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You are on page 1of 250

FACULTY OF SCIENCE

DEPARTMENT OF

MATHEMATICS AND STATISTICS

MATH 329 2004 01

THEORY OF INTEREST

Information for Students

(Winter Term, 2003/2004)

Pages 1 - 8 of these notes may be considered the

Course Outline for this course.

W. G. Brown

April 29, 2004

Information for Students in MATH 329 2004 01

Contents

1 General Information 1

1.1 Instructor and Times . . . . . . 1

1.2 Course Description . . . . . . . 1

1.2.1 Calendar Description . . 1

1.2.2 Syllabus (in terms of sec-

tions of the text-book) . 1

1.2.3 Verbal arguments . . 4

1.3 Evaluation of Your Progress . . 4

1.3.1 Term Mark . . . . . . . 4

1.3.2 Assignments. . . . . . . 4

1.3.3 Class Test . . . . . . . . 4

1.3.4 Final Examination . . . 5

1.3.5 Supplemental Assessments 5

1.3.6 Machine Scoring . . . . 5

1.3.7 Plagiarism . . . . . . . . 5

1.4 Published Materials . . . . . . 6

1.4.1 Required Text-Book . . 6

1.4.2 Website . . . . . . . . . 6

1.4.3 Reference Books . . . . 6

1.5 Other information . . . . . . . 7

1.5.1 Prerequisites . . . . . . 7

1.5.2 Calculators . . . . . . . 7

1.5.3 Self-Supervision . . . . . 7

1.5.4 Escape Routes . . . . . 7

1.5.5 Showing your work; good

mathematical form; sim-

plifying answers . . . . . 7

2 Timetable 9

3 First Problem Assignment 11

4 Second Problem Assignment 12

5 Solutions, First Problem Assign-

ment 14

6 Third Problem Assignment 18

7 Solutions, Second Problem Assign-

ment 20

8 Solutions, Third Problem Assign-

ment 30

9 Class Tests 41

9.1 Class Test, Version 1 . . . . . . 41

9.2 Class Test, Version 2 . . . . . . 46

9.3 Class Test, Version 3 . . . . . . 51

9.4 Class Test, Version 4 . . . . . . 56

10 Fourth Problem Assignment 61

11 Solutions to Problems on the Class

Tests 63

12 Fifth Problem Assignment 73

13 Solutions, Fourth Problem Assign-

ment 75

14 Solutions, Fifth Problem Assign-

ment 80

15 References 901

A Supplementary Lecture Notes 2001

A.1 Supplementary Notes for the Lec-

tures of January 5th, 7th, and

9th, 2004 . . . . . . . . . . . . 2001

A.1.1 1.2 The accumulation and

amount functions . . . . 2001

A.1.2 1.3 The eective rate of

interest . . . . . . . . . 2002

A.1.3 1.4 Simple interest . . 2003

A.1.4 1.5 Compound interest 2003

A.1.5 1.6 Present value . . . 2003

A.1.6 1.7 The eective rate of

discount . . . . . . . . . 2004

A.1.7 1.8 Nominal rates of in-

terest and discount . . . 2005

A.2 Supplementary Notes for the Lec-

ture of January 12th, 2004 . . . 2006

A.2.1 1.9 Forces of interest and

discount . . . . . . . . . 2006

A.2.2 1.10 Varying interest . 2008

Information for Students in MATH 329 2004 01

A.2.3 1.11 Summary of results 2008

A.3 Supplementary Notes for the Lec-

ture of January 16th, 2004 . . . 2009

A.3.1 2.1 Introduction . . . . 2009

A.3.2 2.2 Obtaining numeri-

cal results . . . . . . . . 2009

A.3.3 2.3 Determining time pe-

riods . . . . . . . . . . . 2011

A.3.4 2.4 The basic problem 2011

A.4 Supplementary Notes for the Lec-

ture of January 19th, 2004 . . . 2012

A.4.1 2.4 The basic problem

(continued) . . . . . . . 2012

A.4.2 2.5 Equations of value 2012

A.4.3 Unknown principal . . . 2012

A.4.4 2.6 Unknown time . . . 2013

A.4.5 2.7 Unknown rate of in-

terest . . . . . . . . . . 2014

A.4.6 2.8 Practical examples 2014

A.5 Supplementary Notes for the Lec-

ture of January 21st, 2004 . . . 2016

A.6 Supplementary Notes for the Lec-

ture of January 23rd, 2004 . . . 2018

A.6.1 3.1 Introduction . . . . 2018

A.6.2 3.2 Annuity-immediate 2018

A.7 Supplementary Notes for the Lec-

ture of January 26th, 2004 . . . 2020

A.7.1 3.2 Annuity-immediate

(continued) . . . . . . . 2020

A.7.2 3.3 Annuity-due . . . . 2022

A.8 Supplementary Notes for the Lec-

ture of January 28th, 2004 . . . 2023

A.8.1 3.3 Annuity-due (contin-

ued) . . . . . . . . . . . 2023

A.9 Supplementary Notes for the Lec-

ture of January 30th, 2004 . . . 2025

A.9.1 3.4 Annuity values on

any date . . . . . . . . . 2025

A.10 Supplementary Notes for the Lec-

ture of February 2nd, 2004 . . . 2029

A.10.1 3.4 Annuity values on

any date (continued) . . 2029

A.11 Supplementary Notes for the Lec-

ture of February 4th, 2004 . . . 2033

A.11.1 3.5 Perpetuities . . . . 2033

A.11.2 3.6 Nonstandard terms

and interest rates . . . . 2034

A.12 Supplementary Notes for the Lec-

ture of February 6th, 2004 . . . 2035

A.12.1 3.6 Nonstandard terms

and interest rates . . . . 2035

A.12.2 3.7 Unknown time . . . 2035

A.13 Supplementary Notes for the Lec-

ture of February 9th, 2004 . . . 2038

A.13.1 3.7 Unknown time (con-

tinued) . . . . . . . . . 2038

A.14 Supplementary Notes for the Lec-

ture of February 11th, 2004 . . 2040

A.14.1 3.8 Unknown rate of in-

terest . . . . . . . . . . 2040

A.14.2 3.9 Varying interest . . 2047

A.14.3 3.10 Annuities not in-

volving compound interest2047

A.15 Supplementary Notes for the Lec-

ture of February 13th, 2004 . . 2048

A.15.1 4.1 Introduction . . . . 2048

A.15.2 4.2 Annuities payable at

a dierent frequency than

interest is convertible . 2048

A.16 Supplementary Notes for the Lec-

ture of February 16th, 2004 . . 2051

A.16.1 4.3 Further analysis of

annuities payable less fre-

quently than interest is

convertible . . . . . . . 2051

A.16.2 4.4 Further analysis of

annuities payable more fre-

quently than interest is

convertible . . . . . . . 2055

A.16.3 4.5 Continuous annuities 2057

A.16.4 4.6 Basic varying annu-

ities . . . . . . . . . . . 2058

A.17 Supplementary Notes for the Lec-

ture of February 18th, 2004 . . 2059

Information for Students in MATH 329 2004 01

A.17.1 4.6 Basic varying annu-

ities (continued) . . . . 2059

A.17.2 4.7 More general vary-

ing annuities . . . . . . 2064

A.17.3 4.8 Continuous varying

annuities . . . . . . . . 2064

A.17.4 4.9 Summary of results. 2064

A.18 Supplementary Notes for the Lec-

ture of February 20th, 2004 . . 2065

A.18.1 5.1 Introduction . . . . 2065

A.18.2 5.2 Discounted cash ow

analysis . . . . . . . . . 2065

A.18.3 5.3 Uniqueness of the yield

rate . . . . . . . . . . . 2065

A.18.4 5.4 Reinvestment rates 2066

A.19 Supplementary Notes for the Lec-

ture of March 1st, 2004 . . . . 2067

A.19.1 5.4 Reinvestment rates

(continued) . . . . . . . 2067

A.19.2 5.5 Interest measurement

of a fund . . . . . . . . 2069

A.19.3 5.6 Time-weighted rates

of interest . . . . . . . . 2069

A.19.4 5.7 Portfolio methods and

investment year methods 2069

A.19.5 5.8 Capital budgeting . 2069

A.19.6 5.9 More general borrow-

ing/lending models . . . 2069

A.20 Supplementary Notes for the Lec-

ture of March 3rd, 2004 . . . . 2070

A.20.1 6.1 Introduction . . . . 2070

A.20.2 6.2 Finding the outstand-

ing loan balance . . . . 2070

A.21 Supplementary Notes for the Lec-

ture of March 5th, 2004 . . . . 2073

A.21.1 6.2 Finding the outstand-

ing loan balance (contin-

ued) . . . . . . . . . . . 2073

A.21.2 6.3 Amortization sched-

ules . . . . . . . . . . . 2075

A.22 Supplementary Notes for the Lec-

ture of March 8th, 2004 . . . . 2078

A.22.1 6.3 Amortization sched-

ules (continued) . . . . 2078

A.22.2 6.4 Sinking funds . . . 2082

A.23 Supplementary Notes for the Lec-

ture of March 12th, 2004 . . . . 2083

A.23.1 6.4 Sinking funds (con-

tinued) . . . . . . . . . 2083

A.24 Supplementary Notes for the Lec-

ture of March 15th, 2004 . . . . 2086

A.24.1 6.4 Sinking funds (con-

cluded) . . . . . . . . . 2086

A.24.2 6.5 Diering payment pe-

riods and interest conver-

sion periods . . . . . . . 2089

A.24.3 6.6 Varying series of pay-

ments . . . . . . . . . . 2089

A.24.4 6.7 Amortization with

continuous payments . . 2089

A.24.5 6.8 Step-rate amounts of

principal . . . . . . . . . 2089

A.25 Supplementary Notes for the Lec-

ture of March 17th, 2004 . . . . 2090

A.25.1 7.1 Introduction . . . . 2090

A.25.2 7.2 Types of securities 2090

A.26 Supplementary Notes for the Lec-

ture of March 19th, 2004 . . . . 2093

A.26.1 7.3 Price of a bond . . 2093

A.27 Supplementary Notes for the Lec-

ture of March 22nd, 2004 . . . 2099

A.27.1 7.4 Premium and dis-

count . . . . . . . . . . 2099

A.28 Supplementary Notes for the Lec-

ture of March 24th, 2004 . . . . 2102

A.28.1 7.4 Premium and dis-

count (concluded) . . . 2102

A.29 Supplementary Notes for the Lec-

ture of March 26th, 2004 . . . . 2104

A.29.1 7.5 Valuation between

coupon payment dates . 2104

A.29.2 7.6 Determination of yield

rates . . . . . . . . . . . 2104

A.29.3 7.7 Callable bonds . . . 2104

Information for Students in MATH 329 2004 01

A.30 Supplementary Notes for the Lec-

ture of March 29th, 2004 . . . . 2105

A.30.1 7.7 Callable bonds (con-

tinued) . . . . . . . . . 2105

A.31 Supplementary Notes for the Lec-

ture of March 31st, 2004 . . . . 2107

A.31.1 7.5 Valuation between

coupon payment dates . 2107

A.31.2 7.8 Serial bonds . . . . 2108

A.31.3 7.9 Some generalizations 2108

A.31.4 7.10 Other securities . 2108

A.31.5 7.11 Valuation of secu-

rities . . . . . . . . . . . 2109

A.32 Supplementary Notes for the Lec-

ture of April 5th, 2004 . . . . . 2110

B Problem Assignments and Tests from

Previous Years 3001

B.1 2002/2003 . . . . . . . . . . . . 3001

B.1.1 First 2002/2003 Problem

Assignment, with Solu-

tions . . . . . . . . . . . 3001

B.1.2 Second 2002/2003 Prob-

lem Assignment, with So-

lutions . . . . . . . . . . 3007

B.1.3 Third 2002/2003 Prob-

lem Assignment, with So-

lutions . . . . . . . . . . 3012

B.1.4 Fourth 2002/2003 Prob-

lem Assignment, with So-

lutions . . . . . . . . . . 3019

B.1.5 Fifth 2002/2003 Problem

Assignment, with Solu-

tions . . . . . . . . . . . 3029

B.1.6 2002/2003 Class Tests, with

Solutions . . . . . . . . 3037

B.1.7 Final Examination, 2002/20033042

Information for Students in MATH 329 2004 01 1

1 General Information

Distribution Date: 0th version, Monday, January 5th, 2004

This version, Monday, January 12th, 2004

(All information is subject to change, either by announcements at lectures,

on WebCT, or in print.)

An updated version may be placed, from time to time, on the Math/Stat

website (cf. 1.4.2 below), and will also be accessible via a link from WebCT.)

The Course Outline for MATH 329 2004 01 can be considered to be pages

1 through 8 of these notes.

1.1 Instructor and Times

INSTRUCTOR: Prof. W. G. Brown

OFFICE: BURN 1224

OFFICE HRS. W 13:2014:15 h.;

(subject to F 1011 h.;

change) and by appointment

TELEPHONE: 3983836

E-MAIL: BROWN@MATH.MCGILL.CA

CLASSROOM: BURN 1B24

CLASS HOURS: MWF 14:3515:25 h.

Table 1: Instructor and Times

1.2 Course Description

1.2.1 Calendar Description

THEORY OF INTEREST. (3 credits) (Prerequisite: MATH 141.) Simple and com-

pound interest, annuities certain, amortization schedules, bonds, depreciation.

1.2.2 Syllabus (in terms of sections of the text-book)

The central part of the course consists of many of the topics in the rst nine chapters of

the textbook [1]

1

; section numbers, where shown, refer to that book. In the list below

1

[n] refers to item n in the bibliography, page 901.

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2

we show the chapters and appendices of the textbook. Following each is a description

as of the date of this revision, of the sections to be excluded. This list will be updated

during the semester, as becomes apparent that certain sections are not appropriate to

the level of the course or the lecture time available.

Chapter 1. The Measurement of Interest 1.1-1.8. Portions of 1.9, will be

omitted. For the present 1.10 will also be omitted.

Chapter 2. Solution of Problems in Interest In 2.6 You may omit the discussion

[1, pp. 45-46] of the method of equated time.

Chapter 3. Elementary Annuities You may omit [1, 3.6 Nonstandard terms and

interest rates], [1, 3.10 Annuities not involving compound interest, pp. 82-88] and corre-

sponding exercises. We will also omit [1, 3.9 Varying interest] for the present (possibly

to return).

Chapter 4. More General Annuities In the following section we shall consider the

problems strictly on an ad hoc basis: students are not expected to derive nor to apply

the identities obtained: [1, 4.2 Annuities payable at a dierent frequency than interest

is convertible; 4.3 Further analysis of annuities payable less frequently than interest is

convertible; 4.4 Further analysis of annuities payable more frequently than interest is

convertible]. Omit [1, 4.5 Continuous annuities] for the present. In [1, 4.6 Nonstandard

terms and interest rates] we shall consider the derivation of formul for (Ia)

n

, (Is)

n

,

(Da)

n

, (Ds)

n

, and their due and perpetual variants, also the question of annuities in

geometric progression. Omit [1, 4.7 More general varying annuities, 4.8 Continuous

varying annuities, 4.9 Summary of results] for the present, together with their exercises.

Chapter 5. Yield Rates Omit [1, 5.2 Discounted cash ow analysis], except for the

denition [1, p. 131] of yield rate. Omit [1, 5.3 Uniqueness of the yield rate] except you

should read and understand the example [1, p. 133] of a problem where the yield rate

is not unique. Omit [1, 5.5 5.9] and accompanying exercises; but we will study [1,

5.4 Reinvestment rates] in preparation for Chapter 6.

Chapter 6. Amortization Schedules and Sinking Funds In [1, 6.4] omit pages

178-179, where the function a

n i&j

is introduced. Omit [1, 6.5 6.8] and accompanying

exercises.

Information for Students in MATH 329 2004 01 3

Chapter 7. Bond and Other Securities Omit [1, 7.6 Determination of yield rates],

[1, 7.8 Serial bonds], [1, 7.9 Some generalizations], [1, 7.10 Other securities], [1, 7.11

Valuation of securities].

Chapter 8. Practical Applications Omit this chapter.

Chapter 9. More Advanced Financial Analysis Omit this chapter.

Chapter 10. A Stochastic Approach to Interest Omit this chapter.

Appendix I. Table of compound interest functions While most calculations will

be done using calculators, these tables may prove useful.

Appendix II. Table numbering the days of the year

Appendix III. Basic mathematical review Topics that are beyond the required

prerequisites will be explained if, as, and when they are used.

Appendix IV. Statistical background Omit this section: no background in prob-

ability is prerequisite to Math 329.

Appendix V. Iteration methods

Appendix VI. Further analysis of varying annuities Omit this Appendix, which

is concerned with the formula for Summation by Parts, analogous to integration by

parts for functions of a continuous variable.

Appendix VII. Illustrative mortgage loan amortization schedule

Appendix VIII. Full immunization Omit this Appendix, which is related to [1,

9.9], which is not in the syllabus.

Appendix IX. Derivation of the variance of an annuity Omit this Appendix.

Appendix X. Derivation of the Black-Scholes formula Omit this Appendix.

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 4

1.2.3 Verbal arguments

An essential feature of investment and insurance mathematics is the need to be able to

understand and to formulate verbal arguments; that is, explanations of the truth of

an identity presented verbally i.e., a proof in words, rather then an algebraic proof. In

a verbal argument we seek more than mathematically correctness: we wish to see an

explanation that could be presented to a layman who is not competent in the mathe-

matical bases of this subject, but is still possessed of reason, and needs to be assured

that he is not being exploited. This facet of the course will be seen, at rst, to be quite

dicult. When the skill has been mastered it can be used to verify the correctness of

statements proved mathematically. Verbal arguments require some care with the under-

lying language; students who have diculty with expression in English are reminded that

all students have the right to submit any written materials in either English or French.

2

1.3 Evaluation of Your Progress

1.3.1 Term Mark

The Term Mark will be computed one-third from the assignment grades, and two-thirds

from the class test. The Term Mark will count for 30 of the 100 marks in the nal

grade, but only if it exceeds 30% of the nal examination percentage; otherwise the nal

examination will be used exclusively in the computation of the nal grade.

1.3.2 Assignments.

A total of about 6 assignments will be worth 10 of the 30 marks assigned to Term Work.

1.3.3 Class Test

A class test, will be held on Wednesday, March 10th, 2004, at the regular class time,

counting for 20 of the 30 marks in the Term Mark. There will be no make-up test

for persons who miss the test. (This date has been changed from the tentative date

announced earlier, after discussion with the class at the lecture of Friday, February 13th,

2004.)

2

For a lexicon of actuarial terms in English/French, see The Canadian Institute of Actuaries English-

French lexicon [8], at

http://www.actuaries.ca/publications/lexicon/

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 5

1.3.4 Final Examination

Written examinations form an important part of the tradition of actuarial mathematics.

The nal examination in MATH 329 2004 01 will count for either 70% or 100% of the

numerical grade from which the submitted nal letter grade will be computed. Where

a students Final Examination percentage is superior to her Term Mark percentage, the

Final Examination grade will replace the Term Mark grade in the calculations.

A 3-hour-long nal examination will be scheduled during the regular examination

period for the winter term (April 15th, 2004 through April 30th, 2004). You are advised

not to make any travel arrangements that would prevent you from being present on

campus at any time during this period. Students who have religious or other constraints

that could aect their ability to write examinations at particular times should watch for

the Preliminary Examination Timetable, as their rights to apply for special consideration

at their faculty may have expired by the time the nal examination timetable is published.

1.3.5 Supplemental Assessments

Supplemental Examination. For eligible students who obtain a Final Grade of F

or D in the course there will be a supplemental examination. (For information about

Supplemental Examinations, see the McGill Calendar, [3].)

There is No Additional Work Option. Will students with marks of D, F, or J

have the option of doing additional work to upgrade their mark? No. (Additional

Work refers to an option available in certain Arts and Science courses, but not available

in this course.)

1.3.6 Machine Scoring

Will the nal examination be machine scored? While there could be Multiple Choice

questions on quizzes, and/or the Final Examination, such questions will not be machine

scored.

1.3.7 Plagiarism

While students are not discouraged from discussing assignment problems with their col-

leagues, the work that you submit whether through homework, the class test, or on

tutorial quizzes or the nal examination should be your own. The Handbook on Student

Rights and Responsibilities states in 15(a)

3

that

3

http://ww2.mcgill.ca/students-handbook/chapter3secA.html

Information for Students in MATH 329 2004 01 6

No student shall, with intent to deceive, represent the work of another person

as his or her own in any academic writing, essay, thesis, research report,

project or assignment submitted in a course or program of study or represent

as his or her own an entire essay or work of another, whether the material so

represented constitutes a part or the entirety of the work submitted.

You are also referred to the following URL:

http://www.mcgill.ca/integrity/studentguide/

1.4 Published Materials

1.4.1 Required Text-Book

The textbook for the course this semester is [1] Stephen G. Kellison, The Theory of

Interest, Second Edition. Irwin/McGraw-Hill, Boston, etc. (1991), ISBN 0-256-09150-1.

1.4.2 Website

These notes, and other materials distributed to students in this course, will be accessible

at the following URL:

http://www.math.mcgill.ca/brown/math329b.html

The notes will be in pdf (.pdf) form, and can be read using the Adobe Acrobat reader,

which many users have on their computers. This free software may be downloaded from

the following URL:

http://www.adobe.com/prodindex/acrobat/readstep.html

4

Where revisions are made to distributed printed materials for example these informa-

tion sheets it is expected that the last version will be posted on the Web.

The notes will also be available via a link from the WebCT URL:

http://webct.mcgill.ca

but not all features of WebCT will be implemented.

1.4.3 Reference Books

The textbook used for 2001-2003 may be used as a reference: [5] Michael M. Parmen-

tier, Theory of Interest and Life Contingencies, with Pension Applications: A Problem-

Solving Approach, 3rd edition. ACTEX Publications, Winstead, Conn. (1999), ISBN

0-56698-333-9.

4

At the time of this writing the current version is 5.1.

Information for Students in MATH 329 2004 01 7

1.5 Other information

1.5.1 Prerequisites

It is your responsibility as a student to verify that you have the necessary calculus

prerequisites. It would be foolish to attempt to take the course without them.

1.5.2 Calculators

The use of non-programmable, non-graphing calculators only will be permitted in home-

work, tests, or the nal examination in this course. Students may be required to convince

examiners and invigilators that all memories have been cleared. The use of calculators

that are either graphing or programmable will not be permitted during test or examina-

tions, in order to level the playing eld.

1.5.3 Self-Supervision

This is not a high-school course, and McGill is not a high school. The monitoring of

your progress before the nal examination is largely your own responsibility. While the

instructor is available to help you, he cannot do so unless and until you identify the

need for help. While the signicance of the homework assignments and class test in the

computation of your grade is minimal, these are important learning experiences, and

can assist you in gauging your progress in the course. This is not a course that can

be crammed for: you must work steadily through the term if you wish to develop the

facilities needed for a strong performance on the nal examination.

Working Problems on Your Own. You are advised to work large numbers of prob-

lems from your textbook. The skills you acquire in solving textbook problems could have

much more inuence on your nal grade than either the homework or the class test.

1.5.4 Escape Routes

At any time, even after the last date for dropping the course, students who are experi-

encing medical or personal diculties should not hesitate to consult their advisors or the

Student Aairs oce of their faculty. Dont allow yourself to be overwhelmed by such

problems; the University has resource persons who may be able to help you.

1.5.5 Showing your work; good mathematical form; simplifying answers

When, in a quiz or examination problem, you are explicitly instructed to show all your

work, failure to do so could result in a substantial loss of marks possibly even all

of the marks; this is the default. The guiding principle should be that you want to be

Information for Students in MATH 329 2004 01 8

able to communicate your precise reasoning to others and to yourself. You are always

expected to simplify any algebraic or numerical expressions that arise in your solutions

or calculations. Verbal proofs are expected to be convincing: it will not be sucient

to simply describe mathematical expressions verbally.

Information for Students in MATH 329 2004 01 9

2 Timetable

Distribution Date: 0th version: Monday, January 5th, 2004

This version, Monday, January 12th, 2004

(Subject to correction and change.)

Section numbers refer to the text-book.

5

MONDAY WEDNESDAY FRIDAY

JANUARY

05 1.1 1.8 07 1.1 1.8 09 1.1 1.8

12 Problems from 1.1

1.8

14 1.9-1.10, prob-

lems

16 Chapter 2

Course changes must be completed on MINERVA by Jan. 18, 2004

19 Chapter 2 21 Chapter 2 23 3.1, 3.2

Deadline for withdrawal with fee refund = Jan. 25, 2004

26 3.2, 3.3

1

_ 28 3.3 30 3.4

FEBRUARY

Verication Period: February 26, 2004

02 3.4 04 3.5 06 3.7

Deadline for withdrawal (with W) from course via MINERVA = Feb. 15, 2004

09 3.7, 3.8

2

_ 11 3.8 13 4.1-4.4

16 4.3, 4.4 18 4.6 20 4.6, 5.4

Study Break: February 2327, 2004

No lectures, no regular oce hours

23 NO LECTURE 25 NO LECTURE 27 NO LECTURE

(Page 10 of the timetable will not be circulated; however, a version is available in the

online version of these notes.)

5

Notation:

n

_ = Assignment #n due today

R

_ = Read Only

X = reserved for eXpansion or review

Information for Students in MATH 329 2004 01 10

MONDAY WEDNESDAY FRIDAY

MARCH

01 5.3, 5.4

3

_ 03 Chapter 6 05 Chapter 6

08 Chapter 6 10 CLASS TEST 12 Chapter

15 Chapter 17 Chapter

4

_ 19 Chapter

22 Chapter 24 Chapter 26 Chapter

29 Chapter 31 Chapter

5

_

APRIL

02 Chapter

05 Chapter 07 09 NO LECTURE

12 NO LECTURE 13 (TUESDAY)

Information for Students in MATH 329 2004 01 11

3 First Problem Assignment

Distribution Date: Thursday, January 15th, 2005 (mounted on the Web)

Hard copy distributed on Monday, January 19th, 2004

Solutions are to be submitted by Monday, January 26th, 2004

(This is a short assignment. Subsequent assignments can be expected to be

longer.)

1. It is known that the accumulation function a(t) is of the form b (1.1)

t

+ct

2

, where

b and c are constants to be determined.

(a) If $100 invested at time t = 0 accumulates to $170 at time t = 3, nd the

accumulated value at time t = 12 of $100 invested at time t = 1.

(b) Show that this function satises the requirement [1, p. 2, #2] that it be non-

decreasing.

(c) Determine a general formula for i

n

, and show that lim

n

i

n

= 10%. (Use

LHopitals Rule.)

2. It is known that 1000 invested for 4 years will earn 250.61 in interest, i.e., that the

value of the fund after 4 years will be 1250.61. Determine the accumulated value

of 3500 invested at the same rate of compound interest for 13 years.

3. It is known that an investment of 750 will increase to 2097.75 at the end of 25

years. Find the sum of the present values of payments of 5000 each which will

occur at the ends of 10, 15, and 25 years.

4. Find the accumulated value of 1000 at the end of 10 years:

(a) if the nominal annual rate of interest is 6% convertible monthly;

(b) if the nominal annual rate of discount is 5% convertible every 2 years.

5. Given that i

(m)

=

5

6

6

2 and d

(m)

= 2 8

compound interest rate, and the equivalent annual compound discount rate.

Information for Students in MATH 329 2004 01 12

4 Second Problem Assignment

Distribution Date: Mounted on the Web on Sunday, January 18th, 2004

Distributed in hard copy on Wednesday, January 28th, 2004

Solutions are to be submitted by Monday, February 9th, 2004

1. Find the present value of 1000, to be paid at the end of 37 months under each of

the following scenarios:

(a) Assume compound interest throughout, and a (nominal) rate of discount of

6% payable quarterly.

(b) Assume compound interest for whole years only at a (nominal) rate of discount

of 6% payable quarterly, and simple discount at the rate of 1.5% per 3 months

during the nal fractional period.

(c) Assume compound interest throughout, and a nominal rate of interest of 8%

payable semi-annually.

2. The sum of 5,000 is invested for the months of April, May, and June at 7% simple

interest. Find the amount of interest earned

(a) assuming exact simple interest in a non-leap year

(b) assuming exact simple interest in a leap year (with 366 days);

(c) assuming ordinary simple interest;

(d) assuming the Bankers Rule.

3. Find how long 4,000 should be left to accumulate at 5% eective in order that it

will amount to 1.25 times the accumulated value of another 4,000 deposited at the

same time at a nominal interest rate of 4% compounded quarterly.

4. The present value of two payments of 100 each, to be made at the end of n years

and 2n years is 63.57. If i = 6.25%, nd n.

5. (a) Find the nominal rate of interest convertible quarterly at which the accumu-

lated value of 1000 at the end of 12 years is 3000.

(b) Find the nominal rate of discount convertible semi-annually at which a pay-

ment of 3000 12 years from now is presently worth 1000.

(c) Find the eective annual rate of interest at which the accumulated value of

1000 at the end of 12 years is 3000.

Information for Students in MATH 329 2004 01 13

6. An investor deposits 20,000 in a bank. During the rst 4 years the bank credits an

annual eective rate of interest of i. During the next 4 years the bank credits an

annual eective rate of interest of i 0.02. At the end of 8 years the balance in the

account is 22,081.10. What would the account balance have been at the end of 10

years if the annual eective rate of interest were i + 0.01 for each of the 10 years?

7. A bill for 1000 is purchased for 950 4 months before it is due. Find

(a) the nominal rate of discount convertible monthly earned by the purchaser;

(b) the annual eective rate of interest earned by the purchaser.

8. A signs a 2-year note for 4000, and receives 3168.40 from the bank. At the end

of 6 months, a year, and 18 months A makes a payment of 1000. If interest is

compounded semi-annually, what is the amount outstanding on the note at the

time if falls due?

9. The Intermediate Value Theorem for continuous functions tells us that such a

function f(x) whose value at x = a has the opposite sign from its value at x = b

will assume the value 0 somewhere between a and b. By computing the value of

f at the point

1

2

(a + b), we can infer that there is a 0 of f in an interval half as

long as [a, b], and this procedure may be repeated indenitely to determine a zero

of f to any desired accuracy. Assuming that polynomials are continuous, use this

idea to determine the nominal quarterly compound interest rate under which the

following payments will accumulate to 1000 at the end of 4 years:

300 today

200 at the end of 1 year

300 at the end of 2 years

Your answer should be accurate to 3 decimal places, i.e., expressed as a percentage

to 1 decimal place.

Information for Students in MATH 329 2004 01 14

5 Solutions, First Problem Assignment

Distribution Date: Mounted on the Web on Wednesday, 4 February, 2004

Assignment was mounted on the Web on Thursday, January 15th, 2005

Hard copy was distributed on Monday, January 19th, 2004

Solutions were to be submitted by Monday, January 26th, 2004

(This is a short assignment. Subsequent assignments can be expected to be

longer.)

1. It is known that the accumulation function a(t) is of the form b (1.1)

t

+ct

2

, where

b and c are constants to be determined.

(a) If $100 invested at time t = 0 accumulates to $170 at time t = 3, nd the

accumulated value at time t = 12 of $100 invested at time t = 1.

(b) Show that this function satises the requirement [1, p. 2, #2] that it be non-

decreasing.

(c) Determine a general formula for i

n

, and show that lim

n

i

n

= 10%. (Use

LHopitals Rule.)

Solution: [1, Exercise 4, p. 30] Denote the corresponding amount function by A(t).

(a) An accumulation function must have the property that a(0) = 1; this implies

that 1 = a(0) = b + 0, so b = 1.

The given data imply that

170 = 100(a(3)) = 100(1(1.331) + c 3

2

) (1)

which implies that c = 0.041. We conclude that

A(t)

A(0)

= a(t) = (1.1)

t

+ 0.041t

2

, (2)

implying that a(1) = 1.141, a(12) = 9.042428377. Then

A(12) = A(1)

A(12)

A(1)

= A(1)

a(12)

a(1)

= A(1)

9.042428377

1.141

= A(1)(7.925002959) = 792.5002959

so $100 at time t = 1 grows to $792.50 at time t = 12.

Information for Students in MATH 329 2004 01 15

(b) It follows from (2) that a

(t) = (1.1)

t

ln 1.1 + 0.082t, which is positive for

positive t; thus a(t) is an increasing function of t for positive t.

(This property may also be proved from rst principles. Let t

1

t

2

. Then

a(t

2

) a(t

1

) = (1.1)

t

2

+ 0.041t

2

2

(1.1)

t

1

+ 0.041t

2

1

= (1.1)

t

1

_

(1.1)

t

2

t

1

1

_

+ (0.041) (t

2

t

1

) (t

2

+ t

1

)

where both of the summands are non-negative for 0 t

1

t

1

.

(c)

i

n

=

a(n) a(n 1)

a(n 1)

=

(0.1)(1.1)

n1

+ (0.041)(2n 1)

(1.1)

n1

(0.041)(n 1)

2

=

0.1 + 0.041

_

2n1

(1.1)

n1

_

1 0.041

_

(n1)

2

(1.1)

n1

_

By LHopitals Rule

lim

x

2x 1

(1.1)

x1

= lim

x

2

(1.1)

x1

ln 1.1

= 0

lim

x

(n 1)

2

(1.1)

n1

= lim

x

2(x 1)

(1.1)

x1

ln 1.1

= lim

x

2

(1.1)

x1

(ln 1.1)

2

= 0

Hence

lim

n

i

n

=

0.1 + 0.041 (0)

1 0.041 (0)

= 0.1 = 10%.

2. It is known that 1000 invested for 4 years will earn 250.61 in interest, i.e., that the

value of the fund after 4 years will be 1250.61. Determine the accumulated value

of 3500 invested at the same rate of compound interest for 13 years.

Solution: [1, Exercise 14, p. 30] Let i be the rate of compound interest. Then

1000(1 + i)

4

= 1250.61. The accumulated value of 3500 after 13 years will be

3500(1 + i)

13

= 3500

_

1250.61

1000

_13

4

= 7239.57 .

3. It is known that an investment of 750 will increase to 2097.75 at the end of 25

years. Find the sum of the present values of payments of 5000 each which will

occur at the ends of 10, 15, and 25 years.

Information for Students in MATH 329 2004 01 16

Solution: [1, Exercise 21, p. 31] Let i be the interest rate. The known fact is that

750(1+i)

25

= 2097.75. Hence (1+i)

25

= 2.797 , so v

25

= 0.357535924. The present

value of three payments of 5000 after 10, 15, and 25 years will, therefore, be

5000(v

10

+ v

15

+ v

25

)

= 5000

_

(0.357535924)

10

25

+ (0.357535924)

15

25

+ (0.357535924)

25

25

_

= 5000(0.662709221 + 0.539500449 + 0.357535924)

= 7798.73.

4. Find the accumulated value of 1000 at the end of 10 years:

(a) if the nominal annual rate of interest is 6% convertible monthly;

(b) if the nominal annual rate of discount is 5% convertible every 2 years.

Solution: [1, Exercise 32, p. 31]

(a) The accumulation factor for each month is 1 +

6%

12

= 1.005. After 10 years

1000 grows to

1000(1.005)

1012

= 1819.40.

(b) The discount factor for each 2 years is 125% = 0.09 (moving backwards),

corresponding to an accumulation factor of

1

0.9

. After 10 years 1000 grows to

1000(0.09)

10

2

= 1693.51 .

5. Given that i

(m)

=

5

6

6

2 and d

(m)

= 2 8

compound interest rate, and the equivalent annual compound discount rate.

Solution: [1, Exercise 30, p. 32] For an mth of a year the relationship between i

(m)

and d

(m)

is given by

_

1 +

i

(m)

m

__

1

d

(m)

m

_

= 1

which is equivalent to

(m+ i

(m)

)(md

(m)

) = m

2

or

m =

i

(m)

d

(m)

i

(m)

d

(m)

.

Substituting the given values

i

(m)

= 0.041241452

d

(m)

= 0.040408205

Information for Students in MATH 329 2004 01 17

gives m = 2. It follows that

i =

_

1 +

i

(2)

2

_

2

1

= (1.020620726)

2

1 = 4.1666667% = 4

1

6

% =

1

24

d = 1

_

1

d

(2)

2

_

2

= 1 0.96 = 4% =

1

25

Information for Students in MATH 329 2004 01 18

6 Third Problem Assignment

Distribution Date: Mounted on the Web on Sunday, February 8th, 2004

Hard copy was distributed on Wednesday, February 11th, 2004

Solutions are to be submitted by Monday, March 1st, 2004

Sketch a time diagram to accompany your solution of all problems except the last.

1. A skier wishes to accumulate 30,000 in a chalet purchase fund fund by the end of

8 years. If she deposits 200 into the fund at the end of each month for the rst 4

years, and 200 + X at the end of each month for the next 4 years, nd X if the

fund earns a nominal (annual) rate of 6% compounded monthly.

2. A fund of 2500 is to be accumulated by n annual payments of 50, followed by n+1

annual payments of 75, plus a smaller nal payment of not more than 75 made 1

year after the last regular payment. If the eective annual rate of interest is 5%,

nd n and the amount of the nal irregular payment.

3. On his 30th birthday, a teacher begins to accumulate a fund for early retirement

by depositing 5,000 on that day and at the beginnings of the next 24 years as

well. Since he expects that his ocial pension will begin at age 65, he plans that,

starting at age 55 he will make an annual level withdrawal at the beginning of each

of 10 years. Assuming that all payments are certain to be made, nd the amount

of these annual withdrawals, if the eective rate of interest is 6% during the rst

25 years, and 7% thereafter.

4. At an eective annual interest rate of i it is known that

(a) The present value of 5 at the end of each year for 2n years, plus an additional

3 at the end of each of the rst n years, is 64.6720.

(b) The present value of an n-year deferred annuity-immediate paying 10 per year

for n years is 34.2642.

Find i.

5. (a) Find a

12

if the eective rate of discount is 5%.

(b) Charles has inherited an annuity-due on which there remain 12 payments of

10,000 per year at an eective discount rate of 5%; the rst payment is due

immediately. He wishes to convert this to a 25-year annuity-immediate at the

same eective rates of interest or discount, with rst payment due one year

from now. What will be the size of the payments under the new annuity?

Information for Students in MATH 329 2004 01 19

6. Give an algebraic proof and a verbal explanation for the formula

m

[a

n

= a

a

m

v

m+n

a

.

7. A level perpetuity-immediate is to be shared by A, B, C, and D. A receives the

rst n payments, B the next 2n payments, C payments ##3n + 1, . . . 5n, and D

the payments thereafter. It is known that the present values of Bs and Ds shares

are equal. Find the ratio of the present value of the shares of A, B, C, D.

8. (a) Find an the present value of an annuity which pays 4,000 at the beginning of

each 3-month period for 12 years, assuming an eective rate of 2% interest

per 4-month period.

(b) Suppose that the owner of the annuity wishes to pay now so that payments

under his annuity will continue for an additional 10 years. How much should

he pay?

(c) How much should he pay now to extend the annuity from the present 12 years

to a perpetuity?

(It is intended that you solve this problem from rst principles, not by substitu-

tion into formul in [1, Chapter 4].)

9. (No time diagram is needed for the solution to this problem.) In Problem 9 of

Assignment 2 you were asked to apply the Bisection Method to determine the

solution to an interest problem to 3 decimal places. The equation in question was:

300(1 + i)

4

+ 200(1 + i)

3

+ 300(1 + i)

2

= 1000 .

and the solution given began with the values of

f(x) = 3x

4

+ 2x

3

+ 3x

2

10 .

at x = 0 (f(0) = 10), x = 2 (f(2) = 66 > 0), and x = 2 (f(2) = 34 >

0), and we were interested in the solution between 0 and 2 a solution that

is unique because f

times in an attempt to determine the solution we seek. (You are not expected

to know the general theory of error estimation.) The intention is that you apply

linear interpolation unintelligently, using it to determine a point where you nd the

function value and thereby conne the zero to a smaller subinterval: the point that

you nd will replace the midpoint in the bisection method. In some situations, as

in the present one, the procedure may not be better than the bisection method.

Indeed, in the present example, it could take many more applications than the

bisection method to obtain the accuracy you obtained with that method.

Information for Students in MATH 329 2004 01 20

7 Solutions, Second Problem Assignment

Distribution Date: Mounted on the Web on Friday, February 20th, 2004

Assignment was mounted on the Web on January 19th, 2004.

Hard copy was distributed on Wednesday, January 28th, 2004

Solutions were due by Monday, February 9th, 2004

(Solutions presented subject to correction of errors and omissions.)

1. Find the present value of 1000, to be paid at the end of 37 months under each of

the following scenarios:

(a) Assume compound interest throughout, and a (nominal) rate of discount of

6% payable quarterly.

(b) Assume compound interest for whole years only at a (nominal) rate of discount

of 6% payable quarterly, and simple discount at the rate of 1.5% per 3 months

during the nal fractional period.

(c) Assume compound interest throughout, and a nominal rate of interest of 8%

payable semi-annually.

Solution: (cf. [1, Exercise 2, p. 53])

(a) Present value = 1000

_

1

0.06

4

_37

3

= 829.94.

(b) Present value = 1000

_

1

0.06

4

_36

3

_

1

0.015

3

_

= 10000.8728230.9995 =

829.96.

(c) Present value = (1.04)

37

6

= 1000 0.785165257 = 785.17.

2. The sum of 5,000 is invested for the months of April, May, and June at 7% simple

interest. Find the amount of interest earned

(a) assuming exact simple interest in a non-leap year

(b) assuming exact simple interest in a leap year (with 366 days);

(c) assuming ordinary simple interest;

(d) assuming the Bankers Rule.

Solution: (cf. [1, Exercise 6, p. 54])

(a) The number of days is 30 + 31 + 30 = 91; exact simple interest is

91

365

5000

(0.07) = 87.26.

Information for Students in MATH 329 2004 01 21

(b) Exact simple interest is

91

366

5000 (0.07) = 87.02

(c) Ordinary simple interest is

30+30+30

360

5000 (0.07) = 87.50

(d) Interest under the Bankers Rule is

91

360

5000 (0.07) = 88.47.

3. Find how long 4,000 should be left to accumulate at 5% eective in order that it

will amount to 1.25 times the accumulated value of another 4,000 deposited at the

same time at a nominal interest rate of 4% compounded quarterly.

Solution: (cf. [1, Exercise 13, p. 55]) The equation of value at n years is

4000(1.05)

n

= (1.25)(4000)(1.01)

4n

so

n =

ln 1.25

ln 105 4 ln 101

= 24.82450822 .

4. The present value of two payments of 100 each, to be made at the end of n years

and 2n years is 63.57. If i = 6.25%, nd n.

Solution: (cf. [1, Exercise 14, p. 55]) Solving the equation of value, 100v

2n

+100v

n

=

63.57, we obtain

v

n

=

1

3.5428

2

,

in which only the + sign is acceptable, since v

n

> 0. Taking logarithms gives

n =

0.818446587

ln 1.0625

= 13.50023411.

We conclude, to the precision of the problem, that n = 13.5 years.

5. (a) Find the nominal rate of interest convertible quarterly at which the accumu-

lated value of 1000 at the end of 12 years is 3000.

(b) Find the nominal rate of discount convertible semi-annually at which a pay-

ment of 3000 12 years from now is presently worth 1000.

(c) Find the eective annual rate of interest at which the accumulated value of

1000 at the end of 12 years is 3000.

Solution:

(a) (cf. [1, Exercise 19, p. 55]) The equation of value at time t = 12 is

1000

_

1 +

i

(4)

4

_

412

= 3000 ,

implying that

i

(4)

= 4

_

3

1

48

1

_

= 9.260676%.

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 22

(b) The equation of value at time t = 12 is

3000

_

1

d

(2)

2

_

212

= 1000 ,

implying that

d

(2)

= 2

_

1 3

1

24

_

= 9.3678763%.

(c) The equation of value at time t = 12 is

1000 (1 + i)

12

= 3000 ,

implying that

i = 3

1

12

1 = 9.5872691%.

6. An investor deposits 20,000 in a bank. During the rst 4 years the bank credits an

annual eective rate of interest of i. During the next 4 years the bank credits an

annual eective rate of interest of i 0.02. At the end of 8 years the balance in the

account is 22,081.10. What would the account balance have been at the end of 10

years if the annual eective rate of interest were i + 0.01 for each of the 10 years?

Solution: (cf. [1, Exercise 32, p. 57]) The equation of value is

20000(1 + i)

4

(1 + (i 0.02))

4

= 22081.10 ,

which we interpret as a polynomial equation. The equation is of degree 8, and we

dont have a simple algebraic method for solving such equations in general. But

this equation has the left side a pure 4th power, so we can extract the 4th roots of

both sides, obtaining

(1 + i)(1 + (i 0.02)) = (1.104055)

1

4

= 1.025056201 ,

which may be expressed as a quadratic equation in 1 + i:

(1 + i)

2

0.02(1 + i) 1.025056 = 0

whose only positive solution is

1 + i =

0.02 +

_

(0.02)

2

+ 4(1.025056)

2

= 1.0225

from which we conclude that i = 2.25%, and that the account balance after 10

years would be 20000(1.0225 + 0.01)

10

= 20000(1.0325)

10

= 27, 737.89.

Information for Students in MATH 329 2004 01 23

7. A bill for 1000 is purchased for 950 4 months before it is due. Find

(a) the nominal rate of discount convertible monthly earned by the purchaser;

(b) the annual eective rate of interest earned by the purchaser.

Solution: (cf. [1, Exercise 25, p. 56])

(a) If d

(12)

be the nominal discount rate, then

1000

_

1

d

(12)

12

_

4

= 950

implying that

1

d

(12)

12

= 0.9872585

so d

(12)

= 15.29%.

(b) Let i be the eective annual interest rate. Then

950(1 + i)

1

3

= 1000

implies that

i =

_

1000

950

_

3

1 = 16.635%.

8. A signs a 2-year note for 4000, and receives 3168.40 from the bank. At the end

of 6 months, a year, and 18 months A makes a payment of 1000. If interest is

compounded semi-annually, what is the amount outstanding on the note at the

time if falls due?

Solution: If i

3168.40(1 + i

)

4

= 4000

so i

= 6.00%; that is i

(2)

= 12.00%. The value of the 3 payments at the time the

note matures is

1000

_

(1.06)

3

+ (1.06)

2

+ (1.06)

1

_

= 3374.62

so the amount outstanding before the nal payment is 625.38.

Information for Students in MATH 329 2004 01 24

9. The Intermediate Value Theorem for continuous functions tells us that such a

function f(x) whose value at x = a has the opposite sign from its value at x = b

will assume the value 0 somewhere between a and b. By computing the value of

f at the point

1

2

(a + b), we can infer that there is a 0 of f in an interval half as

long as [a, b], and this procedure may be repeated indenitely to determine a zero

of f to any desired accuracy. Assuming that polynomials are continuous, use this

idea to determine the nominal quarterly compound interest rate under which the

following payments will accumulate to 1000 at the end of 4 years:

300 today

200 at the end of 1 year

300 at the end of 2 years

Your answer should be accurate to 3 decimal places, i.e., expressed as a percentage

to 1 decimal place.

Solution: (We will carry the computations to an accuracy greater than requested

in the problem.)

(a) Let the eective annual interest rate be i. The equation of value at the end

of 4 years is

300(1 + i)

4

+ 200(1 + i)

3

+ 300(1 + i)

2

= 1000 . (3)

(b) We need a continuous function to which to apply the Intermediate Value

Theorem. Some choices may be better than others. We will choose

f(x) = 3x

4

+ 2x

3

+ 3x

2

10 .

