Faculty of Actuaries Institute of Actuaries

EXAMINATION

6 April 2005 (am)

Subject CT1 Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
CT1 A2005 Institute of Actuaries
1 A bond is priced at £95 per £100 nominal, has a coupon rate of 5% per annum
payable half-yearly, and has an outstanding term of five years.

An investor holds a short position in a forward contract on £1 million nominal of this

bond, with a delivery price of £98 per £100 nominal and maturity in exactly one year,
immediately following the coupon payment then due.

The continuously compounded risk-free rates of interest for terms of six months and
one year are 4.6% per annum and 5.2% per annum, respectively.

Calculate the value of this forward contract to the investor assuming no arbitrage. [5]

2 An investment fund had a market value of £2.2 million on 31 December 2001 and
£4.2 million on 31 December 2004. It had received a net cashflow of £1.44 million
on 31 December 2003.

The money weighted rate of return and the time weighted rate of return for the period
from 31 December 2001 to 31 December 2004 are equal (to two decimal places).

Calculate the market value of the fund immediately before the net cashflow on
31 December 2003. [7]

3 A computer manufacturer is to develop a new chip to be produced from 1 January

2008 until 31 December 2020. Development begins on 1 January 2006. The cost of
development comprises £9 million payable on 1 January 2006 and £12 million
payable continuously during 2007.

From 1 January 2008 the chip will be ready for production and it is assumed that
income will be received half yearly in arrear at a rate of £5 million per annum.

(i) Calculate the discounted payback period at an effective rate of interest of 9%

per annum. [6]

(ii) Without doing any further calculations, explain whether the discounted
payback period would be greater than, less than or equal to that given in part
(i) if the effective interest rate were substantially greater than 9% per annum.
[2]
[Total 8]

CT1 A2005 2
4 The force of interest, (t ) , is a function of time and at any time t (measured in years)
is given by

0.07 0.005t for t 8

(t )
0.06 for t 8

(i) Calculate the accumulation at time t = 10 of £500 invested at time t = 0. [3]

(ii) Calculate the present value at time t = 0 of a continuous payment stream at the
rate of £200e0.1t paid from t = 10 to t = 18. [5]
[Total 8]

5 A university student receives a 3-year sponsorship grant. The payments under the
grant are as follows:

Year 1 £5,000 per annum paid continuously.

Year 2 £5,000 per annum paid monthly in advance.
Year 3 £5,000 per annum paid half yearly in advance.

Calculate the total present value of these payments at the beginning of the first year
using a rate of interest of 8% per annum convertible quarterly. [8]

6 At time t = 0 an investor purchased an annuity-certain which paid her £10,000 per

annum annually in arrear for three years. The purchase price paid by the investor was
£25,000.

The value of the retail price index at various times was as shown in the table below:

Time t (years): t=0 t=1 t=2 t=3

Retail price index: 170.7 183.3 191.0 200.9

(i) Calculate, to the nearest 0.1%, the following effective rates of return per
annum achieved by the investor from her investment in the annuity:

(a) the real rate of return; and

(b) the money rate of return
[7]

(ii) By considering the average rate of inflation over the three-year period, explain
the relationship between your answers in (a) and (b) of (i). [2]
[Total 9]

CT1 A2005 3 PLEASE TURN OVER

7 A loan of nominal amount £100,000 is to be issued bearing coupons payable quarterly
in arrear at a rate of 5% per annum. Capital is to be redeemed at 103 on a single
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 20% and capital gains tax of 25% 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 4% per annum. [9]

8 A small insurance fund has liabilities of £4 million due in 19 years time and £6
million in 21 years time. The manager of the fund has sold the assets previously held
and is creating a new portfolio by investing in the zero-coupon bond market. The
manager 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 manager to immunise the fund against
small changes in the rate of interest by purchasing a single zero-coupon bond.
[2]

(ii) In fact, the manager purchases two zero-coupon bonds, one paying £3.43
million in 15 years time and the other paying £7.12 million in 25 years time.
The current interest rate is 7% per annum effective.

Investigate whether the insurance fund satisfies the necessary conditions to be

immunised against small changes in the rate of interest.
[8]
[Total 10]

9 The one-year forward rate of interest at time t = 1 year is 5% per annum effective.

The gross redemption yield of a two-year fixed interest stock issued at time t = 0
which pays coupons of 3% per annum annually in arrear and is redeemed at 102 is
5.5% per annum effective.

The issue price at time t = 0 of a three-year fixed interest stock bearing coupons of
10% per annum payable annually in arrear and redeemed at par is £108.9 per £100
nominal.

(i) Calculate the one-year spot rate per annum effective at time t = 0. [4]

(ii) Calculate the one-year forward rate per annum effective at time t = 2 years.
[3]

(iii) Calculate the two-year par yield at time t = 0. [3]

[Total 10]

CT1 A2005 4
10 (i) In any year, the interest rate per annum effective on monies invested with a
given bank has mean value j and standard deviation s and is independent of the
interest rates in all previous years.

Let Sn be the accumulated amount after n years of a single investment of 1 at

time t = 0.

(a) Show that E[ Sn ] = (1 j )n .

(b) Show that Var [Sn ] = (1 2 j j2 s 2 ) n (1 j ) 2 n .

[5]

(ii) The interest rate per annum effective in (i), in any year, is equally likely to be
i1 or i2 (i1 i2 ) . No other values are possible.

(a) Derive expressions for j and s2 in terms of i1 and i2.

(b) The accumulated value at time t = 25 years of £1 million invested with

the bank at time t = 0 has expected value £5.5 million and standard
deviation £0.5 million.

Calculate the values of i1 and i2.

[8]
[Total 13]

CT1 A2005 5 PLEASE TURN OVER

11 (i) A loan is repayable over 20 years by level instalments of £1,000 per annum
made annually in arrear. Interest is charged at the rate of 5% per annum
effective for the first 10 years, increasing to 7% per annum effective for the
remaining term.

Show that the amount of the original loan is £12,033.56. (Minor discrepancies
due to rounding will not be penalised). [2]

(ii) The following are the details from the loan schedule for year x, i.e. the year
running from exact duration x 1 years to exact duration x years.

Instalment paid at the end of the year

Loan outstanding at the
beginning of the year Interest Capital

Year x £8,790.48 £439.52 £560.48

Determine the value of x. [4]

(iii) At the beginning of year 11, it is agreed that the increase in the rate of interest
will not take place, so that the rate remains at 5% per annum effective for the
remainder of the loan. The annual instalment will continue to be payable at
the same level so that there may be a reduced term and a reduced final
instalment.

(a) Calculate by how many years, if any, the repayment schedule is

shortened.

(b) Calculate the amount of the reduced final instalment.

(c) Calculate the reduction in the total interest paid during the existence of
the loan as a result of the interest rate not increasing.
[7]
[Total 13]

END OF PAPER

CT1 A2005 6
Faculty of Actuaries Institute of Actuaries

EXAMINATION
April 2005

Subject CT1 Financial Mathematics

Core Technical

EXAMINERS REPORT

Introduction

The attached subject report has been written by the Principal Examiner with
the aim of helping candidates. The questions and comments are based around
Core Reading as the interpretation of the syllabus to which the examiners are
working. They have however given credit for any alternative approach or
interpretation which they consider to be reasonable.

M Flaherty
Chairman of the Board of Examiners

15 June 2005

Faculty of Actuaries
Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

r T t
1 f S I Ke

where:

t is the present time

T is the time of maturity of the forward contract
r is the continuously compounded risk-free rate of interest for the interval from t
to T
S is the spot price of the security at time t
I is the present value, at the risk-free interest rate, of the income generated by the
security during the interval from t to T
K is the delivery price of the forward contract
f is the value of a long position in the forward contract

Here, working with £100 nominal,

S = 95, K = 98, T t =1, r = 0.052

0.046 0.5 0.052 1

I 2.5 e e 4.81648

0.052
f 95 4.81648 98e 2.85071

The value of the investor s short position in a forward contract on £1 million is

therefore

1, 000, 000
f 10, 000 2.85071
100
= £28,507

3
2 MWRR: 2.2 1 i 1.44 1 i 4.2

Estimate i 6% , LHS 4.1466

i 7% , LHS 4.2359

4.2 4.1466
i 0.06 0.01
4.2359 4.1466

= 6.60% p.a. to two decimal places

Let F = Fund value before net cashflow on 31 December 2003

Page 2
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

Then,

TWRR = 6.60% p.a. means that

F 4.2
1.0663
2.2 F 1.44

F
0.63452
F 1.44

0.63452 F 0.63452 x 1.44 F

F =£2.5m

3 (i) Work in millions:

PV of liabilities 9 12v a1 at 9%

i
9 12v. v

9 12 0.917432 1.044354

= 19.54811

The assets up to k 2 years from 1 January 2006 have:

2 i
PV 5v 2 a 5v 2 ak
k 2
i

5 0.84168 1.022015 ak

4.301048 ak

With k 6, PV 4.301048 4.4859

= 19.2941

The next payment of 2.5 million at k = 6.5 is made at time

8.5 and has present value = 2.5 v8.5 1.2018

Page 3
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

This would make PV of assets (20.5m) > PV of liabilities (19.5m)

Discounted payback period = 8.5 years.

(ii) The income of the development is received later than the costs are incurred.
Hence an increase in the rate of interest will reduce the present value of the
income more than the present value of the outgo. Hence the DPP will increase.

10
s ds
4 (i) Accumulation = 500 e 0

8 10
0.07 0.005 s ds 0.06 ds
0 8
= 500 e

8
0.005 2 10
0.07 S S 0.06 S 8
2 0
= 500 e

= 500e0.40 0.12

= 841.01

t
18 s ds
(ii) PV 200e0.1t .e 0 dt
10

8 t
18 0.07 0.005 s ) ds 0.06 ds
0.1t 0 8
200e .e
10

18
200e0.1t . e 0.40
. e0.48 0.06t
dt
10

18 0.04t
200e0.08 e dt
10

200e0.08 0.04t 18
e
0.04 10

5000 e0.08 e0.72 e0.40 3047.33

Page 4
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

12 2
5 Present Value = 5000 a1 v.a v 2 .a at i %
1 1

4
where 1 i 1.02 i 8.24322% p.a. effective

i 0.0824322 1
a1 .v .
Ln 1.0824322 1.0824322

0.9614201

12 1
12
1 v
and a 1.0824322 .
1 12
i

where
12
12
i 12
1.0824322 = 1 i 0.0794725
12
12
a 0.9645970
1

2 1 1 v
and a 1.0824322 2 .
1 2
i

2
2
i 2
where 1.0824322 1 i 0.0808000
2
2
a = 0.9805844
1

So PV 5000 0.9614201 v 0.9645970 v 2 0.9805844 13, 447.39

Examiners Comment: There are other valid methods for obtaining the required
answer which also received full credit.

Page 5
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

6 (i) (a) Work in t = 0 monetary values

170.7 2 170.7 3 170.7

25000 = 10000 v v v
183.3 191.0 200.9

1
where v with i = real rate of return
1 i

Try 4% RHS = 24770.94

3% RHS = 25241.25

25241.25 25000
i 0.03 0.01
25241.25 24770.94

= 0.0351 i.e. 3.5%

(b) 25000 = 10000 a3 at i % p.a.

a 2.5
3

From tables, a 2.5313 at 9%

3

= 2.4869 at 10%

2.5313 2.5
i 0.09 0.01
2.5313 2.4869

= 0.097

i.e. 9.7% p.a.

1 i
(ii) We should find that 1 e
1 i

where e = average annual rate of inflation over the period.

1 i 1.097
Hence 1
1.06
1 i 1.035

which implies 6% p.a. inflation over the period

Page 6
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

The actual average inflation rate was:

3 200.9
1 e e 5.6% p.a.
170.7

The inflation rate would not be expected to be exactly 6% p.a. since the Retail
Price Index is not increasing by a constant amount each year.

4
4
i 4
7 1 1.04 i 0.039414
4

0.05
g 1 t1 0.80 0.038835
1.03

4
i 1 t1 g

Capital gain on contract

Assume redeemed as late as possible (ie: after 20 years) to obtain minimum yield.

Price of stock, P:

4
P 100000 0.05 0.80 a
20

103000 0.25 103000 P v 20 at 4%

4
4000 a 77250v 20
20
P
1 0.25v 20

4000 1.014877 13.5903 77250 0.45639

1 0.25 0.45639

= 102,072.25

Page 7
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

8 (i) No, because the spread (convexity) of the liabilities would always be greater
than the spread (convexity) of the assets 3rd Redington condition would
never be satisfied.

(ii) Conditions required: (a) VA VL

(b) VA' VL'.
(c) VA" VL"

where differentiation can be in respect of delta or i. In this solution, it is in

respect of delta.

(a) VA 3.43v15 7.12v 25 @ 7%

= 2.5550

VL 4v19 6v 21

= 2.5551

VA VL (ignoring rounding)

(b) V 'A 3.43 15v15 7.12 25v 25

= 51.444

V 'L 4 19v19 6 21v 21

= 51.445

V ' A V ' L (ignoring rounding)

(c) V "A 3.43 152 v15 7.12 252 v 25

= 1099.627

V "L 4 192 v19 6 212 v 21

1038.322

V " A V "L

all 3 conditions are satisfied.

Page 8
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

Examiners Comment: There are other valid methods for obtaining the
required answer which also received full credit.

9 (i) From two year stock information:

Price = 3a2 102v 2 at 5.5%

= 3 1.84632 + 102 0.89845

= 97.1811

Therefore, from one-year forward rate information,

3 3 102
97.1811
1 i1 1 i1 1 f1,1

where i1 =one-year spot rate

f1,1 = one-year forward rate from t = 1

3 105
97.1811
1 i1 1 i1 1.05

103
97.1811
1 i1

i1 5.9877% p.a.

(ii) From three-year stock information:

10 10 110
108.9 =
1 i1 1 ii 1.05 1 i1 1.05 1 f 2,1

where f 2,1 =one-year forward rate from t = 2

Hence

10 10 110
108.9
1.059877 1.059877 1.05 1.059877 1.05 1 f 2,1

110
108.9 9.4351 8.9858
1.11287 1 f 2,1

Page 9
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

f 2,1 9.245% p.a.

(iii) Let y2 % p.a. be the two-year par yield

1 1 100
100 = y2
1 i1 1 i1 i f1,1 1 i1 1 f1,1

1 1 100
100 = y2
1.059877 1.059877 1.05 1.059877 1.05

100 y2 1.84208 89.8577

y2 5.506% p.a.

10 (i) (a) Let it be the (random) rate of interest in year t . Let Sn be the
accumulation of a single investment of 1 unit after n years:

E Sn E 1 i1 1 i2 1 in

E Sn E 1 i1 E 1 i2 E 1 in as it are independent

E it j

n
E Sn 1 j

2
(b) E S n2 E 1 i1 1 i2 1 in

2 2 2
E 1 i1 E 1 i2 E 1 in (using independence)

E 1 2i1 i12 E 1 2i2 i22 E 1 2in in2

n
1 2 j s2 j2

Page 10
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

2
as E ii2 V it E it s2 j2

n 2n
Var Sn 1 2 j s2 j2 1 j

1
(ii) (a) E Interest j i1 i2
2

2
Var Interest s2 E Interest 2 E Interest

2
1 2 2 1
i1 i2 i1 i2
2 2

1 2 2 1
= i1 i2 i1.i2
4 2

2
1
i1 i2
2

25
(b) E S25 1 j 5.5

j 0.0705686

25 50 2
Var S 25 1 2j j2 s2 1 j 0.5

25 50
1 2 0.0705686 0.07056862 s2 1.0705686 0.25

s2 0.000377389

1 2
Hence, s 2 0.000377389 i1 i2
4

i1 i2 0.0388530 (taking positive root since i1 i2 )

i1 i2 2 0.07056862 = 0.1411372

2i1 0.0388530 0.1411372

i1 0.089995 8.9995%p.a.

Page 11
 Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

and i2 0.051142 5.1142%p.a.

5%
11 (i) Loan 1000 a10 v10 7%
5% a10

= 1000 7.7217 0.61391 7.0236

= 12033.56

439.52
(ii) Note 0.05 x 10
8790.48

5%
8790.48 1000 a11 x
v11 x 7%
5% a10

1 v11 x
8.79048 v11 x
7.0236
0.05

8.79048 20 20 7.0236 v11 x

11.20952
v11 x
0.86384 at 5%
12.9764

x 8

(iii) Let Y = reduced final payment

n = new total term of loan

7%
Loan outstanding after 10 years = 1000 a10 = £7,023.60

After change is made:

7023.60 = 1000 an 11
Yv n 10
at 5%

try n = 20 (i.e., keep to original term)

RHS = 1000 7.1078 Y 0.61391

Y 137.15

doesn t work

try n = 19

Page 12
Subject CT1 (Financial Mathematics Core Technical) April 2005 Examiners Report

RHS = 1000 6.4632 Y 0.64461

Y 869.36

Hence:

(a) Term shortened by 1 year

(b) Final instalment = £869.36

(c) Under original terms, total interest paid is:

20 1000 12033.56 7966.44

Under changed terms, total interest paid is:

18 1000 869.36 12033.56 6835.80

difference = £1,130.64

END OF EXAMINERS REPORT

Page 13
Faculty of Actuaries Institute of Actuaries

EXAMINATION

7 September 2005 (am)

Subject CT1 Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
CT1 S2005 Institute of Actuaries
1 Describe how cashflows are exchanged in an interest rate swap . [2]

2 An investor has earned a money rate of return from a portfolio of bonds in a particular
country of 1% per annum effective over a period of ten years. The country has
experienced deflation (negative inflation) of 2% per annum effective during the
period.

Calculate the real rate of return per annum over the ten years. [2]

3 Calculate the time in days for £1,500 to accumulate to £1,550 at:

(a) a simple rate of interest of 5% per annum

(b) a force of interest of 5% per annum
[4]

4 The force of interest (t) at time t is a + bt2 where a and b are constants. An amount of
£200 invested at time t = 0 accumulates to £210 at time t = 5 and £230 at time t = 10.

Determine a and b. [5]

5 (i) Calculate the present value of £100 over ten years at the following rates of
interest/discount:

(a) a rate of interest of 5% per annum convertible monthly

(b) a rate of discount of 5% per annum convertible monthly
(c) a force of interest of 5% per annum
[4]

(ii) A 91-day treasury bill is bought for $98.91 and is redeemed at $100.
Calculate the annual effective rate of interest obtained from the bill. [3]
[Total 7]

6 (i) State the features of a eurobond. [3]

(ii) An investor purchases a eurobond on the date of issue at a price of £97 per
£100 nominal. Coupons are paid annually in arrear. The bond will be
redeemed at par twenty years from the issue date. The rate of return from the
bond is 5% per annum effective.

(a) Calculate the annual rate of coupon paid by the bond.

(b) Calculate the duration of the bond.
[6]
[Total 9]

CT1 S2005 2
7 A bank makes a loan to be repaid in instalments annually in arrear. The first
instalment is 50, the second 48 and so on with the payments reducing by 2 per annum
until the end of the 15th year after which there are no further payments. The rate of
interest charged by the lender is 6% per annum effective.

(i) Calculate the amount of the loan. [6]

(ii) Calculate the interest and capital components of the second payment. [3]

(iii) Calculate the amount of capital repaid in the instalment at the end of the
fourteenth year. [3]
[Total 12]

8 An insurance company has just written contracts that require it to make payments to
policyholders of £1,000,000 in five years time. The total premiums paid by
policyholders amounted to £850,000. The insurance company is to invest half the
premium income in fixed interest securities that provide a return of 3% per annum
effective. The other half of the premium income is to be invested in assets that have
an uncertain return. The return from these assets in year t, it, has a mean value of
3.5% per annum effective and a standard deviation of 3% per annum effective. (1 + it)
is independently and lognormally distributed.

(i) Deriving all necessary formulae, calculate the mean and standard deviation of
the accumulation of the premiums over the five-year period. [9]

(ii) A director of the company suggests that investing all the premiums in the
assets with an uncertain return would be preferable because the expected
accumulation of the premiums would be greater than the payments due to the
policyholders.

Explain why this still may be a more risky investment policy. [2]
[Total 11]

CT1 S2005 3 PLEASE TURN OVER

9 (i) Explain what is meant by the expectations theory for the shape of the yield
curve. [2]

(ii) Short-term, one-year annual effective interest rates are currently 8%; they are
expected to be 7% in one years time, 6% in two years time and 5% in three
years time.

(a) Calculate the gross redemption yields (spot rates of interest) from
1-year, 2-year, 3-year and 4-year zero coupon bonds assuming the
expectations theory explanation of the yield curve holds.

(b) The price of a coupon paying bond is calculated by discounting

individual payments from the bond at the zero-coupon bond yields
in (a).

Calculate the gross redemption yield of a bond that is redeemed at par

in exactly four years and pays a coupon of 5 per annum annually in
arrear.

(c) A two-year forward contract has just been issued on a share with a
price of 400p. A dividend of 4p is expected in exactly one year.

Calculate the forward price using the above spot rates of interest,
assuming no arbitrage. [12]
[Total 14]

10 An investor purchased a bond with exactly 15 years to redemption. The bond,

redeemable at par, has a gross redemption yield of 5% per annum effective. It pays
coupons of 4% per annum, half yearly in arrear. The investor pays tax at 25% on the
coupons only.

(i) Calculate the price paid for the bond. [3]

(ii) After exactly eight years, immediately after the payment of the coupon then
due, this investor sells the bond to another investor who pays income tax at a
rate of 25% and capital gains tax at a rate of 40%. The bond is purchased by
the second investor to provide a net return of 6% per annum effective.

(a) Calculate the price paid by the second investor.

(b) Calculate, to one decimal place, the annual effective rate of return
earned by the first investor during the period for which the bond was
held. [10]
[Total 13]

CT1 S2005 4
11 (i) Explain what is meant by the following terms:

(a) equation of value

(b) discounted payback period from an investment project
[4]

(ii) An insurance company is considering setting up a branch in a country in

which it has previously not operated. The company is aware that access to
capital may become difficult in twelve years time. It therefore has two
decision criteria. The cashflows from the project must provide an internal rate
of return greater than 9% per annum effective and the discounted payback
period at a rate of interest of 7% per annum effective must be less than twelve
years.

The following cashflows are generated in the development and operation of

the branch.

Cash Outflows

Between the present time and the opening of the branch in three years time the
insurance company will spend £1.5m per annum on research, development and
the marketing of products. This outlay is assumed to be a constant continuous
payment stream. The rent on the branch building will be £0.3m per annum
paid quarterly in advance for twelve years starting in three years time. Staff
costs are assumed to be £1m in the first year, £1.05m in the second year, rising
by 5% per annum each year thereafter. Staff costs are assumed to be incurred
at the beginning of each year starting in three years time and assumed to be
incurred for 12 years.

Cash Inflows

The company expects the sale of products to produce a net income at a rate of
£1m per annum for the first three years after the branch opens rising to £1.9m
per annum in the next three years and to £2.5m for the following six years.
This net income is assumed to be received continuously throughout each year.
The company expects to be able to sell the branch operation 15 years from the
present time for £8m.

Determine which, if any, of the decision criteria the project fulfils.

[17]
[Total 21]

END OF PAPER

CT1 S2005 5
Faculty of Actuaries Institute of Actuaries

EXAMINATION
September 2005

Subject CT1 Financial Mathematics

Core Technical

EXAMINERS REPORT

Faculty of Actuaries
Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

As is in some recent diets, the questions requiring descriptions of concepts, definitions or

verbal reasoning (such as Q1, Q8(ii) and Q9(i)) tended not to be well answered with
candidates producing vague statements which did not demonstrate that they understood the
relevant points. It is important that candidates understand the subject well enough to express
important topics and issues in their own words as well as in mathematical language. In show
that questions or questions where students are asked to derive formulae (such as Q8 part (i))
candidates are required to show detailed steps in deriving the results required in order to
obtain full marks.

Please note that differing answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates were not penalised for this. However, candidates were penalised
where excessive rounding had been used or where insufficient working had been shown.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

1 One party agrees to pay to the other a regular series of fixed amounts for a certain
term. In exchange the second party agrees to pay a series of variable amounts based
on the level of a short term interest rate.

2 If f = the rate of inflation; j = the real rate of return and i = the money rate of return,
then j = (i f)/(1 + f). In this case, f = 2%, i= 1% and therefore j = 3.061%.

3 (a) Let the answer be t days

1,500(1 + 0.05 t/365) = 1,550

t = 243.333 days

(b) Let the answer be t days

1,500e0.05(t/365) = 1,550

0.05 (t/365) = ln (1,550/1500)

t = 239.366 days

5
5
4 210 200 exp a bt 2 dt 200 exp at 1 bt 3
3
200 5a 41.667b
0
0
10
10
230 200 exp a bt 2 dt 200 exp at 1 bt 3
3
200 10a 333.333b
0
0

ln(1.05) 5a 41.667b
ln(1.15) 10a 333.333b

The second expression less twice the first expression gives:

ln(1.15) 2 ln(1.05) 250b b 0.0001687

ln(1.15) 333.333 0.0001687
a 0.0083520
10

Page 3
 Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

5 (i) (a) 100 (1 + 0.05/12) 12 10 = £60.716

(b) 100 (1 0.05/12)12 10 = £60.590
(c) 100 e 10 = £60.6531

(ii) 98.91 = 100(1 + i) 91/365

ln(1 + i) = ( 65/91) ln(98.91/100) = 0.04396

therefore i = 0.04494

6 (i)
Used for medium or long-term borrowing
Unsecured
Regular annual coupon payments
Generally repayable at par
Generally issued by large companies and on behalf of governments
Yields depend on risk and marketability
Generally innovative market designed to attract different types of investor
Issued internationally (normally by a syndicate of banks)
Can be issued in any currency (not necessarily the domestic currency of
the borrower)

(ii) (a) 97 = ga20 + 100v20 at 5% per annum effective

a20 = 12.4622; v20 = 0.37689 therefore 97 = 12.4622g + 100

0.37689

g = (97 37.689)/12.4622 = 4.75927

(b) Duration = Ct tvt/ Ctvt where Ct is the amount of the cash flow at
time t

( Ia )20 = tvt Therefore duration of the eurobond is:

(4.75927 ( Ia )20 + 100 20v20)/(4.75927 a20 + 100v20)

( Ia )20 = 110.9506 all other values have been used in (a) above

therefore duration is:

(4.75927 110.9506 + 100 20 0.37689)/(4.75927

12.4622 + 100 0.37689) =1281.8239/97 = 13.2147

Page 4
 Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

7 (i) Value of loan = 50v + 48v2 + 46v3 + 44v4 + + 22v15

= 52(v +v2 +v3 + + v14 + v15) 2(v + 2v2 +4v3 + + 28v14+30 v15)

= 52 a15 - 2 ( Ia )15

( Ia )15 = 67.2668
a15 = 9.7122

Therefore amount of the loan is 52 9.7122 - 2 67.2668 = 370.501

Candidates who derived an appropriate formula for a decreasing annuity directly or

who calculated the value of the loan by summing the individual terms received full
credit.

(ii) Interest component in first year is 0.06 370.504 = 22.23024; therefore

capital component is 50 22.23024 = 27.76976.

Capital remaining after first instalment is 370.504 27.76976 = 342.73424.

Interest paid in second instalment is 0.06 342.73424 = 20.56405

Capital in second instalment is 48 20.56405 = 27.43595.

(iii) At the end of the thirteenth year, the capital outstanding is:

24v + 22v2 = 24 0.94340 + 22 0.89000 = 42.2216

The interest due in the fourteenth instalment 0.06 42.2216 = 2.53330

The capital payment is therefore 24 2.53330 = 21.46670

Page 5
 Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

8 (i) Let it be the (random) rate of interest in year t . Let S5 be the accumulation of
a single investment of 1 unit after 5 years:

5
E S5 E 1 it
t 1
5
E 1 it
t 1
as it are independent
5
E S5 E 1 it
E 1 it 1 E it = 1.035

5
E S5 1.035 1.187686
5 5
2 2
E S52 E 1 it E 1 it (using independence)
t 1 t 1
2 5 5 5
E 1 it E 1 2it it2 1 2 E it E it2

2 5
1 2 E it Var it E it
2
Var S5 E S52 E S5

2 5 10
1 2 E it Var it E it E 1 it

E it 0.035
Var it 0.032
5 10
Var S5 1 2 0.035 0.032 0.0352 1.035
1.416534 1.410598
0.0059356

Mean value of the accumulation of premiums is:

425000 E S5 425000(1.03)5 425000 1.187686 425000 1.15927
997458

Standard deviation is 425000 SD S5 425000 0.0059356 32743.21

Candidates who obtained slightly different answers by first deriving the parameters of
the lognormal distribution received full credit.

Page 6
 Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

(ii) Investing all premiums in the risky assets is likely to be more risky because,
although there may be a higher probability of the assets accumulating to more
than £1 million, the standard deviation would be twice as high so the
probability of a large loss would be greater.

9 (i) Bond yields are determined by investors expectations of future short-term

interest rates, so that returns from longer-term bonds reflect the returns from
making an equivalent series of short-term investments

(ii) (a) Let it be the spot yield over t years:

One year: yield is 8% therefore i1 = 0.08

two years: (1 + i2)2 = 1.08 1.07 therefore i2 = 0.074988
three years: (1 + i3)3 = 1.08 1.07 1.06 therefore i3 = 0.06997
four years: (1 + i4)4 = 1.08 1.07 1.06 1.05 therefore i4 = 0.06494

(b) Price of the bond is 5[(1.08) 1 + (1.074988) 2 + (1.06997) 3]

+ 105 (1.06494) 4 = 13.03822 + 81.6373 = 94.67552

Find gross redemption yield from

94.67552 = 5 a4 + 100v4

try 7%; a4 = 3.3872; v4 = 0.76290

gives RHS = 93.226

GRY must be lower, try 6%; a4 = 3.4651; v4 = 0.79209

gives RHS = 96.5345

interpolate between 6% and 7%.

i = 0.07 0.01 (94.67552 93.226)/(96.5345 93.226)
i = 0.07 0.0043812 = 0.06562

(c) Present value of the dividend is 4v calculated at 8% per annum

effective = 3.70370.

Therefore forward price is

F = (400 3.70370) 1.08 1.07 = 457.9600

Page 7
 Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

10 (i) Price paid by first investor is P1

P1 4a (2) 100v15
15 5%

i
(2)
1.012348
i

v15 0.48102
a15 10.3797

P1 4 1.012348 10.3797 100 0.48102

42.0315 48.1020 90.1335

2
2
i 2
(ii) (a) 1 1.06 i 0.059126
2

g 1 t1 0.04 0.75 0.03

2
i 1 t1 g

Capital gain on contract

Price paid by second investor is P2

P2 0.75 4a (2) 7
100v6% 7
0.4 100 P2 v6%
7 6%

7
P2 1 0.4v6% 0.75 4a (2) 7
0.6 100v6%
7 6%

i
(2)
1.014782
i

v7 0.66506
a7 5.5824

0.75 4 1.014782 5.5824 60 0.66506

P2
1 0.4 0.66506
77.5207

Page 8
 Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

(b) Rate of return earned by the first investor is the solution to:

90.1335 0.75 4a (2) 77.5207v8

8

i 2%
i
(2)
1.004975
i

v8 0.85349
a8 7.3255

RHS 88.2490
i 1.5%
i
(2)
1.003736
i

v8 0.88771
a8 7.4859

RHS 91.3575
90.1335 88.2490
i 0.02 0.005 1.697% 1.7%
91.3575 88.2490

11 (i) (a) An equation of value expresses the equality of the present value of
positive and negative (or incoming and outgoing) cash flows that are
connected with an investment project, investment transaction etc.

(b) The discounted payback period from an investment project is the first
time at which the net present value of the cash flows from the project is
positive.

Page 9
 Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

(ii) Consider first the NPV at 9% per annum effective. Working in £million.

Present value of cash outflows:

1.5a3 9% 0.3a (4) v9%

3 3
v9% 4
1.05v9% 1.052 v9%
5
1.0511 v14
9%
12 9%

1.5 1.044354 2.5313 0.3 1.055644 7.1607 0.77218

1 1.0512 v12
0.77218 5.71647 7.60679 13.32326
1 1.05v

Present value of cash inflows:

a6 9% a3 9% 1.9 a9 9% a6 9% 2.5 a15 9% a9 9% 8v15

9%

2.5a15 0.6a9 0.9a6 a3 8v15

1.044354 2.5 8.0607 0.6 5.9952 0.9 4.4859 2.5313 8 0.27454

12.6253

Hence NPV of project @ 9% = 12.6253 13.3233 = £0.698 million

so the IRR is less than 9% p.a. effective

To find whether the discounted payback period is less than 12 years at 7% per
annum effective, we need to find the NPV @ 7% of first twelve years
cashflows

Present value of cash outflows:

1.5a3 7% 0.3a (4) v7%

3 3
v7% 4
1.05v7% 1.052 v7%
5
1.058 v11
7%
9 7%

1.5 1.034605 2.6243 0.3 1.043380 6.5152 0.81630

1 1.059 v9
0.81630 5.73739 6.82096 12.55835
1 1.05v

Page 10
Subject CT1 (Financial Mathematics Core Technical) September 2005 Examiners Report

Present value of cash inflows:

a6 7% a3 7% 1.9 a9 7% a6 7% 2.5 a12 7% a9 7%

2.5a12 0.6a9 0.9a6 a3

1.034605 2.5 7.9427 0.6 6.5152 0.9 4.7665 2.6243

9.3461

NPV is negative so the discounted payback period is more than 12 years.

Project fulfils neither the discounted payback period criterion nor the internal
rate of return criterion.

END OF EXAMINERS REPORT

Page 11
Faculty of Actuaries Institute of Actuaries

EXAMINATION

4 April 2006 (am)

Subject CT1 Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 12 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
CT1 A2006 Institute of Actuaries
1 An investment is discounted for 28 days at a simple rate of discount of 4.5% per
annum. Calculate the annual effective rate of interest. [3]

2 An annuity certain with payments of £150 at the end of each quarter is to be replaced
by an annuity with the same term and present value, but with payments at the
beginning of each month instead.

Calculate the revised payments, assuming an annual force of interest of 10%. [3]

3 At time t = 0 the n-year spot rate of interest is equal to (2.25 + 0.25n)% per annum
effective (1 n 5).

(a) Calculate the 2-year forward rate of interest from time t = 3 expressed as an
annual effective rate of interest.

(b) Calculate the 4-year par yield.

(c) Without performing any further calculations, explain how you would expect
the gross redemption yield of a 4-year bond paying annual coupons of 3.5% to
compare with the par yield calculated in (b).
[7]

4 An investor, who is liable to income tax at 20% but is not liable to capital gains tax,
wishes to earn a net effective rate of return of 5% per annum. A bond bearing
coupons payable half-yearly in arrear at a rate 6.25% per annum is available. The
bond will be redeemed at par on a coupon date between 10 and 15 years after the date
of issue, inclusive. The date of redemption is at the option of the borrower.

Calculate the maximum price that the investor is willing to pay for the bond. [5]

5 A share currently trades at £10 and will pay a dividend of 50p in one month s time. A
six-month forward contract is available on the share for £9.70. Show that an investor
can make a risk-free profit if the risk-free force of interest is 3% per annum. [4]

6 An actuarial student has created an interest rate model under which the annual
effective rate of interest is assumed to be fixed over the whole of the next ten years.
The annual effective rate is assumed to be 2%, 4% and 7% with probabilities 0.25,
0.55 and 0.2 respectively.

(a) Calculate the expected accumulated value of an annuity of £800 per annum
payable annually in advance over the next ten years.

(b) Calculate the probability that the accumulated value will be greater than
£10,000.
[4]

CT1 A2006 2
7 A company has entered into an interest rate swap. Under the terms of the swap the
company makes fixed annual payments equal to 6% of the principal of the swap. In
return, the company receives annual interest payments on the principal based on the
prevailing variable short-term interest rate which currently stands at 5.5% per annum.

(a) Describe briefly the risks faced by a counterparty to an interest rate swap.

(b) Explain which of the risks described in (a) are faced by the company. [4]

8 An ordinary share pays annual dividends. A dividend of 25p per share has just been
paid. Dividends are expected to grow by 2% next year and by 4% the following year.
Thereafter, dividends are expected to grow at 6% per annum compound in perpetuity.

(i) State the main characteristics of ordinary shares. [4]

(ii) Calculate the present value of the dividend stream described above at a rate of
interest of 9% per annum effective from a holding of 100 ordinary shares. [4]

(iii) An investor buys 100 shares in (ii) for £8.20 each. He holds them for two
years and receives the dividends payable. He then sells them for £9
immediately after the second dividend is paid.

Calculate the investor s real rate of return if the inflation index increases by
3% during the first year and by 3.5% during the second year assuming
dividends grow as expected. [4]
[Total 12]

9 The force of interest (t ) is a function of time and at any time t, measured in years, is
given by the formula:

0.04 0 t 5
(t ) 0.008t 5 t 10
2 10 t
0.005t 0.0003t

(i) Calculate the present value of a unit sum of money due at time t = 12. [5]

(ii) Calculate the effective annual rate of interest over the 12 years. [2]

(iii) Calculate the present value at time t = 0 of a continuous payment stream

that is paid at the rate of e 0.05t per unit time between time t = 2 and time
t = 5. [3]
[Total 10]

CT1 A2006 3 PLEASE TURN OVER

10 A piece of land is available for sale for £5,000,000. A property developer, who can
lend and borrow money at a rate of 15% per annum, believes that she can build
housing on the land and sell it for a profit. The total cost of development would be
£7,000,000 which would be incurred continuously over the first two years after
purchase of the land. The development would then be complete.

The developer has three possible project strategies. She believes that she can sell the
completed housing:

in three years time for £16,500,000

in four years time for £18,000,000
in five years time for £20,500,000

The developer also believes that she can obtain a rental income from the housing
between the time that the development is completed and the time of sale. The rental
income is payable quarterly in advance and is expected to be £500,000 in the first year
of payment. Thereafter, the rental income is expected to increase by £50,000 per
annum at the beginning of each year that the income is paid.

(i) Determine the optimum strategy if this is based upon using net present value
as the decision criterion. [9]

(ii) Determine which strategy would be optimal if the discounted payback period
were to be used as the decision criterion. [2]

(iii) If the housing is sold in six years time, the developer believes that she can
obtain an internal rate of return on the project of 17.5% per annum. Calculate
the sale price that the developer believes that she can receive. [6]

(iv) Suggest reasons why the developer may not achieve an internal rate of return
of 17.5% per annum even if she sells the housing for the sale price calculated
in (iii). [2]
[Total 19]

CT1 A2006 4
11 An actuarial student has taken out two loans.

Loan A: a five-year car loan for £10,000 repayable by equal monthly instalments of
capital and interest in arrear with a flat rate of interest of 10.715% per
annum.

Loan B: a five-year bank loan of £15,000 repayable by equal monthly instalments of

capital and interest in arrear with an effective annual interest rate of 12% for
the first two years and 10% thereafter.

The student has a monthly disposable income of £600 to pay the loan interest after all
other living expenses have been paid.

Freeloans is a company which offer loans at a constant effective interest rate for all
terms between three years and ten years. After two years, the student is approached
by a representative of Freeloans who offers the student a 10-year loan on the capital
outstanding which is repayable by equal monthly instalments of capital and interest in
arrear. This new loan is used to pay off the original loans and will have repayments
equal to half the original repayments.

(i) Calculate the final disposable income (surplus or deficit) each month after the
loan payments have been made. [5]

(ii) Calculate the capital repaid in the first month of the third year assuming that
the student carries on with the original arrangements. [5]

(iii) Estimate the capital repaid in the first month of the third year assuming that
the student has taken out the new loan. [5]

(iv) Suggest, with reasons, a more appropriate strategy for the student. [2]
[Total 17]

CT1 A2006 5 PLEASE TURN OVER

12 A pension fund has liabilities of £3 million due in 3 years time, £5 million due in 5
years time, £9 million due in 9 years time, and £11 million due in 11 years time.
The fund holds two investments, X and Y. Investment X provides income of £1
million payable at the end of each year for the next five years with no capital
repayment. Investment Y is a zero coupon bond which pays a lump sum of £R at the
end of n years (where n is not necessarily an integer). The interest rate is 8% per
annum effective.

(i) Investigate whether values of £R and n can be found which ensure that the
fund is immunised against small changes in the interest rate.

5
You are given that t 2 vt 40.275 at 8%. [8]
t 1

(ii) (a) The interest rate immediately changes to 3% per annum effective.
Calculate the revised present values of the assets and liabilities of the
fund.

(b) Explain your answer to (ii)(a). [4]

[Total 12]

END OF PAPER

CT1 A2006 6
Faculty of Actuaries Institute of Actuaries

EXAMINATION
April 2006

Subject CT1 Financial Mathematics

Core Technical

EXAMINERS REPORT
Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M Flaherty
Chairman of the Board of Examiners

June 2006

Comments

Individual comments are shown after each question.

General comments

As is in some recent diets, the questions requiring verbal reasoning (such as Q3(c), Q7(b),
Q10(iv) and Q11(iv)) tended not to be well answered with candidates producing vague
statements which did not demonstrate that they understood the relevant points.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this.

However, candidates may be penalised where excessive rounding has been used or where
insufficient working is shown.

Faculty of Actuaries
Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

1
28d 28 / 365
1 Annual rate of interest is i where 1 1 i
365

365 / 28
28 0.045
This gives i 1 1 4.611%
365

Comments on question 1: This was generally well answered.

2 We require X where:

a (4) d (12)
600a (4) 12 Xa (12) X 50 n
(12)
50
n n a i (4)
n

1/12
d (12) 12 1 1 d 12 1 e 12 0.099584

1/ 4
i (4) 4 1 i 1 4 e 4 1 0.101260

Hence X 49.1724 or £49.17

Comments on question 2: Candidates were not penalised for assuming that the annuities
were for a specific term even though this was not needed for the calculations.

5 5
2 1 y5 1.035
3 (a) 1 f3,2 3 3
f3,2 4.255%
1 y3 1.03

(b) Par yield is yc4 where yc4 v y1 v 2y2 v3y3 v 4y4 v 4y4 1

1 2 3 4 4
Thus yc4 1.025 1.0275 1.03 1.0325 1.0325 1

0.12009
yc4 3.230%
3.71785

(c) The par yield is equal to the gross redemption yield for a par yield bond.
Coupons for the 3.5% bond are higher than for the par yield bond. Thus a
lower proportion of the total proceeds are included within the redemption
payment which is when spot yields/discount rates are highest. The present
value of the proceeds of the 3.5% bond will be higher and so the gross
redemption yield will be lower than that of the par yield bond and thus less
than the par yield.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

Comments on question 3: Part (a) was answered well but some candidates struggled with
the calculation of the par yield in part (b). In part (c) the marks were awarded for a clear
explanation. Many candidates, who just stated their conclusion, were unable to explain their
reasoning clearly and so failed to score full marks on this part.

2
4 i 0.049390

g 1 t1 0.0625 0.80 0.05

2
i 1 t1 g

Capital loss on contract

Assume redeemed as early as possible (i.e.: after 10 years) to obtain minimum

yield.

Price of stock per £100 nominal, P:

2
P 100 0.0625 0.80 a 100v10at 5%
10

2
P 5a 100v10
10

5 1.012348 7.7217 100 0.61391

39.0852 61.3910 £100.4762

Comments on question 4: Well answered although some candidates who recognised that the
investor faced a capital loss did not recognise that this meant that the minimum yield would
be obtained if the bond was redeemed at the earliest possible date.

Page 3
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

5 An investor can borrow £10 at the risk-free rate, buy one share for £10, enter into the
forward contract to sell the share in six months time.

The initial cashflow is zero.

After one month the 50p dividend from the share is invested at the risk-free rate. After
six months the share can be sold for £9.70, the dividend proceeds are worth
0.03 5
0.5e 12 and the borrowing is repaid at 10 e0.015 . This gives a net cashflow of 9.7
0.03 5
+ 0.5e 12 10 e0.015 = 0.0552

The investor has made a deal with zero initial cost, no risk of future loss and a risk-
free future profit.

Comments on question 5: The majority of candidates were able to calculate the non-
arbitrage forward price by use of the appropriate formula. However, marks were lost for not
clearly explaining how a risk-free profit could thus be made.

6 (a) Expected accumulated value

800 0.25s10 0.02 0.55s10 0.04 0.2 s10 0.07

800 0.25 s11 0.02 1 0.55 s11 0.04 1 0.2 s11 0.07 1

800 0.25 11.1687 0.55 12.4864 0.2 14.7836

0.25 8934.96 0.55 9989.12 0.2 11826.88

£10, 093.13

(b) Accumulation is only over £10,000 if the interest rate is 7% p.a. which has
probability 0.2

Comments on question 6: The most poorly answered question on the paper. This model of
interest rates had not been examined recently and the majority of candidates assumed instead
that the interest rate changed each year (in line with previous examination questions on this
topic).

Page 4
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

7 (a) The counterparty faces market risk which is the risk that market conditions
will change so that the present value of the net outgo under the agreement
increases.

The counterparty also faces credit risk which is the risk that the other
counterparty will default on its payments.

(b) The company still faces the market risk since the interest rates could fall
further which will make the value of the swap even more negative to the
company.

The company does not currently face a credit risk since the value of the swap
is positive to the other counterparty.

Comments on question 7: Part (a) was answered well but many candidates failed to
recognise in (b) that the company would not currently face credit risk in this example.

8 (i) Main characteristics of ordinary shares:

Issued by commercial undertakings and other bodies.

Entitle holders to receive all net profits of the company in the form of
dividends after interest on loans and other fixed interest stocks has been
paid.
Higher expected returns than for most other asset classes
but risk of capital losses
and returns can be variable.
Lowest ranking form of finance.
Low initial running yield but dividends should increase with inflation.
Marketability varies according to size of company.
Voting rights in proportion to number of shares held.

(ii) Present value of future dividends

100 0.25 1.02v 1.02 1.04v 2 1.02 1.04 1.06v3 1.02 1.04 1.062 v 4

25 1.02v 25 1.02 1.04v 2 1 1.06v 1.062 v 2

1.09
25 1.02v 25 1.02 1.04v 2
0.03

23.3945 811.0092 834.4037 £834.40

Page 5
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

(iii) Real rate of return is i such that:

100 100 100 2

820 100 0.25 1.02 v 100 0.25 1.02 1.04 v
103 103 103.5

100 100 2
900 v
103 103.5

24.7573v 869.1150v 2

24.7573 24.75732 4 869.1150 820

v 0.95719
2 869.1150
(taking positive root)

Hence i = 4.47%

Comments on question 8: Despite being a bookwork question, part (i) was answered patchily
with few students getting all of the required points. Part (ii) was answered well. In part (iii),
it was expected that students would solve the quadratic equation. However, full credit was
given to students who used interpolation methods.

5 5
0.04 dt 0.04t
9 (i) A(0,5) e 0 e 0 e0.2 1.22140

10
10
0.008tdt 0.004t 2
A(5,10) e 5 e 5 e0.3 1.34986

12 12
0.005t 0.0003t 2 dt 0.0025t 2 0.0001t 3
A(10,12) e 10
e 10 e0.1828 1.20057

Required present value

1 1 1
A 0,5 A 5,10 A 10,12 1.22140 1.34986 1.20057 1.97941

= 0.50520

12
(ii) Equivalent effective annual rate is i where 1 i 1.97941 i 5.855%

Page 6
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

(iii) Present Value at time t = 0

5 t 5
0.05t 0.04 ds 0.05t 0.04t
e e 0 dt e e dt
2 2

5 0.09t 5 0.18 0.45

0.09t e e e
e dt 2.1960
0.09 0.09
2 2

Comments on question 9: Well answered.

10 (i) Net present value of costs

i
5, 000, 000 3,500, 000a2 5, 000, 000 3,500, 000 a2

5, 000, 000 3,500, 000 1.073254 1.6257 11,106, 762

Net present value of benefits

4 (4)
450, 000v 2 a 50, 000v 2 Ia n 2
Sn v n
n 2

i i
450, 000v 2 (4)
an 2
50, 000v 2 (4)
Ia n 2
Sn v n
d d

where n is the year of sale and Sn are the sale proceeds if the sale is made in
year n.

If n = 3 the NPV of benefits

450, 000 0.75614 1.092113 0.86957

50, 000 0.75614 1.092113 0.86957
16,500, 000 0.65752
323,137 35,904 10,849, 080 11, 208,121

Hence net present value of the project is 11,208,121 11,106,762 = 101,359

Note that if n = 4 the extra benefits in year 4 consist of an extra £1.5 million
on the sale proceeds and an extra £650,000 rental income. This is clearly less
than the amount that could have been obtained if the sale had been made at the
end of year 3 and the proceeds invested at 15% per annum. Hence selling in
year 4 is not an optimum strategy.

Page 7
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

If n = 5 the NPV of benefits

450, 000 0.75614 1.092113 2.2832

50, 000 0.75614 1.092113 4.3544
20,500, 000 0.49718
848, 450 179, 791 10,192,190 11, 220, 431

Hence net present value of the project is 11,220,431 11,106,762 = 113,669

Hence the optimum strategy if net present value is used as the criterion is to
sell the housing after 5 years.

(ii) If the discounted payback period is used as the criterion, the optimum strategy
is that which minimises the first time when the net present value is positive.
By inspection, this is when the housing is sold after 3 years.

(iii) We require

i 4 (4)
5, 000, 000 3,500, 000 a2 450, 000v 2 a 50, 000v 2 Ia n 2
Sn v n at 17.5%
n 2

2
1 v0.175 1 0.72431
LHS 5, 000, 000 3,500, 000 5, 000, 000 3,500, 000
0.175 0.16127

10,983, 227

4 4
2 1 v0.175 2 a4 4v0.175 6
RHS 450, 000v0.175 50, 000v0.175 S6v0.175
4 4
d d

4 1
d 0.175 41 v 4 0.15806

1 v4
a4 3.1918
d

Therefore we have on the RHS

3.1918 2.0985
450, 000 0.72431 3.0076 50, 000 0.72431 0.37999 S6
0.15806

980, 296 250,502 0.37999 S6

Page 8
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

10,983, 227 1, 230, 798

For equality S6 £25, 665, 000
0.37999

(iv) Reasons investor may not achieve the internal rate of return:

Allowance for expenses when buying/selling which may be significant.

There may be periods when the property is unoccupied and no rental

income is received.

Rental income may be reduced by maintenance expenses.

Tax on rental income and/or sale proceeds

Comments on question 10: A significant number of candidates assumed that the development
costs amounted to £7 million per annum and subsequently found that no strategy would lead
to a profit. Otherwise the calculations were performed well. In part (iv), credit was given for
other valid answers. Despite this, few students scored full marks on this part.

11 (i) Let X A , X B be the monthly repayments under Loans A and B respectively.

For loan A:

Flat rate of interest = 10.715%

60 X A LA 60 X A 10000
XA £255.96
5 LA 50000

For loan B:

LB 15000 12 X B a (12) 2
v12% a (12)
2 12% 3 10%

1, 250
XB
i 2 i
12
a2 v12% 12
a3
i 12% i 10%

1, 250
1.053875 1.6901 0.79719 1.045045 2.4869

XB £324.43

Hence student s overall surplus = 600 XA X B = £19.61

Page 9
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

(ii) Effective rate of interest under loan A is i % where

12 12
12 255.96a 10000 a 3.2557
5 5

12
Try i = 20%: a = 3.2557
5
12
So capital outstanding after 24 months is 12 255.96 a at 20%
3

12 255.96 1.088651 2.1065 7043.74

12
Capital outstanding under B is 12 324.43 a at 10%
3

12 324.43 1.045045 2.4869 10118.02

So interest paid in month 25 under loans A and B

12 12
i 20% i10%
7043.74 10118.02 107.84 80.68 £188.52
12 12

and capital repaid

255.96 107.84 324.43 80.68 148.12 243.75 £391.87

(iii) Under the new loan the capital outstanding is the same as under the original
arrangement = 17161.76.

255.96 324.43
The monthly repayment £290.20
2

The effective rate of interest on the new loan A is i where

12 12
12 290.20a 17161.76 a 4.9281
10 10

12
Try i = 20%: a 4.5642
10

12
Try i = 15%: a 5.3551
10

5.3551 4.9281
By interpolation i 15% 20% 15% 17.7%
5.3551 4.5642

Page 10
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

Hence interest paid in month 25

12
i17.7%
17161.76 234.66
12

and capital repaid is £290.20 £234.66 = £55.54

(iv) The new strategy reduces the monthly payments but repays the capital more
slowly. The student could consider the following options:

Keeping loan B and taking out a smaller new loan to repay loan A
(which has the highest effective interest rate).

Taking out the new loan for a shorter term to repay the capital more
quickly.

Comments on question 11: In part (i) some candidates struggled to deal with the flat rate of
Loan A whilst others failed to deal with the change in interest rate of Loan B. Part (ii) was
answered well. In part (iii), different answers for the effective rate of interest (and hence the
interest paid) for the new loan could be obtained according to the actual interpolation used
and full credit was given for a range of answers. If calculated exactly, the effective rate of
interest is actually 17.5%. In part (iv), credit was again given for any valid strategy suitably
explained.

12 (i) We will consider three conditions necessary for immunisation

(1) VA VL (all expressions in terms of £m)

VA a5 Rv n at 8%
3.9927 Rv n

VL 3v 3 5v 5 9v 9 11v11 at 8%
15.0044

Rv n 11.0117

VA VL
(2) VA' VL' where VA' & VL'

VA' Ia 5
nRv n
11.3651 nRv n

VL' 9v3 25v5 81v9 121v11

116.5741

Page 11
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

nRv n 105.2090
105.2090
n 9.5543
11.0117
9.5543
R 11.0117 1.08 £22.9720m

Alternatively:

VA VL
VA' VL' where VA' & VL'
i i

VA' v Ia 5
nRv n 1

11.3651v nRv n 1

10.5233 nRv n 1

VL' 9v 4 25v 6 81v10 121v12

107.9389

nRv n 1
97.4156

97.4156
n 9.5543
11.0117v
9.5543
R 11.0117 1.08 £22.9720m

2 2
VA VL
(3) VA'' VL'' (where VA'' 2
& VL'' 2
)

5
VA'' t 2vt n 2 Rv n
t 1
2
40.275 9.5543 22.9720 v 9.5543
1045.483

VL'' 27v 3 125v 5 729v 9 1331v11

1042.031

Page 12
 Subject CT1 (Financial Mathematics Core Technical) April 2006 Examiners Report

Alternatively (differentiating with respect to i):

5
VA'' t t 1 vt 2
n n 1 Rv n 2

t 1
5
v2 t 2vt v 2 Ia 5
n n 1 Rv n 2

t 1

0.85734 40.275 0.85734 11.3651 9.5543 10.5543 22.9720 v11.5543

34.53 9.74 952.00 996.27

VL'' 3 3 4 v5 5 5 6 v 7 9 9 10 v11 11 11 12 v13

993.32

Thus n 9.5543, R £22.9720m will satisfy all three conditions and so will
achieve immunisation.

(ii) (a) Value of assets at 3% a5 Rv n 4.5797 22.9720v 9.5543 £21.900m

3 5 9 11
Value of liabilities at 3% = 3v 5v 9v 11v £21.903m
Hence fund has a deficit of approximately £3,000.

(b) Immunisation will only enable to be a fund to be protected against a

small change in interest rates. It will not be necessarily protected
against sudden large changes as in this case.

Comments on question 12: Part (i) was answered surprisingly poorly, given that it required
the same techniques as those required in previous examination questions on the same topic.
Full credit was given to students who observed directly that the spread of the assets around
the mean term was greater than the spread of the liabilities. Few students answered part (ii)
fully and the examiners felt that students should have recognised that immunisation would
not protect the fund against such a large change in interest rates even if they had not
answered part (i) correctly.

END OF EXAMINERS REPORT

Page 13
Faculty of Actuaries Institute of Actuaries

EXAMINATION

12 September 2006 (am)

Subject CT1 Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 12 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

Faculty of Actuaries
CT1 S2006 Institute of Actuaries
1 (a) Distinguish between a future and an option.
(b) Explain why convertibles have option-like characteristics.
[3]

2 An individual makes an investment of £4m per annum in the first year, £6m per
annum in the second year and £8m per annum in the third year. The investments are
made continuously throughout each year. Calculate the accumulated value of the
investments at the end of the third year at a rate of interest of 4% per annum effective.
[3]

3 An individual has invested a sum of £10m. Exactly one year later, the investment is
worth £11.1m. An index of prices has a value of 112 at the beginning of the
investment and 120 at the end of the investment. The investor pays tax at 40% on all
money returns from investment. Calculate:

(a) The money rate of return per annum before tax.

(b) The rate of inflation.
(c) The real rate of return per annum after tax.
[4]

4 An investor is able to purchase or sell two specially designed risk-free securities, A

and B. Short sales of both securities are possible. Security A has a market price of
20p. In the event that a particular stock market index goes up over the next year, it
will pay 25p and, in the event that the stock market index goes down, it will pay 15p.
Security B has a market price of 15p. In the event that the stock market index goes up
over the next year, it will pay 20p and, in the event that the stock market index goes
down, it will pay 12p.

(i) Explain what is meant by the assumption of no arbitrage used in the pricing
of derivative contracts. [2]

(ii) Find the market price of B, such that there are no arbitrage opportunities and
assuming the price of A remains fixed. Explain your reasoning. [2]
[Total 4]

5 (i) Calculate the time in days for £3,600 to accumulate to £4,000 at:

(a) a simple rate of interest of 6% per annum

(b) a compound rate of interest of 6% per annum convertible quarterly
(c) a compound rate of interest of 6% per annum convertible monthly
[4]

(ii) Explain why the amount takes longest to accumulate in (i)(a) [1]
[Total 5]

CT1 S2006 2
6 The rate of interest is a random variable that is distributed with mean 0.07 and
variance 0.016 in each of the next 10 years. The value taken by the rate of interest in
any one year is independent of its value in any other year. Deriving all necessary
formulae calculate:

(i) The expected accumulation at the end of ten years, if one unit is invested at the
beginning of ten years. [3]

(ii) The variance of the accumulation at the end of ten years, if one unit is invested
at the beginning of ten years. [5]

(iii) Explain how your answers in (i) and (ii) would differ if 1,000 units had been
invested. [1]
[Total 9]

7 A life insurance fund had assets totalling £600m on 1 January 2003. It received net
income of £40m on 1 January 2004 and £100m on 1 July 2004. The value of the fund
was:

£450m on 31 December 2003;

£500m on 30 June 2004;
£800m on 31 December 2004.

(i) Calculate, for the period 1 January 2003 to 31 December 2004, to three
decimal places:

(a) The time weighted rate of return per annum.

(b) The linked internal rate of return, using sub intervals of a calendar
year.
[8]

(ii) Explain why the linked internal rate of return is higher than the time weighted
rate of return. [2]
[Total 10]

8 The force of interest (t ) at time t is at bt 2 where a and b are constants. An amount

of £100 invested at time t = 0 accumulates to £150 at time t = 5 and £230 at time
t = 10.

(i) Calculate the values of a and b. [5]

(ii) Calculate the constant force of interest that would give rise to the same
accumulation from time t = 0 to time t = 10. [2]

(iii) At the force of interest calculated in (ii), calculate the present value of a
continuous payment stream of 20e0.05t paid between from time t = 0 to time
t = 10. [4]
[Total 11]

CT1 S2006 3 PLEASE TURN OVER

9 An individual took out a loan of £100,000 to purchase a house on 1 January 1980.
The loan is due to be repaid on 1 January 2010 but the borrower can repay the loan
early if he wishes. The borrower pays interest on the loan at a rate of 6% per annum
convertible monthly, paid in arrears. The loan instalments only cover the interest on
the loan. At the same time, the borrower took out a thirty-year investment policy,
which was expected to repay the loan, and into which monthly premiums were paid,
in advance, at a rate of £1,060 per annum. The individual was told that premiums in
the investment policy were expected to earn a rate of return of 7% per annum
effective. After twenty years, the individual was informed that the premiums had
only earned a rate of return of 4% per annum effective and that they would continue
to do so for the final ten years of the policy. The borrower agrees to increase his
monthly payments into the investment policy to £5,000 per annum for the final ten
years.

(a) Calculate the amount to which the investment policy was expected to
accumulate at the time it was taken out.

(b) Calculate the amount by which the investment policy would have fallen short
of repaying the loan had extra premiums not been paid for the final ten years.

(c) Calculate the amount of money the individual will have, after using the
proceeds of the investment policy to repay the loan, after allowing for the
increase in premiums.

(d) Suggest another course of action the borrower could have taken which would
have been of higher value to him, explaining why this higher value arises.

(e) Calculate the level annual instalment that the investor would have had to pay
from outset if he had repaid the loan in equal instalments of interest and
capital.
[11]

10 A financial regulator has brought in a new set of regulations and wishes to assess the
cost of them. It intends to conduct an analysis of the costs and benefits of the new
regulations in their first twenty years.

The costs are estimated to be as follows:

The cost to companies who will need to devise new policy terms and computer
systems is expected to be incurred at a rate of £50m in the first year increasing by
3% per annum over the twenty year period.

The cost to financial advisers who will have to set up new computer systems and
spend more time filling in paperwork is expected to be incurred at a rate of £60m
in the first year, £19m in the second year, £18m in the third year, reducing by £1m
every year until the last year, when the cost incurred will be at a rate of £1m.

The cost to consumers who will have to spend more time filling in paperwork and
talking to their financial advisers is expected to be incurred at a rate of £10m in
the first year, increasing by 3% per annum over the twenty year period.

CT1 S2006 4
 The benefits are estimated as follows:

The benefit to consumers who are less likely to buy inappropriate policies is
estimated to be received at a rate of £30m in the first year, £33m in the second
year, £36m in the third year and so on, rising by £3m per year until the end of
twenty years.

The benefit to companies who will spend less time dealing with complaints from
customers is estimated to be received at a rate of £12m per annum for twenty
years.

Calculate the net present value of the benefit or cost of the regulations in their first
twenty years at a rate of interest of 4% per annum effective. Assume that all costs and
benefits occur continuously throughout the year.
[12]

11 (i) Describe the characteristics of an index-linked government bond. [3]

(ii) On 1 July 2002, the government of a country issued an index-linked bond of

term seven years. Coupons are paid half-yearly in arrears on 1 January and 1
July each year. The annual nominal coupon is 2%. Interest and capital
payments are indexed by reference to the value of an inflation index with a
time lag of eight months.

You are given the following values of the inflation index.

Date Inflation index

November 2001 110.0

May 2002 112.3
November 2002 113.2
May 2003 113.8

The inflation index is assumed to increase continuously at the rate of 2½% per
annum effective from its value in May 2003.

An investor, paying tax at the rate of 20% on coupons only, purchased the
stock on 1 July 2003, just after a coupon payment had been made.

Calculate the price to this investor such that a real net yield of 3% per annum
convertible half yearly is obtained and assuming that the investor holds the
bond to maturity. [10]
[Total 13]

CT1 S2006 5 PLEASE TURN OVER

12 A pension fund has the following liabilities: annuity payments of £160,000 per annum
to be paid annually in arrears for the next 15 years and a lump sum of £200,000 to be
paid in ten years. It wishes to invest in two fixed-interest securities in order to
immunise its liabilities. Security A has a coupon rate of 8% per annum and a term to
redemption of eight years. Security B has a coupon rate of 3% per annum and a term
to redemption of 25 years. Both securities are redeemable at par and pay coupons
annually in arrear.

(i) Calculate the present value of the liabilities at a rate of interest of 7% per
annum effective. [2]

(ii) Calculate the discounted mean term of the liabilities at a rate of interest of 7%
per annum effective. [4]

(iii) Calculate the nominal amount of each security that should be purchased so
that both the present value and discounted mean terms of assets and liabilities
are equal. [7]

(iv) Without further calculation, comment on whether, if the conditions in (iii) are
fulfilled, the pension fund is likely to be immunised against small, uniform
changes in the rate of interest. [2]
[Total 15]

END OF PAPER

CT1 S2006 6
Faculty of Actuaries Institute of Actuaries

EXAMINATION
September 2006

Subject CT1 — Financial Mathematics

Core Technical

EXAMINERS’ REPORT
Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

November 2006

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report

Comments

As in many recent diets, the questions requiring verbal reasoning (e.g. Question 4(i)) tended
not to be well answered with candidates producing vague statements which did not
demonstrate that they understood the relevant points

Please note that differing answers may be obtained from those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this.

However, candidates may be penalised where excessive rounding has been used or where
insufficient working is shown.

Comments on solutions presented to individual questions for this September 2006 paper are
given below.

Question 1

Generally well answered. To gain full marks candidates were required to specify the
difference between futures and options rather than just defining each contract separately.

Question 2

Well answered. This was a question where some candidates were penalised if answers had
been rounded excessively.

Question 3

1 + 0.6i 1 + 0.6 × 0.11

Generally well answered. Another possible solution is to use 1 + j = =
1+ f 1.07143
which leads to the same answer.

Question 4

For full marks in part (i), an answer should have included a description of the ‘risk-free’
concept (rather than just saying arbitrage profits are impossible). Many students had
difficulty with part (ii).

