# 1 Cash-flows, discounting, interest rate models

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1 Assignment 1 BS4a Actuarial Science Oxford MT Cash-flows, discounting, interest rate models Please hand in your answers to questions 3, 4, 5 and 8 for marking. The rest are for further practice. 1. Discuss the cash-flows of a typical final-year undergraduate over 5 years. Aim for a concise presentation. 2. If the effective annual rate of interest is 9%, calculate the total accumulated value at 1 January 2010 of payments of 100 made on 1 January 2009, 1 April 2009, 1 July 2009 and 1 October A man stipulates in his will that 50,000 from his estate is to be placed in a fund from which his three children are each to receive an equal amount when they reach age 21. When the man dies, the children are ages 19, 15 and 13. If this fund earns 6% interest per half-year (i.e. nominal 12% p.a. compounded each 6 months), what is the amount that they each receive? Is the distribution fair? 4. (i) Establish a table of relationships between (constant) δ, i, v and d. (ii) Show that d = vi and interpret this. (iii) Show that δ i i 2 /2 and d i i 2 for small i, and that d δ δ 2 /2 for small δ. 5. Calculate the equivalent effective annual rate of interest of (a) a force of interest of 7.5% p.a. (b) a discount rate of 9% p.a. (c) a nominal rate of interest of 8% p.a. convertible half-yearly (d) a nominal rate of interest of 9% p.a. convertible monthly. 6. A borrower is under an obligation to repay a bank 6,280 in four years time, 8,460 in seven years time and 7,350 in thirteen years time. As part of a review of his future commitments the borrower now offers either (a) to discharge his liability for these three debts by making an appropriate single payment five years from now; or (b) to repay the total amount owed (i.e. 22,090) in a single payment at an appropriate future time. On the basis of a constant interest rate of 8% per annum, find the appropriate single payment if offer (a) is accepted by the bank, and the appropriate time to repay the entire indebtedness if offer (b) is accepted. (You should work on the basis that the present value of the single payment under the revised arrangement should equal the present value of the three payments due under the current obligation). 7. Calculate the accumulated value of 1,000 after 2 years if δ(t) = 0.06(t + 1) for 0 t 2.

2 Assignment 1 BS4a Actuarial Science Oxford MT Stoodley s formula. Suppose the force of interest is given by where p, r R + and s p. δ(t) = p + s 1 + re st, t R + Calculate the discount factor v(t), t R +, and show that the model can be reparametrized such that v(t) = λv t 1 + (1 λ)v t 2. Interpret this! 9. In valuing future payments an investor uses the formula v(t) = α(α + 1) (α + t)(α + t + 1), t R + where α is a given positive constant, for the value at time 0 of 1 due at time t (measured in years). Show that the above formula implies that (i) the force of interest per annum at time t will be δ(t) = 2t + 2α + 1 (α + t)(α + t + 1) (ii) the effective rate of interest for the period r to r + 1 will be i(r) = 2 r + α (iii) the present value of a series of n payments, each of amount 1 (the rth payment being due at time r) is a(n) = nα n + α + 1. (iv) Suppose now that α = 15. Find the level annual premium, payable in advance for twelve years, which will provide an annuity of 1,800 per annum, payable annually for ten years, the first annuity payment being made one year after payment of the final premium. What is the value at time 12 of the series of annuity payments, what at time 0? Course webpage, where all other assignments and solutions will be posted: deligian/teaching/bs4a.html Class allocations and hand-in times:

3 Assignment 2 BS4a Actuarial Science Oxford MT Yields, pthly payments, annuities and loans Please hand in your answers to questions 2, 3, 6, 7 and 8 for marking. The rest are for further practice. 1. Under the terms of a savings scheme an investor who makes an initial investment of 4,000 may receive either 2,000 after 2 years and a further 3,000 after 7 years; or 4,400 at the end of 4 years. Which of these options corresponds to a higher rate of interest on the investor s money? 2. Find the yield of the following cash-flows: (a) an investment of X at time s, followed by a single payment of Y received at time t > s. How does the yield change as X, Y, s, t vary? (b) a bond costing P at time 0, which generates coupon payments of X at times 1, 2,..., n and a redemption payment of P at time n. 3. For m N, the prefix m before an annuity symbol indicates that the sequence of payments concerned is deferred by an amount of time m. For example, the discounted present value (in the constant interest-rate model) of a deferred annuity, with unit payments per unit time payable from m + 1 to m + n, is denoted by m a n. (a) Express m a n in terms of the ordinary annuity symbols introduced in the lectures. (b) The case m = 1 corresponds to an annuity-due and is denoted by ä n. Express ä n as simply as you can (i) in terms of a n and (ii) in terms of a n 1 (c) The discounted present value of an increasing annuity with payments j at time j = 1,..., n is denoted by (Ia) n. Express (Ia) n in terms of ordinary annuity symbols. (d) Consider a security redeemable at par, with term n and pthly coupon payments at nominal rate j. Express the accumulated (time n) and discounted (time 0) values in the constant i model in terms of annuity symbols. 4. Find, on the basis of an effective interest rate of 4% per unit time, the values of a (4) 67, s(12) 18, ä (4) 16.5, s(12) 15.25, 4.25 a (4) 3.75, (Is) 4. Describe the meaning of each of the symbols. 5. Buy now, pay later!! A luxury sofa is sold with the following payment options: either pay immediately and receive a 5% discount, or pay by monthly instalments (in arrears) for 15 months. To calculate the monthly payments, add a 5% finance charge to the purchase price, then divide the total amount into 15 equal payments. What annual effective rate of interest is being charged for paying by instalments?

4 Assignment 2 BS4a Actuarial Science Oxford MT Show that in any constant i interest rate model, the cash-flows c (s) = δ, 0 s 1, and c p = (k/p, i (p) /p) k=1,...,p are equivalent (have the same value) for all p N. 7. A loan of 30,000 is to be repaid by a level annuity payable monthly in arrears for 25 years, and calculated on the basis of an (effective) interest rate of 12% pa. Calculate the intitial monthly repayments. After ten years of repayments the borrower asks to: (a) pay off the loan which is outstanding. Calculate the lump sum which would be required to pay off the outstanding loan. (b) extend the loan by a further five years (i.e. to 30 years in total), and with repayments changed from monthly to quarterly in arrears. Calculate the revised level of quarterly repayments. (c) reduce the loan period by five years (i.e. to 20 years in total) and for repayments to be biannually (i.e. once every two years) in arrears. Calculate the revised level biannual repayments. [Hint: calculate annual repayment levels first, then combine each two consecutive payments into an equivalent single payment.] 8. An insurance company issues an annuity of 10,000 p.a. payable monthly in arrears for 25 years. The cost of the annuity is calculated using an effective rate of 10% p.a. (a) Calculate the interest component of the first instalment of the sixth year. (b) Calculate the total interest paid in the first 5 years. 9. A ten-year loan for 10,000 has a fixed rate of 5% for the first 3 years. Thereafter the rate is 8% for the rest of the term. Repayments are annual. Find the amounts (i) of the first 3 repayments and (ii) of the remaining 7 payments. Show that the APR of the loan is 6.4%. 10. (a) An annuity-certain is payable annually in advance for n years. The first payment of the annuity is 1. Thereafter the amount of each payment is (1 + r) times that of the preceding payment. Show that, on the basis of an interest rate of i per annum, the present value of the annuity is ä n j where j = (i r)/(1 + r). (b) Suppose instead that the annuity is payable annually in arrear. Is its present value (at rate i) now equal to a n j? (c) In return for a single premium of 10,000 an investor will receive an annuity payable annually in arrear for 20 years. The annuity payments increase from year to year at the (compound) rate of 5% per annum. Given that the initial amount of the annuity is determined on the basis of an interest rate of 9% per annum, find the amount of the first payment.

