Bs4a Lectures PDF

BS4a
Actuarial Science I
George Deligiannidis
Department of Statistics
University of Oxford
MT 2012
BS4a
Actuarial Science I
16 lectures MT 2012
Aims
This unit is supported by the Institute of Actuaries. It has been designed to give the under-
graduate mathematician an introduction to the nancial and insurance worlds in which the
practising actuary works. Students will cover the basic concepts of discounted cash-ows and
applications.
In the examination, a student obtaining at least an upper second class mark on the whole
unit BS4/OBS4 can expect to gain exemption from the Institute of Actuaries paper CT1, which
is a compulsory paper in their cycle of professional actuarial examinations. An Independent
Examiner approved by the Institute of Actuaries will inspect examination papers and scripts
and may adjust the pass requirements for exemptions.
Synopsis
Fundamental nature of actuarial work. Use of cash-ow models to describe nancial transac-
tions. Time value of money using the concepts of compound interest and discounting.
Interest rate models. Present values and the accumulated values of a stream of equal or
unequal payments using specied rates of interest. Interest rates in terms of dierent time
periods. Equation of value, rate of return of a cash-ow, existence criteria.
Loan repayment schemes. Investment project appraisal, funds and weighted rates of return.
Ination modelling, ination indices, real rates of return, ination adjustments. Valuation of
xed-interest securities, taxation and index-linked bonds.
Price and value of forward contracts. Term structure of interest rates, spot rates, forward
rates and yield curves. Duration, convexity and immunisation. Simple stochastic interest rate
models. Investment and risk characteristics of investments.
Reading
All of the following are available from the Publications Unit, Institute of Actuaries, 4 Worcester
Street, Oxford OX1 2AW
Subject CT1 [102]: Financial Mathematics Core reading. Faculty & Institute of Actuaries
J. J. McCutcheon and W. F. Scott: An Introduction to the Mathematics of Finance.
Heinemann (1986)
P. Zima and R. P. Brown: Mathematics of Finance. McGraw-Hill Ryerson (1993)
N. L. Bowers et al, Actuarial mathematics, 2nd edition, Society of Actuaries (1997)
J. Danthine and J. Donaldson: Intermediate Financial Theory. 2nd edition, Academic
Press Advanced Finance (2005)
Contents iii
Notes
These notes have been assembled from earlier notes produced by Matthias Winkel and Daniel
Clarke.
Contents
1 Introduction 1
1.1 The actuarial profession . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 The generalised cash-ow model . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 Examples and course overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2 The theory of compound interest 5
2.1 Simple versus compound interest . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 Nominal and eective rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.3 Discount factors and discount rates . . . . . . . . . . . . . . . . . . . . . . . . . . 8
3 Valuing cash-ows 9
3.1 Accumulating and discounting in the constant-i model . . . . . . . . . . . . . . . 9
3.2 Time-dependent interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.3 Accumulation factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3.4 Time value of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3.5 Continuous cash-ows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3.6 Example: withdrawal of interest as a cash-ow . . . . . . . . . . . . . . . . . . . 12
4 The yield of a cash-ow 13
4.1 Denition of the yield of a cash-ow . . . . . . . . . . . . . . . . . . . . . . . . . 13
4.2 General results ensuring the existence of yields . . . . . . . . . . . . . . . . . . . 14
4.3 Example: APR of a loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
4.4 Numerical calculation of yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
5 Annuities and xed-interest securities 17
5.1 Annuity symbols . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
5.2 Fixed-interest securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
6 Mortgages and loans 21
6.1 Loan repayment schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
6.2 Loan outstanding, interest/capital components . . . . . . . . . . . . . . . . . . . 22
6.3 Fixed, capped and discount mortgages . . . . . . . . . . . . . . . . . . . . . . . . 23
6.4 Comparison of mortgages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
iv
Contents v
7 Funds and weighted rates of return 25
7.1 Money-weighted rate of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
7.2 Time-weighted rate of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
7.3 Units in investment funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
7.4 Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
7.5 Fund types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
8 Ination 29
8.1 Ination indices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
8.2 Modelling ination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
8.3 Constant ination rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
8.4 Index-linking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
9 Taxation 33
9.1 Fixed-interest securities and running yields . . . . . . . . . . . . . . . . . . . . . 33
9.2 Income tax and capital gains tax . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
9.3 Osetting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
9.4 Indexation of CGT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
9.5 Ination adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
10 Project appraisal 37
10.1 Net cash-ows and a rst example . . . . . . . . . . . . . . . . . . . . . . . . . . 37
10.2 Payback periods and a second example . . . . . . . . . . . . . . . . . . . . . . . . 38
10.3 Protability, comparison and cross-over rates . . . . . . . . . . . . . . . . . . . . 39
10.4 Reasons for dierent yields/protability curves . . . . . . . . . . . . . . . . . . . 40
11 Modelling future lifetimes 41
11.1 Introduction to life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
11.2 Valuation under uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
11.2.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
11.2.2 Uncertain payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
11.3 Pricing of corporate bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
11.4 Expected yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
11.5 Lives aged x . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
11.6 Curtate lifetimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
11.7 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
12 Lifetime distributions and life-tables 50
12.1 Actuarial notation for life products. . . . . . . . . . . . . . . . . . . . . . . . . . 50
12.2 Simple laws of mortality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
12.3 The life-table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
12.4 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
13 Select life-tables and applications 54
13.1 Select life-tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
13.2 Multiple premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
13.3 Interpolation for non-integer ages x +u, x N, u (0, 1) . . . . . . . . . . . . . 56
13.4 Practical concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Contents vi
14 Evaluation of life insurance products 58
14.1 Life assurances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
14.2 Life annuities and premium conversion relations . . . . . . . . . . . . . . . . . . . 59
14.3 Continuous life assurance and annuity functions . . . . . . . . . . . . . . . . . . . 60
14.4 More general types of life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 60
15 Premiums 62
15.1 Dierent types of premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
15.2 Net premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
15.3 Oce premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
15.4 Prospective policy values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
16 Reserves 66
16.1 Reserves and random policy values . . . . . . . . . . . . . . . . . . . . . . . . . . 66
16.2 Thieles dierential equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
A 70
A.1 Some old exam questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
B Notation and introduction to probability 72
Lecture 1
Introduction
Reading: CT1 Core Reading Unit 1
Further reading: http://www.actuaries.org.uk
After some general information about relevant history and about the work of an actuary, we
introduce cash-ow models as the basis of this course and as a suitable framework to describe
and look beyond the contents of this course.
1.1 The actuarial profession
Actuarial Science is a discipline with its own history. The Institute of Actuaries was formed in
1848, (the Faculty of Actuaries in Scotland in 1856, the two merged in 2010), but the roots go
back further. An important event was the construction of the rst life table by Sir Edmund
Halley in 1693. However, Actuarial Science is not oldfashioned. The language of probability
theory was gradually adopted as it developed in the 20th century; computing power and new
communication technologies have changed the work of actuaries. The growing importance and
complexity of nancial markets continues to fuel actuarial work; current debates and changes
in life expentancy, retirement age, viability of pension schemes are core actuarial topics that
the profession vigorously embraces.
Essentially, the job of an actuary is risk assessment. Traditionally, this was insurance risk,
life insurance, later general insurance (health, home, property etc). As typically large amounts
of money, reserves, have to be maintained, this naturally extended to investment strategies
including the assessment of risk in nancial markets. Today, the Actuarial Profession claims
yet more broadly to make nancial sense of the future.
To become a Fellow of the Institute/Faculty of Actuaries in the UK, an actuarial trainee has
to pass nine mathematics, statistics, economics and nance examinations (core technical series
CT), examinations on risk management, reporting and communication skills (core applications
CA), and three specialist examinations in the chosen areas of specialisation (specialist technical
and specialist applications series ST and SA) and for a UK fellowship an examination on
UK specics. This programme takes normally at least three or four years after a mathematical
university degree and while working for an insurance company under the guidance of a Fellow
of the Institute/Faculty of Actuaries.
This lecture course is an introductory course where important foundations are laid and an
overview of further actuarial education and practice is given. An upper second mark in the
examination following the full OBS4/BS4 unit normally entitles to an exemption from the CT1
1
Lecture Notes BS4a Actuarial Science Oxford MT 2012 2
paper. The CT3 paper is covered by the Part A Probability and Statistics courses. A further
exemption, from CT4, is available for BS3 Stochastic Modelling.
1.2 The generalised cash-ow model
The cash-ow model systematically captures payments either between dierent parties or, as
we shall focus on, in an inow/outow way from the perspective of one party. This can be done
at dierent levels of detail, depending on the purpose of an investigation, the complexity of the
situation, the availability of reliable data etc.
Example 1 Look at the transactions on a bank statement for September 2011.
Date Description Money out Money in
01-09-11 Gas-Elec-Bill 21.37
04-09-11 Withdrawal 100.00
15-09-11 Telephone-Bill 14.72
16-09-11 Mortgage Payment 396.12
28-09-11 Withdrawal 150.00
30-09-11 Salary 1,022.54
Extracting the mathematical structure of this example we dene elementary cash-ows.
Denition 2 A cash-ow is a vector (t
j
, c
j
)
1jm
of times t
j
R and amounts c
j
R. Positive
amounts c
j
> 0 are called inows. If c
j
< 0, then |c
j
| is called an outow.
Example 3 The cash-ow of Example 80 is mathematically given by
j t
j
c
j
1 1 21.37
2 4 100.00
3 15 14.72
j t
j
c
j
4 16 396.12
5 28 150.00
6 30 1,022.54
Often, the situation is not as clear as this, and there may be uncertainty about the time/amount
of a payment. This can be modelled stochastically.
Denition 4 A random cash-ow is a random vector (T
j
, C
j
)
1jM
of times T
j
R and
amounts C
j
R with a possibly random length M N.
Sometimes, in fact always in this course, the random structure is simple and the times or the
amounts are deterministic, or even the only randomness is that a well specied payment may
fail to happen with a certain probability.
Example 5 Future transactions on a bank account (say for November 2011)
j T
j
C
j
Description
1 1 21.37 Gas-Elec-Bill
2 T
2
C
2
Withdrawal?
3 15 C
3
Telephone-Bill
j T
j
C
j
Description
4 16 396.12 Mortgage payment
5 T
5
C
5
Withdrawal?
6 30 1,022.54 Salary
Here we assume a xed Gas-Elec-Bill but a varying telephone bill. Mortgage payment and
salary are certain. Any withdrawals may take place. For a full specication of the random
cash-ow we would have to give the (joint!) laws of the random variables.
This example shows that simple situations are not always easy to model. It is an important
part of an actuarys work to simplify reality into tractable models. Sometimes, it is worth
dropping or generalising the time specication and just list approximate or qualitative (big,
small, etc.) amounts of income and outgo. cash-ows can be represented in various ways as
the following important examples illustrate.
1.3 Examples and course overview
Example 6 (Zero-coupon bond) Usually short-term investments with interest paid at the
end of the term, e.g. invest 99 for ninety days for a payo of 100.
j t
j
c
j
1 0 99
2 90 100
Example 7 (Government bonds, xed-interest securities) Usually long-term investments
with annual or semi-annual coupon payments (interest), e.g. invest 10, 000 for ten years at 5%
per annum. [The government borrows money from investors.]
10, 000 +500 +500 +500 +500 +10, 500
0 1 2 3 9 10
Example 8 (Corporate bonds) The underlying cash-ow looks the same as for government
bonds, but they are not as secure. Credit rating agencies assess the insolvency risk. If a company
goes bankrupt, invested money is often lost. One may therefore wish to add probabilities to the
cash-ow in the above gure. Typically, the interest rate in corporate bonds is higher to allow
for this extra risk of default that the investor takes.
Example 9 (Equities) Shares in the ownership of a company that entitle to regular dividend
payments of amounts depending on the prot and strategy of the company. Equities can be
bought and sold on stock markets (via a stock broker) at uctuating market prices. In the above
diagram (including payment probabilities) the inow amounts are not xed, the term at the
discretion of the shareholder and sales proceeds are not xed. There are advanced stochastic
models for stock price evolution. A wealth of derivative products is also available, e.g. forward
contracts, options to sell or buy shares. We will discuss forward contracts, but otherwise refer
to B10b Mathematical Models for Financial Derivatives.
.
Example 10 (Index-linked securities) Ination-adjusted securities: coupons and redemp-
tion payment increase in line with ination, by tracking an ination index.
Example 11 (Annuity-certain) Long term investments that provide a series of regular an-
nual (semi-annual or monthly) payments for an initial lump sum, e.g.
10, 000 +1, 400 +1, 400 +1, 400 +1, 400 +1, 400
0 1 2 3 9 10
Here the term is n = 10 years. Perpetuities provide regular payment forever (n = ).
Example 12 (Loans) Formally the negative of a bond cash-ow (interest-only loan) or annuity-
certain (repayment loan), but the rights of the parties are not exactly opposite. Whereas the
bond investor may be able to redeem or sell the bond early, the lender of a loan often has to
obey stricter rules, to protect the borrower.
Example 13 (Appraisal of investment projects) Consider a building project. An initial
construction period requires certain payments, the following exploitation (e.g. letting) yields
income in return for the investment, but maintenance has to be taken into accout as well. Under
what circumstances is the project protable? How reliable are the estimated gures?
These qualitative questions, that can be answered qualitatively using specications as
stable, predictable, variable, increasing etc. are just as important as precise estimates.
Example 14 (Life annuity) Life annuities are like annuities-certain, but do not terminate
at a xed time but when the beneciary dies. Risks due to age, health, profession etc. when
entering the annuity contract determine the payment level. They are a basic form of a pension.
Several modications exist (minimal term, maximal term, etc.).
Example 15 (Life assurance) Pays a lump sum on death for monthly or annual premiums
that depend on age and health of the policy holder when the policy is underwritten. The sum
assured may be decreasing in accordance with an outstanding mortgage.
Example 16 (Property insurance) A class of general insurance (others are health, building,
motor etc.). In return for regular premium payments, an insurance company replaces or refunds
any stolen or damaged items included on the policy. From the insurers point of view, all policy
holders pay into a common fund to provide for those who claim. The claim history of policy
holders aects their premium.
-
time
6
fund
T
1
T
2
T
3
T
4
T
5
T
6
R
u
A branch of an insurance company is said to suer technical ruin if the fund runs empty.
Lecture 2
The theory of compound interest
Reading: CT1 Core Reading Units 2-3, McCutcheon-Scott Chapter 1, Sections 2.1-2.4
Quite a few problems that we deal with in this course can be approached in an intuitive way.
However, the mathematical and more powerful approach to problem solving is to set up a
mathematical model in which the problem can be formalised and generalised. The concept of
cash-ows seen in the last lecture is one part of such a model. In this lecture, we shall construct
another part, the compound interest model in which interest on capital investments, loans etc.
can be computed. This model will play a crucial role throughout the course.
In any mathematical model, reality is only partially represented. An important part of
mathematical modelling is the discussion of model assumptions and the interpretation of the
results of the model.
2.1 Simple versus compound interest
We are familiar with the concept of interest in everyday banking: the bank pays interest on
positive balances on current accounts and savings accounts (not much, but some), and it charges
interest on loans and overdrawn current accounts. Reasons for this include that
people/institutions borrowing money are willing to pay a fee (in the future) for the use
of this money now,
there is price ination in that 100 lose purchasing power between the beginning and the
end of a loan as prices increase,
there is often a risk that the borrower may not be able to repay the loan.
To develop a mathematical framework, consider an interest rate h per unit time, under which
an investment of C at time 0 will receive interest Ch by time 1, giving total value C(1 +h):
C C(1 +h),
e.g. for h = 4% we get C 1.04C.
There are two natural ways to extend this to general times t:
Denition 17 (Simple interest) Invest C, receive C(1 + th) after t years. The simple in-
terest on C at rate h for time t is Cth.
5
Denition 18 (Compound interest) Invest C, receive C(1 + i)
t
after t years. The com-
pound interest on C at rate i for time t is C((1 +i)
t
1).
For integer t = n, this is as if a bank balance was updated at the end of each year
C C(1 +i) (C(1 +i))(1 +i) = C(1 +i)
2
(C(1 +i)
n1
)(1 +i) = C(1 +i)
n
.
Example 19 Given an interest rate of i = 6% per annum (p.a.), investing C = 1, 000 for
t = 2 years yields
I
simp
= C2i = 120.00 and I
comp
= C
_
(1 +i)
2
1
_
= C(2i +i
2
) = 123.60,
where we can interpret Ci
2
as interest on interest, i.e. interest for the second year paid at rate
i on the interet Ci for the rst year.
Compound interest behaves well under term-splitting: for t = s +r
C C(1 +i)
s
(C(1 +i)
s
) (1 +i)
r
= C(1 +i)
t
,
i.e. investing C at rate i rst for s years and then the resulting C(1 +i)
s
for a further r years
gives the same as directly investing C for t = s +r years. Under simple interest
C C(1 +hs) C(1 +hs)(1 +hr) = C(1 +ht +srh
2
) > C(1 +ht),
(in the case C > 0, r > 0, s > 0). The dierence Csrh
2
= (Chs)hr is interest on the interest
Chs that was already paid at time s for the rst s years.
What is the best we can achieve by term-splitting under simple interest?
Denote by S
t
(C) = C(1 +th) the accumulated value under simple interest at rate h for time t.
We have seen that S
r
S
s
(C) > S
r+s
(C).
Proposition 20 Fix t > 0 and h. Then
sup
nN,r
1
,...,r
n
R
+
:r
1
++r
n
=t
S
r
n
S
r
n1
S
r
1
(C) = lim
n
S
t/n
S
t/n
(C) = e
th
C.
Proof: For the second equality we rst note that
S
t/n
S
t/n
(C) =
_
1 +
t
n
h
_
n
C e
th
C,
because
log((1 +th/n)
n
) = nlog(1 +th/n) = n(th/n +O(1/n
2
)) th.
For the rst equality,
e
rh
= 1 +rh +
r
2
h
2
2
+ 1 +rh
so if r
1
+ +r
n
= t, then
e
th
C = e
r
1
h
e
r
2
h
e
r
n
h
C (1 +r
1
h)(1 +r
2
h) (1 +r
n
h)C = S
r
n
S
r
n1
S
r
1
(C).
2
So, the optimal achievable is C Ce
th
. If e
th
= (1 +i)
t
, i.e. e
h
= 1 +i or h = log(1 +i),
we recover the compound interest case.
From now on, we will always consider compound interest.
Denition 21 Given an eective interest rate i per unit time and an initial capital C at time
0, the accumulated value at time t under the compound interest model (with constant rate) is
given by
C(1 +i)
t
= Ce
t
,
where
= log(1 +i) =

