ACTEX Academic Series

Mathematics
of Investment
& Credit
8
th

Eighth Edition
Samuel Broverman, ph.d., asa
Samuel Broverman, Ph.D., ASA

Mathematics
of Investment
& Credit

ACTEX Learning · Greenland, New Hampshire

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Table of Contents

Preface xiii
1 INTEREST RATE MEASUREMENT 1
1.0 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Interest Accumulation and Effective Rates of Interest . . . . 5
1.1.1 Effective Rates of Interest . . . . . . . . . . . . . . . . . . 8
1.1.2 Compound Interest . . . . . . . . . . . . . . . . . . . . . 10
1.1.3 Simple Interest . . . . . . . . . . . . . . . . . . . . . . . 13
1.1.4 Comparison of Compound Interest and Simple Interest . . . . 15
1.1.5 Accumulated Amount Function . . . . . . . . . . . . . . . 17
1.2 Present Value . . . . . . . . . . . . . . . . . . . . . . . . . 18
1.2.1 Canadian Treasury Bills . . . . . . . . . . . . . . . . . . . 21
1.3 Equation of Value . . . . . . . . . . . . . . . . . . . . . . 22
1.4 Nominal Rates of Interest . . . . . . . . . . . . . . . . . . 24
1.4.1 Actuarial Notation for Nominal Rates of Interest . . . . . . . 28
1.5 Effective and Nominal Rates of Discount . . . . . . . . . . 31
1.5.1 Annual Effective Rate of Discount . . . . . . . . . . . . . . 31
1.5.2 Equivalence Between Discount and Interest Rates . . . . . . 32
1.5.3 Simple Discount and Valuation of US Treasury Bills . . . . . 33
1.5.4 Nominal Annual Rate of Discount . . . . . . . . . . . . . . 35
1.6 Force of Interest . . . . . . . . . . . . . . . . . . . . . . . 36
1.6.1 Continuous Investment Growth . . . . . . . . . . . . . . . 36
1.6.2 Investment Growth Based on the Force of Interest . . . . . . 38
1.6.3 Constant Force of Interest . . . . . . . . . . . . . . . . . . 40
1.7 Inflation and The “Real” Rate of Interest . . . . . . . . . . 41
1.8 Factors Affecting Interest Rates . . . . . . . . . . . . . . . 45
1.8.1 Government Policy . . . . . . . . . . . . . . . . . . . . . 45

v
vi Mathematics of Investment & Credit

1.8.2 Risk Premium . . . . . . . . . . . . . . . . . . . . . . . . 47

1.9 Summary of Definitions and Formulas . . . . . . . . . . . . 49
1.10 Notes and References . . . . . . . . . . . . . . . . . . . . . 52
1.11 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2 VALUATION OF ANNUITIES 67
2.0 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . 67
2.1 Level Payment Annuities . . . . . . . . . . . . . . . . . . . 69
2.1.1 Accumulated Value of an Annuity . . . . . . . . . . . . . . 69
2.1.1.1 Accumulated Value of an Annuity Some Time after
the Final Payment . . . . . . . . . . . . . . . . . . . . . 73
2.1.1.2 Accumulated Value of an Annuity with Non-Level Interest Rates 75
2.1.1.3 Accumulated Value of an Annuity With a Changing Payment . 77
2.1.2 Present Value of an Annuity . . . . . . . . . . . . . . . . . 79
2.1.2.1 Present Value of an Annuity Some Time Before Payments Begin 83
2.1.2.2 Present Value of an Annuity with Non-Level Interest Rates . . 85
2.1.2.3 Relationship Between a n i and s n i . . . . . . . . . . . . . 86
2.1.2.4 Valuation of Perpetuities . . . . . . . . . . . . . . . . . . 87
2.1.3 Annuity-immediate and Annuity-due . . . . . . . . . . . . . 89
2.2 Level Payment Annuities – Some Generalizations . . . . . . 93
2.2.1 Differing Interest and Payment Period . . . . . . . . . . . . 93
2.2.2 m-thly Payable Annuities . . . . . . . . . . . . . . . . . . 95
2.2.3 Continuous Annuities . . . . . . . . . . . . . . . . . . . . 96
2.2.4 Solving for the Number of Payments in an Annuity
(Unknown Time) . . . . . . . . . . . . . . . . . . . . . . 99
2.2.5 Solving for the Interest Rate in an Annuity (Unknown Interest) 102
2.3 Annuities With Non-constant Payments . . . . . . . . . . . 104
2.3.1 Annuities whose Payments form A Geometric Progression . . 105
2.3.1.1 Differing Payment Period and Geometric Frequency . . . . . 107
2.3.1.2 Dividend Discount Model for Valuing a Stock . . . . . . . . 108
2.3.2 Annuities whose Payments form an Arithmetic Progression . . 110
2.3.2.1 Increasing Annuities . . . . . . . . . . . . . . . . . . . . 110
2.3.2.2 Decreasing Annuities . . . . . . . . . . . . . . . . . . . 114
2.3.2.3 Continuous Annuities with Varying Payments . . . . . . . . 116
2.3.2.4 Unknown Interest Rate for Annuities with Varying Payments . 117
 Table of Contents vii

2.4 Applications and Illustrations . . . . . . . . . . . . . . . . 118

2.4.1 Yield Rates and Reinvestment Rates . . . . . . . . . . . . . 118
2.4.2 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . 122
2.4.2.1 Depreciation Method 1 – The Declining Balance Method . . . 123
2.4.2.2 Depreciation Method 2 – The Straight-Line Method . . . . . 123
2.4.2.3 Depreciation Method 3 – The Sum of Years Digits Method . . 124
2.4.2.4 Depreciation Method 4 – The Compound Interest Method . . 124
2.4.3 Capitalized Cost . . . . . . . . . . . . . . . . . . . . . . 126
2.4.4 Book Value and Market Value . . . . . . . . . . . . . . . . 128
2.4.5 The Sinking Fund Method of Valuation . . . . . . . . . . . 128
2.5 Summary of Definitions and Formulas . . . . . . . . . . . . 132
2.6 Notes and References . . . . . . . . . . . . . . . . . . . . . 134
2.7 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
3 LOAN REPAYMENT 155
3.1 The Amortization Method of Loan Repayment . . . . . . . 155
3.1.1 The General Amortization Method . . . . . . . . . . . . . 157
3.1.2 The Amortization Schedule . . . . . . . . . . . . . . . . . 159
3.1.3 Retrospective Form of the Outstanding Balance . . . . . . . 162
3.1.4 Prospective Form of the Outstanding Balance . . . . . . . . 163
3.1.5 Additional Properties of Amortization . . . . . . . . . . . . 164
3.1.5.1 Non-Level Interest Rate . . . . . . . . . . . . . . . . . . 164
3.1.5.2 Capitalization of Interest . . . . . . . . . . . . . . . . . . 165
3.1.5.3 Amortization with Level Payments of Principal . . . . . . . . 166
3.1.5.4 Interest Only With Lump Sum Principal Payment at the End of the
Amortization Period . . . . . . . . . . . . . . . . . . . . 168
3.1.6 Loan Default . . . . . . . . . . . . . . . . . . . . . . . . 168
3.2 Amortization of a Loan with Level Payments . . . . . . . . 170
3.2.1 Mortgage Loans in Canada . . . . . . . . . . . . . . . . . 175
3.2.2 Mortgage Loans in the US . . . . . . . . . . . . . . . . . 175
3.3 The Sinking-fund Method of Loan Repayment . . . . . . . 178
3.3.1 Sinking-fund Method Schedule . . . . . . . . . . . . . . . 180
3.4 Applications and Illustrations . . . . . . . . . . . . . . . . 180
3.4.1 Makeham’s Formula . . . . . . . . . . . . . . . . . . . . . 180
3.4.2 The Merchant’s Rule . . . . . . . . . . . . . . . . . . . . 183
viii Mathematics of Investment & Credit

