CM1: CMP Upgrade 2023/24 Page 1

Subject CM1
CMP Upgrade 2023/24

CMP Upgrade
This CMP Upgrade lists the changes to the Syllabus, Core Reading and the ActEd material since
last year that might realistically affect your chance of success in the exam. It is produced so that
you can manually amend your 2023 CMP to make it suitable for study for the 2024 exams. It
includes replacement pages and additional pages where appropriate.

Alternatively, you can buy a full set of up-to-date Course Notes / CMP at a significantly reduced
price if you have previously bought the full-price Course Notes / CMP in this subject. Please see
our 2024 Student Brochure for more details.

We only accept the current version of assignments for marking, ie those published for the
sessions leading to the 2024 exams. If you wish to submit your scripts for marking but only have
an old version, then you can order the current assignments free of charge if you have purchased
the same assignments in the same subject in a previous year, and have purchased marking for the
2024 session.

This CMP Upgrade contains:

· all significant changes to the Syllabus and Core Reading
· additional changes to the ActEd Course Notes and Assignments that will make them
suitable for study for the 2024 exams.

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0 Retaker discounts
When ordering retaker-price material, please tick the relevant box when using the e-store.

Students have the choice of purchasing the full CMP (printed or eBook) or just the Course Notes
(printed).

Further information on retaker discounts can be found at:

acted.co.uk/paper_reduced_prices.html

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1 Changes to the Syllabus

There have been a large number of changes to the wordings of the syllabus objectives and topic
weightings have changed. The updated syllabus objectives are set out in full below.

Objectives

1. Theory of interest rates (25%)

Understand the principles of time preference theory of interest and the time value of money,
including the term structure of interest rates and standard actuarial compound interest rate
functions. Apply these principles to real world examples of interest rates, discounting and
evaluation of present value of cashflows.

1.1 Show how interest rates may be expressed in different time periods:
(Chapters 1 and 2)

1.1.1 Relationship between the rates of interest and discount over one effective
period, considered arithmetically and by general reasoning.

1.1.2 Determine, when given a rate of interest under a specific payment

frequency, the equivalent rate under an alternative payment frequency
including:

· annual effective rate of interest or discount

· rate of interest of discount payable pthly (p>1)
· force of interest.
1.1.3 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.

1.2 Account for the time value of money using the concepts of compound interest
and discounting: (Chapter 1)

1.2.1 Accumulate a single investment at a constant rate of interest under the

operation of simple and compound interest.

1.2.2 Calculate the present value of a future payment by discounting a single

investment.

1.3 Extend the techniques in 1.1 and 1.2 where appropriate to allow for inflation.
(Chapters 3 and 10)

1.4 Describe the operation of financial instruments and insurance contracts as a

cashflow model (where cashflows may be fixed or uncertain in terms of both
amount and timing). (Chapters 7, 8 and 10)

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1.5 Calculate the present value and accumulated value for a given stream of
cashflows under the following individual combination of scenarios: (Chapter 4)

1.5.1 Cashflows are equal at each time period;

1.5.2 Cashflows vary with time, which may or may not be a continuous function
of time;

1.5.3 Some of the cashflows are deferred for a long period of time;

1.5.4 Rate of interest or discount is constant; and

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

1.6 Evaluate the following annuity and accumulation functions, when given the values
for the term, n, and the appropriate interest or discount function i , v , d , d ,
i(p) and d ( p) : (Chapters 5 and 6)

1.6.1 && , &s& , &a&(p ) , &s&(p ) , a and s .

an , sn , a(p) , s( p ) , a
n n n n n n n n

1.6.2 m an , m a (p ) , m a
&& , m &a&(p) and m a .
n n
n n

1.6.3 &&) , (Ia) and ( Ia ) and the respective deferred annuities.

(Ia)n , (Ia n n n

1.7 Demonstrate an understanding of the term structure of interest rates:

(Chapter 11)

1.7.1 Understand the main factors influencing the term structure of interest
rates.

1.7.2 Understand and calculate:

· discrete spot rates and forward rates.
· continuous spot rates and forward rates.

1.7.3 Understand and calculate the par yield and yield to maturity.

1.8 Understand duration, convexity and immunisation of cashflows: (Chapter 11)

1.8.1 Demonstrate how the duration and convexity of a cashflow sequence may
be used to estimate the sensitivity of the value of the cashflow sequence
to a shift in interest rates.

1.8.2 Understand, apply and discuss Redington’s conditions for immunisation of

a portfolio of liabilities.

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2. Equation of value and its applications (20%)

Understand and apply equation of value principles to evaluate financial problems, in particular
relating to loan schedules, bond prices, bond yields and project appraisals:

2.1 Understand an apply the concept of an equation of value in terms of: (Chapter 7)

· where payment or receipt is certain

· where payment or receipt is uncertain
· the two conditions required for there to be an exact solution
2.2 Use the concept of equation of value to solve various practical problems:
(Chapters 8 and 10)

2.2.1 Apply the equation of value to loans repaid by regular instalments of

interest and capital. Obtain repayments, interest and capital components,
the effective interest rate (APR) and construct a schedule of repayments.

2.2.2 Calculate the price of, or yield (nominal or real allowing for inflation)
from, a bond (fixed-interest or index-linked) where the investor is subject
to deduction of income tax on coupon payments and redemption
payments are subject to deduction of capital gains tax.

2.2.3 Calculate the running yield and the redemption yield for the financial
instrument as described in 2.2.2.

2.2.4 Calculate the upper and lower bounds for the present value of the
financial instrument as described in 2.2.2, when the redemption date can
be a single date within a given range at the option of the borrower.

2.2.5 Calculate the present value or yield (nominal or real allowing for inflation)
from an ordinary share or property, given constant or variable rate of
growth of dividends or rents.

2.3 Apply cashflow and equation of value techniques to project appraisals:

(Chapter 9)

2.3.1 Calculate the net present value and accumulated profit of the receipts and
payments from an investment project at given rates of interest.

2.3.2 Calculate the internal rate of return, payback period and discounted
payback period and discuss their suitability for assessing the suitability of
an investment project.

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3. Decrement and multiple life models (20%)

Understand how to model uncertain future cashflows, which may depend on the death or survival
of an individual, or other uncertain events. Be introduced to the life table, calculation of the
mean and variance of the present value of all of the main life insurance and annuity contracts,
and their relationship in actuarial terms. Extend the single decrement model to evaluate health
insurance contracts involving two lives as well as the valuation of cashflows in a competing risk
environment using multiple state models:

3.1 Demonstrate an understanding of the operation of key assurance and annuity

contracts: (Chapters 12, 13, 14, 16 and 23)

3.1.1 Understand the following contracts, for example by explaining the timing
and nature of the cashflows involved:
· whole-life assurance
· term assurance
· pure endowment
· endowment assurance
· whole-life level annuity
· temporary level annuity
· guaranteed level annuity
· deferred benefits
3.1.2 Understand the operation of conventional with-profits contracts, where
profits are distributed by the use of regular reversionary bonuses and by
terminal bonuses.

3.1.3 Understand the operation of conventional unit-linked contracts, where

death benefits are expressed as combination of absolute amount and
relative to a unit fund.

3.1.4 Understand the operation of accumulating with-profits contracts where

benefits take the form of an accumulating fund of premiums, where:
· the fund is defined in monetary terms, has no explicit charges,
and is increased by the addition of regular guaranteed and bonus
interest payments plus a terminal bonus; or
· the fund is defined in terms of the value of a unit fund, is subject
to explicit charges, and is increased by regular bonus additions
(through unit price increases or allocations of additional units)
plus a terminal bonus (unitised with-profits).

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3.2 Apply formulae for the means and variances of the payments under various
assurance and annuity contracts, assuming constant deterministic interest rate:
(Chapters 12, 13, 14, 15, 16 and 18)

3.2.1 Life table functions l x and d x and their select equivalents l[ x]+r and
d[ x]+r .

3.2.2 Describe the meaning of the following probabilities: n px , n qx , n m qx ,

n qx and their select equivalents n p[ x]+r , n q[ x ]+r , n m q[ x ]+ r , n q[ x ]+ r .

3.2.3 Express the probabilities defined in 3.2.2 in terms of life table functions
defined in 3.2.1.

3.2.4 Use assurance and annuity factors and their select and continuous
equivalents including the extension of the annuity factors to allow for the
possibility that payments are more frequent than annual but less frequent
than continuous.

3.2.5 Use the relationship between annuities payable in advance and in arrear,
and between temporary, deferred and whole life annuities.

3.2.6 Use the relationship between assurance and annuity factors using
equation of value, and their select and continuous equivalents.

3.2.7 Obtain the mean and variance of the present value of benefit payments as
sums / integrals under each contract defined in 3.1.1, in terms of the
(curtate) random future lifetime, assuming:
· contingent benefits (constant, increasing or decreasing) are
payable at the middle or end of the year of contingent event or
continuously.
· annuities are paid in advance, in arrear or continuously, and the
amount is constant, increases or decreases by a constant
monetary amount or by a fixed or time-dependent variable rate.
· premiums are payable in advance, in arrear or continuously; and
for the full policy term or for limited period.

Where appropriate, simplify the above expressions into a form suitable

for evaluation by table look-up or other means.

3.2.8 Evaluate the expected accumulations in terms of expected values for the
contracts described in 3.1.1 and contract structures described in 3.2.7.

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3.3 Describe and use assurance and annuity functions involving two lives:
(Chapters 19 and 20)

3.3.1 Extend the techniques of objectives 3.2 to deal with cashflows dependent
upon the death or survival of either or both of two lives.

3.3.2 Extend technique in 3.3.1 to deal with functions dependent upon a fixed
term as well as age.

3.4 Describe and apply methods of valuing cashflows that are contingent upon
multiple transition events: (Chapter 22)

3.4.1 Demonstrate an understanding of simple health insurance premium and

benefit structures.

3.4.2 Describe how a cashflow, contingent upon multiply transition events, may
be valued using a multiple state Markov model, in terms of the forces and
probabilities of transition.

3.4.3 Construct formulae for the expected present values of cashflows that are
contingent upon multiple transition events, including simple health
insurance premiums and benefits, and calculate these in simple cases.
This includes regular premiums and sickness benefits that are payable
continuously and assurance benefits that are payable immediately on
transition.

3.5 Describe and use methods of projecting and valuing expected cashflow that are
contingent upon multiple decrement events: (Chapter 22)

3.5.1 Understand the construction and use of multiple decrement tables.

3.5.2 Understand the operation of a multiple decrement model as a special case

of multiple-state Markov model.

3.5.3 Determine dependent probabilities for a multiple decrement model in

terms of given forces of transition, assuming forces of transition are
constant over single years of age.

3.5.4 Determine forces of transition from given dependent probabilities,

assuming forces of transition are constant over single years of age.

