18 MATHEMATICAL TECHNIQUES IN FINANCE

each month for the next five years (60 payments). As opposed to a
coupon bond, an annuity does not have a final principal payment, and the
$1,000,000 is called a notional principal.
Using a compounding yield with the same frequency as the payments,
the price of an annuity, PA (C, y, N, m), with N periodic payments with an
annuity rate of C per annum paid m times a year is
( )
∑
N
C∕m C 1
PA (C, y, N, m) = = 1−
i=1
(1 + y∕m)i y (1 + y∕m)N

Note that a coupon bond can be considered as a combination of an annuity

and a zero-coupon bond (see Figure 2.4).

100%

Coupon Bond

4% 4% 4% 4%
2 2 2 2

0 6m 1y 1.5y 2y

100%

Zero-Coupon Bond

0 6m 1y 1.5y 2y

Annuity
4% 4% 4% 4%
2 2 2 2

0 6m 1y 1.5y 2y

FIGURE 2.4 Cash flows of a 2-year 4% semiannual coupon bond versus a 2-year 4%
semiannual annuity versus a 2-year zero-coupon bond.