Batch 4

Subject CM1
Revision Notes
For the 2019 exams

Discounting, accumulating and

annuities

Booklet 2

covering

Chapter 3 Cashflow models

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

The Actuarial Education Company

Batch 4
 Batch 4

CONTENTS

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

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

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LINKS TO THE COURSE NOTES AND SYLLABUS

Material covered in this booklet

Chapter 3 Cashflow models

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

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

Syllabus items covered in this booklet

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

transactions.

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

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

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

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

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

over one effective period arithmetically and by general reasoning.

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

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

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

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

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

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

the operation of simple and compound interest.

2. Define the present value of a future payment.

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

(commercial) discount at a constant rate of discount.

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

1. Cashflows are equal at each time period.

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

function of time.

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

4. Rate of interest or discount is constant.

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

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

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

n n n n

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

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

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OVERVIEW

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

Breakdown of topics

We discount and accumulate single payments or regular payments using

interest rates, discount rates and forces of interest.

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

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

Exam questions

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

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

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CORE READING

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

Chapter 1 – Cashflow models

The practical work of the actuary often involves the management of

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

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

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

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

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

In this section, we provide examples of practical situations with

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Equity shares do not earn a fixed rate of interest as fixed-interest

securities do. Instead the shareholders are entitled to a share in the
company’s profits, in proportion to the number of shares owned.

The distribution of profits to shareholders takes the form of regular

payments of dividends. Since they are related to the company profits
that are not known in advance, dividend rates are variable. It is expected
that company profits will increase over time. It is therefore expected
also that dividends per share will increase – though there are likely to be
fluctuations. This means that in order to construct a cashflow schedule
for an equity it is necessary first to make an assumption about the
growth of future dividends. It also means that the entries in the cashflow
schedule are uncertain – they are estimates rather than known
quantities.
____________

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8 In practice the relationship between dividends and profits is not a simple

one. Companies will, from time to time, need to hold back some profits
to provide funds for new projects or expansion. They may also hold
back profits in good years to subsidise dividends in years with poorer
profits. Additionally, companies may be able to distribute profits in a
manner other than dividends, such as by buying back the shares issued
to some investors.
____________

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

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

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

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

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

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

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

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

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

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The cashflows are similar to those for an annuity certain.

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

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

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

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

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

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

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

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

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

cashflow followed by a known number of regular negative cashflows.

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

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Insurance contracts

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Typical examples of contingent annuities include:

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

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

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

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

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

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

The cashflows for the policyholder will usually be a single negative

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

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

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

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

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

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

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

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

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

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

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

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Chapter 4 – The time value of money

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

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

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

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

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

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

Interest

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

an account, does not itself earn further interest.

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

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

C (1 + ni ) (1.1)
____________

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

____________

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

interest.

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____________

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

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

C (1 + i )n (1.2)
____________

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

investment of 1 at time t 1 .
____________

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

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

CA(t1 , t 2 ) (1.3)
____________

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

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

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

____________

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Present values

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

C (1 + i )n (2.1)

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

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

36 We now define the function:

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

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

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

Cv n (2.3)
____________

Discount rates

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

use discount rates.

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

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

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

C (1 - nd ) (3.1)
____________

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

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

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

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

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

C (1 - d )n (3.2)
____________

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

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

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

We can demonstrate the equivalence of compound and effective rates

by an alternative way of thinking about effective rates.
____________

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

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

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

we have:

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

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

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

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

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

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

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

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

Equivalent rates

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

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

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

v = 1- d (5.1)

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

d = iv (5.2)

i
and: d= (5.3)
1+ i

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

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

Chapter 5 – Interest rates

Nominal rates of interest and discount

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

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

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

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

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

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

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

of i ( p ) p .
____________

51 Therefore the effective interest rate i is obtained from:

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

52 Note that i (1) = i .

The treatment of problems involving nominal rates of interest (or

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

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

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

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

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

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

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

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

discount of d ( p ) p .
____________

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55 Therefore the effective discount rate d is obtained from:

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

56 Note that d (1) = d .

____________

The force of interest

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

lim i ( p ) = d
p Æ•
____________

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

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

59 Euler’s rule states that:

n
Ê xˆ
lim Á 1 + ˜ = e x
n Æ• Ë n¯

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

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

Hence:

1 + i = ed (7.1)
____________

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

v = e -d (7.2)
____________

61 From equation (7.2) we have:

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

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

v (n) = e -d n
____________

62 It can also be shown that:

lim d ( p ) = d
p Æ•

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

limit from above.
____________

63 Hence, we have:

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

Relationships between effective, nominal and force of interest

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

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

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

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

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

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

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

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

Hence:

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

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

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

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

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

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

is:

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

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

Hence:

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

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

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

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

payments is:

1
1- t
Ú d (1 + i ) dt
0

which, by symmetry, is equal to:

1
t
Ú d (1 + i ) dt = i
0

Hence:

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

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

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

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

(1) d

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

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

(5) d

Figure 1 Equivalent payments

____________

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Force of interest as a function of time

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

expressed as an annualized percentage of the current fund value.

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

Vt¢
d (t ) =
Vt

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

Hence:

d
d (t ) = ln Vt
dt

Integrating this from t 1 to t2 gives:

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

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

____________

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

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

n
Úd dt
A(0, n ) = e 0 = ed n

Hence:

(1 + i )n = ed n

Therefore:

(1 + i ) = ed

as before.
____________

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

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

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

Chapter 7 – Discounting and accumulating

Present values of cashflows

73 In many compound interest problems one must find the discounted

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

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

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

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

•
 ct j v (t j )
j =1

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

____________

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

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

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

r (t ) = M ¢(t ) for all t

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

time b is:

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

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

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

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

T
Ú v (t ) r (t )dt
0
____________

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

•
Ú v (t ) r (t )dt
0
____________

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

obtain the formula:

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

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

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

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

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

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

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

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

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

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

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

Since:

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

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

due at time t2 is:

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

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

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

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

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

____________

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

•
 ct v (t ) + Ú -• r (t ) v (t )dt

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

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

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

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

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

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

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

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

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

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

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

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

we obtain the result:

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

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

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

Interest income

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

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

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

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

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

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

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

T
C Ú d (t )v (t )dt and Cv (T )
0

respectively.

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Since:

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

we obtain:

T
C = C Ú d (t )v (t )dt + Cv (T )
0

as one would expect by general reasoning.

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

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

Chapter 8 – Level annuities

Present values

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

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

1 1 1 ... 1 1 Payment

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

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

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

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

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

an | = v + v 2 + v 3 +  + v n

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

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

____________

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

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

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

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

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92 It follows directly from the above definitions that:

an| = (1 + i )an|

… and that, for n ≥ 2 : (10.3)

an| = 1 + an -1|
____________

Accumulations

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

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

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

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

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

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

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

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

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 | are defined to be zero.

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

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

sn| = (1 + i )sn|

and that:

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

____________

Continuously payable annuities

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

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

99 Clearly:

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

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

____________

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

____________

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101 Since equation (12.1) may be written as:

i Ê 1- v n ˆ
an| = Á ˜
d Ë i ¯

it follows immediately that, if n is an integer:

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

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

By definition, therefore:

n
sn| = Ú ed (n -t )dt
0

Hence:

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

103 If the rate of interest is non-zero:

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

Annuities payable pthly

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

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

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

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

105 This means that:

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

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

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

which confirms equation (13.1).

____________

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

n

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

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

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

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

i
a( p| ) = an | (13.3)
n d (p)

Alternatively, from first principles, we may write:

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

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

____________

109 Note that:

a( p| ) = v 1/ p a( p| ) (13.5)
n n

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

110 Note that, since:

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

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

lim a ( p| ) = lim a( p| ) = an|

p Æ• n p Æ• n
____________

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

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

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

Also:

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

The above proportional arguments may be applied to other varying

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

n
a= Â xt v t (13.6)
t =1

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

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

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

i
a( p ) = a
i ( p)

where a is given by equation (13.6) above.

____________

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

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

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

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

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

It follows that this value equals:

1 - v 28
(0.25). È (1 + i )4 - 1˘
Î ˚

This last expression may be written in the form:

È ˘
Í 4 ˙ 1 - v 28 4
Í ˙. = .a28|
4
Í (1 + i ) - 1 ˙ i s 4|
Í ˙
Î i ˚
____________

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Non-integer values of n

113 Let p be a positive integer. Until now the symbol a ( p| ) has been defined
n
only when n is a positive integer. For certain non-integral values of n
the symbol a ( p| ) has an intuitively obvious interpretation.
n
____________

114 For example, it is not clear what meaning, if any, may be given to a23.5| ,

but the symbol a(4) ought to represent the present value of an

23.5|
immediate annuity of 1 per annum payable quarterly in arrear for 23.5
years (ie a total of 94 quarterly payments, each of amount 0.25). On the
other hand, a(2) has no obvious meaning.
23.25|
____________

115 Suppose that n is an integer multiple of 1 p , say n = r p , where r is

an integer. In this case we define a ( p| ) to be the value at time 0 of a

n
series of r payments, each of amount 1p, at times

1 p , 2 p , 3 p , ..., r p = n . If i = 0 , then clearly a( p| ) = n . If i π 0 , then:

n

1 1/ p
a ( p| ) = (v + v2/ p + v3/ p +  + vr / p)
n p

1 1/ p Ê 1 - v r / p ˆ 1 È 1- v r / p ˘
= v Á 1/ p ˜ = Í ˙
p Ë 1- v ¯ p ÍÎ (1 + i )1/ p - 1˙˚

Thus:

Ï1- v n
Ô if i π 0
a ( p| ) = Ì i ( p ) (14.1)
n
Ôn if i = 0
Ó
____________

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116 Note that, by working in terms of a new time unit equal to 1 p times the
original time unit and with the equivalent effective interest rate of i ( p ) / p
per new time unit, we see that:

a ( p| ) (at rate i ) = 1
p
anp| (at rate i ( p ) / p )
n

This formula is useful when i ( p ) / p is a tabulated rate of interest.

Note that the definition of a ( p| ) given by equation (14.1) is

n
mathematically meaningful for all non-negative values of n. For our
present purpose, therefore, it is convenient to adopt equation (14.1) as
a definition of a ( p| ) for all n.
n

If n is not an integer multiple of 1/ p , there is no universally recognised

definition of a ( p| ) . For example, if n = n1 + f , where n1 is an integer
n

multiple of 1 p and 0 < f < 1 p , some writers define a ( p| ) as:

n

a ( p|) + fv n
n1

With this alternative definition:

a(2) = a(2) | + 1 4 v 23.75

23.75| 23.5

which is the present value of an annuity of 1 per annum, payable half-

yearly in arrear for 23.5 years, together with a final payment of 0.25 after
23.75 years. Note that this is not equal to the value obtained from
definition (14.1).
____________

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117 If i π 0 , we define for all non-negative n :

(1 - v n ) ¸
a( p| ) = (1 + i )1/ p a ( p| ) = Ô
n n d ( p) Ô
(1 + i )n - 1ÔÔ
s ( p| ) = (1 + i )n a ( p| ) = ˝ (14.2)
n n i ( p) Ô
(1 + i ) n
- 1 Ô
( p ) n ( p )
s | = (1 + i ) a | = ( p )
Ô
n n d Ô˛

If i = 0 , each of these last three functions is defined to equal n.

Whenever n is an integer multiple of 1 p , say n = r p , then

a( p| ) , s ( p| ) , s( p| ) , are values at different times of an annuity-certain of r

n n n
payments, each of amount 1 p , at intervals of 1 p time unit.
____________

 | , s | and s | to denote

118 As before, we use the simpler notations an| , a n n n

a(1)| , a(1)| , s (1)| and s(1)| respectively, thus extending the definition of an|
n n n n
etc, to all non-negative values of n . It is a trivial consequence of our
definitions that the formulae:

i ¸
a ( p| ) = an| Ô
( p)
n i Ô
i Ô
a( p| ) = ( p ) an| Ô
n d Ô
˝ (14.3)
i
s ( p| ) = ( p ) sn | Ô
n i Ô
Ô
i
s( p| ) = ( p ) sn | Ô
n d Ô˛

(valid when i π 0 ) now hold for all values of n.

____________

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Perpetuities

119 We can also consider an annuity that is payable forever.

This is called a perpetuity.