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4. Pricing and reserving (35%)

Understand the future loss random variable and its application to the calculation of premiums for
conventional life assurance and annuity contracts. Use the prospective and retrospective
approaches to calculate reserves, the recursive relationship between reserves, and calculate
mortality profit. Project cashflows to profit test life insurance contracts and apply projected
cashflow techniques to pricing and reserving:

4.1 Determine the gross random future loss random variable under an insurance
contract. (Chapter 18)

4.2 Calculate gross premiums and reserves of assurance and annuity contracts:
(Chapters 17 and 18)

4.2.1 Calculate gross premiums for the insurance contract benefits listed in
3.1.1 under the following scenarios, or a combination thereof, using the
equivalence principle or otherwise:

· contracts may accept only a single premium

· regular premiums and annuity benefits may be payable annually,
more frequently than annually or continuously
· death benefits (which increase or decrease by a constant
compound rate or by a constant monetary amount) may be
payable at the end of the year of death or immediately on death

· survival benefits (other than annuities) may be payable at defined

intervals other than at maturity.

4.2.2 Understand why an insurance company will set up reserves.

4.2.3 Calculate gross prospective and retrospective reserves.

4.2.4 Understand the equivalence of the prospective reserve and the

retrospective reserve under certain conditions, with or without allowance
for expenses, for all fixed benefit and increasing/decreasing benefit
contracts.

4.2.5 Obtain recursive relationships between successive periodic gross premium

reserves, and use this relationship to calculate the profit earned from a
contract during the period.

4.2.6 Understand the concepts of net premiums and net premium valuation
and how they relate to gross premiums and gross premium valuation
respectively.

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4.3 Describe and calculate, for a single policy or a portfolio of policies (as
appropriate):

· death strain at risk;

· expected death strain;
· actual death strain; and
· mortality profit

for policies with death benefits payable immediately on death or at the end of the
year of death, policies paying annuity benefits at the start of the year or on
survival to the end of the year, and policies where single or non-single premiums
are payable. (Chapter 21)

4.4 Project expected future cashflows for whole life, endowment and term
assurances, annuities, unit-linked contracts, and conventional/unitised
with-profits contracts, incorporating multiple decrement models as appropriate:
(Chapters 24 and 25)

4.4.1 Profit test life insurance contracts of the types listed above and determine
the profit vector, the profit signature, the net present value, and the
profit margin.

4.4.2 Show how a profit test may be used to price a product, and use a profit
test to calculate a premium for life insurance contracts of the types listed
above.

4.4.3 Show how gross premium reserves can be computed using the above
cashflow projection model and included as part of profit testing.

4.5 Show how, for unit-linked contracts, non-unit reserves can be established to
eliminate (‘zeroise’) future negative cashflows, using a profit test model.
(Chapter 25)

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2 Changes to the Core Reading

This section contains all the non-trivial changes to the Core Reading.

Chapters 1 & 2
The Core Reading from Chapters 1 & 2 has largely been removed. The retained Core Reading has
been moved to Chapter 9 (see below).

Chapter 9 (now Chapter 7)

Core Reading relating to fixed-interest securities, index-linked securities and cash on deposit have
been relocated to Chapter 9 from Chapter 2. Core Reading on stochastic and deterministic
models and sensitivity testing have been relocated to Chapter 9 from Chapter 1. The new Chapter
9 is appended in full to this upgrade.

Chapter 19 (now Chapter 17)

Section 3.3

A new paragraph of Core Reading has been added at the very end of Section 3.3:

The formulae in this and the following chapter all require the independence of decrements
assumptions, as defined in syllabus objective 4.4.2 to hold. Therefore, the application of
lapses and surrender is largely ignored, however could be examined as part of the
computer based assessment where cashflow models could be used instead.

Section 3.4

A line has been added to the second bullet point at the opening to Section 3.4.

Note: A variant of the annual premium contract is limited premium paying term contracts,
where the premium term is less than the contract term.

Chapter 20 (now Chapter 18)

Section 0

The following paragraph of Core Reading has been added to the introduction:

It is important to note that policyholder behaviour is a key consideration for insurers in

reserving and profit testing of life insurance business. For instance, in insurance lines
where contracts are regularly renewed (usually annually), insurers are mainly concerned
with the extent to which policyholders renew or continue their contracts. As a result, lapses
and surrenders are major decrements that impact pricing and reserving in practice.
Additionally the mortality experience of life insurance companies may depend on their
lapses and surrender experience.

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Chapter 24 (now Chapter 22)

Section 3.3

The opening paragraph to Section 3.3 leads into the wrong equation. It should read:

We can use the Kolmogorov forward differential equations to derive transition probabilities,
as in the case of multiple state models. We note from Section 2.1 that, in the multiple state
model, this produces the following general result:

æ t ö
ò å mx + sds ÷
ii = exp ç - ij
p
t x
ç ÷
è 0 j ¹i ø

Section 4

The form of the deferred dependent probability on page 26 is incorrect. It has been corrected to
read:

We can also use the table to calculate deferred dependent probabilities of the form:

k ( ad )kx + n
n (aq ) x =
(al ) x

A line of Core Reading on page 27 contains the wrong notation. The corrected notation is below.

The notation used is I xj , d xj , qxj , pxj , m xj etc for mode of decrement j .

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3 Changes to the ActEd material

This section contains all the non-trivial changes to the ActEd text.

Chapters 1 & 2
These chapters have been removed. All subsequent chapter numbers and references have been
reduced by 2. The chapter numbers below refer to the 2023 version of the Course Notes.

Chapter 9 (now Chapter 7)

There have been a number of changes to this chapter. The new Chapter 9 is appended in full to
this upgrade.

Chapter 13 (now Chapter 11)

Page 10

A formatting error had interfered with the timeline diagram at the top of the page. It has been
corrected to read as follows:

Chapter 17 (now Chapter 15)

Page 16

The first non-bold equation on page 17 contains an erroneous n subscript on the left-hand side.
The equation has been corrected to read:

1
a(xm) =
&& + a(xm)
m

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Chapter 20 (now Chapter 18)

Page 17

The solution to the question at the bottom of page 16 was incorrect. It has been corrected to the
following:

The accumulated fund will be:

1,000,000 ´ 1.0420 = 2,191,123

The expected number of survivors will be:

l 9,287.2164
10,000 ´ 60 = 10,000 ´ = 9,422.63
l40 9,856.2863

So the expected payout per survivor is:

2,191,123
= £232.54
9,422.63

Chapter 26 (now Chapter 24)

Page 24

The table at the top of the page was incorrect as the expected claim expense had not been
allowed for in the expected profit per policy in force at the start of the year.

The table now reads:

Year Premium Expense Interest Expected Expected Expected Expected

claim death maturity profit per
expense cost cost policy in
force at
start of
year
1 2,000 –200 90.00 –5.00 -104.00 1,781.00
2 2,000 –30 98.50 –5.10 -216.40 1,847.00
3 2,000 –30 98.50 –5.20 -337.63 1,725.67
4 2,000 –30 98.50 –5.30 -468.13 1,595.07
5 2,000 –30 98.50 –100 -608.36 -11,723.35 -10,363.21

In the solution section there was also an error in the interest earned in year 5, which has been
corrected to:

(2,000 - 30) ´ 0.05 = 98.50

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Hence the verification of the expected profit per policy in force at start of year 5 should be:

2,000 - 30 + 98.50 - 100 - 608.36 - 11,723.35 = -10,363.21

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4 Changes to the X Assignments

Overall
There have been minor changes throughout the assignments, including changes to mark
allocations.

More significant changes are listed below.

Assignment X1
A number of changes have been made to the questions and solutions. Replacement pages can be
found at the end of this Upgrade.

Assignment X2
X2.2

There has been a minor rewording to this question:

A borrower has agreed to repay a loan of £20,000 with payments of £427.90 made monthly in
arrears for 5 years.

Calculate, without using Goal Seek or Solver and showing all workings, the APR charged on the
loan.

X2.7

There has been a minor rewording to part (i):

(i) Show that the amount of the loan is approximately £38,000. [3]

Assignment X3
X3.5

Part (ii) has been removed and adjustments made to the marks in parts (i) and (iii):

A man aged exactly 42 purchases a whole life assurance policy with a sum assured of 5,000
payable immediately on death.

(i) Write down an expression for the random variable representing the present value of the
benefits from this policy. [1]

(ii) Calculate the variance of the present value of the benefits from this assurance policy,
assuming AM92 Ultimate mortality and 4% pa interest. [3]
[Total 4]

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X3.12

Part (ii) has been removed and marks updated in parts (i) and (iii):

Let K denote the curtate future lifetime random variable of a life aged exactly x .

(i) Describe the benefit whose present value random variable is:

ìï10,000 a&&K +1 if K < 10

W=í [2]
ïî10,000 a&&10 if K ³ 10

(ii) Calculate the expected present value and the standard deviation of the present value of
the benefit in (i), assuming:
· a force of interest of 0.04 pa
· the life is subject to a constant force of mortality of 0.02 pa. [9]
[Total 11]

Assignment X4
X4.5

This question has been removed.

X4.9

Part (iii) has been removed.

Assignment X5
X5.4

This question has been removed.

X5.6

The alternative solution presented for part (ii) contained a couple of errors. The term and
following explanation has been corrected to read:

10 -d t
50,000 ò e ai ii
t -1 p50 1 p50 +t -1u50 +t dt
1

ai ii
This time the PDF is t -1 p50 1 p50+t -1 , that is at time t the life was sick one year ago, has remained
sick for the last year and then has died from the sick state. This can be evaluated between the
limits of 1 and 10.

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5 Changes to the Y Assignments

There are no changes to the Y assignments.

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6 Other tuition services

In addition to the CMP you might find the following services helpful with your study.

6.1 Study material

We also offer the following study material in Subject CM1:

· Flashcards
· Revision Notes
· ASET (ActEd Solutions with Exam Technique) and Mini-ASET
· Mock Exam and AMP (Additional Mock Pack).

For further details on ActEd’s study materials, please refer to the 2024 Student Brochure, which is
available from the ActEd website at ActEd.co.uk.

6.2 Tutorials

We offer the following (face-to-face and/or online) tutorials in Subject CM1:

· a set of Regular Tutorials (lasting a total of five days)
· a Split Block Tutorial (lasting five full days)
· a Preparation Day for the Paper B exam
· six-day Bundles in both Regular and Block format, covering the five days for the Paper A
exam, plus the Preparation Day for the Paper B exam
· an Online Classroom.

For further details on ActEd’s tutorials, please refer to our latest Tuition Bulletin, which is available
from the ActEd website at ActEd.co.uk.

6.3 Marking

You can have your attempts at any of our assignments or mock exams marked by ActEd. When
marking your scripts, we aim to provide specific advice to improve your chances of success in the
exam and to return your scripts as quickly as possible.

For further details on ActEd’s marking services, please refer to the 2024 Student Brochure, which
is available from the ActEd website at ActEd.co.uk.

