Annuities

Mathematics of Finance
Chapter 3:
Annuities
Selim MANKAÏ
Université d’Auvergne
Semester 2, 2019
1
Learning objectives
1. Annuity-immediate and annuity-due

2. Present and future values of annuities
3. Perpetuities and deferred annuities
4. Payment periods and compounding periods
5. Varying annuities
2
Definition
An annuity is a stream of payments made at equal

intervals of time.
The interval between annuity payments is called a
payment period, often just called a period.
3
Examples of Annuities
• Student Loan Payments

• Car Loan Payments
• Insurance Premiums
• Mortgage Payments
• Retirement Savings
4
Types of annuities
Annuity-immediate: Payments or receipts occur at the

end of each period.
Annuity Due: Payments or receipts occur at the beginning
of each period.
5
According to the duration of the payout
Contingent annuities have no fixed number of payments

but depend on an uncertain event (e.g., life insurance
payments that cease when the insured dies).
Annuities certain have a specific stated number of
payments (e.g., mortgage payments on a home)
6
Part 1 : Simple Annuities
7
Annuity-immediate
An annuity under which payments are made at the end

of each period for n periods is called an annuity-immediate
or ordinary annuity.
The cash stream represented by the annuity can be

visualized on a time diagram as shown:
8
Annuity-immediate: Present value
The present value at t=0 of an annuity is equal to the sum

of the different discounted payments:
9
The present value V0 at t=0 of an annuity-immediate is

given by the formula:
n
a a a a
V0    .....  
(1  i) (1  i) 2
(1  i) n
k 1 (1  i )
k
10

n
a a a a
V0    .....  
(1  i) (1  i) 2
(1  i) n
k 1 (1  i )
k
1  (1  i)  n
V0  a 
i
11

n
a a a a
V0    .....  
(1  i) (1  i) 2
(1  i) n
k 1 (1  i )
k
1  (1  i)  n
V0  a 
i
The present value can be given in actuarial notation by:

1  (1  i )  n
an |i 
i
12
Present value : Financial table
13
Sum of a geometric progression:

1  X n 1
1 X  X 2   X n  1  X 1
1 X
14

1  X n 1
1  X  X 2   X n  1  X 1
1 X
a a a
V0    ..... 
(1  i) (1  i) 2
(1  i) n
a  1 1 
 1  ... 
1  i  (1  i )1
(1  i) n 1 
15

1  X n 1
1 X  X 2   X n  1  X 1
1 X
a a a a  1 1 
V0    .....   1  ... 
(1  i ) (1  i ) 2
(1  i) 1  i  (1  i)
n 1
(1  i) n 1 
a 1  (1  i )  n
 
1  i 1  (1  i ) 1
a 1  (1  i )  n a 1  (1  i )  n
   
1 i 1 1  i 1  i 1
1
1 i 1 i
16

1  X n 1
1  X  X 2   X n  1  X 1
1 X
a a a
V0    ..... 
(1  i) (1  i) 2
(1  i) n
a  1 1 
 1  ... 
1  i  (1  i )1
(1  i) n 1 
a 1  (1  i )  n a 1  (1  i )  n a 1  (1  i )  n
     
1  i 1  (1  i ) 1
1 i 1 1 i 1  i 1
1
1 i 1 i
1  (1  i)  n
V0  a 
i 17
Example
The annual payment on a house is $15,000. If payments

are made at the end of 30 years, how much is the house
worth assuming annual interest rate of 6%?
18
Example
n= 30
i = 6%
a= 15000
Present value of the annuity:
1  (1  6%)30
V0  15000   206472, 46
6%
19
Annuity-immediate: Future value
The future value at t=n of a series of n payments is equal

to the sum of the different future value of the payments
20
Future value at t=n of the annuity-immediate of n

payments :
Vn  a(1  i)n1  a(1  i)n2  ...  a(1  i)  a
 a (1  i ) n 1
 (1  i ) n2
 ...  (1  i )  1
sum of a geometric progression
21

payments :
Vn  a(1  i)n1  a(1  i)n2  ...  a(1  i)  a
 a (1  i ) n1  (1  i ) n2  ...  (1  i )  1

