The basic deterministic model

Week 3

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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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 𝑉𝑎𝑙0 𝑐 = 𝑉𝑎𝑙𝑛 𝑐 𝑣(𝑚, 𝑛)
𝑉𝑎𝑙0 𝑐 = 𝑉𝑎𝑙𝑘 𝑐 𝑣(0, 𝑘)
𝑣(𝑘)
Time shifting and splitting identity
𝑘
𝑎ሷ 𝑐 = 𝑎ሷ 𝑘 𝑐 + 𝑣(𝑘)𝑉𝑎𝑙 𝑘 ( 𝑐) (Splitting identity)

Cashflow before time k

To see this, note that by the relation
𝑘
𝑐= 𝑘𝑐 + 𝑐
and the linearity of Val:
𝑘
𝑉𝑎𝑙0 𝑐 = 𝑉𝑎𝑙0 𝑘 𝑐 + 𝑉𝑎𝑙 0 ( 𝑐)
𝑎(𝑐)
ሷ 𝑎(
ሷ 𝑘𝑐)
4 𝑘
𝑎ሷ 𝑐 = 𝑎ሷ 𝑘 𝑐 + 𝑉𝑎𝑙0 𝑐
 Treat time k as time zero and measure time from that point!

Notation for time shifting

⚫ Given a cashflow vector c, define

(𝑐 ∘ 𝑘)𝑛 = 𝑐𝑘+𝑛
𝑘
𝑐 ∘ 𝑘 is just 𝑐 with the first k elements removed
Example 𝑐 = (2, 2, 3, 4, 5)
𝑐 ∘ 2 = (3, 4, 5)
Given a discount function v, define the discount function 𝑣 ∘ 𝑘 by
𝑣 ∘ 𝑘 𝑛, 𝑚 = 𝑣(𝑘 + 𝑛, 𝑘 + 𝑚)
5 𝑣 ∘ 𝑘 𝑛 = 𝑣(𝑘, 𝑘 + 𝑛)
 Notation for time shifting

⚫ If interest rate is constant,

𝑣∘𝑘 =𝑣
𝑁
Can write:
𝑘
𝑉𝑎𝑙𝑘 𝑐 = ෍ 𝑣(𝑘, 𝑖)𝑐𝑖
𝑖=𝑘
𝑁

= ෍ 𝑣 ∘ 𝑘(𝑖 − 𝑘)(𝑐 ∘ 𝑘)𝑖−𝑘

𝑖=𝑘
𝑁−𝑘

= ෍ 𝑣 ∘ 𝑘(𝑖)(𝑐 ∘ 𝑘)𝑖 = 𝑎(𝑐

ሷ ∘ 𝑘, 𝑣 ∘ 𝑘)
6 𝑖=0
 Notation for time shifting

⚫ The splitting identity

𝑎ሷ 𝑐 = 𝑎ሷ 𝑘𝑐 + 𝑣 𝑘 𝑉𝑎𝑙𝑘 ( 𝑘𝑐)
can be written as:
𝑎ሷ 𝑐; 𝑣 = 𝑎ሷ 𝑘 𝑐; 𝑣 + 𝑣(𝑘)𝑎(𝑐
ሷ ∘ 𝑘; 𝑣 ∘ 𝑘)
Simplifies to:
𝑎ሷ 𝑐 = 𝑎ሷ 𝑐 + 𝑣 𝑘 𝑎ሷ 𝑐 ∘ 𝑘
𝑘
Under constant interest rate

Splitting identity can be useful in determining

7 changes in certain quantities
 Example

⚫ Suppose that 𝑎ሷ 𝑐 = 19.6 and 𝑎(

ሷ 10𝑐) = 10
If v(9,10) increases from 0.8 to 0.81 while all other values
of v(k,k+1) remain the same, what is the new value of
𝑎(𝑐)
ሷ ?

