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Examination: Subject CT1 Financial Mathematics Core Technical
Examination: Subject CT1 Financial Mathematics Core Technical
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.
Faculty of Actuaries
CT1 A2005 Institute of Actuaries
1 A bond is priced at £95 per £100 nominal, has a coupon rate of 5% per annum
payable half-yearly, and has an outstanding term of five years.
The continuously compounded risk-free rates of interest for terms of six months and
one year are 4.6% per annum and 5.2% per annum, respectively.
Calculate the value of this forward contract to the investor assuming no arbitrage. [5]
2 An investment fund had a market value of £2.2 million on 31 December 2001 and
£4.2 million on 31 December 2004. It had received a net cashflow of £1.44 million
on 31 December 2003.
The money weighted rate of return and the time weighted rate of return for the period
from 31 December 2001 to 31 December 2004 are equal (to two decimal places).
Calculate the market value of the fund immediately before the net cashflow on
31 December 2003. [7]
From 1 January 2008 the chip will be ready for production and it is assumed that
income will be received half yearly in arrear at a rate of £5 million per annum.
(ii) Without doing any further calculations, explain whether the discounted
payback period would be greater than, less than or equal to that given in part
(i) if the effective interest rate were substantially greater than 9% per annum.
[2]
[Total 8]
CT1 A2005 2
4 The force of interest, (t ) , is a function of time and at any time t (measured in years)
is given by
(ii) Calculate the present value at time t = 0 of a continuous payment stream at the
rate of £200e0.1t paid from t = 10 to t = 18. [5]
[Total 8]
5 A university student receives a 3-year sponsorship grant. The payments under the
grant are as follows:
Calculate the total present value of these payments at the beginning of the first year
using a rate of interest of 8% per annum convertible quarterly. [8]
The value of the retail price index at various times was as shown in the table below:
(i) Calculate, to the nearest 0.1%, the following effective rates of return per
annum achieved by the investor from her investment in the annuity:
(ii) By considering the average rate of inflation over the three-year period, explain
the relationship between your answers in (a) and (b) of (i). [2]
[Total 9]
An investor who is liable to income tax at 20% and capital gains tax of 25% wishes to
purchase the entire loan at the date of issue. Calculate the price which the investor
should pay to ensure a net effective yield of at least 4% per annum. [9]
8 A small insurance fund has liabilities of £4 million due in 19 years time and £6
million in 21 years time. The manager of the fund has sold the assets previously held
and is creating a new portfolio by investing in the zero-coupon bond market. The
manager is able to buy zero-coupon bonds for whatever term he requires and has
adequate monies at his disposal.
(i) Explain whether it is possible for the manager to immunise the fund against
small changes in the rate of interest by purchasing a single zero-coupon bond.
[2]
(ii) In fact, the manager purchases two zero-coupon bonds, one paying £3.43
million in 15 years time and the other paying £7.12 million in 25 years time.
The current interest rate is 7% per annum effective.
9 The one-year forward rate of interest at time t = 1 year is 5% per annum effective.
The gross redemption yield of a two-year fixed interest stock issued at time t = 0
which pays coupons of 3% per annum annually in arrear and is redeemed at 102 is
5.5% per annum effective.
The issue price at time t = 0 of a three-year fixed interest stock bearing coupons of
10% per annum payable annually in arrear and redeemed at par is £108.9 per £100
nominal.
(i) Calculate the one-year spot rate per annum effective at time t = 0. [4]
(ii) Calculate the one-year forward rate per annum effective at time t = 2 years.
[3]
CT1 A2005 4
10 (i) In any year, the interest rate per annum effective on monies invested with a
given bank has mean value j and standard deviation s and is independent of the
interest rates in all previous years.
(ii) The interest rate per annum effective in (i), in any year, is equally likely to be
i1 or i2 (i1 i2 ) . No other values are possible.
Show that the amount of the original loan is £12,033.56. (Minor discrepancies
due to rounding will not be penalised). [2]
(ii) The following are the details from the loan schedule for year x, i.e. the year
running from exact duration x 1 years to exact duration x years.
(iii) At the beginning of year 11, it is agreed that the increase in the rate of interest
will not take place, so that the rate remains at 5% per annum effective for the
remainder of the loan. The annual instalment will continue to be payable at
the same level so that there may be a reduced term and a reduced final
instalment.
(c) Calculate the reduction in the total interest paid during the existence of
the loan as a result of the interest rate not increasing.
[7]
[Total 13]
END OF PAPER
CT1 A2005 6
Faculty of Actuaries Institute of Actuaries
EXAMINATION
April 2005
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with
the aim of helping candidates. The questions and comments are based around
Core Reading as the interpretation of the syllabus to which the examiners are
working. They have however given credit for any alternative approach or
interpretation which they consider to be reasonable.
M Flaherty
Chairman of the Board of Examiners
15 June 2005
Faculty of Actuaries
Institute of Actuaries
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
r T t
1 f S I Ke
where:
0.052
f 95 4.81648 98e 2.85071
1, 000, 000
f 10, 000 2.85071
100
= £28,507
3
2 MWRR: 2.2 1 i 1.44 1 i 4.2
i 7% , LHS 4.2359
4.2 4.1466
i 0.06 0.01
4.2359 4.1466
Page 2
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
Then,
F 4.2
1.0663
2.2 F 1.44
F
0.63452
F 1.44
F =£2.5m
PV of liabilities 9 12v a1 at 9%
i
9 12v. v
9 12 0.917432 1.044354
= 19.54811
2 i
PV 5v 2 a 5v 2 ak
k 2
i
5 0.84168 1.022015 ak
4.301048 ak
= 19.2941
Page 3
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
(ii) The income of the development is received later than the costs are incurred.
Hence an increase in the rate of interest will reduce the present value of the
income more than the present value of the outgo. Hence the DPP will increase.
10
s ds
4 (i) Accumulation = 500 e 0
8 10
0.07 0.005 s ds 0.06 ds
0 8
= 500 e
8
0.005 2 10
0.07 S S 0.06 S 8
2 0
= 500 e
= 500e0.40 0.12
= 841.01
t
18 s ds
(ii) PV 200e0.1t .e 0 dt
10
8 t
18 0.07 0.005 s ) ds 0.06 ds
0.1t 0 8
200e .e
10
18
200e0.1t . e 0.40
. e0.48 0.06t
dt
10
18 0.04t
200e0.08 e dt
10
200e0.08 0.04t 18
e
0.04 10
Page 4
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
12 2
5 Present Value = 5000 a1 v.a v 2 .a at i %
1 1
4
where 1 i 1.02 i 8.24322% p.a. effective
i 0.0824322 1
a1 .v .
Ln 1.0824322 1.0824322
0.9614201
12 1
12
1 v
and a 1.0824322 .
1 12
i
where
12
12
i 12
1.0824322 = 1 i 0.0794725
12
12
a 0.9645970
1
2 1 1 v
and a 1.0824322 2 .
1 2
i
2
2
i 2
where 1.0824322 1 i 0.0808000
2
2
a = 0.9805844
1
Examiners Comment: There are other valid methods for obtaining the required
answer which also received full credit.
Page 5
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
1
where v with i = real rate of return
1 i
3% RHS = 25241.25
25241.25 25000
i 0.03 0.01
25241.25 24770.94
a 2.5
3
= 2.4869 at 10%
2.5313 2.5
i 0.09 0.01
2.5313 2.4869
= 0.097
1 i
(ii) We should find that 1 e
1 i
1 i 1.097
Hence 1
1.06
1 i 1.035
Page 6
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
3 200.9
1 e e 5.6% p.a.
170.7
The inflation rate would not be expected to be exactly 6% p.a. since the Retail
Price Index is not increasing by a constant amount each year.
4
4
i 4
7 1 1.04 i 0.039414
4
0.05
g 1 t1 0.80 0.038835
1.03
4
i 1 t1 g
Assume redeemed as late as possible (ie: after 20 years) to obtain minimum yield.
Price of stock, P:
4
P 100000 0.05 0.80 a
20
4
4000 a 77250v 20
20
P
1 0.25v 20
= 102,072.25
Page 7
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
8 (i) No, because the spread (convexity) of the liabilities would always be greater
than the spread (convexity) of the assets 3rd Redington condition would
never be satisfied.
= 2.5550
VL 4v19 6v 21
= 2.5551
VA VL (ignoring rounding)
= 51.444
= 51.445
= 1099.627
1038.322
V " A V "L
Page 8
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
Examiners Comment: There are other valid methods for obtaining the
required answer which also received full credit.
= 97.1811
3 3 102
97.1811
1 i1 1 i1 1 f1,1
3 105
97.1811
1 i1 1 i1 1.05
103
97.1811
1 i1
i1 5.9877% p.a.
10 10 110
108.9 =
1 i1 1 ii 1.05 1 i1 1.05 1 f 2,1
Hence
10 10 110
108.9
1.059877 1.059877 1.05 1.059877 1.05 1 f 2,1
110
108.9 9.4351 8.9858
1.11287 1 f 2,1
Page 9
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
1 1 100
100 = y2
1 i1 1 i1 i f1,1 1 i1 1 f1,1
1 1 100
100 = y2
1.059877 1.059877 1.05 1.059877 1.05
y2 5.506% p.a.
10 (i) (a) Let it be the (random) rate of interest in year t . Let Sn be the
accumulation of a single investment of 1 unit after n years:
E Sn E 1 i1 1 i2 1 in
E Sn E 1 i1 E 1 i2 E 1 in as it are independent
E it j
n
E Sn 1 j
2
(b) E S n2 E 1 i1 1 i2 1 in
2 2 2
E 1 i1 E 1 i2 E 1 in (using independence)
n
1 2 j s2 j2
Page 10
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
2
as E ii2 V it E it s2 j2
n 2n
Var Sn 1 2 j s2 j2 1 j
1
(ii) (a) E Interest j i1 i2
2
2
Var Interest s2 E Interest 2 E Interest
2
1 2 2 1
i1 i2 i1 i2
2 2
1 2 2 1
= i1 i2 i1.i2
4 2
2
1
i1 i2
2
25
(b) E S25 1 j 5.5
j 0.0705686
25 50 2
Var S 25 1 2j j2 s2 1 j 0.5
25 50
1 2 0.0705686 0.07056862 s2 1.0705686 0.25
s2 0.000377389
1 2
Hence, s 2 0.000377389 i1 i2
4
i1 i2 2 0.07056862 = 0.1411372
i1 0.089995 8.9995%p.a.
Page 11
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
5%
11 (i) Loan 1000 a10 v10 7%
5% a10
= 12033.56
439.52
(ii) Note 0.05 x 10
8790.48
5%
8790.48 1000 a11 x
v11 x 7%
5% a10
1 v11 x
8.79048 v11 x
7.0236
0.05
11.20952
v11 x
0.86384 at 5%
12.9764
x 8
7%
Loan outstanding after 10 years = 1000 a10 = £7,023.60
7023.60 = 1000 an 11
Yv n 10
at 5%
Y 137.15
doesn t work
try n = 19
Page 12
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report
Y 869.36
Hence:
difference = £1,130.64
Page 13
Faculty of Actuaries Institute of Actuaries
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.
Faculty of Actuaries
CT1 S2005 Institute of Actuaries
1 Describe how cashflows are exchanged in an interest rate swap . [2]
2 An investor has earned a money rate of return from a portfolio of bonds in a particular
country of 1% per annum effective over a period of ten years. The country has
experienced deflation (negative inflation) of 2% per annum effective during the
period.
Calculate the real rate of return per annum over the ten years. [2]
4 The force of interest (t) at time t is a + bt2 where a and b are constants. An amount of
£200 invested at time t = 0 accumulates to £210 at time t = 5 and £230 at time t = 10.
5 (i) Calculate the present value of £100 over ten years at the following rates of
interest/discount:
(ii) A 91-day treasury bill is bought for $98.91 and is redeemed at $100.
Calculate the annual effective rate of interest obtained from the bill. [3]
[Total 7]
(ii) An investor purchases a eurobond on the date of issue at a price of £97 per
£100 nominal. Coupons are paid annually in arrear. The bond will be
redeemed at par twenty years from the issue date. The rate of return from the
bond is 5% per annum effective.
CT1 S2005 2
7 A bank makes a loan to be repaid in instalments annually in arrear. The first
instalment is 50, the second 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.
(ii) Calculate the interest and capital components of the second payment. [3]
(iii) Calculate the amount of capital repaid in the instalment at the end of the
fourteenth year. [3]
[Total 12]
8 An insurance company has just written contracts that require it to make payments to
policyholders of £1,000,000 in five years time. The total premiums paid by
policyholders amounted to £850,000. The insurance company is to invest half the
premium income in fixed interest securities that provide a return of 3% per annum
effective. The other half of the premium income is to be invested in assets that have
an uncertain return. The return from these assets in year t, it, has a mean value of
3.5% per annum effective and a standard deviation of 3% per annum effective. (1 + it)
is independently and lognormally distributed.
(i) Deriving all necessary formulae, calculate the mean and standard deviation of
the accumulation of the premiums over the five-year period. [9]
(ii) A director of the company suggests that investing all the premiums in the
assets with an uncertain return would be preferable because the expected
accumulation of the premiums would be greater than the payments due to the
policyholders.
Explain why this still may be a more risky investment policy. [2]
[Total 11]
(ii) Short-term, one-year annual effective interest rates are currently 8%; they are
expected to be 7% in one years time, 6% in two years time and 5% in three
years time.
(a) Calculate the gross redemption yields (spot rates of interest) from
1-year, 2-year, 3-year and 4-year zero coupon bonds assuming the
expectations theory explanation of the yield curve holds.
(c) A two-year forward contract has just been issued on a share with a
price of 400p. A dividend of 4p is expected in exactly one year.
Calculate the forward price using the above spot rates of interest,
assuming no arbitrage. [12]
[Total 14]
(ii) After exactly eight years, immediately after the payment of the coupon then
due, this investor sells the bond to another investor who pays income tax at a
rate of 25% and capital gains tax at a rate of 40%. The bond is purchased by
the second investor to provide a net return of 6% per annum effective.
(b) Calculate, to one decimal place, the annual effective rate of return
earned by the first investor during the period for which the bond was
held. [10]
[Total 13]
CT1 S2005 4
11 (i) Explain what is meant by the following terms:
Cash Outflows
Between the present time and the opening of the branch in three years time the
insurance company will spend £1.5m per annum on research, development and
the marketing of products. This outlay is assumed to be a constant continuous
payment stream. The rent on the branch building will be £0.3m per annum
paid quarterly in advance for twelve years starting in three years time. Staff
costs are assumed to be £1m in the first year, £1.05m in the second year, rising
by 5% per annum each year thereafter. Staff costs are assumed to be incurred
at the beginning of each year starting in three years time and assumed to be
incurred for 12 years.
Cash Inflows
The company expects the sale of products to produce a net income at a rate of
£1m per annum for the first three years after the branch opens rising to £1.9m
per annum in the next three years and to £2.5m for the following six years.
This net income is assumed to be received continuously throughout each year.
The company expects to be able to sell the branch operation 15 years from the
present time for £8m.
END OF PAPER
CT1 S2005 5
Faculty of Actuaries Institute of Actuaries
EXAMINATION
September 2005
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
Please note that differing 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 were not penalised for this. However, candidates were penalised
where excessive rounding had been used or where insufficient working had been shown.
Page 2
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
1 One party agrees to pay to the other a regular series of fixed amounts for a certain
term. In exchange the second party agrees to pay a series of variable amounts based
on the level of a short term interest rate.
2 If f = the rate of inflation; j = the real rate of return and i = the money rate of return,
then j = (i f)/(1 + f). In this case, f = 2%, i= 1% and therefore j = 3.061%.
t = 243.333 days
1,500e0.05(t/365) = 1,550
t = 239.366 days
5
5
4 210 200 exp a bt 2 dt 200 exp at 1 bt 3
3
200 5a 41.667b
0
0
10
10
230 200 exp a bt 2 dt 200 exp at 1 bt 3
3
200 10a 333.333b
0
0
ln(1.05) 5a 41.667b
ln(1.15) 10a 333.333b
Page 3
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
therefore i = 0.04494
6 (i)
Used for medium or long-term borrowing
Unsecured
Regular annual coupon payments
Generally repayable at par
Generally issued by large companies and on behalf of governments
Yields depend on risk and marketability
Generally innovative market designed to attract different types of investor
Issued internationally (normally by a syndicate of banks)
Can be issued in any currency (not necessarily the domestic currency of
the borrower)
(b) Duration = Ct tvt/ Ctvt where Ct is the amount of the cash flow at
time t
( Ia )20 = 110.9506 all other values have been used in (a) above
Page 4
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
= 52(v +v2 +v3 + + v14 + v15) 2(v + 2v2 +4v3 + + 28v14+30 v15)
= 52 a15 - 2 ( Ia )15
( Ia )15 = 67.2668
a15 = 9.7122
(iii) At the end of the thirteenth year, the capital outstanding is:
Page 5
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
8 (i) Let it be the (random) rate of interest in year t . Let S5 be the accumulation of
a single investment of 1 unit after 5 years:
5
E S5 E 1 it
t 1
5
E 1 it
t 1
as it are independent
5
E S5 E 1 it
E 1 it 1 E it = 1.035
5
E S5 1.035 1.187686
5 5
2 2
E S52 E 1 it E 1 it (using independence)
t 1 t 1
2 5 5 5
E 1 it E 1 2it it2 1 2 E it E it2
2 5
1 2 E it Var it E it
2
Var S5 E S52 E S5
2 5 10
1 2 E it Var it E it E 1 it
E it 0.035
Var it 0.032
5 10
Var S5 1 2 0.035 0.032 0.0352 1.035
1.416534 1.410598
0.0059356
Candidates who obtained slightly different answers by first deriving the parameters of
the lognormal distribution received full credit.
