Professional Documents
Culture Documents
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
(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 3.4: [loaB3] Exercise 3.1.7 from Broverman 4th Ed (3.1.2 in 3rd Ed).
Exercise 3.5: [loaB4] Exercise 3.1.8 from Broverman 4th Ed (3.1.3 in 3rd Ed).
Exercise 3.6: [loaB5] Exercise 3.1.11 from Broverman 4th Ed (3.1.11 in 3rd Ed).
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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 3.15: [loaB6] Exercise 4.3.4 from Broverman 4th Ed (4.3.7 in 3rd Ed).
Exercise 3.16: [loaB7] Exercise 4.3.1 from Broverman 4th Ed (4.3.5 in 3rd Ed).
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
(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
Financial Mathematics Exercises Actuarial Studies UNSW
(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
Financial Mathematics Exercises Actuarial Studies UNSW
(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
_
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)
Exercise 1.13 [int15]
(SOA Course 2 Nov 2000, Question 2)
For the rst investment (the $100 at beginning of 1990), the interest credited in
1993 is 8% of the accumulated value at the beginning of 1993 (ie. after 3 years):
100(1.10)(1.10)(1 + 0.01x)(0.08) = 9.68 + 0.0968x
Similarly, for the second investment, the interest credited is:
100(1.12)(1.05)(0.10) = 11.76
and for the third investment:
100(1.08)(0.01(x 2)) = 1.08x 2.16
Therefore, the total interest credited in 1993 is:
19.28 + 1.1768x = 28.40
x = 7.7498
34
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 1.14 [int19]
Using v =
1
1+r
, we have the following present values for the two payment options:
PV
A
= 610 + 475v + 340v
2
PV
B
= 560 + 580v + 274v
2
Option A is preferred when PV
B
PV
A
= 50 + 105v 66v
2
> 0. Note that the
quadratic 50 + 105v 66v
2
= 0 has no real roots. The quadratic is negative at
v = 1, since 50 +105 66 = 11 < 0. This implies that PV
B
< PV
A
for all values
of r, so Option B is always preferred to A.
Exercise 1.15 [int18]
(a) The equation of value for each of the alternative is given as follows with the
corresponding yield (rate of interest) r:
Alternative A:
1000(1 + r)
3
= 1330
r = 9.9724%
Alternative B:
1000(1 + r)
5
= 1550
r = 9.1607%
Alternative C:
1000(1 + r)
5
= 425
_
1 +
1
1 + r
+
_
1
1 + r
_
2
+
_
1
1 + r
_
3
_
r = 8.5761%
Note: for C, the yield must be found numerically (eg. using uniroot in R)
R Code:
f = function(v) {
1000*(1/v)^5 - 425*(1+v+v^2+v^3)
}
v = uniroot(f,c(0,1)) # solve f = 0
v = v$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
Financial Mathematics Exercises Actuarial Studies UNSW
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.
Exercise 1.16 [int20]
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.
Exercise 1.17 [int6]
d = 1 v = 0.06
v =
1
1+i
i =
1
v
1 = 0.06383
Also: i = d/v = 0.06383
Exercise 1.18 [int14]
(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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 1.19 [int24]
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.
Exercise 1.20 [int25]
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
Exercise 1.21 [int21]
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
Financial Mathematics Exercises Actuarial Studies UNSW
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)
Exercise 1.22 [int22]
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
Exercise 1.23 [int23]
We have
a(t) =
_
1 + 0.1t t k
(1 + 0.1k) exp [0.08(t k)] t > k
38
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Exercise 1.26 [ann2]
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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 1.27 [ann3]
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.
Exercise 1.35 [ann4]
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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 1.36 [ann5]
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
Exercise 1.37 [ann6]
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
Exercise 1.38 [ann7]
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.
Exercise 1.41 [ann13]
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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 1.42 [ann8]
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.
Exercise 1.43 [ann9]
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
Exercise 1.44 [ann12]
The annual eective rate i is given by:
1 + i = 1.025
4
i = 0.103813
44
Financial Mathematics Exercises Actuarial Studies UNSW
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
Exercise 1.45 [new8]
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)
Exercise 1.46 [ann14]
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 1.47 [ann15]
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
Exercise 1.48 [new4]
(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
Financial Mathematics Exercises Actuarial Studies UNSW
(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.
Exercise 1.49 [new1]
(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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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.
Exercise 1.58 [new2]
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
Exercise 1.59 [ann11]
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
=
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
# 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]
}
# Create and display loan schedule
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
# Initialise vectors (and first year)
I = OB96*i
PR = X-I[1]
OB = OB96-PR[1]
# Recursive relations
for(t in 2:4) { # 2,3,4 corresponding to 98,99,100
I[t] = OB[t-1]*i
PR[t] = X-I[t]
OB[t] = OB[t-1]-PR[t]
61
Financial Mathematics Exercises Actuarial Studies UNSW
}
# Create and display loan schedule
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
# Initialise vectors (and first year)
I = OB0*i
PR = Y[1]-I[1]
OB = OB0-PR[1]
# Recursive relations
for(t in 2:36) {
I[t] = OB[t-1]*i
PR[t] = Y[t]-I[t]
OB[t] = OB[t-1]-PR[t]
}
# Create and display loan schedule
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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 3.11 [loa4]
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.
