FM All Exercises

Australian School of Business
School of Actuarial Studies
Financial Mathematics
Exercises
S1 2012
17 March 2012
Contents
1 Time Value of Money and Cash Flow Valuation
1.1
Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.1 [int1] . . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.2 [int2] . . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.3 [int3] . . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.4 [int4] . . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.5 [int5] . . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.6 [int7] . . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.7 [int8] . . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.8 [int9] . . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.9 [int10]
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Exercise 1.24 [new10] . . . . . . . . . . . . . . . . . . . . . . .
Financial Mathematics Exercises
1.2
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Exercise 1.25 [ann1] . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.26 [ann2] . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.27 [ann3] . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.28 [annB1] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.29 [annB2] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.30 [annB3] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.31 [annB4] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.32 [annB5] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.33 [annB6] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.34 [annB7] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.35 [ann4] . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.36 [ann5] . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.37 [ann6] . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.38 [ann7] . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.39 [annB8] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.40 [annB9] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.41 [ann13] . . . . . . . . . . . . . . . . . . . . . . .

1.3
Level Annuities
Actuarial Studies UNSW
Non-Level and Continuous Annuities
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Exercise 1.42 [ann8] . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.43 [ann9] . . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.44 [ann12] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.45 [new8]
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Exercise 1.46 [ann14] . . . . . . . . . . . . . . . . . . . . . . .
Exercise 1.47 [ann15] . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 1.50 [annB10]

Exercise 1.51 [loaB2]
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ii
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10
Exercise 1.59 [ann11] . . . . . . . . . . . . . . . . . . . . . . .
10
2 Life Contingencies
11
Exercise 2.1 [lif1]
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Exercise 2.2 [lif2]
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Exercise 2.3 [lif3]
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Exercise 2.4 [lif4]
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Exercise 2.5 [lif5]
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12
3 Loans and Investments

3.1
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13
Exercise 3.1 [loa1] . . . . . . . . . . . . . . . . . . . . . . . . .
13
Exercise 3.2 [loa2] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 3.3 [loa3] . . . . . . . . . . . . . . . . . . . . . . . . .
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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] . . . . . . . . . . . . . . . . . . . . . . . .

3.2
Loan Repayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
15
Investments
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Exercise 3.11 [loa4] . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 3.12 [loa9] . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 3.13 [new13] . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 3.14 [loa10]
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Exercise 3.18 [ann16] . . . . . . . . . . . . . . . . . . . . . . .
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iii
4 Interest Rate Risk

4.1
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18
Exercise 4.1 [irr1] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 4.2 [irr2] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 4.3 [irr3] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 4.4 [irr4] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 4.5 [irr5] . . . . . . . . . . . . . . . . . . . . . . . . .
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Price Sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 4.6 [irr6] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 4.7 [irr7] . . . . . . . . . . . . . . . . . . . . . . . . .
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4.2
Term Structure of Interest Rates
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Exercise 4.9 [lif6]

4.3
Immunisation
Exercise 4.10 [irr8]
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Exercise 4.11 [irr9]
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Exercise 4.12 [irr10] . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 4.13 [new12] . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 4.14 [irr11] . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 4.15 [irr12] . . . . . . . . . . . . . . . . . . . . . . . .
22
5 Derivatives
5.1
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Forwards, Futures and Swaps
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24
Exercise 5.1 [der1]
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Exercise 5.2 [der2]
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Exercise 5.3 [der3]
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Exercise 5.4 [der4]
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Exercise 5.5 [der5]
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Exercise 5.6 [der6]
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Exercise 5.7 [der7]
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Exercise 5.8 [der8]
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Exercise 5.9 [der9]
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Exercise 5.10 [der10]

5.2
Options
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iv
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6 Stochastic Interest Rates

6.1
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27
Exercise 6.2 [sto2] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 6.3 [sto3] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 6.4 [sto4] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 6.5 [sto5] . . . . . . . . . . . . . . . . . . . . . . . . .
28
Lognormal Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 6.6 [sto6] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 6.7 [sto7] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 6.8 [sto8] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 6.9 [sto9] . . . . . . . . . . . . . . . . . . . . . . . . .
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Exercise 6.10 [sto10]

6.3
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Exercise 6.1 [sto1] . . . . . . . . . . . . . . . . . . . . . . . . .
6.2
IID Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Dependence and Further Concepts
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7 Solutions to Exercises
32
7.1
Module 1
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7.2
Module 2
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7.3
Module 3
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7.4
Module 4
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63
7.5
Module 5
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7.6
Module 6
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82
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
invested today under compound interest with

with
i = 0.05,
th
year by
$100
and under simple interest
i = 0.05.
Exercise 1.2:
grow to
$275
in
to accumulate to
$275
at
[int2] At what rate of compound interest will
$200
5 years?
Exercise 1.3:
[int3] How many years does it take
an eective annual rate of
Exercise 1.4:
now of
$275
$200
5%?
[int4] With compound interest at
i = 0.05,
what is the present value
in 5 years?
Exercise 1.5:
[int5] If
$150
grows to
$240
in
years, what will
$1000
grow to over
the same period?
Exercise 1.6:
at least
5%
[int7] If funds invested today will earn
8%
for the next 10 years and
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
years followed by
Exercise 1.8:
5%
8%
for the next 10
for the following 10 years?
[int9] Assuming an eective rate of
cash ows below at times
t=0
and
t = 3.
i = 0.10,
nd the value of the
Exercise 1.9:
(assuming
[int10] The following cash ows have a value of
7.7217
at time
t=0
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
11% per
deposited n years
today and another $30 in ve years into a fund paying simple interest of
year. Tina will make the same two deposits, but the $10 will be
from today and the $30 will be deposited
2n
years from today. Tina's deposits earn
an annual eective rate of 9.15%. At the end of 10 years, the accumulated amount
of Tina's deposits equals the accumulated amount of Joe's deposits. What is the
value of
n?
Exercise 1.13:
[int15] (SOA Course 2 Nov 2000, Question 2) The following table
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
i1
10%
12%
8%
9%
7%
1990
1991
1992
1993
1994
Calendar Year of
Portfolio Rates
i2
10%
5%
(x 2)%
11%
7%
Portfolio
Rate
i3
x%
10%
12%
6%
10%
1993
1994
1995
1996
1997
8%
(x 1)%
6%
9%
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
Exercise 1.14:
x?
[int19] You wish to buy a new home theatre system and have two
potential payment options.
Option A.
You pay $610 down (at
following year (at
Option B.
You pay $560 down (at
following year (at
t = 0),
$475 next year (at
t = 1)
and $340 the
t = 0),
$580 next year (at
t = 1)
and $274 the
t = 2).
t = 2).
Assuming a compound interest accumulation function, determine the values of the

rate of interest
Exercise 1.15:
for which Option A is preferred to Option B.
[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?
(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
Exercise 1.18:
[int14] (SOA Course 2 May 2001, Question 12) Bruce and Robbie
v = 0.94,
what are
each open up new bank accounts at time 0.
and
i?
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 Bruce's account during the
11th year is equal to
X.
The amount of interest earned in Robbie's account during
the 17th year is also equal to
Exercise 1.19:
X.
What is the value of
X?
[int24] Tina issues a 2-year promissory note for a face value of
$6000 and receives $4843.30 in return (ie.

repay $6000 after 2 years).
she borrows $4843.30 and promises to
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%
(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
41
2
years based on
each of the above interest options?
Exercise 1.22:
with
(t) = 0.04(1 + t)1 ,

a(t):
[int22] Assume that the force of interest is
measured in years. Using an accumulation function
(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

at time
k.
[int23] A fund credits simple interest with
After time
k,
(a) Find the value of
i = 10%
that maximises
8%.
a(4).
from (a), nd the force of interest as function of time
0 t 4).
Exercise 1.24:
[new10] Suppose the force of interest is =

i(m) against m and (ii) d(m) against
(on the same graph) (i)
1.2
from time zero
the fund accumulates at a constant force of interest of
(b) Using the value of

(for
of an investment that accumulates to $200,000
t = 4.
Exercise 1.23:
to time
t=2
0.05. Using Excel, plot

m, for 0.5 < m < 50
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) Find the present value of this annuity.
(b) 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,
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 accumulate the funds, she plans on making ten annual deposits of
into an account paying
eective annual interest of 6%. Having computed the least possible amount
(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 5th Ed (2.1.11 in 4th Ed).
Exercise 1.29:
[annB2] Exercise 2.1.19S from Broverman 5th Ed (2.1.19S in 4th
Ed).
Exercise 1.30:
Exercise 1.31:
Exercise 1.32:
Exercise 1.33:
Exercise 1.34:
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%. After making payments for 10 years, the insurance company decides to increase the
monthly payments for the remaining 15 years by changing the eective annual interest 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 5th Ed: 2.2.13 (2.2.13 in 4th Ed). Also solve for
the case if Smith repays the loan over 5 years (monthly payments).
Exercise 1.39:
Exercise 1.40:
Exercise 1.41:
[ann13] Given that
1.3
(t) =
1
,
20t
t 0,
nd
s10 .
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
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
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
Exercise 1.44:
X.
[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 Paulo's initial deposit to the fund.
Exercise 1.45:
[new8] Using Excel, nd the present value of a 30-year annuity

t3 + ln(10t + 12) at the end of year t, assuming an eective
immediate which pays

interest rate of 5%.
Exercise 1.46:
[ann14] Value the following set of cashows at a rate of 10% p.a.:

2
1
2
1
1
and time 1 , $30 at times 1,1 and 2 , $40 at times
$10 at time , $20 at times
3
3
3
3
3
2
2, 2 3 and 3 1 , $50 at times 3 and 3 2 , and $60 at time 4.
3
3
Exercise 1.47:
[ann15] Mary purchases an increasing annuity-immediate for $50,000
that makes twenty annual payments as follows:
(i)
(ii)
P, 2P, . . . , 10P
in years 1 through 10; and
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.
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 Excel by
considering the 500 payments only.
against time
t.
Plot the present value of each payment
Does this shape remind you of something?
Exercise 1.50:
Exercise 1.51:
[loaB2] Exercise 2.3.8 from Broverman 5th Ed (2.3.8 in 4th Ed).
Exercise 1.52:
[annB11] Exercise 2.3.15 from Broverman 5th Ed (2.3.15 in 4th
Ed).
Exercise 1.53:
Exercise 1.54:
Ed).
Exercise 1.55:
Ed).
Exercise 1.56:
Ed).
Exercise 1.57:
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