For example, consider an equity that pays a dividend of £10 at the end
of each year. An investor who purchases the equity pays an amount
equal to the present value of the dividends.
____________

120 The present value of the dividends is:

10v + 10v 2 + 10v 3 + 

This can be summed using the formula for an infinite geometric

progression:

10v 10
10v + 10v 2 + 10v 3 +  = =
1- v i

Recall the formula for the present value of an annuity of £10 pa that
continues for n years:

10(1 - v n )
10an =
i

We have let n Æ • in this expression in order to arrive at the formula

10
.
i

Note that this formula only holds when i is positive.

____________

In general:

121 The present value of payments of 1 pa payable at the end of each year
1 1
forever is . This present value is written as a• , ie a• = .
i i
____________

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122 The present value of payments of 1 pa payable at the start of each year
1 1
forever is . This present value is written as a• , ie a• = .
d d
____________

Perpetuities payable pthly

1
123 The present value of payments of 1 pa payable in instalments of p
at
the end of each pthly time period forever is:

1
a(p) =
• i (p)
1
124 The present value of payments of 1 pa payable in instalments of p
at
the start of each pthly time period forever is:

1
a( p ) =
• d (p)
____________

Deferred annuities

Suppose that m and n are non-negative integers. The value at time 0 of

a series of n payments, each of amount 1, due at times
( m + 1), ( m + 2),  , ( m + n ) is denoted by m | an| (see the figure below).

1 1 ... 1 payment

0 1 m m +1 m +2 … m+n time

Such a series of payments may be considered as an immediate annuity,

deferred for m time units.
____________

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125 When n > 0 :

m | an| = v m +1 + v m + 2 + v m + 3 +  + v m + n

= (v + v 2 + v 3 +  + v m + n ) - (v + v 2 + v 3 +  + v m )
= v m (v + v 2 + v 3 +  + v n )
____________

126 The last two equations show that:

m | an | = am + n| - am | (15.1)

= v m an| (15.2)
____________

127 Either of these two equations may be used to determine the value of a
deferred immediate annuity. Together they imply that:

am + n| = am| + v m an|
____________

128 We may define the corresponding deferred annuity-due as:

 = v m a |
m | an| n
____________

129 If m is a non-negative number, we use the symbol m| an| to denote the

present value of a continuously payable annuity of 1 per unit for n time
units, deferred for m time units. Thus:

m +n n m +n m
m| an| =Ú e -d t dt = e -d m Ú e -d sds = Ú e -d t dt - Ú e -d t dt
m 0 0 0

Hence:

m| an| = am +n| - am| = v m an|

____________

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130 The present values of an immediate annuity and an annuity-due, payable

p thly at the rate of 1 per unit time for n time units and deferred for m
time units, are denoted by:

( p)
m| an| = v m a( p| ) and ( p )
m| an| = v m a( p| ) (15.3)
n n

respectively.

( p) ( p)
We may also extend the definitions of m| an| and m| an| to all values of

n by the formulae:

( p)
m| an| = v m a( p| ) ( p )
m| an| = v m a( p| ) (15.4)
n n

and so:

( p)
m| an| = a( p) - a( p|) ( p )
m| an| = a( p) - a( p|) (15.5)
n + m| m n + m| m
____________

Chapter 9 –Increasing annuities

Varying annuities

131 For an annuity in which the payments are not all of an equal amount it is
a simple matter to find the present (or accumulated) value from first
principles. Thus, for example, the present value of such an annuity may
always be evaluated as:

n
 X i v ti
i =1

where the i th payment, of amount X i , is made at time t i .

In the particular case when X i = t i = i the annuity is known as an

increasing annuity and its present value is denoted by (Ia )n| .
____________

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132 Thus:

(Ia )n| = v + 2v 2 + 3v 3 +  + nv n

Hence:

(1 + i )(Ia )n| = 1 + 2v + 3v 2 +  + nv n -1 (16.1)

By subtraction, we obtain:

i (Ia )n| = 1 + v + v 2 + v 3 +  + v n -1 - nv n = an| - nv n

So:
an| - nv n
(Ia)n| =
i
____________

133 The present value of any annuity payable in arrear for n time units for
which the amounts of successive payments form an arithmetic
progression can be expressed in terms of an| and (Ia )n| . If the first

payment of such an annuity is P and the second payment is (P + Q ) ,

the t th payment is (P - Q ) + Qt , then the present value of the annuity is:

(P - Q )an| + Q (Ia )n| (16.2)

Alternatively, the present value of the annuity can be derived from first
principles.
____________

) | is used to denote the present value of an increasing

134 The notation (Ia n
annuity-due payable for n time units, the t th payment (of amount t )
being made at time t - 1 . Thus:

(Ia)n| = 1 + 2v + 3v 2 +  + nv n -1 = (1 + i )(Ia )n|

= 1 + an -1| + (Ia )n -1|

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 Batch 4

____________
135 For increasing annuities which are payable continuously it is important
to distinguish between an annuity which has a constant rate of payment
r (per unit time) throughout the r th period and an annuity which has a
rate of payment t at time t . For the former the rate of payment is a step
function taking the discrete values 1, 2, . For the latter the rate of
payment itself increases continuously. If the annuities are payable for
n time units, their present values are denoted by (Ia )n| and (Ia )n|
respectively.

n r
Clearly (Ia )n| = Â ( Úr -1 rv t dt ) , and:
r =1

n
(Ia)n| = Ú tv t dt
0

and it can be shown that:

an| - nv n
(Ia )n| =
d

and:

an| - nv n
(Ia)n| =
d
____________

136 The present values of deferred increasing annuities are defined in the
obvious manner, for example:

m| (Ia)n = v m (Ia)n
____________

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PAST EXAM QUESTIONS

This section contains all the Subject CT1 exam questions from the period
2008 to 2017 that are related to the topics covered in this booklet.

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

We first provide you with a cross reference grid that indicates the main
subject areas of each exam question. You can use this, if you wish, to select
the questions that relate just to those aspects of the topic that you may be
particularly interested in reviewing.

Alternatively you can choose to ignore the grid, and instead attempt each
question without having any clues as to its content.

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 Batch 4

Cross reference grid

Variable
Basic interest force of Annuities
interest

Payment streams
General A(t) / v(t)
Cashflow models

interest/discount

Level annuties
Accumulation/

Accumulation/
Treasury bill

expression
Converting

Increasing
Tick when
attempted

annuities
discount

discount
Nominal
Question

1   
2 
3 
4  
5 
6   
7    
8   
9  
10 
11 
12  
13  
14  
15    
16  
17  
18  
19  
20   ()
21  ()
22  
23   
24 
25 
26   
27   
28  
29  

© IFE: 2019 Examinations Page 51

Page 52
41
40
39
38
37
36
35
34
33
32
31
30
Question
Tick when
attempted
Cashflow models


Accumulation/


discount




Converting



Treasury bill
Basic interest

Nominal






Batch 4

interest/discount
Accumulation/






discount
General A(t) / v(t)
expression
interest
force of
Variable





Payment streams




Level annuties

Increasing
Annuities

annuities

© IFE: 2019 Examinations

 Batch 4

1 Subject CT1 April 2008 Question 9

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï0.06 0£t £4
Ô
d (t ) = Ì0.10 - 0.01t 4<t £7
Ô0.01t - 0.04 7<t
Ó

(i) Calculate the value at time t = 5 of £1,000 due for payment at time
t = 10 . [5]

(ii) Calculate the constant rate of interest per annum convertible monthly
which leads to the same result as in (i) being obtained. [2]

(iii) Calculate the accumulated amount at time t = 12 of a payment stream,

paid continuously from time t = 0 to t = 4 , under which the rate of
payment at time t is r (t ) = 100e0.02t . [6]
[Total 13]

2 Subject CT1 September 2008 Question 7

The force of interest,  (t ) , is a function of time and at any time t (measured

in years) is given by:

0.05  0.02t for 0  t  5

 (t )  
0.15 for t  5

(i) Calculate the present value of £1,000 due at the end of 12 years. [5]

(ii) Calculate the annual effective rate of discount implied by the transaction
in (i). [2]
[Total 7]

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 Batch 4

3 April 2009 Question 2

Describe the characteristics of:

(a) an interest-only loan (or mortgage); and

(b) a repayment loan (or mortgage). [4]

4 Subject CT1 September 2009 Question 1

A 182-day government bill, redeemable at £100, was purchased for £96 at the
time of issue and was later sold to another investor for £97.89. The rate of
return received by the initial purchaser was 5% per annum effective.

(a) Calculate the length of time in days for which the initial purchaser held
the bill.

(b) Calculate the annual simple rate of return achieved by the second
investor. [4]

5 Subject CT1 September 2009 Question 5

The force of interest d (t ) at time t is a + bt 2 where a and b are constants.

An amount of £100 invested at time t = 0 accumulates to £130 at time t = 5
and £200 at time t = 10 .

(i) Calculate the values of a and b . [6]

(ii) Calculate the constant rate of interest per annum convertible monthly that
would give rise to the same accumulation from time t = 0 to time t = 5 .
[2]

(iii) Calculate the constant force of interest that would give rise to the same
accumulation from time t = 5 to time t = 10 . [2]
[Total 10]

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6 Subject CT1 April 2010 Question 11

The force of interest d (t ) is a function of time and at any time t , measured

in years, is given by the formula:

Ï 0.04 + 0.02t 0£t <5

d (t ) = Ì
Ó0.05 5£t

(i) Derive and simplify as far as possible expressions for v (t ) , where v (t )

is the present value of a unit sum of money due at time t . [5]

(ii) (a) Calculate the present value of £1,000 due at the end of 17 years.

(b) Calculate the rate of interest per annum convertible monthly implied
by the transaction in part (ii)(a). [4]

A continuous payment stream is received at a rate of 10e0.01t units per

annum between t = 6 and t = 10 .

(iii) Calculate the present value of the payment stream. [4]

[Total 13]

7 Subject CT1 September 2010 Question 8

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï0.05 + 0.001t 0 £ t £ 20
d (t ) = Ì
Ó0.05 t > 20

(i) Derive and simplify as far as possible expressions for v (t ) , where v (t )

is the present value of a unit sum of money due at time t . [5]

(ii) (a) Calculate the present value of £100 due at the end of 25 years.

(b) Calculate the rate of discount per annum convertible quarterly

implied by the transaction in part (ii)(a). [4]

(iii) A continuous payment stream is received at rate 30e -0.015t units per
annum between t = 20 and t = 25 . Calculate the accumulated value of
the payment stream at time t = 25 . [4]
[Total 13]

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8 Subject CT1 April 2011 Question 1

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

ÔÏ0.04 + 0.003t 2 for 0 < t £ 5

d (t ) = Ì
ÔÓ0.01 + 0.03t for 5 < t

(i) Calculate the amount to which £1,000 will have accumulated at t = 7 if it

is invested at t = 3 . [4]

(ii) Calculate the constant rate of discount per annum, convertible monthly,
which would lead to the same accumulation as that in (i) being obtained.
[3]
[Total 7]

9 Subject CT1 September 2011 Question 1

A 91-day treasury bill is issued by the government at a simple rate of discount

of 8% per annum.

Calculate the annual effective rate of return obtained by an investor who

purchases the bill at issue. [3]

10 Subject CT1 September 2011 Question 3

An individual intends to retire on his 65th birthday in exactly four years’ time.
The government will pay a pension to the individual from age 68 of £5,000 per
annum monthly in advance. The individual would like to purchase an annuity
certain so that his income, including the government pension, is £8,000 per
annum paid monthly in advance from age 65 until his 78th birthday. He is to
purchase the annuity by a series of payments made over four years quarterly
in advance starting immediately.

Calculate the quarterly payments the individual has to make if the present
value of these payments is equal to the present value of the annuity he wishes
to purchase at a rate of interest of 5% per annum effective. Mortality should
be ignored. [6]

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11 Subject CT1 September 2011 Question 6

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is a + bt where a and b are constants. An amount of £45 invested
at time t = 0 accumulates to £55 at time t = 5 and £120 at time t = 10 .