Question 5

Full marks were given if either 365 or 365.25 days were used in the calculation. Most
students scored well on this question.

Question 6

This question was well answered. For full marks, candidates were required to show detailed
steps in deriving the result required including a definition of the initial terms used and a
correct explanation of the relevance of the independence assumption.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report

Question 7

This question was poorly answered to the surprise of the examiners. Many candidates
struggled to deal with the linked internal rate of return.

Question 8

Well answered.

Question 9

This question appeared to reward candidates who had a good understanding of the topic.
Whilst the best candidates usually scored close to full marks on this question, weaker or less-
prepared candidates often scored very badly.

Whilst the question did state that payments were made monthly, the examiners recognised
that there was some potential for misinterpretation as to the frequency of the loan repayments
in part (e) and took this into account. Thus students who used the formula Xa30 = 100, 000
(12 )
with i = 6% & i =6.168% to get an answer of £7,396 in this part were awarded full marks.

Question 10

Generally well answered.

Question 11

This was the worst answered question on the paper by some margin with very few candidates
scoring close to full marks. This may be because this type of question has not appeared in
recent diets. Candidates needed to show that they could derive logically the amounts that will
be paid, the real values of those amounts and their present values in real terms. Appropriate
formulae then needed to be developed.

Question 12

Many candidates answered this question well although a minority scored very badly (possibly
due to time pressure).

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report

1 (i) A future is a contract binding buyer and seller to deliver or take delivery of an
asset at a given price at a given time in the future. An option is a contract that
gives the buyer the option to deliver or take delivery of the asset at the given
price. The seller of the option must deliver/take delivery if the buyer of the
option wishes to exercise the option.

(ii) Convertibles have option-like characteristics because they give the holder the
option to purchase equity in a company on pre-arranged terms.

2 The accumulated value is

4 s3 + 2 s2 + 2 s1

=
i
(4s + 2s2 + 2 s1
δ 3
)
0.04
= ( 4 × 3.1216 + 2 × 2.0400 + 2 )
0.039221

= 18.9352

3 (a) The money rate of return is i where (1+i) = 11.1/10

i = 0.11 or 11%

(b) The rate of inflation is f where (1+f) = 120/112

f = 0.07143 or 7.143%

(c) The net real rate of return per annum is j

0.6i − f 0.6 × 0.11 − 0.07143
where j = = = −0.005068 or −0.5068%
1+ f 1.07143

4 (i) The no arbitrage assumption means that it is assumed that an investor is unable
to make a risk-free trading profit.

(ii) In all states of the world, security B pays 80% of A. Therefore its price must
be 80% of A’s price, or the investor could obtain a better payoff by only
purchasing one security and make risk-free profits by selling one security short
and buying the other. The price of B must therefore be 16p.

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report

5 (i) (a) Let the answer be t days

3,600(1 + 0.06 × t/365) = 4,000

t = 675.9 days

(b) Let the answer be t days

( )
4t
3,600 1 + 0.06
4
365
= 4,000

(4t/365) ln(1.015) = ln (4,000/3,600)

t = 645.7 days

(c) Let the answer be t days

( )
12 t
3,600 1 + 0.06
12
365
= 4,000

(12t/365) ln(1.005) = ln (4,000/3,600)

t = 642.5 days

(ii) (i)(a) takes longest because, under conditions of simple interest, interest does
not earn interest.

6 (i) Let it be the (random) rate of interest in year t . Let S10 be the accumulation of
the unit investment after 10 years:

E ( S10 ) = E ⎡⎣(1 + i1 )(1 + i2 ) …(1 + i10 ) ⎤⎦

E ( S10 ) = E [1 + i1 ] E [1 + i2 ]… E [1 + i10 ] as {it } are independent

E [it ] = j

∴ E ( S10 ) = (1 + j )
10
= 1.0710 = 1.96715

(ii) ( )
2
E S10 = E ⎡ ⎡⎣(1 + i1 )(1 + i2 ) …(1 + i10 ) ⎤⎦ ⎤
⎣⎢
2
⎥⎦

= E (1 + i1 ) E (1 + i2 ) … E (1 + i10 ) (using independence)

2 2 2

( ) ( ) (
= E 1 + 2i1 + i12 E 1 + 2i2 + i22 … E 1 + 2i10 + i10
2
)

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report

( ) ( )
10 10
= ⎡ E 1 + 2it + it2 ⎤ = 1 + 2 j + s2 + j 2
⎣ ⎦

as E ⎡ii2 ⎤ = V [it ] + E [it ] = s 2 + j 2

2
⎣ ⎦

( ) − (1 + j )
10
∴ Var [ S n ] = 1 + 2 j + s 2 + j 2
20

= (1 + 2 × 0.07 + 0.016 + 0.07 )

10
− (1.07 )
20
2
= 0.5761

(iii) If 1,000 units had been invested, the expected accumulation would have been
1,000 times bigger. The variance would have been 1,000,000 times bigger.

450 500 800

7 (i) (a) (1 + i )2 = ⇒ i = 1.015%
600 450 + 40 500 + 100

(b) First sub-interval is first year. Money weighted rate of return is i1

450
where (1 + i1 ) = ⇒ i1 = −25%
600

Second sub-interval is second year. Money weighted rate of return is i2

where 490 (1 + i2 ) + 100 (1 + i2 )
1
2
= 800

−100 ± 1002 − 4 × 490 × (−800) −100 ± 1256.1847

Then (1 + i2 )
1
2
= =
2 × 490 980

= 1.17978 (taking positive root)

(1 + i2 ) = 1.39188 ⇒ i2 = 39.188%
Linked internal rate of return is i
where (1 + i ) = 0.75 ×1.39188 ⇒ i = 2.1719%
2

(ii) The linked IRR is higher because it relies on two money weighted rates of
return. With the calculation of the second money weighted rate of return, there
is more money in the fund when the fund is performing well (in the second
half of the year).

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report

⎧⎪ 5 ⎫⎪
( )
5
8 (i) 150 = 100 exp ⎨ ∫ at + bt 2 dt ⎬ = 100 exp ⎡ 12 at 2 + 13 bt 3 ⎤ = 100 exp [12.5a + 41.667b ]
⎣ ⎦0
⎪⎩ 0 ⎪⎭
⎧⎪10 ⎫⎪
( )
10
230 = 100 exp ⎨ ∫ at + bt 2 dt ⎬ = 100 exp ⎡ 12 at 2 + 13 bt 3 ⎤ = 100 exp [50a + 333.333b ]
⎣ ⎦0
⎪⎩ 0 ⎪⎭

ln(1.5) = 12.5a + 41.667b

ln(2.3) = 50a + 333.333b

The second expression less four times the first expression gives:

ln(2.3) − 4 ln(1.5) = 166.667b ⇒ b = −0.0047337

ln(2.3) − 333.333 × −0.0047337

a= = 0.0482162
50

(ii) 100e10δ = 230 ⇒ 10δ = ln 2.3 ⇒ δ = 0.08329

10
0.05t −0.08329t
(iii) Present Value = ∫ 20e e dt
0

10
−0.03329t
= ∫ 20e dt
0

10
⎡ e −0.03329t ⎤
= 20 ⎢ ⎥
⎣⎢ −0.03329 ⎦⎥ 0

= 20 × 8.5058 = 170.116

9 (a) Premiums were expected to accumulate to

(12 ) i
1, 060s at 7% = 1, 060 s = 1, 060 × 1.037525 × 94.4608 = £103,885.77
d )
(
30 12 30

(b) Premiums would have accumulated to

(12 ) i
1, 060s at 4% = 1, 060 s = 1, 060 × 1.021537 × 56.0849 = £60, 730.37
30
d (12 ) 30

The shortfall is 100,000 – 60,730.37 = £39,269.63

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report

(c) Accumulation will be

(12 )
1, 060 s
20 4%
(1.04 )10 + 5, 000s10(124%
)

i i
s20 (1.04 ) + 5, 000
10
= 1, 060 s
d( ) d( )
12 12 10

= 1, 060 × 1.021537 × 29.7781×1.48024 + 5, 000 × 1.021537 × 12.0061

= £109, 053.12

Therefore the excess is £9,053.12

(d) The investor has earned a return of 4 % by investing extra premiums in the
investment policy. The investor could have obtained a lower present value of
total payments on the loan by paying off part of the loan instead. This is
because the interest being paid on the loan was greater than the interest he was
earning on his premiums.

(e) If he had repaid the loan by a level annuity, the annual instalment would have
been X where

X (12 ) (12 )
a360 = 100, 000 at 0.5% (or Xa = 100, 000 with i = 6% & i = 6.168%)
12 30

12 × 100, 000 1, 200, 000

X= = = £7,194.61
a360 166.7916

10 Present value of companies’ and consumers’ costs is (in £ million)

i
δ
(
( 50 + 10 ) v + 1.03v 2 + 1.032 v3 + … + 1.0319 v 20 )
i
(
= 60v 1 + 1.03v + (1.03v ) + … + (1.03v )
δ
2 19
)
i
= 60v
(
1 − (1.03v )
20
) = 1.019869 × 60 × 0.96154 × ⎛ 1 −1.80611× 0.45639 ⎞
⎜ ⎟
δ 1 − 1.03v ⎝ 1 − 1.03 × 0.96154 ⎠

= 1.019869 × 60 × 0.96154 × 18.27680 = 1075.383

Page 8
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report

Present value of costs to financial advisors (in £ million)

i
δ
(
60v + 19v 2 + 18v3 + … + v 20 )
= 40
iv i
(
+ 20v + 19v 2 + 18v3 + … + v 20
δ δ
)

= 40
iv i
( i
) (
+ 21a20 − Ia20 = 40v + 21a20 − Ia20
δ δ δ
)
= 1.019869 × ( 40 × 0.96154 + 21× 13.5903 − 125.1550 )

= 1.019869 × 198.7029 = 202.651

Total PV of all costs = £1278.034 million

Present value of benefits (in £ million)

i
δ
( i
)
30v + 33v 2 + 36v3 + … + 87v 20 + 12a20
δ

i
δ
(
27 a20 + 3v + 6v 2 + 9v3 + … + 60v 20 + 12a20 )

=
i
δ
(
3 ( Ia )20 + 39a20 )

= 1.019869 ( 3 × 125.1550 + 39 × 13.5903)

= 1.019869 × 905.4867

= 923.478

Net present value of costs = PV(costs) – PV(benefits)

= 1278.034 – 923.478 = £354.556 million

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report

11 (i)
• Payments guaranteed by government.
• Can be various different indexation provisions but, in general, protection is
given against a fall in the purchasing power of money.
• Fairly liquid (i.e. large issue size and ability to deal in large quantities)
compared with corporate issues, but not compared with conventional
issues.
• Normally coupon and capital payments both indexed to increases in a
given price index with a lag.
• Low volatility of return and low expected real return.
• More or less guaranteed real return if held to maturity (can vary due to
indexation lag).
• Nominal return is not guaranteed.

(ii) The first coupon the investor will receive will be on 31st December 2003. The
net coupon per £100 nominal will be:

113.8
0.8 ×1× (Index May 2003/Index November 2001) = 0.8 ×1×
110
113.8 v
In real present value terms, this is 0.8
110 (1 + r )0.5

where r = 2.5% per annum and v is calculated at 1.5% (per half year)

The second coupon on 30th June 2004 per £100 nominal will be
113.8
0.8 ×1× (1 + r )0.5
110
2
0.5 113.8 v
In real present value terms, this is 0.8 (1 + r )
110 (1 + r )

The third coupon on 31st December 2004 per £100 nominal will be
113.8
0.8 ×1× (1 + r )
110

113.8 v3
In real present value terms, this is 0.8 (1 + r )
110 (1 + r )1.5

Continuing in this way, the last coupon payment on 30 June 2009 per £100
113.8
nominal will be 0.8 ×1× (1 + r )5.5
110

5.5 113.8 v12

In real present value terms, this is 0.8 (1 + r )
110 (1 + r )6

Page 10
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report

By similar reasoning, the real present value of the redemption payment is

5.5 113.8 v12

100 (1 + r )
110 (1 + r )6

The present value of the succession of coupon payments and the capital
payment can be written as:

P=
1
(1 + r )
113.8
0.5 110 ( ( )
0.8 v + v 2 + … + v12 + 100v12 )

=
1 113.8
1.0124224 110
(
0.8a12 1.5% + 100v1.5%
12
)
= 1.02185 × ( 0.8 × 10.9075 + 100 × 0.83639 )

= 94.3833

12 (i) Present value of liabilities is 160, 000a15 + 200, 000v10 at 7%

= 160, 000 × 9.1079 + 200, 000 × 0.50835
= £1,558,934

(ii) Discounted mean term (DMT) of liabilities is

=
(1×160, 000 × v + 2 ×160, 000 × v 2
)
+ … + 15 × 160, 000 × v15 + 200, 000 × 10 × v10
160, 000a15 + 200, 000v 10

=
( )
160, 000 × Ia15 + 200, 000 × 10 × v10
160, 000a15 + 200, 000v10

160, 000 × 61.5540 + 200, 000 ×10 × 0.50835

=
1,558,934

10,865,340
= = 6.9697 years (½ mark deducted for no units)
1,558,934

Page 11
 Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’Report

(iii) Let the nominal amounts in each security equal A and B respectively.

If the present values of assets and liabilities are to be equal then:

( ) ( )
A 0.08a8 + v8 + B 0.03a25 + v 25 = 1,558,934 (1)

If the DMTs of the assets and liabilities are equal, then:

( ) (
A 0.08 ( Ia )8 + 8v8 + B 0.03 ( Ia )25 + 25v 25 ) = 6.9697
1,558,934

( ) ( )
or A 0.08 ( Ia )8 + 8v8 + B 0.03 ( Ia )25 + 25v 25 = 10,865,340 (2)

From (1)

A ( 0.08 × 5.9713 + 0.58201) + B ( 0.03 × 11.6536 + 0.18425 ) = 1,558,934

⇒ 1.059714 A + 0.533858 B = 1,558,934

From (2)

A ( 0.08 × 24.7602 + 8 × 0.58201) + B ( 0.03 ×112.3301 + 25 × 0.18425 ) = 10,865,340

⇒ 6.636896 A + 7.976153B = 10,865,340

Therefore

⎛ 1,558,934 − 0.533858 B ⎞
6.636896 ⎜ ⎟ + 7.976153B = 10,865,340
⎝ 1.059714 ⎠

⎛ 6.636896 × 0.533858 ⎞ 6.636896 × 1,558,934

⇒ B ⎜ 7.976153 − ⎟ = 10,865,340 −
⎝ 1.059714 ⎠ 1.059714

1,101,872.85
⇒B= = £237,850
4.632647

⎛ 1,558,934 − 0.533858 B ⎞
A=⎜ ⎟ = £1,351, 266
⎝ 1.059714 ⎠

Page 12
Subject CT1 (Financial Mathematics Core Technical) — September 2006 — Examiners’ Report

(iv) It appears that the asset payments are more spread out than the liability
payments. The third condition for immunisation is that that convexity of the
assets is greater than that of the liabilities, or that the asset times are more
spread around the discounted mean term than the liability times. From
observation is appears likely that this condition is met.

END OF EXAMINERS’ REPORT

Page 13
Faculty of Actuaries Institute of Actuaries

EXAMINATION

12 April 2007 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

© Faculty of Actuaries
CT1 A2007 © Institute of Actuaries
1 An investor pays £400 every half-year in advance into a 25-year savings plan.

Calculate the accumulated fund at the end of the term if the interest rate is 6% per
annum convertible monthly for the first 15 years and 6% per annum convertible half-
yearly for the final 10 years. [5]

2 The force of interest δ ( t ) is a function of time and at any time, measured in years, is
given by the formula:

δ ( t ) = 0.04 + 0.01t 0≤t≤4

δ ( t ) = 0.12 − 0.01t 4<t ≤8
δ ( t ) = 0.06 8<t

Calculate the present value at time t = 0 of a payment stream, paid continuously from
time t = 9 to t = 12, under which the rate of payment at time t is 50e0.01t .
[6]

3 An ordinary share pays annual dividends. The next dividend is due in exactly eight
months’ time. This dividend is expected to be £1.10 per share. Dividends are expected
to grow at a rate of 5% per annum compound from this level and are expected to
continue in perpetuity. Inflation is expected to be 3% per annum. The price of the
share is £21.50.

Calculate the expected effective annual real rate of return for an investor who
purchases the share. [7]

4 An investor entered into a long forward contract for a security five years ago and the
contract is due to mature in seven years’ time. The price of the security was £95 five
years ago and is now £145. The risk-free rate of interest can be assumed to be 3% per
annum throughout the 12-year period.

Assuming no arbitrage, calculate the value of the contract now if:

(i) The security will pay dividends of £5 in two years’ time and £6 in four years’
time. [3]

(ii) The security has paid and will continue to pay annually in arrear a dividend of
2% per annum of the market price of the security at the time of payment. [3]
[Total 6]

CT1 A2007—2
5 In a particular bond market, n-year spot rates per annum can be approximated by the
function 0.08 − 0.04e −0.1n .

Calculate:

(i) The price per unit nominal of a zero coupon bond with term nine years. [2]

(ii) The four-year forward rate at time 7 years. [3]

(iii) The three-year par yield. [3]

[Total 8]

6 A fund had a value of £21,000 on 1 July 2003. A net cash flow of £5,000 was
received on 1 July 2004 and a further net cash flow of £8,000 was received on 1 July
2005. Immediately before receipt of the first net cash flow, the fund had a value of
£24,000, and immediately before receipt of the second net cash flow the fund had a
value of £32,000. The value of the fund on 1 July 2006 was £38,000.

(i) Calculate the annual effective money weighted rate of return earned on the
fund over the period 1 July 2003 to 1 July 2006. [3]

(ii) Calculate the annual effective time weighted rate of return earned on the fund
over the period 1 July 2003 to 1 July 2006. [3]

(iii) Explain why the values in (i) and (ii) differ. [2]
[Total 8]

7 An insurance company has liabilities of £87,500 due in 8 years’ time and £157,500
due in 19 years’ time. Its assets consist of two zero coupon bonds, one paying
£66,850 in four years’ time and the other paying £X in n years’ time. The current
interest rate is 7% per annum effective.

(i) Calculate the discounted mean term and convexity of the liabilities. [5]

(ii) Determine whether values of £X and n can be found which ensure that the
company is immunised against small changes in the interest rate. [5]
[Total 10]

CT1 A2007—3 PLEASE TURN OVER

8 A company has borrowed £800,000 from a bank. The loan is to be repaid by level
instalments, payable annually in arrear for 10 years from the date the loan is made.
The annual repayments are calculated at an effective rate of interest of 8% per annum.

(i) Calculate the amount of the level annual payment and the total amount of
interest which will be paid over the 10 year term. [3]

(ii) At the beginning of the eighth year, immediately after the seventh payment
has been made, the company asks for the term of the loan to be extended by
two years. 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 remainder of the term
and that payments are made quarterly in arrear.

(a) Calculate the amount of the new quarterly payment.

(b) Calculate the capital and interest components of the first quarterly
instalment of the revised loan repayments.
[6]
[Total 9]

9 A property developer is constructing a block of offices. It is anticipated that the

offices will take six months to build. The developer incurs costs of £40 million at the
beginning of the project followed by £3 million at the end of each month for the
following six months during the building period. It is expected that rental income
from the offices will be £1 million per month, which will be received at the start of
each month beginning with the seventh month. Maintenance and management costs
paid by the developer are expected to be £2 million per annum payable monthly in
arrear with the first payment at the end of the seventh month. The block of offices is
expected to be sold 25 years after the start of the project for £60 million.

(i) Calculate the discounted payback period using an effective rate of interest of
10% per annum. [7]

(ii) Without doing any further calculations, explain whether your answer to (i)
would change if the effective rate of interest were less than 10% per annum.
[3]
[Total 10]

CT1 A2007—4
10 A loan is issued bearing interest at a rate of 9% per annum and payable half-yearly in
arrear. The loan is to be redeemed at £110 per £100 nominal in 13 years’ time.

(i) The loan is issued at a price such that an investor, subject to income tax at
25%, and capital gains tax at 30%, would obtain a net redemption yield of 6%
per annum effective. Calculate the issue price per £100 nominal of the stock.
[5]

(ii) Two years after the date of issue, immediately after a coupon payment has
been made, the investor decides to sell the stock and finds a potential buyer,
who is subject to income tax at 10% and capital gains tax at 35%. The
potential buyer is prepared to buy the stock provided she will obtain a net
redemption yield of at least 8% per annum effective.

(a) Calculate the maximum price (per £100 nominal) which the original
investor can expect to obtain from the potential buyer.

(b) Calculate the net effective annual redemption yield (to the nearest 1%
per annum effective) that will be obtained by the original investor if
the loan is sold to the buyer at the price determined in (ii) (a).
[10]
[Total 15]

11 £80,000 is invested in a bank account which pays interest at the end of each year.
Interest is always reinvested in the account. The rate of interest is determined at the
beginning of each year and remains unchanged until the beginning of the next year.
The rate of interest applicable in any one year is independent of the rate applicable in
any other year.

During the first year, the annual effective rate of interest will be one of 4%, 6% or 8%
with equal probability.

During the second year, the annual effective rate of interest will be either 7% with
probability 0.75 or 5% with probability 0.25.

During the third year, the annual effective rate of interest will be either 6% with
probability 0.7 or 4% with probability 0.3.

(i) Derive the expected accumulated amount in the bank account at the end of
three years. [5]

(ii) Derive the variance of the accumulated amount in the bank account at the end
of three years. [8]

(iii) Calculate the probability that the accumulated amount in the bank account is
more than £97,000 at the end of three years. [3]
[Total 16]

END OF PAPER

CT1 A2007—5
Faculty of Actuaries Institute of Actuaries

EXAMINATION
April 2007

Subject CT1 — Financial Mathematics

Core Technical

EXAMINERS’ REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

June 2007

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

Comments

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this.

However, candidates may be penalised where excessive rounding has been used or where
insufficient working is shown.

Q1.

Whilst most candidates made a good attempt at this question on basic compound interest
accumulation, comparatively few students completed the question without error.

Q2.

Well answered.

Q3.

Most students answered this question well although candidates were expected to note that the
sum of the geometric progression would only converge if the rate of return was below the
dividend growth rate. Depending on the interpolation used, the final answer can justifiably
vary from that given.

Q4.

This proved to be the most difficult question on the paper. Other related methods to
determine the answers were available e.g. calculating the forward price of each contract and
working out the present value of the difference in these prices.

Q5.

Well answered.

Q6.

The calculations in parts (i) and (ii) were generally well done. Again, depending on the
interpolation used, the final answer can justifiably vary from that given although the
examiners penalised the use of too wide a range of interpolation.
The explanation in part (iii) was very poorly handled. In such cases, the examiners are not
simply looking for a statement lifted directly from the Core Reading. Instead, candidates are
expected to apply the relevant theory to the actual situation described in the question.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

Q7.

Generally well answered.

Q8.

This was the best answered question on the paper.

Q9.

Many candidates struggled with this question, firstly in determining when the various
costs/payments would be made and then in manipulating the resulting equation(s). A common
error was not to recognise that the DPP should be expressed as a whole number of months
since payments at the relevant time were being made at monthly intervals. In part (ii) little
credit was given for a correct conclusion without any accompanying explanation.

Q10.

This question seemed to provide a significant differentiation between candidates with many
scoring well and a sizeable minority scoring very badly. This seemed surprising given that
this topic is regularly examined. A common omission on part (ii)(b) was not to state whether
a capital gain had been made.

Q11.

The workings for parts (i) and (ii) were often too brief (the questions said ‘Derive…’). Note
that the final answer in part (ii) can justifiably vary significantly according to the rounding
used in intermediate calculations. Part (iii) was poorly done with many candidates assuming
a lognormal distribution for this discrete example.

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

1 Fund after 25 years =

400S30i × (1.03) + 400S20

*% 20 3%

where 1 + i* = (1.005 )
6

⇒ i∗ = 3.03775% per ½-year

⎡ (1.0303775 )30 − 1 ⎤
s30 @ 3.03775% = 1.0303775 × ⎢ ⎥
⎢⎣ 0.0303775 ⎥⎦

= 49.3215

⎡ (1.03)20 − 1 ⎤

S20 @ 3% = 1.03 × ⎢ ⎥ = 27.6765
⎢⎣ 0.03 ⎥⎦

Hence fund =

400 × 49.3215 × (1.03)

20
+ 400 × 27.6765

= 35632.06 + 11070.60

= £46,702.66

− ∫ δ( t )dt
t
12
2 (i) PV = ∫ 50 e 0.01t
. e 0
dt
9

where

t 4 8 t
∫0 δ ( t ) dt = ∫ ( 0.04 + 0.01t ) dt + ∫ 4 ( 0.12 − 0.01t ) dt + ∫ 8 0.06dt
0

4 8
= ⎡0.04t + 0.005t 2 ⎤ + ⎡0.12t − 0.005t 2 ⎤ + [ 0.06t ] 8
t
⎣ ⎦0 ⎣ ⎦4

= [ 0.24] + [ 0.64 − 0.40] + [ 0.06t − 0.48]

= 0.06t

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

Hence

12
PV = ∫ 50e0.01t . e−0.06t dt
9

12 −0.05t
= ∫ 50 e dt
9

12
⎡ −50 −0.05t ⎤
=⎢ e ⎥
⎣ 0.05 ⎦9

= –548.812 + 637.628

= 88.816

3 Let i = money rate of return

i′ = real rate of return

⇒ 1 + i = (1 + i′ )(1.03) here

21.50 = (1 + i )
4
12
( )
⋅ 1.10v + 1.05 × 1.10v 2 + (1.05 ) × 1.10v3 + ""
2

= (1 + i )
4
12
⎛ 1 − 1.05 ∞
× 1.10v ⎜ 1+i ( ) ⎞
⎟
⎜ 1 − 1.05
⎜
⎝ 1+i ( ) ⎟
⎟
⎠

1 1
= 1.10 × assuming i > 0.05
(1 + i )
8
12 (1 − 1.05
1+i )

1 1
19.5455 = ×
(1 + i )
8
12 1 − 1.05
1+i

Try i = 10% RHS = 20.6456

11% RHS = 17.2566

20.6456 − 19.5455
⇒ i = 0.10 + × 0.01 = 0.10325
20.6456 − 17.2566

1.10325
⇒ i′ comes from 1 + i′ = ⇒ i′ = 7.1% p.a.
1.03

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

4 (i) The current value of the forward price of the old contract is:

−2 −4
95 × (1.03) − 5 (1.03) − 6 (1.03)
5

whereas the current value of the forward price of a new contract is:

−2 −4
145 − 5 (1.03) − 6 (1.03)

Hence, current value of old forward contract is:

145 − 95 (1.03) = £34.87

5

(ii) The current value of the forward price of the old contract is:

−12
95 (1.02 ) (1.03)5 = 86.8376
whereas the current value of the forward price of a new contract is:

−7
145 (1.02 ) = 126.2312

⇒ current value of old forward contract is:

126.23 - 86.84 = £39.39

5 (i) Let Yk = spot rate for k year term

Pk = Price per unit nominal for k year term

Y9 = 0.063737

9
⎛ 1 ⎞
P9 = ⎜ ⎟ = 0.57344
⎝ 1 + Y9 ⎠

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

−0.1( 7 )
(ii) Y7 = 0.08 − 0.04 e = 0.060137

−0.1(11)
Y11 = 0.08 − 0.04e = 0.066685

(1 + Y11 )
11
(1.066685 )
11
(1 + f7,4 )
4
= =
(1 + Y7 )7 (1.060137 )7
= 1.35165

∴ 4-year forward rate is 7.824% at time 7.

(iii) Y1 = 0.04381, Y2 = 0.04725, Y3 = 0.05037

( ) ( vY1 + vY2 + vY3 ) + vY3

1 = Yc3 1 2 3 3

Yc3 = 0.05016 i.e. 5.016% p.a.

6 (i) Work in £000’s

MWRR is i such that:

21(1 + i ) + 5 (1 + i ) + 8 (1 + i ) = 38
3 2

Try i = 5%, LHS = 38.223

i = 4%, LHS = 37.350

By interpolation i = 4.74% p.a.

(ii) TWRR is i such that:

24 32 38
(1 + i )3 = × × ⇒ i = 6.21% p.a.
21 29 40

(iii) MWRR is lower than TWRR because of the large cash flow on 1/7/05; the
overall return in the final year is much lower than in the first 2 years, and the
payment at 1/7/05 gives this final year more weight in the MWRR, but does
not affect the TWRR.

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

7 Let PVL be PV of liabilities, DMTL be DMT of liabilities, CL be convexity of

liabilities.

(i) PVL = 87,500v8 + 157,500v19 at 7%

= 94,475.86

87,500 × 8v8 + 157,500 × 19v19

⇒ DMTL = at 7%
94, 475.86

1, 234,857.56
=
94, 475.86

= 13.070615 years

87,500 × 8 × 9v10 + 157,500 × 19 × 20v 21

CL = at 7%
94, 475.86

17, 657,158.78
=
94, 475.86

= 186.895985

(ii) Firstly, PVs should be equal:

⇒ 66,850v 4 + Xv n = 94, 475.86 at 7%

⇒ Xv n = 43, 476.31507

Secondly, DMTs should be equal

⇒ 66,850 × 4v 4 + Xnv n = 1, 234,857.56

⇒ Xnv n = 1, 030,859.38
⇒ n = 23.710827 years
⇒ X = 43, 476.31507 × 1.07 n
= 216,255.12

Page 8
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

Lastly, verify 3rd condition

(
C A = 66,850 × 4 × 5v 6 + 216, 255.12n ( n + 1) v(
n+ 2)
) / 94, 475.86
= 23,140,343.20/94,475.86
= 244.93393

> CL

Hence, immunisation is achieved.

8 (i) 800, 000 = P a10

8%
= P × 6.7101

⇒ P = 119, 223.26

Total amount of interest = 10 × 119,223.26 – 800,000

= £392,232.60

(ii) (a) Capital o/s at start of 8th year

= 119,223.26 a38% = 119, 223.26 ∗ 2.5771 = 307, 250.26

Let new payment be P′ per annum, then

P′a (4) = P′ ∗1.043938 ∗ 3.6048 = 307, 250.26

5
12%

⇒ P′ = 81, 646.28

⇒ q'ly payment = 20, 411.57

(b) Capital o/s after 7 years = 307,250.26

⇒ Interest in 1st q'ly payment = 30, 7250.26 ∗ ⎛⎜ (1.12 ) 4 − 1⎞⎟ = 8,829.56

1

⎝ ⎠

⇒ capital component = 20,411.57 − 8,829.56 = 11,582.01

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

9 (i) The discounted payback period is the first point at which the present value of
the income exceeds the present value of the outgoings. The present value of
all payments and income up to time t is given by (working in £m)

(12 ) 1
(12 ) 1
(12 )
PV = −40 − 36a 1 − 2v 2 a 1 + 12v 2 a 1
2 t− 2 t − 2 + 112

(12 ) 1
(12 ) 1
⎛1 (12 ) ⎞
= −40 − 36a 1 − 2v 2 a 1 + 12v 2 ⎜ 12 +a 1 ⎟
2 t− 2 ⎝ t− 2 ⎠

(12 ) t − 0.5
= −40 − 36a 1 + v 2 + 10v 2 1−v(12)
1 1

2 i

1
(12 ) 1− v 2 1 − 0.9534626
a1 = at 10% = = 0.48634
i( )
2
12 0.0956897

⇒ 0.56758 = 1 - vt-0.5
⇒ vt-0.5 = 0.43242
log( 0.43242 )
⇒t = log 0.90909 + 0.5
( )
⇒t ≥ 9.296

Hence, the discounted pay back period is 9 years and 4 months.

(ii) If the effective rate of interest were less than 10% p.a. then the present values
of the income and outgo would both increase. However, the bigger impact
would be on the present value of the income since the bulk of the outgo occurs
in the early years when discounting has less effect. Hence, the DPP would
decrease.

i ( ) = 0.059126
2
10 (i)

0.09
g (1 − t1 ) = × 0.75=0.06136
1.10

⇒ i ( ) < (1 − t1 ) g
2

⇒ No capital gain

Page 10
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

Price of £100 nominal stock

( 2)
= 0.75 × 9 a +110v13 at 6%
13

= 0.75 × 9 × 1.014782 × 8.8527 + 110 × 0.46884

= 60.639 + 51.572

= £112.21

i ( ) = 0.078461
2
(ii) (a)

0.09
g (1 − t1 ) = × 0.90= 0.073636
1.10

⇒ i ( ) > (1 − t1 ) g
2

⇒ Capital gain

( 2)
Price, P = 0.90 × 9 × a + (110 − (110 − P ) × 0.35 ) v11 at 8%
11

0.90 × 9 × 1.019615 × 7.1390 + 0.65 ×110 × 0.42888

⇒P=
1 − 0.35 × 0.42888

89.62508
= = 105.455
0.849892

(b) No capital gain made

( 2)
112.21 = 0.75 × 9 × a + 105.455v 2
2

Try i = 3%, RHS = 112.41

i = 4%, RHS = 110.36

⇒ yield = 3% p.a. to nearest 1%

Page 11
 Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

11 (i) Let S3 = Accumulated fund after 3 years of investment of 1 at time 0

it = Interest rate for year t

Then, fund after 3 years

= 80,000 S3 = 80000 (1 + i1 )(1 + i2 ) (1 + i3 )

E ( i1 ) = 13 ( 0.04+0.06+0.08 ) =0.06

E ( i2 ) = 0.75 × 0.07+0.25 × 0.05=0.065

E ( i3 ) = 0.7 × 0.06 + 0.3 × 0.04 = 0.054

Then:

E [80000 S3 ] = 80, 000 E [ S3 ]

= E ⎡⎣80,000 (1 + i1 )(1 + i2 ) (1 + i3 ) ⎤⎦

= 80,000 E (1 + i1 ) . E (1 + i2 ) . E (1 + i3 )

since it ' s are independent

= 80,000 × 1.06 × 1.065 × 1.054 = £95,188.85

(ii) Var [80000S3 ] = 80,0002 × Var [ S3 ]

where Var [ S3 ] = E ⎡ S32 ⎤ − ( E [ S3 ])

2
⎣ ⎦

E ⎡ S32 ⎤ = E ⎡⎢(1 + i1 ) (1 + i2 ) (1 + i3 ) ⎤⎥
2 2 2
⎣ ⎦ ⎣ ⎦

= E ⎡⎢(1 + i1 ) ⎤⎥ . E ⎡⎢(1 + i2 ) ⎤⎥ . E ⎡⎢(1 + i3 ) ⎤⎥

2 2 2
⎣ ⎦ ⎣ ⎦ ⎣ ⎦

using independence

( )( )(
= 1 + 2 E [i1 ] + E ⎡i12 ⎤ . 1 + 2 E [i2 ] + E ⎡i22 ⎤ ⋅ 1 + 2 E [i3 ] + E ⎡i32 ⎤
⎣ ⎦ ⎣ ⎦ ⎣ ⎦ )

Page 12
Subject CT1 (Financial Mathematics Core Technical) — April 2007 — Examiners’ Report

Now,

( ) ( )
E i12 = 13 0.042 + 0.062 + 0.082 = 0.0038667

( )
E i22 = 0.75 × 0.07 2 + 0.25 × 0.052 = 0.0043

( )
E i32 = 0.7 × 0.062 + 0.3 × 0.042 = 0.0030

Hence, E ⎡ S32 ⎤
⎣ ⎦

= (1 + 2 × 0.06 + 0.0038667 ) × (1 + 2 × 0.065 + 0.0043) × (1 + 2 × 0.054 + 0.003)

=1.41631

Hence Var [80, 000 S3 ]

= 80, 0002 Var [ S3 ]

(
= 80, 0002 1.41631 − (1.18986 )
2
)
= 3,476,355

(iii) Note: 80,000 × 1.08 × 1.07 × 1.06 = 97,995 > 97,000

But, if in any year, the highest interest rate for the year is not achieved then the
fund after 3 years falls below £97,000.

Hence, answer is probability that highest interest rate is achieved in each year

1
= × 0.75 × 0.7 = 0.175
3

END OF EXAMINERS’ REPORT

Page 13
Faculty of Actuaries Institute of Actuaries

EXAMINATION

25 September 2007 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the
Formulae and Tables and your own electronic calculator.

© Faculty of Actuaries
CT1 S2007 © Institute of Actuaries
1 A 90-day government bill is purchased for £96 at the time of issue and is sold after 45
days to another investor for £97.90. The second investor holds the bill until maturity
and receives £100.

Determine which investor receives the higher rate of return. [2]

2 An investor purchases a share for 769p at the beginning of the year. Halfway through
the year he receives a dividend, net of tax, of 4p and immediately sells the share for
800p. Capital gains tax of 30% is paid on the difference between the sale and the
purchase price.

Calculate the net annual effective rate of return the investor obtains on the investment.
[4]

3 An insurance company offers a customer two payment options in respect of an

invoice for £456. The first option involves 24 payments of £20 paid at the beginning
of each month starting immediately. The second option involves 24 payments of
£20.50 paid at the end of each month starting immediately. The customer is willing to
accept a monthly payment schedule if the annual effective interest rate per annum he
pays is less than 5%.

Determine which, if any, of the payment options the customer will accept. [4]

4 State the characteristics of an equity investment. [4]

5 A one-year forward contract is issued on 1 April 2007 on a share with a price of 900p
at that date. Dividends of 50p per share are expected on 30 September 2007 and 31
March 2008. The 6-month and 12-month spot, risk-free rates of interest are 5% and
6% per annum effective respectively on 1 April 2007.

Calculate the forward price at issue, stating any assumptions. [4]

6 The annual effective forward rate applicable over the period t to t + r is defined as
ft ,r where t and r are measured in years. f 0,1 = 4%, f1,1 = 4.25% f 2,1 = 4.5%,
f 2,2 = 5%. Calculate the following:

(i) f3,1 [1]

(ii) All possible zero coupon (spot) yields that the above information allows you
to calculate. [4]

(iii) The gross redemption yield of a four-year bond, redeemable at par, with a 3%
coupon payable annually in arrears. [6]

(iv) Explain why the gross redemption yield from the four-year bond is lower than
the one-year forward rate up to time 4, f3,1 [2]
[Total 13]

CT1 S2007—2
7 The force of interest, δ(t ) , is a function of time and at any time t (measured in years)
is given by

⎧0.04 + 0.01t for 0 ≤ t ≤ 10

δ(t ) = ⎨
⎩0.05 for t > 10

(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 15 years.

(b) Calculate the annual effective rate of discount implied by the

transaction in (a). [4]
−0.01t
(iii) A continuous payment stream is received at a rate of 20e units per
annum between t = 10 and t = 15. Calculate the present value of the payment
stream.
[4]
[Total 13]

8 A pension fund makes the following investments (£m):

1 January 2004 1 July 2004 1 January 2005 1 January 2006

12.5 6.6 7.0 8.0

The rates of return earned on money invested in the fund were as follows:

1 January 2004 1 July 2004 to 1 January 2005 to 1 January 2006 to

to 30 June 2004 31 December 2004 31 December 2005 31 December 2006

5% 6% 6.5% 3%

You may assume that 1 January to 30 June and 1 July to 31 December are precise half
year periods.

(i) Calculate the linked internal rate of return per annum over the three years from
1 January 2004 to 31 December 2006, using semi-annual sub-intervals. [3]

(ii) Calculate the time weighted rate of return per annum over the three years from
1 January 2004 to 31 December 2006. [3]

(iii) Calculate the money weighted rate of return per annum over the three years
from 1 January 2004 to 31 December 2006. [4]

(iv) Explain the relationship between your answers to (i), (ii) and (iii) above. [2]

[Total 12]

CT1 S2007—3 PLEASE TURN OVER

9 The expected effective annual rate of return from a bank’s investment portfolio is 6%
and the standard deviation of annual effective returns is 8%. The annual effective
returns are independent and (1+ it ) is lognormally distributed, where it is the return in
year t.

Deriving any necessary formulae:

(i) calculate the expected value of an investment of £2 million after ten years. [6]

(ii) calculate the probability that the accumulation of the investment will be less
than 80% of the expected value. [3]
[Total 9]

10 A government is holding an inquiry into the provision of loans by banks to consumers

at high rates of interest. The loans are typically of short duration and to high risk
consumers. Repayments are collected in person by representatives of the bank making
the loan. Campaigners on behalf of the consumers and campaigners on behalf of the
banks granting the loans are disputing one particular type of loan. The initial loans are
for £2,000. Repayments are made at an annual rate of £2,400 payable monthly in
advance for two years.

The consumers’ association case

The consumers’ association asserts that, on this particular type of loan, consumers
who make all their repayments pay interest at an annual effective rate of over 200%.

The banks’ case

The banks state that, on the same loans, 40% of the consumers default on all their
remaining payments after exactly 12 payments have been made. Furthermore half of
the consumers who have not defaulted after 12 payments default on all their
remaining payments after exactly 18 payments have been made. The banks also argue
that it costs 30% of each monthly repayment to collect the payment. These costs are
still incurred even if the payment is not made by the consumer. Furthermore, with
inflation of 2.5% per annum, the banks therefore assert that the real rate of interest
that the lender obtains on the loan is less than 1.463% per annum effective.

(i) (a) Calculate the flat rate of interest paid by the consumer on the loan
described above.

(b) State why the flat rate of interest is not a good measure of the cost of
borrowing to the consumer. [4]

(ii) Determine, for each of the cases above, whether the assertion is correct. [10]
[Total 14]

CT1 S2007—4
11 A pension fund has liabilities to pay pensions each year for the next 60 years. The
pensions paid will be £100m at the end of the first year, £105m at the end of the
second year, £110.25m at the end of the third year and so on, increasing by 5% each
year. The fund holds government bonds to meet its pension liabilities. The bonds
mature in 20 years time and pay an annual coupon of 4% in arrears.

(i) Calculate the present value of the pension fund’s liabilities at a rate of interest
of 3% per annum effective. [4]

(ii) Calculate the nominal amount of the bond that the fund needs to hold so that
the present value of the assets is equal to the present value of the liabilities. [3]

(iii) Calculate the duration of the liabilities. [6]

(iv) Calculate the duration of the assets. [4]

(v) Using your calculations in (iii) and (iv), estimate by how much more the value
of the liabilities would increase than the value of the assets if there were a
reduction in the rate of interest to 1.5% per annum effective. [4]
[Total 21]

END OF PAPER

CT1 S2007—5
Faculty of Actuaries Institute of Actuaries

EXAMINATION
September 2007

Subject CT1 — Financial Mathematics

Core Technical

MARKING SCHEDULE

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

December 2007

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

Comments

Please note that different answers may be obtained from those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this.

However, candidates may be penalised where excessive rounding has been used or where
insufficient working is shown.

It should be noted that the rubric of the examination paper does ask for candidates to show
their calculations where this is appropriate. Candidates often failed to show sufficient clarity
and detail in their working and lost marks as a result.

Q1.

Well answered.

Q2.

Well answered.

Q3.

Whilst this question was generally answered well, some candidates lost marks by not stating
the conclusions that arose from their calculations i.e. that neither deal was acceptable.

Q4.

This question was very poorly answered which was disappointing given that this was a
bookwork question.

Q5.

Reasonably well answered but some candidates failed to obtain full marks by not stating the
required assumption.

Q6.

Parts (i) and (ii) were well answered but part (iii) was a good differentiator with weaker
candidates failing to recognise the correct method for calculating the gross redemption yield.
As with many previous diets, many candidates in part (iv) had great difficulty in giving a
clear explanation of their calculations.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

Q7.

Generally well answered. Some candidates lost marks by not giving an explicit formula for
v(t) when t ≤ 10.

Q8.

This question was very poorly answered to the surprise of the examiners who felt that the
question should have been relatively straightforward.

Q9.

Part (i) can be done much more simply than by using the method given in this report but the
calculations given would still need to be done for part (ii).

Q10.

This question was the worst answered on the paper. Part (ii) did successfully differentiate
between candidates with weaker candidates appearing to struggle to apply the theory to a
real-life situation.

Q11.

The first three parts were generally answered well by the candidates who attempted the
question. Many struggled to complete part (iv) although it is possible that this was due to
time pressure. When calculating DMTs, candidates were expected to give the answer in terms
of the correct units.

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

1 The first investor receives the higher rate of return if:

97.9 100
>
96 97.9

This inequality does not hold, therefore the second investor receives the higher rate of
return.

2 Start by working in half years. The half yearly effective return is i such that:

769 = 4v + 800v – 0.3(800 – 769)v

769 = (804 - 240 + 230.7)v

769
v= = 0.967661 therefore i = 3.3420%
794.7

Annual effective rate is (1.033422 – 1) = 6.7957%

3 The annual rate of payment for the first deal is 240.

This deal is acceptable if:

(12 )
240 a < 456 at a rate of interest of 5%
2

(12 )
240 a = 240 × 1.8594 × 1.026881 = 458.252
2

Therefore first deal is not acceptable

The annual rate of payment on the second deal is 246.

This deal is acceptable if:

(12 )
246 a = 246 × 1.8594 × 1.022715 = 467.803
2

Therefore second deal is also not acceptable

4 Main characteristics of equity investments:

• Issued by commercial undertakings and other bodies.

• Entitle holders to receive all net profits of the company in the form of
dividends after interest on loans and other fixed interest stocks has been paid.
• Higher expected returns than for most other asset classes …

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

• …but risk of capital losses

• … and returns can be variable.
• Lowest ranking form of finance.
• Low initial running yield…
• … but dividends should increase with inflation.
• Marketability varies according to size of company.
• Voting rights in proportion to number of shares held.

5 Assuming no arbitrage:
Present value of dividends is (in£):
0.5v1/2 (at 5%) + 0.5v (at 6%) = 0.5(0.97590+0.94340) = 0.95965

Hence forward price is: F = (9-0.95965) × 1.06 = £8.5228

6 (i) f3,1 is such that 1.045 × f3,1 = 1.052. Therefore f3,1 = 5.5024%

(ii) One-year spot rate is same as one-year forward rate = 4%

Two-year spot rate is i2 such that (1+ i2 )2 = 1.04 × 1.0425.

Therefore i2 = 4.1249%

Three-year spot rate is i3 such that (1+ i3 )3 = 1.04 × 1.0425 × 1.045.

Therefore i3 = 4.2498%

Four year spot rate is such that (1+ i4 )4 = 1.04 × 1.0425 × 1.045 × 1.055024
Therefore i4 = 4.5615%

(iii) Present value of the payments from the bond is:

P = 3(1.04-1 + 1.041249-2 + 1.042498-3 + 1.045615-4)

+ 100 × 1.045615-4

Therefore P = 3(0.96154 + 0.92234 + 0.88262 + 0.83659)

+ 100 × 0.83659 = 94.468

Equation of value to find the gross redemption yield from the bond is such
that:

94.468 = 3 a4 + 100v4

Try i = 4.5%

v4 = 0.83856, a4 = 3.58753, RHS = 94.619

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

Try i = 5%

v4 = 0.82270, a4 = 3.5460, RHS = 92.908

Interpolation:

Yield = 0.045 + 0.005 × (94.619 – 94.468) /(94.619 – 92.908)

= 4.544%

(iv) The yield from the bond is lower than the one-year forward rate up to time 4
because the bond can be seen to be a series of zero coupon bonds (1 year, 2
years etc.) each with lower yields than the forward rate. The gross redemption
yield from the bond is, in effect, an average of spot rates that are themselves a
weighted average of earlier forward rates.

7 (i) For t ≤ 10
t
t
− ∫ 0.04+ 0.01sds − ⎡ 0.04 s + 0.005 s 2 ⎤
v (t ) = e = e −0.04t −0.005t
2
⎣ ⎦0
0 =e

For t > 10
t
−[ 0.05 s ]10
t
−0.05( t −10 )
=e (
− ∫ 0.05ds − 0.4+ 0.05t )
v ( t ) = v (10 ) e 10 = e−0.9 e = e−0.9 e

Present value = 1000e (

− 0.4+ 0.05×15 )
(ii) (a) = 1000e −1.15 = 316.637

(b) 1000(1 − d )15 = 316.637 ⇒ d = 7.380%

15 − (0.4+ 0.05t )
(iii) Present value = ∫ e 20e−0.01t dt
10
15 −0.4 −0.06t
= 20 ∫ e e dt
10

15
⎡ e −0.06t ⎤
= 20e −0.4
⎢ ⎥ = 20e
−0.4
( −6.77616 + 9.14686 ) = 31.783
⎣⎢ −0.06 ⎦⎥10

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

8 (i) Linked internal rate of return is found by linking the money weighted rate of
return from the sub-periods.

(LIRR)3 = 1.05 × 1.06 × 1.065 × 1.03

Therefore LIRR = 0.06879 or 6.879%

(ii) The TWRR requires the value of the fund every time a payment is made.

Size of the fund after six months is: 12.5 × (1.05) = 13.125
Size of the fund after one year is: (13.125 + 6.6) × 1.06 = 20.909
Size of the fund after two years is: (20.909 + 7) × 1.065 = 29.723
Size of the fund after three years is: (29.723 + 8) × 1.03 = 38.855

The TWRR is i where i is the solution to:

(1+i)3 = (13.125/12.5) × [20.909/(13.125+6.6)] × [29.723/(20.909+7)]

× [38.855/(29.723+8)]

or just use the rates of return given to give:

(1+i)3 = 1.05 × 1.06 × 1.065 × 1.03

giving i = 6.879%

(iii) For MWRR, we need to know the size of the fund at the end of the period. We
can use the values above to give:

MWRR is solution to: 12.5(1+i)3 + 6.6(1+i)2.5 + 7(1+i)2 + 8(1+i) = 38.855

Solve by iteration and interpolation, starting with i = 7%.

i = 7% gives LHS = 39.704

i = 6% gives LHS = 38.868
i = 5.5% gives LHS = 38.454

Interpolate between 5.5% and 6%.

i = 0.055 + 0.005× (38.855-38.454)/(38.868-38.454) = 5.98%

(iv) (i) and (ii) are the same because there are no cash flows within sub-periods to
“distort” the LIRR away from the TWRR. The MWRR is lower because the
fund has a smaller amount of money in it at the beginning when rates of return
are higher.

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

9 (i) (1 + it ) ~ Lognormal ( μ, σ2 )

(
ln (1 + it ) ~ N μ, σ2 )
ln (1 + it )
10
(
= ln (1 + it ) + ln (1 + it ) + … + ln (1 + it ) ~ N 10μ,10σ 2 )
since it ' s are independent
(1 + it )10 ~ Lognormal (10μ,10σ2 )
[½] for correct use of independence assumption
⎛ σ2 ⎞
E (1 + it ) = exp ⎜ μ + ⎟ = 1.06
⎜ 2 ⎟⎠
⎝

( ) ( )
Var (1 + it ) = exp 2μ + σ 2 ⎡exp σ 2 − 1⎤ = 0.082
⎣ ⎦

0.082
1.06 2⎣ ( )
= ⎡ exp σ2 − 1⎤ ∴σ2 = 0.0056798
⎦

⎛ 0.0056798 ⎞ 0.0056798
exp ⎜ μ + ⎟ = 1.06 ⇒ μ = ln1.06 − = 0.055429
⎝ 2 ⎠ 2
10μ = 0.55429 , 10σ2 = 0.056798

Let S10 be the accumulation of one unit after 10 years:

⎛ 0.056798 ⎞
E ( S10 ) = exp ⎜ 0.55429 + ⎟ = 1.790848
⎝ 2 ⎠

Expected value of investment = 2, 000, 000 E ( S10 ) = £3.5817 m

(ii) We require P [ S10 < 0.8 ×1.790848 = 1.4327 ]

P [ ln S10 < ln1.4327 ] where ln S10 ~N(0.55429,0.056798)

⎡ ln1.4327 − 0.55429 ⎤
⇒ P ⎢ N ( 0,1) < ⎥
⎣ 0.056798 ⎦
⇒ P ⎡⎣ N ( 0,1) < −0.8171⎤⎦ = 0.207 ≈ 21%

Page 8
 Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

10 (i) (a) The flat rate of interest is: (2× 2,400 – 2,000)/(2× 2,000) = 70%

(b) The flat rate of interest is not a good measure of the cost of borrowing
because it takes no account of the timing of payments and the timing of
repayment of capital.

(ii) If the consumers’ association is correct, then the present value of the
repayments is greater than the loan at 200%

i
i.e. 2, 000 < 2, 400 a2
d( )
12

i =2; a2 = 0.44444; d ( ) = 1.04982 gives RHS = 2,032

12

The consumers’ association is correct.

If the banks are correct, then the present value of the payments received by the
bank, after expenses, is less than the amount of the loan at a nominal (before
inflation) rate of interest of (1.01463 × 1.025 -1) per annum effective = 0.04.
i i i i
i.e. 2, 000 > 720 a + 720 a + 960 a − 0.3 × 2, 400 a
d (12 ) 2
d (12 ) 1.5
d (12 ) 1
d (12 ) 2

i 1 − 1.04−1.5
= 1.021529; a2 = 1.8861; a1 = 0.9615; a1.5 = = 1.4283
d( )
12 0.04
So RHS = 720 × 1.021529 × 1.8861+ 720 × 1.021529 × 1.4283 +
960× 1.021529× 0.9615 – 0.3× 2,400× 1.021529× 1.8861

= 1,387.23+ 1,050.52 + 942.91 – 1,387.23 = 1,993.43

Therefore, the banks are also correct.

11 (i) Present value of the fund’s liabilities (in £m) is:

(
100 v + 1.05v 2 + 1.052 v3 + … + 1.0559 v60 )
(
= 100v 1 + 1.05v + (1.05v ) + … + (1.05v )
2 59
)
⎛ 1- 1.05
( ) ⎞
60
⎛ 1 − (1.05v )60
⎞
= 100v ⎜ ⎟ = 100 × 0.97087 ⎜ 1.03 ⎟
⎜ 1 − 1.05v
⎝
⎟
⎠
⎜ 1- 1.05
⎜
⎝ 1.03 ( ) ⎟
⎟
⎠
= 97.087 × 111.7795 = £10,852m

(ii) Let the nominal holding of bonds = N in £m

The present value of the bonds must equal £10,852m

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

Therefore 0.04 Na20 + Nv 20 = 10,852 at 3%

a20 = 14.8775, v20 = 0.55368

So 10,852 = 0.04N × 14.8775 + N × 0.55368

N = 10,852 /(0.04 × 14.8775 + 0.55368) = £9,446.54m

(iii) The numerator for the duration of the liabilities can be expressed as follows:

100v (1 × 1 + 1.05v × 2 + 1.052v2 × 3+…+1.0559v59 × 60)

1.03
= 100 v (1.05v × 1 + 1.052v2 × 2 + 1.053v3 × 3+…+1.0560v60 × 60)
1.05
The part inside the brackets can be regarded as ( Ia )60 evaluated at a rate of
interest i such that v = 1.05/1.03; the discount factor outside the brackets
should be evaluated at 3%

1.03 100
100 v = = 95.2381
1.05 1.05

For the ( Ia )60 function, v = 1.019417; i = -0.019048; (1 + i ) a60 = 111.7727

111.7727 − 60 ×1.01941760
( Ia )60 = = 4118.567
−0.019048

Therefore numerator for duration is: 95.2381 × 4118.567 = 392,244

Therefore the duration is: 392,244/10,852 = 36.1 years.

(iv) The duration of the assets can be expressed as the sum of payments times time
of receipt times present value factors divided by total present value.

The equation for the numerator is

0.04 × 9,446.54 ( Ia )20 + 9,446.54 × 20 × v20 at 3%

( Ia )20 = 141.6761, v20 = 0.55368

Numerator is: 158,141

Therefore the duration is: 158,141/10,852 = 14.6 years.

(v) Duration of the liabilities is 36.1 years. Therefore volatility of the liabilities is:
36.1/1.03 = 35. If there were a reduction in interest rates to 1.5%, the liabilities
would increase in value by approximately 35 × 1.5 = 52.5%

Page 10
Subject CT1 (Financial Mathematics Core Technical) — September 2007 — Examiners’ Report

Duration of the assets is 14.6 years. Therefore volatility of the assets is:
14.6/1.03 = 14.2. If there were a reduction in interest rates to 1.5%, the assets
would increase in value by approximately 14.2 × 1.5 = 21.3%.

The liabilities would increase in value by an additional 31.2% of their original

value i.e. by £3,386 more than the value of the assets.

END OF EXAMINERS’ REPORT

Page 11
Faculty of Actuaries Institute of Actuaries

EXAMINATION

15 April 2008 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT1 A2008 © Institute of Actuaries
1 An eleven month forward contract is issued on 1 March 2008 on a stock with a price
of £10 per share at that date. Dividends of 50 pence per share are expected to be paid
on 1 April and 1 October 2008.

Calculate the forward price at issue, assuming a risk-free rate of interest of 5% per
annum effective and no arbitrage. [4]

2 Describe the characteristics of the following investments:

(a) Eurobonds
(b) Certificates of deposit [4]

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]

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]

CT1 A2008—2
5 The n –year spot rate of interest, in , is given by:

in = 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]

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]

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]

CT1 A2008—3 PLEASE TURN OVER

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]

9 The force of interest, δ ( t ) , is a function of time and at any time t, measured in years,
is given by the formula:

⎧0.06 0≤t ≤4
⎪
δ ( t ) = ⎨0.10 − 0.01t 4<t ≤7
⎪0.01t − 0.04 7<t
⎩

(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 ρ ( t ) = 100e0.02t . [6]
[Total 13]

CT1 A2008—4
10 An insurance company holds a large amount of capital and wishes to distribute some
of it to policyholders by way of two possible options.

Option A

£100 for each policyholder will be put into a fund from which the expected annual
effective rate of return from the investments will be 5.5% and the standard deviation
of annual returns 7%. The annual effective rates of return will be independent and
(1+ it ) is lognormally distributed, where it is the rate of return in year t. The
policyholder will receive the accumulated investment at the end of ten years.

Option B

£100 will be invested for each policyholder for five years at a rate of return of 6% per
annum effective. After five years, the accumulated sum will be invested for a further
five years at the prevailing five-year spot rate. This spot rate will be 1% per annum
effective with probability 0.2, 3% per annum effective with probability 0.3, 6% per
annum effective with probability 0.2, and 8% per annum effective with probability
0.3. The policyholder will receive the accumulated investment at the end of ten years.

Deriving any necessary formulae:

(i) Calculate the expected value and the standard deviation of the sum the
policyholders will receive at the end of the ten years for each of options A and
B. [17]

(ii) Determine the probability that the sum the policyholders will receive at the
end of ten years will be less than £115 for each of options A and B. [5]

(iii) Comment on the relative risk of the two options from the policyholders’
perspective. [2]
[Total 24]

END OF PAPER

CT1 A2008—5
Faculty of Actuaries Institute of Actuaries

Subject CT1 — Financial Mathematics

Core Technical
EXAMINERS’ REPORT
April 2008

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

M A Stocker
Chairman of the Board of Examiners

June 2008

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report

Comments

Comments on solutions presented to individual questions for this April 2008 paper are given
below.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Question 1 Well answered.

Question 2 As has often been the case when words rather than numbers have been
required, this bookwork question was answered poorly.

Question 3 Generally well answered, although some students treated the fees on Product
B paid by the customer as a cost to the mortgage company.

Question 4 Well answered although many candidates’ working was unclear when
performing the CGT test.

Question 5 Part (i) was answered well but in part (ii) many candidates failed to recognise
the need to calculate the 4-year spot rate before calculating the bond price.

Question 6 Part (i) of this question did appear to differentiate between stronger
candidates who often scored very well and weaker candidates who often failed
to score at all. As with many previous diets, many candidates in part (ii) had
difficulty in giving a clear explanation of their results.

Question 7 This question was answered relatively poorly with, particularly in part (ii),
candidates often appearing confused between real and money rates of interest.

Question 8 Most candidates managed to make a reasonable attempt at this question

although marks were often lost in part (i) through a combination of
calculation errors and insufficient working being shown. Candidates generally
made a better attempt at the explanation required in part (ii) when compared
to similar questions both on this paper and in previous diets.

Question 9 Well answered.

Question 10 Part (i) (for Option A) can be done much more simply than by using the
method given in this report but the calculations given would still need to be
done for part (ii). It was disappointing to see many candidates incorrectly
calculate the mean accumulated value for Option B by using the mean rate of
interest. Few candidates brought together the answers from (i) and (ii) to fully
answer part (iii).

Page 2
 Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report

1 The present value of the dividends, I, is:

= 0.5 ( 0.99594 + 0.97194 ) = 0.98394 calculated at i = 5%

1 7
I = 0.5v 12 + 0.5v 12

Hence forward price is (again calculated at i = 5%):

F = (10 − 0.98394 )(1 + i )
11
12
= 9.42845
= £9.43

2 (a) Eurobonds
ƒ form of unsecured medium or long-term borrowing
ƒ issued in a currency other than the issuer's home currency outside the
issuer's home country
ƒ pay regular interest payments and a final capital repayment at par.
ƒ issued by large companies, governments and supra-national organisations.
ƒ yields depend upon the issuer and issue size but will typically be slightly
lower than for the conventional unsecured loan stocks of the same issuer.
ƒ issuers have been free to add novel features to their issues in order to
make them appeal to different investors.
ƒ usually issued in bearer form
(b) Certificates of Deposit
ƒ a certificate stating that some money has been deposited
ƒ issued by banks and building societies
ƒ terms to maturity are usually in the range 28 days to 6 months.
ƒ interest is payable on maturity
ƒ security and marketability will depend on the issuing bank
ƒ active secondary market

3 For Product A, the annual rate of return satisfies the equation:

7, 095.25a25 = 100, 000
⇒ a25 = 14.0939
This equates to the value of a25 at 5%. Hence the annual effective rate of return is
5%.

For Product B, the annual rate of payment is X such that:

(12 )
Xa = 100, 000 at 4%
25
(12 ) i
a = a = 1.021537 × 15.6221 = 15.95855
d( )
25 12 25

100,000
⇒ X= = 6, 266.23
15.95855

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report

The equation of value to calculate the rate of return from Product B is:
i
6,000 + 5,000v 25 + 6, 266.23 a = 100, 000
d )
(12 25

Clearly the rate of return must be greater than 4%. Try 5%.
LHS = 6, 000 + 5, 000 × 0.29530 + 6,266.2335 ×1.026881×14.0939 = 98,166

At 5% the present value of the payments is less than the amount of the loan at 5% so
the rate of return must be less than 5%. Try 4%:
LHS = 6, 000 + 5, 000 × 0.37512 + 100, 000 = 107,876

Interpolate between 4% and 5% to get the effective rate of return, i:

⎛ 107,876 − 100,000 ⎞
i = 0.04 + 0.01⎜ ⎟ ≈ 4.81% (actual answer is 4.80%)
⎝ 107,876 − 98,166 ⎠
Therefore Product B charges a lower effective annual return than Product A.

⎛ i ( 4) ⎞
4
( 4)
4 ⎜⎜1 + ⎟⎟ = 1.05 ⇒ i = 0.049089
⎝ 4 ⎠
0.07
g (1 − t1 ) = × 0.75 = 0.04861
1.08

⇒ i ( 4) > (1 − t1 ) g

⇒ Capital gain on contract and we assume loan is redeemed as late as possible (i.e.
after 20 years) to obtain minimum yield.

