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EXAMINATIONS
November 2004
SUBJECT  102 : Financial Mathematics
Indicative Solution
Question 1
Convert to amounts at time 0 values:
Loan = 20,000
Interest at t = 1 : 969.15
t = 2 : 927.68
t = 3 : 875.00
Capital repaid at t = 3 : 17500
Equation of Value is
3 3 2
17500 875 68 . 927 15 . 969 20000 v v v v + + + ·
By trial and error the real rate of return is 0.47%
Question 2
Let S be the investment made.
Real value of payments is:
...
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
3
3 2
2
2
+
+
+
+
+
+
+
+
·
e
v g dS
e
v g dS
e
dSv
S where v is calculated using the real rate of
interest i
ˆ
.
Simplifying we get
) 1 ( )
ˆ
1 )( 1 (
1
g i e
d
+ − + +
·
g d e i + + · + + ∴ 1 ) 1 )(
ˆ
1 (
Thus
) 1 (
ˆ
e
e g d
i
+
− +
·
Question 3
(a) E(i) = 0.3 * 7 + 0.5 * 8 + 0.2 * 10 = 8.1%
Single premium is X such that X * ) 081 . 1 (
25
= 10,000
Hence X = Rs 1,426.78
(b) Expected profit is
= 1,426.78 * [0.3 * ) 07 . 1 (
25
+ 0.5 * ) 08 . 1 (
25
+ 0.2 * ) 1 . 1 (
25
]  10,000
= Rs 300.52
Question 4
a) Earliest redemption date i.e., at the tenth anniversary. Valid reasons should include
remarks about gross redemption yield being less than the coupon and the relative
advantage to the borrower to repay the loan (and reissue at a lower coupon if required).
b) i) The bond is likely to be redeemed later than assumed at the time of issue.
ii) The redemption yield for the buyer of the bond would be higher than that expected
at the time of the issue.
Question 5
a) For the Treasury Stock if the RPI is assumed to grow continuously at a rate of 2.5%
p.a. then if “j” is the real rate of return
9 9 2 / 1
)] 025 . 1 )( 1 [(
100
)] 025 . 1 )( 1 [(
1
...
)] 025 . 1 )( 1 [(
1
)] 025 . 1 )( 1 [(
1
75 . 3 107
j j j j +
+
¹
'
¹
¹
'
¹
+
+ +
+
+
+
·
i.e.
9 ) 2 (
9
100 50 . 7 107 v a + · at i where (1+i) = (1+j)(1.025)
By interpolation (@ 7%, RHS = 104.1 and @ 6%, RHS = 110.96), i = 6.6%
So j = (1.066)/(1.025) 1 = 4%
Alternately, students can evaluate LHS assuming (1+i) = (1.04)(1.025) and prove that
RHS is very close to 107. However when such a method is adopted they should prove
that they have actually calculated LHS and equated that to RHS.
b) The nominal and real values of the future receipts per Rs 100 nominal may be found
as follows:
Date Nominal Value Real value
01/10/04
2 / 1
5 . 69
5 . 158
v
2 / 1
2 / 1
) 025 . 1 (
1
5 . 69
5 . 158
v
01/04/05
2 / 1
) 025 . 1 (
5 . 69
5 . 158
v
) 025 . 1 (
) 025 . 1 (