t
(1 +i)
t
t=0
,
is called the force of interest.
The second expression for the force of interest means that it is the instantaneous rate of growth
per unit capital per unit time.
2.2 Nominal and eective rates
The eective annual rate is i such that C C(1+i) after one year. We have already seen the
force of interest = log(1 + i) as a way to describe the same interest rate model. In practice,
rates are often quoted in other ways still.
Denition 22 A nominal rate h convertible pthly (or compounded p times per year) means
that an accumulated value C(1 +h/p) is achieved after time 1/p.
By compounding, the accumulated value at time 1 is C(1+h/p)
p
, and at time t is C(1+h/p)
pt
.
This again describes the same model of accumulated values if (1 + h/p)
p
= 1 + i, i.e. if
h = p((1 +i)
1/p
1. Actuarial notation for the nominal rate convertible pthly associated with
eective rate i is i
(p)
= p((1 +i)
1/p
1).
Example 23 An annual rate of 8% convertible quarterly, i.e. i
(4)
= 8% means that i
(4)
/4 = 2%
is credited each 3 months (and compounded) giving an annual eecive rate i = (1+i
(4)
/4)
4
1
8.24%.
The most common frequencies are for p = 2 (half-yearly, semi-annually), p = 4 (quarterly),
p = 12 (monthly), p = 52 (weekly), although the latter used to be approximated using
lim
p
i
(p)
= lim
p
(1 +i)
1/p
1
1/p
=

t
(1 +i)
t
t=0
= log(1 +i) = ;
the force of interest can be called the nominal rate of interest convertible continuously.
Example 24 Here are two genuine and one articial options for a savings account.
(1) 3.25% p.a. eective (i
1
= 3.25%)
(2) 3.20% p.a. nominal convertible monthly (i
(12)
2
= 3.20%)
(3) 3.20% p.a. nominal convertible continuously (
3
= 3.20%)
After one year, an initial capital of 10,000 accumulates to
(1) 10, 000 (1 + 3.25%) = 10, 325.00 = R
1
,
(2) 10, 000 (1 + 3.20%/12)
12
= 10, 324.74 = R
2
,
(3) 10, 000 e
3.20%
= 10, 325.18 = R
3
.
Although interest may be credited to the account dierently, an investment into (j) just consists
of deposit and withdrawal, so the associated cash-ow is ((0, 10000), (1, R
j
)), and we can use
R
j
to decide between the options. We can also compare i
2
3.2474% and i
3
3.2518% or
calculate
1
and
2
to compare with
3
etc.
Interest rates always refer to some time unit. The standard choice is one year, but it
sometimes eases calculations to choose six months, one month or one day. All denitions we
have made reect the assumption that the interest rate does not vary with the initial capital C
nor with the term t. We refer to this model of accumulated values as the constant-i model, or
the constant- model.
2.3 Discount factors and discount rates
Before we more fully apply the constant-i model to cash-ows in Lecture 3, let us discuss the
notion of discount. We are used to discounts when shopping, usually a percentage reduction in
price, time being implicit. Actuaries use the notion of an eective rate of discount d per time
unit to represent a reduction of C to C(1 d) if payment takes place a time unit early.
This is consistent with the constant-i model, if the payment of C(1 d) accumulates to
C = (C(1 d))(1 +i) after one time unit, i.e. if
(1 d)(1 +i) = 1 d = 1
1
1 +i
.
A more prominent role will be played by the discount factor v = 1 d, which answers the
question
How much will we have to invest now to have 1 at time 1?
Denition 25 In the constant-i model, we refer to v = 1/(1 + i) as the associated discount
factor and to d = 1 v as the associated eective annual rate of discount.
Example 26 How much do we have to invest now to have 1 at time t? If we invest C, this
accumulates to C(1 +i)
t
after t years, hence we have to invest C = 1/(1 +i)
t
= v
t
.
Lecture 3
Valuing cash-ows
Reading: CT1 Core Reading Units 3 and 5, McCutcheon-Scott Chapter 2
In Lecture 2 we set up the constant-i interest rate model and saw how a past deposit accumulates
and a future payment can be discounted. In this lecture, we combine these concepts with the
cash-ow model of Lecture 1 by assigning time-t values to cash-ows. We also introduce general
(deterministic) time-dependent interest models, and continuous cash-ows that model many
small payments as innitesimal payment streams.
3.1 Accumulating and discounting in the constant-i model
Given a cash-ow c = (c
j
, t
j
)
1jm
of payments c
j
at time t
j
and a time t with t t
j
for all j,
we can write the joint accumulated value of all payments by time t according to the constant-i
model as
AVal
t
(c) =
m
j=1
c
j
(1 +i)
tt
j
=
m
j=1
c
j
e
(tt
j
)
,
because each payment c
j
at time t
j
earns compound interest for tt
j
time units. Note that some
c
j
may be negative, so the accumulated value could become negative. We assume implicitly
that the same interest rate applies to positive and negative balances.
Similarly, given a cash-ow c = (c
j
, t
j
)
1jm
of payments c
j
at time t
j
and a time t < t
j
for
all j, we can write the joint discounted value at time t of all payments as
DVal
t
(c) =
m
j=1
c
j
v
t
j
t
=
m
j=1
c
j
(1 +i)
(t
j
t)
=
m
j=1
c
j
e
(t
j
t)
.
This discounted value is the amount we invest at time t to be able to spend c
j
at time t
j
for all
j.
3.2 Time-dependent interest rates
So far, we have assumed that interest rates are constant over time. Suppose, we now let i = i(k)
vary with time k N. We dene the accumulated value at time n for an investment of C at
time 0 as
C(1 +i(1))(1 +i(2)) (1 +i(n 1)) (1 +i(n)).
9
Example 27 A savings account pays interest at i(1) = 2% in the rst year and i(2) = 5% in
the second year, with interest from the rst year reinvested. Then the account balance evolves
as 1, 000 1, 000(1 +i(1)) = 1, 020 1, 000(1 +i(1))(1 +i(2)) = 1, 071.
When varying interest rates between non-integer times, it is often nicer to specify the force of
interest (t) which we saw to have a local meaning as the innitesimal rate of capital growth
under compound interest:
C C exp
__
t
0
(s)ds
_
= R(t).
Note that now (under some right-continuity assumptions)
t
R(t)
t=0
= (0) and more generally

t
R(t) = (t)R(t),
so that the interpretation of (t) as local rate of capital growth at time t still applies.
Example 28 If () is piecewise constant, say constant
j
on (t
j1
, t
j
], j = 1, . . . , n, then
C Ce
1
r
1
e
2
r
2
e
n
r
n
, where r
j
= t
j
t
j1
.
Denition 29 Given a time-dependent force of interest (t), t R
+
, we dene the accumulated
value at time t 0 of an initial capital C R under a force of interest () as
R(t) = C exp
__
t
0
(s)ds
_
.
Also, we may refer to I(t) = R(t) C as the interest from time 0 to time t under ().
3.3 Accumulation factors
Given a time-dependent interest model (), let us dene accumulation factors from s to t
A(s, t) = exp
__
t
s
(r)dr
_
, s < t. (1)
Just as C R(t) = CA(0, t) for an investment of C at time 0 for a term t, we use A(s, t) as a
factor to turn an investment of C at time s into its accumulated value CA(s, t) at time t. This
behaves well under term-splitting, since
C CA(0, s) (CA(0, s))A(s, t)=C exp
__
s
0
(r)dr
_
exp
__
t
s
(r)dr
_
=CA(0, t).
More generally, note the consistency property A(r, s)A(s, t) = A(r, t), and conversely:
Proposition 30 Suppose, A: {(s, t) : s t} (0, ) satises the consistency property and
t A(s, t) is dierentiable for all s, then there is a function () such that (1) holds.
Proof: Since consistency for r = s = t implies A(t, t) = 1, we can dene as (right-hand)
derivative
(t) = lim
h0
A(t, t +h) A(t, t)
h
= lim
h0
A(0, t +h) A(0, t)
hA(0, t)
,
where we also applied consistency. With g(t) = A(0, t) and f(t) = log(A(0, t))
(t) =
g
(t)
g(t)
= f
(t) log(A(0, t)) = f(t) =

_
t
0
(s)ds.
Since consistency implies A(s, t) = A(0, t)/A(0, s), we obtain (1). 2
We included the apparently unrealistic A(s, t) < 1 (accumulated value less than the initial
capital) that leads to negative (). This can be useful for some applications where () is not
pre-specied, but connected to investment performance where prices can go down as well as
up, or to ination/deation. Similarly, we allow any i (1, ), so that the associated 1-year
accumulation factor 1 +i is positive, but possibly less than 1.
3.4 Time value of money
We have discussed accumulated and discounted values in the constant-i model. In the time-
varying () model with accumulation factors A(s, t) = exp(
_
t
s
(r)dr), we obtain
AVal
t
(c) =
m
j=1
c
j
A(t
j
, t) if all t
j
t, DVal
t
(c) =
m
j=1
c
j
V (t, t
j
) if all t
j
> t,
where V (s, t) = 1/A(s, t) = exp(
_
t
s
(r)dr) is the discount factor from time t back to time
s t. With v(t) = V (0, t), we get V (s, t) = v(t)/v(s). Notation v(t) is useful, as it is often the
present value, i.e. the discounted value at time 0, that is of interest, and we then have
DVal
0
(c) =
m
j=1
c
j
v(t
j
), if all t
j
> 0,
where each payment is discounted by v(t
j
). Each future payment has a dierent present value.
Note that the formulas for AVal
t
and DVal
t
are identical, if we express A(s, t) and V (s, t) in
terms of ().
Denition 31 The time-t value of a cash-ow c is dened as
Val
t
(c) = AVal
t
(c
t
) + DVal
t
(c
>t
),
where c
t
and c
>t
denote restrictions of c to payments at times t
j
t resp. t
j
> t.
Proposition 32 For all s t we have Val
t
(c) = Val
s
(c)A(s, t) = Val
s
(c)
v(s)
v(t)
.
The proof is straightforward and left as an exercise. Note in particular, that if Val
t
(c) = 0 for
some t, then Val
t
(c) = 0 for all t.
Remark 33 1. A sum of money without time specication is meaningless.
2. Do not add or directly compare values at dierent times.
3. If values of two cash-ows are equal at one time, they are equal at all times.
3.5 Continuous cash-ows
If many small payments are spread evenly over time, it is natural to model them by a continuous
stream of payment.
Denition 34 A continuous cash-ow is a function c: R R. The total net inow between
times s and t is
_
t
s
c(r)dr,
and this may combine periods of inow and outow.
As before, we can consider random c. We can also mix continuous and discrete parts. Note
that the net inow adds values at dierent times ignoring the time-value of money. More
useful than the net inow are accumulated and discounted values
AVal
t
(c) =
_
t
0
c(s)A(s, t)ds and DVal
t
(c) =
_

