EF5370 Mathematics and Statistics for Financial Service

Lecture 1 Xuan S. Tam

Sept. 3, 2013

Outline

Cashows Discount Functions Calculating the Discount Function Constant Interest Values and Actuarial Equivalence Regular Pattern Cashows

Cashows

A basic application of actuarial mathematics is to model the transfer of money Insurance companies, banks and other nancial institutions engage in transactions that involve accepting sums of money at certain times, and paying out sums of money at other times Let time 0 refer to the present time, and time k will then denote k time units in the future Assume that all funds are paid out or received at integer time points, that is, at time 0, 1, 2, ....

Cashows

The amount of money received or paid out at time k will be called the net cashow at time k and denoted by ck A positive value of ck denotes that a sum is to be received, while a negative value indicates that a sum is paid out The entire transaction is then described by listing the sequence of cashows, which will refer to this as a cashow vector, c = (c0 , c1 , ..., cN ) N is the nal duration for which a payment is made

Cashows

Suppose I lend you 10 units of capital now and a further 5 units a year from now. You repay the loan by making three yearly payments of 7 units each, beginning 3 years from now. The resulting cashow vector from my point of view is c = (10, 5, 0, 7, 7, 7) From your point of view, the transaction is represented by c = (10, 5, 0, 7, 7, 7) This lecture is to provide methods for analyzing transactions in terms of their cashow vectors

Cashows

There are several basic questions that could be asked:

When is a transaction worthwhile undertaking? How much should one pay in order to receive a certain sequence of cashows? How much should one charge in order to provide a certain sequence of cashows? How does one compare two transactions to decide which one is preferable?

we could answer all of them if we could nd a method to put a value on a sequence of future cashows

Cashows

We pay interest for the privilege of borrowing money today, which lets us consume now, or we advance money to others, giving up our present consumption and expecting to be compensated with interest earnings In addition, there is the eect of risk. If we are given a unit of money today, we have it. If we forego it now in return for future payments, there could be a chance that the party who is supposed to make remittance to us may be unable or unwilling to do, and we expect to be compensated for the possible loss

An Analogy with Currencies

Suppose that I give you 300 Canadian dollars, 200 US dollars, and 100 Australian dollars. How much money did I give you? Let v (c , u ) denote the value in Canadian dollars of 1 US dollar. Assume that v (c , u ) = 1.20, which means that a US dollar is worth 1.20 Canadian dollars Similarly, letting a stand for Australian, we will assume that v (c , a) equals 0.90, which means 90 Canadian cents will buy 1 Australian dollar

An Analogy with Currencies

v function returns the value of one unit of the second coordinate currency in terms of the rst coordinate currency Let v (c , u ) denote the value in Canadian dollars of 1 US dollar. Assume that v (c , u ) = 1.20, which means that a US dollar is worth 1.20 Canadian dollars If it takes 1.20 Canadian dollars to buy 1 US dollar, then a single Canadian dollar is worth 1/1.2 = 0.833 US dollars. That is, v (u , c ) = v (c , u )1 = 0.833, v (a, c ) = v (c , a)1 = 1.111 Consider v (u , a): the amount of US dollars needed to buy one Australian dollar v (u , a) = v (u , c )v (c , a) = 0.750 The real-life currency relationships do not hold exactly due to commissions and other charges

An Analogy with Currencies

Lets return to the original problem, we could say that the total was equivalent to 300 + 200v (c , u ) + 100v (c , a) = 630 Canadian dollars or 630v (u , c ) = 525 US dollars Similarly, the total in Australian dollars can be computed immediately as 630v (a, c ) or alternatively as 525v (a, u ), both of which are equal to 700

Discount Functions

We want to value a sequence of cashows, which are all in the same currency, but which are paid at dierent times Conversion factors are needed to convert the value of money paid at one time to that paid at another Let v (s , t ) denote the value at time s , of 1 unit paid at time t [Note again that our convention is that the 1 unit goes with the second coordinate. In other words, 1 unit paid at time t is equivalent to v (s , t ) paid at time s .]

