The basic deterministic model

Week 2

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 Road Map

⚫ Cashflows
⚫ An analogy with currencies
⚫ Discount functions
⚫ Computing the discount function
⚫ Interest and discount rates
⚫ Constant interest
⚫ The constant interest rates
⚫ Values and actuarial equivalence
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 Road Map cont’d

⚫ Regular pattern Cashflows

⚫ Balances and reserves
⚫ Time shifting and splitting identity
⚫ Change of discount function
⚫ Forward prices and term structure
⚫ Internal rates of return
⚫ Standard notation and terminology
⚫ Spreadsheet calculations
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 𝑐𝑘 < 0 receiving −𝑐𝑘 𝑣(𝑘) will let us pay out −𝑐𝑘 at time k

What is the PV of a cashflow at time k?

Values and actuarial equivalence

⚫ Given the cashflow vector:

𝑐 = (𝑐0 , 𝑐1 , . . . , 𝑐𝑁 )
and the discount function v,
we want to calculate the single payment at time 0
that is equivalent to all the cashflows
We assume that time value of money is modelled by v
𝑐𝑘 𝑣(𝑘)
𝑐𝑘 > 0 paying out 𝑐𝑘 𝑣 𝑘 will let us receive 𝑐𝑘 at time k
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 Values and actuarial equivalence
cont’d

⚫ PV(all cashflows): 𝑁

෍ 𝑐𝑘 𝑣(𝑘)
𝑘=0
⚫ Example:
– Let 𝜐 𝑘 = 2−𝑘 ∀𝑘 (money doubles every period)
– Suppose we are to receive 12 units at time 2, but will
be required to pay out 8 units at time 3. Find the PV
and verify that it is correct

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 Values and actuarial equivalence
cont’d

⚫ We will often work with unrealistic interest rates

in order to simplify the computation to allow you
focus on the underlying concepts
⚫ Accumulated value at time 𝑁:
𝑁

෍ 𝑐𝑘 𝜐(𝑁, 𝑘)
𝑘=0

(the amount at time N, resulting from all the cashflows)

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 Values and actuarial equivalence
cont’d

⚫ Definition
– For any time n = 0, 1, 2, . . . , 𝑁, the value at time n
of the cashflow vector c with respect to the discount
function, v (denoted 𝑉𝑎𝑙𝑛 (𝑐; 𝜐)) is given by
𝑁

𝑉𝑎𝑙𝑛 𝑐; 𝜐 = ෍ 𝑐𝑘 𝜐(𝑛, 𝑘)
𝑘=0

(the single amount we will accept at time n in place of all the

cashflow, assuming ck accumulates according to the discount
7 function v)
a is standard actuarial symbol for annuity
𝑉𝑎𝑙0 𝑐 𝑜𝑟 𝑎(𝑐)
ሷ
Values and actuarial equivalence
cont’d

⚫ Since 𝜐 𝑚, 𝑘 = 𝜐 𝑚, 𝑛 𝜐(𝑛, 𝑘)

𝑉𝑎𝑙𝑚 𝑐; 𝜐 = 𝑉𝑎𝑙𝑛 𝑐; 𝜐 𝜐(𝑚, 𝑛)

**
(the single amount we would accept at time m in place of
all the cashflows must be the value at time m of the single
payment that we accept at time n)
Notation
At time 0, we set:
8 𝑎ሷ 𝑐; 𝜐 = 𝑉𝑎𝑙0 (𝑐; 𝜐)
 Values and actuarial equivalence
cont’d

𝑎ሷ can be expressed conveniently in vector form

𝑎ሷ 𝑐 = 𝜐 ∙ 𝑐 = 𝜐𝑐 𝑇
Scalar inner product

Calculating values is a linear operation:

𝑉𝑎𝑙𝑘 𝑐 + 𝑑 = 𝑉𝑎𝑙𝑘 𝑐 + 𝑉𝑎𝑙𝑘 (𝑑)

𝑉𝑎𝑙𝑘 𝛼𝑐 = 𝛼𝑉𝑎𝑙𝑘 𝑐
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 Values and actuarial equivalence
cont’d

⚫ Definition
– Two cashflows vectors c and e are said to be
actuarially equivalent with respect to the discount
function v, if for 𝑛 𝜖 ℤ+

𝑉𝑎𝑙𝑛 𝑐; 𝜐 = 𝑉𝑎𝑙𝑛 (𝑒; 𝜐)

Nature of many actuarial problems
Given a payment vector c, and another payment vector e that
depends on some unknown parameters, we have to solve for
the unknown parameters in order to make the two vectors
10 actuarially equivalent
 Example

⚫ A lends B 20 units now and another 10 units at

time 1. B promises to repay the loan by two
payments, made at times 2 and 3. The
repayment at time 3 is to be twice as much as
that at time 2. If A wishes to earn interest of
25% per period, what should these repayment
be?

