Mount Kenya University

BMA1101 : Financial Mathematics

Lecturer: Gikonyo Kiguta

Tutorial Fellow Department of Statistics and Actuarial Science

Contents
1 Course Content 2
1.1 Expected Learning Outcomes of the Course . . . . . . . . . . . . . . . . . . . . . 2
1.2 Content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 Core Text Books . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 Cashflows: 3

3 The Time Value of Money. 5

4 Interest 5
4.1 Simple Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.2 Compound interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.3 Simple discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

5 Accumulation factors 15

6 Force of interest 17

7 Present Value of Cashflows 21

7.1 Discrete cashflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
7.2 Continuous cashflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

8 Annuities and loans 22

9 Present values of Annuities 23

9.1 Payments made in arrear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
9.2 Payments made in advance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

10 Accumulations 26

1
11 Continuously payable annuities 29

12 Annuities payable pthly 30

13 Perpetuities 31

14 Deferred and increasing annuities 35

14.1 Deferred annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
14.2 Continuously payable annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
14.3 Annuities payable pthly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
14.4 Increasing Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
14.5 Continuously payable annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
14.6 Decreasing payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

15 Loan schedules 46
15.1 Finding the Loan Balance Using Prospective and Retrospective Methods. . . . . . 46

1 Course Content
1.1 Expected Learning Outcomes of the Course
By the end of the course unit the learners should be able to:-

1. Explain the role of finance mathematics in organizations

2. Apply capital budgeting concepts and techniques in planning capital structure of a firm

3. Appraise the performance of organizations and make appropriate forecasts

1.2 Content
Role of financial management: development of financial thought, goal of the firm, financial de-
cisions and risk return relationships, price and value, and ethics. Compound interest: single and
regular periodic investments, with interest compounded annually or monthly applications such as
hire purchase, loans and mortgages. Net present value: future payments, compound annuities and
their present value, amortized loans, uneven stream, perpetuities, bonds, project appraisal tech-
niques and use of tables. Asset: pricing method, the term structure of interest rates and stochastic
interest rate models.

2
1.3 Core Text Books
1. Van Horne J.C (2007), Fundamentals of Finance Management (9th Edition) Prentice- Hall

2. Chandra P, (2008), Fundamentals of Financial Management (3rd Edition), McGraw Hill

3. The faculty of Actuaries and institute of Actuaries subjects CT1: Financial Mathematics
core reading for the 2009 release.

2 Cashflows:
- When assessing the value of an investment often it is helpful to list the times and value of any
cashflows.
- The timings and values of these cashfows may be certain or uncertain
- Therefore cashflow can be defined as sums of money that are paid or received at particular times.
- When there is uncertainty about the amount or timing of cashfows an actuary can assign a prob-
ability of both the amount and the existence of the cashflows.

Here are examples of cashflows:

(i) Zero-coupon bond. This is a security which provides a specified cash amount at some specified
future time and no other cashflows.
Suppose the investor purchases the bond for the price c0 and receives the lump sum S at time n.
Then the cash-flow sequence can be represented by the following table:

Time 0 n
Cash flow −c0 S
(ii) Fixed-interest security. The holder of the fixed interest security will receive the lumpsum
of specified amount at a specified future time together with a series of regular level interest pay-
ments until the repayment of the lumpsum.

Suppose the maturity date is n and the investor receives a coupon (or interest payment) at times
1, 2, . . . , n and a lump sum S (called the redemption value) at time n. Then the cash flow is:

Time 0 1 ··· n−1 n

Cash flow −c0 c ··· c c+S
where
- C0 is the price of the security
- S is the redemption value.
- C are the coupons paid / interest paid

(iii) An Index-linked security: With a conventional fixed-interest security, the interest payments
are all of the same amount. If inflation is not under control, then the purchasing power of a given

3
sum of money may diminish with the passage of time. For this reason some investors prefer 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.

The initial negative cash ow is followed by a series of unknown positive cash flows and a sin-
gle larger unknown positive cash ow on specified dates. These cash flows relate to the inflation
index and are said to be in real terms. Real terms means taking into account inflation whereas
nominal means ignoring inflation Sometimes in practice the current index is not used as it may be
unknown. An earlier index may then be used. This is called an indexation lag. If inflation is high
then the regular payments will rise by larger amounts than if inflation is low.

(iv) Equity. Equity shares are securities that are held by the owners of an organization. Eq-
uity shares do not earn a fixed rate of interest; instead the shareholders are entitled to a share in
the company’s profits in proportion to the number of shares owned. This distribution of profits is
known as dividends and is unknown beforehand and subject to fluctuations since they are related
to company profits which are not known in advance.

For a cashflow model of an equity, it is necessary to make an assumption about the growth in
dividends. This also means that the timing of the cashflows should also be estimated. The other
forms that the distribution of profits may take up, should also be considered such as the company
buying back shares issued to investors. Share buy-backs imply that the remaining share holders
will hold greater percentages of these companies hence they will be entitled to higher profits in the
future.

(v)Loans and Mortgages. The borrower initially receives a loan and then repays it by a series
of payments which consist of partial repayment of the loan capital and interest.

Loans can take two forms:

(a) Interest only Loan A loan that is repayable by a series of interest payment followed by the
return of initial loan amount.

b) Repayment loan. A loan that is repayable by a series of interest payments, each including a
partial repayment of the loan capital and the interest payment

(vi) Motor and Other General Insurance. The insurance company receives a premium (positive
cash flow) at the start of the year. The amounts and times of any claims (or negative cash flows)
are uncertain. The negative cash flows may occur after the end of the period of cover-especially
for personal injury claims.

4
3 The Time Value of Money.
Many financial arrangement involves the borrower and a lender. Borrowers reward lenders by pay-
ing interest to lenders.

Interest may therefore be regarded as reward paid by one person organisation for the use of an
asset (capital) belonging another person/organization (lender).

4 Interest
Interest is the payment made by a borrower for using a lender’s capital. It can also be viewed as the
cost of doing business and takes into account the risk of default. If there is a higher risk of default
then the lender will expect a higher rate of interest.

Determinants of the levels of interest

Basic economic theory stipulates the forccs of supply and demand. However the major factors that
influence interest rates are:-

i The underlying "pure" rate of interest.

Economists look at this as the long term productivity growth of the economy. This rate would
prevail on a risk-free investment if there were no inflation and this rate has proven to be relatively
stable.

ii Inflation
This is the allowance for the possible depreciation or appreciation in the value of the currency in
which the transaction is carried out. Inflation shows a positive correlation with interest rates.

iii Risk and uncertainty.

These have a significant effect on interest rates. If there were some risk of default, the lender would
be expected to ask for a higher rate of interest than would otherwise be the case. The additional
interest in this situation would be considered as a further reward for the lender’s acceptance of the
increased risk.

iv Length of investment.
There will always be a difference in the market between the rates of investment on short- term and
long term investments, all other factors being constant.

v Quality of information.
The effect of this is efficient markets and inefficient markets.

vi Legal restrictions.

5
vii Government policy.
This is mainly influence and control through fiscal and monetary policies

viii Random fluctuations.

4.1 Simple Interest

Interest on short term financial instruments are usually simple rather than compound. Under sim-
ple interest the interest earned on the capital C lent over the period n at a rate I is;

Interest earned = nic0

The accumulated value is given by C0 + nic0 = C0 (1 + ni)

Example How much interest do you get if you put 1000 pounds for two years in a savings ac-
count that pays simple interest at a rate of 9% per annum? What is the accumulated amount if you
leave it in the account for only half an year?

Solution
If you leave it for two years, you get

2 · 0.09 · 1000 = 180 pounds in interest.

If you leave it for only half a year, then you get 1000(1 + 1
2
· 0.09) = 1045 pounds.

Questions

1. How many days does it take for 1450 to accumulate to 1500 under 4% p.a. simple interest?

2. (From the sample exam) A bank charges simple interest at a rate of 7% p.a. on a 90 -day
loan of 1500. Compute the interest.

4.2 Compound interest

In the case of compound interest the interest already earned is re-invested to accrue further interest.
If an investor invests an amount C in an account that earns compound interest at the rate of i p.a
then at the end of one year the investor receives C(1 + i). Let An represents the amount received

6
after n years
A1 = C(1 + i)
A2 = A1 + iA1 = C(1 + i) + i(C(1 + i)) = C(1 + i)2


A3 = A2 + iA2 = C(1 + i)2 + i C(1 + i)2 = C(1 + i)3
..
.
∴ An = C(1 + i)n

Example
How much do you have after you put 1000 pounds for two years in a savings acount that pays
compound interest at a rate of 9% per annum? And if you leave it in the account for only half ar
year?

