Top 10 Actuarial Technical Interview Topics For Freshers

Interview Preparation Guide
Top 10
Actuarial
Interview
Topics
Designed for College Graduates
1. Endowment vs Term
Both Term Insurance and Endowment plans are traditional life insurance plans.
Both offer comprehensive life coverage and are good tax-saving instruments.
Which one is better will be concluded at the end but note the differences:
 If you buy a term plan, the beneficiaries will receive the guaranteed death
benefit only in case of your death within the stipulated time. But in case of
an endowment plan, you will receive the entire sum assured along with
bonuses that you have built over time, once the policy tenure is over. Under
Endowment if you died in between the time your beneficiary get the
payment. So Term is a pure life insurance policy an endowment plan, on the
other hand, is a combination of investment and insurance
 Insurance agents are not much inclined to sell a term plan because the sales
of endowment plans get them higher profits. A term plan offers
comprehensive life coverage at very low premium rates. For the same
amount of coverage, an endowment plan will charge higher and if you add
riders with your basic plan, the premiums will increase.
 Example: If you are 20 Year old , non smoker and earn between 3-5 Lacs
per annum then
Endowment plan- 24,000 annual premium for 30 years gives you sum assured of
24 lakhs (PNB Metlife )
Term Plan - you can get insurance for 2 crores for 40 year term at just rs.14000
per annum (ICICI PRUDENTIAL )
 So, an endowment plan is more beneficial if taken mainly for the purpose of
saving, but the better alternative is to invest in mutual funds or any other
financial instrument. On the other hand, term plans are beneficial for those
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who want higher coverage at low premium rates, providing financial
protection for their family in case they die.
So Term insurance is the better Option.

2. Bayesian Statistics
What is Bayesian Statistics: (I will try to explain in easy terms)
Often researchers investigating an unknown population parameter have

information available from other sources in advance of the study that provides a
strong indication of what values the parameter is likely to take. This additional
information might be in a form that cannot be incorporated directly in the current
study. The classical statistical approach offers no scope for the researchers to take
this additional information into account. However, the Bayesian statistics is the
approach which allows to take this additional information into account while
estimating a population parameter.
Let me explain you with the help of an example:
4 championship races had been done between Mr. A and Mr. B. Out of which A
has won 3 races and B has won 1 race. SO, on whom are you going to bet your
money in the next race?
You will Say Mr. A because P(A) = 0.75 and P(B) = 0.25
So your initial estimate about B is P(B) = 0.25
Now I will give you additional information say, there was a rain when Mr. B won
and there was rain once when Mr. A won. And in the next match there will
definitely be a rain.
So now I ask you again on whom will you bet your money?
Let’s decode the answer:
1. P(R) = 0.50 (Because rain happened twice out of 4 matches)
2. P(R|B) = 1 (Because whenever Mr. B won there was a rain)
So I want to find out that what is probability that in the next race Mr. B will won if
it is given that there will be a rain:
P(B|R) = P(R|B)*P(B)/P(R) = 0.50
I hope you know how this formula comes up otherwise you can mention me in
comments I will tell you how.
Conclusion: Initially we comes up with an answer that P(B) = 0.25 which is my
prior estimate and then I give additional information about rain which we
incorporated in the form of conditional probability i.e. P(R|B) = 1 and then
ultimately we find P(B|R) which is my posterior probability.
So you see how with the help of Bayesian statistics I incorporated additional
information into my current study and how my value changes from 0.25 to 0.50.
Statistics seems easy now. 😊

Its an art and you are an artist.

3. Censored vs Truncated
Censored vs Truncated:
Censored data have unknown values beyond a bound on either end of the number
line or both. When the data is observed and reported at the boundary, the
researcher has made the decision to restrict the range of the scale.
An example of a lower censoring boundary is
The recording of pollutants in our water. The researcher may not care about (or
instruments may not be able to detect) the level of pollutants if it falls below a
certain threshold (e.g., .005 parts per million). In this case, any pollutant level
below .005 ppm is reported as “<.005 ppm.”
Truncation occurs when values beyond a boundary are either excluded when
gathered or excluded when analysed.
For example, if someone conducting a survey asks you if you make more than
$100,000, and you answer “yes” and the surveyor says “thanks but no thanks”,
then you’ve been truncated.
So, to summarize, data are censored when we have partial information about the
value of a variable—we know it is beyond some boundary, but not how far above
or below it.
In contrast, data are truncated when the data set does not include observations in
the analysis that are beyond a boundary value.

