Module 2 Chapter 13 solutions

Chapter 13 solutions

Solution 13.1

(i) E (S5 )  1.055  0.4  1.085  0.6  1.392109

 E (1,000S5 )  1,000E (S5 )  £1,392.11

(ii) E (S52 )  (1.055 )2  0.4  (1.085 )2  0.6  1.946913

var(S5 )  E (S52 )  [E (S5 )]2  1.946913  1.3921092  0.008944

 sd (S5 )  var(S5 )  0.008944  0.09457

 sd (1,000S5 )  1,000sd (S5 )  £94.57

(iii) Calculating the possible accumulated values and their associated probabilities:

Interest rate over the 5

Accumulated value Probability
years

5% 1,000  1.055  £1,276.28 0.4

8% 1,000  1.085  £1,469.33 0.6

We see that only the 8% interest rate gives an accumulated value greater than
£1,300. So the required probability is 0.6.

Solution 13.2
Drawing up a table showing the possible outcomes and their probabilities:

Interest rate over the

Accumulated value Profit Probability
10 years

4% 3,000  1.0410  £4, 440.73 £559.27 0.4

5% 3,000  1.0510  £4,886.68 £113.32 0.3

7% 3,000  1.0710  £5,901.45 £901.45 0.3

So the expected profit is given by:

E (profit)   profit  probability

 ( £559.27  0.4)  ( £113.32  0.3)  (£901.45  0.3)
 £12.73

Alternatively, we could calculate the expected accumulated value and the subtract the
premium:

E (profit)  3,000E (S10 )  5,000

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Chapter 13 solutions Module 2

Solution 13.3
Calculating the possible accumulated values (AVs) and their associated probabilities:

Interest rate over the

Accumulated value, AV Probability
10 years

5% then 1% 200  1.055  1.015  £268.28 0.2

5% then 3% 200  1.055  1.035  £295.91 0.3

5% then 6% 200  1.055  1.065  £341.59 0.5

E (AV)  £268.28  0.2  £295.91 0.3  £341.59  0.5

 £313.22

E (AV 2 )  £268.282  0.2  £295.912  0.3  £341.592  0.5

 £ 299,005.73

var(AV)  E (AV 2 )  [E ( AV ]2
 99,005.73  313.222
 896.29

 sd (AV)  var(AV)  896.29  £29.94

Note we have kept all the figures in our calculator – rounding the answers to 2 DP gives a
standard deviation of £29.98.
Alternatively, we could have calculated the mean and standard deviation for an investment of
£1 over the final five years and then multiplied the answers by £200  1.055 .

Solution 13.4
First of all we need to calculate the mean and variance of the interest rates:
i  E (it )  (0.05  0.4)  (0.08  0.6)  0.068

E (it2 )  (0.052  0.4)  (0.082  0.6)  0.00484

  i2  var(it )  E (it2 )  [E (it )]2  0.00484  0.0682  0.000216

(i) Using the formula the mean accumulated value of £1 over the 5 years gives:

E (S5 )  (1  i )5  1.0685  1.38949

 E (1,000S5 )  1,000E (S5 )  £1,389.49

(ii) Using the formula for the variance of the accumulated value of £1 over 5 years gives:
5
var(S5 )   i2  (1  i )2   (1  i )10
 
 (0.000216  1.0682 )5  1.06810
 0.0018288

 sd (S5 )  var(S5 )  0.0018288  0.04276

 sd (1,000S5 )  1,000sd (S5 )  £42.76

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Module 2 Chapter 13 solutions

Solution 13.5
(i) The mean will increase as one of the rates is higher. However the standard deviation
will decrease as the interest rates are closer together and so less spread out.
(ii) The investment has had less time to grow so the mean will be smaller. Similarly the
extreme accumulated values will be less spread out and so the standard deviation will
be smaller.

Solution 13.6

We will simply take our accumulated values (AVs) and multiply them by 1.045 so our mean
and standard deviation will also be multiplied by 1.045 :

E (AV)  £1,389.49  1.045  £1,690.53

sd (AV)  £42.76  1.045  £52.02

Note that we will get £52.03 if we kept all the accuracy from Solution 13.4.