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

(ii) Calculate the constant force of interest per annum that would give rise to
the same accumulation from time t = 0 to time t = 10 . [2]
[Total 7]

12 Subject CT1 April 2012 Question 8

The force of interest, d (t ) , at time t is given by:

Ï0.04 + 0.003t 2 for 0 < t £ 5

Ô
d (t ) = Ì0.01 + 0.03t for 5 < t £ 8
Ô0.02 for t > 8
ÔÓ

(i) Calculate the present value (at time t = 0 ) of an investment of £1,000

due at time t = 10 . [4]

(ii) Calculate the constant rate of discount per annum convertible quarterly,
which would lead to the same present value as that in part (i) being
obtained. [2]

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

stream payable at the rate of 100e0.01t from time t = 10 to t = 18 . [4]
[Total 10]

13 Subject CT1 September 2012 Question 1

An investor is considering two investments. One is a 91-day deposit which

pays a rate of interest of 4% per annum effective. The second is a treasury
bill.

Calculate the annual simple rate of discount from the treasury bill if both
investments are to provide the same effective rate of return. [3]

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14 Subject CT1 September 2012 Question 2

The nominal rate of discount per annum convertible quarterly is 8%.

(i) Calculate the equivalent force of interest. [1]

(ii) Calculate the equivalent effective rate of interest per annum. [1]

(iii) Calculate the equivalent nominal rate of discount per annum convertible
monthly. [2]
[Total 4]

15 Subject CT1 September 2012 Question 8

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula

Ï0.03 + 0.01t for 0 £ t £ 9

d (t ) = Ì
Ó 0.06 for 9<t

(i) Derive, and simplify as far as possible, expressions for v (t ) where v (t )

is the present value of a unit sum of money due at time t . [5]

(ii) (a) Calculate the present value of £5,000 due at the end of 15 years.

(b) Calculate the constant force of interest implied by the transaction in

part (a). [4]

A continuous payment stream is received at rate 100e -0.02t units per annum
between t = 11 and t = 15 .

(iii) Calculate the present value of the payment stream. [4]

[Total 13]

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16 Subject CT1 April 2013 Question 5

The force of interest per unit time at time t , d (t ) , is given by:

Ï0.1 - 0.005t for t < 6

d (t ) = Ì
Ó0.07 for t ≥ 6

(i) Calculate the total accumulation at time 10 of an investment of £100 made

at time 0 and a further investment of £50 made at time 7. [4]

(ii) Calculate the present value at time 0 of a continuous payment stream at

the rate £50e0.05t per unit time received between time 12 and time 15.
[5]
[Total 9]

17 Subject CT1 September 2013 Question 1

The rate of interest is 4.5% per annum effective.

(i) Calculate:
(a) the annual effective rate of discount.
(b) the nominal rate of discount per annum convertible monthly.
(c) the nominal rate of interest per annum convertible quarterly.
(d) the effective rate of interest over a five year period. [5]

(ii) Explain why your answer to part (i)(b) is higher than your answer to part
(i)(a). [2]
[Total 7]

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18 Subject CT1 September 2013 Question 10 (part)

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

d (t ) = 0.05 + 0.002t

Calculate the accumulated value of a unit sum of money:

(i) (a) accumulated from time t = 0 to time t = 7 .

(b) accumulated from time t = 0 to time t = 6 .
(c) accumulated from time t = 6 to time t = 7 . [5]

(iv) Calculate the present value of an annuity that is paid continuously at a

2
rate of 30e -0.01t + 0.001t units per annum from t = 3 to t = 10 . [5]
[Total 10]

19 Subject CT1 April 2014 Question 3

£900 accumulates to £925 in four months.

Calculate the following:

(i) the nominal rate of interest per annum convertible half-yearly [2]

(ii) the nominal rate of discount per annum convertible quarterly [2]

(iii) the simple rate of interest per annum. [2]

[Total 6]

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20 Subject CT1 April 2014 Question 11

An individual can obtain a force of interest per annum at time t , measured in

years, as given by the formula:

Ï0.03 + 0.01t 0 £ t < 4

Ô
d (t ) = Ì0.07 4£t <6
Ô0.09 6 £t
Ó

(i) Calculate the amount the individual would need to invest at time t = 0 in
order to receive a continuous payment stream of $3,000 per annum from
time t = 4 to t = 10 . [6]

(ii) Calculate the equivalent constant annual effective rate of interest earned
by the individual in part (i). [3]
[Total 9]

21 Subject CT1 September 2014 Question 3

A 91-day treasury bill is bought for £98.83 and is redeemed at £100.

(i) Calculate the annual effective rate of interest from the bill. [3]

(ii) Calculate the annual equivalent simple rate of interest. [2]

[Total 5]

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22 Subject CT1 September 2014 Question 5

Calculate, at a rate of interest of 5% per annum effective:

(i) a(12) [1]

5

(ii) 4| a15 [1]

(iii) (Ia )10 [1]

(iv) ( Ia )10 [1]

(v) the present value of an annuity that is paid annually in advance for 10
years with a payment of 12 in the first year, 11 in the second year and
thereafter reducing by 1 each year. [2]
[Total 6]

23 Subject CT1 September 2014 Question 7

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï0.03 for 0 < t £ 10

Ô
d (t ) = Ì0.003t for 10 < t £ 20
Ô 2
Ó0.0001t for t > 20

(i) Calculate the present value of a unit sum of money due at time t = 28 .
[7]

(ii) (a) Calculate the equivalent constant force of interest from t = 0 to

t = 28 .

(b) Calculate the equivalent annual effective rate of discount from t = 0

to t = 28 . [3]

A continuous payment stream is paid at the rate of e -0.04t per unit time
between t = 3 and t = 7 .

(iii) Calculate the present value of the payment stream. [4]

[Total 14]

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24 Subject CT1 April 2015 Question 2

Calculate the time in days for £3,000 to accumulate to £3,800 at:

(a) a simple rate of interest of 4% per annum.

(b) a compound rate of interest of 4% per annum effective. [4]

25 Subject CT1 April 2015 Question 3

A 182-day treasury bill, redeemable at $100, was purchased for $96.50 at the
time of issue and later sold to another investor for $98 who held the bill to
maturity. The rate of return received by the initial purchaser was 4% per
annum effective.

(i) Calculate the length of time in days for which the initial purchaser held
the bill. [2]

(ii) Calculate the annual simple rate of return achieved by the second
investor. [2]

(iii) Calculate the annual effective rate of return achieved by the second
investor. [2]
[Total 6]

26 Subject CT1 April 2015 Question 5

An investor pays £120 per annum into a savings account for 12 years. In the
first four years, the payments are made annually in advance. In the second
four years, the payments are made quarterly in advance. In the final four
years, the payments are made monthly in advance.

The investor achieves a yield of 6% per annum convertible half-yearly on the

investment.

Calculate the accumulated amount in the savings account at the end of 12

years. [7]

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27 Subject CT1 April 2015 Question 10

The force of interest, d (t ) , is a function of time and at any time t (measured

in years) is given by

Ï0.08 for 0 £ t £ 4
Ô
d (t ) = Ì0.12 - 0.01t for 4 < t £ 9
Ô0.05 for t > 9
Ó

(i) Determine the discount factor, v (t ) , that applies at time t for all t ≥ 0 .
[5]

(ii) Calculate the present value at t = 0 of a payment stream, paid

continuously from t = 10 to t = 12 , under which the rate of payment at
time t is 100e0.03t . [4]

(iii) Calculate the present value of an annuity of £1,000 paid at the end of
each year for the first three years. [3]
[Total 12]

28 Subject CT1 September 2015 Question 1

An investor wishes to obtain a rate of interest of 3% per annum effective from

a 91-day treasury bill.

Calculate:

(a) the price that the investor must pay per £100 nominal.

(b) the annual simple rate of discount from the treasury bill. [3]

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29 Subject CT1 September 2015 Question 2

The nominal rate of discount per annum convertible monthly is 5.5%.

(i) Calculate, giving all your answers as a percentage to three decimal

places:

(a) the equivalent force of interest.

(b) the equivalent effective rate of interest per annum.

(c) the equivalent nominal rate of interest per annum convertible

monthly. [3]

(ii) Explain why the nominal rate of interest per annum convertible monthly
calculated in part (i)(c) is less than the equivalent annual effective rate of
interest calculated in part (i)(b). [1]

(iii) Calculate, as a percentage to three decimal places, the effective annual

rate of discount offered by an investment that pays £159 in eight years’
time in return for £100 invested now. [1]

(iv) Calculate, as a percentage to three decimal places, the effective annual

rate of interest from an investment that pays 12% interest at the end of
each two-year period. [1]
[Total 6]

30 Subject CT1 September 2015 Question 5

An individual can obtain a force of interest per annum at time t , measured in

years, as given by the formula:

Ï0.03 + 0.005t 0 £ t £ 3
d (t ) = Ì
Ó 0.005 t >3

(i) Determine the amount the individual would need to invest at time t = 0
in order to receive a continuous payment stream of £5,000 per annum
from time t = 3 to time t = 6 . [5]

(ii) Determine the equivalent constant annual effective rate of interest earned
by the individual in part (i). [3]

(iii) Determine the amount an individual would accumulate from the

investment of £300 from time t = 0 to time t = 50 . [2]
[Total 10]

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31 Subject CT1 April 2016 Question 6

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï 0.06 0£t £4
Ô
d (t ) = Ì 0.10 - 0.01t 4<t £7
Ô 0.01t - 0.04 7<t
Ó

(i) Calculate, showing all working, the value at time t = 5 of £10,000 due for
payment at time t = 10 . [5]

(ii) Calculate the constant rate of discount per annum convertible monthly
which leads to the same result as in part (i). [2]
[Total 7]

32 Subject CT1 September 2016 Question 1

The nominal rate of interest per annum convertible quarterly is 5%.

Calculate, giving all the answers as a percentage to three decimal places:

(i) the equivalent annual force of interest. [1]

(ii) the equivalent effective rate of interest per annum. [1]

(iii) the equivalent nominal rate of discount per annum convertible monthly.
[2]
[Total 4]

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33 Subject CT1 September 2016 Question 2

The nominal rate of interest per annum convertible quarterly is 2%.

Calculate the present value of a payment stream paid at a rate of €100 per
annum, monthly in advance for 12 years. [4]

34 September 2016 Question 3

Describe the characteristics of a repayment loan (or repayment mortgage).

[3]

35 Subject CT1 September 2016 Question 6

At the beginning of 2015 a 182-day commercial bill, redeemable at £100, was

purchased for £96 at the time of issue and later sold to a second investor for
£97.50. The initial purchaser obtained a simple rate of interest of 3.5% per
annum before selling the bill.

(i) Calculate the annual simple rate of return which the initial purchaser
would have received if they had held the bill to maturity. [2]

(ii) Calculate the length of time in days for which the initial purchaser held
the bill. [2]

The second investor held the bill to maturity.

(iii) Calculate the annual effective rate of return achieved by the second
investor. [2]
[Total 6]

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 Batch 4

36 Subject CT1 September 2016 Question 12

The force of interest, d (t ) , is a function of time and at any time t (measured

in years) is given by:

 0.03 for 0  t  10

  t   a t for 10  t  20
b t for t  20


where a and b are constants.

The present value of £100 due at time 20 is 50.

(i) Calculate a . [5]

The present value of £100 due at time 28 is 40.

(ii) Calculate b. [4]

(iii) Calculate the equivalent annual effective rate of discount from time 0 to
time 28. [2]

A continuous payment stream is paid at the rate of e -0.04t per annum

between t = 3 and t = 7 .

(iv) (a) Calculate, showing all workings, the present value of the payment
stream.

(b) Determine the level continuous payment stream per annum from
time t = 3 to time t = 7 that would provide the same present value
as the answer in part (iv)(a) above. [8]
[Total 19]

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37 Subject CT1 April 2017 Question 1

Calculate the nominal rate of discount per annum convertible monthly which
is equivalent to:

(i) an effective rate of interest of 1% per quarter. [2]

(ii) a force of interest of 5% per annum. [2]

(iii) a nominal rate of discount of 4% per annum convertible every three

months. [2]
[Total 6]

38 Subject CT1 September 2017 Question 1

(i) Calculate the time in days for £6,000 to accumulate to £7,600 at:

(a) a simple rate of interest of 3% per annum.

(b) a compound rate of interest of 3% per annum effective.

(c) a force of interest of 3% per annum. [6]

Note: You should assume there are 365 days in a year.

(ii) Calculate the effective rate of interest per half-year which is equivalent to
a force of interest of 3% per annum. [1]
[Total 7]

39 Subject CT1 September 2017 Question 3

An investor is considering two investments. One is a 91-day deposit which

pays a compound rate of interest of 3% per annum effective. The second is
a government bill.