Page 6
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
(ii) Investing all premiums in the risky assets is likely to be more risky because,
although there may be a higher probability of the assets accumulating to more
than £1 million, the standard deviation would be twice as high so the
probability of a large loss would be greater.
94.67552 = 5 a4 + 100v4
Page 7
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
P1 4a (2) 100v15
15 5%
i
(2)
1.012348
i
v15 0.48102
a15 10.3797
2
2
i 2
(ii) (a) 1 1.06 i 0.059126
2
2
i 1 t1 g
P2 0.75 4a (2) 7
100v6% 7
0.4 100 P2 v6%
7 6%
7
P2 1 0.4v6% 0.75 4a (2) 7
0.6 100v6%
7 6%
i
(2)
1.014782
i
v7 0.66506
a7 5.5824
Page 8
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
(b) Rate of return earned by the first investor is the solution to:
i 2%
i
(2)
1.004975
i
v8 0.85349
a8 7.3255
RHS 88.2490
i 1.5%
i
(2)
1.003736
i
v8 0.88771
a8 7.4859
RHS 91.3575
90.1335 88.2490
i 0.02 0.005 1.697% 1.7%
91.3575 88.2490
11 (i) (a) An equation of value expresses the equality of the present value of
positive and negative (or incoming and outgoing) cash flows that are
connected with an investment project, investment transaction etc.
(b) The discounted payback period from an investment project is the first
time at which the net present value of the cash flows from the project is
positive.
Page 9
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
(ii) Consider first the NPV at 9% per annum effective. Working in £million.
1 1.0512 v12
0.77218 5.71647 7.60679 13.32326
1 1.05v
12.6253
To find whether the discounted payback period is less than 12 years at 7% per
annum effective, we need to find the NPV @ 7% of first twelve years
cashflows
1 1.059 v9
0.81630 5.73739 6.82096 12.55835
1 1.05v
Page 10
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report
9.3461
Project fulfils neither the discounted payback period criterion nor the internal
rate of return criterion.
Page 11
Faculty of Actuaries Institute of Actuaries
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 12 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.
Faculty of Actuaries
CT1 A2006 Institute of Actuaries
1 An investment is discounted for 28 days at a simple rate of discount of 4.5% per
annum. Calculate the annual effective rate of interest. [3]
2 An annuity certain with payments of £150 at the end of each quarter is to be replaced
by an annuity with the same term and present value, but with payments at the
beginning of each month instead.
Calculate the revised payments, assuming an annual force of interest of 10%. [3]
3 At time t = 0 the n-year spot rate of interest is equal to (2.25 + 0.25n)% per annum
effective (1 n 5).
(a) Calculate the 2-year forward rate of interest from time t = 3 expressed as an
annual effective rate of interest.
(c) Without performing any further calculations, explain how you would expect
the gross redemption yield of a 4-year bond paying annual coupons of 3.5% to
compare with the par yield calculated in (b).
[7]
4 An investor, who is liable to income tax at 20% but is not liable to capital gains tax,
wishes to earn a net effective rate of return of 5% per annum. A bond bearing
coupons payable half-yearly in arrear at a rate 6.25% per annum is available. The
bond will be redeemed at par on a coupon date between 10 and 15 years after the date
of issue, inclusive. The date of redemption is at the option of the borrower.
Calculate the maximum price that the investor is willing to pay for the bond. [5]
5 A share currently trades at £10 and will pay a dividend of 50p in one month s time. A
six-month forward contract is available on the share for £9.70. Show that an investor
can make a risk-free profit if the risk-free force of interest is 3% per annum. [4]
6 An actuarial student has created an interest rate model under which the annual
effective rate of interest is assumed to be fixed over the whole of the next ten years.
The annual effective rate is assumed to be 2%, 4% and 7% with probabilities 0.25,
0.55 and 0.2 respectively.
(a) Calculate the expected accumulated value of an annuity of £800 per annum
payable annually in advance over the next ten years.
(b) Calculate the probability that the accumulated value will be greater than
£10,000.
[4]
CT1 A2006 2
7 A company has entered into an interest rate swap. Under the terms of the swap the
company makes fixed annual payments equal to 6% of the principal of the swap. In
return, the company receives annual interest payments on the principal based on the
prevailing variable short-term interest rate which currently stands at 5.5% per annum.
(a) Describe briefly the risks faced by a counterparty to an interest rate swap.
(b) Explain which of the risks described in (a) are faced by the company. [4]
8 An ordinary share pays annual dividends. A dividend of 25p per share has just been
paid. Dividends are expected to grow by 2% next year and by 4% the following year.
Thereafter, dividends are expected to grow at 6% per annum compound in perpetuity.
(ii) Calculate the present value of the dividend stream described above at a rate of
interest of 9% per annum effective from a holding of 100 ordinary shares. [4]
(iii) An investor buys 100 shares in (ii) for £8.20 each. He holds them for two
years and receives the dividends payable. He then sells them for £9
immediately after the second dividend is paid.
Calculate the investor s real rate of return if the inflation index increases by
3% during the first year and by 3.5% during the second year assuming
dividends grow as expected. [4]
[Total 12]
9 The force of interest (t ) is a function of time and at any time t, measured in years, is
given by the formula:
0.04 0 t 5
(t ) 0.008t 5 t 10
2 10 t
0.005t 0.0003t
(i) Calculate the present value of a unit sum of money due at time t = 12. [5]
(ii) Calculate the effective annual rate of interest over the 12 years. [2]
The developer has three possible project strategies. She believes that she can sell the
completed housing:
The developer also believes that she can obtain a rental income from the housing
between the time that the development is completed and the time of sale. The rental
income is payable quarterly in advance and is expected to be £500,000 in the first year
of payment. Thereafter, the rental income is expected to increase by £50,000 per
annum at the beginning of each year that the income is paid.
(i) Determine the optimum strategy if this is based upon using net present value
as the decision criterion. [9]
(ii) Determine which strategy would be optimal if the discounted payback period
were to be used as the decision criterion. [2]
(iii) If the housing is sold in six years time, the developer believes that she can
obtain an internal rate of return on the project of 17.5% per annum. Calculate
the sale price that the developer believes that she can receive. [6]
(iv) Suggest reasons why the developer may not achieve an internal rate of return
of 17.5% per annum even if she sells the housing for the sale price calculated
in (iii). [2]
[Total 19]
CT1 A2006 4
11 An actuarial student has taken out two loans.
Loan A: a five-year car loan for £10,000 repayable by equal monthly instalments of
capital and interest in arrear with a flat rate of interest of 10.715% per
annum.
The student has a monthly disposable income of £600 to pay the loan interest after all
other living expenses have been paid.
Freeloans is a company which offer loans at a constant effective interest rate for all
terms between three years and ten years. After two years, the student is approached
by a representative of Freeloans who offers the student a 10-year loan on the capital
outstanding which is repayable by equal monthly instalments of capital and interest in
arrear. This new loan is used to pay off the original loans and will have repayments
equal to half the original repayments.
(i) Calculate the final disposable income (surplus or deficit) each month after the
loan payments have been made. [5]
(ii) Calculate the capital repaid in the first month of the third year assuming that
the student carries on with the original arrangements. [5]
(iii) Estimate the capital repaid in the first month of the third year assuming that
the student has taken out the new loan. [5]
(iv) Suggest, with reasons, a more appropriate strategy for the student. [2]
[Total 17]
(i) Investigate whether values of £R and n can be found which ensure that the
fund is immunised against small changes in the interest rate.
5
You are given that t 2 vt 40.275 at 8%. [8]
t 1
(ii) (a) The interest rate immediately changes to 3% per annum effective.
Calculate the revised present values of the assets and liabilities of the
fund.
END OF PAPER
CT1 A2006 6
Faculty of Actuaries Institute of Actuaries
EXAMINATION
April 2006
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M Flaherty
Chairman of the Board of Examiners
June 2006
Comments
General comments
As is in some recent diets, the questions requiring verbal reasoning (such as Q3(c), Q7(b),
Q10(iv) and Q11(iv)) tended not to be well answered with candidates producing vague
statements which did not demonstrate that they understood the relevant points.
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.
However, candidates may be penalised where excessive rounding has been used or where
insufficient working is shown.
Faculty of Actuaries
Institute of Actuaries
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
1
28d 28 / 365
1 Annual rate of interest is i where 1 1 i
365
365 / 28
28 0.045
This gives i 1 1 4.611%
365
2 We require X where:
a (4) d (12)
600a (4) 12 Xa (12) X 50 n
(12)
50
n n a i (4)
n
1/12
d (12) 12 1 1 d 12 1 e 12 0.099584
1/ 4
i (4) 4 1 i 1 4 e 4 1 0.101260
Comments on question 2: Candidates were not penalised for assuming that the annuities
were for a specific term even though this was not needed for the calculations.
5 5
2 1 y5 1.035
3 (a) 1 f3,2 3 3
f3,2 4.255%
1 y3 1.03
(b) Par yield is yc4 where yc4 v y1 v 2y2 v3y3 v 4y4 v 4y4 1
1 2 3 4 4
Thus yc4 1.025 1.0275 1.03 1.0325 1.0325 1
0.12009
yc4 3.230%
3.71785
(c) The par yield is equal to the gross redemption yield for a par yield bond.
Coupons for the 3.5% bond are higher than for the par yield bond. Thus a
lower proportion of the total proceeds are included within the redemption
payment which is when spot yields/discount rates are highest. The present
value of the proceeds of the 3.5% bond will be higher and so the gross
redemption yield will be lower than that of the par yield bond and thus less
than the par yield.
Page 2
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
Comments on question 3: Part (a) was answered well but some candidates struggled with
the calculation of the par yield in part (b). In part (c) the marks were awarded for a clear
explanation. Many candidates, who just stated their conclusion, were unable to explain their
reasoning clearly and so failed to score full marks on this part.
2
4 i 0.049390
2
i 1 t1 g
2
P 100 0.0625 0.80 a 100v10at 5%
10
2
P 5a 100v10
10
Comments on question 4: Well answered although some candidates who recognised that the
investor faced a capital loss did not recognise that this meant that the minimum yield would
be obtained if the bond was redeemed at the earliest possible date.
Page 3
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
5 An investor can borrow £10 at the risk-free rate, buy one share for £10, enter into the
forward contract to sell the share in six months time.
After one month the 50p dividend from the share is invested at the risk-free rate. After
six months the share can be sold for £9.70, the dividend proceeds are worth
0.03 5
0.5e 12 and the borrowing is repaid at 10 e0.015 . This gives a net cashflow of 9.7
0.03 5
+ 0.5e 12 10 e0.015 = 0.0552
The investor has made a deal with zero initial cost, no risk of future loss and a risk-
free future profit.
Comments on question 5: The majority of candidates were able to calculate the non-
arbitrage forward price by use of the appropriate formula. However, marks were lost for not
clearly explaining how a risk-free profit could thus be made.
800 0.25 s11 0.02 1 0.55 s11 0.04 1 0.2 s11 0.07 1
£10, 093.13
(b) Accumulation is only over £10,000 if the interest rate is 7% p.a. which has
probability 0.2
Comments on question 6: The most poorly answered question on the paper. This model of
interest rates had not been examined recently and the majority of candidates assumed instead
that the interest rate changed each year (in line with previous examination questions on this
topic).
Page 4
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
7 (a) The counterparty faces market risk which is the risk that market conditions
will change so that the present value of the net outgo under the agreement
increases.
The counterparty also faces credit risk which is the risk that the other
counterparty will default on its payments.
(b) The company still faces the market risk since the interest rates could fall
further which will make the value of the swap even more negative to the
company.
The company does not currently face a credit risk since the value of the swap
is positive to the other counterparty.
Comments on question 7: Part (a) was answered well but many candidates failed to
recognise in (b) that the company would not currently face credit risk in this example.
100 0.25 1.02v 1.02 1.04v 2 1.02 1.04 1.06v3 1.02 1.04 1.062 v 4
1.09
25 1.02v 25 1.02 1.04v 2
0.03
Page 5
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
100 100 2
900 v
103 103.5
24.7573v 869.1150v 2
Hence i = 4.47%
Comments on question 8: Despite being a bookwork question, part (i) was answered patchily
with few students getting all of the required points. Part (ii) was answered well. In part (iii),
it was expected that students would solve the quadratic equation. However, full credit was
given to students who used interpolation methods.
5 5
0.04 dt 0.04t
9 (i) A(0,5) e 0 e 0 e0.2 1.22140
10
10
0.008tdt 0.004t 2
A(5,10) e 5 e 5 e0.3 1.34986
12 12
0.005t 0.0003t 2 dt 0.0025t 2 0.0001t 3
A(10,12) e 10
e 10 e0.1828 1.20057
1 1 1
A 0,5 A 5,10 A 10,12 1.22140 1.34986 1.20057 1.97941
= 0.50520
12
(ii) Equivalent effective annual rate is i where 1 i 1.97941 i 5.855%
Page 6
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
5 t 5
0.05t 0.04 ds 0.05t 0.04t
e e 0 dt e e dt
2 2
i
5, 000, 000 3,500, 000a2 5, 000, 000 3,500, 000 a2
4 (4)
450, 000v 2 a 50, 000v 2 Ia n 2
Sn v n
n 2
i i
450, 000v 2 (4)
an 2
50, 000v 2 (4)
Ia n 2
Sn v n
d d
where n is the year of sale and Sn are the sale proceeds if the sale is made in
year n.
Note that if n = 4 the extra benefits in year 4 consist of an extra £1.5 million
on the sale proceeds and an extra £650,000 rental income. This is clearly less
than the amount that could have been obtained if the sale had been made at the
end of year 3 and the proceeds invested at 15% per annum. Hence selling in
year 4 is not an optimum strategy.
Page 7
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
Hence the optimum strategy if net present value is used as the criterion is to
sell the housing after 5 years.
(ii) If the discounted payback period is used as the criterion, the optimum strategy
is that which minimises the first time when the net present value is positive.
By inspection, this is when the housing is sold after 3 years.
(iii) We require
i 4 (4)
5, 000, 000 3,500, 000 a2 450, 000v 2 a 50, 000v 2 Ia n 2
Sn v n at 17.5%
n 2
2
1 v0.175 1 0.72431
LHS 5, 000, 000 3,500, 000 5, 000, 000 3,500, 000
0.175 0.16127
10,983, 227
4 4
2 1 v0.175 2 a4 4v0.175 6
RHS 450, 000v0.175 50, 000v0.175 S6v0.175
4 4
d d
4 1
d 0.175 41 v 4 0.15806
1 v4
a4 3.1918
d
3.1918 2.0985
450, 000 0.72431 3.0076 50, 000 0.72431 0.37999 S6
0.15806
Page 8
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
(iv) Reasons investor may not achieve the internal rate of return:
Comments on question 10: A significant number of candidates assumed that the development
costs amounted to £7 million per annum and subsequently found that no strategy would lead
to a profit. Otherwise the calculations were performed well. In part (iv), credit was given for
other valid answers. Despite this, few students scored full marks on this part.
For loan A:
For loan B:
LB 15000 12 X B a (12) 2
v12% a (12)
2 12% 3 10%
1, 250
XB
i 2 i
12
a2 v12% 12
a3
i 12% i 10%
1, 250
1.053875 1.6901 0.79719 1.045045 2.4869
XB £324.43
Page 9
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
12 12
12 255.96a 10000 a 3.2557
5 5
12
Try i = 20%: a = 3.2557
5
12
So capital outstanding after 24 months is 12 255.96 a at 20%
3
12
Capital outstanding under B is 12 324.43 a at 10%
3
12 12
i 20% i10%
7043.74 10118.02 107.84 80.68 £188.52
12 12
(iii) Under the new loan the capital outstanding is the same as under the original
arrangement = 17161.76.
255.96 324.43
The monthly repayment £290.20
2
12 12
12 290.20a 17161.76 a 4.9281
10 10
12
Try i = 20%: a 4.5642
10
12
Try i = 15%: a 5.3551
10
5.3551 4.9281
By interpolation i 15% 20% 15% 17.7%
5.3551 4.5642
Page 10
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
12
i17.7%
17161.76 234.66
12
(iv) The new strategy reduces the monthly payments but repays the capital more
slowly. The student could consider the following options:
Keeping loan B and taking out a smaller new loan to repay loan A
(which has the highest effective interest rate).
Taking out the new loan for a shorter term to repay the capital more
quickly.
Comments on question 11: In part (i) some candidates struggled to deal with the flat rate of
Loan A whilst others failed to deal with the change in interest rate of Loan B. Part (ii) was
answered well. In part (iii), different answers for the effective rate of interest (and hence the
interest paid) for the new loan could be obtained according to the actual interpolation used
and full credit was given for a range of answers. If calculated exactly, the effective rate of
interest is actually 17.5%. In part (iv), credit was again given for any valid strategy suitably
explained.
VA a5 Rv n at 8%
3.9927 Rv n
VL 3v 3 5v 5 9v 9 11v11 at 8%
15.0044
Rv n 11.0117
VA VL
(2) VA' VL' where VA' & VL'
VA' Ia 5
nRv n
11.3651 nRv n
Page 11
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
nRv n 105.2090
105.2090
n 9.5543
11.0117
9.5543
R 11.0117 1.08 £22.9720m
Alternatively:
VA VL
VA' VL' where VA' & VL'
i i
VA' v Ia 5
nRv n 1
11.3651v nRv n 1
10.5233 nRv n 1
nRv n 1
97.4156
97.4156
n 9.5543
11.0117v
9.5543
R 11.0117 1.08 £22.9720m
2 2
VA VL
(3) VA'' VL'' (where VA'' 2
& VL'' 2
)
5
VA'' t 2vt n 2 Rv n
t 1
2
40.275 9.5543 22.9720 v 9.5543
1045.483
Page 12
Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report
5
VA'' t t 1 vt 2
n n 1 Rv n 2
t 1
5
v2 t 2vt v 2 Ia 5
n n 1 Rv n 2
t 1
Thus n 9.5543, R £22.9720m will satisfy all three conditions and so will
achieve immunisation.
