Batch 4

Subject CM1
Revision Notes
For the 2019 exams

Stochastic process models

Booklet 1

Covering

Chapter 1 Data analysis

Chapter 2 Principles of actuarial modelling

The Actuarial Education Company

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CONTENTS

Contents Page

Links to the Course Notes and Syllabus 2

Overview 4
Core Reading 5
Past Exam Questions 27
Solutions to Past Exam Questions 33
Factsheet 50
Final comments 53

Copyright agreement

All of this material is copyright. The copyright belongs to Institute and

Faculty Education Ltd, a subsidiary of the Institute and Faculty of Actuaries.
The material is sold to you for your own exclusive use. You may not hire
out, lend, give, sell, transmit electronically, store electronically or photocopy
any part of it. You must take care of your material to ensure it is not used or
copied by anyone at any time.

Legal action will be taken if these terms are infringed. In addition, we may
seek to take disciplinary action through the profession or through your
employer.

These conditions remain in force after you have finished using the course.

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LINKS TO THE COURSE NOTES AND SYLLABUS

Material covered in this booklet

Chapter 1 Data analysis

Chapter 2 Principles of actuarial modelling

These chapter numbers refer to the 2019 edition of the ActEd course notes.

Syllabus objectives covered in this booklet

The numbering of the syllabus items is the same as that used by the Institute
and Faculty of Actuaries.

1.1 Data analysis

1. Describe the possible aims of data analysis (eg descriptive,

inferential and predictive).

2. Describe the stages of conducting a data analysis to solve real-

world problems in a scientific manner and describe tools suitable for
each stage.

3. Describe sources of data and explain the characteristics of different

data sources, including extremely large data sets.

4. Explain the meaning and value of reproducible research and

describe the elements required to ensure a data analysis is
reproducible.

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1.2 Describe the principles of actuarial modelling.

1. Describe why and how models are used including, in general terms,
the use of models for pricing, reserving and capital modelling.

2. Explain the benefits and limitations of modelling.

3. Explain the difference between a stochastic and a deterministic

model, and identify the advantages/disadvantages of each.

4. Describe the characteristics of, and explain the use of, scenario-
based and proxy models.

5. Describe, in general terms, how to decide whether a model is

suitable for any particular application.

6. Explain the difference between the short-run and long-run

properties of a model, and how this may be relevant in deciding
whether a model is suitable for any particular application.

7. Describe, in general terms, how to analyse the potential output from

a model, and explain why this is relevant to the choice of model.

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OVERVIEW

This booklet covers Syllabus objectives 1.1.1 to 1.1.4 and 1.2.1 to 1.2.7,
which relate to data analysis and the principles of actuarial modelling.

Breakdown of topics

The first chapter provides a brief introduction to data analysis, including the
various forms in which data can arise, the ways that it can be manipulated
and processed, and the steps that should be taken to collect and analyse
data. It also introduces the concept of a reproducible data analysis.

The process of specifying, estimating and testing stochastic process models

is the subject of the second chapter. You are expected to be able to discuss
different models, model verification and sensitivity analysis as well as to be
aware of the practicalities of using models and of communicating the results
of modelling to decision makers.

Exam questions

The general ideas of modelling and the properties of models are sometimes
examined as part of longer questions about a specific model rather than as
stand-alone questions.

However, you should be prepared for questions testing your explicit

knowledge of the ideas and definitions in the first two chapters. You should
also practise ‘data response’ questions where the question sets a particular
context, say by describing a situation, and you are asked to use your
knowledge of the issues discussed in the first two chapters to comment on
various aspects of it.

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CORE READING

All of the Core Reading for the topics covered in this booklet is contained in
this section.
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Chapter 1 – Data analysis

Introduction

1 Data analysis is the process by which data is gathered in its raw state
and analysed or processed into information which can be used for
specific purposes. This section will describe some of the different
forms of data analysis, the steps involved in the process and consider
some of the practical problems encountered in data analytics.

Aims of a data analysis

Three keys forms of data analysis will be covered in this section:

1. descriptive

2. inferential

3. predictive.
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Descriptive analysis

2 Data presented in its raw state can be difficult to manage and draw
meaningful conclusions from, particularly where there is a large
volume of data to work with. A descriptive analysis solves this problem
by presenting the data in a simpler format, more easily understood and
interpreted by the user.

Simply put, this might involve summarising the data or presenting it in

a format which highlights any patterns or trends. A descriptive analysis
is not intended to enable the user to draw any specific conclusions.
Rather, it describes the data actually presented.
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3 Two key measures, or parameters, used in a descriptive analysis are

the measure of central tendency and the dispersion. The most common
measurements of central tendency are the mean, the median and the
mode. Typical measurements of the dispersion are the standard
deviation and ranges such as the interquartile range. These
measurements are described in CS1.

It can also be important to describe other aspects of the shape of the

(empirical) distribution of the data, for example by calculating
measures of skewness and kurtosis.
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Inferential analysis

4 Often it is not feasible or practical to collect data in respect of the

whole population, particularly when that population is very large. For
example, when conducting an opinion poll in a large country, it may
not be cost effective to survey every citizen. A practical solution to this
problem might be to gather data in respect of a sample, which is used
to represent the wider population. The analysis of the data from this
sample is called inferential analysis.

The sample analysis involves estimating the parameters as described

above and testing hypotheses. It is generally accepted that if the
sample is large and taken at random (selected without prejudice), then
it quite accurately represents the statistics of the population, such as
distribution, probability, mean, standard deviation, However, this is
also contingent upon the user making reasonably correct hypothesis
about the population in order to perform the inferential analysis.

Sampling, inferential analysis and parameter estimation are covered in

more detail in CS1.
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Predictive analysis

5 Predictive analysis extends the principles behind inferential analysis in

order for the user to analyse past data and make predictions about
future events.

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It achieves this by using an existing set of data with known attributes

(also known as features), known as the training set in order to discover
potentially predictive relationships. Those relationships are tested
using a different set of data, known as the test set, to assess the
strength of those relationships.

A typical example of a predictive analysis is regression analysis, which

is covered in more detail in CS1 and CS2. The simplest form of this is
linear regression where the relationship between a scalar dependent
variable and an explanatory or independent variable is assumed to be
linear and the training set is used to determine the slope and intercept
of the line. A practical example might be the relationship between a
car’s braking distance against speed.
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The data analysis process

6 While the process to analyse data does not follow a set pattern of
steps, it is helpful to consider the key stages which might be used by
actuaries when collecting and analysing data.
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7 The key steps in a data analysis process can be described as follows:

1. Develop a well-defined set of objectives which need to be met by

the results of the data analysis

2. Identify the data items required for the analysis

3. Collection of the data from appropriate sources

4. Processing and formatting data for analysis, eg inputting into a

spreadsheet, database or other model

5. Cleaning data, eg addressing unusual, missing or inconsistent

values

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6. Exploratory data analysis, which may include:

(a) Descriptive analysis; producing summary statistics on

central tendency and spread of the data

(b) Inferential analysis; estimating summary parameters of the

wider population of data, testing hypotheses

(c) Predictive analysis; analysing data to make predictions about

future events or other data sets

7. Modelling the data

8. Communicating the results

9. Monitoring the process; updating the data and repeating the

process if required.
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8 Throughout the process, the modelling team needs to ensure that any
relevant professional guidance has been complied with. For example,
the Financial Reporting Council has issued a Technical Actuarial
Standard (TAS) on the principles for Technical Actuarial Work (TAS100)
which includes principles for the use of data in technical actuarial
work. Knowledge of the detail of this TAS is not required for CM1.

Further, the modelling team should also remain aware of any legal
requirement to be complied with. Such legal requirement may include
aspects around consumer/customer data protection and gender
discrimination.
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Data sources

9 Step 3 of the process described above refers to collection of the data

needed to meet the objectives of the analysis from appropriate
sources. As consideration of Steps 3, 4, and 5 makes clear, getting
data into a form ready for analysis is a process, not a single event.
Consequently, what is seen as the source of data can depend on your
viewpoint.

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Suppose you are conducting an analysis which involves collecting

survey data from a sample of people in the hope of drawing inferences
about a wider population. If you are in charge of the whole process,
including collecting the primary data from your selected sample, you
would probably view the ‘source’ of the data as being the people in
your sample. Having collected, cleaned and possibly summarized the
data you might make it available to other investigators in JavaScript
object notation (JSON) format via a web Application programming
interface (API). You will then have created a secondary ‘source’ for
others to use.

In this section we discuss how the characteristics of the data are

determined both by the primary source and the steps carried out to
prepare it for analysis – which may include the steps on the journey
from primary to secondary source.

Details of particular data formats (such as JSON), or of the

mechanisms for getting data from an external source into a local data
structure suitable for analysis, are not covered in CM1.
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10 Primary data can be gathered as the outcome of a designed experiment

or from an observational study (which could include a survey of
responses to specific questions). In all cases, knowledge of the details
of the collection process is important for a complete understanding of
the data, including possible sources of bias or inaccuracy. Issues that
the analyst should be aware of include:

1. whether the process was manual or automated

2. limitations on the precision of the data recorded

3. whether there was any validation at source

4. if data wasn’t collected automatically, how was it converted to an

electronic form.
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11 Where randomization has been used to reduce the effect of bias or

confounding variables it is important to know the sampling scheme
used:

1. simple random sampling

2. stratified sampling

3. another sampling method.

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12 Data may have undergone some form of pre-processing. A common

example is grouping (eg by geographical area or age band). In the past,
this was often done to reduce the amount of storage required and to
make the number of calculations manageable. The scale of computing
power available now means that this is less often an issue, but data
may still be grouped: perhaps to anonymise it, or to remove the
possibility of extracting sensitive (or perhaps commercially sensitive)
details.
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13 Other aspects of the data which are determined by the collection

process, and which affect the way it is analysed include the following:

 Cross-sectional data involves recording values of the variables of

interest for each case in the sample at a single moment in time

 Longitudinal data involves recording values at intervals over time

 Censored data occurs when the value of a variable is only partially

known, for example, if a subject in a survival study withdraws, or
survives beyond the end of the study: here a lower bound for the
survival period is known but the exact value isn’t

 Truncated data occurs when measurements on some variables

are not recorded so are completely unknown.
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Big data

14 The term big data is not well defined but has come to be used to
describe data with characteristics that make it impossible to apply
traditional methods of analysis (for example, those which rely on a
single, well-structured data set which can be manipulated and analysed
on a single computer). Typically, this means automatically collected
data with characteristics that have to be inferred from the data itself
rather than known in advance from the design of an experiment.
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15 Given the description above, the properties that can lead data to be
classified as ‘big’ include:

1. size, not only does big data include a very large number of
individual cases, but each might include very many variables, a
high proportion of which might have empty (or null) values –
leading to sparse data

2. speed, the data to be analysed might be arriving in real time at a

very fast rate – for example, from an array of sensors taking
measurements thousands of time every second

3. variety, big data is often composed of elements from many

different sources which could have very different structures – or
is often largely unstructured;

4. reliability, given the above three characteristics we can see that

the reliability of individual data elements might be difficult to
ascertain and could vary over time (for example, an internet
connected sensor could go offline for a period).

Although the four points above have been presented in the context of
big data, they are characteristics that should be considered for any
data source. For example, an actuary may need to decide if it is
advisable to increase the volume of data available for a given
investigation by combining an internal data set with data available
externally. In this case, the extra processing complexity required to
handle a variety of data, plus any issues of reliability of the external
data, will need to be considered.
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Data security, privacy and regulation

16 In the design of any investigation consideration of issues related to

data security, privacy and complying with relevant regulations should
be paramount. It is especially important to be aware that combining
different data from different ‘anonymized’ sources can mean that
individual cases become identifiable.

Another point to be aware of is that just because data has been made
available on the internet, doesn’t mean that that others are free to use it
as they wish. This is a very complex area and laws vary between
jurisdictions.
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Reproducible research

An example reference for this section is in Peng (2016). For the full
reference, see the end of this section.

17 Reproducibility refers to the idea that when the results of a statistical

analysis are reported, sufficient information is provided so that an
independent third party can repeat the analysis and arrive at the same
results.

In science, reproducibility is linked to the concept of replication which

refers to someone repeating an experiment and obtaining the same (or
at least consistent) results. Replication can be hard, or expensive or
impossible, for example if:

 the study is big

 the study relies on data collected at great expense or over many

years, or

 the study is of a unique occurrence (the standards of healthcare

in the aftermath of a particular event).

Due to the possible difficulties of replication, reproducibility of the

statistical analysis is often a reasonably alternative standard.
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Elements required for reproducibility

18 Typically, reproducibility requires the original data and the computer

code to be made available (or fully specified) so that other people can
repeat the analysis and verify the results. In all but the most trivial
cases, it will be necessary to include full documentation
(eg description of each data variable, an audit trail describing the
decisions made when cleaning and processing the data, and full
documented code). Documentation of models is covered in Subject
CP2.

Full documented code can be achieved through literate statistical

programming (as defined by Knuth, 1992, full reference at the end of
this section) where the program includes an explanation of the
program in plain language, interspersed with code snippets. Within the
R environment, a tool which allows this is R-markdown.
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19 Although not strictly required to meet the definition of reproducibility, a

good version control process can ensure evolving drafts of code,
documentation and reports are kept in alignment between the various
stages of development and review, and changes are reversible if
necessary. There are many tools that are used for version control. A
popular tool used for version control is git.

In addition to version control, documenting the software environment,

the computing architecture, the operating system, the software
toolchain, external dependencies and version numbers can all be
important in ensuring reproducibility.
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Example

As an example, in the R programming language, the command

> sessionInfo()

provides information about the operating system, version of R and

version of all R packages being used.

Where there is randomness in the statistical or machine learning

techniques being used (for example random forests or neural
networks) or where simulation is used, replication will require the
random seed to be set.
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20 Doing things ‘by hand’ is very likely to create problems in reproducing

the work. Examples of doing things by hand are:

 manually editing spreadsheets (rather than reading the raw data

into a programming environment and making the changes there)

 editing tables and figures (rather than ensuring that the

programming environment creates them exactly as needed)

 downloading data manually from a website (rather than doing it

programmatically)

 pointing and clicking (unless the software used creates an audit

trail of what has been clicked).
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The value of reproducibility

21 Many actuarial analyses are undertaken for commercial, not scientific,

reasons and are not published, but reproducibility is still valuable:

 reproducibility is necessary for a complete technical work review

(which in many cases will be a professional requirement) to
ensure the analysis has been correctly carried out and the
conclusions are justified by the data and analysis

 reproducibility may be required by external regulators and

auditors

 reproducible research is more easily extended to investigate the

effect of changes to the analysis, or to incorporate new data

 it is often desirable to compare the results of an investigation with

a similar one carried out in the past; if the earlier investigation
was reported reproducibly an analysis of the differences between
the two can be carried out with confidence

 the discipline of reproducible research, with its emphasis on good

documentation of processes and data storage, can lead to fewer
errors that need correcting in the original work and, hence,
greater efficiency.
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22 There are some issues that reproducibility does not address:

 Reproducibility does not mean that the analysis is correct. For

example, if an incorrect distribution is assumed, the results may
be wrong – even though they can be reproduced by making the
same incorrect assumption about the distribution. However, by
making clear how the results are achieved, it does allow
transparency so that incorrect analysis can be appropriately
challenged.

 If activities involved in reproducibility happen only at the end of

an analysis, this may be too late for resulting challenges to be
dealt with. For example, resources may have been moved on to
other projects.
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References

Further information on the material in this section is given in the

references:

Knuth, Donald E. (1992). Literate Programming. California: Stanford

University Center for the Study of Language and Information.
ISBN 978-0-937073-80-3.

Peng, R. D., 2016, Report Writing for Data Science in R,

www.Leanpub.com/reportwriting
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Chapter 2 – Principles of actuarial modelling

Why models are used

23 A model is an imitation of a real world system or process.

Models of many activities can be developed, for example, the economy

of a country, the workings of the human heart, the future cashflows of
the broker distribution channel of a life insurance company.
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24 Suppose we wished to ‘predict’ the effect that a real world change

would have on these three models. In some cases it might be (1) too
risky, or (2) too expensive or (3) too slow, to try a proposed change in
the real world even on a sample basis. Trying out the change first
without the benefit of a model could have serious consequences.

The economy might go into recession costing a government the next

election, the patient might die and the life office could suffer a surge in
new business but at highly unprofitable premium rates.
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Parameters

25 A model enables the possible consequences to be investigated. The

effect of changing certain input parameters can be studied before a
decision is made to implement the plans in the real world.
____________

26 To build a model of a system or process, a set of mathematical or

logical assumptions about how it works needs to be developed.

The complexity of a model is determined by the complexity of the

relationships between the various model parameters. For example, in
modelling a life office, consideration must be given to issues such as
regulations, taxation and cancellation terms. Future events affecting
investment returns, inflation, new business, lapses, mortality and
expenses also affect these relationships.
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Data

27 In order to produce the model and determine suitable parameters, data

need to be considered and judgements need to be made as to the
relevance of the observed data to the future environment. Such data
may result from past observations, from current observations (such as
the rate of inflation) or from expectations of future changes.

Where observed data are considered to be suitable for producing the

parameters for a chosen model, statistical methods can be used to fit
the data.
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Objectives

28 Before finalising the choice of model and parameters, it is important to

consider (1) the objectives for creation and (2) the use of the model.
For example, in many cases there may not be a desire to create the
most accurate model, but instead to create a model that will not
understate costs or other risks that may be involved.

How models are used

While in reality a modelling process does not follow a rigid pattern of

prescribed steps, it is helpful in introducing the topic to imagine a set
of key steps. In practice, actuaries who build and use models move
back and forth between these key steps continuously to improve the
model.
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29 The key steps in a modelling process can be described as follows:

1. Develop a well-defined set of objectives that need to be met by the

modelling process.

2. Plan the modelling process and how the model will be validated.

3. Collect and analyse the necessary data for the model.

4. Define the parameters for the model and consider appropriate

parameter values.

5. Define the model initially by capturing the essence of the real

world system. Refining the level of detail in the model can come at
a later stage.

6. Involve experts on the real world system you are trying to imitate
so as to get feedback on the validity of the conceptual model.

7. Decide on whether a simulation package or a general purpose

language is appropriate for the implementation of the model.
Choose a statistically reliable random number generator that will
perform adequately in the context of the complexity of the model.

8. Write the computer program for the model.

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9. Debug the program to make sure it performs the intended

operations in the model definition.

10. Test the reasonableness of the output from the model.

11. Review and carefully consider the appropriateness of the model in

the light of small changes in input parameters.

12. Analyse the output from the model.

13. Ensure that any relevant professional guidance has been complied
with. For example the Board for Actuarial Standards has issued
Technical Actuarial Standards on data, modelling and reporting:
TAS D, TAS M and TAS R. (A knowledge of the detail of these
TASs is not required for CT4.)

14. Communicate and document the results and the model.

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Advantages of models

30 In actuarial work, one of the most important benefits of modelling is

that systems with long time frames – such as the operation of a
pension fund  can be studied in compressed time.

Other benefits include:

 Complex systems with stochastic elements such as the operation

of a life insurance company cannot be properly described by a
mathematical or logical model that is capable of producing results
that are easy to interpret. Simulation modelling is a way of
studying the operation of a life insurance company.

 Different future policies or possible actions can be compared to

see which best suits the requirements or constraints of a user.

 In a model of a complex system we can usually get control over the

experimental conditions so that we can reduce the variance of the
results output from the model without upsetting their mean values.
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Disadvantages

31 However, models are not the simple solution to all actuarial problems 
they have drawbacks that must be understood when interpreting the
output from a model and communicating the results to clients.

The drawbacks include:

 Model development requires a considerable investment of time,

and expertise.

The financial costs of development can be quite large given the

need to check the validity of the model’s assumptions, the
computer code, the reasonableness of results and the way in
which results can be interpreted in plain language by the target
audience.

 In a stochastic model, for any given set of inputs each run gives
only estimates of a model’s outputs. So to study the outputs for
any given set of inputs, several independent runs of the model are
needed.
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32 As a general rule, models are more useful for comparing the results of
input variations than for optimising outputs.
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33 Models can look impressive when run on a computer so that there is a

danger that one gets lulled into a false sense of confidence. If a model
has not passed the tests of validity and verification its impressive
output is a poor substitute for its ability to imitate its corresponding
real world system.
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34 Models rely heavily on the data input. If the data quality is poor
or lacks credibility then the output from the model is likely to be
flawed.

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It is important that the users of the model understand the model and
the uses to which it can be safely put. There is a danger of using a
model as a ‘black box’ from which it is assumed that all results are
valid without considering the appropriateness of using that model for
the particular data input and the output expected.
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35 It is not possible to include all future events in a model. For example, a

change in legislation could invalidate the results of a model, but may
be impossible to predict when the model is constructed.

It may be difficult to interpret some of the outputs of the model. They

may only be valid in relative rather than absolute terms, as when, for
example comparing the level of risk of the outputs associated with
different inputs.
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Stochastic and deterministic models

36 If it is desired to represent reality as accurately as possible the model

needs to imitate the random nature of the variables. A stochastic
model is one that recognises the random nature of the input
components. A model that does not contain any random component is
deterministic in nature.
____________

37 In a deterministic model, the output is determined once the set of fixed

inputs and the relationships between them have been defined. By
contrast, in a stochastic model the output is random in nature  like the
inputs, which are random variables. The output is only a snapshot or
an estimate of the characteristics of the model for a given set of inputs.
Several independent runs are required for each set of inputs so that
statistical theory can be used to help in the study of the implications of
the set of inputs.

Whether one wishes to use a deterministic or a stochastic model

depends on whether one is interested in the results of a single
‘scenario’ or in the distribution of results of possible ‘scenarios’.

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A deterministic model will give one the results of the relevant

calculations for a single scenario; a stochastic model gives
distributions of the relevant results for a distribution of scenarios. If
the stochastic model is investigated by using ‘Monte Carlo’ simulation,
then this provides a collection of a suitably large number of different
deterministic models, each of which is considered equally likely.
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38 A deterministic model is really just a special (simplified) case of a

stochastic model.
____________

39 The results for a deterministic model can often be obtained by direct

calculation, but sometimes it is necessary to use numerical
approximations, either to integrate functions or to solve differential
equations.
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40 If a stochastic model is sufficiently tractable, it may be possible to

derive the results one wishes by analytical methods. If this can be
done it is often preferable to, and also often much quicker than, Monte
Carlo simulation. One gets precise results and can analyse the effect
of changes in the assumptions more readily.
____________

41 Many practical problems, however, are too complicated for analytical

methods to be used easily, and Monte Carlo simulation is an extremely
powerful method for solving complicated problems.
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42 But if even part of a model can be treated analytically, it may provide a

check on any simulation method used. It may be possible to use a
deterministic method to calculate the expected values, or possibly the
median values, for a complicated problem, where the distributions
around these central values are estimated by simulation.
____________

43 One also needs to recognise that a simulation method generally

provides ‘what if?’ answers; what the results are on the basis of the
assumptions that have been made. It is much harder to use simulation
to provide the optimum solution; in other words to find the set of
assumptions that maximises or minimises some desired result.
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44 A further limitation is that the precision of a simulated result depends

on the number of simulations that are carried out.
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Discrete and continuous state spaces and time sets

45 The state of a model is the set of variables that describe the system at
a particular point in time taking into account the goals of the study. It
is possible to represent any future scenarios as states, as will be
developed in the later chapters.
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46 Discrete states are where the variables exhibit step function changes in
time. For example from a state of alive to dead, or an increase in the
number of policies for an insurer.
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47 Continuous states are where the variables change continuously with

respect to time: for example, real time changes in values of
investments.
____________

48 The decision to use a discrete or continuous state model for a

particular system is driven by the objectives of the study, rather than
whether or not the system itself is of a discrete or continuous nature.
____________

49 A model may also consider time in a discrete or a continuous way.

This may reflect the fact that outputs from the model are only required
at discrete points in time, or may be to satisfy the objectives of the
modelling.
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50 One cannot in practice use Monte Carlo simulation for a continuous

time problem; one has to discretise the time step.

This can be done with whatever precision one likes, but the higher the
precision the longer the time taken to process any particular model.
This may or may not be a limitation in practice. And it should be
remembered that some results for continuous time, continuous space
models cannot be obtained by discrete simulation at all.
____________

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Scenario-based and proxy models

51 Most models depend on many input parameters. A scenario-based

model would take into consideration a particular scenario; that is a
series of input parameters based on this scenario. Different scenarios
would be useful in decision analysis as one can evaluate the expected
impact of a course of action.

The projected valuation of assets and liabilities for an insurer can be

very complex, requiring significant runs of Monte Carlo simulation.
Therefore, proxy models are used to replace Monte Carlo simulations.
These are expected to be faster but less accurate.

For example, a Monte Carlo simulation evaluating the total claims paid
each year of a car insurer may depend on the number of cars insured
and written premium (this is too simplistic for a real-life example). A
Monte-Carlo simulation would provide a range of results, including the
mean for different input scenarios.

However, given a range of inputs and outputs, a regression function

can be set up based on these two parameters and their derivatives
(such as squared value). This would then act as a proxy model for the
actual expected total amount of claims paid for other intermediate
values.
____________

Suitability of a model

52 In assessing the suitability of a model for a particular exercise it is

important to consider the following:

(1) The objectives of the modelling exercise.

(2) The validity of the model for the purpose to which it is to be put.

(3) The validity of the data to be used.

(4) The validity of the assumptions.

(5) The possible errors associated with the model or parameters used
not being a perfect representation of the real world situation being
modelled.

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(6) The impact of correlations between the random variables that

‘drive’ the model.

(7) The extent of correlations between the various results produced

from the model.

(8) The current relevance of models written and used in the past.

(9) The credibility of the data input.

(10) The credibility of the results output.

(11) The dangers of spurious accuracy.

(12) The ease with which the model and its results can be
communicated.

(13) Regulatory requirements.

____________

53 The stability of the relationships incorporated in the model may not be

realistic in the longer term. For example exponential growth can
appear linear if surveyed over a short period of time. If changes can be
predicted they can be incorporated in the model, but often it must be
accepted that longer-term models are suspect.

Models are by definition, simplified versions of the real world. They

may therefore ignore ‘higher order’ relationships which are of little
importance in the short term, but which may accumulate in the longer
term.
____________

Analysing the output of a model

54 Statistical sampling techniques are needed to analyse the output of a

model, as a simulation is just a computer-aided statistical sampling
project.

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The actuary must exercise great care and judgement at this stage of
the modelling process as the observations in the process are
correlated with each other and the distributions of the successive
observations change over time. The useless and fatally attractive
temptation of assuming that the observations are independent and
identically distributed is to be avoided.
____________

55 If there is a real world system against which results can be compared,

a ‘Turing’ test should be used. In a Turing test, experts on the real
world system are asked to compare several sets of real world and
model data without being told which are which. If these experts can
differentiate between the real world and model data, their techniques
for doing so could be used to improve the model.
____________
Sensitivity testing

56 It is important to test the reasonableness of the output from the model

against the real world if possible. An examination of the sensitivity of
the outputs to small changes in the inputs or their statistical
distributions should be carried out.
____________

57 The appropriateness of the model should then be reviewed, particularly

if small changes in inputs or their statistical distributions give rise to
large changes in the outputs. In this way, the key inputs and
relationships to which particular attention should be given in designing
and using the model can be determined.

The model should be tested by designing appropriate simulation

experiments. Through this process the model can be refined.
____________

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Communication of the results

58 The final step in the modelling process is the communication and

documentation of the results and the model itself to others. The
communication must be such that it takes account of the knowledge of
the target audience and their viewpoint. A key issue here is to make
sure that the client accepts the model as being valid and a useful tool
in decision-making. It is important to ensure that any limitations on the
use and validity of the model are fully appreciated.
____________

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PAST EXAM QUESTIONS

This section contains all the Subject CT4 exam questions from 2008 to 2017
that are related to the topics covered in this booklet.

Solutions are given after the questions. These give enough information for
you to check your answer, including working, and also show you what an
adequate examination answer should look like. Further information may be
available in the Examiners’ Report, ASET or Course Notes. (ASET can be
ordered from ActEd.)

We have not provided a cross-reference grid for this booklet as the material
in Chapter 1 is new and so has no past paper questions relating to it. All the
past paper questions that follow relate to the material in Chapter 2, which
was previously in Subject CT4.

1 Subject CT4 April 2008 Question 4

Describe the benefits and limitations of modelling in actuarial work. [6]

2 Subject CT4 September 2008 Question 1

You work for a consultancy which has created an actuarial model and is now
preparing documentation for the client.

List the key items you would include in the documentation on the model. [4]

3 Subject CT4 April 2009 Question 3

List the benefits and limitations of modelling in actuarial work. [5]

4 Subject CT4 September 2009 Question 2

(i) List the key steps in constructing a new actuarial model. [4]

You work for an actuarial consultancy which is taking over responsibility for a
modelling process which has previously been conducted in house by a
client.

(ii) Discuss the extent to which the steps required for this task differ from
those listed in your answer to (i). [2]
[Total 6]

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5 Subject CT4 April 2010 Question 5

Ten years ago, a confectionery manufacturer launched a new product, the

Scrummy Bar. The product has been successful, with a rapid increase in
consumption since the product was first sold. In order to plan future
investment in production capacity, the manufacturer wishes to forecast the
future demand for Scrummy Bars. It has data on age-specific consumption
rates for the past ten years, together with projections of the population by
age over the next twenty years. It proposes the following modelling strategy:
 extrapolate past age-specific consumption rates to forecast age-specific
consumption rates for the next 20 years
 apply the forecast age-specific consumption rates to the projected
population by age to obtain estimated total consumption of the product
by age for each of the next 20 years
 sum the results to obtain the total demand for each year.

Describe the advantages and disadvantages of this strategy. [5]

6 Subject CT4 September 2010 Question 1

Following a review of the results of a stochastic model run, an actuary

requests that a parameter is changed. The change is not expected to alter
the results significantly, but results on the final basis are required in order to
complete a report. Unfortunately the actuarial student who produced the
original model run is away on study leave, and so the revised run is
assigned to a different student.

When the revised results are produced, they are significantly different from
the original results.

Discuss possible reasons why the results are different. [3]

7 Subject CT4 September 2010 Question 2

Compare the characteristics of deterministic and stochastic models, by

considering the relationship between inputs and outputs. [4]

8 Subject CT4 September 2010 Question 3

The government of a small island state intends to set up a model to analyse

the mortality of the island’s population over the past 50 years.

Describe the process that would be followed to carry out the analysis. [6]

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9 Subject CT4 April 2011 Question 3

Describe the ways in which the design of a model used to project over only a
short time frame may differ from one used to project over fifty years. [4]

10 Subject CT4 September 2011 Question 5(i)

(i) List the factors which should be considered in assessing the suitability
of a model for a particular exercise. [3]

11 Subject CT4 April 2012 Question 6

(i) List the advantages and disadvantages of using models in actuarial

work. [4]

A new town is planned in a currently rural area. A model is to be developed

to recommend the number and size of schools required in the new town.
The proposed modelling approach is as follows:

 The current age distribution of the population in the area is multiplied by

the planned population of the new town to produce an initial population
distribution.

 Current national fertility and mortality rates by age are used to estimate
births and deaths.

 The births and deaths are applied to the initial population distribution to
generate a projected distribution of the town’s population by age for
each future year, and hence the number of school age children.

(ii) Discuss the appropriateness of the proposed modelling approach. [5]

[Total 9]

12 Subject CT4 September 2012 Question 1

Describe two benefits and two limitations of using models in actuarial work.
[4]

13 Subject CT4 September 2012 Question 2

A large company wishes to construct a model of sickness rates among its

employees to use in evaluating the present and future financial health of its
sick pay scheme. Outline factors which the company should take into
consideration when developing the model. [5]

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14 Subject CT4 April 2013 Question 1

Describe the differences between deterministic and stochastic models. [4]

15 Subject CT4 September 2013 Question 4

(i) State what needs to be assessed when considering the suitability of a

model for a particular purpose. [5]

A city has care homes for the elderly. When an elderly person in the city is
no longer able to cope alone at home they can move into a care home
where they will be looked after until they die.

The city council runs some of the care homes and is reviewing the number of
rooms it needs in all the council-run care homes. The following model has
been proposed.

The age distribution of the city population over the age of 60 is taken from
the latest census. Statistics from the national health service on the average
age of entry into a care home and the proportion of elderly who go into
council-run care homes are applied to the current population to give the rate
at which people enter care homes. A recent national mortality table is then
applied to give the rate at which care home residents die.

(ii) Discuss the suitability of this model. [4]

[Total 9]
16 Subject CT4 April 2014 Question 1

State the benefits of modelling in actuarial work. [4]

17 Subject CT4 April 2014 Question 3

Explain what a stochastic model is and how it differs from a deterministic

model. [4]

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18 Subject CT4 September 2014 Question 2

(i) List eight factors which should be considered when assessing whether a
model is suitable for a particular application. [4]

(ii) State, giving reasons, a factor which would be particularly important in

each of the following applications:

 Calculating the pension contribution for a medium-sized pension

scheme.
 Helping a friend construct a business case to secure a loan from a
bank for his new ice cream van venture.
 Working out how much it will cost to buy each member of your team
their favourite cake on your birthday in six months’ time. [3]
[Total 7]

19 Subject CT4 April 2015 Question 4

(i) List the stages you would go through in creating a model. [4]

(ii) Discuss, for three of these stages, the specific issues that could arise
when creating a model to price a new sickness benefit product. [3]
[Total 7]

20 Subject CT4 September 2015 Question 2

Describe the differences between a stochastic and a deterministic model. [4]

21 Subject CT4 September 2015 Question 5(i)

(i) Describe why models are used in actuarial work. [4]

22 Subject CT4 April 2016 Question 2

List the advantages and disadvantages of using models in actuarial work. [4]

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23 Subject CT4 September 2016 Question 7

(i) List EIGHT factors which should be considered when deciding whether
a model is suitable for a particular purpose. [4]

A colleague has been asked to present a model which might be used to

determine the number of new schools required throughout a country over the
next 40 years. He forgot all about it until the last minute when he was
reading an article in a newspaper about immigration and education which
provided some figures to back up the article. Your colleague has the
following suggestion for a model:

 Start with the number of children in the education system over the last
twenty years (as provided by the country’s central statistical office).
Project these forward using a straight line approach.
 Use the number of immigrants predicted to arrive in each of the next five
years as given in the newspaper article. Apply to this an estimate of
‘number and age of children for each immigrant’ also provided by the
newspaper. Project this forward also using a straight line approach.
 Add the two together to get the total number of children in the education
system for the next 40 years.

(ii) Assess whether this model is suitable with regards to SIX of the factors
which you listed in your answer to part (i). [6]
[Total 10]

24 Subject CT4 September 2017 Question 5

(i) List the key steps involved in developing an actuarial model. [4]

(ii) Comment on considerations which would apply if you were developing a

model of the spread of a newly discovered disease. [3]
[Total 7]

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SOLUTIONS TO PAST EXAM QUESTIONS

The solutions presented here are just outline solutions for you to use to
check your answers. See ASET for full solutions to some questions.

1 Subject CT4 April 2008 Question 4

The benefits of modelling in actuarial work include the following:

 Systems with long time frames, such as the operation of a pension fund,
can be studied quickly.
 Systems with stochastic elements, such as the operation of a life
insurance company, can be modelled more realistically to capture the
randomness.
 Different future policies or possible actions can be compared to see
which best suits the requirements or constraints of a user.
 In a model of a complex system, we can usually get much better control
over the experimental conditions so that we can reduce the variance of
the output results without changing their mean values.
 We can study the impact of changing inputs before making decisions,
and hence avoid the costs and risks of making real changes.

The limitations include:

 Model development requires a considerable investment of time and
expertise, which can be costly.
 A stochastic model can only give estimates of a model’s outputs. So to
study the outputs for any given set of inputs, several independent runs
of the model are needed.
 Models are more useful for comparing the results of input variations
than they are for optimising outputs.
 Models can look impressive when run on a computer so that there is a
danger that one gets lulled into a false sense of confidence. Models
must still pass tests of validity and verification.
 Models rely heavily on the data input. If the data quality is questionable
then the output from the model will also be suspect.

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 There is a danger of using a model as a ‘black box’ from which it is

assumed that all results are valid, without the users properly
understanding the scope of the model.
 It is not possible to include all future events in a model. For example, a
change in legislation could invalidate the results of a model, but this may
be impossible to predict when the model is constructed.
 It may be difficult to interpret some of the outputs from a model.

2 Subject CT4 September 2008 Question 1

The following should be included:

 Purpose of the model and its objectives.
 Recommended/required hardware and software specifications.
 Whether the model is deterministic or stochastic.
 The parameters used and their assumed values.
 Probability models assumed for any stochastic variables.
 Data sources used.
 Input variables.
 Output variables, and how they should be interpreted.
 Description of the statistical sampling carried out on the results (if
stochastic).
 Description of calculation routines.
 Assumptions and approximations made.
 Correlations and linkages built in to the model.
 Instructions as to how the model should be used and operated
(eg number of simulations).
 Circumstances in which the model will produce valid output.
 How the model could be adapted or extended for other uses.
 Sensitivity of output to changes in input variables.
 Sensitivity of output to the assumptions and approximations made in the
model.
 Appropriate range of projection period; effect of time period on model
validity.

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 Correlations within the model outputs.

 How the model can be checked for accuracy and for reasonableness.

3 Subject CT4 April 2009 Question 3

See Core Reading paragraphs 31 to 35.

4 Subject CT4 September 2009 Question 2

(i) Key steps in constructing a new actuarial model

The key steps in constructing a new model are:

1. Develop a well-defined set of objectives that need to be met by the
modelling process, ie state the point of the exercise.
2. Plan the modelling process and how the model will be validated.
3. Collect and analyse the necessary data for the model.
4. Define the parameters for the model and consider appropriate
parameter values.
5. Define the model firstly by capturing the essence of the real-world
system. Refining the level of detail in the model can come at a later
stage.
6. Involve people with expert knowledge of the real-world system you are
trying to imitate so as to get feedback on the validity of the conceptual
model.
7. Decide on whether a simulation package or a general-purpose language
is appropriate for the implementation of the model. Choose a
statistically reliable random number generator that will perform
adequately in the context of the complexity of the model.
8. Write the computer program for the model.
9. Debug the program to make sure it performs the intended operations
defined in the initial model specification.
10. Test the reasonableness of the output from the model.
11. Review and carefully consider the appropriateness of the model in the
light of small changes in input parameters.
12. Analyse the output from the model.

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13. Ensure that any relevant professional guidance has been complied with,
eg the Board for Actuarial Standards has issued Technical Actuarial
Standards on data, modelling and reporting (TAS D, TAS M and
TAS R).
14. Communicate and document the results of the model to the client.

(ii) How the steps differ when there is an existing model

The list of steps in (i) would still be relevant, though they may be applied in a
different order. So, the consultancy may start off by looking at the output of
the model to decide if it is reasonable, before considering the detail of how
the model works.

Some of the steps may involve reviewing the appropriateness of the existing
model. For example:
 the input data will already be established, but they should be reviewed
to check that they are still up-to-date and appropriate
 the form of the model and the language in which it is written would be
reviewed to establish if it is still suitable.

It would be a good idea to involve the previous modellers in the process if

their expertise is available, to understand the approach taken and decisions
made. It may be possible to reuse some of their model documentation.

The amount of work required will depend on whether the existing model is to
be used as it is, adapted, or completely rewritten. Any changes will need to
be agreed with the company, and it would be necessary to understand the
effect on the model’s output of any such changes and communicate these
clearly.

5 Subject CT4 April 2010 Question 5

This method has the advantage that it uses a fairly simple model. However,
it is a deterministic model that doesn’t allow for any possible (random)
variation in the future.

It is good that the approach focuses on the underlying factors, ie age, and it
is probably true that consumption of sweets is highly age-specific. But it may
depend on other factors too, eg changes in eating habits, health campaigns,
the state of the economy.

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The model should produce reliable results if the underlying variables exhibit
clear trends that can be extrapolated in an obvious way. However, the rapid
increase cannot continue indefinitely and the model needs to take account of
this.

Unless birth rates (or migration rates) have been changing a lot recently,
taking into account ages may constitute spurious accuracy. A sufficiently
accurate alternative may just be to project the total sales directly without
worrying about age, eg by fitting a time series model. Factors such as
advertising campaigns for the product or the pricing strategy are likely to
have far more impact than changes in the age profile.

In order to fit the model it will be necessary to obtain data on the age of the
consumers. This will be difficult, especially since sweets for children,
particularly very young children, are often bought by older family members,
not by the children themselves.

The accuracy of the model could be tested using a chi-square goodness of

fit test, and as more data are obtained in the future, the model could be
improved.

6 Subject CT4 September 2010 Question 1

Reasons why the results might be different include the following:

 the assumption that changing the parameter value will not significantly
alter the results may be wrong
 the inputs to the model may have changed, eg one of the inputs might
be a current share price or interest rate, or a different set of random
numbers may have been used by the second student
 the model may be time-dependent in some way
 one (or both) of the runs of the model may contain errors, possibly
because the second student did not fully understand the process
 the model may not have been robust, ie it might only give valid results
over a very narrow range of parameter values.

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7 Subject CT4 September 2010 Question 2

A stochastic model is a model where at least one of the inputs is a random

variable. Since the input contains a random component, the output of a
stochastic model is also random. Each run of a stochastic model gives an
estimate of the feature of interest, and several independent runs are carried
out for each set of inputs. Because of the random nature of the model, each
run will produce a different result. So if we repeat the process several times
with the same set of inputs (but a different set of random numbers), we get a
sample of different outputs. The distribution of the output can then be
analysed statistically. (Note that a stochastic model can reproduce the same
output if the same random numbers are re-used.)

In contrast, the inputs to a deterministic model are all fixed quantities. So,
for a deterministic model, the output is determined once the fixed set of
inputs and the relationships between them have been specified. In other
words, repeated runs of a deterministic model with the same set of inputs will
give exactly the same output. The output of a deterministic model is only a
snap-shot or an estimate of the characteristics of the model for a given set of
inputs.

A deterministic model is really just a special (simplified) case of a stochastic

model.

8 Subject CT4 September 2010 Question 3

See Core Reading paragraph 29

Specific to this case, we should also mention:

 What aspects of mortality are to be analysed,

eg average mortality rates, split of males/females, trends in mortality
over the last 50 years.
 The numbers of deaths over the last 50 years and any available census
data. Problems may arise as some of the data may be missing or
inaccurate, and recording practices may have changed over the last 50
years.
 We should identify the main features of mortality.

 We could check that the model is a good fit to the actual mortality
experience of the island over subsets of the last 50 years.

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9 Subject CT4 April 2011 Question 3

For 4 marks, you would only need to come up with 4 of the ideas or
examples.

The short-term model may need to produce more accurate results than the
50-year model. For example, the short-term model may be required for
budgeting purposes, whereas the 50-year model may only be needed to
gauge the possible effects of general trends.

More detailed output may be required from the short-term model, eg a

breakdown of population numbers by age, rather than just the overall
numbers.

Different variables may be used in the short-term and long-term models. For
example, in the short-term model it may be acceptable to ignore inflation,
mortality, company defaults and general trends. It may also be possible to
ignore interactions between variables in the short-term model for simplicity.

The same variables may be modelled differently in the short term, eg using
different statistical distributions or using different approximations. For
example, exponential growth is approximately linear over short time scales.

The short-term model may need to incorporate realistic current values for
parameters such as interest rates and mortality rates, whereas it might be
sufficient to assume average long-term values for these parameters in the
50-year model.

Similarly, more detailed data might be required for the short-term model, eg
current asset values or individuals’ salaries, current state of health and
marital status.

In a short-term model it may be acceptable to ignore possible changes in the

overall framework, such as new legislation, changes in tax rules, the
emergence of new diseases, changes in the general economic climate, the
effects of wars or new technology.

In a short-term model, it may be acceptable to ignore the possibility of

extreme events that occur only rarely, eg earthquakes or severe stock
market crashes.
We might select a different time step for projections in the short-term model
(eg daily or monthly), compared to a yearly time step in the 50-year model.

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A short-term stochastic model is likely to produce a fairly ‘tight’ spread of

results and the output may only need to show best estimates, whereas the
output from the long-term model may need to show confidence bands or
worst case / best case scenarios.

Sensitivity testing and stress testing may be less important for the short-term
model, as there is less time for the results to diverge because of stochastic
effects.

10 Subject CT4 September 2011 Question 5(i)

(i) Factors in assessing the suitability of a model

Factors to be considered when assessing the suitability include:

 the objectives of the modelling exercise

 the validity of the model for the purpose to which it is to be put

 the validity of the data to be used

 the possible errors associated with the model or parameters used not
being a perfect representation of the real world situation being modelled

 the impact of correlations between the random variables that ‘drive’ the
model

 the extent of correlations between the various results produced from the
model
 the current relevance of models written and used in the past

 the credibility of the data input

 the credibility of the results output

 the dangers of spurious accuracy

 the ease with which the model and its results can be communicated.

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11 Subject CT4 April 2012 Question 6

(i) Advantages / disadvantages of using models in actuarial work

Advantages

Models allow you to investigate the future behaviour of a process in

compressed time.

Models allow you to vary the input parameters to see what effect this will
have.

Models allow you to compare a large number of different scenarios (in a

short space of time) to determine the best strategy.

Models allow you to consider scenarios that would not be feasible in

practice, eg because of cost or other business considerations.

Models allow you to study the stochastic nature of the results, eg using
Monte Carlo simulation.

Disadvantages

Models can be time-consuming and expensive to set up.

Models may not capture sufficiently accurately the real-world situation.

Models require simplifying assumptions that might turn out to be wrong, eg

they may ignore certain features (eg inflation) or certain types of events that
could occur (eg catastrophes).

Models can give an impression of greater accuracy and reliability than they
actually have, and so may create a sense of false security.

Some models may be difficult to explain to clients.

Stochastic models require a large number of simulations to be carried out to

get accurate results.

Users of the model may not understand fully how it works and its limitations.

The results from models are dependent on the data used, which may be
inaccurate or unreliable.

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(ii) Appropriateness of the proposed modelling approach

The model uses an established method that is straightforward to understand.

If the rural area is in a developed country, mortality will probably have little
effect (since the mortality of children and those of child-bearing age will be
relatively low) and so the model could be simplified by ignoring this factor.

The results will probably be accurate over the short term (ie for the next few
years), but may become less reliable if applied over longer periods.

The model makes no allowance for migration, ie people moving in or out of

the town. This could be an important factor (particularly in the current
difficult economic climate) that could increase or reduce the size of the
population.

It should be possible to obtain sufficiently accurate data about the current

age distribution. However, the model assumes that the initial population
profile of the town will be the same as for the rural area in which it is located,
which may not be true for a new town. It will depend on the type of housing
(eg family homes, bungalows for the elderly) and the type of employment
opportunities available in the town.

It should be possible to obtain reliable estimates for fertility rates and

mortality rates, but these may change in the future, eg people may have
fewer children during an economic recession. Also the rates may be
different in different areas, so that the national rates would not be
appropriate.

There could be changes to government education policy that would affect

the number of school places required. For example, the ages when school
attendance is compulsory could be changed or new types of school could be
introduced (eg boarding schools, where children are schooled outside the
area).

12 Subject CT4 September 2012 Question 1

See Core Reading paragraphs 30 and 31. Core Reading paragraphs 32, 33,
34 and 35 are also possible answers.

13 Subject CT4 September 2012 Question 2

The nature of the existing sickness data the company possesses since the
model can only be as complex as the data will allow it to be.

Whether the company has made any previous attempts to model sickness
rates among its employees, and how successful they were.

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The complexity of the model. More complex models will be costlier to

prepare and run, but eventually there may be diminishing returns to
additional complexity.

General trends in sickness at the national level may need to be built in.

Whether the company plans to change the characteristics of its employees.

For example, it may plan to recruit more mature staff.

The ease of communication of the model.

The budget and resources available for the construction of the model.

The capability of its staff and whether outside consultants are required.

Who the model will be used by and whether they are capable of
understanding and using it.

Consider if the model needs to interface with models of other aspects of the
company’s business (eg taking data from other systems).

14 Subject CT4 April 2013 Question 1

A stochastic model is one that recognises the random nature of the variables
in the model. A deterministic model is one that does not include a random
component.

With a deterministic model, once the input values have been set, the output
values can be determined. A stochastic model uses random numbers to do
the calculations and the outputs will be random in nature.

A deterministic model will give a single set of results (based on a given set of
input parameters), whereas a stochastic model will produce a distribution of
possible results.

The results of a deterministic model can often be determined by direct

calculation, whereas stochastic models tend to be more complicated and
often need to use Monte Carlo simulation.

Deterministic models can be considered to be a special case of stochastic

models, where the random component is set to zero.

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15 Subject CT4 September 2013 Question 4

(i) Factors in assessing the suitability of a model

See Core Reading pragraph 52.

(ii) Assess the suitability of the model

The model should be able to meet the objective of determining the number
of rooms required.

Reliable data should be available about the current population numbers.

The model makes a number of assumptions. In particular:

 the population numbers and age distribution of the city may change

 the rooms may not always be fully occupied, eg while a room is being
reallocated to a new resident
 different types of rooms may be needed for different types of occupants
(eg severely disabled people)

 economic factors and new government schemes may be introduced that

could significantly affect the take-up rates

 mortality rates have improved in recent years and may continue to do so

in the future.

Other similar models used previously by other town councils may be able to
be adapted and used here.

The model should be quite easy and cheap to set up.

It can probably be set up on a spreadsheet so that it won’t need specially

trained staff to use it.

The results of the model should be quite easy to present and explain.

16 Subject CT4 April 2014 Question 1

See Core Reading paragraph 30.

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17 Subject CT4 April 2014 Question 3

A stochastic model is one that recognises the random nature of the variables
in the model. A deterministic model is one that does not include a random
component.

With a deterministic model, once the input values have been set, the output
values can be determined. A stochastic model uses random numbers to do
the calculations and the outputs will be random in nature.

A deterministic model will give a single set of results (based on a given set of
input parameters), whereas a stochastic model will produce a distribution of
possible results.

The results of a deterministic model can often be determined by direct

calculation, whereas stochastic models tend to be more complicated and
often need to use Monte Carlo simulation.

Deterministic models can be considered to be a special case of stochastic

models, where the random component is set to zero.

18 Subject CT4 September 2014 Question 2

(i) Factors in assessing the suitability of a model

See Core Reading paragraph 52.

(ii) Factors that are particularly important

Calculating pension contributions

A point that would be of particular importance here would be:

 the possible errors associated with the model or parameters used not
being a perfect representation of the real world situation being
modelled.

When carrying out a pension scheme valuation it is important to use realistic

values for parameters such as the investment return, the rate of salary
increases and the rate of price inflation that will apply to benefit payments.

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Ice cream van venture

A point that would be of particular importance here would be:

 the ease with which the model and its results can be communicated.

It is important that your friend will be able to understand the model and can
present it clearly to the business loans manager at the bank.

Birthday cakes

A point that would be of particular importance here would be:

 the dangers of spurious accuracy.

The cost is relatively small and staff will come and go. So there’s no point
trying to be too precise about the cost.

19 Subject CT4 April 2015 Question 4

(i) Stages in creating a model

See Core Reading paragraph 29.

(ii) Specific issues for 3 stages

Step 3 – Data

We will need past data for sickness and recovery rates. If we do not have
these from other similar policies, we may need to use industry data or
national statistics.

Step 5 – Define the model

A jump process may be suitable with transition rates depending on age and
duration. It will be important to specify precise definitions of sickness and
recovery.

Step 10 – Reasonableness

One of the outputs of the model would be the premium rates for different
ages. We should compare these with the rates for any similar policies
available in the market to ensure that they are not uncompetitive and don’t
appear to be too low.

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There were many other possible answers here. For example:

Step 11 – Sensitivity testing

We could make small changes to each important parameter (sickness rates,

recovery rates, expenses) to ensure that the impact on the premium rates is
not huge. If it is, we may need to review the product design.

Step 13 – Professional guidance (and regulatory environment)

Could Solvency II have an impact on the cost of capital, making the product
uncompetitive or uneconomic?

20 Subject CT4 September 2015 Question 2

See Core Reading paragraphs 36 to 38.

21 Subject CT4 September 2015 Question 5(i)

(i) Why models are used in actuarial work

Models are an imitation of a real-world system or process.

Models allow us to make predictions about the real world.

Many actuarial activities are suitable for modelling.

Models allow systems to be studied in compressed time.

Stochastic models allow us to see the range of possible outcomes that might
arise.

It is usually cheaper and quicker to use a model than to try things out in real
life.

Models avoid the risks involved with trying things out in real life.

Models allow us to study the impact of changes before they have happened.

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22 Subject CT4 April 2016 Question 2

See Core Reading paragraphs 31 to 35.

23 Subject CT4 September 2016 Question 7

(i) Factors for deciding whether a model is suitable

See Core Reading paragraph 52.

(ii) Assess the suitability of the model

Objectives of the modelling exercise

The model will produce overall estimates for the number of schools required,
but will not give an accurate geographical breakdown of where they are
required, which would be essential information.

Validity of the model for the purpose to which it is to be put

This is too simplistic an approach for a model that might be used for
planning the number of schools required. Incorrect estimates could prove
very expensive.

Validity of the data to be used

The historical data from the central statistical office should be reliable, but
the predictions in the newspaper relating to immigrants may not be
trustworthy.

Possible errors associated with the model or parameters used not being a
perfect representation of the real world situation being modelled

The model does not allow for people leaving the country. Nor does it take
into account the geographical distribution of the immigrants (eg more may
come to big cities such as London). The straight line approach does not
allow for ‘baby booms’ or sudden influxes of immigrants at particular times
(eg due to economic conditions).

Credibility of the results output

The results of this model are unlikely to be reliable – especially over a 40-
year period, which would span two generations of children.

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Dangers of spurious accuracy

As this is a grossly oversimplified model, it would be important to treat the

results only as very rough estimates.
Ease with which the model and its results can be communicated

This model would be relatively easy to explain – but also easy to criticise!

Cost of buying or construction, and of running the model

This model would be very cheap to set up and maintain, as it requires very
little data and does not need any special software. However, the
government probably has much better models set up already.

24 Subject CT4 September 2017 Question 5

(i) Key steps

See Core Reading paragraph 29.

(ii) Considerations for a model of a newly discovered disease

There will be very little past data here, although it may be possible to use
data from other similar diseases.

It will be particularly important to get the views from medical experts, eg

when setting the assumptions.

Sensitivity testing and continuous monitoring will be important to ensure that

the model reflects the way the disease is spreading and that the model
incorporates appropriately all the latest information.

The model could include parameters for:

 how many people are already infected

 the probabilities for different outcomes for an infected person

 the probability of an infected person passing it on

 the average time that people are contagious (which might be indefinite)

 the effectiveness of the treatments being used.

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FACTSHEET

This factsheet summarises the main methods, formulae and information

required for tackling questions on the topics in this booklet.

Chapter 1 – Data analysis

There are three forms of data analysis:

 descriptive, which presents the data in a simplified manner which is

easier to understand

 inferential, which involves analysing data from a sample of the

population and inferring results from that sample onto the whole
population

 predictive, which involves taking past data with known attributes

(training set) and looking for predictive relationships.

Data can be described as follows, depending on the manner in which is has

been processed:

 Cross-sectional data involves recording values of the variables of

interest for each case in the sample at a single moment in time

 Longitudinal data involves recording values at intervals over time

 Censored data occurs when the value of a variable is only partially

known

 Truncated data occurs when measurements on some variables are not

recorded so are completely unknown.

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Reproducability of data analysis is important because of the following:

 reproducibility is necessary for a complete technical work review

 reproducibility may be required by external regulators and auditors

 reproducible research is more easily extended to investigate the effect

of changes to the analysis, or to incorporate new data

 it is often desirable to compare the results of an investigation with a

similar one carried out in the past

 the discipline of reproducible research

However the following problems exist with reproducability:

 Reproducibility does not mean that the analysis is correct.

 If activities involved in reproducibility happen only at the end of an

analysis, this may be too late for resulting challenges to be dealt with.

Chapter 2 – Principles of actuarial modelling

A model is an imitation of a real world system or process. In actuarial work,

it is usually represented by one or more equations involving random
variables.

It enables possible consequences to be investigated without carrying out the

actions themselves.

There are benefits to modelling, such as the possibility of looking at long-

term phenomena in an accelerated time frame, but there are also limitations
that must be considered such as the time and expertise required to develop
and run a model.

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While there is no rigid pattern for the construction and use of a model,
14 key steps can be considered:
1. Develop a well-defined set of objectives that need to be met by the
modelling process.
2. Plan the modelling process and how the model will be validated.
3. Collect and analyse the necessary data for the model.
4. Define the parameters for the model and consider appropriate
parameter values.
5. Define the model firstly by capturing the essence of the real-world
system. Refining the level of detail in the model can come at a later
stage.
6. Involve the experts on the real-world system you are trying to model in
order to get feedback on the validity of the conceptual model.
7. Decide on whether a simulation package or general-purpose language
is appropriate for the implementation of the model. If necessary, choose
a statistically reliable random number generator that will perform
adequately in the context and complexity of the model.
8. Write the computer program for the model.
9. Debug the program to make sure it performs the intended operations in
the model definition.
10. Test the reasonableness of the output from the model.
11. Review and carefully consider the appropriateness of the model in the
light of small changes to the input parameters.
12. Analyse the output from the model.
13. Ensure that any relevant professional guidance has been complied with.
For example the Board for Actuarial Standards has issued Technical
Actuarial Standards on data, modelling and reporting

14. Communicate and document the results and the model.

To build a model, the suitability of that model to the objectives should be

borne in mind. Some mathematical or logical assumptions about the
workings of the real-world system must be made. Input parameters need to
be chosen, possibly by statistical analysis of past data. Sensitivity analysis
of the dependence of the output on these parameters can be carried out.

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A model may be stochastic or deterministic. For stochastic models it is

better to use direct calculation if possible, but in complex situations it may be
necessary to use Monte Carlo simulation on a computer.

The precision of Monte Carlo simulations depends on the number of runs.

Models may also be constructed in discrete or continuous time and with

discrete or continuous state spaces. Monte Carlo simulations have to be run
in discrete time.

To validate the model, the output needs to be examined. This can be done
using a Turing test – can an expert tell the difference between a set of
simulated outputs and actual occurrences?

The results need to be communicated to other people. The key questions

are whether or not the user understands the scope and limitations of both
the model and the results.

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FINAL COMMENTS

The examiners can ask a question on any part of the Core Reading. So
there is always a chance that some ‘new’ area – ie one that has not been
examined before – might come up.

Beware though that you don’t just write down what you can remember from
the Core Reading without considering carefully the specific situation given in
the question. The examiners are keen to see that you can apply your
knowledge to the question in front of you.

We also stress that learning proofs, definitions, methods, etc is not a

substitute to understanding. Many of the methods we have described in this
booklet (and in the course) become ‘obvious’ once you have fully understood
the concepts involved. So, if you do not feel that the subject has become
‘obvious’ to you, then it may be that you need to take a step back and revisit
the course notes, or maybe do some more end of chapter questions.

Bear in mind that Chapter 1 of the CM1 course is new, and there will be no
past paper questions on this material.

Finally we stress again how useful and important it is to do some exam

questions, including preferably a complete past paper or Mock Exam, under
examination conditions. Only by completing questions successfully in the
time and conditions available in the exam room will you know if you are fully
prepared to sit the exam.

We hope that you have found this booklet to be a useful revision aid. If you
have any comments that might help us to improve this set of booklets then
please email your ideas to [email protected].

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NOTES

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NOTES

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NOTES

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NOTES

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Subject CM1
Revision Notes
For the 2019 exams

Discounting, accumulating and

annuities

Booklet 2

covering

Chapter 3 Cashflow models

Chapter 4 The time value of money
Chapter 5 Interest rates
Chapter 7 Discounting and accumulating
Chapter 8 Level annuities
Chapter 9 Increasing annuities

The Actuarial Education Company

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CONTENTS

Contents Page
Links to the Course Notes and Syllabus 2
Overview 4
Core Reading 5
Past Exam Questions 49
Solutions to Past Exam Questions 70
Factsheet 117

Copyright agreement

All of this material is copyright. The copyright belongs to Institute and Faculty
Education Ltd, a subsidiary of the Institute and Faculty of Actuaries. The
material is sold to you for your own exclusive use. You may not hire out, lend,
give, sell, transmit electronically, store electronically or photocopy any part of
it. You must take care of your material to ensure it is not used or copied by
anyone at any time.

Legal action will be taken if these terms are infringed. In addition, we may
seek to take disciplinary action through the profession or through your
employer.

These conditions remain in force after you have finished using the course.

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LINKS TO THE COURSE NOTES AND SYLLABUS

Material covered in this booklet

Chapter 3 Cashflow models

Chapter 4 The time value of money
Chapter 5 Interest rates
Chapter 7 Discounting and accumulating
Chapter 8 Level annuities
Chapter 9 Increasing annuities

These chapter numbers refer to the 2019 edition of the ActEd course notes.

Syllabus items covered in this booklet

1.3 Describe how to use a generalised cashflow model to describe financial

transactions.

1. State the inflows and outflows in each future time period and discuss
whether the amount or the timing (or both) is fixed or uncertain for a
given cashflow process.

2. Describe in the form of a cashflow model the operation of financial

instruments like a zero-coupon bond, a fixed-interest security, an
index-linked security, cash on deposit, an equity, an interest-only
loan, a repayment loan, and an annuity-certain; and insurance
contracts like an endowment, a term assurance, a contingent
annuity, car insurance and health cash plans.

2.1 Show how interest rates may be expressed in different time periods.

1. Describe the relationship between the rates of interest and discount

over one effective period arithmetically and by general reasoning.

2. Derive the relationships between the rate of interest payable once

per measurement period (effective rate of interest) and the rate of
interest payable p (>1) times per measurement period (nominal rate
of interest) and the force of interest.

3. Calculate the equivalent annual rate of interest implied by the

accumulation of a sum of money over a specified period where the
force of interest is a function of time.

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2.3 Describe how to take into account the time value of money using the
concepts of compound interest and discounting.

1. Accumulate a single investment at a constant rate of interest under

the operation of simple and compound interest.

2. Define the present value of a future payment.

3. Discount a single investment under the operation of a simple

(commercial) discount at a constant rate of discount.

2.4 Calculate the present value and accumulated value for a given stream of
cashflows under the following individual or combination of scenarios:

1. Cashflows are equal at each time period.

2. Cashflows vary with time which may or may not be a continuous

function of time.

3. Some of the cashflows are deferred for a period of time.

4. Rate of interest or discount is constant.

5. Rate of interest or discount varies with time which may or may not be
a continuous function of time.

2.5 Define and derive the following compound interest functions (where
payments can be in advance or in arrears) in terms of i , v , n , d , d ,
i ( p) and d ( p ) :

1. an , sn , a( p ) , s ( p ) , an , sn , a( p ) , s( p ) , an and sn

n n n n

2. m an , m a( p ) , m a
 ,
n m a( p ) and m an
n n

3. (Ia )n , (Ia)n , (Ia )n , (Ia )n and the respective deferred annuities.

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OVERVIEW

This booklet covers Syllabus objectives 2.1, 2.3, 2.4 and 2.5, which relate to
the time value of money and annuities.

Breakdown of topics

We discount and accumulate single payments or regular payments using

interest rates, discount rates and forces of interest.

The regular payments can be level payments at equally spaced intervals;

increasing or decreasing payments at equally spaced intervals or a
continuously payable payment stream.

Exam questions

There are lots of past exam questions on finding the present value or
accumulated value of a continuous payment stream using a force of interest
that depends upon time.

However, the rest of these chapters tend to be examined in the context of the
work covered in the later chapters.

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CORE READING

All of the Core Reading for the topics covered in this booklet is contained in
this section.

Chapter 1 – Cashflow models

The practical work of the actuary often involves the management of

various cashflows. These are simply sums of money, which are paid or
received at different times. The timing of the cashflows may be known
or uncertain. The amount of the individual cashflows may also be known
or unknown in advance. From a theoretical viewpoint one may also
consider a continuously payable cashflow.

For example, a company operating a privately owned bridge, road or

tunnel will receive toll payments. The company will pay out money for
maintenance, debt repayment and for other management expenses.
From the company’s viewpoint the toll payments are positive cashflows
(i.e. money received) while the maintenance, debt repayments and other
expenses are negative cashflows (ie money paid out). Similar cashflows
arise in all businesses. In some businesses, such as insurance
companies, investment income will be received in relation to positive
cashflows (premiums) received before the negative cashflows (claims
and expenses).

Where there is uncertainty about the amount or timing of cashflows, an

actuary can assign probabilities to both the amount and the existence
of a cashflow. In this Subject we will assume that the existence of the
future cashflows is certain.

In this section, we provide examples of practical situations with

cashflows that are assumed to be certain. In reality this may not be the
case as the counterparty of a particular cashflow may not be able to pay
out. For example, a company may fail and not be able to pay out interest
on issued bonds.
____________

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1 The term ‘zero-coupon bond’ is used to describe a security that is simply

a contract to provide a specified lump sum at some specified future date.
For the investor there is a negative cashflow at the point of investment
and a single known positive cashflow on the specified future date.
____________

2 A body such as an industrial company, a local authority, or the

government of a country may raise money by floating a loan on the stock
exchange.

In many instances such a loan takes the form of a fixed-interest security,

which is issued in bonds of a stated nominal amount.
____________

3 The characteristic feature of such a security in its simplest form is that

the holder of a bond will receive a lump sum of specified amount at some
specified future time together with a series of regular level interest
payments until the repayment (or ‘redemption’) of the lump sum.

The investor has an initial negative cashflow, a single known positive

cashflow on the specified future date, and a series of smaller known
positive cashflows on a regular set of specified future dates.
____________

4 With a conventional fixed-interest security, the interest payments are all

of the same amount. If inflationary pressures in the economy are not
kept under control, the purchasing power of a given sum of money
diminishes with the passage of time, significantly so when the rate of
inflation is high. For this reason some investors are attracted by a
security for which the actual cash amount of interest payments and of
the final capital repayment are linked to an ‘index’ which reflects the
effects of inflation.
____________

5 Here the initial negative cashflow is followed by a series of unknown

positive cashflows and a single larger unknown positive cashflow, all on
specified dates. However, it is known that the amounts of the future
cashflows relate to the inflation index. Hence these cashflows are said
to be known in ‘real’ terms.

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Note that in practice the operation of an index-linked security will be

such that the cashflows do not relate to the inflation index at the time of
payment, due to delays in calculating the index. It is also possible that
the need of the borrower (or perhaps the investors) to know the amounts
of the payments in advance may lead to the use of an index from an
earlier period.
____________

6 If cash is placed on deposit, the investor can choose when to disinvest

and will receive interest additions during the period of investment. The
interest additions will be subject to regular change as determined by the
investment provider. These additions may only be known on a day-to-
day basis. The amounts and timing of cashflows will therefore be
unknown.
____________

7 Equity shares (also known as ‘shares’ or ‘equities’ in the UK and as

‘common stock’ in the USA) are securities that are held by the owners
of an organisation. Equity shareholders own the company that issued
the shares. For example if a company issues 4,000 shares and an
investor buys 1,000, the investor owns 25% of the company. In a small
company all the equity shares may be held by a few individuals or
institutions. In a large organisation there may be many thousands of
shareholders.

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 proportion to the number of shares owned.

The distribution of profits to shareholders takes the form of regular

payments of dividends. Since they are related to the company profits
that are not known in advance, dividend rates are variable. It is expected
that company profits will increase over time. It is therefore expected
also that dividends 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.
____________

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8 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. They 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.
____________

9 Since equities do not have a fixed redemption date, but can be held in
perpetuity, we may assume that dividends continue indefinitely (unless
the investor sells the shares or the company buys them back), but it is
important to bear in mind the risk that the company will fail, in which
case the dividend income will cease and the shareholders would only be
entitled to any assets which remain after creditors are paid. The future
positive cashflows for the investor are therefore uncertain in amount
and may even be lower, in total, than the initial negative cashflow.
____________

10 An ‘interest-only’ loan is a loan that is repayable by a series of interest

payments followed by a return of the initial loan amount.
____________

11 In the simplest of cases, the cashflows are the reverse of those for a
fixed-interest security. The provider of the loan effectively buys a fixed-
interest security from the borrower.

In practice, however, the interest rate need not be fixed in advance. The
regular cashflows may therefore be of unknown amounts.

It may also be possible for the loan to be repaid early. The number of
cashflows and the timing of the final cashflows may therefore be
uncertain.
____________

12 A repayment loan is a loan that is repayable by a series of payments that

include partial repayment of the loan capital in addition to the interest
payments.

In its simplest form, the interest rate will be fixed and the payments will
be of fixed equal amounts, paid at regular known times.

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The cashflows are similar to those for an annuity certain.

As for the ‘interest-only’ loan, complications may be added by allowing

the interest rate to vary or the loan to be repaid early. Additionally, it is
possible that the regular repayments could be specified to increase (or
decrease) with time. Such changes could be smooth or discrete.
____________

13 It is important to appreciate that with a repayment loan the breakdown

of each payment into ‘interest’ and ‘capital’ changes significantly over
the period of the loan. The first repayment will consist almost entirely
of interest and will provide only a very small capital repayment. In
contrast, the final repayment will consist almost entirely of capital and
will have a small interest content.
____________

14 An annuity certain provides a series of regular payments in return for a

single premium (ie a lump sum) paid at the outset. The precise
conditions under which the annuity payments will be made will be
clearly specified. In particular, the number of years for which the annuity
is payable, and the frequency of payment, will be specified. Also, the
payment amounts may be level or might be specified to vary – for
example in line with an inflation index, or at a constant rate.
____________

15 The cashflows for the investor will be an initial negative cashflow

followed by a series of smaller regular positive cashflows throughout
the specified term of payment. In the case of level annuity payments,
the cashflows are similar to those for a fixed-interest security.

From the perspective of the annuity provider, there is an initial positive

cashflow followed by a known number of regular negative cashflows.

The theory can be extended to deal with annuities where the payment
term is uncertain, that is, for which payments are made only so long as
the annuity policyholder survives.
____________

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Insurance contracts

16 The cashflows for the examples covered in this section differ than the
previous in that the frequency, severity, and/or timing of the cashflow
may be unkown. For example, a typical cover of a life cover may have a
specified date on which a pre-agreed amount is paid on survival – but
the benefit payment may not be paid if the individual does not survive.

Similarly, a pension pays out a known amount at a specified time per

month, but only if the individual is alive. Typically the severity is known
and pre-specified in life-insurance contracts.

On the other hand, a non-life (general) insurance cover tends to not have
known severities. For example, the cost of a car accident may range
from a few pounds in the case of a small collision to millions in case of
a major accident that caused death.
____________

17 A pure endowment is an insurance policy which provides a lump sum

benefit on survival to the end of a specified term usually in return for a
series of regular premiums. In some cases a lump-sum premium is paid.
In this case, the cashflows for the policyholder will be a negative
cashflow at inception and a positive cashflow at the end of term, only if
the policyholder has survived.

The cashflows for the policyholder will be a series of negative cashflows

throughout the specified term or until death, if earlier. A large, positive
cashflow occurs at the end of the term, only if the policyholder has
survived. If the policyholder dies before the end of the term there is no
positive cashflow.

From the perspective of the insurer, there is a stream of regular positive

cashflows which cease at a specified point (or earlier, if the policyholder
dies) followed by a large negative cashflow, contingent on policyholder
survival.
____________

18 An endowment assurance is similar in that it provides a survival benefit

at the end of the term, but it also provides a lump sum benefit on death
before the end of the term. The benefits are provided in return for a
series of regular premiums

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The cashflows for the policyholder will be a series of negative cashflows

throughout the specified term or until death, if earlier, followed by a large
positive cashflow at the end of the term (or death, if earlier). Depending
on the terms of the policy, the amount payable on death may not be the
same as that payable on survival.

From the perspective of the insurer, there is a stream of regular positive

cashflows which cease at a specified point (or earlier, if the policyholder
dies) followed by a large negative cashflow. The negative cashflow is
certain to be paid, but the timing of that payment depends on
whether/when the policyholder dies.
____________

19 A term assurance is an insurance policy which provides a lump sum

benefit on death before the end of a specified term usually in return for
a series of regular premiums.

The cashflows for the policyholder will be a series of negative cashflows

throughout the specified term or until death (or one negative cashflow
at inception if paid on a lump-sum basis), if earlier, followed by a large
positive cashflow payable on death, if death occurs before the end of the
term. If the policyholder survives to the end of the term there is no
positive cashflow.

From the perspective of the insurer, there is a stream of regular positive

cashflows which cease at a specified point (or earlier, if the policyholder
dies) followed by a large negative cashflow, contingent on policyholder
death during the term.

Generally, the negative cashflow (death benefit), if it occurs, is

significantly higher than the positive cashflow (premiums), when
compared to, say, a pure endowment. This is because, for each
individual policy, the probability of the benefit being paid is generally
lower than for endowments because it is contingent on death, rather
than on survival.
____________

20 A contingent annuity is a similar contract to the annuity certain but the

payments are contingent upon certain events, such as survival, hence
the payment term for the regular cashflows (which will be negative from
the perspective of the annuity provider) is uncertain.

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Typical examples of contingent annuities include:

 a single life annuity – where the regular payments made to the

annuitant are contingent on the survival of that annuitant.
 a joint life annuity – which covers two lives, where the regular
payments are contingent on the survival of one or both of those
lives.
 a reversionary annuity – which is based on two lives, where the
regular payments start on the death of the first life if, and only if,
the second life is alive at the time. Payments then continue until
the death of the second life.
____________

21 A typical car insurance contract lasts for one year. In return for a
premium which can be paid as a single lump sum or at monthly intervals,
the insurer will provide cover to pay for damage to the insured vehicle
or fire or theft of the vehicle, known as ‘property cover’. In many
countries, such as the UK, the contract also provides cover for
compensation payable to third parties for death, injury or damage to
their property, known as ‘liability cover’.

Depending on the terms of the policy, the insurance company may settle
claims directly with the policyholder or with another party. For example,
in the case of theft or total loss, the insurance company may pay a lump
sum to the policyholder in lieu of that loss. In the case of damage to the
insured vehicle the insurance company may settle the claim directly with
the party undertaking the repairs without involving the policyholder. In
the case of third party liability claims the insurance company may settle
the claims directly with the third party.