4. Duration
Before going to the concept of Duration and related terms lets see what is YTM =
Yield To Maturity
Yield To Maturity :
The Yield to Maturity for a Coupon Paying Bond has been defined as the effective
rate of interest at which the discounted value of proceeds of a bond equals the
price.
Now let's Come to Duration
Background: An Investor is concerned whether his assets in a portfolio are

sufficient enough to fund the liabilities or not. So for portfolio with investments in
Fixed interest securities investor is more concerned in knowing the change in its
portfolio due to change in its interest rate.
Now for simplicity, suppose interest rate will remain same throughout the term of a
security.
Effective Duration:
also known as Volatility. It measures sensitivity in cashflows due to change in

interest rate. Let X be the present value of Payments at rate YTM. So Effective
duration is the change in the X with respect to change in "i"(i.e. YTM) .
Duration:
 also known as Macaulay Duration and Discounted Mean Term.

 It is a measure of a bond's sensitivity to interest rate changes. Technically,
duration is the weighed average number of years the investor must hold a
bond until the Present Value of the bond’s cash flows equals the amount
paid for the bond.
 Macaulay duration is simply the weighted average life of the cash flows
.The weight is the present value of that cash flow divided by the total
present value and then you're simply multiplying that by the time when the
cash flow is receives that's why it's the weighted average life.

Duration is measured in years. Generally, the higher the duration of a bond or a
bond fund (meaning the longer you need to wait for the payment of coupons and
return of principal), the more its price will drop as interest rates rise.
For example, if a bond has a duration of five years and interest rates increase by
1%, the bond's price will decline by approximately 5%. Conversely, if a bond has a
duration of five years and interest rates fall by 1%, the bond's price will increase by
approximately 5%.
So we have seen that Duration = Macaulay Duration = DMT

and Effective Duration = Volatility
Modified Duration: used to estimate percentage price change when interest

changes by one percent.
To find the modified duration, You have to take the Macauley duration and divide
it by 1 + (yield-to-maturity / number of coupon periods per year).
Notes to Remember:
 First, as maturity increases, duration increases and the bond becomes more
volatile.
 Second as a bond's coupon increases, its duration decreases and the bond
becomes less volatile.
 Third, as interest rates increase, duration decreases and the bond's sensitivity
to further interest rate increases goes down.
 Fourth, The duration of "n" year zero coupon bond is "n". Because there is
only one payment that must be the time of that cashflow
Other Notes:
YIELD DURATION: Measures bond price sensitivity to its Yield to Maturity

Examples: Macaulay Duration , Modified Duration.
CURVE DURATION: Measures Sensitivity of a Security to a benchmark yield

Curve.
Example: Effective Duration

Effective Duration*(1+i)= DMT
The difference between modified duration and effective duration is that modified
duration assumes that the cash flows won’t change, while effective duration allows
that the cash flows might change. The cash flows could change because:
1. The bond has embedded options (call option, put option, conversion option,
prepayment option)
2. The bond has a floating interest rate

5. Convexity
Definition: Convexity describes how much a bond's duration changes when
interest rates change
Where the cashflow series have payments coming Close to each other will have
a lower convexity.
Where the Cashflow series payments is more spread out over time will have a
higher convexity.
Now let’s Consider three cases

1. There is a zero-coupon bond of say 20 years
2. There is a bond having cashflows at time 3 and at time 10
3. There is a bond having cashflows at time 1,2, 3,….,11,12
Now Zero-Coupon bond will have lower convexity because it consists of just
one payment. But in 3rd case convexity is high because payments are spread out
over a longer period of time.
In Technical Terms , let’s say X is the present value of all cashflows. So take
the double derivative of X with respect to change in interest rate and then divide
it by X will gives us the Convexity.
Now question will be that what exactly is the use of convexity.
It is the measure of change in Duration of the bond with respect to change in
interest rate.
Positive convexity implies that change in interest rate is inversely proportional
to change in bond, i.e. decrease in interest rate leads to increase in Duration of
bond.
(Convexity will always have a positive value in normal market condition.
But it can be negative also which means decrease in yields leads to decrease
in duration as in case of callable bonds.)
In our above example that if we decrease the interest rate in all of them , then
the change will be high in case 3 where convexity is high and will be low in
case of scenario 1.
Now from graph point of view, higher convexity will have a curved shape
whereas lower convexity will have flatter shape curve.
Note: Both DMT and effective duration measures the average life of an
investment. Investment with longer term will have more impact than with
shorter term when there is a change in interest rate.