3.4.3 The U.S. Rule . . . . . . . . . . . . . . . . . . . . . . . 183

3.5 Summary of Definitions and Formulas . . . . . . . . . . . . 185
3.6 Notes and References . . . . . . . . . . . . . . . . . . . . . 186
3.7 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
4 BOND VALUATION 201
4.1 Determination of Bond Prices . . . . . . . . . . . . . . . . 203
4.1.1 The Price of a Bond on a Coupon Date . . . . . . . . . . . 205
4.1.2 Bonds Bought or Redeemed at a Premium or Discount . . . 208
4.1.3 Bond Prices Between Coupon Dates . . . . . . . . . . . . . 210
4.1.4 Book Value of a Bond . . . . . . . . . . . . . . . . . . . 213
4.1.5 Finding the Yield Rate for a Bond . . . . . . . . . . . . . . 215
4.2 Amortization of a Bond . . . . . . . . . . . . . . . . . . . 218
4.3 Callable Bonds: Optional Redemption Dates . . . . . . . . 222
4.4 Applications and Illustrations . . . . . . . . . . . . . . . . 226
4.4.1 Bond Default and Risk Premium . . . . . . . . . . . . . . 226
4.4.2 Serial Bonds and Makeham’s Formula . . . . . . . . . . . . 229
4.4.3 Other Fixed Income Investments . . . . . . . . . . . . . . 230
4.4.3.1 Certificates of Deposit . . . . . . . . . . . . . . . . . . . 230
4.4.3.2 Money Market Funds . . . . . . . . . . . . . . . . . . . 231
4.4.3.3 Mortgage-backed Securities (MBS)T]Mortgage-backed Securities 231
4.4.4 Collateralized Debt Obligations (CDO) . . . . . . . . . . . 233
4.4.5 Treasury Inflation Protected Securities (TIPS)
and Real Return Bonds . . . . . . . . . . . . . . . . . . . 233
4.4.6 Convertible Bonds . . . . . . . . . . . . . . . . . . . . . 235
4.5 Definitions and Formulas . . . . . . . . . . . . . . . . . . . 237
4.6 Notes and References . . . . . . . . . . . . . . . . . . . . . 238
4.7 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
5 MEASURING THE RATE OF RETURN
OF AN INVESTMENT 247
5.1 Internal Rate of Return and Net Present Value . . . . . . . 248
5.1.1 Internal Rate of Return Defined . . . . . . . . . . . . . . . 248
5.1.2 Uniqueness of the Internal Rate of Return . . . . . . . . . . 251
5.1.3 Project Evaluation using Net Present Value . . . . . . . . . 254
5.2 Dollar-weighted and Time-weighted Rate of Return . . . . . 255
 Table of Contents ix

5.2.1 Dollar-weighted Rate of Return . . . . . . . . . . . . . . . 256

5.2.2 Time-weighted Rate of Return . . . . . . . . . . . . . . . 258
5.3 Applications and Illustrations . . . . . . . . . . . . . . . . 261
5.3.1 The Portfolio Method and the Investment Year Method . . . 261
5.3.2 Interest Preference Rates for Borrowing and Lending . . . . . 263
5.3.3 Another Measure for the Yield on a Fund . . . . . . . . . . 264
5.3.4 Alternative Methods of Valuing Investment Returns . . . . . 268
5.3.4.1 Profitability Index . . . . . . . . . . . . . . . . . . . . . 268
5.3.4.2 Payback Period . . . . . . . . . . . . . . . . . . . . . . 269
5.3.4.3 Modified Internal Rate of Return (MIRR) . . . . . . . . . . 269
5.3.4.4 Project Return Rate and Project Financing Rate . . . . . . . 270
5.4 Definitions and Formulas . . . . . . . . . . . . . . . . . . . 271
5.5 Notes and References . . . . . . . . . . . . . . . . . . . . . 272
5.6 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
6 THE TERM STRUCTURE OF INTEREST RATES 281
6.1 SPOT RATES OF INTEREST . . . . . . . . . . . . . . . . 286
6.2 The Relationship Between Spot Rates of Interest
and Yield to Maturity on Coupon Bonds . . . . . . . . . . 292
6.3 Forward Rates of Interest . . . . . . . . . . . . . . . . . . 295
6.3.1 Forward Rates of Interest as Deferred Borrowing
or Lending Rates . . . . . . . . . . . . . . . . . . . . . . 295
6.3.2 Arbitrage with Forward Rates of Interest . . . . . . . . . . . 296
6.3.3 General Definition of Forward Rates of Interest . . . . . . . 297
6.4 Applications and Illustrations . . . . . . . . . . . . . . . . 301
6.4.1 ARBITRAGE . . . . . . . . . . . . . . . . . . . . . . . . 301
6.4.2 Forward Rate Agreements . . . . . . . . . . . . . . . . . . 304
6.4.3 The Force of Interest as a Forward Rate . . . . . . . . . . . 308
6.4.4 At-par Yield . . . . . . . . . . . . . . . . . . . . . . . . 310
6.5 Definitions and Formulas . . . . . . . . . . . . . . . . . . . 316
6.6 Notes and References . . . . . . . . . . . . . . . . . . . . . 317
6.7 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
7 CASHFLOW DURATION AND IMMUNIZATION 325
7.1 Duration of a Set of Cashflows and Bond Duration . . . . . 327
7.1.1 Duration of a Zero Coupon Bond . . . . . . . . . . . . . . 331
x Mathematics of Investment & Credit

