# Annuities, Insurance and Life

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1 Annuities, Insurance and Life by Pat Goeters Department of Mathematics Auburn University Auburn, AL

2 2 These notes cover a standard one-term course in Actuarial Mathematics with a primer from the Theory of Interest. The notes are to be presented at Auburn University, Fall 2003, as part of the Actuarial Mathematics sequence. Furthermore, this is a work in progress, hopefully converging over the course of the term. Students, please be patient (this is saving you big bucks), and please offer questions and comments concerning the material. This will help me formulate a presentation that will presumably be more accessible to others. Thanks, Pat Goeters

3 Chapter 1 An Introduction to Interest and Mortality 1.1 Life and Death The premise that must be remembered in this course is that money is effected by interest rates. The basic subject of this course can be summarized in two sentences. We will consider the value now of a payment made in the future by investigating the question; how much is it worth to us now, to be given \$1 t years from now? We then add the stipulation that the payment is made contingent upon a certain event occurring, and then examine the question. A fundamental issue in the insurance business is to be able to estimate when an accident will occur, a stock crashes, or when an insured passes. It is common practice in the study of insurance from an actuarial stand-point to lump these things together. We are interested in the probability (the percentage of time) that a life aged x expires or dies within t years. Often this is softened by referring to a life aged x as decrementing within t years. From the insured s side, we wish to know the probability that a life aged x lives or survives at least t years. If a company has been selling a policy, they will periodically review the rates. In this case, they have some experience about lives aged x (say female drivers 21 years old, driving a Nissan Pathfinder). If our company s experience is ample, we can estimate with some degree of certainty the portion of lives aged x that will decrement (get into an accident). If our company s experience is inadequate or the policy has not been offered before, as actuaries, 3

4 4 CHAPTER 1. THE INTRODUCTION we may seek data from the actuaries at a company selling a similar product. A third option is to develop an educated guess as to a mathematical model (formula) for the probabilities - a few standard models will be given later. The careful student has noted that our data set is finite but as is the often the case, we will assume that mortality is continuous. That is, we assume that a life age x may expire at any positive time t (not just at year s end say), and yet the chance of anyone expiring at the exact time t is zero. Insurance policies are not payable at the moment of decrement though, so the companies often will not be concerned with the exact time of decrement only the chance of decrement within a given year (or month). The curtate-future-life of a life age x is the whole number of years completed before death. Using this, the chance of a life age 30 having curtatefuture-life 3, say, may not be zero. In summary, we will assume that we have a continuous model of mortality though often we will limit consideration to discrete (yearly, monthly) times. The probability that a life aged x survives at least t years is denoted by t p x. In building our data table we start with a given population, and watch its development over time. The only way for a member to leave the population is through decrement and, no new members can be added to the population. We refer to members of the population as lives, and l t is the number of lives aged t. Then, the probability that a life aged x lives t or more additional years is just tp x = l x+t l x, provided we have the numbers l x, l x+t at our fingers. An important special case of the symbolism t p x and t q x is the case when t = 1. In this case, the 1 is not written, and and p x = the probability (x) survives at least one year, q x = the probability (x) dies before the first year is up. We represent the generic or average life aged x by (x). The probability that (x) decrements before t years is denoted by t q x and by elementary reasoning tp x + t q x = 1.