Note: Degree to which a bond's price changes when interest rates change is
called duration, which often is represented visually by a yield curve. Convexity
describes how much a bond's duration changes when interest rate change.

6. Immunisation
Definition:
Immunisation is a strategy of managing a Portfolio of Assets such that business
is immune to interest rate fluctuations. In other words, it is a process where an
investment manager select an asset portfolio in such a way that his surplus
(Present Value of Asset-Present Value of Liabilities) is protected against change
in interest rate.
Background: During early 1900’s we usually saw our portfolio changes due to
changes in our cashflows but then there was an increase in interest rate volatility
due to which we started seeing the change/impact on our portfolio due to
change in interest rate.
3 conditions:
1)VA(i0) = VL(i0) which means Present Value of Assets = Present Value of
Liabilities.
Suppose we have to pay Rs.10,000 after 2 years, so what we can we do is

purchase 2 year Zero coupon bond whose maturity value will be Rs.10,000,
which means that after 2 years proceeds from bond helps in paying our
liabilities. So now if discount rate is same in both the cases, our Present Value
will be same for both Assets and Liabilities. Thus, our Fund is immune.
Note: Here the Surplus is zero as PVA - PVL = 0 , which further means that at
i0 Surplus is zero.
So, question is what will be the impact on Surplus when there is Change in
interest rate.
2) VA’(i0) = VL’(i0) which means Volatilities of asset and liabilities cashflow

series are equal or we can say that DMT (or Duration) of both should be same
Now as we know that decrease in interest rate leads to increase in Present Value
of Assets and Liabilities. Increase in interest rate leads to decrease in Present
Value of Assets and Liabilities.
But the question is which will have more impact. So we are saying here that
whatever be the change in interest rate, it will have same impact on both assets
and liabilities that’s why we are saying that volatility of both assets and
liabilities should be same.
So now present value of both is same and volatilities are also same. Now
question is what will happen if there is a cash outflow and then there is cash
inflow after some period of time and at the time of cash outflow we don’t have
enough money. Now, let’s see the third Condition.

3)VA”(i0) >VL”(i0) which means Convexity of Assets has to be greater than
convexity of Liabilities.
Here we are saying that cash inflow series is more spread out than cash outflow
series.
It means that bonds will always have a higher value than the liability, even if the
interest rate changes. This means that our portfolio of bonds will always sell for
enough money to cover the liability.
Limitations of Immunization:
1. It is only valid for sufficiently small change in interest rate (as we ignored
third-order and higher-order derivatives)
2. The value of our portfolio of assets changes over time, so we need to
rebalance the portfolio to continue satisfying the conditions for Redington
immunization.
3. This theory assumes flat yield curve and requires same change in interest
rate at all terms, in practice it is rarely the case.
4. Immunisation removes likelihood of making profits.

7. Effective vs Nominal vs Force
What exactly is Effective interest rate? The Effective interest rate
over a given time period is the amount of interest a single initial
investment will earn at the end of time period.
We will clear now it in detail.
1.Effective annual interest had interest paid once at the end of each
year.
2.Effective annual Discount had interest paid once at the start of
each year.
So, what will happen if interest paid is not once in a measurement
period, then there comes a Nominal Rate.
Nominal is used where is interest is paid more (or less) frequently

than once per measurement period.
Application of Nominal rate in real life: Bank accounts normally use

nominal rates. They quote the annual interest rate but interest is
actually added at the end of each month. Thus, here interest is paid
more frequently than once per unit time year.
8 points for Interest Rates: Nominal and Effective

