ACTUARIAL SOCIETY OF INDIA

EXAMINATIONS – May 2002

Subject 102 – FINANCIAL MATHEMATCS

MODEL SOLUTIONS
Qn.(1):

∴1 = v n + d (p)
!!
a (p)
n

Proof by General Reasoning

Consider an investment of Re.1/- for ‘n’ years in an account that pays interest at the rate
of ‘i’ per annum per unit. The payment of I at the end of each year is equivalent to
1
payment of d (p) p.a. payable P times a year at the beginning of every th of a year.
p
Then, in return for your initial investment if Re.1, you will receive ‘np’ interest payments
d ( p) 1
of each at the beginning of every th of a year. for n years and return of your
P p
initial investment of Re.1 at the end of n years.
The present value of your receipt @ ‘i’ p.a. per unit is d (p) !!
a (p)
n
+ V n , which equal 1, The
initial investment.

∴ 1 + d (P) !!
a (p)
n
+ vn
1-v n
∴ !!
a (p) =
n
d (p)

Q2 (1) (a) Given i(4) = 0.05

4
 i (4) 
∴ 1+i = 1+ 
 4 
∴1 + i = (1.0125) 4
∴ i = 0.5095 or 5.095%

(b) Given d = 0.07

1+I = (1-d)-1
1
∴1 + i =
1-d
1 d 0.07
∴i = −1 = = = 0.0793 or 7.53%
1− d 1-a 0.93
(c) Given
 δ = 0.054
1 + i = eδ
∴ i = e0.054 − 1
= 1.05548 - 1 = 00555 or 5.55%

2 (ii) Working in terms of monthly periods Act

i1 the interest p.m. p.u. for 1st 3 years,
i2 the interest p.m. p.u. for next 3 years, and
i3 the interest p.m. p.u. thereafter for 4 years

Then, the required present value

{
= 1000 a36 (1) + a36 (2) v 36
(1) + a 48 (3) v (2) v (1)
36 36
}
where,
1 − v136
a =  0.10 
36 (1)
i1 (1 + i1 )6 = 1 +  = 1.05
 2 
1-v 6 1
= @ 5%
1
6
i1 = (1.05) 6 − 1 = 0.008165
(1.05)
v136 = v0.5
6
= 0.746215
1-0.746215
=
0.008165
= 31.082058

1-v36  0.01 
a36 (2) = 2
Where (1+1s) =  1 +  = 1.0075
i2  12 
1-v36 3
= 2
∈ % i2 = 0.0075
i2 4
v36
2 = 0.764149

1-0.764149
=
0.0075
= 31.446800
 1-v348
Q a48 (3) = where (1+i3 )12 = 1.08
i3
1
i3 = (1.08) 12
−1
4
1-v
= 1
@8% v348 = v.08
4
= 0.735030
(1.08) − 1 12

1-0.735030
=
0.006434
= 41.182779

∴ The required p.v.

= 1000 { 31.082058
+ 31.4468) (0.746215)
+ 1.182779) (0.764149) (0.746215)}
= 1000 { 31.082058
+ 23.466074
+ 23.483221 }

= 1000 (78.031353)
= 78031.353
= 78031

Q.3 The three factories of the term structure of interest rates are –
(a) Expectation theory. The expectation theory describes the shape of
yield curve as being determined by the market expectations for
future short-term interest rates. For example an expectation of a
fall in interest rates will make short term investments less attractive
and long term investments more attractive.
(b) Liquidity Preference theory – It is based on the general accepted
belief that investers prefer liquid assets to illiquid ones.

(c) Market Segmentation theory – this theory says that yields at each
term to redemption are determined by supply and demand from
investors with liabilities of that term. Different investors are active
at different terms of the yield curve.

Q.4 (i)

Example 1 :- Suppose an investor is considering purchasing an equity investment.

The – will continue to be found the propriety is value fot the accumulated profit.
The investor would have to pick & assure that the holding would be held on
that date. The value ---- for the accumulated profit will then ------ on which date ---
 Example 2 :- Suppose ---- man ( is good health) is considering using a ---- in buy
a pension payable for the rest or has life once be does not know when be will due be
cannot know what date to accumulate the ---

(ii) 1) Cash Flow, 2) Borrowing requirements

3) Resources 4) Rvt. 5) Investment Entries.

NPVA = - 100,000
+ 7500 [v+(1.05)v2+(1.05) 2v3+…………. + (1.05) 9- v10 + (1.05) 10 V11
+ 1,50,000 v11 @ 10%

11
 1.05 
1−  
= -100,000 + 7500 v  1.10  + 150000
 1.5 
1−  
 1.10 
1 − (1.05 )
11

= −100, 000 + 7500 1.10 + 150000(0.35)

1.10 − 1.05
1 − 0.4005365
= −100, 000 + 7500 + 52573.5
0.05
= -100,000 + 7500 (8.01073) + 52573.5
= -100,000 + 60080.475 + 52573.5
= 12653.975
= 12654

NPVB = -100,000 + 300,000 V11 @10%

= -100,000 + 300,000 (0.35049)
= -100,000 + 105147
= 5147

(iii) (b)
Project A is better than Project B As it has a higher NPV

Q.5

Loan amount = 100,000 term = 10 years

Interest rate 12.5% p.a.
Let X be amount of Installment. Then,
100,000 = X a 5 + 3 X a5 vs @ 12.5% p.a.
100,000 100, 000
∴X = =
a5 (1 + 3V ) 3.56060(0.6648)
5

= 10,539.31
The loan outstanding one year before the end of term equals the payment value of final
installment which is 3V(10,539.31) = 28,104.83

Q6.