2
for 13 years. The rate of payment at time t is t 1 per annum, and the force of
1
. Find the present value of the annuity.
interest at time t is
1+t
10
Module 2
Life Contingencies
Exercise 2.1:
[lif1]
is the present value random variable for a special continuous
whole life insurance issued to
(x),
bt
paying
at death at
x+t
where:
bt = e0.05t
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
are equivalent:
v k k px
ak+1 k px qx+k =
k=0
k=0
Interpret both sides of the equation and explain why it has to be true.
Exercise 2.3:
[lif3] Prove the following identity:
dx + Ax = 1
a
Exercise 2.4:
[lif4] You are given the following probabilities of death:
qx
0.10
0.05
0.10
0.20
0.40
0.70
1.00
Given a technical rate of interest of 5%, calculate by hand and using Excel:
1
Pr[K(0) = k], e0 , Pr[K(2) = k], e2 , A2 , 2 A2 , A1 , A2:3 , A2:3 , a2 , a2 , a2:3
2:3
11
ax
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.
2.
cx
is the force of mortality for smokers for
and
0 x < ,
c>1
is the force of mortality for non-smokers for
0 x < ,
and
where
is a constant
Calculate the probability that the remaining lifetime of the smoker exceeds that of
the non-smoker.
Check for the reasonableness of your answer.
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 company's 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 ) Using Excel, 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
(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 although 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 interest being charged. Do this by hand using Newton-Raphson with 5 iterations
(starting at 10%), then using Excel 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:
Exercise 3.5:
Exercise 3.6:
Exercise 3.7:
[loa5] A loan of $20000 is being repaid by monthly instalments of

1
years. Provide a schedule in
3
Excel showing the principal and interest contained in each of the last four monthly
principal and interest (18% p.a. nominal) over 8

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) payments under the consolidated loan being equal to the total remaining payments
under the existing loans.
14
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 Excel 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 Excel.
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
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
Exercise 3.13:
R.
[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) Using the Newton's Ralphson method in Excel, 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:
Exercise 3.16:
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.
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.
16
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 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 7%. Find the price paid, given that his rates of taxation
for income and capital gains are both 15%. Do this question in Excel.
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 Excel.
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
(2)
assuming interest compounds semi-annually (ie. they are i
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

t is es(t)t . Show explicitly that if the
present value of a dollar to be received at time

spot rate curve is at and that
s(t) = r,
then all forward rates must be the same.
18
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
Time Period
% p.a.
1-1.5
7.5082
1.5-2
2.0290
and forward rates:
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
tinuous compounding)
D()
tinuously at the annual rate

nominal in
be the duration, at a constant force of interest (con-
p.a., of a xed-interest security with interest payable con-
years time. Let
D per unit nominal and

g = D/R. Show that:
D() =
Exercise 4.7:
redeemable at
per unit
a
g(I)n + nv n
gn + v n
a
[irr7] Consider a xed-interest security bearing interest of 5% p.a.
payable continuously and redeemable at par in
years time, where
is not neces-
sarily an integer. Assuming a constant continuously compounding force of interest

of 7% p.a:
19
(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
= 0.07,
, may be considered as a function of n.
Assuming
show that the duration is maximised when the following equation is
satised:
0.07n + 0.05(n an ) =
a
0.07
0.07 0.05
Hence (or otherwise) nd the maximum duration and the corresponding value
of
at which the duration is maximised.
Exercise 4.8:
[new11] Consider a level
10-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) For
i = 5%,
nd the modied duration and the convexity.
(c) Using Excel and a Taylor's approximation, nd an approximate modied duration and convexity. Compare this with the answer in (b).
Exercise 4.9:
[lif6] Show that the Macaulay Duration of
ax
is equal to:
wk k
Dx =
k=0
where
wk
is given by:
wk =
4.3
v k k px
l
l=0 v l px
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
M5
and a
the value of liabilities
VL (i).
the proceeds to purchase a 5-year zero coupon bond with maturity value
15-year maturity bond with maturity value
M15 .
(a) Give expressions for the value of assets
VA (i) and
(b) What is meant by an arbitrage opportunity?

(c) By suitable choice of
M5
and
M15
such that
VA (.08) VL (.08)
is zero, demon-
strate that arbitrage prots are possible with parallel shifts to a at yield
curve.
20
Exercise 4.11:
[irr9] Consider 3 coupon paying bonds
x, y
and
z.
You have
calculated their Price to be (Px , Py , Pz ), and their duration and convexity to be

(Dx , Dy , Dz ) and (Cx , Cy , Cz ) 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
3m
4m
3m
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.
Using Excel, analyse:

(a) What happens to the surplus if the yield shifts in a parallel fashion to 6.5%?
(b) What happens to the surplus if the yield shifts in a parallel fashion to 2.5%?
(c) 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%
3.5%
1.5
4%
4.5%
2.5
5%
5.5%
3.5
6%
6.5%
4.5
7%
7.5%
(d) Determine the surplus if we are faced with a term structure where the
t-year
spot rate is given by:
st = +
where
1 et
t
= 0.06, = 0.01, = 0.08,

21
+
and
1 et
et
t
= 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:
1 e
s = + t
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
2
independent and identically distributed with t N (0.01, 0.002 ).
where
and
(a) Using Excel, plot the spot curve (for maturities

parameters and when
0 < < 20)
for the given
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 assume 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
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. 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
3m
4m
3m
2m
Assume that the spot rate is at and is equal to 4%.

available for investment two coupon bonds.
Suppose the insurer has
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.)
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.
22
(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
(3 + T )%.
is equal to
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
Exercise 5.5:
[der5] Explain the cost of carry formula:
Ft,T = St er(T t) der(T t1 )

There are no storage costs but there is a payment to the holder of the spot asset
(eg. dividend) of
Exercise 5.6:
at time
t1 .
[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
(corresponding to the two 90-day forward rates). 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:
Exercise 5.9:
Exercise 5.10:
[der10] Consider an agreement where party A receives the spot
N units of a commodity each period while paying a xed amount X per

N units. If the agreement is made for M periods (ie. at times t1 , t2 , .., tM ),
derive a formula that can be used to determine the swap price X on inception of the
price for
unit for
swap contract. Assume that no storage costs or dividends occur during the period,
and the risk free interest rate is
5.2
(continuous compounding).
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
of one year. The annual risk-free interest rate is
285 or decrease to 250 at the

5% compounded continuously
end
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
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
of one year. The annual risk-free interest rate is
285 or decrease to 250 at the

4% compounded continuously
end
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

the option is at time
T.
G(0)
at time 0, and the maturity of
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 probability 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
jt
and standard deviation
st .
In
any year, the yield is independent of the yield in any other year. The accumulated
value, after
years, of a unit sum of money invested at time 0 is
(a) Derive formulae for the mean and variance of

years
Sn
if
jt = j
Sn .
and
st = s
for all
t.
(b) Calculate the expected value of
S8
if
(c) Calculate the standard deviation of
Exercise 6.3:
j = 0.06.
S8
if
j = 0.06
and
s = 0.08.
[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
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 expected 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 i1 or i2
(i1 > i2 ),
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
i1
and
i2 .
(b) The accumulated value at time

bank at time
$0.5 million.
Exercise 6.5:
t = 25
t = 0 has expected
Find i1 and i2 .
years of $1 million invested with the
value $5.5 million and standard deviation
[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:
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 policyholders 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 uncertain return. The return from these assets in year t, it , has a mean value of 3.5% per
annum eective and a standard deviation of 3% per annum eective. The random
variables
(1 + it )
(for
t = 1, 2, . . .)
are independent and lognormally distributed.
28
(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
it
is the return in the
tth
(1 + it ) is lognormally distributed where
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. Calculate 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 bank's investment portfolio is 6% and
the standard deviation of annual eective returns is 8%. The annual eective returns are independent and
in year
(1 + it )
is lognormally distributed, where it is the return
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:
vestment bank models the expected performance of its assets over a ve-day period.
Over that period, the return on the bank's portfolio,
and standard deviation of 0.2%.
Calculate the value of
(1 + i)
i,
has a mean value of 0.1%
is lognormally distributed.
such that the probability that
is less than or equal to
is
0.05.
Exercise 6.10:
[sto10] (Institute of Actuaries Examination September 2004) The
expected annual eective rate of return from an insurance company's investments is
29
6% and the standard deviation of annual returns is 8%. The annual eective returns
are independent and
tth
(1 + it ) is lognormally distributed,
where it is the return in the
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
assumed to be independent for each year, and
with
it
(1 + it )
it
in year
is
is lognormally distributed
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 Excel, 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
yt
(for year t) follows a mean
reverting process dened by:
yt = + (yt1 ) + t
where
t N (0, 1)
iid for each time
= 0.05, = 0.4,
years time as S1 . Find:
It is also known that

value of $1 in one
(a)
t = 0, 1, . . ..
and
= 0.01.
Denote the accumulated
E(S1 )
(b) Var(S1 )
(c)
Pr(S1 < 1.04)
if the interest rate last year was (i) 4% and (ii) 6%.
Exercise 6.13:
[new6] Suppose that the interest rate
yt
(for year t) follows a mean
reverting process dened by:
yt = + (yt1 ) + t
It is also known that
= 0.05, = 0.4, and = 0.01. Denote the accumulated

S10 . Using 1000 simulations in Excel, estimate:
value of $1 in ten years time as
30
(a)
E(S10 )
(b) Var(S10 )
(c)
Pr(S10 < 1.55)
(d) Plot the histogram of
S10 .
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
(1 + it ) LN (, 2 ) and it having mean 4% and
and identically distributed, with
standard deviation 2%. Denote as s30 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
(b) Using Excel and the formulae in (a), nd
(c) Estimate
E(30 )
s
E(30 )
s
E(30 )
s
and Var(30 ).
s
and Var(30 ).
s
and Var(30 ) using simulation in Excel, and compare your

s
answers with those in (b).
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
t = 5: 100(1.05)5 = 127.6282
Interest earned = 6.08

Under simple interest:
t = 4: 100(1 + 4 0.05) = 120

t = 5: 100(1 + 5 0.05) = 125
Interest earned = 5.00
Exercise 1.2
[int2]
200(1 + i)5 = 275 i =
Exercise 1.3
ln(275/200)
ln 1.05
= 6.527
years
[int4]
275v = 215.47,
Exercise 1.5
1 = 0.06576
[int3]
200(1.05)t = 275 t =
Exercise 1.4
275 1/5
200
where
v=
1
1+i
[int5]
150(1 + i) = 240
1000(1 + i)n = 1000 150(1 + i)n =
150
Exercise 1.6
1000
150
240 = 1600
[int7]
The most one requires will be the amount
which is sucient even when the
interest rate is always at its minimum of 5% in the latter 10 years (as this minimises
32
the interest earned). Therefore:

10
10
X(1.08) (1.05)
X = 284360
Exercise 1.7
= 1000000
[int8]
The accumulation of $1 under the eective rate and the 8% and 5% rates should be
equivalent:
20
(1 + i) = (1.08)10 (1.05)10
i = 0.06489
Exercise 1.8
[int9]
t = 0:
5 + 3v + v = 8.2307
Value at time
2
3
t = 3:
8.2307(1 + i) = 10.9550
Value at time
3
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 = 1. Thus,
7.7217 + v7.7217 = 15.0757
another starting at
Exercise 1.10
t = 0
the value is given by:
[int11]
100 (1.10)3 20 (1.10)2 20 (1.10) = 86.90
Exercise 1.11
[int12]
100(1 + i) = 200
i = 0.12246
Exercise 1.12
[int13]
(SOA Course 2 May 2000, Question 1)