Borrower pays: 16.83 at time 2 and 33.66 at time 3

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 “Active Learning”

⚫ Occasionally I will introduce a break in the

lecture for you to work on your own or with
an in-class partner. “Cognitive balancing”

⚫ Please identify your “partner” now

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 Active learning

⚫ If v(t) = 2-t , and you are given cashflow vectors c =

(1,2,3) and e = (2, K,1) find K so that c and e are
actuarially equivalent
⚫ You are given interest rates i0 = i1 = 0.25, i2 = i3 = 1.
You have entered into a business transaction where
you will receive 2 at time 0, 5 at time 3, and 10 at time
4, in return for a payment by you of 3 at time 2. In place
of all these cashflows you are offered a single payment
made to you at time 1. What is the smallest payment
you will accept?

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 Values and actuarial equivalence

⚫ Replacement Principle
– Given a cashflow vector and some subset of
the entries (0, 1, 2, . . . ,N). Take the value at
time k of just those cashflows in the subset
and then replace all entries in the subset by a
single payment at time k equal to that value.
This leaves a vector that is actuarially
equivalent to the original

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 e = (2, 0, 0, -2.5)

Values and actuarial equivalence

⚫ Example
– Consider c = (2, 4, -3, -5)
Assume a constant interest rate of 0.25
Find an actuarially equivalent vector by applying the replacement
principle with k = 3 and subset {1,2}.

c = (2, 4, -3, -5)

At time k = 3
Value of c1 and c2 at time 3:
15 4(1.25)2 -3(1.25)1 = 2.5
 Notation

⚫ ei is the ith basis vector, i = 0,1,2, . . . ,N

e2 = (0,0,1,0, . . . ,0)

For any 𝑟 𝜖 ℝ, 𝑟𝑘 denotes k entries of r

– Example

(13 , 24 ) = (1, 1, 1, 2, 2, 2, 2, 0, . . . , 0)
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 Notation cont’d

For a given vector 𝑏 = 𝑏0 , 𝑏1 , … 𝑏𝑛 , let

∆𝑏 = (𝑏0 , 𝑏1 − 𝑏0 , 𝑏2 − 𝑏1 , . . . , 𝑏𝑛 −𝑏𝑛−1 , −𝑏𝑛 )
Note that, Σ∆𝑏 = 0 and by our notational convention, 𝑏𝑗 =
0, for 𝑗 > 𝑛
Use * to denote pointwise multiplication of vectors
[i.e., 𝑎1 , 𝑎2 , … , 𝑎𝑛 ∗ 𝑏1 , 𝑏2 , … , 𝑏𝑛 = 𝑎1 𝑏1 , 𝑎2 𝑏2 , … , 𝑎𝑛 𝑏𝑛 ]
For any vector 𝑏 = (𝑏0 , 𝑏1 , 𝑏2 , … , 𝑏𝑛 ) and a discount function
𝑣, define a new vector 𝛻𝑏 whose entry of index 𝑘 is given by
𝛻𝑏𝑘 = 𝑏𝑘 − 𝑣(𝑘, 𝑘 + 1)𝑏𝑘+1
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 𝛻𝑏𝑘 = 𝑏𝑘 − 𝑣(𝑘, 𝑘 + 1)𝑏𝑘+1

Notation cont’d

⚫ Note
– 𝛻 depends on 𝑣 and it will be denoted by 𝛻𝑣 if there is
any confusion
Main result
For any vector 𝑐 = (𝑐0 , 𝑐1 , 𝑐2 , … )
𝑎ሷ 𝛻𝑏 ∗ 𝑐 = 𝑎(𝑏
ሷ ∗ ∆𝑐)
(i.e. When computing the PV of a pointwise product of one
vector multiplied by ∆ applied to a second vector, the ∆
slide off the second vector and become a 𝛻 on the first)
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 Notation cont’d