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6.4 Feedback on the study material

ActEd is always pleased to receive feedback from students about any aspect of our study
programmes. Please let us know if you have any specific comments (eg about certain sections of
the notes or particular questions) or general suggestions about how we can improve the study
material. We will incorporate as many of your suggestions as we can when we update the course
material each year.

If you have any comments on this course, please send them by email to [email protected].

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CM1-07: Equations of value Page 1

Equations of value
Syllabus objectives
1.4 Describe the operation of financial instruments and insurance contracts as a
cashflow model (where cashflows may be fixed or uncertain in terms of both amount
and timing).
2.1 Understand and apply the concept of an equation of value in terms of:

 where payment or receipt is certain.

 where payment or receipt is uncertain
 the two conditions required for there to be an exact solution.

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0 Introduction
An equation of value equates the present value of money received to the present value of money
paid out:

‘PV income = PV outgo’

or equivalently:

‘PV income – PV outgo = 0’

Equations of value are used throughout actuarial work. For example:

 the ‘fair price’ to pay for an investment such as a fixed-interest security or an equity
(ie PV outgo) equals the present value of the proceeds from the investment, discounted at
the rate of interest required by the investor.
 the premium for an insurance policy is calculated by equating the present value of the
expected amounts received in premiums to the present value of the expected benefits
and other outgo.

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1 The equation of value and the yield on a transaction

1.1 The theory

Consider a transaction that provides that, in return for outlays of amount at1 , at2 ,  , atn at
time t1, t2 ,  , t n , an investor will receive payments of bt1 , bt2 ,  , btn at these times
respectively. (In most situations only one of at r and bt r will be non-zero.) At what force or
rate of interest does the series of outlays have the same value as the series of receipts? At
force of interest  the two series are of equal value if and only if:

n n
 atr e  t r   bt e  t
r
r

r 1 r 1

This equation may be written as:

n
 ct e  t
r
r 0 (1.1)
r 1

where ctr  btr  atr is the amount of the net cashflow at time tr . (We adopt the convention
that a negative cashflow corresponds to a payment by the investor and a positive cashflow
represents a payment to the investor.)

Equation (1.1), which expresses algebraically the condition that, at force of interest  , the
total value of the net cashflows is 0, is called the equation of value for the force of interest
implied by the transaction. If we let e  1  i , the equation may be written as:

n
 ct r
(1  i )tr  0 (1.2)
r 1

The latter form is known as the equation of value for the rate of interest or the ‘yield
equation’. Alternatively, the equation may be written as:

n
 ct v t r
r 0
r 1

In relation to continuous payment streams, if we let 1(t ) and 2 (t ) be the rates of paying
and receiving money at time t respectively, we call  (t )  2 (t )  1(t ) the net rate of
cashflow at time t . The equation of value (corresponding to Equation (1.1)) for the force of
interest is:


0  (t )e  t dt  0

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When both discrete and continuous cashflows are present, the equation of value is:

n 
 ct e  t  0  (t )e  t dt  0
r
r (1.3)
r 1

and the equivalent yield equation is:

n 
 ct r
(1  i )tr  0  (t )(1  i ) t dt  0 (1.4)
r 1

For any given transaction, Equation (1.3) may have no roots, a unique root, or several roots.
If there is a unique root,  0 say, it is known as the force of interest implied by the
transaction, and the corresponding rate of interest i0  e 0  1 is called the ‘yield’ per unit
time. (Alternative terms for the yield are the ‘internal rate of return’ and the ‘money-weighted
rate of return’ for the transaction.) Thus the yield is defined if and only if Equation (1.4) has
precisely one root greater than 1 and, when such a root exists, it is the yield.

The yield must be greater than –1, since e0  0 , so i0  e 0  1  1 . A yield of –1 corresponds
to a return of –100%, ie losing all the money originally invested.

Question

An investor pays £100 now in order to receive £60 in 5 years’ time and £60 in 10 years’ time.

Calculate the annual effective rate of interest earned on this investment.

Solution

The equation of value is:

100  60v 5  60v10

This is a quadratic in v 5 , which can be solved to give:

60  602  4  60  100

v 5  (1  i)5   0.8844 or  1.884
120

Rearranging, this gives i to be 2.49% or –188%. Since i must be greater than –1, the annual
effective rate of interest is 2.49%.

The analysis of the equation of value for a given transaction may be somewhat complex
depending on the shape of the function f (i ) denoting the left-hand side of Equation (1.4).
However, when the equation f (i )  0 is such that f is a monotonic function, its analysis is
particularly simple. The equation has a root if and only if we can find i1 and i2 with f (i1 )
and f (i2 ) of opposite sign. In this case, the root is unique and lies between i1 and i2 . By
choosing i1 and i2 to be ‘tabulated’ rates sufficiently close to each other, we may
determine the yield to any desired degree of accuracy.

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A monotonic function is one without any turning points, so it either always increases, or always
decreases.

Having identified suitable values of i1 and i2 , linear interpolation could be used to obtain the
yield i0 from these. Examples of this method are given a little later in this chapter.

It should be noted that, after multiplication by (1  i )t0 , Equation (1.2) takes the equivalent
form:

n
 ct r
(1  i )t0 t r  0
r 1

This slightly more general form may be called the equation of value at time t0 . It is of
course directly equivalent to the original equation (which is now seen to be the equation of
value at time 0). In certain problems a particular choice of t0 may simplify the solution.

Real world examples of assets with certain cashflow streams that work as described above
are outlined below.

1.2 A fixed-interest security

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.

This means that the organisation borrows money by issuing a loan to investors. The loan is
simultaneously listed on the stock exchange so that after issue the securities can be traded on the
stock exchange. This means that investors can sell their right to receive the future cashflows.

In many instances such a loan takes the form of a fixed-interest security, which is issued in
bonds of a stated nominal amount. 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 regular level interest payments are referred to as coupons. Thus a zero-coupon bond has no
interest payments.

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.

An investor might buy a 20-year fixed-interest security of nominal amount £10,000. This means
that the face value of the loan is £10,000. The investor is unlikely to pay exactly £10,000 for this
security but will pay a price that is acceptable to both parties. This may be higher or lower than
£10,000. The investor will then receive a lump sum payment in 20 years’ time. This lump sum is
most commonly equal to the nominal amount, in this case £10,000, but could be a pre-specified
amount higher or lower than this. The investor will also receive regular payments throughout the
20 years of, say, £500 pa. These regular payments could be made at the end of each year or
half-year or at different intervals.

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In the case where the regular payments are made at the end of each year, the cashflows of the
investor can be represented on a timeline, as follows:

– £price +£500 +£500 +£500 … +£500 +£10,500

0 1 2 3 … 19 20

The last payment is made up of the final regular payment (£500) and the lump sum payment
(£10,000).

1.3 An index-linked security

Inflation is a measure of the rate of change of the price of goods and services, including salaries.
High inflation implies that prices are rising quickly and low inflation implies that prices are rising
slowly.

If a pair of socks costs £1, then £5 could be used to buy 5 pairs of socks. However, if inflation is
high, then the cost of socks in 1 year’s time might be £1.25. £5 would then only buy 4 pairs of
socks.

This simple example shows how the ‘purchasing power’ of a given sum of money, ie the quantity
of goods that can be bought with the money, can diminish if inflation is high. In the socks
example, the annual rate of inflation is 25%.

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.

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.

Real terms means taking into account inflation, whereas nominal (or money) terms means
ignoring inflation. For example, if your salary is rising at 5% pa and inflation is 7% pa, your salary
is falling in real terms (as you will be able to buy less with your ‘higher salary’), even though your
salary is rising in nominal (or money) terms.

So for an index-linked bond, the cashflows are known in real terms, but are unknown in nominal
(or money) terms. For a fixed-interest bond, on the other hand, the cashflows are known in
nominal (or money) terms, but are unknown in real terms.

Both the regular interest payments and the final capital payment from an index-linked security
are linked to the inflation index. If inflation is high, then the regular payments will rise by larger
amounts than if inflation is low.

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If inflation is 10% per time period and the regular interest payment after one time period is £500,
then the payment after two time periods will be £550 (  500  1.1 ), and the payment after three
time periods will be £605 (  500  1.12 ) etc.

Inflation is often measured by reference to an index. For example an inflation index might take
values as set out in the table below.

Date 1.1.2019 1.1.2020 1.1.2021 1.1.2022

Index 100.00 105.00 108.00 113.00

Based on this, the rate of inflation during 2020 is 2.86% pa (ie 108 105  1 ).

Question

An investor purchased a three-year index-linked security on 1.1.2019. In return, the investor

received payments at the end of each year plus a final redemption payment, all of which were
increased in line with the index given in the table above. The payments would have been £600
each year and £11,000 on redemption if there had been no inflation.

Calculate the payments actually received by the investor.

Solution

The payments received by the investor are calculated in the table below:

Payment date Payment amount

105
1.1.2020 600   £630
100
108
1.1.2021 600   £648
100
113
1.1.2022 (11,000  600)   £13,108
100

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.

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Question

An investor purchased a two-year index-linked security on 1.1.2020. In return, the investor

received payments at the end of each year plus a final redemption payment, all of which were
increased in line with the index given in the table above, with a one-year indexation lag, ie the
index value one year before each payment is used. The payments would have been £600 each
year and £11,000 on redemption if there had been no inflation.

Calculate the payments actually received by the investor.

Solution

The payments received by the investor are calculated in the table below:

Payment date Payment amount

105
1.1.2021 600   £630
100
108
1.1.2022 (11,000  600)   £12,528
100

The one-year indexation lag means that the payment on 1 January 2021 is calculated using the
index values on 1 January 2019 (one year before the date of issue of the bond) and on 1 January
2020 (one year before the date of payment).

1.4 Cash on deposit

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.

This is describing a bank account that pays interest and allows instant access. Consider your own
bank account. You can choose when to invest money, ie pay money in, and when to disinvest
money, ie withdraw money. The interest you receive on your money will depend on the current
interest rate and this may change with little or no notice.

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1.5 Solving for an unknown quantity

Many problems in actuarial work can be reduced to solving an equation of value for an unknown
quantity. We will look at how to do this using examples based on a hypothetical fixed-interest
security which operates as follows:

Security S
A price P is paid (by the investor) in return for a series of interest payments of D payable at the
end of each of the next n years and a final redemption payment of R payable at the end of the n
years. The investor earns an annual effective rate of return of i .

R
Cashflows P D … D D

Time 0 1 … n–1 n

The equation of value for this investment is:

P  Dan  Rv n calculated at interest rate i

In the remainder of this section we will consider how to solve this equation when each of the
quantities P , D or R , n and i is unknown.

Solving for the present value (P)

The present value (which, in this case, represents the price) can be found using formulae we derived
earlier in the course.

Question

Calculate P , given that D  5 , R  125 , i  10% and n  10 .

Solution

The price P can be calculated directly (using 10% interest):

P  5a10  125v10  5  6.1446  125  0.38554  £78.92

Note from this example that the equation of value holds for the values P  78.92 , D  5 , R  125 ,
i  10% and n  10 . We will treat these values as our reference values.

