ACST202/851 : Mathematics of Finance

Tutorial Solutions 3
Question 1
For many of these questions there is more than one method which will give the required answer.
The solutions simply give one possible approach. For ease of explanation, some of the solutions
assume we are working in a yearly time frame, but remember that there is nothing in the i ( ) , d ( )
p p

and δ notations which forces the time frame to be years.

1 + i = eδ = e 0.1
(a)
i = 10.517%
(b) Consider the factors used to accumulate for 1 year

 i ( 2) 
2
δ
1 +  = e = e
0.11

 2 
i ( 2 ) = 11.308%
(c) Consider the factors used to accumulate for 1 year
12
δ
 i (12)   .15 
12

e = 1 +  = 1 + 
 12   12 
δ = 14.907%
(d) Consider the factors for discounting for a year.

 d ( 4) 
4
−δ −0.16
1 −  = e = e
 4 
d ( ) = 15.684%
4

(e) Consider the factors for discounting for a year.

 d (4 )   .12  4
4
−δ
e = v = 1 −  = 1 − 
 4   4 
δ = 12.184%
Question 2
The force of interest of 6% p.a. is equivalent to 0.5% per month.
Using the monthly force to accumulate the $1,000 for 29 months gives $1, 000 × e0.005×29 = $1,156.04
0.06× 2 12
5
Using the annual force to accumulate the $1,000 for 2 125 years gives $1, 000 × e = $1,156.04

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Question 3
Present value

= $10,000 × e −0.05×2 × e −0.055×2 × e −0.06×2 × e −0.065×2 × e −0.07×2

−( 0.05+ 0.055+ 0.06 + 0.065+ 0.07 )×2
= $10,000e
= $10,000e −0.6
= $5, 488.12

Alternatively, define:

δ t = the force of interest t years from now.

We can graph this function.

δt

7%

5%

t
0 10

10

∫δ t dt = Area of shaded region = 2 × {5% + 5.5% + 6% + 6.5% + 7%} = 0.6

0

 10 
Present value = $10, 000 × exp − ∫ δ t dt  = $10, 000e −0.6 as before.
 0 

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Question 4
(a) The required interest rate is i p.a. where

(1 + i ) = 1.03 × 1.05
2

i = 3.995%
While i is close to 4%, the arithmetic mean of 3% and 5%, it isn’t exact. It is close because we
could expand the above equation to
1 + 2i + i 2 = 1 + 0.03 + 0.05 + 0.03 × 0.05
2i ≈ 0.03 + 0.05
The approximation relies on the product of two small interest rates being very small, so the
approximation works less well for larger interest rates.
It’s interesting to note that 1 + i is the geometric mean of 1.03 and 1.05.
(b) The required force is δ p.a. where
e2δ = e0.03 × e0.05 = e0.03+ 0.05
δ = 12 × ( 3% + 5% ) = 4%
That is, δ is the arithmetic mean of 3% and 5%. It’s clear that this result will generalise to
any 2 forces, and with a little thought you should be able to prove it generalises to n years
with n forces each applying for one year.
(c) The required force is δ p.a. where
e4δ = e1×0.03 × e3×0.05 = e1×0.03+3×0.05
1× 3% + 3 × 5%
δ= = 4.5%
1+ 3
That is, δ is the weighted arithmetic mean of 3% and 5%, the weights being the lengths of
time those rates are earned. This result can also be generalised to an arbitrary number of
forces applying for contiguous time periods of arbitrary length.
The above properties are another reason that working with forces can sometimes give neater
answers than working with interest rates, particularly when working with stochastic interest rate
models. You’ll learn more about these in the CT8 units ACST306/307 or ACST816/817.

Question 5
$1,000 $2,000
+------------+-----------+--------+------------+
1/1/00 1/1/02 1/1/06 1/1/07 1/1/09
|<-- 5%pa -->|<-- 3.5% per half ->|<- δ = 5% ->|

Accumulated Value at 1/1/09

= $1, 000 × 1.052 × 1.03510 × e 2×0.05 + $2, 000 × 1.0352 × e 2×0.05
= $1, 718.745 + $2, 367.773
= $4, 086.52

