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4.5)
700A(10
8) = $750.04
1
= 1.037
A(t, T )
b. The present value is given by 8000 1.037
(T
t)
= $6917.91.
4.74
10
= $14, 731.49.
15.2
= $21, 325.24.
150
1
1
1
1
1
+
+
+
+
A(0, 1) A(0, 2) A(0, 3) A(0, 4) A(0, 5)
500
= $1088.30
A(0, 6)
7000
1
1
1
1
1
1
1
+
+
+
+
+
+
A(0, 10) A(0, 20) A(0, 30) A(0, 40) A(0, 50) A(0, 60) A(0, 70)
1
1
1
+
+
+
= $17, 008.34
A(0, 80) A(0, 90) A(0, 100)
1
2
3
4
5
6
20 A
,1 + A
,1 + A
,1 + A
,1 + A
,1 + A
,1
12
12
12
12
12
12
7
8
9
10
11
+A
,1 + A
,1 + A
,1 + A
,1 + A
, 1 + A (1, 1) = $243.72
12
12
12
12
12
Solution 2.4. We have cashflows of
10, 000 =
5000
7000
+
2
(1 + i)
(1 + i)4
NPV(i) =
10, 000 +
5000
7000
+
(1 + i)2
(1 + i)4
$5.36
iii. NPV(8%) =
$568.10
c. The internal yield is given by the value of i that corresponds to a root of the equation of value.
This is a quadratic in 1/(1 + i)2 and can be solved to give i = 5.98% 6% per annum. Note that
the value must be positive as a total of $12,000 is obtained from a $10,000 investment. Note also
that the root of the EoV is also i such that NPV(i) = 0; i 6% is consistent with the results of
part b.
d. The investment yields only 6% per annum and the borrowing costs exceed this. The investment
should not then go ahead unless borrowing can be obtained at a rate lower than 6%.
P =
10
20
30
100
+
+
+
(1 + i) (1 + i)2
(1 + i)3
(1 + i)5
10
20
30
100
+
+
+
(1 + i) (1 + i)2
(1 + i)3
(1 + i)5
5000A(0, 9) + 5000A(4, 9) + 20, 000A(8, 9) =5000 {A(0, 3)A(3, 5) + A(4, 5)} A(5, 8)A(8, 9) + 20, 000A(8, 9)
=5000 1.044 1.062 + 1.061 1.053 1.081 + 20, 000 1.081
=$36, 443.12
1000
1
1
1
+
+
A(0, 0) A(0, 5) A(0, 10)
=1000 1 +
1
1
+
A(0, 3)A(3, 5) A(0, 3)A(3, 5)A(5, 8)A(8, 10)
=$2376.27
Solution 3.2. In each case we begin by converting the nominal rate to an eective compounding rate.
a. 3% per annum converted half yearly is equivalent to 1.5% per 6 months. The accumulated value
is therefore 10 1.01525 = $11.61.
b. 4% per annum converted every 2 years is equivalent to 8% per 2 years. The present value is
therefore 100 1.08
= $73.50.
c. 6% per annum converted monthly is equivalent to 0.5% per month. The accumulated value is
therefore 5 1.0051012 + 7 1.005512 = $18.54.
d. 1% per annum converted half yearly is equivalent to 0.5% per 6 months. The required value is
therefore 1 1.0055
1 1.005
= 0.97.
Solution 3.3. Let the annual nominal rate converted over a period of length
rate over that time interval is the
i(p)
p .
1
p
that
1+i=
1+
i(p)
p
where i = 5.6%.
a. Our expression with p = 52 leads to i(52) = 5.452% per annum.
b. Our expression with p = 12 leads to i(12) = 5.461% per annum.
We note that
i(0.5) > i > i(12) > i(52) >
which is consistent with the definition
Solution 3.4. We have
= lim i(p) .
p!1
= e0.032t .
