity (omitting the rst three payments of 0):
PV
Y
= 10a
3 j
(Ia)
3 i
= 135.6289
Summing these up, we obtain the same present value:
PV
X
+PV
Y
= 329.95
46
The present value (at time t = 0) of the rst ten payments is:
P(Ia)
10 0.07
The present value (at time t = 10) of the last ten payments is:
10(10P) = 100P
since each payment is discounted at the same rate as the payment growth rate (each
payment is of amount 10(1.05)
n
P which is worth 10(1.05)
n
Pv
n
at time t = 10, and
v
n
= (1.05)
n
cancels with the factor (1.05)
n
).
Therefore, the present value of all payments at time t = 0 is:
P(Ia)
10 0.07
+ 100P(1.07)
10
= 50000
Since (Ia)
10 0.07
= 34.739133, we get:
P = 584.29
(a) Let the annual payment be X. Therefore:
Xa
20 0.05
= 10000
X = 802.4259
R code:
v = 1/1.05
X = 10000/sum(v^(1:20))
(b) Let the rst annual payment be X. Therefore:
(1.03)Xv + (1.03)
2
Xv
2
+ . . . + (1.03)
20
Xv
20
= 10000
1.03Xv
_
1 (1.03v)
20
1 1.03v
_
= 10000
X = 608.1346
R code:
v = 1/1.05
X = 10000/sum((1.03*v)^(1:20))
47
(c) To be fair, we need the present value of both payment streams to be equal (to
10000).
In nominal terms:
20
k=1
608.13(1.03)
k
v
k
0.05
=
20
k=1
802.43v
k
0.05
= 10000
or in real terms:
20
k=1
608.13v
k
r
=
20
k=1
802.43(1.03)
k
v
k
r
= 10000
where r =
1.05
1.03
1.
(a) The annual eective interest rate is i = e
1 = 0.05127.
We note that the payment at time n is 1+2+. . .+n. Therefore, the perpetuity
can be decomposed into a level perpetuity of 1 (1st payment at time 1), plus a
level perpetuity of 2 (1st payment at time 2), etc. This can be interpreted as
an increasing perpetuity, with each regular payment being a level perpetuity
itself:
PV = v a
+ 2v
2
a
+ 3v
3
a
+ . . .
= a
_
v + 2v
2
+ 3v
3
+. . .
_
= a
(Ia)
Therefore:
PV =
_
1
d
__
a
i
_
=
1
d
2
i
= 8820
where d = iv = 0.04877.
(b) R code:
n = 1:500
x = n*(n+1)/2 # sum of an AP: 1+2+...+n
v = 1/1.05
y = x*v^n
sum(y)
plot(n, y, xlab="Time", ylab="PV of payment")
48
0 100 200 300 400 500
0
2
0
4
0
6
0
8
0
1
0
0
1
2
0
Time
P
V

o
f

p
a
y
m
e
n
t
Aside: The graph is actually related to the Gamma function. The present value of
the nth payment is:
1
2
n
2
v
n
+
1
2
nv
n
=
1
2
n
2
e
n
+
1
2
ne
n
Thus, we require:
n=1
n
2
e
n
and
n=1
ne
n
These can be approximated using the Gamma function by noting that:
(k) = (k 1)! =
_

0
x
k1
e
x
dx
k=1
x
k1
e
x
Therefore, the present value is:
PV =
1
2
_

n=1
n
2
e
n
+
n=1
ne
n
_
1
2
__

0
x
2
e
x
dx +
_

0
xe
x
dx
_
=
1
2
_
1
3
_

0
u
2
e
u
du +
1
2
_

0
ue
u
du
_
where u = x
=
1
2
_
2!
3
+
1!
2
_
49
The force of interest is = ln 1.05 = 0.04879, which results in:
PV 8820.04
Exercises 1.501.57
[annB10annB15] See the solutions in the Broverman text and solutions manuals.
We require 100(Ia)
10
, 100(Ia)
(12)
10
, and 100(I a)
10
. The monthly eective rate is:
j = (1 +i)
1/12
1 = 0.004074
and therefore the nominal rate (payable monthly) is:
i
(12)
= 12j = 0.04889
The force of interest is:
= ln(1 +i) = 0.04879
Therefore:
100(Ia)
10
=
a
10
10v
10
i
= 39.3738
100(Ia)
(12)
10
=
a
(12)
10
10v
10
i
(12)
= 44.0352
100(I a)
10
=
a
10
10v
10
= 40.3501
The present value of the annuity is given by:
PV =
_
14
1
(t
2
1)v
t
dt
where the discount factor v
t
varies (continuously) with time t:
v
t
= exp
_
_
t
0
1
1 + s
ds
_
= exp (ln(1 + t)) =
1
1 + t
Therefore, we have:
PV =
_
14
1
t
2
1
t + 1
dt =
_
14
1
(t 1)dt = 84.50
50
7.2 Module 2
Exercise 2.1 [lif1]
Note that if the force of mortality is constant, then the survival function is expo-
nential:
t
p
x
= exp
_
_
t
0
x+s
ds
_
= e
t
Therefore:
E[Z] =
_

0
b
t
v
t
t
p
x
x+t
dt
=
_

0
e
0.05t
e
0.06t
e
0.01t
0.01dt
= 0.01
_

0
e
0.02t
dt
=
1
2
E[Z
2
] =
_

0
e
0.1t
e
0.12t
e
0.01t
0.01dt
= 0.01
_

0
e
0.03t
dt
=
1
3
Var(Z) = E[Z
2
] (E[Z])
2
=
1
3

1
4
=
1
12
Exercise 2.2 [lif2]
Writing out the (contingent) annuity-certain in terms of the interest rate:
k=0
a
k+1
k
p
x
q
x+k
=
k=0
_
1 v
k+1
d
_
k
p
x
q
x+k
This gives us a v term, which is similar to the RHS. We dont want the q, so we
write it in terms of p:
51
=
k=0
_
1 v
k+1
d
_
k
p
x
(1 p
x+k
)
=
k=0
_
1 v
k+1
d
_
(
k
p
x
k+1
p
x
)
=
1
d
_

k=0
(
k
p
x
k+1
p
x
)
k=0
v
k+1
(
k
p
x
k+1
p
x
)
_
=
1
d
__

k=0
k
p
x
k=1
k
p
x
_
v
k=0
v
k
k
p
x
+
k=0
v
k+1
k+1
p
x
_
=
1
d
_
1 v
k=0
v
k
k
p
x
+
k=1
v
k
k
p
x
_
=
1
d
_
v
k=0
v
k
k
p
x
+
k=0
v
k
k
p
x
_
since v
0
0
p
x
= 1. Therefore:
=
1 v
d
k=0
v
k
k
p
x
=
k=0
v
k
k
p
x
The LHS is an annuity certain with a term equal to the future lifetime of the
individual. The RHS considers each annual payment separately, noting that the
individual will receive it if he/she is alive. Both describe the cash ows of a term
annuity, and therefore they must be equal.
Exercise 2.3 [lif3]
Let K(x) be the curtate lifetime random variable of (x). We have:
a
x
= E
_
a
K(x)+1
_
=
k=0
a
k+1
Pr [K(x) = k]
=
k=0
a
k+1
k|
q
x
=
k=0
_
1 v
k+1
d
_
k|
q
x
=
1
d
_

k=0
k|
q
x
k=0
v
k+1
k|
q
x
_
=
1 A
x
d
52
d a
x
+ A
x
= 1
Exercise 2.4 [lif4]
The required values are:
Pr[K(0) = k] =
k
p
0
q
k
= {0.1, 0.045, 0.0855, 0.1539, 0.2462, 0.2586, 0.1108, 0} for k = 0, . . . , 7
e
0
= E[K(0)] =
6
k=0
k Pr[K(0) = k]
= 3.6203
Pr[K(2) = k] =
k
p
2
q
2+k
= {0.1, 0.18, 0.288, 0.3024, 0.1296, 0} for k = 0, . . . , 5
e
2
= E[K(2)] =
4
k=0
k Pr[K(2) = k]
= 2.1816
A
2
=
4
k=0
v
k+1
Pr[K(2) = k]
= 0.8576
2
A
2
=
4
k=0
v
2(k+1)
Pr[K(2) = k]
= 0.7379
A
1
2:3
=
2
k=0
v
k+1
Pr[K(2) = k]
= 0.5073
A
1
2:3
= v
3
3
p
2
= 0.3732
A
2:3
= A
1
2:3
+ A
1
2:3
= 0.8805
a
2
=
4
k=0
v
k
k
p
2
= 2.9900
a
2
= a
2
1 = 1.9900
a
2:3
=
2
k=0
v
k
k
p
2
= 2.5102
R code:
v = 1/1.05
x = 0:6
53
q = c(0.1, 0.05, 0.1, 0.2, 0.4, 0.7, 1)
kp0 = c(1,cumprod(1-q)) # k = 0,1,...,6
kp2 = c(1,cumprod(1-q[3:7])) # k = 0,1,...,4
# Values based on individual starting at age 0
k = 0:6
PrK0 = kp0[1+k]*q[1+k]
e0 = sum(k*PrK0)
# Values based on individual starting at age 2
k = 0:4
PrK2 = kp2[1+k]*q[1+(k+2)]
e2 = sum(k*PrK2)
A2 = sum(v^(k+1)*PrK2)
A22 = sum(v^(2*(k+1))*PrK2)
A123 = sum(v^(0:2+1)*PrK2[1+0:2])
A231 = v^3*kp2[1+3]
A23 = A123 + A231
a2d = sum(v^k*kp2[1+k])
a2i = a2d - 1
a23 = sum(v^(0:2)*kp2[1+0:2])
Exercise 2.5 [lif5]
Let T = T(x) be the (random) lifetime of the non-smoker and T
S
= T
S
(x) be the
lifetime of the smoker. We want to nd:
Pr
_
T
S
> T
_
=
_

0
Pr
_
T
S
> t
_
f
T
(t) dt
where we have conditioned on the future lifetime T to construct the integral.
Note that:
Pr
_
T
S
> t
_
=
t
p
S
x
= exp
_
_
t
0
c
x+u
du
_
= (
t
p
x
)
c
where
t
p
x
= Pr(T > t). Also, the density of T is given by:
f
T
(t) =
d
dt
F
T
(t) =
d
dt
(1 S(t)) =
d
dt
t
p
x
since the survival function S(t) is equivalent to
t
p
x
. Therefore:
Pr
_
T
S
> T
_
=
_