t
c(s)V (t, s)ds =
1
v(t)
_

t
c(s)v(s)ds.
Everything said in the previous section applies in an analogous way.
3.6 Example: withdrawal of interest as a cash-ow
Consider a savings account that does not credit interest to the savings account itself (where it
is further compounded), but triggers a cash-ow of interest payments.
1. In a ()-model, 1 1 + I = exp(
_
1
0
(ds)). Consider the interest cash-ow (1, I).
Then Val
1
((0, 1), (1, I)) = 1 is again the capital, at time 1.
2. In the constant-i model, recall the nominal rate i
(p)
= p((1 + i)
1/p
1). Interest on an
initial capital 1 up to time 1/p is i
(p)
/p. After one or indeed k such pthly interest payments
of i
(p)
/p, we have Val
k/p
((0, 1), (1/p, i
(p)
/p), . . . , (k/p, i
(p)
/p)) = 1.
3. In a ()-model, continuous cash-ow c(s) = (s) has Val
t
((0, 1), c
t
)=1 for all t.
We leave as an exercise to check these directly from the denitions.
Note, in particular, that accumulation of interest itself does not correspond to events in
the cash-ow. Cash-ows describe external inuences on the account. Although interest is not
credited continuously or at every withdrawal in practice, our mathematical model does assign a
balance=value that changes continuously between instances of external cash-ow. We include
the eect of interest in a cash-ow by withdrawal.
Lecture 4
The yield of a cash-ow
Reading: CT1 Core Reading Unit 7, McCutcheon-Scott Section 3.2
Given a cash-ow representing an investment, its yield is the constant interest rate that makes
the cash-ow a fair deal. Yields allow to assess and compare the performance of possibly quite
dierent investment opportunities as well as mortgages and loans.
4.1 Denition of the yield of a cash-ow
In that follows, it does not make much dierence whether a cash-ow c is discrete, continuous
or mixed, whether the time horizon of c is nite or innite (like e.g. for perpetuities). However,
to keep statements and technical arguments simple, we assume:
The time horizon of c is nite and payment rates of c are bounded. (H)
Since we will compare values of cash-ows under dierent interest rates, we need to adapt our
notation to reect this:
NPV(i) = i-Val
0
(c)
denotes the Net Present Value of c discounted in the constant-i interest model, i.e. the value
of the cash-ow c at time 0, discounted using discount factors v(t) = v
t
= (1 +i)
t
.
Lemma 35 Given a cash-ow c satifying hypothesis (H), the function i NPV(i) is continu-
ous on (1, ).
Proof: In the discrete case c = ((t
1
, c
1
), . . . , (t
n
, c
n
)), we have NPV(i) =
n
k=1
c
k
(1 + i)
t
k
, and
this is clearly continuous in i for all i > 1. For a continuous-time cash-ow c(s), 0 s t
(and mixed cash-ows) we use the uniform continuity of i (1 + i)
s
on compact intervals
s [0, t] for continuity to be maintained after integration
NPV(i) =
_
t
0
c(s)(1 +i)
s
ds.
2
Corollary 36 Under hypothesis (H), i i-Val
t
(i) is continuous on (1, ) for any t.
Often the situation is such that an investment deal is protable (NPV(i) > 0) if the interest
rate i is below a certain level, but not above, or vice versa. By the intermediate value theorem,
this threshold is a zero of i NPV(i), and we dene
13
Denition 37 Given a cash-ow c, if i NPV(i) has a unique root on (1, ), we dene the
yield y(c) to be this root. If i NPV(i) does not have a root in (1, ) or the root is not
unique, we say that the yield is not well-dened.
The yield is also known as the internal rate of return or also just rate of return. We can
say that the yield is the xed interest rate at which c is a fair deal. The equation NPV(i) = 0
is called yield equation.
Example 38 Suppose that for an initial investment of 1,000 you obtain a payment of 400 af-
ter one year and 770 after two years. What is the yield of this deal? Clearly c = ((0, 1000), (1, 400), (2, 770).
By denition, we are looking for roots i (1, ) of
NPV(i) = 1, 000 + 400(1 +i)
1
+ 800(1 +i)
2
= 0
1, 000(i + 1)
2
400(i + 1) 770 = 0
The solutions to this quadratic equation are i
1
= 1.7 and i
2
= 0.1. Since only the second zero
lies in (1, ), the yield is y(c) = 0.1, i.e. 10%.
Sometimes, it is onvenient to solve for v = (1 + i)
1
, here 1, 000 400v 770v
2
= 0 etc.
Note that i (1, ) v (0, ).
Example 39 Consider the security of Example 7 in Lecture 1. The yield equation NPV(i) = 0
can be written as
10, 000 = 500
10
k=1
(1 +i)
k
+ 10, 000(1 +i)
10
.
We will introduce some short-hand actuarial notation in Lecture 5. Note, however, that we
already know a root of this equation, because the cash-ow is the same as for a bank account
with capital 10, 000 and a cash-ow of annual interest payments of 500, i.e. at 5%, so i = 5%
solves the yield equation. We will now see in much higher generality that there is usually only
one solution to the yield equation for investment opportunities.
4.2 General results ensuring the existence of yields
Since the yield does not always exist, it is useful to have sucient existence criteria.
Proposition 40 If c has in- and outows and all inows of c precede all outows of c (or vice
versa), then the yield y(c) exists.
Remark 41 This includes the vast majority of projects that we will meet in this course. Es-
sentially, investment projects have outows rst, and inows afterwards, while loan schemes
(from the borrowers perspective) have inows rst and outows afterwards.
Proof: By assumption, there is T such that all inows are strictly before T and all outows
are strictly after T. Then the accumulated value
p
i
= i-Val
T
(c
<T
)
is positive strictly increasing in i with p
1
= 0 and the discounted value p
= (by assumption
there are inows) and
n
i
= i-Val
T
(c
>T
)
is negative strictly increasing with n
1
= (by assumption there are outows) and n
= 0.
Therefore
b
i
= p
i
+n
i
= i-Val
T
(c)
is strictly increasing from to , continuous by Corollary 36; its unique root i
0
is also the
unique root of i NPV(i) = (1 +i)
T
(i-Val
T
(c)) by Corollary 32.
For the vice versa part, replace c by c and use Val
0
(c) = Val
0
(c) etc. 2
Corollary 42 If all inows precede all outows, then
y(c) > i NPV(i) < 0.
If all outows precede all inows, then
y(c) > i NPV(i) > 0.
Proof: In the rst setting assume y(c) > 0, we know b
y(c)
= 0 and i b
i
increases with i, so
i < y(c) b
i
< 0, but b
i
= i-Val
T
(c) = (1 +i)
T
NPV(i).
The second setting is analogous (substitute c for c). 2
As a useful example, consider i = 0, when NPV(0) is the sum of undiscounted payments.
Example 39 (continued) By Proposition 40, the yield exists and equals y(c) = 5%.
4.3 Example: APR of a loan
A yield that is widely quoted in practice, is the Annual Percentage Rate (APR) of a loan. This
is straightforward if the loan agreement is based on a constant interest rate i. Particularly for
mortgages (loans to buy a house), it is common, however, to have an initial period of lower
interest rates and lower monthly payments followed by a period of higher interest rates and
higher payments. The APR then gives a useful summary value:
Denition 43 Given a cash-ow c representing a loan agreement (with inows preceding out-
ows), the yield y(c) rounded down to next lower 0.1% is called the Annual Percentage Rate
(APR) of the loan.
Example 44 Consider a mortgage of 85,000 with interest rates of 2.99% in year 1, 4.19%
in year 2 and 5.95% for the remainder of a 20-year term. A Product Fee of 100 is added to
the loan amount, and a Funds Transfer Fee is deducted from the Net Amount provided to the
borrower. We will discuss in Lecture 6 how this leads to a cash ow of
c = ((0, 84975), (1, 5715), (2, 6339), (3, 7271), (4, 7271), . . . , (20, 7271)),
and how the annual payments are further transformed into equivalent monthly payments. Let
us here calculate the APR, which exists by Proposition 40. Consider
f(i) = 84, 975 5, 715(1 +i)
1
6, 339(1 +i)
2
7, 271
20
k=3
(1 +i)
k
.
Solving the geometric progression, or otherwise, we nd the root iteratively by evaluation
f(5%) = 3, 310, f(5.5%) = 396, f(5.4%) = 326, f(5.45%) = 36.
From the last two, we see that y(c) 5.4%, actually y(c) = 5.44503 . . . %. We can see that
APR=5.4% already from the middle two evaluations, since we always round down, by denition
of the APR.
4.4 Numerical calculation of yields
Suppose we know the yield exists, e.g. by Proposition 40. Remember that f(i) = NPV(i) is
continuous and (usually) takes values of dierent signs at the boundaries of (1, ).
Interval splitting allows to trace the root of f : (l
0
, r
0
) = (1, ), make successive guesses
i
n
(l
n
, r
n
), calculate f(i
n
) and dene
(l
n+1
, r
n+1
) := (i
n
, r
n
) or (l
n+1
, r
n+1
) = (l
n
, i
n
)
such that the values at the boundaries f(l
n+1
) and f(r
n+1
) are still of dierent signs. Stop
when the desired accuracy is reached.
The challenge is to make good guesses. Bisection
i
n
= (l
n
+r
n
)/2
(once r
n
< ) is the ad hoc way, linear interpolation
i
n
= l
n
f(r
n
)
f(r
n
) f(l
n
)
+r
n
f(l
n
)
f(r
n
) f(l
n
)
an ecient improvement. There are more ecient variations of this method using some kind of
convexity property of f, but that is beyond the scope of this course.
Actually, the iterations are for computers to carry out. For assignment and examination
questions, you should make good guesses of l
0
and r
0
and carry out one linear interpolation,
then claiming an approximate yield.
Example 44 (continued) Good guesses are r
0
= 6% and l
0
= 5%, since i = 5.95% is mostly
used. [Better, but a priori less obvious guess would be r
0
= 5.5%.] Then
f(5%) = 3, 310.48
f(6%) = 3874.60
_
y(c) 5%
f(6%)
f(6%) f(5%)
+ 6%
f(5%)
f(6%) f(5%)
= 5.46%.
Lecture 5
Annuities and xed-interest
securities
Reading: CT1 Core Reading Units 6, 10.1, McCutcheon-Scott 3.3-3.6, 4, 7.2
In this chapter we introduce actuarial notation for discounted and accumulated values of regular
payment streams, so-called annuity symbols. These are useful not only in the pricing of annuity
products, but wherever regular payment streams occur. Our main example here will be xed-
interest securities.
5.1 Annuity symbols
Annuity-certain. An annuity-certain of term n entitles the holder to a cash-ow
c = ((1, X), (2, X), . . . , (n 1, X), (n, X)).
Take X = 1 for convenience. In the constant-i model, its Net Present Value is
a
n|
= a
n|i
= NPV(i) = Val
0
(c) =
n
k=1
v
k
= v
1 v
n
1 v
=
1 v
n
i
.
The symbols a
n|
and a
n|i
are annuity symbols, pronounced a angle n (at i).
The accumulated value at end of term is
s
n|
= s
n|i
= Val
n
(c) = v
n
Val
0
(c) =
(1 +i)
n
1
i
.
pthly payable annuities. A pthly payable annuity spreads (nominal) payment of 1 per unit
time equally into p payments of 1/p, leading to a cash-ow
c
p
= ((1/p, 1/p), (2/p, 1/p), . . . , (n 1/p, 1/p), (n, 1/p))
with
a
(p)
n|
= Val
0
(c
p
) =
1
p
np
k=1
v
k/p
= v
1/p
1 v
n
1 v
1/p
=
1 v
n
i
(p)
,
where i
p
= p((1 + i)
1/p
1) is the nominal rate of interest convertible pthly associated with i.
This calculation hence the symbol is meaningful for n any integer multiple of 1/p.
17
We saw in Section 3.6 that, (now expressed in our new notation)
ia
n|
=Val
0
((1, i), (2, i), . . . , (n, i))=Val
0
((1/p, i
(p)
/p), (2/p, i
(p)
/p), . . . , (n, i
(p)
/p))=i
(p)
a
(p)
n|
,
since both cash-ows correspond to the income up to time n on 1 unit invested at time 0, at
eective rate i.
The accumulated value of c
p
at the end of term is
s
(p)
n|
= Val
n
(c
p
) = v
n
Val
0
(c
p
) =
(1 +i)
n
1
i
(p)
.
Perpetuities. As n , we obtain perpetuities that pay forever
a
|
= Val
0
((1, 1), (2, 1), (3, 1), . . .) =
k=1
v
k
=
v
1 v
=
1
i
.
Continuously payable annuities. As p , the cash-ow c
p
tends to the continuous
cash-ow c(s) = 1, 0 s n, with
a
n|
= Val
0
(c) =
_
n
0
c(s)v
s
ds =
_
n
0
v
s
ds =
_
n
0
e
s
ds =
1 e
n
=
1 v
n
.
Or a
n|
= Val
0
(c) = lim
p
a
(p)
n|
= lim
p
1 v
n
i
(p)
=
1 v
n
. Similarly s
n|
= Val
n
(c) = v
n
a
n|
.
Annuity-due. This simply means that the rst payment is now
((0, 1), . . . , (n 1, 1))
with
a
n|
= Val
0
((0, 1), (1, 1), . . . , (n 1, 1)) =
n1
k=0
v
k
=
1 v
n
1 v
=
1 v
n
d
and
s
n|
= Val
n
((0, 1), (1, 1), . . . , (n 1, 1)) = v
n
a
n|
=
(1 +i)
n
1
d
.
Similarly
a
(p)
n|
= Val
0
((0, 1/p), (1/p, 1/p), . . . , (n 1/p, 1/p))
and
s
n|
= Val
n
((0, 1/p), (1/p, 1/p), . . . , (n 1/p, 1/p)).
Also a
|
, a
(p)
|
, etc.
Deferred and increasing annuities. Further important annuity symbols dealing with reg-
ular cash-ows starting some time in the future, and with cash-ows with regular increasing
payment streams, are introduced on Assignment 2. The corresponding symbols are
m
|a
n|
,
m
|a
(p)
n|
,
m
| a
n|
,
m
| a
(p)
n|
,
m
|a
n|
, (Ia)
n|
, (I a)
n|
, (Ia)
n|
, (Ia)
n|
,
m
|(Ia)
n|
etc.
5.2 Fixed-interest securities
Simple xed-interest securities. A simple xed-interest security entitles the holder to a
cash-ow
c = ((1, Nj), (2, Nj), . . . , (n 1, Nj), (n, Nj +N)),
where j is the coupon rate, N is the nominal amount and n is the term. The value in the
constant-j model is
NPV(j) = Nja
n|j
+N(1 +j)
n
= Nj
1 (1 +j)
n
j
+N(1 +j)
n
= N.
This is not a surprise: compare with point 2. of Section 3.6. The value in the constant-i model
is
NPV(i) = Nja
n|i
+N(1 +i)
n
= Nj
1 (1 +i)
n
i
+N(1 +i)
n
= Nj/i +Nv
n
(1 j/i).
More general xed-interest securities. There are xed-interest securities with pthly payable
coupons at a nominal coupon rate j and with a redemption price of R per unit nominal
c = ((1/p, Nj/p), (2/p, Nj/p), . . . , (n 1/p, Nj/p), (n, Nj/p +NR)),
where we say that the security is redeemable at (resp. above or below) par if R = 1 (resp. R > 1
or R < 1). We compute
NPV(i) = Nja
(p)
n|
+NR(1 +i)
n
.
If NPV(i) = N (resp. > N or < N), we say that the security is valued or traded at (resp.
above or below) par. Redemption at par is standard. If redemption is not at par, this is usually
expressed as e.g. redemption at 120% meaning R = 1.2. If redemption is not at par, we
can calculate the coupon rate per unit redemption money as j
= j/R; with N
= NR, the
cash-ow of a pthly payable security of nominal amount N
with coupon rate j
redeemable at
par is identical.
Interest payments are always calculated from the nominal amount. Redemption at par is
the standard. In practice, a security is a piece of paper (with coupon strips to cash in the
interest) that can change owner (sometimes under some restrictions).
Fixed-interest securities as investments. Fixed-interest securities are issued by Govern-
ments and are also called Government bonds as opposed to corporate bonds, which are issued
by companies. Corporate bonds are less secure than Government bonds since (in either case,
actually) bankruptcy can stop the payment stream. Since Government typically issues large
quantities of bonds, they form a very liquid/marketable form of investment that is actively
traded on bond markets.
Government bonds are either issued at a xed price or by tender, in which case the highest
bidders get the bonds at a set issue date. Government bonds usually have a term of several
years. There are also shorter-term Government bills which have no coupons, so they are just
oered at a discount on their nominal value.
Example 45 Consider a xed-interest security of N = 100 nominal, coupon rate j = 3%
payable annually and redeemable at par after a term of n = 2. If the security is currently
trading below par, with a purchase price of P = 97, the investment has a cash-ow
c = ((0, 97), (1, 3), (2, 103))
and we can calculate the yield by solving the equation of value
97 + 3(1 +i)
1
+ 103(1 +i)
2
= 0 97(1 +i)
2
3(1 +i) 103 = 0
to obtain 1 + i = 1.04604, i.e. i = 4.604% (the second solution of the quadradic is 1 + i =
1.01512, i.e. i = 2.01512, which is not in (1, ); note that we knew already by Proposition
40 that there can only be one admissible solution).
Here, we could solve the quadratic equation explicitly; for xed-interest securities of longer
term, it is useful to note that the yield is composed of two eects, rst the coupons payable at
rate j/R per unit redemption money (or at rate jN/P per unit purchasing price) and then any
capital gain/loss RN P spread over n years. Here, these rough considerations give
j/R + (R P/N)/n = 4.5%, or more precisely (j/R +jN/P)/2 + (R P/N)/n = 4.546%,
and often even rougher considerations give us an idea of the order of magnitute of a yield that
we can then use as good initial guesses for a numerical approximation.
Lecture 6
Mortgages and loans
Reading: CT1 Core Reading Unit 8, McCutcheon-Scott Sections 3.7-3.8
As we indicated in the Introduction, interest-only and repayment loans are the formal inverse
cash-ows of securities and annuities. Therefore, most of the last lecture can be reinterpreted
for loans. We shall here only translate the most essential formulae and then pass to specic
questions and features arising in (repayment) loans and mortgages, e.g. calculations of out-
standing capital, proportions of interest/repayment, discount periods and rates used to compare
loans/mortgages.
6.1 Loan repayment schemes
Denition 46 A repayment scheme for a loan of L in the model () is a cash-ow
c = ((t
1
, X
1
), (t
2
, X
2
), . . . , (t
n
, X
n
))
such that
L = Val
0
(c) =
n
k=1
v(t
k
)X
k
=
n
k=1
e
R
t
k
0
(t)dt
X
k
. (1)
This ensures that, in the model given by (), the loan is repaid after the nth payment since
it ensures that Val
0
((0, L), c) = 0 so also Val
t
((0, L), c) = 0 for all t.
Example 47 A bank lends you 1,000 at an eective interest rate of 8% p.a. initially, but due
to rise to 9% after the rst year. You repay 400 both after the rst and half way through the
second year and wish to repay the rest after the second year. How much is the nal payment?
We want
1, 000 = 400v(1) + 400v(1.5) +Xv(2) =
400
1.08
+
400
(1.09)
1/2
1.08
+
X
(1.09)(1.08)
,
which gives X = 323.59.
Example 48 Often, the payments X
k
are constant (level payments) and the times t
k
are are
regularly spaced (so we can assume t
k
= k). So
L = Val
0
((1, X), (2, X), . . . , (n, X)) = X a
n|
in the constant-i model.
21
6.2 Loan outstanding, interest/capital components
The payments consist both of interest and repayment of the capital. The distinction can be
important e.g. for tax reasons. Earlier in term, there is more capital outstanding, hence more
interest payable, hence less capital repaid. In later payments, more capital will be repaid, less
interest. Each payment pays rst for interest due, then repayment of capital.
Example 48 (continued) Let n = 3, L = 1, 000 and assume a constant-i model with i = 7%.
Then
X = 1, 000/a
3|7%
= 1, 000/(2.624316) = 381.05.
Furthermore,
time 1 time 2 time 3
interest due 1, 000 0.07 688.95 0.07 356.12 0.07
= 70 = 48.22 = 24.93
capital repaid 381.05 70 381.05 48.22 381.05 24.93
= 311.05 = 332.83 = 356.12
amount outstanding 1, 000 311.05 688.95 332.83 0
= 688.95 = 356.12
Let us return to the general case. In our example, we kept track of the amount outstanding
as an important quantity. In general, for a loan L in a ()-model with payments c
t
=
((t
1
, X
1
), . . . , (t
m
, X
m
)), the outstanding debt at time t is L
t
such that
Val
t
((0, L), c
t
, (t, L
t
)) = 0,
i.e. a single payment of L
t
would repay the debt.
Proposition 49 (Retrospective formula) Given L, (), c
t
,
L
t
= Val
t
((0, L)) Val
t
(c
t
) = A(0, t)L
m
k=1
A(t
k
, t)X
k
.
Recall here that A(s, t) = e
R
t
s
(r)dr
.
Alternatively, for a given repayment scheme, we can also use the following prospective for-
mula.
Proposition 50 (Prospective formula) Given L, ()) and a repayment scheme c,
L
t
= Val
t
(c
>t
) =
1
v(t)
k:t
k
>t
v(t
k
)X
k
. (2)
Proof: Val
t
((0, L), c
t
, (t, L
t
)) = 0 and Val
t
((0, L), c
t
, c
>t
) = 0 (since c is a repayment
scheme), so
L
t
= Val
t
((t, L
t
)) = Val
t
(c
>t
).
2
Corollary 51 In a repayment scheme c = ((t
1
, X
1
), (t
2
, X
2
), . . . , (t
n
, X
n
)), the jth payment
consists of
R
j
= L
t
j1
L
t
j
capital repayment and
I
j
= X
j
R
j
= L
t
j1
(A(t
j1
, t
j
) 1)
interest payment.
Note I
j
represents the interest payable on a sum of L
t
j1
over the period (t
j1
, t).
6.3 Fixed, capped and discount mortgages
In practice, the interest rate of a mortgage is rarely xed for the whole term and the lender
has some freedom to change their Standard Variable Rate (SVR). Usually changes are made in
accordance with changes of the UK base rate xed by the Bank of England. However, there is
often a special initial period:
Example 52 (Fixed period) For an initial 2-10 years, the interest rate is xed, usually below
the current SVR, the shorter the period, the lower the rate.
Example 53 (Capped period) For an initial 2-5 years, the interest rate can fall parallel to
the base rate or the SVR, but cannot rise above the initial level.
Example 54 (Discount period) For an initial 2-5 years, a certain discount on the SVR is
given. This discount may change according to a prescribed schedule.
Regular (e.g. monthly) payments are always calculated as if the current rate was valid for
the whole term (even if changes are known in advance). So e.g. a discount period leads to lower
initial payments. Any change in the interest rate leads to changes in the monthly payments.
Initial advantages in interest rates are usually combined with early redemption penalties
that may or may not extend beyond the initial period (e.g. 6 months of interest on the amount
redeemed early).
Example 55 We continue Example 44 and consider the discount mortgage of 85,000 with
interest rates of i
1
= SVR2.96% = 2.99% in year 1, i
2
= SVR1.76% = 4.19% in year 2 and
SVR of i
3
= 5.95% for the remainder of a 20-year term; a 100 Product Fee is added to the
initial loan amount, a 25 Funds Transfer Fee is deducted from the Net Amount provided to the
borrower. Then the borrower receives 84, 975, but the initial loan outstanding is L
0
= 85, 100.
With annual payments, the repayment scheme is c = ((1, X), (2, Y ), (3, Z), . . . , (20, Z)), where
X =
L
0
a
20|2.99%
, Y =
L
1
a
19|4.19%
, Z =
L
0
a
18|5.95%
.
With
a
20|2.99%
=
1 (1.0299)
20
0.0299
= 14.89124 X =
L
0
a
20|2.99%
= 5, 714.77,
we will have a loan outstanding of L
1
= L
0
(1.0299) X = 81, 929.72 and then
Y =
L
1
a
19|4.19%
= 6, 339.11, L
2
= L
1
(1.0419) Y = 79, 023.47, Z =
L
0
a
18|5.95%
= 7270.96.
With monthly payments, we can either repeat the above with 12
X = L
0
/a
(12)
20|2.99%
etc. to
get monthly payments ((1/12,

X), (2/12,

X), . . . , (11/12,

X), (1,

X)) for the rst year and then
proceed as above. But, of course, L
1
and L
2
will be exactly as above, and we can in fact replace
parts of the repayment scheme c = ((1, X), (2, Y ), (3, Z), . . . , (20, Z)) by equivalent cash-ows,
where equivalence means same discounted value. Using in each case the appropriate interest
rate in force at the time
((1, X)) is equivalent to ((1/12,

X), . . . , (11/12,

X), (1,

X)) in the constant i
1
-model, where
12
Xs
(12)
1|2.99%
= X, so

X = X/12s
(12)
1|2.99%
=
1
12
Xi
(12)
1
/i
1
= 469.83.
((2, Y )) is equivalent to ((1+1/12,
Y ), . . . , (1+11/12,
Y ), (2,
Y )) in the constant i
2
-model,
where