Let Price of stock = P

( 4)
P = 0.07 ×100, 000 × 0.75 × a20

+ (108, 000 − 0.35 (108, 000 − P ) ) v 20 at 5%

( )
+ 70, 200v 20
4
5250a20
⇒P=
1 − 0.35v 20

5250 ×1.018559 ×12.4622 + 70, 200 × 0.37689

=
1 − 0.35 × 0.37689

= 107,245.38

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report

5 Assuming no arbitrage.

i1 = f 0 and (1 + i2 ) = (1 + i1 )(1 + f1 ) .
2
(i)

Hence a – b = 0.061

⇒ a = b + 0.061
(1 + a − 2b ) = 1.061× 1.065
2

⇒ 1 + a − 2b = 1.061× 1.065

⇒ b = − 0.002
⇒ a = 0.059

(ii) Firstly, find the 4-year spot rate. Consider £1 nominal:

1 = 0.07 (v i1 )
+ vi22 + vi33 + vi44 + vi44
= 0.07 (1.061−1 + 1.063−2 + 1.065−3 ) + 1.07 × vi44
⇒ (1 + i4 ) = 1.31429212
4

⇒ i4 = 7.0713% p.a

Let bond price per £1 nominal be P. Then

(
P = 0.05 vi1 + vi22 + vi33 + vi44 + 1.03vi44 )
( −2
= 0.05 1.061−1 + 1.063 + 1.065−3 + 1.08 × 1.070713−4)
= 0.9545

i.e. 95.45 pence per £1 nominal

6 (i) (a) The duration is:

(
500 v + 2v 2 + 3v3 + … + 20v 20 ) at 8%
500(v + v 2 + v3 + … + v 20 )
( Ia )20 78.9079
= = = 8.037 years
a20 9.8181

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report

(b) The duration is:

( ) ( )
500 ⎡v + 1.08 × 2v 2 + 1.082 × 3v3 + … + 1.0819 × 20v 20 ⎤
⎣ (
⎦ at 8% )
⎣ ( ) ( 2 3
)
500 ⎡v + 1.08v + 1.08 v + … + 1.08 v ⎤
2 19 20
(
⎦ )
v (1 + 2 + 3 + … + 20 ) 2 ( 20 × 21)
1
= = = 10.5 years
20v 20

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

7 (i) (
260 = 12 v (1 + e ) + v 2 (1 + e ) + v 3 (1 + e ) + ......
2 3
)
1
where v = and e denotes inflations rate.
1.06

Then,
1 1+ e 0.06 − e
260 = 12a∞ at j % where = i.e. j =
1+ j 1+ i 1+ e
12
⇒ 260 =
j
⇒ j = 0.046153846
⇒ e = 0.01324 i.e 1.324% pa

(ii) 260 = 12 (1.03v + 1.032 v 2 + ..... + 1.0312 v12 ) +500v12

i − 0.03
= 12 a12 + 500 v12 where j =
j%
i% 1.03

Try i = 10%, RHS = 255.67

i = 9%, RHS = 279.35
279.35 − 260
Hence, i = 0.09 + × 0.01
279.35 − 255.67

= 0.098

Let i′ = real return

Then (1 + i′ )(1 + e ) = 1 + i

1.0982
⇒ 1 + i′ = ⇒ i′ = 6.62% pa
1.03

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report

8 (i) Working in £000s

Outlay

Pv = 500 + 90a5 + 10 ( Ia )5 @11%

1 − v5
a5 = = 3.695897
0.11

a5 − 5v5 1.11× 3.695897 − 5v5

( Ia )5 = =
0.11 0.11

= 10.319900

⇒ PV = 500 + 90 × 3.695897 + 10 × 10.3199

= 935.8297

Income

(
PV = 80 a1 + 1.04v a1 + (1.04 ) v 2 a1 + " " + (1.04 ) v 24 a1
2 24
)
⎡1 − (1.04v )25 ⎤
= 80a1 × ⎢ ⎥
⎢⎣ 1 − (1.04v ) ⎥⎦

i 0.11 1
where a1 = .v = . = 0.949589
δ ln1.11 1.11

⇒ PV = 80 × 0.949589 × 12.74554 = 968.2421

PV of cost of further investment

= 300v15 = 62.7013

PV of sale = 700v 25 = 51.5257

Hence NPV = 968.2421 + 51.5257 - 935.8297 - 62.7013

= 21.2368 (£21,237)

1
(ii) If interest > 11% then decreases.
1+ i

⇒ PV of both income and outgo ↓

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report

However, PV of outgo is dominated by initial outlay of £500k at time 0 which

is unaffected.

⇒ PV of income decreases by more than decrease in PV of outgo

⇒ NPV = PV of income – PV of outgo

would reduce (and possibly become negative)

pv = 1, 000 ∗ exp ⎡ − ∫ ( 0.01t − 0.04 ) dt ⎤ ∗ exp ⎡ − ∫ ( 0.10 − 0.01t ) dt ⎤

10 7
9 (i)
⎣⎢ 7 ⎦⎥ ⎣⎢ 5 ⎦⎥

⎛ ⎡ 0.01t 2 ⎤ ⎞
10
⎛ ⎡ 0.01t 2 ⎤ ⎞
7

= 1000 ∗ exp ⎜ − ⎢ − 0.04t ⎥ ⎟ ∗ exp ⎜ − ⎢0.10t − ⎥ ⎟

⎜ ⎣ 2 ⎦ ⎟ ⎜ ⎣ 2 ⎦5 ⎟
⎝ 7 ⎠ ⎝ ⎠

⎛ ⎡ 0.01∗ 51 ⎤⎞ ⎛ ⎡ 0.01 ∗ 24 ⎤ ⎞
= 1000 ∗ exp ⎜ − ⎢ − 0.04 × 3⎥ ⎟ ∗ exp ⎜ − ⎢ 0.10 ∗ 2 − ⎥⎦ ⎟
⎝ ⎣ 2 ⎦⎠ ⎝ ⎣ 2 ⎠
= 1000 ∗ exp ( −0.255 + 0.12 − 0.20 + 0.12 )

= 1000 ∗ exp ( −0.215 )

= 806.54

(ii) Required interest rate p.a. convertible monthly is given by

12×5
⎛ i (12) ⎞
806.54 ⎜⎜1 + ⎟ = 1, 000
⎝ 12 ⎟⎠
⇒ i (12) = 4.3077% p.a. convertible monthly

4 7 12

× e ∫t × e ∫4 × e ∫7
4 ( 0.10 − 0.01r ) dr ( 0.01r − 0.04 ) dr
∫ 100e
0.02 t 0.06 dr
(iii) Accumulated amount = dt
0

7 12
⎡ 0.10 r − 0.01 r 2 ⎤ ⎡ 0.01 r 2 − 0.04 r ⎤
4 [0.06 r ]t4
= 100 ∫ e ×e ×e ⎣⎢ ⎥4
×e ⎣⎢ 2 ⎦⎥ 7
0.02 t 2 ⎦
dt
0

= 100 ∫ e0.02t e(
0.24 − 0.06 t )
e(
0.30 − 0.165)
e(
4 0.475− 0.200 )
dt
0

4
= 100e0.24 e0.135e0.275 ∫ e −0.04t dt
0

4
⎡ −e −0.04t ⎤
0.65
= 100e ⎢ ⎥
⎣ 0.04 ⎦ 0
= 2,500e0.65 (1 − e−0.16 )

Page 8
 Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report

= 2,500 * 1.915540829 * 0.1478562

= 708.06

10 (i) Option A:

(1 + it ) ~ Lognormal ( μ, σ2 )

(
ln (1 + it ) ~ N μ, σ2 )
ln (1 + it )
10
(
= ln (1 + it ) + ln (1 + it ) + … + ln (1 + it ) ~ N 10μ,10σ2 )
since it ' s are independent
(1 + it )10 ~ Lognormal (10μ,10σ2 )
⎛ σ2 ⎞
E (1 + it ) = exp ⎜ μ + ⎟⎟ = 1.055
⎜ 2
⎝ ⎠
( ) ( )
Var (1 + it ) = exp 2μ + σ2 ⎡exp σ2 − 1⎤ = 0.07 2
⎣ ⎦
0.07 2
1.055 2⎣ ⎦ ( )
= ⎡exp σ2 − 1⎤ ∴σ2 = 0.0043928

⎛ 0.0043928 ⎞ 0.0043928
exp ⎜ μ + ⎟ = 1.055 ⇒ μ = ln1.055 − = 0.051344
⎝ 2 ⎠ 2
10μ = 0.51344 , 10σ2 = 0.043928

Let S10 be the accumulation of one unit after 10 years:

⎛ 0.043928 ⎞
E ( S10 ) = exp ⎜ 0.51344 + ⎟ = 1.70814
⎝ 2 ⎠
Accumulated sum is 100 E ( S10 ) = £170.81

Option B:

The accumulated sum at the end of five years is:

100 × 1.065 = 100 × 1.33823 = £133.823

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — April 2008 — Examiners’ Report

The expected value of the accumulated sum at the end of ten years is:
(
133.823 0.2 ×1.015 + 0.3 ×1.035 + 0.2 × 1.065 + 0.3 × 1.085 )
= 133.823 ( 0.2 × 1.05101 + 0.3 × 1.15927 + 0.2 × 1.33823 + 0.3 × 1.46933)
= £169.48

Option A:
Var ( S10 ) = exp ( 2 × 0.51344 + 0.043928 ) ⎡⎣exp ( 0.043928 ) − 1⎤⎦
= 2.91776 × 0.04491 = 0.13103
Therefore standard deviation of £100 is 100 0.13103 = £36.20

Option B:
Here we need to find the expected value of the square of the accumulation as
follows:
(
133.8232 0.2 ×1.051012 +0.3 × 1.15927 2 +0.2 × 1.338232 +0.3 × 1.469332 )
= 29,189.86

The variance of the accumulation is therefore:

29,189.86 − 169.482 = £ 2 467.54
and the standard deviation is £21.62

(ii) For option A we require P [ S10 < 1.15]

P [ ln S10 < ln1.15] where ln S10 ~N(0.51344,0.043928)

⎡ ln1.15 − 0.51344 ⎤
⇒ P ⎢ N ( 0,1) < ⎥
⎣ 0.043928 ⎦
⇒ P ⎡⎣ N ( 0,1) < −1.7829 ⎤⎦ = 0.0373 ≈ 4%

For option B we first examine the lowest payout possible.

There is a probability of 0.2 that the amount will be 100 × 1.065 × 1.015 or less
which equals 133.823 ×1.05101 = £140.65 . Therefore the probability of a
payment of less than £115 is zero.

(iii) Option A is riskier both from the perspective of having a higher standard
deviation of return and also a higher probability of a very low value.

END OF EXAMINERS’ REPORT

Page 10
Faculty of Actuaries Institute of Actuaries

EXAMINATION

23 September 2008 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 12 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

 Faculty of Actuaries
CT1 S2008  Institute of Actuaries
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]

2 (i) State the strengths and weaknesses of using the money-weighted rate of return
as opposed to the time-weighted rate of return as a measure of an investment
manager’s skill. [3]

(ii) An investor had savings totalling £41,000 in an account on 1 January 2006.

He invested a further £12,000 in this account on 1 August 2006. The total
value of the account was £45,000 on 31 July 2006 and was £72,000 on 31
December 2007.

Assuming that the investor made no further deposits or withdrawals in relation

to this account, calculate the annual effective time-weighted rate of return for
the period 1 January 2006 to 31 December 2007. [2]
[Total 5]

3 (i) A forward contract with a settlement date at time T is issued based on an

underlying asset with a current market price of B.

The annualised risk-free force of interest applying over the term of the forward
contract is  and the underlying asset pays no income. Show that the
theoretical forward price is given by K  Be T , assuming no arbitrage. [3]

(ii) An asset has a current market price of 200p, and will pay an income of 10p in
exactly three months’ time.

Calculate the price of a forward contract to be settled in exactly six months,

assuming a risk-free rate of interest of 8% per annum convertible quarterly. [3]
[Total 6]

4 Describe the characteristics of commercial property (i.e. commercial real estate) as an

investment. [5]

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]

CT1 S2008—2
6 A pension fund holds an asset with current value £1 million. The investment return
on the asset in a given year is independent of returns in all other years. The annual
investment return in the next year will be 7% with probability 0.5 and 3% with
probability 0.5. In the second and subsequent years, annual investment returns will be
2%, 4% or 6% with probability 0.3, 0.4 and 0.3, respectively.

(i) Calculate the expected accumulated value of the asset after 10 years, showing
all steps in your calculations. [3]

(ii) Calculate the standard deviation of the accumulated value of the asset after 10
years, showing all steps in your calculations. [4]

(iii) Without doing any further calculations explain how the mean and variance of
the accumulation would be affected if the returns in years 2 to 10 were 1%,
4%, or 7%, with probability 0.3, 0.4 and 0.3 respectively. [2]
[Total 9]

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]

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]

CT1 S2008—3 PLEASE TURN OVER

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]

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.

(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]

CT1 S2008—4
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]

CT1 S2008—5 PLEASE TURN OVER

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% p.a. [5]

(ii) The individual believes that he can earn a nominal rate of interest convertible
half-yearly of 9% p.a. 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]

END OF PAPER

CT1 S2008—6
Faculty of Actuaries Institute of Actuaries

Subject CT1 — Financial Mathematics

Core Technical

EXAMINERS’ REPORT

September 2008

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

November 2008

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

Comments

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Candidates appeared to be less well prepared than in previous recent diets. As has often been
the case when words rather than numbers have been required, Q4 was answered relatively
poorly despite only involving bookwork with a wide range of available points that could be
made. Many candidates also struggled with the first part of Q2 where explanation rather
than calculation was required. The remainder of the shorter questions were answered well
with candidates scoring particularly highly on Q7.

The more application styled questions (especially Qs 8, 11 and 12) tended to act as a clear
discriminator between stronger and weaker candidates with a significant minority of
candidates scoring very few marks on these questions. By contrast, Q9 on spot and forward
yields was answered relatively well compared to questions in previous diets on this topic.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

1 If j = real rate of return then equation of value in real terms is:

220
95 (1 + j )
91/ 365
= 100
222

(1 + j )91/ 365 = 1.04315

therefore j = 18.465%

2 (i) MWRR
• Requires less information compared to TWRR
But
• Affected by amount and timing of net cashflows, which may not be in the
manager’s control and less fair measure than TWRR
• More difficult equation to solve than TWRR
• Also: equation may not have unique (or any) solution

(ii) Let TWRR = i

Then

45 72
(1 + i ) 2 = ×
41 57
= 1.386392811
⇒ i = 17.745% p.a.

3 (i) Consider two portfolios A and B at time 0.

Portfolio A: - buy forward at price of K

- deposit Ke −δT in risk-free asset

Portfolio B: - buy asset at price of B

Then, at maturity, both portfolios have the same value (i.e. hold the underlying
asset).

Thus, by the no-arbitrage principle, both portfolios must have same value at
time 0.

⇒ Ke −δT = B ⇒ K = BeδT

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

(ii) i = 2% per quarter

⇒ K = 200 × (1.02 ) − 10 ×1.02 = 197.88

2

( using K = Be δT
− Ce ( 1 )
δ T −t
)
4 Main characteristics of commercial property investments:

• Many different types of properties available for investment, e.g. offices, shops and
industrial properties.
• Return comes from rental income and from the proceeds on sale.
• Total expected return higher than for gilts
• Rents and capital values are expected to increase broadly with inflation in the long
term
• Neither rental income nor capital values are guaranteed – capital values in
particular can fluctuate in the short term…
• …but rental income more secure than dividends
• Rents and capital values expected to increase when the price level rises (though
the relationship is far from perfect).
• Rental terms are specified in lease agreements. Typically, rents increase every
three to five years, Some leases have clauses which specify upward-only
adjustments of rents.
• Large unit sizes, leading to less flexibility than investment in shares
• Each property is unique…
• …. so can be difficult to value.
• Valuation is expensive, because of the need to employ an experienced surveyor
• Marketability and liquidity are poor because of uniqueness …
• …and because buying and selling incurs high costs.
• Rental income received gross of tax.
• Net rental income may be reduced by maintenance expenses
• There may be periods when the property is unoccupied, and no income is
received.
• The running yield from property investments will normally be higher than that for
ordinary shares.

5 Present value in first case is

i
1, 200 × × a10 = 1200 × 1.024877 × 8.1109 = £9,975.210
d( )
4

Present value in second case is:

2,520 × (v 2
+ v 4
+…+ v ) = 2,520 × v
10 2
×
(1 − v )
10

(1 − v )
2

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

= 2,520 × 0.92456 ×
(1 − 0.67556 ) = £10, 020.01
(1 − 0.92456 )
Therefore first option is better for the borrower.

6 (i) Let it = investment return for year t

Then, the expected value of the accumulation ( S10 ) is given by (in £ millions):

⎛ 10 ⎞
E ( S10 ) = E ⎜ ∏ (1 + it ) ⎟
⎜ ⎟
⎝ t =1 ⎠
10
= ∏ E (1 + it ) using independence
t =1
10
= ∏ (1 + E ( it ) )
t =1

Now, E ( i1 ) = 0.5 × ( 0.07 + 0.03) = 0.05

and for t ≠ 1, E ( it ) = ( 0.3 × 0.02 + 0.4 × 0.04 + 0.3 × 0.06 )
= 0.04

So the expected value of the accumulation is

1.05 × 1.049 = 1.494477 (i.e. £1,494,477)

(ii) The variance of the accumulation is

( ( )
1, 000, 0002 × E S10
2
− E ( S10 )
2
)
⎛ 10 2⎞
where E S102
( )
= E ⎜ ∏ (1 + it ) ⎟
⎜ ⎟
⎝ t =1 ⎠
⎛ ⎞
( )
10
= E ⎜ ∏ 1 + 2it + it2 ⎟
⎜ ⎟
⎝ t =1 ⎠

∏ (1 + 2 E ( it ) + E ( it2 ) ) from independence

10
=
t =1

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

( ) (
Now E i12 = 0.5 × 0.07 2 + 0.032 = 0.0029 )
( )
for t ≠ 1, E it 2 = 0.3 × 0.022 + 0.4 × 0.042 + 0.3 × 0.062

= 0.00184

Hence,

( )
2
E S10 = (1 + 0.1 + 0.0029 ) × (1 + 0.08 + 0.00184 )
9

= 2.238739

Standard deviation of the accumulation is

( )
1
1, 000, 000 × 2.238739 − 1.494477 2 = £72, 646
2

(iii) The mean would remain unchanged as the expected rate of return in years 2-10
is unchanged. The variance of the rate in years 2-10 has increased and this will
lead to an increase in the variance of the 10 year accumulation.

7 (i) Discounting from t = 12 to t = 5

v (12,5 ) = exp ⎛⎜ − ∫ 0.15ds ⎞⎟

12

⎝ 5 ⎠
= exp [ −0.15s ]5 = e −1.05 = 0.34994
12

Discounting from t = 5 to t = 0

v ( 5, 0 ) = exp ⎛⎜ − ∫ 0.05 + 0.02 sds ⎞⎟

5

⎝ 0 ⎠
5
= exp ⎡ −0.05s − 0.01s 2 ⎤ = e −0.5 = 0.60653
⎣ ⎦0

Hence present value of £1,000 at time t = 12

= 1, 000v (12,5 ) v ( 5, 0 ) = 1, 000 × 0.34994 × 0.60653 = £212.25

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

(ii) The annual effective rate of discount is d such that:

1000 (1 − d )
12
= 212.25
1
⇒ d = 1 − 0.21225 12 = 12.117%

8 (i) Investment A: the gross rate of return per annum effective is clearly 10%. The
net return is therefore (1-0.4 ) ×10% = 6% per annum effective.

Investment B: the investment will accumulate to £1m × 1.110 = £2.5937 m at the

end of the ten years. The equation of value is:

−10 −10
1 = 2.59374 (1 + i ) − 0.4 ( 2.59374 -1)(1 + i )
−10
= 1.95625 (1 + i )
⇒ (1 + i )
10
= 1.95625
⇒ i = 6.94%

Investment C: again the investment will accumulate to £2.5937m at the end of

ten years. However, the indexed purchase price is subtracted from the value of
the investment in this case. Thus the equation of value is:

1 = 2.59374 (1 + i )
−10
(
− 0.4 2.59374 -1× 1.0410 (1 + i )) −10

−10 −10 −10

= 2.5937 (1 + i ) − 0.4 × 2.59374 (1 + i ) + 0.4 × 1.0410 × (1 + i )
−10
= 2.14834 (1 + i )
⇒ (1 + i )
10
= 2.14834
⇒ i = 7.95%

(ii) All investments give a gross return of 10% per annum effective. Investment B
gives a higher return than A because the tax is deferred until the end of the
investment as capital gains tax is paid and not income tax. [However,
candidates might note that tax is paid on the interest earned by deferral of tax].
Investment C gives a higher return than investment B because the tax is only
paid on the real return over the ten year period which is lower than the
nominal return.

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

9 (i) 103 = 6a3 + 105v3

try i = 6%: a3 = 2.6730 v3 = 0.83962

RHS = 104.1981

try i = 7%: a3 = 2.6243 v3 = 0.81630

RHS = 101.4573

Using linear interpolation:

i = 0.06 +
(104.1981 − 103) × 0.01 = 0.06437 = 6.44%
(104.1981 − 101.4573)
(ii) Let in = spot yield for term n

Then

103 (1 + i1 ) = 111 ⇒ i1 = 7.767%

−1 −2
103 = 6 (1.07767 ) + 111(1 + i2 ) ⇒ i2 = 6.736%
−1 −2 −3
103 = 6 (1.07767 ) + 6 (1.06736 ) + 111(1 + i3 ) ⇒ i3 = 6.394%

(iii) First year forward rate is 7.767% (same as spot rate).

Forward rate from time one to time two is i such that:

1.07767 (1 + i ) = 1.067362 ⇒ i = 5.715%

Forward rate from time two to time three is i such that:

1.067362 (1 + i ) = 1.063943 ⇒ i = 5.713%

Forward rate from time one to time three is i such that:

1.07767 (1 + i ) = 1.063943 ⇒ i = 5.714%
2

Forward rate from time zero to two and from time zero to three are the same as
the respective spot rates (no additional marks for this point).

10 (i) NPV of first project in £m is:

( )
0.5 a27 − a7 + 5v 27 − 0.1( Ia )10 − 0.25 at 7%
= 0.5 (11.9867 − 5.3893) + 5 × 0.16093 − 0.1× 34.7391 − 0.25
= £0.379m

Page 8
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

The NPV of second project in £m is:

0.21v + 0.21(1.05)v 2 + 0.21(1.05) 2 v3 + … + 0.21(1.05)9 v10 + 5.64v10 − 4.2

⎛ 1 − 1.0510 v10 ⎞
= 0.21v ⎜ + 5.64v10 − 4.2
⎜ 1 − 1.05v ⎟⎟
⎝ ⎠
v = 0.93458 v10 = 0.50835

Therefore NPV = 1.8055 + 5.64 × 0.50835 − 4.2 = £0.473m

The second project has the higher net present value at 7% per annum effective.

(ii) The second project clearly has a discounted mean term of less then ten years.
However, the discounted mean term of the first project must be greater than
ten years because the undiscounted incoming cash flows are less than the
undiscounted outgoing cash flows after ten years.

11 (i) Working in ‘000s

Let X = Nominal amount of Zero Coupon Bond

Y = Nominal amount of 8% bond

VL = 400v10 = 185.2774

VA = 18.52774 + Xv12 + 0.08Ya16 +1.1Yv16

Then, since VA = VL (1st condition)

⇒ 166.74966 = 0.39711 X + 0.08 × 8.8514 Y + 0.32108 Y

⇒ 166.74966 = 0.39711 X + 1.02919 Y ...... (1)

2nd condition is VA' = VL'

VL' = 4000 v10 = 1852.7740

VA' = 12 X v12 + 0.08 ( Ia )16 .Y +1.1∗16 Y v16

= 4.76537 X + 0.08 ∗ 61.1154 Y + 5.13727 Y

⇒ 1852.7740 = 4.76537 X + 10.0265 Y ..... ( 2 )

⇒ 148.2429 = 2.32391Y

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

⎡ 4.76537 ⎤
⎢⎣ from ( 2 ) − 0.39711 ∗ (1) ⎥⎦

Hence Y = 63,790

X = 254,583

(ii) Amount invested in X is 254,583 v12

= 101,098

and amount invested in Y is:

185,277 - 18,528 - 101,098 = 65,651

(iii) The spread of the assets is clearly greater than the spread of the liability
(which is a single point).

Hence, Redington’s 3rd condition is satisfied and the fund is immunised.

12 (i) First 15 years:

Interest paid each month

12
i( ) ⎛ i(12 ) ⎞
12
= × 300, 000 where 1.085 = ⎜ 1 + ⎟
12 ⎜ 12 ⎟
⎝ ⎠
i( )
12
⇒ = 0.0068215
12

⇒ monthly interest = 0.0068215 × 300,000 = £2,046.45

After repayment of £150,000 after 15 years:

Interest paid each quarter

4
i( ) ⎛ i( 4) ⎞
4
= × 150, 000 where 1.085 = ⎜1 + ⎟
4 ⎜ 4 ⎟
⎝ ⎠
i( )
4
⇒ = 0.020604
4

⇒ Quarterly interest = 0.020604 × 150,000 = £3,090.66

Page 10
Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

Total interest paid over the 25 years

= (2046.45 × 12 × 15) + (3090.66 × 4 × 10) = £491,987.40

( 6)
(ii) 150,000 = X s @ 4½ %
30

where X = Amount paid in each 6 month period

s
( 6)
=
(1.045 ) − 1
30

d( )
30 6
6
1 ⎛ d ( 6) ⎞
where = ⎜1 − ⎟
1.045 ⎜ 6 ⎟
⎝ ⎠

⇒ d (6) = 0.043856

150000 150000
Hence X = = = 2396.23
⎡ (1.045) −1 ⎤
30
62.5985
⎢ 0.043856 ⎥
⎣ ⎦
2396.23
⇒ Monthly contribution = = £399.37 per month
6

(iii) Savings proceeds after 15 years:

(12 )
12 × 399.37 s15
10%

(12 ) i
where s = × s15
d( )
15 12

= 1.0533781× 31.7725
= 33.46845

Hence, savings proceeds

= 4792.44 × 33.46845 = 160,395.56

⇒ Loan o/s after 15 years

= 300,000 - 160,395.56 = 139,604.44

Page 11
 Subject CT1 (Financial Mathematics Core Technical) — September 2008 — Examiners’ Report

Let Y = new monthly payment

(12 )
139,604.44 = 12 Y a
10
7%
0.07
= 12Y × 7.02358
0.06785

⇒ Y = £1, 605.50 per month

END OF EXAMINERS’ REPORT

Page 12
Faculty of Actuaries Institute of Actuaries

EXAMINATION

21 April 2009 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT1 A2009 © Institute of Actuaries
1 Describe the characteristics of Government Bills. [3]

2 Describe the characteristics of:

(a) an interest-only loan (or mortgage); and

(b) a repayment loan (or mortgage). [4]

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]

4 (i) Explain what is meant by the “no arbitrage” assumption in financial

mathematics. [2]

An investor entered into a long forward contract for £100 nominal of a security eight
years ago and the contract is due to mature in four years’ time. The price per £100
nominal of the security was £94.50 eight years ago and is now £143.00. The risk-free
rate of interest can be assumed to be 5% per annum effective throughout the contract.

(ii) Calculate the value of the contract now if it were known from the outset that
the security will pay coupons of £9 two years from now and £10 three years
from now. You may assume no arbitrage. [5]
[Total 7]

CT1 A2009—2
5 A company’s required return for a particular investment project can be expressed as a
force of interest, δ(t). This force of interest is a function of time and at any time t,
measured in years, is given by the formula:

δ(t ) = 0.05 + 0.002t 0 ≤ t ≤ 5

δ(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]

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.

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]

7 A fund had a value of £150,000 on 1 July 2006. A net cash flow of £30,000 was
received on 1 July 2007 and a further net cash flow of £40,000 was received on 1 July
2008. The fund had a value of £175,000 on 30 June 2007 and a value of £225,000 on
30 June 2008. The value of the fund on 1 January 2009 was £280,000.

(i) Calculate the time-weighted rate of return per annum earned on the fund
between 1 July 2006 and 1 January 2009. [3]

(ii) Calculate the money-weighted rate of return per annum earned on the fund
between 1 July 2006 and 1 January 2009. [4]

(iii) Explain why the time-weighted rate of return is more appropriate than the
money-weighted rate of return when comparing the performance of two
investment managers over the same period of time. [2]
[Total 9]

CT1 A2009—3 PLEASE TURN OVER

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]

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]

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]

CT1 A2009—4
11 An individual wishes to receive an annuity which is payable monthly in arrears for 15
years. The annuity is to commence in exactly 10 years at an initial rate of £12,000 per
annum. The payments increase at each anniversary by 3% per annum. The individual
would like to buy the annuity with a single premium 10 years from now.

(i) Calculate the single premium required in 10 years’ time to purchase the
annuity assuming an interest rate of 6% per annum effective. [5]

The individual wishes to invest a lump sum immediately in an investment product

such that, over the next 10 years, it will have accumulated to the premium calculated
in (i). The annual effective returns from the investment product are independent and
(1 + it ) is lognormally distributed, where it is the return in the tth year. The expected
annual effective rate of return is 6% and the standard deviation of annual returns is
15%.

(ii) Calculate the lump sum which the individual should invest immediately in
order to have a probability of 0.98 that the proceeds will be sufficient to
purchase the annuity in 10 years’ time. [9]

(iii) Comment on your answer to (ii). [2]

[Total 16]

END OF PAPER

CT1 A2009—5
Faculty of Actuaries Institute of Actuaries

Subject CT1 — Financial Mathematics

Core Technical

EXAMINERS’ REPORT

April 2009

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

June 2009

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

Comments

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

There were some excellent performances and well-prepared candidates scored well across the
whole paper. However, the comments below on each question concentrate on areas where
candidates could have improved their performance.

Q1, Q2.

As has often been the case when words rather than numbers have been required, these
bookwork questions were answered relatively poorly (although Q2 was answered better than
Q1).

Q3.

Well answered.

Q4.

Defining an arbitrage profit correctly was also acceptable as an answer to (i) although a
description of both possible arbitrage scenarios was required for full marks. Many
candidates performed the calculations well although the methodology being used was not
always clear.

Q5.

The question required an ability to bring together two separate elements of the syllabus and
less well-prepared candidates seemed to struggle with this.

Q6.

This was another question where students scored relatively poorly with many candidates
having difficulty with the income calculation. A common error was to assume that the income
rose by 4% every three years.

Q7.

This was answered much better than questions on the same topic in previous exams.
However, some candidates did confuse the money-weighted and time-weighted rates of
return.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

Q8.

It was particularly disappointing to see many candidates using the wrong formula for DMT
in part (i) but ending their proof with‘=14.42 QED’ in the final line. This suggests a lack of
professionalism, honesty and integrity which are key attributes of the actuarial profession.

Part (ii) was well-answered with various different methods leading to the correct answer.

Q9.

This was the worst-answered question on the paper although it was still possible to score
significant marks by calculating forward rates using the correct formula even if the spot rates
had been calculated incorrectly.

Q10.

Part (i) was answered well but many candidates lost marks in part (ii) by not realising that a
separate test was required to ascertain the worst time to redemption. Many candidates
calculated the annual effective yield rather than the yield per annum convertible quarterly in
part (iii).

Q11.

Many candidates seemed confused as to what to calculate in part (i) and failed to distinguish
between the premium needed in 10 years’ time and the present value of that premium. Part
(ii) was answered well (although some candidates appeared to be short of time at this stage).
Part (iii) was answered very poorly with many candidates not appreciating the effects of the
high variance.

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

1 Characteristics of government bills:

• short-dated securities issued by governments to fund their short-term spending

requirements.
• issued at a discount and redeemed at par with no coupon.
• mostly denominated in the domestic currency, although issues can be made in
other currencies.
• yield is typically quoted as a simple rate of discount for the term of the bill
• absolutely secure
• often highly marketable despite being unquoted.
• often used as a benchmark risk-free short-term investment.

2 (a) An interest-only loan requires the borrower only to pay interest on the entire
loan in each time period. The loan does not reduce over time so the interest
remains constant. A separate investment or savings account can be established
in which payments are made to extinguish the whole loan at the end of the
term.

(b) A repayment loan involves level repayments of capital and interest. The first
part of the payment is used to pay interest on any remaining capital. The
remaining part of the payment is then used to repay capital so that the capital
gradually reduces over the term of the loan.

3 (i) 300a20 + 30v ( Ιa )19 at 7%

= 300 (10.594 ) + 30 × 1.07

1 × 82.9347 = 5503.47

(ii) Capital outstanding after 5 payments:

420a15 + 30 ( Ιa )15

= 420 × 9.1079 + 30 × 61.5540 = 5671.94

(iii) Cap o/s after 19 payments = 870v @ 7% = £813.08

= Capital in the final payment

Interest in the final payment = 870 – 813.08 = £56.92

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

4 (i) The “no arbitrage” assumption means that neither of the following applies:

(a) an investor can make a deal that would give her or him an immediate
profit, with no risk of future loss;

nor

(b) an investor can make a deal that has zero initial cost, no risk of future
loss, and a non-zero probability of a future profit.

(ii) The forward price at the outset of the contract was:

(94.5 − 9v 10
5% − 10v11 )
5% × (1.05 )
12
= 149.29

The forward price that should be offered now is:

(143 − 9v2
5% − 10v5%
3
)
× (1.05 ) = 153.39
4

Hence the value of the contract now is:

(153.39 − 149.29 ) v5%

4
= 3.37

Note:

This result can also be obtained directly from:

143 − 94.5 × (1.05 ) = 3.38

8

since the coupons are irrelevant in this calculation.

5 Working in £000’s

− ( 0.05+ 0.002t )dt

2
PV of outgo = 100 + 80e ∫0

2
− ⎡0.05t +0.001t 2 ⎤
⎣ ⎦0
= 100 + 80e

= 100 + 80e−0.104 = 172.10

DPP is value of T for which:

PV (income paid up to T) = PV (outgo)

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

Where

T
PV (income paid up to T) = ∫8 100e
0.001t
v ( t ) dt

− ⎡ ∫ ( 0.05+0.002t )dt + ∫ 0.06 dt ⎤

5 t
⎢⎣ 0 ⎥⎦
and v(t) =e 5

5
− ⎡0.05t + 0.001t 2 ⎤
.e (
⎣ ⎦0 − 0.06t −0.30 )
=e

= e −0.275 . e −0.06t e0.30

= e0.025 e −0.06t

T
⇒ PV ( income paid up to T ) = ∫ 100e0.001t e0.025 e−0.06t dt
8

T
= ∫ 100e0.025 e −0.059t dt
8

100 0.025 ⎡ −0.059T

= e e − e −0.059×8 ⎤
−0.059 ⎣ ⎦

= −1737.8222 e−0.059T + 1083.97

⇒ DPP is T such that

172.10 = −1737.8222e −0.059T + 1083.97

⇒ e−0.059T = 0.52472
⇒ −0.059T = Ln(0.52472) ⇒ T = 10.93 years

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

6 Working in 000’s

11
PV of costs = 5000 + 900v 12 at 8%

= 5838.695

PV of income = 800v
1312
( a( ) + 1.04 v a( ) +
3
4 3 3
3
4
+ (1.04 ) v12 a
12 ( 4)
3 )
= 800v
1312
a
( 4)
3 (1 + (1.04v ) +
3
(1.04v )12 )
⎛ 1−
( 1.04
1.08 ) ⎟
⎞
15

= 800 × 0.908281×1.049519 × 2.5771× ⎜

⎜ 3 ⎟
⎜ 1−
⎝ ( 1.04
1.08 ) ⎠
⎟

= 1965.3133 × 4.038121

= 7936.173

16 312
PV of proceeds from sale = 6000v = 1717.969

NPV of project = 7936.173+1717.969 – 5838.695

= 3815.447 (i.e. £3,815,447)

7 Working in 000’s

(i) TWRR is i such that

175 225 280

(1 + i )2
1
2
= × ×
150 175 + 30 225 + 40

175 225 280

= × × = 1.352968
150 205 265

∴ i = 12.85% p.a.

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

(ii) MWRR is i such that

150 (1 + i ) + 30 (1 + i ) + 40 (1 + i )
2 12 112 1
2
= 280

Try: i = 12%, LHS = 277.02

i = 12.5%, LHS = 279.58
i = 13%, LHS = 282.16

∴ i = 12.5% +
( 28 − 27.958) × 0.5%
(28.216 − 27.958)

= 12.58% p.a.

(iii) The TWRR is better for comparing 2 investment manager’s performances as it

is not sensitive to cash flow amounts and timing of payments. The MWRR is
sensitive to both.

8 (i) Working in £m

Discounted mean term =

10v10 + 11v11 + 12v12 + ............... + 20v 20

v10 + v11 + v12 + ................. + v 20

10v + 11v 2 + 12v3 + ............ + 20v11

=
v + v 2 + v3 + ................ + v11

9a11 + ( Ιa )11 ( Ιa )11

= =9+ at 6%
a11 a11

( Ιa )11 = 42.7571
42.7571
⇒ DMT = 9 + = 14.42128
7.8869
⇒ to 4 significent figures DMT = 14.42

(ii) First condition: pv assets = pv liabilities

⇒ Xv10 + Yv 20 = v9 a11 *1 at 6%.

X ∗ 0.55839 + Y ∗ 0.31180 = 0.59190*7.8869 (using tables)

= 4.668256 ………….(1)

Page 8
Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

2nd condition: DMT assets = DMT liabilities

X *10v10 + Y * 20v 20
⇒ = 14.42128 (use of 14.42 from (i) will be
Xv10 + Yv 20
accepted)

⇒ X *5.5839 + Y *6.236 = 14.42128 ∗ Xv10 + Yv 20( )

= 14.42128* 4.668256 from (1)

= 67.3222 (or 67.3163 if DMT of 14.42 is used)…………(2)

Equ n (2) – 10* Equ n (1) ⇒

Y *6.236 − Y *3.1180 = 67.3222 − 10* 4.668256

20.639667
⇒Y = = 6.6195 (or 6.6176 if DMT of 14.42 is used)
3.1180
[or VA' = VL' (differentiating with respect to i)

10 Xv11 + 20Yv 21 = 10v11 + 11v12 + … + 20v 21

(
= v10 9a11 + ( Ia )11 )
⇒ 5.2679 X + 5.8831Y = 63.5112 ………….(2)

5.2679
Equ n (2) – × Equ n (1)
5.8831

⇒ 2.94155Y = 19.4711 ⇒ Y = 6.6193 ]

Equ n (1) ⇒ X * 0.55839 = 4.668256 – 6.6195 * 0.31180

⇒ X = 4.6639 (or 4.6650 if DMT of 14.42 is used)

[check, in equ n (2). 4.6639 * 5.5839 + 6.6195 * 6.236 = 67.3222]

(iii) For the third condition to be satisfied, it is necessary for the spread of the
assets to exceed the spread of the liabilities. This appears to be the case given
that the liabilities occur in equal annual amounts at durations from 10 years to
20 years, whereas the assets are concentrated in two lumps at the two most
extreme durations, 10 years and 20 years.

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

9 Let the 1-year and 2-year zero-coupon yields (spot rates) be ii and i2 respectively.

105
= 105v @ 4.5%
1 + i1

∴ i1 = 0.045

For the 2-year spot rate:

5 105
+ = 5a2 5.3% + 100v5.3%
2
1 + i1 (1 + i2 ) 2

⎛1 − 1 ⎞
⎜ 2⎟
5
+
105
= 5 ⎝ 1.053 ⎠ + 100
1.045 (1 + i2 )2 0.053 1.0532

= 9.257681 + 90.186858

= 99.444539

105 5
= 99.444539 −
(1 + i2 ) 2 1.045

105
⇒ (1 + i2 ) =
2
94.659850

⇒ i2 = 5.3202% p.a.

For the 3-year spot rate:

The 3-year par yield is 5.6% p.a.

⎛ 1 1 1 ⎞ 1
⇒ 1 = 0.056 ⎜ + + ⎟+
⎜ 1 + i1 (1 + i ) 2
(1 + i3 ) ⎠⎟ (1 + i3 )3
3
⎝ 2

1.056 0.056 0.056

⇒ = 1− −
(1 + i3 ) 3 1.045 (1.053202 )2

1.056
⇒ (1 + i3 ) =
3
0.895926

⇒ i3 = 5.6324% p.a.

Page 10
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

1-year forward rates:

f 0 = i1 = 4.5% p.a.

(1 + i1 )(1 + f1 ) = (1 + i2 )2

1.0532022
⇒ 1 + f1 =
1.045

⇒ f1 = 6.1468% p.a.

(1 + i2 )2 (1 + f 2 ) = (1 + i3 )3

⇒ 1 + f2 =
(1.056324 )
3

(1.053202 )2

⇒ f 2 = 6.2596% p.a.

10 (i) check for capital gain:

0.11
g (1 − t1 ) = ∗ (1 − 0.3)
1.15

= 0.06696

i = 8% ⇒ i ( ) = 0.077706
4

⇒ i ( ) > g (1 − t1 )
4

⇒ There’s a capital gain and thus loan should be assumed to be redeemed at

the latest possible date.

Let P be price at which the investor bought the loan.

Then

( 4)
P = 11× 0.7 a + 115v15 − 0.25 (115 − P ) v15 at 8%
15

7.7 ×1.029519 × 8.5595 + 0.75 ×115 × 0.31524

⇒P=
1 − 0.25 × 0.31524

= £103.17 per £100 nominal

Page 11
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

(ii) check for capital gain:

0.11
g (1 − t1 ) = = 0.095652
1.15

i = 9% ⇒ i ( ) = 0.087113
4

⇒ i( ) < g 1 − t( )
4
1

⇒ There’s no capital gain and thus loan should be assumed to be redeemed at

the earliest possible date.

Let P ' be the price at which the investor sold the loan. Then

( 4)
P ' = 11a + 115v 7 at 9%
7

= 11×1.033144 × 5.033 + 115 × 0.54703

= £120.1064 per £100 nominal

(iii) Let j be the yield per quarter. Then

11
103.17 = × 0.7a12 + 120.1064v12 −0.25 (120.1064 − 103.17 ) v12 at j %
4

⇒ 103.17 = 1.925 a12 + 115.8723 v12

Try

j = 3%: RHS = 100.4319638

j = 2.5%: RHS = 105.9042724

Linear interpolation:

j = 0.025 + 0.005 ×
(103.17 − 105.9042724 )
(100.4319638 − 105.9042724 )
= 0.02749828

Hence, net yield is 11% p.a. (or 10.99931% p.a.) payable quarterly.

Page 12
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

11 (i) In 10 years’ time the single premium P is

P = 12000 a (( 1
12 )
+ 1.03a
(12 )
1
v+ (1.03)2 a1(12)v 2 + ... + (1.03)14 v14a1(12) )
(12 ) ⎛ 1.03 ⎛ 1.03 ⎞
2 14 ⎞
⎛ 1.03 ⎞
⎜1 + + + ... + ⎜ ⎟
⎜ 1.06 ⎜⎝ 1.06 ⎟⎠ ⎟
= 12000a
1 ⎝ 1.06 ⎠ ⎟
⎝ ⎠

⎛ ⎛ 1.03 ⎞15 ⎞
⎜ 1− ⎜ ⎟ ⎟
(12 ) ⎜ ⎝ 1.06 ⎠ ⎟
= 12000a
1 ⎜ 1.03 ⎟
⎜⎜ 1 − 1.06 ⎟⎟
⎝ ⎠

(12 ) i
where a = v
1
i (12 )

1.027211
= = 0.969067
1.06

0.3499146
⇒ P = 12000 × 0.969067 ×
0.0283019

= 143,774.45

2
μ+ σ
(ii) E (1 + it ) = 1.06 = e 2

Var (1 + it ) = ( 0.15 ) = e2μ+σ . eσ − 1

2 2
( 2
)
0.152
= eσ − 1
2
Then
(1.06 ) 2

⇒ σ2 = 0.01982706

0.01982706
∴μ = n 1.06 −
2

= 0.04835538

⇒ S10 ∼ LN ( 0.4835538, 0.1982706 )

Let X be the amount to be invested at time 0

Page 13
 Subject CT1 (Financial Mathematics Core Technical) — April 2009 — Examiners’ Report

We want Pr ( X .S10 ≥ 143, 774.45 ) = 0.98

⎛ 143, 774.45 ⎞
so Pr ⎜ S10 ≥ ⎟ = 0.98
⎝ X ⎠

⎛ Ln 143774.45 − 10μ ⎞
so 1 − Φ ⎜ X
⎟ = 0.02
⎜ ⎟
⎝ 10 σ 2
⎠

Ln 143774.45 − 10μ
⇒ X = − 2.0537
10σ2

143774.45
So Ln = − 2.0537 × 0.1982706 + 0.4835538
X

= − 0.430909

143774.45
⇒ = 0.6499179
X

⇒ X = £221, 219.41

(iii) It might seem odd that the initial investment needs to be substantially higher
than the single premium required in 10 years’ time to have a 98% probability
of accumulating to the single premium.

This strange result is explained by the fact that the variance of the interest rate
is so high relative to the mean. There is therefore a significant risk that the
investment will decrease in value over the next 10 years.

END OF EXAMINERS’ REPORT

Page 14
Faculty of Actuaries Institute of Actuaries

EXAMINATION

30 September 2009 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT1 S2009 © Institute of Actuaries
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]

2 List the characteristics of an equity investment. [4]

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]

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]

CT1 S2009—2
5 The force of interest δ(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]

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]

CT1 S2009—3 PLEASE TURN OVER

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]

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]

CT1 S2009—4
9 A life insurance company is issuing a single premium policy which will pay out
£20,000 in twenty years time. The interest rate the company will earn on the invested
funds over the first ten years of the policy will be 4% per annum with a probability of
0.3 and 6% per annum with a probability of 0.7. Over the second ten years the
interest rate earned will be 5% per annum with probability 0.5 and 6% per annum
with probability 0.5.

(i) Calculate the premium that the company would charge if it calculates the
premium using the expected annual rate of interest in each ten year period. [2]

(ii) Calculate the expected profit to the company if the premium is calculated as in
(i). The rate of interest in the second ten year period is independent of that in
the first ten year period. [3]

(iii) Explain why, despite the company using the expected rate of interest to
calculate the premium, there is a positive expected profit. [2]

(iv) By considering each possible outcome in (ii):

(a) Find the range of possible profits.

(b) Calculate the standard deviation of the profit to the company. [7]
[Total 14]

CT1 S2009—5 PLEASE TURN OVER

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:

ƒ 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.

ƒ Communities affected by climate change will incur costs of $20bn per annum
incurred continuously, increasing at a continuous rate of 1% per annum.

ƒ Other costs, assumed to be $40bn per annum, will be incurred annually in

arrear.

Benefits arising from climate change:

ƒ 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]

(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]

END OF PAPER

CT1 S2009—6
Faculty of Actuaries Institute of Actuaries

Subject CT1 — Financial Mathematics.

Core Technical.

September 2009 examinations

EXAMINERS REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

December 2009

Comments for individual questions are given with the solutions that follow.

Faculty of Actuaries
Institute of Actuaries
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

Please note that different answers may be obtained to those shown in these solutions depending
on whether figures obtained from tables or from calculators are used in the calculations but
candidates are not penalised for this. However, candidates may be penalised where excessive
rounding has been used or where insufficient working is shown.
Well-prepared candidates scored well across the whole paper. However, the comments below on
each question concentrate on areas where candidates could have improved their performance.

1
t t 97.89
a. 96 1.05 97.89 1.05
96

ln 97.89
96
t 0.400 years or 146 days
ln 1.05

b. Second investor held the bill for 36 days. Therefore

36 365 100
97.89 1 i 100 i 1 21.854%
365 36 97.89

This was answered well except by the very weakest candidates.

2
Issued by corporations.
Holders entitled to a distribution (dividend) declared from profits.
Potential for high returns relative to other asset classes.
Commensurate risk of capital losses.
Lowest ranking finance issued by companies.
Initial running yield low but has potential to increase with dividend growth.
Dividends and capital values have the potential to grow in nominal terms during times of inflation.
Return made up of income return and capital gains.
Marketability depends on the size of the issue.
Ordinary shareholders receive voting rights in proportion to their holding.

This question was not answered as well as the examiners would have expected given that
the topic is standard bookwork.

3
We convert all cash flow to amounts in time 0 values:

Page 2
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

147.7
Dividend paid at t 1:10000 0.041 394.77
153.4

147.7
Dividend paid at t 2 :10000 0.046 428.39
158.6

147.7
Dividend paid at t 3:10000 0.051 456.25
165.1

147.7
Sale proceeds at t 3:10000 0.93 8319.87
165.1

1
Equation of value involving v where v
1 r
and r = real rate of return:

7800 394.77v 428.39v2 8776.17v3..... (1)

[To estimate r:

Approx nominal rate of return is

93 78
4.6 / 78 12.3% p.a.
3

Average inflation over 3 year period comes from

1
3
165.1
1 3.8 % p.a.
147.7

1.123
Approx real return: 1 8.2 % p.a. ]
1.038

Try r 8%, RHS of (1) 7699.61

r 7%, RHS of (1) 7907.09

7907.09 7800
r 7% 1%
7907.69 7699.61

= 7.52 % p.a.

Page 3
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

Some candidates seemed to struggle to derive the equation of value based on a real rate
of return and multiplied (rather than divided) the payments by the increase in the
inflation index.

4
(i) Let required price = P:

2
P 1 0.2 5a 100v20 at 6%
20
2 i 0.06
a a20 = 11.4699 11.6394; v 20 0.311805
20 2 0.059126
i
Therefore

P 1 0.2 5 11.6394 100 0.311805

46.5576 31.1805 77.7381

(ii) The equation of value for the gross rate of return is:

2
77.7381 5a 100v20
20
If i = 8%

2 i
a a20 = 1.019615 9.8181 10.0107; v 20 0.21455
20 2
i
RHS = 50.0534 + 21.4550 = 71.5084

If i = 7%

2 i
a a20 = 1.017204 10.5940 10.7763; v 20 0.25842
20 2
i
RHS = 53.8813 + 25.8420 = 79.7233

79.7233 77.7381
Interpolating gives i 0.07 0.01 7.24% 7.2% say
79.7233 71.5084

(iii) If the nominal rate of return is 7.2% per annum effective and inflation is 3% per
annum effective, then the real rate of return is calculated from:
1.072
1 4.1%
1.03

This question was answered very well.

Page 4
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

5
5
5
(i) 130 100exp a bt 2 dt 100exp at 1 bt 3
3
100exp 5a 41.667b
0
0

10
10
200 100exp a bt 2 dt 100exp at 1 bt 3
3
100exp 10a 333.333b
0
0

ln 1.3 5a 41.667b
ln 2 10a 333.333b

The second expression less twice times the first expression gives:

ln(2) 2ln(1.3) 250b b 0.0006737

ln(2) 333.333 0.0006737

a 0.04686
10

60 1
12 60
i 12 130 12
(ii) 100 1 130 i 12 1 i 5.259% p.a.
12 100

200
(iii) 130e5 200 5 ln 8.616% p.a.
130

This question was answered very well.

6
(i) A future is a contract which obliges the parties to deliver/take delivery of a
particular quantity of a particular asset at a particular time at a fixed price.

An option is the right to buy or sell a particular quantity of a particular asset at (or
before) a particular time at a given price.

(ii) Assume no arbitrage

a. Buying the forward is exactly the same as buying the bond except that the
forward will not pay coupons and the forward does not require immediate
settlement.

Page 5
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

Let the forward price = F. The equation of value is:

1.06
F 97 1.06 3.5 1
3.5
2
1.05
102.82 3.62059 3.5 95.6994

1.06
b. Let six month forward interest rate f 0.5,0.5 1
1 3.4454%
2
1.05
This does not have to be expressed as a rate of interest per annum
effective, though it could be.

0.5 1
c. P 2 1.05 102 1.06 1.9518 96.2264 98.1782

d. Gross redemption yield is i such that

0.5 1
98.1782 2 1 i 102 1 i

Using the formula for solving a quadratic (interpolation will do):

0.5
1 i 0.97133 . Therefore, i ≈ 6% (in fact 5.99%).

e. Answer is very close to 6% (the one-year spot rate) because the payments
from the bond are so heavily weighted towards the redemption time in one
year.

This was generally well-answered apart from part (e). A common error in parts (c) and
(d) was to assume that the coupon payments were 4% per half-year.

7 .
12 20 12 12 20
(i) The accumulation is 1200s 1.06 2300s 100 Ia 1.06
20 20 20
i 20 20
1200s20 1.06 2300 s20 100 Ia 20
1.06
12
d
1, 200 36.7856 3.20714 2,300 36.7856
1.032211
100 98.7004 3.20714
1.032211 141,571.88 84, 606.88 31, 654.60
266,138

Page 6
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

(ii) Let half-yearly payment = X

Xa40 266,138 at 2.5%

266,138
X 10,601.94
25.1028
Therefore, annual rate of payment = £21,203.88

(iii) Work in half-years. Discounted mean term is:

10,601.94 v + 2v2 ++40v40 /266,138

Numerator = 10,601.94 Ia at 2.5% per half year effective.

40
10,601.94 433.3248 4,584,075

Therefore DMT = 17.26 half years or 8.63 years.

In part (i), many candidates developed the correct formula although calculation errors
were common. In such cases, candidates also lost marks for not showing and explaining
their working fully. Part (ii) was answered well but many candidates surprisingly had
trouble calculating the DMT in part (iii). In this part, candidates often lost marks for not
showing the units properly at the end of the answer; indeed, in many cases, showing the
units may well have alerted candidates to possible mistakes.

2
(i) The equation of value for the borrower is 4, 012.13a20 50, 000 .

50,000
Therefore a 20 = = 12.4622
4,012.13

From inspection of tables, i = 5%

(ii) The second customer pays interest of 0.055 50,000 = £2,750 per annum, annually in arrear.
The annual rate of monthly payments in advance from the savings policy is X such that:

Page 7
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

12
Xs =50, 000 at 4%
20
i
Xs20 50, 000
12
d
50, 000
X £1, 643.69
29.7781 1.021537

The equation of value for this borrower is:

12
50, 000 2, 750a20 1, 643.686a
20
i
2, 750a20 1, 643.686 a20
12
d
Try i = 6%: RHS = 51,002.41

Try i = 7%: RHS = 47,200.14

By interpolation i = 6.3%

Part (i) was well answered but weaker candidates failed to recognise the need to
calculate separately the payments into the savings policy in part (ii).

3
(i) The expected annual interest rate in the first ten years is 0.3 0.04 + 0.7 0.06 =
0.054. The expected interest rate in the second ten years is clearly 5.5%.
If the premium is calculated on the basis of these interest rates, then the premium will be P such
that:

10 10
20, 000 P 1.054 1.055
20, 000 2.89022 P P 6,919.89

(ii) The expected accumulation factor in the first ten years is:

0.3 1.0410 0.7 1.0610 1.69767

The expected accumulation factor in the second ten years is:

10 10
0.5 1.05 1.06 1.70987

As they are independent, we can multiply the accumulation factors together and multiply by the
premium to give an expected accumulation of: 6,919.89 1.69767 1.70987 = 20,087.04.

Page 8
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

The expected profit is 87.04.

(iii) There is an expected profit because (in general) the accumulation of a sum of money at the
expected interest rate is not equal to the expected accumulation when the interest rate is a random
variable.

(iv) The highest possible outcome for the accumulation factor is:

1.0610 1.0610 = 3.20714 with probability 0.7 0.5 = 0.35

The lowest possible outcome is:

1.0410 1.0510 = 2.41116 with probability 0.3 0.5 = 0.15.

The range is therefore: 6,919.89 (3.20714 – 2.41116) = 5,508.05.

The other two possible outcomes are:

1.0610 1.0510 = 2.91710 with probability 0.7 0.5 = 0.35

10
and 1.04 1.0610 = 2.65089 with probability 0.3 0.5 = 0.15
The mean accumulation factor is: 1.69767 1.70987 = 2.90280

The variance of the accumulation from one unit of investment is:

0.35(3.20714-2.90280)2 + 0.15(2.41116-2.90280)2
+ 0.35 (2.91710-2.90280)2 +0.15 (2.65089-2.90280)2

= 0.03241 + 0.03626 + 0.00007 + 0.00952 = 0.07826.

Standard deviation is 0.07826 = 0.27976.

Standard deviation of the accumulation of the whole premium is: 6,919.89 0.27976 = £1,935.88
which is also the standard deviation of the profit.

This was the worst answered question on the paper with many candidates not recognising
that the accumulation of a sum of money at the expected interest rate is not equal to the
expected accumulation when the interest rate is a random variable. The calculation of the
standard deviation of the accumulation was generally only calculated correctly by the
strongest candidates.

4
(i) The discounted payback period is the first time at which the accumulated profit
from/net present value of the cash flows from a project is positive at a given
interest rate.

Page 9
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

It is an inappropriate decision criterion because it does not tell us anything about

the overall profitability of the project.

(ii) If the internal rate of return were greater than 1.5% then the net present value of
the project at 1.5% must be greater than zero. As such, there must be a discounted
payback period as the discounted payback period is the first time at which the net
present value is greater than zero: such a time must exist.

(iii) Returns are real rates of return and figures are in 2009 dollar terms so we are
automatically working with real rather than nominal values. All figures below are
in $bn.
The net benefits from using the technology are the $30 every three years; $20 incurred
continuously increasing at 1% per annum and $30 per annum incurred annually in arrears.

The costs of the technology are $440 incurred immediately and $50 incurred annually in arrears.

The net present value of the project at 1% per annum effective is:
30 v3 v6 v48 50 20 30a50 440 50a50

The 20 does not need to be discounted because the cash flows are growing at the same rate as they
are being discounted.
1 v 48
3
30v 560 20a50 calculated at 1%
1 v3
1 0.62026
30 0.97059 560 20 39.1961
1 0.97059
= 375.967 560 783.922
152.045

(iv) The net present value of the project at 4% per annum effective is:
30 v3 v6 v48 '
20a50 30a50 440 50a50

'
All are calculated at 4% except a50 which is calculated at

1.04
i -1 2.97%
1.01
1 v 48 i '
3
30v 20 a50 440 20a50
1 v3
1 0.15219
30 0.88900 20 1.014779 25.8755 440 20 21.4822
1 0.88900

Page 10
Subject CT1 (Financial Mathematics. Core Technical) — September 2009 —Examiners’ Report

203.704 525.158 440 429.644

140.790

(v) Whether the investment should go ahead would depend on the choice of the interest rate – it is
clearly a crucial assumption (students could make a choice themselves and indicate whether it
should go ahead on the basis of that rate but there must be some justification for the choice).

This question was also poorly answered possibly because project appraisal using real
interest rates has rarely been examined in the past (and also possibly because of time
pressure). Whilst some parts of the question were challenging (e.g. the treatment of the
increasing costs of climate change), it was disappointing that many candidates failed to
recognise that the costs of climate change no longer incurred would be a benefit of the
carbon storing technology project and so failed to score many marks.

END OF EXAMINERS’ REPORT

Page 11
Faculty of Actuaries Institute of Actuaries

EXAMINATION

27 April 2010 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT1 A2010 © Institute of Actuaries
1 (i) Explain the difference

(a) between options and futures

(b) between call options and put options
[4]

A security is priced at £60. Coupons are paid half-yearly. The next coupon is due in
two months’ time and will be £2.80. The risk-free force of interest is 6% per annum.

(ii) Calculate the forward price an investor should agree to pay for the security in
three months’ time assuming no arbitrage. [3]
[Total 7]

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]

CT1 A2010—2
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]

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]

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% p.a. 4.7% p.a. 4.9% p.a. 5.0% p.a.

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]

CT1 A2010—3 PLEASE TURN OVER

6 The annual returns, i, on a fund are independent and identically distributed. Each
year, the distribution of 1 + i is lognormal with parameters μ = 0.05 and σ2 = 0.004,
where i denotes the annual return on the fund.

(i) Calculate the expected accumulation in 25 years’ time if £3,000 is invested in

the fund at the beginning of each of the next 25 years. [5]

(ii) Calculate the probability that the accumulation of a single investment of £1

will be greater than its expected value 20 years later. [5]
[Total 10]

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]

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]

CT1 A2010—4
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]

10 A pension fund’s assets were invested with two fund managers.

On 1 January 2007 Manager A was given £120,000 and Manager B was given
£100,000. A further £10,000 was invested with each manager on 1 January 2008 and
again on 1 January 2009.

The values of the funds were:

31 December 2007 31 December 2008 31 December 2009

Manager A £130,000 £135,000 £180,000

Manager B £140,000 £145,000 £150,000

(i) Calculate the time-weighted rates of return earned by Manager A and Manager
B over the period 1 January 2007 to 31 December 2009. [4]

(ii) Show that the money-weighted rate of return earned by Manager A over the
period 1 January 2007 to 31 December 2009 is approximately 9.4% per
annum. [2]

(iii) Explain, without performing further calculations, whether the money-weighted

rate of return earned by Manager B over the period 1 January 2007 to
31 December 2009 was higher than, lower than or equal to that earned by
Manager A. [3]

(iv) Discuss the relative performance of the two fund managers. [3]
[Total 12]

CT1 A2010—5 PLEASE TURN OVER

11 The force of interest δ(t) is a function of time and at any time t, measured in years, is
given by the formula

⎧0.04 +0.02t 0≤t <5

δ(t ) = ⎨ .
⎩0.05 5≤t

(i) Derive and simplify as far as possible expressions for v(t), where for v(t) is the
present value of a unit sum of money due at time t. [5]

(ii) (a) Calculate the present value of £1000 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]

END OF PAPER

CT1 A2010—6
Faculty of Actuaries Institute of Actuaries

EXAMINERS’ REPORT

April 2010 Examinations

Subject CT1 — Financial Mathematics

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart
Chairman of the Board of Examiners

July 2010

© Faculty of Actuaries
© Institute of Actuaries
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

Comments

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Well-prepared candidates scored well across the whole paper and the examiners were
pleased with the general standard of answers. However, questions that required an element
of explanation or analysis were less well answered than those which just involved
calculation. The comments below concentrate on areas where candidates could have
improved their performance.

Q2.

A common error was to divide the nominal payments by the increase in the index factor
(rather than multiplying).

Q3.

Many candidates made calculation errors in this question but may have scored more marks if
their working had been clearer.

Q6.

Many candidates assumed that the accumulation in part (i) was for a single payment.

Q7.

The calculation was often performed well. In part (ii), many explanations were unclear and
some candidates seemed confused between DMT and convexity although a correct
explanation could involve either of these concepts.

Q9.

A common error was to assume that income only started after three years rather than
‘starting from the beginning of the third year’.

Q10.

This question was answered well but examiners were surprised by the large number of
candidates who used interpolation or other trial and error methods in part (ii) when the
answer had been given in the question. The examiners recommend that students pay attention
to the details given in the solutions to parts (iii) and (iv). For such questions, candidates
should be looking critically at the figures given/calculated and making points specific to the
scenario rather than just making general statements taken from the Core Reading.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

1 (i) (a) Options – holder has the right but not the obligation to trade
Futures – both parties have agreed to the trade and are obliged to do so.

(b) Call Option – right but not the obligation to BUY specified asset at
specified price at specified future date.

Put Option – right but not the obligation to SELL specified asset at
specified price at specified future date.

0.06× 312 0.06× 112

(ii) K = 60e − 2.80e = 60.90678 − 2.81404 = £58.09

2 (i) Cash flows:

Issue price: Jan 08 −0.98 × 100, 000 = –£98,000

112.1
Interest payments: July 08 0.02 × 100, 000 × = £2,028.96
110.5

115.7
Jan 09 0.02 × 100, 000 × = £2,094.12
110.5

119.1
July 09 0.02 × 100, 000 × = £2,155.66
110.5

123.2
Jan 10 0.02 × 100, 000 × = £2,229.86
110.5

123.2
Capital redeemed: Jan 10 100, 000 × = £111,493.21
110.5

(ii) Equation of value is:

1 11
98000 = 2028.96v 2 + 2094.12v + 2155.66v 2 + 2229.86v 2 + 111493.21v 2

At 11%, RHS = 97955.85 ≈ 98000

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

3 Purchase price = 0.45 × 1,000,000 = £450,000

⎡ ⎤
PV of dividends = 50000 × (1 − 0.2 ) × ⎢⎛⎜ v 2 + v 2 ⎞⎟ + 1.03 ⎛⎜ v3 + v 2 ⎞⎟ + 1.032 ⎛⎜ v 4 + v 2 ⎞⎟ +
21 31 41
⎣⎝ ⎠ ⎝ ⎠ ⎝ ⎠ ⎥⎦

= 40000 ⎜⎛ v 2 + v 2 ⎟⎞ ⎡1 + 1.03v + 1.032 v 2 +

21
⎤ @ 8%
⎝ ⎠⎣ ⎦

⎛ 1 ⎞
= 40000 ×1.68231× ⎜ ⎟ = 1, 453,516
⎝ 1 − 1.03 1.08 ⎠

⇒ NPV = 1,453,516 – 450,000 = £1,003,516

4 Let i = money yield

⇒ 1 + i = 1.0285714 ×1.05 = 1.08 ⇒ i = 8% p.a.

Check whether CGT is payable: compare i ( ) with (1 − t ) g

2

6
(1 − t ) g = 0.8 × = 0.04571
105

From tables, i ( ) = 7.8461% ⇒ i( ) > (1 − t ) g

2 2

⇒ CGT is payable

( 2)
P = 0.8 × 6a + 105v10 − 0.25(105 − P)v10 @ 8%
10

( 2)
0.8 × 6a + 0.75 ×105v10
10
=
1 − 0.25v10

4.8 × 1.019615 × 6.7101 + 78.75 × 0.46319

=
1 − 0.25 × 0.46319

= £78.39

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

5 (i) Let P denote the current price (per £100 nominal) of the security.

Then, we have:

7 7 7 107
P= + + + = 108.0872
1.044 1.044 × 1.047 1.044 × 1.047 × 1.049 1.044 × 1.047 × 1.049 × 1.05

(ii) The gross redemption yield, i , is given by:

108.09 = 7 × a4i % + 100 × vi4%

Then, we have:

i = 5% ⇒ RHS = 107.0919 ⎫ ⎛ 108.0872 − 108.9688 ⎞

⎬ ⇒ i ≈ 0.045 + ( 0.05 − 0.045 ) × ⎜ ⎟ = 0.0473
i = 4.5% ⇒ RHS = 108.9688 ⎭ ⎝ 107.0919 − 108.9688 ⎠

(iii) The gross redemption yield represents a weighted average of the forward rates
at each duration, weighted by the cash flow received at that time.

Thus, increasing the coupon rate will increase the weight applied to the cash
flows at the early durations and, as the forward rates are lower at early
durations, the gross redemption yield on a security with a higher coupon rate
will be lower than above.

