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You are on page 1of 115

Financial Mathematics

Exercises

S1, 2010

22 February 2010

Contents

1 Time Value of Money and Cash Flow Valuation 2

1.1 Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Exercise 1.1 [int1] . . . . . . . . . . . . . . . . . . . . . . . . . 2

Exercise 1.2 [int2] . . . . . . . . . . . . . . . . . . . . . . . . . 2

Exercise 1.3 [int3] . . . . . . . . . . . . . . . . . . . . . . . . . 2

Exercise 1.4 [int4] . . . . . . . . . . . . . . . . . . . . . . . . . 2

Exercise 1.5 [int5] . . . . . . . . . . . . . . . . . . . . . . . . . 2

Exercise 1.6 [int7] . . . . . . . . . . . . . . . . . . . . . . . . . 2

Exercise 1.7 [int8] . . . . . . . . . . . . . . . . . . . . . . . . . 2

Exercise 1.8 [int9] . . . . . . . . . . . . . . . . . . . . . . . . . 2

Exercise 1.9 [int10] . . . . . . . . . . . . . . . . . . . . . . . . 3

Exercise 1.10 [int11] . . . . . . . . . . . . . . . . . . . . . . . 3

Exercise 1.11 [int12] . . . . . . . . . . . . . . . . . . . . . . . 3

Exercise 1.12 [int13] . . . . . . . . . . . . . . . . . . . . . . . 3

Exercise 1.13 [int15] . . . . . . . . . . . . . . . . . . . . . . . 3

Exercise 1.14 [int19] . . . . . . . . . . . . . . . . . . . . . . . 4

Exercise 1.15 [int18] . . . . . . . . . . . . . . . . . . . . . . . 4

Exercise 1.16 [int20] . . . . . . . . . . . . . . . . . . . . . . . 5

Exercise 1.17 [int6] . . . . . . . . . . . . . . . . . . . . . . . . 5

Exercise 1.18 [int14] . . . . . . . . . . . . . . . . . . . . . . . 5

Exercise 1.19 [int24] . . . . . . . . . . . . . . . . . . . . . . . 5

Exercise 1.20 [int25] . . . . . . . . . . . . . . . . . . . . . . . 5

Exercise 1.21 [int21] . . . . . . . . . . . . . . . . . . . . . . . 5

Exercise 1.22 [int22] . . . . . . . . . . . . . . . . . . . . . . . 6

Exercise 1.23 [int23] . . . . . . . . . . . . . . . . . . . . . . . 6

Exercise 1.24 [new10] . . . . . . . . . . . . . . . . . . . . . . . 6

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Financial Mathematics Exercises Actuarial Studies UNSW

1.2 Level Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Exercise 1.25 [ann1] . . . . . . . . . . . . . . . . . . . . . . . . 6

Exercise 1.26 [ann2] . . . . . . . . . . . . . . . . . . . . . . . . 6

Exercise 1.27 [ann3] . . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.28 [annB1] . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.29 [annB2] . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.30 [annB3] . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.31 [annB4] . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.32 [annB5] . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.33 [annB6] . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.34 [annB7] . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.35 [ann4] . . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.36 [ann5] . . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.37 [ann6] . . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.38 [ann7] . . . . . . . . . . . . . . . . . . . . . . . . 7

Exercise 1.39 [annB8] . . . . . . . . . . . . . . . . . . . . . . . 8

Exercise 1.40 [annB9] . . . . . . . . . . . . . . . . . . . . . . . 8

Exercise 1.41 [ann13] . . . . . . . . . . . . . . . . . . . . . . . 8

1.3 Non-Level and Continuous Annuities . . . . . . . . . . . . . . . . . . 8

Exercise 1.42 [ann8] . . . . . . . . . . . . . . . . . . . . . . . . 8

Exercise 1.43 [ann9] . . . . . . . . . . . . . . . . . . . . . . . . 8

Exercise 1.44 [ann12] . . . . . . . . . . . . . . . . . . . . . . . 8

Exercise 1.45 [new8] . . . . . . . . . . . . . . . . . . . . . . . 8

Exercise 1.46 [ann14] . . . . . . . . . . . . . . . . . . . . . . . 8

Exercise 1.47 [ann15] . . . . . . . . . . . . . . . . . . . . . . . 8

Exercise 1.48 [new4] . . . . . . . . . . . . . . . . . . . . . . . 9

Exercise 1.49 [new1] . . . . . . . . . . . . . . . . . . . . . . . 9

Exercise 1.50 [annB10] . . . . . . . . . . . . . . . . . . . . . . 9

Exercise 1.51 [loaB2] . . . . . . . . . . . . . . . . . . . . . . . 9

Exercise 1.52 [annB11] . . . . . . . . . . . . . . . . . . . . . . 9

Exercise 1.53 [loaB1] . . . . . . . . . . . . . . . . . . . . . . . 9

Exercise 1.54 [annB12] . . . . . . . . . . . . . . . . . . . . . . 9

Exercise 1.55 [annB13] . . . . . . . . . . . . . . . . . . . . . . 9

Exercise 1.56 [annB14] . . . . . . . . . . . . . . . . . . . . . . 10

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Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.57 [annB15] . . . . . . . . . . . . . . . . . . . . . . 10

Exercise 1.58 [new2] . . . . . . . . . . . . . . . . . . . . . . . 10

Exercise 1.59 [ann11] . . . . . . . . . . . . . . . . . . . . . . . 10

2 Life Contingencies 11

Exercise 2.1 [lif1] . . . . . . . . . . . . . . . . . . . . . . . . . 11

Exercise 2.2 [lif2] . . . . . . . . . . . . . . . . . . . . . . . . . 11

Exercise 2.3 [lif3] . . . . . . . . . . . . . . . . . . . . . . . . . 11

Exercise 2.4 [lif4] . . . . . . . . . . . . . . . . . . . . . . . . . 11

Exercise 2.5 [lif5] . . . . . . . . . . . . . . . . . . . . . . . . . 12

Exercise 2.6 [new7] . . . . . . . . . . . . . . . . . . . . . . . . 12

3 Loans and Investments 13

3.1 Loan Repayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Exercise 3.1 [loa1] . . . . . . . . . . . . . . . . . . . . . . . . . 13

Exercise 3.2 [loa2] . . . . . . . . . . . . . . . . . . . . . . . . . 13

Exercise 3.3 [loa3] . . . . . . . . . . . . . . . . . . . . . . . . . 14

Exercise 3.4 [loaB3] . . . . . . . . . . . . . . . . . . . . . . . . 14

Exercise 3.5 [loaB4] . . . . . . . . . . . . . . . . . . . . . . . . 14

Exercise 3.6 [loaB5] . . . . . . . . . . . . . . . . . . . . . . . . 14

Exercise 3.7 [loa5] . . . . . . . . . . . . . . . . . . . . . . . . . 14

Exercise 3.8 [loa6] . . . . . . . . . . . . . . . . . . . . . . . . . 14

Exercise 3.9 [loa7] . . . . . . . . . . . . . . . . . . . . . . . . . 15

Exercise 3.10 [loa8] . . . . . . . . . . . . . . . . . . . . . . . . 15

3.2 Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Exercise 3.11 [loa4] . . . . . . . . . . . . . . . . . . . . . . . . 15

Exercise 3.12 [loa9] . . . . . . . . . . . . . . . . . . . . . . . . 15

Exercise 3.13 [new13] . . . . . . . . . . . . . . . . . . . . . . . 16

Exercise 3.14 [loa10] . . . . . . . . . . . . . . . . . . . . . . . 16

Exercise 3.15 [loaB6] . . . . . . . . . . . . . . . . . . . . . . . 16

Exercise 3.16 [loaB7] . . . . . . . . . . . . . . . . . . . . . . . 16

Exercise 3.17 [loa11] . . . . . . . . . . . . . . . . . . . . . . . 16

Exercise 3.18 [ann16] . . . . . . . . . . . . . . . . . . . . . . . 17

Exercise 3.19 [loa12] . . . . . . . . . . . . . . . . . . . . . . . 17

Exercise 3.20 [loa13] . . . . . . . . . . . . . . . . . . . . . . . 17

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Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 3.21 [loa14] . . . . . . . . . . . . . . . . . . . . . . . 17

4 Interest Rate Risk 18

4.1 Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . 18

Exercise 4.1 [irr1] . . . . . . . . . . . . . . . . . . . . . . . . . 18

Exercise 4.2 [irr2] . . . . . . . . . . . . . . . . . . . . . . . . . 18

Exercise 4.3 [irr3] . . . . . . . . . . . . . . . . . . . . . . . . . 18

Exercise 4.4 [irr4] . . . . . . . . . . . . . . . . . . . . . . . . . 19

Exercise 4.5 [irr5] . . . . . . . . . . . . . . . . . . . . . . . . . 19

4.2 Price Sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Exercise 4.6 [irr6] . . . . . . . . . . . . . . . . . . . . . . . . . 19

Exercise 4.7 [irr7] . . . . . . . . . . . . . . . . . . . . . . . . . 19

Exercise 4.8 [new11] . . . . . . . . . . . . . . . . . . . . . . . 20

Exercise 4.9 [lif6] . . . . . . . . . . . . . . . . . . . . . . . . . 20

4.3 Immunisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Exercise 4.10 [irr8] . . . . . . . . . . . . . . . . . . . . . . . . 20

Exercise 4.11 [irr9] . . . . . . . . . . . . . . . . . . . . . . . . 21

Exercise 4.12 [irr10] . . . . . . . . . . . . . . . . . . . . . . . . 21

Exercise 4.13 [new12] . . . . . . . . . . . . . . . . . . . . . . . 22

Exercise 4.14 [irr11] . . . . . . . . . . . . . . . . . . . . . . . . 22

Exercise 4.15 [irr12] . . . . . . . . . . . . . . . . . . . . . . . . 23

5 Derivatives 24

5.1 Forwards, Futures and Swaps . . . . . . . . . . . . . . . . . . . . . . 24

Exercise 5.1 [der1] . . . . . . . . . . . . . . . . . . . . . . . . 24

Exercise 5.2 [der2] . . . . . . . . . . . . . . . . . . . . . . . . 24

Exercise 5.3 [der3] . . . . . . . . . . . . . . . . . . . . . . . . 24

Exercise 5.4 [der4] . . . . . . . . . . . . . . . . . . . . . . . . 24

Exercise 5.5 [der5] . . . . . . . . . . . . . . . . . . . . . . . . 24

Exercise 5.6 [der6] . . . . . . . . . . . . . . . . . . . . . . . . 25

Exercise 5.7 [der7] . . . . . . . . . . . . . . . . . . . . . . . . 25

Exercise 5.8 [der8] . . . . . . . . . . . . . . . . . . . . . . . . 25

Exercise 5.9 [der9] . . . . . . . . . . . . . . . . . . . . . . . . 25

Exercise 5.10 [der10] . . . . . . . . . . . . . . . . . . . . . . . 25

5.2 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

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Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 5.11 [der11] . . . . . . . . . . . . . . . . . . . . . . . 25

Exercise 5.12 [der12] . . . . . . . . . . . . . . . . . . . . . . . 25

Exercise 5.13 [der13] . . . . . . . . . . . . . . . . . . . . . . . 26

Exercise 5.14 [der14] . . . . . . . . . . . . . . . . . . . . . . . 26

Exercise 5.15 [der15] . . . . . . . . . . . . . . . . . . . . . . . 26

Exercise 5.16 [der16] . . . . . . . . . . . . . . . . . . . . . . . 26

Exercise 5.17 [der17] . . . . . . . . . . . . . . . . . . . . . . . 26

6 Stochastic Interest Rates 27

6.1 IID Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

Exercise 6.1 [sto1] . . . . . . . . . . . . . . . . . . . . . . . . . 27

Exercise 6.2 [sto2] . . . . . . . . . . . . . . . . . . . . . . . . . 27

Exercise 6.3 [sto3] . . . . . . . . . . . . . . . . . . . . . . . . . 27

Exercise 6.4 [sto4] . . . . . . . . . . . . . . . . . . . . . . . . . 28

Exercise 6.5 [sto5] . . . . . . . . . . . . . . . . . . . . . . . . . 28

6.2 Lognormal Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Exercise 6.6 [sto6] . . . . . . . . . . . . . . . . . . . . . . . . . 28

Exercise 6.7 [sto7] . . . . . . . . . . . . . . . . . . . . . . . . . 29

Exercise 6.8 [sto8] . . . . . . . . . . . . . . . . . . . . . . . . . 29

Exercise 6.9 [sto9] . . . . . . . . . . . . . . . . . . . . . . . . . 29

Exercise 6.10 [sto10] . . . . . . . . . . . . . . . . . . . . . . . 29

6.3 Dependence and Further Concepts . . . . . . . . . . . . . . . . . . . 30

Exercise 6.11 [new3] . . . . . . . . . . . . . . . . . . . . . . . 30

Exercise 6.12 [new5] . . . . . . . . . . . . . . . . . . . . . . . 30

Exercise 6.13 [new6] . . . . . . . . . . . . . . . . . . . . . . . 30

Exercise 6.14 [new9] . . . . . . . . . . . . . . . . . . . . . . . 31

7 Solutions to Exercises 32

7.1 Module 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

7.2 Module 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

7.3 Module 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

7.4 Module 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

7.5 Module 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

7.6 Module 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

1

Module 1

Time Value of Money and Cash Flow

Valuation

1.1 Time Value of Money

Exercise 1.1: [int1] Determine the interest earned during the 5

th

year by $100

invested today under compound interest with i = 0.05, and under simple interest

with i = 0.05. Perform the calculations both by hand and using R.

Exercise 1.2: [int2] At what rate of compound interest will $200 grow to $275 in

5 years? Use R to nd your answer.

Exercise 1.3: [int3] How many years does it take $200 to accumulate to $275 at

an eective annual rate of 5%?

Exercise 1.4: [int4] With compound interest at i = 0.05, what is the present value

now of $275 in 5 years? Use R to nd your answer.

Exercise 1.5: [int5] If $150 grows to $240 in n years, what will $1000 grow to over

the same period?

Exercise 1.6: [int7] If funds invested today will earn 8% for the next 10 years and

at least 5% for the following 10 years, what is the most one must invest today to

accumulate $1 million in 20 years?

Exercise 1.7: [int8] What level rate of interest is equivalent to 8% for the next 10

years followed by 5% for the following 10 years?

Exercise 1.8: [int9] Assuming an eective rate of i = 0.10, nd the value of the

cash ows below at times t = 0 and t = 3.

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Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.9: [int10] The following cash ows have a value of 7.7217 at time t = 0

(assuming i = 0.05):

Find the value of the following cash ows at time 0:

Exercise 1.10: [int11] If $100 is deposited at time t = 0 into an account earning

10% interest and $20 is withdrawn at t = 1 and 2, then how much can be withdrawn

at t = 3?

Exercise 1.11: [int12] At what rate of interest will $100 accumulate to $200 in 6

years?

Exercise 1.12: [int13] (SOA Course 2 May 2000, Question 1) Joe deposits $10

today and another $30 in ve years into a fund paying simple interest of 11% per

year. Tina will make the same two deposits, but the $10 will be deposited n years

from today and the $30 will be deposited 2n years from today. Tinas deposits earn

an annual eective rate of 9.15%. At the end of 10 years, the accumulated amount

of Tinas deposits equals the accumulated amount of Joes deposits. What is the

value of n? Perform the calculations both by hand and using R. You may nd the

function uniroot useful.

Exercise 1.13: [int15] (SOA Course 2 Nov 2000, Question 2) The following table

3

Financial Mathematics Exercises Actuarial Studies UNSW

shows the annual eective interest rates being credited by an investment account,

by calendar year of investment. The investment year method is applicable for the

rst 3 years, after which a portfolio rate is used.

Calendar Year of

Investment

Investment

Year Rates

Calendar Year of

Portfolio Rates

Portfolio

Rate

i

1

i

2

i

3

1990 10% 10% x% 1993 8%

1991 12% 5% 10% 1994 (x 1)%

1992 8% (x 2)% 12% 1995 6%

1993 9% 11% 6% 1996 9%

1994 7% 7% 10% 1997 10%

An investment of $100 is made at the beginning of years 1990, 1991, and 1992. The

total amount of interest credited by the fund during the year 1993 is equal to 28.40.

What is the value of x?

Exercise 1.14: [int19] You wish to buy a new home theatre system and have two

potential payment options.

Option A. You pay $610 down (at t = 0), $475 next year (at t = 1) and $340 the

following year (at t = 2).

Option B. You pay $560 down (at t = 0), $580 next year (at t = 1) and $274 the

following year (at t = 2).

Assuming a compound interest accumulation function, determine the values of the

rate of interest r for which Option A is preferred to Option B.

Exercise 1.15: [int18] In return for a single payment of $1000, an investment bank

oers the following alternatives:

A. A lump sum of $1330 after three years

B. A lump sum of $1550 after ve years

C. Four annual payments, each of amount $425, the rst payment being made

after ve years

You wish to decide what alternative is the best.

(a) Write down an equation of value for each alternative and nd the yield for

each.

(b) Assume that an investor selects alternative A and that after three years she

invests the proceeds for a further two years at a xed rate of interest. How

large must this rate of interest be in order for her to receive at least $1550 at

the end of 5 years?

Why do we ask this question?

4

Financial Mathematics Exercises Actuarial Studies UNSW

(c) Assume that an investor selects alternative B and that after ve years he wants

to compare his proceeds with the value of alternative C. Determine the value

of alternative C in 5 years time. What interest rate should you use?

Exercise 1.16: [int20] Use an equation of value to determine the level annual pay-

ment (in arrears) equal in value to $1,000,000 (at time t = 0) at an interest rate of

13% p.a. eective, allowing for 5 payments.

Exercise 1.17: [int6] If v = 0.94, what are d and i?

Exercise 1.18: [int14] (SOA Course 2 May 2001, Question 12) Bruce and Robbie

each open up new bank accounts at time 0. Bruce deposits $100 into his bank

account and Robbie deposits $50 into his. Each account earns an annual eective

discount rate of d. The amount of interest earned in Bruces account during the

11th year is equal to X. The amount of interest earned in Robbies account during

the 17th year is also equal to X. What is the value of X?

Exercise 1.19: [int24] Tina issues a 2-year promissory note for a face value of

$6000 and receives $4843.30 in return (ie. she borrows $4843.30 and promises to

repay $6000 after 2 years). At the end of 6 months, 1 year, and 18 months, she

deposits $1000, $1000, and $2000 into her bank account and earns the same interest

rate as the implied rate on the promissory note. Assuming interest is compounded

semi-annually, determine how much extra money (in addition to the amount in her

bank account) she will need to redeem (repay) the note for its face value in 2 years

time.

Exercise 1.20: [int25] A trust account quotes a nominal annual interest rate of 6%.

Interest is credited quarterly, on the last day of each March, June, September and

December. Simple interest is paid for amounts on deposit for less than a quarter of

a year. In 2001, Maria made 4 deposits of $1000 into her trust account every 1st day

of March, June, September, December. By 31 December 2005, how much interest

will Maria have earned from these deposits?

Exercise 1.21: [int21] You are given the following interest options:

A. an eective rate of discount of 5% per annum

B. a nominal rate of interest of 5% per annum convertible semi-annually

C. a nominal rate of interest of 5% per annum convertible monthly

D. a nominal rate of discount of 5% per annum converted semi-annually

E. a nominal rate of discount of 5% per annum converted monthly

F. a force of interest of 5%

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Financial Mathematics Exercises Actuarial Studies UNSW

(a) Discuss dierences between the above interest rates by expressing each option

as eective rates of interest.

(b) How much will an investment of $10,000 accumulate to in 4

1

2

years based on

each of the above interest options?

Perform all computations both by hand and using R.

Exercise 1.22: [int22] Assume that the force of interest is (t) = 0.04(1 + t)

1

,

with t measured in years. Using an accumulation function a(t):

(a) Calculate the equivalent eective rate of interest for the period t = 1 to t = 2.

(b) Calculate the equivalent eective rate of interest for the period t = 2 to t = 3.

(c) Find the value at time t = 2 of an investment that accumulates to $200,000

at time t = 4.

Exercise 1.23: [int23] A fund credits simple interest with i = 10% from time zero

to time k. After time k, the fund accumulates at a constant force of interest of 8%.

(a) Find the value of k that maximises a(4).

(b) Using the value of k from (a), nd the force of interest as function of time t

(for 0 t 4).

Exercise 1.24: [new10] Suppose the force of interest is = 0.05. Using R, plot (on

the same graph) (i) i

(m)

against m and (ii) d

(m)

against m, for 0.5 < m < 50

1.2 Level Annuities

Exercise 1.25: [ann1] You are given a combined annuity-immediate payable monthly

such that payments are $1000 p.a. for the rst 6 years and $400 p.a. for the next

4 years together with a lump sum of $2000 at the end of the 10 years. An interest

rate of 12% p.a convertible monthly is assumed.

(a) Write a function in R that calculates the value a

n i

given inputs of n and i.

(b) Find the present value of this annuity.

(c) Calculate the amount of the level annuity-immediate payable for 10 years

having the same present value as the payments in (a).

Exercise 1.26: [ann2] Bill leaves an inheritance to four charities, Faith Foundation

(F), Hope Institution (H), Love Trust (L) and Peace, Inc. (P). The total inheritance

is a series of level payments at the end of each year forever. During the rst 20 years,

6

Financial Mathematics Exercises Actuarial Studies UNSW

F, H, and L share each payment equally. All payments after 20 years revert to P.

The present values of the shares of the four charities are known to be all equal.

What is the implied eective rate of interest?

Exercise 1.27: [ann3] Cathy must pay o a loan with ve annual payments of

$15,000 each. The rst loan payment is due 10 years from now. In order to accumu-

late the funds, she plans on making ten annual deposits of C into an account paying

eective annual interest of 6%. Having computed the least possible amount C (and

assuming she succeeded in her nancial mathematics course and thus it took her a

negligible amount of time), she immediately makes the rst deposit. Calculate C.

Exercise 1.28: [annB1] Exercise 2.1.11 from Broverman 4th Ed (2.1.14 in 3rd Ed).

Exercise 1.29: [annB2] Exercise 2.1.19 from Broverman 4th Ed (2.1.17 in 3rd Ed).

Exercise 1.30: [annB3] Exercise 2.1.25 from Broverman 4th Ed (2.1.27 in 3rd Ed).

Exercise 1.31: [annB4] Exercise 2.1.28 from Broverman 4th Ed (2.1.30 in 3rd Ed).

Exercise 1.32: [annB5] Exercise 2.1.31 from Broverman 4th Ed (2.1.33 in 3rd Ed).

Exercise 1.33: [annB6] Exercise 2.2.20 from Broverman 4th Ed (2.2.17 in 3rd Ed).

Exercise 1.34: [annB7] Exercise 2.2.26 from Broverman 4th Ed (2.2.29 in 3rd Ed).