7.1.2 Duration of a Coupon Bond . . . . . . . . . . . . . . . . . 331

7.1.3 Duration Applied to Approximate Changes in Present Value
of a Series of Cashflows: First Order Approximations . . . . . 333
7.1.4 Duration of a Portfolio of Series of Cashflows . . . . . . . . 336
7.1.5 Duration and Shifts in Term Structure . . . . . . . . . . . . 338
7.2 Asset-liability Matching and Immunization . . . . . . . . . 340
7.2.1 Redington Immunization and Convexity . . . . . . . . . . . 342
7.2.2 Full Immunization . . . . . . . . . . . . . . . . . . . . . . 348
7.3 Applications and Illustrations . . . . . . . . . . . . . . . . 351
7.3.1 Duration Based on Changes in a Nominal Annual Yield Rate
Compounded Semiannually . . . . . . . . . . . . . . . . . 351
7.3.2 Duration Based on Changes in the Force of Interest . . . . . 353
7.3.3 Duration Based on Shifts in the Term Structure . . . . . . . 353
7.3.4 Effective Duration . . . . . . . . . . . . . . . . . . . . . 357
7.3.5 Duration and Convexity Applied to Approximate Changes
in Present Value of A Series of Cashflows: Second Order Approxi-
mations of Present Value . . . . . . . . . . . . . . . . . . 359
7.3.6 Shortcomings of Duration as a Measure of Interest Rate Risk 361
7.3.7 A Generalization of Redington Immunization . . . . . . . . . 363
7.4 Definitions and Formulas . . . . . . . . . . . . . . . . . . . 365
7.5 Notes and References . . . . . . . . . . . . . . . . . . . . . 367
7.6 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
8 INTEREST RATE SWAPS 375
8.1 Interest Rate Swaps . . . . . . . . . . . . . . . . . . . . . 375
8.1.1 Swapping a Floating-Rate Loan for a Fixed-Rate Loan . . . . 377
8.1.2 The Swap Rate . . . . . . . . . . . . . . . . . . . . . . . 381
8.1.3 Deferred Interest Rate Swap . . . . . . . . . . . . . . . . . 386
8.1.4 Market Value of an Interest Rate Swap . . . . . . . . . . . 387
8.1.5 Interest Rate Swap with Non-Annual Payments . . . . . . . 389
8.2 Comparative Advantage Interest Rate Swap . . . . . . . . . 391
8.3 Definitions and Formulas . . . . . . . . . . . . . . . . . . . 393
8.4 Notes and References . . . . . . . . . . . . . . . . . . . . . 393
8.5 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 394
9 ADVANCED TOPICS IN EQUITY INVESTMENTS
AND FINANCIAL DERIVATIVES 397
 Table of Contents xi

9.1 The Dividend Discount Model of Stock Valuation . . . . . 398

9.2 Short Sale of Stock in Practice . . . . . . . . . . . . . . . 400
9.3 Additional Equity Investments . . . . . . . . . . . . . . . . 405
9.3.1 Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . 405
9.3.2 Stock Indexes and Exchange-traded Funds . . . . . . . . . . 406
9.3.3 Over-the-counter Market . . . . . . . . . . . . . . . . . . 407
9.3.4 Capital Asset Pricing Model . . . . . . . . . . . . . . . . . 407
9.4 Financial Derivatives Defined . . . . . . . . . . . . . . . . 408
9.5 Forward Contracts . . . . . . . . . . . . . . . . . . . . . . 411
9.5.1 Forward Contract Defined . . . . . . . . . . . . . . . . . . 411
9.5.2 Prepaid Forward Price on an Asset Paying No Income . . . . 413
9.5.3 Forward Delivery Price Based on an Asset Paying No Income 414
9.5.4 Forward Contract Value . . . . . . . . . . . . . . . . . . . 414
9.5.5 Forward Contract on an Asset Paying Specific Dollar Income . 416
9.5.6 Forward Contract on an Asset Paying Percentage
Dividend Income . . . . . . . . . . . . . . . . . . . . . . 418
9.5.7 Synthetic Forward Contract . . . . . . . . . . . . . . . . . 420
9.5.8 Strategies with Forward Contracts . . . . . . . . . . . . . . 422
9.6 Futures Contracts . . . . . . . . . . . . . . . . . . . . . . 423
9.7 Commodity Swaps . . . . . . . . . . . . . . . . . . . . . . 428
9.8 Definitions and Formulas . . . . . . . . . . . . . . . . . . . 433
9.9 Notes and References . . . . . . . . . . . . . . . . . . . . . 434
9.10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 434
10 OPTIONS 441
10.1 Call Options . . . . . . . . . . . . . . . . . . . . . . . . . 442
10.2 Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . 449
10.3 Equity Linked Payments and Insurance . . . . . . . . . . . 453
10.4 Option Strategies . . . . . . . . . . . . . . . . . . . . . . . 456
10.4.1 Floors, Caps, and Covered Positions . . . . . . . . . . . . . 456
10.4.2 Synthetic Forward Contracts . . . . . . . . . . . . . . . . 460
10.5 Put Call Parity and Other Option Relationships . . . . . . . 460
10.6 More Option Combinations . . . . . . . . . . . . . . . . . 463
10.7 Using Forwards and Options for Hedging and Insurance . . 468
10.8 The Binomial Option Pricing Model For One Period . . . . 469
xii Mathematics of Investment & Credit

10.9 The Binomial Option Pricing Model For Two Periods . . . . 477
10.10 The Black-Scholes-Merton Option Pricing Model . . . . . . 484
10.11 Foreign Currency Exchange Rates . . . . . . . . . . . . . . 485
10.12 Definitions and Formulas . . . . . . . . . . . . . . . . . . . 488
10.13 Notes and References . . . . . . . . . . . . . . . . . . . . . 490
10.14 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . 491
Answers to Text Exercises 497
Bibliography 519
Websites 521
Index 523
Preface

While teaching an intermediate level university course in mathematics of invest-

ment over a number of years, I found an increasing need for a textbook that
provided a thorough and modern treatment of the subject, while incorporating
theory and applications. This book is an attempt (as an 8th edition, it must be
an eighth attempt) to satisfy that need. It is based, to a large extent, on notes
that I have developed while teaching and my use of a number of textbooks for
the course. The university course for which this book was written has also been
intended to help students prepare for the mathematics of investment topic that
is covered on one of the professional examinations of the Society of Actuaries
and the Casualty Actuarial Society. A number of the examples and exercises in
this book are taken or adapted from questions on past SOA/CAS examinations.

As in many areas of mathematics, the subject of mathematics of investment

has aspects that do not become outdated over time, but rather become the
foundation upon which new developments are based. The traditional topics of
compound interest and dated cashflow valuations, and their applications, are
developed in the first five chapters of the book. In addition, in Chapters 6 to 10,
a number of topics are introduced which have become of increasing importance in
modern financial practice over the past number of years. The past four decades
or so have seen a great increase in the use of derivative securities, particularly
financial options. The subjects covered in Chapters 6 to 9, such as the term
structure of interest rates, interest rate swaps and forward contracts, form the
foundation for the mathematical models used to describe and value derivative
securities, which are introduced in Chapter 10. This 8th edition expands on and
updates the 7th edition’s coverage of options, particularly the binomial model
for valuing options.