(t) =
t2
100
0.01t
) (t) = 0.04t
) (t) =
0.01
2
t
cos t
1+sin t
d
ln A(0, t)
dt
300e60.032
D(i0 ) =
1 dP (i0 )
P (i1 )
)
P (i0 ) di
i1
P (i0 )
'
i0
D(i0 )P (i0 )
where P (i0 ) is the price of the asset at the previous interest rate and i1 a new interest rate. Using the
data given to us, we see that
(i1
8.2(i1
0.05)}
(i0 ) =
1 dP ( 0 )
P ( 1)
)
P ( 0) d
1
P ( 0)
0
'
( 0 )P ( 0 )
where P ( 0 ) is the price of the asset at the previous force of interest and
P ( 1 ) ' P ( 0 ) {1
a. Using i1 = 5.9% )
b. Using i1 = 6.12% )
c. Using
0 )D( 0 )}
) P ( 1 ) ' 50 {1
12.3(
0.06)}
d. Using
P (i) =
10
10
110
+
+
= 10e
1 + i (1 + i)2
(1 + i)3
+ 10e
+ 110e
P0
10e
=
P
10e
+ 20e
+ 10e
2
2
+ 330e
+ 110e
3
3
P ( 1 ) ' 113.62 {1
2.75(ln 1.045
ln 1.05)} = $115.11
This estimate is close to the actual value of $115.12 which reflects that there has been a very
small change in
Solution 4.4. We consider $100 nominal of the bond. The cash flows are therefore
-$P at t = 0
$1.6 at t = 0.5
$1.6 at t = 1
.
..
$1.6 at t = 4.5
$101.6 at t = 5
a. The equation of value for this system is
P (i) = 1.6
1
1
1
100
+
+ ... +
+
= 1.6 e
(1 + i)0.5
(1 + i)1
(1 + i)5
(1 + i)5
0.5
+e
+ ... + e
+100e
P ( 1 ) ' 88.40 {1
4.63(ln(1 + i1 )
We therefore obtain
i. i1 = 5.2% )
ii. i1 = 6.3% )
iii. i1 = 7.4% )
ln 1.06)}
-$200 at t = 0
$100 at t = 2
$120 at t = 4
$x at t = 6
The price is given by the equation of value (at t = 0)
200 = 100e
+ 120e
+ xe
+ 480e
+ 6xe
These represent two simultaneous equations that can be solved using Wolfram Alpha to give x 100.69
and
1 (1+i)
i
each of n years.
a. $2 paid at the end of every year for 15 years has present value $2a15 = $23.88.
b. $340 paid at the start of every year for 25 years has present value $340a25 = $5920.47.
c. A 20-year payment stream with $50 paid at the end of the first 10 years and $100 paid at the end
of the second ten years can be considered as an immediate annuity and a deferred annuity. The
100
present value is given by $ 50 + (1+i)
a10 = $1061.24
10
d. We work in time units of 2-years and an eective interest rate of 1 + j = 1.032 . The present value
j%
of $100 paid at t = 2, 4, . . . , 20 is therefore given by $100aat
= $732.88.
10
$1 at t = 1
.
..
$1 at t = 20
$50 at t = 25
We identify the regular cash flow as an 20-year annuity.
a. The equation of value is given by
47.34 = a20 +
50
1
=
(1 + i)25
(1 + i)
i
20
50
(1 + i)25
b. Wolfram Alpha or Goal Seek can be used to determine that the equation of value is solved by
i 1.9% per annum. The keen reader may wish to implement their own numerical method to
solve this equation.
Solution 5.3. The cash flows of 2 every half-year mean that it is sensible to work in units of half
years. The dividend cash flow is then a perpetuity in arrears and the equation of value is
P (j) =
2
j
.
..
x(1 + r)n
at t = n
n #
x
1+r
1+r
1+r
=
+
+ ... +
1+r 1+i
1+i
1+i
P =x
where 1 + j =
x at j%
a
1+r n
1+i
1+r .
b. We evaluate the above expression at n = 10, x = $2, r = 3% and i = 4% per annum and obtain
P = $18.42.
c. We evaluate the above expression at n = 10, x = $2, r = 3% and i = 2% per annum and
obtain P = $20.50. Note that j is negative. This reflects that the discount rate i is less than the
inflation rate r. Each additional cash flow (as t increases) therefore adds an increasing amount
to the overall present value.
Solution 5.5. The cash flows are
-P at t = 0
x at t = 1
x + a at t = 2
.
..
x + (n
1)a at t = n
(1 + i)an n(1 + i) n
=(x a)an + a
i
P =
b. We evaluate the above expression at n = 10, x = $2, a = $1 and i = 4% per annum and obtain
P = $50.10.
