Actuarial Society of India

EXAMINATIONS
October / November 2003

SUBJECT : 102 – FINANCIAL MATHEMATICS

Indicative Solution
Solution to Q1:

d
a&&n( p ) = * a&&n
d ( p)
d
= ( p ) * (1 + i ) * an
d
i
= 1
* an
( p) p
i *v
i 1
= ( p ) * (1 + i ) p * a n
i
i  i( p) 
= ( p ) * 1 + * a
i  p  n
 i i
=  ( p ) +  * a n
i p
= (1.012348 + 0.025) * 7.721735
= 8.010126

(Give 3 marks for correct answer with proper steps showing the working, else 0).
- Total [ 3]

Solution 2

Let the retail price be Rs.100. The cash price is Rs.70, or one may pay Rs.75 in 6
months’ time. The effective rate of discount per annum d is found by solving the
equation
½
70 = 75*(1-d)

This implies d=12.89%. [1 mark]

The effective annual rate of interest is i = d/(1-d) = 14.8% [1½ mark]

One may pay Rs.72.50 in three months’ time instead of Rs.70 now, so the effective
annual rate of discount d is found from the equation
¼
70 = 72.50*(1-d) [1 mark]

which gives d =13.10%.

2
The new arrangement therefore offers a greater effective annual rate of discount to cash
purchasers. [1½ mark]

Total [ 5]

Solution to Q3 (a):

For 0 ≤ t ≤ 5 ;

∫
− ( 0 .02 + 0. 05t ) dt

v (t ) = e 0

t
 0 .05 t 2 
−  0 .02 t + 
 2 
=e 0

= e − [0 .02 t + 0. 025t ]
2

[2½ marks]

For t > 5 ;
5 t

∫0
− ( 0 .02 + 0 .05 t ) dt ∫5
− 0 .06 dt
v (t ) = e *e
= e−[
2 5
0 .02 t + 0. 025t 0 ] * e −[0.06t ] t
5

= e − [0. 725] * e −[0 .06 t − 0 .3 ]

= e − [0. 425+ 0 .06 t ]
[2½ marks]
Total [5]

Solution to Q3 (b):

Present value of the income stream is given by

12

= ∫ 25e −0 .03 t e −( 0 .425+ 0 .06 t ) dt

7
12
 e − 0. 09 t − 0 .425 
= 25 *  
 − 0.09  7

=
25
− 0.09
[
* e −1 .505 − e −1. 055 ]
= 35.048648

(3 marks for correct equation)

(1 mark for correct evaluation)
Total [ 4]

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Solution to Q4:

If the effective rate be i the value of n is given by the equation

(1 + i ) n = 2

and hence

log e 2
n=
log e (1 + i )
log e 2
n=
1 1
i − i 2 + i 3 − ...
2 3

or, if powers of i above the first are neglected

log e 2  1 
n= 1+ i
i  2 
.69315
n= + .35 approximately
i

(Give 3 marks for correct answer with proper steps showing the working, else 0)

Total [3]

Solution 5

Let x be the amount of the revised annuity, and consider the position at the date of the
request. The equation of value is

X *(1 + i)1 / 4 * a21.5 = 200* v1 / 4 * &

a&22 + 320*(1 + i) 1/12 * a16.25 + 180* a18.75
(2) (4) (12)

At 8% , we get X= 6899.89/10.5091 = 656.56

(21/2 marks per each item)

Total [10]

Solution 6

Let X be the annual repayment. The amount lent is the present value, on the stated
interest basis, of the repayments. Thus

4
 X *  a6 @10% + v6 @10%* a12 @9%  = 2000
X = 238.17 [2 marks]

The loan outstanding just after payment of the third payment is

2000(1.1)3 – 238.17* s3 @10% = 1873.65 [2 marks]

The loan outstanding just after payment of the fourth payment is

2000(1.1)4 – 238.17* s4 @10% = 1822.84 [2 marks]

