Semester 2 & Trimester 3B, 2015

MATH5000 Theory of Interest

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Department of Mathematics and Statistics

EXAMINATION
Semester 2 & Trimester 3B, 2015

MATH5000 Theory of Interest

This paper is for Bentley Campus students.

This examination has a total of 100 marks.

Examination Duration: 180 minutes

Reading Time: 10 minutes

Exam Conditions:
For Examiner Use Only
This is a CLOSED BOOK exam - no text books or written materials permitted
Q Mark
Students are permitted to write notes during reading time in the margins or the
reverse of the exam paper 1

This paper MUST NOT be released to students after the exam 2

The student’s exam paper must be returned inside the answer book 3

A Scientific calculator is permitted in this exam 4

Materials Permitted In The Exam Venue: 5

6
Actuarial Science – Selected Compound Interest Tables
7
Materials To Be Supplied To Students:
8
1 x 16 page answer book
9
Statistical tables and formulae book
10
Instructions To Students:
11

12

13

14

15

16

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18

Total ________
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 Semester 2 & Trimester 3B, 2015
MATH5000 Theory of Interest

IMPORTANT INFORMATION

The possession or use of mobile phones, or any other device capable of communicating information, is prohibited during
examinations.

Electronic Organisers/PDAs (with the exception of calculators) or other similar devices capable of storing text or restricted
information are prohibited during examinations.

Only calculators approved specifically by the school/department may be used during this examination. Prior to the
commencement of the examination, calculators will be checked for compliance by the examiner.

Any breach of examination regulations will be considered cheating and appropriate action will be taken in accordance
with University policy.

Question 1

To provide for her retirement in 20 years’ time, Jane has decided to put 20% of her
monthly salary, currently $5,000 a month, into a savings account at the start of each
month starting now, for the next 20 years. Jane’s salary is expected to increase by 3%
each year, with the first increase one year from now. Assume that the interest on the fund
is 5% pa effective.

(a) Show that the present value of Jane’s contributions can be written in the following
form, and give values for the constants X , n , i and i * :
Xa1(12|i ) an |i*

(5 marks)

(b) Upon retirement in 20 years’ time, Jane intends to withdraw $37,000 at the start of
each year for 25 years.

(i) Calculate the present value at time 0, of her intended withdrawals.

(4 marks)

(ii) If her intended salary contributions are not sufficient to fund her retirement
plans, Jane will make a lump sum contribution 10 years from now. What
lump sum, if any, must she contribute in 10 years’ time from now, so that her
fund is just sufficient for her intended withdrawals?
(5 marks)

(A total of 14 marks for this question)

Question 2 is on the next page

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 Semester 2 & Trimester 3B, 2015
MATH5000 Theory of Interest

Question 2

an | − nv n n − an |
(a) Using (Ia )n | = , prove that (Da )n | = .
i i
(3 marks)

(b) A loan is to be repaid in installments annually in arrears. The first installment is

$50, the second is $48 and so on with the payments reducing by $2 per annum until
the end of the 15th year after which there are no further payments. The rate of
interest charged by the lender is 6% per annum effective.

(i) Calculate the amount of the loan.

(5 marks)

(ii) Calculate the interest and capital components of the second payment.
(4 marks)

(iii) Calculate the amount of capital repaid in the installment at the end of the 14th
year.
(4 marks)

(A total of 16 marks for this question)

Question 3

A company intends to borrow $500,000 at a rate of interest of 8% pa payable quarterly to

invest in a project. The project is expected to generate income of $70,000 pa payable
quarterly in arrear for 25 years.

(a) Calculate the net present value of the project at a rate of interest of 8% pa payable
quarterly.
(4 marks)

(b) Calculate the discounted payback period.

(6 marks)

(A total of 10 marks for this question)

Question 4 is on the next page

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 Semester 2 & Trimester 3B, 2015
MATH5000 Theory of Interest

Question 4

A loan of nominal amount $500,000 was issued 5 years ago. The security pays half-
yearly coupons of 10% pa in arrear and is redeemable at 120% between 20 and 25 years
after the date of issue, inclusive, with the date of redemption being at the option of the
borrower. In addition to the redemption proceeds, the coupon then due is also paid.
Investor A, who is liable to income tax at 20% and capital gains tax of 15%, purchased
the entire loan at a price which gave him a net redemption yield of at least 9.5% pa
effective. Investor A decides to sell the entire holding now, immediately after the
payment of the coupon due, to Investor B who requires a net redemption yield of at least
6% pa effective. Investor B is liable to income tax at 20% and capital gains tax of 20%.

(a) Calculate the price at which Investor A purchased the loan.

(7 marks)

(b) Calculate the price at which Investor A sold the loan.

(7 marks)

(c) Calculate the net effective yield per annum that was actually obtained by Investor A
during the period of ownership of the loan.
(6 marks)

(A total of 20 marks for this question)

Question 5

An outstanding, long term bond has a coupon rate of 10% with coupons payable semi-
annually. The price of the bond today is 80 per 100 nominal, and the next coupon is due
six months from now. An individual takes a long position in a forward contract on the
bond with $100 par value, with delivery to take place one year from today. Find the value
of the long position on the forward contract six months from the time the contract was
made, if the bond price at that time is 86 per 100 nominal after the coupon due then has
been paid. Assume no arbitrage opportunities and a risk-free rate of return of 11% pa
compounded semi-annually for all maturities.

(A total of 8 marks for this question)

Question 6 is on the next page

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 Semester 2 & Trimester 3B, 2015
MATH5000 Theory of Interest

Question 6

An insurance company has liabilities of $1,400,000 due in 5 years’ time and $2,000,000
due in 8 years’ time. The company holds 2 investments, A and B. Investment A provides
income of $200,000 payable at the end of each year for the next 10 years. Investment B is
a zero coupon bond which pays $X at the end of n years (where n is not necessarily an
integer). The interest rate is 7% pa effective. Determine whether values of $X and n can
be found which ensures that the insurance company is immunized against small changes
in the interest rate.

(A total of 20 marks for this question)

Question 7

$80,000 is invested in a bank account which pays interest at the end of each year. Interest
is always reinvested in the account. The rate of interest is determined at the beginning of
each year and remains unchanged until the beginning of the next year. The rate of interest
applicable in any one year is independent of the rate applicable in any other year. During
the first year, the annual effective rate of interest will be one of 4%, 6% or 8% with equal
probability. During the second year, the annual effective rate of interest will be either 7%
with probability 0.75 or 5% with probability 0.25. During the third year, the annual
effective rate of interest will be either 6% with probability 0.7 or 4% with probability 0.3.

(a) Derive the expected accumulated amount in the account at the end of 3 years.
(4 marks)

(b) Derive the variance of the accumulated amount in the account at the end of 3 years.
(5 marks)

(c) Calculate the probability that the accumulated amount in the bank account is more
than $97,000 at the end of 3 years.
(3 marks)

(A total of 12 marks for this question)

END OF EXAMINATION

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