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 𝑑𝑘
𝑑𝑘 𝑣 𝑘 + 1, 𝑘 =
1 − 𝑑𝑘
Active learning

⚫ Let c = (1, 2, 4,-3, 8, -12). Suppose v(0,1) = v(1,2) =

0.8, v(2,3) = v(3,4) = 0.75, v(4,5) = 0.5. Find
a) 3V
b) B3
⚫ You given rates of discount as follows: dk = 1/3, for k =
0, 1, 2, and dk = ¼, for k = 3, 4. The vector c =
(62,93,12). Find
a) The discount vector v
b) 𝑎(𝑐)
ሷ
c) Val2(c)
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 Active learning

⚫ A discount function satisfies

v(k) = 2-k (1-k/6), k = 0, 1, 2, . . . ,5
For the vector c = (1, -2, 4, 3, -3, -5) find
a) 3V
b) B3

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 𝐵𝑘+1 𝑐 = 𝐵𝑘 𝑐 + 𝑐𝑘 𝑣(𝑘 + 1, 𝑘)

Change of discount function

⚫ Theorem
– Given cashflow vector 𝑐 and a discount function 𝑣, let
𝑣 ′ be another discount function. Define a new
cashflow vector 𝑐 ′ whose entry is giving by

𝑐𝑘′ = 𝑐𝑘 + 𝑣 ′ 𝑘, 𝑘 + 1 − 𝑣(𝑘, 𝑘 + 1) 𝐵𝑘+1

then
𝐵𝑘 𝑐; 𝑣 = 𝐵𝑘 (𝑐 ′ ; 𝑣 ′ )

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 Change of discount function

⚫ Corollary
– If 𝑐 has a zero value with respect to 𝑣 then 𝑐 ′ has
a zero value with respect to 𝑣 ′ .

Follows because a cashflow has a zero value if, and

only if, its balances equal 0

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 We can repay any loan by paying the interest each year
on the prior advances and paying the principal at the end

Change of discount function

⚫ Proposition
– Consider a loan of N periods made according to
the discount function, 𝑣 .′ Let 𝑑′ and 𝑖 ′ be the
discount and interest rates. Suppose the loan advances
are given by the vector 𝑐 = (𝑐0 , . . . , 𝑐𝑁−1 )
Let 𝑁−1

𝑠 = ෍ 𝑐𝑘
𝑘=0
′
𝑟= (𝑑0′ 𝑐0 , 𝑑1′ 𝑐0 + 𝑐1 , 𝑑2′ 𝑐0 + 𝑐1 + 𝑐2 , . . . , 𝑑𝑁−1𝑠)

then 𝑐 is actuarially equivalent to 𝑟 + 𝑠𝑒 𝑁 with

13 respect to 𝑣 ′
 Internal rates of return

⚫ Consider an investor or lender undertaking a

transaction that involves investing funds with the
hope of getting back amount greater than what
was put. Let 𝑐 = (𝑐0 , 𝑐1 , . . . , 𝑐𝑁 )
be the net cashflow vector of the transaction
We are not given a discount function
Want to find the constant interest rate that will make 𝑐
a zero-value vector

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 The definition is unchanged if we use 𝐵 in place of 𝐵෨ because
𝐵𝑘+1 = 𝐵෨ 𝑘 (1 + 𝑖𝑘 )

Internal rates of return

⚫ Definition
– An internal rate of return (abbreviated i.r.r) of the
transaction is a number 𝑖 ∈ (−1, ∞) such that
for the discount function
𝑣 𝑛 = (1 + 𝑖)−𝑛
෨ 𝑁 𝑐; 𝑣 = 0 and
(i) 𝐵
෨ 𝑘 𝑐; 𝑣
(ii) 𝐵 ≤ 0 for 𝑘 = 0, 1, . . . , 𝑁 − 1
i.r.r is sometimes called the yield rate
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 Forward prices and term structure

An example of a discount function is provided by

forward prices on risk-free zero-coupon bond!

What is a zero-coupon bond?

When do we say an asset is risk-free?

A zero-coupon bond pays fixed sum on maturity, and has

no coupons (intervening payments) before maturity

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 The party with a “short position” will be the
seller of the underlying asset or commodity
What problems do you expect to be associated
with this type of contract?