Exercise 1.35: [ann4] To settle a $100,000 death benet, Tim, the primary ben-

eciary, opted to take an annuity-immediate payable monthly for 25 years. The

monthly payment was calculated using an eective annual interest rate of 3%. Af-

ter making payments for 10 years, the insurance company decides to increase the

monthly payments for the remaining 15 years by changing the eective annual in-

terest rate to 5%. By how much will the monthly payment increase?

Exercise 1.36: [ann5] Find the present value of a set of cash ows which pay $100

at the end of year 1, $200 at the end of year 2, $100 at end of year 3, $200 at the end

of year 4, and so on ($100 at odd years, $200 at even), with the nal payment being

at the end of the 20th year. The interest rate is 5% p.a. semi-annual compounding.

Exercise 1.37: [ann6] Bob has inherited an annuity-due on which there remain 12

payments of $18,000 per year at an eective discount rate of 10%; the rst payment

is due immediately. He wishes to convert this to a 20-year annuity-immediate at

the same eective rate of discount. What will be the size of the payments under the

new annuity?

Exercise 1.38: [ann7] Broverman 4th ed: 2.2.13 (2.2.14 in 3rd ed). Also solve for

the case if Smith repays the loan over 5 years (monthly payments).

7

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.39: [annB8] Exercise 2.2.1 from Broverman 4th Ed (2.2.6 in 3rd Ed).

Exercise 1.40: [annB9] Exercise 2.2.18 from Broverman 4th Ed (2.2.21 in 3rd Ed).

Exercise 1.41: [ann13] Given that (t) =

1

20t

, t 0, nd s

10

.

1.3 Non-Level and Continuous Annuities

Exercise 1.42: [ann8] A loan of $4000 is being repaid by a 30-year increasing

annuity-immediate where payments increase each year and payments are in arrears.

The initial payment is P, each subsequent payment is P larger than the preceding

payment. The annual eective interest rate is 4%. Calculate the value of the future

payments (ie. the loan principal outstanding) after the ninth payment. Compare

your result with the initial loan amount and explain it. Is such a payment pattern

likely to exist in reality? Why?

Exercise 1.43: [ann9] Nicole, a UNSW Business part-time student, expects an

increasing amount of income as she advances through her program but will need to

borrow to cover her university costs. Accordingly, she plans to borrow a decreasing

annual amount from a student credit loan during her 5 years at university, and to

repay the loan with increasing amounts for 15 years after graduation. She borrows

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 the rst year after

graduation she pays $500, then increases the amount by $200 each year until a nal

payment of $3300. If the eective annual interest rate assumed is 5%, determine X.

Exercise 1.44: [ann12] Paulo is saving madly to buy his rst home ten years from

now. He deposits to a fund each January 1 and July 1 for the years 2004 through

2014. The deposit he makes on each July 1 will be 10.25% greater than the one on

the immediately preceding January 1. The amount he deposits on each January 1

(except for January 1, 2004) will be the same amount as the deposit made on the

immediately preceding July 1. The fund will be credited with interest at a nominal

annual rate of 10%, compounded quarterly. On December 31, 2014, the fund will

have a balance of $110,000, an amount Paulo considers is enough for a home deposit

and other miscellaneous expenses. Determine Paulos initial deposit to the fund.

Exercise 1.45: [new8] Using R, nd the present value of a 30-year annuity imme-

diate which pays t

3

+ln(10t +12) at the end of year t, assuming an eective interest

rate of 5%.

Exercise 1.46: [ann14] Value the following set of cashows at a rate of 10% p.a.:

$10 at time

1

3

, $20 at times

2

3

and time 1

1

3

, $30 at times 1,1

2

3

and 2

1

3

, $40 at times

2, 2

2

3

and 3

1

3

, $50 at times 3 and 3

2

3

, and $60 at time 4.

8

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.47: [ann15] Mary purchases an increasing annuity-immediate for $50,000

that makes twenty annual payments as follows:

(i) P, 2P, . . . , 10P in years 1 through 10; and

(ii) 10(1.05)P, 10(1.05)

2

P, . . . , 10(1.05)

10

P in years 11 through 20.

The annual eective interest rate is 7% for the rst 10 years and 5% thereafter.

Calculate P.

Exercise 1.48: [new4] Suppose the interest rate is a constant 5% p.a. eective, and

the ination rate is a constant 3% p.a. Determine the (initial) annual payment from

a 20 year annuity-immediate which is purchased at the fair price with $10,000 in

the case of:

(a) a xed annuity (level payments)

(b) an ination-indexed annuity

(c) Show that (a) and (b) are equally fair. Explain your calculations.

Find the solution (i) analytically and (ii) using R by considering the present value

of each of the 20 payments directly.

Exercise 1.49: [new1] A perpetuity has annual payments (in arrears) of 1, 3, 6,

10, 15, etc. For a constant force of interest of = 0.05:

(a) Find the present value of the perpetuity analytically.

(b) Verify your answer by nding the approximate present value using R by con-

sidering the 500 payments only. Plot the present value of each payment against

time t. Does this shape remind you of something?

Exercise 1.50: [annB10] Exercise 2.3.7 from Broverman 4th Ed (2.3.6 in 3rd Ed).

Exercise 1.51: [loaB2] Exercise 2.3.8 from Broverman 4th Ed (2.3.7 in 3rd Ed).

Exercise 1.52: [annB11] Exercise 2.3.15 from Broverman 4th Ed (2.3.15 in 3rd

Ed).

Exercise 1.53: [loaB1] Exercise 2.3.19 from Broverman 4th Ed (2.3.19 in 3rd Ed).

Exercise 1.54: [annB12] Exercise 2.3.20 from Broverman 4th Ed (2.3.20 in 3rd

Ed).

Exercise 1.55: [annB13] Exercise 2.3.22 from Broverman 4th Ed (2.3.24 in 3rd

Ed).

9

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.56: [annB14] Exercise 2.3.23 from Broverman 4th Ed (2.3.26 in 3rd

Ed).

Exercise 1.57: [annB15] Exercise 2.3.24 from Broverman 4th Ed (2.3.27 in 3rd

Ed).

Exercise 1.58: [new2] Find the present value of a 10-year increasing annuity that

pays at an annual rate of 100, 200, . . . , 1000, given that the annual eective interest

rate is 5% and:

(a) payments are made annually in arrears

(b) payments are made monthly in arrears

(c) payments are made continuously

Exercise 1.59: [ann11] A one-year deferred continuous varying annuity is payable

for 13 years. The rate of payment at time t is t

2

1 per annum, and the force of

interest at time t is

1

1+t

. Find the present value of the annuity.

10

Module 2

Life Contingencies

Exercise 2.1: [lif1] Z is the present value random variable for a special continuous

whole life insurance issued to (x), paying b

t

at death at x +t where:

b

t

= e

0.05t

For all t, it is given that

x+t

= 0.01 and

t

= 0.06. Determine the expected value

and variance of Z.

Exercise 2.2: [lif2] Show that the following two denitions of the life annuity a

x

are equivalent:

k=0

a

k+1

k

p

x

q

x+k

=

k=0

v

k

k

p

x

Interpret both sides of the equation and explain why it has to be true.

Exercise 2.3: [lif3] Prove the following identity:

d a

x

+A

x

= 1

Exercise 2.4: [lif4] You are given the following probabilities of death:

x q

x

0 0.10

1 0.05

2 0.10

3 0.20

4 0.40

5 0.70

6 1.00

Given a technical rate of interest of 5%, calculate by hand and using R:

Pr[K(0) = k], e

0

, Pr[K(2) = k], e

2

, A

2

,

2

A

2

, A

1

2:3

, A

1

2:3

, A

2:3

, a

2

, a

2

, a

2:3

11

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 2.5: [lif5] (Gerber (1997), Exercise 17, p. 1356) Consider two independent

lives which are identical except that one is a smoker and the other is a non-smoker.

It is known that:

1.

x

is the force of mortality for non-smokers for 0 x < , and

2. c

x

is the force of mortality for smokers for 0 x < , where c is a constant

and c > 1

Calculate the probability that the remaining lifetime of the smoker exceeds that of

the non-smoker.

Check for the reasonableness of your answer.

Exercise 2.6: [new7] Benjamin is currently 65 years old, and has just purchased

a life annuity (at a fair price) using his superannuation lump sum of $1,000,000 to

pay for his retirement. The annuity will pay X at the end of each year as long as

the policyholder is alive. The interest rate is assumed a constant 5%. Furthermore,

the force of mortality is assumed to follow the Gompertz-Makeham law:

x

= A +Bc

x

It is known that A = 0.0003225, B = 0.000031, and c = 1.0966413. Using R:

(a) Find and plot the survival probabilities for a 65-year old, S

65

(t), t > 0.

(b) What annual payment does Benjamin receive each year?

(c) Suppose instead that the annuity pays X(1 + f)

t

at the end of year t, where

f = 0.03 is the annual ination rate (assumed to be constant). Find the new

value of X under this arrangement.

You may assume that no individual will survive beyond age 120.

12

Module 3

Loans and Investments

3.1 Loan Repayments

Exercise 3.1: [loa1] A bank decides to lend a company $15000 at a rate of interest

of 5% p.a. to be repaid by annual instalments over 5 years (in arrears).

(a) Calculate the annual payment.

(b) Calculate the loan outstanding at the end of the second payment using the

retrospective method.

(c) Calculate the loan outstanding at the end of the second payment using the

prospective method.

(d) At the end of the second year the bank tells you that from that time onwards

the rate of interest charged is going to be increased to 7.5% p.a. If you still

want to payo the loan by the end of the fth year what must your annual

payment change to?

(e) Having reviewed your companys free cash ows you decide that the amount

calculated in (d) is not aordable. You renegotiate with the bank and they

oer to extend your loan so that you can pay o the loan in an additional 4

years (instead of 3 years), at 7.6% p.a. What is the new annual repayment?

(f) Setup a loan schedule for part (e) above.

Exercise 3.2: [loa2] A loan of $20000 is to be repaid by 6 annual payments begin-

ning one year after the loan is made. The lender wants annual payments of interest

only at a rate of 7% and repayments of the principal in a single lump sum at the

end of 6 years. The borrower can accumulate the principal in a sinking fund earning

an annual interest rate of 5%, and decides to do this by means of 6 level deposits

starting one year after the loan is made.

(a) What should the annual payment be?

13

Financial Mathematics Exercises Actuarial Studies UNSW

(b) What if the sinking fund interest rate was 7%?

(c) Suppose you can decide whether you can setup a sinking fund arrangement

or to have a standard loan arrangement (ie. repay both capital and interest

with each payment) to repay the loan. If the sinking fund rate was 5% which

method would you prefer?

(Hint: you should not need to do any extra calculations to decide this al-

though you can use it to check your answer if you wish)

(d) Model the cash ows of this sinking fund arrangement in a spreadsheet (for

the 5% case).

Exercise 3.3: [loa3] An individual borrows $5000 to buy a plasma TV. The sum

borrowed is repayable by 24 monthly instalments in arrears, which are calculated

on the basis of a at rate of interest of 10% p.a.

(a) Calculate the monthly repayment and the true (eective) annual rate of inter-

est being charged. Do this by hand using Newton-Raphson with 5 iterations

(starting at 10%), then using R with 10 iterations.

(b) Just after making the 12th repayment, the outstanding loan is to be repaid.

What is the outstanding balance which must be repaid at this time?

Exercise 3.4: [loaB3] Exercise 3.1.7 from Broverman 4th Ed (3.1.2 in 3rd Ed).

Exercise 3.5: [loaB4] Exercise 3.1.8 from Broverman 4th Ed (3.1.3 in 3rd Ed).

Exercise 3.6: [loaB5] Exercise 3.1.11 from Broverman 4th Ed (3.1.11 in 3rd Ed).

Exercise 3.7: [loa5] A loan of $20000 is being repaid by monthly instalments of

principal and interest (18% p.a. nominal) over 8

1

3

years. Provide a schedule in both

Excel and R showing the principal and interest contained in each of the last four

monthly instalments.

Exercise 3.8: [loa6] A householder is paying o four debts by monthly payments

all at an eective rate of 1% per month (12% p.a. nominal). The monthly payments

and respective terms to run are:

Monthly Payment ($) Terms to Run (Months)

4.36 11

17.20 15

35.00 12

20.24 18

The householder arranges a consolidation of these debts, with the total (sum) pay-

ments under the consolidated loan being equal to the total remaining payments

under the existing loans.

14

Financial Mathematics Exercises Actuarial Studies UNSW

Calculate the monthly instalment and the term to run of the consolidated loan so

that the eective rate of interest involved will be unchanged. Note that a nal

repayment may be required to ensure the loan is fully repaid. For this exercise, this

nal repayment is assumed to be made one month after the last monthly instalment.

You may nd R helpful in speeding up algebraic computation.

Exercise 3.9: [loa7] Paul takes out a loan of $47,500 to purchase a new car. The

interest applicable is 12% p.a. (monthly compounding). Instead of paying o the

loan using level instalments, he decides to pay it o using monthly payments over

3 years. The payments within each year is the same, but the payments in the 2nd

year are 10% higher than the payments in the 1st year, and the payments in the 3rd

year are 10% higher than the payments in the 2nd year. Set out the loan schedule

for this loan in both Excel and R.

Exercise 3.10: [loa8] A recently married couple have decided to buy a new house

in Sydney. After an investigation of their nancial situation they nd that they will

need to borrow $600,000 from the bank. The rate of interest charged is 6.75% p.a

eective.

(a) If they want to pay o the loan in 10 years using annual payments, how much

would they have to pay in total over the 10 years?

(b) If they want to pay o the loan in 10 years using monthly payments, how much

would they have to pay in total over the 10 years?

(c) Suppose they choose to follow (a). At the end of year 5 (just after the payment

at time 5), interest rates increase to 7.25% p.a. eective. How much do they

need to pay to settle the loan at that time?

3.2 Investments

Exercise 3.11: [loa4] (McCutcheon & Scott, 1986, p. 158) A loan of $75,000 is to

be issued bearing interest at the rate of 8% per annum payable quarterly in arrears.

The loan will be repaid at par (ie. 100 per 100 face value) in 15 equal annual

instalments, with the rst instalment being repaid ve years after the issue date.

Find the price to be paid on the issue date by a purchaser of the whole loan who

wishes to realise a yield of (a) 10% per annum eective, and (b) 10% per annum

convertible half-yearly.

Exercise 3.12: [loa9] (McCutcheon & Scott, 1986, p. 197) A loan of nominal

amount $500,000 was issued bearing interest of 8% per annum payable quarterly in

arrears. The loan principal will be repaid at $105% by 20 annual instalments, each

of nominal amount $25,000, the rst repayment being ten years after the issue date.

An investor, liable to both income tax and capital gains tax, purchased the entire

loan on the issue date at a price to obtain a net eective annual yield of 6%. Assume

15

Financial Mathematics Exercises Actuarial Studies UNSW

that capital losses cannot oset capital gains for tax purposes. Find the price paid,

given that his rates of taxation for income and capital gains are:

(a) 40% and 30% respectively

(b) 20% and 30% respectively

Do this question in both Excel and R.

Exercise 3.13: [new13] Consider a 10-year bond of face value $100 and annual

coupons at a rate of 6%.

(a) Write down an equation of value given the price of the bond is $80.

(b) Write a function newton in R which takes an expression (in terms of x), a preci-

sion (percentage change since last estimate), and an initial estimate as inputs,

and outputs the estimated root using Newton-Raphson where the number of

iterations is chosen to obtain the desired precision.

(c) Hence nd the yield to maturity of the bond using a precision of 0.01%. Use

any appropriate initial estimate.

Exercise 3.14: [loa10] (McCutcheon & Scott, 1986, p. 206) Two bonds (100 face

value) each have an outstanding term of four years. Redemption will be at par for

both bonds. Interest is payable annually in arrears at the annual rate of 15% for

the rst bond and 8% for the second bond. Interest payments have just been made

and the prices of the bonds are $105.80 and $85.34 respectively.

(a) Verify that an investor, liable for income tax at the rate of 35% and capital

gains tax at the rate of 50% who purchases either of these bonds (but not

both) will obtain a net yield on his transaction of 8% per annum.

(b) Assume now that the investor is allowed to oset capital gains by capital

losses. Show that, if the proportion of his available funds invested in the 8%

bond is such that the overall capital gain is zero, he will achieve a net yield of

combined transaction of 8.46% per annum.

Exercise 3.15: [loaB6] Exercise 4.3.4 from Broverman 4th Ed (4.3.7 in 3rd Ed).

Exercise 3.16: [loaB7] Exercise 4.3.1 from Broverman 4th Ed (4.3.5 in 3rd Ed).

Exercise 3.17: [loa11] An investor purchased an Australian Government bond on

11 June 2006 paying a coupon 5.75% p.a with a maturity of 15 June 2011. The bond

is ex-interest within 7 days prior to the coupon payment. Explain what is meant

by ex-interest for an Australian government bond and describe the payments that

the buyer will receive on an ex-interest Australian government bond. Determine

the price paid for the Australian Government bond at a yield of 4.75% p.a on 11

June 2006.

16

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 3.18: [ann16] Outline the payments made on ination indexed bonds and

give an example of an investor who would invest in these nancial instruments.

Exercise 3.19: [loa12] A loan of nominal amount $500,000 was issued bearing in-

terest of 8% per annum payable quarterly in arrears. The loan will be repaid at

$110% by 10 annual instalments, each of nominal amount $50,000, the rst repay-

ment being ten years after the issue date. An investor, liable to both income tax and

capital gains tax, purchased the entire loan on the issue date at a price to obtain a

net eective annual yield of 7%. Find the price paid, given that his rates of taxation

for income and capital gains are both 15%. Do this question in both Excel and R.

Exercise 3.20: [loa13] A loan, on which interest is payable half-yearly, was issued

on 1 January 1974. The loan was to be redeemed with deferred annual payments

(always on 1 January) in accordance with the following schedule:

Amount redeemed Redemption

in each year rate

1 Jan 1984 to 1 Jan 1992 (inclusive) $150 000 105%

1 Jan 1993 to 1 Jan 2003 (inclusive) $250 000 110%

1 Jan 2004 $300 000 112%

Interest is payable at the rate of 7% p.a. until the payment on 1 July 2000 has been

made and thereafter at 8% p.a. What was the issue price if a purchaser of the whole

loan secured a yield of 6.5% p.a. eective on his or her investment? Do this question

using both Excel and R.

Exercise 3.21: [loa14] A loan of nominal amount $1,200 was issued bearing interest

of 10% per annum payable annually in arrears. The loan will be repaid by 3 annual

nominal payments of equal value, the rst repayment being two years after the issue

date. The actual repayment will be at $100% for the rst two instalments, and

$120% for the nal instalment. An investor, liable to both income tax and capital

gains tax at 20%, purchased the entire loan on the issue date at a price to obtain a

net eective annual yield of 8%. Find the price paid, given that it is greater than

$1,200.

17

Module 4

Interest Rate Risk

4.1 Term Structure of Interest Rates

Exercise 4.1: [irr1]

Consider the following spot interest rates that are quoted on a nominal p.a. basis

assuming interest compounds semi-annually (ie. they are i

(2)

interest rates).

Term (Years) % p.a.

0.5 4.875180

1.0 5.031182

1.5 5.234408

2.0 5.448436

(a) Use these spot rates to calculate the value of a 6.75% bond paying semi-annual

coupons maturing in two years time with a face value of $100.

(b) Calculate the yield to maturity on this bond for the price calculated above.

(c) Determine the par yield, as a semi-annual compounding yield, for one year

and two year maturity bonds corresponding to the above rates. Interpret your

result.

(d) Determine the 6 month forward rates corresponding to these spot rates.

Exercise 4.2: [irr2] Consider two 5 year bonds. One has a 9% coupon and sells for

101.00; the other has a 7% coupon and sells for 93.20. Find the price of a 5 year

zero coupon bond.

Exercise 4.3: [irr3] Let s(t), 0 t denote a spot rate curve, that is, the

present value of a dollar to be received at time t is e

s(t)t

. Show explicitly that if the

spot rate curve is at and that s(t) = r, then all forward rates must be the same.

18

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 4.4: [irr4] The half year forward rates are as follows (semi-annual com-

pounding):

Time Period % p.a

0 0.5 5.00

0.5 1 5.50

1 1.5 6.00

1.5 2 6.10

2 2.5 6.25

2.5 3 7.00

Calculate the 1 year forward rates for time periods 0 1, 0.5 1.5, 1 2, 1.5 2.5,

2 3.

Exercise 4.5: [irr5]

Consider the following spot rates (semi-annual compounding):

Term (Years) % p.a.

0.5 4.5000

1.0 5.2500

and forward rates:

Time Period % p.a.

1-1.5 7.5082

1.5-2 2.0290

Calculate the value of a bond paying semi-annual coupons of 8% p.a., maturing in

2 years time.

4.2 Price Sensitivity

Exercise 4.6: [irr6] Let D() be the duration, at a constant force of interest (con-

tinuous compounding) p.a., of a xed-interest security with interest payable con-

tinuously at the annual rate D per unit nominal and redeemable at R per unit

nominal in n years time. Let g = D/R. Show that:

D() =

g(

I a)

n

+ nv

n

g a

n

+ v

n

Exercise 4.7: [irr7] Consider a xed-interest security bearing interest of 5% p.a.

payable continuously and redeemable at par in n years time, where n is not neces-

sarily an integer. Assuming a constant continuously compounding force of interest

of 7% p.a:

19

Financial Mathematics Exercises Actuarial Studies UNSW

(a) Determine the duration of the security for n = 20 and n = 60.

(b) Note that the duration of the security, on the basis of a specied constant

force of interest per annum , may be considered as a function of n. Assuming

= 0.07, show that the duration is maximised when the following equation is

satised:

0.07 a

n

+ 0.05(n a

n

) =

0.07

0.07 0.05

Hence (or otherwise) nd the maximum duration and the corresponding value

of n at which the duration is maximised.

Exercise 4.8: [new11] Consider a level n-year annuity-immediate paying $1 at the

end of each year.

(a) Write down the expressions which relate the modied duration and convexity

with derivatives of the price (present value).

(b) Write R functions to nd (analytically) the modied duration and convexity

of the annuity. You may nd the functions D, expression, and eval useful.

(c) Write R functions to nd the approximate modied duration and convexity

(using a Taylor approximation).

(d) Use your functions to nd the modied duration and convexity of a 10-year

annuity.

Exercise 4.9: [lif6] Show that the Macaulay Duration of a

x

is equal to:

D

x

=

k=0

w

k

k

where w

k

is given by:

w

k

=

v

k

k

p

x

l=0

v

l

l

p

x

4.3 Immunisation

Exercise 4.10: [irr8] (Boyle, 1992) Suppose the term structure of spot rates is level

for all maturities and equal to 8% p.a. Suppose that in the next instant, the term

structure of interest rates will be either 9% p.a. for all maturities or 7% p.a. for all

maturities. Consider the following strategy. An investor goes short a zero coupon

bond with a 10-year maturity and a face value of 1000. Simultaneously, she uses

the proceeds to purchase a 5-year zero coupon bond with maturity value M

5

and a

15-year maturity bond with maturity value M

15

.