In some cases, the policyholder may be required to cover the cost of

damage or repairs first before the insurance company settles the claim,
in which case the insurance company will pay the policyholder directly.

The cashflows for the policyholder will usually be a single negative

cashflow at the beginning of the year. Further cashflows only take place
in the event of a claim. If the policyholder has to pay for repairs or
compensation, this will incur a further negative cashflow, followed by a
positive cashflow when the insurance company settles the claim. If the
insurance company settles the claim directly with the repair company or
third party, the policyholder may not experience further cashflows.

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From the insurer’s perspective there will be a positive cashflow at the

beginning of the policy, followed by a negative cashflow when the claim
is settled.

The timing of the cashflows will depend on how long the claim takes to
be reported and settled. Typically property claims take less time to settle
than liability claims. Where liability claims involve disputes, for example
necessitating court judgements, they can take years to settle and the
amounts are less certain.

Cashflows tend to be short term and are payable within the year.
____________

22 A typical health insurance contract lasts for one year. In return for a
premium, the policyholder is entitled to benefits which may include
hospital treatment either paid for in full or in part, and/or cash benefits
in lieu of treatment, such as a fixed sum per day spent in hospital as an
in-patient.

From the policholder’s perspective the cashflows will include a negative

cashflow at the beginning of the year followed by positive cashflows in
the event of a claim in the case of a cash benefit. Where the insurance
company pays for hospital treatment directly, the policyholder may
experience no more cashflows after paying the initial premium.

From the perspective of the insurer, there will be an initial positive

cashflow at the start of the policy followed by negative cashflows in the
event of a claim, when those claims are settled.

Cashflows tend to be short term and are payable within the year.
____________

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Chapter 4 – The time value of money

23 Interest may be regarded as a reward paid by one person or organisation

(the borrower) for the use of an asset, referred to as capital, belonging
to another person or organisation (the lender).

When the capital and interest are expressed in monetary terms, capital
is also referred to as principal. The total received by the lender after a
period of time is called the accumulated value. The difference between
the principal and the accumulated value is called the interest. Note that
we are assuming here that no other payments are made or incurred (eg
charges, expenses).
____________

24 If there is some risk of default (ie loss of capital or non-payment of

interest) a lender would expect to be paid a higher rate of interest than
would otherwise be the case.
____________

25 Another factor that may influence the rate of interest on any transaction
is an allowance for the possible depreciation or appreciation in the value
of the currency in which the transaction is carried out. This factor is
very important in times of high inflation.
____________

Interest

26 The essential feature of simple interest is that interest, once credited to

an account, does not itself earn further interest.

27 Suppose an amount C is deposited in an account that pays simple

interest at the rate of i ¥ 100% per annum. Then after n years the
deposit will have accumulated to:

C (1 + ni ) (1.1)
____________

28 When n is not an integer, interest is paid on a pro-rata basis.

____________

29 The essential feature of compound interest is that interest itself earns

interest.

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____________

30 Suppose an amount C is deposited in an account that pays compound

interest at the rate of i ¥ 100% per annum. Then after n years the
deposit will have accumulated to:

C (1 + i )n (1.2)
____________

31 For t1 £ t 2 we define A(t1 , t 2 ) to be the accumulation at time t 2 of an

investment of 1 at time t 1 .
____________

32 The number A(t1 , t 2 ) is often called an accumulation factor, since the

accumulation at time t 2 of an investment of C at time t 1 is, by
proportion:

CA(t1 , t 2 ) (1.3)
____________

33 A(n ) is often used as an abbreviation for the accumulation factor

A(0, n ) .
____________
34 Now let t 0 £ t1 £ t 2 and consider an investment of 1 at time t 0 . The
proceeds at time t 2 will be A(t 0 , t 2 ) if one invests at time t 0 for term
t 2 - t 0 , or A(t 0 , t1 ) A(t1 , t 2 ) if one invests at time t 0 for term t 1 - t 0 and
then, at time t 1 , reinvests the proceeds for term t 2 - t1 . In a consistent
market these proceeds should not depend on the course of action taken
by the investor. Accordingly, we say that under the principle of
consistency:

A(t 0 , t n ) = A(t 0 , t1 ) A(t1 , t 2 )  A(t n - 1 , t n ) (1.4)

____________

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Present values

35 It follows by formula (1.2) that an investment of:

C (1 + i )n (2.1)

at time 0 (the present time) will give C at time n ≥ 0 .

This is called the discounted present value (or, more briefly, the present
value) of C due at time n ≥ 0 .
____________

36 We now define the function:

v = 1/(1 + i ) (2.2)
____________

37 It follows It follows by formulae (2.1) and (2.2) that the discounted

present value of C due at time n ≥ 0 is:

Cv n (2.3)
____________

Discount rates

38 An alternative way of obtaining the discounted value of a payment is to

use discount rates.

As has been seen with simple interest, the interest earned is not itself
subject to further interest. The same is true of simple discount, which
is defined below.

Suppose an amount C is due after n years and a rate of simple

discount of d per annum applies. Then the sum of money required to
be invested now to amount to C after n years (ie the present value of
C ) is:

C (1 - nd ) (3.1)
____________

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39 In normal commercial practice, d is usually encountered only for

periods of less than a year. If a lender bases his short-term transactions
on a simple rate of discount d then, in return for a repayment of X after
a period t (t < 1) he will lend X (1 - td ) at the start of the period. In this
situation, d is also known as a rate of commercial discount.
____________

40 As has been seen with compound interest, the interest earned is subject
to further interest. The same is true of compound discount, which is
defined below.

Suppose an amount C is due after n years and a rate of compound (or

effective) discount of d per annum applies. Then the sum of money
required to be invested now to accumulate to C after n years (ie the
present value of C ) is:

C (1 - d )n (3.2)
____________

41 In the same way that the accumulation factor A(n ) gives the
accumulation at time n of an investment of 1 at time 0, we define v (n )
to be the present value of a payment of 1 due at time n . Hence:

1
v (n ) = (3.3)
A(n )
____________

42 Effective rates are compound rates that have interest paid once per unit
time either at the end of the period (effective interest) or at the beginning
of the period (effective discount). This distinguishes them from nominal
rates where interest is paid more frequently than once per unit time.

We can demonstrate the equivalence of compound and effective rates

by an alternative way of thinking about effective rates.
____________

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43 An investor will lend an amount 1 at time 0 in return for a repayment of

(1 + i ) at time 1. Hence we can consider i to be the interest paid at the
end of the year. Accordingly i is called the rate of interest (or the
effective rate of interest) per unit time.

So denoting the effective rate of interest during the n th period by i n ,

we have:

A(n ) - A(n - 1)
in = (4.1)
A(n - 1)
____________

44 If i is the compound rate of interest, we have:

(1 + i )n - (1 + i )n - 1
in = = (1 + i ) - 1 = i (4.2)
(1 + i )n - 1

Since this is independent of n , we see that the effective rate of interest

is identical to the compound rate of interest we met earlier
____________

45 We can think of compound discount as an investor lending an amount

(1 - d ) at time 0 in return for a repayment of 1 at time 1. The sum of
(1 - d ) may be considered as a loan of 1 (to be repaid after 1 unit of time)
on which interest of amount d is payable in advance. Accordingly d is
called the rate of discount (or the effective rate of discount) per unit time.

We can also show that the effective rate of discount is identical to the
compound rate of discount we met earlier.
____________

Equivalent rates

46 Two rates of interest and/or discount are equivalent if a given amount of

principal invested for the same length of time produces the same
accumulated value under each of the rates.
____________

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47 Comparing formulae (2.3) and (3.2), we see that:

v = 1- d (5.1)

And from (2.2) and (5.1) we obtain the rearrangements:

d = iv (5.2)

i
and: d= (5.3)
1+ i

Recall that d is the interest paid at time 0 on a loan of 1, whereas i is

the interest paid at time 1 on the same loan. If the rates are equivalent
then if we discount i from time 1 to time 0 we will obtain d . This is the
interpretation of equations (5.2) and (5.3).
____________

Chapter 5 – Interest rates

Nominal rates of interest and discount

48 Recall from earlier that ‘effective’ rates of interest and discount have
interest paid once per measurement period, either at the end of the
period or at the beginning of the period.

‘Nominal’ is used where interest is paid more (or less) frequently than
once per measurement period.
____________

49 We denote the nominal rate of interest payable p times per period by i ( p )

. This is also referred to as the rate of interest convertible pthly or
compounded pthly.
____________

50 A nominal rate of interest per period, payable pthly, i ( p ) , is defined to be

a rate of interest of i ( p ) p applied for each pth of a period. For example,
a nominal rate of interest of 6% pa convertible quarterly means an
interest rate of 6 / 4  1.5% per quarter.

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Hence, by definition, i ( p ) is equivalent to a pthly effective rate of interest

of i ( p ) p .
____________

51 Therefore the effective interest rate i is obtained from:

p
Ê i ( p) ˆ
1 + i = Á1 + ˜ (6.1)
Ë p ¯
____________

52 Note that i (1) = i .

The treatment of problems involving nominal rates of interest (or

discount) is almost always considerably simplified by an appropriate
choice of the time unit.

By choosing the basic time unit to be the period corresponding to the

frequency with which the nominal rate of interest is convertible, we can
use i ( p ) p as the effective rate of interest per unit time. For example, if
we have a nominal rate of interest of 18% per annum convertible
monthly, we should take one month as the unit of time and 1½% as the
rate of interest per unit time.
____________

53 We denote the nominal rate of discount payable p times per period by

d ( p) . This is also referred to as the rate of discount convertible pthly or
compounded pthly.
____________

54 A nominal rate of discount per period payable pthly, d ( p) , is defined as

a rate of discount of d ( p ) p applied for each pth of a period.

Hence, by definition, d ( p) is equivalent to a pthly effective rate of

discount of d ( p ) p .
____________

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55 Therefore the effective discount rate d is obtained from:

p
Ê d ( p) ˆ
1 - d = Á1 - ˜ (6.2)
Ë p ¯
____________

56 Note that d (1) = d .

____________

The force of interest

57 We assume that for each value of i there is number, d , such that:

lim i ( p ) = d
p Æ•
____________

58 d is the nominal rate of interest per unit time convertible continuously

(or momently). This is also referred to as the rate continuously
compounded. We call it the force of interest.
____________

59 Euler’s rule states that:

n
Ê xˆ
lim Á 1 + ˜ = e x
n Æ• Ë n¯

Applying this to the right-hand-side of (6.1) gives:

p
Ê i ( p) ˆ (•)
lim Á 1 + ˜ = ei
p Æ• Ë p ¯

Hence:

1 + i = ed (7.1)
____________

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60 Since v = (1 + i )-1 , we have:

v = e -d (7.2)
____________

61 From equation (7.2) we have:

v t = (e -d )t = e -d t

Hence, the discount factor for a force of interest d is:

v (n) = e -d n
____________

62 It can also be shown that:

lim d ( p ) = d
p Æ•

However, d ( p) tends to this limit from below whereas i ( p ) tends to this

limit from above.
____________

63 Hence, we have:

d < d (2) < d (3) <  < d <  < i (3) < i (2) < i
____________

Relationships between effective, nominal and force of interest

64 Recall that effective interest i can be thought of as interest paid at the

end of the period. Hence, an investor lending an amount 1 at time 0
receives a repayment of (1 + i ) at time 1.
____________

65 Similarly, nominal interest convertible pthly can be thought of as the

total interest per unit of time paid on a loan of amount 1 at time 0, where
interest is paid in p equal instalments at the end of each pth subinterval
(ie at times 1 p , 2 p , 3 p ,  ,1 ).

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Since i ( p ) is the total interest paid and each interest payment is of

amount i ( p ) p then the accumulated value at time 1 of the interest
payments is:

i (p) i (p) i (p)

(1 + i )( p - 1) p
+ (1 + i )( p - 2) p
+ + =i
p p p

Hence:

i ( p) = p È(1 + i )1 p - 1˘
Î ˚
____________

66 Recall that effective discount d can be thought of as interest paid at the

start of the period. Hence, an investor lending an amount 1 at time 0
receives a repayment of 1 at time 1, but d is paid at the start so a sum
of (1 - d ) is lent at time 0.
____________

67 Similarly, d ( p) is the total amount of interest per unit of time payable in

equal instalments at the start of each pth subinterval (ie at times
0,1 p , 2 p ,  , ( p - 1) p ).

As a consequence the present value at time 0 of the interest payments

is:

d (p) d (p) d (p)

+ (1 - d )1 p +  + (1 - d )( p - 1) p
=d
p p p

Hence:

d ( p ) = p È1 - (1 - d )1 p ˘
Î ˚
____________

68 Now d is the total amount of interest payable as a continuous payment

stream, ie an amount d dt is paid over an infinitesimally small period dt
at time t .

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As a consequence the accumulated value at time 1 of these interest

payments is:

1
1- t
Ú d (1 + i ) dt
0

which, by symmetry, is equal to:

1
t
Ú d (1 + i ) dt = i
0

Hence:

d = ln(1 + i ) or ed = 1 + i

It is essential to appreciate that, at force of interest d per unit time, the

five series of payments illustrated in Figure 1 below all have the same
value.

1 2 3 p -1
0 ... 1 time
p p p p

(1) d

d ( p) d ( p) d ( p) d ( p) d ( p)
(2) ...
p p p p p

i ( p) i ( p) i ( p) i (p) i (p)
(3) ...
p p p p p equivalent
(4) i payments

(5) d

Figure 1 Equivalent payments

____________

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Force of interest as a function of time

69 The force of interest is the instantaneous change in the fund value,

expressed as an annualized percentage of the current fund value.

So the force of interest at time t is defined to be:

Vt¢
d (t ) =
Vt

where Vt is the value of the fund at time t and Vt¢ is the derivative of
Vt with respect to t .

Hence:

d
d (t ) = ln Vt
dt

Integrating this from t 1 to t2 gives:

t2 Ê Vt ˆ
t
Ú d (t )dt = ÈÎln Vt ˘˚t2 = ln Vt2 - ln Vt1 = ln Á 2 ˜
t1
1
Ë Vt1 ¯

Vt2  t2 
  exp    (t ) dt 
Vt1 t 
1 

____________

70 Hence:
 t2 
A(t1, t2 )  exp    (t ) dt 
t 
 1 
____________

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71 For the case when the force of interest is constant, d , between time 0
and time n , we have:

n
Úd dt
A(0, n ) = e 0 = ed n

Hence:

(1 + i )n = ed n

Therefore:

(1 + i ) = ed

as before.
____________

72 Although the force of interest is a theoretical measure it is the most

fundamental measure of interest (as all other interest rates can be
derived from it). However, since the majority of transactions involve
discrete processes we tend to use other interest rates in practice.

It still remains a useful conceptual and analytical tool and can be used
as an approximation to interest paid very frequently, eg daily.
____________

Chapter 7 – Discounting and accumulating

Present values of cashflows

73 In many compound interest problems one must find the discounted

present value of cashflows due in the future. It is important to
distinguish between (a) discrete and (b) continuous payments.
____________

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74 The present value of the sums ct1 , ct2 , ..., ctn due at times t1, t 2 , ..., t n
(where 0 £ t1 < t 2 <  < t n ) is:

n
ct1v (t1) + ct2 v (t2 ) +  + ctn v (t n ) = Â ct j v (t j )
j =1

If the number of payments is infinite, the present value is defined to be:

•
 ct j v (t j )
j =1

provided that this series converges. It usually will in practical problems.

____________

75 Suppose that T > 0 and that between times 0 and T an investor will be
paid money continuously, the rate of payment at time t being £ r (t ) per
unit time. What is the present value of this cashflow?

In order to answer this question it is essential to understand what is

meant by the rate of payment of the cashflow at time t. If M(t) denotes
the total payment made between time 0 and time t, then by definition:

r (t ) = M ¢(t ) for all t

Then, if 0 £ a £ b £ T , the total payment received between time a and

time b is:

b b
M ( b ) - M (a ) = Ú M ¢(t )dt = Ú r (t )dt (8.1)
a a

Thus the rate of payment at any time is simply the derivative of the total
amount paid up to that time, and the total amount paid between any two
times is the integral of the rate of payments over the appropriate time
interval.
____________

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76 Between times t and t + dt the total payment received is

M (t + dt ) - M (t ) . If dt is very small this is approximately M ¢(t )dt or
r (t )dt . Theoretically, therefore, we may consider the present value of
the money received between times t and t + dt as v (t ) r (t )dt . The
present value of the entire cashflow is obtained by integration as:

T
Ú v (t ) r (t )dt
0
____________

77 If T is infinite we obtain, by a similar argument, the present value:

•
Ú v (t ) r (t )dt
0
____________

78 By combining the results for discrete and continuous cashflows, we

obtain the formula:

•
 ct v (t ) + Ú v (t ) r (t )dt (8.2)
0

for the present value of a general cashflow (the summation being over
those values of t for which ct , the discrete cashflow at time t, is
non-zero).
____________

79 So far we have assumed that all payments, whether discrete or

continuous, are positive. If one has a series of income payments (which
may be regarded as positive) and a series of outgoings (which may be
regarded as negative) their net present value is defined as the difference
between the value of the positive cashflow and the value of the negative
cashflow.
____________

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80 Consider times t 1 and t2 , where t 2 is not necessarily greater than t 1 .

The value at time t 1 of the sum C due at time t2 is defined as:

(a) If t1 ≥ t 2 , the accumulation of C from time t 2 until time t 1 ; or

(b) If t1 < t 2 , the discounted value at time t 1 of C due at time t2 .

In both cases the value at time t 1 of C due at time t2 is:

C exp ÈÍ - Ú 2 d (t )dt ˘˙
t
(9.1)
Î t1 ˚

t2 t1
(Note the convention that, if t1 > t 2 , Út1 d (t )dt = - Út2 d (t )dt .)

Since:

t2 t2 t
Út1 d (t )dt = Ú0 d (t )dt - Ú 1 d (t )dt
0

it follows immediately from Equation (9.1) that the value at time t 1 of C

due at time t2 is:

v (t2 )
C (9.2)
v (t1)
____________

81 The value at a general time t 1 of a discrete cashflow of ct at time t (for

various values of t ) and a continuous payment stream at rate r (t ) per
time unit may now be found, by the methods given earlier, as:

v (t ) • v (t )
 ct v (t )
+ Ú r (t )
-• v (t1)
dt (9.3)
1

where the summation is over those values of t for which ct π 0 .

____________

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82 We note that in the special case when t1 = 0 (the present time), the value
of the cashflow is:

•
 ct v (t ) + Ú -• r (t ) v (t )dt

where the summation is over those values of t for which ct π 0 .

This is a generalisation of formula (8.2) to cover the past as well as

present or future payments. If there are incoming and outgoing
payments, the corresponding net value may be defined, as earlier, as the
difference between the value of the positive and the negative cashflows.
If all the payments are due at or after time t 1 , their value at time t 1 may
also be called their ‘discounted value’, and if they are due at or before
time t 1 , their value may be referred to as their ‘accumulation’.

It follows that any value may be expressed as the sum of a discounted

value and an accumulation. This fact is helpful in certain problems.
Also, if t1 = 0 and all the payments are due at or after the present time,
their value may also be described as their ‘(discounted) present value’,
as defined by formula (8.2).
____________

83 It follows from formula (9.2) that the value at any time t 1 of a cashflow
may be obtained from its value at another time t2 by applying the factor
v (t 2 ) / v (t1) , ie:

È Value at time t1˘ È Value at time t2 ˘ È v (t2 ) ˘

Í ˙= Í ˙ Í ˙
Î of cash flow ˚ Î of cash flow ˚ Î v (t1) ˚
or:

È Value at time t1 ˘ È Value at time t 2 ˘

Í ˙ ÈÎv (t1)˘˚ = Í ˙ ÈÎv (t 2 )˘˚ (9.4)
Î of cash flow ˚ Î of cash flow ˚

Each side of Equation (9.4) is the value of the cashflow at the present
time (time 0).

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In particular, by choosing time t 2 as the present time and letting t1 = t ,

we obtain the result:

È Value at time t ˘ È Value at the present ˘ È 1 ˘

Í ˙= Í ˙ Í ˙
Î of cash flow ˚ Î time of cash flow ˚ Î v (t ) ˚

These results are useful in many practical examples. The time 0 and the
unit of time may be chosen so as to simplify the calculations.
____________

Interest income

84 Consider now an investor who wishes not to accumulate money but to

receive an income while keeping his capital fixed at C. If the rate of
interest is fixed at i per time unit, and if the investor wishes to receive
income at the end of each time unit, it is clear that the income will be iC
per time unit, payable in arrear, until such time as the capital is
withdrawn.
____________

85 However, if interest is paid continuously with force of interest   t  at

time t then the income received between times t and t  dt will be
C t  dt .
____________

86 So the total interest income from time 0 to time T will be:

T
 I (T ) = Ú0 Cd (t ) dt 
____________

87 If the investor withdraws the capital at time T , the present values of the
income and capital at time 0 are:

T
C Ú d (t )v (t )dt and Cv (T )
0

respectively.

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Since:

( )
T
T T È t ˘ È t ˘
Ú0 d (t )v (t )dt = Ú0 d (t ) exp ÎÍ - Ú0 d (s )ds ˚˙ dt = ÍÎ - exp - Ú0 d (s )ds ˙˚
0
= 1 - v (T )

we obtain:

T
C = C Ú d (t )v (t )dt + Cv (T )
0

as one would expect by general reasoning.

So far we have described the difference between money returned at the

end of the term and the cash originally invested as ‘interest’. In practice,
however, this quantity may be divided into interest income and capital
gains, the term capital loss being used for a negative capital gain.
____________

Chapter 8 – Level annuities

Present values

88 Consider a series of n payments, each of amount 1, to be made at time

intervals of one unit, the first payment being made at time t + 1 .

1 1 1 ... 1 1 Payment

t t +1 t +2 t +3 ... t +n -1 t +n Time

Such a sequence of payments is illustrated in the diagram above, in

which the rth payment is made at time t + r .

The value of this series of payments one unit of time before the first
payment is made is denoted by an | .
____________

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89 Clearly, if i = 0 , then an| = n ; otherwise:

an | = v + v 2 + v 3 +  + v n

v (1 - v n ) 1 - v n 1- v n
= = -1 = (10.1)
1- v v -1 i

If n = 0 , an| is defined to be zero.

____________

90 Thus an| is the value at the start of any period of length n of a series
of n payments, each of amount 1, to be made in arrears at unit time
intervals over the period. It is common to refer to such a series of
payments, made in arrear, as an immediate annuity-certain and to call
an | the present value of the immediate annuity-certain. When there is
no possibility of confusion with a life annuity (ie a series of payments
dependent on the survival of one or more human lives), the term annuity
may be used as an alternative to annuity-certain.
____________

91 The value of this series of payments at the time the first payment is made
is denoted by an| .If i = 0 , then a
 | = n ; otherwise:
n

1- v n 1- v n
an| = 1 + v + v 2 +  + v n -1 = = (10.2)
1- v d

Thus an| is the value at the start of any given period of length n of a
series of n payments, each of amount 1, to be made in advance at unit
time intervals over the period. It is common to refer to such a series of
payments, made in advance, as an annuity-due and to call an| the
present value of the annuity-due.
____________

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92 It follows directly from the above definitions that:

an| = (1 + i )an|

… and that, for n ≥ 2 : (10.3)

an| = 1 + an -1|
____________

Accumulations

93 The value of the series of payments at the time the last payment is made
is denoted by s n | . The value one unit of time after the last payment is
 | .
made is denoted by s n
____________

 | = n ; otherwise
94 If i = 0 then sn| = s n

sn| = (1 + i )n -1 + (1 + i )n - 2 + (1 + i )n - 3 +  + 1 = (1 + i )n an|

(1 + i )n - 1
= (11.1)
i

and:
sn| = (1 + i )n + (1 + i )n -1 + (1 + i )n - 2 +  + (1 + i ) = (1 + i )n an|

(1 + i )n - 1
= (11.2)
d
____________

 | are the values at the end of any period of length n of

95 Thus s n | and s n
a series of n payments, each of amount 1, made at unit time intervals
over the period, where the payments are made in arrear and in advance
respectively. Sometimes sn | and s | are called the ‘accumulation’ (or
n
the ‘accumulated amount’) of an immediate annuity and an annuity-due
respectively.
____________

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 | are defined to be zero.

96 When n = 0 , s n | and s n
____________

97 It is an immediate consequence of the above definition that:

sn| = (1 + i )sn|

and that:

sn +1| = 1 + sn| or sn| = sn +1| - 1

____________

Continuously payable annuities

98 Let n be a non-negative number. The value at time 0 of an annuity

payable continuously between time 0 and time n , where the rate of
payment per unit time is constant and equal to 1, is denoted by an| .
____________

99 Clearly:

n -d t 1 - e -d n 1- v n
an| = Ú0 e dt =
d
=
d
(if d π 0) (12.1)

Note that an| is defined even for non-integral values of n.

____________

100 If d = 0 (or, equivalently, i = 0 ), an| is of course equal to n .

____________

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101 Since equation (12.1) may be written as:

i Ê 1- v n ˆ
an| = Á ˜
d Ë i ¯

it follows immediately that, if n is an integer:

i
an| = an| (if d π 0 )
d
____________

102 The accumulated amount of such an annuity at the time the payments
cease is denoted by sn| .

By definition, therefore:

n
sn| = Ú ed (n -t )dt
0

Hence:

sn| = (1 + i )n an|
____________

103 If the rate of interest is non-zero:

(1 + i )n - 1 i
sn| = = sn|
d d
____________

Annuities payable pthly

104 If p and n are positive integers, the notation a ( p| ) is used to denote the
n
value at time 0 of a level annuity payable pthly in arrear at the rate of 1
per unit time over the time interval [0, n ] . For this annuity the payments
are made at times 1 p ,2 p , 3 p , , n and the amount of each payment is
1p.

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By definition, a series of p payments, each of amount i ( p ) p in arrear at

pthly subintervals over any unit time interval, has the same value as a
single payment of amount i at the end of the interval. By proportion, p
payments, each of amount 1/ p in arrear at pthly subintervals over any
unit time interval, have the same value as a single payment of amount
i i ( p ) at the end of the interval.

Consider now that annuity for which the present value is a ( p| ) . The
n
remarks in the preceding paragraph show that the p payments after time
r - 1 and not later than time r have the same value as a single payment
of amount i i ( p ) at time r. This is true for r = 1, 2,  , n , so the annuity
has the same value as a series of n payments, each of amount i i ( p ) , at
times 1, 2,  , n .
____________

105 This means that:

i
a ( p| ) = an | (13.1)
n i ( p)
____________

106 An alternative approach, from first principles, is to write:

np
1 t / p 1 v 1/ p (1 - v n ) 1- v n 1- v n
a ( p| ) = Â v =
p 1 - v 1/ p
= = (13.2)
n
t =1 p p È(1 + i )1/ p - 1˘ i ( p)
Î ˚

which confirms equation (13.1).

____________

107 Likewise we define a( p| ) to be the present value of a level annuity-due

n

payable p thly at the rate of 1 per unit time over the time interval [0, n ] .
(The annuity payments, each of amount 1 p , are made at times
0, 1 p , 2 p , , n - (1 p ) .)

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By definition, a series of p payments, each of amount d ( p ) p , in advance

at pthly subintervals over any unit time interval has the same value as a
single payment of amount i at end of the interval. Hence, by proportion,
p payments, each of amount 1 p in advance at pthly subintervals, have
the same value as a single payment of amount i d ( p ) at the end of the
interval.
____________

108 This means (by an identical argument to that above) that:

i
a( p| ) = an | (13.3)
n d (p)

Alternatively, from first principles, we may write:

np
1 1- v n
a( p| ) = Â p v (t -1) / p = (13.4)
n
t =1 d ( p)

(on simplification), which confirms equation (13.3).

____________

109 Note that:

a( p| ) = v 1/ p a( p| ) (13.5)
n n

(1 - v n )
each expression being equal to .
i ( p)
____________

110 Note that, since:

lim i ( p ) = lim d ( p ) = d
p Æ• p Æ•

it follows immediately from equation (13.2) and (13.4) that:

lim a ( p| ) = lim a( p| ) = an|

p Æ• n p Æ• n
____________

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111 Similarly, we define s ( p| ) and s( p| ) to be the accumulated amounts of the

n n
corresponding p thly immediate annuity and annuity-due respectively.
Thus:

i
s ( p| ) = (1 + i )n a ( p| ) = (1 + i )n an| (by (13.1))
n n i ( p)
i
= (p)
sn|
i

Also:

i
s( p| ) = (1 + i )n a( p| ) = (1 + i )n ( p)
an| (by (13.3))
n n d
i
= sn|
d ( p)

The above proportional arguments may be applied to other varying

series of payments. Consider, for example, an annuity payable annually
in arrear for n years, the payment in the tth year being x t . The present
value of this annuity is obviously:

n
a= Â xt v t (13.6)
t =1

Consider now a second annuity, also payable for n years with the
payment in the tth year, again of amount x t , being made in p equal

instalments in arrear over that year. If a( p ) denotes the present value of

this second annuity by replacing the p payments for year t (each of
amount x t p ) by a single equivalent payment at the end of the year of
amount xt [ i i ( p ) ] , we immediately obtain:

i
a( p ) = a
i ( p)

where a is given by equation (13.6) above.

____________

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112 Earlier the symbol a ( p| ) was introduced. Intuitively, with this notation
n
one considers p to be an integer greater than 1 and assumes that the
product n . p is also an integer. (This, of course, will be true when n
itself is an integer, but one might for example, have p = 4 and n = 5.75
so that np = 23 .) Then a ( p| ) denotes the value at time 0 of n . p
n
payments, each of amount 1 p , at times 1 p , 2 p , ... , (np ) p .

From a theoretical viewpoint it is perhaps worth noting that when p is

the reciprocal of an integer and n . p is also an integer (eg when p = 0.25
and n = 28 ), a ( p| ) still gives the value at time 0 of n . p payments, each
n
of amount 1 p , at times 1 p , 2 p , ... , (np ) p .

For example, the value at time 0 of a series of seven payments, each of

amount 4, at times 4, 8, 12 ,..., 28 may be denoted by a(0.25)
| .
28

It follows that this value equals:

1 - v 28
(0.25). È (1 + i )4 - 1˘
Î ˚

This last expression may be written in the form:

È ˘
Í 4 ˙ 1 - v 28 4
Í ˙. = .a28|
4
Í (1 + i ) - 1 ˙ i s 4|
Í ˙
Î i ˚
____________

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Non-integer values of n

113 Let p be a positive integer. Until now the symbol a ( p| ) has been defined
n
only when n is a positive integer. For certain non-integral values of n
the symbol a ( p| ) has an intuitively obvious interpretation.
n
____________

114 For example, it is not clear what meaning, if any, may be given to a23.5| ,

but the symbol a(4) ought to represent the present value of an

23.5|
immediate annuity of 1 per annum payable quarterly in arrear for 23.5
years (ie a total of 94 quarterly payments, each of amount 0.25). On the
other hand, a(2) has no obvious meaning.
23.25|
____________

115 Suppose that n is an integer multiple of 1 p , say n = r p , where r is

an integer. In this case we define a ( p| ) to be the value at time 0 of a

n
series of r payments, each of amount 1p, at times

1 p , 2 p , 3 p , ..., r p = n . If i = 0 , then clearly a( p| ) = n . If i π 0 , then:

n

1 1/ p
a ( p| ) = (v + v2/ p + v3/ p +  + vr / p)
n p

1 1/ p Ê 1 - v r / p ˆ 1 È 1- v r / p ˘
= v Á 1/ p ˜ = Í ˙
p Ë 1- v ¯ p ÍÎ (1 + i )1/ p - 1˙˚

Thus:

Ï1- v n
Ô if i π 0
a ( p| ) = Ì i ( p ) (14.1)
n
Ôn if i = 0
Ó
____________

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116 Note that, by working in terms of a new time unit equal to 1 p times the
original time unit and with the equivalent effective interest rate of i ( p ) / p
per new time unit, we see that:

a ( p| ) (at rate i ) = 1
p
anp| (at rate i ( p ) / p )
n

This formula is useful when i ( p ) / p is a tabulated rate of interest.

Note that the definition of a ( p| ) given by equation (14.1) is

n
mathematically meaningful for all non-negative values of n. For our
present purpose, therefore, it is convenient to adopt equation (14.1) as
a definition of a ( p| ) for all n.
n

If n is not an integer multiple of 1/ p , there is no universally recognised

definition of a ( p| ) . For example, if n = n1 + f , where n1 is an integer
n

multiple of 1 p and 0 < f < 1 p , some writers define a ( p| ) as:

n

a ( p|) + fv n
n1

With this alternative definition:

a(2) = a(2) | + 1 4 v 23.75

23.75| 23.5

which is the present value of an annuity of 1 per annum, payable half-

yearly in arrear for 23.5 years, together with a final payment of 0.25 after
23.75 years. Note that this is not equal to the value obtained from
definition (14.1).
____________

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117 If i π 0 , we define for all non-negative n :

(1 - v n ) ¸
a( p| ) = (1 + i )1/ p a ( p| ) = Ô
n n d ( p) Ô
(1 + i )n - 1ÔÔ
s ( p| ) = (1 + i )n a ( p| ) = ˝ (14.2)
n n i ( p) Ô
(1 + i ) n
- 1 Ô
( p ) n ( p )
s | = (1 + i ) a | = ( p )
Ô
n n d Ô˛

If i = 0 , each of these last three functions is defined to equal n.

Whenever n is an integer multiple of 1 p , say n = r p , then

a( p| ) , s ( p| ) , s( p| ) , are values at different times of an annuity-certain of r

n n n
payments, each of amount 1 p , at intervals of 1 p time unit.
____________

 | , s | and s | to denote

118 As before, we use the simpler notations an| , a n n n

a(1)| , a(1)| , s (1)| and s(1)| respectively, thus extending the definition of an|
n n n n
etc, to all non-negative values of n . It is a trivial consequence of our
definitions that the formulae:

i ¸
a ( p| ) = an| Ô
( p)
n i Ô
i Ô
a( p| ) = ( p ) an| Ô
n d Ô
˝ (14.3)
i
s ( p| ) = ( p ) sn | Ô
n i Ô
Ô
i
s( p| ) = ( p ) sn | Ô
n d Ô˛

(valid when i π 0 ) now hold for all values of n.

____________

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Perpetuities

119 We can also consider an annuity that is payable forever.

This is called a perpetuity.

For example, consider an equity that pays a dividend of £10 at the end
of each year. An investor who purchases the equity pays an amount
equal to the present value of the dividends.
____________

120 The present value of the dividends is:

10v + 10v 2 + 10v 3 + 

This can be summed using the formula for an infinite geometric

progression:

10v 10
10v + 10v 2 + 10v 3 +  = =
1- v i

Recall the formula for the present value of an annuity of £10 pa that
continues for n years:

10(1 - v n )
10an =
i

We have let n Æ • in this expression in order to arrive at the formula

10
.
i

Note that this formula only holds when i is positive.

____________

In general:

121 The present value of payments of 1 pa payable at the end of each year
1 1
forever is . This present value is written as a• , ie a• = .
i i
____________

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122 The present value of payments of 1 pa payable at the start of each year
1 1
forever is . This present value is written as a• , ie a• = .
d d
____________

Perpetuities payable pthly

1
123 The present value of payments of 1 pa payable in instalments of p
at
the end of each pthly time period forever is:

1
a(p) =
• i (p)
1
124 The present value of payments of 1 pa payable in instalments of p
at
the start of each pthly time period forever is:

1
a( p ) =
• d (p)
____________

Deferred annuities

Suppose that m and n are non-negative integers. The value at time 0 of

a series of n payments, each of amount 1, due at times
( m + 1), ( m + 2),  , ( m + n ) is denoted by m | an| (see the figure below).

1 1 ... 1 payment

0 1 m m +1 m +2 … m+n time

Such a series of payments may be considered as an immediate annuity,

deferred for m time units.
____________

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125 When n > 0 :

m | an| = v m +1 + v m + 2 + v m + 3 +  + v m + n

= (v + v 2 + v 3 +  + v m + n ) - (v + v 2 + v 3 +  + v m )
= v m (v + v 2 + v 3 +  + v n )
____________

126 The last two equations show that:

m | an | = am + n| - am | (15.1)

= v m an| (15.2)
____________

127 Either of these two equations may be used to determine the value of a
deferred immediate annuity. Together they imply that:

am + n| = am| + v m an|
____________

128 We may define the corresponding deferred annuity-due as:

 = v m a |
m | an| n
____________

129 If m is a non-negative number, we use the symbol m| an| to denote the

present value of a continuously payable annuity of 1 per unit for n time
units, deferred for m time units. Thus:

m +n n m +n m
m| an| =Ú e -d t dt = e -d m Ú e -d sds = Ú e -d t dt - Ú e -d t dt
m 0 0 0

Hence:

m| an| = am +n| - am| = v m an|

____________

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130 The present values of an immediate annuity and an annuity-due, payable

p thly at the rate of 1 per unit time for n time units and deferred for m
time units, are denoted by:

( p)
m| an| = v m a( p| ) and ( p )
m| an| = v m a( p| ) (15.3)
n n

respectively.

( p) ( p)
We may also extend the definitions of m| an| and m| an| to all values of

n by the formulae:

( p)
m| an| = v m a( p| ) ( p )
m| an| = v m a( p| ) (15.4)
n n

and so:

( p)
m| an| = a( p) - a( p|) ( p )
m| an| = a( p) - a( p|) (15.5)
n + m| m n + m| m
____________

Chapter 9 –Increasing annuities

Varying annuities

131 For an annuity in which the payments are not all of an equal amount it is
a simple matter to find the present (or accumulated) value from first
principles. Thus, for example, the present value of such an annuity may
always be evaluated as:

n
 X i v ti
i =1

where the i th payment, of amount X i , is made at time t i .

In the particular case when X i = t i = i the annuity is known as an

increasing annuity and its present value is denoted by (Ia )n| .
____________

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132 Thus:

(Ia )n| = v + 2v 2 + 3v 3 +  + nv n

Hence:

(1 + i )(Ia )n| = 1 + 2v + 3v 2 +  + nv n -1 (16.1)

By subtraction, we obtain:

i (Ia )n| = 1 + v + v 2 + v 3 +  + v n -1 - nv n = an| - nv n

So:
an| - nv n
(Ia)n| =
i
____________

133 The present value of any annuity payable in arrear for n time units for
which the amounts of successive payments form an arithmetic
progression can be expressed in terms of an| and (Ia )n| . If the first

payment of such an annuity is P and the second payment is (P + Q ) ,

the t th payment is (P - Q ) + Qt , then the present value of the annuity is:

(P - Q )an| + Q (Ia )n| (16.2)

Alternatively, the present value of the annuity can be derived from first
principles.
____________

) | is used to denote the present value of an increasing

134 The notation (Ia n
annuity-due payable for n time units, the t th payment (of amount t )
being made at time t - 1 . Thus:

(Ia)n| = 1 + 2v + 3v 2 +  + nv n -1 = (1 + i )(Ia )n|

= 1 + an -1| + (Ia )n -1|

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____________
135 For increasing annuities which are payable continuously it is important
to distinguish between an annuity which has a constant rate of payment
r (per unit time) throughout the r th period and an annuity which has a
rate of payment t at time t . For the former the rate of payment is a step
function taking the discrete values 1, 2, . For the latter the rate of
payment itself increases continuously. If the annuities are payable for
n time units, their present values are denoted by (Ia )n| and (Ia )n|
respectively.

n r
Clearly (Ia )n| = Â ( Úr -1 rv t dt ) , and:
r =1

n
(Ia)n| = Ú tv t dt
0

and it can be shown that:

an| - nv n
(Ia )n| =
d

and:

an| - nv n
(Ia)n| =
d
____________

136 The present values of deferred increasing annuities are defined in the
obvious manner, for example:

m| (Ia)n = v m (Ia)n
____________

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PAST EXAM QUESTIONS

This section contains all the Subject CT1 exam questions from the period
2008 to 2017 that are related to the topics covered in this booklet.

Solutions are given later in this booklet. These give enough information for
you to check your answer, including working, and also show you what an
adequate examination answer should look like. Further information may be
available in the Examiners’ Report, ASET or Course Notes. (ASET can be
ordered from ActEd.)

We first provide you with a cross reference grid that indicates the main
subject areas of each exam question. You can use this, if you wish, to select
the questions that relate just to those aspects of the topic that you may be
particularly interested in reviewing.

Alternatively you can choose to ignore the grid, and instead attempt each
question without having any clues as to its content.

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 Batch 4

Cross reference grid

Variable
Basic interest force of Annuities
interest

Payment streams
General A(t) / v(t)
Cashflow models

interest/discount

Level annuties
Accumulation/

Accumulation/
Treasury bill

expression
Converting

Increasing
Tick when
attempted

annuities
discount

discount
Nominal
Question

1   
2 
3 
4  
5 
6   
7    
8   
9  
10 
11 
12  
13  
14  
15    
16  
17  
18  
19  
20   ()
21  ()
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© IFE: 2019 Examinations Page 51

Page 52
41
40
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Question
Tick when
attempted
Cashflow models


Accumulation/


discount




Converting



Treasury bill
Basic interest

Nominal


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Batch 4

interest/discount
Accumulation/


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


discount
General A(t) / v(t)
expression
interest
force of
Variable


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Payment streams




Level annuties

Increasing
Annuities

annuities

© IFE: 2019 Examinations

 Batch 4

1 Subject CT1 April 2008 Question 9

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï0.06 0£t £4
Ô
d (t ) = Ì0.10 - 0.01t 4<t £7
Ô0.01t - 0.04 7<t
Ó

(i) Calculate the value at time t = 5 of £1,000 due for payment at time
t = 10 . [5]

(ii) Calculate the constant rate of interest per annum convertible monthly
which leads to the same result as in (i) being obtained. [2]

(iii) Calculate the accumulated amount at time t = 12 of a payment stream,

paid continuously from time t = 0 to t = 4 , under which the rate of
payment at time t is r (t ) = 100e0.02t . [6]
[Total 13]

2 Subject CT1 September 2008 Question 7

The force of interest,  (t ) , is a function of time and at any time t (measured

in years) is given by:

0.05  0.02t for 0  t  5

 (t )  
0.15 for t  5

(i) Calculate the present value of £1,000 due at the end of 12 years. [5]

(ii) Calculate the annual effective rate of discount implied by the transaction
in (i). [2]
[Total 7]

© IFE: 2019 Examinations Page 53

 Batch 4

3 April 2009 Question 2

Describe the characteristics of:

(a) an interest-only loan (or mortgage); and

(b) a repayment loan (or mortgage). [4]

4 Subject CT1 September 2009 Question 1

A 182-day government bill, redeemable at £100, was purchased for £96 at the
time of issue and was later sold to another investor for £97.89. The rate of
return received by the initial purchaser was 5% per annum effective.

(a) Calculate the length of time in days for which the initial purchaser held
the bill.

(b) Calculate the annual simple rate of return achieved by the second
investor. [4]

5 Subject CT1 September 2009 Question 5

The force of interest d (t ) at time t is a + bt 2 where a and b are constants.

An amount of £100 invested at time t = 0 accumulates to £130 at time t = 5
and £200 at time t = 10 .

(i) Calculate the values of a and b . [6]

(ii) Calculate the constant rate of interest per annum convertible monthly that
would give rise to the same accumulation from time t = 0 to time t = 5 .
[2]

(iii) Calculate the constant force of interest that would give rise to the same
accumulation from time t = 5 to time t = 10 . [2]
[Total 10]

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 Batch 4

6 Subject CT1 April 2010 Question 11

The force of interest d (t ) is a function of time and at any time t , measured

in years, is given by the formula:

Ï 0.04 + 0.02t 0£t <5

d (t ) = Ì
Ó0.05 5£t

(i) Derive and simplify as far as possible expressions for v (t ) , where v (t )

is the present value of a unit sum of money due at time t . [5]

(ii) (a) Calculate the present value of £1,000 due at the end of 17 years.

(b) Calculate the rate of interest per annum convertible monthly implied
by the transaction in part (ii)(a). [4]

A continuous payment stream is received at a rate of 10e0.01t units per

annum between t = 6 and t = 10 .

(iii) Calculate the present value of the payment stream. [4]

[Total 13]

7 Subject CT1 September 2010 Question 8

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï0.05 + 0.001t 0 £ t £ 20
d (t ) = Ì
Ó0.05 t > 20

(i) Derive and simplify as far as possible expressions for v (t ) , where v (t )

is the present value of a unit sum of money due at time t . [5]

(ii) (a) Calculate the present value of £100 due at the end of 25 years.

(b) Calculate the rate of discount per annum convertible quarterly

implied by the transaction in part (ii)(a). [4]

(iii) A continuous payment stream is received at rate 30e -0.015t units per
annum between t = 20 and t = 25 . Calculate the accumulated value of
the payment stream at time t = 25 . [4]
[Total 13]

© IFE: 2019 Examinations Page 55

 Batch 4

8 Subject CT1 April 2011 Question 1

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

ÔÏ0.04 + 0.003t 2 for 0 < t £ 5

d (t ) = Ì
ÔÓ0.01 + 0.03t for 5 < t

(i) Calculate the amount to which £1,000 will have accumulated at t = 7 if it

is invested at t = 3 . [4]

(ii) Calculate the constant rate of discount per annum, convertible monthly,
which would lead to the same accumulation as that in (i) being obtained.
[3]
[Total 7]

9 Subject CT1 September 2011 Question 1

A 91-day treasury bill is issued by the government at a simple rate of discount

of 8% per annum.

Calculate the annual effective rate of return obtained by an investor who

purchases the bill at issue. [3]

10 Subject CT1 September 2011 Question 3

An individual intends to retire on his 65th birthday in exactly four years’ time.
The government will pay a pension to the individual from age 68 of £5,000 per
annum monthly in advance. The individual would like to purchase an annuity
certain so that his income, including the government pension, is £8,000 per
annum paid monthly in advance from age 65 until his 78th birthday. He is to
purchase the annuity by a series of payments made over four years quarterly
in advance starting immediately.

Calculate the quarterly payments the individual has to make if the present
value of these payments is equal to the present value of the annuity he wishes
to purchase at a rate of interest of 5% per annum effective. Mortality should
be ignored. [6]

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 Batch 4

11 Subject CT1 September 2011 Question 6

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is a + bt where a and b are constants. An amount of £45 invested
at time t = 0 accumulates to £55 at time t = 5 and £120 at time t = 10 .

(i) Calculate the values of a and b . [5]

(ii) Calculate the constant force of interest per annum that would give rise to
the same accumulation from time t = 0 to time t = 10 . [2]
[Total 7]

12 Subject CT1 April 2012 Question 8

The force of interest, d (t ) , at time t is given by:

Ï0.04 + 0.003t 2 for 0 < t £ 5

Ô
d (t ) = Ì0.01 + 0.03t for 5 < t £ 8
Ô0.02 for t > 8
ÔÓ

(i) Calculate the present value (at time t = 0 ) of an investment of £1,000

due at time t = 10 . [4]

(ii) Calculate the constant rate of discount per annum convertible quarterly,
which would lead to the same present value as that in part (i) being
obtained. [2]

(iii) Calculate the present value (at time t = 0 ) of a continuous payment

stream payable at the rate of 100e0.01t from time t = 10 to t = 18 . [4]
[Total 10]

13 Subject CT1 September 2012 Question 1

An investor is considering two investments. One is a 91-day deposit which

pays a rate of interest of 4% per annum effective. The second is a treasury
bill.

Calculate the annual simple rate of discount from the treasury bill if both
investments are to provide the same effective rate of return. [3]

© IFE: 2019 Examinations Page 57

 Batch 4

14 Subject CT1 September 2012 Question 2

The nominal rate of discount per annum convertible quarterly is 8%.

(i) Calculate the equivalent force of interest. [1]

(ii) Calculate the equivalent effective rate of interest per annum. [1]

(iii) Calculate the equivalent nominal rate of discount per annum convertible
monthly. [2]
[Total 4]

15 Subject CT1 September 2012 Question 8

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula

Ï0.03 + 0.01t for 0 £ t £ 9

d (t ) = Ì
Ó 0.06 for 9<t

(i) Derive, and simplify as far as possible, expressions for v (t ) where v (t )

is the present value of a unit sum of money due at time t . [5]

(ii) (a) Calculate the present value of £5,000 due at the end of 15 years.

(b) Calculate the constant force of interest implied by the transaction in

part (a). [4]

A continuous payment stream is received at rate 100e -0.02t units per annum
between t = 11 and t = 15 .

(iii) Calculate the present value of the payment stream. [4]

[Total 13]

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 Batch 4

16 Subject CT1 April 2013 Question 5

The force of interest per unit time at time t , d (t ) , is given by:

Ï0.1 - 0.005t for t < 6

d (t ) = Ì
Ó0.07 for t ≥ 6

(i) Calculate the total accumulation at time 10 of an investment of £100 made

at time 0 and a further investment of £50 made at time 7. [4]

(ii) Calculate the present value at time 0 of a continuous payment stream at

the rate £50e0.05t per unit time received between time 12 and time 15.
[5]
[Total 9]

17 Subject CT1 September 2013 Question 1

The rate of interest is 4.5% per annum effective.

(i) Calculate:
(a) the annual effective rate of discount.
(b) the nominal rate of discount per annum convertible monthly.
(c) the nominal rate of interest per annum convertible quarterly.
(d) the effective rate of interest over a five year period. [5]

(ii) Explain why your answer to part (i)(b) is higher than your answer to part
(i)(a). [2]
[Total 7]

© IFE: 2019 Examinations Page 59

 Batch 4

18 Subject CT1 September 2013 Question 10 (part)

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

d (t ) = 0.05 + 0.002t

Calculate the accumulated value of a unit sum of money:

(i) (a) accumulated from time t = 0 to time t = 7 .

(b) accumulated from time t = 0 to time t = 6 .
(c) accumulated from time t = 6 to time t = 7 . [5]

(iv) Calculate the present value of an annuity that is paid continuously at a

2
rate of 30e -0.01t + 0.001t units per annum from t = 3 to t = 10 . [5]
[Total 10]

19 Subject CT1 April 2014 Question 3

£900 accumulates to £925 in four months.

Calculate the following:

(i) the nominal rate of interest per annum convertible half-yearly [2]

(ii) the nominal rate of discount per annum convertible quarterly [2]

(iii) the simple rate of interest per annum. [2]

[Total 6]

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 Batch 4

20 Subject CT1 April 2014 Question 11

An individual can obtain a force of interest per annum at time t , measured in

years, as given by the formula:

Ï0.03 + 0.01t 0 £ t < 4

Ô
d (t ) = Ì0.07 4£t <6
Ô0.09 6 £t
Ó

(i) Calculate the amount the individual would need to invest at time t = 0 in
order to receive a continuous payment stream of $3,000 per annum from
time t = 4 to t = 10 . [6]

(ii) Calculate the equivalent constant annual effective rate of interest earned
by the individual in part (i). [3]
[Total 9]

21 Subject CT1 September 2014 Question 3

A 91-day treasury bill is bought for £98.83 and is redeemed at £100.

(i) Calculate the annual effective rate of interest from the bill. [3]

(ii) Calculate the annual equivalent simple rate of interest. [2]

[Total 5]

© IFE: 2019 Examinations Page 61

 Batch 4

22 Subject CT1 September 2014 Question 5

Calculate, at a rate of interest of 5% per annum effective:

(i) a(12) [1]

5

(ii) 4| a15 [1]

(iii) (Ia )10 [1]

(iv) ( Ia )10 [1]

(v) the present value of an annuity that is paid annually in advance for 10
years with a payment of 12 in the first year, 11 in the second year and
thereafter reducing by 1 each year. [2]
[Total 6]

23 Subject CT1 September 2014 Question 7

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï0.03 for 0 < t £ 10

Ô
d (t ) = Ì0.003t for 10 < t £ 20
Ô 2
Ó0.0001t for t > 20

(i) Calculate the present value of a unit sum of money due at time t = 28 .
[7]

(ii) (a) Calculate the equivalent constant force of interest from t = 0 to

t = 28 .

(b) Calculate the equivalent annual effective rate of discount from t = 0

to t = 28 . [3]

A continuous payment stream is paid at the rate of e -0.04t per unit time
between t = 3 and t = 7 .

(iii) Calculate the present value of the payment stream. [4]

[Total 14]

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 Batch 4

24 Subject CT1 April 2015 Question 2

Calculate the time in days for £3,000 to accumulate to £3,800 at:

(a) a simple rate of interest of 4% per annum.

(b) a compound rate of interest of 4% per annum effective. [4]

25 Subject CT1 April 2015 Question 3

A 182-day treasury bill, redeemable at $100, was purchased for $96.50 at the
time of issue and later sold to another investor for $98 who held the bill to
maturity. The rate of return received by the initial purchaser was 4% per
annum effective.

(i) Calculate the length of time in days for which the initial purchaser held
the bill. [2]

(ii) Calculate the annual simple rate of return achieved by the second
investor. [2]

(iii) Calculate the annual effective rate of return achieved by the second
investor. [2]
[Total 6]

26 Subject CT1 April 2015 Question 5

An investor pays £120 per annum into a savings account for 12 years. In the
first four years, the payments are made annually in advance. In the second
four years, the payments are made quarterly in advance. In the final four
years, the payments are made monthly in advance.

The investor achieves a yield of 6% per annum convertible half-yearly on the

investment.

Calculate the accumulated amount in the savings account at the end of 12

years. [7]

© IFE: 2019 Examinations Page 63

 Batch 4

27 Subject CT1 April 2015 Question 10

The force of interest, d (t ) , is a function of time and at any time t (measured

in years) is given by

Ï0.08 for 0 £ t £ 4
Ô
d (t ) = Ì0.12 - 0.01t for 4 < t £ 9
Ô0.05 for t > 9
Ó

(i) Determine the discount factor, v (t ) , that applies at time t for all t ≥ 0 .
[5]

(ii) Calculate the present value at t = 0 of a payment stream, paid

continuously from t = 10 to t = 12 , under which the rate of payment at
time t is 100e0.03t . [4]

(iii) Calculate the present value of an annuity of £1,000 paid at the end of
each year for the first three years. [3]
[Total 12]

28 Subject CT1 September 2015 Question 1

An investor wishes to obtain a rate of interest of 3% per annum effective from

a 91-day treasury bill.

Calculate:

(a) the price that the investor must pay per £100 nominal.

(b) the annual simple rate of discount from the treasury bill. [3]

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29 Subject CT1 September 2015 Question 2

The nominal rate of discount per annum convertible monthly is 5.5%.

(i) Calculate, giving all your answers as a percentage to three decimal

places:

(a) the equivalent force of interest.

(b) the equivalent effective rate of interest per annum.

(c) the equivalent nominal rate of interest per annum convertible

monthly. [3]

(ii) Explain why the nominal rate of interest per annum convertible monthly
calculated in part (i)(c) is less than the equivalent annual effective rate of
interest calculated in part (i)(b). [1]

(iii) Calculate, as a percentage to three decimal places, the effective annual

rate of discount offered by an investment that pays £159 in eight years’
time in return for £100 invested now. [1]

(iv) Calculate, as a percentage to three decimal places, the effective annual

rate of interest from an investment that pays 12% interest at the end of
each two-year period. [1]
[Total 6]

30 Subject CT1 September 2015 Question 5

An individual can obtain a force of interest per annum at time t , measured in

years, as given by the formula:

Ï0.03 + 0.005t 0 £ t £ 3
d (t ) = Ì
Ó 0.005 t >3

(i) Determine the amount the individual would need to invest at time t = 0
in order to receive a continuous payment stream of £5,000 per annum
from time t = 3 to time t = 6 . [5]

(ii) Determine the equivalent constant annual effective rate of interest earned
by the individual in part (i). [3]

(iii) Determine the amount an individual would accumulate from the

investment of £300 from time t = 0 to time t = 50 . [2]
[Total 10]

© IFE: 2019 Examinations Page 65

 Batch 4

31 Subject CT1 April 2016 Question 6

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï 0.06 0£t £4
Ô
d (t ) = Ì 0.10 - 0.01t 4<t £7
Ô 0.01t - 0.04 7<t
Ó

(i) Calculate, showing all working, the value at time t = 5 of £10,000 due for
payment at time t = 10 . [5]

(ii) Calculate the constant rate of discount per annum convertible monthly
which leads to the same result as in part (i). [2]
[Total 7]

32 Subject CT1 September 2016 Question 1

The nominal rate of interest per annum convertible quarterly is 5%.

Calculate, giving all the answers as a percentage to three decimal places:

(i) the equivalent annual force of interest. [1]

(ii) the equivalent effective rate of interest per annum. [1]

(iii) the equivalent nominal rate of discount per annum convertible monthly.
[2]
[Total 4]

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33 Subject CT1 September 2016 Question 2

The nominal rate of interest per annum convertible quarterly is 2%.

Calculate the present value of a payment stream paid at a rate of €100 per
annum, monthly in advance for 12 years. [4]

34 September 2016 Question 3

Describe the characteristics of a repayment loan (or repayment mortgage).

[3]

35 Subject CT1 September 2016 Question 6

At the beginning of 2015 a 182-day commercial bill, redeemable at £100, was

purchased for £96 at the time of issue and later sold to a second investor for
£97.50. The initial purchaser obtained a simple rate of interest of 3.5% per
annum before selling the bill.

(i) Calculate the annual simple rate of return which the initial purchaser
would have received if they had held the bill to maturity. [2]

(ii) Calculate the length of time in days for which the initial purchaser held
the bill. [2]

The second investor held the bill to maturity.

(iii) Calculate the annual effective rate of return achieved by the second
investor. [2]
[Total 6]

© IFE: 2019 Examinations Page 67

 Batch 4

36 Subject CT1 September 2016 Question 12

The force of interest, d (t ) , is a function of time and at any time t (measured

in years) is given by:

 0.03 for 0  t  10

  t   a t for 10  t  20
b t for t  20


where a and b are constants.

The present value of £100 due at time 20 is 50.

(i) Calculate a . [5]

The present value of £100 due at time 28 is 40.

(ii) Calculate b. [4]

(iii) Calculate the equivalent annual effective rate of discount from time 0 to
time 28. [2]

A continuous payment stream is paid at the rate of e -0.04t per annum

between t = 3 and t = 7 .

(iv) (a) Calculate, showing all workings, the present value of the payment
stream.

(b) Determine the level continuous payment stream per annum from
time t = 3 to time t = 7 that would provide the same present value
as the answer in part (iv)(a) above. [8]
[Total 19]

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37 Subject CT1 April 2017 Question 1

Calculate the nominal rate of discount per annum convertible monthly which
is equivalent to:

(i) an effective rate of interest of 1% per quarter. [2]

(ii) a force of interest of 5% per annum. [2]

(iii) a nominal rate of discount of 4% per annum convertible every three

months. [2]
[Total 6]

38 Subject CT1 September 2017 Question 1

(i) Calculate the time in days for £6,000 to accumulate to £7,600 at:

(a) a simple rate of interest of 3% per annum.

(b) a compound rate of interest of 3% per annum effective.

(c) a force of interest of 3% per annum. [6]

Note: You should assume there are 365 days in a year.

(ii) Calculate the effective rate of interest per half-year which is equivalent to
a force of interest of 3% per annum. [1]
[Total 7]

39 Subject CT1 September 2017 Question 3

An investor is considering two investments. One is a 91-day deposit which

pays a compound rate of interest of 3% per annum effective. The second is
a government bill.

Calculate the annual simple rate of discount from the government bill if both
investments are to provide the same effective rate of return. [3]

© IFE: 2019 Examinations Page 69

 Batch 4

40 Subject CT1 Septmber 2017 Question 6

An investor has a choice of two 15-year savings plans, A and B, issued by a

company. In both plans, the investor pays contributions of $100 at the start
of each month and the contributions accumulate at an effective rate of interest
of 4% per annum before any allowance is made for expenses.

In plan A, the company charges for expenses by deducting 1% from the

annual effective rate of return.

In plan B, the company charges for expenses by deducting $15 from each of
the first year’s monthly contributions before they are invested. In addition it
deducts 0.3% from the annual effective rate of return.

Calculate the percentage by which the accumulated amount in Plan B is

greater than the accumulated amount in Plan A, at the end of the 15 years.
[6]

41 Subject CT1 Septmber 2017 Question 9

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï0.09 - 0.003t 0 £ t £ 10
d (t ) = Ì
Ó0.06 t > 10

(i) Calculate the corresponding constant effective annual rate of interest for
the period from t = 0 to t = 10. [4]

(ii) Express the rate of interest in part (i) as a nominal rate of discount per
annum convertible half-yearly. [1]

(iii) Calculate the accumulation at time t = 15 of £1,500 invested at time

t = 5. [3]

(iv) Calculate the corresponding constant effective annual rate of discount for
the period t = 5 to t = 15. [1]

(v) Calculate the present value at time t = 0 of a continuous payment stream

payable at a rate of 10e0.01t from time t = 11 to time t = 15. [6]
[Total 15]

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SOLUTIONS TO PAST EXAM QUESTIONS

The solutions presented here are just outline solutions for you to use to check
your answers. See ASET for full solutions.

1 Subject CT1 April 2008 Question 9

(i) Value at time 5 of £1,000 due at time 10

The value at time 5 of £1,000 at time 10 is given by the expression:

Ê 7 ˆ Ê 10 ˆ
V5 = 1,000 exp Á - Ú (0.1 - 0.01t ) dt ˜ exp Á - Ú (0.01t - 0.04) dt ˜
Ë 5 ¯ Ë 7 ¯
Ê 7ˆ Ê 10 ˆ
= 1,000 exp Á - È0.1t - 0.005t 2 ˘ ˜ exp Á - È0.005t 2 - 0.04t ˘ ˜
Ë Î ˚5 ¯ Ë Î ˚7 ¯

= 1,000 e -0.455 + 0.375 e -0.1- 0.035

= 1,000e -0.08e -0.135
= 1,000e -0.215
= £806.54

(ii) Equivalent rate of interest convertible monthly

To find the value of i (12) , we must solve the equation:

60
Ê i (12) ˆ
806.54 Á1 + ˜ = 1,000 fi i (12) = 4.3077%
Ë 12 ¯

© IFE: 2019 Examinations Page 71

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(iii) Accumulated value of payment stream

The accumulated value of the payment stream at time 4 is:

( )
4 Ê4 ˆ 4
4
V4 = Ú 100e0.02t exp Á Ú 0.06ds ˜ dt = Ú 100e0.02t exp ÈÎ0.06s ˘˚t dt
0 Ë t ¯ 0
4
= Ú 100e0.02t e0.24 - 0.06t dt
0
4
0.24
4
-0.04t 0.24
È e -0.04t ˘
= 100e Úe dt = 100e Í- ˙
0 ÎÍ 0.04 ˙˚0

=
100e0.24
0.04
( )
1 - e -0.04 ¥ 4 = 469.9052

The accumulated value of the payment stream at time 12 is:

V12 = 469.9052 ¥ A(4,7) ¥ A(7,12)

Ê7 ˆ Ê 12 ˆ
= 469.9052 exp Á Ú (0.1 - 0.01t )dt ˜ exp Á Ú (0.01t - 0.04)dt ˜
Ë4 ¯ Ë7 ¯
Ê 7ˆ Ê 12 ˆ
= 469.9052 exp Á È0.1t - 0.005t 2 ˘ ˜ exp Á È0.005t 2 - 0.04t ˘ ˜
Ë Î ˚ 4¯ Ë Î ˚ 7 ¯

= 469.9052 e0.455 - 0.32 e0.24 -( -0.035)

= 469.9052 ¥ e0.135 ¥ e0.275
= 708.0615

2 Subject CT1 September 2008 Question 7

(i) Present value of £1,000 due at the end of 12 years

The value at time 0 of a payment of £1,000 at time 12 is given by:

 5   12 
1,000 exp     0.05  0.02t  dt  exp    0.15 dt 
   
 0   5 

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 Batch 4

Now:

 5   5
exp     0.05  0.02t  dt   exp   0.05t  0.01t 2  

 0

   0 

 exp  0.05  5  0.01 25   exp( 0.5)

and:

 
 12  12
exp    0.15 dt   exp  0.15t  5
 
 5 
 exp  0.15  12  0.15  5   exp( 1.05)

Therefore, the value at time 0 is:

1,000e 0.5e 1.05  1,000e 1.55

 £212.25

(ii) Equivalent rate of discount

Let d be the equivalent annual rate of discount. Then:

1,000(1  d )12  1,000e 1.55

 (1  d )12  e 1.55

Hence:

 
1
d  1  e 1.55
12
 12.12%

© IFE: 2019 Examinations Page 73

 Batch 4

3 April 2009 Question 2

(a) Interest-only loan

An interest-only loan is a loan repayable by a series of interest payments

during the term of the loan, followed by repayment of the full capital amount
at the end of the loan. The amount of capital outstanding therefore remains
fixed over the term of the loan.

If the interest rate is fixed, the amount of each interest cashflow is known in
advance. If the interest rate is variable, the interest payments will be unknown
at outset.

(b) Repayment loan

A repayment loan is a loan repayable by a series of payments, each of which

includes partial repayment of the loan capital in addition to interest. This
means the amount of capital outstanding reduces over the term of the loan.

If the interest rate is fixed over the term of the loan, the repayments will all be
for fixed amounts. If the interest rate varies, so will the repayment amounts.

4 Subject CT1 September 2009 Question 1

(a) Length of time for which the initial purchaser held the bill

If the first investor sells the bill at time t years, his equation of value is:

Ê 97.89 ˆ
96 ¥ 1.05t = 97.89 fi t ln1.05 = ln Á
Ë 96 ¯˜
fi t = 0.400 years = 146 days

(b) Annual simple rate of return achieved by the second investor

Let i be the annual simple rate of return earned by the second investor:

Ê 36 ˆ
97.89 Á1 + i = 100 fi i = 21.85%
Ë 365 ˜¯

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 Batch 4

5 Subject CT1 September 2009 Question 5

(i) Values of a and b

100 A(0,5) = 130 fi A(0,5) = 1.3

100 A(0,10) = 200 fi A(0,10) = 2

Since d (t ) = a + bt 2 , we have:

n n
2
Ú d (t ) dt Ú (a + bt ) dt Èat + 1 bt 3 ˘
n
an + 31 bn 3
A(0, n ) = e 0 =e 0 = eÎ 3 ˚0 =e

Hence:

5a + 125
3
b = ln1.3 (1)
1,000
10a + 3
b = ln 2 (2)

(2) - 2 ¥ (1) fi 250b = ln 2 - 2ln1.3 = 0.16842 fi b = 0.0006737

(1) fi a= 1
5 (ln1.3 - 125
3 )
b = 0.04686

(ii) Constant rate of interest convertible monthly

( ) ( )
60
i (12)
A(0,5) = 1.3 = 1 + 12
fi i (12) = 12 1.31/ 60 - 1 = 5.259%

(iii) Constant force of interest

A(5,10) =
A(0,10)
A(0,5)
fi e 5d = 2
1.3
fi d = 1
5
2
( ) = 8.616%
ln 1.3

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 Batch 4

6 Subject CT1 April 2010 Question 11

(i) Expressions for the present value

If 0 £ t < 5 , the PV is:

È t ˘ Ï t ¸
v (t ) = exp Í - Ú 0.04 + 0.02s ds ˙ = exp Ì - È0.04s + 0.01s 2 ˘ ˝
Î ˚
ÎÍ 0 ˙˚ Ó ˛
0

{
= exp - È0.04t + 0.01t 2 ˘
Î ˚ }
If t ≥ 5 , the PV is:

ÏÔ 5 ¸Ô ÏÔ t ¸Ô
v (t ) = exp Ì - Ú 0.04 + 0.02s ds ˝ exp Ì - Ú 0.05 ds ˝
ÓÔ 0 Ô˛ ÓÔ 5 ˛Ô

{
= v (5) exp - ÎÈ0.05s ˚˘5
t
}
From the expression for 0 £ t < 5 , we have v (5) = exp {-0.45} . Hence:

v (t ) = exp {-0.45} exp {-0.05(t - 5)} = exp {-0.05t - 0.2}

(ii)(a) Present value of £1,000 due at time 17

Using the second expression from part (i), with t = 17 :

1,000v (17) = 1,000 exp {-0.2 - 0.05 ¥ 17} = 1,000e -1.05 = £349.94

(ii)(b) Rate of interest convertible monthly

Since v (17) = e -1.05 , we have:

e -1.05 = (1 + i )-17 fi i = 0.063712

Ê 1
ˆ
fi i (12) = 12 Á1.063712 12 - 1˜ = 6.1924%
Ë ¯

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 Batch 4

(iii) Present value of the payment stream

The PV of this payment stream at time 6 is:

ÔÏ Ô¸
10 t 10
V6 = Ú 10e
0.01t
exp Ì - Ú 0.05 ds ˝ dt = Ú 10e0.01t exp {-0.05(t - 6)} dt
6 ÔÓ 6 Ô˛ 6

10
-0.04t 0.3
= Ú 10e e dt
6

10
È e -0.04t ˘
= 10e0.3 Í - ˙
ÎÍ 0.04 ˙˚ 6

=
10e0.3
0.04
(
-e -0.4 + e -0.24 )
= 39.24978

Using the second expression from part (i) with t = 6 , the PV at time 0 is:

V0 = 39.24978v (6) = 39.24978 exp {-0.5} = 23.806

7 Subject CT1 September 2010 Question 8

(i) Derive expressions for v(t)

We have the following forces of interest:

0.05 + 0.001t 0.05 Force of interest

0 20 Time

For 0 £ t £ 20 , we have:

t
- Ú 0.05 + 0.001s ds
v (t ) = e 0

2 t
= e -[0.05s + 0.0005s ]0

2
= e -0.05t - 0.0005t (1)

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 Batch 4

For t > 20

20 t
- Ú 0.05 + 0.001s ds - Ú 0.05 ds
v (t ) = e 0 e 20 (2)

The first integral is v (20) and so we can use equation (1) with t = 20 :
t
- Ú 0.05 ds
-0.05(20) - 0.0005(20)2
v (t ) = e e 20

-[0.05s ]t20
= e -1.2 e
= e -1.2 e -0.05t +1
= e -0.05t - 0.2

(ii)(a) Present value of £100 due at the end of 25 years

The present value is given by:

PV = 100v (25) = 100e -0.05(25) - 0.2 = 100e -1.45 = 23.457 , ie £23.46

(ii)(b) Equivalent rate of discount convertible quarterly

We have:

4 ¥ 25
Ê d (4) ˆ
100 Á1 - ˜ = 23.457
Ë 4 ¯

100
Ê d (4) ˆ
fi Á1 - ˜ = 0.23457 fi d (4) = 4 È1 - 0.234750.01 ˘ = 5.758% pa
Ë 4 ¯ Î ˚

(iii) Accumulated value of payment stream

We have:

– 0.015t
30e Payment stream
0.05 Force of interest

20 25 Time

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 Batch 4

The accumulated value of this payment stream at time 25 is given by:

25
25 Ú 0.05 ds
AV25 = Ú 30e -0.015t e t dt
20
25 25
= Ú 30e -0.015t e[0.05s ]t dt
20
25
= Ú 30e -0.015t e1.25 - 0.05t dt
20
25
= Ú 30e1.25 - 0.065t dt
20
25
È 30 ˘
=Í e1.25 - 0.065t ˙
Î -0.065 ˚20
30 È -0.375
=- e - e -0.05 ˘ = 121.819 , ie £121.82
0.065 Î ˚

8 Subject CT1 April 2011 Question 1

(i) The accumulation of £1,000 from time 3 to time 7

We calculate A(3,5) as:

5 2
A(3,5) = e Ú3
0.04 + 0.003t dt [0.04t + 0.003 t 3 ]53
=e 3 = e[0.325 - 0.147] = e0.178

We calculate A(5,7) as:

A(5,7) = e Ú5
0.01+ 0.03tdt [0.01t + 0.03 t 2 ]75
=e 2 = e[0.805 - 0.425] = e0.380

Therefore:

A(3,7) = A(3,5) ¥ A(5,7) = e0.178 ¥ e0.380 = e0.558 = 1.74717

So, £1,000 accumulates to £1,000 ¥ 1.74717 = £1,747.17 .

© IFE: 2019 Examinations Page 79

 Batch 4

(ii) The equivalent discount rate convertible monthly

We use the following relationship:

( )
(12) 48
1,747.17 1 - d = 1,000
12

Rearranging:

1
È 48 ˘
1

(1 - )d (12)
12
Ê 1,000 ˆ 48
=Á
Ë 1,747.17 ¯˜
fi d (12)
= 12 Í1 - Ê 1,000 ˆ ˙ = 0.138692
Í ÁË 1,747.17 ˜¯ ˙
Î ˚

So the annual rate of discount convertible monthly is 13.87%.

