Chapter 3.

Yield Rates
C.Y. Ng
Section 1. Yield Curve

CHAPTER 3 Yield Rates

Related Readings …

Financial Mathematics for Actuaries (3rd edition)

Sections 3.1  3.4, 4.1, 4.5

The Theory of Interest (2nd edition)

Section 5.4, 5.8, 9.6

L earning Objectives
Yield curve, spot and forward rates, IRR, inflation, reinvestment rates

In this chapter we briefly discuss non-level interest rates and how a yield curve can be used to
price cash flows. We also discuss the concept of interest crediting a lower return rate than principal.

1 Yield Curve

Sometimes a yield curve (收益率曲線) is provided for doing interest and PV/FV calculation. In
the yield curve, a series of spot interest rates is provided. For example,

Length of investment (in years) Spot rate

1 4.40%
2 4.75%
3 5.00%
4 5.15%
5 5.25%

The term “spot rate” is analogous to “spot price” (現貨價格, the price that can be used to buy a
goods immediately). We use itS to denote the annualized spot interest rate applicable for an
investment horizon of t years. Then

From Spot Rates to Accumulation Function

a(t)  (1  itS )t

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 Chapter 3. Yield Rates
C.Y. Ng
Section 1. Yield Curve

The discount function is v(t)  a–1(t)  (1  itS )t .

? Example 1. 1
Find the present value of a 3-year annuity-immediate of level payments of $100 using the spot
rates in the table above.

The annual spot rates in the table implies a set of annual rates applicable for each year. The 1 st year
rate i1 is obviously 4.40%. What about ik for k  2, 3, 4 and 5? Using a(k ‒ 1)(1  ik)  a(k),

The series of ik above is also known as (k ‒ 1)-year deferred 1-year forward rates (遠期利率). We
can generalize this concept to define isF,t , the s-year deferred, t-year (annualized) forward rate, from

Forward Rates
(1  isSt ) s  t  (1  isS ) s (1  isF,t )t

or even from annual forward rates and the relation (1  isF,t )t  (1  is 1 )(1  is  2 ) (1  is t ) . For
example, the 2-year deferred, 2-year forward rate implied from the table can be computed from:

A note on terminology in macro-economics: The fact that short-term and long-term interest rates
are different is known as the term structure of interest rate (利率期限結構). In general, a yield
curve is upward slopping. A flat yield curve is one that has a major portion of the periods that is
flat. In some special occasions we may observe an inverted (倒掛) yield curve.

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 Chapter 3. Yield Rates
C.Y. Ng
Section 3. Internal Rate of Return

Note that spot rates can only be used accumulate cash flows made at time 0 or discount cash flows
from a future time point to time 0.

? Example 1. 2
You are given the following table of term structure of interest rates:
Length of investment (in years) 1 2 3 4 5
Spot rate 3.7% 4.0% 4.5% 5.2% 5.6%
A financial instrument pays $3 at the end of year 1, 2, 3, and $103 at time 4. Find the future value
of the financial instrument at time 5.

If you want to directly accumulate the 4 cash flows to time 5, you need to use the appropriate
forward rates (which is troublesome to obtain). Alone this line, note also that in terms of the
notation in Section 1.4, we have as (t )  (1  isF,t )t , so that isF,t can be used to build the as(t) and then
used to accumulate cash flows made at any arbitrary time point.

2 Recognition of Inflation

The interest rate we have discussed so far incorporates the effect of inflation. In macro-economics,
Fisher’s equation expresses the relationship between “nominal” and “real” rates of interest (名義,
實質利率). Here, “nominal” does not share the same meaning as i(m).