1) Here is the notation; i(p) = Nominal rate of interest convertible pthly
or compounded pthly (we meant to say that interest is payable p times
per period)
2) It also means that rate of interest of i(p)/p is applicable for each
pth of a period.
3) For example: Nominal rate of interest is 6%p.a. convertible
quarterly. It means i(4) = 6%. So i(4)/4 = 1.5%. So, this is the rate
(i.e.1.5) which is applicable for each pth of a period where p=4
4) If you see carefully 3rd point then we are just annualising a pthly
effective interest rate.
5) Let’s see one more example: Suppose we have given monthly
effective interest rate of 2% then what will be the nominal annual

interest rate convertible monthly? We have given i(12)/12 = 2%, and
we have to find i(12) = 2%*12 = 24%
6) Effective interest rate will always be greater than nominal interest
rate as we have taken into account the effect of compounding too.
7) Note the important formula: 1+i = (1+ip/p)p . With the help of this
formula we can calculate effective pthly rate into effective annual
rate.
8) Let’s see example to justify above point: Suppose nominal rate =
8%p.a. convertible half yearly. So what will be the value of Rs.500
after 3 years? we have given i(2) = 8%. So i(2)/2 = 4%. Now we can use
the above formula: 1+i = (1+.04)2. By solving this we get i= 8.16%.
So accumulated value will be 500(1.0816)3 = 632.66
9) Point is simple that if half year effective rate is 3% then it does
not mean that effective annual rate will be 6%. Rather it is 1.03 2 -
1 = 6.09% due to effect of compounding.
8 points for Discounting and Force of Interest Rates

1. Important formula: 1-d = (1-d(p)/p)p
2. Discounting for n years denoted by v(n)= (1-d)n and Accumulating
for n years denoted by A(n) = (1+i)n = 1/v(n) = (1-d)-n
3. We have seen where interest is paid once per measurement period
(effective) and more or less than once per measurement period
(Nominal). What will happen if the interest is paid continuously, then
there comes Force of Interest. ( ) denoted by delta
4. Force of interest (delta) it is like i(p) where p leads to infinity (∞).
5. Euler’s rule: limit (n approaches to ∞) (1+x/n)n = ex and we have
seen that 1+i = (1+ip/p)p . Thus 1+i = exp(delta)
6. d<d(2)<d(4)<……. delta< ………<i(4)<i(2)<i. Here what we are saying

is that if we have suppose i=10% then i(2) < 10%, you can calculate
too using formula given in point no.7 of interest. Similarly when you
calculate delta, it is also less than i(4). You can find both of them using
i=10%. Suppose i(2) comes out to be 9% then delta will be less than
9%.

Case study question: If you go to bank for a loan, and your banker
said either you will get loan at d(4)= 10% or d(12) = 10%, at which
rate will you want the loan?
Case study answer: Simple thing is that you can convert both the
rates into effective annual interest rate i.e. “i” whichever i is lower
you will prefer than loan. But without calculating the i we can tell i.e.
using point no. 6 result above. d(4) < d(12)<i .
So here we suppose when i=10% then we found out that d (12)=9% and
d(4)=8% . (these are not correct figures however you can find them
using formulas given above). So, there is a common sense that when
d(12)= 10% then i will be more than 10% (let’s say 11% , this is not
correct figure) and when d(4)=10% then i will be more than 11% (this
11% means is that it will be more than d(12)=10%) . So, as a rational
borrower, I want the loan at less rate of interest so I would prefer
d(12)=10%.
If you still didn’t get the above answer that here is the trick, use the
result given in point no.6 that the interest rate which will be in the
right , you will prefer that condition is that both rates should be same.
I am saying is that if d(2)=10% given and d(12)=10% is given than you
prefer which one is in the right in that equation i.e. d (12). Similarly for
i(2)=10% and i(12)=10% , I would prefer i(2) , because it is in the right.
7. Application of force of interest: Although it is a theoretical measure

but can be used as an approximation to interest paid very frequently
i.e. daily or weekly.
8. If force of interest is a function of time then we can find
accumulation factor: A(t1,t2) = exp(∫t2t1 f(t) dt
Conclusion:
Effective interest: When paid once per measurement period
Nominal interest: When paid more(or less) than once per
measurement period
Force of interest: When paid very frequently in a measurement period.