The purpose of the methods developed in this book is to facilitate financial val-
uations. This book emphasizes a direct calculation approach, assuming that
the reader has access to a financial calculator with standard financial functions
as well as more sophisticated computer facilitated financial calculations. Com-
puter routines can do such calculations much faster and more efficiently than
direct calculation, but it is my strong opinion that anyone using automated cal-
culation to determine crucial financial information must fully understand the
mathematical theory underlying that calculation,

xiii
xiv Mathematics of Investment & Credit

The mathematical background required for the book is a course in calculus at the
freshman level. Chapters 8 and 10 cover a couple of topics that involve the notion
of probability, but mostly at an elementary level. A very basic understanding
of probability concepts should be sufficient background for those topics.

The topics in the first five Chapters of this book are arranged in an order that is
similar to traditional approaches to the subject, with Chapter 1 introducing the
various measures of interest rates, Chapter 2 developing methods for valuing
a series of payments, Chapter 3 considering amortization of loans, Chapter 4
covering bond valuation, and Chapter 5 introducing the various methods of
measuring the rate of return earned by an investment.

The content of this book is probably more than can reasonably be covered in a
one-semester course at an introductory or even intermediate level, but it might
be possible for the material found in the SOA/CAS FM (Financial Mathematics)
Exam to be covered in a one semester course. At the University of Toronto, the
contents of this books are covered in two consecutive one-semester courses at
the Sophomore (2nd year) level.

I would like to acknowledge the support of the Actuarial Education and Research
Foundation, which provided support for the early stages of development of this
book. I would also like to thank those who provided so much help and insight in
the earlier and current editions of this book: John Mereu, Michael Gabon, Steve
Linney, Walter Lowrie, Srinivasa Ramanujam, Peter Ryall, David Promislow,
Robert Marcus, Sandi Lynn Scherer, Marlene Lundbeck, Richard London, David
Scollnick. Robert Alps, Sam Cox and Yijia Liu.

I would like to acknowledge ACTEX Learning for their great support for this
book over the years and particularly for their editorial and technical support.

Finally, I am grateful to have had the continuous support of my wife, Sue Foster,
throughout the development of each edition of this book.

Samuel A. Broverman, ASA, Ph.D. University of Toronto, May 2023

2

VALUATION OF ANNUITIES

“A nickel ain’t worth a dime anymore.”

–– Yogi Berra, former NY Yankee catcher and Baseball Hall of Fame
member

2.0 Introduction

Many financial transactions involve a series of payments, such as periodic divi-

dend payments to someone owning common stock, monthly payments on a loan,
or annual interest payments on a coupon bond. It is often the case (as in the loan
and bond examples) that the payments are made at regularly scheduled intervals
of time. In the examples in Chapter 1 that dealt with transactions involving
more than one payment, each payment was treated and valued separately. When
a transaction involves a number of payments made in a systematic way, it is of-
ten possible to apply algebraic methods to simplify the valuation of the series.
In this chapter we will develop methods for valuing a series of payments.

Prior to the availability of sophisticated calculators and computer spreadsheet

programs, it was important to have algebraic representations for series of pay-
ments that required as little calculation by hand as possible. Many of the meth-
ods developed in the past are no longer important for calculation purposes,
but some remain useful for the insight that they may provide in analyzing and
valuing a series of payments.

The generic term used to describe a series of periodic payments is annuity.

In a life insurance context, an annuity is a “life-contingent” series of payments
that are contingent on the survival of a specific individual or group of individu-
als. The more precise term for a series of payments that are not contingent on
the occurrence of any specified events is annuity-certain (an annuity whose
payments will definitely be made). Since this book deals almost entirely with
annuities-certain, we shall use the term annuity to refer to an annuity-certain,
unless otherwise specified.

67
68 CHAPTER 2

The calculations in many of the examples presented here can be done in an ef-
ficient way using a financial calculator or computer spreadsheet program. The
presentation here emphasizes understanding the underlying principles and alge-
braic relationships involved in annuity valuation.

A key algebraic relationship used in valuing a series of payments is the geometric

series summation formula
1 − xk+1 xk+1 − 1
1 + x + x2 + · · · + xk = = . (2.1)
1−x x−1
This is illustrated in the following example.

EXAMPLE 2.1 (Accumulation of a level payment annuity)

The federal government sends Smith a family allowance payment of $30 every
month for Smith’s child. Smith deposits the payments in a bank account on the
last day of each month. The account earns interest at the annual rate of 9%
compounded monthly and the interest is paid into the account on the last day
of each month. If the first payment is deposited on May 31, 2012, what is the
account balance on December 31, 2023, including the payment just made and
interest paid that day?

SOLUTION

The following line diagram illustrates the accumulation in the account from one
deposit to the next.

May 31 June 30 July 31

30 → 30(1 + j) → 30(1 + j)2 →

+30 +30(1 + j)

+30

Figure 2.1

The one-month compound interest rate is j = .0075. The balance in the account
on June 30, 2012, including the payment just deposited and the accumulated
value of the May 31 deposit is
C2 = 30(1 + j) + 30 = 30 [(1 + j) + 1] .
The balance on July 31, 2012 is
h i
C3 = C2 (1 + j) + 30 = 30 [(1 + j) + 1] (1 + j) + 30 = 30 (1 + j)2 + (1 + j) + 1 .
VALUATION OF ANNUITIES 69

Continuing
in this way we see that the balance just
after the mth deposit is
Cm = 30 (1 + j) m−1 + · · · + (1 + j) + (1 + j) + 1 , which is the accumulation
2

of those first m deposits. By applying the geometric series formula, the balance
on December 31, 2023, just after the 140th deposit is
 
30 (1 + j)139 + (1 + j)138 + · · · + (1 + j) + 1
" #
(1 + j)140 − 1
= 30
(1 + j) − 1
" #
(1.0075)140 − 1
= 30 = 7385.91.
.0075

2.1 Level Payment Annuities

2.1.1 Accumulated Value of an Annuity

In Example 2.1, the expression for the aggregate accumulated value on December
31, 2023 is

30(1 + j)139 + 30(1 + j)138 + · · · + 30(1 + j) + 30.

This is the sum of the accumulated values of the individual deposits. 30(1+j)139
is the accumulated value on December 31, 2023 of the deposit made on May 31,
2012, 30(1 + j)138 is is the accumulated value on December 31, 2023 of the
deposit made on June 30, 2012, and so on.

