November 2002 examination

Indicative Solutions
Subject 102-Financial Mathematics

Solution to Q 1:
We define, i h (t), the nominal rate of interest per unit time on transactions of term h beginning
at time t, to be such that the effective rate of interest for the period of length h beginning at
time t is h. i h (t). Thus, if the sum of C is invested at time t for a term h, the sum to be received
at time t+h is, by definition, C [1 + h. i h (t)].
[3 marks if all points covered, else 0]
Solution to Q 2(a):

0.08
= 1
4

1
i (2)
1 + 2

[1]

i (2) = 0.08247

[1]

8.247% pa convertible half-yearly

Solution to Q 2(b):

d (12)
1 12

12

0.08
= 1
4

d (12) = 0.080539

[1]

[1]

8.0539% pa convertible monthly

Solution to Q 3(a):

(Ia) n = v + 2v 2 + 3v 3 + 4v 4 + .... + nv n

1
2

(D) n = n + (n 1)v + ( n 2) v 2 + ( n 3)v 3 + ... + v n 1

1
2

(Ia) n + (D) n = n + nv + nv 2 + nv 3 + ... + v n = n n +1

[1]

Solution to Q 3(b):

(I) n = 1 + 2v + 3v 2 + 4v 3 + ... + nv n 1

1
2

(Da) n = nv + ( n 1)v 2 + ( n 2) v 3 + ( n 3) v 4 + .... + v n

1
2

(I) n + (Da) n = 1 + ( n + 2)( v + v 2 + v 3 + ... + v n 1 ) + v n

= (n + 2) a n -1 + 1 + v n

[1]

Solution to Q 4:
The par yield is the coupon rate C% such that

1
1
1

100
100 = C
+
+
+

1.06 (1.06)(1.065) (1.06)(1.065)(1.07) (1.06 )(1.065 )(1.07 )

1 1
2
C =

17.21
= 6.477%
2.6571
1 1
2

Solution to Q 5:
9
9
9

1
2

2
12
12
12
100
v
100
(
1
.
05
)
v
100
(
1
.
05
)
v

2500 = 1.03 4
+
+
+ ...
2
3
1.03
1.03
1.03

2 1
2

9
1
100 v 12 (1.03)1

2500 =
1.03 4

1.05

1 1.03 v

2500 = 2548.543689v + 97.8074827v 12

Real return should be approximately 6% (=dividend yield + dividend growth inflation)
Try i = 6%, RHS = 2497.911683
For i = 5.5%, RHS = 2509.639

i = 5.5 +

9.639
0. 5 = 5.910963578 = 5.91%
11.72731661

2 1
2

Solution to Q 6:
Let X be the initial annual amount of the annuity.
The payments and the rates of interests for different periods are as follows:
2% per
4% per
8% per
Rate of interest

quarter

half-year

X/2 each

annum

10

11

X/2 each

Half-year in arrear

12

13

14

15

time in years

X/3 monthly in arrear

payments

quarter in arrear
[2 marks for the above]

The present value of the annuities in each of the periods:

1 to 4 years:

X
2 a16

Present value =
S2

@ 2 %

(A)

1 1
2

(B)

1 1
2

(C)

1 1
2

{ }

(D)

1 1
2

{ }

(E)

1 1
2

Year 5:

Present value =

{v }
16

@ 2%

a 2
2
@ 4%

Year 6 to 10:

Present value =

{ }

X v16

{ }

2
@ 2% v

@ 4%

{ }

a10(2 )

@ 4%

Year 11to 12:

Present value =

{ }

{ }

v16

2X v

16

@ 2%

{ }

a4

{ }

a 3(12 )

12

@ 4%

(6)

@ 4%

Year 13 to 15:

Present value =

4 X v 16

@ 2%

@ 4%

Sum of (A), (B), (C), (D) & (E) = 17.0763X

This is equal to 2,049.

X =

2049
= 119.99 or 120.
17.0763

@ 8%

1
2

Solution to Q 7:

(2)

Since g 1 t = 0.055 > i @ 4% , the maximum price will be paid if the redemption of loan
takes place as soon as possible.
[1]
The present value of capital =

{ }

100 v 31.5

@ 4%

= 29.0703

Present value of net interest payments =

[1]

{ }

(1 0.5) 0.11 100 a 31(2).5

[1]

@ 4%

= 98.493547
The price = 29.0703 + 98.493547
= 127.564
The greatest net yield will be obtained if the stock is never redeemed, i.e. if it is taken to be a
perpetuity.
[1]
The net yield per annum is the solution of the equation

{ }

127.564 = 5.50 a (2 )

[1]

@i

1
= 5.5 (2 )
i
i (2) =

5.5
= 0.043116
127.564

i (2 )
Maximum net yield, i = 1 +
2

1 = .04358 = 4.358%

[1]