Forward prices and term structure

⚫ A forward contract is a commitment to purchase
at a future date a given amount of a commodity
or asset at a price agreed on today

Agreement Settlement

0 T
The price fixed now for the future is the forward price
The party with a “long position” will be the buyer of the underlying
17 asset or commodity
 Forward prices and term structure

⚫ Features of forward contract

– Traded over the counter (not on exchanges)
– No money changes hands until maturity
– Non-trivial counter-party risk
– Cost nothing to enter into a forward contract
Forward contracts have two limitations:
• illiquidity
• counter-party risk
Future contracts were designed to address these two limitation!
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 Why would someone want to enter into such an arrangement?

Forward prices and term structure

⚫ Buyer may need the item at some future date and wish to
lock in the price now, to avoid future price increase
⚫ The buyer may be a speculator
⚫ Seller may be owner of the asset who wishes to lock in
the price of the asset now to avoid future falling prices
⚫ Seller could also be a speculator who predicts prices will
fall and hopes to profit by buying the item at the delivery
date

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 What will this forward prices be?

Forward prices and term structure

Let 𝑣෤ 𝑡 = 𝑣෤ 0, 𝑡 be the price at time 0 of 1-unit,

zero-coupon, risk-free bond maturing at time t
For any 𝑠 ≤ 𝑡, let 𝑣෤ 𝑠, 𝑡 be the forward price for 1-unit,
zero-coupon bond, maturing at time t, where the delivery
date is time s
Under a certain assumption, they are determined from the
term structure (i.e. relation between the bond prices and various
maturity dates) by the rule:
𝑣෤ 𝑡
𝑣෤ 𝑠, 𝑡 =
𝑣෤ 𝑠
20 𝑣෤ is a discount function!
 Why?

Forward prices and term structure

⚫ An arbitrage opportunity is said to exists in

market if a party can buy and sell a financial
asset with no risk of loss
⚫ In a market where all parties have perfect
information, arbitrage opportunity cannot exists!
⚫ These assumptions are
– No arbitrage opportunity
– Arbitrary number of units of a bond can be bought or
sold at any time
21 – Buying and selling do not involve any transaction costs
 Forward prices and term structure

⚫ Find an arbitrage opportunity for

𝑣෤ 𝑡
i. 𝑣෤ 𝑠, 𝑡 <
𝑣෤ 𝑠
𝑣෤ 𝑡
ii. 𝑣෤ 𝑠, 𝑡 >
𝑣෤ 𝑠

and provide a proof in each case

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 Standard notation and terminology

⚫ a is used for the PV of cashflow stream

𝑎ሷ 𝑛|
ത = 𝑎(0,
ሷ 1𝑛 ) (Immediate annuity)
‘angle’ is used to signify duration of time as opposed to an age
𝑎𝑛ത = 𝑎(1
ሷ 𝑛) (Due annuity)

(;. there is payment at time 0)

𝐼𝑎𝑛|
ത = 𝑎(0,
ሷ 1, 2, . . . , 𝑛, 0, . . . , 0)
𝐼 𝑎ሷ 𝑛|
ത = 𝑎(1,
ሷ 2, . . . , 𝑛, 0, . . . , 0)
23 𝐼 is used for an increasing sequence of payments
 Standard notation and terminology

𝐷𝑎𝑛|
ത = 𝑎(0,
ሷ 𝑛, 𝑛 − 1 , 𝑛 − 2 , . . . , 1, 0, . . . , 0)
𝐷𝑎𝑛|ത = 𝑎(𝑛,
ሷ 𝑛 − 1 , 𝑛 − 2 , . . . , 1, 0, . . . , 0)
𝐷 is used for a decreasing sequence of payments
𝑠 is used to indicate accumulated value:
𝑠𝑛|
ത = 𝑉𝑎𝑙𝑛 0, 1𝑛 = 𝑣 𝑛, 0 𝑎𝑛|
ത

𝑠ሷ𝑛|
ത = 𝑉𝑎𝑙𝑛 1𝑛 = 𝑣 𝑛, 0 𝑎ሷ 𝑛|
ത

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 Spreadsheet calculations

⚫ A loan of 20000, made at an interest rate of 6%, is to

be repaid by level yearly payments for ten years,
beginning 1 year after the loan is advanced. Just
before making the seventh repayment, the borrower
wishes to repay the entire loan.
a) If the interest rate remain unchanged, what is the outstanding
balance?
b) Suppose interest rate has dropped to 5%. How much will the
borrower have to pay if the lender uses the lower interest to
calculate the outstanding balance?