We observe that f(0) = 10, that f(2) = 48+16+1210 = 66 > 0, and that

f(2) = 48 16 + 12 10 = 34 > 0. This tells us that there is a solution to

equation (3) for 2 x 0, equivalently for 3 i 1: such a solution is

of no interest to us, as it does not t the constraints of this problem. But the

function is a cubic polynomial, and has 2 other zeros. We see that it also has

a solution in the interval 0 x 2, and we proceed to progressively halve

intervals.

(c) The midpoint of interval [0, 2] is 1;

f(1) = 3 + 2 + 3 10 = 2 < 0 < 66 = f(2) ,

so there must be a root in the interval [1, 2].

Information for Students in MATH 329 2004 01 25

(d) The midpoint of [1, 2] is 1.5;

f(1.5) = 3(1.5)

4

+ 2(1.5)

3

+ 3(1.5)

2

10

= 15.1875 + 6.75 + 6.75 10 = 18.6875

> 0

so there must be a zero in the interval [1, 1.5], whose midpoint is 1.25.

(e)

f(1.25) = 3(1.25)

4

+ 2(1.25)

3

+ 3(1.25)

2

10

= 7.3242 + 3.9063 + 4.6875 10 = 5.918

> 0

so there must be a zero in the interval [1, 1.25], whose midpoint is 1.125.

(f)

f(1.125) = 3(1.125)

4

+ 2(1.125)

3

+ 3(1.125)

2

10

= 4.8054 + 2.8477 + 3.7969 10 = 1.45

> 0

so there must be a zero in the interval [1, 1.125], whose midpoint is 1.0625.

(g)

f(1.0625) = 3(1.0625)

4

+ 2(1.0625)

3

+ 3(1.0625)

2

10

= 3.8233 + 2.3989 + 3.3867 10 = 0.3911

< 0

so there must be a zero in the interval [1.0625, 1.125], whose midpoint is

1.09375.

(h)

f(1.09375) = 3(1.09375)

4

+ 2(1.09375)

3

+ 3(1.09375)

2

10

= 4.2933 + 2.6169 + 3.5889 10 = 0.4991

> 0

so there must be a zero in the interval [1.0625, 1.09375], whose midpoint is

1.078125.

Information for Students in MATH 329 2004 01 26

(i)

f(1.078125) = 3(1.078125)

4

+ 2(1.078125)

3

+ 3(1.078125)

2

10

= 4.053197 + 2.506325 + 3.487061 10 = 0.046582

> 0

so there must be a zero in the interval [1.0625, 1.078125], whose midpoint is

1.0703125.

(j)

f(1.0703125) = 3(1.0703125)

4

+ 2(1.0703125)

3

+ 3(1.0703125)

2

10

= 3.936984 + 2.452233 + 3.436707 10 = 0.174076

< 0

so there must be a zero in the interval [1.0703125, 1.078125], whose midpoint

is 1.07421875.

(k) f(1.07421875) = .064207958 < 0 so there must be a zero in the interval

[1.07421875, 1.078125], whose midpoint is 1.076172.

(l) f(1.076172) = .008925 < 0 so there must be a zero in the interval

[1.076172, 1.078125], whose midpoint is 1.077149.

(m) f(1.077149) = .018814 > 0 so there must be a zero in the interval

[1.076172, 1.077149], whose midpoint is 1.076661.

(n) f(1.076661) = .004952 > 0 so there must be a zero in the interval

[1.076172, 1.076661], whose midpoint is 1.076417.

(o) f(1.076417) = .001974 < 0 so there must be a zero in the interval

[1.076417, 1.076661], whose midpoint is 1.076539.

(p) f(1.076539) = .001488 > 0 so there must be a zero in the interval

[1.076417, 1.076539], whose midpoint is 1.076478.

(q) f(1.076478) = .000243 < 0 so there must be a zero in the interval

[1.076478, 1.076539], whose midpoint is 1.076509.

(r) f(1.076509) = .000637 > 0 so there must be a zero in the interval

[1.076478, 1.076509], whose midpoint is 1.076494.

(s) f(1.076494) = .000211 > 0 so there must be a zero in the interval

[1.076478, 1.076494], whose midpoint is 1.076486.

(t) f(1.076486) = .000016 > 0 so there must be a zero in the interval

[1.076486, 1.076494], whose midpoint is 1.07649.

Information for Students in MATH 329 2004 01 27

(u) f(1.07649) = .000097 > 0 so there must be a zero in the interval

[1.076486, 1.07649], whose midpoint is 1.076488.

(v) f(1.076488) = .000041 > 0 so there must be a zero in the interval

[1.076486, 1.076488], whose midpoint is 1.076487.

(w) f(1.076487) = .000012. One zero will be approximately x = 1.07649. Thus

the eective annual interest rate is approximately 7.649%. This, however, is

not what the problem asked for. The accumulation function for 3-months will

then be (1.0749)

1

4

= 1.01822, so the eective interest rate for a 3-month period

will be 1.822%, and the nominal annual interest rate, compounded quarterly,

will be 7.288, or 7.3% to the accuracy requested.

THE FOLLOWING PROBLEM WAS CONSIDERED FOR INCLUSION IN THE AS-

SIGNMENT, BUT WAS (FORTUNATELY) NOT INCLUDED.

10. [1, Exercise 6, p. 88]

(a) Show that

a

mn

= a

m

v

m

s

n

= (1 + i)

n

a

m

s

n

where 0 < n < m.

(b) Show that

s

mn

= s

m

(1 + i)

m

a

n

= v

n

s

m

a

n

where 0 < n < m.

(c) Interpret the results in (a) and (b) verbally.

Solution:

(a) We prove the rst of these identities by technical substitutions in sums, anal-

ogous to changes of variables in a denite integral. For the second identity we

give a less formal proof.

a

mn

=

mn

r=1

v

r

=

m

r=1

v

r

r=mn+1

v

r

=

m

r=1

v

r

v

m

m

r=mn+1

v

rm

=

m

r=1

v

r

v

m

1

s=n

v

1s

Information for Students in MATH 329 2004 01 28

under the change of variable s = mr + 1

=

m

r=1

v

r

v

m

n

s=1

v

1s

reversing the order of the 2nd summation

=

m

r=1

v

r

v

m

n

s=1

(1 + i)

s1

= a

m

v

m

s

n

a

mn

= v + v

2

+. . . +v

mn

= v

n+1

+ v

n+2

+ . . . + v

0

+ v

1

+ v

2

+ . . . + v

mn

_

v

n+1

+ v

n+2

+ . . . + v

0

_

= v

n

_

v

1

+ v

2

+ . . . + v

n

+ v

n+1

+ v

n+2

+ . . . + v

m

_

_

(1 + i)

n1

+ (1 + i)

n2

+ . . . + (1 + i)v

0

_

= (1 + i)

n

_

v

1

+ v

2

+ . . . + v

n

+v

n+1

+ v

n+2

+ . . . + v

m

_

_

(1 + i)

0

+ (1 + i)

1

+ . . . + (1 + i)v

n1

_

= (1 + i)

n

a

m

s

n

(b) These identities could be proved in similar ways to those used above. Instead,

we shall show that these identities can be obtained from the preceding simply

by multiplying the equations by (1 + i)

mn

:

s

mn

= (1 + i)

mn

a

mn

[1, (3.5), p. 60]

= (1 + i)

mn

((1 + i)

n

a

m

s

n

)

= (1 + i)

m

a

m

(1 + i)

m

(1 + i)

n

s

n

= s

m

(1 +i)

m

a

n

s

mn

= (1 + i)

mn

a

mn

= (1 + i)

mn

(a

m

v

m

s

n

)

= (1 + i)

n

(1 + i)

m

a

m

(1 + i)

n

s

n

= (1 + i)

n

s

m

a

n

(c) i. An (mn)-payment annuity-immediate of 1 has the same present value

as an annuity for a total term of m = (mn) + n years minus a correc-

tion paid today equal to the value of the deferred n payments. Those n

payments are worth s

m

at time t = m, which amount can be discounted

to the present by multiplying by v

m

.

The preceding explanation was based on values at the commencement of

the rst year of an m-year annuity-immediate. Let us now interpret the

Information for Students in MATH 329 2004 01 29

mn payments as being the last payments of an m-year annuity whose

mth payment has just been made. That m-payment annuity was worth

a

m

, n years ago a year before its rst payment; today it is worth

(1 + i)

n

a

n

, including the payments we attached at the beginning. Those

payments are worth s

n

today, for a net value as claimed.

ii. Consider an value of the rst mn payments of an m-payment annuity-

immediate of 1, just after the (m n)th payment. Since these could be

considered simply the accumulated value of an (mn)-payment annuity,

they are worth s

mn

. But the payments of the m-payment annuity not

yet made are worth a

n

, and the entire annuity is worth s

m

at termination,

hence v

n

s

m

today; hence v

m

s

m

a

n

is also the value today. This gives

the equality between the extreme members of the alleged inequality.

Now lets evaluate the same mn payments, but this time consider them

to be the last m n payments of an m-payment annuity-certain; again,

the m nth payment has just been made. From rst principles, the

accumulated value of the payments actually received is s

mn

, and we are

viewing them from the context of an annuity-certain of m payments that

would be worth s

m

today: lets determine the amount that would have

to be paid out today to correct for that expanded annuity. The value of

the n payments we have tacked on in the past was a

n

one year before

the payments began, and (1 +i)

m

s

n

today; so we can also view the value

today as s

m

(1 + i)

m

a

n

.

Information for Students in MATH 329 2004 01 30

8 Solutions, Third Problem Assignment

Distribution Date: Mounted on the Web on Wednesday, March 3rd, 2004.

Assignment was mounted on the Web on February 8th, 2004,

hard copy of assignment was distributed on Wednesday, February 11th, 2004.

Solutions were to be submitted by 9 a.m., Monday, March 3rd, 2004

SUBJECT TO CORRECTION OF TYPOS AND OTHER ERRORS

Sketch a time diagram to accompany your solution of all problems except the last.

1. A skier wishes to accumulate 30,000 in a chalet purchase fund by the end of 8

years. If she deposits 200 into the fund at the end of each month for the rst 4

years, and 200 + X at the end of each month for the next 4 years, nd X if the

fund earns a nominal (annual) rate of 6% compounded monthly.

Solution: The equation of value at the end of 8 12 = 96 months is

200s

96

+X s

48

= 30000 ,

which we may solve to yield

X =

30000

s

48 0.005

200

s

96 0.005

s

48 0.005

=

30000

s

48 0.005

200

(1.005)

96

1

(1.005)

48

1

= 30000s

1

48 0.005

200((1.005)

48

+ 1)

= 30000(0.018485) 200(2.27049) from the tables

= 100.452.

2. A fund of 2500 is to be accumulated by n annual payments of 50, followed by n+1

annual payments of 75, plus a smaller nal payment of not more than 75 made 1

year after the last regular payment. If the eective annual rate of interest is 5%,

nd n and the amount of the nal irregular payment.

Solution: We shall interpret the payments to be made under two annuities-due: the

rst, for 2n + 1 years, consists of an annual deposit of 50 in advance; the second,

for n + 1 years, deferred n years after the rst, consists of an annual deposit of 25

in advance. It is at the end of year 2n + 1 that the nal drop payment is to

be made, and it is to be under 75. (Note that this is the type of problem where the

drop payment could turn out to be negative.) We seek the smallest n for which

50 s

2n+1

+ 25 s

n+1

> 2500 75 = 2425

Information for Students in MATH 329 2004 01 31

2(1.05) ((1.05)

n

)

2

+ (1.05)

n

_

3 +

0.05(2425)

25(1.05)

_

((1.05)

n

)

2

+

1

2.1

(1.05)

n

1

2.1

_

3 +

0.05(2425)

25(1.05)

_

_

(1.05)

n

+

1

4.2

_

2

>

1

(4.2)

2

+

1

2.1

_

3 +

0.05(2425)

25(1.05)

_

(1.05)

n

+

1

4.2

>

_

1

(4.2)

2

+

1

2.1

_

3 +

0.05(2425)

25(1.05)

__1

2

= 1.919585178

n >

ln 1.919585178

ln 1.05

= 10.65133267

Thus the drop payment will be when t = 11 + 12, i.e., 23 years after the rst

payment under the annuity with payments of 50. Just before the drop payment

the accumulated value of all previous payments is

50 s

23

+ 25 s

12

=

1.05

0.05

_

50 (1.05)

23

+ 25 (1.05)

12

75

_

= 2592.924516

so the drop payment at time t = 23 is 2500 2592.924516 = 92.92.

Thus we have an example here of a negative drop payment. Could this mean

that we should have taken n = 10? No. In that case we would nd that the

nal payment would be larger than the permitted 75. (If tables like those in the

textbook were available, one could determine the value of n by inspecting the value

of 2s

2n+1

+ s

n+1

. We observe from the 5% tables the following values:

n 2s

2n+1

+ s

n

10 84.0165

11 97.0678

12 111.3713

We seek the smallest n such that

50 s

2n+1

+ 25 s

n

> 2500 75

i.e., such that

2 s

2n+1

+ s

n

> 97 ,

equivalently,

2s

2n+1

+ s

n

>

97

1.05

= 92.38 ,

and so can conclude that n = 11.)

Information for Students in MATH 329 2004 01 32

3. On his 30th birthday, a teacher begins to accumulate a fund for early retirement

by depositing 5,000 on that day and at the beginnings of the next 24 years as

well. Since he expects that his ocial pension will begin at age 65, he plans that,

starting at age 55 he will make an annual level withdrawal at the beginning of each

of 10 years. Assuming that all payments are certain to be made, nd the amount

of these annual withdrawals, if the eective rate of interest is 6% during the rst

25 years, and 7% thereafter.

Solution: Let the constant amount of the withdrawals beginning at age 55 be X.

The equation of value at age 55, just before the rst withdrawal, is

5000 s

25 6%

= X a

10 7%

Annual Withdrawal X =

5000 s

25 6%

a

10 7%

= 5000

1.06

1.07

0.07

0.06

(1.06)

25

1

1 (1.07)

10

= 33477.74

4. At an eective annual interest rate of i it is known that

(a) The present value of 5 at the end of each year for 2n years, plus an additional

3 at the end of each of the rst n years, is 64.6720.

(b) The present value of an n-year deferred annuity-immediate paying 10 per year

for n years is 34.2642.

Find i.

Solution: It is convenient to distinguish two cases.

Case i ,= 0: From (4a) we have an equation of value

64.6720 = 5 a

2n

+ 3 a

n

; (4)

from (4b) we have the equation of value

34.2642 = v

n

10 a

n

= 10

_

a

2n

a

n

_

. (5)

Solving these equations, we obtain

a

2n

= 9.3689 (6)

a

n

= 5.9425 , (7)

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 33

implying that

1 v

2n

1 v

n

=

9.3689

5.9425

1 + v

n

= 1.5766

v

n

= 0.5766.

We can substitute in equation (7) to obtain

i = 0.07125 = 7.125%

which implies that

n =

ln 0.5766

ln 1.07125

= 8.000 years.

Case i = 0: Here Equations (4) and (5) become

64.6720 = 5(2n) + 3n = 13n

34.2642 = 10n = 10(2n n)

which are inconsistent. Thus this case is impossible.

5. (a) Find a

12

if the eective rate of discount is 5%.

(b) Charles has inherited an annuity-due on which there remain 12 payments of

10,000 per year at an eective discount rate of 5%; the rst payment is due

immediately. He wishes to convert this to a 25-year annuity-immediate at the

same eective rates of interest or discount, with rst payment due one year

from now. What will be the size of the payments under the new annuity?

Solution:

(a) Since (1 d)(1 + i) = 1, v = 1 d = 0.95 when d = 0.05.

a

12

=

1 (0.95)

12

0.05

= 9.19279825.

(b) i = d(1 + i) =

d

v

=

0.05

0.95

=

1

19

. Let X be the size of the new payments. We

must solve the equation of value,

91927.9825 = X a

25i

Information for Students in MATH 329 2004 01 34

where v = 0.95. Hence

X =

91927.9825

a

25i

=

91927.9825i

1 v

25

=

91927.9825

(1 (0.95)

25

) 19

= 6695.606220

So the new annuity-immediate will pay 25 annual payments of 6695.61, be-

ginning one year from now.

6. Give an algebraic proof and a verbal explanation for the formula

m

[a

n

= a

a

m

v

m+n

a

.

Solution:

(a)

a

a

m

v

m+n

a

=

1

i

1 v

m

i

v

m+n

1

i

=

1 (1 v

m

) v

m+n

i

=

v

m

(1 v

n

)

i

= v

m

1 v

n

i

= v

m

a

n

=

m

[a

n

(b) a

i

is the present value of a perpetuity at rate i of 1 per year, payments

starting a year from now. a

m

is the present value of the rst m payments of

that perpetuity; if we subtract this we have the present value of a perpetuity-

immediate that starts m years from now, i.e., where the rst payment is m+1

years from now. v

m+n

a

m + n years from now, i.e., where the rst payment is m + n + 1 years from

now; if we subtract this term as well, we are left with the present value of

payments at the ends of years m+1, m+2, . . ., m+n, i.e., with the present

value of an n-payment annuity-certain of 1, deferred m years, i.e., of

m

[a

n

7. A level perpetuity-immediate is to be shared by A, B, C, and D. A receives the

rst n payments, B the next 2n payments, C payments ##3n + 1, . . . , 5n, and D

the payments thereafter. It is known that the present values of Bs and Ds shares

are equal. Find the ratio of the present value of the shares of A, B, C, D.

Information for Students in MATH 329 2004 01 35

Solution: The present values of the shares of A, B, C, D are, respectively, a

n

,

v

n

a

2n

= a

3n

a

n

, v

3n

a

2n

= a

5n

a

3n

, and v

5n

a

= a

a

5n

. The fact that Bs

and Ds shares are equal implies that

v

n

i

(1 v

2n

) =

v

5n

i

which is equivalent to (v

2n

)

2

+ v

2n

1 = 0, implying that

v

2n

=

1

5

2

.

Since v is positive, only the + sign is admissible:

v

2n

=

1 +

5

2

= 0.618033988...

so

v

n

= 0.7861513777... .

Then the shares of A, B, C, D will be in the ratio

1 v

n

: v

n

v

3n

: v

3n

v

5n

: 1 v

5n

i.e.

0.2138486221 : 0.3002831059 : 0.1855851657 : 0.6997168937

8. (a) Find the present value of an annuity which pays 4,000 at the beginning of

each 3-month period for 12 years, assuming an eective rate of 2% interest

per 4-month period.

(b) Suppose that the owner of the annuity wishes to pay now so that payments

under his annuity will continue for an additional 10 years. How much should

he pay?

(c) How much should he pay now to extend the annuity from the present 12 years

to a perpetuity?

(It is intended that you solve this problem from rst principles, not by substitu-

tion into formul in [1, Chapter 4].)

Solution:

(a) If i be the eective interest rate per 4-month period, the eective rate per

3-month period will be j = (1 +i)

3

4

1. Accordingly the value of the desired

Information for Students in MATH 329 2004 01 36

annuity is

4000 a

48 j

= 4000(1 + j)

1 (1 + j)

48

j

= 4000(1 + i)

3

4

1 (1 + i)

36

(1 + i)

3

4

1

= 4000

1 (1.02)

36

1 (1.02)

3

4

= 138, 317.4894.

(b) Repeating the calculations above for 48 + 40 = 88 payments, we obtain

4000 a

88 j

= 4000(1 + j)

1 (1 + j)

88

j

= 4000(1 + i)

3

4

1 (1 + i)

66

(1 + i)

3

4

1

= 4000

1 (1.02)

66

1 (1.02)

3

4

= 197, 897.4338,

so the additional payments will cost 197, 897.4338138, 317.4894 = 59, 579.9444

today.

(c) The cost of the perpetuity-due today would be

4000 a

88 j

= 4000(1 + j)

1

j

= 4000(1 + i)

3

4

1

(1 + i)

3

4

1

=

4000

1 (1.02)

3

4

= 271, 329.4837,

so the additional payments will cost

271, 329.4837 138, 317.4894 = 133, 011.9943

today.

9. (No time diagram is needed for the solution to this problem.) In Problem 9 of

Assignment 2 you were asked to apply the Bisection Method to determine the

Information for Students in MATH 329 2004 01 37

solution to an interest problem to 3 decimal places. The equation in question was

(3):

300(1 + i)

4

+ 200(1 + i)

3

+ 300(1 + i)

2

= 1000 .

and the solution given began with the values of

f(x) = 3x

4

+ 2x

3

+ 3x

2

10 .

at x = 0 (f(0) = 10), x = 2 (f(2) = 66 > 0), and x = 2 (f(2) = 34 >

0), and we were interested in the solution between 0 and 2 a solution that

is unique because f

times in an attempt to determine the solution we seek. (You are not expected

to know the general theory of error estimation.) The intention is that you apply

linear interpolation unintelligently, using it to determine a point where you nd the

function value and thereby conne the zero to a smaller subinterval: the point that

you nd will replace the midpoint in the bisection method. In some situations, as

in the present one, the procedure may not be better than the bisection method.

Indeed, in the present example, it could take many more applications than the

bisection method to obtain the accuracy you obtained with that method.

Solution: We take x

1

= 0, x

2

= 2. Then

x

3

= 0 + (2 0)

10

10 66

= 0.2631578947

f(x

3

) = 9.741407754

x

4

= 0.2631578947 + (2 0.2631578947)

9.741407754

9.741407754 66

= 0.4865401588

f(x

4

) = 8.891376200

x

5

= 0.4865401588 + (2 0.4865401588)

8.891376200

8.891376200 66

= 0.6662236083

f(x

5

) = 7.486007579

x

6

= 0.6662236083 + (2 0.6662236083)

7.486007579

7.486007579 66

= 0.8020951913

f(x

6

) = 5.796139773

x

7

= 0.8020951913 + (2 0.8020951913)

5.796139773

5.796139773 66

= 0.8988026707

Information for Students in MATH 329 2004 01 38

f(x

7

) = 4.166425912

x

8

= 0.8988026707 + (2 0.8988026707)

4.166425912

4.166425912 66

= 0.9641908820

f(x

8

) = 2.825434839

x

9

= 0.9641908820 + (2 0.9641908820)

2.825434839

2.825434839 66

= 1.006713115

f(x

9

) = 1.837664218

x

10

= 1.006713115 + (2 1.006713115)

1.837664218

1.837664218 66

= 1.033620406

f(x

10

) = 1.162055435

x

11

= 1.033620406 + (2 1.033620406)

1.162055435

1.162055435 66

= 1.050340958

f(x

11

) = 0.721587971

x

12

= 1.050340958 + (2 1.050340958)

0.721587971

0.721587971 66

= 1.060611435

f(x

12

) = 0.442976533

x

13

= 1.060611435 + (2 1.060611435)

0.442976533

0.442976533 66

= 1.066874356

f(x

13

) = 0.270019571

x

14

= 1.066874356 + (2 1.066874356)

0.270019571

0.270019571 66

= 1.070676410

f(x

14

) = 0.163879567

x

15

= 1.070676410 + (2 1.070676410)

0.163879567

0.163879567 66

= 1.072978227

f(x

15

) = 0.099198908

x

16

= 1.072978227 + (2 1.072978227)

0.099198908

0.099198908 66

= 1.074369462

f(x

16

) = 0.059950550

Information for Students in MATH 329 2004 01 39

x

17

= 1.074369462 + (2 1.074369462)

0.059950550

0.059950550 66

= 1.075209488

f(x

17

) = 0.036195811

x

18

= 1.075209488 + (2 1.075209488)

0.036195811

0.036195811 66

= 1.075716385

f(x

18

) = 0.021840825

x

19

= 1.075716385 + (2 1.075716385)

0.021840825

0.021840825 66

= 1.076022149

f(x

19

) = 0.013174269

x

20

= 1.076022149 + (2 1.076022149)

0.013174269

0.013174269 66

= 1.076206548

f(x

20

) = 0.007944937

x

21

= 1.076206548 + (2 1.076206548)

0.007944937

0.007944937 66

= 1.076317739

f(x

21

) = 0.004790698

x

22

= 1.076317739 + (2 1.076317739)

0.004790698

0.004790698 66

= 1.076384781

f(x

22

) = 0.002888504

x

23

= 1.076384781 + (2 1.076384781)

0.002888504

0.002888504 66

= 1.076425201

f(x

23

) = 0.001741533

x

24

= 1.076425201 + (2 1.076425201)

0.001741533

0.001741533 66

= 1.076449571

f(x

24

) = 0.001049952

x

25

= 1.076449571 + (2 1.076449571)

0.001049952

0.001049952 66

= 1.076464263

f(x

25

) = 0.000632996

x

26

= 1.076464263 + (2 1.076464263)

0.000632996

0.000632996 66

Information for Students in MATH 329 2004 01 40

= 1.076473120

f(x

26

) = 0.000381633

x

27

= 1.076473120 + (2 1.076473120)

0.000381633

0.000381633 66

= 1.076478460

f(x

27

) = 0.000230079

x

28

= 1.076478460 + (2 1.076478460)

0.000230079

0.000230079 66

= 1.076481679

f(x

28

) = 0.000138723

x

29

= 1.076481679 + (2 1.076481679)

0.0001387233

0.0001387233 66

= 1.076483620

f(x

29

) = 0.000083635

x

30

= 1.076483620 + (2 1.076483620)

0.000083635

0.000083635 66

= 1.076484790

f(x

30

) = 0.000050430

x

31

= 1.076484790 + (2 1.076484790)

0.000050430

0.000050430 66

= 1.076485496

f(x

31

) = 0.000030391

The reason that the method is not ecient here is that the graph of the function

is far from linear in the interval under consideration.

6

6

Issues of this type are beyond MATH 329, and are not covered adequately in the current textbook;

if you are interested in Numerical Anaylsis, consider taking MATH 317.

Information for Students in MATH 329 2004 01 41

9 Class Tests

9.1 Class Test, Version 1

McGILL UNIVERSITY, FACULTY OF SCIENCE

CLASS TEST in MATH 329, THEORY OF INTEREST

EXAMINER: Professor W. G. Brown DATE: Wednesday, 10 March, 2004.

ASSOCIATE EXAMINER: Professor N. Sancho TIME: 45 minutes, 14:3515:20

FAMILY NAME:

GIVEN NAMES:

STUDENT NUMBER:

Instructions

The time available for writing this test is about 45 minutes.

This test booklet consists of this cover, Pages 42 through 44 containing questions together

worth 60 marks; and Page 45, which is blank.

Show all your work. All solutions are to be written in the space provided on the page where

the question is printed. When that space is exhausted, you may write on the facing page, on

the blank page, or on the back cover of the booklet, but you must indicate any continuation

clearly on the page where the question is printed! (Please inform the instructor if you nd

that your booklet is defective.)

All your writing even rough work must be handed in.

Calculators. While you are permitted to use a calculator to perform arithmetic and/or expo-

nential calculations, you must not use the calculator to calculate such actuarial functions as

a

ni

, s

ni

, (Ia)

ni

, (Is)

ni

, (Da)

ni

, (Ds)

ni

, etc. without rst stating a formula for the value of

the function in terms of exponentials and/or polynomials involving n and the interest rate.

You must not use your calculator in any programmed calculations. If your calculator has

memories, you are expected to have cleared them before the test.

In your solutions to problems on this test you are expected to show all your work. You are

expected to simplify algebraic and numerical answers as much as you can.

Your neighbours may be writing a version of this test which is dierent from yours.

PLEASE DO NOT WRITE INSIDE THIS BOX

1(a) 1(b) 1(c) 1(d) 2 3 Total

/5 /5 /5 /5 /15 /25 /60

Information for Students in MATH 329 2004 01 42

1. (a) [5 MARKS] Suppose that the nominal annual rate of interest, compounded

8 times per year, is 5%. Showing all your work, determine the equivalent

eective annual rate of discount.

(b) [5 MARKS] Suppose that the nominal annual rate of discount, compounded 3

times per year, is 7%. Showing all your work, determine the equivalent annual

rate of interest.

(c) [5 MARKS] State the nominal annual interest rate, compounded instanta-

neously, which is equivalent to an eective annual interest rate of 4%.

(d) [5 MARKS] Suppose that the eective interest rate for

1

4

year is 3%. Deter-

mine the equivalent nominal interest rate, compounded every 2 years.

Information for Students in MATH 329 2004 01 43

2. [15 MARKS] The accumulated value just after the last payment under a 12-year

annuity of 1000 per year, paying interest at the rate of 5% per annum eective,

is to be used to purchase a perpetuity at an interest rate of 6%, rst payment to

be made 1 year after the last payment under the annuity. Showing all your work,

determine the size of the payments under the perpetuity.

Information for Students in MATH 329 2004 01 44

3. [25 MARKS] A loan of 5000 is to be repaid by annual payments of 250 to commence

at the end of the 6th year, and to continue thereafter for as long as necessary. Find

the time and amount of the nal payment if the nal payment is to be larger than

the regular payments. Assume i = 4%.

Information for Students in MATH 329 2004 01 45

continuation page for problem number

You must refer to this continuation page on the page where the problem is printed!

Information for Students in MATH 329 2004 01 46

9.2 Class Test, Version 2

McGILL UNIVERSITY, FACULTY OF SCIENCE

CLASS TEST in MATH 329, THEORY OF INTEREST

EXAMINER: Professor W. G. Brown DATE: Wednesday, 10 March, 2004.

ASSOCIATE EXAMINER: Professor N. Sancho TIME: 45 minutes, 14:3515:20

FAMILY NAME:

GIVEN NAMES:

STUDENT NUMBER:

Instructions

The time available for writing this test is about 45 minutes.

This test booklet consists of this cover, Pages 47 through 49 containing questions together

worth 60 marks; and Page 50, which is blank.

Show all your work. All solutions are to be written in the space provided on the page where

the question is printed. When that space is exhausted, you may write on the facing page, on

the blank page, or on the back cover of the booklet, but you must indicate any continuation

clearly on the page where the question is printed! (Please inform the instructor if you nd

that your booklet is defective.)

All your writing even rough work must be handed in.

Calculators. While you are permitted to use a calculator to perform arithmetic and/or expo-

nential calculations, you must not use the calculator to calculate such actuarial functions as

a

ni

, s

ni

, (Ia)

ni

, (Is)

ni

, (Da)

ni

, (Ds)

ni

, etc. without rst stating a formula for the value of

the function in terms of exponentials and/or polynomials involving n and the interest rate.

You must not use your calculator in any programmed calculations. If your calculator has

memories, you are expected to have cleared them before the test.

In your solutions to problems on this test you are expected to show all your work. You are

expected to simplify algebraic and numerical answers as much as you can.

Your neighbours may be writing a version of this test which is dierent from yours.

PLEASE DO NOT WRITE INSIDE THIS BOX

1 2(a) 2(b) 2(c) 2(d) 3 Total

/25 /5 /5 /5 /5 /15 /60

Information for Students in MATH 329 2004 01 47

1. [25 MARKS] A loan of 1000 is to be repaid by annual payments of 100 to commence

at the end of the 5th year, and to continue thereafter for as long as necessary. Find

the time and amount of the nal payment if the nal payment is to be NO larger

than the regular payments. Assume i = 4.5%.

Information for Students in MATH 329 2004 01 48

2. (a) [5 MARKS] Suppose that the eective interest rate for

1

5

year is 0.02. Deter-

mine the equivalent nominal interest rate, compounded every 3 years.

(b) [5 MARKS] Suppose that the nominal annual rate of interest, compounded

9 times per year, is 6%. Showing all your work, determine the equivalent

eective annual rate of discount.

(c) [5 MARKS] Suppose that the nominal annual rate of discount, compounded 6

times per year, is 5%. Showing all your work, determine the equivalent annual

rate of interest.

(d) [5 MARKS] State the nominal annual interest rate, compounded instanta-

neously, which is equivalent to an eective annual interest rate of 8%.

Information for Students in MATH 329 2004 01 49

3. [15 MARKS] The accumulated value just after the last payment under a 12-year

annuity of 1000 per year, paying interest at the rate of 5% per annum eective,

is to be used to purchase a perpetuity of 500 per annum forever, rst payment to

be made 1 year after the last payment under the annuity. Showing all your work,

determine the eective interest rate of the perpetuity, assuming it comes into eect

just after the last payment under the annuity.

Information for Students in MATH 329 2004 01 50

continuation page for problem number

You must refer to this continuation page on the page where the problem is printed!

Information for Students in MATH 329 2004 01 51

9.3 Class Test, Version 3

McGILL UNIVERSITY, FACULTY OF SCIENCE

CLASS TEST in MATH 329, THEORY OF INTEREST

EXAMINER: Professor W. G. Brown DATE: Wednesday, 10 March, 2004.

ASSOCIATE EXAMINER: Professor N. Sancho TIME: 45 minutes, 14:3515:20

FAMILY NAME:

GIVEN NAMES:

STUDENT NUMBER:

Instructions

The time available for writing this test is about 45 minutes.

This test booklet consists of this cover, Pages 52 through 54 containing questions together

worth 60 marks; and Page 55, which is blank.

Show all your work. All solutions are to be written in the space provided on the page where

the question is printed. When that space is exhausted, you may write on the facing page, on

the blank page, or on the back cover of the booklet, but you must indicate any continuation

clearly on the page where the question is printed! (Please inform the instructor if you nd

that your booklet is defective.)

All your writing even rough work must be handed in.

Calculators. While you are permitted to use a calculator to perform arithmetic and/or expo-

nential calculations, you must not use the calculator to calculate such actuarial functions as

a

ni

, s

ni

, (Ia)

ni

, (Is)

ni

, (Da)

ni

, (Ds)

ni

, etc. without rst stating a formula for the value of

the function in terms of exponentials and/or polynomials involving n and the interest rate.

You must not use your calculator in any programmed calculations. If your calculator has

memories, you are expected to have cleared them before the test.

In your solutions to problems on this test you are expected to show all your work. You are

expected to simplify algebraic and numerical answers as much as you can.

Your neighbours may be writing a version of this test which is dierent from yours.

PLEASE DO NOT WRITE INSIDE THIS BOX

1 2 3(a) 3(b) 3(c) 3(d) Total

/15 /25 /5 /5 /5 /5 /60

Information for Students in MATH 329 2004 01 52

1. [15 MARKS] The accumulated value just after the last payment under a 9-year

annuity of 2000 per year, paying interest at the rate of 8% per annum eective,

is to be used to purchase a perpetuity at an interest rate of 4%, rst payment to

be made 1 year after the last payment under the annuity. Showing all your work,

determine the size of the payments under the perpetuity.

Information for Students in MATH 329 2004 01 53

2. [25 MARKS] A loan of 1000 is to be repaid by annual payments of 200 to commence

at the end of the 4th year, and to continue thereafter for as long as necessary. Find

the time and amount of the nal payment if the nal payment is to be larger than

the regular payments. Assume i = 5%.

Information for Students in MATH 329 2004 01 54

3. (a) [5 MARKS] State the nominal annual interest rate, compounded instanta-

neously, which is equivalent to an eective annual interest rate of 6%.

(b) [5 MARKS] Suppose that the eective interest rate for

1

6

year is 0.015. De-

termine the equivalent nominal interest rate, compounded every 4 years.

(c) [5 MARKS] Suppose that the nominal annual rate of interest, compounded

3 times per year, is 8%. Showing all your work, determine the equivalent

eective annual rate of discount.

(d) [5 MARKS] Suppose that the nominal annual rate of discount, compounded

12 times per year, is 6%. Showing all your work, determine the equivalent

annual rate of interest.

Information for Students in MATH 329 2004 01 55

continuation page for problem number

You must refer to this continuation page on the page where the problem is printed!

Information for Students in MATH 329 2004 01 56

9.4 Class Test, Version 4

McGILL UNIVERSITY, FACULTY OF SCIENCE

CLASS TEST in MATH 329, THEORY OF INTEREST

EXAMINER: Professor W. G. Brown DATE: Wednesday, 10 March, 2004.

ASSOCIATE EXAMINER: Professor N. Sancho TIME: 45 minutes, 14:3515:20

FAMILY NAME:

GIVEN NAMES:

STUDENT NUMBER:

Instructions

The time available for writing this test is about 45 minutes.

This test booklet consists of this cover, Pages 57 through 59 containing questions together

worth 60 marks; and Page 60, which is blank.

Show all your work. All solutions are to be written in the space provided on the page where

the question is printed. When that space is exhausted, you may write on the facing page, on

the blank page, or on the back cover of the booklet, but you must indicate any continuation

clearly on the page where the question is printed! (Please inform the instructor if you nd

that your booklet is defective.)

All your writing even rough work must be handed in.

Calculators. While you are permitted to use a calculator to perform arithmetic and/or expo-

nential calculations, you must not use the calculator to calculate such actuarial functions as

a

ni

, s

ni

, (Ia)

ni

, (Is)

ni

, (Da)

ni

, (Ds)

ni

, etc. without rst stating a formula for the value of

the function in terms of exponentials and/or polynomials involving n and the interest rate.

You must not use your calculator in any programmed calculations. If your calculator has

memories, you are expected to have cleared them before the test.

In your solutions to problems on this test you are expected to show all your work. You are

expected to simplify algebraic and numerical answers as much as you can.

Your neighbours may be writing a version of this test which is dierent from yours.

PLEASE DO NOT WRITE INSIDE THIS BOX

1(a) 1(b) 1(c) 1(d) 2 3 Total

/5 /5 /5 /5 /25 /15 /60

Information for Students in MATH 329 2004 01 57

1. (a) [5 MARKS] Suppose that the nominal annual rate of discount, compounded

6 times per year, is 0.5%. Showing all your work, determine the equivalent

annual rate of interest.

(b) [5 MARKS] State the nominal annual interest rate, compounded instanta-

neously, which is equivalent to an eective annual interest rate of 10%.

(c) [5 MARKS] Suppose that the eective interest rate for

1

5

year is 2%. Deter-

mine the equivalent nominal interest rate, compounded every 6 years.

(d) [5 MARKS] Suppose that the nominal annual rate of interest, compounded

7 times per year, is 2%. Showing all your work, determine the equivalent

eective annual rate of discount.

Information for Students in MATH 329 2004 01 58

2. [25 MARKS] A loan of 1000 is to be repaid by annual payments of 200 to commence

at the end of the 4th year, and to continue thereafter for as long as necessary. Find

the time and amount of the nal payment if the nal payment is to be NO larger

than the regular payments. Assume i = 5%.

Information for Students in MATH 329 2004 01 59

3. [15 MARKS] The accumulated value just after the last payment under a 10-year

annuity of 1000 per year, paying interest at the rate of 6% per annum eective,

is to be used to purchase a perpetuity of 800 per annum forever, rst payment to

be made 1 year after the last payment under the annuity. Showing all your work,

determine the eective interest rate of the perpetuity, assuming it comes into eect

just after the last payment under the annuity.

Information for Students in MATH 329 2004 01 60

continuation page for problem number

You must refer to this continuation page on the page where the problem is printed!

Information for Students in MATH 329 2004 01 61

10 Fourth Problem Assignment

Distribution Date: Mounted on the Web on Wednesday, March 3rd, 2004

Hard copy distributed on Friday, March 5th, 2004

Solutions are due by Wednesday, March 17th, 2004

1. (a) Find, to the nearest unit, the accumulated value 19 years after the rst pay-

ment is made of an annuity on which there are 7 payments of 3000 each made

at 1

1

2

-year intervals. The nominal rate of interest convertible semiannually is

6%.

(b) Find, to the nearest unit, the present value of a 20-year annuity-due which

pays 200 at the beginning of each half-year for the rst 8 years, increasing to

250 per half-year thereafter. The eective annual rate of interest is 6%.

2. (a) The present value of a perpetuity-immediate paying 1 at the end of every 5

years is 1.637975. Find i and d.

(b) The present value of a perpetuity-due paying 1 at the beginning of every 5

years is 1.637975. Find d and i.

3. Determine the present value, at a nominal interest rate of 6% compounded quar-

terly, of the following payments made under an annuity: 120 at the end of the 3rd

year, 110 at the end of the 4th year, decreasing by 10 each year until nothing is

paid.

4. Find the present value, at an eective annual interest rate of 5.75%, of a perpetuity-

immediate under which a payment of 100 is made at the end of the 1st year, 300 at

the end of the 2nd year, increasing until a payment of 2500 is made, which level is

maintained for exactly a total of 10 payments of 2500 (including the rst of them

in the count of 10), after which the payments fall by 400 each year until they reach

a level of 100, which is maintained in perpetuity. (Note: You are expected to show

explicitly how you decompose the payments; it is not sucient to simply show a

few numbers and a sum.)

5. Find, to the nearest unit, the present value of a 25-year annuity-due which pays

100 immediately, 104 at the end of the 1st year, 108.16 at the end of the 2nd year,

where each subsequent payment is obtained from its predecessor by multiplying by

a factor of 1.04. The annual eective rate of interest is 8.%.

6. (a) A loan of 15,000 is being repaid with payments of 1,500 at the end of each

year for 20 years. If each payment is immediately reinvested at 6% eective,

nd the eective annual rate of interest earned over the 20-year period.

Information for Students in MATH 329 2004 01 62

(b) A loan of 15,000 is being repaid with payments of 1,500 at the end of each

year for 10 years. Determine the yield rate to the investor.

Information for Students in MATH 329 2004 01 63

11 Solutions to Problems on the Class Tests

Distribution Date: Wednesday, March 17th, 2004, in hard copy.

The test was administered on Wednesday, March 11th, 2004.

(Subject to correction.)

The rst four problems listed are concerned with equivalent rates of interest and

discount (each in 4 parts); the next four concern annuities and perpetuities; and the last

four are concerned with unknown type and nal balloon or drop payments.

1. (a) [5 MARKS] [VERSION 1 #1(a)] Suppose that the nominal annual rate of in-

terest, compounded 8 times per year, is 5%. Showing all your work, determine

the equivalent eective annual rate of discount.

Solution: We are given that i

(8)

= 0.05, and asked to determine d.

_

1 +

i

(8)

8

_

8

= 1 + i

and (1 d)(1 + i) = 1

d = 1

_

1 +

i

(8)

8

_

8

= 0.0486225508 = 4.86%

(b) [5 MARKS] [VERSION 1 #1(b)] Suppose that the nominal annual rate of dis-

count, compounded 3 times per year, is 7%. Showing all your work, determine

the equivalent annual rate of interest.

Solution: We are given that d

(3)

= 0.07, and asked to determine i.

_

1

d

(3)

3

_

3

= 1 d

and (1 d)(1 + i) = 1

i =

_

1

d

(3)

3

_

3

1 = 0.073398300 = 7.34%

(c) [5 MARKS] [VERSION 1 #1(c)] State the nominal annual interest rate, com-

pounded instantaneously, which is equivalent to an eective annual interest

rate of 4%.

Solution: The rate we seek is the solution i to the equation

lim

n

_

1 +

i

n

_

n

= 1.04

which is equivalent to e

i

= 1.04. Solving by taking logarithms, we obtain

i = ln(1.04) = 0.039220713151 = 3.92%.

Information for Students in MATH 329 2004 01 64

(d) [5 MARKS] [VERSION 1 #1(d)] Suppose that the eective interest rate for

1

4

year is 3%. Determine the equivalent nominal interest rate, compounded

every 2 years.

Solution: We are given the value of

i

(4)

4

= 3%, and asked to determine i

(

1

2

)

.

The equation we have to solve is

_

1 +

i

(4)

4

_

4

= 1 + i =

_

1 +

i

(

1

2

)

1

2

_

1

2

.

This equation implies that

i

(

1

2

)

=

1

2

_

_

1 +

i

(4)

4

_

8

1

_

= 0.1333850405 = 13.3%.

2. (a) [5 MARKS] [VERSION 2 #2(b)] Suppose that the nominal annual rate of in-

terest, compounded 9 times per year, is 6%. Showing all your work, determine

the equivalent eective annual rate of discount.

Solution: We are given that i

(9)

= 0.06, and asked to determine d.

_

1 +

i

(9)

9

_

9

= 1 + i

and (1 d)(1 + i) = 1

d = 1

_

1 +

i

(9)

9

_

9

= 0.0580479306 = 5.80%

(b) [5 MARKS] [VERSION 2 #2(c)] Suppose that the nominal annual rate of dis-

count, compounded 6 times per year, is 5%. Showing all your work, determine

the equivalent annual rate of interest.

Solution: We are given that d

(6)

= 0.05, and asked to determine i.

_

1

d

(6)

6

_

6

= 1 d

and (1 d)(1 + i) = 1

i =

_

1

d

(6)

6

_

6

1 = 0.051491358 = 5.15%

Information for Students in MATH 329 2004 01 65

(c) [5 MARKS] [VERSION 2 #2(d)] State the nominal annual interest rate, com-

pounded instantaneously, which is equivalent to an eective annual interest

rate of 8%.

Solution: The rate we seek is the solution to the equation

lim

n

_

1 +

i

n

_

n

= 1.08

which is equivalent to e

i

= 1.08. Solving by taking logarithms, we obtain

i = ln(1.08) = 0.07696104114 = 7.70%.

(d) [5 MARKS] [VERSION 2 #2(a)] Suppose that the eective interest rate for

1

5

year is 0.02. Determine the equivalent nominal interest rate, compounded

every 3 years.

Solution: We are given the value of

i

(5)

5

= 2%, and asked to determine i

(

1

3

)

.

The equation we have to solve is

_

1 +

i

(5)

5

_

5

= 1 + i =

_

1 +

i

(

1

3

)

1

3

_

1

3

.

This equation implies that

i

(

1

3

)

=

1

3

_

_

1 +

i

(5)

5

_

15

1

_

= 0.1152894460 = 11.5%

3. (a) [5 MARKS] [VERSION 3 #3(c)] Suppose that the nominal annual rate of in-

terest, compounded 3 times per year, is 8%. Showing all your work, determine

the equivalent eective annual rate of discount.

Solution: We are given that i

(3)

= 0.08, and asked to determine d.

_

1 +

i

(3)

3

_

3

= 1 + i

and (1 d)(1 + i) = 1

d = 1

_

1 +

i

(3)

3

_

3

= 0.0759156521 = 7.59%

(b) [5 MARKS] [VERSION 3 #3(d)] Suppose that the nominal annual rate of

discount, compounded 12 times per year, is 6%. Showing all your work,

determine the equivalent annual rate of interest.

Information for Students in MATH 329 2004 01 66

Solution: We are given that d

(12)

= 0.06, and asked to determine i.

_

1

d

(12)

12

_

12

= 1 d

and (1 d)(1 + i) = 1

i =

_

1

d

(12)

12

_

12

1 = 0.061996367 = 6.20%

(c) [5 MARKS] [VERSION 3 #3(a)] State the nominal annual interest rate, com-

pounded instantaneously, which is equivalent to an eective annual interest

rate of 6%.

Solution: The rate we seek is the solution to the equation

lim

n

_

1 +

i

n

_

n

= 1.06

which is equivalent to e

i

= 1.06. Solving by taking logarithms, we obtain

i = ln(1.06) = 0.05826890812 = 5.83%.

(d) [5 MARKS] [VERSION 3 #3(b)] Suppose that the eective interest rate for

1

6

year is 0.015. Determine the equivalent nominal interest rate, compounded

every 4 years.

Solution: We are given the value of

i

(6)

6

= 1.5%, and asked to determine i

(

1

4

)

.

The equation we have to solve is

_

1 +

i

(6)

6

_

6

= 1 + i =

_

1 +

i

(

1

4

)

1

4

_

1

4

.

This equation implies that

i

(

1

4

)

=

1

4

_

_

1 +

i

(6)

6

_

24

1

_

= .1073757030 = 10.7%

4. (a) [5 MARKS] [VERSION 4 #1(d)] Suppose that the nominal annual rate of in-

terest, compounded 7 times per year, is 2%. Showing all your work, determine

the equivalent eective annual rate of discount.