Y =
1
12
Y i
(12)
2
/i
2
= 518.38.
((k, Z)) is equivalent to ((k 11/12,

Z), (k 10/12,

Z), . . . , (k 1/12,

Z), (k,

Z)) in the
constant i
3
-model, where

Z =
1
12
Zi
(12)
3
/i
3
= 589.99.
6.4 Comparison of mortgages
How can we compare deals, e.g. describe the overall rate of variable-rate mortgages?
A method that is still used sometimes, is the at rate
F =
total interest
total terminitial loan
=
n
j=1
I
j
t
n
L
=
n
j=1
X
j
L
t
n
L
.
This is not a good method: we should think of interest paid on outstanding debt L
t
, not on all
of L. E.g. loans of dierent terms but same constant rate have dierent at rates.
A better method to use is the Annual Percentage Rate (APR) of Section 4.3.
Example 55 (continued) The Net Amount provided to the borrower is L = 84, 975, so the
at rate with annual payments is
F
annual
=
X +Y + 18Z L
20 L
= 3.41%,
while the yield is 5.445%, i.e. the APR is 5.4% we calculated this in Example 44.
With monthly payments we obtain
F
monthly
=
12
X + 12
Y + 18 12
Z L
20 L
= 3.196%,
while the yield is 5.434%, i.e. the APR is still 5.4%.
The yield is also more stable under changes of payment frequency than the at rate.
Lecture 7
Funds and weighted rates of return
Reading: CT1 Core Reading Unit 9.4, McCutcheon-Scott Sections 5.6-5.7
Funds are pools of money into which various people pay for various reasons, e.g. investment
opportunities, reserves of pension schemes etc. A fund manager maintains a portfolio of in-
vestment products (xed-interest securities, equities, derivative products etc.) adapting it to
current market conditions, often under certain constraints, e.g. at least some xed proportion
of xed-interest securities or only certain types of equity (high-tech stocks, or only ethical
companies, etc.). In this lecture we investigate the performance of funds from several dierent
angles.
7.1 Money-weighted rate of return
Consider a fund, that is in practice a portfolio of asset holdings whose composition changes over
time. Suppose we look back at time T over the performance of the fund during [0, T]. Denote
the value of the fund at any time t by F(t) for t [0, T]. If no money is added/withdrawn
between times s and t, then the value changes from F(s) to F(t) by an accumulation factor of
A(s, t) = F(t)/F(s) that reects the rate of return i(s, t) such that A(s, t) = (1 +i(s, t))
ts
. In
particular, the yield of the fund over the whole time interval [0, T] is then i(0, T), the yield of
the cash-ow ((0, F(0)), (T, F(T))).
Note that we do not specify the portfolio or any internal change in composition here. This
is up to a fund manager, we just assess the performance of the fund as reected by its value. If,
however, there have been external changes, i.e. deposits/withdrawals in [0, T], then rates such
as i(0, T) in terms of F(0) and F(T) as above, become meaningless. We record such external
changes in a cash-ow c. What rate of return did the fund achieve?
Denition 56 Let F(s) be the value of a fund at time s, c
(s,t]
the cash-ow describing its in-
and outows during the time interval (s, t], and F(t) the fund value at time t. The money-
weighted rate of return MWRR(s, t) of the fund between times s and t is dened to be the yield
of the cash-ow
((s, F(s)), c
(s,t]
, (t, F(t))).
If the fund is an investment fund belonging to an investor, the money-weighted rate of return
is the yield of the investor.
25
7.2 Time-weighted rate of return
Consider again a fund as in the last section, using the same notation. If no money is added/withdrawn
between times s and t, then i(s, t) reects the yield achieved by the fund manager purely by
adjusting the portfolio to current market conditions. If the value of the fund goes up or down
at any time, this reects purely the evolution of assets held in the portfolio at that time, assets
which were selected by the fund manager.
If there are deposits/withdrawals, they also aect the fund value, but are not under the
control of the fund manager. What rate of return did the fund manager achieve?
Denition 57 Let F(s+) be the initial value of a fund at time s, c
(s,t]
= (t
j
, c
j
)
1jn
the
cash-ow describing its in- and outows during the time interval (s, t], F(t) the value at time
t. The time weighted rate of return TWRR(s, t) is dened to to be i (1, ) such that
(1 +i)
ts
=
F(t
1
)
F(s+)
F(t
2
)
F(t
1
+)

F(t
n
)
F(t
n1
+)
F(t)
F(t
n
+)
,
i.e.
log(1 +i) =
n
j=0
t
j+1
t
j
t s
log(1 +i(t
j
, t
j+1
)),
where F(t
j
) and F(t
j
+) are the fund values just before and just after time t
j
, so that c
j
=
F(t
j
+) F(t
j
), and where t
0
= s and t
n+1
= t.
The time-weighted rate of return is a time-weighted (geometric) average of the yields
achieved by the fund manager between external cash-ows. Compared to the TWRR, the
MWRR gives more weight to periods where the fund is big.
7.3 Units in investment funds
When two or more investors invest into the same fund, we want to keep track of the value of
each investors money in the fund.
Example 58 Suppose a fund is composed of holdings of two investors, as follows.
Investor A invests 100 at time 0 and withdraws his holdings of 130 at time 3.
Investor B invests 290 at time 2 and withdraws his holdings of 270 at time 4.
The yields of the two investors are y
A
= 9.14% and y
B
= 3.51%, based respectively on
cash-ows ((0, 100), (3, 130)) and ((2, 290), (4, 270)).
The cash-ow of the fund is
c = ((0, 100), (2, 290), (3, 130), (4, 270)).
Its yield is MWRR(0, 4) = 1.16%.
To calculate the TWRR, we need to know fund values. Clearly F(0+) = 100 and F(4) =
270. Suppose furthermore, that F(2) = 145, then F(2+) = 145 + 290 = 435. During
the time interval (2, 3), both investors achieve the same rate of return, so 145 130 means
F(2+) = 435 390 = F(3), then F(3+) = 390 130 = 260. Now
(1 + TWRR)
4
=
F(2)
F(0+)
F(3)
F(2+)
F(4)
F(3+)
=
145
100
390
435
270
260
= 1.35 TWRR = 7.79%.
We can see that the yield of Investor B pulls MWRR down because Investor B put higher
money weights than Investor A. On the other hand the TWRR is high, because three good
years outweigh the single bad year it does not matter for TWRR that the bad year was when
the fund was biggest, but this is again what pulls MWRR down.
A convenient way to keep track of the value of each investors money is to assign units to
investors and to track prices P(t) per unit. There is always a normalisation choice, typically
but not necessarily xed by setting 1 per unit at time 0. The TWRR is now easily calculated
from the unit prices:
Proposition 59 For a fund with unit prices P(s) and P(t) at times s and t, we have
(1 + TWRR(s, t))
ts
=
P(t)
P(s)
.
Proof: Consider the external cash-ow c
(s,t]
= (t
j
, c
j
)
1jn
. Denote by N(t
j
) and N(t
j
+)
the total number of units in the fund just before and just after t
j
. Since the number of units
stays constant on (t
j1
, t
j
), we have N(t
j1
+) = N(t
j
). With F(t
j
) = N(t
j
)P(t
j
), we
obtain
(1 + TWRR(s, t))
ts
=
F(t
1
)
F(s+)
F(t
2
)
F(t
1
+)

F(t
n
)
F(t
n1
+)
F(t)
F(t
n
+)
=
N(t
1
)P(t
1
)
N(s+)P(s)
N(t
2
)P(t
2
)
N(t
1
+)P(t
1
)

N(t
n
)P(t
n
)
N(t
n1
+)P(t
n1
)
N(t)P(t)
N(t
n
+)P(t
n
)
=
P(t)
P(s)
.
2
Cash-ows of investors can now be conveniently described in terms of units. The yield
achieved by an investor I making a single investment buying N
I
units for N
I
P(s) and selling
N
I
units for N
I
P(t) is the TWRR of the fund between these times, because the number of units
cancels in the yield equation N
I
P(s)(1 +i)
ts
= N
I
P(t).
Example 58 (continued) With P(0) = 1, Investor A buys 100 units, we obtain P(2) = 1.45
(from F(2) = 145), P(3) = 1.30 (from the sale proceeds of 130 for Investor As 100 units).
With P(2) = 1.45, Investor B receives 200 units for 290, and so P(4) = 1.35(from the sale
proceeds of 270 for Investor Bs 200 units).
7.4 Fees
In practice, there are fees payable to the fund manager. Two types of fees are common.
The rst is a xed rate f on the fund value, e.g. if unit prices would be

P(t) without the fee
deducted, then the actual unit price is reduced to P(t) =

P(t)/(1 + f)
t
. Or, for an associated
force = log(1 +f), with the portfolio accumulating according to

A(s, t) = exp(
_
t
s
(r)dr), i.e.
P(t) = P(0)
A(0, t) satises

P
(t) = (t)P(t), then P
(t) = ((t) )P(t), i.e.

P(t) = exp(
_
t
0
((s) )ds)P(0) = e
t
P(t).
This fee is to cover costs associated with portfolio changes between external cash-ows. It is
incorporated in the unit price.
A second type of fee is often charged when adding/withdrawing money, e.g. a 2% fee could
mean that the purchase price per unit is 1.02P(t) and/or the sale price is 0.98P(t).
7.5 Fund types
Investment funds oer a way to invest indirectly into a wide variety of assets. Some of these
assets, such as equity shares, can be risky with prices uctuating heavily over time, but with
thousands of investors investing into the same fund and the fund manager spreading the com-
bined money over many dierent assets (diversication), funds form a less risky investment and
give access to further advantages such as lower transaction costs for larger volumes traded.
Funds are extremely popular as shown by the fact that the Financial Times has 7 pages
devoted to their prices each day (there are only 2 pages for share prices on the London Stock
Exchange). There is a wide spectrum of funds. Apart from dierent constraints on the portfolio,
we distinguish
active strategy: a fund manager takes active decisions to beat the market;
passive strategy: investments are chosen according to a simple rule.
A simple rule can be to track an investment index. E.g., the FTSE 100 Share Index consists of
the 100 largest quoted companies by market capitalisation (number of shares times share price),
accounting for about 80% of the total UK equity market capitalisation. The index is calculated
on a weighted arithmetic average basis with the market capitalisation as the weights.
Lecture 8
Ination
Reading: CT1 Core Reading Units 4 and 11.3, McCutcheon-Scott Sections 5.5, 7.11
Further reading: http://www.statistics.gov.uk/hub/economy/prices-output-and-
productivity/price-indices-and-ination
Ination means goods become more expensive over time, the purchasing power of money falls.
In this lecture we develop a model for ination.
8.1 Ination indices
An ination index records the price at successive times of some basket of goods. The most
commonly used indices are the Retail Price Index (RPI) and the Consumer Price Index (CPI).
Their baskets contain food, clothing, cars, electricity, insurance, council tax etc., and in the
case of the RPI (but not the CPI) also housing-related costs such as mortgage payments.
Year 2006 2007 2008 2009 2010 2011
Retail Price Index in January 193.4 201.6 209.8 210.1 217.9 229.0
Annual Ination rate 4.2% 4.1% 0.1% 3.7% 5.1%
Here the ination rates are calculated e.g. as e
2010
= 229.0/217.9 1 = 5.1%. Theoretically,
e
k
is the interest rate earned by buying the basket at time k and selling it at time k + 1. (In
practice, many goods in the basket dont allow this.)
Although we will work with one ination index at a time, often RPI, it should be noted
that there are other important indices that are worth mentioning. Also, prices for any specic
good are likely to behave in a completely dierent way from the RPI. When buying a house,
you may wish to consult the House Price Index (house prices increased much faster than general
ination, up to 20% in some years, for about 15 years before reaching a plateau; now there is
some evidence that they have started sinking - house price deation, negative ination rates).
As a pensioner you have dierent needs and there is an ination index that takes this into
account (no salaries, no mortgage rates, more weight on medical expenses etc.).
Lets use RPI for the sake of argument. To track real value, we can work in units of
purchasing power, not units of currency.
29
Example 60 In January 2009 an investor put 1,000 in a savings account at an eective rate
of 4% interest. His balance in January 2010 was 1,040. The RPI basket cost
2009
210.10 in
2009 and
2010
217.90 in 2010, so
2009
210.10 =
2010
217.90
and hence
2010
1, 040 =
2009
1, 040 210.10/217.90 =
2009
1002.77 =
2009
1, 000(1 +i
R
),
and we say that the real eective interest rate was i
R
= 0.277%. Alternatively, we can use the
RPI table to express every payment in multiples of RPI, i.e. relative to the index. Then i
R
satises
1, 000
210.1
(1 +i
R
) =
1, 030
217.9
.
We regard an ination index Q(t) as a function of time. In practice, ination indices
typically give monthly values. Q(m/12). If more frequency is required, use interpolation, either
linear interpolation of index value Q(t), or (normally more appropriate) linear interpolation of
log(Q(t)) (since ination acts as a multiplier).
Only the ratio of indices at dierent times matters. So we can x Q = 1 or Q = 100 at a
particular time.
8.2 Modelling ination
Since Q(t) represents the accumulated value of some basket of goods, we can give Q(t) the
same structure as the accumulation factors A(0, t). Recall A(0, t) = exp(
_
t
0
(s)ds).
Denition 61 If Q has the form
Q(t) = Q(0) exp
__
t
0
(s)ds
_
for a function : [0, ) R, then is called the (time-dependent) force of ination.
In the long term, we would expect A(0, t) > Q(t)/Q(0) (interest above ination), i.e. real
interest rates should be positive, but this may easily fail over short intervals.
Denition 62 Given an interest rate model () and an ination model (), we call () ()
the (time-dependent) real force of interest.
The real accumulation factor A
(s, t) = exp(
_
t
s
((r) (r))dr) captures real investment
return, over and above ination. With A(s, t) = A
(s, t)Q(t)/Q(s), we split the accumulation

factor A(s, t) into a component in line with ination Q(t)/Q(s), and the remaining A
(s, t).
The real force of interest measures interest in purchasing power.
Denition 63 For a cash-ow c = ((t
1
, c
1
), . . . , (t
n
, c
n
)) on paper, the cash-ow net of ina-
tion or in real terms is given by
c
Q
=
__
t
1
,
Q(t
0
)
Q(t
1
)
c
1
_
, . . . ,
_
t
n
,
Q(t
0
)
Q(t
n
)
c
n
__
.
Everything is now expressed in time-t
0
money units (units of purchasing power).
We dene the real yield y
Q
(c) = y(c
Q
).
The value of t
0
or Q(t
0
) is not important: Q(t
0
) is just a constant in the yield equation.
Example 64 In January 1980, a bank issued a loan of 25,000. The loan was repayable after
3 years, with 10% interest payable annually in arrears. What is the real rate of return of the
deal? With
Jan 1980 Jan 1981 Jan 1982 Jan 1983
RPI 245.3 277.3 310.6 325.9
With money units of 2, 500, the cash-ow on paper is ((0, 10), (1, 1), (2, 1), (3, 11)), while the
real cash-ow in time-0 money units is
_
(0, 10),
_
1,
245.3
277.3
_
,
_
2,
245.3
310.6
_
,
_
3, 11
245.3
325.9
__
= ((0, 10), (1, 0.8846), (2, 0.7898), (3, 8.2795)).
We solve the equation for the real yield
f(i) = 10 + 0.8846(1 +i)
1
+ 0.7898(1 +i)
2
+ 8.2795(1 +i)
3
= 0
in an approximate way guessing two values and using a linear interpolation
f(0%) = 0.04611, f(0.5%) = 0.09174, i 0.17%.
8.3 Constant ination rate
If the force of ination () is constant equal to , then e = e
1 is the rate of increase in the

value of goods per year. We have Q(t + 1) = (1 +e)Q(t) and Q(t) = Q(0)(1 +e)
t
.
If also the force of interest is constant, , and i = e
1, then so is the real force of interest

