Annuity (finance theory)

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The term annuity is used in finance theory to refer to any terminating stream of fixed payments over a
specified period of time. This usage is most commonly seen in discussions of finance, usually in
connection with the valuation of the stream of payments, taking into account time value of money
concepts such as interest rate and future value.
[1]
Examples of annuities are regular deposits to a savings account, monthly home mortgage payments and
monthly insurance payments. Annuities are classified by payment dates. The payments (deposits) may
be made weekly, monthly, quarterly, yearly, or at any other interval of time.
Contents
1 Ordinary annuity
1.1 Proof
1.2 Additional formula
2 Annuity-due
3 Other types
4 See also
5 References
6 External links
Ordinary annuity
An ordinary annuity (also referred as annuity-immediate) is an annuity whose payments are made at
the end of each period (e.g. a month, a year). The values of an ordinary annuity can be calculated
through the following:
[2]
Let:
r = the yearly nominal interest rate.
t = the number of years.
m = the number of periods per year.
i = the interest rate per period.
n = the number of periods.
Note:
Also let:
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P = the principal (or present value).
S = the future value of an annuity.
R = the periodic payment in an annuity (the amortized payment).
(annuity notation)
Also:
Clearly, in the limit as n increases,
Thus, even an infinite series of finite payments (perpetuity) with a non-zero discount rate has a finite
present value.
Proof
The next payment is to be paid in one period. Thus, the present value is computed to be:
.
We notice that the second factor is a geometric progression of scale factor 1 and of common ratio
. We can write
.
Finally, after simplifications, we obtain
.
Similarly, we can prove the formula for the future value. The payment made at the end of the last year
would accumulate no interest and the payment made at the end of the first year would accumulate
interest for a total of (n1) years. Therefore,
.
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Hence:
.
Additional formula
If an annuity is for repaying a debt P with interest, the amount owed after n payments is:
because the scheme is equivalent with lending an amount and putting part of that, an amount
, in the bank to grow due to interest. See also fixed rate mortgage.
Annuity-due
An annuity-due is an annuity whose payments are made at the beginning of each period.
[3]
Deposits in
savings, rent or lease payments, and insurance premiums are examples of annuities due.
Because each annuity payment is allowed to compound for one extra period, the value of an annuity-due
is equal to the value of the corresponding ordinary annuity multiplied by (1+i). Thus, the future value of
an annuity-due can be calculated through the formula (variables named as above):
[2]
(annuity notation)
It can also be written as
(1 + i)
An annuity-due with n payments is the sum of one annuity payment now and an ordinary annuity with
one payment less, and also equal, with a time shift, to an ordinary annuity with one payment more,
minus the last payment.
Thus we have:
(value at the time of the first of n payments of 1)
(value one period after the time of the last of n payments of
1)
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Other types
Fixed annuities These are annuities with fixed payments. They are primarily used for low risk
investments like government securities or corporate bonds. Fixed annuities offer a fixed rate but
are not regulated by the Securities and Exchange Commission.

Variable annuities Unlike fixed annuities, these are regulated by the SEC. They allow you to
invest in portions of money markets.

Equity-indexed annuities Lump sum payments are made to an insurance company.

See also
Annuity (financial contracts)
Perpetuity
Life annuity
Fixed rate mortgage
Amortization calculator
References
^ Lasher, William (2008). Practical financial management. Mason, Ohio: Thomson South-
Western. p. 230. ISBN0-324-42262-8.
1.
^
a

b
Finite Mathematics, Eighth Edition, by Margaret L. Lial, Raymond N. Greenwell, and
Nathan P. Ritchey. Published by Addison Wesley. ISBN 032122826X
2.
^ Jordan, Bradford D.; Ross, Stephen David; Westerfield, Randolph (2000). Fundamentals of
corporate finance. Boston: Irwin/McGraw-Hill. p. 175. ISBN0-07-231289-0.
3.
External links
Annuity lecture (http://wikilecture.org/Annuity_(finance_theory)) by Professor Robert Shiller
from Yale

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Categories: Finance theories
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