Exercise 3.12 [loa9]
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
Financial Mathematics Exercises Actuarial Studies UNSW
The spreadsheet model can be found in loa9.xls. The solution is (a) $439,608.30 and
(b) $538,334.94.
Note that each component of the price can be expressed as follows (where i = 0.06):
t
v
t
APR
t
= 25000(1.05)v
10
a
10
t
v
t
(I
t
IT
t
) = (1
I
) (0.08)
t
v
t
OB
t
1
4
t
v
t
CGT
t
= 0.3
_
25000(1.05)
25000
500000
P
_
+
v
10
a
10
where:
t
v
t
OB
t
1
4
= 500000a
(4)
10
+ 475000v
10
a
(4)
1
+. . . + 25000v
28
a
(4)
1
= 500000a
(4)
10
+ 25000v
10
a
(4)
1
(Da)
(4)
19
The modelling can be performed in R using the following code:
# Initialise values
L = 500000
j = 0.06
v = 1/(1+j)
Time = seq(0,29,by=0.25)
n = length(Time)
taxI = 0.4 # also taxI = 0.2
taxCG = 0.3
# Simple function to convert from time(s) to index
ind = function(x) {
ind = c()
for(y in x) {ind = c(ind,which(Time==y))}
ind
}
# Setup values for interest rates and principal repaid
i = 0.02
R = 1.05
NPR = rep(0,n)
NPR[ind(10:29)] = L/20
APR = NPR*R
# Squared difference between price and PV(cash flows)
# (as a function of the price P)
# Aim is to minimise this function (set to 0)
# Note: "<<-" is used to make sure the values remain assigned even
66
Financial Mathematics Exercises Actuarial Studies UNSW
# after the function has ended
temp = function(P) {
# Initialise vectors (t = 0)
OB <<- L
I <<- 0
# Recursive relations
for(t in 2:n) { # t = 0.25, ..., 29
I[t] <<- OB[t-1]*i
OB[t] <<- OB[t-1]-NPR[t]
}
# Tax
IT <<- taxI * I
CGT <<- taxCG * (APR - NPR/L * P)
CGT <<- pmax(CGT,0)
# Cash flows and present value (at reqd yield)
CF <<- I+APR-IT-CGT
PVCF <<- CF*v^Time
# Squared difference (to ensure non-negative)
(P - sum(PVCF))^2
}
# Minimise by changing P over sufficiently large range (0,2L)
opt = optimize(temp,c(0,2*L))
P = opt$minimum # get P corresponding to minimum
print(round(P,2),digits=20)
# Create and display loan schedule
sched = data.frame(NPR,APR,I,OB,IT,CGT,CF,PVCF)
round(sched,2)
Exercise 3.13 [new13]
(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
Financial Mathematics Exercises Actuarial Studies UNSW
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%.
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Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 3.14 [loa10]
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
Financial Mathematics Exercises Actuarial Studies UNSW
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.
Exercise 3.17 [loa11]
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Exercise 3.18 [ann16]
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
Exercise 3.19 [loa12]
Using a spreadsheet model similar to Exercise 3.12, we obtain a price of $516,099.04.
The spreadsheet is provided in loa12.xls.
R code:
# Initialise values
L = 500000
j = 0.07
v = 1/(1+j)
Time = seq(0,19,by=0.25)
n = length(Time)
taxI = 0.15
taxCG = 0.15
# Simple function to convert from time(s) to index
ind = function(x) {
ind = c()
for(y in x) {ind = c(ind,which(Time==y))}
ind
}
# Setup values for interest rates and principal repaid
71
Financial Mathematics Exercises Actuarial Studies UNSW
i = 0.02
R = 1.1
NPR = rep(0,n)
NPR[ind(10:19)] = L/10
APR = NPR*R
# Squared difference between price and PV(cash flows)
# (as a function of the price P)
# Aim is to minimise this function (set to 0)
# Note: "<<-" is used to make sure the values remain assigned even
# after the function has ended
temp = function(P) {
# Initialise vectors (t = 0)
OB <<- L
I <<- 0
# Recursive relations
for(t in 2:n) { # t = 0.25, ..., 19
I[t] <<- OB[t-1]*i
OB[t] <<- OB[t-1]-NPR[t]
}
# Tax
IT <<- taxI * I
CGT <<- taxCG * (APR - NPR/L * P)
CGT <<- pmax(CGT,0)
# Cash flows and present value (at reqd yield)
CF <<- I+APR-IT-CGT
PVCF <<- CF*v^Time
# Squared difference (to ensure non-negative)
(P - sum(PVCF))^2
}
# Minimise by changing P over sufficiently large range (0,2L)
opt = optimize(temp,c(0,2*L))
P = opt$minimum # get P corresponding to minimum
print(round(P,2),digits=20)
# Create and display loan schedule
sched = data.frame(NPR,APR,I,OB,IT,CGT,CF,PVCF)
round(sched,2)
72
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 3.20 [loa13]
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)
# 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 = 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)
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Financial Mathematics Exercises Actuarial Studies UNSW
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
# Initialise vectors (t = 0)
OB = sum(NPR)
I = 0
# Recursive relations
for(t in 2:n) { # t = 0.5, ..., 30
I[t] = OB[t-1]*i[t]
OB[t] = OB[t-1]-NPR[t]
}
# Cash flows and present value (at reqd yield)
CF = I+APR
PVCF = CF*v^Time
# Create and display loan schedule
sched = data.frame(Time,NPR,APR,i,I,OB,CF,PVCF)
round(sched,2)
# Calculate price
P = sum(PVCF)
print(round(P,2),digits=20)
Exercise 3.21 [loa14]
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
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Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
(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
Financial Mathematics Exercises Actuarial Studies UNSW
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
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Financial Mathematics Exercises Actuarial Studies UNSW
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
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Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
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.