5 . 69
5 . 158
2 / 1
2 / 1
v and so on
01/04/13
5 . 8 9
) 025 . 1 (
5 . 69
5 . 158
) 100 ( v
9
5 . 8
9
) 025 . 1 (
) 025 . 1 (
5 . 69
5 . 158
) 100 ( v
Summing the real value of these payments gives
{ ¦
9 ) 2 (
9
2 / 1
100 2
) 025 . 1 ( 5 . 69
5 . 158
v a +
c) The real yield is found from the expression
{ ¦
9 ) 2 (
9
2 / 1
100 2
) 025 . 1 ( 5 . 69
5 . 158
203 v a + ·
By interpolation, real yield = 3.3%
(@ 3%, RHS = 207.98, @ 3.5%, RHS = 199.85).
Question 6
Interest 4%
v factor 0.9615
Year Annuity v factor Loan o/s (t1)
Interest on
loan Capital repaid
Loan o/s
(t)
1 100 0.9615 472.2761 18.8910 81.1090 391.1671
2 90 0.9246 391.1671 15.6467 74.3533 316.8138
3 80 0.8890 316.8138 12.6726 67.3274 249.4863
4 70 0.8548 249.4863 9.9795 60.0205 189.4658
5 60 0.8219 189.4658 7.5786 52.4214 137.0444
6 50 0.7903 137.0444 5.4818 44.5182 92.5262
7 40 0.7599 92.5262 3.7010 36.2990 56.2272
8 30 0.7307 56.2272 2.2491 27.7509 28.4763
9 20 0.7026 28.4763 1.1391 18.8609 9.6154
10 10 0.6756 9.6154 0.3846 9.6154 0.0000
Initial loan amount 472.2761
Interest content of the fifth instalment 7.5786
Capital paid in 6th, 7th and 8th instalment 6
th
 44.5182
7
th
 36.2990
8
th
 27.7509
Question 7
a) Let A be the price per 100 nominal.
15 ) 4 (
15
110 * 8 v a A + ·
@ 9% per annum effective
A = 66.62291 + 30.19918 = 96.82210
b) (i) 07 . 0 · i 068234 . 0
) 4 (
· i
1 . 1
08 . 0
· g 2 . 0
2 1
· · t t
) 4 (
1
058182 . 0 ) 1 ( i t g < · − and hence there is a capital gain.
If B is the price per 100 nominal
10 10 ) 4 (
10
) 110 ( 2 . 0 110 ) 2 . 1 ( 8 v B v a B − − + − ·
i.e. B = 46.11437 + 55.91842 – 11.18368 + 0.10167 B
i.e. B = 101.13109
b) (ii) Equation of value for the institution on the whole transaction is
5 ) 4 (
5
13109 . 101 * 8 82210 . 96 v a + ·
By trial and error and interpolation, yield = 9.3%
(@ 9% RHS = 97.88, @ 10% RHS = 94.23 ).
Question 8
(i) The nyear spot rate of interest is the yield to maturity on a zero coupon bond
with remaining time to maturity of term n years.
(ii) Let
n t
f
,
= n year forward rate at time t
Let
k
y
, 0
= kyear spot rate of interest at time t = 0
Then
2 , 3
f is such that
5
5 , 0
2
2 , 3
3
3 , 0
) 1 ( ) 1 ( ) 1 ( y f y + · + +
So (1+
2 , 3
f ) =
3
5
06 . 1
075 . 1
= 1.09790
and hence the two year forward rate at time t=3 is 9.79%
(iii) Let
n
S = n year spot yield
Let
n
P = n year par yield
Then 6year par yield is given by
6 6 5 4 3 2
6
08 . 1
1
08 . 1
1
075 . 1
1
07 . 1
1
06 . 1
1
05 . 1
1
04 . 1
1
1 +
,
`
.

