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Mathematics of Finance

Instructor:

Dr. Alexandre Karassev

COURSE OUTLINE

• Theory of Interest

1. Interest: the basic theory

2. Interest: basic applications

3. Annuities

4. Amortization and sinking funds

5. Bonds

• Life Insurance

6. Preparation for life contingencies

7. Life tables and population problems

8. Life annuities

9. Life insurance

Chapter 1

INTEREST: THE BASIC THEORY

• Accumulation Function

• Simple Interest

• Compound Interest

• Present Value and Discount

• Nominal Rate of Interest

• Force of Interest

1.1 ACCUMULATION FUNCTION

Definitions

• The amount of money initially invested is

called the principal.

• The amount of money principal has grown to

after the time period is called the

accumulated value and is denoted by

A(t) – amount function.

t ≥0 is measured in years (for the moment)

• Define Accumulation function a(t)=A(t)/A(0)

• A(0)=principal

• a(0)=1

• A(t)=A(0)∙a(t)

Natural assumptions on a(t)

• increasing

• (piece-wise) continuous

a(t) a(t)

a(t)

t t t

Note: a(0)=1

Definition of Interest

and

Rate of Interest

• Interest = Accumulated Value – Principal:

Interest = A(t) – A(0)

• Effective rate of interest i (per year):

a(1) a(0) A(1) A(0)

i a(1) 1

a(0) A(0)

(since A(t) A(0) a(t))

A(n) A(n - 1) a(n) a(n - 1)

in

A(n - 1) a(n - 1)

Example (p. 5)

a(t)=t2+t+1

• Show that a(t) is increasing for all t ≥ 0

• Is a(t) continuous?

• Find the effective rate of interest i for a(t)

• Find in

Two Types of Interest

( ≡ Two Types of Accumulation Functions)

• Simple interest:

– only principal earns interest

– beneficial for short term (1 year)

– easy to describe

• Compound interest:

– interest earns interest

– beneficial for long term

– the most important type of accumulation

function

1.2 SIMPLE INTEREST

a(t)=1+it, t ≥0

a(t) =1+it

1+i

•Amount function:

(0,1) A(t)=A(0) ∙a(t)=A(0)(1+it)

t

1

•Effective rate is i

•Effective rate in nth year:

i

in

1 i (n 1)

a(t)=1+it

Example (p. 5)

Jack borrows 1000 from the bank on

January 1, 1996 at a rate of 15% simple

interest per year. How much does he owe

on January 17, 1996?

Solution

A(0)=1000 i=0.15

A(t)=A(0)(1+it)=1000(1+0.15t)

t=?

How to calculate t in practice?

t = number of days

365

• Ordinary simple interest (Banker’s Rule)

t= number of days

360

Number of days: count the last day but not the first

A(t)=1000(1+0.15t)

Number of days (from Jan 1 to Jan 17) = 16

t=16/365

A(t)=1000(1+0.15 ∙ 16/365) = 1006.58

• Ordinary simple interest (Banker’s Rule)

t=16/360

A(t)=1000(1+0.15 ∙ 16/360) = 1006.67

1.3 COMPOUND INTEREST

Interest earns interest

a(1) = 1+i

• After two years:

a(2) = 1+i+i(1+i) = (1+i)(1+i)=(1+i)2

• Similarly after n years:

a(n) = (1+i)n

COMPOUND INTEREST •Amount function:

Accumulation Function A(t)=A(0) ∙a(t)=A(0) (1+i)t

•Effective rate is i

a(t)=(1+i)t

•Moreover effective rate in

nth year is i (effective rate is

a(t)=(1+i)t

constant):

1+it

1+i

(1 i) n (1 i ) n 1

(0,1) in n 1

1 i 1 i

(1 i )

t

1

How to evaluate a(t)?

• If t is not an integer, first find the value for the

integral values immediately before and after

• Use linear interpolation

• Thus, compound interest is used for integral values

of t and simple interest is used between integral

values

a(t)=(1+i)t

(1+i)2

1+i

1

1 t 2

Example (p. 8)

Jack borrows 1000 at 15% a(t)=(1+i)t

compound interest.

a) How much does he owe after 2 years?

b) How much does he owe after 57 days, A(t)=A(0)(1+i)t

assuming compound interest between

integral durations?

c) How much does he owe after 1 year and 57 A(0)=1000, i=0.15

days, under the same assumptions as

in (b)?

d) How much does he owe after 1 year and 57

days, assuming linear interpolation A(t)=1000(1+0.15)t

between integral durations

e) In how many years will his principal have

accumulated to 2000?

1.4 PRESENT VALUE AND

DISCOUNT

Definition

The amount of money that will accumulate to

the principal over t years is called the

present value t years in the past.

VALUE VALUE

Calculation of present value

• t=1, principal = 1

• Let v denote the present value

• v (1+i)=1

• v=1/(1+i)

v=1/(1+i)

In general:

• t is arbitrary

• a(t)=(1+i)t

• [the present value of 1 (t years in the past)]∙ (1+i)t = 1

t

1 t

v

t

(1 i )

1 i

a(t)=(1+i)t

gives the value of one unit (at time 0)

at any time t, past or future

a(t)=(1+i)t

(0,1)

t

If principal is not equal to 1…

VALUE A (0) VALUE

A(0) (1+i)t A(0) (1+i)t

Example (p. 11)

The Kelly family buys a new house for 93,500 on May 1, 1996.

How much was this house worth on May 1, 1992 if real estate

prices have risen at a compound rate for 8 % per year during

that period?

Solution a(t)=(1+i)t

996 - 1992 = 4 years in the past

• t = - 4, i = 0.08

• Present value = A(0) (1+i)t = 93,500 (1+0.8) -4

= 68,725.29

If simple interest is assumed…

• a (t) = 1 + it

• Let x denote the

present value of one

NOTE:

unit t years in the

past

In the last formula,

• x ∙a (t) = x (1 + it) =1 t is positive

• x = 1 / (1 + it) t>0

Thus, unlikely to the case of compound interest,

we cannot use the same formula for present

value and accumulated value in the case of

simple interest

1 1

1 / (1 + it) 1 / (1 - it)

t t

Discount

Alternatively:

basic amount

• After one year it

accumulates to • Imagine that 12

112 were deducted from

112 at the beginning

• The interest 12

of the year

was added at the

end of the term • Then 12 is amount

of discount

Rate of Discount

Definition Effective rate of discount d

accumulated value after 1 year – principal = A(1) – A(0)

d= accumulated value after 1 year A(1)

A(0) ∙a(1) a(1)

Recall:

accumulated value after 1 year – principal a(1) – 1

i= principal

=

a(0)

In n th year…

a(n) a(n 1)

dn

a ( n)

Identities relating d to i and v

a (1) a (0) (1 i ) 1 i

d

a (1) 1 i 1 i

i d

d i Note: d < i

1 i 1 d

i (1 i ) i 1

1 d 1 v

1 i 1 i 1 i

Present and accumulated values in

terms of d:

1

1 d v

1 i

• Present value = principal * (1-d)t

• Accumulated value = principal * [1/(1-d)t]

If we consider positive and negative values of t then:

a(t) = (1 - d)-t

Examples (p. 13)

1. 1000 is to be accumulated by January 1,

1995 at a compound rate of discount of 9%

per year.

a) Find the present value on January 1, 1992

b) Find the value of i corresponding to d

2. Jane deposits 1000 in a bank account on

August 1, 1996. If the rate of compound

interest is 7% per year, find the value of

this deposit on August 1, 1994.

1.5 NOMINAL RATE OF INTEREST

Example (p. 13)

A man borrows 1000 at an effective rate

of interest of 2% per month. How much

does he owe after 3 years?

interest periods in any particular

problem

More examples… (p. 14)

• You want to take out a mortgage on a house and

discover that a rate of interest is 12% per year.

However, you find out that this rate is “convertible

semi-annually”. Is 12% the effective rate of interest

per year?

• Credit card charges 18% per year convertible

monthly. Is 18% the effective rate of interest per

year?

of interest (12% and 18%) were nominal rates of interest

Definition

m times per year

• The nominal rate of interest i(m) is

defined so that i(m) / m is an effective

rate of interest in 1/m part of a year

Note:

If i is the effective

rate of interest per In other words,

year, it follows that i is the effective rate of

m interest

i (m)

1 i 1

convertible annually

which is equivalent to the

m

effective rate of interest

Equivalently: i(m) /m convertible mthly.

