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EXAMINATIONS – May 2002
Subject 102 – FINANCIAL MATHEMATCS
MODEL SOLUTIONS
Qn.(1):
n (p) (p)
n
1 v + d a ∴ · !!
Proof by General Reasoning
Consider an investment of Re.1/ for ‘n’ years in an account that pays interest at the rate
of ‘i’ per annum per unit. The payment of I at the end of each year is equivalent to
payment of d
(p)
p.a. payable P times a year at the beginning of every
1
p
th of a year.
Then, in return for your initial investment if Re.1, you will receive ‘np’ interest payments
of
( ) p
d
P
each at the beginning of every
1
p
th of a year. for n years and return of your
initial investment of Re.1 at the end of n years.
The present value of your receipt @ ‘i’ p.a. per unit is
(p) (p)
n
d a
n
V + !! , which equal 1, The
initial investment.
(P) (p) n
n
(p)
(p) n
1 + d a + v
1v
a =
d
n
∴
∴
!!
!!
Q2 (1) (a) Given i
(4)
= 0.05
4
(4)
4
i
1+i = 1+
4
1 i = (1.0125)
0.5095 5.095% i or
 `
∴
. ,
∴ +
∴ ·
(b) Given d = 0.07
1+I = (1d)
1
1
1 i =
1d
1 d 0.07
1 0.0793 or 7.53%
1 1a 0.93
i
d
∴ +
∴ · − · · ·
−
(c) Given
0.054
0.054
1
i = 1
= 1.05548  1 = 00555 or 5.55%
i e
e
δ
δ ·
+ ·
∴ −
2 (ii) Working in terms of monthly periods Act
i
1
the interest p.m. p.u. for 1
st
3 years,
i
2
the interest p.m. p.u. for next 3 years, and
i
3
the interest p.m. p.u. thereafter for 4 years
Then, the required present value
{ ¦
36 36 36
(1) (2) (1) (2) (1)
36 36 48 (3)
1000 v v v a a
a
· + +
where,
36
1
36 (1)
1
6
1
6
1
1v
= @5%
(1.05)
10.746215
=
0.008165
= 31.082058
v
i
a
−
·
6
1
1
6
1
36 6
1 0.5
0.10
(1 ) 1 1.05
2
i = (1.05) 1 0.008165
0.746215
i
v v
 `
+ · + ·
. ,
− ·
· ·
36
2
2
36
2
2
2
36
2
1v 0.01
a36 (2) Where (1+1s) = 1 1.0075
i 12
1v 3
= % i = 0.0075
i 4
v = 0.764149
=
 `
· + ·
. ,
∈
10.764149
0.0075
= 31.446800
48
12 3
3
3
1
12
3
4
48 4
3 .08 1
12
1v
Q a48 (3) = where (1+i ) = 1.08
i
i = (1.08) 1
1v
= @8% v = v = 0.
(1.08) 1
−
−
735030
10.735030
=
0.006434
= 41.182779
∴ The required p.v.
= 1000 { 31.082058
+ 31.4468) (0.746215)
+ 1.182779) (0.764149) (0.746215)}
= 1000 { 31.082058
+ 23.466074
+ 23.483221 }
= 1000 (78.031353)
= 78031.353
= 78031
Q.3 The three factories of the term structure of interest rates are –
(a) Expectation theory. The expectation theory describes the shape of
yield curve as being determined by the market expectations for
future shortterm interest rates. For example an expectation of a
fall in interest rates will make short term investments less attractive
and long term investments more attractive.
(b) Liquidity Preference theory – It is based on the general accepted
belief that investers prefer liquid assets to illiquid ones.
(c) Market Segmentation theory – this theory says that yields at each
term to redemption are determined by supply and demand from
investors with liabilities of that term. Different investors are active
at different terms of the yield curve.
Q.4 (i)
Example 1 : Suppose an investor is considering purchasing an equity investment.
The – will continue to be found the propriety is value fot the accumulated profit.
The investor would have to pick & assure that the holding would be held on
that date. The value  for the accumulated profit will then  on which date 
Example 2 : Suppose  man ( is good health) is considering using a  in buy
a pension payable for the rest or has life once be does not know when be will due be
cannot know what date to accumulate the 
(ii) 1) Cash Flow, 2) Borrowing requirements
3) Resources 4) Rvt. 5) Investment Entries.
NPV
A
=  100,000
+ 7500 [v+(1.05)v
2
+(1.05)
2
v
3
+…………. + (1.05)
9
 v
10
+ (1.05)
10
V
11
+ 1,50,000 v
11
@ 10%
= 100,000 + 7500 v
11
1.05
1
1.10
150000
1.5
1
1.10
 `
−
. ,
+
 `
−
. ,
( )
11
1 1.05
1.10
100, 000 7500 150000(0.35)
1.10 1.05
1 0.4005365
100, 000 7500 52573.5
0.05
100,000 + 7500 (8.01073) + 52573.5
−
· − + +
−
−
· − + +
·
= 100,000 + 60080.475 + 52573.5
= 12653.975
= 12654
NPV
B
= 100,000 + 300,000 V
11
@10%
= 100,000 + 300,000 (0.35049)
= 100,000 + 105147
= 5147
(iii) (b)
Project A is better than Project B As it has a higher NPV
Q.5
Loan amount = 100,000 term = 10 years
Interest rate 12.5% p.a.
Let X be amount of Installment. Then,
100,000 =
s
5 5
3 v @ 12.5% p.a. X a X a +
5
5
100,000 100, 000
=
3.56060(0.6648) (1 3V )
= 10,539.31
X
a
∴ ·
+
The loan outstanding one year before the end of term equals the payment value of final
installment which is 3V(10,539.31) = 28,104.83
Q6.