5 1.2. INTRODUCTION TO INTEREST 5 Also, of the l x+t lives aged x + t, q x+t represents the percentage of them that die with the year. I.e., d x+t = l x+t q x+t is the number of lives aged x + t that die before reaching age x + t + 1. So, tp x q x+t = dx l x is the probability that a life aged x lives to be x + t but dies before age x + t + 1. The Illustrative Life Table I is a widely known and referenced mortality table. It was derived using certain assumptions on mortality using census data for the U.S. 1.2 Introduction to Interest In the case of money placed into a savings account at your local bank, your money is affected positively by the interest the bank affords and negatively by the inflation rate. Of course, if ı is the given interest rate per period, then \$1 now will be worth 1 + ı dollars one period hence. A point of departure is whether or not the interest computation for periods 2, 3,... involves the interest earned in previous periods. Simple interest is said to apply if the interest computation is only applied to the original sum of money invested (note that borrowing money can be viewed as an investment by the lender). For example, under simple interest, an amount P, accumulates to P + P ı = P (1 + ı) at the end of one period, and accumulates to P ı + P (1 + ı) = P (1 + 2ı) at the end of two periods, and so on. At the end of n periods, P accumulates to P (1 + nı). In this course, we will eschew simple interest in favor of the common practice of using compound interest. For compound interest, the interest computation at the end of a given period involves the interest already accrued or earned in previous periods as part of the balance. Under compound interest, P dollars today is worth P (1 + ı) n = P (1 + ı) n 1 + P (1 + ı) n 1 ı n periods hence. The factor 1 + ı is called the accumulation factor in that multiplying a balance P by (1 + ı) n allows us to accumulate P forward in time n years (with cumulative interest). When the interest conversion period is a year and ı is the interest rate for the year, ı is called the effective rate of interest. The effective rate is

6 6 CHAPTER 1. THE INTRODUCTION an annual rate of interest. Sometimes it is convenient to adopt an interest conversion period other than a year (a month say) as is the case with most conventional loans, and we may wish refer to the effective rate of interest for a given conversion period. However, most often in the text and the literature, we simply regard the standard conversion period to be 1 year, under the realization that no loss of generality occurs since we can easily replace the year with another conversion period if warranted. Exercises : 1.1 Using the ILT I, calculate 25 p 40, 20 q 20, 40 p 20, 50 q Using the ILT I, calculate the probabilities that (a) (20) dies when they are 30. (b) a 1 year old lives to age 21. (c) a 12 year old dies in their 20 s. (d) a person age 47 dies within a year. 1.3 If the interest rate is ı =.06 per year, how long will it take for an amount of money to double under interest compounding with rate ı? Give an equation which answers this question for general ı.

7 Chapter 2 The Theory of Interest 2.1 Introduction to Interest We will assume that we are given an effective rate ı which is an annual rate. A nominal interest rate j refers to an annual interest rate where interest calculation or conversion is done more frequently than once a year (but is still compounded). It has been my experience that whenever you are quoted an interest rate, you assume that it is a nominal rate, converted monthly. For example, the interest rate usually quoted for an automobile loan or other conventional loans with monthly payments (while credit cards compute interest on a daily basis). We use the phrase interest is compounded to replace interest is converted under compounding of interest. When the annual rate j is given as a nominal rate compounded m th ly, what is meant is that interest is compounded at the rate j, every m mth of the year. (The effective rate for each m th is then j.) So, at the end of k number m of m th s of a year, P accumulates to P (1 + j m )k by the formula for compound interest. We say that a nominal rate j is equivalent to the effective rate ı if over any number of years, 1 dollar accumulates to the same amount under each plan for interest computation. Assume that j is a nominal rate with m th ly compounding. If j is equivalent to an effective rate ı, then 1 + ı = (1 + j m )m. Solving for j, we have j = m[(1 + ı) 1/m 1]. 7

8 8 CHAPTER 2. THE THEORY OF INTEREST Conversely, if j = m[(1 + ı) 1/m 1], then j satisfies 1 + ı = (1 + j m )m and \$1 accumulates to (1 + ı) t = (1 + j m )mt, after t years under each form of interest conversion. So, m[(1 + ı) 1/m 1] compounded m th ly is equivalent to ı. The symbol ı (m) represents the nominal interest rate m[(1+ı) 1/m 1] (with compounding every m th of the year) that is equivalent to ı. This results in the relational formulas ı = (1 + ı(m) m )m 1 and ı (m) = m[ m 1 + ı 1]. We ve seen that if you start with P dollars and apply the effective rate ı, the balance at the end of n years is P (1 + ı) n. Conversely, if you have Q dollars n years after a deposit of P dollars, then P (1 + ı) n = Q, so that P = 1 Q = ν n Q, where ν = 1 1. We call ν = the discount factor (1+ı) n 1+ı 1+ı corresponding to ı. To reiterate, in order to have P dollars n years from now, you must invest ν n P today. Just as the accumulation factor 1+ı allows us to move money forward, the discount factor ν = 1 allows us to draw money 1+ı back in time; Q dollars today was worth ν n Q at the time exactly n years ago. The number δ = lim m ı (m) has meaning as the interest rate assuming continuous compounding corresponding to the effective rate ı. We call δ the force of interest. By L Hospital s Rule, ı (m) = (1+ı)1/m 1 converges to 1/m δ = ln(1 + ı) = ln ν. It follows that the accumulation factor is then 1 + ı = e δ, and therefore the balance of a loan (or the accumulation of savings), t years after the initial loan (or deposit) of amount P - assuming no adjustments have been made - is P e δt = P (1 + ı) t, which we interpret as correct even when t is not a whole number. Conversely, the discount factor is ν = e δ,