1  (1  i ) n 1  (1  i ) n (1  i ) n  1
 a  a  a
1  (1  i ) i i
22

payments :
Vn  a(1  i)n1  a(1  i)n2  ...  a(1  i)  a
 a (1  i ) n1  (1  i ) n2  ...  (1  i )  1

1  (1  i ) n 1  (1  i ) n (1  i ) n  1
 a  a  a
1  (1  i ) i i
(1  i )n  1
Vn  a 
i
23
Relationship between the future value Vn and the present

value V0:
Vn  V0 (1  i ) n
 1  (1  i ) n

Vn  (1  i )  a 
n

 i 
V0
(1  i )n  1
Vn  a 
i
24
Example
Calculate the future value of an annuity-immediate of

amount 5000 paid annually for 5 years at the rate of
interest of 6%.
25
Example
a = 5000: i= 6% and n = 5
Future value at the 5th payement :
Accumulated interests :
28185,46 — (5x5000) = 3185,46
26
Annuity in Advance: Annuity Due
An annuity under which payments are made at the

beginning of each period for n periods is called an annuity-
due.
The cash stream represented by the annuity can be

visualized on a time diagram as shown:
27
Annuity Due: Present value
The present value at t=0 of an annuity is equal to the sum

of the different discounted payments:
28
The present value V0 at t=0 of an annuity due is given by

the formula:
a a
V0  a   ... 
(1  i)1
(1  i) n 1
29
The present value V0 at t=0 of an annuity due is given by

the formula:
a a
V0  a   ... 
(1  i)1
(1  i) n 1
 a a 
V0  (1  i )   ...  n 
 (1  i )1
(1  i ) 
Present value of an annuity immediate
1  (1  i) n
V0  a(1  i ) 
i 30
Annuity Due: Future value
The future value at t=n of a series of n payments is equal

to the sum of the different future value of the payments
31
Annuity Due: Future value
Future value at t=n of the annuity-due of n payments :
Vn  a(1  i)n  a(1  i)n1  ...  a(1  i)  0
 (1  i )  a (1  i ) n 1  a (1  i ) n 1  ...  a 
Annuity  immediate: Future value
(1  i )n  1
Vn  a(1  i )
i
32
Annuity-due: Future value
Relationship between Future value Vn and present value V0:
Vn  V0 (1  i ) n
 1  (1  i ) n

Vn  (1  i )  a  (1  i ) 
n

 i 
V0
 (1  i ) n  1 
Vn  a   (1  i )  
 i 
33
Exemple
A 5-year annuity due has annual cash-flows of €5000 at

the beginning of each year. The effective annual interest
rate is 6%.
- Find the present value of this annuity at t=0.

- Find the accumulated value of this annuity at t=5.
34
Exemple
The present value of the annuity at t=0 :
1  (1  6%) 5
V0  5000(1  6%)   € 22 325.52
6%
35
Exemple
The present value of the annuity at t=0 :
1  (1  6%) 5
V0  5000(1  6%)   € 22 325.52
6%
The accumulated value of this annuity at t=5 :
(1  6%)5  1
V5  5000(1  6%)  €29876.56
6%
36
Annuity Values on Any Date: Deferred Annuity
We shall consider evaluating the:

1- present value of an annuity more than one period
before the first payment date,
2- accumulated value of an annuity more than one period
after the last payment date,
37
Present value before the first payment date
Consider an the present value at t=0 of an (n payments)

annuity-immediate p periods before the first payment date.
38
Consider an the present value at t=0 of an (n payments)

annuity-immediate p periods before the first payment date.
39
The present value at t=0 of an (n payments) annuity-

immediate p periods before the first payment date.
40
Example
Exactly 3 years from now is the first of four $200 yearly

payments for an annuity-immediate, with an effective 8%
rate of interest. Find the present value of the annuity at t=0.
41
Example
The present value of the annuity at t=0:

p=3 and n= 4
 1  (1  8%)1 3 4
1  (1  8%)1 3

V0  200 
3
 
 8% 8% 
V03  567,92
42
Future value after the last payment date
The future value an (n payments) annuity-immediate p

periods after the last payment date
43

44

45
Example
For four years, an annuity pays $200 at the end of each

year with an effective 8% rate of interest.
Find the accumulated value of the annuity 3 years after the
last payment.
46
Example
The accumulated value of the annuity 3 years after the last

payment.
n=4 and p= 3
 (1  8% ) 43
 1 1  8% ) 3
 1
V4  200 
3
 
 8% 8% 
V43  200(9,922  3.246)  1135, 28
47
Perpetuity
A perpetuity is an annuity for which the payments

continue forever.
An example that resembles a perpetuity is the dividends
of a preferred stock.
48
Present value of a perpetuity (annuity-immediate)
The present value at t=0 of a perpetuity (annuity-

immediate) is given by :
 1  (1  i )  n 
V0  lim  a 
n 
 i 
49
Present value of a perpetuity (annuity-immediate)
The present value at t=0 of a perpetuity (annuity-

immediate) is given by :
 1  (1  i )  n 
V0  lim  a 
n 
 i 
a
V0 
i
1
lim 0
n  (1  i ) n
50
Present value of a perpetuity (annuity-due)
The present value at t=0 of a perpetuity (annuity-due) is

given by :
 1  (1  i )  n 
V0  lim (1  i ) a 
n 
 i 
a (1  i )
V0 
i
1
lim 0
n  (1  i ) n
51
Present value of a perpetuity (deferred annuity)
The present value at t=0 V0 of a deferred perpetuity-

annuity that starts in (m) periods time is given by :
a
V0  1  i 
 m 1
52
Example 1
Suppose a company issues a stock that pays a dividend at

the end of each year of $10 indefinitely and the company
cost of capital is 6%.
What is the value of the stock at the beginning of the
year?
53
Example 1
The value of the stock at the beginning of the year:
10
V0   166.66
6%
54
Example 2
What would you be willing to pay for an infinite stream of

$37 annual payments (cash inflows) beginning now if the
interest rate is 8% per annum?
55
Example 2
What would you be willing to pay for an infinite stream of

$37 annual payments (cash inflows) beginning now if the
interest rate is 8% per annum?
37(1  8%)
V0   500
8%
56
Example 3
Fifty dollars is paid at the end of each year forever starting

six years from now. Assume the annual effective rate of
interest is 10%.
Find the present value of the investment.
57
Example 3
The present value of the investment:
50
1  10% 
5
V0 
10%
 310, 46
58
Solving for the Unknown Number of Payments
We consider the question of finding the number of

payments n given the regular payment a; the interest per
period i and either the present value or the accumulated
value of an annuity.
59
Example
An investment of $10,000 is to be used to make payments

of $700 at the end of every year for as long as possible.
If the effective annual rate if interest is 6%.
Find the number of payments the fund will make.
60
Example
The number of payments:

1  (1  6%) n
10000  700 
6%
(1  6%)  n  1.0857
ln(1  6%)  n  ln(0.914)
ln(0.914)
n   33.4
ln(1  6%)
61
Varying Interest of an Annuity
Interest rate can vary each period.
62
Example
How much must a person deposit now into a special

account in order to withdraw $1,000 at the end of each year
for the next fifteen years, if the effective rate of interest is
equal to 7% for the first five years, and equal to 9% for the
last ten years?
63
Example
How much must a person deposit now into a special

account in order to withdraw $1,000 at the end of each year
for the next fifteen years, if the effective rate of interest is
equal to 7% for the first five years, and equal to 9% for the
last ten years?
1  (1  7%) 5 1  (1  9%) 10 5 

 1000    (1  7%) 
 7% 9% 
 8675,9€
64
Annuities payable at a different frequency than interest is convertible
Annuities can be payable less frequently than interest is

convertible
Example: an annuity-due with monthly payment of
$2,000 and with an annual interest rate say 12%
convertible quarterly.
Annuities can be payable more frequently than interest is

convertible
Example: an annuity-due with annual payment of $1,000
and with interest rate say 12% convertible monthly.
65
Example 1
What is the present and future value of the payment of