Solution
If you leave it in the account for two years, then at the end you have

(1 + 0.09)2 · 1000 = 1188.10

Example
Suppose that a capital of 500 dollars earns 150 dollars of interest in 6 years. What was the interest
rate if compound interest is used? What if simple interest is used?

Solution
The capital accumulated to $650, so in the case of compound interest we have to solve the rate i
from the equation

(1 + i)6 · 500 = 650 ⇐⇒ (1 + i)6 = 1.3

⇐⇒ 1 + i = 1.31/6 = 1.044698 . . .
⇐⇒ i = 0.044698 . . .

Thus, the interest rate is 4.47%, rounded to the nearest basis point

4.3 Simple discount

A discount can be looked at as the interest paid at the beginning of the time period. Suppose a
sum C is due after n years and a rate of simple discount applies at d p.a. Then the sum of money
required to be invested now to amount to C after n years is

C(1 − nd)

7
Note: While the rate of interest is applied on the balance at the beginning of the year, the rate of
discount is applied on the balance at the end of the year.

Present Values:

The present value is sometimes called the discounted value. It tell us the amount we need now
so that we can provide a certain amount of payment later.

Example
An investor must make a payment of shs 500,000 in 5 years’ time. The investor wished to make
provisions for this payment by investing a single sum now in a deposit account that pays 10% pa
compound interest. How much should the initial investment be?

Solution
By the end of 5 years an initial payment of sh sX should have accumulated to shsX(1 + 0.1)5 .
Therefore X × 1.15 = 500, 000 ⇒ X = 500,000
1.15
= 500, 000 × (1.1)−5 = shs310, 460.6615.

Discounting is the reverse of accumulating and since (1 + i)n is an accumulation factor mean-
ing it tells us what our investment will have accumulated to after n years from now, (1 + i)−n is a
discounting value as it gives us the value today of some amount due n years from today.

We define a function v = (1+i)1

= (1 + i)−1 as the one time period discounting factor. An in-
vestment of amount C in a years time will be worth Cv today and an investment worth C in n
years time will be worth Cv n = C(1 + i)−n today. Therefore Cv n gives us the present value or
discounted value of an amount C due in n years time.

Example
(i) Given an investment of 1, 000 find the accumulation after 5 years using:
(a) simple discount of 8%pa
(b) compound discount of 8%pa
(c) compound interest of 8%pa.

(ii) Given a payment of 2, 000 due in 4 years’ time, calculate the present value using:
(a) simple interest of 3%pa
(b) simple discount of 3%pa
(c) compound interest of 3%pa.

Solution

8
(i)(a) Using (3.3) and (3.1) the accumulation is:
1 1
1, 000A(5) = 1, 000 × = 1, 000 × = 1, 666.67
v(5) 1 − 5 × 0.08

(i)(b) Using (3.3) and (3.2) the accumulation is:

1 1
1, 000A(5) = 1, 000 × = 1, 000 × = 1, 517.26
v(5) (1 − 0.08)5

(i)(c) Just using (1.2) the accumulation is:

1, 000A(5) = 1, 000 × 1.085 = 1, 469.33

(ii)(a) Using (3.3) and (1.1) the present value is:

1 1
2, 000v(4) = 2, 000 × = 2, 000 × = 1, 785.71
A(4) 1 + 4 × 0.03

(ii)(b) Just using (3.1) the present value is:

2, 000v(4) = 2, 000 × (1 − 4 × 0.03) = 1, 760

(ii)(c) Using (3.3) and (1.2) the present value is:

1 1
2, 000v(4) = 2, 000 × = 2, 000 × = 1, 776.97
A(4) (1.03)4

Effective rate of interest

The effective rate of interest i is the amount of money that a unit amount invested at the begin-
ning of the year will earn during the year where interest is paid at the end of the year. It is usually
expressed as a percentage. It can also be looked at as the ration of the amount earned during the
year to the balance at the beginning of the year.

Recall that A1 = C(1 + i). If C = 1 then A1 = (1 + i) and A0 = (1 + i)0 = 1. We can

therefore say that 1 = A1 − A0

The effective rate of interest is usually expressed as a percentage of the principal amount eg5%
which can also be looked at as 0.05 per unit of principal.

The effective rate of interest i is also the ratio of the amount of interest earned during the year
to the amount of principal invested at the beginning of the year. Therefore

A1 − A0 (1 + i) − 1 i1
i1 = = =
A0 1 A0

9
and
An − An−1
in =
An−1

Example
Suppose an investment pays a rate of interest 12% p.a compounded 12 times per year. Calculate
the corresponding effective annual rate of interest.

Solution
Consider an investment of 1 for 1 year.

Accumulated value = (1 + i)n

0.12 12
In this case the accumulated value = 1 + 12
 12
0.12
∴ (1 + i) = 1 +
1
−1
12
= 0.1268 ∴ 12.686%

where i is the effective rate of interest

Effective rate of discount

The effective rate of discount d is a measure of the interest paid at the beginning of the year.
It is the ratio of the amount of money earned during the year to the amount at the end of the year.

Note: Interest is paid at the end of the year on the balance at the beginning of the year while
discount is charged at the beginning of the year on the balance at the end of the year.

d can be viewed as the present value of i, or i as the accumulated value of d. Therefore

An − An−1
dn =
An

Relationship between i and d

Assume an investor borrows 1 at an effective rate of discount d. In effect the original principal
is 1-d and the discount is d and the final value of the fund is 1.

10
Similarly if an investor invests a unit amount at an effective rate of interest i, then the accumu-
lated value after one year is 1 + i.
A1 − A0
i=
A0
1 − (1 − d)
=
1−d
d
= : ratio of the discount paid to the amount at the begining of the period
1−d
A1 − A0
d=
A1
(1 + i) − 1
=
1+i
i
= : ratio of the interest paid to the amount at the end of the period
1+i
Let C be the initial principal amount invested (C > 0). A defines the accumulated value that C
grows to in n years. The accumulated value at time n is the product of the initial capital investment
of C made at time zero and the accumulation value factor.
A = C × AV F
where AV F = (1+ni) if simple interest is being applied and AV F = (1+i)n if compound interest
is applicable. 1-d is referred to as a discounting factor. 1 + i is referred to as an accumulating
factor.
1
1−d=
1+i
1
1+i=
1−d
Define v = 1+i = 1 − d ∴ v = 1 − d
1

Question
1 An investor puts sh.5000 into a savings account that pays simple interest at the rate of 10% p.a.
Compare how much the investor would have after 6 years if the money was invested:-
a) for 6 years
b) for 3 years then immediately re-invested for a further 6 years

2 An 8 month loan repayable by a single installment is issued at a commercial rate of discount

of 15% p.a. If the amount of repayment is sh. 100,000 how much was initially lent to the borrower.

Nominal rate of Interest

Here we look at situations whereby interest is payable more frequently than annually. The fre-
quency with which interest is paid and re-invested to add additional interest is referred to as interest

11
conversion period. Nominal rates are adjusted to reflect the rate to be paid during each sub-period.

Consider a transaction of a term h time units ( h is not negative). Define ih (t) as the nominal
rate of interest per time unit on transactions of term h beginning at time t such that the effective
rate of interest for the period of length h beginning at time t is hih (t).

If a sum C is invested at time t for a term h then the amount received at time t + h is by defi-
nition C (1 + hih (t))

Assume 1 year is divided into p sub-periods (months,quarters, half-years). If h = p1 where p

is a positive integer it is usual to write i(p) rather than i 1 i.e i(p) is the nominal rate of interest per
p
annum convertible pthly.

Example:

i(12) : nominal rate of interest convertible monthly

i(2) : nominal rate of interest convertible semi-annually
i(p)
To find the effective rate of interest payable pthly, p
consider

Given that i(P ) is the nominal rate of interest convertible pthly then the effective rate of interest
payable pthly is i(p)
p  p
ip
1+i= 1+
p
 p
ip
i= 1+ −1
p
 p 
ip
p
i =p 1+ −1
p
 p
ip ip
= 1+ −1
p p
Nominal rate of Discount

The nominal rate of discount is also used to refer to interest payable more frequently than annu-
ally. The nominal rate of discount convertible pthly is d(p) such that the effective rate of discount
(P )
payable pthly is d P .

12
  p
dp)
1−d= 1−
p
h 1
i
d = p 1 − (1 − d)
p p

Recall, 1 − d = v h i h i
1 1
d (p)
= p 1 − (1 − d) p =p 1−v p

There is also a close relationship between nominal rates of interest and nominal rates of discount.
Recall that  p
i(p)
1+ = (1 + i) = v −1
p
and  p
d(p)
1− = (1 − d) = v = (1 + i)−1
p
Therefore  p  −p
i(p) d(p)
1+ = 1−
p p
and    −1
i(p) d(p)
1+ = 1−
p p
The other relationships can be deduced from this.