To see this, observe that

𝛻𝑏0 = 𝑏0 − 𝑣(0,1)𝑏1
𝛻𝑏1 = 𝑏1 − 𝑣(1,2)𝑏2
𝛻𝑏2 = 𝑏2 − 𝑣(2,3)𝑏3
∙ ∙ ∙ ∙
∙ ∙ ∙ ∙
∙ ∙ ∙ ∙
𝛻𝑏 ∗ 𝑐 = 𝑏𝑜 − 𝑣 1 𝑏1 , 𝑏1 − 𝑣 1,2 𝑏2 , 𝑏2 − 𝑣 2,3 𝑏3 , … ∗ 𝑐0 , 𝑐1 , 𝑐2 , …

= 𝑏0 − 𝑣 1 𝑏1 𝑐0 , 𝑏1 − 𝑣 1,2 𝑏2 𝑐1 , 𝑏2 − 𝑣 2,3 𝑏3 𝑐2 , …
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 𝑎ሷ 𝛻𝑏 ∗ 𝑐 = 𝑎(𝑏
ሷ ∗ ∆𝑐)

Notation cont’d

➔ 𝐿𝐻𝑆 = 𝑎(𝛻𝑏
ሷ ∗ 𝑐)
= 𝑏0 − 𝑣 1 𝑏1 𝑐0 𝑣 0 + 𝑏1 − 𝑣 1,2 𝑏2 𝑐1 𝑣 1
+ 𝑏2 − 𝑣 2,3 𝑏3 𝑐2 𝑣 2 + ⋯
= 𝑏0 𝑐0 + [𝑏1 𝑐1 𝑣 1 − 𝑣 1 𝑏1 𝑐0 ] +
[𝑏2 𝑐2 𝑣 2 − 𝑣 1,2 𝑏2 𝑐1 𝑣(1)] + ⋯
= 𝑏0 𝑐0 + 𝑏1 𝑐1 − 𝑐0 𝑣 1 + 𝑏2 𝑐2 − 𝑐1 𝑣 2 + ⋯
Note also that
𝑐 = 𝑐0 , 𝑐1 , 𝑐2 , 𝑐3 , … = 0, 𝑐0 , 𝑐1 , 𝑐2 , 𝑐3 , …
∆𝑐 = (𝑐0 , 𝑐1 − 𝑐0 , 𝑐2 − 𝑐1 , … )
 𝑎ሷ 𝛻𝑏 ∗ 𝑐 = 𝑎(𝑏
ሷ ∗ ∆𝑐)

Notation cont’d

➔ 𝑏 ∗ ∆𝑐 = 𝑏0 , 𝑏1 , 𝑏2 , … ∗ (𝑐0 , 𝑐1 − 𝑐0 , 𝑐2 − 𝑐1 , … )

= [𝑏0 𝑐0 , 𝑏1 𝑐1 − 𝑐0 , 𝑏2 𝑐2 − 𝑐1 , …]

𝑅𝐻𝑆 = 𝑎(𝑏
ሷ ∗ ∆𝑐)
= 𝑏0 𝑐0 𝑣 0 + 𝑏1 𝑐1 − 𝑐0 𝑣 1 + 𝑏2 𝑐2 − 𝑐1 𝑣 2 + ⋯
= 𝐿𝐻𝑆

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 Regular pattern cashflows

⚫ Suppose 𝜐 𝑛 = 𝜐 𝑛 for some constant v

⚫ Consider (1𝑛 ) and 𝑗 𝑛 = (1, 2, . . . , 𝑛 − 1, 𝑛)

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 Regular pattern cashflows

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 Regular pattern cashflows

(There is an alternative way of deriving these formulas

24 which does not involve series summation)
 Balances and reserves

⚫ Suppose we enter into a financial transaction,

represented by the cashflow vector c
⚫ At any time k in the future, there are two
fundamental quantities to compute
– The total amount accumulated from all payments of
the transaction up to this point
– How much we will need at that time in order to
discharge our future obligations under the transaction