Comments on question 12: Part (i) was answered surprisingly poorly, given that it required
the same techniques as those required in previous examination questions on the same topic.
Full credit was given to students who observed directly that the spread of the assets around
the mean term was greater than the spread of the liabilities. Few students answered part (ii)
fully and the examiners felt that students should have recognised that immunisation would
not protect the fund against such a large change in interest rates even if they had not
answered part (i) correctly.
Page 13
Faculty of Actuaries Institute of Actuaries
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 12 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.
Faculty of Actuaries
CT1 S2006 Institute of Actuaries
1 (a) Distinguish between a future and an option.
(b) Explain why convertibles have option-like characteristics.
[3]
2 An individual makes an investment of £4m per annum in the first year, £6m per
annum in the second year and £8m per annum in the third year. The investments are
made continuously throughout each year. Calculate the accumulated value of the
investments at the end of the third year at a rate of interest of 4% per annum effective.
[3]
3 An individual has invested a sum of £10m. Exactly one year later, the investment is
worth £11.1m. An index of prices has a value of 112 at the beginning of the
investment and 120 at the end of the investment. The investor pays tax at 40% on all
money returns from investment. Calculate:
(i) Explain what is meant by the assumption of no arbitrage used in the pricing
of derivative contracts. [2]
(ii) Find the market price of B, such that there are no arbitrage opportunities and
assuming the price of A remains fixed. Explain your reasoning. [2]
[Total 4]
5 (i) Calculate the time in days for £3,600 to accumulate to £4,000 at:
(ii) Explain why the amount takes longest to accumulate in (i)(a) [1]
[Total 5]
CT1 S2006 2
6 The rate of interest is a random variable that is distributed with mean 0.07 and
variance 0.016 in each of the next 10 years. The value taken by the rate of interest in
any one year is independent of its value in any other year. Deriving all necessary
formulae calculate:
(i) The expected accumulation at the end of ten years, if one unit is invested at the
beginning of ten years. [3]
(ii) The variance of the accumulation at the end of ten years, if one unit is invested
at the beginning of ten years. [5]
(iii) Explain how your answers in (i) and (ii) would differ if 1,000 units had been
invested. [1]
[Total 9]
7 A life insurance fund had assets totalling £600m on 1 January 2003. It received net
income of £40m on 1 January 2004 and £100m on 1 July 2004. The value of the fund
was:
(i) Calculate, for the period 1 January 2003 to 31 December 2004, to three
decimal places:
(b) The linked internal rate of return, using sub intervals of a calendar
year.
[8]
(ii) Explain why the linked internal rate of return is higher than the time weighted
rate of return. [2]
[Total 10]
(ii) Calculate the constant force of interest that would give rise to the same
accumulation from time t = 0 to time t = 10. [2]
(iii) At the force of interest calculated in (ii), calculate the present value of a
continuous payment stream of 20e0.05t paid between from time t = 0 to time
t = 10. [4]
[Total 11]
(a) Calculate the amount to which the investment policy was expected to
accumulate at the time it was taken out.
(b) Calculate the amount by which the investment policy would have fallen short
of repaying the loan had extra premiums not been paid for the final ten years.
(c) Calculate the amount of money the individual will have, after using the
proceeds of the investment policy to repay the loan, after allowing for the
increase in premiums.
(d) Suggest another course of action the borrower could have taken which would
have been of higher value to him, explaining why this higher value arises.
(e) Calculate the level annual instalment that the investor would have had to pay
from outset if he had repaid the loan in equal instalments of interest and
capital.
[11]
10 A financial regulator has brought in a new set of regulations and wishes to assess the
cost of them. It intends to conduct an analysis of the costs and benefits of the new
regulations in their first twenty years.
The cost to companies who will need to devise new policy terms and computer
systems is expected to be incurred at a rate of £50m in the first year increasing by
3% per annum over the twenty year period.
The cost to financial advisers who will have to set up new computer systems and
spend more time filling in paperwork is expected to be incurred at a rate of £60m
in the first year, £19m in the second year, £18m in the third year, reducing by £1m
every year until the last year, when the cost incurred will be at a rate of £1m.
The cost to consumers who will have to spend more time filling in paperwork and
talking to their financial advisers is expected to be incurred at a rate of £10m in
the first year, increasing by 3% per annum over the twenty year period.
CT1 S2006 4
The benefits are estimated as follows:
The benefit to consumers who are less likely to buy inappropriate policies is
estimated to be received at a rate of £30m in the first year, £33m in the second
year, £36m in the third year and so on, rising by £3m per year until the end of
twenty years.
The benefit to companies who will spend less time dealing with complaints from
customers is estimated to be received at a rate of £12m per annum for twenty
years.
Calculate the net present value of the benefit or cost of the regulations in their first
twenty years at a rate of interest of 4% per annum effective. Assume that all costs and
benefits occur continuously throughout the year.
[12]
The inflation index is assumed to increase continuously at the rate of 2½% per
annum effective from its value in May 2003.
An investor, paying tax at the rate of 20% on coupons only, purchased the
stock on 1 July 2003, just after a coupon payment had been made.
Calculate the price to this investor such that a real net yield of 3% per annum
convertible half yearly is obtained and assuming that the investor holds the
bond to maturity. [10]
[Total 13]
(i) Calculate the present value of the liabilities at a rate of interest of 7% per
annum effective. [2]
(ii) Calculate the discounted mean term of the liabilities at a rate of interest of 7%
per annum effective. [4]
(iii) Calculate the nominal amount of each security that should be purchased so
that both the present value and discounted mean terms of assets and liabilities
are equal. [7]
(iv) Without further calculation, comment on whether, if the conditions in (iii) are
fulfilled, the pension fund is likely to be immunised against small, uniform
changes in the rate of interest. [2]
[Total 15]
END OF PAPER
CT1 S2006 6
Faculty of Actuaries Institute of Actuaries
EXAMINATION
September 2006
EXAMINERS’ REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M A Stocker
Chairman of the Board of Examiners
November 2006
© Faculty of Actuaries
© Institute of Actuaries
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report
Comments
As in many recent diets, the questions requiring verbal reasoning (e.g. Question 4(i)) tended
not to be well answered with candidates producing vague statements which did not
demonstrate that they understood the relevant points
Please note that differing answers may be obtained from 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.
However, candidates may be penalised where excessive rounding has been used or where
insufficient working is shown.
Comments on solutions presented to individual questions for this September 2006 paper are
given below.
Question 1
Generally well answered. To gain full marks candidates were required to specify the
difference between futures and options rather than just defining each contract separately.
Question 2
Well answered. This was a question where some candidates were penalised if answers had
been rounded excessively.
Question 3
Question 4
For full marks in part (i), an answer should have included a description of the ‘risk-free’
concept (rather than just saying arbitrage profits are impossible). Many students had
difficulty with part (ii).
Question 5
Full marks were given if either 365 or 365.25 days were used in the calculation. Most
students scored well on this question.
Question 6
This question was well answered. For full marks, candidates were required to show detailed
steps in deriving the result required including a definition of the initial terms used and a
correct explanation of the relevance of the independence assumption.
Page 2
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report
Question 7
This question was poorly answered to the surprise of the examiners. Many candidates
struggled to deal with the linked internal rate of return.
Question 8
Well answered.
Question 9
This question appeared to reward candidates who had a good understanding of the topic.
Whilst the best candidates usually scored close to full marks on this question, weaker or less-
prepared candidates often scored very badly.
Whilst the question did state that payments were made monthly, the examiners recognised
that there was some potential for misinterpretation as to the frequency of the loan repayments
in part (e) and took this into account. Thus students who used the formula Xa30 = 100, 000
(12 )
with i = 6% & i =6.168% to get an answer of £7,396 in this part were awarded full marks.
Question 10
Question 11
This was the worst answered question on the paper by some margin with very few candidates
scoring close to full marks. This may be because this type of question has not appeared in
recent diets. Candidates needed to show that they could derive logically the amounts that will
be paid, the real values of those amounts and their present values in real terms. Appropriate
formulae then needed to be developed.
Question 12
Many candidates answered this question well although a minority scored very badly (possibly
due to time pressure).
Page 3
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report
1 (i) A future is a contract binding buyer and seller to deliver or take delivery of an
asset at a given price at a given time in the future. An option is a contract that
gives the buyer the option to deliver or take delivery of the asset at the given
price. The seller of the option must deliver/take delivery if the buyer of the
option wishes to exercise the option.
(ii) Convertibles have option-like characteristics because they give the holder the
option to purchase equity in a company on pre-arranged terms.
4 s3 + 2 s2 + 2 s1
=
i
(4s + 2s2 + 2 s1
δ 3
)
0.04
= ( 4 × 3.1216 + 2 × 2.0400 + 2 )
0.039221
= 18.9352
4 (i) The no arbitrage assumption means that it is assumed that an investor is unable
to make a risk-free trading profit.
(ii) In all states of the world, security B pays 80% of A. Therefore its price must
be 80% of A’s price, or the investor could obtain a better payoff by only
purchasing one security and make risk-free profits by selling one security short
and buying the other. The price of B must therefore be 16p.
Page 4
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report
t = 675.9 days
( )
4t
3,600 1 + 0.06
4
365
= 4,000
t = 645.7 days
( )
12 t
3,600 1 + 0.06
12
365
= 4,000
t = 642.5 days
(ii) (i)(a) takes longest because, under conditions of simple interest, interest does
not earn interest.
6 (i) Let it be the (random) rate of interest in year t . Let S10 be the accumulation of
the unit investment after 10 years:
E [it ] = j
∴ E ( S10 ) = (1 + j )
10
= 1.0710 = 1.96715
(ii) ( )
2
E S10 = E ⎡ ⎡⎣(1 + i1 )(1 + i2 ) …(1 + i10 ) ⎤⎦ ⎤
⎣⎢
2
⎥⎦
( ) ( ) (
= E 1 + 2i1 + i12 E 1 + 2i2 + i22 … E 1 + 2i10 + i10
2
)
Page 5
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report
( ) ( )
10 10
= ⎡ E 1 + 2it + it2 ⎤ = 1 + 2 j + s2 + j 2
⎣ ⎦
( ) − (1 + j )
10
∴ Var [ S n ] = 1 + 2 j + s 2 + j 2
20
(iii) If 1,000 units had been invested, the expected accumulation would have been
1,000 times bigger. The variance would have been 1,000,000 times bigger.
(1 + i2 ) = 1.39188 ⇒ i2 = 39.188%
Linked internal rate of return is i
where (1 + i ) = 0.75 ×1.39188 ⇒ i = 2.1719%
2
(ii) The linked IRR is higher because it relies on two money weighted rates of
return. With the calculation of the second money weighted rate of return, there
is more money in the fund when the fund is performing well (in the second
half of the year).
Page 6
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report
⎧⎪ 5 ⎫⎪
( )
5
8 (i) 150 = 100 exp ⎨ ∫ at + bt 2 dt ⎬ = 100 exp ⎡ 12 at 2 + 13 bt 3 ⎤ = 100 exp [12.5a + 41.667b ]
⎣ ⎦0
⎪⎩ 0 ⎪⎭
⎧⎪10 ⎫⎪
( )
10
230 = 100 exp ⎨ ∫ at + bt 2 dt ⎬ = 100 exp ⎡ 12 at 2 + 13 bt 3 ⎤ = 100 exp [50a + 333.333b ]
⎣ ⎦0
⎪⎩ 0 ⎪⎭
The second expression less four times the first expression gives:
10
0.05t −0.08329t
(iii) Present Value = ∫ 20e e dt
0
10
−0.03329t
= ∫ 20e dt
0
10
⎡ e −0.03329t ⎤
= 20 ⎢ ⎥
⎣⎢ −0.03329 ⎦⎥ 0
= 20 × 8.5058 = 170.116
(12 ) i
1, 060s at 7% = 1, 060 s = 1, 060 × 1.037525 × 94.4608 = £103,885.77
d )
(
30 12 30
(12 ) i
1, 060s at 4% = 1, 060 s = 1, 060 × 1.021537 × 56.0849 = £60, 730.37
30
d (12 ) 30
Page 7
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report
(12 )
1, 060 s
20 4%
(1.04 )10 + 5, 000s10(124%
)
i i
s20 (1.04 ) + 5, 000
10
= 1, 060 s
d( ) d( )
12 12 10
= £109, 053.12
(d) The investor has earned a return of 4 % by investing extra premiums in the
investment policy. The investor could have obtained a lower present value of
total payments on the loan by paying off part of the loan instead. This is
because the interest being paid on the loan was greater than the interest he was
earning on his premiums.
(e) If he had repaid the loan by a level annuity, the annual instalment would have
been X where
X (12 ) (12 )
a360 = 100, 000 at 0.5% (or Xa = 100, 000 with i = 6% & i = 6.168%)
12 30
i
δ
(
( 50 + 10 ) v + 1.03v 2 + 1.032 v3 + … + 1.0319 v 20 )
i
(
= 60v 1 + 1.03v + (1.03v ) + … + (1.03v )
δ
2 19
)
i
= 60v
(
1 − (1.03v )
20
) = 1.019869 × 60 × 0.96154 × ⎛ 1 −1.80611× 0.45639 ⎞
⎜ ⎟
δ 1 − 1.03v ⎝ 1 − 1.03 × 0.96154 ⎠
Page 8
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report
i
δ
(
60v + 19v 2 + 18v3 + … + v 20 )
= 40
iv i
(
+ 20v + 19v 2 + 18v3 + … + v 20
δ δ
)
= 40
iv i
( i
) (
+ 21a20 − Ia20 = 40v + 21a20 − Ia20
δ δ δ
)
= 1.019869 × ( 40 × 0.96154 + 21× 13.5903 − 125.1550 )
i
δ
( i
)
30v + 33v 2 + 36v3 + … + 87v 20 + 12a20
δ
i
δ
(
27 a20 + 3v + 6v 2 + 9v3 + … + 60v 20 + 12a20 )
=
i
δ
(
3 ( Ia )20 + 39a20 )
= 923.478
Page 9
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report
11 (i)
• Payments guaranteed by government.
• Can be various different indexation provisions but, in general, protection is
given against a fall in the purchasing power of money.
• Fairly liquid (i.e. large issue size and ability to deal in large quantities)
compared with corporate issues, but not compared with conventional
issues.
• Normally coupon and capital payments both indexed to increases in a
given price index with a lag.
• Low volatility of return and low expected real return.
• More or less guaranteed real return if held to maturity (can vary due to
indexation lag).
• Nominal return is not guaranteed.
(ii) The first coupon the investor will receive will be on 31st December 2003. The
net coupon per £100 nominal will be:
113.8
0.8 ×1× (Index May 2003/Index November 2001) = 0.8 ×1×
110
113.8 v
In real present value terms, this is 0.8
110 (1 + r )0.5
where r = 2.5% per annum and v is calculated at 1.5% (per half year)
The second coupon on 30th June 2004 per £100 nominal will be
113.8
0.8 ×1× (1 + r )0.5
110
2
0.5 113.8 v
In real present value terms, this is 0.8 (1 + r )
110 (1 + r )
The third coupon on 31st December 2004 per £100 nominal will be
113.8
0.8 ×1× (1 + r )
110
113.8 v3
In real present value terms, this is 0.8 (1 + r )
110 (1 + r )1.5
Continuing in this way, the last coupon payment on 30 June 2009 per £100
113.8
nominal will be 0.8 ×1× (1 + r )5.5
110
Page 10
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report
The present value of the succession of coupon payments and the capital
payment can be written as:
P=
1
(1 + r )
113.8
0.5 110 ( ( )
0.8 v + v 2 + … + v12 + 100v12 )
=
1 113.8
1.0124224 110
(
0.8a12 1.5% + 100v1.5%
12
)
= 1.02185 × ( 0.8 × 10.9075 + 100 × 0.83639 )
= 94.3833
=
(1×160, 000 × v + 2 ×160, 000 × v 2
)
+ … + 15 × 160, 000 × v15 + 200, 000 × 10 × v10
160, 000a15 + 200, 000v 10
=
( )
160, 000 × Ia15 + 200, 000 × 10 × v10
160, 000a15 + 200, 000v10
10,865,340
= = 6.9697 years (½ mark deducted for no units)
1,558,934
Page 11
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report
(iii) Let the nominal amounts in each security equal A and B respectively.
( ) ( )
A 0.08a8 + v8 + B 0.03a25 + v 25 = 1,558,934 (1)
( ) (
A 0.08 ( Ia )8 + 8v8 + B 0.03 ( Ia )25 + 25v 25 ) = 6.9697
1,558,934
( ) ( )
or A 0.08 ( Ia )8 + 8v8 + B 0.03 ( Ia )25 + 25v 25 = 10,865,340 (2)
From (1)
From (2)
Therefore
⎛ 1,558,934 − 0.533858 B ⎞
6.636896 ⎜ ⎟ + 7.976153B = 10,865,340
⎝ 1.059714 ⎠
1,101,872.85
⇒B= = £237,850
4.632647
⎛ 1,558,934 − 0.533858 B ⎞
A=⎜ ⎟ = £1,351, 266
⎝ 1.059714 ⎠
Page 12
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report
(iv) It appears that the asset payments are more spread out than the liability
payments. The third condition for immunisation is that that convexity of the
assets is greater than that of the liabilities, or that the asset times are more
spread around the discounted mean term than the liability times. From
observation is appears likely that this condition is met.
