BASIC ANNUITIES

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Basic Annuities
After this lesson you should be able to
understand and discuss analytically about
different problems in annuities, more specifically:

Annuity immediate
Annuity due
Annuity values
Perpetuities
Different problems in annuities

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Definitions
The fundamental principle in financial
mathematics is equivalency principle.
Value of an amount of money at any given point
in time depends upon the time elapsed since the
money was paid in the past or upon the time
which will elapse in the future before it is paid.
= Time value of money
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Definitions contd
Annuity
series of payment made at equal intervals of
time

Annuity certain
annuity with payments that are certain to be
made for fixed period of time

Contingent annuity
an annuity under which the payments are not
certain to be made (i.e. life annuity)
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Definitions contd
Term of the annuity the fixed period of time for
which payments are made
Payment period the interval between annuity
payments
In this lesson we consider annuities for which
the payment period and the interest conversion
period are equal and coincide and for which the
payments are of level amount.
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Annuity - immediate
Annuity under which payments of 1 are made at
the end of each period for n periods (n is
positive integer)
Rate of interest is i per period
Present value an versus accumulated value sn

n-1

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Expression for an
The total present value of an must equal the
sum of the present values of each payment

an = v + v 2 + v3 + ... + v n 1 + v n
1 vn
an = v
1 v
1 vn
an = v
i v
1 vn
an =
i

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Expression for sn
The total accumulated value of sn must equal
the sum of the accumulated values of each
payment

sn = 1 + (1 + i ) + (1 + i ) + ... + (1 + i )
2

n2

+ (1 + i )

n 1

(1 + i ) n 1
sn =
(1 + i ) 1
(1 + i ) n 1
sn =
i
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Relationship between an and sn

1
i
+i =
+i
n
(1 + i ) 1
sn
1
i + i (1 + i ) n i
+i =
(1 + i ) n 1
sn
1
i
+i =
1 vn
sn
1
1
+i =
sn
aQMF
n

Example 1
Find the present value of an annuity which pays
500 KM at the end of each half-year for 20 years
if the rate of interest is 9% convertible
semiannually.

500 a40 0.045

1 (1.045) 40
500
= 9, 200.79
0.045
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Example 2
If your rich uncle invests 10,000 KM at 8% per
annum convertible quarterly, how much can be
withdrawn at the end of every quarter to use up
the fund exactly at the end of four years of
college?

R a16 0.02 = 10, 000

1 (1.02) 16
R
= 10, 000
0.02
R = 735.50
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Example 3
Compare the total amount of interest that would
be paid on a 1,000 KM loan over 10-yr period, if
the effective rate of interest is 9% per annum,
under the following three repayment methods
i.

The entire loan plus accumulated interest is

paid in one lump-sum at the end of ten years
ii. Interest is paid each year as accrued and the
principal is paid at the end of 10 years
iii. The loan is repaid by level payments over 10year period
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Example 3 contd
i.

The accumulated value of the loan is

1, 000 (1.09)10 = 2,367.36

The total amount of interest is

2,367.36 1, 000.00 = 1,367.36

ii. Each year loan accrues interest of

1, 000 (0.09) = 90
The total amount of interest is

90 10 = 900
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Example 3 contd
iii. The total amount of interest is

R a10 0.09 = 1, 000

1 (1.09) 10
R
= 1, 000
0.09
1, 000
R=
a10 0.09
R = 155.82

10 155.82 1, 000 = 558.20

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Annuity - due
Annuity under which payments of 1 are made at
the beginning of each period for n periods (n is
positive integer)
Rate of interest is i per period
Present value n versus accumulated value &s&n
1

n-1

QMF

&&n
Expression for a
&&n must equal the
The total present value of a
sum of the present values of each payment
a&&n = 1 + v + v 2 + v 3 + ... + v n 1
1 vn
a&&n =
1 v
1 vn
a&&n =
i v
1 vn
a&&n =
d

