ACTUARIAL SOCIETY OF INDIA

EXAMINATIONS: NOVEMBER 2000

Subject 102: Mathematics of Finance.
INDICATIVE SOLUTIONS.
Time allowed: Three hours- Maximum marks 100

1) l – v20 -– 20v20 l -e –20δ –20e

–20δ

( Iä )20
ä20 – 20 v
20
d l – e– δ .
= = =
d d 1– δ
10.380169 – 4.037930
________________________
= = 82.50 [ δ = 0.08 ]
0.076884

2) The yield can take one of the two possible (equally likely) values, depending on whether further
payment of Rs. 5000/- is received or not.

Without Rs. 5000: 10 = 12.5 → ∴ V5 0.8 → i = 4.564%

With Rs. 5000: 10 = 12.5 V5 + V5 +V10 V10 + 12.5 V5 – 10 =0

∴ V5 = 0.637459 → i = 9.4232

∴The expected yield = E(i) = (0.5 x 4.5640)+ (0.5 x 9.4232) = 6.9936 = 6.99%
3) Given δ = 0.10. i = eδ -1 = 0.1052 ∴i = 10.52%
i(4) 4
δ.
δ
1+
_______
= e ∴i (4)
= 4 ( e4 –1 ) = - 0.1052 i.e. i(4) – 10.13%
4

d(12) 4
δ.

1+
_______
= e
-δ
∴d (12 12
= 4 ( 1- e –1 ) = 0.0996 i.e. d (12) – 9.96%
12

4) Hodging is a general term which describes the use of financial instruments (including stocks, bonds,
forward contracts and more complex financial contracts such as options) to reduce or eliminate a
future risk of loss.

5) The dividends expected to be received (in Paise) per share each year-end are
Time 1 2 3 4 5 .......
Amount 90 90(1.09) 90(1.09) (1308)[=x, say] x(1.05)2 x (1.05)
The present value at 8% p.a effective = 90v +90(1.09)v2 + xv3+ xv4 (1.05)+ xv5(1.05) +...

xv3 90 98.1 x 1
_______ _____ ______ _____ _____
= 90v +98.1 v 2 + = + + + where x = 90 x 1.09 x 1.08

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 1-(1.05)v , 1.08 (1.08)2 (1.08)2 1.03

= 93.33 + 84.10 + 3027.78 = 3195.21 3195. 21 .

6) If a sum of 1 is invested in a bank account at the beginning of each year for n years, the investor, in
order to receive a yield of i p.a. will expect to receive interest at rate at the end of each year on the
amount invested plus a return of the total capital invested at the end of n years.

Since I is invested every year the present value of the amounts invested is = ä n
The interest payments are i in the first year, 2 i in the second year and so on.. The capital returned at
the end of n years is n.

The value of the proceeds of the investment is, therefore, = i x ( Ia ) + n vn

n

Since the yield is i the present value of the investment equals the present value of the proceeds.
ä n - n vn
i.e. ä n = i x ( Ia ) + n vn ∴ ( Ia ) = ___________________
n n
i .

7)
i) Futures: A futures contract is a standardized exchange tradable contract between two
parties to trade a specified asset in the future at a specified price. The underlying asset/bench
mark might be a bond, a currency, an index reflecting the level of a stock market, or an interest
rate.
ii) Options: An option gives an investor the right, but not the obligation to buy or sell a
specified asset on a specified future date. There are two basic types of options:
A call option gives the right, but not obligation, to buy a specified asset on a set date in the
future for a specified price.
A put option gives the right, but not the obligation, to sell a specified asset on a set date in the
future for a specified price.
An American style option is an option that can be exercised on any date before its expiry. A
European style option is an option that can only be exercised at the expiry.
8) Let the loan amount be = L
Total interest charge on the loan for 1 year = L x (0.075) x 1

∴ each of the six equal installment = L x (0.075)

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Now working in terms of interest per month for this transaction is given by the equation

L x (1.075) x v6 a 6 = L ∴ v6 a6 = (1.075) . -1

= 5.5814
6 6
1. .
Since the flat rate of 7 1/2% p.a corresponds roughly to (1.075)12 -1 = 0.69% we start with
approximation of 0.7% p.m.

