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8th November 2002 (am)

**Subject 102 – Financial Mathematics
**

Time allowed: Three Hours INSTRUCTIONS TO THE CANDIDATE 1. Do not write your name anywhere on the answer scripts. You have only to write your Candidate’s Number on each answer script. 2. Mark allocations are shown in brackets. 3. Attempt all 14 questions, beginning your answer to each question on a separate sheet. 4. In addition to this paper you should have available graph paper, Actuarial Tables and an electronic calculator.

AT THE END OF THE EXAMINATION Hand in BOTH your answer booklet and this question paper

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Q.1 Q.2 (a)

Define nominal rate of interest. The rate of discount per annum convertible quarterly is 8%. Calculate: the equivalent rate of interest per annum convertible half-yearly.

[3]

(b)

the equivalent rate of discount per annum convertible monthly. [4]

Q.3 (a) (b)

Prove the following identities: (Ia) n + (Dä) n = n × ä n + 1 (Iä) n + (Da) n = (n + 2) × a n - 1 + 1 + v n [4]

Q.4

The 1-year forward rates for transactions beginning at times t = 0, 1, 2 are f t where f 0 = 0.06; f 1 = 0.065; f 2 = 0.07. Compute the par yield for a 3-year bond. [3]

Q.5

An ordinary share pays annual dividends. The next dividend is expected to be Rs 100 per share and is due in exactly 9 months time. It is expected that subsequent dividends will grow at a rate of 5% per annum compound and that inflation will be 3% per annum. The price of the share is Rs 2500 and dividends are expected to continue in perpetuity. Calculate the expected effective real rate of return per annum for an investor who purchases the share. An annuity is payable in arrear for 15 years. The annuity is payable half-yearly for the first five years, quarterly for the next five years, and monthly for the final five years. The annual amount of the annuity is doubled after each five-year period. On the basis of an interest rate of 8% per annum convertible quarterly for the first four years, 8% per annum convertible half-yearly for the next eight years, and 8% per annum effective for the final three years, the present value of the annuity is Rs.2,049. Find the initial annual amount of the annuity.

[5]

Q.6

[10]

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Q.7

A loan stock bears interest at the rate of 11% per annum payable half-yearly. Interest is payable on 15 May and 15 November each year and the entire loan is redeemable at par on either of these dates in the year 2033 or in any subsequent year. An investor, who is liable to income tax at the rate of 50%, purchased the loan on 15 November 2001 (just after payment of the interest then due). Find the maximum price per 100 nominal he should pay to be certain of obtaining a net effective annual yield of 4%. Assuming that he paid this price, find the maximum possible net yield per annum he may obtain from the investment. [6]

Q.8 (a) (b) Define the term “discounted payback period” in the context of project appraisal. [1] A property is purchased by a businessman for Rs.80,000, with a further payment of Rs.5,000 for repairs in one year’s time. This property has been given on lease with an income of Rs.10,000 per annum, payable continuously for 20 years commencing in two years’ time. This deal is financed by a bank loan on the basis of an effective annual interest rate of 7%. Assume that the loan may be repaid continuously. Find the discounted payback period for the transaction. [4] (c) After the loan has been repaid by the businessman, he will deposit all the available income in an account which will earn interest at 6% per annum effective, find the accumulated amount of the account in 22 years’ time. [2] Q.9 (a) (b) Describe the characteristics of a repayment loan or mortgage. [4] A loan of Rs.19,750 was repayable by a level annuity payable monthly in arrear for 20 years and calculated on the basis of an interest rate of 9% per annum effective. The lender had the right to alter the conditions of the loan at any time and, immediately after the 87th monthly repayment had been made, the effective annual rate of interest was increased to 10%. The borrower was given the option of either increasing the amount of his level monthly repayment or extending the term of the loan (the monthly repayment remaining unchanged). (i) Find the revised monthly installment, if the borrower had opted to pay a higher monthly installment. [4]

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(ii) Assume that the borrower elected to continue with the monthly repayment unchanged. Find the revised term of the loan and the amount of the final monthly repayment. [6] Q.10 (a) In the context of derivative investments, define: i) Option ii) Call option iii) Put option [3] (b) Explain why buying a call option is not the same as selling a put option. [3] Q.11 (a) Using the “No Arbitrage” principle, describe how you would calculate the forward price for a security with fixed cash income. [6] (b) An asset has a current price of Rs 100. It will pay an income of Rs 5 in 20 days time. Given a risk free rate of interest of 6% per annum convertible half-yearly and assuming no arbitrage, calculate the forward price to be paid in 40 days. [4] Q.12 (a) List the conditions for Redington’s immunization theory for constructing investment portfolios. [3] (b) List four limitations of this theory to apply in practice. [4] Q.13 In any year, the growth rate in the share price of a large company is independent of the growth rates in all previous years. Each year the growth rate is log-normally distributed with a mean value of 10% and a standard deviation of 5%. (a) Determine the parameters µ and σ 2 of the log-normal distribution of the growth rate. [5] (b) S4 denotes the growth rate in the share price over 4 years. i) Determine the distribution of S4 ii) If the current share price is Rs 345, determine the probability that the share price 4 years from now will exceed Rs 550. [4]

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Q.14

A financial institution has issued a large number of 20-year policies. Under these policies: • • Premiums are payable annually in advance A maturity benefit of Rs 10,000 is payable at the end of 20 years.

Premiums are calculated such that the present value of benefits payable and expenses incurred equal that of the premiums under the policies. In doing this calculation, the financial institution makes the following assumptions: Interest Expenses at the start of the policy Ongoing expenses (a) 5% per annum effective 2% of the maturity benefit 3% of each premium paid.

Calculate the annual premium for each of these policies assuming that premiums under all policies continue to be paid for each of the 20 years. [4] The financial institution observes that on each premium due date, 4.5456% of the policies that had paid premiums in the preceding year, defaulted on their premiums. It has been decided that policies that defaulted in premiums would be immediately refunded the premiums already paid under them, without any interest. Also, they would not be eligible for the maturity benefit of Rs 10,000. The financial institution wishes to recalculate the premiums for these policies to allow for these premium defaults. Calculate the revised annual premium. [8]

(b)

*************

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