Solution to Q 8(a):
The discounted payback period for an investment project is the earliest time after the start of
the project when the accumulated value of the past cash flows (positive and negative),
calculated using the borrowing rate, becomes greater or equal to zero.
[1]
Solution to Q 8(b):
The discounted payback period (DPP) is the value of

80000 (1.07) 5000 (1.07 )

t

By interpolation, we get
Solution to Q 8(c):

t 1

t such that

+ 10000 S t 2 = 0

t = 17.767 = 17.77 years

[1]
[3]

The accumulated profit after 22 years is found by accumulating the income, after the DPP has
elapsed, at 6% per annum.
This gives

10000 S 4 .233

@ 6%

= 48000

The accumulated profit is Rs. 48,000

[2]

Solution to Q 9(a):
A repayment loan is a loan that is repayable by a series of payments that include partial
repayment of the loan capital in addition to the interest payments.
In its simplest form, the interest rate will be fixed and the payments will be of fixed equal
amounts, paid at regular known times. The number of cashflows will usually be fixed, rather
than related to survival.
Complications may be added by allowing the interest rate to vary or the loan to be repaid
early. Additionally, it is possible that the regular repayments could be specified to increase (or
decrease) with time. Such changes could be smooth or discrete.
The breakdown of each payment, into interest and capital, changes significantly over the
period of the loan. The first repayment will consist almost entirely of interest and only a very
small capital repayment. In contrast, the final repayment will consist almost entirely of capital
and will have a small interest content.
[1 mark for the point in each paragraph]
Solution to Q 9(b)(i):
Let

X
Y
be the original monthly repayment and
be the monthly payment payable if the
12
12

borrower had decided to pay higher monthly instalment.

{ }

(12 )
X a 20

= 19750

[1]

@ 9%

X = 2079.12
th

The loan outstanding just after the 87 monthly payment had been made is

{ }

X a12(12. 75)

And hence

1 1
2

= 16027.52

@ 9%

{ }

Y a12(12.75)

= 16027.52

@ 10%

Y = 2180 .52 , and the revised monthly instalment is

2180.52
= 181.71
12

1 1
2

Solution to Q 9(b)(ii):
Let the revised outstanding term of the loan be n months. We have the inequalities:

1 1
2

)
2079.12 a (n121) < 16027.52 2079.12 a (12
@ 10%
n
12

12

By trial, we obtain n=169, so the revised outstanding term is 14 years and 1 month.
[3 marks for finding n]
Final monthly repayment is given by the equation,

169
2079.12 a14(12 ) + (final payment ) v 12 = 16027.52 @ 10%

1 1
2

Final payment = Rs 81.78

Solution to Q 10(a):

An option gives an investor the right, but not the obligation, to buy or sell a specified asset on
a specified future date.
A call option gives the right, but not the obligation, to buy a specified asset on a set date in
the future for a specified price.
A put option gives the right, but not the obligation, to sell a specified asset on a set date in the
future for a specified price.
[1 mark for each paragraph]
Solution to Q 10(b):
The difference is between right and obligation. Buying a call costs you money and allows you
to choose whether or not to buy the underlying asset. Selling a put means that you receive
money and must buy the underlying asset if, and only if, the holder of the option wants.
If you buy a call you are likely to choose to buy the underlying asset if the market price is
more than the exercise price. If you sell a put you are likely to be forced to buy the underlying
asset if the market price is lower than the exercise price.

1 1 marks for the point in each paragraph

2

Solution to Q 11(a):
Assume now that at some time t 1 , 0 < t 1 < T , the security underlying the forward contract
provides a fixed amount c to the holder. For example, if the security is a government bond,
there will be fixed coupon payments due every six months.
Now consider the following two portfolios:
Portfolio A:
Enter a forward contract to buy one unit of an asset
time

T ; simultaneously invest an amount Ke

Portfolio B:

S , with forward price K , maturing at

+ ce t1 in the risk free investment.

Buy one unit of the asset, at the current price

S 0 . At time t 1 , invest the income of c in the

risk-free investment.
At time t = 0 , the price of Portfolio A is
for the forward contract.

Ke T + ce t1 for the risk-free investment and zero

S0 .

The price of Portfolio B is

t = T the payout from Portfolio A is: Income of K + ce (T t 1 ) from the risk-free

investment; Outgo of K on the forward contract. Receive 1 unit of the asset, value ST . The
(T t 1 )
net portfolio at T is one unit of the asset S plus ce
units of the risk-free security.
At time

The payout from Portfolio B is one unit of asset, value

security, from the invested coupon payment.

