Lecture 3: Annuity

Goals: Learn continuous annuity and perpetuity. Study annuities whose payments form a geometric progression or a arithmetic progression. Discuss yield rates. Introduce Amortization Suggested Textbook Readings: Chapter 2: 2.2, 2.3, and 2.4.1 Practice Problems: Section 2.2: 1-5, 7-10, 12-17 Section 2.3: 1-5, 7-8, 10 Section 2.4: 1(a) part (i), (b) part (i), 2, practice examples 2.24, 2.25 in the text book.

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Diering interest and payment periods

It may happen that the quoted interest rate has a compounding period that doesnt coincide with the annuity payment period. For the purpose of evaluation we can nd the interest rate per payment period that is equivalent to the quoted interest rate, or nd the equivalent payment in each quoted interest period. Example 1: (Example 2.12 (a)) On the last day of March, June, September and December, Smith makes a deposit of $1000 into a saving account that earns nominal rate i(12) = 9%. The rst deposit is on Mar 31, 1995 and the last is December 31, 2010. What is the balance on January 1, 2011?

m-thly payable annuities Example 2: (Example 2.12 (b)) In the above example, if the interest rate is quoted at an eective annual rate of 10%, what is the balance in Smiths account on January 1, 2011?

mthly payable annuity-immediate If the eective annual interest rate is i, and m payments of X are made each year, then the accumulated value over n years is Ksn|i = K
(m)

(1 + i)n 1 i = Ksn|i (m) ( m ) i i

where K = mX . The present value of this series of payments is Kan|i = Kan|i

(m)

i i(m)

MATH 384 Fall 2012

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Perpetuities
If an annuity has no end point, it is called a perpetuity. We cannot nd the future value of a perpetuity, but we can always calculate the present value.

1 Annuity-immediate: a|i = lim an|i = n i 1 Similarly, for annuity-due: a |i = d 1 (m) thly and for m payable annuity-immediate: a|i = (m) i

Continuous Annuity
If payments are made more frequently, it is more convenient to approximate the calculation by assuming the payments are made continuously.

The accumulated value of the continuous annuity, paid at 1 per period for n periods, denoted by sn|i , is i sn|i = sn|i i Similarly an|i = an|i . If accumulation is based on force of interest r , then
n

an|r =
0

Rt
0

r dr

dt

and sn|r =
0

n R n

r dr

dt. Also sn|r = an|r e

Rt
0

r dr

MATH 384 Fall 2012

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Geometric Progression
Sometimes the annuity payment is adjusted periodically for ination. Such an annuity would have payments that increase geometrically. Example 3: (Example 2.17, page 110) Smith wishes to purchase a 20-year annuity at an eective annual rate of 11% with annual payments beginning one year from now. Smith anticipates an eective annual ination rate over the next 20 years is 4%, so he would like each payment after the rst to be 4% larger than the previous one. If Smiths rst payment is 26000, what is the present value of the annuity?

Suppose a series of n periodic payments has a rst payment of amount 1 and all subsequent payments are (1 + r) times the previous payment. At a rate i per payment period, one period before the rst payment, what is the present value, and what is the accumulated value at the time of the nal payment?

The present value of the series is

r 1 1+ 1+i ir and the accumulated value at the time of the last payment is r 1 1+ 1+i ir n

(1 + i)n =

(1 + i)n (1 + r)n ir

Question: What is the present value of the above series if r = i?

MATH 384 Fall 2012

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Dividend Discount Model

The value of a share of stock is the present value of the future dividends that will be paid on the stock. In general we assume a constant rate of increase in the amount of the dividend paid, so that the future stream of dividends forms a geometric payment perpetuity. Example 4: Common Stock X pays a dividend of 50 at the end of the rst year, with each subsequent annual dividend being 5% greater than the precedding one. Suppose the eective annual interest rate is 10%. What is the theoretical price of the stock?

If the next dividend payable one year from now is of amount K , the annual compound growth rate of the dividend is r, and the interest rate used for calculating present value is i, the present value one payment period before the rst dividend payment is
r 1 1+ 1+i K v + (1 + r)v + (1 + r) v + = K lim n ir 2 2 3 n

K ir

under the assumption that i > r. This is usually referred to as the theoretical price of the stock.

MATH 384 Fall 2012

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Arithmetic Progression
Example 5: (Increasing annuities) Consider an annuity whose rst payment is 1. If each subsequent payment increases by 1 for n periods, with an interest rate i per period and equally spaced payments, what is the present value of the series of payments one period before the rst payment?

The present value is

a n|i nv n (Ia)n|i = i and the accumulated value at the nal payment is (Is)n|i = s n|i n i

Increasing perpetuity immediate If the payments in an increasing annuity immediate are allowed to continue forever, the present value is (Ia)|i = lim a n|i nv n 1 1 = 2+ n i i i

Example 6: (Decreasing annuities) Consider an annuity whose rst payment is n. If each subsequent payment is of amount 1 less than the previous payment, with an interest rate i per period, what is the present value of the series of payments one period before the rst payment?

The present value is

n an|i i and the accumulated value at the nal payment is (Da)n|i = (Ds)n|i n(1 + i)n sn|i = = (Da)n|i (1 + i)n i MATH 384 Fall 2012

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Example 7: Mary make deposits of 1000 into an account with an eective annual rate of 10% at the end of each year for 5 years. Each year just after the interest is credited, Mary withdraw only the interest and redeposit it into a second account with an eective annual interest rate of 8%. What is the value of Marys investment at the end of 5 years?

Yield Rates
The interest rate earned by the lender is referred to yield rate earned on the investment. The expression yield rate is used in dierent investment contexts with dierent meanings. In each case it will be important to relate the meaning of the yield rate to the context in which it is being used. Example 8: Consider a 10-year loan of 10000 at i = 5%. Find the yield rate in each of the following cases. 1. The loan is repaid by a single payment at the end of 10 years.

2. The loan is repaid by 10 equal annual payments with the rst payment one year from now. Then the payments are reinvested at 3% as they are received.

3. The loan receive 10 level interest payments of 500 per year at the end of each year, plus a return of the entire 10000 principal at the end of ten years. The interest payments are also reinvested at 3%.

MATH 384 Fall 2012

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Amortization Method
Denition: An amortized loan of amount L made at time 0 at periodic interest rate i and to be repaid by n payments of amounts K1 , K2 , , Kn at times 1, 2, , n (where the payment period corresponds to the interest period) is based on the equation L = K1 v + K2 v 2 + + Kn v n1 The amortization method of loan repayment applies payments rst to interest, with excess payment applied to outstanding principal. Amortization Schedule t 0 1 2 . . . t t+1 . . . n At time t, Interest due in the payment is It Outstanding balance just after the payment is OBt Principal repaid in the payment is P Rt Example 9: Smith takes out a $100, 000 mortgage to buy a house. The mortgage is repaid with monthly payments of $716.43, starting one month after the mortgage begins, for 20 years at a nominal rate of i(12) = 6%. How much of the second payment is used to repay interest? 0 Payment Interest Due Principal Repaid Outstanding Principal L

MATH 384 Fall 2012