Discount Functions

In the case where s < t , you can interpret v (s , t ) as the amount you must invest at time s in order to accumulate 1 at time t In the case where s > t you can interpret v (s , t ) as the amount that you will have accumulated at time s from an investment of 1 at time t The fundamental relationship: v (s , t )v (t , u ) = v (s , u ), for all s , t , u . (2.1) 1 unit at time u is equivalent to v (t , u ) at time t , and this v (t , u ) at time t is equivalent to v (s , t )v (t , u ) at time s , showing that 1 unit at time u is indeed equivalent to v (s , t )v (t , u ) at time s

Discount Functions

Denition 2.1: A discount function is a positive valued function v , of two nonnegative variables, satisfying (2.1) for all values of s , t , u .
Taking s = t = u , we deduce that v (s , s )v (s , s ) = v (s , s ) and, since v (s , s ) is nonzero, we verify that v (s , s ) = 1, for all s . (2.2) From this we deduce that v (s , t )v (t , s ) = v (s , s ) = 1 so that we recover the relationship that v (s , t ) = v (t , s )1 . (2.3)

Discount Functions

Although we have called v a discount function, the common English usage of the word really applies to the case where s<t In that case, v (s , t ) will be normally less than 1, and the function is returning the discounted amount of 1 unit paid at a later date Some authors would prefer to dene accumulation function where s > t We will suppose that, given any nancial transaction, there is a suitable discount function that governs the investment of all funds

Discount Functions

There are many factors governing this choice and it will depend on the nature of the transaction
It may simply reect the preferences of the parties for present as opposed to future consumption It may reect the desired return that an investor wishes to achieve In many cases it is based on a prediction of market conditions that will determine what returns can be expected on invested capital

Calculating the Discount Function

The currency example indicated that we can calculate all the values of a discount function just by knowing those at points with a common comparison point. In most applications it is convenient to take this as time 0 To simplify notation, we drop the rst coordinate in this case and dene v (t ) = v (0, t ) (2.4) It follows from (2.1) that v (s , t ) = v (s , 0)v (0, t ) and then v (t ) from (2.3) that v (s , t ) = v (s ) (2.4)

Calculating the Discount Function

From (2.4), it will be sucient to know v (n) where n is any nonnegative integer To calculate v (n), (2.1) can be extended from one involving three terms to an arbitrary number. That is, given times t1 , t2 , ..., tn , v (t1 , t2 )v (t2 , t3 )v (tn1 , tn ) = v (t1 , tn ) (2.5) Take for example n = 4. v (t1 , t2 )v (t2 , t3 )v (t3 , t4 ) is equal to V (t1 , t3 )V (t3 , t4 ) by applying (2.1) to the rst two terms. By another application of (2.1) it is equal to v (t1 , t4 ) We have extended (2.1) to a formula involving four terms

Calculating the Discount Function

It follows from (2.5) that v (n) = v (0, 1)v (1, 2)...v (n 1, n), (2.6) We need only know v (n 1, n) for all positive integers n. Given such values, we can use the recursion formula v (n) = v (n 1)v (n 1, n), v (0) = 1, (2.7) to calculate all values of v (n) The information we need is then summarized by the vector v = [v (0), v (1), v (2), ..., v (N )] , where N is the nal duration at which a nonzero cashow occurs

Calculating the Discount Function

Exercise: You are given a discount function v where v (1, 3) = 0.9, v (3, 6) = 0.8, v (8, 6) = 1.2
How much must you invest at time 1, in order to accumulate 10 at time 8? If you invest 100 at time 3, how much will have accumulated by time 8?

Interest and Discount Rates

In practice, rather than specifying v (k 1, k ) directly, it is more common to deduce this quantity from the corresponding rates of interest or discount Given any discount function v and a nonnegative integer k , these are dened as follows Denition 2.2 The rate of interest for the time interval k to k + 1 is the quantity ik = v (k + 1, k ) 1 .

