QF1100 (Week 4)

▶ Annuities

▶ Perpetuity

▶ Loans

▶ Probability

▶ Properties of Probability

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Annuities
Question: How to build your retirement fund?
An annuity is a contract that pays the holder (the annuitant) money
periodically, according to a predetermined schedule or formula.
A perpetuity is an annuity which pays a fixed sum periodically
forever. For example, it might pay $1,000 every Jan 1 forever.

Perpetual annuity formula:

Suppose an amount A is paid at the end of each period, starting at
the end of the first period, and the interest rate is r.
Then the present value is
∞ ∞
X A A X 1 A 1 A
PV = = × = × 1 = r .
(1 + r)k 1+r (1 + r)k 1 + r 1 − 1+r
k=1 k=0

n ∞
X xm − xn+1 X 1
Recall that xk = (where m ≤ n) and xk =
1−x 1−x
k=m k=0
for |x| < 1.

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Example
A man wants to accumulate a sum of at least $200, 000 by the end of
20 years. He plans to deposit $x yearly into an account that pays 5%
interest compounded annually, for the first 10 years, and $2x yearly
into the same account for the next 10 years. He intends to make the
first deposit at the beginning of year 1.
Find the least value of x.

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Solution
The cash flow stream is (x, x, . . . , x, 2x, 2x, . . . , 2x, 0). That is, xk = x
| {z } | {z }
10 years 10 years
if 0 ≤ k ≤ 9 and xk = 2x if 10 ≤ k ≤ 19.

We have the future value

9
X 19
X
F V20 = x × (1 + 5%)20−k + 2x × (1 + 5%)20−k
k=0 k=10
20
X 10
X
=x (1 + 5%)k + 2x (1 + 5%)k
k=11 k=1
9
X
= x(1 + 5%)11 + 2x(1 + 5%) (1 + 5%)k


k=0
 1.0510 − 1
=x (1 + 5%)11 + 2(1 + 5%) ×

.
1.05 − 1
Thus
F V20 ≥ 2 × 105 ⇒ x ≥ $4173.1.
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Exercise: Annuities with varying payments
The first payment of $100 of a 10-year annuity is made at the
beginning of the first year. Every subsequent payment increases by
10%. Assuming an annual interest rate of 5%, calculate the present
value of this annuity.
1. Find the cash flow stream.

2. Calculate the present value of this annuity.

3. If the first payment is made at the end of the third year, is the
cash flow stream different?

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Example: Perpetuity
A perpetual annuity pays
$2 at t = 2, 4, 6, 8, . . . .
Find, to 4 significant figures, the present value of this annuity given
that the interest rate of 3% is compounded continuously.

Solution Note that the payments occur at times t0 = 2, t1 = 4,

t2 = 6,. . . . That is, tk+1 = tk + 2 (Arithmetic series), equivalently,
tk = 2k + 2 for k = 0, 1, 2, 3, . . . ,
We have the present value
∞
X ∞
X
PV = 2e−0.03tk = 2e−0.03×2(k+1)
k=0 k=0
∞
X
=2e−0.06 e−0.06k
k=0
2e−0.06
= = $32.34.
1 − e−0.06
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Loans
Loans are normally repaid by a series of installment payments made
at periodic intervals. The size of each installment can be determined
using a present-value analysis.

Specifically, if we let L be the amount of loan taken at time t = 0 and

let C = (x0 , x1 , . . . , xn ) occurring at times (t0 , t1 , . . . , tn ) be the series
of repayments, then
L = the present value of C.

Example. If you borrow $1000 for a term of 4 years at an annual

interest rate of 5% and wish to completely pay off the loan by equal
installments, with the first payment made at the end of the first year,
how much should you pay per year?

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Solution
Assume c to be the installment for each year.
Then cash flow stream is (0, c, c, c, c), that is, x0 = 0 and xk = c for
1 ≤ k ≤ 4.
We have

L =P V = 1000
4 3
X c X
= c × (1 + 5%)−k = × 1.05−k
1.05
k=1 k=0
c 1 − 1.05−4
= × .
1.05 1 − 1.05−1
Solve for c in the equation

c 1 − 1.05−4
× = 1000.
1.05 1 − 1.05−1
We have c = $282.01.

Remark. In total, we pay 4c = 1128.05 > 1000. Note that we do not

only pay back 103 but also pay the interest. 8/22
Example
A loan is being repaid with 20 annual payments of $1000, with
payment made at the end of each year. Immediately after the 5th
payment has been made, the borrower wishes to pay an additional
$2000 and then repay the balance over 12 years by annual installment
of $x. If the effective annual interest rate is 9%, find x.