The result shown in the following question is sometimes useful.

Question

For Security S, show algebraically that if D  iR , then P  R .

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Solution

The price P is given by the equation of value:

P  iRan  Rv n (calculated at interest rate i )

Using the formula for the annuity and simplifying gives:

 1  vn 
P  iR    Rv n  R(1  v n )  Rv n  R
 i 
 

We can also obtain this result by general reasoning.

Suppose an investor deposits a sum of money R into a bank account that pays an effective annual
interest rate i . The investor leaves the money in the account for n years. If interest is paid at the
end of each year, and is withdrawn as soon as it is paid, the investor will receive interest payments
of iR at the end of each year and the initial deposit of R will be repaid at the end of n years.

Under this arrangement the cashflows the investor receives exactly match the cashflows received by
investing an amount P in Security S . Also, the rate of return obtained from the bank account will
be i (by definition), which is the same as the interest rate i required from Security S .

So, investing R in the bank account or P in Security S leads to the same cashflows and gives the
same rate of return. So P and R must be equal.

Question

Calculate P , given that D  10 , R  125 , i  8% and n  10 .

Solution

The value of P is:

P  10a10  125v10  10  6.7101  125  0.46319  £125.00

This calculation verifies the result just proved, since here D  10  0.08  125  iR and we find that
P  125  R .

Solving for the amount of a payment (D or R)

Solving the equation of value for D or R is straightforward.

Question

Calculate D , given that P  127.12 , R  125 , i  7.75% and n  10 .

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Solution

The equation of value is:

127.12  Da10  125v10

1  1.077510
So: 127.12  D   125  1.077510
0.0775

ie 127.12  D  6.7864  125  0.47405

This can be rearranged to find D :

127.12  125  0.47405

D  10.00
6.7864

Solving for the timing of a payment (n)

We can solve the equation of value for n by expressing the annuity function in terms of v .

Question

Calculate n , given that P  78.92 , D  5 , R  125 and i  0.10 .

Solution

The equation of value is:

78.92  5an  125v n

Substituting the formula for an gives:

1  vn
78.92  5   125v n
0.10

ie 78.92  50(1  v n )  125v n  50  75v n

This can be rearranged to find v n :

78.92  50
vn   0.38560
75

ie 1.10n  0.38560

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Taking logs, and using the result log ab  b log a , we find:

log 0.38560
n log1.10  log 0.38560 ie n  10.00
log1.10

Solving for the interest rate (i)

Finding the interest rate is the hardest type of calculation, since the equation of value cannot
usually be solved explicitly. If the equation of value cannot be solved explicitly, we could use trial
and error, based on a rough initial guess.

To obtain an initial guess, we can approximate the interest rate by combining the cashflows into a
single payment, payable on an average payment date. This is illustrated in the following question.

Question

Given that P  78.92 , D  5 , R  125 and n  10 , determine a rough estimate for the value of i .

Solution

The equation of value is:

78.92  5a10  125v10 (calculated at interest rate i )

Here, a payment of 5 is received at the end of each of years 1 to 10 (roughly equivalent to a total
of 50 paid on average at time 5½), and in addition a payment of 125 is received at the end of
year 10. Combining these (and weighting the timings by amounts) gives a single payment of 175
(ie 50  125 ) at time 8.7 (ie (50  5½  125  10) / 175 ). This gives an equation we can solve more
easily:

78.92  175v 8.7 (calculated at rate i )

So:

1

 78.92  8.7
1 i    1.096 ie i  9.6%
 175 

This rough estimate is quite close to the exact value of 10% (which we know from earlier
questions).

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An alternative method for finding a first guess is to use a first-order binomial expansion, replacing
(1  i)n by (1  ni) . However, this is better suited to equations of value that contain no annuities.
For example, using this method here we would have attained a first guess of 7.7%:

 1  (1  i)10 
78.92  5    125(1  i)10
 i 
 
 1  (1  10i ) 
 78.92  5    125(1  10i)
 i 
 78.92  50  125(1  10i)
96.08
 i  7.7%
1,250

Once an initial estimate has been obtained, a more accurate solution can then be found from the
exact equation by linear interpolation, using the initial estimate as a starting point.

Estimating an unknown interest rate using linear interpolation

Suppose that the present values, calculated at interest rates i1 and i2 , are P1 and P2
respectively, and we wish to work out the approximate interest rate corresponding to a present
value of P .

This situation is illustrated on the following diagram

P1 P P2 Present value

i1 i i2 Yield

If the present value is a linear function of the interest rate, then the proportionate change in the
interest rates will equal the proportionate change in the present values:

i  i1 P  P1

i2  i1 P2  P1

Rearranging this relationship gives the approximate value of i :

P  P1
i  i1   (i2  i1 )
P2  P1

This approximation works best if the trial values are close to the true value, eg values that are 1%
apart. This formula also works even if the true value does not lie between the two trial values, but
we would not recommend this approach (ie extrapolation) in the exam. We recommend that you
interpolate between values that are either side of the true value and are a maximum of 1% apart. It
is even better if the two values are 0.5% apart.

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Question

Given that P  75 , D  5 , R  125 and n  10 , calculate the value of i .

Solution

The equation of value is:

75  5a10  125v10

We know that when i  10% , the right-hand side of this equation is equal to 78.92.

The price paid (75) is lower than this. So the value of i must be greater than 10%. Using i  11% ,
the right-hand side is:

 1  1.1110 
5a10  125v 10  5    125(1.11)10  73.47
 0.11 
 

Interpolating linearly using these two values gives:

75  78.92
i  10%   (11%  10%)  10.7%
73.47  78.92

1.6 Example applications

Later in the course we will use equations of value in the context of the most common types of
investment: fixed-interest bonds, index-linked bonds, equities (ie shares) and property.

Here, as an example, we will look at a question involving a property investment.

Question

A company has just bought an office block for £5m, which it will rent out to a number of small
businesses. The total rent for the first year will be £100,000, and this is expected to increase by
4% pa compound in each future year. The office block is expected to be sold after 20 years for
£7.5m.

Assuming that rent is paid in the middle of each year, calculate the yield the company will obtain
on this investment.

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Solution

Working in £000s, the equation of value here is:

5,000  100(v ½  1.04v1½  1.042 v 2½    1.0419 v 19.5 )  7,500v 20

The terms in brackets form a geometric progression of 20 terms, with first term v ½ and common
ratio 1.04v . So the equation of value can be written:

5,000 

100v ½ 1  (1.04v )20   7,500v20 provided v 
1
1  1.04v 1.04

We can solve this by trial and error. At 4%, the right-hand side (using the first expression) is:


100 1.04 ½  1.04 ½    1.04 ½ +  7,500
1.04 20
 100  20  1.04 ½ +
7,500
1.0420
 5,384.06

At 5%, the right-hand side (using the second expression) is 4,611.57. Interpolating between these
two values, we obtain:

5,000  5,384.06
i  4%   (5%  4%)  4.5%
4,611.57  5,384.06

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2 Uncertain payment or receipt

If there is uncertainty about the payment or receipt of a cashflow at a particular time,
allowance can be made in one of two ways:

 apply a probability of payment/receipt to the cashflow at each time, or

 use a higher rate of discount.

2.1 Probability of cashflow

The probability of payment/receipt can be allowed for by adapting the earlier equations. For
example, Equation (1.4) can be revised to produce:

n 
 pt ctr r
(1  i ) tr  0 p(t )  (t )(1  i ) t dt  0 (2.1)
r 1

where pt and p(t ) represent the probability of a cashflow at time t.

Where the force of interest is constant, and we can say that the probability is itself in the
form of a discounting function, then Equation (1.3) can be generalised as:

n 
 ct e  t e   t  0
r
r r  (t )e  t e   t dt  0 (2.2)
r 1

where  is a constant force, rather than rate, of the probability of a cashflow at time t .

These probabilities of cashflows may often be estimated by consideration of the experience

of similar cashflows. For example, this approach is used to assess the probabilities of
cashflows that are dependent on the survival of a life – this is the theme of later chapters.

In other cases, there may be lack of data from which to determine an accurate probability
for a cashflow. Instead a more approximate probability, or likelihood, may be determined
after careful consideration of the risks.

In some cases, it may be spurious to attempt to determine the probability of each cashflow
and so more approximate methods may be justified.

Wherever the uncertainty about the probability of the amount or timing of a cashflow could
have significant financial effect, a sensitivity analysis may be performed. This involves
calculations performed using different possible values for the likelihood and the amounts of
the cashflows. Alternatively, a stochastic approach could be used to indicate possible
outcomes.

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Question

A lottery ticket costs £1. The following table shows the different prizes available together with
the chance of winning and the delay before receiving the prize money.

Prize Probability of winning Time before payment

£20 1 in 50 1 day
£200 1 in 1,000 1 day
£2,000 1 in 50,000 1 week
£200,000 1 in 2 million 2 weeks
£2 million 1 in 14 million 4 weeks

Calculate the expectation of the present value of the prize money assuming an effective rate of
interest of 0.016% per day.

Solution

To calculate the expectation of the present value of the prize money, we take each possible
present value, multiply it by the probability that it occurs, and then sum over all possibilities.

So, working in days, the expectation of the present value of the prize money is:

1  20v  1  200v  1  2,000v 7

50 1,000 50,000

1
 2,000,000  200,000v14  14,000,000
1  2,000,000v 28

 £0.88

It is important to understand the different approaches to modelling and what is meant by

sensitivity analysis. A brief outline of these topics is included below.

2.2 Stochastic and deterministic models

If it is desired to represent reality as accurately as possible, the model needs to imitate the
random nature of the variables. A stochastic model is one that recognises the random
nature of the input components. A model that does not contain any random component is
deterministic in nature.

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

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

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The following example illustrates the difference between the two approaches.

Question

An investor has bought shares worth £5,000 and wants to estimate how much they will be worth
in a year’s time. Describe both a deterministic and stochastic model based on an expected
growth rate of 7% over the year.

Solution

Deterministic model

The outcome from a deterministic model is the prediction that the value in a year’s time would
be:

5,000  1.07  £5,350

Stochastic model

A stochastic model allows for randomness in the growth rate. For example, it might be decided
(based on past performance of the company and prospects for the company, the investment
sector and the economy in general) that the probabilities of different growth rates for the shares
are:

20% with probability 0.1

10% with probability 0.6

growth  
0% with probability 0.2
10% with probability 0.1

These probabilities add up to 1 and the expected growth rate is 7% for this model since:

0.1  20%  0.6  10%  0.2  0%  0.1  (10%)  7%

The outcome from this model, if it is run 100 times, is a list of 100 predicted values, which might
look like this:

£5500, £5000, £5000, £6000, £5000, … , £4500, £6000

Whether one wishes to use a deterministic or a stochastic model depends on whether one
is interested in the results of a single ‘scenario’ or in the distribution of results of possible
‘scenarios’. A deterministic model will give one the results of the relevant calculations for a
single scenario; a stochastic model gives distributions of the relevant results for a
distribution of scenarios. If the stochastic model is investigated by using ‘Monte Carlo’
simulation, then this provides a collection of a suitably large number of different
deterministic models, each of which is considered equally likely.