Interest and Discount Rates

Denition 2.3 The rate of discount for the time interval k to k + 1 is the quantity dk = 1 v (k , k + 1) Note that an investment of 1 unit at time k will produce v (k + 1, k ) = 1 + ik units at time k + 1 Similarly, an investment of 1 dk = v (k , k + 1) units at time k will accumulate to 1 unit at time k + 1 Given any of the three quantities v (k , k + 1), ik or dk we can easily obtain the other two

Interest and Discount Rates

For example, using the denitions and (2.3), it is straightforward to deduce that dk = ik v (k , k + 1) = ik = dk v (k + 1, k ) = ik 1 + ik

dk (2.8) 1 dk

Remark: i0 is the interest rate for the rst time interval

Constant Interest

Suppose we believe that accumulation of invested funds depends only on the length of time for which the capital is invested, and not on the particular starting time. That is, we postulate that for all nonnegative s , t , h, v (s , s + h) = v (t , t + h) (2.9) If this holds, then

v (s +t ) = v (0, s +t ) = v (0, s )v (s , s +t ) = v (0, s )v (0, t ) = v (s )v (t )

Constant Interest

If we assume that v be continuous, we must have v (t ) = v t and therefore that v (s , t ) = v t s for some constant v For such a discount function, the rate of interest ik is a constant i = v 1 1, and the rate of discount dk is a constant d = 1 v The discount function is therefore conveniently given by i , the constant rate of interest If we want to know how much we will accumulate at time n from an investment of 1 at time 0, this is just v (n, 0) = (1 + i )n , the usual starting point for the compound interest

Values and actuarial equivalence

Suppose we are given a cashow vector c = (c0 , c1 , ..., cN ) and a discount function v We want to calculate the single payment at time zero that is equivalent to all the cashows, assuming that the time value of money is modeled by the given discount function v This amount is commonly referred to as the present value of the sequence of cashows, and sometimes abbreviated as PV It is the amount we would pay at time zero in order to receive all of the cashows

Values and actuarial equivalence

The cashow at time k has a present value of ck v (k ) by denition of the discount function When ck > 0 this is what we have to pay now in order to receive ck at time k . When ck < 0, receiving ck v (k ) now will let us payout ck at time k . Present value of all cashows =
N k =0 ck v (k )

(2.10)

Values and actuarial equivalence

Example 2.1 Let v (k ) = 2k for all k . This is a constant interest rate per period of 100%. In other words, money doubles itself every period. Suppose we are to receive 12 units at time 2, but will be required to payout 8 units at time 3. Find the present value, and verify that it makes sense.

Values and actuarial equivalence

Example 2.1 Let v (k ) = 2k for all k . This is a constant interest rate per period of 100%. In other words, money doubles itself every period. Suppose we are to receive 12 units at time 2, but will be required to payout 8 units at time 3. Find the present value, and verify that it makes sense. Solution: From (2.10) the present value is 12v (2) 8v (3) = 12(1/4) 8(1/8) = 2. Note that the 12 units received at time 2 will accumulate to 24 at time 3. We then have to payout 8, leaving an accumulation of 16 units by time 3

Values and actuarial equivalence

Note that it was convenient in the above example to compare the amounts accumulated at the time of the last payment. This is known as the accumulated value and in general is given by
N

ck v (N , k )
k =0

Denition 2.4 : For any time n = 0, 1, ..., N , the value at time n of the cashow vector c with respect to the discount function v is given by
N

Valn (c ; v ) =
k =0

ck v (n, k )

A single amount that we would accept at time n in place of all the other cashows according to the discount function v

Values and actuarial equivalence

The values at various times are related in a simple way. Since v (m, k ) = v (m, n)v (n, k ), it follows immediately that Valm (c ; v ) = Valn (c ; v )v (m, n) (2.11) For the particular case of values at time 0 we will use a special symbol: a (c ; v ) = Val0 (c , v ) The letter a is a standard actuarial symbol that is used to stand for annuity, another name for a sequence of periodic payments

