ST226 2012 Solutions

1. We have that
1
b(i, n, p) = (1 (1 + i)n).
p
So we see that it is decreasing in p, increasing in i and increasing in n.
2. Forward contract is an agreement to buy or sell some asset at a certain time in the future
for a certain price. European call option is an option to buy some asset at a certain time
in the future for a certain price. European put option is an option to sell some asset at a
certain time in the future for a certain price.
3. We observe that
 Z
v(t) = exp


1
10
ds = exp (ln (10 + t) + ln (10)) =
.
10 + s
10 + t

Hence the value of the annuity is

11

10
10
10
+ 12 +
+ 20 = 100.
11
12
20

The accumlation is
100

10 + 10
= 200.
10

4. The money weighted rate of return is the solution of the equation



107
107
100 + 100(1 + i)1 + 100(1 + i)2 = 107 + 100
(1 + i)3
+ 100
105
103
Both sides are equal to 293.88 if we set i = 0.021. The time weighted rate of return is
1.07(1/3) 1 = 0.0228.
5. Suppose an investor with a wealth of 100 invests 100 in A and 100(1 ) in B. If A wins
the contract, he will end up with 104 + 96(1 ) . If B wins the contract, he will end up
with Y + 108(1 ). To eliminate arbitrage both quantities should equal to 102. Since
104 + 96(1 ) = 102,
3

we have = 4 . Therefore
Y

3
1
+ 108 = 102
4
4

and therefore Y = 100.

1

6. The present value is

3(0.98 + 0.982 +
+ 0.985) + 3(0.98)5(1.031 + 1.032 +
+ 1.035) +
2(0.98)5(1.03)5(1.031 + 1.032 +
+ 1.035) +
2(0.98)5(1.03)10 (e0.04 + e0.04 2 +
+ e0.04 5) =
3 0.98
2(0.98)5(1.03)5

1 0.985
1 1.035
+ 3(0.98)5
+
1 0.98
0.03

1 exp (0.04 5)
1 1.035
+ 2(0.98)5(1.03)10
=
exp (0.04) 1
0.03

14.124 + 12.419 + 7.142 + 5.975 = 39.66.

The accumulation is
39.66

1
1.0310 exp(0.04 5) = 72.02
0.985

7.
a) The price will be
(2)

(2)

100(1.03)5 + 100(1.03)10 + 0.7 4a5| + 0.7 4a10| =

100(1.03)5 + 100(1.03) 10 + 0.7 4

1 1.035
1 1.0310

+ 0.7 4

= 197.65.
1/2
2 1.03 1
2 1.031/2 1

b) Note now that 197.65(1.01)5 = 207.73 > 200, so there is no capital gains tax to be
paid after 5 years. Similarly 197.65(1.01)10 > 200, so there is no capital gains tax at
all. So the price is still 197.65.

8.
a) Investor A receives exactly 1000 every year, so the price he will pay is 1000a10|
calculated at an effective interest rate of 4% per annum, which is
1000

1 1.0410
= 8110.90.
0.04

b) As 8 0.5 = 4, 8110.90 is also the amount of the loan.

c) Investor A receives exactly 1000 every year, so the price he will pay is 1000a10|
calculated at an effective interest rate of 6% per annum, which is
1000

1 1.0610
= 7360.09.
0.06

d) Let K be the present value of capital repayments and I be the present value of
interest payments. We then have
K + 0.5I = 7360.09.
2

Using Makehams formula

K+

0.04 0.5
(8110.90 K) = 7360.09
0.06

which leads to K = 6984.69. This means that 0.5I = 375.40 and therefore I = 750.80.
Hence the price B will pay is
K + 0.8I = 6984.69 + 0.8 750.80 = 7585.33.
9.
a)
96.15 =

100
1 + y1

and therefore y1 = 0.04.

103.78 =

107
7
107
7
+
=
+
2
1.04 (1 + y2)2
1 + y1 (1 + y2)

and therefore y2 = 0.05.

83.96 =

100
(1 + y3)3

and therefore y3 = 0.06.

b)
1.063 = 1.04(1 + f12 )2
and therefore f12 = 7.01%.
c) The prices will be
100 1.061 = 94.34
for bond A and
7
107
+
= 101.83
1.06 1.062
for bond C. The price for bond B will be 83.96 as before.
d) Let nA and nB be the numbers of bonds A and B needed. We then have
nA94.34 + nB 83.96 = 10000(1.06) 2
and
nA94.34 + 3nB 83.96 = 2 10000(1.06)2.
Solving the two equations, we get nA = 47.17 and nB = 53. We also check that
47.17 94.34 + 9 53 83.96 > 4 10000(1.06)2
is satisfied (it is).
3

e) Note that if we assume that the curve is flat and remains flat after a change, there
is arbitrage as money will be made if the interest rate moves without any possibility
of loss.
10.
a) The accumulation is exp (Y1 + 2Y2 + 2Y3 + Y4). So
E(exp (Y1 + 2Y2 + 2Y3 + Y4)) = E(exp (Y1))E(exp (2Y2))E(exp (2Y3))E(exp (Y4)) =



1 2
1 2
2
2
exp + exp(2 + 2 )exp(2 + 2 )exp + = exp (6 + 5 2)
2
2


and
E(exp (2(Y1 + 2Y2 + 2Y3 + Y4))) = exp (2 + 2 2 + 4 + 8 2 + 4 + 8 2 + 2 + 2 2) =
exp (12 + 20 2)
so the variance is exp (12 + 20 2) exp (12 + 10 2).
b) The accumulation is C = exp (Y1 + 2Y2 + 2Y3 + Y4) + 2exp(Y3 + Y4). So



1 2
1 2
E(C) = exp (6 + 5 ) + exp + + + =
2
2
2

exp (6 + 5 2) + exp (2 + 2)
and
E(C 2) = E(exp (2(Y1 + 2Y2 + 2Y3 + Y4))) + 4E(exp (2Y3 + 2Y4)) +
4E(exp (Y1 + 2Y2 + 3Y3 + 2Y4)) = exp (12 + 20 2) +


9 2
1 2
2
2
4exp(4 + 4 ) + 4exp + + 2 + 2 + 3 + + 2 + 2 =
2
2
2

exp (12 + 20 2) + 4exp(4 + 4 2) + 4exp(8 + 9 2).

So the variance is
exp (12 + 20 2) + 4exp(4 + 4 2) + 4exp(8 + 9 2) (exp (6 + 5 2) +

exp (2 + 2))2.

c) Let and 2 be the mean and variance of Y1. We then have E(1 + Z1) = exp (2 + 2)
and E(1 + Z1)2 = exp (4 + 4 2). We then have
exp (2 + 2) = 1.05
and
exp (4 + 4 2) = (1.05)2 + 0.04 = 1.1425
4

so
2 + 2 = ln (1.05) = 0.04879
4 + 4 2 = ln (1.1425) = 0.13322
and therefore = 0.015485 and 2=0.01782. The random variable Y1 + 2Y2 +
2Y3 + Y4 is then normally distributed with mean 6 0.015485=0.09391 and variance
10 0.01782=0.1782. The probability it will exceed 1 is therefore


0.09391
= (0.2225) = 0.588
Pr (Y1 + 2Y2 + 2Y3 + Y4 > 0) = 1
0.1782
d) The distribution of this quantity is not a well known and tabulated distribution as
the normal and log-normal distributions are.