Institute of Actuaries of India

Subject CT1 – Financial Mathematics

October 2014 Examination

INDICATIVE SOLUTION
IAI CT1-1014

Solution 1:
i. [1]
ii. [1]
iii. [1]
iv. [1]

v. [1]

[5 Marks]
Solution 2:

(i) (a) the duration is:

2 3 15
= 8000 (v + 2v + 3v + …. + 15v ) at 9%
8000 (v + v 2 + v 3 + …. + v 15 )

= (Ia) 15¯| / a15¯| = 51.8676 /8.0607

= 6.4346 years
[2]

(b) The duration is:

2 3 15
= 8000 (v + (1.09 x 2v ) + (1.092 x 3v ) + …. + (1.0914 x 15v ) at 9%
8000 (v + (1.09 x v 2 ) + (1.092 x v 3 ) + …. + (1.0914 x v 15 )

=v (1+2+3+…. +15) / v (1+1+1+…..+1)

= 120 / 15 = 8 years

[3]

(ii) The duration in (i) (b) is higher because the payments increase over time so that the
weighting of the payments is more towards end of the series of payments.

[1]

[6 Marks]

Solution 3:

Forward price of the contract is K 0 = (S 0 – I) e T = (91 – I) e 0.09*1

Where I is the present value of the income expected during the contract = 3.8 e 0.09*6 / 12

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IAI CT1-1014

⇒K 0 = (91 - 3.8 e 0.09*6 / 12 ) e 0.09 = 95.595

Forward price of contract set up at time r (4 months) is

K r = (S r – I r ) e  (T r ) = (109 – I r ) e 0.085*8 / 12

Where I r is the present value of the income expected during the contract = 3.8
e 0.085*2 / 12

⇒ K r = (109 - 3.8 e 0.085*2 / 12 ) e 0.085*8 / 12 = 111.39

Value of original forward contract = (K r – K 0 ) e  (T r )

= (111.39 – 95.595) e 0.085*8 / 12

= ₹14.9248

[6 Marks]

Solution 4:

(i) (1 + i t ) Lognormal (μ, σ 2 )

ln (1 + i t ) N (μ, σ 2 )

ln (1 + i t ) 12 = ln (1 + i t )+ln (1 + i t ) + ......+ ln (1 + i t ) = N (12μ, 12σ 2 )

Since i t ’s are independent,

12
(1 + i t ) = Lognormal (12μ, 12σ 2 )

E (1 + i t ) = exp (μ + σ 2 /2) = 1.09

Var (1 + i t ) = exp (2μ + σ 2 ) [exp (σ 2 ) -1] = 0.1 2

0.1 2 /1.09 2 = [exp (σ 2 ) -1] ⇒ σ 2 = 0.0083815

exp (μ + 0.0083815/2 ) = 1.09

μ = ln 1.09 - 0.0083815/2 = 0.081986

12 μ = 0.983832, 12 σ 2 = 0.100578

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IAI CT1-1014

Assuming S 12 being the accumulation of 1 unit in 12 years’ time,

E (S 12 ) = exp (0.983832 + 0.100578 / 2) = 2.81263

Expected value of investment = ₹12, 00,000 E (S 12 ) = ₹33, 75,156

[5]

(ii) We require P[S 12 < 0.9 x 2.81263 = 2.53136]

P [ln S 12 < ln 2.53136], where ln S 12 N (0.983832, 0.100578)

⇒ P [N (0, 1) < (ln 2.53136 – 0.983832) /√ (0.100578)]

⇒P [N (0, 1) < -0.1736] ≈ 0.43 ≈ 43%

[3]

[8 Marks]

Solution 5:
i. 1,000A (2, 22) =1,000[ X ]

= 1.27125

= 2.316

=1.3532

Accumulated value = ₹1,000 X 1.27125 X 2.316X1.3532 = ₹3,984.11

[4]
ii. The effective rate of interest per annum =

1,000 X = 3,984.11

= 1.0716
]
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IAI CT1-1014

=0.0689

(OR)

[2]

iii. = 1.1024

[2]

iv.

=3.489 [3]

[11 Marks]

Solution 6:
i. The price of the bonds may have fallen because interest rates have risen or because
their risk has increased (for example credit risk).

[1]

ii. a) Money weighted rate of return “i” is:

..

On interpolation, i = 4.65% (Exact answer is 4.652%) ...

[2]

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IAI CT1-1014

b)
Per annum [2]

iii. a) Money weighted rate of return “i” is:

Substituting i=4.65%, LHS of above equation will be ₹527,685/-.

The above indicates that the money-weighted rate of return for the Fund manager Y is
lower when compared to the Fund Manager X. [3]

b)

[3]

[11 Marks]

Solution 7:
(i) Let ‘t’ be the discounted payback period.

Then a

=>1.014782

=0.49321

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IAI CT1-1014

t=12.13yrs .

Otherwise, this can be arrived by using interpolation of a¬n factors @6% using tables.

Therefore, DPP = 12.5yrs (as annuity paid every 6months)

[4]

(ii) PV of profit =

...

(Students can also arrive this by interpolation of factors available in actuarial formula
tables- Its value is 8.7456)

Hence PV of profit =

=411, 613.07 .

Profit after 25yrs

=411,613.07(1.06) 12.5 (1.04) 12.5

=1,392,288.43

[6]

[10 Marks]

Solution 8:
i) The amount of loan is
@6% .

.00

[3]

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IAI CT1-1014

ii) The 10th instalment is ₹16,000

Loan amount outstanding after 9th instalment is

@6% ...

..........

