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9711456 Financial Mathematics

9711456 Financial Mathematics

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FINANCIALMATHEMATICSA Practical Guide for Actuariesand other Business Professionals
Second EditionCHRIS RUCKMAN, FSA, MAAAJOE FRANCIS, FSA, MAAA, CFA
Study Notes Prepared byKevin Shand, FSA, FCIAAssistant ProfessorWarren Centre for ActuarialStudies and Research
 
Contents
1 Interest Rates and Factors 2
1.1 Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.2 Simple Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.3 Compound Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.4 Accumulated Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.5 Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.6 Rate of Discount:
d
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.7 Constant Force of Interest:
δ
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71.8 Varying Force of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81.9 Discrete Changes in Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . 9Exercises and Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2 Level Annuities 21
2.1 Annuity-Immediate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212.2 AnnuityDue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252.3 Deferred Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302.4 Continuously Payable Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362.5 Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402.6 Equations of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44Exercises and Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
3 Varying Annuities 58
3.1 Increasing Annuity-Immediate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 583.2 Increasing Annuity-Due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613.3 Decreasing Annuity-Immediate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 663.4 Decreasing Annuity-Due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 673.5 Continuously Payable Varying Annuities . . . . . . . . . . . . . . . . . . . . . . . . 693.6 Compound Increasing Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 713.7 Continuously Varying Payment Streams . . . . . . . . . . . . . . . . . . . . . . . . 743.8 Continuously Increasing Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . 753.9 Continuously Decreasing Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . 76Exercises and Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4 Non-Annual Interest Rate and Annuities 88
4.1 Non-Annual Interest and Discount Rates . . . . . . . . . . . . . . . . . . . . . . . . 884.2 Nominal
p
thly
Interest Rates:
i
(
 p
)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . 884.3 Nominal
p
thly
Discount Rates:
d
(
 p
)
. . . . . . . . . . . . . . . . . . . . . . . . . . . 894.4 Annuities-Immediate Payable
p
thly
. . . . . . . . . . . . . . . . . . . . . . . . . . . 914.5 Annuities-Due Payable
p
thly
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94Exercises and Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
5 Project Appraisal and Loans 108
5.1 Discounted Cash Flow Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1085.2 Nominal vs. Real Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1145.3 Investment Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1155.4 Allocating Investment Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1175.5 Loans: The Amortization Method . . . . . . . . . . . . . . . . . . . . . . . . . . . 1185.6 Loans: The Sinking Fund Method . . . . . . . . . . . . . . . . . . . . . . . . . . . 1201
 
Exercises and Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
6 Financial Instruments 132
6.1 Types of Financial Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1326.1.1 Money Market Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . 1326.1.2 Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1336.1.3 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1336.1.4 Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1346.1.5 Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1346.1.6 Guaranteed Investment Contracts (GIC) . . . . . . . . . . . . . . . . . . . . 1346.1.7 Derivative Sercurities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1356.2 Bond Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1376.3 Stock Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148Exercises and Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
7 Duration, Convexity and Immunization 156
7.1 Price as a Function of Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1567.2 Modied Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1567.3 Macaulay Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1577.4 Eective Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1597.5 Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1597.5.1 Macaulay Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1607.5.2 Eective Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1607.6 Duration, Convexity and Prices: Putting it all Together . . . . . . . . . . . . . . . 1607.6.1 Revisiting the Percentage Change in Price . . . . . . . . . . . . . . . . . . . 1607.6.2 The Passage of Time and Duration . . . . . . . . . . . . . . . . . . . . . . . 1617.6.3 Portfolio Duration and Convexity . . . . . . . . . . . . . . . . . . . . . . . . 1617.7 Immunization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1627.8 Full Immunization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166Exercises and Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
8 The Term Structure of Interest Rates 177
8.1 Yield-to-Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1778.2 Spot Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1772

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