Fisher’s Equation (費雪方程式)

1  i  (1  rI)(1  rR)

where rI is the inflation rate, and rR is the real interest rate. rI can be estimated from CPI data. A
good approximation of r can then be computed from
i  rI
rR   i  rI.
1  rI

3 Internal Rate of Return

Recall in Chapter 1 the concept of NPV:

Ct
NPV(i)    Initial outlay.
t  0 (1  i )
t

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 Chapter 3. Yield Rates
C.Y. Ng
Section 3. Internal Rate of Return

In usual capital budgeting, we use an appropriate i that accounts for the risk level of {Ct}. If {Ct}
is risk-free, then i should be the risk-free rate. If {Ct} is risky, the average value of the cash flows
is used for discounting and the rate should take into account the risk level so that the resulting NPV
is reduced when compared to the same {Ct} but is riskless. The NPV rule states that projects with
negative NPV is not profitable and should not be carried out.

Sometimes, one would find the root(s) of NPV(i)  0, i.e., the project breaks even. Such i’s are
called the internal rate of return (IRR, 內部回報率) or yield rate and is a measure of the rate of
return on an investment. In the past, the IRR rule states that companies can rank projects using
internal rate of return, and projects with a higher IRR (or IRR beyond a certain cut-off rate known
as “required rate of return”) are more favorable. However, this is incorrect for many reasons, some
of which are stated below:
(1) IRR may not be unique, and may even not exist. (If the cash flows are initially negative and
then change to positive only once, then there would be at most one IRR. †)
(2) IRR ignores size. It can happen that one project has very high IRR but small NPV, which is
less preferably that another project with small IRR but a much higher NPV.
(3) IRR does not indicate the length of the investment. Consider an option to invest 100 at 9% for
2 years without any guarantee of the reinvestment rate afterwards, and an option to invest
100 at 8% for 4 years. Such options cannot be directly compared.

To fix idea of (3), the first option seems to be more attractive as it yields a higher return. However,
the investor is uncertain about how the proceed can be invested after 2 years. If the reinvestment
rate in during years 3 and 4 is less than

1.084
 1  7.009%,
1.092
then the overall yield rate of the first investment would be lower.
IRR can be calculated using the IRR function in Excel easily.

? Example 3. 1
Consider two mutually exclusive projects:
Year 0 1 2 3
Project A –15,000 9,500 6,000 2,400
Project B –18,000 10,500 7,000 6,000
Compute the IRR for the two projects. Based on the IRR rule with a required return of 15%, which
project(s) should be carried out?

†
Descrates’ rule of sign in algebra states that the maximum number of positive roots is the
number of sign changes in the sequence of polynomial’s coefficients (ignoring 0 coeffs).
FINA 2200 | Introduction to Actuarial Science 39
 Chapter 3. Yield Rates
C.Y. Ng
Section 3. Internal Rate of Return

? Example 3. 2
Compute the IRR for the following two projects by plotting the graph NPV(i):
(a) A project with an initial outlay of $76, and generate a cash flow of $80 at time 1, $95 at time
2 and $100 at time 3.
(b) A project with an initial outlay of $73, and generate a cash flow of $80 at time 1, $90 at time
2 and $100 at time 3.

Reinvestment Rates of Interest Payments

Compound interest assumes that interest payments earn the same rate as principal, while simple
interest assumes that interest payments do not generate any new interest. Now let us consider a
way to unify and generalize simple and compound interest.
‒ In the principal account, interest is credited at an annual rate of i. New investments are always
deposited into this account.
‒ Interests are kept separately in another account, earning an annual reinvestment rate of j (≤ i).
For simple interest, j  0, while for compound interest, j  i.

In the simplest case, consider a single deposit of $1 made at time 0. Then

Hence, for t  N,
a(t) 

? Example 3. 3
For a savings account, principal of $100 earns 10% interest per annum compounded annually.
Interest (and interest on interest) earns a return of 5% compounded annually. Find the smallest
integer value of t for which the accumulated value at time t exceeds $175.