(a) Give expressions for the value of assets V

A

(i) and the value of liabilities V

L

(i).

20

Financial Mathematics Exercises Actuarial Studies UNSW

(b) What is meant by an arbitrage opportunity?

(c) By suitable choice of M

5

and M

15

such that V

A

(.08) V

L

(.08) is zero, demon-

strate that arbitrage prots are possible with parallel shifts to a at yield

curve.

Exercise 4.11: [irr9] Consider 3 coupon paying bonds x, y and z. You have

calculated their Price to be (P

x

, P

y

, P

z

), and their duration and convexity to be

(D

x

, D

y

, D

z

) and (C

x

, C

y

, C

z

) respectively. Consider a portfolio by buying 1 unit

of each bond. Derive a formula for the duration and convexity for the portfolio in

terms of the price, duration, and convexity of the individual bonds.

Exercise 4.12: [irr10] Consider a portfolio of insurance liabilities. Your best esti-

mate of the future outgoes (claims) are as follows

Time Outgo

1 3m

2 4m

3 3m

4 2m

Assume that the spot rate term structure is at and equal to 4.5%. Assume that

the insurer can only invest in 2 ZCBs. One matures in 0.5 years while the other

matures in 5 years. Find an immunisation strategy using the two bonds.

(a) Using R, write a function s which outputs the surplus when given an input of

i, where i is a function itself that outputs the t-year spot rate when given t.

(b) What happens to the surplus if the yield shifts in a parallel fashion to 6.5%?

(c) What happens to the surplus if the yield shifts in a parallel fashion to 2.5%?

(d) What happens to the surplus if the yield curve twists and you are faced with

the following spot rate curve?

Time Rate

0.5 3%

1 3.5%

1.5 4%

2 4.5%

2.5 5%

3 5.5%

3.5 6%

4 6.5%

4.5 7%

5 7.5%

21

Financial Mathematics Exercises Actuarial Studies UNSW

(e) Determine the surplus if we are faced with a term structure where the t-year

spot rate is given by:

s

t

= +

_

1 e

t

t

_

+

_

1 e

t

t

e

t

_

where = 0.06, = 0.01, = 0.08, and = 0.6 are known parameters.

Exercise 4.13: [new12] The Nelson-Siegel class of term structure models are com-

monly used in practice to model the yield curve through time. One example is the

model used in Exercise 4.12(e). Another simple example is the following yield curve,

which describes the zero coupon yield of maturity (ie. -year spot rate) as:

s

= +

t

_

1 e

_

where and are constant parameters and

t

is a time-varying parameter. It is

assumed that = 0.06 and = 0.6, while the values of

t

for each time t are

independent and identically distributed with

t

N(0.01, 0.002

2

).

(a) Write an R function which outputs the spot rate s

,

t

, and the term to maturity . Plot the spot curve (for maturities 0 <

< 20) for the given parameters and when

t

is equal to its mean of -0.01.

(b) Why is the use of Fisher-Weil duration more realistic?

(c) Consider the portfolio of insurance liabilities in Exercise 4.12, and again as-

sume that the insurer can only invest in 2 ZCBs of maturity 0.5 and 5 years

respectively. Find an immunisation strategy if the current value of

t

is 0.01.

(d) Simulate 1000 outcomes for the yield curve in the next moment and determine

the surplus in each case. Also plot a histogram for the surplus and estimate

the probability of a negative surplus. Is your portfolio fully immunised? Why?

Exercise 4.14: [irr11] Consider a portfolio of insurance liabilities. Your best esti-

mate of the future outgoes (claims) are as follows

Time Outgo

1 3m

2 4m

3 3m

4 2m

Assume that the spot rate is at and is equal to 4%. Suppose the insurer has

available for investment two coupon bonds. One is a 4% coupon bond with 0.75

years till maturity. The second bond is a 8% coupon bond with 8 years till maturity.

Find an immunisation strategy using the two bonds. (Derive your solutions without

using Excel.)

22

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 4.15: [irr12] Suppose you have a liability of $2 million due at time 3. As-

sume that the spot rate is at and is equal to 6%. You have available for investment

ve ZCBs, with maturities at 1, 2, 3, 4 and 5 respectively.

(a) Suppose you wish to use an immunisation strategy using 2 bonds. Derive the

portfolio.

(b) Explain the term cash ow matching. Derive the portfolio (using 1, 2, 3, 4 or

all 5 bonds) that corresponds to a cash ow matching strategy.

(c) Suppose the spot rate moves to 7% at. What happens to your surplus for

the strategies in (a) and (b)?

(d) Suppose the spot rate curve such that the spot rate for maturity T is equal to

(3 + T)%. What happens to your surplus for the strategies in (a) and (b)?

23

Module 5

Derivatives

5.1 Forwards, Futures and Swaps

Exercise 5.1: [der1] On 12 May 1987, the closing value of the S&P 500 Index was

293.3 and the December 1987 S&P 500 futures closing index, with delivery in 210

days, was 299.0. Calculate the theoretical futures index assuming transactions and

storage costs are negligible, a constant annual continuously compounding interest

rate of 7%, and that the S&P 500 portfolio pays dividends continuously at an annual

rate of 3.5% of its market value on 12 May 1987. You may also assume that interest

rates are deterministic so that the futures price is equal to the theoretical forward

price.

Exercise 5.2: [der2] Consider a forward contract to buy 6.5% coupon 6 year Trea-

sury bonds in 2 years time (immediately after the coupon then due has been paid).

These bonds are assumed to be currently available as 6.5% 8 year Treasury bonds

at a yield of 6.96% p.a. (semi-annual). Funding costs for the rst year are 6.5% p.a.

(monthly compounding) and 7% p.a. (monthly compounding) for the second year.

Determine the forward price and forward yield in two years time.

Exercise 5.3: [der3] An investor holds a short position in a forward contract on

gold for delivery in 90 days at $450 an ounce. The current spot price of gold is $420

an ounce and insurance and storage cost for gold are 2.5% p.a of the spot price paid

on delivery. Ninety day (simple) interest rates are 9.75% p.a. What is the value of

this forward contract?

Exercise 5.4: [der4] Consider a forward contract on 10000 shares, deliverable in 6

months time. The share is currently trading at $10.00. Assume that there will be a

dividend payment of 0.40 per share in 3 months time. Funding costs for 6 months

are 6% p.a. (monthly compounding). Transaction costs are 2% of the value of the

shares purchased. Determine the forward price for sale of the shares in 6 months at

which all net funding and other costs will be covered.

24

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 5.5: [der5] Explain the cost of carry formula:

F

t,T

= S

t

e

r(Tt)

de

r(Tt

1

)

There are no storage costs but there is a payment to the holder of the spot asset

(eg. dividend) of d at time t

1

.

Exercise 5.6: [der6] Suppose the current spot and forward rates are as given in

Table 6.4 of Sherris (1996, p. 109). Calculate the implied repo rate (the risk-

free rate implied by current spot and forward prices) associated with each forward

contract. Also, for each forward contract, outline an arbitrage strategy you could

use to realise your arbitrage prot now. Give the amount of the prot in both

instances. Use simple interest as the contracts are for terms less than one year.

Exercise 5.7: [der7] Review Example 7.1 of Sherris (p. 133)

Exercise 5.8: [der8] Review Example 7.4 of Sherris (p. 138)

Exercise 5.9: [der9] Review Example 7.10 of Sherris (p. 149)

Exercise 5.10: [der10] Consider an agreement where party A receives the spot

price for N units of a commodity each period while paying a xed amount X per

unit for N units. If the agreement is made for M periods (ie. at times t

1

, t

2

, .., t

M

),

derive a formula that can be used to determine the swap price X on inception of the

swap contract. Assume that no storage costs or dividends occur during the period,

and the risk free interest rate is r (continuous compounding).

5.2 Options

Exercise 5.11: [der11] In a one-period binomial model, it is assumed that the

current share price of 260 will either increase to 285 or decrease to 250 at the end

of one year. The annual risk-free interest rate is 5% compounded continuously and

assume that this share pays no dividends.

(a) Calculate the price of a one-year European call option with a strike price of

275 by replicating the payo with a portfolio of shares and bonds.

(b) Calculate the price of a one-year European put option with a strike price of

275 by replicating the payo with a portfolio of shares and bonds.

(c) Verify numerically that the put-call parity relationship holds in this case.

Exercise 5.12: [der12] Assume that the stock price is currently $50, and will in-

crease or decrease by 10% at the end of the month. The interest rate is 5% p.a.

(simple). Find the price of a call option with a strike price of $50.

25

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 5.13: [der13] In the pricing of forwards, futures, swaps and options, the

expected value of the underlying asset for these contracts has not appeared in the

valuation. Explain why this is the case. (Do you nd it surprising?)

Exercise 5.14: [der14] In a one-period binomial model, it is assumed that the

current share price of 260 will either increase to 285 or decrease to 250 at the end

of one year. The annual risk-free interest rate is 4% compounded continuously and

assume that this share pays no dividends. Calculate the price of an option that pays

the cash dierence between the square of the share price at the end of the year and

70225, provided that the dierence is positive (ie. otherwise it pays nothing).

Exercise 5.15: [der15] The current stock price is $20, and the risk free rate (simple)

is 5% p.a. One year call and put options with strike price $22 are priced at $1.2245

and $2.5000 respectively. Verify that there is an arbitrage opportunity, and identify

the transactions required.

Exercise 5.16: [der16] Suppose we want to price a call option on a share using

a binomial model of the share price. Consider a portfolio of the share and bond.

Suppose however that the stock pays a xed dividend of $D on the maturity date

of the option (ie at time T) and that the owner of the option will not receive the

share dividend. Derive a formula for the number of stocks and bond that need to

be held to replicate this option payo.

Exercise 5.17: [der17] Consider call and put (European) options (with the same

strike price) on gold. The spot price of gold is G(0) at time 0, and the maturity of

the option is at time T. Storage costs of $c per unit of gold are payable at time T.

By equating the cost at time 0 of two portfolios that have the same payo at time

T, nd an updated version of the put-call parity that takes into account the storage

costs.

26

Module 6

Stochastic Interest Rates

6.1 IID Returns

Exercise 6.1: [sto1] (Institute of Actuaries Examination April 2003) $1000 is in-

vested for 10 years. In any year, the yield on the investment will be 4% with prob-

ability 0.4, 6% with probability 0.2, 8% with probability 0.4, and is independent of

the yield in any other year.

(a) Calculate the mean accumulation at the end of 10 years.

(b) Calculate the standard deviation of the accumulation at the end of 10 years.

(c) Without carrying out any further calculations, explain how your answers to

(a) and (b) would change (if at all) if:

(i) the yields had been 5%, 6% and 7% instead of 4%, 6%, and 8% p.a.

respectively.

(ii) the investment had been made for 12 years instead of 10 years.

Exercise 6.2: [sto2] (Institute of Actuaries Examination September 2003) In any

year t, the yield on a fund of investments has mean j

t

and standard deviation s

t

. In

any year, the yield is independent of the yield in any other year. The accumulated

value, after n years, of a unit sum of money invested at time 0 is S

n

.

(a) Derive formulae for the mean and variance of S

n

if j

t

= j and s

t

= s for all

years t.

(b) Calculate the expected value of S

8

if j = 0.06.

(c) Calculate the standard deviation of S

8

if j = 0.06 and s = 0.08.

Exercise 6.3: [sto3] (Institute of Actuaries Examination September 2002) $10,000

is invested in a bank account which pays interest at the end of each year. The rate

of interest is xed randomly at the beginning of each year and remains unchanged

27

Financial Mathematics Exercises Actuarial Studies UNSW

until the beginning of the next year. The rate of interest applicable in any one year

is independent of the rate applicable in any other year.

During the rst year, the rate of interest per annum eective will be one of 3%,

4% or 6% with equal probability. During the second year, the rate of interest per

annum eective will be either 5% with probability 0.7, or 4% with probability 0.3.

(a) Assuming that interest is always reinvested in the account, calculate the ex-

pected accumulated amount in the bank account at the end of two years.

(b) Calculate the variance of the accumulated account in the bank account at the

end of two years.

Exercise 6.4: [sto4] (Institute of Actuaries Examination April 2005) In any year,

the interest rate per annum eective on monies invested with a given bank is equally

likely to be i

1

or i

2

(i

1

> i

2

), and is independent of the interest rates in all previous

years.

(a) Express the mean and variance of the eective rate in a particular year in

terms of i

1

and i

2

.

(b) The accumulated value at time t = 25 years of $1 million invested with the

bank at time t = 0 has expected value $5.5 million and standard deviation

$0.5 million. Find i

1

and i

2

.

Exercise 6.5: [sto5] (Institute of Actuaries Examination September 2000) An in-

surance company calculates the single premium for a contract paying $10,000 in ten

years time as the present value of the benet payable at the expected rate of interest

it will earn on its funds. The annual eective rate of interest over the whole of the

next ten years will be 7%, 8% or 10% with probabilities 0.3, 0.5 and 0.2 respectively.

(a) Calculate the single premium.

(b) Calculate the expected prot at the end of the term of the contract.

6.2 Lognormal Model

Exercise 6.6: [sto6] (Institute of Actuaries Examination September 2005) An in-

surance company has just written contracts that require it to make payments to

policyholders of $1,000,000 in ve years time. The total premiums paid by policy-

holders amounted to $850,000. The insurance company is to invest half the premium

income in xed interest securities that provide a return of 3% per annum eective.

The other half of the premium income is to be invested in assets that have an uncer-

tain return. The return from these assets in year t, i

t

, has a mean value of 3.5% per

annum eective and a standard deviation of 3% per annum eective. The random

variables (1 + i

t

) (for t = 1, 2, . . .) are independent and lognormally distributed.

28

Financial Mathematics Exercises Actuarial Studies UNSW

(a) Deriving all necessary formulae, calculate the mean and standard deviation of

the accumulation of the premiums over the ve-year period.

(b) A director of the company suggests that investing all the premiums in the

assets with an uncertain return would be preferable because the expected

accumulation of the premiums would be greater than the payments due to the

policyholders.

Explain why this still may be a more risky investment policy.

Exercise 6.7: [sto7] (Institute of Actuaries Examination April 2002) A company

is adopting a particular investment strategy such that the expected annual eective

rate of return from investments is 7% and the standard deviation of annual returns

is 9%. Annual returns are independent and (1+i

t

) is lognormally distributed where

i

t

is the return in the tth year. The company has received a premium of $1,000 and

will pay the policyholder $1,400 after 10 years.

(a) Calculate the expected value and standard deviation of an investment of $1,000

over 10 years, deriving all formulae that you use.

(b) Calculate the probability that the accumulation of the investment will be less

than 50% of its expected value in ten years time.

(c) The company has invested $1,200 to meet its liability in 10 years time. Cal-

culate the probability that it will have insucient funds to meet its liability.

Exercise 6.8: [sto8] (Institute of Actuaries Examination September 2007) The ex-

pected eective annual rate of return from a banks investment portfolio is 6% and

the standard deviation of annual eective returns is 8%. The annual eective re-

turns are independent and (1 +i

t

) is lognormally distributed, where i

t

is the return

in year t.

Deriving any necessary formulae:

(a) Calculate the expected value of an investment of $2 million after ten years.

(b) Calculate the probability that the accumulation of the investment will be less

than 80% of the expected value.

Exercise 6.9: [sto9] (Institute of Actuaries Examination September 2000) An in-

vestment bank models the expected performance of its assets over a ve-day period.

Over that period, the return on the banks portfolio, i, has a mean value of 0.1%

and standard deviation of 0.2%. (1 + i) is lognormally distributed.

Calculate the value of j such that the probability that i is less than or equal to j is

0.05.

Exercise 6.10: [sto10] (Institute of Actuaries Examination September 2004) The

expected annual eective rate of return from an insurance companys investments is

29

Financial Mathematics Exercises Actuarial Studies UNSW

6% and the standard deviation of annual returns is 8%. The annual eective returns

are independent and (1 +i

t

) is lognormally distributed, where i

t

is the return in the

tth year.

(a) Calculate the expected value of an investment of $1 million after ten years.

(b) Calculate the probability that the accumulated of the investment will be less

than 90% of the expected value.

6.3 Dependence and Further Concepts

Exercise 6.11: [new3] Company A and Company B currently have a swap contract

where A pays (annually) a oating interest rate on a principal of $1 million to B

in exchange for a xed rate of 5% from B to A. The oating rate i

t

in year t is

assumed to be independent for each year, and (1 + i

t

) is lognormally distributed

with i

t

having mean 4% and standard deviation 2%.

(a) Find the expected value of the accumulated value after 10 years of the net

receipts (from the perspective of A) from the swap.

(b) Using R, simulate (1000 times) the interest rate for the next 10 years and verify

your answer in (a). In addition, nd the variance and plot the distribution of

the accumulated value.

(c) In what situation may a company wish to enter into a xed-for-oating swap?

Exercise 6.12: [new5] Suppose that the interest rate y

t

(for year t) follows a mean

reverting process dened by:

y

t

= +(y

t1

) +

t

where

t

N(0, 1) iid for each time t = 0, 1, . . ..

It is also known that = 0.05, = 0.4, and = 0.01. Denote the accumulated

value of $1 in one years time as S

1

. Find:

(a) E(S

1

)

(b) Var(S

1

)

(c) Pr(S

1

< 1.04)

if the interest rate last year was (i) 4% and (ii) 6%.

Exercise 6.13: [new6] Suppose that the interest rate y

t

(for year t) follows a mean

reverting process dened by:

y

t

= +(y

t1

) +

t

It is also known that = 0.05, = 0.4, and = 0.01. Denote the accumulated

value of $1 in ten years time as S

10

. Using 1000 simulations in R, estimate:

30

Financial Mathematics Exercises Actuarial Studies UNSW

(a) E(S

10

)

(b) Var(S

10

)

(c) Pr(S

10

< 1.55)

(d) Plot the histogram of S

10

.

if the interest rate last year was (i) 4% and (ii) 6%.

Exercise 6.14: [new9] Suppose that the interest rates in each year are independent

and identically distributed, with (1 + i

t

) LN(,

2

) and i

t

having mean 4% and

standard deviation 2%. Denote as s

30

the expected value and variance of the 30

year accumulated value of an annual payment of $1 in advance.

(a) Derive recursive formulae which can be used to nd E( s

30

) and Var( s

30

).

(b) Using R and the formulae in (a), nd E( s

30

) and Var( s

30

).

(c) Estimate E( s

30

) and Var( s

30

) using simulation in R, and compare your answers

with those in (b). Also plot the simulated density of s

30

and provide the

quartiles of the distribution.

31

Module 7

Solutions to Exercises

7.1 Module 1

Exercise 1.1 [int1]

Under compound interest:

Accumulated amount at t = 4: 100(1.05)

4

= 121.5506

Accumulated amount at t = 5: 100(1.05)

5

= 127.6282

Interest earned = 6.08

Under simple interest:

Accumulated amount at t = 4: 100(1 + 4 0.05) = 120

Accumulated amount at t = 5: 100(1 + 5 0.05) = 125

Interest earned = 5.00

R code:

100*(1.05^5-1.04^5)

100*0.05

Exercise 1.2 [int2]

200(1 + i)

5

= 275 i =

_

275

200

_

1/5

1 = 0.06576

R Code:

(275/200)^(1/5) - 1

Exercise 1.3 [int3]

200(1.05)

t

= 275 t =

ln(275/200)

ln 1.05

= 6.527 years

Exercise 1.4 [int4]

275v

5

= 215.47, where v =

1

1+i

R Code:

32

Financial Mathematics Exercises Actuarial Studies UNSW

v = 1/1.05

275*v^5

Exercise 1.5 [int5]

150(1 + i)

n

= 240

1000(1 + i)

n

=

1000

150

150(1 + i)

n

=

1000

150

240 = 1600

Exercise 1.6 [int7]

The most one requires will be the amount X which is sucient even when the

interest rate is always at its minimum of 5% in the latter 10 years (as this minimises

the interest earned). Therefore:

X(1.08)

10

(1.05)

10

= 1000000

X = 284360

Exercise 1.7 [int8]

The accumulation of $1 under the eective rate and the 8% and 5% rates should be

equivalent:

(1 + i)

20

= (1.08)

10

(1.05)

10

i = 0.06489

Exercise 1.8 [int9]

Value at time t = 0:

5 + 3v

2

+ v

3

= 8.2307

Value at time t = 3:

8.2307(1 + i)

3

= 10.9550

Alternatively: 5(1 + i)

3

+ 3(1 + i) + 2 = 10.9550

Exercise 1.9 [int10]

The 2nd set of cash ows contains two of the 1st set, one starting at t = 0 and

another starting at t = 1. Thus, the value is given by:

7.7217 + v7.7217 = 15.0757

Exercise 1.10 [int11]

100 (1.10)

3

20 (1.10)

2

20 (1.10) = 86.90

Exercise 1.11 [int12]

100(1 + i)

6

= 200

i = 0.12246

Exercise 1.12 [int13]

(SOA Course 2 May 2000, Question 1)

33

Financial Mathematics Exercises Actuarial Studies UNSW

Accumulated value of 1st account after 10 years:

10(1 + 0.11 10) + 30(1 + 0.11 5) = 67.50

Therefore, accumulated value of 2nd account after 10 years must also be 67.50:

10(1.0915)

10n

+ 30(1.0915)

102n

= 67.50

30(1.0915)

10

v

2n

+ 10(1.0915)

10

v

n

67.50 = 0

v

n

=

10(1.0915)

10

_

100(1.0915)

20

+ 120(1.0915)

10

67.50

60(1.0915)

10

= 0.8158 or 1.1491

Since v

n

> 0, we have v

n

= 0.8158 n =

ln 0.8158

ln v

= 2.325

R code:

a = 30*1.0915^10

b = 10*1.0915^10

c = -67.5

v = 1/1.0915

f = function(x) { a*x^2 + b*x + c }

vn = uniroot(f) # find the root

vn = vn$root # extract the root only

n = log(vn)/log(v)

Exercise 1.13 [int15]

(SOA Course 2 Nov 2000, Question 2)

For the rst investment (the $100 at beginning of 1990), the interest credited in

1993 is 8% of the accumulated value at the beginning of 1993 (ie. after 3 years):

100(1.10)(1.10)(1 + 0.01x)(0.08) = 9.68 + 0.0968x

Similarly, for the second investment, the interest credited is:

100(1.12)(1.05)(0.10) = 11.76

and for the third investment:

100(1.08)(0.01(x 2)) = 1.08x 2.16

Therefore, the total interest credited in 1993 is:

19.28 + 1.1768x = 28.40

x = 7.7498

34

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.14 [int19]

Using v =

1

1+r

, we have the following present values for the two payment options:

PV

A

= 610 + 475v + 340v

2

PV

B

= 560 + 580v + 274v

2

Option A is preferred when PV

B

PV

A

= 50 + 105v 66v

2

> 0. Note that the

quadratic 50 + 105v 66v

2

= 0 has no real roots. The quadratic is negative at

v = 1, since 50 +105 66 = 11 < 0. This implies that PV

B

< PV

A

for all values

of r, so Option B is always preferred to A.