(m)

i

[1 i ]

1/ m

1

m

Examples (p. 15)

1. Find the accumulated value of 1000 after

three years at a rate of interest of 24 %

per year convertible monthly

rate of interest convertible semi-annually

Nominal rate of discount

defined so that d (m) / m is an effective

rate of interest in 1/m part of a year

• Formula:

m

d (m)

1 d 1

m

Formula relating nominal rates of

interest and discount

n m

d (n)

i (m)

1 d 1 1 i 1

n m

1

1 d

1 i i (m) m

d (n) n

1 1

m n

1

1 i (1 d )

Example

• Find the nominal rate of discount

convertible semiannualy which is

equivalent to a nominal rate of interest

of 12% convertible monthly

m n

i (m)

d (n)

1 1

m n

1.6 FORCE OF INTEREST

periods is very large?

• One can consider mathematical model

of interest which is convertible

continuously

• Then the force of interest is the nominal

rate of interest, convertible continuously

Definition

Nominal rate of interest

equivalent to i:

i ( m)

m[(1 i) 1/ m

1]

Let m approach infinity: lim i

( m)

lim m[(1 i) 1/ m

1]

m m

lim i ( m)

lim m[(1 i) 1/ m

1]

m m

Formula

• Force of interest δ = ln (1+i)

• Therefore eδ = 1+i

• and t

a (t) = (1+i) =e δt

formula gives good approximation

to a(t) when m is very large

Example

• A loan of 3000 is taken out on June 23,

1997. If the force of interest is 14%, find

each of the following:

– The value of the loan on June 23, 2002

– The value of i

– The value of i(12)

Remark

t

[(1 i ) ] (1 i ) ln(1 i ) (1 i )

t t

[(1 i ) ] a(t )

t

(1 i ) t

a (t )

of interest for arbitrary accumulation function a(t)

Definition

The force of interest corresponding to a(t):

a(t )

t

a (t )

Note:

1) in general case,

force of interest depends on t

2) it does not depend on t ↔ a(t)= (1+i)t !

Example (p. 19)

• Solution

a(t ) (1 it ) i

t

a(t ) 1 it 1 it

How to find a(t)

if we are given by δt ?

a(t )

We have: t

a (t )

is unknown function:

a a

t

t

Since a(0) = 1

r dr

a (t ) e

its solution is given by 0

Applications

• Prove that if δt = δ is a constant then

a(t) = (1+i)t for some i

• Prove that for any amount function A(t) we

have: n

A(t ) t dt A(n) A(0)

0

interest over the infinitesimal “period of time”

dt . Hence A(t)δt dt is the amount of interest

earned in this period and the integral is the

total amount

Remarks

• Do we need to define the force of discount?

• It turns out that the force of discount

coincides with the force of interest!

(Exercise: PROVE IT)

• Moreover, we have the following

inequalities:

d d (m)

d ( m 1)

i ( m 1)

i (m)

i

• and formulas:

1 1 1 1 1

1 and (m)

d i d i (m) m

Chapter 2

INTEREST: BASIC APPLICATIONS

• Equation of Value

• Unknown Rate of Interest

• Time-Weighted Rate of Return

2.1 Equation of Value

• Four numbers:

• principal A(0)

• accumulated value A(t) = A(0) ∙ a(t)

• period of investment t (determine

effective period in order to compute t)

• rate of interest i

• Time diagram

• Bring all entries of the diagram to the

same point in time and set

equation of value

Examples

1. Find the accumulated value of 500 after 173 months

at a rate of compound interest of 14% convertible

quarterly (p. 30)

2. Alice borrows 500 from FF Company at a rate of

interest 18% per year convertible semi-annually.

Two years later she pays the company 3000. Three

years after that she pays the company 2000. How

much does she owe seven years after the loan is

taken out? (p. 31)

3. Eric deposits 8000 on Jan 1, 1995 and 6000 on

Jan 1, 1997 and withdraws 12000 on Jan 1, 2001.

Find the amount in Eric’s account on Jan 1, 2004 if

the rate of compound interest is 15% per year (p. 31)

More Examples…

4. (Unknown time) John borrows 3000

from FFC. Two years later he borrows

another 4000. Two years after that he

borrows an additional 5000. At what

point in time would a single loan of

1200 be equivalent if i = 0.18 ? (p. 32)

5. (Unknown rate of interest) Find the rate

of interest such that an amount of

money will triple itself over 15 years

(p. 32)

2.2 UNKNOWN RATE OF INTEREST

• Set up equation of value and solve it for i

• Very often the resulting equation is a polynomial

equation in i of degree higher than 2

• In general, there is no formula for solutions of

equation of degree ≥ 5 (and the formulas for

degrees 3 or 4 are very complicated)

• Use approximations (numerical methods)

Examples

1. Joan deposits 2000 in her bank

account on January 1, 1995, and then

deposits 3000 on January 1, 1998. If

there are no other deposits or

withdrawals and the amount of money

in the account on January 1, 2000 is

7100, find the effective rate of interest.

2. Obtain a more exact answer to the

previous question

2.3 TIME-WEIGHTED RATE OF RETURN

• Let B0, B1, … , Bn-1, Bn denote balances in a fund such

that precisely one deposit or withdrawal (denoted by

Wt) is made immediately after Bt starting from t=1

• Let W1, … , Wn-1 denote the amounts of deposits

(Wt > 0) or withdrawals (Wt > 0) and let W0 = 0

• Determine rate of interest earned in the time period

between balances: Bt

it 1

Bt 1 Wt 1

i = (1+i1) (1+i2) … (1+in) - 1

Example (p. 35)

On January 1, 1999, Graham’s stock portfolio is worth

500,000. On April 30, 1999, the value has increased to

525,000. At that point, Graham adds 50,000 worth of stock

to this portfolio. Six month later, the value has dropped to

560,000, and Graham sells 100,000 worth of stock. On

December 31, 1999, the portfolio is again worth 500,000.

Find the time-weighted rate of return for Graham’s

portfolio during 1999.

Chapter 3

ANNUITIES

• Basic Results

• Perpetuities

• Unknown Time and

Unknown Rate of Interest

• Continuous Annuities

• Varying Annuities

3.2 Basic Results

• Definition: Annuity is a series of

payments made at regular intervals

• Practical applications: loans, mortgages,

periodic investments

• Basic model: consider an annuity under

which payments of 1 are made at the

end of each period for n equal periods

Formulas

Series of n payments

present value of of 1 unit accumulated value

annuity an| of annuity sn|

1 1 1 1

0 1 2 3 ….. n

to the sum of present (accumulated) values of each payment

an v v 2 v 3 v n

1 vn sn (1 i ) n an

an

i

(1 i ) n 1

sn

i

Examples (p. 46)

1. (Loan) John borrows 1500 and wishes to pay it

back with equal annual payments at the end of

each of the next ten years. If i = 17% determine the

size of annual payment

2. (Mortgage) Jacinta takes out 50,000 mortgage. If

the mortgage rate is 13% convertible semiannually,

what should her monthly payment be to pay off the

mortgage in 20 years?

3. (Investments) Eileen deposits 2000 in a bank

account every year for 11 years. If i = 6 % how

much has she accumulated at the time of the last

deposit?

One more example… (p. 47)

• Elroy takes out a loan of 5000 to buy a

car. No payments are due for the first 8

months, but beginning with the end of

9th month, he must make 60 equal

monthly payments. If i = 18%, find:

a) the amount of each payment

b) the amount of each payment if there

is no payment-free period

Annuity-immediate and Annuity-due

an| Annuity-immediate sn|

(payments made at the end)

1 1 1 1

0 1 2 3 ….. n

än|

Annuity-due ..

(payments made at the beginning) sn|

1 1 1 1

1 2 3 ….. n n+1

an an (1 i) 1 vn 1 vn 1 vn

an an (1 i) (1 i) i

i 1 i

d

sn sn (1 i) 1 vn (1 i ) n 1

an sn

d d

Example (p. 50)

repays it with 10 equal yearly payments,

the first one due at the time of the loan.