Solution: We are given that i

(7)

= 0.02, and asked to determine d.

_

1 +

i

(7)

7

_

7

= 1 + i

Information for Students in MATH 329 2004 01 67

and (1 d)(1 + i) = 1

d = 1

_

1 +

i

(7)

7

_

7

= 0.197733746 = 1.98%

(b) [5 MARKS] [VERSION 4 #1(a)] Suppose that the nominal annual rate of

discount, compounded 6 times per year, is 0.5%. Showing all your work,

determine the equivalent annual rate of interest.

Solution: We are given that d

(6)

= 0.005, and asked to determine i.

_

1

d

(6)

6

_

6

= 1 d

and (1 d)(1 + i) = 1

i =

_

1

d

(6)

6

_

6

1 = 0.005014616 = 0.5014616%

(c) [5 MARKS] [VERSION 4 #1(b)] State the nominal annual interest rate, com-

pounded instantaneously, which is equivalent to an eective annual interest

rate of 10%.

Solution: The rate we seek is the solution to the equation

lim

n

_

1 +

i

n

_

n

= 1.10

which is equivalent to e

i

= 1.10. Solving by taking logarithms, we obtain

i = ln(1.10) = 0.09531017980 = 9.53%.

(d) [5 MARKS] [VERSION 4 #1(c)] Suppose that the eective interest rate for

1

5

year is 2%. Determine the equivalent nominal interest rate, compounded

every 6 years.

Solution: We are given the value of

i

(5)

5

= 2%, and asked to determine i

(

1

6

)

.

The equation we have to solve is

_

1 +

i

(5)

5

_

5

= 1 + i =

_

1 +

i

(

1

6

)

1

6

_

1

6

.

This equation implies that

i

(

1

6

)

=

1

6

_

_

1 +

i

(5)

5

_

30

1

_

= 0.1352269307 = 13.5%.

Information for Students in MATH 329 2004 01 68

5. [15 MARKS] [VERSION 1 #2] The accumulated value just after the last payment

under a 12-year annuity of 1000 per year, paying interest at the rate of 5% per

annum eective, is to be used to purchase a perpetuity at an interest rate of 6%,

rst payment to be made 1 year after the last payment under the annuity. Showing

all your work, determine the size of the payments under the perpetuity.

Solution: Let X be the level payment under the perpetuity. The equation of value

just after the last annuity payment is

1000 s

12 5%

= X a

6%

implying that

X = 1000

s

12 5%

a

6%

= 1000

6

5

_

(1.05)

12

1

_

= 955.03.

6. [15 MARKS] [VERSION 2 #3] The accumulated value just after the last payment

under a 12-year annuity of 1000 per year, paying interest at the rate of 5% per

annum eective, is to be used to purchase a perpetuity of 500 per annum forever,

rst payment to be made 1 year after the last payment under the annuity. Showing

all your work, determine the eective interest rate of the perpetuity, assuming it

comes into eect just after the last payment under the annuity.

Solution: Let i be the interest rate of the perpetuity. The equation of value just

after the last annuity payment is

1000 s

12 5%

= 500 a

i

=

500

i

implying that

i =

500

1000

1

s

12 5%

=

500

1000

0.05

((1.05)

12

1)

= 3.14%.

7. [15 MARKS] [VERSION 3 #1] The accumulated value just after the last payment

under a 9-year annuity of 2000 per year, paying interest at the rate of 8% per

annum eective, is to be used to purchase a perpetuity at an interest rate of 4%,

rst payment to be made 1 year after the last payment under the annuity. Showing

all your work, determine the size of the payments under the perpetuity.

Information for Students in MATH 329 2004 01 69

Solution: Let X be the level payment under the perpetuity. The equation of value

just after the last annuity payment is

2000 s

9 8%

= X a

4%

implying that

X = 2000

s

9 8%

a

4%

= 2000

4

8

_

(1.08)

9

1

_

= 999.00

8. [15 MARKS] [VERSION 4 #3] The accumulated value just after the last payment

under a 10-year annuity of 1000 per year, paying interest at the rate of 6% per

annum eective, is to be used to purchase a perpetuity of 800 per annum forever,

rst payment to be made 1 year after the last payment under the annuity. Showing

all your work, determine the eective interest rate of the perpetuity, assuming it

comes into eect just after the last payment under the annuity.

Solution: Let i be the interest rate of the perpetuity. The equation of value just

after the last annuity payment is

1000 s

10 6%

= 800 a

i

=

800

i

implying that

i =

800

1000

1

s

10 6%

=

800

1000

0.06

((1.06)

10

1)

= 6.07%.

9. [25 MARKS] [VERSION 1 #3] A loan of 5000 is to be repaid by annual payments

of 250 to commence at the end of the 6th year, and to continue thereafter for

as long as necessary. Find the time and amount of the nal payment if the nal

payment is to be larger than the regular payments. Assume i = 4%.

Solution: (cf. [1, Exercise 32, p. 91]) Let the time of the last balloon payment

be n, and let the amount of the last payment be X. Then n is the largest integer

solution to the inequality

5000 250(1.04)

5

a

n5

= 250(1.04)

5

1 (1.04)

(n5)

0.04

Information for Students in MATH 329 2004 01 70

(1.04)

(n5)

1

5000 0.04 (1.04)

5

250

(n 5) ln 1.04 ln

_

1 20 0.04 (1.04)

5

_

(n 5)

ln (1 0.8(1.04)

5

)

ln 1.04

n 5

ln (1 0.8(1.04)

5

)

ln 1.04

= 97.39832188.

Thus we conclude that the balloon payment is made at time t = 97. The equation

of value at time t = 22 is

5000(1.04)

97

= 250s

92

+ (X 250)

implying that

X = 250 + 5000(1.04)

97

250

0.04

_

(1.04)

92

1

_

= 346.8818 .

10. [25 MARKS] [VERSION 2 #1] A loan of 1000 is to be repaid by annual payments

of 100 to commence at the end of the 5th year, and to continue thereafter for

as long as necessary. Find the time and amount of the nal payment if the nal

payment is to be NO larger than the regular payments. Assume i = 4.5%.

Solution: Let the time of the last drop payment be n, and let the amount of

the last payment be X. Then n is the smallest integer solution to the inequality

1000 100(1.045)

4

a

n4

= 100(1.045)

4

1 (1.045)

(n4)

0.045

(1.045)

(n4)

1

1000 0.045 (1.045)

4

100

(n 4) ln 1.045 ln

_

1 10 0.045 (1.045)

4

_

(n 4)

ln (1 0.45(1.045)

4

)

ln 1.045

n 4

ln (1 0.45(1.045)

4

)

ln 1.045

= 21.47594530.

Thus we conclude that the drop payment is made at time t = 22. The equation of

value at time t = 22 is

1000(1.045)

22

= 100 s

17

+ X

implying that

X = 1000(1.045)

22

100 1.045

0.045

_

(1.045)

17

1

_

= 48.143638 .

Information for Students in MATH 329 2004 01 71

11. [25 MARKS] [VERSION 3 #2] A loan of 1000 is to be repaid by annual payments

of 200 to commence at the end of the 4th year, and to continue thereafter for

as long as necessary. Find the time and amount of the nal payment if the nal

payment is to be larger than the regular payments. Assume i = 5%.

Solution: (cf. [1, Exercise 32, p. 91]) Let the time of the last balloon payment

be n, and let the amount of the last payment be X. Then n is the largest integer

solution to the inequality

1000 200(1.05)

3

a

n3

= 200(1.05)

3

1 (1.05)

(n3)

0.05

(1.05)

(n3)

1

1000 0.05 (1.05)

3

200

(n 3) ln 1.05 ln

_

1

1000 0.05 (1.05)

3

200

_

(n 3)

ln (1 0.25(1.05)

3

)

ln 1.05

n 3

ln (1 0.25(1.05)

3

)

ln 1.05

= 10.00252595

Thus we conclude that the balloon payment is made at time t = 10. The equation

of value at time t = 10 is

1000(1.05)

10

= 200s

7

+ (X 200)

implying that

X = 200 + 1000(1.05)

10

200

0.05

_

(1.05)

7

1

_

= 200.492935 .

12. [25 MARKS] [VERSION 4 #2] A loan of 1000 is to be repaid by annual payments

of 200 to commence at the end of the 4th year, and to continue thereafter for

as long as necessary. Find the time and amount of the nal payment if the nal

payment is to be NO larger than the regular payments. Assume i = 5%.

Solution: Let the time of the last drop payment be n, and let the amount of

the last payment be X. Then n is the smallest integer solution to the inequality

1000 200(1.05)

3

a

n3

= 200(1.05)

3

1 (1.05)

(n3)

0.05

(1.05)

(n3)

1

1000 0.05 (1.05)

3

200

(n 3) ln 1.05 ln

_

1 5 0.05 (1.05)

3

_

Information for Students in MATH 329 2004 01 72

(n 3)

ln (1 0.25(1.05)

3

)

ln 1.05

n 3

ln (1 0.25(1.05)

3

)

ln 1.05

= 10.00252595.

Thus we conclude that the drop payment is made at time t = 11. The equation of

value at time t = 11 is

1000(1.05)

11

= 200 s

7

+ X

implying that

X = 1000(1.05)

11

200 1.05

0.05

_

(1.05)

7

1

_

= 0.517581.

Information for Students in MATH 329 2004 01 73

12 Fifth Problem Assignment

Distribution Date: Mounted on the Web on Wednesday, March 17th, 2004.

hard copy of assignment was distributed on Friday, March 19th, 2004.

Solutions are to be submitted by Wednesday, March 31st, 2004

1. A loan is being repaid with instalments of 1000 at the end of each year for 15 years,

followed by payments of 2000 at the end of each year for 10 years. Interest is at

an eective rate of 4% for the rst 10 years, and an eective rate 6% for the next

15 years.

(a) Showing all your work, nd the numeric value of the amount of interest paid

in the 4th instalment without making use of a schedule.

(b) Showing all your work, nd the amount of principal repaid in the 20th instal-

ment, without making use of a schedule.

(c) Then use the information you have computed to compile the lines of a schedule

corresponding to the payments at the ends of years 20, 21, . . . , 25.

(d) Now solve (a), (b), (c) again, this time assuming that all payments are at the

beginnings of the years: the interest rates remain precisely the same.

2. On a loan of 30,000, the borrower has agreed to pay interest at 7% eective at the

end of each year until the loan is repaid. The borrower has decided to deposit a

xed amount at the beginning of each year into a sinking fund earning 4% eective.

At the end of 11 years the sinking fund is exactly sucient to pay o exactly two-

thirds of the loan. He plans to continue accumulating the sinking fund until a year

when a deposit of not more than this xed amount will bring the fund balance up

to 30,000 and the loan can be immediately repaid.

(a) Calculate the total amount the borrower has to pay out each year (at the

beginning, and at the end), except possibly in the year when the loan is

repaid.

(b) Complete the following table to show how the sinking fund attains the target

value of 30,000, and the net amount of the loan after payments ##10, 11, . . .

until the loan is paid o.

Payment Interest Sinking Interest earned Amount in Net amount

Number paid fund deposit on sinking fund sinking fund of loan

10

11

12

. . .

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 74

3. A borrows 12,000 for 10 years, and agrees to make semiannual payments of 1,000,

plus a nal payment. The lender receives 12% convertible semiannually on the

investment each year for the rst 5 years and 10% convertible semiannually for the

second 5 years. The balance of each payment is invested in a sinking fund earning

8% convertible semiannually.

(a) Find the amount by which the sinking fund is short of repaying the loan at

the end of the 10 years.

(b) Complete the following table to show how the sinking fund attains its maxi-

mum value, and the net amount of the loan after payments.

Payment Interest Sinking Interest earned Amount in Net amount

Number paid fund deposit on sinking fund sinking fund of loan

09

10

11

12

4. (a) A borrower takes out a loan of 3000 for 10 years at 8% convertible semiannu-

ally. The borrower replaces one-third of the principal in a sinking fund earning

5% convertible semiannually, and the other two-thirds in a sinking fund earn-

ing 7% convertible semiannually. Find the total semiannual payment.

(b) Rework (a) if the borrower each year puts one-third of the total sinking fund

deposit into the 5% sinking fund and the other two-thirds into the 7% sinking

fund.

5. A payment of 800 is made at the end of each month for 10 years to repay a loan

of 30,000. The borrower replaces the capital by means of a sinking fund earning a

nominal annual rate of 6% compounded monthly.

(a) Find the eective annual rate i paid to the lender on the loan.

(b) Suppose that the lender had elected to amortize the loan by equal monthly

payments, at the same rate as he is now paying to the lender. What would

be the amount of those equal payments?

Information for Students in MATH 329 2004 01 75

13 Solutions, Fourth Problem Assignment

Distribution Date: Mounted on the Web on Wednesday, March 31st, 2004

Solutions were due by Wednesday, March 17th, 2004

Corrected as of April 29th, 2004.

(Solutions presented subject to further correction of errors and omissions.)

1. (a) Find, to the nearest unit, the accumulated value 19 years after the rst pay-

ment is made of an annuity on which there are 7 payments of 3000 each made

at 1

1

2

-year intervals. The nominal rate of interest convertible semiannually is

6%.

(b) Find, to the nearest unit, the present value of a 20-year annuity-due which

pays 200 at the beginning of each half-year for the rst 8 years, increasing to

250 per half-year thereafter. The eective annual rate of interest is 6%.

Solution:

(a) We will interpret the payments as being made under an annuity-immediate

with time-intervals of 1

1

2

years. The clock starts ticking (i.e. t = 0) 1

1

2

years

before the rst payment; the last payment is made at time t = 7 1.5 = 10.5.

The evaluation is to be made at time t = 191.5 = 17.5, i.e., 7 years after the

last payment; this is

14

3

intervals of length 1

1

2

years; it is simpler to view this

as 14 intervals of length

1

2

year, for each of which the eective interest rate is

3%. The eective interest rate call it j per 1

1

2

years is j = (1.03)

3

1 .

The accumulated value is, therefore,

3000(1.03)

14

s

7

=

3000

j

(1.03)

14

_

(1 + j)

7

1

_

=

3000

(1.03)

3

1

(1.03)

14

_

(1.03)

21

1

_

= 42100.12386

which is 42,100 to the nearest unit.

(b) With 1 + i = (1.06)

1

2

, v = (1.06)

1

2

,

Present Value = 250 a

40

50 a

16

= (250 50) + 250

_

1 v

39

i

_

50

_

1 v

15

i

_

= 200 +

250 (1 v

39

) 50 (1 v

15

)

i

= 200 +

200 250v

39

+ 50v

15

i

= 5342.993032.

Information for Students in MATH 329 2004 01 76

To the nearest unit the present value is 5343.

2. (a) The present value of a perpetuity-immediate paying 1 at the end of every 5

years is 1.637975. Find i and d.

(b) The present value of a perpetuity-due paying 1 at the beginning of every 5

years is 1.637975. Find d and i.

Solution:

(a) A payment of 1 at the end of every 5th year for 5 years is equivalent to a

payment of s

1

5

at the end of every year. The equation of value is

1.637975 = s

1

5

1

i

1.637975 =

1

(1 + i)

5

1

(1 + i)

5

= 1.610500

i = 10.0000%,

d =

0.1

1.1

=

1

11

.

(b) A payment of 1 at the beginning of every 5th year is equivalent to a payment

of a

1

5

at the beginning of every year. The equation of value is

1.637975 = s

1

5

1

d

1.637975 =

1

1 (1 + i)

5

(1 + i)

5

= 0.389490

i = 20.7538%,

d = 15.1703%.

3. Determine the present value, at a nominal interest rate of 6% compounded quar-

terly, of the following payments made under an annuity: 120 at the end of the 3rd

year, 110 at the end of the 4th year, decreasing by 10 each year until nothing is

paid.

Solution: The payments decrease until a payment of 10 at the end of the 14th

year. We can think of a decreasing annuity-immediate of value 10 (Da)

14

starting

with a payment of 140 at the end of the 1st year, and then make corrections. The

Information for Students in MATH 329 2004 01 77

eective annual interest rate i is given by

1 + i =

_

1 +

0.06

4

_

4

= (1.015)

4

.

We need only subtract the present values of the payments due at the end of the

rst and second years.

Present Value = 10(Da)

14

140v 130v

2

=

10

_

14 a

14

_

i

140(1.015)

4

130(1.015)

8

=

10

_

14

1(1.015)

56

(1.015)

4

1

_

(1.015)

4

1

140(1.015)

4

130(1.015)

8

= 532.1438213

4. Find the present value, at an eective annual interest rate of 5.75%, of a perpetuity-

immediate under which a payment of 100 is made at the end of the 1st year, 300 at

the end of the 2nd year, increasing until a payment of 2500 is made, which level is

maintained for exactly a total of 10 payments of 2500 (including the rst of them

in the count of 10), after which the payments fall by 400 each year until they reach

a level of 100, which is maintained in perpetuity. (Note: You are expected to show

explicitly how you decompose the payments; it is not sucient to simply show a

few numbers and a sum.)

Solution: The payments reach the level of 2500 at the end of year 13, and continue

at that level until the end of year 22, after which they fall by 400 annually until

they reach 100 at the end of year 28.

Since the steady state is a constant perpetuity, we can begin with a perpetuity-

immediate of 100 per year, whose present value is

100

0.0575

. The remaining non-zero

portions of payments are nite in number: there are additional amounts of 200

at the end of year 2, 400 at the end of year 3, . . . , 2400 at the ends of years 13

through 22, 2000 at the end of year 23, . . . , and a nal amount of 400 at the end

of year 27.

The value at time t = 22 of the remaining amounts for years 23 through 27 is

400 (Da)

5

, so the value at time t = 0 is (1.0575)

22

400 (Da)

6

. The present value

of the remainders of the payments at the ends of years 2, 3, ..., 12 is (1.0575)

1

200 (Ia)

11

. Thus the sum

100

0.0575

+ (1.0575)

22

400 (Da)

5

+ (1.0575)

1

200 (Ia)

11

Information for Students in MATH 329 2004 01 78

covers all the payments except for a level annuity of 2400 payable at the ends of

years ##13. . . 22, whose present value is

2400

_

a

22

a

12

_

.

Thus the present value of the entire scheme of payments is

100

0.0575

+ (1.0575)

22

400 (Da)

5

+ (1.0575)

1

200 (Ia)

11

+2400

_

a

22

a

12

_

=

100

0.0575

+ (1.0575)

22

400

5 a

5

0.0575

+ (1.0575)

1

200

a

11

11v

11

0.0575

+2400

_

a

22

a

12

_

=

100

0.0575

+ (1.0575)

22

400

5

1(1.0575)

5

0.0575

0.0575

+(1.0575)

1

200

1.0575(1.0575)

10

0.0575

11(1.0575)

11

0.0575

+2400

(1.0575)

12

(1.0575)

22

0.0575

= 1739.130435 + 1543.013920 + 8225.826240 + 9138.807264 = 20646.77786 .

5. Find, to the nearest unit, the present value of a 25-year annuity-due which pays

100 immediately, 104 at the end of the 1st year, 108.16 at the end of the 2nd year,

where each subsequent payment is obtained from its predecessor by multiplying by

a factor of 1.04. The annual eective rate of interest is 8.%.

Solution:

Present Value =

24

n=0

100v

n

(1.04)

n

= 100

1

_

1.04

1.08

_

25

1

1.04

1.08

= 1648.998444

or 1649 to the nearest unit.

6. (a) A loan of 15,000 is being repaid with payments of 1,500 at the end of each

year for 20 years. If each payment is immediately reinvested at 6% eective,

nd the eective annual rate of interest earned over the 20-year period.

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 79

(b) A loan of 15,000 is being repaid with payments of 1,500 at the end of each

year for 10 years. Determine the yield rate to the investor.

Solution:

(a) Let the eective yield rate be i. The payments do not become available until

the maturity date, after 20 years. Until that time they are locked into a

payment-scheme that accumulates to value 1500s

20 6%

. We are asked for the

interest rate that was earned. There are thus just two transactions: the loan

at time 0, in the amount of 15,000, and the repayment at time 20, in the

amount given above. The equation of value at time t = 0 is

1500s

20 6%

(1 + i)

20

= 15000

(1 + i)

20

=

10(0.06)

(1.06)

20

1

i = 6.7293555%.

(b) We have to determine i such that 1500 a

10 i

= 15000. This may appear to be

a dicult problem. But remember that

a

10

= v +v

2

+ v

3

+ . . . + v

10

and that v 1. That means that the sum cannot be more than 10; in order

for it to equal 10, each of the summands must equal 1, so v = 1. 1 + i = 1,

and i = 0.

Information for Students in MATH 329 2004 01 80

14 Solutions, Fifth Problem Assignment

Distribution Date: Mounted on the Web on Monday, April 7th, 2004.

Assignment was mounted on the Web on Wednesday, March 17th, 2004,

hard copy of the assignment was distributed on Friday, March 19th, 2004.

Solutions were to be submitted by Friday, April 2nd, 2004

(SUBJECT TO CORRECTION OF TYPOS AND OTHER ERRORS)

1. A loan is being repaid with instalments of 1000 at the end of each year for 15 years,

followed by payments of 2000 at the end of each year for 10 years. Interest is at

an eective rate of 4% for the rst 10 years, and an eective rate 6% for the next

15 years.

(a) Showing all your work, nd the numeric value of the amount of interest paid

in the 4th instalment without making use of a schedule.

(b) Showing all your work, nd the amount of principal repaid in the 20th instal-

ment, without making use of a schedule.

(c) Then use the information you have computed to compile the lines of a schedule

corresponding to the payments at the ends of years 20, 21, . . . , 25.

(d) Now solve (a), (b), (c) again, this time assuming that all payments are at the

beginnings of the years: the interest rates remain precisely the same.

Solution:

(a) By the prospective method, the unpaid balance of the loan at time t = 0 is

1000 a

10 4%

+ (1.04)

10

_

2000 a

15 6%

1000 a

5 6%

_

= 1000

1 (1.04)

10

0.04

+2000 (1.04)

10

1 (1.06)

15

0.06

1000 (1.04)

10

1 (1.06)

5

0.06

= 18387.66857 .

By the retrospective method, the unpaid balance just after the 3rd payment

of 1000 is, therefore,

18387.66857(1.04)

3

1000 s

3 4%

= 18387.66857(1.04)

3

1000

(1.04)

3

1

0.04

= 17562.02642 .

The interest component of the 4th instalment is, therefore,

0.04(17562.02642) = 702.48 .

Information for Students in MATH 329 2004 01 81

(b) By the prospective method, the unpaid balance just after the 19th instalment

is

2000 a

6 6%

= 2000

1 (1.06)

6

0.06

= 9834.648653 .

The interest component of the 20th instalment is, therefore,

0.06(9834.648653) = 590.0789192 ,

so the component for reduction of principal is

2000 590.0789192 = 1409.921081 .

(c)

Payment Payment Interest Principal Outstanding

Number amount paid repaid loan balance

19 2000 . . . . . . 9834.65

20 2000 590.08 1409.92 8424.73

21 2000 505.48 1494.52 6930.21

22 2000 415.81 1584.19 5346.02

23 2000 320.76 1679.23 3666.78

24 2000 220.01 1779.99 1886.79

25 2000 113.21 1886.79 0

(d) Since the only interest rate aecting the last payments has not changed, there

will be no changes at all in (b) or (c).

By the prospective method, the unpaid balance of the loan at time t = 0, just

before the rst payment, is

1000 a

10 4%

+ (1.04)

10

_

2000 a

15 6%

1000 a

5 6%

_

= 1000(1.04)

1 (1.04)

10

0.04

+ 2000(1.06) (1.04)

10

1 (1.06)

15

0.06

1000(1.06) (1.04)

10

1 (1.06)

5

0.06

= 19328.71077 .

By the retrospective method, the unpaid balance just after the 3rd payment

of 1000 is, therefore,

19328.71077(1.04)

2

1000 s

3 4%

= 19328.71077(1.04)

2

1000

(1.04)

3

1

0.04

= 17784.33357 .

The interest component of the 4th instalment is, therefore,

0.04(17784.33357) = 711.37 .

Information for Students in MATH 329 2004 01 82

2. (This problem is modelled on [1, Exercise 23, p. 198].)

On a loan of 30,000, the borrower has agreed to pay interest at 7% eective at the

end of each year until the loan is repaid. The borrower has decided to deposit a

xed amount at the beginning of each year into a sinking fund earning 4% eective.

At the end of 11 years the sinking fund is exactly sucient to pay o exactly two-

thirds of the loan. He plans to continue accumulating the sinking fund until a year

when a deposit of not more than this xed amount will bring the fund balance up

to 30,000 and the loan can be immediately repaid.

(a) Calculate the total amount the borrower has to pay out each year (at the

beginning, and at the end), except possibly in the year when the loan is

repaid.

(b) Complete the following table to show how the sinking fund attains the target

value of 30,000, and the net amount of the loan after payments ##10, 11, . . .

until the loan is paid o.

Payment Interest Sinking Interest earned Amount in Net amount

Number paid fund deposit on sinking fund sinking fund of loan

10

11

12

. . .

Solution:

(a) The borrower is paying a constant amount each year of 7% of 30,000, or 2,100

to cover the interest costs of servicing the loan; denote by X the constant

amount the borrower spends each year; thus the amount she contributes to

the sinking fund is X 2100. An equation of value at time t = 11 is (X

2100) s

11 4%

= 20000, so

X = 2100 +

20000 0.04

((1.04)

11

1) 1.04

= 3525.943064 .

Thus the level contribution to the sinking fund at the beginning of each year

except the last is 3525.94 2100.00 = 1425.94.

(b) The intention is that the column labelled Amount in sinking fund shows

the amount just after the payment with the given number.

Information for Students in MATH 329 2004 01 83

Payment Interest Sinking Interest earned Amount in Net amount

Number paid fund deposit on sinking fund sinking fund of loan

10 2,100.00 1,425.94 603.62 17,120.03 12,879.97

11 2,100.00 1,425.94 684.80 19,230.77 10,769.23

12 2,100.00 1,425.94 769.23 21,425.64 8,574.36

13 2,100.00 1,425.94 857.03 23,708.61 6,291.39

14 2,100.00 1,425.94 948.34 26,082.89 3,917.11

15 2,100.00 1,425.94 1,043.32 28,552.15 1,447.85

16 2,100.00 305.76 1,142.09 30,000.00 0.00

3. A borrows 12,000 for 10 years, and agrees to make semiannual payments of 1,000,

plus a nal payment. The lender receives 12% convertible semiannually on the

investment each year for the rst 5 years and 10% convertible semiannually for the

second 5 years. The balance of each payment is invested in a sinking fund earning

8% convertible semiannually.

(a) Find the amount by which the sinking fund is short of repaying the loan at

the end of the 10 years.

(b) Complete the following table to show how the sinking fund attains its maxi-

mum value, and the net amount of the loan after payments.

Payment Interest Sinking Interest earned Amount in Net amount

Number paid fund deposit on sinking fund sinking fund of loan

09

10

11

12

Solution:

(a) The interest payments for the rst 10 half-years are 6% of 12,000, i.e. 720

per half-year; and, for the second 10 half-years, 600 per half-year. This leaves

280 at the end of each of the rst 10 half-years, and 400 at the end of each

of the second 10 half-years to accumulate in the sinking fund, which earns

4% eective every half year. The accumulated balance in the sinking fund at

maturity will be

120s

10 4%

+ 280s

20 4%

=

1

0.04

_

120

_

(1.04)

10

1

_

+ 280

_

(1.04)

20

1

__

= 25

_

120(1.04)

10

+ 280(1.04)

20

400

_

= 9778.594855

Information for Students in MATH 329 2004 01 84

implying that the shortfall to repay the loan will be 12, 000 9778.59 =

2221.41.

(b) Just after the 8th payment the balance in the fund is

280 s

8 4%

=

280 ((1.04)

8

1)

0.04

= 2579.98 .

Interest earned by the 9th payments is 103.20. We can now begin to ll in

the schedule:

Payment Interest Sinking Interest earned Amount in Net amount

Number paid fund deposit on sinking fund sinking fund of loan

09 720.00 280.00 103.20 2963.18 9036.82

10 720.00 280.00 118.53 3361.71 8638.29

11 600.00 400.00 134.47 3896.18 8103.82

12 600.00 400.00 155.85 4452.03 7547.97

4. (a) A borrower takes out a loan of 3000 for 10 years at 8% convertible semiannu-

ally. The borrower replaces one-third of the principal in a sinking fund earning

5% convertible semiannually, and the other two-thirds in a sinking fund earn-

ing 7% convertible semiannually. Find the total semiannual payment.

(b) Rework (a) if the borrower each year puts one-third of the total sinking fund

deposit into the 5% sinking fund and the other two-thirds into the 7% sinking

fund.

Solution:

(a) The semiannual contribution to the sinking funds is

1000

s

20 2.5%

+

2000

s

20 3.5%

and the semiannual interest payment is 4% of 3, 000, or 120. Hence the total

semiannual payment is

1000

s

20 2.5%

+

2000

s

20 3.5%

+ 120 =

25

(1.025)

20

1

+

70

(1.035)

20

1

+ 120

= 229.8692824

(b) Let the total sinking fund deposit be D. Then the equation of value at ma-

turity is

D

3

s

20 2.5%

+

2D

3

s

20 3.5%

= 3000 ,

Information for Students in MATH 329 2004 01 85

implying that

D =

9000

s

20 2.5%

+ 2s

20 3.5%

=

9000

(1.025)

20

1

0.025

+ 2

(1.035)

20

1

0.035

= 109.6170427 ,

so the total semi-annual payment is 109.6170427+120=229.6170427.

5. A payment of 800 is made at the end of each month for 10 years to repay a loan

of 30,000. The borrower replaces the capital by means of a sinking fund earning a

nominal annual rate of 6% compounded monthly.

(a) Find the eective annual rate i paid to the lender on the loan.

(b) Suppose that the lender had elected to amortize the loan by equal monthly

payments, at the same rate as he is now paying to the lender. What would

be the amount of those equal payments?

Solution:

(a) The monthly contribution to the sinking fund is

30000

s

120 0.5%

=

600

(1.005)

120

1

= 183.0615058 .

Hence the monthly interest payment is 800 183.0615058 = 616.9384942,

i.e., 2.056461647% of the principal of 30,000. The eective annual rate is,

therefore,

(1.02056461647)

12

1 = 27.6691838%.

(b) The level monthly payment necessary to amortize a loan of 30000 over 120

payments at an eective rate of 2.056461647% is

30000

a

120 2.056461647%

=

(30000)(0.02056461647)

1 (1.02056461647)

120

= 675.6703969 .

(The amount is lower than the borrower is now paying because he is holding

funds in his sinking fund and earning less there than he his paying the lender

for the use of the capital.)

Information for Students in MATH 329 2004 01 901

References to these sources are often given in the notes for completeness. Students

are not expected to look up sources, but may wish to do so out of curiosity.

The entries in this list may not be in alphabetical order. As the notes are con-

structed, new entries will be added at the end, so as not to upset the earlier

numbering of references.

15 References

[1] S. G. Kellison, The Theory of Interest, Second Edition. Irwin/McGraw Hill, Inc.,

Boston, etc. (1991). ISBN 0-256-04051-1.

[2] S. G. Kellison, The Theory of Interest. Richard D. Irwin, Inc., Homewood, Ill. (1970).

ISBN ???-083841.

[3] McGill Undergraduate Programs Calendar 2003/2004. Also accessible at

http://upload.mcgill.ca/courses/UGFirstPage0304.pdf.

[4] R. Muksian, Mathematics of Interest Rates, Insurance, Social Security, and Pen-

sions. Pearson Education, Inc., Upper Saddle River, NJ. (2003). ISBN 0-13-009425-

0.

[5] M. M. Parmenter, Theory of Interest and Life Contingencies, with Pension Appli-

cations. A Problem-Solving Approach, 3rd Edition. ACTEX Publications, Winsted

CT, (1999). ISBN 1-56698-333-9.

[6] J. Stewart, Single Variable Calculus (Early Transcendentals), Fourth Edition.

Brooks/Cole (1999). ISBN 0-534-35563-3.

[7] H. S. Hall and S. R. Knight, Higher Algebra, Fourth Edition, MacMillan & Co.

(London, 1891).

[8] The Canadian Institute of Actuaries English-French lexicon,

http://www.actuaries.ca/publications/lexicon/

Information for Students in MATH 329 2004 01 2001

A Supplementary Lecture Notes

A.1 Supplementary Notes for the Lectures of January 5th, 7th,

and 9th, 2004

Distribution Date: Friday, January 9th, 2004, subject to further revision

At present these notes are following the textbook very closely.

Textbook Chapter 1. The measurement of interest.

A.1.1 1.2 The accumulation and amount functions

We begin with a list of denitions. In this list we deviate from the usual practice in

mathematics, of clearly separating denitions from results; some of the comments below

should not appear in a formal denition, but we are including them to simplify the

introduction of this terminology.

Denition A.1 1. Interest = the compensation that a borrower of capital pays to

a lender of capital for its use; the numerical amount of Interest will be called just

that:

2. (Amount of ) Interest; we will often suppress the words Amount of

3. Interest is said to be earned, or to accrue.

4. Principal = initial amount of money (capital) invested or borrowed

5. time will be denoted by t

6. (Measurement) Period = unit in which time is measured the default will be

1 year. Where there is a prescribed measurement period the default will be 1

year we will be adopting a discrete point of view: unless otherwise stated, the

amount of principal is to remain constant throughout a measurement period.

Sometimes we will consider t to be a continuous real variable, and there will be no

positive measurement period.

7. Accumulated Value = total amount owed or received after a period of time =

Principal + Amount of Interest. The accumulated value will, in general, be denoted

by the

8. Amount function A(t); with this notation the principal is A(0).

Information for Students in MATH 329 2004 01 2002

9. Accumulation Function a(t) = accumulated value at time t 0 of an investment

having principal 1. Thus a is a normalized version of A, giving the amount per

unit of principal. We have the relationship

A(t) = A(0) a(t) .

10. Interest earned during nth period = I

n

= A(n) A(n1) for integral n 1. Thus

I

n

is the dierence usually denoted by A(n1) in the nite dierence calculus.

Denition A.2 One convention is that the compensation we call interest is normally

payable at the end of the measurement period, or at the end of individual of units of the

measurement period. When that compensation is payable or credited at the beginning

of the period, the convention is to continue to call the compensation interest, but to also

speak of the payment as being a payment of discount.

The functions a(t) and A(t) will be continuous only if we choose to adopt a model where

interest is accruing in that way. If the understanding is that no interest is payable

until the end or beginning of a period, then the functions will have discontinuities at

those times. A decision as to what happens for fractions of a measurement period needs

to be made either explicitly, or implicitly from some prevailing practice. We will return

to this topic.

A.1.2 1.3 The eective rate of interest

Denition A.3 1. The eective rate of interest, i = a(1) a(0) = a(1) 1.

2. More generally, for integer n 1, the eective rate of interest during the nth period

i

n

=

A(n) A(n 1)

A(n 1)

=

I

n

A(n 1)

.

3. Thus i = i

1

.

The term eective is used when interest is paid once, at the end of each period;

the term can be contrasted with the nominal rate of interest, in which interest is

paid at other intervals, either more than once during the period, or after multiple

periods; or, more generally, whenever a measurement period dierent from the

established period is being used.

i =

(1 + i) 1

1

=

a(1) a(0)

a(0)

=

A(1) A(0)

A(0)

=

I

1

A(0)

.

For one very important accumulation function compound interest the ef-

fective rate of interest will be constant over successive measurement periods.

Information for Students in MATH 329 2004 01 2003

A.1.3 1.4 Simple interest

Innitely many accumulation functions a have the property that a(0) = 1, a(1) = 1 + i

for given i. Of those 2 are in common use: simple interest, discussed in this section,

and compound interest in the next section.

Denition A.4 Under simple interest

a(t) = 1 + it (t 0). (8)

Under simple interest, for non-negative integer n, i

n

=

i

1+i(n1)

, a decreasing function

of n. The author of the textbook begins by assuming equation (8) only for non-negative

integers t, and then justies extending his denition to all non-negative real t. You may

skip that justifying discussion. Note that, while the rate of interest is not constant under

simple interest, the derivative of the function a(t) is constant.

A.1.4 1.5 Compound interest

Under compound interest at a constant rate i, we either dene

a(t) = (1 + i)

t

(9)

for integral t 0; or we make another assumption that leads to this formula. Here

again, the author begins by assuming the function is dened only at the integers, and

then justies the extension to all real numbers. As with the preceding denition, you may

skip that justifying discussion. Note that, in this case, it is the rate of interest which

is constant, while the derivative of the function a(t) is not, it is a constant multiple

of the function value (the dening property of all exponential functions). He observes

that, while both simple and compound interest at rate i produce the same results over

a period of 1, compound interest produces a greater return over larger periods. Another

comparison is that, under simple interest, it is the absolute amount of growth that is

constant over equal periods of time; while, under compound interest, it is the relative

rate of growth, i.e. the rate as a fraction of the value at the beginning of the period.

He observes that simple interest is often used as an approximation to compound over

fractional periods.

A.1.5 1.6 Present value

Denition A.5 1. The growth of 1 during 1 period is determined by multiplication

by an accumulation factor 1 + i.

2. The discount factor for one period associated with the interest rate i is v = (1+i)

1

.

Multiplication by this factor gives the value one period earlier.

Information for Students in MATH 329 2004 01 2004

3. The discount function is a

1

(t) =

1

a(t)

. [NOTE: This is NOT the inverse function

of a.]

4. Present value or discounted value is the value now of payments to be made in the

future.

5. Accumulated value is the value now of payments made in the past.

6. The term Current value will be used to denote the value now of payments made

at some other times past or future.

7

A.1.6 1.7 The eective rate of discount

Whereas the rate of interest is the ratio of A(1) A(0) to A(0), the rate of discount will

be the ratio of A(1) A(0) to A(1); more generally, the rate of discount during the nth

period is given by

d

n

=

A(n) A(n 1)

A(n)

=

I

n

A(n)

for integer n 1. Relationships between discount and interest are developed. For

example, note that we can discount an amount X of money at time t = n back to

t = n 1 by either multiplying the the discount factor, v, or by subtracting d per unit;

hence vX = X dX, so

d = 1 v .

Here are some other relationships:

d = iv

i d = id

for all of which a simple verbal explanation should be available. It is also possible to

speak of simple discount analogously to simple interest, and to obtain a relationship like

a

1

(t) = 1 dt for 0 t

1

d

;

and of compound discount, where

a

1

(t) = v

t

= (1 d)

t

for 0 t ;

7

Some authors use the term present value for this.

Information for Students in MATH 329 2004 01 2005

A.1.7 1.8 Nominal rates of interest and discount

The author describes the use of several terms that are sometimes taken to be synonymous:

payable, compounded, and convertible. While they all can describe the periodic payment

of compound interest, they make dierent suggestions about when the interest is credited.

1. The symbol i

(m)

denotes compound interest that is paid m times a year; the rate

for each of the mths of the year is dened to be

i

(m)

m

; the symbol is intended to

be used alongside the symbol i, which will denote the equivalent eective rate of

interest for the whole year. The relationship is

1 + i =

_

1 +

i

(m)

m

_

m

and this equation may be solved to express each of i, i

(m)

in terms of the other:

i =

_

1 +

i

(m)

m

_

m

1

i

(m)

= m

_

(1 + i)

1

m

1

_

2. Analogously to the preceding, we may dene d

(m)

to be the nominal rate of discount

compounded m times a year, corresponding to an eective annual rate of discount

of d. Here the relationships are

1 d =

_

1

d

(m)

m

_

m

d = 1

_

1

d

(m)

m

_

m

d

(m)

= m

_

1 (1 d)

1

m

_

= m

_

1 v

1

m

_

Another interesting relationship is

i

(m)

m

d

(m)

m

=

i

(m)

m

d

(m)

m

.

Information for Students in MATH 329 2004 01 2006

A.2 Supplementary Notes for the Lecture of January 12th,

2004

Distribution Date: Monday, January 12th, 2004, subject to further revision

A.2.1 1.9 Forces of interest and discount

(This discussion omits much of the material in 1.9, and does not follow the presentation

in the textbook.)

The equation

1 + i =

_

1 +

i

(m)

m

_

m

(10)

is equivalent to

i

(m)

=

(1 + i)

1

m

1

1

m

(11)

As m we obtain

lim

m

i

(m)

= lim

m

(1 + i)

1

m

1

1

m

= lim

x0

+

(1 + i)

x

1

x

= lim

x0

+

(1 + i)

x

(1 + i)

0

x

=

d

dx

((1 + i)

x

)

x=0

= (1 + i)

x

ln(1 + i)[

x=0

= ln(1 + i)

Thus, if the frequency of compounding is permitted to become arbitrarily large, the

nominal interest rate equivalent to an eective rate of i is

ln(1 + i) = i

i

2

2

+

i

3

3

. . .

which is denoted by , and called the force of interest equivalent to an eective annual

interest rate of i.

Lets repeat the preceding calculations, but this time apply them to discount. The

equation

1 d =

_

1

d

(m)

m

_

m

(12)

Information for Students in MATH 329 2004 01 2007

is equivalent to

d

(m)

=

(1 d)

1

m

+ 1

1

m

(13)

As m we obtain

lim

m

d

(m)

= lim

m

(1 d)

1

m

+ 1

1

m

= lim

x0

+

(1 d)

x

+ 1

x

= lim

x0

+

(1 d)

x

+ (1 d)

0

x

=

d

dx

((1 d)

x

)

x=0

= (1 d)

x

ln(1 d)[

x=0

= ln(1 d)

But 1 d =

1

1 + i

, where i is the eective annual interest rate corresponding to an

eective annual discount rate of d;

ln(1 d) = ln

1

1 d

= ln(1 + i) = .

Thus, if the frequency of compounding is permitted to become arbitrarily large, the

nominal discount rate equivalent to an eective interest rate of i is again .

The main topic in this section is the general question of a measure of interest dened

by

t

=

a

(t)

a(t)

.

This equation can be integrated to yield

_

u

0

t

dt = ln a(u) ln a(0) = ln a(u) ln 1 = ln a(u)

so

a(u) = e

_

t

0

t

dt

. (14)

Note that, in the case of compound interest given by a(t) = (1+i)

t

,

t

= , dened above

so the function is constant, independent of time. For the present you are asked to

delete all general references to force of interest, and all problems based on this concept,

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2008

except those that explicitly stated in these notes; you are expected to know the denition

of in terms of i in the compound interest case and to be able to work problems involving

it, and to remember the denition in equation (14) above. You are not expected to be

able to reproduce the limit computations above.

A.2.2 1.10 Varying interest

Omit this section for the present.

A.2.3 1.11 Summary of results

Information for Students in MATH 329 2004 01 2009

A.3 Supplementary Notes for the Lecture of January 16th,

2004

Distribution Date: Friday, January 16th, 2004, subject to further revision

Textbook Chapter 2. Solutions of problems in interest

A.3.1 2.1 Introduction

The purpose of this chapter is to develop a systematic approach by which the basic

principles from Chapter 1 can be applied to more complex nancial transactions.

A.3.2 2.2 Obtaining numerical results

Numerical results will be obtained by using

calculators or personal computers

tables (like those at the back of the textbook); in this case we may interpolate

between entries in the tables; more information will be provided you are not

expected to have any prior knowledge about interpolation;

using approximating series, such as

(1 + i)

k

= 1 + ki +

k(k 1)

2!

i

2

+

k(k 1)(k 2)

3!

i

3

+. . . (15)

e

x

= 1 + x +

x

2

2!

+

x

3

3!

+ . . . (16)

ln(1 + x) = x

x

2

2

+

x

3

3

. . . (17)

which are MacLaurin series (a special case of Taylor series), and have restric-

tions on the numbers for which they are valid. (The rst is always valid if [i[ < 1,

and also for any i if k is a non-negative integer; the second is valid for all x; and the

third is valid for 1 < x 2.) The error that occurs when one truncates a series

i.e., when one stops adding at a particular term can be estimated. These

are results that appear in Calculus 3, and cannot be considered a prerequisite for

the course. You may be presented with certain approximating series from time to

time, but you will not be expected to use skills beyond Calculus 1 and Calculus 2,

unless everything new is provided in this course.

Information for Students in MATH 329 2004 01 2010

Approximating compound interest for fractions of a measurement period

The author observes that a method that is often used when a fraction of a measure-

ment period is involved is to approximate compound interest by simple interest. This

amounts to using series (15) above, but stopping after the 1st degree term:

(1 + i)

k

1 +ki .

It can also be interpreted as linear interpolation between values of (1 + i)

x

for integer

x. Suppose that we are interested in the accumulation factor for compound interest

between t = n and t = n + k, where 0 k 1. If we think of a line joining the points

(n, (1 + i)

n

) and (n + 1, (1 +i)

n+1

), and take as a value approximating (1 + i)

n+k

, the

ordinate of the point where this line meets the line x = n +k, we have similar triangles,

leading to the equation

k

1

=

approximation (1 + i)

n

(1 +i)

n+1

(1 +i)

n

from which we determine that the approximation is

k(1 + i)

n+1

+ (1 k)(1 + i)

n

= (1 + i)

n

(k(1 + i) + (1 k)) = (1 + i)

n

(1 + ki).

The author remarks that linear approximation between successive integer values of v

x

is

equivalent to simple discount. We can obtain a better approximation by truncating the

MacLaurin expansion after a higher term than the rst degree term. In the following

example the accumulation factor is approximated by a quadratic not a linear

function.

Example A.1 [1, Exercise 1, 2.2, p. 53] 10000 is invested for 4 months at 12.6%,

where interest is computed using a quadratic to approximate an exact calculation. Find

the accumulated value.

Solution: The exact value using compound interest is

10000(1.126)

4

12

= 10403.50 .

Alternatively, when we approximate by a quadratic, we truncate the MacLaurin series

after the 2nd degree term (cf. (15))

(1 + i)

1

3

= 1 +

1

3

i +

1

3

_

2

3

_

1

2!

i

2

+

1

3

_

2

3

_

5

3

_

1

3!

i

3

+. . .

1 +

1

3

i +

1

3

_

2

3

_

1

2!

i

2

= 1.040236

hence the accumulated value is approximately 10402.36.

Information for Students in MATH 329 2004 01 2011

Note that a linear approximation, which would be equivalent to simple interest, would

give 10420: as the period of time is less than one unit, a linear approximation is higher

than the value given by compound interest equivalently, the line joining the points

(x, y) = (0, (1.043)

0

) and (x, y) = (1, (1.043)

1

), passes over the graph of y = (1.043)

x

.

A.3.3 2.3 Determining time periods

A number of schemes are in common use for calculating interest for fractions of a period:

Under exact simple interest or actual/actual one counts the exact number of

days, and assumes the year has 365 days.

Under ordinary simple interest or 30/360 one assumes that each calendar month

has 30 days, and the year has 360 days.

Under Bankers Rule or actual/360 one uses the exact number of days but treats

a year as having 360 days. The treatment of February 29th in leap years (like the

present) is not completely standardized. These calculation bases can be used for

either simple or compound interest.

Example A.2 Here is a statement I found at the bottom of a bank statement that I

received today from a large Canadian bank: (name of bank) calculates interest daily

using a 365-day year, including leap years. The interest rate charged in a leap year will

be equal to the Annual Interest Rate in eect on each day in that year multiplied by 366

and divided by 365. Although this results in slightly more interest being charged, the

eective annual rate is the same when rounded to the nearest 1/8th of 1%.