Exercise 1.15 [int18]

(a) The equation of value for each of the alternative is given as follows with the

corresponding yield (rate of interest) r:

Alternative A:

1000(1 + r)

3

= 1330

r = 9.9724%

Alternative B:

1000(1 + r)

5

= 1550

r = 9.1607%

Alternative C:

1000(1 + r)

5

= 425

_

1 +

1

1 + r

+

_

1

1 + r

_

2

+

_

1

1 + r

_

3

_

r = 8.5761%

Note: for C, the yield must be found numerically (eg. using uniroot in R)

R Code:

f = function(v) {

1000*(1/v)^5 - 425*(1+v+v^2+v^3)

}

v = uniroot(f,c(0,1)) # solve f = 0

v = v$root # keep only the numerical value

r = 1/v-1

(b) We need the accumulated value of $1330 at a rate r to be at least $1550:

1330(1 + r)

2

1550

1330r

2

+ 2660r 220 0

35

Financial Mathematics Exercises Actuarial Studies UNSW

For equality, we have:

r =

2660

2660

2

+ 4 1330 220

2660

= 0.079543 or 2.0795

r 7.9543%

We ask this question to compare A and B. If we chose A, then after 3 years, we

would need to invest the $1330 at some interest rate (eg. by putting the money in

the bank) for 2 years, after which it can be compared with the $1550 from B (at 5

years). Thus, we must be able to earn at least 7.95% during this 2 year period for

A to be a better choice than B.

(c) The value of alternative C is:

425

_

1 +

1

1 + r

+

_

1

1 + r

_

2

+

_

1

1 + r

_

3

_

= 1508.97

which is less than the value of B ($1550). Note that we have used the interest rate

from alternative C.

Exercise 1.16 [int20]

Equation of value:

P(v + v

2

+v

3

+ v

4

+v

5

) = 1000000

where v =

1

1.13

. Therefore, we obtain P = 284314.54.

Exercise 1.17 [int6]

d = 1 v = 0.06

v =

1

1+i

i =

1

v

1 = 0.06383

Also: i = d/v = 0.06383

Exercise 1.18 [int14]

(SOA Course 2 May 2001, Question 12)

Note the relationship between accumulating using eective interest and discount

rates:

1 + i = (1 d)

1

Thus:

X = 100[(1 d)

11

(1 d)

10

] = 50[(1 d)

17

(1 d)

16

]

For clarity, denote R = (1 d)

1

.

100R

10

(R 1) = 50R

16

(R 1)

2R

10

= R

16

R

6

= 2

R = 2

1/6

X = 100(R

11

R

10

) = 38.8793

36

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.19 [int24]

An equation of value to solve for the eective semi-annual interest rate i is

4843.30(1 + i)

4

= 6000

whose only positive solution is i = 0.055. The total value of the three payments at

the time the note matures is

1000(1.055)

3

+ 1000(1.055)

2

+ 2000(1.055) = 4397.27

so she will need a top up of $1602.73 to redeem the note for $6000.

Exercise 1.20 [int25]

Each deposit accumulates under simple interest for 1 month, then under compound

interest for the remaining quarters. Therefore, by the end of December 2005:

March deposit accumulates to:

1000

_

1 + 0.06

1

12

__

1 +

0.06

4

_

19

= 1333.59

June deposit accumulates to:

1000

_

1 + 0.06

1

12

__

1 +

0.06

4

_

18

= 1313.88

September deposit accumulates to

1000

_

1 + 0.06

1

12

__

1 +

0.06

4

_

17

= 1294.46

December deposit accumulates to

1000

_

1 + 0.06

1

12

__

1 +

0.06

4

_

16

= 1275.33

Therefore, the total interest would be:

1333.59 + 1313.88 + 1294.46 + 1275.33 4000 = 1217.25

Exercise 1.21 [int21]

Using the relations for equivalent rates

1 + i =

_

1 +

i

(m)

m

_

m

= (1 d)

1

=

_

1

d

(m)

m

_

m

= e

we have:

37

Financial Mathematics Exercises Actuarial Studies UNSW

Given rate Equivalent eective rate i A(4.5) = 10000(1 +i)

4.5

d = 0.05 0.0526316 12596.32

i

(2)

= 0.05 0.0506250 12488.63

i

(12)

= 0.05 0.0511619 12517.38

d

(2)

= 0.05 0.0519395 12559.10

d

(12)

= 0.05 0.0513809 12529.11

= 0.05 0.0512711 12523.23

R code:

i = c() # initialise vector

i[1] = (1-0.05)^(-1) - 1

i[2] = (1+0.05/2)^2 - 1

i[3] = (1+0.05/12)^12 - 1

i[4] = (1-0.05/2)^(-2) - 1

i[5] = (1-0.05/12)^(-12) - 1

i[6] = exp(0.05) - 1

rows = c("A","B","C","D","E","F") # row names

cols = c("i","A(4.5)") # column names

names = list(rows,cols) # create list of row/col names

matrix(c(i,10000*(1+i)^4.5),ncol=2,dimnames=names)

Exercise 1.22 [int22]

Note that the accumulation function is given by:

a(t) = exp

__

t

0

(s)ds

_

= exp

__

t

0

0.04

1 + s

ds

_

= (1 +t)

0.04

(a)

a(2) a(1)

a(1)

=

(3)

0.04

(2)

0.04

(2)

0.04

= 0.01635084

(b)

a(3) a(2)

a(2)

=

(4)

0.04

(3)

0.04

(3)

0.04

= 0.01157375

(c) Since A(t) = A(0)(1 + t)

0.04

, then A(0) =

200000

(5)

0.04

= 187530.19. Therefore:

A(2) =

200000

(5)

0.04

(3)

0.04

= 195954.86

Exercise 1.23 [int23]

We have

a(t) =

_

1 + 0.1t t k

(1 + 0.1k) exp [0.08(t k)] t > k

38

Financial Mathematics Exercises Actuarial Studies UNSW

Hence

a(4) =

_

(1 + 0.1k) exp [0.08(4 k)] k < 4

1.4 k 4

(a) To maximize a(4), dierentiate w.r.t. k (assuming a(4) = (1 + 0.1k)e

0.08(4k)

,

ie. k < 4; will need to check this)

d

dk

a(4) = 0.1 exp [0.08(4 k)] 0.08 (1 + 0.1k) exp [0.08(4 k)]

and set to be zero. Solving for k (and noting that the exponential is positive) we

have:

0.1 = 0.08 (1 + 0.1k)

k = 2.5

Check: at k = 2.5, a(4) > 1.4, so assumption of k < 4 is OK. Note that if the as-

sumption of k < 4 was violated, then a(4) = 1.4 as opposed to our earlier expression

of (1 + 0.1k)e

0.08(4k)

, and a(4) will have a maximum of 1.4 (at any k 4).

(b)

a(t) =

_

1 + 0.1t t 2.5

1.25e

0.08(t2.5)

t > 2.5

ln a(t) =

_

ln(1 + 0.1t) t 2.5

ln 1.25 + 0.08(t 2.5) t > 2.5

(t) =

d

dt

ln a(t) =

_

0.1

1+0.1t

t 2.5

0.08 t > 2.5

Exercise 1.24 [new10]

We use the result:

1 + i =

_

1 +

i

(m)

m

_

m

= (1 d)

1

=

_

1

d

(m)

m

_

m

= e

Therefore:

i

(m)

= m

_

e

/m

1

_

d

(m)

= m

_

e

/m

1

_

R code:

delta = 0.05

m = seq(0.5,50,length.out=1000)

im = m*(exp(delta/m)-1)

dm = -m*(exp(-delta/m)-1)

plot(m,im,type="l",ylim=c(0.045,0.055),

39

Financial Mathematics Exercises Actuarial Studies UNSW

main="Nominal Interest/Discount Rates",

xlab="Compounding Frequency",ylab="Nominal Rate")

lines(m,dm,col=2)

legend(50,0.055,c("i(m)","d(m)"),lty=c(1,1),col=c(1,2),xjust=1)

0 10 20 30 40 50

0

.

0

4

6

0

.

0

4

8

0

.

0

5

0

0

.

0

5

2

0

.

0

5

4

Nominal Interest/Discount Rates

Compounding Frequency

N

o

m

i

n

a

l

R

a

t

e

i(m)

d(m)

Note that = 0.05 and all the points on this plot yield the same eective rate of

interest!

Exercise 1.25 [ann1]

(a) R code:

a = function(n,i) (1-(1/(1+i))^n)/i

(b) Each monthly payment is

1

12

of the nominal amount. The eective monthly

rate i is given by:

i =

0.12

12

= 0.01

Therefore:

PV =

1000

12

a

72 0.01

+

_

1

1.01

_

72

400

12

a

48 0.01

+

_

1

1.01

_

120

2000

=

1000

12

_

1 (

1

1.01

)

72

0.01

_

+

_

1

1.01

_

72

400

12

_

1 (

1

1.01

)

48

0.01

_

+

_

1

1.01

_

120

2000

= 4262.50 + 618.34 + 605.99

= 5486.80

40

Financial Mathematics Exercises Actuarial Studies UNSW

R code (contd):

PV = 1000/12*a(72,0.01) + 400/12*a(48,0.01)/1.01^72 + 2000/1.01^120

Alternatively, we can obtain the annual eective rate j:

j = 1.01

12

1 = 0.1268

Then, using annuities payable monthly:

PV = 1000a

(12)

6

+

_

1

1 + j

_

6

400a

(12)

4

+

_

1

1 + j

_

10

2000

= 1000

_

1 v

6

j

0.12

_

+

_

1

1 + j

_

6

400

_

1 v

4

j

0.12

_

+

_

1

1 + j

_

10

2000

= 5486.80

(c) Assume level annuity payments payable monthly, then

X

_

1 (

1

1.01

)

120

0.01

_

= 5486.80

X = 78.720

The quoted annual payment is then 78.720 12 = 944.64.

R code (contd):

X = PV/a(120,0.01)

12*X

Exercise 1.26 [ann2]

The equation of value is based on the present value of the amount received by each

charity (which are known to be equal):

P

3

a

20

= v

20

Pa

P

3

_

1 v

20

i

_

= v

20

P

i

1 v

20

= 3v

20

v

20

= 0.25

i = (0.25)

1/20

1 = 0.07177

41

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.27 [ann3]

The accumulated value of the deposits 10 years after the rst deposit is:

AV = C s

10 0.06

= C(1.06)

10

_

1

_

1

1.06

_

10

0.06

_

= 13.1808C

The present value of the loan payments as at the end of 10 years is:

PV = 15000 a

5 0.06

= 15000

_

1

_

1

1.06

_

5

0.06

_

= 63185.4568

where we have used a rate of 6% because that is the amount paid by the account

(so the remaining funds in the bank will be earning 6% between years 10 and 15).

Equating these values and solving for C, we obtain C = 4793.75.

Exercises 1.281.34

[annB1annB7] See the Mathematics of Investment and Credit solutions manual.

Exercise 1.35 [ann4]

The original and nal monthly eective interest rates i and j are given by:

(1 + i)

12

= 1.03 i = 0.00246627

(1 + j)

12

= 1.05 j = 0.00407412

The original monthly payment P is given by:

Pa

300 i

= 100000 P =

100000

a

300 i

= 472.1087

After 10 years, the remaining value of the annuity is:

Pa

180 i

This will also be the present value of the new annuity (with annual payments of P

),

which is valued at the new interest rate j:

Pa

180 i

= P

a

180 j

Therefore, the new payment is:

P

= P

a

180 i

a

180 j

= 538.1869

Thus, the payment increase is:

P

P = 66.08

42

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.36 [ann5]

The 1-year eective rate i and 2-year eective rate j are given by:

i = 1.025

2

1 = 0.050625

j = 1.025

4

1 = 0.103813

By drawing a cash ow diagram, it can be seen that the cash ow stream is a 20-year

annuity with annual payments of $100, plus an additional $100 every 2nd year (ie.

an additional 20-year annuity with biannual payments of $100). Thus:

PV = 100a

20 i

+ 100a

10 j

= 1844.16

Exercise 1.37 [ann6]

A discount rate of 10% p.a. is equivalent to an interest rate of i = 11.11% p.a.

Therefore, the current cash ows are worth:

18000 a

12 i

= 18000 (1 +a

11 i

) = 129162.10

We want annual payments of X where:

129162.10 = Xa

20 i

X = 16337.69

Exercise 1.38 [ann7]

See solutions manual. For 5 years, monthly payment required is 296.94.

Exercises 1.391.40

[annB8annB9] See the solutions in the Broverman text and solutions manuals.

Exercise 1.41 [ann13]

s

10

is the accumulated value (at time 10) of $1 paid at each time t = 1, . . . , 10. The

accumulated value (at time 10) of a single $1 paid at time n is given by:

exp

__

10

n

1

20 t

dt

_

= exp [ln(20 10) + ln(20 n)]

= exp

_

ln

_

20 n

10

__

=

20 n

10

Therefore:

s

10

=

10

n=1

20 n

10

=

19 + 18 +. . . + 10

10

= 20

1

10

10(10 + 1)

2

= 14.5

43

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.42 [ann8]

The loan repayments are an increasing annuity with payments of P, 2P, . . . , 30P at

times t = 1, 2, . . . , 30. To determine the value of P, we use an equation of value (at

time t = 0):

4000 = P(Ia)

30 0.04

=

_

a

30 0.04

30v

30

0.04

_

P = 18.32

Immediately after the ninth payment, the outstanding loan is found by decomposing

the remaining payments into a level annuity and an increasing annuity:

10Pv + 11Pv

2

+ 12Pv

3

+... + 30Pv

21

= 9Pa

21 0.04

+P(Ia)

21 0.04

= 4774.80

This is greater than the original loan amount, and is because the earlier payments

are (very) small relative to the latter payments. Therefore, the earlier payments are

insucient to pay o the interest, let alone pay o part of the principal. Hence, this

is also unlikely to exist in reality.

Exercise 1.43 [ann9]

The borrowings are a decreasing annuity, whereas the repayments can be decom-

posed into a level annuity of $300 and an increasing annuity starting at $200. An

equation of value (at the end of year when nal loan amount is received) is:

X(Ds)

5 0.05

(1 + i) = 300a

15 0.05

+ 200(Ia)

15 0.05

Noting that:

a

15 0.05

= 10.379658

(Ia)

15 0.05

=

a

15 0.05

15v

15

0.05

= 73.667689

(Ds)

5 0.05

= (1 +i)

5

(Da)

5 0.05

= (1 +i)

5

[6a

5 0.05

(Ia)

5 0.05

]

= (1 +i)

5

_

6a

5 0.05

a

5 0.05

5v

5

0.05

_

= 17.115531

We obtain:

X =

300a

15 0.05

+ 200(Ia)

15 0.05

(Ds)

5 0.05

(1 + i)

= 993.11

Exercise 1.44 [ann12]

The annual eective rate i is given by:

1 + i = 1.025

4

i = 0.103813

44

Financial Mathematics Exercises Actuarial Studies UNSW

For convenience, we will determine the initial deposit by discounting all cash ows

to time t = 0 (1/1/2004).

The entire series of deposits can be decomposed into two series:

A. Deposits of X, 1.1025X, . . . , (1.1025)

10

X at times t = 0, 1, . . . , 10

B. Deposits of 1.1025X, (1.1025)

2

X, . . . , (1.1025)

11

X at times t =

1

2

, 1

1

2

, . . . , 10

1

2

where time t is measured in years.

These two series are (geometrically) increasing annuities, and can be present valued

as geometric progressions:

PV

A

= X + 1.1025Xv +. . . + (1.1025)

10

Xv

10

= X

_

1 (1.1025v)

11

1 1.1025v

_

= 10.934815X

PV

B

= v

1/2

(1.1025)

_

X + 1.1025Xv +. . . + (1.1025)

10

Xv

10

= v

1/2

(1.1025) PV

A

= 11.474726X

Therefore, the initial deposit X is found as follows:

PV

A

+ PV

B

= 110000v

11

X = 1656.19

Exercise 1.45 [new8]

The present value is $3311.51.

R code:

i = 0.05

v = 1/(1+i)

t = 1:30

X = t^3 + log(10*t+12)

sum(X*v^t)

Exercise 1.46 [ann14]

There are a number of ways to decompose the payments into annuity streams, which

allow the present value to be determined more easily.

A simple method is to consider 3 cash ow streams, each containing payments 1

year apart (which also means we will use the annual eective rate of 0.10):

A. 10, 20, 30, 40 at times t =

1

3

, 1

1

3

, 2

1

3

, 3

1

3

45

Financial Mathematics Exercises Actuarial Studies UNSW

B. 20, 30, 40, 50 at times t =

2

3

, 1

2

3

, 2

2

3

, 3

2

3

C. 30, 40, 50, 60 at times t = 1, 2, 3, 4

Each of these streams is the combination of an increasing annuity and a level annuity.

Therefore:

PV

A

= 10v

1/3

(I a)

4

PV

B

= 10v

2/3

(I a)

4

+ 10v

2/3

a

4

PV

C

= 10v(I a)

4

+ 20v a

4

The annuity factors are given by:

(I a)

4

= v + 2v

2

+ 3v

3

+ 4v

4

= 8.302780

a

4

= (1.1)

_

1 v

4

0.1

_

= 3.486852

Therefore, we obtain the present value:

PV

A

+ PV

B

+PV

C

= 329.95

A more elegant method involves decomposing the original payments into:

X. 10,20,30,. . . ,10,20,30 at all times (t =

1

3

,

2

3

, 1, . . . , 4)

Y. 0,0,0,10,10,10,. . . ,30,30,30 at all times (t =

1

3

,

2

3

, 1, . . . , 4)

The payments of X can be grouped by year, resulting in four payments of (10,20,30).

Thus, X is a 4-year level annuity-due, with each payment being an increasing annu-

ity:

PV

X

= 10(Ia)

3 j

a

4 i

= 194.3179

where i = 0.1 is the annual eective rate, and j = (1.1)

1/3

1 is the

1

3

-year eective

rate.

Conversely, the payments of Y can are a 3-year increasing annuity, with each pay-

ment being a level annuity (omitting the rst three payments of 0):

PV

Y

= 10a

3 j

(Ia)

3 i

= 135.6289

Summing these up, we obtain the same present value:

PV

X

+PV

Y

= 329.95

46

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 1.47 [ann15]

The present value (at time t = 0) of the rst ten payments is:

P(Ia)

10 0.07

The present value (at time t = 10) of the last ten payments is:

10(10P) = 100P

since each payment is discounted at the same rate as the payment growth rate (each

payment is of amount 10(1.05)

n

P which is worth 10(1.05)

n

Pv

n

at time t = 10, and

v

n

= (1.05)

n

cancels with the factor (1.05)

n

).

Therefore, the present value of all payments at time t = 0 is:

P(Ia)

10 0.07

+ 100P(1.07)

10

= 50000

Since (Ia)

10 0.07

= 34.739133, we get:

P = 584.29

Exercise 1.48 [new4]

(a) Let the annual payment be X. Therefore:

Xa

20 0.05

= 10000

X = 802.4259

R code:

v = 1/1.05

X = 10000/sum(v^(1:20))

(b) Let the rst annual payment be X. Therefore:

(1.03)Xv + (1.03)

2

Xv

2

+ . . . + (1.03)

20

Xv

20

= 10000

1.03Xv

_

1 (1.03v)

20

1 1.03v

_

= 10000

X = 608.1346

R code:

v = 1/1.05

X = 10000/sum((1.03*v)^(1:20))

47

Financial Mathematics Exercises Actuarial Studies UNSW

(c) To be fair, we need the present value of both payment streams to be equal (to

10000).

In nominal terms:

20

k=1

608.13(1.03)

k

v

k

0.05

=

20

k=1

802.43v

k

0.05

= 10000

or in real terms:

20

k=1

608.13v

k

r

=

20

k=1

802.43(1.03)

k

v

k

r

= 10000

where r =

1.05

1.03

1.

Exercise 1.49 [new1]

(a) The annual eective interest rate is i = e

1 = 0.05127.

We note that the payment at time n is 1+2+. . .+n. Therefore, the perpetuity

can be decomposed into a level perpetuity of 1 (1st payment at time 1), plus a

level perpetuity of 2 (1st payment at time 2), etc. This can be interpreted as

an increasing perpetuity, with each regular payment being a level perpetuity

itself:

PV = v a

+ 2v

2

a

+ 3v

3

a

+ . . .

= a

_

v + 2v

2

+ 3v

3

+. . .

_

= a

(Ia)

Therefore:

PV =

_

1

d

__

a

i

_

=

1

d

2

i

= 8820

where d = iv = 0.04877.

(b) R code:

n = 1:500

x = n*(n+1)/2 # sum of an AP: 1+2+...+n

v = 1/1.05

y = x*v^n

sum(y)

plot(n, y, xlab="Time", ylab="PV of payment")

48

Financial Mathematics Exercises Actuarial Studies UNSW

0 100 200 300 400 500

0

2

0

4

0

6

0

8

0

1

0

0

1

2

0

Time

P

V

o

f

p

a

y

m

e

n

t

Aside: The graph is actually related to the Gamma function. The present value of

the nth payment is:

1

2

n

2

v

n

+

1

2

nv

n

=

1

2

n

2

e

n

+

1

2

ne

n

Thus, we require:

n=1

n

2

e

n

and

n=1

ne

n

These can be approximated using the Gamma function by noting that:

(k) = (k 1)! =

_

0

x

k1

e

x

dx

k=1

x

k1

e

x

Therefore, the present value is:

PV =

1

2

_

n=1

n

2

e

n

+

n=1

ne

n

_

1

2

__

0

x

2

e

x

dx +

_

0

xe

x

dx

_

=

1

2

_

1

3

_

0

u

2

e

u

du +

1

2

_

0

ue

u

du

_

where u = x

=

1

2

_

2!

3

+

1!

2

_

49

Financial Mathematics Exercises Actuarial Studies UNSW

The force of interest is = ln 1.05 = 0.04879, which results in:

PV 8820.04

Exercises 1.501.57

[annB10annB15] See the solutions in the Broverman text and solutions manuals.