0
(
t
p
x
)
c
(
t
p
x
)
dt
=
_
(
t
p
x
)
c+1
c + 1
_
0
=
1
1 + c
The answer is reasonable because:
54
If c = 1, then the two lives are identical so the probability should be 1/2
(which is the case here)
If c > 1 (as it is assumed), then the mortality of the smoker is higher, so the
probability that he outlives the non-smoker should be less than 1/2 (which is
also the case here)
Exercise 2.6 [new7]
(a) The survival probabilities can be found using integration:
S
x
(t) = exp
_
_
x+t
x
A +Bc
y
dy
_
R code:
A = 0.0003225
B = 0.000031
c = 1.0966413
mu = function(x) { A + B*c^x }
# Get survival probabilities
S65 = c()
for(t in 1:45) {
S65[t] = exp(-integrate(mu,65,65+t)$value)
}
plot(S65, xlab="Years", ylab="Probability",
main="Survival Probabilities for 65 year old")
55
0 10 20 30 40 50
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8
1
.
0
Survival Probabilities for 65 year old
Years
P
r
o
b
a
b
i
l
i
t
y
(b) The annual payment X is given by:
Xa
65
= 1, 000, 000
where:
a
65
=
t=1
v
t
t
p
65
R code (contd):
i = 0.05
v = 1/(1+i)
t = x-65+1
a65 = sum(v^t * S65[t])
X = 1000000/a65
The annual payment is X = 88817.64.
(c) The value of X is given by:
(1 + f)Xvp
65
+ (1 + f)
2
Xv
2
2
p
65
+. . . = 1, 000, 000
or:
X
t=1
(1 + f)
t
v
t
t
p
65
= 1, 000, 000
R code (contd):
f = 0.03
X = 1000000/sum((1+f)^t * v^t * S65[t])
The answer is X = 65577.37.
56
7.3 Module 3
Exercise 3.1 [loa1]
(a) The repayments involve annual payments (in arrears) of X, ie. an annuity-
immediate:
Xa
5
= 15000
X = 3464.62
(b) The retrospective method considers the accumulated value of past cash ows:
OB
2
= 15000(1.05)
2
Xs
2
= 9435.02
(c) The prospective method considers the present value of future cash ows:
OB
2
= Xa
3
= 9435.02
(d) Let the new annual payment be Y . The new future repayments must be able
to repay the outstanding balance calculated in (b) and (c). Therefore:
Y a
3 0.075
= OB
2
= 9435.02
Y = 3628.12
(e) Let the renegotiated payment be Z. We have:
Za
4 0.076
= OB
2
= 9435.02
Z = 2823.31
(f) See the tutorial solution spreadsheet (loa1.xls).
The loan schedule can also be performed in R using the following code:
# Calculated values
X = 15000/(1-(1/1.05)^5)*0.05
OB2 = X*(1-(1/1.05)^3)/0.05
Z = OB2/(1-(1/1.076)^4)*0.076
# Initialise interest rate and repayments
i = c(rep(0.05,2),rep(0.076,4))
X = c(rep(X,2),rep(Z,4))
OB0 = 15000
# Initialise vectors (and first year)
I = OB0*i[1]
57
PR = X[1]-I[1]
OB = OB0-PR[1]
# Calculate other years recursively
for(t in 2:6) {
I[t] = OB[t-1]*i[t]
PR[t] = X[t]-I[t]
OB[t] = OB[t-1]-PR[t]
}
# Create and display loan schedule
sched = data.frame(Repayment = X, I = I, PR = PR, OB = OB)
round(sched,2)
Exercise 3.2 [loa2]
(a) The annual payment consists of two components: the interest repayment, and
the payment into the sinking fund. The interest payment is simply 7% of the
loan:
20000(0.07) = 1400
The sinking fund payment is an amount X such that the sinking fund will
accumulate to the $20000 principal after 6 years:
Xs
6 0.05
= 20000
X = 2940.35
Therefore, the annual repayment is:
1400 + 2940.35 = 4340.35
(b) Similarly to (a), we have:
Xs
6 0.07
= 20000
X = 2795.92
Therefore, the annual repayment is 4195.92.
(c) The standard loan arrangement would require annual payments of $4195.92 as
the two methods are equivalent when the sinking fund and loan interest rates
are the same. Hence, we would prefer the standard loan arrangement, as it
involves lower annual repayments. In general, the standard loan is preferable
if the sinking fund rate is below the loan interest rate (which is usually true
loan interest rate higher than savings interest rate).
(d) See the tutorial solution spreadsheet (loa2.xls).
The loan schedule can also be performed in R using the following code:
58
# Initialise values
i = 0.07
j = 0.05
X = 20000/((1+j)^6-1)*j
Y = 1400+X
# Loan repayments
OB = 20000
I = i*OB
PR = 0
# Sinking fund: initialise vectors
SFA0 = 0
SFP = Y-I
SFI = 0
SFA = SFP + SFI
# Recursive relations
for(t in 2:6) {
SFI[t] = SFA[t-1]*j
SFA[t] = SFA[t-1]+SFP+SFI[t]
}
sched = data.frame(Repayment = Y, I = I, PR = PR, OB = OB,
SFPayment = SFP, SFInterest = SFI, SFAcc = SFA)
round(sched,2)
Exercise 3.3 [loa3]
(a) Total interest to be repaid:
I = Lfn = 5000 0.10 2 = 1000
Monthly loan repayments are:
R =
L +I
N
=
6000
24
= 250
The monthly eective rate j is the solution to the following equation of value:
Ra
24 j
= 5000
Using Newton-Raphson, we dene the function f as follows:
f(j) = Ra
24 j
5000 = 250
_
1 (1 + j)
24
j
_
5000
The derivative is:
f
(j) = 250
_
24j(1 + j)
25
(1 (1 + j)
24
)
j
2
_
59
Starting with j
0
= 0.10:
j
1
= j
0
f(j
0
)
f
(j
0
)
= 0.062716
j
2
= j
1
f(j
1
)
f
(j
1
)
= 0.022528
j
3
= j
2
f(j
2
)
f
(j
2
)
= 0.004878
j
4
= j
3
f(j
3
)
f
(j
3
)
= 0.014291
j
5
= j
4
f(j
4
)
f
(j
4
)
= 0.015125
This results in an annual eective rate i of:
i = (1 +j
5
)
12
1 = 19.74%
Using R:
# Define f and f (both expression and function)
f_expr = expression(250*(1-1/(1+j)^24)/j - 5000)
Df_expr = D(expr)
f = function(j) eval(f_expr,list(j=j))
Df = function(j) eval(Df_expr,list(j=j))
# Newton-Raphson
j = 0.1 # first estimate
numit = 10 # number of iterations
for(k in 2:numit) {
j[k] = j[k-1] - f(j[k-1])/Df(j[k-1])
}
j[numit]
# Convert to annual effective rate
(1+j[numit])^12 - 1
The solution is j = 0.015131. Therefore, the eective annual rate i is:
i = (1 +j)
12
1 = 19.75%
(b) The outstanding balance (using the prospective method) is:
250a
12 j
= 2724.66
Exercises 3.43.6
[loaB3loaB5] See the Mathematics of Investment and Credit solutions manual.
60
Exercise 3.7 [loa5]
The eective monthly rate is
0.18
12
= 0.015. Therefore, the monthly repayment X is
given by:
Xa
100 0.015
= 20000 X = 387.41
As we are only required to provide the last four instalments (ie. 97th100th pay-
ments), we can begin the loan schedule at time t = 96 (months). The outstanding
balance at time t = 96 is:
OB
96
= Xa
4 0.015
= 1493.23
The loan schedule for times t = 97, . . . , 100 can then be found using the following
recursive equations:
I
t
= OB
t1
0.015
PR
t
= X I
t
OB
t
= OB
t1
PR
t
Therefore, we obtain:
Time Interest Principal Repaid Outstanding Balance
(t) (I
t
) (PR
t
) (OB
t
)
96 ? ? 1493.23
97 22.40 365.01 1128.22
98 16.92 370.49 757.73
99 11.37 376.05 381.69
100 5.73 381.69 0
The full loan schedule is shown in the tutorial spreadsheet provided (loa5.xls).
The loan schedule can be performed in R using the following code:
# Setup values from previous sections
i = 0.18/12
v = 1/(1+i)
X = 20000/(1-v^100)*i
OB96 = X*(1-v^4)/i
I = OB96*i
PR = X-I[1]
OB = OB96-PR[1]
for(t in 2:4) { # 2,3,4 corresponding to 98,99,100
I[t] = OB[t-1]*i
PR[t] = X-I[t]
61
}
sched = data.frame(Time = 97:100, I = I, PR = PR, OB = OB)
round(sched,2)
Exercise 3.8 [loa6]
The present value of the original four loans is:
PV = 4.36a
11 0.01
+ 17.2a
15 0.01
+ 35a
12 0.01
+ 20.24a
18 0.01
= 1009.51
The total (sum) payments is:
11 (4.36) + 15 (17.2) + 35 (12) + 18 (20.24) = 1090.28
For the new consolidated loan, denote the term to run (in months) as n. Since
n must be an integer, the consolidated loan cannot have level repayments with a
further restriction that these repayments must sum to the original total (1090.28).
Therefore, the loan will be assumed to involve monthly repayments of X, with an
additional nal payment of Y to account for any remaining outstanding balance.
We have two equations to describe the two constraints (repayments must sum to
original total; eective rate must remain the same):
nX + Y = 1090.28
Xa
n 0.01
+Y v
n+1
= 1009.51
Here, we have three variables and two equations. Therefore, we must x one variable,
after which we can determine the other two as a function of the rst variable. A
logical choice would be to set n to dierent values (as it has to be an integer) and
get X and Y by solving the simultaneous equations (noting that the coecients
n, v
n+1
, a
n 0.01
are all known once n is known). Here are the results for various
choices of n:
n X Y
11 95.43 40.60
12 88.53 27.90
13 82.60 16.53
14 77.43 6.22
15 72.90 -3.25
16 68.89 -12.03
17 65.32 -20.24
18 62.13 -27.99
Intuitively, the nal payment should not be negative and should be as small as
possible as it represents an extra top-up payment to ensure the loan is fully repaid
to the nearest cent. The purpose of the nal payment is not to repay a signicant
62
portion of the loan. Hence, the solution where n = 14 is the most appropriate, and
so we choose n = 14 with X = 77.43 and Y = 6.22. In other words, the consolidated
annuity is of $77.43 for 14 months, with a nal payment of $6.22 at the end of 15th
month.
Note: the necessity of the nal payment Y can be veried by observing (from the
table) that there is no solution where n is an integer and Y = 0.
The table was produced using the following R code:
# Initialise values
i = 0.01
a = function(n,i) (1-(1/(1+i))^n)/i # annuity-immediate
pmt = c(4.36,17.2,35,20.24)
num = c(11,15,12,18)
PV = sum(pmt*a(num,i)) # present value of payments
S = sum(pmt*num) # sum of payments
# Try n = 11,...,18
n = 11:18
table = matrix(NA,length(n),2,dimnames=list(n,c("X","Y")))
for(k in 1:length(n)) {
# Solve linear system: Ax=b
A = matrix(c(n[k],1,a(n[k],i),v^(n[k]+1)),ncol=2,nrow=2,byrow=TRUE)
b = c(S,PV)
x = solve(A) %*% b
table[k,] = x
}
round(table,2)
Exercise 3.9 [loa7]
The initial payment X can be found as follows, noting the monthly eective rate is
0.12
12
= 0.01:
Xa
12 0.01
+ (1.1)Xv
12
a
12 0.01
+ (1.1)
2
Xv
24
a
12 0.01
= 47500
X = 1440.80
The loan schedule is shown in the tutorial spreadsheet provided (loa7.xls).
The loan schedule can be performed in R using the following code:
# Initialise values
i = 0.01
v = 1/(1+i)
X = 47500 / ((1-v^12)/i) / (1 + 1.1*v^12 + 1.1^2*v^24)
Y = X*c(rep(1,12),rep(1.1,12),rep(1.1^2,12))
OB0 = 47500
63
I = OB0*i
PR = Y[1]-I[1]
OB = OB0-PR[1]
for(t in 2:36) {
I[t] = OB[t-1]*i
PR[t] = Y[t]-I[t]
}
sched = data.frame(Repayment = Y, I = I, PR = PR, OB = OB)
round(sched,2)
Exercise 3.10 [loa8]
(a) Let X be the annual payment. We have:
Xa
10 0.0675
= 600000 X = 84441.97
Hence total payment is 10X = 844419.69.
(b) Let Y be the monthly payment. The monthly eective rate i is given by:
1 + i = (1.0675)
1/12
i = 0.005458
Therefore:
Y a
120 i
= 600000 Y = 6828.08
Hence the total payment is 120Y = 819369.39, which is 25050.30 less than the
total payment in (a).
(c) The amount to settle the loan is the outstanding balance at time t = 5. This
will not change when the interest rate changes, as the outstanding balance
is determined from the past (ie. using the recursive relationships of a loan
schedule). Therefore, the amount will be OB
5
under the old interest rate of
6.75%:
OB
5
= Xa
5 0.0675
= 348558.74
Note that this implies the prospective method (based on the future) becomes
incorrect when interest rates change, while the retrospective method (based
on the past) remains correct. If we used the prospective method, we would
have calculated an outstanding balance of:
Xa
5 0.0725
= 343923.44
This is the present value of future repayments (as payments now have to be
discounted at the new rate), but it is not the outstanding balance.
64
Note that we cannot nd a solution analytically due to the complexity of the loan
(dierent period for interest and principal (re)payments; non-equal actual pay-
ments). Therefore, we will model the loan using a spreadsheet (loa4.xls).
The time step will be one quarter, ie. t = 0,
1
4
, . . . , 19. The interest (I
t
), principal re-
paid (PR
t
) outstanding balance (OB
t
), and nominal/actual payments (NPR
t
, APR
t
)
are described using a set of recursive relationships:
I
t
= OB
t
1
4
0.02
PR
t
= APR
t
I
t
OB
t
= OB
t
1
4
PR
t
NPR
t
=
75000
15
= 5000 (t = 5, 6, . . . , 19)
APR
t
= 5000 (t = 5, 6, . . . , 19)
where we note that the quarterly eective interest rate is
0.08
4
= 0.02, and the
nominal and actual payments are equal since the loan is repaid at par.
The net cash ows received by the purchaser are the payments of interest (I
t
) and
principal (APR
t
). The price for a required eective yield i is found by discounting
these cash ows at the rate i. Therefore:
P =
t
_
1
1 + i
_
t
(I
t
+ APR
t
)
where the summation is taken over t = 0,
1
4
, . . . , 19.
For i = 0.10, the price is P = 66636.60.
For i =
_
1 +
0.10
2
_
2
1 = 0.1025, the price is P = 65565.63.
This question requires a spreadsheet model due to the complexity of the capital
gains tax. A spreadsheet model can be setup using the standard recursive formulae,
along with the following formulae for tax purposes:
IT
t
=
I
I
t
CGT
t
= (
CG
CG
t
)
+
=
CG
_
APR
t
NPR
t
500000
P
_
+
The capital gain is determined as the actual repayment less the purchase price. The
portion of the loan repaid by APR
t
is
NPR
t
500000
of the entire loan, and this portion of
the loan was purchased at a price of
NPR
t
500000
P.
The price is the present value of the net cash ows at the eective yield of 6%:
P =
t
v
t
CF
t
=
t
v
t
(APR
t
+I
t
IT
t
CGT
t
)
65
The spreadsheet model can be found in loa9.xls. The solution is (a) $439,608.30 and
(b) $538,334.94.
Note that each component of the price can be expressed as follows (where i = 0.06):
t
v
t
APR
t
= 25000(1.05)v
10
a
10
t
v
t
(I
t
IT
t
) = (1
I
) (0.08)
t
v
t
OB
t
1
4
t
v
t
CGT
t
= 0.3
_
25000(1.05)
25000
500000
P
_
+
v
10
a
10
where:
t
v
t
OB
t
1
4
= 500000a
(4)
10
+ 475000v
10
a
(4)
1
+. . . + 25000v
28
a
(4)
1
= 500000a
(4)
10
+ 25000v
10
a
(4)
1
(Da)
(4)
19
The modelling can be performed in R using the following code:
# Initialise values
L = 500000
j = 0.06
v = 1/(1+j)
Time = seq(0,29,by=0.25)
n = length(Time)
taxI = 0.4 # also taxI = 0.2
taxCG = 0.3
# Simple function to convert from time(s) to index
ind = function(x) {
ind = c()
for(y in x) {ind = c(ind,which(Time==y))}
ind
}
# Setup values for interest rates and principal repaid
i = 0.02
R = 1.05
NPR = rep(0,n)
NPR[ind(10:29)] = L/20
APR = NPR*R
# Squared difference between price and PV(cash flows)
# (as a function of the price P)
# Aim is to minimise this function (set to 0)
# Note: "<<-" is used to make sure the values remain assigned even
66
# after the function has ended
temp = function(P) {
# Initialise vectors (t = 0)
OB <<- L
I <<- 0
for(t in 2:n) { # t = 0.25, ..., 29
I[t] <<- OB[t-1]*i
OB[t] <<- OB[t-1]-NPR[t]
}
# Tax
IT <<- taxI * I
CGT <<- taxCG * (APR - NPR/L * P)
CGT <<- pmax(CGT,0)
# Cash flows and present value (at reqd yield)
CF <<- I+APR-IT-CGT
PVCF <<- CF*v^Time
# Squared difference (to ensure non-negative)
(P - sum(PVCF))^2
}
# Minimise by changing P over sufficiently large range (0,2L)
opt = optimize(temp,c(0,2*L))
P = opt$minimum # get P corresponding to minimum
print(round(P,2),digits=20)
sched = data.frame(NPR,APR,I,OB,IT,CGT,CF,PVCF)
round(sched,2)
(a) The equation of value is:
80 = 6a
10
+ 100v
10
(b) Newton-Raphson nds the root of f(x) = 0 recursively as follows:
x
n
= x
n1
f(x
n1
)
f
(x
n1
)
where x
n
is the root obtained from the nth iteration.
R code:
67
newton = function(f_expr,precision,init) {
# Find derivative
Df_expr = D(f_expr,"x")
# Allow evaluation of functions
f = function(x) eval(f_expr,list(x=x))
Df = function(x) eval(Df_expr,list(x=x))
# Initialise variables
k = 1
x = init
# Do first iteration
x[k+1] = x[k] - f(x[k])/Df(x[k])
k = k+1
# While loop for finding the root iteratively
while(abs(x[k]-x[k-1]) > precision*abs(x[k-1])) {
x[k+1] = x[k] - f(x[k])/Df(x[k])
k = k+1
}
x[k]
}
(c) The equation we need to solve is:
0 = 6
_
1 v
10
i
_
+ 100v
10
80
=
6
i