5 Assignment 2 BS4a Actuarial Science Oxford MT Course webpage with assignments and, after the classes, solutions: deligian/teaching/bs4a.html

7 Assignment 3 BS4a Actuarial Science Oxford MT (ii) A second set of accounts was constructed to show the dates at which the new investments were received, the dates at which the withdrawals and other payments actually occurred, and the value of the fund at various times during the year: million Value of fund at 1 January Value of fund at 31 March 36 Value of fund at 15 May 35 New investments at 16 May 18 Value of fund at 30 June 51 Value of fund at 30 September 45 Withdrawals on 1 October 30 Value of fund at 31 December (a) Show that the annual yield (i.e. the annual money weighted rate of return) on the fund for the year ending 31 December 2004 is approximately 8.87%. (b) Calculate the annual TWRR on the fund for the year ending 31 Dec (iii) Explain the differences between your answers for (i), (ii)(a) and (ii)(b). 4. In a particular accumulation fund income is retained and used to increase the value of the fund unit. The middle price of the unit on 1 April in each of the years 1999 to 2005 is given in the following table: Year 1 April Middle price of unit in (a) On the basis of the above prices and ignoring taxation and expenses: (i) Find the time-weighted rate of return over the period 1 April 1999 to 1 April 2005, (ii) Show that the yield obtained by an investor who purchased 200 units on 1 April in each year from 1999 to 2004 inclusive, and who sold his holding on 1 April 2005, is approximately 10.60%. (iii) Show that the yield obtained by a person who invested 500 in the fund on 1 April each year from 1999 to 2004 inclusive, and who sold back his holding to the fund managers on 1 April 2005, is approximately 10.67% (You should assume that investors may purchase fractional parts of units.) (b) Suppose that, in order to allow for expenses, the fund s managers sell units 2% above the published middle price and buy back units 2% below the middle price. On this basis find revised answers to (ii) and (iii) of (a). 5. A loan of 25,000 was issued and was repaid at par after three years. Interest was paid on the loan at the rate of 8% per annum, payable annually in arrears. The value of the Retail Price Index at various times was as follows

8 Assignment 3 BS4a Actuarial Science Oxford MT At issue One year later Two years later Three years later Calculate the real rate of return of the loan. 6. Calculate the time-dependent force of inflation between two successive index values if intermediate values are computed by (a) linear (b) exponential interpolation. Course webpage: deligian/teaching/bs4a.html

9 Assignment 4 BS4a Actuarial Science Oxford MT Inflation, taxation and project appraisal Please hand in your answers to questions 3, 4, 5 and 6 for marking. The rest are for further practice. 1. On 15 May 1997 the government of a country issued an index-linked bond of term 15 years. Coupons are payable half-yearly in arrears, and the annual nominal coupon rate is D = 4%. Interest and capital repayments are indexed by reference to the value of a retail price index with a time lag of 8 months. The retail price index value in September 1996 was Q( 8/12) = 200 and in March 1997 was Q( 2/12) = 206. The issue price of the bond was such that, if the retail price index Q were to increase continuously at a rate of e 1 = 7% p.a. from March 1997, a tax exempt purchaser of the bond at the issue date would obtain a real yield of y = 3% p.a. convertible half-yearly. (i) Determine Q(t) for all t 0 and hence the coupon and redemption payments of the bond per 100 nominal, assuming inflation at constant rate e 1. (ii) Derive the formula for the price of the bond at issue to a tax-exempt investor and show that the issue price of the bond is per 100 nominal. (iii) An investor purchases a bond at the price calculated in (ii) and holds it to redemption. The actual rate of increase of the retail price index is e 2 = 5% p.a. from March A new tax is introduced such that the investor pays tax at 40% on any real capital gain, where the real capital gain is the difference between the redemption money and the purchase price revalued according to the retail price index to the redemption date. Tax is only due if the real capital gain is positive. Calculate the real annual yield convertible half-yearly actually obtained by the investor. 2. A zero-coupon bond was purchased m years ago by investor A who is liable to capital gains tax at rate t. At the time of purchase the outstanding term of the bond was n years (n > m). The price paid by A will provide him with a net effective annual yield of i > 0 if he holds the bond until it is redeemed. Investor A now wishes to sell the bond. He will be liable to capital gains tax on the excess of his selling price over his purchase price. (a) Derive an expression in terms of t, n, and i for the purchase price (per unit redemption money) paid by A. (b) Derive also an expression in terms of t, n, m, and i for the price (per unit redemption money) at which A should now sell the bond in order to obtain a net annual yield of i on the completed transaction. (c) Assume that in fact the bond is sold by A to a second investor, who is also liable to capital gains tax at rate t, at a price which will provide the new purchaser with a net annual yield of i, if he holds the bond until it is redeemed.