9 Subject CT1 September 2011 Question 1

The discount factor for a 91-day period using a simple rate of discount of 8%
is:

91
1 - nd = 1 - 365 ¥ 0.08 = 0.980055

The discount factor for the same period using an effective rate of interest is:

- 365
91
(1 + i )

Equating the two:

- 365
91
(1 + i ) = 0.980055 fi i = 8.42% pa

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 Batch 4

10 Subject CT1 September 2011 Question 3

A timeline showing the cashflows involved is shown below:

5,000 pa
payable monthly
by government

8,000 pa 3,000 pa
Q per quarter payable monthly payable monthly

61 65 68 78

The PV (at age 61) of the quarterly payments made to purchase the annuity
is:

4Qa(4)
4

The PV (at age 61) of the annuity payments received is:

8,000v 4a(12) + 3,000v 7a(12)

3 10

Equating these:

4Qa(4) = 8,000v 4a(12) + 3,000v 7a(12)

4 3 10

Calculating at an annual effective rate of 5% gives:

4Q ¥ 3.65609 = 8,000(1.05)-4 ¥ 2.79645 + 3,000(1.05)-7 ¥ 7.92931

14.62434Q = 35,310.820
Q = £2,414.52

© IFE: 2019 Examinations Page 81

 Batch 4

11 Subject CT1 September 2011 Question 6

(i) Values of a and b

Since £45 at time 0 accumulates to £55 by time 5, we have:

5
Ú (a + bt ) dt
45 e0 = 55

Carrying out the integration and rearranging:

5
Èat + 1 bt 2 ˘
45 eÎ 2 ˚0 = 55

55 Ê 55 ˆ
fi e5a +12.5b = fi 5a + 12.5b = ln Á ˜ (1)
45 Ë 45 ¯

We also know that £55 at time 5 accumulates to £120 by time 10, so:

10
Ú (a + bt ) dt
55 e 5 = 120

Again, carrying out the integration and simplifying:

10
Èat + 1 bt 2 ˘
55 eÎ 2 ˚5 = 120

120 Ê 120 ˆ
fi e(10a + 50b ) -(5a +12.5b ) = fi 5a + 37.5b = ln Á (2)
55 Ë 55 ˜¯

Subtracting Equation (1) from Equation (2):

Ê 120 ˆ Ê 55 ˆ
25b = ln Á - ln Á ˜ fi b = 0.0231795
Ë 55 ˜¯ Ë 45 ¯

Rearranging Equation (1) and substituting in our value for b :

1 Ê Ê 55 ˆ ˆ
a= ln - 12.5b˜ fi a = -0.0178146
5 ÁË ÁË 45 ˜¯ ¯

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(ii) Equivalent constant force of interest

We want £45 at time 0 to accumulate to £120 at time 10 at a constant force of

interest d :

1 Ê 120 ˆ
45e10d = 120 fi d = ln = 9.808%
10 ÁË 45 ˜¯

12 Subject CT1 April 2012 Question 8

(i) Present value of an investment of £1,000 due at time 10

5 2 8 10

PV = £1,000e Ú0
- 0.04 + 0.003t dt - Ú5 0.01+ 0.03tdt - Ú8 0.02dt
e e
-[0.04t + 0.003 t 3 ]05 -[0.01t + 0.03 t 2 ]58 -[0.02t ]10
= £1,000e 3 e 2 e 8

-0.325 -0.615 -0.04

= £1,000e e e
-0.98
= £1,000e
= £375.31

(ii) Equivalent discount rate convertible quarterly

( )
40
1,000 1 - d ( 4) = 375.31 fi d (4) = 9.681%
4

(iii) Present value of payment stream

t
18 0.01t - Ú10 0.02ds
Value at time 10 = Ú10 100e e dt
18 t
0.01t -ÈÎ0.02s ˚˘ 10
= Ú10 100e e dt
18 0.01t -(0.02t - 0.2)
= Ú10 100e e dt
18 0.2 - 0.01t
= Ú10 100e dt
18
= 100e0.2 Ú e -0.01t dt
10
18
È e -0.01t ˘
= 100e0.2 Í ˙
ÎÍ -0.01 ˚˙10
= 849.6958

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 Batch 4

We then need to discount this value from time 10 to time 0:

PV = 849.6958 ¥ v (10)
= 849.6958 ¥ e -0.98
= 318.900

13 Subject CT1 September 2012 Question 1

Equating discount factors using an effective rate of interest of 4% pa we get:

(1 - )
91
91 - 365
365
¥ d = 1.04 fi d = 3.903% pa

14 Subject CT1 September 2012 Question 2

(i) Force of interest

4 -4
Ê d (4) ˆ -1 Ê 0.08 ˆ
Á1 - ˜ = 1 - d = v = (1 + i ) fi i = Á1 - - 1 = 8.4166%
Ë 4 ¯ Ë 4 ˜¯

fi d = ln(1 + i ) = ln(1.084166) = 8.081%

(ii) Rate of interest

i = 8.417%

(iii) Nominal rate of discount

d (12) = 12 ÊÁ1 - (1 + i ) 12 ˆ˜ = 12 ÊÁ1 - 1.084166 12 ˆ˜ = 8.054%

-1 -1
Ë ¯ Ë ¯

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 Batch 4

15 Subject CT1 September 2012 Question 8

(i) Discount factor

If 0 £ t £ 9 :

Ê t ˆ Ê È 0.01 2 ˘ ˆ
t
v (t ) = exp Á - Ú 0.03 + 0.01u du ˜ = exp Á - Í0.03u + u ˙ ˜
Ë 0 ¯ ËÁ Î 2 ˚0 ¯˜

= exp( -0.03t - 0.005t 2 )

If t > 9 :

Ê t ˆ
v (t ) = exp( -0.03 ¥ 9 - 0.005 ¥ 92 ) exp Á - Ú 0.06 du ˜
Ë 9 ¯

(
= exp( -0.27 - 0.405) exp - ÈÎ0.06u ˘˚9
t
)
= exp( -0.675) exp( -0.06t + 0.54)
= exp( -0.06t - 0.135)

(ii)(a) Present value

We can use the expression from part (i) to answer this question:

PV = 5,000v (15) = 5,000 exp( -0.06 ¥ 15 - 0.135) = 5,000e -1.035 = £1,776.13

(ii)(b) Equivalent constant force of interest

Equating the PV expression from (ii)(a) to a constant force of interest PV

expression, we get:

5,000e -1.035 = 5,000e -15d fi 15d = 1.035 fi d = 6.9%

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 Batch 4

(iii) Present value of the payment stream

The present value of this payment stream at time 11 is given by:

( )
15 15
-0.02t t -0.02t -0.06t + 0.66
PV11 = Ú 100e exp - ÎÈ0.06u ˚˘11 dt = Ú 100e e dt
11 11
15
15
-0.08t
È e -0.08t ˘
= 100e0.66 Úe dt = 100e0.66 Í ˙
11 ÍÎ -0.08 ˙˚11

=
-0.08
e (
100e0.66 -1.2
)
- e -0.88 = 274.713

However, we require the present value at time 0, so we again need to use the
expression from part (i) of the question:

PV0 = 274.713v (11) = 274.713e -0.06 ¥11- 0.135 = 274.713e -0.795

= 124.06

16 Subject CT1 April 2013 Question 5

(i) Total accumulation at time 10

The investment of £50 made at t = 7 will accumulate to:

Ê 10 ˆ
50 exp Á Ú 0.07 dt ˜ = 50e0.21 = 61.6839
Ë7 ¯

The investment of £100 made at t = 0 will accumulate to:

Ê6 10 ˆ
100 exp Á Ú 0.1 - 0.005t dt + Ú 0.07 dt ˜
Ë0 6 ¯
Ê 6 10 ˆ
= 100 exp Á È 0.1t - 0.0025t 2 ˘ + ÈÎ0.07t ˘˚ 6 ˜ = 100 e0.79 = 220.3396
Ë Î ˚ 0 ¯

So the total accumulated value is:

100 e0.79 + 50 e0.21 = £282.02

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(ii) Present value of continuous payment stream

The value at time t = 12 of the whole payment stream is:

15
0.05t
Ê t ˆ
PV12 = Ú 50 e exp Á - Ú 0.07 ds ˜ dt
12 Ë 12 ¯

( )
15
0.05t t
= Ú 50 e exp -[0.07s ]12 dt
12
15
0.05t -0.07t + 0.84
= Ú 50 e e dt
12
15
È e0.84 - 0.02t ˘
( )
15
0.84 - 0.02t 0.6 0.54
= 50 Ú e dt = 50 Í ˙ = 2,500 e - e
12 ÎÍ -0.02 ˙˚12

So the value at time t = 6 is:

Ê 12 ˆ
(
PV6 = PV12 ¥ exp Á - Ú 0.07 dt ˜ = 2,500 e0.6 - e0.54 ¥ e -0.07 ¥ 6
Ë 6 ¯
)
(
= 2,500 e0.18 - e0.12 )
Hence the value at t = 0 is:

Ê 6 ˆ
PV0 = PV6 ¥ exp Á - Ú 0.1 - 0.005t dt ˜
Ë 0 ¯

( Ê
)
6ˆ
= 2,500 e0.18 - e0.12 ¥ exp Á - È0.1t - 0.0025t 2 ˘ ˜
Ë Î ˚ 0¯

= 2,500 (e 0.18
- e0.12 )¥e -0.51

= 2,500 (e -0.33
- e -0.39)
= £104.67

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 Batch 4

17 Subject CT1 September 2013 Question 1

(i)(a) Effective rate of discount

i 0.045
d= = = 4.306%
1 + i 1.045

(i)(b) Nominal rate of discount

1 1
- 12 - 12
d (12) = 12(1 - (1 + i ) ) = 12(1 - 1.045 ) = 4.394%

(i)(c) Nominal rate of interest

1 1
i (4) = 4((1 + i ) 4 - 1) = 4(1.045 4 - 1) = 4.426%

(i)(d) Effective rate of interest

Equating accumulation factors over a one-year period:

1
(1 + i ) 5 = 1.045 fi i = 1.0455 - 1 = 24.62%

(ii) Why is it higher?

Effective discount, d , is equivalent to an interest payment of d at the start

of the year, ie at time 0. Nominal discount convertible monthly, d (12) , is
d (12)
equivalent to interest payments of 12
at the start of each month.

In this question we have d = 4.3062% and d (12) = 4.3936% , so for an

investment of £100, we would have interest of £4.31 (4.3062% of £100) at the
4.3936
start of the year or £0.37 ( 12
at the start of each month). Payments
received later need to be higher to compensate for the fact that the payments
are being received later. In this question this means that 12 ¥ £0.37 > £4.31.
In general, d (12) > d .

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18 Subject CT1 September 2013 Question 10 (part)

(i) Accumulated values

Ê t2 ˆ
A(t1, t2 ) = exp Á Ú 0.05 + 0.002t dt ˜
ÁË t ˜¯
1

t2
= exp È0.05t + 0.001t 2 ˘
Î ˚t1

(
= exp 0.05(t2 - t1 ) + 0.001(t22 - t12 ) )
(a) From time 0 to time 7

( )
A(0,7) = exp 0.05(7 - 0) + 0.001(72 - 0) = e0.399 = 1.4903

(b) From time 0 to time 6

( )
A(0,6) = exp 0.05(6 - 0) + 0.001(62 - 0) = e0.336 = 1.3993

(c) From time 6 to time 7

A(0,7) e 0.399
A(6,7) = = = e0.063 = 1.0650
A(0,6) e 0.336

(iv) Present value

The present value of this payment stream at time 3 is given by:

10
-0.01t + 0.001t 2
Ê t ˆ
PV3 = Ú 30e exp Á - Ú 0.05 + 0.002u du ˜ dt
3 Ë 3 ¯

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 Batch 4

We can proceed as follows:

10
-0.01t + 0.001t 2 Ê t ˆ
PV3 = Ú 30e exp Á - È0.05u + 0.001u 2 ˘ ˜ dt
3
Ë Î ˚3 ¯
10
( 2
-0.01t + 0.001t 2 - 0.05( t - 3) + 0.001( t - 9) ) dt
= Ú 30e e
3
10
-0.06t
= 30e0.159 Úe dt
3
10
0.159
È e -0.06t ˘
= 30e Í ˙
ÎÍ -0.06 ˙˚3
= 167.913

Ê 3 ˆ
PV0 = 167.913 exp Á - Ú 0.05 + 0.002t dt ˜
Ë 0 ¯
Ê 3ˆ
= 167.913 exp Á - È0.05t + 0.001t 2 ˘ ˜
Ë Î ˚ 0¯

= 167.913e -0.159
= 143.229

19 Subject CT1 April 2014 Question 3

(i) Nominal rate of interest convertible half-yearly

We find first the effective annual rate of interest:

900 (1 + i )
1/ 3
= 925 fi i = 0.085670

i (2) = 2 È(1 + i ) - 1˘ = 2 È(1.085670) - 1˘ = 8.39% pa (3 SF)

1/ 2 1/ 2
ÎÍ ˚˙ ÍÎ ˙˚

(ii) Nominal rate of discount convertible quarterly

d (4) = 4 È1 - (1 + i )
-¼ ˘
= 4 È1 - (1.085670)
-¼ ˘
= 8.14% pa (3 SF)
ÎÍ ˚˙ ÎÍ ˚˙

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(iii) Simple rate of interest

Ê 1 ˆ
900 Á1 + i ˜ = 925 fi i = 8.33% pa (3 SF)
Ë 3 ¯

20 Subject CT1 April 2014 Question 11

(i) Present value of continuous payment stream

The value at time 4 of the payment stream is:

PV4 = 3,000 Èad = 7% + e -2 ¥ 0.07 ¥ a d = 9% ˘

Î 2 4 ˚

Evaluating the functions:

1 - e -2d 1 - e -4d
a d = 7% = = 1.866311 a d = 9% = = 3.359152
2 d 4 d

fi PV4 = 3,000 È1.866311 + e -2 ¥ 0.07 ¥ 3.359152˘ = 14,359.852

Î ˚

We now need to discount this back to time zero. The discount factor from time
four to time zero will be:

4
- Ú 0.03 + 0.01s ds - È0.03s + 0.005s 2 ˘
4
- ÈÎ0.12 + 0.08˘˚
v (4) = e 0 =e Î ˚0 =e = e -0.2

So the amount that would need to be invested at time zero is:

PV0 = e -0.2 ¥ 14,359.852 = $11,756.85

(ii) Equivalent constant rate

We now need to solve the equation of value for the equivalent constant rate:

PV0 = 3,000v 4a6 = 11,756.852

1- v6
ie: v4 ¥ = 3.918951
d

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 Batch 4

We will use trial and improvement to find a solution to this equation:

i = 0.06 , LHS = 4.0107

i = 0.07 , LHS = 3.7622

So, using linear interpolation between these values, we find that:

4.0107 - 3.918951
0.06 + ¥ (0.07 - 0.06) = 0.063692
4.0107 - 3.7622

So the equivalent constant annual effective rate of interest is 6.4% pa.

21 Subject CT1 September 2014 Question 3

(i) Annual effective rate of interest

365
Ê 100 ˆ
98.83 (1 + i )
91/365 91
= 100 fi 1+ i = Á fi i = 4.834% pa
Ë 98.83 ˜¯

(ii) Equivalent simple rate

Ê 91i ˆ
98.83 Á1 + = 100 fi i = 4.748% pa
Ë 365 ˜¯

22 Subject CT1 September 2014 Question 5

1- v5 1 - 1.05 -5 1 - 1.05 -5
(i) a(12) = = = = 4.42782
5 i (12) 12 È(1.05 )
1/12
- 1˘ 0.0488895
ÎÍ ˚˙

1 - 1.05-15
(ii) 4| a15 = v 4 ¥ a15 = 1.05-4 ¥ = 8.53937 .
0.05

1 - 1.05 -10
a10 - 10v 10 -1
- 10 ¥ 1.05 -10
-
(iii) (Ia )10 =
d
= 1 1.05
ln1.05
= 40.35012

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1 - 1.05 -10
a10 - 10v 10 - 10 ¥ 1.05 -10
(iv) (Ia) 10
=
d
= ln1.05
ln1.05
= 36.36135

(v) Decreasing annuity

PV = 12 + 11v + 10v 2 +  + 3v 9

( ) (
= 13 1 +  + v 9 - 1 + 2v + 3v 2 +  + 10v 9 )
= 13a10 - (Ia)10

1 - 1.05 -10
-10 - 10 ¥ 1.05 -10
1 - 1.05 -1
= 13 ¥ - 1 - 1.05
1 - 1.05 -1 1 - 1.05 -1
= 13 ¥ 8.10782 - 41.34247
= 64.05921

23 Subject CT1 September 2014 Question 7

(i) Present value of a unit sum due at time 28

The present value is:

10 20 28
- Ú 0.03 dt - Ú 0.003t dt - Ú 0.0001t 2 dt
PV = e 0 ¥e 10 ¥e 20

Evaluating the integrals:

10
10
Ú 0.03 dt = ÈÎ0.03t ˘˚0 = 0.3
0

( )
20 20
Ú 0.003t dt = È0.0015t 2 ˘ = 0.0015 202 - 102 = 0.45
Î ˚10
10

and:

28
È t3 ˘
( )
28
2 0.0001 3 3
Ú 0.0001t dt = Í0.0001 3 ˙ = 3 28 - 20 = 0.46507
20 Í
Î ˙
˚20

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So the present value is:

PV = e -0.3 ¥ e -0.45 ¥ e -0.46507 = e -1.21507 = 0.29669

(ii)(a) Equivalent constant force of interest

We want the value of d that satisfies the equation:

e -28d = 0.29669

ln 0.29669
Solving this equation, we find that d = = 0.04340 , or 4.34% pa.
-28

(ii)(b) Equivalent annual effective rate of discount

We have:

d = 1 - v = 1 - e -d = 1 - e -0.04340 = 0.04247

The rate of discount is 4.247% pa.

(iii) Present value of the payment stream

The present value at time zero is:

7 7
PV = Ú e -0.04t e -0.03t dt = Ú e -0.07t dt
3 3
7
È e -0.07t ˘ e -0.49 - e -0.21
=Í ˙ = = 2.82797
ÎÍ -0.07 ˙˚3 -0.07

24 Subject CT1 April 2015 Question 2

(a) Simple interest

Working in years, we have the equation:

3, 000(1 + 0.04t ) = 3, 800

Solving this equation, we find that t = 6.6667 years.

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Converting this to days, we find that:

t = 6.6667 ¥ 365 = 2, 433.33 days

(b) Compound interest

Again, working in years, the equation is now:

3, 000 ¥ 1.04t = 3, 800

Taking logs of both sides gives:

log 3, 000 + t log1.04 = log 3, 800

Rearranging this, we find that:

log 3, 800 - log 3, 000

t= = 6.02714
log1.04

Again, converting this into days we have:

t = 6.02714 ¥ 365 = 2,199.91 days

25 Subject CT1 April 2015 Question 3

(i) Length of time held

We have:

96.5 ¥ 1.04t = 98

Taking logs of both sides of this equation gives:

log 96.5 + t log1.04 = log 98

Rearranging this, we find that:

log 98 - log 96.5

t= = 0.39327
log1.04

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Converting this to days, we find that the length of time is:

t = 0.39327 ¥ 365 = 143.545

or about 144 days.

(ii) Annual simple rate of return

Since the original investor held the bill for 144 days, the bill was held by the
second investor for 182 - 144 = 38 days. So the simple rate of return
experienced by the second investor is the solution of the equation:

Ê 38 ˆ
98 Á1 + ¥ i = 100
Ë 365 ˜¯

Solving this equation, we find that:

Ê 100 ˆ 365
i =Á - 1˜ ¥ = 0.19603
Ë 98 ¯ 38

(iii) Annual effective rate of return

The equation of value is now:

98 (1 + i )
38/365
= 100

Taking logs of both sides of this equation, we obtain:

38
log 98 + log (1 + i ) = log100
365

Rearranging this, we find that:

log100 - log 98
log (1 + i ) = = 0.19405
38 / 365

This gives:

i = e0.19405 - 1 = 0.21416

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26 Subject CT1 April 2015 Question 5

A yield of 6% per annum convertible half-yearly is equivalent to an effective

half-yearly rate of 3%. So the effective annual rate of interest is:

1.032 - 1 = 6.09%

The accumulated value of the cashflows is:

120 Ès4 (1 + i ) + s(4) (1 + i ) + s(12) ˘

8 4
ÎÍ 4 4 ˚˙

Evaluating the various factors using an effective interest rate of 6.09% pa, we
obtain:

s4 =
(1 + i )4 - 1 = 1.06094 - 1
= 4.647231
d 0.0609 / 1.0609

d (4) = 4 È1 - 1.0609-1/4 ˘ = 0.058683

Î ˚

d (12) = 12 È1 - 1.0609-1/12 ˘ = 0.058972

Î ˚

s(4) =
(1 + i )4 - 1 = 1.06094 - 1 = 4.545960
4 d (4) 0.058683

and:

s(12) =
(1 + i )4 - 1 = 1.06094 - 1 = 4.523657
4 d (12) 0.058972

Putting all this together gives an accumulated value of:

120 È 4.647231 ¥ 1.06098 + 4.545960 ¥ 1.06094 + 4.523657 ˘

Î ˚
= 2,128.7742

or about £2,128.77.

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27 Subject CT1 April 2015 Question 10

(i) Discount factor

If 0 £ t < 4 , then the discount factor is calculated at a constant force of 8% pa

for t years. So:

È t ˘ È t ˘
v (t ) = exp Í - Ú d (s ) ds ˙ = exp Í - Ú 0.08 ds ˙ = e -0.08t
ÎÍ 0 ˙˚ ÎÍ 0 ˙˚

Setting t = 4 , we see that v (4) = e -0.32 .

For values of t between 4 and 9, we have:

È Ê4 t ˆ˘
v (t ) = exp Í - Á Ú 0.08 ds + Ú 0.12 - 0.01s ds ˜ ˙
Í Ë0 ¯ ˙˚
Î 4

È Êt ˆ˘
= v (4) exp Í - Á Ú 0.12 - 0.01s ds ˜ ˙
Í Ë4 ¯ ˙˚
Î

Simplifying this expression:

È Êt ˆ˘
v (t ) = exp ÎÈ -0.32 ˚˘ exp Í - Á Ú 0.12 - 0.01s ds ˜ ˙
Í Ë4 ¯ ˙˚
Î
È t ˘
= exp ÎÈ -0.32 ˚˘ exp Í - È0.12s - 0.005s 2 ˘ ˙
Î Î ˚ 4˚

= exp ÈÎ -0.32 ˘˚ exp È -0.12t + 0.005t 2 + 0.48 - 0.08 ˘

Î ˚

= exp ÈÎ -0.32˘˚ exp È0.4 - 0.12t + 0.005t 2 ˘

Î ˚
2
= e0.08 - 0.12t + 0.005t

Setting t = 9 , we see that:

v (9) = e0.08 - 0.12¥ 9 + 0.005 ¥ 81 = e -0.595

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Finally, for values of t > 9 , we have:

È Ê4 9 t ˆ˘
v (t ) = exp Í - Á Ú 0.08 ds + Ú 0.12 - 0.01s ds + Ú 0.05 ds ˜ ˙
Í Ë0 ¯ ˙˚
Î 4 9

È t ˘
= v (9) exp Í - Ú 0.05 ds ˙
ÍÎ 9 ˙˚

= exp ÎÈ -0.595 ˚˘ exp ÈÎ -0.05 (t - 9) ˘˚

= e -0.145 - 0.05t

Putting all these results together, we have the following:

Ïe -0.08t 0£t £4
Ô
Ô 2
v (t ) = Ìe0.08 - 0.12t +0.005t 4<t £9
Ô -0.145 -0.05t
ÔÓe t >9

(ii) Present value of the payment stream

The present value at time 0 of the payment stream is:

12 12
Ú 100e
0.03t
v (t ) dt = Ú 100e
0.03t
e -0.145 - 0.05t dt
10 10
12
= 100e -0.145 Ú e -0.02t dt
10
12
È e -0.02t ˘
= 100e -0.145 Í ˙
ÍÎ -0.02 ˙˚10
= 5, 000e -0.145 (e -0.2 - e -0.24 )
= 138.85

(iii) Annuity

The present value of the annuity is:

1, 000 ÈÎv (1) + v (2) + v (3)˘˚ = 1, 000 Èe -0.08 + e -0.16 + e -0.24 ˘ = £2, 561.89
Î ˚

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28 Subject CT1 September 2015 Question 1

(a) Price

The price of £100 nominal will be:

P = 100v 91 365
= 100 ¥ 1.03 - 91 365
= £99.27

(b) Annual rate of simple discount

Equating discount factors gives:

91
1.03 - 91 365 = 1 - d
365

Rearranging this gives:

d=
365
91
( )
1 - 1.03 - 91 365 = 2.945%

29 Subject CT1 September 2015 Question 2

(i)(b) Effective rate of interest

0.055 = 12 È1 - (1 + i )-1 12 ˘
Î ˚

Rearranging this gives:

-12
Ê 0.055 ˆ
(1 + i ) = Á1 - fi i = 0.0566742 = 5.667% pa
Ë 12 ˜¯

(i)(a) Force of interest

Using the full figure from part (i)(b) we have:

d = ln1.0566742 = 5.513% pa

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(i)(c) Nominal interest convertible monthly

i (12) = 12 È1.05667421 12 - 1˘ = 5.525% pa

Î ˚

(ii) Explain

An annual nominal rate of interest convertible monthly, i ( p ) , is equivalent to

receiving 12 payments of i (12) p at the end of each month. Whereas an
annual effective rate is equivalent to receiving a single payment of i at the
end of the year.

Since interest is earned on the payments received earlier in the year this
means that a smaller rate is required to accumulate them to the same amount,
i , at the end of the year.

(iii) Annual effective rate

The equation of value is:

159(1 - d )8 = 100

Rearranging gives:

18
Ê 100 ˆ
d = 1- Á = 5.632% pa
Ë 159 ˜¯

(iv) Annual effective rate

Equating accumulation factors over two years gives:

(1 + i )2 = 1.121

fi i = 1.12½ - 1 = 5.830% pa

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30 Subject CT1 September 2015 Question 5

(i) Present value of payment stream

The value of this payment stream at time 3 is given by:

t
6 - Ú 0.005 ds
PV3 = Ú 5,000e 3 dt
3
6 t
= Ú 5,000e -[0.005s ]3 dt
3
6
= Ú 5,000e -0.005t + 0.015 dt
3
6
È 5,000 -0.005t + 0.015 ˘
=Í e ˙
Î -0.005 ˚3
= -1,000,000 Èe -0.015 - e0 ˘
Î ˚
= £14,888

Hence, the value at time t = 0 is:

3
- Ú 0.03 + 0.005t dt
PV0 = 14,888e 0

3
- È0.03t + 0.0025t 2 ˘
Î ˚0
= 14,888e
= 14,888e -0.1125
= £13,304

(ii) Equivalent constant annual effective rate

The present value at time 0 is given by:

PV0 = 5,000v 3a3

Equating this gives:

5,000v 3a3 = 13,304

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Using trial and error:

i = 2% fi LHS = 13,723
i = 3% fi LHS = 13,136

Interpolating between these gives:

13,304 - 13,723
i = 2% + (3% - 2%) = 2.71% pa
13,136 - 13,723

(iii) Accumulation

AV = 300 A(0,3)A(3,50)
3 50
Ú 0.03 + 0.005t dt Ú 0.005 dt
= 300e 0 e3
3
È0.03t + 0.0025t 2 ˘ È0.005t ˘50
= 300e Î ˚0 Î
e ˚3

0.1125 0.235
= 300e e
= £424.66

31 Subject CT1 April 2016 Question 6

(i) Value at time 5 of £10,000 due at time 10

We need to discount back from time 10 to time 7 using the force function
d (t ) = 0.01t - 0.04 , and then back from time 7 to time 5 using the force
function d (t ) = 0.10 - 0.01t :

È 10 ˘ È 7 ˘
PV = 10,000exp Í - Ú 0.01t - 0.04 dt ˙ ¥ exp Í - Ú 0.10 - 0.01t dt ˙
ÎÍ 7 ˚˙ ÎÍ 5 ˙˚

Evaluating the first of these integrals gives:

10 10
Ú 0.01t - 0.04 dt = ÈÎ0.005t - 0.04t ˘
2
˚7
7
= (0.5 - 0.4 ) - (0.245 - 0.28 ) = 0.135

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Evaluating the second of these integrals gives:

7 7
Ú 0.10 - 0.01t dt = ÈÎ0.10t - 0.005t
2˘
˚5
5
= (0.7 - 0.245) - (0.5 - 0.125) = 0.08

So the present value is:

PV = 10,000e -0.135e -0.08 = 10,000e -0.215 = £8,065.41

(ii) Equivalent constant rate of discount convertible monthly

We have the equation of value (assuming a constant rate of interest) of:

10,000v 5 = 8,065.41

From this we find that:

v = 0.957911

12
È d (12) ˘
Using Í1 - ˙ = 1 - d = v = 0.957911 and rearranging, we find that:
ÎÍ 12 ˚˙

d (12) = 12 È1 - 0.9579111/12 ˘ = 0.042923

Î ˚

So the equivalent constant rate of discount convertible monthly is 4.29% pa.

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32 Subject CT1 September 2016 Question 1

(i) Equivalent annual force of interest

Expressing the accumulation factor for a quarter of a year in two different

ways:

ed /4 = 1.0125

Solving this equation, we find that:

d = 4log1.0125 = 0.04969

So the equivalent annual force is 4.969% pa.

(ii) Equivalent annual rate

We have:

4
Ê 0.05 ˆ
1 + i = Á1 + = 1.05095
Ë 4 ˜¯

So the equivalent annual effective rate of interest is 5.095% pa.

(iii) Equivalent nominal rate of discount convertible monthly

We have:

d ( p ) = p È1 - (1 - d )
1/ p ˘
= p È1 - (1 + i )
-1/ p ˘
ÍÎ ˙˚ ÍÎ ˙˚

So:

d (12) = 12 È1 - (1.05095)
-1/12 ˘
= 0.04959
ÍÎ ˙˚

The equivalent nominal rate of discount convertible monthly is 4.959% pa.

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33 Subject CT1 September 2016 Question 2

The present value of the payment stream can be written as:

PV = 100 a(12)
12

Since i (4) = 0.02 , we have:

4 4
Ê i (4) ˆ Ê 0.02 ˆ
i = Á1 + ˜ - 1 = ÁË1 + ˜ - 1 = 1.02015 - 1 = 0.02015
Ë 4 ¯ 4 ¯

1
From this, v = = 0.98025 . So:
1.02015

d (12) = 12 È1 - (1 - d )
1/12 ˘
= 12 È1 - 0.980251/12 ˘ = 0.01993
ÎÍ ˚˙ Î ˚

So the present value is:

1 - v 12 1 - 1.02015 -12
PV = 100 a(12) = 100 ¥ (12)
= 100 ¥ = 1,068.0543
12 d 0.01993

The present value is €1,068.05.

34 September 2016 Question 3

 A fixed amount is borrowed at the start of the term; repayments are made
regularly (often monthly) over the period of the loan.
 The repayments are usually level but could vary (eg increase or decrease
in a specified way).
 Repayments are made up partly of interest and partly of capital
repayment.
 Over time, the interest component of each payment will decrease, and
the capital repayment component will increase.
 The interest rate may be fixed for the term (or part of the term), but is
more usually variable.
 A repayment mortgage will be secured on the value of the relevant
property (ie if the borrower defaults, the lender will be able to take and
sell the property to repay the loan).

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 The interest rate will be based on the general level of interest rates,
although the creditworthiness of the borrower may also be taken into
account.
 The loan may be allowed to be repaid early.

35 Subject CT1 September 2016 Question 6

(i) Annual simple rate of return

Using a simple rate of interest, and using a denominator of 365 for the number
of days in 2015, we have:

Ê 182 ˆ 365 Ê 100 ˆ

96 Á1 + i = 100 fi i= ¥ - 1˜ = 0.08356
Ë 365 ˜¯ 182 ÁË 96 ¯

So the annual simple rate of interest is 8.356%.

(ii) Length of time period

Writing down an equation of value for the actual holding period, n , using the
simple rate of interest of 3.5% pa and working in years, we have:

96 (1 + 0.035n ) = 97.50 fi n = 0.44643 years

Converting this into days (again using 365 days in a year), we have a time
period of 162.946 days, or say 163 days.

(iii) Annual effective rate of return

If the initial purchaser held the bond for 163 days, the second investor held it
for 182 - 163 = 19 days. So the equation of value for the second investor is
(using an effective rate of interest):

97.50 (1 + i )
19/365
= 100

Solving this equation of value, we find that:

365/19
Ê 100 ˆ
i =Á - 1 = 0.62640
Ë 97.50 ˜¯

So the second investor achieved an effective rate of interest of 62.64% pa.

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36 Subject CT1 September 2016 Question 12

(i) Calculate a

Discounting back from time 20 to time zero, we have:

20

-0.03 ¥10
- Ú at dt
50 = 100 e ¥e 10

20
È1 ˘
- Í at 2 ˙
Î2 ˚ 10
= 100 e -0.3 ¥ e
= 100 e - (0.3 +150a )

Taking logs:

- (0.3 + 150a ) = ln0.5

Solving this equation, we find that:

- ln0.5 - 0.3
a= = 0.00262
150

(ii) Calculate b

Discounting again:

28
- Ú bt dt
40 = 100e -0.3e -150ae 20

28
È1 ˘
- Í bt 2 ˙
-(0.3 +150 ¥ 0.00262) Î 2 ˚20
= 100e e
-0.69315 -192b
= 100e

Again taking logs:

-0.69315 - 192b = ln0.4

Solving this equation, we find that:

- ln0.4 - 0.69315
b= = 0.00116
192

(iii) Equivalent annual rate of discount

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Discounting from time 28 to time zero at a constant rate of interest:

100v 28 = 40 fi 100(1 - d )28 = 40

Solving this equation, we find that d = 0.03220 . So the rate of discount is

3.22% pa.

(iv)(a) Present value of the payment stream

The present value of the payment stream is:

7 7
-0.03t
Úe ¥ e -0.04t dt = Ú e -0.07t dt
3 3
7
È e -0.07t ˘
=Í ˙
ÎÍ -0.07 ˙˚3
e -0.49 - e -0.21
=
-0.07
= 2.82797

(iv)(b) Level of continuous payment stream

The present value of a continuous payment stream made at a rate of k per

annum is:

7
7
-0.03t
È e -0.03t ˘ e -0.21 - e -0.09
Úk e dt = k Í ˙ = k = 3.44490k
3 ÎÍ -0.03 ˙˚3 -0.03

Equating this to the present value in the previous part, we obtain:

2.82797
k= = 0.82092
3.44490

So the equivalent level payment stream should be made at a rate of 0.821 pa.

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37 Subject CT1 April 2017 Question 1

(i) d (12) equivalent to an effective rate of interest of 1% per quarter

The annual effective interest rate i that is equivalent to a quarterly effective

interest rate of 1% is:

i  1.014  1  4.0604%
So:

 
d (12)  12 1  1.0406041 12  3.974%

(ii) d (12) equivalent to a force of interest of 5% pa

The annual effective interest rate i that is equivalent to a force of interest of

5% pa is:

i  e  1  e0.05  1  5.1271%

So:

 
d (12)  12 1  1.0512711 12  4.990%

(iii) d (12) equivalent to a nominal rate of discount of 4% pa convertible

quarterly

The annual effective interest rate i that is equivalent to d (4)  4% is:

4
 d (4)  4
i  1    1  1  0.01  1  4.1020%
 4 


So:

 
d (12)  12 1  1.0410201 12  4.013%

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38 Subject CT1 September 2017 Question 1

(i)(a) Simple rate of interest

Assuming a time period t (in years) for the investment, the equation of value
is:
6,000 (1 + ti ) = 7,600

Using an interest rate of 3% pa and solving, we have:

Ê 7,600 ˆ
ÁË 6,000 ˜¯ - 1
t= = 8.88889
0.03

Converting this to days, we have:

t = 8.88889 ¥ 365 = 3,244.444

or about 3,244 days.

(i)(b) Compound rate of interest

We now have:

6,000 (1.03) = 7,600

t

Taking logs:

7,600
t log1.03 =
6,000

So:

log (7,600 6,000 )

t= = 7.99724
log1.03

Converting to days, we have:

t = 7.99724 ¥ 365 = 2,918.992

or about 2,919 days.

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(i)(c) Force of interest

We now have:

6,000e0.03t = 7,600

Rearranging this equation:

1 Ê 7,600 ˆ
t= ln = 7.87963
0.03 ÁË 6,000 ˜¯

Converting to days:

t = 7.87963 ¥ 365 = 2,876.063

or about 2,876 days.

(ii) Effective rate of interest per half-year

The effective rate of interest per half-year is the value of i which is the solution
of the equation:

(1 + i )2 = e0.03
Solving this equation to find i :

i = e0.03/2 - 1 = 0.01511

So the effective rate of interest per half-year is 1.511%.

39 Subject CT1 September 2017 Question 3

Using a simple rate of discount of d , the discounting factor over 91 days for
the government bill is:

91
1- d
365

The corresponding discount factor for the deposit account is:

v 91/365 = 1.03-91/365 .

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Equating these two expressions:

91
1- d = 1.03 -91/365
365

Rearranging:

365 È
d= 1 - 1.03 -91/365 ˘ = 0.02945
91 Î ˚

So the annual simple rate of discount is 2.945% pa.

40 Subject CT1 September 2017 Question 6

Consider first Plan A. The accumulated value at the end of 15 years for the
cashflows under Plan A (using a reduced interest rate of 3% pa effective) is:

AVA = 12 ¥ 100 s(12) = 1,200 ¥

(1 + i )15 - 1 = 1,200 ¥ 1.0315 - 1
15 d (12) 12 È1 - 1.03 -1/12 ˘
Î ˚
= 1,200 ¥ 18.89978 = 22,679.74

Now consider the cashflows under Plan B. The net cashflows after expenses
in the first year are $85 per month, or $1,020 for the whole year. So the
accumulated value of the first year’s cashflows at the end of the first year is:

1,020 s(12)
1

The value of d(12) at a rate of interest of 3.7% pa is:

d (12) = 12 È1 - 1.037-1/12 ˘ = 0.03628

Î ˚

So the accumulated value of these cashflows at time 15 is:

Ê (1 + i ) - 1ˆ
1,020 s(12) ¥ 1.03714 = 1,020 ¥ Á ˜ ¥ 1.037
14
1
Ë d (12) ¯
0.037
= 1,020 ¥ ¥ 1.03714 = 1,730.108
0.03628

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The accumulated value at time 15 of the remaining fourteen years of

cashflows is:

1,200 s(12) = 1,200

(1 + i )14 - 1 = 1,200 ¥ 1.03714 - 1
14 d (12) 0.03628
= 1,200 ¥ 18.2771 = 21,932.570

So the total accumulated value for Plan B is:

AVB = 1,730.108 + 21,932.570 = 23,662.68

Hence the accumulated value for Plan B is greater by $982.94, and the
percentage by which Plan B is bigger is:

982.94
= 4.334%
22,679.74

or about 4.33%.

41 Subject CT1 September 2017 Question 9

(i) Constant effective annual rate

Accumulating from time zero to time 10 using the variable force, we get:

È10 ˘ È 10 ˘
A(0,10) = exp Í Ú 0.09 - 0.003t dt ˙ = exp Í È0.09t - 0.0015t 2 ˘ ˙
ÍÎ 0 ˙˚ Î Î ˚ 0 ˚

= exp ÈÎ(0.9 - 0.15 ) - 0 ˘˚ = e0.75

Accumulating using an equivalent constant annual rate, the accumulation

factor is (1 + i )
10
. Equating these:

(1 + i )10 = e0.75
Solving this equation, we find that:

i = e0.75/10 - 1 = e0.075 - 1 = 0.07788

The constant effective annual rate is 7.788% pa.

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(ii) Nominal rate of discount convertible half-yearly

Using the relationship between i and d(2) :

-2
Ê d (2) ˆ
1 + i = Á1 - ˜ = 1.07788
Ë 2 ¯

Rearranging this:

d (2) = 2 È1 - 1.07788-½ ˘ = 0.07361

Î ˚

So the rate of discount convertible half-yearly is 7.36% pa.

(iii) Accumulation at time 15

The accumulation factor from time 5 to time 10, using the variable force, is
given by:

È10 ˘ È 10 ˘
exp Í Ú 0.09 - 0.003t dt ˙ = exp Í È0.09t - 0.0015t 2 ˘ ˙
ÍÎ 5 ˙˚ Î Î ˚ 5 ˚

= exp ÎÈ(0.9 - 0.15) - (0.45 - 0.0375)˚˘ = exp ÈÎ0.3375 ˘˚

The accumulation factor from time 10 to time 15 is:

exp ÈÎ5 ¥ 0.06˘˚ = e0.3

So the accumulation at time 15 of an investment of £1,500 at time 5 is:

1,500 ¥ e0.3375 ¥ e0.3 = 1,500 ¥ e0.6375 = 2,837.618

or about £2,837.62.

(iv) Corresponding constant effective annual rate of discount

We know that:

2,837.618 = 1,500 (1 + i ) = 1,500v -10 = 1,500 (1 - d )

10 -10

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Rearranging this:

1/10
Ê 1,500 ˆ
d = 1- Á = 0.06176
Ë 2,837.618 ˜¯

So the corresponding effective annual rate of discount is 6.176% pa.

(v) Present value of a continuous payment stream

The force of interest for a period from time 11 to time t , where t is between
11 and 15, is just 0.06. So the discount factor v (t ) is just v (t ) = e -0.06(t -11) .

So the present value at time 11 of the payment stream is:

15 15
PV11 = Ú 10 e
0.01t
¥ e -0.06(t -11) dt = 10 e0.66 Úe
-0.05t
dt
11 11
15
È e -0.05t ˘ È Ê e -0.75 ˆ Ê e -0.55 ˆ ˘
= 10 e0.66 Í ˙ = 10 e0.66 Í Á ˜ -Á ˜ ˙ = 40.46938
ÎÍ -0.05 ˙˚11 ÍÎ Ë -0.05 ¯ Ë -0.05 ¯ ˙˚

We now discount this back to time zero:

PV0 = 40.46938 ¥ e -0.06 ¥ e -0.75 = 18.00313

So the present value at time zero of the payment stream is 18.003.

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FACTSHEET
This factsheet summarises the main methods, formulae and information
required for tackling questions on the topics in this booklet.

1 Time value of money

The accumulated value of 1 (invested at time 0) at time t is (1 + ti ) if we have

simple interest and (1 + i )t if we have compound interest.

1
The discount factor, v , is .
1+ i

The discount factor for a period of n years using a simple rate of discount d
is 1 - nd .

The connection between compound rates of interest and discount is

d = 1 - v = 1 - (1 + i )-1 .

2 Interest rates

A(t , t + h ) - 1
The definition of the force of interest d (t ) is lim .
h Æ0 + h

È t2 ˘
The accumulation factor from time t1 to time t 2 is A(t1, t 2 ) = exp Í Ú d (t ) dt ˙ .
Ít ˙
Î1 ˚
Correspondingly, the discount factor from time t 2 to time t1 is
È t2 ˘
exp Í - Ú d (t ) dt ˙ .
Í t ˙
Î 1 ˚

The present value at time a of a payment stream of r ( t ) received between

time a and time b where the force of interest is d (t ) is:

b È t ˘
Ú r (t ) exp Í - Ú d (s ) ds ˙ dt
ÍÎ ˙˚
a a

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The accumulated value at time b of a payment stream of r ( t ) received

between time a and time b where the force of interest is d (t ) is:

b Èb ˘
Ú r (t ) exp ÍÍ Ú d (s ) ds ˙˙ dt
a Ît ˚

If the force of interest is a constant, d , then A(t1, t 2 ) = exp ÎÈd (t 2 - t1)˚˘ ,

i = ed - 1 , d = ln(1 + i ) , v = e -d and 1 - d = e -d .

The connections between nominal and effective rates of interest are:

p
Ê i ( p) ˆ Ê 1
ˆ
1 + i = Á1 + ˜ i ( p ) = p Á (1 + i ) p - 1˜
Ë p ¯ Ë ¯

The connections between nominal and effective rates of discount are:

p
Ê d ( p) ˆ Ê 1
ˆ
1 - d = Á1 - ˜ d ( p ) = p Á1 - (1 - d ) p ˜
Ë p ¯ Ë ¯

3 Annuities

The present value at time 0 of payments of 1 at time 1, 1 at time 2, 1 at time

3 and so on until 1 at time n , is given by an . The formula for an is:

1- v n
an =
i

The present value at time 0 of payments of 1 at time 0, 1 at time 1, 1 at time

2 and so on until 1 at time n - 1 , is given by an . The formula for an is:

1- v n
an =
d

The connections between these values are an = (1 + i )an and an = 1 + an -1 .

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The accumulated value at time n of payments of 1 at time 1, 1 at time 2, 1 at

time 3 and so on until 1 at time n , is given by sn . The formula for sn is:

(1 + i )n - 1
sn = = (1 + i )n an
i

The accumulated value at time n of payments of 1 at time 0, 1 at time 1, 1 at

time 2 and so on until 1 at time n - 1 , is given by sn . The formula for sn is:

(1 + i )n - 1
sn = = (1 + i )n an
d

The connections between these values are sn = (1 + i )sn , and sn + 1 = sn +1 .

The present value at time 0 of payments of 1 pa payable continuously for n

years is given by an . The formula for an is:

1- v n
an =
d

The accumulated value at time n of payments of 1 pa payable continuously

for n years is given by sn . The formula for sn is:

(1 + i )n - 1
sn = = (1 + i )n an
d

The present value at time 0 of payments of 1 pa payable p thly in arrears for

n years is given by a( p ) . The amount of each payment is 1
p
. The formula
n

for a( p ) is:
n

1- v n i
a( p ) = = an
n i (p) i ( p)

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The present value at time 0 of payments of 1 pa payable p thly in advance for

n years is given by a( p ) . The amount of each payment is 1
p
. The formula
n

for a( p ) is:

n

1- v n i
a( p ) = ( p ) = ( p ) an
n d d

1
The connection between these values is a( p ) = v p a( p ) .
n n

There are equivalent formulae for s ( p ) and s( p ) , namely:

n n

(1 + i )n - 1 i (1 + i )n - 1 i
s( p ) = = (1 + i )n an , s( p ) = = (1 + i )n ( p ) an
n i ( p) i ( p) n d (p)
d

4 Deferred and increasing annuities

The present value at time 0 of payments of 1 at time m + 1 , 1 at time m + 2 ,

1 at time m + 3 and so on until 1 at time m + n , is given by m| an . The formula
for m| an is:

m| an = am +n - am = v man

The corresponding annuity due, continuously payable annuity and p thly

annuities are given by:

m| an
 = a
m +n
- am = v man m|an = am + n - am = v man

( p)
m| an = a( p ) - a( p ) = v ma( p ) ( p )
m|an = a( p ) - a( p ) = v ma( p )
m +n m n m +n m n

The present value at time 0 of payments of 1 at time 1, 2 at time 2, 3 at time

3 and so on until n at time n , is given by (Ia )n . The formula for (Ia )n is:

an - nv n
(Ia )n =
i

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The present value at time 0 of payments of 1 at time 0, 2 at time 1, 3 at time

2 and so on until n at time n - 1 , is given by (Ia)n . The formula for (Ia)n is:

an - nv n
(Ia)n =
d

The present value at time 0 of payments of r made continuously through year

r for n years is given by (Ia )n . The formula for (Ia )n is:

an - nv n
(Ia )n =
d

The present value at time 0 of a rate of payment of t at time t for n years is

given by ( I a )n . The formula for ( I a )n is:

an - nv n
( I a )n =
d

The accumulated values can be found by accumulating the present values,

for example:

(Is )n = (1 + i )n (Ia)n

Deferred annuities can be calculated in the obvious way, for example:

m|(Ia)n = v m (Ia)n

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NOTES

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NOTES

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NOTES

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NOTES

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Subject CM1
Revision Notes
For the 2019 exams

Equations of value and loans

Booklet 3

covering

Chapter 10 Equations of value

Chapter 11 Loan schedules

The Actuarial Education Company

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CONTENTS

Contents Page
Links to the Course Notes and Syllabus 2
Overview 3
Core Reading 5
Past Exam Questions 17
Solutions to Past Exam Questions 29
Factsheet 54

Copyright agreement

All of this material is copyright. The copyright belongs to Institute and

Faculty Education Ltd, a subsidiary of the Institute and Faculty of Actuaries.
The material is sold to you for your own exclusive use. You may not hire out,
lend, give, sell, transmit electronically, store electronically or photocopy any
part of it. You must take care of your material to ensure it is not used or
copied by anyone at any time.

Legal action will be taken if these terms are infringed. In addition, we may
seek to take disciplinary action through the profession or through your
employer.

These conditions remain in force after you have finished using the course.

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LINKS TO THE COURSE NOTES AND SYLLABUS

Material covered in this booklet

Chapter 10 Equations of value

Chapter 11 Loan schedules

These chapter numbers refer to the 2019 edition of the ActEd course notes.

Syllabus objectives covered in this booklet

The numbering of the syllabus items is the same as that used by the Institute
and Faculty of Actuaries.

3.1 Define an equation of value.

1. Define an equation of value, where payment or receipt is certain.

2. Describe how an equation of value can be adjusted to allow for

uncertain receipts or payments.

3. Understand the two conditions required for there to be an exact

solution to an equation of value.

3.2 Use the concept of equation of value to solve various practical

problems.

1. Apply the equation of value to loans repaid by regular instalments

of interest and capital. Obtain repayments, interest and capital
components, the effective interest rate (APR) and construct a
schedule of repayments.

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OVERVIEW

This booklet covers Syllabus objectives 3.1.1 to 3.1.3 and 3.2.1, which relate
to equations of value and loan schedules.

Breakdown of topics

The chapter on equations of value forms the foundation for the later chapters
of this course. For any investment, the equation of value is:

PV income = PV outgo

We have to be able to solve this equation to calculate the value of an

unknown quantity, eg price, coupon, redemption proceeds or yield.

The chapter on loans, however, is a stand-alone chapter. This chapter

describes how to calculate:

 the amount of each repayment, given the initial loan amount and the
interest rate
 the amount borrowed, given the amount of the repayments and the
interest rate
 the amount outstanding just after a repayment has been made
 the interest component of each instalment
 the capital component of each instalment
 the total capital and interest repaid over a series of instalments
 the APR of a loan.

We have to be able to do all of the above when the repayments are level,
increasing or decreasing, and when the repayments are annual or more
frequent than annual. The procedure is similar in each case – you just have
to be careful with the details. When dealing with simple increasing or
decreasing repayments, you work with increasing or decreasing annuities.
When dealing with compound increasing or decreasing repayments, you
adjust the rate of interest and use a level annuity approach, or rely on
geometric progressions to sum the series from first principles.

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Exam questions

There are no exam questions simply on equations of value, since this is just
foundation work for other chapters.

However, most exam papers contain a question on loans. You are likely to
be asked to calculate several of the items listed above.

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CORE READING
All of the Core Reading for the topics covered in this booklet is contained in
this section.
____________

Chapter 10 – Equations of value

Consider a transaction that provides that in return for outlays of

amount at1 , at2 ,  , atn at time t1, t 2 ,  , t n , an investor will receive
payments of bt1 , bt2 ,  , btn at these times respectively. (In most
situations only one of atr and btr will be non-zero.) At what force or rate
of interest does the series of outlays have the same value as the series
of receipts?
____________

1 At force of interest d the two series are of equal value if and only if:

n n
 atr e -d tr =  btr e -d tr
r =1 r =1

This equation may be written as:

n
 ctr e -d tr =0 (1.1)
r =1

where ctr = btr - atr is the amount of the net cashflow at time t r . (We
adopt the convention that a negative cashflow corresponds to a
payment by the investor and a positive cashflow represents a payment
to the investor.)
____________

2 Equation (1.1), which expresses algebraically the condition that, at

force of interest d , the total value of the net cashflows is 0, is called
the equation of value for the force of interest implied by the
transaction.
____________

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3 If we let ed = 1 + i , the equation may be written as:

n
 ctr (1 + i )-tr =0 (1.2)
r =1

The latter form is known as the equation of value for the rate of interest
or the ‘yield equation’. Alternatively, the equation may be written as:

n
 ctr v tr =0
r =1
____________

4 In relation to continuous payment streams, if we let r1(t ) and r2 (t ) be

the rates of paying and receiving money at time t respectively, we call
r (t ) = r2 (t ) - r1(t ) the net rate of cashflow at time t. The equation of
value (corresponding to Equation (1.1)) for the force of interest is:

•
Ú0 r (t )e -d t dt = 0
____________

5 When both discrete and continuous cashflows are present, the

equation of value is:

n •
 ctr e -d tr + Ú0 r (t )e -d t dt = 0 (1.3)
r =1

and the equivalent yield equation is:

n •
 ctr (1 + i )-tr + Ú0 r (t )(1 + i )-t dt = 0 (1.4)
r =1
____________

6 For any given transaction, Equation (1.3) may have no roots, a unique
root, or several roots.

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If there is a unique root, d 0 say, it is known as the force of interest

implied by the transaction, and the corresponding rate of interest
i0 = ed 0 - 1 is called the ‘yield’ per unit time.
____________

7 Alternative terms for the yield are the ‘internal rate of return’ and the
‘money-weighted rate of return’ for the transaction.
____________

8 Thus the yield is defined if and only if Equation (1.4) has precisely one
root greater than 1 and, when such a root exists, it is the yield.

The analysis of the equation of value for a given transaction may be

somewhat complex depending on the shape of the function f (i )
denoting the left hand side of Equation (1.4). However, when the
equation f (i ) = 0 is such that f is a monotonic function, its analysis is
particularly simple. The equation has a root if and only if we can find
i1 and i2 with f (i1) and f (i2 ) of opposite sign. In this case, the root is
unique and lies between i1 and i2 . By choosing i1 and i2 to be
‘tabulated’ rates sufficiently close to each other, we may determine the
yield to any desired degree of accuracy.

It should be noted that, after multiplication by (1 + i )t0 , Equation (1.2)

takes the equivalent form:

n
 ctr (1 + i )t0 -tr =0
r =1

This slightly more general form may be called the equation of value at
time t0 . It is of course directly equivalent to the original equation
(which is now seen to be the equation of value at time 0). In certain
problems a particular choice of t0 may simplify the solution.
____________

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9 If there is uncertainty about the payment or receipt of a cashflow at a

particular time, allowance can be made in one of two ways:
 apply a probability of payment/receipt to the cashflow at each time
 use a higher rate of discount.

The probability of payment/receipt can be allowed for by adapting the

earlier equations. For example, Equation (1.4) can be revised to
produce:

n •
 pt ctr (1 + i )-tr + Ú0 p(t ) r (t )(1 + i )-t dt = 0 (2.1)
r =1

where pt and p(t ) represent the probability of a cashflow at time t.

Where the force of interest is constant, and we can say that the
probability is itself in the form of a discounting function, then Equation
(1.3) can be generalised as:

n •
 ctr e -d tr e - mtr + Ú0 r (t )e -d t e - m t dt = 0 (2.2)
r =1

where m is a constant force, rather than rate, of the probability of a

cashflow at time t.
____________

10 These probabilities of cashflows may often be estimated by

consideration of the past experience of similar cashflows. For
example, this approach is used to assess the probabilities of cashflows
that are dependent on the survival of a life – this is the theme of later
chapters.

In other cases, there may be lack of data from which to determine an

accurate probability for a cashflow. Instead a more approximate
probability, or likelihood, may be determined after careful
consideration of the risks.

In some cases, it may be spurious to attempt to determine the

probability of each cashflow and so more approximate methods may
be justified.

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11 Wherever the uncertainty about the probability of the amount or timing

of a cashflow could have significant financial effect, a sensitivity
analysis may be performed. This involves calculations performed
using different possible values for the likelihood and the amounts of
the cashflows.
____________

12 Alternatively a stochastic approach could be used to indicate possible

outcomes.
____________

13 As the discounting functions and the probability functions in

Equations (2.1) and (2.2) are both dependent on time, they can be
combined into a single time-dependent function. In cases where there
is insufficient information to objectively produce the probability
functions, this combined function can be viewed as an adjusted
discounting function that makes an implicit allowance for the
probability of the cashflow.

Where the probability of the cashflow is a function that is of similar

form to the discounting function, the combination can be treated as if a
different discount rate were being used. For example, Equation (2.2)
becomes:

n •
 ctr e -d ¢tr + Ú0 r (t )e -d ¢t dt = 0
r =1

where d ¢ = d + m . The revised force of discount is therefore greater

than the actual force of discount, as m must be positive in order to
give a probability between 0 and 1. It can therefore be shown that the
rate of discount that is effectively used is greater than the actual rate of
discount before the implicit allowance for the probability of the
cashflow.
____________

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Chapter 11 – Loan schedules

A very common transaction involving compound interest is a loan that

is repaid by regular instalments, at a fixed rate of interest, for a
predetermined term.

Consider a very simple example. Assume a bank lends an individual

£1,000 for three years, in return for three payments of £X, say, one at
the end of each year. The bank will charge an effective rate of interest
of 7% per annum.
____________

14 The equation of value for the transaction gives:

1, 000 = Xa3| fi X = 381.05

So the borrower pays £381.05 at times t = 1, 2 and 3 in return for the

loan of £1,000 at time 0. These three payments cover both the interest
due and the £1,000 capital.

It is helpful to see how this works in detail.

____________

15 At time 1 the interest due on the loan of £1,000 is £70. The total
payment made is £381.05. This leaves £311.05 that is available to
repay some of the capital. The capital outstanding after this is then
£(1, 000 - 311.05) = £688.95 .

At time 2 the interest due is now only 7% of £688.95 = £48.22 , as the

borrower does not pay interest on the capital that is already repaid,
only on the amount outstanding. This leaves
£(381.05 - 48.22) = £332.83 available to repay capital. The capital
outstanding after this is then £(688.95 - 332.83) = £356.12 .

Finally, at time 3 the interest due is 7% of £356.12 = £24.93 , leaving

£(381.05 - 24.93) = £356.12 available to pay the outstanding sum of
£356.12, and the capital is precisely repaid.

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One important point is that each repayment must pay first for interest
due on the outstanding capital. The balance is then used to repay
some of the capital outstanding. Each payment therefore comprises
both interest and capital repayment. It may be necessary to identify
the separate elements of the payments – for example if the tax
treatment of interest and capital differs. Notice also that, where
repayments are level, the interest component of the repayment
instalments will decrease as capital is repaid, with the consequence
that the capital payment will increase.

Let Lt be the amount of the loan outstanding at time t = 0, 1,  , n ,

immediately after the repayment at t . The repayments are assumed to
be in regular instalments, of amount X t at time t , t = 1, 2, 3,  , n .
(Note that we are not assuming all instalments are the same amount.)
Let i be the effective rate of interest, per time unit, charged on the
loan. Let ft be the capital repaid at t , and let bt be the interest paid at
t , so that X t = ft + bt .
____________

16 The equation of value for the loan at time 0 is:

L0 = X 1v + X 2v 2 +  + X nv n (2.1)
____________

17 We can find the loan outstanding at t prospectively or retrospectively.

____________

18 Consider the loan transactions at time n, which is the end of the

contract term. After the final instalment of capital and interest the loan
is exactly repaid. So the final instalment, X n , must exactly cover the
capital that remains outstanding after the instalment paid at n - 1 ,
together with the interest due on that capital. That is:

bn = iLn -1 ; fn = Ln -1

so that:

X n = iLn -1 + Ln -1 = (1 + i )Ln -1 fi Ln -1 = X nv
____________

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19 Similarly, at any time t + 1 , t £ n - 2 we know that the capital repaid is

Lt - Lt +1 , so that the instalment X t +1 is:

X t +1 = iLt + (Lt - Lt +1) fi Lt = (Lt +1 + X t +1)v

Similarly, Lt +1 = (Lt + 2 + X t + 2 )v , and working forward, successively

substituting for Lt + r until we get to Ln = 0 , we get:

Lt = (Lt +1 + X t +1)v
= ((Lt + 2 + X t + 2 )v + X t +1)v = X t +1v + X t + 2v 2 + Lt + 2v 2
= X t +1v + X t + 2v 2 + X t + 3v 3 + Lt + 3v 3
=
= X t +1v + X t + 2v 2 + X t + 3v 3 +  + X nv n -t

This gives the ‘prospective method’ for calculating the loan

outstanding. What this equation tells us is that, for calculating the loan
outstanding immediately after the repayment at t , say, we have:

Prospective Method: The loan outstanding at time t is the present (or

discounted) value at time t of the future repayment instalments.

Note the condition for this method – the present value must be
calculated at a repayment date.
____________

20 At t = 1 the interest due is b1 = iL0 , so the capital repaid is

f1 = X 1 - iL0 , leaving a loan outstanding of:

L1 = L0 - ( X 1 - iL0 ) = L0 (1 + i ) - X 1
____________

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21 In general, at time t ≥ 1 the interest due is bt = iLt -1 , leaving capital

repaid at t of X t - iLt -1 , giving:

Lt = Lt -1(1 + i ) - X t

Similarly, Lt -1 = Lt - 2 (1 + i ) - X t -1 and, working back from t to 0 we have:

Lt = Lt -1(1 + i ) - X t
= (Lt - 2 (1 + i ) - X t -1)(1 + i ) - X t = Lt - 2 (1 + i )2 - X t -1(1 + i ) - X t
=
= Lo (1 + i )t - ( X 1(1 + i )t -1 + X 2 (1 + i )t - 2 +  + X t -1(1 + i ) + X t )

This gives the ‘retrospective method’ of calculating the outstanding

loan. This may be described in words as:

Retrospective Method: The loan outstanding at time t is the

accumulated value at time t of the original loan less the accumulated
value at time t of the repayments to date.

Both approaches are very useful in calculating the capital outstanding

at any time. Neither result depends on the interest rate being constant.
It may be useful to work through the equations assuming the interest
charged on the loan in year r - 1 to r is ir , say.

Given the outstanding capital at any time we can calculate the interest
and capital element of any instalment.

For example, consider the instalment X t at time t. We can calculate

the interest element contained in this payment by calculating the loan
outstanding immediately after the previous instalment, at t - 1 , Lt -1 .
____________

22 The interest due on capital of Lt -1 for one unit of time at effective rate i
per time unit is iLt -1 , and this is the interest paid at t.
____________

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23 The capital repaid may be found using X t - iLt -1 , or by Lt -1 - Lt .

Similarly, it is a simple matter to calculate the interest paid and capital

repaid over several instalments. For example, consider the five
instalments from t + 1 to t + 5 , inclusive.
____________

24 The loan outstanding immediately before the first instalment is Lt .

The loan outstanding after the fifth instalment is Lt +5 . The total capital
repaid is therefore Lt - Lt + 5 . The total capital and interest paid is
X t +1 + X t + 2 +  + X t + 5 . Hence, the total interest paid is:

t +5
 bk = ( X t +1 + X t + 2 +  + X t + 5 ) - (Lt - Lt + 5 )
k = t +1
____________

25 The loan payments can be expressed in the form of a table, or

‘schedule’, as follows.

Year Capital
Loan Instalment Int due Loan
r Æ r +1 repaid at
o/s at r at r + 1 at r + 1 o/s at r + 1
r +1
L1
0Æ1 L0 X1 iL0 X 1 - iL0 = L0 - ( X 1 - iL0 )

     
Lt +1
t Æ t +1 Lt X t +1 iLt X t +1 - iLt = Lt - ( X t +1 - iLt )

     
n - 1Æ n Ln -1 Xn iLn -1 X n - iLn -1 0

With spreadsheet software it is a simple matter to construct the entire

schedule for any loan.

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 Batch 4

Most loans will be repaid in quarterly, monthly or weekly instalments.

No new principles are involved where payments are made more
frequently than annually, but care needs to be taken in calculating the
interest due at any instalment date.

If the rate of interest used is effective over the same time unit as the
frequency of the repayment instalments, then the calculations proceed
exactly as above, with the time unit redefined appropriately.

For the case where the interest is expressed as an effective annual

rate, with repayment instalments payable pthly, we have the equation
of value for the loan, given repayments of X t at time
t= 1
p
, p2 , p3 ,  , n :
____________

26 L0 = X 1/ pv 1/ p + X 2 / pv 2 / p + X 3 / pv 3 / p +  + X nv n

It is easy to show that the two basic principles for calculating the loan
outstanding hold when repayments are more frequent than annual.
That is, the loan outstanding at any repayment date, immediately after
an instalment has been paid, may still be calculated as the present
value of the remaining repayment instalments, or as the accumulated
value of the original loan less the repayments made to date.
____________

27 Prospectively:

Lt = X t +1/ pv 1/ p + X t + 2 / pv 2 / p +  + X nv n -t
____________

28 Retrospectively:

Lt = L0 (1 + i )t - ( X 1/ p (1 + i )t -1/ p + X 2 / p (1 + i )t - 2 / p

+ X 3 / p (1 + i )t - 3 / p +  + X t -1/ p (1 + i )1/ p + X t )
____________

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29 Given an annual effective rate of interest of i, the effective rate of

interest over a period 1
p
is (1 + i )1/ p - 1 , which is equal to i ( p ) p .
____________

1
30 The interest due at t + p
, given capital outstanding of Lt at some

repayment date t, is therefore bt +1/ p = ((1 + i )1/ p - 1)Lt . The capital

1
repaid at t + p
is then:

i ( p)
ft +1/ p = X t +1/ p - ((1 + i )1/ p - 1)Lt = X t +1/ p - Lt
p
____________

31 As we have seen in earlier chapters, there are various ways to display

an interest rate. For example, it could be nominal but compounded
monthly, or effective. We also noticed that 10% compounded monthly
has an effective rate greater than 10% compounded quarterly.

This affects the interest rate being advertised for a loan. Moreover,
loans may have additional costs, such as opening costs or display
simpler rates (for example, 1% daily for a pay-day loan). Since such an
advertised rate ignores the effects of compounding or other costs, it
will be considerably lower than the true effective rate of interest
charged on the loan.

To ensure that consumers can make informed judgements about the

interest rates charged, lenders are required (in most circumstances) to
give information about the effective rate of interest charged. In the UK,
this is in the form of the Annual Percentage Rate of charge, or APR,
which is defined as the effective annual rate of interest, rounded to the
nearer 1/10th of 1%.

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PAST EXAM QUESTIONS

This section contains all the Subject CT1 exam questions from the period
2008 to 2017 that are related to the topics covered in this booklet.

Solutions are given later in this booklet. These give enough information for
you to check your answer, including working, and also show you what an
adequate examination answer should look like. Further information may be
available in the Examiners’ Report, ASET or Course Notes. (ASET can be
ordered from ActEd.)

We first provide you with a cross reference grid that indicates the main
subject areas of each exam question. You can use this, if you wish, to
select the questions that relate just to those aspects of the topic that you
may be particularly interested in reviewing.

Alternatively you can choose to ignore the grid, and instead attempt each
question without having any clues as to its content.

© IFE: 2019 Examinations Page 17

 Batch 4

Cross reference grid

Type Calculations Interest

Loan outstanding
Original loan size

Loan schedule
Interest/capital
circumstances

Repayments
Increasing/
decreasing
Change in
Tick when
attempted

elements

Flat rate
Other
Level

APR
Question

1   ()
2  
3    
4    
5   ()
6   
7    
8    () 
9    () 
10     ()  
11    () 
12    
13    
14    
15  
16     () 

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 Batch 4

1 Subject CT1 April 2008 Question 3

A mortgage company offers the following two deals to customers for twenty-
five year mortgages.

Product A

A mortgage of £100,000 is offered with level repayments of £7,095.25 made

annually in arrear. There are no arrangement or exit fees.

Product B

A mortgage of £100,000 is offered whereby a monthly payment in advance

is calculated such that the customer pays an effective rate of return of 4%
per annum ignoring arrangement and exit fees. In addition the customer
also has to pay an arrangement fee of £6,000 at the beginning of the
mortgage and an exit fee of £5,000 at the end of the twenty-five year term of
the mortgage.

Compare the annual effective rates of return paid by customers on the two
products. [8]

2 Subject CT1 September 2008 Question 5

A bank offers two repayment alternatives for a loan that is to be repaid over
ten years. The first requires the borrower to pay £1,200 per annum quarterly
in advance and the second requires the borrower to make payments at an
annual rate of £1,260 every second year in arrears.

Determine which terms would provide the best deal for the borrower at a rate
of interest of 4% per annum effective. [5]

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3 Subject CT1 September 2008 Question 12

An individual takes out a 25-year bank loan of £300,000 to purchase a

house.

The individual agrees to pay only the interest payments, monthly in arrear,
for the first 15 years whereupon he repays half of the capital as a lump sum.
He then pays only the interest for the remaining 10 years, quarterly in arrear,
and repays the other half of the capital as a lump sum at the end of the term.

(i) Calculate the total amount of interest paid by the individual, assuming
an effective rate of interest of 8½% pa. [5]

(ii) The individual believes that he can earn a nominal rate of interest
convertible half-yearly of 9% pa from a separate savings account.

Calculate the level contribution he must make monthly in advance to the

savings account in order to repay half the capital after 15 years. [4]

(iii) The individual made the monthly contributions calculated in (ii) to the
savings account. However, over the first 15 years, the effective rate of
return earned on the savings account was 10% per annum.

The individual used the proceeds at that time to repay as much of the
loan as possible and then decided to repay the remainder of the loan by
level instalments of interest and capital. After the first 15 years, the
effective rate of interest changed to 7% per annum.

Calculate the level payment he must make, payable monthly in arrear,

to repay the loan over the final 10 years of the loan. [5]
[Total 14]

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4 Subject CT1 April 2009 Question 3

A loan is to be repaid by an annuity payable annually in arrear. The annuity

starts at a rate of £300 per annum and increases each year by £30 per
annum. The annuity is to be paid for 20 years.

Repayments are calculated using a rate of interest of 7% per annum

effective.

Calculate:

(i) The amount of the loan. [3]

(ii) The capital outstanding immediately after the 5th payment has been
made. [2]

(iii) The capital and interest components of the final payment. [2]
[Total 7]

5 Subject CT1 September 2009 Question 8

A bank offers a customer two different repayment options on a loan of

£50,000 as follows:

Option 1 – level instalments of capital and interest are paid annually in arrear
over a period of 20 years.

Option 2 – over the 20-year term the customer pays only interest on the
loan, annually in arrear at a rate of 5.5% per annum with the whole of the
capital amount payable at the end of the term. The customer will take out a
separate savings policy which involves making monthly payments in
advance such that the proceeds will be sufficient to repay the loan at the end
of its term. The payments into the savings policy accumulate at a rate of
interest of 4% per annum effective.

(i) Determine the effective rate of interest per annum that would be paid by
the customer on the loan under Option 1, given that the level annual
instalment on this loan is £4,012.13. [3]

(ii) Determine the annual effective rate of interest paid by a customer under
Option 2. [7]
[Total 10]

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 Batch 4

6 Subject CT1 April 2010 Question 8

A loan is repayable by annual instalments paid in arrear for 20 years. The

first instalment is £4,650 and each subsequent instalment is £150 greater
than the previous instalment.

Calculate the following, using an interest rate of 9% per annum effective:

(i) the amount of the original loan [3]

(ii) the capital repayment in the tenth instalment [4]

(iii) the interest element in the last instalment [2]

(iv) the total interest paid over the whole 20 years. [2]
[Total 11]

7 Subject CT1 April 2011 Question 7

A loan of £60,000 was granted on 1 July 1998.

The loan is repayable by an annuity payable quarterly in arrear for 20 years.

The amount of the quarterly repayment increases by £100 after every four
years. The repayments were calculated using a rate of interest of 8% per
annum convertible quarterly.

(i) Show that the initial quarterly repayment is £1,370.41. [5]

(ii) Calculate the amount of capital repaid that was included in the payment
made on 1 January 1999. [3]

(iii) Calculate the amount of capital outstanding after the quarterly

repayment due on 1 July 2011 has been made. [4]
[Total 12]

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8 Subject CT1 April 2012 Question 3

A company has borrowed £500,000 from a bank. The loan is to be repaid by

level instalments, payable annually in arrear for ten years from the date the
loan is made. The annual instalments are calculated at an effective rate of
interest of 9% per annum.

(i) Calculate:

(a) the amount of the level annual instalments.

(b) the total amount of interest which will be paid over the ten-year
term. [3]

At the beginning of the eighth year, immediately after the seventh instalment
has been made, the company asks for the loan to be rescheduled over a
further four years from that date. The bank agrees to do this on condition
that the rate of interest is increased to an effective rate of 12% per annum
for the term of the rescheduled instalments and that repayments are made
quarterly in arrear.

(ii) (a) Calculate the amount of the new quarterly instalment.

(b) Calculate the interest content of the second quarterly instalment of

the rescheduled loan repayments. [5]
[Total 8]

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 Batch 4

9 Subject CT1 September 2012 Question 6

A loan is to be repaid by an increasing annuity. The first repayment will be

£200 and the repayments will increase by £100 per annum. Repayments
will be made annually in arrear for ten years. The repayments are calculated
using a rate of interest of 6% per annum effective.

(i) Calculate the amount of the loan [2]

(ii) (a) Calculate the interest component of the seventh repayment.

(b) Calculate the capital component of the seventh repayment. [4]

(iii) Immediately after the seventh repayment, the borrower asks to have the
original term of the loan extended to fifteen years and wishes to repay
the outstanding loan using level annual repayments. The lender agrees
but changes the interest rate at the time of the alteration to 8% per
annum effective.

Calculate the revised annual repayment. [3]

[Total 9]

10 Subject CT1 April 2013 Question 10

A loan is repayable by annual instalments in arrear for 20 years. The initial

instalment is £5,000, with each subsequent instalment decreasing by £200.

The effective rate of interest over the period of the loan is 4% per annum.

(i) Calculate the amount of the original loan. [3]

(ii) Calculate the capital repayment in the 12th instalment. [3]

After the 12th instalment is paid, the borrower and lender agree to a
restructuring of the debt.

The £200 reduction per year will no longer continue. Instead, future
instalments will remain at the level of the 12th instalment and the remaining
term of the debt will be shortened. The final payment will then be a reduced
amount which will clear the debt.

(iii) (a) Calculate the remaining term of the revised loan.

(b) Calculate the amount of the final reduced payment.

(c) Calculate the total interest paid during the term of the loan. [8]
[Total 14]

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 Batch 4

11 Subject CT1 September 2013 Question 9

A bank makes a loan to be repaid by instalments paid annually in arrear.

The first instalment is £400, the second is £380 with the payments reducing
by £20 per annum until the end of the 15th year, after which there are no
further repayments. The rate of interest charged is 4% per annum effective.

(i) Calculate the amount of the loan. [3]

(ii) Calculate the capital and interest components of the first payment. [2]

At the beginning of the ninth year, the borrower can no longer make the
scheduled repayments. The bank agrees to reduce the capital by 50 per
cent of the loan outstanding after the eighth repayment. The bank requires
that the remaining capital is repaid by a 10-year annuity paid annually in
arrear, increasing by £2 per annum. The bank changes the rate of interest
to 8% per annum effective.

(iii) Calculate the first repayment under the revised loan. [5]
[Total 10]

12 Subject CT1 April 2014 Question 10

A loan of £20,000 is repayable by an annuity payable annually in arrear for

25 years. The annual repayment is calculated at an effective interest rate of
8% per annum and increases by £50 each year.

(i) Calculate the amount of the first payment. [3]

(ii) Calculate the capital outstanding after the first three payments have
been made. [2]

(iii) Explain your answer to part (ii). [2]

(iv) Calculate the total amount of interest paid over the term of the loan. [3]
[Total 10]

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 Batch 4

13 Subject CT1 April 2015 Question 11

On 1 January 2016, a student plans to take out a five-year bank loan for
£30,000 that will be repayable by instalments at the end of each month.
Under this repayment schedule, the instalment at the end of January 2016
will be X , the instalment at the end of February 2016 will be 2X and so on,
until the final instalment at the end of December 2020 will be 60 X . The
bank charges a rate of interest of 15% per annum convertible monthly.

an - nv n
(i) Prove that (Ia )n = . [3]
i

(ii) Show that X = £26.62 . [4]

The student is concerned that she will not be able to afford the later
repayments and so she suggests a revised repayment schedule. The
student would borrow £30,000 on 1 January 2016 as before. She would
now repay the loan by 60 level monthly instalments of 36X = £958.32 but the
first repayment would not be made until the end of January 2019 and hence
the final instalment is paid at the end of December 2023.