Exercise 1.58 [new2]

We require 100(Ia)

10

, 100(Ia)

(12)

10

, and 100(I a)

10

. The monthly eective rate is:

j = (1 +i)

1/12

1 = 0.004074

and therefore the nominal rate (payable monthly) is:

i

(12)

= 12j = 0.04889

The force of interest is:

= ln(1 +i) = 0.04879

Therefore:

100(Ia)

10

=

a

10

10v

10

i

= 39.3738

100(Ia)

(12)

10

=

a

(12)

10

10v

10

i

(12)

= 44.0352

100(I a)

10

=

a

10

10v

10

= 40.3501

Exercise 1.59 [ann11]

The present value of the annuity is given by:

PV =

_

14

1

(t

2

1)v

t

dt

where the discount factor v

t

varies (continuously) with time t:

v

t

= exp

_

_

t

0

1

1 + s

ds

_

= exp (ln(1 + t)) =

1

1 + t

Therefore, we have:

PV =

_

14

1

t

2

1

t + 1

dt =

_

14

1

(t 1)dt = 84.50

50

Financial Mathematics Exercises Actuarial Studies UNSW

7.2 Module 2

Exercise 2.1 [lif1]

Note that if the force of mortality is constant, then the survival function is expo-

nential:

t

p

x

= exp

_

_

t

0

x+s

ds

_

= e

t

Therefore:

E[Z] =

_

0

b

t

v

t

t

p

x

x+t

dt

=

_

0

e

0.05t

e

0.06t

e

0.01t

0.01dt

= 0.01

_

0

e

0.02t

dt

=

1

2

E[Z

2

] =

_

0

e

0.1t

e

0.12t

e

0.01t

0.01dt

= 0.01

_

0

e

0.03t

dt

=

1

3

Var(Z) = E[Z

2

] (E[Z])

2

=

1

3

1

4

=

1

12

Exercise 2.2 [lif2]

Writing out the (contingent) annuity-certain in terms of the interest rate:

k=0

a

k+1

k

p

x

q

x+k

=

k=0

_

1 v

k+1

d

_

k

p

x

q

x+k

This gives us a v term, which is similar to the RHS. We dont want the q, so we

write it in terms of p:

51

Financial Mathematics Exercises Actuarial Studies UNSW

=

k=0

_

1 v

k+1

d

_

k

p

x

(1 p

x+k

)

=

k=0

_

1 v

k+1

d

_

(

k

p

x

k+1

p

x

)

=

1

d

_

k=0

(

k

p

x

k+1

p

x

)

k=0

v

k+1

(

k

p

x

k+1

p

x

)

_

=

1

d

__

k=0

k

p

x

k=1

k

p

x

_

v

k=0

v

k

k

p

x

+

k=0

v

k+1

k+1

p

x

_

=

1

d

_

1 v

k=0

v

k

k

p

x

+

k=1

v

k

k

p

x

_

=

1

d

_

v

k=0

v

k

k

p

x

+

k=0

v

k

k

p

x

_

since v

0

0

p

x

= 1. Therefore:

=

1 v

d

k=0

v

k

k

p

x

=

k=0

v

k

k

p

x

The LHS is an annuity certain with a term equal to the future lifetime of the

individual. The RHS considers each annual payment separately, noting that the

individual will receive it if he/she is alive. Both describe the cash ows of a term

annuity, and therefore they must be equal.

Exercise 2.3 [lif3]

Let K(x) be the curtate lifetime random variable of (x). We have:

a

x

= E

_

a

K(x)+1

_

=

k=0

a

k+1

Pr [K(x) = k]

=

k=0

a

k+1

k|

q

x

=

k=0

_

1 v

k+1

d

_

k|

q

x

=

1

d

_

k=0

k|

q

x

k=0

v

k+1

k|

q

x

_

=

1 A

x

d

52

Financial Mathematics Exercises Actuarial Studies UNSW

d a

x

+ A

x

= 1

Exercise 2.4 [lif4]

The required values are:

Pr[K(0) = k] =

k

p

0

q

k

= {0.1, 0.045, 0.0855, 0.1539, 0.2462, 0.2586, 0.1108, 0} for k = 0, . . . , 7

e

0

= E[K(0)] =

6

k=0

k Pr[K(0) = k]

= 3.6203

Pr[K(2) = k] =

k

p

2

q

2+k

= {0.1, 0.18, 0.288, 0.3024, 0.1296, 0} for k = 0, . . . , 5

e

2

= E[K(2)] =

4

k=0

k Pr[K(2) = k]

= 2.1816

A

2

=

4

k=0

v

k+1

Pr[K(2) = k]

= 0.8576

2

A

2

=

4

k=0

v

2(k+1)

Pr[K(2) = k]

= 0.7379

A

1

2:3

=

2

k=0

v

k+1

Pr[K(2) = k]

= 0.5073

A

1

2:3

= v

3

3

p

2

= 0.3732

A

2:3

= A

1

2:3

+ A

1

2:3

= 0.8805

a

2

=

4

k=0

v

k

k

p

2

= 2.9900

a

2

= a

2

1 = 1.9900

a

2:3

=

2

k=0

v

k

k

p

2

= 2.5102

R code:

v = 1/1.05

x = 0:6

53

Financial Mathematics Exercises Actuarial Studies UNSW

q = c(0.1, 0.05, 0.1, 0.2, 0.4, 0.7, 1)

kp0 = c(1,cumprod(1-q)) # k = 0,1,...,6

kp2 = c(1,cumprod(1-q[3:7])) # k = 0,1,...,4

# Values based on individual starting at age 0

k = 0:6

PrK0 = kp0[1+k]*q[1+k]

e0 = sum(k*PrK0)

# Values based on individual starting at age 2

k = 0:4

PrK2 = kp2[1+k]*q[1+(k+2)]

e2 = sum(k*PrK2)

A2 = sum(v^(k+1)*PrK2)

A22 = sum(v^(2*(k+1))*PrK2)

A123 = sum(v^(0:2+1)*PrK2[1+0:2])

A231 = v^3*kp2[1+3]

A23 = A123 + A231

a2d = sum(v^k*kp2[1+k])

a2i = a2d - 1

a23 = sum(v^(0:2)*kp2[1+0:2])

Exercise 2.5 [lif5]

Let T = T(x) be the (random) lifetime of the non-smoker and T

S

= T

S

(x) be the

lifetime of the smoker. We want to nd:

Pr

_

T

S

> T

_

=

_

0

Pr

_

T

S

> t

_

f

T

(t) dt

where we have conditioned on the future lifetime T to construct the integral.

Note that:

Pr

_

T

S

> t

_

=

t

p

S

x

= exp

_

_

t

0

c

x+u

du

_

= (

t

p

x

)

c

where

t

p

x

= Pr(T > t). Also, the density of T is given by:

f

T

(t) =

d

dt

F

T

(t) =

d

dt

(1 S(t)) =

d

dt

t

p

x

since the survival function S(t) is equivalent to

t

p

x

. Therefore:

Pr

_

T

S

> T

_

=

_

0

(

t

p

x

)

c

(

t

p

x

)

dt

=

_

(

t

p

x

)

c+1

c + 1

_

0

=

1

1 + c

The answer is reasonable because:

54

Financial Mathematics Exercises Actuarial Studies UNSW

If c = 1, then the two lives are identical so the probability should be 1/2

(which is the case here)

If c > 1 (as it is assumed), then the mortality of the smoker is higher, so the

probability that he outlives the non-smoker should be less than 1/2 (which is

also the case here)

Exercise 2.6 [new7]

(a) The survival probabilities can be found using integration:

S

x

(t) = exp

_

_

x+t

x

A +Bc

y

dy

_

R code:

A = 0.0003225

B = 0.000031

c = 1.0966413

mu = function(x) { A + B*c^x }

# Get survival probabilities

S65 = c()

for(t in 1:45) {

S65[t] = exp(-integrate(mu,65,65+t)$value)

}

plot(S65, xlab="Years", ylab="Probability",

main="Survival Probabilities for 65 year old")

55

Financial Mathematics Exercises Actuarial Studies UNSW

0 10 20 30 40 50

0

.

0

0

.

2

0

.

4

0

.

6

0

.

8

1

.

0

Survival Probabilities for 65 year old

Years

P

r

o

b

a

b

i

l

i

t

y

(b) The annual payment X is given by:

Xa

65

= 1, 000, 000

where:

a

65

=

t=1

v

t

t

p

65

R code (contd):

i = 0.05

v = 1/(1+i)

t = x-65+1

a65 = sum(v^t * S65[t])

X = 1000000/a65

The annual payment is X = 88817.64.

(c) The value of X is given by:

(1 + f)Xvp

65

+ (1 + f)

2

Xv

2

2

p

65

+. . . = 1, 000, 000

or:

X

t=1

(1 + f)

t

v

t

t

p

65

= 1, 000, 000

R code (contd):

f = 0.03

X = 1000000/sum((1+f)^t * v^t * S65[t])

The answer is X = 65577.37.

56

Financial Mathematics Exercises Actuarial Studies UNSW

7.3 Module 3

Exercise 3.1 [loa1]

(a) The repayments involve annual payments (in arrears) of X, ie. an annuity-

immediate:

Xa

5

= 15000

X = 3464.62

(b) The retrospective method considers the accumulated value of past cash ows:

OB

2

= 15000(1.05)

2

Xs

2

= 9435.02

(c) The prospective method considers the present value of future cash ows:

OB

2

= Xa

3

= 9435.02

(d) Let the new annual payment be Y . The new future repayments must be able

to repay the outstanding balance calculated in (b) and (c). Therefore:

Y a

3 0.075

= OB

2

= 9435.02

Y = 3628.12

(e) Let the renegotiated payment be Z. We have:

Za

4 0.076

= OB

2

= 9435.02

Z = 2823.31

(f) See the tutorial solution spreadsheet (loa1.xls).

The loan schedule can also be performed in R using the following code:

# Calculated values

X = 15000/(1-(1/1.05)^5)*0.05

OB2 = X*(1-(1/1.05)^3)/0.05

Z = OB2/(1-(1/1.076)^4)*0.076

# Initialise interest rate and repayments

i = c(rep(0.05,2),rep(0.076,4))

X = c(rep(X,2),rep(Z,4))

OB0 = 15000

# Initialise vectors (and first year)

I = OB0*i[1]

57

Financial Mathematics Exercises Actuarial Studies UNSW

PR = X[1]-I[1]

OB = OB0-PR[1]

# Calculate other years recursively

for(t in 2:6) {

I[t] = OB[t-1]*i[t]

PR[t] = X[t]-I[t]

OB[t] = OB[t-1]-PR[t]

}

# Create and display loan schedule

sched = data.frame(Repayment = X, I = I, PR = PR, OB = OB)

round(sched,2)

Exercise 3.2 [loa2]

(a) The annual payment consists of two components: the interest repayment, and

the payment into the sinking fund. The interest payment is simply 7% of the

loan:

20000(0.07) = 1400

The sinking fund payment is an amount X such that the sinking fund will

accumulate to the $20000 principal after 6 years:

Xs

6 0.05

= 20000

X = 2940.35

Therefore, the annual repayment is:

1400 + 2940.35 = 4340.35

(b) Similarly to (a), we have:

Xs

6 0.07

= 20000

X = 2795.92

Therefore, the annual repayment is 4195.92.

(c) The standard loan arrangement would require annual payments of $4195.92 as

the two methods are equivalent when the sinking fund and loan interest rates

are the same. Hence, we would prefer the standard loan arrangement, as it

involves lower annual repayments. In general, the standard loan is preferable

if the sinking fund rate is below the loan interest rate (which is usually true

loan interest rate higher than savings interest rate).

(d) See the tutorial solution spreadsheet (loa2.xls).

The loan schedule can also be performed in R using the following code:

58

Financial Mathematics Exercises Actuarial Studies UNSW

# Initialise values

i = 0.07

j = 0.05

X = 20000/((1+j)^6-1)*j

Y = 1400+X

# Loan repayments

OB = 20000

I = i*OB

PR = 0

# Sinking fund: initialise vectors

SFA0 = 0

SFP = Y-I

SFI = 0

SFA = SFP + SFI

# Recursive relations

for(t in 2:6) {

SFI[t] = SFA[t-1]*j

SFA[t] = SFA[t-1]+SFP+SFI[t]

}

# Create and display loan schedule

sched = data.frame(Repayment = Y, I = I, PR = PR, OB = OB,

SFPayment = SFP, SFInterest = SFI, SFAcc = SFA)

round(sched,2)

Exercise 3.3 [loa3]

(a) Total interest to be repaid:

I = Lfn = 5000 0.10 2 = 1000

Monthly loan repayments are:

R =

L +I

N

=

6000

24

= 250

The monthly eective rate j is the solution to the following equation of value:

Ra

24 j

= 5000

Using Newton-Raphson, we dene the function f as follows:

f(j) = Ra

24 j

5000 = 250

_

1 (1 + j)

24

j

_

5000

The derivative is:

f

(j) = 250

_

24j(1 + j)

25

(1 (1 + j)

24

)

j

2

_

59

Financial Mathematics Exercises Actuarial Studies UNSW

Starting with j

0

= 0.10:

j

1

= j

0

f(j

0

)

f

(j

0

)

= 0.062716

j

2

= j

1

f(j

1

)

f

(j

1

)

= 0.022528

j

3

= j

2

f(j

2

)

f

(j

2

)

= 0.004878

j

4

= j

3

f(j

3

)

f

(j

3

)

= 0.014291

j

5

= j

4

f(j

4

)

f

(j

4

)

= 0.015125

This results in an annual eective rate i of:

i = (1 +j

5

)

12

1 = 19.74%

Using R:

# Define f and f (both expression and function)

f_expr = expression(250*(1-1/(1+j)^24)/j - 5000)

Df_expr = D(expr)

f = function(j) eval(f_expr,list(j=j))

Df = function(j) eval(Df_expr,list(j=j))

# Newton-Raphson

j = 0.1 # first estimate

numit = 10 # number of iterations

for(k in 2:numit) {

j[k] = j[k-1] - f(j[k-1])/Df(j[k-1])

}

j[numit]

# Convert to annual effective rate

(1+j[numit])^12 - 1

The solution is j = 0.015131. Therefore, the eective annual rate i is:

i = (1 +j)

12

1 = 19.75%

(b) The outstanding balance (using the prospective method) is:

250a

12 j

= 2724.66

Exercises 3.43.6

[loaB3loaB5] See the Mathematics of Investment and Credit solutions manual.

60

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 3.7 [loa5]

The eective monthly rate is

0.18

12

= 0.015. Therefore, the monthly repayment X is

given by:

Xa

100 0.015

= 20000 X = 387.41

As we are only required to provide the last four instalments (ie. 97th100th pay-

ments), we can begin the loan schedule at time t = 96 (months). The outstanding

balance at time t = 96 is:

OB

96

= Xa

4 0.015

= 1493.23

The loan schedule for times t = 97, . . . , 100 can then be found using the following

recursive equations:

I

t

= OB

t1

0.015

PR

t

= X I

t

OB

t

= OB

t1

PR

t

Therefore, we obtain:

Time Interest Principal Repaid Outstanding Balance

(t) (I

t

) (PR

t

) (OB

t

)

96 ? ? 1493.23

97 22.40 365.01 1128.22

98 16.92 370.49 757.73

99 11.37 376.05 381.69

100 5.73 381.69 0

The full loan schedule is shown in the tutorial spreadsheet provided (loa5.xls).

The loan schedule can be performed in R using the following code:

# Setup values from previous sections

i = 0.18/12

v = 1/(1+i)

X = 20000/(1-v^100)*i

OB96 = X*(1-v^4)/i

# Initialise vectors (and first year)

I = OB96*i

PR = X-I[1]

OB = OB96-PR[1]

# Recursive relations

for(t in 2:4) { # 2,3,4 corresponding to 98,99,100

I[t] = OB[t-1]*i

PR[t] = X-I[t]

OB[t] = OB[t-1]-PR[t]

61

Financial Mathematics Exercises Actuarial Studies UNSW

}

# Create and display loan schedule

sched = data.frame(Time = 97:100, I = I, PR = PR, OB = OB)

round(sched,2)

Exercise 3.8 [loa6]

The present value of the original four loans is:

PV = 4.36a

11 0.01

+ 17.2a

15 0.01

+ 35a

12 0.01

+ 20.24a

18 0.01

= 1009.51

The total (sum) payments is:

11 (4.36) + 15 (17.2) + 35 (12) + 18 (20.24) = 1090.28

For the new consolidated loan, denote the term to run (in months) as n. Since

n must be an integer, the consolidated loan cannot have level repayments with a

further restriction that these repayments must sum to the original total (1090.28).

Therefore, the loan will be assumed to involve monthly repayments of X, with an

additional nal payment of Y to account for any remaining outstanding balance.

We have two equations to describe the two constraints (repayments must sum to

original total; eective rate must remain the same):

nX + Y = 1090.28

Xa

n 0.01

+Y v

n+1

= 1009.51

Here, we have three variables and two equations. Therefore, we must x one variable,

after which we can determine the other two as a function of the rst variable. A

logical choice would be to set n to dierent values (as it has to be an integer) and

get X and Y by solving the simultaneous equations (noting that the coecients

n, v

n+1

, a

n 0.01

are all known once n is known). Here are the results for various

choices of n:

n X Y

11 95.43 40.60

12 88.53 27.90

13 82.60 16.53

14 77.43 6.22

15 72.90 -3.25

16 68.89 -12.03

17 65.32 -20.24

18 62.13 -27.99

Intuitively, the nal payment should not be negative and should be as small as

possible as it represents an extra top-up payment to ensure the loan is fully repaid

to the nearest cent. The purpose of the nal payment is not to repay a signicant

62

Financial Mathematics Exercises Actuarial Studies UNSW

portion of the loan. Hence, the solution where n = 14 is the most appropriate, and

so we choose n = 14 with X = 77.43 and Y = 6.22. In other words, the consolidated

annuity is of $77.43 for 14 months, with a nal payment of $6.22 at the end of 15th

month.

Note: the necessity of the nal payment Y can be veried by observing (from the

table) that there is no solution where n is an integer and Y = 0.

The table was produced using the following R code:

# Initialise values

i = 0.01

a = function(n,i) (1-(1/(1+i))^n)/i # annuity-immediate

pmt = c(4.36,17.2,35,20.24)

num = c(11,15,12,18)

PV = sum(pmt*a(num,i)) # present value of payments

S = sum(pmt*num) # sum of payments

# Try n = 11,...,18

n = 11:18

table = matrix(NA,length(n),2,dimnames=list(n,c("X","Y")))

for(k in 1:length(n)) {

# Solve linear system: Ax=b

A = matrix(c(n[k],1,a(n[k],i),v^(n[k]+1)),ncol=2,nrow=2,byrow=TRUE)

b = c(S,PV)

x = solve(A) %*% b

table[k,] = x

}

round(table,2)

Exercise 3.9 [loa7]

The initial payment X can be found as follows, noting the monthly eective rate is

0.12

12

= 0.01:

Xa

12 0.01

+ (1.1)Xv

12

a

12 0.01

+ (1.1)

2

Xv

24

a

12 0.01

= 47500

X = 1440.80

The loan schedule is shown in the tutorial spreadsheet provided (loa7.xls).

The loan schedule can be performed in R using the following code:

# Initialise values

i = 0.01

v = 1/(1+i)

X = 47500 / ((1-v^12)/i) / (1 + 1.1*v^12 + 1.1^2*v^24)

Y = X*c(rep(1,12),rep(1.1,12),rep(1.1^2,12))

OB0 = 47500

63

Financial Mathematics Exercises Actuarial Studies UNSW

# Initialise vectors (and first year)

I = OB0*i

PR = Y[1]-I[1]

OB = OB0-PR[1]

# Recursive relations

for(t in 2:36) {

I[t] = OB[t-1]*i

PR[t] = Y[t]-I[t]

OB[t] = OB[t-1]-PR[t]

}

# Create and display loan schedule

sched = data.frame(Repayment = Y, I = I, PR = PR, OB = OB)

round(sched,2)

Exercise 3.10 [loa8]

(a) Let X be the annual payment. We have:

Xa

10 0.0675

= 600000 X = 84441.97

Hence total payment is 10X = 844419.69.

(b) Let Y be the monthly payment. The monthly eective rate i is given by:

1 + i = (1.0675)

1/12

i = 0.005458

Therefore:

Y a

120 i

= 600000 Y = 6828.08

Hence the total payment is 120Y = 819369.39, which is 25050.30 less than the

total payment in (a).

(c) The amount to settle the loan is the outstanding balance at time t = 5. This

will not change when the interest rate changes, as the outstanding balance

is determined from the past (ie. using the recursive relationships of a loan

schedule). Therefore, the amount will be OB

5

under the old interest rate of

6.75%:

OB

5

= Xa

5 0.0675

= 348558.74

Note that this implies the prospective method (based on the future) becomes

incorrect when interest rates change, while the retrospective method (based

on the past) remains correct. If we used the prospective method, we would

have calculated an outstanding balance of:

Xa

5 0.0725

= 343923.44

This is the present value of future repayments (as payments now have to be

discounted at the new rate), but it is not the outstanding balance.

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Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 3.11 [loa4]

Note that we cannot nd a solution analytically due to the complexity of the loan

(dierent period for interest and principal (re)payments; non-equal actual pay-

ments). Therefore, we will model the loan using a spreadsheet (loa4.xls).

The time step will be one quarter, ie. t = 0,

1

4

, . . . , 19. The interest (I

t

), principal re-

paid (PR

t

) outstanding balance (OB

t

), and nominal/actual payments (NPR

t

, APR

t

)

are described using a set of recursive relationships:

I

t

= OB

t

1

4

0.02

PR

t

= APR

t

I

t

OB

t

= OB

t

1

4

PR

t

NPR

t

=

75000

15

= 5000 (t = 5, 6, . . . , 19)

APR

t

= 5000 (t = 5, 6, . . . , 19)

where we note that the quarterly eective interest rate is

0.08

4

= 0.02, and the

nominal and actual payments are equal since the loan is repaid at par.

The net cash ows received by the purchaser are the payments of interest (I

t

) and

principal (APR

t

). The price for a required eective yield i is found by discounting

these cash ows at the rate i. Therefore:

P =

t

_

1

1 + i

_

t

(I

t

+ APR

t

)

where the summation is taken over t = 0,

1

4

, . . . , 19.

For i = 0.10, the price is P = 66636.60.

For i =

_

1 +

0.10

2

_

2

1 = 0.1025, the price is P = 65565.63.

Exercise 3.12 [loa9]

This question requires a spreadsheet model due to the complexity of the capital

gains tax. A spreadsheet model can be setup using the standard recursive formulae,

along with the following formulae for tax purposes:

IT

t

=

I

I

t

CGT

t

= (

CG

CG

t

)

+

=

CG

_

APR

t

NPR

t

500000

P

_

+

The capital gain is determined as the actual repayment less the purchase price. The

portion of the loan repaid by APR

t

is

NPR

t

500000

of the entire loan, and this portion of

the loan was purchased at a price of

NPR

t

500000

P.