Page 13
Faculty of Actuaries Institute of Actuaries
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.
© Faculty of Actuaries
CT1 A2007 © Institute of Actuaries
1 An investor pays £400 every half-year in advance into a 25-year savings plan.
Calculate the accumulated fund at the end of the term if the interest rate is 6% per
annum convertible monthly for the first 15 years and 6% per annum convertible half-
yearly for the final 10 years. [5]
2 The force of interest δ ( t ) is a function of time and at any time, measured in years, is
given by the formula:
Calculate the present value at time t = 0 of a payment stream, paid continuously from
time t = 9 to t = 12, under which the rate of payment at time t is 50e0.01t .
[6]
3 An ordinary share pays annual dividends. The next dividend is due in exactly eight
months’ time. This dividend is expected to be £1.10 per share. Dividends are expected
to grow at a rate of 5% per annum compound from this level and are expected to
continue in perpetuity. Inflation is expected to be 3% per annum. The price of the
share is £21.50.
Calculate the expected effective annual real rate of return for an investor who
purchases the share. [7]
4 An investor entered into a long forward contract for a security five years ago and the
contract is due to mature in seven years’ time. The price of the security was £95 five
years ago and is now £145. The risk-free rate of interest can be assumed to be 3% per
annum throughout the 12-year period.
(i) The security will pay dividends of £5 in two years’ time and £6 in four years’
time. [3]
(ii) The security has paid and will continue to pay annually in arrear a dividend of
2% per annum of the market price of the security at the time of payment. [3]
[Total 6]
CT1 A2007—2
5 In a particular bond market, n-year spot rates per annum can be approximated by the
function 0.08 − 0.04e −0.1n .
Calculate:
(i) The price per unit nominal of a zero coupon bond with term nine years. [2]
6 A fund had a value of £21,000 on 1 July 2003. A net cash flow of £5,000 was
received on 1 July 2004 and a further net cash flow of £8,000 was received on 1 July
2005. Immediately before receipt of the first net cash flow, the fund had a value of
£24,000, and immediately before receipt of the second net cash flow the fund had a
value of £32,000. The value of the fund on 1 July 2006 was £38,000.
(i) Calculate the annual effective money weighted rate of return earned on the
fund over the period 1 July 2003 to 1 July 2006. [3]
(ii) Calculate the annual effective time weighted rate of return earned on the fund
over the period 1 July 2003 to 1 July 2006. [3]
(iii) Explain why the values in (i) and (ii) differ. [2]
[Total 8]
7 An insurance company has liabilities of £87,500 due in 8 years’ time and £157,500
due in 19 years’ time. Its assets consist of two zero coupon bonds, one paying
£66,850 in four years’ time and the other paying £X in n years’ time. The current
interest rate is 7% per annum effective.
(i) Calculate the discounted mean term and convexity of the liabilities. [5]
(ii) Determine whether values of £X and n can be found which ensure that the
company is immunised against small changes in the interest rate. [5]
[Total 10]
(i) Calculate the amount of the level annual payment and the total amount of
interest which will be paid over the 10 year term. [3]
(ii) At the beginning of the eighth year, immediately after the seventh payment
has been made, the company asks for the term of the loan to be extended by
two years. The bank agrees to do this on condition that the rate of interest is
increased to an effective rate of 12% per annum for the remainder of the term
and that payments are made quarterly in arrear.
(b) Calculate the capital and interest components of the first quarterly
instalment of the revised loan repayments.
[6]
[Total 9]
(i) Calculate the discounted payback period using an effective rate of interest of
10% per annum. [7]
(ii) Without doing any further calculations, explain whether your answer to (i)
would change if the effective rate of interest were less than 10% per annum.
[3]
[Total 10]
CT1 A2007—4
10 A loan is issued bearing interest at a rate of 9% per annum and payable half-yearly in
arrear. The loan is to be redeemed at £110 per £100 nominal in 13 years’ time.
(i) The loan is issued at a price such that an investor, subject to income tax at
25%, and capital gains tax at 30%, would obtain a net redemption yield of 6%
per annum effective. Calculate the issue price per £100 nominal of the stock.
[5]
(ii) Two years after the date of issue, immediately after a coupon payment has
been made, the investor decides to sell the stock and finds a potential buyer,
who is subject to income tax at 10% and capital gains tax at 35%. The
potential buyer is prepared to buy the stock provided she will obtain a net
redemption yield of at least 8% per annum effective.
(a) Calculate the maximum price (per £100 nominal) which the original
investor can expect to obtain from the potential buyer.
(b) Calculate the net effective annual redemption yield (to the nearest 1%
per annum effective) that will be obtained by the original investor if
the loan is sold to the buyer at the price determined in (ii) (a).
[10]
[Total 15]
11 £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.
(i) Derive the expected accumulated amount in the bank account at the end of
three years. [5]
(ii) Derive the variance of the accumulated amount in the bank account at the end
of three years. [8]
(iii) Calculate the probability that the accumulated amount in the bank account is
more than £97,000 at the end of three years. [3]
[Total 16]
END OF PAPER
CT1 A2007—5
Faculty of Actuaries Institute of Actuaries
EXAMINATION
April 2007
EXAMINERS’ REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M A Stocker
Chairman of the Board of Examiners
June 2007
© Faculty of Actuaries
© Institute of Actuaries
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
Comments
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.
However, candidates may be penalised where excessive rounding has been used or where
insufficient working is shown.
Q1.
Whilst most candidates made a good attempt at this question on basic compound interest
accumulation, comparatively few students completed the question without error.
Q2.
Well answered.
Q3.
Most students answered this question well although candidates were expected to note that the
sum of the geometric progression would only converge if the rate of return was below the
dividend growth rate. Depending on the interpolation used, the final answer can justifiably
vary from that given.
Q4.
This proved to be the most difficult question on the paper. Other related methods to
determine the answers were available e.g. calculating the forward price of each contract and
working out the present value of the difference in these prices.
Q5.
Well answered.
Q6.
The calculations in parts (i) and (ii) were generally well done. Again, depending on the
interpolation used, the final answer can justifiably vary from that given although the
examiners penalised the use of too wide a range of interpolation.
The explanation in part (iii) was very poorly handled. In such cases, the examiners are not
simply looking for a statement lifted directly from the Core Reading. Instead, candidates are
expected to apply the relevant theory to the actual situation described in the question.
Page 2
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
Q7.
Q8.
Q9.
Many candidates struggled with this question, firstly in determining when the various
costs/payments would be made and then in manipulating the resulting equation(s). A common
error was not to recognise that the DPP should be expressed as a whole number of months
since payments at the relevant time were being made at monthly intervals. In part (ii) little
credit was given for a correct conclusion without any accompanying explanation.
Q10.
This question seemed to provide a significant differentiation between candidates with many
scoring well and a sizeable minority scoring very badly. This seemed surprising given that
this topic is regularly examined. A common omission on part (ii)(b) was not to state whether
a capital gain had been made.
Q11.
The workings for parts (i) and (ii) were often too brief (the questions said ‘Derive…’). Note
that the final answer in part (ii) can justifiably vary significantly according to the rounding
used in intermediate calculations. Part (iii) was poorly done with many candidates assuming
a lognormal distribution for this discrete example.
Page 3
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
where 1 + i* = (1.005 )
6
⎡ (1.0303775 )30 − 1 ⎤
s30 @ 3.03775% = 1.0303775 × ⎢ ⎥
⎢⎣ 0.0303775 ⎥⎦
= 49.3215
⎡ (1.03)20 − 1 ⎤
S20 @ 3% = 1.03 × ⎢ ⎥ = 27.6765
⎢⎣ 0.03 ⎥⎦
Hence fund =
= 35632.06 + 11070.60
= £46,702.66
− ∫ δ( t )dt
t
12
2 (i) PV = ∫ 50 e 0.01t
. e 0
dt
9
where
t 4 8 t
∫0 δ ( t ) dt = ∫ ( 0.04 + 0.01t ) dt + ∫ 4 ( 0.12 − 0.01t ) dt + ∫ 8 0.06dt
0
4 8
= ⎡0.04t + 0.005t 2 ⎤ + ⎡0.12t − 0.005t 2 ⎤ + [ 0.06t ] 8
t
⎣ ⎦0 ⎣ ⎦4
= 0.06t
Page 4
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
Hence
12
PV = ∫ 50e0.01t . e−0.06t dt
9
12 −0.05t
= ∫ 50 e dt
9
12
⎡ −50 −0.05t ⎤
=⎢ e ⎥
⎣ 0.05 ⎦9
= –548.812 + 637.628
= 88.816
⇒ 1 + i = (1 + i′ )(1.03) here
21.50 = (1 + i )
4
12
( )
⋅ 1.10v + 1.05 × 1.10v 2 + (1.05 ) × 1.10v3 + ""
2
= (1 + i )
4
12
⎛ 1 − 1.05 ∞
× 1.10v ⎜ 1+i ( ) ⎞
⎟
⎜ 1 − 1.05
⎜
⎝ 1+i ( ) ⎟
⎟
⎠
1 1
= 1.10 × assuming i > 0.05
(1 + i )
8
12 (1 − 1.05
1+i )
1 1
19.5455 = ×
(1 + i )
8
12 1 − 1.05
1+i
20.6456 − 19.5455
⇒ i = 0.10 + × 0.01 = 0.10325
20.6456 − 17.2566
1.10325
⇒ i′ comes from 1 + i′ = ⇒ i′ = 7.1% p.a.
1.03
Page 5
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
4 (i) The current value of the forward price of the old contract is:
−2 −4
95 × (1.03) − 5 (1.03) − 6 (1.03)
5
whereas the current value of the forward price of a new contract is:
−2 −4
145 − 5 (1.03) − 6 (1.03)
(ii) The current value of the forward price of the old contract is:
−12
95 (1.02 ) (1.03)5 = 86.8376
whereas the current value of the forward price of a new contract is:
−7
145 (1.02 ) = 126.2312
Y9 = 0.063737
9
⎛ 1 ⎞
P9 = ⎜ ⎟ = 0.57344
⎝ 1 + Y9 ⎠
Page 6
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
−0.1( 7 )
(ii) Y7 = 0.08 − 0.04 e = 0.060137
−0.1(11)
Y11 = 0.08 − 0.04e = 0.066685
(1 + Y11 )
11
(1.066685 )
11
(1 + f7,4 )
4
= =
(1 + Y7 )7 (1.060137 )7
= 1.35165
21(1 + i ) + 5 (1 + i ) + 8 (1 + i ) = 38
3 2
24 32 38
(1 + i )3 = × × ⇒ i = 6.21% p.a.
21 29 40
(iii) MWRR is lower than TWRR because of the large cash flow on 1/7/05; the
overall return in the final year is much lower than in the first 2 years, and the
payment at 1/7/05 gives this final year more weight in the MWRR, but does
not affect the TWRR.
Page 7
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
= 94,475.86
1, 234,857.56
=
94, 475.86
= 13.070615 years
17, 657,158.78
=
94, 475.86
= 186.895985
Page 8
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
(
C A = 66,850 × 4 × 5v 6 + 216, 255.12n ( n + 1) v(
n+ 2)
) / 94, 475.86
= 23,140,343.20/94,475.86
= 244.93393
> CL
⇒ P = 119, 223.26
= £392,232.60
⇒ P′ = 81, 646.28
⎝ ⎠
Page 9
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
9 (i) The discounted payback period is the first point at which the present value of
the income exceeds the present value of the outgoings. The present value of
all payments and income up to time t is given by (working in £m)
(12 ) 1
(12 ) 1
(12 )
PV = −40 − 36a 1 − 2v 2 a 1 + 12v 2 a 1
2 t− 2 t − 2 + 112
(12 ) 1
(12 ) 1
⎛1 (12 ) ⎞
= −40 − 36a 1 − 2v 2 a 1 + 12v 2 ⎜ 12 +a 1 ⎟
2 t− 2 ⎝ t− 2 ⎠
(12 ) t − 0.5
= −40 − 36a 1 + v 2 + 10v 2 1−v(12)
1 1
2 i
1
(12 ) 1− v 2 1 − 0.9534626
a1 = at 10% = = 0.48634
i( )
2
12 0.0956897
⇒ 0.56758 = 1 - vt-0.5
⇒ vt-0.5 = 0.43242
log( 0.43242 )
⇒t = log 0.90909 + 0.5
( )
⇒t ≥ 9.296
(ii) If the effective rate of interest were less than 10% p.a. then the present values
of the income and outgo would both increase. However, the bigger impact
would be on the present value of the income since the bulk of the outgo occurs
in the early years when discounting has less effect. Hence, the DPP would
decrease.
i ( ) = 0.059126
2
10 (i)
0.09
g (1 − t1 ) = × 0.75=0.06136
1.10
⇒ i ( ) < (1 − t1 ) g
2
⇒ No capital gain
Page 10
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
( 2)
= 0.75 × 9 a +110v13 at 6%
13
= 60.639 + 51.572
= £112.21
i ( ) = 0.078461
2
(ii) (a)
0.09
g (1 − t1 ) = × 0.90= 0.073636
1.10
⇒ i ( ) > (1 − t1 ) g
2
⇒ Capital gain
( 2)
Price, P = 0.90 × 9 × a + (110 − (110 − P ) × 0.35 ) v11 at 8%
11
89.62508
= = 105.455
0.849892
( 2)
112.21 = 0.75 × 9 × a + 105.455v 2
2
Page 11
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
E ( i1 ) = 13 ( 0.04+0.06+0.08 ) =0.06
Then:
= E ⎡⎣80,000 (1 + i1 )(1 + i2 ) (1 + i3 ) ⎤⎦
= 80,000 E (1 + i1 ) . E (1 + i2 ) . E (1 + i3 )
E ⎡ S32 ⎤ = E ⎡⎢(1 + i1 ) (1 + i2 ) (1 + i3 ) ⎤⎥
2 2 2
⎣ ⎦ ⎣ ⎦
using independence
( )( )(
= 1 + 2 E [i1 ] + E ⎡i12 ⎤ . 1 + 2 E [i2 ] + E ⎡i22 ⎤ ⋅ 1 + 2 E [i3 ] + E ⎡i32 ⎤
⎣ ⎦ ⎣ ⎦ ⎣ ⎦ )
Page 12
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report
Now,
( ) ( )
E i12 = 13 0.042 + 0.062 + 0.082 = 0.0038667
( )
E i22 = 0.75 × 0.07 2 + 0.25 × 0.052 = 0.0043
( )
E i32 = 0.7 × 0.062 + 0.3 × 0.042 = 0.0030
Hence, E ⎡ S32 ⎤
⎣ ⎦
=1.41631
(
= 80, 0002 1.41631 − (1.18986 )
2
)
= 3,476,355
But, if in any year, the highest interest rate for the year is not achieved then the
fund after 3 years falls below £97,000.
Hence, answer is probability that highest interest rate is achieved in each year
1
= × 0.75 × 0.7 = 0.175
3
Page 13
Faculty of Actuaries Institute of Actuaries
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.
© Faculty of Actuaries
CT1 S2007 © Institute of Actuaries
1 A 90-day government bill is purchased for £96 at the time of issue and is sold after 45
days to another investor for £97.90. The second investor holds the bill until maturity
and receives £100.
2 An investor purchases a share for 769p at the beginning of the year. Halfway through
the year he receives a dividend, net of tax, of 4p and immediately sells the share for
800p. Capital gains tax of 30% is paid on the difference between the sale and the
purchase price.
Calculate the net annual effective rate of return the investor obtains on the investment.
[4]
Determine which, if any, of the payment options the customer will accept. [4]
5 A one-year forward contract is issued on 1 April 2007 on a share with a price of 900p
at that date. Dividends of 50p per share are expected on 30 September 2007 and 31
March 2008. The 6-month and 12-month spot, risk-free rates of interest are 5% and
6% per annum effective respectively on 1 April 2007.
6 The annual effective forward rate applicable over the period t to t + r is defined as
ft ,r where t and r are measured in years. f 0,1 = 4%, f1,1 = 4.25% f 2,1 = 4.5%,
f 2,2 = 5%. Calculate the following:
(ii) All possible zero coupon (spot) yields that the above information allows you
to calculate. [4]
(iii) The gross redemption yield of a four-year bond, redeemable at par, with a 3%
coupon payable annually in arrears. [6]
(iv) Explain why the gross redemption yield from the four-year bond is lower than
the one-year forward rate up to time 4, f3,1 [2]
[Total 13]
CT1 S2007—2
7 The force of interest, δ(t ) , is a function of time and at any time t (measured in years)
is given by
(i) Derive, and simplify as far as possible, expressions for v (t ) where v(t ) is the
present value of a unit sum of money due at time t. [5]
(ii) (a) Calculate the present value of £1,000 due at the end of 15 years.
The rates of return earned on money invested in the fund were as follows:
5% 6% 6.5% 3%
You may assume that 1 January to 30 June and 1 July to 31 December are precise half
year periods.
(i) Calculate the linked internal rate of return per annum over the three years from
1 January 2004 to 31 December 2006, using semi-annual sub-intervals. [3]
(ii) Calculate the time weighted rate of return per annum over the three years from
1 January 2004 to 31 December 2006. [3]
(iii) Calculate the money weighted rate of return per annum over the three years
from 1 January 2004 to 31 December 2006. [4]
(iv) Explain the relationship between your answers to (i), (ii) and (iii) above. [2]
[Total 12]
(i) calculate the expected value of an investment of £2 million after ten years. [6]
(ii) calculate the probability that the accumulation of the investment will be less
than 80% of the expected value. [3]
[Total 9]
The consumers’ association asserts that, on this particular type of loan, consumers
who make all their repayments pay interest at an annual effective rate of over 200%.
