AMS 318 Notes

Instructor: Tyler Mayer

12/8/2015

1 Chapter 2. Equations of Value and Yield Rates

1.1 Introduction
Def 1.1: Equation of value - c a(t) = c(1 + i)t (for compound interest case e.g)
Problem 1.1: An account was opened with principal p at AEIR 8%. 5 years later the account has
$3673.32 in it. What was the initial principal?
Problem 1.2: An account was opened with 1000 at AEIR 4% how long will it take to reach $1342?

1.2 Equation of Value for Investments With Multiple Contributions

Let {Ctk } be a sequence of contributions. i.e the contribution at time tk = Ctk Contributions
may be negative representing a withdraw.
the sequence of investments is governed by some amount/accumulation function a(t).
The sequence of investments is liquidated at time T and produces a balance of $B.
Suppose we pick an arbitrary time at which to value all of our contributions.
KEY value of all contributions at = value of liquidated amount at .

Def 1.2: Time equation of value -

X a( ) a( )
C tk =B
a(tk ) a(T )
k

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Notice that a(0) = 1 and v(t) = a(t)
P . If we replace with 0 we get the time 0 equation of
value (Present value of a cash flow). k Ctk v(tk ) = Bv(T )

To value any cash flow you need to choose a time (at random or whats convenient) and
discount each contribution on the time horizon to that common point to compare.
KEY if you solve for some unknown using the time equation of value, your results are
independent of .

Problem 1.3: A loan of 1000 is governed by compound interest at AEIR 10%. it is repaid by a
payment of 600 at the end of year 1, and a payment P at the end of year 2. Calculate P .

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Problem 1.4: The following deposits into a savings account with compound interest at rate i are
made:
5000 @ t = 0.
3000 @ t = 1.
2000 @ t = 2.
At t = 2 (just after the 2000 deposit) the balance is 11000. Calculate i.
Problem 1.5: Franklin borrows 1000 at t=0 with compound interest AEIR = 10%. He will repay
loan with two equally spaced payments of 525. When are the two payments made?
P 1.6: An investor makes a sequence of investments {Ctk }. Find T so that a single payment
Problem
C = k Ctk at time T has the same value at t = 0 as the sequence of investments.

1.3 Investment Return

We previously considered the time eqn of value:
X
Ctk (1 + i) tk = B(1 + i) T
k

Def 1.3: Yield rate - Any rate of interest i which satisfies the time eqn of value for a given cash
flow.
Problem 1.7: investments of:
1000 @ t=0
600 @ t=2
are made paying back
600 @ t=1
1265 @ t=3
find the annual yield rate.
Notice when we solve these types of problems we have a higher order polynomial in (1+i) to
solve, meaning that we can get multiple solutions etc.
Problem 1.8: A bank agrees to pay 100,000 immediately and again in 2 years for a loan of 180,000
1 year from now. find the associated yield rate.
Problem 1.9: Afshan gives Alice:
1000 @ t=0 and
1556 @ t = 2
in return for: 2500 @ t=1. find the yield rate:
Problem 1.10: 3 party example. Bryan pays Filemon 1000 now. Filemon pays Brian 300 @ t=1.
Filemon pays Harold 800 @ t=1. Harold will pay Bryan 900 @ t=2.
Find Bryans annual yield rate for the 2 year span.

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1.4 Reinvestment Considerations
Notice that in general the yield rate of the investor is necessarily not equal to the interest rate
paid by any borrower in a multi parti investment. Typically if a lender reinvests the mondy he
gained he will be involved in a multi-parti agreement where this often the case. So it is important
to understand the difference and be able to calculate each.
Problem 1.11: Jose loans martin 12000 @ t=0. Martin repais the loan with 5000 @ t=2 and
10000 at t=4. The money recieved @t=2 is immediately reinvested at AEIR 2.4% elsewhere. Find
Martins AEIR rate, and find Joses APY.
Problem 1.12: Julie pays chan 1000 @ t=0. In return chan pays her 300 @ t = 1,2,3,4. Each of
these payments is immediately reinvested by Julie elsewhere earning AEIR 3%. She liquidates the
other account at t=4. Find the AEIR paid by chan. Find the APY earned by Julie.

1.5 Apx Dollar Weighted Yield Rates

1. Rescale the interval we wish to study to be of length 1.
2. Let A = amount of money in fund at t = 0.
3. Let B = amount of money in fund at t = 1.
4. let Ct be the contribution at time 0 t 1.
P
5. let C = t Ct .
6. Let I = total interest earned from t = 0 to t = 1.
7. Fact: B = A + C + I.
8. Let j = interest rate over the interval t (o, 1). Then:
X
I =Aj+ Ct [(1 + j)1t 1]
t

This quantity may be in general hard to evaluate as j assumes compound interest, especially
with many contributions. Idea: approximate it by supposing we earn simple interest on each
contribution Ct from time of deposit until t = 1. Then:
Ct [(1 + j)1t 1] Ct (1 t)j
Therefore we get a simpler form:
X I
I Aj+ Ct (1 t)j j P
t
A+ t Ct (1 t)

We may also appriximate each t for which Ct 6= 0 by a constant k.

I I
j P =
A+ C
t t (1 t) A + C(1 k)
Recall that B = A + C + I
I
j
A + (B A I)(1 k)
Most use the dollar weighted average for k. k = t CCt t
P

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1.6 Fund Performance
Consider an investment fund over a given time. The dollar weighted yield rate measures how well
the fund grew.
Def 1.4: Time weighted yield rate - measures how well the fund was managed
Again rescale the life of the investment to 1.
Let Bt = account balance just before any time t contribution Ct .
Qr+1
Def 1.5: Time weighted yield rate - jtw such that 1 + jtw = i=1 (1 + ji )
Note jtw is the time weighted yield rate over the life of the investment. Need to convert to get
an annual, quarterly etc.
Problem 1.13: An account has 20000 at t=0 at t=1 the ballance is 21200, and a deposit of 5000
was made. At t = 2 the account balance was 27300. Assume no other contributions. Find the
annual time weighted yield rate and find the APY.

1.7 Problems
These problems are taken directly from an actuarial exam. Source not given.
Problem 1.14: David can receive either:

100 @ t=0, 200 @ t = n and 300 @ t = 2n.

600 @ t = 10
at an annual effective interest rate of i the PV of the two streams are equal. Given v n = 0.76
calculate i.
Problem 1.15: Bruce and Robbie open up a new bank account at t = 0. Bruce deposits 100 into
his account and robbie deposits 50 into his. Each account earns the same AEIR. The amount of
interest earned in Bruces account during the 11th year = X. The ammount of interest earned on
Robbies account during the 17th year = X. Calculate X.
Problem 1.16: An investor pays 100,000 today for a 4 year investment that returns cash flows of
60,000 @ t = 3,4. The cash flows can be reinvested at 4% AEIR. If the rate of interest which the
investment is to be valued is 5% what is the PV of the investment today?
Problem 1.17: Project P requires an investment of 4000 @ t = 0 the investment pays 2000 @ t =
1 and 4000 @ t = 2. Project Q requires an investment of X @ t = 2. The investment pays 2000 @ t
= 0 and 4000 @ t = 1. The PV of the two projects are equal at an interest rate of 10%. Calculate
X