The interest component in the 10th instalment is:0.06X91, 320.20 =₹5,479.20

The Capital portion = ₹16,000 – ₹5,479.20= ₹10,520.80

[3]

iii) a) The capital outstanding after the payment of the 10th instalment is:

Capital o/s after the 10th instalment = 91,320.20-105, 20.80 =₹80,799.40

This will be repaid by an instalment of ₹16000/- per annum. ...

Let the remaining term be ‘n’ years.

From tables, we can find that n will be 7 years. Therefore, the loan completes by end of 17years.
[3]

b) Let ‘R’ be the reduced final payment i.e., final instalment.

Then, .

R= ₹3,191.60 [3]

c) Total interest paid during the term

=25,000+24,000+.....+16,000+6X16, 000+3191.60-199,517.60

=205,000+96,000+3,191.60-199,517.60

=₹104,674 [2]

[14 Marks]
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IAI CT1-1014

Solution 9: i) Eurobonds:

 A form of medium or long-term borrowing

 Usually unsecured
 Pay regular interest payments and a final capital repayment
 Issued by large companies, governments and supra-national organisations
 Issued and traded internationally
 Often not denominated in native currency of the issuer
 Yields depend on the risk of the issuer and issue size
 Absence of full-blown government control
 Usually have novel features
[2]

ii. Preference Shares:

 A form of equity-type finance
 Offer fixed stream of investment income, if issuer makes sufficient profits
 Dividends are limited when compared with those on ordinary shares
 Preference shareholders rank above ordinary shareholders both for
dividends and, usually, on winding up
 Voting rights only if dividends are unpaid or on matters having direct
affects their rights
 Usually offered on cumulative basis, which means unpaid dividends are
carried forward
 Less riskier than ordinary shares
 Expected return is likely to be lower than on ordinary shares
 Marketability is similar to that of loan capital

[2]

iii. Time Benchmark Interest rate Present

in years bond yield to value Eurobond value factor

1 0.03 0.0458 0.95620

2 0.06 0.0766 0.86276
3 0.09 0.1074 0.73635
4 0.12 0.1382 0.59583
5 0.15 0.169 0.45806

From the above, the present value of the Eurobond is:

11 (0.9562 + 0.86276 + 0.73635 + 0.59583 + 0.45806) + 100 (0.45806)

= ₹85.5072 [5]
[9 Marks]

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IAI CT1-1014

Solution 10:
The investor will receive first coupon on 30th September 2014. The net coupon per ₹100
nominal will be:

0.9 x 1.5 x (Index - March 2014 / Index – September 2012)

= 0.9 x 1.5 x 110/105

In real present value terms, this is 0.9 x 1.5 x (110/105) x v x (1+g) 0.5

Where g = 4 % per annum and v is calculated at 2.5% (per half year)

The second coupon on 31st March 2015 will be: = 0.9 x 1.5 x 110/105 x (1+g) 0.5

In real present value terms, this is 0.9 x 1.5 x 110/105 x (1+g) 0.5 x v2 x (1+g) 1

Continuing this way, the last coupon payment on 31st March 2023 will be:

= 0.9 x 1.5 x 110/105 x (1+g) 8.5

In real present value terms, this is 0.9 x 1.5 x (110/105) x (1+g) 8.5 x v18 x (1+g) 9

Similarly, the real present value of redemption payment is

100 x (110/105) x(1+g) 8.5 x v18 x (1+g) 9

The present value of all the coupon payments and redemption payment is:

P = (1+g) 0.5 x (110/105) x (0.9 (v + v 2 + …… + v 18 ) + 100v 18 )

P = 0.98058 x 1.04762 (0.9 a18¯|2.5% + 100v 18 2.5%)

P = 1.02727 (0.9 x 14.3533 + 100 x 0.64116)

= ₹79.1346

[8 Marks]

Solution 11:
(i) The one-year spot rate of interest, say i 1 is 8% per annum

To calculate two-year spot rate of interest, we need to arrive at the price of the
two year bond, P

P = 9 a2¯| + 100 v 2 at 7%

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IAI CT1-1014

From tables,

a2¯| = 1.808, v 2 = 0.87344

⇒ P = 9 x 1.808 + 100 x 0.87344 = 103.616

Then the two-year spot rate of interest, i 2 is such that:

103.616 = 9 / (1.08) + 109 / (1+ i2) 2

⇒ (1+ i2) 2 = 1.14396 ⇒i 2 = 6.9562%

To calculate three-year spot rate of interest, we need to arrive at the price of the
three year bond, Q

Q = 9 a3¯| + 100 v 3 at 7%

From tables,

a3¯| = 2.6243, v 3 = 0.8163

⇒ Q = 9 x 2.6243 + 100 x 0.8163 = 105.2487

Then the three-year spot rate of interest, i 3 is such that:

105.2487 = 9 / (1.08) + 9 / (1.069562) 2 + 109 / (1+ i 3 ) 3

105.2487 = 8.33334 + 7.86738 + 109 / (1+ i 3 ) 3

⇒ (1+ i 3 ) 3 = 1.22406 ⇒i 3 = 6.9714%

[8]

(ii) The one year forward rate of interest beginning from now is 8%

The forward rate for one year beginning in one year from now is f1,1 such that:

1.08 (1+ f 1,1 ) = (1.069562) 2

⇒ f 1,1 = 5.9224%

The forward rate for one year beginning in two year from now is f 2 ,1 such that:

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IAI CT1-1014

(1.069562) 2 (1+ f 2 ,1 ) = (1.069714) 3

⇒ f 2 ,1 = 7.0018%

The forward rate for two year beginning in one year from now is f 1, 2 such that:

1.08 (1+ f 1, 2 ) 2 = (1.069714) 3

⇒ f 1, 2 = 6.4608%

[4]

[12 Marks]

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