(iii) Calculate the APR on the revised loan schedule and hence determine
whether you believe the bank should accept the student’s suggestion. [5]

(iv) Explain the difference in the total repayments made under the two
arrangements. [2]
[Total 14]

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 Batch 4

14 Subject CT1 April 2016 Question 5

A loan is to be repaid by a series of instalments payable annually in arrear

for 15 years. The first instalment is £1,200 and payments increase
thereafter by £250 per annum.

Repayments are calculated using a rate of interest of 6% per annum

effective.

Determine:

(i) the amount of the loan. [3]

(ii) the capital outstanding immediately after the 9th instalment has been
made. [2]

(iii) the capital and interest components of the final instalment. [2]
[Total 7]

15 Subject CT1 April 2017 Question 2

A bank offers two repayment alternatives for a loan that is to be repaid over
sixteen years:

Option 1: the borrower pays £7,800 per annum quarterly in arrear.

Option 2: the borrower makes payments at an annual rate of £8,200 every

second year in arrear.

Determine which option would provide the better deal for the borrower at a
rate of interest of 5% per annum effective. [5]

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 Batch 4

16 Subject CT1 September 2017 Question 8

A loan is to be repaid by an increasing annuity. The first payment will be

£100 and the payments will increase by £50 per annum. Payments will be
made annually in arrear for ten years. The repayments are calculated using
a rate of interest of 5% per annum effective.

(i) Calculate the amount of the loan. [2]

(ii) Calculate:
(a) the interest component of the sixth instalment.
(b) the capital component of the sixth instalment. [4]

Immediately after the sixth instalment, the borrower asks to repay the
remaining loan using level annual instalments. The lender agrees, but
changes the interest rate at the time of the alteration to 6% per annum
effective.

(iii) Calculate the revised instalment. [3]

[Total 9]

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 Batch 4

SOLUTIONS TO PAST EXAM QUESTIONS

The solutions presented here are just outline solutions for you to use to
check your answers. See ASET for full solutions.

1 Subject CT1 April 2008 Question 3

Product A

The equation of value for Product A is:

100,000 = 7,095.25a25 fi a25 = 14.0939

From the Tables:

i = 5% fi a25 = 14.0939

So, the annual effective rate of interest for Product A is 5% pa.

Product B

Let M be the level monthly payment made under product B. Working in

years, this can be found by solving the equation:

100,000 = 12Ma(12)
25 4%

1 - 1.04 -25
= 12M ¥ fi M = £522.19
(
12 1 - 1.04 -1 12 )
The equation of value for product B is:

100,000 = 12 ¥ 522.19a(12) + 6,000 + 5,000v 25

25

fi 94,000 = 12 ¥ 522.19a(12) + 5,000v 25

25

i = 5% fi RHS = £92,167.20
i = 4.5% fi RHS = £96,831.00

© IFE: 2019 Examinations Page 29

 Batch 4

Interpolating gives the annual effective rate of interest for Product B to be:

Ê 96,831.00 - 94,000.00 ˆ
i = 4.5 + 0.5 Á = 4.80% pa
Ë 96,831.00 - 92,167.20 ¯˜

So, the effective annual rate of return paid by customers on Product A is

higher than that paid on Product B.

2 Subject CT1 September 2008 Question 5

Alternative 1

The present value of the repayments under this alternative is:

 
 1  1.0410 
1,200a(4)  1,200 
10

 4 1  (1.04)

0.25
 


 1,200  8.31267
 £9,975.21

Alternative 2

Under this repayment alternative, payments are made at an annual rate of

£1,260 every second year in arrears for ten years. This means that £2,520
(ie two times £1,260) is paid every two years.

Working in a time period of two years, the present value of repayments is:

2  1,260a5

calculated at an effective two-yearly interest rate of:

1.042  1  8.16%

The present value is therefore:

 1  1.08165 
2,520    2,520  3.97593
 0.0816 
 
 £10,019.34

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 Batch 4

Since the present value of repayments under Alternative 1 is lower than that
under Alternative 2, Alternative 1 would provide the better deal for the
borrower, at a rate of interest of 4% pa effective.

3 Subject CT1 September 2008 Question 12

(i) Total interest paid

For the first 15 years, the individual pays interest monthly on the whole loan
1
outstanding of £300,000. The monthly interest rate is 1.085 12  1 . This
means the monthly interest payment for the first 15 years is:


300,000 1.085
1
12

 1  £2,046.45

The total interest paid in the first 15 years of the loan is then:

2,046.45  12  15  £368,360.64

For the final 10 years, the individual pays interest quarterly on the remaining
1
loan outstanding of £150,000. The quarterly interest rate is 1.085 4 1 .
This means the quarterly interest payment for the final 10 years is:


150,000 1.085
1
4

 1  £3,090.66

The total interest paid in the final 10 years of the loan is then:

3,090.66  4  10  £123,626.38

So the total interest paid over the full term of the loan is:

368,360.64  123,626.37  £491,987

© IFE: 2019 Examinations Page 31

 Batch 4

(ii) Level monthly contribution for the first 15 years

The level monthly contributions paid must accumulate to a value of £150,000

by time 15.

Let M be the level monthly contribution paid by the individual. Working in

years, this must satisfy the equation:

12Ms(12)  150,000
15

The interest rate is 9% pa convertible half-yearly. So:

2
 0.09 
i (2)  9%  i   1    1  9.2025%
 2 
and


d (12)  12 1  1.092025
1
12
  8.77116%
Using these to evaluate the accumulation, gives:

15
1.092025  1
s(12)   31.29936
15 0.0877116

Solving for the monthly contribution:

12M  31.29936  150,000  M  £399.37

(iii) Level repayments for the final 10 years

The accumulated value of the monthly savings for the first 15 years is:

12  399.37  s(12)
15

evaluated at an effective interest rate of 10% pa. Now:


i  10%  d (12)  12 1  1.1
1
12
  9.49326%

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Using this to evaluate the accumulation, gives:

1.115  1
s(12)   33.46843
15 0.0949326

So the accumulated value of the monthly savings is:

12  399.37  33.46844  £160,395.47

This amount is used to repay as much of the loan as possible, so the loan
outstanding at time 15 is:

300,000  160,395.47  £139,604.53

This remaining amount outstanding is repaid monthly in arrear over the final
10 years.

Letting X be the monthly repayment, we must solve the equation of value:

12 Xa(12)  139,604.53
10

evaluated at 7% pa.

Now:


i (12)  12 1.07
1
12

 1  6.78497%

1  1.0710
a(12)   7.24617
10 0.0678497

Solving for the monthly repayment:

12 X  7.24617  139,604.53  X  £1,605.50

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4 Subject CT1 April 2009 Question 3

(i) Amount of the loan

The original loan amount, L0 , is equal to the present value of the repayments
made over the term of the loan:

300 330 360 390 420 450... 870

0 1 2 3 4 5 6 .... 20 time

L0 = 270a20 + 30(Ia )20 @ 7% pa

= 270 ¥ 10.5940 + 30 ¥ 88.1031
= £5,503.47

(ii) Capital outstanding after the fifth repayment

The capital outstanding at time 5 is equal to:

L5 = 420a15 + 30(Ia )15 @ 7% pa

= 420 ¥ 9.1079 + 30 ¥ 61.5540
= £5, 671.94

(iii) Capital and interest components of the final payment

The capital outstanding after the 19th payment is:

L19 = 870v = £813.08

Since there is only one remaining payment of £870 to be made at time 20,
the capital component of the final repayment is £813.08.

Hence:

interest component = 870 - 813.08 = £56.92

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5 Subject CT1 September 2009 Question 8

(i) Effective annual rate of interest under Option 1

The equation of value for Option 1 is:

4,012.13a20 = 50,000 fi a20 = 12.4622

From the Tables, we see that this corresponds to an interest rate of exactly
5%.

(ii) Effective annual rate of interest under Option 2

Under Option 2, the customer makes an interest payment of

0.055 ¥ 50,000 = £2,750 at the end of each year for 20 years.

He also makes payments monthly in advance into a savings account. These

payments accumulate to £50,000 at the end of 20 years and this amount is
used to repay the loan.

Letting X denote the total amount paid into the savings account each year,
we have:

Xa(12) = 50,000v 20 @ 4%
20
22,819.35
fi X = 13.8830
= £1, 643.69

So the equation of value for the customer under Option 2 is:

50,000 = 2,750 a20 + 1, 643.69 a(12)

20

Using trial and error with linear interpolation we get:

i = 6% fi RHS = £51,003
i = 7% fi RHS = £47, 200
i = 6.5% fi RHS = £49,043

Interpolating between 6% and 6.5% gives an effective annual rate of interest

of:

Ê 50,000 - 51,003 ˆ
6% + Á ¥ (6.5% - 6%) = 6.26%
Ë 49,043 - 51,003 ˜¯

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Note: The correct figure to 3 SF is 6.25%.

6 Subject CT1 April 2010 Question 8

(i) Amount of the original loan

The original loan amount is:

L0 = 4,500a20 + 150(Ia )20

Evaluating this at 9%:

L0 = 4,500 ¥ 9.1285 + 150 ¥ 70.9055 = £51,714 (5 SF)

(ii) Capital repayment in the tenth instalment

4,650 4,800... 5,850 6,000 6,150... 7,500

0 1 2... 9 10 11 .... 20 time

The capital outstanding after the ninth repayment is:

L9 = 5,850a11 + 150(Ia )11

= 5,850 ¥ 6.8052 + 150 ¥ 35.0533 = £45,068 (5 SF)

The interest element in the tenth repayment is:

0.09 ¥ 45,068.42 = £4,056.16

Since the amount of the tenth repayment is £6,000, the capital repaid in the
tenth instalment is:

6,000 - 4,056.16 = £1,943.84

(iii) Interest element of the final payment

The capital outstanding after the nineteenth payment is:

L19 = 7,500v = £6,880.73

since there is only one remaining payment of £7,500 to be made at time 20.

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Therefore, the interest element of the final repayment is:

0.09 ¥ 6,880.73 = £619.27

(iv) Total interest paid

The total of all the repayments made is:

4, 650 + 4,800 + 4,950 +  + 7,500

This is an arithmetic progression of n = 20 terms with first term a = 4, 650

and last term l = 7,500 . Hence:

20
S20 = 2
(4, 650 + 7,500) = £121,500

So, the total interest paid over the 20 years is the difference between the
payments made and the original loan:

121,500 - 51,714.28 = £69,786 (% SF)

7 Subject CT1 April 2011 Question 7

(i) The initial quarterly payment

It makes sense to work in quarters. Let Q be the first payment.

1/7/98 1/7/02 1/7/06 1/7/10 1/7/14 1/7/18 time

0 16 32 48 64 80 quarters

-60,000 cashflows

Q per qtr

+100 per qtr

+100 per qtr

+100 per qtr

+100 per qtr

The equation of value can be written as:

60,000 = Qa80 + 100v 16a64 + 100v 32a48 + 100v 48a32 + 100v 64a16 @ 2%

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Evaluating at an interest rate of 2% per quarter, we have:

60,000 = Q ¥ 39.7445 + 2,616.695465 + 1,627.606705 + 907.1436682 + 382.30961

= Q ¥ 39.7445 + 5,533.755449

60,000 - 5,533.755449
fi Q= = 1,370.41
39.7445

Therefore the first quarterly payment is £1,370.41.

(ii) The amount of capital repaid in the January 1999 payment

The loan of £60,000 is granted on 1 July 1998. The loan schedule for the
first two quarters is as follows:

Date Loan Payment Interest Capital

outstanding at component of component of
the beginning of the payment the payment
this period
1 October
£60,000.00 £1,370.41 £1,200.00 £170.41
1998
1 January
£59,829.59 £1,370.41 £1,196.59 £173.82
1999

The capital component of the January 1999 payment is £173.82.

(iii) The capital outstanding after the July 2011 payment

The capital outstanding on 1 July 2011 is the present value of the future
payments, which are:

(1,370.41 + 300)a12 + (1,370.41 + 400)a16 v 12 @ 2%

The present value of the future payments is:

1,670.41 ¥ 10.5753 + 1,770.41 ¥ 13.5777 ¥ 0.78849

= 36,618.89

The capital outstanding is £36,618.89 .

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8 Subject CT1 April 2012 Question 3

(i)(a) The annual instalment

Let X be the annual payment. Then, the equation of value is:

500,000 = Xa10 9% fi X = £77,910.04

(i)(b) The interest paid over the ten years

total interest = total payments - loan

= (77,910.04 ¥ 10) - 500,000
= £279,100

(ii)(a) The new quarterly instalment

The capital (or loan) outstanding at the end of Year 7 is:

L7 = 77,910.04a3 @ 9% = £197, 213.28

Let Q be the quarterly payment. Then, the equation of value is:

197, 213.28 = 4Qa(4) fi Q = £15,549.16

4 @12%

(ii)(b) The interest content of the second quarterly instalment

The capital (or loan) outstanding at time 7 is £197,213.28.

Loan Quarterly Interest Capital

outstanding at payment at component component
Date
the beginning the end of of the of the
of this period this period payment payment
First
£197,213.28 £15,549.16 £5,667.39 £9,881.77
quarter
Second
£187,331.51 £15,549.16 £5,383.41 £10,165.75
quarter

The interest component of the second quarterly payment is £5,383.41.

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9 Subject CT1 September 2012 Question 6

(i) Amount of loan

200 200+100=300 200+2x100=400 200+9x100=1,100

1 2 3 10

The loan is the PV of the payments:

L0 = 100a10 + 100(Ia )10

= 100 ¥ 7.36009 + 100 ¥ 36.96241
= £4, 432.25

(ii)(a) Interest component

800 1,100
=200+(6)(100) =200+(9)(100)

6 7 10

The loan outstanding at time 6 is:

L6 = 700a4 + 100(Ia )4
-4

1 - 1.06 -4
1-1.06
0.06 1.06
- 4(1.06 -4 )
= 700 + 100
0.06 0.06
= 700 ¥ 3.46511 + 100 ¥ 8.41062
= £3,266.64

Alternatively, L6 = 800v + 900v 2 + 1,000v 3 + 1,100v 4 .

So the interest component of the 7th payment is:

0.06 ¥ 3, 266.64 = £196.00

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(ii)(b) Capital component

800 - 196 = £604

(iii) Revised annual payment

The capital outstanding at time 7 is:

3,266.64 - 604 = £2,662.64

Alternatively, L7 = 900v + 1,000v 2 + 1,100v 3 .

Under the new terms, there will be 8 years left, so if the revised annual
payment is X then:

2,662.64 = Xa8 @ 8%

1 - 1.08 -8
=X
0.08
= 5.7466 X fi X = £463.34

10 Subject CT1 April 2013 Question 10

(i) Amount of original loan

PV = 5,000v + 4,800v 2 + 4, 600v 3 +  + 1, 200v 20

= 5,200a20 - 200 (Ia )20
= 5,200 ¥ 13.590326 - 200 ¥ 125.155012
= £45, 638.69

(ii) Capital repayment in the 12th instalment

The loan outstanding immediately after the 11th instalment is:

L11 = 2,800v + 2, 600v 2 + 2, 400v 3 +  + 1, 200v 9

= 3,000a9 - 200 (Ia )9
= 3,000 ¥ 7.435332 - 200 ¥ 35.236606
= £15,258.67

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The interest payment at the end of the 12th year will be:

£15, 258.67 ¥ 0.04 = £610.35

Since the repayment at time 12 is £2,800 the capital repaid in the 12th
instalment is:

£2,800 - £610.35 = £2,189.65

(iii)(a) Remaining term of revised loan

The amount outstanding at time 12 is:

£15, 258.67 - £2,189.65 = £13,069.02

This is equal to the present value of the new future level repayments of
2,800. So if there are n years left then our equation of value is:

2,800 an = 13,069.02 fi an = 4.6675

From the Tables we see that a5 = 4.45 and a6 = 5.24 . So we need

6 repayments (5 level payments of 2,800, plus a reduced final payment at
time 6, or time 18 from the start of the original loan). The remaining term is
6 years.

(iii)(b) Amount of final reduced payment

If the reduced final payment at time 6 is R , we have:

2,800a5 + Rv 6 = 13,069.02

Substituting in the values, we find that:

2,800 ¥ 4.451822 + R ¥ 1.04 -6 = 13,069.02 fi R = £764.15

(iii)(c) Total interest paid

The total interest paid will be the total amount of all the repayments less the
amount of the original loan:

5,000 + 4,800 +  + 2,800 + 5 ¥ 2,800 + 764.15 - 45, 638.69

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Summing the first 12 repayments using the arithmetic progression result:

n 12
S12 =
2
(2a + (n - 1)d ) = 2 (10,000 + 11 ¥ ( -200)) = 46,800

So the total amount of interest is:

46,800 + 5 ¥ 2,800 + 764.15 - 45, 638.69 = £15,925.46

11 Subject CT1 September 2013 Question 9

(i) Amount of loan

A diagram showing the payments is as follows:

400 – 20 400 – 2  20 400 – 14  20

400 ...
= 380 = 360 = 120

0 1 2 3 ... 15

The loan is:

420a15 - 20(Ia )15

-15

1 - 1.04 -15
1-1.04
0.04 1.04
- 15(1.04 -15 )
= 420 - 20
0.04 0.04
= 420 ¥ 11.118387 - 20 ¥ 80.853885 = £3,052.65

(ii) Capital and interest payments

The interest component of the first payment is:

0.04 ¥ 3,052.65 = £122.11

Hence, the capital component of the first payment is:

400 - 122.11 = £277.89

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(iii) New repayment

A diagram showing the payments is as follows:

400 – 8  20 400 – 9  20 400 – 14  20

...
=240 =220 =120

8 9 10 ... 15

The loan outstanding at time 8 is:

260a7 - 20(Ia )7
-7

1 - 1.04 -7
1-1.04
0.04 1.04
- 7(1.04 -7 )
= 260 - 20
0.04 0.04
= 260 ¥ 6.00205 - 20 ¥ 23.06780 = £1,099.18

The bank reduces the capital outstanding by 50%, so the new loan is based
on a capital value of:

0.5 ¥ 1,099.18 = £549.59

The payments have now changed:

X X+2 ... X + 18

8 9 10 ... 18

The present value of the future repayments at time 8 is:

( X - 2)a10 + 2(Ia )10

This is evaluated at 8%:

PV = ( X - 2) ¥ 6.71008 + 2 ¥ 32.686913
= 6.71008 X + 51.953663

6.71008 X + 51.953663 = 549.59 fi X = 74.16

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12 Subject CT1 April 2014 Question 10

(i) Amount of the first payment

-20,000 X X + 50 X + 100 ... X + 1, 200

0 1 2 3 ... 25

The equation of value for the cashflows on the loan is:

20,000 = ( X - 50) a25 + 50 (Ia )25 @ 8% pa

This gives:

20,000 = ( X - 50) ¥ 10.67478 + 50 ¥ 98.47888

15,076.05584 = ( X - 50) ¥ 10.67478

X - 50 = 1, 412.3065
X = £1, 462.31

(ii) Capital outstanding after three payments.

L3 X + 150 X + 200
= 1, 612.31 = 1, 662.31 ...

3 4 5 ... 25

L3 = 1,562.31a22 + 50 (Ia )22 @ 8% pa

This gives:

L3 = 1,562.31 ¥ 10.20074 + 50 ¥ 87.12640 = £20, 293

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(iii) Explanation

The loan outstanding at time 3 is greater than the amount of the original
loan.

The interest in the first year is 8% of £20,000, or £1,600. But the first loan
repayment is less than this, at about £1,462. So, since the initial payment is
not sufficient to pay the interest for the year, the capital outstanding actually
increases during the first year.

This process is repeated until the increasing repayments have become

sufficient to meet the current year’s interest, and to start to pay off some
capital as well. At this point the balance outstanding will start to decrease.

(iv) Total interest

We can use the formula for the sum of 25 terms of an arithmetic progression
to work out the total amount of all the repayments:

25 25
S25 = È 2a + 24 ¥ d ˚˘ = È 2 ¥ 1, 462.31 + 24 ¥ 50 ˚˘ = 51,557.66
2 Î 2 Î

Of this figure, £20,000 is repayment of capital. So the total interest paid is

this figure less £20,000, that is £31,558.

13 Subject CT1 April 2015 Question 11

(i) Proof

We have:

(Ia) n = v + 2v 2 + 3v 3 +  + nv n

Multiplying both sides of this equation by 1 + i , we obtain:

(1 + i )(Ia) n = 1 + 2v + 3v 2 +  + nv n -1

Subtracting these two equations, we find that:

( ) ( )
i (Ia ) n = (1 - 0) + (2v - v ) + 3v 2 - 2v 2 +  nv n -1 - (n - 1)v n -1 - nv n

= 1 + v + v 2 +  + v n -1 - nv n = an - nv n

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Dividing through by i , this gives us the required result:

an - nv n
(Ia) n =
i

(ii) Show that X = £26.62

A rate of interest of 15% per annum convertible monthly is equal to a rate of

15
= 1.25% per month effective.
12

So, working with a time unit of one month, we can equate the amount of the
loan to the present value of the repayments at this rate of interest to obtain:

X (Ia ) 60 = 30, 000

Evaluating the increasing annuity at 1.25%:

a60 - 60v 60
(Ia) 60 =
i
60
1- v
- 60v 60
= d
i
42.560024 - 28.474056
=
0.0125
= 1,126.8774

So the equation becomes:

1,126.8774 X = 30, 000

which gives X = 26.6222 , or £26.62.

(iii) APR on revised loan schedule

The equation of value for the new arrangement is:

( ) ( )
30, 000 = 36 X v 37 +  + v 96 = 36 X v 36 v +  + v 60 = 36 X v 36a60

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This gives us:

30, 000
v 36a60 = = 31.304783
36 X

At i = 1.1% :

1 - 1.011-60
v 36a60 = 1.011-36 ¥ = 29.509784
0.011

At i = 1% :

1 - 1.01-60
v 36a60 = 1.01-36 ¥ = 31.420198
0.01

So the monthly interest rate here is between 1% and 1.1%.

Interpolating between these values, we see that:

31.304783 - 31.420198
i  1% + ¥ (1.1% - 1%) = 0.0100604
29.509784 - 31.420198

Finally we convert this monthly rate of interest to an effective annual rate:

1.010060412 - 1 = 0.127634

Rounding this to the nearest 0.1% to obtain the APR, we have an APR of
12.8%.

The bank obtains a lower monthly rate of interest under the second
arrangement (1% instead of 1.25%). So the bank achieves a higher rate of
return under the first arrangement, and is perhaps unlikely to accept the
student’s suggestion.

(iv) Difference in the total repayments

The average repayment under the first arrangement will be:

1 + 60
¥ 26.62 = 811.91
2

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So the total amount of the repayments under the first arrangement will be:

811.91 ¥ 60 = £48, 715

Under the second arrangement, the total repayments will be:

60 ¥ 36 ¥ 26.62 = £57, 499

Although the total repayment is higher under the second arrangement, the
APR is lower. The APR is a function of the timings of the repayments, as
well as the amounts. A lower APR can still lead to a greater total repayment
if instalments are made later in time. This is the case with the second
arrangement here.

14 Subject CT1 April 2016 Question 5

(i) Amount of the loan

The amount of the loan is the total present value at the start of all the
repayments at 6% pa:

L0 = 950a15 + 250 (Ia )15

Evaluating these functions at 6% pa:

1 - v 15 1 - 1.06 -15
a15 = = = 9.712249
i 0.06

a15 - 15 ¥ v 15 1.06 ¥ 9.712249 - 15 ¥ 1.06 -15

and: (Ia )15 = = = 67.266800
i 0.06

This gives:

L0 = 950 ¥ 9.712249 + 250 ¥ 67.266800 = 26,043.34

So the amount of the loan is £26,043.34.

(ii) Capital outstanding after the ninth instalment

Working prospectively, the capital outstanding at time 9 is the present value

at time 9 of all the future repayments that are yet to be made.

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The present value of the six remaining repayments is:

3,450v + 3,700v 2 +  + 4,700v 6 = 3,200a6 + 250 (Ia )6

Evaluating these functions at 6% pa:

1 - v 6 1 - 1.06 -6
a6 = = = 4.917324
i 0.06

a6 - 6 ¥ v 6 1.06 ¥ 4.917324 - 6 ¥ 1.06 -6

and: (Ia )6 = = = 16.376676
i 0.06

So the present value at time 9 of the future repayments is:

3,200a6 + 250 (Ia )6 = 3,200 ¥ 4.917324 + 250 ¥ 16.376676 = 19,829.61

The capital outstanding immediately after the ninth instalment has been
made is £19,829.61.

(iii) Capital and interest components of the final instalment

The final instalment (made at time 15) is:

1,200 + 14 ¥ 250 = 4,700

The balance outstanding one year before the end of the loan will therefore
be:

4,700
4,700v = = 4,433.9623
1.06

The interest on this balance during the final year will be:

4,433.9623 ¥ 0.06 = 266.04

So the final instalment is made up of £4,433.96 of capital and £266.04 of

interest (total £4,700).

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15 Subject CT1 April 2017 Question 2

Option 1

The present value of the repayments under this option, using i  5% , is:

 16 
 1  1.05 
7,800a(4)  7,800 
16
  14
 4 1.05  1  


 7,800  11.0389
 £86,103.52

Option 2

Working in a time period of two years, the present value of the repayments
under this option is:

2  8,200a8

calculated at an effective two-yearly interest rate of:

1.052  1  10.25%

The present value is therefore:

 1  1.1025 8 
16,400    16,400  5.2867
 0.1025 
 
 £86,702.16

The present value of the repayments under Option 1 is lower than that under
Option 2. Given that both options are available to repay the same loan
amount, this means that Option 1 would provide the better deal for the
borrower, at a rate of interest of 5% pa effective.

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16 Subject CT1 September 2017 Question 8

(i) Amount of the loan

The present value of all the future repayments is:

PV = 100v + 150v 2 + 200v 3 +  + 550v 10

( ) (
= 50 v + v 2 +  + v 10 + 50 v + 2v 2 +  + 10v 10 )
= 50 a10 + 50 (Ia )10

1 - v 10 a - 10v 10
= 50 ¥ + 50 ¥ 10
i i
1 - 1.05 -10
-10 - 10 ¥ 1.05 -10
1 - 1.05 -1
= 50 ¥ + 50 ¥ 1 - 1.05
0.05 0.05
-10
1 - 1.05 8.10782 - 10 ¥ 1.05 -10
= 50 ¥ + 50 ¥
0.05 0.05
= 50 ¥ 7.72173 + 50 ¥ 39.37378
= 2,354.776

So the amount of the loan is £2,354.78.

(ii)(a) Interest component of the sixth instalment

The outstanding balance of the loan at time 5 is the present value at that
time of all the payments yet to be made:

PV = 350v + 400v 2 +  + 550v 5

( ) (
= 300 v + v 2 +  + v 5 + 50 v + 2v 2 +  + 5v 5 )
= 300a5 + 50 (Ia )5

Calculating this in the same way as before, and using:

1 - 1.05 -5
a5 = = 4.54595
0.05 1.05

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we have:

1 - 1.05 -5 4.54595 - 5 ¥ 1.05 -5

PV = 300 ¥ + 50 ¥
0.05 0.05
= 300 ¥ 4.32948 + 50 ¥ 12.56639
= 1,927.163

So the balance of the loan at time 5 is £1,927.16.

So the interest component of the 6th instalment is:

1,927.163 ¥ 0.05 = 96.3581

or £96.36 …

(ii)(b) Capital component of the sixth instalment

… and the capital component of the 6th instalment is:

350 - 96.3581 = 253.6419 , or £253.64.

(iii) Revised instalment

The balance of the loan at time 6 is now:

1,927.163 ¥ 1.05 - 350 = 1,673.52

Equating this to the present value of the repayments:

1 - 1.06 -4
1,673.52 = Xa4 = X ¥ = 3.4651X
0.06

Solving this equation, we find that X = 482.964 , or about £482.96.

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FACTSHEET

This factsheet summarises the main methods, formulae and information

required for tackling questions on the topics in this booklet.

1 Equations of value

An equation of value equates the present value of the money received to the
present value of the money paid out:

PV income = PV outgo

The general form of the equation of value, when there are both discrete and
continuous cashflows present, is:

n •
 ctt e -d tr + Ú0 r (t ) e -d t dt = 0 (*)
r =1

2 Equation of value for a bond

For example, suppose that Bond B has a price of P and provides a series of
interest payments of c payable at the end of each of the next n years and
a final redemption payment of R at the end of the n years. The equation of
value for this investment is:

P = can + R v n calculated at interest rate i

3 Yield

For any given transaction, the equation of value (*) may have no roots, a
unique root, or several roots. If there is a unique root, d 0 say, then this is
said to be the force of interest implied by the transaction.

The corresponding rate of interest i0 = ed 0 - 1 is called the yield (per unit of

time). So the yield is defined if and only if the equation:

n •
 ctt (1 + i )
- tr
+ Ú r (t ) (1 + i )
-t
dt = 0
0
r =1

has exactly one root greater than –1. When such a root exists, it is defined
to be the yield.

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More simply, the yield on an investment is the unique interest rate that
solves the equation of value. The yield is also sometimes called the internal
rate of return or the money-weighted rate of return.

4 Calculating the yield

The yield often has to be found using trial and error. Once you have found
two values, at most 1% apart and one on either side of the yield, you can
approximate the yield using linear interpolation.

For Bond B described above, the yield can be found algebraically when
P =R.

5 Linear interpolation

Suppose you want to work out the interest rate i that gives a price of P . If
i1 gives a price of P1 and i 2 gives a price of P2 , and i1 and i 2 satisfy the
conditions in the paragraph above, then:

P - P1
i ª i1 +
P2 - P1
(i2 - i1)

6 Uncertain payments

If there is uncertainty about the payment or receipt of a cashflow at a

particular time, allowance can be made for this in one of two ways:

 by applying a probability of payment or receipt to each uncertain

cashflow

 by using a higher rate of discount to find the present value of the

cashflows.

7 Loans

A very common transaction involving compound interest is a loan that is

repaid over a predetermined term by a series of regular instalments.
Instalments may be level, or may increase or decrease in some
predetermined way.

Each repayment must first pay the interest due on the outstanding balance.
The remainder of the repayment goes towards reducing the capital
outstanding.

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8 Calculating the amount outstanding

This can be done prospectively or retrospectively.

Working prospectively, we calculate the present value of the future

cashflows.

Working retrospectively, we calculate the accumulated value of the original

loan minus the accumulated value of the repayments to date.

It is usually easier to work prospectively.

9 Calculating the interest component

We can calculate the interest component of a single repayment by taking the

loan outstanding immediately after the previous instalment and multiplying it
by the appropriate effective interest rate eg for quarterly payments, the
quarterly effective interest rate is appropriate.

10 Calculating the capital component

We can calculate the capital component of a single repayment by

subtracting the interest component from the repayment.

We can calculate the capital repaid over a period of time by working out the
amount outstanding at the beginning of the period and at the end of the
period and taking the difference between these two figures.

11 Dealing with simple increasing or decreasing repayments

We can deal with simple increasing or decreasing repayments by using a

combination of an increasing annuity and a level annuity.

12 Dealing with compound increasing or decreasing repayments

We can deal with compound increasing or decreasing repayments by

adjusting the rate of interest and using a level annuity, or using geometric
progressions to sum the series.

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13 Flat rate of interest

The flat rate of interest is defined by the equation:

total interest paid

original loan amount ¥ n

where n is the number of years over which the loan is repaid.

The flat rate ignores the repayment of capital over the term of the loan, so
flat rates are only useful for comparing loans of the same term. Two loans of
different terms calculated using the same effective rate of interest will have
different flat rates.

14 APR

To ensure that consumers are able to compare credit agreements, lenders

are usually required to give information about the effective rate of interest
that they charge. In the UK, this takes the form of the Annual Percentage
Rate or APR, which is defined to be the effective annual rate of interest
rounded to the nearer 0.1 of 1%.

The APR usually has to be calculated using trial and error. It is a little bit
less than twice the flat rate.

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NOTES

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NOTES

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NOTES

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NOTES

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NOTES

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Subject CM1
Revision Notes
For the 2019 exams

Project appraisal
Booklet 4

covering

Chapter 12 Project appraisal

The Actuarial Education Company

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CONTENTS

Contents Page
Links to the Course Notes and Syllabus 2
Overview 3
Core Reading 4
Past Exam Questions 13
Solutions to Past Exam Questions 30
Factsheet 69

Copyright agreement

All of this material is copyright. The copyright belongs to Institute and

Faculty Education Ltd, a subsidiary of the Institute and Faculty of Actuaries.
The material is sold to you for your own exclusive use. You may not hire out,
lend, give, sell, transmit electronically, store electronically or photocopy any
part of it. You must take care of your material to ensure it is not used or
copied by anyone at any time.

Legal action will be taken if these terms are infringed. In addition, we may
seek to take disciplinary action through the profession or through your
employer.

These conditions remain in force after you have finished using the course.

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LINKS TO THE COURSE NOTES AND SYLLABUS

Material covered in this booklet

Chapter 12 Project Appraisal

These chapter numbers refer to the 2019 edition of the ActEd course notes.

Syllabus objectives covered in this booklet

The numbering of the syllabus items is the same as that used by the Institute
and Faculty of Actuaries.

3.3 Show how discounted cashflow and equation of value techniques can
be used in project appraisals.

1. Calculate the net present value and accumulated profit of the

receipts and payments from an investment project at given rates of
interest.

2. Calculate the internal rate of return, payback period and discounted

payback period and discuss their suitability for assessing the
suitability of an investment project.

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OVERVIEW

This booklet covers Syllabus objectives 3.3.1 and 3.3.2, which relate to
appraisal of business projects.

Breakdown of the topic

We compare different projects on the basis of key criteria, to decide which is

the ‘best’ project. The criteria are mathematical measures of present value,
profit, yield, and how long the project takes to show some profit. You need
to be able to calculate the measures and comment on the suitability of
projects.

Exam questions

The most common type of exam question requires you to calculate values
such as the net present value or discounted payback period.

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CORE READING

All of the Core Reading for the topics covered in this booklet is contained in
this section.
____________

Chapter 12 – Project appraisal

Suppose an investor is considering the merits of an investment or

business project.
____________

1 The investment or project will normally require an initial outlay and

possibly other outlays in future, which will be followed by receipts,
although in some cases the pattern of income and outgo is more
complicated. The cashflows associated with the investment or
business venture may be completely fixed (as in the case of a secure
fixed-interest security maturing at a given date) or they may have to be
estimated.
___________

2 The estimation of the cash inflows and outflows associated with a

business project usually requires considerable experience and
judgement. All the relevant factors (such as taxation and investment
grants) and risks (such as construction delays) should be considered
by the actuary, with assistance from experts in the relevant field (eg
Civil Engineering for building projects). The identification and
assessment of the risks may be done using the Risk Analysis and
Management for Projects (RAMP) approach for that has been
developed by, and published on behalf of, the actuarial and civil
engineering professions.
___________

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3 Considerable uncertainty will exist in the assessment of many of the

risks, so it is prudent to perform calculations on more than one set of
assumptions, eg on the basis of ‘optimistic’, ‘average’, and
‘pessimistic’ forecasts respectively.

More complicated techniques (using statistical theory) are available to

deal with this kind of uncertainty. Precision is not attainable in the
estimation of cashflows for many business projects and hence extreme
accuracy is out of place in many calculations.
___________

4 Net cashflow ct at time t (measured in suitable time units) is:

ct = cash inflow at time t  cash outflow at time t

If any payments may be regarded as continuous then r (t ) , the net rate

of cashflow per unit time at time t, is defined as:

r (t ) = r1(t ) - r2 (t )

where r1(t ) and r2 (t ) denote the rates of inflow and outflow at time t
respectively.
____________

5 Having ascertained or estimated the net cashflows of the investment or

project under scrutiny, the investor will wish to measure its profitability
in relation to other possible investments or projects. In particular, the
investor may wish to determine whether or not it is prudent to borrow
money to finance the venture.

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Assume for the moment that the investor may borrow or lend money at
a fixed rate of interest i per unit time. The investor could accumulate
the net cashflows connected with the project in a separate account in
which interest is payable or credited at this fixed rate. By the time the
project ends (at time T , say), the balance in this account will be:

T
 ct (1 + i )T -t + Ú0 r (t )(1 + i )T -t dt (1.1)

where the summation extends over all t such that ct π 0 .

____________

6 The accumulated value, at time T , of a cashflow can be expressed as:

T
A(T ) = Â ct (1 + i )T -t + Ú r (t )(1 + i )T -t dt
0
____________

7 The present value at rate of interest i of the net cashflows is called the
‘net present value’ at rate of interest i of the investment or business
project, and is usually denoted by NPV (i ) . Hence:
____________

T
8 NPV (i ) = Â ct (1 + i )-t + Ú r (t )(1 + i )-t dt (1.2)
0

(If the project continues indefinitely, the accumulation (1.1) is not

defined, but the net present value may be defined by Equation (1.2)
with T = • .) If r (t ) = 0 , we obtain the simpler formula:

NPV (i ) = Â ct v t

where v = (1 + i )-1 .
____________

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9 Since the equation:

NPV (i ) = 0

is the equation of value for the project at the present time, the yield i0
on the transaction is the solution of this equation, provided that a
unique solution exists.

It may readily be shown that NPV (i ) is a smooth function of the rate of

interest i and that NPV (i ) Æ c0 as i Æ • .
____________

10 In economics and accountancy the yield per annum is often referred to

as the ‘internal rate of return’ (IRR) or the ‘yield to redemption’.

The latter term is frequently used when dealing with fixed-interest

securities, for which the ‘running’ (or ‘flat’) yield is also considered.
____________

11 The practical interpretation of the net present value function NPV (i )

and the yield is as follows. Suppose that the investor may lend or
borrow money at a fixed rate of interest i1 . Since, from Equation (1.2),
NPV (i1) is the present value at rate of interest i1 of the net cashflows
associated with the project, we conclude that the project will be
profitable if and only if:

NPV (i1) > 0

____________

12 Also, if the project ends at time T , then the profit (or, if negative, loss)
at that time is (by Expression (1.1)):

NPV (i1)(1 + i1)T

Let us now assume that, as is usually the case in practice, the yield i0
exists and NPV (i ) changes from positive to negative when i = i0 .
____________

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13 Under these conditions it is clear that the project is profitable if and

only if:

i1 < i0

ie the yield exceeds that rate of interest at which the investor may lend
or borrow money.
____________

14 Many projects will need to provide a return to shareholders and so

there will not be a specific fixed rate of interest that has to be
exceeded. Instead a target, or hurdle, rate of return may be set for
assessing whether a project is likely to be sufficiently profitable.

Suppose now that an investor is comparing the merits of two possible

investments or business ventures, which we call projects A and B
respectively. We assume that the borrowing powers of the investor are
not limited.

Let NPVA (i ) and NPVB (i ) denote the respective net present value
functions and let i A and iB denote the yields (which we shall assume
to exist).
____________

15 It might be thought that the investor should always select the project
with the higher yield, but this is not invariably the best policy. A better
criterion to use is the profit at time T (the date when the later of the
two projects ends) or, equivalently, the net present value, calculated at
the rate of interest i1 at which the investor may lend or borrow money.
This is because A is the more profitable venture if:

NPVA (i1) > NPVB (i1)

____________

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16 The fact that i A > iB may not imply that NPVA (i1) > NPVB (i1) is
illustrated in the following diagram. Although i A is larger than iB , the
NPV (i ) functions ‘cross-over’ at i¢ . It follows that
NPVB (i1) > NPVA (i1) for any i1 < i ¢ , where i ¢ is the cross-over rate.
There may even be more than one cross-over point, in which case the
range of interest rates for which project A is more profitable than
project B is more complicated.

____________

Example

An investor is considering whether to invest in either or both of the

following loans:

 Loan X: For a purchase price of £10,000, the investor will

receive £1,000 per annum payable quarterly in arrears for
15 years.

 Loan Y: For a purchase price of £11,000, the investor will

receive an income of £605 per annum, payable annually in arrears
for 18 years, and a return of his outlay at the end of this period.

The investor may lend or borrow money at 4% per annum. Would you
advise the investor to invest in either loan, and, if so, which would be
the more profitable?

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Solution

17 We first consider loan X:

NPVX (i ) = -10,000 + 1,000a (4)|

15

and the yield is found by solving the equation NPVX (i ) = 0 , or

a(4)| = 10 , which gives i X ª 5.88% .
15

For loan Y we have:

NPVY (i ) = -11,000 + 605a18| + 11,000v 18

and the yield (ie the solution of NPVY (i ) = 0 ) is iY = 5.5% .

The rate of interest at which the investor may lend or borrow money is
4% per annum, which is less than both i X and iY , so we compare
NPVX (0.04) and NPVY (0.04) .

Now NPV X (0.04) = £1,284 and NPVY (0.04) = £2,089 , so it follows that,
although the yield on loan Y is less than on loan X, the investor will
make a larger profit from loan Y. We should, therefore, advise him that
an investment in either loan would be profitable, but that, if only one of
them is to be chosen, then loan Y will give the higher profit.

The above example illustrates the fact that the choice of investment
depends very much on the rate of interest i1 at which the investor may
lend or borrow money. If this rate of interest were 5¾%, say, then loan
Y would produce a loss to the investor, while loan X would give a
profit.
____________

18 We have assumed so far that the investor may borrow or lend money at
the same rate of interest i1 . In practice, however, the investor will
probably have to pay a higher rate of interest ( j1 , say) on borrowings
than the rate ( j2 , say) he receives on investments.

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The difference j1 - j2 between these rates of interest depends on

various factors, including the credit-worthiness of the investor and the
expense of raising a loan.
____________

19 The concepts of net present value and yield are in general no longer
meaningful in these circumstances. We must calculate the
accumulation of net cashflows from first principles, the rate of interest
depending on whether or not the investor’s account is in credit. In
many practical problems the balance in the investor’s account (ie the
accumulation of net cashflows) will be negative until a certain time t1
and positive afterwards, except perhaps when the project ends.

In some cases the investor must finance his investment or business

project by means of a fixed-term loan without an early repayment
option. In these circumstances the investor cannot use a positive
cashflow to repay the loan gradually, but must accumulate this money
at the rate of interest applicable on lending, ie j2 .
____________

20 In many practical problems the net cashflow changes sign only once,
this change being from negative to positive. In these circumstances
the balance in the investor’s account will change from negative to
positive at a unique time t1 , or it will always be negative, in which case
the project is not viable. If this time t1 exists, it is referred to as the
‘discounted payback period’ (DPP). It is the smallest value of t such
that A(t ) ≥ 0 , where:

t
A(t ) = Â cs (1 + j1)t - s + Ú0 r (s )(1 + j1)t - s ds (2.1)
s £t
____________

21 Note that t1 does not depend on j2 but only on j1 , the rate of interest
applicable to the investor’s borrowings.
____________

22 Suppose that the project ends at time T . If A(T ) < 0 (or, equivalently,
if NPV ( j1) < 0 ) the project has no discounted payback period and is
not profitable.

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23 If the project is viable (ie there is a discounted payback period t1 ) the

accumulated profit when the project ends at time T is:

T
P = A(t1)(1 + j2 )T -t1 + Â ct (1 + j2 )T -t + Út1 r (t )(1 + j2 )T -t dt
t > t1

This follows since the net cashflow is accumulated at rate j2 after the
discounted payback period has elapsed.
____________

24 If interest is ignored in the formula (2.1) (ie if we put j1 = 0 ), the

resulting period is called the ‘payback period’.

However, its use instead of the discounted payback period often leads
to erroneous results and is therefore not to be recommended.

The discounted payback period is often employed when considering a

single investment of C, say, in return for a series of payments each of
R, say, payable annually in arrears for n years. The discounted
payback period t1 years is clearly the smallest integer t such that
A* (t ) ≥ 0 , where:

A* (t ) = -C (1 + j1)t + Rst | at rate j1

ie the smallest integer t such that:

Rat | ≥ C at rate j1

The project is therefore viable if t1 £ n , in which case the accumulated

profit after n years is clearly:

P = A* (t1)(1 + j2 )n -t1 + Rsn -t | at rate j2

1

____________

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PAST EXAM QUESTIONS

This section contains all the Subject CT1 exam questions from the period
2008 to 2017 that are related to the topics covered in this booklet.

Solutions are given later in this booklet. These give enough information for
you to check your answer, including working, and also show you what an
adequate examination answer should look like. Further information may be
available in the Examiners’ Report, ASET or Course Notes. (ASET can be
ordered from ActEd.)

We first provide you with a cross reference grid that indicates the main
subject areas of each exam question. You can use this, if you wish, to
select the questions that relate just to those aspects of the topic that you
may be particularly interested in reviewing.

Alternatively you can choose to ignore the grid, and instead attempt each
question without having any clues as to its content.

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Cross reference grid

accum. profit
Tick when
attempted
NPV

DPP
IRR

PP
Question

1 
2 
3 
4 
5  
6   
7  
8  
9  
10 
11  
12 
13   
14 
15   
16 
17  
18 
19 
20 

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1 Subject CT1 April 2008 Question 8

An investor is considering investing in a capital project.

The project requires an outlay of £500,000 at outset and further payments at

the end of each of the first 5 years, the first payment being £100,000 and
each successive payment increasing by £10,000.

The project is expected to provide a continuous income at a rate of £80,000

in the first year, £83,200 in the second year and so on, with income
increasing each year by 4% per annum compound. The income is received
for 25 years.

It is assumed that, at the end of 15 years, a further investment of £300,000

will be required and that the project can be sold to another investor for
£700,000 at the end of 25 years.

(i) Calculate the net present value of the project at a rate of interest of 11%
per annum effective. [9]

(ii) Without doing any further calculations, explain how the net present
value would alter if the interest rate had been greater than 11% per
annum effective. [3]
[Total 12]

Please note that the final part of the following question relates to discounted
mean term, which is covered in a later booklet.

2 Subject CT1 September 2008 Question 10

An insurance company is considering two possible investment options.

The first investment option involves setting up a branch in a foreign country.

This will involve an immediate outlay of £0.25m, followed by investments of
£0.1m at the end of one year, £0.2m at the end of two years, £0.3m at the
end of three years and so on until a final investment is made of £1m in ten
years’ time. The investment will provide annual payments of £0.5m for
twenty years with the first payment at the end of the eighth year. There will
be an additional incoming cash flow of £5m at the end of the 27th year.

The second investment option involves the purchase of 1 million shares in a

bank at a price of £4.20 per share. The shares are expected to provide a
dividend of 21p per share in exactly one year, 22.05p per share in two years
and so on, increasing by 5% per annum compound. The shares are
expected to be sold at the end of ten years, just after a dividend has been
paid, for £5.64 per share.

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(i) Determine which of the options has the higher net present value at a
rate of interest of 7% per annum effective. [9]

(ii) Without doing any further calculations, determine which option has the
higher discounted mean term at a rate of interest of 7% per annum
effective. [2]
[Total 11]

3 Subject CT1 April 2009 Question 5

A company’s required return for a particular investment project can be

expressed as a force of interest, d (t ) . This force of interest is a function of
time and at any time t , measured in years, is given by the formula:

d (t ) = 0.05 + 0.002t 0 £ t £ 5
d (t ) = 0.06 5<t

The expenditure required for this project is a payment of £100,000 at t = 0

and a further payment of £80,000 at t = 2 .

The income received from the project is a payment stream paid continuously
from t = 8 to t = 12 under which the annual rate of payment at time t is
£100,000e0.001t .

Calculate the discounted payback period for this project. [8]

4 Subject CT1 April 2009 Question 6

A pension fund purchased an office block nine months ago for £5 million.

The pension fund will spend a further £900,000 on refurbishment in two

months’ time.

A company has agreed to occupy the office block six months from now. The
lease agreement states that the company will rent the office block for fifteen
years and will then purchase the property at the end of the fifteen year rental
period for £6 million.

It is further agreed that rents will be paid quarterly in advance and will be
increased every three years at the rate of 4% per annum compound. The
initial rent has been set at £800,000 per annum with the first rental payment
due immediately on the date of occupation.

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Calculate, as at the date of purchase of the office block, the net present
value of the project to the pension fund assuming an effective rate of interest
of 8% per annum. [8]

5 Subject CT1 September 2009 Question 10

A group of experts is analysing options to try to avert problems caused by

climate change. They agree on the following expected costs and benefits of
climate change over the next 50 years, starting from the current time. All
figures are given in 2009 dollars.

Costs of climate change:

 Serious events will occur once every three years, in arrear, each
giving rise to costs of $30bn, incurred immediately on the date of
the event.
 Communities affected by climate change will incur costs of $20bn
per annum incurred continuously, increasing at a continuous rate of
1% per annum.
 Other costs, assumed to be $40bn per annum, will be incurred
annually in arrear.

Benefits arising from climate change:

 Benefits from higher crop yields and lower heating costs are
assumed to be $10bn per annum, incurred annually in arrear.

The experts are considering whether to recommend investment in a carbon

storing technology which, it is believed, will reduce all the costs and benefits
listed above to zero. The technology requires a one-off investment
immediately of $440bn. Costs are then assumed to be $50bn per annum
incurred annually in arrear for 50 years.

The experts do not agree about the appropriate rate of interest at which to
evaluate the options available. One group believes that the net present
value of using the carbon storage technology should be evaluated at a real
rate of return of 4% per annum effective. A second group believe that it
should be evaluated at a real rate of return of 1% per annum effective.

(i) Define what is meant by the discounted payback period of an

investment and indicate its main disadvantage as an investment
decision criterion. [3]

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(ii) Explain why the project must have a discounted payback period when
the interest rate is 1.5% and the internal rate of return is higher than
1.5%. [2]

(iii) Calculate the net present value of the carbon storing technology at a
real rate of interest of 1% per annum effective. [5]

(iv) Calculate the net present value of the carbon storing technology at a
real rate of interest of 4% per annum effective. [5]

(v) Comment on whether the investment in the carbon storing technology

should go ahead. [2]
[Total 17]

6 Subject CT1 April 2010 Question 9

A company is undertaking a new project. The project requires an investment

of £5m at the outset, followed by £3m three months later.

It is expected that the investment will provide income over a 15 year period
starting from the beginning of the third year. Net income from the project will
be received continuously at a rate of £1.7m per annum. At the end of this 15
year period there will be no further income from the investment.

Calculate at an effective rate of interest of 10% per annum:

(i) the net present value of the project [3]

(ii) the discounted payback period. [4]

A bank has offered to loan the funds required to the company at an effective
rate of interest of 10% per annum. Funds will be drawn from the bank when
required and the loan can be repaid at any time. Once the loan is paid off,
the company can earn interest on funds from the venture at an effective rate
of interest of 7% per annum.

(iii) Calculate the accumulated profit at the end of the 17 years. [4]
[Total 11]

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7 Subject CT1 September 2010 Question 6

On 1 January 2001 the government of a particular country bought 200

million shares in a particular bank for a total price of £2,000 million. The
shares paid no dividends for three years. On 30 June 2004 the shares paid
dividends of 10 pence per share. On 31 December 2004, they paid
dividends of 20 pence per share. Each year, until the end of 2009, the
dividend payable every 30 June rose by 10% per annum compound and the
dividend payable every 31 December rose by 10% per annum compound.
On 1 January 2010, the shares were sold for their market price of £3,500
million.

(i) Calculate the net present value on 1 January 2001 of the government’s
investment in the bank at a rate of interest of 8% per annum effective. [5]

(ii) Calculate the accumulated profit from the government’s investment in

the bank on the date the shares are sold using a rate of interest of 8%
per annum effective. [1]
[Total 6]

8 Subject CT1 April 2011 Question 9

A company is considering investing in a project. The project requires an

initial investment of three payments, each of £105,000. The first is due at
the start of the project, the second six months later, and the third payment is
due one year after the start of the project.

After 15 years, it is assumed that a major refurbishment of the infrastructure

will be required, costing £200,000.

The project is expected to provide a continuous income stream as follows:

 £20,000 in the second year
 £23,000 in the third year
 £26,000 in the fourth year
 £29,000 in the fifth year.

Thereafter the continuous income stream is expected to increase by 3% per

annum (compound) at the start of each year. The income stream is
expected to cease at the end of the 30th year from the start of the project.

(i) Show that the net present value of the project at a rate of interest of 8%
per annum effective is £4,000 (to the nearest £1,000). [7]

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 Batch 4

(ii) Calculate the discounted payback period for the project, assuming a
rate of interest of 8% per annum effective. [5]
[Total 12]

9 Subject CT1 September 2011 Question 10 (corrected)

A country’s football association is considering whether to bid to host the

World Cup in 2026. Several countries aspiring to host the World Cup will be
making bids. Regardless of whether the bid is successful, the association
will incur various costs. For two years, starting on 1 January 2012, the
association will incur costs at a rate of £2m per annum, assumed to be paid
continuously, to prepare the bid.

If the football association is successful, the following costs will be incurred

from 1 January 2016 until 31 December 2026:

 One stadium will be built each year for ten years. The first stadium will
be built in 2016 and is expected to cost £200m; the stadium built in 2017
is expected to cost £210m; and so on, with the cost of each stadium
rising by 5% each year. The costs of building each stadium are
assumed to be incurred halfway through the relevant year.
 Administration costs at a rate of £100m per annum will be incurred,
payable monthly in advance from 1 January 2025 until 31 December
2026.
 Revenues from television, ticket receipts, advertising and so on are
expected to be £3,300m and are assumed to be received continuously
throughout 2026.

(i) Explain why the payback period is not a good indicator of whether this
project is worthwhile. [3]

The football association decides to judge whether to go ahead with the bid
by calculating the net present value of the costs and revenues from a
successful bid on 1 January 2012 at a rate of interest of 4% per annum
effective.

(ii) Determine whether the association should make the bid. [13]

The football association is discussing how it might factor into its calculations
the fact that it is not certain to win the right to host the World Cup because
other countries are also bidding.

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 Batch 4

(iii) Explain how you might adjust the above calculations if the probability of
winning the right to host the World Cup is 0.1 and whether this
adjustment would make it more likely or less likely that the bid will go
ahead. [3]
[Total 19]

10 Subject CT1 April 2012 Question 5

An investor is considering two projects, Project A and Project B. Project A

involves the investment of £1,309,500 in a retail outlet. Rent is received
quarterly in arrear for 25 years, at an initial rate of £100,000 per annum. It is
assumed that the rent will increase at a rate of 5% per annum compound,
but with increases taking place every five years. Maintenance and other
expenses are incurred quarterly in arrear, at a rate of £12,000 per annum.
The retail outlet reverts to its original owner after 25 years for no payment.

Project B involves the purchase of an office building for £1,000,000. The

rent is to be received quarterly in advance at an initial rate of £85,000 per
annum. It is assumed that the rent will increase to £90,000 per annum after
20 years. There are no maintenance or other expenses. After 25 years the
property reverts to its original owner for no payment.

(i) Show that the internal rate of return for Project A is 9% per annum
effective. [5]

(ii) Calculate the annual effective internal rate of return for Project B. Show
your working. [4]

(iii) Discuss the extent to which the answers to parts (i) and (ii) above will
influence the investor’s decision over which project to choose. [3]
[Total 12]

11 Subject CT1 April 2013 Question 8

A car manufacturer is to develop a new model to be produced from 1

January 2016 for six years until 31 December 2021. The development costs
will be £19 million on 1 January 2014, £9 million on 1 July 2014 and £5
million on 1 January 2015.

It is assumed that 6,000 cars will be produced each year from 2016 onwards
and that all will be sold.

The production cost per car will be £9,500 during 2016 and will increase by
4% each year with the first increase occurring in 2017. All production costs
are assumed to be incurred at the beginning of each calendar year.

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 Batch 4

The sale price of each car will be £12,600 during 2016 and will also increase
by 4% each year with the first increase occurring in 2017. All revenue from
sales is assumed to be received at the end of each calendar year.

(i) Calculate the discounted payback period at an effective rate of interest

of 9% per annum. [9]

(ii) Without doing any further calculations, explain whether the discounted
payback period would be greater than, equal to, or less than the period
calculated in part (i) if the effective rate of interest were substantially
less than 9% per annum. [2]
[Total 11]

12 Subject CT1 September 2013 Question 6

A pension fund is considering investing in a major infrastructure project. The

fund has been asked to make an investment of £2m for a 1% share in
revenues from building a road. No other costs will be incurred by the
pension fund. The following revenues are expected to arise from the project:

In the first year, 40,000 vehicles a day will use the road, each paying a toll of
£1.

In the second year, 50,000 vehicles a day will use the road, each paying a
toll of £1.10.

In the third year, both the number of vehicles using the road and the level of
tolls will rise by 1% from their level in the second year. They will both
continue to rise by 1% per annum compound until the end of the 20th year.

At the end of the 20th year, it is assumed that the road has no value as it will
have to be completely rebuilt.

You should assume that all revenue is received continuously throughout the
year and that there are 365 days in all years.

Calculate the net present value of the investment in the road at a rate of
interest of 8% per annum effective. [10]

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13 Subject CT1 April 2014 Question 8

An insurance company borrows £50 million at an effective interest rate of 9%

per annum. The insurance company uses the money to invest in a capital
project that pays £6 million per annum payable half-yearly in arrear for 20
years. The income from the project is used to repay the loan. Once the loan
has been repaid, the insurance company can earn interest at an effective
interest rate of 7% per annum.

(i) Calculate the discounted payback period for this investment. [4]

(ii) Calculate the accumulated profit the insurance company will have made
at the end of the term of the capital project. [5]
[Total 9]

14 Subject CT1April 2015 Question 9

A property development company has just purchased a retail outlet for

$4,000,000. A further $900,000 will be spent refurbishing the outlet in six
months’ time.

An agreement has been made with a prospective tenant who will occupy the
outlet beginning one year after the purchase date. The tenant will pay rent
to the owner for five years and will then immediately purchase the outlet from
the property development company for $6,800,000. The initial rent will be
$360,000 per annum and this will be increased by the same percentage
compound rate at the beginning of each successive year. The rental income
is received quarterly in advance.

Calculate the compound percentage increase in the annual rent required to

earn the company an internal rate of return of 12% per annum effective. [9]

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15 Subject CT1 September 2015 Question 9

A student has inherited £1m and is considering investing the money in two
projects, A and B.

Project A requires the investment of the whole sum in properties that are to
be let out to tenants. The details are:
 The student expects to receive an income from rents at an annual rate
of £60,000 a year for four years after an initial period of one year in
which no income will be received.
 Rents are expected to rise thereafter at the start of each year at a rate
of 0.5% per annum.
 The income will be received monthly in advance.
 The project involves costs of £10,000 per annum in the first year, rising
at a constant rate of 0.5% per annum.
 The costs will be incurred at the beginning of each year.
 At the end of 20 years, the student expects to be able to sell the
properties for £2m after which there will be no further revenue or costs.

Project B involves the investment of the whole sum in an investment fund.

The fund is expected to pay an income of £60,000 per annum annually in
advance and return the whole invested sum at the end of 20 years.

(i) (a) Calculate the payback period for Project B.

(b) Show, by general reasoning or otherwise, that the payback period
from Project A is longer than that from Project B. [5]

(ii) (a) Define the discounted payback period.

(b) Determine the discounted payback period from Project B at a rate
of interest of 1% per annum effective.
(c) Show, by general reasoning or otherwise, that the discounted
payback period from Project A is longer than that from Project B. [5]

(iii) Determine the internal rate of return from Project B expressed as an

annual effective return. [3]

(iv) Show that the internal rate of return from Project A is higher than that
from Project B. [10]

(v) Discuss which project is the better project given your answers to parts
(i)–(iv) above. [3]
[Total 26]

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16 Subject CT1 April 2016 Question 12

(i) Show that:

a n - nv n
( )n
Ia =
d
[4]

A company is considering the purchase of a gold mine which has recently

ceased production.

The company forecasts that:

 the cost of re-opening the mine will be $900,000, which will be incurred
continuously over the first twelve months.

 additional costs are expected to be constant throughout the term of the

project at $200,000 per annum, excluding the first year. These are also
incurred continuously.

 after the first twelve months, the rate of revenue will grow continuously
and linearly from zero per annum to $3,600,000 per annum at a
constant rate of $300,000 per annum.

 when the rate of revenue reaches $3,600,000 per annum it will then
decline continuously and linearly at a constant rate of $150,000 per
annum until it reaches $600,000 per annum.

 when the rate of revenue declines to $600,000 per annum production

will stop and the mine will have zero value.

(ii) Determine the overall term of the project. [2]

(iii) Calculate, showing all working, the price that the company should pay in
order to earn an internal rate of return (IRR) of 25% per annum
effective. [12]
[Total 18]

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17 Subject CT1 September 2016 Question 10

A particular charity invests its assets in a fund on which it has a target rate of
return of 8% per annum effective. From time-to-time, the charity also invests
in projects that help achieve its charitable objectives whilst providing a rate
of return. Projects that are accepted by the charity must fulfil each of the
following criteria:

1. a minimum annual effective internal rate of return of 2% less than the

target return on the investment fund.

2. a payback period of no more than ten years.

3. a positive cash flow during the fifth year or earlier.

The charity is considering investing in a social enterprise project that

involves providing loans to farmers in low-income countries to help them
develop better resilience against poor weather conditions. The details are
as follows:

 The project involves making loans of £1m at the start of each year for
three years, the first loan being made at the beginning of 2017.
 The loans will be paid back from the extra income obtained by the
farmers from the beginning of 2020.
 The repayments in each year will be through level monthly instalments
paid in advance with the rate of payment of the instalments increasing
by 1% per year for 10 years after which the payments stop.
 The annual rate of repayment in 2020 will be £495,000.
 The charity will also incur costs at the end of each of the years in which
income is received of £50,000 per annum.

(i) Explain why, in general, the payback period is not an appropriate

decision criterion for an investment project. [2]

(ii) Determine which of the three criteria used by the charity are met in this
case. [12]
[Total 14]

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18 Subject CT1 April 2017 Question 4

An investor borrows money from a bank in order to invest in a business

venture. The initial loan is £500,000, with further loans of £250,000 made in
6 months’ time and £250,000 made in 12 months’ time.

The business venture will provide the investor with an income of £2 million in
exactly 10 years’ time and £3 million in exactly 15 years’ time.

The bank offers a force of interest,  (t ) , as a function of time t (measured

in years) which is given by:

0.04 for 0  t  2
 (t )  
0.02  kt for t  2

(i) Derive expressions for v (t ) which cover all values of t . [5]

(ii) Determine the minimum value of k that would ensure that the
discounted payback period is exactly 10 years. [4]
[Total 9]

19 Subject CT1 April 2017 Question 6

Exactly three months ago an investor purchased an office building for

£5.8 million with the intention of renting it out. In three months’ time the
investor will spend £850,000 on necessary refurbishments and
improvements.

A tenant has agreed to lease the building in six months’ time for 35 years.
The tenant will pay an initial rent of £1.250 million per annum payable
monthly in arrear. The rent will be increased at five-yearly intervals at a rate
of 4.2% per annum compound. It has further been agreed that at the end of
the lease period the tenant will buy the building from the investor for
£11.5 million.

The investor pays income tax at a rate of 35% and is expecting a net
effective rate of return of 8% per annum.

Calculate, showing all workings, the net present value of the project to the
investor at the time of purchase. [11]

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20 Subject CT1 September 2017 Question 8

A university offers its students three financing options for a degree course
that lasts exactly three years.

Option A
Fees are paid during the term of the course monthly in advance. The fees
are £10,000 per annum in the first year and rise by 5% on the first and
second anniversaries of the start of the course.

Option B
The university makes a loan to the students which is repaid in instalments
after the end of the course. The instalments are determined as follows:

 No payments are made until three years after the end of the course.
 Over the following 15 years, students pay the university £1,300 per
year, quarterly in advance.
 After 15 years of payments, the quarterly instalments are increased to
£1,500 per year, quarterly in advance.
 After a further 15 years of payments, the quarterly instalments are
increased to £1,800 per year, quarterly in advance, for a further 15-
year period after which there are no more payments.

Option C
Students pay to the university 3% of all their future earnings from work, with
the payments made annually in arrears.

A particular student wishes to attend the university. He expects to leave

university at the end of the three-year course and immediately obtain
employment. The student expects that his earnings will rise by 3% per
annum compound at the end of each year for 10 years and then he will take
a five-year career break.

After the career break, he expects to restart work on the salary he was
earning when the career break started. He then expects to receive salary
increases of 1% per annum compound at the end of each year until retiring
45 years after graduating.

The student wishes to take the financing option with the lowest net present
value at a rate of interest of 3% per annum effective.

(i) Calculate the present value of the payments due under Option A. [4]

(ii) Calculate the present value of the payments due under Option B. [5]

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 Batch 4

(iii) Calculate the initial level of salary that will lead the payments under
Option C to have the lowest present value of the three options. [8]

(iv) Comment on whether the student should use the same interest rate to
evaluate all three options. [2]

The university is concerned that this scheme exposes it to considerable

financial risk.

(v) Explain three risks which the university faces. [4]

[Total 23]

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SOLUTIONS TO PAST EXAM QUESTIONS

The solutions presented here are just outline solutions for you to use to
check your answers. See ASET for full solutions.

1 Subject CT1 April 2008 Question 8

(i) Net present value

The timeline below shows the outgo (in thousands) under the project:

500 100 110 120 130 140 300

0 1 2 3 4 5 15 time

The NPV of these cashflows is:

NPV (outgo ) = -500 - 100v - 110v 2 - 120v 3 - 130v 4 - 140v 5 - 300v 15

(
= -500 - 100v + 110v 2 + 120v 3 + 130v 4 + 140v 5 - 300v 15 )
(
= -500 - 90a5 + 10(Ia )5 - 300v ) 15

Evaluating this at 11% and converting back to £ gives:

NPV (outgo ) = -500 - (90 ¥ 3.6959 + 10 ¥ 10.3199) - 300v 15

= -£998,531

The timeline below shows the income (in thousands) under the project:

2 24
80 80(1.04) 80(1.04) 80(1.04)
...
700

0 1 2 3 ... 24 25 time

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 Batch 4

The NPV of these cashflows is:

NPV (income ) = 80a1 + 80(1.04)a1v +  + 80(1.04)24 a1v 24 + 700v 25

( )
= 80a1 1 + 1.04v +  + (1.04v )24 + 700v 25

= 80a (1 + v ¢ +  + (v ¢ ) ) + 700v
1
24 25

( ) 25
= 80a1 @11% a25 @ i ¢ + 700v @11%

The rate of interest, i ¢ , is given by:

1 1.04 0.07
v¢ = = fi i¢ = = 6.73077%
1 + i ¢ 1.11 1.04

Evaluating this expression gives:

1 - 1.11-1
a1 @11% = = 0.9496
ln(1.11)

1 - 1.0673077 -25
a25 @ i ¢ = 0.0673077
= 12.7455
1.0673077

and (converting back to £):

NPV (income ) = £968,242 + £51,526 = £1,019,768

The gives the overall net present value to be:

NPV = 1,019,768 - 998,531 = £21,236

(ii) Effect on NPV of higher interest rate

The majority of the income from the project is received towards the end of
the 25 years, because the income stream receives compound increases.
On the other hand, the majority of the outgo under the project occurs in the
first five years.

This means that a change in the effective interest rate will have a greater
impact on the income payments than on the outgo payments, due to the
longer period over which discounting applies to them.

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 Batch 4

In general, an increase in interest rates will lead to a reduction in present

values. Here, therefore, the reduction in the present value of the income will
exceed the reduction in the present value of the outgo, meaning that at an
interest rate above 11% pa the NPV will be lower than that calculated here.

2 Subject CT1 September 2008 Question 10

(i) Net present values

Option 1

The PV of the outgoing cashflows (in millions) is:

PV (outgo )  0.25  0.1v  0.2v 2  0.3v 3    1v 10


 0.25  0.1 v  2v 2  10v 10 
 0.25  0.1(Ia )10
 0.25  0.1 34.7391
 3.72391

The PV of the incoming cashflows (in millions) is:

PV (income )  0.5v 7a20  5v 27

 0.5(1.07)7 (10.5940)  5(1.07)27
 4.10336

Putting these two values together gives the NPV:

NPV  PV (income )  PV (outgo )

 4.10336  3.72391
 £0.37945 million

Option 2

The net present value of the cashflows under Option 2 (in millions) is:

NPV  4.2  0.21v  0.21(1.05)v 2    0.21(1.05)9 v 10   5.64v 10

 

The terms in the square brackets form a geometric progression, with first
term 0.21v and common ratio 1.05v .

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 Batch 4

So, using the formula for the sum of 10 terms of a geometric progression:

  1  1.0510 v 10 
NPV  4.2  0.21v     5.64v 10
  1  1.05v 
 
 4.2  1.80550  2.86709
 £0.47259 million

The second option therefore has the higher net present value.

(ii) Discounted mean term

The discounted mean term (DMT) of an investment is defined to be the

weighted average of the times of the cashflows, where the weights are the
present values of the cashflows.

Under the first option, the payments are received over a longer period of
time, with the largest cashflow, and hence highest weight, applying at time
27. This will be the biggest contributor to the DMT calculation for the first
option. Therefore, the DMT of the first option will exceed that of the second
option, where the highest weighting will be at time 10.

3 Subject CT1 April 2009 Question 5

Let the discounted payback period (DPP) end at time T . This means that:

PV (outgo ) = PV ( income up to time T )

Starting off with the outgo, and working in thousands:

2
- Ú (0.05 + 0.002t ) dt
PV (outgo ) = 100 + 80 e 0

2
- È0.05t + 0.001t 2 ˘
Î ˚0
= 100 + 80 e
= 100 + 80 e -(0.05 ¥ 2 + 0.001¥ 4)
= 100 + 80e -0.104
= 172.10

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 Batch 4

The present value at time 8 of the income received up to time T is:

t
T - Ú 0.06 ds
0.001t
PV (income )t = 8 = Ú 100e e 8 dt
8
T t
-ÈÎ0.06s ˘˚ 8
= Ú 100e0.001t e dt
8
T
= Ú 100e0.001t e -0.06t + 0.48 dt
8
T
= Ú 100e0.48 - 0.059t dt
8
T
È 100e0.48 - 0.059t ˘
=Í ˙
ÍÎ -0.059 ˙˚8

=
100
0.059
(
e0.008 - e0.48 - 0.059T )
Discounting, the present value of this income stream at time 0 is:

1 1
PV (income )t = 0 = PV (income )t = 8
A(0,5) A(5,8)
5 8
- Ú (0.05 + 0.002t ) dt - Ú 0.06 dt
=e 0 e 5 PV (income )t = 8
5
- È0.05t + 0.001t 2˘
-ÈÎ0.06t ˚˘5
8
=e Î ˚0 e PV ( income )t = 8

= e -0.275e -0.18
100
0.059
(
e0.008 - e0.48 - 0.059T )
=
100e -0.455 0.008
0.059
e (
- e0.48 - 0.059T )
To find the value of T we must equate this to the present value of the outgo:

0.059
(
100e -0.455 0.008
e - e0.48 - 0.059T = 172.10 )
e0.48 - 0.059T = 0.84799
0.48 - 0.059T = ln(0.84799) fi T = 10.93 years

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 Batch 4

4 Subject CT1 April 2009 Question 6

The timeline below shows the cashflows (in millions) under the project:

3 3
-5 -0.9 0.2 0.2 ... 0.2(1.04) 0.2(1.04) ... 6

11 1 3 6 ...
1 12 4 3 6 ...
4 12 3
0 12 12 12
16 12
time

Note that the rents increase every three years, at a rate of 4% pa. This
means that each time the rents go up, they go up by a factor of (1.04)3 .

We have:

11 - 1112
PV (outgo) = 5 + 0.9v 12 = 5 + 0.9(1.08) = 5.83870

= 6(1.08)-16.25 = 1.71797
16 3 12
PV (income from sale) = 6v

(
PV (rent income) = v 1.25 0.8a(4) + 0.8(1.04)3 v 3a(4) +  + 0.8(1.04)12 v 12a(4)
3 3 3 )
(
= 0.8v 1.25a(4) 1 + (1.04)3 v 3 +  + (1.04)12 v 12
3 )
(
ˆ Ê 1 - (1.04)3 v 3
) ˆ˜
5
Ê
1.25 Á 1 - (1.08)-3 ˜Á
= 0.8v
Ë (
Á 4 1 - (1.08)-0.25
) ˜ Á 1 - (1.04)3 v 3 ˜
¯ ÁË ˜
¯
= 0.8(1.08)-1.25 (2.70471)(4.03812)

= 7.93617

Hence:

NPV = PV (rent income) + PV (income from sale) - PV (outgo)

= 7.93617 + 1.71797 - 5.83870

= £3.81544 million

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 Batch 4

5 Subject CT1 September 2009 Question 10

(i) Discounted payback period

The DPP is the smallest time t for which the net present value (or
accumulated value) of the returns up to time t exceeds the net present
value (or accumulated value) of the costs up to time t .

Its main disadvantage as an investment decision criterion is that it doesn’t

tell us anything about the amount of the profit we can expect from a project.

(ii) Explanation of why the DPP exists

If IRR is greater than 1.5%, then the NPV of all of the cashflows from the
project is positive when i = 1.5% .

Due to the large initial investment, the NPV of the initial cashflows is
negative. Since the NPV of all the cashflows up to time t is negative for
small values of t and is positive for large values of t , there must be some t
at which it changes from negative to positive. This value of t is the DPP.

