Actuarial Society of India EXAMINATIONS

5th June 2004 (a.m.) Subject 102– Financial Mathematics
Time allowed: Three Hours INSTRUCTIONS TO THE CANDIDATES 1. Do not write your name anywhere on the answer scripts. You have only to write your Candidate’s Number on each answer script. 2. Mark allocations are shown in brackets. 3. Attempt all questions, beginning your answer to each question on a separate sheet. 4. Fasten your answer sheets together in numerical order of questions. This, you may complete immediately after expiry of the examination time. 5. In addition to this paper you should have available graph paper, Actuarial Tables and an electronic calculator.

AT THE END OF THE EXAMINATION Hand in both your answer scripts and this question paperto the supervisor.

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102 0604

1)

Describe the operation of a motor vehicle insurance policy in the form of a cash flow process. [3]

2)

A money lender lends small sums and charges interest at the rate of Rs 3 per Rs 100 per month, payable in advance. After 1 month the loan may be renewed for a further month on payment of a further Rs 3 per Rs 100, and so on till the loan is repaid. What effective rate of interest does he charge per annum? [2]

3)

An investor is considering two investments. The first is a 91 day Treasury Bill discounted at a simple rate of discount of 6% per annum. The second is a 91 day deposit at a rate of interest of 6.15% per annum convertible daily. Determine which provides the higher effective rate of return. Assume that there are 365 days in a year. [3]

4)

Fund A accumulates at a rate of interest of 5% effective per annum and fund B at 7% effective per annum. At the end of 20 years the total of the two funds is Rs 1,000. At the end of 10 years the amount of fund A is half that of fund B. What is the amount of the combi ned funds after 5 years? [5]

5)

a) A prize fund is to be set up out of which a payment of Rs 5,000 will be made to each person who in any year qualifies for membership of a certain profession. It is expected that 10 persons will qualify at the end of 1 year from now, 15 at the end of 2 years, 20 at the end of 3 years, and so on till the number of qualifiers is 50 per annum, when it will remain constant. Find at 3% per annum effective what sum must be paid into the fund now so that it may be sufficient to meet the outgo. [5] b) If instead of paying a lump sum now it was desired to pay 10 equal half-yearly instalments, the first instalment due now, what would the amount of the instalments be? [3] Total [8]

6)

Rs 100,000 is invested in a bank account which pays interest at the end of each year. The rate of interest is fixed randomly at the beginning of each year and remains unchanged until the beginning of the next year. The rate of interest applicable in any one year is independent of the rate applicable in any other year. During the first year the rate of interest per annum effective will be one of 3%, 4% or 6% with equal probability. During the second year, the rate of interest per annum effective will be either 5% with probability 0.7 or 4% with probability 0.3. Assuming that interest is always reinvested in the account, calculate the expected accumulated amount in the bank account at the end of two years. [4]

7)

On 15 March 1998 the government of a country issued an index-linked bond of term 6 years. Coupons are payable half -yearly in arrears, and the annual nominal coupon rate is

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102 0604 3%. Interest and capital payments are indexed by reference to the value of an inflation index with a time lag of 8 months. A tax-exempt investor purchased the stock at Rs 111 per Rs 100 nominal on 16 September 2001, just after the coupon payment had been made. You are given the following values of the inflation index: Date July 1997 March 1998 July 2001 September 2001 Inflation index 110.5 112.1 126.7 127.4