Solution 13.7
We are given:
i  E (it )  0.04  i  sd(it )  0.01
Using the formulae, we get:

E (S10 )  (1  i )10  1.0410  1.480244

var(S10 )  ( i2  (1  i )2 )10  (1  i )20  (0.012  1.042 )10  1.0420  0.002027

 sd(S10 )  0.002027  0.04502

But we have €2,000 invested, so:

E (2,000S10 )  2,000E (S10 )  €2,960

sd(2,000S10 )  2,000 sd(S10 )  €90.04

Solution 13.8
First of all we need to calculate the mean and variance of the interest rates in each year:
E (i1)  (0.05  0.4)  (0.08  0.6)  0.068

E ( i12 )  (0.052  0.4)  (0.082  0.6)  0.00484

 var( i1)  E ( i12 )  [E ( i1)]2  0.00484  0.0682  0.000216

E (i2 )  (0.06  1 )  (0.07  1 )  0.065

2 2

E ( i 22 )  (0.062  21 )  (0.072  21 )  0.00425

 var( i 2 )  E ( i 22 )  [E ( i 2 )]2  0.00425  0.0652  0.000025

E (i3 )  (0.02  0.3)  (0.04  0.7)  0.034

E ( i32 )  (0.022  0.3)  (0.042  0.7)  0.00124

 var( i3 )  E ( i32 )  [E ( i3 )]2  0.00124  0.0342  0.000084

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Chapter 13 solutions Module 2

(i) Using the formula the mean accumulated value of £1 over the 3 years gives:
E (S3 )  (1  E (i1))(1  E (i2 ))(1  E (i3 ))
 1.068  1.065  1.034
 1.17609
 E (500S3 )  500E (S3 )  $588.05

(ii) Using the formula for the variance of the accumulated value of £1 over 3 years gives:

E (S32 )   var(i1)  (1  E (i1))2   var(i2 )  (1  E (i2 ))2   var(i3 )  (1  E (i3 ))2 

   
 (0.000216  1.0682 )(0.000025  1.0652 )(0.000084  1.0342 )
 1.383594

 var(S3 )  E (S32 )  [E (S3 )]2  1.383594  1.176092  0.0004011

 var(500S3 )  5002 var(S3 )  $2100.28

(iii) Calculating the possible accumulated values and their associated probabilities under
the varying rate model we get:

Accumulated
1st yr 2nd yr 3rd yr Probability
value
5% 6% 2% $567.63 0.4  0.5  0.3  0.06
5% 6% 4% $578.76 0.4  0.5  0.7  0.14
5% 7% 2% $572.99 0.4  0.5  0.3  0.06
5% 7% 4% $584.22 0.4  0.5  0.7  0.14
8% 6% 2% $583.85 0.6  0.5  0.3  0.09
8% 6% 4% $595.30 0.6  0.5  0.7  0.21
8% 7% 2% $589.36 0.6  0.5  0.3  0.09
8% 7% 4% $600.91 0.6  0.5  0.7  0.21

Summing the combinations with accumulated values that are greater than the mean of
$588.05 gives:
0.21  0.09  0.21  0.51
Note that we could have answered parts (i) and (ii) using these accumulated values in the
table instead of working with £1 and multiplying the answers.

Solution 13.9
We require:
500E (S8 )  700  E (S8 )  1.4

Using the formula for the mean accumulated value, we have:

(1  i )8  1.4  i  0.042956
We also require:
500sd (S8 )  400  sd (S8 )  0.8

Using the formula for the variance of the accumulated value, we have:

( i2  (1  i )2 )8  (1  i )16  0.82

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Module 2 Chapter 13 solutions

Substituting in j we get:

( i2  1.0429562 )8  1.42  0.64

( i2  1.0429562 )8  2.6
 i2  0.039107
 i  0.1978

Solution 13.10
Since the rate is the same for the whole of each of the 10 years we have a fixed rate model,
but then the two periods are independent so this is the varying rate model….so the best
option is to simply work with all the possible outcomes and calculate the mean and standard
deviation from them.

1st 2nd
Accumulated value (AV) Probability
10 yrs 10 yrs

3% 3% 5,000  1.0310  1.0310  $9,030.56 0.3  0.4  0.12

3% 4% 5,000  1.0310  1.0410  $9,946.62 0.3  0.6  0.18

5% 3% 5,000  1.0510  1.0310  $10,945.49 0.7  0.4  0.28

5% 4% 5,000  1.0510  1.0410  $12,055.81 0.7  0.6  0.42

E (AV)  (9,030.56  0.12)  (9,946.62  0.18)  (10,945.49  0.28)

 (12,055.81 0.42)
 $11,002.24

E (AV 2 )  (9,030.562  0.12)  (9,946.622  0.18)  (10,945.492  0.28)

 (12,055.812  0.42)
 $2122,183,395

var(AV)  E (AV 2 )  [E (AV)]2

 122,183,395  11,002.242
 1,134,189

 sd (AV)  var(AV)  1,134,189  $1,065

Note we have kept all the figures in our calculator – rounding the answers to 2 DP gives a
different value for E (AV 2 ) .