+ + + + + · P
i.e. 63017 . 0 ) 797811 . 4 ( * ) ( 1
6
+ · P
i.e. % 708 . 7 07708 . 0
6
· · P
Question 9
DPP is t such that 20 ≤ t , t 4 is an integer and t is the smallest such number satisfying
10000 1800
) 4 (
≥
t
a
5556 . 5
) 4 (
≥
t
a at 15%
79019 . 0 1 ≥ −
t
v
209814 . 0 ≤
t
v
209814 . 0 ln ln ≥ v t
17 . 11 ≥ t
25 . 11 · t
Question 10
a) DMT (i) =
∑
∑
·
·
n
k
t
i t
n
k
t
i t k
k
k
k
k
v C
v C t
1
1
b) Volatility =
,
`
.

− ) (
) (
1
i P
di
d
i P
=
i
v * DMT
Question 11 a)
∫
−
·
n
jt
n
dt te Ia
0
) (
∫
−
·
n
jt
dt e t
0

∫
,
`
.

−
− n jt
dt
j
e
0
n
jt
e
j
t
0
−
−
· +
j
an
j
ne
jn
−
·
−
+
j
an
j
ne a
jn
n
−
−
·
(Note: Since the question did not specify the term as ‘n’, marks shall be granted to the
students who have derived formula for perpetuity.)
Question 11 b)
Present value of net revenue
= { ¦
18
18
11
10
) ( 50000 1000000 ) ( 100000 Ia a v Ia v − +
= 100000*13.63859 + 0.134588 {1000000*5.2788 – 50000 * 25.24496}
= 1904438.631
Present value of fixed costs and initial cost
=
29 1
80000 500000 a a +
= 500000 * 0.914136 + 80000 * 5.457088
= 893634.933
Maximum price to yield 20% pa is
= 1904438.631 – 893634.933
= 1010804
Question 12
Convertible:
Ranks ahead of equity
May be secure
Higher initial coupon than equity
Typically conversion premium paid
Less liquid than equity
Less volatile than equity
Question 13
Call option: A financial instrument that gives the holder of this instrument a right (but not
an obligation) to buy a specified financial asset on a set date (or dates) in future for a
specified price.
Put option: A financial instrument that gives the holder of this instrument a right (but not
an obligation) to sell a specified financial asset on a set date (or dates) in future for a
specified price.
Long party: In a forward or a futures contract, the party who agrees to purchase the
underlying asset is called a long party.
Question 14
a) No arbitrage enables us to find the price of complex instruments by replicating the
payoffs.
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.
b) Consider the following 2 investment portfolios:
Portfolio A: enter a forward contract to buy one unit of an asset S , with forward price
K , maturing at time T ; simultaneously invest an amount
T
Ke
δ −
in the riskfree
investment.
Portfolio B: Buy one unit of the asset, at the current price
0
S .
At time 0 · t the price of Portfolio A is
T
Ke
δ −
for the riskfree investment; recall that the
price of a forward contract is zero.
The price of Portfolio B is
0
S .
At time T t · the cashflows for Portfolio A are:
An amount K is received from the risk free investment (
T
Ke
δ −
invested at the force of
interest δ for T years gives an accumulated value of K ). The same amount K is paid
on the forward contract. Receive 1 unit of asset S .
The payout from Portfolio B is one unit of asset S .
Now, the future cashflows of portfolio A are identical to those of portfolio B – both give
a net portfolio of one unit of the underlying asset S . The no arbitrage assumption states
that when the future cashflows of the two portfolios are identical, the price must also be
the same – that is:
0
S Ke
T
·
−δ
T
e S K
δ
0
· ⇒
Question 15
a) Let
n
S = Accumulated value and let
t
i = interest rate t1 to t.
n
S =
) 2 1
1 )...( 1 )( 1 (
n
i i i + + +
E[
n
S ] = E[
) 2 1
1 )...( 1 )( 1 (
n
i i i + + + ]
Using the fact that yield each year is independent of the yields in other years and
that the expected yield is j
E[
n
S ] =
n
j ) 1 ( + and
E[
2
n
S ] = ] ) 1 [(
2
1
i E + ] ) 1 [(
2
2
i E + … ] ) 1 [(
2
n
i E +
] ) 1 [(
2
t
i E + = ] 2 1 [
2
t t
i i E + +
= ) ( 2 1
2 2
s j j + + + for all t
⇒ E[
2
n
S ] =
n
s j j )] ( 2 1 [
2 2
+ + +
⇒ V[
n
S ] =
n n
j s j j
2 2 2
) 1 ( )] ( 2 1 [ + − + + +
=
n n
j s j
2 2 2
) 1 ( )] ) 1 [( + − + +
b)
n
S =
) 2 1
1 )...( 1 )( 1 (
n
i i i + + +
log
n
S =
∑
·
+
n
k
k
i
1
) 1 log( each variable ) 1 log(
k
i + follow ) , (
2
σ µ N
⇒
∑
·
+
n
k
k
i
1
) 1 log( follows ) , (
2
σ µ n n N
⇒
16
S follows lognormal ) 16 . 0 04 . 0 * 4 , 28 . 1 08 . 0 * 16 ( · · · · ′ σ µ
∴ ] 25 . 4 Pr[
16
> S =
∫
,
`
.

−
−
16 . 0
28 . 1 4469 . 1
1 = 0.1486
(Please note that in this sub section students will have to derive the distribution of
16
S to get full marks.)
**************
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