Find the amount of each payment if

i = 16%

3.3 Perpetuities

whose payments continue forever

• Practical applications: perpetual bonds

• Basic model: consider perpetuity under

which payments of 1 are made forever

Formulas

present value of

perpetuity a∞|

1 1 1

0 1 2 3 …..

1

a v v v v ... v

2 3 n k

a

k 1

i

1 vn 1

a lim an lim

n n i i

1 1 i 1 1

a a (1 i ) (1 i ) a

i i d d

3.4 Unknown Time and Unknown

Rate of Interest

Examples – Unknown Time

1. A fund of 5000 is used to award scholarships of amount 500, one

per year, at the end of each year for as long as possible. If i=9%

find the number of scholarships which can be awarded, and the

amount left in the fund one year after the last scholarship has

been awarded

2. A trust fund is to be built by means of deposits of amount 5000 at

the end of each year, with a terminal deposit, as small as

possible, at the end of the final year. The purpose of this fund is to

establish monthly payments of amount 300 into perpetuity, the

first payment coming one month after the final deposit. If the rate

of interest is 12% per year convertible quarterly, find the number

of deposits required and the size of the final deposit

Example – Unknown Rate of Interest

the present value of 300 paid at the end of

every month, for the next 5 years, equal to

15,000?

• 1st method: linear interpolation

• 2nd method: successive approximations

3.5 Continuous Annuities

Let effective period be 1/m part of the year and i(m)/m

be the effective rate of interest: (1+ i(m)/m)m = 1 + i

of 1/m

(m) ( m)

a s

n| 1/m 1/m 1/m 1/m n|

n = nm(1/m)

1 v n

a (m)

(m)

n| i

(1 i ) 1

n

s (m)

( m)

n| i

Let m approach infinity…

t

1 i mn (m)

mn

1( m) t / m

a lim a lim 1

• Present

(m) value a lim

lim a v

m of ncontinuous

m annuity

n| |

t 1 m m n| mmt1 mn|

n n n n

v 1 v 1 v 1

0of continuous sn| lim s

( m)

• v dt

t

Accumulated

value

1 lnm1

ln v annuity i n|

ln

1 i

Formulas:

1 vn 1 vn

ln1 i

1 v n

(1 i ) 1 n

a sn|

n|

3.6 Varying Annuities

• Arithmetic annuities

– increasing

– decreasing

• Arithmetic increasing perpetuities

Arithmetic annuity

• Definition: Arithmetic annuity is a series

of payments made at regular intervals

such that

– the first payment equals P

– payments increase by Q every year

• Thus payments form arithmetic

progression P, P+Q, P+2Q, …, P+(n-1)Q

Formulas

Series of n payments

k-th payment = P+ (k-1)Q

k=1,2,…, n accumulated value

present value S

A

P P+Q P+2Q P+(n-1)Q

0 1 2 3 ….. n

an nvn sn n

A Pan Q S Psn Q

i i

1) Increasing annuity with P = 1, Q = 1

Series of n payments

k-th payment = k accumulated value

present value

k=1,2,…, n

(Ia)n| (Is)n|

1 2 3 n

0 1 2 3 ….. n

an nvn sn n

We have: A Pan Q S Psn Q

i i

P=1 an nvn sn n

Q=1 ( Ia ) n an ( Is ) n sn

i i

2) Decreasing annuity with P = n, Q = -1

Series of n payments

k-th payment = n – k + 1 accumulated value

present value

k=1,2,…, n

(Da)n| (Ds)n|

n n-1 n-2 1

0 1 2 3 ….. n

an nvn sn n

We have: A Pan Q S Psn Q

i i

P=n an nvn sn n

Q = -1 ( Da) n nan ( Ds) n nsn

i i

Two Special Cases

n an n(1 i) sn

n

( Da ) n ( Ds) n

i i

Increasing perpetuity

present value k-th payment = k

continues forever

(Ia)∞|

1 2 3

0 1 2 3 …..

1 v n

an nv n nv n

n n i n i

1 1

( Ia ) 2

i i

Examples (p. 62 - 65)

1. Find the value, one year before the first payment, of a

series of payments 200, 500, 800,… if i = 8% and the

payments continue for 19 years

2. Find the present value of an increasing perpetuity

which pays 1 at the end of the 4th year, 2 at the end of

the 8th year, 3 at the end of the 12th year, and so on, if i

= 0.06

3. Find the value one year before the first payment of an

annuity where payments start at 1, increase by annual

amounts of 1 to a payment of n, and then decrease by

annual amounts of 1 to a final payment of 1

4. Show both algebraically and verbally that

(Da)n| = (n+1)an| - (Ia)n|

More examples: Geometric annuities

1. (Geometric annuity) An annuity provides for 15 annual

payments. The first is 200, each subsequent is 5% less

than the one preceding it. Find the accumulated value

of annuity at the time of the final payment if i = 0.9

2. (Inflation and real rate of interest) In settlement of a

lawsuit, the provincial court ordered Frank to make 8

annual payments to Fred. The firs payment of 10,000 is

made immediately, and future payments are to increase

according to an assumed rate of inflation of 0.04 per

year. Find the present value of these payments

assuming

i = .07

Chapter 4

AMORTIZATION AND

SINKING FUNDS

• Amortization

• Amortization Schedule

• Sinking Funds

• Yield Rates

4.1 Amortization

• Amortization method: repay a loan by means of

installment payments at periodic intervals

• This is an example of annuity

• We already know how to calculate the amount

of each payment

• Our goal: find the outstanding principal

• Two methods to compute it:

– prospective

– retrospective

Two Methods

• Prospective method:

outstanding principal at any point in time is equal

to the present value at that date of all remaining

payments

• Retrospective method:

outstanding principal is equal to the original

principal accumulated to that point in time minus

the accumulated value of all payments previously

made

• Note: of course, this two methods are equivalent.

However, sometimes one is more convenient than

the other

Examples (p. 75-76)

• (prospective) A loan is being paid off with

payments of 500 at the end of each year for the

next 10 years. If i = .14, find the outstanding

principal, P, immediately after the payment at the

end of year 6.

• (retrospective) A 7000 loan is being paid of with

payments of 1000 at the end of each year for as

long as necessary, plus a smaller payment one

year after the last regular payment. If i = 0.11

and the first payment is due one year after the

loan is taken out, find the outstanding principal,

P, immediately after the 9th payment.

One more example… (p. 77)

mortgage at 12.5 % convertible semi-annually. He

pays off the mortgage with monthly payments for 20

years, the first one is due one month after the

mortgage is taken out. Immediately after his 60th

payment, John renegotiates the loan. He agrees to

repay the remainder of the mortgage by making an

immediate cash payment of 10,000 and repaying the

balance by means of monthly payments for ten

years at 11% convertible semi-annually. Find the

amount of his new payment.

4.2 Amortization Schedule

• Goal: divide each payment (of annuity) into two parts – interest

and principal

• Amortization schedule – table, containing the following columns:

– payments

– interest part of a payment

– principal part of a payment

– outstanding principal Amortization schedule:

Duration Payment Interest Principal Outstanding

Example: Repaid Principal

5000

at 12 % per year 0 5000.00

repaid by 5 annual 1 13875.05 600.00 787.05 4212.95

payments

2 13875.05 505.55 881.50 3331.45

3 13875.05 399.77 987.28 2344.17

4 13875.05 281.30 1105.75 1238.42

5 13875.05 148.61 1238.44 0

Outstanding Interest earned during

principal interval (t-1,t) is iP

P Therefore interest portion

Payment of payment X is iP

X and principal portion is

X - iP

t-1 t

be found by prospective or retrospective methods

Example

A 1000 loan is repaid by annual payments of 150, plus a

smaller final payment. If i = .11, and the first payment is made

one year after the time of the loan, find the amount of principal

and interest contained in the third payment

General method

outstanding principal at t

present value = outst.

principal at 0 an-t|

an|

1 1 1 1 1

….. …..