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 Chapter 3. Yield Rates
C.Y. Ng
Section 3. Internal Rate of Return

Now consider deposits of $1 made at time 0, 1, 2, …, n ‒ 1. The accumulated value at time n can
be obtained by applying the previous idea n times:

Future Value of an Annuity-due

FV of a $1 level n-year annuity-due is n  i ( Is ) n j

? Example 3. 4
(a) Consider a 6-year annuity-due with payments of $200. Payments earn interest at 6% effective,
but interest can only be reinvested at 3% effective. Find the future value of the annuity-due.
Compare this with the case when interest can be reinvested at 6%.

(b) A $1,000 loan is repaid by level payments over 7 years. The effective rate of interest is 8%.
However, the lender can only reinvest payments at 6% effective.
Find the accumulated value of all payments and hence find the yield rate.

FINA 2200 | Introduction to Actuarial Science 41

 Chapter 4. Loan Amortization
C.Y. Ng
Section 1. Two Illustrations

CHAPTER 4 Loan Amortization

Related Readings …

Financial Mathematics for Actuaries (3rd edition)

Sections 5.1  5.2, 5.4

The Theory of Interest (2nd edition)

Section 6.1  6.3, 6.6

L earning Objectives
Outstanding loan balance calculation, decomposition of interest and
principal portion

In this chapter we discuss the first application of financial mathematics: loans. We investigate
loans that are long-term in nature.

1 Two Illustrations

A long-term loan is usually taken to mean a debt that is paid off over a period of three or more
years. When a borrower takes out a mortgage, car loan, or personal loan, they usually make
monthly payments to the lender. Loan amortization (攤分) is the gradual reduction of the loan over
a given period.

Consider a loan of $1,000. The interest rate is 2%, and the loan is repaid by yearly instalments of
$300 each, until the loan is paid off completely. Since
300a3 2%  865.16498 and 300a4 2%  1,142.319,
3 regular instalments and 1 final drop payment would pay off the loan.

Let us investigate how the loan is gradually paid off throughout the years.

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 Chapter 4. Loan Amortization
C.Y. Ng
Section 1. Two Illustrations

Time Outstanding balance Interest Instalment Principal payment

0 1,000
1 720 20 300 280
2 434.4 14.4 300 285.6
3 143.088 8.688 300 291.312
4 2.86176

Year 1: Interest due  1,000  0.02  20

Split the instalment into 300  20  280
Outstanding balance reduces to 1,000  280  720
or 1,000  1.02  300  720
Year 2: Interest due  720  0.02  14.4
Split the instalment into 300  14.4  285.6
Outstanding balance reduces to 720  285.6  434.4
or 720  1.02  300  434.4
Year 3: Interest due  434.4  0.02  8.688
Split the instalment into 300  8.688  291.312
Outstanding balance reduces to 434.4  291.312  143.088
or 434.4  1.02  300  143.088

The outstanding balance has dropped so much that the next interest due would only be 143.088 
0.02  2.86176, and as already verified before, the loan would be completely paid off at time 4.

Let the drop payment be D.

Year 4: Interest due  2.86176
Principal payment  143.088
The instalment must then be D  143.088  2.86176  145.94976.
Notice that
D 145.94976
4
 300a3 2%   865.16498  1,000.
1.02 1.024
Finally, we look at the payment breakdown:

Total instalment made  300  3  D  1,045.94976,

Total interest paid  20  14.4  8.688  2.86176 or 1,045.94976  100  45.94976.

Interest accounts for about 4.4% of the total instalment made. (But note that the rate on the loan is
2%.)

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 Chapter 4. Loan Amortization
C.Y. Ng
Section 1. Two Illustrations

? Example 1. 1
Consider a loan of $1,000. The interest rate is 6%, and the loan is repaid by annual instalments of
$150 each for the first 3 years, and raise to $250 for the rest, except for a last balloon payment.
Construct the amortization schedule.