8. NPV vs IRR
NPV: popularly known as Net present value. This is the difference between the
present value of cash inflows and cash outflows.
· If you are investing in certain investments or projects if it produces positive
NPV or NPV>0 then you can accept that project.
· And in case of negative NPV or NPV<0, you should not accept the project.
Now there are some advantages and disadvantages:
Advantages:
1. It helps you to maximize your wealth as it will show your returns greater than
its cost of capital or not.
2.It takes into consideration both before & after cash flow over the life span of a
project.
3. It considers all discount rates that may exist at different point of time while
discounting back our cashflows.
Disadvantages:
1.Calculating Appropriate discount rate is difficult.
2.It will not give accurate decision if two or more projects are of unequal life.
3. It doesn’t provide accurate answer at what period of time you will achieve
positive NPV.
IRR: also referred as “yield to redemption or yield per annum. The internal rate
of return for an investment project is the effective rate of interest that equates
the present value of inflows and outflows. Higher IRR represents a more
profitable project.
However, IRR need not be positive. Zero return implies investor receives no
return on investment. If the project has only cash inflows then the IRR is
infinity.
Now when IRR> cost of capital, then NPV will be positive
When IRR< cost of capital, NPV will be negative.
Advantages:
1.This approach is mostly used by financial managers as it is expressed in
percentage form so it is easy for them to compare to the required cost of capital.
2. IRR method gives you the advantage of knowing the actual returns of the
money which you invested today.
Disadvantages:
1.If an analyst is evaluating two projects, both of which share a common
discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR
will probably work. The catch is that discount rates usually change substantially
over time. Thus, IRR will not be effective.
2. IRR is the discount rate that makes a project break even. If market conditions
change over the years, this project can have two or more IRR. (we will justify
with the example).
Now let’s see which method is better and why:

We have seen the advantages and disadvantages of both the methods. But NPV
is much better as compared to IRR.
1. IRR assumes the single discount rate which will not be case in reality. For
example, return on 1- year Treasury bills is varied between 1% - 12% in last 20
years. Now this problem is easily solved by NPV method as it discounts back
the future cashflows at different discount rates easily.
2. IRR can be more than one also which will not only make confusion but also
make analysis difficult. For ex:
If the project has cash flows of -$50,000 in year one (initial capital outlay),
returns of $115,000 in year two and costs of $66,000 in year three because the
marketing department needed to revise the look of the project
3. IRR can be negative too which is difficult to interpret, whereas in case of

NPV if it is negative it surely means Deficit and positive implies profitability in
the project.
4.Positive NPV indicates addition to shareholder’s wealth and negative NPV
implies vice-versa. But this thumb rule will not applicable in case of IRR.
So, why is the IRR method still commonly used in capital budgeting? Its because
of its reporting simplicity. The NPV method is inherently complex and requires
assumptions at each stage. The result is simple, but for any project that is long-
term, that has multiple cash flows at different discount rates, or that has uncertain
cash flows - in fact, for almost any project at all - simple IRR isn't good for much
more than presentation value.

9. MWRR vs TWRR vs LIRR
We can decide between various projects that which one is better and which one
is not on the basis of different criteria such as:
NPV, IRR, DPP
But how can we measure the investment performance? Well, there are basically
three measures of investment performance:
1. Money Weighted rate of return (MWRR)
2.Time Weighted rate of return (TWRR)
3.Linked internal rate of return (LIRR)
It is necessary to measure the performance of a fund which can be a pension

fund, funds of an insurance company or funds of an asset management
company. It is important for those who are responsible for the investment funds
for example: trustees in case of pension fund will monitor how fund is
performing i.e. they find out the rate of return of the fund and then compare it
with performance of other funds.
Before looking at different measures, let’s see some definitions:
a.) Income generate by fund: it includes interest payments, dividends received
from the fund assets.
b.)Change in market value-Capital gain/Loss: Change in the value of our assets
will leads to capital gain/loss accordingly.
c.)New Money: It includes extra money that is put into the fund, which is not
generated by fund itself but more like a capital infusion. Similarly, withdrawals
form fund leads to negative new money.
Money Weighted Rate of return: It is purely based on cash that is getting

invested/withdrawn. Any cashflows generated by fund itself is ignored.
Suppose there is fund for tenure 3 years. I invested Rs.X today and Rs.Y after 1
year and Rs. Z after 2.5years.
So equation will be like X(1+r)3+Y(1+r)2+Z(1+r)1/2 = Fund Value. So here there
are different cashflows that are being invested at different time periods.
Future value/Accumulated value of all cashflows and the rate at which it
equals the Fund Value, that rate is MWRR.
It is like the IRR of the project. As if we say Future value of all cashflows
should equal to Fund value or Present value of all cashflows (i.e. PV of inflows
– PV of outflows) should equal to zero. Thing is same
Important Example: The value of fund on 1 JAN 2017 is Rs.800 and the value
on 31 DEC 2017 is Rs.1500. During the year 2017 following transactions occur:
1.Interest and dividends received on investments Rs. 50 on 1 st JULY 2017