Note to markers: no marks for simply plugging 9% pa in, and providing no

explanation for result.

μ+ 1 2 σ 2
6 (i) E (1 + i ) = e

0.05+ 1 2 × 0.004
=e

= 1.0533757

∴ E [i ] = 0.0533757 since E (1 + i ) = 1 + E ( i )

Let A be the accumulation at the end of 25 years of £3,000 paid annually in

advance for 25 years.

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

Then E [ A] = 3000 S 25 at rate j = 0.0533757

= 3000
((1 + j ) −1) × (1 + j )
25

= 3000
(1.0533757 25
) ×1.0533757
−1
0.0533757

= £158, 036.43

(ii) Let the accumulation be S20

S20 has a log-normal distribution with parameters 20μ and 20σ2

20μ+ 1 2×20σ2
∴ E [ S 20 ] = e

{or (1 + j ) }
20

= exp ( 20 × 0.05 + 10 × 0.004 )

= e1.04 = 2.829217

(
In S20 ~ N 20μ, 20σ2 )
⇒ In S20 ~ N (1, 0.08)

Pr ( S20 > 2.829217 ) = Pr (1n S20 > 1n 2.829217 )

⎛ 1n 2.829217-1 ⎞
= Pr ⎜ Ζ > ⎟ where Ζ ∼ N ( 0,1)
⎝ 0.08 ⎠

= Pr ( Z > 0.14 ) = 1 − Φ ( 0.14 )

= 1 – 0.55567

= 0.44433 i.e. 44.4%

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

7 (i) DMT of liabilities is given by:

2 39
1× 1× v7% + 2 × (1.038835 ) × v7%
2
+ 3 × (1.038835 ) × v7%
3
+ … + 40 × (1.038835 ) × v7%
40

2 39
1× v7% + (1.038835 ) × v7%
2
+ (1.038835 ) × v7%
3
+ … + (1.038835 ) × v7%
40

⎡ 2 3 40 ⎤
(1.038835 )−1 × ⎢⎛⎜ 1.038835 ⎞⎟ + 2 × ⎛⎜ 1.038835 ⎞⎟ + 3 × ⎛⎜ 1.038835 ⎞⎟ + … + 40 × ⎛⎜ 1.038835 ⎞⎟ ⎥
= ⎣⎝ 1.07 ⎠ ⎝ 1.07 ⎠ ⎝ 1.07 ⎠ ⎝ 1.07 ⎠ ⎦
⎡ 2 3 40 ⎤
(1.038835 )−1 × ⎢⎛⎜ 1.038835 ⎞⎟ + ⎛⎜ 1.038835 ⎞⎟ + ⎛⎜ 1.038835 ⎞⎟ + … + ⎛⎜ 1.038835 ⎞⎟ ⎥
⎣⎝ 1.07 ⎠ ⎝ 1.07 ⎠ ⎝ 1.07 ⎠ ⎝ 1.07 ⎠ ⎦

vi* + 2 × vi2* + 3 × vi3* + … + 40 × vi40

*
=
vi* + vi2* + vi3* + … + vi40
*

*
( Ia )i
40
=
i*
a40

1 1.038835 1.07 0.07 − 0.038835

where vi* ≡ *
= ⇒ i* = −1 = = 0.03 .
1+ i 1.07 1.038835 1.038835

Hence, DMT of liabilities is:

( Ia )3% 384.8647
40
3%
= = 16.65 years
a40 23.1148

(Alternative method for DMT formula

v(1 + 2 gv + 3g 2v 2 + " + 40 g 39v39 ) v( Ia)3% ( Ia)3% ( Ia )3%

40 40 40
DMT = = = =
v(1 + gv + g 2v 2 + " + g 39v39 ) 3%
va40 3%
a40 3%
a40

where g = 1.038835 .)

(ii) Even if the fund manager invested entirely in the 15-year zero-coupon bond,
the DMT of the assets will be only 15 years (and, indeed, any other portfolio
of securities will result in a lower DMT).

Thus, it is not possible to satisfy the second condition required for

immunisation (i.e. DMT of assets = DMT of liabilities).

Hence, the fund cannot be immunised against small changes in the rate of
interest.

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

(iii) The other problems with implementing an immunisation strategy in practice

include:

• the approach requires a continuous re-structuring of the asset portfolio to

ensure that the volatility of the assets remains equal to that of the liabilities
over time

• for most institutional investors, the amounts and timings of the cash flows
in respect of the liabilities are unlikely to be known with certainty

• institutional investor is only immunised for small changes in the rate of

interest

• the yield curve is unlikely to be flat at all durations

• changes in the term structure of interest rates will not necessarily be in the
form of a parallel shift in the curve (e.g. the shape of the curve can also
change from time to time)

8 (i) Loan = 4500a20 + 150 ( Ia )20 at 9%

⇒ Loan = 4500 × 9.1285 + 150 × 70.9055

= 41, 078.25 + 10, 635.83 = 51, 714.08

(ii) Loan o/s after 9th year = ( 4500 + 1350 ) a11 + 150 ( Ia )11 at 9%

Loan o/s = 5,850 × 6.8052 + 150 × 35.0533

= 39,810.42 + 5258.00 = 45, 068.42

Repayment = 6000 − 45, 068.42 × 0.09 = £1, 943.84

(Alternative solution to (ii)

(ii) Loan o/s after 9th year = ( 4500 + 1350 ) a11 + 150 ( Ia )11 at 9%

= 5,850 × 6.8052 + 150 × 35.0533 = 45, 068.42 as before

Loan o/s after 10th year = ( 4500 + 1500 ) a10 + 150 ( Ia )10 at 9%

= 6, 000 × 6.4177 + 150 × 30.7904 = 43,124.76

Repayment = 45, 068.42 − 43,124.76 = £1,943.66 )

Page 8
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

(iii) Last instalment = 4650 + 19 × 150 = 7500

Loan o/s = 7500a1 = 7500v

Interest = 7500 × 0.91743 × 0.09 = £619.27

1
(iv) Total payments = 20 × 4650 + × 19 × 20 × 150
2

= 93, 000 + 28,500 = 121,500

Total interest = 121,500 – 51,714.08 = £69,785.92

1
9 (i) NPV = −5 − 3v 4 + 1.7a15 v 2 @10%

i
NPV = −5 − 3 × 0.976454 + 1.7 × 0.82645 × a15 @10%
δ

= −5 − 2.929362 + 1.404965 ×1.049206 × 7.6061

= −7.929362 + 11.21213458

= 3.282772575

NPV = £3.283m

(ii) DPP is t + 2 such that

1
1.7 at v 2 = 5 + 3v 4 ⇒ 1.474097708at = 7.929362 @10%

1 − 1.1−t
= 5.379129 ⇒ 1 − 1.1−t = 0.5379129
0.1

⇒ 0.4620871 = 1.1−t ⇒ 1n 0.4620871 = −t 1n 1.1

⇒ t = 8.100

∴ DPP = 10.1 years

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

(iii) Accumulated profit 17 years from start of project:

= 1.7 s6.9 7% = 1.7 ×

(1.07 6.9
) @ 7%
−1
δ

= 1.7 ×
(1.07 6.9
)
−1
0.067659

= 1.7 × 8.79346

= £14.95m

10 (i) The values of the funds before and after the cash injections are:

Manager A Manager B

1 January 2007 120,000 100,000

31 December 2007 130,000 140,000 140,000 150,000
31 December 2008 135,000 145,000 145,000 155,000
31 December 2009 180,000 150,000

Thus, TWRR for Manager A is given by:

130 135 180

(1 + i )3 = × × ⇒ i = 0.0905 or 9.05%
120 140 145

And, TWRR for Manager B is given by:

140 145 150

(1 + i )3 = × × ⇒ i = 0.0941 or 9.41%
100 150 155

(ii) MWRR for Manager A is given by:

120 × (1 + i ) + 10 × (1× i ) + 10 × (1 + i ) = 180

3 2

Then, putting i = 0.094 gives LHS = 180.03 which is close enough to 180.

(iii) Both funds increased by 50% over the three year period and received the same
cashflows at the same times.

Since the initial amount in fund B was lower, the cash inflows received
represent a larger proportion of fund B and hence the money weighted return
earned by fund B over the period will be lower, particularly since the returns
were negative for the 2nd and 3rd years.

Page 10
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

[Could also note that for fund B:

100 × (1 + i ) + 10 × (1× i ) + 10 × (1 + i ) = 150

3 2

So by a proportional argument 120 × (1 + i ) + 12 × (1× i ) + 12 × (1 + i ) = 180

3 2

which when compared with the equation for fund A in (ii) clearly shows that
the return for B is lower.]

(iv) The money weighted rate of return is higher for fund A, whilst the time
weighted return is higher for fund B.

When comparing the performance of investment managers, the time weighted

rate of return is generally better because it ignores the effects of cash inflows
or outflows being made which are beyond the manager’s control.

In this case, Manager A’s best performance is in the final year, when the fund
was at its largest, whilst Manager B’s best performance was in the first year,
where his fund was at its lowest.

Overall, it may be argued that Manager B has performed slightly better than
Manager A since Manager B achieved the higher time weighted return.

11 (i) t <5

− ∫ ( 0.04+ 0.02 s )ds

t

v (t ) = e 0

t
− ⎡0.04 s + 0.01s 2 ⎤
⎣ ⎦0
=e

− ⎡0.04t +0.01t 2 ⎤
=e ⎣ ⎦

t ≥5

v (t ) = e
{∫ (0.04+0.02s )ds+∫ 0.05ds}
−
5
0
t
5

− ⎣⎡0.05( t −5 ) ⎦⎤
= v ( 5) × e

− ⎣⎡0.05( t −5) ⎦⎤
=e [
− 0.05t +0.2]
= e−0.45 × e

Page 11
 Subject CT1 (Financial Mathematics Core Technical) — April 2010 — Examiners’ Report

PV = 1, 000e [
− 0.05×17 + 0.2]
(ii) (a) = e −1.05

= 349.94

−204
⎛ i (12 ) ⎞
(b) 1000 ⎜1 + ⎟ = 349.94
⎜ 12 ⎟
⎝ ⎠

⇒ i ( ) = 6.1924%
12

10 −0.45 −[ 0.05t −0.25]

(iii) PV = ∫ e e 10e0.01t dt
6

10 −0.04t
= 10e−0.2 ∫ e dt
6
10
−0.2 ⎡ e−0.04t ⎤
= 10e ⎢− ⎥
⎢⎣ 0.04 ⎥⎦ 6

= 8.18733 × 2.90769

= 23.806

(Alternative Solution to (iii)

Accumulated value at time t = 10

= ∫ 10e0.01t ⎛⎜ exp ∫ 0.05ds ⎞⎟dt

10 10
6 ⎝ t ⎠
10
(
= ∫ 10e0.01t exp [ 0.05s ]t dt
6
10
)
10 10
= ∫ 10e0.01t e0.5−0.05t dt = ∫ 10e0.5−0.04t dt
6 6

⎡10e 0.5−0.04t ⎤10

=⎢ ⎥ = −276.293 + 324.233 = 47.940
⎣⎢ −0.04 ⎦⎥ 6

Present value = v (10 ) × 47.940 = 0.63763e−[0.05×10−0.25] × 47.940 = 23.806

END OF EXAMINERS’ REPORT

Page 12
Faculty of Actuaries Institute of Actuaries

EXAMINATION

7 October 2010 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

© Faculty of Actuaries
CT1 S2010 © Institute of Actuaries
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]

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]

3 The annual rates of return from an asset are independently and identically distributed.
The expected accumulation after 20 years of £1 invested in this asset is £2 and the
standard deviation of the accumulation is £0.60.

(a) Calculate the expected effective rate of return per annum from the asset,
showing all the steps in your working.

(b) Calculate the variance of the effective rate of return per annum.
[6]

4 A six-month forward contract was issued on 1 April 2009 on a share with a price of
700p at that date. It was known that a dividend of 20p per share would be paid on
1 May 2009. The one-month spot, risk-free rate of interest at the time of issue was
5% per annum effective and the forward rate of interest from 1 May to 30 September
was 3% per annum effective.

(i) Calculate the forward price at issue, assuming no arbitrage, explaining your
working. [3]

It has been suggested that the forward price cannot be calculated without making a
judgement about the expected price of the share when the forward contract matures.

(ii) Explain why this statement is not correct. [2]

(iii) Comment on whether the method used in part (i) would still be valid if it was
not known with certainty that the dividend due on 1 May 2009 would be paid.
[1]
[Total 6]

CT1 S2010—2
5 (a) Describe the characteristics of Eurobonds.
(b) Describe the characteristics of convertible bonds.
[6]

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]

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]

CT1 S2010—3 PLEASE TURN OVER

8 The force of interest, δ(t), is a function of time and at any time t, measured in years, is
given by the formula

⎧0.05 + 0.001t 0 ≤ t ≤ 20
δ (t ) = ⎨
⎩0.05 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]

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]

CT1 S2010—4
10 On 1 April 2003 a company issued securities that paid no interest and that were to be
redeemed for £70 after five years. The issue price of the securities was £64. The
securities were traded in the market and the market prices at various different dates
are shown in the table below.

Date Market price

of securities (£)

1 April 2003 64
1 April 2004 65
1 April 2005 60
1 April 2006 65
1 April 2007 68
1 April 2008 70

(i) Explain why the price of the securities might have fallen between 1 April 2004
and 1 April 2005. [1]

Two investors bought the securities at various dates. Investor X bought 100 securities
on 1 April 2003 and 1,000 securities on 1 April 2005. Investor Y bought 100
securities every year on 1 April from 2003 to 2007 inclusive. Both investors held the
securities until maturity.

(ii) Construct a table showing the nominal amount of the securities held and the
market value of the holdings for X and Y on 1 April each year, just before any
purchases of securities. [5]

(iii) (a) Calculate the effective money weighted rate of return per annum for X
for the period from 1 April 2003 to 1 April 2008.

(b) Calculate the effective time weighted rate of return per annum for X
for the period from 1 April 2003 to 1 April 2008.
[6]

(iv) (a) Determine whether the effective money weighted rate of return for Y is
lower or higher than that for X for the period from 1 April 2003 to
1 April 2008.

(b) Determine the effective time weighted rate of return per annum for Y
for the period from 1 April 2003 to 1 April 2008.
[7]

(v) Discuss the relationship between the different rates of return that have been
calculated. [3]
[Total 22]

END OF PAPER

CT1 S2010—5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT

September 2010 Examinations

Subject CT1 — Financial Mathematics

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

T J Birse
Chairman of the Board of Examiners

December 2010

© Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

Comments

Please note that different answers may be obtained from those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown. Candidates
also lose marks for not showing their working in a methodical manner which the examiner
can follow. This can particularly affect candidates on the pass/fail borderline when the
examiners have to make a judgement as to whether they can be sure that the candidate has
communicated a sufficient command of the syllabus to be awarded a pass.

The general standard of answers was noticeably lower than in previous sessions and there
were a significant number of very ill-prepared candidates. As in previous exams, questions
that required an element of explanation or analysis were less well answered than those which
just involved calculation.

Comments on individual questions, where relevant, can be found after the solution to each
question. These comments concentrate on areas where candidates could have improved their
performance.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

1 Working in half years:

3.5
The present value of the security on 1st June would have been
i( )
2

3.5
(1 + i ) 365
80
20 August is 80 days later so the present value is
i ( 2)

3.5
(1.1) 365 = £36.611
80
Hence the price per £100 nominal is
0.097618

2 (i) (a) Gross rate of return convertible half yearly is simply 4/110 = 0.03636
or 3.636%.

2
⎛ 0.03636 ⎞
(b) Gross effective rate of return is ⎜1 + ⎟ − 1 = 0.03669 or 3.669%
⎝ 2 ⎠

0.03636
(ii) The net effective rate of return per half year is 0.75 × = 0.013635 .
2

The net effective rate of return per annum is therefore:

(1.013635)2 − 1 = 0.02746 or 2.746%.

A common error was to divide the nominal payments by the increase in the index factor
(rather than multiplying).

3 (a) Let S20 be the accumulation of the unit investment after 20 years:

E ( S20 ) = E ⎡⎣(1 + i1 )(1 + i2 ) …(1 + i20 ) ⎤⎦

E ( S 20 ) = E [1 + i1 ] E [1 + i2 ]… E [1 + i20 ] as {it } are independent

E [it ] = j ∴ E ( S 20 ) = (1 + j )
20
=2

1
⇒ j=2 20 − 1 = 3.5265%

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

(b) The variance of the effective rate of return per annum is s 2 where

( )
20
Var [ Sn ] = (1 + j ) + s 2 − (1 + j )
2 40
= 0.62

( ) ⎥⎦
1
⎡ 2⎤ 20
s = ⎢0.62 + (1 + j ) − (1 + j )
2 20 2

( )
1
1
= 0.62 + 22 −2 = 0.004628
20
10

Many candidates made calculation errors in this question but may have scored more marks if
their working had been clearer.

4 (i) Assuming no arbitrage, buying the share is the same as buying the forward
except that the cash does not have to be paid today and a dividend will be
payable from the share.

Therefore, price of forward is:

700 (1.05 ) (1.03) 12 − 20 (1.03) 12

1 5 5
12

= 711.562 – 20.248 = 691.314

(ii) The no arbitrage assumption means that we can compare the forward with the
asset from which the forward is derived and for which we know the market
price. As such we can calculate the price of the forward from this, without
knowing the expected price at the time of settlement. [It could also be
mentioned that the market price of the underlying asset does, of course,
already incorporate expectations].

(iii) If it was not known with certainty that the dividend would be received we
could not use a risk-free interest rate to link the cash flows involved with the
purchase of the forward with all the cash flows from the underlying asset.

5 (a) Eurobonds

• Medium-to-long-term borrowing.
• Pay regular coupon payments and a capital payment at maturity.
• Issued by large corporations, governments or supranational organisations.
• Yields to maturity depend on the risk of the issuer.
• Issued and traded internationally (not in core reading).
• Often have novel features.
• Usually unsecured
• Issued in any currency
• Normally large issue size
• Free from regulation of any one government

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

(b) Convertible Securities

• Generally unsecured loan stocks.

• Can be converted into ordinary shares of the issuing company.
• Pay interest/coupons until conversion.
• Provide levels of income between that of fixed-interest securities and equities.
• Risk characteristics vary as the final date for convertibility approaches.
• Generally less volatility than in the underlying share price before conversion.
• Combine lower risk of debt securities with the potential for gains from
equity investment.
• Security and marketability depend upon issuer
• Generally provide higher income than ordinary shares and lower income than
conventional loan stock or preference shares

6 (i) Net present value (all figures in £m)

(
= −2, 000 + 0.1× 200 × v3 v 0.5 + 1.1v1.5 + 1.12 v 2.5 + … + 1.15 v5.5 )
( )
+0.2 × 200 × v3 v + 1.1v 2 + 1.12 v3 + … + 1.15 v 6 + 3,500v9

at 8% per annum effective.

= −2, 000 +
200
1.1
( )( 2 3 6
)
0.1v 2.5 + 0.2v3 1.1v + (1.1v ) + (1.1v ) + … + (1.1v ) + 3,500v9

= −2, 000 +
200
1.1
( )
0.1v 2.5 + 0.2v3 a6' + 3,500v9

0.08 − 0.1
where the annuity is evaluated at a rate of = −1.818% per annum
1 + 0.1
effective.

−6
1 − (1 − 0.018181)
a6' = = 6.4011
−0.018181

and so net present value is

−2, 000 +
200
1.1
( )
0.1×1.08−2.5 + 0.2 ×1.08−3 × 6.4011 + 3,500 ×1.08−9 = £31.66m

(ii) Accumulated profit at the time of sale is 31.66 ×1.089 = £63.30m

Many candidates assumed that the accumulation in part (i) was for a single payment.

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

7 (i) The present value of the assets is equal to the present value of the liabilities.
The duration of the assets is equal to the duration of the liabilities.

The spread of the asset terms around the duration is greater than that for the
liability terms (or, equivalently, convexity of assets is greater).

(ii) (a) Present value of liabilities (in £m)

= 10a10 at 4% = 10 × 8.1109 = 81.109

10 ( Ia )10 41.9922
(b) Duration is equal to at 4% = = 5.1773 years
10a10 8.1109

(c) Let the amounts to be invested in the two zero coupon bonds be X and
Y.

Xv3 + Yv12 = 81.109 (1)

3 Xv3 + 12Yv12 = 419.922 (2)

(2) less 3 times (1) gives:

9Yv12 = 176.595

176.595
⇒Y = = £31.415m
9 × 0.62460

Substituting back into (1) gives:

X=
(81.109 − 31.415 × 0.62460 ) = £69.164m
0.88900

(iii) (a) In one year, the present value of the liabilities is:

10 + 10a9 at 5% = 10 + 10 × 7.1078 = 81.078

Numerator of duration is 10 × 0 + 10 ( Ia )9 = 332.347

332.347
Duration of liabilities is therefore = 4.0991 years
81.078

Present value of assets is:

69.164 × v 2 + 31.415 × v11 = 69.164 × 0.90703 + 31.415 × 0.58468

= 81.101

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

Duration of assets will be:

2 × 69.164 × v 2 + 11× 31.415 × v11

81.101

2 × 69.164 × 0.90703 + 11× 31.415 × 0.58468

= = 4.0383 years
81.101

(b) One of the problems of immunisation is that there is a need to

continually adjust portfolios. In this example, a change in the interest
rate means that a portfolio that has a present value and duration equal
to that of the liabilities at the outset does not have a present value and
duration equal to that of the liabilities one year later.

The calculation was often performed well. In part (ii), many explanations were unclear and
some candidates seemed confused between DMT and convexity although a correct
explanation could involve either of these concepts.

8 (i) t ≤ 20 :

v ( t ) = exp ⎛⎜ − ∫ 0.05 + 0.001sds ⎞⎟

t

⎝ 0 ⎠
⎧ ⎡ t ⎫
⎪ 0.001s 2 ⎤ ⎪
= exp ⎨− ⎢0.05s + ⎥ ⎬
⎪⎩ ⎣⎢ 2 ⎦⎥ ⎪
0⎭

= e −0.05t −0.0005t
2

t > 20 :

⎧ ⎫
v ( t ) = exp ⎨− ⎛⎜ ∫ δ ( s ) ds + ∫ 0.05ds ⎞⎟ ⎬
20 t

⎩ ⎝ 0 20 ⎠⎭

{
= v ( 20 ) exp − [ 0.05s ] 20
t
}
= e−1.2e1−0.05t = e −0.2−0.05t

(ii) (a) PV = 100v ( 25 ) = 100e −0.2−0.05×25

= 100e−1.45 = £23.46

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

4×25
⎛ d ( 4) ⎞
(b) 100 ⎜1 − ⎟ = 100v ( 25 ) = 23.46
⎜ 4 ⎟
⎝ ⎠

(
⇒ d ( ) = 4 1 − 0.2346 100 = 0.05758
4 1
)
25 −0.015t − (0.2+0.05t )
(iii) PV = ∫ 20 30e e dt

−0.2 25 −0.065t 30e −0.2 ⎡ −0.065t ⎤ 25

= 30e ∫ 20
e dt =
−0.065 ⎣
e
⎦ 20

30e −0.2 −1.625 −1.3

=
−0.065
e ( −e = 28.575 )
28.575
Accumulated value = = 28.575e0.2+ 0.05×25 = 28.575e1.45 = 121.82
v ( 25 )

9 (i) The one-year spot rate of interest is simply 4% per annum effective.

For two-year spot rate of interest

First we need to find the price of the security, P:

P = 8a2 + 100v 2 at 3% per annum effective.

a2 = 1.91347 v 2 = 0.942596

⇒ P = 8 × 1.91347 + 100 × 0.942596 = 109.5673

Let the t-year spot rate of interest be it.

We already know that i1 = 4%. i2 is such that:

8 108
109.56736 = +
1.04 (1 + i2 )2
−2
⇒ (1 + i2 ) = 0.943287

⇒ i2 = 0.029623 or 2.9623%.

Page 8
Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

For three-year spot rate of interest we need to find the price of the security P:

P = 8a3 + 100v3 at 3% per annum effective.

a3 = 2.8286 v3 = 0.91514

⇒ P = 8 × 2.8286 + 100 × 0.91514 = 114.1428

i3 is such that:

8 8 108
114.1428 = + +
1.04 (1.029623) (1 + i3 )3
2

108
⇒ = 114.1428 − 15.23860 = 98.9042
(1 + i3 )
3

⇒ i3 = 0.02976 or 2.976%.

(ii) The one year forward rate of interest beginning at the present time is clearly
4%.

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

1.04 (1 + f1,1 ) = 1.0296232 ⇒ f1,1 = 0.01935 = 1.935%.

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

1.0296232 (1 + f 2,1 ) = 1.029763 ⇒ f 2,1 = 0.03003 = 3.003%.

The forward rate for two years beginning in one year is f1,2 such that:

1.029763 = 1.04 (1 + f1,2 )

2

⇒ f1,2 = 0.02468 = 2.468%

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

(iii) Let the t-year “spot rate of inflation” be et

(1 + it )t = 1.02 ⇒ (1 + et )
t t ⎛ 1 + it ⎞
=⎜
t
For each term ⎟
(1 + et )t ⎝ 1.02 ⎠

1.04
(1 + e1 ) = ⇒ e1 = 1.96%
1.02

and so the value of the retail price index after one year would be 101.96

2
⎛ 1.029623 ⎞
(1 + e2 ) 2
=⎜ ⎟ ⇒ e2 = 0.943%
⎝ 1.02 ⎠

and so the value of the retail price index after two years would be
100 (1.00943) = 101.90
2

3
⎛ 1.02976 ⎞
(1 + e3 ) 3
=⎜ ⎟ ⇒ e3 = 0.9569%
⎝ 1.02 ⎠

and so the value of the retail price index after three years would be
100 (1.009569 ) = 102.90
3

(iv) The “spot” rates of inflation or the price index values could be used.

Clearly the expected rate of inflation in the first year is 1.96%.

The expected rate of inflation in the second year is:

101.90 − 101.96
= − 0.06%.
101.96

The expected rate of inflation in the third year is:

102.90 − 101.90
= 0.98%
101.90

A common error was to assume that income only started after three years rather than
“starting from the beginning of the third year”.

Page 10
 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

10 (i) The price of the securities might have fallen because interest rates have risen
or because their risk has increased (for example credit risk).

(ii)

Date Market X Y
price of No of Market No of Market
securities securities value of securities value of
(£) held holdings held holdings
before before before before
purchases purchases purchases purchases
(£) (£)

1 April 2003 64 – – – –
1 April 2004 65 100 6,500 100 6,500
1 April 2005 60 100 6,000 200 12,000
1 April 2006 65 1,100 71,500 300 19,500
1 April 2007 68 1,100 74,800 400 27,200
1 April 2008 70 1,100 77,000 500 35,000

(iii) (a) Money weighted rate of return is i where:

6, 400 (1 + i ) + 60, 000 (1 + i ) = 77, 000

5 3

try i = 5% LHS = 77,625.70

try i = 4% LHS = 75,278.42

interpolation implies that

77, 625.70 − 77, 000

i = 0.05 − 0.01× = 4.73%
77, 625.70 − 75, 278.42

(Note true answer is 4.736%)

(b) Time weighted rate of return is i where using figures in above table:

6, 000 77, 000

(1 + i )5 = = 1.09375.
6, 400 6, 000 + 60, 000

⇒ i = 1.808%

Page 11
 Subject CT1 (Financial Mathematics Core Technical) — September 2010 — Examiners’ Report

(iv) (a) Money weighted rate of return is i where:

6, 400 (1 + i ) + 6,500 (1 + i ) + 6, 000 (1 + i ) + 6,500 (1 + i ) + 6,800 (1 + i )

5 4 3 2

= 35,000

Put in i = 4.73%; LHS = 37,026.95

Therefore the money weighted rate of return for Y is less to make LHS
less.

(b) Time weighted rate of return for Y uses the figures in the above table:

6,500 12, 000 19,500 27, 200 35, 000

(1 + i )5 =
6, 400 6,500 + 6,500 12, 000 + 6, 000 19,500 + 6,500 27, 200 + 6,800

= 1.09375.

⇒ i = 1.808%

(Student may reason that the TWRRs are the same and can be derived
from the security prices in which case, time would be saved.)

(v) The money weighted rate of return was higher for X than for Y because there
was a much greater amount invested when the fund was performing well than
when it was performing badly.

The money weighted rate of return for X (and probably for Y) was more than
the time weighted rate of return because the latter measures the rate of return
that would be achieved by having one unit of money in the fund from the
outset for five years: both X and Y has less in the fund in the years it
performed badly.

This question was answered well but examiners were surprised by the large number of
candidates who used interpolation or other trial and error methods in part (ii) when the
answer had been given in the question. The examiners recommend that students pay attention
to the details given in the solutions to parts (iii) and (iv). For such questions, candidates
should be looking critically at the figures given/calculated and making points specific to the
scenario rather than just making general statements taken from the Core Reading.

END OF EXAMINERS’ REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

19 April 2011 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 A2011 © Institute and Faculty of Actuaries

1 The force of interest, δ(t), is a function of time and at any time t, measured in years, is
given by the formula

⎧⎪0.04 + 0.003t 2 for 0 < t ≤ 5

δ(t ) = ⎨
⎪⎩0.01 + 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]

2 A one-year forward contract on a stock is entered into on 1 January 2011 when the
stock price is £68 and the risk-free force of interest is 14% per annum. The stock is
expected to pay an annual dividend of £2.50 with the next dividend due in eight
months’ time.

On 1 April 2011, the price of the stock is £71 and the risk-free force of interest is 12%
per annum. The dividend expectation is unchanged.

Calculate the value of the contract to the holder of the long forward position on
1 April 2011. [6]

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 Rate of dividend per Retail price

in year share (£) index

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]

CT1 A2011—2
4 The n-year spot rate of interest yn , is given by:

n
yn = 0.03 + for n = 1, 2, 3 and 4
1000

(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]

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]

CT1 A2011—3 PLEASE TURN OVER

6 The value of the assets held by a pension fund on 1 January 2010 was £10 million.
On 30 April 2010, the value of the assets had fallen to £8.5 million. On 1 May 2010,
the fund received a contribution payment of £7.5 million and paid out £2 million in
benefits. On 31 December 2010, the value of the fund was £17.1 million.

(i) Calculate the annual effective money-weighted rate of return (MWRR) for
2010. [3]

(ii) Calculate the annual effective time-weighted rate of return (TWRR) for 2010.
[3]

(iii) Explain why the MWRR is higher than the TWRR for 2010. [2]

The fund manager’s bonus for 2010 is based on the return achieved by the fund over
the year.

(iv) State, with reasons, which of the two rates of return calculated above would be
more appropriate for this purpose. [2]
[Total 10]

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]

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]

CT1 A2011—4
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]

(ii) Calculate the discounted payback period for the project, assuming a rate of
interest of 8% per annum effective. [5]
[Total 12]

10 The annual rates of return from a particular investment, Investment A, are

independently and identically distributed. Each year, the distribution of (1 + it ) , where
it is the rate of interest earned in year t , is log-normal with parameters μ and σ2 .

The mean and standard deviation of it are 0.06 and 0.03 respectively.

(i) Calculate μ and σ2 . [5]

An insurance company has liabilities of £15m to meet in one year’s time. It currently
has assets of £14m. Assets can either be invested in Investment A, described above,
or in Investment B which has a guaranteed return of 4% per annum effective.

(ii) Calculate, to two decimal places, the probability that the insurance company
will be unable to meet its liabilities if:

(a) All assets are invested in Investment B.

(b) 75% of assets are invested in Investment A and 25% of assets are
invested in Investment B. [6]

(iii) Calculate the variance of return from each of the portfolios in (ii)(a) and
(ii)(b). [3]
[Total 14]

END OF PAPER
CT1 A2011—5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2011 examinations

Subject CT1 — Financial Mathematics

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.

T J Birse
Chairman of the Board of Examiners

July 2011

© Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

General comments

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

The general performance was slightly worse than in April 2010 but well-prepared candidates
scored well across the whole paper. As in previous diets, questions that required an element
of explanation or analysis, such as Q3(ii) and Q6(iii) were less well answered than those that
just involved calculation. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Where no comment is made the
question was generally answered well by most candidates.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

∫ 3 δ( s ) ds
7

1 (i) We want 1000e

∫
= 1000 e ⎢⎣ 3
( ∫5 )
⎡ 5 0.04+ 0.003s 2 ds + 7 ( 0.01+ 0.03s )ds ⎤
⎥⎦

∫3 ( 0.04 + 0.003s ) ds = ⎡⎣0.04s + 0.001 s ⎤⎦3

5 2 3 5
where

= 0.325 – 0.147 = 0.178

7
7 ⎡ 0.03 2 ⎤
and ∫ ( 0.01 + 0.03s ) ds = ⎢0.01s + s ⎥
5 ⎣ 2 ⎦5

= 0.805 − 0.425 = 0.380

⇒ accumulation at t = 7 is

1000e(
0.178+ 0.380 )
= 1000e0.558 = 1, 747.17

4×12
⎛ d (12 ) ⎞
(ii) 1747.17 ⎜ 1 − ⎟ = 1000
⎜ 12 ⎟
⎝ ⎠

⇒ d ( ) = 0.138692
12

2 Forward price of the contract is K 0 = ( S0 − I ) eδT = ( 68 − I ) e0.14×1

−0.14× 812
where I is the present value of income during the term of the contract = 2.5e

(
⇒ K 0 = 68 − 2.5e
−0.14× 812
)e 0.14
= 75.59919

Forward price a new contract issued at time r (3 months) is

( )
K = S − I * e ( ) = 71 − I ∗ e
r r
δ T −r
(
0.12× 912
)
(where I * is the present value of income during the term of the contract)
= 2.5e
−0.12× 512
( )
⇒ K 0.25 = 71 − 2.5e −0.05 e0.09 = 75.08435

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

Value of original contract = ( K r − K 0 ) e ( )

−δ T − r

−0.12×912
= ( 75.08435 − 75.59919 ) e

= −0.47053 = −47.053 p

Many candidates failed to incorporate the change in the value of δ. Another common error
was in counting the number of months.

121.4 121.4 2 121.4 3

3 (i) 135, 000 = 7,900 × . ν + 8, 400 × ν + 8,800 × ν
125.6 131.8 138.7

121.4 4 121.4 5
+9, 400 × ν + (10,100 + 151, 000 ) × v
145.3 155.2

at i′ % where i′ = real yield

Approx yield:

135, 000 = (7635.828 + 7737.178 + 7702.379 + 7853.820 + 126015.077) ν5

⇒ i′ 3.1% p.a.

Try i′ = 3%, RHS = 137434.955

Try i′ = 3.5%, RHS = 134492.919

135000 − 134492.919
i′ = 0.035 − 0.005 ×
137434.955 − 134492.919

= 0.03414 (i.e. 3.4% p.a.)

(ii) The term:

121.4
8,800 ×
RPI (June 2008)

would have a lower value (i.e. the dividend paid on 30 June 2008 would have
a lower value when expressed in June 2005 money units). The real yield
would therefore be lower than 3.4% p.a.

The most common error on this question was incorrect use of the indices, e.g. many
candidates inverted them. Several candidates also had difficulty in setting up the equation of

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

value. The examiners noted that a large number of final answers were given to excessive
levels of accuracy given the approximate methods used.

4 (i) We can find forward rates f2,1 and f2,2 from:

(1 + y3 )3 = (1 + y2 )2 (1 + f 2,1 ) and

(1 + y4 )4 = (1 + y2 )2 (1 + f 2,2 )
2

⇒ (1.033) = (1.032 ) (1 + f 2,1 )

3 2

⇒ f 2,1 = 3.50029 % p.a.

and (1.034 ) = (1.032 ) (1 + f 2,2 )

4 2 2

⇒ f 2,2 = 3.60039 % p.a.

(ii) (a) Price per £100 nominal

(
4 v
3.1%
+ v2
3.2%
+ v3
3.3%
) + 115 v
3.3%
3

= 4 ( 0.969932 + 0.938946 + 0.907192 ) + 115 × 0.907192

= 115.59

(b) Let yc3 = 3 − year par yield

1 = yc3 v (
3.1%
+ v2
3.2%
+ v3
3.3%
)+ v 3.3%
3

1 = yc3 ( 0.969932 + 0.938946 + 0.907192 ) + 0.907192

⇒ yc3 = 0.032957

i.e. 3.2957% p.a.

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

2
⎛ i( 2) ⎞
5 (i) ⎜1 + ⎟ = 1.05 ⇒ i ( 2 ) = 4.939% (or use tables)
⎜ 2 ⎟
⎝ ⎠

0.06
g (1 − t1 ) = × 0.80 = 0.0457
1.05

So i ( ) > g (1 − t1 ) ⇒ there is a capital gain on the contract

2

(ii) Since there is a capital gain, the loan is least valuable to the investor if the
repayment is made by the borrower at the latest possible date. Hence, we
assume redemption occurs 25 years after issue in order to calculate the
minimum yield achieved.

(iii) If A is the price per £100 of loan:

( 2)
(1.05)12 + (105 − 0.35 (105 − A) ) v
2 2410
A = 100 × 0.06 × 0.80 a 12 at 5%
25

= 4.8 × 1.012348 × 14.0939 × (1.05 )12 + (105 − 0.35 (105 − A ) ) × 0.29771

2

69.0452 + 20.3187
Hence A = = 99.759
1 − 0.35 × 0.29771

⇒ Price of loan = £99,759

The majority of this question was well-answered but most candidates struggled with the two
month adjustment. This adjustment needs to be directly incorporated into the equation of
value. Calculating the price first without adjustment and then multiplying by (1+i)1/6 will lead
to the wrong answer.

6 (i) MWRR is given by:

8
10.0 × (1 + i ) + 5.5 × (1 + i ) 12 = 17.1

Try 11%, LHS = 16.996

Try 12%, LHS = 17.132

17.1 − 16.996
MMRR = 0.11 + 0.01× = 11.8%p.a.
17.132 − 16.996

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

(ii) TWRR is given by:

8.5 17.1
× = 1 + i ⇒ i = 3.821%p.a.
10.0 8.5 + 5.5

(iii) MWRR is higher since fund received a large (net) cash flow at a favourable
time (i.e. just before the investment returns increased).

(iv) TWRR is more appropriate. Cash flows into and out of the fund are outside
the control of the fund manager, and should not influence the level of bonus
payable. TWRR is not distorted by amount and/or timing of cash flows
whereas MWRR is.

The calculations in parts (i) and (ii) were generally well done but parts (iii) and (iv) were
poorly answered (or not answered at all) even by many of the stronger candidates. In (iii) for
example, candidates were expected to comment on the timing of the cashflows for this
particular year.

7 (i) Let initial quarterly amount be X . Work in time units of one quarter. The
effective rate of interest per time unit is

0.08
= 0.02 (i.e.2% per quarter)
4

So

60, 000 = X a80 + 100v16 a64 + 100v32 a48 + 100v 48 a32 + 100v 64 a16 at 2%

1 − v 64
2%
(where a64 = = 35.921415)
0.02

= 39.7445 X + 2, 616.695465 + 1, 627.606705 + 907.1436682 + 382.3097071

60, 000 − 5,533.756

⇒X=
39.7445

= £1,370.41 per quarter

(ii) Interest paid at the end of the first quarter (i.e. on 1 October 1998) is

60, 000 × 0.02 = £1, 200

Hence, capital repaid on 1 October 1998 is

1370.41 − 1200 = £170.41

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

Therefore, interest paid on 1 January 1999 is

( 60000 − 170.41) × 0.02 = 1196.59

⇒ capital repaid on 1 January 1999 is

1370.41 − 1196.59 = 173.82

(iii) Loan outstanding at 1 July 2011 (after repayment of instalment)

= 1670.41 a12 + 1770.41 ν12 a16 at 2%

= 1670.41×10.5753 + 1770.41× 0.78849 × 13.5777

= £36,619

Candidates found this to be the most challenging question on the paper. The easiest method
was to work in quarters with an effective rate of 2% per quarter. Where candidates worked
using a year as the time period the most common error was to allow for an increase to
payments of £100 pa when the increases were £400pa when they occurred. In part (i), the
examiners were disappointed to see many attempts with incorrect and/or insufficient working
end with the numerical answer that had been given in the question. A candidate who claims
to have obtained a correct answer after making obvious errors in the working is not
demonstrating the required level of skill and judgement and, indeed, is behaving
unprofessionally.

Part (iii) was very poorly answered with surprisingly few candidates recognising the
remaining loan was simply the present value of the last 28 payments.

8 (i) No, because the spread (convexity) of the liabilities would always be greater
than the spread (convexity) of the assets then the 3rd Redington condition
would never be satisfied.

(ii) Work in £millions

Let proceeds from four-year bond = X

Let proceeds from 20-year bond = Y

Require PV Assets = PV Liabilities

X ν 4 + Y ν 20 = 10ν3 + 20ν 6 (1)

Require DMT Assets = DMT Liabilities

⇒ 4 X ν 4 + 20Y ν 20 = 30ν3 + 120ν 6 (2)

Page 8
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

(2) − 4 × (1)

⇒ 16Yν20 = 40ν6 − 10ν3

40ν 6 − 10ν3 31.61258 − 8.88996

⇒Y = = = £3.11175m
16ν 20 7.30219

From (1):

10ν3 + 20ν 6 − Y ν 20 8.88996 + 15.80629 − 1.42016

X= = = £27.22973m
ν4 0.8548042

So amount to be invested in 4‐year bond is

Xν4=£23.27609m

And amount to be invested in 20-year bond is

Yν20 = £1.42016m

Require Convexity of Assets > Convexity of Liabilities

⇒ 20 X ν 6 + 420Y ν 22 > 120ν5 + 840ν8

LHS = 981.869 > 712.411 = RHS

Therefore condition is satisfied and so above strategy will immunise company

against small changes in interest rates.

Or state that spread of assets (t = 4 to t = 20) is greater than spread of

liabilities (t = 3 to t = 6).

Part (i) was poorly answered. In part (ii) many candidates correctly derived X and Y as the
proceeds from the two bonds. However, only the better candidates recognised that the
amounts to be invested (as required by the question) were therefore Xv4 and Yv20.

9 (i) PV of outgo (£000s)

⎛ 1 ⎞
105 ⎜1 + v 2 + v ⎟ + 200v15 = 366.31 at 8%
⎜ ⎟
⎝ ⎠

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

PV of income

⎡ 20v + 23v 2 + 26v3 + 29v 4 ⎤

⎢ ⎥
( )
a1
⎢ + 29v51.03 1 + (1.03v ) + (1.03v ) + ... + (1.03v ) ⎥
2 24
⎣ ⎦
⎡ ⎛ 1 − (1.03)25 v 25 ⎞ ⎤
= a1 ⎢ 20v + 23v + 26v + 29v + 29v 1.03 × ⎜
2 3 4 5 ⎟⎥
⎢ ⎜ 1 − 1.03v ⎟⎥
⎣ ⎝ ⎠⎦

PV of income

= a1 {80.193 + 20.329 ×14.996} = 370.61

So NPV is 4.30 (=£4,300)

(ii) The NPV is very small. It is considerably less than the PV of the final year’s
( )
income 29 × (1.03) × a1 × v 29 = 6.272 ; therefore the DPP must fall in the
25

final year.

We know the DPP exists as the NPV > 0.

So DPP is 29 + r where

⎧ ⎛ 1 − (1.03)24 v 24 ⎞ ⎫⎪
⎪
366.31 = a1 × ⎨80.193 + 20.329 × ⎜ ⎟⎬
⎪⎩ ⎜ 1 − 1.03v ⎟⎪
⎝ ⎠⎭

+29 × 1.0325 × v 29 × ar at 8%

⇒ 366.31 = 364.335 + 6.5169ar

⇒ ar = 0.3031

⇒ v r = 0.97668 ⇒ r = 0.307

So the DPP is 29.31.

This question tended to separate out the stronger and weaker candidates. The most common
errors in part (i) were discounting for an extra year, not including the one-year annuity
factor and incorrectly calculating the geometric progression. Many candidates also lost
marks through poorly presented or illegible methods that were therefore difficult for the
examiners to follow. Part (ii) was poorly attempted with few candidates completing the
question.

Page 10
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

10 (i)
E (1 + it ) = 1.06

Var (1 + it ) = 0.032 = 0.0009

⎛ μ+ σ2 ⎞
⎜ 2 ⎟⎠
⇒ 1.06 = e⎝ (1)

0.0009 = e
( 2μ+σ2 )
( eσ − 1
2
) (2)

⇒
( 2 ) = 0.0009 = eσ2 − 1
(1)2 (1.06 )2
⎛ 0.0009 ⎞
⇒ σ = Ln ⎜
2
+ 1⎟
⎜ (1.06 )2 ⎟
⎝ ⎠

= 0.000800676 ( and σ = 0.0282962 )

⎛ 0.000800676 ⎞
⎜ μ+ ⎟
⇒ 1.06 = e⎝ 2 ⎠

0.000800676
∴μ = Ln (1.06 ) −
2

= 0.0578686

(ii) (a) Working in £m. Assets would accumulate to 14 × 1.04 = 14.56 < 15

⇒ Probability = 1.00

(b) The guaranteed portion of the fund would accumulate to

0.25 ×14 × 1.04 = 3.64.

Page 11
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, April 2011

∴ non-guaranteed portion needs to accumulate to

15 − 3.64 = 11.36

∴ we require probability that

( 0.75 ×14 ) (1 + it ) < 11.36

= Pr (1 + it ) < 1.081905

= Pr ( ln (1 + it ) < ln 1.081905 )

⎛ ln (1 + it ) − 0.0578686 ln1.081905 − 0.0578686 ⎞

= Pr ⎜ < ⎟
⎝ 0.0282962 0.0282962 ⎠

= Pr ( Z < 0.7370169 ) where Z ∼ N ( 0,1) .

= 0.77

(iii) (a) Return is fixed (= 4% p.a.) ⇒ variance of return = 0

(b) Return from portfolio = 0.25 × 0.04 + 0.75 it

∴ Variance of return = 0.752Var ( it )

= 0.752 × 0.0009 = 0.00050625

[In monetary terms the variance of return for (iii)(b) will be

( £14m )2 × 0.00050625 = £ 299, 225m which is equivalent to a standard
deviation of £315,000]

This question was generally well answered by those candidates who had left enough time to
fully attempt the question. In part (i) the common errors were equating the mean to 0.06
instead of 1.06 and using 0.03 as the variance instead of 0.032. Part (ii) was also well
answered although many candidates quoted the probability of meeting liabilities when the
probability of not meeting the liabilities was asked for. Part (iii) a) was answered well by the
candidates who attempted it, while part b) was not answered well. In part (iii) answers given
in terms of the annual return and in terms of the monetary amounts were both fully
acceptable.

END OF EXAMINERS’ REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

27 September 2011 (am)

Subject CT1 — Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 S2011 © Institute and Faculty of Actuaries

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]

2 State the characteristics of index-linked government bonds. [3]

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]

4 A pension fund makes the following investments (£m):

1 January 2009 1 July 2009 1 January 2010

1.5 6.0 4.0

The rates of return earned on money invested in the fund were as follows:

1 January 2009 to 1 July 2009 to 1 January 2010 to

30 June 2009 31 December 2009 31 December 2010
1% 2% 5%

Assume that 1 January to 30 June and 1 July to 31 December are precise half-year
periods.

(i) Calculate the time-weighted rate of return per annum effective over the two
years from 1 January 2009 to 31 December 2010. [3]

(ii) Calculate the money-weighted rate of return per annum effective over the two
years from 1 January 2009 to 31 December 2010. [3]
[Total 6]

CT1 S2011—2
5 A nine-month forward contract is issued on 1 March 2011 on a stock with a price of
£9.56 per share at that date. Dividends of 20 pence per share are expected on both
1 April 2011 and 1 October 2011.

(i) Calculate the forward price, assuming a risk-free rate of interest of 3% per
annum effective and no arbitrage. [4]

(ii) (a) Explain why the expected price of the share in nine months’ time is not
needed to calculate the forward price.

(b) Explain why the price of an option would be explicitly dependent on

the variance of the share price but the price of a forward would not be.
[4]
[Total 8]

6 The force of interest, δ(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]

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]
(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]

CT1 S2011—3 PLEASE TURN OVER

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]

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]

CT1 S2011—4
 (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]

10 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 2025:

• 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.

(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]

END OF PAPER

CT1 S2011—5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2011 examinations

Subject CT1 — Financial Mathematics

Core Technical

Purpose of Examiners’ Reports

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners are not required to examine the content of Core Reading. Notwithstanding that,
the questions set, and the following comments, will generally be based on Core Reading.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report. Other valid approaches are always given appropriate credit; where there is a
commonly used alternative approach, this is also noted in the report. For essay-style
questions, and particularly the open-ended questions in the later subjects, this report contains
all the points for which the Examiners awarded marks. This is much more than a model
solution – it would be impossible to write down all the points in the report in the time allowed
for the question.

T J Birse
Chairman of the Board of Examiners

December 2011

© Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

General comments on Subject CT1

CT1 provides a grounding in financial mathematics and its simple applications. It introduces
compound interest, the time value of money and discounted cashflow techniques which are
fundamental building blocks for most actuarial work.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Comments on the September 2011 paper

The general performance was considerably better than in September 2010 and also slightly
better than in April 2011. Well-prepared candidates scored well across the whole paper.
As in previous diets, questions that required an element of explanation or analysis, such as
Q5(ii) and Q9(iv) were less well answered than those that just involved calculation. Marginal
candidates should note that it is important to explain and show understanding of the concepts
and not just mechanically go through calculations. The comments that follow the questions
concentrate on areas where candidates could have improved their performance. Where no
comment is made the question was generally answered well by most candidates.
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

(1 − 365 ) ( )
−91
1 91 × 0.08 = 1 + i 365

−91
0.980055 = (1 + i ) 365

1 + i = 1.08416 ⇒ i = 8.416%

2 Issued by the government

Pay regular interest
Redeemable at a given redemption date
Normally liquid/marketable
More or less risk-free relative to inflation
Low expected return
Low default risk
Coupon and capital payments linked to an index of prices…
… with a time lag.

This type of bookwork question is common in CT1 exam papers. As such, it was disappointing
that only about one-sixth of candidates obtained full marks here (which could be achieved by
listing six distinct features).

3 Let the annual rate of payment = X

( 4)
Present value of the payments = Xa
4

Present value of the payments needed from the annuity is:

(12 ) (12 )
8, 000a v 4 + 3, 000a v 7
3 10

( 4) (12 ) (12 )
Xa = 8, 000a v 4 + 3, 000a v 7
4 3 10

a3 = 2.7232 i = 1.031059
d( )
4

a4 = 3.5460 a10 = 7.7217 i = 1.026881 v 4 = 0.82270 v 7 = 0.71068

d( )
12

i i i
X a4 = 8, 000 a v 4 + 3, 000 a v7
d (4)
d (12 ) 3
d (12 ) 10

X ×1.031059 × 3.5460 = 8, 000 ×1.026881× 2.7232 × 0.82270

+3, 000 × 1.026881× 7.7217 × 0.71068

3.65614 X = 18, 404.80 + 16.905.51

Page 3
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

X = £9, 657.81

∴ Quarterly payment is: £2,414.45.

Many candidates struggled to allow correctly for the Government pension. In some cases,
candidates would have scored more marks if they had explained their methodology and their
workings more clearly.

4 (i) The fund value on 30 June 2009 will be:

1.5 × 1.01 = 1.515

The fund value on 31 December 2009 will be:

(1.5 ×1.01 + 6 ) ×1.02 = 7.6653

The fund value on 31 December 2010 will be:

⎡⎣(1.5 ×1.01 + 6 ) ×1.02 + 4 ⎤⎦ ×1.05 = 12.2486

TWRR is i such that:

1.515 7.6653 12.2486

= (1 + i ) = 1.0817
2
× ×
1.5 7.515 11.6653

∴ i = 4.005%

(This can also be calculated directly from the rates of return for which no
marks would be lost).

(ii) The equation of value is:

1.5 (1 + i ) + 6.0 (1 + i ) + 4 (1 + i ) = 12.2486

2 11 2

Try i = 4% LHS = 12.146

Try i = 4.5% LHS = 12.22754

Try i = 5% LHS = 12.3094

Page 4
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

Interpolate:

12.2486 − 12.22754
i = 0.045 + × 0.005
12.3094 − 12.22754

= 0.04629 or 4.63%

A common error was to assume that the 1% and 2% rates of return were annualised figures
rather than returns over a six-month period.

5 (i) Forward price is accumulated value of the share less the accumulated value of
the expected dividends:

F = 9.56 (1.03) − 0.2 (1.03) − 0.2 (1.03)

9 8 2
12 12 12

= 9.7743 – 0.20398 – 0.20099

= £9.3693

(ii) (a) Although the share will be bought in nine months, it is not necessary to
take into account the expected share price. The current share price
already makes an allowance for expected movements in the price and
the investor is simply buying an instrument that is (more or less)
identical to the underlying share but with deferred payment. As such,
under given assumptions, the forward can be priced from the underlying
share.

(b) An option does not have to be exercised. As such, movements in the

share price in one direction will benefit the holder whereas movements
in the other direction will not harm him. The more volatile is the
underlying share price, the more potential there is for gain for the
holder of the option (with limited risk of loss), compared with holding
the underlying share. This is not the case for a forward which has to be
exercised.

Part (i) was well-answered but part (ii) was very poorly answered. The examiners anticipated
that many candidates would find part (ii)(b) challenging but it was pleasing to see some of
the strongest candidates give some well-reasoned explanations for this part.

Page 5
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

( a +bt )dt
5
6 (i) 45e ∫0 = 55 (1)

( a +bt )dt
10
45e ∫0 = 120 (2)

From (1)
5
⎡ bt 2 ⎤
45exp ⎢ at + ⎥ = 55
⎣⎢ 2 ⎦⎥
0

⎛ 55 ⎞
ln ⎜ ⎟ = 5a + 12.5b = 0.2007 (1a)
⎝ 45 ⎠

From (2)

10
⎡ bt 2 ⎤
45exp ⎢ at + ⎥ = 120
⎢⎣ 2 ⎥⎦
0

⎛ 120 ⎞
ln ⎜ ⎟ = 10a + 50b = 0.98083
⎝ 45 ⎠

From (1a)

10a = 0.4014 − 25b (2a)

Substituting into (2a)

0.4014 + 25b = 0.98083

0.98083 − 0.4014
∴b = = 0.02318
25

Substituting into (1a)

5a + 12.5 × 0.02318 = 0.2007

0.2007 − 12.5 × 0.0231772

∴a = = −0.01781
5

(ii) 45e10δ = 120

120 ⎛ 120 ⎞
e10δ = ;10δ = ln ⎜ ⎟ = 0.98083
45 ⎝ 45 ⎠

∴δ = 0.09808 or 9.808 %

Page 6
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

7 (i) Expected price of the shares in five years is:

X = 2v + 2.5v 2 + 2.5 ×1.01× v3 + 2.5 ×1.012 v 4 + ...

(
= 2v + 2.5v 2 + 2.5v 2 1.01v + 1.012 v 2 + .... )
1
1.01v + 1.012 v 2 + ... at 8% =
i'
1.08
where i ' = − 1 = 0.069307
1.01
2.5 × 0.85734
X = 2 × 0.92593 + 2.5 × 0.85734 +
0.069307

= 3.9952 + 30.9254 = 34.9206

Equation of value for the investor is:

12 (1 + i ) = 34.9206
5

i = 0.23817 or 23.817%

12 (1 + i ) = 34.9206 − ( 34.9206 − 12 ) × 0.25

5
(ii)

where i is the net rate of return.

12 (1 + i ) = 29.1905
5

i = 0.1946 or 19.46%

(iii) The cash flow received in nominal terms is still the same: 29.190495

The equation of value expressed in real terms is:

29.1905
12 = v5 where f = 0.04
(1 + f ) 5

12 × (1.04 )
5
v =
5
= 0.50016
29.1905
1
∴ v = 0.50016 5 = 0.87061

i = 14.86%

Page 7
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

8 (i) The present value of the assets is equal to the present value of the liabilities at
the starting rate of interest.

The duration /discounted mean term/volatility of the assets is equal to that of

the liabilities.

The convexity of the assets (or the spread of the timings of the asset
cashflows) around the discounted mean term is greater than that of the liabilities.

(ii) (a) PV of liabilities is: £100m a40 at 4%

= £100m×19.7928

= £1,979.28m

(b) The duration of the liabilities is:

t = 40 t = 40
∑ 100t vt / ∑ 100vt (working in £m)
t =1 t =1

t = 40
100 ∑ t vt
t =1
100 ( Ιa )40
= = at 4%
1,979.28 1,979.28

100 × 306.3231
= = 15.4765 years
1,979.28

(iii) Let x = nominal amount of five-year bond

y = nominal amount of 40-year bond.

working in £m

1,979.28 = xv5 + yv 40 ⎯ (1)

30, 632.31 = 5 xv5 + 40 yv 40 ⎯ (2)

multiply equation (1) by 5.

9,896.4 = 5 xv5 + 5 yv 40 ⎯ (1a)

subtract (1a) from (2) to give

20735.91 = 35yv 40

20, 735.91
=y
35 × v 40

Page 8
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

with v 40 = 0.20829

y = 2,844.38

Substitute into (1) to give:

1,979.28 = Xv5 + 2,844.38 × 0.20829

v5 = 0.82193

1,979.28 − 2,844.38 × 0.20829

= x = 1, 687.28
0.82193

Therefore £1,687.28m nominal of the five-year bond and £2,844.38m nominal

of the 40-year bond should be purchased.

(iv) (a) The duration of the liabilities is 15.4765

15.4765
Therefore the volatility of the liabilities is =14.88125%
1.04

The value of the liabilities would therefore change by:

1.5 × 0.1488125 × 1,979.28m = £441.81m

and the revised present value of the liabilities will be £2,421.09m.

(b) PV of liabilities is: £100m a40 at 2.5%

1 − 1.025−40
= £100m× 0.025

= £2,510.28m.

(c) The PV of liabilities has increased by £531m. This is significantly

greater than that estimated in (iv) (a). This estimation will be less valid
for large changes in interest rates as in this case.

The first three parts were generally well-answered but, in part (iv), the examiners were
surprised that so few candidates were able to use the duration to estimate the change in the
value of the liability.

Page 9
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

9 (i) (a) The theoretical rate of return that could be achieved over a given time
period in the future from investment in government bonds today.

(b) The theoretical rate of return that could be achieved between the
current time and a given future time from investment in government
bonds.

(c) The gross redemption yield that could be theoretically achieved by

investing in government bonds of different terms to redemption. The
yield curve represents a statistical average gross redemption yield.

(ii)
Time Government Valuation rate P.V factor
bond yield of interest
1 0.02 0.031 0.96993
2 0.04 0.052 0.90358
3 0.06 0.073 0.80947
4 0.08 0.094 0.69812
5 0.1 0.115 0.58026

PV = 10 ( 0.96993 + 0.90358 + 0.80947 + 0.69812 + 0.58026 ) + 100 × 0.58026

= 97.6396.

(iii) GRY is such that: 97.6396 = 10a5 + 100v5

Try 11% a5 = 3.69590 v5 = 0.59345 RHS = 96.30397
Try 10% a5 = 3.7908 v5 = 0.62092 RHS = 100 [calculation not necessary]

Interpolate to find i:

97.6396 − 96.30397
i=− × 0.01 + 0.11
100 − 96.30397

⇒ i = 0.10639 or 10.64%

(iv) It is reasonable for the investor to price a corporate bond with reference to the
rates of return from government bonds which may be (more or less) risk free.

A risk premium will then need to be added.

It is also not unreasonable that this risk premium rises with term as the
uncertainty regarding credit risk rises.

This question proved to be the most difficult on the paper. The examiners had anticipated that
some candidates would have difficulty with part (i) but it was disappointing to see the number
of candidates who were unable to give even a basic description of a spot rate and a forward
rate. Part (iv) was also very poorly answered and whilst it had been anticipated that only the

Page 10
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

strongest candidates would make all the relevant points, the examiners were surprised at how
many candidates failed to score any marks on this part.

10 (i) The payback period measures the earliest time at which the project breaks
even but takes no account either of interest on borrowings or on cash flows
received after the payback period. It is therefore a poor measure of ultimate
profitability.

(ii) The present value of preparation costs is (in £m):

2a2 @ 4% per annum effective.

i i
= 2. .a2 = 1.019869 a2 = 1.8861
δ δ

= 2 × 1.019869 ×1.8861 = 3.847

The present value the stadium building costs is (in £m):

4 12 5 12 6 12 13 12
200v + 200 × 1.05v + 200 ×1.052 v + ... + 200 ×1.059 v

200v
4 12
(1 + 1.05v + 1.05 v 2 2
+ ... + 1.059 v9 )
4 12 ⎡1 − 1.0510 v10 ⎤
= 200v ⎢ ⎥
⎣⎢ 1 − 1.05v ⎦⎥

4 12
with v = 0.96154 v10 = 0.67556 1.0510 = 1.62889 v = 0.83820

⎛ 1 − 1.62889 × 0.67556 ⎞
= 200 × 0.83820 × ⎜ ⎟
⎝ 1 − 1.05 × 0.96154 ⎠

= £1, 750.837

Present value of admin. costs is (£m):

(12 )
100a v13 @ 4%
2

i
with = 1.021537 v13 = 0.60057 a2 = 1.8861
d (12 )

= 100 ×1.021537 ×1.8861× 0.60057

= 115.714

Page 11
 Subject CT1 (Financial Mathematics Core Technical) — Examiners’ Report, September 2011

Present value of revenue (£m):

i
3,300a1 v14 with = 1.019869 a1 = 0.9615 v14 = 0.57748
δ

= 3,300 ×1.019869 × 0.9615 × 0.57748

= 1,868.781

NPV = 1,868.781 – 115.714 – 1,750.837 – 3.847 = –£1.617m.

Therefore should not make a bid.

(iii) One way of dealing with this would be to multiply the NPV of all the revenues
and costs that are only received if the bid is won by 0.1.

The costs of preparing the bid would be incurred for certain and therefore not
multiplied by 0.1. This adjustment would make it less likely the bid will go
ahead because the only certain item is a cost.

This question contained a potential ambiguity regarding the timing of the administration
costs. Although the examiners felt that the approach given in the model solution was the most
logical, candidates who assumed that the administration costs were only payable during
2025 were given full credit. This question was answered well and it was very pleasing to see
that (a) candidates managed their time efficiently and so left enough time to make a good
attempt at the question with the most marks and (b) candidates who made calculation errors
still clearly explained their method and so were able to pick up significant marks for their
working.

END OF EXAMINER’S REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

24 April 2012 (am)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 A2012 © Institute and Faculty of Actuaries

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 3-year bond which pays coupons of
3% annually in arrear, and is redeemed at par. Show all workings. [6]

(ii) Calculate the 4-year par yield. [3]

[Total 9]

2 The value of the assets held by an investment fund on 1 January 2011 was £2.3
million.

On 30 April 2011, the value of the assets had risen to £2.9 million and, on 1 May
2011, there was a net cash inflow to the fund of £1.5 million. On 31 December 2011,
the value of the assets was £4.2 million.

(i) Calculate the annual effective time-weighted rate of return (TWRR) for 2011.
[2]

(ii) Calculate, to the nearer 0.1%, the annual effective money-weighted rate of
return (MWRR) for 2011. [4]

(iii) Explain why the TWRR is significantly higher than the MWRR for 2011. [2]
[Total 8]

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]

CT1 A2012–2
4 (i) Explain what is meant by the “no arbitrage” assumption in financial
mathematics. [2]

An investor entered into a long forward contract for a security four years ago and the
contract is due to mature in five years’ time. The price of the security was £7.20 four
years ago and is now £10.45. The risk-free rate of interest can be assumed to be 2.5%
per annum effective throughout the nine-year period.

(ii) Calculate, assuming no arbitrage, the value of the contract now if the security
will pay dividends of £1.20 annually in arrear until maturity of the contract.
[3]

(iii) Calculate, assuming no arbitrage, the value of the contract now if the security
has paid and will continue to pay annually in arrear a dividend equal to 3% of
the market price of the security at the time of payment. [3]
[Total 8]

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]

CT1 A2012–3 PLEASE TURN OVER

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]

7 The annual yields from a fund are independent and identically distributed. Each year,
the distribution of 1 + i is log-normal with parameters μ = 0.05 and σ2 = 0.004, where
i denotes the annual yield on the fund.

(i) Calculate the expected accumulation in 20 years’ time of an annual investment

in the fund of £5,000 at the beginning of each of the next 20 years. [5]

(ii) Calculate the probability that the accumulation of a single investment of £1

made now will be greater than its expected value in 20 years’ time. [5]
[Total 10]

CT1 A2012–4
8 The force of interest, δ(t), at time t is given by:

⎧0.04 + 0.003t 2 for 0 < t ≤ 5

⎪
δ ( t ) = ⎨0.01 + 0.03t for 5 < t ≤ 8
⎪0.02 for t > 8
⎩

(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 100e 0.01t from time t = 10 to t = 18. [4]
[Total 10]

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 110.0 112.3 113.2 113.8

at start of year:
[5]
[Total 9]

CT1 A2012–5 PLEASE TURN OVER

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]

END OF PAPER

CT1 A2012–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2012 examinations

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners are not required to examine the content of Core Reading. Notwithstanding that,
the questions set, and the following comments, will generally be based on Core Reading.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report. Other valid approaches are always given appropriate credit; where there is a
commonly used alternative approach, this is also noted in the report. For essay-style
questions, and particularly the open-ended questions in the later subjects, this report contains
all the points for which the Examiners awarded marks. This is much more than a model
solution – it would be impossible to write down all the points in the report in the time allowed
for the question.