Calculate the annual simple rate of discount from the government bill if both
investments are to provide the same effective rate of return. [3]

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40 Subject CT1 Septmber 2017 Question 6

An investor has a choice of two 15-year savings plans, A and B, issued by a

company. In both plans, the investor pays contributions of $100 at the start
of each month and the contributions accumulate at an effective rate of interest
of 4% per annum before any allowance is made for expenses.

In plan A, the company charges for expenses by deducting 1% from the

annual effective rate of return.

In plan B, the company charges for expenses by deducting $15 from each of
the first year’s monthly contributions before they are invested. In addition it
deducts 0.3% from the annual effective rate of return.

Calculate the percentage by which the accumulated amount in Plan B is

greater than the accumulated amount in Plan A, at the end of the 15 years.
[6]

41 Subject CT1 Septmber 2017 Question 9

The force of interest, d (t ) , is a function of time and at any time t , measured

in years, is given by the formula:

Ï0.09 - 0.003t 0 £ t £ 10
d (t ) = Ì
Ó0.06 t > 10

(i) Calculate the corresponding constant effective annual rate of interest for
the period from t = 0 to t = 10. [4]

(ii) Express the rate of interest in part (i) as a nominal rate of discount per
annum convertible half-yearly. [1]

(iii) Calculate the accumulation at time t = 15 of £1,500 invested at time

t = 5. [3]

(iv) Calculate the corresponding constant effective annual rate of discount for
the period t = 5 to t = 15. [1]

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

payable at a rate of 10e0.01t from time t = 11 to time t = 15. [6]
[Total 15]

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SOLUTIONS TO PAST EXAM QUESTIONS

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

1 Subject CT1 April 2008 Question 9

(i) Value at time 5 of £1,000 due at time 10

The value at time 5 of £1,000 at time 10 is given by the expression:

Ê 7 ˆ Ê 10 ˆ
V5 = 1,000 exp Á - Ú (0.1 - 0.01t ) dt ˜ exp Á - Ú (0.01t - 0.04) dt ˜
Ë 5 ¯ Ë 7 ¯
Ê 7ˆ Ê 10 ˆ
= 1,000 exp Á - È0.1t - 0.005t 2 ˘ ˜ exp Á - È0.005t 2 - 0.04t ˘ ˜
Ë Î ˚5 ¯ Ë Î ˚7 ¯

= 1,000 e -0.455 + 0.375 e -0.1- 0.035

= 1,000e -0.08e -0.135
= 1,000e -0.215
= £806.54

(ii) Equivalent rate of interest convertible monthly

To find the value of i (12) , we must solve the equation:

60
Ê i (12) ˆ
806.54 Á1 + ˜ = 1,000 fi i (12) = 4.3077%
Ë 12 ¯

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(iii) Accumulated value of payment stream

The accumulated value of the payment stream at time 4 is:

( )
4 Ê4 ˆ 4
4
V4 = Ú 100e0.02t exp Á Ú 0.06ds ˜ dt = Ú 100e0.02t exp ÈÎ0.06s ˘˚t dt
0 Ë t ¯ 0
4
= Ú 100e0.02t e0.24 - 0.06t dt
0
4
0.24
4
-0.04t 0.24
È e -0.04t ˘
= 100e Úe dt = 100e Í- ˙
0 ÎÍ 0.04 ˙˚0

=
100e0.24
0.04
( )
1 - e -0.04 ¥ 4 = 469.9052

The accumulated value of the payment stream at time 12 is:

V12 = 469.9052 ¥ A(4,7) ¥ A(7,12)

Ê7 ˆ Ê 12 ˆ
= 469.9052 exp Á Ú (0.1 - 0.01t )dt ˜ exp Á Ú (0.01t - 0.04)dt ˜
Ë4 ¯ Ë7 ¯
Ê 7ˆ Ê 12 ˆ
= 469.9052 exp Á È0.1t - 0.005t 2 ˘ ˜ exp Á È0.005t 2 - 0.04t ˘ ˜
Ë Î ˚ 4¯ Ë Î ˚ 7 ¯

= 469.9052 e0.455 - 0.32 e0.24 -( -0.035)

= 469.9052 ¥ e0.135 ¥ e0.275
= 708.0615

2 Subject CT1 September 2008 Question 7

(i) Present value of £1,000 due at the end of 12 years

The value at time 0 of a payment of £1,000 at time 12 is given by:

 5   12 
1,000 exp     0.05  0.02t  dt  exp    0.15 dt 
   
 0   5 

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 Batch 4

Now:

 5   5
exp     0.05  0.02t  dt   exp   0.05t  0.01t 2  

 0

   0 

 exp  0.05  5  0.01 25   exp( 0.5)

and:

 
 12  12
exp    0.15 dt   exp  0.15t  5
 
 5 
 exp  0.15  12  0.15  5   exp( 1.05)

Therefore, the value at time 0 is:

1,000e 0.5e 1.05  1,000e 1.55

 £212.25

(ii) Equivalent rate of discount

Let d be the equivalent annual rate of discount. Then:

1,000(1  d )12  1,000e 1.55

 (1  d )12  e 1.55

Hence:

 
1
d  1  e 1.55
12
 12.12%

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3 April 2009 Question 2

(a) Interest-only loan

An interest-only loan is a loan repayable by a series of interest payments

during the term of the loan, followed by repayment of the full capital amount
at the end of the loan. The amount of capital outstanding therefore remains
fixed over the term of the loan.

If the interest rate is fixed, the amount of each interest cashflow is known in
advance. If the interest rate is variable, the interest payments will be unknown
at outset.

(b) Repayment loan

A repayment loan is a loan repayable by a series of payments, each of which

includes partial repayment of the loan capital in addition to interest. This
means the amount of capital outstanding reduces over the term of the loan.

If the interest rate is fixed over the term of the loan, the repayments will all be
for fixed amounts. If the interest rate varies, so will the repayment amounts.

4 Subject CT1 September 2009 Question 1

(a) Length of time for which the initial purchaser held the bill

If the first investor sells the bill at time t years, his equation of value is:

Ê 97.89 ˆ
96 ¥ 1.05t = 97.89 fi t ln1.05 = ln Á
Ë 96 ¯˜
fi t = 0.400 years = 146 days

(b) Annual simple rate of return achieved by the second investor

Let i be the annual simple rate of return earned by the second investor:

Ê 36 ˆ
97.89 Á1 + i = 100 fi i = 21.85%
Ë 365 ˜¯

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5 Subject CT1 September 2009 Question 5

(i) Values of a and b

100 A(0,5) = 130 fi A(0,5) = 1.3

100 A(0,10) = 200 fi A(0,10) = 2

Since d (t ) = a + bt 2 , we have:

n n
2
Ú d (t ) dt Ú (a + bt ) dt Èat + 1 bt 3 ˘
n
an + 31 bn 3
A(0, n ) = e 0 =e 0 = eÎ 3 ˚0 =e

Hence:

5a + 125
3
b = ln1.3 (1)
1,000
10a + 3
b = ln 2 (2)

(2) - 2 ¥ (1) fi 250b = ln 2 - 2ln1.3 = 0.16842 fi b = 0.0006737

(1) fi a= 1
5 (ln1.3 - 125
3 )
b = 0.04686

(ii) Constant rate of interest convertible monthly

( ) ( )
60
i (12)
A(0,5) = 1.3 = 1 + 12
fi i (12) = 12 1.31/ 60 - 1 = 5.259%

(iii) Constant force of interest

A(5,10) =
A(0,10)
A(0,5)
fi e 5d = 2
1.3
fi d = 1
5
2
( ) = 8.616%
ln 1.3

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6 Subject CT1 April 2010 Question 11

(i) Expressions for the present value

If 0 £ t < 5 , the PV is:

È t ˘ Ï t ¸
v (t ) = exp Í - Ú 0.04 + 0.02s ds ˙ = exp Ì - È0.04s + 0.01s 2 ˘ ˝
Î ˚
ÎÍ 0 ˙˚ Ó ˛
0

{
= exp - È0.04t + 0.01t 2 ˘
Î ˚ }
If t ≥ 5 , the PV is:

ÏÔ 5 ¸Ô ÏÔ t ¸Ô
v (t ) = exp Ì - Ú 0.04 + 0.02s ds ˝ exp Ì - Ú 0.05 ds ˝
ÓÔ 0 Ô˛ ÓÔ 5 ˛Ô

{
= v (5) exp - ÎÈ0.05s ˚˘5
t
}
From the expression for 0 £ t < 5 , we have v (5) = exp {-0.45} . Hence:

v (t ) = exp {-0.45} exp {-0.05(t - 5)} = exp {-0.05t - 0.2}

(ii)(a) Present value of £1,000 due at time 17

Using the second expression from part (i), with t = 17 :

1,000v (17) = 1,000 exp {-0.2 - 0.05 ¥ 17} = 1,000e -1.05 = £349.94

(ii)(b) Rate of interest convertible monthly

Since v (17) = e -1.05 , we have:

e -1.05 = (1 + i )-17 fi i = 0.063712

Ê 1
ˆ
fi i (12) = 12 Á1.063712 12 - 1˜ = 6.1924%
Ë ¯

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(iii) Present value of the payment stream

The PV of this payment stream at time 6 is:

ÔÏ Ô¸
10 t 10
V6 = Ú 10e
0.01t
exp Ì - Ú 0.05 ds ˝ dt = Ú 10e0.01t exp {-0.05(t - 6)} dt
6 ÔÓ 6 Ô˛ 6

10
-0.04t 0.3
= Ú 10e e dt
6

10
È e -0.04t ˘
= 10e0.3 Í - ˙
ÎÍ 0.04 ˙˚ 6

=
10e0.3
0.04
(
-e -0.4 + e -0.24 )
= 39.24978

Using the second expression from part (i) with t = 6 , the PV at time 0 is:

V0 = 39.24978v (6) = 39.24978 exp {-0.5} = 23.806

7 Subject CT1 September 2010 Question 8

(i) Derive expressions for v(t)

We have the following forces of interest:

0.05 + 0.001t 0.05 Force of interest

0 20 Time

For 0 £ t £ 20 , we have:

t
- Ú 0.05 + 0.001s ds
v (t ) = e 0

2 t
= e -[0.05s + 0.0005s ]0

2
= e -0.05t - 0.0005t (1)

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For t > 20

20 t
- Ú 0.05 + 0.001s ds - Ú 0.05 ds
v (t ) = e 0 e 20 (2)

The first integral is v (20) and so we can use equation (1) with t = 20 :
t
- Ú 0.05 ds
-0.05(20) - 0.0005(20)2
v (t ) = e e 20

-[0.05s ]t20
= e -1.2 e
= e -1.2 e -0.05t +1
= e -0.05t - 0.2

(ii)(a) Present value of £100 due at the end of 25 years

The present value is given by:

PV = 100v (25) = 100e -0.05(25) - 0.2 = 100e -1.45 = 23.457 , ie £23.46

(ii)(b) Equivalent rate of discount convertible quarterly

We have:

4 ¥ 25
Ê d (4) ˆ
100 Á1 - ˜ = 23.457
Ë 4 ¯

100
Ê d (4) ˆ
fi Á1 - ˜ = 0.23457 fi d (4) = 4 È1 - 0.234750.01 ˘ = 5.758% pa
Ë 4 ¯ Î ˚

(iii) Accumulated value of payment stream

We have:

– 0.015t
30e Payment stream
0.05 Force of interest

20 25 Time

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The accumulated value of this payment stream at time 25 is given by:

25
25 Ú 0.05 ds
AV25 = Ú 30e -0.015t e t dt
20
25 25
= Ú 30e -0.015t e[0.05s ]t dt
20
25
= Ú 30e -0.015t e1.25 - 0.05t dt
20
25
= Ú 30e1.25 - 0.065t dt
20
25
È 30 ˘
=Í e1.25 - 0.065t ˙
Î -0.065 ˚20
30 È -0.375
=- e - e -0.05 ˘ = 121.819 , ie £121.82
0.065 Î ˚

8 Subject CT1 April 2011 Question 1

(i) The accumulation of £1,000 from time 3 to time 7

We calculate A(3,5) as:

5 2
A(3,5) = e Ú3
0.04 + 0.003t dt [0.04t + 0.003 t 3 ]53
=e 3 = e[0.325 - 0.147] = e0.178

We calculate A(5,7) as:

A(5,7) = e Ú5
0.01+ 0.03tdt [0.01t + 0.03 t 2 ]75
=e 2 = e[0.805 - 0.425] = e0.380

Therefore:

A(3,7) = A(3,5) ¥ A(5,7) = e0.178 ¥ e0.380 = e0.558 = 1.74717

So, £1,000 accumulates to £1,000 ¥ 1.74717 = £1,747.17 .