, and we can dene the real rate of interest
j = exp( ) 1 =
1 +i
1 +e
1 =
i e
1 +e
.
Under a constant ination rate e, real yields and yields satisfy the same relationship as real
interest rates and interest rates:
Proposition 65 Consider a constant ination rate e. Let c be a cash-ow with yield y(c).
Then the real yield of c exists and is given by
y
e
(c) =
y(c) e
1 +e
.
Proof: Write c = ((t
1
, c
1
), . . . , (t
n
, c
n
)) and Q(t) = (1 +e)
t
. The real yield corresponds to the
yield (if it exists) of
c
Q
= ((t
1
, (1 +e)
t
1
c
1
), . . . , (t
n
, (1 +e)
t
n
c
n
).
We are looking for j, the unique solution of the real yield equation
n
k=1
(1 +e)
t
k
c
k
(1 +j)
t
k
= 0
n
k=1
((1 +j)(1 +e))
t
k
= 0.
We know that the yield equation
n
k=1
(1 +i)
t
k
c
k
= 0
has a solution i = y(c) that is unique in (1, ). But we now see that j solves the real yield
equation if and only if i with (1 +i) = (1 +e)(1 +j) satises the yield equation. Also j > 1
if and only if i := (1 +e)(1 +j) 1 > 1, so the real yield equation has the unique solution
j =
1 +y(c)
1 +e
1 =
y(c) e
1 +e
.
Therefore, this is the real yield y
e
(c). 2
8.4 Index-linking
Suppose we wish to realise a cash-ow in real terms, in time-t
0
units, say c = ((t
1
, c
1
), . . . , (t
n
, c
n
)),
with reference to some ination index R(t). Then the corresponding cash-ow on paper is
c
R
=
__
t
1
,
R(t
1
)
R(t
0
)
c
1
_
, . . . ,
_
t
n
,
R(t
n
)
R(t
0
)
c
n
__
.
This is the principle of index-linked securities (and pensions, benets, etc.), which are supposed
to produce a reliable income in real terms.
Mathematically, this concept is the inverse of c
Q
. The ratios R(t
j
)/R(t
0
) now create time-t
j
money units, whereas for c
Q
, the ratio Q(t
0
)/Q(t
j
) removed time-t
j
money units expressing
everything in terms of time-t
0
units. In fact, (c
Q
)
Q
= c and (c
Q
)
Q
= c.
We will provide an example in Lecture 9 in the context of xed-interest securities.
Lecture 9
Taxation
Reading: CT1 Core Reading Unit 11.1, 11.4-11.5, McCutcheon-Scott 2.10, 7.4-7.10, 8
Further reading: http://www.hmrc.gov.uk/cgt
Detailed taxation legislation is beyond this course, but we do address a distinction that is
commonly made between (regular) income and capital gain from asset sales. In practice, both
may be subject to taxation, but often at dierent rates. We will discuss the impact of ination
in this context, and possible ination-adjustments.
9.1 Fixed-interest securities and running yields
Lecture 5 dealt with calculating the price of a xed-interest security given an interest rate
model and the yield given a price. In the context of securities, the use precise terminology is
essential. The following denition introduces dierent notions of yield.
Denition 66 Given a security, the yield y(c) of the underlying cash-ow
c = ((0, NP
0
), (1, Nj), . . . , (n 1, Nj), (n, Nj +NR))
is called the yield to redemption.
If the security is traded for P
k
per unit nominal at time k, then the ratio j/P
k
of dividend
(coupon) rate and price per unit nominal is called the running yield of the security at time k.
For equities the denition of the running yield applies with price P
k
per share and dividend
D
k
instead of coupon rate j. The price P
k
determines the current capital value of the secu-
rity/share, and the running yield then expresses the rate at which interest is paid on the capital
value. This distinction of yield to redemption and running yield is related to the notions of
interest income and capital gains relevant for taxation.
Income Tax may be payable on income (including interest, coupon payments, dividend
payments);
Capital Gains Tax (CGT) may be payable when goods (including shares, securities etc.)
are sold for a prot.
33
Suppose a good was bought at a purchase price C and sold at a sale price S, this gives a capital
gain S C (a capital loss, if negative). If S > C, then CGT may by payable on S C.
Tax is payable if neither the investor nor the asset are exempt from tax. Tax rates may vary
between dierent investors (e.g. income tax bands of 20%, 40% and 50%).
The yield to redemption reects both income and capital gains (or losses), whereas the
running yield only reects the income part.
Example 67 Given a security with semi-annual coupons at 6%, with redemption date three
years from now that is currently traded above par at 105%, the running yield is 6/105 5.7%.
The yield to redemption is the solution of
0 = i-V al
0
((0, 105), (0.5, 3), (1, 3), (1.5, 3), (2, 3), (2.5, 3), (3, 103))
= 105 + 6a
(2)
3|i
+ (1 +i)
3
100
and numerically, we calculate a yield to redemption of 4.3%. The dierence is due to the
capital loss that is ignored by the running yield.
9.2 Income tax and capital gains tax
For simplicity, we will assume that tax is always due at the time of the relevant cash-ow, i.e. if
an investor is to receive a payment c
k
, but is subject to income tax at rate r
1
, then the cash-ow
is reduced to c
k
(1 r
1
), and if an investor is to receive a payment c
n
= C +(S C) consisting
of capital C and capital gain/loss S C, but is subject to CGT at rate r
2
, then the cash-ow
is reduced to S r
2
(S C)
+
, where (S C)
+
= max(S C, 0) denotes the positive part.
Example 68 The holder of a savings account paying interest at 2.5% gross, subject to income
tax at 20%, receives net interest payments at rate 2.5%(1-20%)=2% net.
Example 69 An investor who bought equities for C = 80 and sells for S = 100 within a
year and is subject to 40% capital gains tax, only receives S (S C)40% = 92.
A key example where usually both income tax and CGT apply is a xed-interest security.
Example 70 If the holder of a xed-interest security is liable to income tax at rate r
1
and
capital gains tax at rate r
2
, in principle, and if the xed-interest security is not exempt from
any of these taxes, then the liabilities are as follows.
After purchase at a price A, the gross cash-ow (ignoring tax, or assuming no liability to
tax) would be
c = ((1/2, Nj/2), (1, Nj/2), . . . , (n 1/2, Nj/2), (n, Nj/2 +NR)),
but income tax reduces coupon payments Nj/2 to Nj(1 r
1
)/2 and CGT reduces the redemp-
tion payment NR to NR r
2
(NR A)
+
.
If the security is not held for the whole term but is sold at time k for P
k
per unit nominal,
capital gains tax reduces the sales proceeds P
k
N to P
k
N r
2
(P
k
N A)
+
.
9.3 Osetting
If capital gains and capital losses occur due to assets sold in the same tax year, a taxpayer
may (under certain restrictions) oset the losses L agains the gains G, to pay CGT only on
(GL)
+
.
Example 71 Asset A (silverware) is sold for 1, 865 (previously bought for 1, 300). Asset B
(a painting) is sold for 500 (previously bought for 900).
Under liability to CGT at 40%, the tax due for Asset A on its own would be
40%(1, 865 1, 300) = 40%565 = 226.
Osetting agains losses from Asset B, tax is only due
40%((1, 865 1, 300) (900 500)) = 40%165 = 66.
9.4 Indexation of CGT
If purchase and sale are far apart, paying CGT on (S C)
+
may not be fair, since no allowance
has been made for ination. The government may decide to tax only on real capital gain, for
which the purchase price C is revalued to account for ination.
Example 72 Suppose shares were bought in March 1990 for 1,000 and sold in April 1996 for
1,800, with CGT charged at 40%. Then without indexation, CGT would be
40%(1, 800 1, 000) = 320.
With RPI in March 1990 at 131.4 and in April 1996 at 152.6, we have
Mar1990
1, 000 =
Apr1996
152.6
131.4
1, 000 =
Apr1996
1, 161.34.
So, CGT due on sale is
40%(1, 800 1, 161.34) = 255.45.
9.5 Ination adjustments
We return to a general ination index R(). Fixed-interest securities are useful to provide a
regular income stream. But with ination reducing the real value of the coupon payments, this
stream is decreasing in real terms. If we want to achieve a cash-ow
c = ((1/2, jN/2), (1, jN/2), . . . , (n 1/2, jN/2), (n, jN/2 +RN))
in real terms, we need to boost the coupon payments by R():
c
R
=
__
1/2,
R(1/2)
R(0)
jN/2
_
,
_
1,
R(1)
R(0)
jN/2
_
, . . . ,
_
n 1/2,
R(n 1/2)
R(0)
jN/2
_
,
_
n,
R(n)
R(0)
(jN/2 +RN)
__
to achieve (c
R
)
R
= c. Since payment of R(k/2)/R(0)jN/2 is made at time k/2, R(k/2) must be
known at time k/2, so we cannot take R(t) = RPI(t), since data collection and aggregation to
form index values is not instantaneous. In practice, the lag is often signicant, e.g. 8 months,
i.e. R(t) = RPI(t 8/12). An advantage is that both parties know the sizes of payments well
in advance. A disadvantage, is that the real yield y
Q
(c
R
) = y((c
R
)
Q
) for Q(t) = RPI(t) will
not exactly equal y(c), but it will normally be similar: with normalisation R(0) = Q(0) = 1, we
obtain
(c
R
)
Q
=
__
1/2,
R(1/2)
Q(1/2)
jN/2
_
,
_
1,
R(1)
Q(1)
jN/2
_
, . . . ,
_
n 1/2,
R(n 1/2)
Q(n 1/2)
jN/2
_
,
_
n,
R(n)
Q(n)
(jN/2 +RN)
__
.
Lecture 10
Project appraisal
Reading: CT1 Core Reading Unit 9, McCutcheon-Scott Sections 5.1-5.4
For a given investment project, the notion of yield (of the underlying cash-ow) provides a
way to assess the project by identifying an internal rate of return (interest rate). We develop
this further in this lecture, focussing on protability as the main criterion, and we also discuss
problems that arise when comparing two investment projects or business ventures.
10.1 Net cash-ows and a rst example
Recall that the yield y(c) of a cash-ow c as unique solution of NPV(i) = i-Val(c) = 0 represents
the boundary between protability (NPV(i) > 0) and unprotability (NPV(i) < 0) as a function
of the interest rate i. Specically, each investment project (with net outows before net inows)
is protable if its yield exceeds the market interest rate (y(c) > i). Here, we use the word net
to refer to the fact that both in- and outows have been incorporated in c and, where they
happen at the same time, just the combined ow at any time is considered.
Example 73 You purchase party furniture for 10, 000 to run a small hire business. You
expect continuous income from hiring fees at rate 1, 200 p.a., but also expect expenditure for
wear and tear of 400 p.a. So, the net rental income will be 800 p.a. After 20 years we expect
to sell the party furniture for 5, 000. The only net outow precedes the inows, so the yield
exists. We solve the yield equation
0 = f(i) = 10, 000 + 800a
20|i
+ 5, 000(1 +i)
20
= 800
1 (1 +i)
20
log(1 +i)
+ 5, 000(1 +i)
20
numerically. Since 800 interest on 10, 000 is 8% and we have 50% capital loss, 2.5% p.a. (this
is a very rough estimate as we ignore compounding over 20 years), we guess i = 6%
f(6%) = 1, 319.37 > 0, f(7%) = 319.01 > 0, f(7.5%) = 129.78 < 0,
so
i 7%
f(7.5%)
f(7%) f(7.5%)
+ 7.5%
f(7%)
f(7%) f(7.5%)
= 7.36%.
37
10.2 Payback periods and a second example
For a protable investment project in a given interest rate model () we can study the evolution
of the accumulated value AVal
t
(c
t
). With outows preceding inows, this accumulated value
will rst be negative, but reach a positive terminal value at or before the end of the project
(positive because the project is protable). We are interested in the time when it becomes rst
positive.
Denition 74 Given a model () and a protable cash-ow c with outows preceding inows.
We dene the discounted payback period
T
+
= inf{t 0 : AVal
t
(c
t
) 0} = inf{t 0 : DVal
0
(c
t
) 0}.
-
time t
6
balance AV al
t
(c)
T
+
If rather than investing existing capital, the investment project is nanced by taking out
loans and then using any inows for repayment, then T
+
is the time when the account balance
changes from negative to positive, i.e. when the debt has been repaid. All remaining inows
after T
+
contribute fully to the prot of the project.
Since the periods of borrowing and saving are well-separated by T
+
, we can here deal with
interest models that have dierent borrowing rates
() and savings rates

+
(). The denition
of T
+
will then be based only on
() and the nal accumulated prot can then be calculated

from
()-AVal
T
+
(c
T
+
) and
+
()-DVal
T
+
(c
>T
+
).
Example 75 A home-owner is considering to invest in a solar energy project. Purchasing
and installing solar panels on his roof costs 10, 000 in three months time. Energy is then
generated continuously at rate 1, 000 p.a. The expected lifetime of the panels is 20 years.
With an interest rate of i = 8% on the loan account, is the investment protable? If so, what
is the discounted payback period?
With money units of 1,000 and a time origin in three months time, the outow of 10
happens at time 0 and the continuous inow, c, at unit rate starts at time 0:
AVal
t
((0, 10), c
t
) = 10(1 +i)
t
+s
t|
= (1 +i)
t
_
1
log(1 +i)
10
_
1
log(1 +i)
.
Then for i = 8% and and t = 20, we have
AVal
20
((0, 10), c
20
) = 0.95939,
so we expect an accumulated prot of 959.39 > 0 making the project protable.
We calculate T
+
= inf{t 0 : AVal
t
((0, 10), c
t
) 0} by solving
AVal
t
((0, 10), c
t
) = 0 t =
log(1 10 log(1 +i))
log(1 +i)
= 19.0744 (19y, 27d)
so seen from now, three months before the installation is complete, the discounted payback
period is 19 years, 3 months and 27 days.
If loan repayment is not made continuously, but quarterly as an equivalent cash-ow (at
i = 8%), then the bank balance at the end of each quarter will be as with continuous payment,
but only an inow (at the end of a quarter) can make the balance nonnegative, so the discounted
payback period will then be 19 years and 6 months.
10.3 Protability, comparison and cross-over rates
Recall that a project is protable at rate i if NPV(i) > 0. Now consider cash-ows c
A
and
c
B
representing two investment projects, and their Net Present Values NPV
A
(i) and NPV
B
(i).
To compare projects A and B, each with all outows before all inows, we can calculate their
yields y
A
and y
B
. Suppose y
A
< y
B
. If the market interest rate is in (y
A
, y
B
), then project B
is protable, project A is not. But this does not mean that project B is more protable than
project A (i.e. NPV
B
(i) > NPV
A
(i)) for all lower interest rates as the following gure shows.
-
market interest rate i
6
Net Present Value
i
X
y
B
y
A
NPV
B
(i)
NPV
A
(i)
i
X
is called a cross-over rate and can be calculated as solution to the yield equation of c
A
c
B
.
For interest rates below i
X
, project B is more protable than project A, although its yield is
smaller. A decision for one or the other project (or against both) now clearly depends on the
expectations on interest rate changes.
Example 76 Compare Project A from Example 73 and Project B from Example 75. For
simplicity, let us delay Project A by 3 months, so that the expenditure of 10,000 happens at
the same time. This does not aect the yield. So far, we have seen that Project A has yield
y
A
7.36% and Project B is protable at i = 8% and therefore has a yield y
B
> 8%.
To investigate potential cross-over rates, consider c
B
c
A
, a continuous cash-ow at rate
800 1, 000 = 200 p.a., i.e. net outow, and an inow of 5, 000 at time 20. We solve
the yield equation (which has a unique solution, by Proposition 40)
200a
20|i
+ 5, 000(1 +i)
20
= 0 i
X
3.89%.
We conclude, that Project A is more protable for i < 3.89%, while Project B is more protable
than Project A for 3.89% < i < 7.36% y
A
, and that Project B is protable while Project A
is not for 7.36% y
A
< i < y
B
. [y
B
8.29%.]
10.4 Reasons for dierent yields/protability curves
For much of the interest rate modelling developments, it is instructive to think that at least the
most secure savings/investment opportunities in the real world are consistent with an underlying
time-varying force of interest. Examples in this lecture seemed to suggest otherwise. In this
section we collect a variety of remarks, some of which motivate further developments of this
course and should be considered again after relevant concepts have been introduced.
There are many government bonds with a variety of redemption dates. We will indeed
extract from such prices a consistent system, an implied term structure of interest rates.
Even though this provides an interest rate model for a few decades, this model is subject
to uncertainty that manifests itself e.g. in that the implied rate for a xed future year will
vary from day to day, month to month, between now and in a years time, say. A more
appropriate model that captures this uncertainty, is a stochastic interest rate model.
In an ecient market with participants optimizing their prot, any denitely protable
investment project should involve something that is as yet unaccounted for. Otherwise,
many market participants would engage in it and market forces would push up prices
(or aect other parts of underlying cash-ow) and remove the prot. We will investigate
related reasoning in a lecture on arbitrage-free pricing.
Unlike our toy examples, assessment of genuine business ventures will have to include
allowances for personal labour, administration costs etc. Such expenditure and indeed
many other positions in the cash-ows will be subject to some uncertainty. A higher yield
of a business venture may be due to a higher risk. As an example of such risk, we will
investigate the risk of default, i.e. the risk that an income stream stops due to bankruptcy
of the relevant party.
The reason why there is a cross-over rate in Example 76 is that the cash-ow of Project
A is more weighted towards later times, due to the big inow after 20 years. As such, its
NPV reacts more strongly to changes in interest rates. We will investigate related notions
of Discounted Mean Term and volatility of a cash-ow, also referred to as duration.
Lecture 11
From uncertainty and corporate
bonds to modelling future lifetimes
Reading: Gerber Sections 2.1, 2.2, 2.4, 3.1, 3.2, 4.1
In this lecture we introduce and apply actuarial notation for lifetime distributions.
11.1 Introduction to life insurance
The lectures that follow are motivated by the following problems.
1. An individual aged x would like to buy a life annuity (e.g. a pension) that pays him a
xed amount N p.a. for the rest of his life. How can a life insurer determine a fair price
for this product?
2. An individual aged x would like to buy a whole life insurance that pays a xed amount S
to his dependants upon his death. How can a life insurer determine a fair single or annual
premium for this product?
3. Other related products include pure endowments that pay an amount S at time n provided
an individual is still alive, an endowment assurance that pays an amount S either upon
an individuals death or at time n whichever is earlier, and a term assurance that pays an
amount S upon an individuals death only if death occurs before time n.
The material so far has been mainly deterministic in the sense that it was generally assumed that
cash-ows as well as interest rates were known, not necessarily constant, but with variability
given by a time-varying rate or force of interest. In practice, such situations arise when analysing
the past or when doing a scenario analysis of the future.
This time, we need to introduce some randomness in order to model an individuals time of
death, but also a companys insolvency time.
The answer to these questions will depend on the chosen model of the future lifetime T
x
of
the individual.
41
11.2 Valuation under uncertainty
In practice, at least some part of a cash-ow is unknown in advance, or at least subject to some
uncertainty. The following denition provides a suitably general framework.
Denition 77 A random vector ((T
j
, C
j
), 1 j N) of times T
j
[0, ) and amounts
C
j
R possibly with random length N is called a (discrete) random cash-ow. A random
locally Riemann integrable function C : [0, ) R of payment rates C(t) at time t 0 is
called a (continuous) random cash-ow.
11.2.1 Examples
Example 78 Suppose, you are oered a zero-coupon bond of 100 nominal redeemable at par
at time 1. Current market interest rates are 4%, but there is also a 10% risk of default, in which
case no redemption payment takes place. What is the fair price?
The present value of the bond is 0 with probability 0.1 and 100(1.04)
1
with probability
0.9. The weighted average A = 0.1 0 + 0.9 100(1.04)
1
86.54 is a sensible candidate for
the fair price.
Denition 79 In an interest model (), the fair premium for a random cash-ow (of xed
length)
C = ((T
1
, C
1
), . . . , (T
n
, C
n
))
(typically of benets C
j
0) is the mean value
A = E(DVal
0
(C)) =
n
j=1
E(C
j
v(T
j
))
where v(t) = exp{
_
t
0
(s)ds} is the discount factor at time t.
Example 80 If the times of a random cash-ow are deterministic T
j
= t
j
and only the amounts
C
j
are random, the fair premium is
A =
n
j=1
E(C
j
)v(t
j
)
and depends only on the mean amounts, since the deterministic v
t
j
can be taken out of the
expectation. Such a situation arises for share dividends.
Example 81 If the amounts of a random cash-ow are xed C
j
= c
j
and only the times T
j
are random, the fair premium is
A =
n
j=1
c
j
E(v(T
j
))
and in the case of constant we have E(v(T
j
)) = E(exp{T
j
}) = E(v
T
j
) which is the so-called
Laplace transform or (moment) generating function. Such a situation arises for life insurance
payments, where usually a single payment is made at the time of death.
The fair premium is just an average of possible values, i.e. the actual random value of
the cash-ow C is higher or lower with positive probability each as soon as DVal
0
(C) is truly
random. In a typical insurance framework when C
j
0 represents benets that the insurer has
to pay us under the policy, we will be charged a premium that is higher than the fair premium,
since the insurer has (expenses that we neglect and) the risk to bear that we want to get rid of
by buying the policy.
Call A
+
the higher premium that is to be determined. Clearly, the insurer is concerned about
his loss (DVal
0
(C) A
+
)
+
, or expected loss E(DVal
0
(C) A
+
)
+
. In some special cases this can
be evaluated, sometimes the quantity under the expectation is squared (so-called squared loss).
A simpler quantity is the probability of loss P(DVal
0
(C) > A
+
). One can use Tchebychevs
inequality to demonstrate that the insurers risk of loss gets smaller with the larger the number
of policies.
11.2.2 Uncertain payment
The following is an important special case of Example 80 which motivates lifetime modelling
and corporate bond pricing.
As you will see the pricing of corporate bonds is not too dierent to the pricing of life
insurance products. In both cases there is a random time when the cash-ows cease, time of
insolvency and time of death respectively.
Example 82 Let t
j
be xed and
C
j
=
_
c
j
with probability p
j
,
0 with probability 1 p
j
.
So we can say C
j
= B
j
c
j
, where B
j
is a Bernoulli random variable with parameter p
j
, i.e.
B
j
=
_
1 with probability p
j
,
0 with probability 1 p
j
.
For the random cash-ow C = ((t
1
, B
1
c
1
), . . . , (t
n
, B
n
c
n
)), we have
A =
n
j=1
E(B
j
c
j
v(t
j
)) =
n
j=1
c
j
v(t
j
)E(B
j
) =
n
j=1
p
j
c
j
v(t
j
).
Note that we have not required the B
j
to be independent (or assumed anything about their
dependence structure).
11.3 Pricing of corporate bonds
Let
c = ((1, DN), . . . , (n 1, DN), (n, DN +N))
be a simple xed-interest security(eg a bond) issued by a company. If the company goes
insolvent, all future payments are lost. So we may wish to look at the random cash-ow
((1, DNB
1
), . . . , (n 1, DNB
n1
), (n, (DN +N)B
n
)),
where B
j
= I(T > j) and T is a random variable representing the insolvency time;
p
j
= P(B
j
= 1) = P(T > j) = F
T
(j).
Here and in the sequel, we will use the following notation for continuous probability distribu-
tions: let T be a continuous random variable taking values in [0, ), modelling a lifetime or
insolvency time. Its distribution function and survival function are given by
F
T
(t) = P(T t) and F
T
(t) = P(T > t) = 1 F
T
(t),
while its density function satises
f
T
(t) =
d
dt
F
T
(t) =
d
dt
F
T
(t), F
T
(t) =
_
t
0
f
T
(s)ds, F
T
(t) =
_

t
f
T
(s)ds.
Denition 83 The function
T
(t) =
f
T
(t)
F
T
(t)
, t 0,
species the force of mortality or hazard rate at (time) t.
Proposition 84 We have
1
P(T t +|T > t)

T
(t) as 0.
Proof: We use the denitions of conditional probabilities and dierentiation:
1
P(T t +|T > t) =

