ST334

UNIVERSITY OF WARWICK
THIRD YEAR, 2009–2010

ACTUARIAL METHODS

Preliminary Examination 3
Time allowed: 1 hour

Answer all questions. The marks for each question are indicated at the end of each question. The
total marks for all questions is 100.

Candidates are advised that the method used to obtain the answer should normally be shown in order
to obtain full marks.

1. The following n-year spot rates were observed at time t = 0:

1 year spot rate of interest: 4% per annum
2 year spot rate of interest: 4.5% per annum
3 year spot rate of interest: 5% per annum
4 year spot rate of interest: 5.5% per annum
5 year spot rate of interest: 6% per annum
(a) Calculate the two-year forward rate of interest at time t = 3.
(b) Using the above n-year spot rates calculate the 4-year par yield at time t = 0. [9 marks]

2. Dividends on a share are paid half-yearly. Assume the dividends increase at a compound rate of
2% per half-year.
Assume price inflation is at a rate of 3% per annum.
Suppose the share is bought for £12 immediately after a dividend payment has been made and the
first dividend (which will be 6 months later) is expected to be £1. Find the expected real rate of
return per annum. [11 marks]

3. (a) A bond has a coupon of a nominal 7% per annum payable half yearly on 1 April and 1 Octo-
ber. It is redeemable at par on any 1 April between 1 April 2004 and 1 April 2010 inclusive
at the option of the borrower.
On 1 July 1995 an investor purchased the bond at a price to give a net yield of 6.5% per
annum effective after allowing for tax at 25% on the coupon payments. Find the price paid
per £100 nominal by this investor.
(b) On 1 April 1999 the investor sold the holding at a price which gave a net yield of 5.5%
per annum effective to another purchaser who is also taxed at a rate of 25% on the coupon
payments. Find the price per £100 nominal at which the stock was sold.
[20 marks]

11:56 on Dec 1, 2010 . . . continued

4. The annual yields from a particular fund are independent and identically distributed. Each year,
the distribution of 1 + i is log-normal with parameters µ = 0.07 and σ 2 = 0.006, where i denotes
the annual yield on the fund.
(a) Find the mean accumulation in 10 years’ time of an investment in the fund of £20,000 at the
end of each of the next 10 years, together with £150,000 invested immediately.
(b) Find the single amount which should be invested in the fund immediately to give an accumu-
lation of at least £600,000 in 10 years’ time with probability 0.99.
[20 marks]

5. (a) An investment company has liabilities of £7 milion due in 5 years’ time and £8 million due
in 8 years’ time. Using an interest rate of 5% per annum effective, find
(i) the net present value,
(ii) the effective duration (or volatility) and
(iii) the convexity.
(b) Suppose the investment company has the following assets: £3 million due in 4 years’ time,
£3 million due in 6 years’ time and £4 million due in 8 years’ time. Suppose the company
also invests in a zero coupon bond which pays £X at the end of n years (where n is not
necessarily an integer).
Investigate whether values of £X and n can be found which ensure that the investment com-
pany is immunised against small changes in the interest rate.
[20 marks]

6. The following investments were made on 15 January 1993.

Investment A: £10,000 was placed in a zero coupon bond with a 5-year term and with a rate
of return which is advertised to be 2% per annum above the rate of inflation. Specifically, the
redemption proceeds are the amount invested multiplied by the ratio of the Retail Price Index
for the month two months prior to that in which redemption fell to the Retail Price Index for
the month two months prior to the date of investment; this amount is further increased by 2%
compound for each complete year the money is invested.
Investment B: An annuity payable annually in arrears for 5 years was purchased for £10,000 to
yield 6% per annum effective.
The Retail Price Index at various times was as follows:
November 1992 237.6
January 1993 240.0
January 1994 250.0
January 1995 264.4
January 1996 266.6
January 1997 270.4
November 1997 274.0
January 1998 275.6
(a) Calculate the real rate of return per annum earned on investment A over the period 15 Jan-
uary 1993 to 15 January 1998.
(b) Determine whether or not investment B yielded a higher real rate of return per annum over
the period 15 January 1993 to 15 January 1998.
[20 marks]