0 1 2 t t+1 n

interest part of kth payment = X (1 – vn-k+1 )

principal part of kth payment = X∙vn-k+1

Example (p. 79)

• A loan of 5000 at 12% per year is to be

repaid by 5 annual payments, the first due

one year hence. Construct an amortization

schedule

General rules to obtain an amortization schedule

Duration Payment Interest Principal Outstanding

Repaid Principal

i = 12 %

0 5000.00

1 13875.05 600.00 787.05 4212.95

2 13875.05 505.55 881.50 3331.45

3 13875.05 399.77 987.28 2344.17

4 13875.05 281.30 1105.75 1238.42

5 13875.05 148.61 1238.44 0

I. Take the entry from “Outs. Principal” of the previous row, multiply it by

i, and enter the result in “Interest”

II. “Payment” – “Interest” = “Principal Repaid”

III. “Outs. Principal” of prev. row - “Principal Repaid” = “Outs. Principal”

IV. Continue

Example (p. 80)

• A 1000 loan is repaid by annual payments of 150, plus a smaller

final payment. The first payment is made one year after the time

of the loan and i = .11. Construct an amortization schedule

0 1000

1 150 110.00 40.00 960.00

2

3

4

5

6

7

8

9

10

11

12

4.3 Sinking Funds

• Alternative way to repay a loan – sinking

fund method:

– Pay interest as it comes due keeping

the amount of the loan (i.e.

outstanding principal) constant

– Repay the principal by a single

lump-sum payment at some point in

the future

lump-sum payment L

interest

iL iL iL

…..

0 1 2 n

Loan L

• Lump-sum payment L is accumulated by periodic

deposits into a separate fund, called the sinking fund

• Sinking fund has rate of interest j usually different from

(and usually smaller than) i

• If (and only if) j is greater than i then sinking fund method

is better (for borrower) than amortization method

Examples (p. 82)

• John borrows 15,000 at 17% effective annually. He agrees to

pay the interest annually, and to build up a sinking fund which

will repay the loan at the end of 15 years. If the sinking fund

accumulates at 12% annually, find

– the annual interest payment

– the annual sinking fund payment

– his total annual outlay

– the annual amortization payment which would pay off this

loan in 15 years

• Helen wishes to borrow 7000. One lender offers a loan in

which the principal is to be repaid at the end of 5 years. In the

mean-time, interest at 11% effective is to be paid on the loan,

and the borrower is to accumulate her principal by means of

annual payments into a sinking fund earning 8% effective.

Another lender offers a loan for 5 years in which the

amortization method will be used to repay the loan, with the

first of the annual payments due in one year. Find the rate of

interest, i, that this second lender can charge in order that

Helen finds the two offers equally attractive.

4.4 Yield Rates

• Investor:

– makes a number of payments at various points in

time

– receives other payments in return

• There is (at least) one rate of interest for which the

value of his expenditures will equal the value of the

payments he received (at the same point in time)

• This rate is called the yield rate he earns on his

investment

• In other words, yield rate is the rate of interest which

makes two sequences of payments equivalent

• Note: to determine yield rate of a certain investor, we

should consider only payments made directly to, or

directly by, this investor

Examples (p. 83 – p. 85)

• Herman borrows 5000 from George and

agrees to repay it in 10 equal annual

instalments at 11%, with first payment

due in one year. After 4 years, George

sells his right to future payments to Ruth,

at a price which will yield Ruth 12%

effective

– Find the price Ruth pays.

– Find George’s overall yield rate.

• At what yield rate are payments of 500

now and 600 at the end of 2 years

equivalent to a payment of 1098 at the

end of 1 year?

• Henri buys a 15-year annuity with a

present value of 5000 at 9% at a price

which will allow him to accumulate a 15-

year sinking fund to replace his capital at

7%, and will produce an overall yield rate

of 10%. Find the purchase price of the

annuity.

Chapter 5

BONDS

• Price of a Bond

• Book Value

• Bond Amortization Schedule

• Other Topics

5.1 Price of a Bond

• Bonds

• certificates issued by a corporation or government

• are sold to investors

• in return, the borrower (i.e. corporation or government) agrees:

– to pay interest at a specified rate (the coupon rate) until a specified

date (the maturity date)

– and, at that time, to pay a fixed sum (the redemption value)

• Usually:

– the coupon rate is a nominal rate convertible semiannually and is

applied to the face (or par) value stated on the front of the bond

– the face and redemption values are equal (not always)

• Thus we have:

– regular interest payments

– lump-sum payment at the end

Example of a bond

• Face amount = 500

• Redemption value = 500

• Redeemable in 10 years with semiannual coupons

at rate 11%, compounded semiannually

• Then in return investor receives:

• 20 half-yearly payments of (.055)(500) = 27.50 interest

• a lump-sum payment of 500 at the end of the 10 years

Notations

• F = the face value (or the par value)

• r = the coupon rate per interest period (we assume

that the quoted rate will be a nominal rate 2r

convertible semiannually)

• Note: the amount of each interest payment (coupon)

is Fr

• C = the redemption value (often C = F, i.e. bond

“redeemable at par”)

• i = the yield rate per interest period

• n = the number of interest periods until the

redemption date (maturity date)

• P = the purchase price of a bond to obtain yield rate i

redemption value C

coupon

(interest)

Note: time is

Fr Fr Fr measured in

…..

half-years

0 1 2 n

purchase price P

n

P ( Fr )an|i C (1 i )

Note: often C = F

Examples (p. 94 – p. 96)

• A bond of 500, redeemable at par after 5

years, pays interest at 13% per year

convertible semiannually. Find the price to

yield an investor

– 8% effective per half-year

– 16% effective per year

• Remarks

– P < C since the yield rate is higher than the

coupon rate, i > r

– therefore the investor is buying the bond at a

discount

– otherwise (if i < r) we would have P > C and

then the investor would have to buy the bond

at a premium of P - C

• A corporation decides to issue 15-years

bonds, redeemable at par, with face

amount of 1000 each. If interest payments

are to be made at a rate of 10% convertible

semiannually, and if George is happy with

a yield of 8% convertible semiannually,

what should he pay for one of these

bonds?

• A 100 par-value 15-year bond with coupon

rate 9% convertible semiannually is selling

for 94. Find the yield rate.

5.2 Book Value

• The book value of a bond at a time t is an analog of an

outstanding balance of a loan

• The book value Bt is the present value of all future

payments

• At time t (the tth coupon has just been paid) we have:

n t

Bt ( Fr )an t| Cv

Remarks

– Usually C = F

– In the last formula, an-t and v are computed using the yield rate

i

– P = B0 < Bt < Bt+1< Bn = C or P = B0 > Bt > Bt+1 > Bn = C

Examples (p. 96 - 97)

1. Find the book value immediately after

the payment of 14th coupon of a 10-year

1,000 par-value bond with semiannual

coupons, if r =.05 and the yield rate is

12% convertible semiannually.

2. Let Bt and Bt+1 be the book values just

after the tth and (t+1)th coupons are paid.

Show that Bt+1 = Bt (1+i) – Fr

3. Find the book value in 1) exactly 2

months after the 14th coupon is paid.

How do we find the book value

between coupon payment dates?

Assume simple interest at rate i per period

between adjacent coupon payments

Example

Find the book value exactly 2 months after the 14th

coupon is paid of a 10-year 1,000 par-value bond

with semiannual coupons, if r =.05 and the yield rate

is 12% convertible semiannually.

Alternative approach

• Since Bt+1 = Bt (1+i) – Fr we can view Bt (1+i) as the book value just

before next (i.e. (t+1)th) coupon is paid

• Book value calculated using simple interest between coupon dates

is called the flat price of a bond

• Using linear interpolation between Bt+1 and Bt we obtain the market

price (or the amortized value) of the bond

• Clearly market price ≤ flat price at any given moment

(1+i) Bt

Fr

Bt Bt+1

t t+1

Example (p. 98)

Find the market price exactly 2 months

after the 14th coupon is paid of a

10-year 1,000 par-value bond with

semiannual coupons, if r =.05 and the

yield rate is 12% convertible

semiannually.