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Question 6
(a)

a+b

a a

a+b

The first graph shows the case where b > 0 and the second where b < 0 .
The shape of the graphs shown above is not accurate. The graphs should be approaching their
asymptote by following an exponential curve. The drawing package used doesn’t contain
exponential curves, so the diagrams have been faked by using a section of an ellipse.
The force of interest should always be positive, else we would hold cash rather than investing
at this force. So we require a > 0 so the long run force is positive, and a + b > 0 so the current
force is positive. These conditions are sufficient to ensure δ ( t ) > 0 for all t ≥ 0 .
(b) Accumulated Value
T 
= exp  ∫ δ ( t ) dt 
0 
T 
= exp  ∫ a + be − ct dt 
0 
   
T
b
= exp   at − e− ct  
  c  0 
 
= exp aT − ( e− cT − 1) 
b
 c 
 
= exp aT + (1 − e − cT ) 
b
 c 
(c) Let the required force be δ p.a.
 
eδ T = exp aT + (1 − e − cT ) 
b
 c 
δ = a + (1 − e− cT )
b
cT
If T = 10 , a = c = ln1.01 , and b = 0.01 , then

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 δ = ln1.01 +
.01
10 ln1.01
(1 − e −10ln1.01 )

= ln1.01 +
.001
ln1.01
(1 − 1.01−10 )

= 1.9469%
(d) Interest earned
T
 
= $100 ∫ δ ( t ) dt = $100 aT + (1 − e− cT )  using the working from part (b)
b
0  c 
(e) Let the required force be δ p.a. The interest earned using this force of interest would be
T
= $100 ∫ δ dt = $100δ T
0

Hence we need to solve the equation

 
$100δ T = $100 aT + (1 − e− cT ) 
b
 c 
δ = a + (1 − e − cT )
b
cT
This is the same equation as in part (c). So, for this set of pronumerals, the answer is
1.9469%, as in part (c).
We can also note that the two problems give the same answer as each other whatever values
the pronumerals take. This is interesting, but not particularly useful in practice and is hence
not worth memorising.

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Question 7
Method 1
Let δ t denote the force of interest t years after the present.

 0.05 + 0.02t 0 ≤ t < 1

δt = 
0.125 − 0.025t 1 ≤ t < 3
(It is arguable whether δ t should be set to 7% or 10% at time 1, but since the rate only applies for
an instant, we just don’t care.)
The force of interest function in not continuous at time 1, but we can get around this by separately
determining the interest in each of the time ranges for which it is continuous.
Total interest
1 3
= $10, 000 ∫ 0.05 + 0.02t dt + $10, 000 ∫ 0.125 − 0.025t dt
0 1

2 1 3
= $10, 000  0.05t + 0.01t  + $10, 000 0.125t − 0.0125t 2 
0 1

= $10, 000 × 0.06 + $10, 000 × 0.15

= $600 + $1,500
= $2,100
Thus Bob will have $12,100
Method 2
Since the force of interest changes linearly the integrals can be found as areas of trapezia.
1

∫ 0.05 + 0.02t dt = × ( 0.05 + 0.07 ) ×1 = 0.06

0
1
2

∫ 0.125 − 0.025t dt = × ( 0.10 + 0.05) × 2 = 0.15

1
1
2

Method 3
Some people prefer to regard the first year and the subsequent 2 years as 2 separate problems.
1
For the first year, set δ t = 0.05 + 0.02t , 0 ≤ t < 1 , and then evaluate $10, 000 ∫ 0.05 + 0.02t dt = $600 .
0

For the subsequent 2 years, we could proceed as in method 1, but an alternative is to redefine δ t so
that it now represents the force of interest t years after the point where the interest rate jumps to
10%. Then δ t = 0.1 − 0.025t , 0 ≤ t < 2 and the interest earned is
2
2
$10, 000 ∫ 0.1 − 0.025t dt = $10, 000 0.1t − 0.0125t 2  = $10, 000 × 0.15 = $1,500
0
0

This method can be confusing, since δ t is defined differently for the two time periods. If you can
cope with that, it has the advantage that for the second time period the formula for δ t is simpler to
find compared to method 1, and the integral is easier to evaluate due to the lower limit be 0.