Example
Suppose the interest rate on a 91 day 10, 000 investment is:
(a) simple 6% per annum;
(b) nominal 6% per annum compounded daily;
(i) Find the amount returned after 91 days. For the two cases, assume the year has 365 days.
(ii) Find the equivalent effective daily interest rates for (a), (b)
(iii) Find the equivalent effective annual interest rates
(iv) Find the equivalent simple interest rates per annum for (a), (b).

Solution
(i)

(a), the amount is 10, 000 1 + 0.06 × 91
365
= 10, 149.59.


0.06 91
(b), it is 10, 000 1 + 365
= 10, 150.70.

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(ii)


91 1/91
(a) 1 + 0.06 × 365
− 1 = 0.000163

0.06
(b) 365
= 0.000164

(iii)


91 365/91
(a) 1 + 0.06 × 365
− 1 = 0.0614


0.06 365
(b) 1 + 365
− 1 = 0.0618

(iv)
(a) 0.06
h
i
0.06 91
(b) 365
91
1+ 365
− 1 = 0.060446

Example
500 is invested in an account which pays nominal interest of 8%pac half-yearly. Find the amount
in the account after 3 years.

Solution

0.08 2
We are given i(2) = 8%. Using equation (3.1) we get an annual effective rate of i = 1 + 2
−
1 = 8.16%. So accumulating the 500 for 3 years at this rate gives:

500 × 1.08163 = 632.66

Example
A payment of $800 is due in 5 years’ time. Calculate the present val payment at an interest rate of
9% pa convertible monthly.

Solution

0.09 12
We are given i(12) = 9%. Using equation (3.1) we get an annual effective rate of i = 1 + 12
−
1 = 9.3806898%. So discounting the $800 for 5 years at this rate gives:

$800 × 1.093806898−5 = $510.96

Example
500 is invested in an account which pays interest equivalent to a nominal discount rate of 8%pa
convertible half-yearly. Find the amount in the account after 3 years.

14
Solution

0.08 −2
We are given d(2) = 8%. The annual effective rate is i = 1 − 2
− 1 = 8.50694%. So
accumulating the 500 for 3 years at this rate gives:

500 × 1.08506943 = 638.77

Example
A payment of $800 is due in 5 years’ time. Calculate the present value of this payment at a discount
rate of 9% pa convertible monthly.

Solution

0.09 −12
We are given d(12) = 9%. The annual effective rate is i = 1 − 12
− 1 = 9.4545487%. So
discounting the $800 for 5 years at this rate gives:

$800 × 1.094545487−5 = $509.24

Example
Express 5% pa effective discount as a nominal annual discount rate convertible quarterly.

Solution


d(4) = 4 1 − (1 − 0.05)1/4 = 5.09658%

Example
Find the annual effective discount rate equivalent to a nominal discount rate of 12% pa convertible
four-monthly.

Solution
There are three four-month periods in a year, so we are given d(3) = 12%.
 3
0.12
1−d= 1− = 0.884736 ⇒ d = 11.5264%
3

5 Accumulation factors
Assume that time is measured in years. For t1 ≤ t2 define A (t1 , t2 ) as the accumulated value
at time t2 of a unit investment at time t1 . By definition of ih (t) for all t and all he wee that

15
A(t, t + h) = 1 + hih (t).

We can see that, ih (t) = A(t,t+h)−1

h
A (t1 , t2 ) is called the accumulation factor since the accumula-
tion of an investment C at time t1 is by proportion C × A (t1 , t2 )

Principle of consistency

Let t0 ≤ t1 ≤ t2 and consider a unit investment made at time t0 . The proceeds at time t2 will
be given by A (t0 , t2 ).

A (t0 , t2 ) = A (t0 , t1 ) A (t1 , t2 )

However, this is only true in a consistent market and by induction we can say it follows that:A (t0 , tn ) =
A (t0 , t1 ) A (t1 , t2 ) . . . A (tn−1 , tn ) for any n.

Example
An investor deposited 10, 000 in a bank account that paid simple interest at a rate of 5% pa. After
3 years it had accumulated to 11, 500. Find the accumulation factor from time 0 to time 3.

Solution
11, 500
A(0, 3) = = 1.15
10, 000

Example
An investment of 1, 000 in an account accumulated to 2, 500 after 5 years.
(i) State the accumulation factor A(0, 5).
(ii) (a) Find the simple annual interest rate which would give the accumulation factor in part (i).
(b) Find the annual compound interest rate which would give the accumulation factor in part (i).

Solution
(i) A(0, 5) = 2,500
1,00
= 2.5
(ii)(a) A(0, 5) = (1 + 5i) = 2.5 ⇒ i = 30%
(ii)(b) A(0, 5) = (1 + i)5 = 2.5 ⇒ i = 20.1%

Example
4, 600 is invested at time 0 and the proceeds at time 10 are 8, 200. Calculate A(7, 10) if A(0, 9) =
1.8, A(2, 4) = 1.1, A(2, 7) = 1.32, A(4, 9) = 1.45.

16
Solution
Representing this on a diagram we have:

One way of solving this is as follows:

1.8
A(0, 9) = A(0, 4)A(4, 9) ⇒ 1.8 = A(0, 4) × 1.45 ⇒ A(0, 4) = = 1.2414
1.45
1.32
A(2, 7) = A(2, 4)A(4, 7) ⇒ 1.32 = 1.1 × A(4, 7) ⇒ A(4, 7) = = 1.2
1.1
8, 200
A(0, 10) = = 1.7826
4, 600
A(0, 10) = A(0, 4)A(4, 7)A(7, 10) ⇒ 1.7826 = 1.2414 × 1.2 × A(7, 10)
1.7826
⇒ A(7, 10) = = 1.197
1.2414 × 1.2

6 Force of interest
If we consider a nominal rate convertible very frequently e.g every second, we will be thinking of
a fund that steadily accumulates over a period as interest is earned and re-invested. As h becomes
smaller and smaller, ih (t) tends to a limiting value. This limiting value depends on t. We can
therefore assume that for each value of t, there exists a number δ(t) such that:
δ(t) = lim ih (t)
h→0

17
δ(t) is called the force of interest per unit time. It is also called the nominal rate of interest per unit
time at time t convertible momently.

By definition,
A(t, t + h) = 1 + hih (l)
hih (t) = A(t, t + h) − 1
A(t, t + h) − 1
∴ ih (t) =
h
We can therefore define the force of interest in terms of the accumulation factors
A(t, t + h) − 1
δ(t) = lim
h→0 h
If the principle of consistency holds, then under general conditions we can express the accu-
mulation factor in terms of the force of interest.

Theorem 2.1 If δ(t) and A (t0 , t1 ) are continuous functions of t for t ≥ t0 and the principle of
consistency holds then for t0 ≤ t1 ≤ t2 ,
Z t2
A (t1 , t2 ) = δ(t)dt
t1

Proof: Define F (t) = A (t0 , t) where t0 is fixed and t0 ≤ t

∴ F (t) = the accumulation at time t of an investment of 1 at time t0 .

A(t0 ,tt+h ) F (t+h)
A(t, t + h) = A(t0 ,t)
= F (t)

If the principle of consistency holds.

A(t + h) − 1
δ(t) = lim
h→0 h
F (t + h) 1
= lim −1×
h→0 F (t) h
F (t + h) − F (t) 1
= lim ×
h→0 F (t) h

18
From first principles
F (t + h) − F (t)
lim = F ′ (t)
h→0 h
F ′ (t) d
∴ δ(t) = = ln F (t)
F (t) dt
⇒ δ(t)dt = d ln F (t)
Z
∴ F (t) = exp δ(t)dt

Since
(t0 , t2 ) F (t2 )
A (t2 , t2 ) = =
(t0 , t1 ) F (t1 )
R t2
exp 0 δ(t)dt
= Rt
exp 0 1 δ(t)dt
Z t2
= exp δ(t)dt
t1

Example

Calculate the accumulation factor given the following force of interest.