6(1 + i)
10
i
+ 100(1 + i)
10
80
Thus, dene:
f(x) =
6
x

6(1 + x)
10
x
+ 100(1 + x)
10
80
R code:
# Define f as an expression
f_expr = expression(6/x - 6/x/(1+x)^10 + 100/(1+x)^10 - 80)
# Solve using Newton-Raphson
newton(f_expr,0.0001,0.06)
The solution is i = 9.1349%.
68
You can (and should) do this question both by hand and by spreadsheet.
(a) The capital gain is already known as the price is given and the bond only has
one capital repayment at the end.
For the 15% bond on its own, the capital gain is:
100 105.80 < 0
Therefore there will be no CGT. The equation of value is then:
105.80 = 15 (1 0.35) a
4 j
+ 100 (1 +j)
4
where j is the annual eective yield. The solution j = 8.00% can easily be
veried by substitution.
For the 8% bond, the capital gain is:
100 85.34 = 14.66 > 0
Therefore there will be CGT. The equation of value is then:
85.34 = 8(1 0.35)a
4 j
+
_
100 14.66(0.5)
_
(1 + j)
4
The solution j = 8.00% can easily be veried by substitution.
Therefore both bonds (on their own) give an eective yield of 8% p.a.
The solution by spreadsheet is provided in loa10.xls. The equations to be used
are:
NPR
t
= 100 (t = 4)
APR
t
= NPR
t
I
t
= i OB
t1
OB
t
= OB
t1
NPR
t
IT
t
= (0.35)I
t
CGT
t
= (0.50)
_
APR
t
NPR
t
100
P
_
P =
t
v
t
(APR
t
+I
t
IT
t
CGT
t
)
where i is the interest rate (15% or 8%) and j is the annual eective yield,
and v = (1 +j)
1
.
We require the yield such that P is (a) 105.80 or (b) 85.34. These both result
in a solution of j = 8.00%.
(b) Instead of putting $100 in one single bond, we now put $x into the 15% bond
and $ (100 x) into the 8% bond. This means that we buy:
x
105.8
of the 15% bond with face value 100
69
and
100 x
85.34
of the 8% bond with face value 100
We want to nd the value x such that the net capital gain is 0. Note that
this would minimise our net CGT liability, as we have minimised the capital
gain and we do not get a refund from capital losses (therefore no advantage in
having a negative CG).
CG =
x
105.8
(100 105.8) +
100 x
85.34
(100 85.34) = 0
x =
100(14.66)
85.34
5.8
105.8
+
14.66
85.34
= 75.81
The equation of value is then:
100 =
x
105.8
_
15(1 0.35)a
4 j
+ 100v
4
j
_
+
100 x
85.34
_
8(1 0.35)a
4 j
+ 100v
4
j
_
The solution j = 8.46% can be veried by substitution.
For the spreadsheet model, we note that the combined portfolio can be con-
sidered as a single bond (since interest payments are still level, and face value
is still $100). The price is $100, since we have zero capital gain (ie. purchasing
a par bond). The interest rate becomes:
i = 0.15 + 0.08(1 )
where =
x
105.8
is the proportion of the rst bond purchased, and 1 =
100x
85.34
is the proportion of the second bond purchased.
The rest of the spreadsheet remains the same. The yield can be solved numer-
ically to obtain j = 8.46%.
Exercises 3.153.16
[loaB6loaB7] See the Mathematics of Investment and Credit solutions manual.
When an Australian government bond is ex-interest, the owner of the bond at the
date of the bond going ex-interest receives the next coupon payment. The buyer
does not receive the next coupon payment. The buyer receives the maturity face
value and all coupons except the next payment.
Price is:
v
f
d
(C +Ga
n
+ 100v
n
)
where the interest rate used is the semi-annual eective rate i =
0.0475
2
= 0.02375,
70
and:
f = number of days to next coupon date (11 Jun 2006 to 15 Jun 2006)
d = number of days between coupon dates (15 Dec 2005 to 15 Dec 2006)
C = next coupon payment
G = regular semi-annual coupon payment
n = is the number of coupons to maturity
Hence f = 4, d = 182, C = 0, G =
5.75
2
= 2.875, and n = 10. Price on 11 June 2006
is (next coupon is not received):
P = v
4
182
_
2.875a
10
+ 100v
10
_
= 0.999484 (2.875 8.808866 + 100 0.790789)
= 0.999484 104.404433
= 104.351
See Sherris (p. 4043). Users that may be interested include superannuation funds
and anyone with long term liabilities that rise in line with ination (such as ination-
linked life annuities, or some general insurance liabilities). See also:
http://en.wikipedia.org/wiki/Ination-indexed_bond
Using a spreadsheet model similar to Exercise 3.12, we obtain a price of $516,099.04.
The spreadsheet is provided in loa12.xls.
R code:
# Initialise values
L = 500000
j = 0.07
v = 1/(1+j)
Time = seq(0,19,by=0.25)
n = length(Time)
taxI = 0.15
taxCG = 0.15
ind = function(x) {
ind = c()
ind
}
71
i = 0.02
R = 1.1
NPR = rep(0,n)
NPR[ind(10:19)] = L/10
APR = NPR*R
# Squared difference between price and PV(cash flows)
# (as a function of the price P)
# Aim is to minimise this function (set to 0)
# Note: "<<-" is used to make sure the values remain assigned even
# after the function has ended
temp = function(P) {
OB <<- L
I <<- 0
for(t in 2:n) { # t = 0.25, ..., 19
I[t] <<- OB[t-1]*i
OB[t] <<- OB[t-1]-NPR[t]
}
# Tax
IT <<- taxI * I
CGT <<- taxCG * (APR - NPR/L * P)
CGT <<- pmax(CGT,0)
CF <<- I+APR-IT-CGT
PVCF <<- CF*v^Time
# Squared difference (to ensure non-negative)
(P - sum(PVCF))^2
}
# Minimise by changing P over sufficiently large range (0,2L)
opt = optimize(temp,c(0,2*L))
P = opt$minimum # get P corresponding to minimum
sched = data.frame(NPR,APR,I,OB,IT,CGT,CF,PVCF)
round(sched,2)
72
A spreadsheet model can be used with the following equations (where time t =
0,
1
2
, . . . , 30 is in years):
i
t
=
_
0.035 t 26.5
0.04 t > 26.5
NPR
t
=
_
_
150000 t = 10, 11, . . . , 18
250000 t = 19, 20, . . . , 29
300000 t = 30
R
t
=
_
_
1.05 t = 10, 11, . . . , 18
1.10 t = 19, 20, . . . , 29
1.12 t = 30
APR
t
= NPR
t
R
t
I
t
= i
t
OB
t
1
2
OB
t
= OB
t
1
2
NPR
t
P =
t
v
t
j
(APR
t
+I
t
)
where j = 0.065 is the required eective yield. Also note that the original outstand-
ing balance (face value) is

