Equity and Fixed Income: A Deterministic

Approach

Tutorial 01 [FEN9X00]
Financial Economics
College of Business and Economics (CBE)
School of Economics (SOE)
Auckland Park Campus
September 2017
Lecturer: Mr Sutene Mwambi
Coordinator: Prof JM Mwamba

1 Accumulation and Amount Functions

1.1 Problem 1:Accumulation and Amount Functions
Consider the amount function A(t) = t2 + 4t + 10
1. Find the accumulation function a(t)
A(t) 1 2
Solution. Recall, A(t) = A(0)a(t) and A(0) = 10 therefore a(t) = A(0) = 10 (t + 4t + 10)

2. Find In (i.e. the amount of interest earned from tn1 to tn

Solution. In = A(n) A(n 1) by direct substitution, we have
= [n2 + 4n + 10] [(n 1)2 + 4(n 1) + 10]
= 2n + 3

2 PV Discrete Cashflows
2.1 Problem 1: PV of Discrete Cashflows
Recall, given a sequence c = (cj , tj )1jm of payments cj at time tj and a time t < tj j, we can write
the joint discounted value at time t of all payments as:

1
Definition 2.1 (Discounting value: Discrete Time).
m
X m
X
Dvalt (c) = c1 t1 t + c2 t2 t + + cm tm t = cj tj t = cj (1 + i)(tj t)
j=1 j=1

Definition 2.2 (Discounting value: Continuous Time).

m
X
Dvalt (c) = c1 e(t1 t) + c2 e(t2 t) + + cm e(tm t) = cj e(tj t)
j=1

Thus, we have:
m
X m
X
Dvalt (c) = cj (tj t) = cj e(tj t)
j=1 j=1
1
= (1+i) denote the discount factor.

(A) A businessman is owed the following amounts: R1,000 on 1 January 2013, R2,500 on 1 January
2014, and R3,000 on 1 July 2014. Assuming an effective rate of interest of 6.18 per annum, find
the value of these payments on
(a) 1 January 2011,
Solution.
1000 2500 3000
PV = + +
(1 + i)2 (1 + i)3 (1 + i)3.5
1000 2500 3000
= 2
+ 3
+ = R5407.41
(1 + 0.0618) (1 + 0.0618) (1 + 0.0618)3.5

(b) 1 March 2012.

Solution. The value of the same debts at 1 March 2012 is found by advancing the present
value forwards by 14 months, by

14
F V = R5407.41(1 + i) 12 = R5798.66

(B) Assuming a constant force of interest of 6% per annum, find the value of these payments on (a) 1
January 2011, (b) 1 March 2012.
Solution. Note that i = e 1 therefore the an effective rate of interest of 6.18% is equivalent to
a 6% force of interest

2.2 Problem: Interest Income Payable

Definition 2.3.
Theorem 2.1. A capital of 1 is invested at an annual interest rate of i for n years. The interest
satisfies A(t2 , t1 ) = (1 + i)t2 t1 . Then the interest can be paid in any of the following ways:
(a) Payment of interest (1 + i)n 1 at the end of year n.
(b) Payment of interest i at the end of each year .
i(p) 1
(c) Payment of interest p at the end of each p year long period.
The outstanding capital after each interest payment is 1.
If the rate of interest is fixed at i per time unit, and if the investor wishes to receive his income at
the end of each time unit, it is clear that his income will be iC per time unit, payable in arrears,
until such time as he withdraws his capital.

2
 More generally, suppose that t > t0 and that an investor wishes to deposit C at time t0 for
withdrawal at time t. Suppose further that n > 1 and that the investor wishes to receive interest
on his deposit at the n equally spaced times The total interest income payable between times t0
and t will then be
n1
X
I(t) = C hih (t0 + jh).
j=0

In the limit the total interest received between times t0 andt is

Z t
I(t) = C (t) ds
t0

(A) We invest 300 at an annual rate of interest of 8% for five years.

(a) How much interest will we get at the end of the fifth year?
The interest at the end of the fifth year will be

300((1.08)5 1) = 300 0.4693 = 140.80

.
(b) If the interest is paid at the end of each year, how much will these payments be?
The yearly interest payment is
300 0.08 = 24
.
(c) How much will the interest payments be if they are paid monthly?
(12)
First we need to determine i 12 which is

i(12)
= (1.08)1/12 1Sothemonthlyinterestpaymentsare300(1.08)1/12 1 = 1.93
12

(B) A deposit of 400 is made on January 1 for 5 years in an account earning 6% interest a year (i.e it
is an effective rate of interest). Assume the interest is paid continuously.
(a) What is the annual rate of the interest payment?
0
Recall, (t) = AA(t)
(t)
and if the accumulation amount is based on the compound interest
t
(1 = i) , then it it easy to show that (t) = ln(1 + i)

400 = 400 ln(1 + i) = 400 ln(1.06) = 400(0.05827) = 23.31

.
(b) What is the total amount of the interest payment?