T J Birse
Chairman of the Board of Examiners

July 2012

© Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

General comments on Subject CT1

CT1 provides a grounding in financial mathematics and its simple applications. It introduces
compound interest, the time value of money and discounted cashflow techniques which are
fundamental building blocks for most actuarial work.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Comments on the April 2012 paper

The general performance was broadly similar to the previous two exams. Well-prepared
candidates scored well across the whole paper. As in previous diets, questions that required
an element of explanation or analysis, such as Q2(iii), Q5(iii) and Q6(iv) were less well
answered than those that just involved calculation. Marginal candidates should note that it is
important to explain and show understanding of the concepts and not just mechanically go
through calculations. The comments that follow the questions concentrate on areas where
candidates could have improved their performance. Where no comment is made the question
was generally answered well by most candidates.

Page 2
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

1 (i) Price, P, of £100 nominal stock is:

P = 3v y1 + 3v 2y2 + 103v3y3
where
y1 = 0.041903
y2 = 0.043625
y3 = 0.045184

⇒ P = 95.845

And gross redemption yield, i%, solves:

95.845 = 3a3 + 100v3 at i %

Try 4% RHS = 97.225

5% RHS = 94.554

97.225 − 95.845
⇒ i = 0.04 + 0.01×
97.225 − 94.554

= 0.0452

i.e. 4.5% p.a.

(ii) y1, y2 and y3 as above. y4 = 0.046594

( )
1 = ( yc4 ) v y1 + v 2y2 + v3y3 + vY44 + v 4y4

⇒ 1 = yc4 × 3.587225 + 0.8334644

⇒ yc4 = 0.04642 i.e. 4.642% p.a.

2 (i) TWRR, i , is given by:

2.9 4.2
× = 1 + i ⇒ i = 0.204 or 20.4% p.a.
2.3 2.9 + 1.5

(ii) MWRR, i , is given by:

8
2.3 × (1 + i ) + 1.5 (1 + i ) 12
= 4.2

Page 3
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

Then, we have:

i = 12% ⇒ LHS = 4.1937 ⎫ ⎛ 4.2 − 4.1937 ⎞

⎬ ⇒ i = 0.12 + ( 0.13 − 0.12 ) × ⎜ ⎟
i = 13% ⇒ LHS = 4.2263 ⎭ ⎝ 4.2263 − 4.1937 ⎠

= 0.122

or 12.2% p.a.

(iii) The MWRR is lower as fund performs better before the cash inflow than after.
Then, as the fund is larger after the cash inflow on 1 May 2011, the effect of
the poor investment performance after this date is more significant in the
calculation of the MWRR.

The calculations were performed well but the quality of the explanations in part (iii) was
often poor. This type of explanation is commonly asked for in CT1 exams. To get full marks,
candidates should address the specific situation given in the question rather than just repeat
the bookwork.

3 (i) Let R = annual repayment

9%
500, 000 = R a10 = R × 6.4177

⇒ R = 77, 910.04

and total interest = 10 × 77,910.04 − 500, 000

= 279,100

(ii) (a) Capital outstanding at beginning of 8th year is:

77910.04 a39% = 77909.53 × 2.5313

= 197, 213.28

Let R ′ be new payment per annum then

( 4)
R′ a = R′ ×1.043938 × 3.0373 = 197, 213.28
4

⇒ R′ = 62,196.62

and quarterly payment is £15,549.16

Page 4
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

(b) Interest content of 2nd quarterly payment is:

(
15549.16 × 1 − v12%
4 33
= 5383.41 )
[Or Capital in 1st quarterly payment is

( 1
15549.16 − 197213.28 × 1.12 4 − 1 = 9,881.77 )
So capital outstanding after 1st quarterly payment

= 197213.28 − 9881.77 = 187331.51

⇒ Interest in next payment is

187331.51× ⎛⎜1.12 4 − 1⎞⎟ = 5383.41 ]

1

⎝ ⎠

Generally answered well but a number of candidates made errors in calculating the
remaining term in part (ii)

4 (i) The “no arbitrage” assumption means that neither of the following applies:

(a) an investor can make a deal that would give her or him an immediate
profit, with no risk of future loss;

nor

(b) an investor can make a deal that has zero initial cost, no risk of future
loss, and a non-zero probability of a future profit.

(ii) The current value of the forward price of the old contract is:

2 12 %
7.20 × (1.025 ) − 1.20 a
4
5

whereas the current value of the forward price of a new contract is:

2 12 %
10.45 − 1.20 a
5

Hence, current value of old forward contract is:

10.45 − 7.20 × (1.025 ) = £2.5025

4

Page 5
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

(iii) The current value of the forward price of the old contract is:

−9
7.20 (1.025 ) (1.03)
4
= 6.0911

whereas the current value of the forward price of a new contract is:

−5
10.45 (1.03) = 9.0143

⇒ current value of old forward contract is:

9.0143 − 6.0911 = £2.9232

This was the most poorly answered question on the paper but well-prepared candidates still
scored full marks. Some candidates in part (ii) assumed that the dividend income was
received during the lifetime of the forward contract. Whilst the examiners did not believe that
such an approach was justified, candidates who assumed this alternative treatment of the
income were not penalised. It was very clear that the poor performance on the question was
not as result of this alternative interpretation.

5 (i) The equation of value is:

1309.5 = 100 a ( ( ) + (1.05) v

5
4 5 5 ( 4)
a
5
( 4)
+ … + (1.05 ) v 20 a
20
5 ) −12a( )
4
25

Rearranging:

⎛ 25 ⎞
( 4 ) ⎜ 1 − (1.05v ) ⎟ ( 4)
1309.5 = 100a − 12a
5 ⎜ 5 ⎟
⎝ 1 − (1.05v ) ⎠
25

At 9%, RHS is:

⎛ ⎛ 1.05 ⎞25 ⎞
⎜ 1− ⎜ ⎟ ⎟
⎜ ⎝ 1.09 ⎠ ⎟
100 ×1.033144 × 3.8897 × − 12 ×1.033144 × 9.8226
⎜ 1.05 ⎞ ⎟
5
⎛
⎜⎜ 1 − ⎜ ⎟ ⎟⎟
⎝ ⎝ 1.09 ⎠ ⎠
0.607292
= 401.8570 × − 121.7779
0.170505

= 1309.53 ⇒ IRR is 9% p.a.

Page 6
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

(ii) For Project B the equation of value is

( 4) ( 4)
1000 = 85a + v 20 90a
20 5

Roughly 1000 85a25 ⇒ i 7%

At 7% RHS is 1039.05
= 85 × 1.043380 × 10.5940 + 0.25842 × 1.043380 × 4.1002 × 90

8% RHS is 956.78
= 85 × 1.049519 × 9.8181 + 0.21455 × 1.049519 × 3.9927 × 90

⇒i 7.5% p.a.

(iii) Project A is more attractive since it has the higher IRR. However, the investor
will also need to take into account other factors such as:

• the outlay is much higher for Project A than Project B

• the interest rate at which the investor might need to borrow at to finance a
project since it will affect the net present values and discounted payback
periods of the projects

• the risks for each project that the rents and expenses will not be those
assumed in the calculations.

In part (i) candidates were asked to demonstrate that the internal rate of return was a given
value. In such questions, candidates should set up the equation of value and clearly show
each stage of their algebra and their calculations (including the evaluation of all factors that
make up the equation). Many candidates claimed that they had shown the correct answer
despite obvious errors and/or insufficient working. Candidates who tried to create a
“proof” where the arguments didn’t follow logically gained few marks. In this type of
question, if you can’t complete a proof, it is better to show how far you have got and be open
about being unable to proceed further. This will generally gain more intermediate markst.

Part (ii) was answered well but in part (iii) few candidates came up with any of the other
factors that should be considered.

Page 7
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

6 (i) Price per £100 nominal is given by:

3.158%
⎛ 1 − v18 ⎞
P = 5 × a18 + 100v18
3.158% = 5 × ⎜⎜ 3.158% 18
⎟⎟ + 100v3.158% = 125.00
⎝ 0.03158 ⎠

(ii) As coupons are payable annually and the gross redemption yield is equal to
the annual coupon rate, the new price per £100 nominal is £100.

5%
⎛ 1 − v13 ⎞
i.e. P = 5a13 + 100v13 = 5⎜ 5% 13
⎟⎟ + 100v5% = 100.00
5% ⎜ 0.05
⎝ ⎠

(iii) Equation of value is:

125.00 = 5a5 + 100v5 ⇒ i = 0%

Thus, the investor makes a return of 0% per annum over the period.

(iv) Longer-dated bonds are more volatile.

Thus, as a result of the rise in gross redemption yields from 3.158% per annum
on 1 March 2007 to 5% on 1 March 2012, the fall in the price of the bond
would be greater.

Thus, as the income received over the period would be unchanged, the overall
return achieved would be reduced (as a result of the greater fall in the capital
value).
[In fact, the price on 1 March 2007 would have been £133.91 per £100
nominal falling to £100 per £100 nominal on 1 March 2012.

i.e. in this case, we need to find i such that 133.91 = 5a5 + 100V 5 ⇒ i < 0% .]

The first three parts were generally well-answered although relatively few candidates noticed
that parts (ii) and (iii) could be answered quickly and consequently many candidates made
avoidable calculation errors.

μ+ 1 2 σ 2
7 (i) E (1 + i ) = e

0.05+ 1 2×0.004
=e

= 1.0533757

∴ E [i ] = 0.0533757 since E (1 + i ) = 1 + E ( i )

Page 8
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

Let A be the accumulation of £5000 at the end of 20 years

then E [ A] = 5000 s20 at rate j = 0.0533757

( (1 + j ) − 1) 20

= 5000 × (1 + j )
j

= 5000
(1.0533757 20
) ×1.0533757
−1
0.0533757

= £180,499

(ii) Let the accumulation be S20

S20 has a log-normal distribution with parameters 20μ and 20σ2

( )
∴ E [ S20 ] = e
20μ+ 12 20σ2
{or (1 + j ) }
20

= exp ( 20 × 0.05 + 10 × 0.004 )

= e1.04 = 2.829217

(
ln S20 ∼ N 20μ, 20σ2 )
i.e. ln S20 ∼ N (1, 0.08)

( )
P S20 > e1.04 = P ( ln S20 > 1.04 )

⎛ 1.04 − 1 ⎞
= P⎜ Z > ⎟ where Z ∼ N ( 0,1)
⎝ 0.08 ⎠

= P ( Z > 0.14 ) = 1 − Φ ( 0.14 )

= 1 − 0.56 = 0.44

Questions regarding annual investments are comparatively rarely asked on this topic and
students seemed to struggle with part (i). Part (ii) was answered better in general than
equivalent questions in previous exams.

Page 9
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

8 (i) for t > 8

v ( t ) = exp − {∫ 5
0
8 t
0.04 + 0.003t 2 dt + ∫ 0.01 + 0.03tdt + ∫ 0.02dt
5 8 }
⎧ 5 8 t⎫
= exp − ⎨ ⎡ 0.04t + 0.001t 3 ⎤ + ⎡ 0.01t + 0.015t 2 ⎤ + [ 0.02t ]8 ⎬
⎩ ⎣ ⎦ 0 ⎣ ⎦ 5 ⎭
{ ( )
= exp − 0.2 + 0.125 + 0.01× 3 + 0.015 82 − 52 + 0.02t − 0.02 × 8 }
= exp − {0.325 + 0.615 + 0.02t − 0.16}
=e (
− 0.78+ 0.02t )

Hence PV of £1,000 due at t = 10 is:

1000 × exp − ( 0.78 + 0.02 ×10 ) = £375.31

4×10
⎛ d ( 4) ⎞
(ii) 1000 ⎜1 − ⎟ = 375.31
⎜ 4 ⎟
⎝ ⎠

40
⎛ d ( 4) ⎞ 375.31
⎜1 − ⎟ =
⎜ 4 ⎟ 1000
⎝ ⎠

⎛ ⎛ 375.31 ⎞ 140 ⎞
d( )
4
= 4 ⎜1 − ⎜ ⎟
⎜ ⎝ 1000 ⎟⎠ ⎟
⎝ ⎠

= 0.09681

18
(iii) PV = ∫ ρ ( t ) v ( t ) dt
10

= ∫ 100e0.01t × e (
18 − 0.78+ 0.02t )
10

18
= 100e−0.78 ∫ e−0.01t dt
10

⎧ −0.01t ⎤18 ⎫
−0.78 ⎪ ⎡ e ⎪
= 100e ⎨⎢ ⎥ ⎬
⎪⎩ ⎢⎣ −0.01 ⎥⎦10 ⎪⎭

Page 10
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

=
0.01
e (
100 −0.78 −0.1 −0.18
e −e )
= £318.90

Parts (i) and (ii) were answered well. Some candidates made errors in part (iii) by not
discounting the payment stream back to time 0.

(i)

(
PV = 100 × 0.35 1.03v + 1.03 × 1.05v 2 + 1.03 × 1.05 × 1.06v3 + 1.03 × 1.05 × 1.062 v 4 + )
⎛ 1.03 × 1.05 × 1.06v3 ⎞
= 35 ⎜1.03v + 1.03 × 1.05v 2 + ⎟⎟ @ 8%
⎜ 1 − 1.06 v
⎝ ⎠
⎛ 1.03 1.03 ×1.05 1.03 × 1.05 ×1.06 1.08 ⎞
= 35 ⎜ + + ×
⎝ 1.08 1.082 1.083 0.02 ⎟⎠
= 35 ( 0.95370 + 0.92721 + 49.14223)
= £1785.81

(ii) Real rate of return is i such that:

⎛ 110 110 2 110 3 ⎞ 110 3

1720 = 35 ⎜1.03 × v + 1.03 ×1.05 × v + 1.03 ×1.05 ×1.06 × v ⎟ + 1800 × v
⎝ 112.3 113.2 113.8 ⎠ 113.8

( )
= 35 1.0089047v + 1.050928v 2 + 1.108110v3 + 1739.894552v3

= 35.3116645v + 36.78248v 2 + 1778.678402v3

For initial estimate, assume all income received at end of 3 years:

1720 ≈ 1850.77v3

⇒ v ≈ 0.9758696 ⇒ i ≈ 2.4727

Try i = 2.5%, RHS = 1721.14 ≈ 1720

so i = 2.5%

Most candidates made a good attempt at part (i) although slight errors in setting up the
equation and/or in the calculation were common. Many candidates struggled with setting up
the required equation in part (ii).

Page 11
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

10 (i) Working in 000’s

PVL = 200a20 + 300v15 @ 8%

= 200 × 9.818147 + 300 × 0.315242
= 2058.20199

i.e. £2,058,201.99

(ii)
200v + 200 × 2v 2 + 200 × 3v3 + + 200 × 20v 20 + 300 ×15v15
DMTL =
200a20 + 300v15
200 ( Ia )20 + 300 ×15v15
= @ 8%
2058.20199
200 × 78.9079 + 300 ×15 × 0.31524
=
2058.20199
17200.175
= = 8.3569 years
2058.20199

(iii) Redington’s first two conditions are:

⇒ PVL = PVA
⇒ DMTL = DMTA

Let the nominal amount in securities A and B be X and Y respectively.

( ) (
PVA = PVL ⇒ X 0.09a12 + v12 + Y 0.04a30 + v30 = 2058201.99 @ 8% )
⇒ X ( 0.09 × 7.5361 + 0.39711) + Y ( 0.04 ×11.2578 + 0.09938 )
⇒ 1.075361X + 0.549689Y = 2058201.99
2058201.99 − 0.549689Y
⇒X=
1.075361

DMTA = DMTL ⇒
( ) (
X 0.09 ( Ia )12 + 12v12 + Y 0.04 ( Ia )30 + 30v30 ) = 8.3569
2058201.99
(
⇒ X 0.09 ( Ia )12 + 12v 12
) + Y ( 0.04 ( Ia )
30 )
+ 30v30 = 17200175 @ 8%
⇒ X ( 0.09 × 42.17 + 12 × 0.39711) + Y ( 0.04 × 114.7136 + 30 × 0.09938 ) = 17200175
⇒ 8.56066 X + 7.56986Y = 17200175

⇒ 8.56066 ×
( 2058201.99 − 0.549689Y ) + 7.56986Y = 17200175
1.075361
⇒ 3.19394Y = 815370.9
⇒ Y = 255287, X = 1783470

Page 12
 Subject CT1 (Financial Mathematics) – April 2012 – Examiners’ Report

Hence company should purchase £1,783,470 nominal of security A and

£255,287 nominal of security B for Redington’s first two conditions to be
satisfied.

(iv) Redington’s third condition is that the convexity of the asset cash flow series
is greater than the convexity of the liability cash flow series. Therefore the
convexities of the asset cash flows and the liability cash flows will need to be
calculated and compared.

Generally well answered but candidates’ workings in part (iii) were often unclear which
made it difficult for examiners to award marks when calculation errors had been made.

END OF EXAMINERS’ REPORT

Page 13
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

3 October 2012 (am)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 S2012 © Institute and Faculty of Actuaries

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]

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]

3 An investment fund is valued at £120m on 1 January 2010 and at £140m on 1 January

2011. Immediately after the valuation on 1 January 2011, £200m is paid into the
fund. On 1 July 2012, the value of the fund is £600m.

(i) Calculate the annual effective time-weighted rate of return over the two-and-a
half year period. [3]

(ii) Explain why the money-weighted rate of return would be higher than the time-
weighted rate of return. [2]
[Total 5]

4 A ten-month forward contract was issued on 1 September 2012 for a share with a
price of £10 at that date. Dividends of £1 per share are expected on 1 December
2012, 1 March 2013 and 1 June 2013.

(i) Calculate the forward price assuming a risk-free rate of interest of 8% per
annum convertible half-yearly and no arbitrage. [4]

(ii) Explain why it is not necessary to use the expected price of the share at the
time the forward matures in the calculation of the forward price. [2]
[Total 6]

CT1 S2012–2
5 (i) State the characteristics of a Eurobond [4]

(ii) (a) State the characteristics of a certificate of deposit.

(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]
[Total 8]

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]

CT1 S2012–3 PLEASE TURN OVER

7 An individual wishes to make an investment that will pay out £200,000 in twenty
years’ time. The interest rate he will earn on the invested funds in the first ten years
will be either 4% per annum with probability of 0.3 or 6% per annum with probability
0.7. The interest rate he will earn on the invested funds in the second ten years will
also be either 4% per annum with probability of 0.3 or 6% per annum with probability
0.7. However, the interest rate in the second ten year period will be independent of
that in the first ten year period.

(i) Calculate the amount the individual should invest if he calculates the
investment using the expected annual interest rate in each ten year period. [2]

(ii) Calculate the expected value of the investment in excess of £200,000 if the
amount calculated in part (i) is invested. [3]

(iii) Calculate the range of the accumulated amount of the investment assuming the
amount calculated in part (i) is invested. [2]
[Total 7]

8 The force of interest, δ(t), is a function of time and at any time t, measured in years, is
given by the formula

⎧0.03 + 0.01t for 0 ≤ t ≤ 9

δ(t ) = ⎨
⎩0.06 for 9 < t

(i) Derive, and simplify as far as possible, expressions for ν(t) where ν(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]

CT1 S2012–4
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]

CT1 S2012–5 PLEASE TURN OVER

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]

END OF PAPER

CT1 S2012–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2012 examinations

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

D C Bowie
Chairman of the Board of Examiners

December 2012

© Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

General comments on Subject CT1

CT1 provides a grounding in financial mathematics and its simple applications. It introduces
compound interest, the time value of money and discounted cashflow techniques which are
fundamental building blocks for most actuarial work.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Comments on the September 2012 paper

The general performance was of a lower standard compared with the previous two exams.
Well-prepared candidates scored well across the whole paper. As in previous diets, questions
that required an element of explanation or analysis, such as Q3(ii), Q4(ii) and Q9(iii) were
less well answered than those that just involved calculation. This is an area to which
attention should be paid. Candidates should note that it is important to explain and show
understanding of the concepts and not just mechanically go through calculations. At the
other end of the spectrum, there was a difficulty for many candidates when it came to
answering questions involving introductory ideas.

The comments that follow the questions concentrate on areas where candidates could have
improved their performance. Where no comment is made the question was generally
answered well by most candidates.

Page 2
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

1 Let d be the annual simple rate of discount.

The discounted value of 100 in the deposit account would be x such that:

x = 100(1.04)−91/365 = 99.0269

∴ to provide the same effective rate of return a treasury bill that pays 100 must have a
⎛ 91 ⎞
price of 99.0269 and 100 ⎜1 − × d ⎟ = 99.0269
⎝ 365 ⎠

91 99.0269
∴ 1− ×d = = 0.990269
365 100

365
d = (1-0.990269) × =0.03903
91

Many candidates scored full marks on this question but many others failed to score any
marks at all. Some candidates incorrectly used (1-nd) as an accumulation factor

−δ /4 0.08
2 (i) e = 1− = 0.98 ∴δ = 0.080811
4

4
⎛ 0.08 ⎞
(ii) (1 + i)−1 = ⎜1 − ⎟ = 0.92237 ∴ i = 0.084166
⎝ 4 ⎠

12 4
⎛ d (12) ⎞ ⎛ 0.08 ⎞ (12)
(iii) ⎜⎜1 − ⎟ = ⎜1 − ⎟ = 0.92237 ∴ d = 0.080539
⎝ 12 ⎟⎠ ⎝ 4 ⎠

A lot of marginal candidates scored very badly on this question even though it was covering
an introductory part of the syllabus.

140 600
3 (i) (1 + i )2.5 = × = 2.05882
120 140 + 200

∴ 1 + i = 1.33490

∴ i = 33.49% p.a. effective.

(ii) The money weighted rate of return weights performance according to the
amount of money in the fund. The fund was performing better after it had
been given the large injection of money on 1/1/2011.

Page 3
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

Part (i) was answered well. The type of explanation asked for in part (ii) is commonly asked
for in CT1 exams. To get full marks, candidates should address the specific situation given in
the question rather than just repeat the bookwork.

4 (i) Present value of dividends, I, is:

I= v ( 1
4 +v
1
2 +v
3
4
)
Calculated at i′% when (1 + i ') = (1.04)2 = 1.0816

−1 − 12 − 34
So I = 1.0816 4 + 1.0816 + 1.0816
= 2.88499

Hence, forward price, F, is:

10
F = (10 − 2.88499)(1 + i′) 12 at 8.16%
= (10 − 2.88499 ) × 1.0816
10
12 = £7.5956

(ii) The price of the forward can be determined from the price of the share (for
which it is a close substitute). The forward is like the share but with delayed
settlement and without dividends.

5 (i) The characteristics of a Eurobond are:

• Medium- or long-term borrowing
• Unsecured
• Regular coupon payments
• Redeemed at par
• Issued and traded internationally/not in the jurisdiction of any one country
• Can be denominated in any currency (e.g. not the currency of issuer)
• Tend to be issued by large companies, governments or supra-national
organisations
• Yields depend on issue size and issuer (or marketability and risk)
• Issue characteristics may vary – market free to allow innovation

(ii) (a) The characteristics of a certificate of deposit are:

• Tradable certificate issued by banks stating that money has been
deposited
• Terms to maturity between one and six months
• Interest payable on maturity/issued at a discount
• Security and marketability will depend on issuing bank
• Active secondary market

Page 4
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

12
⎛ i (12 ) ⎞
Answer is i such that (1.01) ⎟ = (1.02 ) giving
12 24
(b) ⎜1 +
⎜ 12 ⎟
⎝ ⎠
i( ) = 36.119%
12

6 (i) Amount of loan is:

100( Ia)10 + 100a10 at 6% p.a.

= 100 ×36.9624 + 100 × 7.3601

= 3696.24 + 736.01 = £4,432.25

(ii) (a) the o/s loan after sixth instalment is:

100( Ia)4 + 700 a4

=100 × 8.4106 + 700 × 3.4651 = 841.06 + 2425.57 = £3,266.64

The interest component is therefore:

0.06 × 3266.64 = £196.00

(b) The capital component =

800-196.00 = £604.00

(iii) The capital remaining after the seventh instalment is

3266.64 – 604.00 = 2662.64

Let the new instalment = X

Xa8 = 2, 662.64 at 8%

a8 = 5.7466; X = 2,662.64/5.7466 = £463.34

7 (i) Expected annual interest rate in both ten-year periods =

0.04 ×0.3 + 0.06 × 0.7 = 0.054 or 5.4%

Amount of the investment would be X such that:

X (1.054)20 = 200,000

∴ X = £69,858.26

Page 5
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

(ii) Expected accumulation factors in both ten-year periods are:

0.3 (1.04)10 + 0.7(1.06)10 = 1.697667

The accumulation factors in each ten-year period are independent.

Therefore the expected accumulation is:

69,858.26 × 1.697667 × 1.697667

= £201,336.55

Therefore the value of investment over and above £200,000 = £1,336.55.

(iii) The extreme outcomes for the investment are:

69,858.26 × 1.0420 = 153,068.06

69,858.26 × 1.0620 = 224,044.91.

Therefore the range is: £70,976.85

Many candidates struggled with this question and seemed to have difficulty particularly with
part (ii). Part (iii) was also badly answered even though part (ii) was not needed to answer
part (iii).

8 (i) t≤9

t
− ∫ (0.03+0.01 s ) ds
v(t ) = e 0

⎡ 0.01s 2 ⎤ t
− ⎢0.03s + ⎥
⎢⎣ 2 ⎥⎦
=e 0

− ⎡0.03t +0.005t 2 ⎤
=e ⎣ ⎦

t>9

⎡9 t ⎤
− ⎢ ∫ δ( s ) ds + ∫ 0.06 ds ⎥
V (t ) = e ⎢⎣ 0 9 ⎥⎦

= V (9).e0.06(t −9)
= e−0.675 .e−0.06(t −9)
= e−(0.135+0.06t )

Page 6
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

(ii) (a) PV = 5, 000 e−(0.135+0.06×15)

= 5, 000 e−1.035
= £1, 776.13

(b) 1,776.13 eδ×15 = 5,000

eδ×15 = 2.81511

15δ = ln 2.81511

ln 2.81511
δ= = 0.0690
15

(iii)
15
− (0.135+ 0.06t )
P.V . = ∫e ×100 e−0.02t dt
11
15
= ∫ 100 e−0.135−0.08t dt
11
15
−0.135 ⎡ e−0.08t ⎤
= 100 e ⎢ ⎥
⎢⎣ −0.08 ⎥⎦11
= 100 e−0.135 (5.18479 − 3.76493)
= 124.055

Generally answered well but some candidates lost marks in part (i) by not deriving the
discount factor for t < 9.

9 (i) Expectations theory: yields on short and long-term bonds are determined by
expectations of future interest rates as it is assumed that a long-term bond is a
substitute for a series of short-term bonds.
[If interest rates are expected to rise (fall) long-term bonds will have higher
(lower) yields that short-term bonds.]

Liquidity preference: it is assumed that investors have an inherent preference

for short-term bonds because interest-rate sensitivity is lower. As such, (there
is an upward bias on the expectations-based yield curve) and longer-term
bonds will offer a higher expected return than implied by expectations theory
on its own. N.B. the part in brackets is not in core reading.

Market segmentation: bonds of different terms to redemption are attractive to

different investors with different liabilities.

Page 7
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

The supply of bonds of different terms to redemption will depend on the

strategy of the relevant issuer. The term structure is determined by the
interaction of supply and demand in each term-to-redemption segment.

(ii) Duration =
∑ tCt νt = 4 × ( Ia)n + 100n vn
∑ Ct νt 4 × an + 100 νn
For n = 1 to 5. Clearly duration on one-year bond is one year.

Term ( Ia)n 100νn an n100νn 4( Ia ) n

3 5.3580 86.384 2.7232 259.152 21.432
5 12.5664 78.353 4.3295 391.765 50.2656

Duration of three-year bond:

21.432 + 259.152
= 2.884 years
4 × 2.7232 + 86.384

Duration of five-year bond:

50.2656 + 391.765
= 4.620 years
4 × 4.3295 + 78.353

(iii) The duration of a bond is the average time of the cashflows weighted by
present value. The coupon payments of the 8% coupon bond will be a higher
proportion of the total proceeds than for the 4% coupon bond. Thus, a greater
proportion of the total proceeds of the 8% coupon bond will be received
before the end of the term. The average time of the cashflows will be shorter
and hence the duration will be lower.

(iv) Option 1

The equation of value would be:

95 = 4a4 + 79ν5

The rate of return is zero (incoming and outgoing cash flows are equal).

Option 2

The equation of value would be:

95 = 4a4 + ν 4 a8 + 100ν12

i = 2.5%

Page 8
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

RHS = 4 × 3.762 + 0.90595 × 7.1701 + 100 × 0.74356

= 15.0479 + 6.4958 + 74.3556 = 95.8993

i = 3%

RHS = 4 × 3.7171 + 0.88849 × 7.0197 + 100 ×0.70138

= 14.8684 + 6.2369 + 70.1380
= 91.2433

By interpolation:

⎛ 95.8998 − 95 ⎞
i = 0.005 × ⎜ ⎟ + 0.025
⎝ 95.8998 − 91.2433 ⎠

= 0.025966 or 2.6% per annum effective.

Hence Option 2 would provide the higher rate of return

(v) Two of the following:

• Option 2 creates a higher duration bond which might not be suitable for
the investor
….e.g. alternative investments may be available in the longer term
• The credit risk over the longer duration may be greater
• The inflation risk over the longer duration may be greater
• There may be tax implications because of the differing capital and income
combinations.
• the institution could reinvest the proceeds from option 1 at whatever rate
of return prevails.

Part (i) was often poorly answered even though this was bookwork and candidates also
struggled with part (ii). In part (ii) it is important to include the correct units for the
duration (in this case, years). Most candidates made a good attempt at part (iv) even if some
made calculation errors (e.g. in the calculation of the outstanding term of the bond under
Option 2). Marginal candidates scored badly on parts (iii) and (v).

10 (i) The payback period simply looks at the time when the total incoming cash
flows are greater than the total outgoing cash flows. It takes no account of
interest at all.

Though the discounted payback period takes account of interest that would
have to be paid on loans, it only looks at when loans used to finance outgoing
cash flows would be repaid and not at the overall profitability of the projects.

(ii) (a) Outgoing cash flow = £3m

In £m, at time t, total incoming cash flows are £0.64t

Page 9
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

We need t such that 3 = 0.64t

t=3 = 4.6875 years

0.64

(b) Present value of incoming cash flows at time t is:

⎛ 1 − νt ⎞
0.64at = 0.64 ⎜
⎜ δ ⎟⎟ where δ = 0.039221
⎝ ⎠

Require t such that:

⎛ 1 − νt ⎞
0.64 ⎜ =3
⎜ 0.039221 ⎟⎟
⎝ ⎠

1 - νt = 0.183848
νt = 0.816152
t ln ν = ln 0.816152

ln 0.816152
t =
ln ν

−0.203155
=− = 5.1798 years
−0.039221

(iii) Crossover point is the rate of interest at which the n.p.v. of the two projects is
equal. As the present value of the cash outflows for both projects is the same
at all rates of interest, the crossover point is the rate of interest at which the
present value of the cash inflows from both projects is equal.

P.V of cash inflows from Project B = 0.64a6

P.V of cash inflows from Project A =

1
1 2 5 12
0.5 ν 2 + 1.1× 0.5 × ν1 + " + 1.15 × 0.5 × ν
⎡1 − 1.16 × ν 6 ⎤
1
= 0.5ν ⎢ 2
⎥
⎢⎣ 1 − 1.1× ν ⎥⎦

Therefore require i such that:

1 ⎡ 1 − 1.1 ν ⎤
6 6
0.64 a6 − 0.5 ν 2 ⎢ ⎥=0
⎣⎢ 1 − 1.1ν ⎦⎥

Page 10
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

Let i = 4%

a6 = 5.2421 i = 1.019869
δ
1
ν 2 = 0.98058 ν = 0.96154
ν 6 = 0.79031
1.16 = 1.77156

⎡1 − 1.77156 × 0.79031 ⎤
LHS = 0.64 × 5.2421× 1.019869 − 0.5 × 0.98058 ⎢
⎣ 1 − 1.1× 0.96154 ⎥⎦
= 3.4216 – 0.49029 ×6.93490 = 3.4216 – 3.4001
= 0.0215

Let i = 0%

⎡1 − 1.77156 ⎤
LHS = 0.64 × 6 − 0.5 × ⎢ = 3.84 - 3.8578 = -0.0178
⎣ 1 − 1.1 ⎥⎦

Given that NPV of Project A is greater than that of project B at 0% per annum
effective and the reverse is true at 4% per annum effective, the NPV of the two
projects must be equal at some point between 0% and 4%.

(iv) Project A

Duration is:

1
ν 2 0.5(0.5 + 1.1×1.5ν + 1.12 × 2.5 ν 2 + 1.13 × 3.5ν3 + 1.14 × 4.5ν 4 + 1.15 × 5.5 × ν5 )
0.49029 × 6.93490

Term in brackets is

0.5 + 1.58654 + 2.79678 + 4.14139 + 5.63183 + 7.28047 = 21.93702.

0.98059 × 0.5 × 21.93702

∴ Duration = = 3.163 years
0.49029 × 6.93490

Project B

6
0.64 ∫ t νt dt
Duration is : 0
=
( Ia )6
=
( i
δ a6 − 6ν 6 )δ
6 a6 i a6
δ
0.64 ∫ νt dt
0

Page 11
 Subject CT1 (Financial Mathematics) – September 2012 – Examiners’ Report

=
(1.019869 × 5.2421 − 6 × 0.79031) 0.039221
1.019869 × 5.2421

15.41000
= 2.882 years
5.3462

(v) Project A has a longer duration and therefore the present value of its incoming
cash flows is more sensitive to changes in the rate of interest. As such, when
the interest rate rises, the present value of incoming cash flows falls more
rapidly than for Project B.

Most candidates could calculate the discounted payback period but struggled with the
undiscounted equivalent. As in Q9, the units should be included within the answer. The
working of many candidates in part (iii) was often unclear even when the formulae were
correctly derived. In part (iv) many candidates incorrectly thought the duration should be
( Ia )6
for Project B.
a6

END OF EXAMINERS’ REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

15 April 2013 (pm)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 A2013 © Institute and Faculty of Actuaries

1 The value of the assets held by an investment fund on 1 January 2012 was £1.3
million.

On 30 September 2012, the value of the assets was £1.9 million.

On 1 October 2012, there was a net cash outflow from the fund of £0.9 million.
On 31 December 2012, the value of the assets was £0.8 million.

(i) Calculate the annual effective time-weighted rate of return (TWRR) for 2012.
[2]

(ii) Calculate the annual effective money-weighted rate of return (MWRR) for
2012 to the nearest 1%. [3]

(iii) Explain why the MWRR is significantly higher than the TWRR. [2]
[Total 7]

2 (i) Explain the main difference:

(a) between options and futures.

(b) between call options and put options.
[4]

(ii) A one-year forward contract is issued on 1 April 2013 on a share with a price
at that date of £10.50. Dividends of £1.10 per share are expected on 30
September 2013 and 31 March 2014. On 1 April 2013, the 6-month risk-free
spot rate of interest is 4.5% per annum convertible half-yearly and the
12-month risk-free spot rate of interest is 5% per annum convertible half-
yearly.

Calculate the forward price at issue, stating any further assumptions made. [4]
[Total 8]

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]

CT1 A2013–2
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]

(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]

5 The force of interest per unit time at time t, δ(t), is given by:

⎧0.1 − 0.005t for t < 6

δ(t ) = ⎨
⎩0.07 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]

CT1 A2013–3 PLEASE TURN OVER

6 A cash sum of £10,000 is invested in a fund and held for 15 years. The yield on the
investment in any year will be 5% with probability 0.2, 7% with probability 0.6 and
9% with probability 0.2, and is independent of the yield in any other year.

(i) Calculate the mean accumulation at the end of 15 years. [2]

(ii) Calculate the standard deviation of the accumulation at the end of 15 years. [5]

(iii) Without carrying out any further calculations, explain how your answers to
parts (i) and (ii) would change (if at all) if:

(a) the yields had been 6%, 7% and 8% instead of 5%, 7%, and 9% per
annum, respectively.

(b) the investment had been held for 13 years instead of 15 years.
[4]
[Total 11]

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]

CT1 A2013–4
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.

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]

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]

CT1 A2013–5 PLEASE TURN OVER

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]

END OF PAPER

CT1 A2013–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2013 examinations

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

July 2013

© Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

General comments on Subject CT1

CT1 provides a grounding in financial mathematics and its simple applications. It introduces
compound interest, the time value of money and discounted cashflow techniques which are
fundamental building blocks for most actuarial work.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Comments on the April 2013 paper

This paper proved to be marginally more challenging than other recent papers and the general
performance was of a slightly lower standard compared with the previous April exams. Well-
prepared candidates scored well across the whole paper. As in previous diets, questions that
required an element of explanation or analysis, such as Q1(iii) and Q4(ii) were less well
answered than those that just involved calculation. This is an area to which attention should
be paid. Candidates should note that it is important to explain and show understanding of the
concepts and not just mechanically go through calculations.

The comments that follow the questions concentrate on areas where candidates could have
improved their performance. Where no comment is made the question was generally
answered well by most candidates.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

1 (i) TWRR, i , is given by:

1.9 0.8
× = 1 + i ⇒ i = 0.169 or 16.9% p.a.
1.3 1.9 − 0.9

(ii) MWRR, i , is given by:

3
1.3 × (1 + i ) − 0.9 × (1 + i )12 = 0.8

Then, we have:

i = 30% ⇒ LHS = 0.729 ⎫ ⎛ 0.8 − 0.729 ⎞

⎬ ⇒ i ≈ 0.3 + ( 0.4 − 0.3) × ⎜ ⎟ = 0.36
i = 40% ⇒ LHS = 0.841 ⎭ ⎝ 0.841 − 0.729 ⎠

or 36% p.a.

(iii) MWRR is higher as fund performs much better before the cash outflow than
after. As the fund is smaller after 1 October 2012, the effect of the poor
investment performance is less significant.

The calculations were performed well but the quality of the explanations in part (iii) was
often poor. A common error was to cite the large withdrawal itself as the reason for the
superior MWRR.

2 (i) (a) Options – holder has the right but not the obligation to trade.

Futures – both parties have agreed to the trade and are obliged to do so.

(b) Call Option – right but not the obligation to BUY specified asset in the
future at specified price.

Put Option – right but not the obligation to SELL specified asset in the
future at specified price.

(ii) Assume no arbitrage.

The present value of the dividends, I , is:

I = 1.1v2.25% + 1.1v2.5%
2
= 1.1× ( 0.977995 + 0.951814 )
= 2.12279

Hence, forward price F = (10.50 − 2.12279 ) ×1.0252

= £8.8013

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

3 (i) 97 = 6 a3 + 103v3

Try 9% RHS = 94.723

Try 8% RHS = 97.227

Interpolation gives

97.227 − 97
0.08 + × 0.01
97.227 − 94.723

= 0.08091

i.e. 8.09% p.a. (exact answer is 8.089%)

(ii) Let in = spot rate for term n

Then 97 = 109vi1%

⇒ i1 = 12.371% p.a.

97 = 6vi1% + 109vi22%

−2 6
109 (1 + i2 ) = 97 −
1.12371

⇒ i2 = 9.049% p.a.

Part (i) was generally well answered. Some candidates wasted time in (ii) through using
linear interpolation to solve the yield for the one year bond.

4 (i) Maximum price payable by investor is given by:

P = 0.30 ×1.05 × v9% + 0.30 × 1.052 × v9%

2
+…

⎛ 1.05 ⎞ ⎡ ⎛ 1.05 ⎞ ⎛ 1.05 ⎞ ⎤

2
= 0.30 × ⎜ ⎟ × ⎢1 + ⎜ +
⎟ ⎜ ⎟ + …⎥
⎝ 1.09 ⎠ ⎣ ⎝ 1.09 ⎠ ⎝ 1.09 ⎠ ⎦

⎛ 1.05 ⎞ 1
= 0.30 × ⎜ ⎟ × 1.05
⎝ 1.09 ⎠ 1 −
1.09

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

⎛ 1.05 ⎞ 1.09 1.05

= 0.30 × ⎜ ⎟× = 0.30 ×
⎝ 1.09 ⎠ 0.09 − 0.05 0.09 − 0.05

= £ 7.875

(ii) (a) Increasing the expected rate of dividend growth, g , will increase the
maximum price that the investor is prepared to pay to purchase the
share since the dividend income is expected to be higher.

(b) An increase in the expected rate of future price inflation is likely to

lead to an increase in both the expected rate of dividend growth (as
nominal level of profits should increase in line with inflation) and the
nominal return required from the investment (as the investor is likely
to want to maintain the required real return).

Thus, the maximum price that the investor is prepared to pay will be
(largely) unchanged – in fact, it will increase slightly due to (1 + g)
term in numerator.

(c) If the investor is more uncertain about the rate of future dividend
growth (whilst the expected dividend growth is unchanged), then the
required return, i, is likely to be increased to compensate for the
increased uncertainty.

Thus, the maximum price that the investor is prepared to pay will
reduce.

Part (i) was generally well answered although common errors included adding an extra 30
pence dividend at the start or to assume that the first dividend was payable immediately.

The examiners expected candidates to find part (ii) challenging and this was indeed the case
with very few candidates scoring full marks. In (ii)(b) full marks were awarded for a
reasoned argument that led to a final answer of either an increase or no change in the price.
In general, some credit was given for valid reasoning even if the final conclusion was
incorrect.

5 (i) Accumulated value at time 10 is:

⎛ 10 ⎞ ⎛ 10 ⎞
100 × exp ⎜ ∫ δ ( t ) dt ⎟ + 50 × exp ⎜ ∫ δ ( t ) dt ⎟
⎜ ⎟ ⎜ ⎟
⎝0 ⎠ ⎝7 ⎠

⎛6 10 ⎞ ⎛ 10 ⎞
= 100 × exp ⎜ ∫ 0.1 − 0.005t dt + ∫ 0.07dt ⎟ + 50 × exp ⎜ ∫ 0.07dt ⎟
( )
⎜ ⎟ ⎜ ⎟
⎝0 6 ⎠ ⎝7 ⎠

( t =6
) (
= 100 × exp [ 0.1t − 0.0025t 2 ]t =0 + [ 0.07t ]t =6 + 50 × exp [ 0.07t ]t =7
t =10 t =10
)

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

= 100 × exp ([ 0.6 − 0.09] + 0.28 ) + 50 × exp ( 0.21)

= 220.34 + 61.68

= £ 282.02

(ii) Present value at time 0 is:

15
= ∫ ρ ( t ) v ( t ) dt
12

15 ⎛ t ⎞
∫ 50e × exp ⎜ − ∫ δ ( s ) ds ⎟ dt
0.05t
=
⎜ ⎟
12 ⎝ 0 ⎠

15 ⎛ ⎡6 t ⎤⎞
∫ ×
⎜ ⎢∫ ∫
⎜ − ⎢ ( 0.1 − 0.005s ) ds + 0.07 ds ⎥ ⎟ dt
0.05t
= 50 e exp
12 ⎝ ⎣0 6 ⎥⎦ ⎟⎠

( )
15
⎡[ 2 ]s =6 [ s =t ⎤
∫ × − − s =0 + 0.07 s ]s =6 ⎦ dt
0.05t
= 50e exp ⎣ 0.1s 0.0025 s
12

15
= ∫ 50e
0.05t
× exp ( − [ 0.51 + ( 0.07t − 0.42 )]) dt
12

15
= ∫ 50e
0.05t
× e−0.09−0.07t dt
12

15
−0.09
= 50e × ∫ e −0.02t dt
12

t =15
−0.09 ⎡ e−0.02t ⎤
= 50e ×⎢ ⎥
⎣ −0.02 ⎦t =12

= 2,500e −0.09 × ( e −0.24 − e −0.30 )

= £ 104.67

Page 6
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

6 (i) j = 0.05 × 0.2 + 0.07 × 0.6 + 0.09 × 0.2

= 0.07

⇒ mean accumulation = 10,000 × (1 + j)15

= 10,000 × (1.07)15

= £27,590.32

(ii) s2 = 0.052 × 0.2 + 0.072 × 0.6 + 0.092 × 0.2 – 0.072

= 0.00506 – 0.00490

= 0.00016

Var (accumulation) = 10,0002{(1 + 2j + j2 + s2)15 – (1 + j)30}

= 10,0002 {1.1450615 – 1.0730}

= 1,597,283.16

SD (accumulation) = 1597283.16 = £1, 263.84

(iii) (a) By symmetry j = 0.07 (as in (i))

Hence, mean (accumulation) will be the same as in (i) (i.e.

£27,590.32).

The spread of the yields around the mean is lower than in (i). Hence,
the standard deviation of the accumulation will be lower than
£1,263.84.

(b) Mean (accumulation) < £27,590.32 since the investment is being

accumulated over a shorter period.

SD (accumulation) < £1,263.84 since investing over a shorter term

than in (i) will lead to a narrower spread of possible accumulated
amounts.

In part (i) some candidates misread the question and assumed the yield was fixed for the
whole ten years rather than varying each year.

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

7 (i) Need VA (i ) = VL (i ) with i = 0.08

VL(i) = 6v8 + 11v15
VA(i) = Xv5 + Yv20

Need VA′ (i ) = VL′ (i ) with i = 0.08

VL′ = −48v9 − 165v16
VA′ = − 5Xv6 – 20Y v21

Thus we have to solve simultaneous equations:

(a) 6v8 + 11v15 = Xv5 + Yv20

(b) −48v9 − 165v16 = − 5Xv6 – 20Y v21

Taking 5 times (a) + (1+i) times (b) we get

−18v8 − 110v15 = −15Yv 20

18 (1 + i ) + 110 (1 + i )
12 5
⇒Y =
15
⇒ Y = 13.79688

Substitute back in (a) to get X = 5.50877

Hence the values of the zero-coupon bonds are £5.50877 million and
£13.79688 million.

(ii) We need to check that the third condition is satisfied:

VA′ = −5 Xv 6 − 20Yv 21
⇒ VA′′ = 30 Xv 7 + 420Yv 22
⇒ VA′′ (0.08) = 30 × 5.50877 × 1.08−7 + 420 ×13.79688 ×1.08−22
= 1162.31

VL′ = −48 v9 − 165 v16

⇒ VL′′ = 432 v10 + 2640 v17
⇒ VL′′(0.08) = 432 × 1.08−10 + 2640 × 1.08−17
= 913.61

Therefore VA′′ (0.08) > VL′′(0.08)

Thus the third condition is satisfied.

[Or note that since the assets have terms of 5 years and 20 years and the liabilities
have terms of 8 years and 15 years, the spread of assets around the mean term is

Page 8
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

greater than that of the liabilities. Hence, the convexity of assets is greater than the
convexity of liabilities].

The best answered question on the paper.

8 (i) Work in £ millions

Let Discounted Payback Period from 1 January 2014 be n.

Then, considering project at the end of year n but before the outgo at the start
of year n + 1

1
− 19 − 9v 2 − 5v

(
− 6 × 9.5 v 2 + 1.04v3 + ... + (1.04 )
n −3 n −1
v )
( v )≥0
n −3 n
+ 6 ×12.6 v3 + 1.04v 4 + ... + (1.04 ) at 9%

⎛ ⎛ 1.04 ⎞ n−2 ⎞
⎜ 1− ⎜ ⎟ ⎟
(
Hence, 19 + 8.6204 + 4.5872 ≤ 75.6v3 − 57v 2 ) ⎜ ⎝ 1.09 ⎠
⎜ 1.04 ⎟
⎟
⎜⎜ 1 − 1.09 ⎟⎟
⎝ ⎠
⎛ ⎛ 1.04 ⎞n−2 ⎞
and RHS = 10.4013 × 21.8 × ⎜ 1 − ⎜ ⎟
⎜ ⎝ 1.09 ⎟⎠ ⎟
⎝ ⎠
n−2
32.2076 ⎛ 1.04 ⎞
Hence, ≤ 1− ⎜ ⎟
10.4013 × 21.8 ⎝ 1.09 ⎠

n− 2
⎛ 1.04 ⎞
⇒⎜ ⎟ ≥ 0.85796
⎝ 1.09 ⎠

⎛ 1.04 ⎞
⇒ ( n − 2 ) log ⎜ ⎟ ≥ log 0.85796
⎝ 1.09 ⎠

−0.06653
⇒ n−2≥ = 3.262
−0.02039

⇒ n ≥ 5.262

But sales are only made at the end of each calendar year.

⇒ DPP = 6 years

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

(ii) The DPP would be shorter using an effective rate of interest less than 9% p.a.
This is because the income (in the form of car sales) does not commence until
a few years have elapsed whereas the bulk of the outgo occurs in the early
years. The effect of discounting means that using a lower rate of interest has a
greater effect on the value of the income than on the value of the outgo
(although both values increase). Hence the DPP becomes shorter.

In part (i), many candidates valued the total outgo for the whole production run and then
attempted to find when the present value of income exceeded this. The working of many
marginal candidates was difficult to follow and it was not clear to the examiners what the
candidates were attempting to do.

× 0.7 = 0.056 < i ( 2 ) = 0.059126

D 0.08
9 (i) (1 − t1 ) =
R 1 6%

⇒ There is a capital gain and assume redeemed as late as possible.

Let P = Price at 1/5/11 per £100 nominal

( 2)
P = ⎡0.7 × 8 a + 100v11 − 0.25 (100 − P ) v11 ⎤ × (1 + i ) 12
4

⎣⎢ 11 ⎦⎥

⇒ P = 5.6 ×1.014782 × 7.8869 × (1.06 )

4 10 812 10 812
12
+ 75v + 0.25 Pv

45.6985 + 40.2839
⇒P =
10 812
1 − 0.25v

= £99.319

D ( 2)
(ii) = 0.08 > i7% = 0.068816
R

⇒ Assume redeemed as soon as possible

(2
4 )
Sale Price per £100 nominal = 8 a( ) + 100v 4 × (1 + i ) 12
3

= ( 8 ×1.017204 × 3.3872 + 100 × 0.76290 ) × (1.07 )

3
12

= £ 105.625

(iii) CGT is payable of (105.625 − 99.319 ) × 0.25

= £1.5765

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

Equation of value:

+ (105.625 − 1.5765 ) v
2 8 12 1812 11112
99.319 = 0.7 × 4 × v 12 + 0.7 × 4 × v
+ 0.7 × 4 × v 12 + 0.7 × 4 × v
12

( 2)
⇒ 99.319 = (1 + i ) 12 × 5.6 a + 104.0485v 12
4 111
2

4 11112
At 8%, RHS is 1.08 12 × 5.6 ×1.019615 ×1.7833 + 104.0485v
= 100.226

At 9% RHS is (1.09 )
4 11112
12
× 5.6 ×1.022015 ×1.7591 + 104.0485v
= 98.568

and since 98.568 < 99.319 < 100.226, the net yield is between 8% and 9% p.a.

Many candidates struggled with the four month adjustment in part (i). Common errors
included:

• ignoring the adjustment completely.

• discounting the present value of payments by four months rather than accumulating.
• adjusting the price at the end of the calculations (which does not allow for CGT
correctly).

In part (iii) some candidates wasted time by trying to solve the yield exactly rather than just
show that 8% was too low and 9% too high.

10 (i) Original amount of loan is:

L = 5, 000v + 4,800v 2 + 4, 600v3 + … + 1, 200v 20

( ) (
= 5, 200 × v + v 2 + … + v 20 − 200 × v + 2v 2 + … + 20v 20 )
= 5, 200a20 − 200 ( Ia )20
= 5, 200 × 13.5903 − 200 × 125.1550
= £45, 638.56

(ii) Amount of 12th instalment is £2,800.

Loan o/s after 11th instalment is given by PV of future repayments:

L11 = 2,800v + 2, 600v 2 + 2, 400v3 + … + 1, 200v9

= 3, 000a9 − 200 ( Ia )9
= 3, 000 × 7.4353 − 200 × 35.2366
= £15, 258.58

Then, interest component of 12th instalment is: 0.04 × 15, 258.58 = £610.34 .

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – April 2013 – Examiners’ Report

Hence, capital repaid in 12th instalment is 2,800 − 610.34 = £2,189.66 .

(iii) (a) Then, after 12th instalment, loan o/s is

15, 258.58 − 2,189.66 = £13, 068.92 .

This will be repaid by level instalments of £2,800.

Thus, remaining term of loan is n given by:

13, 068.92 ≤ 2,800 × an4% ⇒ an4% ≥ 4.6675 ⇒ n = 6

i.e. remaining term is 6 years (i.e. loan is repaid by time 18)

(b) We need to find reduced final payment, R , such that:

13, 068.92 = 2,800 × a54% + Rv4%

6
⇒ 0.79031R
= 13, 068.92 − 2,800 × 4.4518 ⇒ R = £764.11

(c) Total amount of interest paid is given by:

5, 000 + 4,800 + 4, 600 + … + 2,800 + 5 × 2,800 + 764.11 − 45, 638.56

= £15, 925.55

In part (ii) the most common error was to not round n up, i.e. quoting a non-integer number
of years for the revised loan. Part (iii) was answered poorly with candidates often not
correctly allowing for the payments prior to the change in payment schedule.

END OF EXAMINERS’ REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

23 September 2013 (pm)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 11 questions, beginning your answer to each question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 S2013 © Institute and Faculty of Actuaries

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]

2 A nine-month forward contract is issued on 1 March 2012 on a share with a price of

£1.80 at that date. Dividends of 10p per share are expected on 1 September 2012.

Calculate the forward price at issue assuming a risk-free rate of interest of 4% per
annum effective and no arbitrage. [3]

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]

4 Describe the characteristics of the cash flows that are paid and received in respect of:

(i) an index-linked security. [2]

(ii) an equity. [3]
[Total 5]

CT1 S2013–2
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]

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]

CT1 S2013–3 PLEASE TURN OVER

7 An insurance company has just written contracts that require it to make payments to
policyholders of £10 million in five years’ time. The total premiums paid by
policyholders at the outset of the contracts amounted to £7.85 million. The insurance
company is to invest the premiums in assets that have an uncertain return. The return
from these assets in year t, it, has a mean value of 5.5% per annum effective and a
standard deviation of 4% per annum effective. (1+it) is independently and
lognormally distributed.

(i) Calculate the mean and standard deviation of the accumulation of the
premiums over the five-year period. You should derive all necessary formulae.
[Note: You are not required to derive the formulae for the mean and variance
of a lognormal distribution.] [9]

A director of the insurance company is concerned about the possibility of a

considerable loss from the investment strategy suggested in part (i). He therefore
suggests investing in fixed-interest securities with a guaranteed return of 4 per cent
per annum effective.

(ii) Explain the arguments for and against the director’s suggestion. [3]
[Total 12]

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]

CT1 S2013–4
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]

10 The force of interest, δ(t), is a function of time and at any time t, measured in years, is
given by the formula:

δ(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]

(iv) Calculate the present value of an annuity that is paid continuously at a rate of
2
30e−0.01t +0.001t units per annum from t = 3 to t = 10. [5]
[Total 15]

CT1 S2013–5 PLEASE TURN OVER

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]

END OF PAPER

CT1 S2013–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2013 examinations

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

December 2013

© Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

General comments on Subject CT1

CT1 provides a grounding in financial mathematics and its simple applications. It introduces
compound interest, the time value of money and discounted cashflow techniques which are
fundamental building blocks for most actuarial work.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Comments on the September 2013 paper

This paper proved to have some questions where the vast majority of candidates scored well
and others where many candidates found challenging. Well-prepared candidates scored well
across the whole paper. As in previous diets, questions that required an element of
explanation or analysis, such as Q1(ii), Q8(iv), Q10(iii) and Q11(v) were less well answered
than those that just involved calculation. This is an area to which attention should be paid.
Candidates should note that it is important to explain and show understanding of the concepts
and not just mechanically go through calculations.

The comments that follow the questions concentrate on areas where candidates could have
improved their performance. Where no comment is made the question was generally
answered well by most candidates.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

0.045
1 (i) (a) =d = 0.043062
= 4.3062%
1.045

(1 − d (12)12 ) =
−1
(b) (1.045) 12

d (12)
∴1 − =0.99634
12

∴ d (12) =
0.043936 or 4.3936%

4
 i (4) 
(c) 1 +  =
1.045
 4 

 i (4) 
∴ 1 + =1.011065
 4 


∴i (4)
=
0.044260 or 4.4260%

(d) 1.0455 = 1.24618

∴ five-yearly effective rate is 24.618%

(ii) The answer to (i)(b) is bigger than the answer to (i)(a) because the rate of
discount convertible monthly is applied each month to a smaller (already
discounted) sum of money. As such, in order to achieve the same total amount
of discounting the rate has to be slightly more than one twelfth of the annual
rate of discount. [An answer relating to the concept of interest payable in
advance would also be acceptable].

The calculations were performed well but the quality of the explanations in part (ii) was often
(1 )
( 1 )
5
poor. A common error in (i)(d) was to state the answer as i rather than
i 5
.
1⁄ 5

2 Present value of dividend = 0.1×1.04−0.5 =

0.09806

Value of forward is (1.8 − 0.09806 ) ×1.040.75 =

£1.75275

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

3 (i) Work in half years.

P = 2a20 + 100v 20 @1 1 2 %
= 2× 17.1686+100× 0.74247
= £108.584

91
(ii) P = (2 × 0.75a20 + 100v 20 )(1.015) 182.5

91
= (2×0.75×17.1686+100×0.74247)× (1.015) 182.5

= £100.7452

Part (i) was answered well although some candidates assumed an annual effective rate of
3%. In part (ii) many candidates did not deal with the 91 days elapsed duration – discounting
instead of accumulating the 10-year bond price and/or assuming that 91 days equated to a
quarter of a year.

4 (i) The investor pays a purchase price at outset.

The investor receives a series of coupon payments and a capital payment at

maturity

The coupon and capital payments are linked to an index of prices (possibly
with a time lag)

[Time lag does not have to be mentioned].

(ii) The investor pays a purchase price at outset

Shareholders are paid dividends. These are not fixed but declared out of
profits.
Dividends may be expected to increase over time ….
….but may cease if the company fails.

There is a high degree of uncertainty with regard to future cash flows.

No maturity date
Would receive a sale price on the sale of the shares

Generally poorly answered with many candidates just writing down all characteristics they
knew about these assets rather than concentrating on the cashflows. Many candidates
omitted mention of the initial purchase price in each part.

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

106
5 (i) The return from the bonds issued by Country A is: − 1 =0.049505
101

The expected cash flows from the bonds from Country B are:

0.1 × 0 + 0.2 × 100 + 0.3 × 50 + 0.4 × 106 = 77.4

The price to provide the same expected return is P such that:

77.4
=P = €73.749
1.049505

(ii) The gross redemption yield from the bond is such that:

73.749 × (1 + i ) =
106
∴ i =43.731%

(iii) The risk is higher for Country B’s bond. Although the gross redemption yield
is such that the expected returns are equal, the investor may want a higher
expected return to compensate for the higher risk.

Many candidates had trouble with part (ii) not recognising that the gross redemption yield
calculation will not include any allowance for default.

6 Divide the number of cars by 100 to obtain the share due to the pension fund

(
PV of income = 365 × 400 a1 +365 × 500 a1 v ×1.1× 1 + 1.012 v + 1.014 v 2 + ...... + 1.0136 v18 )
i i  1 − 1.0138 v19 
= 365 × 400 a1 + 365 × 500 a1 v ×1.1× 
δ δ  1 − 1.012 v 
 

= 365 × 400 × 1.039487 × 0.92593

 1 − 1.45953 × 0.23171 
+365 × 500 × 1.039487 × 0.92593 × 0.92593 × 1.1 ×  
 1 − 1.0201 × 0.92593 

= 140,523 + 178,907 × 11.93247

= 140,523 + 2,134,801 = 2,275,324 so NPV = £275,324

Candidates made a variety of errors in this question often ignoring one or more parts of the
scenario (e.g. pension fund’s 1% share of the project, the fact that daily vehicle numbers
were given in the question, 1% increases in both vehicle numbers and tolls from the second
year). Nevertheless, candidates who set out their workings clearly and logically often scored
the majority of the available marks.

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

7 (i) (1 + it) ~ lognormal (μ, σ2)

ln(1 + it ) ~ N (µ, σ2 )

5
ln ∏ (1 + it ) = ln(1 + it ) + ln(1 + it ) + L + ln(1 + it )
t =1

~ N (5µ,5σ2 ) by independence

5
∴ ∏ (1 + it ) ~ lognormal (5µ,5σ2 )
t =1

 σ2 
E (1 +=
it ) exp  µ + =  1.055
 2
 

it ) exp(2µ + σ2 ) exp(σ2 ) =
Var(1 += − 1 0.042
 

0.042 
=
1.055 2  ( )
exp σ2 − 1 ∴σ

= 2
0.0014365

 0.0014360 
exp  µ + =  1.055 ⇒
 2 

0.0014365
=µ ln1.055 − = 0.052823
2

5µ = 0.264113

5σ2 = 0.007182.

Let S5 be the accumulation of one unit after five years:

 5σ2   0.007182 
E ( S5 ) = exp =5×µ +  exp  0.264113 + 
 2   2 


= 1.30696

 ( )
Var( S5 ) = exp(2 × 5µ + 5σ2 ) exp 5σ2 − 1


= exp(2 × 0.264113 + 0.007182).(exp 0.007182 − 1)

Page 6
Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

= exp 0.53541 (exp 0.007182 − 1)

= 0.012313

Mean value of the accumulation of premiums is

7,850,000 × 1.30696 = £10,259,636.

Standard deviation of the accumulated value of the premiums is

7,850, 000 × 0.012313 =

£871, 061

Alternatively:

Let it be the (random) rate of interest in year t . Let S5 be the accumulation of a

single investment of 1 unit after five years:

E ( S5 ) = E (1 + i1 )(1 + i2 ) K (1 + i5 ) 

E ( S5 ) = E [1 + i1 ] E [1 + i2 ]K E [1 + i5 ] as {it } are independent

E [it ] = 0.055

∴ E ( S5 ) = (1.055 ) = 1.30696
5

( )
E S52 = E  (1 + i1 )(1 + i2 ) K (1 + i5 )  

2


E (1 + i1 ) E (1 + i2 ) K E (1 + i5 ) (using independence)
2 2 2
=

( ) ( ) (
= E 1 + 2i1 + i12 E 1 + 2i2 + i22 K E 1 + 2i5 + i52 )
( )
5
= 1 + 2 × 0.055 + 0.042 + 0.0552

as E ii2  =V [it ] + E [it ] =0.042 + 0.0552

2
 

( )
5
∴ Var [ S5 ] = 1 + 2 × 0.055 + 0.042 + 0.0552 − (1.055 )
10

∴ 1.1146255 − (1.055 ) 0.0123128 10

= =

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

Mean value of the accumulation of premiums is

7,850,000 × 1.30696 = £10,259,636.

Standard deviation of the accumulated value of the premiums is

7,850, 000 × 0.012313 =

£871, 061

(ii) If the company invested in fixed-interest securities, it would obtain a

guaranteed accumulation of £7,850,000 (1.04)5 = £9,550,725. In one sense,
there is a 100% probability that a loss will be made and therefore the policy is
unwise. The “risky” investment strategy leads to an expected profit. On the
other hand, the standard deviation of the accumulation from the risky
investment strategy is £871,061. Whilst there is a chance of an even greater
profit from this strategy, there is also a chance of a more considerable loss
than from investing in fixed-interest securities.

A poorly answered questions with many candidates not including enough derivation of the
required results in part (i). Some candidates mixed their answers between the two methods
given above e.g. they calculated µ and σ2 for the log normal route, then used these in the
alternative method for the mean and variance of it. Other candidates just used 0.055 and
.042 as their values of µ and σ2 .

8 (i) Purchase price of the annuity (working in half-years)

5, 000a (6) calculated at i = 2%

50

i
= 5, 000 (6)
a50
i

i = 0.02

i(6) = 0.019835

a50 = 31.4236

0.02
Purchase price = 5, 000 × × 31.4236
0.019835

= £158,422

Page 8
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

Individual needs to invest X such that: (working in years)

X 1.0520 = 158,422

1.0520 = 2.653297

158, 422
=
∴X = £59, 708
2.653297

(ii) Real return is j such that:

158, 422 143

=
59, 708 ×
(1 + j ) 20 340

158, 422 143

∴ (i + j ) 20 = ×
59, 708 340

=1.11595

∴j = 0.550%

(iii) The amount of the capital gain is:

158,422 – 59,708 = 98,714

Tax = 0.25 × 98,714 = 24,679

Proceeds of investment = 133,744

Net real return is j ′ such that:

133, 744 143

=
59, 708 ×
(1 + j ′) 20 340

133, 744 143

∴ (1 + j ′) 20 = ×
59, 708 340

= 0.942106

∴ j ′ = −0.2977%

(iv) The capital gains taxed has taxed the nominal gain, part of which is merely to
compensate the investor for inflation. The tax has therefore reduced the real
value of the investor’s capital and led to a negative real return.