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Question 8
Present value in dollars
4
= ∫ ( 4 + 3t ) × e −0.05t dt
0

4
= ∫ ( 4 + 3t ) ×
d
dt
( −20e −0.05t ) dt
0

4
= ( 4 + 3t ) ( −20e−0.05t )  − ∫ 3 × ( −20e −0.05t ) dt
4
using integration by parts
0
0

{ }
= 16 ( −20e −0.2 ) − 4 ( −20 ) − 3 × 20 2 e −0.05t 
4

= −320e −0.2 + 80 − 1200 {e−0.2 − 1}

= 1280 − 1520e −0.2

= 35.5293
That is, the present value is $35.53.
That was fairly tedious. Since we frequently need to perform this sort of calculation with linearly
varying rates of payment, we’ll look at a neater way to do it in a later topic.

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 Additional Exercise Solutions 3
Question 1
2
 i ( 2) 
(1 − .12 ) = (1 + i ) =  1 +
−1 δ
 = e
 2 
Hence i = 13.636% i ( 2 ) =13.201% δ = 12.783%
Question 2
16
 i (2) 
$1, 000 (1 + i ) = $1, 000 1 +  = $1, 000 ×1.05 = $2,182.87
8 16
(a)
 2 

$1, 000 (1 + i ) = $1, 000 e.1×8 = $2, 225.54

8
(b)

$1, 000 (1 + i ) = $1, 000 (1 − d ) = $1, 000 × 0.9−8 = $2,323.06

8 −8
(c)
−16
 d (2) 
$1, 000 (1 + i ) = $1, 000 1 − = $1, 000 × 0.95−16 = $2, 272.07
8
(d) 
 2 

Question 3
$2, 000 (1.12 ) + $3, 000 (1.12 ) + $4, 000 (1.12 )
−3.25
= $9,133.33
3 1.5
(a)

$2, 000 (1.06 ) + $3, 000 (1.06 ) + $4, 000 (1.06 )

−6.5
= $9,148.96
6 3
(b)

(c) $2,000e.12 ×1e.1225×2 + $3,000e.1225×1.5 + $4,000e −.1225×3.25 = $9,172.49

(d) Let δ ( t ) = the force of interest at time t measured in years from 1/1/87.

δ ( t ) = 0.06 + 0.01t
Total value at 1 January 1990
3  3   6.25 
= $2, 000exp  ∫ .06 + .01t dt  + $3, 000 exp  ∫ .06 + .01t dt  + $4, 000 exp − ∫ .06 + .01t dt 
0  1.5   3 
= $2, 000e0.225 + $3, 000e0.12375 + $4, 000e−0.3453125
= $8, 731.84
The integrals can evaluated in the normal way (tedious working omitted) or as areas of
trapezia.
3

∫ .06 + .01t dt = × (.06 + .09 ) × 3 = 0.225

0
1
2

∫ .06 + .01t dt = × ( 0.075 + 0.09 ) ×1.5 = 0.12375

1.5
1
2

6.25

∫ .06 + .01t dt = × ( 0.09 + 0.1225) × 3.25 = 0.3453125

3
1
2

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Question 4
Method 1 – Working in years
Measure time in years from the start of the two year period. The rate of payments increases
exponentially from $100 pa at t = 0 to $120 pa at t = 2. That is, the growth rate is 20% per 2 years.
Hence the rate of payment at time t, meaning after 2t periods of 2 years, is $100 × 1.2 2 .
t

The required present value is

2 2

∫ $100 × 1.2 ×e − 0.06 t

dt = $100 × ∫ 12
. 2 × e −0.06t dt
t t
2

0 0

( )
2
t
= $100 × ∫ 1.2 2 × e − 0.06 dt
1

=
(
$100
. 2 × e − 0.06
ln 12
1
) [(1.2 1
2
× e −0.06 )]
t 2

{1.2 × e −0.12 − 1}
$100
=
ln 1.2 − 0.06
1
2

= $206.36
Two less efficient methods of determining the rate of payment

Let $ r ( t ) denote the rate of payment t years after the commencement of the period.

