Actuarial Society of India

EXAMINATIONS
8th November 2002 (am)

Subject 102 – Financial Mathematics

Time allowed: Three Hours

INSTRUCTIONS TO THE CANDIDATE

1. Do not write your name anywhere on the answer scripts. You have only to write
your Candidate’s Number on each answer script.
2. Mark allocations are shown in brackets.
3. Attempt all 14 questions, beginning your answer to each question on a separate
sheet.
4. In addition to this paper you should have available graph paper, Actuarial
Tables and an electronic calculator.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet and this question paper

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Q.1 Define nominal rate of interest. [3]

Q.2 The rate of discount per annum convertible quarterly is 8%. Calculate:
(a) the equivalent rate of interest per annum convertible half-yearly.

(b) the equivalent rate of discount per annum convertible monthly.

[4]

Q.3 Prove the following identities:

(a) (Ia) n + (Dä) n = n × ä n + 1

(b) (Iä) n + (Da) n = (n + 2) × a n - 1 + 1 + v n

[4]

Q.4 The 1-year forward rates for transactions beginning at times t = 0, 1, 2 are f t where
f 0 = 0.06; f 1 = 0.065; f 2 = 0.07.
Compute the par yield for a 3-year bond.
[3]

Q.5 An ordinary share pays annual dividends. The next dividend is expected to be Rs
100 per share and is due in exactly 9 months time. It is expected that subsequent
dividends will grow at a rate of 5% per annum compound and that inflation will be
3% per annum. The price of the share is Rs 2500 and dividends are expected to
continue in perpetuity. Calculate the expected effective real rate of return per
annum for an investor who purchases the share. [5]

Q.6 An annuity is payable in arrear for 15 years. The annuity is payable half-yearly for
the first five years, quarterly for the next five years, and monthly for the final five
years. The annual amount of the annuity is doubled after each five-year period. On
the basis of an interest rate of 8% per annum convertible quarterly for the first four
years, 8% per annum convertible half-yearly for the next eight years, and 8% per
annum effective for the final three years, the present value of the annuity is
Rs.2,049.

Find the initial annual amount of the annuity.

[10]

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Q.7 A loan stock bears interest at the rate of 11% per annum payable half-yearly.
Interest is payable on 15 May and 15 November each year and the entire loan is
redeemable at par on either of these dates in the year 2033 or in any subsequent
year.

An investor, who is liable to income tax at the rate of 50%, purchased the loan on
15 November 2001 (just after payment of the interest then due).

Find the maximum price per 100 nominal he should pay to be certain of obtaining a
net effective annual yield of 4%. Assuming that he paid this price, find the
maximum possible net yield per annum he may obtain from the investment.
[6]

Q.8
(a) Define the term “discounted payback period” in the context of project appraisal.
[1]
(b) A property is purchased by a businessman for Rs.80,000, with a further payment of
Rs.5,000 for repairs in one year’s time. This property has been given on lease with
an income of Rs.10,000 per annum, payable continuously for 20 years commencing
in two years’ time.

This deal is financed by a bank loan on the basis of an effective annual interest rate
of 7%. Assume that the loan may be repaid continuously.

Find the discounted payback period for the transaction.

[4]
(c) After the loan has been repaid by the businessman, he will deposit all the available
income in an account which will earn interest at 6% per annum effective, find the
accumulated amount of the account in 22 years’ time.
[2]

Q.9
(a) Describe the characteristics of a repayment loan or mortgage.
[4]
(b) A loan of Rs.19,750 was repayable by a level annuity payable monthly in arrear for
20 years and calculated on the basis of an interest rate of 9% per annum effective.
The lender had the right to alter the conditions of the loan at any time and,
immediately after the 87th monthly repayment had been made, the effective annual
rate of interest was increased to 10%. The borrower was given the option of either
increasing the amount of his level monthly repayment or extending the term of the
loan (the monthly repayment remaining unchanged).

(i) Find the revised monthly installment, if the borrower had opted to pay a
higher monthly installment.
[4]

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 (ii) Assume that the borrower elected to continue with the monthly repayment
unchanged. Find the revised term of the loan and the amount of the final
monthly repayment.
[6]

Q.10 (a) In the context of derivative investments, define:

i) Option
ii) Call option
iii) Put option
[3]
(b) Explain why buying a call option is not the same as selling a put option.
[3]

Q.11 (a) Using the “No Arbitrage” principle, describe how you would calculate the forward
price for a security with fixed cash income.
[6]
(b) An asset has a current price of Rs 100. It will pay an income of Rs 5 in 20 days
time. Given a risk free rate of interest of 6% per annum convertible half-yearly and
assuming no arbitrage, calculate the forward price to be paid in 40 days.
[4]

Q.12
(a) List the conditions for Redington’s immunization theory for constructing
investment portfolios.
[3]
(b) List four limitations of this theory to apply in practice.
[4]

Q.13 In any year, the growth rate in the share price of a large company is independent of
the growth rates in all previous years. Each year the growth rate is log-normally
distributed with a mean value of 10% and a standard deviation of 5%.

(a) Determine the parameters µ and σ 2 of the log-normal distribution of the growth
rate.
[5]
(b) S4 denotes the growth rate in the share price over 4 years.

i) Determine the distribution of S4

ii) If the current share price is Rs 345, determine the probability that the
share price 4 years from now will exceed Rs 550.
[4]

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Q.14 A financial institution has issued a large number of 20-year policies. Under these
policies:

• Premiums are payable annually in advance

• A maturity benefit of Rs 10,000 is payable at the end of 20 years.

Premiums are calculated such that the present value of benefits payable and
expenses incurred equal that of the premiums under the policies. In doing this
calculation, the financial institution makes the following assumptions:

Interest 5% per annum effective

Expenses at the start of the policy 2% of the maturity benefit
Ongoing expenses 3% of each premium paid.

(a) Calculate the annual premium for each of these policies assuming that premiums
under all policies continue to be paid for each of the 20 years.
[4]
(b) The financial institution observes that on each premium due date, 4.5456% of the
policies that had paid premiums in the preceding year, defaulted on their premiums.
It has been decided that policies that defaulted in premiums would be immediately
refunded the premiums already paid under them, without any interest. Also, they
would not be eligible for the maturity benefit of Rs 10,000.

The financial institution wishes to recalculate the premiums for these policies to
allow for these premium defaults. Calculate the revised annual premium.
[8]

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