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
33
and
vn =
10(1.0915)10
= 0.8158
Since
v n > 0,
we have
Exercise 1.13
100(1.0915)20 + 120(1.0915)10 67.50

60(1.0915)10
1.1491
or
v n = 0.8158 n =
ln 0.8158
ln v
= 2.325
[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
Exercise 1.14
Using
v=
[int19]
1
, we have the following present values for the two payment options:
1+r
P VA = 610 + 475v + 340v 2

P VB = 560 + 580v + 274v 2
P VB P VA = 50 + 105v 66v 2 > 0. Note that the
quadratic 50 + 105v 66v = 0 has no real roots. The quadratic is negative at
v = 1, since 50 + 105 66 = 11 < 0. This implies that P VB < P VA for all values
of r , so Option B is always preferred to A.
Option A is preferred when

(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%
34
Alternative B:
1000(1 + r)5 = 1550

r = 9.1607%
Alternative C:
1000(1 + r)5 = 425 1 +
1
1+r
1
+
1+r
1
1+r
r = 8.5761%
Note: for C, the yield must be found numerically (eg. using Solver in Excel - See
Spreadsheet int18.xlsx)
(b) We need the accumulated value of $1330 at a rate r
to be at least $1550:
1330(1 + r)2 1550

1330r2 + 2660r 220 0
For equality, we have:
2660
r=
26602 + 4 1330 220

= 0.079543
2660
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
1
1+r
A to be a better choice than B.
(c) The value of alternative C is:

1
425 1 +
+
1+r
1
1+r
= 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
. Therefore, we obtain
1.13
Exercise 1.17
P = 284314.54.
[int6]
d = 1 v = 0.06
1
1
v = 1+i i = v 1 = 0.06383
Also:
i = d/v = 0.06383
35
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 .
100R10 (R 1) = 50R16 (R 1)
2R10 = R16
R6 = 2
R = 21/6
X = 100(R11 R10 ) = 38.8793
Exercise 1.19
[int24]
An equation of value to solve for the eective semi-annual interest rate
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:
1
1000 1 + 0.06
12
0.06
1+
4
19
0.06
4
18
0.06
1+
4
17
= 1333.59
June deposit accumulates to:
1000 1 + 0.06
1
12
1+
= 1313.88
September deposit accumulates to
1
1000 1 + 0.06
12
36
= 1294.46
December deposit accumulates to
1
1000 1 + 0.06
12
16
0.06
1+
4
= 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
i(m)
1+
m
1+i=
m
1
= (1 d)
d(m)
1
m
= e
we have:
Given rate
Equivalent eective rate
d = 0.05
i(2) = 0.05
i(12) = 0.05
d(2) = 0.05
d(12) = 0.05
= 0.05
Exercise 1.22
A(4.5) = 10000(1 + i)4.5

12596.32
12488.63
12517.38
12559.10
12529.11
12523.23
0.0526316
0.0506250
0.0511619
0.0519395
0.0513809
0.0512711
[int22]
Note that the accumulation function is given by:
a(t) = exp
(s)ds
= exp
(a)
(b)
0.04
ds
1+s
= (1 + t)0.04
a(2) a(1)
(3)0.04 (2)0.04
=
= 0.01635084
a(1)
(2)0.04
a(3) a(2)
(4)0.04 (3)0.04
= 0.01157375
=
a(2)
(3)0.04
(c) Since A(t) = A(0)(1 + t)0.04 , then A(0) =

A(2) =
200000
(5)0.04
= 187530.19.
200000 0.04
(3)
= 195954.86
(5)0.04
37
Therefore:
Exercise 1.23
[int23]
We have
a(t) =
1 + 0.1t
(1 + 0.1k) exp [0.08(t k)]
tk
t>k
a(4) =
(1 + 0.1k) exp [0.08(4 k)]

1.4
k<4
k4
Hence
(a)
ie.
To maximize
k < 4;
a(4),
dierentiate w.r.t.
(assuming
a(4) = (1 + 0.1k)e0.08(4k) ,
will need to check this)
d
a(4) = 0.1 exp [0.08(4 k)] 0.08 (1 + 0.1k) exp [0.08(4 k)]
dk
and set to be zero. Solving for
(and noting that the exponential is positive) we
have:
0.1 = 0.08 (1 + 0.1k)

k = 2.5
k = 2.5, a(4) > 1.4, so assumption of k < 4 is OK. Note that if the assumption of k < 4 was violated, then a(4) = 1.4 as opposed to our earlier expression
0.08(4k)
of (1 + 0.1k)e
, and a(4) will have a maximum of 1.4 (at any k 4).
Check: at
(b)
a(t) =
ln a(t) =
(t) =
Exercise 1.24
d
ln a(t) =
dt
t 2.5
t > 2.5
1 + 0.1t
1.25e0.08(t2.5)
ln(1 + 0.1t)
ln 1.25 + 0.08(t 2.5)
0.1
1+0.1t
0.08
t 2.5
t > 2.5
t 2.5
t > 2.5
[new10]
We use the result:
1+i=
1+
i(m)
m
= (1 d)1 =
d(m)
m
= e
Therefore:
i(m) = m e/m 1
d(m) = m e/m 1
See spreadsheet new10.xlsx for plotting
i(m)
the one below.
38
and
d(m) .
The plot should be similar to
Nominal Interest/Discount Rates
0.046
0.048
0.050
Nominal Rate
0.052
0.054
i(m)
d(m)
10
20
30
40
50
Compounding Frequency
Note that
= 0.05
and all the points on this plot yield the same eective rate of
interest!
Exercise 1.25
[ann1]
(a) Each monthly payment is

rate
1
of the nominal amount. The eective monthly
12
is given by:
i=
0.12
= 0.01
12
Therefore:
72
120
1000
1
400
1
PV =
a72 0.01 +
a48 0.01 +
2000
12
1.01
12
1.01
72
1
1
1
400 1 ( 1.01 )48
1000 1 ( 1.01 )72
+
+
=
12
0.01
1.01
12
0.01
= 4262.50 + 618.34 + 605.99
= 5486.80
Alternatively, we can obtain the annual eective rate
j = 1.0112 1 = 0.1268
39
j:
1
1.01
120
2000
Then, using annuities payable monthly:
(12)
P V = 1000a6
1
1+j
6
1 vj
0.12
= 5486.80
= 1000
(12)
400a4
1
1+j
400
1
1+j
4
1 vj
0.12
10
2000
+
1
1+j
10
2000
(b) Assume level annuity payments payable monthly, then
1
1 ( 1.01 )120
= 5486.80
0.01
X = 78.720
The quoted annual payment is then
Exercise 1.26
78.720 12 = 944.64.
[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
a = v 20 P a
3 20
P
3
1 v 20
P
= v 20
i
i
20
20
1 v = 3v
v 20 = 0.25
i = (0.25)1/20 1 = 0.07177
Exercise 1.27
[ann3]
The accumulated value of the deposits 10 years after the rst deposit is:
AV = C s10 0.06
10
= C(1.06)
10
1
1.06
0.06
= 13.1808C
The present value of the loan payments as at the end of 10 years is:
P V = 150005 0.06
a
1
1 1.06
0.06
= 15000
= 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
40
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
and
are given by:
(1 + i)12 = 1.03 i = 0.00246627

(1 + j)12 = 1.05 j = 0.00407412
The original monthly payment
is given by:
P a300 i = 100000 P =
100000
= 472.1087
a300 i
After 10 years, the remaining value of the annuity is:
P a180 i
This will also be the present value of the new annuity (with annual payments of
which is valued at the new interest rate
),
j:
P a180 i = P a180 j
Therefore, the new payment is:
P =P
a180 i
= 538.1869
a180 j
Thus, the payment increase is:
P P = 66.08
Exercise 1.36
[ann5]
The 1-year eective rate
and 2-year eective rate
are given by:
i = 1.0252 1 = 0.050625
j = 1.0254 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:
P V = 100a20 i + 100a10 j = 1844.16
Exercise 1.37
[ann6]
A discount rate of 10% p.a. is equivalent to an interest rate of

Therefore, the current cash ows are worth:
1800012 i = 18000 (1 + a11 i ) = 129162.10

a
We want annual payments of
where:
129162.10 = Xa20 i
X = 16337.69
41
i = 11.11%
p.a.
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
s10
[ann13]
is the accumulated value (at time 10) of $1 paid at each time
accumulated value (at time 10) of a single $1 paid at time
10
exp
n
1
dt
20 t
t = 1, . . . , 10.
The
is given by:
= exp [ ln(20 10) + ln(20 n)]

= exp ln
=
20 n
10
20 n
10
Therefore:
10
s10 =
n=1
Exercise 1.42
20 n
19 + 18 + . . . + 10
1 10(10 + 1)
=
= 20
= 14.5
10
10
10
2
[ann8]
The loan repayments are an increasing annuity with payments of
t = 1, 2, . . . , 30.
t = 0):
times
time
To determine the value of
P,
P, 2P, . . . , 30P
at
we use an equation of value (at
a30 0.04 30v 30
0.04
P = 18.32
4000 = P (Ia)30 0.04 =
Immediately after the ninth payment, the outstanding loan is found by decomposing
the remaining payments into a level annuity and an increasing annuity:
10P v + 11P v 2 + 12P v 3 + ... + 30P v 21 = 9P a21 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 decomposed 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) = 300a15 0.05 + 200(Ia)15 0.05

42
Noting that:
a15 0.05 = 10.379658

15v 15
a
(Ia)15 0.05 = 15 0.05

= 73.667689
0.05
(Ds)5 0.05 = (1 + i)5 (Da)5 0.05
= (1 + i)5 [6a5 0.05 (Ia)5 0.05 ]
a5 0.05 5v 5
5
= (1 + i) 6a5 0.05
0.05
= 17.115531
We obtain:
X=
Exercise 1.44
300a15 0.05 + 200(Ia)15 0.05

= 993.11
(Ds)5 0.05 (1 + i)
[ann12]
The annual eective rate
is given by:
1 + i = 1.0254 i = 0.103813
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
B. Deposits of
1.1025X, (1.1025)2 X, . . . , (1.1025)11 X
where time
at times
t = 0, 1, . . . , 10
at times
1
1
t = 2 , 1 1 , . . . , 10 2
2
is measured in years.
These two series are (geometrically) increasing annuities, and can be present valued
as geometric progressions:
P VA = X + 1.1025Xv + . . . + (1.1025)10 Xv 10
1 (1.1025v)11
=X
1 1.1025v
= 10.934815X
P VB = v 1/2 (1.1025) X + 1.1025Xv + . . . + (1.1025)10 Xv 10
= v 1/2 (1.1025) P VA
= 11.474726X
Therefore, the initial deposit
is found as follows:
P VA + P VB = 110000v 11
X = 1656.19
43
Exercise 1.45
[new8]
The present value is $67989.65.