The banks state that, on the same loans, 40% of the consumers default on all their
remaining payments after exactly 12 payments have been made. Furthermore half of
the consumers who have not defaulted after 12 payments default on all their
remaining payments after exactly 18 payments have been made. The banks also argue
that it costs 30% of each monthly repayment to collect the payment. These costs are
still incurred even if the payment is not made by the consumer. Furthermore, with
inflation of 2.5% per annum, the banks therefore assert that the real rate of interest
that the lender obtains on the loan is less than 1.463% per annum effective.
(i) (a) Calculate the flat rate of interest paid by the consumer on the loan
described above.
(b) State why the flat rate of interest is not a good measure of the cost of
borrowing to the consumer. [4]
(ii) Determine, for each of the cases above, whether the assertion is correct. [10]
[Total 14]
CT1 S2007—4
11 A pension fund has liabilities to pay pensions each year for the next 60 years. The
pensions paid will be £100m at the end of the first year, £105m at the end of the
second year, £110.25m at the end of the third year and so on, increasing by 5% each
year. The fund holds government bonds to meet its pension liabilities. The bonds
mature in 20 years time and pay an annual coupon of 4% in arrears.
(i) Calculate the present value of the pension fund’s liabilities at a rate of interest
of 3% per annum effective. [4]
(ii) Calculate the nominal amount of the bond that the fund needs to hold so that
the present value of the assets is equal to the present value of the liabilities. [3]
(v) Using your calculations in (iii) and (iv), estimate by how much more the value
of the liabilities would increase than the value of the assets if there were a
reduction in the rate of interest to 1.5% per annum effective. [4]
[Total 21]
END OF PAPER
CT1 S2007—5
Faculty of Actuaries Institute of Actuaries
EXAMINATION
September 2007
MARKING SCHEDULE
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M A Stocker
Chairman of the Board of Examiners
December 2007
© Faculty of Actuaries
© Institute of Actuaries
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
Comments
Please note that different answers may be obtained from 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.
However, candidates may be penalised where excessive rounding has been used or where
insufficient working is shown.
It should be noted that the rubric of the examination paper does ask for candidates to show
their calculations where this is appropriate. Candidates often failed to show sufficient clarity
and detail in their working and lost marks as a result.
Q1.
Well answered.
Q2.
Well answered.
Q3.
Whilst this question was generally answered well, some candidates lost marks by not stating
the conclusions that arose from their calculations i.e. that neither deal was acceptable.
Q4.
This question was very poorly answered which was disappointing given that this was a
bookwork question.
Q5.
Reasonably well answered but some candidates failed to obtain full marks by not stating the
required assumption.
Q6.
Parts (i) and (ii) were well answered but part (iii) was a good differentiator with weaker
candidates failing to recognise the correct method for calculating the gross redemption yield.
As with many previous diets, many candidates in part (iv) had great difficulty in giving a
clear explanation of their calculations.
Page 2
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
Q7.
Generally well answered. Some candidates lost marks by not giving an explicit formula for
v(t) when t ≤ 10.
Q8.
This question was very poorly answered to the surprise of the examiners who felt that the
question should have been relatively straightforward.
Q9.
Part (i) can be done much more simply than by using the method given in this report but the
calculations given would still need to be done for part (ii).
Q10.
This question was the worst answered on the paper. Part (ii) did successfully differentiate
between candidates with weaker candidates appearing to struggle to apply the theory to a
real-life situation.
Q11.
The first three parts were generally answered well by the candidates who attempted the
question. Many struggled to complete part (iv) although it is possible that this was due to
time pressure. When calculating DMTs, candidates were expected to give the answer in terms
of the correct units.
Page 3
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
97.9 100
>
96 97.9
This inequality does not hold, therefore the second investor receives the higher rate of
return.
2 Start by working in half years. The half yearly effective return is i such that:
769
v= = 0.967661 therefore i = 3.3420%
794.7
(12 )
240 a < 456 at a rate of interest of 5%
2
(12 )
240 a = 240 × 1.8594 × 1.026881 = 458.252
2
(12 )
246 a = 246 × 1.8594 × 1.022715 = 467.803
2
Page 4
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
5 Assuming no arbitrage:
Present value of dividends is (in£):
0.5v1/2 (at 5%) + 0.5v (at 6%) = 0.5(0.97590+0.94340) = 0.95965
6 (i) f3,1 is such that 1.045 × f3,1 = 1.052. Therefore f3,1 = 5.5024%
Four year spot rate is such that (1+ i4 )4 = 1.04 × 1.0425 × 1.045 × 1.055024
Therefore i4 = 4.5615%
Equation of value to find the gross redemption yield from the bond is such
that:
94.468 = 3 a4 + 100v4
Try i = 4.5%
Page 5
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
Try i = 5%
Interpolation:
= 4.544%
(iv) The yield from the bond is lower than the one-year forward rate up to time 4
because the bond can be seen to be a series of zero coupon bonds (1 year, 2
years etc.) each with lower yields than the forward rate. The gross redemption
yield from the bond is, in effect, an average of spot rates that are themselves a
weighted average of earlier forward rates.
7 (i) For t ≤ 10
t
t
− ∫ 0.04+ 0.01sds − ⎡ 0.04 s + 0.005 s 2 ⎤
v (t ) = e = e −0.04t −0.005t
2
⎣ ⎦0
0 =e
For t > 10
t
−[ 0.05 s ]10
t
−0.05( t −10 )
=e (
− ∫ 0.05ds − 0.4+ 0.05t )
v ( t ) = v (10 ) e 10 = e−0.9 e = e−0.9 e
15 − (0.4+ 0.05t )
(iii) Present value = ∫ e 20e−0.01t dt
10
15 −0.4 −0.06t
= 20 ∫ e e dt
10
15
⎡ e −0.06t ⎤
= 20e −0.4
⎢ ⎥ = 20e
−0.4
( −6.77616 + 9.14686 ) = 31.783
⎣⎢ −0.06 ⎦⎥10
Page 6
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
8 (i) Linked internal rate of return is found by linking the money weighted rate of
return from the sub-periods.
(ii) The TWRR requires the value of the fund every time a payment is made.
Size of the fund after six months is: 12.5 × (1.05) = 13.125
Size of the fund after one year is: (13.125 + 6.6) × 1.06 = 20.909
Size of the fund after two years is: (20.909 + 7) × 1.065 = 29.723
Size of the fund after three years is: (29.723 + 8) × 1.03 = 38.855
giving i = 6.879%
(iii) For MWRR, we need to know the size of the fund at the end of the period. We
can use the values above to give:
(iv) (i) and (ii) are the same because there are no cash flows within sub-periods to
“distort” the LIRR away from the TWRR. The MWRR is lower because the
fund has a smaller amount of money in it at the beginning when rates of return
are higher.
Page 7
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
9 (i) (1 + it ) ~ Lognormal ( μ, σ2 )
(
ln (1 + it ) ~ N μ, σ2 )
ln (1 + it )
10
(
= ln (1 + it ) + ln (1 + it ) + … + ln (1 + it ) ~ N 10μ,10σ 2 )
since it ' s are independent
(1 + it )10 ~ Lognormal (10μ,10σ2 )
[½] for correct use of independence assumption
⎛ σ2 ⎞
E (1 + it ) = exp ⎜ μ + ⎟ = 1.06
⎜ 2 ⎟⎠
⎝
( ) ( )
Var (1 + it ) = exp 2μ + σ 2 ⎡exp σ 2 − 1⎤ = 0.082
⎣ ⎦
0.082
1.06 2⎣ ( )
= ⎡ exp σ2 − 1⎤ ∴σ2 = 0.0056798
⎦
⎛ 0.0056798 ⎞ 0.0056798
exp ⎜ μ + ⎟ = 1.06 ⇒ μ = ln1.06 − = 0.055429
⎝ 2 ⎠ 2
10μ = 0.55429 , 10σ2 = 0.056798
⎛ 0.056798 ⎞
E ( S10 ) = exp ⎜ 0.55429 + ⎟ = 1.790848
⎝ 2 ⎠
⎡ ln1.4327 − 0.55429 ⎤
⇒ P ⎢ N ( 0,1) < ⎥
⎣ 0.056798 ⎦
⇒ P ⎡⎣ N ( 0,1) < −0.8171⎤⎦ = 0.207 ≈ 21%
Page 8
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
10 (i) (a) The flat rate of interest is: (2× 2,400 – 2,000)/(2× 2,000) = 70%
(b) The flat rate of interest is not a good measure of the cost of borrowing
because it takes no account of the timing of payments and the timing of
repayment of capital.
(ii) If the consumers’ association is correct, then the present value of the
repayments is greater than the loan at 200%
i
i.e. 2, 000 < 2, 400 a2
d( )
12
If the banks are correct, then the present value of the payments received by the
bank, after expenses, is less than the amount of the loan at a nominal (before
inflation) rate of interest of (1.01463 × 1.025 -1) per annum effective = 0.04.
i i i i
i.e. 2, 000 > 720 a + 720 a + 960 a − 0.3 × 2, 400 a
d (12 ) 2
d (12 ) 1.5
d (12 ) 1
d (12 ) 2
i 1 − 1.04−1.5
= 1.021529; a2 = 1.8861; a1 = 0.9615; a1.5 = = 1.4283
d( )
12 0.04
So RHS = 720 × 1.021529 × 1.8861+ 720 × 1.021529 × 1.4283 +
960× 1.021529× 0.9615 – 0.3× 2,400× 1.021529× 1.8861
(
100 v + 1.05v 2 + 1.052 v3 + … + 1.0559 v60 )
(
= 100v 1 + 1.05v + (1.05v ) + … + (1.05v )
2 59
)
⎛ 1- 1.05
( ) ⎞
60
⎛ 1 − (1.05v )60
⎞
= 100v ⎜ ⎟ = 100 × 0.97087 ⎜ 1.03 ⎟
⎜ 1 − 1.05v
⎝
⎟
⎠
⎜ 1- 1.05
⎜
⎝ 1.03 ( ) ⎟
⎟
⎠
= 97.087 × 111.7795 = £10,852m
Page 9
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
(iii) The numerator for the duration of the liabilities can be expressed as follows:
1.03
= 100 v (1.05v × 1 + 1.052v2 × 2 + 1.053v3 × 3+…+1.0560v60 × 60)
1.05
The part inside the brackets can be regarded as ( Ia )60 evaluated at a rate of
interest i such that v = 1.05/1.03; the discount factor outside the brackets
should be evaluated at 3%
1.03 100
100 v = = 95.2381
1.05 1.05
111.7727 − 60 ×1.01941760
( Ia )60 = = 4118.567
−0.019048
(iv) The duration of the assets can be expressed as the sum of payments times time
of receipt times present value factors divided by total present value.
(v) Duration of the liabilities is 36.1 years. Therefore volatility of the liabilities is:
36.1/1.03 = 35. If there were a reduction in interest rates to 1.5%, the liabilities
would increase in value by approximately 35 × 1.5 = 52.5%
Page 10
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report
Duration of the assets is 14.6 years. Therefore volatility of the assets is:
14.6/1.03 = 14.2. If there were a reduction in interest rates to 1.5%, the assets
would increase in value by approximately 14.2 × 1.5 = 21.3%.
Page 11
Faculty of Actuaries Institute of Actuaries
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
© Faculty of Actuaries
CT1 A2008 © Institute of Actuaries
1 An eleven month forward contract is issued on 1 March 2008 on a stock with a price
of £10 per share at that date. Dividends of 50 pence per share are expected to be paid
on 1 April and 1 October 2008.
Calculate the forward price at issue, assuming a risk-free rate of interest of 5% per
annum effective and no arbitrage. [4]
(a) Eurobonds
(b) Certificates of deposit [4]
3 A mortgage company offers the following two deals to customers for twenty-five year
mortgages.
Product A
Product B
Compare the annual effective rates of return paid by customers on the two products.
[8]
An investor who is liable to income tax at 25% and capital gains tax at 35% wishes to
purchase the entire loan at the date of issue.
Calculate the price which the investor should pay to ensure a net effective yield of at
least 5% per annum. [8]
CT1 A2008—2
5 The n –year spot rate of interest, in , is given by:
in = a − bn
The one-year forward rates applicable at time 0 and at time 1 are 6.1% per annum
effective and 6.5% per annum effective respectively. The 4–year par yield is 7% per
annum.
(ii) calculate the price per £1 nominal at time 0 of a bond which pays annual
coupons of 5% in arrear and is redeemed at 103% after 4 years. [5]
[Total 9]
(ii) Explain why the answer in (i)(b) is higher than the answer in (i)(a). [2]
[Total 8]
7 The shares of a company currently trade at £2.60 each, and the company has just paid
a dividend of 12p per share. An investor assumes that dividends will be paid annually
in perpetuity and will grow in line with a constant rate of inflation. The investor
estimates the assumed inflation rate from equating the price of the share with the
present value of all estimated future gross dividend payments using an effective
interest rate of 6% per annum.
(i) Calculate the investor’s estimation of the effective inflation rate per
annum based on the above assumptions. [4]
(ii) Suppose that the actual inflation rate turns out to be 3% per annum effective
over the following twelve years, but that all the investor’s other assumptions
are correct.
Calculate the investor’s real rate of return per annum from purchase to sale, if
she sold the shares after twelve years for £5 each immediately after a dividend
has been paid. You may assume that the investor pays no tax. [6]
[Total 10]
The project requires an outlay of £500,000 at outset and further payments at the end
of each of the first 5 years, the first payment being £100,000 and each successive
payment increasing by £10,000.
The project is expected to provide a continuous income at a rate of £80,000 in the first
year, £83,200 in the second year and so on, with income increasing each year by 4%
per annum compound. The income is received for 25 years.
(i) Calculate the net present value of the project at a rate of interest of 11% per
annum effective. [9]
(ii) Without doing any further calculations, explain how the net present value
would alter if the interest rate had been greater than 11% per annum effective.
[3]
[Total 12]
9 The force of interest, δ ( t ) , is a function of time and at any time t, measured in years,
is given by the formula:
⎧0.06 0≤t ≤4
⎪
δ ( t ) = ⎨0.10 − 0.01t 4<t ≤7
⎪0.01t − 0.04 7<t
⎩
(i) Calculate the value at time t = 5 of £1,000 due for payment at time t = 10. [5]
(ii) Calculate the constant rate of interest per annum convertible monthly which
leads to the same result as in (i) being obtained. [2]
CT1 A2008—4
10 An insurance company holds a large amount of capital and wishes to distribute some
of it to policyholders by way of two possible options.
Option A
£100 for each policyholder will be put into a fund from which the expected annual
effective rate of return from the investments will be 5.5% and the standard deviation
of annual returns 7%. The annual effective rates of return will be independent and
(1+ it ) is lognormally distributed, where it is the rate of return in year t. The
policyholder will receive the accumulated investment at the end of ten years.
Option B
£100 will be invested for each policyholder for five years at a rate of return of 6% per
annum effective. After five years, the accumulated sum will be invested for a further
five years at the prevailing five-year spot rate. This spot rate will be 1% per annum
effective with probability 0.2, 3% per annum effective with probability 0.3, 6% per
annum effective with probability 0.2, and 8% per annum effective with probability
0.3. The policyholder will receive the accumulated investment at the end of ten years.
(i) Calculate the expected value and the standard deviation of the sum the
policyholders will receive at the end of the ten years for each of options A and
B. [17]
(ii) Determine the probability that the sum the policyholders will receive at the
end of ten years will be less than £115 for each of options A and B. [5]
(iii) Comment on the relative risk of the two options from the policyholders’
perspective. [2]
[Total 24]
END OF PAPER
CT1 A2008—5
Faculty of Actuaries Institute of Actuaries
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M A Stocker
Chairman of the Board of Examiners
June 2008
© Faculty of Actuaries
© Institute of Actuaries
Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report
Comments
Comments on solutions presented to individual questions for this April 2008 paper are given
below.
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. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.
Question 2 As has often been the case when words rather than numbers have been
required, this bookwork question was answered poorly.
Question 3 Generally well answered, although some students treated the fees on Product
B paid by the customer as a cost to the mortgage company.
Question 4 Well answered although many candidates’ working was unclear when
performing the CGT test.
Question 5 Part (i) was answered well but in part (ii) many candidates failed to recognise
the need to calculate the 4-year spot rate before calculating the bond price.
Question 6 Part (i) of this question did appear to differentiate between stronger
candidates who often scored very well and weaker candidates who often failed
to score at all. As with many previous diets, many candidates in part (ii) had
difficulty in giving a clear explanation of their results.
Question 7 This question was answered relatively poorly with, particularly in part (ii),
candidates often appearing confused between real and money rates of interest.
Question 10 Part (i) (for Option A) can be done much more simply than by using the
method given in this report but the calculations given would still need to be
done for part (ii). It was disappointing to see many candidates incorrectly
calculate the mean accumulated value for Option B by using the mean rate of
interest. Few candidates brought together the answers from (i) and (ii) to fully
answer part (iii).