Parts (i) and (ii) were generally answered well but many candidates struggled with the
calculation of the capital gain in part (iii) not recognising that this would be based on money
values.

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

9 (i) PV is:

400v + 380v 2 + 360v3 + L + 120v5

420 a15 − 20 ( Ia )15 @ 4%

= 420 × 11.1184 - 20 × 80.8539

= 4,669.728 – 1,617.078 = £3,052.65.

(ii) Interest component:

= 0.04 × 3,052.65 = £122.106

Capital component = 400 – 122.106

= £277.894

(iii) Seven repayments remain and the PV of the remaining payments is:

240v + 220v 2 + L + 120 v 7

260 a7 − 20 ( Ia )7 @ 4%

= 260 × 6.0021 − 20 × 23.0678 = £1, 099.19

The loan is written down to: 0.5 × 1,099.19

= £549.595

The present value of the new repayment is:

( X − 2 ) a10 + 2( Ia )10 @8%

∴ 549.595= ( X − 2 ) 6.7101 + 2 × 32.6869

549.595 − 2 × 32.6869
=∴X −2 = 72.163
6.7101

∴X =
£74.16

The best answered question on the paper although some candidates, when calculating the
outstanding loan in part (iii), stated that the repayment in year 8 was £420. Some candidates
also used the incorrect formula Xa10 + 2( Ia )10 for the repayment in part (iv).

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

7
∫ 0.05+0.002t dt
10 (i) (a) e0

 0.002t 2  7
0.05t + 
 2 
= e 0

0.002 × 49
= exp [ 0.05 × 7 ] +
2

= exp (0.399) = 1.490331

6
∫ 0.05+0.002t dt
(b) e 0

 0.002×36 
0.05×6+ 2 
= e

= exp (0.336) = 1.399339

1.490331
(c) = 1.06503
1.399339

(ii) (a) Let spot rate = i7

(1 + i7 )7 =
1.490334

⇒ i7 =
5.8656% p.a. effective

(b) (1 + i6 )6 =
1.39934

∴ i6 =
5.7598% p.a. effective

(c) From (i) (c) 6.503% per annum effective.

(iii) The forward rate is the rate of interest in the seventh year. The spot rate, in
effect, is the rate of interest per annum averaged over the seven years (a form
of geometric average). As the force of interest is rising the rate of interest in
the seventh year must be higher than the rate averaged over the full seven year
period.

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

t
− ∫ 0.05+ 0.002 s ds
(iv) v(t ) = e 0

 0.002 s 2  t
− 0.05 s + 
= e 
2 
0

= e−0.05t −0.001t
2

We require

10

∫ ρ(t )v(t )dt

3

30 e −0.01t
10

∫ .e−0.05t .e −0.001t dt
2
=
e−0.001t
2
3

10
30 ∫ e−0.06t dt
3

30  −0.06t 10
e
−0.06  3

30  −0.6 −0.18 
= e −e
−0.06  

= −500(0.548812 − 0.83527)

=143.229

The calculations were well-done but only the best candidates clearly explained their
reasoning in part (iii).

11 (i) Present value of liabilities annuity

10 a40 at 4% a40 = 19.7928

= 10 × 19.7928 = £197.928m

(ii) Call 10 year security “security A” and five year security “security B”.

We need to calculate the PV of £100 nominal for each of security A and

security B

Page 12
Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

P.V of £100 nominal of A is:

5a10 + 100v10 @4%

= =
a10 8.1109 v10 0.67556

∴PV = 5×8.1109 + 67.556 = 108.1105

P.V of £100 nominal of B is:

10 a5 + 100v5 @ 4%

= =
a5 4.4518 v5 0.82193

∴ PV = 44.518 + 82.193 = 126.711

£98.964m, is invested in each security.

98,964, 000
×100 per £100 nominal of A is bought.
108.1105

= £91,539,674 nominal

98,964, 000
×100 per £100 nominal of B is bought
126.711

= £78,102,138 nominal

[other ways of expressing units are okay, but marks will be deducted if units
are not correct]

(iii) Duration of the liabilities

=
∑ tct vt
∑ ct vt
40
Numerator = ∑10 t vt (in £ m)
t =1

= 10( Ia ) 40 =
10 × 306.3231 =
3063.231 at 4% p.a. effective

∴ Duration = 3063.231/197.928 = 15.48 years

Page 13
 Subject CT1 (Financial Mathematics Core Technical) – September 2013 – Examiners’ Report

(iv) Numerator of duration is:

(5( Ia )10 + 10 ×100 v10 ) × 915,396.74

+(10( Ia )5 + 5 ×100 v5 ) × 781, 021.38

Following the same reasoning as for the calculation of the duration of the
annuity payments, adding the capital repayment and multiplying by the
number of units of £100 nominal bought.

( Ia )10 = 41.9922

v10 = 0.67556
( Ia )5 = 13.0065

v5 = 0.82193
= (5 × 41.9922 + 10 × 100 × 0.67556) × 915,396.74
+(10 × 13.0065 + 5 × 100 × 0.82193) × 781, 021.38

= 810, 603, 000 + 422,554, 000

= 1, 233,157, 000

∴Duration = 1,233,157,000/197,928,000
= 6.23 years

(v) The duration (and therefore the volatility) is greater for the liabilities than for
the assets. As a result, when interest rates fall, the present value of the
liabilities will rise by more than the present value of the assets and so a loss
will be made.

Many candidates wrongly assumed that the same nominal amounts were bought of each asset
rather than each asset amount having the same present value. This assumption made the
calculations in part (ii) somewhat easier and the marks awarded in this part took this into
account. Part (iii) was answered well. The explanations in part (v) were often poorly stated
although time pressures at the end of the paper may have contributed to this.

END OF EXAMINERS’ REPORT

Page 14
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

22 April 2014 (am)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 12 questions, beginning your answer to each question on a new page.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 A2014 Institute and Faculty of Actuaries

1 You are given the following information in respect of a pension fund:

Calendar Value of fund Value of fund Net cash flow

Year at 1 January at 30 June received on 1 July
2011 £870,000 £872,000 £26,000
2012 £914,000 £902,000 £27,000
2013 £953,000 £962,000 £33,000
2014 £990,000

Calculate, to the nearest 0.1%, the annual effective money-weighted rate of return
earned by the fund during the period from 1 January 2011 to 1 January 2014. [4]

2 Describe the main features of:

(a) debenture stocks.

(b) unsecured loan stocks. [5]

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]

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]

CT1 A2014–2
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]

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]

7 Six months ago, an investor entered into a one-year forward contract to purchase a
non-dividend paying stock. The risk-free force of interest was 4% per annum. The
value of the stock is now 98% of its original value.

Calculate the minimum value for the risk-free force of interest at which the original
forward contract still has a positive value to the investor. [6]

CT1 A2014–3 PLEASE TURN OVER

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]

9 The effective n-year spot rate of interest yn , is given by:

n
yn = 0.035 + for n = 1, 2 and 3
1000

(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]

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]

CT1 A2014–4
11 An individual can obtain a force of interest per annum at time t , measured in years, as
given by the formula:

⎧0.03 + 0.01t 0≤t <4

⎪
δ(t ) = ⎨0.07 4≤t <6
⎪0.09 6≤t
⎩

(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]

12 An investor is considering investing £18,000 for a period of 12 years. Let it be the

effective rate of interest in the t th year, t ≤ 12. Assume, for t ≤ 12, that it has mean
value of 0.08 and standard deviation 0.05 and that 1 + it is independently and
lognormally distributed.

(i) Determine the distribution of S12 where St is the accumulation of £1 over t

years. [5]

At the end of the 12 years the investor intends to use the accumulated amount of the
investment to purchase a 12-year annuity certain paying:

£4,000 per annum monthly in advance during the first four years;
£5,000 per annum quarterly in advance during the second four years;
£6,000 per annum continuously during the final four years.

The effective rate of interest will be 7% per annum in years 13 to 18 and 9% per
annum in years 19 to 24 where the years are counted from the start of the initial
investment

(ii) Calculate the probability that the investor will meet the objective. [12]
[Total 17]

END OF PAPER

CT1 A2014–5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2014 examinations

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

June 2014

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

General comments on Subject CT1

CT1 provides a grounding in financial mathematics and its simple applications. It introduces
compound interest, the time value of money and discounted cashflow techniques which are
fundamental building blocks for most actuarial work.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Comments on the April 2014 paper

The comments that follow the questions concentrate on areas where candidates could have
improved their performance. Where no comment is made the question was generally
answered well by most candidates
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

1 We can ignore the fund values given at 30 June.

Working in £000s:

870 1  i   26 1  i   27 1  i  2  33 1  i  2  990
3 2 12 11 1

Approximate i comes from:

870  26  27  331  i 3  990

 i  1.2%

Try 1%, LHS = 983.587

Try 2%, LHS = 1011.713

So
990  983.587
i = 0.01   0.02  0.01 
1011.713  983.587

= 0.0123

Answer = 1.2% p.a.

Well answered although many candidates ignored the instruction to give the answer to the
nearest 0.1%, and were penalised accordingly.

2 (a) Debentures

Debentures are part of the loan capital of companies.

The term “loan capital” usually refers to long-term borrowings rather than
short-term.
Payments consist of regular coupons…
…and a final redemption payment
The issuing company provides some form of security to holders of the
debenture…
…e.g. via a fixed or floating charge on the company’s assets
Debenture stocks are considered more risky than government bonds…
…and are considered less marketable than government bonds.
Accordingly the yield required by investors will be higher than for a
comparable government bond.

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

(b) Unsecured loan stocks

Issued by various companies.

They are unsecured – holders rank alongside other unsecured creditors.
Yields will be higher than on comparable debentures issued by the same
company…
…to reflect the higher default risk.

This question was poorly answered despite being completely based on bookwork.

The above shows the variety of points that could be made (and not all were required for full
marks). Many marginal candidates either made no significant attempt at the question or did
not make enough distinct points.

4
2
 i 2   12
3 (i) 900  1    925
 2 
 

8
12
 i  2  12 925 i    925  8
2

 1    1    1.041954693
 2  900 2  900 
 

 i   8.39% 8.3909385
2

4
4*
 d  4   12
(ii) 900  925  1  
 4 
 

16
12
 d  4 12 900 d    900 16
4
 1     1    0.979660466
 4  925 4  925 
 

 d    8.14% 8.1358136
4

 4 
(iii)
 12 
 
900   1  i   925  i  8.33% 8.3

Where i is the simple rate of interest per annum.

This question was answered very well although some candidates calculated i   rather than
4

d   for part (ii).

4

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

Firstly we must consider i   and 1  t 

2 D
4
R

where i   is evaluated at the net yield rate (6% p.a.) = 5.9126%

2

t  0.30 , the income tax rate

D 8 D
  7.7670 p.a.  1  t   5.4369%
R 1.03 R

We have i   1  t 
2 D
R

 there is a capital gain and the stock will be redeemed at the last possible date if the
minimum yield is received. i.e. at the end of 25 years.
Hence, let P be price per £100 nominal, then

 2
P = 1  0.3 8 a  103  103  P   0.4  v 25at 6% p.a.
25

 2
= 5.6a   61.8  0.4 P  v 25
25

i
5.6 a  61.8v 25
i  2  25
P =
1  0.4v 25

5.6  1.014782 12.7834  61.8  0.23300

=
1  0.4  0.23300

72.6452  14.3994
=
1  0.0932

= £95.99

Generally well-answered although some candidates’ arguments for choosing the latest
possible date were unclear.

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

5 (i) The amounts of cash flows:

Coupon on 25/4/2013

0.03 RPI 4/2013

= 10, 000  
2 RPI10/2008

0.03 171.4
= 10000   = £172.319
2 149.2

Coupon on 25/10/2013

0.03 RPI10/ 2013

= 10000  
2 RPI10/ 2008

0.03 173.8
= 10000   = £174.732
2 149.2

173.8
Redemption on 25/10/2013 = 10000 
149.2

= £11, 648.794

(ii) Purchase Price at 25/10/2012 = PV at real rate of 3 12 % p.a. effective of future

cash flows.

= PV at 3 12 % p.a. effective of “25/10/2012

money values” of future cash flows.

Future cash flows expressed in 25/10/2012 money values

RPI10/2012
Coupon at 25/4/2013  172.319 
RPI 4/2013

169.4
 172.319   £170.308
171.4

RPI10/2012
Coupon at 25/10/2013  174.732 
RPI10/2013

169.4
= 174.732   £170.308
173.8

(same as 25/4/2013, as expected)

Page 6
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

169.4
Redemption at 25/10/2013 = 11648.794   £11,353.888
173.8

 RPI10/2012 169.4 
or 10000   10000   11353.888
 RPI10/2008 149.2 

Hence Price at 25/10/2012

1 170.308  11353.888
 170.308  
1.035
1
2 1.035

 £11,301.89

Many candidates had difficulty in recognising that the real yield would be based on using the
inflation-adjusted cashflows as at the time of purchase. Some candidates made no
adjustment at all whereas others incorrectly assumed that the inflation rate would be
constant throughout the holding period.

6 (i) Redington’s first condition states that the pv of the assets should equal the
pv of the liabilities.

Working in £ million:

pv of assets  7.404v 2  31.834v 25 at 7%

 7.404  0.87344  31.834  0.18425
 6.467  5.865
 12.3323

pv of liabilities  10v10  20v15 at 7%

=10  0.50835  20  0.36245
 5.0835  7.249
 12.3324

Allowing for rounding, Redington’s first condition is satisfied.

Redington’s second condition states that the DMT of the assets should equal
the DMT of the liabilities. Given denominator of DMTs of assets and
liabilities have been shown to be equal, we only need to consider the
numerators.

Numerator of DMT of assets  7.404  2  v 2  31.834  25  v 25 at 7%

 6.467  2  5.865  25
 159.569

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

Numerator of DMT of liabilities  10 10  v10  20 15  v15 at 7%

 5.0835 10  7.249 15
 159.569

Allowing for rounding, Redington’s 2nd condition is satisfied.

(ii) Profit  7.404v 2  31.834v 25  10v10  20v15 at 7.5%

 6.40692  5.22011  4.85194  6.75932
 0.015772 i.e. a profit of £15,772

(iii) It can be seen that the spread of the assets is greater than the spread of the
liabilities. This will mean that Redington’s third condition for immunization
is also satisfied, and that therefore a profit will occur if there is a small change
in the rate of interest. Hence we would have anticipated a profit in (ii).

Parts (i) was answered well. Equating volatilities instead of DMTs was perfectly acceptable
in this part. Part (ii) was also generally answered well although some candidates estimated
the answer by using an estimation based on volatility rather than calculating the answer
directly as asked. Part (iii) was less well answered with some candidates ignoring this part
completely and others stating that Redington’s 3rd condition was satisfied without further
explanation.

7 Let Kt and St denote the forward price of the contract at time t , and the stock price at
time t respectively.

Let r be the risk-free rate per annum at time t  1

2

Then, K 0  S0e0.04

1r
and K 1  0.98 S0 e 2
2


The value of the contract V1 is K 1  K 0 e
2 2
  12 r


Hence V1 = K 1  K 0 e
2 2
  12 r

= S0   0.98e 2  e0.04  e 2
1r 1r
 

Page 8
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

And

1r
V1  0 when 0.98e 2  e0.04
2

 e0.04 
which is when r  2 ln   12.041% p.a.
 0.98 
 

One of the worst answered questions on the paper. Some candidates, who did not complete
the question, lost some of the marks that would have been available to them by not showing
clear working e.g. writing down one half of a formula without explaining what the formula
was supposed to represent.

8 (i) Let DPP be t . We want (all figures in £000s)

 2
50, 000 = 6, 000a at 9% p.a.
t

i
= 6, 000   at
i 
2

50
 at =
6 1.022015

= 8.1538268

 vt  1  8.1538268  0.09

ln 1  8.1538268  0.09 
t   15.360
ln1.091

Take DPP as 15.5 years

(ii) Profit at the end of 20 years is

50, 000  1.09   1.07   

 6, 000  s15.5  1.07  X
15.5 4.5 2 4.5

where

s
 2
=
1  i 15.5  1 at 9%
i 
15.5 2

1.0915.5  1
=
0.088061

= 31.8285476

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

and to find X we work in half-years:

= 3, 000s9 at j % where 1  j   1.07

2
X

= 3, 000 
1  j  1
9

1.07   1
9/2
= 3, 000 
1.07 1/2  1
= 31, 030.35528

 Profit = -257,814.7272+258,937.5717+31,030.35528

= 32,153.20

  £32,153, 200 
Part (i) was answered well although candidates lost marks for not recognising that the DPP
could only be at the time of income receipt i.e. at the end of a half-year. Part (ii) was
answered badly with some candidates ignoring the initial profit obtained at the end of the
DPP. A common error in the calculation of the profit arising after the DPP was to calculate
the present value rather than the accumulated value.

9 (i) We can find the one-year forward rates f1,1 and f 2,1 from the spot rates
y1, y2 and y3 :

1  y2 2  1  y1  1  f1,1 

 1  0.037   1  0.036  1  f1,1 

2

 f1,1  3.800% p.a.

and

1  y3 3  1  y2 2 1  f 2,1 

 1.038   1.037  1  f 2,1 

3 2

 f 2,1  4.000 % p.a.

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

(ii) (a) Price per £100 nominal

= 4  v  v 2  v3   105 v3
 3.6% 3.7% 3.8%  3.8%

= 4  2.78931  105  0.89414

= £105.0425

(b) Let yc2  two-year par yield

1  yc2  v  v 2   v 2
 3.6% 3.7%  3.7%

 yc2  3.6982 % p.a.

Questions on the term structure of interest rates have caused significant problems for
candidates in past years but this question was generally answered very well.

10 (i) Let X = initial payment

20000 =  X  50  a25  50  Ia 25

=  X  50  10.6748  50  98.4789

= 10.6748 X  533.74  4923.95

15609.80
X  £1, 462.31.
10.6748

(ii) After 3 years, capital o/s is:

1562.31a22  50  Ia 22

= 1562.3110.2007  50  87.1264

= £ 20, 293.01

(iii) The loan has actually increased from £20,000 to £20,293.01. The reason for
this is that the loan is being repaid by an increasing annuity and, in the early
years, the interest is not covered by the repayments (e.g. 1st year: Interest is
0.08 × 20000 = £1,600 but 1st instalment is £1462.31 and so interest is not
covered).

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

(iv) Total of instalments paid

24  25
 25  1462.31   50  51557.66
2

 Total interest = 51557.66  20000 = £31557.66

Parts (i) and (ii) were answered well, although in part (ii) some candidates incorrectly
calculated the instalment that would be paid in the fourth year. Part (iii) was also answered
relatively better than similar explanation questions in previous years. Many candidates
failed to include the effect of the increasing payments in the calculation of the total
instalments in part (iv) despite having correctly allowed for this in earlier parts.

10
11 (i) PV   3, 000  t  dt
4

where   t  is as follows:

0t 4

 0.030.01t dt
t
  0.03t  12 x 0.01t 2 
 t   e o
e  

4t 6

t
0.20   4 0.07 dt
 e 0.20.e
0.07 t 0.28 
 t   e .e

 e0.080.07t

t6

t
0.34   6 0.09 dt
 e0.34 .e
0.09t  0.54 
 t   e .e

 e
0.20 0.09t 

 e0.08 0.07  dt 3, 000  e

0.200.09t 
6  10
 PV  3, 000 t
dt
4 6

3, 000e0.08  0.42 0.28  3, 000e0.20  0.90 0.54 

 e e  e e
0.07   0.09  

 4584.02  7172.83  $11, 756.85

Page 12
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

(ii) 
11.75685  3 a10  a4 
at i = 6%, RHS = 3(1.029709)[7.3601  3.4651] = 12.03215

at i = 7%, RHS = 3(1.034605)[7.0236  3.3872] = 11.28671

by interpolation

 12.03215  11.75685 
 i  0.06    0.01  0.06369 i.e. 6.4%
 12.03215  11.28671 
(actual answer is 6.36%)

One of the worst answered questions on the paper with the different formulation of a question
based on varying forces of interest causing problems for many candidates. It is also possible
to answer part (i) as a combination of continuous deferred annuities. Part (ii) was poorly
answered even by candidates who had made a good attempt to part (i).

12 (i) 
1  it  LogNormal ,  2 
12
S12   1  it 
1

 
12
 ln S12   ln 1  it   N 12, 12 2
1

E 1  it   1.08  exp   2 / 2 
Var 1  it   0.052  exp 2   2    exp     1
2

   
 1.082 exp  2  1

0.052
 e
2
 1
1.082

 2  0.002141053

  ln 1.08  2 / 2

 0.075890514

Hence S12 has LogNormal distribution with parameters 0.910686 and

0.025692636

Page 13
 Subject CT1 (Financial Mathematics Core Technical) – April 2014 – Examiners’ Report

(ii) PV of annuity at time 12:

PV  4000 a   5000 a  v 4  5000 a  v6  6000 a4 v 2 v6

12 4 4
 4 
2  7%
2  7%
7% 7% 9% 9%

 1000 (4 1.037525  3.3872  5 1.043380 1.8080  0.76290

 5 1.055644 1.7591 0.66634
 6 1.044354  3.2397  0.84168  0.66634)

 1000  (14.057219  7.195791  6.186911  11.385358)

 38,825.28

Hence

Prob (18, 000 S12  38,825.28) = Prob ( S12  2.15696)

 ln  2.15696   0.910686 
= Prob  Z  
 0.025692636 

= Prob ( Z  0.8858)

=   0.89 

= 0.81

i.e. 81%

This question provided the greatest range of quality of answers. Many candidates scored
well on part (i) although common errors included assuming that E 1  it   0.08 and/or that
Var 1  it   0.05 . Few candidates calculated the correct value of the required present value
in part (ii) and candidates who made errors in this part lost further marks by not showing
clear working or sufficient intermediate steps (although the examiners recognise that some
candidates might have been under time pressure by the time they attempted this question).
The probability calculation was often answered well by candidates who attempted this part.

END OF EXAMINERS’ REPORT

Page 14
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

22 September 2014 (am)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a new page.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 S2014  Institute and Faculty of Actuaries

1 Describe how cash flows are exchanged in an interest rate swap. [2]

2 A life insurance company is issuing a single premium policy which will pay out
£200,000 in 20 years’ time. The interest rate the company will earn on the invested
fund throughout the 20 years will be 4% per annum effective with probability 0.25 or
7% per annum effective with probability 0.75. The insurance company uses the
expected annual interest rate to determine the premium.

(i) Calculate the premium. [2]

(ii) Calculate the expected profit made by the insurance company at the end of the
policy. [2]
[Total 4]

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]

4 A fund had a value of £2.0 million on 1 January 2013. On 1 May 2013, £2.5 million
was invested. Immediately before this investment, the value of the fund was £2.1
million. At the close of business on 31 December 2013, the value of the fund was
£4.2 million.

(i) Calculate the annual effective time-weighted rate of return for 2013. [2]

(ii) Calculate the annual effective money-weighted rate of return for 2013. [3]

(iii) Comment on your answers to parts (i) and (ii). [2]

[Total 7]

5 Calculate, at a rate of interest of 5% per annum effective:

12 
(i) a [1]
5

(ii) 4| a15 [1]

(iii) ( Ia )10 [1]

(iv) ( Ia )10 [1]

CT1 S2014–2
 (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]

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]

7 The force of interest, (t), is a function of time and at any time t, measured in years, is
given by the formula:

0.03 for 0  t  10

(t )  0.003t for 10  t  20

0.0001t
2
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]

CT1 S2014–3 PLEASE TURN OVER

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]

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.

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

CT1 S2014–4
 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]

CT1 S2014–5 PLEASE TURN OVER

10 A student is considering whether to attend university or enter a profession
immediately upon leaving school. If he enters the profession immediately, his salary
is expected to be as follows.

Year 1: £15,000
Year 2: £18,000
Year 3: £20,000

In each subsequent year the expected salary would rise by 1% per annum compound.
The salary is assumed to be received monthly in arrear for 40 years.

If he attends university, the fees and other costs will be £15,000 per annum for three
years, paid annually in advance. After attending university, the student’s potential
earnings will rise. Immediately after leaving university, he expects to earn £22,000 in
the first year, £25,000 in the second year and £28,000 in the third year. Thereafter,
his salary is expected to rise each year by 1.5% per annum compound. The salary
would be paid monthly in arrear for 37 years.

(i) Calculate the present value of the student’s earnings if he enters the profession
immediately at a rate of interest of 7% per annum effective. [7]

(ii) Calculate the net present value of the decision to attend university at a rate of
interest of 7% per annum effective and hence determine whether attending
university would be a more attractive option. [9]

(iii) Explain why attending university would be relatively more attractive at lower
interest rates. [2]

The student wishes to consider the effect of taxation on earnings.

(iv) Determine the rate of income tax above which the option of attending
university would be less attractive financially than that of entering the
profession immediately. [2]
[Total 20]

END OF PAPER

CT1 S2014–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2014 examinations

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners

November 2014

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

General comments on Subject CT1

CT1 provides a grounding in financial mathematics and its simple applications. It introduces
compound interest, the time value of money and discounted cashflow techniques which are
fundamental building blocks for most actuarial work.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Comments on the September 2014 paper

The comments that follow the questions concentrate on areas where candidates could have
improved their performance. Where no comment is made the question was generally
answered well by most candidates. In general the non-numerical questions were answered
poorly by marginal candidates. This applied to bookwork questions such as Q1 and Q8(i) as
well as questions requiring interpretation of answers such as Q4(iii), Q8(iv) and (v) and
Q9(iv) and (v).

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

1 One party agrees to pay to the other a regular series of fixed amounts for a certain
term. In exchange, the second party agrees to pay a series of variable amounts in the
same currency based on the level of a short term interest rate. [2]

2 (i) Expected annual interest rate

= 0.25 × 4 + 0.75 × 7 = 6.25%

Let premium = P

P (1.0625)20 = 200,000

 P = £59,490.99 [2]

(ii) Expected accumulation is:

59,490.99 (0.25 × 1.0420 + 0.75 × 1.0720)

= 205,246.55

 Expected profit = £5,246.55 [2]

[Total 4]

Many candidates struggled to distinguish between the use of an expected annual interest rate
and the expected accumulation after 20 years.

3 (i) 98.83 = 100 (1 + i)91/365

 365 
ln(1  i )      ln(98.83 / 100)  0.047205
 91 

Therefore i = 0.04834. [3]

(ii) The rate of interest over 91 days is

(100 – 98.83) / 98.83 = 0.011839

The simple rate per annum is:

365
0.011839   0.04748 [2]
91
[Total 5]
 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

4 (i) Let i be the TWRR per annum effective, then:

2.1 4.2
1 i    0.95870
2.0 2.1  2.5

 TWRR   4.130%p.a. [2]

(ii) Let i be the MWRR per annum effective, then:

2
2.0(1  i )  2.5(1  i ) 3  4.2

Try:  8% LHS = 4.20482

 9% LHS = 4.16765

 4.20482  4.2 
Then i  0.08  0.01  
 4.20482  4.16765 

i  8.130%  8.1%p.a. (Exact answer is -8.12985%) [3]

(iii) The MWRR is affected by the timing and amount of cashflows. The fund
performs relatively worse when the size of the fund is largest and this will
have a greater effect on the MWRR which is consequently lower than the
TWRR. [2]
[Total 7]

Parts (i) and (ii) were well-answered. In part (iii), examiners were looking for specific
comments regarding this scenario and not just a statement of the bookwork.

i
a5
5 (i) i (12) = 1.022715 × 4.3295 = 4.4278 [1]

(ii) a19  a4 = 12.0853 – 3.5460 [1]

= 8.5394

a10  10v 10
(iii)


1.05 7.7217  10 0.61391

=
0.04879

= 40.3501 [1]

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

a10  10v10 1.024797  7.7217  10 0.61391

(iv) =
 0.04879

= 36.3613. [1]

(v) Present value is:

13a10  ( Ia)10

= 1.05  (13  7.7217  39.3738)

= 64.0592 [2]
[Total 6]

Generally well-answered although some candidates were unable to distinguish between the
increasing annuities in parts (iii) and (iv).

6 (i) P  0.8  5 a10  100v10 @ 4% per annum.

a10  8.1109 v10  0.67556

P = 0.8 × 5×8.1109 + 100 × 0.67556 = 100

No loss of marks for general reasoning. [2]

(ii) DMT =
 tCt vt
 Ct vt
5( Ia )10  10  100v10
=
5a10  100v10

5  41.9922  10  100  0.67556

=
5  8.1109  100  0.67556

885.525
= = 8.19 years [3]
108.1108
 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

(iii) (a) On average the gross cash flows are earlier because of the higher
coupon payments. Therefore the discounted mean term would be
lower.

(b) Term of the bond

The gross redemption yield/interest rate at which payments are
discounted.
[3]

(iv) All payments are 3 months closer. Therefore, purchase price would be

100(1.04)¼  100.9853 [1]

[Total 9]

Parts (i) and (ii) were answered well. Many candidates’ arguments in part (iii)(a) were
unclear.

10
A(0,10) = e 0
0.03 dt 10
7 (i)  e[0.03t ]0  e0.3

20
A(10, 20) = e 10
0.003t dt

 0.003t 2  20
 
=e  2  10

= e(0.60.15)  e0.45

28
0.0001t 2 dt
A(20, 28) = e 20

28
 0.0001t 3 
 
 3  20
=e  e0.731730.26666  e0.46507

Required PV

1
=  e0.30.450.46507  e1.21507
A  0,10  A 10, 20  A  20, 28 

= 0.29669 [7]

(ii) (a) 0.29669 = e28

ln 0.29669
   0.04340  4.340% per annum
28

Page 6
 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

(b) (1  d)28 = 0.29669

1 – d = 0.95753

d = 0.04247 = 4.247% per annum [3]

t
  0.03ds
(iii) v(t )  e 0  e0.03t

ρ(t) = e 0.04t

We require:

7 0.03t 0.04t 7
3 e e dt   e0.07t dt
3

7
 e 0.07t 
=  
 0.07  3

= 8.75181 + 11.57977

= 2.82797 [4]
[Total 14]

Answered well. The common mistake was to calculate the effective rate of interest rather
than the effective rate of discount in part (ii)(b).

8 (i) (a) Bonds of different terms are attractive to different investors, who will
choose assets that are appropriate for their liabilities. The shape of the
yield curve is determined by supply and demand at different terms to
redemption.

(b) 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.
[4]

(ii) Let it be the spot yield over t years.

One year: yield is 6% therefore i1 = 0.06

Two years: (1 + i2)2 = 1.06 × 1.05 therefore i2 = 0.054988
Three years: (1 + i3)3 = 1.06 × 1.05 ×1.04 therefore i3 = 0.049968.
Four years: (1 + i4)4 = 1.06 × 1.05 × 1.04 × 1.03 therefore i4 = 0.04494.
[4]
 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

(iii) Price of bond is:

4[(1.06)1 + (1.054988)2 + (1.049968)3 + (1.04494)4]

+ 110 × 1.044944
= 4 × 3.54454 + 92.26294
= 106.4411

Find the gross redemption yield from:

106.4411  4a4  110v 4

Try 4%

a4 =3.6299 v 4  0.85480

RHS = 108.5476

Try 5%

a4 = 3.5460 v 4  0.82270

RHS = 104.681

Interpolate between 4% and 5%:

108.5476  106.4411
i = 0.04  0.01
108.5476  104.681

= 0.0454

= 4.54%
[5]

(iv) On average, the payments would be received earlier and discounted at higher
spot rates. This means that the gross redemption yield (which is a weighted
average of the interest rates used to discount the payments) would be higher.
[2]

(v) The earlier spot rates are likely to fall as a result of greater demand for the
bonds with shorter terms to redemption. [2]
[Total 17]

Parts (i) and (iii) were generally answered well with correct approaches in part (iii) given
full credit even if the calculations in part (ii) had been incorrect. In common with other
similar questions on this paper, the reasoning questions in parts (iv) and (v) were poorly
answered.

Page 8
 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

9 (i)
Date Nominal Cash Flow Indexed Cash Flow
£m £m
1/12/2012 0.0075×3.5 = 0.02625 (116/112)×0.02625 = 0.0271875
1/6/2013 0.0075×3.5 = 0.02625 (117/112)×0.02625 = 0.0274219
1/12/2013 0.0075×3.5 = 0.02625 (120/112)×0.02625 = 0.028125
1/6/2014 (1 + 0.0075)×3.5 = 3.52625 (121/112)×3.52625 = 3.8096094

[5]

(ii)
Date Indexed Cash Flow Index Ratio Real Value of Cash flow
£m £m
1/12/2012 0.0271875 113/117 0.0262580
1/6/2013 0.0274219 113/118 0.0262599
1/12/2013 0.028125 113/121 0.0262655
1/6/2014 3.8096094 113/122 3.5285726

[4]

(iii) Value of £3.5m nominal is:

0.0262580v½ + 0.0262599v + 0.0262655v1½ + 3.5285726v2

= 0.0262580 × 0.992583 + 0.0262599 ×0.98522 + 0.0262655 ×0.97791

+ 3.5285726 × 0.97066

= £3.502657m
3.502671
Per £100 nominal =  100
3.5

= £100.0763 [3]

(iv) The expected rate of return at issue is likely to have been higher. Although the
investor is compensated for the higher-than-expected inflation, the time lag
used for indexation is likely to mean that he is not fully compensated.
Therefore the actual real value of the cash flows is less than the expected real
value of the cash flows at issue. [2]

(v) It is likely that the price will fall. The expected real value of the cash flows
measured will be lower because the cash flows will be linked to an index
expected to rise at a lower rate. [2]
[Total 16]

The most poorly answered question on the paper. Better candidates took advantage of the
relatively large number of marks available in parts (i) and (ii) for straightforward
calculation work. The important point in part (iii) is to note that the real redemption yield
 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

equation uses inflation adjusted cashflows (in terms of 1 June 2012 prices in this case). In
part (iv), the important point is that the time lag causes the investor not to be fully protected
against inflation. If there had been no time lag, the actual increase in the retail price index
would have no effect on the investor’s real rate of return.

10 (i) Present value of earning if university is not attended:

15, 000 a (12)  18, 000 a (12) v  20, 000 a (12) v 2  20, 000a (12)
1 1 1 1

1.01v3 (1  1.01v  ...  1.0136 v36 )

i
= (12)
a1 (15, 000  18, 000v  20, 000v 2 )
i

3   1  1.01 v 
37 37
 i
  20, 000 (12) a1 *1.01v   
 i   1  1.01v 

i
= 1.031691; a1  v  0.93458
i (12)

v2 = 0.87344; v3 = 0.81630; 1.0137 = 1.445076

v37 = 0.08181.

1.031691 × 0.93458 (15,000 + 18,000 × 0.93458 + 20,000 × 0.8734)

+ (20,000 × 1.031691 × 0.93458

 1  1.445076  0.081809 
×1.01 × 0.81630)  
 1  1.01 0.9346 

= 47,527.46 + 15,898.86 × 15.7252

= £297,537.30 [7]

(ii) The cost of going to university is:

15, 000  a3 @ 7%  42,120.27

a3  2.6243 1.07  2.8080

Page 10
Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

The PV of the salary from attending university at the time of leaving

university is:

22, 000 a (12)  25, 000 (12) v  28, 000 a (12) v 2

1 1 1

28, 000 a (12) 1.015v3 (1  1.015v    1.01533 v33 )

1

i
= a (22, 000  25, 000v  28, 000v 2 )
(12) 1
i

  1  1.015 v 
34 34
 i
+  28, 000 (12) a1 1.015v3   
 i   1  1.015v 

1.01534 = 1.658996

v34 = 0.10022

= 1.031691 × 0.93458(22,000 + 25,000 × 0.93458

+ 28,000 × 0.87344) + 28,000 × 1.031691 × 0.93458 × 1.015

 1  1.658996  0.10022 
× 0.81630  
 1  1.015  0.93458 

= 67,321.02 + 22,368.60 × 16.21996

= 430,138.80

PV at time of decision = 430,138.80 × v3

= 430,138.80 × 0.81630 = £351,121.46

There are various ways in which the answer can be rationalised.

NPV of benefit of going to university (net of earnings lost through the

alternative course of action)

= 351,121.46 – 42,120.27 – 297,537.30

= £11,463.89 [9]

(iii) The costs of going to university are incurred earlier and the benefits received
later. If the rate of interest is lower, then any loans taken out to finance
attendance at university will be repaid more easily at a lower interest cost
(answer could say that value of payments received later will rise by more
when the interest rate falls). [2]
 Subject CT1 (Financial Mathematics Core Technical) – September 2014 – Examiners’ Report

(iv) Tax is paid on income only at rate t.

Therefore, equation of value is:

351,121.46 (1 – t) = 42,120.27 + 297,537.30 × (1  t)

351,121.46 – 42,120.27 – 297,537.30

= t (351,121.46 – 297,537.30)

 11,463.89 = 53,584.16t

 t = 0.2139 or 21.39% [2]

[Total 20]

Parts (i) and (ii) were often well-answered although marginal candidates would have
benefited from setting out their working more clearly and some candidates failed to’
determine whether attending university would be a more attractive option’ despite having
completed the requisite calculations.

Part (iii) was poorly answered by marginal candidates with few such candidates correctly
considering the relative timing of the costs and benefits. Few such candidates attempted part
(iv) perhaps because of time pressure. Stronger candidates, however, often obtained close to
full marks on the question.

END OF EXAMINERS’ REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

20 April 2015 (pm)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 12 questions, beginning your answer to each question on a new page.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 A2015  Institute and Faculty of Actuaries

1 Explain why the running yield from property investments tends to be greater than that
from equity investments. [3]

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]

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]

4 (i) Describe what is meant by the “no arbitrage” assumption in financial

mathematics. [2]

A 9-month forward contract is issued on 1 April 2015 on a stock with a price of £6

per share on that date. Dividends are assumed to be received continuously and the
dividend yield is 3.5% per annum.

(ii) Calculate the theoretical forward price per share of the contract, assuming no
arbitrage and a risk-free force of interest of 9% per annum. [2]

The actual forward price per share of the contract is £6.30 and the risk-free force of
interest is as in part (ii).

(iii) Outline how an investor could make an arbitrage profit. [2]

[Total 6]

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]

CT1 A2015–2
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]

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]

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]

CT1 A2015–3 PLEASE TURN OVER

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]

10 The force of interest, δ(t), is a function of time and at any time t (measured in years) is
given by

0.08 for 0  t  4

(t )  0.12  0.01t for 4  t  9
0.05 for t  9


(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]

CT1 A2015–4
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 60X. 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]

12 In any year, the yield on investments with an insurance company has mean j and
standard deviation s and is independent of the yields in all previous years.

(i) Derive formulae for the mean and variance of the accumulated value after n
years of a single investment of 1 at time 0 with the insurance company. [5]

Each year the value of (1  it ), where it is the rate of interest earned in the t th year, is
lognormally distributed. The rate of interest has a mean value of 0.04 and standard
deviation of 0.12 in all years.

(ii) (a) Calculate the parameters µ and  2 for the lognormal distribution of
(1  it ).

(b) Calculate the probability that an investor receives a rate of return

between 6% and 8% in any year.
[8]

(iii) Explain whether your answer to part (ii) (b) looks reasonable. [2]
[Total 15]

END OF PAPER

CT1 A2015–5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2015 examinations

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context at the date the
examination was set. Candidates should take into account the possibility that circumstances
may have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners

June 2015

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

General comments on Subject CT1

CT1 provides a grounding in financial mathematics and its simple applications. It introduces
compound interest, the time value of money and discounted cashflow techniques which are
fundamental building blocks for most actuarial work.

Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.

Comments on the April 2015 paper

The comments that follow the questions concentrate on areas where candidates could have
improved their performance. Where no comment is made the question was generally
answered well by most candidates. In general, the non-numerical questions were answered
poorly by marginal candidates.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

1 Dividends usually increase annually whereas rents are reviewed less often.
Property is less marketable.
Expenses associated with property investment are higher.
Large, indivisible units of property are less flexible.
On average, dividends will tend to rise more rapidly than rents because dividends
benefit from retention and reinvestment of profits in earlier years.

The worst answered question on the paper with over one-third of candidates scoring no
marks.

2 (a) Let the answer be t days

 t 
3,000  1  0.04   =3,800
 365 

t = 2,433.33 days

(b) Let the answer be t days:

t
3,000 (1.04) 365 = 3,800

t
3,800
 (1.04) 365 =
3, 000

t  3,800 
ln1.04 = ln  
365  3, 000 

t = 2,199.91 days.

3 (i) 96.5(1.04)t = 98

t × ln(1.04) = ln(98/96.5)

Therefore, t = 0.3933 years = 143.54 days (144 days)

(ii) The second investor held the bill for 182–144 = 38 days

 38 
Therefore 98  1  i  = 100
 365 

 100  365
i=   1  = 0.19603 or 19.603%
 98  38

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

(iii) The actual rate of interest over 38 days was (100/98) – 1 = 0.020408

Annual effective rate over 1 year would be:

(1 + 0.020408)365/38  1 = 0.21416 or 21.416%

4 (i) The “no arbitrage” assumption means that neither of the following applies:

(a) an investor can make a deal that would give her or him an immediate
profit, with no risk of future loss;

(b) an investor can make a deal that has zero initial cost, no risk of future
loss, and a non-zero probability of a future profit.

 0.090.035129
(ii) The theoretical price per share of the forward contract is £6e
 £6.2527

(iii) In this case the actual forward price is too expensive in relation to the stock.

0.035 9 0.035 9
The investor should borrow £6e 12 and use this to buy e 12 units of

the stock. The investor will also go short in one forward contract. The
continuous dividends are reinvested in the stock. (Mark given for general
strategy, exact amounts not required).

0.035 9
12  e
0.035 9
[After nine months, the investor will have e 12 =1 unit of stock

that can be sold under the terms of the forward contract for £6.30. The
9 0.09 9
0.03512
investor will also have to repay cash of £6e e 12  £6.2527 .]

Whilst it was not required for candidates to give a full mathematical explanation for part
(iii), they were expected to recognise that the forward was overpriced and to determine the
arbitrage strategy accordingly.

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

5 We will use the ½-year as the time unit because the interest rate is convertible half
yearly. The effective rate of interest is 3% per half year.

120
s8  1.03  60s 2   1.03  60s 6  at 3%
16 8
Accumulated amount =
a2 8 8

6
 6  d  6  1 1
We need d from 1    1  d  
 6  1  i 1.03

d  6  1  6   1  
1 1
6
6
 1    d = 1    6

6  1.03    1.03  

= 0 .029486111

Thus accumulated amount =

120 i i
s8  1.03  60 s8  1.03  60
16 8
s at 3%
d  d 
a2 2 6 8

120 0.03
  8.8923 1.60471  60  1.022445  8.8923 1.26677  60   8.8923
1.9135 0.029486111

= 894.877 + 691.040 + 542.837

= £2,128.75

(above uses factors in formulae and tables book; if book not used then exact answer is
£2,128.77).

Generally well-answered but marginal candidates would have benefited from showing their
intermediate working in greater depth and/or with greater clarity.

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

6 Let:

i  nominal yield
e  inflation rate
i  real rate

Then

1  i  1  i 1  e 

We first find i and then use above equation to find i :

6  1.06 
2
6 6 1.06
175 = 1
 1
 1

1  i  2
1  i 1 2 1  i 2 2

6  1.06 1.06 2 
 1     
1  i 
1
2  1  i 1  i 2 
 
 
6  1 
 1  1.06 
1  i  2
 1 
 1 i 
1
6 1  i  2

1  i  1 
1.06 

 1 i 
1
6 1  i  2

i  0.06

Let i  10%, RHS = 157.32

i  9% , RHS = 208.81

Hence

 208.81  175 
i  0.09  0.01   
 208.81  157.32 

= 0.09657 (answer to nearest 0.1% is 9.6%)

Page 6
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

Then we have

1.09657  1  i 1.04

 i  5.44% p.a. real return (answer to nearest 0.1% is 5.4%)

An alternative method of formulating the equation in real terms to find i’ directly was
perfectly valid.

7 (i) Time Spot rate of interest

½ 0.01
1½ 0.03
2½ 0.05
3½ 0.07
4½ 0.09

Value of liabilities (£m)

 0.5
V  1 v1% 1.5
 v3% 2.5
 v5%  v7%
3.5 4.5
 2v9%

½ = 0.99504
1%v
1.5 = 0.95663
3%v
2.5 = 0.88517
5%v
3.5 = 0.78914
7%v
4.5 = 0.67855
9%v
V = 4.98308

(ii) Because expectations of short-term interest rates rise with term and the yield
curve is determined by expectations theory.

Because investors have a preference for liquidity which puts an upwards bias
on the yield curve (e.g. because long-term bonds are more volatile). A rising
curve would be compatible, for example, with constant expectations of interest
rates.

Because the market segmentation theory holds and investors short-term bonds
might be in demand by investors such as banks (or there is an undersupply of
short-term bonds or less demand/more supply for long-term bonds).

(iii) Spot rate to time 4.5 is 9%. Spot rate to time 3.5 is 7%. Therefore:

1.094.5/(1.07)3.5 = forward rate from 3.5 to 4.5 = 16.3%

Common errors in part (i) were to assume payments at the end of the year and/or to assume
that the payments should be valued with the end of year spot rate (2%, 4%, 6% etc.)

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

8 (i) P  9a10 7%  100v10

7%

v10  0.50835; a10  7.02358

P = 9  7.02358  100  0.50835

 114.047

(ii) Discounted mean term

 tCt vt

 Ct vt

9  Ia 10  10 100v10

114.047

9  34.7391  10 100  0.50835


114.047

= 7.199 years

(iii) Duration will be higher because the payments will be more weighted towards
the end of the term.

(iv) (a) Effective duration = duration / 1  i 

 7.199 /1.07  6.728 years

(b) Effective duration would indicate the extent to which the value of the
bond would change if there were a uniform change in interest rates. It
is therefore an indication of the risk to which the investor is exposed if
interest rates rise and the price of the security falls before it is sold.

Many of the explanations from candidates in part (iii) were very unclear.

Page 8
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

9 Present value of outgoings = 4,000,000 + 900,000v½

@12%  4,850, 420

Present value of income =

 4  4
360, 000va  360, 000 1  k  v 2 a
1 1

4  4
   360, 000v5 1  k  a  6,800, 000 v 6
1
 4
 
 360, 000 a v 1  v j  v 2j  v3j  v 4j  6,800, 000 v 6
1

1.12
where j  1
1 k

 4
a  0.95887@12%
1
1
So, present value of income  360, 000  0.95887   a j  6,800, 000 v 6
1.12 5

 308, 209a j  3, 445, 092

5

Hence, for IRR = 12%, 4,850,420 = 308, 209 a j  3, 445, 092
5

so a j  4.55966
5

At 4% a5  4.62990

5% a5  4.54595

4.62990  4.55966
j  4  4.837%
4.62990  4.54595

1.12
j 1
1 k
1.12
0.04837  1
1 k
1.04837 1  k   1.12

1.12
k  1  0.0683  6.83% (exact answer is 6.84%)
1.04837

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

Marginal candidates again would have benefited from showing more intermediate working.
In project appraisal questions, it is good exam technique to show working and answers for
each component of income and outgo separately so that partial marks can be given if any
errors are made within a component.

10 (i) For 0  t  4 :

v  t  = exp      s  ds   exp    0.08ds 

t t

 0   0 

 e 0.08t and v  4   e 0.084  e0.32

For 4  t  9 :

v  t  = exp      s  ds     s  ds   e0.32 exp    0.12  0.01sds 

4 t t

 0 4   4 

t
= e 0.32 exp  0.12 s  0.005s 2 
 4


 e0.32 exp 0.48  0.08  0.12t  0.005t 2 
2
= e0.080.12t 0.005t

and v  9   e0.080.1290.00581  e 0.595

For t  9 :

v  t  = exp      s  ds     s  ds   e0.595 exp    0.05ds 

9 t t

 0 9   9 

= e 0.595 exp  0.05s 9  e0.595 exp  0.45  0.05t   e 0.1450.05t

t

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

(ii) Present value is

12 0.03t    t  s ds   dt
10 100 e  exp  0    
  

12
  100e0.03t e 0.1450.05t dt
10

12
12 0.1450.02t 100e 0.1450.02t 
  100e dt   
10  0.02 10

 
12
  5, 000e 0.1450.02t   5, 000 e 0.345  e0.385
 10

 138.85

1  e0.083
(iii) Present value = 1, 000a3 8%  1, 000  £2,561.89
e0.08  1

11 (i)  Ia n  v  2v 2  3v3    nv n (1)

1  i  Ia n  1  2v  3v 2    nv n1 (2)

 2   1  i  Ia n  1  v  v 2    v n1  nv n

  Ia n 
1  v  v 2

   v n 1  nv n

an  nv n
i i

(ii) Work in months i.e. use a monthly interest rate of 1.25% per month effective:

 a  60v 60 
2
30, 000  Xv  2 Xv    60 Xv 60
 X  Ia 60 @1.25%  X  60 
 i 
 

 1  v 60  1  1.012560 60 
60    60  1.0125 
  60v 
 0.0125 1.0125 
X  d  X
 i   0.0125 
   
   

 1126.8774X  X  £26.62

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

(iii) Equation of value:

30, 000  v36 958.32a60

 v36 a60  31.3048

Try i = 1%: LHS = 31.4202

Try i = 1.1%: LHS = 29.5098

 31.3048  31.4202 
Interpolate: i  1%  0.1%    1.0060%
 29.5098  31.4202 

APR is 1  0.010060   1  12.8% to 1 d.p.

12

The bank is unlikely to be happy to accept the suggestion as it will be earning

a lower rate of return compared with the original proposal of 15% per annum
convertible monthly (=16.1% per annum effective).

(iv) The student’s arrangement will lead to a greater total of payments

(60 payments of 36X) when compared to the original arrangement
(60 payments of 30.5X on average) but will incur a lower rate of interest. This
is because under the student’s arrangement no capital or interest will be paid
for three years. The extra total of payments will not be sufficient to cover the
deferred interest at the bank’s preferred rate.

In part (i), candidates were expected to show the first and last terms of each series used to
derive the result so that the proof is absolutely clear. In part (ii), candidates should show
enough steps to demonstrate that they have performed the calculations required to actually
prove the answer (e.g. show the numerical values for the factors used) . In part (iv), if
interpolating on a monthly interest rate (as in the above solution) the guesses most be close
enough together to ensure the estimated annual rate is close enough to the correct answer.

12 (i) Let S n  Accumulated value at time n of £1 invested at time 0

Sn = 1  i1 1  i2  .... 1  in 

 E  Sn  = E 1  i1 1  i2  .... 1  in  

 E 1  i1  . E 1  i2  .... .E 1  in  by independence

and E 1  it   1  E  it   1  j

Page 12
Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

Hence

E  Sn   1  j 
n

Now

Var  Sn  = E  Sn2    E  Sn 
2
 

= E 1  i1  1  i2  .... 1  in  
2 2 2
E  Sn2 
   

= E 1  i1   . E 1  i2   .... .E 1  in  

2 2 2
     

by independence

and

   
E 1  it   = E  1  2it  it2 
2
 
= 1  2 E  it   E it2  
and

 
Var it   s 2 = E it2   E  it  
2

 
= E it2  j 2

 
 E it2  s 2  j 2

Hence

 
n
E  Sn2   1  2 j  j 2  s 2
 

and

 
n
Var  Sn   1  2 j  j 2  s 2  1  j 
2n

Page 13
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

(ii) (a) E 1  it   1  E  it   1  j  1.04  e

 
2
2

Var 1  it   Var  it   s 2  0.122  e

 22  
e 1
2

0.122 2
  e  1
1.04  2

2
  0.12 2 
   Ln 1    
  1.04  

 2  0.013226

 0.013226 
  
1.04  e 2 

0.013226
  = Ln 1.04 
2
= 0.032608

(b) Ln 1  it   N  0.032608, 0.013226 

and we require probability 0.06  it  0.08

 Pr 1.06  1  it  1.08

 Pr  Ln 1.06  Ln 1  it   Ln 1.08 

 Ln 1.06  0.032608 Ln 1  it    Ln 1.08  0.032608 

 Pr    
 0.013226  0.013226 

 Pr  0.22    0.39  where   N  0,1

=   0.39     0.22 

 0.65173  0.58706  0.0647

i.e. 6% probability (using exact Φ function gives probability of 6.2%)

(iii) The probability in (ii) (b) is small. This is reasonable since the expected
return in any year is 4%, and we are being asked to calculate the probability
that the return is between 6%, and 8% (i.e. a range which does not include the
expected value).

Page 14
 Subject CT1 (Financial Mathematics Core Technical) – April 2015 – Examiners’ Report

In part (i), it is important to note when the assumption of independence is required for both
proofs. Common mistakes in the calculation of ߤ and ߪ were to assume that s2 was 0.12
(rather than s) and 1 + j was 0.04 (rather than 1.04).

END OF EXAMINERS’ REPORT

Page 15
1
2 INSTITUTE AND FACULTY OF ACTUARIES
3
4
5
6
7
EXAMINATION
8
9 30 September 2015 (pm)
10
11 Subject CT1 – Financial Mathematics
12 Core Technical
13
14
Time allowed: Three hours
15
INSTRUCTIONS TO THE CANDIDATE
16
17 1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
18
2. You must not start writing your answers in the booklet until instructed to do so by the
19
supervisor.
20
3. Mark allocations are shown in brackets.
21
22 4. Attempt all nine questions, beginning your answer to each question on a new page.

23 5. Candidates should show calculations where this is appropriate.

24
25 Graph paper is NOT required for this paper.

26
AT THE END OF THE EXAMINATION
27
28 Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
29
30 In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
31
32
33
34
35 CT1 S2015  Institute and Faculty of Actuaries
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]

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]

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]

CT1 S2015–2
4 A nine-month forward contract was issued on 1 October 2015 on a share with a price
at that date of £10. Dividends of 50 pence per share are expected on 1 November
2015 and 1 May 2016. The risk-free force of interest is 5% per annum.

(i) Calculate the forward price at issue, stating any further assumptions made and
showing all workings. [4]

(ii) Explain why the expected price of the share nine months after issue does not
have to be taken into account when pricing the forward. [2]
[Total 6]

5 An individual can obtain a force of interest per annum at time t, measured in years, as
given by the formula:

0.03  0.005t 0  t  3
(t )  
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]

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,
f 2,1 . [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]

CT1 S2015–3 PLEASE TURN OVER

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 (i.e. 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]

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]

CT1 S2015–4
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 of 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]

CT1 S2015–5 PLEASE TURN OVER

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]

END OF PAPER
CT1 S2015–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2015

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

F Layton
Chairman of the Board of Examiners
December 2015

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. CT1 provides a grounding in financial mathematics and its simple applications. It

introduces compound interest, the time value of money and discounted cashflow
techniques which are fundamental building blocks for most actuarial work.

2. Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be
penalised where excessive rounding has been used or where insufficient working is
shown.

B. General comments on student performance in this diet of the

examination

1. The comments that follow the questions concentrate on areas where candidates could
have improved their performance. Where no comment is made the question was
generally answered well by most candidates.

2. Student performance was poorer than in previous years. The performance across all
questions was of a lower standard which indicated that the lower performance was not as
the result of some particularly difficult individual questions.

3. There were some ambiguities in the wording and mark scheme for Q8 but the marking
process was adjusted to ensure that candidates were not disadvantaged.

4. There were also elements of non-numerical explanation and analysis required in several
questions and, as in previous papers, students performed relatively badly on these
sections.

5. Finally, it appeared that many students left themselves short of time for the last question,
Q9, which was worth 26 marks.

C. Comparative pass rates for the past 3 years for this diet of examination

Year %
September 2015 44
April 2015 55
September 2014 57
April 2014 60
September 2013 57
April 2013 60

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

Reasons for any significant change in pass rates in current diet to those in the
past:

Historically, the papers have been set by experienced examiners and this has led to very
stable pass marks and relatively stable pass rates. This paper was set by the same
examining team.

As highlighted in Section B, the performance by candidates on this paper has been

significantly poorer than for past exams in this subject. The examiners do not believe that the
paper was significantly different this session and any potential ambiguities in the paper were
fully allowed for within the marking process.

We have no definite cause for the lower marks. An analysis on a question by question basis
shows that candidates on average were only scoring above 60% on average on two
questions out of nine, one of which was the 3-mark Q1. This all suggests a relatively weak
cohort.

Solutions

Q1 P = 100(1.03)91/365 = 0.99266 or £99.266

Let annual simple rate of discount = d

99.266 91
 1 d
100 365

91
Therefore d = 0.00734; d = 0.02945
365

 12   12   0.055 12 

  ln(1  i )  ln  1     ln  1 
d
Q2 (i) (a)
    0.055126
12   
  12  
  
= 5.513%

12
 d 12   0.055 
12

(b) 1  i   1    i  1    1  0.056674 = 5.667%

 12   12 

1
i   d     0.055  1 
12 12
12 
(c) 1  1    i  12  1    1  0.055253
12  12   12  

= 5.525%

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

(ii) When interest is paid monthly, the interest that is paid in earlier months itself
earns interest. This means that to achieve the same effective rate over the year,
the nominal rate must be lower.
1
 100 
8

(iii) 100  159(1  d )  d  1  

8
  0.056319 = 5.632%
 159 

1  i  1.12 2  i  0.058301  5.830%

1
(iv)

Parts (i) and (iii) were generally calculated well although many candidates
chose not to give their final answer to the requested accuracy. Some
candidates attempted to use their answers to parts (i)((a) and (i)(b) to find an
answer to part (i)(c) – this was not accepted by the examiners . Part (iv)
proved more challenging to many candidates. Amongst the marginal
candidates, there were very few who gave a clear explanation for part (ii). It
is a matter of concern that so many candidates were unable to articulate the
relationship between nominal and effective interest rates.

( Ia )12 56.6328
Q3 (i) Duration of the annuity payment is =  6.0343 years
a12 9.3851

(ii) Duration of bond is:

5( Ia )8  800v8
5a8  100v8

5  28.9133  800  0.73069

=
5  6.7327  100  0.73069

729.119
  6.8313 years
106.733

(iii) The duration of the assets (the bond) is greater than the duration of the
liabilities (pension payments). If there is a rise in interest rates, the present
value of the assets will fall by more than the present value of the liabilities and
the insurance company will make a loss.

Parts (i) and (ii) were answered well. Where a term is calculated, it is
particularly important to include the units in the final answer. Part (iii) was
very poorly answered with many candidates stating that the company must
make a loss because the durations were not equal.

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 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

Q4 (i) Assuming no arbitrage

The present value of the dividends (in £), I, is:

I = 0.5(e0.05× (1/12) + e0.05× (7/12) ) = 0.5 × (0.995842 + 0.971255) = 0.98355

Hence, forward price F = (10 – 0.98355)e0.05(9/12) = £9.3610

(ii) The expected price of the share does not have to be taken into account
because, using the no-arbitrage assumption, the purchaser of the forward is
simply able to use the current price of the share (and the value of the
dividends) given that the forward is simply an alternative way of exposing the
investor to the same set of cash flows.

[The expected future price of the share will be taken into account by investors
when determining the price they wish to pay for the share and therefore the
current share price.]

Part (i) was often answered well although some candidates miscalculated the
timing of the dividends and the statement of the arbitrage assumption was
often missed. Part (ii) was poorly answered despite being similar to previous
exam questions.

Q5 (i) Present value is

6 6

 (t )v(t )dt   5000v(t )dt

3 3

For t  3

v(t )  exp      t  dt   exp    0.03  0.005t dt   0.005 dt 

t 3 t

 0   0 3 
3
 exp  0.03t  0.0025t 2  exp  0.005t  3
t
 0

 exp  0.1125 exp  0.015  0.005t 

 exp(0.005t  0.0975)

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

Hence present value is

 5, 000 exp(0.005t  0.0975)dt

3

6
0.0975 0.005t
 5, 000e e dt
3

5, 000e0.0975  0.005t  6
 e  1, 000, 000e0.0975 (e 0.03  e0.015 )
0.005   3

 880.293.42  893,597.35  £13,303.93

(ii) 5, 000(a6  a3 )  13,303.93

i = 2%: LHS = 13,723

i = 3%: LHS = 13,136

Interpolating

13,304  13, 723

i  0.02  0.01  2.714% say 2.7%
13,136  13, 723

(iii) Accumulation =

 300 A(50)  300exp(0.005  50  0.0975)

 300e0.3475  £424.66

The discount factor was usually calculated correctly although some

candidates just calculated this factor for t = 6 and assumed that the value of a
single payment at this time was required. Part (ii) was poorly answered. The
important point is that the rate of interest is obtained by equating the amount
initially invested as calculated in part (i) with the present value of the annuity.

Q6 (i) 101  3a3  100v3

i = 3%: RHS = 100

i = 2.5%: RHS = 101.428

Interpolating

101  101.428
i  0.025  0.005   2.65%
100  101.428

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 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

(ii) Let in = spot rate for term n

One year bond gives

101  103vi1

101
vi1   0.98058
103
103
 i1   1  1.980%
101

Two year bond gives

101  3vi1  103vi22

101
101  3
 vi22  103  0.95202
103
 i2  2.489%

Three year bond gives

101  3vi1  3vi22  103vi33

101  3  0.98058  3  0.95202

 vi33   0.92429
103
 i3  2.659%

(iii) Forward rate is f2,1 where

(1  i3 )3 1.026593
1  f 2,1    1.03000  f 2,1  3.000%
(1  i2 )2 1.024892

(iv) Reasons could include:

Expectations theory suggests that if short-term interest rates are expected to

rise then if yields are the same on both long- and short-term bonds, short-term
bonds will be more attractive and longer term bonds less attractive and so the
yields on short-term bonds will fall relative to those on long-term bonds.

[Expected higher inflation could be a reason for this but could be allowed as a
distinct point]

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 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

Liquidity preference theory suggests that investors demand higher rates of

return for less liquid/longer term-to-maturity investments which are more
sensitive to interest rate movements.

Market segmentation with the supply of bonds being restricted at shorter terms
or some factor that leads to the demand for bonds of longer terms to be lower

Common errors on this question included assuming the price of each bond
was 100 and that the gross redemption yield of the 3-year bond was equal to
the three-year spot rate. In part (iv) many candidates just gave the names of
theories of the yield curve without explaining how this applied in this particular
scenario. Otherwise, this was the best answered question on the paper apart
from Q1.

Q7 (i) Maximum rate of return after 20 years

 
100  0.75 7 a (2)  3a (2)  130v 20
20 10

Try i = 5%:

 7  (1  1.0520 )  3  (1  1.0510 ) 
RHS = 0.75    130  1.0520
 1
2(1.05 2  1) 
 

 48.6460  48.9956  97.6417

Try i = 4%:

 7  (1  1.04 20 )  3  (1  1.04 10 ) 

RHS = 0.75    130  1.04 20
 1
2(1.04 2  1) 
 

 53.6255+59.3303  112.9558

Interpolating

100  112.9558
i  0.04  0.01  4.846%  4.8%
97.6417  112.9558

(Exact answer is 4.8338%.)

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Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

(ii) Minimum rate of return after 10 years

In this case, the investor invests 100, receives 100 back and receives a net
income at a rate of 1.5 per half-year. The rate of return per half-year effective
is therefore 1.5 per cent.

The annual effective rate of return is 1.0152 – 1 = 3.0225%.

(iii) There is a 0.5 probability of both early redemption and of late redemption. The
expected return is therefore 0.5(4.8338%  3.0225%)  3.928%

(iv) If the investor buys the whole loan, the present value of the cash flows from
the loan is as follows (per €100 nominal):


 0.75  4 a (2)  0.5  100v10  0.5 0.75  7 a (2) v10  130v 20
10 10 
At i = 3.928% this is

1  1.0392810
3 1
 50  1.0392810
2(1.03928 2  1)

 1  1.0392810 
0.5  5.25 1.0392810  130  1.0392820 
 1
2(1.03928 2  1) 
 

 24.6575  34.0125  0.5(29.3538  60.1562)

 103.4264

This is greater than 100 and so the rate of return will be greater than 3.928%
(exact return is 4.212%).

This was the worst answered question on the paper with many candidates not
recognising that the cases where the bond is redeemed after 10 years and
after 20 years have to be calculated separately for parts (i) and (ii). If
candidates obtained answers for parts (i) and (ii) then part (iii) was usually
done well. However, few candidates recognised that substituting the return
from part (iii) into the required equation for part (iv) would lead to the required
answer.

The question did not state specifically that the coupons in the second
10 years were semi-annual although most students assumed this.
Candidates who assumed a different coupon frequency were given full credit.

