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EXAMINATIONS May / June 2004

SUBJECT - 102 : Financial Mathematics

Indicative Solution

1

Solution to Q1: Motor insurance is one particular class of general insurance. Typically, a motor insurance policy will provide cover for a period of one year. In return for a premium received at the start of the year, an insurance company will accept the financial risks that are associated with the policyholder’s motoring. While the amount and time of receipt of the positive cashflow (i.e. the premium) is known precisely, the amounts and times (and number) of any negative cashflows are uncertain. In many cases, the negative cashflows occur some time after the conclusion of the period of cover. This is particularly common for injury-type claims for which recovery time must be allowed and court settlements may be necessary.

Solution to Q2: Consider a loan of Rs 100. The amount actually lent by the lender is Rs 97, and, after a month, this has amounted to Rs 100. Hence if i (12 ) is the nominal rate convertible monthly i (12) 97 * 1 + 12 = 100

** i (12 ) 100 = or 1 + 12 97 The corresponding effective rate is i (12) = 1 + 12
**

12 12

−1

100 = −1 97 = 1.4412 – 1 = 0.4412 = 44.12%

Solution to Q3: Price of Rs 100 Treasury Bill 91 100 * 1 − * 0.06 = 98 .504 365

2

**[1½ marks] Amount to be invested in 91 day deposit to give Rs 100 will be 0 .0615 100 * 1 + 365
**

−91

= 98 .479 [1½ marks]

∴ Deposit gives higher rate of return.

**Solution to Q4: Let Rs a be invested in Fund A and Rs b be invested in Fund B. It follows that
**

a * 1. 05 20 + b * 1 . 07 20 = 1000

…1 …2

a * 1 .05 10 = 0 .50 * b * 1 .07 10 From 2 above a= 0 .50 * b * 1.07 10 1 .05 10

Substituting this value in 1 above 0 .50 * b * 1.07 10 * 1 .05 10 + b * 1.07 20 = 1000 ⇒ b = 182 .75 ∴a = 0 .5 * 182 .75 * 1 .07 10 1 .05 10

⇒ a = 110 .35 Amount of the combined fund after 5 years is given by = 110 . 35 * 1. 05 5 + 182 .75 * 1 .07 5 = 397 .15

Solution to Q5)a): The present value of the outgo at 3% = 5000 * (10 v + 15 v 2 + ... + 50 v 9 + 50 * v 9 * a ∞ )

3

= 5000 * (5 * a 9 + 5 * Ia9 ) + 5000 * 50 * v 9 *

1 0 .03 1 0.03

= 5000 * (5 * 7.78610892 2 + 5 * 37.3980532 8) + 5000 * 50 * 0.76641673 2 * = 1129604 .055 + 6386806 .103 = 7516410 .158

**Solution to Q5)b): If the equivalent level sum be X then, && 7516410 .158 = X * a 10 X = 802607 .0818 @ 1.03 2 − 1
**

1

Solution to Q6: Let i1 and i 2 be the interest rates in years 1 and 2 respectively. The value of the account after 2 years is a random variable, S , where

S = 100000* (1+ i1 ) *(1 + i2 )

Let S 2 = (1 + i1 ) * (1 + i 2 ) Now E(S 2 ) = E[(1 + i1 ) * (1 + i 2 )] = E(1 + i1 ) * E(1 + i2 ) using independence = (1 + E[i1 ]) * (1 + E[i 2 ]) 1 1 1 where E (i1 ) = * 0.03 + * 0.04 + * 0.06 3 3 3 = 0 .043333 where E(i 2 ) = 0.7 * 0.05 + 0.3 * 0.04 = 0 .047

E(S 2 ) = 1.043333* 1.047 = 1.09237

4

E (S ) = 109236 .97

Solution to Q7)a): The coupon will be: = 0 .03 * 100 2 126 .7 110 .5 IndexJuly2001 * IndexJuly1997

= 1.5 *

= Rs 1.72 per Rs 100 nominal.

Solution to Q7)b): Measure time, t , in half years from 16 September 2001 and let i be the real yield per half year.

1

**Set (1 + r ) = (1.04 ) 2 and month 0 = September 2001 Then Q(t ) = Q(0) * (1 + r ) t is the estimated value of the index at time t , where
**

Q (0 ) = 127 .4

The first interest payment at time 1 is 1.72 and the value of the index will be Q(1) = Q(0 ) * (1 + r) For t ≥ 2 , the investor’s t th interest payment will be received in month 6t , and will be of amount (1 + r) 110 .5

( 6t −8 ) 6

1.5 *

* Q (0 )

4 t− 3

=

(1 + r ) 1.5 * Q (0) * 110 .5

This payment will be received at time t , when the value of the index will be Q(t ) . [4 marks] Redemption proceeds will be paid at time 5 with the final coupon payment.