t
NPR
t
= 4, 400, 000.
The spreadsheet is provided in loa13.xls. The price is $4,797,748.66.
The modelling can be performed in R using the following code:
# Initialise values
j = 0.065
v = 1/(1+j)
Time = seq(0,30,by=0.5) # 1/1/1974 (t=0) to 1/1/2004 (t=61)
n = length(Time)
ind = function(x) {
ind = c()
ind
}
i = rep(0.035,n)
temp = which(Time==27):n # 1/1/2001 (t=27) to End
i[temp] = 0.04
NPR = rep(0,n)
R = rep(1,n)
NPR[ind(10:18)] = 150000 # 1/1/84,...,1/1/92 (t=10,...,18)
73
R[ind(10:18)] = 1.05
NPR[ind(19:29)] = 250000 # 1/1/93,...,1/1/03 (t=19,...,29)
R[ind(19:29)] = 1.10
NPR[ind(30)] = 300000 # 1/1/04 (t=30)
R[ind(30)] = 1.12
APR = NPR*R
OB = sum(NPR)
I = 0
for(t in 2:n) { # t = 0.5, ..., 30
I[t] = OB[t-1]*i[t]
OB[t] = OB[t-1]-NPR[t]
}
CF = I+APR
PVCF = CF*v^Time
sched = data.frame(Time,NPR,APR,i,I,OB,CF,PVCF)
round(sched,2)
# Calculate price
P = sum(PVCF)
The price P is the present value of all cash ows at the net eective yield of j = 0.08.
This question is not too complex, and can be solved by hand. The complexity
arises from capital gains tax. However, note that the capital gain for the rst two
repayments (at times t = 2, 3) is:
400
400
1200
P < 0
since we are given P > 1200. Therefore, the only possibility of a capital gain is with
the 3rd repayment (at time t = 4). For the 3rd repayment, the capital gain is:
400(1.2)
400
1200
P = 480
1
3
P
which will only be positive if P < 1440. Therefore, the capital gains tax for the 3rd
repayment is:
CGT
4
=
_
0.20
_
480
1
3
P
_
P < 1440
0 P 1440
74
Thus, we can solve this question by considering two cases: P < 1440 and P 1440.
(i) For P < 1440, there is CGT, and the price is given by:
P = (1 0.20)
_
0.10
_
1200v + 1200v
2
+ 800v
3
+ 400v
4
_
+ 400(v
2
+v
3
+ 1.2v
4
) 0.20
_
480
1
3
P
_
v
4
which can be solved to obtain P = 1249.47. This is consistent with the
assumption of P < 1440, so it is a valid solution.
(ii) For P 1440, there is no CGT, and the price is given by:
P = (1 0.20)
_
0.10
_
1200v + 1200v
2
+ 800v
3
+ 400v
4
_
+ 400(v
2
+v
3
+ 1.2v
4
)
= 1258.80
This is not consistent with the assumption of P 1440, so it is not a valid
solution.
Therefore, the price of the loan is $1249.47.
7.4 Module 4
Exercise 4.1 [irr1]
(a) From the spot rates we can work out the discount factors:
v(0.5) =
_
1 +
0.04875180
2
_
1
= 0.976204
v(1) =
_
1 +
0.05031182
2
_
2
= 0.951525
v(1.5) =
_
1 +
0.05234408
2
_
3
= 0.925421
v(2) =
_
1 +
0.05448436
2
_
4
= 0.898067
and hence the value of the bond is:
P =
6.75
2
[v(0.5) + v(1) + v(1.5) + v(2)] + 100v(2) = 102.467
(b) To determine the yield (eective yearly), we need to solve:
6.75a
(2)
2 i
+ 100v
2
i
= 102.467
This can be done numerically to obtain i = 5.50537% (using the function
written earlier in Exercise 3.13). The equivalent semi-annual eective yield is
j = (1 +i)
1/2
1 = 2.7158% (ie. i
(2)
= 5.43161%).
75
(c) The par yield of the 1 year coupon bond can be determined by solving:
100i [v(0.5) + v(1)] + 100v(1) = 100
or equivalently:
i[v(0.5) + v(1)] + v(1) = 1
i =
1 v(1)
v(0.5) + v(1)
= 0.025146
The equivalent nominal rate (payable semi-annually) is i
(2)
= 5.0292%.
Similarly, the par yield of the 2 year coupon bond is:
1 v(2)
v(0.5) + v(1) + v(1.5) + v(2)
= 0.027173
which is equivalent to a nominal yield (payable semi-annually) of i
(2)
= 5.4346%.
This means that if these bonds have coupon rates equal to these par yields,
then their price will be 100 using the spot rates of this question.
(d) Recall the following relationship between spot rates and forward rates, which
holds due to no arbitrage (ie. accumulation of $1 with certainty must be the
same under spot and forward rates):
(1 + s
t
)
t
= (1 +s
t1
)
t1
(1 + f
t1,t
)
This can be rewritten as:
f
t1,t
=
(1 + s
t
)
t
(1 + s
t1
)
t1
1
Using the above equation in semi-annual time steps, we obtain:
f
0,
1
2
= s
0.5
= 0.024376
f1
2
,1
=
(1 + s
1
)
2
(1 + s
0.5
)
1 = 0.025937
f
1,1.5
=
(1 + s
1.5
)
3
(1 + s
1
)
2
1 = 0.028207
f
1.5,2
=
(1 + s
2
)
4
(1 + s
1.5
)
3
1 = 0.030459
where the spot and forward rates are semi-annual eective rates. These for-
ward rates are equivalent to nominal p.a. rates (payable semi-annually) of
4.8752%, 5.1873%, 5.6415%, and 6.0919%.
76
Exercise 4.2 [irr2]
A zero coupon bond can be constructed by purchasing a combination of the two
bonds (ie. x 9% bonds and y 7% bonds).
To have a net coupon each period of zero, we require:
9x + 7y = 0
To have a face value of $100 on maturity, we require:
x +y = 1
Solving these simultaneously, we obtain x = 3.5 and y = 4.5. The price of the
ZCB is therefore:
P = 3.5 101.00 + 4.5 93.20 = 65.9
Exercise 4.3 [irr3]
For all t, by equating the accumulation of $1 with certainty, we obtain:
exp
__
t1
0
s(x)dx
_
exp (f
t1,t
) = exp
__
t
0
s(x)dx
_
_
t1
0
s(x)dx +f
t1,t
=
_
t
0
s(x)dx
f
t1,t
= rt r(t 1) = r
which is a at forward rate curve.
Exercise 4.4 [irr4]
Denote f
t1,t
as the nominal forward rate (semi-annual compounding) for time period
(t 1, t). The forward rates can be found by equating the accumulation of $1 over
the corresponding time periods:
_
1 +
f
0,1
2
_
2
=
_
1 +
f
0,0.5
2
__
1 +
f
0.5,1
2
_
= (1.025)(1.0275) = 1.053188
_
1 +
f
0.5,1.5
2
_
2
=
_
1 +
f
0.5,1
2
__
1 +
f
1,1.5
2
_
= (1.0275)(1.03) = 1.058325
_
1 +
f
1,2
2
_
2
=
_
1 +
f
1,1.5
2
__
1 +
f
1.5,2
2
_
= (1.03)(1.0305) = 1.061415
_
1 +
f
1.5,2.5
2
_
2
=
_
1 +
f
1.5,2
2
__
1 +
f
2,2.5
2
_
= (1.0305)(1.03125) = 1.062703
_
1 +
f
2,3
2
_
2
=
_
1 +
f
2,2.5
2
__
1 +
f
2.5,3
2
_
= (1.03125)(1.035) = 1.067344
77
These can be solved to obtain:
f
0,1
= 5.2498%
f
0.5,1.5
= 5.7498%
f
1,2
= 6.0500%
f
1.5,2.5
= 6.1750%
f
2,3
= 6.6247%
Exercise 4.5 [irr5]
The value of the bond is given by:
P = 4 [v(0.5) + v(1) + v(1.5) + v(2)] + 100v(2)
where v(t) is the discount factor associated with the t-year (semi-annual compound-
ing) spot rate:
v(t) =
1
(1 +
s
t
2
)
2t
v(0.5) = 0.977995 and v(1) = 0.949497 are calculated by substituting the given spot
rates, whereas v(1.5) and v(2) are determined using spot and forward rates:
v(1.5) =
1
_
1 +
s
1.5
2
_
3
=
1
_
1 +
s
1
2
_
2
_
1 +
f
1,1.5
2
_
=
1
_
1 +
0.0525
2
_
2
_
1 +
0.075082
2
_
= 0.915142
v(2) =
1
_
1 +
s
2
2
_
4
=
1
_
1 +
s
1
2
_
2
_
1 +
f
1,1.5
2
__
1 +
f
1.5,2
2
_
=
1
_
1 +
0.0525
2
_
2
_
1 +
0.075082
2
_ _
1 +
0.020290
2
_
= 0.905951
The resulting price is P = 105.591.
Exercise 4.6 [irr6]
We have:
P = D a
n
+Re
n
P
= D

a
n
nRe
n
78
where:
a
n
=

_
n
0
e
t
dt
=
_
n
0
e
t
dt
=
_
n
0
te
t
dt
= (
I a)
n
Therefore, the duration is given by:
D() =
1
P