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 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

Q8 (i)
 Generally issued by commercial undertakings and other bodies.
 Shares are held by the owners of a company who receive a share in the
company’s profits in the form of dividends
 Potential for high returns relative to other asset classes…
 …but high risk particularly risk of capital losses
 Dividends are not fixed or known in advance and…
 …the proportion of profits paid out as dividends will vary from time-to-
time
 No fixed redemption date
 Lowest ranking finance issued by companies.
 Return made up of income return and capital gains.

 Initial running yield low but has potential to increase with dividend
growth…
 …in line with inflation and real growth in company earnings.
 Marketability depends on the size of the issue.
 Ordinary shareholders receive voting rights in proportion to their holding.

(ii) Let

P = price investor is willing to pay

d = next expected dividend
g = expected annual dividend growth rate
r = annual required return
t = tax rate

Then

d (1  t ) d (1  t )(1  g ) d (1  t )(1  g ) 2
P   
1 r (1  r )2 (1  r )3

d (1  t )  1  g  1  g   1  g  
2 3

 1       
1  r  1  r  1  r   1  r  
d (1  t ) 1 d (1  t )
 
1 r 1 1 g rg
1 r

(iii) d = 6p
g = 0.01
r = 0.06
t = 0.2

d (1  t ) 6(1  0.2)
P   96 p
rg 0.06  0.01

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

(iv) If the share were regarded as more risky, then the required return, r, would
increase. If r were to increase, this would reduce the value of the share as r is
in the denominator (and is positive).

(v) Equation of value would be (working in money terms):

960  0.8  60v  1200v  0.25 1200  960  v

96
v
118.8
118.8
Therefore net money rate of return, i, is  1  23.75%
96

1.2375
Net real rate of return is  1  20.80%
126 123

There was an error in the paragraph prior to part (v) of this question where
the calculation was designed to be based on the purchase/sale of 1,000
shares but the question referred to the sale of “the share”. Nearly all
candidates based their calculation on the purchase/sale of the same number
of shares (whether it be 1 share or 1,000) but candidates who made a
different assumption were not penalised.

There was no split of the marks between parts (ii) and part (iii) given on the
paper. Candidates who just performed the calculation without the derivation
of the formula were give appropriate credit but a formula derivation was
required to obtain the full five marks for these parts. The question did not
state specifically that the dividends were paid annually although almost all
candidates assumed this. Candidates who assumed other payment
frequencies were given full credit.

Q9 (i) (a) The payback period is the first time at which the total incoming cash
flows are equal or greater in amount than the total outgoing cash flows.

Total incoming cash flows at the beginning of year t = 60,000t.

Determine t for which 60, 000t  1, 000, 000  t  16.67

Therefore the payback period is 16 years.

(b) The net total income received in any year from project A is never
greater than £60,000. As the costs are incurred at the beginning of the
year, there is no point at which the total income from project A is
greater than the total income from project B until the very end of the
project when the properties are sold. The payback period for B must
therefore be less than that for A.

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 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

(ii) (a) The discounted payback period occurs where the present value (or
accumulated value) of incoming cash flows is equal to or greater than
that of outgoing cash flows for the first time.

(b) Equation of value for project B is (in £000):

60at  1, 000

1, 000 1, 000
 at    16.5016
60(1  i ) 60.6

Need to solve for t. From inspection of tables, t = 19 and so the

discounted payback period is 18 years.

(c) Again, given that the net income from project A is never greater in an
individual year, than that from project B, at no rate of interest can the
discounted value of the net income from project A be greater than that
for the income from project B.

(iii) Internal rate of return from project B is the solution to the following equation
of value (all figures in 000s):

1, 000  60a20  1, 000v 20

This can be solved by general reasoning.

As the investor invests 1,000 and receives an annual income of 60 in advance

and receives his capital back at the end, the total rate of return, d, expressed as
an effective rate of discount per annum is 6 per cent.

d 0.06
Internal rate of return is i    6.383%
1  d 0.94

(iv) If the IRR from project A is higher then it must have a net present value > zero
at a rate of interest of 6.383 per cent.

Note that v = 0.94 at i = 6.383%

Present value of costs for project A:

 1, 000  10(1  1.005v  1.0052 v 2  ...  1.00519 v19 )

 1  1.00520 v 20 
 1, 000  10  
 1  1.005v 

 1  (1.005  0.94) 20 
 1, 000  10  
 1  1.005  0.94 

Page 12
Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

0.67946
 1, 000  10  1,122.869
0.0553

Present value of revenue for project A:

 2, 000v 20  60a(12) v  60a(12) v5 (1.005  1.0052 v    1.00515 v14 )

4 1

 2, 000v 20  60a(12) v  60a(12)1.005v5 (1  1.005v    1.00514 v14 )

4 1

 1  1.00515 v15 
 2, 000v 20  60a(12) v  60a(12)1.005v5 
4 1  1  1.005 v 
 
 1  0.94 4 
 2, 000  0.9420  60  0.94  
 12(1  (1  0.06) 12 ) 
1
 

 1  0.94   1  (1.005  0.94)15 

60  1.005  0.945   
 12(1  (1  0.06) 112 )   1  1.005  0.94 
  

 580.212  200.365  446.577  1, 227.154

NPV of project at IRR from project A is: 1,227.154 – 1,122.869 = 104.285

(= £104,285)

This is clearly positive so project A has a higher IRR.

(v) Project B would be preferred on the basis of both payback period and
discounted payback period.

However, both these measures have shortcomings. The first does not take into
account interest at all and the second does not take into account cash flows
after the discounted payback period [or in the case of project A the occurrence
of one large cash flow at the time of the discounted payback period]

Project A would be preferred on the basis of internal rate of return.

The internal rate of return measures the total return on the project and
therefore is a better decision criterion than payback period or discounted
payback period.

There may be other factors (comparison of NPVs at a particular rate of interest

or the risk of the two projects) that should be taken into account.

Page 13
 Subject CT1 (Financial Mathematics Core Technical) – September 2015 – Examiners’ Report

Other factors could include, for example:

student’s need for return of original investment

reliability of estimates of future cashflows

It appeared that many candidates were under time pressure when attempting
this question. Nearly all candidates failed to recognise how the payments
being at the start of the year for project B would impact on the payback period
and the discounted payback period. Many candidates’ general reasoning
arguments for parts (i)(b) and (ii)(c) were unclear. In part (c), a common
mistake was to miss out the return of the original investment in the calculation
of the IRR. In part (iv), common errors were to miscount the number of terms
(for both costs and revenue). As for similar long questions in previous years,
marginal candidates would have benefited from showing their intermediate
working in greater depth and/or with greater clarity. There were a wide range
of points that could be made to score marks in part (v) but few candidates
scored well on this part.

END OF EXAMINERS’ REPORT

Page 14
1
2 INSTITUTE AND FACULTY OF ACTUARIES
3
4
5
6
7
EXAMINATION
8
9
12 April 2016 (am)
10
11 Subject CT1 – Financial Mathematics
12
Core Technical
13
14 Time allowed: Three hours
15
INSTRUCTIONS TO THE CANDIDATE
16
1. Enter all the candidate and examination details as requested on the front of your answer
17 booklet.
18
2. You must not start writing your answers in the booklet until instructed to do so by the
19 supervisor.
20
3. Mark allocations are shown in brackets.
21
4. Attempt all 12 questions, beginning your answer to each question on a new page.
22
23 5. Candidates should show calculations where this is appropriate.

24
Graph paper is NOT required for this paper.
25
26
AT THE END OF THE EXAMINATION
27
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
28 question paper.
29
In addition to this paper you should have available the 2002 edition of the Formulae
30 and Tables and your own electronic calculator from the approved list.
31
32
33
34
35 CT1 A2016  Institute and Faculty of Actuaries
1 List the characteristics of convertible bonds. [3]

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]

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]

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]

CT1 A2016–2
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]

6 The force of interest, (t), is a function of time and at any time t, measured in years, is
given by the formula:

0.06 0t 4

(t )  0.10  0.01t 4  t  7 .
0.01t  0.04 7  t


(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]

7 A one-year forward contract on a share was agreed on 1 September 2015 when the
share price was £8.70 and the risk-free force of interest was 7% per annum. The stock
was expected to pay a dividend of £1.10 eight months after the date of issue.

The price of the share was £9.90 on 1 February 2016 and the risk-free force of interest
was 6.5% per annum. The dividend expectation was unchanged.

Calculate, showing all working, the value of the contract to the holder of the long
forward position on 1 February 2016. [7]

CT1 A2016–3 PLEASE TURN OVER

8 An individual is planning to purchase £100,000 nominal of a bond on 1 June 2016
which will be redeemable at 110% on 1 June 2020. The bond will pay coupons of 3%
per annum at the end of each year.

The individual wishes to invest the coupon payments on deposit until the bond is
redeemed. It is assumed that, in any year, there is a 55% probability that the rate of
interest will be 6% per annum effective and a 45% probability that it will be 5.5% per
annum effective. It is also assumed that the rate of interest in any one year is
independent of that in any other year.

(i) Derive the necessary formula to determine the mean value of the total
accumulated investment on 1 June 2020. [4]

(ii) Calculate the mean value of the total accumulated investment on 1 June 2020.
[2]
[Total 6]

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

(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]

CT1 A2016–4
10 The following table gives information concerning a fund held by an investment
manager:

Year 2012 2013 2014 2015

Value of fund at 30 June  12,700,000 13,000,000 14,100,000
Net cash flow received on 1 July  2,600,000 3,700,000 1,800,000
Value of fund at 31 December 12,000,000 13,500,000 12,900,000 17,200,000

(i) Calculate, to the nearest 0.1% and showing all working, the annual effective
time-weighted rate of return (TWRR) achieved by the fund during the period
from 31 December 2012 to 31 December 2015. [3]

(ii) Show that the annual effective money-weighted rate of return (MWRR)
achieved by the fund over the same period is less than the answer obtained in
part (i) above. [2]

(iii) Explain why you would expect the outcome described in part (ii) for this fund.
[2]

(iv) Explain which of the two measures referred to in parts (i) and (ii) is a better
indicator of the investment manager’s performance over the period. [2]
[Total 9]

CT1 A2016–5 PLEASE TURN OVER

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]

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]

CT1 A2016–6
12 (i) Show that:

an  nv n
 Ia  
n 
. [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]

END OF PAPER

CT1 A2016–7
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2016 (with mark allocations)

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

F Layton
Chair of the Board of Examiners
June 2016

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. CT1 provides a grounding in financial mathematics and its simple applications. It

introduces compound interest, the time value of money and discounted cashflow
techniques which are fundamental building blocks for most actuarial work.

2. Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be
penalised where excessive rounding has been used or where insufficient working is
shown.

B. General comments on student performance in this diet of the

examination

1. The comments that follow the questions concentrate on areas where candidates could
have improved their performance. Where no comment is made the question was
generally answered well by most candidates.

2. Performance was of a similar standard to most recent diets with the weaker performance
in September 2015 being an exception to the general standard. As in previous diets, the
non-numerical questions were often answered poorly by marginal candidates.

C. Pass Mark

The Pass Mark for this exam was 60%.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

Solutions

Q1 Convertible Securities

• Generally unsecured loan stocks.

• Can be converted into ordinary shares of the issuing company.
• Pay interest/coupons until conversion.
• The date of conversion might be a single date or, at the option of the holder, one
of a series of specified dates.
• Risk characteristics of convertible vary as the final date for convertibility
approaches (behaviour will tend towards the security into which it is likely to
convert)
• Generally less volatility than in the underlying share price before conversion.
• Combine lower risk of debt securities with the potential for gains from equity
investment.
• Security and marketability depend upon issuer.
• Generally provide higher income than ordinary shares and lower income than
conventional loan stock or preference shares.
• Option to convert will have time value which is reflected in price of the security.
[½ mark for each valid point]
[MAX 3]

Despite being a bookwork question, this was answered poorly. This

performance is consistent with questions in previous years on the same area
of the syllabus.

Q2 (i) PV of asset proceeds is:

5 20
VA ( 0.08 ) = 5.5088v8% + 13.7969v8% = 6.7093

PV of liability outgo is:

8 15
VL ( 0.08 ) = 6v8% + 11v8% = 6.7093 = VA ( 0.08 )

Hence, condition (1) for immunisation is satisfied. [2]

Also, DMT of asset proceeds is:

5 20
5 × 5.5088v8% + 20 × 13.7969v8%
τ A ( 0.08 ) = = 11.618
6.7093

And, DMT of liability outgo is:

8 15
8 × 6v8% + 15 × 11v8%
τ L ( 0.08 ) = = 11.618 = τ A ( 0.08 )
6.7093

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

Hence, condition (2) for immunisation is also satisfied. [3]

(ii) Yes, the insurance company is immunised.

As the asset proceeds are received at times 5 and 20, whereas the liability
outgo is paid at times 8 and 15, the spread of the asset proceeds around the
DMT is greater than the spread of the liability outgo around the same DMT.
[2]
[TOTAL 7]

Part (i) was generally answered well; however, candidates must include
sufficient factors and workings to demonstrate that the respective asset and
liability values are the same for each of the two conditions. Part (ii) was often
answered poorly. To get full marks for this part, candidates were required to
make reference to the actual data in the question rather than just repeating
the theory (e.g. stating the actual figures for the spread of the assets and the
liabilities around the DMT).

4 4 4 105
Q3 (i) Issue price (per £100 nominal) = + 2
+ 3
+ [1½]
1 + ii (1 + i2 ) (1 + i3 ) (1 + i3 )3

where it is the t-year zero coupon rate at time t = 0 and we have that:

(1 + it −1 )t −1 * (1 + ft −1,1 ) = (1 + it )t

where ft−1,1 is the one-year forward rate at time t − 1

we have 1 + i1 = 1.04 (i1 is given)

(1 + i2 )2 = (1 + i1 )(1 + f1,1 )

= 1.04 *1.05

(1 + i3 )3 = (1 + i2 ) 2 (1 + f 2,1 )

= 1.04 *1.05*1.06 [1½]

 Issue Price = 4 4 4 + 105

+ +
1.04 1.04*1.05 1.04 *1.05*1.06

= £101.68 [1]

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

(ii) Let yc3 be the 3 year par yield (%). Then yc3 is given by

 1 1 1  100
100 = yc3  + +  + [1½]
 1 + i1 (1 + i ) 2
(1 + i3 )  (1 + i3 )3
3
 2

 1 1 1  100
= yc3  + + +
 1.04 1.04*1.05 1.04*1.05*1.06  1.04*1.05*1.06

= yc3 *2.741205336 + 86.39159583

 yc3 = 4.9644% [1½]

[TOTAL 7]

Generally well answered.

4
 i (4) 
Q4 (i)  1 +
(4)
 = 1.05  i = 0.049089
 4 

D 0.07
(1 − t1 ) = × 0.75 = 0.04861
R 1.08

 i (4) > (1 − t1 ) g

 Capital gain on contract and we assume loan is redeemed as late as possible

(i.e. after 20 years) to obtain minimum yield. [2]

Let price of stock = P

P = 0.07 ×100000 × 0.75 × a (4) + (108000 − 0.40(108000 − P))v 20 at 5%

20

5250 a (4) + 64800 v 20

20
P=
1 − 0.40 v 20

5250 × 1.018559 × 12.4622 + 64800 × 0.37689

=
1 − 0.40 × 0.37689

= £ 107, 228.63 [3]

(above uses factors from Formulae and Tables Book – exact answer is
£107,228.67)

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

(ii) As the redemption date is at the option of the borrower, it is outside the
investor’s control when the stock will be redeemed. Hence the investor must
assume a worst case scenario in pricing the loan. [2]
[TOTAL 7]

Part (i) was answered well. The reasoning of marginal candidates in part (ii)
was often unclear. The key point is that the date of redemption is out of the
control of the investor.

Q5 (i) Loan = 950 a15 + 250( Ia )15 at 6%

= 950 × 9.7122 + 250 × 67.2668

= £26,043.29
[3]

(ii) Capital outstanding after 9 payments:

3200 a6 + 250( Ia ) 6 = 3200 × 4.9173 + 250 × 16.3767 = £19,829.54

[2]

(iii) Capital outstanding after 14 payments = 4700v at 6%

= £4,433.96
= Capital in final payment
 Interest in final payment = 4700 – 4433.96
= £266.04
[2]

(above uses factors from Formulae and Tables Book – exact answers are
£26,043.34 for (i) and £19,829.61 for (ii))
[TOTAL 7]

The best answered question on the paper.

Page 6
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

pv = 10, 000 × exp  −  ( 0.01t − 0.04 ) dt  × exp  −  ( 0.10 − 0.01t ) dt 

10 7
Q6 (i) [1]
 7   5 

   
10   7
 0.01t 2   0.01t 2  
= 10, 000 exp× −  − 0.04t  × exp − 0.10t − 
  2  7    2  
   5

  0.01*51    0.01*24  
= 10, 000 × exp  −  − 0.04 × 3  × exp  − 0.10*2 −  
  2    2 

= 10,000exp(−0.255 + 0.12 – 0.20 + 0.12)

= 10,000exp(−0.215)

= £8,065.41 [4]

(ii) Required discount rate p.a. convertible monthly is given by

12×5
 d (12) 
10, 000 1 −  = 8, 065.41
 12 


d(12) = 4.2923% p.a. convertible monthly.

[2]
[TOTAL 7]

Generally well answered.

Q7 Forward price of the contract is:

K 0 = ( S0 − I )eδT = (8.70 − I )e0.07 [1]

where I is the present value of the income expected during the contract

−0.07×812
 I = 1.10 × e = 1.049846 [1]

 K 0 = (8.70 − 1.049846) × e0.07 = 8.204853 [½]

Forward price of contract set up at time r (where r = 5 months) is

Kr = (Sr − I r )eδ(T −r ) [1]

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

where Ir is the value at time r of the income expected during the contract

−0.065× 312
= 1.10 × e = 1.082269 [1]

0.065×712
 K r = (9.90 − 1.082269)e = 9.158489 [½]

Value of original forward contract

= ( K r − K 0 )e−δ(T −r )

7
−0.065×12
= (9.158489 − 8.204853)e

= 0.918154

= £0.92 [2]
[TOTAL 7]

Although this question was answered better than similar questions in past
diets, the workings shown by marginal candidates were often unclear.

Q8 (i) Work in £000’s

Let total accumulation at 1/6/20 be X, and iy = investment return for the year
starting from 1 June 2016 + y

E ( X ) = E 3 (1 + i1 )(1 + i2 ) (1 + i3 ) + 3 (1 + i2 ) (1 + i3 ) + 3 (1 + i3 ) + 3 + 110 [1½]

Due to independence:

E ( X ) = 3  E (1 + i1 ) E (1 + i2 ) E (1 + i3 ) + E (1 + i2 ) E (1 + i3 ) + E (1 + i3 )  + 113
[1]

= 3 (1 + E [i1 ]) (1 + E [i2 ]) (1 + E [i3 ]) + (1 + E [i2 ]) (1 + E [i3 ]) + (1 + E [i3 ])  + 113

[½]

where E(iy) = 0.55 × 6% + 0.45 × 5.5%

= 5.775% [1]

Page 8
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

(ii) s35.775% + 113

E ( X ) = 3 

 1.057753 − 1 
= 3 + 113
 0.05775 /1.05775 
 

= 123.080 (= £123,080 for £100,000 nominal)

[2]
[TOTAL 6]

Whilst the calculations were often correct, relatively few candidates followed
the instructions to derive the required formula for these calculations. For full
marks, such derivation was required including identifying where the
independence assumption is used.

Q9 (i) Cash Flows:

Issue Price: Jan 14 −0.97×100,000 = −£97,000

122.3
Interest Payments: July 14 0.03×100,000 × = £3,057.50
120.0

124.9
Jan 15 0.03×100,000 × = £3,122.50
120.0

127.2
July 15 0.03×100,000 × = £3,180.00
120.0

129.1
Jan 16 0.03×100,000 × = £3,227.50
120.0

129.1
Capital redeemed: Jan 16 100,000 × = £107,583.33
120.0
[3]

(ii) Express all amounts in “January 2014 money”, and we get:

122.3 12 122.3
97000 = 3057.50 × v + 3122.50 × v
124.9 127.2

122.3 112 122.3

+3180.00 × v + × (107583.33 + 3227.50)v 2 [2]
129.1 131.8

1 11
 97000 = 2993.85v 2 + 3002.22v + 3012.50v 2 + 102823.71v 2 [1]

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

Try 7%, RHS = 98232.04

8%, RHS = 96499.48

 98232.04 − 97000 
i = 0.07 +   × 0.01 [2]
 98232.04 − 96499.48 

= 7.7% p.a. effective real yield (exact answer is 7.708%).

[TOTAL 8]

This question seemed to strongly differentiate between stronger and weaker

candidates. Common errors from the latter included not correctly allowing for
the time lag in part (i) or not uplifting the nominal cashflows for inflation at all.

Q10 (i) TWRR is i such that:

12, 700 13, 000 14,100 17, 200

(1 + i )3 = × × ×
12, 000 12, 700 + 2, 600 13, 000 − 3, 700 14,100 + 1,800

= 1.474830  i = 13.8% [2 for formula, 1 for solution]

(ii) If the MWRR achieved by the fund were 13.8% p.a., then fund value at
31 December 2015 would be (in £000’s):

21 11 1
12000 × (1.138)3 + 2600 × (1.138) 2 − 3700 × (1.138) 2 + 1800 × (1.138) 2
=18,706 which is greater than 17,200. This means that the MWRR must be
less than 13.8% p.a. [2]

(iii) The MWRR is lower because the fund performed badly immediately after
receiving the large positive cash flow in July 2013 and also performed well
immediately after the large negative cash flow in July 2014. [2]

(iv) The TWRR is not influenced by the amount and timing of the cash flows
(which are generally considered to be outside of the control of the fund
manager) and, thus, better reflects the manager’s performance over the period.
[2]
[TOTAL 9]

Parts (i) and (ii) were answered well. In part (ii), it is not necessary to
calculate the MWRR.

As in previous diets, candidates had difficulty explaining the relative values for
the MWRR and TWRR. For full marks in part (iii), candidates needed to make
reference to the actual data in the question. In part (iv), the key point is that

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

the amount and timing of the cash flows are generally considered to be
outside of the control of the fund manager.

Q11 (i) 10,000 shares give a total dividend on the next payment date of £650.

Then, working in half-year periods, we have:

( 2
V = 650 × v6% + 1.02v6% + 1.022 v6%
3
+. . . ) [2]


( ) 
2
= 650v6% × 1 + 1.02v6% + 1.02v6% + . . .
 

 1 
= 650v6% ×  
 1 −1.02v6% 

=£16,250 [2]

(ii) (a) We now have

 1 
v = 650v6% ×   = £18,571.43 [1]
 1 − 1.025v6% 

(b) The higher rate of dividend growth means that expected future
dividend income is increased and, thus, the investor is prepared to pay
a higher price to purchase the shares. [1]

(iii) (a) The rumoured change in legislation might be thought of as increasing

the uncertainty of the future growth prospects for the company
(without necessarily either increasing or decreasing them).

Thus it is appropriate that the investor requires a higher return to

compensate for this greater uncertainty. [1]

(b) We now have:

 1 
v = 650v7% ×   = £13,000 [1]
 1 − 1.02v7% 

(c) The higher risk (as reflected by the higher effective rate of return
required) means that the investor is now prepared to pay a lower
maximum price to purchase the shares. [1]

(iv) (a) Lower inflation is likely to lead to lower (nominal) profits and, thus,
lower (nominal) dividend payments.

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

Also, as many investors are more concerned with real returns (i.e. in
excess of inflation), it is appropriate to reduce the effective rate of
return to reflect the lower expected inflation. [2]

(b) We now have:

 1 
v = 650v5% ×   = £16, 250 [1]
 1 − 1.01v5% 

(c) In this case, the maximum price that the investor is prepared to pay is
unchanged. Lower expected inflation leads to lower nominal dividend
payments, which are then discounted at a lower nominal interest rate.
Thus, the price is unaffected (i.e. equities are a real asset).
[2]
[TOTAL 14]

The calculations in this question were relatively simple and generally done
well. The explanatory parts of the questions were answered better than
expected.

n
n  e−δt  n e −δt
Q12 (i) ( Ia )n =  te −δt
dt = t ×  − 0 dt
 −δ  0 −δ
0

n.e−δn 1 n −δt
=− +  e dt
δ δ 0

n
n.e −δn 1  e −δt 
=− + − 
δ δ  δ 
o

n
n.e−δn 1 1 − e−δn  an − nv
=− +  =
δ δ  δ  δ
[4]

(ii) Project lasts for 33 years as follows:

Time take to reopen mine = 1 year

Time taken for net revenue to go from zero to $3,600,000 is 12 years

 3, 600, 000 
 from 300, 000 = 12 
 

Page 12
Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

Time taken for net revenue to decline to $600,000 is 20 years

 3, 600, 000 − 600, 000 

 from 150, 000
= 20 
 
[2]

(iii) PV of reopening costs and additional costs = 700,000 a1 + 200,000 a33 at

25%

where

i
a125% = a = 1.120355 × 0.8 = 0.896284
δ 1

25% i
a33 = . a = 1.120355 × 3.9975 = 4.478619
δ 33

 PV = 627,399 + 895,724 = 1,523,123 [3]

PV of net revenue

v . 300, 000 ( Ia )
12 {
+ v13 3, 600, 000 a 20 − 150, 000 ( Ia )
20 } [2]

i
where a12 = . a12 = 1.120355 × 3.7251 = 4.173434 [1]
δ

a12 − 12v12 4.173434 − 12 × 0.06872

( Ia )12 =
δ
=
0.223144
= 15.0073 [1]

i
a20 = . a20 = 1.120355 × 3.9539 = 4.429772 [1]
δ

4.429772 − 20v 20
( Ia )20 =
δ
= 18.818324 [1]

 PV of net revenue

300, 000
= × 15.0073 + 0.05498{3, 600, 000 × 4.429772
1.25
−150, 000 × 18.818324} [1]

= 3,601,752 + 721,581 = 4,323,333 [1]

Page 13
 Subject CT1 (Financial Mathematics Core Technical) – April 2016 – Examiners’ Report

 Price to obtain IRR of 25% p.a. is:

4,323,333 – 1,523,123 = $2,800,210. [1]

(above uses factors from Formulae and Tables Book – exact answer is
4,323,319 – 1,523,115 = $2,800,204)
[TOTAL 18]

The proof in part (i) was answered very poorly. Also, since the result is given,
candidates must provide enough steps in deriving the result to convince the
examiners that they haven’t just jumped to the result. In part (iii), the
workings of many marginal candidates were very unclear. The examiners
recommend that candidates set out their working clearly e.g. by calculating
each component of the costs and benefits separately. This enables examiners
to give full credit for correct working even if errors are made in the
calculations.

END OF EXAMINERS’ REPORT

Page 14
1
2 INSTITUTE AND FACULTY OF ACTUARIES
3
4
5
6
EXAMINATION
7 EXAMINATION
8
9
27 September 2016 (am)
27 September 2016 (am)
10
11 Subject CT1 – Financial Mathematics
Subject CT1 – Financial
Core Mathematics
Technical
12
Core Technical
13
14 Time allowed: Three hours
15
INSTRUCTIONS TO THE CANDIDATE
16
1. Enter all the candidate and examination details as requested on the front of your answer
17 booklet.
18
2. You must not start writing your answers in the booklet until instructed to do so by the
19 supervisor.
20
3. You have
Mark 15 minutes
allocations are of planning
shown and reading time before the start of this examination.
in brackets.
21 You may make separate notes or write on the exam paper but not in your answer
4. booklet. Calculators
Attempt all are beginning
12 questions, not to be used
yourduring
answerthetoreading time. You
each question on will
a newthen have
page.
22 three hours to complete the paper.
23 5. Candidates should show calculations where this is appropriate.
4. Mark allocations are shown in brackets.
24
5. Attempt all 12 questions, beginning
Graph paper your
is NOT answerfor
required to each question on a new page.
this paper.
25
26 6. Candidates should show calculations where this is appropriate.
AT THE END OF THE EXAMINATION
27 Graph paper is NOT required for this paper.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
28 question paper.
29 AT THE END OF THE EXAMINATION
In addition to this paper you should have available the 2002 edition of the Formulae
30 Hand in BOTHand your answer
Tables andbooklet,
your ownwith any additional
electronic calculatorsheets firmly
from the attached,
approved list. and this
question paper.
31
32 In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
33
34
CT1 S2016  Institute and Faculty of Actuaries
35 CT1 S2016  Institute and Faculty of Actuaries
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]

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]

3 Describe the characteristics of a repayment loan (or repayment mortgage). [3]

4 The following table shows the cashflows paid into a fund on three different dates,
together with the value of the fund on each date immediately before the cash flow
takes place. There were no other cashflows except on the dates shown.

1 January 2014 1 January 2015 1 January 2016

Value of fund (£m) 112 X 160

Cash flow (£m) 23 43 32

During 2014, the rate of return on the fund was 10% per annum effective.

(i) Calculate X. [1]

(ii) Calculate, showing all workings, the annual effective time weighted rate of
return on the fund over the two-year period from 1 January 2014 to 1 January
2016. [3]
[Total 4]

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]

CT1 S2016–2
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]

7 A nine-month forward contract was issued on 1 April 2015 on a share with a price of
£1.10 at that date. Dividends of £0.10 per share were expected on 1 July 2015,
1 October 2015 and 1 January 2016.

(i) Calculate, showing all workings, the forward price assuming a risk-free rate of
interest of 8% per annum convertible half-yearly and no arbitrage. [4]

(ii) Explain why you do not need to use the expected price of the share at the time
the forward matures in the calculation of the forward price. [2]
[Total 6]

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]

CT1 S2016–3 PLEASE TURN OVER

9 An insurance company has just written single premium contracts that require it to
make payments to policyholders of £10,000,000 in five years’ time. The total single
premiums paid by policyholders amounted to £8,000,000.

The insurance company is to invest the premiums in assets that have an uncertain
return. The return from these assets in year t, it, is independent of the returns in all
previous years with a mean value of 5.5% per annum effective and a standard
deviation of 4% per annum effective. (1 + it) is lognormally distributed.

(i) Calculate, deriving all necessary formulae, the mean and standard deviation of
the accumulation of the premiums over the five-year period. [9]

A director of the company is concerned about the possibility of a considerable loss

from the investment in the assets suggested in part (i). Instead, the director suggests
investing in fixed interest securities with a guaranteed return of 4% per annum
effective.

(ii) Set out the arguments for and against the director’s position. [3]
[Total 12]

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.

CT1 S2016–4
 (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]

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]

CT1 S2016–5 PLEASE TURN OVER

12 The force of interest, δ(t), is a function of time and at any time t (measured in years) is
given by:

0.03 for 0  t  10

(t )  at for 10  t  20
bt 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]

END OF PAPER

CT1 S2016–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2016

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

Luke Hatter
Chair of the Board of Examiners
December 2016

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. CT1 provides a grounding in financial mathematics and its simple applications. It

introduces compound interest, the time value of money and discounted cashflow
techniques which are fundamental building blocks for most actuarial work.

2. Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may lose
marks where excessive rounding has been used or where insufficient working is shown.

B. General comments on student performance in this diet of the

examination

1. The comments that follow the questions concentrate on areas where candidates could
have improved their performance. Where no comment is made, the question was
generally answered well by most candidates. The examiners look most closely at the
performance of the candidates close to the pass mark and the comments therefore often
relate to those candidates.

2. Performance was very slightly weaker when compared with most recent diets. As in
previous diets, the non-numerical questions were often answered poorly by marginal
candidates.

C. Pass Mark

The Pass Mark for this exam was 60.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

Solutions

Q1 (i) eδ 4 = 1.0125  δ = 4 × ln1.0125 = 0.0496901 = 4.969% [1]

(ii) 1 + i = 1.01254  i = 0.0509453 = 5.095% [1]

(iii) From (i) (though could be done in other ways)

 d (12 ) 
1 −  = e−δ 12 = e−0.0041408 = 0.9958677  d (12 ) = 0.049587 = 4.959%
 12 
 
[2]
[Total 4]

This was generally answered well although many candidates ignored the
specific rounding instructions or rounded incorrectly.

Q2 Various approaches (e.g. effective interest period can be changed etc.).

Work in quarters. Interest rate per quarter = 0.5%. Rate of payment per quarter = 25.
Number of quarters = 48.

i
PV = 25a( ) = 25
3
a [2]
48
d ( 3) 48

3
( −1
)
d ( ) = 3 1 − 1.005 3 = 0.0049834, a48 = 42.5803 [1]

Therefore, PV = 25 × (0.005/0.0049834) × 42.5803 = €1,068.05 [1]

[Total 4]

Generally well answered

Q3 A loan repayable by a series of payments at fixed times set in advance.

Typically issued by banks and building societies

Typically long-term …
…e,g. used to fund house purchase
…and secured against the property

Each payment contains an element to pay interest on the loan with the remainder
being used to repay capital

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

In its simplest form, the interest rate will be fixed …

….and the payments will be of fixed equal amounts.

The interest payment portion of the repayments will fall over time…
… and the capital payments will rise over time.

Risk that borrower defaults on loan

Complications might be added such as (i) allowing the loan to be repaid early or (ii)
allowing the interest rate to vary
[½ mark for each point]
[Max 3]
[Total 3]

Despite being a bookwork question, this was the worst answered question on
the paper. It was not necessary to make all the above points for full marks.

Q4 (i) X = (112 + 23) × 1.1 = £148.5m [1]

(ii) TWRR is found from

148.5 160
(1 + i )2 = = 0.91906  i = −0.04132 = −4.132% [3]
135 148.5 + 43
[Total 4]

A significant number of marginal candidates failed to answer part (i) correctly.

Q5 Let original price of zero coupon bond = P

P = 100v80 at 2.5%

 P = 100 × 0.13870 = 13.87 [2]

Equation of value for the purchaser:

13.87eδt = 80 [1]

ln ( 80 13.67 ) ln 5.7678
t= t = = 36.506 years [1]
δ 0.048

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

0.506 years is 185 days. There are 181 days to the end of June. Default is therefore
on 4 July 2011. [1]
[Total 5]

This question was answered poorly with many candidates not able to
formulate separate equations of value for:

• the original terms to determine the issue price.

• the revised terms to determine the date of default.

Q6 (i) Simple rate of return is (100 – 96)/96 = 0.041666 [1]

Expressed as an annual rate, this is: 0.041666 × (365/182) = 8.3562% [1]

(ii) Let the time in years = t

(97.5 – 96)/96 = 0.035t [1]

t = (97.5 – 96)/(0.035 × 96) = 0.44643 years = 163 days [1]

(iii) Equation of value for the second investor:

97.5(1 + i)(182–163)/365 = 100 [1]

365
19 100  100  19
(1 + i ) 365
= i=  − 1 = 62.640% [1]
97.5  97.5 
[Total 6]

Parts (i) and (ii) were very well answered. In part (iii), some candidates
continued to assume a simple rate of return was required. Alternative
answers to part (iii) based on different rounding of the answer in part (ii) were
given full credit.

Q7 (i) Present value of dividends, I, is:

(
0.1 v
1
4 +v
1
2 +v
3
4
)
Calculated at i′% when 1 + i′ = 1.042 = 1.0816

So I = 0.1 (1.0816–0.25 + 1.0816–0.5 + 1.0816–0.75) = 0.288499 [2]

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

Hence, forward price, K, is:

K = (1.1 − 0.288499 ) × 1.08160.75 = 0.86068 = 86.068 p [2]

(ii) The price of the forward can be determined from the price of the share (for
which it is a close substitute). The forward is like the share but with delayed
settlement and without dividends. [Could also be said that the price of the
share already takes into account expectations.] [2]
[Total 6]

Part (i) was answered well although some candidates ignored the fact that the
interest rate given was a convertible half-yearly rate. Part (ii) was answered
less well with the arguments of many marginal candidates being very unclear.

Q8 (i) 96 = 4a3 + 100v3 [1]

Try 6% RHS = 94.654 [½]

Try 5% RHS = 97.2768 [½]

Interpolation gives

97.2768 − 96
i ≈ 0.05 + 0.01× = 0.0549 ≈ 5.5% [1]
97.2768 − 94.6540

(ii) Let in = spot rate for term n

104
Then 96 = 104v at i1  1 + i1 =  i1 = 8.333% [1]
96

2 104 104
96 = 4vi1 +104vi22  (1 + i2 ) = =  i2 = 6.145% [2]
96 − 4vi1 96 − 3.69231

(iii) Let the forward rate be f1,1

(1 + i2 )2 = (1 + i1 ) (1 + f1,1 ) [1]

 1.061452 = 1.08333 × (1 + f1,1 )  f1,1 = 0.04000 = 4% [1]

(iv) The three year gross redemption yield is a complex form of weighted average
of the three spot rates. [1]

Page 6
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

The one-year spot rate is over 8%, the two-year rate is over 6% and the gross
redemption yield is 5.5%. Therefore, the three-year rate must be less than
5.5% if the weighted average is 5.5%. [1]
[Total 10]

Part (i), (ii) and (iii) were generally answered well, although in part (iii) some
candidates were not clear as to the forward rate required by the question.
Part (iv) was very poorly answered. For this part no marks were available for
calculation without explanation.

Q9 (i) Let S n = Accumulated value at time n of £1 invested at time 0

Sn = (1 + i1 )(1 + i2 ) .... (1 + in )

 E [ Sn ] = E (1 + i1 )(1 + i2 ) .... (1 + in ) 

= E (1 + i1 ) . E (1 + i2 ) .... .E (1 + in ) by independence

and E (1 + it ) = 1 + E ( it ) = 1 + j

n
Hence E ( Sn ) = (1 + j )

Now

Var [ Sn ] = E  Sn2  − ( E [ Sn ])
2
 

E  Sn2  = E (1 + i1 ) (1 + i2 ) .... (1 + in ) 

2 2 2
   

= E (1 + i1 )  . E (1 + i2 )  .... .E (1 + in ) 

2 2 2
[1]
     
by independence [½]

and


2
  (  ) ( )
E (1 + it )  = E  1 + 2it + it2  = 1 + 2 E ( it ) + E it2

( ) 2
( )
and Var [it ] = s 2 = E it2 −  E ( it )  = E it2 − j 2

( )
 E it2 = s 2 + j 2 [1]

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

Hence

( )
n
E  Sn2  = 1 + 2 j + j 2 + s 2
 

( )
n 2n
And Var [ Sn ] = 1 + 2 j + j 2 + s 2 − (1 + j ) [1]

Hence mean accumulation = 8, 000, 000E ( S5 ) [½]

5
= 8, 000, 000 (1.055 ) = £10, 455, 680 [1]

Standard deviation of accumulation = 8, 000, 000 Var ( S5 ) [½]

( )
5 10
= 8, 000, 000 1 + 2 × 0.055 + 0.0552 + 0.042 − (1.055 )

= 8, 000, 000 1.7204573 − 1.7081445 = 8, 000, 000 × 0.01231284

= £887, 706 [2]

Alternative Solution

(1+it) ~ lognormal (µ,σ2)

ln(1 + it ) ~ N (μ, σ2 )

ln(1 + it )5 = ln(1 + it ) + ln(1 + it ) +  + ln(1 + it ) ~ N (5μ,5σ2 )

Given assumption that they are independent and identically distributed

∴ (1 + it )5 ~ lognormal (5μ,5σ2 ) [2]

 σ2 
E (1 + it ) = exp  μ +  = 1.055 [1]
 2 


Var(1 + it ) = exp(2μ + σ2 )  exp(σ2 ) − 1 = 0.042 [1]

 

0.042
1.055 2  ( )
= exp σ2 − 1  σ2 = 0.0014365

[1]

 0.0014360 
exp  μ +  = 1.055 
 2 

Page 8
Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

0.0014365
μ = ln1.055 − = 0.052823 [1]
2

5µ = 0.264113

5σ2 = 0.0071825.

Let S5 be the accumulation of one unit after five years:

 5σ 2   0.0071825 
E ( S5 ) = exp  5 × μ +  = exp  0.264113 + 
 2   2 


=1.30696 [½]

 ( )
Var( S5 ) = exp(2 × 5μ + 5σ 2 )  exp 5σ 2 − 1


= exp(2 × 0.264113 + 0.0071825) . (exp 0.0071825 –1)

= exp 0.53541 (exp 0.0071825 – 1)

= 0.01231284 [½]

Mean value of the accumulation of premiums is

8,000,000 × 1.30696 = £10,455,680. [1]

Standard deviation of the accumulated value of the premiums is

8,000,000 × 0.0123128490.5 = £887,706 [1]

(ii) If the company invested in fixed-interest securities, it would obtain a

guaranteed accumulation of £8,000,000 * (1.04)5 = £9,733,223. In one sense,
there is a 100% probability that a loss will be made and therefore the policy is
unwise. [1]

The “risky” investment strategy leads to an expected profit. [1]

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

On the other hand, the standard deviation of the accumulation from the risky
investment strategy will be higher than investing in the fixed-interest
securities. Whilst there is a chance of an even greater profit from this strategy,
there is also a chance of a more considerable loss than from investing in fixed-
interest securities. [1]
[Total 12]

Many candidates either ignored the requirement in part (i) to derive the
necessary formulae or had difficulty in performing the derivation often trying to
combine the two methods above without success. Part (ii) was better
answered than the other explanation questions on the paper.

Q10 (i) The payback period simply tells an investor when the total cash inflows from
the investment have exceeded the total cash outflows. This tells the investor
nothing about the overall profitability of the project. [2]

(ii) The present value of outgoing cash flows at a rate of return of 6% per annum
effective is as follows (in £m):

(
a3 + 0.05 a13 − a3 )
= 1.06 × 2.6730 + 0.05(8.8527 – 2.6730) = 3.14238 [2]

The present value of the incoming cash flows is as follows (in £m):

(
= 0.495v3a(12) 1 + 1.01v + 1.012 v 2 + ... + 1.019 v9
1 )
= 0.495v3
d
d
(12 ) (
1 + 1.01v + 1.012 v 2 + ... + 1.019 v9 )
= 0.495 × 0.83962 × 0.973784 × (1 – 1.0110/1.0610) / (1 – 1.01/1.06)

= 0.404716 × 8.12352 = 3.2877 [3½]

NPV of cash flows at 6% = 3.2877 – 3.1424 = £0.1453m = £145,300 [1]

The project has a positive NPV at 6% and therefore an IRR higher than 6%
and the first criteria is met. [½]

By the end of the 10th year, the total outgoing cash flows will have been:
£3,000,000 plus 7 × £50,000 or £3,350,000. [1]

Total incoming cash flows are:

495,000 × (1 + 1.01 + 1.012 +...+ 1.016) (i.e. rate of payment of £495,000

rising by 1% per year for seven years). [1]

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

Geometric progression with common ratio 1.01 and seven terms

= 495,000(1 – 1.017)/(1 – 1.01) = £3,570,700 [1]

This is greater than total outgoing cash flows and therefore second criterion is
met. [½]

There is clearly a positive cash flow in the fifth year as the incoming cash
flows will be greater than £495,000 and the outgoing cash flows will be
£50,000. [1]

Therefore final criterion is met. [½]

[Total 14]

This was the worst answered of the longer questions. The examiners strongly
recommend that candidates take a systematic approach to the question and
e.g. derive the PVs of the outgo and income separately. Marginal candidates
would have benefited from showing their intermediate working in greater
depth and/or with greater clarity, explaining all steps.

Candidates who assumed that the repayments continued for 11 years, rather
than 10, were not penalised.

Q11 (i) Duration =  tCt vt  Ct vt

t t

 3   10 
  4 × 0.04 × tv  +   5 × 0.04 × tv  + 4 ×1× 3v + 5 ×1×10v
t t 3 10

=  t =1   t =1 
 3   10 
  4 × 0.04 × v  +   5 × 0.04 × v  + 4 ×1× v + 5 ×1× v
t t 3 10

 t =1   t =1 

0.16 ( Ia )3 + 0.20 ( Ia )10 + 12v3 + 50v10

= [4]
0.16a3 + 0.20a10 + 4v3 + 5v10

Therefore, duration

0.16 × 5.2422 + 0.20 × 36.9624 + 12 × 0.83962 + 50 × 0.55839 46.2264

= =
0.16 × 2.6730 + 0.20 × 7.3601 + 4 × 0.83962 + 5 × 0.55839 8.05015

= 5.742 years [3]

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

1
(ii) Present value of new portfolio per unit nominal = [1]
i

d 1
  1
Volatility of new portfolio per unit nominal = − di  i  = [1]
1 i
i

Duration of new portfolio, applying equation above is

1 + i 1.06
volatility × (1 + i ) = =
i 0.06

= 17.666 years [2]

(iii) Present value of existing bonds:

= £8.05013bn [½]

Let the nominal amount of new bonds issued = X

0.05 X
Present value of new bonds = 0.05 Xa∞ =
0.06

0.05 X
 = 0.8 × 8.05013  X = £7.728bn
0.06
[1½]
[Total 13]

In part (i), many candidates incorrectly calculated DMTs separately for the two
bonds which simplified the question and did not produce the DMT of the
whole portfolio. Part (ii) was poorly answered with many candidates not
recognising the relationship between DMT and volatility. It is also important in
such questions to state the time units in the final answer. Part (iii) did seem to
act as a differentiator between candidates, with the strongest candidates able
to proceed clearly through the question.

Q12 (i) 50 = 100v ( 20 )

 10   20 
where v ( 20 ) = exp  −  0.03dt  exp  −  at dt  [3]
   
 0   10 

20
10  at 2 
= exp [ −0.03t ]0
exp  − 
 2 10

Page 12
Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

= e−0.3e−150 a = e−0.3−150a = 0.5 [1]

ln 2 − 0.3
a= = 0.0026210 [1]
150

(ii) 40 = 100v ( 28)

 28 
where v ( 28 ) = v ( 20 ) exp  −  bt dt  [1]
 
 20 

28
 −bt 2 
= −0.5exp  
 2  20

= 0.5e−192b = 0.4 [2]

− ln 0.8
b= = 0.0011622 [1]
192

(iii) Equivalent annual effective rate of discount can be found from:

28 28
100 (1 − d ) = 40  (1 − d ) = 0.4 [1]

 d = 0.032195 = 3.220% [1]

7 7 7
(iv) (a) We require:  ρ ( t ) v ( t ) dt =  e −0.04t −0.03t
e dt =  e−0.07t dt [1½]
3 3 3

e −0.07t  7
=  [1]
 −0.07  3

= −8.751806 + 11.579775 = 2.827969 [1½]

(b) The present value of the payment stream 2.827969 = X a7 − a3 ( )

where X is the continuous payment stream using δ = 0.03. [2]

2.827969 2.827969
X= =
a7 − a3  1 − e−0.03×7   1 − e−0.03×3 
  −  
 0.03   0.03 

2.827969
= = 0.82092 [2]
6.31386 − 2.86896
[Total 19]

Page 13
 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

This was well answered apart from part (iv)(b). It was pleasing to see many
candidates using good exam technique to leave enough time for this question
which proved to be more straightforward than the other longer questions.

END OF EXAMINERS’ REPORT

Page 14
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

18 April 2017 (pm)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. You have 15 minutes of planning and reading time before the start of this examination.
You may make separate notes or write on the exam paper but not in your answer
booklet. Calculators are not to be used during the reading time. You will then have
three hours to complete the paper.

4. Mark allocations are shown in brackets.

5. Attempt all 10 questions, beginning your answer to each question on a new page.

6. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 A2017  Institute and Faculty of Actuaries

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]

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]

3 A one-year forward contract on a stock was agreed on 1 March 2017 when the stock
price was £78 and the risk-free force of interest was 14% per annum. The stock was
expected to pay dividends of £3.20 on 1 June and 1 December 2017.

On 1 April 2017, the price of the stock was £80 and the risk-free force of interest was
11% per annum. The dividend expectations were unchanged.

Determine the value of the contract to the holder of the long forward position on
1 April 2017. [7]

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, δ(t), as a function of time t (measured in years)
which is given by:

0.04 for 0 ≤ t ≤ 2
δ(t ) = 
0.02 + kt for t > 2

(i) Derive expressions for v(t) which cover all values of t. [5]

CT1 A2017–2
 (ii) Determine the minimum value of k that would ensure that the discounted
payback period is exactly 10 years. [4]
[Total 9]

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]

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]

CT1 A2017–3 PLEASE TURN OVER

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]

8 Two investment funds A and B are administered by different managers. The initial
values of the two funds on 1 January 2015 were £1.5 million and £2.3 million,
respectively. The funds received additional net cash flows at the beginning of 2015
and 2016, as follows:

Fund Net Cash Flows

1 January 2015 1 January 2016
Fund A £300,000 £1,700,000
Fund B £2,000,000 £200,000

The fund managers achieved the following annual returns during 2015 and 2016:

Fund Annual Returns

2015 2016
Fund A 42% 3%
Fund B 36% 2%

(i) Calculate the annual effective time weighted rate of return for each fund for
the period 1 January 2015 to 31 December 2016. [3]

(ii) Calculate the annual effective money weighted rate of return per annum for
each fund for the period 1 January 2015 to 31 December 2016. [8]

(iii) Comment on your answers to parts (i) and (ii) by explaining which of the two
measures is the better indicator of the comparative performance of the
managers for the given two-year period. [3]
[Total 14]

CT1 A2017–4
9 Let f t 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, i2 and i3 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]

10 An individual aged exactly 65 intends to retire in five years’ time and receive an
annuity-certain. The annuity will be payable monthly in advance and will cease after
20 years. The annuity will increase at each anniversary of the commencement of
payment at the rate of 3% per annum.

The individual would like the initial level of annuity to be £20,000 per annum. The
price of the annuity will be the present value of the payments on the date it
commences using an interest rate of 7% per annum effective.

(i) Calculate the price of the annuity. [4]

In order to purchase the annuity described in part (i), the individual invests £200,000
on his 65th birthday in a particular fund.

The investment return on the fund in any given year is independent of returns in all
other years and the annual return is:

• 4% with a probability of 60%.

• 7% with a probability of 40%.

(ii) Calculate, showing all workings, the expected accumulation of the investment
at the time of retirement. [3]

(iii) Calculate, showing all workings, the standard deviation of the investment at
the time of retirement. [4]

(iv) Determine the probability that the individual will have sufficient funds to
purchase the annuity. [3]
[Total 14]

END OF PAPER

CT1 A2017–5
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2017

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both
those who are sitting the examination for the first time and using past papers as a revision aid and
also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have
access to the Core Reading, which is designed to interpret the syllabus, and will generally base
questions around it but are not required to examine the content of Core Reading specifically or
exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this
report; other valid approaches are given appropriate credit. For essay-style questions, particularly the
open-ended questions in the later subjects, the report may contain more points than the Examiners
will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the
examination was set. Candidates should take into account the possibility that circumstances may
have changed if using these reports for revision.

Luke Hatter
Chair of the Board of Examiners
July 2017

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. CT1 provides a grounding in financial mathematics and its simple applications. It

introduces compound interest, the time value of money and discounted cashflow
techniques which are fundamental building blocks for most actuarial work.

2. Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may lose
marks where excessive rounding has been used or where insufficient working is shown.

B. General comments on student performance in this diet of the

examination

1. The comments that follow the questions concentrate on areas where candidates could
have improved their performance. Where no comment is made, the question was
generally answered well by most candidates. The examiners look most closely at the
performance of the candidates close to the pass mark and the comments therefore often
relate to those candidates.

2. Performance was of a similar standard to that of most recent examinations. As in

previous examinations, the non-numerical questions were often answered poorly by
marginal candidates.

C. Pass Mark

The Pass Mark for this exam was 60.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

Solutions

i 
4
Q1 (i)  4%

 
12  3 1
1  d12  v4


= 1 i 4 
 4  1

 
  4  13 
 d 
1
  12(1  1.01 3 )
12
 12  1  1  i 4
 
 

 3.9735% [2]

d 
12 1
12
(ii) 1 e
12

 d   12 1  e 
1
0.0512
12

 

 4.9896% [2]

 4 1
(iii) 1 d4  v4


 1  d12 
12  3

 
  4
1

 d    12  1  1  d 4
12 3

 
 

 4.0134% [2]
[Total 6]

Generally well-answered.

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

Q2 Present value for 1st option:

7,800 a (4)  7,800  1.018559  10.8378

16

 £86,103.52 [2]

Present value for 2nd option:


16, 400  v 2  v 4  ...  v16 
 1  v16 
16, 400 v 2 
 1  v 2 
 

 1  0.45811 
16, 400  0.90703  
 1  0.90703 
 

= £86,702.94 [2]

(above uses factors from Formulae and Tables Book – exact answer is £86.702.16)

Therefore, 1st option is better for the borrower as the total value of the repayments is
less than with the 2nd option. [1]
[Total 5]

For the second option, a common mistake was to assume the annual rate of
payment was £8,200. Some students omitted to give a final conclusion (and
so did not actually answer the question).

Q3 Forward price of the contract is K 0  ( S0  I )eT  (78  I )e0.141 [1]

where I is the present value of income during the term of the contract.

 0.14 123 9
0.14  12 
 I  3.2  e e   5.97098 [1]
 

 K 0   78  5.97098  e 0.14  82.85309 [½]

Forward price when new contract issued at time r (1 month) is

 
11
0.11 12
K r  Sr  I * e(T r )  (80  I * )e [1]

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

where I * is the present value of income during the term of the contract.

 I *  3.2  e   6.115599
2
0.1112 8
0.1112
e  [1]
 

11
0.1112
 K 1   80  6.115599  e
12

 81.72297 [½]

Value of original contract   K r  K 0  e (T  r ) [½]

11
0.11 12
  81.72297  82.85309  e

 1.02172  £1.02172 [1½]

(above uses the rounded forward prices shown – exact answer is –£1.02174)
[Total 7]

Reasonably well-answered although a common mistake was not to deal with

the change in the interest rate correctly. There are quicker ways to answer
the question but candidates who took a methodical approach such as that
outlined above were able to maximise the marks for working even if they
made calculation errors.

  s  ds
t
Q4 (i) v(t )  e 0

For 0  t  2

t
  0.04ds
v(t )  e 0  e0.04t [2]

For t > 2

t
   0.02 k .s ds
v (t )  v(2).e 2

t
0.08  0.02 s  12 ks 2 
 2
e e

 e0.08  e  
  0.02t  12 kt 2  0.04 2 k  


0.02t  12 kt 2 0.04  2 k
e [3]

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

(ii) To calculate maximum value of k:

Now PV of outlay (in £000s)


 500  250 e0.02  e0.04 
= 985.247 [1]

At t =10, PV of sale proceeds

 2000 e0.08 .e(0.250k 0.042k )

 2000e 0.2448k [1]

So, for DPP = 10 years, we need PV of sale proceeds ≥ PV of outlay

 2000 e 0.2448k  985.247

 ln  0.4926235  0.24  48k

 k  0.00975 so maximum value is 0.00975 [2]

[Total 9]

In part (i), it was important to give the required expression for 2 explicitly.

Unfortunately in part (ii), there was a typographical error in the question

paper. The intention was to ask for the maximum value of k rather than the
minimum and the solution above obtains this maximum value. The answer to
the question actually on the paper is that the minimum value would be
∞. Students who gave this answer were given full credit as were
students who obtained the maximum value above. Marginal candidates did
not appear to have been disadvantaged as such candidates had typically
been unable to calculate the PV of the sale proceeds in terms of k.

Q5 (i) No, as with only a single asset, the spread of the asset proceeds would be less
than the spread of the liability outgo (at times 7 and 11). [1]
Thus, the convexity of the assets would be less than the convexity of the
liabilities and the third condition of immunisation could not be satisfied. [1]

(ii) Redington’s first condition states that the PV of the assets should equal the PV
 1 
of the liabilities  using v   0.94787  and working in £ millions:
 1.055 

VA  15.363v 7.5  3.787v14.25  12.048 [1]

Page 6
Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

VL  11v 7  8.084v11  12.048 [1]

Allowing for rounding (using three decimal places), Redington’s first

condition applies. [½]

Redington’s second condition states that the discounted mean term (DMT) of
the assets should be equal to the DMT of the liabilities, which equivalently can
be written as

VA  VL (where in the calculations below the derivatives are with respect to
the force of interest)

VA  15.363  7.5 7.5  3.787 14.2514.25  102.28 . [1]

VL  11 77  8.084 1111  102.28 [1]

Allowing for rounding (using 2 decimal places), Redington’s second condition

applies. [½]

Since the spread of asset proceeds exceeds the spread of liability outgo (as
asset proceeds are received at times 7.5 and 14.25, whereas liability outgo is
paid at times 7 and 11), the convexity of the assets is greater than the
convexity of the liabilities.

Alternatively:

VA''  15.363  7.52 v 7.5  3.787 14.252 v14.25  936.94 .

VL''  11 7 2 v 7  8.084 112 v11  913.32  VA'' .

[1½]

Thus, the third condition is also satisfied and the company is immunised
against small changes in the rate of interest. [½]
[Total 9]

In part (i), candidates tended to score 0 or 2 marks depending on whether

they recognised the problem with using a single asset. Part (ii) was answered
well.

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

Q6 The investor’s proceeds in £ millions at the time of purchase can be calculated as:

9
PVin  1.25  (1  0.35)a5|(12) 5 5 10 10
[1  1.042 v  1.042 v  ...  1.042 v 30 30
]v 12

9
35
11.5v 12 @ i  8% p.a.
[3]
1  r 7  0.75
 0.8125  a5|(12)   v  11.5v35.75 @ i  8% p.a. [1½]
 1 r
 

 0.8125  4.1371 [1]

 4.35767 [1]
 0.94391 [½]
 11.5  0.06384 [1]
 14.56039 [½]

where we have:

5
 1.042  (12) 1  0.68058
r    0.836026 ; a5|   4.1371
 1.08  0.07721

At the same time, the investor’s costs (in millions) are:

6
PVout  5.8  0.85v 12 @ i  8% p.a.

 5.8  0.85  0.96225  6.6179 [1½]

Thus, the investor’s net proceeds (in millions) are given by:

NPV  PVin  PVout  14.5604  6.6179  £7.9425m [1]

[Total 11]

This was a question where it was beneficial to use a methodical approach.

Common errors included not allowing for the three month period since
purchase and assuming the rent increases were 4.2% every five years.

Q7 (i) Let i = money rate of return

Then

5 20 512
9,800  400 a (2)  10,500v 20 0.30  400v 12 a20  0.40 (10,500  9,800)v
20
[4]

Page 8
Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

Try i = 3%

RHS = 400  1.007445  14.8775 + 10,500  0.55368 – 120  0.98776 

14.8775 – 280  0.546898 = 9,892.37 [1½]

Try i =4%

RHS = 400 1.009902  13.5903 + 10,500 0.45639 – 120  0.983791 

13.5903 – 280  0.448989 = 8551.92 [1]

Since 8551.92 < 9800 < 9892.37

then 3% < i < 4% [½]

(ii) We can find i from:

9892.37  9800
i  0.03   0.01
9892.37  8551.92

= 0.0307 i.e. i = 3.07% p.a. [1½]

If inflation = 2% p.a. = e, then i = net real yield can be found from

1  i 1.0307
1  i  
1 e 1.02

 i = net real yield = 1.05% p.a. [1½]

(iii) If tax were collected on 1 April instead of 1 June each year then tax payments
would be brought forward which would increase the present value of these
payments. [1]

This would decrease both the net money yield and the net real yield. [1]
[Total 12]

In terms of average mark, this was the worst answered question on the paper.
Many candidates simplified part (a) to assume that taxes were paid at the
same time as the coupon/redemption payments (ignoring the 5-month time
lag and/or assuming income tax was paid half-yearly) and they lost marks
accordingly. It was possible to get full marks on part (b) even if part (a) was
answered incorrectly. Part (c) was very poorly answered even though the
points required were straightforward.

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

Q8 (i) The TWRR for fund A and B results from the annual rates achieved for 2015
and 2016:

TWRR A : 1  i 2  1.42  1.03 => i = 20.94%

TWRR B : (1  i ) 2  1.36  1.02 => i = 17.78%
[3]

(ii) In order to calculate the MWRR, first we need to calculate the values of the
funds at the beginning and at the end of 2016. Working in £m, we have for
fund A and B where Ft , A and Ft ,B are the fund values at the end of 2014 + t
for Funds A and B respectively:

F1, A  (1.5  0.3)  1.42 = 2.556 and

F2, A  ( F1, A  1.7)  1.03 = 4.38368

F1,B  (2.3  2)  1.36 = 5.848 and

F2, B  ( F1, B  0.2)  1.02 = 6.1689 6 [2]

Then the MWRR result from the EV at the end of 2016:

MWRR A : (1.5  0.3)  (1 + i ) 2  1.7  (1  i ) = 4.38368

 1.8 x 2  1.7 x  4.38368  0

 x  1.158229  iA  15.823% [3]

2
MWRR B : (2.3  2)  (1 + i )  0.2  (1 + i )  6.16896

 4.3x 2  0.2 x  6.16896  0

 x  1.174735  iB  17.474% [3]

(iii) The TWRR is a more reliable indicator of the manager’s performance since it
is independent of the size of the amounts and the time at which investments
are made … [½]
…both of which are outside the manager’s control. [½]

In this case, manager A performed better than manager B for both 2015 and
2016 by achieving a higher TWRR for each of those years (i.e. 42%  36%
and 3%  2%). [1]

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

It should be noted that manager A had a worse MWRR for the 2 year period
than manager B because manager A had so few funds invested during the best
period for investment which was 2015/manager A received a large cashflow
just before a period of poor performance. [1]
[Total 14]

Many candidates failed to notice the quick way that part (i) could be solved
although much of the extra working that they undertook was needed for part
(ii) anyway.
Part (iii) was poorly answered although other approaches to those given
above could be used to gain full credit. It is important in this type of question
to refer to the actual results obtained and the actual data given.
Unsubstantiated answers to this part were given no credit.

Q9 (i) Let p  t  = Price of t -year bond

g1 = i1 = 0.071 = 7.100% p.a. [½]

p  2   5a2  100v 2 @ g 2 7.2% p.a. [1]

= 5  1.8030185 + 100  0.8701827

= 96.0334 [1]

5 105
and 96.0334 =  [1]
1.071 1  i2 2
 i2  7.203% p.a. [1]

p  3  5a3  100v3 @ g3  7.3% p.a.

= 5  2.609998 + 100  0.8094701

= 93.9970 [1]

5 5 105
 93.9970 =   [½]
1.071 1.07203 2
1  i3 3
 i3  7.307% p.a. [1]

(ii) f0  i1  7.1% = 7.100% p.a. [½]

1  f0  1  f1   1  i2 2 [1]

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

 1  f1 
1.072032
1.071

 f1  7.306% p.a. [1]

(Above answer is based on rounded answer for i2 . Exact answers is 7.305%).

1  i2 2 1  f 2   1  i3 3

 1  f2 
1.07307 
3

1.072032

 f 2  7.515% p.a. [1½]

(Above answer is based on rounded answers for i2 and i3 . Exact answers is

7.516%).

(iii) The spot rate for a term is the geometric average of the forward rates making
up that term. [1]
Since the spot rates increase with term, the forward rates must increase at a
faster rate than the spot rates to ensure that the geometric average of the
forward rates is itself increasing with term. [1]
[Total 13]

Many marginal candidates answered part (i) as if the gross redemption yields
given were actually spot yields. Others assumed the price of the bonds all to
be par. Part (ii) was answered well even by candidates who had struggled
with part (i). The examiners recognised that part (iii) would stretch many
candidates and indeed this part was found to be challenging.

Q10 (i)
1 
Value of annuity = 20, 000 a(12) 1  1.03v  1.032 v 2  ...  1.0319 v19  [2]

  1.03  20 
 1   
  1.07  
 20, 000 1.037525  0.93458  [1]
 1.03 
 1  1.07 
 
= 19,393.417314.26488

= £276,645. [1]

(above uses factors from Formulae and Tables Book – exact answer is
£276,639)

Page 12
Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

(ii) Let S5 = Accumulation of £1 after 5 years and let it = investment return for
year t.

 5 
[ E ( S5 )  E  1  it 
 
 t 1 

5
  E (1  it ) using independence
t 1

5
  (1  E (it )) ]
t 1

Now E (it )  0.6  0.04  0.4  0.07

 0.052 for t = 1, 2, … 5 [1]

 Expected accumulation  200, 000 E ( S5 )

 200, 000  (1.052)5 [1]
 200, 000  1.288483
 £257, 696.60 [1]

(iii) The variance of the accumulation is

  
200, 0002  E S52  E  S5 
2
 [1]

 5 2
 
[where E S52  E   1  it  
 
 t 1 

 5 

 E   1  2it  it2
  
 t 1 
5
 
  1  2 E (it )  E (it2 ) from independence]
t 1

Now E (it2 )  0.6  0.042  0.4  0.07 2

 0.00292 for t = 1, 2, …5 [1]

Hence, E (S52 )  (1  2  0.052  0.00292)5

 1.661809 [1]

Page 13
 Subject CT1 (Financial Mathematics Core Technical) – April 2017 – Examiners’ Report

 Standard deviation of accumulated fund is

 
1
200, 000  1.661809  1.2884832 2

= £8,051.23 [1]

(above uses factors from Formulae and Tables Book – exact answer is
£8,051.74)

(iv) Note that 200, 000  (1.07)4 (1.04) = 272,645.57 < 276,639
and 200, 000  (1.07)5 = 280,510.35 > 276,639

Hence, the individual would require the annual return to be 7% p.a. for each of
the 5 years in order to reach the required fund. [2]

The probability of this happening is

(0.4)5  0.01024 [1]

[Total 14]

Parts (i) and (ii) were answered reasonably well although a few candidates
appeared to be under time pressure if this was the last question to be
attempted. Part (iii) was less well answered with many marginal candidates
2
confusing E (it ) and Var(it ) . Part (iv) was generally only answered by the
strongest candidates with many candidates incorrectly applying a lognormal
distribution to the problem.