10 Assignment 4 BS4a Actuarial Science Oxford MT Derive an equation from which can be found the value of j, the net annual yield obtained by A on the completed transaction. Find the value of j when n = 10, m = 5, t = 0.4, and i = A bond pays coupons twice yearly in arrears at nominal annual rate j (2) = 5%, and will be redeemed at par after 5 years. An investor will be liable to capital gains tax at 40% on the difference between redemption price and purchase price, adjusted for inflation over the 5-year period. Under the assumption of a constant inflation rate of 2% p.a., find the purchase price which provides the investor with a yield (after capital gains tax) of (i) 6% (ii) 8%. What is the corresponding real yield in each case? 4. An investor purchases a bond 3 months after issue. The bond will be redeemed at par ten years after issue and pays coupons of 6% p.a. annually in arrears. The investor pays tax of 25% on both income and capital gains (no relief for indexation). (a) Calculate the purchase price of the bond per 100 nominal to provide the investor with a rate of return of 8% per annum effective. (b) The real rate of return expected by the investor from the bond is 3% per annum effective. Calculate the annual rate of inflation expected by the investor. 5. Two business projects, each of which takes two years to complete, produce the following cash-flows: Project A: Project B initial income of 2000; initial income of 360; after one year, expenditure of 3900; after one year, expenditure of 4000; after two years, income of 2000; after two years, income of An investor considering the two projects has no spare cash, but can borrow or invest money at rate i > 0 for any desired term. For what range of i is each of the projects profitable? What can you say about the yields of the two projects? If both projects are profitable and the investor must choose between them, which is the more profitable (for various possible values of i)? 6. An investor has decided to purchase a leasehold property for 80,000, with a further payment of 5000 for repairs in one year s time. The income associated with letting the property will be 10,000 per annum, payable continuously for 20 years commencing in two years time. (a) i. Given that the venture will be financed by bank loans on the basis of an effective annual interest rate of 7% and that the loans may be repaid continuously, find the discounted payback period for the project. ii. Given, further, that after the loans have been repaid the investor will deposit all the available income in an account which will earn interest at 6% per annum effective, find the accumulated amount of the account in 22 years time.

11 Assignment 4 BS4a Actuarial Science Oxford MT (b) Suppose that the bank loans may be repaid partially, but only at the end of each complete year, and that the investor may still deposit money at any time for any term at an annual rate of interest of 6% effective. Find i. the discounted payback period for the project, and ii. the accumulated amount in the investor s account in 22 years time. Course webpage: deligian/teaching/bs4a.html