The price is the present value of the net cash ows at the eective yield of 6%:

P =

t

v

t

CF

t

=

t

v

t

(APR

t

+I

t

IT

t

CGT

t

)

65

Financial Mathematics Exercises Actuarial Studies UNSW

The spreadsheet model can be found in loa9.xls. The solution is (a) $439,608.30 and

(b) $538,334.94.

Note that each component of the price can be expressed as follows (where i = 0.06):

t

v

t

APR

t

= 25000(1.05)v

10

a

10

t

v

t

(I

t

IT

t

) = (1

I

) (0.08)

t

v

t

OB

t

1

4

t

v

t

CGT

t

= 0.3

_

25000(1.05)

25000

500000

P

_

+

v

10

a

10

where:

t

v

t

OB

t

1

4

= 500000a

(4)

10

+ 475000v

10

a

(4)

1

+. . . + 25000v

28

a

(4)

1

= 500000a

(4)

10

+ 25000v

10

a

(4)

1

(Da)

(4)

19

The modelling can be performed in R using the following code:

# Initialise values

L = 500000

j = 0.06

v = 1/(1+j)

Time = seq(0,29,by=0.25)

n = length(Time)

taxI = 0.4 # also taxI = 0.2

taxCG = 0.3

# Simple function to convert from time(s) to index

ind = function(x) {

ind = c()

for(y in x) {ind = c(ind,which(Time==y))}

ind

}

# Setup values for interest rates and principal repaid

i = 0.02

R = 1.05

NPR = rep(0,n)

NPR[ind(10:29)] = L/20

APR = NPR*R

# Squared difference between price and PV(cash flows)

# (as a function of the price P)

# Aim is to minimise this function (set to 0)

# Note: "<<-" is used to make sure the values remain assigned even

66

Financial Mathematics Exercises Actuarial Studies UNSW

# after the function has ended

temp = function(P) {

# Initialise vectors (t = 0)

OB <<- L

I <<- 0

# Recursive relations

for(t in 2:n) { # t = 0.25, ..., 29

I[t] <<- OB[t-1]*i

OB[t] <<- OB[t-1]-NPR[t]

}

# Tax

IT <<- taxI * I

CGT <<- taxCG * (APR - NPR/L * P)

CGT <<- pmax(CGT,0)

# Cash flows and present value (at reqd yield)

CF <<- I+APR-IT-CGT

PVCF <<- CF*v^Time

# Squared difference (to ensure non-negative)

(P - sum(PVCF))^2

}

# Minimise by changing P over sufficiently large range (0,2L)

opt = optimize(temp,c(0,2*L))

P = opt$minimum # get P corresponding to minimum

print(round(P,2),digits=20)

# Create and display loan schedule

sched = data.frame(NPR,APR,I,OB,IT,CGT,CF,PVCF)

round(sched,2)

Exercise 3.13 [new13]

(a) The equation of value is:

80 = 6a

10

+ 100v

10

(b) Newton-Raphson nds the root of f(x) = 0 recursively as follows:

x

n

= x

n1

f(x

n1

)

f

(x

n1

)

where x

n

is the root obtained from the nth iteration.

R code:

67

Financial Mathematics Exercises Actuarial Studies UNSW

newton = function(f_expr,precision,init) {

# Find derivative

Df_expr = D(f_expr,"x")

# Allow evaluation of functions

f = function(x) eval(f_expr,list(x=x))

Df = function(x) eval(Df_expr,list(x=x))

# Initialise variables

k = 1

x = init

# Do first iteration

x[k+1] = x[k] - f(x[k])/Df(x[k])

k = k+1

# While loop for finding the root iteratively

while(abs(x[k]-x[k-1]) > precision*abs(x[k-1])) {

x[k+1] = x[k] - f(x[k])/Df(x[k])

k = k+1

}

x[k]

}

(c) The equation we need to solve is:

0 = 6

_

1 v

10

i

_

+ 100v

10

80

=

6

i

6(1 + i)

10

i

+ 100(1 + i)

10

80

Thus, dene:

f(x) =

6

x

6(1 + x)

10

x

+ 100(1 + x)

10

80

R code:

# Define f as an expression

f_expr = expression(6/x - 6/x/(1+x)^10 + 100/(1+x)^10 - 80)

# Solve using Newton-Raphson

newton(f_expr,0.0001,0.06)

The solution is i = 9.1349%.

68

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 3.14 [loa10]

You can (and should) do this question both by hand and by spreadsheet.

(a) The capital gain is already known as the price is given and the bond only has

one capital repayment at the end.

For the 15% bond on its own, the capital gain is:

100 105.80 < 0

Therefore there will be no CGT. The equation of value is then:

105.80 = 15 (1 0.35) a

4 j

+ 100 (1 +j)

4

where j is the annual eective yield. The solution j = 8.00% can easily be

veried by substitution.

For the 8% bond, the capital gain is:

100 85.34 = 14.66 > 0

Therefore there will be CGT. The equation of value is then:

85.34 = 8(1 0.35)a

4 j

+

_

100 14.66(0.5)

_

(1 + j)

4

The solution j = 8.00% can easily be veried by substitution.

Therefore both bonds (on their own) give an eective yield of 8% p.a.

The solution by spreadsheet is provided in loa10.xls. The equations to be used

are:

NPR

t

= 100 (t = 4)

APR

t

= NPR

t

I

t

= i OB

t1

OB

t

= OB

t1

NPR

t

IT

t

= (0.35)I

t

CGT

t

= (0.50)

_

APR

t

NPR

t

100

P

_

P =

t

v

t

(APR

t

+I

t

IT

t

CGT

t

)

where i is the interest rate (15% or 8%) and j is the annual eective yield,

and v = (1 +j)

1

.

We require the yield such that P is (a) 105.80 or (b) 85.34. These both result

in a solution of j = 8.00%.

(b) Instead of putting $100 in one single bond, we now put $x into the 15% bond

and $ (100 x) into the 8% bond. This means that we buy:

x

105.8

of the 15% bond with face value 100

69

Financial Mathematics Exercises Actuarial Studies UNSW

and

100 x

85.34

of the 8% bond with face value 100

We want to nd the value x such that the net capital gain is 0. Note that

this would minimise our net CGT liability, as we have minimised the capital

gain and we do not get a refund from capital losses (therefore no advantage in

having a negative CG).

CG =

x

105.8

(100 105.8) +

100 x

85.34

(100 85.34) = 0

x =

100(14.66)

85.34

5.8

105.8

+

14.66

85.34

= 75.81

The equation of value is then:

100 =

x

105.8

_

15(1 0.35)a

4 j

+ 100v

4

j

_

+

100 x

85.34

_

8(1 0.35)a

4 j

+ 100v

4

j

_

The solution j = 8.46% can be veried by substitution.

For the spreadsheet model, we note that the combined portfolio can be con-

sidered as a single bond (since interest payments are still level, and face value

is still $100). The price is $100, since we have zero capital gain (ie. purchasing

a par bond). The interest rate becomes:

i = 0.15 + 0.08(1 )

where =

x

105.8

is the proportion of the rst bond purchased, and 1 =

100x

85.34

is the proportion of the second bond purchased.

The rest of the spreadsheet remains the same. The yield can be solved numer-

ically to obtain j = 8.46%.

Exercises 3.153.16

[loaB6loaB7] See the Mathematics of Investment and Credit solutions manual.

Exercise 3.17 [loa11]

When an Australian government bond is ex-interest, the owner of the bond at the

date of the bond going ex-interest receives the next coupon payment. The buyer

does not receive the next coupon payment. The buyer receives the maturity face

value and all coupons except the next payment.

Price is:

v

f

d

(C +Ga

n

+ 100v

n

)

where the interest rate used is the semi-annual eective rate i =

0.0475

2

= 0.02375,

70

Financial Mathematics Exercises Actuarial Studies UNSW

and:

f = number of days to next coupon date (11 Jun 2006 to 15 Jun 2006)

d = number of days between coupon dates (15 Dec 2005 to 15 Dec 2006)

C = next coupon payment

G = regular semi-annual coupon payment

n = is the number of coupons to maturity

Hence f = 4, d = 182, C = 0, G =

5.75

2

= 2.875, and n = 10. Price on 11 June 2006

is (next coupon is not received):

P = v

4

182

_

2.875a

10

+ 100v

10

_

= 0.999484 (2.875 8.808866 + 100 0.790789)

= 0.999484 104.404433

= 104.351

Exercise 3.18 [ann16]

See Sherris (p. 4043). Users that may be interested include superannuation funds

and anyone with long term liabilities that rise in line with ination (such as ination-

linked life annuities, or some general insurance liabilities). See also:

http://en.wikipedia.org/wiki/Ination-indexed_bond

Exercise 3.19 [loa12]

Using a spreadsheet model similar to Exercise 3.12, we obtain a price of $516,099.04.

The spreadsheet is provided in loa12.xls.

R code:

# Initialise values

L = 500000

j = 0.07

v = 1/(1+j)

Time = seq(0,19,by=0.25)

n = length(Time)

taxI = 0.15

taxCG = 0.15

# Simple function to convert from time(s) to index

ind = function(x) {

ind = c()

for(y in x) {ind = c(ind,which(Time==y))}

ind

}

# Setup values for interest rates and principal repaid

71

Financial Mathematics Exercises Actuarial Studies UNSW

i = 0.02

R = 1.1

NPR = rep(0,n)

NPR[ind(10:19)] = L/10

APR = NPR*R

# Squared difference between price and PV(cash flows)

# (as a function of the price P)

# Aim is to minimise this function (set to 0)

# Note: "<<-" is used to make sure the values remain assigned even

# after the function has ended

temp = function(P) {

# Initialise vectors (t = 0)

OB <<- L

I <<- 0

# Recursive relations

for(t in 2:n) { # t = 0.25, ..., 19

I[t] <<- OB[t-1]*i

OB[t] <<- OB[t-1]-NPR[t]

}

# Tax

IT <<- taxI * I

CGT <<- taxCG * (APR - NPR/L * P)

CGT <<- pmax(CGT,0)

# Cash flows and present value (at reqd yield)

CF <<- I+APR-IT-CGT

PVCF <<- CF*v^Time

# Squared difference (to ensure non-negative)

(P - sum(PVCF))^2

}

# Minimise by changing P over sufficiently large range (0,2L)

opt = optimize(temp,c(0,2*L))

P = opt$minimum # get P corresponding to minimum

print(round(P,2),digits=20)

# Create and display loan schedule

sched = data.frame(NPR,APR,I,OB,IT,CGT,CF,PVCF)

round(sched,2)

72

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 3.20 [loa13]

A spreadsheet model can be used with the following equations (where time t =

0,

1

2

, . . . , 30 is in years):

i

t

=

_

0.035 t 26.5

0.04 t > 26.5

NPR

t

=

_

_

150000 t = 10, 11, . . . , 18

250000 t = 19, 20, . . . , 29

300000 t = 30

R

t

=

_

_

1.05 t = 10, 11, . . . , 18

1.10 t = 19, 20, . . . , 29

1.12 t = 30

APR

t

= NPR

t

R

t

I

t

= i

t

OB

t

1

2

OB

t

= OB

t

1

2

NPR

t

P =

t

v

t

j

(APR

t

+I

t

)

where j = 0.065 is the required eective yield. Also note that the original outstand-

ing balance (face value) is

t

NPR

t

= 4, 400, 000.

The spreadsheet is provided in loa13.xls. The price is $4,797,748.66.

The modelling can be performed in R using the following code:

# Initialise values

j = 0.065

v = 1/(1+j)

Time = seq(0,30,by=0.5) # 1/1/1974 (t=0) to 1/1/2004 (t=61)

n = length(Time)

# Simple function to convert from time(s) to index

ind = function(x) {

ind = c()

for(y in x) {ind = c(ind,which(Time==y))}

ind

}

# Setup values for interest rates and principal repaid

i = rep(0.035,n)

temp = which(Time==27):n # 1/1/2001 (t=27) to End

i[temp] = 0.04

NPR = rep(0,n)

R = rep(1,n)

NPR[ind(10:18)] = 150000 # 1/1/84,...,1/1/92 (t=10,...,18)

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Financial Mathematics Exercises Actuarial Studies UNSW

R[ind(10:18)] = 1.05

NPR[ind(19:29)] = 250000 # 1/1/93,...,1/1/03 (t=19,...,29)

R[ind(19:29)] = 1.10

NPR[ind(30)] = 300000 # 1/1/04 (t=30)

R[ind(30)] = 1.12

APR = NPR*R

# Initialise vectors (t = 0)

OB = sum(NPR)

I = 0

# Recursive relations

for(t in 2:n) { # t = 0.5, ..., 30

I[t] = OB[t-1]*i[t]

OB[t] = OB[t-1]-NPR[t]

}

# Cash flows and present value (at reqd yield)

CF = I+APR

PVCF = CF*v^Time

# Create and display loan schedule

sched = data.frame(Time,NPR,APR,i,I,OB,CF,PVCF)

round(sched,2)

# Calculate price

P = sum(PVCF)

print(round(P,2),digits=20)

Exercise 3.21 [loa14]

The price P is the present value of all cash ows at the net eective yield of j = 0.08.

This question is not too complex, and can be solved by hand. The complexity

arises from capital gains tax. However, note that the capital gain for the rst two

repayments (at times t = 2, 3) is:

400

400

1200

P < 0

since we are given P > 1200. Therefore, the only possibility of a capital gain is with

the 3rd repayment (at time t = 4). For the 3rd repayment, the capital gain is:

400(1.2)

400

1200

P = 480

1

3

P

which will only be positive if P < 1440. Therefore, the capital gains tax for the 3rd

repayment is:

CGT

4

=

_

0.20

_

480

1

3

P

_

P < 1440

0 P 1440

74

Financial Mathematics Exercises Actuarial Studies UNSW

Thus, we can solve this question by considering two cases: P < 1440 and P 1440.

(i) For P < 1440, there is CGT, and the price is given by:

P = (1 0.20)

_

0.10

_

1200v + 1200v

2

+ 800v

3

+ 400v

4

_

+ 400(v

2

+v

3

+ 1.2v

4

) 0.20

_

480

1

3

P

_

v

4

which can be solved to obtain P = 1249.47. This is consistent with the

assumption of P < 1440, so it is a valid solution.

(ii) For P 1440, there is no CGT, and the price is given by:

P = (1 0.20)

_

0.10

_

1200v + 1200v

2

+ 800v

3

+ 400v

4

_

+ 400(v

2

+v

3

+ 1.2v

4

)

= 1258.80

This is not consistent with the assumption of P 1440, so it is not a valid

solution.

Therefore, the price of the loan is $1249.47.

7.4 Module 4

Exercise 4.1 [irr1]

(a) From the spot rates we can work out the discount factors:

v(0.5) =

_

1 +

0.04875180

2

_

1

= 0.976204

v(1) =

_

1 +

0.05031182

2

_

2

= 0.951525

v(1.5) =

_

1 +

0.05234408

2

_

3

= 0.925421

v(2) =

_

1 +

0.05448436

2

_

4

= 0.898067

and hence the value of the bond is:

P =

6.75

2

[v(0.5) + v(1) + v(1.5) + v(2)] + 100v(2) = 102.467

(b) To determine the yield (eective yearly), we need to solve:

6.75a

(2)

2 i

+ 100v

2

i

= 102.467

This can be done numerically to obtain i = 5.50537% (using the function

written earlier in Exercise 3.13). The equivalent semi-annual eective yield is

j = (1 +i)

1/2

1 = 2.7158% (ie. i

(2)

= 5.43161%).

75

Financial Mathematics Exercises Actuarial Studies UNSW

(c) The par yield of the 1 year coupon bond can be determined by solving:

100i [v(0.5) + v(1)] + 100v(1) = 100

or equivalently:

i[v(0.5) + v(1)] + v(1) = 1

i =

1 v(1)

v(0.5) + v(1)

= 0.025146

The equivalent nominal rate (payable semi-annually) is i

(2)

= 5.0292%.

Similarly, the par yield of the 2 year coupon bond is:

1 v(2)

v(0.5) + v(1) + v(1.5) + v(2)

= 0.027173

which is equivalent to a nominal yield (payable semi-annually) of i

(2)

= 5.4346%.

This means that if these bonds have coupon rates equal to these par yields,

then their price will be 100 using the spot rates of this question.

(d) Recall the following relationship between spot rates and forward rates, which

holds due to no arbitrage (ie. accumulation of $1 with certainty must be the

same under spot and forward rates):

(1 + s

t

)

t

= (1 +s

t1

)

t1

(1 + f

t1,t

)

This can be rewritten as:

f

t1,t

=

(1 + s

t

)

t

(1 + s

t1

)

t1

1

Using the above equation in semi-annual time steps, we obtain:

f

0,

1

2

= s

0.5

= 0.024376

f1

2

,1

=

(1 + s

1

)

2

(1 + s

0.5

)

1 = 0.025937

f

1,1.5

=

(1 + s

1.5

)

3

(1 + s

1

)

2

1 = 0.028207

f

1.5,2

=

(1 + s

2

)

4

(1 + s

1.5

)

3

1 = 0.030459

where the spot and forward rates are semi-annual eective rates. These for-

ward rates are equivalent to nominal p.a. rates (payable semi-annually) of

4.8752%, 5.1873%, 5.6415%, and 6.0919%.

76

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 4.2 [irr2]

A zero coupon bond can be constructed by purchasing a combination of the two

bonds (ie. x 9% bonds and y 7% bonds).

To have a net coupon each period of zero, we require:

9x + 7y = 0

To have a face value of $100 on maturity, we require:

x +y = 1

Solving these simultaneously, we obtain x = 3.5 and y = 4.5. The price of the

ZCB is therefore:

P = 3.5 101.00 + 4.5 93.20 = 65.9

Exercise 4.3 [irr3]

For all t, by equating the accumulation of $1 with certainty, we obtain:

exp

__

t1

0

s(x)dx

_

exp (f

t1,t

) = exp

__

t

0

s(x)dx

_

_

t1

0

s(x)dx +f

t1,t

=

_

t

0

s(x)dx

f

t1,t

= rt r(t 1) = r

which is a at forward rate curve.

Exercise 4.4 [irr4]

Denote f

t1,t

as the nominal forward rate (semi-annual compounding) for time period

(t 1, t). The forward rates can be found by equating the accumulation of $1 over

the corresponding time periods:

_

1 +

f

0,1

2

_

2

=

_

1 +

f

0,0.5

2

__

1 +

f

0.5,1

2

_

= (1.025)(1.0275) = 1.053188

_

1 +

f

0.5,1.5

2

_

2

=

_

1 +

f

0.5,1

2

__

1 +

f

1,1.5

2

_

= (1.0275)(1.03) = 1.058325

_

1 +

f

1,2

2

_

2

=

_

1 +

f

1,1.5

2

__

1 +

f

1.5,2

2

_

= (1.03)(1.0305) = 1.061415

_

1 +

f

1.5,2.5

2

_

2

=

_

1 +

f

1.5,2

2

__

1 +

f

2,2.5

2

_

= (1.0305)(1.03125) = 1.062703

_

1 +

f

2,3

2

_

2

=

_

1 +

f

2,2.5

2

__

1 +

f

2.5,3

2

_

= (1.03125)(1.035) = 1.067344

77

Financial Mathematics Exercises Actuarial Studies UNSW

These can be solved to obtain:

f

0,1

= 5.2498%

f

0.5,1.5

= 5.7498%

f

1,2

= 6.0500%

f

1.5,2.5

= 6.1750%

f

2,3

= 6.6247%

Exercise 4.5 [irr5]

The value of the bond is given by:

P = 4 [v(0.5) + v(1) + v(1.5) + v(2)] + 100v(2)

where v(t) is the discount factor associated with the t-year (semi-annual compound-

ing) spot rate:

v(t) =

1

(1 +

s

t

2

)

2t

v(0.5) = 0.977995 and v(1) = 0.949497 are calculated by substituting the given spot

rates, whereas v(1.5) and v(2) are determined using spot and forward rates:

v(1.5) =

1

_

1 +

s

1.5

2

_

3

=

1

_

1 +

s

1

2

_

2

_

1 +

f

1,1.5

2

_

=

1

_

1 +

0.0525

2

_

2

_

1 +

0.075082

2

_

= 0.915142

v(2) =

1

_

1 +

s

2

2

_

4

=

1

_

1 +

s

1

2

_

2

_

1 +

f

1,1.5

2

__

1 +

f

1.5,2

2

_

=

1

_

1 +

0.0525

2

_

2

_

1 +

0.075082

2

_ _

1 +

0.020290

2

_

= 0.905951

The resulting price is P = 105.591.

Exercise 4.6 [irr6]

We have:

P = D a

n

+Re

n

P

= D

a

n

nRe

n

78

Financial Mathematics Exercises Actuarial Studies UNSW

where:

a

n

=

_

n

0

e

t

dt

=

_

n

0

e

t

dt

=

_

n

0

te

t

dt

= (

I a)

n

Therefore, the duration is given by:

D() =

1

P

P

=

D(

I a)

n

nRe

n

D a

n

+Re

n

=

g(

I a)

n

+nv

n

g a

n

+v

n

where g = D/R.

Exercise 4.7 [irr7]

(a) Consider a nominal amount of $1 of bond. The coupon income is g = 0.05 p.a.,

payable continually to redemption at time n. The duration is (from Exercise

4.6):

D() =

g(

I a)

n

+nv

n

g a

n

+v

n

at = 0.07, which results in 11.592 for n = 20 and 14.345 for n = 60.

(b) To nd the maximum duration, we need to dierentiate D() w.r.t. n (and set

this to zero). To do so, it is useful to note the following intermediate results:

n

v

n

= v

n

ln v = v

n

n

nv

n

= nv

n

ln v + v

n

= (1 n) v

n

n

a

n

=

1

n

(1 v

n

) =

1

(v

n

) = v

n

n

_

I a

_

n

=

1

n

( a

n

nv

n

) =

1

(v

n

+ (1 n)v

n

) = nv

n

Therefore:

n

D() =

(g a

n

+ v

n

) (gnv

n

+ (1 n)v

n

)

_

g(

I a)

n

+nv

n

_

(gv

n

v

n

)

(g a

n

+v

n

)

2

79

Financial Mathematics Exercises Actuarial Studies UNSW

Setting this to zero:

0 = (g a

n

+ v

n

)

_

gnv

n

+ (1 n)v

n

_

_

g(

I a)

n

+ nv

n

_

(gv

n

v

n

)

= (g a

n

+ v

n

)

_

1 + (g )n

_

v

n

_

g(

I a)

n

+ nv

n

_

(g ) v

n

= (g a

n

+ v

n

) + (g )

_

gn a

n

+ nv

n

g(

I a)

n

nv

n

= (g a

n

+ v

n

) + (g )

_

gn a

n

g(

I a)

n

n

(ie. without v

n

and (

I a)

n

):

0 = (g a

n

+ 1 a

n

) + (g )

_

gn a

n

g

( a

n

nv

n

)

_

= 1 + (g )

_

a

n

+gn a

n

g

( a

n

n +n a

n

)

_

= 1 + (g )

_

a

n

g

( a

n

n)

_

( g)

_

a

n

g

( a

n

n)

_

= 1

a

n

+

g

(n a

n

) =

1

g

a

n

+g(n a

n

) =

g

as required (g = 0.05, = 0.07). This can then be solved numerically to

obtain n = 64.349 and a corresponding duration of 14.349.