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 The Life table
(Mortality table)

Week 3

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 The Life table

⚫ Objective
– To estimate the mortality pattern exhibited by a
group of individuals

⚫ Purpose
– To be able to assign the right rate for the group

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 Road Map

⚫ Basic definitions
⚫ Probabilities
⚫ Constructing life tables from the values of qx
⚫ Life expectancy
⚫ Choice of life tables
⚫ Standard notation and terminology
⚫ A sample table

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 Basic definitions

⚫ Let 𝑙0 be an arbitrary number, say 100,000

Start with a group of 𝑙0 of newly born babies
Predict how many of these individuals will still be
alive at any given time in the future
𝑙𝑥 Number of those original lives aged 0 who will still
be alive at age 𝑥
𝑑𝑥 Number of those original lives aged 0 who die
between ages 𝑥 and 𝑥 + 1
29 Basic relationship: 𝑙𝑥+1 = 𝑙𝑥 − 𝑑𝑥
 Basic definitions and

⚫ A life table is a tabulation of 𝑙𝑥 and 𝑑𝑥

where 𝑥 ∈ ℤ+ 𝑥 𝑙𝑥 𝑑𝑥
0 100000 2000
1 98000 1500
2 96500 1000
𝑙𝜔 = 0 3 95500 900
. . .
. . .
Age at which all the original . . .
30 group will have died 𝜔 0
 Age against probability of dying
1

0.9

0.8
Probability of dying

0.7 ⚫ .
0.6

0.5

0.4

0.3

0.2

0.1

0
0 10 20 30 40 50 60 70 80 90 100
31 Age
 Age against Probability of dying

0.018

0.016

0.014
Probability of dying

0.012

0.01

0.008

0.006

0.004

0.002

0
0 10 20 30 40 50 60
32 Age
 What does this represent?
A person aged x will be denoted by (x)

Probabilities

⚫ Pretend 𝑙𝜔 can be predicted exactly

⚫ Let 𝑙 𝑥+𝑛 +
𝑝
𝑛 𝑥 = , 𝑛, 𝑥 ∈ ℤ
𝑙𝑥

(Probability that a person aged 𝑥 will live to age 𝑥 + 𝑛)

Consider: 𝑙𝑥 − 𝑙𝑥+𝑛
𝑛𝑞𝑥 =
𝑙𝑥

(Probability that (𝑥) will die between ages 𝑥 and 𝑥 + 𝑛)

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 What is the probability that (𝑥) will die between the
ages of 𝑥 + 𝑛 and 𝑥 + 𝑛 + 𝑘?

Probabilities

⚫ Notation:
𝑝𝑥 = 1𝑝𝑥 ; 𝑞𝑥 = 1𝑞𝑥
𝑞𝑥 is the mortality rate at age x

𝑙𝑥+𝑛 − 𝑙𝑥+𝑛+𝑘
(1) = 𝑛|𝑘 𝑞𝑥
𝑙𝑥
(2) 𝑛𝑝𝑥 − 𝑛+𝑘 𝑝𝑥 = 𝑛|𝑘 𝑞𝑥

(3) 𝑛𝑝𝑥 𝑘 𝑞𝑥+𝑛 = 𝑛|𝑘 𝑞𝑥

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 Probabilities

⚫ Multiplicative rule:
𝑛+𝑘 𝑝𝑥 = 𝑛𝑝𝑥 𝑘𝑝𝑥+𝑛 ∀𝑛, 𝑘, 𝑥 ∈ ℤ+
(In order for (𝑥) to live 𝑛 + 𝑘 years, the individual must first live
𝑛 years, and then being age 𝑥 + 𝑛, must live another 𝑘 years)

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 Assignment 3

⚫ Ex. 2.17, 2.25

⚫ Due on Wednesday February 10, 2021 at 5pm
⚫ Late submissions will not be accepted!

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