P
=
D(
I a)
n
nRe
n
D a
n
+Re
n
=
g(
I a)
n
+nv
n
g a
n
+v
n
where g = D/R.
Exercise 4.7 [irr7]
(a) Consider a nominal amount of $1 of bond. The coupon income is g = 0.05 p.a.,
payable continually to redemption at time n. The duration is (from Exercise
4.6):
D() =
g(
I a)
n
+nv
n
g a
n
+v
n
at = 0.07, which results in 11.592 for n = 20 and 14.345 for n = 60.
(b) To nd the maximum duration, we need to dierentiate D() w.r.t. n (and set
this to zero). To do so, it is useful to note the following intermediate results:
n
v
n
= v
n
ln v = v
n
n
nv
n
= nv
n
ln v + v
n
= (1 n) v
n
n
a
n
=
1
n
(1 v
n
) =
1
(v
n
) = v
n
n
_
I a
_
n
=
1
n
( a
n
nv
n
) =
1
(v
n
+ (1 n)v
n
) = nv
n
Therefore:
n
D() =
(g a
n
+ v
n
) (gnv
n
+ (1 n)v
n
)
_
g(
I a)
n
+nv
n
_
(gv
n
v
n
)
(g a
n
+v
n
)
2
79
Setting this to zero:
0 = (g a
n
+ v
n
)
_
gnv
n
+ (1 n)v
n
_
_
g(
I a)
n
+ nv
n
_
(gv
n
v
n
)
= (g a
n
+ v
n
)
_
1 + (g )n
_
v
n
_
g(
I a)
n
+ nv
n
_
(g ) v
n
= (g a
n
+ v
n
) + (g )
_
gn a
n
+ nv
n
g(
I a)
n
nv
n
= (g a
n
+ v
n
) + (g )
_
gn a
n
g(
I a)
n
Noting that we require an equation in terms of a

n
(ie. without v
n
and (
I a)
n
):
0 = (g a
n
+ 1 a
n
) + (g )
_
gn a
n

g
( a
n
nv
n
)
_
= 1 + (g )
_
a
n
+gn a
n

g
( a
n
n +n a
n
)
_
= 1 + (g )
_
a
n

g
( a
n
n)
_
( g)
_
a
n

g
( a
n
n)
_
= 1
a
n
+
g
(n a
n
) =
1
g
a
n
+g(n a
n
) =

g
as required (g = 0.05, = 0.07). This can then be solved numerically to
obtain n = 64.349 and a corresponding duration of 14.349.
(a) The modied duration and convexity are:
MD =
1
P
P
i
C =
1
P
2
P
i
2
(b) R code:
# Function to get kth derivative by using D recursively
DD <- function(expr,name, order = 1) {
if(order < 1) stop("order must be >= 1")
if(order == 1) D(expr,name)
else DD(D(expr,name), name, order - 1)
}
# PV of annuity as an expression and a function
a_expr = expression((1-1/(1+i)^n)/i)
a = function(i,n) eval(a_expr,list(i=i,n=n))
# Get modified duration and convexity
80
MD = function(i,n) {
-eval(DD(a_expr,"i",1),list(i=i,n=n))/a(i,n)
}
C = function(i,n) {
eval(DD(a_expr,"i",2),list(i=i,n=n))/a(i,n)
}
(c) The rst and second derivatives of the price are approximated by:
P
i
=
P(i + h) P(i h)
2h
2
P
i
2
=
P(i + h) 2P(i) + P(i h)
h
2
where h is a small increment in the interest rate. For this question, we shall
take h = 0.005.
R code (contd):
h = 0.005
MD2 = function(i,n) {
d1 = (a(i+h,n)-a(i-h,n))/(2*h)
-d1/a(i,n)
}
C2 = function(i,n) {
d2 = (a(i+h,n)-2*a(i,h)+a(i-h,n))/(h^2)
d2/a(i,n)
}
(d) The modied duration and convexity are 4.856 and 35.602 respectively. The
approximation should be similar but will depend on the choice of h.
R code:
print(MD(0.05,10))
print(C(0.05,10))
print(MD2(0.05,10)) # 4.857618
print(C2(0.05,10)) # 35.60934
Exercise 4.9 [lif6]
Recall that:
a
x
=
k=0
v
k
k
p
x
=
k=0
(1 + i)
k
k
p
x
To nd the duration, we dierentiate w.r.t. i:
d
di
a
x
=
k=0
k(1 + i)
k1
k
p
x
=
k=0
kv
k+1
k
p
x
81
Therefore the modied duration of a
x
is:
MD
x
= v
k=0
kv
k
k
p
x
l=0
v
l
l
p
x
and the Macaulay Duration is:
D
x
=
MD
x
v
=
k=0
kv
k
k
p
x
l=0
v
l
l
p
x
=
k=0
w
k
k, where w
k
=
v
k
k
p
x
l=0
v
l
l
p
x
.
Again, this is the weighted average of the payment maturities, where the weights
take into account both the time value of money and the probabilities of survival
(since the payments are contingent to the survival of (x)).
Exercise 4.10 [irr8]
(a) The present value of assets (5-year and 15-year bonds) and liabilities (10-year
ZCB) are:
V
A
(i) = M
5
v
5
+M
15
v
15
V
L
(i) = 1000v
10
where v = (1 +i)
1
.
(b) A zero cost portfolio that provides a positive (non negative) prot with zero
chance of loss.
(c) To ensure that V
A
(i) = V
L
(i), we require:
M
5
+M
15
v
10
= 1000v
5
The duration of the assets and liabilities are:
D
A
(i) =
t
tC
t
v
t
t
C
t
v
t
=
5M
5
v
5
+ 15M
15
v
15
M
5
v
5
+M
15
v
15
D
L
(i) =
10v
t
v
t
= 10
Therefore, to ensure that D
A
(i) = D
L
(i), we require:
5M
5
v
5
+ 15M
15
v
15
M
5
v
5
+M
15
v
15
= 10
which simplies to:
M
5
= M
15
v
10
Solving these simultaneous equations, we get M
5
= 340.29 and M
15
= 734.66.
We can check that this is an arbitrage opportunity by looking at V
A
(i)V
L
(i)
for each parallel shift in the at yield curve:
i V
A
(i) V
L
(i)
7% 0.55
8% 0
9% 0.45
This shows that the surplus will be positive regardless of the direction in which
interest rates shift (as long as we have a parallel shift in a at yield curve).
82
See Sherris p. 87.
At i = 4.5%, we have (for the liabilities):
V
L
=
t
C
t
v
t
= 3v + 4v
2
+ 3v
3
+ 2v
4
= 10.84
D
L
=
t
tC
t
v
t
V
L
=
3v + 8v
2
+ 9v
3
+ 8v
4
10.84
= 2.29
C
L
=
t
t(t + 1)C
t
v
t+2
V
L
=
6v
3
+ 24v
4
+ 36v
5
+ 40v
6
10.84
= 7.84
For the assets:
V
A
= M
0.5
v
0.5
+ M
5
v
5
D
A
=
0.5M
0.5
v
0.5
+ 5M
5
v
5
V
A
Ensuring that V
A
= V
L
and D
A
= D
L
, we get:
M
0.5
v
0.5
+ M
5
v
5
= 10.84
0.5M
0.5
v
0.5
+ 5M
5
v
5
= 24.79
These can be solved to obtain M
0.5
= 6.6803 and M
5
= 5.3647 using the following
R code:
v = 1/1.045
t = 1:4
C = c(3,4,3,2)
VL = sum(C*v^t)
DL = sum(t*C*v^t)/VL
A = matrix(c(v^0.5,0.5*v^0.5,v^5,5*v^5),2,2)
b = c(VL,VL*DL)
M = solve(A,b)
The eect of a change in interest rates on the surplus is determined using the fol-
lowing R code:
83
# Surplus function
# i(t) is a function which outputs the t-year spot rate
s = function(i) {
vn = function(t) 1/(1+i(t))^t
M[1]*vn(0.5) + M[2]*vn(5) - (3*vn(1)+4*vn(2)+3*vn(3)+2*vn(4))
}
# Apply different interest rate shifts
i = function(t) 0.025
s(i)
s(i)
s(i)
i = function(t) 0.025+0.01*t
s(i)
i = function(t) 0.025+0.01*t
s(i)
a = 0.06; b = 0.01; c = -0.08; l = 0.6;
i = function(t) {
a + b*(1-exp(-l*t))/(l*t) + c*((1-exp(-l*t))/(l*t) - exp(-l*t))
}
s(i)
The results are shown in the following table:
Rate V
A
V
L
S
6.5% 10.39 10.38 0.01
4.5% 10.84 10.84 0.00
2.5% 11.34 11.33 0.01
Twist (d) 10.32 10.67 0.35
Twist (e) 10.86 10.89 0.03
The negative surplus for the twist scenarios illustrate the failure of immunisation to
protect against non-parallel shifts in the yield curve.
(a) R code:
# Spot rate function
s = function(tau,lambda,alpha,beta) {
alpha + beta*(1-exp(-lambda*tau))/lambda/tau
}
# Evaluate spot curve
alpha = 0.06
84
beta = -0.01
lambda = 0.6
tau = seq(0.01,20,length.out=500)
plot(tau,s(tau,lambda,alpha,beta),xlab="Term",ylab="Spot Rate",
main="Spot Curve",type="l")
0 5 10 15 20
0
.
0
5
0
0
.
0
5
2
0
.
0
5
4
0
.
0
5
6
0
.
0
5
8
Spot Curve
Term
S
p
o
t