Refer to Spreadsheet new8.xlsx.
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
1
t = 3, 11, 21, 31
3
3
3
B. 20, 30, 40, 50 at times
t = 2, 12, 22, 32
3
3
3
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:
P VA = 10v 1/3 (I)4

a
P VB = 10v 2/3 (I)4 + 10v 2/3 a4
a
P VC = 10v(I)4 + 20v4
a
a
The annuity factors are given by:
(I)4 = 1 + 2v + 3v 2 + 4v 3
a
= 8.302780
1 v4
a4 = (1.1)
0.1
= 3.486852
Therefore, we obtain the present value:
P VA + P VB + P VC = 329.95
A more elegant method involves decomposing the original payments into:
X. 10,20,30,. . . ,10,20,30 at all times (t
= 1 , 2 , 1, . . . , 4)
3 3
Y. 0,0,0,10,10,10,. . . ,30,30,30 at all times (t
= 1 , 2 , 1, . . . , 4)
3 3
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 annuity:
P VX = 10(Ia)3 j a4 i = 194.3179
44
where
i = 0.1
is the annual eective rate, and
j = (1.1)1/3 1
is the
1
-year eective
3
rate.
Conversely, the payments of Y can are a 3-year increasing annuity, with each payment being a level annuity (omitting the rst three payments of 0):
P VY = 10a3 j (Ia)3 i = 135.6289

Summing these up, we obtain the same present value:
P VX + P VY = 329.95
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
n
n
n
payment is of amount 10(1.05) P which is worth 10(1.05) P v 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:
Xa20 0.05 = 10000

X = 802.4259
(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
X = 608.1346
45
= 10000
(c) To be fair, we need the present value of both payment streams to be equal (to
10000).
In nominal terms:
20
20
k
608.13(1.03)k v0.05 =
k=1
k
802.43v0.05 = 10000
k=1
or in real terms:
20
20
k
608.13vr
k=1
where
1.05
1.03
r=
Exercise 1.49
k
802.43(1.03)k vr = 10000
=
k=1
1.
[new1]
(a) The annual eective interest rate is

We note that the payment at time
i = e 1 = 0.05127.
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:
P V = v + 2v 2 a + 3v 3 a + . . .
a
= a v + 2v 2 + 3v 3 + . . .
= a (Ia)
Therefore:
1
d
1
= 2
di
= 8200
PV =
where
d = iv = 0.04877.
(b) See spreadsheet new1.xlsx. The plot should be similar to the one below.
46
60
0
20
40
PV of payment
80
100
120
q
q
q
q
q
qq
qq
q
qq
q q
q
q q
q q
q q
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q
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q
q
q
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q
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q
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q
q
q
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q
q
q
q
q
q
q
q
q
q
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q
q
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qq
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q
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qq
qqq
qqq
q
qqq
qqqq
qqqq
qqqq
qqqqqq
qqqqqq
qqqqqqqqqqqqqqq
qqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqq
q
qqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqq
qqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqq
qqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqqq
100
200
300
400
500
Time
Aside: The graph is actually related to the Gamma function. The present value of
the
nth
payment is:
1 2 n 1 n 1 2 n 1 n
n v + nv = n e
+ ne
2
2
2
2
Thus, we require:
2 n
ne
nen
and
n=1
n=1
These can be approximated using the Gamma function by noting that:
xk1 ex
xk1 ex dx
(k) = (k 1)! =
0
k=1
Therefore, the present value is:
PV =
1
2
2
1
=
2
1
=
2
n2 en +
n=1
nen
n=1
2 x
xe
0
xex dx
dx +
0
1
1
u2 eu du + 2
3
0
2!
1!
+ 2
3
47
ueu du
0
where
u = x
The force of interest is
= 0.05,
which results in:
P V 8200
Exercises 1.501.57
[annB10annB15] See the solutions in the Broverman text and solutions manuals.
Exercise 1.58
We require
[new2]
(12)
100(Ia)10 , 100(Ia)10
100(I)10 .
a
, and
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:
a10 10v 10
i
= 3937.38
a 10v 10
= 10 (12)
i
= 4026.81
a 10v 10
= 10
= 4035.01
100(Ia)10 =
(12)
100(Ia)10
100(I)10
a
Exercise 1.59
[ann11]
The present value of the annuity is given by:
14
(t2 1)v t dt
PV =
1
where the discount factor
vt
varies (continuously) with time
v t = exp
0
1
ds
1+s
t:
= exp ( ln(1 + t)) =
1
1+t
Therefore, we have:
14 2
PV =
1
t 1
dt =
t+1
48
14
(t 1)dt = 84.50
1
7.2
Module 2
Exercise 2.1
[lif1]
Note that if the force of mortality is constant, then the survival function is exponential:
t
t px
= exp
x+s ds
= et
0
Therefore:
bt v t t px x+t dt
E[Z] =
0
e0.05t e0.06t e0.01t 0.01dt
=
0
e0.02t dt
= 0.01
0
1
=
2
e0.1t e0.12t e0.01t 0.01dt
E[Z 2 ] =
0
e0.03t dt
= 0.01
0
1
=
3
Var(Z) = E[Z 2 ] (E[Z])2 =
Exercise 2.2
1 1
1
=
3 4
12
[lif2]
Writing out the (contingent) annuity-certain in terms of the interest rate:
ak+1 k px qx+k =
k=0
k=0
This gives us a
1 v k+1
d
k px qx+k
term, which is similar to the RHS. We don't want the
write it in terms of
p:
49
q,
so we
1 v k+1
d
k=0
=
k=0
k px
1 v k+1
d
(k px k+1 px )
(1 px+k )
1
=
d
k=0
1
=
d
k=0
k px
k=0
k=1
k px
v k+1 k+1 px
v k px +
k=0
v k+1 (k px k+1 px )
(k px k+1 px )
k=0
1
1v
v k k px +
v k k px
d
k=0
k=1
1
v
v k k px +
=
v k k px
d
k=0
k=0
since
v 0 0 px = 1.
Therefore:
1v
=
d
v k k px
k=0
v k k px
=
k=0
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
Let
K(x)
[lif3]
be the curtate lifetime random variable of
(x).
ax = E aK(x)+1
ak+1 Pr [K(x) = k]
k=0
ak+1 k| qx
k=0
=
k=0
1
d
1 v k+1
d
k| qx
v k+1 k| qx
k| qx
k=0
k=0
1 Ax
=
d
50
We have:
dx + Ax = 1
a
Exercise 2.4
[lif4]
The required values are:
Pr[K(0) = k] = k p0 qk
= {0.1, 0.045, 0.0855, 0.1539, 0.2462, 0.2586, 0.1108, 0}
6
e0 = E[K(0)] =
k Pr[K(0) = k]
k=0
= 3.6203
Pr[K(2) = k] = k p2 q2+k
= {0.1, 0.18, 0.288, 0.3024, 0.1296, 0}
for
e2 = E[K(2)] =
k Pr[K(2) = k]
k=0
= 2.1816
4
v k+1 Pr[K(2) = k]
A2 =
k=0
= 0.8576
4
2
v 2(k+1) Pr[K(2) = k]
A2 =
k=0
= 0.7379
2
A1 =
2:3
v k+1 Pr[K(2) = k]
k=0
1
A2:3
A2:3
= 0.5073
= v 3 3 p2 = 0.3732
1
= A1 + A2:3 = 0.8805
2:3
4
v k k p2
a2 =
k=0
= 2.9900
a2 = a2 1 = 1.9900
v k k p2
a2:3 =
k=0
= 2.5102
See Excel spreadsheet lif4.xlsx for the calculations.
51
k = 0, . . . , 5
for
k = 0, . . . , 7
Exercise 2.5
Let
T = T (x)
[lif5]
be the (random) lifetime of the non-smoker and
T S = T S (x)
be the
lifetime of the smoker. Note that we are comparing newborns. We want to nd:
Pr T S > t fT (t) dt
Pr T > T =
0
where we have conditioned on the future lifetime

Note that:
to construct the integral.
Pr T S > t = t pS = exp
0
cu du
= (t p0 )c
0
where t p0
= Pr(T > t).
Also, the density of
fT (t) =
since the survival function
is given by:
d
d
d
FT (t) = (1 S(t)) = t p0
dt
dt
dt
S(t)
is equivalent to t p0 . Therefore:
(t p0 )c (t p0 ) dt
Pr T > T =
0
(t p0 )c+1
=
c+1
1
=
1+c
(because t p0 is of the form
[parameter]
The answer is reasonable because:
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)
7.3
Module 3
Exercise 3.1
[loa1]
(a) The repayments involve annual payments (in arrears) of
X,
ie. an annuity-
immediate:
Xa5 = 15000
X = 3464.62
(b) The retrospective method considers the accumulated value of past cash ows:
OB2 = 15000(1.05)2 Xs2

= 9435.02
52
(c) The prospective method considers the present value of future cash ows:
OB2 = Xa3
= 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 a3 0.075 = OB2 = 9435.02

Y = 3628.12
(e) Let the renegotiated payment be
Z.
We have:
Za4 0.076 = OB2 = 9435.02

Z = 2823.31
(f ) See the tutorial solution spreadsheet (loa1.xls).
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
such that the sinking fund will
accumulate to the $20000 principal after 6 years:
Xs6 0.05 = 20000

X = 2940.35
Therefore, the annual repayment is:
1400 + 2940.35 = 4340.35

(b) Similarly to (a), we have:
Xs6 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).
53
Exercise 3.3
[loa3]
(a) Total interest to be repaid:
I = Lf n = 5000 0.10 2 = 1000

Monthly loan repayments are:
R=
The monthly eective rate
L+I
6000
=
= 250
N
24
is the solution to the following equation of value:
Ra24 j = 5000
Using Newton-Raphson, we dene the function
f (j) = Ra24 j 5000 = 250
as follows:
1 (1 + j)24
j
5000
The derivative is:
f (j) = 250
Starting with
24j(1 + j)25 (1 (1 + j)24 )

j2
j0 = 0.10:
j1 = j0
j2 = j1
j3 = j2
j4 = j3
j5 = j4
f (j0 )
f (j0 )
f (j1 )
f (j1 )
f (j2 )
f (j2 )
f (j3 )
f (j3 )
f (j4 )
f (j4 )
This results in an annual eective rate
= 0.062716
= 0.022528
= 0.004878
= 0.014291
= 0.015125
of:
i = (1 + j5 )12 1 = 19.74%
Using spreadsheet loa3.xlsx for 10 iterations of Newton Ralphson. The solution
is
j = 0.015131.
Therefore, the eective annual rate
is:
i = (1 + j)12 1 = 19.75%
(b) The outstanding balance (using the prospective method) is:
250a12 j = 2724.66
54
Exercises 3.43.6
[loaB3loaB5] See the Mathematics of Investment and Credit solutions manual.
Exercise 3.7
[loa5]
The eective monthly rate is
0.18
12
= 0.015.
Therefore, the monthly repayment
is
given by:
Xa100 0.015 = 20000 X = 387.41

