Actuarial Society of India

EXAMINATIONS

May 2003

Subject 102 – Financial Mathematics

Indicative Solution
Solution to Q1:

Consider a loan of Re 1 which is to be repaid by “n" equal installments annually in arrear.

If the annual rate of interest is i then the amount of each repayment is X, where

X * a n = 1 . Thus, X = 1 / a n

When the lender receives each repayment he may consider an amount i of the payment
as interest and deposit the balance of the payment, i.e., 1 / a n − i , in a savings account
which earns interest at rate i per annum.

After n years the accumulated savings account must be sufficient to repay the original
loan, i.e., Re 1. Thus, at the rate of interest i

(1 / a n − i ) * S n = 1

1 1
⇒ = +i
an S n
[3 marks]

Note: Credit can be given to students who have concluded in other ways.

Solution to Q2 (a):

Let A be the accumulated proceeds:

10 10

∫0 δ (t )dt ∫ δ (t )dt
A = 100 e + 100e 5

  .001t 2 .0001t 3 
10
 .001t 2 .0001t 3  
10

= 100exp .05t + + + exp .05t + + 

  2 3  0  2 3  5 


{
= 100 e .58333 + e 0. 58333− 0. 26667 }
= 316.45
[5 marks]
Solution to Q2 (b):

The equivalent constant force is δ where

(
316.45 = 100 e10 δ + e 5 δ )
 − 100 ± 100 2 + 4 * 316.45 *100
⇒e 5δ
= and e 5δ > 0
2 *100

e 5 δ = 1.34784 ⇒ ä = .05970 or 5.97%

[3 marks]

Solution to Q3:

(
1000000 = 125000 * v + (1 + p )v 2 + ... + (1 + p )9 v 10 ) @ 8%
0.08-p
= 125000* v * &&
a10 @
1+p

[3 marks]

at p = 4.0%, RHS = 982,376.322

at p = 4.5%, RHS = 1,002409.346

p = 4.4398682
= 4.44% per annum

[2 marks]

Solution to Q4(a):

(X * S&& 15
+ X * S&&10 + 2 X * S&&5 )
@ 7%
* (1 + i )
5
@ 7% = 50000 + 10000 * a12 @ 3%

[3 marks]

75.70726601 * X = 149540.0399

X = 1975.240262

[2 marks]

Solution to Q4(b):

(
1975.240262 * S&&15 + S&&10 + 2 * S&&5 )
@ 6%
* (1 + i )
5
@ 6% = X ′ + 10000a12 @ 2 .5 %

[3 marks]
133738.1176 = X ′ + 102577.646

X ′ = 31160 .47

[2 marks]

Solution to Q5:

1
12
( )
* 120000 * S 1 * (1 + i )11 + 110000 * S 1 * (1 + i )10 + ... + 10000 * S 1 − 100000 * (1 + i )12

[2 marks]

where i = (1.03) 6 − 1 = 0.004938622

1

[1 mark]

S 1 *10000  12 * (1 + i ) − S12
12


=  − 100000 * (1 + i )
12
*
12  i
 

= - 38525.51501, this being negative represents a Loss.

[2 marks]

Solution to Q6:

The instalments under the two loans are

4000 / a 30 @ 2 .5 % = 191.112 and [1½ marks]

1500 / a 2 0 @ 2% = 91.735 [1½ marks]

The loans outstanding are

= 191.112 * a18 @ 2 .5 % + 91.735 * a12 @ 2 % [2 marks]

=191.112*14.3534+91.735*10.5753

=2743.107+970.125 = 3713.23 [2 marks]

The total sum to be paid in future by the borrower is to be the same and he must therefore
pay:
= (191.112 * 18 + 91.735 * 12) / 20 per annum

= 227.04 per annum [2 marks]

Hence 227.04 * a 20 = 3713.23

From the interest tables it will be seen that as nearly as may be, the value of a 20 @ 2 %
satisfies the equation.

The new rate of interest is therefore 4% per annum convertible half- yearly.