(iii) NPV at 1% pa interest

No action is taken to combat climate change

50
PVcost = 30(v 3 + v 6 +  + v 48 ) + 20 Ú 1.01t v t dt + 40a50
0
3
(
v 1-(v ) 3 16
) + 20 (v ¢)t dt + 40a
50
= 30
1-v 3 Ú 50
0

= 30
(
v 3 1-(v 3 )16 ) + 20a + 40a50
1-v 3 50 @ i '%

1+ i i - 0.01
where i ¢ = -1= .
1.01 1.01

PVbenefits = 10a50

Hence:

PVnet cost = 30
(
v 3 1-(v 3 )16 ) + 20 a + 30a50
1-v 3 50 @ i '%

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 Batch 4

When i = 1% we have

50
i ¢ = 0% fi v' =1 fi a50 @ i ' % = Ú 1 dt = 50
0

Therefore:

PVnet cost = 30(12.5322) + 20(50) + 30(39.1961)

= $2,551.851 bn

Investment in the carbon storing technology

All net costs would be removed – this would be the benefit. Hence at 1%:

PVbenefits = $2,551.851 bn

The PV of the cost of the technology at 1% would be:

PVcost = 440 + 50a50 = 440 + 50(39.1961) = $2,399.806 bn

Hence:

NPV=2,551.851 - 2,399.806 = $152.045 bn

(iv) NPV at 4% pa interest

For i = 4% :

1 - 1.029703 -50
i ¢ = 2.9703% fi a50 @ i ' % = = 26.2579
ln1.029703

( ) + 20a
( )
v 3 1- (v 3 )16
NPV = 30 50 @ i ' %
+ 30a50 - 440 + 50a50
1- v 3

= 30
(
v 3 1- (v 3 )16 ) + 20a - 20a50 - 440
1- v 3 50 @ i ' %

= 30(6.7898) + 20(26.2579) - 20(21.4822) - 440

= -$140.790 bn

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 Batch 4

(v) Comment

At 1% interest, the NPV is positive, but at 4%, it is negative. If a decision is

to be made based solely on NPV, it would depend on the interest rate
assumption.

However, there may be other factors affecting the decision, eg the human
cost, rather than the financial cost, of doing nothing. Also, we don’t know
anything about the potential costs and benefits after 50 years.

6 Subject CT1 April 2010 Question 9

(i) NPV of the project

Working in millions, the timeline for the cashflows is:

1.7
–5 –3

0 3 1 2... 17 time
12

The NPV of the project is:

3
NPV = -5 - 3v 12 + 1.7v 2a15 @10% pa

3 1.7 Ê 1 - 1.1-15 ˆ
= -5 - + Á ˜
1.12 Ë ln(1.1) ¯
3
1.1
12

= £3.2827m

(ii) Discounted payback period

Let n be the number of years of income needed to reach the DPP (ie when
the NPV up to that point is 0). Hence:

3 3
-5 - 3v 12 + 1.7v 2an = 0 fi 1.7v 2an = 5 + 3v 12

Using an interest rate of 10% pa:

1.7 Ê 1 - 1.1- n ˆ 3
2 Á ln(1.1) ˜
=5+ 3
fi (1.1)- n = 0.462085
1.1 Ë ¯ 1.112

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 Batch 4

Taking logs of both sides of this equation:

- n ln(1.1) = ln(0.462085) fi n = 8.100

Since n is the number of years of income needed to reach the DPP, and the
income starts to be received at time 2, the DPP is of length 10.1 years.

(iii) Accumulated profit

Since the DPP is 10.1 years the accumulated value of the cashflows
received up to 10.1 is 0. So, to obtain the accumulated profit after 17 years,
we need to accumulate those cashflows received after the end of the DPP to
time 17, using an interest rate of 7% pa:

Ê 1.076.9 - 1ˆ
Accumulated profit = 1.7s6.9 @ 7% = 1.7 Á ˜
Ë ln(1.07) ¯

= 1.7 ¥ 8.79346 = £14.949m

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 Batch 4

7 Subject CT1 September 2010 Question 6

(i) NPV

Working in £millions:
3500
5 5
-2000 20 40 20(1.1) 40(1.1) ... 20(1.1) 40(1.1)

1/1/1 1/7/4 1/1/5 1/7/5 1/1/6 ... 1/7/9 1/1/10

So from first principles the NPV of these payments are:

NPV = -2,000 + 20v 3.5 + 40v 4 + 20(1.1)v 4.5 + 40(1.1)v 5 + 

+ 20(1.1)5 v 8.5 + 40(1.1)5 v 9 + 3,500v 9

(
NPV = -2,000 + 20v 3.5 1 + (1.1)v +  + (1.1)5 v 5 )
(
+ 40v 4 1 + (1.1)v +  + (1.1)5 v 5 + 3,500v 9 )
fi ( )(
NPV = -2,000 + 20v 3.5 + 40v 4 1 + (1.1)v +  + (1.1)5 v 5 + 3,500v 9 )
Using geometric series we have:

Ê 1 - (1.1v )6 ˆ
(
NPV = -2,000 + 20v 3.5 + 40v 4 Á
Ë 1 - 1.1v ¯
)
˜ + 3,500v
9

Calculating this at 8% pa we get:

( )
NPV = -2,000 + 20v 3.5 + 40v 4 (6.284732) + 3,500v 9
= £31.664m

(ii) Accumulation

The accumulated profit on 1/1/10 is:

NPV ¥ 1.089 = 31.664 ¥ 1.089 = £63.296m

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 Batch 4

8 Subject CT1 April 2011 Question 9

(i) Net present value of the project

0 1 2 3 4 5 15 30 time (years)

........... ..........

-105 -105 -105 -200 cashflows

+20 +23 +26 +29 +29(1.03) + ... + 29(1.03) 25

all income payable continuously

Working in £000s, the net present value (NPV) is:

1
NPV = -105 - 105v 2 - 105v - 200v 15
+ 20a1v + 23a1v 2 + 26a1 v 3 + 29a1 v 4
+ 29(1.03)a1v 5 + 29(1.03)2 a1v 6 + .... + 29(1.03)25 a1v 29 @ 8%

Calculating and simplifying:

NPV = -105 - 101.036 - 97.222 - 63.048

(
+ a1 20v + 23v 2 + 26v 3 + 29v 4 )
(
+ a1 29(1.03)v 5 1 + (1.03)1v 1 + (1.03)2 v 2 + ... + (1.03)24 v 24 )
Therefore:

È È 1 - (1.03)25 v 25 ˘ ˘
NPV = -366.307 + a1 Í 80.193 + 29(1.03)v 5 Í ˙˙
ÍÎ ÍÎ 1 - (1.03)v ˙˚ ˙˚
= -366.307 + 0.962488 ÈÎ80.193 + 20.329 ¥ 14.996 ˘˚
= -366.307 + 370.608
= +4.301

The NPV is approximately £4,000.

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 Batch 4

(ii) The discounted payback period

By examining the cashflows and the NPV, we can see that the discounted
payback period (DPP) is very close to the end of the project’s life.

The present value of the income in the final year is

29(1.03)25 a1v 29 = 6.272 , which is greater than the NPV, so the DPP must
be in the final year.

The NPV of the first 29 years’ cashflows can be calculated as follows:

È È 1 - (1.03)24 v 24 ˘ ˘
-366.307 + a1 Í 80.193 + 29(1.03)v 5 Í ˙˙
ÎÍ ÎÍ 1 - (1.03)v ˚˙ ˚˙
= -366.307 + 0.962488 ÎÈ80.193 + 20.329 ¥ 14.676 ˚˘
= -366.307 + 364.335
= -1.971

So the NPV of the first 29 + t years’ cashflows is:

-1.971 + 29(1.03)25 v 29at = -1.971 + 6.517at

Setting this equal to zero:

1.971 = 6.517at
fi at = 0.303

Solving for t:

Ê 1- v t ˆ
ÁË ˜ = 0.303
ln1.08 ¯
fi v t = 0.9767
fi t ln(1.08 -1) = ln 0.9767
fi t = 0.306

So the DPP is 29.306 years.

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 Batch 4

9 Subject CT1 September 2011 Question 10 (corrected)

(i) Why the PP is not a good indicator of whether this project is worthwhile

The payback period tells us when the income from the project exceeds the
outgo on the project, ignoring any interest payments. Considering that this
project covers a long period of time, it is inappropriate to ignore the
operation of interest.

Looking at the cashflows involved in the project, all the income is received in
the final year. This means that if the project does move into profit it must do
so during 2026. We can see this without doing any calculations at all, and to
calculate exactly when during 2026 the project moves into profit doesn’t add
very much information.

The payback period only considers those cashflows that occur up to the
point that the project moves into profit, and ignores any that come
afterwards. Therefore, it’s not a good measure of overall profitability, as it
does not take into account all the project cashflows.

(ii) Whether the association should make the bid

Working in millions the cashflow diagram is as follows:

–2
continuously – 200 – 200 (1.05 ) 2
– 200 (1.05 ) . . .

1/1/12 1/1/13 1/1/14 ... 1/7/16 1/7/17 1/7/18 ...

3300
continuously

– 100
monthly in advance
9
– 200 (1.05 )

1/1/25 1/1/26 1/1/27

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 Batch 4

Calculating the PVs as at 1 January 2012 of each part at 4% pa gives:

PV (initial costs) = 2a2 = 2 ¥ 1.92357 = 3.847

PV (stadia) = 200v 4.5 + 200(1.05)v 5.5 + 200(1.05)2 v 6.5

+  + 200(1.05)9 v 13.5

= 200v 4.5 È1 + (1.05)v + (1.05)2 v 2 +  + (1.05)9 v 9 ˘

Î ˚

Ê 1 - (1.05)10 v 10 ˆ
= 200v 4.5 Á ˜ using geometric series
Ë 1 - (1.05)v ¯

200
= ¥ 10.4440
1.04 4.5
= 1,750.837

PV (admin costs) = 100v 13a(12)

2
100
= ¥ 1.92672
1.0413
= 115.714

PV (revenues) = 3,300v 14a1

3,300
= ¥ 0.98064
1.0414
= 1,868.781

fi NPV = PV (revenues) - PV (initial costs) - PV (stadia) - PV (admin costs)

= 1,868.781 - 3.847 - 1,750.837 - 115.714

= -£1.617m

Since this is negative, the project will not be profitable at this rate of interest,
so the association should not make the bid.

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 Batch 4

(iii) Adjusting the calculations for the probability of a successful bid

One way of allowing for the probability that the bid is successful would be to
multiply those cashflows dependent on winning the bid by 0.1 to reflect the
likelihood of their occurrence.

The initial costs are certain to occur, so their contribution to the NPV remains
unchanged. The other cashflows are not certain to happen, and so the
value of these will be proportionately reduced. The NPV of the project
ignoring the initial costs is £2.23m, which becomes £0.223m when multiplied
by the probability of winning the bid of 0.1. This means the NPV would go
down, and the bid would be less likely to go ahead.

© IFE: 2019 Examinations Page 45

 Batch 4

10 Subject CT1 April 2012 Question 5

(i) Internal rate of return for Project A

0 1 5 10 15 20 25
........... ........... ........... .......... ..........
-1,309.5
-3 - 3 - 3 - 3 .................................... ........................................ ................................... -3
+25 + 25 + 25 + 25 ........... ....31.91.... ....40.72.... ....51.97.... ....66.33....
10 15 20
rent = 100pa 100(1.05) 5 pa 100(1.05) pa 100(1.05) pa 100(1.05) pa

Working in £000s, the net present value (NPV) of Project A is:

NPVA = -1,309.5 - 12a(4)

25

+ 100a(4) + v 5 100(1.05)5 a(4) + v 10 100(1.05)10 a(4)

5 5 5

+v 15
100(1.05)15 a(4) +v 20
100(1.05)20 a(4) @ 9%
5 5

Simplifying:

NPVA = -1,309.5 - 12a(4)

25

+ 100a(4)
5 (1 + v 5
(1.05)5 + v 10 (1.05)10 + +v 15 (1.05)15 + v 20 (1.05)20 )
Ê 1 - v 25 (1.05)25 ˆ
= -1,309.5 - 12a(4) + 100a(4) Á 5 5 ˜
25 5
Ë 1 - v (1.05) ¯

Evaluating at 9%:

Ê ˆ
1 - 1.09 -25 1 - 1.09 -5 1 - (1.05 1.09)25
NPVA = -1,309.5 - 12 + 100 ¥Á ˜
(
4 1.09
1
4 -1 ) (
4 1.09
1
4
)
- 1 ÁË 1 - (1.05 1.09) ˜¯
5

= -1,309.5 - 121.778 + 1, 431.308

= 0.0299
ª0

The NPV is approximately £0 when i = 9% , so the IRR is 9%.

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 Batch 4

(ii) The internal rate of return for Project B

Working in £000s, the net present value (NPV) of Project B is:

NPVB = -1,000 + 85a(4) + v 20 90a(4)

20 5

At i = 7% , RHS = -1,000 + 939.555 + 99.498 = 39.053

At i = 8% , RHS = -1,000 + 875.868 + 80.914 = -43.217

Using interpolation, we get:

0 - 39.053
i = 7% + (8% - 7%) = 7.47%
-43.217 - 39.053

(iii) The importance of the internal rate of return in investment appraisal

The IRR is the yield on the project. Our calculations show that Project A will
yield a 9% return whereas Project B will yield a 7.5% return. Project A
therefore looks more attractive. However, we might like to consider two of
the following factors:

 the interest rate that the investor uses to discount the cashflows.
This is sometimes known as the ‘hurdle’ rate and will be linked to
the cost of raising finance for the projects.
 Project A has a higher initial outlay than Project B and might have a
longer discounted payback period.
 the risks involved in the projects. The investor will have to consider
the assumptions made about expenses and rental income and will
also have to consider how sensitive the projects would be to a
change in the risk discount rate.
 the availability of finance and the repayment period offered by
financiers.
 the resources required for the project. Does the investor have
sufficient knowledge and expertise in the particular parts of the
property market under consideration (retailing for Project A and
office space for Project B)?

© IFE: 2019 Examinations Page 47

 Batch 4

11 Subject CT1 April 2013 Question 8

The income (sales revenue) occurs at the end of each year (31 Dec),
therefore we will ‘break even’ at the end of a year. So when calculating the
NPV we should calculate it up to the end of the relevant year even though
the outgo (production costs) occur on the following day (1 Jan) as the Core
Reading defines the DPP as the smallest value of t such that A(t ) ≥ 0 even
if it goes negative the following day.

(i) DPP

The cashflow diagram from 1 January 2014 (time t = 0 ) in £millions (with

arrows showing whether the payments are at the beginning or the end of the
year) is:
2 3 4 5
-19 -9 -5 -57 -57  1.04 -57  1.04 -57  1.04 -57  1.04 -57  1.04

0 1 2 3 4 5 6 7 8

2 4 5
75.6 75.6  1.04 75.6  1.04 75.6  1.043 75.6  1.04 75.6  1.04

Using the payment period (PP) as a rough guide to when the DPP is we get:

-19 - 9 - 5 - 57 + 75.6 - (57 ¥ 1.04) + (75.6 ¥ 1.04) = 4.944 > 0

So the PP would be just before time 4. Hence the DPP will be after this.

The NPV to just before time 5 (ie 31 Dec 2018) is:

NPV5- = -19 - 9v ½ - 5v - 57v 2 + (75.6 - 57 ¥ 1.04)v 3

+ (75.6 ¥ 1.04 - 57 ¥ 1.042 )v 4 + 75.6 ¥ 1.042 v 5

= -2.4132

The NPV to just before time 6 (ie 31 Dec 2019) is:

NPV6- = -2.4132 - 57 ¥ 1.043 v 5 + 75 ¥ 1.043 v 6

= 6.219
So on 31 December 2019 (at time 6 - ), the NPV of the cashflows first
becomes positive. Hence this is the DPP.

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(ii) Explanation

If the rate of interest is reduced substantially, this increases the present

values of the future cashflows. However, the cashflows further in the future
are increased more.

In this project, the greater part of the outgo occurs early, whereas the
greater part of the income occurs later. So the incoming cashflows will be
affected more by the reduction in the interest rate, and this will tend to bring
the DPP earlier in time. The discounted payback period will be shorter.

12 Subject CT1 September 2013 Question 6

– £2m
400  1 500  1.1 500  1.1 500  1.1 500  1.1
2 4 36
 365  365  1.01  365  1.01  365  1.01  365
...

0 1 2 3 4 ... 19 20

The net present value of the payments is given by:

-2,000,000 + 400 ¥ 365a1 + 500 ¥ 1.1 ¥ 365a1 v + 500 ¥ 1.1 ¥ 1.012 ¥ 365a1 v 2
+ 500 ¥ 1.1 ¥ 1.014 ¥ 365a1 v 3 +  + 500 ¥ 1.1 ¥ 1.0136 ¥ 365a1 v 19
= -2,000,000 + 146,000a1 + 200,750a1 v + 200,750 ¥ 1.012 a1 v 2
+ 200,750 ¥ 1.014 a1 v 3 +  + 200,750 ¥ 1.0136 a1 v 19

Pulling out common factors from all but the first two terms:

-2,000,000 + 146,000a1 + 200,750a1 (v + 1.012 v 2 + 1.014 v 3 +  + 1.0136 v 19 )

The terms in the bracket form a geometric progression. The first term is v ,
the common ratio is 1.012 v and there are 19 terms, so the NPV is:

Ê
( )
19 ˆ
v Á1 - 1.012 v ˜¯
Ë
-2,000,000 + 146,000a1 + 200,750a1 2
1 - 1.01 v

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 Batch 4

Substituting in the interest rate of 8% pa effective (giving a1 = 0.962488 ),

we get:

-2,000,000 + 140,523.2395 + 2,134,800.565 = 275,323.8045

So the NPV is £275,324.

13 Subject CT1 April 2014 Question 8

(i) Discounted payback period

The discounted payback period will be the point in time when the balance on
our account turns positive for the first time.

We require the smallest value of n for which:

NPV = -50 + 6a(2) > 0

n

a(2) > 8.333

n
-n
1 - 1.09
> 8.333
2(1.09½ - 1)
0.2662 > 1.09 - n
ln 0.2662 > - n ln1.09
ln 0.2662
n>-
ln1.09
n > 15.36

Since the payments are half-yearly the DPP is 15.5 years.

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(ii) Accumulated profit

The NPV at time zero of the cashflows occurring up to and including time
15.5 are:

1 - v 15.5
-50 + 6a(2) = -50 + 6 ¥ = -50 + 6 ¥ 8.369627 = 0.217763
15.5 i (2)

So the accumulated value at time 15.5 of these cashflows is:

0.217763 ¥ 1.0915.5 = 0.828123

So the total accumulated profit at time 20 will be:

0.828123 ¥ 1.07 4.5 + 6s (2) = 1.122850 + 6 ¥ 5.171726 = 32.153204

4.5

The accumulated profit at the end of the project is £32.153 million.

14 Subject CT1 April 2015 Question 9

The total present value of the rental payments is:

PV = 0.36 v a(4) È1 + (1 + b )v +  + (1 + b ) v 4 ˘
4
1 ÎÍ ˚˙

where b is the compound increase in the rental rate.

Using the formula for the sum of five terms of a geometric progression, we
have a total present value of:

È È 5˘
(4) Í
1 - Î(1 + b ) v ˘˚ ˙

PV = 0.36 v a Í
1 1 - (1 + b ) v ˙
ÍÎ ˙˚

So the equation of value for all the cashflows is as follows:

È È 5˘
1 - (1 + b ) v ˘˚ ˙
0 = -4 - 0.9v ½ + 0.36 v a(4) ÍÍ Î + 6.8v 6
1 1 - (1 + b ) v ˙
ÍÎ ˙˚

at a rate of interest of 12% pa.

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 Batch 4

Evaluating the compound interest functions at 12%:

v ½ = 0.944911

v 6 = 0.506631

d (4) = 4 È1 - 1.12-¼ ˘ = 0.111738

Î ˚

1 - v 1 - 1.12-1
a(4) = (4) = = 0.958873
1 d 0.111738

So the equation of value becomes:

1 1- X 5
0 = -4 - 0.9 ¥ 0.944911 + 0.36 ¥ ¥ 0.958873 ¥
1.12 1- X
+ 6.8 ¥ 0.506631

1+ b
where X = .
1.12

Simplifying this, we obtain:

1- X 5
0 = -4 - 0.850420 + 0.308209 ¥ + 3.445092
1- X
Rearranging this equation, we find that:

1- X 5
= 4.559658
1- X

We will now have to solve this by trial and improvement. Choosing an initial
starting value of X = 0.9 , we obtain the following values:

1- X 5
X
1- X
0.9 4.0951
0.92 4.2615
0.94 4.4349
0.96 4.6157
0.953 4.5516
0.954 4.5607

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 Batch 4

Interpolating, we obtain:

4.559658 - 4.5516
X  0.953 + ¥ 0.001
4.5607 - 4.5516
0.008082
= 0.953 + ¥ 0.001
0.009102
= 0.95389

Finally this gives us a compound growth rate of:

b = 1.12 ¥ 0.95389 - 1 = 0.06835

The required compound growth rate is 6.84%.

15 Subject CT1 September 2015 Question 9

(i)(a) Payback period for Project B

The number of £60,000 payments required will be:

1,000,000
= 16.6
60,000

So we need 17 payments. Hence the payback period will be 16 years.

(i)(b) Payback period for Project A

The net income received in any year during Project A is always less than
£60,000 and the costs are incurred at the start of each year. So there will be
no point when the total net income from Project A will be greater than Project
B until the sale.

Hence the payback period for Project A will be greater than for Project B.

(ii)(a) Define the discounted payback period

The discounted payback period is the first time, t , when the NPV of the
payments up to time t becomes positive.

(ii)(b) Discounted Payback period for Project B

The NPV for Project B (in £000s) for t payments is:

NPV = -1,000 + 60at @1% pa

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 Batch 4

This will be positive when:

60at ≥ 1,000

1 - 1.01- t
≥ 16.6
1 - 1.01-1
1.01- t £ 0.83498
-t ln1.01 £ ln 0.83498
t ≥ 18.124

So we need 19 payments. Hence the DPP is 18 years.

(ii)(c) Discounted payback period for Project A

The net income received in any year during Project A is always less than
£60,000 and the costs are incurred at the start of each year. So there will be
no point when the discounted total net income from Project A will be greater
than Project B.

(iii) Internal rate of return for Project B

The NPV for Project B (in £000s) is:

NPV = -1,000 + 60a20 + 1,000v 20

The IRR is the interest rate which solves:

1,000 = 60a20 + 1,000v 20

100 = 6a20 + 100v 20

This gives:

1 - v 20
100(1 - v 20 ) = 6
d
6
100 =
d
6
d= = 6% pa
100

d 0.06 3
fi i= = =  6.3830% pa
1 - d 1 - 0.06 47

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(iv) Internal rate of return for Project A

The PV of the outgo for Project A (in £000s) is:

1,000 + 10 + 10 ¥ 1.005v + 10 ¥ 1.0052 v 2 +  + 10 ¥ 1.00519 v 19

Summing the geometric series gives:

10(1 - (1.005v )20 )

1,000 +
1 - 1.005v

Calculating this at 6.3830% pa gives 1,122.87.

The PV of the income for Project A (in £000s) is:

60va(12) + 60 ¥ 1.005v 5 a(12) + 60 ¥ 1.0052 v 6a(12) +  + 60 ¥ 1.00515 v 15 a(12)

4 1 1 1

+ 2,000v 20

Summing the geometric series gives:

1 - (1.005v )15 )
60va(12) + 60 ¥ 1.005v 5a(12) + 2,000v 20
4 1 1 - 1.005v

Calculating the components at 6.3830% pa gives:

d (12) = 12(1 - 1.063830 -1 12 ) = 0.061716

1 - 1.063830 -1
a(12) = = 0.972193
1 d (12)
1 - 1.063830 -4
a(12) = = 3.55257
4 d (12)
1 - (1.005v )15 1 - (1.005 ¥ 1.063830 -1 )15
= = 10.380
1 - 1.005v 1 - 1.005 ¥ 1.063830 -1

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 Batch 4

Hence the PV of the income for Project A (in £000s) is:

60 ¥ 1.063830 -1 ¥ 3.55257 + 60 ¥ 1.005 ¥ 1.063830 -5 ¥ 0.972193 ¥ 10.380

+ 2,000 ¥ 1.063830 -20
= 200.365 + 446.576 + 580.210
= 1, 227.15

Hence the NPV at 6.38% pa gives 1, 227.15 - 1,122.87 = 104.28 , ie

£104,280 (5 SF).

Since the NPV > 0 at 6.38% pa the IRR must be greater than 6.38% pa.

(v) Discuss which is the better project

The payback period and discounted payback period for Project B are both
shorter. So we break-even sooner under Project B which is preferable.

However, both these measures ignore cashflows after the break-even point
(including the huge £2m cashflow in Project A).
The IRR is greater for Project A. This indicates a better return is achieved
under Project A which is preferable.

However, whilst the IRR includes all the cashflows, a better measure would
be to calculate the NPV at the rate of interest at which the student can lend
or borrow money.

16 Subject CT1 April 2016 Question 12

(i) Increasing annuity formula

Consider a payment stream of r (t ) = t , 0 £ t £ n . The total present value of

this payment stream is:

n
PV = Ú tv t dt
0

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Integrating this by parts, using the formula on page 3 of the Tables with
dv
u = t and = v t , we obtain:
dt

n n n
n È vt ˘ È ˘
t vt vn Í vt ˙
PV = Ú tv dt = Ít ˙ -Ú dt = n -
ÍÎ ln v ˙˚0 0 ln v ln v Í (ln v ) ˙
2
0 Î ˚0
vn vn 1
=n - +
ln v (ln v ) 2
(ln v )2

vt
Note that Ú v t dt = .
ln v

Since ed = 1 + i , v = (1 + i )-1 = e -d , and lnv = -d . So we can write the

present value as:

1- v n
n n - nv n an - nv n
nv v 1 d
PV = - 2 + 2 = =
-d d d d d

as required.

(ii) Overall term

After the first year, the rate of revenue will grow continuously for:

3,600,000
= 12
300,000

years. At this point the rate of revenue starts to decline, and continues to
decline for:

3,600,000 - 600,000
= 20
150,000

years. So the overall term of the project is 1 + 12 + 20 = 33 years.

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(iii) Price required for the given IRR

The cashflows are as follows

increase by $3.6m decrease by

$0.3m pa $0.15m pa
revenue

$0.6m

0 1 13 33 time
–P
costs
– $0.9m – $0.2m pa

Working in units of $1 million, the items of outgo have present value:

PVoutgo = P + 0.9 a1 + 0.2 v a32

The items of income have present value:

PVincome = 0.3 v Ia ( ) 12 ÎÍ
( )
+ v 13 È3.6 a20 - 0.15 Ia
20
˘
˚˙

Equating the income and the outgo, we have:

P + 0.9 a1 + 0.2 v a32 = 0.3v Ia ( ) 12

+ v 13 È3.6a20 - 0.15 Ia
ÎÍ
( ) 20
˘
˚˙

Evaluating the various functions at 25% pa, we have:

1- v 1 - 1.25 -1
a1 = = = 0.896284
d ln1.25

1 - v 12 1 - 1.25 -12
a12 = = = 4.173459
d ln1.25

1 - v 20 1 - 1.25 -20
a20 = = = 4.429753
d ln1.25

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1 - v 32 1 - 1.25 -32
a32 = = = 4.477870
d ln1.25

a12 - 12v 12 4.173459 - 12 ¥ 1.25 -12

(Ia)
12
=
d
=
ln1.25
= 15.007494

a20 - 20v 20 4.429753 - 20 ¥ 1.25 -20

(Ia)20
=
d
=
ln1.25
= 18.818238

So substituting these numbers into the equation of value, we have:

P + 0.9 ¥ 0.896284 + 0.2 ¥ 1.25 -1 ¥ 4.477870

= 0.3 ¥ 1.25 -1 ¥ 15.007494
+ 1.25 -13 ÈÎ3.6 ¥ 4.429753 - 0.15 ¥ 18.818238 ˘˚

Evaluating the various expressions:

P + 0.806656 + 0.716459 = 3.601799 + 0.721520

Solving this, we find that:

P = 2.800204

So the price the company should pay is about $2.8 million.

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17 Subject CT1 September 2016 Question 10

(i) Payback period not appropriate

Investment projects will often involve a company borrowing money to fund

the project. The rate of interest that the company has to pay on this
borrowed money will affect the overall profitability of the project. The
payback period ignores the interest rate (ie it ignores the time value of the
cashflows).

Since the payback period only looks at the cashflows until the project breaks
even, it tells us nothing about the project’s overall profitability.

(ii) Which criteria are satisfied

The project’s cashflows are shown on the timeline below:

-0.05 -0.05 -0.05

9
0.495 pa 0.495(1.01) 0.495(1.01)
monthly monthly monthly
in advance in advance in advance
Cashflow
-1 -1 -1 ... (£m)

0 1 2 3 4 5 ... 12 13 Time

2017 2018 2019 2020 2021 2022 2029 2030 Year

We will start with the third criterion, which is easily examined.

In Year 5 we receive 0.495 ¥ 1.01 , whereas we pay out 0.05. Since

0.495 ¥ 1.01 - 0.05 > 0 , the overall cashflow in the fifth year is positive, so
the third criterion is satisfied.

Next, we will look at the second criterion.

The total of all the cashflows up to and including time 10 (without making
any allowance for interest, and working in millions of pounds) is:

-3 + 0.495 È1 + 1.01 +  + 1.016 ˘ - 0.05 ¥ 7

Î ˚

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Using the formula for the sum of a geometric progression to evaluate the
expression in square brackets:

1 - 1.017
1 + 1.01 +  + 1.016 = = 7.21354
1 - 1.01

So the total of the cashflows is:

-3 + 0.495 ¥ 7.21354 - 0.35 = +0.22070

This is positive, so the payback period is before time 10, and the second
criterion is satisfied.

Finally, we will look at the first criterion. We want an internal rate of return
that is at least 6% (2% less than the target rate of return of 8%).

The NPV of all the cashflows arising under the project is:

( )
-a3 - 0.05 v 4 +  + v 13 + 0.495 v 3 a(12) È1 + 1.01v +  + (1.01v ) ˘
1 ÍÎ
9
˙˚

The expression in square brackets can be calculated using the formula for
the sum of a geometric progression (as before):

1 - (1.01v ) 1 - (1.01/ 1.06)

10 10
1 + 1.01v +  + (1.01v ) =
9
= = 8.12352
1 - 1.01v 1 - 1.01/ 1.06

The monthly annuity due is:

1- v 1 - 1.06 -1 1 - 1.06 -1
a(12) = (12) = = = 0.97378
12 È1 - (1 - d )
1/12 ˘
1 d 12 È1 - 1.06 -1/12 ˘
ÍÎ ˙˚ Î ˚

We also have:

( ) ( )
0.05 v 4 +  + v 13 = 0.05v 3 v + v 2 +  + v 10 = 0.05v 3a10

1 - 1.06 -10
= 0.05 ¥ 1.06 -3 ¥
0.06
= 0.05 ¥ 0.83962 ¥ 7.36009
= 0.30898

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-3
1 - 1.06
Also: a3 = = 2.83339
1 - 1.06 -1

So, putting it all together, the NPV of the cashflows at 6% pa is:

NPV = -2.83339 - 0.30898 + 0.495 ¥ 1.06 -3 ¥ 0.97378 ¥ 8.12352

= 0.14534

The NPV is £145,340.

So the NPV is positive at 6%, and so the IRR is greater than 6% pa, and the
first criterion is satisfied.

So all the criteria are satisfied by this project.

18 Subject CT1 April 2017 Question 4

(i) Derive expressions for v(t)

For 0  t  2 , the discount factor is:

 
 t 
v (t )  exp    0.04 ds   exp  0.04s  0  exp  0.04t 
t
 
 0 

For t  2 , the discount factor is:

 t 
v (t )  v (2)exp    (0.02  ks ) ds 
 
 2 

 t 
 exp  0.04  2  exp   0.02s  0.5ks 2  
   2


 exp  0.08  exp 0.02t  0.5kt 2  0.02  2  0.5k  22 

 exp 0.02t  0.5kt 2  0.04  2k 

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(ii) Discounted payback period of 10 years

The net present value of the project’s cashflows up to and including time
10 years (working in £m) is:

NPV  0.5  0.25v (0.5)  0.25v (1)  2v (10)

Using the function v (t ) derived in part (i), this becomes:

2
NPV  0.5  0.25e 0.040.5  0.25e 0.041  2e 0.0210 0.5k 10 0.04  2k

 0.5  0.25e 0.02  0.25e 0.04  2e 0.24  48k

 0.985247  2e 0.24  48k

For the project’s discounted payback period to be exactly 10 years, we need

NPV  0 :

0.985247  2e 0.24  48k  0  e 0.24  48k  0.492624

Taking logs and rearranging:

1
0.24  48k  ln0.492624  k
48
 0.24  ln0.492624 

So k  0.00975 , meaning that the maximum value of k to ensure a DPP of

exactly 10 years is 0.00975 (and the minimum value is negative infinity).

19 Subject CT1 April 2017 Question 6

Working in £millions, and ignoring tax, the timeline for the project’s cashflows
is:
5 30
1.25 pa 1.25 (1.042 ) pa 1.25 (1.042 ) pa
monthly, monthly, ... monthly,
11.5 Cashflows
-5.8 -0.85 arrears arrears arrears
(£m)

0 0.5 0.75 5.75 10.75 ... 30.75 35.75 Time

Purchase (years)
date

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The present value of the outgo under the project, at an interest rate of
8% pa, is:

PV (outgo )  5.8  0.85v 0.5  6.617913

The present value of the income from the sale of the office building is:

PV (sale )  11.5v 35.75  0.734173

The present value of the rental income is given by:


PV (rent )  1.25v 0.75a(12) 1  (1.042)5 v 5    (1.042)30 v 30
5 
The summation in brackets forms a geometric progression of 7 terms, with
first term 1 and common ratio (1.042)5 v 5 . So:

 
7
1  (1.042)5 v 5
5 5 30 30
1  (1.042) v    (1.042) v   4.357670
1  (1.042)5 v 5

To evaluate the present value of the rental income, we also need to

calculate the annuity:

1 v 5 1  1.08 5
a(12)    4.137075
5 i (12) 
12 1.081 12  1 
Putting these values together, we have:


PV (rent )  1.25v 0.75a(12) 1  (1.042)5 v 5    (1.042)30 v 30
5 
 1.25(1.08)0.75 (4.137075)(4.357670)

 21.271100

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Allowing for tax on the rental income at a rate of 35%, the net present value
of the project as a whole is:

NPV  (1  0.35)PV (rent )  PV (sale )  PV (outgo )

 0.65  21.271100  0.734173  6.617913

 7.94248

So the net present value of the project is £7.9425 million.

20 Subject CT1 September 2017 Question 11

(i) Present value of the payments under Option A

The present value of the payments under Option A is:

PVA = 10,000 a(12) + 1.05 ¥ 10,000 v a(12) + 1.052 ¥ 10,000 v 2 a(12)

1 1 1

= 10,000 a(12) È1 + 1.05v + 1.052 v 2 ˘

1 Î ˚

Using an interest rate of 3% pa, we have:

1- v È 1.05 1.052 ˘
PVA = 10,000 ¥ ¥ Í1 + + ˙
d (12) 2
ÍÎ 1.03 1.03 ˙˚
1 - 1.03 -1
= 10,000 ¥ ¥ 3.05863 = 30,175.80
12 È1 - 1.03 -1/12 ˘
Î ˚

The present value under Option A is £30,175.80.

(ii) Present value of the payments under Option B

The present value of the payments under Option B is:

PVB = 1,300 v 6a(4) + 1,500 v 21a(4) + 1,800 v 36a(4)

15 15 15

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So we have:

PVB = a(4) È1,300v 6 + 1,500v 21 + 1,800v 36 ˘

15 Î ˚
1 - v 15 È
= 1,300v 6 + 1,500v 21 + 1,800v 36 ˘
d (4) Î ˚
1 - 1.03 -15
= ¥ È1,300 ¥ 1.03 -6 + 1,500 ¥ 1.03 -21 + 1,800 ¥ 1.03 -36 ˘
4 È1 - 1.03 -1/4 ˘ Î ˚
Î ˚
= 12.160944 ¥ 2,516.112 = 30,598.30

So under Option B the present value is £30,598.30.

(iii) Initial level of salary under option C

Let the student’s initial salary be £ X pa . Then the present value of the
payments under Option C, in terms of X , are:

PVC = 0.03 Xv 3 Èv + 1.03v 2 + 1.032 v 3 +  + 1.039 v 10 ˘

Î ˚
+ 0.03 Xv 1.03 v + 1.03 ¥ 1.01v 17 +  + 1.0310 ¥ 1.0129 ¥ v 45 ˘
3È 10 16 10
Î ˚

Consider the expression for the first ten years of payments. Taking out an
1
additional factor of , we can write this as:
1.03

0.03 Xv 3 È
1.03v + 1.032 v 2 + 1.033 v 3 +  + 1.0310 v 10 ˘
1.03 Î ˚

So the present value of the first ten years of payments is:

0.03 Xv 3
¥ 10 = 0.26655 X
1.03

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Now we look at the expression for the remaining payments. Taking out a
1.0310 v 15
common factor of from the second bracket, we can write the
1.01
present value as:

0.03 Xv 18 ¥ 1.0310 È
1.01v + 1.012 v 2 +  + 1.0130 v 30 ˘
1.01 Î ˚
0.03 Xv 18 ¥ 1.0310 È
= V + V 2 +  + V 30 ˘
1.01 Î ˚

1.01 1
where V = = .
1.03 1.019802

So the total value of the terms in the square bracket is a30 , calculated at a
rate of interest of 1.9802% pa.

So the second component of the total present value is equal to:

0.03 Xv 18 ¥ 1.0310 1.9802% 0.03 X ¥ 1.03 -18 ¥ 1.0310 1 - 1.019802 -30

a30 = ¥
1.01 1.01 0.019802
= 0.02345 X ¥ 22.45756 = 0.52658 X

So the total present value is:

PVC = 0.26655 X + 0.52658 X = 0.79313 X

For this to have a lower present value than either of the other two options,
we need:

0.79313 X < 30,175.80

which gives X < 38,046.65 .

So the highest initial level of salary that will lead to the payments under
Option C having the lowest present value is about £38,047.

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(iv) Same interest rate?

The risks to the student vary with the different options. For example, under
Option C there is a risk that the student will end up paying more for his
university education than he would under either of the other two options.

So using the same interest rate for each of the calculations does not seem
sensible.

(v) Risks for the university

 Risks for the university include the following:

 The student’s future earnings might be very low (Option C).
 Students may default, or be unable to make the required repayments.
 The university has no security for any of these loans.
 There may be a cashflow issue; the university is having to wait many
years to recoup the costs it is experiencing now.

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FACTSHEET

This factsheet summarises the main methods, formulae and information

required for tackling questions on the topics in this booklet.

1 Net present value

The formula for the net present value is:

T
NPV (i ) = Â ct (1 + i )- t + Ú r (t )(1 + i )-t dt
0

2 Internal rate of return

The yield, or internal rate of return, is given by the solution to the equation:

NPV (i ) = 0

3 Accumulated profit

The accumulated profit (or loss) at time T is given by:

NPV (i )(1 + i )T

If trying to compare two or more projects, the accumulated profit is a good

way of discovering which is better.

4 Lending and borrowing at different rates

The concepts of net present value and yield are in general no longer
meaningful. We must calculate the accumulation of net cashflows from first
principles, the rate of interest depending on whether or not the investor’s
account is in credit. In many practical problems the balance in the investor’s
account (ie the accumulation of net cashflows) will be negative until a certain
time and positive afterwards, except perhaps when the project ends.

In some cases the investor must finance his investment or business project
by means of a fixed-term loan without an early repayment option. In these
circumstances the investor cannot use a positive cashflow to repay the loan
gradually, but must accumulate this money at the rate of interest applicable
on lending.

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5 Discounted payback period

In many practical problems the net cashflow changes sign only once, this
change being from negative to positive. In these circumstances the balance
in the investor’s account will change from negative to positive at a unique
time t1 , or it will always be negative, in which case the project is not viable.
If this time t1 exists, it is referred to as the discounted payback period
(DPP). It is the smallest value of t such that A(t ) ≥ 0 , where:

t
A(t ) = Â cs (1 + j1)t -s + Ú0 r (s )(1 + j1)t -s ds
s £t

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NOTES

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NOTES

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Subject CM1
Revision Notes
For the 2019 exams

Elementary compound interest

& bonds, equity, and property
Booklet 5

covering

Chapter 6 Real and money interest rates

Chapter 13 Bonds, equity and property

The Actuarial Education Company

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CONTENTS

Contents Page
Links to the Course Notes and Syllabus 2
Overview 3
Core Reading 4
Past Exam Questions 25
Solutions to Past Exam Questions 48
Factsheet 96

Copyright agreement

All of this material is copyright. The copyright belongs to Institute and

Faculty Education Ltd, a subsidiary of the Institute and Faculty of Actuaries.
The material is sold to you for your own exclusive use. You may not hire out,
lend, give, sell, transmit electronically, store electronically or photocopy any
part of it. You must take care of your material to ensure it is not used or
copied by anyone at any time.

Legal action will be taken if these terms are infringed. In addition, we may
seek to take disciplinary action through the profession or through your
employer. These conditions remain in force after you have finished using
the course.

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LINKS TO THE COURSE NOTES AND SYLLABUS

Material covered in this booklet

Chapter 6 Real and money rates of interest

Chapter 13 Bonds, equity and property

These chapter numbers refer to the 2019 edition of the ActEd course notes.

Syllabus objectives covered in this booklet

The numbering of the syllabus items is the same as that used by the Institute
and Faculty of Actuaries.

2.2 Demonstrate a knowledge and understanding of real and money interest

rates.

3.2 Use the concept of equation of value to solve various practical

problems.

2. Calculate the price of, or yield (nominal or real allowing for inflation)
from, a bond (fixed-interest or index-linked) where the investor is
subject to deduction of income tax on coupon payments and
redemption payments are subject to deduction of capital gains tax.

3. Calculate the running yield and the redemption yield for the
financial instrument as described in 3.2.2.

4. Calculate the upper and lower bounds for the present value of the
financial instrument as described in 3.2.2 when the redemption date
can be a single date within a given range at the option of the
borrower.

5. Calculate the present value or yield (nominal or real allowing for

inflation) from an ordinary share or property, given constant or
variable rate of growth of dividends or rents.

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OVERVIEW

This booklet covers Syllabus objectives 2.2 and 3.2.2 to 3.2.5, which relate
to real rates, and valuing bonds, equity shares and property assets.

Breakdown of topics

In Chapter 13, we describe how to calculate the price and the yield for a
fixed-interest security. The situation is complicated slightly if the investor is
liable to tax. The types of tax covered here are income tax, which applies to
the coupon payments, and capital gains tax, which applies to the capital gain
– ie the difference between the redemption value and the purchase price,
provided this is positive. We also consider how to deal with securities that
have optional redemption dates.

Also covered in this booklet are real rates of return and index-linked bonds,
where the coupon and redemption payments are linked to an inflation index.
This builds on the introductory material on real and money rates covered in
Chapter 6.

We also consider the valuation of equities and property by discounting future

cashflows.

Exam questions

There are lots of exam questions on calculating the price or the return on a
fixed-interest security. By the time of the exam, once you’ve had some
practice, you should find these relatively straightforward. Many students find
questions on real yields and/or index-linked bonds much harder.

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CORE READING
All of the Core Reading for the topics covered in this booklet is contained in
this section.
____________

Chapter 6 – Real and money interest rates

1 Accumulating an investment of 1 for a period of time t from time 0

produces a new total accumulated value A(0, t ) , say. Typically the
investment of 1 will be a sum of money, say £1 or $1 or 1 Euro.

In this case, if we are given the information on the initial investment of

1 in the specified currency, the period of the investment, and the cash
amount of money accumulated, then the underlying interest rate is
termed a ‘money rate of interest’.

More generally, given any series of monetary payments accumulated

over a period, a money rate of interest is that rate which will have been
earned so as to produce the total amount of cash in hand at the end of
the period of accumulation.

In practice, most such accumulations will take place in economies

subject to inflation, where a given sum of money in the future will have
less purchasing power than at the present day. It is often useful,
therefore, to reconsider what the accumulated value is worth allowing
for the eroding effects of inflation.
____________

2 Returning to the initial Core Reading example above, suppose the

accumulation took place in an economy subject to inflation so that the
cash A(0, t ) is effectively worth only A* (0, t ) after allowing for inflation,
where A* (0, t ) < A(0, t ) . In this case, the rate of interest at which the
original sum of 1 would have to be accumulated to produce the sum
A* is lower than the money rate of interest.

The sum A* (0, t ) is referred to as the real amount accumulated, and the
underlying interest rate, reduced for the effects of inflation, is termed a
‘real rate of interest’.

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More generally, given any series of monetary payments accumulated

over a period, a real rate of interest is that rate which will have been
earned so as to produce the total amount of cash in hand at the end of
the period of accumulation reduced for the effects of inflation.
____________

3 The above descriptions assume that the inflation rate is positive.

Where the inflation rate is negative, termed ‘deflation’, the above theory
still applies and A* (0, t ) > A(0, t ) , giving rise to the conclusion that the
real rate of interest in such circumstances would be higher than the
money rate of interest.
____________

4 As might be expected, where there is no inflation A* (0, t ) = A(0, t ) , and

the real and money rates of interest are the same.

We assume here that we have a positive inflation rate.

____________

5 Which of the two rates of interest, real or money, is the more useful will
depend on a two main factors:

 the purpose to which the rate will be put

 whether the underlying data have or have not already been

adjusted for inflation.
____________

6 The purpose to which the rate will be put.

Generally, where the actuary is performing calculations to determine

how much should be invested to provide for future outgo, the first step
will be to determine whether the future outgo is real or monetary in
nature. The type of interest rate to be assumed would then be,
respectively, a real or a monetary rate.

For example, first suppose that an actuary was asked to calculate the
sum to be invested by a person aged 40 to provide for a round-the-
world cruise when the person reaches 60, and where the person says
the cruise costs £25,000.

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Unless the person has, for some reason, already made an allowance
for inflation in suggesting a figure of £25,000 then that amount is
probably today’s cost of the cruise. In this case, the actuary would be
wise to assume (checking his understanding with the person) an
inflation rate and this could be achieved by assuming a real rate of
interest.

As an alternative example, suppose that a person has a mortgage of

£50,000 to be paid off in twenty years’ time. Here, the party that
granted the mortgage would contractually be entitled to only £50,000 in
twenty years’ time. Accordingly, in working out how much should be
invested to repay the outgo in this case, a money rate of interest would
be assumed.
____________

7 Whether the underlying data has or has not already been adjusted for
inflation.

In the first example above, we see that the data may already have been
adjusted for inflation and in that case it would not be appropriate to
allow for inflation again. A money rate would then be assumed.

More generally in actuarial work, the nature of the data provided must
be understood before choosing the type and amount of assumptions to
be made.
____________

Chapter 13 – Bonds, equity and property

As in other compound interest problems, one of two questions may be

asked:

(1) What price P per unit nominal, should be paid by an investor to

secure a net yield of i per annum?

(2) Given that the investor pays a price P per unit nominal, what net
yield per annum will be obtained?

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8 The price, P, to be paid to achieve a yield of i per annum is equal to:

Ê Present value, at rate ˆ Ê Present value, at rate ˆ

P = Á of interest i per annum, ˜ + Á of interest i per annum,˜ (1.1)
Á ˜ Á ˜
ÁË of net interest payments˜¯ ÁË of net capital payments ˜¯
____________

9 The yield available on a stock that can be bought at a given price, P,

can be found by solving equation (1.1) for the net yield i.
____________

10 If the investor is not subject to taxation the yield i is referred to as a

gross yield.
____________

11 The yield on a security is sometimes referred to as the yield to

redemption or the redemption yield to distinguish it from the flat (or
running) yield, which is defined as D/P, the ratio of the coupon rate to
the price per unit nominal of the stock.
____________

12 Consider an n year fixed interest security which pays coupons of D per

annum, payable pthly in arrear and has redemption amount R.

The price of this bond, at an effective rate of interest i per annum, with
no allowance for tax (ie i represents the gross yield) is:

P = Da ( p ) + Rv n at rate i per annum (1.2)

n
____________

13 Note: One could also work with a period of half a year. The
corresponding equation of value would then be:

D
P= a + Rv 2n at rate i ¢ where (1 + i ¢)2 = 1 + i
2 2n
____________

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14 Suppose an investor is liable to income tax at rate t1 on the coupons,

which is due at the time that the coupons are paid. The price, P ¢ , of
this bond, at an effective rate of interest i per annum, where i now
represents the net yield, is now:

P ¢ = (1 - t1)Da ( p ) + Rv n at rate i per annum (1.3)

n

It is possible in some countries that the tax is paid at some later date,
for example at the calendar year end.

This does not cause any particular problems as we follow the usual
procedure — identify the cashflow amounts and dates and set out the
equation of value.

For example, suppose that income tax on the bond is paid in a single
instalment, due, say, k years after the second half-yearly coupon
payment each year.
____________

15 Then the equation of value for a given net yield i and price (or value)
P ¢ is, immediately after a coupon payment,

P ¢ = Da ( p ) + Rv n - t1Dv k an
n

Other arrangements may be dealt with similarly from first principles.

____________

Capital gains tax

16 If the price paid for a bond is less than the redemption (or sale price if
sold earlier) then the investor has made a capital gain.
____________

17 Capital gains tax is a tax levied on the capital gain. In contrast to

income tax, this tax is normally payable once only in respect of each
disposal, at the date of sale or redemption.

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Capital gains test

Consider an n year fixed-interest security which pays coupons of D per

annum, payable pthly in arrear and has redemption amount R. An
investor, liable to income tax at rate t1 , purchases the bond at price
P ¢ . If R > P ¢ then there is a capital gain and from (1.3), we have:

R > (1 - t1)Da ( p ) + Rv n
n
1- v n
fi R (1 - v n ) > (1 - t1)D
i ( p)
D
fi R > (1 - t1) ( p)
i
( p) D
fi i > (1 - t1) (1.4)
R

If the investor is also subject to tax at rate t2 (0 < t2 < 1) on the capital
gains, then let the price payable, for a given net yield i , be P ¢¢ .
____________

D
18 If i ( p ) > (1 - t1) then there is a capital gain.
R
____________

19 At the redemption date of the loan there is therefore an additional

liability of t2 (R - P ¢¢) .

In this case:

P ¢¢ = (1 - t1)Da ( p ) + Rv n - t2 (R - P ¢¢)v n at rate i per annum (1.5)

n
____________

20 Note that if a stock is sold before the final maturity date, the capital
gains tax liability will in general be different, since it will be calculated
with reference to the sale proceeds rather than the corresponding
redemption amount.
____________

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D
21 If i ( p ) £ (1 - t1)
then there is no capital gain and no capital gains tax
R
liability due at redemption. Hence P ¢¢ = P ¢ in (1.3). (We are assuming
that it is not permissible to offset the capital loss against any other
capital gain).

Finding the yield when there is capital gains tax

An investor who is liable to capital gains tax may wish to determine the
net yield on a particular transaction in which he has purchased a loan
at a given price.

One possible approach is to determine the price on two different net

yield bases and then estimate the actual yield by interpolation. This
approach is not always the quickest method. Since the purchase price
is known, so too is the amount of the capital gains tax, and the net
receipts for the investment are thus known. In this situation one may
more easily write down an equation of value which will provide a
simpler basis for interpolation, as illustrated by the next question.

Question

A loan of £1,000 bears interest of 6% per annum payable yearly and will
be redeemed at par after ten years. An investor, liable to income tax
and capital gains tax at the rates of 40% and 30% respectively, buys the
loan for £800. What is his net effective annual yield?
____________

22 Solution

Note that the net income each year of £36 is 4.5% of the purchase
price. Since there is a gain on redemption, the net yield is clearly
greater than 4.5%.

The gain on redemption is £200, so that the capital gains tax payable
will be £60 and the net redemption proceeds will be £940. The net
effective yield pa is thus that value of i for which

800 = 36a10 + 940v 10

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If the net gain on redemption (ie £140) were to be paid in equal

instalments over the ten-year duration of the loan rather than as a lump
sum, the net receipts each year would be £50 (ie £36 + £14). Since £50
is 6.25% of £800, the net yield actually achieved is less than 6.25%.
When i = 0.055 , the right-hand side of the above equation takes the
value 821.66, and when i = 0.06 the value is 789.85. By interpolation,
we estimate the net yield as

821.66 - 800
i = 0.055 + 0.005 = 0.0584
821.66 - 789.85

The net yield is thus 5.84% per annum.

Alternatively, we may find the prices to give net yields of 5.5% and 6%
per annum. These prices are £826.27 and £787.81, respectively. The
yield may then be obtained by interpolation. However, this alternative
approach is somewhat longer than the first method.

Optional redemption dates

Sometimes a security is issued without a fixed redemption date. In

such cases the terms of issue may provide that the borrower can
redeem the security at the borrower’s option at any interest date on or
after some specified date. Alternatively, the issue terms may allow the
borrower to redeem the security at the borrower’s option at any
interest date on or between two specified dates (or possibly on any one
of a series of dates between two specified dates).
____________

23 The latest possible redemption date is called the final redemption date
of the stock, and if there is no such date, then the stock is said to be
undated.

It is also possible for a loan to be redeemable between two specified

interest dates, or on or after a specified interest date, at the option of
the lender, but this arrangement is less common than when the
borrower chooses the redemption date.

An investor who wishes to purchase a loan with redemption dates at

the option of the borrower cannot, at the time of purchase, know how
the market will move in the future and hence when the borrower will
repay the loan. The investor thus cannot know the yield which will be
obtained.

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However, by using (1.4) the investor can determine either:

(1) The maximum price to be paid, if the net yield is to be at least

some specified value;

or

(2) The minimum net yield the investor will obtain, if the price is some
specified value.

Consider a fixed interest security which pays coupons of D per annum,

payable pthly in arrear and has redemption amount R. The security
has an outstanding term of n years, which may be chosen by the
borrower subject to the restriction that n1 £ n £ n2 . (We assume that
n1 and n2 are integer multiples of 1/p.) Suppose that an investor,
liable to income tax at rate t1 , wishes to achieve a net annual yield of
at least i.
____________

D
24 It follows from equations (1.3) and (1.4) that if i ( p ) > (1 - t1)
then the
R
purchaser will receive a capital gain when the security is redeemed.
From the investor’s viewpoint, the sooner a capital gain is received the
better. The investor will therefore obtain a greater yield on a security
which is redeemed first.
____________

25 So to ensure the investor receives a net annual yield of at least i then

they should assume the worst case result: that the redemption money
is paid as late as possible, ie n = n2 .
____________

D
26 Similarly if i ( p ) < (1 - t1)
then there will be a capital loss when the
R
security is redeemed. The investor will wish to defer this loss as long
as possible, and will therefore obtain a greater yield on a security
which is redeemed later.
____________

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27 So to ensure the investor receives a net annual yield of at least i then

they should assume the worst case result: that the redemption money
is paid as soon as possible, ie n = n1 .
____________

D
28 Finally, if i ( p ) = (1 - t1)
then there is neither a capital gain nor a
R
capital loss. So it will make no difference to the investor when the
security is redeemed. The net annual yield will be i irrespective of the
actual redemption date chosen.

Suppose, alternatively, that the price of the loan is given. The

minimum net annual yield is obtained by again assuming the worst
case result for the investor. So if:
____________

29 P < R , then the investor receives a capital gain when the security is
redeemed. The worst case is that the redemption money is repaid at
the latest possible date. If this does in fact occur, the net annual yield
will be that calculated. If redemption takes place at an earlier date, the
net annual yield will be greater than that calculated.
____________

30 P > R , then the investor receives a capital loss when the security is
redeemed. The worst case is that the redemption money is repaid at
the earliest possible date. The actual yield obtained will be at least the
value calculated on this basis.
____________

31 P = R , then the investor receives neither a capital gain nor a capital

D
loss. The net annual yield is i , where i ( p ) = (1 - t1) , irrespective of
R
the actual redemption date chosen.
____________

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32 Note that a capital gains tax liability does not change any of this. For
example, an investment which has a capital gain before allowing for
capital gains tax must still have a net capital gain after allowing for the
capital gains tax liability, so that the ‘worst case’ for the investor is still
the latest redemption. However, in some cases, for example if the
redemption price varies, the simple strategy described above will not
be adequate, and several values may need to be calculated to
determine which is lowest.
____________

Uncertain income securities

33 Securities with uncertain income include:

1. Equities, which have regular declarations of dividends. The

dividends vary according to the performance of the company
issuing the stocks and may be zero.

2. Property which carries regular payments of rent, which may be

subject to regular review.

3. Index-linked bonds which carry regular coupon payments and a

final redemption payment, all of which are increased in proportion
to the increase in a relevant index of inflation.

For all of these investments investors may be interested in calculating

the yield for a given price, or the price or value of the security for a
given yield. In order to calculate the value or the yield it is necessary
to make assumptions about the future income.
____________

34 Given the uncertain nature of the future income, one method of

modelling the cashflows is to assume statistical distributions for, say,
the inflation or dividend growth rate. In this course however we will
make simpler assumptions – for example that dividends increase at a
constant rate. It is important to recognise that modelling random
variables deterministically, ignoring the variability of the payments and
the uncertainty about the expected growth rate, is not adequate for
many purposes and stochastic methods will be required.

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In all three cases, using this deterministic approach means that we

estimate the future cashflows and then solve the equation of value
using the estimated cashflows.

Index linked bonds differ slightly from the other two in that the income
is certain in real terms. These are therefore covered separately, later.

Given deterministic assumptions about the growth of dividends, we

can estimate the future dividends for any given equity, and then solve
the equation of value using estimated cashflows for the yield or the
price or value.

So, let the value of an equity just after a dividend payment be P , and
let D be the amount of this dividend payment. Assume that dividends
grow in such a way that the dividend due at time t is estimated to be
Dt .
____________

35 We generally value the equity assuming dividends continue in

perpetuity, and without explicit allowance for the possibility that the
company will default and the dividend payments will cease. In this
case, assuming annual dividends:

•
P= Â Dt v it
t =1

where i is the return on the share, given price P .

____________

36 If we assume a constant dividend growth rate of g , say, then

Dt = (1 + g )t D and:

1+ i
P = Da• i ¢ where i ¢ = -1
1+ g

D (1 + g )
fiP =
i -g
____________

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37 At certain times close to the dividend payment date the equity may be
offered for sale excluding the next dividend. This allows for the fact
that there may not be time between the sale date and the dividend
payment date for the company to adjust its records to ensure the buyer
receives the dividend. An equity which is offered for sale without the
next dividend is called ex-dividend or ‘xd’. The valuation of ex-
dividend stocks requires no new principles.
____________

38 The valuation of property by discounting future income follows very

similar principles to the valuation of equities. Both require some
assumption about the increase in future income; both have income
which is related to the rate of inflation (both property rents and
company profits will be broadly linked to inflation, over the long term);
in both cases we use a deterministic approach.

The major differences between the approach to the property equation

of value, compared with the equity equation of value, are:

(1) property rents are generally fixed for a number of years at a time
and

(2) some property contracts may be fixed term, so that after a certain
period the property income ceases and ownership passes back to
the original owner (or another investor) with no further payments.
____________

39 Let P be the price immediately after receipt of the periodic rental

payment. Let m be the frequency of the rental payments each year.
We estimate the future cashflows, such that Dt m is the rental income
at time t, t = 1 2 ,  . If the rents cease after some time n then clearly
,m
m
Dt = 0 for t > n .

Then the equation of value is:

•
P= Â 1
m
Dk / mv k / m
k =1
____________

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Real rates of interest

The idea of a real rate of interest, as distinct from a money rate of

interest, was introduced in Chapter 6. Ways of calculating real rates of
interest will now be examined.

The real rate of interest of a transaction is the rate of interest after

allowing for the effect of inflation on a payment series.
____________

40 The effect of inflation means that a unit of money at, say, time 0 has
different purchasing power than a unit of money at any other time. We
find the real rate of interest by first adjusting all payment amounts for
inflation, so that they are all expressed in units of purchasing power at
the same date.

As a simple example, consider a transaction represented by the

following payment line:

Time: 0 1

Payment: 100 120

That is, for an investment of 100 at time 0 an investor receives 120 at

time 1.
____________

41 The effective rate of interest on this transaction is clearly 20% per

annum. The real rate of interest is found by first expressing both
payments in units of the same purchasing power. Suppose that
inflation over this one-year period is 5% per annum. This means that
120 at time 1 has a value of 120 1.05 = 114.286 in terms of time 0
money units. So, in ‘real’ terms, that is, after adjusting for the rate of
inflation, the transaction is represented as:

Time: 0 1

Payment: 100 114.286

Hence, the real rate of interest is 14.286%.

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42 Where the rates of inflation are known (that is, we are looking back in
time at a transaction that is complete) we may adjust payments for the
rate of inflation by reference to a relevant inflation index.

For example, assume we have an inflation index, Q (t k ) at time t k , and

a payment series as follows:

Time, t : 0 1 2 3

Payment: 100 8 8 108

Q (t ) 150 156 166 175
____________

43 Clearly the rate of interest on this transaction is 8%.

Now we can change all these amounts into time 0 money values by
dividing the payment at time t by the proportional increase in the
inflation index from 0 to t. For example the inflation-adjusted value of
the payment of 8 at time 1 is 8 ∏ (Q(1) / Q (0)) . The series of payments in
time 0 money values is then as follows:

Time, t: 0 1 2 3

Payment: 100 7.6923 7.2289 92.5714

This gives a yield equation for the real yield:

-100 + 7.6923v i ¢ + 7.2289v i2¢ + 92.5714v i3¢ = 0

where i ¢ is the real rate of interest, which can be solved using

numerical methods to give i ¢ = 2.63% .
____________

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44 In general, the real yield equation for a series of cashflows

{Ct1 , Ct2 ,  , Ctn } , given associated inflation index values
{Q (0), Q (t1), Q (t2 ),  , Q (t n )} is, using time 0 money units:

n Q (0) tk
 Ctk v =0
Q (t k ) i ¢
k =1

n Ctk t
fi  v i k¢ = 0
k =1 Q (t k )

The second equation here, in which all terms are divided by Q (0) ,
demonstrates that the solution of the yield equation is independent of
the date the payment units are adjusted to.

If we are considering future cashflows, the actual inflation experience

will not be known, and some assumption about future inflation will be
required. For example, if it is assumed that a constant rate of inflation
of j per annum will be experienced, then a cashflow of, say, 100 due
at t has value 100(1 + j )-t in time 0 money values.
____________

45 So, for a fixed net cashflow series {Ctk } , k = 1, 2,  , n , assuming a rate

of inflation of j per annum, the real, effective rate of interest, i ¢ , is the
solution of the real yield equation:

n
t t
 Ctk v jk v i k¢ =0
k =1
____________

46 We also know that the effective rate of interest with no inflation

adjustment which may be called the ‘money yield’ to distinguish from
the real yield, is i where:

n
 Ctk v itk =0
k =1
____________

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47 So the relationship between the real yield i ¢ , the rate of inflation j and
the money yield i is:

i-j
v i = v jv i ¢ fi i ¢ =
1+ j
___________

48 Conversely, if we know the real yield i ¢ which we have obtained from

an equation of value using inflation-adjusted cashflows then we can
calculate the money yield as follows:

i = i ¢ + j (1 + i ¢)

In some cases a combination of known inflation index values and an

assumed future inflation rate may be used to find the real rate of
interest.

Some contracts specify that the cashflows will be adjusted to allow for
future inflation, usually in terms of a given inflation index.
____________

49 The index-linked government security is an example.

The actual cashflows will be unknown until the inflation index at the
relevant dates are known.
____________

50 The contract cashflows will be specified in terms of some nominal

amount to be paid at time t, say ct . If the inflation index at the base
date is Q (0) and the relevant value for the time t payment is Q (t ) then
the actual cashflow is:

Q (t )
Ct = ct
Q (0)
____________

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51 It is easy to show that if the real yield i ¢ is calculated by reference to

the same inflation index as is used to inflate the cashflows, then i ¢ is
the solution of the real yield equation:

n Q (0) tk n
t
 Ctk Q (t k )
v i ¢ = 0 fi  ctk v i k¢ = 0
k =1 k =1

In other words we can solve the yield equation using the nominal
amounts.

However, it is not always the case that the index used to inflate the
cashflows is the same as that used to calculate the real yield. For
example the index-linked UK government security has coupons inflated
by reference to the inflation index value three months before the
payment is made. The real yield, however, is calculated using the
inflation index at the actual payment dates.

Consider the simplest situation, in which an investor can lend and

borrow money at the same rate of interest i1 . In certain economic
conditions the investor may assume that some or all elements of the
future cashflows should incorporate allowances for inflation
(ie increases in prices and wages). The extent to which the various
items in the cashflow are subject to inflation may differ. For example,
wages may increase more rapidly than the prices of certain goods, or
vice versa, and some items (such as the income from rent-controlled
property) may not rise at all, even in highly inflationary conditions.

The case when all items of cashflow are subject to the same rate of
escalation j per time unit is of special interest.
____________

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52 In this case we find or estimate ctj and r j (t ) , the net cashflow and the
net rate of cashflow allowing for escalation at rate j per unit time, by
the formulae:

ctj = (1 + j )t ct

r j (t ) = (1 + j )t r (t )

where ct and r (t ) are estimates of the net cashflow and the net rate of
cashflow respectively at time t without any allowance for inflation.
____________

53 It follows that, with allowance for inflation at rate j per unit time, the
net present value of an investment or business project at rate of
interest i is:

•
NPV j (i ) = Â ct (1 + j )t (1 + i )-t + Ú r (t )(1 + j )t (1 + i )-t dt
0
•
= Â ct (1 + i0 )-t + Ú r (t )(1 + i0 )-t dt (3.1)
0

where:

1+ i
1 + i0 =
1+ j

or:

i-j
i0 = (3.2)
1+ j
____________

54 If j is not too large, and 1 + j is close to 1, one sometimes uses the

approximation:

i0 ª i - j

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These results are of considerable practical importance, because

projects which are apparently unprofitable when rates of interest are
high may become highly profitable when even a modest allowance is
made for inflation. It is, however, true that in many ventures the
positive cashflow generated in the early years of the venture is
insufficient to pay bank interest, so recourse must be had to further
borrowing (unless the investor has adequate funds of their own). This
does not undermine the profitability of the project, but the investor
would require the agreement of his lending institution before further
loans could be obtained and this might cause difficulties in practice.
____________

Index-linked bonds

55 Index-linked bond cashflows are described in Chapter 3. The coupon

and redemption payments are increased according to an index of
inflation.

Given simple assumptions about the rate of future inflation it is

possible to estimate the future payments. Given these assumptions we
may calculate the price or yield by solving the equation of value using
the estimated cashflows.

For example, let the nominal annual coupon rate for an n -year
index-linked bond be D per £1 nominal face value with coupons
payable half-yearly, and let the nominal redemption price be R per £1
nominal face value. We assume that payments are inflated by
reference to an index with base value Q (0) , such that…
____________

56 … the coupon due at time t years is:

D Q (t )
2 Q (0)
____________

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57 Then the equation of value, given an effective (money) yield of i per

annum, and a present value or price P per £1 nominal at issue or
immediately following a coupon payment, is:

2n D Q (k 2) k /2 Q (n ) n
P= Â 2 Q (0)
vi + R
Q (0)
vi
k =1
____________

58 We estimate the unknown value of Q (t ) using some assumption about

future inflation and using the latest known value – which may be Q (0) .
For example, assume inflation increases at rate jt per annum in the
year t - 1 to t, then we have:

Q (½) = Q (0)(1 + j1)½

Q (1) = Q (0)(1 + j1)

Q (1½) = Q (0)(1 + j1)(1 + j2 )½

Q (2) = Q (0)(1 + j1)(1 + j2 )

etc

It is important to bear in mind that the index used may not be the same
as the actual inflation index value at time t that one would use, for
example, to calculate the real (inflation-adjusted) yield. In the case of
UK index-linked bonds, the payments are increased using the index
values from three months before the payment date. Real yields would
be calculated using the inflation index values at the payment date.

Like equities, index-linked bonds (and fixed-interest bonds) may be

offered for sale ‘ex-dividend’. No new principles are involved in the
valuation of ex-dividend index linked bonds.
____________

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PAST EXAM QUESTIONS

This section contains all the Subject CT1 exam questions from the period
2008 to 2017 that are related to the topics covered in this booklet.

Solutions are given later in this booklet. These give enough information for
you to check your answer, including working, and also show you what an
adequate examination answer should look like. Further information may be
available in the Examiners’ Report, ASET or Course Notes. (ASET can be
ordered from ActEd.)

We first provide you with a cross reference grid that indicates the main
subject areas of each exam question. You can use this, if you wish, to
select the questions that relate just to those aspects of the topic that you
may be particularly interested in reviewing.

Alternatively you can choose to ignore the grid, and instead attempt each
question without having any clues as to its content.

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Cross reference grid

Bonds

Equity price/yield
income/CG tax

Index linked
redemption
Tick when
attempted

Real yield
Optional
Price

Yield
Question

1   
2  
3 
4  
5    
6 
7    
8  
9  
10   ()
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income/CG tax
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Bonds

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Index linked
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Equity price/yield

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1 Subject CT1 April 2008 Question 4

A loan of nominal amount £100,000 is to be issued bearing coupons payable

quarterly in arrear at a rate of 7% per annum. Capital is to be redeemed at
108% on a coupon date between 15 and 20 years after the date of issue,
inclusive. The date of redemption is at the option of the borrower.

An investor who is liable to income tax at 25% and capital gains tax at 35%
wishes to purchase the entire loan at the date of issue.

Calculate the price which the investor should pay to ensure a net effective
yield of at least 5% per annum. [8]

2 Subject CT1 April 2008 Question 7

The shares of a company currently trade at £2.60 each, and the company
has just paid a dividend of 12p per share. An investor assumes that
dividends will be paid annually in perpetuity and will grow in line with a
constant rate of inflation. The investor estimates the assumed inflation rate
from equating the price of the share with the present value of all estimated
future gross dividend payments using an effective interest rate of 6% per
annum.

(i) Calculate the investor’s estimation of the effective inflation rate per
annum based on the above assumptions. [4]

(ii) Suppose that the actual inflation rate turns out to be 3% per annum
effective over the following twelve years, but that all the investor’s other
assumptions are correct.

Calculate the investor’s real rate of return per annum from purchase to
sale, if she sold the shares after twelve years for £5 each immediately
after a dividend has been paid. You may assume that the investor pays
no tax. [6]
[Total 10]
3 Subject CT1 September 2008 Question 1

A 91-day government bill is purchased for £95 at the time of issue and is
redeemed at the maturity date for £100. Over the 91 days, an index of
consumer prices rises from 220 to 222.

Calculate the effective real rate of return per annum. [3]

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4 Subject CT1 September 2008 Question 8

A tax advisor is assisting a client in choosing between three types of

investment. The client pays tax at 40% on income and 40% on capital
gains.

Investment A requires the investment of £1m and provides an income of

£0.1m per year in arrears for ten years. Income tax is deducted at source.
At the end of the ten years, the investment of £1m is returned.

In Investment B, the initial sum of £1m accumulates at the rate of 10% per
annum compound for ten years. At the end of the ten years, the
accumulated value of the investment is returned to the investor after
deduction of capital gains tax.

Investment C is identical to Investment B except that the initial sum is

deemed, for tax purposes, to have increased in line with the index of
consumer prices between the date of the investment and the end of the ten-
year period. The index of consumer prices is expected to increase by 4%
per annum compound over the period.

(i) Calculate the net rate of return expected from each of the investments.
[7]

(ii) Explain why the expected rate of return is higher for Investment C than
for Investment B and is higher for Investment B than for Investment A. [3]
[Total 10]

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5 Subject CT1 April 2009 Question 10

A loan pays coupons of 11% per annum quarterly on 1 January, 1 April,

1 July and 1 October each year. The loan will be redeemed at 115% on any
1 January from 1 January 2015 to 1 January 2020 inclusive, at the option of
the borrower. In addition to the redemption proceeds, the coupon then due
is also paid.

An investor purchased a holding of the loan on 1 January 2005, immediately

after the payment of the coupon then due, at a price which gave him a net
redemption yield of at least 8% per annum effective. The investor pays tax
at 30% on income and 25% on capital gains.

On 1 January 2008 the investor sold the holding, immediately after the
payment of the coupon then due, to a fund which pays no tax. The sale
price gave the fund a gross redemption yield of at least 9% per annum
effective.

Calculate the following:

(i) The price per £100 nominal at which the investor bought the loan. [6]

(ii) The price per £100 nominal at which the investor sold the loan. [4]

(iii) The net yield per annum convertible quarterly that was actually obtained
by the investor during the period of ownership of the loan. [5]
[Total 15]

6 Subject CT1 September 2009 Question 3

An investor bought a number of shares at 78 pence each on 31 December

2005. She received dividends on her holding on 31 December 2006, 2007
and 2008. The rate of dividend per share is given in the table below:

Date Rate of dividend per share Retail price index

31.12.2005 ------ 147.7
31.12.2006 4.1 pence 153.4
31.12.2007 4.6 pence 158.6
31.12.2008 5.1 pence 165.1

On 31 December 2008, she sold her shares at a price of 93 pence per

share.

Calculate, using the retail price index values shown in the table, the effective
annual real rate of return achieved by the investor. [7]

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7 Subject CT1 September 2009 Question 4

A fixed-interest security has just been issued. The security pays half-yearly
coupons of 5% per annum in arrear and is redeemable at par 20 years after
issue.

(i) Calculate the price to provide an investor with a net redemption yield of
6% per annum effective. The investor pays tax at a rate of 20% on
income and is not subject to capital gains tax. [3]

(ii) Determine the annual effective gross redemption yield of this security
assuming the price calculated in (i) is paid. [5]

(iii) Determine the real annual effective gross redemption yield of this
security if the rate of inflation is constant over the twenty years at 3%
per annum. [2]
[Total 10]

8 Subject CT1 April 2010 Question 2

In January 2008, the government of a country issued an index-linked bond

with a term of two years. Coupons were payable half-yearly in arrear, and
the annual nominal coupon rate was 4%. Interest and capital payments
were indexed by reference to the value of an inflation index with a time lag of
six months.

A tax-exempt investor purchased £100,000 nominal at issue and held it to

redemption. The issue price was £98 per £100 nominal.

The inflation index was as follows:

Date Inflation Index

July 2007 110.5
January 2008 112.1
July 2008 115.7
January 2009 119.1
July 2009 123.2

(i) Calculate the investor’s cashflows from this investment and state the
month when each cashflow occurs. [3]

(ii) Calculate the annual effective money yield obtained by the investor to
the nearest 0.1% per annum. [3]
[Total 6]

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9 Subject CT1 April 2010 Question 3

A company issues ordinary shares to an investor who is subject to income

tax at 20%.