As we are only required to provide the last four instalments (ie. 97th100th payments), we can begin the loan schedule at time
balance at time
t = 96
t = 96
(months). The outstanding
is:
OB96 = Xa4 0.015 = 1493.23

The loan schedule for times
t = 97, . . . , 100
can then be found using the following
recursive equations:
It = OBt1 0.015
P Rt = X It
OBt = OBt1 P Rt
Therefore, we obtain:
Time
Interest
Principal Repaid
Outstanding Balance
(t)
(It )
(P Rt )
(OBt )
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
The full loan schedule is shown in the tutorial spreadsheet provided (loa5.xls).
Exercise 3.8
[loa6]
The present value of the original four loans is:
P V = 4.36a11 0.01 + 17.2a15 0.01 + 35a12 0.01 + 20.24a18 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
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).
55
Therefore, the loan will be assumed to involve monthly repayments of

additional nal payment of
X,
with an
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
Xan 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
X and Y
n, v n+1 , an 0.01
choices of n:
get
to dierent values (as it has to be an integer) and
by solving the simultaneous equations (noting that the coecients

are all known once
is known).
Here are the results for various
11
69.25
328.56
12
72.45
220.86
13
74.02
128.05
14
74.51
47.13
15
74.29
-24.11
16
73.60
-87.40
17
72.61
-144.05
18
71.41
-195.13
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
portion of the loan.
and so we choose
Hence, the solution where
n = 14
with
X = 74.51
and
n = 14 is the most appropriate,

Y = 47.13. In other words, the
consolidated annuity is of $74.51 for 14 months, with a nal payment of $47.13 at

the end of 15th month.
Note: the necessity of the nal payment
table) that there is no solution where
can be veried by observing (from the
is an integer and
Y = 0.
The table can be found in spreadsheet loa6.xlsx.
Exercise 3.9
[loa7]
The initial payment

0.12
= 0.01:
12
can be found as follows, noting the monthly eective rate is
Xa12 0.01 + (1.1)Xv 12 a12 0.01 + (1.1)2 Xv 24 a12 0.01 = 47500

X = 1440.80
The loan schedule is shown in the tutorial spreadsheet provided (loa7.xls).
56
Exercise 3.10
(a) Let
[loa8]
be the annual payment. We have:
Xa10 0.0675 = 600000 X = 84441.97

Hence total payment is
(b) Let
10X = 844419.69.
be the monthly payment. The monthly eective rate
is given by:
1 + i = (1.0675)1/12 i = 0.005458
Therefore:
Y a120 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
OB5
under the old interest rate of
6.75%:
OB5 = Xa5 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:
Xa5 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.
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 payments). Therefore, we will model the loan using a spreadsheet (loa4.xls).
1
t = 0, 4 , . . . , 19. The interest (It ), principal repaid (P Rt ) outstanding balance (OBt ), and nominal/actual payments (N P Rt , AP Rt )
The time step will be one quarter, ie.
are described using a set of recursive relationships:
It = OBt 1 0.02
4
P Rt = AP Rt It
OBt = OBt 1 P Rt
4
75000
N P Rt =
= 5000 (t = 5, 6, . . . , 19)
15
AP Rt = 5000 (t = 5, 6, . . . , 19)
57
0.08
= 0.02, and the
4
nominal and actual payments are equal since the loan is repaid at par.
where we note that the quarterly eective interest rate is
The net cash ows received by the purchaser are the payments of interest
principal
(AP Rt ).
these cash ows at the rate
i.
1
1+i
t
where the summation is taken over
For
and
(It + AP Rt )
t = 0, 1 , . . . , 19.
4
i = 0.10, the price is P = 66636.60.

2
i = 1 + 0.10 1 = 0.1025, the price
2
Exercise 3.12
(It )
is found by discounting
Therefore:
P =
For
The price for a required eective yield
is
P = 65565.63.
[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:
ITt = I It
CGTt = (CG CGt )+ = CG AP Rt
N P Rt
P
500000
The capital gain is determined as the actual repayment less the purchase price. The
N P Rt
portion of the loan repaid by AP Rt is
of the entire loan, and this portion of
500000
N P Rt
P.
the loan was purchased at a price of
500000
The price is the present value of the net cash ows at the eective yield of 6%:
v t (AP Rt + It ITt CGTt )
v t CFt =
P =
t
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
v t AP Rt = 25000(1.05)v 10 a10
t
t
v t OBt 1
v (It ITt ) = (1 I ) (0.08)

t
25000
v CGTt = 0.3 25000(1.05)
P
500000
t
v 10 a10
where:
(4)
(4)
(4)
v t OBt 1 = 500000a10 + 475000v 10 a1 + . . . + 25000v 28 a1

4
t
(4)
(4)
(4)
= 500000a10 + 25000v 10 a1 (Da)19

58
i = 0.06):
Exercise 3.13
[new13]
(a) The equation of value is:
80 = 6a10 + 100v 10
(b) Newton-Raphson nds the root of
f (x) = 0
xn = xn1
where
xn
is the root obtained from the
recursively as follows:
f (xn1 )
f (xn1 )
nth
iteration.
The equation we need to solve is:
1 v 10
+ 100v 10 80
i
6 6(1 + i)10
=
+ 100(1 + i)10 80
i
i
0=6
Thus, dene:
f (x) =
6 6(1 + x)10
+ 100(1 + x)10 80
x
x
See Spreadsheet new13.xlsx for the iterations in Excel.
The solution is
i =
9.1349%.
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) a4 j + 100 (1 + j)4

where
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)a4 j + 100 14.66(0.5) (1 + j)4

59
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:
N P Rt
AP Rt
It
OBt
ITt
= 100 (t = 4)
= N P Rt
= i OBt1
= OBt1 N P Rt
= (0.35)It
CGTt = (0.50) AP Rt
N P Rt
P
100
v t (AP Rt + It ITt CGTt )
P =
t
i is the interest
v = (1 + j)1 .
where
and
rate (15% or 8%) and
We require the yield such that

in a solution of
is the annual eective yield,
is (a) 105.80 or (b) 85.34. These both result
j = 8.00%.
(b) Instead of putting $100 in one single bond, we now put

and
$ (100 x)
into the 15% bond
into the 8% bond. This means that we buy:
x
105.8
and
$x
of the 15% bond with face value 100
100 x
85.34
of the 8% bond with face value 100
We want to nd the value
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 =
100 x
x
(100 105.8) +
(100 85.34) = 0
105.8
85.34
x=
100(14.66)
85.34
5.8
+ 14.66
105.8
85.34
= 75.81
The equation of value is then:
100 =
x
100 x
4
4
15(1 0.35)a4 j + 100vj +
8(1 0.35)a4 j + 100vj
105.8
85.34
The solution
j = 8.46%
can be veried by substitution.
For the spreadsheet model, we note that the combined portfolio can be considered as a single bond (since interest payments are still level, and face value
60
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 )
x
is the proportion of the rst bond purchased, and
105.8
is the proportion of the second bond purchased.
where
1 =
100x
85.34
The rest of the spreadsheet remains the same. The yield can be solved numerically 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 d (C + Gan + 100v n )
where the interest rate used is the semi-annual eective rate
i=
0.0475
2
= 0.02375,
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):

4
P = v 182 2.875a10 + 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 inationlinked life annuities, or some general insurance liabilities). See also:
http://en.wikipedia.org/wiki/Ination-indexed_bond
61
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.
Exercise 3.20
[loa13]
A spreadsheet model can be used with the following equations (where time
1
0, 2 , . . . , 30 is in years):
t =
0.035 t 26.5
0.04 t > 26.5
150000 t = 10, 11, . . . , 18
N P Rt = 250000 t = 19, 20, . . . , 29
300000 t = 30
1.05 t = 10, 11, . . . , 18
Rt = 1.10 t = 19, 20, . . . , 29
1.12 t = 30
it =
AP Rt = N P Rt Rt
It = it OBt 1
2
OBt = OB
t 1
2
N P Rt
t
vj (AP Rt + It )
P =
t
j = 0.065 is the required eective yield. Also note that the original outstandbalance (face value) is
t N P Rt = 4, 400, 000.
where
ing
The spreadsheet is provided in loa13.xls. The price is $4,797,748.66.
Exercise 3.21
The price
[loa14]
is the present value of all cash ows at the net eective yield of
This question is not too complex, and can be solved by hand.
j = 0.08.
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
P <0
1200
P > 1200. Therefore, the only possibility of a capital gain is with

repayment (at time t = 4). For the 3rd repayment, the capital gain is:
since we are given

the 3rd
400
1
P = 480 P
1200
3
P < 1440. Therefore, the capital
400(1.2)
which will only be positive if
repayment is:
CGT4 =
0.20 480 1 P
3
0
62
P < 1440
P 1440
gains tax for the 3rd
Thus, we can solve this question by considering two cases:
(i) For
P < 1440,
P < 1440 and P 1440.
there is CGT, and the price is given by:
P = (1 0.20) 0.10 1200v + 1200v 2 + 800v 3 + 400v 4

1
+ 400(v 2 + v 3 + 1.2v 4 ) 0.20 480 P v 4
3
P = 1249.47.
which can be solved to obtain

assumption of
(ii) For
P 1440,
P < 1440,
This is consistent with the
so it is a valid solution.
there is no CGT, and the price is given by:
P = (1 0.20) 0.10 1200v + 1200v 2 + 800v 3 + 400v 4

= 1258.80
This is not consistent with the assumption of
+ 400(v 2 + v 3 + 1.2v 4 )
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:
0.04875180
2
v(1) =
0.05031182
1+
2
v(1.5) =
0.05234408
1+
2
0.05448436
2
v(0.5) =
v(2) =
1+
1+
= 0.976204
= 0.951525
= 0.925421
= 0.898067
and hence the value of the bond is:
P =
6.75
[v(0.5) + v(1) + v(1.5) + v(2)] + 100v(2) = 102.467
2
(b) To determine the yield (eective yearly), we need to solve:
(2)
2
6.75a2 i + 100vi = 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%).
63
(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)
= 0.025146
v(0.5) + v(1)
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)
= 0.027173
v(0.5) + v(1) + v(1.5) + v(2)
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 + st )t = (1 + st1 )t1 (1 + ft1,t )

This can be rewritten as:
ft1,t
(1 + st )t
1
=
(1 + st1 )t1
Using the above equation in semi-annual time steps, we obtain:
f0, 1 = s0.5 = 0.024376