A.3.4 2.4 The basic problem

The author states that An interest problem involves four basic quantities:

1. the principal originally invested

2. the length of the investment period

3. the rate of interest

4. the accumulated value of the principal at the end of the investment period,

and observes that 3 of these variables can be used to determine the 4th.

Information for Students in MATH 329 2004 01 2012

A.4 Supplementary Notes for the Lecture of January 19th,

2004

Distribution Date: Monday, January 19th, 2004, subject to further revision

A.4.1 2.4 The basic problem (continued)

Read the authors comments on language. He observes that many problems have two

point of view the borrowers point of view, and the lenders; you should be comfortable

with both, and with the terminology of both. He also observes that some of the accepted

terminology of the industry is ambiguous, or not intuitive, or even counter-intuitive. If a

statement doesnt make sense it could be that you are interpreting a denition literally,

instead of using its denition, which may be misleading.

A.4.2 2.5 Equations of value

We will often express the relationship between dierent sums in a problem in an equation

of value, which is simply a statement obtained by bringing all amounts to a particular

time (by accumulating or discounting according to whatever accumulation functions are

appropriate). Sometimes we will have an inequality rather than an equation. The time

where the various amounts are compared is the comparison date. Under compound inter-

est equations of value for the same payments, made a dierent comparison dates, should

be equivalent: you should be able to extract one from the other simply by multiplying

or dividing by the appropriate accumulation factors.

Time diagrams A time diagram is a one-dimensional diagram where the only variable

is time, shown on a single coordinate axis. We may show above or below the coordinate

of a point on the time-axis values of money intended to be associated with dierent

funds. As in any mathematical exercises, the diagram is not a formal part of a solution,

but may be very helpful in visualizing the solution. Some authors use variants of time

diagrams where there may be several parallel horizontal axes, representing several funds;

alternatively, you could use the usual type of graph that you have seen in calculus,

where the values of the fund will be shown as points in the plane, with the horizontal

axis representing time, and the second coordinate giving the function value. (The system

I am using for these notes accommodates gures with great diculty; I will usually not

attempt to show time diagrams for that reason.)

A.4.3 Unknown principal

(The textbook does not have a section with this title.)

Information for Students in MATH 329 2004 01 2013

Example A.3 [1, Exercise 2, p. 53] Find the present value of 5000 to be paid at the

end of 25 months at a rate of discount of 8% convertible quarterly

a) assuming compound discount throughout;

b) assuming simple discount during the nal fractional period.

Solution: Of the 4 basic quantities, the one we are lacking is the principal originally

invested. The length of the investment period is 2

1

12

years.

a) To discount at 8% we need to multiply by the appropriate power of 1

d

(4)

4

=

1 0.02 = 0.98. The number of time periods is

25

3

= 8

1

3

quarter-years. Assuming

compound discount throughout, we nd that the present value is 5000(0.98)

25

3

=

5000(0.845053031) = 4225.27.

b) We discount through

24

3

= 8 quarter years by multiplying by (0.98)

8

. To discount

through the last month by simple discount, we multiply by the factor 1

1

3

(0.02) =

0.993333333. The present value will be

5000(0.98)

8

_

1

1

3

(0.02)

_

= 5000(0.850763022)(0.993333333) = 4225.46 .

A.4.4 2.6 Unknown time

You may omit the discussion [1, pp. 45-46] of the method of equated time.

Read the discussion of the Rule of 72. The textbook shows that, at a given rate i of

compound interest, money will double in

n =

ln 2

ln(1 + i)

=

ln 2

i

i

ln(1 + i)

measurement periods. He then approximates the last ratio when i = 8%, so

time for money to double

ln 2

i

0.8

ln(1.08)

0.72

i

and observes that the approximation is surprisingly accurate over a wide range of in-

terest rates. To justify this rule we could investigate the behavior of

i

ln(1+i)

, whose

MacLaurin expansion begins 1 +

i

2

i

2

12

+ . . ., but that investigation is beyond this

course.

Information for Students in MATH 329 2004 01 2014

A.4.5 2.7 Unknown rate of interest

The textbook describes 4 methods for determining an unknown rate of interest:

Sometimes particularly if only one payment is involved it may be possible to

solve the equation of value by using the fact that the logarithm and exponential

functions are mutually inverse.

Sometimes the equation may be solved by algebraic techniques, for example when

the equation is equivalent to a polynomial equation that factorizes.

Sometimes the equation can be solved by interpolation in interest tables.

When all else fails, it may be necessary to solve by successive approximation or

iteration. There are various methods, and some converge much faster than others.

The justication of the better methods is beyond this course, but is the subject

matter of courses like MATH 317 (Numerical Analysis).

A.4.6 2.8 Practical examples

[1, Exercise 2, p. 53] Find the present value of 5000, to be paid at the end of 25

months, at a rate of discount of 8% convertible quarterly:

1. assuming compound discount throughout;

2. assuming simple discount during the nal fractional period.

Solution: The nominal discount rate compounded quarterly corresponds to an

eective discount rate of

d

(4)

4

= 2% per quarter.

1. Under compound discount the present value of 5000 is (10.02)

25

3

= 4225.27.

(Twenty-ve months is

25

3

quarter-years.)

2. We discount through 8 full quarter-years by multiplying by (1 0.02)

8

: this

brings the payment to one month from the present. For that month we are

instructed to discount by simple discount; as the time is one-third of a period

of 3 months, the discount factor is 1

0.02

3

= 0.9933333. We obtain a present

value of

5000(0.98)

8

(0.9933333) = 4225.46.

[1, Exercise 9, p. 54] At a certain interest rate the present values of the following

two payment patterns are equal:

(i) 200 at the end of 5 years plus 500 at the end of 10 years;

Information for Students in MATH 329 2004 01 2015

(ii) 400.94 at the end of 5 years.

At the same interest rate 100 invested now plus 120 invested at the end of 5 years

will accumulate to P at the end of 10 years. Calculate P.

Solution: Payment schemes (i) and (ii), both with comparison date t = 0, give rise

to the following equations of value:

200(1 + i)

5

+ 500(1 + i)

10

= 400.94(1 + i)

5

(18)

100 + 120(1 + i)

5

= P(1 + i)

10

(19)

Equation (18) implies that

(1 + i)

5

= 0.40188 . (20)

Substituting in (19) yields

P =

100

(0.40188)

2

+

120

0.40188

= 917.76.

Information for Students in MATH 329 2004 01 2016

A.5 Supplementary Notes for the Lecture of January 21st, 2004

Distribution Date: Wednesday, January 21st, 2004, subject to further revision

[1, Exercise 16, p. 55] You are asked to develop a rule of n to approximate how long

it takes money to triple. Find n.

Solution: In A.4.4 of these notes we have considered the Rule of 72. Let us

consider the rationale of that rule:

(1 + i)

n

= 2 n =

ln 2

ln(1 + i)

=

ln 2

i

i

ln(1 + i)

=

ln 2

i

i

i

i

2

2

+

i

3

3

i

4

4

+ . . .

=

ln 2

i

1

1

i

2

+

i

2

3

i

3

4

+ . . .

=

ln 2

i

1

1

_

i

2

i

2

3

+

i

3

4

. . .

_

=

ln 2

i

_

1 +

_

i

2

i

2

3

+

i

3

4

. . .

_

+

_

i

2

i

2

3

+

i

3

4

. . .

_

2

+ . . .

_

=

ln 2

i

_

1 +

i

2

i

2

12

+. . .

_

(ln 2)

_

1 +

i

2

i

2

12

+ . . .

_

i

The only change if we wish to obtain a rule for the time for money to triple is that

we obtain

n

(ln 3)

_

1 +

i

2

i

2

12

+ . . .

_

i

.

If we approximate i in the numerator by 8%, we obtain a numerator of approxi-

mately 1.14; the rule could be called the Rule of 114.

[1, Exercise 20, p. 55] Find an expression for the exact eective rate of interest at

which payments of 300 at the present, 200 at the end of one year, and 100 at the

end of two years will accumulate to 700 at the end of two years.

Information for Students in MATH 329 2004 01 2017

Solution: For the unknown interest rate i, which we assume to be non-negative,

the equation of value at time 2 is

300(1 + i)

2

+ 200(1 + i)

1

+ 100 = 700 ,

yielding a quadratic equation in 1 + i:

3(1 + i)

2

+ 2(1 + i) 6 = 0 ,

whose only positive solution is 1 +i =

1+

19

3

= 1.119632981, so i = 11.9632981%.

[1, Exercise 25, p. 56] A bill for 100 is purchased for 96 three months before it is

due. Find

1. The nominal rate of discount convertible quarterly earned by the purchaser.

2. The annual eective rate of interest earned by the purchaser.

Solution:

1. 100

_

1

d

(4)

4

_

= 96 d

(4)

= 16%.

2. 96(1 + i)

1

4

= 100 i =

_

100

96

_

4

1 = 17.7375701%.

[1, Exercise 27, p. 56] A savings and loan association pays 7% eective on deposits

at the end of each year. At the end of every 3 years a 2% bonus is paid on the

balance at that time. Find the eective rate of interest earned by an investor if

the money is left on deposit

1. Two years.

2. Three years.

3. Four years.

Solution: Let i denote the eective rate of interest in each case.

1. There being no bonus, i = 7%.

2. Here (1 + i)

3

= (1.07)

3

(1.02), so i = (1.07)(1.02)

1

3

1 = 7.7086300%.

3. This time i = (1.07)(1.02)

1

4

1 = 7.5410377%.

Information for Students in MATH 329 2004 01 2018

A.6 Supplementary Notes for the Lecture of January 23rd,

2004

Distribution Date: Friday, January 23rd, 2004, subject to further revision

Textbook Chapter 3. Basic Annuities

A.6.1 3.1 Introduction

Denition A.6 1. An annuity is a series of payments, usually made at equal inter-

vals of time.

2. The total period during which payments will be made is called the term.

3. The interval between payments is called the payment period; the name annuity

suggests a default period of 1 year, but, in some specic applications, the default

period may have some other length; there can, in fact, be two distinct periods

involved one associated with the interest calculations, and one associated with

the payments under the annuity.

4. An annuity-certain consists of payments that are all certain to be made. Otherwise

an annuity is a contingent annuity. An annuity whose payments are contingent on

whether a given individual is alive is a life annuity; the study of such annuities is

concerned with life contingencies, and is outside of this course.

A.6.2 3.2 Annuity-immediate

In an annuity-immediate the payments are made at the end of each period. The present

value of an annuity-certain for n periods is denoted by a

n

, or, if the interest rate needs

to be stated explicitly a

n i

. The author uses a diagram to denote annuities, with 2

arrows, one sometimes labelled t

1

and the other sometimes labelled t

2

. The rst shows

the beginning of the rst period, at the end of which a payment is due under the annuity-

certain. The second arrow, labelled t

2

, indicates the last payment date more precisely,

just after the payment has been made. I shall usually not include diagrams in these notes,

as they are very time-consuming to arrange using the text-preparation software that I

am using.

The accumulated value of the payments as of time t

2

is denoted by s

n

, or, if the

interest rate needs to be stated explicitly s

n i

. We can prove the following basic formul:

a

n

= v + v

2

+ . . . + v

n1

+ v

n

= v

1 v

n

1 v

when i ,= 0

Information for Students in MATH 329 2004 01 2019

=

1 v

n

i

(21)

s

n

= 1 + (1 + i) + (1 + i)

2

+ . . . + (1 + i)

n1

=

(1 + i)

n

1

(1 + i) 1

when i ,= 0

=

(1 + i)

n

1

i

(22)

Note that we have assumed as is usually the case that i ,= 0.

8

We can also prove

the following identities, both algebraically and verbally:

1 = ia

n

+ v

n

(23)

s

n

= a

n

(1 + i)

n

(24)

1

s

n

=

1

a

n

+i (25)

Example A.4 [1, Exercise 1, p. 88]

9

A family wishes to accumulate 50,000 in a college

education fund (by) the end of 20 years. If they deposit 1000 into the fund at the end of

each of the rst 10 years, and 1000 + X at the end of each of the second 10 years, nd

X to the nearest unit if the fund earns 7% eective.

Solution: The equation of value at time t

2

= 20 is

1000s

20

+ X s

10

= 50000 ,

which we may solve to yield

X =

50000

s

10 0.07

1000

s

20 0.07

s

10 0.07

=

50000

s

10 0.07

1000

(1.07)

20

1

(1.07)

10

1

= 50000s

1

10 0.07

1000((1.07)

10

+ 1)

= 50000(0.072378) 1000(2.96715) from the tables

= 651.75.

A more precise computation would yield 651.724; the dierence is due to rounding errors

and/or the limited precision of the tables.

8

When i = 0 a

n

= n = s

n

.

9

Remember to sketch a time diagram as you read each of these problems.

Information for Students in MATH 329 2004 01 2020

A.7 Supplementary Notes for the Lecture of January 26th,

2004

Distribution Date: Monday, January 26th, 2004, subject to further revision

A.7.1 3.2 Annuity-immediate (continued)

[1, Exercise 2, p. 88] The cash price of a new automobile is 10,000. The purchaser

is willing to nance the car at 18% convertible monthly and to make payments of

250 at the end of each month for 4 years. Find the down payment which will be

necessary.

Solution: Let X be the down payment. Then the equation of value at time t = 0

is X + 250a

48 1.5%

= 10000, from which we determine the down payment, X =

1489.361590. (Here again, the answer obtained using the tables in the text-book

is slightly incorrect, at 1489.35.)

[1, Exercise 5, p. 88] 1. Show that

a

m+n

= a

m

+ v

m

a

n

= v

n

a

m

+ a

n

2. Show that

s

m+n

= s

m

+ (1 + i)

m

s

n

= (1 + i)

n

s

m

+ s

n

3. Interpret the results in (a) and (b) verbally.

Solution:

1. (supply an algebraic proof)

2. (supply an algebraic proof)

3. (a) The present value of the rst m payments of an (m + n)-year annuity-

immediate of 1 is a

m

. The remaining n payments have value a

n

at time

t = m; discounted to the present, these are worth v

m

a

n

at time t = 0.

Since m+n = n+m, the same argument shows that a

m+n

= v

n

a

m

+a

n

.

(b) We can obtain similar results for the s functions by analogous arguments;

or by multiplying both sides of the previous equations by (1 + i)

m+n

.

[1, Exercise 7, p. 88] You are given the following annuity values. Find i:

a

7 i

= 5.153 a

11 i

= 7.036 a

18 i

= 9.180.

Solution: Lets rst prove a useful identity:

a

m+n

= a

m

+a

n

ia

m

a

n

(26)

Information for Students in MATH 329 2004 01 2021

This identity follows from

a

m+n

=

1 v

m

v

n

i

=

1 (1 ia

m

)(1 ia

n

)

i

.

For a verbal explanation, consider an annuity-immediate of 1 per year for m + n

years, the rst payment at the end of year #1. The present value of the rst m

payments is a

m

. The value of the remaining payments at time t = m is v

m

a

n

, which

may be interpreted as the value of an n-year annuity-immediate whose payments

are each v

m

. The proof may be completed by replacing v

m

by 1 ia

m

, for which

a verbal proof is given in [1, p. 60]

The identity implies that

i =

a

m

+ a

n

a

m+n

a

m

a

n

.

With m = 7 and n = 11, we obtain

i =

5.153 + 7.036 9.180

(5.153)(7.036)

= .08299199691

or approximately 8.3%.

Note that we didnt need three equations to nd i we could have determined it

from any one of the equations. For example, since a

7 i

is a continuous, decreasing

function of i, and since it is 7 when i = 0 and it approaches 0 as i becomes large,

the function must take on all intermediate values, so a

7 i

5.153 takes on the value

0 for just one positive number, which may be found by Successive Bisection [1, p.

399].

[1, Exercise 8, p. 88] Show that

1

1 v

10

=

1

s

10

_

s

10

+

1

i

_

Solution:

1

1 v

n

=

(1 + i)

n

(1 + i)

n

1

=

((1 + i)

n

1) + 1

(1 + i)

n

1

=

i

(1 + i)

n

1

((1 + i)

n

1) + 1

i

Information for Students in MATH 329 2004 01 2022

=

1

i

(1+i)

n

1

_

(1 + i)

n

1

i

+

1

i

_

=

1

s

n

_

s

n

+

1

i

_

In an annuity-due the payments are made at the beginning of each period. The present

value of an annuity-certain for n periods is denoted by a

n

, or, if the interest rate needs

to be stated explicitly a

n i

. Again the author uses a diagram to denote annuities, with

2 arrows, one labelled t

1

and the other labelled t

2

. The rst shows the beginning of the

rst period, just before a payment is due under the annuity-due. The second arrow,

labelled t

2

, indicates the end of the last period at the beginning of which a payment was

made. The accumulated value of the payments as of time t

2

is denoted by s

n

, or, if the

interest rate needs to be stated explicitly s

n i

.

(TO BE CONTINUED AT THE NEXT LECTURE)

Information for Students in MATH 329 2004 01 2023

A.8 Supplementary Notes for the Lecture of January 28th,

2004

Distribution Date: Wednesday, January 28th, 2004, subject to further revision

A.8.1 3.3 Annuity-due (continued)

We can prove the following basic formul:

a

n

= 1 + v +v

2

+ . . . + v

n2

+ v

n1

=

1 v

n

1 v

when i ,= 0

=

1 v

n

d

(27)

s

n

= (1 + i) + (1 + i)

2

+ . . . + (1 + i)

n

=

(1 + i)

n

1

d

when i ,= 0 . (28)

Note that we have assumed as is usually the case that i ,= 0. We can also prove

the following identities, both algebraically and verbally:

a

n

= (1 + i)a

n

(29)

s

n

= (1 + i)s

n

(30)

a

n

= 1 + a

n1

(31)

s

n

= 1 +s

n+1

(32)

s

n

= (1 + i)

n

a

n

(33)

[1, Exercise 9, p. 89] Find the present value of payments of 200 every six months

starting immediately and continuing through four years from the present, and 100

every six months thereafter through ten years from the present, if i

(2)

= 0.06.

Solution: The reader is likely to make assumptions in a casual reading that were

not intended by the author. Reading carefully, one might see that he intends that,

though the payments start immediately, they continue to the end of 4 years from

now that is, that there be 9 payments of 200, not 8. Similarly, it is the payments

that end after 10 years, not the years for which they are prepaid so there are

payments over 21 half-years in all. With this interpretation, at the eective rate

of

1

2

i

(2)

= 3% per half-year,

Present value = 100 a

21 3%

+ 100 a

9 3%

= 100(1.03)

_

100a

21 3%

+ 100a

9 3%

_

= 2389.716705

Information for Students in MATH 329 2004 01 2024

[1, Exercise 10, p. 89] A worker aged 40 wishes to accumulate a fund for retirement

by depositing 1000 at the beginning of each year for 25 years. Starting at age 65

the worker plans to make 15 annual withdrawals at the beginning of each year.

Assuming that all payments are certain to be made, nd the amount of each with-

drawal starting at age 65 to the nearest dollar, if the eective rate of interest is 8%

during the rst 25 years, but only 7% thereafter.

Solution: Let the constant amount of the withdrawals beginning at age 65 be X.

The equation of value at age 65 is

1000 s

25 8%

= X a

15 7%

X =

1000 s

25 8%

a

15 7%

= 1000

1.08

1.07

0.07

0.08

(1.08)

25

1

1 (1.07)

15

= 8101.654558

so, to the nearest dollar, the annual withdrawals will be 8102.

[1, Exercise 11, p. 89] (not discussed in the lecture) Find a

8

if the eective rate of

discount is 10%.

Solution: Since (1 d)(1 + i) = 1, v = 1 d = 0.9 when d = 0.1.

a

8

=

1 (0.9)

8

0.1

= 5.695327900.

[1, Exercise 12, p. 89] (not discussed in the lecture) Prove that

1

a

n

=

1

s

n

+ d .

Solution: Here is a verbal proof: The left side is the amount of each of n equal

annual payments in advance whose present value is 1. Decompose these payments

into two parts: an annual contribution in advance to a fund which will repay the

loan after n full years, and an annual payment of d in advance to account for the

delayed repayment of the loan.

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2025

A.9 Supplementary Notes for the Lecture of January 30th,

2004

Distribution Date: Friday, January 30th, 2004, subject to further revision

A.9.1 3.4 Annuity values on any date

Three cases are considered: the date is always an integral number of periods from each

payment date.

1. present values more than one period before the rst payment date

2. accumulated values more than one period after the last payment date;

3. current values at a date strictly between the rst and last payment dates.

Present values more than one period before the rst payment date An annuity

is said to be deferred by m time units if the rst payment is m time units later than

the type of annuity in question would normally be paid, and the subsequent payments

occur at the expected intervals. The notation of the earlier edition of the textbook was

standard: the value of an annuity that is deferred through k periods is denoted by the

earlier symbol, prexed by

k

[. Thus

k

[a

n

is the present value of an annuity-immediate

whose rst payment has been deferred through k time periods; analogous symbols can

be used for a

n

. It can be seen that

k

[a

n

= v

k

a

n

= a

n+k

a

k

,

k

[ a

n

= v

k

a

n

= a

n+k

a

k

.

Accumulated values more than 1 period after the last payment date Here

we can express the current values by multiplying by the appropriate power of 1 + i; or,

alternatively, by taking the dierence of two annuity values.

Summary You are urged to follow the textbooks suggestion, The reader should not

try to work problems by memorizing formulas... Remember the reasoning that was used

to derive the formul, and apply that reasoning from rst principles in each case.

Information for Students in MATH 329 2004 01 2026

Some exercises from the textbook

[1, Exercise 16, p. 89]] The textbook asks you to prove several formul. There are

two levels at which such exercises should be approached:

an algebraic proof

a verbal justication

Usually an algebraic proof should not be dicult; I will not normally include proofs

in these notes, but you can see me if you have diculty working through a proof.

The issue is not to nd an elegant proof just to show that the two sides of the

equation are equal. As for a verbal proof, that will be much harder, and I will

spend increasing amounts of time at the lectures discussing problems of this type.

[1, Exercise 17, p. 89] (not discussed in the lecture) Payments of 100 per quarter

are made from June 7, year Z through December 7, year Z + 11, inclusive. If the

nominal rate of interest, convertible quarterly, is 6%:

1. nd the present value on September 7, year Z 1;

2. nd the current value on March 7, year Z + 8;

3. nd the accumulated value on June 7, year Z + 12.

Solution:

1. As of September 7, year Z1, no payments have yet been made. The present

value is

10

(1.015)

2

100a

44+3 1.5%

= 3256.879998 .

2. As of March 7, year Z + 8, the value as of March 7, year Z will accumulate

by a factor (1.015)

(84)

, for an accumulated value of 5403.152103.

3. As of June 7, year Z + 12, the originally computed value will accumulate by

a factor (1.015)

(134)1

, for an accumulated value of 6959.369761.

[1, Exercise 18, p. 89] To prove that

15

t=10

_

s

t

s

t

_

= s

16

s

10

6 .

10

Why is the exponent 2 and not 3 even though the the evaluation is being made 9 months before

the rst payment? Because I am viewing the payments as an annuity-immediate: the clock starts

ticking one period before the rst payment. And why have 3 periods been added, even though June

and December are only 2 quarter-years apart? Again because the rst payment is associated with the

3-month period ending with the payment, so the actual length of the annuity period is 3 months longer.

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2027

Solution: Here is a verbal proof: s

t

s

t

can be interpreted as the excess over 1 of

the value after t + 1 years of a payment of 1 at time t = 0, which is (1 +i)

t+1

1;

for the present purposes, let us interpret this as the excess over 1 of the present

value of a payment t +1 years ago. The sum

15

t=10

is, therefore, the excess over 6 of

the value accumulated to the present of an annuity of 6 annual payments of 1, the

rst 16 years ago, the last 11 years ago; hence the sum is equal to

s

16

s

10

6 .

[1, Exercise 19, p. 89] Annuities X and Y provide the following payments:

End of Year Annuity X Annuity Y

110 1 K

1120 2 0

2130 1 K

Annuities X and Y have equal present values at an annual eective interest rate

i such that v

10

=

1

2

. Determine K.

Solution: As of today, the present values of annuities X and Y are respectively

1 a

30

+1

_

a

20

a

10

_

and K a

30

K

_

a

20

a

10

_

. Setting these amounts equal and

solving, we obtain

K =

a

30

+ a

20

a

10

a

30

a

20

+ a

10

=

1 v

30

v

20

+v

10

1 v

30

+v

20

v

10

=

1

1

8

1

4

+

1

2

1

1

8

+

1

4

1

2

=

9

5

= 1.8.

[1, Exercise 21, p. 90] It is known that

a

7

a

11

=

a

3

+ s

x

a

y

+ s

z

.

Find x, y, and z.

Solution: Intuitively we usually expect that the determination of 3 variables re-

quires 3 constraints. While this is not always the case, the fact that only one

equation has been presented here should ring an alarm bell. The variable i has

Information for Students in MATH 329 2004 01 2028

not been mentioned, and we might also wish to know whether the solution we are

asked to nd should be dependent on i.

11

At time t = 0 the present values of annuities-due of 1 per year for respectively 7

and 11 years have value in the ratio

a

7

a

11

. Both of these values should increase by

a factor of 1 +i per year under compound interest. Hence, 4 years later, the ratio

will not have changed. But, at that time, it can be interpreted as

a

3

+ s

4

a

7

+ s

4

. Thus

one solution to the problem is

(x, y, z) = (4, 7, 4), (34)

and this solution is valid for all i.

THIS PROBLEM WILL BE DISCUSSED FURTHER AT THE LECTURE OF

Monday, February 2nd, 2004. It appears from the textbook that the values given

above are the only solution the textbook was seeking but there exist others!.

11

This can explain the apparent paucity of equations: to assume that the solution holds for all i is

equivalent to assuming an equation for every value of i innitely many equations, for the 3 unknowns

we are trying to determine. In such a situation we should not be surprised if there is no solution at all.

Information for Students in MATH 329 2004 01 2029

A.10 Supplementary Notes for the Lecture of February 2nd,

2004

Distribution Date: Monday, February 2nd, 2004, subject to further revision

A problem on simple discount One student asked about the following

Example A.5 [1, Exercise 33, p. 57] A signs a 1-year note for 1000, and receives 920

from the bank. At the end of 6 months A makes a payment of 288. Assuming simple

discount, to what amount does this reduce the face amount of the note?

Solution: The rate of simple discount is

80

1000

= 8%. At the due date, 1 year from now,

the 288 accumulates to

288

10.04

= 300, which is the reduction in the face value of the note.

The original face value was 1000: it is reduced to 1000 300 = 700.

A.10.1 3.4 Annuity values on any date (continued)

Exercises from the textbook (continued)

[1, Exercise 21, p. 90] (continued) It is known that

a

7

a

11

=

a

3

+ s

x

a

y

+ s

z

.

Find x, y, and z.

Solution: Intuitively we usually expect that the determination of 3 variables re-

quires 3 constraints. While this is not always the case, the fact that only one

equation has been presented here should ring an alarm bell. The variable i has

not been mentioned, and we might also wish to know whether the solution we are

asked to nd should be dependent on i.

1. At time t = 0 the present values of annuities-due of 1 per year for respectively

7 and 11 years have value in the ratio

a

7

a

11

. Both of these values should increase

by a factor of 1 + i per year under compound interest. Hence, 4 years later,

the ratio will not have changed. But, at that time, it can be interpreted as

a

3

+ s

4

a

7

+ s

4

. Thus one solution to the problem is

(x, y, z) = (4, 7, 4), (35)

and this solution is valid for all i.

I would not expect students to be able to generate the rest of this solution!

Information for Students in MATH 329 2004 01 2030

2. Having found one solution, which we can see from the solutions [1, p. 418] to

be the solution the author is seeking, we might be expected to stop. But, to

a mathematician, an instruction like Find x, y, and z means, implicitly,

Find all possible sets of values for x, y, and z.

So lets investigate whether we have all solutions. This raises new issues. The

solution we found above in (35) is valid for all i. We have two subquestions:

Could there be other solutions for all i?

Could there be solutions that hold for specic values of i, but not for all

i?

3. Could there be other solutions for all i? When i = 0, equation

a

7

a

11

=

a

3

+ s

x

a

y

+ s

z

(36)

becomes

7

11

=

3 + x

y + z

,

implying that

11x 7y 7z = 33 . (37)

As i , v 0, and the left side of equation (36) approaches

lim

i

1 (1 + i)

7

1 (1 + i)

11

= 1 ;

the limit of the right side will be 1 only if

x = z . (38)

Then (37) becomes

4x 7y = 33 . (39)

Our earlier solution (35) satises this last diophantine equation; some other

solutions are

(x, y, z) = (11, 11, 11), (18, 15, 18), (3, 3, 3) .

If we dene

w =

y 3

4

=

x + 3

7

,

Information for Students in MATH 329 2004 01 2031

we nd that equation (35) is equivalent to

1 v

7

1 v

11

=

1 v

7w

1 v

11w

.

Values of w other than w = 1 produce a polynomial equation which constrains

v, so the equality will not hold for all interest rates. Thus solution (35) is the

only solution valid for all i.

[1, Exercise 20, p. 90] At an annual eective interest rate i it is known that

1. The present value of 2 at the end of each year for 2n years, plus an additional

1 at the end of each of the rst n years, is 36.

2. The present value of an n-year deferred annuity-immediate paying 2 per year

for n years is 6.

Find i.

Solution: It is convenient, because of a situation that will develop later in the

proof, to distinguish two cases.

Case i ,= 0: From (1) we have an equation of value

36 = 2 a

2n

+ 1 a

n

; (40)

from (ii) we have the equation of value

6 = v

n

2 a

n

= 2

_

a

2n

a

n

_

. (41)

Solving these equations, we obtain a

2n

= 13, a

n

= 10, implying that

1 v

2n

1 v

n

=

1.3

1

(v

n

)

2

1.3v

n

+ 0.3 = 0

v

n

=

1.3 0.7

2

= 0.3 or 1 .

The value v

n

= 1 corresponds to i = 0, which we shall treat in the next case.

Since v

n

= 0.3, we can substitute in the second equation of value:

6 = (0.3) 2

1 0.3

i

and solve for i, obtaining i = 7%.

Information for Students in MATH 329 2004 01 2032

Case i = 0: Here Equations (40) and (41) become

36 = 2(2n) + n

6 = 2n = 2(2n n)

which are inconsistent. Thus this case is impossible.

[1, Exercise 22, p. 90] Simplify a

15

(1 + v

15

+ v

30

) to one symbol.

Solution:

a

15

_

1 + v

15

+ v

30

_

=

1 v

15

i

_

1 + v

15

+ v

30

_

=

1 v

45

i

= a

45

[1, Exercise 23, p. 90] (not discussed in the lecture) Find the present value to the

nearest dollar on January 1 of an annuity which pays 2000 every six months for

ve years. The rst payment is due on the next April 1, and the rate of interest is

9% convertible semiannually.

Solution: On April 1st the annuity is worth 2000 a

10 4.5%

. Discounting back to

January 1st, i.e. through half of a half-year period, we obtain a value of

(1.045)

1

2

2000 a

10 4.5%

= (1.045)

1

2

2000a

10 4.5%

= (1.045)

1

2

2000

1 (1.045)

10

0.045

= 16177.59053

or 16178 to the nearest dollar.

Information for Students in MATH 329 2004 01 2033

A.11 Supplementary Notes for the Lecture of February 4th,

2004

Distribution Date: Wednesday, February 4th, 2004, subject to further revision

A.11.1 3.5 Perpetuities

The symbol a

of payments, the rst one period from now; where the interest rate is not clear from the

context, we may write a

i

. When the interest rate i is 0 the present value would be

innite. Otherwise we sum an innite geometric series, obtaining

v + v

2

+ v

3

+ . . . =

v

1 v

=

v

iv

=

1

i

.

It can be seen that this is the limit of the usual formula for a

n

as n . An innite

annuity of this type is called a perpetuity-immediate, or usually just a perpetuity.

Analogously we may dene a perpetuity-due to be an innite sequence of equal pay-

ments, where the rst is made immediately. We use the symbol a

its present value is

1

d

. While perpetuities do exist in the real world, for example in the

bond market, they are also useful in providing verbal explanations of identities. For

example, we can explain the formula a

n

=

1v

n

i

by expressing the quotient on the right

as a dierence,

1

i

v

n 1

i

and interpreting the n-payment annuity as the dierence of 2

perpetuities, one beginning a year from now, and the other n + 1 years from now; i.e.,

a

n

= a

(

n

[a

)

[1, Exercise 24, p. 90] A sum P is used to buy a deferred perpetuity-due of 1 payable

annually. The annual eective rate of interest is i > 0. Find an expression for the

deferred period.

Solution: Denote the deferral period by n. Then P = v

n 1

d

n = 1 +

ln P+lni

lnv

=

1

lnP+lni

ln

= 1

ln Pi

ln

.

[1, Exercise 25, p. 90] Deposits of 1000 are placed into a fund at the beginning of

each year for the next 20 years. After 30 years, annual payments commence, and

continue forever, with the rst payment at the end of the 30th year. Find an

expression for the amount of each payment.

Solution: The deposits accumulate to a fund worth 1000 s

20

a year after the last

payment, and 1000(1 + i)

10

s

20

10 years after the last payment. A perpetuity-due

bought with this amount will have annual payments of

1000 s

20

(1 + i)

10

d = 1000(1 + i)

10

(1 + i)

21

(1 + i)

i

iv

= 1000

_

(1 + i)

30

(1 + i)

10

_

.

Information for Students in MATH 329 2004 01 2034

Alternatively, we could set up an equation of value at any other time, for example

at time t = 0. The value of the deposits will be 1000 a

20

. Suppose that the level

amount of the withdrawals is X. These withdrawals may be interpreted as either

an perpetuity-due for which the clock starts at the time of the rst payment, 30

years from now; or as a perpetuity-immediate for which the clock starts 29 years

from now in order that the rst payment occur at the end of that year. This leads

to equations, either

1000 a

20

= Xv

30

a

or

1000 a

20

= Xv

29

a

[1, Exercise 26, p. 90] (not discussed in detail in the lecture) A benefactor leaves an

inheritance to 4 charities, A, B, C, and D. The total inheritance is a series of level

payments at the end of each year forever. During the rst n years, A, B, and C

share each payment equally. All payments after n years revert to D. If the present

values of the shares of A, B, C, and D are all equal, nd (1 + i)

n

.

Solution: Imposing the condition that the sum of the rst n payments is equal to 3

times the present value of payments ##n +1, n +2, . . ., we obtain a

n

= 3v

n

a

v

n

=

1

4

(1 + i)

n

= 4.

[1, Exercise 27, p. 90] (not discussed in detail in the lecture) A level perpetuity-

immediate is to be shared by A, B, C, and D. A receives the rst n payments, B

the second n payments, C the third n payments, and D the payments thereafter.

It is known that the ratio of the present value of Cs share to As share is 0.49.

Find the ratio of the present value of Bs share to Ds share.

Solution: The present values of the shares of A, B, C, D are, respectively, a

n

, v

n

a

n

,

v

2n

a

n

, and v

3n

a

implies that v

n

= 0.7. The ratio of Bs share to Ds is then seen to be

v

n

a

n

v

3n

a

=

0.7 0.3

(0.7)

3

=

30

49

.

A.11.2 3.6 Nonstandard terms and interest rates

Omit this section.

Information for Students in MATH 329 2004 01 2035

A.12 Supplementary Notes for the Lecture of February 6th,

2004

Distribution Date: Friday, February 6th, 2004, subject to further revision

A.12.1 3.6 Nonstandard terms and interest rates

Omit this section.

A.12.2 3.7 Unknown time

In this section the textbook considers situations where n, the number of annuity pay-

ments, is not known. Rather than solving such problems for some non-integer n

which is not practical because there would not likely be universal agreement about the

interpretation such problems are usually resolved by having a nal payment in an

otherwise regular sequence of payments cover the amount necessary to make up the dif-

ference. Where the nal payment needed to meet a goal is larger than a regular payment,

it is called a balloon payment; where it is smaller, it is called a drop payment. Solving

problems in this section typically involves two phases:

Determination of the number of regular payments.

Determination of the value of the nal payment, subject to given constraints (e.g.

that it be a balloon or drop payment).

The author uses tables in the rst phase, but we can solve such problems without ta-

bles, by rst solving an inequality. Read [1, Example 3.7, pp. 74-75], where the author

considers a problem where a planned nal payment turns out to be negative.

[1, Exercise 32, p. 91] A loan of 1000 is to be repaid by annual payments of 100 to

commence at the end of the 5th year, and to continue thereafter for as long as

necessary. Find the time and amount of the nal payment if the nal payment is

to be larger than the regular payments. Assume i = 4.5%.

Solution: Let the time of the last balloon payment be n, and let the amount

of the last payment be X. Then n is the largest integer solution to the inequality

1000 100(1.045)

4

a

n4

= 100(1.045)

4

1 (1.045)

(n4)

0.045

(1.045)

(n4)

1

1000 0.045 (1.045)

4

100

(n 4) ln 1.045 ln

_

1 10 0.045 (1.045)

4

_

Information for Students in MATH 329 2004 01 2036

(n 4)

ln (1 0.45(1.045)

4

)

ln 1.045

n 4

ln (1 0.45(1.045)

4

)

ln 1.045

= 21.47594530.

Thus we conclude that the balloon payment is made at time t = 21. The equation

of value at time t = 21 is

1000(1.045)

21

= 100s

17

+ (X 100)

implying that

X = 100 + 1000(1.045)

21

100

0.045

_

(1.045)

17

1

_

= 146.070467 .

[1, Exercise 33, p. 91] A fund of 2000 is to be accumulated by n annual payments

of 50, followed by n annual payments of 100, plus a smaller nal payment made 1

year after the last regular payment. if the eective rate of interest is 4.5%, nd n

and the amount of the nal irregular payment.

Solution: We shall interpret the payments to be made under two annuities-due:

the rst, for 2n years, consists of an annual deposit of 50 in advance; the second,

for n years, deferred n years after the rst, also consists of an annual deposit of 50

in advance. It is at the end of year 2n that the nal, drop payment is to be made,

and it is to be under 100. (Note that this is the type of problem where the drop

payment could turn out to be negative. We seek the smallest n for which

50 s

2n

+ 50 s

n

> 2000 100

50(1.045)

(1.045)

2n

+ (1.045)

n

2

0.045

> 1900

(1.045)

2n

+ (1.045)

n

2 >

1900

50

0.045

1.045

_

(1.045)

n

+

1

2

_

2

>

1900

50

0.045

1.045

+ 2.25 = 3.886363636

Since the exponential is positive, the preceding inequality is equivalent to (1.045)

n

>

1.471386222, and, in turn, to

n >

ln 1.471386222

ln 1.045

= 8.774018446 .

Thus the drop payment will be when t = 2 9, i.e., 18 years after the rst pay-

ment under the annuity with payments of 50. Just before the drop payment the

accumulated value of all previous payments is

50

_

s

9

+ s

18

_

= 50(1.045)

(1.045)

18

+ (1.045)

9

2

0.045

= 1967.588591

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2037

so the drop payment at time t = 18 is 2000 1967.588591 = 32.411409.

Note that there is an error in the answers in the textbook: while n = 9 is correct,

the payment of 32.41 is not at time n = 9.

(If tables like those in the textbook were available, one could determine the value

of n by inspecting the value of s

2n

+ s

n

. We observe from the 4.5% tables the

following values:

n s

2n

+ s

n

8 32.0993

9 37.6572

10 43.6596

We seek the smallest n such that

50 s

2n

+ 50 s

n

> 2000 100

i.e., such that

s

2n

+ s

n

> 38 ,

equivalently,

s

2n

+ s

n

>

38

1.045

= 36.37 ,

and so can conclude that n = 9.)

Information for Students in MATH 329 2004 01 2038

A.13 Supplementary Notes for the Lecture of February 9th,

2004

Distribution Date: Monday, February 9th, 2004, subject to further revision

A.13.1 3.7 Unknown time (continued)

[1, Exercise 34, p. 91] One annuity pays 4 at the end of each year for 36 years.

Another annuity pays 5 at the end of each year for 18 years. The present values

of both annuities are equal at eective rate of interest i. If an amount of money

invested at the same rate i will double in n years, nd n.

Solution: If i ,= 0, the equation of value for the two annuities may be solved as

follows:

4a

36

= 5a

18

4

_

1 v

36

_

= 5

_

1 v

18

_

4

_

v

18

_

2

5

_

v

18

_

+ 1 = 0

v

18

= 1 or v

18

=

1

4

Of these equations, the rst is inadmissible, since it corresponds to the excluded

case i = 0; the second equation is the only valid conclusion, and it implies that

(1 + i)

18

= 4 = 2

2

, so money doubles in

18

2

= 9 years.

As for the case i = 0, the equation of value can be transformed as follows:

4a

36

= 5a

18

4 36 = 5 18 (42)

which is a contradiction; hence i ,= 0, and the preceding conclusion is the only

valid one.

[1, Exercise 35, p. 91] A fund earning 8% eective is being accumulated with pay-

ments of 500 at the beginning of each year for 20 years. Find the maximum number

of withdrawals of 1000 which can be made at the ends of years under the condition

that once withdrawals start they must continue through the end of the 20-year

period.

Solution: Suppose that the rst withdrawal occurs at time t = n. We must deter-

mine the smallest n satisfying the following sequence of equivalent inequalities:

500 s

20

1000s

21n

(1.08)

_

(1.08)

20

1

_

2

_

(1.08)

21n

1

_

(1.08)

21

1.08 2

(1.08)

21

(1.08)

n

2

Information for Students in MATH 329 2004 01 2039

(1.08)

n

2

1 +

0.92

(1.08)

21

n 6.825449633 ,

hence n = 7. The maximum number of withdrawals of 1000 is, therefore, 21 7 =

14.

[1, Exercise 36, p. 91] A borrower has the following two options for repaying a loan:

(i) Sixty monthly payments of 100 at the end of each month.

(ii) A single payment of 6000 at the end of K months.

Interest is at the nominal annual rate of 12% convertible monthly. The two options

have the same present value. Find K.

Solution: The equation of value at the present time t = 0 leads to the following

sequence of equivalent equations:

100a

60 1%

= 6000(1.01)

K

1 (1.01)

60

0.01

=

60

(1.01)

K

(1.01)

K

=

0.01 60

1 (1.01)

60

K =

ln

0.0160

1(1.01)

60

ln 1.01

= 29.01227333 .

To the precision of the problem, K = 29.

Information for Students in MATH 329 2004 01 2040

A.14 Supplementary Notes for the Lecture of February 11th,

2004

Distribution Date: Wednesday, February 11th, 2004, subject to further revision

A.14.1 3.8 Unknown rate of interest

Where it is the interest rate that is not known, there can be several dierent approaches:

Algebraic methods:

Where possible, one tries to nd a solution using algebraic methods. Since

the various formul we work with are usually polynomial in i or ratios of

polynomials in i, it may be possible to nd the particular solution(s) we seek

by algebraic means.

Algebraic means may still be available where solving for i fails, if we can nd

another convenient intermediary variable.

It may be possible to solve by interpolation on tables, provided the functions we

are interested in are tabulated.

The favoured method is by successive approximation, to obtain a solution to any

desired accuracy.

Linear Interpolation Suppose that we know the values of f at distinct points x = x

1

and at x = x

2

, and that f(x

1

) ,= f(x

2

). If [x

1

x

2

[ is small, it may be reasonable to

assume that the graph of f is approximately linear between x

1

and x

2

; or, more generally,

near x

1

and x

2

. That is equivalent to assuming that

f(x) = f(x

1

) +

f(x

2

) f(x

1

)

x

2

x

1

(x x

1

)

=

f(x

2

) f(x

1

)

x

2

x

1

x +

x

2

f(x

1

) x

1

f(x

2

)

x

2

x

1

.

If now we wish to determine an approximate value of x where f(x) has a specic value

y

0

, we may use this equation for that purpose provided f(x

2

) f(x

1

) is not too small:

x = x

1

+ (x

2

x

1

)

y

0

f(x

1

)

f(x

2

) f(x

1

)

.

Information for Students in MATH 329 2004 01 2041

In particular, if we wish to nd a zero of f near the given points, and if f(x

1

) ,= f(x

2

),

a good approximation could be

x x

1

+ (x

2

x

1

)

0 f(x

1

)

f(x

2

) f(x

1

)

=

x

1

f(x

2

) x

2

f(x

1

)

f(x

2

) f(x

1

)

.

When we apply these formul for points between two points x

1

and x

2

, we speak of linear

interpolation; otherwise linear extrapolation. Interpolation may be used to improve the

eciency of the Method of Successive Bisection [1, p. 349, Appendix V], or to provide a

rst approximation prior to the application of other approximation methods.

Newton-Raphson iteration method In [1, Appendix V, pp. 399-400] the author

considers several Iteration methods. In all of these methods one is interested in solving

an equation

f(x) = 0 , (43)

i.e. in nding the zeroes of f; usually there are several solutions, and one is interested

in a zero in a certain interval. For example, if x is to represent an interest rate, or

an accumulation factor, we would not normally be interested in a solution that was

negative. One of the iteration methods discussed is the method of Successive bisection

[1, B, pp. 399-400] which you have already seen in an assignment problem. Another is

the Newton-Raphson method [1, D, p. 400].

The general idea we are applying to (43) is to nd a xed point for a mapping

x h(x). It can be shown that if, in an interval where f

1 in magnitude, we start with an approximation call it x

0

and replace it by a

succession of approximations [1, p. 76]:

x

1

= h(x

0

)

x

2

= h(x

1

)

x

3

= h(x

2

)

x

n

= h(x

n1

)

x

n+1

= h(x

n

)

this iteration algorithm will converge in the interval within which x

0

is chosen; that is,

the sequence x

0

, x

1

, . . . will approach a limit x which satises equation

x = h(x) . (44)

Information for Students in MATH 329 2004 01 2042

In applying the Newton-Raphson method to solve (43) for a function f, we take

h(x) = x

f(x)

f

(x)

.

The condition [h

f(x) f

(x)

(f

(x))

2

< 1 . (45)

Any solution to (43) will be a xed point x for the transformation h. Here the successive

approximations are:

x

0

x

1

= x

0

f(x

0

)

f

(x

0

)

x

2

= x

1

f(x

1

)

f

(x

1

)

. . .

x

n+1

= x

n

f(x

n

)

f

(x

n

)

. . .

and the sequence converges to a point x with the property that

x = x

f(x)

f

(x)

,

so f(x) = 0. This method can be shown to produce an extremely fast rate of conver-

gence, called second-order convergence

12

. While the theory of approximations of this

type is beyond this course, we shall use the method when it is useful.

Newton-Raphson iteration to solve a

n i

= k for i The given equation must be

recast as an equivalent equation in the form f(i) = 0. Our usual formula for a

n i

gives

1 (1 i)

n

i

= k

so we might express this as an equivalent constraint on a function

f(i) =

1 (1 i)

n

i

k ,

12

cf., http://mathworld.wolfram.com/NewtonsMethod.html

Information for Students in MATH 329 2004 01 2043

asking that

f(i) =

1 (1 i)

n

i

k = 0 .

It can be shown that condition (45) is satised for this function. The iteration is given

by [1, (3.28), p. 77]

i

r+1

= i

r

_

1 +

1 (1 + i

r

)

n

ki

r

1 (1 + i

r

)

(n+1)

(1 + (n + 1)i

r

)

_

(46)

Newton-Raphson iteration to solve s

n i

= k for i Analogously to the preceding,

it may be shown that the iteration is given by [1, (3.28), p. 78]

i

r+1

= i

r

_

1 +

(1 + i

r

)

n

1 ki

r

(1 + i

r

)

n1

(1 i

r

(n 1)) 1

_

(47)

Some remaining exercises from [1, Chapter 3] (not all were discussed in the

lecture):

[1, Exercise 38, p. 92] If a

2

= 1.75, nd an exact expression for i.

