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INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2015 examinations

Subject CT1 – Financial Mathematics
Core Technical
Introduction
The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.
The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.
For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.
The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.
F Layton
Chairman of the Board of Examiners
June 2015

 Institute and Faculty of Actuaries

candidates may be penalised where excessive rounding has been used or where insufficient working is shown. the non-numerical questions were answered poorly by marginal candidates. Page 2 . In general. However. It introduces compound interest. Please note that different answers may be obtained to those shown in these solutions depending on whether figures obtained from tables or from calculators are used in the calculations but candidates are not penalised for this. the time value of money and discounted cashflow techniques which are fundamental building blocks for most actuarial work.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report General comments on Subject CT1 CT1 provides a grounding in financial mathematics and its simple applications. Comments on the April 2015 paper The comments that follow the questions concentrate on areas where candidates could have improved their performance. Where no comment is made the question was generally answered well by most candidates.

000  3.433.5) Therefore.91 days. 000  t = 2.04   =3.3933 years = 143.04)t = 98 t × ln(1. 3 (i) 96. indivisible units of property are less flexible.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report 1 Dividends usually increase annually whereas rents are reviewed less often.199.603%  1   98  38 Page 3 .800 365   t = 2.04 = ln   365  3. Expenses associated with property investment are higher.800 3.000 t 365 (1.04) = ln(98/96.5(1. The worst answered question on the paper with over one-third of candidates scoring no marks. t = 0.04) = = 3. Large. dividends will tend to rise more rapidly than rents because dividends benefit from retention and reinvestment of profits in earlier years. Property is less marketable.19603 or 19.000  1  0.04) t 365  (1. 2 (a) Let the answer be t days t   3.33 days (b) Let the answer be t days: 3.800  t ln1.800 3.54 days (144 days) (ii) The second investor held the bill for 182–144 = 38 days 38   Therefore 98  1  i  = 100  365   100  365 i=  = 0. On average.

035 9 0. The investor will also have to repay cash of £6e 9 0.2527 (iii) In this case the actual forward price is too expensive in relation to the stock.21416 or 21.30.020408)365/38  1 = 0.035 9 0. 0. The continuous dividends are reinvested in the stock.03512 12 e  £6.09 9 0.090. exact amounts not required).035 9 12  e 12 =1 unit of stock [After nine months. (Mark given for general strategy. with no risk of future loss. and a non-zero probability of a future profit.416% 4 (i) The “no arbitrage” assumption means that neither of the following applies: (a) an investor can make a deal that would give her or him an immediate profit. Page 4 . The investor will also go short in one forward contract.035 9 12 and use this to buy e 12 units of The investor should borrow £6e the stock.035129 (ii) The theoretical price per share of the forward contract is £6e  £6. they were expected to recognise that the forward was overpriced and to determine the arbitrage strategy accordingly.020408 Annual effective rate over 1 year would be: (1 + 0.2527 .  0.] Whilst it was not required for candidates to give a full mathematical explanation for part (iii). no risk of future loss. 0.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report (iii) The actual rate of interest over 38 days was (100/98) – 1 = 0. the investor will have e that can be sold under the terms of the forward contract for £6. (b) an investor can make a deal that has zero initial cost.

8923 1.03  60 s at 3% 2 6 8 a2 d  d   120 0.03  60 s8  1. if book not used then exact answer is £2.26677  60   8.837 = £2.03    1.03  60s 2   1. The effective rate of interest is 3% per half year. Page 5 .128. Accumulated amount = 120 16 8 s8  1.128.60471  60  1.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report 5 We will use the ½-year as the time unit because the interest rate is convertible half yearly. Generally well-answered but marginal candidates would have benefited from showing their intermediate working in greater depth and/or with greater clarity.03  60s 6  at 3% 8 8 a2 6  d  6  1 1 6   We need d from 1    1  d  6  1  i 1.8923 1.03  8.029486111 = 894.03  1 6  6   = 0 .75 (above uses factors in formulae and tables book.022445  8.040 + 542.77).03  1   1  d  6  1  6 6  1     d = 1   6  1.877 + 691.029486111 Thus accumulated amount = 120 i i 16 8 s8  1.9135 0.8923 1.

09  0.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report 6 Let: i  nominal yield e  inflation rate i  real rate Then 1  i  1  i 1  e  We first find i and then use above equation to find i : 175 =   6 1  i  1  2 6 1  i  1 2 6 1  i  1 2 6 1.81 Hence  208.09657 (answer to nearest 0.06 1 1  i 1 2  6  1.32  = 0.1% is 9.06  1  i 2 1 2  2  1. RHS = 208. RHS = 157.01     208.06 1.6%) Page 6 .06  1  i  1    1 i   Let 6 1  i  1 2 i  0.32 i  9% .06   1   1 i  1 6 1  i  2  1.81  157.06 i  10%.06 2  1       1  i 1  i 2       1   1.81  175  i  0.