2.Withdrawal or benefit payment made to a participant Rs. 100 on 1 st July on
31st DEC 2017
3. Contribution by Employer of Rs.200 into the fund on 31st DEC 2017
Now note here that we will not take into consideration 1 st scenario while
calculating MWRR. Equation will be like
800(1+r) – 100(1+r)1/2 + 200 = 1500. The “r” that we calculate here is MWRR.
So, we do not consider interest and dividends because as the name suggests
MWRR we consider only new money (Deposits) or negative new money
(withdrawals) from the fund.
If you think that why cashflows like interest, dividends, or capital appreciation
which are generated by fund are not considered in the equation of value. Well
the answer is that these values are already absorbed in the value of “i”.
Including them in equation would leads to double counting, whereas cashflows
like new money are not reflected in the value of “i” so it is included in equation
of value.
But the fund manager performance cannot be judged through the MWRR
method because he does not control the timing and amount of cashflows
and this method is sensitive to the timing and amount of cashflows; fund
manager is merely responsible for investing the cashflows. To remove this
limitation there comes a TWRR.
Time Weighted Rate of Return (TWRR): Here weightage is given to Time of

investment. The rationale here is to calculate growth factors to reflect change in
the value of fund between the times of consecutive cashflows. Then the TWRR
is found from product of growth factors between consecutive cashflows.
Let’s pick the above example:
Suppose the fund tenure is of 3 years. Now I invested Rs. X today for 3 years.
Rs. Y after 1 year and Rs. Z after 2.5 years.
When Rs. Y is getting invested after 1 year, there is a change in cashflow. We
want to know before Y got added, what was the total value of X at that time.
Suppose X becomes X+a.
So now X+a+Y is getting invested. Similarly, we can do for Z also.
Here we are trying to find the return on each stage i.e.:
(X+a)/X * (X+a+Y+b)/(X+a+Y) * (Fund Value)/(X+a+Y+b+Z) =
(1+i)T Note here T = 3, because here T means Total time period of the
fund.
What is happening in the above equation is that it tells us that the product of
these factors gives the notional income factor for single investment of Rs. 1 at
time t=0 invested until time T i.e 3 in this case.

Using TWRR, it eliminates the effects of cashflows amounts and timing,
therefore gives the fair view on investment performance of the fund.
· Can it be possible that the fund has negative MWRR and Positive TWRR?
o Yes, it can be possible. When the fund has growth factors where positive return
are more than negative returns at different time periods that TWRR will be
positive. On the other hand, if one large cashflow comes into the fund and it
generate negative returns in the fund then the MWRR may become negative.
The point is simple that MWRR is sensitive to amount of cashflows.
Snapshots: In MWRR, we don’t require the Value of previous investment, while

investing a new amount. We only bothered about cashflows which we have
invested or pulled out. In TWRR, we require the value of fund at each stage of
periods before the new amount is invested or existing amount pulled out. Before
and after every cashflow process we are looking at what is the value of fund and
then taking all the returns, multiply those return and equate it to the (1+i) T .
Conclusion: TWRR is better than MWRR, we can simply conclude from above.
As while finding the investment performance we are not bothered too much
about cashflows, we are bothered about return, whatever may be the cashflow
how much it is able to generate. As in MWRR, Once you see large cashflow
associated with higher return. Immediately MWRR goes very high. But same
large cashflow associated with lower return, MWRR goes very down. One more
problem is that it can be more than one MWRR possible especially when there
are many positive and negative cashflows.
But the point is that both methods have disadvantages: TWRR requires
Fund Values at all Cashflow dates. MWRR may not have unique solution
and fund manager performance cannot be judged. If the fund performance
is reasonably stable in the period of assessment, the TWRR and MWRR
may give similar results. Then there comes LIRR
Linked internal Rate of Return (LIRR) : In TWRR, we calculate fund values at

every time when cashflow come into picture. To remove this limitation there
comes a LIRR, where we pre-defined the periods at which we will calculate
return and then find overall return accordingly. Here both MWRR and TWRR
got combined because we are talking about different fund values at different
cashflows at different point of time. So this concept leads to different returns for
different periods and then overall return calculated accordingly.
Suppose in our above example:
The fund tenure is of 3 years. We calculated return after every 1 year. So the
equation is like: (1+r1)(1+r2)(1+r3) = (1+i)3. Here r1,r2,r3 represents after one
year , 2nd year, 3rd year. And the “i” represents LIRR. The rate of return over

each different sub-period is weighted according to the duration of the sub-
period.