exam09-3.tex 11:56 on Dec 1, 2010 End

 Dec 1, 2010(11:56) Page 1
p
1. (a) Let f3,2 denote the answer. Then 1.065 = 1.053 (1 + f3,2 )2 gives f3,2 = 1.065 /1.053 − 1 =
0.075179 or 7.5179%. [4 marks]
(b) Let r denote the 4-year par yield. Then
µ ¶
1 1 1 1 1
1=r + + + +
1.04 1.0452 1.053 1.0554 1.0554
and hence
1.0554 − 1
r=
1.0554 (1/1.04 + 1/1.0452 + 1/1.053 ) + 1
= 0.0543308120569
or 5.433%. [5 marks]
2. Let α = 1.02 and β = 1.03. Then the cash flow is:
Time (in years) 0 1/2 1 3/2 2 5/2 ...
Cash flow −12 1 α α2 α3 α4 ...
Inflation factor 1 β 1/2 β β 3/2 β2 β 5/2 ...
Thus if ν = 1/(1 + iR ) where iR denotes the required annual effective real rate, then
X∞ ∞
αk−1 ν k/2 ν 1/2 X αk−1 ν (k−1)/2 ν 1/2 1 ν 1/2
12 = = = =
k=1
β k/2 β 1/2 k=1 β (k−1)/2 β 1/2 1 − αν 1/2 /β 1/2 β 1/2 − αν 1/2

and hence
12β 1/2 = ν 1/2 (1 + 12α) = 13.24ν 1/2
giving ν = 144β/(13.242 ) = 148.32/(13.242 ) and hence iR = 0.18188 or 18.19%.
Or, first find money rate of return, iM . Let νM = 1/(1 + iM ). Then
X ∞ 1/2
k/2 νM
12 = αk−1 νM = 1/2
k=1 1 − ανM
1/2
Hence νM = 12/13.24. Hence νR = νM (1 + q) = 1.03(12/13.24)2 and hence iR = 0.18188.
3. Now each coupon after tax is 3.5 × 0.75 = 2.625. If the bond is redeemed at the final possible
date, the cash flow is
Time 1/7/95 1/10/95 1/4/96 ... 1/10/2009 1/4/2010
Payment no. 0 1 2 ... 29 30
Cash flow −P 2.625 2.625 ... 2.625 102.625

Now i(2) = 0.063977 and (1 − t1 )g = 0.75 × 0.07 = 0.0525. As i(2) > (1 − t1 )g, assume bond
will be redeemed at the latest possible date (and then yield will be at least 6.5% whatever the
redemption date).
Let ν = 1/1.065. Hence
29
X
P = 2.625 ν 0.25+0.5k + 100ν 14.75
k=0
1 − ν 15
= 2.625ν 0.25
1/2
+ 100ν 14.75 = 90.449 or £90.45.
1−ν
(2)
OR use P = (5.25a 15 + 100ν ) × 1.0650.25 = 89.03619 × 1.0650.25 = 90.45.
15 [10 marks]
(ii) Now i(2) = 0.054264 at 5.5% and (1 − t1 )g = 0.75 × 0.07 = 0.0525. As i(2) > (1 − t1 )g, the
second purchaser should also price the bond on the assumption it will be redeemed at the latest
possible date of 1/4/2010 (and then yield will be at least 5.5% whatever the redemption date).
exam09-3.tex 11:56 on Dec 1, 2010 . . . continued
Page 2 Dec 1, 2010(11:56) ST334 Actuarial Methods °
c R.J. Reed

Hence the cash flow for the second purchaser is as follows:

Time 1/4/99 1/10/99 1/4/00 ... 1/10/2003 1/4/2010
Payment no. 0 1 2 ... 21 22
Cash flow −P 2.625 2.625 ... 2.625 102.625
Let ν = 1/1.055. Hence
i
P = 5.25a(2) + 100ν 11 = 5.25 a 11 + 100ν 11
11 i(2)
= 5.25 × 1.013566 × 8.092536 + 55.4911 = 98.55 [10 marks]
4. The cash flow is as follows:
Time 0 1 2 3 ... 9 10
Cash Flow (thousands) 150 20 20 20 ... 20 20
Hence A10 = 150(1 + i1 ) · · · (1 + i10 ) + 20(1 + i2 ) · · · (1 + i10 ) + · · · + 20 where the 1 + ij are i.i.d.
1 2
lognormal(µ = 0.07, σ 2 = 0.006). Let α = eµ+ 2 σ = e0.073 . Then
X0
10
E[A10 ] = 150α + 20αj = 150α10 + 20(α10 − 1)/(α − 1) = 595.18471
j=9
giving the answer £595,184.71. [10 marks]
(b) Let x denote the required amount. We require P[x(1 + i1 ) · · · (1 + i10 ) ≥ 600] = 0.99. Now
Z = (1+i1 ) · · · (1+i10 ) ∼ lognormal(10µ, 10σ 2 ) and hence ln Z ∼ N (10µ, 10σ 2 ) = N (0.7, 0.06).
So we require x where
· ¸
ln Z − 0.7 ln(600/x) − 0.7
0.99 = P[xZ ≥ 600] = P[ln Z ≥ ln(600/x)] = P √ ≥ √
0.06 0.06
√ √
where (ln Z − 0.7)/ 0.06 √ ∼ N (0, 1). Hence (ln(600/x) − 0.7)/ 0.06 = −2.326 348 or ln x =
ln 600 − 0.7 + 2.326 348 0.06 giving £526,771.15. [10 marks]
5. (a) Liabilities.
(i) Net present value:
Xn
ltk 7 8
P = t
= 5
+ = 10.899 [3 marks]
(1 + i) k 1.05 1.058
k=1