Strategy.
1. Write the cash flows of two installment payments:

C1 =

C2 =

2. Goal: Loan = P V (C1 ) = P V (C2 ). Set an equation of x.

3. Solve for x.
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Solution
We have two cash flow streams:

C1 = (0, 103 , 103 , . . . , 103 ), that is, x0 = 0, xk = 103 for 1 ≤ k ≤ 20;

| {z }
20 years

and
C2 = (0, 103 , 103 , 103 , 103 , 103 + 2 × 103 , x, x, . . . , x),
| {z }
12 years

that is, y0 = 0, yk = 10 for 1 ≤ k ≤ 4, y5 = 10 + 2 × 103 , yk = x for

3 3

6 ≤ k ≤ 17.
X20
Then L = P V (C1 ) = 103 (1 + 9%)−k and
k=1

4
X 17
X
L = P V (C2 ) = 103 (1+9%)−k +(103 +2×103 )(1+9%)−5 + x(1+9%)−k .
k=1 k=6

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Solution
By P V (C1 ) = P V (C2 ), we obtain
20
X 4
X 17
X
103 1.09−k = 103 1.09−k + (103 + 2 × 103 )1.09−5 + x 1.09−k
k=1 k=1 k=6
20
X 17
X
⇒103 1.09−k = 2 × 103 × 1.09−5 + x 1.09−k
k=6 k=6

103 1 − 1.09−15 3 −5 x 1 − 1.09−12

⇒ × = 2 × 10 × 1.09 + × .
1.096 1 − 1.09−1 1.096 1 − 1.09−1
Therefore x = 846.38.

Remark. We only need to compute the present values of the

remaining installment payments.
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Example
A loan of $10, 000 is to be repaid by annual installments of $1000.
The effective interest rate is 4.5% per annum. Determine the total
number of payments to be made and the amount of the last payment,
given that the last payment will be made
(i) together with the last installment payment of $1000
(ii) one year after the last installment payment of $1000 (Exercise).

Strategy.
1. Write down the cash flow:

C1 =

2. Set up the equation L = P V (C1 ) of n.

3. Solve for n (⇒ a real cash flow).

Remark.
Quit often, the solution of n is not an integer. The loan will be repaid
with ⌊n⌋ (the greatest integer less than or equal to n) full payments of
A plus a final payment B made at some time such as ⌊n⌋ or ⌊n⌋ + 1,
according to a predetermined schedule or formula. 12/22
Solution
Assume n to be the total number of payments. We have the present
value of the cash flow (0, 103 , 103 , . . . , 103 ):
| {z }
n years

n
X 103 1 − 1.045−n
P V (C1 ) = 103 × (1 + 4.5%)−k = · .
1.045 1 − 1.045−1
k=1

Then
P V (C1 ) = L = 104 =⇒ n = 13.5.
We need to make ⌊13.5⌋ = 13 payments of 103 .

Next, we have a real cash flow

C2 = (0, 103 , 103 , . . . , 103 , 103 + B).

| {z }
12 years

Our goal is to solve for B such that P V (C2 ) = L = 104 .

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Solution
We have the present value of C2
12
X
P V (C2 ) = 103 × (1 + 4.5%)−k + (103 + B) × (1 + 4.5%)−13
k=1
13
X B
= 103 × (1 + 4.5%)−k + .
(1 + 4.5%)13
k=1

Solve for B satisfying the equation P V (C2 ) = L = 104 and obtain

B = 562.05.

Exercise (ii). The last payment B will be made one year after the last
installment payment of $1000.
▶ True/False: The real cash flow (0, 103 , 103 , . . . , 103 , B).
| {z }
13 years
▶ Solve for B.
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Fixed-income securities
Fixed-income securities are financial instruments that traded in
well-developed markets and promise a fixed (that is, definite) income
to the holder over a span of time.

Example
▶ Savings Deposits: DSB Fixed Deposits, POSB MySavings
Account, etc.
▶ Government Securities: U.S. Treasury bills/bonds/notes,
Singapore Saving bonds.
▶ Other bonds: Municipal bonds, Corporate bonds.
▶ Mortgages
▶ Annuities: pension.

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Derivative Securities
A derivative security is a security whose payoff is explicitly tied to
the value of some other variable, usually based on the price of some
other financial security, the stock price, the price of commodities, the
yield of bonds for instance.
▶ Forward contracts and Future contracts
▶ Options

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Probability

Risk is the possibility of something bad happening.