$100 per month (annuity–immediate) for 30 years if the
effective annual interest rate is 6%.
66
Example 1
Interest rate convertible monthly:

i12 12
(1  )  (1  i )
12
i12 12
 (1  i )  1
12
i12 12
 1,1  1  0.797%
12
67
Example 1
Interest rate convertible monthly:

i12 12
(1  )  (1  i )
12
i12 12
 (1  i )  1
12
i12 12
 1,1  1  0.797%
12
Number of periods : (30*12= 360)
1  (1  0.797%) 360
V0  100   11 821.86
0.797%
(1  0.797%)360  1
Vn  100   206 284.3
0.797%
68
Example 2
Find the present and accumulated value of $1500 paid

every four years for 40 years at the annual rate of interest
of 8%. The first payment is due is four years.
69
Example
Equivalent interest rate convertible quadri-annually:
(1  i(4) )  (1  i) 4
i(4)  (1  i ) 4  1
i(4)  (1  8%) 4  1  36.04%
70
Example
Interest rate convertible quadri-annually:
(1  i(4) )  (1  i) 4
i(4)  (1  i ) 4  1
i(4)  (1  8%) 4  1  36.04%
Number of periods : (40/4=10)
1  (1  36.04%) 10
V0  1500   3 969.48
36.04%
(1  36.04%)10  1
Vn  1500   86 235.05€
36.04%
71
Part 2 : Varying Annuity
72
Varying Annuity-Immediate: Geometric Progression
Consider an annuity-immediate with a term of n periods

where the interest rate is i per period, and where the first
payment is P and successive payments increase in
geometric progression with common ratio 1 + k:
73
Present value
P (1  k ) P (1  k ) 2 P (1  k ) n 1 P
V0     
(1  i ) (1  i ) 2
(1  i ) 3
(1  i ) n
74
Present value
P (1  k ) P (1  k ) 2 P (1  k ) n 1 P
V0     
(1  i ) (1  i ) 2
(1  i ) 3
(1  i ) n
     1+k  
2 n 1
P 1+ k 1+ k
V0  1     
(1  i )  (1  i ) (1  i )
n 1
(1  i )
2

75
Present value
P (1  k ) P (1  k ) 2 P (1  k ) n 1 P
V0     
(1  i ) (1  i ) 2
(1  i ) 3
(1  i ) n
 1+k  1+k  1+k  

2 n 1
P
V0  1     
(1  i )  (1  i ) (1  i )
n 1
(1  i )
2

P
V0 = 1  W + W 2 + +W n 1 
(1  i )
76
Present value
P (1  k ) P (1  k ) 2 P (1  k ) n 1 P
V0     
(1  i ) (1  i ) 2
(1  i ) 3
(1  i ) n
     1+k  
2 n 1
P 1+ k 1+ k
V0  1     
(1  i )  (1  i ) (1  i )
n 1
(1  i )
2

P
V0 = 1  W + W 2 + +W n 1 
(1  i )
P 1  W n 
(1  i )  1-W 
V0 =
77
Present value
P 1  W n 
(1  i )  1-W 
V0 =
78
Present value
P 1  W n 1 
(1  i)  1-W 
V0 =
  1  k n 
1   
P   1  i  
V0 =
(1  i )   1  k  
 1-  1  i  
   
79
Present value
P 1  W n 1 
(1  i)  1-W 
V0 =
  1  k n 
1    
P   1 i  
V0 =
(1  i )   1  k  
 1-  1  i  
   
  1  k n 
1    

V0 = P     i  k
1 i
 i-k 
 
 
80
Future value
Le relationship between the present and future value:
Vn  V0 1  i 
n
  1  k n 
1    

V0 = P    
1 i
 i-k 
 
 
81
Future value
Vn  V0 1  i 
n
  1  k n 
1    

V0 = P    
1 i
 i-k 
 
 
  1  k n 
1    
1 i  
Vn =(1+i) n P   i  k
 i-k 
 
 
82
Example
The first of 10 payments of an annuity occurs in exactly

one year and is equal to $500. The payments increase so
that each payment is 20% greater than the preceding
payment. The annual effective rate of interest is 2%.
1- Find the present value of these payments at time 0;

2- Find accumulated value of these payments at the time
of the last payment.
83
Example
The total number of payments is 10.