(i)
1. Investment characteristics may be similar to convention bonds.
2. or to ordinary shares
3. or can be a combination of both
4. it depends on whether or not conversion is likely
5. if conversion is almost certain, a convertible is in effect the same as the
underlying share with a different stream in the period before conversion.
6. If conversion is unlikely, the convertible is very similar to a normal fixed
interest bond.
7. In all cases the option to convert will have some possible values.
8. This value will be highest when there is mot uncertainty as to whether
conversion will occur or not
9. convertibles generally provide higher income than ordinary shares and
lower income than conventional loan stock or preference shares.
10. There will generally be less volatility in the price of the convertible than in
the share price of the underlying equity.
Q.7 The amount of redemption payment will be
3
I(1.7.2004) 193
25000 25000 32601.35
I(1.7.1999) 148
32601.35 25625(1 )
8.36%
x
i
i
· · ·
· +
⇒ ·
Working in terms of 1.1.2002 prices, the real return
'
'
(1.1.2002)
25625(1 )3 32601.35 32601.35
(1.1.2005)
i = 3.47%
I
i x
I
+ · ·
Q.8 (i) Forward price is calculated from the equation :
t
0
K= (S I)e where
δ
So is the price of security at time 0
I is the Present value of fixed income payments during the term of the
forward contract
(2) 6
6
6 (2)
6
K = (1039 ) (1+i) @ 5%
= 103 (1.05) +9
= 103 x 1.34  9x 6.8019 x 1.012348 = 76.05%
a
S
Q.9 The accumulated amount at the end of n years is
S
n
(1+i
1
)(1+i
2
)………..(1+i
n
)
The mean value is :
E( S
n
)= E[(1+i
1
)(1+i
2
)……..(1+i
n
)]
Since the yields in different years are independent, expectation on the RHS can be
shown as :
E( S
n
)= E[(1+i
1
)(1+i
2
)……..(1+i
n
)]
= (1+j)(1+j)(1+j)…….n terms = (1+j)
n
The second moment is
E S
n
2
= E[(1+i
1
)
2
(1+i
2
)
2
……. (1+i
n
)
2
]
= E[(1+i
1
)
2
(1+i
2
)
2
…….E (1+i
n
)
2
]
Take
E[1+i
k
)
2
)] = E[1+2i
k
)+i
k
2
)] = 1+2E(i
k)
+ E(i
k
)
2
E(i
k
)
2
can be derived from the variance,
2 2
k k k
2 2 2 2
k k k
2 2 2
k
Var (i ) = E(i ) [E(i )]
E(i ) = [E(i )] +var (i ) = j +s
E[(1+i ) 1 2 j j s
−
⇒
∴ · − + +
Hence the second moment of S
n
is
E(S
2
n
) = (1+2j+j
2
+S
2
)
and variance
2 2 2 2 n 2n
n n n
Var (S ) = E(S ) [E(S )] = (1+2j+j +s )  (1+j) −
Q.10 (iii)
Let X be the level of payment in the first 5 years
5 10

5
100, 000 Xa 2Xa V · +
Given i
(4)
= 8%
i = 8.24%
5
5
10
10
e =1+i = 7.918%
1
4.1289
1
6.908
v
a
v
a
δ
δ
δ
δ
⇒
−
· ·
−
· ·
100,000 = X (4.1289) + 2X (6.908)(0.67307)
100, 000
13.4280
X · ·7447.11 per year or 143.21 per week in the first 5 years (assuming
52 weaks per year)
And 2 x 143.21 = 286.42 per week in the next 10 years.
Q.10 (i)
100,000
(12)
15
X @ i a
Given i(4) = 8%
4
(4)
1
(4) 3
(12)
5
(12)
(12) 15
1 1 +
4
8.24%
1
12 1 1 7.947%
4
1v
8.7465
i
100, 000 X*8.7465
X = 11433.19 per annum or 952.77 per month
i
i
i
i
a
 `
+ ·
. ,
·
]
 `
]
· + − ·
]
. ,
]
· ·
∴ ·
Qn.10(ii)
(2)
15
(4)
1
(2)
2
15
(2)
(2) 15
100, 000 4
Given i = 8%
i = 8.24%
d = iV = 7.613%
d = 2 1(1d) 7.764%
1v
a = = 8.9526
d
100,000
X =
8.9526*0.72
X a v ·
]
·
]
]
!!
!!
15332.79 per year or 7666.40 per half year
85
·
Q8 (ii) After 3 years the price of the security is
(2) 12
3
2
P = 9 .05 @ 9%
= 9*7.1607*1.022015+105*0.35553
= 103.20%
a v +
In order to calculate the value of the forward contract, consider the following two
portfolios
Portfolio A – Buy the forward contract at Price V and simultaneously invest
3 (2)
3
K (1+i) +9a in the risk free asset where ‘i’ is the risk free return. The price of
this portfolio is
V +
3 (2)
3
K (1+i) +9a
Portfolio B – Buy the security at current price P
3
= 103.20%
Therefore
3 (2)
3
3
(2) 3
3
3
3
V + K(1+i) + 9a P
V = P 9a K(1+i)
 103.20  9x 2.7232x1.012348  76.05 (1.05)
= 12.69%
·
− −
Qn.6(ii) Term = 6.5 years
Coupon = 6% p.a. hly.
Redempn.. Value = 105%
Purchase price = 93%
Working in half yearly terms
13
13
93 3a 105 @ % v i · +
By trial & error method
@ 3.5% ⇒3*10.3027 + 105 * 0.6394 = 98.0451
@ 4.5% ⇒ 3*9.6829 + 105 * 0.5643 = 88.3002
I = 4.02% per half year
Effective annual yield
1.0402
2
– 1 = 8.20%
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