The capital repaid at time 4 is therefore 1873.65-1822.84 = 50.81

The loan outstanding just after payment of the eleventh payment is

238.17* a7 @9% = 1198.71 [1 mark]

The loan outstanding just after payment of the twelfth payment is

238.17* a6 @9% = 1068.42 [1 mark]

Hence the capital repaid at the time 12 year is 1198.71-1068.42 = 130.29

After the special payment, the capital outstanding is Rs.968.42. The revised annual
repayment, Y, is found from the equation of value

Y* a6 @9% = 968.42

Hence Y = 215.88 [2 mark]

Total [10]

Solution 7

Since g(1-t)=0.048 is less than 0.07 , the lender should assume that the capital repayments
have the least possible value. Since the repayments must be made in ten consecutive
years, the lender should assume that redemption occurs as late as possible, i.e. the first
repayment will be after 25 years.
[1 mark]
24
The present value of capital (K) = 10000*v * a10 at 7%
= 13846.75 [2 mark]
The present value of net interest payments is

=100000*0.08*0.6* a24 + v24 *0.6*0.08*(100000*v+90000*v2 +80000*v3

5
 +……..+20000*v9 +10000*v10 ) at 7%
[3 mark]

Let X = 100000*v+90000*v2 +80000*v3 +……..+20000*v9 +10000*v10

X(1-v) = 100000v-10000*v* a10

X = (100000v-10000*v* a10 )/(1- v)

Present value of net interest payments = 100000*0.08*0.6*(11.469334) +

(0.1971466)*0.6*0.08*(425203.03)
= 55052.803 + 4023.7119 = 59076.515
The price that should be paid = 13846.75+59076.515 = 72923.265

[5 marks for solving]

[4 marks]
Total [10]

Solution 8

(a) The internal rate of return I is the solution of the equation of value

1000[-10+6*v+6.6*v2 ] =0
which gives I=16.6%

[1 mark for writing the equation and 2 marks for solving]

[3 marks]

(b)(1) Since the internal rate of return exceeds 16% the person should proceed with the
investment. The balance at the end of one year (just after receipt of the payment then
due) is
-10,000(1.16)+6,000 = -5,600
[1 mark]

so the balance at the end of two years(just after receipt of the payment then due) is

-5,600(1.16)+6,600 = 104 [1 mark]

(2) Under the conditions of the loan, the borrower must pay Rs.1,600 in interest at time 1
year, and Rs.11,600 in interest and capital repayment at time 2 years. He will therefore
have Rs.4,400 to invest at time 1 year, which gives Rs.4,400(1.13) = Rs.4,972 at time 2
years.
[1 mark]

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Together with the second payment of Rs.6,600, the person will have Rs.11,572 available
at time 2 years. But this is less than Rs.11,600

The loss will be equal to 11,600-11,572 = 28 [1 mark]

Total [7]

Solution to Q9:

The discounted payback period is equal to that value of t when the value of the
following equation is positive for the first time.

−1500000
−500000* v (1/2)
−500000* v
+6000*500*  v 3 + v 4 + v 5 .................... + v t 
−4000*500* a1 * v 2 + (1.05)v 3 + (1.05) 2 v 4 + ....................(1.05) ( t −3) v( t −1) 

For t = 6 ; the value of the equation is -24791.15

For t = 7 ; the value of the equation is 305586.18

Discounted payback period = 7 years

(2 marks for concept right)

(5 marks for correct equation of value)
(2 marks for correct evaluation of equation of value)
Total [ 9]

Solution 10

(a) A swap is a contract between two parties under which they agree to exchange a series
of payments according to a prearranged formula.
[1 mark]

(b) The swap will be priced so that the present value of the cash flows is slightly negative
for the investor and positive for the issuing organization. The difference represents the
price that the investor is prepared to pay for the advantages brought by the swap on the
one hand, and the issuer’s expected profit margin on the other.
[2 marks]