1
P(T > t, T t +)
P(T > t)
=
1
P(T t +) P(T t)
P(T > t)
=
1
F
T
(t)
F
T
(t +) F
T
(t)
T
(t)
F
T
(t)
=
f
T
(t)
F
T
(t)
=
T
(t).
2
So, we can say informally that P(T (t, t +dt)|T > t)
T
(t)dt, i.e.
T
(t) represents for each
t 0 the current rate of dying (or bankruptcy etc.) given survival up to t.
Example 85 The exponential distribution of rate is given by
F
T
(t) = 1 e
t
, F
T
(t) = e
t
, f
T
(t) = e
t
,
T
(t) =
e
t
e
t
= constant.
Lemma 86 We have F
T
(t) = exp
_
_
t
0
T
(s)ds
_
.
Proof: First note that F
T
(0) = P(T > 0) = 1. Also
d
dt
log F
T
(t) =
F
T
(t)
F
T
(t)
=
f
T
(t)
F
T
(t)
=
T
(t).
So
log F
T
(t) = log F
T
(0) +
_
t
0
d
ds
log F
T
(s)ds = 0 +
_
t
0
T
(s)ds.
2
Let c be a deterministic cash-ow on [0, ) and consider c
[0,T)
, the cash-ow killed at time
T: all events from time T on are cancelled. If T is random, c
[0,T)
is a random cash-ow.
Proposition 87 Let () be an interest rate model, c a cash-ow and T a continuous insolvency
time, then
E
_
-Val
0
_
c
[0,T)
__
=
-Val
0
(c)
where

(t) = (t) +
T
(t) and (t) = f
T
(t)/F
T
(t).
Proof: Let c = ((t
j
, c
j
), j 1). Then
-Val
0
(c) =
j1
c
j
v(t
j
), where v(t
j
) = exp
_
_
t
j
0
(s)ds
_
,
and
-Val
0
(c
[0,T)
) =
j1
c
j
v(t
j
)I(T > t
j
),
so that
E
_
-Val
0
(c
[0,T)
)
_
=
j1
c
j
v(t
j
)E(I(T > t
j
)), where E(I(T > t
j
)) = P(T > t
j
) = F
T
(t
j
).
By the previous lemma, the main expression equals
j1
c
j
exp
_
_
t
j
0
(s)ds
_
exp
_
_
t
j
0
T
(s)ds
_
=
j1
c
j
exp
_
_
t
j
0
(s)ds
_
=
-Val
0
(c).
2
The important special case is when and are constant and c is a corporate bond whose
payment stream stops at the insolvency time T.
Corollary 88 Given a constant model, the fair price for a corporate bond C with insolvency
time T Exp() is
A = E(-DVal
0
(C)) =

-DVal
0
(c)
where

= +.
Often, problems arise in a discretised way. Remember that a geometric random variable
with parameter p can be thought of as the rst 0 in a series of Bernoulli 0-1 trials with success
(1) probability p.
Proposition 89 Let c be a discrete cash-ow with t
k
N for all k = 1, . . . , n, T geom(p),
i.e. P(T = k) = p
k1
(1 p), k = 1, 2, . . .. Then in the constant i model,
E
_
i-Val
0
(c
[0,T)
)
_
= j-Val
0
(c)
where j = (1 +i p)/p.
Proof: P(T > k) = p
k
. Therefore
E
_
i-Val
0
(c
[0,T)
)
_
=
n
k=1
p
t
k
c
k
(1 +i)
t
k
.
2
11.4 Expected yield
For deterministic cash-ows that can be interpreted as investment deals (or loan schemes), we
dened the yield as an intrinsic rate of return. For a random cash-ow, this notion gives a
random yield which is usually dicult to use in practice. Instead, we dene:
Denition 90 Let C be a random cash-ow. The expected yield of C is the interest rate
i (1, ), if it exists and is unique such that
E(NPV(i)) = 0,
where NPV(i) = i-Val
0
(C) denotes the net present value of C at time 0 discounted at interest
rate i.
This corresponds to the yield of the average cash-ow. Note that this terminology may be
misleading this is not the expectation of the yield of C, even if that were to exist.
Example 91 An investment of 500, 000 provides
a continuous income stream of 50, 000 per year, starting at an unknown time S and
ending in 6 years time;
a payment of unknown size A in 6 years time.
Suppose that
S is uniformly distributed between [2years, 3years] (time from now);
the mean of A is 700, 000.
What is the expected yield?
We use units of 10, 000 and 1 year. The time-0 value at rate y is
50 +
_
6
s=S
5(1 +y)
s
ds + (1 +y)
6
A.
The expected time-0 value is
50 +
_
6
s=2
P(S < s)5(1 +y)
s
ds + (1 +y)
6
E(A)
= 50 +
_
3
s=2
(s 2)5(1 +y)
s
ds +
_
6
s=3
5(1 +y)
s
ds + (1 +y)
6
70 =: f(y).
Set f(y) = 0 and nd
f(10.45%) = 0.1016... and f(10.55%) = 0.1502...
So the expected yield is 10.5% to 1d.p. (note that we only need to use the mean of A).
As a consequence of Proposition 89, we note:
Corollary 92 If T geom(p) and c a cash-ow at integer times with yield y(c), then the
expected yield of c
[0,T)
is p(1 +y(c)) 1.
Proof: Note that y(c)-Val
0
(c) = 0, and by Proposition 89, we have E(i-Val
0
(c
[0,T)
) = 0, if
y(c) = (1 +i p)/p, i.e. 1 +i = p(1 +y(c)), as required. Also, this is the unique solution to the
expected yield equation as otherwise the relationship 1+i = p(1+j) would give more solutions
to the yield equation. 2
11.5 Lives aged x
Now we are back to life-insurance products.
Recall our standard notation for continuous lifetime distributions. For a continuously dis-
tributed random lifetime T, we write F
T
(t) = P(T t) for the cumulative distribution function,
f
T
(t) = F
T
(t) for the probability density function, F
T
(t) = P(T > t) for the survival function
and
T
(t) = f
T
(t)/F
T
(t) for the force of mortality. Let us write
T
= inf{t 0 : F
T
(t) = 0}
for the maximal possible lifetime. Also recall
F
T
(t) = exp
_
_
t
0
T
(s)ds
_
.
We omit index T if there is no ambiguity.
Suppose now that T models the future lifetime of a new-born person. In life insurance
applications, we are often interested in the future lifetime of a person aged x, or more precisely
the residual lifetime T x given {T > x}, i.e. given survival to age x. For life annuities this
determines the random number of annuity payments that are payable. For a life assurance
contract, this models the time of payment of the sum assured. In practice, insurance companies
perform medical tests and/or collect employment/geographical/medical data that allow more
accurate modelling. However, let us here assume that no such other information is available.
Then we have, for each x [0, ),
P(T x > y|T > x) =
P(T > x +y)
P(T > x)
=
F(x +y)
F(x)
, y 0,
by the denition of conditional probabilities P(A|B) = P(A B)/P(B).
It is natural to directly model the residual lifetime T
x
of an individual (a life) aged x as
F
x
(y) = P(T
x
> y) =
F(x +y)
F(x)
= exp
_
_
x+y
x
(s)ds
_
= exp
_
_
y
0
(x +t)dt
_
.
We can read o
x
(t) =
T
x
(t) = (x + t), i.e. the force of mortality is still the same, just
shifted by x to reect the fact that the individual aged x and dying at time T
x
is aged x + T
x
at death. We can also express cumulative distribution functions
F
x
(y) = 1 F
x
(y) =
F(x) F(x +y)
F(x)
=
F(x +y) F(x)
1 F(x)
,
and probability density functions
f
x
(y) =
_
F
x
(y) =
f(x+y)
1F(x)
=
f(x+y)
F(x)
, 0 y x,
0, otherwise.
There is also actuarial lifetime notation, as follows
t
q
x
= F
x
(t),
t
p
x
= 1
t
q
x
= F
x
(t), q
x
=
1
q
x
, p
x
=
1
p
x
,
x
= (x) =
x
(0).
In this notation, we have the following consistency condition on lifetime distributions for dier-
ent ages:
Proposition 93 For all x 0, s 0 and t 0, we have
s+t
p
x
=
s
p
x
t
p
x+s
.
By general reasoning, the probability that a life aged x survives for s + t years is the same as
the probability that it rst survives for s years and then, aged x + s, survives for another t
years.
Proof: Formally, we calculate the right-hand side
s
p
x
t
p
x+s
= P(T
x
> s)P(T
x+s
> t) =
P(T > x +s)
P(T > x)
P(T > x +s +t)
P(T > x +s)
= P(T
x
> s +t)
=
s+t
p
x
.
2
We can also express other formulas, that we have already established, in actuarial notation:
f
x
(t) =
t
p
x
x+t
,
t
p
x
= exp
_
_
t
0
x+s
ds
_
,
t
q
x
=
_
t
0
s
p
x
x+s
ds.
The rst one says that to die at t, life x must survive for time t and then die instantaneously.
11.6 Curtate lifetimes
In practice, many cash ows pay at discrete times, often at the end of each month. Let us
begin here by discretising continuous lifetimes to integer-valued lifetimes. This is often done in
practice, with interpolation being used for ner models.
Denition 94 Given a continuous lifetime random variable T
x
, the random variable K
x
= [T
x
],
where [] denotes the integer part, is called the associated curtate lifetime.
Of course, one can also model curtate lifetimes directly. Note that, for continuously dis-
tributed T
x
P(K
x
= k) = P(k T
x
< k + 1) = P(k < T
x
k + 1) =
k
p
x
q
x+k
.
Also, by Proposition 93,
P(K
x
k) =
k
p
x
=
k1
j=0
p
x+j
,
i.e. K
x
can be thought of as the number of successes before the rst failure in a sequence of
independent Bernoulli trials with varying success probabilities p
x+j
, j 0. Here, success is the
survival of a year, while failure is death during the year.
Proposition 95 We have E(K
x
) =
[x]
k=1
k
p
x
.
Proof: By denition of the expectation of a discrete random variable,
[x]
k=1
k
p
x
=
[x]
k=1
P(K
x
k) =
[x]
k=1
[x]
m=k
P(K
x
= m)
=
[x]
m=1
m
k=1
P(K
x
= m) =
[x]
m=0
mP(K
x
= m) = E(K
x
).
2
Example 96 If T is exponentially distributed with parameter (0, ), then K = [T] is
geometrically distributed:
P(K = k) = P(k T < k + 1) = e
k
e
(k+1)
= (e
)
k
(1 e
), k 0.
We identify the parameter of the geometric distribution as e
. Note also that here p

x
= e
and q
x
= 1 e
for all x.
In general, we get
P(K
x
k) =
k1
j=0
p
x+j
=
k
p
x
= exp
_
_
k
0
(x +t)dt
_
=
k1
j=0
exp
_
_
x+j+1
x+j
(s)ds
_
,
so that we read o
p
x
= exp
_
_
x+1
x
(s)ds
_
, x 0.
In practice, is often assumed constant between integer points (denoted
x+0.5
) or continuous
piecewise linear between integer points.
11.7 Examples
Let us now return to our motivating problem.
Example 97 (Whole life insurance) Let K
x
be a curtate future lifetime. A whole life in-
surance pays one unit at the end of the year of death, i.e. at time K
x
+ 1. In the model of a
constant force of interest , the random discounted value at time 0 is Z = e
(K
x
+1)
, so the fair
premium for this random cash-ow is
A
x
= E(Z) = E(e
(K
x
+1)
) =
k=1
e
k
P(K
x
= k 1) =
m=0
(1 +i)
m1
m
p
x
q
x+m
,
where i = e
1 and A
x
is just the actuarial notation for this expected discounted value.
Lecture 12
Lifetime distributions and life-tables
Reading: Gerber Sections 2.3, 2.5, 3.2
In this lecture we give an introduction to life-tables. We will not go into the details of con-
structing life-tables, which is one of the subjects of BS3b Statistical Lifetime-Models. What we
are mostly interested in is the use of life-tables to price life insurance products.
12.1 Actuarial notation for life products.
Recall the motivating problems. Let us introduce the associated notation.
Example 98 (Term assurance, pure endowment and endowment) The fair premium of
a term insurance is denoted by
A
1
x:n|
=
n1
k=0
v
k+1
k
p
x
q
x+k
.
The superscript 1 above the x indicates that 1 is only paid in case of death within the period
of n years.
The fair premium of a pure endowment is denoted by A
1
x:n|
= v
n
n
p
x
. Here the superscript 1
indicates that 1 is only paid in case of survival of the period of n years.
The fair premium of an endowment is denoted by A
x:n|
= A
1
x:n|
+A
1
x:n|
, where we could have
put a 1 above both x and n, but this is omitted being the default, like in previous symbols.
Example 99 (Life annuities) Given a constant i interest model, the fair premium of an
ordinary (respectively temporary) life annuity for a life aged x is given by
a
x
=
k=1
v
k
k
p
x
respectively a
x:n|
=
n
k=1
v
k
k
p
x
.
For an ordinary (respectively temporary) life annuity-due, an additional certain payment at
time 0 is made (and any payment at time n omitted):
a
x
= 1 +a
x
respectively a
x:n|
= 1 +a
x:n1|
.
50
12.2 Simple laws of mortality
As we have seen, the theory is nicest for exponentially distributed lifetimes. However, the
exponential distribution is not actually a good distribution to model human lifetimes:
One reason that we have seen is that the curtate lifetime is geometric, i.e. each year given
survival up to then, there is the same probability of dying in the next year. In practice,
you would expect that this probability increases for higher ages.
There is clearly signicantly positive probability to survive up to age 70 and zero proba-
bility to survive to age 140, and yet the exponential distribution suggests that
P(T > 140) = e
140
= (e
70
)
2
= (P(T > 70))
2
.
Specically, if we think there is at least 50% chance of a newborn to survive to age 70,
there would be at least 25% chance to survive to age 140; if we think that the average
lifetime is more than 70, then < 1/70, so P(T > 140) > e
2
> 10%.
More formally, the exponential distribution has the lack of memory property, which here
says that the distribution of T
x
is still exponential with the same parameter, independent
of x. This would mean that there is no ageing.
These observations give some ideas for more realistic models. Generally, we would favour models
with an eventually increasing force of mortality (in reliability theory such distributions are called
IFR distributions increasing failure rate).
1. Gompertz Law: (t) = Bc
t
for some B > 0 and c > 1.
2. Makehams Law: (t) = A + Bc
t
for some A 0, B > 0 and c > 1 (or c > 0 to include
DFR decreasing failure rate cases).
3. Weibull: (t) = kt
for some k > 0 and > 0.

Makehams Law actually gives a reasonable t for ages 30-70.
12.3 The life-table
Suppose we have a population of newborn individuals (or individuals aged > 0, some lowest
age in the table). Denote the size of the population by
. Then let us observe each year the

number
x
of individuals still alive, until the age when the last individual dies reaching
= 0.
Then out of
x
individuals,
x+1
survived age x, and the proportion
x+1
/
x
can be seen as the
probability for each individual to survive. So, if we set
p
x
=
x+1
/
x
for all x 1.
we specify a curtate lifetime distribution. The function x
x
is usually called the life-table
in the strict sense. Note that also vice versa, we can specify a life-table with any given curtate
lifetime distribution by choosing
0
= 100, 000, say, and setting
x
=
0
x
p
0
. In this case, we
should think of
x
as the expected number of individuals alive at age x. Strictly speaking, we
should distinguish p
x
and its estimate p
x
=
x+1
/
x
, but this notion had not been developed
when actuaries rst did this, and rather leave the link to statistics and the interpretation of
x
as an observed quantity, which it usually isnt anyway for real life-tables that were set up by
rather more sophisticated methods.
There is a lot of notation associated with life-tables, and the 1967/70 life-table that we
will work with actually consists of several pages of tables of dierent life functions. We work
with the table for q
x
, and there is also a table containing all
x
, or indeed d
x
=
x

x+1
,
x 1. Observe that, with this notation, q
x
= d
x
/
x
.
See Figure 12.1 for plots of hazard function (x q
x
) and probability mass functions (x
P(K = x)). Note that initially and up to age 35, the one-year death probabilities are below
0.001, then increase to cross 0.1 at age 80 and 0.5 at age 100.
12.4 Example
We will look at the 1967/70 life-table in more detail in the next lecture. Let us nish this
lecture by giving an (articial) example of a life-table constructed from a parametric family. A
more realistic example is on the next assignment sheet.
Example 100 We nd records about a group of 10,000 from when they were all aged 20, which
reveal that 8,948 were still alive 5 years later and 7,813 another 5 years later. This means, that
we are given
20
= 10, 000,
25
= 8, 948 and
30
= 7, 813.
Of course, this is not enough to set up a life-table, since all we would be able to calculate is
5
p
20
=