Time Outstanding balance Interest Instalment Principal payment

0 1,000
1 150
2 150
3 150
4 250
5
6

Total instalment made 

Total interest paid 

Now let us move on to the second illustration with features negative amortization. When the
instalment is less than the interest due, then the borrower is effectively borrowing new loan as the
principal repayment is negative. The outstanding balance would rise.

Consider a loan of $800, with i  0.05. Instalments of $20, $40, $60, $80, … are made at the end
of each year. Since
20( Ia)10 5%  787.4757 and 20( Ia)11 5%  916.1051 ,
the loan can be paid off by 10 regular instalments plus one small drop payment:

Time Outstanding balance Interest Instalment Principal payment

0 800
1 820 40 20 20
2 821 41 40 1
3 802.05 41.05 60 18.95
4 762.1525 40.1025 80 39.8975
5 700.26013 38.107625 100 61.892375
6 615.27313 35.0130063 120 84.9869938
7 506.03679 30.7636566 140 109.236343
8 371.33863 25.3018394 160 134.698161
9 209.90556 18.5669314 180 161.433069
10 20.400836 10.4952779 200 189.504722
11 0 1.02004182 21.42087832 20.4008365

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 Chapter 4. Loan Amortization
C.Y. Ng
Section 2. Long-term Loans with Level Instalments

2 Long-term Loans with Level Instalments

Determining the outstanding balance and the principal component of an instalment is important
for both parties of the loan. Consider the following setting:
 n level instalments of P are made at time 1, 2, …, n
 The interest rate per period is i
 Outstanding balance at time t, after the reduction of principal payment, is Bt
 The split of the instalment of P at time t into interest portion and principal portion is It  Rt

Using the general machinery in the next section, it is easy to see that

Outstanding Balance at Time k

Bk  Pank

The equation can be understood prospectively. Think about the remaining payments in the future:

A direct consequence of the above is the following:

Interest Portion and Principal Portion at Time k

Ik  P(1  vnk+1), Rk  Pvnk+1

Proof: Note that Ik  iBk1 and Rk  P  Ik.

Notice that the principal portion down the row are increasing with common ratio 1  i. (This holds
even if the final payment is a balloon or drop payment! See Exercise 5.23 of the text.)
Also, as a sanity check, the total interest payment is
I1  I2  …  In  nP  P(vn  vn1  …  v)  nP  Pan  nP  B0.

? Example 2. 1
A $50,000 loan is repaid by monthly instalments of P for 8 years. The nominal interest rate,
convertible monthly, is i(12)  6.6%. Find
(a) the amount of principal and interest in the 14th payment;
(b) the total amount of interest paid as a percentage of the total payments made.

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 Chapter 4. Loan Amortization
C.Y. Ng
Section 2. Long-term Loans with Level Instalments

? Example 2. 2 [FM Sample #211]

A small business takes out a 10-year loan with level end-of-quarter payments. The payments are
based on an annual nominal interest rate of 12% convertible quarterly.
The amount of principal repaid in the 15th payment is 10,030.27.
Calculate the amount of interest paid in the 25 th payment.
Extra questions:
(a) Calculate the loan amount.
(b) If an extra amount of 56,000 is paid together with the 15 th payment, and the later payment sizes
are unchanged, except with a balloon payment, calculate the revised length of the loan and the
size of the balloon payment.

? Example 2. 3
A $25,000 loan is repaid by level semi-annual instalments for 10 years. The nominal interest rate,
convertible semi-annually, is i(2)  0.075. When the 12th instalment is due, the borrower repays the
outstanding loan balance.
Calculate the total amount of interest that the borrower has saved.

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 Chapter 4. Loan Amortization
C.Y. Ng
Section 3. Long-term Loans with General Instalments

? Example 2. 4
A loan is repaid by level annual instalments for 4 years. If the ratio of the interest portion in the
first payment to the interest portion in the third payment is 1.8464, find the ratio of the interest
portion to the principal portion in the second payment.