Let us consider a series of n payments (or deposits) of amount 1 each, made

at equally spaced intervals of time, and for which interest is at compound rate
i per payment period, with interest credited on payment dates. The accumu-
lated value of the series of payments, valued at the time of (and including) the
final payment, can be represented as the sum of the accumulated values of the
individual payments. This is

(1 + i)n − 1 (1 + i)n − 1
(1 + i)n−1 + (1 + i)n−2 + · · · + (1 + i) + 1 = = . (2.2)
(1 + i) − 1 i

This is illustrated in the following diagram. We can see from the diagram that
since the valuation point is the time that the nth deposit is made, this is actually
n − 1 periods after the first deposit. Therefore the first deposit has grown with
compound interest for n − 1 periods.
70 CHAPTER 2

0 1 2 ... n−1 n

1 (1+i)n−1

1 (1+i)n−2
... ...
1 (1+i)
1

Figure 2.2

There is standard actuarial notation and terminology that describes this annuity.

Definition 2.1 – Accumulated Value of an n-Payment Annuity

of 1 Per Period

The symbol s n i denotes the accumulated value, at the time of (and in-
cluding) the final payment of a series of n payments of 1 each made at
equally spaced intervals of time, where the rate of interest per payment
period is i.

s n i = (1 + i)n−1 + (1 + i)n−2 + · · · + (1 + i) + 1
X
n−1
(1 + i)n − 1 (2.3)
= (1 + i)t =
t=0
i

The symbol s n i and other related annuity symbols provide notation that can be
used to efficiently represent transactions that involve a series of level payments.
If there is no possibility of confusion with other interest rates in a particular
situation, the subscript i is omitted from s n i and the accumulated value is
denoted s n , without the subscript i. The number of payments in the series is
called the term of the annuity, and the time between successive payments is
called the payment period, or frequency. Note that for any interest rate i,
s 1 i = 1, but if i > 0 and n > 1, then s n i > n because of interest accumulation
on earlier deposits.

It should be emphasized that the s n i notation can be used to express the accu-
mulated value of an annuity provided the following conditions are met:

(1) the interest rate is constant at i per payment period for the full term of
the annuity

(2) the payments are of equal amount;

VALUATION OF ANNUITIES 71

(3) the payments are made at equal intervals of time, with the same frequency
as the interest rate is compounded;

(4) the accumulated value is found at the time of and including the final
payment.

This series of payments is referred to in actuarial terminology as an accumulated

annuity-immediate. When we are finding the accumulated value of a series
of payments, the phrase “annuity-immediate” indicates that the value is being
calculated at the time of the final payment. We often see a series of payments
described with the phrase “payments occur at the end of each year (or month,
etc.),” with a valuation made at the end of n years, which makes the valuation
point the time of the final payment. The conventional interpretation of this
phrase is to regard the valuation as an accumulated annuity-immediate.

Figure 2.3 plots the accumulated value of the annuity as a function of the number
of annuity payments (using a 10% interest rate).

n-Payment Accumulated Annuity-Immediate

60

50 n
(1.1) −1 n−1
s n .1 = .1
= (1.1) + ⋯ + (1.1) + 1
40

30

20

10

2 4 6 8 10 12 14 16 18 20
Number of Payments n

Figure 2.3

General reasoning suggests that if the interest rate is increased, accumulated

values increase. Figure 2.4 plots the accumulated value of a 20-payment annuity
as a function of the interest rate. If the interest rate is 0, then there is no interest
accumulation, and the accumulated value of the annuity is

s 20 i=0 = (1 + 0)19 + (1 + 0)18 + · · · + (1 + 0) + 1 = 20.

This accumulated annuity value is just the sum of the 20 annuity payments of
amount 1 each.
72 CHAPTER 2

70 19 18 20
(1+i) −1
s 20 i = (1 + i) + (1 + i) + ⋯ + (1.1) + 1 = i
60
50
40
30
20
10
i
.01 .02 .03 .04 .05 .06 .07 .08 .09 .10 .11
Interest Rate i

Figure 2.4

Equation 2.3 can be rewritten as

h i
(1 + i)n = i × s n i + 1 = i × (1 + i)n−1 + (1 + i)n−2 + · · · + (1 + i) + 1 + 1.

We can interpret this expression in the following way. Suppose that a single
amount of 1 is invested at time 0 at periodic interest rate i, so that an interest
payment of i is generated at the end of each period. Suppose further that each
interest payment is reinvested and continues to earn interest at rate i. This
is allowed to continue for n periods. Then the accumulation of the reinvested
interest, along with the original amount 1 invested (the right hand side of the
equation above), must be equal to the compound accumulation of 1 at rate i per
period invested for n periods.

EXAMPLE 2.2 (Accumulated value of an annuity-immediate)

What level amount must be deposited on May 1 and November 1 each year
from 2018 to 2025, inclusive, to accumulate to 7000 on November 1, 2025 if the
nominal annual rate of interest compounded semi-annually is 9%?

SOLUTION

A first step in translating the verbal description of this annuity into an algebraic
form is to determine the number of deposits being made. There are a total of
16 deposits (2 per year for each of the 8 years from 2018 to 2025 inclusive) and
they occur every 12 year. As a second step, we note that the 12 -year interest
rate is 4.5%, and the 21 -year payment period corresponds to the 12 -year interest
compounding period. If the level amount deposited every 21 -year is denoted by
VALUATION OF ANNUITIES 73

X, the accumulated value of the deposits at the time of the 16th (final) deposit
is  
X × (1.045)15 + (1.045)14 + · · · + 1.045 + 1
(1.045)16 − 1
=X× = X s 16 .045 = 22.719337X
.045
(note that the factor (1.045)15 arises as a result of there being 15 half-year
periods from the time of the first deposit on May 1, 2018 to the time of the 16th
deposit on November 1, 2025). Then
7000 7000 × .045 7000
X= = = = 308.11.
s 16 .045 (1.045) − 1
16 22.719337

All financial calculators have functions that calculate the accumulated value of
an annuity at the time of the final payment if the payment amount, number of
payments, and interest rate are known.

2.1.1.1 Accumulated Value of an Annuity Some Time after the

Final Payment

After a series of deposits to an account is completed, the balance in the account

can continue to accumulate with interest only. The following example illustrates
this.

EXAMPLE 2.3 (Accumulated value of an annuity some time after the

final payment)

Suppose that in Example 2.1, Smith’s child is born in April, 2012 and the
first payment is received in May and deposited at the end of May. The payments
continue and the deposits are made at the end of each month until (and including
the month of) the child’s 16th birthday. The payments cease after the 16th
birthday, but the balance in the account continues to accumulate with interest
until the end of the month of the child’s 21st birthday. What is the balance in
the account at that time?

SOLUTION

At the end of the month of the child’s 16th birthday, Smith makes the 192nd
deposit into the account. This is at the end of April, 2028 (there are 12 deposits
per year for 16 years for a total of 192 deposits). The accumulated value at that
time is
 
30 × (1.0075)191 + (1.0075)190 + · · · + (1.0075) + 1
(1.0075)192 − 1
= 30 × s 192 .0075 = 30 × = 12,792.31.
.0075
74 CHAPTER 2

Five years (60 months) later, at the end of the month of the child’s 21st birthday
(April 30, 2033), the account will have grown, with interest only, to

12,792.31(1.0075)60 = 20,028.68.