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 CM1-07: Equations of value Page 19

‘Monte Carlo’ simulation is where a computer is set up to run a stochastic model a number of
times, eg 10,000 times, using pseudo-random numbers generated by the computer. The results
look like the list of numbers in the stochastic model in the example above. The numbers
generated by the computer are pseudo-random rather than truly random because they are
generated using a prescribed method.

As stochastic models provide a distribution of outputs, they can be used to estimate the
probability that a particular event occurs, or to calculate approximate confidence intervals. This
wouldn’t be possible using a deterministic model.

The results for a deterministic model can often be obtained by direct calculation, but
sometimes it is necessary to use numerical approximations, either to integrate functions or
to solve differential equations.

If a stochastic model is sufficiently tractable, it may be possible to derive the results one
wishes by analytical methods. If this can be done it is often preferable to, and also often
much quicker than, Monte Carlo simulation. One gets precise results and can analyse the
effect of changes in the assumptions more readily. Monte Carlo simulation is covered in
CS1.

Many practical problems, however, are too complicated for analytical methods to be used
easily, and Monte Carlo simulation is an extremely powerful method for solving complicated
problems. But if even part of a model can be treated analytically, it may provide a check on
any simulation method used. It may be possible to use a deterministic method to calculate
the expected values, or possibly the median values, for a complicated problem, where the
distributions around these central values are estimated by simulation.

One also needs to recognise that a simulation method generally provides ‘what if?’
answers; what the results are on the basis of the assumptions that have been made. It is
much harder to use simulation to provide the optimum solution; in other words to find the
set of assumptions that maximises or minimises some desired result.

A further limitation is that the precision of a simulated result depends on the number of
simulations that are carried out. This is covered in more detail in CS1.

2.3 Sensitivity testing

Where possible, it is important to test the reasonableness of the output from the model
against the real world. To do this, an examination of the sensitivity of the outputs to small
changes in the inputs or their statistical distributions should be carried out. The
appropriateness of the model should then be reviewed, particularly if small changes in
inputs or their statistical distributions give rise to large changes in the outputs. In this way,
the key inputs and relationships to which particular attention should be given in designing
and using the model can be determined.

If small changes in the inputs give rise to large changes in the outputs, then our initial choices are
more crucial. How confident are we in our choices of input? If the resulting changes in output are
small, then our initial choices are less important in this respect.

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 Page 20 CM1-07: Equations of value

Sensitivity testing also refers to the approach of using a deterministic model with changes in one
or more of the assumptions to see the range of possible outcomes that might occur. For example,
an insurance company providing personal pension plans might give illustrations to policyholders
showing how much pension they would get if growth rates were 2%, 5% and 8% pa in the period
before retirement. This allows the policyholder to gauge the extent to which the resulting
pension will be affected by changes in the growth rate.

The model should be tested by designing appropriate simulation experiments. It is through

this process that the model can be refined.

An approach that has been traditionally used by actuaries in the fields of insurance, pensions and
investment is to carry out a set of deterministic calculations using different actuarial bases,
ie under different sets of assumptions. By varying the assumptions, the actuary could use the
model to arrive at figures that are ‘best estimates’ (the most likely, or median, result) or
‘optimistic’ (if things work out favourably) or ‘cautious’ (if things work out badly). This is an
example of a scenario-based approach to modelling.

2.4 Higher discount rate

As the discounting functions and the probability functions in Equations (2.1) and (2.2) are
both dependent on time, they can be combined into a single time-dependent function. In
cases where there is insufficient information to objectively produce the probability
functions, this combined function can be viewed as an adjusted discounting function that
makes an implicit allowance for the probability of the cashflow.

Where the probability of the cashflow is a function that is of similar form to the discounting
function, the combination can be treated as if a different discount rate were being used. For
example, Equation (2.2) becomes:

n 
 ct e  t  0  (t )e  t dt  0
r
r

r 1

where       .

The revised force of discount is therefore greater than the actual force of discount, as 
must be positive in order to give a probability between 0 and 1. It can therefore be shown
that the rate of discount that is effectively used is greater than the actual rate of discount
before the implicit allowance for the probability of the cashflow.

© IFE: 2024 Examinations The Actuarial Education Company

CM1-07: Equations of value Page 21

Question

An individual has invested in a company run by some ex-criminals. In return for the investment
they expect to receive £100 at the end of each of the next ten years. The annual effective interest
rate is 5%.

Calculate the present value of their investment by:

(i) ignoring the possibility that the payments might not be made.

(ii) assuming the probability of receiving the first payment is 0.95, the second payment is 0.9,
the third payment is 0.85 etc.

(iii) increasing the force of interest by 0.04652.

Solution

(i) PV  100a@5%  100  7.7217  £772.17

10

(ii) The present value allowing for the probabilities of payment is:

PV  100v  0.95  100v 2  0.9    100v10  0.5

 95v  90v 2    50v10

This is equivalent to an annuity in arrears with decreases of 5 each year. So the present
value is:

PV  100a10  5(Ia)10  100  7.7217  5  39.3738  £575.30

(iii) The new force of interest is ln(1.05)  0.04652  ln(1.1) . Therefore we can use an effective
rate of interest of 10% pa:

PV  100a@10%  100  6.1446  £614.46

10

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Page 22 CM1-07: Equations of value

The chapter summary starts on the next page so that you can
keep all the chapter summaries together for revision purposes

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CM1-07: Equations of value Page 23

Chapter 7 Summary
An equation of value equates the present value of money received to the present value of
money paid out:

PV income – PV outgo = 0

n 
 ctr e  tr  0  (t )e  t dt  0
r 1

n 
 ctr (1  i)tr  0  (t )(1  i)t dt  0
r 1

To calculate the yield on a transaction from an equation of value of the form f (i)  0 , we
need:
 to find i1 and i2 such that f (i1 ) and f (i2 ) are of opposite sign, and

 the final value obtained for i to be greater than 1 .

Some equations of value cannot be solved algebraically. In such cases, we might calculate
the yield using a trial and error approach, in conjunction with linear interpolation. The
formula for linear interpolation is:

P  P1
i  i1   (i2  i1 )
P2  P1

If there is uncertainty about the payment or receipt of a cashflow at a particular time,

allowance can be made in one of two ways:
 apply a probability of payment/receipt to the cashflow at each time
 use a higher rate of discount such as a new force of interest   , where       .

A model may be stochastic or deterministic. For stochastic models it is better to use direct
calculation if possible, but in complex situations it may be necessary to use Monte Carlo
simulation on a computer.

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Page 24 CM1-07: Equations of value

The practice questions start on the next page so that you can
keep the chapter summaries together for revision purposes.

© IFE: 2024 Examinations The Actuarial Education Company

 CM1-07: Equations of value Page 25

Chapter 7 Practice Questions

Questions 7.1 to 7.3 relate to financial security S, which operates as follows:

A price P is paid (by the investor) in return for a series of interest payments of D payable at the
end of each of the next n years, and a final redemption payment of R payable at the end of the
n years. The investor earns an annual effective rate of return of i .

7.1 Calculate P , given that D  5 , R  125 , i  10% and n  20 .

7.2 Calculate n , given that P  83.73 , D  4 , R  101 and i  6% .

7.3 Calculate i , given that P  75 , D  5 , R  120 and n  10 .

7.4 An investor is to pay £80,000 for a property. The investor will then be entitled to receive rental
payments at the end of each year for 99 years. The rental payment will be fixed for the first 33
years, increasing to double the original amount for the next 33 years, and three times the original
amount for the remaining 33 years. The value of the property at the end of the 99 years is
expected to be £1,500,000.

Calculate the amount of the rent payable in the first year, if the investor expects to obtain a rate
of return of 8% pa effective on the purchase.

7.5 An investor deposits £2,000 into an account, then withdraws level annual payments starting one
year after the deposit is made. Immediately after the 11th annual withdrawal, the investor has
£400 left in the account. Calculate the amount of each withdrawal, given that the effective
annual rate of interest is 8%.

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Page 26 CM1-07: Equations of value

The solutions start on the next page so that you can

separate the questions and solutions.

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 CM1-07: Equations of value Page 27

Chapter 7 Solutions
7.1 The price P can be calculated directly as follows:

P  5a20  125v 20  5  8.5136  125  0.14864  61.15

7.2 The term n satisfies the equation:

 1  1.06n 
83.73  4an  101v n  4    101  1.06 n
 0.06 
 

Rearranging gives:

 4  n 4
 101  0.06  1.06  83.73  0.06  1.06 n  0.49699
 

Taking logs, we find:

ln0.49699
n ln1.06  ln0.49699  n  12.00 years
ln1.06

7.3 To find the yield, we must solve the equation of value:

75  5a10  120v10

At 10%, RHS = 76.99.

At 11%, RHS = 71.71.

76.99  75
Interpolating, we find that i  0.10  (0.11  0.10)  0.1038 .
76.99  71.71

So i is approximately 10.4% pa.

7.4 If the amount of the rent payable in the first year is X , the equation of value is:

80,000  Xa33  2 Xv 33a33  3 Xv 66 a33  1,500,000v 99

ie 80,000  X (1  2v 33  3v 66 )a33  1,500,000v 99

So:

80,000  X (1  2  1.0833  3  1.08 66 )  11.5139  1,500,000  1.0899

This can be rearranged to find X :

80,000  736.444
X  £5,852
13.545

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 Page 28 CM1-07: Equations of value

7.5 If the amount of the annual withdrawal is X , then we need to solve the equation:

2,000  Xa11  400v11

So:

2,000  7.1390 X  400  1.0811

Rearranging to find X gives:

1,828.45
X  £256.12
7.1390

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CM1-07: Equations of value Page 29

End of Part 1

What next?
1. Briefly review the key areas of Part 1 and/or re-read the summaries at the end of
Chapters 1 to 7.
2. Ensure you have attempted some of the Practice Questions at the end of each chapter in
Part 1. If you don’t have time to do them all, you could save the remainder for use as part
of your revision.
3. Attempt Assignment X1.
4. Attempt the questions relating to Chapters 1 to 7 of the Paper B Online Resources
(PBOR).

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 CM1: Assignment X1 – Questions Page 1

X1.1 Calculate the present value of a perpetuity paying £50 pa in arrears at an annual effective rate of
interest of 6%. [1]

X1.2 Calculate the length of time it will take £800 to accumulate to £1,000 at a simple rate of interest
of 4% pa. [2]

X1.3 Explain the main differences between a deterministic model and a stochastic model. [3]

X1.4 A 91-day government bill is discounted at a simple rate of discount of 10% pa. Calculate the
annual effective rate of interest earned on this investment. [3]

X1.5 An annuity of $300 pa is paid annually in advance for seven years, followed by $100 pa paid
quarterly in arrears for a further five years. The rate of interest is 6% pa convertible half-yearly.