(a) δt = δ

(b) δt = a + bt

Solution (a) Z t2
A (t1 , t2 ) = exp δ(s)ds
t
Z 1t2
= exp δds
t1
= exp(δs)|tt21
= exp δ (t2 − t1 )

19
(b) Z t2
A (t1 , t2 ) = exp (a + bt)ds
t1
t
bt2 2
= exp at +
2 t1
   
bt22 bt21
= exp at2 + − at1 +
2 2

Note

If δ(t) = δ ∀t then,

Z n

A (t0 , tn ) = A(0, n) = exp δdt = exp δn = eδn
0
δ
If n = 1, A(0, 1) = e but A(0, 1) = 1 + i

⇒ 1 + i = eδ
∴ δ = ln(1 + i)

Exercise

Find an expression for the accumulation factor from time t1 to t2

(a) δ(t) = 0.08 + 0.02

t+1

0.06 , t < 5

(b) δ(t) = 0.05 , 5 ≤ t < 10


0.03 , t ≥ 10

20
7 Present Value of Cashflows
7.1 Discrete cashflows

The present values of Ct1 , Ct2 , Ct3 , . . . Ctn due at times t1 , t2 , t3 , . . . tn is given by;

Ct1 v (t1 ) + Ct2 v (t2 ) + Ct3 v (t3 ) + . . . + Ctn v (tn )

Xn
= Ctj v (tj )
j=1

7.2 Continuous cashflows

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

Let M (t) denote the total payment made between time 0 and t then by definition ρ(t) will be;
ρ(t) = M ′ (t) ∀t

If 0 ≤ α ≤ β ≤ T then the total payment received between time α and β

Z β
= M (β) − M (α) = M ′ (t)dt
α
Z β
= ρ(t)dt
α

The rate of payment of any time is the derivative of the total amount paid up to that time and the
total amount paid between any two times is the integral pf the rate of payment over the appropriate
time intervals.

If δ(t) is very small then M ′ (t) = ρ(t) Therefore theoretically, the present value of the entire
RT
cashflow is 0 v(t)ρ(t)dt

Example
(
0.04 , t < 10
1. Assuming time is measured in years and δ(t) =
0.02 , t ≥ 10
Find an expression for v(t)∀t hence find the present value of a continuous payment stream re-
ceived at the rate of 1 per annum for 15 years beginning at time 0 .

Solution

21
 Z t
v(t) = exp − δsds
0
Z 10 Z t
v(t) = exp − 0.04ds exp − 0.02ds
0 10
v(t) = exp −0.4 exp −0.02t + 0.2
v(t) = exp(−0.02t − 0.2)
Z T
P.V = v(t)ρ(t)dt
0
Z 15
P.V = exp(−0.02t − 0.2)dt
0
−0.02t−0.2 15
e
−0.02 0
=??

2. The force of interest is given by



0.008 − 0.001t , 0 ≤ t < 3
δ(t) = 0.025t ,3 ≤ t < 5


0.03 ,t ≥ 5

Calculate the present value at time 2 of a payment of 1000 at due at time 10

8 Annuities and loans

An annuity is a regular series of [Link] are categorized into two:

1. Annuity Arrear/ Annuity-Immediate

This is an annuity where payments are made at the the end of each time period.

22
 2. Annuity Advance/ Annuity due
This is an annuity where payments are made at the beginning of each time period.

Where the first payment is made during the first time period, this is an immediate annuity. Where
no payments are made during the first time period, this is a deferred annuity.
If each payment is for the same amount, this is a level annuity. If payments increase (decrease)
each time by the same amount, this is a simple increasing (decreasing) annuity.

9 Present values of Annuities

9.1 Payments made in arrear
Consider a series of n payments, each of amount 1, to be made at time intervals of one unit, the
first payment being made at time t + 1.

Such a sequence of payments is illustrated in the diagram above, in which the r th payment is made
at time t + r. The value of this series of payments one unit of time before the first payment is made
is denoted by a n .
The symbol a n (pronounced "A.N.") represents the PV of an annuity consisting of n payments of
1 unit made at the end of each of the next n time periods. This is called an annuity paid in arrear.
Clearly, if i = 0, then a n = n; otherwise:

an = v + v2 + v3 + · · · + vn

We recognize the expression on the right-hand side as a geometric progression. Thus, multiplying
both sides by ν to obtain
νa n = ν 2 + ν 3 + · · · + ν n + ν n+1 .

23
Subtracting this from the previous equation we find
(1 − ν)a n = ν (1 − ν n ) .
Hence,
v (1 − v n )
=
1−v
1 − vn
= −1
v −1
1 − vn
=
i
Example
Calculate the present value of an annuity-immediate of amount $100 paid annually for 5 years at
the rate of interest of 9%.

Solution. −5
The answer is 100a 5 = 100 1−(1.09)
0.09
≈ 388.97

Example
Calculate the present value as at 1 March 2005 of a series of payments of 1, 000 payable on the
first day of each month from April 2005 to December 2005 inclusive, assuming a rate of interest
of 6% pa convertible monthly.

Solution.
An interest rate of 6% pa convertible monthly is equivalent to an effective monthly interest rate of
1/2%. There are 9 payments of 1, 000 each, starting in one month’s time. So, working in terms of
months, the PV of the payments is:
@1/2%
1, 000a 9
@1/2%
You can look up a 9 in the Tables or alternatively apply the formula:

@1/2% 1 − 1.005−9
1, 000a 9 = 1000 × = 1000 × 8.7791 = 8, 779
0.005

Example
A loan of 2500 at a rate of 6 21 % is paid off in ten years, by paying ten equal installments at the end
of every year. How much is each installment?

Solution.
Suppose that each installment is x euros. Then the loan is paid off by a 10-year annuity immediate.
The present value of this annuity is xa 10 at 6 12 %. We compute v = 1+i
i
= 0.938967 and
1 − v 10 1 − 0.93896710
a 10 = = = 7.188830.
i 0.065
24
The present value should be equal to 2500, so the size of each installment is

x = 2500/a 10 = 347.7617 euros

. Rounded to the nearest cent, this is 347.76.

9.2 Payments made in advance

Now consider a series of n payments made at the start of each time period as represented on the
time line below. The first payment is made at time zero and the last at time n - 1.

The value of this series of payments at the time the first payment is made is denoted by ä n . The
symbol ä n is pronounced "A due n ".
If i = 0, then ä n = n; otherwise:

ä n = 1 + ν + ν 2 + · · · + ν n−1

We recognize the expression on the right-hand side as a geometric progression. Thus, multiplying
both sides by ν to obtain

νä n = ν + ν 2 + ν 3 + · · · + ν n−1 + ν n

Subtracting this from the previous equation we find

(1 − ν)ä n = (1 − ν n )

Hence,
1 − νn
ä n = .
1−ν
Since 1 − ν = d, we have
1 − νn 1 − (1 + i)−n 1 − (1 − d)n 1 − νn
ä n = = = = .
d d d d

Example
Find ä 8 if the effective rate of discount is 10%.

Solution.

25
 1−(0.9)8
Since d = 0.10, we have ν = 1 − d = 0.9. Hence, ä 8 = 0.1
= 5.6953279

Example
What amount must you invest today at 6% interest rate compounded annually so that you can with-
draw $5, 000 at the beginning of each year for the next 5 years?

Solution.
1−(1.06)−5
The answer is 5000ä 5 = 5000 · 0.06(1.06)−1
= $22, 325.53

Note
It follows directly from the above definitions that:

ä n = (1 + i)a n

and that, for n ≥ 2 :

ä n = 1 + a n−1

Question
Prove algebraically and by general reasoning that ä n = a n−1 + 1.

Question
Calculate a 25 and ä 25 at 13 21 %pa effective.

10 Accumulations
The value of the series of payments at the time the last payment is made is denoted by s n . The
value one unit of time after the last payment is made is denoted by s̈ n .

Consider an annuity immediate paying one unit of capital at the end of every period for n peri-
ods. The accumulated value of this annuity at the end of the nth period is denoted s n .

s n = 1 + (1 + i) + (1 + i)2 + · · · + (1 + i)n−1
s n = 1 + (1 + i) + (1 + i)2 + · · · + (1 + i)n−1
(1 + i)n − 1 (1 + i)n − 1
= = .
(1 + i) − 1 i
Now, let s̈ n denote the accumulated value of an annuity-due at the end of n periods. To determine
s̈ n we proceed in a way analogous to determining s̈ n .

26
 s̈ n = (1 + i) + (1 + i)2 + · · · + (1 + i)n−1 + (1 + i)n
(1 + i)n − 1
= (1 + i)
(1 + i) − 1
(1 + i) − 1
n
(1 + i)n − 1
= =
iν d

Example
What amount will accumulate if we deposit $5, 000 at the beginning of each year for the next 5
years? Assume an interest of 6% compounded annually.

Solution.
(1.06)5 −1
The answer is 5000s̈ 5 = 5000 · 0.06(1.06)−1
= $29, 876.59

Example
Calculate the future value of an annuity-immediate of amount $100 paid annually for 5 years at the
rate of interest of 9%.