9 2.1. INTRODUCTION TO INTEREST 9 so an amount P, t years forward from now is worth P e δt at present. Observe, we now have that ı (m) = m[e δ/m 1]. If we define a function f(x) = x[e δ/x 1], then f (x) = e δ/x (1 δ x ) 1. Reasonable bounds on ı insure that δ < 1. The Maclaurin series for e (δ/x) is e (δ/x) = 1 δ x x 1 2 3! x +. 3 Since δ < 1, the Maclaurin series above has absolutely monotonically decreasing, alternating terms and so e (δ/x) > 1 δ. Hence, 1 > x e(δ/x) (1 δ ) x x and consequently f (x) < 0. That is, the ı (m) s are monotonically decreasing as m increases. We have established δ 2 δ 3 ı = ı (1) > ı (2) > ı (3) >... > δ > 0. Although most loans and savings plans are formulated using an effective or nominal rate plan, an analogous practice is not uncommon in the issuing of bonds, that of paying the interest up front. When borrowing P dollars, the bank may offer take a percentage d at the beginning of an interest cycle (in lieu of collecting interest at the end), so that at the end of 1 year, the remaining debt is P ; d is called the effective rate of discount and is an annual rate. For example, on August 7 th, 2003, a U.S. EE Patriot Bond sold for \$25 and matures to \$50; that is, the government borrows \$50 from you less a 50% discount, in order to pay you back \$50 at the maturity date. The effective rate ı associated with d can be found in terms of d as follows (in the EE Patriot Bond example, ı = 2.66%): Using the accumulation factor 1 + ı, (1 + ı)(1 d)p = P, from which we obtain (1 + ı)(1 d) = 1 and ı = 1 1 d 1 and d = 1 ν = ı 1 + ı. So, d is the ratio of the interest earned in 1 year to the balance after 1 year (as defined in some books).

10 10 CHAPTER 2. THE THEORY OF INTEREST The nominal rate of discount d (m) is an annual rate such that a discount rate of d(m) is applied at the beginning of each m mth of the year. It follows that if ı is the effective rate for d (m), then (1 + ı(m) d(m) )(1 m m ) = 1, and so, for example, d (m) = m[1 ν 1/m ]. In a manner analogous to obtaining, we obtain d = d (1) < d (2) < d (3) <... < δ, and δ = lim m d(m). 2.2 Annuities-Certain A regular annuity or annuity-certain is any timed series of payments in which the payments are certain to be paid. Examples include payments on your financed automobile, mobile home, or house, as well as the paying off of credit card balances. The term certain refers to the legal obligation rather than a force of will. If you cease making payments, the lender will recoup the outstanding balance in some other way and/or write it off as a loss, marking the debt paid. There is another type of annuity, called a life-annuity, that will be considered in Chapter 3, but at this point there will be no confusion if we refer to an annuity-certain as simply an annuity. While, conceivably, the payments can occur at various times we will stick to consideration of the standard annuities where the payments are equal and are made at equal increments. In order to evaluate these payments, as we ve learned, we must pick a set point in time in which to calculate payments. The term present time refers to the arranged time in which the payment schedule goes into effect (which is not necessarily the time the payments start). We will now cover the standard annuities. Most of the standard annuities are level, meaning that the payments are equal, and in all, the scheduled