We have seen that the value at nthe time of the nth deposit of a series of n
deposits of amount 1 each is (1+i)i −1 = s n . If there are no further deposits, but
the balance continues to grow with compound interest, then the accumulated
value k periods after the nth deposit is
 
(1 + i)n−1 +(1 + i)n−2 + · · · (1 + i) + 1 × (1 + i)k
= (1 + i)n+k−1 + (1 + i)n+k−2 + · · · + (1 + i)k+1 + (1 + i)k
(1 + i)n − 1
= × (1 + i)k
i
= s n × (1 + i)k
= (Value at time n) × (growth factor from time n to time n + k).

This can be also be represented in the following way.

(1 + i)n − 1 (1 + i)n+k − (1 + i)k

s n × (1 + i)k = × (1 + i)k =
i i (2.4)
(1 + i) n−k − 1 (1 + i) − 1
k
= − = s n+k − s k .
i i

Using Equation 2.4 with n = 192 and k = 60, the accumulated value of the
account on April 30, 2033 in Example 2.3 can be written as 30[s 252 − s 60 ].

Figures 2.5a and 2.5b below illustrate the formulations given in Equation 2.4.
If the annuity payments had continued to time n + k, which is the time of valu-
ation, the accumulated value would be s n+k . Since there are not any payments
actually made for the final k payment periods, s n+k must be reduced by s k ,
the accumulated value of k payments of 1 each ending at time n + k.

Payment Number
1 2 ... n (n + 1) ... (n + k)

1 1 ... 1
↓
sn (1 + i)k · s n

Figure 2.5a
VALUATION OF ANNUITIES 75

Payment Number
1 2 ... n (n + 1) ... (n + k)

1 1 ... 1 1 ... 1 →s n+k

– 1 ... 1 → −s k

Figure 2.5b

Equation 2.4 can be reformulated as

s n+k = s n (1 + i)k + s k . (2.5)
Equation 2.5 shows that a series of payments can be separated into components,
and the accumulated value of the entire series at a valuation point can be rep-
resented as the sum of the accumulated values (at that valuation point) of the
separate component series.

2.1.1.2 Accumulated Value of an Annuity with Non-Level Interest

Rates

The concept of dividing a series of payments into subgroups and valuing each
subgroup separately can be applied to find the accumulated value of an annuity
when the periodic interest rate changes during the term of the annuity. This is
illustrated in the following modification of Example 2.1.

EXAMPLE 2.4 (Annuity accumulation with non-level interest rates)

Suppose that in Example 2.1 the nominal annual interest rate earned on
the account changes to 7.5% (still compounded monthly) as of January 1, 2018.
What is the accumulated value of the account on December 31, 2023?

SOLUTION

In a situation in which the interest rate is at one level for a period of time and
changes to another level for a subsequent period of time, in order to simplify
the algebraic analysis, it is necessary to separate the full term into separate
time intervals over which the interest rate is constant. We first calculate the
accumulated value in the account on December 31, 2017, since the nominal
interest rate is level at 9% up until this point. This accumulated value is
(1.0075)68 − 1
30 × = 30 × s 68 .0075 = 2,648.50.
.0075
76 CHAPTER 2

From January 1, 2018 onward, the accumulation in the account can be separated
into two components: the accumulation of the 2,648.50 that was on balance as of
January 1, 2018, and the accumulation of the continuing deposits from January
31, 2018 onward. The monthly rate of interest is 0.075
12 = 0.00625 from January
1, 2018 onward, so the 2,648.50 accumulates to
2,648.50 × (1.00625)72 = 4,147.86
as of December 31, 2023, and the remaining deposits continuing from January
31, 2018 accumulate to
(1.00625)72 − 1
30 × = 30 × s 72 .00625 = 2,717.36,
0.00625
for a total of 4,147.86+2,717.36 = 6,865.22. The accumulated value on December
31, 2023 can be written as
h i
30 × s 68 .0075 × (1.00625)72 + s 72 .00625 .

We can generalize the concept presented in Example 2.4. Suppose that we

consider an n+k-payment annuity with equally spaced payments of 1 per period
and with an interest rate of i1 per payment period up to the time of the nth
payment, followed by an interest rate of i2 per payment period from the time of
the nth payment onward. The accumulated value of the annuity at the time of
the final payment can be found in the following way.

(a) The accumulated value of the first n payments valued at the time of the
nth is s n i1 .

← i1 →
0 1 2 ... n−1 n

1 1 ... 1 1
↑
s n i1

(b) The accumulated value found in part (a) grows with compound interest for
an additional k periods at compound periodic interest rate i2 , to a value
of s n i × (1 + i2 )k as of time n + k.

i1 1 i2
0 1 2 ... n−1 n n+1 n+2 ... n+k

1 1 ... 1
↑
s n i1 s n i1 × (1 + i2 )k
VALUATION OF ANNUITIES 77

(c) The accumulated value of the final k payments is s k i2 .

i1 1 i2
0 1 2 ... n−1 n n+1 n+2 ... n+k

1 1 ... 1
↑
s k i2

(d) The total accumulated value at time n + k is the sum of (b) and (c), and
equals s n i × (1 + i2 )k + s k i2 .

0 1 2 ... n−1 n n+1 n+2 ... n+k

1 1 ... 1 1 1 1 ... 1
↑
s n i1 × (1 + i2 )k + s k i2

Note that if the interest rate is level over the n + k periods, so that i2 = i1 , then
Equation 2.5 is the same as the expression in (d). This method can be extended
to situations in which the interest rate changes more than once during the term
of the annuity.

2.1.1.3 Accumulated Value of an Annuity With a Changing

Payment

The relationship in Equation 2.5 can also be used to find the accumulated value
of an annuity for which the payment amount changes during the course of the
annuity. The following example illustrates this point.

EXAMPLE 2.5 (Annuity whose payment amount changes during an-

nuity term)

Suppose that 10 monthly payments of 50 each are followed by 14 monthly

payments of 75 each. If interest is at an effective monthly rate of 1%, what is
the accumulated value of the series at the time of the final payment?
78 CHAPTER 2

SOLUTION

We can use the same technique as in Example 2.3 for finding the accumulated
value of an annuity some time after the final payment. The accumulated value
of the first 10 payments of 50 each, valued at the time of the 10th payment is
50s 10 .01 . If we accumulate this amount for another 14 months (ignoring, for the
moment the remaining 14 payments of 75 each), we get the accumulated value
at time 24 (months) of the first 10 payments, which is
50s 10 .01 × (1.01)14 = 601.30.
The value of the final 14 payments valued at the time of the 14th of those
payments, which is also time 24 is
75s 14 .01 = 1,121.06.
The total accumulated value at time 24 is 1722.36. The following diagram
illustrates this accumulation.