5.3 Bond Amortization Schedule

• Goal: trace changes of the book value

• Bond amortization schedule – table, containing the following

columns:

Time Coupon Interest Principal Book Value

– time adjustment

– coupon 0 1037.17

– interest

1 40 31.12 8.88 1028.29

– principal adjustment

2 40 30.85 9.15 1019.14

– book value 3 40 30.57 9.43 1009.71

4 40 30.29 9.71 1000.00

Example

1000 par value two-year bond which pays interest at 8%

convertible semiannually; yield rate is 6% convertible

semiannually

Algorithm

• Book value at time t is Bt

• Amount of coupon at time t+1 is Fr

• The amount of interest contained in this coupon is iBt

• Fr – iBt represents the change in the book value

between these dates

adjustment

0 1037.17

2 40 30.85 9.15 1019.14

3 40 30.57 9.43 1009.71

4 40 30.29 9.71 1000.00

Example (p. 99)

with semiannual coupons, r = .05 and the

yield rate i = 0.06 effective semiannually.

Find the amount of interest and change in

book value contained in the 15th coupon

of the bond.

Example (p. 99)

• Construct a bond amortization schedule

for a 1000 par-value two-year bond which

pays interest at 8% convertible

semiannually, and has a yield rate of 6%

convertible semiannually

0 1037.17

1 40 31.12 8.88 1028.29

2

3

4

5.4 Other Topics

• Different frequency of coupon payments

• Increasing or decreasing coupon

payments

• Different yield rates

• Callable bonds

Examples (p. 101 – p. 102)

• (Different frequency) Find the price of a 1000 par-value

10-year bond which has quarterly 2% coupons and is

bought to yield 9% per year convertible semiannually

• (Increasing coupon payments) Find the price of a 1000

par-value 10-year bond which has semiannual coupons of

10 the first half-year, 20 the second half-year,…, 200 the

last half-year, bought to yield 9% effective per year

• (Different yield rates) Find the price of a 1000 par-value

10-year bond with coupons at 11% convertible

semiannually, and for which the yield rate is 5% per half-

year for the first 5 years and 6% per half-year for the last 5

years

Callable bonds

to redeem the bond at any of several time points

• The earliest possible date is the call date and the latest is

the usual maturity date

• Once the bond is redeemed, no more coupons will be paid

possible

redemption

Examples (p. 103 – p. 105)

• Consider a 1000 par-value 10-year bond with semiannual

5% coupons. Assume this bond can be redeemed at par at

any of the last 4 coupon dates. Find the price which will

guarantee an investor a yield rate of

– 6% per half-year

– 4% per half-year

• Consider a 1000 par-value 10-year bond with semiannual

5% coupons. This bond can be redeemed for 1100 at the

time of the 18th coupon, for 1050 at the time of the 19th

coupon, or for 1000 at the time of 20th coupon. What price

should an investor pay to be guaranteed a yield rate of

– 6% per half-year

– 4% per half-year

Chapter 6

PREPARATION FOR

LIFE CONTINGENCIES

• Introduction

• Contingent

Payments

6.1 Introduction

• Ideal situation: all payments are made

• Real-life situations:

– failure to make a payment

– default on a loan

– bad credit ratings

– life contingencies and life insurance

• Contingent payments (we need to combine

the theory of interest and elementary

probability)

6.3 Contingent Payments

• Assume that for each payment of the loan (annuity,

bond etc.) there is a probability that this payment is

made

• Finding the present value of such sequence of

payments we need to take into account these

probabilities

• We need to find present value of expected values of all

payments

Contingent Payments - Example

• Example Henry borrows 1000 from Amicable

Trust and agrees to repay the loan in one

year. If payment were certain, the company

would charge 13% interest. From prior

experience, however, it is determined that

there is a 5% chance that Henry will not repay

any money at all. What should Amicable Trust

ask Henry to repay?

Examples

• (Loan) The All-Mighty Bank lends 50,000,000 to a small Central

American country, with the loan to be repaid in one year. It is felt that

there is a 20% chance that a revolution will occur and that no money

will be repaid, a 30% chance that due to inflation only half the loan will

be repaid, and a 50% chance that the entire loan will be repaid. If

payments were certain, the bank would charge 9%. What rate of

interest should the bank charge?

• (Payments contingent upon survival) Mrs. Rogers receives 1000 at

the end of each year as long as she is alive. The probability is 80%

she will survive one year, 50% she will survive 2 years, 30% she will

survive 3 years, and negligible that she will survive longer than 3

years. If the yield rate is 15%, what should Mrs. Rogers place on

these payments now?

• (Life insurance) An insurance company issues a policy which pays

50,000 at the end of the year of death, if death should occur during

the next two years. The probability that a 25-year-old will live for one

year is .99936, and the probability he will live for two years is .99858.

What should the company charge such a policy holder to earn 11% on

its investments?

• Alphonse wishes to borrow some money form Friendly

Trust. He promises to repay 500 at the end of each year

for the next 10 years, but there is a 5% chance of default

in any year. Assume that once default occurs, no further

payments will be received. How much can Friendly Trust

lend Alphonse if it wishes to earn 9% on its investments?

• Redo the last example, without the restriction that once

default occurs, no further payments will be received

• A 20-year 1000 face value bond has coupons at 14%

convertible semiannually and is redeemable at par.

Assume a 2% chance that, in any given half-year, the

coupon is not issued, and that once default occurs, no

further payments are made. Assume as well that a bond

can be redeemed only if all coupons have been paid. Find

the purchase price to yield on investor 16% convertible

semiannulllay.

Chapter 7

LIFE TABLES AND

POPULATION PROBLEMS

• Introduction

• Life Tables

• The Stationary Population

• Expectation of Life

7.1 Introduction

• How do we find probabilities?

• Data obtained from practice

• Data required to find

probabilities of surviving

to certain ages (or, equivalently, of

dying before certain ages) are

contained in life tables

7.2 Life Tables

Age lx dx 1000 qx

0 1,000,000 1580 1.58

1 998,420 680 . 68

2 997,740 485 .49

3 997,255 435 .44

• Thus l0 = 1,000,000 is a starting population

• Survival function S(x) = lx / l0 is the probability of surviving

to age x

• dx = lx – lx+1 – number of lives who died between (x, x+1)

• qx = dx /lx – probability that x – year-old will not survive to

age x + 1

Examples (p. 129 – p. 130)

Age lx dx 1000 qx

0 1,000,000 1580 1.58

1 998,420 680 68

2 997,740 485 .49

3 997,255 435 .44

• Find

– the probability that a newborn will live to age 3

– the probability that a newborn will die between

age 1 and age 3

• Find an expression for each of the following:

– the probability that an 18-year-old lives to age 65

– the probability that a 25-year-old dies between ages

40 and 45

– the probability that a 25-year-old does not die

between ages 40 and 45

– the probability that a 30-year-old dies before age 60

• There are four persons, now aged 40, 50, 60 and 70.

Find an expression for the probability that both the 40-

year-old and the 50-year-old will die within the five-year

period starting ten years from now, but neither the 60-

year-old nor the 70-year-old will die during that five-year

period

Note:

• If we are already given by probabilities qx and

starting population l0 we can construct the

whole life table step-by-step since dx = qx lx

and lx+1 = lx - dx

Example

Given the following probabilities of deaths

q q q q

0 = .40, 1 = .20, 2 = .30, 3 = .70, q4 = 1 and

l

starting with 0 = 100 construct a life table

More notations…

• qx = dx / lx – probability that x – year-old will not

survive to age x + 1

• px = 1- qx – probability that x – year-old will survive to

age x + 1

• Note: qx = (lx – lx+1) / lx and px = lx+1 / lx

• nqx – probability that x – year-old will not survive to age

x+n

• npx = 1- nqx – probability that x – year-old will survive to

age x + n

• Note: nqx = (lx – lx+n) / lx and n px = lx+n / lx

• Formulas:

lx – lx+n = dx + dx+1 + …+ dx+n

n+mpx = mpx ∙ npx+m

What is mPx when m is not integer?