11 2.2. ANNUITIES-CERTAIN 11 time between payments is the same. We refer to an annuity as discrete is the payments are made either annually or at some other fixed points in time. Annuity-Immediate In this situation it is assumed that a series of payments is made in unit amount ( \$1) at the end of every period (or year) and that ı is the effective rate for that period (or year). The immediate modifier conveys that the payments are to be made at the end of the period (or year), perhaps contrary to a direct reading of the word immediate. Also, it is common to assume that payments cease at some point, say n periods (or years). The present value of a payment is the value of the payment when discounted back to the present. For example, the present value to the first payment is ν. The present value of the second payment is ν 2, and so on. Reasonably, the present value of an annuity is the sum of the present values of all of the payments. The present value of an annuity-immediate payable for n years is therefore ν + ν ν n. The symbol a n represents the present value of an annuity-immediate payable in unit amount for n years in which the frequency of payments coincides with the interest conversion period. Thus, a n = ν + ν ν n = ν(1 + ν + + ν n 1 ) = ν( 1 νn 1 ν ) = 1 νn. ı Again, a n = ν + ν ν n = 1 νn. ı Note: If payments are P instead of \$1 in our annuity-immediate, then the present value of the annuity, i.e., the present value of all payments, is

12 12 CHAPTER 2. THE THEORY OF INTEREST P a n. What this means is that the certainty of payments in amount P made according to the schedule described is worth P a n presently. For example, suppose you wish to purchase a car and you learn that after the down payment (if any), taxes and fees the cost will be \$18, 731. You are told that you can be financed at the annual rate of 5.99% for 5 years. Having lived in this world for some time, you realize you are to make monthly payments in some amount P to pay off your vehicle. What may not be clear until you read the fine print is that the quoted 5.99% is a nominal rate, convertible (or, to be compounded) monthly. So the effective rate ı for each month is ı =.0599 and the number of payments is n = 60. The present value 12 of payments must equal the loan amount. So, \$18, 731 = P a 60 and P = \$ This payment is about a half-penny over the true amount \$18,731 (please a 60 excuse the = above) so the final payment is usually adjusted to make things even. Annuity-Due In this situation it is assumed that a series of payments is made in unit amount ( \$1) at the beginning of every period (or year) and that ı is the effective rate for that period (or year). The word due conveys that payments are made at the beginning of the year. Again, it is often assumed that payments cease after some fixed number of years, and we will let n be the number of years (=payments). The present value of an annuity-due payable for n years in unit amount

13 2.2. ANNUITIES-CERTAIN 13 is denoted by ä n, and as above we find that ä n = 1 + ν + + ν n 1 = 1 νn 1 ν = 1 νn. d As before, if the payments are P instead of \$1 in our annuity-immediate, then the present value of the annuity is P ä n. For example, suppose you wish to lease a car for 3 years and that after the capital reduction (if any), taxes and fees the cost will be \$18, 731. You are quoted an interest rate of 5.99% for your lease which you interpret to be a nominal rate convertible monthly. If you are told that the payments are P = \$ per month, payable in advance (as is the convention with leases). What is the residual value of the car in 3 years? That is, what will be the purchase price left to you in case you wish to buy the vehicle when the lease runs out? The present value of your payments is P ä 36 = \$11, (to the nearest penny). This leaves \$7, unpaid in present dollars. Of course, your lease terminates 3 years forward from the present, so at the time of the leaseexpiration, the residual payment will be \$7, ( )36 = \$8, to the nearest penny. This assumes that no funny business is being waged. Annuities Payable m th ly Another set of standard annuities arises when \$1 is paid per annum but in installments of 1 m every mth of the year. The payments are to last a fixed number of years, say n. Given the effective annual rate ı, we calculate the nominal rate ı (m). As in the case of annual payments, the payments may occur at the beginning or end of the payment period. An annuity-immediate payable m th ly