[1 mark]

Solution to Q7:

The possible reasons could be:

1. The investor may need to reinvest the coupon payments at the same rate. The
terms that will be available for reinvestment are not the same as expected
2. The ultimate sale price is not known at outset if he sells the investment before
redemption
3. Tax rates may change, affecting the income and capital proceeds received by the
investor
4. The real return (i.e., in excess of inflation) is uncertain. If inflation turns out to be
higher than expected at outset, the real returns from fixed interest bonds will be
lower than originally anticipated

Note: Any three points will get each of one mark [Max.3
marks]

Solution to Q 8(a):

Equity shares do not earn a fixed rate of interest as fixed interest securities do. Instead the
shareholders are entitled to a share in the company’s profits in the proportion of the
number of shares owned.

[1 mark]

The distribution of profits to the shareholders takes the form of regular payouts of
dividends. Since they are related to the company’s profits that are not known in advance,
dividends are variable. It is expected that company profits will increase over time, it is
therefore also expected that dividend per share will increase – though there are likely to
be fluctuations. This means that in order to construct a cashflow schedule for an equity it
is necessary first to make an assumption about the growth of future dividends; it also
means that the entries in the cashflow schedule are uncertain – they are estimates rather
than known quantities.

[1 mark]

In practice the relationship between dividends and profits is not a simple one. Companies
will from time to time need to hold back some profits to provide funds for new projects
or expansion. Companies may also hold back profits in good years to subsidise dividends
in years with poorer profits. Additionally, companies may be able to distribute profits in a
manner other than dividends, such as by buying back the shares issued to some investors.

[3 marks]

Solution to Q8 (b):

The reasons for being so are:

1. Dividends usually increase annually, where as rents are reviewed less often
2. Property is much less marketable
3. Expenses associated with property investment are much higher
4. Large, indivisible units of property are much less flexible

Note: one and one-fourth for each point. [5 marks]

Solution to Q9 (a):

1
 352  6
The time-weighted rate of returns is   − 1 = 1.1122 − 1 or 11.22%
 186 

[1 mark]

The linked rate of return is equal to time–weighted rate of return.

[1 mark]

Solution to Q9 (b):

Let U r be the unit price on 1 April 1996 + r .

The yield per annum i is found from the equation

5
200 * ∑ (1.02 *U r ) * (1 + i ) 6 − r = 1200 * 0.98 *U 6
r= 0

[2 marks]
Solution to Q9 (c):

Let U r be the unit price on 1 April 1996 + r .

The yield is derived from the equation,

5  1 
500 * S 6 = 500 * ∑    * 0.98 *U 6
 r = 0 1.02 *U r  

[2 marks]

Solution to Q9 (d):

Money weighted rate of return

1. This is sensitive to the amount and timing of the cashflows. Fund manager does not
control the timing or amount of the cashflows. [1½ marks]
2. The equation of value may not have a unique solution [½ mark]

Time weighted rate of return (TWRR)

1. To calculate TWRR, we need to know the value of the fund every time there is a
cash flow. [1½ marks]

Note: Credit can be given to any other valid points. [Max. 3 marks]

Solution to Q10:

1. Futures are standardized and tradable through a clearing house.

2. Forward contracts are tailor- made contracts and are not standardized.

Note: Any reasonable other reasons are to be given credit. [Each carries one mark]
[Max. 2 marks]

Solution to Q11:

( 0. 05− 0. 03 )* 3 1
0 .05*
Forward price = 500 * e 12
− 100 * e 12

= 402.09
[3 marks]
Solution 12 (a):

The present value of liabilities is

4
V = ∑ (1000 + 100t ) * v 5 t @ 5%
t =1

= 2751.54

[2 marks]

Discounted mean term is

4
5t * (1000 + 100t ) * v 5 t
∑ V
@ 5%
t =1

31609
= 11.4877 years
2751.54

[2 marks]

Solution to Q12 (b):

Supposed that the amounts invested in the 10- year stock and in the 30- year stock are A
and B respectively. Then

A + B = 2751.54 from part (a) above

[½ mark]

The cash- flows arising from the 10- year stock have present value:

V1 = A * (0.05a10 + v10 ) [1/2 mark]

[½ mark]

0.05 * ( Ia10 + 10v10 )

and discounted mean term t 1 =
0.05a10 + v 10

[1 mark]
At an interest rate of 5%, these values are

V1 = A and t 1 = &a&10 = 8.10782 at 5%.