Solution:

a

2

= 1.75

(1 + i)

2

1

i

= 1.75(1 + i)

2

1.75i

2

+ 2.5i 0.25 = 0 (48)

7i

2

+ 10i 1 = 0

i =

10 +

100 + 28

14

=

5 4

2

7

or

5 + 4

2

7

. (49)

Since i > 0, the second solution is inadmissible, and i = 0.09383632129.

[1, Exercise 41, p. 92] A fund of 17,000 is to be accumulated at the end of 5 years

with payments at the end of each half-year. The rst 5 payments are 1,000 each,

while the second 5 payments are 2,000 each. Find the nominal rate of interest

convertible semiannually earned on the fund.

Solution: The equation of value at time 5, just after the last payment, is

1000

_

s

10

+ s

5

_

= 17000 (50)

_

(1 + i)

5

_

2

+ (1 + i)

5

2 = 17i. (51)

There is a unique solution to this problem, since the sum on the left side of equation

(50) is an increasing function of positive i.

Information for Students in MATH 329 2004 01 2044

Dene

f(x) = (1 + i)

10

+ (1 + i)

5

2 17i .

We can approximate with successive bisection, beginning with f(0.03) = 0.006809547

and f(0.04) = 0.016897187.

f(0.035) = 0.016897187

f(0.0325) = 0.002194300

f(0.03375) = 0.000436424

f(0.033125) = 0.000906060

f(0.0334375) = 0.000241612

f(0.03359375) = 0.000095705

f(0.033515625) = 0.000073378

f(0.033554687) = 0.000011056

f(0.033535156) = 0.000031188

f(0.033544922) = 0.000010071

f(0.033549805) = 0.000000491

f(0.033547364) = 0.000004790

f(0.033548585) = 0.000002148

f(0.033549195) = 0.0000008286

f(0.033549500) = 0.000000169

f(0.033549653) = 0.000000162

f(0.033549577) = 0.000000001

f(0.033549615) = 0.000000080

f(0.033549587) = 0.000000020

f(0.033549582) = 0.000000009

f(0.033549580) = 0.000000005

f(0.033549579) = 0.000000002

f(0.033549578) = 0.000000000

This is the eective interest rate for a half-year. The nominal annual rate, com-

pounded semi-annually will be 2 0.033549578 = 6.7099156%.

[1, Exercise 42, p. 92] A beneciary receives a 10,000 life insurance benet. If the

beneciary uses the proceeds to buy a 10-year annuity-immediate, the annual pay-

out will be 1,538. If a 20-year annuity-immediate is purchased, the annual payout

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2045

will be 1,072. Both calculations are based on an annual eective interest rate of i.

Find i.

Solution: The equations of value at time 0 are

10000 = 1538 a

10

= 1072 a

20

The last equation alone implies that 1 + v

10

= 1.434701492, which implies that

i = 8.6878222%. I dont see why the amount of the insurance benet was given

(although it is consistent with the other other information.)

[1, Exercise 50, p. 93] 1. Show that

s

n

= n +

n(n 1)

2!

i +

n(n 1)(n 2)

3!

i

2

+ . . .

2. Show that

1

s

n

=

1

n

_

1

n 1

2

i +

n

2

1)

12

i

2

+ . . .

_

Solution:

1. The sum on the right a nite sum is obtained from the expansion of

the 10th power of the binomial 1 + i by

deleting the term for i

0

, which is 1;

dividing by i.

2. Unlike the preceding expansion, this one is innite. It can be obtained from

the preceding result as follows:

1

s

n

=

i

(1 + i)

n

1

=

1

n

_

1 + i

_

n 1

2

+

(n 1)(n 2)

6

i +

(n 1)(n 2)(n 3)

24

i

2

+ . . .

__

1

=

1

n

_

1

_

n 1

2

+

(n 1)(n 2)

6

i +

(n 1)(n 2)(n 3)

24

i

2

+ . . .

_

i

+

_

n 1

2

+

(n 1)(n 2)

6

i +

(n 1)(n 2)(n 3)

24

i

2

+ . . .

_

2

i

2

+ . . .

_

=

1

n

_

1

n 1

2

i +

n

2

1

12

i

2

+

(n 1)(n

2

n 1)

24

i

3

+ . . .

_

Information for Students in MATH 329 2004 01 2046

[1, Exercise 51, p. 93] A loan of 1,000 is to be repaid with annual payments at the

end of each year for the next 20 years. For the next 5 years the payments are k

per year; the second 5 years, 2k per year; the third 5 years, 3k per year; and the

fourth 5 years, 4k per year. Find an expression for k.

Solution: The equation of value at time 0 is

kv

20

_

s

20

+ s

15

+ s

10

+ s

5

= 1000

_

,

implying that

k =

1000

s

20

+ s

15

+ s

10

+ s

5

=

1000i a

5

s

20

[1, Exercise 52, p. 93] The present value of an annuity-immediate which pays 200

every 6 months during the next 10 years and 100 every 6 months during the follow-

ing 10 years is 4,000. The present value of a 10-year deferred annuity-immediate

which pays 250 every 6 months for 10 years is 2,500. Find the present value of an

annuity-immediate which pays 200 every 6 months during the next 10 years and

300 every 6 months during the following 10 years. (Hint: Payments made during

the rst 10 years are discounted at a dierent rate than payments made during the

second 10 years.)

Solution: The Hint is objectionable, as it reveals a datum that should have been

stated in the problem.

Denote the eective semi-annual interest rates during the rst and second 10 years

by i and j respectively. The equations of value at time 0 are

200 a

20 i

+ 100 a

20 j

(1 + i)

20

= 4000

250 a

20 j

(1 + i)

20

= 2500

Solving these equations, we infer that

a

20 i

= 15

a

20 j

(1 + i)

20

= 10

200 a

20 i

+ 300 a

20 j

(1 + i)

20

= 6000

where the last sum is the present value of the desired annuity-immediate.

Information for Students in MATH 329 2004 01 2047

[1, Exercise 53, p. 94] A depositor puts 10,000 into a bank account that pays an

annual eective interest rate of 4% for 10 years. If a withdrawal is made during

the rst 5

1

2

years, a penalty of 5% of the withdrawal amount is made. The depositor

withdraws K at the end of each of years 4, 5, 6, and 7. The balance in the account

at the end of year 10 is 10,000. Find K.

Solution: We shall assume that the account is debited by each penalty after the

withdrawal that triggers it. An equation of value at time 10 is

10000(1.04)

10

K(1.05)

_

(1.04)

6

+ (1.04)

5

_

K

_

(1.04)

4

+ (1.04)

3

_

= 10000 .

Hence

K =

(1.04)

10

1

(1.04)

3

(2.04) ((1.05)(1.04)

2

+ 1)

= 979.9317732 .

[1, Exercise 54, p. 94] Simplify

40

n=15

s

n

.

Solution:

1

i

_

40

n=15

(1 +i)

n

40

n=15

1

_

=

1

i

_

(1 + i)

41

(1 + i)

15

i

26

_

=

1

i

_

s

41

s

15

26

_

[1, Exercise 55, p. 94] Show that s

n

a

n

> n

2

if i > 0 and n > 1.

Solution:

s

n

a

n

=

_

(1 + i)

n

1

i

_

2

1

(1 +i)

n1

= (s

n

)

2

(1 + i)

n1

.

But s

n

is a strictly increasing function of i; its minimum value is when i = 0, where

it is equal to n. And 1 + i > 1 (1 +i)

n1

> 1.

A.14.2 3.9 Varying interest

Omit this section for now.

A.14.3 3.10 Annuities not involving compound interest

Omit this section.

Information for Students in MATH 329 2004 01 2048

A.15 Supplementary Notes for the Lecture of February 13th,

2004

Distribution Date: Friday, February 13th, 2004, subject to further revision

Textbook Chapter 4. More General Annuities.

A.15.1 4.1 Introduction

The textbook considers

annuities whose payments do not have the same frequency as the interest conversion

periods;

annuities whose payments are not constant.

For the rst of these topics, contained in the following three sections of the textbook, we

shall not study all the material carefully, but shall consider ad hoc solutions to problems.

A.15.2 4.2 Annuities payable at a dierent frequency than interest is con-

vertible

A typographical error. The following example, given in the textbook [1, Example

4.1, p. 96] contains a serious error. Example 4.1 Find the accumulated value at the

end of 45 years of an investment fund in which 100 is deposited at the beginning of each

quarter for the rst 2 years, and 200 is deposited at the beginning of each quarter for

the second 2 years, if the fund earns 12% convertible quarterly.

Solution: If the interest rate were as stated the problem would be of a type studied in

Chapter 2. A reading of the solution shows that the author intended the last word to be

monthly.

Some Exercises

[1, Exercise 1, p. 122] Find the accumulated value 18 years after the rst payment

is made of an annuity on which there are 8 payments of 2000 each made at 2-year

intervals. The nominal rate of interest convertible semiannually is 7%. Answer to

the nearest dollar.

Solution: The nominal biennial interest rate i

(

1

2

)

is given by

_

1 +

i

(

1

2

)

1

2

_

1

2

= 1 + i =

_

1 +

i

(2)

2

_

2

Information for Students in MATH 329 2004 01 2049

=

_

1 +

0.07

2

_

2

i

(

1

2

)

= 2

_

(1.035)

4

1

_

and the eective biennial rate call it j is

j =

i

(

1

2

)

1

2

= (1.035)

4

1 .

Using this interest rate and a scale with time unit of a 2 year interval, the payments

2 intervals after the last are worth

2000

_

s

10

s

2

_

=

2000

j

_

(1 + j)

10

(1 + j)

8

_

= 2000

_

(1.035)

40

(1.035)

32

(1.035)

4

1

_

= 35824.25354

which is 35824 to the nearest unit. (Why, then, does the textbook give the value

as 35825? Because the author is using his tables. If we work with the 3.5% tables

[1, p. 383], we obtain

2000

_

s

10

s

2

_

= 2000

_

s

40 0.035

s

8 0.035

s

4 0.035

_

= 2000

_

84.5503 9.0517

4.2149

_

= 35824.62217 .

The tables also contain values of the inverse of s

4 0.035

:

2000

_

s

40 0.035

s

8 0.035

s

4 0.035

_

= 2000s

1

4 0.035

_

s

40 0.035

s

8 0.035

_

= 2000(0.237251)(84.5503 9.0517)

= 35824.23670 ,

which gives an answer which is closer to the correct one.)

[1, Exercise 2, p. 122] (not discussed in the lecture) Find the present value of a 10-

year annuity which pays 400 at the beginning of each quarter for the rst 5 years,

increasing to 600 per quarter thereafter. The annual eective rate of interest is

12%. Answer to the nearest dollar.

Information for Students in MATH 329 2004 01 2050

Solution: With 1 + i = (1.12)

1

4

,

Present Value = 600 a

40

200 a

20

= (600 200) + 600

_

1 v

39

i

_

200

_

1 v

19

i

_

= 11466.12687

[1, Exercise 3, p. 122] (not discussed in the lecture) A sum of 100 is placed into a

fund at the beginning of every other year for 8 years. If the fund balance at the

end of 8 years is 520, nd the rate of simple interest earned by the fund.

Solution: The wording of this problem is not as precise as it could be while it

is clear that the payments into the fund are 2 years apart, it is not clear whether

they are at the beginnings of years ##0, 2, 4, 6 or the beginnings of years ##1, 3,

5, 7. From the authors answer we see that he intended the former interpretation.

Let i be the annual rate of simple interest. Then the equation of value at time

t = 8 is

100[(1 + 8i) + (1 + 6i) + (1 + 4i) + (1 + 2i)] = 520 i = 6%

(The other interpretation mentioned would have given

100[(1 + 7i) + (1 + 5i) + (1 + 3i) + (1 + 1i)] = 520 i = 7.5%.)

Information for Students in MATH 329 2004 01 2051

A.16 Supplementary Notes for the Lecture of February 16th,

2004

Distribution Date: Monday, February 16th, 2004, subject to further revision

A.16.1 4.3 Further analysis of annuities payable less frequently than inter-

est is convertible

Some Exercises

[1, Exercise 4, p. 122] Rework [1, Exercise 1, p. 122] using the approach developed

in [1, 4.3].

Solution: There is more than one approach in the section. It would appear that

the textbook wishes the student to apply the formul developed in the section,

whereby a scaling factor is used. Preferring to work from rst principles, I interpret

this instruction to refer to the replacement of the biennial payments by payments

spaced according to the interest compounding interval here a half-year. If we

let R denote the amount of such a payment under an annuity-immediate paying

2000 every 2 years, we have

R s

4 3.5%

= 2000

so R =

2000

s

4 3.5%

. The value 18 years after the rst biennial payment is made i.e. 4

years after the last biennial payment of 2000 is made will be equal to the value of

a semi-annual 32-payment annuity-immediate of R per half-year, 8 half-years after

the last payment, i.e.

(1.035)

8

R s

32 3.5%

= (1.035)

8

2000

s

4 3.5%

s

32 3.5%

= 2000(1.035)

8

s

32 3.5%

s

4 3.5%

= 2000(1.035)

8

57.3345

4.2149

= 35824.61636.

[1, Exercise 5, p. 122] Give an expression in terms of functions assuming a rate of

interest per month for the present value, 3 years before the rst payment is made,

of an annuity on which there are payments of 200 every 4 months for 12 years:

1. expressed as an annuity-immediate;

2. expressed as an annuity-due.

Information for Students in MATH 329 2004 01 2052

Solution: In order to use these functions, we need to replace the regular payment

every 4 months by an equivalent monthly payment. Let i represent the eec-

tive monthly interest rate, and A and B respectively be the monthly payments

at the end of the month/in advance equivalent to a payment under an annuity-

immediate/annuity-due of 200 every 4 months. Then

As

4 i

= 200

B a

4 i

= 200

Both replacement annuities will pay 12 12 = 144 monthly payments.

1. The annuity is deferred 3 years, i.e. 3 12 = 36 months, before the rst

payment is made that means 32 months before the beginning of annuity-

immediate at 4-month intervals, and also 32 months before the beginning of

the replacement annuity-immediate with monthly payments of A.

Value = A

_

32

a

144i

_

= 200

v

32

a

144

s

4

= 200

a

176

a

32

s

4

2. This annuity is deferred 36 months.

Value = B

_

36

a

144i

_

= 200

v

36

a

144

a

4

= 200

a

180

a

36

a

4

= 200

a

180

a

36

a

4

[1, Exercise 6, p. 122] s

3

+ a

1

is the present value just after the third payment

of a 4-payment annuity-immediate of 1 for which the clock started ticking 2

units ago, i.e., for which the rst payment was 1 unit ago. An n-payment annuity-

immediate that pays 1 every 4 years, starting in 2 years i.e., with rst payment

in 3 years, may be replaced by a 4n-payment annuity-immediate starting now, with

rst payment in 4 years, whose present value is

a

4n

s

3

+a

1

.

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2053

In the problem the rst payment of the given annuity is excluded; this corresponds

to the rst 4 payments of the replacement annuity. Thus the present value of the

annuity described is

a

28

a

4

s

3

+a

1

.

[1, Exercise 7, p. 122] A perpetuity of 750 payable at the end of every year, and a

perpetuity of 750 payable at the end of every 20 years are to be replaced by an

annuity of R payable at the end of every year for 30 years. If i

(2)

= 0.04, show that

R = 37500

_

1

s

2

+

v

40

a

40

_

s

2

a

60

where all functions are evaluated at 2% interest.

Solution: The given nominal annual interest rate of 4%, compounded semi-annually,

is equivalent to an eective semi-annual rate of 2%.

1. Each payment of 750 at the end of a year is equivalent to 2 payments of

750

s

2 2%

,

one at the end of 6 months, the other at the end of the year. Thus the present

value of the rst perpetuity is

750

s

2 2%

a

2%

.

2. The perpetuity of 750 payable at the end of 20-year intervals, is, analogously,

worth at present

750

s

40 2%

a

2%

.

3. Hence the amount available to purchase the annuity is

750 a

2%

_

1

s

2 2%

+

1

s

40 2%

_

= 750

1

0.02

_

1

s

2 2%

+

v

40

v

40

s

40 2%

_

= 37500

_

1

s

2 2%

+

v

40

a

40 2%

_

(52)

4. A payment of R at the end of a year is equivalent to a payment of

R

s

2

at the

end of every 6 months. The present value of the 30-year annuity is, therefore,

R

a

60

s

2

(53)

since we are replacing it by a 60-half-year annuity-immediate.

Information for Students in MATH 329 2004 01 2054

5. The equation of value equates amounts (52) and (53), implying that

R =

37500

_

1

s

2 2%

+

v

40

a

40 2%

_

a

60

s

2

= 37500

_

1

s

2 2%

+

v

40

a

40 2%

_

s

2

a

60

[1, Exercise 8, p. 122] Find an expression for the present value of an annuity-due of

600 per annum payable semiannually for 10 years, if d

(12)

= 0.09.

Solution: The eective discount rate per month is

0.09

12

=

3

4

%. The eective discount

rate per 6 months is, therefore, d

=

d

(2)

2

= 1 (1 0.0075)

6

. The textbook wishes

us to interpret the statement ...600 per annum payable semiannually to mean

...300 paid per half-year. With this interpretation the present value of the 20-

half-year annuity-due is, therefore,

300 a

20

= 600

1 (1 d

)

20

d

= 300

1 (1 0.0075)

120

1 (1 0.0075)

6

[1, Exercise 9, p. 122] The present value of a perpetuity paying 1 at the end of every

3 years is

125

91

. Find i.

Solution: A payment of 1 at the end of the year for 3 years is equivalent to a

payment of s

1

3

at the end of every year. The equation of value is

125

91

= s

1

3

1

i

125

91

=

1

(1 +i)

3

1

(1 + i)

3

=

_

6

5

_

3

i = 20%.

[1, Exercise 10, p. 123] Find an expression for the present value of an annuity on

which payments are 100 per quarter for 5 years, just before the rst payment is

made, if = 0.08.

Information for Students in MATH 329 2004 01 2055

Solution: The eective interest rate per quarter is i = e

0.08

4

1, so v = e

0.02

.

Accordingly, the present value of the annuity-due is

100 a

20 i

= 100

(1 + i) (1 v

20

)

i

= 100

1 e

0.4

e

0.02

(1 + e

0.02

)

[1, Exercise 11, p. 123] A perpetuity paying 1 at the beginning of each year has a

present value of 20. If this perpetuity is exchanged for another perpetuity paying R

at the beginning of every 2 years, nd R so that the values of the two perpetuities

are equal.

Solution: An equation of value now for the perpetuity is

1

d

= 20, implying that

i =

1

19

. At an eective annual discount rate of d, a payment of 1 now is equivalent to

a 2-year annuity-due paying

1

1+v

=

1+i

2+i

each year, in advance. The perpetuity-due

paying R at the beginning of each 2-year period is equivalent to a perpetuity-

due paying R

1+i

2+i

at the beginning of every year. Equating this to 20 yields

R =

39

20

= 1.95.

[1, Exercise 12, p. 123] Find an expression for the present value of an annuity on

which payments are 1 at the beginning of each 4-month period for 12 years, as-

suming a rate of interest per 3-month period.

Solution: If the eective interest rate per 3-month period is i, then the equivalent

eective rate per 4-month period will be j = (1 +i)

4

3

1. The present value of the

annuity-due at this rate for 12 3 4-month periods will be

a

36 j

=

(1 +j) (1 + j)

36

j

=

(1 +i)

4

3

(1 + i)

48+

4

3

(1 + i)

4

3

1

=

1 v

48

1 v

4

3

A.16.2 4.4 Further analysis of annuities payable more frequently than in-

terest is convertible

In 4.4 we have a new notation. A right-superscribed (m) indicates that the annuity is

payable m times in a time unit for compounding of interest. More than that, we will

assume that the unit previously associated with one payment is divided into m parts;

this usage is analogous to the use of the upper right parentheses in i

(m)

. Thus a

(m)

n i

Information for Students in MATH 329 2004 01 2056

represents the present value of an annuity of

1

m

payable at m times regularly spaced

through an interest period. There will be immediate and due versions of the symbol,

analogous symbols for perpetuities, and a corresponding symbol for s.

Some Exercises

[1, Exercise 14, p. 123]

a

(m)

n

=

1

m

_

1 + v

1

m

+ v

2

m

+ . . . + v

n

1

m

_

=

1

m

1 v

n

d

(m)

[1, Exercise 20, p. 123] A sum of 10000 is used to buy a deferred perpetuity-due

paying 500 every 6 months forever. Find an expression for the deferred period

expressed as a function of d.

Solution: The eective discount rate per 6 months is 1 v

1

2

. If the perpetuity-due

has been deferred for n full years, the equation of value is

10000 = 500 v

n

1

1

v

from which it follows that

n =

ln(20(1

v))

ln v

=

ln(20(1

1 d))

ln(1 d)

[1, Exercise 21, p. 124] If 3 a

(2)

n

= 2 a

(2)

2n

= 45 s

(2)

1

, nd i.

Solution:

3 a

(2)

n

= 2 a

(2)

2n

= 45 s

(2)

1

3

2

(1 v

n

) =

2

2

_

1 v

2n

_

=

45

2

i

The rst equation implies that 1 + v

n

=

3

2

(1 + i)

n

= 2. Substitution in the

equations yields i =

1

30

.

[1, Exercise 22, p. 124] Find an expression for the present value of an annuity which

pays 1 at the beginning of each 3-month period for 12 years, assuming a rate of

interest per 4-month period.

Information for Students in MATH 329 2004 01 2057

Solution: If i be the eective interest rate per 4-month period, the eective rate

per 3-month period will be j = (1 + i)

3

4

1. Accordingly the value of the desired

annuity is

a

48 j

= (1 + j)

1 (1 + j)

48

j

= (1 + i)

3

4

1 (1 + i)

36

(1 + i)

3

4

1

=

1 (1 + i)

36

1 (1 + i)

3

4

An alternative approach to this problem would be to dene A to be the amount

of payment that would have to be made under an annuity-due every four months

for 12 years to give the same present value as the annuity-due described in the

problem. We can look at a single year in order to determine A. The present value

of payments of A now, 4 months from now, and 8 months from now, is

A

_

1 + (1 + i)

1

+ (1 + i)

2

_

= A (1 + i)

1 (1 + i)

3

i

and the value of the 4-payment annuity-due at 3 month intervals is

1(1 + (1 + j) + (1 + j

2

+ (1 + j)

3

= (1 + j)

1 (1 + j)

4

j

.

Equating the two, and recalling that (1 + i)

3

= (1 + j)

4

, gives A =

i(1 + j)

j(1 + i)

. The

value of the annuity will then be

a

48 j

= A a

36 i

=

i(1 + j)

j(1 + i)

(1 + i)

1 (1 + i)

36

i

=

1 (1 + i)

36

1 (1 + i)

3

4

as found previously.

A.16.3 4.5 Continuous annuities

Omit this section for the present.

Information for Students in MATH 329 2004 01 2058

A.16.4 4.6 Basic varying annuities

Payments varying in arithmetic progression. A general formula will be developed

for an annuity-immediate with a term of n periods, with payments beginning at P and

increasing by Q per period thereafter, at interest rate i, showing that its present value

A is

A = P a

n

+ Q

a

n

nv

n

i

and the accumulated value just after the last payment is

S = P s

n

+ Q

s

n

n

i

.

When P = Q = 1, a specic symbol is used:

(Ia)

n

=

a

n

nv

n

i

(Is)

n

=

s

n

n

i

=

s

n+1

(n + 1)

i

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2059

A.17 Supplementary Notes for the Lecture of February 18th,

2004

Distribution Date: Wednesday, February 18th, 2004, subject to further revision

A.17.1 4.6 Basic varying annuities (continued)

Similarly, when P = n and Q = 1, we have a decreasing annuity for which the present

and accumulated values are given by

(Da)

n

=

n a

n

i

,

(Ds)

n

=

n(1 + i)

n

s

n

i

.

Other symbols of interest are (I a)

n

, (I s)

n

, (D a)

n

, (D s)

n

, (I a)

, (Ia)

.

Payments varying in geometric progression. We shall work some problems to

illustrate that problems of this type are not hard to solve, since the eect of the geometric

progression is equivalent to altering the interest rate.

Other payment patterns

Some Exercises

[1, Exercise 29, p. 124] In [1, Example 4.13, p. 116] it is shown that the present value

of an annuity-immediate such that payments start at 1, increase by annual amounts

of 1 to a payment of n, and then decrease by annual amounts of 1 to a nal payment

of 1, is a

n

a

n

. The present exercise is to justify this value verbally.

Solution: Consider a sequence of n annuities-due, each of them consisting of n

payments of 1. The rst of these annuities is to make its rst payment 1 year

from now, the second 2 years from now, ..., the nth n years from now. The total

payments made will increase from 1 to n, then decrease to a payment of 1, 2n 1

years from now. The value of the payments under each of these annuities-due is a

n

just before the rst payment. These values, when discounted to the present, have

value a

n

a

n

.

[1, Exercise 31, p. 124] (discussed in the lecture) Show algebraically, and by means

of a time diagram, the following relationship between

(Da)

n

= (n + 1) a

n

(Ia)

n

.

Information for Students in MATH 329 2004 01 2060

Solution: In this method of presenting notes it is dicult to present a time diagram;

instead, I give a verbal explanation. To simplify, I shall move the subtracted term

from the right side to an added term on the left side of the identity. Then we are

summing two variable annuities: as the amount of one decreases by 1 unit, the

amount of the other takes up the slack and increases by one unit, so the sum of

the two remains constant for n payments. And that sum begins with value n + 1,

so that is the amount that remains constant, giving an annuity-immediate of that

constant payment for n payments.

Algebraically, we have

(n + 1) a

n

(Ia)

n

= (n + 1)

1 v

n

i

a

n

nv

n

i

=

(n + 1) v

n

a

n

i

=

(n + 1) v

n

1 a

n1

i

=

(n + 1 1)

_

a

n1

+v

n

_

i

=

n a

n

i

= (Da)

n

[1, Exercise 32, p. 124] (discussed in the lecture) The following payments are made

under an annuity: 10 at the end of the 5th year, 9 at the end of the 6th year,

decreasing by 1 each year until nothing is paid. Show that the present value is

10 a

14

+ a

4

(1 10i)

i

.

Solution: The payments decrease until a payment of 1 at the end of the 14th year.

We can think of a decreasing annuity starting with a payment of 14 at the end of

the 1st year, and then make corrections. We can subtract a 4-payment decreasing

annuity-immediate beginning with a payment of 4 at the end of the year, and a

4-payment annuity-immediate with a constant payment of 10. Thus we have

(Da)

14

(Da)

4

10a

4

=

_

14 a

14

_

_

4 a

4

_

10i a

4

i

=

10 a

14

+ a

4

(1 10i)

i

Information for Students in MATH 329 2004 01 2061

[1, Exercise 33, p. 124] (discussed in the lecture) Find the present value of a perpe-

tuity under which a payment of 1 is made at the end of the 1st year, 2 at the end

of the 2nd year, increasing until a payment of n is made at the end of the nth year,

and thereafter payments are level at n per year forever.

Solution: We can begin with a perpetuity-immediate of n per year, and subtract

from it a decreasing annuity-immediate which begins with a payment of n 1 and

decreases by 1 unit per year.

n a

(Da)

n1

=

n

_

(n 1) a

n1

_

i

=

1 + a

n1

i

=

a

n

i

=

(1 + i)a

n

i

=

a

n

vi

=

a

n

d

[1, Exercise 34, p. 124] (discussed in the lecture) A perpetuity-immediate has an-

nual payments of 1, 3, 5, 7, . . . . If the present value(s) of the 6th and 7th payments

are equal, nd the present value of the perpetuity.

Solution: We equate the values of the 6th and 7th payments:

(1 + (6 1)2)v

6

= (1 + (7 1)2)v

7

1 +i =

13

11

i =

2

11

The perpetuity can be viewed as the sum of an increasing perpetuity with pay-

ments increasing by 2 each year, i.e., 2(Ia)

immediate a

:

2 (Ia)

= 2

lim

n

_

a

n

n

(1+i)

n

_

i

1

i

=

2 a

1

i

by lHopitals Rule

= 66

Information for Students in MATH 329 2004 01 2062

[1, Exercise 35, p. 124] If X is the present value of a perpetuity of 1 per year with

the rst payment at the end of the 2nd year and 20X is the present value of a

series of annual payments 1, 2, 3, . . . with the rst payment at the end of the 3rd

year, nd d.

Solution: The constraints are:

X =

1

i

v =

v

i

20X = (Ia)

2a

+ v

=

v

i

2

,

implying that i =

1

20

, d =

1

21

.

[1, Exercise 36, p. 125] An annuity-immediate has semiannual payments of 800, 750,

700, . . . , 350, at i

(2)

= 0.16. If a

10 0.08

= A, nd the present value of the annuity in

terms of A.

Solution: We will be working with an eective semi-annual interest rate of j =

i

(2)

2

= 8%. The truncated decreasing annuity-immediate that we wish to evaluate

has present value

50(Da)

10

50v

10

(Da)

6

= 50

_

16 a

16

_

v

10

_

6 a

6

_

i

=

50

i

__

16 6v

10

_

_

a

16

v

10

a

6

__

=

50

i

_

10 + 6ia

10

a

10

_

=

50

i

_

10 + (6i 1)a

10

_

= 625(10 0.52A) = 6250 325A.

[1, Exercise 37, p. 125] Annual deposits are made into a fund at the beginning of

each year for 10 years. The rst 5 deposits are 1,000 each, and deposits increase by

5% per year thereafter. If the fund earns 8% eective, nd the accumulated value

at the end of 10 years.

Solution: The rst 5 deposits are today worth

1000 a

5 8%

= 4312.12684 .

I see 2 ways of interpreting the words increase by 5% per year thereafter: either

the increase is geometric, by a factor of 1.05 applied repeatedly; or the deposits

Information for Students in MATH 329 2004 01 2063

increase in arithmetic progression (before discounting). If the deposits increase in

geometric progression, then the present value will be

1000

_

v

5

(1.05) + v

6

(1.05)

2

+ . . . + v

9

(1.05)

5

_

= 1000v

5

(1.05)

_

1 (v(1.05))

5

_

1 v(1.05)

= 36000(1.05)(1.08)

5

_

1

_

1.05

1.08

_

5

_

= 3379.996182.

The present value will then be 4312.1268+3379.9962 = 7692.1230; the accumulated

value at the end of 10 years will be 16606.72. This is the answer given by the

textbook, so, presumably, our interpretation is the one the author intended.

But the language is ambiguous, and the other interpretation is plausible also. If

the deposits increase in arithmetic progression, then the present value will be

1000(1.08)

5

a

5 8%

+ 50(1.08)

5

(I a)

5 8%

= 3510.09347

so the present value is 7822.2203, and the value after 10 years is 16,887.59.

[1, Exercise 38, p. 125] Find the present value of a 20-year annuity with annual

payments which pays 600 immediately and each subsequent payment is 5% greater

than the preceding payment. The annual eective rate of interest is 10.25%.

Solution:

Present Value =

19

n=0

600v

n

(1.05)

n

= 600

1

_

1.05

1.1025

_

20

1

1.05

1.1025

= 7851.1926 .

[1, Exercise 58, p. 127] There are two perpetuities. The rst has level payments of

p at the end of each year. The second is increasing such that the payments are q,

2q, 3q, . . . . Find the rate of interest that will make the dierence in present value

between these perpetuities

a) Zero;

b) A maximum.

Information for Students in MATH 329 2004 01 2064

Solution: I assume that the second perpetuity is a perpetuity-immediate, like

the rst. The present value of the rst perpetuity-immediate is

p

i

. The second

perpetuity-immediate is worth

q(Ia)

= q

a

i

=

q

di

.

a) For the present values to be equal,

p

i

=

q

id

p

i

=

q(1 + i)

i

2

i =

q

p q

b) The dierence is

p

i

q

id

=

(p q)

2

4q

q

_

1

i

p q

2q

_

2

which is maximized when

1

i

p q

2q

= 0

i.e., when i =

2q

p q

.

A.17.2 4.7 More general varying annuities

We will not formally study this section and its interesting generalizations, e.g.,

_

I

(m)

a

_

(m)

n

is an increasing annuity with payments of

1

m

per interest conversion period at the end of

the rst mth of an interest conversion period,

2

m

per interest conversion period at the end

of the second mth of an interest conversion period, etc. Thus the rst payment is

1

m

2

,

the second is

2

m

2

, etc. If you meet any problems of these types, they should be solvable

by rst principles.

A.17.3 4.8 Continuous varying annuities

Omit this section.

A.17.4 4.9 Summary of results.

Omit this section.

Information for Students in MATH 329 2004 01 2065

A.18 Supplementary Notes for the Lecture of February 20th,

2004

Distribution Date: Friday, February 20th, 2004, subject to further revision

Textbook Chapter 5. Yield Rates.

A.18.1 5.1 Introduction

A.18.2 5.2 Discounted cash ow analysis

Denition A.7 The yield rate is that rate of interest at which the present value of

returns from the investment is equal to the present value of contributions into the in-

vestment.

Finding the yield rate may require the use of various approximation methods, since the

equations that have to be solved may be polynomial of high degree.

A.18.3 5.3 Uniqueness of the yield rate

Example A.6 [1, p. 133]A person makes payments of 100 immediately and 132 at the

end of 2 years, in exchange for a payment in return of 230 at the end of 1 year. The

yield rate i can be shown to satisfy the equation

((1 + i) 1.1)((1 + i) 1.2) = 0

which has two distinct solutions.

Example A.7 [1, Example 5.3, p. 136] A is able to borrow 1000 from B for 1 year at

8% eective, and to lend it to C for 1 year at 10% eective. What is As yield rate on

this transaction.

Solution: The equation of value at time 0 is

1000 v(1080) = 1000 v(1100) ,

which has no nite solution. We can say that the yield rate is innite.

Read [1, Example 5.4, p. 136], in which the borrow cannot possibly earn sucient

interest to cover her payments; in this case we might wish to speak of an imaginary

yield rate.

Information for Students in MATH 329 2004 01 2066

A.18.4 5.4 Reinvestment rates

Single payment with interest reinvested Suppose 1 is invested at time 0, with

interest being paid at rate i at the ends of n years, but where the interest can be

reinvested only at rate j. At the end of n years the total accumulated value of the

investment is

1 + is

n j

Annuity-immediate at rate i, with reinvestment at rate j If an annuity-immediate

of 1 pays interest at rate i, but the interest can be reinvested only at rate j, the accu-

mulated value at time n is

n + i(Is)

n1 j

= n +

i

j

(s

n j

n)

Some exercises on reinvestment rates

[1, Exercise 10, p. 161] It is desired to accumulate a fund of 1,000 at the end of 10

years by equal deposits at the beginning of each year. If the deposits earn interest

at 8% eective, but the interest can only be reinvested at only 4% eective, show

that the deposit necessary is

1000

2s

11 0.04

12

.

Solution: Let x denote the necessary deposit. We will sum the principal payments

(x10) and treat the interest payments as forming an increasing annuity-immediate

with increments of 0.08x.

x

_

10 + 0.08 (Is)

10 4%

_

= 1000

x

_

10 + 0.08

s

10 4%

10

0.04

_

= 1000

x =

1000

2s

11 0.04

12

.

Information for Students in MATH 329 2004 01 2067

A.19 Supplementary Notes for the Lecture of March 1st, 2004

Distribution Date: Monday, March 1st, 2004, subject to further revision

A.19.1 5.4 Reinvestment rates (continued)

[1, Exercise 11, p. 161] A loan of 10,000 is being repaid with payments of 1,000 at

the end of each year for 20 years. If each payment is immediately reinvested at 5%

eective, nd the eective annual rate of interest earned over the 20-year period.

Solution: Let the eective yield rate be i. The payments do not become available

until the maturity date, after 20 years. Until that time they are locked into a

payment-scheme that accumulates to value 1000s

20 5%

. We are asked for the interest

rate that was earned. There are thus just two transactions: the loan at time 0, in

the amount of 10,000, and the repayment at time 20, in the amount given above.

The equation of value at time t = 0 is

1000s

20 5%

(1 + i)

20

= 10000

(1 + i)

20

=

10(0.05)

(1.05)

20

1

i = 6.1619905%.

[1, Exercise 12, p. 161] An investor purchases a 5-year nancial instrument having

the following features:

(i) The investor receives payments of 1000 at the end of each year for 5 years.

(ii) These payments earn interest at an eective rate of 4% per annum. At the end

of the year, this interest is reinvested at the eective rate of 3% per annum.

Find the purchase price to the investor to produce a yield rate of 4%.

Solution: To determine the yield we need to consider when the payment is nally

released to the investor. The payments of 1000 are to be invested at 4%; they will

generate an increasing annuity whose payments start at 40 at the end of year 2,

up to 160 at the end of year 5. But they are not released to the investor; rather,

they earn interest at 3%. At the end of 5 years and only then the investor

receives

5(1000) + 40(Is)

4 3%

and these amounts have to be discounted to the present at 4%, giving a present

value of

(1.04)

5

_

5(1000) + 40(Is)

4 3%

_

= 5000 +

40

0.03

_

s

5 3%

5

_

Information for Students in MATH 329 2004 01 2068

= (1.04)

5

_

5000 +

40

0.03

_

(1.03)

5

1

0.03

5

__

= 4448.418326

if the yield is to be 4%.

[1, Exercise 13, p. 161] An investor deposits 1,000 at the beginning of each year

for ve years in a fund earning 5% eective. The interest from this fund can be

reinvested at only 4% eective. Show that the total accumulated value at the end

of ten years is

1250

_

s

11 0.04

s

6 0.04

1

_

.

Solution: The 5 deposits of 1000 would be worth 1000

_

s

10 4%

s

5 4%

_

at the end of

10 years if they were earning interest together with the reinvested annual interest

payments. But they are locked into a fund where they earn 5%, and are not released

until time 10, still worth 5,000. The interest payments constitute an increasing

annuity to the investor, beginning with 50 at time 1, increasing to 250 at time 5,

and then remaining constant until time 10. They are available to the investor as

they are paid, but she reinvests them at 4%. Their value at time 10 is, therefore

50

_

(Is)

10 4%

(Is)

5 4%

_

. Summing yields

5000 + 50

_

(Is)

10 4%

(Is)

5 4%

_

= 5000 +

50

0.04

_

s

11 4%

11 s

6 4%

+ 6

_

= (5000 6250) + 1250

_

s

11 4%

s

6 4%

_

= 1250

_

s

11 0.04

s

6 0.04

1

_

= 7316.719914

Using the tables in the textbook, we would nd the answer to be

1250

_

s

11 0.04

s

6 0.04

1

_

= 1250(13.4864 6.6330 1)

= 7316.7500 .

[1, Exercise 14, p. 161] (not discussed at the lecture) A invests 2,000 at an eective

interest rate of 17% for 10 years. Interest is payable annually and is reinvested

at an eective rate of 11%. At the end of 10 years the accumulated interest is

5,685.48. B invests 150 at the end of each year for 20 years at an eective interest

rate of 14%. Interest is payable annually and is reinvested at an eective rate of

11%. Find Bs accumulated interest at the end of 20 years.

Solution: As interest payments begin at the end of year 1, in the amount of

17% 2000 = 340 and continue at the same level for 10 years. The equation of

value at the end of year 10 is

340s

10 11%

= 5685.48 ,

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2069

implying that

s

10 11%

=

5685.48

340

= 16.722.

It follows that (1.11)

10

= (16.722)(0.11) + 1 = 2.83942, and that

s

20 11%

=

(1.11)

20

1

0.11

= s

10 11%

_

(1.11)

10

+ 1

_

= s

10 11%

_

s

10 11%

+ 2

_

= 16.722 3.83942 = 64.20278124.

Bs interest payments constitute an increasing annuity-immediate whose rst pay-

ment is at the end of year 2, in the amount of 21. The accumulated value of Bs

accumulated interest is

21(Is)

19 11%

= 21

s

20 11%

20

0.11

= 21

64.20278124 20

0.11

= 8438.712782.

A.19.2 5.5 Interest measurement of a fund

Omit this section.

A.19.3 5.6 Time-weighted rates of interest

Omit this section.

A.19.4 5.7 Portfolio methods and investment year methods

Omit this section.

A.19.5 5.8 Capital budgeting

Omit this section.

A.19.6 5.9 More general borrowing/lending models

Omit this section.

Information for Students in MATH 329 2004 01 2070

A.20 Supplementary Notes for the Lecture of March 3rd, 2004

Distribution Date: Wednesday, March 3rd, 2004, subject to further revision

Textbook Chapter 6. Amortization schedules and sinking

funds.

A.20.1 6.1 Introduction

We consider methods of repaying a loan, in particular

The Amortization Method: In this method the borrow makes instalment payments

to the lender. Usually these payments are a regularly spaced periodic intervals; the

progressive reduction of the amount owed is described as the amortization of the

loan.

The Sinking Fund Method: In this method the loan will be repaid by a single lump

sum payment at the end of the term of the loan. However the borrow may prepare

himself for the repayment by making deposits to a fund called a sinking fund to

accumulate the repayment amount. (Sometimes the lender may be aware of the

existence of the sinking fund; for example, an institutional borrower that issues a

series of bonds may let the public know that the accumulation of funds to redeem

the bonds may be disciplined by a sinking fund.)

A.20.2 6.2 Finding the outstanding loan balance

When a loan is being amortized the outstanding balance is being reduced by the amor-

tization payments. Each payment may be analyzed an interpreted as consisting of an

interest component and a component for reduction of principal . An equation of value

can be set up at any time during the amortization, equating

Current value of payments = Accumulated value of Loan

where Payments consists of both past and future payments. Decomposing the term

and rearranging the equation gives

Present Value of Future Payments

=Accumulated Value of Loan-Accumulated Value of Past Payments

Synonymous terms:

outstanding loan balance

outstanding principal

Information for Students in MATH 329 2004 01 2071

unpaid balance

remaining loan indebtedness

[1, Exercise 1, p. 195] A loan of 1,000 is being repaid with quarterly payments at the

end of each quarter for 5 years, at 6% convertible quarterly. Find the outstanding

loan balance at the end of the 2nd year.

Solution: The level payments under this annuity-immediate will be

1000

a

20 1.5%

.

Retrospective method: The value of the payments already made is

1000

a

20 1.5%

s

8 0.015

= 491.1769.

Subtracting this from 1000(1.015)

8

yields 635.3157.

Prospective method: The value of the 12 remaining payments is

1000

a

20 1.5%

a

12 1.5%

= 635.3157 .

[1, Exercise 2, p. 195] A loan of 10,000 is being repaid by instalments of 2,000 at the

end of each year, and a smaller nal payment made one year after the last regular

payment. Interest is at the eective rate of 12%. Find the amount of outstanding

loan balance remaining when the borrower has made payments equal to the amount

of the loan.

Solution: The problem asks for the outstanding loan balance just after payments

totalling 10,000 have been made; this will be immediately after the 5th payment.

We shall use the retrospective method only here. The accumulated value of the

loan at time t = 5 is 10000(1.12)

5

. The accumulated value of the payments made

is 2000s

5

. The outstanding loan balance will, therefore be

10000(1.12)

5

2000s

5

= 10000(1.12)

5

2000

0.12

_

(1.12)

5

1

_

= 4917.72212

Were we to use the prospective method, we would need to determine the value

of the last drop payment. This is interesting information, and we could have been

asked for it. But it has not been requested, and so we shall not bother nding it.

(But you should know how to do that if it is necessary.)

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2072

[1, Exercise 3, p. 195] A loan is being repaid by quarterly instalments of 1,500 at

the end of each quarter, at 10% convertible quarterly. If the loan balance at the

end of the rst year is 12,000, nd the original loan balance.

Solution: Denote the original loan balance by L. Here the retrospective method is

the most appropriate, since we dont know how many future payments have to be

made. The equation of value at time 1 year is

L(1.025)

4

1500s

4 2.5%

= 12000

which we solve to yield

L = (1.025)

4

_

1200 + 1500

_

(1.025)

4

1

__

= 48000(1.025)

4

+ 60000 = 16514.36905.

Information for Students in MATH 329 2004 01 2073

A.21 Supplementary Notes for the Lecture of March 5th, 2004

Distribution Date: Friday, March 5th, 2004, subject to further revision

A.21.1 6.2 Finding the outstanding loan balance (continued)

[1, Exercise 4, p. 195] A loan is being repaid by annual payments at the ends of 15

successive years. The rst 5 instalments are 4,000 each, the next 5 are 3,000 each,

and the nal 5 are 2,000 each. Find expressions for the outstanding loan balance

immediately after the second 3,000 instalment.

1. prospectively;

2. retrospectively.

Solution:

1. Prospective Method. The value at time 7 of the payments yet to be made

is 2000a

8

+ 1000a

3

.

2. Retrospective Method. We have to use the prospective method at some

time to obtain the initial value of the loan. This will be the value of all

payments at time t = 0, i.e., 2000a

15

+ 1000a

10

+ 1000a

5

. The value of all

payments made before and at time t = 7 is 4000s2s

2

. The outstanding loan

balance is, therefore

_

2000a

15

+ 1000a

10

+ 1000a

5

_

(1 + i)

7

4000s

7

+ 1000s

2

[1, Exercise 5, p. 196] A loan is to be repaid with level instalments payable at the

end of each half-year for 3

1

2

years, at a nominal rate of interest of 8% convertible

semiannually. After the fourth payment the outstanding loan balance is 5,000.

Find the initial amount of the loan.

Solution: The eective semiannual rate is 4%. There are to be 7 level payments in

all. The amount of the payments is, by the prospective method

5000

a

3 4%

=

5000 0.04

1 (1.04)

3

.

It follows that the amount of the loan, now by the prospective method, is

5000

a

3 2%

a

7 2%

= 5000

_

1 (1.04)

7

1 (1.04)

3

_

= 10814.15817 .

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2074

[1, Exercise 6, p. 196] A 20,000 loan is to be repaid with annual payments at the end

of each year for 12 years. If (1 +i)

4

= 2, nd the outstanding balance immediately

after the fourth payment.

Solution: The annual payment is, by the prospective method,

20000

a

12 i

. Again by

the prospective method, the outstanding balance after the 4th payment is

20000

a

12 i

a

8 i

= 20000

_

1 (1 + i)

8

1 (1 + i)

12

_

=

6

7

20000 = 17142.85714.

[1, Exercise 7, p. 196] A 20,000 mortgage is being repaid with 20 annual instalments

at the end of each year. The borrower makes 5 payments, and then is temporarily

unable to make payments for the next 2 years. Find an expression for the revised

payment to start at the end of the 8th year if the loan is still to be repaid at the

end of the original 20 years.

Solution: The original payments are (by the prospective method)

20000

a

20

. The

outstanding balance at the end of the 7th year (with no payment then or at the

end of the previous year) is the value then of all unpaid payments, i.e.

20000

a

20

_

a

13

+s

2

_

.

It follows that the level payment needed to repay the loan in 13 payments (under

an annuity-immediate) is

20000

a

20

_

a

13

+ s

2

_

1

a

13

=

20000 (1 + i)

2

a

15

a

20

a

13

.

[1, Exercise 8, p. 196] A loan of 1 was originally scheduled to be repaid by 25 equal

annual payments at the end of each year. An extra payment K with each of the 6th

through the 10th scheduled payments will be sucient to repay the loan 5 years

earlier than under the original schedule. Show that

K =

a

20

a

15

a

25

a

5

.