01 0.04  i  5.5 3%v 2. for example. (iii) Spot rate to time 4.) Page 7 . 4%.5 9%v V (ii) = 0.67855 = 4. Spot rate to time 3.05 0.44% p. Therefore: 1. 7 (i) Time Spot rate of interest ½ 1½ 2½ 3½ 4½ 0. real return (answer to nearest 0. because long-term bonds are more volatile). Because the market segmentation theory holds and investors short-term bonds might be in demand by investors such as banks (or there is an undersupply of short-term bonds or less demand/more supply for long-term bonds).g.5 = 16.09657  1  i 1.5 5%v 3.09 Value of liabilities (£m)   0.5/(1. with constant expectations of interest rates.5 is 7%.5 2.5 4.5 7%v 4.5 1.094.88517 = 0.78914 = 0.03 0.5 is 9%.07 0. 6% etc.5 3.99504 = 0.5 to 4. A rising curve would be compatible.3% Common errors in part (i) were to assume payments at the end of the year and/or to assume that the payments should be valued with the end of year spot rate (2%.a. Because investors have a preference for liquidity which puts an upwards bias on the yield curve (e.4%) An alternative method of formulating the equation in real terms to find i’ directly was perfectly valid.5 V  1 v1%  v3%  v5%  v7%  2v9% ½ 1%v 1.98308 Because expectations of short-term interest rates rise with term and the yield curve is determined by expectations theory.95663 = 0.1% is 5.5 = forward rate from 3.07)3.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report Then we have 1.

02358  100  0.047 = 7.50835. It is therefore an indication of the risk to which the investor is exposed if interest rates rise and the price of the security falls before it is sold.199 /1. Page 8 .199 years (iii) Duration will be higher because the payments will be more weighted towards the end of the term. (iv) (a) Effective duration = duration / 1  i   7.728 years (b) Effective duration would indicate the extent to which the value of the bond would change if there were a uniform change in interest rates.02358 P = 9  7.07  6.7391  10 100  0.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report 8 (i) P  9a10 7%  100v10 7% v10  0. Many of the explanations from candidates in part (iii) were very unclear.047 9  34.50835 114.50835  114. a10  7.047 (ii) Discounted mean term  tCt vt     Ct vt 9  Ia 10  10 100v10 114.

850.62990  4.000.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report 9 Present value of outgoings = 4. 000  0.04837 Page 9 .04837 1  k   1.000v½ @12%  4.420 = 308. 000 a v 1  v j  v 2j  v3j  v 4j  6.12  308.12 1 1 k  4 a  0.800. 000 v 6 5 1. 445.000 + 900. 209 a j  3.84%) 1. for IRR = 12%.62990  4.54595 1.800.95887@12% 1 So.800. present value of income  360.837% 4.62990 5% a5  4. 445.54595 j  4 j 4. 209a j  3.83% (exact answer is 6. 000va  360. 000 1  k  v 2 a 1 1 4  4    360.12  1  0. 092 5 Hence.04837  1.0683  6. 420 Present value of income =  4  4 360. 000 v 6  1   4  360.850.12 1 1 k 0.55966  4.12 1 1 k 1. 4. 000 v 6 1 where j  1.55966 5 At 4% a5  4.12 k 1. 092 5 so a j  4. 000v5 1  k  a  6.95887  1  a j  6.

595 exp  0.12t 0.05ds  9  0   9  = e 0.595 For t  9 : 9 t t v  t  = exp      s  ds     s  ds   e0.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report Marginal candidates again would have benefited from showing more intermediate working.1290.595 exp  0.1450.32 exp 0.05s 9  e0. 10 (i) For 0  t  4 : t t v  t  = exp      s  ds   exp    0.08t and v  4   e 0.084  e0. In project appraisal questions.32 For 4  t  9 : 4 t t v  t  = exp      s  ds     s  ds   e0.08  0.32 exp    0.45  0.080. it is good exam technique to show working and answers for each component of income and outgo separately so that partial marks can be given if any errors are made within a component.005t  2 and v  9   e0.005t 2 = e0.32 exp  0.005s 2   4   e0.05t t Page 10 .12 s  0.595 exp    0.12t  0.080.00581  e 0.08ds   0   0   e 0.05t   e 0.48  0.12  0.01sds  4  0   4  t = e 0.