END OF EXAMINERS’ REPORT

Page 14
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

25 September 2017 (pm)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. You have 15 minutes of planning and reading time before the start of this examination.
You may make separate notes or write on the exam paper but not in your answer
booklet. Calculators are not to be used during the reading time. You will then have
three hours to complete the paper.

4. Mark allocations are shown in brackets.

5. Attempt all 11 questions, beginning your answer to each question on a new page.

6. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 S2017  Institute and Faculty of Actuaries

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]

2 Describe how cash flows are exchanged in an interest rate swap. [2]

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]

4 A one-year forward contract was issued on 1 April 2016 on a share with a price of
$4.00 at that date. Dividends of $0.10 per share were expected on 30 September 2016
and 31 March 2017. The 6-month and 12-month risk-free spot rates of interest were
5% and 6% per annum effective respectively on 1 April 2016.

Calculate the forward price at issue, stating any assumptions. [4]

5 An individual invests £100 in an asset. The expected accumulation of this asset after
20 years is £200 and the standard deviation of the accumulation after 20 years is £50.

(i) Calculate the expected effective rate of return per annum. [1]

(ii) Calculate the standard deviation of the effective rate of return per annum. [4]
[Total 5]

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.

CT1 S2017–2
 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]

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, yt
is given by yt = 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]

CT1 S2017–3 PLEASE TURN OVER

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]

9 The force of interest, δ(t), is a function of time and at any time t, measured in years, is
given by the formula:

0.09 − 0.003t 0 ≤ t ≤ 10
δ(t ) = 
0.06 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]

CT1 S2017–4
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 arrear. 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]

11 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.

CT1 S2017–5 PLEASE TURN OVER

 • 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 arrear.

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]

(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]

END OF PAPER

CT1 S2017–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2017

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both those who
are sitting the examination for the first time and using past papers as a revision aid and also those who have
previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The Examiners have access to
the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are
not required to examine the content of Core Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in this report; other
valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions
in the later subjects, the report may contain more points than the Examiners will expect from a solution that
scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that the examination
was set. Candidates should take into account the possibility that circumstances may have changed if using these
reports for revision.

Luke Hatter
Chair of the Board of Examiners
December 2017

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. CT1 provides a grounding in financial mathematics and its simple applications. It

introduces compound interest, the time value of money and discounted cashflow
techniques which are fundamental building blocks for most actuarial work.

2. Please note that different answers may be obtained to those shown in these
solutions depending on whether figures obtained from tables or from calculators
are used in the calculations but candidates are not penalised for this. However,
candidates may lose marks where excessive rounding has been used or where
insufficient working is shown.

B. General comments on student performance in this diet of the examination

The comments that follow the questions concentrate on areas where candidates
could have improved their performance. Where no comment is made, the
question was generally answered well by most candidates.

C. Pass Mark

The Pass Mark for this exam was 60.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

Solutions

 0.03t 
Q1 (i) (a) 6, 000 1    7, 600 [1]
 365 
 7, 600  365
t   1  = 3,244.4 days [1]
 6, 000  0.03
6, 000 1  0.03
t
(b) 365
 7, 600 [1]
ln1.03  7, 600 
t  ln    ln1.26667  0.23639
365  6, 000 
0.23639
 t  365  = 2,919.0 days [1]
ln1.03
0.03t
(c) 6, 000e 365  7, 600 [1]
365  7, 600 
t 
0.03  6, 000 
ln = 2,876.1 days [1]

i 
2
(ii) Effective interest rate per half year is where
2
 i 2   i 
2
1  e 2 e 0.015
 1.0151131   1.51131% [1]
 2  2
 
[Total 7]

Well answered although some candidates gave i   as their final

2

answer to part (ii).

Q2 One party agrees to pay to the other a regular series of fixed amounts… [½]
…for a certain/given term. [½]
In exchange, the second party agrees to pay a series of variable amounts [½]
…based on the level of a short-term interest rate. [½]
[Total 2]

The worst-answered question on the paper even though the above

comes directly from the Core Reading.

Q3 Let d be the annual simple rate of discount.

The discounted value of 100 in the deposit account would be X such that:

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

91

X  100 1.03
365
 99.26576 [1]

To provide the same effective rate of return a government bill that pays 100 must have
 91d 
a price of 99.26576 and so 100 1    99.26576
 365 

365
d 1  0.9926576  0.029450 [2]
91
[Total 3]

There was a potential ambiguity with this question in that the term of
the government bill was not separately stated. Most students assumed
the term of the bill was also 91 days as the examiners intended but
candidates who assumed another term were also given credit.

Q4 Assuming no arbitrage: [1]

Present value of dividends

 0.10v5%
0.5
 0.10v6%  0.1 0.97590  0.1 0.94340  0.19193 [2]
Forward price   4  0.19193 1.06  $4.03655 [1]
[Total 4]

No comments.

Q5 (i) Let S 20  Accumulated value at time 20 of £1 invested at time 0

then E  S20   1  j 
20

E 100S20   100 E  S20   200  E  S20   2

1  j 20  2  j  0.035265 [1]

(ii) Let s be the standard deviation of the annual effective rate of return.

Var 100 S20   502

10, 000Var  S20   2,500  Var  S20   0.25 [1]

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

 
20
Var  S20   1  j   s 2  E  S20 
2 2
[1]

 
1 20
0.25  2 10  s2  22

 
1
1
 s 2  0.25  22 2  0.00325372
20
10

 s  0.057041 [2]
[Total 5]

Part (i) was well answered although many candidates struggled with
part (ii). The above solution uses the formulae developed in the core
reading in the case where the returns in each year are assumed to be
independent and identically distributed although these assumptions are
not necessary for the calculation of the above answer.

Q6 Accumulated amount from Fund A

12  1.0315  1
 12 100s  1, 200
15 3%

12 1  1.03
 112

 $22, 679.74
[2]
Accumulated amount from Fund B

12  12 
 12 100s
15 3.7%
 12 15s
1 3.7%
1.037 14
1.03715  1 1.037  1
 1, 200  180 1.037 14

12 1  1.037
 112
 
12 1  1.037
 112

 23,967.992  305.313  $23, 662.68
[3]

The percentage by which B is greater is found from

23, 662.68  22, 679.74
 1  4.33% [1]
22, 679.74
A comparatively straightforward question that was poorly done by
marginal candidates.

Q7 (i) Let P be the price per £100 nominal.

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

 2
P  0.8  5a  110v2 with a gross redemption yield of 4% per annum. [1]
2

1  1.042
 P  0.8  5  110 1.042
 1
2 1.04 2  1 
 P  4 1.904771 110  0.924556  £109.320 [2]

(ii)
Time Government bond Present value Payment Present value
t spot rate yt + 1% factor of payment

0.5 0.0175 0.99136 2 1.9827

1 0.025 0.97561 2 1.9512

1.5 0.0325 0.95316 2 1.9063

2 0.04 0.92456 112 103.5503

Total present value = £109.391 per £100 nominal [3]


1  y2 
2
1 
1.032
 1  0.04522
(iii) Forward rate [2]
1  y1 1.015

(iv) It may be because interest rates are expected to rise in the future and the yield
curve is determined by expectations theory.

And/or because investors might expect inflation to rise leading to expectations

of higher interest rates over the longer term.

And/or because investors have a preference for liquidity which puts an

upwards bias on the yield curve. A rising curve would be compatible, for
example, with constant expectations of interest rates.

And/or because the market segmentation theory holds and short-term bonds
might be in demand by investors such as banks.
[1½ each point, maximum 3]
[Total 11]

Marginal candidates struggled with this question with a common error

in part (ii) being to assume coupons were annual (which simplified the
question considerably).
Part (iv) was poorly answered. Explanations of why the yield curve
would be the given shape were required. It was not sufficient just to
name the various theories of the yield curve.

Page 6
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

Q8 (i) Amount of loan is 50  Ia 10  50a10 at 5% per annum effective [1]

 50  39.3738  50  7.7217

= 1968.69 + 386.09 = £2,354.78 [1]

(ii) (a) The outstanding loan after fifth instalment is:

50  Ia 5  300a5 [1]

 628.32  1, 298.85 = £1,927.17 [1]

The interest component is therefore 0.05 1,927.17  £96.36 [1]

(b) The capital component = 350 - 96.36 = £253.64 [1]

(iii) The capital remaining after the sixth instalment is

1,927.17 – 253.64 = £1,673.53 [1]

Let the new instalment = X

Xa4 6%  1,673.53

1, 673.53
X  £482.96 [2]
3.4651
[Total 9]

The best answered question on the paper (excluding Q1)

10
Q9 (i) A  0,10   exp  0.09  0.003s ds
0
10
 exp 0.09s  0.0015s 2   exp  0.9  0.15  e0.75 =2.1170 [3]
 0

Require i where 1  i 
10
 2.1170  i  0.077884 [1]

(ii) 
d  2  2 1  1  i 
 12
  0.073611 [1]

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

10
(iii) A  5,10   exp  0.09  0.003s ds
5
10
 exp 0.09s  0.0015s 2   exp  0.75  0.45  0.0375  e0.3375
 5

A 10,15   e50.06  e0.3

A  5,15   A  5,10  A 10,15   e0.6375  1.89175

Accumulated amount = 1,500 e0.6375 =£2,837.62 [3]

(iv) Equivalent annual effective rate of discount is d such that

1  d   e0.6375  d  0.061760
10
[1]

(v) For t > 10,

 t 
v  t   v 10  exp   0.06 ds 
 10 

 e0.75 exp  0.06s 10

t

 e0.75 exp  0.06t  0.6  e0.06t 0.15

[3]
15 15 15
Present value     t  v  t  dt   10e0.01t e 0.06t 0.15 dt   10e 0.05t 0.15 dt
11 11 11

15
 e0.05t 0.15 
 10 

  200 e
0.9

 e0.7 
 0.05 11

 81.314  99.317  18.003

[3]

Another standard question that was well-answered.

Q10 (i) (a) Work in £ millions

PV of liabilities = 100v10  200v 20 at 3% per annum

Page 8
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

 100  0.74409  200  0.55368  185.145 [1½]

1,000  0.74409  4,000  0.55368 2,958.797

(b) DMT of liabilities = 
185.145 185.145
=15.981 years [2½]

(ii) PV of assets = 144.054v15  Xat where t is the term of the annuity and X is the
annual payment.

So Xat  185.145  144.054v15  185.145  144.054  0.64186  92.682 for first

condition to be satisfied. [1]
144.054 15  0.64186  X  Ia t
DMT of assets = = 15.981 years [2½]
185.145
So X  Ia t  2,958.797  144.054 15  0.64186  1,571.859 for second
condition to be satisfied. [1]

X  Ia t 1,571.859  Ia t
Thus    16.960
Xat 92.682 at

From inspection of tables, t = 41 years. [1½]

(iii) Xa41  92.682  X  £3.95865m [1]

(iv) Redington’s third condition requires that the convexity or spread of the terms
of the asset proceeds around the discounted mean term is greater than that for
the liabilities.
It is likely that this is the case given that the asset proceeds consist in part of
an annuity of term 41 years (though not certain). [2]

(v) If the insurance company sells the security and buys one with a shorter term,
the discounted mean term of its assets will no longer be equal to that of its
liabilities (it will be shorter). This will mean that, if interest rates were to fall,
the insurance company would make a loss. [2]
[Total 15]

Part (i) was answered well. In a ‘Show that…’ question as in part (ii),
it is important to show steps clearly. Many marginal candidates did not
do this or, more seriously, appeared to claim that incorrect workings
led to the required final answer.
Part (v) was answered very poorly with few candidates explaining the
precise scenario where a loss would be made.

12 12 12

Q11 (i) PVA  10,000a  10,000 1.05v  a  10,000 1.052 v2  a [2]
1 1 1

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

 10, 000a
12 
1 1  1.05v  1.05v   2

12  1  1.05v 
3
 10, 000a
1 1  1.05v
1  v 1  1.05v 
3
 10, 000
d   1  1.05v
12

 10, 000  0.986579  3.058629

 £30,176
[2]

[or from 2nd line in 1 above:

1 v
 10, 000  1  1.019417  1.039212 
d 
12

 10, 000  0.986579  3.058629

 £30,176]

(ii) PVB 1  i   1,300a

6  4
45
 200 a     a    300 a   a  
4
45
4
15
4
45
4
30
[2]

 4  4  4
PVB  v6 1,800a  200a  300a 
 45 15 30  

 PVB  1.036
  
1,800 1  v 45  200 1  v15  300 1  v30 
    

4 1  1.03
 14

1,800  0.735561  200  0.358138  300  0.588013
 PVB  0.837484   £30,598
0.0294499

[3]

[or
 4  4  4
PVB 1  i   1,300a
6
 1,500v15a  1,800v30 a
15 15 15

a
 4
15 1,300  1,500v  1,800v  15 30


1  v   1,300  1,500  0.641862  1,800  0.411987
15


4 1  1.03
 14

0.358138
  3, 004.3696
0.0294499

 PVB  0.837484  36,535.91  £30,598 ]

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

(iii) Option A has the lower present value out of A and B. Therefore, the student
has to calculate the salary level so that PVC  30,176 [1]
Let the initial salary level in relation to option C be SC


30,176  0.03SC v3 v  1.03v2   
 1.039 v10  0.03SC1.0310 v18 v  1.01v2   1.0129 v30 
[3]
4

 0.03SC v 10  1.03 v 10 15
1  1.01v   1.01 v
29 29

 1  1.0130 v30 
 0.03SC v 4 10  v5 
 1  1.01v 


 0.03SC 1.034 10  0.862609  22.90226   0.79313SC

 SC  £38, 047 [3]

Therefore, the starting salary has to be less than £38,047 for option C to have the
lowest net present value. [1]

(iv) The risks to the students of the three options are very different. For example, the
payments under option C vary with salaries and probably with general inflation and
the time spent out of the labour market, whereas under options A and B payments are
fixed. Therefore, it does not seem reasonable to use the same interest rate (and
therefore risk premium) to evaluate all three options. [2]

(v) Possible risks could be:

Student defaults on loan payments (for those that choose option B)
Student salaries are less than the university expects (for those that choose option C) –
this could include lower than expected general inflation
Salary earning periods being shorter than expected (for those that choose option C)
e.g. because of periods of maternity/paternity leave.
Mortality risk: e.g. under options B and C, if mortality were higher than expected,
payments received would be lower than expected.
Students select against the university with those expecting low salaries or poor
employment prospects choosing C and those expecting high salaries choosing options
A or B.
Students choosing option C artificially restrict official salary (e.g. ‘cash-in-hand’,
payment via dividends, working abroad). [1½ each point, maximum 4]
[Total 23]

There was an ambiguity in part (iii) where the examiners intended for
the maximum initial level of salary to be given as the answer. All
marginal candidates appeared to read this part as the examiners had
intended.
Parts (i) and (ii) were answered well but the later parts were answered
poorly, possibly as a result of time pressure. Parts (iv) and (v) did not

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – September 2017 – Examiners’ Report

require reference to the earlier calculations but were still not answered
well by marginal candidates.
END OF EXAMINERS’ REPORT

Page 12
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

17 April 2018 (am)

Subject CT1 – Financial Mathematics

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. You have 15 minutes of planning and reading time before the start of this examination.
You may make separate notes or write on the exam paper but not in your answer
booklet. Calculators are not to be used during the reading time. You will then have
three hours to complete the paper.

4. Mark allocations are shown in brackets.

5. Attempt all 11 questions, beginning your answer to each question on a new page.

6. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 A2018  Institute and Faculty of Actuaries

1 State the characteristics of a Eurobond. [4]

2 (i) Describe what is meant by the term “ex-dividend”. [1]

An individual purchased 10,000 shares on 1 December 2017. Dividends are payable

on 1 January and 1 July each year, and are assumed to be payable in perpetuity. The
next dividend, due on 1 January 2018, is $0.07 per share.

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 2% per
annum compound.

Assume that the share is ex-dividend on 1 December 2017 and use an effective rate of
interest of 7% per annum.

(ii) Calculate the present value of the investment at the date of purchase. [5]
[Total 6]

3 An investor pays £80 at the start of each month into a 25-year savings plan.

The contributions accumulate at an effective rate of interest of 3% per half-year for

the first 10 years, and at a force of interest of 6% per annum for the final 15 years.

Calculate the accumulated amount in the savings plan at the end of 25 years. [6]

4 The annual investment return achieved by an insurance company in year t is it .

Returns in successive years are assumed to be independent and:

ln(1  it ) ~ N (, 2 ) , where   0.08 and   0.15 .

The insurance company has a liability of €800,000 payable at the end of year 10.

The company wishes to invest an amount now so that there is a 95% probability that
the accumulated amount at the end of year 10 will be sufficient to meet this liability.

(i) Calculate the amount of money that the insurance company should invest. [5]

(ii) Explain, without doing any further calculations, how your answer to part (i)
would change if each of the following occurs separately, with all other
parameters as in part (i):

(a) The value of  is increased to 0.1.

(b) The value of  is increased to 0.2.
(c) The desired probability of meeting the liability is increased to 99%.
[3]
[Total 8]

CT1 A2018–2
5 (i) Describe what is meant by the “no arbitrage” assumption in financial
mathematics. [2]

An investor entered into a long forward contract for a security three years ago and the
contract is due to mature in six years’ time. The price of the security was £7.10 three
years ago and is now £10.20. The risk-free rate of interest can be assumed to be
2% per annum effective throughout the nine-year period.

(ii) Calculate the current value of the contract with the following dividend
payments, assuming no arbitrage:

(a) The security will pay dividends of £1.10 annually in arrear from now
until the maturity of the contract.

(b) The security has paid and will continue to pay annually in arrear a
dividend equal to 2.5% of the market price of the security at the time
of payment.
[6]
[Total 8]

6 On 1 April 2018 a government issued a 10-year bond redeemable at £105 per £100
nominal and paying coupons at the rate of 3% per annum half-yearly in arrear. The
price of the bond was £102 per £100 nominal.

An investor subject to income tax of 25% and capital gains tax of 35% purchased
£10,000 nominal of the bond at issue.

The investor assumes that inflation will be constant over the term of the bond at a rate
of 2% per annum.

(i) Calculate the net effective real redemption yield which the investor expects to
earn on the investment. [6]

(ii) Explain how your answer to part (i) would change if inflation were less than
2% per annum throughout the term. [2]
[Total 8]

CT1 A2018–3 PLEASE TURN OVER

7 A retailer is considering opening a new store as a business venture. The purchase
price of the store will be £2 million and there will be a further investment required of
£0.5 million 6 months after purchase.

The store will open 12 months after purchase. Revenues less running costs are
expected to occur continuously and will be £0.2 million in the first year of operation,
£0.25 million in the second year of operation and thereafter increasing at yearly
intervals by 4% per annum compound.

Eight years after purchase, a major refit costing £0.8 million will be required. Fifteen
years after purchase, it is assumed that the store will be closed and sold for
£6.4million.

The retailer requires a rate of return on its investment of 10% per annum effective.

(i) Calculate the net present value of the venture. [8]

It is now assumed that the revenue less running costs will be received mid-way
through each year, rather than continuously.

(ii) Explain how your answer to part (i) would change. [2]
[Total 10]

8 An investment fund has liabilities of £20 million due in 8 years’ time and £15 million
due in 12 years’ time.

The manager wishes to immunise the fund against small changes in the rate of interest
and seeks to achieve this by purchasing two zero-coupon bonds. One bond is for a
term of exactly 7 years and the other bond is for a term of exactly 14 years. The
current interest rate is 4.5% per annum effective.

(i) Calculate the amount that should be invested in each bond, demonstrating that
all three Redington conditions are met. [9]

(ii) Explain, without performing any further calculations, how the relative values
of the assets and the liabilities will change if the interest rate changes
immediately to 4.7% per annum effective. [2]
[Total 11]

CT1 A2018–4
9 Two bonds paying annual coupons of 6% in arrear and redeemable at par have terms
to maturity of exactly one year and two years.

The gross redemption yield from the 1-year bond is 5.2% per annum effective. The
gross redemption yield from the 2-year bond is 6.1% per annum effective. The 3-year
par yield is 6.6% per annum.

Calculate the following as a percentage to three decimal places:

(i) the annual effective spot yields for each of the three years [8]

(ii) the annual effective one-year forward rates for each of the three years [4]
[Total 12]

10 The force of interest (t) is a function of time, and at any time t, measured in years is
given by the formula:

0.24  0.02t 0 t 6
(t )  
 0.12 6 t

(i) Derive, and simplify as far as possible, expressions in terms of t for the present
value of a unit investment made at any time, t. You should derive separate
expressions for each time interval 0  t  6 and 6  t . [5]

(ii) Determine the discounted value at time t = 4 of an investment of £1,000 due at

time t = 10. [2]

(iii) Calculate the constant nominal annual interest rate convertible monthly
implied by the transaction in part (ii). [2]

(iv) Calculate the present value of a continuous payment stream invested from
time t = 6 to t = 10 at a rate of (t )  20e0.360.32t per annum. [4]
[Total 13]

CT1 A2018–5 PLEASE TURN OVER

11 An n-year decreasing annuity is payable annually in arrear where the payment at the
end of the first year is n, the payment at the end of the second year is (n – 1), and so
on until the final payment at the end of year n is 1.

n -a
(i) Show that the present value of this annuity is n [3]
i

A loan is to be repaid over 25 years by means of annual instalments payable in arrear.

The amount of the first instalment is £8,000 and each subsequent instalment reduces
by £200.

The effective rate of interest charged by the lender is 5.5% per annum.

(ii) Calculate the initial amount of the loan. [3]

(iii) Determine the interest and capital components of the 10th instalment. [6]

(iv) Calculate the total amount of interest payable over the term of the loan. [2]
[Total 14]

END OF PAPER

CT1 A2018–6
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
April 2018

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

Luke Hatter
Chair of the Board of Examiners
June 2018

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. CT1 provides a grounding in financial mathematics and its simple applications. It

introduces compound interest, the time value of money and discounted cashflow
techniques which are fundamental building blocks for most actuarial work.

2. Please note that different answers may be obtained to those shown in these
solutions depending on whether figures obtained from tables or from calculators
are used in the calculations but candidates are not penalised for this. However,
candidates may lose marks where excessive rounding has been used or where
insufficient working is shown.

B. General comments on student performance in this diet of the examination

1. The comments that follow the questions concentrate on areas where candidates
could have improved their performance. Where no comment is made, the
question was generally answered well by most candidates. The examiners look
most closely at the performance of the candidates close to the pass mark and the
comments therefore often relate to those candidates.
2. Student performance was similar to that in recent diets with the average mark
being very close to the average of the previous six diets although lower than that
in September 2017. Students seemed to have difficulty with the early part of the
paper with the four worst answered questions all in the first five questions.

C. Pass Mark

The Pass Mark for this exam was 60.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

Solutions

Q1 The characteristics of a Eurobond are:

• Medium- or long-term borrowing
• Usually unsecured
• Regular interest payments
• Redeemed at par
• Issued and traded internationally/not in the jurisdiction of any one country
• Can be denominated in any currency (e.g. not the currency of issuer)
• Tend to be issued by large companies, governments or supra-national
• organisations
• Yields depend on issue size and issuer (or marketability and risk)…
• …(although typically yields will be higher than those on gilts and lower than
those on equities)
• Issue characteristics may vary – market free to allow innovation
[½ mark for each point, max 4]

This was a bookwork question similar to the type asked in most diets.
This was generally answered poorly particularly by marginal
candidates.

Q2 (i) An equity which is offered for sale without the next dividend is called ex-
dividend [1]

(ii) Value of dividends to investor =

0.07 ×10, 000 × v ( 7

12 + 1.02 v( 13
12 +v
19
12
) + 1.02 ( v
2 25
12 +v
31
12
) + ....) [1]

= 700v
1
12
(v 6
12 + 1.02 v + v ( 112
) + 1.02 ( v2 2
+v
2 12
) + ....)
= 700v
7
12 + 700v
1
12
(
1.02 v + v
112
) × 1 + 1.02v + 1.02 v 2 2
+ ... @ 7%


= 700v
7
12 + 700v
1
12
(
1.02 v + v
112
) ×  1 − (1.021 /1.07)  [2]

 1 
= 672.91 + 709.99 ×1.83807 ×  
 1 − (1.02 /1.07) 

= $28,600 [2]

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

Candidates who scored well on this question tended to score very well
overall but this was poorly answered by marginal candidates. Very few
got the timing right, with many failing to include the extra one month
offset. Many also struggled with simplifying the long equation into a
format which could be more easily calculated.

Q3 Effective rate of interest per month for first 10 years, i1 , comes from:

1
1=
+ i1 (1.03) 6 =
⇒ i1 0.49386% per month [1]

and effective rate of interest per month for last 15 years, i2 , comes from:

0.06
1 + i=
2 e
12 ⇒ i=
2 0.50125% per month [1]

× (1.0050125 )
180
⇒ Accumulation after 25 years = 80 s120
0.49386%
+ 80 s180
0.50125%

(1.0049386120 − 1)
s120
where = 0.49386%
1.0049386 ×
0.0049386

= 164.0318 [1½]

and s180
= 0.50125%
1.0050125 ×
(1.0050125 180
) = 292.6504
−1
[1½]
0.0050125

⇒ Accumulation = 80 × 164.0318 × 1.0050125180 + 80 ×292.6504

= 32276.13 + 23412.03 = £55,688.16 (exact answer is £55,688.38)

[1]
[or working in years:

1=
+ i1 (1.03) 2 ⇒
= i1 6.09% per year
1 + i2= e0.06 ⇒ i2= 6.1837% per year

(12 ) @ 6.09% (12 ) @ 6.1837%

× (1.061837 ) + 960 s
15
⇒ Accumulation after 25 years = 960 s
10 15
(1.0609 − 1) 10
where s( )
12 @ 6.09%
= = 13.6693
10   0.0609  112 
12 × 1 − 1 − 
  1.0609  
 

Page 4
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

(1.06183715 − 1)
and s( )
12 @ 6.1837%
= = 24.3877
15   0.061837  112 
12 × 1 − 1 − 
  1.061837  
 
⇒ Accumulation = 960 × 13.6693 × 1.06183715 + 960 × 24.3877

= 32276.42 + 23412.17 = £55,688.59]

Many of the comments on Q2 also apply here although the

performance on this question was better. Common errors included
those in the calculation of the appropriate interest rate and in the
calculation of the accumulation factors.

Q4 (i) Let Sn denote the accumulation at time n of an initial investment of 1 at

time 0.

Then, the accumulation at time 10 is:

10 10
S10= ∏ (1 + it ) ⇒ ln ( S10=) ∑ ln (1 + it ) ~ N (10µ,10σ2 ) [1]
t =1 t =1

Also, an initial investment of X at time 0 will accumulate to XS10 at time 10.

Then, we require to find the value of X such that:

P ( XS10 ≥ 800, 000 ) =

0.95 [1]
 800, 000 
⇒ P  S10 ≥ = 0.95
 X 
  800, 000  
⇒ P ln ( S10 ) ≥ ln   =0.95
  X 
  800, 000  
 ln   − 10µ 
⇒ P Z ≥  X 
=0.95
 10σ 2 

 800, 000 
ln   − 10µ
⇒  X  = −1.645
10σ2
 800, 000 
⇒ ln  = 0.019708
 X 
⇒= X 784,388 ≈ €784, 000
(exact answer is £784,333) [3]

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

(ii) (a) Increasing the value of µ will increase the expected annual investment
return and so the amount required at time 0 (to meet the liability with
probability 95%) will decrease. [1]

(b) Increasing the value of σ will increase the volatility of the annual
investment return ⇒ the amount required at time 0 (to meet the
liability with probability 95%) will increase. [1]

(c) If the probability of meeting the liability is increased from 95% to

99%, then the risk of not meeting the liability has been reduced and so
the amount required to be invested now must be increased so that, with
a greater initial investment, there is more certainty that the target figure
of £800.000 after 10 years will be reached. [1]

This was the worst answered question on the paper. Some candidates
tried to calculate the parameters of the distribution for the 10-year
accumulation from first principles and others made method/calculation
errors when manipulating the Normal distribution.

In part (ii), many candidates stated conclusions with no supporting

reasoning. No credit was awarded in such cases.

Q5 (i) The “no arbitrage” assumption means that neither of the following applies:

(a) an investor can make a deal that would give her or him an immediate
profit, with no risk of future loss; nor

(b) an investor can make a deal that has zero initial cost, no risk of future
loss, and a non-zero probability of a future profit. [2]

(ii) (a) The current value of the forward price of the old contract is:

7.10 × (1.02)3 − 1.1a62%

whereas the current value of the forward price of a new contract is:

10.20 − 1.1 a62%

Hence, current value of old forward contract is:

10.20 − 7.10 × (1.02)3 =

£2.6654 [3]

Alternative solution

Page 6
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

K 0 =(7.1 − 1.1v3a6 ) ×1.029 =1.5462

K3 = (10.2 − 1.1a6 ) ×1.026 = 4.5479
V4 = (4.5479 − 1.5462) ×1.02−6 = £2.6654

Solution if it is assumed that dividends are paid from the start:

K0 = (7.1 − 1.1a9 ) ×1.029 =−2.22449
K3 = (10.2 − 1.1a6 ) ×1.026 = 4.5479
V3 = (4.5479 + 2.2449) ×1.02−6 = £6.0319

(ii) (b) The current value of the forward price of the old contract is:

7.10(1.02)3 (1.025) −9 = 6.0331

Whereas the current value of the forward price of a new contract is

−6
10.20 (1.025 ) = 8.7954
⇒ current value of old forward contract is

8.7954 – 6.0331 = £2.7623 [3]

Alternative Solution

7.1×1.025−9 ×1.029 =
K0 = 6.7943
K3 =10.2 ×1.025−6 ×1.026 =9.9051
V3 = (9.9051 − 6.7943) ×1.02−6 = £2.7623

In part (i), many candidates seemed confused between ‘arbitrage’ and

‘no arbitrage’. In part (ii)(a), candidates who assumed the dividends
were payable from outset also received full credit.

Q6 (i) Let i = money yield per annum.

Consider £100 nominal stock purchased on 1/4/2018.

= 0.75 × 3 × a (2) + (105 − 0.35 × (105 − 102) ) v10

102
10

⇒ 102
= 2.25 a (2) + 103.95 v10 [2]
10

Try 2%, RHS = 2.25 × 1.004975 × 8.9826 + 85.2752

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

= 105.59

Try 3%, RHS = 2.25 × 1.007445 ×8.5302 + 77.3486

= 96.68

105.59 − 102
i=
0.02 + × 0.01
105.59 − 96.68

= 0.0240 (exact answer is 0.0239)

[3]

and (1 + i) = (1 + i′)(1 + e)

1.0239
⇒ i′
= =− 1 0.00382 i.e. Real yield = 0.4% per annum [1]
1.02

(ii) If inflation had been less than 2% per annum throughout the term then the real
rate of return would have been higher. This is because one would be stripping
out a lower rate of inflation from the money yield to obtain the real yield. [2]

Generally well-attempted although in part (b) some candidates, as in

Q4, gave a conclusion without supporting reasoning.

1
Q7 (i) Present value of initial outlay =
2 + 0.5 v 2 =
2.4767 [1]

PV of 1st year’s net revenue = 0.2 v a1 = 0.2 v 2 i

δ

= 0.2 × 0.82645 × 1.049206

= 0.1734 [2]
PV of 2nd to 14th year of net revenue

= 0.25 v 2 a1 + 0.25 ×1.04 v3 a1 + ....... + 0.25 ×1.0412 v14 a1

(
= 0.25v 2 a1 1 + 1.04 v + ... + 1.0412 v12 )

( )
13 
 1 − 1.04
i
= 0.25v3  1.10 
δ 1 − 1.04 
 1.10 
 

Page 8
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

= 0.25×0.75131×1.049206×9.49094

= 1.8704 [3]

PV of refit = 0.8 v 8 = 0.3732 [½]

PV of sale proceeds = 6.4 v 15

= 1.5321 [½]

⇒ NPV = 0.1734 + 1.8704 + 1.5321 – 2.4767 – 0.3732

= £0.726m [1]

(ii) If the net revenue had been received mid-year rather than continuously then
1
we would be replacing a1 with v 2 in the formulae for the PV of the net
revenue.

i 1
Since we can observe that a= v > v 2 we can see that the PV of the net
1 δ
revenue would decrease. Therefore, the NPV of the profit would decrease.
[2]

Generally well-attempted. In questions like part (i), candidates are

advised to show their working for each element separately as this
provides a clear ‘audit trail’ for markers to follow and appropriate
partial credit can be awarded for correct elements.

Q8 (i) Let X and Y be the maturity proceeds from the amounts invested in the 7-year
and 14-year zero-coupon bonds respectively.

Redington’s first condition states that the PV of the assets should equal the PV
1
= = 0.95694 and working in £million):
of the liabilities (using
1.045

VL = 20ν8 + 15ν12 = 22.9087

VA = X ν 7 + Y ν14 = 22.9087 (1) [2]

Redington’s second condition states that the discounted mean term (DMT) of
the assets should be equal to the DMT of the liabilities. The denominators for
the DMTs will be the respective PVs, which are assumed to be equal from the
first condition above, so we can just consider the numerators:

For the liabilities: = 20 × 8ν8 + 15 ×12ν12 = 218.6491

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

For the assets: = 7 X ν 7 + 14Y ν14= 218.6491 (2) [2]

Taking (2) – 7 × (1):

=
7Y ν14 218.6491 − 7 × 22.9087
= 58.2882 [1]

58.2882
=Y = £15.421m
7 ×1.045−14
with an amount invested of Y ν14 =
£8.327 m [1]

Sub back in (1):

22.9087 − 15.421×1.045−14
= X = £19.844m
1.045−7
with an amount invested of X ν 7 = £14.582m [1]
Since the spread of asset proceeds exceeds the spread of liability outgo (as
asset proceeds are received at times 7 and 14, whereas liability outgo is paid at
times 8 and 12), the convexity of the assets is greater than the convexity of the
liabilities. Thus, the third condition is also satisfied and the company is
immunised against small changes in the rate of interest. [2]

(ii) The small increase in interest rates will mean that the present value of both
assets and liabilities will fall. The greater convexity of the assets mean that the
assets will fall by a smaller amount. There is a greater positive contribution
from the convexity term in the present value of the assets than that of the
present value of the liabilities. [2]

Part (i) was answered well although, for full credit, the amounts
invested needed to be given rather than the maturity values. Part (ii)
was less well answered with many marginal candidates not
appreciating how the greater asset convexity would influence the
change in relative values.

Q9 (i) Let the 1-year and 2-year zero-coupon yields (spot rates) be i1 and i2
respectively.

106
= 106v @ 5.2%
1 + i1

∴ i1 =0.052 (=5.200% to 3 dp) [1]

For the 2-year spot rate:

Page 10
Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

6 106
+ = 6a2 6.1% + 100v6.1%
2
[1]
1 + i1 (1 + i2 ) 2

1 − 1 
 2
6 1.061  + 100
6 106
+ =
1.052 (1 + i2 ) 2 0.061 1.0612

= 10.984960 + 88.831957

= 99.816917

106 6
= 99.816917 −
(1 + i2 ) 2 1.052

106
⇒ (1 + i2 ) 2 =
94.113495

⇒ i2 =
6.1273% p.a.(= 6.127% to 3 dp) [3]

For the 3- year spot rate:

The 3-year par yield is 6.6% p.a.

 1 1 1  1
=⇒ 1 0.066  + + +
 1 + i1 (1 + i ) 2 (1 + i )3  (1 + i )3
[1]
 2 3  3

1.066 0.066 0.066

⇒ =
1− −
(1 + i3 )3 1.052 (1.061273) 2

1.066
⇒ (1 + i3 )3 =
0.878663

⇒ i3 =
6.6543% p.a. (= 6.654% to 3 dp) [2]

(ii) 1-year forward rates:

f 0= 1i= 5.2% p.a. [1]

(1 + i1 )(1 + f1 ) =(1 + i2 ) 2

1.0612732
⇒ 1 + f1 =
1.052

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

⇒ f1 =
7.0628% p.a (=7.063% to 3dp). [1½]

(answer is 7.062% if rounded spot rates used)

(1 + i2 ) 2 (1 + f 2 ) =(1 + i3 )3

(1.066543)3
⇒ 1 + f2 =
(1.061273) 2

⇒ f2 =
7.7162% p.a. (= 7.716% to 3 dp) [1½]

(answer unchanged if rounded spot rates used)

Candidates who made errors in part (i) often scored full marks in part
(ii) after allowance was made for the effects of the earlier errors.

 t 
Q10 (i) We make use of: ( )
v = t exp  − ∫δ ( s ) ds  .
 
 0 
 t 
For 0 <   t ≤ 6 v ( t ) =exp  − ∫ ( 0.24 − 0.02 s ) ds 
 
 0 


( )
t 
= exp  − 0.24 s + 0.01s 2  = exp −0.24t + 0.01t 2 [2]
 0

 t 
For t > 6 v ( t ) = v ( 6 ) × exp  − 0.12ds 
∫
 
 6 

(
= exp ( −0.24 × 6 + 0.01× 36 ) × exp − 0.12 s 6
t
)
= exp ( −0.36 − 0.12t ) [3]

(ii) Discounted value

v (10 ) exp ( −0.36 − 0.12 ×10 )
1, 000 × v ( 4,10 ) =
= =
( )
1, 000 1, 000
v ( 4) exp −0.24 × 4 + 0.01× 42

−1.56−( −0.8 )
= 1, 000e = 000e−0.76 467.67
1,= [2]

Page 12
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

12×(10− 4 )
 i (12 )  1, 000
(iii) 1 +  = =e0.76
 12  1, 000e −0.76
 
=
72
(
> i ( ) = e0.76 − 1 ×12 =
12
)
0.12734 [2]
10 10
(iv) PV =∫ρ ( t ) v ( t ) dt =∫ 20 exp ( 0.36 + 0.32t ) × exp ( −0.36 − 0.12t ) dt
6 6

10
= ∫ 20e
0.2t
dt =
20 0.2t 10
0.2
e
6
( )
= 100 × e 2 − e1.2 = 406.89 [4]
6

This calculation question was the best-answered on the paper.

Q11 (i) Denote PV of annuity by:

( Da )n = nv + ( n − 1) v 2 + ( n − 2 ) v3 +  + 2v n−1 + v n [1]
⇒ (1 + i ) × ( Da )n =n + ( n − 1) v + ( n − 2 ) v 2 +  + 2v n−2 + v n−1
⇒ i × ( Da )n = n − ( v + v 2 +  + v n )
n − an
⇒ ( Da )n =
i
[2]
(ii) Initial amount of loan, L , is given by:

=L 8, 000v5.5% + 7,800v5.5%
2
+ 7, 600v5.5%
3
+  + 3, 200v5.5%
25

+ 200 × ( Da )
5.5%
= 3, 000 × a25
5.5%
25
[1]

1 − v5.5%
25
where =5.5%
a25 = 13.4139 , and
0.055

25 − a25
5.5%
( Da )5.5%
= = 210.6558 [1½]
25 0.055

Thus, initial amount of loan is:

L= 3, 000 ×13.4139 + 200 × 210.6558= £82,372.95 [½]

[or can use

Page 13
 Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

− 200 × ( Ia )
5.5%
L= 8, 200 × a25
5.5%
25
= 8, 200 ×13.4139 − 200 ×138.1065
= £82,372.95

a25
5.5%
− 25v5.5%
25
1.055 ×13.4139 − 25 ×1.055−25
=
where ( Ia )5.5% = = 138.1065 ]
25 0.055 0.055

(iii) Need loan outstanding immediately after 9th instalment (i.e. PV of future
repayments).

Amount of tenth instalment is £6,200.

Loan outstanding is PV of future repayments, given by:

L* = 6, 200v5.5% + 6, 000v5.5%
2
+ 5,800v5.5%
3
+  + 3, 200v16
5.5%

+ 200 × ( Da )
5.5%
= 3, 000 × a16
5.5%
16
where
5.5% 16 − a16
5.5%
1 − v16
=5.5%
a16 5.5% (
= 10.4622 and = Da ) = 100.6880
0.055 16 0.055

Thus, amount of loan outstanding is:

L*= 3, 000 ×10.4622 + 200 ×100.6880= £51,524.08 [4]

[or can use

− 200 × ( Ia )
5.5%
L*= 6, 400 × a16
5.5%
16
= 6, 400 ×10.4622 − 200 × 77.1688
= £51,524.08
a16
5.5%
− 16v16 1.055 ×10.4622 − 16 ×1.055−16
=
where ( Ia )5.5% =
5.5%
= 77.1688 ]
16 0.055 0.055

Then, we have:
• interest component of 10th instalment is 0.055 × 51, 524.08 =£2,833.83 ,
and
• capital component of 10th instalment is 6, 200 − 2,833.83 = £3,366.17
[2]
(iv) Total amount repaid is:

3, 200 + 3, 400 + 3, 600 +  + 7,800 + 8, 000

Page 14
Subject CT1 (Financial Mathematics Core Technical) – April 2018 – Examiners’ Report

= ( 3, 000 + 3, 000 +  + 3, 000 ) + ( 200 + 400 +  + 5, 000 )

= 3, 000 × 25 + 200 × 0.5 × 25 × 26

= 140, 000 [1½]

Thus, total interest paid is:

140, 000 − 82,372.95 =

£57, 627.05 [½]

Many attempts at proofs in part (i) were unclear. Part (ii) was generally answered well
although a common error was to miscalculate the amount of the level annuity component of
the loan outstanding. Some candidates also deducted the decreasing annuity component (or
equivalently added the increasing component).

END OF EXAMINERS’ REPORT

Page 15
 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

28 September 2018 (pm)

Subject CT1 – Financial Mathematics

Core Technical
Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your
answer booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. You have 15 minutes of planning and reading time before the start of this examination.
You may make separate notes or write on the exam paper but not in your answer
booklet. Calculators are not to be used during the reading time. You will then have
three hours to complete the paper.

4. Mark allocations are shown in brackets.

5. Attempt all 10 questions, beginning your answer to each question on a new page.

6. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT1 S2018 © Institute and Faculty of Actuaries

1 An investor is considering two investments. One investment is a 91-day bond issued
by a bank which pays a rate of interest of 4% per annum effective. The second is a
91-day treasury bill which pays out €100.

(i) Calculate the price of the treasury bill and the annual simple rate of discount
from the treasury bill if both investments are to provide the same effective rate
of return. [3]

(ii) Suggest one factor, other than the rate of return, which might determine which
investment is chosen. [1]
 [Total 4]

2 The effective rate of discount per annum is 5%.

Calculate:

(i) the equivalent force of interest; [1]

(ii) the equivalent rate of interest per annum convertible monthly; [2]

(iii) the equivalent rate of discount per annum convertible monthly. [1]
 [Total 4]

3 An investment fund is valued at £60m on 1 January 2016 and at £70m on 1 January

2017. Immediately after the valuation on 1 January 2017, £100m is paid into the
fund. On 1 July 2018, the value of the fund is £300m.

(i) Calculate the effective time-weighted rate of return per annum over the whole
period.[3]

(ii) Explain why the money-weighted rate of return per annum would be higher
than the time-weighted rate of return per annum. [2]
 [Total 5]

CT1 S2018–2
4 A company issues a loan stock which pays coupons at a rate of 6% per annum
half-yearly in arrears. The stock is to be redeemed at 103% after 25 years.

(i) (a) Calculate the price per £100 nominal at issue which would provide a
gross redemption yield of 3% per annum convertible half yearly.

(b)
Calculate the price per £100 nominal three months after issue which
would provide a gross redemption yield of 3% per annum convertible
half-yearly.
[3]

An investor, who is liable to income tax at 30% and capital gains tax at 40%, bought
the stock at issue at a price which gave him a net redemption yield of 10% per annum
effective.

(ii) Calculate the price the investor paid. [4]

 [Total 7]

5 (i) Explain the main difference:

(a) between options and futures;

(b) between call options and put options.

[4]

A 12-month forward contract is issued on 1 March 2017 on a share with a price of

£1.10 at that date. Dividends of £0.10 per share are expected on 1 June, 1 September
and 1 December 2017.

(ii) Calculate the forward price at issue assuming a risk-free rate of interest of 5%
per annum convertible half-yearly and no arbitrage. [4]
 [Total 8]

6 In a particular investment fund, it is the effective rate of return in the t th year. Let Sn
be the accumulation of £1 invested over a period of n years.

Assume the mean of it is 0.08, the standard deviation of it is 0.07 and that 1 + it is
independently and lognormally distributed.

(i) Determine the distribution of S10.[5]

An investor is considering investing £6,000 in the fund for 10 years.

(ii) Determine the amount of the accumulated value after 10 years such that there
is a 97.5% probability of the investor actually achieving an amount greater
than this. [3]
 [Total 8]

CT1 S2018–3 PLEASE TURN OVER

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:

⎧0.03 0 ≤ t ≤ 10
δ(t ) = ⎨
⎩0.003t t > 10

(i) Calculate the present value of a unit sum of money due at time t = 20. [4]

(ii) Calculate the equivalent constant force of interest from t = 0 to t = 20. [2]

(iii) Calculate the present value at time t = 0 of a continuous payment stream

payable at a rate of e–0.06t from time t = 4 to time t = 8. [4]
 [Total 10]

CT1 S2018–4
8 Two countries have recently signed a free-trade treaty and an insurance company in
one of the countries is considering establishing a subsidiary in the other. The country
in which the investment will take place currently has a small insurance market, but it
is expected to grow slowly over the next ten years and then rapidly thereafter.

The company expects to make investments of £15m in each of the next five years to
establish the subsidiary. These costs are assumed to be incurred at the end of each
year.

The subsidiary will start business immediately. Upon starting business, the following
costs and revenues are expected.

• Costs at a rate of £3m per year will be incurred continuously throughout the first
30 years of the subsidiary’s life.
• Revenues of £3.1m per year will be received continuously throughout the first
10 years of the subsidiary’s life.
• In the 11th year, revenues will be received continuously at a rate of £3.2m. The
rate at which revenues will be received is then expected to increase at a rate of 5%
per annum from the end of the 11th year to the end of the 30th year with increases
occurring at the end of each year from the end of the 11th year.

At the end of the 30th year, the company assumes that it will sell the subsidiary.

(i) (a) Define the term “payback period”.

(b)
State two reasons why the payback period is a poor decision-making
criterion in the above circumstances.
[4]

(ii) Calculate the amount for which the company will have to sell the subsidiary
at the end of 30 years so that the project breaks even at a rate of interest of 6%
per annum effective. [9]

Some directors are concerned that the project is too risky.

(iii) Suggest two ways in which risk could be taken into account when appraising
the project. [2]
 [Total 15]

CT1 S2018–5 PLEASE TURN OVER

9 (i) Describe the cash flows which are paid and received in respect of an
index‑linked security. [2]

An investor bought £1m nominal of an index-linked bond on 31 December 2015 for

£100 per £100 nominal. Nominal coupon payments of 1% were received on 30 June
and 31 December each year. The bond was sold for £101 per £100 nominal on
31 December 2017 immediately after the coupon due on that date had been received.

The coupon payments from the bond were linked to the retail prices index (RPI)
with a three-month lag with cash payments being rounded to the nearest pound. RPI
inflation was 2% per annum effective from three months before the bond was issued
until three months before it was sold.

Assume that all months are of equal length.

(ii) Calculate the cash payments received by the investor from the index-linked
bond.[3]

(iii) Calculate, to the nearest 0.1%, the effective rate of return per annum obtained
from the bond over the holding period (before allowing for inflation). [5]

The real rate of return obtained from the bond over the holding period was 1% per
annum convertible half-yearly.

(iv) Calculate the rate of inflation in the three months to 31 December 2017,
expressing your answer as an annual effective rate. [7]
 [Total 17]

CT1 S2018–6
10 (i) Describe the characteristics of a repayment mortgage. [3]

A bank has just granted a loan of $10,000 to a business to be repaid in ten equal
instalments, annually in arrears. The rate of interest is 4% per annum effective.

(ii) (a) Calculate the amount of the annual repayment.

(b) Calculate the duration (discounted mean term) of the repayments.

[5]

The bank wishes to immunise itself from changes in interest rates in relation to this
particular asset. For this purpose, the bank has issued two zero-coupon bonds. The
first bond is of nominal amount $5,000 and has a term to redemption of two years.

(iii) Determine the nominal amount of the second zero-coupon bond and its term
to redemption such that the present value and durations of the assets and
liabilities are equal. [6]

Immediately upon the loan being granted, the bank agrees to a request to change the
terms of the loan. The loan is now to be repaid monthly in arrears over 25 years and
the rate of interest remains unchanged.

(iv) (a) Calculate the revised monthly instalment.

(b) Explain, without further calculation, the main risk to the bank of a
change in interest rates.

(c)
Determine the interest and capital portions of the 121st repayment
under this new arrangement.
[8]
 [Total 22]

END OF PAPER

CT1 S2018–7 PLEASE TURN OVER

 INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2018

Subject CT1 – Financial Mathematics

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

Mike Hammer
Chair of the Board of Examiners
December 2018

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. CT1 provides a grounding in financial mathematics and its simple applications. It

introduces compound interest, the time value of money and discounted cashflow
techniques which are fundamental building blocks for most actuarial work.

2. Please note that different answers may be obtained to those shown in these
solutions depending on whether figures obtained from tables or from calculators
are used in the calculations but candidates are not penalised for this. However,
candidates may lose marks where excessive rounding has been used or where
insufficient working is shown.

B. General comments on student performance in this diet of the examination

1. The comments that follow the questions concentrate on areas where candidates
could have improved their performance. Where no comment is made, the
question was generally answered well by most candidates. The examiners look
most closely at the performance of the candidates close to the pass mark and the
comments therefore often relate to those candidates.
2. The number of candidates taking this exam was much lower than in previous
diets. This was not surprising given that non-members were not permitted to take
this exam due to the fact CT1 without CT5 will not translate to a pass in any
subject under the Curriculum 2019 structure.

C. Pass Mark

The Pass Mark for this exam was 60.

Page 2
 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

Solutions

Q1
(i) Let d be the annual simple rate of discount.

Assume the bank bond also pays out €100.

The present value of the amount invested in the bank bond would be X such
that:
−91

(1.04 )
365
= =
X 100 99.0269 (99.0276 if 365.25 days in a year used) [1]

To provide the same effective rate of return a treasury bill that pays 100 must
 91d 
have a price of 99.0269 and so 100 1 − = 99.0269 [1]
 365 

365
d = (1 − 0.990269 ) = 0.03903 (unchanged if 365.25 days in a year used) [1]
91
(ii) An additional factor could be the risk of the investments [1]
[Total 4]

Part (i) was well answered although some candidates did not explicitly
give the price of treasury bill as asked for in the question. In part (ii),
answers referring to present value (which is directly related to the rate
of return) or term (which was the same for both investments) were not
given credit. Credit was given for answers mentioning marketability or
liquidity.

Q2
(i) δ = ln (1 + i ) = − ln (1 − d ) = − ln 0.95 = 0.051293 [1]

12
 i (12 ) 
(ii) 1 +


12 
 = 1+ i =

1
1− d
12
(
−1
)
= 0.95−1 ⇒ i ( ) = 12 0.95 12 − 1 = 0.051403 [2]

12
 d (12 ) 
(iii) 1 −


12 

( )
 =1 − d =0.95 ⇒ d (12 ) =12 1 − 0.95 12 =0.051184
1
[1]

[Total 4]

The best answered question on the paper.

Page 3
 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

Q3 (i) Time-weighted rate of return is i where:

70 300
(1 +=
i)
2.5
= 2.05882 [2]
60 70 + 100

⇒=
1 + i 1.33489=
⇒ i 0.3349 [1]

(ii) The money weighted rate of return gives a greater weighting to performance
when there is more money in the fund. [½]
The fund was performing better after it had been given the large injection of
money on 1 January 2017. [1½]
[Total 5]

Part (i) was answered well. As with similar questions in previous diets,
part (ii) was poorly answered. It is important in this type of question to
refer to the actual results obtained and the actual data given and the
majority of marks in this part were awarded for this.

Q4 (i) (a) = 3a50 + 103v50 at 1.5% working in half-years

Price [1]

=×
3 34.9997 + 103 × 0.47500 =
153.925 [1]

(1.015) 2 155.075 [1]

1
(b) =
Three months later the =
price will be 153.925

(ii) Is there a Capital gain?

= (
i ( 2) 2 1.1 2 −=
1
)
1 9.762% [½]
D 6
(1 − t1 )= × 0.7= 4.078% [½]
R 1.03
i ( 2) ≤ g (1 − t ) ⇒ Capital gain [½]

Price paid per £100 nominal = P where

( )
P =0.7 × 6a25 + 103v 25 − 0.4 (103 − P ) v 25at 10%
2

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 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

( )
0.7 × 6a25 + 0.6 × 103v 25
2

P=
1 − 0.4v 25
0.7 × 6 × 1.024404 × 9.0770 + 0.6 × 103 × 0.09230
=
1 − 0.4 × 0.09230
39.05395 + 5.70389
= = 46.474
0.96308

Price = £46.474 per £100 nominal [2½]

[Total 7]

The convertible half-yearly interest rate seemed to confuse some

candidates but otherwise the questions was generally answered well.

Q5 (i) (a) Options – holder has the right but not the obligation to trade. [1]
Futures – both parties have agreed to the trade and are obliged to do so.
[1]

(b) Call Option – right but not the obligation to BUY specified asset in the
future at specified price. [1]
Put Option – right but not the obligation to SELL specified asset in the
future at specified price. [1]

(ii) Present value of dividends

(
= 0.1 1.025− 2 + 1.025−1 + 1.025−=
1
2
3
0.29270 ) [2]

(1.1 − 0.29270 ) ×1.0252 =

Forward price = £0.84817 [2]
[Total 8]

Well answered although some candidates in part (i) seemed to write

down everything that they knew about options whereas the answer
required was quite specific. In part (i)(a), partial credit was given for
stating the option involved the payment of an initial premium by the
holder.

(1 + it )  log N ( µ , σ 2 ) ⇒ S10 = Π (1 + it )  log N (10µ ,10σ 2 )

10
Q6 (i)
t =1
[1]

E (1 + it ) =1 + E ( it ) =1 + j =1.08 =e
( µ+ σ
2
2 )

Page 5
 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

Var (1 + it ) = Var ( it ) = s 2 = 0.07 2 = e

( 2µ+σ2 ) ×
( eσ − 1
2
) [1]

0.07 2
eσ 1
2
⇒ =−
(1.08) 2

  0.07 2 
⇒ σ= ln 1 + 
2
=  0.0041922
  1.08  
[1]
 0.0041922 
 µ+ 
1.08 = e 2 

0.0041922
⇒ µ = ln1.08 − = 0.074865 [1]
2

⇒ S10 ~ log N ( 0.74865, 0.041922 ) [1]

(ii) ln S10 ~ N ( 0.74865, 0.041922 )

and we require X such that P ( 6, 000 S10 > X ) =

0.975

 X 
⇒ P  ln S10 > ln =
6, 000 
0.975 [1]

 X 
 ln 6, 000 − 0.74865 
⇒ 1− Φ   = 0.975 [1]
 0.041922 
 
 
X
ln − 0.74865
6, 000
⇒ = −1.96
0.041922

= (
⇒ X 6, 000 exp −1.96 × 0.041922 + 0.74865
= £8, 492 )
[1]
[Total 8]

This question proved to be a good differentiator with strong candidates

scoring well on both parts but many weaker candidates scoring very
little. Full marks could still be scored in part (ii) even if candidates
made errors.

Page 6
 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

δ( s ) ds
20
Present value is v(20) = e ∫0
−
Q7 (i) [1]

20 10 20
∫0 δ ( s ) ds = ∫ 0.03ds + ∫ 0.003sds
0 10
20
= [0.03s ]100 + 0.0015s 2 10
=0.3 + 0.0015 ( 400 − 100 ) =0.75
[2]
( 20 ) e= 0.47237
v= −0.75
[1]

−20δ
(ii) Require δ such that e= e −0.75 =
⇒ δ 0.0375 [2]

8 8 8
(iii) Present value ∫ ρ ( t ) v (=
t ) dt ∫e
−0.06t −0.03t
e =dt ∫e
−0.09t
dt [2]
4 4 4

e −0.09t 8
=  [1]
 −0.09  4

= -5.40836 + 7.75196 = 2.34360 [1]

[Total 10]

Well answered.

Q8 (i) (a) The payback period is the first point at which the total revenues from a
project exceed the total cost, with no allowance made for interest. [1½]

(b) The payback period takes no account of interest at all. It is therefore

inappropriate for assessing an investment project which should provide
the investor with a return or be paid for from borrowings. [1]

The payback period takes no account of what happens after the

payback period. In this particular case, it is known that the revenue
from the project might be weighted towards the end and the payback
period will make no allowance for this. [1½]

(ii) Work in £2017 millions at 6% per annum

PV of initial costs = 15a5= 15 × 4.2124 = 63.1855 [1]

1 − 1.06−30
PV of running costs = 3a30 =
3× =
3 ×14.1738 =
42.5213 [1½]
ln (1.06 )

Page 7
 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

PV of revenue in first ten years =

1 − 1.06−10
3.1a10 = 3.1× = 3.1× 7.57875 =
23.4941 [1½]
ln (1.06 )

PV of revenue in years 11 to 30 =
(
v10 3.2a1 + 3.2 ×1.05va1 + 3.2 ×1.0519 v19 a1 ) [1½]

(
= 3.2v10 a1 1 + 1.05v + (1.05v )
19
)
1 − (1.05v )
20
= 3.2v a1
10
1 − 1.05v
[1]
1 − 1.06−1 1 − (1.05 1.06 )
20
3.2 1.06−10 ×
=×
ln1.06 1 − 1.05 1.06
=
3.2 × 0.55839 × 0.97142 ×18.30506 = 31.7739
[1]
Sales proceeds are P such that
Pv30 = 63.1855 + 42.5213 − 23.4941 − 31.7739 = 50.4388

P = 50.4388 ×1.0630 = £289.69m [1½]

(iii) Probabilities could be assigned to the cash flows… [1]

… or a higher discount rate could be used to account for risk. [1]
[Total 15]

The calculations in part (ii) were generally done well but parts (i) and
(iii) were poorly answered. Part (i) has been asked in previous diets
and generally answered better by candidates. Whilst part (iii) has not
often been asked, the answer comes directly from the Core Reading.

Q9 (i) The investor pays a purchase price at outset. [½]

The investor receives a series of coupon payments and a capital payment at
maturity. [1]
The coupon and capital payments are linked to an index of prices (possibly
with a time lag). [½]
[Time lag does not have to be mentioned].

(ii) Let the RPI three months before issue (end 9/2015) = 100
Relevant RPI values are three months before first coupon payment (end
3/2016), three months before second coupon payment (end 9/2016) etc.

Cash payments from the bond are in the following table:

Page 8
 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

Nominal Base index Index three (3) divided Cash payment

payment per months before by (2) (4) ×1%×£1m
£100 nominal payment
(1) (2) (3) (4)
1 100 100(1.02)0.5 1.00995 £10,100
1 100 100(1.02) 1.02 £10,200
1 100 100(1.02)1.5 1.0301 £10,301
1 100 100(1.02)2 1.0404 £10,404
There is also the sale value of £1,010,000 [3]

(iii) Equation of value is:

1, 000, 000= 10,100v 0.5 + 10, 200v + 10,301v1.5 + 10, 404v 2 + 1, 010, 000v 2 [2½]

Try 2.5%.
RHS of equation of value becomes 1,001,089

Try 3%
RHS of equation of value becomes 991, 538 [1½]

Interpolating:
1, 000, 000 − 1, 001, 089
i = 0.025 + ( 0.03 − 0.025 ) × ≈ 0.0256 [1]
991,538 − 1, 001, 089

(iv)
The equation of value for the real cash flows is as follows (working in half
years):
RPI ( March 2016 ) RPI ( December 2015 )
=1, 000, 000 10, 000 × v
RPI ( September 2015 ) RPI ( June 2016 )
RPI ( September 2016 ) RPI ( December 2015 )
+10, 000 × v2
RPI ( September 2015 ) RPI ( December 2016 )
RPI ( March 2017 ) RPI ( December 2015 )
+10, 000 × v3
RPI ( September 2015 ) RPI ( June 2017 )
RPI ( September 2017 ) RPI ( December 2015 )
+10, 000 × v4
RPI ( September 2015 ) RPI ( December 2017 )
RPI ( December 2015 )
+1, 010, 000 v4
RPI ( December 2017 )

All the RPI factors cancel out except the last two because each is the ratio of
RPI at three-month intervals multiplied by the inverse of that ratio. [4]

The equation of value therefore becomes:

Page 9
 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

1, 000, 000 =10, 000v + 10, 000v 2 + 10, 000v3

RPI ( December 2015 )
+ (10, 404 + 1, 010, 000 ) × v4
RPI ( December 2017 )
Let rate of inflation per annum in the last three months = x

Equation of value becomes:

1, 020, 404
1,=
000, 000 10, 000a3 + v 4 at 0.5%
1.021.75
(1 + x ) 0.25

1, 020, 404 ×1.005−4

⇒ (1 + x )
0.25
= = 0.995755
( )
1, 000, 000 − 10, 000a3 × 1.021.75

⇒ (1 + x ) =0.98313 ⇒ x =−0.01687 [3]

[Total 17

This proved to be the most difficult question on the paper by some

margin. Whilst the examiners expected the calculations in part (iii) and
especially part (iv) to be challenging, it was more surprising to see
candidates having considerable difficulty with part (ii).

Q10 (i) A loan repayable by a series of payments at fixed times set in advance. [½]

Typically issued by banks and building societies [½]

Typically long-term … [½]

…e,g. used to fund house purchase
…and secured against the property [½]

Each payment contains an element to pay interest on the loan with the
remainder being used to repay capital [½]

In its simplest form, the interest rate will be fixed … [½]

….and the payments will be of fixed equal amounts. [½]

The interest payment portion of the repayments will fall over time… [½]
… and the capital payments will rise over time. [½]

Risk that borrower defaults on loan [½]

Complications might be added such as allowing the loan to be repaid early or

allowing the interest rate to vary. [½]
[Max 3]

Page 10
 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

(ii) (a) Annual repayment is X where

10, 000 = Xa10 at 4%
10, 000
=X = $1, 232.91 [2]
8.1109
(b) DMT of repayments =
10
∑1, 232.91× tvt 1, 232.91× ( Ia )10
t =1
10
=
10, 000
∑1, 232.91× vt [1½]
t =1
1, 232.91× 41.9922
= = 5.1773 years
10, 000
[1½ including ½ for units]
(iii) Let the nominal amount invested in the second zero coupon bond = X and let
term = n
If the present values are to be equal:
10, 000 5, 000v 2 + Xv n (1)
= [1]
If the discounted mean terms are to be equal:
2 × 5, 000v 2 + nXv n
5.1773 =
10, 000
⇒ 51,773= 10, 000v 2 + nXv n ( 2)
[1½]
(
Sub (1) into ( 2 ) ⇒ 51,773= 10, 000v + n 10, 000 − 5, 000v
2 2
)
51,773 − 10, 000v 2 42,527
=⇒n = = 7.909 years
10, 000 − 5, 000v 2 5,377
[2½]
10, 000 − 5, 000v 2
=
Sub back in (1) ⇒ X = $7,332.81 [1]
v 7.909

(iv) (a) Monthly instalment is M where

(12 )
10, 000 = 12Ma [1]
25

10, 000 = 12 M
(1 − 1.04 ) −25

(
12 1.04
1
12 −1)
10, 000 × 0.0032737
=⇒M = $52.39
0.62488
[1½]

(b) The assets now have a much longer duration than the liabilities. [1]
Therefore, if interest rates rise, the assets will fall in value by more than
the liabilities and the bank will make a loss. [1]

Page 11
 Subject CT1 (Financial Mathematics Core Technical) – September 2018 – Examiners’ Report

(12 )
(c) After ten years of payments, the capital outstanding is 12 × 52.39a
15
[1]
−15
1 − 1.04
=
12 × 52.39 =
7,117.15 [1]
0.039289
0.039289
Interest component of 121st payment =7,117.15 × =$23.30
12
[1]

Capital component of 121st payment = 52.39 − 23.30 = $29.09 [½]

[Total 22]

It was pleasing to see that many candidates scored well on this

question even if they had struggled with the previous question. Parts
(ii), (iii), (iv)(a) and (iv)(c) were also generally answered well. Part (i)
was answered less well despite the wide range of mark-scoring points
available to be made.

END OF EXAMINERS’ REPORT

Page 12