Under the terms of the ordinary share issue, the investor is to purchase
1,000,000 shares at a purchase price of 45p each on 1 January 2011.

No dividend is expected to be paid for 2 years. The first dividend payable on

1 January 2013 is expected to be 5p per share. Dividends will then be paid
every 6 months in perpetuity. The two dividend payments in any calendar
year are expected to be the same, but the dividend payment is expected to
increase at the end of each year at a rate of 3% per annum compound.

Calculate the net present value of the investment on 1 January 2011 at an

effective rate of interest of 8% per annum. [5]

10 Subject CT1 April 2010 Question 4

An investor is considering purchasing a fixed-interest bond at issue which

pays half-yearly coupons at a rate of 6% per annum. The bond will be
redeemed at £105 per £100 nominal in 10 years’ time. The investor is
subject to income tax at 20% and capital gains tax at 25%.

The inflation rate is assumed to be constant at 2.8571% per annum.

Calculate the price per £100 nominal if the investor is to obtain a net real
yield of 5% per annum. [7]

11 Subject CT1 September 2010 Question 1

A bond pays coupons in perpetuity on 1 June and 1 December each year.

The annual coupon rate is 3.5% per annum. An investor purchases a
quantity of this bond on 20 August 2009.

Calculate the price per £100 nominal to provide the investor with an effective
rate of return per annum of 10%. [3]

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12 Subject CT1 September 2010 Question 2

A bond is redeemed at £110 per £100 nominal in exactly four years’ time. It
pays coupons of 4% per annum half-yearly in arrear and the next coupon is
due in exactly six months’ time. The current price is £110 per £100 nominal.

(i) (a) Calculate the gross rate of return per annum convertible half-yearly
from the bond.

(b) Calculate the gross effective rate of return per annum from the
bond. [2]

(ii) Calculate the net effective rate of return per annum from the bond for an
investor who pays income tax at 25%. [2]
[Total 4]

13 Subject CT1 April 2011 Question 3

An investment trust bought 1,000 shares at £135 each on 1 July 2005. The
trust received dividends on its holding on 30 June each year that it held the
shares.

The rate of dividend per share was as given in the table below:

30 June in year Rate of dividend Retail price index

per share (£)
2005 … 121.4
2006 7.9 125.6
2007 8.4 131.8
2008 8.8 138.7
2009 9.4 145.3
2010 10.1 155.2

On 1 July 2010, the investment trust sold its entire holding of the shares at a
price of £151 per share.

(i) Using the retail price index values shown in the table, calculate the real
rate of return per annum effective achieved by the trust on its
investment. [6]

(ii) Explain, without doing any further calculations, how your answer to (i)
would alter (if at all) if the retail price index for 30 June 2008 had been
greater than 138.7 (with all other index values unchanged). [2]
[Total 8]

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14 Subject CT1 April 2011 Question 5

A loan of nominal amount £100,000 was issued on 1 April 2011 bearing

interest payable half-yearly in arrear at a rate of 6% per annum. The loan is
to be redeemed with a capital payment of £105 per £100 nominal on any
coupon date between 20 and 25 years after the date of issue, inclusive, with
the date of redemption being at the option of the borrower.

An investor who is liable to income tax at 20% and capital gains tax of 35%
wishes to purchase the entire loan on 1 June 2011 at a price which ensures
that the investor achieves a net effective yield of at least 5% per annum.

(i) Determine whether the investor would make a capital gain if the
investment is held until redemption. [3]

(ii) Explain how your answer to (i) influences the assumptions made in
calculating the price the investor should pay. [2]

(iii) Calculate the maximum price the investor should pay. [5]
[Total 10]

15 Subject CT1 September 2011 Question 7

An investment manager is considering investing in the ordinary shares of a

particular company.

The current price of the shares is 12 pence per share. It is highly unlikely
that the share will pay any dividends in the next five years. However, the
investment manager expects the company to pay a dividend of 2 pence per
share in exactly six years’ time, 2.5 pence per share in exactly seven years’
time, with annual dividends increasing thereafter by 1% per annum in
perpetuity.

In five years’ time, the investment manager expects to sell the shares. The
sale price is expected to be equal to the present value of the expected
dividends from the share at that time at a rate of interest of 8% per annum
effective.

(i) Calculate the effective gross rate of return per annum the investment
manager will obtain if he buys the share and then sells it at the expected
price in five years’ time. [6]

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(ii) Calculate the net effective rate of return per annum the investment
manager will obtain if he buys the share today and then sells it at the
expected price in five years’ time if capital gains tax is payable at 25%
on any capital gains. [3]

(iii) Calculate the net effective real rate of return per annum the investment
manager will obtain if he buys the share and then sells it at the expected
price in five years’ time if capital gains tax is payable at 25% on any
capital gains and inflation is 4% per annum effective. There is no
indexation allowance. [3]
[Total 12]

16 Subject CT1 April 2012 Question 6

A fixed-interest bond pays annual coupons of 5% per annum in arrear on 1

March each year and is redeemed at par on 1 March 2025.

On 1 March 2007, immediately after the payment of the coupon then due,
the gross redemption yield was 3.158% per annum effective.

(i) Calculate the price of the bond per £100 nominal on 1 March 2007. [3]

On 1 March 2012, immediately after the payment of the coupon then due,
the gross redemption yield on the bond was 5% per annum.

(ii) State the new price of the bond per £100 nominal on 1 March 2012. [1]

A tax-free investor purchased the bond on 1 March 2007, immediately after

payment of the coupon then due, and sold the bond on 1 March 2012,
immediately after payment of the coupon then due.

(iii) Calculate the gross annual rate of return achieved by the investor over
this period. [2]

(iv) Explain, without doing any further calculations, how your answer to part
(iii) would change if the bond were due to be redeemed on 1 March
2035 (rather than 1 March 2025). You may assume that the gross
redemption yield at both the date of purchase and the date of sale
remains the same as in parts (i) and (ii) above. [3]
[Total 9]

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17 Subject CT1 April 2012 Question 9

An ordinary share pays dividends on each 31 December. A dividend of 35p

per share was paid on 31 December 2011. The dividend growth is expected
to be 3% in 2012, and a further 5% in 2013. Thereafter, dividends are
expected to grow at 6% per annum compound in perpetuity.

(i) Calculate the present value of the dividend stream described above at a
rate of interest of 8% per annum effective for an investor holding 100
shares on 1 January 2012. [4]

An investor buys 100 shares for £17.20 each on 1 January 2012. He

expects to sell the shares for £18 on 1 January 2015.

(ii) Calculate the investor’s expected real rate of return.

You should assume that dividends grow as expected and use the following
values of the inflation index:

Year: 2012 2013 2014 2015

Inflation index at start of year: 110.0 112.3 113.2 113.8
[5]
[Total 9]

18 Subject CT1 April 2013 Question 4

An investor is interested in purchasing shares in a particular company.

The company pays annual dividends, and a dividend payment of 30 pence

per share has just been made.

Future dividends are expected to grow at the rate of 5% per annum

compound.

(i) Calculate the maximum price per share that the investor should pay to
give an effective return of 9% per annum. [4]

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(ii) Without doing any further calculations, explain whether the maximum
price paid will be higher, lower or the same if:

(a) after consulting the managers of the company, the investor

increases his estimate of the rate of growth of future dividends to
6% per annum.

(b) as a result of a government announcement, the general level of

future price inflation in the economy is now expected to be 2% per
annum higher than previously assumed.

(c) general economic uncertainty means that, whilst the investor still
estimates future dividends will grow at 5% per annum, he is now
much less sure about the accuracy of this assumption.

You should consider the effect of each change separately. [6]

[Total 10]

19 Subject CT1 April 2013 Question 9

A fixed-interest security pays coupons of 8% per annum half yearly on 1

January and 1 July. The security will be redeemed at par on any 1 January
from 1 January 2017 to 1 January 2022 inclusive, at the option of the
borrower.

An investor purchased a holding of the security on 1 May 2011, at a price

which gave him a net yield of at least 6% per annum effective. The investor
pays tax at 30% on interest income and 25% on capital gains.

On 1 April 2013 the investor sold the holding to a fund which pays no tax at
a price to give the fund a gross yield of at least 7% per annum effective.

(i) Calculate the price per £100 nominal at which the investor bought the
security. [5]

(ii) Calculate the price per £100 nominal at which the investor sold the
security. [3]

(iii) Show that the effective net yield that the investor obtained on the
investment was between 8% and 9% per annum. [6]
[Total 14]

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20 Subject CT1 September 2013 Question 3

A fixed-interest security pays coupons of 4% per annum, half-yearly in arrear

and will be redeemed at par in exactly ten years.

(i) Calculate the price per £100 nominal to provide a gross redemption
yield of 3% per annum convertible half-yearly. [2]

(ii) Calculate the price, 91 days later, to provide a net redemption yield of
3% per annum convertible half-yearly if income tax is payable at 25%. [2]
[Total 4]

21 Subject CT1 September 2013 Question 5

An investor is considering the purchase of two government bonds, issued by

two countries A and B respectively, both denominated in euro.

Both bonds provide a capital repayment of €100 together with a final coupon
payment of €6 in exactly one year. The investor believes that he will receive
both payments from the bond issued by Country A with certainty. He
believes that there are four possible outcomes for the bond from Country B,
shown in the table below.

Outcome Probability

No coupon or capital payment 0.1

Capital payment received, but no coupon payment received 0.2
50% of capital payment received, but no coupon payment received 0.3
Both coupon and capital payments received in full 0.4

The price of the bond issued by Country A is €101.

(i) Calculate the price of the bond issued by Country B to give the same
expected return as that for the bond issued by Country A. [3]

(ii) Calculate the gross redemption yield from the bond issued by Country B
assuming that the price is as calculated in part (i). [1]

(iii) Explain why the investor might require a higher expected return from the
bond issued by Country B than from the bond issued by Country A. [2]
[Total 6]

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22 Subject CT1 September 2013 Question 8

Mrs Jones invests a sum of money for her retirement which is expected to be
in 20 years’ time. The money is invested in a zero coupon bond which
provides a return of 5% per annum effective. At retirement, the individual
requires sufficient money to purchase an annuity certain of £10,000 per
annum for 25 years. The annuity will be paid monthly in arrear and the
purchase price will be calculated at a rate of interest of 4% per annum
convertible half-yearly.

(i) Calculate the sum of money the individual needs to invest at the
beginning of the 20-year period. [5]

The index of retail prices has a value of 143 at the beginning of the 20-year
period and 340 at the end of the 20-year period.

(ii) Calculate the annual effective real return the individual would obtain
from the zero coupon bond. [2]

The government introduces a capital gains tax on zero coupon bonds of 25

per cent of the nominal capital gain.

(iii) Calculate the net annual effective real return to the investor over the 20-
year period before the annuity commences. [3]

(iv) Explain why the investor has achieved a negative real rate of return
despite capital gains tax only being a tax on the profits from an
investment. [2]
[Total 12]

23 Subject CT1 April 2014 Question 4

A company issues a loan stock bearing interest at a rate of 8% per annum

payable half-yearly in arrear. The stock is to be redeemed at 103% on any
coupon payment date in the range from 20 years after issue to 25 years after
issue inclusive, to be chosen by the company.

An investor, who is liable to income tax at 30% and tax on capital gains at
40%, bought the stock at issue at a price which gave her a minimum net
yield to redemption of 6% per annum effective.

Calculate the price that the investor paid. [7]

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24 Subject CT1 April 2014 Question 5

On 25 October 2008 a certain government issued a 5-year index-linked

stock. The stock had a nominal coupon rate of 3% per annum payable half-
yearly in arrear and a nominal redemption price of 100%. The actual coupon
and redemption payments were index-linked by reference to a retail price
index as at the month of payment.

An investor, who was not subject to tax, bought £10,000 nominal of the stock
on 26 October 2012. The investor held the stock until redemption.

You are given the following values of the retail price index:

2008 ----- 2012 2013

April ----- ----- ----- 171.4
October 149.2 ----- 169.4 173.8

(i) Calculate the coupon payment that the investor received on 25 April
2013 and the coupon and redemption payments that the investor
received on 25 October 2013. [3]

(ii) Calculate the purchase price that the investor paid on 25 October 2012
if the investor achieved an effective real yield of 3.5% per annum
effective on the investment. [4]
[Total 7]

25 Subject CT1 September 2014 Question 9

A government issued a number of index-linked bonds on 1 June 2012 which

were redeemed on 1 June 2014. Each bond had a nominal coupon of 2%
per annum, payable half yearly in arrear and a nominal redemption price of
100%. The actual coupon and redemption payments were indexed
according to the increase in the retail price index between three months
before the issue date and three months before the relevant payment dates.
No adjustment is made to allow for the actual date of calculation of the price
index within the month or the precise coupon payment date within the
month.

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The values of the retail price index in the relevant months were:

Date Retail Price Index

March 2012 112
June 2012 113
September 2012 116
December 2012 117
March 2013 117
June 2013 118
September 2013 120
December 2013 121
March 2014 121
June 2014 122

An investor purchased £3.5m nominal of the bond at the issue date and held
it until it was redeemed. The investor was subject to tax on coupon
payments at a rate of 25%.

(i) Calculate the incoming net cash flows the investor received. [5]

(ii) Express the cash flows in terms of 1 June 2012 prices. [4]

(iii) Calculate the purchase price of the bond per £100 nominal if the real net
redemption yield achieved by the investor was 1.5% per annum
effective. [3]

When the investor purchased the security, he expected the retail price index
to rise much more slowly than it did in practice.

(iv) Explain whether the investor’s expected net real rate of return at
purchase would have been greater than 1.5% per annum effective. [2]

In September 2012, the government indicated that it might change the price
index to which payments were linked to one which tends to rise more slowly
than the retail price index.

(v) Explain the likely impact of such a change on the market price of index-
linked bonds. [2]
[Total 16]

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26 Subject CT1 April 2015 Question 6

An ordinary share pays annual dividends. The next dividend is expected to

be 6p per share and is due in exactly six months’ time. It is expected that
subsequent dividends will grow at a rate of 6% per annum compound and
that inflation will be 4% per annum. The price of the share is 175p and
dividends are expected to continue in perpetuity.

Calculate the expected effective real rate of return per annum for an investor
who purchases the share. [6]

Part (i) of Subject CT1 April 2015 Question 8 is about bond pricing.
However, later parts of this question concern discounted mean term and
volatility, so we have included it in an earlier booklet.

27 Subject CT1 September 2015 Question 7

A special type of loan is to be issued by a company. The loan is made up of

100,000 bonds, each of nominal value €100. Coupons will be paid semi-
annually in arrear at a rate of 4% per annum. The bonds are to be issued on
1 October 2015 at a price of €100 per €100 nominal. Income tax will be paid
by the bond holders at a rate of 25% on all coupon payments.

Exactly half the bonds will be redeemed after ten years at €100 per €100
nominal. The bonds that are redeemed will be determined by lot (ie the
bonds will be numbered and half the numbered bonds will be chosen
randomly for redemption). Coupon payments on the remaining bonds will be
increased to 7% per annum and these bonds will be redeemed 20 years
after issue at €130 per €100 nominal.

An individual buys a single bond.

Calculate, as an effective rate of return per annum:

(i) the maximum rate of return the individual can obtain from the bond. [5]

(ii) the minimum rate of return the individual can obtain from the bond. [2]

(iii) the expected rate of return the individual will obtain from the bond [2]

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An investor is considering buying the whole loan.

(iv) Show that the rate of return that the investor will obtain is greater than
the expected rate of return that the above individual who buys a single
bond will receive. [5]
[Total 14]

28 Subject CT1 September 2015 Question 8

(i) State the characteristics of an equity. [4]

An investor was considering investing in the shares of a particular company

on 1 August 2014. The investor assumed that the next dividend would be
payable in exactly one year and would be equal to 6 pence per share.

Thereafter, dividends will grow at a constant rate of 1% per annum and are
assumed to be paid in perpetuity. All dividends will be taxed at a rate of
20%. The investor requires a net rate of return from the shares of 6% per
annum effective.

(ii) Derive and simplify as far as possible a general formula which will allow
you to determine the value of a share for different values of:
 the next expected dividend.
 the dividend growth rate.
 the required rate of return.
 the tax rate.

(iii) Calculate the value of one share to the investor. [5]

The company announces some news that makes the shares more risky.

(iv) Explain what would happen to the value of the share, using the formula
derived in part (ii). [2]

The investor bought 1,000 shares on 1 August 2014 for the price calculated
in part (iii). He received the dividend of 6 pence on 1 August 2015 and paid
the tax due on the dividend. The investor then sold the share immediately
for 120 pence. Capital gains tax was charged on all gains at a rate of 25%.
On 1 August 2014, the index of retail prices was 123. On 1 August 2015,
the index of retail prices was 126.

(v) Determine the net real return earned by the investor. [3]
[Total 14]

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29 Subject CT1 April 2016 Question 4

A loan of nominal amount £100,000 is to be issued bearing coupons payable

quarterly in arrear at a rate of 7% per annum. Capital is to be redeemed at
£108 per £100 nominal on a coupon date between 15 and 20 years inclusive
after the date of issue. The date of redemption is at the option of the
borrower.

An investor who is liable to income tax at 25% and capital gains tax at 40%
wishes to purchase the entire loan at the date of issue.

(i) Determine the price which the investor should pay to ensure a net
effective yield of at least 5% per annum. [5]

(ii) Explain the significance of the redemption date being at the option of the
borrower in relation to your calculation in part (i). [2]
[Total 7]

30 Subject CT1 April 2016 Question 9

In January 2014, the government of a country issued an index-linked bond

with a term of two years. Coupons were payable half-yearly in arrear, and
the annual nominal coupon rate was 6%. The redemption value, before
indexing, was £100 per £100 nominal. Interest and capital payments were
indexed by reference to the value of an inflation index with a time lag of six
months.

A tax-exempt investor purchased £100,000 nominal at issue and held it to

redemption. The issue price was £97 per £100 nominal.

The inflation index was as follows:

Date Inflation Index

July 2013 120.0
January 2014 122.3
July 2014 124.9
January 2015 127.2
July 2015 129.1
January 2016 131.8

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(i) Set out a schedule of the investor’s cashflows, showing the amount and
month of each cashflow. [3]

(ii) Determine the annual effective real yield obtained by the investor to the
nearest 0.1% per annum. [5]
[Total 8]

31 Subject CT1 April 2016 Question 11

An investor is considering the purchase of 10,000 ordinary shares in

Enterprise plc.

Dividends from the shares are payable half-yearly in arrear. The next
dividend is due in exactly six months and is expected to be 6.5 pence per
share.

The required rate of return is 6% per half-year effective and an estimated

rate of future dividend growth is 2% per half-year.

(i) Calculate, showing all working, the maximum price that the investor
should pay for the shares. [4]

As a result of a recently announced expansion plan, the investor increases

the estimated rate of future dividend growth to 2.5% per half-year.

(ii) (a) Calculate, showing all working, the maximum price the investor
should now pay for the shares.

(b) Explain the difference between your answers to part (i) and part
(ii)(a). [2]

It is rumoured that new legislation may affect the operation of Enterprise plc.

As a result, the investor decides to increase her required rate of return to 7%

per half-year effective. The estimated dividend growth rate remains at 2%
per half-year

(iii) (a) Explain why it might be appropriate for the investor to increase her
required rate of return.

(b) Calculate the maximum price that the investor should now pay for
the shares.

(c) Explain the difference between your answers to part (i) and part
(iii)(b). [3]

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In the prevailing economic circumstances, investors are expecting lower

inflation in the wider economy.

As a result, the investor decides to reduce both the assumed rate of dividend
growth and her required rate of return to 1% and 5% per half-year effective
respectively.

(iv) (a) Explain why it is appropriate for the investor to reduce both the
future dividend growth rate and the required rate of return in this
case.

(b) Calculate the maximum price that the investor should now pay for
the shares.

(c) Explain the difference between your answers to part (i) and part
(iv)(b). [5]
[Total 14]

32 Subject CT1 September 2016 Question 5

A zero-coupon bond was issued on 1 January 1975 with a redemption date

of 1 January 2015. An investor bought the bond to provide a yield to
maturity of 5% per annum convertible half yearly. On a particular date the
borrower defaulted, repaying 80% of the capital to all bondholders. The
investor obtained a rate of return until the date of default which was
equivalent to a force of interest of 4.8% per annum.

Determine the date on which the borrower defaulted. [5]

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33 Subject CT1 April 2017 Question 7

A fixed-interest bond was issued on 1 January 2017 with a term of 20 years

and is redeemable at 105%. The security pays a coupon of 4% per annum,
payable half-yearly in arrear.

An investor is liable to income tax at the rate of 30% and capital gains tax at
the rate of 40%. Income tax and capital gains tax are both collected on
1 June each year in relation to gross payments made during the previous
12 months.

The investor bought £10,000 nominal of the stock at an issue price of

£9,800.

(i) Show that the net redemption yield obtained by the investor will be
between 3% and 4% per annum effective. [7]

The inflation rate over the term of the bond is assumed to be 2% per annum.

(ii) Calculate the net effective annual real redemption yield that would be
obtained by the investor. [3]

(iii) Explain, without doing any further calculations, how your answers to
parts (i) and (ii) would alter if the tax were collected on 1 April instead of
1 June each year. [2]
[Total 12]

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SOLUTIONS TO PAST EXAM QUESTIONS

The solutions presented here are just outline solutions for you to use to
check your answers. See ASET for full solutions.

1 Subject CT1 April 2008 Question 4

Carrying out a capital gains test for £100 nominal:

i (4) @ 5% = 4(1.050.25 - 1) = 0.049089

D 7
(1 - t1 ) = (1 - 0.25) = 0.048611
R 108

Since i (4) > (1 - t1 ) R

D
, the investor will make a capital gain. The worst case
for the investor is that the receipt of this capital gain is delayed as long as
possible. We therefore assume that the bond is redeemed at the latest
possible date, ie in 20 years’ time.

Let P be the price per £100 nominal of the issue. The equation of value is:

P  7(1  0.25)a(4)  108v 20  0.35(108  P )v 20 @5%

20

Solving for P:

(1  0.35v 20 )P  5.25a(4)  70.2v 20

20

5.25a(4)  70.2v 20 66.641  26.458

P 20 
20 0.86809
1  0.35v
 £107.245%

So the price for £100,000 nominal is £107,245.

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2 Subject CT1 April 2008 Question 7

(i) Calculating the assumed inflation rate

Let j be the constant rate of inflation assumed by the investor in her

calculation of the share price.

A dividend of £0.12 has just been paid (and so is not included in the
calculations). The timeline below shows the cashflows for the investor (in £):

-2.60 0.12(1+j) 0.12(1+j)² ...

0 1 2 ... time

Working in pounds, and using an interest rate of 6% pa effective, the

equation of value used by the investor is:

2.60 = 0.12(1 + j )v + 0.12(1 + j )2 v 2 + 

Ê 1 + j (1 + j )2 ˆ
= 0.12 Á + 2
+ ˜
Ë 1.06 1.06 ¯

0.12(1+ j ) 1+ j
The RHS is an infinite geometric series with a = 1.06
and r = 1.06
.

Summing this gives:

0.12(1 + j )
1.06 0.12(1 + j )
2.60 = =
1+ j 1.06 - (1 + j )
1-
1.06

Rearranging and solving for j gives an assumed rate of inflation of:

2.60[1.06 - (1 + j )] = 0.12(1 + j ) fi 2.72 j = 0.036 fi j = 1.3235%

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(ii) Real rate of return

The timeline below shows the investor’s cashflows at each future time:

2 12
-2.60 0.12(1.03) 0.12(1.03) ... 5 + 0.12(1.03)

0 1 2 ... 12 time

We need to convert each of the cashflows into Time 0 monetary amounts.

Time Cashflow Cashflow converted to Time 0 money

0 -2.60 -2.60
0.12(1.03)
1 0.12(1.03) = 0.12
1.03
0.12(1.03)2
2 0.12(1.03)2 = 0.12
1.032
… … …
5 + 0.12(1.03)12 5
12 5 + 0.12(1.03)12 12
= + 0.12
1.03 1.0312

Using the final column of the table, we can set up an equation of value for
the investor’s cashflows in real terms:

5v 12
2.60 = 0.12a12 +
1.0312

0.12
The share pays real dividends of 2.6
= 4.62% and the price paid (2.60) is

much less than the real sale price amount ( 5

1.0312 )
= 3.51 . Hence the yield

will be much more than 4.62%. Using trial and error, we get:

i = 7% fi RHS = 2.5102
i = 6.5% fi RHS = 2.6262

Interpolating between these values gives a real rate of return of:

2.60 - 2.6262
i = 6.5 + (7 - 6.5) = 6.61% pa
2.5102 - 2.6262

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3 Subject CT1 September 2008 Question 1

Think of the time at which the government bill is purchased as time 0. Using
the inflation index given to convert the redemption payment of £100 to a time
0 monetary amount gives a value of:

220
100 
222

The equation of value for the transaction in real terms is therefore:

220 91
95  100   v 365
222

Solving this gives:

v  0.844139  i  0.184639

The real rate of return is therefore 18.46% pa.

4 Subject CT1 September 2008 Question 8

(i) Net rate of return

Investment A

Since the amount of the investment returned at the end of the 10 years is
equal to the amount invested, there is no capital gain.

The equation of value to solve for the net interest rate is (in millions):

1  0.1 (1  0.4)a10  v 10  1  0.06a10  v 10

The net income of 0.06 represents interest of 6% pa on the initial investment

of 1, which is returned at the end of the 10 years. It is therefore clear that
the net rate of return on Investment A is 6% pa.

Investment B

No income is received during the course of the ten years under Investment
B, so no income tax will be payable.

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The initial investment is £1 million. After 10 years, this has accumulated to:

1,000,000(1.1)10

The capital gain is therefore:

1,000,000(1.1)10  1,000,000  1,000,000(1.110  1)

This gives a capital gains tax liability of:

0.4  1,000,000(1.110  1)

So, the equation of value for Investment B is (in millions):

 
1  1.110 v 10  0.4 1.110  1 v 10

This gives:

1.9562455v 10  1  i  6.94%

Hence, the net rate of return on Investment B is 6.94% pa.

Investment C

This is the same as Investment B, so the accumulated value of the

investment after 10 years will be as calculated above. Now, however,
indexation of capital gains is allowed, with the amount of the initial
investment being increased in line with inflation at 4% pa. The capital gain is
therefore:

1,000,000(1.1)10  1,000,000(1.04)10  1,000,000(1.110  1.0410 )

This gives a capital gains tax liability of:

0.4  1,000,000(1.110  1.0410 )

So, the equation of value for Investment C is (in millions):

 
1  1.110 v 10  0.4 1.110  1.0410 v 10

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This gives:

2.1483432v 10  1  i  7.95%

Hence, the net rate of return on Investment C is 7.95% pa.

(ii) Explanation

Why the return on Investment C exceeds that on Investment B

Investments B and C are the same except for the rules surrounding the
payment of capital gains tax. Since indexation of capital gains is allowed for
Investment C, there is a lower capital gain for tax purposes and hence a
lower capital gains tax liability than for Investment B. This means that the
investor pays less tax under Investment C and hence receives a higher
return.

Why the return on Investment B exceeds that on Investment A

The returns from Investment A and Investment B are the same when tax is
ignored, as both investments give a gross return of 10% pa. The tax on
income and that on capital gains are also the same. However, when
comparing these investments, the tax on Investment A is paid sooner than
that on Investment B, as it is paid as soon as the income is received during
the term of the investment, rather than in a lump sum at the end. Since the
tax payment is deferred under Investment B, this gives a higher return than
Investment A.

5 Subject CT1 April 2009 Question 10

(i) Price paid by the original investor

Carrying out a capital gains test for £100 nominal:

i (4) @ 8% = 4(1.080.25 - 1) = 0.077706

D 11
(1 - t1 ) = (1 - 0.3) = 0.066957
R 115

Since i (4) > (1 - t1 ) R

D
, the investor makes a capital gain. The worst case for
the investor is that the receipt of this capital gain is delayed as long as
possible. We therefore assume that the bond is redeemed at the latest
possible date, ie 1 January 2020. This gives a term of 15 years.

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Letting P1 be the price per £100 nominal of the bond:

P1 = 11(1 - 0.3)a(4) + 115v 15 - 0.25(115 - P1 )v 15 @ 8%

15

(1 - 0.25v 15 )P1 = 7.7a(4) + 86.25v 15

15

7.7a(4) + 86.25v 15 67.854 + 27.190

15
P1 = =
1 - 0.25v 15 0.92119
= £103.174

(ii) Price at which the investor sells the bond

Carrying out the capital gains test from the point of view of the fund:

i (4) @ 9% = 4(1.090.25 - 1) = 0.0871127

D 11
(1 - t1 ) = 1 ¥ = 0.0956522
R 115

Since i (4) < (1 - t1 ) R

D
, the fund makes a capital loss. The worst case for the
fund is that this capital loss is received at the earliest possible date. We
therefore assume that the bond is redeemed on 1 January 2015. This gives
a remaining term of 7 years.

Letting P2 be the price per £100 nominal paid by the fund:

P2 = 11a(4) + 115v 7 @ 9%
7
P2 = 57.197 + 62.909 = £120.106

(iii) Net yield convertible quarterly

For £100 nominal the original investor will receive 12 net quarterly coupons
of (1 - 0.3) ¥ 11
4
= 1.925 and make a capital gain of 120.106 - 103.174
= 16.932 when the stock is sold. Working in quarters the equation of value
is:

103.174 = 1.925a + 120.106v 12 - 0.25 ¥ 16.932v 12 @ i%

12
12
= 1.925a + 115.873v
12

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As the bond pays net coupons of 1.925% and the price paid is less than the
sale price after tax, the yield will be greater than 1.925%. Using trial and
error, we get:

i = 3% fi RHS = 100.432
i = 2.5% fi RHS = 105.904

Using interpolation, we get:

103.174 - 105.904
i = 2.5 + (3 - 2.5) = 2.75%
100.432 - 105.904

So the net yield convertible quarterly is:

4 ¥ 2.75% = 11.0%

6 Subject CT1 September 2009 Question 3

Date Cashflow Real cashflow

31.12.05 –78 –78
147.7
31.12.06 4.1 4.1 ¥ = 3.94765
153.4
147.7
31.12.07 4.6 4.6 ¥ = 4.28386
158.6
147.7
31.12.08 5.1 + 93 = 98.1 98.1 ¥ = 87.76118
165.1

The equation of value with the real cashflows is:

78 = 3.94765v + 4.28386v 2 + 87.76118v 3

Using trial and error with linear interpolation gives:

i = 7% fi RHS = 79.070
i = 7.5% fi RHS = 78.023
i = 8% fi RHS = 76.996

Ê 78 - 78.023 ˆ
fi i = 7.5% + Á ¥ (8% - 7.5%) = 7.51%
Ë 76.996 - 78.023 ˜¯

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7 Subject CT1 September 2009 Question 4

(i) Price

Let P denote the price per £100 nominal of the bond. Then:

P = 0.8 ¥ 5 a(2) + 100v 20 @ 6%

20
= 4 ¥ 11.63946 + 31.18047
= £77.738%

(ii) Gross redemption yield

The equation of value before tax is:

77.738 = 5 a(2) + 100v 20

20

Using trial and error with linear interpolation gives:

i = 7% fi RHS = 79.723
i = 8% fi RHS = 71.508
i = 7.5% fi RHS = 75.452

Interpolating between 7% and 7.5% gives an annual effective GRY of:

Ê 77.738 - 79.723 ˆ
i = 7% + Á ¥ (7.5% - 7%) = 7.23%
Ë 75.452 - 79.723 ˜¯

(iii) Real rate of return

Since inflation is constant, the real annual GRY is:

i - j 0.0723 - 0.03
i¢ = = = 4.1%
1+ j 1.03

8 Subject CT1 April 2010 Question 2

(i) Cashflows received and timing of cashflows

A timeline showing the times of cashflows under the index-linked bond is

given below:

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R
– P C1 C2 C3 C4

1/08 7/08 1/09 7/09 1/10 time

The first cashflow is the amount paid to buy the bond. The investor
purchases £100,000 nominal, which is the same as 1,000 lots of £100
nominal of the bond. So, since the price per £100 nominal is £98:

P = 98 ¥ 1,000 = £98,000

This is a negative cashflow from the investor’s point of view.

The first positive cashflow is the first half-yearly coupon received in July
2008. The nominal amount of this coupon is £2 per £100 nominal, which
needs to be increased to allow for 6 months of inflation. Allowing for the 6
month time lag, and using I for the inflation index value, this is:

IJan 08 112.1
C1 = 2 ¥ ¥ 1,000 = 2 ¥ ¥ 1,000 = £2,028.96
IJuly 07 110.5

The other cashflows are calculated similarly and are shown in the table
below:

Date Cashflow Calculation Amount

January
-P -98 ¥ 1,000 -£98,000
2008
July IJan 08 112.1
C1 2¥ ¥ 1,000 = 2 ¥ ¥ 1,000 £2,028.96
2008 IJuly 07 110.5

January IJuly 08 115.7

C2 2¥ ¥ 1,000 = 2 ¥ ¥ 1,000 £2,094.12
2009 IJuly 07 110.5

July IJan 09 119.1

C3 2¥ ¥ 1,000 = 2 ¥ ¥ 1,000 £2,155.66
2009 IJuly 07 110.5

January IJuly 09 123.2

C4 2¥ ¥ 1,000 = 2 ¥ ¥ 1,000 £2,229.86
2010 IJuly 07 110.5

January IJuly 09 123.2

R 100 ¥ ¥ 1,000 = 100 ¥ ¥ 1,000 £111,493.21
2010 IJuly 07 110.5

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(ii) Money yield

The money yield is the rate of interest, i , that satisfies the equation of value:

98,000 = 2,028.96v 0.5 + 2,094.12v + 2,155.66v 1.5 + 2, 229.86v 2 + 111, 493.21v 2

i = 11% fi RHS = £97,955.89

i = 10.9% fi RHS = £98,127.49

So the money yield is 11.0% to the nearest 0.1%.

9 Subject CT1 April 2010 Question 3

Working in thousands, a timeline of the cashflows under the investment is

given below:

2
-450 40 40 40(1.03 ) 40(1.03 ) 40(1.03 ) ...

1/1/2011 1/1/2013 1/7/2013 1/1/2014 1/7/2014 1/1/2015 ...

The NPV of the investment is:

NPV = -450 + 40v 2 + 40v 2.5 + 40(1.03)v 3 + 40(1.03)v 3.5 + 40(1.03)2 v 4 + 

( )(
= -450 + 40v 2 1 + v 0.5 1 + 1.03v + 1.032 v 2 +  )
We have an infinite geometric series in the second brackets with a = 1 and
r = 1.03v . Hence:

(
NPV = -450 + 40v 2 1 + v 0.5 ¥ ) 1
1 - 1.03v

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Evaluating this at 8% pa interest gives:

NPV = -450 +
1.08
40
2 (1 + 1.08 ) ¥ 1 - 1
-0.5
1.03
1.08

40
= -450 + ¥ 1.96225 ¥ 21.6
1.082
= -450 + 1, 453.519

= 1,003.519

So the NPV of the investment is £1,003,519.

10 Subject CT1 April 2010 Question 4

We’re given a net real yield of 5% pa, but it will be easiest to use a money
rate to calculate the price of the bond. Since inflation is constant over the
term of the bond, the money rate of return, i , is given by:

1 + i = (1.05)(1.028571) = 1.08000

So, we can use a net money rate of 8% pa.

Carrying out a capital gains test:

i (2) @ 8% = 2(1.080.5 - 1) = 7.846%

D 6
(1 - t1 ) R = (1 - 0.2) 105 = 4.5714%

Since i (2) > (1 - t1 ) R

D
, the investor makes a capital gain.

Letting P represent the price per £100 nominal of the bond:

P = 6(1 - 0.2)a(2) + 105v 10 - 0.25(105 - P )v 10

10

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Rearranging this gives:

( )
P 1 - 0.25v 10 = 4.8a(2) + 78.75v 10
10
@ 8% pa
0.88420P = 69.31665
P = £78.39

11 Subject CT1 September 2010 Question 1

We are purchasing £100 nominal so we will receive coupons of 3.5% of

£100 nominal (ie £3.50) per annum. Since the payments are twice yearly
that’s £1.75 per payment.

Drawing a time line, we have:

1.75 1.75 1.75

1/6/9 1/12/9 1/6/10 1/12/10

20/8/9

The PV on the 1 December 2009:

3.5
PV1/ 12 / 9 = 3.5a(2) =
• d (2)

Calculating this at 10% gives:

3.5 3.5
PV1/ 12 / 9 = -½
= = 37.6042
2[1 - 1.1 ] 0.0930748

So the PV on the purchase date of 20 August 2009 is:

103 103
-
PV20 / 8 / 9 = 37.6042v 365 = 37.6042 ¥ 1.1 365 = £36.61

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12 Subject CT1 September 2010 Question 2

(i)(a) Calculate gross convertible rate of return

Since there is no capital gain or loss, the capital gains test gives:

D 4 
i (2) = fi i (2) = = 0.036
R 110

ie 3.64% (3 SF)

(i)(b) Calculate the gross effective rate of return

Using our answer from part (i)(a), we have:

Ê   ˆ2
0.036
1 + i = Á1 + fi i = 3.67%
Ë 2 ˜¯

(ii) Calculate the net effective rate of return

Since there is no capital gain or loss, we have:

D 4 
i (2) = (1 - t1 ) fi i (2) = 0.75 ¥ = 0.027
R 110

Therefore:

(
i = 1+
 2
0.027
2 ) - 1 = 0.027459 , ie 2.75% (3 SF)

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13 Subject CT1 April 2011 Question 3

(i) The real rate of return

Date Money cashflows RPI Real cashflows

1/7/05 -135,000 121.4 -135,000
121.4
30/6/06 +7,900 125.6 7,900 ¥ = 7,635.828
125.6
121.4
30/6/07 +8,400 131.8 8, 400 ¥ = 7,737.178
131.8
121.4
30/6/08 +8,800 138.7 8,800 ¥ = 7,702.379
138.7
121.4
30/6/09 +9,400 145.3 9, 400 ¥ = 7,853.820
145.3
121.4
30/6/10 +10,100 + 151,000 155.2 161,100 ¥ = 126,015.077
155.2
=161,100

The real rate of return, iˆ , satisfies the following equation of value:

135,000 = 7,635.828vˆ + 7,737.178vˆ 2 + 7,702.379vˆ 3 + 7,853.820vˆ 4 + 126,015.077vˆ 5

1
where vˆ = .
1 + iˆ

Using iˆ = 3% , RHS = 137,434.955.

Using iˆ = 3.5% , RHS = 134,492.919

Interpolating:

(137, 434.955 - 135,000)

iˆ = 3% + ¥ 0.5% = 3.414%
(137, 434.955 - 134, 492.919)

So the real rate of return is approximately 3.4% pa.

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(ii) The effect on the real rate of return of a higher RPI in June 2008

The real value of the June 2008 dividend is calculated as:

121.4
8,800 ¥
RPI for June 2008

So, if the RPI for June 2008 had been higher than 138.7, the real value of
the June 2008 payment would have been lower and therefore the real rate of
return would have been lower.

14 Subject CT1 April 2011 Question 5

(i) Capital gain

The investor wishes to make a net (ie after-tax) effective return of at least
5%, so i (2) = 4.939% .

The annual coupon per £100 nominal is £6, the investor’s income tax rate is
20% and the redeemable value is £105, so:
D 6
(1 - t1) = 0.8 ¥ = 4.5714%
R 105

D
Since i (2) > (1 - t1), the investor will have to make a capital gain in order
R
to make a net effective return of 5%.

(ii) Effect of capital gain on assumptions made in calculating the price

The capital gains test is made for two reasons:

1. to see if the investor needs to pay capital gains tax – in this case, the
investor will pay tax at 35% on the capital gain made
2. to work out which of the optional redemption dates we’re going to
choose when calculating the price – in this case, we assume the latest
date possible, ie after 25 years.

Since the investor makes a capital gain, the return would be greater the
earlier the redemption date. Therefore, assuming the worst case scenario
for the investor, we assume the latest redemption date. If we calculate the
maximum price that will give the required return to the investor in the worst
case scenario, the investor will then earn at least this return whatever the
redemption date.

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(iii) The maximum price the investor should pay

Considering cashflows per £100 nominal of the bond:

1/4/11 1/10/11 1/4/12 1/4/36 time

1/6/11
.............

+3 +3 +3+105 cashflows

-P
Investor
purchases
bond

We can write the price equation as though the investor were buying it on
2
1 April 2011 and then multiply it by 1.05 12 to accumulate the value forward
from 1 April 2011 to 1 June 2011. The maximum price, P , that the investor
will be prepared to pay for the bond is:

P = È(1 - t1)Da(2) + Rv n - t2 (R - P )v n ˘ (1.05) 12 @5%

2

Î n ˚
= È0.8 ¥ 6a(2) + 105v 25 - 0.35(105 - P )v 25 ˘ (1.05) 12
2

Î 25 ˚
2 2 2 2
= 4.8a(2) (1.05) 12 + 105v 25 (1.05) 12 - 0.35 ¥ 105v 25 (1.05) 12 + 0.35 ¥ Pv 25 (1.05) 12
25

Rearranging and calculating:

(
P 1 - 0.35v 25 (1.05)
2
12
) = 4.8a (2)
25
2
(1.05) 12 + 0.65 ¥ 105v 25 (1.05)
2
12

P (1 - 0.35 ¥ 0.2953 ¥ 1.00816 ) = (4.8 ¥ 14.0939 ¥ 1.012348 ¥ 1.00816)

+(68.25 ¥ 0.2953 ¥ 1.00816)
P (1 - 0.1042) = 69.0452 + 20.3187
89.3639
fi P= = 99.759
0.8958

The maximum price the investor would pay for the whole £100,000 loan is
£99,759.

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15 Subject CT1 September 2011 Question 7

(i) Gross effective rate of return

Let P be the sale price of the share in five years’ time. If the investment
manager buys the share now for 12p, then because no dividends are
expected in the next 5 years, the gross rate of return earned on the
investment is the interest rate that solves the following equation of value:

12(1 + i )5 = P

The following timeline shows the expected dividends:

2
2 2.5 2.5(1.01 ) 2.5(1.01 ) ...

0 5 6 7 8 9 ...

P is the PV at time 5 of the dividends to be received after time 5:

P = 2v + 2.5v 2 + 2.5(1.01)v 3 + 2.5(1.01)2 v 4 + 

= 2v + 2.5v 2 È1 + (1.01)v + (1.01)2 v 2 + ˘

Î ˚

The infinite summation in the set of square brackets is an infinite geometric

progression, with a = 1 and r = (1.01)v . Hence:

Ê 1 ˆ
P = 2v + 2.5v 2 Á
Ë 1 - (1.01)v ¯˜
2 2.5 1
= + ¥
1.08 1.082 1 - 1.01
1.08

= 34.9206p

Substituting this value for P into our equation of value, we obtain:

12(1 + i )5 = 34.9206 fi i = 23.817% pa

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(ii) Net effective rate of return

The capital gain achieved by the investor is 34.9206 - 12 = 22.9206 .

So the investor’s CGT liability is 22.9206 ¥ 0.25 .

This tax will need to be paid at time 5, when the share is sold. The net rate
of return earned from this investment is the solution of the equation of value:

12(1 + i )5 = 34.9206 - 22.9206 ¥ 0.25 = 29.1905 fi i = 19.457% pa

(iii) Net effective real rate of return

From (ii) we know that the net effective money rate of return (ie ignoring any
allowance for inflation) is 19.457% pa.

Given a constant rate of inflation of 4% pa, the net effective real rate of
return is:

0.19457 - 0.04
i¢ = = 14.863% pa
1.04

16 Subject CT1 April 2012 Question 6

(i) The price of the bond on 1 March 2007

The price, P1 , per £100 nominal of the bond on 1 March 2007 is:

P1 = 5a18 + 100v 18 @ 3.158%

= £125 per £100 nominal

(ii) The price of the bond on 1 March 2012

The price, P2 , of the bond on 1 March 2012 is:

P2 = 5a13 + 100v 13 @ 5%

If the GRY is 5% and the annual coupon return is 5%, we are earning no
capital gain (or loss), so the price we pay must be equal to the redemption.

The price of the bond on 1 March 2012 is £100 per £100 nominal.

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(iii) The gross annual rate of return earned by the investor

The equation of value is:

125 = 5a5 + 100v 5 @ i %

The investor is receiving £5 coupon per year along with £100 at the end of
the five-year period. This adds up to £125 with no discounting. Therefore
the i that satisfies the equation of value is i = 0% .

(iv) The effect of a longer term

In part (i), we calculated the price, P1 , of the bond on 1 March 2007 as:

P1 = 5a18 + 100v 18 @ 3.158% = 125

With a redemption date of 2035, the new price, P1¢ would be found as:

P1¢ = 5a28 + 100v 28 @ 3.158%

Since the coupons are being earned for a longer period of time, this will help
to offset the capital loss. The investor will be prepared to pay more for the
bond, so it will rise in price.

In part (ii), we calculated the price, P2 , of the bond on 1 March 2012 as:

P2 = 5a13 + 100v 13 @ 5% = £100

With a redemption date of 2035, the new price, P2¢ would be found as:

P2¢ = 5a23 + 100v 23 @ 5% = £100

The price is unchanged at £100 because the investor is earning an annual

return of 5% from the coupons alone.

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The longer redemption date has increased the March 2007 price (the
purchase price for the investor) but left the March 2012 price unchanged (the
selling price for the investor), so the investor would make a larger capital
loss. Since the income earned from the coupon payments is unchanged, the
investor’s return would be lower, ie less than 0%.

17 Subject CT1 April 2012 Question 9

(i) The present value of the dividend stream

The PV of the future dividends on 100 shares on 1 January 2012 is:

PV = 35(1.03)v + 35(1.03)(1.05)v 2 + 35(1.03)(1.05)(1.06)v 3

+ 35(1.03)(1.05)(1.06)2 v 4 + ◊ ◊ ◊
= 35(1.03)v + 35(1.03)(1.05)v 2
+ 35(1.03)(1.05)(1.06)v 3 (1 + 1.06v + 1.062 v 2 + ◊ ◊ ◊)

Using the formula for an infinite geometric progression for the final
expression:

È 1 ˘
PV = 35(1.03)v Í1 + 1.05v + (1.05)(1.06)v 2 ¥
Î 1 - 1.06v ˙˚

1.03 ÈÍ 1.05 1.05 ¥ 1.06 1 ˘˙

= 35 ¥ 1+ + ¥
1.08 Í 1.08 1.082 1 - 1.06 ˙
Î 1.08 ˚
= £1,785.81

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(ii) The expected real rate of return

The following table shows the real and money cashflows per 100 shares.

Money cashflows Inflation Real cashflows

Date
(£) index (£)
1/1/12 -1,720.00 110.0 -1,720.00
+35(1.03) 110
31/12/12 112.3 36.05 ¥ = 35.31167
= +36.05 112.3
+35(1.03)(1.05) 110
31/12/13 113.2 37.8525 ¥ = 36.78246
= +37.8525 113.2
+35(1.03)(1.05)(1.06) 110
31/12/14 113.8 40.12365 ¥ = 38.78384
= +40.12365 113.8
110
1/1/15 +1,800.00 113.8 1,800.00 ¥ = 1,739.89455
113.8

The real rate of return, i ¢ , satisfies the following equation of value:

1,720 = 35.31167v + 36.78246v 2 + 1,778.67840v 3

1
where v = .
1+ i ¢

Using i ¢ = 2.5% , RHS = 1,721.14.

Using i ¢ = 3% , RHS = 1,696.70.

Interpolating gives:

1,720 - 1,721.14
i ¢ = 2.5% + (3% - 2.5%) = 2.52%
1, 696.70 - 1,721.14

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18 Subject CT1 April 2013 Question 4

(i) Price per share

30  1.05 30  1.05
2
30  1.05
3
30  1.05
4
... payments

...
0 1 2 3 4 time

The present value of the future dividends is:

PV = 30 ¥ 1.05v + 30 ¥ 1.052 v 2 + 30 ¥ 1.053 v 3 + 

= 30 ¥ 1.05v È1 + (1.05v ) + (1.05v ) + (1.05v ) + ˘

2 3
ÎÍ ˚˙

Summing using a geometric series:

30 ¥ 1.05v 30 ¥ 1.05 1.09

PV = = = 787.5 pence
1 - 1.05v 1 - 1.05 1.09

(ii)(a) Higher dividend growth rate

If the future dividends grow more quickly, they will have a higher present
value. So the price the investor is prepared to pay will increase.

(ii)(b) Higher general future inflation

The calculation is not affected by the general level of inflation. So

theoretically the price the investor is prepared to pay will be the same.

However, if the company can increase its prices in line with the new higher
level of inflation, it may be able to generate higher profits, and hence pay
higher dividends. In this case the dividend growth rate will increase, and the
price the investor should pay may go up.

But this is only an increase in value in nominal terms. If the investor wishes
to maintain his real rate of return (which is probably more likely), he will now
need a nominal return higher than 9%. So the price that he is prepared to
pay would stay about the same, depending on the nominal rate of return
used in the calculation.

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(ii)(c) Higher general economic uncertainty

The level of uncertainty is not built into the model. So again the price the
investor is prepared to pay will remain the same.

However, in this case the investor may require a higher rate of return to
compensate him for the greater uncertainty. If this is true, the price he is
prepared to pay should decrease.

19 Subject CT1 April 2013 Question 9

(i) Price at which the investor bought

Applying the capital gains tax test, we have:

(
i (2) at 6% = 2 1.06½ - 1 = 0.059126)
D 8
and: (1 - t1 ) = 0.7 ¥ = 0.056
R 100

Since i (2) > (1 - t1 ) R

D
the investor will need to make a capital gain in order to
achieve his 6% yield.

So the worst case scenario for the investor is for this capital gain to be
deferred for as long as possible. We assume for the purposes of the
calculation that the bond is redeemed at the last possible date, on 1 January
2022.
100
4 4 4 ... 4

1/1/11 1/7/11 1/1/12 1/7/12 ... 1/1/22

1/5/11
purchase date

- t2 (100 - P ) v
4 8 8
10 12 10 12
P = (1 - t1 )(1 + i ) 12 8a(2) + 100 v
11

- 0.25 (100 - P ) v
4 8 8
10 12 10 12
= 5.6(1 + i ) 12 a(2) + 100v
11

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Rearranging and evaluating at 6% gives:

4 1 - 1.06 -11
P ÊÁ1 - 0.25v ˆ
8
10 12 10 8
= 5.6(1.06) 12 + 75v 12
Ë ¯˜ 0.059126
0.8657202P = 45.69838 + 40.28395
85.98233
P= = £99.31885 per £100 nominal
0.8657202

(ii) Price at which the investor sold

Carrying out the capital gains tax test again:

( )
i (2) at 7% = 2 1.07½ - 1 = 0.068816

D 8
and: (1 - t1 ) = 1¥ = 0.08
R 100

Since i (2) < (1 - t1 ) R

D
the fund must make a capital loss to achieve its 7%
return. The worst case scenario for the fund will therefore be for the bond to
be redeemed as soon as possible. So we must now assume that
redemption takes place on 1 January 2017.

100
4 4 4 ... 4

1/1/13 1/7/13 1/1/14 1/7/14 ... 1/1/17

1/4/13
purchase date

The equation of value for the fund is:

3 9
3 12
P = (1 + i ) 12 8a(2) + 100 v
4

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Evaluating this at 7% gives:

1 - 1.07 -4
1
33
P = 8 ¥ 1.07 4 +100v 4
0.068816
= 28.03408 + 77.59091
= £105.62499 per £100 nominal

(iii) Net effective yield

The cashflows (before tax) for the first investor are as follows:

-99.31885 105.62499

4 4 4 4

1/1/11 1/7/11 1/1/12 1/7/12 1/1/13

1/5/11 1/4/13
purchase date sale date

So the equation of value is:

4
99.31885 = 5.6 (1 + i ) 12 a(2) + 105.62499v
11
112
2

- 0.25 (105.62499 - 99.31885) v

11
112

4
= 5.6 (1 + i ) 12 a(2) + 104.04845v
11
112
2

Evaluating the right hand side of this equation at both 8% and 9%:

i = 8% fi RHS = 5.6 ¥ 1.084 /12 ¥ 1.8182439 + 89.778722 = 100.226

i = 9% fi RHS = 5.6 ¥ 1.094 /12 ¥ 1.797839 + 88.206684 = 98.568

We see that the price actually paid by the investor (99.31885) lies in
between these two figures. Therefore the yield obtained by the investor
must lie between 8% and 9% per annum.

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20 Subject CT1 September 2013 Question 3

We are given i (2) = 0.03 , so:

2 2
Ê i (2) ˆ Ê 0.03 ˆ
i = Á1 + ˜ - 1 = ÁË1 + ˜ - 1 = 3.0225%
Ë 2 ¯ 2 ¯

(i) Price at outset

P = 4a(2) + 100v 10
10

1 - 1.030225 -10
=4 + 100(1.030225)-10
0.03
= 34.3373 + 74.2470
= £108.58

(ii) Price after 91 days

Evaluating the cashflows at the outset and then accumulate for ¼ of a year:

( )
P = 4(0.75)a(2) + 100v 10 (1 + i )0.25
10
Ê 1 - 1.030225 -10 ˆ
= Á 4 ¥ 0.75 + 100(1.030225)-10 ˜ (1.030225)0.25
Ë 0.03 ¯
= (25.7530 + 74.2470)(1.030225)0.25
= £100.75

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21 Subject CT1 September 2013 Question 5

(i) Price of bond issued by Country B

For Country A, the rate of return is:

101 = 106v fi i = 4.9505%

For Country B there are four possible outcomes (as listed in the question):

PV PV evaluated at i = 4.9505% Probability

0 0 0.1
100v 95.2830 0.2
50v 47.6415 0.3
106v 101 0.4

EPV = Â PV ¥ prob
= 95.2830 ¥ 0.2 + 47.6415 ¥ 0.3 + 101 ¥ 0.4
= €73.75

So the price paid for the bond issued by Country B is €73.75.

(ii) GRY

We can calculate the GRY using the price and the cashflow:

73.75 = 106v fi i = 43.7307%

(iii) Higher return from Country B

There is more uncertainty about the cashflows for the bond from Country B.
This means there is more risk and investors will want a higher expected
return to compensate for that risk.

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22 Subject CT1 September 2013 Question 8

Let X be the amount of money Mrs Jones invests. A timeline showing the
investment described in the question is as follows:
20
X X  1.05
£10,000 pa annuity
zero coupon bond monthly in arrear

0 i = 5% 20 (2) 45
i = 4%
RPI=143 RPI=340

(i) Money invested

The present value of the annuity at time 20 is:

10,000a(12)
25

We are given i (2) = 0.04 , so:

2 2
Ê i (2) ˆ Ê 0.04 ˆ
i = Á1 + ˜ - 1 = ÁË1 + ˜ - 1 = 4.04%
Ë 2 ¯ 2 ¯

i (12) = 12 ÊÁ (1 + i ) 12 - 1ˆ˜ = 12 ÊÁ (1.0404) 12 - 1ˆ˜ = 3.96707%

1 1

Ë ¯ Ë ¯

Equating the accumulated value of the investment to the present value of the
annuity, we get:

1 - (1 + i )-25
X (1.05)20 = 10,000a(12) = 10,000
25 i (12)
1 - (1.0404)-25
= 10,000 = 158, 422.31
0.0396707

Solving this equation:

X = 158, 422.31(1.05)-20 = 59,707.70

In other words Mrs Jones has to invest £59,708 (5SF) in the zero-coupon
bond.

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(ii) Annual effective real yield

The annual rate of inflation over the 20-year period is:

1
Ê 340 ˆ 20
j =Á - 1 = 4.4256%
Ë 143 ˜¯

The real yield is:

i - j 0.05 - 0.044256
i¢ = = = 0.550%
1+ j 1.044256

(iii) Net effective real yield

The capital gain is:

( )
X (1.05)20 - X = 59,708 1.0520 - 1 = 98,714.60

The capital gains tax is 25% of this, so the proceeds from the zero-coupon
band are therefore:

X (1.05)20 - 0.25 ¥ 98,714.60 = 133,743.65

The return on the bond is given by i , where:

X (1 + i )20 = 133,743.65 fi i = 4.1147%

The real yield is:

i - j 0.041147 - 0.044256
= = -0.298%
1+ j 1.044256

(iv) Why a negative real rate of return

The rate of inflation (4.4256%) exceeds the nominal return on the money
invested (4.1147%), which leads to a negative real rate of return. Effectively
the tax and inflation have eroded the real value of the investor’s capital.

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23 Subject CT1 April 2014 Question 4

Using the capital gains tax test:

i (2) at 6% = 0.059126

(1 - t1) RD = 0.7 ¥ 103

8
= 0.054369

Since i (2) > (1 - t1 ) R

D
we have a capital gain. The worst case would be for
this gain to be deferred for as long as possible, ie 25 years.

Allowing for both income and capital gains tax, we have:

P = 0.7 ¥ 8a(2) + 103v 25 - 0.4 (103 - P ) v 25 @ 6% pa

25

= 5.6a(2) + 103v 25 - 0.4 (103 - P ) v 25

25

1 - v 25
= 5.6 ¥ + 103v 25 - 41.2v 25 + 0.4Pv 25
i (2)

Rearranging this:

P (1 - 0.4v 25 ) = 5.6a(2) + 61.8v 25

25

P (1 - 0.4 ¥ 1.06 -25 ) = 5.6 ¥ 12.972313 + 14.399315

P = 95.9905

The price is £95.99 per £100 nominal of stock.

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24 Subject CT1 April 2014 Question 5

(i) Coupon and redemption payments

Since the coupon rate is 3% pa, we actually receive 1.5% (indexed) per half
year. So the coupon payment received on 25 April 2013 is:

171.4
0.015 ¥ ¥ 10,000 = £172.319
149.2

The coupon payment received on 25 October 2013 is:

173.8
0.015 ¥ ¥ 10,000 = £174.732
149.2

The redemption proceeds also received on 25 October 2013 are:

173.8
¥ 10,000 = £11, 648.794
149.2

(ii) Purchase price

We first calculate the real values as at 25 October 2012 of the 2013

cashflows.

The April 2013 coupon has real value:

169.4
172.319 ¥ = 170.308
171.4

The total of the final coupon and redemption proceeds (in real values) is:

169.4
(174.732 + 11, 648.794) ¥ = 11,524.196
173.8

So the real equation of value, using the effective real yield of 3.5% pa, is:

P = 170.308v 0.5 + 11,524.196v 1

= 170.308 ¥ 1.035 -0.5 + 11,524.196 ¥ 1.035 -1
= 11,301.893

So the purchase price is £11,301.89.

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25 Subject CT1 September 2014 Question 9

(i) Net cashflows

Coupons are 2% each year, so 1% each half year with tax of 25% on them.
So for £3.5m nominal the cashflows are:

3.5m
+
3.5m 3.5m 3.5m 3.5m
 0.01  0.75  0.01  0.75  0.01  0.75  0.01  0.75

1/6/12 1/12/12 1/6/13 1/12/13 1/6/14

112 116 117 120 121

We now need to inflate these cashflows using the RPI figures given below
each cashflow (which have a three month lag).

The first incoming net cashflow is the coupon paid in December 2012. This
is (working in millions of pounds):

116
C1 = 3.5 ¥ 0.01 ¥ 0.75 ¥ = 0.0271875
112

Similarly, the coupon paid in June 2013 will be:

117
C2 = 3.5 ¥ 0.01 ¥ 0.75 ¥ = 0.0274219
112

The coupon paid in December 2013 will be:

120
C3 = 3.5 ¥ 0.01 ¥ 0.75 ¥ = 0.0281250
112

The coupon paid in June 2014 will be:

121
3.5 ¥ 0.01 ¥ 0.75 ¥ = 0.0283594
112

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The redemption proceeds (which are not subject to income tax), will be:

121
3.5 ¥ 1 ¥ = 3.78125
112

So the total final cashflow is:

C4 = 0.0283594 + 3.78125 = 3.8096094

(ii) In terms of 1 June 2012 prices

We now convert these to real values (based on 1 June 2012), using the RPI
ratios given below each cashflow in this diagram (which has no time lag).

0.0271875 0.0274219 0.0281250 3.8096094

1/6/12 1/12/12 1/6/13 1/12/13 1/6/14

113 117 118 121 122

The real values in June 2012 terms of the cash flows are:

0.0271875
RC1 = = 0.0262580
117 113

0.0274219
RC2 = = 0.0262599
118 113

0.0281250
RC3 = = 0.0262655
121 113

3.8096094
RC4 = = 3.5285726
122 113

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(iii) Purchase price

The equation of value for the price of the bond, working in real terms, is:

P = RC1 ¥ 1.015 -0.5 + RC2 ¥ 1.015 -1 + RC3 ¥ 1.015 -1.5

+ RC4 ¥ 1.015 -2
= 0.0262580 ¥ 1.015 -0.5 + 0.0262599 ¥ 1.015 -1 + 0.0262655 ¥ 1.015 -1.5
+ 3.5285726 ¥ 1.015 -2
= 3.50267

So for £100 nominal (rather than £3.5m nominal) the price is:

100
3.50267 ¥ = £100.08
3.5

(iv) Explanation

If there had been no time lag, the investor’s expected net real rate of return
would be unchanged. The higher inflation would increase the cashflows
received by the investor, and then the real values would equal the original
nominal payments.

However, the investor is not protected against inflation during the last three
months for which the bond is held, due to the time lag. Since the inflation in
this period is higher than expected, the investor’s real rate of return will fall a
little. However, the effect is unlikely to be great, as the lag is not that great.

(v) Impact on market prices

The actual inflation experienced by an investor would have been unaltered.

But the money received would be less under the new arrangement.

So an investor’s real return from buying such a bond would fall. This would
make the bonds less attractive to these investors, and so the price they
would be prepared to pay would have fallen. Hence, the market prices
would have fallen.

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26 Subject CT1 April 2015 Question 6

The real equation of value for the cashflows is:

6 6 ¥ 1.06 6 ¥ 1.062
PV = ½
v½ + 1½
v 1½ + 2½
v 2½ + 
1.04 1.04 1.04

So we have:

6
v½
1.04½ 6v ½ ¥ 1.04½
175 = =
1.06v 1.04 - 1.06v
1-
1.04

At 5%, the value of the expression on the right hand side of our equation is
195.935. At 6%, the corresponding value is 148.578. So the real return is
between these two values.

At 5.4%, we obtain a value of 173.724, and at 5.3% we obtain 178.784.

Interpolating between these two figures, we find that the effective real rate of
return is approximately:

178.784 - 175
5.3% + ¥ 0.1% = 5.37% pa
178.784 - 173.724

27 Subject CT1 September 2015 Question 7

(i) Maximum rate of return

The maximum rate of return will be received after 20 years.

The equation of value is:

100 = 0.75 ¥ 4a(2) + 0.75 ¥ 7v 10 a(2) + 130v 20

10 10

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Simplifying this gives:

100 = (3 + 5.25v 10 )a(2) + 130v 20

10

Using trial and error:

i = 5% fi RHS = 97.642
i = 4% fi RHS = 112.956
i = 4.5% fi RHS = 104.953

Interpolating between these gives:

100 - 104.953
i = 4.5% + (5% - 4.5%) = 4.84% pa
97.642 - 104.953

(ii) Minimum rate of return

The minimum rate of return will be received after 10 years.

The equation of value is:

100 = 0.75 ¥ 4a(2) + 100v 10

10

Simplifying this gives:

100 = 3a(2) + 100v 10

10

Since there is no capital gain or loss, we have:

D 3
i (2) = fi i (2) = = 0.03
R 100

This gives:

2
Ê 0.03 ˆ
1 + i = Á1 + fi i = 3.0225%
Ë 2 ˜¯

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(iii) Calculate the expected rate of return

The expected return is:

(0.5 ¥ 4.84) + (0.5 ¥ 3.02) = 3.93% pa

(iv) Rate of return if the investor purchases the whole loan

The equation of value is:

100 = 0.5 ÈÍ3a(2) + 100v 10 ˘˙ + 0.5 ÈÍ(3 + 5.25v 10 )a(2) + 130v 20 ˘˙

Î 10 ˚ Î 10 ˚

Simplifying this gives:

100 = (3 + 2.625v 10 )a(2) + 50v 10 + 65v 20

10

Substituting i = 3.93% pa into the RHS of the above equation gives:

1 - 1.0393 -10
RHS = (3 + 2.625 ¥ 1.0393 -10 ) + 50 ¥ 1.0393 -10 + 65 ¥ 1.0393 -20
2(1.0393½ - 1)
= €103.72

Since this is greater than €100 the rate of return must be greater than 3.93%
pa, ie it is greater than the average rate of return an individual who
purchases a single bond will receive.

28 Subject CT1 September 2015 Question 8

(i) Characteristics of an equity

Any EIGHT of the following:

 Securities that are held by the owners of an organisation.

 Entitles their holders to a share in the net profits of the company in
proportion to the number of shares owned.
 The distribution of profits to shareholders takes the form of regular
payments of dividends.
 The cash paid out each year (dividend) depends on the company’s
profits and how much is retained by the company (which is at the
discretion of the directors).

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 Since they are related to the company profits that are not known in
advance, dividend rates are variable.
 The return on ordinary shares is made up of two components, the
dividends received and any increase in the market price of the shares.
 Higher return than for most other classes of security to compensate for
the greater risk of default, and for the variability of returns.
 Ordinary shares are the lowest ranking form of finance issued by
companies (so only receive payment in a windup after all other creditors
have been paid).
 The initial running yield on ordinary shares is low but dividends should
increase with inflation and real growth in a company’s earnings.
 Marketability of ordinary shares varies according to the size of the
company.
 Shareholders get voting rights in proportion to the number of shares
held, so shareholders may have the ability to influence the decisions
taken by the directors and managers of the company.

(ii) General formula

We will assume that dividends are paid annually with the next dividend due
in exactly one year.

Using d for the next dividend payment, g for the expected annual growth
rate and t for the tax rate on the dividends, we have the following equation
of value:

P = d (1 - t )v + d (1 - t )(1 + g )v 2 + d (1 - t )(1 + g )2 v 3 + 

Summing this geometric series gives:

d (1 - t )v
P=
1 - (1 + g )v

Let i be the interest rate. Simplifying we get:

d (1 - t ) d (1 - t )
P= =
(1 + i ) - (1 + g ) i -g

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(iii) Value to the investor

We have d = 6 , g = 0.01 , t = 0.2 and i = 0.06 . Substituting these into our

formula from part (i) gives:

6 ¥ 0.8
P= = 96
0.06 - 0.01

So the value of the share to the investor is 96 pence.

(iv) Explain

Investors will demand more return to compensate them for the increased
risk.

This will reduce the value of the share (as the denominator will increase).

(v) Net real return

The net payment will be 0.8 ¥ 6 + 120 - 0.25(120 - 96) = 118.8 . So the real
equation of value (in 2014 prices) is:

123
96 = 118.8v ¥
126

Simplifying and rearranging gives:

96 = 115.97v
115.97
1+ i = fi i = 0.208
96

So the net real rate of return is 20.8% pa.

29 Subject CT1 April 2016 Question 4

(i) Price to obtain at least 5% pa

Working in units of £100 nominal, we have D = 7 , R = 108 , t1 = 0.25 ,

i = 5% pa and p = 4 . So:

(1 - t1) RD = 0.75 ¥ 108

7
= 0.048611

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We compare this with i (4) at 5%:

i (4) = 4 È(1 + i ) - 1˘ = 4 [1.050.25 - 1] = 0.049089

1/ 4
ÍÎ ˙˚

Since the second amount is a little bigger, the investor will make a small
capital gain.

In order to ensure that the investor always makes at least 5% pa, we need to
consider the investor’s worst case scenario. The worst case is that the gain
is deferred for as long as possible, and so we should assume that the bond
is redeemed at the latest possible date.

Assuming that the bond is redeemed on the last redemption date (after 20
years), we have the following equation of value for the price of the bond:

P = 0.75 ¥ 7a(4) + 108v 20 - 0.4 ¥ (108 - P ) v 20

20

Evaluating the annuity at 5% pa, we have:

1 - v 20 1 - 1.05 -20
a(4) = (4)
= = 12.693502
20 i 0.049089

So we have:

P = 5.25 ¥ 12.693502 + 108 ¥ 1.05 -20 - 0.4 ¥ (108 - P ) ¥ 1.05 -20

Rearranging this equation, we find that:

0.849244P = 91.063324

This gives us P = 107.229 , or about £107.23 per £100 nominal.

So the price is £107,229 per £100,000 nominal.

(ii) Significance of the borrower holding the option

The calculation in part (i) does not depend on which party has the option.

In either case, we want to calculate the worst case scenario for the investor,
in order to defer the investor’s capital gain for as long as possible. This will
be the case whether the option is with the investor or with the borrower.

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30 Subject CT1 April 2016 Question 9

(i) Schedule of cashflows

The annual nominal coupon rate is 6% pa. So each half year the investor
will receive a coupon of nominal value £3,000 per £100,000 nominal.
However, the actual amounts of these coupons will be indexed using the
inflation index, with a time-lag of six months. So the first coupon (payable in
July 2014) will be for an amount of:

IJuly 2014 - 6 months 122.3

3,000 ¥ = 3,000 ¥ = 3,057.50
IJanuary 2014 - 6 months 120.0

where I is the inflation index. The other cashflows are calculated similarly.

The dates and amounts of the cashflows are summarised as follows:

Date Amount
January 2014 –£97,000
122.3
July 2014 3,000 ¥ = £3,057.50
120
124.9
January 2015 3,000 ¥ = £3,122.50
120
127.2
July 2015 3,000 ¥ = £3,180
120
129.1
January 2016 103,000 ¥ = £110,810.83
120

(ii) Effective real yield

Using time units of a year, and working for the moment using £100 nominal
of the bond, the real equation of value is:

3.0575 3.1225
97 = v½ + v1
124.9 / 122.3 127.2 / 122.3
3.180 110.81083 2
+ v 1½ + v
129.1/ 122.3 131.8 / 122.3

Working out these numerical values, we obtain:

97 = 2.993853v ½ + 3.002215v + 3.012502v 1½ + 102.823709v 2

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Using trial and improvement, and starting with a first guess of i = 7% pa, we
find that:

i RHS of equation
0.07 98.232
0.08 96.499
0.0775 96.928
0.0765 97.100

We see from these values that the real annual rate of return lies between
7.65% pa and 7.75% pa. So, to the nearest 0.1% pa, the real return is
7.7% pa.

31 Subject CT1 April 2016 Question 11

(i) Maximum price for the shares

Working in time units of a half-year, and in amount units of pence, the

present value of all the future dividends from one share can be written as:

PV = 6.5v + 6.5 ¥ 1.02v 2 + 6.5 ¥ 1.022 v 3 + 

This is an infinite geometric progression, with first term a = 6.5v and

common ratio r = 1.02v . So the sum to infinity is:

a 6.5v
PV = =
1 - r 1 - 1.02v

Evaluating this at i = 6% pa, we have:

6.5 / 1.06
PV = = 162.5 pence
1 - 1.02 / 1.06

So the maximum price an investor should pay for 10,000 shares is £16,250.

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(ii)(a) New maximum price

Using the same approach as before, the new maximum price of a share is:

6.5 / 1.06
PV = = 185.714 pence
1 - 1.025 / 1.06

So the new maximum price for 10,000 shares is £18,571.

(ii)(b) Difference

If the growth rate is greater, the investor will receive more dividends in the
future. So the investor is prepared to pay a higher price for the shares.

(iii)(a) Why increase the required rate of return?

The new legislation may adversely affect the operation of the company. If it
does so, the investor will require a higher rate of return to compensate for
the additional risk of investing in the company.

(iii)(b) New maximum price

The maximum price payable is now:

6.5 / 1.07
PV = = 130 pence
1 - 1.02 / 1.07

So the price payable for 10,000 shares is now £13,000.

(iii)(c) Comparison with part (i)

The price payable is now less than in part (i). If she requires a higher return
on her investment, she needs to pay less now for the same quantity of
shares. The greater uncertainty of return is compensated for by a lower
entry price for the investment.

(iv)(a) Explanation

If investors’ expectations for future inflation are reduced, then the likely
future rate of dividend growth will also be reduced. In times of higher
inflation, companies are more able to pass this inflation on the customers by
raising their prices. These higher prices should in the long term lead to
greater company profits, and hence to a higher rate of growth in the
dividends that the company is able to pay.

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Higher inflation is also one of the risks facing the investor, since higher
inflation reduces the real value of the returns from her investment. So if
expectations of inflation are reduced, the inflation risk facing the investor is
also reduced. So she can reduce the required rate of return, as the inflation
risk she is facing is lower.

(iv)(b) New maximum price

The maximum price payable is now:

6.5 / 1.05
PV = = 162.5 pence
1 - 1.01/ 1.05

So the price payable for 10,000 shares is now £16,250.

(iv)(c) Explanation of the difference

In both cases the maximum price the investor is prepared to pay is the
same.

In part (i), we can rewrite the maximum price as:

6.5 / 1.06 6.5

PV = =
1 - 1.02 / 1.06 1.06 - 1.02

In part (iv)(b), we can rewrite the maximum price as:

6.5 / 1.05 6.5

PV = =
1 - 1.01/ 1.05 1.05 - 1.01

In each case we see that the maximum price is determined by the difference
between the assumed dividend growth rate and the required rate of return.
In both cases here this difference is 4%. So the price the investor should be
prepared to pay is the same.

This is intuitively reasonable. An equity share is a real investment. In both

cases the investor is expecting a real return of about 4% pa. So the fact that
the investor is prepared to pay the same price in both cases is not
unreasonable.

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32 Subject CT1 September 2016 Question 5

The zero-coupon bond has a term of 40 years. So, working in terms of £100
nominal, the present value of the redemption proceeds is:

PV = 100v 40

At an interest rate of i (2) = 0.05 , we have an effective annual rate of:

2
Ê 0.05 ˆ
i = Á1 + - 1 = 5.0625% pa
Ë 2 ˜¯

So:

PV = 100 ¥ 1.050625 -40 = 13.87046

The price paid for the bond is £13.87 per £100 nominal.

Now assume that the default occurs at time t. Then the equation of value for
the actual transaction (using the force of interest, which is what we are
given), is:

80 e -0.048t = 13.87046

We can solve this equation by dividing through by 80 and taking logs of both
sides:

1 Ê 13.87046 ˆ
t= ln Á ˜¯ = 36.50553
-0.048 Ë 80

Since the 37th year of the bond’s life is 2011, we don’t need to worry about
leap years. Converting 0.50553 of a year into days by multiplying by 365,
we have a default time of 36 years and 184.519 days.