R
a
t
e
(b) Fisher-Weil duration relaxes the assumption that the yield curve is at. In
practice, yield curves are rarely at. Therefore, dierent interest rates must
be used when present valuing cash ows of dierent maturities. By splitting
the cash ows into ZCBs of dierent maturities, we can value the cash ows by
valuing the ZCBs (which is done using spot rates). The time-weighted value
(duration) is also calculated using these principles.
(c) The immunisation strategy is found using the Fisher-Weil duration (since the
yield curve is no longer at):
V
L
=
t
C
t
(1 + s
t
)
t
= 10.609
D
L
=
t
tC
t
(1 + s
t
)
t
V
L
= 2.275
C
L
=
t
t(t + 1)C
t
(1 + s
t
)
(t+2)
V
L
= 7.572
85
For the assets:
V
A
= M
0.5
(1 + s
0.5
)
0.5
+ M
5
(1 + s
5
)
5
D
A
=
0.5M
0.5
(1 + s
0.5
)
0.5
+ 5M
5
(1 + s
5
)
5
V
A
Ensuring that V
A
= V
L
and D
A
= D
L
, we get:
M
0.5
(1 + s
0.5
)
0.5
+M
5
(1 + s
5
)
5
= 10.609
0.5M
0.5
(1 + s
0.5
)
0.5
+ 5M
5
(1 + s
5
)
5
= 24.134
These can be solved to obtain M
0.5
= 6.588 and M
5
= 5.516.
R code:
# Function to get discount factor (ie. ZCB price)
v = function(tau,lambda,alpha,beta) {
(1+s(tau,lambda,alpha,beta))^(-tau)
}
# Get value, duration, convexity of liabilities
xL = c(3,4,3,2)
tL = c(1,2,3,4)
xA = c(1,1)
tA = c(0.5,5)
VL = sum(xL*v(tL,lambda,alpha,beta))
DL = sum(tL*xL*v(tL,lambda,alpha,beta))/VL
CL = sum(tL*(tL+1)*xL*v(tL+2,lambda,alpha,beta))/VL
# Get strategy by solving linear system (equating V and D)
A = matrix(c(v(tA,lambda,alpha,beta),
tA*v(tA,lambda,alpha,beta)),2,2,byrow=TRUE)
M = solve(A) %*% c(VL,DL*VL)
(d) R code:
numsim = 1000
S = c() # initialise surplus
B = rnorm(numsim,-0.01,0.002)
# Get surplus
for(k in 1:numsim) {
S[k] = sum(M*xA*v(tA,lambda,alpha,B[k]))
- sum(xL*v(tL,lambda,alpha,B[k]))
}
# Plot histogram
hist(S,20,xlab="Surplus",main="Histogram of Surplus")
86
# Probability of loss
sum(S<0)/length(S) # should be close to 0.5
Histogram of Surplus
Surplus
F
r
e
q
u
e
n
c
y
0.02 0.01 0.00 0.01 0.02
0
5
0
1
0
0
1
5
0
As shown from the results and the graph, the portfolio is not fully immunised
as there is a chance we can make a loss.
At i = 4%, we have:
V
L
= 10.96
D
L
= 2.29
C
L
= 7.94
Letting P
1
be the price of the 0.75 year bond, and P
2
be the price of the 8 year
bond, we have (assuming annual coupons and $100 face value):
P
1
= 100.99
D
1
= 0.75
C
1
= 1.31
P
2
= 126.93
D
2
= 6.43
C
2
= 53.31
87
Let x
1
be the number of units of the 0.75 yr bond, and x
2
be the units of the 8 yr
bond. Therefore, we have:
V
A
= x
1
P
1
+x
2
P
2
D
A
=
x
1
P
1
D
1
+x
2
P
2
D
2
V
A
Ensuring that:
V
A
= V
L
D
A
= D
L
we obtain two simultaneous equations which can be solved to give x
1
= 7.905 and
x
2
= 2.345. These correspond to investing 7.983 and 2.977 in the two bonds respec-
tively.
A check of convexity shows that C
A
C
L
= 7.49 > 0, so the portfolio is immunised.
(a) At i = 6%, we have:
V
L
= 1.68
D
L
= 3
C
L
= 10.68
To form an immunised portfolio of bonds, it is clear that we need to use 2 or
more bonds with maturities on either side of 3 (as the portfolio duration would
be an average). Furthermore, to maximise the asset convexity (as immunisa-
tion suggests) we would wish to use the 1 year and 5 year bonds (Barbell
strategy). Using the 1 year and 5 year bonds, and solving using methods sim-
ilar to previous exercises, we obtain an investment strategy of $0.8396m into
both bonds (ie. face values of 0.8900 and 1.1236). The convexity of the assets
would be 14.240 > 10.680.
(b) Cashow matching involves nding assets that match the liability CF perfectly
without considering the costs. Since we have ZCBs available, we would simply
invest in a 3 year ZCB with a face value of $2m.
(c) If interest rates increase to 7%, then for the immunised portfolio:
V
A
V
L
= 0.8900v + 1.1236v
5
2v
3
= 0.0003
For the CF matching, we have:
V
A
V
L
= 2v
3
2v
3
= 0
Therefore, both methods have surpluses of approximately zero (exact for CF
matching).
(d) If interest rates twist, then the surplus of the immunised portfolio is:
0.8900
_
1
1.04
_
+ 1.1236
_
1
1.08
_
5
2
_
1
1.06
_
3
= 0.0588
The CF matching surplus is still exactly zero.
88
7.5 Module 5
Exercise 5.1 [der1]
The theoretical futures index is determined as follows (accumulated value of spot
index and storage costs):
f
t
= S
t
e
r(Tt)
d s
Tt
= 293.3e
0.07(210/365)
(0.035)(293.3) s
210/365 0.07
= 305.353447 (0.035)(293.3)(0.587085)
= 299.326724
This is close to the observed index of 299.0 (only 0.11% dierence).
Aside: The dierence between the actual and theoretical futures price is usually
quite small (less than 1%), except for major events (eg. 1987 nancial crisis). The
dierence (f
t
S
t
) is called the futures to cash spread or basis, whereas (f
t
S
t
)
is the theoretical basis.
Exercise 5.2 [der2]
The forward price will be the accumulated cost (purchase and funding) less coupons
received.
The price of the bond today is:
3.25a
16 i
+ 100v
16
i
= 97.214171
where i =
0.0696
2
= 0.0348 is the semi-annual eective rate.
This price (purchasing cost) is accumulated 2 years at the funding costs:
97.214171
_
_
1 +
0.065
12
_
12
_
1 +
0.07
12
_
12
_
= 111.223057
The accumulated value of coupons received at the funding costs is:
3.25s
2 i
1
(1 + i
2
)
2
+ 3.25s
2 i
2
= 13.700113
where i
1
=
_
1 +
0.065
12
_
6
1 and i
2
=
_
1 +
0.07
12
_
6
1 are the semi-annual eective
funding costs.
The forward price is therefore 111.223057 13.700113 = 97.522944
The forward yield is the yield on the (6-year) bond which is locked in by the purchase
of the forward contract:
97.522944 = 3.25a
12 j
+ 100v
12
j
which results in j = 3.50% per half-year, equivalent to an eective 7.013% p.a.
89
Exercise 5.3 [der3]
The current 90-day forward price implied by the market is (accumulated spot price
and costs):
f
90
= 420
_
1 + (0.0975)
90
365
_
+ (0.025) (420)
90
365
= 432.69
However, our short contract is for a forward price of $450, ie. we have an agreement
to sell gold for $450 in 90 days time. Thus, based on todays market conditions, we
should be able to make a prot of 450 432.69 = 17.31 in 90 days time. Today, this
prot is worth:
17.31
1 + (0.0975)
90
365
= $16.90
Exercise 5.4 [der4]
(Also see Example 6.9 in Sherris, p. 112) The forward price is the accumulated
costs less receipts (dividends). The cost of purchasing the shares now (including
transaction costs) is:
1.02 (10000 10) = 102000
This is accumulated to account for funding costs over the next 6 months:
102000
_
1 +
0.06
12
_
6
= 105098.506
The accumulated dividends are:
0.4 (10000)
_
1 +
0.06
12
_
3
= 4060.3005
Therefore the forward price is 105098.506 4060.3005 = $101038.21
Exercise 5.5 [der5]
The cost of carry formula is based on no-arbitrage arguments. If it is violated, for
example if F
t,T
> S
t
e
r(Tt)
de
r(Tt
1
)
, then one could short a forward, purchase the
asset with funds borrowed at the risk-free rate, invest the dividend at the risk-free
rate (at time t
1
), and exercise the forward contract at time T. This would lock in a
positive prot (at time T) with certainty at zero cost.
See lecture notes for further details. It may be helpful to draw a diagram.
Exercise 5.6 [der6]
For the 1st contract, the forward rate for days 90120 is 7.3%, whereas the 120-day
spot rate is 7.5%. Therefore, for no-arbitrage, we require a repo rate r given by:
_
1 +
30
365
r
__
1 +
90
365
0.073
_
=
_
1 +
120
365
0.074
_
r = 0.075639
However, the 30-day spot rate is 7.5% (< 7.5639%). Therefore, we could:
90
Action (t = 0) (t = 30) (t = 120)
Borrow $1m at 30-day spot (7.5%) 1,000,000 1,006,164 0
Short forward for $1,006,164 (7.3%) 0 1,006,164 1,024,275
Invest $999,948 in 120-day spot (7.4%) 999,948 0 1,024,275
Total 52 0 0
This results in a guaranteed prot of $52 at zero cost.
For the 2nd contract, the forward rate for days 90180 is 7.0%, whereas the 180-day
spot rate is 7.4%. Similarly, we have:
_
1 +
90
365
r
__
1 +
90
365
0.070
_
=
_
1 +
180
365
0.074
_
r = 0.076677
The 90-day spot rate is 7.4% (< 7.6677%). Therefore:
Action (t = 0) (t = 30) (t = 120)
Borrow $1m at 90-day spot (7.4%) 1,000,000 1,018,247 0
Short forward for $1,018,247 (7.0%) 0 1,018,247 1,035,822
Invest $999,352 in 180-day spot (7.4%) 999,352 0 1,035,822
Total 648 0 0
This results in a guaranteed prot of $648 at zero cost.
Exercise 5.7 [der7]
See details in Sherris Example 7.1 (p. 133)
Exercise 5.8 [der8]
Exercise 5.9 [der9]
Exercise 5.10 [der10]
Let the random future commodity price be S
t
i
. The swap provides for party A at
time t
i
:
S
t
i
X
The swap allows to get the dierence between the spot price at time t
i
and X
without actually exchanging the commodity. The swap price X is set such that the
initial value of the swap is 0.
To value the swap, consider what happens if party A enters into a series of short
forward positions (which cost nothing to enter in) to replicate the swap. In order to
91
settle the forward contract (buy the commodity and sell it to the long party at the
pre-specied price at the same time), the payo is
F
0,t
i
S
t
i
where F
0,t
i
represents the forward price set at time 0 (now) for settlement at time
t
i
. The initial value of this forward is 0. Hence for times t
1
, t
2
, . . . , t
M
the net eect
of the swap and forward must be equal to 0:
0 =
M
i=1
e
rt
i
[(S
t
i
X) + (F
0,t
i
S
t
i
)]
=
M
i=1
_
F
0,t
i
e
rt
i
Xe
rt
i
_
=
M
i=1
_
S
0
Xe
rt
i
_
= MS
0
X
M
i=1
e
rt
i
X =
MS
0
M
i=1
e
rt
i
(a) Let (h
C
, B
C
) be the units of stocks and bonds we hold in our portfolio to
replicate the payo of the call.
For the call option with exercise price 275, the payo function is :
C
1
=
_
max (285 275, 0) = 10 if stock price goes up
max (250 275, 0) = 0 if stock price goes down
Hence we want to nd a portfolio such that the value at time 1 is:
C
1
=
_
h
C
285 + B
C
e
0.05
= 10 if stock price goes up
h
C
250 + B
C
e
0.05
= 0 if stock price goes down
Solving these equations:
h
C
=
10
285 250
B
C
= e
0.05
(250)
_
10
285 250
_
Since this portfolio pays the same amount as the option at time 1 regardless of
the stock price, to have an arbitrage free market this portfolio must be worth
the same as the option at time 0. Hence:
C
0
= h
C
260 + B
C
= 6.34
92
(b) For the put option with exercise price 275, the payo function is
P
1
=
_
max (275 285, 0) = 0 if stock price goes up
Hence we want to nd a portfolio such that the value at time 1 is:
P
1
=
_
h
P
285 + B
P
e
0.05
h
P
250 + B
P
e
0.05
h
C
=
25
285 250
B
C
= e
0.05
(285)
_
25
285 250
_
Since this portfolio pays the same amount as the option at time 1 regardless of
the stock price, to have an arbitrage free market this portfolio must be worth
the same as the option at time 0. Hence:
P
0
= h
P
260 + B
P
= 7.93
(c) The put-call parity relationship states that (in words):
Call Value + Discounted Strike Price = Put value + Share Price
ie.
C
0
+Xe
rt
= P
0
+S
0
This is satised, since (for t = 1) :
C
0
+Xe
rt
= 6.34 + 275e
0.05
= 267.93
P
0
+S
0
= 7.93 + 260 = 267.93
For the call option with exercise price 50, the payo function is
C
1
=
_
max (55 50) = 5 if stock price goes up
Hence we want to nd a portfolio holding (h, B) units of the stock and bond, such
that the value at time 1 is:
C
1
=
_
h55 + B
_
1 + 0.05
1
12
_
h45 + B
_
1 + 0.05
1
12
_
h =
5
55 45
B =
(45)
_
1 + 0.05
1
12
_
_
5
55 45
_
Therefore:
C
0
= h50 + B = 2.59
93
The pricing is done by ensuring that there are no arbitrage properties, rather than
through any particular probability assessments (except to decide where the stock
can go to, eg. up to 55 or down to 45). In terms of pricing, there is no dierence
between a model where the stock price can go up to 55 with probability 99% and
a model where the stock price can go up to 55 with probability 2%. An important
observation is that these contracts are priced as a function of the current underlying
asset price, that is, they are relative prices. The probability of movements in the
asset price do impact the underlying asset price but once this is known, these other
contracts are determined by no-arbitrage based on the current underlying asset price.
This option (which is no longer a simple call or put option) pays:
X
1
=
_
max (285
2
265
2
, 0) = 11000 if stock price goes up
max (250
2
265
2
, 0) = 0 if stock price goes down
Hence we want to nd a portfolio holding (h, B) units of the stock and bond such
that the value at time 1 is:
X
1
=
_
h285 + Be
0.04
h250 + Be
0.04
h =
11000
285 250
B = e
0.04
(250)
_
11000
285 250
_
Since this portfolio pays the same amount as the option at time 1, to have an
arbitrage free market this portfolio must be worth the same as the option at time
0. Hence:
X
0
= h260 + B = 6223.81
Put call parity does not hold since:
C
0
+
K
1 + i
= 1.2245 +
22
1.05
= 22.1769
P
0
+S
0
= 20 + 2.5 = 22.5
Therefore we want to buy the LHS (call and bond of face value 22 and maturity 1)
and short the RHS (put and share). The cost of this transaction today is:
22.1769 22.5 < 0
This is a prot, since it is a negative cost.
At time 1, the cash ows of the put, stock, call and bond will all cancel out.
94
The stock is assumed to either go up to s
u
or down to s
d
. The bond starts o as 1
and rises to e
rt
at time t, where r is the risk free rate.
Suppose we want to price this derivative that pays x
u
or x
d
. For a call option, we
have:
x
u
= (s
u
K)
+
x
d
= (s
d
K)
+
Consider a portfolio that holds stocks and bonds. The value of this portfolio
today is:
V (0) = s
0
+ 1
The value of this portfolio at time T is:
(s
u
+D) + e
rT
if the stock goes up
(s
d
+D) + e
rT
if the stock goes down
Therefore, we need and such that the payos are identical (so that this portfolio
will have the same value as our derivative):
(s
u
+D) + e
rT
= x
u
(s
d
+ D) + e
rT
= x
d
=
x
u
x
d
s
u
s
d
= e
rT
_
x
u
_
x
u
x
d
s
u
s
d
_
(s
u
+D)
_
The value of the portfolio with these and will be the same as the value of our
derivative.
Consider two investment portfolios:
Portfolio A: one call plus cash of (K c) e
rT
Portfolio B: one put plus one unit of gold
The value of portfolio A at expiry is given by:
_
G
T
K +K c = G
T
c if G
T
> K (i.e. option is exercised)
0 + K c = K c if G
T
K (i.e. option is worthless)
The value of portfolio B at expiry is given by:
_
0 + G
T
c = G
T
c if G
T
> K (i.e. option is exercised)
K G
T
+G
T
c = K c if G
T
K (i.e. option is worthless)
95
Therefore, both portfolios have a payo at expiry of:
max {K, G
T
} c
Because the two portfolios have equal payo at expiry and the options cannot be
exercised before expiry, the portfolios must also have equal value for any time t < T.
In particular, at issue (t = 0), we must have:
c
0
+ (K c)e
rT
= p
0
+S
0
or:
c
0
+Ke
rT
= p
0
+ S
0
+ce
rT
7.6 Module 6
Exercise 6.1 [sto1]
(a) The mean accumulation is:
E(1000S
10
) = 1000E [(1 + i
1
) . . . (1 + i
10
)]
= 1000E(1 + i
1
) . . . E(1 + i
10
) (by independence)
= 1000 [E(1 + i)]
10
(identically distributed)
= 1000(1.06)
10
= 1790.85
(b) The variance of the accumulation is:
Var(1000S
10
) = 1000
2
_
E
_
S
2
10
_
[E (S
10
)]
2
where:
E
_
S
2
10
_
= E
_
(1 + i
1
)
2
. . . (1 + i
10
)
2
= E
_
(1 + i)
2
10
=
_
0.4(1.04)
2
+ 0.2(1.06)
2
+ 0.4(1.08)
2
10
= 1.12392
10
Therefore:
Var(1000S
10
) = 9145.60
and:
(1000S
10
) = 95.63
(c) (i) The mean accumulation depends only on the mean interest rate, which
is not changed. However, the variance of the accumulation will be lower,
as the variance in interest rates is lower.
(ii) The mean will be larger as we are accumulating over a longer period. The
standard deviation will also be larger, as investing in a longer term will
result in a greater spread of possible accumulated amounts.
96
Exercise 6.2 [sto2]
E(S
n
) = E [(1 + i
1
) (1 + i
n
)]
= E(1 + i
1
) E(1 + i
n
) (by independence)
= [E(1 + i)]
n
= (1 +j)
n
The variance of the accumulation is:
Var(S
n
) = E
_
S
2
n
_
[E (S
n
)]
2
where:
E
_
S
2
n
_
= E
_
(1 + i
1
)
2
(1 + i
n
)
2
=
_
E
_
(1 + i)
2
_
n
=
_
E
_
1 + 2i +i
2
_
n
=
_
1 + 2j +j
2
+s
2
_
n
noting that E(X
2
) = Var(X) + [E(X)]
2
for a random variable X. Therefore:
Var(S
n
) =
_
1 + 2j +j
2
+ s
2
_
n
(1 + j)
2n
(b) E(S
8
) = 1.59385
(c) (S
8
) =
2.65844 2.54035 = 0.34364