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(ii) The equivalent discount rate convertible monthly

We use the following relationship:

( )
(12) 48
1,747.17 1 - d = 1,000
12

Rearranging:

1
È 48 ˘
1

(1 - )d (12)
12
Ê 1,000 ˆ 48
=Á
Ë 1,747.17 ¯˜
fi d (12)
= 12 Í1 - Ê 1,000 ˆ ˙ = 0.138692
Í ÁË 1,747.17 ˜¯ ˙
Î ˚

So the annual rate of discount convertible monthly is 13.87%.

9 Subject CT1 September 2011 Question 1

The discount factor for a 91-day period using a simple rate of discount of 8%
is:

91
1 - nd = 1 - 365 ¥ 0.08 = 0.980055

The discount factor for the same period using an effective rate of interest is:

- 365
91
(1 + i )

Equating the two:

- 365
91
(1 + i ) = 0.980055 fi i = 8.42% pa

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10 Subject CT1 September 2011 Question 3

A timeline showing the cashflows involved is shown below:

5,000 pa
payable monthly
by government

8,000 pa 3,000 pa
Q per quarter payable monthly payable monthly

61 65 68 78

The PV (at age 61) of the quarterly payments made to purchase the annuity
is:

4Qa(4)
4

The PV (at age 61) of the annuity payments received is:

8,000v 4a(12) + 3,000v 7a(12)

3 10

Equating these:

4Qa(4) = 8,000v 4a(12) + 3,000v 7a(12)

4 3 10

Calculating at an annual effective rate of 5% gives:

4Q ¥ 3.65609 = 8,000(1.05)-4 ¥ 2.79645 + 3,000(1.05)-7 ¥ 7.92931

14.62434Q = 35,310.820
Q = £2,414.52

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11 Subject CT1 September 2011 Question 6

(i) Values of a and b

Since £45 at time 0 accumulates to £55 by time 5, we have:

5
Ú (a + bt ) dt
45 e0 = 55

Carrying out the integration and rearranging:

5
Èat + 1 bt 2 ˘
45 eÎ 2 ˚0 = 55

55 Ê 55 ˆ
fi e5a +12.5b = fi 5a + 12.5b = ln Á ˜ (1)
45 Ë 45 ¯

We also know that £55 at time 5 accumulates to £120 by time 10, so:

10
Ú (a + bt ) dt
55 e 5 = 120

Again, carrying out the integration and simplifying:

10
Èat + 1 bt 2 ˘
55 eÎ 2 ˚5 = 120

120 Ê 120 ˆ
fi e(10a + 50b ) -(5a +12.5b ) = fi 5a + 37.5b = ln Á (2)
55 Ë 55 ˜¯

Subtracting Equation (1) from Equation (2):

Ê 120 ˆ Ê 55 ˆ
25b = ln Á - ln Á ˜ fi b = 0.0231795
Ë 55 ˜¯ Ë 45 ¯

Rearranging Equation (1) and substituting in our value for b :

1 Ê Ê 55 ˆ ˆ
a= ln - 12.5b˜ fi a = -0.0178146
5 ÁË ÁË 45 ˜¯ ¯

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(ii) Equivalent constant force of interest

We want £45 at time 0 to accumulate to £120 at time 10 at a constant force of

interest d :

1 Ê 120 ˆ
45e10d = 120 fi d = ln = 9.808%
10 ÁË 45 ˜¯

12 Subject CT1 April 2012 Question 8

(i) Present value of an investment of £1,000 due at time 10

5 2 8 10

PV = £1,000e Ú0
- 0.04 + 0.003t dt - Ú5 0.01+ 0.03tdt - Ú8 0.02dt
e e
-[0.04t + 0.003 t 3 ]05 -[0.01t + 0.03 t 2 ]58 -[0.02t ]10
= £1,000e 3 e 2 e 8

-0.325 -0.615 -0.04

= £1,000e e e
-0.98
= £1,000e
= £375.31

(ii) Equivalent discount rate convertible quarterly

( )
40
1,000 1 - d ( 4) = 375.31 fi d (4) = 9.681%
4

(iii) Present value of payment stream

t
18 0.01t - Ú10 0.02ds
Value at time 10 = Ú10 100e e dt
18 t
0.01t -ÈÎ0.02s ˚˘ 10
= Ú10 100e e dt
18 0.01t -(0.02t - 0.2)
= Ú10 100e e dt
18 0.2 - 0.01t
= Ú10 100e dt
18
= 100e0.2 Ú e -0.01t dt
10
18
È e -0.01t ˘
= 100e0.2 Í ˙
ÎÍ -0.01 ˚˙10
= 849.6958

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We then need to discount this value from time 10 to time 0:

PV = 849.6958 ¥ v (10)
= 849.6958 ¥ e -0.98
= 318.900

13 Subject CT1 September 2012 Question 1

Equating discount factors using an effective rate of interest of 4% pa we get:

(1 - )
91
91 - 365
365
¥ d = 1.04 fi d = 3.903% pa

14 Subject CT1 September 2012 Question 2

(i) Force of interest

4 -4
Ê d (4) ˆ -1 Ê 0.08 ˆ
Á1 - ˜ = 1 - d = v = (1 + i ) fi i = Á1 - - 1 = 8.4166%
Ë 4 ¯ Ë 4 ˜¯

fi d = ln(1 + i ) = ln(1.084166) = 8.081%

(ii) Rate of interest

i = 8.417%

(iii) Nominal rate of discount

d (12) = 12 ÊÁ1 - (1 + i ) 12 ˆ˜ = 12 ÊÁ1 - 1.084166 12 ˆ˜ = 8.054%

-1 -1
Ë ¯ Ë ¯

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15 Subject CT1 September 2012 Question 8

(i) Discount factor

If 0 £ t £ 9 :

Ê t ˆ Ê È 0.01 2 ˘ ˆ
t
v (t ) = exp Á - Ú 0.03 + 0.01u du ˜ = exp Á - Í0.03u + u ˙ ˜
Ë 0 ¯ ËÁ Î 2 ˚0 ¯˜

= exp( -0.03t - 0.005t 2 )

If t > 9 :

Ê t ˆ
v (t ) = exp( -0.03 ¥ 9 - 0.005 ¥ 92 ) exp Á - Ú 0.06 du ˜
Ë 9 ¯

(
= exp( -0.27 - 0.405) exp - ÈÎ0.06u ˘˚9
t
)
= exp( -0.675) exp( -0.06t + 0.54)
= exp( -0.06t - 0.135)

(ii)(a) Present value

We can use the expression from part (i) to answer this question:

PV = 5,000v (15) = 5,000 exp( -0.06 ¥ 15 - 0.135) = 5,000e -1.035 = £1,776.13

(ii)(b) Equivalent constant force of interest

Equating the PV expression from (ii)(a) to a constant force of interest PV

expression, we get:

5,000e -1.035 = 5,000e -15d fi 15d = 1.035 fi d = 6.9%

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(iii) Present value of the payment stream

The present value of this payment stream at time 11 is given by:

( )
15 15
-0.02t t -0.02t -0.06t + 0.66
PV11 = Ú 100e exp - ÎÈ0.06u ˚˘11 dt = Ú 100e e dt
11 11
15
15
-0.08t
È e -0.08t ˘
= 100e0.66 Úe dt = 100e0.66 Í ˙
11 ÍÎ -0.08 ˙˚11

=
-0.08
e (
100e0.66 -1.2
)
- e -0.88 = 274.713

However, we require the present value at time 0, so we again need to use the
expression from part (i) of the question:

PV0 = 274.713v (11) = 274.713e -0.06 ¥11- 0.135 = 274.713e -0.795

= 124.06

16 Subject CT1 April 2013 Question 5

(i) Total accumulation at time 10

The investment of £50 made at t = 7 will accumulate to:

Ê 10 ˆ
50 exp Á Ú 0.07 dt ˜ = 50e0.21 = 61.6839
Ë7 ¯

The investment of £100 made at t = 0 will accumulate to:

Ê6 10 ˆ
100 exp Á Ú 0.1 - 0.005t dt + Ú 0.07 dt ˜
Ë0 6 ¯
Ê 6 10 ˆ
= 100 exp Á È 0.1t - 0.0025t 2 ˘ + ÈÎ0.07t ˘˚ 6 ˜ = 100 e0.79 = 220.3396
Ë Î ˚ 0 ¯

So the total accumulated value is:

100 e0.79 + 50 e0.21 = £282.02

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(ii) Present value of continuous payment stream

The value at time t = 12 of the whole payment stream is:

15
0.05t
Ê t ˆ
PV12 = Ú 50 e exp Á - Ú 0.07 ds ˜ dt
12 Ë 12 ¯

( )
15
0.05t t
= Ú 50 e exp -[0.07s ]12 dt
12
15
0.05t -0.07t + 0.84
= Ú 50 e e dt
12
15
È e0.84 - 0.02t ˘
( )
15
0.84 - 0.02t 0.6 0.54
= 50 Ú e dt = 50 Í ˙ = 2,500 e - e
12 ÎÍ -0.02 ˙˚12

So the value at time t = 6 is:

Ê 12 ˆ
(
PV6 = PV12 ¥ exp Á - Ú 0.07 dt ˜ = 2,500 e0.6 - e0.54 ¥ e -0.07 ¥ 6
Ë 6 ¯
)
(
= 2,500 e0.18 - e0.12 )
Hence the value at t = 0 is:

Ê 6 ˆ
PV0 = PV6 ¥ exp Á - Ú 0.1 - 0.005t dt ˜
Ë 0 ¯

( Ê
)
6ˆ
= 2,500 e0.18 - e0.12 ¥ exp Á - È0.1t - 0.0025t 2 ˘ ˜
Ë Î ˚ 0¯

= 2,500 (e 0.18
- e0.12 )¥e -0.51

= 2,500 (e -0.33
- e -0.39)
= £104.67

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17 Subject CT1 September 2013 Question 1

(i)(a) Effective rate of discount

i 0.045
d= = = 4.306%
1 + i 1.045

(i)(b) Nominal rate of discount

1 1
- 12 - 12
d (12) = 12(1 - (1 + i ) ) = 12(1 - 1.045 ) = 4.394%

(i)(c) Nominal rate of interest

1 1
i (4) = 4((1 + i ) 4 - 1) = 4(1.045 4 - 1) = 4.426%

(i)(d) Effective rate of interest

Equating accumulation factors over a one-year period:

1
(1 + i ) 5 = 1.045 fi i = 1.0455 - 1 = 24.62%

(ii) Why is it higher?

Effective discount, d , is equivalent to an interest payment of d at the start

of the year, ie at time 0. Nominal discount convertible monthly, d (12) , is
d (12)
equivalent to interest payments of 12
at the start of each month.

In this question we have d = 4.3062% and d (12) = 4.3936% , so for an

investment of £100, we would have interest of £4.31 (4.3062% of £100) at the
4.3936
start of the year or £0.37 ( 12
at the start of each month). Payments
received later need to be higher to compensate for the fact that the payments
are being received later. In this question this means that 12 ¥ £0.37 > £4.31.
In general, d (12) > d .