10. Term Structure of Interest Rates
The term structure of interest rates, also called the yield curve, is a graph
that plots the yields of similar-quality bonds against their maturities, from
shortest to longest
Important Notes:
The graph that plots coupon rates against a range of maturities -- that graph is
called the spot curve.
The graph that plots yields against a range of maturities – that graph is called
the Yield curve.
So, what is the difference between coupon rates and yield rates? - Yield rate is
the interest earned by the buyer on the bond purchased, and is expressed as a
percentage of the total investment. Coupon rate is the amount of interest
derived every year, expressed as a percentage of the bond’s face value. Yield
rate and coupon rate are directly correlated. The higher the rate of coupon
bonds, the higher the yield rate.
As you know that the interest rate will not remain same as the markets are
dynamic and constantly changing. The variation in interest rates arises because
interest rates that lenders expect to receive and borrowers are prepared to pay
are influenced by some factors which do not remain constant over the time;
such factors are as follows:
Supply and Demand: We all know how the prices influence by the supply and
demand factors, same happens in case on interest rates also. If there is more
demand of finance in the market, then it will push the interest rates up and if
there is little demand of finance, then it will push interest rates down.
Expected Future Inflation: As we know that the return we receive on our
investments is not the real return because of inflation. Suppose you earn 8%p.a.
and inflation exists in market at 6% p.a. So, in real terms you approximately
earned 2% p.a. So, lenders will expect the interest rates they obtain that will
cover inflation atleast. So, in the periods of high inflation, interest rates will be
high.
Tax Rates: Now investors will require a certain level of return after tax. So, if
tax rates are high, then the interest rates may also high.
The term structure of interest rates takes three primary shapes.
1.If short-term yields are lower than long-term yields, the curve slopes
upwards and the curve is called a positive (or "normal") yield curve. the
yield curve is positive, this indicates that investors desire a higher rate of
return for taking the increased risk of lending their money for a longer time
period. Many economists also believe that a steep positive curve means that
investors expect strong future economic growth with higher future inflation
and thus higher interest rates.

2.If short-term yields are higher than long-term yields, the curve slopes
downwards and the curve is called a negative (or "inverted") yield curve. a
sharply inverted curve means that investors expect sluggish economic
growth with lower future inflation and thus lower interest rates.
3.A flat term structure of interest rates exists

when there is little or no variation between short and long-term yield rates. A
flat curve generally indicates that investors are unsure about future economic
growth and inflation. Note that we also assume flat yield curve in case on
Immunisation.
The three most popular explanations for the fact that interest rates vary
according to the term of investment (or the three central theories that attempt
to explain why yield curves are shaped the way they are)
1. Expectations Theory
2. Liquidity Preference
3. Market Segmentation
1.Expectations Theory: Theory assumes that the term structure of an interest