12 Assignment 5 BS4a Actuarial Science Oxford MT Life tables, force of mortality and standard life insurance products Please hand in your answers to questions 2, 4, 6(ii), 9 and 11 for marking. The rest are for further practice. 1. Let µ x be the force of mortality, and l x the corresponding life table. (i) Show that n m q x = n+m n tp x µ x+t dt [Here n m q x means the probability of death of a life currently aged x between times x + n and x + n + m.] (ii) Show that µ x+0.5 log p x and µ x 0.5 (log p x + log p x 1 ). (iii) If l x = 100(100 x) 1/2, find µ 84 exactly. 2. (i) Gompertz s Law has µ (1) x = Bc x. Show that the corresponding survival function is given by t p (1) x = g cx (c t 1) where log g = B/ log c. (ii) Makeham s Law has µ (2) x = A + Bc x. Show that t p (2) x = s t tp (1) x where s = e A. (iii) If µ x = A log x, find an expression for l x /l 0. (iv) If it is assumed that A table follows Makeham s Law, use l 30, l 40, l 50 and l 60 to find A, B and c. (l 30 = 33839, l 40 = 33542, and l 50 = 32670, l 60 = 30040). 3. The force of mortality for table 2 has twice the force of mortality for table 1. (i) Show that the probability of survival for n years under table 2 is the square of that under table 1. (ii) Suppose that table 1 follows the Gompertz Law from the previous question. Show that the probability of survival for n years for a life aged x under table 2 is the same as that under table 1 for a life aged x + a, for some a > 0. Find a. Comment on the result. 4. (i) Show algebraically that A x:n = vä x:n a x:n 1. Also demonstrate the result verbally. (ii) Show algebraically that (IA) x = ä x d(iä) x. Demonstrate the result verbally. [Here (IA) x is the expected time-0 value (assuming an age of x at time 0) of a single payment of size K + 1 made at time K + 1, where death occurs in the year (K, K + 1). (Iä) x is the expected value of the stream of payments of 1 at time 0, 2 at time 1,..., K + 1 at time K, with the last payment made at the beginning of the year of death.] 5. (a) Show that at age x if 0 a < b 1 then b a q x+a = 1 b p x ap x. (b) Hence, or otherwise, show that if deaths occurring in the year of age (x, x + 1) are uniformly distributed that year, then b a q x+a = (b a)q x 1 aq x.

13 Assignment 5 BS4a Actuarial Science Oxford MT Suppose that the future lifetime of a life aged x (x > 0) is represented by a random variable T x distributed on the interval (0, ω x), where ω is some maximum age. (i) For 0 x < y < ω, state a consistency condition between the distributions of T x and of T y. (ii) Suppose that 0 x < y < ω, and let t = y x. Define the force of mortality at age y: (a) in terms of T 0 ; and (b) in terms of T x, and show that the two definitions are equivalent. (iii) Prove that t p x = exp { t 0 } µ x+s ds. 7. Given a curtate lifetime K = [T ] and a constant-δ interest model, consider the following insurance products: (i) pure endowment with term n; (ii) whole life assurance; (iii) term assurance with term n; (iv) endowment assurance with term n (under this product, there is a payment of one unit at the end of the year of death or at end of term whichever is earlier). (a) Write each one as a random cash-flow of the form C = ( (t k, c k B k ) ) k=1,2,..., where the B k are Bernoulli random variables defined in terms of K. (b) Find expressions for the net premiums and variances of these products. (c) Relate the products, premiums and variances of (iv) and (i) and (iii). (d) Comment on (a) and (b) for the corresponding products where payment is made at death rather than at the end of the year of death (and n is not necessarily an integer). 8. A cash-flow is payable continuously at a rate of ρ(t) per annum at time t provided a life who is aged x at time 0 is still alive. T x is a random variable which models the residual lifetime in years of a life aged x. (a) Write down an expression, in terms of T x, for the (random) present value at time 0 of this cash-flow, at a constant force of interest δ p.a., and show that the expected present value at time 0 of the cash-flow is equal to 0 e δs ρ(s)p(t x > s)ds. (b) An annuity is payable continuously during the lifetime of a life now aged 30, but for at most 10 years. The rate of payment at all times t during the first 5 years is 5,000 p.a., and thereafter 10,000 p.a. The force of mortality to which this life is subject is assumed to be 0.01 p.a. at all ages between 30 and 35, and 0.02 p.a. between 35 and 40. Find the expected present value of this annuity at a force of interest of 0.05 p.a.