A(0, t) = exp
(s)ds
0
A(0, t) = exp
A(0, t) = exp
1
t
10 e
0.001sds
0
= exp 0.0005t2
= exp
0.01t we find
A(0, t) = exp
d. Using (t) =
(0.0001s2
0.01s)ds
0.0001 3
t
3
0.005t2
2 we find
0.002 s3 + s2
2 ds
4
t
t3
= exp 0.002
+
4
3
2t
we find
A(0, t) = exp
t
0
1
e
10
ds
= exp
1
1
10
A(t1 , t2 ) = exp
t2
t1
1
(2
100
cos t) ds
= e 100 (2(t2
t1 )+sin(t1 ) sin(t2 ))
$500
A(0,)
= $469.55.
$1000
1
1
1
+
+
A(2, 5) A(2, 10) A(2, 15)
= $2533.24
(t) =
8
>
< 0.05,
>
: 0.05 + 0.003(t
0t<5
5),
t>5
and so the accumulation factor will also be a piecewise function. Using the principle of consistency, we
write
A(0, t) =
and so
A(0, t) =
8
>
< A(0, t),
>
: A(0, 5)A(5, t),
0t<5
t>5
8
>
< e0.05t ,
0t<5
3
>
+0.0015t2 +0.035t
: e 80
,
t>5
8
>
>
0.05,
>
>
<
(t) =
0.07,
>
>
>
>
: at + bt2 ,
0t<2
2t<6
t
8
>
>
A(0, t) = e0.05t
>
>
<
A(0, t) =
A(0, 2)A(2, t) = e0.1 e0.07(t 2) = e0.07t 0.04
>
>
>
>
: A(0, 2)A(2, 6)A(6, t) = e0.38 e 12 a(t2 36)+ 13 b(t3
0t<2
2t<6
216)
We have two accumulations that can be used to form two simultaneous equations
1
These can be solved (using Wolfram Alpha, say) to obtain a 0.01577 and b
0.00073.
A(0, t) = exp
t
2
0.001s ds
0
= exp
0.001 3
t
3
The payment stream is received continuously at rate (t). Consider a small element of time dt placed
at time t, the amount of cash received in this element is (t)dt and this has present value
0.001 3
3 t
t2 dt
t2 e
0.001 3
3 t
dt = $28.66
50 p0 .
b. The probability that an 18 year old does not survive to retirement at age 65 is denoted
c. The probability that a 25 year old dies before his 90th birthday is denoted
d. The probability that a 30 year old lives to her 100th birthday is denoted
47 q18 .
65 q25 .
70 p30 .
50 p0 .5 q55 .
20 p18 .q38
c. The probability that a 25 year old will die between her 70th and 80th birthday is denoted
45 p25 .10 q70 .
d. The probability that a 30 year old will die aged either 40, 50 or 60 is denoted 10 p30 .q40 + 20 p30 .q50 +
30 p30 .q60 .
t px
lx+t
lx
and
t qx
lx
lx+t
lx
leading to
10 p30 .q40
=1.85%
.e
.e
.e
p4 )
3
. 1
=0.24%
5 p0 . 2 q 5
2 p5 )
1 1 1 1 1
1 1
= . . . . . 1
.
1 2 3 4 5
6 7
=81.3%
6 0.1
6
P =6
6 0.1
4
0
0.8
0.5
0.6
3
0.1 7
7
0.4 7
7
5
0.4
P (2)
6 0.1
6
=6
6 0.1
4
0
0.8
0.5
0.6
32
0.1 7 6 0.1
76
6
0.4 7
7 6 0.1
54
0.4
0
0.8
0.5
0.6
3 2
0.1 7 6 0.09
7 6
6
0.4 7
7 = 6 0.06
5 4
0.4
0.06
0.54
0.57
0.54
3
0.37 7
7
0.37 7
7
5
0.4
(3)
6 0.063 0.564
6
=P =P P =6
6 0.063 0.555
4
0.06 0.558
3
0.373 7
7
0.382 7
7
5
0.382
P (4)
6 0.0627
6
4
3
=P =P P =6
6 0.0618
4
0.0618
0.5562
0.5571
0.5562
3
0.3811 7
7
0.3811 7
7
5
0.382
P (5)
6 0.06189
6
= P5 = P4 P = 6
6 0.06189
4
0.0618
0.55692
0.55665
0.55674
3
0.38119 7
7
0.38146 7
7
5
0.38146
Note that the n-step matrices appear to be converging towards a stationary structure. That is,
additional time steps will eventually make no dierence to the transition probabilities.