0 1 2 ... 10 11 12 13 ... 24

50 50 ... 50
↑ ↑
50s 10 50s 10 × (1.01)14
75 75 75 ... 75
↑
75s 14

There is an alternative way of approaching the situation in Example 2.5. Note in

Figure 2.6 that the original (non-level) sequence of payments can be decomposed
into two separate level sequences of payments, both of which end at time 24.

Time 0 1 2 ··· 10 11 12 ··· 24

Original Series 50 50 ··· 50 75 75 ··· 75
New Series 1 50 50 ··· 50 50 50 ··· 50
New Series 2 25 25 ··· 25

Figure 2.6

The accumulated value (at time 24) of the alternate form of the series is
50s 24 .01 + 25s 14 .01 = 1,348.67 + 373.69 = 1,722.36.

It should be emphasized again that s n i is very specific in its meaning. It is the

valuation at the time of the n-th payment of n equally spaced payments
of 1 each with effective interest rate i per payment period.
VALUATION OF ANNUITIES 79

2.1.2 Present Value of an Annuity

The discussion up to now in this chapter has been concerned with formulating
and calculating the accumulated value of a series of payments. We now consider
the present value of an annuity, which is a valuation of a series of payments
some time before the payments begin.

EXAMPLE 2.6 (Present value of a series of payments)

Smith’s grandchild will begin a four year college program in one year. Smith
wishes to open a bank account with a single deposit today to provide some
funding for the grandchild’s college education. Smith would like the grandchild
to be able to withdraw 1000 from the account each year for four years, with the
first withdrawal taking place one year from now, and subsequent withdrawals
each year after that. Smith would like the account balance to be 0 immediately
after the final withdrawal is made four years from now. The account has an
annual effective interest rate of 6%. Determine the amount of the deposit Smith
makes today.

SOLUTION

Suppose that the amount of the initial deposit is X. If we track the account
balance after each withdrawal, we see the following:
Balance after 1st withdrawal:
X(1.06) − 1000
Balance after 2nd withdrawal:
[X(1.06) − 1000] (1.06) − 1000 = X(1.06)2 − 1000(1.06) − 1000
Balance after 3rd withdrawal:
 
X(1.06)2 −1000(1.06) (1.06) − 1000
= X(1.06)3 − 1000(1.06)2 − 1000(1.06) − 1000
Balance after 4th withdrawal:
X(1.06)4 − 1000(1.06)3 − 1000(1.06)2 − 1000(1.06) − 1000.
In order for the balance to be 0 just after the 4th withdrawal, we must have
X(1.06)4 = 1000(1.06)3 + 1000(1.06)2 + 1000(1.06) + 1000,
or equivalently,
1000 1000 1000 1000
X= + 2
+ 3
+
1.06 (1.06) (1.06) (1.06)4
h i
= 1000 v + v 2 + v 3 + v 4 = 3,465.11.
80 CHAPTER 2

Note that in Example 2.6 there is an implicit assumption that interest is credited
into the account one year after the initial deposit and every year after that.

It can be seen from Example 2.6 that the deposit amount needed is the combined
present value of the four withdrawals that will be made. The present value of
an annuity of payments is the value of the payments at the time, or some time
before, the payments begin.

Consider again a series of n payments of amount 1 each, made at equally spaced

intervals for which interest is at effective interest rate i per payment period.
The present value of the series of payments, valued one period before the first
payment, can be represented as the sum of the present values of the individual
payments:
1 1 1 1
+ 2
+ ··· + n−1
+
(1 + i) (1 + i) (1 + i) (1 + i)n
h i
= v + v 2 + · · · + v n−1 + v n = v × 1 + v + · · · + v n−1 (2.6)
1− vn 1− vn 1− 1−vn vn
=v× =   = =
1−v (1 + i) 1 − 1 1+i−1 i
1+i

Applying Equation 2.6 to Example 2.6 we see that the present value of the four
payment annuity received by Smith’s grandchild is:
" #
h i 1 − v.06
4
2 3 4
1000 v + v + v + v = 1000 = 3,465.11
.06

It is often the case that, as in Example 2.6, a valuation of a series of payments is

done one period before the first payment. There is a specific actuarial symbol
and terminology that represents the present value of such an annuity.

Definition 2.2 – Present Value of an n-Payment

Annuity- Immediate of 1 Per Period

The symbol a n i is specifically used to denote the present value of a series

of equally spaced payments of amount 1 each when the valuation point is
one payment period before the payments begin and the interest rate is i
per payment period.
X
n
1 − vn
an i = v + v2 + · · · + vn = vt = (2.7)
t=1
i
VALUATION OF ANNUITIES 81

This valuation is illustrated in the following line diagram.

0 1 2 ··· n

v ← 1
v 2 ← 1
..
.
vn ← 1
an i ← 1 1 ··· 1

Similar to the use of the notation s n , the symbol a n can be used to express the
present value of an annuity provided the following conditions are met:

(1) The interest rate is constant at i per payment period for the full term of
the annuity.
(2) There are n payments of equal amount.
(3) The payments are made at equal intervals of time, with the same frequency
as the frequency of interest compounding.
(4) The valuation point is one payment period before the first payment is
made.

A typical situation in which the present value of an annuity-immediate arises

is the repayment of a loan. In financial practice, a loan being repaid with a
series of payments is structured so that the original loan amount advanced to
the borrower is equal to the present value of the loan payments to be made by
the borrower, and it is often the case that the first loan payment is made one
payment period after the loan is made. The present value is calculated using
the loan interest rate.

EXAMPLE 2.7 (Loan repayment)

Smith has bought a new car and requires a loan of 12,000 to pay for it. The
car dealer offers Smith two alternatives on the loan:

(a) monthly payments for 3 years, starting one month after purchase, with an
annual interest rate of 12% compounded monthly, or
(b) monthly payments for 4 years, also starting one month after purchase, with
annual interest rate 15%, compounded monthly.

Find Smith’s monthly payment and the total amount paid over the course of
the repayment period under each of the two options.
82 CHAPTER 2

SOLUTION

We denote the monthly payment under option (a) by P1 and under option (b)
by P2 . “12% compounded monthly” refers to a one month interest rate of 1%,
and alternative (b) refers to a one-month interest rate of 1.25%. Since payments
begin one month (one payment period) after the loan, the equations of value for
the two options are
 
(a) 12,000 = P1 × v.01 + v.01
2 + · · · + v 36 = P × a
.01 1 36 .01 and

(b) 12,000 = P2 × a 48 .0125 .

Then
12,000 12,000(.01) 12,000
P1 = = = = 398.57,
a 36 .01 1 − (1.01)−36 30.107505
and
12,000 12,000
P2 = = = 333.97.
a 48 .0125 35.931363

The total paid under option (a) would be 36P1 = 14,348.52, and under option
(b) it would be 48 × P2 = 16,030.56.