• Assuming that deaths are distributed

uniformly during any given year we can use

linear interpolation to find tpx :

l x td x l x t (l x l x 1 ) (1 t )l x tlx 1

t px

lx lx lx

Examples (p. 132 – p. 133)

• 30% of those who die between ages 25 and 75 die

before age 50. The probability of a person aged 25 dying

before age 50 is 20%. Find 25P50

• Using the following life table and assuming a uniform

distribution of deaths over each year, find:

– 4/3P1

– The probability that a newborn will survive the first year but die in

the first two months thereafter

Age lx dx 1000 qx

0 1,000,000 1580 1.58

1 998,420 680 .68

2 997,740 485 .49

3 997,255 435 .44

7.3 Analytic Formulas for lx

• Properties of lx

• de Moivre’s Law

• Force of mortality

• Gompertz and Makeham formulas

Properties of lx and S(x) = lx / l0

• Decreasing

• Vanishes after terminal age of the

population ω

• Decreases more rapidly near 0 and

ω-∆ (population-dependant, e.g. 65-70)

lx

l0

ω-∆ ω

de Moivre’s Law

• First approximation – linear

x

l x a1

• Derivative is constant

• Hence, the function does not satisfy the

last property

• However, is reasonable in the middle

range of ages

Examples

• Find probabilities of survival tPx and of

dying tqx for de Moivre’s law

• Let

lx x

– Find tPx and t qx

– Henry and Henrietta are 19 years old. Find

the probability that Henry survives at least 17

years, Henrietta lives at most 45 more years,

and at least one of them survives for 32 years

Force of mortality

• Given that a person survived to age x, what is the probability that a

person does not survive to age x+∆x?

S ( x) S ( x x)

P( x X x x | X x)

S ( x)

• Dividing by ∆x and letting ∆x → 0 we get the force of mortality, that can

be interpreted as conditional density of dying at age x given that

person survived to age x

S ( x) S ( x x)

lim

P( x X x x | X x) x0 x

x lim

x 0 x S ( x)

S ( x x) S ( x)

lim

x 0 x

S 'x

ln l x

l 'x d

S ( x) Sx lx dx

Force of mortality

• Unconditional density of dying at age x is

μx Sx = - S’x

(recall: Sx is the probability of surviving to age x)

• Indeed, if a random variable X denotes age, then

Sx = P(X ≥ x ) = 1 – P(X < x) = 1 – F(x)

and therefore

-S’x = F’(x), the density of dying

Force of mortality

lx as follows:

x ln l x

d x

lx r dr

dx S ( x) e 0

x l0

dr ln l

0

r x ln l0

Gompertz formula (age-dependant)

x Bc x

x x

r dr Bc r dr

l x l0 S ( x ) l0 e 0

l0 e 0

x

Bc ln c B ln c c

l0 e l0 e l0 g

x

cx

l x l0 g , 0 g 1

cx

Makeham formula

(introduces age-independent term)

x A Bc x

x x

r dr A Bc r dr

l x l0 S ( x ) l0 e 0

l0 e 0

e

x

( Ax Bc ln c ) Ax B ln c c

l0 e l0 e l0 s g

x

x cx

l x l0 s g , 0 g 1

x cx

Exercise

• Check whether Gompertz and

Makeham formulas satisfy properties of

survival function. Which requirements

should we impose on the constants in

theses formulas (A, B, c, g, etc.)?

7.4 The Stationary Population

• Assume that in every given year (or, more precisely, in any

given 12-months period) the number of births and deaths is

the same and is equal to l0

• Then after a period of time the total population will remain

stationary and the age distribution will remain constant

• px and qx are defined as before

• lx denotes the number of people who reach their xth birthday

during any given year

• dx = qx lx represent the number of people who die before

reaching age x+1

• Also, dx represent the number of people who die during any

given year between ages x and x + 1

• Similarly lx – lx + n represent the number of people who die

during any given year between ages x and x + n

Number of people aged x

• Let Lx denote the number of people aged x

(last birthday) at any given moment

• Note: Lx ≠ lx

obtain: L l 1 d l 1 (l l ) 1 (l l )

x x x x x x 1 x x 1

2 2 2

• More precisely: 1

Lx l x t dt

0

Number of people aged x and over

• Let Tx denote the number of people

aged x and over at any given moment

• Then Tx Lxi

i 0

1 1

Tx (l x i l x i 1 ) l x l x i

i 0 2 2 i 1

• More precisely:

Tx l x t dt

0

Example (p. 139)

• An organization has a constant total membership. Each

year 500 new members join at exact age 20.

20% leave after 10 years, 10% of those remaining

leave after 20 years, and the rest retire at age 65.

Express each of the following in terms of life table

functions:

– The number who leave at age 40 each year

– The size of the membership

– The number of retired people alive at any given time

– The number of members who die each year

7.5 Expectation of Life

• What is the average future life time ex of

a person aged x now?

• The answer is given by expected value

(or mathematical expectation) and is

called the curtate expectation:

ex t (t p x t 1 p x ) 1(1 p x 2 p x ) 2( 2 p x 3 p x ) 3( 3 p x 4 p x )

t 1

px 2 px 3 px t px

t 1

Complete Expectation

l x t

(1) ex t p x (2) Tx l x t dt (3) t px

t 1 0

lx

0

Tx

(2)&(3)&(4) imply: e x

lx

1

(since Tx 2 lx lx i )

1

Approximation: e x

ex

i 1

2

Remarks

Tx

e x

Tx l x e x

lx

Thus Tx can be interpreted

as the total number of years of future life

of those who form group lx

in any population (stationary or not)

Average age at death

• Average age at death of a person currently

aged x is given by

Tx

x ex x

lx

death for all deaths among l0 individuals

T0

e 0

l0

Examples (p. 142 – 143)

• If tp35 = (.98)t for all t, find e35 and eo35

without approximation. Compare the

value for eo35 with its approximate value

Tx-Tx+n – nlx+n

who die between age x and age x+n

Chapter 8

LIFE ANNUITIES

• Basic Concepts

• Commutation Functions

8.1 Basic Concepts

• We know how to compute present value of

contingent payments

surviving

present values of payments which are

contingent on either survival or death

Example (pure endowment), p. 155

age 65, he will receive a single payment

of 50,000. If i = .12, find an expression

for the value of this payment to Yuanlin

today. Use the following entries in the

life table: l38 = 8327, l65 = 5411

Pure Endowment

• Pure endowment: 1 is paid t years from

now to an individual currently aged x if

the individual survives

• Probability of surviving is t px

• Therefore the present value of this

payment is the net single premium for

the pure endowment =

= t Ex = (t px ) (1 + t) – t = v t t px

Example (life annuity), p. 156

• Aretha is 27 years old. Beginning one year

from today, she will receive 10,000 annually

for as long as she is alive. Find an expression

for the present value of this series of

payments assuming i = .09

• Find numerical value of this expression if

px = .95 for each x

Life annuity

Series of payments of 1 unit

present value

as long as individual is alive

(net single premium)

of annuity ax

1 1 1

…..

probability px 2px npx

ax vpx v 2

2 px v 3 px v

3 n

n p x v t p x

t

t 1

Temporary life annuity

Series of n payments of 1 unit

(contingent on survival)

present value

last payment

ax:n|

1 1 1

probability px 2px npx

n

ax:n| vpx v 2

2 px v 3 px v

3 n

n p x v t p x

t

t 1

n - years deferred life annuity

Series of payments of 1 unit as long as individual is alive

in which the first payment is at x + n + 1

n|ax 1 1

probability n+1px n+2px

n2 n 3 n t

n | a x v n1

p

n 1 x v p

n2 x v p

n 3 x v n t p x

v n t n t p x s px

v s

t 1 s n 1

| a x a x a x:n|

Note: n

äx Life annuities-due

1 1 1 1

ax 1 ax 1 v t t px

x x+1 x+2 ….. x+n … t 1

1 1 1 1 n 1

ax:n| 1 ax:n1| 1 vt t px

x x+1 x+2 ….. x + n-1 x+n t 1

px 2px n-1px

n|äx

1 1 1

n | ax n 1 | a x

x x+1 x+2 … x+n x + n +1 x + n + 2 …

npx n+1px n+2px

Note

ax:n| 1 ax:n1| but ax:n| (1 i)ax:n|

8.2 Commutation Functions

• Recall: present value of a pure endowment

of 1 to be paid n years hence to a life

currently aged x

n lxn xn

v lxn

n Ex v n px v

n

x

lx v lx

• Denote Dx = v xlx

• Then nEx = Dx+n / Dx

Life annuity and commutation function

a x v t p x t E x

t

E = Dx+n / Dx

Since n x

t 1 t 1 we have

ax

Dx t

1

Dx1 Dx2 Dx3

t 1 Dx Dx

N x Dx t v x t l x t

Define commutation function

Nx as follows: t 0 t 0

N x 1 Note:

Then: ax

Dx Dx N x 1 N x

Identities for other types of life annuities

n

Dx t N x 1 N x n 1

a x:n|

t 1 Dx Dx

N x n1

n | ax

Dx

temporary life annuity-due

N x N xn

ax:n|

Dx

Accumulated values of life annuities

temporary life annuity ax:n| n Ex s x:n|

N x 1 N x n1 Dx n

since ax:n| and n Ex

Dx Dx

we have N x 1 N x n1

sx:n|

Dx n

similarly for temporary life annuity-due:

and sx:n|

Dx n

Examples (p. 162 – p. 164)

38, purchases a life annuity of 1000 per year. From

tables, we learn that N38 = 5600 and N39 = 5350. Find

the net single premium Marvin should pay for this

annuity

– if the first 1000 payment occurs in one year

– if the first 1000 payment occurs now

• Stay verbally the meaning of (N35 – N55) / D20

• (unknown rate of interest) Given Nx = 5000, Nx+1=4900,

Nx+2 = 4810 and qx = .005, find i

Select group

• Select group of population is a group with the

probability of survival different from the

probability given in the standard life tables

probability of survival (e.g. due to excellent

health) or, conversely, higher mortality rate

(e.g. due to dangerous working conditions)

Notations

• Suppose that a person aged x is

in the first year of being in the select group

• Then p[x] denotes the probability of survival for 1 year

and q[x] = 1 – p[x] denotes the probability of dying during

1 year for such a person

• If the person stays within this group for subsequent

years, the corresponding probabilities of survival for 1

more year are denoted by p[x]+1, p[x]+2, and so on

• Similar notations are used for life annuities:

a[x] denotes the net single premium for a life annuity of

1 (with the first payment in one year) to a person aged

x in his first year as a member of the select group

• A life table which involves a select group is called a

select-and-ultimate table

Examples (p. 165 – p. 166)

• (select group) Margaret, aged 65, purchases a life annuity

which will provide annual payments of 1000 commencing at

age 66. For the next year only, Margaret’s probability of

survival is higher than that predicted by the life tables and, in

fact, is equal to p65 + .05, where p65 is taken from the

standard life table. Based on that standard life table, we have

the values D65 = 300, D66 = 260 and N67 = 1450. If i = .09,

find the net single premium for this annuity

• (select-and-ultimate table) A select-and-ultimate table has a

select period of two years. Select probabilities are related to

ultimate probabilities by the relationships p[x] = (11/10) px and

p[x]+1 = (21/20) px+1. An ultimate table shows D60 = 1900,

D61 = 1500, and ä 60:20| = 11, when i = .08. Find the select

temporary life annuity ä[60]:20|

• The following values are based on a unisex life table:

N38 = 5600, N39 = 5350, N40 = 5105, N41 = 4865,

N42 = 4625.

It is assumed that this table needs to be set forward

one year for males and set back two years for

females. If Michael and Brenda are both age 40, find

the net single premium that each should pay for a life

annuity of 1000 per year, if the first payment occurs

immediately.

8.3 Annuities Payable mthly

• Payments every mth part of the year

• Problem: commutation functions reflect

annual probabilities of survival

• First, we obtain an approximate formula

for present value

• Assume for a moment that the values Dy

are also given for non-integer values of y

Usual life annuity

ax

1 1 1

…..

a(m)x

1/m 1/m 1/m 1/m

…..

1/m 2/m (m-1)/m

Annuity payable every 1/m part of the year

a(m)x

1/m 1/m 1/m 1/m

…..

1/m 2/m (m-1)/m

1 1/ m

a v 1/ m p x v 2 / m 2 / m p x v i j / m i j / m p x

( m)

x

m

1 1/ m l x 1/ m 2 / m lx2 / m

l

i j / m x i j / m

v v v

m lx lx lx

1 v x 1/ ml x 1/ m v x 2 / ml x 2 / m

x i j / m

v l x i j / m

x

x

m v l x v lx v xl x

1 Dx 1/ m Dx 2 / m Dx i j / m

m Dx Dx Dx

Annuity payable every 1/m part of the year

a(m)x

1/m 1/m 1/m 1/m

…..

1/m 2/m (m-1)/m

1 Dx 1/ m Dx 2 / m Dx i j / m

a (m)

x

m Dx Dx Dx

1 Dx 1/ m Dx 2 / m Dx ( m 1) / m Dx 1

mDx Dx 11/ m Dx 1 2 / m Dx 1 ( m 1) / m Dx 2

1 m m 1 m

Dx 1 j / m Dx 1 j / m Dx i j / m

mDx j 1 j 1 mDx i 0 j 1

Using linear interpolation for Dx+i+j/m

Dx i j / m Dx i mj Dx i 1 Dx i

m m

D x i j / m Dx i mj Dx i 1 Dx i

j 1 j 1

m

m(m 1)

mDx i Dx i 1 Dx i mj mDx i Dx i 1 Dx i

j 1 2m

(m 1)

mDx i Dx i 1 Dx i

2

m

D

i 0 j 1

x i j / m

(m 1) (m 1) (m 1)

mDx Dx 1 Dx mDx 1 Dx 2 Dx 1 mDx 2 Dx 3 Dx 2

2 2 2

(m 1)

mDx 1 Dx 2 mDx Dx 1 Dx Dx 2 Dx1 Dx3 Dx 2

2

m 1

mN x 1 Dx

2

Using linear interpolation for Dx+i+j/m

m

m 1

D

i 0 j 1

x i j / m mN x 1

2

Dx

1 m 1 N x 1 m 1 m 1

a ( m)

x mN x 1 2 Dx D 2m a x 2m

mDx x

m 1

a (m)

x ax

2m

Continuous life annuity

m 1 1

a x lim a ( m)

x lim ax ax

m m

2m 2

a x lim a x( m )

m

1 1/ m

lim v 1/ m p x v 2 / m 2 / m p x v i j / m i j / m p x v t t p x dt

m m

0

1

a x ax a x v t p x dt

t

2 0

Annuity payable m-thly, deferred

n|a(m)x a(m)x+n

1/m 1/m 1/m 1/m

age x

… x+n x+ x+ ….. x +n+ x + n+1 …..

n+1/m n+2/m (m-1)/m

Dx n ( m )

na (m)

x v n

n px a (m)

xn axn

Dx

Dx n m 1 Dx n m 1

xn

a n a x

Dx 2m Dx 2 m

Dx n m 1

na (m)

x n ax

Dx 2m

Annuity payable m-thly, temporary

a(m)x:n|

1/m 1/m 1/m 1/m

1/m 2/m (m-1)/m

m 1 Dx n m 1

a na ax n a x

(m) (m) (m)

a x:n | x x

2m Dx 2m

Dx n m 1 Dx n m 1

a x n a x 1 a x:n | 1

Dx 2m Dx 2m

Dx n m 1

a (m)

x:n | a x:n | 1

Dx 2 m

8.4 Varying Life Annuities

• Arithmetic increasing annuities

Example

• Ernest, aged 50, purchases a life

annuity, which pays 5,000 for 5 years,

3,000 for 5 subsequent years, and

8,000 each year after. If the first

payment occurs in exactly 1 year, find

the price in terms of commutation

functions.

(Ia)x Arithmetic increasing annuity

1 2 n

…..

probability px 2px npx

v t p x v t p x v t t p x a x 1 | a x 2 | a x

t t

t 1 t 2 t 3

N x t 1

t | ax

t 0 t 0 Dx

S x N x t Ia x

S x 1

t 0 Dx

Arithmetic increasing annuity, temporary

(Ia)x:n|

1 2 n

probability px 2px npx

S x 1 S x n1 nN x n1

Ia x:n|

Dx

Arithmetic decreasing annuity, temporary

(Da)x:n|

n n-1 1

1 2 n

(n+1)ax:n|

n+1 n+1 n+1

Arithmetic decreasing annuity, temporary

(Da)x:n|

n n-1 1

probability px 2px npx

Dx

Da x:n|

N x 1 N x n1 Dx

ax:n|

Dx

Examples

• Georgina, aged 50, purchases a life annuity which will pay

her 5000 in one year, 5500 in two years, continuing to

increase by 500 per year thereafter. Find the price if S51 =

5000, N51 = 450, and D50 = 60

maximum level of 8000, and then remain constant for life.