The 185th day of 2011 is 4th July. So the date on which the borrower
defaulted is 4 July 2011.

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33 Subject CT1 April 2017 Question 7

(i) Net redemption yield

Allowing for income tax at a rate of 30% and capital gains tax at a rate of
40%, and for the delay in the collection of the tax payments, the investor’s
equation of value is:

5 5
20 12
9,800  400a(2)  10,500v 20  0.3  400 v 12 a20  0.4(10,500  9,800)v
20
5 5
20 12
ie 9,800  400a(2)  10,500v 20  120 v 12 a20  280v
20

When i  3% :

1  1.03 20 1  1.0320

a20   14.87747 and a(2)   14.98823
0.03 20 2(1.031 2  1)

So, the right-hand side of the above equation gives:

 12
5 20 12
5
400  14.98823  10,500(1.03)20  120(1.03)  14.87747  280(1.03)

 9,892.3126

When i  4% :

1  1.0420 1  1.0420
a20   13.59033 and a(2)   13.72490
0.04 20 2(1.041 2  1)

So, the right-hand side of the above equation gives:

 12
5 20 12
5
400  13.72490  10,500(1.04)20  120(1.04)  13.59033  280(1.04)

 8,551.9001

Since the value of the right-hand side at 3% exceeds £9,800, but the value
at 4% is less than £9,800, the investor’s net redemption yield must lie
between 3% pa effective and 4% pa effective.

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(ii) Net real redemption yield

Using the values obtained in part (i) and linear interpolation, the net
redemption yield obtained by the investor is:

 9,800  9,892.3126 
i  3%    (4%  3%)  3.069%
 8,551.9001  9,892.3126 

So, assuming an annual rate of inflation of 2%, the investor’s net real
redemption yield is:

0.03069  0.02
i   1.05% pa
1.02

(iii) Effect of tax being collected on 1 April rather than 1 June

If tax were collected on 1 April each year, rather than on 1 June, the tax
payments will have been brought forward. This would increase the present
value of the tax payments.

Since the tax payments are outgo from the investor’s point of view,
increasing their present value will cause the net redemption yield and the net
real redemption yield to fall.

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FACTSHEET

This factsheet summarises the main methods, formulae and information

required for tackling questions on the topics in this booklet.

1 Real and money interest rates

Real rates of interest are used when inflation needs to be taken into account.
Money rates of interest are used when inflation can be ignored.

2 Price of a fixed-interest security

The price P to be paid to achieve a yield of i pa on a fixed-interest security

is equal to the present value, calculated at the rate of interest of i pa, of the
interest and capital payments less any taxes payable by the investor.

For example, in the simple case where no taxes apply, the price to be paid
per £100 nominal for a fixed-interest stock bearing interest, payable half-
yearly, at the rate of D% pa and redeemable at par in n years’ time is
calculated as:

P = Da(2) + 100v n @ i
n

3 Yield on a fixed-interest security

The yield available on a security that can be bought for a given price P per
100 nominal can be found by solving the equation of value for i . If the
investor is not subject to taxation, the yield is referred to as the gross
redemption yield. If the investor is subject to taxation, you must include tax
in the equation of value and then the yield is referred to as the net
redemption yield.

The flat yield or running yield on a stock is defined as D / P , the ratio of the
coupon rate to the price of the stock.

4 Income tax

For an investor subject to income tax at the rate of tI on all income, payable
at the time the income is received, the equation of value for the security
described above is:

P = (1 - tI ) Da(2) + 100v n
n

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5 Capital gains tax

For an investor who is also subject to capital gains tax at the rate of tCG on
any capital gain, the equation of value for the security described above is:

P = (1 - tI ) Da(2) + 100v n - tCG (R - P ) v n

n

provided that R > P , ie there is a capital gain on redemption. If there is no

capital gain, then there is no capital gains tax liability.

6 Optional redemption dates

Sometimes a security is issued without a fixed redemption date. The terms

of issue may state that the borrower can redeem the security at any interest
date on or after some specified date, or any interest date between two
specified dates.

Suppose that an investor wants to calculate the maximum price P that he

should pay for a stock in order to obtain a minimum net yield of i pa. We
first carry out the capital gains test to determine whether or not there is a
capital gain. Let p denote the number of coupons payable each year.

D
If i ( p ) > (1 - tI )
, then there is a capital gain on redemption and the latest
R
possible redemption date should be assumed when valuing the loan. If
redemption does occur on this date, the net annual yield will be i . If
redemption occurs before this date, the net annual yield will exceed i .

D
If i ( p ) < (1 - tI )
, then there is a capital loss on redemption and the earliest
R
possible redemption date should be assumed when valuing the loan. If
redemption does occur on this date, the net annual yield will be i . If
redemption occurs after this date, the net annual yield will exceed i .

D
If i ( p ) = (1 - tI )
, then there is neither a capital gain nor a capital loss on
R
redemption. The net annual yield will be i irrespective of the actual
redemption date chosen.

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7 Equities

Suppose that the value of an equity just after a dividend payment is P and
suppose that the dividend due at time t is expected to be Dt . Assuming
that dividends are payable annually, the equation of value for the equity is:

•
P= Â Dt v t
t =1

If the dividend just paid was of amount D and we assume a constant

dividend growth rate of g pa, then Dt = D (1 + g ) and:
t

• È1+ g Ê 1+ g ˆ 2 Ê 1+ g ˆ 3 ˘ D (1 + g )
 D (1 + g )
t
P= vt = D Í +Á ˜ +Á ˜ + ˙ =
t =1 Í 1+ i Ë 1+ i ¯ Ë 1+ i ¯ ˙ i -g
Î ˚

8 Property

The valuation of property by discounting future income follows very similar

principles to the valuation of equities.

Let P denote the price of a property immediately after the receipt of a

periodic rental payment. Suppose that m is the frequency of the rental
payments each year and that the rental income at time t is expected to be
Dt / m , t = 1/ m, 2 / m,... . Then the equation of value is:

• 1
P= Â Dk / m v k / m
k =1 m

It is usually much easier to work from first principles than to apply this
formula to every question about property values.

9 Real rates of interest

The real rate of interest on a transaction is the rate of interest after allowing
for the effects of inflation.

When the rates of inflation are known, we can adjust cashflows for the
effects of inflation by reference to a relevant inflation index. For example, if
the value of an inflation index at time t is Q(t ) , then to change a cashflow
Q(0)
of ct at time t into time 0 money values, we multiply ct by .
Q( t )

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Using the inflation-adjusted cashflows, we can write down an equation for

the real yield:

Q(0) t
 ct Q( t )
v =0
t

1
where the sum is taken over all the cashflows, v = and i ¢ is the real
1+ i ¢
rate of return.

If the rate of inflation is constant at e pa, then the real rate of return is given
by:

i -e
i¢ =
1+ e

where i is the effective annual rate of return with no inflation adjustment.

10 Index-linked bonds

Index-linked bonds have coupon and redemption payments that are

increased according to an index of inflation. For example, suppose that the
nominal annual coupon rate for an n -year index-linked bond is D per unit
nominal with coupons payable half-yearly, and the nominal redemption price
is R per unit nominal. If the payments are inflated by reference to an index
Q(t ) , then the amount of the coupon payable at time k per unit nominal is:

Q( k )
½D k = ½,1, 1½, ..., n
Q(0)

and the redemption amount per unit nominal is:

Q( n )
R
Q(0)

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NOTES

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NOTES

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NOTES

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NOTES

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NOTES

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Subject CM1
Revision Notes
For the 2019 exams

Term structure of interest rates

Booklet 6

covering

Chapter 14 Term structure of interest rates

The Actuarial Education Company

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CONTENTS

Contents Page
Links to the Course Notes and Syllabus 2
Overview 3
Core Reading 4
Past Exam Questions 20
Solutions to Past Exam Questions 50
Factsheet 126

Copyright agreement

All of this material is copyright. The copyright belongs to Institute and

Faculty Education Ltd, a subsidiary of the Institute and Faculty of Actuaries.
The material is sold to you for your own exclusive use. You may not hire out,
lend, give, sell, transmit electronically, store electronically or photocopy any
part of it. You must take care of your material to ensure it is not used or
copied by anyone at any time.

Legal action will be taken if these terms are infringed. In addition, we may
seek to take disciplinary action through the profession or through your
employer. These conditions remain in force after you have finished using
the course.

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LINKS TO THE COURSE NOTES AND SYLLABUS

Material covered in this booklet

Chapter 14 Term structure of interest rates

This chapter number refers to the 2019 edition of the ActEd course notes.

Syllabus objectives covered in this booklet

The numbering of the syllabus items is the same as that used by the Institute
and Faculty of Actuaries.

2.6 Show an understanding of the term structure of interest rates.

1. Describe the main factors influencing the term structure of interest

rates.

2. Explain what is meant by, derive the relationships between, and

evaluate:

 discrete spot rates and forward rates

 continuous spot rates and forward rates.

3. Explain what is meant by the par yield and yield to maturity.

2.7 Understanding duration, convexity and immunisation of cashflows.

1. Define the duration and convexity of a cashflow sequence, and

illustrate how these may be used to estimate the sensitivity of the
value of the cashflow sequence to a shift in interest rates.

2. Evaluate the duration and convexity of a cashflow sequence.

3. Explain how duration and convexity are used in the (Redington)

immunisation of a portfolio of liabilities.

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OVERVIEW
This booklet covers Syllabus Objectives 2.6.1 to 2.6.3 and 2.7.1 to 2.7.3,
which relates to the term structure of interest rates (spot rates, forward rates,
immunisation, etc).

Breakdown of topics

We have different definitions of interest rates depending on whether the

period over which the interest rate is valid starts now or in the future. The
two rates are called spot rates (ones that start now) and forward rates (ones
that start in the future).

The topic of immunisation is also covered in this chapter. This is where a

fund manager protects a fund against small changes in the interest rate by
ensuring that assets will still cover liabilities under those circumstances.
There are three numerical values that are associated with immunisation,
namely:

 discounted mean term

 volatility
 convexity.

Exam questions

The most common type of exam question requires you to calculate values
for the discounted mean term or volatility for some cashflows. Very often the
question will expect you to set up and solve simultaneous equations in order
to find an unknown amount of assets. These questions can be quite long.

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CORE READING

All of the Core Reading for the topics covered in this booklet is contained in
this section.
____________

Chapter 14 – Term structure of interest rates

So far in this course it has generally been assumed that the interest
rate i or force of interest d earned on an investment are independent
of the term of that investment. In practice the interest rate offered on
investments does usually vary according to the term of the investment.
It is often important to take this variation into consideration.

In investigating this variation we make use of unit zero-coupon bond

prices.
____________

1 A unit zero-coupon bond of term n, say, is an agreement to pay £1 at

the end of n years. No coupon payments are paid. It is also called a
pure discount bond.
____________

2 We denote the price at issue of a unit zero-coupon bond maturing in n

years by Pn .
____________

3 The yield on a unit zero-coupon bond with term n years, y n , is called

the ‘n-year spot rate of interest’.
____________

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4 Using the equation of value for the zero-coupon bond we find the yield
on the bond, y n , from:

1 - n1
Pn = n
fi (1 + y n ) = Pn
(1 + y n )

Since rates of interest differ according to the term of the investment, in

general y s π y t for s π t . Every fixed-interest investment may be
regarded as a combination of (perhaps notional) zero-coupon bonds.
For example, a bond paying coupons of D every year for n years, with a
final redemption payment of R at time n may be regarded as a
combined investment of n zero-coupon bonds with maturity value D,
with terms of 1 year, 2 years ..., n years, plus a zero-coupon bond of
nominal value R with term n years.
____________

5 Defining v y t = (1 + y t ) -1 , the price of the bond is:

A = D (P1 + P2 +  + Pn ) + RPn
= D (v y 1 + v y2 2 +  + v ynn ) + Rv ynn

This is actually a consequence of ‘no arbitrage’; the portfolio of

zero-coupon bonds has the same payouts as the fixed-interest bond,
and the prices must therefore be the same.

Arbitrage is the existence of risk-free profits. This is discussed in

great detail in Subject CM2.
____________

6 The variation by term of interest rates is often referred to as the term

structure of interest rates.

The curve of spot rates { y t } is an example of a yield curve.

____________

7 The discrete time forward rate, ft ,r , is the annual interest rate agreed at
time 0 for an investment made at time t > 0 for a period of r years.
____________

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8 That is, if an investor agrees at time 0 to invest £100 at time t for r

years, the accumulated investment at time t + r is:

100(1 + ft ,r )r

Forward rates, spot rates and zero-coupon bond prices are all
connected. The accumulation at time t of an investment of 1 at time 0
is (1 + y t )t . If we agree at time 0 to invest the amount (1 + y t )t at time t
for r years, we will earn an annual rate of ft ,r . So we know that £1

invested for t + r years will accumulate to (1 + y t )t (1 + ft ,r )r . But we

also know from the (t + r ) spot rates that £1 invested for t + r years
accumulates to (1 + y t + r )t + r , and we also know from the zero-coupon
bond prices that £1 invested for t + r years accumulates to Pt-+1r .
Hence we know that:

(1 + y t )t (1 + ft ,r )r = (1 + y t + r )t + r = Pt-+1r

from which we find that:

____________

(1 + y t + r )t + r Pt
9 (1 + ft ,r )r = =
(1 + y t )t Pt + r

so that the full term structure may be determined given the spot rates,
the forward rates or the zero-coupon bond prices.
____________

10 One-period forward rates are of particular interest. The one-period

forward rate at time t (agreed at time 0) is denoted ft = ft ,1 .
____________

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11 We define f0 = y 1 . Comparing an amount of £1 invested for t years at

the spot rate y t , and the same investment invested 1 year at a time
with proceeds reinvested at the appropriate one-year forward rate, we
have:

(1 + y t )t = (1 + f0 )(1 + f1)(1 + f2 )  (1 + ft -1)

____________

12 Let Pt be the price of a unit zero-coupon bond of term t. Then the

t-year spot force of interest is Yt where:

1
Pt = e -Yt t fi Yt = - log Pt
t
____________

13 This is also called the continuously compounded spot rate of interest

or the continuous-time spot rate.

Yt and its corresponding discrete annual rate y t are connected in the

same way as d and i; an investment of £1 for t years at a discrete spot
rate y t accumulates to (1 + y t )t ; at the continuous-time rate it

accumulates to eYt t ; these must be equal, so:

____________

14 y t = eYt - 1
____________

15 The continuous time forward rate Ft ,r is the force of interest equivalent

to the annual forward rate of interest ft ,r .

A £1 investment of duration r years, starting at time t, agreed at time

0 £ t accumulates using the annual forward rate of interest to (1 + ft ,r )r
at time t + r .

Using the equivalent forward force of interest the same investment

Ft , r r
accumulates to e .

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16 Hence the annual rate and continuous-time rate are related as:

Ft , r
ft ,r = e -1
____________

17 The relationship between the continuous-time spot and forward rates

may be derived by considering the accumulation of £1 at a
continuous-time spot rate of Yt for t years, followed by the
continuous-time forward rate of Ft ,r for r years. Compare this with an
investment of £1 at a continuous-time spot rate of Yt + r for t + r years.
The two investments are equivalent, so the accumulated values must
be the same. Hence:

rF
e tYt e t ,r = e (t + r )Yt + r
fi tYt + rFt ,r = (t + r )Yt + r
(t + r )Yt + r - tYt
fi Ft ,r =
r
____________

1
18 Also, using Yt = - log Pt , we have:
t

1 Ê P ˆ
Ft ,r = log Á t ˜
r Ë Pt + r ¯
____________

19 The instantaneous forward rate Ft is defined as:

Ft = lim Ft ,r
r Æ0

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20 The instantaneous forward rate may broadly be thought of as the

forward force of interest applying in the instant of time t Æ t + Dt .

1 Ê P ˆ
Ft = lim log Á t ˜ (1)
r Æ0 r Ë Pt + r ¯

log Pt + r - log Pt
= - lim (2)
r Æ0 r

d
=- log Pt (3)
dt

1 d
=- Pt (4)
Pt dt
____________

21 We also find, by integrating both sides of (3) and using the fact that
P0 = 1 (as the price of a unit zero-coupon bond of term zero years must
be 1), that:

Pt = e Ú0 s
- F ds

We have described in this unit the initial term structure, where

everything is fixed at time 0. In practice the term structure varies
rapidly over time, and the 5-year spot rate tomorrow may be quite
different from the 5-year spot rate today. In more sophisticated
treatments we model the change in term structure over time.

In this case all the variables we have used, ie:

Pt yt ft ,r Yt Ft ,r

need another argument, v, say, to give the ‘starting point’.

____________

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22 For example, y v ,t would be the t-year discrete spot rate of interest

applying at time v; Fv ,t ,r would be the force of interest agreed at time
v, applying to an amount invested at time v + t for the r-year period to
time v + t + r .
____________

Yield curves

23 Some examples of typical (spot rate) yield curves are given below.

Figure 1: Decreasing yield curve (used with permission from Dominic

Cortis)

In Figure 1 the long-term bond yields are lower than the short-term
bonds. Since price is a decreasing function of yield, an interpretation
is that long-term bonds are more expensive than short-term bonds.
There are several possible explanations – for example it is possible
that investors believe that they will get a higher overall return from
long-term bonds, despite the lower current yields, and the higher
demand for long-term bonds has pushed up the price, which is
equivalent to pushing down the yield, compared with short-term bonds.
Other explanations for different yield curve shapes are given below.

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Figure 2: Increasing yield curve: Euro Area Yield Curve for all bonds
(obtained from European Central Bank website on 7 February 2018)

In Figure 2 the long-term bonds are higher yielding (or cheaper) than
the short-term bonds. This shows the case of an increasing yield
curve.

Figure 3: Humped yield curve (used with permission from Dominic

Cortis)

In Figure 3 the short-term bonds are generally cheaper than the long
bonds, but the very short rates (with terms less than one year) are
lower than the one-year rates.
____________

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24 The three most popular explanations for the fact that interest rates vary
according to the term of the investment are:

1. Expectations theory

2. Liquidity preference

3. Market segmentation
____________

25 The relative attraction of short and longer-term investments will vary

according to expectations of future movements in interest rates. An
expectation of a fall in interest rates will make short-term investments
less attractive and longer-term investments more attractive. In these
circumstances yields on short-term investments will rise and yields on
long-term investments will fall. An expectation of a rise in interest
rates will have the converse effect.

In Figure 1 it appears that the demand for long-term bonds may be

greater than for short, implying an expectation that interest rates will
fall. By buying long-term bonds investors can continue getting higher
rates after a future fall in interest rates, for the duration of the long
bond.

In Figure 2 the demand is higher for short-term bonds – perhaps

indicating an expectation of a rise in interest rates.
____________

26 Longer dated bonds are more sensitive to interest rate movements

than short-dated bonds. It is assumed that risk averse investors will
require compensation (in the form of higher yields) for the greater risk
of loss on longer bonds. This might explain some of the excess return
offered on long-term bonds over short-term bonds in Figure 2.
____________

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27 Bonds of different terms are attractive to different investors, who will

choose assets that are similar in term to their liabilities. The liabilities
of banks, for example, are very short term (investors may withdraw a
large proportion of the funds at very short notice); hence banks invest
in very short-term bonds. Many pension funds have liabilities that are
very long-term, so pension funds are more interested in the longest
-dated bonds. The demand for bonds will therefore differ for different
terms.

The supply of bonds will also vary by term, as governments and

companies’ strategies may not correspond to the investors’
requirements.

The market segmentation hypothesis argues that the term structure

emerges from these different forces of supply and demand.

These theories are covered in more detail in Subject CP1.

____________

28 The yield to maturity for a coupon paying bond (also called the
redemption yield) has been defined as the effective rate of interest at
which the discounted value of the proceeds of a bond equal the price.
It is widely used, but has the disadvantage that it depends on the
coupon rate of the bond, and therefore does not give a simple model of
the relationship between term and yield.

In the UK, yield curves plotting the average (smoothed) yield to

maturity of coupon-paying bonds are produced separately for ‘low
coupon’, ‘medium coupon’ and ‘high coupon’ bonds.
____________

Par Yield

29 The n-year par yield represents the coupon per £1 nominal that would
be payable on a bond with term n years, which would give the bond a
current price under the current term structure of £1 per £1 nominal,
assuming the bond is redeemed at par.

That is, if ycn is the n-year par yield:

1 = ycn (v y 1 + v y2 2 + v y3 3 +  + v ynn ) + 1v ynn

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30 The par yields give an alternative measure of the relationship between

the yield and term of investments. The difference between the par yield
rate and the spot rate is called the ‘coupon bias’.

In this section we consider simple measures of vulnerability to interest

rate movements.
____________

31 For simplicity we assume a flat yield curve, and that when interest
rates change, all change by the same amount, so that the curve stays
flat. A flat yield curve implies that y t = ft ,r = i for all t, r and
Yt = Ft ,r = Ft = d for all t, r.
____________

32 Suppose an institution holds assets of value VA , to meet liabilities of

value VL . Since both VA and VL represent the discounted value of
future cashflows, both are sensitive to the rate of interest. We assume
that the institution is healthy at time 0 so that currently VA ≥ VL .
____________

33 If rates of interest fall, both VA and VL will increase. If rates of interest

rise then both will decrease. We are concerned with the risk that
following a downward movement in interest rates the value of assets
increases by less than the value of liabilities, or that, following an
upward movement in interest rates the value of assets decreases by
more than the value of the liabilities.

In order to examine the impact of interest rate movements on different

cashflow sequences we will use changes in the yield to maturity to
represent changes in the underlying term structure. This is
approximately (but not exactly) the same as assuming a constant
movement of similar magnitude in the one-period forward rates.
____________

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34 One measure of the sensitivity of a series of cashflows to movements

in the interest rates, is the effective duration (or volatility). Consider a
series of cashflows {Ctk } for k = 1,2, , n . Let A be the present value of
the payments at rate (yield to maturity) i, so that:

n
t
A= Â Ctk vi k
k =1

Then the effective duration is defined to be:

1 d A¢
n (i ) = - A=- (4.1)
A di A

n
t +1
 Ctk tk v i k
= k =1
n
t
 Ctk v i k
k =1
____________

35 This is a measure of the rate of change of value of A with i, which is

independent of the size of the present value.
____________

36 Equation (4.1) assumes that the cashflows do not depend on the rate of
interest.
____________

37 For a small movement e in interest rates, from i to i + e , the relative

change in value of the present value is approximately -en (i ) so the
new present value is approximately A(1 - e n (i )) .
____________

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38 Another measure of interest rate sensitivity is the duration, also called

Macaulay Duration or discounted mean term (DMT). This is the mean
term of the cashflows {Ctk } , weighted by present value. That is, at rate
i, the duration of the cashflow sequence {Ctk } is:

n
S t k Ctk v itk
t = k =1
n
S Ctk v itk
k =1
____________

39 Comparing this expression with the equation for the effective duration
it is clear that:

t = (1 + i )n (i )
____________

40 Another way of deriving the Macaulay duration is in terms of the force

of interest, d :

1 d di
t =- A= n (i )
A dd dd
di
i = ed - 1 fi = ed
dd

fi t = ed n (i ) = (1 + i )n (i )

The equation for t in terms of the cashflows Ctk may be found by

differentiating A with respect to d , recalling that v itk = e -d tk .

____________

41 The duration of an n-year coupon paying bond, with coupons of D

payable annually, redeemed at R, is:

D (Ia )n + Rnv n
t =
Dan + Rv n

____________

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42 The duration of an n year zero-coupon bond of nominal amount 100,

say, is:

100nv n
t = =n
100v n

Note that another definition of duration exists; the modified duration.

This can be expressed in terms of the Macauley Duration as:

t
i ( p)
1+
p

where i ( p ) and p are as defined in Booklet 1.

____________

43 The convexity of the cashflow series {Ctk } is defined as:

1 d2 A¢¢
c (i ) = A=
A di 2 A

Ê ˆ
Á 1 ˜Ê n t +2 ˆ
=Á n ˜ Á S Ctk t k (t k + 1) v i k ˜
Á S C v tk ˜ Ë k =1 ¯
ÁË tk i ˜¯
k =1
____________

44 Combining convexity and duration gives a more accurate

approximation to the change in A following a small change in interest
rates. For small e :

A(i + e ) - A(i ) ∂A 1 ∂2 A 1
= ¥ ¥e +½ ¥ 2 ¥ ¥ e2 + 
A ∂i A ∂i A

ª -en (i ) + e 2 ¥ ½ ¥ c (i )
____________

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45 Convexity gives a measure of the change in duration of a bond when

the interest rate changes. Positive convexity implies that t (i ) is a
decreasing function of i. This means, for example, that A increases
more when there is a decrease in interest rates than it falls when there
is an increase of the same magnitude in interest rates.

Consider a fund with asset cashflows { Atk } and liability cashflows

{Ltk } . Let VA (i ) be the present value of the assets at effective rate of
interest i and let VL (i ) be the present value of the liabilities at rate i; let
n A (i ) and n L (i ) be the volatility of the asset and liability cashflows
respectively, and let c A (i ) and cL (i ) be the convexity of the asset and
liability cashflows respectively.
____________

46 At rate of interest i0 the fund is immunised against small movements

in the rate of interest of e if and only if VA (i0 ) = VL (i0 ) and
VA (i0 + e ) ≥ VL (i0 + e ) .
____________

47 Then consider the surplus S (i ) = VA (i ) - VL (i ) .

From Taylor’s theorem:

e2
S (i 0 + e ) = S (i 0 ) + e S ¢( i 0 ) + S ¢¢(i0 ) + 
2
____________

48 Consider the terms on the right hand side. We know that S (i0 ) = 0 .

The second term, e S ¢(i0 ) , will be equal to zero for any values of e
(positive or negative) if and only if S ¢(i0 ) = 0 , that is if VA¢ (i0 ) = VL¢ (i0 ) .

This is equivalent to requiring that n A (i ) = n L (i ) or (equivalently) that

the durations of the two cashflow series are the same.

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e2
In the third term, is always positive, regardless of the sign of e .
2
Thus, if we ensure that S ¢¢(i0 ) > 0 , then the third term will also always
be positive.

This is equivalent to requiring that VA¢¢(i0 ) > VL¢¢(i0 ) , which is equivalent

to requiring that c A (i ) > cL (i ) .

For small e the fourth and subsequent terms in the Taylor expansion
will be very small. Hence, given the three conditions above, the fund is
protected against small movements in interest rates. This result is
known as Redington’s immunisation after the British actuary who
developed the theory.
____________

49 The conditions for Redington’s immunisation may be summarised as

follows:

1. VA (i0 ) = VL (i0 ) – that is, the value of the assets at the starting rate
of interest is equal to the value of the liabilities.

2. The volatilities of the asset and liability cashflow series are equal,
that is, n A (i0 ) = n L (i0 ) .

3. The convexity of the asset cashflow series is greater than the

convexity of the liability cashflow series – that is, c A (i0 ) > cL (i0 ) .
____________

50 In practice there are difficulties with implementing an immunisation

strategy based on these principles. For example, the method requires
continuous rebalancing of portfolios to keep the asset and liability
volatilities equal. There may be options or other uncertainties in the
assets or in the liabilities, making the assessment of the cashflows
approximate rather than known. Assets may not exist to provide the
necessary overall asset volatility to match the liability volatility.
Despite these problems, immunisation theory remains an important
consideration in the selection of assets.
___________

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PAST EXAM QUESTIONS

This section contains all the Subject CT1 exam questions from 2008 to 2017
that are related to the topics covered in this booklet.

Solutions are given later in this booklet. These give enough information for
you to check your answer, including working, and also show you what an
adequate examination answer should look like. Further information may be
available in the Examiners’ Report, ASET or Course Notes. (ASET can be
ordered from ActEd.)

We first provide you with a cross reference grid that indicates the main
subject areas of each exam question. You can use this, if you wish, to
select the questions that relate just to those aspects of the topic that you
may be particularly interested in reviewing.

Alternatively, you can choose to ignore the grid, and instead attempt each
question without having any clues as to its content.

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Cross reference grid

Term structure Immunisation

Bond price/GRY
using spot/fwd

DMT/volatility

immunisation
Spot/forward

Yield curve
Tick when
attempted

Convexity
Par yield

theories

Check
rates
Question

1   
2 
3  
4   
5   
6   
7  
8 
9  
10 
11 
12  
13   
14   
15  
16  
17   
18  () 
19 
20  
21 
22  
23   
24 
25 
26  
27   
28 
29  
30  

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Page 22
41
40
39
38
37
36
35
34
33
32
31
Question

Tick when
attempted
Spot/forward




rates
Bond price/GRY






using spot/fwd

Par yield
Term structure
Exclusive use Batch 4a

Yield curve




theories








DMT/volatility


Convexity
Immunisation

Check



immunisation

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1 Subject CT1 April 2008 Question 5

The n -year spot rate of interest, i n , is given by:

i n = a - bn

for n = 1, 2 and 3, and where a and b are constants.

The one-year forward rates applicable at time 0 and at time 1 are 6.1% per
annum effective and 6.5% per annum effective respectively. The 4-year par
yield is 7% per annum.

Stating any assumptions:

(i) calculate the values of a and b . [4]

(ii) calculate the price per £1 nominal at time 0 of a bond which pays annual
coupons of 5% in arrear and is redeemed at 103% after 4 years. [5]
[Total 9]

2 Subject CT1 April 2008 Question 6

(i) An investor is considering the purchase of an annuity, payable annually

in arrear for 20 years. The first payment is £500. Using a rate of
interest of 8% per annum effective, calculate the duration of the annuity
when:

(a) the payments remain level over the term.

(b) the payments increase at a rate of 8% per annum compound. [6]

(ii) Explain why the answer in (i)(b) is higher than the answer in (i)(a). [2]
[Total 8]

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3 Subject CT1 September 2008 Question 9

Three bonds, paying annual coupons in arrears of 6%, are redeemable at

£105 per £100 nominal and reach their redemption dates in exactly one, two
and three years’ time respectively. The price of each of the bonds is £103
per £100 nominal.

(i) Calculate the gross redemption yield of the three-year bond. [3]

(ii) Calculate to three decimal places all possible spot rates, implied by the
information given, as annual effective rates of interest. [4]

(iii) Calculate to three decimal places all possible forward rates, implied by
the information given, as annual effective rates of interest. [4]
[Total 11]

Two marks of September 2008 Question 10 relate to discounted mean term.

This question is included in Book 4, should you wish to attempt that now.

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4 Subject CT1 September 2008 Question 11

A company has a liability of £400,000 due in ten years’ time.

The company has exactly enough funds to cover the liability on the basis of
an effective interest rate of 8% per annum. This is also the interest rate on
which current market prices are calculated and the interest rate earned on
cash.

The company wishes to hold 10% of its funds in cash, and to invest the
balance in the following securities:
 a zero-coupon bond redeemable at par in twelve years’ time
 a fixed-interest stock which is redeemable at 110% in sixteen years’
time bearing interest at 8% per annum payable annually in arrear.

(i) Calculate the nominal amounts of the zero-coupon bond and the fixed-
interest stock which should be purchased to satisfy Redington’s first two
conditions for immunisation. [10]

(ii) Calculate the amount which should be invested in each of the assets
mentioned in (i). [2]

(iii) Explain whether the company would be immunised against small

changes in the rate of interest if the quantities of stock in part (i) are
purchased. [2]
[Total 14]

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5 Subject CT1 April 2009 Question 8

An insurance company has liabilities consisting of eleven annual payments

of £1 million, with the first payment due to be made in 10 years’ time and the
last payment due to be made in 20 years’ time. The rate of interest is 6%
per annum effective.

(i) Show that the discounted mean term of these liabilities, to four
significant figures, is 14.42 years. [3]

The insurance company holds two zero-coupon bonds, one paying £ X in 10

years’ time and the other paying £Y in 20 years’ time.

(ii) Find values of X and Y such that Redington’s first two conditions for
immunisation from small changes in the rate of interest are satisfied. [6]

(iii) Explain, without making any further calculations, whether you would
expect Redington’s third condition for immunisation to be satisfied for
the values of X and Y calculated in (ii). [2]
[Total 11]

6 Subject CT1 April 2009 Question 9

Two bonds paying annual coupons of 5% in arrear and redeemable at par

have terms to maturity of exactly one year and two years, respectively.

The gross redemption yield from the 1-year bond is 4.5% per annum
effective; the gross redemption yield from the 2-year bond is 5.3% per
annum effective. You are informed that the 3-year par yield is 5.6% per
annum.

Calculate all zero-coupon yields and all one-year forward rates implied by
the yields given above. [12]

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7 Subject CT1 September 2009 Question 6

(i) Distinguish between a future and an option. [2]

An investor wishes to purchase a one-year forward contract on a risk-free

bond which has a current market price of £97 per £100 nominal. The bond
will pay coupons at a rate of 7% per annum half-yearly. The next coupon
payment is due in exactly six months and the following coupon payment is
due just before the forward contract matures. The six-month risk-free spot
interest rate is 5% per annum effective and the 12-month risk-free spot
interest rate is 6% per annum effective.

(ii) Stating all necessary assumptions:

(a) Calculate the forward price of the bond.

(b) Calculate the six-month forward rate for an investment made in six
months’ time.

(c) Calculate the purchase price of a risk-free bond with exactly one
year to maturity which is redeemed at par and which pays coupons
of 4% per annum half-yearly in arrears.

(d) Calculate the gross redemption yield from the bond in (c).

(e) Comment on why your answer in (d) is close to the one-year spot
rate. [10]
[Total 12]

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8 Subject CT1 September 2009 Question 7

A member of a pensions savings scheme invests £1,200 per annum in

monthly instalments, in advance, for 20 years from his 25th birthday. From
the age of 45, the member increases his investment to £2,400 per annum.
At each birthday thereafter the annual rate of investment is further increased
by £100 per annum. The investments continue to be made monthly in
advance for 20 years until the individual’s 65th birthday.

(i) Calculate the accumulation of the investment at the age of 65 using a

rate of interest of 6% per annum effective. [6]

At the age of 65, the scheme member uses his accumulated investment to
purchase an annuity with a term of 20 years to be paid half-yearly in arrear.
At this time the interest rate is 5% per annum convertible half-yearly.

(ii) Calculate the annual rate of payment of the annuity. [3]

(iii) Calculate the discounted mean term of the annuity, in years, at the time
of purchase. [3]
[Total 12]

9 Subject CT1 April 2010 Question 5

Let ft denote the one-year forward rate of interest over the year from time t
to time t + 1 .

The current forward rates in the market are:

time, t 0 1 2 3
one-year forward rate, ft 4.4% pa 4.7% pa 4.9% pa 5.0% pa

A fixed-interest security pays coupons annually in arrear at the rate of 7%

per annum and is redeemable at par in exactly four years.

(i) Calculate the price per £100 nominal of the security assuming no
arbitrage. [3]

(ii) Calculate the gross redemption yield of the security. [3]

(iii) Explain, without doing any further calculations, how your answer to
part (ii) would change if the annual coupon rate on the security were
9% per annum (rather than 7% per annum). [2]
[Total 8]

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10 Subject CT1 April 2010 Question 7

A pension fund has to pay out benefits at the end of each of the next 40
years. The benefits payable at the end of the first year total £1 million.
Thereafter, the benefits are expected to increase at a fixed rate of 3.8835%
per annum compound.

(i) Calculate the discounted mean term of the liabilities using a rate of
interest of 7% per annum effective. [5]

The pension fund can invest in both coupon-paying and zero-coupon bonds
with a range of terms to redemption. The longest-dated bond currently
available in the market is a zero-coupon bond redeemed in exactly 15 years.

(ii) Explain why it will not be possible to immunise this pension fund against
small changes in the rate of interest. [2]

(iii) Describe the other practical problems for an institutional investor who is
attempting to implement an immunisation strategy. [3]
[Total 10]

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11 Subject CT1 September 2010 Question 7

(i) State the three conditions that are necessary for a fund to be immunised
from small, uniform changes in the rate of interest. [2]

(ii) A pension fund has liabilities of £10m to meet at the end of each of the
next ten years. It is able to invest in two zero-coupon bonds with a term
to redemption of three years and 12 years respectively. The rate of
interest is 4% per annum effective.

Calculate:

(a) the present value of the liabilities of the pension fund

(b) the duration of the liabilities of the pension fund

(c) the nominal amount that should be invested in the zero-coupon

bonds to ensure that the present values and durations of the assets
and liabilities is the same. [7]

(iii) One year later, just before the pension payment then due, the rate of
interest is 5% per annum effective.

(a) Determine whether the duration of the assets and the liabilities are
still equal.

(b) Comment on the practical usefulness of the theory of immunisation

in the context of the above result. [6]
[Total 15]

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12 Subject CT1 September 2010 Question 9

The government of a particular country has just issued three bonds with
terms to redemption of exactly one, two and three years respectively. Each
bond is redeemed at par and pays coupons of 8% annually in arrear. The
annual effective gross redemption yields from the one, two and three-year
bonds are 4%, 3% and 3% respectively.

(i) Calculate the one-year, two-year and three-year spot rates of interest at
the date of issue. [8]

(ii) Calculate all possible forward rates of interest from the above spot rates
of interest. [4]

An index of retail prices has a current value of 100.

(iii) Calculate the expected level of the retail prices index in one year, two
years’ and three years’ time if the expected real spot rates of interest
are 2% per annum effective for all terms. [5]

(iv) Calculate the expected rate of inflation per annum in each of the next
three years. [2]
[Total 19]

13 Subject CT1 April 2011 Question 4

The n-year spot rate of interest y n is given by:

n
y n = 0.03 + for n = 1, 2, 3 and 4
1, 000

(i) Calculate the implied one-year and two-year forward rates applicable at
time t = 2. [3]

(ii) Calculate, assuming no arbitrage:

(a) the price at time t = 0 per £100 nominal of a bond which pays
annual coupons of 4% in arrear and is redeemed at 115% after 3
years.

(b) the 3-year par yield. [6]

[Total 9]

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14 Subject CT1 April 2011 Question 8

A company has liabilities of £10 million due in three years’ time and
£20 million due in six years’ time. The investment manager for the company
is able to buy zero-coupon bonds for whatever term he requires and has
adequate monies at his disposal.

(i) Explain whether it is possible for the investment manager to immunise

the fund against small changes in the rate of interest by purchasing a
single zero-coupon bond. [2]

The investment manager decides to purchase two zero-coupon bonds, one

for a term of four years and the other for a term of 20 years. The current
interest rate is 4% per annum effective.

(ii) Calculate the amount that must be invested in each bond in order that
the company is immunised against small changes in the rate of interest.
You should demonstrate that all three Redington conditions are met. [10]
[Total 12]

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15 Subject CT1 September 2011 Question 8

(i) State the conditions that are necessary for an insurance company to be
immunised from small, uniform changes in the rate of interest. [2]

An insurance company has liabilities to pay £100m annually in arrear for the
next 40 years. In order to meet these liabilities, the insurance company can
invest in zero coupon bonds with terms to redemption of five years and 40
years.

(ii) (a) Calculate the present value of the liabilities at a rate of interest of
4% per annum effective.

(b) Calculate the duration of the liabilities at a rate of interest of 4% per

annum effective. [5]

(iii) Calculate the nominal amount of each bond that the fund needs to hold
so that the first two conditions for immunisation are met at a rate of
interest of 4% per annum effective. [5]

(iv) (a) Estimate, using your calculations in (ii)(b), the revised present value
of the liabilities if there were a reduction in interest rates by 1.5%
per annum effective.

(b) Calculate the present value of the liabilities at a rate of interest of

2.5% per annum effective.

(c) Comment on your results to (iv)(a) and (iv)(b). [6]

[Total 18]

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16 Subject CT1 September 2011 Question 9

(i) Describe the information that an investor can obtain from the following
yield curves for government bonds:

(a) a forward rate yield curve

(b) a spot rate yield curve
(c) a gross redemption yield curve. [6]

An investor is using the information from a government bond spot yield curve
to calculate the present value of a corporate eurobond with a term to
redemption of exactly five years. The investor will value each payment that
is due from the bond at a rate of interest equal to j = i + 0.01 + 0.001t where:

 t is the time in years at which the payment is due

 i is the annual t -year effective spot rate of interest from the

government bond spot yield curve and i = 0.02t for t £ 5 .

The eurobond pays annual coupons of 10% of the nominal amount of the
bond and is redeemed at par.

(ii) Calculate the present value of the eurobond. [6]

(iii) Calculate the gross redemption yield from the eurobond. [3]

(iv) Explain why the investor might use such a formula for j to determine
the interest rates at which to value the payments from the corporate
eurobond. [3]
[Total 18]

17 Subject CT1 April 2012 Question 1

In a particular bond market, n -year spot rates can be approximated by the

function 0.06 - 0.02e -0.1n .

(i) Calculate the gross redemption yield for a three-year bond which pays
coupons of 3% annually in arrear, and is redeemed at par. Show all
workings. [6]

(ii) Calculate the four-year par yield. [3]

[Total 9]

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18 Subject CT1 April 2012 Question 10

A company has the following liabilities:

 annuity payments of £200,000 per annum to be paid annually in arrear

for the next 20 years
 a lump sum of £300,000 to be paid in 15 years.

The company wishes to invest in two fixed-interest securities in order to

immunise its liabilities.

Security A has a coupon rate of 9% per annum and a term to redemption of

12 years. Security B has a coupon rate of 4% per annum and a term to
redemption of 30 years.

Both securities are redeemable at par and pay coupons annually in arrear.
The rate of interest is 8% per annum effective.

(i) Calculate the present value of the liabilities. [3]

(ii) Calculate the discounted mean term of the liabilities. [4]

(iii) Calculate the nominal amount of each security that should be purchased
so that Redington’s first two conditions for immunisation against small
changes in the rate of interest are satisfied for this company. [8]

(iv) Describe the further calculations that will be necessary to determine

whether the company is immunised against small changes in the rate of
interest. [2]
[Total 17]

19 Subject CT1 September 2012 Question 5 (part)

(ii) (b) Two certificates of deposit issued by a given bank are being traded.
A one-month certificate of deposit provides a rate of return of 12 per
cent per annum convertible monthly. A two-month certificate of
deposit provides a rate of return of 24 per cent per annum
convertible monthly.

Calculate the forward rate of interest per annum convertible monthly

in the second month, assuming no arbitrage. [4]

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20 Subject CT1 September 2012 Question 9

(i) Describe three theories that have been put forward to explain the shape
of the yield curve. [7]

The government of a particular country has just issued five bonds with terms
to redemption of one, two, three, four and five years respectively. The
bonds are redeemed at par and have coupon rates of 4% per annum
payable annually in arrear.

(ii) Calculate the duration of the one-year, three-year and five-year bonds at
a gross redemption yield of 5% per annum effective. [6]

(iii) Explain why a five-year bond with a coupon rate of 8% per annum would
have a lower duration than a five-year bond with a coupon rate of 4%
per annum. [2]

Four years after issue, immediately after the coupon payment then due the
government is anticipating problems servicing its remaining debt. The
government offers two options to the holders of the bond with an original
term of five years:

Option 1: the bond is repaid at 79% of its nominal value at the scheduled
time with no final coupon payment being paid.

Option 2: the redemption of the bond is deferred for seven years from the
original redemption date and the coupon rate reduced to 1% per annum for
the remainder of the existing term and the whole of the extended term.

Assume the bonds were issued at a price of £95 per £100 nominal.

(iv) Calculate the effective rate of return per annum from Options 1 and 2
over the total life of the bond and determine which would provide the
higher rate of return. [6]

(v) Suggest two other considerations that bond holders may wish to take
into account when deciding which options to accept. [2]
[Total 23]

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21 Subject CT1 September 2012 Question 10

Two investment projects are being considered.

(i) Explain why comparing the two discounted payback periods or

comparing the two payback periods are not generally appropriate ways
to choose between two investment projects. [3]

The two projects each involve an initial investment of £3m. The incoming
cash flows from the two projects are as follows:

Project A
In the first year, Project A generates cash flows of £0.5m. In the second
year it will generate cash flows of £0.55m. The cash flows generated by the
project will continue to increase by 10% per annum until the end of the sixth
year and will then cease. Assume that all cash flows are received in the
middle of the year.

Project B
Project B generates cash flows of £0.64m per annum for six years. Assume
that all cash flows are received continuously throughout the year.

(ii) (a) Calculate the payback period from Project B.

(b) Calculate the discounted payback period from Project B at a rate of

interest of 4% per annum effective. [5]

(iii) Show that there is at least one ‘cross-over point’ for Projects A and B
between 0% per annum effective and 4% per annum effective where the
cross-over point is defined as the rate of interest at which the net
present value of the two projects is equal. [6]

(iv) Calculate the duration of the incoming cash flows from Projects A and B
at a rate of interest of 4% per annum effective. [6]

(v) Explain why the net present value of Project A appears to fall more
rapidly than the net present value of Project B as the rate of interest
increases. [2]
[Total 22]

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22 Subject CT1 April 2013 Question 3

Three bonds each paying annual coupons in arrear of 6% and redeemable

at £103 per £100 nominal reach their redemption dates in exactly one, two
and three years’ time, respectively. The price of each bond is £97 per £100
nominal.

(i) Calculate the gross redemption yield of the 3-year bond. [3]

(ii) Calculate the one-year and two-year spot rates implied by the
information given. [3]
[Total 6]

23 Subject CT1 April 2013 Question 7

An insurance company has liabilities of £6 million due in 8 years’ time and

£11 million due in 15 years’ time. The assets consist of two zero-coupon
bonds, one paying £ X in 5 years’ time and the other paying £Y in 20
years’ time. The current interest rate is 8% per annum effective. The
insurance company wishes to ensure that it is immunised against small
changes in the rate of interest.

(i) Determine the values of £ X and £Y such that the first two conditions
for Redington’s immunisation are satisfied. [8]

(ii) Demonstrate that the third condition for Redington’s immunisation is

also satisfied. [2]
[Total 10]

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24 Subject CT1 September 2013 Question 10 (part)

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

d (t ) = 0.05 + 0.002t

Calculate the accumulated value of a unit sum of money:

(i) (a) accumulated from time t = 0 to time t = 7 .

(b) accumulated from time t = 0 to time t = 6 .
(c) accumulated from time t = 6 to time t = 7 . [5]

(ii) Calculate, using your results from part (i) or otherwise:

(a) the seven-year spot rate of interest per annum from time t = 0 to
time t = 7 .
(b) the six-year spot rate of interest per annum from time t = 0 to time
t =6.
(c) f6,1 where f6,1 is the one-year forward rate of interest per annum
from time t = 6 . [3]

(iii) Explain why your answer to part (ii)(c) is higher than your answer to part
(ii)(a).
[2]
[Total 10]

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25 Subject CT1 September 2013 Question 11

A pension fund has liabilities to meet annuities payable in arrear for 40 years
at a rate of £10 million per annum.

The fund is invested in two fixed-interest securities. The first security pays
annual coupons of 5% and is redeemed at par in exactly ten years’ time.
The second security pays annual coupons of 10% and is redeemed at par in
exactly five years’ time. The present value of the assets in the pension fund
is equal to the present value of the liabilities of the fund and exactly half the
assets are invested in each security. All assets and liabilities are valued at a
rate of interest of 4% per annum effective.

(i) Calculate the present value of the liabilities of the fund. [1]

(ii) Calculate the nominal amount held of each security purchased by the
pension fund. [6]

(iii) Calculate the duration of the liabilities of the pension fund. [3]

(iv) Calculate the duration of the assets of the pension fund. [4]

(v) Without further calculations, explain whether the pension fund will make
a profit or loss if interest rates fall uniformly by 1.5% per annum
effective. [2]
[Total 16]

26 Subject CT1 April 2014 Question 6

An insurance company has liabilities of £10 million due in 10 years’ time and
£20 million due in 15 years’ time. The company’s assets consist of two zero-
coupon bonds. One pays £7.404 million in 2 years’ time and the other pays
£31.834 million in 25 years’ time. The current interest rate is 7% per annum
effective.

(i) Show that Redington’s first two conditions for immunisation against
small changes in the rate of interest are satisfied for this insurance
company. [6]

(ii) Calculate the present value of profit that the insurance company will
make if the interest rate increases immediately to 7.5% per annum
effective. [2]

(iii) Explain, without any further calculation, why the insurance company
made a profit as a result of the change in the interest rate. [2]
[Total 10]

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27 Subject CT1 April 2014 Question 9

The effective n -year spot rate of interest y n is given by:

n
y n = 0.035 + for n = 1,2 and 3
1,000

(i) Determine the implied one-year forward rates applicable at times t = 1

and t = 2 to four significant figures. [4]

(ii) Calculate, assuming no arbitrage:

(a) The price at time t = 0 per £100 nominal of a bond which pays
annual coupons of 4% in arrear and is redeemed at 105% per £100
nominal after three years.

(b) The two-year par yield. [6]

[Total 10]

28 Subject CT1 September 2014 Question 6

A Eurobond has been issued by a company that pays annual coupons of 5%

per annum annually in arrear and is redeemable at par in exactly 10 years’
time.

(i) Calculate the purchase price of the bond at issue at a rate of interest of
4% per annum effective assuming that tax is paid on the coupon
payments at a rate of 20%. [2]

(ii) Calculate the discounted mean term of the bond at a rate of interest of
4% per annum effective, ignoring tax. [3]

(iii) (a) Explain why the discounted mean term of the gross payments from
the bond is lower than the discounted mean term of the net
payments.

(b) State two factors other than the size of the coupon payments that
would affect the discounted mean term of the bond. [3]

(iv) Calculate the price of the bond three months after issue at a rate of
interest of 4% per annum effective assuming tax is paid on the coupon
payments at a rate of 20%. [1]
[Total 9]

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29 Subject CT1 September 2014 Question 8

(i) Explain what is meant by the following theories of the shape of the yield
curve:

(a) market segmentation theory

(b) liquidity preference theory [4]

Short-term, one-year annual effective interest rates are currently 6%; they
are expected to be 5% in one year’s time; 4% in two years’ time and 3% in
three years’ time.

(ii) Calculate the gross redemption yields from one-year, two-year, three-
year and four-year zero coupon bonds using the above expected
interest rates. [4]

The price of a coupon-paying bond is calculated by discounting individual

payments from the bond at the zero-coupon yields in part (ii).

(iii) Calculate the gross redemption yield of a bond that pays a coupon of
4% per annum annually in arrear and is redeemed at 110% in exactly
four years. [5]

(iv) Explain why the gross redemption yield of a bond that pays a coupon of
8% per annum annually in arrear and is redeemed at par would be
greater than that calculated in part (iii). [2]

The government introduces regulations that require banks to hold more

government bonds with very short terms to redemption.

(v) Explain, with reference to market segmentation theory, the likely effect
of this regulation on the pattern of spot rates calculated in part (ii). [2]
[Total 17]

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30 Subject CT1 April 2015 Question 7

In a particular country, insurance companies are required by regulation to

value their liabilities using spot rates of interest derived from the government
bond yield curve.

Over time t (measured in years), the spot rate of interest is equal to:

i = 0.02t for t £ 5

An insurance company in this country has a group of annuity policies which

involve making payments of £1m per annum for four years and £2m per
annum in the fifth year. All payments are assumed to be paid halfway
through the year.

(i) Calculate the value of the insurance company’s liabilities. [3]

(ii) Outline two reasons why the spot yield curve might rise with term to
redemption. [3]

(iii) Calculate the forward rate of interest from time t = 3.5 to time t = 4.5 .
[2]
[Total 8]

31 Subject CT1 April 2015 Question 8

A fixed-interest security, redeemable at par in 10 years, pays annual

coupons of 9% in arrear and has just been issued at a price to give an
investor who does not pay tax a rate of return of 7% per annum effective.

(i) Calculate the price of the security at issue. [2]

(ii) Calculate the discounted mean term (duration) of the security at issue.
[3]

(iii) Explain how your answer to part (ii) would differ if the annual coupons
on the security were 3% instead of 9%. [2]

(iv) (a) Calculate the effective duration (volatility) of the security at the time
of issue.

(b) Explain the usefulness of effective duration for an investor who

expects to sell the security over the next few months. [3]
[Total 10]

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32 Subject CT1 September 2015 Question 3

An insurance company has sold a pension product to an individual. Under

the arrangement, the individual is to receive an immediate annuity of £500
per year annually in arrear for 12 years. The insurance company has
invested the premium it has received in a fixed-interest bond that pays
coupons annually in arrear at the rate of 5% per annum and which is
redeemable at par in exactly eight years.

(i) Calculate the duration of the annuity at an interest rate of 4% per annum
effective. [2]

(ii) Calculate the duration of the bond at an interest rate of 4% per annum
effective. [3]

(iii) State with reasons whether the insurance company will make a profit or
a loss if there is a small increase in interest rates at all terms. [2]
[Total 7]

33 Subject CT1 September 2015 Question 6

Three bonds, each paying annual coupons in arrear of 3% and redeemable

at £100 per £100 nominal, reach their redemption dates in exactly one, two
and three years’ time, respectively.

The price of each bond is £101 per £100 nominal.

(i) Determine the gross redemption yield of the three-year bond. [3]

(ii) Calculate the one-year, two-year and three-year spot rates of interest
implied by the information given. [5]

(iii) Calculate the one-year forward rate starting from the end of the second
year, f2,1 . [2]

The pattern of spot rates is upward sloping throughout the yield curve.

(iv) Explain, with reference to the various theories of the yield curve, why
the yield curve might be upward sloping. [4]
[Total 14]

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34 Subject CT1 April 2016 Question 2

An insurance company has liabilities of £6 million due in exactly 8 years’

time and a further £11 million due in exactly 15 years’ time.

The assets held by the insurance company consist of:

 a 5-year zero-coupon bond of nominal amount £5.5088 million; and
 a 20-year zero-coupon bond of nominal amount £13.7969 million.

The current rate of interest is 8% per annum effective at all durations.

(i) Show that the first two conditions of Redington’s theory for immunisation
against small changes in the rate of interest are satisfied. [5]

(ii) Explain, without doing any further calculations, whether the insurance
company will be immunised against small changes in the rate of
interest. [2]
[Total 7]

35 Subject CT1 April 2016 Question 3

At time t = 0 , the one-year zero-coupon yield is 4% per annum effective and

the one-year forward rate per annum effective at time t (t = 1,2,) is given
by:

ft ,1 = ( 4 + t ) %

(i) Determine the issue price per £100 nominal of a three-year 4% coupon
bond issued at time t = 0 , paying coupons annually in arrear and
redeemable at 105%. [4]

(ii) Determine the three-year par yield at time t = 0 . [3]

[Total 7]

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36 Subject CT1 September 2016 Question 8

Three bonds, each paying annual coupons in arrear of 4% and redeemable

at par, reach their redemption dates in exactly one, two and three years’
time, respectively. The price of each bond is £96 per £100 nominal.

(i) Calculate the gross redemption yield of the three-year bond. [3]

(ii) Calculate, showing all workings, the one-year and two-year spot rates of
interest implied by the information given. [3]

(iii) Calculate the forward rate of interest applicable over the second year. [2]

(iv) Explain whether the three-year spot rate will be higher than or lower
than the three-year gross redemption yield. [2]
[Total 10]

37 Subject CT1 September 2016 Question 11

The government of a heavily indebted country has a range of bonds

currently in issue. These include bonds with nominal amounts outstanding of
£4bn and £5bn with terms to redemption of exactly three years and ten
years respectively from the current time. Both bonds pay annual coupons in
arrear of 4%. The government is negotiating a restructuring of its debt
portfolio and proposes to transform the three and ten year bonds into
perpetuities paying an annual coupon of 5% in arrear. The yield curve is
currently flat with gross redemption yields at 6% per annum effective.

(i) Calculate, showing all workings, the duration of the current portfolio of
three year and ten-year bonds. [7]

(ii) Calculate, showing all workings, the duration of the proposed portfolio of
bonds. [4]

The government’s objective is that the present value of the proposed

portfolio of bonds will be 80% of the present value of the current portfolio of
three-year and ten-year bonds.

(iii) Determine the nominal amount of the new bonds that the government
will have to issue to achieve the objective. [2]
[Total 13]

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38 Subject CT1 April 2017 Question 5

An investment fund has liabilities of £11 million due in 7 years’ time and
£8.084 million in 11 years’ time.

The manager of the fund will meet the liabilities by investing in zero-coupon
bonds. The manager is able to buy zero-coupon bonds for whatever term is
required and there are adequate funds at the manager’s disposal.

(i) Explain whether it is possible for the manager to immunise the fund
against small changes in the rate of interest by purchasing a single
zero-coupon bond. [2]

The manager decides to purchase two zero-coupon bonds, one paying

£15.363 million in 7.5 years’ time and the other paying £3.787 million in
14.25 years’ time. The current interest rate is 5.5% per annum effective.

(ii) Determine whether the investment fund satisfies the necessary

conditions to be immunised against small changes in the rate of interest.
[7]
[Total 9]

39 Subject CT1 April 2017 Question 9

Let ft denote the one-year effective forward rate of interest over the year
from time t to (t  1) . Let it be the t -year effective spot rate over the
period 0 to t .

The annual effective gross redemption yield from an n-year bond which pays
coupons of 5% annually in arrear is given by:

gn  0.07  0.001n for n  1,2 and 3

Each bond is redeemed at par and is exactly one year from the next coupon
payment. It is assumed that no arbitrage takes place.

(i) Calculate i1 , i 2 and i 3 as percentages to three decimal places. [7]

(ii) Calculate f0 , f1 and f2 as percentages to three decimal places. [4]

(iii) Explain why the one-year forward rates increase more quickly with term
than the spot rates. [2]
[Total 13]

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40 Subject CT1 September 2017 Question 7

Two investors, A and B, value corporate bonds using different models:

Investor A uses the average gross redemption yield from all government
securities with the addition of a risk premium of 1% per annum effective.
Investor B uses the spot rates of interest derived from the government bond
yield curve also with the addition of a risk premium of 1% per annum
effective to value each payment.

The investors are valuing a particular corporate bond which has half-yearly
coupon payments paid at a rate of 5% per annum and a term to redemption
of exactly two years. The bond is redeemed at 110% and tax is payable on
coupons only at a rate of 20%.

The average gross redemption yield from all government securities is 3% per
annum effective.

(i) Calculate the price that investor A would pay for the corporate bond. [3]

Over time t, the spot rate of interest from the yield curve of government
securities, y t is given by y t = 0.015t per annum effective for t £ 2 .

(ii) Calculate the price that investor B would pay for the corporate bond. [3]

(iii) Calculate the forward rate of interest from government securities from
t = 1 to t = 2. [2]

(iv) Giving two reasons, explain why the spot yield curve might rise with
term to redemption. [3]
[Total 11]

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41 Subject CT1 September 2017 Question 10

An insurance company has liabilities of £100 million due in 10 years’ time

and £200 million due in 20 years’ time.

The company’s assets consist of a zero-coupon bond and a level annuity

paid annually in arrears. The zero coupon bond will pay £144.054 million in
15 years’ time. The current interest rate is 3% per annum effective at all
terms to redemption.

Redington’s first two conditions for immunisation against small changes in

the rate of interest have been satisfied for this insurance company.

(i) (a) Calculate the present value of the liabilities.

(b) Calculate the discounted mean term of the liabilities. [4]

(ii) Show that the term of the annuity is 41 years. [6]

(iii) Determine the annual rate of payment of the annuity. [1]

(iv) State Redington’s third condition for immunisation, explaining whether

you think it is fulfilled. [2]

The insurance company decides to sell the zero-coupon bond it holds and
invest the proceeds in another zero-coupon bond with a shorter term to
maturity.

(v) Explain the risks of implementing this decision. [2]

[Total 15]

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SOLUTIONS TO PAST EXAM QUESTIONS

The solutions presented here are just outline solutions for you to use to
check your answers. See ASET for full solutions.

1 Subject CT1 April 2008 Question 5

(i) Values of a and b

Let ft denote the one-year forward rate applicable at time t . We are given:

f0 = 0.061 and f1 = 0.065

Therefore, we have:

f0 = i1 fi 0.061 = a - b (Equation 1)

Also, under the assumption of no arbitrage, we have:

(1 + f0 )(1 + f1) = (1 + i 2 )2 fi (1.061)(1.065) = (1 + a - 2b )2

Since we expect (1 + i 2 ) to be greater than zero, when taking the square root
of both sides of this equation we can exclude the negative root. This gives:

1 + a - 2b = (1.061)(1.065) (Equation 2)

We must solve these two equations simultaneously to obtain the values of a

and b . Equation 2 can be written as:

1 + (a - b ) - b = (1.061)(1.065)

Substituting Equation 1 into this gives us:

1 + 0.061 - b = (1.061)(1.065)

Rearranging this gives:

b = 1.061 - (1.061)(1.065) fi b = -0.00200

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Substituting this value into Equation 1 gives a = 0.05900 .

Therefore a = 0.05900 and b = -0.00200 .

(ii) Price of the bond

Let P be the price per £1 nominal of the bond. This is given by:

0.05 0.05 0.05 (0.05 + 1.03)

P= + + + (Equation 3)
1 + i1 (1 + i 2 )2 (1 + i 3 )3 (1 + i 4 )4

We are given the 4-year par yield. This satisfies the equation:

0.07 0.07 0.07 1.07

1= + + +
1 + i1 (1 + i 2 )2 (1 + i3 )3 (1 + i 4 )4
1.07 0.07 0.07 0.07
fi = 1- - -
(1 + i 4 )4 1.061 1.0632 1.0653

This gives us:

(1 + i 4 )4 = 1.31429

Substituting this, and our values for i1, i 2 and i3 , into Equation 3 gives:

0.05 0.05 0.05 1.08

P= + + + = £0.9545
1.061 1.0632 1.0653 1.31429

2 Subject CT1 April 2008 Question 6

(i)(a) Level payments

The duration is given by:

1 ¥ 500v + 2 ¥ 500v 2 +  + 20 ¥ 500v 20

=
(
500 v + 2v 2 +  + 20v 20 )
( 2
500 v + v +  + v 20
) ( 2
500 v + v +  + v 20
)
(Ia )20
=
a20

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Using values from the Tables, gives the duration as:

78.9079
= 8.037 years
9.8181

(i)(b) Increasing payments

The duration is given by:

1 ¥ 500v + 2 ¥ 500(1.08)v 2 +  + 20 ¥ 500(1.08)19 v 20

(
500 v + 1.08v 2 +  + (1.08)19 v 20 )
Since 1.08v = 1 this gives:

1 ¥ 500v + 2 ¥ 500v +  + 20 ¥ 500v 500v (1 + 2 +  + 20)

=
500 (v + v +  + v ) 500v ¥ 20

Cancelling 500v , leaves:

1 + 2 +  + 20
20

So, the duration is:

20 ¥ 21
2 210
= = 10.5 years
20 20

(ii) Why (i)(b) is higher

The duration is a weighted average of the times at which cashflows are

received, where the weights are the present values of the cashflows.

In (i)(a) and (i)(b) the cashflows are received at the same times, but are for
different amounts. This affects the weightings. Under the increasing
annuity, the later payments are larger than under the level annuity, giving a
higher weighting to later times. This, in turn, means that the duration of the
increasing annuity is longer than that of the level annuity.

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3 Subject CT1 September 2008 Question 9

(i) Gross redemption yield

The gross redemption yield is the interest rate that satisfies the equation of
value for the bond:

103  6a3  105v 3

Taking 6.5% pa as a first guess for the gross redemption yield and
evaluating the RHS gives 102.8150. This is too low.

Taking a second guess of 6% pa gives a value for the RHS of 104.1981.

Interpolating between these two values gives a gross redemption yield of:

 104.1981  103 
6  0.5    6.43% pa
 104.1981  102.81501 

(ii) Spot rates

Let y t denote the t -year spot rate of interest.

The equation of value for the bond to be redeemed in one year’s time is:

6  105 111
103   1  y1 
1  y1 103

This gives y1  7.767% to 3 decimal places.

The equation of value for the bond to be redeemed in two years’ time is:

6 6  105
103  
1  y1 (1  y 2 )2

Using the value for y1 already calculated gives:

111
 97.432432  (1  y 2 )2  1.139251
(1  y 2 )2

This gives y 2  6.736% to 3 decimal places.

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The equation of value for the bond to be redeemed in three years’ time is:

6 6 6  105
103   
1  y1 (1  y 2 )2 (1  y 3 )3

Using the values for y1 and y 2 already calculated gives:

111
3
 92.165814  (1  y 3 )3  1.2043511
(1  y 3 )

This gives y 3  6.394% to 3 decimal places.

(iii) Forward rates

Let ft ,r denote the forward rate that applies from time t for r years.

Using our results from (ii), we have:

f0,1  y1  7.767%
f0,2  y 2  6.736%
f0,3  y 3  6.394%

Now we must calculate the remaining forward rates. Firstly:

1.139251
(1  y1)(1  f1,1)  (1  y 2 )2  1  f1,1  111
103

This gives f1,1  5.714% to 3 decimal places.

Also:

1.2043511
(1  y1)(1  f1,2 )2  (1  y 3 )3  (1  f1,2 )2  111
103

This gives f1,2  5.714% to 3 decimal places.

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Finally, we have:

1.2043511
(1  y 2 )2 (1  f2,1)  (1  y 3 )3  1  f2,1 
1.139251

This gives f2,1  5.714% to 3 decimal places.

4 Subject CT1 September 2008 Question 11

(i) Nominal amounts of zero-coupon bond and fixed-interest stock

The present value of the liability cashflow at an interest rate of 8% pa is:

PVL  400,000v 10  400,000(1.08)10  £185,277.40

Since we know that the company has funds equal to the present value of the
liabilities, it holds £185,277.40. The company holds 10% of this amount in
cash, and uses the remainder to purchase holdings of the zero-coupon bond
and the fixed-interest bond.

Let A be the nominal amount of the zero-coupon bond and B be the

nominal amount of the fixed-interest bond. The present value of the asset
cashflows is therefore:


PVA  0.1 185,277.40  Av 12  B 0.08a16  1.1v 16 
So Redington’s first condition of PVA  PVL , gives us the equation:


185,277.40  0.1 185,277.40  Av 12  B 0.08a16  1.1v 16 
 166,749.66  Av 12

 B 0.08a16  1.1v 16
 (1)

Next consider Redington’s second condition for immunisation, in the form

PVA  PVL .

The derivative of the present value of the liability cashflow is:

PVL  10  400,000v 11  1,715,531.4

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The present value of the cash element of the asset portfolio does not change
when interest rates change. For instance, if you have £100 in the bank
today and interest rates change, you will still have £100 in the bank.

So, the derivative of the present value of the asset cashflows is:


PVA  12 Av 13  B 0.08v (Ia )16  16  1.1v 17 
Redington’s second condition implies that:


1,715,531.4  12 Av 13  B 0.08v (Ia )16  16  1.1v 17 
ie 
1,715,531.4  12 Av 13  B 0.08v (Ia )16  16  1.1v 17  (2)

We need to solve equations (1) and (2) simultaneously. To do this, first

evaluate the coefficient of B in each of them at a rate of interest of 8% pa.

Using the Tables, the coefficient of B in (1) is:

0.08a16  1.1v 16  0.08  8.8514  1.1(1.08)16

 1.02919

Using the Tables, the coefficient of B in (2) is:

0.08
0.08v (Ia )16  16  1.1v 17   61.1154  16  1.1(1.08)17
1.08
 9.28380

So the equations to be solved are:

166,749.66  Av 12  1.02919B (1)

and:

1,715,531.4  12 Av 13  9.28380B (2)

Multiplying (1) by 12v and then subtracting (2) gives:

137,242.52  2.15163B  B  63,785.24

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Substituting this into (1) gives:

Av 12  166,749.66  63,785.24  1.02919  A  254,593.51

So, the company should purchase £254,600 nominal of the zero-coupon

bond and £63,790 of the fixed-interest bond.

(ii) Amount to be invested

The amount to be invested in the zero-coupon bond is the present value of

the cashflows received from it:

254,593.51v 12  101,102.6

The amount to be invested in the fixed-interest bond is the present value of

the cashflows received from it:

 
63,785.24 0.08a16  1.1v 16  63,785.24  1.02919
 65,647.07

So the company should invest £101,100 in the zero-coupon bond and

£65,650 in the fixed-interest bond.

(iii) Is the company immunised?

Convexity is a measure of the spread of cashflows, with a higher convexity

indicating that the cashflows are more spread out. Since the asset
cashflows (received over a 16-year period) are more spread out than the
liability cashflow (which occurs at just one point in time), the convexity of the
assets will exceed the convexity of the liabilities. So, Redington’s third
condition will be satisfied and the company will be immunised against small
changes in interest rates.

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5 Subject CT1 April 2009 Question 8

(i) Discounted mean term (DMT)

The DMT of the liabilities, working in millions, is:

10v 10 + 11v 11 +  + 20v 20 (Ia )20 - (Ia )9

DMTL = 10 11 20
= @ 6%
v +v + +v v 9 a11
98.7004 - 31.3785 67.3219
= = = 14.421
4.66823 4.66823

(ii) Values of X and Y

Starting with the liabilities (and still working in millions):

PVL = v 9 a11 = 4.66823

The present value of the assets is given by the expression:

PVA = Xv 10 + Yv 20

Equating the present values gives us:

Xv 10 + Yv 20 = 4.66823 (1)

The DMT of the assets is:

10 ¥ Xv 10 + 20 ¥ Yv 20
DMTA =
PVA

Equating the DMTs gives us:

10 Xv 10 + 20Yv 20 = 67.3219 (2)

Multiplying (1) by 10 and subtracting it from (2) gives:

10Yv 20 = 20.640 fi Y = £6.619 million

Substituting this into (1) gives:

X = £4.664 million

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(iii) Is the third condition satisfied?

Redington’s third condition for immunisation is that the convexity of the

assets should exceed the convexity of the liabilities, where convexity is
defined as:

PV ¢¢
PV

Convexity is a measure of how spread out the cashflows are over time.

Here, both the assets and liabilities consist of payments starting at time 10
and ending at time 20. However, the liabilities take the form of regular
payments over this period, whilst the assets consist of two payments at each
extremity. The asset cashflows are therefore more spread out over time
(being further apart from one another), meaning that Redington’s third
condition would be satisfied.

6 Subject CT1 April 2009 Question 9

Spot rates (zero-coupon yields)

Let y n be the n -year spot rate.

By definition, y1 is the GRY of the one-year bond. Hence y1 = 4.5% pa.

Since the GRY of the two-year bond is 5.3% pa, the price of this bond is:

P = 5a2 + 100v 2 @ 5.3%

= 9.25768 + 90.18686
= 99.4445

The equation of value for the two-year bond in terms of y1 and y 2 is:

5 5 + 100
99.4445 = +
1 + y1 (1 + y 2 )2
5 5 + 100
= +
1.045 (1 + y 2 )2

fi (1 + y 2 )2 = 1.109235 fi y 2 = 5.3202% pa

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The 3-year par yield is 5.6% pa. So the 3-year par yield equation is:

5.6 5.6 5.6 + 100

100 = + +
1 + y1 (1 + y 2 )2 (1 + y 3 )3
5.6 5.6 5.6 + 100
= + +
1.045 1.109235 (1 + y 3 )3

Rearranging gives:

(1 + y 3 )3 = 1.178668 fi y 3 = 5.6324% pa

One-year forward rates

Let ft denote the one-year forward rate that applies from time t for 1 year.
3
(1 + y3)
2
(1 + y2)

(1 + y1)

0 1 2 3
(1 + f 0)
(1 + f 1)
(1 + f 2)

Firstly, we have:

f0 = y1 = 4.5% pa.

Secondly,

1.109235
(1 + y1 )(1 + f1 ) = (1 + y 2 )2 fi 1 + f1 = fi f1 = 6.1469% pa
1.045

Finally, we have:

1.178668
(1 + y 2 )2 (1 + f2 ) = (1 + y 3 )3 fi 1 + f2 =
1.109235
fi f2 = 6.2596% pa

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7 Subject CT1 September 2009 Question 6

(i) Futures and options

A futures contract is a standardised, exchange-tradable contract between

two parties to trade a specified asset on a set date in the future at a
specified price. The parties to a futures contract are obliged to trade the
asset.

Unlike a future, an option gives an investor the right, but not the obligation,
to buy or sell a specified asset on a specified future date.

(ii)(a) Forward price

Throughout part (ii) we assume that there is no arbitrage, ie it is not possible

to make a risk-free profit.

È Ê 3.5 3.5 ˆ ˘
K = (S0 - I ) (1.06) = Í97 - Á + ˙ ¥ 1.06 = £95.70%
Î Ë 1.05½ 1.06 ˜¯ ˚

(ii)(b) 6-month forward rate for an investment made in 6 months’ time

2
Ê 1.06 ˆ
(
1.05½ 1 + f½,½ )½ = 1.06 fi f½,½ = Á
Ë 1.05½ ˜¯
- 1 = 7.0095%

(ii)(c) Purchase price of a risk-free bond

The purchase price is:

2 102
P= ½
+ = £98.1782%
1.05 1.06

(ii)(d) Gross redemption yield

The GRY is the interest rate that is the solution of the equation:

98.1782 = 2v ½ + 102v

Setting x = v ½ we get the quadratic equation:

102 x 2 + 2 x - 98.1782 = 0

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Solving gives:

-2 ± 4 + 4 ¥ 102 ¥ 98.1782
x= = 0.97133 or - 0.99094
2 ¥ 102

So the GRY is:

v ½ = 0.97133 fi i = 0.97133 -2 - 1 = 5.99%

(ii)(e) Comment

The GRY is a weighted average of the 6-month spot rate and the 12-month
spot rate. The weighting is dependent on the size of the cashflows. In this
case the GRY is very close to the 12-month spot rate because the cashflow
at time 1 is much bigger than the cashflow at time ½.