2
f 1 ,1
2
f1,1.5
f1.5,2
(1 + s1 )2
1 = 0.025937
=
(1 + s0.5 )
(1 + s1.5 )3
=
1 = 0.028207
(1 + s1 )2
(1 + s2 )4
=
1 = 0.030459
(1 + s1.5 )3
where the spot and forward rates are semi-annual eective rates. These forward rates are equivalent to nominal p.a. rates (payable semi-annually) of
4.8752%, 5.1873%, 5.6415%, and 6.0919%.
64
Exercise 4.2
[irr2]
A zero coupon bond can be constructed by purchasing a combination of the two

bonds (ie.
9% bonds and
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
For all
t,
[irr3]
by equating the accumulation of $1 with certainty, we obtain:
t1
s(x)dx
s(x)dx exp (ft1,t ) = exp
exp
0
t1
s(x)dx + ft1,t =
s(x)dx
0
ft1,t = rt r(t 1) = r
which is a at forward rate curve.
Exercise 4.4
[irr4]
ft1,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
Denote
the corresponding time periods:
f0,1
1+
2
f0.5,1.5
2
f1,2
1+
2
f1.5,2.5
1+
2
f2,3
2
1+
1+
1+
f0,0.5
2
1+
f0.5,1
2
= (1.025)(1.0275) = 1.053188
1+
f0.5,1
2
1+
f1,1.5
2
= (1.0275)(1.03) = 1.058325
1+
f1,1.5
2
1+
f1.5,2
2
= (1.03)(1.0305) = 1.061415
1+
f1.5,2
2
1+
f2,2.5
2
= (1.0305)(1.03125) = 1.062703
1+
f2,2.5
2
1+
f2.5,3
2
= (1.03125)(1.035) = 1.067344
65
These can be solved to obtain:
f0,1 = 5.2498%
f0.5,1.5 = 5.7498%
f1,2 = 6.0500%
f1.5,2.5 = 6.1750%
f2,3 = 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:
1
(1 + st )2t
2
v(t) =
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:
1
v(1.5) =
s1.5 3
2
1+
s1
2
1+
1+
0.0525 2
2
1+
f1,1.5
2
1+
0.075082
2
= 0.915142
v(2) =
1
4
s2
2
1+
s1 2
2
1+
1+
0.0525 2
2
1+
f1,1.5
2
1+
0.075082
2
= 0.905951
Exercise 4.6
f1.5,2
2
The resulting price is
1+
P = 105.591.
[irr6]
We have:
P = D an + Ren
= D an nRen
66
1+
0.020290
2
where:
an =
=
0
et dt
0
t
e dt
tet dt
=
0
a
= (I)n
Therefore, the duration is given by:
1 P
P
a
D(I)n nRen
=
D an + Ren
a)n + nv n
g(I
=
gn + v n
a
D() =
where
g = D/R.
Exercise 4.7
[irr7]
(a) Consider a nominal amount of $1 of bond. The coupon income is

payable continually to redemption at time
4.6):
D() =
at
= 0.07,
n.
g = 0.05 p.a.,
The duration is (from Exercise
a
g(I)n + nv n
gn + v n
a
which results in 11.592 for
n = 20
and 14.345 for
(b) To nd the maximum duration, we need to dierentiate
n = 60.
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
nv n
n
an
n

I n
a
n
= v n ln v = v n
= nv n ln v + v n = (1 n) v n
1
1
(1 v n ) = (v n ) = v n
n
1
1
=
(n nv n ) = (v n + (1 n)v n ) = nv n
a
n
Therefore:
a
(gn + v n ) (gnv n + (1 n)v n ) g(I)n + nv n (gv n v n )
a
D() =
n
(gn + v n )2
a
67
Setting this to zero:
a
0 = (gn + v n ) gnv n + (1 n)v n g(I)n + nv n (gv n v n )
a
a
= (gn + v n ) 1 + (g )n v n g(I)n + nv n (g ) v n
a
a
= (gn + v n ) + (g ) gnn + nv n g(I)n nv n
a
a
a
= (gn + v n ) + (g ) gnn g(I)n
a
a
Noting that we require an equation in terms of
an
(ie. without
vn
and
a
(I)n ):
g
a
a
a
0 = (gn + 1 n ) + (g ) gnn (n nv n )
a
g
a
= 1 + (g ) an + gnn (n n + nn )
a
a
g
a
= 1 + (g ) an (n n)
g
( g) an (n n) = 1
g
1
an + (n an ) =
n + g(n an ) =
a
g
as required (g = 0.05, = 0.07). This can then be solved numerically
obtain n = 64.349 and a corresponding duration of 14.349.
Exercise 4.8
[new11]
(a) The modied duration and convexity are:
1 P
P i
1 2P
C=
P i2
MD =
(b) For a 10 year annuity, we note that:
1 (1 + i)10
i
P
10i(1 + i)11 + (1 + i)10 1
=
i
i2
2
2
P
2(55i (1 + i)12 10i(1 + i)11 (1 + i)10 + 1)
=
i2
i3
i = 0.05 we see that:
P (i) =
For
P (0.05) = 7.7217
1 P
MD =
P i
= 4.856
1 2P
C=
P i2
= 35.602
68
to
(c) The rst and second derivatives of the price are approximated by:
P
P (i + h) P (i h)
=
i
2h
2P
P (i + h) 2P (i) + P (i h)
=
i2
h2
h is a small increment in the interest rate. For this question, we shall
take h = 0.005. See Excel spreadsheet new11.xlsx. For h = 0.005, modied
duration is 4.8576 and convexity is 35.6093.
where
Exercise 4.9
[lif6]
Recall that:
(1 + i)k k px
ax =
v k px =
k=0
k=0
To nd the duration, we dierentiate w.r.t.
i:
d
k(1 + i)k1 k px =
kv k+1 k px
ax =
di
k=0
k=0
Therefore the modied duration of
ax
is:
k
k=0 kv k px
l
l=0 v l px
MDx = v
and the Macaulay Duration is:
MDx
Dx =
=
v
k
k=0 kv k px
l
l=0 v l px
wk k,
where
wk =
k=0
v k k px
.
l
l=0 v l px
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
Exercise 4.10
(x)).
[irr8]
(a) The present value of assets (5-year and 15-year bonds) and liabilities (10-year
ZCB) are:
VA (i) = M5 v 5 + M15 v 15
VL (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.
69
(c) To ensure that
VA (i) = VL (i),
we require:
M5 + M15 v 10 = 1000v 5
The duration of the assets and liabilities are:
tCt v t
5M5 v 5 + 15M15 v 15
=
t
M5 v 5 + M15 v 15
t Ct v
10v t
DL (i) = t = 10
v
DA (i) =
Therefore, to ensure that
DA (i) = DL (i),
we require:
5M5 v 5 + 15M15 v 15
= 10
M5 v 5 + M15 v 15
which simplies to:
M5 = M15 v 10
M15 = 734.66.
We can check that this is an arbitrage opportunity by looking at VA (i) VL (i)
Solving these simultaneous equations, we get
M5 = 340.29
and
for each parallel shift in the at yield curve:
VA (i) VL (i)
7%
0.55
8%
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).
Exercise 4.11
[irr9]
See Sherris p. 87.
70
Exercise 4.12
At
i = 4.5%,
[irr10]
we have (for the liabilities):
Ct v t
VL =
t
= 3v + 4v 2 + 3v 3 + 2v 4
= 10.84
tCt v t
DL = t
VL
3v + 8v 2 + 9v 3 + 8v 4
=
10.84
= 2.29
t(t + 1)Ct v t+2
CL = t
VL
3
6v + 24v 4 + 36v 5 + 40v 6
=
10.84
= 7.84
For the assets:
VA = M0.5 v 0.5 + M5 v 5
0.5M0.5 v 0.5 + 5M5 v 5
DA =
VA
Ensuring that
VA = VL
and
DA = DL ,
we get:
M0.5 v 0.5 + M5 v 5 = 10.84

0.5M0.5 v 0.5 + 5M5 v 5 = 24.79
These can be solved to obtain
M0.5 = 6.6803
and
M5 = 5.3647.
The eect of a change in interest rates on the surplus is determined in Excel Spreadsheet irr10.xlsx. The results are shown in the following table:
Rate
VA
VL
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) Refer to Excel Spreadsheet new12.xlsx (Worksheet 1) to nd a plot similar to

the one below.
71
0.054
0.050
0.052
Spot Rate
0.056
0.058
Spot Curve
10
15
20
Term
(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):
Ct (1 + st )t
VL =
t
= 10.609
tCt (1 + st )t
DL = t
VL
= 2.275
t(t + 1)Ct (1 + st )(t+2)
CL =
VL
= 7.572
t
For the assets:
VA = M0.5 (1 + s0.5 )0.5 + M5 (1 + s5 )5

0.5M0.5 (1 + s0.5 )0.5 + 5M5 (1 + s5 )5
DA =
VA
72
Ensuring that
VA = VL
and
DA = DL ,
we get:
M0.5 (1 + s0.5 )0.5 + M5 (1 + s5 )5 = 10.609

0.5M0.5 (1 + s0.5 )0.5 + 5M5 (1 + s5 )5 = 24.134
These can be solved (with Solver in Excel - see spreadsheet new12.xlsx) to
obtain
M0.5 = 6.588
and
M5 = 5.516.
(d) See Excel Spreadsheet new12.xlsx for the simulations and histogram similar
to that of below.
50
Frequency
100
150
Histogram of Surplus
0.02
0.01
0.00
0.01
0.02
Surplus
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
At
i = 4%,
[irr11]
we have:
VL = 10.96
DL = 2.29
CL = 7.94
73
Letting
P1
P2
be the price of the 0.75 year bond, and
be the price of the 8 year
bond, we have (assuming annual coupons and $100 face value):
P1
D1
C1
P2
D2
C2
Let
x1
= 100.99
= 0.75
= 1.21
= 126.93
= 6.43
= 49.29
be the number of units of the 0.75 yr bond, and
x2
be the units of the 8 yr
bond. Therefore, we have:
V A = x1 P 1 + x2 P 2
x1 P1 D1 + x2 P2 D2
DA =
VA
Ensuring that:
VA = VL
DA = DL
we obtain two simultaneous equations which can be solved to give
x2 = 2.345.
These correspond to investing
7.983
and
2.977
x1 = 7.905
and
in the two bonds respec-
tively.
A check of convexity shows that
Exercise 4.15
(a) At
CA CL = 7.49 > 0,
so the portfolio is immunised.
[irr12]
i = 6%,
we have:
VL = 1.68
DL = 3
CL = 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 immunisation 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 similar 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.
74
(c) If interest rates increase to 7%, then for the immunised portfolio:
VA VL = 0.8900v + 1.1236v 5 2v 3 = 0.0003

For the CF matching, we have:
VA VL = 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
1
1.06
= 0.0588
The CF matching surplus is still exactly zero.
7.5
Module 5
Exercise 5.1
[der1]
The theoretical futures index is determined as follows (accumulated value of spot

index and storage costs):
ft = St er(T t) dT t
s
= 293.3e0.07(210/365) (0.035)(293.3)210/365 0.07
s
= 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
(ft St )
is called the futures to cash spread or basis, whereas
(ft St )
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:
16
3.25a16 i + 100vi = 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+
75
0.07
12
12
= 111.223057
The accumulated value of coupons received at the funding costs is:
3.25s2 i1 (1 + i2 )2 + 3.25s2 i2 = 13.700113

where
i1 = 1 +
0.065 6
12
and
i2 = 1 +
0.07 6
12
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:
12
97.522944 = 3.25a12 j + 100vj
which results in
Exercise 5.3
j = 3.50%
per half-year, equivalent to an eective
7.013%
p.a.
[der3]
The current 90-day forward price implied by the market is (accumulated spot price
and costs):
f90 = 420 1 + (0.0975)
90
365
+ (0.025) (420)
90
= 432.69
365
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 today's market conditions, we
should be able to make a prot of
prot is worth:
Exercise 5.4
450 432.69 = 17.31 in 90 days time.
Today, this
17.31
90 = $16.90
1 + (0.0975) 365
[der4]
(Also see Example 6.9 in Sherris, p.