Page 2
Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report
2 (a) Eurobonds
form of unsecured medium or long-term borrowing
issued in a currency other than the issuer's home currency outside the
issuer's home country
pay regular interest payments and a final capital repayment at par.
issued by large companies, governments and supra-national organisations.
yields depend upon the issuer and issue size but will typically be slightly
lower than for the conventional unsecured loan stocks of the same issuer.
issuers have been free to add novel features to their issues in order to
make them appeal to different investors.
usually issued in bearer form
(b) Certificates of Deposit
a certificate stating that some money has been deposited
issued by banks and building societies
terms to maturity are usually in the range 28 days to 6 months.
interest is payable on maturity
security and marketability will depend on the issuing bank
active secondary market
(12 )
Xa = 100, 000 at 4%
25
(12 ) i
a = a = 1.021537 × 15.6221 = 15.95855
d( )
25 12 25
100,000
⇒ X= = 6, 266.23
15.95855
Page 3
Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report
The equation of value to calculate the rate of return from Product B is:
i
6,000 + 5,000v 25 + 6, 266.23 a = 100, 000
d )
(12 25
Clearly the rate of return must be greater than 4%. Try 5%.
LHS = 6, 000 + 5, 000 × 0.29530 + 6,266.2335 ×1.026881×14.0939 = 98,166
At 5% the present value of the payments is less than the amount of the loan at 5% so
the rate of return must be less than 5%. Try 4%:
LHS = 6, 000 + 5, 000 × 0.37512 + 100, 000 = 107,876
⎛ i ( 4) ⎞
4
( 4)
4 ⎜⎜1 + ⎟⎟ = 1.05 ⇒ i = 0.049089
⎝ 4 ⎠
0.07
g (1 − t1 ) = × 0.75 = 0.04861
1.08
⇒ i ( 4) > (1 − t1 ) g
⇒ Capital gain on contract and we assume loan is redeemed as late as possible (i.e.
after 20 years) to obtain minimum yield.
( 4)
P = 0.07 ×100, 000 × 0.75 × a20
( )
+ 70, 200v 20
4
5250a20
⇒P=
1 − 0.35v 20
= 107,245.38
Page 4
Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report
5 Assuming no arbitrage.
i1 = f 0 and (1 + i2 ) = (1 + i1 )(1 + f1 ) .
2
(i)
Hence a – b = 0.061
⇒ a = b + 0.061
(1 + a − 2b ) = 1.061× 1.065
2
⇒ 1 + a − 2b = 1.061× 1.065
⇒ b = − 0.002
⇒ a = 0.059
1 = 0.07 (v i1 )
+ vi22 + vi33 + vi44 + vi44
= 0.07 (1.061−1 + 1.063−2 + 1.065−3 ) + 1.07 × vi44
⇒ (1 + i4 ) = 1.31429212
4
⇒ i4 = 7.0713% p.a
(
P = 0.05 vi1 + vi22 + vi33 + vi44 + 1.03vi44 )
( −2
= 0.05 1.061−1 + 1.063 + 1.065−3 + 1.08 × 1.070713−4)
= 0.9545
Page 5
Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report
(ii) The duration in (i)(b) is higher because the payments increase over time so
that the weighting of the payments is further towards the end of the series.
7 (i) (
260 = 12 v (1 + e ) + v 2 (1 + e ) + v 3 (1 + e ) + ......
2 3
)
1
where v = and e denotes inflations rate.
1.06
Then,
1 1+ e 0.06 − e
260 = 12a∞ at j % where = i.e. j =
1+ j 1+ i 1+ e
12
⇒ 260 =
j
⇒ j = 0.046153846
⇒ e = 0.01324 i.e 1.324% pa
= 0.098
Then (1 + i′ )(1 + e ) = 1 + i
1.0982
⇒ 1 + i′ = ⇒ i′ = 6.62% pa
1.03
Page 6
Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report
Outlay
1 − v5
a5 = = 3.695897
0.11
= 10.319900
= 935.8297
Income
(
PV = 80 a1 + 1.04v a1 + (1.04 ) v 2 a1 + " " + (1.04 ) v 24 a1
2 24
)
⎡1 − (1.04v )25 ⎤
= 80a1 × ⎢ ⎥
⎢⎣ 1 − (1.04v ) ⎥⎦
i 0.11 1
where a1 = .v = . = 0.949589
δ ln1.11 1.11
= 21.2368 (£21,237)
1
(ii) If interest > 11% then decreases.
1+ i
Page 7
Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report
⎛ ⎡ 0.01t 2 ⎤ ⎞
10
⎛ ⎡ 0.01t 2 ⎤ ⎞
7
⎛ ⎡ 0.01∗ 51 ⎤⎞ ⎛ ⎡ 0.01 ∗ 24 ⎤ ⎞
= 1000 ∗ exp ⎜ − ⎢ − 0.04 × 3⎥ ⎟ ∗ exp ⎜ − ⎢ 0.10 ∗ 2 − ⎥⎦ ⎟
⎝ ⎣ 2 ⎦⎠ ⎝ ⎣ 2 ⎠
= 1000 ∗ exp ( −0.255 + 0.12 − 0.20 + 0.12 )
4 7 12
× e ∫t × e ∫4 × e ∫7
4 ( 0.10 − 0.01r ) dr ( 0.01r − 0.04 ) dr
∫ 100e
0.02 t 0.06 dr
(iii) Accumulated amount = dt
0
7 12
⎡ 0.10 r − 0.01 r 2 ⎤ ⎡ 0.01 r 2 − 0.04 r ⎤
4 [0.06 r ]t4
= 100 ∫ e ×e ×e ⎣⎢ ⎥4
×e ⎣⎢ 2 ⎦⎥ 7
0.02 t 2 ⎦
dt
0
= 100 ∫ e0.02t e(
0.24 − 0.06 t )
e(
0.30 − 0.165)
e(
4 0.475− 0.200 )
dt
0
4
= 100e0.24 e0.135e0.275 ∫ e −0.04t dt
0
4
⎡ −e −0.04t ⎤
0.65
= 100e ⎢ ⎥
⎣ 0.04 ⎦ 0
= 2,500e0.65 (1 − e−0.16 )
Page 8
Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report
= 708.06
10 (i) Option A:
(1 + it ) ~ Lognormal ( μ, σ2 )
(
ln (1 + it ) ~ N μ, σ2 )
ln (1 + it )
10
(
= ln (1 + it ) + ln (1 + it ) + … + ln (1 + it ) ~ N 10μ,10σ2 )
since it ' s are independent
(1 + it )10 ~ Lognormal (10μ,10σ2 )
⎛ σ2 ⎞
E (1 + it ) = exp ⎜ μ + ⎟⎟ = 1.055
⎜ 2
⎝ ⎠
( ) ( )
Var (1 + it ) = exp 2μ + σ2 ⎡exp σ2 − 1⎤ = 0.07 2
⎣ ⎦
0.07 2
1.055 2⎣ ⎦ ( )
= ⎡exp σ2 − 1⎤ ∴σ2 = 0.0043928
⎛ 0.0043928 ⎞ 0.0043928
exp ⎜ μ + ⎟ = 1.055 ⇒ μ = ln1.055 − = 0.051344
⎝ 2 ⎠ 2
10μ = 0.51344 , 10σ2 = 0.043928
⎛ 0.043928 ⎞
E ( S10 ) = exp ⎜ 0.51344 + ⎟ = 1.70814
⎝ 2 ⎠
Accumulated sum is 100 E ( S10 ) = £170.81
Option B:
Page 9
Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report
The expected value of the accumulated sum at the end of ten years is:
(
133.823 0.2 ×1.015 + 0.3 ×1.035 + 0.2 × 1.065 + 0.3 × 1.085 )
= 133.823 ( 0.2 × 1.05101 + 0.3 × 1.15927 + 0.2 × 1.33823 + 0.3 × 1.46933)
= £169.48
Option A:
Var ( S10 ) = exp ( 2 × 0.51344 + 0.043928 ) ⎡⎣exp ( 0.043928 ) − 1⎤⎦
= 2.91776 × 0.04491 = 0.13103
Therefore standard deviation of £100 is 100 0.13103 = £36.20
Option B:
Here we need to find the expected value of the square of the accumulation as
follows:
(
133.8232 0.2 ×1.051012 +0.3 × 1.15927 2 +0.2 × 1.338232 +0.3 × 1.469332 )
= 29,189.86
⎡ ln1.15 − 0.51344 ⎤
⇒ P ⎢ N ( 0,1) < ⎥
⎣ 0.043928 ⎦
⇒ P ⎡⎣ N ( 0,1) < −1.7829 ⎤⎦ = 0.0373 ≈ 4%
There is a probability of 0.2 that the amount will be 100 × 1.065 × 1.015 or less
which equals 133.823 ×1.05101 = £140.65 . Therefore the probability of a
payment of less than £115 is zero.
(iii) Option A is riskier both from the perspective of having a higher standard
deviation of return and also a higher probability of a very low value.
Page 10
Faculty of Actuaries Institute of Actuaries
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 12 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
© Faculty of Actuaries
CT1 S2008 © Institute of Actuaries
1 A 91-day government bill is purchased for £95 at the time of issue and is redeemed at
the maturity date for £100. Over the 91 days, an index of consumer prices rises from
220 to 222.
2 (i) State the strengths and weaknesses of using the money-weighted rate of return
as opposed to the time-weighted rate of return as a measure of an investment
manager’s skill. [3]
The annualised risk-free force of interest applying over the term of the forward
contract is δ and the underlying asset pays no income. Show that the
theoretical forward price is given by K = Beδ T , assuming no arbitrage. [3]
(ii) An asset has a current market price of 200p, and will pay an income of 10p in
exactly three months’ time.
5 A bank offers two repayment alternatives for a loan that is to be repaid over ten years.
The first requires the borrower to pay £1,200 per annum quarterly in advance and the
second requires the borrower to make payments at an annual rate of £1,260 every
second year in arrears.
Determine which terms would provide the best deal for the borrower at a rate of
interest of 4% per annum effective. [5]
CT1 S2008—2
6 A pension fund holds an asset with current value £1 million. The investment return
on the asset in a given year is independent of returns in all other years. The annual
investment return in the next year will be 7% with probability 0.5 and 3% with
probability 0.5. In the second and subsequent years, annual investment returns will be
2%, 4% or 6% with probability 0.3, 0.4 and 0.3, respectively.
(i) Calculate the expected accumulated value of the asset after 10 years, showing
all steps in your calculations. [3]
(ii) Calculate the standard deviation of the accumulated value of the asset after 10
years, showing all steps in your calculations. [4]
(iii) Without doing any further calculations explain how the mean and variance of
the accumulation would be affected if the returns in years 2 to 10 were 1%,
4%, or 7%, with probability 0.3, 0.4 and 0.3 respectively. [2]
[Total 9]
7 The force of interest, δ(t ) , is a function of time and at any time t (measured in years)
is given by
(i) Calculate the present value of £1,000 due at the end of 12 years. [5]
(ii) Calculate the annual effective rate of discount implied by the transaction in (i).
[2]
[Total 7]
8 A tax advisor is assisting a client in choosing between three types of investment. The
client pays tax at 40% on income and 40% on capital gains.
Investment A requires the investment of £1m and provides an income of £0.1m per
year in arrears for ten years. Income tax is deducted at source. At the end of the ten
years, the investment of £1m is returned.
In Investment B, the initial sum of £1m accumulates at the rate of 10% per annum
compound for ten years. At the end of the ten years, the accumulated value of the
investment is returned to the investor after deduction of capital gains tax.
Investment C is identical to Investment B except that the initial sum is deemed, for tax
purposes, to have increased in line with the index of consumer prices between the date
of the investment and the end of the ten-year period. The index of consumer prices is
expected to increase by 4% per annum compound over the period.
(i) Calculate the net rate of return expected from each of the investments. [7]
(ii) Explain why the expected rate of return is higher for Investment C than for
Investment B and is higher for Investment B than for Investment A. [3]
[Total 10]
(i) Calculate the gross redemption yield of the three-year bond. [3]
(ii) Calculate to three decimal places all possible spot rates, implied by the
information given, as annual effective rates of interest. [4]
(iii) Calculate to three decimal places all possible forward rates, implied by the
information given, as annual effective rates of interest. [4]
[Total 11]
The first investment option involves setting up a branch in a foreign country. This will
involve an immediate outlay of £0.25m, followed by investments of £0.1m at the end
of one year, £0.2m at the end of two years, £0.3m at the end of three years and so on
until a final investment is made of £1m in ten years’ time. The investment will
provide annual payments of £0.5m for twenty years with the first payment at the end
of the eighth year. There will be an additional incoming cash flow of £5m at the end
of the 27th year.
The second investment option involves the purchase of 1 million shares in a bank at a
price of £4.20 per share. The shares are expected to provide a dividend of 21p per
share in exactly one year, 22.05p per share in two years and so on, increasing by 5%
per annum compound. The shares are expected to be sold at the end of ten years, just
after a dividend has been paid, for £5.64 per share.
(i) Determine which of the options has the higher net present value at a rate of
interest of 7% per annum effective. [9]
(ii) Without doing any further calculations, determine which option has the higher
discounted mean term at a rate of interest of 7% per annum effective. [2]
[Total 11]
CT1 S2008—4
11 A company has a liability of £400,000 due in ten years’ time.
The company has exactly enough funds to cover the liability on the basis of an
effective interest rate of 8% per annum. This is also the interest rate on which current
market prices are calculated and the interest rate earned on cash.
The company wishes to hold 10% of its funds in cash, and to invest the balance in the
following securities:
(i) Calculate the nominal amounts of the zero-coupon bond and the fixed-interest
stock which should be purchased to satisfy Redington’s first two conditions
for immunisation. [10]
(ii) Calculate the amount which should be invested in each of the assets mentioned
in (i). [2]
(iii) Explain whether the company would be immunised against small changes in
the rate of interest if the quantities of stock in part (i) are purchased. [2]
[Total 14]
The individual agrees to pay only the interest payments, monthly in arrear, for the first
15 years whereupon he repays half of the capital as a lump sum. He then pays only
the interest for the remaining 10 years, quarterly in arrear, and repays the other half of
the capital as a lump sum at the end of the term.
(i) Calculate the total amount of interest paid by the individual, assuming an
effective rate of interest of 8½% p.a. [5]
(ii) The individual believes that he can earn a nominal rate of interest convertible
half-yearly of 9% p.a. from a separate savings account.
(iii) The individual made the monthly contributions calculated in (ii) to the savings
account. However, over the first 15 years, the effective rate of return earned
on the savings account was 10% per annum.
The individual used the proceeds at that time to repay as much of the loan as
possible and then decided to repay the remainder of the loan by level
instalments of interest and capital. After the first 15 years, the effective rate of
interest changed to 7% per annum.
Calculate the level payment he must make, payable monthly in arrear, to repay
the loan over the final 10 years of the loan. [5]
[Total 14]
END OF PAPER
CT1 S2008—6
Faculty of Actuaries Institute of Actuaries
EXAMINERS’ REPORT
September 2008
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
R D Muckart
Chairman of the Board of Examiners
November 2008
© Faculty of Actuaries
© Institute of Actuaries
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
Comments
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. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.
Candidates appeared to be less well prepared than in previous recent diets. As has often been
the case when words rather than numbers have been required, Q4 was answered relatively
poorly despite only involving bookwork with a wide range of available points that could be
made. Many candidates also struggled with the first part of Q2 where explanation rather
than calculation was required. The remainder of the shorter questions were answered well
with candidates scoring particularly highly on Q7.
The more application styled questions (especially Qs 8, 11 and 12) tended to act as a clear
discriminator between stronger and weaker candidates with a significant minority of
candidates scoring very few marks on these questions. By contrast, Q9 on spot and forward
yields was answered relatively well compared to questions in previous diets on this topic.
Page 2
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
220
95 (1 + j )
91/ 365
= 100
222
2 (i) MWRR
• Requires less information compared to TWRR
But
• Affected by amount and timing of net cashflows, which may not be in the
manager’s control and less fair measure than TWRR
• More difficult equation to solve than TWRR
• Also: equation may not have unique (or any) solution
Then
45 72
(1 + i ) 2 = ×
41 57
= 1.386392811
⇒ i = 17.745% p.a.
Then, at maturity, both portfolios have the same value (i.e. hold the underlying
asset).
Thus, by the no-arbitrage principle, both portfolios must have same value at
time 0.
⇒ Ke −δT = B ⇒ K = BeδT
Page 3
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
( using K = Be δT
− Ce ( 1 )
δ T −t
)
4 Main characteristics of commercial property investments:
• Many different types of properties available for investment, e.g. offices, shops and
industrial properties.
• Return comes from rental income and from the proceeds on sale.
• Total expected return higher than for gilts
• Rents and capital values are expected to increase broadly with inflation in the long
term
• Neither rental income nor capital values are guaranteed – capital values in
particular can fluctuate in the short term…
• …but rental income more secure than dividends
• Rents and capital values expected to increase when the price level rises (though
the relationship is far from perfect).
• Rental terms are specified in lease agreements. Typically, rents increase every
three to five years, Some leases have clauses which specify upward-only
adjustments of rents.
• Large unit sizes, leading to less flexibility than investment in shares
• Each property is unique…
• …. so can be difficult to value.
• Valuation is expensive, because of the need to employ an experienced surveyor
• Marketability and liquidity are poor because of uniqueness …
• …and because buying and selling incurs high costs.
• Rental income received gross of tax.
• Net rental income may be reduced by maintenance expenses
• There may be periods when the property is unoccupied, and no income is
received.
• The running yield from property investments will normally be higher than that for
ordinary shares.
i
1, 200 × × a10 = 1200 × 1.024877 × 8.1109 = £9,975.210
d( )
4
2,520 × (v 2
+ v 4
+…+ v ) = 2,520 × v
10 2
×
(1 − v )
10
(1 − v )
2
Page 4
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
= 2,520 × 0.92456 ×
(1 − 0.67556 ) = £10, 020.01
(1 − 0.92456 )
Therefore first option is better for the borrower.