5(400) = 5(23.31) = 116.55

.
(c) What is the interest paid in one month?
1
(400) = 12(23.31) = 1.94
12
.

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3 Cashflow Valuation: Discrete and Continuous
3.1 Problem 1: Cashflow Valuation
An individual makes an investment of R4m per annum in the first year, R6m per annum in the second
year and R8m per annum in the third year. The investments are made continuously throughout each
year. Calculate the accumulated value of the investments at the end of the third year at a rate of
interest of 4% per annum effective.
Solution. Recall, The present value (PV) at (time 0) of the continuous rate of payment
(t) : (0, t) R is
Z t Z t  Z u 
P V () = (u)(u)du = (u) exp (s) ds du (1)
0 0 0

where (t) denotes the present value (time 0) of the amount 1 at time t for t 0.
For a constant interest rate i, equation (1) simplifies to
Z t u
(u)
P V () = du (2)
0 1+i

The accumulated value A(t) at (time t) of the continuous rate of payment (t) : (0, t) R is
Z t Z t Z t 
(u)
A(t, ) = (u) du = (u) exp s (s) ds du (3)
0 (t) 0 u

where (t) denotes the present value (time 0) of the amount 1 at time t for t 0.
For a constant interest rate i, equation (3) simplifies to
Z t
P V () = (u)(1 + i)tu du (4)
0

Since we have a constant interest i model, Applying equation (2) model:

Z 1 Z 2 Z 3
P V () = 4(1 + i)u du + 6(1 + i)u du + 8(1 + i)u du
0 1 2
Z 1 Z 2 Z 3
= 4 u du + 6 u du + 8 u du
0 1 2
= 4( 1) + 6( ) + 8( 2 )/ ln() = 8 3 2 2 2 4/ ln()
2 3

the accumulated value is

PV
A(3) = 3 = 8(1 + .04)3 2(1 + .04)2 2(1 + .04) 4/ ln(1 + .04) = 18.935

3.2 Problem 2: Cashflow Valuation

Suppose a fund has value A(0) at time 0. Suppose further that investments are deposited into a fund at
a continuous rate with value (t) at time t and the force of interest function has value (t) at time t.
(a) Find A(t), the value of the fund at time t.
Solution. The Fund value at time 0 (i.e. the present value) is:
Z t Rs
A(t) = P V = A(0) + (s)(s) ds where (s) = e 0 (u) du
0

Hence value at time t (i.e the future value) is:

Z t  Z t  Z t Z t 
P V exp (u) du = A(0)exp (u) du + (s)exp (u) du ds
0 0 0 s

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(b) Suppose the force of interest is constant and corresponds to the effective annual interest rate i.
Express A(t) in terms of i and .
Z t
A(t) = A(0)(1 + i)t + (1 + i)ts (s) ds
0

3.3 Problem 3 : Cashflow Valuation

The force of interest t at time t is given by
(
0, 06 if 0 < t 6;
(5)
0, 05 + 0, 0002t2 if 6 < t 12.

Calculate the accumulated value at time t = 12 of a continuous payment stream of R100 per annum
payable from time t = 0 to time t = 6.
Solution. p(t) = 100 and
Z t
PV = (u)(u) du
0
Z 6  Z t 
= 100 (u) du where (t) = exp (u) du
0 0
Z 6 Z t 
Hence,P V = 100 exp 0.06 du dt
0 0
Z 6
= 100 exp[0.06t] dt
0
= 100[1 e0.36 ]/0.06

Now, the accumulation amount A(12) is given as

PV
A(12) =
(12)
Z 12  Z 12 Z 6 Z 12
= P V exp (u) du where (u) du = 0.06 du + 0, 05 + 0, 0002u2 d
0 0 0 6
0.36
= 100[1 e ]/0.06 exp(0.760800) = 1078.281485

3.4 Problem 4 : Cashflow Valuation

The force of interest t at time t is given by
(
0, 05 if 0 < t 8;
0, 04 + 0, 0004t2 if 8 < t 15.

Calculate the accumulated value at time t = 15 of a continuous payment stream of R50 per annum
payable from time t = 0 to time t = 8.