8 Subject CT1 September 2009 Question 7

(i) Accumulated value at age 65

PV = 1, 200a(12)
20

+v 20
(2, 400a
(12)
1
+ 2,500v a(12) + 2, 600v 2a(12) +  + 4,300v 19 a(12)
1 1 1 )
(
= 1, 200a(12) + v 20 a(12) 2, 400 + 2,500v + 2, 600v 2 +  + 4,300v 19
20 1 )
= 1, 200a(12) + v 20 a(12)
20 1 (2,300a20
+ 100 (I a)
20 )
At an effective annual interest rate of 6%, we have:

PV = 1, 200 ¥ 11.8394 + 0.9738(1.06 -20 ) (2,300 ¥ 12.1581 + 100 ¥ 104.6224)

= £25,874.52

Hence the accumulated value at time 40 is:

AV = 25,874.52 ¥ 1.0640 = £266,138

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(ii) Annual rate of payment

Let X denote the half-yearly payment. Working in half-years, the equation

of value is:

266,138
266,138 = Xa40 2.5% = 25.1028 X fi X = = £10, 601.94
25.1028

and the annual rate of annuity payment is:

2 X = £21, 203.87

(iii) Discounted mean term

Working in half-years, we have:

DMT =
(
10,601.94 v + 2v 2 + 3v 3 +  + 40v 40 ) = (I a) 40 2.5%

( 2
10, 601.94 v + v + v +  + v 3 40
) a40 2.5%

433.3248
= = 17.26 half years or 8.63 years
25.1028

9 Subject CT1 April 2010 Question 5

(i) Price of the bond

The price of the bond, P , is equal to the PV of the payments received from
it. In terms of the forward rates given, we can use the expression:

7 7 7 107
P= + + +
1 + f0 (1 + f0 )(1 + f1 ) (1 + f0 )(1 + f1 )(1 + f2 ) (1 + f0 )(1 + f1 )(1 + f2 )(1 + f3 )

Evaluating this:

7 7 7 107
P= + + +
1.044 (1.044)(1.047) (1.044)(1.047)(1.049) (1.044)(1.047)(1.049)(1.05)

= £108.09

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(ii) Gross redemption yield

The gross redemption yield is the interest rate that solves the equation:

108.09 = 7a4 + 100v 4 @ GRY

We find:

i = 5% fi RHS = 107.0919
i = 4.5% fi RHS = 108.96881

Using linear interpolation we get:

Ê 108.96881 - 108.09 ˆ
GRY = 4.5 + 0.5 Á = 4.73%
Ë 108.96881 - 107.0919 ˜¯

(iii) Explanation

The gross redemption yield is a weighted average of the interest rates that
apply over the term of the bond, where the weights are the cashflows that
occur at the different durations.

A bond with 9% coupons would give higher weighting to those interest rates
applying earlier in the bond’s life. In this case, the forward rates are lower at
the start of bond. So the gross redemption yield would also be lower.

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10 Subject CT1 April 2010 Question 7

(i) Discounted mean term (DMT)

The DMT of the liabilities, working in millions, is:

1 ¥ v + 2 ¥ 1.038835v 2 + 3 ¥ 1.0388352 v 3 +  + 40 ¥ 1.03883539 v 40

DMT =
v + 1.038835v 2 + 1.0388352 v 3 +  + 1.03883539 v 40

We can simplify the numerator and denominator by re-writing them as

annuities. To do this we need to make the power of the increase factor and
the discount factor match.

DMT =
1
1.038835 (1¥ 1.038835v + 2 ¥ 1.038835 v +  + 40 ¥ 1.038835 v )
2 2 40 40

1
1.038835 (1.038835v + 1.038835 v +  + 1.038835 v )
2 2 40 40

1
Substituting V = 1.038835v , and cancelling the factor of 1.038835
:

V + 2 ¥ V 2 + 3 ¥ V 3 +  + 40 ¥ V 40
DMT =
V + V 2 + V 3 +  + V 40

1
Now, if V = , then:
1+ I

1 1.038835
= fi I = 3%
1+ I 1.07

So, the discounted mean term is given by:

(Ia )40 @ 3% 384.8647

DMT = = = 16.65 years
a40 @ 3% 23.1148

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(ii) Why immunisation is not possible

The assets available in the market all have a duration of 15 years or less.
Therefore any portfolio of assets put together as part of an immunisation
strategy will have a discounted mean term of 15 years at most.

Since the discounted mean term of the liabilities as calculated in part (i) is
16.65 years, it will not be possible to satisfy Redington’s second condition
using the available assets. Hence it is not possible to immunise this pension
fund against small changes in the interest rate.

(iii) Practical problems of immunisation

The practical problems faced when trying to implement an immunisation

strategy include:
 rebalancing of the asset portfolio is required when the interest rate
changes to ensure that the discounted mean terms of the assets and
liabilities continue to be equal. This process will take time and incur
dealing costs.
 there may be options or uncertainties in the asset or liability cashflows,
meaning that the cashflows are estimated rather than being known with
certainty
 Redington’s theory assumes that the yield curve is flat (ie the interest
rate is the same at all durations) and that the interest rate changes by
the same amount at all durations, which may not be the case in reality
 Redington’s theory only provides immunisation against small changes in
the interest rate.

11 Subject CT1 September 2010 Question 7

(i) Immunisation conditions

Using the subscripts A and L to denote assets and liabilities and dashes to
indicate differentiation with respect to the interest rate, the three conditions
are:

1. PVA = PVL

2. volatility A = volatilityL or DMTA = DMTL or PVA¢ = PVL¢

3. convexity A > convexityL or PVA¢¢ > PVL¢¢

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(ii)(a) PV of liabilities

PVL = 10a10 4% = £81.109m

(ii)(b) Duration of liabilities

10v ¥ 1 + 10v 2 ¥ 2 +  + 10v 10 ¥ 10 10(Ia )10

DMTL = =
PVL 10a10

Calculating this at 4% pa we get:

419.922
DMTL = = 5.177 years
81.109

(ii)(c) Calculate nominal of zero-coupon bonds required

Using X and Y for the redemption (= nominal) amounts, we have:

PVA = Xv 3 + Yv 12

3 Xv 3 + 12Yv 12
DMTA =
PVA

Equating the PV’s and DMT’s of the assets and liabilities, we get:

Xv 3 + Yv 12 = 81.109 (1)
3 12
3 Xv + 12Yv = 419.922 (2)

Subtracting 3 times equation (1) from equation (2) gives:

9Yv 12 = 176.596 fi Y = £31.415m

Substituting this into equation (1) gives:

Xv 3 = 61.487 fi X = £69.165m

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(iii)(a) Duration of assets and liabilities one year later

Let’s consider the liabilities, we are now at time 1 (just before the payment):

10 10 10 ... 10 Payment

0 1 2 3 ... 10 Time

fi PVL = 10a10 5% = 81.0782

10 ¥ 0 + 10v ¥ 1 +  + 10v 9 ¥ 9 10(Ia )9

DMTL = =
PVL 10a10
332.347
= = 4.0991 years
81.0782

For the assets:

X Y

0 1 3 12

fi PVA = Xv 2 + Yv 11 = 69.165v 2 + 31.415v 11 = 81.1022

2 Xv 2 + 11Yv 11 327.514
DMTA = = = 4.0383 years
PVA 81.1022

So the durations of the assets and liabilities are no longer equal.

(iii)(b) Comment on practical usefulness

With both the interest rate change and change over time the duration of the
assets and liabilities are no longer equal. Therefore we would have to
rebalance the portfolio to make them equal again.

In practice we would need to continually rebalance the portfolio to maintain

equal durations which will be costly in time and money. Hence this limits the
usefulness of immunisation.

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12 Subject CT1 September 2010 Question 9

(i) Calculate the spot rates of interest

The 1-year bond has a GRY of 4% pa. This means that the 1-year spot rate,
y1 , is also 4% pa.

The 2-year bond has a GRY of 3% pa. So the price of this bond is given by:

P2 = 8 ¥ 1.03 -1 + 108 ¥ 1.03 -2 = 109.567

Now using the spot rates to discount these payments we have:

8(1 + y1 )-1 + 108(1 + y 2 )-2 = 109.567

Since y1 = 4% pa, we have:

8(1.04)-1 + 108(1 + y 2 )-2 = 109.567 fi y 2 = 2.96224% pa

The 3-year bond has a GRY of 3% pa. So the price of this bond is given by:

P3 = 8 ¥ 1.03 -1 + 8 ¥ 1.03 -2 + 108 ¥ 1.03 -3 = 114.143

Now using the spot rates to discount these payments we have:

8(1 + y1 )-1 + 8(1 + y 2 )-2 + 108(1 + y 3 )-3 = 114.143

Since y1 = 4% pa and y 2 = 2.9622% pa, we have:

8(1.04)-1 + 8(1.029622)-2 + 108(1 + y 3 )-3 = 114.143

fi y 3 = 2.9760% pa

(ii) Calculate the forward rates

We have:

f0,1 = y1 = 4% pa
f0,2 = y 2 = 2.9622% pa
f0,3 = y 3 = 2.9760% pa

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Also:

2.9622% pa
4% pa

0 1 2 3

f1, 1

A(0,1)A(1, 2) = A(0,2) fi 1.04 ¥ (1 + f1,1 ) = 1.0296222

1.0296222
fi (1 + f1,1 ) = fi f1,1 = 1.9348% pa
1.04

2.9760% pa
2.9622% pa

0 1 2 3

f2, 1

A(0, 2)A(2,3) = A(0,3) fi 1.029622 ¥ (1 + f2,1 ) = 1.0297603

2

1.0297603
fi (1 + f2,1 ) = fi f2,1 = 3.0035% pa
1.0296222

2.9760% pa

4% pa

0 1 2 3

f1, 2

A(0,1)A(1,3) = A(0,3) fi 1.04 ¥ (1 + f1,2 )2 = 1.0297603

1.0297603
fi (1 + f1,2 )2 = fi f1,2 = 2.4678% pa
1.04

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(iii) Calculate the retail price index

The 1-year money spot rate is i = 4% pa and 1-year real spot rate is
i ¢ = 2% pa , so the 1 year inflation spot rate, e1 :

1.04
1 + e1 = fi e1 = 1.96% pa
1.02

So the index will grow from 100 at time zero to:

100(1 + e1 ) = 101.96 at time 1

The 2-year money spot rate is i = 2.9622% pa and 2-year real spot rate is
i ¢ = 2% pa , so over the 2 years:

1.0296222
(1 + e2 )2 = = 1.0190 fi e2 = 0.943% pa
1.022

So the index will grow from 100 at time zero to:

100(1 + e2 )2 = 101.90 at time 2

The 3-year money spot rate is i = 2.9760% pa and 3-year real spot rate is
i ¢ = 2% pa , so over the 3 years:

1.0297603
(1 + e3 )3 = = 1.0290 fi e3 = 0.956% pa
1.023

So the index will grow from 100 at time zero to:

100(1 + e3 )3 = 102.90 at time 3

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(iv) Calculate the rate of inflation in each of the next three years

We have:

100 101.96 101.90 102.90

0 1 2 3

The inflation over the first year is:

101.96 - 100
= +1.96% pa
100

The inflation over the second year is:

101.90 - 101.96
= -0.06% pa
101.96

The inflation over the third year is:

102.90 - 101.90
= +0.98% pa
101.90

13 Subject CT1 April 2011 Question 4

(i) The forward rates at time 2

The information in the question can be illustrated as follows:

(1 + f 2,2 ) 2

0 1 2
(1 + f 2,1 ) 3 4
time
(1 + y1 ) = 1.031

(1 + y2 ) 2 = 1.032 2
(1 + y3 )3 = 1.033 3

(1 + y4 ) 4 = 1.034 4

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Assuming no arbitrage:

(1 + y 2 )2 ¥ (1 + f2,1) = (1 + y 3 )3

(1 + y 3 )3 1.0333
fi (1 + f2,1) = 2
= = 1.0350029
(1 + y 2 ) 1.0322

So, the one-year forward rate from time 2 is 3.5% pa.

Similarly:

(1 + y 2 )2 ¥ (1 + f2,2 )2 = (1 + y 4 )4

(1 + y 4 )4 1.034 4
fi (1 + f2,2 ) = = = 1.0360039
(1 + y 2 )2 1.0322

So, the two-year forward rate from time 2 is 3.6% pa.

(ii)(a) The price of the bond

Using the spot interest rates given in the question:

4 4 119
P= + + = 115.5913
1.031 1.0322 1.0333

The price per £100 nominal is £115.59.

(ii)(b) The three-year par yield

The par yield, c, is the solution of the following equation of value:

c c c 1
1= + + +
1.031 1.0322 1.0333 1.0333
Ê 1 1 1 ˆ 1
1= cÁ + + +
Ë 1.031 1.0322 1.0333 ˜¯ 1.0333
1 = 2.81607c + 0.907192

fi c = 0.032957 , ie 3.2957% pa.

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14 Subject CT1 April 2011 Question 8

(i) Immunisation with a single zero-coupon bond

The investment manager will not be able to immunise the fund with a single
zero-coupon bond because of the third Redington condition, ie that the
convexity of the assets is greater than the convexity of the liabilities, will not
be met. The liabilities are due in three years’ time and twenty years’ time, so
a single zero-coupon bond (with only one payment) cannot be more spread
(ie more convex) than the liabilities.

(ii) Immunisation with two zero-coupon bonds

The asset portfolio must be chosen to satisfy Redington’s conditions. Using

the subscripts A and L to denote assets and liabilities and dashes to indicate
differentiation with respect to the interest rate, the three conditions are:

1. PVA = PVL

2. volatility A = volatilityL or DMTA = DMTL or PVA¢ = PVL¢

3. convexity A > convexityL or PVA¢¢ > PVL¢¢

Working in millions and using the Tables:

PVL = 10v 3 + 20v 6 @ 4% = 24.6962

Using A and B to represent the cash invested in (ie the present value of) the
four-year bond, Bond A, and the twenty-year bond, Bond B, respectively, the
present value of the assets ( PVA ) can be written as PVA = A + B .

Therefore, Redington’s first condition is that:

A + B = 24.6962 (1)

Since the denominator of the DMT is the present value, the second condition
can be reduced to showing that the top line of the DMT formulae are equal
for assets and liabilities. The calculations are:

Top line DMTL = Â tkCtk v tk = 3 ¥ 10v 3 + 6 ¥ 20v 6 @ 4% = 121.5072

tk

Top line DMTA = 4 A + 20B

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Therefore, Redington’s second condition is that:

4 A + 20B = 121.5072 (2)

Solving simultaneously:

(2) - 4 ¥ (1) fi 16B = 22.7224 fi B = 1.4202

Substituting in (1), A = 23.2761 .

Therefore, the amount to be invested in the four-year bond is £23.2761m

and the amount to be invested in the twenty-year bond is £1.4202m.

The third Redington condition for immunisation requires that the convexity of
the assets is greater than the convexity of the liabilities. This condition is
met since the spread of the assets is greater (from 4 to 20 years) than the
spread of the liabilities (from 3 to 6 years). Therefore, the chosen portfolio of
assets will immunise the company from small changes in interest rates.

Alternative solution

If A and B represent the nominal amount of the four-year bond (Bond A)

and the twenty-year bond (Bond B), respectively, then the first two
conditions are:

Av 4 + Bv 20 = 10v 3 + 20v 6 (1)

4 20 3 6
4 Av + 20Bv = 30v + 120v (2)

Solving simultaneously, A = 27.22973 and B = 3.11175 . Therefore, the

4 20
amounts invested in A and B are Av = 23.2761 and Bv = 1.4202 .

To show that this portfolio meets the third condition, we could show that
PVA¢¢ > PVL¢¢ . For the assets, we have:

PVA = Av 4 + Bv 20 È = A(1 + i )-4 + B(1 + i )-20 ˘

Î ˚
PVA¢ = -4 Av 5 - 20Bv 21
PVA¢¢ = 5 ¥ 4 Av 6 + 21 ¥ 20Bv 22 @ 4% = 981.869

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Similarly, for the liabilities, we have:

PVL = 10v 3 + 20v 6

PVL¢ = -30v 4 - 120v 7
PVL¢¢ = 120v 5 + 840v 8 @ 4% = 712.411

Therefore, the convexity of the assets is greater than the convexity of the
liabilities and Redington’s third condition for immunisation is met.

15 Subject CT1 September 2011 Question 8

(i) Redington’s conditions for immunisation

1. PVA = PVL
2. DMTA = DMTL or vol A = vol L
3. conv A > conv L .

These three conditions must be satisfied at the given starting rate of interest.

(ii)(a) Present value of the liabilities

PVL = 100a40 = 100 ¥ 19.7928 = £1,979.28m

(ii)(b) Duration of the liabilities

1 ¥ 100v + 2 ¥ 100v 2 + 3 ¥ 100v 3 +  + 40 ¥ 100v 40

DMTL =
100v + 100v 2 + 100v 3 +  + 100v 40

=
(
100 v + 2v 2 + 3v 3 +  + 40v 40 )
( 2 3
100 v + v + v +  + v 40
)
100(Ia )40
=
100a40

30,632.31
= = 15.4765 years
1,979.28

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(iii) Nominal amount of each bond required

Let A and B be the nominal amounts (in £m) of the five-year and forty-year
zero-coupon bonds purchased by the company (ie the amounts received
when the bonds are redeemed). Hence:

PVA = Av 5 + Bv 20
5 Av 5 + 20Bv 20
DMTA =
PVA

Equating the PV’s and DMTs of the assets and liabilities gives:

Av 5 + Bv 40 = 1,979.28 Equation (1)

5 40
5 Av + 40Bv = 30,632.31 Equation (2)

(2) – 5(1) gives:

35Bv 40 = 20,735.91 fi B = 2,844.39

Substituting this value into (2):

5 Av 5 = 30,632.31 - 40Bv 40 = 6,934.13 fi A = 1,687.29

So the company should purchase £1,687.29m nominal of the five-year zero-

coupon bond and £2,844.39m nominal of the forty-year zero-coupon bond.

(iv)(a) Estimate the revised present value of the liabilities

To estimate the change in the PVL when the interest rate changes, we need
to work out the volatility of the liabilities. Since DMT = (1 + i ) ¥ vol we have:

15.4765
vol L = = 14.8813
1.04

This tells us that a 1% change in the current interest rate will lead to a
change in the PVL of approximately 14.8813%. So a 1.5% change in the
current interest rate will lead to a change in the PVL of approximately
1.5 ¥ 14.8813 = 22.3219% .

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A reduction in the interest rate will lead to an increase in the PV, so the
estimated PV of the liabilities if the interest rate reduced by 1.5% to 2.5% pa
is:

PVL ª £1,979.28m ¥ 1.223219 = £2, 421.09m

(iv)(b) Calculate the revised present value of the liabilities

The PV of the liabilities (working in £m) at an interest rate of 2.5% pa:

PVL = 100a40 = 100 ¥ 25.1028 = £2,510.28m

(iv)(c) Comment

Our answers to (iv)(a) and (iv)(b) are approximately equal, as expected,

although the estimated value in (iv)(a) is too low. The difference between
the estimate and the accurate value is £89m, which is about 3.5% of the
accurate value.

The reason for the discrepancy is that the volatility tells us about the change
in the PV resulting from an infinitesimally small change in the underlying
interest rate. Here, we have used the volatility to approximate the change in
PV caused by a larger change in the interest rate, so the resulting estimate
will be less accurate.

16 Subject CT1 September 2011 Question 9

(i)(a) Forward rate yield curve

From a forward rate yield curve, we can obtain the forward rate ft ,r , which is
the effective annual interest rate that applies over the future time period from
t to t + r , based on current market prices.

Forward rates tell us the rate of return that could be achieved over a given
future time period from investment in government bonds made today.

(i)(b) Spot rate yield curve

From a spot rate yield curve, we can obtain the spot rate y t , which is the
effective annual interest rate that applies for the t -year time period starting
now.

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Spot rates tell us the rate of return that could be achieved over a period that
starts now from investment in government bonds.

(i)(c) Gross redemption yield curve

From the gross redemption yield curve, we can obtain the gross redemption
yield, which is the effective annual overall pre-tax return, from both the
coupons and the redemption payment, on a government bond if it is held to
maturity.

Since government bonds exist with a variety of different coupon rates, the
gross redemption yield curve will show gross redemption yields that are a
statistical average of those obtained from bonds with different coupons.

(ii) Price of the eurobond

We need to calculate the price of a five-year eurobond, which pays annual

coupons of 10% and is redeemed at par. Each payment from the eurobond
will be valued using a rate of interest equal to:

j = i + 0.01 + 0.001t

where t is the time in years when the payment is due, and i = 0.02t is the
annual effective t -year spot rate of interest. So:

j = 0.02t + 0.01 + 0.001t = 0.01 + 0.021t

If t = 1, j = 0.031 or 3.1%.
If t =2, j = 0.052 or 5.2%.
If t =3, j = 0.073 or 7.3%.
If t = 4, j = 0.094 or 9.4%.
If t =5, j = 0.115 or 11.5%.

The price per 100 nominal of the eurobond is:

10 10 10 10 110
P= + + + + = 97.640
1.031 1.0522 1.0733 1.0944 1.1155

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(iii) Gross redemption yield

The equation of value of for the eurobond is:

97.640 = 10a5 + 100v 5

Using trial and error we get:

i = 10% pa fi RHS = 100

i = 11% pa fi RHS = 96.304

Interpolating between these values:

97.640 - 100
GRY ª 10% + (11% - 10%) = 10.6%
96.304 - 100

(iv) Why this formula for interest rates might be used

Eurobonds are a form of unsecured borrowing. As such, there is a greater

risk of default associated with a eurobond than with secured debt.

The formula used here is based on spot yields derived from government
bonds. These spot yields can be viewed as risk-free rates. An investor
purchasing a eurobond will require a higher return than the risk-free rates to
reflect the riskiness of the investment. This is reflected in the formula by the
additions made to the spot rates.

It seems reasonable that the formula for the interest rate includes an
element that increases over time, to take into account the fact that the
further into the future the payment is due to be received the more uncertainty
there is over whether it will be made.

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17 Subject CT1 April 2012 Question 1

(i) The gross redemption yield for a three-year bond

Using the formula given:

y1 = 0.06 - 0.02e -0.1 = 0.041903

y 2 = 0.06 - 0.02e -0.2 = 0.043625
y 3 = 0.06 - 0.02e -0.3 = 0.045184

We can therefore calculate the price as:

3 3 103
P= + + = 95.845
1.041903 1.0436252 1.0451843

The GRY is the interest rate, i , that satisfies the following equation of value:

95.845 = 3v + 3v 2 + 103v 3

When i = 4% , RHS = 97.225

When i = 5% , RHS = 94.554

By interpolation:

(97.225 - 95.845)
i = 4% + ¥ 1% = 4.52%
(97.225 - 94.554)

(ii) The four-year par yield

The four-year spot rate is:

y 4 = 0.06 - 0.02e -0.4 = 0.046594

The par yield, c, is the solution of the following equation of value:

c c c c 1
1= + + + +
1.041903 1.0436252 1.0451843 1.0465944 1.0465944
1 = 3.587226c + 0.833466

fi c = 4.642% pa

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18 Subject CT1 April 2012 Question 10

(i) The present value of the liabilities

PVL = 200,000a20 + 300,000v 15 @ 8%

= 2,058, 201.99

(ii) The discounted mean term of the liabilities

1 ¥ 200,000v + 2 ¥ 200,000v 2 + ◊ ◊ ◊ + 20 ¥ 200,000v 20 + 15 ¥ 300,000v 15

DMTL =
200,000a20 + 300,000v 15

=
( )
200,000 v + 2v 2 + ◊ ◊ ◊ + 20v 20 + 15 ¥ 300,000v 15
200,000a20 + 300,000v 15

200,000 (Ia )20 + 15 ¥ 300,000v 15

= @ 8%
200,000a20 + 300,000v 15
17, 200,175
=
2,058, 201.99
= 8.3569 years

(iii) The asset choice to satisfy Redington’s first two conditions

Let A and B denote the nominal amounts of each of the securities. The
present value of the assets is:

PVA = A(0.09a12 + 1v 12 ) + B(0.04a30 + 1v 30 ) @ 8%

= A(1.075361) + B(0.549689)

Equating the present values:

A(1.075361) + B(0.549689) = 2,058, 201.99 (1)

The numerator of the DMT for the assets is:

numerator DMTA = A(0.09(Ia )12 + 12v 12 ) + B(0.04(Ia )30 + 30v 30 ) @ 8%

= A(8.56066) + B(7.56986)

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Equating the numerators of the DMTs:

A(8.56066) + B(7.56986) = 17, 200,175 (2)

Using (1):

2,058, 201.99 - 0.549689B

fi A=
1.075361

Substituting back in (2):

È 2,058, 201.99 - 0.549689B ˘

Í 1.075361 ˙ ¥ (8.56066) + 7.56986B = 17, 200,175
Î ˚

fi 3.19394B = 17, 200,175 - 16,384,804 fi B = 255, 287

2,058, 201.99 - 0.549689(255, 287)

fi A= = 1,783, 470
1.075361

Therefore, the company should purchase £1,783,470 nominal of Security A

and £255,287 nominal of Security B.

(iv) Further calculations to ensure immunisation

The third of Redington’s conditions for immunisation requires that the

convexity of the assets is greater than the convexity of the liabilities. The
convexity of the assets will have to be calculated and compared with the
convexity of the liabilities.

19 Subject CT1 September 2012 Question 5 (part)

(ii)(b) Forward rate of interest

Working in months with y1 and y 2 the spot rates and f1,1 the forward rate,
we have:

(1 + y1 )(1 + f1,1 ) = (1 + y 2 )2
(1.01)(1 + f1,1 ) = (1.02)2 fi f1,1 = 3.0099%

So the nominal rate convertible monthly is 12 ¥ 3.0099% = 36.12% .

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20 Subject CT1 September 2012 Question 9

(i) Theories for the shape of the yield curve

The expectations theory states that the relative attraction of short-term and
long-term investments will vary according to expectations of future
movements in interest rates. An expectation of a fall in interest rates will
make short-term investments less attractive and long-term investments more
attractive. This will make yields on short-term investments rise, and yields
on long-term investments fall. An expectation of a rise in interest rates will
have the opposite effect.

The liquidity preference theory states that investors prefer short-term

investments to long-term investments. This is because long-term bonds are
more sensitive to interest rate movements than short-term bonds. Risk-
averse investors will require compensation for this extra risk (in the form of
higher yields). This preference for short-term investments helps to increase
the yield on longer-term bonds.

The market segmentation hypothesis says that the term structure is

determined by different forces of supply and demand. Bonds of different
terms are attractive to different types of investors who will choose assets that
are similar in term to their liabilities. For example, banks prefer very short-
term investments, as their liabilities are very short-term. Pension funds have
liabilities that are very long-term. So the longest-term bonds are attractive
investments for pension funds. The demand for bonds will therefore differ
for bonds of different terms. The supply of bonds will also vary by term, as
governments, and companies’ strategies may not correspond to the
investors’ requirements.

(ii) Duration of the bonds

For the one-year bond there is only one cashflow which is 104 at time 1, so
the duration is 1.

The duration of the three-year bond is:

1 ¥ 4v + 2 ¥ 4v 2 + 3 ¥ 104v 3 280.583
= = 2.88 years
4v + 4v 2 + 104v 3 97.277

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The duration of the five-year bond is:

1 ¥ 4v + 2 ¥ 4v 2 + 3 ¥ 4v 3 + 4 ¥ 4v 4 + 5 ¥ 104v 5
4a5 + 100v 5

4(Ia )4 + 520v 5 4 ¥ 8.6488 + 520v 5 442.029

= = = = 4.62 years
4 ¥ 4.3295 + 100v 5 95.671 95.671

(iii) Why is the duration lower?

The coupons for a five-year bond with a coupon rate of 8% will be a higher
percentage of the total proceeds than the coupons with a coupon rate of 4%.
Since a greater proportion of the proceeds are received before the end of
the term the average time of the payments will be less. Hence the duration
will be lower.

(iv) Effective rates of return

The cashflows for Option 1 are:

P=95
4 4 4 4 79

0 1 2 3 4 5

The equation of value is:

95 = 4v + 4v 2 + 4v 3 + 4v 4 + 79v 5

Note that the sum of the income is 4 + 4 + 4 + 4 + 79 = 95 , so the effective

rate of interest is 0%.

The cashflows for Option 2 are:

P=95
4 4 4 4 1 1 101

0 1 2 3 4 5 6 12

The equation of value is:

95 = 4a4 + a7 v 4 + 101v 12

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Using trial and error, we get:

i = 3% fi 4a4 + a7 v 4 + 101v 12 = 91.24

I = 2% fi 4a4 + a7 v 4 + 101v 12 = 100.85

Interpolating between these two values:

i - 2% 95 - 100.85
= fi i = 2.6%
3% - 2% 91.24 - 100.85

This means the higher rate of return is achieved on Option 2.

(v) Other considerations

Any TWO of the following:

 can the investor wait until time 12 to get the redemption payment or
does he need the cash before that time?
 will the higher duration of Option 2 be suitable for the investor?
 is the credit risk higher for Option 2 because of the longer duration?
 what is the tax situation for the investor – is one option better than the
other because of income and capital gains tax?
 what else could the investor do with the redemption payment from
Option 1 in the time between 5 and 12 (ie could they reinvest the
money)?

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21 Subject CT1 September 2012 Question 10

(i) Why the payback period and discounted payback period are not good
indicators of whether this project is worthwhile

The PP tells us when the income from the project exceeds the outgo on the
project, ignoring interest.

The DPP also calculates when a project moves into profit but it takes into
account interest. However it ignores the overall profitability of the project.

There may not be a unique time when the net cashflow changes from
negative to positive.

(ii)(a) Payback period for Project B

Working in £millions, the cashflows for Project B are:

0.64 0.64 0.64 0.64 0.64 0.64

-3

0 1 2 3 4 5 6

The total of the cashflows up to time t is -3 + 0.64t . The payback period is

when the total of the cashflows is zero which is:

3
= 4.6875 years
0.64

(ii)(b) Discounted payback period for Project B

If the discounted payback period is n , then:

3 = 0.64an

Rearranging this using i = 4% :

1 - 1.04 - n
3 = 0.64 fi 1.04 - n = 0.8162
ln1.04
ln 0.8162
fi ln1.04 - n = ln 0.8162 fi n=- = 5.18 years
ln1.04

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(iii) Cross-over point

Project A:

NPVA = -3 + 0.5v 0.5 + 0.5(1.1)v 1.5 + 0.5(1.1)2 v 2.5 +  + 0.5(1.1)5 v 5.5

Summing the geometric series:

1 - (1.1v )6
NPVA = -3 + 0.5v 0.5
1 - 1.1v

Project B:

NPVB = -3 + 0.64a6

At i = 0% , we have that v = 1 , so for Project A:

1 - (1.1v )6 1 - (1.1)6
NPVA = -3 + 0.5v 0.5 = -3 + 0.5 = 0.8578
1 - 1.1v 1 - 1.1

From first principles, under Project B we receive income of 0.64 pa for 6

years, at 0% interest this gives 0.64 ¥ 6 . So:

NPVB = -3 + 0.64 ¥ 6 = 0.84

This means that NPVA > NPVB at 0%.

At i = 4% , we have:

1 - (1.1v )6
NPVA = -3 + 0.5v 0.5
1 - 1.1v

( )
6
1.1
1- 1.04
-0.5
= -3 + 0.5 ¥ 1.04 1.1
= 0.4001
1 - 1.04

1 - 1.04 -6
NPVB = -3 + 0.64 ¥ = 0.4216
ln1.04

This means that NPVA < NPVB at 4%.

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At one rate the net present value for A exceeds B and at the other rate B
exceeds A. This means there is a cross-over point.

(iv) Duration of incoming cashflows

From (iii) the present value of the incoming cashflows is the NPV plus the
outgo which is 3. So for Project A this is 3 + 0.4001 = 3.4001 and for Project
B it is 3 + 0.4216 = 3.4216 .

For Project A, the duration of the incoming cashflows at 4% pa is:

0.5 ¥ 0.5v 0.5 + 1.5 ¥ 0.5(1.1)v 1.5 + 2.5 ¥ 0.5(1.1)2 v 2.5 +

3.5 ¥ 0.5(1.1)3 v 3.5 + 4.5 ¥ 0.5(1.1)4 v 4.5 + 5.5 ¥ 0.5(1.1)5 v 5.5
3.4001
10.7556
= = 3.16 years
3.4001

For Project B, the incoming cashflows are paid continuously so the duration
of the incoming cashflows at 4% pa is:

6
0.64 Ú tv t dt
0
=
( )
0.64 Ia
6
=
(Ia) 6
=
15.4104
= 2.88 years
6 0.64a6 a6 5.3463
0.64 Ú v t dt
0

(v) NPV for Project A falls more rapidly than for Project B

Since the duration is higher for Project A than Project B, the present value of
the incoming cashflows is more sensitive to changes in the rate of interest.
Hence the NPV of Project A falls more rapidly than that of Project B when
the rate of interest increases.

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22 Subject CT1 April 2013 Question 3

(i) GRY of the three year bond

103
-97 6 6 6 payments

0 1 2 3 time

The equation of value for the three-year bond is:

97 = 6v + 6v 2 + 109v 3

Using trial and improvement we get:

i = 8% fi RHS = 97.2273
i = 9% fi RHS = 94.7227
i = 8.5% fi RHS = 95.9637

So interpolating between 8% and 8.5%, we have:

97 - 97.2273
GRY = 8% + ¥ (8.5% - 8%) = 8.09% pa
95.9637 - 97.2273

(ii) Spot rate

103
-97 6 payments

0 1 time

y1

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103
-97 6 6 payments

0 1 2 time

y1

y2

The equation of value for the one-year bond (with one-year spot rate y1 ) is:

1
97 = 109 ¥ fi y1 = 12.3711% pa
1 + y1

The equation of value for the two-year bond (with two-year spot rate y 2 ) is:

1 1
97 = 6 ¥ + 109 ¥ fi y 2 = 9.0491% pa
1 + y1 (1 + y 2 )2

23 Subject CT1 April 2013 Question 7

(i) Values of X and Y

Working in units of £1million, the present value of the assets and liabilities
(at 8% pa) are:

PVA = Xv 5 + Yv 20

PVL = 6v 8 + 11v 15 = 6.709272

Equating these we have:

Xv 5 + Yv 20 = 6.709272 (1)

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The DMT of the assets and liabilities are:

Xv 5 ¥ 5 + Yv 20 ¥ 20
DMTA =
Xv 5 + Yv 20

6v 8 ¥ 8 + 11v 15 ¥ 15
DMTL =
6v 8 + 11v 15

Equating the numerators (as the denominators are equal from (1)), we have:

5 Xv 5 + 20Yv 20 = 48v 8 + 165v 15 = 77.947788 (2)

Alternatively, we could have worked with the numerators of the volatility to

obtain 5 Xv 6 + 20Yv 21 = 48v 9 + 165v 16 = 72.173878 for our second
equation.

Multiplying Equation (1) by 5, and subtracting it from Equation (2), we get:

15Yv 20 = 77.947788 - (5 ¥ 6.709272) = 44.401427

44.401427 ¥ 1.0820
fi Y = = 13.796877
15

Substituting this into Equation (1) and rearranging gives:

6.709272 - 13.796877v 20
X = = 5.508771
v5

So we need to purchase £5.509 million nominal of the 5-year bond, and

£13.797 million nominal of the 20-year bond.

(ii) Third condition

Differentiating the present values with respect to the interest rate, i :

PVL = 6v 8 + 11v 15
PVL¢ = -8 ¥ 6v 9 - 15 ¥ 11v 16
PVL¢¢ = 9 ¥ 8 ¥ 6v 10 + 16 ¥ 15 ¥ 11v 17 = 913.610

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PVA = Xv 5 + Yv 20
PVA¢ = -5 Xv 6 - 20Yv 21
PVA¢¢ = 6 ¥ 5 Xv 7 + 21 ¥ 20Yv 22 = 1,162.307

Since PVA¢¢ > PVL¢¢ Redington’s third condition for immunisation is satisfied.

Alternatively, we could have calculated the convexities:

PVL¢¢ 913.610 PVA¢¢ 1,162.307

conv L = = = 136.17 conv A = = = 173.24
PVL 6.709272 PVA 6.709272

And see that conv A > conv L .

24 Subject CT1 September 2013 Question 10 (part)

(i) Accumulated values

Ê t2 ˆ
A(t1, t2 ) = exp Á Ú 0.05 + 0.002t dt ˜
ÁË t ˜¯
1

t2
= exp È0.05t + 0.001t 2 ˘
Î ˚t1

(
= exp 0.05(t2 - t1 ) + 0.001(t22 - t12 ) )
(a) From time 0 to time 7

( )
A(0,7) = exp 0.05(7 - 0) + 0.001(72 - 0) = e0.399 = 1.4903

(b) From time 0 to time 6

( )
A(0, 6) = exp 0.05(6 - 0) + 0.001(62 - 0) = e0.336 = 1.3993

(c) From time 6 to time 7

A(0,7) e0.399
A(6,7) = = = e0.063 = 1.0650
A(0, 6) e0.336

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(ii)(a) Seven-year spot rate

(1 + y 7 )7 = A(0,7) = 1.4903 fi y 7 = 5.866% pa

(ii)(b) Six-year spot rate

(1 + y 6 )6 = A(0, 6) = 1.3993 fi y 6 = 5.760% pa

(ii)(c) One-year forward rate

(1 + f6,1 )1 = A(6,7) = 1.0650 fi f6,1 = 6.503% pa

(iii) Why is the forward rate higher?

The seven-year spot rate ‘averages’ the interest rates throughout the seven
years. The rate of interest increases with time, so you would expect the one-
year forward rate at the end of the seven years to be higher than the
‘average’ rate across the whole time period.

25 Subject CT1 September 2013 Question 11

(i) Present value of the liabilities

Working in £millions, the present value of the liabilities at 4% pa is:

1 - 1.04 -40
10a40 = 10 = 197.928
0.04

(ii) Nominal amount held in each security

Let X be the nominal amount (in £millions) invested in the first security and
Y be the nominal amount (in £millions) invested in the second security.

The present value of a unit sum invested in the first security is:

0.05a10 + v 10

The present value of a unit sum invested in the second security is:

0.1a5 + v 5

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Therefore:

197.928
2
(
= 98.964 = X 0.05a10 + v 10 )
= X (0.40554 + 0.67556)
= 1.0811X

fi X = 91.539

197.928
2
(
= 98.964 = Y 0.1a5 + v 5 )
= Y (0.44518 + 0.82193)
= 1.2671Y

fi Y = 78.102

So the nominal amounts invested in the securities are £91,539,000 (5SF)

and £78,102,000 (5SF) respectively.

(iii) Duration of the bonds

The duration of the liabilities evaluated at 4% pa is:

t =
 time ¥ PV =
1 ¥ 10v + 2 ¥ 10v 2 +  + 40 ¥ 10v 40
 PV 10a40

=
(
10 v + 2v 2 +  + 40v 40 )
10 a40
(Ia )40
=
a40
306.323
= = 15.477 years
19.793

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(iv) Duration of the assets

The duration of the assets is:

X (1 ¥ 0.05v + 2 ¥ 0.05v 2 +  + 10 ¥ 0.05v 10 + 10v 10 )

+ Y (1 ¥ 0.1v + 2 ¥ 0.1v 2 +  + 5 ¥ 0.1v 5 + 5v 5 )
197.928
(
X 0.05(v + 2v 2 +  + 10v 10 ) + 10v 10 )
=
(
+ Y 0.1(v + 2v 2 +  + 5v 5 ) + 5v 5 )
197.928

=
( ) (
X 0.05(Ia )10 + 10v 10 + Y 0.1(Ia )5 + 5v 5 )
197.928

Calculating this at 4% pa gives:

810.603 + 422.554
= = 6.230 years
197.928

(v) Profit or loss?

Here, the duration of the assets is less than the duration of the liabilities so
the fund is not immunised. The drop in interest rate will result in a larger rise
in the PV of the liabilities than the PV of the assets and hence a loss will be
made.

26 Subject CT1 April 2014 Question 6

(i) Two conditions for immunisation

The present value of the assets and liabilities at 7% pa are:

PVA = 7.404v 2 + 31.834v 25 = 12.332

PVL = 10v 10 + 20v 15 = 12.332

Since these are equal, the first condition for immunisation is satisfied.

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The discounted mean terms for the assets and liabilities at 7% pa are:

7.404v 2 ¥ 2 + 31.834v 25 ¥ 25 159.569

DMTA = =
PVA PVA

10v 10 ¥ 10 + 20v 15 ¥ 15 159.569

DMTL = =
PVL PVL

Since we know that the denominators are equal and we can see that the
numerators are equal, the DMTs are also equal.

So the first two conditions for immunisation are both satisfied.

Alternatively, we could have shown that the DMTs were both equal to
12.939, or the volatilities were both equal to 12.093, or the first derivatives of
the PVs were both equal to –149.130.

(ii) Present value of profit

The present value of the profit at the new interest rate of 7.5%pa is:

PVprofit = PVA - PVL

= 7.404v 2 + 31.834v 25 - 10v 10 - 20v 15
= 0.015773

This gives us a present value of profit of about £15,800.

(iii) Explanation of profit

We can see that the third condition for immunisation will also be satisfied.
The spread of the assets about the discounted mean term is greater than the
corresponding spread of the liabilities. So the third condition for
immunisation will also be satisfied, and we will be immunised against any
losses arising from a small change in the interest rate. So, when the rate
changes to 7.5% pa, we make a small profit.

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27 Subject CT1 April 2014 Question 9

(i) One year forward rates

y2% pa
y1% pa

0 1 2 3

f1, 1% pa

Using the formula given in the question, the spot rates are:

y1 = 0.035 + 0.001 = 0.036

y 2 = 0.035 + 0.002 = 0.037

Equating equivalent accumulation factors gives:

(1 + y 2 )2 = (1 + y1) (1 + f1,1)
1.0372
fi 1 + f1,1 = = 1.03800 fi f1,1 = 3.800% (4 SF)
1.036

y3% pa
y2% pa

0 1 2 3

f2, 1% pa

We have:

y 3 = 0.035 + 0.003 = 0.038

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Equating equivalent accumulation factors gives:

(1 + y 3 )3 = (1 + y 2 )2 (1 + f2,1)
1.0383
fi 1 + f2,1 = = 1.04000 fi f2,1 = 4.000% (4 SF)
1.0372

(ii)(a) Price of a three year bond

105
–P 4 4 4

0 1 2 3
3.6% pa
3.7% pa
3.8% pa

4 4 109
P= + + = 105.0425
1.036 1.0372 1.0383

The price is £105.04 per £100 nominal.

(ii)(b) Two-year par yield

The two-year par yield is the annual coupon rate, C , at which a two year
bond redeemed at par needs to pay in order to be priced at par.

100
-100 C C

0 1 2
3.6% pa
3.7% pa

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So we have:

C 100 + C
100 = +
1.036 1.0372

Ê 1 ˆ Ê 1 1 ˆ
fi 100 Á1 - =CÁ +
Ë 1.0372 ˜¯ Ë 1.036 1.0372 ˜¯
fi C = 3.6982

So the par yield is 3.698% pa.

28 Subject CT1 September 2014 Question 6

(i) Purchase price

The purchase price for £100 nominal is:

P = 0.8 ¥ 5a10 + 100v 10

Evaluating these functions at 4% pa:

1  1.04 10
P  0.8  5   100  1.0410  32.44358  67.55642  £100
0.04

(ii) Discounted mean term

1 ¥ 5v + 2 ¥ 5v 2 +  + 10 ¥ 5v 10 + 10 ¥ 100v 10
DMT =
5v + 5v 2 +  + 5v 10 + 100v 10

=
( )
5 v + 2v 2 +  + 10v 10 + 10 ¥ 100v 10

(
5 v + v 2 +  + v 10 ) + 100v 10

5 (Ia )10 + 10 ¥ 100v 10

=
5a10 + 100v 10

Evaluating this at 4% pa gives:

5 ¥ 41.99225 + 10 ¥ 100 ¥ 0.67556

DMT = = 8.19090
5 ¥ 8.11090 + 100 ¥ 0.67556

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(iii)(a) Discounted mean term gross versus net

If we use the gross coupon payments of 5%, rather than the net coupons of
4%, the coupons form a greater proportion of the overall cashflows. So the
coupons receive a higher weighting in the calculation of the weighted
average. But the coupons are received earlier than the redemption
proceeds, so the DMT will be lower.

(iii)(b) State two factors

 the term of the bond

 the interest rate used in the calculation.

(iv) New price of the bond

By accumulating the price by three months the new price of the bond is:

100 ¥ 1.041/ 4 = £100.99

29 Subject CT1 September 2014 Question 8

(i)(a) Market segmentation theory

Market segmentation theory says that the shape of the yield curve is
determined by supply and demand at different terms. So, for example,
yields at the short end of the curve will be determined by demand from
investors who have a preference for short dated stocks, ie those with short-
dated liabilities, as well as by the supply of short-dated stock. Similarly,
yields at the long end will be a function of demand from investors interested
in buying long bonds to match long-dated liabilities, and of supply of long-
dated stock.

(i)(b) Liquidity preference theory

Liquidity preference theory states that investors will in general prefer more
liquid (ie shorter) stocks to less liquid ones, as short-dated stocks are less
sensitive to changes in interest rates. Hence, investors purchasing long-
dated bonds will require higher yields in order to compensate them for the
greater volatility of the stock they are purchasing.

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(ii) Gross redemption yields

The diagram of the rates we are given in the question is:

0 1 2 3 4 time

forward rates
6% pa 5% pa 4% pa 3% pa
y1
y2 spot rates
y3
y4

The gross redemption yields for the zero-coupon bonds are the spot rates.
Hence:

y1 = 6% pa

(1 + y 2 )2 = 1.06 ¥ 1.05 fi y 2 = 5.499% pa

(1 + y 3 )3 = 1.06 ¥ 1.05 ¥ 1.04 fi y 3 = 4.997% pa

(1 + y 4 )4 = 1.06 ¥ 1.05 ¥ 1.04 ¥ 1.03 fi y 4 = 4.494% pa

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(iii) Gross redemption yield

The cashflow diagram is:

110
–P 4 4 4 4 cashflow

0 1 2 3 4 time
6% pa
5.499% pa
4.997% pa
4.494% pa

So the price of the bond is given by:

P = 4 È(1.06) + (1.05499) + (1.04997) ˘ + 114 (1.04494)

-1 -2 -3 -4
ÍÎ ˙˚
= 4 ÈÎ0.94340 + 0.89847 + 0.86392 ˘˚ + 114 ¥ 0.83875 = 106.441

The equation for the gross redemption yield is:

106.441 = 4a4 + 110v 4

We will use trial and improvement to solve this for the GRY. However, since
we discounted the cashflows at spot rates of 6%, 5.499%, 4.997% and
4.494%, the GRY will lie between these values. Because most of the
cashflow arises at the end of four years, it is likely that y 4 will give us a
reasonable first approximation.

i = 4.5% fi 4a4 + 110v 4 = 106.592

i = 5% fi 4a4 + 110v 4 = 104.681

Using linear interpolation between these two values, we obtain a gross

redemption yield of:

106.441 - 106.592
4.5% + ¥ (5% - 4.5%) = 4.54%
104.681 - 106.592

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(iv) Explain why ...

For the bond with the 8% coupon redeemed at par, a greater proportion of
the proceeds are received earlier, in the coupon payments, rather than in the
redemption proceeds. Since interest rates are higher earlier on, the GRY
(which is a weighted average of the rates used to discount the payments)
would be higher.

(v) Effect of regulation

If banks are required to hold more short-dated bonds, demand for these
types of bonds will increase. If the supply of these bonds remains the same,
this will push up the price of these bonds, causing their gross redemption
yields and hence spot rates to fall.

30 Subject CT1 April 2015 Question 7

(i) Value of the liabilities

Discounting using the appropriate spot rates, y t , the present value is:

1 1 1 1 2
PV = ½
+ 1½
+ 2½
+ 3½
+
(1 + y ½ ) (1 + y1½ ) (1 + y 2½ ) (1 + y 3½ ) (1 + y 4½ )4½
1 1 1 1 2
= ½
+ 1½
+ 2½
+ 3½
+
1.01 1.03 1.05 1.07 1.094½
= 0.995037 + 0.956630 + 0.885170 + 0.789145 + 1.357097

= 4.983079

ie about £4.983 million.

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(ii) Reasons for a rising yield curve

The spot yield curve might rise with term to redemption because:
 investors’ expectations are that short term interest rates will rise over
the next few years (expectations theory)
 short term bonds may be in demand from institutional investors, leading
to higher bond prices and hence lower yields at shorter terms to
redemption (market segmentation)
 investors may have a preference for more liquid investments, leading to
higher bond prices in the shorter term (liquidity preference)

(iii) Forward rate of interest

Using the notation y t for the t-year spot rate of interest, and f3½,1 for the
one-year forward rate starting at time 3½, we have:

(1 + y 3½ )3½ (1 + f3½,1) = (1 + y 4½ )4½

Then setting y 3½ = 0.07 and y 4½ = 0.09 gives:

f3½,1 =
(1 + y 4½ )4½ - 1 = 1.094½ - 1 = 0.16299
(1 + y 3½ )3½ 1.073½

So the one-year forward rate at time 3½ is 16.3% pa.

31 Subject CT1 April 2015 Question 8

(i) Price of the security

The price of the security at issue for 100 nominal is:

P = 9a10 + 100v 10

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Evaluating these functions at 7% interest, we obtain:

1 - 1.07 -10
P =9¥ + 100 ¥ 1.07 -10
0.07
= 9 ¥ 7.02358 + 100 ¥ 0.50835

= 114.0472

The price is about 114.05 per 100 nominal.

(ii) Discounted mean term of the security at issue

The discounted mean term is:

1 ¥ 9v + 2 ¥ 9v 2 + 3 ¥ 9v 3 +  + 10 ¥ 9v 10 + 10 ¥ 100v 10
DMT =
( )
9 v +  + v 10 + 100v 10

9 (Ia )10 + 100 ¥ 10v 10

=
9a10 + 100v 10

9 ¥ 34.7391 + 508.3493
=
114.0472
= 7.1988

ie approximately 7.20 years.

(iii) Explanation

If the coupons are only 3% instead of 9%, the cashflows arising are now
even more weighted towards the end of the term, as a smaller proportion of
the cashflow arises from the coupons. Hence the DMT will be longer.

(iv)(a) Volatility

The volatility of the security is:

7.1988
= 6.7278
1.07

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(iv)(b) Explanation

Volatility or effective duration tells us how much the price of the bond is likely
to change given a 1% change in underlying interest rates. So it tells
investors the extent of the risk to which they are exposed.

32 Subject CT1 September 2015 Question 3

(i) Duration of the annuity

The duration of the annuity (liability) is given by:

DMT =
 time ¥ PV =
500(1v + 2v 2 +  + 12v 12 )
=
(Ia )12
 PV 2
500(v + v +  + v 12
) a12

Calculating this at 4% pa we get:

56.6328
= 6.03 years
9.38507

(ii) Duration of bond

The duration of the bond (asset) is given by:

5(1v + 2v 2 +  + 8v 8 ) + 8 ¥ 100v 8 5(Ia )8 + 800v 8

=
5(v + v 2 +  + v 8 ) + 100v 8 5a8 + 100v 8

Calculating this at 4% pa we get:

5 ¥ 28.9133 + 800 ¥ 1.04 -8 729.12

-8
= = 6.83 years
5 ¥ 6.73274 + 100 ¥ 1.04 106.73

(iii) What happens when there is an increase in interest rates?

Since the duration of the bond (the asset) is greater than the duration of the
annuity (the liability) its present value will decrease more than the liability
with an increase in interest rates. Hence the insurance company will make a
loss.

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33 Subject CT1 September 2015 Question 6

(i) Gross redemption yield

The GRY is redemption yield is the interest rate that satisfies:

101 = 3a3 + 100v 3

Using trial and error:

i = 2% fi RHS = 102.884
i = 3% fi RHS = 100

Interpolating between these gives:

101 - 102.884
i = 2% + (3% - 2%) = 2.65% pa
100 - 102.884

(ii) Spot rates

Let y n denote the n -year spot rate of interest.

The equation of value for the 1 year bond is:

103
101 =
1 + y1

Solving this gives:

103
1 + y1 = fi y1 = 0.01980198
101

So the 1-year spot rate is 1.980% pa to 4 significant figures.

The equation of value for the 2 year bond is:

3 103
101 = +
1 + y1 (1 + y 2 )2

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Using the value for y1 already calculated gives:

103
= 98.0582524
(1 + y 2 )2
(1 + y 2 )2 = 1.05039604
y 2 = 0.02488831

So the 2-year spot rate is 2.489% pa to 4 significant figures.

The equation of value for the 3 year bond is:

3 3 103
101 = + +
1 + y1 (1 + y 2 )2 (1 + y 3 )3

Using the values for y1 and y 2 already calculated gives:

103
= 95.2021868
(1 + y 3 )3
(1 + y 3 )3 = 1.08190792
y 3 = 0.02658938

So the 3-year spot rate is 2.659% pa to 4 significant figures.

(iii) Forward rates

We have:

(1 + y 3 )3 = (1 + y 2 )2 (1 + f2,1 )

Substituting in our spot rates from part (ii) gives:

1.08190792 = 1.05039604 ¥ (1 + f2,1 )

f2,1 = 0.03

So the 1-year forward rate from time 2 is 3% pa exactly.

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(iv) Explain

The investors expect a rise in future interest rates.

This will make short-term investments more attractive and longer-term

investments less attractive. So demand for short-term investments will rise,
prices will rise and yields on short-term investments will fall. Demand for
longer-term investments will fall, prices will fall and yields on longer-term
investments will rise.

Because of liquidity preference investors will require higher yields on longer-

term bonds to compensate them for the risk.

Market segmentation theory would imply that there is less demand or more
supply of longer-term bonds. Alternatively, there is more demand or less
supply of shorter-term bonds.

34 Subject CT1 April 2016 Question 2

(i) Conditions for immunisation

The first condition for immunisation is that the present value of the assets
equals the present value of the liabilities.

Working in units of millions of pounds, the present value of the liabilities is:

PVL = 6v 8 + 11v 15 = 6 ¥ 1.08 -8 + 11 ¥ 1.08 -15 = 6.709272

The corresponding figure for the present value of the assets is:

PVA = 5.5088v 5 + 13.7969v 20

= 5.5088 ¥ 1.08 -5 + 13.7969 ¥ 1.08 -20 = 6.709297

So the present values are equal (to 5SF).

The second condition for immunisation is that the DMT of the assets equals
the DMT of the liabilities. Since the denominator of the DMT is the present
value of the cashflows and we have already shown that these are equal, it is
enough to consider the numerators of the DMT.

The numerator of the DMT for the liabilities is:

8 ¥ 6v 8 + 15 ¥ 11v 15 = 48 ¥ 1.08 -8 + 165 ¥ 1.08 -15 = 77.947788

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The numerator of the corresponding DMT for the assets is:

5 ¥ 5.5088v 5 + 20 ¥ 13.7969v 20
= 27.544 ¥ 1.08 -5 + 275.938 ¥ 1.08 -20
= 77.947987

Again these are equal to 5SF.

So the first two conditions for Redington’s theory of immunisation are

satisfied.

(ii) Is the company immunised?

In order to be immunised, the convexity of the assets must be greater than

the convexity of the liabilities, that is, the assets must be more spread out
than the liabilities around the discounted mean term.

Here, the terms of the assets are 5 and 20 years, whereas the terms of the
liabilities are less spread out, being only 8 and 15 years. So the third
condition for immunisation is also satisfied, and the company will be
immunised against small changes in interest rates.

35 Subject CT1 April 2016 Question 3

(i) Issue price

The cashflow diagram for the 3-year bond is:

£105
-£P £4 £4 £4 Payment

0 1 2 3 Time

f0, 1 = 4% f1, 1 = 5% f2, 1 = 6%

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Using the appropriate discount factor for each of the cashflows, the price P
is the present value of the cashflows arising from holding the bond:

4 4 105 + 4
P= + +
1.04 1.04 ¥ 1.05 1.04 ¥ 1.05 ¥ 1.06
= 3.846154 + 3.663004 + 94.166839 = 101.675997

So the issue price is £101.68 per £100 nominal.

(ii) Three-year par yield

Using C for the required coupon, we have the following equation of value:

C C 100 + C
100 = + +
1.04 1.04 ¥ 1.05 1.04 ¥ 1.05 ¥ 1.06

Rearranging gives:

Ê 1 1 1 ˆ Ê 1 ˆ
CÁ + + = 100 Á1 -
Ë 1.04 1.04 ¥ 1.05 1.04 ¥ 1.05 ¥ 1.06 ˜¯ Ë 1.04 ¥ 1.05 ¥ 1.06 ¯˜
2.741205C = 13.608404

So:

C = 4.964387

So the par yield here is about 4.96% pa.

36 Subject CT1 September 2016 Question 8

(i) Gross redemption yield

The equation of value for the three-year bond is:

96 = 4a3 + 100v 3

At i = 5% pa , the value of the right-hand side of this equation is 97.277.

At i = 5.5% pa , the PV is 95.953.

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So interpolating between 5% and 5.5%, we obtain:

96 - 97.277
i = 0.05 + ¥ 0.005 = 0.05482
95.953 - 97.277

So the gross redemption yield on the three-year bond is 5.48% pa.

(ii) One-year and two-year spot rates

1
Let y t be the t-year spot rate, and let v t = .
1 + yt

The equation of value for the one-year bond is:

96 1
96 = 104v1 fi v1 = = 0.92308 fi y1 = - 1 = 0.08333
104 v1

So the one-year spot rate is 8.333% pa.

For the two-year spot rate, we use the equation of value for the two-year
bond:

96 = 4v1 + 104v 22

Rearranging this, and using the value of v1 that we have already found:

96 - 4v1 96 - 4 ¥ 0.92308
v2 = = = 0.94211
104 104

So that:

1
y2 = - 1 = 0.06145
0.94211

So the two-year spot rate is 6.145% pa.

(iii) One-year forward rate at time one

Using f1,1 for the one-year forward rate at time one, we know that:

(1 + y1) (1 + f1,1) = (1 + y 2 )2

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Rearranging this:

f1,1 =
(1 + y 2 )2 - 1 = 1.061452 - 1 = 0.04000
1 + y1 1.08333

So the one-year forward rate at time one is 4% pa.

(iv) Explanation

The three-year gross redemption yield will be a weighted average of the

three spot rates y1 , y 2 and y 3 .

We know that the gross redemption yield is 5.48% pa, and that y1 = 8.333%
and y 2 = 6.145% . For the gross redemption yield to be a weighted
average, y 3 must be lower than the gross redemption yield, since the other
two spot rates are both higher.

37 Subject CT1 September 2016 Question 11

(i) Duration of the current portfolio

The duration is another name for the discounted mean term (DMT).

Working in billions of pounds, the present value of the cashflows arising from
the current bond holdings, calculated at 6% pa, is:

PV = 0.04 ¥ 4 a3 + 4 v 3 + 0.04 ¥ 5 a10 + 5 v 10

Working out the values of the compound interest functions:

1 - 1.06 -3 1 - 1.06 -10

PV = 0.16 ¥ + 4 ¥ 1.06 -3 + 0.2 ¥ + 5 ¥ 1.06 -10
0.06 0.06
= 0.16 ¥ 2.67301 + 3.35848 + 0.2 ¥ 7.36009 + 2.79197 = 8.05015

The numerator of the DMT expression is given by:

 t ¥ Ct v t = 0.16(Ia )3 + 4 ¥ 3v 3 + 0.2(Ia )10 + 5 ¥ 10v 10

where the first two terms on the right-hand side relate to the three-year bond
and the final two terms relate to the ten-year bond.

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Evaluating these functions:

0.16 (Ia )3 + 4 ¥ 3v 3 + 0.2 (Ia )10 + 5 ¥ 10v 10

a3 - 3v 3 a10 - 10v 10

= 0.16 ¥ + 12v 3 + 0.2 ¥ + 50v 10
i i
= 0.16 ¥ 5.24225 + 10.07543 + 0.2 ¥ 36.96241 + 27.91974 = 46.2264

So the duration is given by:

46.2264
DMT = = 5.7423
8.05015

The duration is about 5.742 years.

(ii) Duration of proposed portfolio

The duration of our new portfolio with £k bn nominal is:

DMT =
 time ¥ PV =
k ¥ 0.05(v 1 + v 2 ¥ 2 + v 3 ¥ 3 + )
 PV k ¥ 0.05(v 1 + v 2 + v 3 + )

(Ia )• 1 di 1
= = =
a• 1i d

Note that:

Ê a - nv n ˆ
1/ d - 0 1
( ) • nÆ• ( ) n nÆ• Á n i ˜˜ = i = di
I a = lim I a = lim Á
Ë ¯

Calculating this gives:

1 1 + i 1.06
= = = 17.66667
d i 0.06

So the duration is about 17.667 years.

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(iii) Nominal amount of new bonds to be issued

The present value of the proposed portfolio is 80% of that of the current
portfolio, whose present value calculated in part (i) was £8.05015bn. This
gives us the following equation for k , the nominal amount of new bonds to
be issued:

0.05 k a• = 0.8 ¥ 8.05015

Using a• = 1/ i , we have:

1
0.05k ¥ = 0.8 ¥ 8.05015
0.06

Solving this equation, we find that k = 7.72814 . So the nominal amount of

new bonds to be issued is £7.728 billion.

38 Subject CT1 April 2017 Question 5

(i) Is it possible to immunise with a single zero-coupon bond?

The investment manager will not be able to immunise the fund with a single
zero-coupon bond because Redington’s third condition, ie that the convexity
of the assets is greater than the convexity of the liabilities, will not be met.
The liabilities are due in 7 years’ time and 11 years’ time, so a single
zero-coupon bond (with only one payment) cannot be more spread (ie more
convex) than the liabilities.

(ii) Is the fund immunised?

For the fund to be immunised against small changes in the rate of interest,
all three of Redington’s conditions need to be satisfied. Using a subscript of
A to refer to the asset cashflows, and a subscript of L to refer to the liability
cashflows, these conditions are:

 PVA  PVL

 DMTA  DMTL , or equivalently volA  volL or PVA  PVL

 conv A  conv L , or equivalently PVA  PVL

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Working in units of millions of pounds, and using i  5.5% , the present

value of the liabilities is:

PVL  11v 7  8.084v 11  12.04770

The corresponding figure for the present value of the assets, again using
i  5.5% , is:

PVA  15.363v 7.5  3.787v 14.25  12.04794

So the present values are equal (to 5 SF), and Redington’s first condition for
immunisation is satisfied.

Since the present values of the assets and liabilities are equal, for the
second condition, we need only consider the numerator of the DMT in each
case.

The numerator of the DMT for the liabilities, using i  5.5% , is:

7  11v 7  11 8.084v 11  102.2775

The numerator of the DMT for the assets, again using i  5.5% , is:

7.5  15.363v 7.5  14.25  3.787v 14.25  102.2789

Again these are equal to 5 SF, so Redington’s second condition for

immunisation is satisfied.

Alternatively, we could show that the DMT is 8.489 years (to 4 SF) for both
the assets and liabilities.

Alternatively, we could calculate the volatility of the assets and the liabilities.
For the liabilities, using i  5.5% :

PVL  11( 7)v 8  8.084( 11)v 12  96.94549

so:

96.94549
volL    8.04680
12.04770

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For the assets, again using i  5.5% :

PVA  15.363( 7.5)v 8.5  3.787( 14.25)v 15.25  96.94682

so:

96.94682
volA    8.04675
12.04794

We can see that the volatilities are equal to 5 SF.

The third condition for immunisation is that the convexity of the assets must
be greater than the convexity of the liabilities, that is, the assets must be
more spread out than the liabilities around the discounted mean term.

Here, the terms of the assets are 7.5 and 14.25 years, whereas the terms of
the liabilities are less spread out, being only 7 and 11 years. So the third
condition for immunisation is also satisfied, and the company will be
immunised against small changes in interest rates.

Alternatively, we could calculate the convexity of the assets and liabilities.

For the liabilities, using i  5.5% , we have:

PVL  11( 7)( 8)v 9  8.084( 11)( 12)v 13  912.4677

So, the convexity of the liabilities is:

912.4677
conv L   75.7379
12.04770

For the assets, again using i  5.5% :

PVA  15.363( 7.5)( 8.5)v 9.5  3.787( 14.25)( 15.25)v 16.25

 933.6906

So, the convexity of the assets is:

933.6906
conv A   77.4979
12.04794

We see that the convexity of the assets is greater than the convexity of the
liabilities, so the third condition for immunisation is indeed satisfied.

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39 Subject CT1 April 2017 Question 9

(i) Spot rates

The gross redemption yield from the one-year bond is:

g1  0.07  0.001  0.071

This, by definition, is equal to the one-year spot rate. So:

i1  g1  7.100%

The gross redemption yield from the two-year bond is:

g2  0.07  0.001 2  0.072

We can use this to calculate the price of the two-year bond:

P2  5v  105v 2 @7.2%

 96.03336

We can now calculate the two-year spot rate, using the equation of value:

5 105
96.03336  
1  i1 (1  i 2 )2

Using the value of i1 obtained earlier:

1 1  5 
  96.03336    0.870141
(1  i 2 )2 105  1.071 

So:

0.5
 1 
i2     1  0.072026 ie i 2  7.203%
 0.870141 

The gross redemption yield from the three-year bond is:

g3  0.07  0.001 3  0.073

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We can use this to calculate the price of the three-year bond:

P3  5v  5v 2  105v 3 @ 7.3%

 93.99700

We can now calculate the three-year spot rate, using the equation of value:

5 5 105
93.99700   
1  i1 (1  i 2 )2 (1  i 3 )3

Using the values of i1 and i 2 obtained earlier:

1 1  5 5 
  93.99700     0.809312
(1  i3 )3 105  1.071 1.072032 

So:

13
 1 
i3     1  0.073070 ie i3  7.307%
 0.809312 

(ii) Forward rates

By definition, f0 , the one-year forward rate over the year from time 0 to
time 1, is equal to the one-year spot rate i1 :

f0  i1  7.100%

To calculate the one-year forward rate over the year from time 1 to time 2,
we use:

(1  i 2 )2  (1  i1)(1  f1)

Rearranging this, and using the values obtained earlier:

(1  i 2 )2 1.072032
f1  1  1  0.073052 ie f1  7.305%
1  i1 1.071

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To calculate the one-year forward rate over the year from time 2 to time 3,
we use:

(1  i3 )3  (1  i 2 )2 (1  f2 )

Rearranging this, and using the values obtained earlier:

(1  i 3 )3 1.073073
f2  1  1  0.075162 ie f2  7.516%
(1  i 2 )2 1.072032

(iii) Explanation

The spot rate is a geometric average of the one-year forward rates over the
term considered.

If the one-year forward rates are increasing with term, then the spot rates
must also be increasing, since the spot rates are an average of the forward
rates. However, the change in the spot rate from one term to the next will be
less than the change in the forward rate. This is because when the term
increases and a new (higher) forward rate is included in the average, any
increase in the forward rate from the previous year’s value is averaged over
all years, leading to a smaller change in the spot rate.

This implies that the rate of growth of the spot rates will be lower than the
rate of growth of the forward rates, or, equivalently, that the rate of growth of
the forward rates must be higher than the rate of growth of the spot rates.

40 Subject CT1 September 2017 Question 7

(i) Price for Investor A

The price that Investor A pays is:

PA = 0.8 ¥ 5 a(2) + 110v 2

2

at an interest rate of 4% pa.

This gives:

1 - 1.04-2
PA = 4 a(2) + 110v 2 = 4 ¥ + 110 ¥ 1.04-2 = 109.32027
2
2 È1.04½ - 1˘
Î ˚

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So the price paid by investor A is £109.32 per £100 nominal.

(ii) Price for Investor B

Using a term-by-term approach, we find that the price paid by Investor B is

given by:

PB = 2 ¥ 1.0175 -½ + 2 ¥ 1.025 -1 + 2 ¥ 1.0325 -1.5 + 112 ¥ 1.04 -2 = 109.39056

So Investor B pays £109.39 per £100 nominal.

(iii) Forward rate from time 1 to time 2

Using the relationship between spot and forward rates (and using f1,1 for the
one-year forward rate at time 1):

(1 + y1) (1 + f1,1) = (1 + y 2 )2
So we have:

( )
1.015 1 + f1,1 = 1.03 2

Solving this equation:

1.032
f1,1 = - 1 = 0.045222
1.015

So the one-year forward rate is 4.52% pa.

(iv) Two reasons

The spot yield curve might rise with term if investors were expecting short-
term interest rates to rise in the future.

The spot yield curve might rise if there was higher demand from institutional
investors for short-dated bonds, compared to long-dated bonds. This would
force up the prices of bonds at the short end of the curve, thus lowering the
yield. The spot rate curve would then be upward-sloping.

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41 Subject CT1 September 2017 Question 10

(i)(a) PV of the liabilities

Using an interest rate of 3% pa, the present value of the liabilities is (working
in millions of pounds):

PVL = 100v 10 + 200v 20 = 100 ¥ 1.03 -10 + 200 ¥ 1.03 -20 = 185.14454

The present value of the liabilities is £185.14 million.

(i)(b) DMT of the liabilities

The discounted mean term of the liabilities (again, using a 3% pa interest

rate) is:

10 ¥ 100v 10 + 20 ¥ 200v 20 1,000 ¥ 1.03 -10 + 4,000 ¥ 1.03 -20

DMTL = 10 20
= = 15.98101
100v + 200v 185.14454

The discounted mean term of the liabilities is 15.981 years.

(ii) Term of the annuity

Using X for the annual amount paid under the annuity, the present value of
the assets is:

PVA = 144.054v 15 + Xan

where n is the term of the annuity.

The discounted mean term of the assets is:

144.054 ¥ 15 v 15 + X (Ia )n
DMTA =
185.14454

Equating the present values of the assets and the liabilities:

144.054v 15 + Xan = 185.14454 (1)

Equating the discounted mean terms:

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144.054 ¥ 15v 15 + X (Ia )n

= 15.98101 (2)
185.14454

Rearranging Equation (1), we find that:

X an = 92.68176 (3)

Rearranging Equation (2), we find that:

X (Ia )n = 1,571.85503 (4)

Dividing Equation (4) by Equation (3), we obtain:

(Ia)n
= 16.95970
an

Using the formulae for level and increasing annuities, we now find that:

an - nv n
i an - nv n
= = 16.95970
1- v n 1- v n
i

Substituting in n = 41 and i = 0.03 , we find that the left-hand side of this

equation becomes:

1 - 1.03 -41
an - nv n -1
- 41 ¥ 1.03 -41
= 1 - 1.03 = 16.95971
1- v n 1 - 1.03 -41

So the equation we have found is satisfied by the value n = 41 , and the

term of the annuity is 41 years.

(iii) Annual rate of payment of the annuity

From Equation (3), we see that:

X a41 = 92.68176

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Evaluating the annuity at 3% pa:

1 - 1.03 -41
a41 = = 23.41240
0.03

So now we have:

92.68176
X = = 3.95866
23.41240

So the amount of the annuity is £3.959 million.

(iv) Redington’s third condition

Redington’s third condition for immunisation is that the convexity of the

assets is greater than the convexity of the liabilities. The convexity of a
series of cashflows is given by the second derivative of the present value
divided by the present value, or:

PV ¢¢
convexity =
PV

where here we are differentiating the present value with respect to i .

Since the times of the asset payments run from time 1 to time 41, but the
times of the liabilities are only at times 10 and 20, it seems likely that the
spread of the assets about the DMT is greater than the spread of the
liabilities, in which case Redington’s third condition will be satisfied.

(v) Risks

If the company sells the zero-coupon bond and buys another bond with a
shorter term, it will no longer be immunised. The DMT of the assets will now
be less than the DMT of the liabilities. This means that if interest rates were
to change, the company would make a loss.

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FACTSHEET

This factsheet summarises the main methods, formulae and information

required for tackling questions on the topics in this booklet.

1 Spot rates and forward rates

The yield on a unit zero-coupon bond with term n years, y n , is called the n-
year spot rate of interest.

The discrete time forward rate, ft ,r , is the annual interest rate agreed at
time 0 for an investment made at time t > 0 for a period of r years.

The connection between forward rates and spot rates is:

(1 + y t + r )t + r
(1 + ft ,r )r =
(1 + y t )t

The one-period forward rate at time t (agreed at time 0) is denoted ft = ft ,1 .

We also have f0 = y1 .

To get spot rates from forward rates, we use:

(1 + y t )t = (1 + f0 )(1 + f1)(1 + f2 ) (1 + ft -1)

Let Pt be the price of a unit zero-coupon bond of term t. Then the t-year
spot force of interest is Yt where:

1
Pt = e -Yt t fi Yt = - log Pt
t

Ft ,r
We also have y t = eYt - 1 and ft ,r = e - 1.

The connection between the continuous spot and forward rates is:

(t + r )Yt + r - tYt
Ft ,r =
r

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The instantaneous forward rate Ft is defined as:

Ft = lim Ft ,r
r Æ0

t
- Ú Fs ds
We also have Pt = e 0
.

2 Yield curves

There are three explanations for why the interest rate varies with the term of
the investment, namely expectations theory, liquidity preference and market
segmentation.

3 Par yield

If ycn is the n-year par yield:

1 = ycn (v y1 + v y22 + v y3 +  + v ynn ) + 1v ynn

3

4 Coupon bias

The coupon bias is defined to be the difference between the par yield and
the spot rate.

5 Effective duration or volatility

The effective duration or volatility is defined to be:

1 d PV ¢
n (i ) = - PV = -
PV di PV

6 Macaulay duration or discounted mean term

The Macaulay duration or discounted mean term (DMT) is the mean term of
the cashflows {Ctk } , weighted by present value. That is, at rate i, the
duration of the cashflow sequence {Ctk } is:

n
t
S tk Ctk v i k
t = k =1 =
 t ¥ PV
n
t
S Ctk v i k
 PV
k =1

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7 Connection between discounted mean term and volatility

Comparing this expression with the equation for the effective duration we
can see that:

t = (1 + i )n (i )

8 Convexity

The convexity of the cashflow series {Ctk } is defined as:

1 d2 PV ¢¢
c(i ) = PV =
PV di 2 PV

9 Redington’s conditions

The conditions for Redington’s immunisation are as follows:

1. VA ( i0 ) = VL (i 0 ) – that is, the value of the assets at the starting rate of

interest is equal to the value of the liabilities.

2. The volatilities of the asset and liability cashflow series are equal, that
is, n A (i 0 ) = n L (i0 ) .

3. The convexity of the asset cashflow series is greater than the convexity
of the liability cashflow series – that is, c A (i 0 ) > cL (i 0 ) .

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Life Table, Life assurance, Life annuity, Evaluation of
assurances and annuities.
Variable benefits, Gross premiums & reserves.
Joint Lives
Mortality Profit
Competing Risks
Profit Testing