Then, the expected value of the accumulation ( S10 ) is given by (in £ millions):
⎛ 10 ⎞
E ( S10 ) = E ⎜ ∏ (1 + it ) ⎟
⎜ ⎟
⎝ t =1 ⎠
10
= ∏ E (1 + it ) using independence
t =1
10
= ∏ (1 + E ( it ) )
t =1
( ( )
1, 000, 0002 × E S10
2
− E ( S10 )
2
)
⎛ 10 2⎞
where E S102
( )
= E ⎜ ∏ (1 + it ) ⎟
⎜ ⎟
⎝ t =1 ⎠
⎛ ⎞
( )
10
= E ⎜ ∏ 1 + 2it + it2 ⎟
⎜ ⎟
⎝ t =1 ⎠
Page 5
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
( ) (
Now E i12 = 0.5 × 0.07 2 + 0.032 = 0.0029 )
( )
for t ≠ 1, E it 2 = 0.3 × 0.022 + 0.4 × 0.042 + 0.3 × 0.062
= 0.00184
Hence,
( )
2
E S10 = (1 + 0.1 + 0.0029 ) × (1 + 0.08 + 0.00184 )
9
= 2.238739
( )
1
1, 000, 000 × 2.238739 − 1.494477 2 = £72, 646
2
(iii) The mean would remain unchanged as the expected rate of return in years 2-10
is unchanged. The variance of the rate in years 2-10 has increased and this will
lead to an increase in the variance of the 10 year accumulation.
⎝ 5 ⎠
= exp [ −0.15s ]5 = e −1.05 = 0.34994
12
Discounting from t = 5 to t = 0
⎝ 0 ⎠
5
= exp ⎡ −0.05s − 0.01s 2 ⎤ = e −0.5 = 0.60653
⎣ ⎦0
Page 6
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
1000 (1 − d )
12
= 212.25
1
⇒ d = 1 − 0.21225 12 = 12.117%
8 (i) Investment A: the gross rate of return per annum effective is clearly 10%. The
net return is therefore (1-0.4 ) ×10% = 6% per annum effective.
−10 −10
1 = 2.59374 (1 + i ) − 0.4 ( 2.59374 -1)(1 + i )
−10
= 1.95625 (1 + i )
⇒ (1 + i )
10
= 1.95625
⇒ i = 6.94%
1 = 2.59374 (1 + i )
−10
(
− 0.4 2.59374 -1× 1.0410 (1 + i )) −10
(ii) All investments give a gross return of 10% per annum effective. Investment B
gives a higher return than A because the tax is deferred until the end of the
investment as capital gains tax is paid and not income tax. [However,
candidates might note that tax is paid on the interest earned by deferral of tax].
Investment C gives a higher return than investment B because the tax is only
paid on the real return over the ten year period which is lower than the
nominal return.
Page 7
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
i = 0.06 +
(104.1981 − 103) × 0.01 = 0.06437 = 6.44%
(104.1981 − 101.4573)
(ii) Let in = spot yield for term n
Then
Forward rate from time zero to two and from time zero to three are the same as
the respective spot rates (no additional marks for this point).
( )
0.5 a27 − a7 + 5v 27 − 0.1( Ia )10 − 0.25 at 7%
= 0.5 (11.9867 − 5.3893) + 5 × 0.16093 − 0.1× 34.7391 − 0.25
= £0.379m
Page 8
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
(ii) The second project clearly has a discounted mean term of less then ten years.
However, the discounted mean term of the first project must be greater than
ten years because the undiscounted incoming cash flows are less than the
undiscounted outgoing cash flows after ten years.
VL = 400v10 = 185.2774
Page 9
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
⎡ 4.76537 ⎤
⎢⎣ from ( 2 ) − 0.39711 ∗ (1) ⎥⎦
Hence Y = 63,790
X = 254,583
= 101,098
(iii) The spread of the assets is clearly greater than the spread of the liability
(which is a single point).
12
i( ) ⎛ i(12 ) ⎞
12
= × 300, 000 where 1.085 = ⎜ 1 + ⎟
12 ⎜ 12 ⎟
⎝ ⎠
i( )
12
⇒ = 0.0068215
12
4
i( ) ⎛ i( 4) ⎞
4
= × 150, 000 where 1.085 = ⎜1 + ⎟
4 ⎜ 4 ⎟
⎝ ⎠
i( )
4
⇒ = 0.020604
4
Page 10
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
( 6)
(ii) 150,000 = X s @ 4½ %
30
s
( 6)
=
(1.045 ) − 1
30
d( )
30 6
6
1 ⎛ d ( 6) ⎞
where = ⎜1 − ⎟
1.045 ⎜ 6 ⎟
⎝ ⎠
⇒ d (6) = 0.043856
150000 150000
Hence X = = = 2396.23
⎡ (1.045) −1 ⎤
30
62.5985
⎢ 0.043856 ⎥
⎣ ⎦
2396.23
⇒ Monthly contribution = = £399.37 per month
6
(12 )
12 × 399.37 s15
10%
(12 ) i
where s = × s15
d( )
15 12
= 1.0533781× 31.7725
= 33.46845
Page 11
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report
(12 )
139,604.44 = 12 Y a
10
7%
0.07
= 12Y × 7.02358
0.06785
Page 12
Faculty of Actuaries Institute of Actuaries
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
© Faculty of Actuaries
CT1 A2009 © Institute of Actuaries
1 Describe the characteristics of Government Bills. [3]
Calculate:
(ii) The capital outstanding immediately after the 5th payment has been made. [2]
(iii) The capital and interest components of the final payment. [2]
[Total 7]
An investor entered into a long forward contract for £100 nominal of a security eight
years ago and the contract is due to mature in four years’ time. The price per £100
nominal of the security was £94.50 eight years ago and is now £143.00. The risk-free
rate of interest can be assumed to be 5% per annum effective throughout the contract.
(ii) Calculate the value of the contract now if it were known from the outset that
the security will pay coupons of £9 two years from now and £10 three years
from now. You may assume no arbitrage. [5]
[Total 7]
CT1 A2009—2
5 A company’s required return for a particular investment project can be expressed as a
force of interest, δ(t). This force of interest is a function of time and at any time t,
measured in years, is given by the formula:
The income received from the project is a payment stream paid continuously from
t = 8 to t = 12 under which the annual rate of payment at time t is £100, 000e0.001t .
6 A pension fund purchased an office block nine months ago for £5 million.
The pension fund will spend a further £900,000 on refurbishment in two months time.
A company has agreed to occupy the office block six months from now. The lease
agreement states that the company will rent the office block for fifteen years and will
then purchase the property at the end of the fifteen year rental period for £6 million.
It is further agreed that rents will be paid quarterly in advance and will be increased
every three years at the rate of 4% per annum compound. The initial rent has been set
at £800,000 per annum with the first rental payment due immediately on the date of
occupation.
Calculate, as at the date of purchase of the office block, the net present value of the
project to the pension fund assuming an effective rate of interest of 8% per annum.
[8]
7 A fund had a value of £150,000 on 1 July 2006. A net cash flow of £30,000 was
received on 1 July 2007 and a further net cash flow of £40,000 was received on 1 July
2008. The fund had a value of £175,000 on 30 June 2007 and a value of £225,000 on
30 June 2008. The value of the fund on 1 January 2009 was £280,000.
(i) Calculate the time-weighted rate of return per annum earned on the fund
between 1 July 2006 and 1 January 2009. [3]
(ii) Calculate the money-weighted rate of return per annum earned on the fund
between 1 July 2006 and 1 January 2009. [4]
(iii) Explain why the time-weighted rate of return is more appropriate than the
money-weighted rate of return when comparing the performance of two
investment managers over the same period of time. [2]
[Total 9]
(i) Show that the discounted mean term of these liabilities, to four significant
figures, is 14.42 years. [3]
The insurance company holds two zero-coupon bonds, one paying £X in 10 years’
time and the other paying £Y in 20 years’ time.
(ii) Find values of X and Y such that Redington’s first two conditions for
immunisation from small changes in the rate of interest are satisfied. [6]
(iii) Explain, without making any further calculations, whether you would expect
Redington’s third condition for immunisation to be satisfied for the values of
X and Y calculated in (ii). [2]
[Total 11]
9 Two bonds paying annual coupons of 5% in arrear and redeemable at par have terms
to maturity of exactly one year and two years, respectively.
The gross redemption yield from the 1-year bond is 4.5% per annum effective; the
gross redemption yield from the 2-year bond is 5.3% per annum effective. You are
informed that the 3-year par yield is 5.6% per annum.
Calculate all zero-coupon yields and all one-year forward rates implied by the yields
given above. [12]
10 A loan pays coupons of 11% per annum quarterly on 1 January, 1 April, 1 July and
1 October each year. The loan will be redeemed at 115% on any 1 January from
1 January 2015 to 1 January 2020 inclusive, at the option of the borrower. In addition
to the redemption proceeds, the coupon then due is also paid.
An investor purchased a holding of the loan on 1 January 2005, immediately after the
payment of the coupon then due, at a price which gave him a net redemption yield of
at least 8% per annum effective. The investor pays tax at 30% on income and 25% on
capital gains.
On 1 January 2008 the investor sold the holding, immediately after the payment of the
coupon then due, to a fund which pays no tax. The sale price gave the fund a gross
redemption yield of at least 9% per annum effective.
(i) The price per £100 nominal at which the investor bought the loan. [6]
(ii) The price per £100 nominal at which the investor sold the loan. [4]
(iii) The net yield per annum convertible quarterly that was actually obtained by
the investor during the period of ownership of the loan. [5]
[Total 15]
CT1 A2009—4
11 An individual wishes to receive an annuity which is payable monthly in arrears for 15
years. The annuity is to commence in exactly 10 years at an initial rate of £12,000 per
annum. The payments increase at each anniversary by 3% per annum. The individual
would like to buy the annuity with a single premium 10 years from now.
(i) Calculate the single premium required in 10 years’ time to purchase the
annuity assuming an interest rate of 6% per annum effective. [5]
(ii) Calculate the lump sum which the individual should invest immediately in
order to have a probability of 0.98 that the proceeds will be sufficient to
purchase the annuity in 10 years’ time. [9]
END OF PAPER
CT1 A2009—5
Faculty of Actuaries Institute of Actuaries
EXAMINERS’ REPORT
April 2009
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
R D Muckart
Chairman of the Board of Examiners
June 2009
© Faculty of Actuaries
© Institute of Actuaries
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
Comments
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. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.
There were some excellent performances and well-prepared candidates scored well across the
whole paper. However, the comments below on each question concentrate on areas where
candidates could have improved their performance.
Q1, Q2.
As has often been the case when words rather than numbers have been required, these
bookwork questions were answered relatively poorly (although Q2 was answered better than
Q1).
Q3.
Well answered.
Q4.
Defining an arbitrage profit correctly was also acceptable as an answer to (i) although a
description of both possible arbitrage scenarios was required for full marks. Many
candidates performed the calculations well although the methodology being used was not
always clear.
Q5.
The question required an ability to bring together two separate elements of the syllabus and
less well-prepared candidates seemed to struggle with this.
Q6.
This was another question where students scored relatively poorly with many candidates
having difficulty with the income calculation. A common error was to assume that the income
rose by 4% every three years.
Q7.
This was answered much better than questions on the same topic in previous exams.
However, some candidates did confuse the money-weighted and time-weighted rates of
return.
Page 2
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
Q8.
It was particularly disappointing to see many candidates using the wrong formula for DMT
in part (i) but ending their proof with‘=14.42 QED’ in the final line. This suggests a lack of
professionalism, honesty and integrity which are key attributes of the actuarial profession.
Part (ii) was well-answered with various different methods leading to the correct answer.
Q9.
This was the worst-answered question on the paper although it was still possible to score
significant marks by calculating forward rates using the correct formula even if the spot rates
had been calculated incorrectly.
Q10.
Part (i) was answered well but many candidates lost marks in part (ii) by not realising that a
separate test was required to ascertain the worst time to redemption. Many candidates
calculated the annual effective yield rather than the yield per annum convertible quarterly in
part (iii).
Q11.
Many candidates seemed confused as to what to calculate in part (i) and failed to distinguish
between the premium needed in 10 years’ time and the present value of that premium. Part
(ii) was answered well (although some candidates appeared to be short of time at this stage).
Part (iii) was answered very poorly with many candidates not appreciating the effects of the
high variance.
Page 3
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
2 (a) An interest-only loan requires the borrower only to pay interest on the entire
loan in each time period. The loan does not reduce over time so the interest
remains constant. A separate investment or savings account can be established
in which payments are made to extinguish the whole loan at the end of the
term.
(b) A repayment loan involves level repayments of capital and interest. The first
part of the payment is used to pay interest on any remaining capital. The
remaining part of the payment is then used to repay capital so that the capital
gradually reduces over the term of the loan.
420a15 + 30 ( Ιa )15
Page 4
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
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, with no risk of future loss;
nor
(b) an investor can make a deal that has zero initial cost, no risk of future
loss, and a non-zero probability of a future profit.
(94.5 − 9v 10
5% − 10v11 )
5% × (1.05 )
12
= 149.29
(143 − 9v2
5% − 10v5%
3
)
× (1.05 ) = 153.39
4
Note:
5 Working in £000’s
2
− ⎡0.05t +0.001t 2 ⎤
⎣ ⎦0
= 100 + 80e
Page 5
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
Where
T
PV (income paid up to T) = ∫8 100e
0.001t
v ( t ) dt
5
− ⎡0.05t + 0.001t 2 ⎤
.e (
⎣ ⎦0 − 0.06t −0.30 )
=e
= e0.025 e −0.06t
T
⇒ PV ( income paid up to T ) = ∫ 100e0.001t e0.025 e−0.06t dt
8
T
= ∫ 100e0.025 e −0.059t dt
8
⇒ e−0.059T = 0.52472
⇒ −0.059T = Ln(0.52472) ⇒ T = 10.93 years
Page 6
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
6 Working in 000’s
11
PV of costs = 5000 + 900v 12 at 8%
= 5838.695
PV of income = 800v
1312
( a( ) + 1.04 v a( ) +
3
4 3 3
3
4
+ (1.04 ) v12 a
12 ( 4)
3 )
= 800v
1312
a
( 4)
3 (1 + (1.04v ) +
3
(1.04v )12 )
⎛ 1−
( 1.04
1.08 ) ⎟
⎞
15
= 1965.3133 × 4.038121
= 7936.173
16 312
PV of proceeds from sale = 6000v = 1717.969
7 Working in 000’s
∴ i = 12.85% p.a.
Page 7
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
150 (1 + i ) + 30 (1 + i ) + 40 (1 + i )
2 12 112 1
2
= 280
∴ i = 12.5% +
( 28 − 27.958) × 0.5%
(28.216 − 27.958)
= 12.58% p.a.
8 (i) Working in £m
( Ιa )11 = 42.7571
42.7571
⇒ DMT = 9 + = 14.42128
7.8869
⇒ to 4 significent figures DMT = 14.42
= 4.668256 ………….(1)
Page 8
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
X *10v10 + Y * 20v 20
⇒ = 14.42128 (use of 14.42 from (i) will be
Xv10 + Yv 20
accepted)
20.639667
⇒Y = = 6.6195 (or 6.6176 if DMT of 14.42 is used)
3.1180
[or VA' = VL' (differentiating with respect to i)
5.2679
Equ n (2) – × Equ n (1)
5.8831
(iii) For the third condition to be satisfied, it is necessary for the spread of the
assets to exceed the spread of the liabilities. This appears to be the case given
that the liabilities occur in equal annual amounts at durations from 10 years to
20 years, whereas the assets are concentrated in two lumps at the two most
extreme durations, 10 years and 20 years.
Page 9
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
9 Let the 1-year and 2-year zero-coupon yields (spot rates) be ii and i2 respectively.
105
= 105v @ 4.5%
1 + i1
∴ i1 = 0.045
5 105
+ = 5a2 5.3% + 100v5.3%
2
1 + i1 (1 + i2 ) 2
⎛1 − 1 ⎞
⎜ 2⎟
5
+
105
= 5 ⎝ 1.053 ⎠ + 100
1.045 (1 + i2 )2 0.053 1.0532
= 9.257681 + 90.186858
= 99.444539
105 5
= 99.444539 −
(1 + i2 ) 2 1.045
105
⇒ (1 + i2 ) =
2
94.659850
⇒ i2 = 5.3202% p.a.
⎛ 1 1 1 ⎞ 1
⇒ 1 = 0.056 ⎜ + + ⎟+
⎜ 1 + i1 (1 + i ) 2
(1 + i3 ) ⎠⎟ (1 + i3 )3
3
⎝ 2
1.056
⇒ (1 + i3 ) =
3
0.895926
⇒ i3 = 5.6324% p.a.
Page 10
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
f 0 = i1 = 4.5% p.a.
(1 + i1 )(1 + f1 ) = (1 + i2 )2
1.0532022
⇒ 1 + f1 =
1.045
⇒ f1 = 6.1468% p.a.
(1 + i2 )2 (1 + f 2 ) = (1 + i3 )3
⇒ 1 + f2 =
(1.056324 )
3
(1.053202 )2
⇒ f 2 = 6.2596% p.a.
0.11
g (1 − t1 ) = ∗ (1 − 0.3)
1.15
= 0.06696
i = 8% ⇒ i ( ) = 0.077706
4
⇒ i ( ) > g (1 − t1 )
4
Then
( 4)
P = 11× 0.7 a + 115v15 − 0.25 (115 − P ) v15 at 8%
15
Page 11
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
0.11
g (1 − t1 ) = = 0.095652
1.15
i = 9% ⇒ i ( ) = 0.087113
4
⇒ i( ) < g 1 − t( )
4
1
Let P ' be the price at which the investor sold the loan. Then
( 4)
P ' = 11a + 115v 7 at 9%
7
11
103.17 = × 0.7a12 + 120.1064v12 −0.25 (120.1064 − 103.17 ) v12 at j %
4
Try
Linear interpolation:
j = 0.025 + 0.005 ×
(103.17 − 105.9042724 )
(100.4319638 − 105.9042724 )
= 0.02749828
Hence, net yield is 11% p.a. (or 10.99931% p.a.) payable quarterly.
