KARATINA UNIVERSITY

UNIVERSITY EXAMINATIONS
2015/2016 ACADEMIC YEAR

THIRD YEAR FIRST SEMESTER SUPPLEMENTARY EXAMINATION

FOR THE DEGREE OF

BACHELOR OF SCIENCE IN ACTUARIAL SCIENCE

COURSE CODE: ACS 304

COURSE TITLE: FINANCIAL MATHEMATICS II

DATE: AUG 2015 TIME: 3 HOURS

INSTRUCTION TO CANDIDATES

 SEE INSIDE

ACS 304Page 1 of 5
INSTRUCTIONS: Answer Question ONE and TWO and any other THREE questions.

SECTION A
QUESTION ONE (11 Marks)

i. An investment is discounted for 28 days at a simple rate of discount of 4.5% per annum.
Calculate the annual effective rate of interest. (4marks)
ii. A fixed interest stock bears a coupon of 7% per annum payable half yearly on 1 April
and 1 October. It is redeemable at par on any 1 April between 1 April 2005 and 1 April
2011 inclusive at the option of the borrower. On 1 July 1991 an investor purchased
£10,000 nominal of the stock at a price to give a net yield of 6% per annum effective after
allowing for tax at 25% on the coupon payments. On 1 April 1999 the investor sold the
holding at a price which gave a net yield of 5% per annum effective to another purchaser
who is also taxed at a rate of 25% on the coupon payments.
a. Calculate the price at which the stock was bought by the original investor. [4 marks]
b. Calculate the price at which the stock was sold by the original investor. [3 marks]

QUESTION TWO (20 Marks)

i. A lump sum of 14000 will be invested at time 0 for 4 years at a constant annual rate
of interest i. (1+i) has a log-normal distribution with mean 1.05 and variance 0.007.
What is the probability that the investment will accumulate to more than 20,000 in 4
years’ time? (7 marks)
ii. A pension fund has a liability to pay £100,000 at the end of one year, £105,000 at the
end of two years, and so on, the amount increasing by £5,000 each year to £195,000 at
the end of 20 years, this being the last payment. The fund values these payments
using an effective interest rate of 7% per annum. This is also the interest rate at
which the current prices of all bonds are calculated. The fund invests an amount
equal to the present value of these liabilities in the following two assets:
(A) a zero coupon bond redeemable in 25 years, and

ACS 304Page 2 of 5
 (B) a fixed interest bond redeemable at par in 12 years’ time which pays a coupon of
8% per annum annually in arrears
a. Calculate the present value and the duration of the liabilities. (6marks)
b. Calculate the amount of cash that should be invested in each asset if the duration
of the assets is to equal that of the liabilities. [7 marks]

SECTION B
QUESTION THREE (13 Marks)
An investor purchases £100 nominal of a fixed interest stock, which pays coupons of
7% p.ahalf-yearly in arrears. The stock is redeemable at par and can be redeemed at the
option of the investor at any time between 5 and 10 years from the date of issue. The
investor is subject to tax at the rate of 40% on income and 25% on capital gains.
i. Calculate the price that the investor should pay in order to obtain a net yield of at least
6% p.a. (10 Marks)
ii. Given that this was the price paid by the investor, calculate his net annual running yield.
(3
marks)

QUESTION FOUR (13 Marks)

An insurance company has liabilities consisting of eleven annual payments of £1
million, with the first payment due to be made in 10 years’ time and the last payment
due to be made in 20 years’ time. The rate of interest is 6% per annum effective.
i. Show that the discounted mean term of these liabilities, to four significant

figures, is 14.42 years. [3 marks]

The insurance company holds two zero-coupon bonds, one paying £X in 10 years’
time and the other paying £Yin 20 years’ time.
ii. Find values of X and Y such that Redington’s first two conditions for immunisation
from small changes in the rate of interest are satisfied. [6 marks]
iii. Explain, without making any further calculations, whether you would expect

Redington’s third condition for immunisation to be satisfied for the values of

X and Y calculated in (ii). [2 marks]

ACS 304Page 3 of 5
 QUESTION FIVE (13 Marks)
A pension fund has liabilities of £3 million due in 3 years’ time, £5 million due in 5years
time, £9 million due in 9 years’ time, and £11 million due in 11 years’ time. The fund
holds two investments, Xand Y. Investment X provides income of £1 million payable at
the end of each year for the next five years with no capital repayment. Investment Yis a
zero coupon bond which pays a lump sumof £R at the end of nyears (where nis not
necessarily an integer). The interest rate is 8% per annum effective.
i. Investigate whether values of £R and n can be found which ensure that the fund is
immunised against small changes in the interest rate.
You are given that ∑5𝑡=1 𝑡 2 𝑣 𝑡 = 40.275 @8% (8marks)
ii. The interest rate immediately changes to 3% per annum effective. Calculate the revised
present values of the assets and liabilities of the fund. (3marks)
iii. Explain your answer to (ii) (2marks)

QUESTION SIX (13 Marks)

i. Explain why Interest rates vary over time. (2marks)
ii. Discuss the three most popular theories which explain the fact that interest rates vary in
accordance to the term of investment. (3marks)
iii. The one-year forward rate of interest at time t= 1 year is 5% per annum effective. The
gross redemption yield of a two-year fixed interest stock issued at time t= 0 which pays
coupons of 3% per annum annually in arrear and is redeemed at 102 is 5.5% per annum
effective. The issue price at time t= 0 of a three-year fixed interest stock bearing coupons
of 10% per annum payable annually in arrear and redeemed at par is £108.9per £100
nominal.
a. Calculate the one-year spot rate per annum effective at time t= 0. (2 marks)
b. Calculate the one-year forward rate per annum effective at time t = 2 years.(3marks)
c. Calculate the two-year par yield at time t= 0. (3marks)

ACS 304Page 4 of 5
 QUESTION SEVEN (13 Marks)

Three bonds, each paying annual coupons in arrear of 3% and redeemable at £100 per
£100 nominal, reach their redemption dates in exactly one, two and three years’ time,
respectively.
The price of each bond is £101 per £100 nominal.
i. Determine the gross redemption yield of the three-year bond. (3 Marks)
ii. Calculate the one-year, two-year and three-year spot rates of interest implied
by the information given. (3 Marks)
iii. Calculate the one-year forward rate starting from the end of the second year, f21 (3
Marks)
The pattern of spot rates is upward sloping throughout the yield curve.
iv. Explain, with reference to the various theories of the yield curve, why the yield
curve might be upward sloping. (3 Marks)

ACS 304Page 5 of 5