14 14 CHAPTER 2. THE THEORY OF INTEREST is such an annuity where payments are made at the end of each m th of a year (again there is often a finite number of years for payments to be made, and we will consider this case and denote this number by n). Using the formula for a geometric sum again we can obtain a closed form for the present value of all payments payable for n years: a (m) n = 1 m ν1/m + 1 m ν2/m + 1 m ν3/m m νnm/m = 1 m ν1/m ( 1 νnm/m 1 ν and therefore, after a little algebra, 1/m ), a (m) n = 1 ν n m((1 + ı) 1/m 1) = 1 νn ı (m). In words, the present value of an annuity-immediate payable m th ly in annual unit amount for n years is a (m) n = 1 νn. If the payments are P per ı (m) year instead of \$1, then the present value of payments is P a (m) n = P 1 νn. ı (m) The standard annuity-due payable m th ly is an annuity with payments of 1 per mth of the year, with payments occurring at the beginning of each m th. Assuming the payments are to be made for n years, the present value of payments is denoted by ä (m) n and as above can written in closed form: ä (m) n = 1 νn d (m). Note: If P is the annual payment made under an annuity-due payable m th ly for n years (so the m th ly payments are P ), then the present value is m P ä (m) n. The annuity-immediate payable monthly is the most frequently encountered annuity for us. The car purchase and lease examples are rightfully annuities payable monthly. We can illustrate how a car or home purchase

15 2.2. ANNUITIES-CERTAIN 15 uses the concepts of an annuity-immediate payable monthly with another example: Suppose you (including your parents perhaps) wish to buy a house off campus with the amount to be financed of \$123, 789, on a 30 mortgage at an effective rate of 6.125%. This leads to an equivalent nominal rate of ı (12) = 5.595% and a discount factor of ν = If P be the total of all payments made in a year (without adjusting for interest), then the present value of all payments must match the loan amount; i.e., P a (12) 30 = P 1 ν30 ı (12) = \$123, 789. Therefore, P = \$ 123,789 = \$8, (they always round up), and so your monthly payments to pay off the house are \$8, or \$ By the 12 way, the amount \$ is called your P+I payment. There are two other amounts that are often required to be payed to your mortgage company: if your loan-to-value ratio is more than 80%, then you must pay PMI (mortgage insurance) which may be around \$100 per month; also, they usually want you to escrow taxes and home insurance, which in Auburn will run you another \$100 per month. While PMI is money lost to you, escrowing taxes and insurance are just easy ways for you to pay those bills. Although we ve found out whether or not we can swing the mortgage there are other aspects of the loan that prove interesting. Suppose we want to sell the house in t years. How much will we still owe the mortgage company? This is a good time to go over the Prospective and Retrospective Methods of evaluation. Sitting at time t (in years), immediately after any payment for year t, we may look forward (there-by adopting a prospective view): We know that we have some outstanding balance on the loan, call the outstanding balance B t. Most loans are configured according to the Equivalence Principle; that is, the assumption that our future payments pay off the remaining balance. We assume we have such a loan. (I have never seen a loan that wasn t based on the Equivalence Principle, but I have seen several

16 16 CHAPTER 2. THE THEORY OF INTEREST loans emphasize that they are based on the Equivalence Principle). Hence, the present value of all payments made subsequent to year t, P a (12), must n t equal B t : B t = (B 0 /a (12) n )a (12) = B 1 ν n t n t 0 1 ν. n For example, when t = 5, 1 νn t is roughly 93%, and so (regardless of 1 ν n what house you are buying) you have paid off 7% of your loan. Couple that with a real estate growth rate in Auburn sometimes in the 5% 10% per year range, you are likely to see a cash equity of over 30% of your original purchase price after 5 years. In contrast to a prospective approach, at time t, we can look back to evaluate our progress on the loan. This is called a retrospective method of evaluation. We might address the question, what is our outstanding balance after t years?, immediately following the last of the payments for year t, retrospectively. To do this we need some standard terminology. The symbol a in the annuity symbols a n, ä n, a (m) n, and ä (m) n refers to the present value of payments. Each of the standard annuity symbols refers to a n-year term annuity. Instead of valuing the payments at present, we can also value the payments at a future time; specifically, at the end of n years, after the last payment has been made. For the n-year term annuity-immediate, the sum of the payments viewed n years past the present is 1 + (1 + ı) + (1 + ı) n 1 = (1 + ı)n ı 1 = (1 + ı)n 1. ı This sum is called the accumulated value of payments of an annuity-immediate and is denoted by s n. Note also, from general reasoning, that Similarly, s n = (1 + ı) n a n. s n = (1 + ı)n 1 d and s n = (1 + ı) n ä n,