Determine the accumulated amount at the end of twelve years. [5]

X1.6 Calculate, at a rate of interest of 8% per annum effective:

(a) a(4)
5
[1]

(b) 
2| a15 [1]

(c) (Ia )10 [2]

(d) ( Ia )10 [2]

[Total 6]

X1.7 An investor, who has a sum of £10,000 to invest, wishes to purchase an annuity certain which
makes payments over a ten-year period. Calculate the amount of the payments that can be
provided if the annuity takes each of the following forms (assuming interest of 8% pa effective):

(i) a level annuity payable monthly in arrears [2]

(ii) a level annuity due payable half-yearly, commencing in 2 years’ time. [2]
[Total 4]

X1.8 Explain when you would use real and money rates of interest. Give an example of when each rate
of interest would be used. [4]

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 Page 2 CM1: Assignment X1 – Questions

X1.9 (i) Calculate the nominal annual rate of discount convertible quarterly equivalent to a
nominal rate of interest of 10% pa convertible quarterly. [2]

(ii) A single investment of £500 is accumulated at a nominal rate of discount of 6% pa

convertible half-yearly for 1 year, followed by a nominal rate of interest of 6% pa
convertible every 4 months for 1 year. Calculate the accumulated amount of this
investment after 2 years. [3]
[Total 5]

X1.10 For each of the following calculate the equivalent effective annual rate of interest:

(i) an effective rate of interest of 12.7% paid every 2 years [1]

(ii) an effective rate of discount of 5.75% pa [1]

(iii) a force of interest of ½% per month [1]

(iv) a nominal rate of discount of 6% pa convertible quarterly [1]

(v) a nominal rate of interest of 14% pa convertible every 2 years. [1]

[Total 5]

X1.11 An investor receives payments half-yearly in arrears for 20 years. The first payment is £250, and
each payment is 2% higher than the previous one.

The interest rate is 6% pa effective for the first 10 years and 4% pa effective for the final 10 years.

Calculate, showing all workings, the present value of the payments. [7]

X1.12 The force of interest,  (t) , is a function of time and at time t , measured in years, is given by:

 (t)  0.03  0.005t  0.001t 2 0  t  10

(i) Calculate the equivalent constant force of interest per annum for the period t  0 to
t 10 . [3]

(ii) Calculate, showing all workings, the accumulated value at time t  7 of an investment of
£250 at time t  0 plus a further investment of £150 at time t  5 . [5]
[Total 8]

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 CM1: Assignment X1 – Questions Page 3

X1.13 An annuity payable monthly in arrears has a first payment of £300, with subsequent payments
decreasing by £10 each month, until a final payment of £70 is made in two years’ time.

Calculate the present value of the payments from this annuity using an effective rate of interest of
6% pa. [4]

X1.14 In return for a fixed initial deposit, an investor receives a continuously payable annuity for a term
of 15 years. The annual rate of payment is 50 in the first year, and the rate of payment increases
in each subsequent year.

The investor can select either:

 Option 1: the rate of payment increases by 2 at the end of each year,
 Option 2: the rate of payment increases by 3.5% pa compound at the end of each year.

Determine which option would provide the better deal for the investor at an annual effective
interest rate of 7%. [8]

X1.15 The force of interest  (t) is a function of time, and at any time t , measured in years, is given by
the formula:

0.04  0.005t 0  t  6

 (t)  0.16  0.015t 6  t  8
 0.04 8t


(i) Derive expressions in terms of t for the accumulated amount at time t of an investment
of 1 at time 0. [6]

(ii) (a) Calculate the value at time 0 of £100 due at time 9.

(b) Calculate the annual effective rate of discount implied by the transaction in (a). [3]

(iii) A continuous payment stream is received at a rate of 45e 0.01t units per annum between
time 10 and time 15. Calculate, showing all workings, the present value at time 4 of this
payment stream. [6]
[Total 15]

END OF PAPER

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All study material produced by ActEd is copyright and is sold
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You must take care of your study material to ensure that it

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Legal action will be taken if these terms are infringed. In

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These conditions remain in force after you have finished

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CM1: Assignment X1 – Solutions Page 1

Assignment X1 – Solutions
Markers: This document sets out one approach to solving each of the questions. Please give
credit for other valid approaches. In particular, in ‘trial and error’ questions, full marks should be
awarded for obtaining the correct final answer whatever method is used (eg ‘table mode’ on a
calculator), so long as sufficient working is given.

Additional solutions to mathematical parts of questions are provided in boxes in order to illustrate
how they could be answered in the exam, using Word. Other presentations and ways of typing
out the notation would also be acceptable.

Solution X1.1

Perpetuities are covered in Chapter 5, Section 6.

50
PV  50a   £833.33 [1]
i
[Total 1]

PV = 50 * a:<infinity> @6% = 50 / 0.06 = £833.33

Solution X1.2

Simple interest is covered in Chapter 1, Section 1.

The length of time can be found from the equation:

800(1  0.04t )  1,000 [1]

 t  6¼years [1]
[Total 2]

Need to find n that solves:

800 * (1 + n*0.04) = 1,000

This makes n = 6.25 years

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Page 2 CM1: Assignment X1 – Solutions

Solution X1.3

Deterministic and stochastic models are introduced in Chapter 7, Section 2.

A deterministic model uses one set of input parameters and gives the results of the relevant
calculations for this single scenario. [1]

A stochastic model involves at least one input parameter varying according to an assumed
probability distribution. As such, the output will vary along with the input and the model
produces distributions of the relevant results for a distribution of scenarios. [1]

Often the output from a stochastic model is in the form of many thousands of simulated
outcomes of the process. We can study the distributions of these outcomes. [1]
[Total 3]

Solution X1.4

Simple discount is covered in Chapter 1, Section 3.

The discount factor for 91 days under simple discount is:

 
91  0.10  0.9751
(1  nd )  1  365 [1]

Equating this to the effective discount factor:

91 91
 365
v 365  0.975  (1  i)  0.975 [1]

 365
 (1  i)  0.975 91  i  10.66% [1]
[Total 3]

91 or even 1 (since 91 days is approximately a quarter of a year) in both

Alternatively, using 365.25 4
calculations will give the same answer to 4 SF.

We need to solve:

(1+i)^-(91/365) = (1 – (91/365) * 0.1) = 0.9751

So i = 10.66%

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CM1: Assignment X1 – Solutions Page 3

Solution X1.5

Accumulations of level annuities are covered in Chapter 5, Sections 2 and 4.

The annual rate of interest, i , is given by:

(1  i)  1.032  1.0609  i  6.09% [½]

The present value of the annuity is given by:

PV  300
a7  100v 7a(4) [1]
5

Now:

1  v 7 1  1.06097

a7    5.90345 [½]
d 1  1.06091

and:

1  v5 1  1.06095 1  1.06095
a(4)     4.29685 [½]
5 i (4) 4 1.0609¼  1 0.059557
 

So:

PV  300  5.90345  100  1.06097  4.29685 [½]

 1771.04  284.07

 $2,055.11 [1]

So the accumulated amount after 12 years is:

$2,055.11  1.060912  $4,178 [1]

[Total 5]

Alternatively, this could be calculated as:

300
s7 (1  i)5  100 s(4)
5

7
We could calculate the second annuity by working in quarters eg 25v6.09% a or
20 @1.4889157%
25s20 @1.4889157% .

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Page 4 CM1: Assignment X1 – Solutions

Accumulated value at time 12 is:

AV = 300 * adue:<7> * (1+i)^12 + 100 * s(4):<5>

where:

adue:<7> = (1 – (1+i)^-7) / d

i = 1.03^2 – 1 = 0.0609

d= i / 1+i

So:

adue:<7> = 5.90345

Also:

s(4):<5 = ((1+i)^5 – 1) / i(4)

where: i(4) = (1.03^0.5 – 1) * 4 = 0.059557

So:

s(4):<5> = 5.77461

So:

AV = 300 * 5.90345 * 1.0609^12 + 100 * 5.77461 = $4,177.61

Solution X1.6

Level annuities payable pthly are covered in Chapter 5, Section 4. Deferred annuities are covered
in Chapter 5, Section 7. Increasing, continuously payable annuities are covered in Chapter 6,
Section 1.

(a) a (4)
5

1  v5 1  1.08 5 1  1.08 5
a(4)     4.110571 [1]
5 i (4) 4 1.08 
1/4
 1 0.077706
 

a(4):<5> = (1 – v^5 / i(4)) = (1 – 1.08^-5) / 0.077706 = 4.110571

(b) 
2| a15

1  1.0815
2|
a  v 2  
a  1.082   7.925443 [1]
15 15 0.08
1.08

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CM1: Assignment X1 – Solutions Page 5

2|adue:<15> =v^2 * (1 – v^15) / d = 1.08^-2 * (1 – 1.08^-15) / (0.08 / 1.08) = 7.925443

(c) (Ia )10


a  10v10
 10 10
Ia  [½]


1  1.08 10

a   7.246888 [½]
10 0.08
1.08

7.246888  10  1.08 10

 Ia 10   33.977621 [1]
ln(1.08)

(Iabar):<10> = (adue:<10> – 10*v^10) / delta

adue:<10> = (1 – 1.08^-10) / (0.08 / 1.08) = 7.246888

(Iabar):<10> = (7.246888 – 10*1.08^-10) / ln(1.08) = 33.977621

(d) ( Ia )10
a  10v10
 Ia 10  10

[½]

1 - 1.08 -10
a10 = = 6.975042 [½]
ln(1.08)

-10
(Ia )10 = 6.975042ln(1.08)
- 10 ´ 1.08
= 30.445370 [1]

[Total 6]

(Ibarabar):<10> = (abar:<10> – 10*v^10) / delta

abar:<10> = (1 – 1.08^-10) / ln(1.08) = 6.975042

(Ibarabar):<10> = (6.975042 – 10*1.08^-10) / ln(1.08) = 30.445370

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Page 6 CM1: Assignment X1 – Solutions

Solution X1.7

Level annuities payable pthly are covered in Chapter 5, Section 4.

(i) Level monthly annuity

Let X be the monthly amount paid. Then the present value of the payments is:

 1  1.08 10 
12 Xa(12)  12 X    83.4324 X [1]
10  i (12) 
 


1

where i (12)  12 1.08 12  1  7.7208% .

10,000
Since the investor paid £10,000, X   £119.86 . [1]
83.4324
[Total 2]

Alternatively, we could work in months: Xa120 @0.643403011% .

Need to find X where:

10,000 = 12 * X * a(12):<10>

and:

a(12):<10> = (1 – 1.08^-10) / i(12) = (1 – 1.08^-10) / 0.077208 = 6.95273

i(12) is taken from the Tables.

So: X = £119.86

(ii) Level annuity payable half yearly

Let Y be the half-yearly amount. Then the present value of the payments is:

 1   1  1.08 10 
2Yv 2
a (2)|  2Y     12.19154Y [1]
10  1.082   d (2) 


 1

where d (2)  2 1  1.08 2  7.5499% .