25
20
= 0.895 and
5
p
25
=

30
25
= 0.873.
However, if we assume that the population has survival function
F
T
(t) = exp(Ax Bx
2
), for some A 0 and B 0,
we can solve two equations to identify the parameters that exactly replicate these two proba-
bilities:
5
p
20
= P(T > 25|T > 20) =
exp(25A25
2
B)
exp(20A20
2
B)
= exp(5A225B)
p
p
25
= exp(5A275B).
(More sophisticated statistical techniques are beyond the scope of this course.) Here, we obtain
that
B =
ln(0.895) ln(0.873)
50
= 0.00049 and A =
ln(0.895) 225B
5
= 0.00018,
and we can then construct the whole associated lifetable as
x
=
20
x20
p
20
= 10, 000 exp((x 20)A(x
2
20
2
)B).
The reliability away from x [20, 30] must be questioned, but we can compute the implied
100
= 89.29.
Figure 12.1: Human lifetime distribution from the 1967/70 life-table constructed using ad-
vanced techniques including graduation/smoothing; notice in the bottom left plot, amplied in
the right-hand plot, infant mortality and accident hump around age 20.
Lecture 13
Select life-tables and applications
Reading: Gerber 2.5, 2.6
13.1 Select life-tables
Some life-tables are select tables, meaning that mortality rates depend on the duration from
joining the population. This is relevant if there is e.g. a medical check at the policy start date,
which can reject applicants with poor health and only oer policies to applicants with better
than average health and lower than average mortality, at least for the next few years. We denote
by
[x] the age at the date of joining the population;
q
[x]
the mortality rate for a life aged x having joined the population at age x;
q
[x]+j
the mortality rate for a life aged x +j having joined the population at age x;
q
x+r
the ultimate mortality for a life aged x having joined the population at age x;
It is supposed that after some select period of r years, mortality no longer varies signicantly
with duration since joining, but only with age: this is the ultimate portion of the table.
Example 101 The 1967/70 life-table has three columns, two select columns for q
[x]
and q
[x]+1
and one ultimate column for q
x+2
. To calculate probabilities for K
[x]
, the relevant entries are
the three entries in row [x] and all ultimate entries below this row. E.g.
P(K
[x]
= 4) = (1 q
[x]
)(1 q
[x]+1
(1 q
x+2
)(1 q
x+3
)q
x+4
.
Using the excerpt of Figure 13.1 of the table for an age [55], we obtain specically
P(K
[55]
= 4) = (1 0.00447)(1 0.00625)(1 0.01050)(1 0.01169)0.01299 0.01257.
Example 102 Consider a 4-year temporary life assurance issued to a checked life [55]. Assum-
ing a constant interest rate of i = 4%, we calculate
A
1
[55]:4|
= vq
[55]
+v
2
p
[55]
q
[55]+1
+v
3
p
[55]
p
[55]+1
q
57
+v
4
p
[55]
p
[55]+1
p
57
q
58
= 0.029067.
Therefore, the fair price of an assurance with sum assured N = 100, 000 is 2, 906.66, payable
as a single up-front premium.
54
Age [x]
53
54
55
56
57
58
59
60
61
62
q
[x]
.00376288
.00410654
.00447362
.00486517
.00528231
.00572620
.00619802
.00669904
.00723057
.00779397
q
[x]+1
.00519413
.00570271
.00625190
.00684424
.00748245
.00816938
.00890805
.00970168
.01055365
.01146756
q
x+2
.00844128
.00941902
.01049742
.01168566
.01299373
.01443246
.01601356
.01774972
.01965464
.02174310
Age x + 2
55
56
57
58
59
60
61
62
63
64
Figure 13.1: Extract from mortality tables of assured lives based on 1967-70 data.
13.2 Multiple premiums
We will return to a more complete discussion of multiple premiums later, but for the purpose
of this section, let us dene:
Denition 103 Given a constant i interest model, let C be the cash ow of insurance benets,
the annual fair level premium of C is dened to be
P
x
=
E(DV al
0
(C))
a
x
.
This denition is based on the following principles:
Proposition 104 In the setting of Denition 103, the expected dicounted benets equal the
expected discounted premium payments. Premium payments stop upon death.
Proof: The expected discounted value of premium payments ((0, P
x
), . . . , (K
x
, P
x
)) is P
x
a
x
=
E(DV al
0
(C)). 2
Example 105 We calculate the fair annual premium in Example 102. Since there should not
be any premium payments beyond when the policy ends either by death or by reaching the end
of term, the premium payments form a eectively a temporary life annuity-due, i.e. cash ow
((0, 1), (1, 1), (2, 1), (3, 1)) restricted to the lifetime K
[55]
. First
a
[55]:4|
= 1 +vp
[55]
+v
2
p
[55]
p
[55]+1
+v
3
p
[55]
p
[55]+1
p
57
3.742157
and the annual premium is therefore calculated from the life table in Figure 13.1 as
P =
NA
1
[55]:4|
a
[55]:4|
= 776.73.
13.3 Interpolation for non-integer ages x + u, x N, u (0, 1)
There are two popular models. Model 1 is to assume that the force of mortality
t
is constant
between each (x, x + 1), x N. This implies
p
x
= exp
_
_
x+1
x
t
dt
_
= exp(
x+0.5
)
x+
1
2
= ln(p
x
).
Also, for 0 u 1,
P(T > x +u|T > x) = exp
_
_
x+u
x
t
dt
_
= exp{u
x+0.5
} = (1 q
x
)
u
,
and with notation T = K+S, where K = [T] is the integer part and S = {T} = T [T] = T K
the fractional part of T, this means that
P(S u|K = x) =
P(x T x +u)/P(T > x)
P(x T < x + 1)/P(T > x)
=
1 exp{u
x+0.5
}
1 exp{
x+0.5
}
, 0 u 1,
a distribution that is in fact the exponential distribution with parameter
x+0.5
, truncated at
= 1: for exponentially distributed E
P(E u|E 1) =
P(E u)
P(E 1)
=
1 exp{u
x+0.5
}
1 exp{
x+0.5
}
, 0 u 1.
Since the parameter depends on x, S is not independent of K here.
Model 2 is convenient e.g. when calculating variances of continuous lifetimes: we assume
that S and K are independent, and that S has a uniform distribution on [0, 1]. Mathematically
speaking, these models are not compatible: in Model 2, we have, instead, for 0 u 1,
F
T
x
(u) = P(T > x +u|T > x)
= P(K x + 1|K x) +P(S > u|K = x)P(K = x|T > x)
= (1 q
x
) + (1 u)q
x
= 1 uq
x
.
We then calculate the force of mortality at x +u as
x+u
=
T
x
(u)
F
T
x
(u)
=
q
x
1 uq
x
and this is increasing in u. Note that is discontinuous at (some if not all) integer times. The
only exception is very articial, as we require q
x+1
= q
x
/(1 q
x
), and in order for this to not
exceed 1 at some point, we need q
0
= = 1/n, and then q
k
=

1k
, k = 1, . . . , n 1, with
= n maximal age. Usually, one accepts discontinuities.
If one of the two assumptions is satised, the above formulas allow to reconstruct the full
distribution of a lifetime T from the entries (q
x
)
xN
of a life-table: from the denition of
conditional probabilities
P(S t [t]|K = [t]) =
P(K = [t], S t [t])
P(K = [t])
=
_
_
_
1 e
(t[t])
x+0.5
1 e
x+0.5
in Model 1,
t [t] in Model 2,
we deduce that
P(T t) = P(K [t] 1) +P(K = [t])P(S t [t]|K = [t]),
and we have already expressed the distribution of K in terms of (q
x
)
xN
.
13.4 Practical concerns
Mortality depends on individual characteristics (rich, athletic, adventurous). Eects on
mortality can be studied. Models include scaling or shifting already existing tables as a
function of the characteristics
We need to estimate future mortality, which may not be the same as current or past
mortality. Note that this is inherently two-dimensional: a 60-year old in 2060 is likely to
have a dierent mortality from a 60-year old in 2010. A two-dimensional life-table should
be indexed separately by calender year of birth and age, or current calender year and age.
Prediction of future mortality is a major actuarial problem. Extrapolating substantially
into the future is subject to considerable uncertainty.
There are other risks, such as possible eects of pills to halt ageing, or major inuenza
outbreak. How can such risks be hedged?
Lecture 14
Evaluation of life insurance products
14.1 Life assurances
Recall that the fair single premium for a whole life assurance is
A
x
= E(v
K
x
+1
) =
k=0
v
k+1
k
p
x
q
x+k
,
where v = e
= (1 +i)
1
is the discount factor in the constant-i model. Note also that higher
moments of the present value are easily calculated. Specically, the second moment
2
A
x
= E(v
2(K
x
+1)
),
associated with discount factor v
2
, is the same as A
x
calculated at a rate of interest i
=
(1 +i)
2
1, and hence
Var(v
K
x
+1
) = E(v
2(K
x
+1)
)
_
E(v
K
x
+1
)
_
2
=
2
A
x
(A
x
)
2
.
Remember that the variance as expected squared deviation from the mean is a quadratic quan-
tity and mean and variance of a whole life assurance of sum assured S are
E(Sv
K
x
+1
) = SA
x
and Var(Sv
K
x
+1
) = S
2
Var(v
K
x
+1
) = S
2
(
2
A
x
(A
x
)
2
).
Similarly for a term assurance,
E
_
Sv
K
x
+1
1
{K
x
<n}
_
= SA
1
x:n|
and Var
_
Sv
K
x
+1
1
{K
x
<n}
_
= S
2
_
2
A
1
x:n|
(A
1
x:n|
)
2
_
for a pure endowment
E
_
Sv
n
1
{K
x
n}
_
= SA
1
x:n|
= Sv
n
n
p
x
and Var(Sv
n
1
{K
x
n}
) = S
2
_
2
A
1
x:n|
(A
1
x:n|
)
2
_
and for an endowment assurance
E(Sv
min(K
x
+1,n)
) = SA
x:n|
and Var(Sv
min(K
x
+1,n)
) = S
2
_
2
A
x:n|
(A
x:n|
)
2
_
58
Note that
S
2
_
2
A
x:n|
(A
x:n|
)
2
_
= S
2
_
2
A
1
x:n|
(A
1
x:n|
)
2
_
+S
2
_
2
A
1
x:n|
(A
1
x:n|
)
2
_
,
because term assurance and pure endowment are not independent, quite the contrary, the
product of their discounted values always vanishes, so that their covariance S
2
A
1
x:n|
A
1
x:n|
is
maximally negative. In other notation, from the variance formula for sums of dependent random
variables,
Var(Sv
min(K
x
+1,n)
) = Var(Sv
K
x
+1
1
{K
x
<n}
+Sv
n
1
{K
x
n}
)
= Var(Sv
K
x
+1
1
{K
x
<n}
) + Var(Sv
n
1
{K
x
n}
) + 2Cov(Sv
K
x
+1
1
{K
x
<n}
, Sv
n
1
{K
x
n}
)
= Var(Sv
K
x
+1
1
{K
x
<n}
) + Var(Sv
n
1
{K
x
n}
) 2E(Sv
K
x
+1
1
{K
x
<n}
)E(Sv
n
1
{K
x
n}
)
= S
2
_
2
A
1
x:n|
(A
1
x:n|
)
2
_
+S
2
_
2
A
1
x:n|
(A
1
x:n|
)
2
_
S
2
A
1
x:n|
A
1
x:n|
.
14.2 Life annuities and premium conversion relations
Recall present values of whole-life annuities, temporary annuities and their due versions
a
x
=
k=1
v
k
k
p
x
, a
x:n|
=
n
k=1
v
k
k
p
x
, a
x
= 1 +a
x
and a
x:n|
= 1 +a
x:n1|
.
Also note the simple relationships (that are easily proved algebraically)
a
x
= vp
x
a
x+1
and a
x:n|
= vp
x
a
x+1:n|
.
By general reasoning, they can be justied by saying that the expected discounted value of
regular payments in arrears for up to n years contingent on a life x is the same as the expected
discounted value of up to n payments in advance contingent on a life x + 1, discounted by a
further year, and given survival of x for one year (which happens with probability p
x
).
To calculate variances of discounted life annuity values, we use premium conversion relations:
Proposition 106 A
x
= 1 d a
x
and A
x:n|
= 1 d a
x:n|
, where d = 1 v.
Proof: The quickest proof is based on the formula a
n|
= (1 v
n
)/d from last term
a
x
= E( a
K
x
+1|
= E
_
1 v
K
x
+1
d
_
=
1 E(v
K
x
+1
)
d
=
1 A
x
d
.
The other formula is similar, with K
x
+ 1 replaced by min(K
x
+ 1, n). 2
Now for a whole life annuity,
Var(a
K
x
|
) = Var
_
1 v
K
x
i
_
= Var
_
v
K
x
+1
d
_
=
1
d
2
Var(v
K
x
+1
) =
1
d
2
_
2
A
x
(A
x
)
2
_
.
For a whole life annuity-due,
Var( a
K
x
+1|
) = Var(1 +a
K
x
|
) =
1
d
2
_
2
A
x
(A
x
)
2
_
.
Similarly,
Var(a
min(K
x
,n)|
) = Var
_
1 v
min(K
x
,n)
i
_
= Var
_
v
min(K
x
+1,n+1)
d
_
=
1
d
2
_
2
A
x:n+1|
(A
x:n+1|
)
2
_
and
Var( a
min(K
x
+1,n)|
) = Var
_
1 +a
min(K
x
,n1)|
_
=
1
d
2
_
2
A
x:n|
(A
x:n|
)
2
_
.
14.3 Continuous life assurance and annuity functions
A whole of life assurance with payment exactly at date of death has expected present value
A
x
= E(v
T
x
) =
_

0
v
t
f
x
(t)dt =
_

0
v
t
t
p
x
x+t
dt.
An annuity payable continuously until the time of death has expected present value
a
x
= E
_
1 v
T
x
_
=
_