Solution.
(1.09)5 −1
The answer is 100s n = 100 × 0.09
≈ $598.47

Worked examples

Example
Calculate the present value of an annuity-immediate of amount $100 payable quarterly for 10 years
at the annual rate of interest of 8% convertible quarterly. Also calculate its future value at the end
of 10 years.

Solution.
Note that the rate of interest per payment period (quarter) is 48 % = 2%, and there are 4 × 10 = 40
payments. Thus, the present value of the annuity-immediate is
 
1 − (1.02)−40
100a 40 0.02 = 100 × = $2, 735.55,
0.02
and the future value of the annuity-immediate is

2, 735.55 × (1.02)40 = $6, 040.20.

Example
A man borrows a loan of $20, 000 to purchase a car at annual rate of interest of 6%. He will pay

27
back the loan through monthly installments over 5 years, with the first installment to be made one
month after the release of the loan. What is the monthly installment he needs to pay?

Solution.
6
The rate of interest per payment period is 12
% = 0.5%. Let P be the monthly installment. As
there are 5 × 12 = 60 payments, we have
20, 000 = P a 60 0.005
 
1 − (1.005)−60
=P×
0.005
= P × 51.7256
so that
20, 000
P = = $386.66
51.7256

Example
A man wants to save $100, 000 to pay for his son’s education in 10 years’ time. An education fund
requires the investors to deposit equal installments annually at the end of each year. If interest of
7.5% per annum is paid, how much does the man need to save each year in order to meet his target?

Solution.
We first calculate s 10 , which is equal to

(1.075)10 − 1
= 14.1471
0.075
Then the required amount of installment is
100, 000 100, 000
P = = = $7, 068.59.
s 10 14.1471

Example
A company wants to provide a retirement plan for an employee who is aged 55 now. The plan will
provide her with an annuity-immediate of $7, 000 every year for 15 years upon her retirement at
the age of 65 . The company is funding this plan with an annuity-due of 10 years. If the rate of
interest is 5%, what is the amount of installment the company should pay?

Solution.
We first calculate the present value of the retirement annuity. This is equal to
 
1 − (1.05)−15
7, 000a 15 = 7, 000 × = $72, 657.61
0.05

28
This amount should be equal to the future value of the company’s installments P , which is P s̈ 10 .
Now we have
(1.05)10 − 1
s̈ 10 = = 13.2068
1 − (1.05)−1
so that
72, 657.61
P = = $5, 501.53
13.2068

11 Continuously payable annuities

Let n be a non-negative number. The value at time 0 of an annuity payable continuously between
time 0 and time n, where the rate of payment per unit time is constant and equal to 1 , is denoted
by ā n .

This is a mathematical idealisation, which makes calculations easier. With a continuously payable
annuity, the payments are considered as a continuous cashflow that is payable at a given rate over
a given period of time. The symbol ā n is pronounced "A bar n ". Clearly:
Z n Z n  n
−δt 1 −δt
ā n = 1 · v dt =
t
e dt = − e
0 0 δ 0

1 − e−δn
=
δ
1−v n
= ( if δ ̸= 0)
δ
Note that ā n is defined even for non-integral values of n. If δ = 0 (or, equivalently, i = 0 ), ā n is
of course equal to n. Since:  
i 1 − vn
ā n =
δ i
it follows immediately that, if n is an integer:
i
ā n = a n ( if δ ̸= 0)
δ
The accumulated amount of such an annuity at the time the payments cease is denoted by s̄ n
By definition, therefore: Z n
s̄ n = eδ(n−t) dt
0
Hence:
s̄ n = (1 + i)n ā n
If the rate of interest is non-zero:
(1 + i)n − 1
s̄ n =
δ
29
 i
= sn
δ

Note

Notice the similarity between the formulae for the present and accumulated values of annuities:
1 − vn 1 − vn 1 − vn
an = ä n = ā n =
i d δ
(1 + i)n − 1 (1 + i)n − 1 (1 + i)n − 1
sn = s̈ n = s̄ n =
i d δ
The numerators are the always consistent, the only difference between the formulae are the de-
nominators.

12 Annuities payable pthly

Where annuity payments are made p times a year (eg p = 12 for a monthly annuity), a superscript
(p) is added in the top right hand corner of the symbol. Note that the annuity is still payable for
n years and still refers to a total annual amount of 1 unit ie the annuity consists of np payments,
each of amount 1/p units.

If p and n are positive integers, the notation a(p)

n is used to denote the value at time 0 of a level
annuity payable p thly in arrear at the rate of 1 per unit time over the time interval [0, n]. For this
annuity the payments are made at times 1/p, 2/p, 3/p, . . . , n and the amount of each payment is
1/p. The required formulae are:
1 − vn i (1 + i)n − 1 i
a(p)
n = (p)
= (p) a n s(p)
n = (p)
= (p) s n
i i i i
1 − vn i (1 + i)n − 1 i
ä(p)
n = (p)
= (p) a n s̈(p)
n = (p)
= (p) s n
d d d d

Non-integer values of n
For certain non-integral values of n the symbol a(p)
n has an intuitively obvious interpretation.
 
(p) 1 i(p)
a n ( at rate i) = a np at rate
p p

30
Example
Consider an annuity of payments of 1000 at the end of every second year. What is the present value
of this annuity if it runs for ten years and the interest rate is 7% ?

Solution.
Since there is one payment per two years.

500 × a(1/2)
10

We compute i(1/2) ,
 1/2
i(1/2) 1

1+i= 1+ =⇒ i(1/2) = (1 + i)2 − 1 = 0.07245
1/2 2

and thus
1 − v 10
a(1/2)
10
= = 6.786069
i(1/2)
500 × a(1/2)
10
= 500 × 6.786069 = 3393.03

13 Perpetuities
An annuity that is payable forever is called a perpetuity. i.e., an annuity whose payments con-
tinue forever with the first payment occurs either immediately (perpetuitydue) or one period from
now (perpetuityimmediate). Thus, accumulated values of perpetuities do not exist. The required
formulae are:
1 1 1 1
a∞ = ä ∞ = a(p)
∞ = (p) ä(p)
∞ = (p)
i d i d

Example
Suppose a company issues a stock that pays a dividend at the end of each year of $10 indefinitely,
and the the companies cost of capital is 6%. What is the the value of the stock at the beginning of
the year?

Solution.
10 · a ∞ = 10 · 1
0.06
= $166.67

Example
What would you be willing to pay for an infinite stream of $37 annual payments (cash inflows)
beginning now if the interest rate is 8% per annum?

Solution.

31
 37
37ä ∞ = 0.08(1.08)−1
= $499.50

Example
You can receive one of the following two sets of cash flows. Under Option A, you will receive
$5, 000 at the end of each of the next 10 years. Under Option B, you will receive X at the begin-
ning of each year, forever. The annual effective rate of interest is 10%. Find the value of X such
that you are indifferent between these two options.

Solution.
The equation of value at time t = 0 is
 
X 1
5000a 10 = =X +1
d i
30722.84 = 11X
X = $2, 792.99

Example
Fifty dollars is paid at the end of each year forever starting six years from now. Assume the annual
effective rate of interest is 10%, find the present value of the investment.

Solution.
The deferred period is t = 5. The answer is
1
50(1 + i)−5 a ∞ = 50(1.1)−5 · = $310.46
0.1

Example
A deferred perpetuity-immediate paying $2000 monthly is bought for a sum of $229, 433.67. Find
the deferred period if the interest rate compounded monthly is 6%.

Solution.
The monthly interest rate is 0.06
12
= 0.005. Let n be the deferred period, i.e. the time it takes
$229, 433.67 to accumulate to 2000aa ∞ . Thus, n satisfies the equation

1
2000a ∞ = 229, 433.67(1.005)n ⇒ 2000 · = 229, 433.67(1.005)n
0.005
Solving this equation for n we find n = 111.45 months

32
Example
Find the present value as at 1 January 2004 of a series of payments of 100 payable on the first day
of each month during 2005,2006 and 2007 , assuming an effective rate of interest of 8% per annum.

Solution.
The present value of the payments as at 1 January 2005 is 1, 200ä(12)
3
So the present value as at 1
January 2004 is:

1 − v3 1 − 0.79383
1, 200vä(12)
3
= 1, 200v (12) = 1, 200 × 0.92593 × = 2, 986
d 0.076714
using the values given in the Tables.

Example
Find the present value as at 1 June 2004 of payments of 1, 000 payable on the first day of each
month from July 2004 to December 2004 inclusive, assuming a rate of interest of 8% per annum
convertible quarterly.