© Each counterparty to a swap faces two kinds of risk:

7
 I. Market risk is the risk that market conditions will change so that the present
value of the net outgo under the agreement increases. The market maker will
often attempt to hedge market risk by entering into an offsetting agreement.
[2 marks]

II. Credit risk is the risk that the other counterparty will default on its payments.
This will only occur if the swap has a negative value to the defaulting party so
the risk is not the same as the risk that the counterparty would default on a loan
of comparable maturity.
[2 marks]
Total [7]

Solution to Q11:

Forward price = (Current asset price – present value of income payments due within the
term of the futures contract) * 1.14
[1 mark]

Current asset price @ 10% per annum effective

= (0.8 * 10) * a19( 2 ) + 110 * v 19
= 86.53836818

[1 mark]

Present value of income payments due, @ 10% per annum effective

= (0.8 * 10) * a 4( 2 )
= 25.9777935

[1 mark]

Forward price
= (86.53836818 − 25.9777935) * 1.14
= 88.6667374

[1 mark]
Total [ 4]

Solution 12

a) Since the demand falls the corresponding prices will also fall. Hence the yields rise.

8
b) Since supply increases the prices will fall and hence the yields rise.
c) There will be more demand for fixed securities means prices rise and hence yields
fall.
[1 mark each] Total [3]

Solution 13

The cash available for investment now is 100000*v8 at a force of interest of 5%

i.e.67,032. The price per unit nominal of the 20- year stock is v20 at δ =0.05 i.e.0.367879.
[1 mark]

Suppose that the company buys a nominal amount of X of the 20-year stock (at a cost of
0.367879X). This means that an amount (67,032-0.367879X) is held in cash, which has a
discounted mean term of zero.
[2 marks]

The discounted mean term of the company’s assets is

[(0.367879X*20)] + [(67,032-0.367879X)*0] 7.357580X

=
0.367879X + (67,032-0.367879X) 67,032
[3 marks]

The discounted mean term of the liabilities equal to 8 (=term of the liability).
By equating the discounted mean term of assets and liabilities, X = 72,885.
[1 mark]

The company should buy 72,885 nominal of 20-year zero coupon bonds at a cost of
26,813 and hold 40,219 in cash.
[1 mark]
Total [8]

Solution 14

a) After taking into account the deductions, the fund at the end of the year k will have
accumulated to:

Sk = 0.98A*(1+i1 )*0.99*(1+i2 )*0.99*……..*0.99*(1+ik )

k
= 0.98*0.99 *(1+i1 )*(1+i2 )*……..*(1+ik ) [2 marks]

so, using the formulae for the mean and variance of the accumulated value for this model:

E[Sk ] = 0.98*0.99k *(1+µ)k *A [1 mark]

9
And Var[Sk ] = 0.982 *0.992k * { k
 (1+ì ) 2 + ó 2  - (1+ì) 2k } A
2
[3 marks]

b) (i) Using the formulae given for the sample mean and sample variance of the past
growth rates, we find that:

i = (1/10)*(0.127+0.123+…….+0.121) = 0.1479 [1 mark]

S2 = (1/9)*(0.1272 +0.1232 +……..+0.1212-10*0.14792 ) = 0.001890 [2 marks]

So our estimates for the values of µ and σ2 in the model are 0.1479 and 0.001890.

(ii) Using the formulae from (i) with A = 6,000 and k=5 and the estimates of µ and σ2
the mean and variance of the proceeds for the investor will be:

E[S5 ] = 0.98*0.995 *(1.1479)5 *6,000 = 11,145 [1 mark]

And Var[S5 ] =

= 0.982 *0.9929 * {  (1.1479) 2 5

+ (0.001890)  - (1.1479)10 } (6000)2

= 893315.9 = 9452

So the estimates of the mean and standard deviation of the proceeds are 11.145
and 945.

[2 marks]
Total [ 12]

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