[1 mark]
Similarly, at an interest rate of 5%, the cashflows arising from the 30-year stock have
present value V2 = B and discounted mean term t 2 = a&&30 = 16.14107 at 5%.

[1 mark]

The discounted mean term of the total asset proceeds is:

( A * 8.10782) + ( B *16 .14107)

t=
A+ B

[1 mark]

= 16.14107 − 0.00291955 A Q A + B = 2751.54

Equating this expression to 11.4877, we obtain A = 1593.87 and hence B = 1157.67

[1 mark]

Solution to Q13 (a):

Let the time unit be half- year. The gross yield per period on 31st August 2001 is the
solution of

49.50 = 2.75 * v * &a&(∞2 )

6

[1 mark]

2.75 * v 6
49.50 =
d ( 2)

2.75 * v 6
49.50 = 1

2 * (1 − v 2 )

By trial and interpolation, the yield per half- year is approximately 5.75%, so the gross
annual yield convertible half- yearly is 11.5%.

[2 marks]

Solution to Q13 (b):

The selling price one year later was

 1

2.75 * v 6
= 1 @ 5% (gross yield per half- year)
2 * (1 − v 2 )

= 56.59

[1 mark]

The equation of value, working in years from 31 August 2001, to find the investor’s net
yield is
1

49.50 = {[0.6*5.5* v12 * &&

a1(4) ]} + {[56.59 − 0.3*(56.59 − 49.50)]* v

[1 mark for each part of the equation] [2 marks]

1
d
49.50 = {3.3 * v12 * } + {54.46 * v}
d (4 )

By trial, the solution is i = 17.25%

[3 marks]

Solution Q14 (a):

Vn = (1 + i1 ) −1 * (1 + i 2 ) − 1 ........... * (1 + i n ) −1

[1 mark]

log Vn = − log( 1 + i1 ) − log( 1 + i 2 )........... − log( 1 + i n )

Since for each value of t , log( 1 + i t ) is normally distributed with mean µ and
variance σ 2 , each term of the right hand side of the last equation is normally distributed
with mean − µ and variance σ 2 . Also the terms are independently distributed. This
means that log Vn is normally distributed with mean − nµ and variance nσ 2 , i.e.) Vn has
log- normal distribution with parameters − nµ and nσ 2 .

[2 marks for proper explanation otherwise

nil]

Solution Q14 (b):

Given that E[i ] = 0.08 and Var[i ] = (0.05) 2 = 0.0025 .

We are given that (1 + i ) has a log- normal distribution with parameters µ and σ 2 .

E[(1 + i ) k ] = exp( nµ + 0.5 * n 2 σ 2 )

Thus 1 + E[i ] = E[1 + i ] = exp( µ + 0.5 *σ 2 )

⇒ E[i ] = exp( µ + 0.5 * σ 2 ) −1

Also, Var[i ] = E[(1 + i ) 2 ] − ( E[1 + i ]) 2

= exp( 2 µ + 2σ 2 ) − [exp( µ + 0.5σ 2 )] 2

= exp( 2 µ + σ 2 ) * (exp( σ 2 ) − 1)

Solving for µ = 0.07589052 and σ 2 = 0.00214105

1 mark for
E[i ]
1 mark for
Var[i ]
3 marks for solving for µ and
σ 2

[Total 5 marks]

′
Let µ ′ = −nµ and σ 2 = nσ 2 . Then,

′
E[Vn ] = exp( µ ′ + 0.5 *σ 2 )

= exp( −nµ + 0.5nσ 2 )

= [exp( −µ + 0.5σ 2 )] n

Multiplying by 1000, we get

= 1000 * [exp( −0.07589052 + 0.5 * 0.00214105)]10

= 473.22
[2 marks]

′
E[(Vn ) 2 ] = exp( 2µ ′ + 2σ 2 )
 = exp( −2 nµ + 2nσ 2 )

= [exp( −µ + σ 2 )]2 n

Multiplying by 1000 2 we get

= 1000 2 * [exp( −0.07589052 + 0.00214105)] 20 = 228781.1521

[2 marks]

The standard deviation of Vn is E[(Vn ) 2 ] − ( E[Vn ]) 2 = 69.62

[1 mark]

[Grand Total 100 marks]

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