At 0.7% p.m. v6 a 6 = 5.6157

At 0.8% p.m. v6 a 6 = 5.5631

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 ∴i % p.m. = 0.7 + 5.5814 - 5.6157 . x (0.1) = 0.7+0.065 = 0.765 which corresponds to
5.5631 - 5.6157

annual effective rate of [ (1.00765)12 -1 ] x 100 = 9.576% APR = 9.5%

9)
a) First we calculate the monetary amount of each payment using the inflation index values 8 months
before the payment date. We will then express amounts in terms of time 0 money units. The results
are shown in the following table:

Time 1 2 3
110
____ 113
____ 117
____
Nominal payment as inflated 5x = 5.24 5x = 5.38 105 x = 117
105 105 105
107
____ 107
____ 107
____
Payment in time 0 unit 5.24x = 5.05 5.38x = 5.05 117x = 104.33
111 114 120

The real yield is then founded by solving for i, the equation of value
97 = 5.05 v + 5.05 v2 + 104.33v3
104.33 – 5.05 ⅓ 505
___________ _____
As a first approximation (1+i ) = + = 1.0599 say, 6%
97 97
RHS @ 6% = 96.856
RHS @ 5.9% = 97.117

97 - 97.117
______________
i = 5.9 + (6-5.9) = 5.9++0.0448 = 5.9448 = 5.94%
96.856 –97.117

Let the actual rate of interest earned by the account be i p. a effective. Since the inflation is at the
b)
rate of 5% p.a, 1+ i = 1.03 ⇒ 1+ i = 1.03 x 1.05 = 1.0815
1.05
∴ the Account earns actually a rate of interest of 8.15% p.a. effective *****
1.
∴ the effective rate of interest per month = (1.0815)12 - 1 = 0.00655
∴ the balance in the account is 5000 x S120 = 913165.5
10) 1.
a) The MWRR is found from the equation 29. 40 (I+i )3 + 1.40 (1+i) 2 = 38.50

38.50 ⅓
_______ - 1 ie i < 0.094 say
As a first approximation take i <
29.40
@9% LHS = 39.5355

@8% LHS = 38.4905 ∴ MWRR is 8% p.a.

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 b) TWRR is found from the equation:

35.70 – 1.40 38.50

_______________ ________
(1 + i )3 = x = ( 1.1667 ) (1.0784) = 1.2582
29.40 38.70
1 +i = 1.07957 ∴ i = 8% p.a [nearest to 0.1 %]

c) There were no cash flows during 1997 or 1998. So the values of (1 +i) for these year were just
32.20 35.70
______ ______
= 1.0952 and = 1.1087
29.40 32.20
The effective rate of return for 1999 can be found from the equation of value
1.
35.70(1 + i) + 1.40 (1+i) 2 = 38.50
________________________
1 -(1.40) ± √
(-1.40)2 - 4(38.50) (37.50)
= 1.01905 ∴ 1+ i = 1.0385
_______________________________________
(1+i)2 =
2 x 35.70
∴The linked annual rate of return is found from the equation:
(1+i)3 = (1.0952) (1.1087) (1.0385) = 1.2610
∴ 1+i = 1.08037 ie. 8% (nearest to 0.1%)

11)
i) An arbitrage opportunity exists if.
(a) an investor can make a deal that would give him an immediate profit, with no risk of loss
(b) an investor can make a deal that has zero initial cost, no risk of future loss and a non-zero
probability of a future profit.
ii) In practice, in the major developed securities markets, arbitrage opportunities, when they arise,
are very quickly eliminated as investors spot them and trade on them. Such opportunities are so
fleeting in nature, according to empirical evidence, that it is sensible, realistic and prudent to
assume that they do not exit. We also assume here that there are no transaction costs or taxes
associated with buying, selling or holding assets. These are idealised assumptions, but they
enable us to develop a methodology that may be adapted to deal with these institutional features
if necessary.
The amount of each coupon = ( ½ )(0.08) 500,000 = Rs. 20,000
The current price of the stock of Rs. 5 lakhs nominal = (0.804) 500000 = Rs. 402000
If the forward price for the whole stock of Rs. 5 lakhs is denoted by K, and we note that two
coupon payments of Rs. 20000 each fall due during the 10 month contract period, we get the
equation giving the value of K as follows:

10 2. 8.
-δ 12 -δ 12 -δ 12
Ke + 20000 [e + e ] = 402000 →
10 8. 2.
δ 12 -δ 12 -δ 12
Ke + 402000 e – 20000 [e + e ] where δ = 0.05

1 1. 1.
24 30 120
∴K = 402000 e – 20000 [e + e ]
= 402000(1.0425469) - 20000 [1.0033895+1.008368]

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 = 419103.85-20000 [2.042263] = 419103.85-40845.26 = Rs. 378258.59

12)
i) Coupons will be paid half yearly in arrears for 8 years and the redemption payment will be
made in 8 years' time. The tax payment will consist of
Rs 0.70 payable on 1-11-97
Rs. 1.40 payable each year from 1-11-98 to 1-11-2004 (inclusive)
Rs. 0.70 payable on 1-11-2005
So the equation of value for Rs.100 of nominal stock is:
(2) 3½.
80 =3.5 a8 + 100 v8 - v 12 [ 0.7 v + 1.4( v2 + v3 + ….v8 ) + 0.7 v9 ] ….. (a)
(2) 7.
1+ 24
= 3.5 a8 + 100 v8 – v [ 0.7+1.4 a 7 + 0.7 v8 ]
1
8
100 3.5(0.6)
____ ________
A first approximation could be calculated as 1+i = + = 1.0545
80 80

∴ RHS of equation (a) @ 5%

= 3.5(6.4632)(1.012348)+ 100(0.67684)- (0.95238)(0.985869){9.274748}
= 81.88
RHS of equation (a) @ 6%
= 3.5(6.2098)(1.014782) + 100(0.62741) - (0.94340)(0.983148)[8.954547]
= 76.49
80 – 81.88
∴ yield % p.a = 5 + ______________ ( 6 – 5 ) = 5 + 0.349 = 5.35%
76.49 – 81.88

ii) The value of capital repayment is:

PV cap = 500000 a 4 x V10 ** at 10% = 500000 x 3.1699 x 0.38554 = 611061.62
The value of interest repayment is:
(2) (2) (2) (2)
PV int = ( 0.085 ) [ 2,000,000 a 11 + 1,500,000 a 1 v11 +1,000,000 a 1 v12 + 500,000 a1 v13 ]
= (0.85) 100000 x [ (20 x 6.4951 x 1.024404)
+(15x0.90909x1.024404x0.35049)
+(10x0.90909x1.024404x0.31863)
+ (5x 0.90909x1.02404x0.28966)] = 1209416.20
Adding PV cap and PV int gives the price of the stock (without taking into account CGT) as
611061.62 + 1209416.20 = 1820477.82
Let the price of the stock be P, allowing for CGT, since there is a capital gain of (2000,000-P).
Since the redemption is in installments, the value of the capital gains fax payments will be in
proportion to the value of redemption payments. Thus:

611061.62
_________
P = 1820477.82-(0.30)(2000000-P) x = 1820477.82-183318.49+0.091659P