ST plus ce (T t 1 ) units of the risk-free

T are identical to those of Portfolio B both give a

(T t 1 )
net portfolio of one unit of the underlying asset S plus ce
units of the risk-free security.
The net cashflows of Portfolio A at time

Using the no arbitrage assumption, the prices must also be the same that is:

Ke T + ce t1 = S 0
K = S 0 e T ce (T t 1 )
For a long forward contract on a fixed interest security there may be more than one coupon
payment. It is easy to adopt the above method to allow for this. If we let I denote the present
value at time t = 0 of the fixed income payments due during the term of the forward contract,
then the forward price at time

t = 0 per unit of security S is K = (S 0 I )e T

[6 marks for all the points, else 0]

Solution to Q 11(b):
Let the forward price be

f 40

f 40 = 100 (1.03)182. 5 5 (1.03)182. 5

40

20

[2]

= 100.64997 5.016223
= 95.63375

[2]

Solution to Q 12(a)
Conditions:
i) Present value of the assets at the starting rate of interest is equal to the value of
the liabilities.
ii) The volatilities of the asset and liability cashflow series are equal OR the
discounted mean term of the asset and liability cashflow series are equal.
iii) The convexity of the asset cashflow series is greater than the convexity of the
liability cashflow series.
[Total 3 with one each]

Solution to Q 12(b)
Limitations of Immunization theory: (any four from the list)
i) It may be necessary to rebalance the portfolio once interest rates have changed
ii) There may be options or other uncertainties in the assets or in the liabilities,
making the assessment of the cashflows approximate rather than known
iii) Assets may not exist to provide the necessary overall asset volatility to match the
liability volatility
iv) The theory relies upon small changes in interest rates. The fund may not be
protected against large changes
v) The theory assumes a flat yield curve and requires the same change in interest
rates at all terms. In practice, this is rarely the case
vi) Immunization removes the likelihood of making large profits.
[Total 4 with one each]
Solution to Q 13(a):
The wording of the question is ambiguous, between the growth rate in any year and the
accumulation factor every year / over 4 years.
In this solution, it is assumed that "i" has a log-normal distribution with mean 10% and SD 5%.
In part (a), the question is about the mean and SD of the accumulation factor, i.e. (1+i).
Hence, used E(1+i) and Var(1+i).
In part (b) also, the accumulation factor only is used, but over 4 years.
It is suggested that the markers be advised of the recommended solution, but with a fiat that if
any candidate appears to be confused by the wording of the question, but has made a
reasonable attempt with an understanding of
the mean and variance formulae for a log-normal distribution, then 4 marks be
awarded in part (a),
the relation between the mean and variance of the accumulation factor every
year to those over 4 years, then 5 marks be awarded in part (b).

E (1 + i ) = 1.10
Var (1 + i ) = (0.05)

[2]

1.10 = exp +

0.0025 = exp 2 + 2 exp 2 1

2

) [ ( ) ]

(2) 0.0025
=
= exp ( 2 ) 1
(1) 2 1.10 2

(1)
(2)

[1]

0.0025

2 = ln
+ 1
2
1.10

[1]

2 = 0.002064
= 0.045431093

0.002064

1.10 = exp +

0.002064
= ln (1.10)
2
= 0.094278187

[1]

Solution to Q 13(b)(i):

ln (1 + i t ) N (0.094278,0.002064)
ln (S 4 ) N (4 0.094278,4 0.002064)

[2]

N (0.377112,0.008256)

Solution to Q 13(b)(ii):

550

Pr S 4 >

345

550
= Pr ln (S 4 ) > ln
= 0.466373861
345

0.466373861 0.377112

= Pr z >
= 0.98238 , where z N (0,1)
0.008256

= 1 (0.98238358 )
= 0.163

[1]

[1]

Solution to Q 14 (a):
Let

P1 be the office premium without allowance for lapses.

Then equation of value will be

P1 20 = 10000 v 20 + 200 + 0.03 P1 20 @ 5%

[1]

0.97 P1 20 = 10000 0.3768894 + 200

[3]

P1 =

10000 0.3768894 + 200

0.97 13.085321
3968.894
12.692761

= 312.68956
Solution to Q 14 (b):

Let

P2 be the office premium with lapses and let L = 0.045456.

Then the equation of value will be

P2 1 + (1 L)v + (1 L )2 v 2 + ... + (1 L )19 v 19

= 200 + 0.03 P2 1 + (1 L )v + (1 L ) 2 v 2 + ... + (1 L)19 v19 @ 5%

19

+ 10000 (1 L ) v 20 + t P2 (1 L )
19

( t 1 )

[2]

L vt

t =1

Note that

(1 L) v

@5% =

v @ 10%

[1]

Hence,

10000 20
L (Ia ) @ 10%
0.97 P 2 20 = 200 +
v + P2

19
1 L
1 L

[2]

10000
0.045456 60.9476
0.97 P 2 9.36496 = 200 +
0.14864 + P 2

1 0.45456
1 0.045456
P2 =

1757.1833
= 284.2581
6.1816473

[3]