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 Example

Let c = (3, 6, 1, 2, -20),

v(0,1) = 0.6, v(1,2) = 0.5, v(2,3) = 0.4, v(3,4) = 0.5,

How much do we have, and how much do we need at time

2, just before the 1-unit payment due at that time?
(1 unit payment due at time 2)
(2.2+1) v(3,2) = 3.2/0.4 = 8
(8+2) v(4,3) = 10/0.5 = 20
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(2 unit payment due at time 3)
 is c
is the zero vector
Balances and reserves

⚫ Notation
– Given any c and , let

Take as the past cashflows

as the future cashflows when measured from
27 time k
 answers the question “how much we will have”

Balances and reserves

⚫ Definition
– For k = 0, 1, . . . ,N, the balance at time k with
respect to c and v, denoted by is

The k payment is not included in !

28 v will be suppressed when there is no confusion
 This is the amount we need to meet future payments!
Negative sign indicates the amount to be paid out of the fund!
Balances and reserves

⚫ Definition
– For k = 0, 1, . . . ,N, the reserve at time k with respect
to the c and v, denoted is:

is the negative of the value at time k of the future

29 payments
 Balances and reserves

⚫ . can be thought of as the capital that must be

set aside for future use

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 Relation between balances and
reserves

⚫ From the linearity of and the relation

we get
*
“The value of the transaction at any point is the difference
between what you have accumulated and what you need
to set from the accumulations to meet future obligations”
For a zero-value cashflow vector c,
*+*
31 Arise frequently and has value zero at all durations!
 What is the outstanding balance on the loan at time k?

Relation between balances and

reserves (the value of payments yet to be paid!)

⚫ If c and d are actuarially equivalent, then

is a zero value vector

Consider an individual who borrows money

From the net cashflow (i.e. advance less

repayment) from the borrower’s point of view

If the advances less repayment are actuarially equivalent,

32 these net cashflows form a zero-value vector
 Prospective and Retrospect
approaches

⚫ Computing the outstanding balance by means

of reserves is called the prospective method,
because it looks to the future

⚫ Computing the outstanding balance by means

of balances is often called the retrospective
method, because it looks to the past

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 Example

⚫ An individual borrows 1000 now and another

2000 at the end of year 1. This loan will be
repaid by yearly instalment for 10 years,
beginning 5 years from the present. The yearly
payment doubles after 5 years. The interest
rate is 0.06 for the first 5 years and 0.07
thereafter. How much is still owing 8 years
from now, prior to the payment at that time?
How much is still owing after the payment at
time 8?
34 Determine the repayment amounts
or

Example

⚫ c denote advances, d = repayment amount

⚫ x be the initial repayment
Either case lead to:
3483.97
Outstanding balance at time 8
3483.97- 362.97 = 3121

First five instalment are each:

Next five instalment are each
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Amount owing at time 8, just prior to the payment due on that date,
 Recursion formula

⚫ f, function defined on ℤ+ . It is often useful to derive

a recursion formula that expresses f(k+1) in terms of f(k).
⚫ Given an initial value f(0), we can successively
compute values for f(k) for all k. This is known as
recursion formula. A recursion formula leads to a
difference formula that gives an expression for
f(k+1) - f(k)

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 Recursion formula

⚫ Recursion formula:

Initial value:

⚫ Difference formula:

Useful for calculating how one quantity changes from

37 one period to another
 LHS is the amount repaid on the loan at time k+1!

Recursion formula

Define

(accumulated amount at time k after the cashflow at time k is paid)

Show that:

(1)
From (1):
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 Interest on
outstanding balance Amount on
principal reduction
Recursion formula

Amount repaid on the

loan at time 𝑘 + 1

−𝑐𝑘+1 = 𝑖𝑘 𝐵෨ 𝑘 𝑐 + [𝐵෨ 𝑘 𝑐 − 𝐵෨ 𝑘+1 𝑐 ]

(Form the basis of the usual amortization schedules!)
These are schedules that shows the balances at each
duration and how they change

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 Recursion formula

⚫ Reserves follows the same recursion relation:

*
Start the recursion with initial value:

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 Time shifting and splitting identity

(Splitting identity)

Cashflow before time k

To see this, note that by the relation

and the linearity of Val:

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 Assignment 2

⚫ Ex. 2.6, 2.12, 2.14

⚫ Due on Wednesday March 16, 2022 at 5pm
⚫ Late submissions will not be accepted!

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