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 2000000
1637159.33
∴P= ___________
Rs. 1802362.51
0.908341
13)
(i) the accumulated value in successive years are related by the recurrence formula
Sn = (1 + in ) Sn – 1 with S0 =1 …………….(a)
Taking expectations: E (Sn) = E[( 1+ in ) Sn-1]
Since the model assumes that the interest rates in successive years are independent with
E(in) = j we get E(Sn) = E( 1+ in ) E(Sn-1) = (1+j) E(Sn –1) Applying this result iteratively
with
E(S0) =1, we get E(Sn) = (1+j)r………………..(1)
Squaring the equation (a) and taking expectations gives:
E(Sn2) = E[(1+in)2 S2 n-1] = E(1+in)2 E (S2 n-1)
Now, E(1+ik)2 = var (1+ik) + [E(1+ik)2]2 = var (ik) + [1+E(ik)]2
=var(ik) + [1+j]2 = S2 +(1+j)2
∴E(Sn2) = [ S2 + (1+j)2 ] E ( S2 n-1) …………………(ii)
∴Applying the results repeatedly [ with E(S02) = 1 ] gives : E(Sn2) = [S2 +(1+j)2 ]n
Combining these results we get:

Var(Sn) = E(Sn2) – [ E(Sn)2 ] =[ S2 +(1+j)2 ]n – (1+j)2n …………(iii)

ii)
(a) Equating the formulae for the mean and variance of a log-normal distribution to the values we
want:
-σ2
-µ + 12
e = E(1+ it ) = 1 +j = 1.08 …………………. .(iv)

-µ + σ2 σ2
and e (e -1 ) = var (1 +it ) = S2 = 0.01…………..(v)

Solving these simultaneously: [square (iv) and divide (v) by it]

0.01 0.01
σ2 σ2
(e -1 ) =
______ ∴e = _____
+1
(1.08)2 (1.08)2

0.01+ (1.08)2
-µ + 0.0042684
∴ σ2 = log
______________
= 0.0085368 and e = 1.08
(1.08)2

∴µ =log(1.08)-0.0042684 = 0.0042684 = 0.0726926

(b) If S20 denotes the accumulation of one unit of money for 20 years.

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 20
S20 = Π (1 + it) log S20 = log (1 + it )
t=1
Because the yields in different years are independent, log S20 has a normal distribution with mean
20µ =1.453852 and variance 20 σ2 = 0.170736 ie S20 has a log normal distribution with these
parameter values.

14)
i) Let the loan be of amount Rs. S
S = 200000 V + 220000 V2 + 240000 V3 +.... + 480000 V15
= [ 180000V + 180000 V2 + 180000 V3 + .... + 180000 V15 ]
+ [20000V + 2 x 20000 V2 + 3 x 20000 V3+.....+15 x 20000 V15 ]
= 180000 x a 15 + 20000 x ( Iaa )15 @12%

ä15 - 15V15 7.6282 –15.18270

___________ ________________
= 180000 x 6.8109 + 20000 x = 1225962+20000
0.12 0.12

= 1225962 + 20000 x 40.730833 = 2040578.66

ii) The loan o/s at the beginning of the ninth year [ie at the end of eighth year]
= [180000v+180000v2+180000v3+.…….+180000 v7]
+[9x20000v+10x20000 v2 + 11 x 20000 v3 +.....+15x20000 v7
= [340000v+340000v2++340000v3+.…....+340000v7]
+[1x20000v+2x2000v2-3x2000 v3 +.…...+7x20000 v7]
= 340000V a 7 + 20000 ( Iaa )7=
5.1114 - 7 X 0.45235
____________________
= 340000 x 4.5638 +20000 x
0.12
= 1551672 + 324158.33 = 1875850.33
Schedule
Year o/s loan at beginning Repayment installment Interest Capital Repayment

9 1875850.33 360000 225102.04 134897.96

10 1740952.37 380000 208914.28 171085.72

11 1569866.65

iii) Let the new installment repayment at the end of eleventh year be = P Then
15,69866.65 = [Pv + Pv2 + Pv3 +………. Pv5 ]
+ [20000v2+2x2000v3+.... pv5]
= (P-20000) a5 +20000 ( Iaa )5 @ 10%
4.1699 – 5 X 0.62092
_____________________
= (P-20000) 3.7908+20000x
0.10
= P(3.7908)+ 20000(10.653-3.7908) = 3.7908P+137244

1569866.65 - 137244
_____________________
=P = = 377920.93
3.7908

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