10,000
Since the investor paid £10,000, Y   £820.24 . [1]
12.19154
[Total 2]

2 
Alternatively, we could calculate the annuity by working in half-years: Yv8% a20 @3.9230485% .

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CM1: Assignment X1 – Solutions Page 7

Need to find Y where:

10,000 = 2 * Y * 1.08^-2 * adue(2):<10>

and:

adue(2):<10> = (1 – 1.08^-10) / d(2) = (1 – 1.08^-10) / 0.075499 = 7.11011

d(2) is taken from the Tables.

So: Y = £820.24

Solution X1.8

Real and money rates of interest are covered in Chapter 3.

A real rate of interest is used when inflation needs to be taken into account. [1]

A money rate of interest is used when inflation does not need to be taken into account. [1]

An example for a real rate of interest: A person is saving to go on a round the world trip, which
they have calculated will cost £10,000 today. [1]

An example for a money rate of interest: A person has a loan of £10,000, which needs to be paid
back in full in 5 years’ time. [1]
[Total 4]

Allow any suitable examples here.

Solution X1.9

Nominal interest and discount are covered in Chapter 2, Section 1.

(i) Rate of discount convertible quarterly

p
 i (p) 
Using the formula 1  i   1   gives:
 p 


4
 0.1 
1  i  1    1.10381 [1]
 4 

Alternatively (1  i )¼  1.025 .

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Page 8 CM1: Assignment X1 – Solutions

 1 
Now using the formula d (p)  p 1  (1  i) p  gives:
 

d (4)  4 1  (1  i)¼   4 1  1.0251   9.76% [1]

   
[Total 2]

i i(4)
Note: Although d  , this formula does not work for nominal rates, ie: d (4)  .
1 i 1  i(4)
However it does work for effective rates so it is true that:

d (4) i (4) 4

4 1  i(4) 4

We have:

d(4)/4 = [i(4)/4] / [1 + i(4)/4]

So:

d(4) = 4 * 0.025 / 1.025 = 9.75610% pa

(ii) Accumulated amount

Let i1 and i2 be the effective annual rates for the first and second years respectively. Then using
p
1  d (p) 
the formula  1   gives:
1  i  p 

2
 0.06 
1  i1   1    1.06281 [1]
 2 

 12
Alternatively (1  i1 )  0.97 .

p
 i (p) 
Now using the formula 1  i   1   gives:
 p 
 

3
 0.06 
1  i2   1    1.061208 [1]
 3 

1
Alternatively (1  i2 ) 3  1.02 .

So accumulating the £500:

500(1  i1 )(1  i2 )  500  1.06281  1.061208  £563.93 [1]

[Total 3]

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CM1: Assignment X1 – Solutions Page 9

Alternatively, we could use the other factors that we calculated:

500(1  i1 )(1  i2 )  500  0.972  1.023  £563.93

Note: It is easy to become confused between a quarter (3 months) and the 4 months given in the
question. Many students incorrectly use a quarterly time period.

After 2 years the accumulated amount will be:

500 * (1 – 0.06 / 2)^-2 * (1 + 0.06 / 3)^3 = £563.93

Solution X1.10

The interest and discount rates used in this question are covered in Chapter 1, Sections 1 and 3,
and in Chapter 2, Sections 1 and 2.

(i) Effective rate

1
(1  i)2  1.127  i  1.127 2  1  6.16026%

So the equivalent effective annual rate of interest is 6.16%. [1]

[Total 1]

Don’t get confused. This is an effective rate paid every two years not a nominal rate convertible
every two years as in part (v).

1.127^0.5 – 1 = 6.16026% pa

(ii) Effective rate

v  1  d  0.9425  (1  i)  0.94251  i  6.1008%

So the equivalent effective annual rate of interest is 6.10%. [1]

[Total 1]

Very often it is easier to turn a rate of discount into a rate of interest by first finding v .
d
Alternatively, we could use i  .
1d

(1 – 0.0575)^-1 – 1 = 6.10080% pa

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Page 10 CM1: Assignment X1 – Solutions

(iii) Effective rate

i  e120.005  1  6.18365%

So the equivalent effective annual rate of interest is 6.18%. [1]

[Total 1]

exp(0.005 * 12) – 1 = 6.18365% pa

(iv) Effective rate

4
1  d (4) 
Using  1   , we have:
1  i  4 

4
 0.06 
i  1    1  6.23193%
 4 

So the equivalent effective annual rate of interest is 6.23%. [1]

[Total 1]

(1 – 0.06 / 4)^-4 – 1 = 6.23193% pa

(v) Effective rate

p
 i (p) 
Using the formula 1  i   1   , we have:
 p 


1
 0.14 
2

i  1   1  13.1371%
 1 
 2 

So the equivalent effective annual rate of interest is 13.14%. [1]

[Total 1]

(1 + 0.14*2)^0.5 – 1 = 13.13708% pa

Solution X1.11

Compound increasing annuities are covered in Chapter 6, Section 2.2.

1
We will work in years, with v1  denoting the one-year discount factor applicable in each of
1.06
1
the first 10 years, and v2  denoting the one-year discount factor applicable in each of the
1.04
final 10 years.

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CM1: Assignment X1 – Solutions Page 11

The times, payments and discount factors are:

Time in years Time in half-years Payment Discount factor

0.5 1 250 v10.5

1 2 250  1.02 v1

1.5 3 250  1.022 v11.5

10 20 250  1.0219 v110

10.5 21 250  1.0220 v110v20.5

11 22 250  1.0221 v110v2

20 40 250  1.0239 v110v210

The total present value of the payments received is therefore:

250v10.5  250(1.02)v1  250(1.02)2 v11.5    250(1.02)19 v110

 250(1.02)20 v110v20.5  250(1.02)21 v110v2    250(1.02)39 v110v210 [2]

The terms in the first line of the present value expression form a geometric progression of 20
terms, with first term 250v10.5 and common ratio (1.02)v10.5 , so:

250v10.5  250(1.02)v1  250(1.02)2 v11.5    250(1.02)19 v110


 
20 
0.5
 1  1.02v1 
 250v10.5  
0.5
1  1.02v1
 4,450.86 [2]

The terms in the second line of the present value expression form a geometric progression of 20
terms, with first term 250(1.02)20 v110v20.5 and common ratio (1.02)v20.5 , so:

250(1.02)20 v110v20.5  250(1.02)21 v110v2    250(1.02)39 v110v210


 
20 
0.5
 1  1.02v2 
 250(1.02)20 v110v20.5  
0.5
1  1.02v2
 4,075.60 [2]

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Page 12 CM1: Assignment X1 – Solutions

So the total present value of the payments is:

4,450.86  4,075.60  £8,526.46 [1]

[Total 7]

1
Alternatively, we could work in half-years, with v3  denoting the half-year discount
1.060.5
1
factor applicable in each of the first 10 years, and v4  denoting the half-year discount
1.04 0.5
factor applicable in each of the final 10 years.

Then the total present value of the payments received is:

250v3  250(1.02)v32  250(1.02)2 v33    250(1.02)19 v320

 250(1.02)20 v320v4  250(1.02)21 v320v42    250(1.02)39 v320v420

The terms in the first line of the present value expression form a geometric progression of 20
terms, with first term 250v3 and common ratio (1.02)v3 , giving a total of:


 
20 
 1  1.02v3 
250v3    4,450.86
1  1.02v3

The terms in the second line of the present value expression form a geometric progression of 20
terms, with first term 250(1.02)20 v320v4 and common ratio (1.02)v4 , giving a total of:


 
20 
 1  1.02v4 
250(1.02)20 v320v4    4,075.60
1  1.02v4

So the total present value of the payments is:

4,450.86  4,075.60  £8,526.46

as before.

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CM1: Assignment X1 – Solutions Page 13

Alternatively, the sum:

250v3  250(1.02)v32  250(1.02)2 v33    250(1.02)19 v320

can be evaluated as an annuity as:

250 1.060.5
a20 @ j where j1   1  0.93755%
1.02 1 1.02

and the sum:

250(1.02)20 v320v4  250(1.02)21 v320v42    250(1.02)39 v320v420

can be evaluated as an annuity as:

1.040.5
250(1.02)19 v320 a20 @ j where j2   1  0.019225%
2 1.02

PV of the first 10 years’ payments is:

PV(0,10) = 250 * v^0.5 + 250 * 1.02 * v + 250 * (1.02^2) * v^1.5 + …{total of 20 terms}

where: v = 1.06^-1.

Using sum of geometric series:

PV(0,10) = 250 * v^0.5 * [1 – (1.02 * v^0.5)^20] / (1 – 1.02 * v^0.5) = 4,450.86

PV at time 0 of the second 10 years’ payments is:

PV(10,20) = (1.06^-10) * [250 * (1.02^20) * v^0.5 + 250 * (1.02^21) * v + …{total of 20 terms}]

where: v = 1.04^-1.

Using sum of geometric series:

PV(10,20) = (1.06^-10) * 250 * (1.02^20) * v^0.5 * [1 – (1.02 * v^0.5)^20] / (1 – 1.02 * v^0.5) =

4,075.60

So the total PV is 4,450.86 + 4,075.60 = 8,526.46

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Page 14 CM1: Assignment X1 – Solutions

Solution X1.12

The force of interest as a function of time is covered in Chapter 2, Section 4.

(i) Equivalent constant force of interest

The accumulation factor from t  0 to t  10 is:

10
2
 0.030.005t  0.001t dt
A(0,10)  e 0
10
 2 0.001 3 
0.03t 0.0025t  3 t 
e 0 [1]

 e 0.383 [1]

Let  be the constant force of interest, then:

e10  e 0.383  10  0.383    3.83% [1]

[Total 3]

Call D the constant force of interest over the 10 years. The accumulation A(0,10) should be the
same in both cases so:

exp[D * 10] = exp[INT(0,10):{0.03 – 0.005t + 0.001t^2}dt]

Take logs of both sides:

D*10 = [0.03t – 0.0025t^2 + (0.001t^3) / 3]:(0,10) = 0.3 – 0.25 + 1/3 – 0 = 0.38333

So: D = 0.038333

(ii) Accumulated value

The accumulated value is:

7 7
2 2
 0.030.005t 0.001t dt  0.030.005t 0.001t dt
250e 0  150e 5 [2]
7 7
 2 0.001 3   2 0.001 3 
0.03t 0.0025t  3 t  0.03t 0.0025t  3 t 
 250e  0  150e  5

 250e 0.20183  150e 0.201830.12917 [1]

 250e 0.20183  150e 0.07267

 305.91  161.31 [1]

 £467.22 [1]
[Total 5]

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CM1: Assignment X1 – Solutions Page 15

Alternatively, we could accumulate 250 to time 5, then add 150, then accumulate further to
time 7.

