THE UNIVERSITY OF HONG KONG

DEPARTMENT OF STATISTICS AND ACTUARIAL SCIENCE

STAT2902 Financial Mathematics
Assignment 4

Due Date: April 30, 2021

1. A loan of nominal amount 10,000,000 is to be issued bearing a coupon of 8% per annum payable
quarterly in arrears. The loan is to be repaid at the end of the 15th years at 110% of the nominal
value. An institution not subject to either income or capital gains tax bought the whole issue to
yield 9% per annum effective.

(a) Calculate the price per 100 nominal which the institution paid.
(b) Exactly 5 years later, immediately after the coupon payment, the institution sold the entire
issue of stock to an investor who pays both income and capital gains tax at a rate of 20%. Cal-
culate the price per 100 nominal which investor pays the institution to earn a net redemption
yield of 7% per annum effective.

2. A number of index-linked bonds of $100 nominal each was issued on 1st June 1995, and were
redeemed at par on 1st June 1997. Each bond had a nominal coupon rate of 5% per annum, payable
semiannually in arrears. The actual coupon and redemption payments were indexed according to
the increase in the consumer price index (CPI) between 6 months before the bond issue date and
6 months before the coupon or redemption payment dates. The values of the CPI in the relevant
months were:

Month: Dec 94 June 95 Dec 95 June 96 Dec 96 June 97

CPI: 100 105 110 113 115 120

An investor purchased 500 bonds at the issue date, and held them until they were redeemed. When
calculating the real rate of return, the investor’s cash flows are indexed according to the increase
in CPI between the month in which the investment was purchased and the month in which it was
redeemed. Calculate the purchase price to obtain a real yield of 7% per annum effective.
3. (a) An investor purchased a holding of common stock two months before payment of the next
dividend was due. Dividends are paid annually and it is expected that the next dividend will
be an amount of 12 per share. The investor anticipates that dividends will grow at a rate of
4% per annum in perpetuity. Calculate the price per share that the investor should pay to
obtain a return of 7% per annum effective.
(b) An investor sells short 500 shares of stock at 10 per share and covers the short position one
year later when the price of the stock has declined to 7.5. The margin requirement is 50%.
Interest on the margin deposit is 8% effective. Four dividends of 0.15 per share are paid.
Calculate the yield rate.
4. The one-year forward rates at time 0,1 are 6.1%, 6.5% per annum effective, respectively. The 3-year
bond which pays annual coupons in arrears of 6% and is redeemable at par is bought to yield 6.3%
per annum effective. Under the no-arbitrage assumption, calculate the 3-year spot rate and the
1-year forward rate over the 3rd year.
5. The annual term structure of interest is (6%; 6:3%; 6:7%; 7%, ... ) and the 3-year deferred 2-year
forward rate is 7.8%. Find the par yield for a 5-year bond.
6. Let It be the annual yield on an insurance company’s fund for the tth year. The yields in dierent
years are independent.
Suppose that random variables (1 + It ) are log-normally distributed with parameters µ and σ 2 .
Given that the mean and the variance of It are 0.06 and 0.01, find the values of µ, σ 2 , and the
probability that the accumulation of an investment of 1,000 for five years will be greater than its
expected value.

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 7. A company must make payments of $10 annually in the form of a 10-year annuity immediate. The
company will receive two payments in turn, one at the end of year 2 and the other at the end of
year 9. At an annual effective rate of 10%, the first two conditions for Redington immunization
are met. Determine whether immunization to small changes in interest rates on either direction of
10% can be achieved.
8. A one-year forward contract is issued on July 1, 2013 on a share with a price at that date of $21.
Dividends of $2 per share are expected on December 31, 2013 and June 30, 2014. On July 1, 2013,
the 6-month spot rate of interest is 2.5% per annum convertible semiannually and the 12-month
spot rate of interest is 3% per annum convertible semiannually. Calculate the forward price at
issue.

Additional problems not for submission

1. A loan of $1,500,000, with interest of 6% per annum payable semiannually in arrears, will be
redeemed at par, by annual installments of $30,000, $50,000, $70,000, $30,000, $50,000, $70,000
and so on until the whole loan is repaid. The first annual installment will be made at the end of
the 5th year.

(a) An investor purchases the entire loan on the issue date at a price to obtain an effective yield
of 7% per annum after tax. Calculate the price if the investor is liable to income tax at 35%
on interest and to capital gains tax at 30%.
(b) Immediately after the 8th interest payment, the investor sells the entire loan at a price of
$1,100,000. Using linear interpolation, calculate the net effective yield per annum, after tax,
obtained on the complete transaction by the investor.

2. Andy purchases a 25-year bond with coupons of 10% payable half-yearly at a price of $1,754.76.
The bond is callable at par on any coupon date starting at the end of 20th year. The price
guarantees that Andy will have a nominal yield rate of at least 6% payable half-yearly.
Mark purchases a 30-year bond identical to the one purchased by Andy except that it is not callable.
How much should Mark pay for the bond if his yield is to be the same as Andy’s yield?
3. Suppose that I1 will be equally likely to be 6%, 8% or 10%; I2 will be equally likely to be 7% or
9%; I3 will be 6%, 7% or 9% with probabilities 0.2, 0.2 and 0.6. Find the mean and variance of
the accumulation of an investment of 1,000 for three years.
4. An amount of $10,000 is to be invested for three years. The yield rate for the first year will be
equally likely to be 5%, 6%, 7%, 8% or 9%; for the second year will be equally likely to be 7% or
9%; for the third year will be 7%, 8% or 9% with probabilities 0.3, 0.5 and 0.2, respectively. The
yield rates in different years are independent. Find the probability that the accumulation of the
investment for the three years will be greater than its expected value.
5. Let Ct be the amount of cash flow at time t. Define P as follows:
X
P = Ct v t
t

dP
(a) Assuming a constant force of interest δ, calculate .
dδ
(b) Divide the answer in part a) by −P , does this tell you anything about duration? Explain
verbally why duration is considered a measure of interest rate sensitivity.

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