costs less receipts (dividends).
112) The forward price is the accumulated
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
= 105098.506
The accumulated dividends are:
0.06
0.4 (10000) 1 +
12
Therefore the forward price is
= 4060.3005
105098.506 4060.3005 = $101038.21
76
Exercise 5.5
[der5]
The cost of carry formula is based on no-arbitrage arguments. If it is violated, for

r(T t)
example if Ft,T > St e
der(T t1 ) , 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
t1 ),
and exercise the forward contract at time
positive prot (at time
T)
T.
This would lock in a
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 30120 is 7.3%, whereas the 120-day
spot rate is 7.4%. Therefore, for no-arbitrage, we require a repo rate
1+
30
r
365
1+
90
0.073
365
1+
given by:
120
0.074
365
r = 0.075639
However, the 30-day spot rate is 7.5% (< 7.5639%). Therefore, we could:
(t = 0)
Borrow $1m at 30-day spot (7.5%)
(t = 30)
(t = 120)
1,000,000
Action
1,006,164
Short forward for $1,006,164 (7.3%)
Total
1,006,164
1,024,275
999,948
1,024,275
52
Invest $999,948 in 120-day spot (7.4%)
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
r
365
1+
90
0.070
365
1+
180
0.074
365
r = 0.076677
The 90-day spot rate is 7.4% (< 7.6677%). Therefore:
(t = 0)
Invest $999,352 in 180-day spot (7.4%)

Total
1,018,247
1,035,822
999,352
1,035,822
648
Short forward for $1,018,247 (7.0%)
(t = 120)
1,018,247
Borrow $1m at 90-day spot (7.4%)
(t = 30)
1,000,000
Action
This results in a guaranteed prot of $648 at zero cost.
Exercise 5.7
[der7]
See details in Sherris Example 7.1 (p. 133)
77
Exercise 5.8
[der8]
Exercise 5.9
[der9]
Exercise 5.10
[der10]
Let the random future commodity price be

time
Sti .
The swap provides for party A at
ti :
Sti X
The swap allows to get the dierence between the spot price at time
without actually exchanging the commodity. The swap price
ti
and
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
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
F0,ti Sti
where
ti .
F0,ti
represents the forward price set at time 0 (now) for settlement at time
The initial value of this forward is 0. Hence for times
t1 , t2 , . . . , tM
the net eect
of the swap and forward must be equal to 0:
erti [(Sti X) + (F0,ti Sti )]
0=
i=1
M
F0,ti erti Xerti
=
i=1
M
S0 Xerti
=
i=1
erti
= M S0 X
i=1
X=
Exercise 5.11
(a) Let
M S0
M
rti
i=1 e
[der11]
(hC , BC )
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
C1 =
275,
max (285 275, 0) = 10

max (250 275, 0) = 0
78
the payo function is :

if stock price goes up
if stock price goes down
Hence we want to nd a portfolio such that the value at time 1 is:
hC 285 + BC e0.05 = 10
hC 250 + BC e0.05 = 0
C1 =

Solving these equations:
hC =
10
285 250
BC = e0.05 (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:
C0 = hC 260 + BC = 6.34
(b) For the put option with exercise price
P1 =
275,
the payo function is
max (275 285, 0) = 0

max (275 250, 0) = 25

Hence we want to nd a portfolio such that the value at time 1 is:
P1 =
hP 285 + BP e0.05 = 0
hP 250 + BP e0.05 = 25

hC =
25
285 250
BC = e0.05 (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:
P0 = hP 260 + BP = 7.93
(c) The put-call parity relationship states that (in words):
Call Value
+ Discounted
Strike Price
= Put
value
+ Share
ie.
C0 + Xert = P0 + S0
This is satised, since (for
t = 1)
C0 + Xert = 6.34 + 275e0.05 = 267.93

P0 + S0 = 7.93 + 260 = 267.93
79
Price
Exercise 5.12
[der12]
For the call option with exercise price
C1 =
50,
the payo function is
max (55 50) = 5

max (45 50, 0) = 0
Hence we want to nd a portfolio holding

(h, B)
units of the stock and bond, such
that the value at time 1 is:
1
h55 + B 1 + 0.05 12 = 5
1
h45 + B 1 + 0.05 12 = 0
C1 =

5
55 45
(45)
B=
1
1 + 0.05 12
h=
5
55 45
Therefore:
C0 = h50 + B = 2.59
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:
X1 =
max (2852 2652 , 0) = 11000

max (2502 2652 , 0) = 0
Hence we want to nd a portfolio holding

(h, B)
units of the stock and bond such
that the value at time 1 is:
X1 =
h285 + Be0.04 = 11000

h250 + Be0.04 = 0
80

h=
11000
285 250
B = e0.04 (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:
X0 = h260 + B = 6223.81
Exercise 5.15
[der15]
Put call parity does not hold since:
22
K
= 1.2245 +
= 22.1769
1+i
1.05
P0 + S0 = 20 + 2.5 = 22.5
C0 +
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.
Exercise 5.16
[der16]
The stock is assumed to either go up to su or down to

ert at time t, where r is the risk free rate.
sd .
The bond starts o as
and rises to
Suppose we want to price this derivative that pays
xu
or
xd .
For a call option, we
have:
xu = (su K)+
xd = (sd K)+
Consider a portfolio that holds
stocks and
bonds. The value of this portfolio
today is:
V (0) = s0 + 1
The value of this portfolio at time
is:
(su + D) + erT
(sd + D) + erT
Therefore, we need
and
if the stock goes up

if the stock goes down
such that the payos are identical (so that this portfolio
will have the same value as our derivative):
(su + D) + erT = xu
(sd + D) + erT = xd
81
xu xd
su sd
= erT
xu xd
su sd
xu
The value of the portfolio with these
and
(su + D)
will be the same as the value of our
derivative.
Exercise 5.17
[der17]
Consider two investment portfolios:
(K c) erT
Portfolio A: one call plus cash of
Portfolio B: one put plus one unit of gold
The value of portfolio A at expiry is given by:
GT K + K c = GT c
0+K c=K c
GT > K
GT K
if
if
(i.e. option is exercised)

(i.e. option is worthless)
The value of portfolio B at expiry is given by:
0 + GT c = GT c
K GT + GT c = K c
GT > K
GT K
if
if
(i.e. option is exercised)

(i.e. option is worthless)
Therefore, both portfolios have a payo at expiry of:
max {K, GT } 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
In particular, at issue (t
= 0),
we must have:
c0 + (K c)erT = p0 + S0
or:
c0 + KerT = p0 + S0 + cerT
7.6
Module 6
Exercise 6.1
[sto1]
(a) The mean accumulation is:
E(1000S10 ) = 1000E [(1 + i1 ) . . . (1 + i10 )]

= 1000E(1 + i1 ) . . . E(1 + i10 )
10
= 1000 [E(1 + i)]

= 1000(1.06)10
= 1790.85
82
(by independence)
(identically distributed)
t < T.
(b) The variance of the accumulation is:

Var(1000S10 )
2
= 10002 E S10 [E (S10 )]2
where:
2
E S10 = E (1 + i1 )2 . . . (1 + i10 )2
= E (1 + i)2
10
= 0.4(1.04)2 + 0.2(1.06)2 + 0.4(1.08)2

= 1.1239210
10
Therefore:
Var(1000S10 )
= 9145.60
and:
(1000S10 ) = 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.
Exercise 6.2
[sto2]
E(Sn ) = E [(1 + i1 ) (1 + in )]
= E(1 + i1 ) E(1 + in ) (by independence)
= [E(1 + i)]n (identically distributed)
= (1 + j)n
The variance of the accumulation is:
Var(Sn )
2
= E Sn [E (Sn )]2
where:
2
E Sn = E (1 + i1 )2 (1 + in )2
= E (1 + i)2
= E 1 + 2i + i2
= 1 + 2j + j 2 + s2
noting that
E(X 2 ) = Var(X) + [E(X)]2

Var(Sn )
(b)
(c)
for a random variable
= 1 + 2j + j 2 + s
E(S8 ) = 1.59385
(S8 ) = 2.65844 2.54035 = 0.34364

83
2 n
(1 + j)2n
X.
Therefore:
Exercise 6.3
[sto3]
E(10000S2 ) = 10000E [(1 + i1 )(1 + i2 )]

= 10000E [1 + i] E [1 + i2 ] (iid)
1
1
1
= 10000
1.03 + 1.04 + 1.06 (0.7 1.05 + 0.3 1.04)
3
3
3
= 10923.70
(b) The variance of the accumulation is:
Var(10000S2 )
2
= 100002 E S2 [E (S2 )]2
where:
2
E S2 = E (1 + i1 )2 (1 + i2 )2
= E (1 + i1 )2 E (1 + i2 )2
1
1
1
=
1.032 + 1.042 + 1.062
3
3
3
= 1.193465
0.7 1.052 + 0.3 1.042
Therefore:
Var(10000S2 )
Exercise 6.4
= 19278
[sto4]
(a) The mean and variance are:
i1 + i2
2
2
2
Var(i) = E(i ) [E(i)]
1
1
= (i2 + i2 ) (i1 + i2 )2
1
2
2
4
1
2
= (i1 i2 )
4
E(i) =
(b) The mean and variance of the accumulated value can be determined using the
formulae in Exercise 6.2:
E (Sn ) = (1 + j)n
Var(Sn )
= 1 + 2j + j 2 + s2
(1 + j)2n
Therefore:
5.5 = (1 + j)25 j = 0.0705686

0.52 = 1 + 2j + j 2 + s2
25
(1 + j)50 s2 = 0.000377389
84
Solving for
i1
and
i2 :
i1 + i2
= j = 0.0705686
2
i1 + i2 = 0.1411372
1
(i1 i2 )2 = s2 = 0.000377389
4
i1 i2 = 0.0388530
Therefore, we obtain
Exercise 6.5
i1 = 0.089995
and
i2 = 0.051142.
[sto5]
(a) The single premium
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
Exercise 6.6
[sto6]
(a) The mean of accumulated premiums is:
E(P ) = 425000(1.03)5 + 425000E [(1 + i1 ) (1 + i5 )]