This is:

AV = 250 * exp[INT(0,7)] + 150 * EXP[INT(5,7)]

where:

INT(0,7) = [0.03t – 0.0025t^2 + (0.001t^3) / 3]:(0,7) = 0.21 – 0.1225 + 0.11433 – 0 = 0.20183

INT(5,7) = [0.03t – 0.0025t^2 + (0.001t^3) / 3]:(5,7)

= 0.21 – 0.1225 + 0.11433 – (0.15 – 0.0625 + 1/24) = 0.072663

So: AV = 467.22

Solution X1.13

Simple increasing annuities are covered in Chapter 6, Section 1.

As the payments decrease each month, we work in months with a monthly effective interest rate
of:

1.061 12  1  0.486755% [½]

A timeline showing the payments is as follows:

300 290 ... 70 Cashflow

0 1 2 ... 24 Time (months)

The present value of the payments (working in months) is therefore:

310a24  10(Ia)24 [1]

Alternatively, the present value of the payments may be written as:

300a24  10v(Ia)23

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Page 16 CM1: Assignment X1 – Solutions

Now:

1  1.0048675524
a24   22.599367 [1]
0.00486755

and:

 1  1.0048675524 
   24  1.0048675524
 0.00486755 1.00486755 
(Ia)24     277.235061 [1]
0.00486755

So the present value is:

310  22.599367  10  277.235061  £4,233.63 [½]

[Total 4]

Work in months, using a monthly effective interest rate of:

im = 1.06^(1/12) – 1 = 0.48676%

The present value is:

PV = 310 * a:<24> – 10 * (Ia):<24>

where:

a:<24> = (1 – (1+im)^-24) / im = 22.59937

adue:<24> = (1+im) * a:<24> = 22.70937

(Ia):<24> = [22.70937 – (24 * (1+im)^-24)] / im = 277.23506

So: PV = 4,233.45

Solution X1.14

Simple increasing annuities are covered in Chapter 6, Section 1. Compound increasing annuities
are covered in Chapter 6, Section 2.2.

For Option 1, a timeline showing the payments made is as follows:

50 pa 52 pa ... 78 pa Cashflows

0 1 2 ... 14 15 Time (years)

The present value of the annuity under Option 1 is therefore:

48a15  2(Ia )15 [1]

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CM1: Assignment X1 – Solutions Page 17

Alternatively, this can be expressed as:

50a15  2v(Ia )14

Now:

1  v15 1  1.0715
a15    9.42310 [1]
 ln(1.07)

and:

 1  1.0715 
   15  1.0715
 0.07 1.07 
(Ia )15     63.68406 [1]
ln(1.07)

So the present value of the annuity under Option 1 is:

48  9.42310  2  63.68406  £579.68 [½]

For Option 2, a timeline showing the payments made is as follows:

14
50 pa 50 ( 1.035) pa ... 50 ( 1.035) pa Cashflows

0 1 2 ... 14 15 Time (years)

The present value of the annuity under Option 2 is therefore:


50a1  50  1.035 v a1    50  1.03514 v14 a1  50a1 1  1.035 v    1.03514 v14  [2]

The terms in brackets form a geometric progression of 15 terms with first term 1 and common
ratio 1.035v , so:

1  (1.035v)15 1  (1.035  1.071 )15

1  1.035 v    1.03514 v 14    12.007738 [1]
1  1.035v 1  1.035  1.071

Alternatively, this summation can be calculated as:

1.07

a15 @ j where j   1  3.381643%
1.035

Also:

1v 1  1.071
a1    0.96692 [½]
 ln(1.07)

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Page 18 CM1: Assignment X1 – Solutions

So the present value of the annuity under Option 2 is:

50  0.96692  12.007738  £580.53 [½]

Since the present value of the payments is higher under Option 2, it provides the better deal for
the investor. [½]
[Total 8]

The better deal is the option that has the higher present value (PV).

We define the force of interest to be:

D = ln(1.07)

The PV of Option 1 is:

PV(1) = 2 * (Iabar):<15> + 48 * abar:<15>

where:

abar:<15> = (1 – 1.07^-15) / D = 9.42310

For (Iabar) we will need:

adue:<15> = (1 – 1.07^-15) * 1.07/0.07 = 9.74547

So:

(Iabar):<15> = (9.74547 – 15 * 1.07^-15) / D = 63.68406

So: PV(1) = 579.68

The PV of Option 2 is:

PV(2) = 50 * abar:<1> + 50 * abar:<1> * 1.035 * v + … {total of 15 terms}

where:

1.035 * v = 1.035/1.07 = 0.96729

abar:<1> = (1 – 1.07^-1) / d = 0.96692

Using the sum of a geometric series:

PV(2) = 50 * abar:<1> * [1 – (1.035 * v)^15] / (1 – 1.035 * v) = 580.53

So Option 2 provides the better deal.

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CM1: Assignment X1 – Solutions Page 19

Solution X1.15

The force of interest as a function of time is covered in Chapter 2, Section 4. Payment streams are
covered in Chapter 4, Sections 1 and 2.

Let A(t1 , t2 ) denote the accumulated value at time t2 of 1 unit paid at time t1 .

(i) Accumulated amount

For 0  t  6 :

t t
2 t 2
  (s) ds   (0.04  0.005s) ds  [0.04 s  0.0025s ]0  0.04t  0.0025t [1]
0 0

So:

2
A(0, t )  e0.04t 0.0025t (0t 6) [1]

and:

A(0,6)  e 0.33

For 6  t  8 :

t t
  (s) ds   (0.16  0.015s) ds
6 6

 [0.16 s  0.0075s2 ]t6

 0.16(t  6)  0.0075(t 2  62 )

 0.69  0.16t  0.0075t 2 [1]

So:

2 2
A(0, t )  e0.33e 0.69 0.16t 0.0075t  e 0.36 0.16t 0.0075t (6t 8) [1]

and:

A(0,8)  e 0.44

For 8  t :

t t
  (s) ds   0.04 ds  0.04(t  8) [1]
8 8

So:

A(0, t )  e0.44 e 0.04(t 8)  e0.12 0.04t ( 8  t ) [1]

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Page 20 CM1: Assignment X1 – Solutions

In summary:

 e 0.04t  0.0025t 2 0t 6


 2
A(0, t )  e 0.360.16t 0.0075t 6t 8

 e 0.12 0.04t 8t

[Total 6]

For 0 <= t <6:

A(0,t) = exp[INT(0,t):{0.04 + 0.005s}ds]

= exp[0.04s + 0.0025s^2]:(0,t)

= exp[0.04t + 0.0025t^2]

For 6 <= t < 8:

A(0,t) = exp[0.04*6 + 0.0025*6^2] * exp[INT(6,t):{0.16 – 0.015s}ds]

= exp(0.33) * exp[0.16s – 0.0075s^2]:(6,t)

= exp(0.33) * exp[0.16t – 0.0075t^2 – 0.69]

= exp[0.16t – 0.0075t^2 – 0.36]

For t >= 8:

A(0,t) = exp[0.16*8 – 0.0075*8^2 – 0.36] * exp[0.04*(t-8)]

= exp[0.12 + 0.04t]

(ii)(a) Present value

The present value is:

100 100 100

   100e 0.48  £61.88 [1½]
A(0,9) e 0.12 0.049 e0.48

Alternatively, we could calculate this from first principles:

6 8 9
  0.04 0.005t dt   0.160.015t dt   0.04 dt
PV  100e 0 e 6 e 8

6 8
 0.04t  0.0025t 2    0.16t 0.0075t 2   0.04t 9
 100e  0 e  6 e 8

 100e 0.33e(0.80.69)e (0.36 0.32)

 100e 0.48  £61.88

© IFE: 2024 Examinations The Actuarial Education Company

CM1: Assignment X1 – Solutions Page 21

This is:

100 / A(0,9) = 100 * exp(– 0.12 – 0.04 * 9) = £61.88

(ii)(b) Equivalent annual effective rate of discount

Letting d denote the equivalent annual effective rate of discount:

100e 0.48  100(1  d )9  e 0.48  (1  d )9 [1]

Therefore:

 
1
d  1  e 0.48
9
 0.051936 ie 5.1936% [½]
[Total 3]

Alternatively, we could calculate the equivalent annual effective interest rate first:

 
1
100e 0.48  100v 9  i  e 0.48
9
 1  0.054781

We can then use this to calculate the annual effective rate of discount:

i 0.054781
d   0.051936 ie 5.1936%
1  i 1.054781

Need to find d such that:

100 * (1 – d)^9 = 61.88

So:

d = 1 – 0.6188^(1/9) = 5.19361% pa

(iii) Present value of payment stream at time 4

The present value at time 10 is:

t
15   0.04 ds
0.01t
PVt 10   45e e 10 dt [2]
10

Carrying out the integration:

15 15 15
 0.04 s10
t
0.01t 0.04t  0.4 0.03t
PVt 10  0.01t
 45e e dt   45e e dt  45e0.4 e dt
10 10 10
15
 e 0.03t  45e 0.4 0.0315 0.0310
 45e0.4   
 0.03 10 0.03
e e  230.912   [2]

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Page 22 CM1: Assignment X1 – Solutions

We now need to discount this back to time 4.

The present value at time 4 is:

230.912
PVt 4 
A(4,10)

where:

A(0,10) e0.120.0410 e0.52

A(4,10)     e 0.32 [1]
A(0,4) e 0.044  0.002542 e0.2

So the present value of this payment stream at time 4 is:

230.912
PVt 4   230.912e 0.32  167.677 [1]
A(4,10)
[Total 6]

Alternatively, the discount factor from time 10 to time 4 could be calculated from first principles:

6 8 10
  0.04  0.005t dt   0.16 0.015t dt   0.04 dt
e 4 e 6 e 8

6 8
 0.04t  0.0025t 2   0.16t 0.0075t 2   0.04t 10
e  4 e  6 e 8

 e (0.330.2)e (0.80.69)e (0.4 0.32)

 e 0.32

Alternatively, the answer could be calculated by first calculating the present value at time 0, using
the integral:

15 15
1 0.01t 0.120.04t
PVt 0   45e 0.01t dt   45e e dt  137.282
A(0, t )
10 10

and then accumulating this forward to time 4:

2
PVt 4  PVt 0  A(0,4)  137.282e 0.044 0.00254  137.282e 0.2  167.677

where the expressions for A(0, t ) are taken from part (i).

© IFE: 2024 Examinations The Actuarial Education Company

CM1: Assignment X1 – Solutions Page 23

First calculate the PV of the payment stream at time 0:

PV(0) = INT(10,15):{45 * exp(0.01*t) * exp[–0.12 – 0.04 * t]}dt

= 45 * exp(–0.12) * INT(10,15):exp(–0.03 * t)dt

= –(45/0.03) * exp(–0.12) * [exp(–0.03 * 15) – exp(–0.03 * 10)]

= 137.28

Then accumulate this to time 4 by multiplying by A(0,4):

PV(4) = 137.28 * exp[0.04*4 + 0.0025 * (4^2)] = 167.68

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