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18 Subject CT1 September 2013 Question 10 (part)

(i) Accumulated values

Ê t2 ˆ
A(t1, t2 ) = exp Á Ú 0.05 + 0.002t dt ˜
ÁË t ˜¯
1

t2
= exp È0.05t + 0.001t 2 ˘
Î ˚t1

(
= exp 0.05(t2 - t1 ) + 0.001(t22 - t12 ) )
(a) From time 0 to time 7

( )
A(0,7) = exp 0.05(7 - 0) + 0.001(72 - 0) = e0.399 = 1.4903

(b) From time 0 to time 6

( )
A(0,6) = exp 0.05(6 - 0) + 0.001(62 - 0) = e0.336 = 1.3993

(c) From time 6 to time 7

A(0,7) e 0.399
A(6,7) = = = e0.063 = 1.0650
A(0,6) e 0.336

(iv) Present value

The present value of this payment stream at time 3 is given by:

10
-0.01t + 0.001t 2
Ê t ˆ
PV3 = Ú 30e exp Á - Ú 0.05 + 0.002u du ˜ dt
3 Ë 3 ¯

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We can proceed as follows:

10
-0.01t + 0.001t 2 Ê t ˆ
PV3 = Ú 30e exp Á - È0.05u + 0.001u 2 ˘ ˜ dt
3
Ë Î ˚3 ¯
10
( 2
-0.01t + 0.001t 2 - 0.05( t - 3) + 0.001( t - 9) ) dt
= Ú 30e e
3
10
-0.06t
= 30e0.159 Úe dt
3
10
0.159
È e -0.06t ˘
= 30e Í ˙
ÎÍ -0.06 ˙˚3
= 167.913

Ê 3 ˆ
PV0 = 167.913 exp Á - Ú 0.05 + 0.002t dt ˜
Ë 0 ¯
Ê 3ˆ
= 167.913 exp Á - È0.05t + 0.001t 2 ˘ ˜
Ë Î ˚ 0¯

= 167.913e -0.159
= 143.229

19 Subject CT1 April 2014 Question 3

(i) Nominal rate of interest convertible half-yearly

We find first the effective annual rate of interest:

900 (1 + i )
1/ 3
= 925 fi i = 0.085670

i (2) = 2 È(1 + i ) - 1˘ = 2 È(1.085670) - 1˘ = 8.39% pa (3 SF)

1/ 2 1/ 2
ÎÍ ˚˙ ÍÎ ˙˚

(ii) Nominal rate of discount convertible quarterly

d (4) = 4 È1 - (1 + i )
-¼ ˘
= 4 È1 - (1.085670)
-¼ ˘
= 8.14% pa (3 SF)
ÎÍ ˚˙ ÎÍ ˚˙

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(iii) Simple rate of interest

Ê 1 ˆ
900 Á1 + i ˜ = 925 fi i = 8.33% pa (3 SF)
Ë 3 ¯

20 Subject CT1 April 2014 Question 11

(i) Present value of continuous payment stream

The value at time 4 of the payment stream is:

PV4 = 3,000 Èad = 7% + e -2 ¥ 0.07 ¥ a d = 9% ˘

Î 2 4 ˚

Evaluating the functions:

1 - e -2d 1 - e -4d
a d = 7% = = 1.866311 a d = 9% = = 3.359152
2 d 4 d

fi PV4 = 3,000 È1.866311 + e -2 ¥ 0.07 ¥ 3.359152˘ = 14,359.852

Î ˚

We now need to discount this back to time zero. The discount factor from time
four to time zero will be:

4
- Ú 0.03 + 0.01s ds - È0.03s + 0.005s 2 ˘
4
- ÈÎ0.12 + 0.08˘˚
v (4) = e 0 =e Î ˚0 =e = e -0.2

So the amount that would need to be invested at time zero is:

PV0 = e -0.2 ¥ 14,359.852 = $11,756.85

(ii) Equivalent constant rate

We now need to solve the equation of value for the equivalent constant rate:

PV0 = 3,000v 4a6 = 11,756.852

1- v6
ie: v4 ¥ = 3.918951
d

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We will use trial and improvement to find a solution to this equation:

i = 0.06 , LHS = 4.0107

i = 0.07 , LHS = 3.7622

So, using linear interpolation between these values, we find that:

4.0107 - 3.918951
0.06 + ¥ (0.07 - 0.06) = 0.063692
4.0107 - 3.7622

So the equivalent constant annual effective rate of interest is 6.4% pa.

21 Subject CT1 September 2014 Question 3

(i) Annual effective rate of interest

365
Ê 100 ˆ
98.83 (1 + i )
91/365 91
= 100 fi 1+ i = Á fi i = 4.834% pa
Ë 98.83 ˜¯

(ii) Equivalent simple rate

Ê 91i ˆ
98.83 Á1 + = 100 fi i = 4.748% pa
Ë 365 ˜¯

22 Subject CT1 September 2014 Question 5

1- v5 1 - 1.05 -5 1 - 1.05 -5
(i) a(12) = = = = 4.42782
5 i (12) 12 È(1.05 )
1/12
- 1˘ 0.0488895
ÎÍ ˚˙

1 - 1.05-15
(ii) 4| a15 = v 4 ¥ a15 = 1.05-4 ¥ = 8.53937 .
0.05

1 - 1.05 -10
a10 - 10v 10 -1
- 10 ¥ 1.05 -10
-
(iii) (Ia )10 =
d
= 1 1.05
ln1.05
= 40.35012

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1 - 1.05 -10
a10 - 10v 10 - 10 ¥ 1.05 -10
(iv) (Ia) 10
=
d
= ln1.05
ln1.05
= 36.36135

(v) Decreasing annuity

PV = 12 + 11v + 10v 2 +  + 3v 9

( ) (
= 13 1 +  + v 9 - 1 + 2v + 3v 2 +  + 10v 9 )
= 13a10 - (Ia)10

1 - 1.05 -10
-10 - 10 ¥ 1.05 -10
1 - 1.05 -1
= 13 ¥ - 1 - 1.05
1 - 1.05 -1 1 - 1.05 -1
= 13 ¥ 8.10782 - 41.34247
= 64.05921

23 Subject CT1 September 2014 Question 7

(i) Present value of a unit sum due at time 28

The present value is:

10 20 28
- Ú 0.03 dt - Ú 0.003t dt - Ú 0.0001t 2 dt
PV = e 0 ¥e 10 ¥e 20

Evaluating the integrals:

10
10
Ú 0.03 dt = ÈÎ0.03t ˘˚0 = 0.3
0

( )
20 20
Ú 0.003t dt = È0.0015t 2 ˘ = 0.0015 202 - 102 = 0.45
Î ˚10
10

and:

28
È t3 ˘
( )
28
2 0.0001 3 3
Ú 0.0001t dt = Í0.0001 3 ˙ = 3 28 - 20 = 0.46507
20 Í
Î ˙
˚20

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So the present value is:

PV = e -0.3 ¥ e -0.45 ¥ e -0.46507 = e -1.21507 = 0.29669

(ii)(a) Equivalent constant force of interest

We want the value of d that satisfies the equation:

e -28d = 0.29669

ln 0.29669
Solving this equation, we find that d = = 0.04340 , or 4.34% pa.
-28

(ii)(b) Equivalent annual effective rate of discount

We have:

d = 1 - v = 1 - e -d = 1 - e -0.04340 = 0.04247

The rate of discount is 4.247% pa.

(iii) Present value of the payment stream

The present value at time zero is:

7 7
PV = Ú e -0.04t e -0.03t dt = Ú e -0.07t dt
3 3
7
È e -0.07t ˘ e -0.49 - e -0.21
=Í ˙ = = 2.82797
ÎÍ -0.07 ˙˚3 -0.07

24 Subject CT1 April 2015 Question 2

(a) Simple interest

Working in years, we have the equation:

3, 000(1 + 0.04t ) = 3, 800

Solving this equation, we find that t = 6.6667 years.

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Converting this to days, we find that:

t = 6.6667 ¥ 365 = 2, 433.33 days

(b) Compound interest

Again, working in years, the equation is now:

3, 000 ¥ 1.04t = 3, 800

Taking logs of both sides gives:

log 3, 000 + t log1.04 = log 3, 800

Rearranging this, we find that:

log 3, 800 - log 3, 000

t= = 6.02714
log1.04

Again, converting this into days we have:

t = 6.02714 ¥ 365 = 2,199.91 days

25 Subject CT1 April 2015 Question 3

(i) Length of time held

We have:

96.5 ¥ 1.04t = 98

Taking logs of both sides of this equation gives:

log 96.5 + t log1.04 = log 98

Rearranging this, we find that:

log 98 - log 96.5

t= = 0.39327
log1.04

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Converting this to days, we find that the length of time is:

t = 0.39327 ¥ 365 = 143.545

or about 144 days.

(ii) Annual simple rate of return

Since the original investor held the bill for 144 days, the bill was held by the
second investor for 182 - 144 = 38 days. So the simple rate of return
experienced by the second investor is the solution of the equation:

Ê 38 ˆ
98 Á1 + ¥ i = 100
Ë 365 ˜¯

Solving this equation, we find that:

Ê 100 ˆ 365
i =Á - 1˜ ¥ = 0.19603
Ë 98 ¯ 38

(iii) Annual effective rate of return

The equation of value is now:

98 (1 + i )
38/365
= 100

Taking logs of both sides of this equation, we obtain:

38
log 98 + log (1 + i ) = log100
365

Rearranging this, we find that:

log100 - log 98
log (1 + i ) = = 0.19405
38 / 365

This gives:

i = e0.19405 - 1 = 0.21416

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26 Subject CT1 April 2015 Question 5

A yield of 6% per annum convertible half-yearly is equivalent to an effective

half-yearly rate of 3%. So the effective annual rate of interest is:

1.032 - 1 = 6.09%

The accumulated value of the cashflows is:

120 Ès4 (1 + i ) + s(4) (1 + i ) + s(12) ˘

8 4
ÎÍ 4 4 ˚˙

Evaluating the various factors using an effective interest rate of 6.09% pa, we
obtain:

s4 =
(1 + i )4 - 1 = 1.06094 - 1
= 4.647231
d 0.0609 / 1.0609

d (4) = 4 È1 - 1.0609-1/4 ˘ = 0.058683

Î ˚

d (12) = 12 È1 - 1.0609-1/12 ˘ = 0.058972

Î ˚

s(4) =
(1 + i )4 - 1 = 1.06094 - 1 = 4.545960
4 d (4) 0.058683

and:

s(12) =
(1 + i )4 - 1 = 1.06094 - 1 = 4.523657
4 d (12) 0.058972

Putting all this together gives an accumulated value of:

120 È 4.647231 ¥ 1.06098 + 4.545960 ¥ 1.06094 + 4.523657 ˘

Î ˚
= 2,128.7742

or about £2,128.77.

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27 Subject CT1 April 2015 Question 10

(i) Discount factor

If 0 £ t < 4 , then the discount factor is calculated at a constant force of 8% pa

for t years. So:

È t ˘ È t ˘
v (t ) = exp Í - Ú d (s ) ds ˙ = exp Í - Ú 0.08 ds ˙ = e -0.08t
ÎÍ 0 ˙˚ ÎÍ 0 ˙˚

Setting t = 4 , we see that v (4) = e -0.32 .

For values of t between 4 and 9, we have:

È Ê4 t ˆ˘
v (t ) = exp Í - Á Ú 0.08 ds + Ú 0.12 - 0.01s ds ˜ ˙
Í Ë0 ¯ ˙˚
Î 4

È Êt ˆ˘
= v (4) exp Í - Á Ú 0.12 - 0.01s ds ˜ ˙
Í Ë4 ¯ ˙˚
Î

Simplifying this expression:

È Êt ˆ˘
v (t ) = exp ÎÈ -0.32 ˚˘ exp Í - Á Ú 0.12 - 0.01s ds ˜ ˙
Í Ë4 ¯ ˙˚
Î
È t ˘
= exp ÎÈ -0.32 ˚˘ exp Í - È0.12s - 0.005s 2 ˘ ˙
Î Î ˚ 4˚

= exp ÈÎ -0.32 ˘˚ exp È -0.12t + 0.005t 2 + 0.48 - 0.08 ˘

Î ˚

= exp ÈÎ -0.32˘˚ exp È0.4 - 0.12t + 0.005t 2 ˘

Î ˚
2
= e0.08 - 0.12t + 0.005t

Setting t = 9 , we see that:

v (9) = e0.08 - 0.12¥ 9 + 0.005 ¥ 81 = e -0.595

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Finally, for values of t > 9 , we have:

È Ê4 9 t ˆ˘
v (t ) = exp Í - Á Ú 0.08 ds + Ú 0.12 - 0.01s ds + Ú 0.05 ds ˜ ˙
Í Ë0 ¯ ˙˚
Î 4 9

È t ˘
= v (9) exp Í - Ú 0.05 ds ˙
ÍÎ 9 ˙˚

= exp ÎÈ -0.595 ˚˘ exp ÈÎ -0.05 (t - 9) ˘˚

= e -0.145 - 0.05t

Putting all these results together, we have the following:

Ïe -0.08t 0£t £4
Ô
Ô 2
v (t ) = Ìe0.08 - 0.12t +0.005t 4<t £9
Ô -0.145 -0.05t
ÔÓe t >9

(ii) Present value of the payment stream

The present value at time 0 of the payment stream is:

12 12
Ú 100e
0.03t
v (t ) dt = Ú 100e
0.03t
e -0.145 - 0.05t dt
10 10
12
= 100e -0.145 Ú e -0.02t dt
10
12
È e -0.02t ˘
= 100e -0.145 Í ˙
ÍÎ -0.02 ˙˚10
= 5, 000e -0.145 (e -0.2 - e -0.24 )
= 138.85

(iii) Annuity

The present value of the annuity is:

1, 000 ÈÎv (1) + v (2) + v (3)˘˚ = 1, 000 Èe -0.08 + e -0.16 + e -0.24 ˘ = £2, 561.89
Î ˚

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28 Subject CT1 September 2015 Question 1

(a) Price

The price of £100 nominal will be:

P = 100v 91 365
= 100 ¥ 1.03 - 91 365
= £99.27

(b) Annual rate of simple discount

Equating discount factors gives:

91
1.03 - 91 365 = 1 - d
365

Rearranging this gives:

d=
365
91
( )
1 - 1.03 - 91 365 = 2.945%

29 Subject CT1 September 2015 Question 2

(i)(b) Effective rate of interest

0.055 = 12 È1 - (1 + i )-1 12 ˘
Î ˚

Rearranging this gives:

-12
Ê 0.055 ˆ
(1 + i ) = Á1 - fi i = 0.0566742 = 5.667% pa
Ë 12 ˜¯

(i)(a) Force of interest

Using the full figure from part (i)(b) we have:

d = ln1.0566742 = 5.513% pa

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(i)(c) Nominal interest convertible monthly

i (12) = 12 È1.05667421 12 - 1˘ = 5.525% pa

Î ˚

(ii) Explain

An annual nominal rate of interest convertible monthly, i ( p ) , is equivalent to

receiving 12 payments of i (12) p at the end of each month. Whereas an
annual effective rate is equivalent to receiving a single payment of i at the
end of the year.

Since interest is earned on the payments received earlier in the year this
means that a smaller rate is required to accumulate them to the same amount,
i , at the end of the year.

(iii) Annual effective rate

The equation of value is:

159(1 - d )8 = 100

Rearranging gives:

18
Ê 100 ˆ
d = 1- Á = 5.632% pa
Ë 159 ˜¯

(iv) Annual effective rate

Equating accumulation factors over two years gives:

(1 + i )2 = 1.121

fi i = 1.12½ - 1 = 5.830% pa

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30 Subject CT1 September 2015 Question 5

(i) Present value of payment stream

The value of this payment stream at time 3 is given by:

t
6 - Ú 0.005 ds
PV3 = Ú 5,000e 3 dt
3
6 t
= Ú 5,000e -[0.005s ]3 dt
3
6
= Ú 5,000e -0.005t + 0.015 dt
3
6
È 5,000 -0.005t + 0.015 ˘
=Í e ˙
Î -0.005 ˚3
= -1,000,000 Èe -0.015 - e0 ˘
Î ˚
= £14,888

Hence, the value at time t = 0 is:

3
- Ú 0.03 + 0.005t dt
PV0 = 14,888e 0

3
- È0.03t + 0.0025t 2 ˘
Î ˚0
= 14,888e
= 14,888e -0.1125
= £13,304

(ii) Equivalent constant annual effective rate

The present value at time 0 is given by:

PV0 = 5,000v 3a3

Equating this gives:

5,000v 3a3 = 13,304

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Using trial and error:

i = 2% fi LHS = 13,723
i = 3% fi LHS = 13,136

Interpolating between these gives:

13,304 - 13,723
i = 2% + (3% - 2%) = 2.71% pa
13,136 - 13,723

(iii) Accumulation

AV = 300 A(0,3)A(3,50)
3 50
Ú 0.03 + 0.005t dt Ú 0.005 dt
= 300e 0 e3
3
È0.03t + 0.0025t 2 ˘ È0.005t ˘50
= 300e Î ˚0 Î
e ˚3

0.1125 0.235
= 300e e
= £424.66

31 Subject CT1 April 2016 Question 6

(i) Value at time 5 of £10,000 due at time 10

We need to discount back from time 10 to time 7 using the force function
d (t ) = 0.01t - 0.04 , and then back from time 7 to time 5 using the force
function d (t ) = 0.10 - 0.01t :

È 10 ˘ È 7 ˘
PV = 10,000exp Í - Ú 0.01t - 0.04 dt ˙ ¥ exp Í - Ú 0.10 - 0.01t dt ˙
ÎÍ 7 ˚˙ ÎÍ 5 ˙˚

Evaluating the first of these integrals gives:

10 10
Ú 0.01t - 0.04 dt = ÈÎ0.005t - 0.04t ˘
2
˚7
7
= (0.5 - 0.4 ) - (0.245 - 0.28 ) = 0.135

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Evaluating the second of these integrals gives:

7 7
Ú 0.10 - 0.01t dt = ÈÎ0.10t - 0.005t
2˘
˚5
5
= (0.7 - 0.245) - (0.5 - 0.125) = 0.08

So the present value is:

PV = 10,000e -0.135e -0.08 = 10,000e -0.215 = £8,065.41

(ii) Equivalent constant rate of discount convertible monthly

We have the equation of value (assuming a constant rate of interest) of:

10,000v 5 = 8,065.41

From this we find that:

v = 0.957911

12
È d (12) ˘
Using Í1 - ˙ = 1 - d = v = 0.957911 and rearranging, we find that:
ÎÍ 12 ˚˙

d (12) = 12 È1 - 0.9579111/12 ˘ = 0.042923

Î ˚

So the equivalent constant rate of discount convertible monthly is 4.29% pa.

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32 Subject CT1 September 2016 Question 1

(i) Equivalent annual force of interest

Expressing the accumulation factor for a quarter of a year in two different

ways:

ed /4 = 1.0125

Solving this equation, we find that:

d = 4log1.0125 = 0.04969

So the equivalent annual force is 4.969% pa.

(ii) Equivalent annual rate

We have:

4
Ê 0.05 ˆ
1 + i = Á1 + = 1.05095
Ë 4 ˜¯

So the equivalent annual effective rate of interest is 5.095% pa.

(iii) Equivalent nominal rate of discount convertible monthly

We have:

d ( p ) = p È1 - (1 - d )
1/ p ˘
= p È1 - (1 + i )
-1/ p ˘
ÍÎ ˙˚ ÍÎ ˙˚

So:

d (12) = 12 È1 - (1.05095)
-1/12 ˘
= 0.04959
ÍÎ ˙˚

The equivalent nominal rate of discount convertible monthly is 4.959% pa.

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33 Subject CT1 September 2016 Question 2

The present value of the payment stream can be written as:

PV = 100 a(12)
12

Since i (4) = 0.02 , we have:

4 4
Ê i (4) ˆ Ê 0.02 ˆ
i = Á1 + ˜ - 1 = ÁË1 + ˜ - 1 = 1.02015 - 1 = 0.02015
Ë 4 ¯ 4 ¯

1
From this, v = = 0.98025 . So:
1.02015

d (12) = 12 È1 - (1 - d )
1/12 ˘
= 12 È1 - 0.980251/12 ˘ = 0.01993
ÎÍ ˚˙ Î ˚

So the present value is:

1 - v 12 1 - 1.02015 -12
PV = 100 a(12) = 100 ¥ (12)
= 100 ¥ = 1,068.0543
12 d 0.01993

The present value is €1,068.05.

34 September 2016 Question 3

 A fixed amount is borrowed at the start of the term; repayments are made
regularly (often monthly) over the period of the loan.
 The repayments are usually level but could vary (eg increase or decrease
in a specified way).
 Repayments are made up partly of interest and partly of capital
repayment.
 Over time, the interest component of each payment will decrease, and
the capital repayment component will increase.
 The interest rate may be fixed for the term (or part of the term), but is
more usually variable.
 A repayment mortgage will be secured on the value of the relevant
property (ie if the borrower defaults, the lender will be able to take and
sell the property to repay the loan).

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 The interest rate will be based on the general level of interest rates,
although the creditworthiness of the borrower may also be taken into
account.
 The loan may be allowed to be repaid early.

35 Subject CT1 September 2016 Question 6

(i) Annual simple rate of return

Using a simple rate of interest, and using a denominator of 365 for the number
of days in 2015, we have:

Ê 182 ˆ 365 Ê 100 ˆ

96 Á1 + i = 100 fi i= ¥ - 1˜ = 0.08356
Ë 365 ˜¯ 182 ÁË 96 ¯

So the annual simple rate of interest is 8.356%.

(ii) Length of time period

Writing down an equation of value for the actual holding period, n , using the
simple rate of interest of 3.5% pa and working in years, we have:

96 (1 + 0.035n ) = 97.50 fi n = 0.44643 years

Converting this into days (again using 365 days in a year), we have a time
period of 162.946 days, or say 163 days.

(iii) Annual effective rate of return

If the initial purchaser held the bond for 163 days, the second investor held it
for 182 - 163 = 19 days. So the equation of value for the second investor is
(using an effective rate of interest):

97.50 (1 + i )
19/365
= 100

Solving this equation of value, we find that:

365/19
Ê 100 ˆ
i =Á - 1 = 0.62640
Ë 97.50 ˜¯

So the second investor achieved an effective rate of interest of 62.64% pa.

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36 Subject CT1 September 2016 Question 12

(i) Calculate a

Discounting back from time 20 to time zero, we have:

20

-0.03 ¥10
- Ú at dt
50 = 100 e ¥e 10

20
È1 ˘
- Í at 2 ˙
Î2 ˚ 10
= 100 e -0.3 ¥ e
= 100 e - (0.3 +150a )

Taking logs:

- (0.3 + 150a ) = ln0.5

Solving this equation, we find that:

- ln0.5 - 0.3
a= = 0.00262
150

(ii) Calculate b

Discounting again:

28
- Ú bt dt
40 = 100e -0.3e -150ae 20

28
È1 ˘
- Í bt 2 ˙
-(0.3 +150 ¥ 0.00262) Î 2 ˚20
= 100e e
-0.69315 -192b
= 100e

Again taking logs:

-0.69315 - 192b = ln0.4

Solving this equation, we find that:

- ln0.4 - 0.69315
b= = 0.00116
192

(iii) Equivalent annual rate of discount

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Discounting from time 28 to time zero at a constant rate of interest:

100v 28 = 40 fi 100(1 - d )28 = 40

Solving this equation, we find that d = 0.03220 . So the rate of discount is

3.22% pa.

(iv)(a) Present value of the payment stream

The present value of the payment stream is:

7 7
-0.03t
Úe ¥ e -0.04t dt = Ú e -0.07t dt
3 3
7
È e -0.07t ˘
=Í ˙
ÎÍ -0.07 ˙˚3
e -0.49 - e -0.21
=
-0.07
= 2.82797

(iv)(b) Level of continuous payment stream

The present value of a continuous payment stream made at a rate of k per

annum is:

7
7
-0.03t
È e -0.03t ˘ e -0.21 - e -0.09
Úk e dt = k Í ˙ = k = 3.44490k
3 ÎÍ -0.03 ˙˚3 -0.03

Equating this to the present value in the previous part, we obtain:

2.82797
k= = 0.82092
3.44490

So the equivalent level payment stream should be made at a rate of 0.821 pa.

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37 Subject CT1 April 2017 Question 1

(i) d (12) equivalent to an effective rate of interest of 1% per quarter

The annual effective interest rate i that is equivalent to a quarterly effective

interest rate of 1% is:

i  1.014  1  4.0604%
So:

 
d (12)  12 1  1.0406041 12  3.974%

(ii) d (12) equivalent to a force of interest of 5% pa

The annual effective interest rate i that is equivalent to a force of interest of

5% pa is:

i  e  1  e0.05  1  5.1271%

So:

 
d (12)  12 1  1.0512711 12  4.990%

(iii) d (12) equivalent to a nominal rate of discount of 4% pa convertible

quarterly

The annual effective interest rate i that is equivalent to d (4)  4% is:

4
 d (4)  4
i  1    1  1  0.01  1  4.1020%
 4 


So:

 
d (12)  12 1  1.0410201 12  4.013%

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38 Subject CT1 September 2017 Question 1

(i)(a) Simple rate of interest

Assuming a time period t (in years) for the investment, the equation of value
is:
6,000 (1 + ti ) = 7,600

Using an interest rate of 3% pa and solving, we have:

Ê 7,600 ˆ
ÁË 6,000 ˜¯ - 1
t= = 8.88889
0.03

Converting this to days, we have:

t = 8.88889 ¥ 365 = 3,244.444

or about 3,244 days.