The following two graphs, Figures 2.7a and 2.7b, illustrate the present value
of an annuity-immediate first as a function the rate of interest, and then as a
function of the number of payments. The first graph is an illustration of the
fact that as interest rates increase, present value decreases. The second graph
shows that the present value of a payment made far in the future is small and
adds little to the present value of the series.

PV
20
Present Value of a 20-payment annuity-immediate as a
18 −20
1−(1+i)
function of the interest rate, a 20 i = i
16
14
12
10
8
6
4
2
i
0.05 0.1 0.15 0.2

Figure 2.7a
VALUATION OF ANNUITIES 83

PV
10
9
8
7
6
5 Present Value of an n-payment annuity-immediate
−n
4 at 10% as a function of n, a n i =
1−(1.1)
.1
3
2
1
n
5 10 15 20 25 30 35 40 45 50

Figure 2.7b

2.1.2.1 Present Value of an Annuity Some Time Before Payments

Begin

Earlier we saw how to find the value of an accumulated annuity some time after
the final payment, Under other circumstances it may be necessary to find the
present value of a series of payments some time before the first payment is made.
This is illustrated in the following modification of Example 2.7.

EXAMPLE 2.8 (Valuation of an annuity some time before payments

begin)

Suppose that in Example 2.7 Smith can repay the loan, still with 36 payments
under option (a) or 48 payments under option (b), with the first payment made
9 months after the car is purchased in either case. Assuming interest accrues
from the time of the car purchase, find the payments required under options (a)
and (b).

SOLUTION

′ ′
We denote the new payments under options (a) and (b) by P1 and P2 , respec-
tively. Then the equation of value for option (a) is
′
h i ′
12,000 = P1 × v 9 + v 10 + · · · + v 44 = P1 × v 8 × a 36 .01 ,
which leads to
′ 12,000 12,000
P1 = = (1.01)8 × = (1.01)8 × P1 = 431.60.
v8 × a 36 .01 a 36 .01
84 CHAPTER 2

In a similar manner,
′ 12,000
P2 = (1.0125)8 × = (1.0125)8 × P2 = 368.86.
a 48 .0125

Since the payments are deferred for 8 months from their original starting date
in Example 2.7 (instead of starting in one month as in the original example,
the payments now start in 9 months, which is 8 months later than the original
start date), it should not be surprising that in each of cases (a) and (b) the new
payment is equal to the old payment multiplied by the 8-month accumulation
factor (1.0125)8 .

To generalize the situation in Example 2.8, suppose an n-payment annuity of

1 per period is to be valued k + 1 payment periods before the first payment is
made. The present value can be expressed as v k+1 + v k+2 + · · · + v k+n , which
can be reformulated as
h i
vk × v + v2 + · · · + vn = vk × an .

Since a n represents the present value of the annuity one period before the first
payment, the value k periods before that (for a total of k + 1 periods before the
first payment) should be v k × a n . With a derivation similar to that for Equation
2.4, we have
v k × a n = a n+k − a k . (2.8)

Such an annuity is called a deferred annuity. The annuity considered in

Equation 2.8 is usually called a k-period deferred, n-payment annuity-immediate
of 1 per period. This present value may be denoted by k| a n . Note that for a
k-period deferred annuity-immediate, the first payment comes k+1 periods after
the valuation date, not k periods after. Equation 2.8 can be rewritten in the
form
a n+k = a k + v k × a n = a n + v n × a k . (2.9)

Valuation of a deferred annuity is illustrated in the following line diagram.

Payment
0 1 2 ··· k k+1 ··· k+n

vk × an an ← 1 ... 1

Figure 2.8
VALUATION OF ANNUITIES 85

2.1.2.2 Present Value of an Annuity with Non-Level Interest Rates

Just as Equation 2.5 can be used for accumulated annuities, Equation 2.9 can be
applied to find the present value of an annuity for which the interest rate changes
during the term of the annuity. If we consider an n + k-payment annuity with
equally spaced payments, with an interest rate of i1 per period up to the time
of the nth payment followed by a rate of i2 per period from the nth payment
onward, the present value of the annuity one period before the first payment can
be found in the following manner.

(a) The present value of the first n payments valued one period before the first
payment is a n i1 .

(b) The present value of the final k payments valued at time n (one period
before the first of the final k payments) at rate i2 is a k i2 .

(c) The value of (b) at time 0 (one period before the first payment of the entire
series) at interest rate i1 per period over the first n periods is vin1 × a k i2 .

(d) The total present value at time 0 is the sum of (a) and (c), which is
a n i1 + vin1 × a k i2 .

This is illustrated in the following line diagram.

Payment i1 i1 i1 i2 i2
0 1 2 ··· n n+1 ··· n+k

a n i1 ← 1 1 ... 1

vin1 × a k i2 a k i2 ← 1 ... 1

Figure 2.9

EXAMPLE 2.9 (Annuity with non-level interest rates)

Smith borrows $10,000 and will repay the loan with monthly payments for
three years, with the first payment to be made one month after the loan is
received. The lender has the following schedule for nominal interest rates com-
pounded monthly on the loan:

1st year: 6%, 2nd year: 9%, 3rd year: 12%

Also, Smith’s loan payments will have the following pattern:

1st yr: X per mo., 2nd yr: X + 25 per mo., 3rd yr: X + 50 per mo.

Determine X.
86 CHAPTER 2

SOLUTION

At the time the loan is received, the present values of the first, second and third
groups of 12 monthly payments are

X a 12 .005 , (X + 25) × v.005

12
× a 12 .0075 , and (X + 50) × v.005
12
× v.0075
12
× a 12 .01 ,

respectively. The total present value is set equal to the loan amount $10,000.
Solving for X results in X = 288.21. The time diagram below illustrates the
valuation of the three separate groups of 12 payments.

.005 per mo. .0075 per mo. .01 per mo.

0 1 ... 12 13 ... 24 25 ... 36

Xa 12 .005
↑ X ... X

(X + 25) × v.005
12
× a 12 .0075 ← (X + 25) × a 12 .0075
↑ X + 25 · · · X + 25

(X + 50) × v.005
12
× v.0075
12
× a 12 .01 ← (X + 50) × a 12 .01
↑ X + 50 · · · X + 50

2.1.2.3 Relationship Between a n i and s n i

We now return to annuities with a level interest rate. The basic valuation point
for an n-payment accumulated annuity-immediate is the time of the nth payment
and the accumulated value at that time is s n i . The basic valuation point for
the present value of an n-payment annuity-immediate is one period before the
first payment, and the present value is a n i . We see that the valuation point for
the present value of the annuity is n periods earlier than the valuation point for
the accumulated value. It follows that

s n i = (1 + i)n × a n i (2.10)

and
an i = vn × sn i. (2.11)
This can be easily verified algebraically by observing that
 
(1 + i)n − 1 1 − vn
v × sn i
n
=v × n
= = an i.
i i