contract only depends on the shorter term segments for determining the pricing
and interest rate of longer maturities. It assumes that yields at higher maturities
(such as that of 5,10, or 30 year bonds), correspond exactly to future realized
rates, and are compounded from the yields on shorter maturities. The theory
explains the yield curve in terms of expected short-term rates. It is based on the
idea that the two-year yield is equal to a one-year bond today plus the expected
return on a one-year bond purchased one year from today. consider the
following two investment strategies:
1: Buy $1 of one-year bond (the short bond) and when it matures buy
another one-year bond.
2: Buy $1 of two-year bond (the long bond) and hold it.
According to the expectations theory, they are perfect substitutes and their
expected returns must be equal.
Scenario1: An expectation of fall in the interest rates (in near future), will make
long term investments more attractive and short-term investments less
attractive. So, investors will be more towards long-term bonds and thus demand
for long term bonds rises and then price for long-term bonds rises and yields
will fall in the long-term investments (due to negative correlation between price
of bond and its yield). For reference, see inverted curve graph
Scenario2: An expectation of rise in the interest rates (in near future), will make
short term investments more attractive and short-term investments less
attractive. So, investors will be more towards short-term bonds and thus demand
for short term bonds rises and then price for short-term bonds rises and yields
will fall in the short-term investments (due to negative correlation between price
of bond and its yield). For reference, see Normal yield curve.
Liquidity Preference: Even the default-free bonds are risky because of
uncertainty about inflation and future interest rates. The reason for the
increase in inflation risk over time is clear-cut. The bondholders care about
the purchasing power of the return – the real return – they receive from
bonds, not just the nominal dollar value of the coupon payments. Uncertainty
about inflation creates uncertainty about a bond’s real return, making the
bond a risky investment. The further we look into the future, the greater the
uncertainly about the level of inflation, which implies that a bond’s inflation
risk increases with its time to maturity. Interest-rate risk arises from a
mismatch between investor’s investment horizon and a bond’s time to
maturity. If a bondholder plans to sell a bond prior to maturity, changes in
the interest rate generate capital gains or losses. The longer the term of the
bond, the greater the price changes for a given change in interest rates and
the larger the potential for capital losses. As in case of inflation, the risk
increases with the term to maturity, so the compensation must increase as
with it. The buyer of long-term bonds would require compensation for the
risks they are taking buying long-term bonds. Therefore, yields on long term
bonds will be higher than short term bonds. The liquidity preference theory
views bonds of different maturities as substitutes, but not perfect
substitutes. Investors prefer short rather than long bonds because they are
free of inflation and interest rate risks. Therefore, they must be paid positive
liquidity (term) premium, to hold long-term bonds. The risk premium
increases with time to maturity, the liquidity premium theory tells us that the
yield curve will normally slope upwards, only rarely will it have lied flat or
slope downwards
Market Segmentation: Under this theory, the future shape of the curve is
going to be based on where the investors are most comfortable and not
where the market expects yields to go in the future. This theory assumes that
markets for different-maturity bonds are completely segmented. The interest
rate for each bond with a different maturity is then determined by the supply
of and demand for the bond with no effects from the expected returns on
other bonds with other maturities. In other words, longer bonds that have
associated with them inflation and interest rate risks are completely different
assets than the shorter bonds. Thus, the bonds of different maturities are not
substitutes at all, so the expected returns from a bond of one maturity has no
effect on the demand for a bond of another maturity. Because bonds of
shorter holding periods have lower inflation and interest rate risks,
segmented market theory predicts that yield on longer bonds will generally
be higher, which explains why the yield curve is usually upward sloping.
Bonds of different terms are attracted to different investors, who will choose
assets that are similar in terms of their liabilities. If you have liability to pay
after 20 years than you invest in long term bonds (as in case of Pension
Funds, where they have start paying pension when person gets age 65 years
or whatever the case may be). If you have the liability to pay in near future
maybe 6 months than its better to invest in short term bonds (as in case of
banks, where investors may withdraw a large proportion of funds at very
short notice.

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So Term insurance is the better Option.

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Often researchers investigating an unknown population parameter have

Let me explain you with the help of an example:

Statistics seems easy now. 😊

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Now let's Come to Duration

Background: An Investor is concerned whether his assets in a portfolio are

also known as Volatility. It measures sensitivity in cashflows due to change in

 also known as Macaulay Duration and Discounted Mean Term.

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So we have seen that Duration = Macaulay Duration = DMT

Modified Duration: used to estimate percentage price change when interest

YIELD DURATION: Measures bond price sensitivity to its Yield to Maturity

CURVE DURATION: Measures Sensitivity of a Security to a benchmark yield

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Now let’s Consider three cases

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Suppose we have to pay Rs.10,000 after 2 years, so what we can we do is

2) VA’(i0) = VL’(i0) which means Volatilities of asset and liabilities cashflow

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We will clear now it in detail.

Nominal is used where is interest is paid more (or less) frequently

Application of Nominal rate in real life: Bank accounts normally use

8 points for Interest Rates: Nominal and Effective

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8 points for Discounting and Force of Interest Rates

6. d<d(2)<d(4)<……. delta< ………<i(4)<i(2)<i. Here what we are saying

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7. Application of force of interest: Although it is a theoretical measure

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Now let’s see which method is better and why:

3. IRR can be negative too which is difficult to interpret, whereas in case of

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It is necessary to measure the performance of a fund which can be a pension

Money Weighted Rate of return: It is purely based on cash that is getting

1.Interest and dividends received on investments Rs. 50 on 1 st JULY 2017

Time Weighted Rate of Return (TWRR): Here weightage is given to Time of

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Snapshots: In MWRR, we don’t require the Value of previous investment, while

Linked internal Rate of Return (LIRR) : In TWRR, we calculate fund values at

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3.A flat term structure of interest rates exists

1.Expectations Theory: Theory assumes that the term structure of an interest

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