Solution
An interest rate of 8%pa convertible quarterly is equivalent to an effective quarterly interest rate
of 2%. There are 6 monthly payments of 1, 000 each, starting in one month’s time. If we work in
terms of quarters, the payments are 3, 000 per quarter, payable 3 times per quarter and starting in
one month’s time.

So, the PV of the payments is:

1 − v2 1 − 0.96117
3, 000a(3)@2%
2
= 3, 000 = 3, 000 × = 3, 000 × 1.9542 = 5, 863
i(3) 0.01987
 
(We have to work out i(3) from the formula i(3) = 3 (1 + i)1/3 − 1 , since i(3) is not shown in the
Tables.)

Alternatively, you could have worked in months using an effective monthly interest rate. The
calculation is then:
1 − 1.0066227−6
1, 000a@0.66227%
6
= 1, 000 × = 5, 863
0.0066227
Or, using an annuity payable in advance, the calculation is:

1 − 1.0066227−6
1, 000vä@0.66227%
6
= 1, 000 × 1.0066227−1 × 0.0066227 = 5, 863
1.0066227

Example
You have just invested 1, 000 in a fixed interest security. In return you will receive 40 at the end of

33
each half year plus your money back on redemption in 12 years. You intend to deposit all of the
proceeds in a bank account that will pay an effective rate of interest of 8%pa. How much money
do you expect there to be in the bank account after 10 years?

Solution
You will receive 80 pa payable half-yearly in arrear. After 10 years you should have:
i
80s(2)@8%
10
= 80 s 10 = 80 × 1.019615 × 14.4866 = 1, 182
i(2)

Example
Calculate a(12)
3.5
given that i = 19.5618%.

Solution
i(12)
If i = 19.5618% then 12
= 1.5%. Therefore it is easier to find a@1.5%
42
since it is tabulated in the
Tables.
1 @1.5%
a(12) = a = 2.583
3.5 12 42

Example
Calculate a(4)
13.25
at 10.3813%pa effective.

Solution
10.3813%pa effective is equivalent to 2.5%pq effective but a 53 is not tabulated and so using the
formula:
1 @2.5% 1 − v 53
a(4) = a = = 7.298
13.25 4 53 4i

Example
Show that ä n = a n + 1 − ν n . Interpret the result verbally.

Solution
n
We have ä n = (1 + i)a n = a n + ia n = a n + i · 1−ν
i
= a n + 1 − ν n . An additional payment of 1
at time 0 results in a n becoming n + 1 payments that now commence at the beginning of the year
and whose present value is ä n + ν n

Example
Show that s̈ n = s n − 1 + (1 + i)n . Interpret the result verbally.

Solution

34
We have s̈ n = (1 + i)s n = s n + i · (1+i)i −1 = s n − 1 + (1 + i)n . An additional payment of 1
n

at time n results in s̈ n becoming n + 1 payments that now commence at the beginning of the year
and whose accumulated value at time t = n is s n + (1 + i)n

Example
Show that
(a) ä n = 1 + a n−1 .
(b) s n = s̈ n−1 + 1.

Solution −n −n+1 +i
(a) We have ä n = 1−(1+i)
d
= i+1
i
[1 − (1 + i)−n ] = 1−(1+i)i = 1 + a n−1 .
The result has the following verbal interpretation: An additional payment of 1 at time 0 results in
a n−1 becoming n payments that now commence at the beginning of each year whose present value
is ä n .

(b) We have s̈ n−1 = (1+i)d −1 = i+1 [(1 + i)n−1 − 1] = (1+i) i −1−i = s n − 1

n−1 n

i
An interpretation of (b) is as follows: A withdrawal of 1 at time n results in s n becoming n − 1
payments that commence at the beginning of each year (starting at t = 1 ) whose accumulated
value at time t = n is s̈ n−1

14 Deferred and increasing annuities

Evaluating annuities thus far has always been done at the beginning of the term( either on the date
of, or one period before the first payment) or at the end of the term (either on the date of, or one
period after the last payment).

14.1 Deferred annuities

Deferred annuities are annuities where no payment is made during the first time period.

Suppose that m and n are non-negative integers. The value at time 0 of a series of n payments,
each of amount 1 , due at times (m + 1), (m + 2), . . . , (m + n) is denoted by m| a n (see the figure
below).

35
Such a series of payments may be considered as an immediate annuity, deferred for m time units.
When n > 0 :
m | a n = v m+1 + v m+2 + v m+3 + · · · + v m+n



= v + v 2 + v 3 + · · · + v m+n − v + v 2 + v 3 + · · · + v m


= vm v + v2 + v3 + · · · + vn

The last two equations show that:

m | a n = a m+n − a m
= vman

We may define the corresponding deferred annuity-due as:

m | ä n = v m ä n

14.2 Continuously payable annuities

If m is a non-negative number, we use the symbol m | ā n to denote the present value of a continu-
ously payable annuity of 1 per unit for n time units, deferred for m time units. Thus:
Z m+n
m | ā n = e−δt dt
m
Z n
−δm
=e e−δs ds
Z m+n 0 Z m
−δt
= e dt − e−δt dt
0 0

Hence:
m | ā n = ā m+n − ā n
= v m ā n

14.3 Annuities payable pthly

The present values of an immediate annuity and an annuity-due, payable pthly at the rate of 1 per
unit time for n time units and deferred for m time units, are denoted by:

m| a(p)
n = v m a(p)
n

and m|ä(p)
n = v m ä(p)
n

respectively.

36
Worked examples

Example
Write down a formula for m|ā n in terms of a n .

Solution
i
m|ā n = v m ā n = v m a n
δ

Example
A being on the planet Xi is currently aged exactly 48 . When the being retires at exact age 60
(in ’Earth’ years) it will receive an income of 35 Dafts (the local currency) per ’Earth’ week. All
beings on the planet Xi die at exact age 76 . Calculate the present value of the retirement benefits
at 10%pa effective.

Solution
Approximating the weekly payments by a continuous annuity:

1 − v 16
P V = 52.18 × 35 × 12|ā 16 = 1826.3v 12 = 4, 777 Dafts
δ

Example
Which is higher, 5|a(2)
10
or 6|ä(2)
10
at 5% pa effective?

Solution
Both annuity functions value a ten year annuity payable half yearly. The first payment of 5|a(2)
10
is
at time 5 12 whereas the first payment of 6|ä(2)
10
is at time 6 . Therefore since the payments are made
sooner, 5|a(2)
10
will be greater.

In fact 5|a(2)
10
= (1 + i)0.5 6|ä(2)
10
.

Alternatively, you could calculate each function:

5|a(2)
10
= 6.125 and 6|ä(2)
10
= 5.977

14.4 Increasing Annuities

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

37
such an annuity may always be evaluated as:
X
n
xi v ti
i=1

where the ith payment, of amount Xi , is made at time ti .

First, let us assume that payments vary in arithmetic progression. That is, the first payment is
P and then the payments increase by Q thereafter, continuing for n years as shown in the time
diagram below

If P V is the present value for this annuity-immediate, then

P V = P ν + (P + Q)ν 2 + (P + 2Q)ν 3 + · · · + [P + (n − 1)Q]ν n .

Multiplying this equation by (1 + i), we obtain

(1 + i)P V = P + (P + Q)ν + (P + 2Q)ν 2 + · · · + [P + (n − 1)Q]ν n−1 .

Subtracting the first equation from the second one we obtain

iP V = P (1 − ν n ) + ν + ν 2 + · · · + ν n Q − nν n Q

or  
a n − nν n
P V = P an + Q .
i
The accumulated value of these payments at time n is
 
s n − n
AV = (1 + i)n P V = P s n + Q .
i
Two special cases of the above varying annuity often occur in practice. The first of these is the
increasing annuity where P = Q = 1 as shown

38
In this particular case when Xi = ti = i the annuity is known as an "increasing annuity" and its
present value is denoted by (Ia) n .

(Ia) n , therefore, represents the present value of payments of 1 at the end of the first time period, 2
at the end of the second time period, . . . , n at the end of the nth time period. Thus:

(Ia) n = v + 2v 2 + 3v 3 + · · · + nv n

Hence: (1 + i)(Ia) n = 1 + 2v + 3v 2 + · · · + nv n−1

By subtraction, we obtain:

i(Ia) n = 1 + v + v 2 + v 3 + · · · + v n−1 − nv n
= ä n − nv n

So:
ä n − nv n
(Ia) n =
i
The accumulated value at time n is given by

s̈ n − n s n+1 − (n + 1)
(Is) n = (1 + i)n (Ia) n = = .
i i

Example
Find the present value as at 1 January 2005 of a series of 10 annual payments starting at 500 on 1
January 2006 and increasing by 100 each year. Assume an effective rate of interest of 8%pa.