Solution: The level payment of this loan of 1 is

1

a

25

. The extra payments are equal

in value to the value of the last 5 payments, so, at time t = 5,

K a

5

=

a

20

a

15

a

25

which yields the desired value for K.

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2075

[1, Exercise 9, p. 196] A loan is being repaid with level payments. If B

t

, B

t+1

, B

t+2

and B

t+3

are four successive outstanding loan balances, show that

1. (B

t

B

t+1

) (B

t+2

B

t+3

) = (B

t+1

B

t+2

)

2

2. B

t

+ B

t+3

< B

t+1

+ B

t+2

Solution:

1. Let P denote the level payment. By the prospective method, the unpaid

balance after payment #t, B

t

= P a

nt

. It follows that

(B

t

B

t+1

) (B

t+2

B

t+3

) = P

_

a

nt

a

nt1

_ _

a

nt2

a

nt3

_

= v

nt

P v

nt2

P

=

_

v

nt1

P

1

_

2

=

_

P a

nt1

P a

nt2

_

2

= (B

t+1

B

t+2

)

2

2.

B

t

+B

t+3

B

t+1

B

t+2

=

_

a

nt

a

nt1

_

_

a

nt2

a

nt3

_

= P v

nt

P v

nt2

= P(v

2

1) v

nt2

in which product P, v

nt2

are positive, and v

2

1 is negative.

A.21.2 6.3 Amortization schedules

An amortization schedule is a chart showing, for each payment date, the information

shown in the columns of the following beginning of such a schedule with n payments of

size x:

Year Payment Interest Principal Outstanding

amount paid repaid loan balance

0 x a

n i

1 x x(1 (1 + i)

n

) x(1 + i)

n

x a

n1 i

2 x x(1 (1 + i)

n+1

) x(1 + i)

1n

x a

n2 i

In practice there will be rounding errors as the table is generated line by line, and the

last line may not quite balance. Standard practice is to adjust the last payment so that

Information for Students in MATH 329 2004 01 2076

it is exactly equal to the amount of interest for the nal period plus the outstanding

loan balance at the beginning of the nal period, in order to bring the outstanding loan

balance to 0. In order to determine the entries in one row of the table, we do not need to

generate the table line by line; the table is useful when a number of rows are of interest.

Some worked examples Few of the exercises in the textbook require extensive com-

putation of schedules. Students should, however, be capable of completing a full table

for a loan when all the information needed is available.

[1, Exercise 10, p. 196] A loan is being repaid with quarterly instalments of 1,000 at

the end of each quarter for 5 years at 12% convertible quarterly. Find the amount

of principal in the 6th instalment.

Solution: The principal is

1000a

20 3%

=

1000

0.03

_

1 (1.03)

20

_

= 14877.47486 .

After the 5th payment, the principal is (by the prospective method) 1000a

205 3%

,

so the interest component of the next payment is 30a

205 3%

=

30

0.03

(1 (1.03)

15

) =

358.1380526, so the amount of principal reduction is 1000358.1380526 = 641.8619474.

[1, Exercise 11, p. 196] Consider a loan which is being repaid with instalments of 1

at the end of each period for n periods. Find an expression at issue for the present

value of the interest which will be paid over the life of the loan.

Solution: We can use the information in [1, Table 6.1, p. 170]. The sum of the

interest portions of the payments is, as shown in the table,

n

r=1

(1 v

r

) = n a

n

.

This, however, is not what the problem requests. The present value of the interest

payments presumably as of time t = 0, is

n

r=1

v

nr+1

(1 v

r

) = a

n

nv

n+1

.

[1, Exercise 12, p. 196] A loan of 10,000 is being repaid with 20 instalments at the

end of each year, at 10% eective. Show that the amount of interest in the 11th

instalment is

1000

1 +v

10

.

Solution: The amount of each payment is, by the prospective method,

10000

a

20 10%

.

Information for Students in MATH 329 2004 01 2077

By the prospective method, the unpaid balance after the 10th payment is

10000

a

20 10%

a

10 10%

=

10000

1 + (1.1)

10

so the interest component of the 11th payment is

0.01

_

10000

1 + (1.1)

10

_

=

100

1 + (1.1)

10

.

[1, Exercise 13, p. 196] A loan is being repaid with 20 instalments at the end of each

year at 9% eective. In what instalment are the principal and interest portions

most nearly equal to each other?

Solution: Without limiting generality, assume the payments are all of size 1, so that

the loan is for a

20 9%

, and [1, Table 6.1, p. 170] applies. In that table we see that the

repayments of principal range between v

20

in the rst payment to v

1

in the last. The

two portions under consideration sum to a constant, so they cannot both exceed

1

2

at any time. Both sequences interest payments and reductions of principal

are monotone: there will be only one pair of values t = a, t = a + 1, where they

reverse their positions from being greater than/less than

1

2

to the reverse. But it

is not clear which of those two will have the closest values! We see from [1, Table

6.1, p. 170] that the dierence between principal and interest components in the

tth payment is [1 2v

nt+1

[. We shall begin by determining the largest value of t

if any for which

v

20t+1

1

2

,

equivalently, the largest value of t such that

(1 + i)

21t

2 ,

equivalently, the largest value of t such that

t 21

ln 2.

ln 1.09

= 12.95676827 ,

i.e., t = 12. This is the best choice where the dierence 1 2v

nt+1

is positive.

We need also to consider the best choice when the dierence is negative, i.e.,

t = 13. We compute the dierences:

t = 12 1 2(1.09)

9

= 0.0791444410

t = 13 1 2(1.09)

8

= 0.003732559

and see that the values are closest when t = 13.

Information for Students in MATH 329 2004 01 2078

A.22 Supplementary Notes for the Lecture of March 8th, 2004

Distribution Date: Monday, March 8th, 2004, subject to further revision

A.22.1 6.3 Amortization schedules (continued)

[1, Exercise 14, p. 197] A loan is being repaid with a series of payments at the end

of each quarter, for 5 years. If the amount of principal in the 3rd payment is 100,

nd the amount of principal in the last 5 payments. Interest is at the rate of 10%

convertible quarterly.

Solution: The loan is being repaid in 5 4 = 20 quarterly payments, and the

eective interest rate per quarter is

1

4

(10%) = 2.5%. Lets assume that the amount

of each level payment is x, and begin by compiling the rst part of the amortization

table.

Payment Payment Interest Principal Outstanding

amount paid repaid loan balance

0 x a

20 2.5%

1 x x(1 (1.025)

20

) x(1.025)

20

x a

19 2.5%

2 x x(1 (1.025)

19

) x(1.025)

19

x a

18 2.5%

3 x x(1 (1.025)

18

) x(1.025)

18

x a

17 2.5%

from which we see that x(1.025)

18

= 100, so

x = 100(1.025)

18

= 155.9658718 .

(We didnt need to use the schedule here. By the Prospective Method, the unpaid

balance just after the 2nd payment is x s

18

, so the interest component of the 3rd

payment is ix s

18

and the residue for reduction of principal is

x

_

1

_

1 v

18

__

= xv

18

.)

We could now compile the last lines of the amortization table backwards. Alter-

natively, if the author is requesting the total amount of principal in the last 5

payments, that is

x(v + v

2

+ v

3

+v

4

+v

5

) = 155.9658718 a

5 0.025

= 724.5906916 .

[1, Exercise 15, p. 197] A loan is being repaid with instalments of 1 at the end of

each year for 20 years. Interest is at eective rate i for the rst 10 years, and

eective rate j for the second 10 years. Find expressions for

Information for Students in MATH 329 2004 01 2079

a) the amount of interest paid in the 5th instalment;

b) the amount of principal repaid in the 15th instalment.

Solution: The present value of the last 10 payments is (1 +i)

10

a

10 j

; the principal

of the loan is, therefore,

P = a

10 i

+ (1 + i)

10

a

10 j

.

We compile the rst lines of the amortization table:

Year Payment Interest Principal Outstanding

amount paid repaid loan balance

0 P

1 1 iP 1 iP P(1 + i) s

1 i

1

2 1 i(P(1 + i) 1) (1 + i)(1 iP) P(1 + i)

2

s

2 i

3 1 i(1 +i)

2

__

P a

2 i

__

s

2 i

i(1 + i)

2

P P(1 + i)

3

s

3 i

4 1 i(1 +i)

3

__

P a

3 i

__

s

3 i

i(1 + i)

3

P P(1 + i)

4

s

4 i

5 1 i(1 +i)

4

__

P a

4 i

__

s

4 i

i(1 + i)

4

P P(1 + i)

5

s

5 i

Thus the amount of interest in the 5th instalment is

i(1 + i)

4

(

_

a

10 i

+ (1 + i)

10

a

10 j

a

4 i

_

= i

_

a

6 i

+ (1 + i)

6

a

10 j

_

.

More simply, we can observe (using the Prospective Method) that the outstanding

balance just after the 4th instalment is

(1 + i)

6

a

10 j

+a

6 i

.

The interest component of the 5th payment is obtained by multiplying this amount

by i.

After the 10th instalment has been paid, we shift to the second interest rate. The

outstanding balance after the 14th payment is, again by the Prospective Method,

a

6 j

; interest one payment later will be

j a

6 j

= 1 v

6

so the payment will reduce principal by 1 (1 v

6

) = v

6

. the 5th of the j-portion

of the loan is (1 + j)

115

.

[1, Exercise 16, p. 197] (not discussed in the lectures) A mortgage with original

principal A is being repaid with level payments of K at the end of each year

for as long as necessary, plus a smaller nal payment. The eective rate of interest

is i.

Information for Students in MATH 329 2004 01 2080

a) Find the amount of principal in the tth instalment.

b) Is the principal repaid column in the amortization schedule in geometric pro-

gression (excluding the irregular nal payment)?

Solution: Just after the (t 1)th instalment the outstanding principal is, by the

retrospective method,

A(1 + i)

t1

K s

t1

and the interest earned during the next interval will be the product with i; hence

the amount of principal in the tth instalment will be

K i

_

A (1 +i)

t1

K s

t1

_

= K s

t

i(1 + i)

t1

A

= (K Ai)(1 + i)

t1

which shows that the column entries are, indeed, in geometric progression, with

common ratio 1 + i.

[1, Exercise 17, p. 197] (not discussed in the lectures) A borrower has a mortgage

which calls for level annual payments of 1 at the end of each year for 20 years. At

the time of the 7th regular payment an additional payment is made equal to the

amount of principal that, according to the original amortization schedule, would

have been repaid by the 8th regular payment. If payments of 1 continue to be made

at the end of the 8th and succeeding years until the mortgage is fully repaid, show

that the amount saved in interest payments over the full term of the mortgage is

1 v

13

.

Solution: At time 0 the amount owing is a

20

. By the 8th regular payment on the

original schedule, the principal repaid would have been

A A(1 + i)

8

+s

8

= (Ai 1)s

8

.

It is intended that this amount is added to the 7th payment. Immediately after

the original 7th payment the principal owing would have been

A(1 + i)

7

s

7

.

The additional payment at time 7 reduces this amount to

A(1 + i)

7

s

7

_

Ai 1)s

8

_

= (1 + i)

7

+A

_

1 i(1 +i)

7

_

[1, Exercise 18, p. 197] (not discussed in the lectures) A loan of L is being amortized

with payments at the end of each year for 10 years. If v

5

=

2

3

, nd the following:

Information for Students in MATH 329 2004 01 2081

a) The amount of principal repaid in the rst 5 payments.

b) The amount due at the end of 10 years if the nal 5 payments are not made

as scheduled.

Solution:

1. The annual level payments constitute an annuity-immediate with annual pay-

ment of

L

a

10

=

Li

1

_

2

3

_

2

=

9iL

5

.

By the prospective method, the amount of principal remaining to be paid

immediately after the 5th annual payment is

9iL

5

a

5

=

9L

5

_

1

2

3

_

=

3L

5

.

Hence the amount of principal that has already been paid at that time is

_

1

3

5

_

L =

2L

5

.

2. If no further payments are made, the amount repayable at the end of 10 years

is

(1 + i)

5

3L

5

=

3

2

3L

5

=

9L

10

.

[1, Exercise 19, p. 197] (not discussed in the lectures) A 35-year loan is to be repaid

with equal instalments at the end of each year. The amount of interest paid in the

8th instalment is 135. The amount of interest paid in the 22nd instalment is 108.

Calculate the amount of interest paid in the 29th instalment.

Solution: Suppose the amount of the loan at time 0 was L. The annual instalments

are each

L

a

35

. By the prospective method the amount of principal outstanding just

after the 7th instalment is

L

a

35

a

28

. This will incur an interest payment of i

L

a

35

a

28

in the 8th instalment; we thus have the equation

iL

1 v

28

1 v

35

= 135 .

A similar computation involving instalments 21 and 22 gives

iL

1 v

14

1 v

35

= 108 .

Information for Students in MATH 329 2004 01 2082

Taking the ratio of the two equations, we obtain

1 +v

14

=

1 v

28

1 v

14

=

135

108

=

5

4

so v

7

=

1

2

; substitution in either equation above yields iL =

279

2

. The amount of

interest in the 29th instalment is

iL

a

7

a

35

= iL

1 v

7

1 v

35

=

16iL

31

= 72 .

A.22.2 6.4 Sinking funds

Dierences between the Amortization and Sinking Fund Methods of repay-

ment In the Amortization Method for repaying a loan, the borrower makes regular

payments often level payments directly to the lender. The Outstanding Loan Bal-

ance at any time is then the net amount owing on the lenders books either the excess

of the accumulated value of the loan minus the accumulated value of the payments made

Retrospective Method or the present value of the payments yet to be made Prospective

Method.

Where a loan is repaid by a Sinking Fund, portions of the borrowers payments are is

not transmitted to the lender until a later date, usually when they have accumulated in

fund the Sinking Fund often at an interest rate dierent from the rate associated

with the loan. Where the borrower is required or permitted to make regular payments

directly to the lender in addition to those paid into the fund, those are described as

service on the loan; where those regular payments cover the interest costs on the loan,

the principal outstanding will remain constant. This should not be confused with the

Net Amount of the loan, which will be the excess of the outstanding principal over the

accumulated value of the sinking fund.

Where the interest rate associated with the Sinking Fund is the same rate as is being

paid on the loan, the Sinking Fund Method is equivalent to the Amortization Method.

The identity

1

a

n

=

1

s

n

+ i. While the identity can easily be proved algebraically,

it admits an interesting verbal proof in terms of a loan of 1 being repaid over n periods.

1

a

n

is the regular payment necessary under an annuity-immediate.

1

s

n

is the portion of

that regular payment that will accumulate in a sinking fund to a value of 1 just after

the nth payment; the complement i is the amount necessary to service the loan

annually until the time that the sinking fund matures.

Information for Students in MATH 329 2004 01 2083

A.23 Supplementary Notes for the Lecture of March 12th, 2004

Distribution Date: Friday, March 12th, 2004, subject to further revision

A.23.1 6.4 Sinking funds (continued)

Omit pages 178-179

[1, Exercise 20, p. 197] A has borrowed 10,000 on which interest is charged at 10%

eective. A is accumulating a sinking fund at 8% eective to repay the loan. At

the end of 10 years the balance in the sinking fund is 5000. At the end of the 11th

year A makes a total payment of 1500.

a) How much of the 1500 pays interest currently on the loan?

b) How much of the 1500 goes into the sinking fund?

c) How much of the 1500 should be considered as interest?

d) How much of the 1500 should be considered as principal?

e) What is the sinking fund balance at the end of the 11th year?

Solution: This problem requires attention to the terminology used.

1. Presumably we are to assume that the borrower is servicing the loan so that

the outstanding balance remains constant. The interest payment necessary at

the end of the 11th year will, therefore, be 0.10 10000 = 1000.

2. The remainder of the payment of 1500 is a contribution of 500 to the sinking

fund.

3. The net interest paid is the excess of the interest paid 1000 over the

8%5000 = 400 interest earned by the sinking fund, or 600.

4. The excess of the contribution over the net interest payment can be assigned

to reducing the principal of the loan. The amount is 1500 600 = 900. This

can be considered as made up of two components: 500 which is paid into

the sinking fund, and 8% of 5000, which is 400 the interest earned by the

sinking fund, and which will ultimately be paid to the lender to retire the

loan.

5. At the end of the 11th year, the sinking fund balance is

5000(1.08) + 500 = 5900 .

Information for Students in MATH 329 2004 01 2084

[1, Exercise 21, p. 198] A loan of 1000 is being repaid with level annual payments of

120 plus a smaller nal payment made one year after the last regular payment. The

eective rate of interest is 8%. Show algebraically and verbally that the outstanding

loan balance after the 5th payment has been made is:

a) 1000(1.08)

5

120 s

5

b) 1000 40s

5

.

Solution: I give only the verbal explanations.

1. Interpret the loan as being amortized by the regular payments and the nal

drop payment. The amount of 1000(1.08)

5

120 s

5

is that given by the

retrospective method.

2. Now interpret the loan as being repaid by the sinking fund method. As there

is no formal sinking fund, one may simply view a portion of the payments

as being contributed to a sinking fund in the hands of the lender, where the

sinking fund earns interest at the same rate as the principal. Each annual

payment of 120 may be interpreted as being the sum of the service cost of

80, plus a contribution of 40 to the sinking fund which will repay the loan at

maturity. After the 5th payment the value of the sinking fund is 40 s

5

. The

outstanding loan balance will be the excess of the face value of the loan

(which has been serviced annually, so there is no additional accumulation of

interest) over the value of the sinking fund.

[1, Exercise 23, p. 198] On a loan of 10,000, interest at 9% eective must be paid

at the end of each year. The borrower also deposits X at the beginning of each

year into a sinking fund earning 7% eective. At the end of 10 years the sinking

fund is exactly sucient to pay o the loan. Calculate X.

Solution: An equation of value at time t = 10 is X s

10 7%

= 10000, so

X =

10000 0.07

((1.07)

10

1) 1.07

= 676.4252593 .

The interest rate of 9% is totally irrelevant.

[1, Exercise 24, p. 198] A borrower is repaying a loan with 10 annual payments of

1,000. Half of the loan is repaid by the amortization method at 5% eective. The

other half of the loan is repaid by the sinking fund method, in which the lender

receives 5% eective on the investment and the sinking fund accumulates at 4%

eective. Find the amount of the loan.

Information for Students in MATH 329 2004 01 2085

Solution: Let the amount of the loan be L. The amortization of the loan of

L

2

entails an annual payment of

L

2a

10 5%

=

0.025L

1 (1.05)

10

. For the other half of the

loan the borrower must pay interest annually in the amount of 0.05

L

2

= 0.025L.

These two expenses the amortization of half the loan, and the servicing of the

other half leave from his annual payment a balance of

1000

0.025L

1 (1.05)

10

0.025L

which must accumulate at 4% in the sinking fund to produce a balance of

L

2

at

maturity. We have the equation of value

1000

0.025L

1 (1.05)

10

0.025L =

L

2s

10 4%

=

0.02L

(1.04)

10

1

L =

40000

1

1(1.05)

10

+ 1 +

0.8

(1.04)

10

1

= 7610.479836

Information for Students in MATH 329 2004 01 2086

A.24 Supplementary Notes for the Lecture of March 15th, 2004

Distribution Date: Monday, March 15th, 2004, subject to further revision

A.24.1 6.4 Sinking funds (concluded)

[1, Exercise 25, p. 198] A borrows 12,000 for 10 years, and agrees to make semian-

nual payments of 1,000. The lender receives 12% convertible semiannually on the

investment each year for the rst 5 years and 10% convertible semiannually for the

second 5 years. The balance of each payment is invested in a sinking fund earning

8% convertible semiannually. Find the amount by which the sinking fund is short

of repaying the loan at the end of the 10 years.

Solution: The interest payments for the rst 10 half-years are 6% of 12,000, i.e.

720 per half-year; and, for the second 10 half-years, 600 per half-year. This leaves

280 at the end of each of the rst 10 half-years, and 400 at the end of each of the

second 10 half-years to accumulate in the sinking fund, which earns 4% eective

every half year. The accumulated balance in the sinking fund at maturity will be

120s

10 4%

+ 280s

20 4%

=

1

0.04

_

120

_

(1.04)

10

1

_

+ 280

_

(1.04)

20

1

__

= 25

_

120(1.04)

10

+ 280(1.04)

20

400

_

= 9778.594855

implying that the shortfall to repay the loan will be 12, 000 9778.59 = 2221.41.

[1, Exercise 26, p. 198] 1. A borrower takes out a loan of 3000 for 10 years at 8%

convertible semiannually. The borrower replaces one-third of the principal

in a sinking fund earning 5% convertible semiannually, and the other two-

thirds in a sinking fund earning 7% convertible semiannually. Find the total

semiannual payment.

2. Rework (a) if the borrower each year puts one-third of the total sinking fund

deposit into the 5% sinking fund and the other two-thirds into the 7% sinking

fund.

3. Justify from general reasoning the relative magnitude of the answers to (a)

and (b).

Solution:

1. The semiannual contribution to the sinking funds is

1000

s

20 2.5%

+

2000

s

20 3.5%

Information for Students in MATH 329 2004 01 2087

and the semiannual interest payment is 4% of 3, 000, or 120. Hence the total

semiannual payment is

1000

s

20 2.5%

+

2000

s

20 3.5%

+ 120 =

25

(1.025)

20

1

+

70

(1.035)

20

1

+ 120

= 229.8692824

2. Let the total sinking fund deposit be D. Then the equation of value at ma-

turity is

D

3

s

20 2.5%

+

2D

3

s

20 3.5%

= 3000 ,

implying that

D =

9000

s

20 2.5%

+ 2s

20 3.5%

=

9000

(1.025)

20

1

0.025

+ 2

(1.035)

20

1

0.035

= 109.6170427 ,

so the total semi-annual payment is 109.6170427+120=229.6170427.

3. In the original repayment scheme the portion of the payment contributed to

the 5% sinking fund grows more slowly than that to the 7% fund. Thus, while

the nal accumulations in the funds will be in the ratio of 1:2, the proportion

of the contribution to the 5% fund would have been more than

1

3

. By reducing

that proportion to

1

3

we increased the interest earned by the fund, so a smaller

total contribution was required for the sinking fund.

[1, Exercise 27, p. 198] (not discussed in the lecture) A payment of 36,000 is made at

the end of each year for 31 years to repay a loan of 400,000. If the borrower replaces

the capital by means of a sinking fund earning 3% eective, nd the eective rate

paid to the lender on the loan.

Solution: The annual contribution to the sinking fund is

400000

s

31 3%

=

12000

(1.03)

31

1

= 7999.571516.

Hence the annual interest payment is 36, 0007, 999.57 = 28000.43, i.e., 7% of the

principal of 400,000.

[1, Exercise 28, p. 198] (not discussed in the lecture) A 20-year annuity-immediate

has a present value of 10,000, where interest is 8% eective for the rst 10 years,

Information for Students in MATH 329 2004 01 2088

and 7% eective for the second 10 years. An investor buys this annuity at a price

which, over the entire period, yields 9% on the purchase price; and, further, allows

the replacement of capital by means of a sinking fund earning 6% for the rst 10

years and 5% for the second 10 years. Find an expression for the amount that is

placed in the sinking fund each year.

Solution: The level annual payments under the annuity will be

10000

a

10 8%

+ (1.08)

10

a

10 7%

.

It appears to be intended that the sinking fund payments be level also. If their

value is S, and the purchase price is P, then

S

_

(1.05)

10

s

10 6%

+ s

10 5%

_

= P .

The purchase price satises the following equation of value at time 0:

_

10000

a

10 8%

+ (1.08)

10

a

10 7%

S

_

a

20 9%

+ (1.09)

20

P = P ,

which implies that

_

10000

a

10 8%

+ (1.08)

10

a

10 7%

S

_

= 0.09P .

Solving with the earlier equation yields

S =

10000

_

a

10 8%

+ (1.08)

10

a

10 7%

_ _

1 + 0.09

_

(1.05)

10

s

10 6%

+ s

10 5%

__ .

[1, Exercise 29, p. 199] (not discussed in the lecture) A loan of 1 yields the lender

rate i per period for n periods, while the borrower replaces the capital in a sinking

fund earning rate j per period. Find expressions for the following if 1 t n:

1. Periodic interest paid to the lender.

2. Period sinking fund deposit.

3. Interest earned on sinking fund during the tth period.

4. Amount in sinking fund at end of the tth period.

5. Net amount of loan at the end of the tth period.

6. Net interest paid in period t.

Information for Students in MATH 329 2004 01 2089

7. Principal repaid in period t.

Solution:

1. The yield rate is i, so the lender must be receiving an amount of i each period.

2. The capital is 1, so the borrower is depositing s

1

n j

regularly into the sinking

fund. (I understand that interest will be paid regularly, and the capital will

be repaid at maturity.)

3. At the beginning of the tth period the balance in the sinking fund is

s

t1 j

s

n j

;

during the period it earns interest in the amount of j

s

t1 j

s

n j

, payable at the

end of the period, i.e., at time t.

4. The amount in sinking fund at end of the tth period is

s

t j

s

n j

.

5. The net amount of loan at the end of the tth period is the excess of 1 over

the balance in the sinking fund, i.e., 1

s

t j

s

n j

.

6. The net interest paid in the tth period is the excess of interest paid over

interest earned, i.e. i j

s

t1 j

s

n j

7. By 5. above, the change in the amount of the loan between the t 1th and

the tth payment is

_

1

s

t j

s

n j

_

_

1

s

t1 j

s

n j

_

=

s

t j

s

t1 j

s

n j

=

(1 + i)

t1

s

n j

.

A.24.2 6.5 Diering payment periods and interest conversion periods

Omit this section.

A.24.3 6.6 Varying series of payments

Omit this section.

A.24.4 6.7 Amortization with continuous payments

Omit this section.

A.24.5 6.8 Step-rate amounts of principal

Omit this section.

Information for Students in MATH 329 2004 01 2090

A.25 Supplementary Notes for the Lecture of March 17th, 2004

Distribution Date: Wednesday, March 17th, 2004, subject to further revision

Textbook Chapter 7. Bonds and other securities.

A.25.1 7.1 Introduction

The chapter is concerned with relations between the price of a security and its yield rate,

and with the value of a security at any time after it has been purchased, even at a time

that is not an interest compounding date.

A.25.2 7.2 Types of securities

We shall conne our study to bonds, which are a commitment by the issuer to repay

a loan at a particular time, with interest payments according to a prescribed rate and

schedule. Many variations are possible, and this type of instrument is still evolving.

[1, Exercise 1, p. 240] Find the price which should be paid for a zero coupon bond

which matures for 1000 in 10 years to yield:

1. 10% eective

2. 9% eective

3. Thus a 10% reduction in the yield rate causes the price to increase by what

percentage?

Solution:

1. The bond is now worth 1000(1.10)

10

= 385.5432894.

2. When the interest rate is reduced to 9%, the present value of the bond in-

creases to 422.4108069.

3. The 10% decrease in the interest rate thereby increases the price by

422.4108069

385.5432894

1 = 9.5624846%.

[1, Exercise 2, p. 240] A 10-year accumulation bond with an initial par value of 1000

earns interest of 8% compounded semiannually. Find the price to yield an investor

10% eective.

Solution:

Information for Students in MATH 329 2004 01 2091

Denition A.8 [1, p. 205] An accumulation bond is one in which the redemption

price includes the original loan plus all accumulated interest.

Solution: The only return payment is at maturity. The price to yield 10% interest

will therefore be

(1.10)

10

_

1000(1.04)

20

_

= 844.7728240.

[1, Exercise 3, p. 240] (not discussed in the lecture) A 26-week (U.S.) T(reasury)-

bill is bought for 9,600 at issue, and will mature for 10,000. Find the yield rate

computed as:

1. A discount

13

rate, using the typical method for counting days on a T-bill

14

.

2. An annual eective rate of interest, assuming the investment period is exactly

half a year.

Solution:

1. The time is 26 weeks, i.e. 267 = 182 days, or, under the actual/360 system,

182

360

of a year. The discount rate will, therefore, be

360

182

400

10000

= 7.912087912%.

2. The eective interest rate for half a year is

400

9600

=

1

24

.

The eective rate for a full year will be

_

1 +

1

24

_

2

1 =

1

12

+

1

576

= 8.506944444%.

[1, Exercise 4, p. 241] (not discussed in the lecture) T-bills of all maturities yield

8% compounded on a discount basis. Find the ratio of the annual eective rate

of interest earned on a 52-week T-bill to that earned on a 13-week T-bill. Use an

approach which does not involve the counting of days.

Solution: The 52-week T-bill will earn interest at the rate

d

1 d

=

0.08

0.92

= 8.695652174%.

13

simple discount

14

i.e., actual/360 [1, p. 39], using the exact number of days, but assuming 360 days in the year.

Information for Students in MATH 329 2004 01 2092

The 13-week T-bill earns interest quarterly at the rate

d

1 d

=

0.02

0.92

= 2.173913043%,

so the eective annual rate is

(1.02173913043)

4

1 = 8.9833377%,

and the ratio to the 52-week rate to this is

8.695652174

8.9833377

= 0.9679756527. THIS IS

NOT THE AUTHORS ANSWER. HE GIVES 1.0332. Note that

1

0.9679756527

=

1.033083836. The eective rate for a shorter period should be higher than that for

a longer period because of the compounding, since the rates of 8% given are simple

discount rates.

Information for Students in MATH 329 2004 01 2093

A.26 Supplementary Notes for the Lecture of March 19th, 2004

Distribution Date: Friday, March 19th, 2004, subject to further revision

A.26.1 7.3 Price of a bond

Remember that a bond is essentially a contract to pay a large amount at maturity,

and smaller amounts of interest periodically on coupon dates until maturity. It diers

from the types of loans we have studied hitherto in that the contract is often (but not

always) transferable from one owner to another, and so it is reasonable to investigate the

value of the entire contract under conditions of varying yield.

Familiarize yourself with the following terms, dened in the textbook, and with the

symbols usually used for them:

The price P paid for a bond. In practice bond prices are usually quoted in terms

of a bond with face value (see next item) of 100.

The par value or face value or face amount. This amount is usually printed in

the bond contract, but may not be the amount paid at maturity. Its function

is to determine, once the coupon rate r has been specied, the magnitude of the

coupons.

The redemption value C is the amount paid when the bond is redeemed. When

a bond is redeemable at par, C = F. Where the redemption value exceeds the

face value, the word premium may be used for the excess; this word premium is

also used to denote the excess of the price paid for a bond over what would have

been the value if the yield rate was the same as the coupon rate.

The coupon rate r is the eective rate per coupon payment period, based on which

the amount of the coupon is calculated. The default payment period is a half-year.

The amount of a coupon is the product Fr.

The modied coupon rate g =

Fr

C

is the coupon rate per unit of redemption value,

rather than per unit of par value.

The yield rate or yield to maturity i is the actual interest rate earned by the

investor.

The number of coupon payment periods from the date of calculation until maturity

is denoted by n.

Information for Students in MATH 329 2004 01 2094

The present value of the redemption value, discounted back to the present by the

yield rate, is denoted by K; so K = C(1 + i)

n

.

The base amount G is

Fr

i

: the amount which, if invested at the yield rate i, would

produce periodic interest payments equal to the coupons.

A callable bond is one where the lender has the right to declare that interest pay-

ments will stop and a bond may be redeemed at certain dates before the maturity

date; there could be a premium paid in addition to the redemption value, to en-

courage lenders to cash in the bond.

The word discount is often used where we have been using the word premium if

the premium is negative: the discount is the negative of the premium.

Four formul for price.

Theorem A.8 (The Basic Formula) P = Fr a

n

+ Cv

n

= Fr a

n

+ K

Theorem A.9 (The Premium/Discount Formula) P = C + (Fr Ci) a

n

Theorem A.10 (The Base Amount Formula) P = G+ (C G)v

n

Theorem A.11 (Makehams Formula) P = K +

g

i

(C K)

[1, Exercise 5, p. 241] A 10-year 100 par value bond bearing a 10% coupon rate

payable semi-annually, and redeemable at 105, is bought to yield 8% convertible

semiannually. Find the price. Verify that all four formul produce the same

answer.

Solution:

F 100

C 105

r 5%

Fr 5

g =

Fr

C

1

21

i 4%

n 20

K = C(1 + i)

n

105(1.04)

20

= 47.92

G =

Fr

i

125

Basic Formula P = 100(0.05)a

20 4%

+105(1.04)

10

= 100(0.05)a

10

+105(1.04)

20

=

115.8722611.

Information for Students in MATH 329 2004 01 2095

Premium/Discount Formula P = 105+(100(0.05)105(0.04))a

20 4%

= 115.8722611.

Base Amount Formula P = 125 + (105 125)(1.04)

20

= 115.8722611.

Makehams Formula P = 105(1.04)

20

+

1

21

0.04

(105 105(1.04)

20

) = 115.8722611.

[1, Exercise 6, p. 241] For the bond in [1, Example 7.3, pp. 212-213] determine the

following:

1. nominal yield based on the par value

2. nominal yield, based on the redemption value

3. current yield

4. yield to maturity.

(The bond is described as a 1000 par value 10-year bond with coupons at 8.4%

convertible semiannually, which will be redeemed at 1050, purchased to yield 10%

convertible semiannually..)

Solution:

1. The nominal yield is simply the annualized coupon rate on the bond. Since

the coupon rate is 8.4% (convertible...), that is the nominal yield.

2. This usage of the term nominal diers slightly from that given in the textbook.

The intention is that we should interpret the coupons as percentages of, not

the face value, but the redemption value, i.e, we should use the modied

coupon rate, which here is

Fr

C

=

42

1050

= 4%. But that is the eective rate

per half-year, so the corresponding nominal annual rate compounded semi-

annually is 8%.

3. The current yield is the ratio of the annualized coupon to the original price

of the bond [1, p. 221]. Here the coupon is 84, and the price has been shown

in the example to be 919.15, so the current yield is

84

919.15

= 9.139%.

4. The purchase price was calculated to yield 10% (convertible semi-annually).

[1, Exercise 7, p. 241] Two 100 par value bonds, both with 8% coupon rates payable

semi-annually are currently selling at par. Bond A matures in 5 years at par, while

Bond B matures in 10 years at par. If prevailing market rates of interest suddenly

go to 10% convertible semiannually, nd the percentage change in the price of

1. Bond A

2. Bond B

Information for Students in MATH 329 2004 01 2096

3. Justify from general reasoning the relative magnitudes of the answers to (a)

and (b).

Solution:

1. For both of the bonds F = C = 100, r = 4%; for bond A n = 10. Using the

Premium/Discount formula we nd that

P = C + (Fr Ci)a

n 4%

= 100 + 100(0.04 0.05)

1 (1.05)

10

0.05

= 92.27826507

The percentage change in the price of this bond is

7.72173493

100

= 7.72173493%.

2. For bond B n = 20. Using the Premium/Discount formula we nd that

P = C + (Fr Ci)a

n 4%

= 100 + 100(0.04 0.05)

1 (1.05)

20

0.05

= 87.53778966

The percentage change in the price of this bond is

12.46221034

100

= 12.46221034%.

3. the last coupon payments under bond B are more aected by the rate change

than the rst.

[1, Exercise 8, p. 241] Two 1000 bonds redeemable at par at the end of the same

period are bought to yield 4% convertible semiannually. One bond costs 1136.78,

and has a coupon rate of 5% payable semiannually. The other bond has a coupon

rate of 2

1

2

% payable semiannually. Find the price of the second bond.

Solution: For the rst bond we have F

1

= C

1

= 1000, i

1

= 2%, P

1

= 1136.78,

r

1

= 2.5%. By the Premium/Discount formula,

1136.78 = 1000 + (25 20) a

n 2%

,

implying that a

n

= 27.356. For the second bond we have F

2

= C

2

= 1000, i

2

= 2%,

r

2

= 1.25%, n

2

= n

1

,

P

2

= 1000 + (12.5 20) a

n

= 794.83 .

Information for Students in MATH 329 2004 01 2097

[1, Exercise 9, p. 241] A 1000 bond with a coupon rate of 9% payable semiannually

is redeemable after an unspecied number of years at 1125. The bond is bought to

yield 10% convertible semiannually. If the present value of the redemption value is

225 at this yield rate, nd the purchase price.

Solution: We have F = 1000, C = 1125, r = 4.5%, i = 5%, K = 225. From this

last fact we have 225 = 1125(1.05)

n

, so (1.05)

n

= 5, and a

n i

=

1

1

5

0.05

= 16. By the

Basic Formula, the price is Fr a

n

+ K = 45(16) + 225 = 945.

[1, Exercise 10, p. 241] A 1000 par value n-year bond maturing at par with annual

coupons of 100 is purchased for 1110. If K = 450, nd the base amount G.

Solution: We have F = C = 1000, Fr = 100 (so r = 10%), P = 1110, K = 450.

By Makehams formula,

1110 = 450 +

Fr

Ci

(C K) = 450 +

100

1000i

(1000 450)

so i =

1

12

, and

G =

Fr

i

= 1200 .

[1, Exercise 11, p. 241] An investor owns a 1000 par value 10% bond with semian-

nual coupons. The bond will mature at par at the end of 10 years. The investor

decides that an 8-year bond would be preferable. Current yield rates are 7% con-

vertible semiannually. The investor uses the proceeds from the sale of the 10%

bond to purchase a 6% bond with semiannual coupons, maturing at par at the end

of 8 years. Find the par value of the 8-year bond.

Solution: We have C = F = 1000, r = 5%, n

1

= 20, i = 3.5%. The price of the

bond presently owned is, by the premium/discount formula,

P

1

= C + (Fr Ci)a

20 3.5%

= 1000 + (50 35)

1 (1.035)

20

0.035

= 1213.186050 .

With these proceeds the investor buys a bond with par value F = C, n = 16,

r = 3%; by the premium/discount formula,

1213.186050 = F + F(0.03 0.035)

1 (1.035)

16

0.035

,

implying that F = 1291.269895.

[1, Exercise 12, p. 241] An n-year 1000 par value bond matures at par and has a

coupon rate of 12% convertible semiannually. It is bought at a price to yield 10%

Information for Students in MATH 329 2004 01 2098

convertible semiannually. If the term of the bound is doubled, the price will increase

by 50. Find the price of the n-year bond.

Solution: We have F = C = 1000, r = 6%, i = 5%. Since we know that

a

2n

= 2 a

n

i (a

n

)

2

,

we can eliminate P between the two equations

P = 1000 + (60 50)a

n

,

P + 50 = 1000 + (60 50)a

2n

,

and deduce that

(a

n

)

2

20a

n

+ 100 = 0

so a

n

= 10, and P = 1000 + 10(10) = 1100.

Information for Students in MATH 329 2004 01 2099

A.27 Supplementary Notes for the Lecture of March 22nd,

2004

Distribution Date: Monday, March 22nd, 2004, subject to further revision

A.27.1 7.4 Premium and discount

Premium = P C = (Fr Ci)a

n i

Discount = C P = (Fr Ci)a

n i

In practice the word premium is used when P C > 0, and discount when P C < 0;

when P = C we speak of a purchase at par.

Book Value For accounting purposes it is necessary to show a gradual progression of

the value of a bond from purchase to maturity that is in some reasonable relationship

with its market value. There are a number of possible methods for doing this in practice,

but we shall adhere to the method whereby the value is shown to be what would be the

price if the yield rate does not change after the purchase of the bond. Of course, the yield

rate could very well change after the purchase, and so this is not a completely realistic

assumption. There are other methods for assigning a value to the bond. In this section

we shall consider the value only at coupon payment dates; generalization to other dates

will be considered in the next section.

When a bond is purchased at a premium

15

the value of the redemption value and

the unpaid coupons just after the payment of the tth coupon i.e. of the book value

B

t

will decrease until the maturity date. Thus the coupons may be interpreted as

consisting of the interest which is earned at the yield rate i and an amount to amortize

the premium. The redemption value C is C = B

n

, and the price is P = B

0

. We will use

this notation even when the bond is purchase with some of its coupons already paid (to

the vendor). The writing down of the premium may be shown on a schedule like

Coupon Coupon Interest Amount for Amortization Book

Number amount earned of Premium value

0 . . . . . .

1 Fr

. . . Fr . . . . . . . . .

[1, Exercise 16, p. 242] For a bond of face value 1 the coupon rate is 150% of the

yield rate, and the premium is p. For another bond of 1 with the same number of

15

mutatis mutandis, at a discount

Information for Students in MATH 329 2004 01 2100

coupons and the same yield rate, the coupon rate is 75% of the yield rate. Find

the price of the second bond.

Solution: We are assuming that C = F for both bonds, and that the common

value is 1. For the rst bond we have

1 + p = C + (Fr Ci)a

n i

= 1 + (1.5 1)ia

n i

so ia

n i

= 2p. The price of the second bond is then, again by the Premium/Discount

formula,

1 + (0.75 1)ia

n i

= 1 0.25ia

n i

= 1

p

2

.

[1, Exercise 17, p. 242] (not discussed in the lecture) For a certain period a bond

amortization schedule shows that the amount for amortization of premium is 5, and

that the required interest is 75% of the coupon. Find the amount of the coupon.

Solution: The bond was purchased at a premium, because the coupon rate exceeds

the yield rate. In the question, the author means by the amount of the coupon,

the total amount of all the coupons under discussion. We have

Frn Fin = 5

and

Fin

Frn

= 0.75 .

implying that Fr = 4(5) = 20.

[1, Exercise 18, p. 242] (not discussed in the lecture) A 10-year bond with semi-

annual coupons is bought at a discount to yield 9% convertible semiannually. If

the amount for accumulation of discount in the next-to-last coupon is 8, nd the

total amount for accumulation of discount during the rst four years in the bond

amortization schedule.

Solution: We have i = 4.5%, n = 20,

C(g i)v

2

= C

_

Fr

C

i

_

v

2

= C

r i

(1 + i)

2

= 8 ,

so

C(g i) = 8(1 + i)

2

.

The total amount for accumulation of discount during the rst four years in the

schedule is

C(g i)(v

20

+ v

19

+ . . . + v

13

) = 8(1 + i)

2

(v

20

+v

19

+ . . . + v

13

)

= 8v

14

a

4 i

= 8

(1.045)

10

(1.045)

18

0.045

= 33.98

Information for Students in MATH 329 2004 01 2101

[1, Exercise 19, p. 242] A 1000 par value 5-year bond with a coupon rate of 10%

payable semi-annually and redeemable at par is bought to yield 12% convertible

semiannually. Find the total of the interest paid column in the bond amortization

schedule. TO BE DISCUSSED AT THE NEXT LECTURE

Information for Students in MATH 329 2004 01 2102

A.28 Supplementary Notes for the Lecture of March 24th, 2004

Distribution Date: Wednesday, March 24nd, 2004, subject to further revision

A.28.1 7.4 Premium and discount (concluded)

We consider again the problem with which we ended the last lecture:

Example A.12

[1, Exercise 19, p. 242] A 1000 par value 5-year bond with a coupon rate of 10% payable

semi-annually and redeemable at par is bought to yield 12% convertible semiannually.

Find the total of the interest paid column in the bond amortization schedule.

Solution: We have C = F = 1000, n = 10, r = 5%, i = 6%. The premium paid for the

bond is

1000(0.05 0.06)a

10 6%

= 73.60

(i.e., a discount of 73.60.) The total of the coupons is 10Fr = 500., so the sum of the

coupons and the discount is 500.00 + 73.60 = 573.60, and this is the true interest paid.

While the problem did not ask us to actually set up the amortization table, lets do it

anyhow:

Coupon Coupon Interest Amount for Amortization Book

Number amount earned of Premium value

0 926.40

1 50.00 55.58 -5.58 931.98

2 50.00 55.92 -5.92 937.90

3 50.00 56.27 -6.27 944.17

4 50.00 56.65 -6.65 950.82

5 50.00 57.05 -7.05 957.87

6 50.00 57.47 -7.47 965.34

7 50.00 57.92 -7.92 973.26

8 50.00 58.39 -8.39 981.65

9 50.00 58.90 -8.90 990.55

10 50.00 59.43 -9.43 999.98

TOTAL 500.00 573.58 -73.58

The following example illustrates a problem where the price P of a bond is not

determined explicitly until an equation for P is determined and solved.

Example A.13 [1, Example 7.4, p. 219] Find the price of a 1,000 par value 2-year

8% bond with semi-annual coupons bought to yield 6% convertible semiannually, if the

Information for Students in MATH 329 2004 01 2103

investor plans to replace the premium by means of a sinking fund earning 5% convert-

ible semi-annually. (Note: The intention is that this plan for a sinking fund has been

considered in calculating the yield rate of the bond.)

Solution: Note that, following the usual convention, the 8% rate is interpreted as a

nominal interest rate compounded twice a year.

The unknown is the price, P. The coupons each have value 0.04 1000 = 40, but

the interest earned is 3% of the price P, which remains to be determined. The sinking

fund is to mature at value P 1000 after 2 years, i.e., after 4 contributions. Thus an

equation of value is

(40 .03P)s

4 2.5%

= P 1000 . (54)

This can be solved for P:

P =

1000 + 40s

4 2.5%

1 + 0.03s

4 2.5%

= 1, 036.93 .

Note the assumption used in equation (54): all of the coupon that exceeds the interest

earned at the yield rate is contributed to the sinking fund; this was not explicitly stated

in the problem, but is the authors interpretation. If, for example, the purchaser had

decided that he would allocate only half of the excess to his sinking fund contributions,

then the price of the bond would be about 1082.43.

Information for Students in MATH 329 2004 01 2104

A.29 Supplementary Notes for the Lecture of March 26th, 2004

Distribution Date: Friday, March 26nd, 2004, subject to further revision

A.29.1 7.5 Valuation between coupon payment dates

(I shall return to this section after discussing [1, 7.7].)

A.29.2 7.6 Determination of yield rates

Omit this section.

A.29.3 7.7 Callable bonds

[1, Exercise 31, p. 243] A 1000 par value bond has 8% semiannual coupons, and is

callable at the end of the 10th through the 15th years at par.

1. Find the price to yield 6% convertible semiannually.

2. Find the price to yield 10% convertible semiannually.

Solution:

1. Let n be the coupon number at whose date the bond is called matures. Then,

by the Premium/Discount Formula

P = 1000 + (40 30)a

n 3%

, (n = 20, 22, 24, 26, 28, 30).

Without knowing which will be the date of call, we take the worst possible

date in order to minimize the price; since a

n 3%

is an increasing function of n,

and is multiplied by a positive number, 10, we minimize by making n as small

as possible, i.e., 2 10 = 20:

P = 1000 + (40 30)a

20 3%

= 1000.00 + 148.78 = 1148.78 .

2. When the semi-annual yield rate is 5%, the multiplier is negative, 40 50 =

10, and we must choose the largest value of n, i.e., n = 30, for a price of

P = 1000 + (40 50)a

30 5%

= 1000.00 153.72 = 846.28 .

Information for Students in MATH 329 2004 01 2105

A.30 Supplementary Notes for the Lecture of March 29th, 2004

Distribution Date: Monday, March 29th, 2004, subject to further revision

A.30.1 7.7 Callable bonds (continued)

[1, Exercise 32, p. 243] If the bond in Exercise 31(b) were actually called at the end

of 10 years, nd the yield rate to the owner of the bond.

Solution: The yield rate i satises the equation

846.28 = 1000 + 1000(0.04 i)a

20 i

,

and can be found by iteration to be 10.52%%.