QMF

Expression for &s&n

The total accumulated value of &s&n must equal
the sum of the accumulated values of each
payment
2
n 1
n

&&
sn = (1 + i ) + (1 + i ) + ... + (1 + i )

+ (1 + i )

(1 + i ) n 1
&&
sn = (1 + i )
(1 + i ) 1
(1 + i ) n 1
&&
sn =
i v
(1 + i ) n 1
&&
sn =
d

QMF

&&n and &s&n

Relationships between a

1
1
+d =
&&
sn
a&&n
&&
sn = a&&n (1 + i ) n

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Relationships between annuity

immediate and annuity due
1. Relation

a&&n = an (1 + i )
&&
sn = sn (1 + i )
2. Relation

a&&n = 1 + an 1
&&
sn = sn +1 1
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Example 4
An investor wishes to accumulate 100,000 KM in
a fund for retirement at the end of 12 years. To
accomplish this the investor plans to make
deposit at the end of each year, the final
payment to be made one year prior to the end of
the investment period. How large should each
deposit be if the fund earns 7% effective?

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Example 4 contd
R &&
s11 0.07 = 100, 000
100, 000 100, 000
100, 000
=
=
&&
(1 + i) n 1 (1 + i ) n 1
s11 0.07
d
i v
100, 000
100, 000
R=
=
= 5,921.21
(1 + 0.07)11 1 16.88845
1
0, 07
1 + 0, 07 QMF

R=

Annuity values on any date

Previously we have considered evaluating
annuities only at the beginning of the term
(either on the date of, or one period after, the
last payment)
Now we will discuss following
Present values more than one period before the
first payment date
Accumulated values more than one period after
the last payment date
Current values between the first and last payment
dates
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Example 5

11

a7

s7

10

11

s7

12

QMF

Present values more than one period

before the first payment date
The present value of annuity at the beginning of
the 1st period is seen to be present value at the
end of 2nd period discounted for two periods

v 2 a7

and

a9 a2

v3 a&&7

and

a&&10 a&&3

This type of annuity is called deferred annuity

since payment commence only after a deferred
period.
Symbol m an annuity immediate deferred for m
periods with a term of n periods after the deferral
&&n )
period ( m a
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Accumulated values more than one

period after the last payment date
The accumulated value of annuity at the end of
the 12th period is seen to be the accumulated
value at the end of 9th period accumulated for
three periods

s7 (1 + i )3

and

s10 s3

It is possible to work with annuities due instead

of annuity immediate

&&
s7 (1 + i ) 2 = &&
s9 &&
s2
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Current values between the first and

last payment dates
The current value of the annuity at the end of the
6th period is seen to be the present value at the
end of 2nd period accumulated for four periods or
accumulated value at the end of 9th period
discounted for three periods

a7 (1 + i ) 4 = v3 s7

s4 + a3

or

It is possible to work with annuities due instead

of annuity immediate

7 (1 + i )3 = v 4 &&
s7 = &&
s3 + 4
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Perpetuities
It is an annuity whose payments continue
forever the term of the annuity is not finite.
Is it unrealistic to have payments continuing
forever?
a = v + v 2 + v 3 + ...

v
1 v
If principal of 1/i
invested at rate i,
v
a =
then interest of i*1/i=1
iv
can be paid at the end of every period
forever,
leaving the original principal intact.
1
a =
QMF
i
a =

Perpetuities contd
For the perpetuity due a&& =

1
d

Accumulated value for perpetuities do not exist

since the payments continue forever
Examples

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Example 6
A leaves an estate of 100,000 USD. Interest on the
estate is paid to beneficiary B for the first 10 years,
to beneficiary C for the second 10 years and to
charity D thereafter. Find the relative shares of B, C
and D in the estate, if it is assumed the estate will
earn a 7% annual effective rate of interest.
B 7000a10 = 7000 (7.02358) = 49,165
C 7000v a10 = 7000 (1.07)
10