0
v
t
t
p
x
dt.
Note also the premium conversion relation A
x
= 1 a
x
.
For a term assurance with payment exactly at the time of death, we obtain
A
1
x:n|
= E(v
T
x
1
{T
x
n}
) =
_
n
0
v
t
t
p
x
x+t
dt.
Similarly, variances can be expressed, as before, e.g.
Var(v
T
x
1
{T
x
n}
) =
2
A
1
x:n|
(A
1
x:n|
)
2
.
14.4 More general types of life insurance
In principle, we can nd appropriate premiums for any cash-ow of benets that depend on T
x
,
by just taking expected discounted values. An example of this was on Assignment 4, where an
increasing whole life assurance was considered that pays K
x
+ 1 at time K
x
+ 1. The purpose
of the exercise was to establish the premium conversion relation
(IA)
x
= a
x
d(I a)
x
that relates the premium (IA)
x
to the increasing life annuity-due that pays k + 1 at time k
for 0 k K
x
. It is natural to combine such an assurance with a regular savings plan and
pay annual premiums. The principle that the total expected discounted premium payments
coincide with the total expected discounted benets yield a level annual premium (IP)
x
that
satises
(IP)
x
a
x
= (IA)
x
= a
x
d(I a)
x
(IP)
x
= 1 d
(I a)
x
a
x
.
Similarly, there are decreasing life assurances. A regular decreasing life assurance is useful to
secure mortgage payments. The (simplest) standard case is where a payment of n K
x
is due
at time K
x
+ 1 provided K
x
< n. This is a term assurance. We denote its single premium by
(DA)
1
x:n|
=
n1
k=0
(n k)v
k+1
k
p
x
q
x+k
and note that
(DA)
1
x:n|
= A
1
x:n|
+A
1
x:n1|
+ +A
1
x:1|
= nA
1
x:n|
(IA)
1
x:n|
,
where (IA)
1
x:n|
denotes the present value of an increasing term-assurance.
Lecture 15
Premiums
In this lecture we incorporate expenses into premium calculations. On average, such expenses
are to cover the insurers administration cost, contain some risk loading and a prot margin for
the insurer. We assume here that expenses are incurred for each policy separately. In practice,
actual expenses per policy also vary with the total number of policies underwritten. There are
also strategic variations due to market forces.
15.1 Dierent types of premiums
Consider the future benets payable under an insurance contract, modelled by a random cash
ow C. Recall that typically payment for the benets are either made by a single lump sum
premium payment at the time the contract is eected (a single-premium contract) or by a
regular annual (or monthly) premium payments of a level amount for a specied term (a regular
premium contract). Note that we will be assuming that all premiums are paid in advance, so
the rst payment is always due at the time the policy is eected.
Denition 107 The net premium (or pure premium) is the premium amount required
to meet the expected benets under a contract, given mortality and interest assumptions.
The oce premium (or gross premium) is the premium required to meet all the costs
under an insurance contract, usually including expected benet cost, expenses and prot
margin. This is the premium which the policy holder pays.
In this terminology, the net premium for a single premium contract is the expected cost of
benets E(Val
0
(C)). E.g., the net premium for a single premium whole life assurance policy of
sum assured 1 issued to a life aged x is A
x
.
In general, recall the principle that the expected present value of net premium payment
equals the expected present value of benet payments. For oce premiums, and later premium
reserves, it is more natural to write this from the insurers perspective as
expected present value of net premium income = expected present value of benet outgo.
62
Then, we can say similarly
expected present value of oce premium income
= expected present value of benet outgo
+ expected present value of outgo on expenses
+ expected present value of required prot loading.
Denition 108 A (policy) basis is a set of assumptions regarding future mortality, investment
returns, expenses etc.
The basis used for calculating premiums will usually be more cautious than the best estimate
for a number of reasons, including to allow for a contingency margin (the insurer does not want
to go bust) and to allow for uncertainty in the estimates themselves.
15.2 Net premiums
We will use the following notation for the regular net premium payable annually throughout
the duration of the contract:
P
x:n|
for an endowment assurance
P
1
x:n|
for a term assurance
P
x
for a whole life assurance.
In each case, the understanding is that we apply a second principle which stipulates that the
premium payments end upon death, making the premium payment cash-ow a random cash-
ow. We also introduce
n
P
x
as regular net premium payable for a maximum of n years.
To calculate net premiums, recall that premium payments form a life annuity (temporary or
whole-life), so we obtain net annual premiums from the rst principle of equal expected dis-
counted values for premiums and benets, e.g.
a
x:n|
P
x:n|
= A
x:n|
P
x:n|
=
A
x:n|
a
x:n|
.
Similarly, P
1
x:n|
=
A
1
x:n|
a
x:n|
, P
x
=
A
x
a
x
,
n
P
x
=
A
x
a
x:n|
.
15.3 Oce premiums
For oce premiums, the basis for their calculation is crucial. We are already used to making
assumptions about an interest rate model and about mortality. Expenses can be set in a variety
of ways, and often it is a combination of several expenses that are charged dierently. It is of
little value to categorize expenses by producing a list of possibilities, because whatever their
form, they describe nothing else than a cash ow, sometimes involving the premium to be
determined. Finding the premium is solving an equation of value, which is usually a linear
equation in the unknown. We give an example.
Example 109 Calculate the premium for a whole-life assurance for a sum assured of 10,000
to a life aged 40, where we have
Expenses: 100 to set up the policy,
30% of the rst premium as a commission,
1.5% of subsequent premiums as renewal commission,
10 per annum maintenance expenses (after rst year).
If we denote the gross premium by P, then the equation of value that sets expected discounted
premium payments equal to expected discounted benets plus expected discounted expenses is
P a
40
= 10, 000A
40
+ 100 + 0.3P + 0.015Pa
40
+ 10a
40
.
Therefore, we obtain
gross premium P =
10, 000A
40
+ 100 + 10a
40
a
40
0.3 0.015a
40
.
In particular, we see that this exceeds the net premium
10, 000A
40
a
40
.
15.4 Prospective policy values
Consider the benet and premium payments under a life insurance contract. Given a policy
basis and given survival to time t, we can specify the expected present value of the contract
(for the insured) at a time t during the term of the contract as
Prospective policy value = expected time-t value of future benets
expected time-t value of future premiums.
We call net premium policy value the prospective policy value when no allowance is made for
future expenses and where the premium used in the calculation is a notional premium, using
the policy value basis. For the net premium policy values of the standard products at time t
we write
t
V
x:n|
,
t
V
1
x:n|
,
t
V
x
,
t
V
x:n|
,
t
V
x
, etc.
Example 110 (n-year endowment assurance) The contract has term max{K
x
+1, n}. We
assume annual level premiums. When we calculate the net premium policy value at time
k = 1, . . . , n 1, this is for a life aged x + k, i.e. a life aged x at time 0 that survived to time
k. The residual term of the policy is up to n k years, and premium payments are still at rate
P
x:n|
. Therefore,
k
V
x:n|
= A
xk:nk|
P
x:n|
a
x+k:nk|
But from earlier calculations of premiums and associated premium conversion relations, we have
P
x:n|
=
A
x:n|
a
x:n|
and A
y:m|
= 1 d a
y:m|
,
so that the value of the endowment assurance contract at time k is
k
V
x:n|
= A
x+k:nk|
A
x:n|
a
x+k:nk|
a
x:n|
= 1 d a
x+k:nk|
(1 d a
x:n|
)
a
x+k:nk|
a
x:n|
= 1
a
x+k:nk|
a
x:n|
,
where we recall that this quantity refers to a surviving life, while the prospective value for a
non-surviving life is zero, since the contract will have ended.
As an aside, for a life aged x at time 0 that did not survive to time k, there are no future
premium or benet payments, so the prospective value of such an (expired) policy at such time
k is zero. The insurer may have made a loss on this individual policy, such loss is paid for by
parts of premiums under other policy contracts (in the same portfolio).
Example 111 (Whole-life policies) Similarly, for whole-life policies with payment at the
end of the year of death, for k = 1, 2, . . .,
k
V
x
= A
x+k
P
x
a
x+k
= A
x+k
A
x
a
x
a
x+k
= (1 d a
x+k
) (1 d a
x
)
a
x+k
a
x
= 1
a
x+k
a
x
,
or with payment at death for any real t 0.
t
V
x
= A
x+t
P
x
a
x+t
= A
x+t
A
x
a
x
a
x+t
= (1 a
x+t
) (1 a
x
)
a
x+t
a
x
= 1
a
x+t
a
x
.
While for whole-life and endowment policies the prospective policy values are increasing (be-
cause there will be a benet payment at death, and death is more likely to happen soon, as the
policyholder ages), the behaviour is quite dierent for temporary assurances (because it is also
getting more and more likely that no benet payment is made):
Example 112 (Term assurance policy) Consider a 40-year policy issued to a life aged 25
subject to A1967/70 mortality. For a sum assured of 100, 000 and i = 4%, the net premium of
this policy can best be worked out by a computer: 100, 000P
25:40|
= 310.53. The prospective
policy values
k
V
1
25:40|
= A
1
25+k,40k|
P
1
25:40|
a
25+k:40k|
per unit sum assured give policy values
as in Figure 15.1, plotted against age, rising up to age 53, then falling.
Figure 15.1: Prospective policy values for a temporary assurance.
Lecture 16
Reserves
Reading: Gerber Sections 6.1, 6.3, 6.11
In many long-term life insurance contracts the cost of benets is increasing over the term but
premiums are level (or single). Therefore, the insurer needs to set aside part of early premium
payments to fund a shortfall in later years of contracts. In this lecture we calculate such reserves.
16.1 Reserves and random policy values
Recall
Prospective policy value = expected time-t value of future benets
expected time-t value of future premiums.
If this prospective policy value is positive, the life oce needs a reserve for that policy, i.e. an
amount of funds held by the life oce at time t in respect of that policy. Apart possibly from
an initial reserve that the insurer provides for solvency reasons, such a reserve typically consists
of parts of earlier premium payments.
If the reserve exactly matches the prospective policy value and if experience is exactly
as expected in the policy basis then reserve plus future premiums will exactly meet future
liabilities. Note, however, that the mortality assumptions in the policy basis usually build a
stochastic model that for a single policy will produce some spread around expected values. If
life oces hold reserves for portfolios of policies, where premiums for each policy are set to
match expected values, randomness will mean that some policies will generate surplus that is
needed to pay for the shortfall of other policies. In practice insurers will usually reserve on a
prudent (slightly cautious) basis so that aggregate future experience would have to be very bad
for reserves plus future income not to cover future liabilities.
If part of the risk of very bad future experience (e.g. untimely death of a large number of
policy holders) is due to specic circumstances (such as acts of terrorism or war) the insurer
may be able to eliminate such risk by exclusions in the policy contract or by appropriate re-
insurance, where the life oce passes on such risk to a re-insurance company by paying an
appropriate premium from their premium income. We will get back to the notion of pooling of
insurance policies, which is one of the essential reasons why insurance works. On a supercial
level, re-insurance can be seen as a pooling of portfolios of insurance policies.
66
When calculating present values of insurance policies and annuity contracts in the rst place,
it was convenient to work with expectations of present values of random cashows depending
on a lifetime random variable T
x
or K
x
= [T
x
].
We can formalise prospective policy values in terms of an underlying stochastic lifetime
model, and a constant-i (or constant-) interest model. A life insurance contract issued to a
life aged x gives rise to a random cash ow C = C
B
C
P
of benet inows C
B
and premium
outows C
P
. The associated prospective policy value is
E(L
t
|T
x
> t), where L
t
= Val
t
(C
B
|(t,)
C
P
|[t,)
),
where the subtlety of restricting to times (t, ) and [t, ), respectively, arises naturally (and
was implicit in calculations for Examples 110 and 111), because premiums are paid in advance
and benets in arrears in the discrete model, so for t = k N, a premium payment at time k
is in advance (e.g. for the year (k, k + 1]), while a benet payment at time k is in arrears (e.g.
for death in [k 1, k)). Note, in particular, that if death occurs during [k 1, k), then L
k
= 0
and L
k1
= v P
x
, where v = (1 +i)
1
.
Proposition 113 (Recursive calculation of policy values) For a whole-life assurance, we
have
(
k
V
x
+P
x
)(1 +i) = q
x+k
+p
x+k k+1
V
x
.
By general reasoning, the value of the policy at time k plus the annual premium for year k
payable in advance, all accumulated to time k + 1 will give the death benet of 1 for death in
year k +1, i.e., given survival to time k, a payment with expected value q
x+k
and, for survival,
the policy value
k+1
V
x
at time k + 1, a value with expectation p
x+k k+1
V
x
.
Proof: The most explicit actuarial proof exploits the relationships between both assurance and
annuity values for consecutive ages (which are obtained by partitioning according to one-year
death and survival)
A
x+k
= vq
x+k
+vp
x+k
A
x+k+1
and a
x+k
= 1 +vp
x+k
a
x+k+1
.
Now we obtain
k
V
x
+P
x
= A
x+k
P
x
a
x+k
+P
x
= vq
x+k
+vp
x+k
A
x+k+1
(1 +vp
x+k
a
x+k+1
)P
x
+P
x
= v(q
x+k
+p
x+k
(A
x+k+1
P
x
a
x+k+1
)
= v(q
x+k
+p
x+k k+1
V
x
).
2
An alternative proof can be obtained by exploiting the premium conversion relationship,
which reduces the recursive formula to a
x+k
= 1 + vp
x+k
a
x+k+1
. However, such a proof does
not use insight into the cash-ows underlying the insurance policy.
A probabilistic proof can be obtained using the underlying stochastic model: by denition,
k
V
x
= E(L
k
|T
x
> k), but we can split the cash-ow underlying L
k
as
C
B
|(k,)
C
P
|[k,)
= ((0, P
x
), (1, 1
{kT
k
<k+1}
), C
B
|(k+1,)
C
P
|[k+1,)
).
Taking Val
k
and E( |T
x
> k) then using E(1
{kT
x
<k+1}
|T
x
> k)=P(T
x
< k +1|T
k
> k)=q
x+k
,
we get
k
V
x
= P
x
+vq
x+k
+vE(L
k+1
|T
x
> k) = P
x
+vq
x+k
+vp
x+k k+1
V
x
,
where the last equality uses E(X|A) = P(B|A)E(X|AB)+P(B
c
|A)E(X|AB
c
), the partition
theorem, where here X = L
k+1
= 0 on B
c
= {T
x
< k + 1}.
There are similar recursive formulas for the other types of life insurance contracts.
16.2 Thieles dierential equation
In the case of continuous time, the analogue of the recursive formula of Proposition 113 is a
dierential equation. In fact, if we write that formula as
k+1
V
x
k
V
x
=
1
p
x+k
(i
k
V
x
+ (1 +i)P
x
q
x+k
(1
k
V
x
)) ,
it describes the variation of the prospective policy value with time. The term i
k
V
x
+(1 +i)P
x
just reects interest and premium payments, while the remainder is an adjustment for the fact
that the increase is between two conditional expectations with dierent conditions; indeed the
denominator p
x+k
= P(T x+k +1|T x+k) is for the extra conditioning needed for
k+1
V
x
,
while q
x+k
(1
k
V
x
) is the expected change in policy value with death occurring in [k, k + 1).
With such interpretations in mind, we expect that for a policy basis
force of interest ,
premiums payable continuously at rate P
x
per annum
sum assured of 1 payable immediately on death
we have
h
p
x
1 for small h > 0, and hence
t+h
V
x
t
V
x
h
t
V
x
+hP
x
(1
t
V
x
)(1 e
h
x+t
).
Dividing by h and letting h 0, we should (and, by the following theorem do) get
t
t
V
x
=
t
V
x
+P
x
x+t
(1
t
V
x
).
Theorem 114 (Thiele) Given a policy basis for an assurance contract for a life aged x:
a force of interest (t) at time t 0,
force of mortality
x+t
at age x +t,
a single benet payment of c(t) payable on death at time t 0,
continuous premium payments at rate (t) at times t 0,
the premiums are net premiums if
_

0
(t)v(t)
t
p
x
dt =
_

0
c(t)v(t)
x+t t
p
x
dt, where v(t) = exp
_
_
t
0
(s)ds
_
.
Furthermore, the prospective policy value V (t) satises
V
(t) = (t)V (t) +(t)

x+t
(c(t) V (t)). (1)
Proof: The rst assertion follows straight from the principle of net premiums to be such that
expected discounted premium payments equal expected discounted benet payments; here, the
former is
E
__
T
x
0
(t)v(t)dt
_
=
_

0
(t)v(t)E(1
{T
x
>t}
)dt =
_

0
(t)v(t)
t
p
x
dt,
where we used E(1
{T
x
>t}
) = P(T
x
> t) = F
x
(t) =
t
p
x
, and the latter is
E(c(T
x
)v(T
x
)) =
_

0
c(t)v(t)f
x
(t)dt =
_

0
c(t)v(t)
x+t t
p
x
dt,
where we used the probability density function f
x
(t) =
x+t t
p
x
of T
x
.
For the second assertion, we note that F
x+t
(r) = F
x
(t +r)/F
x
(t) and dierentiate
V (t) =
1
v(t)F
x
(t)
_

t
c(s)v(s)
x+s
F
x
(s)ds
1
v(t)F
x
(t)
_

t
(s)v(s)F
x
(s)ds
using elementary dierentiation
1
v(t)
= exp
__
t
0
(s)ds
_

_
1
v
_
(t) =
(t)
v(t)
,
and similarly (1/F
x
)
(t) =
x+t
/F
x
(t), then applying the three-factor product rule (fgh)
=
(fg)
h +fgh
= f
gh +fg
h +fgh
and the Fundamental Theorem of Calculus, to get

V
(t) = ((t) +
x+t
)V (t) c(t)
x+t
+(t).
2
We can also interpret Thieles dierential equation 1, as follows, in the language of a large
group of policies: the change in expected reserve V (t) for a given surviving policy holder at
time t consists of an innitesimal increase due to the force of interest (t) acting on the current
reserve volume V (t), a premium inow at rate (t) and an outow due to the force of mortality
x+t
acting on the shortfall c(t) V (t) that must be met and is hence deducted from the
reserve of all surviving policy holders including our given surviving policy holder. As in the
model of discrete premium/benet cash-ows, actual reserves per policy here will uctuate
around expected reserves discussed here because the mortality part will not act continuously,
but discretely (at continuously distributed random times) when the policyholders in the group
of policies die; similarly the reserve of our given policyholder will actually drop to zero at death,
the shortfall for the benet payment being recovered from the reserves of surviving policyholders
in the group (but remember that V (t) is a conditional expectation given survival to t, so V (t)
itself will never jump to zero in a model with continuously distributed lifetimes).
Appendix A
A.1 Some old exam questions
1. (i) Dene and briey discuss the concept of the yield y(c) of a cash-ow c. Quote
(without proof) a general condition, in terms of positive and negative cash-ows,
that ensures the existence of the yield in most practical situations.
(ii) Show that (Ia)
n|
=
a
n|
nv
n
i
.
(iii) A special savings account pays out annual interest over 25 years at interest rates
increasing annually by 0.25%, from 2% at the end of the rst year to 8% at the
end of the 25th year. The account does not allow any deposits except at the very
beginning. Also interest is not reinvested into the account. Write down the cash-ow
associated with an investment of 10,000 into the account. Show that the yield on
this account is greater than 4.44% if no withdrawals are made before the end of the
25th year.
(iv) An investment project gives rise to the following cash-ows. For an initial outlay of
3,000,000, continuous income is received for 25 years at a monthly rate of 20,000.
Based on a market interest rate of 4% per annum, verify that the discounted payback
period exists and calculate it.
2. (i) An investor is considering investing in the shares of a company. The shares pay
a dividend every 6 months, with the most recent dividend paid exactly 2 months
ago. This last dividend was d
0
, the purchase price of a single share is P and the
annual eective rate of return expected from the investment is 100i%. Dividends are
expected to grow at a rate of 100g% per annum from the level of d
0
where g < i.
Dividends are expected to be paid in perpetuity.
(a) Show that the discounted dividend price P satises
P =
d
0
(1 +i)
1/3
(1 +g)
1/2
(1 +i)
1/2
.
(b) The investor delays purchasing the shares for exactly 1 month, at which time
the price of a single share is 20 and 100g% = 3%. Given that d
0
= 0.40,
calculate the annual eective rate of return expected by the investor.
(ii) The same company also oers investments into their corporate bonds, which are
default-free. These corporate bonds have a term of 10 years, pay semi-anual coupons,
in arrears, of 4% per annum and are redeemable at 110% per unit nominal. The
purchase price is such as to provide a gross rate of return of 6% per annum.
70
Exam paper 1 BS4a Actuarial Science Oxford MT 2012 71
(a) Show that the purchase price is 91.30 per 100 nominal.
(b) The investor buys bonds at the purchase price given in (a). He is liable to income
tax at 20% and capital gains tax at 30%. Calculate his net rate of return.
Appendix B
Notation and introduction to
probability
We cannot give a full development of required probability theory here, but we shall discuss
some of the main concepts by introducing our notation.
In the preceding example, the redemption payment R is to be modelled as a random variable
that can take the values 100 and 0. The important information about R is its distribution, that
is given by probabilities p
R
(0)+p
R
(100) = 1. This specication allows to derive the distribution
of related random variables like S = (1 +i)
n
R.
Denition 115 The distribution of a discrete random variable R is represented by its set of
possible outcomes {r
j
: j N} R (e.g. r
j
= j) and its probability mass function (p.m.f.)
p
R
: R [0, 1] satisfying p
R
(r) = 0 for all r {r
j
: j N} and

jN
p
R
(r
j
) = 1. We write for
A R
P(R A) =
jN:r
j
A
p
R
(r
j
).
To dene a multivariate discrete random variable (R
1
, . . . , R
n
), we replace R by R
n
in the above
phrases and denote the p.m.f. by p
(R
1
,...,R
n
)
.
72
Lecture B: Notation and introduction to probability 73
Finally, we dene for functions g : {r
j
: j N} R
E(g(R)) =
jN
g(r
j
)p
R
(r
j
)
provided the series converges.
Denition 116 The distribution of a continuous random variable R is represented by its Rie-
mann integrable probability density function (p.d.f.) f
R
: R [0, ) satisfying
_
f
R
(r)dr =
1. We write for A R
P(R A) =
_
A
f
R
(r)dr =
_

1
{rA}
f
R
(r)dr.
and for functions g : R
n
R
E(g(R)) =
_

g(r)f
R
(r)dr
provided the Riemann integrals exist.
To dene multivariate continuous random variables (R
1
, . . . , R
n
), replace R by R
n
and in-
tegrals by multiple integrals, denote the p.d.f. by f
(R
1
,...,R
n
)
.
Denition 117 For a (discrete or continuous) random variable R we dene the distribution
function F
R
and the survival function

F
R
by
F
R
(t) = P(R t) = P(R (, t])
F
R
(t) = P(R > t) = P(R (t, )) = 1 F
R
(t), t R.
If they exist, we dene the mean
R
and the variance
2
R
of R as
R
= E(R) and
2
R
= V ar(R) = E((R E(R))
2
).
R
=
_
2
R
is called the standard deviation of R.
Denition 118 (Discrete or continuous) Random variables R
1
, . . . , R
n
are said to be indepen-
dent if
P((R
1
, . . . , R
n
) A
1
. . . A
n
) = P(R
1
A
1
) . . . P(R
n
A
n
) (1)
for all A
1
, . . . , A
n
R (such that the integrals exist in the continuous case). Here P(R
j

A
j
) = P((R
1
, . . . , R
j
, . . . , R
n
) R. . . A
j
. . . R) and we call the p.m.f. p
R
j
or p.d.f. f
R
j
of R
j
the marginal p.m.f. or p.d.f.
Proposition 119 R and S are independent if and only if (1) holds for all A
j
= (, t
j
],
t
j
R, j = 1, . . . , n, if and only if
p
(R,S)
(r, s) = p
R
(r)p
S
(s) or f
(R,S)
(r, s) = f
R
(r)f
S
(s)
for all r, s R in the respective discrete and continuous cases (for the continuous case we
actually need some continuity assumptions or exceptional sets, that are irrelevant in practice.
In fact p.d.f.s are only essentially unique).
Lecture B: Notation and introduction to probability 74
In practice, the dependence structure can always be derived from a small set of independent
random variables, and dependencies only arise when these are transformed.
Example 120 Assume, that the life time T of a light bulb has a geometric distribution with
parameter q (0, 1), i.e. P(T = n) = (1 q)q
n
, n = 0, 1, . . .. Then the random variables
B
n
= 1
{T=n}
, i.e. B
n
= 1 if T = n and B
n
= 0 if T = n, are Bernoulli variables with parameter
(1 q)q
n
. Of course, the B
n
are not independent, since e.g.
P(B
0
= 1, B
1
= 1) = P(T = 0, T = 1) = 0 = P(B
0
= 1)P(B
1
= 1).
We recall that
R
is the average value of R, also in the sense that
Proposition 121 (Weak law of large numbers, Tchebychevs inequality) Given a sequence
of independent, identically distributed random variables (R
j
)
j1
with existing mean =
R
j
,
we have
P
_
_
1
n
n
j=1
R
j
>
_
_
0 as n
for all > 0, i.e. P lim
n
1
n
n
j=1
R
j
= , where P lim denotes the limit in probability.
More precisely, if the variance
2
=
2
R
j
exists, P
_
_
1
n
n
j=1
R
j
>
_
_

2
n
2
.
2
R
is a measure for the spread of the distribution of R. Its denition
2
R
= E((R
R
)
2
)
can be read as the expected (squared) deviation from the mean. Also the preceding proposition
indicates that a high
2
R
means more deviation from the mean.

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BS4a

(t) log(A(0, t)) = f(t) =

with coupon rate j

(t) = (t)P(t), then P

(t) = ((t) )P(t), i.e.

(s, t)Q(t)/Q(s), we split the accumulation

1 is the rate of increase in the

1, then so is the real force of interest

() and savings rates

() and the nal accumulated prot can then be calculated

P(T t +|T > t)

P(T t +|T > t) =

. Note also that here p

for some k > 0 and > 0.

. Then let us observe each year the

(t) = (t)V (t) +(t)

and the Fundamental Theorem of Calculus, to get

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