Exercise 4.8 [new11]

(a) The modied duration and convexity are:

MD =

1

P

P

i

C =

1

P

2

P

i

2

(b) R code:

# Function to get kth derivative by using D recursively

DD <- function(expr,name, order = 1) {

if(order < 1) stop("order must be >= 1")

if(order == 1) D(expr,name)

else DD(D(expr,name), name, order - 1)

}

# PV of annuity as an expression and a function

a_expr = expression((1-1/(1+i)^n)/i)

a = function(i,n) eval(a_expr,list(i=i,n=n))

# Get modified duration and convexity

80

Financial Mathematics Exercises Actuarial Studies UNSW

MD = function(i,n) {

-eval(DD(a_expr,"i",1),list(i=i,n=n))/a(i,n)

}

C = function(i,n) {

eval(DD(a_expr,"i",2),list(i=i,n=n))/a(i,n)

}

(c) The rst and second derivatives of the price are approximated by:

P

i

=

P(i + h) P(i h)

2h

2

P

i

2

=

P(i + h) 2P(i) + P(i h)

h

2

where h is a small increment in the interest rate. For this question, we shall

take h = 0.005.

R code (contd):

h = 0.005

MD2 = function(i,n) {

d1 = (a(i+h,n)-a(i-h,n))/(2*h)

-d1/a(i,n)

}

C2 = function(i,n) {

d2 = (a(i+h,n)-2*a(i,h)+a(i-h,n))/(h^2)

d2/a(i,n)

}

(d) The modied duration and convexity are 4.856 and 35.602 respectively. The

approximation should be similar but will depend on the choice of h.

R code:

print(MD(0.05,10))

print(C(0.05,10))

print(MD2(0.05,10)) # 4.857618

print(C2(0.05,10)) # 35.60934

Exercise 4.9 [lif6]

Recall that:

a

x

=

k=0

v

k

k

p

x

=

k=0

(1 + i)

k

k

p

x

To nd the duration, we dierentiate w.r.t. i:

d

di

a

x

=

k=0

k(1 + i)

k1

k

p

x

=

k=0

kv

k+1

k

p

x

81

Financial Mathematics Exercises Actuarial Studies UNSW

Therefore the modied duration of a

x

is:

MD

x

= v

k=0

kv

k

k

p

x

l=0

v

l

l

p

x

and the Macaulay Duration is:

D

x

=

MD

x

v

=

k=0

kv

k

k

p

x

l=0

v

l

l

p

x

=

k=0

w

k

k, where w

k

=

v

k

k

p

x

l=0

v

l

l

p

x

.

Again, this is the weighted average of the payment maturities, where the weights

take into account both the time value of money and the probabilities of survival

(since the payments are contingent to the survival of (x)).

Exercise 4.10 [irr8]

(a) The present value of assets (5-year and 15-year bonds) and liabilities (10-year

ZCB) are:

V

A

(i) = M

5

v

5

+M

15

v

15

V

L

(i) = 1000v

10

where v = (1 +i)

1

.

(b) A zero cost portfolio that provides a positive (non negative) prot with zero

chance of loss.

(c) To ensure that V

A

(i) = V

L

(i), we require:

M

5

+M

15

v

10

= 1000v

5

The duration of the assets and liabilities are:

D

A

(i) =

t

tC

t

v

t

t

C

t

v

t

=

5M

5

v

5

+ 15M

15

v

15

M

5

v

5

+M

15

v

15

D

L

(i) =

10v

t

v

t

= 10

Therefore, to ensure that D

A

(i) = D

L

(i), we require:

5M

5

v

5

+ 15M

15

v

15

M

5

v

5

+M

15

v

15

= 10

which simplies to:

M

5

= M

15

v

10

Solving these simultaneous equations, we get M

5

= 340.29 and M

15

= 734.66.

We can check that this is an arbitrage opportunity by looking at V

A

(i)V

L

(i)

for each parallel shift in the at yield curve:

i V

A

(i) V

L

(i)

7% 0.55

8% 0

9% 0.45

This shows that the surplus will be positive regardless of the direction in which

interest rates shift (as long as we have a parallel shift in a at yield curve).

82

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 4.11 [irr9]

See Sherris p. 87.

Exercise 4.12 [irr10]

At i = 4.5%, we have (for the liabilities):

V

L

=

t

C

t

v

t

= 3v + 4v

2

+ 3v

3

+ 2v

4

= 10.84

D

L

=

t

tC

t

v

t

V

L

=

3v + 8v

2

+ 9v

3

+ 8v

4

10.84

= 2.29

C

L

=

t

t(t + 1)C

t

v

t+2

V

L

=

6v

3

+ 24v

4

+ 36v

5

+ 40v

6

10.84

= 7.84

For the assets:

V

A

= M

0.5

v

0.5

+ M

5

v

5

D

A

=

0.5M

0.5

v

0.5

+ 5M

5

v

5

V

A

Ensuring that V

A

= V

L

and D

A

= D

L

, we get:

M

0.5

v

0.5

+ M

5

v

5

= 10.84

0.5M

0.5

v

0.5

+ 5M

5

v

5

= 24.79

These can be solved to obtain M

0.5

= 6.6803 and M

5

= 5.3647 using the following

R code:

v = 1/1.045

t = 1:4

C = c(3,4,3,2)

VL = sum(C*v^t)

DL = sum(t*C*v^t)/VL

A = matrix(c(v^0.5,0.5*v^0.5,v^5,5*v^5),2,2)

b = c(VL,VL*DL)

M = solve(A,b)

The eect of a change in interest rates on the surplus is determined using the fol-

lowing R code:

83

Financial Mathematics Exercises Actuarial Studies UNSW

# Surplus function

# i(t) is a function which outputs the t-year spot rate

s = function(i) {

vn = function(t) 1/(1+i(t))^t

M[1]*vn(0.5) + M[2]*vn(5) - (3*vn(1)+4*vn(2)+3*vn(3)+2*vn(4))

}

# Apply different interest rate shifts

i = function(t) 0.025

s(i)

i = function(t) 0.045

s(i)

i = function(t) 0.065

s(i)

i = function(t) 0.025+0.01*t

s(i)

i = function(t) 0.025+0.01*t

s(i)

a = 0.06; b = 0.01; c = -0.08; l = 0.6;

i = function(t) {

a + b*(1-exp(-l*t))/(l*t) + c*((1-exp(-l*t))/(l*t) - exp(-l*t))

}

s(i)

The results are shown in the following table:

Rate V

A

V

L

S

6.5% 10.39 10.38 0.01

4.5% 10.84 10.84 0.00

2.5% 11.34 11.33 0.01

Twist (d) 10.32 10.67 0.35

Twist (e) 10.86 10.89 0.03

The negative surplus for the twist scenarios illustrate the failure of immunisation to

protect against non-parallel shifts in the yield curve.

Exercise 4.13 [new12]

(a) R code:

# Spot rate function

s = function(tau,lambda,alpha,beta) {

alpha + beta*(1-exp(-lambda*tau))/lambda/tau

}

# Evaluate spot curve

alpha = 0.06

84

Financial Mathematics Exercises Actuarial Studies UNSW

beta = -0.01

lambda = 0.6

tau = seq(0.01,20,length.out=500)

plot(tau,s(tau,lambda,alpha,beta),xlab="Term",ylab="Spot Rate",

main="Spot Curve",type="l")

0 5 10 15 20

0

.

0

5

0

0

.

0

5

2

0

.

0

5

4

0

.

0

5

6

0

.

0

5

8

Spot Curve

Term

S

p

o

t

R

a

t

e

(b) Fisher-Weil duration relaxes the assumption that the yield curve is at. In

practice, yield curves are rarely at. Therefore, dierent interest rates must

be used when present valuing cash ows of dierent maturities. By splitting

the cash ows into ZCBs of dierent maturities, we can value the cash ows by

valuing the ZCBs (which is done using spot rates). The time-weighted value

(duration) is also calculated using these principles.

(c) The immunisation strategy is found using the Fisher-Weil duration (since the

yield curve is no longer at):

V

L

=

t

C

t

(1 + s

t

)

t

= 10.609

D

L

=

t

tC

t

(1 + s

t

)

t

V

L

= 2.275

C

L

=

t

t(t + 1)C

t

(1 + s

t

)

(t+2)

V

L

= 7.572

85

Financial Mathematics Exercises Actuarial Studies UNSW

For the assets:

V

A

= M

0.5

(1 + s

0.5

)

0.5

+ M

5

(1 + s

5

)

5

D

A

=

0.5M

0.5

(1 + s

0.5

)

0.5

+ 5M

5

(1 + s

5

)

5

V

A

Ensuring that V

A

= V

L

and D

A

= D

L

, we get:

M

0.5

(1 + s

0.5

)

0.5

+M

5

(1 + s

5

)

5

= 10.609

0.5M

0.5

(1 + s

0.5

)

0.5

+ 5M

5

(1 + s

5

)

5

= 24.134

These can be solved to obtain M

0.5

= 6.588 and M

5

= 5.516.

R code:

# Function to get discount factor (ie. ZCB price)

v = function(tau,lambda,alpha,beta) {

(1+s(tau,lambda,alpha,beta))^(-tau)

}

# Get value, duration, convexity of liabilities

xL = c(3,4,3,2)

tL = c(1,2,3,4)

xA = c(1,1)

tA = c(0.5,5)

VL = sum(xL*v(tL,lambda,alpha,beta))

DL = sum(tL*xL*v(tL,lambda,alpha,beta))/VL

CL = sum(tL*(tL+1)*xL*v(tL+2,lambda,alpha,beta))/VL

# Get strategy by solving linear system (equating V and D)

A = matrix(c(v(tA,lambda,alpha,beta),

tA*v(tA,lambda,alpha,beta)),2,2,byrow=TRUE)

M = solve(A) %*% c(VL,DL*VL)

(d) R code:

numsim = 1000

S = c() # initialise surplus

B = rnorm(numsim,-0.01,0.002)

# Get surplus

for(k in 1:numsim) {

S[k] = sum(M*xA*v(tA,lambda,alpha,B[k]))

- sum(xL*v(tL,lambda,alpha,B[k]))

}

# Plot histogram

hist(S,20,xlab="Surplus",main="Histogram of Surplus")

86

Financial Mathematics Exercises Actuarial Studies UNSW

# Probability of loss

sum(S<0)/length(S) # should be close to 0.5

Histogram of Surplus

Surplus

F

r

e

q

u

e

n

c

y

0.02 0.01 0.00 0.01 0.02

0

5

0

1

0

0

1

5

0

As shown from the results and the graph, the portfolio is not fully immunised

as there is a chance we can make a loss.

Exercise 4.14 [irr11]

At i = 4%, we have:

V

L

= 10.96

D

L

= 2.29

C

L

= 7.94

Letting P

1

be the price of the 0.75 year bond, and P

2

be the price of the 8 year

bond, we have (assuming annual coupons and $100 face value):

P

1

= 100.99

D

1

= 0.75

C

1

= 1.31

P

2

= 126.93

D

2

= 6.43

C

2

= 53.31

87

Financial Mathematics Exercises Actuarial Studies UNSW

Let x

1

be the number of units of the 0.75 yr bond, and x

2

be the units of the 8 yr

bond. Therefore, we have:

V

A

= x

1

P

1

+x

2

P

2

D

A

=

x

1

P

1

D

1

+x

2

P

2

D

2

V

A

Ensuring that:

V

A

= V

L

D

A

= D

L

we obtain two simultaneous equations which can be solved to give x

1

= 7.905 and

x

2

= 2.345. These correspond to investing 7.983 and 2.977 in the two bonds respec-

tively.

A check of convexity shows that C

A

C

L

= 7.49 > 0, so the portfolio is immunised.

Exercise 4.15 [irr12]

(a) At i = 6%, we have:

V

L

= 1.68

D

L

= 3

C

L

= 10.68

To form an immunised portfolio of bonds, it is clear that we need to use 2 or

more bonds with maturities on either side of 3 (as the portfolio duration would

be an average). Furthermore, to maximise the asset convexity (as immunisa-

tion suggests) we would wish to use the 1 year and 5 year bonds (Barbell

strategy). Using the 1 year and 5 year bonds, and solving using methods sim-

ilar to previous exercises, we obtain an investment strategy of $0.8396m into

both bonds (ie. face values of 0.8900 and 1.1236). The convexity of the assets

would be 14.240 > 10.680.

(b) Cashow matching involves nding assets that match the liability CF perfectly

without considering the costs. Since we have ZCBs available, we would simply

invest in a 3 year ZCB with a face value of $2m.

(c) If interest rates increase to 7%, then for the immunised portfolio:

V

A

V

L

= 0.8900v + 1.1236v

5

2v

3

= 0.0003

For the CF matching, we have:

V

A

V

L

= 2v

3

2v

3

= 0

Therefore, both methods have surpluses of approximately zero (exact for CF

matching).

(d) If interest rates twist, then the surplus of the immunised portfolio is:

0.8900

_

1

1.04

_

+ 1.1236

_

1

1.08

_

5

2

_

1

1.06

_

3

= 0.0588

The CF matching surplus is still exactly zero.

88

Financial Mathematics Exercises Actuarial Studies UNSW

7.5 Module 5

Exercise 5.1 [der1]

The theoretical futures index is determined as follows (accumulated value of spot

index and storage costs):

f

t

= S

t

e

r(Tt)

d s

Tt

= 293.3e

0.07(210/365)

(0.035)(293.3) s

210/365 0.07

= 305.353447 (0.035)(293.3)(0.587085)

= 299.326724

This is close to the observed index of 299.0 (only 0.11% dierence).

Aside: The dierence between the actual and theoretical futures price is usually

quite small (less than 1%), except for major events (eg. 1987 nancial crisis). The

dierence (f

t

S

t

) is called the futures to cash spread or basis, whereas (f

t

S

t

)

is the theoretical basis.

Exercise 5.2 [der2]

The forward price will be the accumulated cost (purchase and funding) less coupons

received.

The price of the bond today is:

3.25a

16 i

+ 100v

16

i

= 97.214171

where i =

0.0696

2

= 0.0348 is the semi-annual eective rate.

This price (purchasing cost) is accumulated 2 years at the funding costs:

97.214171

_

_

1 +

0.065

12

_

12

_

1 +

0.07

12

_

12

_

= 111.223057

The accumulated value of coupons received at the funding costs is:

3.25s

2 i

1

(1 + i

2

)

2

+ 3.25s

2 i

2

= 13.700113

where i

1

=

_

1 +

0.065

12

_

6

1 and i

2

=

_

1 +

0.07

12

_

6

1 are the semi-annual eective

funding costs.

The forward price is therefore 111.223057 13.700113 = 97.522944

The forward yield is the yield on the (6-year) bond which is locked in by the purchase

of the forward contract:

97.522944 = 3.25a

12 j

+ 100v

12

j

which results in j = 3.50% per half-year, equivalent to an eective 7.013% p.a.

89

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 5.3 [der3]

The current 90-day forward price implied by the market is (accumulated spot price

and costs):

f

90

= 420

_

1 + (0.0975)

90

365

_

+ (0.025) (420)

90

365

= 432.69

However, our short contract is for a forward price of $450, ie. we have an agreement

to sell gold for $450 in 90 days time. Thus, based on todays market conditions, we

should be able to make a prot of 450 432.69 = 17.31 in 90 days time. Today, this

prot is worth:

17.31

1 + (0.0975)

90

365

= $16.90

Exercise 5.4 [der4]

(Also see Example 6.9 in Sherris, p. 112) The forward price is the accumulated

costs less receipts (dividends). The cost of purchasing the shares now (including

transaction costs) is:

1.02 (10000 10) = 102000

This is accumulated to account for funding costs over the next 6 months:

102000

_

1 +

0.06

12

_

6

= 105098.506

The accumulated dividends are:

0.4 (10000)

_

1 +

0.06

12

_

3

= 4060.3005

Therefore the forward price is 105098.506 4060.3005 = $101038.21

Exercise 5.5 [der5]

The cost of carry formula is based on no-arbitrage arguments. If it is violated, for

example if F

t,T

> S

t

e

r(Tt)

de

r(Tt

1

)

, then one could short a forward, purchase the

asset with funds borrowed at the risk-free rate, invest the dividend at the risk-free

rate (at time t

1

), and exercise the forward contract at time T. This would lock in a

positive prot (at time T) with certainty at zero cost.

See lecture notes for further details. It may be helpful to draw a diagram.

Exercise 5.6 [der6]

For the 1st contract, the forward rate for days 90120 is 7.3%, whereas the 120-day

spot rate is 7.5%. Therefore, for no-arbitrage, we require a repo rate r given by:

_

1 +

30

365

r

__

1 +

90

365

0.073

_

=

_

1 +

120

365

0.074

_

r = 0.075639

However, the 30-day spot rate is 7.5% (< 7.5639%). Therefore, we could:

90

Financial Mathematics Exercises Actuarial Studies UNSW

Action (t = 0) (t = 30) (t = 120)

Borrow $1m at 30-day spot (7.5%) 1,000,000 1,006,164 0

Short forward for $1,006,164 (7.3%) 0 1,006,164 1,024,275

Invest $999,948 in 120-day spot (7.4%) 999,948 0 1,024,275

Total 52 0 0

This results in a guaranteed prot of $52 at zero cost.

For the 2nd contract, the forward rate for days 90180 is 7.0%, whereas the 180-day

spot rate is 7.4%. Similarly, we have:

_

1 +

90

365

r

__

1 +

90

365

0.070

_

=

_

1 +

180

365

0.074

_

r = 0.076677

The 90-day spot rate is 7.4% (< 7.6677%). Therefore:

Action (t = 0) (t = 30) (t = 120)

Borrow $1m at 90-day spot (7.4%) 1,000,000 1,018,247 0

Short forward for $1,018,247 (7.0%) 0 1,018,247 1,035,822

Invest $999,352 in 180-day spot (7.4%) 999,352 0 1,035,822

Total 648 0 0

This results in a guaranteed prot of $648 at zero cost.

Exercise 5.7 [der7]

See details in Sherris Example 7.1 (p. 133)

Exercise 5.8 [der8]

See details in Sherris Example 7.4 (p. 138)

Exercise 5.9 [der9]

See details in Sherris Example 7.10 (p. 149)

Exercise 5.10 [der10]

Let the random future commodity price be S

t

i

. The swap provides for party A at

time t

i

:

S

t

i

X

The swap allows to get the dierence between the spot price at time t

i

and X

without actually exchanging the commodity. The swap price X is set such that the

initial value of the swap is 0.

To value the swap, consider what happens if party A enters into a series of short

forward positions (which cost nothing to enter in) to replicate the swap. In order to

91

Financial Mathematics Exercises Actuarial Studies UNSW

settle the forward contract (buy the commodity and sell it to the long party at the

pre-specied price at the same time), the payo is

F

0,t

i

S

t

i

where F

0,t

i

represents the forward price set at time 0 (now) for settlement at time

t

i

. The initial value of this forward is 0. Hence for times t

1

, t

2

, . . . , t

M

the net eect

of the swap and forward must be equal to 0:

0 =

M

i=1

e

rt

i

[(S

t

i

X) + (F

0,t

i

S

t

i

)]

=

M

i=1

_

F

0,t

i

e

rt

i

Xe

rt

i

_

=

M

i=1

_

S

0

Xe

rt

i

_

= MS

0

X

M

i=1

e

rt

i

X =

MS

0

M

i=1

e

rt

i

Exercise 5.11 [der11]

(a) Let (h

C

, B

C

) be the units of stocks and bonds we hold in our portfolio to

replicate the payo of the call.

For the call option with exercise price 275, the payo function is :

C

1

=

_

max (285 275, 0) = 10 if stock price goes up

max (250 275, 0) = 0 if stock price goes down

Hence we want to nd a portfolio such that the value at time 1 is:

C

1

=

_

h

C

285 + B

C

e

0.05

= 10 if stock price goes up

h

C

250 + B

C

e

0.05

= 0 if stock price goes down

Solving these equations:

h

C

=

10

285 250

B

C

= e

0.05

(250)

_

10

285 250

_

Since this portfolio pays the same amount as the option at time 1 regardless of

the stock price, to have an arbitrage free market this portfolio must be worth

the same as the option at time 0. Hence:

C

0

= h

C

260 + B

C

= 6.34

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Financial Mathematics Exercises Actuarial Studies UNSW

(b) For the put option with exercise price 275, the payo function is

P

1

=

_

max (275 285, 0) = 0 if stock price goes up

max (275 250, 0) = 25 if stock price goes down

Hence we want to nd a portfolio such that the value at time 1 is:

P

1

=

_

h

P

285 + B

P

e

0.05

= 0 if stock price goes up

h

P

250 + B

P

e

0.05

= 25 if stock price goes down

Solving these equations:

h

C

=

25

285 250

B

C

= e

0.05

(285)

_

25

285 250

_

Since this portfolio pays the same amount as the option at time 1 regardless of

the stock price, to have an arbitrage free market this portfolio must be worth

the same as the option at time 0. Hence:

P

0

= h

P

260 + B

P

= 7.93

(c) The put-call parity relationship states that (in words):

Call Value + Discounted Strike Price = Put value + Share Price

ie.

C

0

+Xe

rt

= P

0

+S

0

This is satised, since (for t = 1) :

C

0

+Xe

rt

= 6.34 + 275e

0.05

= 267.93

P

0

+S

0

= 7.93 + 260 = 267.93

Exercise 5.12 [der12]

For the call option with exercise price 50, the payo function is

C

1

=

_

max (55 50) = 5 if stock price goes up

max (45 50, 0) = 0 if stock price goes down

Hence we want to nd a portfolio holding (h, B) units of the stock and bond, such

that the value at time 1 is:

C

1

=

_

h55 + B

_

1 + 0.05

1

12

_

= 5 if stock price goes up

h45 + B

_

1 + 0.05

1

12

_

= 0 if stock price goes down

Solving these equations:

h =

5

55 45

B =

(45)

_

1 + 0.05

1

12

_

_

5

55 45

_

Therefore:

C

0

= h50 + B = 2.59

93

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 5.13 [der13]

The pricing is done by ensuring that there are no arbitrage properties, rather than

through any particular probability assessments (except to decide where the stock

can go to, eg. up to 55 or down to 45). In terms of pricing, there is no dierence

between a model where the stock price can go up to 55 with probability 99% and

a model where the stock price can go up to 55 with probability 2%. An important

observation is that these contracts are priced as a function of the current underlying

asset price, that is, they are relative prices. The probability of movements in the

asset price do impact the underlying asset price but once this is known, these other

contracts are determined by no-arbitrage based on the current underlying asset price.