3 Long-term Loans with General Instalments

Suppose that for an n-period loan,

 The instalment at time t is Pt
 The interest rate per period is i
 Outstanding balance at time t, after the reduction of principal payment, is Bt
 The instalment Pt at time t is split into interest portion and principal portion It  Rt

Outstanding Balance at Time k

Retrospectively, Bk is the accumulated value of the loan at time k, subtracted by the accumulated
value of the instalments made on or before time k:
Bk  B(1  i)k  [P1(1  i)k1  P2(1  i)k2  …  Pk]  B(1  i)k  FV at time k of (P1 to Pk)
Prospectively, Bk is the present value of the instalments made in the future:
Bk  vPk+1  v2Pk+2  …  vnkPn  PV at time k of (Pk+1 to Pn)

Proof: We first prove the retrospective formula. Starting with B0  B and by iterating the recursive
relation Bk  Bk1  Rk  Bk1  (Pk  iBk1)  Bk1(1  i)  Pk, we have
B1  B(1  i)  P1,
B2  B1(1  i)  P2  [B(1  i)  P1](1  i)  P2  B(1  i)2  P1(1  i)  P2,
B3  B2(1  i)  P3  [B(1  i)2  P1(1  i)  P2](1  i)  P3  B(1  i)3  P1(1  i)2  P2(1  i)  P3
and the retrospective formula holds by repeating the procedure.
Since the PV of all instalments must be equal to the loan, we have
B  PV at time 0 of (P1 to Pk)  PV at time 0 of (Pk+1 to Pn),
Multiplying both sides by (1  i)k,
B(1  i)k  FV at time k of (P1 to Pk)  PV at time k of (Pk+1 to Pn),
and hence

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 Chapter 4. Loan Amortization
C.Y. Ng
Section 3. Long-term Loans with General Instalments

Bk B(1  i)k  FV at time k of (P1 to Pk)  PV at time k of (Pk+1 to Pn).

The retrospective formula is useful when only the instalments in the beginning is known.

? Example 3. 1
Refer to the second illustration in Section 1. Calculate the outstanding balance at time 5 using both
the prospective and retrospective methods.

? Example 3. 2
Rikka borrows a 21-year loan of $45,000. He is scheduled to repay with 20 level payments of
$3,500 and a drop payment at the end of the term. The lender charges interest at an annual effective
rate of 4.75%.
In view of the falling interest rates, Rikka refinances the loan with an interest rate of 4.2% after 5
years. The term is shortened to 12 years counting from the time of refinancing. The penalty for
refinancing is $1,275, for which Rikka adds to the outstanding loan balance.
Calculate the level payment for the refinanced loan.

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 Chapter 4. Loan Amortization
C.Y. Ng
Section 3. Long-term Loans with General Instalments

? Example 3. 3
A $50,000 loan is repaid by annual instalments for 16 years. The effective interest rate is 5%. The
instalments are set such that the outstanding balance decreases linearly. Find
(a) the principal and interest portion in the 7 th payment;
(b) the total amount of interest paid;
(c) the total instalment.
Compare (c) with the total instalment if the instalment is level.

? Example 3. 4
A loan is amortized over 6 years with quarterly payments at an annual nominal interest of 8%
compounded quarterly. The first payment is $750 and each succeeding quarterly payment will be
1.75% greater than the prior payment. Find
(a) the initial loan amount;
(b) the outstanding loan balance at time 9;
(c) the principal and interest portion in the 10 th payment.

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 Chapter 4. Loan Amortization
C.Y. Ng
Section 3. Long-term Loans with General Instalments

? Example 3. 5
A 25-year loan of 30,000 is repaid with payments at the end of each year. Each of the first 10
payments equal 130% of the amount of interest due. Each of the last 15 payments is X. The lender
charges interest at an annual effective rate of 10%.
Calculate the outstanding loan balance at time 5 and time 15.

FINA 2200 | Introduction to Actuarial Science 50