(ii) Volatility:
n µ ¶
1 X tk ltk 1 5×7 8×8
d(i) = = +
P (1 + i)tk +1 P 1.056 1.059
k=1
µ ¶
1 35 64 35 × 1.053 + 64
= + = = 6.1813 years [3 marks]
P 1.056 1.059 7 × 1.054 + 8 × 1.05
(iii) Convexity:
n
1 X tk (tk + 1)ltk
c(i) =
P (1 + i)tk +2
k=1
µ ¶
1 5×6×7 8×9×8 210 × 1.053 + 576
= + = = 46.136 [4 marks]
P 1.057 1.0510 7 × 1.055 + 8.82
(b) Assets. Equating the net present values and volatilities gives
(i) Net present value:
Xn
atk 3 3 4
P = t
= 4
+ 6
+ 8
+ Xν n
(1 + i) k 1.05 1.05 1.05
k=1

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 Dec 1, 2010(11:56) Page 3

7 4 3 3
Xν n = + − − = 3.485 287
1.055 1.058 1.054 1.056
(ii) Volatility:
n µ ¶
1 X tk atk 1 12 18 32 n+1
d(i) = = + + + nXν
P (1 + i)tk +1 P 1.055 1.057 1.059
k=1
35 32 12 18
nXν n+1 = + − −
1.056 1.059 1.055 1.057
Let α = 1.05. Hence
nXν n+1 α9 35α3 + 32 − 12α4 − 18α2
n= = = 7.396 225 [4 marks]
Xν n α8 7α3 + 4 − 3α4 − 3α2
and so
X = 4.999 878 [4 marks]
(iii) Convexity:
n
1 X tk (tk + 1)atk
c(i) =
P (1 + i)tk +2
k=1
µ ¶
1 60 126 288 n+2
= + + + n(n + 1)Xν
P 1.056 1.058 1.0510
= 46.1677 by using Xν n = 3.485 287.
Hence convexity of assets is larger than convexity of liabilities. Hence Redington immunisation.
[2 marks]
6. (a) Redemption proceeds in January 1998 are 10,000 × (274.0/237.6) × 1.025 . [2 marks]
Hence, if iM denotes the effective money rate of return per annum, then
(1 + iM )5 = (274.0/237.6) × 1.025 [3 marks]
Of course, we want the real rate of return, iR where (1 + iR )(1 + e) = 1 + iM and (1 + e)5 =
275.6/240.0. Hence
µ ¶1/5
274.0 × 240.0
iR = 1.02 − 1 = 0.02086 or 2.086%. [5 marks]
237.6 × 275.6
(b) Investment B. The cash flows are as follows:
Date 1/93 1/94 1/95 1/96 1/97 1/98
Cash flow −10,000 x x x x x
Inflation index 240 250 264.4 266.6 270.4 275.6
where 10 000 = xa 5 ,0.06 and hence x = 2,373.96. [4 marks]
Hence the real rate of return,
µ iR , satisfies ¶
240 240 2 240 3 240 4 240 5
10,000 = x νR + ν + ν + ν + ν
250 264.4 R 266.6 R 270.4 R 275.6 R
à !
2
νR 3
νR 4
νR
1 νR
= 240xνR + + + + [4 marks]
250 264.4 266.6 270.4 275.6
Question only asks which is the greatest real rate of return. So we need to decide if iR > 0.02086.
Substituting iR = 0.02086 gives RHS ≈ 10,113.
Hence real yield from Investment B is greater than 2.09% and the answer is Investment B.
[2 marks]
(Following was not required: substituting iR = 0.024 gives RHS ≈ 10,023. Substituting iR =
0.025 gives RHS ≈ 9,995. Hence real yield from investment B satisfies iR ∈ [0.024, 0.025].)

exam09-3.tex 11:56 on Dec 1, 2010 End