Solution 10.2. We refer to the no-claims discount model has 4 states and associated 1-step transition
probabilities shown in Figure 10.2.
a. The 1-step transition matrix is given by
2
6
6
6 0.5
6
P =6
6
6 0
4
0
0.5
0.5
7
7
0 7
7
7
7
0.5 7
5
1
P (2)
6
6
6 0.5
6
2
=P =6
6
6 0.25
4
0
0.25
0.25
7
7
0.25 7
7
7
7
0.5 7
5
1
P (3)
6
6
6 0.625
0
6
3
=P =6
6
6 0.25 0.125
4
0
0
0.125
0
0
7
7
0.25 7
7
7
7
0.625 7
5
1
Solution 10.3. The probability that a policyholder currently in State 2 will be in State 2 after 3 time
(3)
steps is given by element p22 = 0. That is there is zero probability. The reader should also convince
himself of this by looking at all possible groups of 3 movements from State 2.
Solution 10.4. A stationary distribution is such that it is unaected by a further time step. That is,
we require {ni } such that
2
n1
n2
n3
n4
6
6
6 0.5
6
6
6
6 0
4
0
0.5
0.5
7
7
0 7
7
7 = n1
7
0.5 7
5
1
n2
n3
n4
>
>
>
0.5n2 = n3
>
>
>
>
>
>
>
:0.5n3 + n4 = n4
This system is solved by any values of n1 and n4 as long as n2 = 0 = n3 . This is to be expected as the
0.9
6
6
6 0.5
6
P =6
6
6 0
4
0
0.1
0.5
0.8
7
7
0 7
7
7
7
0.2 7
5
0
The steady annual revenue is determined by the stationary distribution obtained from
2
n1
n2
n3
n4
0.9
6
6
6 0.5
6
6
6
6 0
4
0
0.1
0.5
0.8
7
7
0 7
7
7 = n1
7
0.2 7
5
0
n2
n3
n4
n2 =
n1
5
n3 =
n1
8
n1
40
2,000,000
27
400,000
27
250,000
27
50,000
27
b
a
f (x)dx '
h
(f (a = x0 ) + 4f (x1 ) + 2f (x2 ) + 4f (x3 ) + 2f (x4 ) + 4f (x5 ) + f (b = x6 ))
3
P (a < X < b) =
fX (x)dx =
a
b
a
1
p e
2
1 2
2x
dx
and so each probability can be evaluated as required to obtain the following. Note that we can approximate 1 by some finite number, say x = 10.
a. P (X < 0.5) = P ( 1 < X < 0.5) ' 69.56%
b. P (X > 1.2) = P (1 > X > 1.2) ' 11.45%
c. P (0.2 < X < 0.5) ' 11.22%
d. P (0.5 < X < 1.2) ' 19.35%
Solution 13.2. We are required to show that
E[X] =
1
1
1
xp e
2
1 2
2x
dx = 0
Of course this is true as the function is odd. However, we can evaluate it numerically to obtain
E[X] '
10
1
xp e
2
10
1
1
cos
1 2
2x
dx = 0
y2
10
p
a. We require hY (y) > 0 for y 2 (0, 2 5), which is true if > 0. Also, we require
Z
p
2 5
0
1
1
cos
y 2 dy = 1
10
p
2 5
0
b. We note that
P (0 < Y < 1) =
cos
y 2 dy ' 3.38125
10
1
1
3.38125
1
0
cos
y 2 dy ' 0.291%
10
c. Using the same approach to part b., we find that P (0 < Y <
5) ' 14.56%.
p
p
d. Using the same approach to part b., we find that P ( 5 < Y < 2 5) ' 85.42%.
Solution 13.4. We have
fX (x) = xe
(x 1)2
That is,
xe
dx = 1
= 0.5505.
0.5505xe
(x 1)2
dx ' 23.71%
0.5505xe
(x 1)2
d. We obtain
E[X] =
0.5505x2 e
dx ' 76.34%
(x 1)2
(y 12)2
dx ' 1.45
is obtained from
0 for all y 2 [8, 16] when ! > 0. The value of ! is obtained from
16
!y 3 e
(y 12)2
dy = 1
16
0.000324y 4 e
(y 12)2
16
0.000324(y
8
12.13)2 y 3 e
dy ' 12.13
(y 12)2
dy ' 0.508