10

(7.02358) = 24,993

(1.07) 20
7000v a = 7000 QMF

= 25,842
0.07
20

Unknown time
Time is unknown - an + k

an + k
an + k
an + k

1 + v n+ k
=
i
1 vn + vn vn+k
=
i
(1 + i )k 1
n+k
= an + v

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Example 7
An investment of 1,000 KM is to be used to make
payments of 100 KM at the end of every year for as
long as possible. If the fund earns as annual
effective rate of interest of 5%, find how many
regular payments can be made and find the amount
of the smaller payment
To be paid on the date of the last regular payment
To be paid one year after the last regular payment
To be paid during the year following the last regular
payment
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Example 7 contd

100 an = 1, 000
an = 10
1 vn
an =
n = 14.33
i

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Example 7 contd
1. The equation of value at the end of 14th year

100 s14 + X = 1, 000 1.0514

X = 20.07
2. The equation of value at the end of 15th year

100 &&
s14 + X = 1, 000 1.0515
X = 21.07

QMF

Example 7 contd
3. The equation of value at the end of last regular
payment year

100 an + k = 1, 000
a14+ k = 10
1 v14+ k
= 10
i
v14+ k = 1 10 i = 0.5
k = 0.2067
(1.05)0.2067 1
X = 100
= 20.27
QMF
0.05

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Unknown rate of interest

Interest rate is unknown

an i = g
i

sn i = g

2(n g )
g (n + 1)

2( g n)
g (n 1)

QMF

Example 8
At what rate of interest, convertible quarterly, is
16,000 EUR the present value of 1,000 EUR
paid at the end of every quarter for five years?

1, 000 a20 j = 16, 000

a20 j = 16

2(20 16)
16 21
j = 0.0238
j=

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Varying interest
Rate of interest can vary each period, compound
interest is still in effect
Portfolio rate method regardless of time when
payment is made

an = (1 + i1 ) 1 + (1 + i1 ) 1 (1 + i2 ) 1 + ... +
+ (1 + i1 ) 1 (1 + i2 ) 1 (1 + in ) 1
t

an = (1 + is ) 1
t =1 s =1

QMF

Varying interest contd

Yield curve method payment is made at time k

an = (1 + i1 ) 1 + (1 + i2 ) 1 + ... + (1 + in ) 1
n

an = (1 + it ) t
t =1

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Varying interest contd

Portfolio rate method regardless of time when
payment is made (accumulated values)

&&
sn = (1 + in ) + (1 + in ) (1 + in 1 ) + ... +
+ (1 + in ) (1 + in 1 ) (1 + i1 )
t

&&
sn = (1 + in s +1 )
t =1 s =1

QMF

Varying interest contd

Yield curve method payment is made at time k
(accumulated values)

&&
sn = (1 + in ) + (1 + in 1 ) 2 + ... + (1 + i1 ) n
n

&&
sn = (1 + in t +1 )t
t =1

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Example 9
Find the accumulated value of a 10-year
annuity-immediate of 100 KM per year if the
effective rate of interest is 5% for the first 6
years and 4% for the last 4 years.
accumulated value of first 6 payments
value at the end of 10th year
accumulated value of last 4 payments
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Example 9 contd
accumulated value of first 6 payments 100 s6 0.05
value at the end of 10th year 100 s6 0.05 (1.04)

accumulated value of last 4 payments 100 s4 0.04

R

100 s6 0.05 (1.04) 4 + s4 0.04

= 100 [ 6.8019 1.16986 + 4.2465]
= 1, 220.38
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Example 9 contd
Previous example portfolio rate method
In a case of yield curve method

100 s6 0.05 (1.05) 4 + s4 0.04

= 100 [ 6.8019 1.21551 + 4.2465]
= 1, 251.43

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Summary...
Questions and Answers

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BASIC ANNUITIES
http://efsa.unsa.ba/

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