P=500 and k=20%
The present value of this annuity at time 0
  1  20% 10 
1    

V0 = 500      11331.61
1 2%
 2% - 20% 
 
 
The future value at the time of the last payment:
  1  20% 10 
1    
 1  2%    13813.17
V10 = (1+2%)  500 
10
 2% - 20% 
 
  84
Present value of a perpetuity-immediate
If k≥ i : Present value tends to infinity.

If k<i :
  1  k  
n
1  nlim 
 1  i
 
V0 = P     1 k 
n
 i-k  lim 
n  1  i
 0
   
 
P
V0 =
i-k
85
Example
What is the present value of a stream of annual

dividends, which starts at $1 at the end of the first year,
and grows at the annual rate of 10%, given that the rate of
interest is 20% ?
86
Example
Common ratio of the geometric progression : 1+ k=1.1

Since k<i, the present value at time 0:
1
V0 =  10€
20% - 10%
87
Varying Annuity due: Geometric Progression
Consider an annuity-immediate with a term of n periods

where the interest rate is i per period, and where the first
payment is P and successive payments increase in
geometric progression with common ratio 1 + k: :
88
Present value
(1  k ) P (1  k ) 2 P (1  k ) n 1 P
V0  P    
(1  i) (1  i) 2
(1  i) n 1
89
Present value
(1  k ) P (1  k ) 2 P (1  k ) n 1 P
V0  P    
(1  i) (1  i) 2
(1  i) n 1
       1+k  
2 n 1
1+ k 1+ k
V0  P 1   
 
n1
(1  i)
2
 (1 i ) (1 i ) 
90
Present value
(1  k ) P (1  k ) 2 P (1  k ) n 1 P
V0  P    
(1  i) (1  i) 2
(1  i) n 1
       1+k  
2 n 1
1+ k 1+ k
V0  P 1   
 
n1
(1  i)
2
 (1 i ) (1 i ) 
V0 = P 1  W + W2 + +W n1 
91
Present value
(1  k ) P (1  k ) 2 P (1  k ) n 1 P
V0  P    
(1  i) (1  i) 2
(1  i) n 1
       1+k  
2 n 1
1+ k 1+ k
V0  P 1   
 
n1
(1  i)
2
 (1 i ) (1 i ) 
V0 = P 1  W + W2 + +W n1 
1  W n 
V0 = P  
 1-W 
.
92
Present value
1  W n 
V0 = P  
 1-W 
93
Present value
1  W n 
V0 = P  
 1-W 
  1  k n 
1    
1 i  
V0 = P  
 1 k  
 1-  1  i  
   
94
Present value
1  W n 
V0 = P  
 1-W 
  1  k n 
1    
1 i  
V0 = P  
 1 k  
 1-  1  i  
   
  1  k n 
1    

V0 = (1+i)P    
1 i
 i-k 
 
.  
95
Future value
Vn  V0 1  i 
n
96
Future value
Vn  V0 1  i 
n
  1  k n 
1    
1 i  
V0 = (1+i)P  
 i-k 
 
 
97
Future value
Vn  V0 1  i 
n
  1  k n 
1    
1 i  
V0 = (1+i)P  
 i-k 
 
 
  1  k n 
1    

Vn =(1+i)n 1 P    
1 i
 i-k 
 
 
98
Example
The first of 10 payments of an annuity occurs at time 0

and is equal to $500. The payments increase so that each
payment is 20% greater than the preceding payment. The
annual effective rate of interest is 2%.
1- Find the present value of these payments at time 0;

2- Find accumulated value of these payments at the time
of the last payment.
99
Example
The total number of payments is 10.