Exercise 4.8 [new11]
(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
Financial Mathematics Exercises Actuarial Studies UNSW
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
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Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 4.11 [irr9]
See Sherris p. 87.
Exercise 4.12 [irr10]
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
Financial Mathematics Exercises Actuarial Studies UNSW
# 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)
i = function(t) 0.045
s(i)
i = function(t) 0.065
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.
Exercise 4.13 [new12]
(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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
# 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.
Exercise 4.14 [irr11]
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
Financial Mathematics Exercises Actuarial Studies UNSW
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.
Exercise 4.15 [irr12]
(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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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]
See details in Sherris Example 7.4 (p. 138)
Exercise 5.9 [der9]
See details in Sherris Example 7.10 (p. 149)
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Exercise 5.11 [der11]
(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
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Financial Mathematics Exercises Actuarial Studies UNSW
(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
max (275 250, 0) = 25 if stock price goes down
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
= 0 if stock price goes up
h
P
250 + B
P
e
0.05
= 25 if stock price goes down
Solving these equations:
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
Exercise 5.12 [der12]
For the call option with exercise price 50, the payo function is
C
1
=
_
max (55 50) = 5 if stock price goes up
max (45 50, 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:
C
1
=
_
h55 + B
_
1 + 0.05
1
12
_
= 5 if stock price goes up
h45 + B
_
1 + 0.05
1
12
_
= 0 if stock price goes down
Solving these equations:
h =
5
55 45
B =
(45)
_
1 + 0.05
1
12
_
_
5
55 45
_
Therefore:
C
0
= h50 + B = 2.59
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Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 5.13 [der13]
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.
Exercise 5.14 [der14]
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
= 11000 if stock price goes up
h250 + Be
0.04
= 0 if stock price goes down
Solving these equations:
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
Exercise 5.15 [der15]
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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 5.16 [der16]
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
Solving these equations:
=
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.
Exercise 5.17 [der17]
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)
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Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 6.2 [sto2]
(a) The mean accumulation is:
E(S
n
) = E [(1 + i
1
) (1 + i
n
)]
= E(1 + i
1
) E(1 + i
n
) (by independence)
= [E(1 + i)]
n
(identically distributed)
= (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
) =
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
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
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]
(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(1.07)
10
= 1967.15
The variance of the accumulation is:
Var(1000S
10
) = 1000
2
_
E
_
S
2
10
_
[E (S
10
)]
2
99
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
(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]
(a) The mean accumulation is:
E(S
10
) = E [(1 + i
1
) (1 + i
10
)]
= E(1 + i
1
) E(1 + i
10
) (by independence)
= [E(1 + i)]
10
(identically distributed)
= (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
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Financial Mathematics Exercises Actuarial Studies UNSW
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.
(a) The mean accumulation is:
E(S
10
) = E [(1 + i
1
) (1 + i
10
)]
= E[1 + i
1
] E[1 + i
10
] (by independence)
= [E(1 + i)]
10
(identically distributed)
= (1.06)
10
102
Financial Mathematics Exercises Actuarial Studies UNSW
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
Exercise 6.11 [new3]
(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
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Financial Mathematics Exercises Actuarial Studies UNSW
(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()
for(k in 1:numsim) {
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
Financial Mathematics Exercises Actuarial Studies UNSW
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.
Exercise 6.12 [new5]
(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
Financial Mathematics Exercises Actuarial Studies UNSW
(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.
Exercise 6.13 [new6]
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
for(k in 1:numsim) {
S[k] = prod(1+y[k,])
}
mean(S)
var(S)
sum(S<1.55)/length(S)
hist(S)
106
Financial Mathematics Exercises Actuarial Studies UNSW
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
Financial Mathematics Exercises Actuarial Studies UNSW
Exercise 6.14 [new9]
(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
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
for(k in 1:numsim) {
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
Financial Mathematics Exercises Actuarial Studies UNSW
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