(i)
1. Investment characteristics may be similar to convention bonds.
2. or to ordinary shares
3. or can be a combination of both
4. it depends on whether or not conversion is likely
5. if conversion is almost certain, a convertible is in effect the same as the
underlying share with a different stream in the period before conversion.
6. If conversion is unlikely, the convertible is very similar to a normal fixed
interest bond.
7. In all cases the option to convert will have some possible values.
8. This value will be highest when there is mot uncertainty as to whether
conversion will occur or not
9. convertibles generally provide higher income than ordinary shares and
lower income than conventional loan stock or preference shares.
10. There will generally be less volatility in the price of the convertible than in
the share price of the underlying equity.

Q.7 The amount of redemption payment will be

I(1.7.2004) 193
25000 = = 25000 x = 32601.35
I(1.7.1999) 148
32601.35 = 25625(1 + i )3
⇒ i = 8.36%

Working in terms of 1.1.2002 prices, the real return

I (1.1.2002)
25625(1 + i ' )3 = 32601.35 x = 32601.35
I (1.1.2005)
i ' = 3.47%

Q.8 (i) Forward price is calculated from the equation :

K= (S0 -I)eδ t where
So is the price of security at time 0
I is the Present value of fixed income payments during the term of the
forward contract

K = (103-9a6(2) ) (1+i)6 @ 5%
= 103 (1.05)6 +9S6(2)
= 103 x 1.34 - 9x 6.8019 x 1.012348 = 76.05%
Q.9 The accumulated amount at the end of n years is
Sn (1+i1)(1+i2)………..(1+in)
The mean value is :
E( Sn )= E[(1+i1)(1+i2)……..(1+in)]

Since the yields in different years are independent, expectation on the RHS can be
shown as :
E( Sn )= E[(1+i1)(1+i2)……..(1+in)]
= (1+j)(1+j)(1+j)…….n terms = (1+j) n

The second moment is

E Sn2 = E[(1+i1)2(1+i2) 2 ……. (1+in) 2]
= E[(1+i1)2(1+i2) 2 …….E (1+in) 2]
Take
E[1+ik)2)] = E[1+2ik)+ik2)] = 1+2E(ik) + E(ik)2
2
E(ik) can be derived from the variance,
Var (i k ) = E(i 2k ) − [E(i k )]2
⇒ E(i 2k ) = [E(i k )]2 +var (i k ) = j2 +s 2
∴ E[(1+i k 2 ) = 1 − 2 j + j 2 + s 2
Hence the second moment of Sn is
E(S2n) = (1+2j+j2+S2)
and variance
Var (Sn ) = E(S2n ) − [E(Sn )]2 = (1+2j+j2 +s 2 ) n - (1+j)2n

Q.10 (iii)
Let X be the level of payment in the first 5 years
-
100, 000 = X a 5 + 2Xa 10 V 5
Given i(4) = 8%
i = 8.24%
δ
e =1+i ⇒ δ = 7.918%
1 − v5
a5 = = 4.1289
δ
1 − v10
a10 = = 6.908
δ
100,000 = X (4.1289) + 2X (6.908)(0.67307)
 100,000
X = = 7447.11 per year or 143.21 per week in the first 5 years (assuming
13.4280
52 weaks per year)

And 2 x 143.21 = 286.42 per week in the next 10 years.

Q.10 (i)
100,000 X a15(12) @ i
Given i(4) = 8%
4
 i (4) 
1 + i = 1 + 
 4 
i = 8.24%
 1(4)  13 
i = 12 1 +
(12)
 − 1 = 7.947%
 4  
 
5
1-v
a15(12) = (12) = 8.7465
i
∴100, 000 = X*8.7465
X = 11433.19 per annum or 952.77 per month

Qn.10(ii)

100, 000 = X a!!15(2) v 4

Given i (4) = 8%
i = 8.24%
d = iV = 7.613%
d (2) = 2 1-(1-d) 2  = 7.764%
1

 
15
1-v
!!(2)
a15 = (2) = 8.9526
d

100,000
X= = 15332.79 per year or 7666.40 per half year
8.9526 * 0.7285
Q8 (ii) After 3 years the price of the security is
P3 = 9 a2(2) + .05v12 @ 9%
= 9*7.1607*1.022015+105*0.35553
= 103.20%

In order to calculate the value of the forward contract, consider the following two
portfolios
Portfolio A – Buy the forward contract at Price V and simultaneously invest
K (1+i)-3 +9a3(2) in the risk free asset where ‘i’ is the risk free return. The price of
this portfolio is
V + K (1+i)-3 +9a3(2)

Portfolio B – Buy the security at current price P3 = 103.20%

Therefore
V + K(1+i)-3 + 9a 3(2) = P3
V = P3 − 9a 3(2) − K(1+i)-3
- 103.20 - 9x 2.7232x1.012348 - 76.05 (1.05)-3
= 12.69%

Qn.6(ii) Term = 6.5 years

Coupon = 6% p.a. hly.
Redempn.. Value = 105%
Purchase price = 93%

Working in half yearly terms

93 = 3a13 + 105v13 @ i %
By trial & error method
@ 3.5% ⇒ 3*10.3027 + 105 * 0.6394 = 98.0451
@ 4.5% ⇒ 3*9.6829 + 105 * 0.5643 = 88.3002

I = 4.02% per half year

Effective annual yield

1.04022 – 1 = 8.20%