Values and actuarial equivalence

When there is only one discount function under consideration we often suppress the v and just write Valn (c ) or a For the particular case of values at time 0 we will use a special symbol: a (c ; v ) = Val0 (c , v ) We can express and calculate a conveniently by expressing it in vector form: a (c ) = v c = vc T (2.12) The second term is the (scalar) inner product of the two vectors. The third views the vectors v and c as 1xN matrices, with the superscript T denoting a matrix transpose

Values and actuarial equivalence

Valk (c + d ) = Valk (c ) + Valk (d ), Valk (c ) = Valk (c ), (2.13) for any cashow vectors c and d , scalar , and duration k . We often wish to compare the values of two sequences of cashows Denition 2.5: Two cash ow vectors c and e are said to be actuarially equivalent with respect to the discount function v if, for some nonnegative integer n, Valn (c ; v ) = Valn (e ; v )

Values and actuarial equivalence

Example 2.2: A lends B 20 units now and another 10 units at time 1. B promises to repay the loan by two payments, made at time 2 and time 3. The repayment at time 3 is to be twice as much as that at time 2. If A wishes to earn interest of 25% per period, what should these repayments be?

Values and actuarial equivalence

Solution: Let K be the unknown payment at time 2. We want to nd K so that the vectors c = (20, 10, 0, 0) and e = (0, 0, K , 2K ) are actuarially equivalent. PV of advances = 20 + 10(0.8) = 28 PV of repayments = K [(0.82 + 2(0.83 )] = 1.664K Equating values to make the advances and repayments actuarially equivalent, K = 28/1.664 = 16.83. The borrower pays 16.83 at time 2 and 33.66 at time 3

Values and actuarial equivalence

Example 2.3: Let c = (2, 4, 3, 5). Assume a constant interest rate of 0.25. Find the actuarially equivalent vector by applying the replacement principle with time k = 2 and the subset {1, 3}. Hint: i.e. nd a K such that e = (2, 0, K , 0) is actuarially equivalent to c

Values and actuarial equivalence

Solution: The value of c1 and c3 at time 2 is 4(1.25) 5(1.25)1 = 1. Making the replacement, we obtain the vector (2, 0, 2, 0) that is actuarially equivalent to c , as can be veried by direct calculation

Regular Pattern Cashows

We assume throughout the section that the discount function is given by v (n) = v n for some constant v . Consider the vectors (1n ) and j n = (1, 2, ..., n 1, n) a (1n ) = 1 + v + v 2 + ... + v n1 Multiplying by v , v a (1n ) = v + v 2 + v 3 + ... + v n Subtracting the second equation from the rst and dividing by (1 v ) gives a (1n ) = 1 vn 1v (2.14)

Regular Pattern Cashows

A similar trick handles the vector j n by reducing to the level payment case: a (j n ) = 1 + 2v + 3v 2 + ... + nv n1 Multiplying by v , v a (jn ) = v + 2v 2 + 3v 3 + ... + nv n Subtracting the second equation from the rst and dividing by (1 v ) gives a (j n ) = a (1n ) v n 1v (2.15)

Regular Pattern Cashows

Exercise 1: You are given interest rates i0 = i1 = 0.25, i2 = i3 = 1. You have entered into business transaction where you will receive 2 at time 0, 5 at time 3, and 10 at time 4, in return for a payment by you of 3 at time 2. In place of all these cashows you are oered a single payment made to you at time 1. What is the smallest payment you would accept?

Regular Pattern Cashows

Exercise 2: A loan of 20, 000, made at an interest rate of 6%, is to be repaid by level yearly payments for 10 years, beginning 1 year after the loan is advanced. Just before making the seventh repayment, the borrower wishes to repay the entire loan.
If interest rates remain unchanged, what is the outstanding balance? Suppose interest rates have dropped to 5%. How much will the borrower have to pay if the lender uses the lower interest rate to calculate the outstanding balance?