5
3.5 Problem 5 : Cashflow Valuation
The force of interest t is:
(
0, 04 if 0 < t 5;
0, 01(t2 t) if 5 < t.
(i) Calculate the present value of a unit sum of money due at time t = 10.
Solution.
 Z 10 
(t) = exp (t) dt
0
 Z 5   Z 10 
= exp 0, 04 dt + exp 0, 01(t2 t) dt
 0  5
15.25
= exp 0.2 + = 0.0645
6

(ii) Calculate the effective rate of interest over the period t = 9 to t = 10.
Solution.
Z 10
(9)
(1 + i) = A(9, 10) = = exp 0, 01(t2 t)dt = 2.244
(10) 9
Hencei = 1.244

(iii) In terms of t, determine an expression for (t), the present value of a unit sum of money due
during the period 0 < t 5.
Solution.
 Z t 
(t) = exp 0.04 ds = e0.04t
0

(iv) Calculate the present value of a payment stream paid continuously for the period 0 < t 5, where
the rate of payment, (t), at time t is e0,04t .
Solution.
Z t  Z t   Z t 
PV = (u)(u) du where (t) = exp (s) ds Hence(t) = exp 0.04 ds = e0.04t T heref or
0 0 0
Z 5
= 1 dt = 5
0

4 Force of Interest
4.1 Problem 6: Deriving t from a(t)
1 12 13
Suppose A(t) = (1.05) 2 (1.04) 3 (1.03) 6 . Find t
d A0 (t)
Solution. Recall, t = dt ln [A(t)] equivalently t = A(t)

d h t t2 t3
i
t = ln (1.05) 2 (1.04) 3 (1.03) 6
dt 
t2 t3

d t
= ln(1.05) + ln(1.04) + ln(1.03)
dt 2 3 6
2
 
1 2t t
= ln(1.05) + ln(1.04) + ln(1.03)
2 3 2
t2
h 1 2t
i
= ln (1.05) 2 + (1.04) 3 + (1.03) 2

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4.2 Problem 7: Deriving a(t) from t
Measuring time in years from the present, suppose that t = 0.06 0.9t for all t. Find a simple
expression for t , and hence find the discounted present value of R100 due in 3.5 years time.
Rt
Solution. Recall, (t) = e 0
r dr

Z t Z t
r dr = 0.06 0.9r dr
0 0
= .06 ln(0.9t 1)
 

t
(t) = e0.06[ln(0.9 1)]

3.5
Hence, the present value of R100 due in 3.5 years time is, by: (3.5) = e0.06[ln(0.9 1)]

4.3 Problem 8: Deriving a(t) from t

3
Suppose t = 13t . Find the corresponding accumulation function a(t)
Rt
r dr
Solution. recall, a(t) = e 0

Z t Z t
3
r dr = dr = ln [1 3r]
0 0 1 3r
1
= ln [1 3t]

1
Rt
a(t) = e 0
r dr
= eln[13t] = (1 3t)1

4.4 Problem 9:Effective Rate

Smith forecasts that interest rates will rise over a 5-year period according to a force of interest function
given by t = 0.08 + 0.025t
t+1 for 0 t 5

(a) According to this scheme, what is the average annual compound effective rate for the 5-year period?
R t R 1
Solution. Hint: t+1 dt = 1 t+1 dt
Z n 
n
(1 + i) = exp t dt
0
Z 5 
0.025t
(1 + i)5 = exp 0.08 + dt
0 t+1
5
= exp [0.08t + 0.025(t ln(t + 1)]0 = 1.6164
i = 1.61641/5 1 = 10.08

(b) What are the equivalent effective annual rates for each of years 1, 2, 3, 4, and, 5
Solution.

(c) What is the present value at t = 2 of R1, 000 due at t = 4?

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 Table 1: Add caption
Rn Rn 1/n i
n 0
t dt A(tn ) = exp[ 0
t dt] i = A(n) 1 A(n) A(n 1) ief f = A(n)

1 0.08767 1.09163 0.09163 0.09163 0.09163

2 0.18253 1.20026 0.09556 0.10863 0.09951
3 0.28034 1.32358 0.09795 0.12333 0.10275
4 0.37976 1.46194 0.09959 0.13836 0.10453
5 0.48021 1.61641 0.10080 0.15447 0.10566

Solution. By definition, the present value at time 0 of an investment amount A(n) due at time n
is given by:  Z n 
A(0) = A(n)exp t dt
0

Therefore, the present value at time 2 of A(4) due in time 4 is given as:
 Z 4 
A(2) = 1000 exp t dt
2
 Z 4 
0.025t
= 1000 exp 0.08 + dt
2 t+1
= 1000 exp(0.197229359) = R821.0023071

(d) A debt of R10 000 bearing interest of 14% per annum, to be paid half-yearly, must be discharged
by the sinking fund method. If the sinking fund earns interest at a rate of 12% per annum
compounded quarterly, and the debt is to be discharged after five years, determine the size of the
quarterly deposits. What is the total yearly cost of the debt?

Please send corrections and suggestions for improvement to sutenem@uj.ac.za