Page 12
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
P = 12000 a (( 1
12 )
+ 1.03a
(12 )
1
v+ (1.03)2 a1(12)v 2 + ... + (1.03)14 v14a1(12) )
(12 ) ⎛ 1.03 ⎛ 1.03 ⎞
2 14 ⎞
⎛ 1.03 ⎞
⎜1 + + + ... + ⎜ ⎟
⎜ 1.06 ⎜⎝ 1.06 ⎟⎠ ⎟
= 12000a
1 ⎝ 1.06 ⎠ ⎟
⎝ ⎠
⎛ ⎛ 1.03 ⎞15 ⎞
⎜ 1− ⎜ ⎟ ⎟
(12 ) ⎜ ⎝ 1.06 ⎠ ⎟
= 12000a
1 ⎜ 1.03 ⎟
⎜⎜ 1 − 1.06 ⎟⎟
⎝ ⎠
(12 ) i
where a = v
1
i (12 )
1.027211
= = 0.969067
1.06
0.3499146
⇒ P = 12000 × 0.969067 ×
0.0283019
= 143,774.45
2
μ+ σ
(ii) E (1 + it ) = 1.06 = e 2
⇒ σ2 = 0.01982706
0.01982706
∴μ = n 1.06 −
2
= 0.04835538
Page 13
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report
⎛ 143, 774.45 ⎞
so Pr ⎜ S10 ≥ ⎟ = 0.98
⎝ X ⎠
⎛ Ln 143774.45 − 10μ ⎞
so 1 − Φ ⎜ X
⎟ = 0.02
⎜ ⎟
⎝ 10 σ 2
⎠
Ln 143774.45 − 10μ
⇒ X = − 2.0537
10σ2
143774.45
So Ln = − 2.0537 × 0.1982706 + 0.4835538
X
= − 0.430909
143774.45
⇒ = 0.6499179
X
⇒ X = £221, 219.41
(iii) It might seem odd that the initial investment needs to be substantially higher
than the single premium required in 10 years’ time to have a 98% probability
of accumulating to the single premium.
This strange result is explained by the fact that the variance of the interest rate
is so high relative to the mean. There is therefore a significant risk that the
investment will decrease in value over the next 10 years.
Page 14
Faculty of Actuaries Institute of Actuaries
EXAMINATION
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
© Faculty of Actuaries
CT1 S2009 © Institute of Actuaries
1 A 182-day government bill, redeemable at £100, was purchased for £96 at the time of
issue and was later sold to another investor for £97.89. The rate of return received by
the initial purchaser was 5% per annum effective.
(a) Calculate the length of time in days for which the initial purchaser held the
bill.
(b) Calculate the annual simple rate of return achieved by the second investor.
[4]
On 31 December 2008, she sold her shares at a price of 93 pence per share.
Calculate, using the retail price index values shown in the table, the effective annual
real rate of return achieved by the investor [7]
4 A fixed-interest security has just been issued. The security pays half-yearly coupons
of 5% per annum in arrear and is redeemable at par 20 years after issue.
(i) Calculate the price to provide an investor with a net redemption yield of 6%
per annum effective. The investor pays tax at a rate of 20% on income and is
not subject to capital gains tax. [3]
(ii) Determine the annual effective gross redemption yield of this security
assuming the price calculated in (i) is paid. [5]
(iii) Determine the real annual effective gross redemption yield of this security if
the rate of inflation is constant over the twenty years at 3% per annum. [2]
[Total 10]
CT1 S2009—2
5 The force of interest δ(t ) at time t is a + bt 2 where a and b are constants. An amount
of £100 invested at time t = 0 accumulates to £130 at time t = 5 and £200 at time
t = 10.
(ii) Calculate the constant rate of interest per annum convertible monthly that
would give rise to the same accumulation from time t = 0 to time t = 5. [2]
(iii) Calculate the constant force of interest that would give rise to the same
accumulation from time t = 5 to time t = 10. [2]
[Total 10]
(b) Calculate the six-month forward rate for an investment made in six
months’ time.
(c) Calculate the purchase price of a risk-free bond with exactly one year
to maturity which is redeemed at par and which pays coupons of 4%
per annum half-yearly in arrears.
(d) Calculate the gross redemption yield from the bond in (c).
(e) Comment on why your answer in (d) is close to the one-year spot rate.
[10]
[Total 12]
(i) Calculate the accumulation of the investment at the age of 65 using a rate of
interest of 6% per annum effective. [6]
At the age of 65, the scheme member uses his accumulated investment to purchase an
annuity with a term of 20 years to be paid half-yearly in arrear. At this time the
interest rate is 5% per annum convertible half-yearly.
(iii) Calculate the discounted mean term of the annuity, in years, at the time of
purchase. [3]
[Total 12]
Option 1 – level instalments of capital and interest are paid annually in arrear over a
period of 20 years.
Option 2 – over the 20-year term the customer pays only interest on the loan, annually
in arrear at a rate of 5.5% per annum with the whole of the capital amount payable at
the end of the term. The customer will take out a separate savings policy which
involves making monthly payments in advance such that the proceeds will be
sufficient to repay the loan at the end of its term. The payments into the savings
policy accumulate at a rate of interest of 4% per annum effective.
(i) Determine the effective rate of interest per annum that would be paid by the
customer on the loan under Option 1, given that the level annual instalment on
this loan is £4,012.13. [3]
(ii) Determine the annual effective rate of interest paid by a customer under
Option 2. [7]
[Total 10]
CT1 S2009—4
9 A life insurance company is issuing a single premium policy which will pay out
£20,000 in twenty years time. The interest rate the company will earn on the invested
funds over the first ten years of the policy will be 4% per annum with a probability of
0.3 and 6% per annum with a probability of 0.7. Over the second ten years the
interest rate earned will be 5% per annum with probability 0.5 and 6% per annum
with probability 0.5.
(i) Calculate the premium that the company would charge if it calculates the
premium using the expected annual rate of interest in each ten year period. [2]
(ii) Calculate the expected profit to the company if the premium is calculated as in
(i). The rate of interest in the second ten year period is independent of that in
the first ten year period. [3]
(iii) Explain why, despite the company using the expected rate of interest to
calculate the premium, there is a positive expected profit. [2]
Serious events will occur once every three years, in arrear, each giving rise to
costs of $30bn, incurred immediately on the date of the event.
Communities affected by climate change will incur costs of $20bn per annum
incurred continuously, increasing at a continuous rate of 1% per annum.
Benefits from higher crop yields and lower heating costs are assumed to be
$10bn per annum, incurred annually in arrear.
The experts do not agree about the appropriate rate of interest at which to evaluate the
options available. One group believes that the net present value of using the carbon
storage technology should be evaluated at a real rate of return of 4% per annum
effective. A second group believe that it should be evaluated at a real rate of return of
1% per annum effective.
(i) Define what is meant by the discounted payback period of an investment and
indicate its main disadvantage as an investment decision criterion. [3]
(ii) Explain why the project must have a discounted payback period when the
interest rate is 1.5% and the internal rate of return is higher than 1.5%. [2]
(iii) Calculate the net present value of the carbon storing technology at a real rate
of interest of 1% per annum effective. [5]
(iv) Calculate the net present value of the carbon storing technology at a real rate
of interest of 4% per annum effective. [5]
`
(v) Comment on whether the investment in the carbon storing technology should
go ahead. [2]
[Total 17]
END OF PAPER
CT1 S2009—6
Faculty of Actuaries Institute of Actuaries
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
R D Muckart
Chairman of the Board of Examiners
December 2009
Comments for individual questions are given with the solutions that follow.
Faculty of Actuaries
Institute of Actuaries
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
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. However, candidates may be penalised where excessive
rounding has been used or where insufficient working is shown.
Well-prepared candidates scored well across the whole paper. However, the comments below on
each question concentrate on areas where candidates could have improved their performance.
1
t t 97.89
a. 96 1.05 97.89 1.05
96
ln 97.89
96
t 0.400 years or 146 days
ln 1.05
36 365 100
97.89 1 i 100 i 1 21.854%
365 36 97.89
2
Issued by corporations.
Holders entitled to a distribution (dividend) declared from profits.
Potential for high returns relative to other asset classes.
Commensurate risk of capital losses.
Lowest ranking finance issued by companies.
Initial running yield low but has potential to increase with dividend growth.
Dividends and capital values have the potential to grow in nominal terms during times of inflation.
Return made up of income return and capital gains.
Marketability depends on the size of the issue.
Ordinary shareholders receive voting rights in proportion to their holding.
This question was not answered as well as the examiners would have expected given that
the topic is standard bookwork.
3
We convert all cash flow to amounts in time 0 values:
Page 2
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
147.7
Dividend paid at t 1:10000 0.041 394.77
153.4
147.7
Dividend paid at t 2 :10000 0.046 428.39
158.6
147.7
Dividend paid at t 3:10000 0.051 456.25
165.1
147.7
Sale proceeds at t 3:10000 0.93 8319.87
165.1
1
Equation of value involving v where v
1 r
and r = real rate of return:
[To estimate r:
93 78
4.6 / 78 12.3% p.a.
3
1
3
165.1
1 3.8 % p.a.
147.7
1.123
Approx real return: 1 8.2 % p.a. ]
1.038
7907.09 7800
r 7% 1%
7907.69 7699.61
= 7.52 % p.a.
Page 3
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
Some candidates seemed to struggle to derive the equation of value based on a real rate
of return and multiplied (rather than divided) the payments by the increase in the
inflation index.
4
(i) Let required price = P:
2
P 1 0.2 5a 100v20 at 6%
20
2 i 0.06
a a20 = 11.4699 11.6394; v 20 0.311805
20 2 0.059126
i
Therefore
(ii) The equation of value for the gross rate of return is:
2
77.7381 5a 100v20
20
If i = 8%
2 i
a a20 = 1.019615 9.8181 10.0107; v 20 0.21455
20 2
i
RHS = 50.0534 + 21.4550 = 71.5084
If i = 7%
2 i
a a20 = 1.017204 10.5940 10.7763; v 20 0.25842
20 2
i
RHS = 53.8813 + 25.8420 = 79.7233
79.7233 77.7381
Interpolating gives i 0.07 0.01 7.24% 7.2% say
79.7233 71.5084
(iii) If the nominal rate of return is 7.2% per annum effective and inflation is 3% per
annum effective, then the real rate of return is calculated from:
1.072
1 4.1%
1.03
Page 4
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
5
5
5
(i) 130 100exp a bt 2 dt 100exp at 1 bt 3
3
100exp 5a 41.667b
0
0
10
10
200 100exp a bt 2 dt 100exp at 1 bt 3
3
100exp 10a 333.333b
0
0
ln 1.3 5a 41.667b
ln 2 10a 333.333b
The second expression less twice times the first expression gives:
60 1
12 60
i 12 130 12
(ii) 100 1 130 i 12 1 i 5.259% p.a.
12 100
200
(iii) 130e5 200 5 ln 8.616% p.a.
130
6
(i) A future is a contract which obliges the parties to deliver/take delivery of a
particular quantity of a particular asset at a particular time at a fixed price.
An option is the right to buy or sell a particular quantity of a particular asset at (or
before) a particular time at a given price.
a. Buying the forward is exactly the same as buying the bond except that the
forward will not pay coupons and the forward does not require immediate
settlement.
Page 5
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
1.06
F 97 1.06 3.5 1
3.5
2
1.05
102.82 3.62059 3.5 95.6994
1.06
b. Let six month forward interest rate f 0.5,0.5 1
1 3.4454%
2
1.05
This does not have to be expressed as a rate of interest per annum
effective, though it could be.
0.5 1
c. P 2 1.05 102 1.06 1.9518 96.2264 98.1782
0.5 1
98.1782 2 1 i 102 1 i
0.5
1 i 0.97133 . Therefore, i ≈ 6% (in fact 5.99%).
e. Answer is very close to 6% (the one-year spot rate) because the payments
from the bond are so heavily weighted towards the redemption time in one
year.
This was generally well-answered apart from part (e). A common error in parts (c) and
(d) was to assume that the coupon payments were 4% per half-year.
7 .
12 20 12 12 20
(i) The accumulation is 1200s 1.06 2300s 100 Ia 1.06
20 20 20
i 20 20
1200s20 1.06 2300 s20 100 Ia 20
1.06
12
d
1, 200 36.7856 3.20714 2,300 36.7856
1.032211
100 98.7004 3.20714
1.032211 141,571.88 84, 606.88 31, 654.60
266,138
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Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
In part (i), many candidates developed the correct formula although calculation errors
were common. In such cases, candidates also lost marks for not showing and explaining
their working fully. Part (ii) was answered well but many candidates surprisingly had
trouble calculating the DMT in part (iii). In this part, candidates often lost marks for not
showing the units properly at the end of the answer; indeed, in many cases, showing the
units may well have alerted candidates to possible mistakes.
2
(i) The equation of value for the borrower is 4, 012.13a20 50, 000 .
50,000
Therefore a 20 = = 12.4622
4,012.13
(ii) The second customer pays interest of 0.055 50,000 = £2,750 per annum, annually in arrear.
The annual rate of monthly payments in advance from the savings policy is X such that:
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Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
12
Xs =50, 000 at 4%
20
i
Xs20 50, 000
12
d
50, 000
X £1, 643.69
29.7781 1.021537
12
50, 000 2, 750a20 1, 643.686a
20
i
2, 750a20 1, 643.686 a20
12
d
Try i = 6%: RHS = 51,002.41
By interpolation i = 6.3%
Part (i) was well answered but weaker candidates failed to recognise the need to
calculate separately the payments into the savings policy in part (ii).
3
(i) The expected annual interest rate in the first ten years is 0.3 0.04 + 0.7 0.06 =
0.054. The expected interest rate in the second ten years is clearly 5.5%.
If the premium is calculated on the basis of these interest rates, then the premium will be P such
that:
10 10
20, 000 P 1.054 1.055
20, 000 2.89022 P P 6,919.89
(ii) The expected accumulation factor in the first ten years is:
10 10
0.5 1.05 1.06 1.70987
As they are independent, we can multiply the accumulation factors together and multiply by the
premium to give an expected accumulation of: 6,919.89 1.69767 1.70987 = 20,087.04.
Page 8
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
(iii) There is an expected profit because (in general) the accumulation of a sum of money at the
expected interest rate is not equal to the expected accumulation when the interest rate is a random
variable.
(iv) The highest possible outcome for the accumulation factor is:
10
and 1.04 1.0610 = 2.65089 with probability 0.3 0.5 = 0.15
The mean accumulation factor is: 1.69767 1.70987 = 2.90280
0.35(3.20714-2.90280)2 + 0.15(2.41116-2.90280)2
+ 0.35 (2.91710-2.90280)2 +0.15 (2.65089-2.90280)2
Standard deviation of the accumulation of the whole premium is: 6,919.89 0.27976 = £1,935.88
which is also the standard deviation of the profit.
This was the worst answered question on the paper with many candidates not recognising
that the accumulation of a sum of money at the expected interest rate is not equal to the
expected accumulation when the interest rate is a random variable. The calculation of the
standard deviation of the accumulation was generally only calculated correctly by the
strongest candidates.
4
(i) The discounted payback period is the first time at which the accumulated profit
from/net present value of the cash flows from a project is positive at a given
interest rate.
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Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
(ii) If the internal rate of return were greater than 1.5% then the net present value of
the project at 1.5% must be greater than zero. As such, there must be a discounted
payback period as the discounted payback period is the first time at which the net
present value is greater than zero: such a time must exist.
(iii) Returns are real rates of return and figures are in 2009 dollar terms so we are
automatically working with real rather than nominal values. All figures below are
in $bn.
The net benefits from using the technology are the $30 every three years; $20 incurred
continuously increasing at 1% per annum and $30 per annum incurred annually in arrears.
The costs of the technology are $440 incurred immediately and $50 incurred annually in arrears.
The net present value of the project at 1% per annum effective is:
30 v3 v6 v48 50 20 30a50 440 50a50
The 20 does not need to be discounted because the cash flows are growing at the same rate as they
are being discounted.
1 v 48
3
30v 560 20a50 calculated at 1%
1 v3
1 0.62026
30 0.97059 560 20 39.1961
1 0.97059
= 375.967 560 783.922
152.045
(iv) The net present value of the project at 4% per annum effective is:
30 v3 v6 v48 '
20a50 30a50 440 50a50
'
All are calculated at 4% except a50 which is calculated at
1.04
i -1 2.97%
1.01
1 v 48 i '
3
30v 20 a50 440 20a50
1 v3
1 0.15219
30 0.88900 20 1.014779 25.8755 440 20 21.4822
1 0.88900
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Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report
(v) Whether the investment should go ahead would depend on the choice of the interest rate – it is
clearly a crucial assumption (students could make a choice themselves and indicate whether it
should go ahead on the basis of that rate but there must be some justification for the choice).
This question was also poorly answered possibly because project appraisal using real
interest rates has rarely been examined in the past (and also possibly because of time
pressure). Whilst some parts of the question were challenging (e.g. the treatment of the
increasing costs of climate change), it was disappointing that many candidates failed to
recognise that the costs of climate change no longer incurred would be a benefit of the
carbon storing technology project and so failed to score many marks.
Page 11