(i)(b) Compound rate of interest

We now have:

6,000 (1.03) = 7,600

t

Taking logs:

7,600
t log1.03 =
6,000

So:

log (7,600 6,000 )

t= = 7.99724
log1.03

Converting to days, we have:

t = 7.99724 ¥ 365 = 2,918.992

or about 2,919 days.

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(i)(c) Force of interest

We now have:

6,000e0.03t = 7,600

Rearranging this equation:

1 Ê 7,600 ˆ
t= ln = 7.87963
0.03 ÁË 6,000 ˜¯

Converting to days:

t = 7.87963 ¥ 365 = 2,876.063

or about 2,876 days.

(ii) Effective rate of interest per half-year

The effective rate of interest per half-year is the value of i which is the solution
of the equation:

(1 + i )2 = e0.03
Solving this equation to find i :

i = e0.03/2 - 1 = 0.01511

So the effective rate of interest per half-year is 1.511%.

39 Subject CT1 September 2017 Question 3

Using a simple rate of discount of d , the discounting factor over 91 days for
the government bill is:

91
1- d
365

The corresponding discount factor for the deposit account is:

v 91/365 = 1.03-91/365 .

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Equating these two expressions:

91
1- d = 1.03 -91/365
365

Rearranging:

365 È
d= 1 - 1.03 -91/365 ˘ = 0.02945
91 Î ˚

So the annual simple rate of discount is 2.945% pa.

40 Subject CT1 September 2017 Question 6

Consider first Plan A. The accumulated value at the end of 15 years for the
cashflows under Plan A (using a reduced interest rate of 3% pa effective) is:

AVA = 12 ¥ 100 s(12) = 1,200 ¥

(1 + i )15 - 1 = 1,200 ¥ 1.0315 - 1
15 d (12) 12 È1 - 1.03 -1/12 ˘
Î ˚
= 1,200 ¥ 18.89978 = 22,679.74

Now consider the cashflows under Plan B. The net cashflows after expenses
in the first year are $85 per month, or $1,020 for the whole year. So the
accumulated value of the first year’s cashflows at the end of the first year is:

1,020 s(12)
1

The value of d(12) at a rate of interest of 3.7% pa is:

d (12) = 12 È1 - 1.037-1/12 ˘ = 0.03628

Î ˚

So the accumulated value of these cashflows at time 15 is:

Ê (1 + i ) - 1ˆ
1,020 s(12) ¥ 1.03714 = 1,020 ¥ Á ˜ ¥ 1.037
14
1
Ë d (12) ¯
0.037
= 1,020 ¥ ¥ 1.03714 = 1,730.108
0.03628

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The accumulated value at time 15 of the remaining fourteen years of

cashflows is:

1,200 s(12) = 1,200

(1 + i )14 - 1 = 1,200 ¥ 1.03714 - 1
14 d (12) 0.03628
= 1,200 ¥ 18.2771 = 21,932.570

So the total accumulated value for Plan B is:

AVB = 1,730.108 + 21,932.570 = 23,662.68

Hence the accumulated value for Plan B is greater by $982.94, and the
percentage by which Plan B is bigger is:

982.94
= 4.334%
22,679.74

or about 4.33%.

41 Subject CT1 September 2017 Question 9

(i) Constant effective annual rate

Accumulating from time zero to time 10 using the variable force, we get:

È10 ˘ È 10 ˘
A(0,10) = exp Í Ú 0.09 - 0.003t dt ˙ = exp Í È0.09t - 0.0015t 2 ˘ ˙
ÍÎ 0 ˙˚ Î Î ˚ 0 ˚

= exp ÈÎ(0.9 - 0.15 ) - 0 ˘˚ = e0.75

Accumulating using an equivalent constant annual rate, the accumulation

factor is (1 + i )
10
. Equating these:

(1 + i )10 = e0.75
Solving this equation, we find that:

i = e0.75/10 - 1 = e0.075 - 1 = 0.07788

The constant effective annual rate is 7.788% pa.

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(ii) Nominal rate of discount convertible half-yearly

Using the relationship between i and d(2) :

-2
Ê d (2) ˆ
1 + i = Á1 - ˜ = 1.07788
Ë 2 ¯

Rearranging this:

d (2) = 2 È1 - 1.07788-½ ˘ = 0.07361

Î ˚

So the rate of discount convertible half-yearly is 7.36% pa.

(iii) Accumulation at time 15

The accumulation factor from time 5 to time 10, using the variable force, is
given by:

È10 ˘ È 10 ˘
exp Í Ú 0.09 - 0.003t dt ˙ = exp Í È0.09t - 0.0015t 2 ˘ ˙
ÍÎ 5 ˙˚ Î Î ˚ 5 ˚

= exp ÎÈ(0.9 - 0.15) - (0.45 - 0.0375)˚˘ = exp ÈÎ0.3375 ˘˚

The accumulation factor from time 10 to time 15 is:

exp ÈÎ5 ¥ 0.06˘˚ = e0.3

So the accumulation at time 15 of an investment of £1,500 at time 5 is:

1,500 ¥ e0.3375 ¥ e0.3 = 1,500 ¥ e0.6375 = 2,837.618

or about £2,837.62.

(iv) Corresponding constant effective annual rate of discount

We know that:

2,837.618 = 1,500 (1 + i ) = 1,500v -10 = 1,500 (1 - d )

10 -10

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Rearranging this:

1/10
Ê 1,500 ˆ
d = 1- Á = 0.06176
Ë 2,837.618 ˜¯

So the corresponding effective annual rate of discount is 6.176% pa.

(v) Present value of a continuous payment stream

The force of interest for a period from time 11 to time t , where t is between
11 and 15, is just 0.06. So the discount factor v (t ) is just v (t ) = e -0.06(t -11) .

So the present value at time 11 of the payment stream is:

15 15
PV11 = Ú 10 e
0.01t
¥ e -0.06(t -11) dt = 10 e0.66 Úe
-0.05t
dt
11 11
15
È e -0.05t ˘ È Ê e -0.75 ˆ Ê e -0.55 ˆ ˘
= 10 e0.66 Í ˙ = 10 e0.66 Í Á ˜ -Á ˜ ˙ = 40.46938
ÎÍ -0.05 ˙˚11 ÍÎ Ë -0.05 ¯ Ë -0.05 ¯ ˙˚

We now discount this back to time zero:

PV0 = 40.46938 ¥ e -0.06 ¥ e -0.75 = 18.00313

So the present value at time zero of the payment stream is 18.003.

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FACTSHEET
This factsheet summarises the main methods, formulae and information
required for tackling questions on the topics in this booklet.

1 Time value of money

The accumulated value of 1 (invested at time 0) at time t is (1 + ti ) if we have

simple interest and (1 + i )t if we have compound interest.

1
The discount factor, v , is .
1+ i

The discount factor for a period of n years using a simple rate of discount d
is 1 - nd .

The connection between compound rates of interest and discount is

d = 1 - v = 1 - (1 + i )-1 .

2 Interest rates

A(t , t + h ) - 1
The definition of the force of interest d (t ) is lim .
h Æ0 + h

È t2 ˘
The accumulation factor from time t1 to time t 2 is A(t1, t 2 ) = exp Í Ú d (t ) dt ˙ .
Ít ˙
Î1 ˚
Correspondingly, the discount factor from time t 2 to time t1 is
È t2 ˘
exp Í - Ú d (t ) dt ˙ .
Í t ˙
Î 1 ˚

The present value at time a of a payment stream of r ( t ) received between

time a and time b where the force of interest is d (t ) is:

b È t ˘
Ú r (t ) exp Í - Ú d (s ) ds ˙ dt
ÍÎ ˙˚
a a

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The accumulated value at time b of a payment stream of r ( t ) received

between time a and time b where the force of interest is d (t ) is:

b Èb ˘
Ú r (t ) exp ÍÍ Ú d (s ) ds ˙˙ dt
a Ît ˚

If the force of interest is a constant, d , then A(t1, t 2 ) = exp ÎÈd (t 2 - t1)˚˘ ,

i = ed - 1 , d = ln(1 + i ) , v = e -d and 1 - d = e -d .

The connections between nominal and effective rates of interest are:

p
Ê i ( p) ˆ Ê 1
ˆ
1 + i = Á1 + ˜ i ( p ) = p Á (1 + i ) p - 1˜
Ë p ¯ Ë ¯

The connections between nominal and effective rates of discount are:

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

3 Annuities

The present value at time 0 of payments of 1 at time 1, 1 at time 2, 1 at time

3 and so on until 1 at time n , is given by an . The formula for an is:

1- v n
an =
i

The present value at time 0 of payments of 1 at time 0, 1 at time 1, 1 at time

2 and so on until 1 at time n - 1 , is given by an . The formula for an is:

1- v n
an =
d

The connections between these values are an = (1 + i )an and an = 1 + an -1 .

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The accumulated value at time n of payments of 1 at time 1, 1 at time 2, 1 at

time 3 and so on until 1 at time n , is given by sn . The formula for sn is:

(1 + i )n - 1
sn = = (1 + i )n an
i

The accumulated value at time n of payments of 1 at time 0, 1 at time 1, 1 at

time 2 and so on until 1 at time n - 1 , is given by sn . The formula for sn is:

(1 + i )n - 1
sn = = (1 + i )n an
d

The connections between these values are sn = (1 + i )sn , and sn + 1 = sn +1 .

The present value at time 0 of payments of 1 pa payable continuously for n

years is given by an . The formula for an is:

1- v n
an =
d

The accumulated value at time n of payments of 1 pa payable continuously

for n years is given by sn . The formula for sn is:

(1 + i )n - 1
sn = = (1 + i )n an
d

The present value at time 0 of payments of 1 pa payable p thly in arrears for

n years is given by a( p ) . The amount of each payment is 1
p
. The formula
n

for a( p ) is:
n

1- v n i
a( p ) = = an
n i (p) i ( p)

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The present value at time 0 of payments of 1 pa payable p thly in advance for

n years is given by a( p ) . The amount of each payment is 1
p
. The formula
n

for a( p ) is:

n

1- v n i
a( p ) = ( p ) = ( p ) an
n d d

1
The connection between these values is a( p ) = v p a( p ) .
n n

There are equivalent formulae for s ( p ) and s( p ) , namely:

n n

(1 + i )n - 1 i (1 + i )n - 1 i
s( p ) = = (1 + i )n an , s( p ) = = (1 + i )n ( p ) an
n i ( p) i ( p) n d (p)
d

4 Deferred and increasing annuities

The present value at time 0 of payments of 1 at time m + 1 , 1 at time m + 2 ,

1 at time m + 3 and so on until 1 at time m + n , is given by m| an . The formula
for m| an is:

m| an = am +n - am = v man

The corresponding annuity due, continuously payable annuity and p thly

annuities are given by:

m| an
 = a
m +n
- am = v man m|an = am + n - am = v man

( p)
m| an = a( p ) - a( p ) = v ma( p ) ( p )
m|an = a( p ) - a( p ) = v ma( p )
m +n m n m +n m n

The present value at time 0 of payments of 1 at time 1, 2 at time 2, 3 at time

3 and so on until n at time n , is given by (Ia )n . The formula for (Ia )n is:

an - nv n
(Ia )n =
i

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The present value at time 0 of payments of 1 at time 0, 2 at time 1, 3 at time

2 and so on until n at time n - 1 , is given by (Ia)n . The formula for (Ia)n is:

an - nv n
(Ia)n =
d

The present value at time 0 of payments of r made continuously through year

r for n years is given by (Ia )n . The formula for (Ia )n is:

an - nv n
(Ia )n =
d

The present value at time 0 of a rate of payment of t at time t for n years is

given by ( I a )n . The formula for ( I a )n is:

an - nv n
( I a )n =
d

The accumulated values can be found by accumulating the present values,

for example:

(Is )n = (1 + i )n (Ia)n

Deferred annuities can be calculated in the obvious way, for example:

m|(Ia)n = v m (Ia)n

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