a) Calculate the amou nt of the coupon payment per Rs 100 nominal stock on 15 March 2002. [3] b) Calculate the effective real annual yield to the investor on 16 September 2001. You should assume that the inflation index will increase continuously from its value in September 2001 at the rate of 4% per annum effective. [11] Total [14] 8) A loan is to be repaid by an immediate annuity. The annuity starts at a rate of Rs 100 p.a. and increases by Rs 10 per annum. The annuity is paid in arrear for 20 years. Repayments are calculated using a rate of interest of 8% p.a. effective. If any annuity payment falls short of the interest then due, the shortfall will be treated as an addition to the outstanding loan. a) Calculate the initial amount of the loan. [3] b) Construct a loan schedule showing the capital and interest elements in and the amount of loan outstanding after the 6th and 7th payments. [5] c) Find the capital and interest element of the last instalment. [2] Total [10] 9) On 1 January 2001, an investor placed part of his assets with two fund managers. Manager A was given Rs 120,000 and manager B was given Rs 100,000. Subsequently, Rs 10,000 was invested with each manager on 1 January 2002 and a further Rs 10,000 invested with each manager on 1 January 2003. The values of the respecti ve funds on 31 December 2001 were Rs 130,000 for manager A and Rs 140,000 for manager B and on 31 December 2002, the values were Rs 135,000 for manager A and Rs 145,000 for manager B. On 31 December 2003, the value of manager A’s fund was Rs 180,000 and of manager B’s fund was Rs 150,000. a) Calculate the time weighted rates of return earned by manager A and manager B over the period 1 January 2001 to 31 December 2003. [4] b) Calculate the money weighted rate of return earned by manager A over the period 1 January 2001 to 31 December 2003. [3] c) Without calculating the money weighted rate of return earned by manager B, state, with reasons, whether the money weighted rate of return earned by manager B over Page 3 of 5

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102 0604 the period 1 January 2001 to 31 December 2003 is higher than, equal to or lower than that earned by manager A. [2]

d) Comment briefly on the relative performance of the two fund managers. [3] Total [12] 10) a) Define the characteristics of a government index-linked bond. [2] b) Explain why most index-linked securities issued carry some inflation risk, in practice. [2] Total [4] 11) a) Describe how short interest rate futures operate. Your answer should include reference to how the contract is structured, how the price is stated and what are the cashflows involved. [3] b) If you think that interest rates are going to rise would you buy or sell the short interest rate future. [1] Total [4] 12) a) Define arbitrage and describe when an arbitrage opportunity may exist. [2] b) Describe how the principle of “no arbitrage” is used to find the price of complex financial instruments. [2] Total [4] 13) a) An investment provides income of Rs 1,000,000 payable at the end of each year for the next ten years. There is no capital repayment. If the interest rate is 7% per annum effecti ve, show that the discounted mean term of the investment is 4.946 years. [4] b) An investment company has liabilities of Rs 7,000,000 due in 5 years time and Rs 8,000,000 due in 8 years time. The company holds two investments, A and B. Investment A is the investment described in part a) and Investment B is a zero coupon bond which pays Rs X at the end of n years (where n is not necessarily an integer). The interest rate is 7% per annum effective. Investigate whether values of Rs X and n can be found which ensure that the investment company is immunized against small changes in the interest rate. You are given that

∑t
t =1

10

2 t

v = 228 .451

at 7% per annum effective. [8] Total [12]

14) The annual rates of interest from a particular investment, in which part of an insurance company’s funds is invested, are independently and identically distributed. Each year, the distribution of log-normal with parameters

i(t ) , where i (t ) is the rate of interest earned in year µ and σ 2 .

t, is

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102 0604

i (t ) has mean value 0.07 and standard deviation 0.02, the parameter µ σ 2 = 0.0003493.

= 0.06748 and

a) The insurance company has liabilities of Rs 1,000,000 to meet in one year from now. It currently has assets of Rs 950,000. Assets can either be invested in the risky investment described above or in an i nvestment which has a guaranteed return of 5% per annum effective. Find, to two decimal places, the probability that the insurance company will be unable to meet its liabilities if: i) All assets are invested in the investment with the guaranteed return. ii) 85% of assets are invested in the investment which does not have the guaranteed return and 15% of assets are invested in the asset with the guaranteed return. [7] b) Determine the variance of the return from the portfolios in a)i) and a)ii) above. [3] Total [10] 15) The yields on an insurance company’s funds in different years are independently and identically distributed. Each year the distribution of (1 + i ) is lognormal with parameters = 0.075 and σ 2 = 0.00064, where i is the annual yield on the company’s funds. Find the probability that a single investment of Rs 2,000 will accumulate over 10 years to more than Rs 4,500. [5]

µ

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