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Definition of Probability
Consider an experiment (e.g flipping a coin) whose outcome is not
predictable (possibly Tail or Head).
▶ An outcome of the experiment (e.g. T ) is called an element or
a sample point.
▶ The collection S (e.g. S = {T, H}) of all outcomes is called the
sample space.
▶ Any subset of the sample space is an event. (e.g. ∅, {T }, {H},
{T, H}).

Example.
1. Toss a dice. The sample space is S = {1, 2, 3, 4, 5, 6}.
{even sides} = {2, 4, 6} is an event.
2. Flip two coins. The sample space is
S = {(H, H), (H, T ), (T, H), (T, T )}.
3. Toss two dice. How many sample points do the sample space
consist of? (Exercise.).

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Events
▶ The sample space S is an event, called a sure event.
▶ The empty set ∅ is an event, called a null event.
▶ The complement of an event A is Ac = S \ A.
▶ The intersection of events A and B is A ∩ B.
▶ The events A, B are mutually exclusive if A ∩ B = ∅.
▶ The union of events A and B is A ∪ B.

Example
1. Let S = {1, 2, 3, 4, 5, 6} be the sample space.
Then neither T , H, nor 10 is a sample point.
2. Let S = {(i, j) | 1 ≤ i, j ≤ 6} and E = {(i, j) ∈ S | i + j = 7}.
Then E is an event and
E = {(1, 6)} ∪ {(2, 5)} ∪ {(3, 4)} ∪ {(4, 3)} ∪ {(5, 2)} ∪ {(6, 1)}.
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Axioms of Probability
The probability P(E) of E gives a precise measure of the chance that
the event E will occur.

Define the probability P of S that satisfies the three axioms:

Axiom 1 0 ≤ P(E) ≤ 1 for any E ⊆ S.
Axiom 2 P(S) = 1.
Axiom 3 If E1 , E2 , . . . are
! mutually exclusive events (Ei ∩ Ej = ∅, ∀i ̸= j),
[∞ X∞
then P Ei = P(Ei ).
i=1 i=1
Facts. (The proofs are not required.)
1. 0 indicates impossibility of the event and 1 indicates certainty.
P∞
2. Axiom 3 implies i=1 P(Ei ) is convergent to a number in [0, 1].
S S∞ P∞
3. P(∅) = 0 because P(S) = P(S i=2 ∅) = P(S) + i=2 P(∅).
n
[ Xn
4. Axiom 3 ⇒ P( Ei ) = P(Ei ) ( ⇐⇒ Axiom 3 if S is finite).
i=1 i=1

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Example
Exercise.
Let S = {T, H}. Define a funtion P of the subsets of S by
P ∅ {T } {H} {T, H} Y/N
1 1 3
P1 0 2 4 4
1 1
P2 0 2 2 1
3
P3 0 2 − 21 1
1 2
P4 0 3 3 1

Example. Toss a fair dice. Let S = {1, 2, 3, 4, 5, 6}. We expect that

the natural probability of S satisfies
1
P({1}) = P({2}) = P({3}) = P({4}) = P({5}) = P({6}) = .
6
It follows from Axiom 3 that
3 1 2 1 5
P({1, 2, 3}) = = , P({3, 6}) = = , P({6}c ) = .
6 2 6 3 6
Remark. Sample spaces have equally likely outcomes. 21/22
Equally likely outcomes
Let a sample space S be a finite set, say S = {1, 2, . . . , N }.
Having equally likely outcomes means
P({1}) = P({2}) = · · · = P({N }).
1
Axioms 2 and 3 imply that P({i}) = N for all i.

Define the function P of the events by

the number of points in E |E|
P(E) = = .
the number of points in S |S|
Show that P is a probability of S. (That is, P satisfies Axioms 1–3.)
Proof.
Axiom 1: For E ⊆ S, by 0 ≤ |E| ≤ |S|, we have 0 ≤ P(E) ≤ 1.
Axiom 2: P(E) = |S|/|S| = 1.
Axiom 3: If P E1 , E2 , · · · , En are mutually exclusive events, then
n
| ∪ni=1 Ei | = i=1 |Ei |. It follows that
Pn n n
| ∪ni=1 Ei | |Ei | X |Ei | X
P(∪ni=1 Ei ) = = i=1 = = P(Ei ).
|S| |S| i=1
|S| i=1
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