17 2.2. ANNUITIES-CERTAIN 17 and and s (m) n = (1 + ı)n 1 ı (m) and s (m) n = (1 + ı) n a (m) n, s (m) n = (1 + ı)n 1 d (m) and s (m) n = (1 + ı) n ä (m) n. Back to a retrospective evaluation of a loan with scheduled payments at the end of each m th. We start with a loan amount of B 0 = P a (m) n (in general), and make mt payments in t years, of P/m at the end of each m th. At the end of year t, after the payments for the t th year have been completed, the accumulated value of all payments to year t is P s (m) t, and the accumulated original loan value is Therefore, we still owe (1 + ı) t P a (m) n. B t = (1 + ı) t P a (m) n P s (m) t = P (1 + ı)t ν n t ((1 + ı) t 1) ı (m), at time t, which can be rewritten as, B t = P 1 νn t ı (m) as obtained by the prospective evaluation. = P a (m) n t, Deferred Annuities, Perpetuities, Continuous and Increasing/Decreasing Annuities A perpetuity is an annuity for which payments never cease. In the conventional notation the symbol replaces the symbol n. Then a = lim n a n = 1 i, ä = lim n ä n = 1 d,

18 18 CHAPTER 2. THE THEORY OF INTEREST and a (m) = lim a (m) n n = 1 ı, (m) ä (m) = lim ä (m) n n = 1 d. (m) Just as we may consider interest to be compounded continuously, we are able to consider an n-year term annuity, payable continuously in unit annual amount. Interpreting this concept, if a n is the present values of annuity payments, where the bar conveys continuity, then a n lim m Σnm k=1 Alternately, one could define, 1 ν n a n lim m a(m) n = lim m ı (m) 1 n k m e m δ = 0 = 1 νn δ e δt dt. = n 0 e δt dt. Of course this is the same as lim m ä (m) n. The perpetuity payable continuously in unit annual amount is a = 0 e δt dt = 1 δ. A deferred annuity refers to an annuity where the payments are postponed or deferred until some future time. The fact that an annuity has been deferred m years is conveyed by having the symbol m appear in the lower left of an annuity symbol. For example, the n-year term, k-year deferred annuity-due in annual unit amount has present value k ä n, while the present value of a k-year deferred perpetuity payable in m th s in annual unit amount is written as k a (m). Do you see that the present value of a k-year deferred annuity is just ν k times the present value of the annuity where the payments begin at present? E.g., k ä n = ν k ä n, k a = ν k a. k a (m) n = ν k a (m) n,

19 2.2. ANNUITIES-CERTAIN 19 for just a few examples. As you ve no doubt recognized, each of the standard annuities we have examined so far are level in that the payments are all the same. There are two important variations on the level annuities and those are the increasing, and the decreasing annuities. The increasing annuities vary according to whether the payments occur at the beginning or end of the year or whether payments are m th ly. At this point in the course one should be able to decipher the meanings of the present values of annuities (Ia) n, (Iä) n, (Ia) (m) n, (Ia) n, (Iä) (m) n, (Ia) n and (Ia) once one has been introduced to a single one. The symbol (Ia) (m) n represents the present value of an annuity-immediate payable m th ly for n years, for which the annual premium in the t th year is \$t. So, (Ia) (m) n = 1 m ν1/m + 1 m ν2/m m νm/m + 2 m ν(m+1)/m + 2 m ν(m+2)/m m ν2m/m + + n m ν(m(n 1)+1)/m + n m ν(m(n 1)+2)/m + + n m νnm/m. There are various manipulations that can be made of this expression, however none lead to simple expressions. For example, we can read the above equation as (Ia) (m) n = a (m) n + 1 a (m) + n 1 2 a (m) n 2 n 1 a (m). 1 is The present value of the n-year increasing annuity payable continuously (Ia) n = can easily be computed using parts; n 0 te δt dt, (Ia) n = te δt δ δ 0 e δt dt = 1 δ 2. Analogously, one can interpret the symbolism (Da) n, (Dä) n, (Da) (m) n, (Dä) (m) n, and (Da) n once one understands that in the corresponding annuities, the annual payments for year t total n t. One can choose to relate increasing and decreasing annuities (for example, (Dä) n = (n+1)ä n (Iä) n ), however we will not make much use of increasing and decreasing annuities in this course.