P=500 and k=20%
The present value of this annuity at time 0
  1  20% 10 
1    

V0 = (1+2%)  500      11558.24
1 2%
 2% - 20% 
 
 
The future value at the time of the last payment:
  1  20% 10 
1    
 1  2%    14089.43
V10 = (1+2%)  500 
11
 2% - 20% 
 
 
100
Present value of a perpetuity-immediate
If k≥ i : Present value tends to infinity.

If k<i :
  1  k  
n
1  nlim 
 1  i
 
V0 = (1+i)P     1 k 
n
 i-k  lim 
n  1  i
 0
   
 
P(1  i )
V0 =
i-k
101
Example
A perpetuity has the following sequence of annual payments

€1; €1.1; €1,21; 1,33 €;…….
Calculate the present value of these payments at the time the
first payment is made using an annual effective rate of 20%.
102
Example
Common ratio of the geometric progression : 1+ k=1.1

P=1.
Since k<i, the present value at time 0:
1 (1  20%)
V0 =  12
20% -10%
103

Annuities

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Annuities

Uploaded by

Copyright:

Available Formats

Mathematics of Finance

1. Annuity-immediate and annuity-due

An annuity is a stream of payments made at equal

• Student Loan Payments

Annuity-immediate: Payments or receipts occur at the

Contingent annuities have no fixed number of payments

An annuity under which payments are made at the end

The cash stream represented by the annuity can be

The present value at t=0 of an annuity is equal to the sum

The present value V0 at t=0 of an annuity-immediate is

The present value V0 at t=0 of an annuity-immediate is

The present value V0 at t=0 of an annuity-immediate is

The present value can be given in actuarial notation by:

Sum of a geometric progression:

Sum of a geometric progression:

Sum of a geometric progression:

Sum of a geometric progression:

The annual payment on a house is $15,000. If payments

Present value of the annuity:

The future value at t=n of a series of n payments is equal

Future value at t=n of the annuity-immediate of n

Future value at t=n of the annuity-immediate of n

 a (1  i ) n1  (1  i ) n2  ...  (1  i )  1

Future value at t=n of the annuity-immediate of n

 a (1  i ) n1  (1  i ) n2  ...  (1  i )  1

Relationship between the future value Vn and the present

Calculate the future value of an annuity-immediate of

Future value at the 5th payement :

28185,46 — (5x5000) = 3185,46

An annuity under which payments are made at the

The cash stream represented by the annuity can be

The present value at t=0 of an annuity is equal to the sum

The present value V0 at t=0 of an annuity due is given by

The present value V0 at t=0 of an annuity due is given by

The future value at t=n of a series of n payments is equal

Future value at t=n of the annuity-due of n payments :

Vn  a(1  i)n  a(1  i)n1  ...  a(1  i)  0

Relationship between Future value Vn and present value V0:

A 5-year annuity due has annual cash-flows of €5000 at

- Find the present value of this annuity at t=0.

The present value of the annuity at t=0 :

The present value of the annuity at t=0 :

The accumulated value of this annuity at t=5 :

We shall consider evaluating the:

Consider an the present value at t=0 of an (n payments)

Consider an the present value at t=0 of an (n payments)

The present value at t=0 of an (n payments) annuity-

Exactly 3 years from now is the first of four $200 yearly

The present value of the annuity at t=0:

The future value an (n payments) annuity-immediate p

The future value an (n payments) annuity-immediate p

The future value an (n payments) annuity-immediate p

For four years, an annuity pays $200 at the end of each

The accumulated value of the annuity 3 years after the last

A perpetuity is an annuity for which the payments

The present value at t=0 of a perpetuity (annuity-

The present value at t=0 of a perpetuity (annuity-

The present value at t=0 of a perpetuity (annuity-due) is

The present value at t=0 V0 of a deferred perpetuity-

Suppose a company issues a stock that pays a dividend at

The value of the stock at the beginning of the year:

What would you be willing to pay for an infinite stream of

What would you be willing to pay for an infinite stream of

Fifty dollars is paid at the end of each year forever starting