[1, Exercise 33, p. 243] A 1,000 par value 8% bond with quarterly coupons is callable

ve years after issue. The bond matures for 1,000 at the end of 10 years, and is

sold to yield a nominal rate of 6% convertible quarterly, under the assumption that

the bond will not be called. Find the redemption value at the end of 5 years that

will provide the purchaser the same yield rate.

Solution: If the bond is certain not to be called, its present value (i.e., its price) is

1000 + (20 15)a

40 1.5%

= 1000 + 5(29.9258) = 1149.63.

Let x denote the redemption value after 5 years that will provide the same yield

rate. Then

1149.63 = x + (20 0.015(x))a

20 1.5%

which implies that

x =

1149.63 20a

20 1.5%

1 0.05a

20 1.5%

= 1085.91 .

[1, Exercise 34, p. 243] A 1000 par value 4% bond with semiannual coupons matures

at the end of 10 years. The bond is callable at 1050 at the ends of years 4 through

6, at 1025 at the ends of years 7 through 9, and at 1000 at the end of year 10. Find

the maximum price that an investor can pay and still be certain of a yield rate of

5% convertible semiannually.

Solution: We have to nd the minimum of the following prices based on the given

call dates and premiums:

1050.00 + (20.000 26.250)a

n 2.5%

(n = 8, 10, 12) (55)

1025.00 + (20.000 25.625)a

n 2.5%

(n = 14, 16, 18) (56)

1000.00 + (20.000 25.000)a

20 2.5%

. (57)

Information for Students in MATH 329 2004 01 2106

In each case the coecient of a

n 2.5%

is negative, so the lowest value will be when

n is as large as possible; that is, we have to compare the following three amounts

1050.00 + (20.000 26.250)a

12 2.5%

= 1050 (6.250)10.2578 = 985.89

1025.00 + (20.000 25.625)a

18 2.5%

= 1025 (5.625)14.3534 = 944.26

1000.00 + (20.000 25.000)a

20 2.5%

= 1000 (5.000)15.5892 = 922.05 ,

whose minimum is the last, the price of the bond if not called before maturity.

That is the highest price the investor may pay if she wishes to be sure that the

yield will not be less than 5% convertible semiannually.

[1, Exercise 35, p. 243] A 1,000 par value 6% bond with semiannual coupons is

callable at par 5 years after issue. It is sold to yield 7% under the assumption

that the bond will be called. The bond is not called, and it matures at the end

of 10 years. The bond issuer redeems the bond for 1000 + X without altering the

buyers yield rate of 7% convertible semiannually. Find X.

Solution: Under the assumption that the bond will be called at par 5 years after

issue, its price, when yielding 3.5% eective semi-annually, would be

1000 + (30 35)a

10 3.5%

= 958.42 .

The premium upon maturity will be given by the equation

958.42 = 1000 + X + (30 (0.035)(1000 + X))a

20 3.5%

.

which implies that

X =

958.42 30a

20 3.5%

1 0.035a

20 3.5%

1000 = 58.66 .

Information for Students in MATH 329 2004 01 2107

A.31 Supplementary Notes for the Lecture of March 31st, 2004

Distribution Date: Thursday, March 31st, 2004, subject to further revision

A.31.1 7.5 Valuation between coupon payment dates

In the preceding section we have considered the price of a bond on coupon payment

dates. We have chosen to use the term book value for the adjusted value of the bond

on coupon payment dates after a coupon has been paid: the book value is the residual

value of the instrument, where the yield rate is taken to be the rate in eect when the

bond was purchased. These rates are related by the recurrence

B

t+1

= (1 + i)B

t

Fr . (58)

Do not confuse this with the equations of value that we computed earlier in the course,

where we found that, under compound interest, sums of money could be moved forward

and backwards on in time by multiplication by the appropriate power of 1 + i. That

principle is still in eect, but the sums we are considering the book values at dierent

times are not one single value, but a whole sequence of values; we normally are

interested in B

t

precisely at time t, and it is not going to be the same as the book value

B

t+1

at time t + 1 for 2 reasons:

maturity is one year further away;

the instrument guarantees one more coupon payment.

One way to prove equation (58) is by considering the value of B

t

at time t + 1.

Market price and Flat price. The market price on a coupon payment date is what

we earlier called simply the price, and will have an associated yield rate. It will be

the book value of a previously purchased bond when the yield rate has not changed since

purchase, and we will normally make such an assumption. But bonds are not always

purchased on a coupon payment date; and, even when they are, there is normally a delay

between the date of the formal order and the delivery of the bond. So we need to have

a method for computing a reasonable price at times between coupon payment dates.

The Flat Price is the actual sum of money that changes hands at the time of formal

purchase. It can be interpreted as being made up of two elements:

the Market Price; and

the Accrued Coupon

The Flat Price at time t +k between coupon dates ##t, t +1 is obtained from the Flat

Price just after the payment of the coupon #t by one of two methods:

Information for Students in MATH 329 2004 01 2108

Theoretical Method: Compound interest, producing (1 + i)

k

B

t

;

Practical Method: Simple interest, producing (1 + ki)B

t

.

The Accrued Coupon can also be calculated by both a Theoretical and a Practical

method:

Theoretical Method: Compound interest, producing Fr

_

(1+i)

k

1

i

_

;

Practical Method: Simple interest, producing kFr.

(Even here there are still some conventions needed, in the way in which we determine

the time interval k as a fraction of a period.) In the Semi-theoretical Method the Flat

Price is calculated by the theoretical method, but the accrued coupon is calculated by

simple interest, i.e., by the Practical Method.

Note that it is the Flat Price that is being calculated by the choice of methods,

not the Market Price. The Market Price can be obtained from the two elements by

subtraction:

Market Price = Flat Price - Accrued Coupon

In practice prices are quoted in the form

Flat Price = Market Price + Accrued Coupon

The graph of the Book Value (which we take to be the same as Market Price) will be

monotonely increasing when i > r, constant when i = r, and monotonely decreasing

when i < r. Between the values at integer points the graph will be linear in the case

of the Practical Method, and exponential in the case of the theoretical method, but

the dierences between the two are very small; in either case the function is continuous.

However, the Flat Price will be discontinuous at coupon payment dates, because its value

drops each time a coupon is paid, by the value of the coupon.

A.31.2 7.8 Serial bonds

Omit this section

A.31.3 7.9 Some generalizations

Omit this section.

A.31.4 7.10 Other securities

Omit this section.

Information for Students in MATH 329 2004 01 2109

A.31.5 7.11 Valuation of securities

Omit this section.

Information for Students in MATH 329 2004 01 2110

A.32 Supplementary Notes for the Lecture of April 5th, 2004

Distribution Date: Monday, April 5th, 2004, subject to further revision

(Friday, April 2nd was spent on a discussion of part of the Final Examination from

2002-03, found in these notes, pages 30423045.)

An amortization problem

[5, Exercise 4-9, p. 87] A loan is being repaid with 30 equal annual install-

ments, at i = 0.17. In what installment are the principal and interest portions

most nearly equal to each other?

Solution: Let A be the amount of the loan, received at time n = 0, and let X be the

annual payment. An equation of value at time n = 0 is Xa

30

= A, yielding the value of

the annual payment to be

X =

A

a

30

.

By the prospective method we see that the unpaid principal immediately after the (r

1)st payment is

Xa

31r

= A

a

31r

a

30

= A

1 v

31r

1 v

30

. (59)

The unpaid principal is a decreasing function of r, and the interest earned on it during

the next period and included in the next regular payment is its product with i, which will

also be a decreasing function of r. Since xed payments are being made, and the portion

of the payment that is interest will be decreasing, the balance of the rth payment, which

is applied to reduction of principal, is an increasing function of r, namely

A

a

30

_

1 i a

31r

_

= A

1 a

31r

a

30

; (60)

note that this amount is always positive until the loan is repaid. If, in the rth payment,

the amount of interest is less than or equal to the amount for reduction of principal,

then the same property will hold for all subsequent payments; if, in the rth payment,

the amount of interest is greater than or equal to the amount for reduction of principal,

then the same property will hold for all prior payments. The observations just made

about functions increasing and decreasing hold even for non-integral values of r. So one

way of solving the present problem is to equate the interest and principal formul, and

solve for r. If r is not an integer which will usually be the case we know that the

Information for Students in MATH 329 2004 01 2111

payment for which the dierence between interest and principal is minimal will be one

of payments ##r| and r| (the integers which are closest to r from below and above).

iA

a

31r

a

30

= A

v

31r

a

30

v

31r

=

1

2

(1.17)

31r

= 2

(31 r) ln 1.17 = ln 2

r = 31

ln 2

ln 1.17

= 31 4.41 = 26.58

so the candidates for closest interest and principal are payments ##26 and 27. The

dierence between the interest and principal in payments ##26 and 27 are, respectively,

A

1 2v

3126

1 v

30

0.087777695

0.990996235

= 0.0886

A

1 2v

3127

1 v

30

0.067300096

0.990996235

= 0.0679

so the payment where these are closest is #27.

The student should note that the formul we have derived above in (59) and (60)

are generally true when a loan is amortized in equal payments, and are found in [5, pp.

78, 79]. But be cautioned these formul are not necessary applicable under other

conditions, e.g. where payments are not level.

A sinking fund problem

16

A borrower takes out a loan of 20000 for three years.

Construct a sinking fund schedule where the lender receives a nominal rate of 10%

eective semi-annually and paid semi-annually on the loan, and the borrower replaces the

amount of the loan with semi-annual deposits into a sinking fund earning 8% convertible

quarterly. Use the following headings

Duration Contribution Interest Interest Earned Balance of

(Months) to Sinking Fund on Loan in Sinking Fund Sinking Fund

0 0 0 0 0

3 . . . . . . . . . . . .

6 . . . . . . . . . . . .

Solution: Every six months the borrower pays the interest that has accrued on the loan

at the rate of

10

2

% = 5% per half-year; i.e. the amount of 5% of 20000, or 1000. In

16

Source of problem: modied from Final Examination in Math 329, April, 2000

Information for Students in MATH 329 2004 01 2112

order that the sinking fund accumulate an amount of 8% convertible quarterly, i.e. 2%

quarterly, the borrower must make 6 semi-annual payments X which satisfy the equation

X s

6(1.02)

2

1

= 20000

whence

X =

20000

s

61.02

2

1

=

808

(1.02)

12

1

= 3012.21

Duration Contribution Interest Interest Earned Balance of

(Months) to Sinking Fund on Loan in Sinking Fund Sinking Fund

0 0.00 0.00 0.00 0.00

3 0.00 0.00 0.00 0.00

6 3012.21 1000.00 0.00 3012.21

9 0.00 0.00 60.24 3072.45

12 3012.21 1000.00 61.45 6146.11

15 0.00 0.00 122.92 6269.03

18 3012.21 1000.00 125.38 9406.62

21 0.00 0.00 188.13 9594.75

24 3012.21 1000.00 191.90 12798.86

27 0.00 0.00 255.98 13054.84

30 3012.21 1000.00 261.10 16328.15

33 0.00 0.00 326.56 16654.71

36 3012.20 1000.00 333.09 20000.00

Note that the last semi-annual payment has been reduced by 1 cent. An equivalent

table could have been compiled with 6 months intervals, with semi-annual interest rate

(1.02)

2

1 = .0404:

Duration Contribution Interest Interest Earned Balance of

(Months) to Sinking Fund on Loan in Sinking Fund Sinking Fund

0 0.00 0.00 0.00 0.00

6 3012.21 1000.00 0.00 3012.21

12 3012.21 1000.00 121.69 6146.11

18 3012.21 1000.00 248.30 9406.62

24 3012.21 1000.00 380.03 12798.86

30 3012.21 1000.00 517.07 16328.14

36 3012.20 1000.00 659.66 20000.00

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 2113

Another nal examination problem

17

An investor plans to buy a twenty-year

mortgage whose amount is 150,000, having equal monthly payments; the nominal interest

rate is 6%, compounded monthly. The investor plans to invest the monthly payments she

receives in a savings account earning a nominal annual rate of 3%, compounded monthly,

in order to accumulate a retirement fund after 20 years.

1. What is the monthly payment on the mortgage?

2. What should the investor pay for this mortgage, in order to receive an eective

annual yield rate of 8%?

3. How much is in the retirement fund after 10 years.

4. How much is in the retirement fund after 20 years?

Solution:

1. The mortgage is amortized over 20 years, i.e., 240 months. The monthly payment

X has the property that X a

240

6

12

%

= 150000, hence

X =

150000

a

2400.5%

= 1074.65

2. (a) Suppose that the intention of the problem is that the mortgage

payments are still to be placed in the sinking fund. The sinking fund

becomes available only at the end of 20 years. Discounting back to the present

at 8%, we nd its present value, i.e. the price to be paid, to be

(1.08)

20

1074.65 s

2400.025%

= (1.08)

20

150, 000

s

2400.025%

a

2400.05%

= 75, 694.46.

(b) Suppose that the intention of the problem is that the mortgage

payments are no longer to be placed in a sinking fund. Let i denote

the monthly interest rate that, when compounded 12 times, is equivalent to

an annual rate of 8%; i.e. i = (1.08)

1

12

1. The present value of all future

payments is

X a

240i

= X

1 (1 + i)

240

(1.08)

1

12

1

= X

1 (1.08)

20

(1.08)

1

12

1

= 1074.65 122.0777 = 131190.83

17

Source of problem: modied from Final Examination in Math 329, April, 1998.

Information for Students in MATH 329 2004 01 2114

3. After 10 years the payments have accumulated to Xs

1200.0025

= 1074.65139.74 =

150171.59.

4. After 20 years the payments have accumulated to Xs

2400.0025

= 1074.65328.30 =

352807.60.

Information for Students in MATH 329 2004 01 3001

B Problem Assignments and Tests from Previous

Years

B.1 2002/2003

B.1.1 First 2002/2003 Problem Assignment, with Solutions

In all of the following problems students were are expected to show your work.

1. (a) What principal will earn interest of 100 in 7 years at a simple interest rate of

6%?

(b) What simple interest rate is necessary for 10,000 to earn 100 interest in 15

months?

(c) How long will it take for money to double at a simple interest rate of 8%?

(d) For the rate stated and the period of time computed in the previous part of

the question, what would 1 grow to if interest were compounded annually?

Solution:

(a) Let P denote the unknown principal. Equating the interest earned, P(0.06)7

to 100 and solving for P, we obtain that P =

100

70.06

= 238.10.

(b) If the interest rate is i, the amount of interest earned will be i

15

12

10000 = 100.

Solving yields i =

4

5

100

10000

= 0.008 or 0.8%.

(c) Let the number of years for money to double be denoted by t. We solve

1 + (0.08)t = 2: t =

21

0.08

= 12.5. Money doubles in 12

1

2

years.

(d) (1.08)

12.5

= 2.62.

2. The total amount of a loan to which interest has been added is 20,000. The term

of the loan was four and one-half years.

(a) If money accumulated at simple interest at a rate of 6%, what was the amount

of the loan?

(b) If the nominal annual rate of interest was 6% and interest was compounded

semi-annually, what was the amount of the loan?

(c) If the rate of interest was 6%, interest was compounded annually for full years,

but simple interest was paid for the last half-year, what was the amount of

the loan?

(d) If the rate of interest was 6%, interest was compounded annually for full and

part years, what was the amount of the loan?

Information for Students in MATH 329 2004 01 3002

(e) If the eective annual rate of interest was 6%, but interest was compounded

semiannually, what was the amount of the loan?

(f) If the nominal annual rate of interest was 6%, but interest was compounded

continuously, what was the amount of the loan?

(g) If interest was compounded continuously, and the force of interest was 6%,

what was the amount of the loan?

Solution:

(a) If the amount of the loan is P, then 20000 = (1 + 0.06 4.5)P = 1.27P, so

P =

20000

1.27

= 15, 748.03.

(b) If the amount of the loan is P, then 20000 = (1 +

0.06

2

)

24.5

P,

P = 20000(1.03)

9

= 15, 328.33 .

(c) If the amount of the loan is P, then 20000 = (1 + 0.06)

4

_

1 +

0.06

2

_

P,

P = 20000(1.06)

4

(1.03)

1

= 15, 380.46 . (61)

(d) If the amount of the loan is P, then 20000 = (1+0.06)

4.5

P, P = 20000(1.06)

4.5

=

15, 386.99.

(e) If the semi-annual rate of interest is denoted by i, then (1 + i)

2

= 1.06, so

1 + i = (1.06)

1

2

. If the amount of the loan is P, then 20000 = (1 + i)

9

P =

(1.06)

4.5

P, so P = 20000 (1.06)

4.5

= 15, 386.99.

Note that this is exactly the same principal as in the preceding version of the

problem, since it is precisely the same problem! Note also that the amount

of the principal is slightly more than in the version in part 2c, since simple

interest for a fraction of a year in that case will have a higher yield than

compound interest in this case.

(f) We are told that the nominal rate of interest, compounded instantaneously,

is 6%; thus, if i is the eective annual rate, 0.06 = = ln(1 +i); equivalently,

e

0.06

= 1 + i, so i = 6.18365%. In a full year an amount of 1 will grow by a

factor 1.0618365; in a half year, by a factor

1.0618365. In 4

1

2

years we have

P(1.0618365)

4.5

= 20000, so P = 20000(1.0618365)

4.5

= 20000(0.763379) =

15267.59.

(g) The force of interest is the nominal rate of interest which is convertible contin-

uously [5, p. 17]. We are told that interest was compounded continuously. The

eective annual rate of interest, which we shall denote by i, has the property

Information for Students in MATH 329 2004 01 3003

that 0.06 = ln(1 + i), or that 1 + i = e

0.06

. If the amount of the loan is P,

then 20000 = (1 + i)

4.5

P = e

4.50.06

= e

0.27

P, so P = 20000e

0.27

= 15267.59,

the same result as in the preceding part.

3. (cf. [5, Exercise 1-13, p. 24]) Henry plans to have an investment of 10,000 on

January 1, 2006, at a compound annual rate of discount d = 0.11.

(a) Find the value that he would have to invest on January 1, 2003.

(b) Find the value of i corresponding to d.

(c) Using your answer to part (b), rework part (a) using i instead of d. Do you

get the same answer?

Solution:

(a) The accumulation of 10,000 will have to be discounted by a factor of (10.11)

three times to reduce it by compound discount to January 1, 2003. The

amount to be invested is, accordingly, 10000(1 0.11)

3

= 7049.69.

(b) The relationship between d and i is given, for example, by (1 +i)(1 d) = 1,

which implies that i =

d

1d

. Here

i =

0.11

1 0.11

=

11

89

= 0.1233596.. = 12.36..%.

(c) When i = 12.36%, v =

1

1+i

=

1

1.1236

= 0.89. The value on January 1, 2003 of

the 10,000 expected on January 1, 2006 will then be 10000(0.89)

3

= 7049.69,

as before.

4. (cf. [5, Exercise 1-24, p. 26]) Recall that (cf. [5, (1.21)])

_

1 +

i

(m)

m

_

m

= 1 + i =

1

1 d

=

_

1

d

(m)

m

_

m

. (62)

(a) Determine whether there is an integer n such that

1 +

i

(n)

n

=

1 +

i

(2)

2

1 +

i

(3)

3

(63)

and, if there is such an integer, nd it.

(b) Replace the right member of (63) by a product

_

1 +

i

(2)

2

__

1

d

(3)

3

_

and then interpret this product verbally to show that it must be equal to

1 +

i

(n)

n

if a suitable n exists.

Information for Students in MATH 329 2004 01 3004

Solution:

(a) i

(2)

is the nominal annual interest rate which, when compounded semi-annually,

yields an eective annual rate of i. Thus 1+

i

(2)

2

=

1 + i; similarly, 1+

i

(3)

3

=

3

1 + i. The ratio

1+

i

(2)

2

1+

i

(3)

3

is, therefore, equal to (1 + i)

1

2

1

3

= (1 + i)

1

6

, which is

the accumulation of 1 after a period of

1

6

of a year; this is, by denition, equal

to 1 +

i

(6)

6

.

(b) Under an eective annual interest rate of i, the factor

_

1 +

i

(2)

2

_

is the value

of 1 after

12

2

= 6 months. If this amount is discounted back

12

3

= 4 months,

it decreases by a reduction factor of

_

1

d

(3)

3

_

. The result is equivalent to a

net accumulation period of 6 4 = 2 months, i.e.

1

6

of a year, under which it

would grow by a factor 1 +

i

(6)

6

.

5. (cf. [5, Exercise 1-30, p. 27]) Show that f(t) = (1 + i)

t

(1 + it) is minimized at

t =

lniln

.

Solution:

If only elementary calculus is used, this problem is more dicult than

it looks. Students were accorded a full grade for showing that the point

claimed is, indeed, a local minimum; the proof that it is a global =

absolute minimum, is more dicult; one possible solution is given below.

No attempt has been made to produce a compact solution.

Applying elementary calculus, we nd that

f

= (1 + i)

t

ln(1 + i) i = (1 + i)

t

i

f

= (1 + i)

t

2

To nd the critical points of the function, we solve for t the equation f

(t) = 0.

Taking natural logarithms yields

t ln(1 + i) + ln = ln i

which is satised only for

t

0

=

ln i ln

=

ln

i

. (64)

The second derivative, f

(t

0

) is positive everywhere, since it is the product of an

exponential always positive and the square of a real number; this tells us

that the point t = t

0

(64) is a local minimum.

Information for Students in MATH 329 2004 01 3005

Does this completely solve the problem? Not yet! To solve an extremum problem

we need to interpret local extremum information with reference to the domain of

the function. For example, if the domain is innite, then the function might not

even have a global or absolute minimum, even though it has a local minimum.

18

And, if the domain of the function is a closed interval, we need to investigate the

behavior at the end points of that interval. The function f is meaningful for all real

values of t. One interpretation would be to take the domain to be t 0; another

interpretation would be to take the domain to be t +.

What follows is just one possible way of completing this problem. We observe that

f(0) = f(1) = 0. Could f(t) = 0 for t dierent from 0, 1? Rolles theorem implies

the existence of a point with zero slope between any two zeros of the function; as we

have seen that there is only one such point with zero slope, there cannot exist more

than two zeros of the function: and thus the point t

0

is the only local extremum.

Thus, by the Intermediate Value Theorem, f has the same sign throughout each

of the intervals < t < 0, 0 < t < 1, 1 < t. As t , limf(t) ; hence

f(t) > 0 for all t > 1; as t , limf(t) ; so the function is positive

in the interval < t < 0 also. Thus the global minimum is in the interval

0 t 1; and, from our investigation of the critical point, we know that the

minimum is attained at one (or more) of t = 0, t = 1 or t = t

0

. We can complete

this investigation if we can argue that f(t

0

) < 0. As we know the sign of the

function will be the same throughout the interval 0 < t < 1, we can take any

convenient value of t in that interval.

f

_

1

2

_

=

1 + i

_

1 +

i

2

_

=

_

1 +i (1 +

i

2

)

_

_

1 + i + (1 +

i

2

)

_

1 + i + (1 +

i

2

)

=

(1 + i)

_

1 + i +

i

2

4

_

1 + i +

_

1 +

i

2

_

=

i

2

4

1

1 + i +

_

1 +

i

2

_ < 0

Thus the global minimum is attained at t

0

.

6. (cf. [5, Exercise 1-33, p. 27]) Find the accumulation function a(t) if it is known

that

t

= 0.04(1 + t)

1

for t > 0.

18

Consider, for example, the function t

3

t, which has a local minimum at t = 1, a local maximum at

t = 1, but has neither a global maximum nor a global minimum over its entire domain < t < +.

Information for Students in MATH 329 2004 01 3006

Solution: Applying denition [5, (1.28), p. 19], we solve the dierential equation

d

dt

ln(a(t)) = 0.04(1 + t)

1

:

Integration gives

ln(a(t)) =

_

0.04

1 + t

dt = 0.04 ln(1 + t) + C

where C is the constant of integration. Setting t = 0, where we know, by denition,

that a(0) = 1, we have

0 = ln 1 = 0.04 ln 1 + C

so C = 0, and

a(t) = e

0.04 ln(1+t)

=

_

e

ln(1+t)

_

0.04

= (1 + t)

0.04

.

7. Let () denote the value of 1 at the end of 3 years, accumulated at an eective

rate of interest ; let () denote the present value of 1, to be paid at the end of 3

years at an eective rate of discount numerically equal to . Suppose it is known

that () + () = 2.0294. Determine .

Solution: (cf. [2, Exercise 52, p. 30]) () = (1 + )

3

; () = (1 )

3

. Summing

yields () +() = 2 +6

2

, which we equate to 2.0294, and from which we infer

that =

_

0.0294

6

= .07 = 7%.

8. Showing your work, determine a formula in terms of the force of interest, , for

the number of years that are needed for a sum of money to double itself. Verify

your answer by determining the value of when the annual interest rate is 100%.

Solution: Let the number of years needed be t, the interest rate be i, and the force

of interest . We solve the equation (1+i)

t

= 2 by taking logarithms of both sides:

t ln(1 + i) = ln 2, so

t =

ln 2

ln(1 + i)

=

ln 2

.

When the interest rate is 100% money doubles in one year; here = ln 2.

Information for Students in MATH 329 2004 01 3007

B.1.2 Second 2002/2003 Problem Assignment, with Solutions

1. (cf. Exercise 2-5, p. 36) A vendor has three oers for a house:

(a) three equal payments one now, one 1 year from now, and the other 2 years

from now;

(b) a single cash payment now of 120,000;

(c) two payments, 45,000 a year from now, and 90,000 two years from now.

He makes the remark that one oer is just as good as another. Determine the

interest rate and the sizes of the equal payments that will make this statement

correct.

Solution: Let the interest rate be i, and the equal payments be k. Equating the

present value of the payments of 45,000 and 90,000 to 120,000 yields

45000v + 90000v

2

= 120000

which we solve for v, obtaining

v =

1

2

_

1

4

+

16

3

2

=

1

22.33333

4

The lower sign yields a negative value of v, and so that solution is extraneous. We

obtain v = 0.931454, so i = 0.0736 = 7.36%.

The present value of the equal payments is then k(1+v+v

2

) = 2.79906k = 120, 000,

so the equal payments will each be 42,871.53.

2. (cf. [5, Exercise 2-9, p. 37]) Fund A accumulates at 9% eective, and Fund B at

8% eective. At the end of 12 years the total of the two funds is 50,000. At the

end of 6 years the amount in Fund B is 4 times that in Fund A. How much is in

Fund A after 15 years?

Solution: Let a and b denote the initial amounts in funds A and B. We have two

constraints relating a and b:

a(1.09)

12

+ b(1.08)

12

= 50000

b(1.08)

6

= 4a(1.09)

6

Information for Students in MATH 329 2004 01 3008

From the second of these we can determine the relative sizes of a and b; substituting

in the rst equation and solving gives

a =

50000

(1.09)

12

+ 4

_

1.09

1.08

_

6

(1.08)

12

=

50000

(1.09)

6

((1.09)

6

+ 4(1.08)

6

)

= 3, 715.25.

Hence b = 4

_

109

108

_

6

a = 15, 705.96. The value of Fund A after 15 years is, therefore,

3, 715.25(1.09)

15

= 13, 532.73.

3. The initial balance in an investment fund was 100,000. At the end of 3 months it

had increased to 105,000; at that time 25,000 was added to the fund. Six months

later the fund had increased to 143,000, and this time 30,000 was removed. Finally,

at the end of a year, the fund had a balance of 120,000. What was the time-weighted

rate of return?

Solution: [4, Example 2.3.2, p. 39] The balances and withdrawals are respectively

B

0

= 100, 000, B

1

= 105, 000, B

2

= 143, 000, B

3

= 120, 000; W

0

= 0, W

1

= 25, 000,

W

2

= 30, 000. Hence the rates of interest in the successive time periods are given

by

1 + i

1

=

B

1

B

0

+ W

0

=

105, 000

100, 000 + 0

= 1.05

1 + i

2

=

B

2

B

1

+ W

1

=

143, 000

105, 000 + 25, 000

= 1.10

1 + i

3

=

B

3

B

2

+ W

2

=

120, 000

143, 000 30, 000

= 1.062

The time-weighted rate of return i is, by denition, given by the product

1 +i = (1.05)(1.10)(1.062) = 1.227

so i = 22.7%.

4. (cf. [5, Exercise 2-15, p. 38]) A trust company pays 5% eective on deposits at the

end of each year. At the end of every 3 years a 2% bonus is paid on the balance at

the time. Find the eective rate of interest earned by an investor if she leaves her

money on deposit

(a) for 2 years;

(b) for 3 years (until after the bonus payment is made);

Information for Students in MATH 329 2004 01 3009

(c) for 4 years;

(d) forever take a limit!

Solution:

(a) Since there are no bonus payments, the eective rate of interest is 5%.

(b) A deposit of 1 grows to 1.05 at the end of the rst year, (1.05)

2

at the end

of the second year, and, after the bonus, (1.05)

3

(1.02) at the end of the 3rd

year. If the eective rate of interest is i, then we must solve the equation

(1 + i)

3

= (1.05)

3

(1.02) .

Taking logarithms, we obtain 3 ln(1 + i) = 3 ln(1.05) + ln(1.02), so

ln(1 + i) =

1

3

(3 ln(1.05) + ln(1.02))

1 + i = e

1

3

(3 ln(1.05)+ln(1.02))

i = e

1

3

(3 ln(1.05)+ln(1.02))

1

= 1.05

3

(c) Analogously to the preceding,

i = e

1

4

(4 ln(1.05)+ln(1.02))

1

= 1.05

4

(d) The eects of the bonuses depend on whether the remainder of the number of

years is, upon division by 3, 0, 1, or 2. We have, for any non-negative integer

n,

(1 + i)

3n

= (1.05)

3n

(1.02)

n

(1 + i)

3n+1

= (1.05)

3n+1

(1.02)

n

(1 + i)

3n+2

= (1.05)

3n+2

(1.02)

n

By taking logarithms and dividing, or, equivalently, by taking the appropriate

(positive) root of both sides of the equation, we obtain

1 +i = (1.05)(1.02)

1/3

1 +i = (1.05)(1.02)

n

3n+1

1 +i = (1.05)(1.02)

n

3n+2

As n , the exponent of 1.02 approaches

1

3

, and so the interest rate

approaches the value of 5.70% we obtained in case of 3 years.

Information for Students in MATH 329 2004 01 3010

5. Alice borrows 5000 from The Friendly Finance Company, at an annual rate of

interest of 18% per year, where the company compounds interest annually, but

charges simple interest for fractions of a year.

(a) She plans to pay the company 5000 at the end of 2 years.

i. How much will she continue to owe the company at that time?

ii. What is the present value of that residual amount, assuming the same

18% interest rate?

(b) Alice discovers that she doesnt need the loan, so she oers to lend the money

to her brother, at an eective annual rate of 18%. When her brother pays o

his loan, Alice will pay o hers. How much will Alice still owe Friendly if

i. Her brother pays o his loan exactly 3 years from now?

ii. Her brother pays o his loan 3.5 years from now?

Solution:

(a) i. The residual amount immediately after the payment will be

5000

_

(1.18)

2

1

_

= 1962 .

ii. The present value of the residual amount is 5000 ((1.18)

2

1) (1.18)

2

=

5000 (1 (1.18)

2

) = 1409.08.

(b) i. If her brother pays o his loan after an integer number of years, and Alice

immediately repays her loan, she will owe nothing to Friendly.

ii. After 3.5 years Alice will receive 5000(1.18)

3.5

, but will be owing

5000(1.18)

3

(1.09); after making her payment, she will continue to owe

5000(1.18)

3.5

+5000(1.18)

3

(1.09) = 5000(1.18)

3

(1.09

1.18) = 30.58 .

6. (cf. [5, Exercise 2-12, p. 37])

(a) Find an equation that gives information about the eective rate of interest i

if payments of 200 at the present, 300 at the end of 1 year, and 400 at the

end of 3 years, are to accumulate to 1000 at the end of 4 years.

(b) Use the Intermediate Value Theorem to argue that there exists a positive rate

of interest less than 100% which can solve this problem. Then use the Mean

Value Theorem to show that there is just one solution to the problem (by

showing that a certain derivative is positive).

Information for Students in MATH 329 2004 01 3011

(c) While there exist more ecient algorithms for solving problems like this, a

naive solution could be found by successively subdividing an interval at whose

ends a certain function would have values with opposite signs. Apply this idea

to nd the interest rate i to within an error of 0.1%.

Solution:

(a) The equation of value at the end of 4 years

19

is

200(1 + i)

4

+ 300(1 + i)

3

+ 400(1 + i) = 1000

Dene f(x) = 200x

4

+300x

3

+400x1000. Then f(1) = 100 < 0 < 5400 =

3200 + 2400 + 800 1000 = f(2). By the Intermediate Value Theorem func-

tion f, which, being a polynomial, is continuous, has a zero somewhere in

1 < x < 2. If there were 2 or more zeroes, then, by Rolles Theorem, (since f,

being a polynomial, is dierentiable), there would be a point between them

where f

would be 0. But f

(x) = 800x

3

+900x

2

+400 > 0 for 1 < x < 2. From

this contradiction we know that there is at most one zero for f, hence exactly

one solution i for our eective interest rate. We can apply the Intermediate

Value Theorem between any two points in the domain. The most naive solu-

tion would be to repeatedly halve the interval. We nd that f(1.5) = 1625, so

we may conne ourselves to the interval 1 < x < 1.5; then f(1.25) = 574.22,

f(1.125) = 197.51, f(1.0625) = 39.72, f(1.03125) = 32.29. We evalu-

ate f at the midpoint of the interval [1.03125, 1.0625]: f(1.046875) = 3.17,

so we next use the interval [1.046875, 1.0625], whose midpoint is 1.0546875,

where f(1.0546875) = 21.30. As there will is a sign change in the interval

[1.03125, 1.0546875], we next evaluate f at its mid-point: f(1.042968750) =

5.80.

In the course of these calculations we have not bothered to round the decimal

expansions of the midpoints. There is nothing to be gained by this persistence,

as the procedure will work even if we do not take the precise midpoints.

Having now conned the root to the interval [1.043, 1.055]. f(1.049) = 8.07,

we try f

_

1.043+1.049

2

_

= f(1.046) = 1.15, f

_

1.043+1.046

2

_

= f(1.0445) = 2.29,

f(1.045) = 1.15, f(1.0455) = 0.002, f(1.04549913) = 0.0000013. Thus

the rate is approximately 4.55%.

19

Non-trivial equations are never unique; also, we could have found an equation of value at another

time. For example, an equation of value at the present could be

200 + 300v + 400v

3

= 1000v

4

.

Information for Students in MATH 329 2004 01 3012

B.1.3 Third 2002/2003 Problem Assignment, with Solutions

1. (a) Find the sum of the positive integers 1, 2, . . . , N.

(b) Find the sum of the odd integers 1, 3, 5, . . . , 2N + 1.

(c) In an arithmetic progression x

1

, x

2

, . . ., x

n

, . . . the third term is 4 times the

rst term, and the sixth term is 17. Find the general term x

n

.

(d) The sum of n terms of the arithmetic series 2, 5, 8, . . . is 950. Find n.

(e) The sum of the rst 6 terms of a geometric progression is equal to 9 times the

sum of the rst 3 terms. Find the common ratio. Is it possible to determine

the sequence from this information?

(f) Use your knowledge of the sum of geometric series to determine a vulgar

fraction of integers

m

n

which is equal to the repeating decimal number

3.157157157157...

Do not use a calculator for this problem.

Solution: These topics were once part of the standard high school curriculum.

These problems were adapted from [7].

(a) The common dierence is 1 and the rst term is also 1; the sum of N terms

is, therefore,

N

2

(1 + N) =

N(N+1)

2

.

20

(b) The common dierence is 2, the rst term is 1, and the N+1st term is 2N+1.

The sum of N + 1 terms is

N+1

2

(2 1 + N 2) = (N + 1)

2

.

[Many students failed to notice that the number of summands was N + 1

not N. An error of this type might have been detected by checking ones

computations for small values of N, e.g. N = 0 or N = 1. Carry out the

summation mechanically, then compare the sum that you obtain with the

value of the formula you have derived; if the values are dierent, you need to

check every step of your work carefully.]

(c) Let the rst term be a and the common dierence be d. We have to solve the

equations:

x

3

= 4x

1

a + 2d = 4a

x

6

= 17 a + 5d = 17

which yield a = 2, d = 3. Hence x

n

= 2 + 3(n 1) = 3n 1.

20

This expression is known, from other considerations, to be the number of ways of choosing 2 objects

from a set of N distinct objects; it is often denoted by

_

N

2

_

.

Information for Students in MATH 329 2004 01 3013

(d) We solve the equation

n

2

(2 2 + (n 1) 3) = 950, which reduces to 3n

2

+n

1900 = 0, whose only positive solution is n = 25.

(e) If the rst term is a and the common ratio is r, the given information implies

that

a

r

6

1

r 1

= 9a

r

3

1

r 1

if r ,= 1 , (65)

6a = 9a if r = 1 . (66)

When a = 0, both equations are satised: the sequence is 0, 0, 0, . . . ; the

common ratio is indeterminate. When r ,= 1, (65) yields r

6

1 = 9(r

3

1),

so r

3

= 1 (which contradicts the hypothesis) or r

3

= 8, hence r = 2 and the

sequence is then

a, 2a, 4a, ..., 2

n1

a, ...

But the sequence is not completely determined, since any value of a is ac-

ceptable including the value 0 which we already saw as the solution to

(66).

(f)

3.157157157157... = 3 +

_

1

10

+

5

100

+

7

1000

_

+

1

1000

_

1

10

+

5

100

+

7

1000

_

+

1

1000

2

_

1

10

+

5

100

+

7

1000

_

+ . . .

= 3 +

157

1000

+

1

1000

157

1000

+

1

1000

2

157

1000

+. . .

= 3 +

157

1000

1

1

1

1000

= 3 +

157

999

=

3154

999

.

2. (cf. [5, Exercise 3-6, p. 66] An annuity pays 1000 per year for 8 years. If i = 0.05,

nd each of the following

(a) The value of the annuity one year before the rst payment.

(b) The value of the annuity one year after the last payment.

(c) The value of the annuity at the time of the 4th payment.

(d) If possible, the number of years an annuity-immediate would have to run in

order that its value, viewed one year before the rst payment should be twice

that of the 8-payment annuity whose value at the same time was determined

above.

Information for Students in MATH 329 2004 01 3014

(e) If possible, the number of years an annuity-immediate would have to run

in order that its value, viewed one year before the rst payment, should be

three times that of the 8-payment annuity whose value at the same time was

determined above.

(f) If possible, the number of years an annuity-immediate would have to run

in order that its value, viewed one year before the rst payment, should be

four times that of the 8-payment annuity whose value at the same time was

determined above.

21

(g) (cf. [5, Exercise 3-58, p. 73]) Redo part (a), assuming now that the annuity

is continuous. (The eective annual interest rate remains 5%, and the time is

still 8 years.)

Solution:

(a) 1000a

8 5%

= 1000

1(1.05)

8

0.05

= 20000 (1 (1.05)

8

) = 6463.21.

(b) 1000 s

8 5%

= 1000

(

1.05

8

1

)

(1.05)

0.05

= 10026.56.

(c)

1000s

4 5%

+ 1000a

4 5%

= 1000(1.05)

4

a

45%

= (1.05)

4

(6463.21) = 7856.07 .

(d) We have to solve for n:

a

n 5%

= 2a

8 5%

1 v

n

= 2 2v

8

v

n

= 2v

8

1

n =

ln(2v

8

1)

ln v

= 21.30 years.

(e) We have to solve for n:

a

n 5%

= 3a

8 5%

1 v

n

= 3 3v

8

v

n

= 3v

8

2

n =

ln(3v

8

2)

ln v

= 71.52 years.

21

Note that the wording of the cited questions in the textbook required a number of assumptions that

have been made more explicit in the present questions.

Information for Students in MATH 329 2004 01 3015

(f) In this case we observe that the value of a perpetuity of 1000 per year at

5% is only

1000

0.05

= 20000 < 4(6463.21); so the problem will have no solution.

If we attempt to solve as in the preceding case, we will obtain the equation

1 v

n

= 4 4v

8

v

n

= 4v

8

3 = 0.29, which has no solution.

(g)

1000a

8 5%

= 1000

8

_

0

v

t

dt

= 1000

1 (1.05)

8

ln(1.05)

= 6623.48.

3. [5, Exercise 3.15] Prove each of the following identities

algebraically; and

verbally

(a) a

n

= a

n

+ 1 v

n

(b) s

n

= s

n

1 + (1 + i)

n

Solution:

(a) a

n

diers from a

n

in that it has an immediate payment of 1 but lacks the nal

payment of 1 n years hence, whose value now is v

n

.

Algebraically,

a

n

= a

n

(1 + i)

= a

n

+ ia

n

= a

n

+ i

1 v

n

i

= a

n

+ (1 v

n

)

(b) s

n

diers from s

n

in that is lacks a payment of 1 at time t = 0, but has a

payment of 1 that has accumulated interest over n years, so that its present

value is (1 + i)

n

.

Algebraically,

s

n

= s

n

(1 +i)

= s

n

+ is

n

= s

n

+ i

(1 + i)

n

1

i

= s

n

+ ((1 + i)

n

1)

Information for Students in MATH 329 2004 01 3016

4. [5, Exercise 3-45, p. 71] Wilbur leaves an inheritance to four charities: A, B, C,

D. The total inheritance is a series of level payments at the end of each year,

payable forever. During the rst 20 years, A, B, C share each payment equally. All

payments after 20 years are to revert to charity D. The present value of the shares

of A, B, C, and D are all equal. Showing all your work, prove that i = 0.07177.

Solution: It does not limit generality to assume that the level payments are all of

1. The present value of the payments to each of A, B, C is

1

3

a

20 i%

. The payments

to D constitute a perpetuity-immediate of 1 deferred 20 years; its value is v

20

1

i

.

Accordingly we have to solve the following equation for i:

1

3

a

20 i%

= v

20

1

i

1 v

20

3

= v

20

v

20

=

1

4

1 + i = 4

1

20

= 1.0717735

so i = 7.177%.

5. Find the present value at i eective of a perpetuity whose annual payments of 1000

begin with a payment of 1000 after one year, with the property that each payment

thereafter is reduced by 10% from the preceding payment. In particular, determine

the present value when i = 2.5%.

Solution: [STUDENTS WERE ASKED NOT TO SUBMIT A SOLUTION TO

THIS PROBLEM.] The present value is

1000(v + 0.9v

2

+ 0.9

2

v

3

+ 0.9

3

v

4

+ ... + 0.9

n1

v

n

+...)

= 1000v

n=0

_

0.9

1 + i

_

n

=

1000v

1 0.9v

=

1000

(1 + i) 0.9

=

1000

0.1 + i

When i = 2.5%, the present value is

1000

0.125

= 8000.

6. A fund of 10,000 is to be accumulated by means of deposits of 1000 made at the

end of every year, as long as necessary. If the fund earns an eective rate of interest

of 2

1

2

%, nd how many regular deposits will be necessary, and the size of a nal

deposit to be made one year after the last regular deposit.

Information for Students in MATH 329 2004 01 3017

Solution: [2, Example 6.5, pp. 59-60] There are often tacit assumptions in inter-

est problems; usually there is an obvious intended interpretation, while other

interpretations might be justied by some unusual reading of the wording. In the

present problem one is to assume that the deposits are not permitted to exceed

1000, and that all deposits (the regular deposits) but the last are to be exactly

1000. The last deposit can be smaller, but not larger.

Let n be the number of regular deposits required. Then n is the largest integer

that satises the inequality of value

1000s

n 2.5%

10000 ;

equivalently, s

n 2.5%

10 . Computing the values of s

n 2.5%

, we nd that s

8 2.5%

=

8.73612, s

9 2.5%

= 9.95452, s

10 2.5%

= 11.20338. Hence n = 9. The nal partial de-

posit will have to be the excess of 10,000 over the accumulated value of s

9 2.5%

after

one year, i.e., the excess of 10,000 over (1.025)s

9 2.5%

= 10, 000(1.025)(9954.52) =

203.38. So rather than a nal deposit, there will be a nal refund of 203.38. This

situation could also have been seen from the value of 10,000s

10 2.5%

= 11203.38,

which would be the value after a 10th deposit; since this exceeds 11,000, no 10th

deposit would be required.

[ADDED March 10th, 2003] Another possible interpretation of the instructions in

this problem is to treat the 8th as the last regular deposit, and to reduce the 9th

deposit so that, when the time arrives for a possible 10th deposit, the balance in

the fund is exactly 10000. If we dene the value of the 9th deposit to be x, then

(1 +i)

_

(1 +i)s

8

+x

_

= 1000

x =

10000

1.025

1025s

8

= 9756.0976 8954.5188 = 801.58.

We can verify the correctness of this computation by observing that the excess

payment of 1000801.58 = 198.42 accumulated at 2.5% to 1.025198.42 = 203.38,

which was computed earlier as the amount refunded one later.

[This assignment was intended as a learning exercise, rather than a testing exercise.

Students were not expected to have seen an example of this type before.]

7. A deferred annuity is one that begins its payments later than might otherwise have

been expected. We dene

m

[a

n

= v

m

a

n

(67)

m

[ a

n

= v

m

a

n

(68)

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 3018

Prove, both algebraically and verbally, that, for non-negative integers m and n,

m

[a

n

= a

m+n

a

m

(69)

(1 + i)

m

s

n

= s

m+n

s

m

(70)

1

[ a

n

= a

n

(71)

Solution:

(a)

m

[a

n

= v

m

(v + v

2

+ . . . + v

n

)

= (v

m+1

+ v

m+2

+ . . . + v

m+n

= (v

1

+ v

2

+ . . . + v

m+n

(v

1

+v

2

+ . . . + v

m

= a

m+n

a

m

In deferring an n-payment annuity-immediate by m years we are planning for

the rst payment to be made m+1 years from now, and the last m+n years

from now. These can be viewed as the last n payments of an m+n-payment

annuity-immediate whose rst payment begins one year hence; thus we obtain

the value of

m

[a

n

by subtracting a

m

from a

m+n

.

(b)

(1 + i)

m

s

n

= (1 + i)

m

_

1 + (1 + i)

1

+. . . + (1 + i)

n1

_

= (1 + i)

m

+ (1 + i)

m+1

+ . . . + (1 + i)

m+n1

=

_

1 + (1 + i)

1

+ . . . + (1 + i)

m+n1

_

_

1 + (1 + i)

1

+ . . . + (1 + i)

m1

_

= s

m+n

s

m

The payments associated with (1 + i)

m

s

n

can be interpreted as the rst m

payments of an m + n-payment annuity whose last payment has just been

made. If we subtract from s

m+n

the value of the last n payments as viewed

from the day of the last payment, we obtain the value of those rst m pay-

ments.

(c)

1

[ a

n

= v

_

1 + v + v

2

+ . . . + v

n1

_

= v +v

2

+ . . . + v

n

= a

n

When we defer an annuity-due one year it becomes an annuity-immediate.

Information for Students in MATH 329 2004 01 3019

B.1.4 Fourth 2002/2003 Problem Assignment, with Solutions

1. (cf. [5, Exercise 3-60, p. 73]) A student attending engineering school has increasing

amounts of income as she advances through her programme. Accordingly she agrees

to borrow a decreasing annual amount from her parents during her 5 training years,

and to repay the loan with increasing amounts for 15 years after graduation. She

receives amounts 5X, 4X, 3X, 2X and X at the beginning of each of 5 years,

where the last payment is paid at the beginning of her nal year. At the end of

her rst year after graduation she pays 500, and then increases the amount by 200

each year until a nal payment of 3300.

22

If the interest rate is 5%, determine X.