08  1  v  2v 2  3v3    nv n 1  i  Ia n   Ia n  £2.1450.083 (2)  1  v  v 2    v n1  nv n 1  v  v  2     v n 1  nv n i  an  nv n i Work in months i.1450.62 Page 11 .0125    60 v   0.8774X  X  £26.0125            1126.0125 1.012560  1  v 60 60  60    60 1. use a monthly interest rate of 1.02t  dt    0.85 11 (iii) Present value = 1.02t   5.03t e 0.03t  100 e exp  0      10    12 12   100e0.25%  a  60v 60    X  60   i    1  1. 000  Xv  2 Xv    60 Xv 60  X  Ia 60 @1.0125 d     X X   i 0.e.05t dt 10 12   100e 12 0. 000e 0. 000a3 8%  1.385  10   138.02  10  12   5.1450.02t 10 100e 0. 000 (i)  Ia n e0.1450.89 (1)  1  2v  3v 2    nv n1  2   1  i  Ia n (ii) 1  e0.25% per month effective: 2 30.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report (ii) Present value is   t  s ds   dt 0.561.345  e0. 000 e 0.

12 (i) Let S n  Accumulated value at time n of £1 invested at time 0 Sn = 1  i1 1  i2  ..Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report (iii) Equation of value: 30.. This is because under the student’s arrangement no capital or interest will be paid for three years... In part (ii).0060%  29.1%: LHS = 29. candidates should show enough steps to demonstrate that they have performed the calculations required to actually prove the answer (e.8% to 1 d.p..4202 Try i = 1.5098  31.4202  Interpolate: i  1%  0.E 1  in  by independence and E 1  it   1  E  it   1  j Page 12 . E 1  i2  . In part (i). candidates were expected to show the first and last terms of each series used to derive the result so that the proof is absolutely clear.32a60  v36 a60  31. 12 The bank is unlikely to be happy to accept the suggestion as it will be earning a lower rate of return compared with the original proposal of 15% per annum convertible monthly (=16. 000  v36 958. The extra total of payments will not be sufficient to cover the deferred interest at the bank’s preferred rate.010060   1  12.g. show the numerical values for the factors used) ..4202  APR is 1  0.1%    1. if interpolating on a monthly interest rate (as in the above solution) the guesses most be close enough together to ensure the estimated annual rate is close enough to the correct answer. In part (iv). . 1  in   E  Sn  = E 1  i1 1  i2  .5X on average) but will incur a lower rate of interest.. (iv) The student’s arrangement will lead to a greater total of payments (60 payments of 36X) when compared to the original arrangement (60 payments of 30..3048  31.. 1  in    E 1  i1  .5098  31.3048 Try i = 1%: LHS = 31.1% per annum effective).

..E 1  in         by independence and   2 E 1  it   = E  1  2it  it2        = 1  2 E  it   E it2 and   Var it   s 2 = E it2   E  it   2   = E it2  j 2    E it2  s 2  j 2 Hence     E  Sn2   1  2 j  j 2  s 2   n and Var  Sn   1  2 j  j 2  s 2 n  1  j  2n Page 13 . ....Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report Hence E  Sn   1  j  n Now Var  Sn  = E  Sn2    E  Sn    E  Sn2    2 2 2 2 = E 1  i1  1  i2  .. 1  in     2 2 2 = E 1  i1   . E 1  i2   .

39     0.122 1.22    0. .04  e   = Ln 1.08   Ln 1.0647 i.032608.013226     2  1.013226 0. This is reasonable since the expected return in any year is 4%. 6% probability (using exact Φ function gives probability of 6.013226    Pr  0.032608 Ln 1  it    Ln 1.04   2  2  0.032608 (b) Ln 1  it   N  0.013226  0.013226  and we require probability 0.2%) (iii) Page 14 The probability in (ii) (b) is small.04  e   Var 1  it   Var  it   s 2  0.12 2     Ln 1       1.06  0.39  where   N  0.e.06  it  0.22   0.65173  0.Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report (ii) (a) E 1  it   1  E  it   1  j  1.58706  0.08  0. and 8% (i.122  e  0.04  0.08  Pr  Ln 1.1 =   0.06  1  it  1.08  Pr 1.032608   Pr      0.013226 2 = 0. and we are being asked to calculate the probability that the return is between 6%.06  Ln 1  it   Ln 1.e. a range which does not include the expected value). 0.04  2 2 2  22   e 1 2 2  e  1   0.

04). it is important to note when the assumption of independence is required for both proofs. Common mistakes in the calculation of ߤ and ߪ were to assume that s2 was 0. END OF EXAMINERS’ REPORT Page 15 .Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report In part (i).04 (rather than 1.12 (rather than s) and 1 + j was 0.