Exercise 5.14 [der14]

This option (which is no longer a simple call or put option) pays:

X

1

=

_

max (285

2

265

2

, 0) = 11000 if stock price goes up

max (250

2

265

2

, 0) = 0 if stock price goes down

Hence we want to nd a portfolio holding (h, B) units of the stock and bond such

that the value at time 1 is:

X

1

=

_

h285 + Be

0.04

= 11000 if stock price goes up

h250 + Be

0.04

= 0 if stock price goes down

Solving these equations:

h =

11000

285 250

B = e

0.04

(250)

_

11000

285 250

_

Since this portfolio pays the same amount as the option at time 1, to have an

arbitrage free market this portfolio must be worth the same as the option at time

0. Hence:

X

0

= h260 + B = 6223.81

Exercise 5.15 [der15]

Put call parity does not hold since:

C

0

+

K

1 + i

= 1.2245 +

22

1.05

= 22.1769

P

0

+S

0

= 20 + 2.5 = 22.5

Therefore we want to buy the LHS (call and bond of face value 22 and maturity 1)

and short the RHS (put and share). The cost of this transaction today is:

22.1769 22.5 < 0

This is a prot, since it is a negative cost.

At time 1, the cash ows of the put, stock, call and bond will all cancel out.

94

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 5.16 [der16]

The stock is assumed to either go up to s

u

or down to s

d

. The bond starts o as 1

and rises to e

rt

at time t, where r is the risk free rate.

Suppose we want to price this derivative that pays x

u

or x

d

. For a call option, we

have:

x

u

= (s

u

K)

+

x

d

= (s

d

K)

+

Consider a portfolio that holds stocks and bonds. The value of this portfolio

today is:

V (0) = s

0

+ 1

The value of this portfolio at time T is:

(s

u

+D) + e

rT

if the stock goes up

(s

d

+D) + e

rT

if the stock goes down

Therefore, we need and such that the payos are identical (so that this portfolio

will have the same value as our derivative):

(s

u

+D) + e

rT

= x

u

(s

d

+ D) + e

rT

= x

d

Solving these equations:

=

x

u

x

d

s

u

s

d

= e

rT

_

x

u

_

x

u

x

d

s

u

s

d

_

(s

u

+D)

_

The value of the portfolio with these and will be the same as the value of our

derivative.

Exercise 5.17 [der17]

Consider two investment portfolios:

Portfolio A: one call plus cash of (K c) e

rT

Portfolio B: one put plus one unit of gold

The value of portfolio A at expiry is given by:

_

G

T

K +K c = G

T

c if G

T

> K (i.e. option is exercised)

0 + K c = K c if G

T

K (i.e. option is worthless)

The value of portfolio B at expiry is given by:

_

0 + G

T

c = G

T

c if G

T

> K (i.e. option is exercised)

K G

T

+G

T

c = K c if G

T

K (i.e. option is worthless)

95

Financial Mathematics Exercises Actuarial Studies UNSW

Therefore, both portfolios have a payo at expiry of:

max {K, G

T

} c

Because the two portfolios have equal payo at expiry and the options cannot be

exercised before expiry, the portfolios must also have equal value for any time t < T.

In particular, at issue (t = 0), we must have:

c

0

+ (K c)e

rT

= p

0

+S

0

or:

c

0

+Ke

rT

= p

0

+ S

0

+ce

rT

7.6 Module 6

Exercise 6.1 [sto1]

(a) The mean accumulation is:

E(1000S

10

) = 1000E [(1 + i

1

) . . . (1 + i

10

)]

= 1000E(1 + i

1

) . . . E(1 + i

10

) (by independence)

= 1000 [E(1 + i)]

10

(identically distributed)

= 1000(1.06)

10

= 1790.85

(b) The variance of the accumulation is:

Var(1000S

10

) = 1000

2

_

E

_

S

2

10

_

[E (S

10

)]

2

where:

E

_

S

2

10

_

= E

_

(1 + i

1

)

2

. . . (1 + i

10

)

2

= E

_

(1 + i)

2

10

=

_

0.4(1.04)

2

+ 0.2(1.06)

2

+ 0.4(1.08)

2

10

= 1.12392

10

Therefore:

Var(1000S

10

) = 9145.60

and:

(1000S

10

) = 95.63

(c) (i) The mean accumulation depends only on the mean interest rate, which

is not changed. However, the variance of the accumulation will be lower,

as the variance in interest rates is lower.

(ii) The mean will be larger as we are accumulating over a longer period. The

standard deviation will also be larger, as investing in a longer term will

result in a greater spread of possible accumulated amounts.

96

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 6.2 [sto2]

(a) The mean accumulation is:

E(S

n

) = E [(1 + i

1

) (1 + i

n

)]

= E(1 + i

1

) E(1 + i

n

) (by independence)

= [E(1 + i)]

n

(identically distributed)

= (1 +j)

n

The variance of the accumulation is:

Var(S

n

) = E

_

S

2

n

_

[E (S

n

)]

2

where:

E

_

S

2

n

_

= E

_

(1 + i

1

)

2

(1 + i

n

)

2

=

_

E

_

(1 + i)

2

_

n

=

_

E

_

1 + 2i +i

2

_

n

=

_

1 + 2j +j

2

+s

2

_

n

noting that E(X

2

) = Var(X) + [E(X)]

2

for a random variable X. Therefore:

Var(S

n

) =

_

1 + 2j +j

2

+ s

2

_

n

(1 + j)

2n

(b) E(S

8

) = 1.59385

(c) (S

8

) =

Exercise 6.3 [sto3]

(a) The mean accumulation is:

E(10000S

2

) = 10000E [(1 + i

1

)(1 + i

2

)]

= 10000E [1 + i] E [1 + i

2

] (iid)

= 10000

_

1

3

1.03 +

1

3

1.04 +

1

3

1.06

_

(0.7 1.05 + 0.3 1.04)

= 10923.70

(b) The variance of the accumulation is:

Var(10000S

2

) = 10000

2

_

E

_

S

2

2

_

[E (S

2

)]

2

where:

E

_

S

2

2

_

= E

_

(1 + i

1

)

2

(1 + i

2

)

2

= E

_

(1 + i

1

)

2

E

_

(1 + i

2

)

2

=

_

1

3

1.03

2

+

1

3

1.04

2

+

1

3

1.06

2

_

_

0.7 1.05

2

+ 0.3 1.04

2

_

= 1.193465

Therefore:

Var(10000S

2

) = 19278

97

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 6.4 [sto4]

(a) The mean and variance are:

E(i) =

i

1

+i

2

2

Var(i) = E(i

2

) [E(i)]

2

=

1

2

(i

2

1

+ i

2

2

)

1

4

(i

1

+ i

2

)

2

=

1

4

(i

1

i

2

)

2

(b) The mean and variance of the accumulated value can be determined using the

formulae in Exercise 6.2:

E (S

n

) = (1 +j)

n

Var(S

n

) =

_

1 + 2j + j

2

+ s

2

_

n

(1 + j)

2n

Therefore:

5.5 = (1 +j)

25

j = 0.0705686

0.5

2

=

_

1 + 2j + j

2

+s

2

_

25

(1 + j)

50

s

2

= 0.000377389

Solving for i

1

and i

2

:

i

1

+i

2

2

= j = 0.0705686

i

1

+ i

2

= 0.1411372

1

4

(i

1

i

2

)

2

= s

2

= 0.000377389

i

1

i

2

= 0.0388530

Therefore, we obtain i

1

= 0.089995 and i

2

= 0.051142.

Exercise 6.5 [sto5]

(a) The single premium X is given by:

X [1 + E(i)]

10

= 10000

X [0.3(1.07) + 0.5(1.08) + 0.2(1.10)]

10

= 10000

X = 4589.26

(b) Expected prot is:

E() = E

_

X(1 + i)

10

10000

= X

_

0.3(1.07)

10

+ 0.5(1.08)

10

+ 0.2(1.10)

10

_

10000

= 42.94

98

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 6.6 [sto6]

(a) The mean of accumulated premiums is:

E(P) = 425000(1.03)

5

+ 425000E [(1 + i

1

) (1 + i

5

)]

= 425000(1.03)

5

+ 425000 [E(1 + i)]

5

(since 1 + i

t

iid)

= 425000(1.03)

5

+ 425000(1.035)

5

= 997458

The standard deviation is found as follows:

Var(P) = Var

_

425000(1.03)

5

+ 425000

5

k=1

(1 + i

k

)

_

= 425000

2

Var

_

5

k=1

(1 + i

k

)

_

= 425000

2

E

_

5

k=1

(1 + i

k

)

2

_

425000

2

(1.035)

10

E

_

5

k=1

(1 + i

k

)

2

_

=

_

E

_

(1 + i)

2

_

5

=

_

E

_

1 + 2i + i

2

_

5

=

_

1 + 2E(i) + [E(i)]

2

+ Var(i)

5

=

_

1 + 2(0.035) + (0.035)

2

+ (0.03)

2

_

5

= 1.416534

(P) =

_

Var(P) = 32743.21

(b) Investing all premiums in the risky assets is likely to be more risky because

although there may be a higher probability of the assets accumulating to more

than $1 million, the standard deviation would be twice as high so the proba-

bility of a large loss would also be greater.

Exercise 6.7 [sto7]

(a) The mean accumulation is:

E(1000S

10

) = 1000E [(1 + i

1

) (1 + i

10

)]

= 1000E(1 + i

1

) E(1 + i

10

) (by independence)

= 1000 [E(1 + i)]

10

(identically distributed)

= 1000(1.07)

10

= 1967.15

The variance of the accumulation is:

Var(1000S

10

) = 1000

2

_

E

_

S

2

10

_

[E (S

10

)]

2

99

Financial Mathematics Exercises Actuarial Studies UNSW

where:

E

_

S

2

10

_

= E

_

(1 + i

1

)

2

(1 + i

10

)

2

= E

_

(1 + i)

2

10

=

_

1 + 2E(i) + [E(i)]

2

+ Var(i)

10

=

_

1 + 2(0.07) + (0.07)

2

+ (0.09)

2

10

= 1.1153

10

Therefore, we have:

(1000S

10

) =

_

Var(1000S

10

) = 531.65

(b) We want to nd Pr (1000S

10

< 0.5(1967.15)). The distribution of the accumu-

lation term S

10

=

10

k=1

(1 + i

k

) is determined as follows:

(1 + i

k

) LN(,

2

)

ln(1 + i

k

) N(,

2

)

10

k=1

ln(1 + i

k

) N(10, 10

2

)

exp

_

10

k=1

ln(1 + i

k

)

_

=

10

k=1

(1 + i

k

) LN(10, 10

2

)

where:

E(1 + i) = 1.07 = e

+

1

2

2

Var(1 + i) = 0.09

2

= e

2+

2

_

e

2

1

_

0.09

2

= (1.07)

2

_

e

2

1

_

2

= 0.007050

= ln 1.07

1

2

(0.007050) = 0.064134

Therefore:

Pr (1000S

10

< 0.5(1967.15)) = Pr (S

10

< 0.983575)

= Pr

_

Z <

ln 0.983575 10

10

_

where Z N(0, 1)

= Pr (Z < 2.4778)

= 0.00661

100

Financial Mathematics Exercises Actuarial Studies UNSW

(c) The probability required is:

Pr (1200S

10

< 1400) = Pr

_

S

10

<

7

6

_

= Pr

_

Z <

ln

7

6

10

10

_

= Pr (Z < 1.8349)

= 0.03326

Exercise 6.8 [sto8]

(a) The mean accumulation is:

E(S

10

) = E [(1 + i

1

) (1 + i

10

)]

= E(1 + i

1

) E(1 + i

10

) (by independence)

= [E(1 + i)]

10

(identically distributed)

= (1.06)

10

Therefore:

E (2, 000, 000 S

10

) = 2, 000, 000 (1.06)

10

= 3, 581, 695

(b) The distribution of S

10

is lognormal:

(1 + i

k

) LN(,

2

)

ln(1 + i

k

) N(,

2

)

10

k=1

ln(1 + i

k

) N(10, 10

2

)

S

10

=

10

k=1

(1 + i

k

) = exp

_

10

k=1

ln(1 + i

k

)

_

LN(10, 10

2

)

where:

E(1 + i) = 1.06 = e

+

1

2

2

Var(1 + i) = 0.08

2

= e

2+

2

_

e

2

1

_

0.08

2

= (1.06)

2

_

e

2

1

_

2

= 0.0056798

= ln 1.06

1

2

(0.0056798) = 0.055429

101

Financial Mathematics Exercises Actuarial Studies UNSW

Therefore, the required probability is:

Pr (S

10

< 0.8 E(S

10

)) = Pr

_

S

10

< 0.8(1.06)

10

_

= Pr (S

10

< 1.4327)

= Pr

_

Z <

ln 1.4327 10

10

_

= Pr (Z < 0.8171)

= 0.207

Exercise 6.9 [sto9]

We have (1 + i) LN(, ), where:

E(1 + i) = e

+

1

2

2

= 1.001

Var(1 + i) = e

2+

2

_

e

2

1

_

= 0.002

2

These can be solved simultaneously to obtain and

2

:

Var(1 + i) =

_

e

+

1

2

2

_

2

_

e

2

1

_

0.002

2

= (1.001)

2

_

e

2

1

_

2

= 0.000003992

= ln 1.001

1

2

(0.000003992) = 0.0009975

Therefore, we can nd j as follows:

0.05 = Pr(i < j)

= Pr(1 +i < 1 + j)

= Pr(ln(1 +i) < ln(1 + j))

= Pr

_

Z <

ln(1 + j)

ln(1 + j)

= 1.645

ln(1 + j) = 0.00228921

j = e

0.00228921

1 = 0.2287%

Exercise 6.10 [sto10]

Note: This question is similar to Exercise 6.8.

(a) The mean accumulation is:

E(S

10

) = E [(1 + i

1

) (1 + i

10

)]

= E[1 + i

1

] E[1 + i

10

] (by independence)

= [E(1 + i)]

10

(identically distributed)

= (1.06)

10

102

Financial Mathematics Exercises Actuarial Studies UNSW

Therefore:

E (1, 000, 000 S

10

) = 1, 000, 000 (1.06)

10

= 1, 790, 848

(b) The distribution of S

10

is lognormal:

(1 + i

k

) LN(,

2

)

ln(1 + i

k

) N(,

2

)

10

k=1

ln(1 + i

k

) N(10, 10

2

)

S

10

=

10

k=1

(1 + i

k

) = exp

_

10

k=1

ln(1 + i

k

)

_

LN(10, 10

2

)

where:

E(1 + i) = 1.06 = e

+

1

2

2

Var(1 + i) = 0.08

2

= e

2+

2

_

e

2

1

_

0.08

2

= (1.06)

2

_

e

2

1

_

2

= 0.0056798

= ln 1.06

1

2

(0.0056798) = 0.055429

Therefore, the required probability is:

Pr (S

10

< 0.9 E(S

10

)) = Pr

_

S

10

< 0.9(1.06)

10

_

= Pr (S

10

< 1.61172)

= Pr

_

Z <

ln 1.61172 10

10

_

= Pr (Z < 0.32304)

= 0.373

Exercise 6.11 [new3]

(a) The accumulated value based on a principal of $1 is:

S

10

= (0.05 i

1

)(1 + i

2

) (1 + i

10

) + + (0.05 i

10

)

The mean of S

10

is:

E(S

10

) = E[(0.05 i

1

)(1 + i

2

) (1 + i

10

) + + (0.05 i

10

)]

= E[0.05 i

1

]E[1 + i

2

] E[1 + i

10

] + +E[0.05 i

10

]

(by independence)

= 0.01(1.04)

9

+ 0.01(1.04)

8

+ + 0.01(1.04) + 0.01

= 0.01s

10 0.04

= 0.120061

103

Financial Mathematics Exercises Actuarial Studies UNSW

(b) The distribution of the interest rate in each year is:

1 + i LN(,

2

)

where:

E(1 + i) = 1.04 = e

+

1

2

2

=Var(1 + i) = 0.02

2

= e

2+

2

_

e

2

1

_

=0.02

2

= (1.04)

2

_

e

2

1

_

=

2

= ln

_

1 +

0.02

2

1.04

2

_

= = ln 1.04

1

2

2

R code:

n = 10

numsim = 1000

sigma = sqrt(log(1+0.02^2/1.04^2))

mu = log(1.04)-0.5*sigma^2

X = rnorm(numsim*n, mu, sigma) # simulate normal RVs

i = matrix(exp(X)-1,numsim,n) # interest rates

S = c()

for(k in 1:numsim) {

temp = c()

for(j in 1:(n-1)) {

# each of the n annual payments

temp[j] = (0.05-i[k,j]) * prod(1+i[k,(j+1):n])

}

S[k] = sum(temp) + (0.05-i[k,n]) # accumulated value

}

mean(S)

var(S)

plot(density(S,adjust=1.5), main="Simulated Density of S",

xlab="S")

104

Financial Mathematics Exercises Actuarial Studies UNSW

0.2 0.1 0.0 0.1 0.2 0.3 0.4

0

1

2

3

4

5

Simulated Density of S

S

D

e

n

s

i

t

y

(c) A company who has an exposure to a oating rate may want to hedge this

interest rate risk by using a xed-for-oating swap. For example, if the com-

pany has a liability to repay a loan at a oating rate, they could enter into a

swap to pay a xed rate and receive a oating rate. The payment and receipt

of the oating rate will net to zero, allowing the company to pay a net rate

which is xed.

Exercise 6.12 [new5]

(a) The mean is:

E(S

1

) = E(1 + y

1

)

= E(1 + +(y

0

))

= 1.05 + 0.4(y

0

0.05)

Therefore E(S

1

) = 1.046 and E(S

1

) = 1.054 for y

0

= 0.04 and y

0

= 0.06

respectively.

(b) The variance is:

Var(S

1

) = Var(1 + y

1

)

= Var(1 + +(y

0

) +

1

)

=

2

= 0.01

2

105

Financial Mathematics Exercises Actuarial Studies UNSW

(c) The probability is:

Pr(S

1

< 1.04) = Pr(1 +y

1

< 1.04)

= Pr( +(y

0

) +

1

< 0.04)

= Pr

_

1

<

0.01 0.4(y

0

0.05)

0.01

_

where

1

N(0, 1)

Therefore Pr(S

1

< 1.04) = 0.3332 and Pr(S

1

< 1.04) = 0.1497 for y

0

= 0.04

and y

0

= 0.06 respectively.

Exercise 6.13 [new6]

R code:

mu = 0.05

beta = 0.4

sigma = 0.01

n = 10

y0 = 0.04 # also y0 = 0.06

numsim = 1000

y = matrix(0,numsim,n) # initialise matrix of interest rates

S = rep(0,numsim) # initialise vector of accumulated values

# mean reverting model

y[,1] = mu + beta*(y0-mu) + sigma*rnorm(numsim)

for(t in 2:n) {

y[,t] = mu + beta*(y[,t-1]-mu) + sigma*rnorm(numsim)

}

# accumulated value

for(k in 1:numsim) {

S[k] = prod(1+y[k,])

}

mean(S)

var(S)

sum(S<1.55)/length(S)

hist(S)

106

Financial Mathematics Exercises Actuarial Studies UNSW

Histogram of S (4%)

S

F

r

e

q

u

e

n

c

y

1.4 1.5 1.6 1.7 1.8 1.9

0

5

0

1

0

0

1

5

0

2

0

0

2

5

0

Histogram of S (6%)

S

F

r

e

q

u

e

n

c

y

1.4 1.5 1.6 1.7 1.8 1.9

0

5

0

1

0

0

1

5

0

2

0

0

2

5

0

107

Financial Mathematics Exercises Actuarial Studies UNSW

Exercise 6.14 [new9]

(a) Denoting the mean and standard deviation of i

t

as j and s respectively (ie.

j = 0.04 and s = 0.02), the formulae can be derived as in the lecture notes:

s

n

= (1 +y

1

) (1 + y

n

) + (1 +y

2

) (1 + y

n

) + + (1 + y

n

)

= (1 +y

n

) [(1 +y

1

) (1 + y

n1

) + + (1 + y

n1

) + 1]

= (1 +y

n

)( s

n1

+ 1)

E( s

n1

) = E[(1 + y

n

)( s

n

+ 1)]

= E(1 + y

n

)E( s

n1

+ 1) by independence

= (1 +j)[E( s

n1

) + 1]

E

_

s

2

n

_

= E

_

(1 + y

n

)

2

( s

n1

+ 1)

2

= E

_

(1 + y

n

)

2

E

_

( s

n1

+ 1)

2

by independence

= E

_

1 + 2y

n

+ y

2

n

_

E

_

s

2

n1

+ 2s

n1

+ 1

_

=

_

1 + 2j +j

2

+s

2

_ _

E

_

s

2

n1

_

+ 2E (s

n1

) + 1

Var ( s

n1

) = E

_

s

2

n1

_

[E ( s

n1

)]

2

(b) R code:

n = 30

j = 0.04

s = 0.02

Es = c()

Es2 = c()

Es[1] = (1+j)

Es2[1] = (1+2*j+j^2+s^2)

# Recursive relationships

for(k in 2:n) {

Es[k] = (1+j)*(Es[k-1]+1)

Es2[k] = (1+2*j+j^2+s^2)*(Es2[k-1]+2*Es[k-1]+1)

}

# Display mean and variance

Es[n]

Es2[n] - Es[n]^2

(c) The distribution of the interest rate in each year is:

1 + i LN(,

2

)

108

Financial Mathematics Exercises Actuarial Studies UNSW

where:

E(1 + i) = 1.04 = e

+

1

2

2

=Var(1 + i) = 0.02

2

= e

2+

2

_

e

2

1

_

=0.02

2

= (1.04)

2

_

e

2

1

_

=

2

= ln

_

1 +

0.02

2

1.04

2

_

= = ln 1.04

1

2

2

R code (contd):

numsim = 10000

sigma = sqrt(log(1+0.02^2/1.04^2))

mu = log(1.04)-0.5*sigma^2

s30 = c()

# Simulate lognormal interest rates (iid)

X = rnorm(n*numsim,mu,sigma)

R = matrix(exp(X),numsim,n)

# Find s30, calculate mean and variance

for(k in 1:numsim) {

s30[k] = sum(cumprod(R[k,]))

}

print(mean(s30))

print(var(s30))

plot(density(s30,adjust=1.5),xlab="s30",

main="Simulated Density of Annuity")

print(summary(s30))

109

Financial Mathematics Exercises Actuarial Studies UNSW

45 50 55 60 65 70 75

0

.

0

0

0

.

0

2

0

.

0

4

0

.

0

6

0

.

0

8

Simulated Density of Annuity

s30

D

e

n

s

i

t

y

110

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