Hence r ( 0 ) = 100 and r ( 2 ) = 120

1. Let r ( t ) = ar t . Solving using the two known values gives a = 100, r = 1.2 so

r ( t ) = 100 ( )
t
1.2 = 100 ×1.2 2 .
t

2. Let r ( t ) = ae kt . Solving using the two known values gives a = 100, e2 k = 1.2, k = 12 ln1.2 so
( 1 ln1.2)t
r ( t ) = 100e 2
t
= 100 × 1.2 2 .
Method 2 – Working in quarters
Measure time in quarters from the start of the two year period. The rate of payments increases
exponentially from $25 per quarter at t = 0 to $30 per quarter at t = 8. Hence the rate of payment at
t

 30  8 t
time t is $25 ×   = $25 × 1.2 8 . The force of interest is 1.5% per quarter. The required present
 25 
value is

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 8 8

∫ $25 ×1.2 8 × e dt = $25 × ∫ 1.2 8 × e dt

−0.015t −0.015t
t t

0 0

( ) dt
8 t
= $25 × ∫ 1.2 8 × e−0.015
1

( )
8

=
$25  1.2 18 × e −0.015 t 
(
ln 1.2 8 × e −0.015
1

)   0

= 1
$25
ln1.2 − 0.015
{1.2 × e −0.12 − 1}
8

= $206.36
Question 5
$2,500 $1,000 $5,000
+---------+--------+---------+----------+----------+--------+
1/3/87 1/6/89 1/3/90 1/1/91 1/9/92 1/9/95 1/1/98
|< 11%pa >|<- 5% per half ->|<-- 3% per quarter ->|<- δ = 9%

Present Value at 1/3/87

. −2.25 × 1.05−1.5 + $1,000 × 111
= $2,500 × 111 . − 6 × 103
. −2.25 × 105 . −3
19 20

. − 6 × 103
. − 2.25 × 105
+ $5,000 × 111 . − 3 × e − .09× 2 3
19 56 1

= $1,837.297 + $556.343 + $1,581480

.
= $3,97512
.
Question 6
(a) Let the required period be n.

(1 + i ) = 2
n

n ln (1 + i ) = ln 2
ln 2 .69301 .70 70
n= 2 3
≈ ≈ =
i i i i 100i
i − + − ...
2 3
Since i is usually small, i 2 , i 3 ,... are small relative to i and so in the above approximate
formula we ignore them.
(b) At 7% money doubles in about 10 years. In 20 years it will double twice, giving about
$12,000.
ln 2
(c) For the Rule of 70 we are trying to find i such that = 0.7i . There are many ways to
ln (1 + i )
ln 2
feed this into the spreadsheet. We could make a cell containing − 0.7i and vary i to
ln (1 + i )
make that cell 0. We could make a cell containing 0.7i ln (1 + i ) and vary i to make it
approach ln 2 . Which ever approach is taken, you should find:
The Rule of 70 is correct at about 1.98486%.
The Rule of 72 is correct at about 7.84825%.

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(d) Let the required period be n.
eδ n = 2
δ n = ln 2
ln 2 .69301 69
n= ≈ ≈
δ δ 100δ
Question 7
(a) Accumulated Value
7 
= $500 × exp ∫ δ ( t ) dt 
0 
7 
= $500 × exp ∫ .05+.0002t 2 dt 
0 
{
= $500 × exp [ .05t + 13 ×.0002t 3 ] 0
7
}
= $500 × exp{0.372 867}
= $725.95
(b) The required rate is i p.a. where
$500 (1 + i ) = $725.95
7

i = 5.471%
Question 8

ehδt − 1 1  ( hδ t ) ( hδ t )   hδ t 2 h 2δ t 3
2 3

lim = lim × 1 + hδ t + + + ...  − 1 = lim δ t + + + ... = δ t

h →0 h h →0 h  2! 3!  h →0 2! 3!
  
Question 9
t
F ( t ) = ∫ r ( s ) ds
0

t
d
F ′(t ) = r ( s ) ds = r ( t ) by the fundamental theorem of calculus.
dt ∫0
Hence the rate of payment at time t is the rate of change of the total payments received up to time t.
The lectures relied on an intuitive understanding of what “rate of payment” means when it is
changing continuously. First we talked about what it meant when the rate of payment stayed
constant for some small length of time ∆t , and then we let ∆t → 0 .
If you want a more rigorous definition, first define F ( t ) as in this question and then define the rate
of payment to be F ′ ( t ) . Most students find this more rigorous approach doesn’t help their
understanding, so we relegated it to an additional exercise.
Non-examinable since this unit has no stats prerequisite: This is analogous to how we cope with
continuous random variables, first defining a cumulative density function FX ( x ) = P ( X ≤ x ) and
d
then defining the probability density function to be f X ( x ) = FX ( x ) .
dx

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