5

**The redemption proceeds will be 100 * Q( 0) * (1 + r) 110 .5
**

4 5− 3

**and the value of the index will be Q(0 ) * (1 + r) 5 . [2 marks] Thus the real yield equation is: 1 .72 (1 + r ) * v + ∑ 1.5 * Q (0) * *vt t (1 + r) 110 .5 * (1 + r) t =2
**

5 4 t− 3

111 .1 =

+

100 * Q (0) * (1 + r ) 110 .5 * (1 + r ) 5

4 5− 3

* v5

111 .1 =

1.72 127 .4 * v + 1 .5 * * (1 + r) (1 + r ) 110 .5

−4

−4 3

∑ vt t =2

5

100 * 127 .4 * (1 + r ) 3 + *v5 110 .5 ⇒ 111 .0 = 1.6866 v + 1 .6848 ( a 5 − v) 112 .3186 v 5 ⇒ 111 .0 = 0 .0018 v + 1.6848 * a 5 + 112 .3186 v 5 [3 marks] At 2%, RHS = 109.67 At 1½%, RHS = 112.32 By linear interpolation: 111 − 109 .67 i = 0 .020 − * 0 .005 112 .32 − 109 .67

= 0.01749 ⇒ yield for year is 3.53% p.a.

6

[2 marks]

Solution to Q8)a): 90 * a 20 + 10 * Ia20 @ 8% 1 .08 * 9 .8181 − 20 * 0.21455 = 90 * 9.8181 + 10 * 0 .08 = 883.629 + 10 * 78.90685 = 1672.6975

Solution to Q8)b): Capital o/s after 5 payments is: 6th payment = 150 Capital o/s = 140 * a15 + 10 * Ia15 1 .08 * 8 .5595 − 15 * 0 .31524 140 * 8.5595 + 10 * 0.08 1762.7875

= = Loan schedule:

interest 5 6 7

capital capital o/s 1762.7875 141.023 8.977 1753.8105 140.305 19.695 1734.1155

Solution to Q8)c): Last instalment = 290 290 = (1 + i ) * capital outstanding Capital outstanding = 268.519 Interest = 290 – 268.519 = 21.4815 This is all paid off.

7

Solution to Q9)a): The values of the funds before and after the cash injections are: A 1 Jan 2001 31 Dec 2001 31 Dec 2002 31 Dec 2003 B

120,000 100,000 130,000 140,000 140,000 150,000 135,000 145,000 145,000 155,000 180,000 150,000

Hence time weighted rate of return for manager A 130 135 180 3 = * * −1 120 140 145 = 1.2968 3 − 1 = 9.05% For manager B, time weighted rate of return 140 145 150 3 = * * −1 100 150 155 = 1.3097 3 − 1 = 9.41%

1 1 1 1

Solution to Q9)b): The money weighted rate of return for manager A is the value of i which satisfies the following equation: 120 * (1 + i ) 3 + 10 * (1 + i ) 2 + 10 * (1 + i) = 180 At 9%, LHS = 178.1845 At 9½%, LHS = 180.4921 By interpolation i = 9.39% At 9.39%, LHS = 179.98

8

Solution to Q9)c): Both funds have increased by 50% over the 3-year period and receivedthe same amounts of cash injections at the same times as each other during the period. Since, initially, fund B was smaller than fund A the cash injections form a larger proportion of fund B and hence the money weighted return earned by fund B will be lower. (Alternatively, if the equation in (ii) above is multiplied by 5/6, the yield will remain the same; the equation is then 100 * (1 + i ) 3 + 8.3 * (1 + i ) 2 + 8 .3 * (1 + i) = 150 The equation to obtain the yield on fund B is 100 * (1 + i ) 3 + 10 * (1 + i ) 2 + 10 * (1 + i) = 150 hence i must be lower for the solution to this equation than for the one above.

Solution to Q9)d): The money weighted rate of return is higher for fund A, whilst the time weighted return is higher for fund B. When comparing the performance of investment managers, the time weighted rate of return is generally better because it ignores the effects of cash inflows or outflows being made which are beyond the manager’s control. In this case, manager A’s best performance is in the 3rd year, when the fund was at its largest, whilst manager B’s best performance was in the 1st year, where his fund was at its lowest. Overall, manager B has performed relatively better than manager A.