Assume S58 = 2100

• Two annuities are of equal value to Jim, aged 25. The first is

guaranteed and pays him 4000 per year for 10 years, with

the first payment in 6 years. The second is a life annuity with

the first payment of X in one year. Subsequent payments are

annual, increasing by .0187 each year.

If i = .09, and from the 7% -interest table, N26=930 and D25=

30, find X.

8.5 Annual Premiums and

Premium Reserves

• Paying for deferred life annuity with a series of payments

instead of a single payment

• Premium reserve is an analog of outstanding principal

• Premiums often include additional expenses and

administrative costs

• In such cases, the total payment is called

gross premium

• Loading = gross premium – net premium

• General approach: actuarial present values of two

sequences of payments must be the same (equation of

value)

Annual premiums P = tP(n|äx)

P P P 1 1 1

• t is the number of premium payments

• Present value of premiums is P äx:t|

• Present value of benefits is n|äx

• Therefore P äx:t| = n|äx

N xn

N xn

n ax t P( n a x )

P

Dx

N xn

ax:t | N x N x t N x N x t N x N x t

Dx

Example

• Arabella, aged 25, purchases a deferred life annuity of 500

per month, with the first benefit coming in exactly 20 years.

She intends to pay for this annuity with a series of annual

payments at the beginning of each year for the next 20

years. Find her net annual premium if D25 = 9000, D 45 =

5000, ä25 = 15 and ä45 = 11.5

Reserves

P P P P 1 1 1

n V ( |ä )

t n x

been paid

• Reserve

n V ( |ä ) = PV of all future benefits – PV of all future premiums

t n x

N x t

ax t , tn

Dx t

tV ( n a x )

n

N P( N x t N x n )

n t | ax t Pax t:n t| x n , tn

Dx t

Loading and Gross premiums

• Arabella, aged 25, purchases a deferred life annuity of 500

per month, with the first benefit coming in exactly 20 years.

She intends to pay for this annuity with a series of annual

payments at the beginning of each year for the next 20

years. Assume that 50% of her first premium is required for

initial underwriting expenses, and 10% of all subsequent

premiums are needed for administration costs. In addition,

100 must be paid for issue expenses. Find Arabella’s annual

gross premium, if D25 = 9000, D 45 = 5000, ä25 = 15,

and ä45 = 11.5

Chapter 9

LIFE INSURANCE

• Basic Concepts

• Commutation Functions and Basic Identities

• Insurance Payable at The Moment of Death

• Varying Insurance

• Annual Premiums and Premium Reserves

9.1 Basic Concepts

• Benefits are paid upon the death of the insured

• Types of insurance

– Term insurance

– Deferred insurance

– Endowment insurance

Whole life policy

• Benefit (the face value) is paid to the beneficiary

at the end of the year of death of inured person

person aged x, the premium is denoted by Ax

Ax

1

probability px 2px tqx

Whole life policy

Ax t px qx t v t 1

t 0

Ax

1

probability px 2px qx+t

Term insurance

• Benefit (the face value) is paid to the beneficiary

at the end of the year of death of inured person,

only if the death occurs within n years

person aged x, the premium is denoted by A1x

n 1

A 1

x:n | t p x q x t v t 1

t 0

Deferred insurance

• Does not come into force until age x+n

person aged x, the premium is denoted by A1x:n|

Ax A n | Ax

1

x:n | n | Ax Ax A 1

x:n |

n-year endowment insurance

• Benefit (the face value) is paid to the beneficiary at the end

of the year of death of inured person, if the death occurs

within n years

• If the insured is still alive at the age x+n, the face value is

paid at that time

aged x, the premium is denoted by Ax:n|

Exercise:

Ax:n | A n Ex

1

x:n | A 1

x:n | Ax Ax:n |

Examples

• Rose is 38 years old. She wishes to purchase a life

insurance policy which will pay her estate 50,000 at the end

of the year of her death. If i=.12, find an expression for the

actuarial present value of this benefit and compute it,

assuming px = .94 for all x.

with face value 100,000. If lx= 1000(1-x/105) and i=.08, find

the price of this policy.

policies are in force for a term of only 30 years.

policies are to be 30 years endowment insurance.

9.2 Commutation Functions

• Recall:

Dx n

Dx v lx x

n Ex

Dx

N x Dx t

t 0

Commutation Functions

• Recall: Ax t px qx t v t 1

t 0

• So we need:

x t 1

t 1 l xt d xt t 1 d x t t 1 d xt v

t p x q x t v v v x

l x l x t lx lxv

Cx d x v x 1 t 1 C x t

t p x q x t v

Dx

Whole life insurance

C x t 1

Ax t p x q x t v

t 1

C x t

t 0 t 0 Dx Dx t 0

M x C x t Ax

Mx

t 0 Dx

Term insurance

n 1

1

A

x:n | t p x q x t v t 1

t 0

n 1

C x t C x t C x t M x M x n

A1x:n |

t 0 Dx t 0 Dx t n Dx Dx Dx

M x M xn

1

A

x:n |

Dx

n-year endowment insurance

Ax:n | A n Ex

1

x:n |

M x M x n Dx n M x M x n Dx n

Ax:n |

Dx Dx Dx

Note

• We can represent insurance premiums

in terms of actuarial present values of

annuities, e.g. Ax = 1 – d äx

• Hence they also can be found using

“old” commutation functions

Examples

• Juan, aged 40, purchases an insurance policy paying

50,000 if death occurs within the next 20 years, 100,000 if

death occurs between ages 60 and 70, and 30,000 if death

occurs after that. Find the net single premium for this policy

in terms of commutation functions.

N40 = 5000, N41 = 4500, and i = .08, find the price.

9.3 Insurance Payable

at the Moment of Death

• We consider scenario when the benefit is paid at

the end of the year of death

moment of death

Divide each year in m parts

Ax( m )

v1/ m 1/ m q x v 2 / m 1/ m p x 1/ m q x 1/ m v i j / m i ( j 1) / m p x 1/ m q x ( j 1) / m

l x l x 1/ m 2 / m l x 1 / m l x 1 / m l x 2 / m

v1/ m

v

lx lx l x 1/ m

i j / m

l x i ( j 1) / m l x i ( j 1) / m l x i j / m

v

lx l x i ( j 1) / m

l x l x 1/ m 2 / m l x 1 / m l x 2 / m

v 1/ m

v

lx lx

i j / m

l x i ( j 1) / m l x i j / m

v

lx

1/ m l x l x 1/ m 2 / m l x 1 / m l x 2 / m

v v

1 1/ m 1/ m

ml x i j / m l x i ( j 1) / m l x i j / m

v 1/ m

1 v1/ m

l '

x s ( 0 ,1) / m v 2/ m

l x s ( 0, 2 ) / m

'

i j / m '

ml x v l x s (i , j ) / m

1 m i j / m '

ml x i 0 j 1

v l x s (i , j ) / m

Taking the limit as m→∞ we get:

m

1

Ax lim A

m

(m)

x lim

m ml

v i j / m

i 0 j 1

l x s (i , j ) / m

'

x

'

l l l '

0 x t

0 lx lxt

x t

x t

dt v t t p x x t dt

t t

v dt v

lx 0

Premium for insurance payable at the moment of

death

Ax v t t p x x t dt

0

• Term policy: n

A : n | v t t p x x t dt

0

Examples

• Find the net single premium for a 100,000 life insurance

policy, payable at the moment of death, purchased by a

person aged 30 if i = .06 and tp30 = (.98)t for all t

insurance, force of interest is .06 and

lx = 105 – x, 0 ≤ x ≤ 105.

Remarks

• Using integration by parts, we can get

Āx = 1 – δ āx

• Approximate formula:

Āx ≈ (i/δ) Ax

expression:

A

lx

1 1/ m

v (l x l x 1/ m ) v 2 / m (l x 1/ m l x 2 / m ) v i j / m (l x i ( j 1) / m l x i j / m )

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