20 20 CHAPTER 2. THE THEORY OF INTEREST Another glimpse at the significance of the symbolism occurs when we understand that (Ia) n has a different meaning than (Ia) n. The existence of the bar over the I in the former term means that the annual premium in the annuity is continually increasing while the lack of the bar over the I in the latter expression means that the annual premium is increasing discretely. So, while Exercises : (Ia) n = n 0 te δt dt, (Ia) n = a n + 1 a n n 1 a 1 < (Ia) n. 2.1 Given ı =.06, compute the equivalent rates and factors d, ν, δ, ı (12), and d (12). 2.2 Show that δ = lim m d (m). 2.3 Show that d < d (2) < d (3) <. 2.4 Suppose you are shopping for a new car. You want to make sure you can handle the monthly payments so before looking, you make a small table, using the nominal interest rates j =.039,.049,.059 (convertible monthly), of the payment-cost per month per dollar financed assuming a 60 month loan. Make this table now (please). 2.5 Derive the expression ä (m) n = 1 νn d (m). 2.6 If you purchased a car for \$18, under financing with a 5.99% nominal rate for 60 months, how much do you need to sell the car for at the end of 3 years to get out from under the vehicle (i.e., pay off the loan exactly)? 2.7 Show that ı δ a n = a n and da n = ıä n. 2.8 If the effective annual rate ı is 7%, calculate ı (m), δ, d, and d (m). 2.9 Suppose that a company knows that expenditures are forthcoming and wishes to plan for the expenses by investing money at present. If the expenses are \$25, 000 next year for advertising, \$5, 000 in two years for additional computers, and \$10, 000 in five years for additional office

21 2.2. ANNUITIES-CERTAIN 21 space, how much must be invested today, at the effective rate 5.25% in order to meet these expenses (assume expenditures are made at the end of the year)? 2.10 An investor accumulates a fund by making payments at the beginning of each month for 6 years. Her monthly payment is 50 for the first 2 years, 100 for the next 2 years, and 150 for the last 2 years. At the end of the 7 th year the fund is worth 10, 000. The effective annual interest rate is ı and the effective monthly rate is signified by j. Which of the following formulas represents the equation of value for this fund accumulation? (a) s 24 ı (1 + ı)[(1 + ı) 4 + 2(1 + ı) 2 + 3] = 200. (b) s 24 ı (1 + j)[(1 + j) 4 + 2(1 + j) 2 + 3] = 200. (c) s 24 j (1 + ı)[(1 + ı) 4 + 2(1 + ı) 2 + 3] = 200. (d) s 24 ı (1 + ı)[(1 + ı) 4 + 2(1 + ı) 2 + 3] = 200. (e) s 24 ı (1 + j)[(1 + j) 4 + 2(1 + j) 2 + 3] = Matthew makes a series of payments at the beginning of each year for 20 years. The first payment is 100. Each subsequent payment through the tenth year increases by 5% from the previous payment. After the tenth payment, each payment decreases by 5% from the previous payment. Calculate the present value of these payments at the time the first payment is made using an effective annual rate of 7%. (a) 1375 (b) 1385 (c) 1395 (d) 1405 (e) Megan purchases a perpetuity-immediate for 3250 with annual payments of 130. At the same price and interest rate, Chris purchases an annuity-immediate with 20 annual payments that begin at amount P and increase by 15 each year thereafter. Calculate P. (a) 90

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ACTUARIAL NOTATION 1) v s, t discount function - this is a function that takes an amount payable at time t and re-expresses it in terms of its implied value at time s. Why would its implied value be different?