Solution to Q10)a): Bond issued and payments made by a government. Coupon and redemption payments linked to an index which reflects inflation (typically lagged inflation). Payments fixed in relation to t his index, therefore bond provides inflation protection. [2 marks]

Solution to Q10)b): Most bonds have payments linked to inflation with a time lag. There is therefore a gap between the reference date for inflation used to calculate the payment from a bond

9

and the date on which a payment is received. If inflation is higher than anticipated between those two dates, the real value of the payments will be reduced. [2 marks]

Solution to Q11)a): Short interest rate futures are based on a benchmark interest rate and settled for cash. The way the quotation is structured means that as interest rates fall the price rises, and vice versa. The price is stated as 100 minus the 3-month interest rate. For example, with an interest rate of 6.25% the future is priced as 93.75. The contract is based on the interest paid on a notional deposit for a specified period from the expiry of the future. However, no principal or interest changes hands. The contract is settled for cash. On expiry the purchaser will have made a profit (or loss) related to the difference between the final settlement price and the original dealing price. The party delivering the contract will have made a corresponding loss (or profit).

Solution to Q11)b): Sell. As with any investment and any future, the seller makes a profit is the price falls down (i.e. if interest rates rise).

Solution to Q12)a): Arbitrage in financial mathematics is generally described as risk -free tradin g profit. An arbitrage opportunity exists if either: 1. an investor can make a deal that would give her or him an immediate profit, with no risk of future loss; or 2. an investor can make a deal that has zero initial cost, no risk of future loss, and a non-zero probability of a future profit.

Solution to Q12)b): The “No Arbitrage” assumption is very simple and very powerful. It enables us to find the price of complex instruments by “replicating” the payoffs. This means that if we can construct a portfolio of assets with exactly the same payments as the investment that we are interested in, then the price of the investment must be the same as the price of the “replicating portfolio”.

10

Solution to Q13)a): 1.v + 2v 2 + ... + 10 v10 DMT = v + v 2 + ... + v10 = ( Ia)10 a10 && a10 − 10 v10 i

=

a10

= =

7 .0236 * 1 .07 − 10 * 0 .50835 0 .07 * 7.0236 4.946 as required

Solution to Q13)b): We will consider the three conditions necessary for immunisation 1. VA = VL V A = a10 + Xv n at 7% = 7.0236 + Xv n V L = 7v 5 + 8v 8 at 7% = 9.64698 ⇒ Xv n = 2.62338 …(a)

′ ′ ′ 2. V A = V L where V A =

dVA dδ

′ and V L =

dVL dδ

V A = ( Ia)10 + n * Xv n at 7% ′

= 34 .7393 + n * Xv n

V L = 5 * 7 v 5 + 8 * 8v 8 at 7%

11

= 62 .20310 ⇒ n * Xv n = 27 .46380 ⇒ n = 10 .46886 ⇒ X = 2.62338 * (1 .07 )10.46886 = 5.32692 3. VA′ > VL′ ′ ′ ′ V A′ = …(b)

(a) and (b)

∑ t 2 * vt + n2 * X *v n t =1

10

= 228 .451 + (10 .46886 ) 2 * 5 .32692 * v10.46886 = 515.966 ′ V L′ = 52 * 7v 5 + 8 2 * 8v8 = 422.761 ⇒ Condition 3 is satisfied [2 marks] Thus, X = 5326920 and n = 10 .46886 years will achieve immunisation. Solution to Q14)a): i) Assets would accumulate to 950000 * 1 .05 = 997500 Probability = 1.00 [2 marks] ii) The guaranteed portion of the fund would accumulate to 0 .15 * 950000 * 1 .05 = 149625 non-guaranteed portion needs to accumulate to 1000000 − 149625 = 850375

12

we require probability that (0 .85 * 950000 ) * (1 + i t ) < 850375 = Pr((1 + i t ) < 1 .053096 ) = Pr(ln( 1 + it ) < ln 1.053096 ) ln(1 + it ) − 0.06748 ln 1 .053096 − 0 .06748 = Pr < 0 .0186896 0.0186896 = Pr(Z < −0.842479 ) where Z ~ N (0,1) = 1 − Pr(Z < 0.842479 ) = 1 – 0.79955 ≈ 0.20

Solution to Q14)b) i) Variance of return = 0 [1 mark] ii) Return from portfolio = 0 .15 * 0 .05 + 0 .85 * i t Variance of return = 0 + 0.85 2 * 0.0004 = 2 .89 * 10 −4 [2 marks]

Solution to Q15: Let I t be the effective annual rate earned in year t . Then 1 + I t is distributed lognormal (0.075, 0.00064). Let S 10 be the accumulated value at time t = 10 of a single investment of 1 at time t =0. Then S 10 = ∏ (1 + I t )

t =1 10

⇒ S 10 is distributed lognormal (10*0.075, 10*0.00064)

13

= lognormal (0. 75, 0 .08 2 ) ⇒ Probability of a single investment of Rs 2000 accumulating to more than Rs 4500 in 10 years is equal to the probability that S10 > 2.25 = probability that log e S 10 > 0 .8109302 which is equal to probability that Z > (0 .810932 − 0 .75 ) / 0.08 where Z is a standard Normal random variable = 1 − Φ(0 .7616 ) = 1− 0.77685 = 0.22315

14

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