Solution: An equation of value at the time of graduation is

(1 + i)X(Ds)

5

= 300a

15

+ 200(Ia)

15

implying that

X =

300a

15

+ 200(Ia)

15

(1 + i)(Ds)

5

=

300(1 v

15

) + 200((1 + i)a

15

15v

15

)

5(1 + i)

6

(1 +i)

6

a

5

= 993.11.

For students who corrected the error in the problem by increasing the number of

years by 1, here is a solution:

Solution: An equation of value at the time of graduation is

(1 + i)X(Ds)

5

= 300a

16

+ 200(Ia)

16

implying that

X =

300a

16

+ 200(Ia)

16

(1 + i)(Ds)

5

=

300(1 v

16

) + 200((1 + i)a

16

16v

16

)

5(1 + i)

6

(1 +i)

6

a

5

= 1082.33.

2. (cf. [5, Exercise 4-2, p. 85]) A loan is being repaid by 36 monthly payments. The

rst 12 installments are 250 each; the next 18 are 300 each; and the last 6 are 500

each. Assuming a nominal annual interest rate of 12% compounded monthly,

22

The original version of this problem gave the nal payment as 3500, which would have required 16

years of payments. A correction was announced at the lecture of March 3rd, 2003.

Information for Students in MATH 329 2004 01 3020

(a) Find the principal, A(0), of the loan.

(b) Using the Prospective Method, nd the loan balance immediately after the

6th payment.

(c) Using the Retrospective Method, nd the loan balance immediately after the

6th payment.

(d) Divide the 7th and 8th payments into principal and interest.

Solution:

(a) Using the Prospective Method, the principal is seen to be

A(0) = 250a

12

+ 300v

12

a

18

+ 500v

30

a

6

= 9, 329.46

(b) Immediately after the 6th payment, the value of the remaining 30 payments

(at an interest rate of 1% per period) is

250a

6

+ 300v

6

a

18

+ 500v

24

a

6

= 250

1 v

6

i

+ 300v

6

1 v

18

i

+ 500v

24

1 v

6

i

=

1

i

_

(250 + 500v

24

)(1 v

6

) + 300v

6

(1 v

18

)

_

=

1

i

_

250 + 50v

6

+ 200v

24

500v

30

_

= 8365.40

(c) The principal of the loan has been determined above. The outstanding prin-

cipal is the accumulated value of this principal decreased by the accumulated

values of the payments that have been made, i.e.

(1.01)

6

A(0) 250s

6

= (1.01

6

)(9, 329.46) 250

(1.01)

6

1

0.01

= 9, 805.38 1, 538.00 = 8, 365.40.

(d) The principal owing immediately after the 6th payment is known to be 8,365.40.

At the time of the 7th payment, this will have accumulated interest of 1%, or

83.65; the balance of the payment, i.e. 250 83.65 = 166.35, will be applied

to reduction of principal. The reduced balance of 8365.40 166.35 = 8199.05

will accumulate interest in the amount of 0.01 8199.05 = 81.99 in the 8th

month. The 8th payment will include, in addition to this amount of interest,

an amount of 250 81.99 = 168.01 for the reduction of principle; the out-

standing principal after the 8th payment will be 8199.05 168.01 = 8031.04.

Information for Students in MATH 329 2004 01 3021

3. (a) [5, Exercise 4-16, p. 87] Harriet is repaying a car loan with payments of 2,000

every three months and a nal payment 3 months after the last full payment

of 2,000. If the amount of interest in the 4th installment (paid at the end of

the rst year) is 1,100, nd the principal of the loan, the time and amount

of the nal payment, and the amounts of principal and interest in that nal

payment. Assume that interest is compounded monthly, at a nominal annual

rate of 18%.

(b) Construct an amortization schedule for the rst year of this loan.

Solution:

(a) The interest rate being charged monthly is 0.18/12 = 1.5%. Let the principal

of the loan be A. The Retrospective Method shows that the amount owing

immediately after the 3rd installment (paid at 9 months) is

2000

_

(1.015)

6

+ (1.015)

3

+ (1.015)

0

_

+ (1.015)

9

A.

This unpaid balance will, in 3 months, earn the lender interest in the amount

of

1100 =

_

(1.015)

3

1

_ _

2000

_

(1.015)

6

+ (1.015)

3

+ (1.015)

0

_

+ (1.015)

9

A

_

.

Thus

A =

1100

(1.015)

12

(1.015)

9

+2000

_

(1.015)

9

+ (1.015)

6

+ (1.015)

3

_

(72)

= 26552.32

We can consider the payments as constituting an annuity, with time interval 3

months, and interest rate per 3 months of (1.015)

3

1 = 0.045678375. Using

the Prospective Method, we see that the value of n installments, as of the day

of the loan, is

2000a

n0.045678375

= 2000

1 (1.015)

3n

0.045678375

.

We seek the smallest n such that

1 (1.015)

3n

26552.32 0.045678375

2000

= 0.6064334

i.e., such that

1.015

3n

0.3935666

Information for Students in MATH 329 2004 01 3022

or

n

ln 0.3935666

3 ln 1.015

= 20.88

Thus there will be 20 full payments of 2,000, the last full payment being made

5 years after the beginning of the loan. At that time the amount outstanding

will be

26552.32(1.015)

60

2000s

200.045678375

= 64873.15 2000

(1.015

3

)

20

1

(1.015)

3

1

= 64873.15 63190.50 = 1682.65

The last payment will be 1682.65(1.015)

3

= 1759.51; of this, the interest

component will be 1682.65 ((1.015)

3

1) = 76.86, and the balance will be the

outstanding principal of 1682.65.

(b)

Duration Payment Interest Principal Repaid Outstanding Principal

(Months)

0 26552.32

3 2000.00 1212.87 787.13 25765.19

6 2000.00 1176.91 823.09 24942.10

9 2000.00 1139.31 860.69 24081.41

12 2000.00 1100.00 900.00 23181.41

4. John has borrowed 10000, on which he is paying interest at 10% eective per

year. He is required to pay the interest on the loan annually, and is permitted to

repay only the entire loan, and only on an anniversary. He decides to accumulate

a sinking fund to accumulate the funds to repay the loan. Suppose that John

has 2400 available at the end of each year, out of which to pay both the interest

on the loan and an annual contribution to his sinking fund. If the sinking fund

accumulates at 6%, complete a table under the following headings to determine

when John will be able to repay the loan.

Duration Contribution Interest Interest Earned Balance of

(Years) to Sinking Fund on Loan in Sinking Fund Sinking Fund

0 0 0 0 0

. . . . . . . . . . . . . . .

Solution: The instructions asked that the student complete a table...to determine

when John will be able to repay the loan. The information could have been

Information for Students in MATH 329 2004 01 3023

obtained without the table, however, by nding the smallest value of n for which

1400s

n

10000; this can be seen to be n = 6, where

10000 1400s

n

= 234.55 . (73)

From (73) we see that the shortfall in the balance of the sinking fund after the last

payment of 1400 is 234.55. The value of the sinking fund is not yet sucient to

repay the loan. Even without a 7th payment the sinking fund will exceed 10000

by the time when that payment is due. It will, however, be necessary to pay the

interest charge of 1000 on the loan. If a full 6th payment of 1400 was made into the

sinking fund, there would be a refund of (1.06)(1400)s

6

1000 = 351.38. However,

a better solution would have been for John to make a smaller 6th deposit into the

sinking fund just sucient to bring the fund up to the level of 10000 at the time

of the 7th interest payment. The balance just after such a 6th payment would need

to be

10000

1.06

, and the balance just prior to the 6th deposit would be (1.06)1400s

5

;

so the appropriate 6th deposit would be

10000

1.06

(1.06)1400s

5

= 9433.963 8365.446 = 1068.52 .

The rst table below shows what would happen if John made a full 6th contribution:

Duration Contribution Interest Interest Earned Balance of

(Years) to Sinking Fund on Loan in Sinking Fund Sinking Fund

0 0.00 0. 0.00 0.00

1 1400.00 1000. 0.00 1400.00

2 1400.00 1000. 84.00 2884.00

3 1400.00 1000. 173.04 4457.04

4 1400.00 1000. 267.42 6124.46

5 1400.00 1000. 367.47 7891.93

6 1400.00 1000. 473.52 9765.45

7 -351.38 1000. 585.93 10351.38

The following table shows the result of a reduced 6th contribution:

Information for Students in MATH 329 2004 01 3024

Duration Contribution Interest Interest Earned Balance of

(Years) to Sinking Fund on Loan in Sinking Fund Sinking Fund

0 0.00 0. 0.00 0.00

1 1400.00 1000. 0.00 1400.00

2 1400.00 1000. 84.00 2884.00

3 1400.00 1000. 173.04 4457.04

4 1400.00 1000. 267.42 6124.46

5 1400.00 1000. 367.47 7891.93

6 1068.51 1000. 473.52 9433.96

7 0.00 1000. 566.04 10000.00

NOTE TO THE GRADER: PLEASE ACCEPT EITHER OF THESE TABLES.

5. (This is a complicated variant of [5, Exercise 4-6, p. 86]. It requires considerable

persistence, but is a very thorough exercise. Dont panic! This is not a typical

examination question.) Gareld is repaying a debt with 25 annual payments of

1000 each, at an annual interest rate of i = 10%. The terms of his loan permit

him to make additional payments on the date of any regular payment. After any

such additional payment, the terms of the loan require the borrower to continue

with payments of 1000 until a last payment of 1000 or less which settles the debt

completely.

(a) At the end of the 7th year Gareld proposes to make, in addition to his

regular annual payment of 1000, an extra payment of 5000. At that time

he also proposes to reduce his remaining payment period by 4 years, and to

make level payments over that time (replacing the originally agreed payments

of 1000). Find the revised annual level payment, computed using the interest

rate i = 10%.

(b) The lender is obliged to accept Garelds extra payment. But he is not obliged

to accept Garelds proposed method to repay the loan in fewer payments.

If, at the time of the change in the payment scheme, the lender insists on

charging an interest rate of i = 12% when the remainder of the loan will be

repaid over 14 equal annual payments, what will be the revised annual level

payment that will have to be paid at the end of the each of the next 14 years?

(c) Determine the premium Gareld is being asked to pay as a result of the

increased interest rate in part 5b. Express the amount as of the date of the

proposed change in the payment scheme. Make two sets of calculations:

i. when the cost of money

23

is 10% per annum;

23

By the statement The cost of money is i we intend that Gareld is able as of this particular date

Information for Students in MATH 329 2004 01 3025

ii. when the cost of money is 12% per annum.

(d) As the loan is repaid, the lender is able to put his money to work. Suppose

that money now costs 12%, instead of the 10% that prevailed when the loan

was written. One might have expected the lender to encourage the borrower to

repay the loan faster. Faced with the lenders intransigence, Gareld makes

the supplementary payment of 5000, but decides to abandon his plans to

change the payment size; his payments will be 1000 per year until possibly

the last payment. Determine whether the lender has suered from his own

stubbornness: express his loss (or gain) as of the time of the supplementary

payment made with the 7th payment.

(e) Suppose that, learning that the cost of money is 12% when he is about to

make his supplementary payment, Gareld changes his plans. He makes no

change to his loan, but invests his 5000 elsewhere in an annuity which will

provide him with payments of 1000 to apply to as many of the nal payments

under his loan as possible. As of the beginning of the 8th year of the loan

(immediately following the 7th payment and any supplementary payment)

compare the cost of this scheme with

i. his commitment under the original loan contract;

ii. his proposed scheme, whereby he would pay 5000 immediately and pay

the rest of the loan over 14 years at 10%;

iii. the lenders proposal, where an immediate payment of 5000 would be

followed by equal payments for 14 years, computed at a rate of 12%.

(f) Determine the yield earned by the lender under each of the following repay-

ment schemes:

i. the loan as originally written 25 annual payments of 1000;

ii. the repayment scheme proposed by Gareld: 1000 per year for 7 years,

5000 additional at the end of the 7th year; level payments for 14 years

thereafter, amount as computed in part 5a above;

iii. the repayment scheme proposed by the lender, in part 5b, where the

level payments are recomputed at 12% charged from the time of the 7th

payment; (in this case it suces to write down an equation that must be

satised by the yield);

iv. the repayment scheme nally followed by Gareld in part 5d, where he

invests in an annuity to provide him with payments of 1000 for the nal

payments, and pays the rest annually from his savings.

to either borrow or lend money in any amount and for any period of time commencing immediately

at the interest rate i.

Information for Students in MATH 329 2004 01 3026

Solution:

(a) Using the Prospective Method, we nd that the unpaid balance immediately

after the 7th payment, but prior to the extra payment, is 1000a

180.1

; after the

extra payment the amount owed is

1000a

180.1

5000 = 8201.41 5000 = 3, 201.41 .

The level payment to repay this principal in 184 = 14 years is (with i = 10%

and v =

1

1.1

)

1000a

180.1

5000

a

140.1

=

1000(1 v

18

) 5000i

1 v

14

(74)

= 434.58.

(b) We will have to evaluate the same ratio as in (74), but where numerator and

denominator involve dierent interest rates.

1000a

180.1

5000

a

140.12

=

1000(1 (1.1)

18

) 5000(0.1)

1 (1.12)

14

0.12

0.1

= 483.

(c) Lets rst determine the nature of Garelds commitment under the loan after

he makes his supplementary payment. We have determined that the loan

balance is 3,201.41. We note that 1, 000a

4.10

= 3, 169.87, while 1, 000a

5.10

=

3, 790.79. Garelds loan contract requires him to make 4 payments of 1000;

and, at the end of the 5th year, to pay the balance of principal that would be

owing at that time. That balance would be

(1.1)

5

(3201.41) 1000

_

s

5.1

1

_

= 5155.90 5105.10 = 50.80 .

These 5 payments are prescribed under his contract, and the calculation of

their values is not aected by the cost of money today. What is aected is the

way in which Gareld nances these payments; or, equivalently, the present

value of these payments, which may not be equal to the loan balance.

i. If the cost of money is 10%, the present value of the 14 payments Gareld

would have to make would be 483a

14.1

= 3558.11; the present value of the

payments required under the loan contract is the outstanding principal,

3201.41; so the premium would be 356.70.

Information for Students in MATH 329 2004 01 3027

ii. If the cost of money is 12%, the present value of the 14 payments would

be the outstanding principal, 3,201.41. The value of the 4 payments of

1000 and one nal payment (i.e. the cost of nancing them at 12%) is

1000a

4.12

+ (1.12)

5

50.80 = 3037.35 + 28.83 = 3066.18 .

In this case he would be paying a premium of

3201.41 3066.18 = 135.23 .

(d) After his supplementary payment, Gareld owes an unpaid balance of 3201.41.

Had he been permitted to repay this with 14 annual payments of 434.58, the

present value of those payments would be 2880.47. But Gareld has now been

driven to repay the loan by continuing the planned payments of 1000 until a

nal payment. In part 5c we have determined that the number of payments

of 1000 is 4, and these are followed by a payment one year later of 50.80. The

value of these payments today, when money costs 12%, is

1000a

40.12

+ (1.12)

5

50.80 = 3037.35 + 28.83

= 3066.18 .

While neither of these repayment schemes yields the full amount owed

because interest rates are higher than at the outset the lender was wise

to be unwilling to accept Garelds oer: he has reduced his losses under the

loan by 3066.18 2880.47 = 185.71.

(e) i. Garelds commitment under the original contract is for payments of 1000

for 18 more years. At a rate of 12%, Gareld could buy an annuity to cover

his payments at a present cost of 1000a

18.12

= 7249.67. We are asked to

compare this cost with the use of the 5000 to purchase a deferred annuity

to cover the last payments due under the contract. We will answer this

question naively and then, when the answer looks interesting, observe

that there is a much simpler solution.

The present value of an annuity that will cover the payments due in years

##k + 1, k + 2, ..., 18 is

1000

_

a

18.12

a

k.12

_

.

Since

1000a

18.12

= 7249.67 5000 = 2249.67

1000a

3.12

= 2401.83

1000a

2.12

= 1690.05 ,

Information for Students in MATH 329 2004 01 3028

Garelds 5000 will buy him a deferred annuity paying 1000 per year,

starting at the end of 4 years from now until 18 years from now, costing

him 1000s

18.12

1000s

3.12

= 7249.672401.83 = 4847.84 and he will have

152.16 left over. The cost of the payments not covered by his 4847.84 is

2401.83; the total of his commitments today is therefore 7249.67, precisely

the same as computed above. This should be no surprise, as both sets

of computations are being made with an interest rate of 12%. Thus the

excess of one over the other is zero.

ii. An annuity to cover the payments of 434.58 per year for 14 years would

cost Gareld today 434.58a

14.12

= 2880.47; under this scheme he would

also be making a payment of 5000, for a total of 7880.47: the deferred

annuity method would cost 7880.47 7249.67 = 630.80 less.

iii. The payments of 483 per year for 14 years are worth today 483a

14.12

=

1000a

180.1

5000 = 3201.41; the sum of the value of these payments and

the supplementary payment is 1000a

180.1

= 8201.41 : the deferred annuity

method would cost 8201.41 7249.67 = 951.74 less.

(f) i. The loan was written to provide a yield of 10%. The fact that the cost

of money may have changed does not aect the yield, which is inuenced

only by the lenders payments and receipts under the loan.

ii. Since Garelds computation of the new level payment is based on an

interest rate of 10%, there has been no change in the yield to the lender:

it remains 10%.

iii. When the lender demands that the computation of the replacement level

payment be based on an interest rate of 12%, he eects a partial im-

provement of the yield; but it cannot aect those funds that were already

repaid. Setting up an equation of value at time 7, just after the supple-

mentary payment and the 7th payment of 1000, we nd that the yield

rate, i, will satisfy the equation:

(1 + i)

7

1000a

2510%

+ 1000s

7i

+ 5000 + 483a

14i

= 0

which is equivalent to

9077.04(1+i)

7

+1000

_

(1 + i)

7

1

i

_

+5000+483

_

(1 + i)

14

1

i(1 + i)

14

_

= 0 .

It can be shown that i = 0.10345 approximately. Thus even the increase

in the interest rate for the nal payments does not eect a marked increase

in the yield rate.

iv. In this case the yield rate is 10%, as there are, from the lenders perspec-

tive, no changes.

Information for Students in MATH 329 2004 01 3029

B.1.5 Fifth 2002/2003 Problem Assignment, with Solutions

1. (a) (cf. [5, Exercise 5.1, p. 105]) A 15-year bond with face value 20000, redeemable

at par, earns interest at 7.5%, convertible semiannually. Find the price to yield

an investor 8% convertible semiannually.

(b) What is the premium or discount at which the bond will be purchased?

(c) (cf. [5, Exercise 5-13, p. 109]) For the bond in part 1a nd the market price

24

and at price at each of the following dates and times:

i. Just after the 7th coupon has been paid.

ii. 3 months after the 7th coupon has been paid. (Use simple interest for

fractions of a period.)

iii. Just before the 8th coupon is paid.

iv. Just after the 8th coupon is paid.

(d) What would the market price and at price have been just before and just

after payment of the 8th coupon if the bond had been purchased at par?

Solution:

(a) Both of the interest rates are nominal annual rates convertible semiannually;

we must divide each by 2. Using the general formula, we nd the price of

the bond to be

(20000)(1.04)

30

+ (0.0375 20000)a

30.04

(75)

= (20000)(1.04)

30

+

_

750

.04

_

_

1 (1.04)

30

_

(76)

= (20000)(1.04)

30

+ 18750

_

1 (1.04)

30

_

(77)

= 18750 + (20000 18750)(1.04)

30

(78)

= 18750.00 385.40 = 19135.40. (79)

Alternatively, using the alternate formula, we nd it to be

200 + (750 800)a

304%

= 2000

50

0.04

_

1 (1.04)

30

_

= 19135.40.

(b) The bond is selling at a discount of 20000.00 19135.40 = 864.60 less than

its redemption value.

24

Market price=amortized value [5, p. 98] is obtained by interpolating linearly between book values

on coupon dates. Thus the market price is a continuous function of time.

Information for Students in MATH 329 2004 01 3030

(c) The book value at the time of an interest payment is the present value of

the unpaid portions of the bond; the coupon payments will enter into the

accounting in some other way, e.g., as income. These computations make use

of the yield rate associated with the owners acquisition of the bond. The

market price at these times will equal the book value.

i. The remaining 30 7 coupons are worth 750a

234%

= 11142.53; the prin-

cipal is worth 20000(1.04)

30+7

= 8114.53. The market price is the book

value, i.e., the sum, 19257.16.

ii. The book value immediately after the payment of the 8th coupon is

the sum of the value of the unpaid coupons, 750a

224%

= 10838.34 and

the present value of the principal, 20000(1.04)

30+8

= 8439.11; together,

19277.45. The average of this book value and that after the payment of

the 7th coupon is 19267.30, and this is what we dene to be the market

price.

iii. By our denition, market price is a continuous function of time: the

market price immediately before a coupon payment will be equal to that

after the payment here, 19277.45.

iv. As seen above, the book value is 19277.45. This could also have been

computed by subtracting the value of the coupon from 1.04 times the

book value after the payment of the 7th coupon:

(1.04 19257.16) 750.00 = 20027.45 750.00 = 19277.45 .

We compute the at prices:

i. The at price associated with yield rate 4% per interest period, just after

payment of the 7th coupon, is the same as the market price, as there is

no accrued interest. Here the value is, as above, 19257.16.

ii. The at price is the book value at the time of the preceding coupon

payment plus accrued simple interest. That is,

_

1 +

1

2

0.04

_

19257.16 = 19642.30 .

In practice this is often quoted as the market price of 19267.30 plus ac-

crued interest of 375.00, (half of the next coupon).

iii. The at price just before the payment of the 8th coupon can be deter-

mined in several dierent ways:

A. Viewed as book value plus accrued interest,

(1 + 0.04) 19257.16 = 20027.45 .

Information for Students in MATH 329 2004 01 3031

B. Viewed as the book value just after the payment of the coupon, plus

the value of the coupon, it is

19277.45 + 750.00 = 20027.45 .

iv. The at price just after payment of a coupon is the book value, here

19277.45. (The at price is discontinuous at such points in time: the

limit as time approaches the point from the right is dierent from the

limit from the left: they dier by the value of the coupon.)

(d) The at price just after payment of the 8th coupon would have been

20000(1.0375)

22

+ 750a

223.75%

= 8897.99 + 11102.01 = 20000.00 ;

are you surprised by this result? The at price just before payment of the

coupon would have been 20000.00 increased by the interest that had been

earned but not paid, i.e. 20000.00 + 750.00 = 20750.00.

The market price would remain constant at 20000 throughout.

2. (a) [5, Exercise 5-3, p. 106] Prove the Alternate Price Formula:

P = C + (Fr Ci)a

n

algebraically.

(b) (cf. [5, Exercise 5.5, p. 106]) Two bonds with face value 10000 each, redeemable

at par at the end of the same period, are bought to yield 10%, convertible

semiannually. The rst bond costs 8246.56, and pays coupons at 7% per year,

convertible semiannually. The second bond pays coupons at 6% per half-year.

Find

i. the price of the second bond;

ii. the number of coupons remaining on each of the bonds.

Solution:

(a) We can derive the Alternate Price Formula from the General Formula [5,

(5.1)] as follows:

P = (Fr)a

n

+Cv

n

= (Fr)a

n

+C(1 ia

n

) [5, (3.6), p. 45]

= C + (Fr Ci)a

n

Information for Students in MATH 329 2004 01 3032

(b) We apply the Alternate Price Formula proved above to the two bonds. Denote

the price of the second bond by P

2

, and the number of coupons remaining by

n. Then

8246.56 = 10000 + (10000(0.035) 10000(0.05))a

n

(80)

P

2

= 10000 + (10000(0.06) 10000(0.05))a

n

(81)

From (80) we nd that

a

n5%

=

8246.56 10000

10000(0.035 0.05)

= 11.6896 . (82)

i. Substituting in (81) yields P

2

= 11168.96 as the price of the second bond.

ii. We solve (82) for n:

1 v

n

0.05

= 11.6896

1 v

n

= 0.58448

v

n

= 0.41552

nln(1.05) = ln(0.41552)

n = 18

There are 18 coupons remaining: the bonds mature in 9 years.

3. (cf. [5, Exercise 5-16, p. 108])

(a) Construct a bond amortization schedule for a 3 year bond of face amount

5000, redeemable at 5250 with semiannual coupons, if the coupon rate is 5%

and the yield rate is 6% both converted semiannually. Use the format

Time Coupon Interest Principal Book

Value Adjustment Value

0

.

.

.

(b) Construct a bond amortization schedule for a 3 year bond of face amount

5000, redeemable at 5250 with semiannual coupons, if the coupon rate is 6%

and the yield rate is 5% both converted semiannually.

Solution:

(a) The purchase price of the bond will be 5250(1.03)

6

+ 125a

63%

= 4396.79 +

677.15 = 5073.94.

UPDATED TO April 29, 2004

Information for Students in MATH 329 2004 01 3033

Time Coupon Interest Principal Book

Value Adjustment Value

0 5073.94

1 125.00 152.22 -27.22 5101.16

2 125.00 153.03 -28.03 5129.19

3 125.00 153.88 -28.88 5158.07

4 125.00 154.74 -29.74 5187.81

5 125.00 155.63 -30.63 5218.44

6 125.00 156.55 -31.55 5249.99

(b) The purchase price of the bond will be 5250(1.025)

6

+150a

62.5%

= 4527.06+

826.22 = 5353.28.

Time Coupon Interest Principal Book

Value Adjustment Value

0 5353.28

1 150.00 133.83 16.17 5337.11

2 150.00 133.43 16.57 5320.54

3 150.00 133.01 16.99 5303.55

4 150.00 132.59 17.41 5286.14

5 150.00 132.15 17.85 5268.29

6 150.00 131.71 18.29 5250.00

4. (cf. [5, Exercise 5-22, p. 109]) A 10-year bond of face value 12000 with semiannual

coupons, redeemable at par, is purchased at a premium to yield 10% convertible

semiannually.

(a) If the book value (just after the payment of the coupon) six months before the

redemption date is 11828.57, nd the total amount of premium or discount in

the original purchase price.

(b) Determine the nominal annual coupon rate of the bond, compounded semi-

annually.

(c) Give the amortization table for the last one and one-half years.

Solution:

(a) The book value just after the pnultimate

25

coupon is

11828.57 = 12000v + Fr a

10.05

= 12000v + Fr v =

12000 + Fr

1.05

25

2nd last

Information for Students in MATH 329 2004 01 3034

so

Fr = 1.05 11828.57 12000 = 420 .

Knowing the amount of each coupon we can now evaluate the purchase price

of the bond to have been

12000(1.05)

20

+ 420a

200.05

= 4522.67 + 5234.13

= 9756.80 .

The bond was purchased at a discount of 12000 9756.80 = 2243.20.

(b) The rate per period was

420

12000

= 3.5%; hence the nominal rate compounded

semi-annually, is 2 3.5% = 7%.

(c) For convenience we will compile this table backwards, beginning with Time=20.

We were given that B

19

= 11828.57. Hence the Principal Adjustment con-

tained in the 20th coupon is

11, 828.57 12, 000 = 171.43 .

book value at Time=18 will be (12000)(1.05)

2

+ 420(1.05

1

+ (1.05)

2

) =

11665.31; the book value at Time=17 will be (12000)(1.05)

3

+ 420(1.05

1

+

(1.05)

2

+ (1.05)

3

) = 11509.81.

Time Coupon Interest Principal Book

Value Adjustment Value

20 420.00 591.43 -171.43 12000.00

19 420.00 583.26 -163.26 11828.57

18 420.00 575.50 -155.50 11665.31

17 420.00 . . . . . . 11509.81

5. A 4.5% bond

26

with par value of 100 and semiannual coupons is issued on July 1,

2003. It is callable at 110 on any coupon date from July 1, 2008 through January

1, 2011; at 105 on any coupon date from July 1, 2011 through January 1, 2013;

and at 102.50 on any coupon date from July 1, 2013 through January 1, 2015;

thereafter it is callable without premium on any coupon date up to January 1,

2018 inclusive; its maturity date is July 1, 2018. Determine the highest price that

an investor can pay and still be certain of a yield of

26

The convention in bonds is that, lacking any indication to the contrary, the term an r% bond refers

to a bond whose coupon rate is a nominal rate of r%; the rate is compounded (or converted) as often as

indicated in the description of the bond, with the default being half-yearly if there is no indication to

the contrary. Under this convention the coupon rate for this bond is 2.25%. This convention is stated

in the textbook [5, p. 93, 1st paragraph]; however, the author usually supplies additional, redundant,

information in his problems.

Information for Students in MATH 329 2004 01 3035

(a) 5% convertible semiannually;

(b) 4% convertible semiannually.

(c) 3% convertible semiannually.

[Hint: For each interest rate, and each range of payments for a given premium,

express the price of the bond as a function of the payment number.]

Solution: As a rst step towards organizing data, the student should determine the

payment numbers being referred to. If we label the payment dates with natural

numbers, and dene the issue date to be (non)-payment #0, the July dates will

have even numbers, and the January dates odd numbers. The premium of 10 is

payable when the calling date is ##10-15; the premium of 5 when the calling date

is ##16-19; the premium of 2.5 when the calling date is ##20-23; and no premium

is payable when the calling date is ##24-29 nor on the maturity date, which is

payment #30.

(a) We tabulate the applicable price formul, based on the call or maturity date:

First Date Last Date Price

10 15 110.00 (1.025)

n

+ 2.25a

n2.5%

= 90 + 20.00(1.025)

n

16 19 105.00 (1.025)

n

+ 2.25a

n2.5%

= 90 + 15.00(1.025)

n

20 23 102.50 (1.025)

n

+ 2.25a

n2.5%

= 90 + 12.50(1.025)

n

24 30 100.00 (1.025)

n

+ 2.25a

n2.5%

= 90 + 10.00(1.025)

n

One way to solve the problem would be to laboriously compute the price for

every possible call date, and then take the minimum. However, as the above

formul express the value in terms of a decreasing function v

n

, it suces to

consider the smallest value in each interval, i.e. the largest value of n. So we

have to compare the following four prices:

Call Date Price

15 103.81

19 99.38

23 97.08

30 94.77

Thus the highest price that the investor may safely pay is 94.77. Because

the prices were expressible in the form 90 + A(1.025)

n

, where A is a non-

increasing function of n and (1.025)

n

also a non-increasing function of n, we

could have stated immediately that the lowest price would be that for the bond

held to maturity: it was not necessary to carry out all these computations.

The situation is not so clear when the yield rate is less than the coupon rate.

Information for Students in MATH 329 2004 01 3036

(b) Again we tabulate the applicable price formul, based on the call or maturity

date:

First Date Last Date Price

10 15 110.00 (1.02)

n

+ 2.25a

n2%

= 112.50 2.50(1.02)

n

16 19 105.00 (1.02)

n

+ 2.25a

n2%

= 112.50 7.50(1.02)

n

20 23 102.50 (1.02)

n

+ 2.25a

n2%

= 112.50 10.00(1.02)

n

24 30 100.00 (1.02)

n

+ 2.25a

n2%

= 112.50 12.50(1.02)

n

These formul express the value in terms of an increasing function v

n

, it

suces to consider the largest value in each interval, i.e. the smallest value of

n. So we have to compare the following four prices:

Call Date Price

10 110.45

16 107.04

20 105.77

24 104.73

Thus the highest price that the investor may safely pay is 104.73.

(c) As before, we tabulate the applicable price formul, based on the call or

maturity date:

First Date Last Date Price

10 15 110.00 (1.015)

n

+ 2.25a

n1.5%

= 150.00 40.00(1.015)

n

16 19 105.00 (1.015)

n

+ 2.25a

n1.5%

= 150.00 45.00(1.015)

n

20 23 102.50 (1.015)

n

+ 2.25a

n1.5%

= 150.00 47.50(1.015)

n

24 30 100.00 (1.015)

n

+ 2.25a

n1.5%

= 150.00 50.00(1.015)

n

As in the case of 4% we have to compare four prices:

Call Date Price

10 115.53

16 114.54

20 114.73

24 115.02

This time the highest price that the investor may safely pay is 114.54.

Information for Students in MATH 329 2004 01 3037

B.1.6 2002/2003 Class Tests, with Solutions

Versions 2 and 4 appear to have been slightly more dicult than Versions 1

and 3, and the grades were adjusted to compensate for this.

Versions 1 (white) and 3 (yellow)

1. Showing your work, solve each of the following problems:

(a) [2 MARKS] Determine the nominal annual interest rate, i

1

, compounded ev-

ery 3 months, which is equivalent to a nominal annual interest rate of 12%

compounded every 4 months.

(b) [4 MARKS] Determine the nominal annual interest rate compounded semi-

annually, i

2

, which is equivalent to an eective annual discount rate of 6%.

(c) [4 MARKS] Determine the nominal annual interest rate, i

3

, compounded in-

stantaneously (=convertible continuously), which is equivalent to an eective

monthly discount rate of 1%.

Solution:

(a) In one year a sum of 1 will grow, under the rst rate, to

_

1 +

i

1

4

_

4

, and under

the second to

_

1 +

0.12

3

_

3

. Equating these two yields 1 +

i

1

4

= (1.04)

3

4

, so

i

1

= 4

_

(1.04)

3

4

1

_

= 0.1194 = 11.94%.

(b) We know several relationships between i and the corresponding d. For exam-

ple, d = iv =

i

1+i

= 1

1

1+i

. Solving these equations for i when d = 0.06, we

obtain, corresponding to an eective annual discount rate of 6%, an eective

annual interest rate of

1

0.94

1 =

6

94

= 0.06383. The eective semi-annual

interest rate corresponding to this eective annual rate will be (1+

6

94

)

1

2

1 =

_

100

94

1 = 0.03142. Corresponding to this semi-annual rate, the nominal

annual interest rate compounded semi-annually will be twice this rate, i.e.

6.284 %.

(c) Since d + v = 1, the value of v corresponding to d = 1% is

99

100

, so 1 + i =

100

99

= 1 +

1

99

and i =

1

99

; hence the corresponding eective annual rate of

interest is

_

1 +

1

99

_

12

1 = 12.81781%. The nominal annual interest rate, i

3

,

compounded instantaneously (=convertible continuously) will be the force

Information for Students in MATH 329 2004 01 3038

of interest

i

3

= = ln

_

_

1 +

1

99

_

12

_

= 12 ln

_

1 +

1

99

_

= 12 ln

100

99

= 0.1206 = 12.06%.

2. (a) [2 MARKS] Dene the sequence of payments whose value is represented by

the symbol s

ni

, using a time diagram showing the payments, and indicating

the point in time where the value of the various payments is being calculated.

(b) [4 MARKS] Derive a formula for s

ni

by using formul known to you for the

summation of arithmetic or geometric progressions. Your nal formula should

be expressed in closed form, i.e., without using summation symbols (

) or

dots (. . .),

(c) [4 MARKS] Dene what is meant by s

ni

. Give, without proof, a formula

which expresses the value of s

ni

in terms of i and n.

Solution:

(a)

1 1 1 1 1

0 2 1 3 n

(b)

s

ni

= 1 + (1 + i) + (1 + i)

2

+ . . . + (1 + i)

n1

= 1

(1 + i)

n

1

(1 + i) 1

=

(1 + i)

n

1

(1 + i) 1

=

(1 + i)

n

1

i

Information for Students in MATH 329 2004 01 3039

(c) s

ni

is the value of the sum of n payments of 1 at the beginning of each year,

evaluated one year after the last payment. Its value is s

n+1i

1 =

(1+i)

n+1

(1+i)

i

;

other formul would also have been acceptable.

3. A loan of 10,000 at i = 10% is to be repaid by ten equal annual payments.

(a) [5 MARKS] Determine the annual payment.

(b) [10 MARKS] Determine an amortization schedule for the rst 5 payments,

showing, for each payment, the interest portion and the portion for reduction

of principal. Use the following format for your table.

Duration Payment Interest Principal Outstanding

(Years) Repaid Principal

. . .

(c) [5 MARKS] If the loan is sold to an investor immediately after the 5th payment

at a price to yield 12% eective annual interest, determine the price paid by

the investor.

Solution: (Source = Deferred/Supplemental Examination in Math 329, August,

2000, Problem 3.)

(a) If the annual payment is denoted by X, it must satisfy the equation X

a

1010%

= 10, 000. Solving this equation yields X =

1000

1(1.1)

10

=

1000

0.61445671

=

1627.45 as the level annual payment.

(b) If we were interested only in the interest portion of the 5th payment, we might

recall having proved that [5, p. 79] to be

X(1 (1.1)

105+1

) = 1627.45 (1 0.56447393) = 708.80.

The portion for reduction of principal would then be

X 708.80 = 1627.45 708.80 = 918.65 .

However, the problem required the construction of an amortization table, so

these data can be used only to verify our computations in the table:

Duration Payment Interest Principal Outstanding

(Years) Repaid Principal

0 10000.00

1 1627.45 1000.00 627.45 9372.55

2 1627.45 937.26 690.19 8682.36

3 1627.45 868.24 759.21 7923.15

4 1627.45 792.31 835.14 7088.01

5 1627.45 708.80 918.65 6169.36

Information for Students in MATH 329 2004 01 3040

(c) While the outstanding principal is shown as 6169.35, that will equal the

present value of the remaining 5 payments of 1627.45 each only if the interest

rate remains at 10%. If the interest rate changes to 12%, the present value

of the remaining 5 payments falls to 1627.45 a

512%

= 1627.45

1(1.12)

5

0.12

=

5866.59. This will be the price paid by an investor who expects the 5 remain-

ing payments to yield 12% eective interest.

Versions 2 (blue) and 4 (green)

1. [20 MARKS] A borrower takes out a loan of 2000 to be paid by one payment with

full interest at the end of two years. Construct a sinking fund schedule using the

headings

Duration Contribution to Interest Interest Earned Balance of Balance of

(Years) Sinking Fund on Loan in Sinking Fund Sinking Fund Principal

. . .

assuming that the lender receives 10% convertible semi-annually on the loan, and

the borrower replaces the amount of the loan with equal semi-annual deposits in a

sinking fund to mature when the loan becomes due, where the sinking fund earns

8% convertible semi-annually.

Solution: (Source = Final Examination in Math 329, April, 2000, Problem 3; the

present problem is simplied from that on the examination.)

(a) [7 MARKS] The sinking fund must attain the value of 2000(1.05)

4

; if we

denote the value of the semi-annual payments into this fund, than X s

40.04

=

2000(1.05)

4

, so

X =

2000 (1.05)

4

0.04

(1.04)

4

1

=

97.2405

0.16986

= 572.48.

(b) [13 MARKS] The schedule is as follows:

Duration Contribution to Interest Interest Earned Balance of Balance of

(Years) Sinking Fund on Loan in Sinking Fund Sinking Fund Principal

0.0 0.00 0.00 0.00 0.00 2000.00

0.5 572.48 100.00 0.00 572.48 2100.00

1.0 572.48 105.00 22.90 1167.86 2205.00

1.5 572.48 110.25 46.71 1787.05 2315.25

2.0 572.48 115.76 71.48 2431.01 2431.01

2. Showing your work, solve each of the following problems:

(a) [4 MARKS] Determine the nominal annual interest rate compounded semi-

annually, i

1

, which is equivalent to an eective annual discount rate of 4%.

Information for Students in MATH 329 2004 01 3041

(b) [2 MARKS] Determine the nominal annual interest rate, i

2

, compounded ev-

ery 6 months, which is equivalent to a nominal annual interest rate of 24%

compounded every 3 months.

(c) [4 MARKS] Determine the nominal annual interest rate, i

3

, compounded in-

stantaneously (=convertible continuously), which is equivalent to an eective

quarterly discount rate of 2%.

Solution:

(a) We know several relationships between i and the corresponding d. For exam-

ple, d = iv =

i

1+i

= 1

1

1+i

. Solving these equations for i when d = 0.04, we

obtain, corresponding to an eective annual discount rate of 4%, an eective

annual interest rate of

1

0.96

1 =

4

96

= 0.04167. The eective semi-annual

interest rate corresponding to this eective annual rate will be (1+

4

96

)

1

2

1 =

_

100

96

1 = 0.02062. Corresponding to this semi-annual rate, the nominal

annual interest rate compounded semi-annually will be twice this rate, i.e.

i1 = 4.124%.

(b) In one year a sum of 1 will grow, under the rst rate, to

_

1 +

i

2

2

_

2

, and under

the second to

_

1 +

0.24

4

_

4

. Equating these two yields 1 +

i

1

2

= (1.06)

2

, so

i

2

= 2

_

(1.06)

2

1

_

= 0.0472 = 24.72%.

(c) Since d+v = 1, the value of v corresponding to d = 2% is

98

100

, so 1+i =

100

98

=

1 +

2

98

and i =

2

98

; hence the corresponding eective annual rate of interest is

_

1 +

2

98

_

4

1 = 8.4166%. The nominal annual interest rate, i

3

, compounded

instantaneously (=convertible continuously) will be the force of interest

i

3

= = ln

_

_

1 +

2

98

_

4

_

= 4 ln

_

1 +

2

98

_

= 4 ln

100

98

= 0.08081 = 8.081%.

3. (a) [2 MARKS] Dene the sequence of payments whose value is represented by

the symbol a

ni

, using a time diagram showing the payments, and indicating

the point in time where the value of the various payments is being calculated.

(b) [4 MARKS] Derive a formula for a

ni

by using formul known to you for the

summation of arithmetic or geometric progressions. Your nal formula should

be expressed in closed form, i.e., without using summation symbols (

) or

dots (. . .).

Information for Students in MATH 329 2004 01 3042

(c) [4 MARKS] By allowing n to approach innity, determine a (closed form)

formula for the value of a

i

.

Solution:

(a)

1 1 1 1 1

0 2 1 3 n

(b)

a

n

= v + v

2

+ . . . + v

n

= v

1 v

n

1 v

= (1 + i)v

1 v

n

(1 + i) (1 + i)v

=

1 v

n

(1 + i) 1

=

1 v

n

i

(c) Since 1 + i > 1, 0 <

1

1+i

< 1, so a

i

= lim

n

1v

n

i

=

lim

n

1 lim

n

v

n

i

=

10

i

=

1

i

.

B.1.7 Final Examination, 2002/2003

1. (a) [3 MARKS] The total amount of a loan to which interest has been added is

5,000. The term of the loan was 4 years. If the nominal annual rate of interest

was 6% and interest was compounded semi-annually, determine the original

amount of the loan, showing all your work.

(b) [3 MARKS] Showing all your work, determine the simple interest rate under

which a sum of money will double in 5 years.

(c) [4 MARKS] Showing all your work, determine the eective annual compound

discount rate under which a sum of money will double in 8 years.

(d) [5 MARKS] Showing all your work, determine the rate of interest, convertible

continuously, that is equivalent to an eective interest rate of 1% per month.

2. (a) [8 MARKS] To repay a loan, X is obliged to pay Y 1,000 at the end of Decem-

ber, 2004, and 1,200 at the end of December, 2006. He proposes to replace

Information for Students in MATH 329 2004 01 3043

these two payments by a single payment of 2,196 at the end of December,

2005. If Y accepts this proposal, what yield rate will he be earning on his

loan? Show all your work.

(b) [7 MARKS] Showing all your work, determine the value at time t = 0 of

a continuous annuity that pays 10,000 per year for 2 years, at an eective

annual interest rate of 5%.

3. Express each of the following only in terms of

x

, and v.

(a) [2 MARKS] d

27

(b) [2 MARKS]

4

q

24

(c) [2 MARKS] a

20:25

(d) [2 MARKS] A

1

20:25

(e) [2 MARKS] A

20:25

(f) [2 MARKS] The probability that a 25-year old will survive 40 years, but will

die before reaching age 75.

(g) [3 MARKS]

12

[a

20:25

4. The Wallace Widget Company is planning to borrow 150,000 from the Bank of

Antigonish, and to undertake to pay interest annually at a rate of 12%; they plan

to contribute equal annual payments to a sinking fund that earns interest at the

rate of 9%. The sinking fund will repay the principal at the end of 10 years.

Showing all your work, determine

(a) [2 MARKS] the annual interest payment,

(b) [3 MARKS] the annual payment into the sinking fund

At the end of 4 years, when Wallace has made its annual interest payment and its

4th payment to the sinking fund, it proposes that this should be the last payment

to the sinking fund. It will apply the balance X accumulated to date in the sinking

fund to repay principal, and it will amortize the remainder of the principal by equal

annual payments over the next 5 years, at a rate of 10%.

(c) [4 MARKS] Determine the annual level payment Y under this proposal.

(d) [6 MARKS] Construct an amortization table for this proposal, under the

following headings, beginning immediately after the 4th and last payment to

the sinking fund; assume also that all outstanding interest on the loan has

been made annually to date:

Information for Students in MATH 329 2004 01 3044

Duration Payment Interest Principal Outstanding

Repaid Principal

4 0.00 0.00 0.00 150000.00X

5 Y =

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

9 0.00

5. Consider a 100 par-value 15-year bond, with semi-annual coupons at the nominal

annual interest rate of 4%, convertible every six months. Let t represent time in

half-years; assume that the bond is callable at 109.00 on any coupon date from

t = 10 to t = 20 inclusive, at 104.50 from t = 21 to t = 29 inclusive, but matures

at 100.00 at t = 30. In each of the following cases, determine what price an investor

should pay to guarantee himself

(a) [7 MARKS] a nominal annual yield rate of 5%, convertible semi-annually;

(b) [8 MARKS] an eective annual yield rate of 3%.

6. In addition to her down payment, Marys purchase of her new home is nanced

by a mortgage of 60,000 payable to the vendor; the mortgage is amortized over 20

years, with a level payment at the end of each month, at a nominal annual rate of

6% compounded monthly.

(a) [3 MARKS] Determine the monthly payments under this mortgage.

(b) [2 MARKS] Divide the rst payment into principal and interest.

(c) [3 MARKS] Determine the outstanding principal immediately after the 60th

payment.

(d) [4 MARKS] Divide the 60th payment into principal and interest.

(e) [3 MARKS] Determine the payment that Mary could make at the end of each

year which would be equivalent to the years 12 monthly payments.

7. (a) [5 MARKS] Dene what is meant by (Da)

n

and (Ia)

n

, and explain verbally

why

(Da)

30

+ (Ia)

30

= 31a

30

.

(b) [10 MARKS] Showing all your work, nd the present value (using eective

annual interest rate i = 6%) of a perpetuity which pays 100 after 1 year, 200

after 2 years, increasing until a payment of 2000 is made, after which payments

are level at 2000 per year forever. [For this problem you may assume that

(Ia)

n

=

a

n

nv

n

i

(83)

Information for Students in MATH 329 2004 01 3045

(Ia)

=

a

i

(84)

(Is)

n

=

s

n

n

i

.] (85)

8. In order to complete the sale of his home in Vancouver, John accepted, in partial

payment, a 200,000 mortgage amortized over 15 years with level semi-annual pay-

ments at a nominal annual rate of 5% compounded semi-annually. Fred has cash

available, and is prepared to buy the mortgage from John and to invest a xed

portion of the semi-annual payments he receives in a sinking fund that will replace

his purchase capital in 15 years. The sinking fund will earn interest at only 4%,

compounded semi-annually. Showing all your work, determine the following:

(a) [3 MARKS] the amount of the semi-annual mortgage payments

(b) [4 MARKS] as a fraction of the purchase price Fred pays for the mortgage,

the semi-annual payment into the sinking fund

(c) [8 MARKS] the amount that Fred should pay for the mortgage in order to ob-

tain an overall yield rate of 6%, compounded semi-annually on his investment.

(Note that the sinking fund earns 4% compounded semi-annually.)

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