14 Assignment 5 BS4a Actuarial Science Oxford MT (c) If the mortality and interest assumptions are as in (b), find the expected present value of the benefits of a term assurance, issued to the life in (ii), which pays 40,000 immediately on death within 10 years. For the questions below, use the A Mortality table whenever table data is needed (all three columns, assuming medical checks were successful). 9. Find the present value of 5000 due in 5 years time at i = 4% if a) the payment is certain to be made; b) the payment is contingent upon a life aged 35 now surviving to age How large a pure endowment, payable at age 65 can a life aged 60 buy with 1000 cash if i = 7%? 11. a) Show that ä x = 1 + (1 + i) 1 p x ä x+1 b) Show that ä x:n = a x:n + 1 A 1 x:n c) Show that A x = (1 + i) 1 ä x a x Course website: deligian/bs4a.html

16 Assignment 6 BS4a Actuarial Science Oxford MT just completed. Expenses are assumed to be incurred at the start of the policy year. Reserve brought forward at the start of the policy year: 12,500 Annual premium: 1,150 Annual expenses: 75 Death benefit: 50,000 Mortality: A1967/70 Interest 5.5% per annum Calculate the reserve at the end of the policy year. 8. A deferred annuity is purchased by 20 annual payments payable by a life aged 40 for a year annuity in advance of 2,500 a year, commencing in 20 years, for life. Find an expression for the premium on the basis of 4% pa interest with expenses of 5% of each premium and 5 at each annuity payment. 9. Suppose that l x = 100, 000(100 x), where 0 x 100, and the interest rate is 5%. (a) Calculate A 50:10 and ä 50:10. (b) Calculate the net annual premium for a 10 year endowment assurance for 10,000 to someone aged 50 and the policy values of years 3 and 4 using the values above. (c) Suppose that expenses are as follows Commission: General Expenses: 50% of First Premium 2% of Subsequent Premiums 150 Initially 10 in each subsequent year. Calculate the office premium for the policy in (b). 10. Show algebraically that the product of and the reserve after t years for an annual premium n-year pure endowment issued to a life aged x the annual premium for pure endowment of like amount issued at the same age but maturing in t years is constant for all values of t. (Ignore expenses.) Try to find an argument for this by general reasoning also. 11. (i) Show that A x = 1 δa x.

17 Assignment 6 BS4a Actuarial Science Oxford MT (ii) Consider a whole life assurance with sum assured 1 payable at the point of death, with a constant premium paid continuously. Show that the reserve at time t satisfies tv x = 1 a x+t a x 12. Thiele s equation for the policy value at duration t, t V x, of a life annuity payable continuously at rate 1 from age x is: t t V x = µ x+t t V x 1 + δ t V x. Derive this result algebraically, and also explain it by general reasoning. 13. Let t V x be the reserve at time t on an insurance policy issued to a life aged x that pays a benefit of S x (t) on death at time t, under which premiums are payable of P (t) at time t. Show by general reasoning that where δ is the force of interest. t t V x = P (t) + δ t V x µ x+t (S x (t) t V x ) 14. An insurer issues n identical policies. Let Y j be the claim amount from the jth policy, and suppose that the random variables Y j, j = 1,..., n are i.i.d. with mean µ > 0 and variance σ 2. The insurer charges a premium of A for each policy. (a) Show that if A = µ + 10σn 1/2, then the probability that total claims exceed total premiums is no more than 1%, for any value of n. (b) Use the Central Limit Theorem to show that if instead A = µ + 3σn 1/2, then this probability is still less than 1%, provided n is large enough. Course website: deligian/bs4a.html

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