= 425000(1.03)5 + 425000 [E(1 + i)]5
= 425000(1.03)5 + 425000(1.035)5
= 997458
85
(since
1 + it
iid)
The standard deviation is found as follows:
5
Var(P )
= Var 425000(1.03) + 425000
(1 + ik )
k=1
= 4250002 Var
(1 + ik )
k=1
5
= 4250002 E
(1 + ik )2
4250002 (1.035)10
k=1
5
(1 + ik )2
= E (1 + i)2
k=1
= E 1 + 2i + i2
= 1 + 2E(i) + [E(i)]2 + Var(i)
= 1 + 2(0.035) + (0.035)2 + (0.03)2

= 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 probability of a large loss would also be greater.
Exercise 6.7
[sto7]
E(1000S10 ) = 1000E [(1 + i1 ) (1 + i10 )]

= 1000E(1 + i1 ) E(1 + i10 )
10
= 1000 [E(1 + i)]

= 1000(1.07)10
= 1967.15
(by independence)
The variance of the accumulation is:

Var(1000S10 )
2
= 10002 E S10 [E (S10 )]2
where:
2
E S10 = E (1 + i1 )2 (1 + i10 )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

= 1.115310
86
10
Therefore, we have:
(1000S10 ) =
Var(1000S10 )
= 531.65
Pr (1000S10 < 0.5(1967.15)). The distribution of the accumuS10 = 10 (1 + ik ) is determined as follows:

k=1
(b) We want to nd

lation term
(1 + ik ) LN (, 2 )
ln(1 + ik ) N (, 2 )
10
ln(1 + ik ) N (10, 10 2 )
k=1
10
exp
10
ln(1 + ik )
(1 + ik ) LN (10, 10 2 )
k=1
k=1
where:
1
E(1 + i) = 1.07 = e+ 2
Var(1
+ i) = 0.092 = e2+
e 1
0.092 = (1.07)2 e 1
2 = 0.007050
1
= ln 1.07 (0.007050) = 0.064134
2
Therefore:
Pr (1000S10 < 0.5(1967.15)) = Pr (S10 < 0.983575)

ln 0.983575 10
= Pr Z <
10
where Z N (0, 1)
= Pr (Z < 2.4778)
= 0.00661
(c) The probability required is:
7
6
ln 7 10
6
= Pr Z <
10
= Pr (Z < 1.8349)
= 0.03326
Pr (1200S10 < 1400) = Pr S10 <
87
Exercise 6.8
[sto8]
E(S10 ) = E [(1 + i1 ) (1 + i10 )]

= E(1 + i1 ) E(1 + i10 )
10
= [E(1 + i)]
= (1.06)10
(by independence)
Therefore:
E (2, 000, 000 S10 ) = 2, 000, 000 (1.06)10 = 3, 581, 695

(b) The distribution of
S10
is lognormal:
(1 + ik ) LN (, 2 )
ln(1 + ik ) N (, 2 )
10
ln(1 + ik ) N (10, 10 2 )
k=1
10
S10 =
10
(1 + ik ) = exp
ln(1 + ik )
k=1
LN (10, 10 2 )
k=1
where:
1
E(1 + i) = 1.06 = e+ 2
Var(1
+ i) = 0.082 = e2+
e 1
0.082 = (1.06)2 e 1
2 = 0.0056798
1
= ln 1.06 (0.0056798) = 0.055429
2
Therefore, the required probability is:
Pr (S10 < 0.8 E(S10 )) = Pr S10 < 0.8(1.06)10

= Pr (S10 < 1.4327)
ln 1.4327 10
= Pr Z <
10
= Pr (Z < 0.8171)
= 0.207
Exercise 6.9
We have
[sto9]
(1 + i) LN (, ),
where:
1
E(1 + i) = e+ 2 = 1.001
Var(1
+ i) = e2+
88
e 1 = 0.0022
These can be solved simultaneously to obtain

Var(1
+ i) = e+ 2
and
2:
e 1
2
0.0022 = (1.001)2 e 1
2 = 0.000003992
1
= ln 1.001 (0.000003992) = 0.0009975
2
Therefore, we can nd
as follows:
0.05 = Pr(i < j)

= Pr(1 + i < 1 + j)
= Pr(ln(1 + i) < ln(1 + j))
ln(1 + j)
= Pr Z <
ln(1 + j)
= 1.645
ln(1 + j) = 0.00228921
j = e0.00228921 1 = 0.2287%
Exercise 6.10
[sto10]
Note: This question is similar to Exercise 6.8.

E(S10 ) = E [(1 + i1 ) (1 + i10 )]

= E[1 + i1 ] E[1 + i10 ]
10
= [E(1 + i)]
= (1.06)10
(by independence)
Therefore:
E (1, 000, 000 S10 ) = 1, 000, 000 (1.06)10 = 1, 790, 848

(b) The distribution of
S10
is lognormal:
(1 + ik ) LN (, 2 )
ln(1 + ik ) N (, 2 )
10
ln(1 + ik ) N (10, 10 2 )
k=1
10
S10 =
10
(1 + ik ) = exp
k=1
ln(1 + ik )
k=1
89
LN (10, 10 2 )
where:
1
E(1 + i) = 1.06 = e+ 2
Var(1
+ i) = 0.082 = e2+
e 1
0.082 = (1.06)2 e 1
2 = 0.0056798
1
= ln 1.06 (0.0056798) = 0.055429
2
Therefore, the required probability is:
Pr (S10 < 0.9 E(S10 )) = Pr S10 < 0.9(1.06)10

= Pr (S10 < 1.61172)
ln 1.61172 10
= Pr Z <
10
= Pr (Z < 0.32304)
= 0.373
Exercise 6.11
[new3]
(a) The accumulated value based on a principal of $1 is:
S10 = (0.05 i1 )(1 + i2 ) (1 + i10 ) + + (0.05 i10 )

The mean of
S10
is:
E(S10 ) = E[(0.05 i1 )(1 + i2 ) (1 + i10 ) + + (0.05 i10 )]

= E[0.05 i1 ]E[1 + i2 ] E[1 + i10 ] + + E[0.05 i10 ]
(by independence)
= 0.01(1.04)9 + 0.01(1.04)8 + + 0.01(1.04) + 0.01

= 0.01s10 0.04
= 0.120061
(b) The distribution of the interest rate in each year is:
1 + i LN (, 2 )
where:
1
E(1 + i) = 1.04 = e+ 2
= Var(1 + i) = 0.022 = e2+

2
= 0.022 = (1.04)2 e 1
0.022
= = ln 1 +
1.042
1
= = ln 1.04 2
2
2
90
e 1
The simulation can be found in Spreadsheet new3.xlsx.
3
0
Density
Simulated Density of S
0.2
0.1
0.0
0.1
0.2
0.3
0.4
(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 company 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(S1 ) = E(1 + y1 )
= E(1 + + (y0 ))
= 1.05 + 0.4(y0 0.05)
Therefore
E(S1 ) = 1.046
and
E(S1 ) = 1.054
for
y0 = 0.04
respectively.
(b) The variance is:
Var(S1 )
= Var(1 + y1 )
= Var(1 + + (y0 ) + 1 )
= 2
= 0.012
91
and
y0 = 0.06
(c) The probability is:
Pr(S1 < 1.04) = Pr(1 + y1 < 1.04)

= Pr( + (y0 ) + 1 < 0.04)
0.01 0.4(y0 0.05)
= Pr 1 <
0.01
where 1 N (0, 1)
Pr(S1 < 1.04) = 0.2743
y0 = 0.06 respectively.
Therefore
and
Exercise 6.13
and
Pr(S1 < 1.04) = 0.0808
for
y0 = 0.04
[new6]
The simulation can be found in Spreadsheet new6.xlsx. The histograms should be

similar to the ones below.
150
100
50
0
Frequency
200
250
Histogram of S (4%)
1.4
1.5
1.6
1.7
S
92
1.8
1.9
150
100
0
50
Frequency
200
250
Histogram of S (6%)
1.4
1.5
1.6
1.7
1.8
1.9
Exercise 6.14
[new9]
(a) Denoting the mean and standard deviation of
j = 0.04
and
s = 0.02),
it
as
and
respectively (ie.
the formulae can be derived as in the lecture notes:
sn = (1 + y1 ) (1 + yn ) + (1 + y2 ) (1 + yn ) + + (1 + yn )
= (1 + yn ) [(1 + y1 ) (1 + yn1 ) + + (1 + yn1 ) + 1]

= (1 + yn )(n1 + 1)
s
E(n1 ) = E[(1 + yn )(n + 1)]
s
s
= E(1 + yn )E(n1 + 1) by independence
s
= (1 + j)[E(n1 ) + 1]
s
s
E s2 = E (1 + yn )2 (n1 + 1)2
n
= E (1 + yn )2 E (n1 + 1)2
s
= E 1 + 2yn +
2
yn
= 1 + 2j + j 2 + s2
s2 +
n1
E s2
n1
by independence
2sn1 + 1
+ 2E (sn1 ) + 1
The variance can then be determined using:

Var (n1 )
s
= E s2
n1 [E (n1 )]2
s
(b) The recursion can be found in Excel spreadsheet new9.xlsx.
E (30 ) = 58.33
s
and
V ar (30 ) = 17.16.
s
(c) The distribution of the interest rate in each year is:
1 + i LN (, 2 )
93
We see that
where:
1
E(1 + i) = 1.04 = e+ 2
= Var(1 + i) = 0.022 = e2+
e 1
= 0.022 = (1.04)2 e 1
0.022
1.042
1
= = ln 1.04 2
2
= 2 = ln 1 +
The simulation can be found in spreadsheet new9.xlsx.
0.04
0.02
0.00
Density
0.06
0.08
Simulated Density of Annuity
45
50
55
60
s30
94
65
70
75

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Australian School of Business

School of Actuarial Studies

Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

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

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

Exercise 1.9 [int10]

Exercise 1.10 [int11]

Exercise 1.11 [int12]

Exercise 1.12 [int13]

Exercise 1.13 [int15]

Exercise 1.14 [int19]

Exercise 1.15 [int18]

Exercise 1.16 [int20]

Exercise 1.18 [int14]

Exercise 1.19 [int24]

Exercise 1.20 [int25]

Exercise 1.21 [int21]

Exercise 1.22 [int22]

Exercise 1.23 [int23]

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

Exercise 1.17 [int6]

Financial Mathematics  Exercises

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Actuarial Studies  UNSW

Non-Level and Continuous Annuities

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

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

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

Exercise 1.45 [new8]

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

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

Exercise 1.48 [new4]

Exercise 1.49 [new1]

Exercise 1.50 [annB10]

Exercise 1.52 [annB11]

Exercise 1.54 [annB12]

Exercise 1.55 [annB13]

Exercise 1.56 [annB14]

Financial Mathematics  Exercises

Actuarial Studies  UNSW

Exercise 1.57 [annB15]

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

Financial Mathematics Exercises

Actuarial Studies UNSW

Financial Mathematics Exercises

Actuarial Studies UNSW

Financial Mathematics Exercises

Actuarial Studies UNSW

Financial Mathematics Exercises

Actuarial Studies UNSW