Exercise 6.3 [sto3]
E(10000S
2
) = 10000E [(1 + i
1
)(1 + i
2
)]
= 10000E [1 + i] E [1 + i
2
] (iid)
= 10000
_
1
3
1.03 +
1
3
1.04 +
1
3
1.06
_
(0.7 1.05 + 0.3 1.04)
= 10923.70
(b) The variance of the accumulation is:
Var(10000S
2
) = 10000
2
_
E
_
S
2
2
_
[E (S
2
)]
2
where:
E
_
S
2
2
_
= E
_
(1 + i
1
)
2
(1 + i
2
)
2
= E
_
(1 + i
1
)
2
E
_
(1 + i
2
)
2
=
_
1
3
1.03
2
+
1
3
1.04
2
+
1
3
1.06
2
_
_
0.7 1.05
2
+ 0.3 1.04
2
_
= 1.193465
Therefore:
Var(10000S
2
) = 19278
97
Exercise 6.4 [sto4]
(a) The mean and variance are:
E(i) =
i
1
+i
2
2
Var(i) = E(i
2
) [E(i)]
2
=
1
2
(i
2
1
+ i
2
2
)
1
4
(i
1
+ i
2
)
2
=
1
4
(i
1
i
2
)
2
(b) The mean and variance of the accumulated value can be determined using the
formulae in Exercise 6.2:
E (S
n
) = (1 +j)
n
Var(S
n
) =
_
1 + 2j + j
2
+ s
2
_
n
(1 + j)
2n
Therefore:
5.5 = (1 +j)
25
j = 0.0705686
0.5
2
=
_
1 + 2j + j
2
+s
2
_
25
(1 + j)
50
s
2
= 0.000377389
Solving for i
1
and i
2
:
i
1
+i
2
2
= j = 0.0705686
i
1
+ i
2
= 0.1411372
1
4
(i
1
i
2
)
2
= s
2
= 0.000377389
i
1
i
2
= 0.0388530
Therefore, we obtain i
1
= 0.089995 and i
2
= 0.051142.
Exercise 6.5 [sto5]
(a) The single premium X is given by:
X [1 + E(i)]
10
= 10000
X [0.3(1.07) + 0.5(1.08) + 0.2(1.10)]
10
= 10000
X = 4589.26
(b) Expected prot is:
E() = E
_
X(1 + i)
10
10000
= X
_
0.3(1.07)
10
+ 0.5(1.08)
10
+ 0.2(1.10)
10
_
10000
= 42.94
98
Exercise 6.6 [sto6]
(a) The mean of accumulated premiums is:
E(P) = 425000(1.03)
5
+ 425000E [(1 + i
1
) (1 + i
5
)]
= 425000(1.03)
5
+ 425000 [E(1 + i)]
5
(since 1 + i
t
iid)
= 425000(1.03)
5
+ 425000(1.035)
5
= 997458
The standard deviation is found as follows:
Var(P) = Var
_
425000(1.03)
5
+ 425000
5
k=1
(1 + i
k
)
_
= 425000
2
Var
_
5
k=1
(1 + i
k
)
_
= 425000
2
E
_
5
k=1
(1 + i
k
)
2
_
425000
2
(1.035)
10
E
_
5
k=1
(1 + i
k
)
2
_
=
_
E
_
(1 + i)
2
_
5
=
_
E
_
1 + 2i + i
2
_
5
=
_
1 + 2E(i) + [E(i)]
2
+ Var(i)
5
=
_
1 + 2(0.035) + (0.035)
2
+ (0.03)
2
_
5
= 1.416534
(P) =
_
Var(P) = 32743.21
(b) Investing all premiums in the risky assets is likely to be more risky because
although there may be a higher probability of the assets accumulating to more
than $1 million, the standard deviation would be twice as high so the proba-
bility of a large loss would also be greater.
Exercise 6.7 [sto7]
E(1000S
10
) = 1000E [(1 + i
1
) (1 + i
10
)]
= 1000E(1 + i
1
) E(1 + i
10
) (by independence)
= 1000 [E(1 + i)]
10
= 1000(1.07)
10
= 1967.15
The variance of the accumulation is:
Var(1000S
10
) = 1000
2
_
E
_
S
2
10
_
[E (S
10
)]
2
99
where:
E
_
S
2
10
_
= E
_
(1 + i
1
)
2
(1 + i
10
)
2
= E
_
(1 + i)
2
10
=
_
1 + 2E(i) + [E(i)]
2
+ Var(i)
10
=
_
1 + 2(0.07) + (0.07)
2
+ (0.09)
2
10
= 1.1153
10
Therefore, we have:
(1000S
10
) =
_
Var(1000S
10
) = 531.65
(b) We want to nd Pr (1000S
10
< 0.5(1967.15)). The distribution of the accumu-
lation term S
10
=
10
k=1
(1 + i
k
) is determined as follows:
(1 + i
k
) LN(,
2
)
ln(1 + i
k
) N(,
2
)
10
k=1
ln(1 + i
k
) N(10, 10
2
)
exp
_
10
k=1
ln(1 + i
k
)
_
=
10
k=1
(1 + i
k
) LN(10, 10
2
)
where:
E(1 + i) = 1.07 = e
+
1
2
2
Var(1 + i) = 0.09
2
= e
2+
2
_
e
2
1
_
0.09
2
= (1.07)
2
_
e
2
1
_