Solution
We can think of this series of payments as a combination of:
a level annuity of 400 and
an increasing annuity of 100
So the present value of the payments as at 1 January 2005 is:
 
ä n − 10v 10
400a 10 + 100(Ia) 10 = 400a 10 + 100
i
7.2469 − 10(0.46319)
= 400 × 6.7101 + 100 ×
0.08
= 5, 953

Example
Calculate the present value at time 0 of payments of 50 at time 0 , 660 at time 1, 70 at time 2 and

39
so on. The last payment is at time 10. Assume that the annual effective rate of interest is 4.2%.

Solution
On a time line we can show the payments as:

Notice that there are 11 payments. Alternatively, these payments can be thought of as the sum of
the following two sets of payments:

ie we have a level annuity with payments of 40 and an increasing annuity which increases by 10
each time.
The present value of these payments is:

40ä 11 + 10(Iä) 11

We have:
1 − 1.042−11
ä 11 = = 9.03074
0.042/1.042
ä 11 − 11v 11 9.03074 − 11 × 1.042−11
(Iä) 11 = = = 50.48174
d 0.042/1.042

40
So the present value is:
40 × 9.03074 + 10 × 50.48174 = 866.05

Example
The following payments are to be received: $500 at the end of the first year, $520 at the end of the
second year, $540 at the end of the third year and so on, until the final payment is $800. Using an
annual effective interest rate of 2%
(a) determine the present value of these payments at time 0 ;
(b) determine the accumulated value of these payments at the time of the last payment.

Solution
In n years the payment is 500 + 20(n − 1). So the total number of payments is 16 . The given
payments can be regarded as the sum of a level annuity immediate of $480 and an increasing
annuity-immediate $20, $40, · · · , $320.
(a) The present value at time t = 0 is

480a 16 + 20(Ia) 16 = 480(13.5777) + 20(109.7065) = $8, 711.43.

(b) The accumulated value at time t = 16 is

480s 16 + 20(Is) 16 = 480(18.6393) + 20(150.6035) = $11, 958.93

14.5 Continuously payable annuities

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

It can be shown that:

ä n − nv n
(Iā) n =
δ
and:
¯ n= ā n − nv n
(Iā)
δ
The present values of deferred increasing annuities are defined in the obvious manner, for example:

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

41
Example
Rent on a property is payable continuously for 5 years. The rent in the first year is 3, 000, there-
after the annual rent increases by 500pa. Calculate the present value of the rent at the start of the 5
years, using an annual effective rate of interest of 6%.

Solution
On a time line the rent is as follows:

The present value of these payments is:

2, 500ā 5 + 500(Iā) 5
Evaluating these annuities:
1 − 1.06−5
ā 5 = = 4.3375
ln 1.06
1 − 1.06−5
ä 5 = = 4.4651
0.06/1.06
4.4651 − 5 × 1.06−5
(Iā) 5 = = 12.5078
ln 1.06
So the present value is:
2, 500 × 4.3375 + 500 × 12.5078 = 17, 097.66

Example
A man agrees to make investments continuously for the next 10 years. He decides that he can
afford to invest 20t at time t, 0 ≤ t ≤ 10. Calculate the:
(i) present value of the investment at time 0
(ii) accumulated value of the investment at time 10 .
You may assume an annual effective rate of interest of 3.7% throughout the 10 years.
Solution
(i) The present value of these payments is:
−10
ā 10 − 10v 10 1−1.037
− 10 × 1.037−10
¯ 10 = 20
20(Iā) = 20 ln 1.037 = 787.82
δ ln 1.037
42
 (ii) The accumulated value is the present value accumulated for 10 years:

787.82 × 1.03710 = 1, 132.96

14.6 Decreasing payments

The other special case is the decreasing annuity-immediate where P = nandQ = 1 as shown
below.

In this case, the present value one year before the first payment (i.e., at time t = 0) is given by
a n − nν n n − nν n − a n + nν n n − an
(Da) n = na n − = =
i i i
The accumulated value at time n is given by
n(1 + i)n − s n
(Ds) n = (1 + i)n (Da) n = = (n + 1)a n − (Ia) n
i

Example
John receives $400 at the end of the first year, $350 at the end of the second year, $300 at the end
of the third year and so on, until the final payment of $50. Using an annual effective rate of 3.5%,
calculate the present value of these payments at time 0 and the accumulated value.

Solution
In year n the payment is 400 − 50(n − 1). Since the final payment is 50 we must have
400 − 50(n − 1) = 50. Solving for n we find n = 8.
Thus, the present value is
8 − a8
50(Da) 8 = 50 · = $1, 608.63
0.035
The Accumulated Value

8(1.035)8 − s 8
50(Ds) 8 = 50 × = $2, 118.27
0.035

Example

43
A man makes payments into an investment account of $200 at time 5, $190 at time 6 , $180 at time
7 , and so on until a payment of $100 at time 15 . Assuming an annual effective rate of interest of
3.5%, calculate:
(i) the present value of the payments at time 4
(ii) the present value of the payments at time 0
(iii) the accumulated value of the payments at time 15

Solution
The payments can be thought of as:
210 at time 5,210 at time 6,210 at time 7, . . . , 210 at time 15

LESS the following payments:

10 at time 5,20 at time 6,30 at time 7, . . . , 110 at time 15

(i) The present value of these at time 4 is:

210a 11 − 10(Ia) 11
Evaluating these, we get:

1 − 1.035−11
a 11 = = 9.0016
0.035
1 − 1.035−11
ä 11 = = 9.3166
0.035/1.035
9.3166 − 11 × 1.035−11
(Ia) 11 = = 50.9201
0.035
So the present value is:

210 × 9.0016 − 10 × 50.9201 = 1, 381.13

(ii) To find the present value at time 0 , we need to discount the answer to part (i) by 4 years:

1, 381.13 × 1.035−4 = 1, 203.57

(iii) To find the accumulated value at time 15 , we need to accumulate the answer to (i) by 11 years:

1, 381.13 × 1.03511 = 2, 016.40

Example
The following payments are made: 1, 000 pa payable quarterly in arrears from 1/1/05 to 31/12/10
The annual effective rate of interest is 3.4% for calendar years 2005 − 2008 and 4.2% thereafter.

44
Calculate:
(i) the present value of the payments at 1/1/05
(ii) the accumulated value of the payments at 1/1/12.

Solution
(i) The present value is:

1, 000a(4)
4
@3.4%
+ 1, 000v (4) @3.4% a(4)
2
@4.2%

Evaluating these:  
(4) 1
i@3.4% = 4 1.034 4 − 1 = 0.03357
 1

(4)
i@4.2% = 4 1.042 − 1 = 0.04135
4

The present value is then:

1 − 1.034−4 1 − 1.042−2
1, 000 + 1, 000 × 1.034−4
0.03357 0.04135
= 3, 728.432 + 1, 670.965 = 5, 399.40

(ii) We need to accumulate the answer to part (i) by 7 years. Four of these years have an interest
rate of 3.4%pa and the remainder have an interest rate of 4.2%pa :

5, 399.40 × 1.0344 × 1.0423 = 6, 982.81

Example
Calculate the present value as at 1 January 2004 of the following payments:
100 on the first day of each quarter during calendar years 2006 to 2015 inclusive.
Assume effective rates of interest of 8% per annum until 31 December 2010 and 6% per annum
thereafter.

Solution
Here we must value a ten-year annuity payable quarterly in advance, deferred for two years. We
have to split the ten-year annuity into two five-year annuities to allow for the change in interest
rates.
The present value here is:
 
400v 2@8% ä(4)
5
@8%
+ v 5@8% (4) @6%
ä 5
 
1 − 0.68058 1 − 0.74726
=400 × 0.85734 + 0.68058 ×
0.076225 0.057847
=400 × 6.1420 = 2, 457

45
15 Loan schedules
Loan is an arrangement in which a lender gives money or property to a borrower, and the bor-
rower agrees to return the property or repay the money, usually along with interest, at some future
point(s) in time.

Various methods of repaying a loan are possible. We will consider two of them: The amorti-
zation method and the sinking fund method.

The amortization method: In this method the borrower makes installment payments to the lender.
Usually these payments are at a regularly spaced periodic intervals; the progressive reduction of
the amount owed is described as the amortization of the loan. Examples include car loan, home
mortgage repayment.

The sinking fund method: In this method the loan will be repaid by a single lump sum pay-
ment at the end of the term of the loan. The borrower pays interest on the loan in installments over
this period. However, the borrower may prepare himself for the repayment by making deposits to
a fund called a sinking fund to accumulate the repayment amount.