2
= 0.007050
= ln 1.07
1
2
(0.007050) = 0.064134
Therefore:
Pr (1000S
10
< 0.5(1967.15)) = Pr (S
10
< 0.983575)
= Pr
_
Z <
ln 0.983575 10
10
_
where Z N(0, 1)
= Pr (Z < 2.4778)
= 0.00661
100
(c) The probability required is:
Pr (1200S
10
< 1400) = Pr
_
S
10
<
7
6
_
= Pr
_
Z <
ln
7
6
10
10
_
= Pr (Z < 1.8349)
= 0.03326
Exercise 6.8 [sto8]
E(S
10
) = E [(1 + i
1
) (1 + i
10
)]
= E(1 + i
1
) E(1 + i
10
) (by independence)
= [E(1 + i)]
10
= (1.06)
10
Therefore:
E (2, 000, 000 S
10
) = 2, 000, 000 (1.06)
10
= 3, 581, 695
(b) The distribution of S
10
is lognormal:
(1 + i
k
) LN(,
2
)
ln(1 + i
k
) N(,
2
)
10
k=1
ln(1 + i
k
) N(10, 10
2
)
S
10
=
10
k=1
(1 + i
k
) = exp
_
10
k=1
ln(1 + i
k
)
_
LN(10, 10
2
)
where:
E(1 + i) = 1.06 = e
+
1
2
2
Var(1 + i) = 0.08
2
= e
2+
2
_
e
2
1
_
0.08
2
= (1.06)
2
_
e
2
1
_

2
= 0.0056798
= ln 1.06
1
2
(0.0056798) = 0.055429
101
Therefore, the required probability is:
Pr (S
10
< 0.8 E(S
10
)) = Pr
_
S
10
< 0.8(1.06)
10
_
= Pr (S
10
< 1.4327)
= Pr
_
Z <
ln 1.4327 10
10
_
= Pr (Z < 0.8171)
= 0.207
Exercise 6.9 [sto9]
We have (1 + i) LN(, ), where:
E(1 + i) = e
+
1
2
2
= 1.001
Var(1 + i) = e
2+
2
_
e
2
1
_
= 0.002
2
These can be solved simultaneously to obtain and
2
:
Var(1 + i) =
_
e
+
1
2
2
_
2
_
e
2
1
_
0.002
2
= (1.001)
2
_
e
2
1
_

2
= 0.000003992
= ln 1.001
1
2
(0.000003992) = 0.0009975
Therefore, we can nd j as follows:
0.05 = Pr(i < j)
= Pr(1 +i < 1 + j)
= Pr(ln(1 +i) < ln(1 + j))
= Pr
_
Z <
ln(1 + j)
ln(1 + j)
= 1.645
ln(1 + j) = 0.00228921
j = e
0.00228921
1 = 0.2287%
Exercise 6.10 [sto10]
Note: This question is similar to Exercise 6.8.
E(S
10
) = E [(1 + i
1
) (1 + i
10
)]
= E[1 + i
1
] E[1 + i
10
] (by independence)
= [E(1 + i)]
10
= (1.06)
10
102
Therefore:
E (1, 000, 000 S
10
) = 1, 000, 000 (1.06)
10
= 1, 790, 848
(b) The distribution of S
10
is lognormal:
(1 + i
k
) LN(,
2
)
ln(1 + i
k
) N(,
2
)
10
k=1
ln(1 + i
k
) N(10, 10
2
)
S
10
=
10
k=1
(1 + i
k
) = exp
_
10
k=1
ln(1 + i
k
)
_
LN(10, 10
2
)
where:
E(1 + i) = 1.06 = e
+
1
2
2
Var(1 + i) = 0.08
2
= e
2+
2
_
e
2
1
_
0.08
2
= (1.06)
2
_
e
2
1
_

2
= 0.0056798
= ln 1.06
1
2
(0.0056798) = 0.055429
Therefore, the required probability is:
Pr (S
10
< 0.9 E(S
10
)) = Pr
_
S
10
< 0.9(1.06)
10
_
= Pr (S
10
< 1.61172)
= Pr
_
Z <
ln 1.61172 10
10
_
= Pr (Z < 0.32304)
= 0.373
(a) The accumulated value based on a principal of $1 is:
S
10
= (0.05 i
1
)(1 + i
2
) (1 + i
10
) + + (0.05 i
10
)
The mean of S
10
is:
E(S
10
) = E[(0.05 i
1
)(1 + i
2
) (1 + i
10
) + + (0.05 i
10
)]
= E[0.05 i
1
]E[1 + i
2
] E[1 + i
10
] + +E[0.05 i
10
]
(by independence)
= 0.01(1.04)
9
+ 0.01(1.04)
8
+ + 0.01(1.04) + 0.01
= 0.01s
10 0.04
= 0.120061
103
(b) The distribution of the interest rate in each year is:
1 + i LN(,
2
)
where:
E(1 + i) = 1.04 = e
+
1
2
2
=Var(1 + i) = 0.02
2
= e
2+
2
_
e
2
1
_
=0.02
2
= (1.04)
2
_
e
2
1
_
=
2
= ln
_
1 +
0.02
2
1.04
2
_
= = ln 1.04
1
2
2
R code:
n = 10
numsim = 1000
sigma = sqrt(log(1+0.02^2/1.04^2))
mu = log(1.04)-0.5*sigma^2
X = rnorm(numsim*n, mu, sigma) # simulate normal RVs
i = matrix(exp(X)-1,numsim,n) # interest rates
S = c()
temp = c()
for(j in 1:(n-1)) {
# each of the n annual payments
temp[j] = (0.05-i[k,j]) * prod(1+i[k,(j+1):n])
}
S[k] = sum(temp) + (0.05-i[k,n]) # accumulated value
}
mean(S)
var(S)
plot(density(S,adjust=1.5), main="Simulated Density of S",
xlab="S")
104
0.2 0.1 0.0 0.1 0.2 0.3 0.4
0
1
2
3
4
5
Simulated Density of S
S
D
e
n
s
i
t
y
(c) A company who has an exposure to a oating rate may want to hedge this
interest rate risk by using a xed-for-oating swap. For example, if the com-
pany has a liability to repay a loan at a oating rate, they could enter into a
swap to pay a xed rate and receive a oating rate. The payment and receipt
of the oating rate will net to zero, allowing the company to pay a net rate
which is xed.
(a) The mean is:
E(S
1
) = E(1 + y
1
)
= E(1 + +(y
0
))
= 1.05 + 0.4(y
0
0.05)
Therefore E(S
1
) = 1.046 and E(S
1
) = 1.054 for y
0
= 0.04 and y
0
= 0.06
respectively.
(b) The variance is:
Var(S
1
) = Var(1 + y
1
)
= Var(1 + +(y
0
) +
1
)
=
2
= 0.01
2
105
(c) The probability is:
Pr(S
1
< 1.04) = Pr(1 +y
1
< 1.04)
= Pr( +(y
0
) +
1
< 0.04)
= Pr
_
1
<
0.01 0.4(y
0
0.05)
0.01
_
where
1
N(0, 1)
Therefore Pr(S
1
< 1.04) = 0.3332 and Pr(S
1
< 1.04) = 0.1497 for y
0
= 0.04
and y
0
= 0.06 respectively.
R code:
mu = 0.05
beta = 0.4
sigma = 0.01
n = 10
y0 = 0.04 # also y0 = 0.06
numsim = 1000
y = matrix(0,numsim,n) # initialise matrix of interest rates
S = rep(0,numsim) # initialise vector of accumulated values
# mean reverting model
y[,1] = mu + beta*(y0-mu) + sigma*rnorm(numsim)
for(t in 2:n) {
y[,t] = mu + beta*(y[,t-1]-mu) + sigma*rnorm(numsim)
}
# accumulated value
S[k] = prod(1+y[k,])
}
mean(S)
var(S)
sum(S<1.55)/length(S)
hist(S)
106
Histogram of S (4%)
S
F
r
e
q
u
e
n
c
y
1.4 1.5 1.6 1.7 1.8 1.9
0
5
0
1
0
0
1
5
0
2
0
0
2
5
0
Histogram of S (6%)
S
F
r
e
q
u
e
n
c
y
1.4 1.5 1.6 1.7 1.8 1.9
0
5
0
1
0
0
1
5
0
2
0
0
2
5
0
107
(a) Denoting the mean and standard deviation of i
t
as j and s respectively (ie.
j = 0.04 and s = 0.02), the formulae can be derived as in the lecture notes:
s
n
= (1 +y
1
) (1 + y
n
) + (1 +y
2
) (1 + y
n
) + + (1 + y
n
)
= (1 +y
n
) [(1 +y
1
) (1 + y
n1
) + + (1 + y
n1
) + 1]
= (1 +y
n
)( s
n1
+ 1)
E( s
n1
) = E[(1 + y
n
)( s
n
+ 1)]
= E(1 + y
n
)E( s
n1
+ 1) by independence
= (1 +j)[E( s
n1
) + 1]
E
_
s
2
n
_
= E
_
(1 + y
n
)
2
( s
n1
+ 1)
2
= E
_
(1 + y
n
)
2
E
_
( s
n1
+ 1)
2
by independence
= E
_
1 + 2y
n
+ y
2
n
_
E
_
s
2
n1
+ 2s
n1
+ 1
_
=
_
1 + 2j +j
2
+s
2
_ _
E
_
s
2
n1
_
+ 2E (s
n1
) + 1
The variance can then be determined using:

Var ( s
n1
) = E
_
s
2
n1
_
[E ( s
n1
)]
2
(b) R code:
n = 30
j = 0.04
s = 0.02
Es = c()
Es2 = c()
Es[1] = (1+j)
Es2[1] = (1+2*j+j^2+s^2)
# Recursive relationships
for(k in 2:n) {
Es[k] = (1+j)*(Es[k-1]+1)
Es2[k] = (1+2*j+j^2+s^2)*(Es2[k-1]+2*Es[k-1]+1)
}
# Display mean and variance
Es[n]
Es2[n] - Es[n]^2
(c) The distribution of the interest rate in each year is:
1 + i LN(,
2
)
108
where:
E(1 + i) = 1.04 = e
+
1
2
2
=Var(1 + i) = 0.02
2
= e
2+
2
_
e
2
1
_
=0.02
2
= (1.04)
2
_
e
2
1
_
=
2
= ln
_
1 +
0.02
2
1.04
2
_
= = ln 1.04
1
2
2
R code (contd):
numsim = 10000
sigma = sqrt(log(1+0.02^2/1.04^2))
mu = log(1.04)-0.5*sigma^2
s30 = c()
# Simulate lognormal interest rates (iid)
X = rnorm(n*numsim,mu,sigma)
R = matrix(exp(X),numsim,n)
# Find s30, calculate mean and variance
s30[k] = sum(cumprod(R[k,]))
}
print(mean(s30))
print(var(s30))
plot(density(s30,adjust=1.5),xlab="s30",
main="Simulated Density of Annuity")
print(summary(s30))
109
45 50 55 60 65 70 75
0
.
0
0
0
.
0
2
0
.
0
4
0
.
0
6
0
.
0
8
Simulated Density of Annuity
s30
D
e
n
s
i
t
y
110

Financial Mathematics Exercises Actuarial Studies UNSW

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Australian School of Business

School of Actuarial Studies

when given the parameters

Noting that we require an equation in terms of a

2.65844 2.54035 = 0.34364

The variance can then be determined using:

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