15.1 Finding the Loan Balance Using Prospective and Retrospective Meth-
ods.
When using the amortization method, the payments form an annuity whose present value is equal
to the original amount of the loan. In this section, we want to determine the unpaid balance, also
referred to as the outstanding loan balance or unpaid principal at any time after the inception of
the loan.

There are two approaches used in finding the amount of the outstanding balance: the prospec-
tive and the retrospective method.

With the prospective method, the outstanding loan balance at any point in time is equal to the
present value at that date of the remaining payments.
With the retrospective method, the outstanding loan balance at any point in time is equal to the
original amount of the loan accumulated to that date less the accumulated value at that date of all
payments previously made.

In general, the two approaches are equivalent. At the time of inception of the loan we have the
following equality

Present Value of All Payments = Amount of Loan

46
Accumulate each side of the equation to the date at which the outstanding loan balance is de-
sired, obtaining

Current Value of Payments = Accumulated Value of Loan Amount

But payments can be divided into past and future payments giving

Accumulated Value of Past Payments + Present Value of Future Payments = Accumulated Value
of Loan Amount

Or

Present Value of Future Payments = Accumulated Value of Loan Amount - Accumulated Value
of Past Payments.

But the left side of this equation represents the prospective approach and the right side repre-
sents the retrospective aporoach.

An amortization schedule is a table which shows the division of each payment into principal
and interest, together with the outstanding loan balance after each payment is made.

We can calculate the capital repaid in a period where there is more than one payment by sub-
tracting the capital outstanding at the end of the period from the capital outstanding at the start of
the period. The interest paid in this period is then the total payment less the capital repaid.

The interest and capital components in the repayments for a loan can be set out in the form of
a loan schedule. The components for any period can be calculated directly using actuarial func-
tions.

How to Prepare an Amortization Schedule

(i) Periodic payments(Installment)

For a loan of amount L where interest and capital are repaid by equal annual payments at the end
of each of the next n years, define P as the periodic payment then
L
P =
an
(ii) Calculating Payment towards Interest
As part of the total loan payment each period, the borrower must make a payment towards interest.
The lender charges interest as the cost to the borrower of, well, borrowing the money.

Interest Payment= Principal outstanding × Interest

47
(iii)Calculating Payment towards Principal

Payment towards Principal= Installment - Payments towards Interest

Example
Create an amortization schedule for a loan of $1, 000 repaid over four years if the annual effective
rate of interest is 8%.

Solution
If P is the periodic payment then
1000
P = = $301.92
a4

Period (P) Installment (A) Interest paid (B) Principal repaid (C) Outstanding loan balance
= (C × Interest) =P −A = (C − B)

0 1000.00
1 301.92 80.00 221.92 778.08
2 301.92 62.25 239.67 538.41
3 301.92 43.07 258.85 279.56
4 301.92 22.36 279.56 0
Example
Create am amortization schedule for a loan of $10, 000 repaid over three years if the annual effec-
tive rate of interest is 7%.

Solution
If P is the periodic payment then
10, 000
P = = $3, 810.52.
a3

Period Payment amount Interest paid Principal repaid Outstanding loan balance
0 10, 000.00
1 3, 810.52 700.00 3, 110.52 6, 889.48
2 3, 810.52 482.26 3, 328.26 3, 561.22
3 3, 810.50 249.28 3, 561.22 0
Example
A 25-year mortgage for $100, 000 bears an interest rate of 5.5% compounded semi-annually. The
payments are made at the end of each month. Find the size of the payment.

48
Solution
1
The monthly interest rate is j = (1.0275) 6 − 1 = .00453168. The size of each payment is
100, 000
P = = 610.39
a 300 j

Example
A loan of 900 is repayable by equal monthly payments for 3 years, with interest payable at 181/2%
pa effective.
(i) Calculate the amount of each monthly payment. (ii) Calculate the interest and capital portions
of the thirteenth payment of the loan.

Solution
(i) Let M equal the monthly payment. Then:

1 − v3
900 = 12M a(12)
3
= 12M
i(12)

900i (12) 900 × 12 1.1851/12 − 1
⇒M = = = 32.13
12 (1 − v 3 ) 12 (1 − 1.185−3 )

(ii) The loan outstanding immediately after the twelfth payment is:

1 − v2
12 × 32.13a(12)
3
= 385.56 × = 385.56 × 1.6839 = 649.25
i(12)
The interest portion of the thirteenth payment is therefore:

i(12)
649.25 × = 9.25
12
The capital portion is:
32.13 − 9.25 = 22.88

Example
A loan of $50, 000 is repayable by equal annual payments at the end of each of the next 5 years.
Interest is 8%pa for the first three years and 12%pa thereafter.
Calculate the loan outstanding immediately after the second repayment.

Solution

49
Let the amount of each repayment be X so that:
3


50, 000 = X a 3 , 8% + v8% a 2 , 12%
50, 000
⇒X=
2.5771 + 0.79383 × 1.6901
⇒ X = $12, 759.16

We can calculate the loan outstanding immediately after the second payment either prospec-
tively or retrospectively. Prospectively:


12, 759.16v8% 1 + a 2 , 12% = 12, 759.16 × 0.92593 × 2.6901 = $31, 781

Retrospectively:
50, 000(1.08)2 − 12, 759.16((1.08) + 1) = $31, 781

Example
A bank lends a company 5, 000 at a fixed rate of interest of 10%pa. The loan is to be repaid by five
level annual payments. Calculate the interest and capital payments at each repayment date.

Solution
First calculate the total amount of each payment Y .
5, 000
Y a 5 = 5, 000 ⇒ Y = = 1, 318.98
3.7908
The following table shows how each payment of 1, 318.98 is split between interest and capital
payments.

Example

50
A loan of 16, 000 is repayable by ten equal annual payments. The annual effective rate of interest
is 4%. Calculate:
(i) the interest element of the 4 th payment
(ii) the capital element of the 7 th payment
(iii) the capital repaid in the last five years of the loan
(iv) the total interest paid over the whole loan.

Solution
If the annual repayment is X then:

Xa 10 = 16, 000
16, 000 16, 000
⇒ X= = = 1, 972.66
a 10 8.1109

(i) The capital outstanding after the 3 rd payment is:

1, 972.66a 7 = 1, 972.66 × 6.0021 = 11, 840.01

The interest element of the 4 th payment is:

0.04 × 11, 840.01 = 473.60

(ii) The capital outstanding after the 6th payment is:

1, 972.66a 4 = 1, 972.66 × 3.6299 = 7, 160.55

The interest element of the 7 th payment is:

0.04 × 7, 160.55 = 286.42

Therefore, the capital element of the 7th payment is:

1, 972.66 − 286.42 = 1, 686.24

(iii) The capital repaid over the last five years of the loan must be the capital outstanding after the
5 th payment, ie:
1, 972.66a 5 = 1, 972.66 × 4.4518 = 8, 781.93
(iv) The total interest payable over the whole loan is the total payment made less the capital bor-
rowed, ie:
10 × 1, 972.66 − 16, 000 = 3, 726.60

Exercises

51
1. (From the 2010 exam) A four-year loan of 5000 is repaid by equal annual payments at the
end of each year. Compute the annual payment on the basis of an interest rate of 6% p.a. and draw
up a loan schedule, showing the interest component of every payment and the outstanding balance.

2. (From the CT1 exam, April ’08) A mortgage company offers the following two deals to cus-
tomers for twenty-five year mortgages.
(a) A mortgage of 100, 000 is offered with level repayments of 7, 095.25 made annually in arrear.
There are no arrangement or exit fees.
(b) A mortgage of 100, 000 is offered whereby a monthly payment in advance is calculated such
that the customer pays an effective rate of return of 4% per annum ignoring arrangement and exit
fees. In addition the customer also has to pay an arrangement fee of 6, 000 at the beginning of the
mortgage and an exit fee of 5, 000 at the end of the twenty-five year term of the mortgage.
Compare the annual effective rates of return paid by customers on the two products.

3. (From the CT1 exam, April ’09) A loan is to be repaid by an annuity payable annually in
arrear. The annuity starts at a rate of 300 per annum and increases each year by 30 per annum. The
annuity is to be paid for 20 years. Repayments are calculated using a rate of interest of 7% per
annum effective.
Calculate:
(a) The amount of the loan.
(b) The capital outstanding immediately after the 5 th payment has been made.
(c) The capital and interest components of the final payment.

4. A loan of 4, 000 is repayable by equal monthly payments for 5 years. Interest is payable at
a rate of 7% pa effective. Calculate the interest paid and the capital repaid in the 4 th year.

52