TUTORIAL SOLUTIONS WEEK 3

Question 1
Find the present value of 1000 due at the end of 10 years if
(a) i (2)  0.09 , (b) i (6)  0.09 , and (c) i (12)  0.09 .

Solution
 mt
 i (m) 
S (0)  S (t )1  i   S (t )1 
t

 m 
It is easiest to work in units of time relating to the compounding periods for each example.
For example, for i ( 2 ) , m  2 and the effective half-yearly interest rate is 0.09 / 2  0.045 .

(a) Number of periods given unit of time is half-year ( m  2) = 10 x 2 = 20

1000  v 020.045  1000 (1.045) 20  414.64

(b) Number of periods given ( m  6) = 10 x 6 = 60. Effective interest rate corresponding to

units of time of 1/6-years is 0.09/6=0.015.

1000  v 060.015  1000 (1.015) 60  409.30

(c) Number of periods given ( m  12 ) = 10 x 12 = 120. Effective interest rate corresponding

to units of time of 1 month is 0.09/12=0.0075.
120
1000  v 0120
.0075  1000 (1.0075 )  407 .94

(d) In Excel, calculate the present value of $1million under each of the following situations /
scenarios.

Annual effective interest rate, i

(2)
$1m received in: i = 4% i(4) = 4% i = 6% i(10) = 8%
2 years
5 years
7.5 years
127 months
20 years

See the worked solutions in ‘Week 3 - Tutorial Solution.xls’.

Question 2
Mountain Bank pays interest at a nominal rate convertible half-yearly of i ( 2)  0.15 . River
Bank pays interest compounded daily. What minimum nominal annual rate convertible daily
must River Bank pay in order to be as attractive as Mountain Bank ?

Solution
River Bank (RB) will be as attractive as Mountain Bank (MB) if an investment in RB
accumulates to an amount equal to or greater than the same investment accumulated in MB.

STAT2032/6046 – Financial Mathematics 1

This is equivalent to finding i ( 365 ) so that the effective annual rate of interest for RB is greater
than or equal to that of MB.

2
 i ( 2) 
Accumulated value of an investment of X in MB = X 1    X 1.075 2  X 1.155625 
 2 
365
 i (365) 
Accumulated value of an investment of X in RB = X 1  
 365 
We want to solve for i ( 365 ) such that:

365
 i (365 ) 
X 1    X 1.155625 
 365 
( 365 )
Solving for i :


i ( 365 )  365  1.155625 
1 / 365

1

i ( 365 )  0.144670

Question 3
Bank A has an effective annual rate of 18%. Bank B has a nominal annual rate of 17%
convertible m times per year. What is the smallest whole number of times per year ( m ) that
Bank B must compound its interest in order that the rate at Bank B be at least as attractive as
that at Bank A on an effective annual basis? Repeat the exercise with a nominal rate of 16%
per annum at Bank B.

Solution
Bank A has an effective rate of interest of i  18% .
Bank B has a nominal annual rate of interest of i ( m )  17% .
The number of compounding periods m is unknown.

From lectures we know that effective and nominal rates of interest are related by:
m
 i (m) 
1  i  1  
 m 
Therefore, we want to find the smallest m so that,
m
 0.17 
f ( m )  1    1.18
 m 

If m  1, f (1)  1.17
If m  2, f ( 2)  1.1772
If m  3, f (3)  1.1798
If m  4, f (4)  1.1811

Therefore, the smallest number of compounding periods per annum is 4 in order for Bank B
to be at least as attractive as Bank A.

STAT2032/6046 – Financial Mathematics 2

We now repeat the exercise with a nominal rate of 16% at Bank B, or i ( m )  16%
Therefore, we want to find the smallest m so that,
m
 0.16 
f ( m )  1    1.18
 m 

If m  1 , f (1)  1.16
If m  12 , f (12)  1.1723
If m  52 , f (52)  1.1732

It appears that no matter how many compounding periods per annum, we may not be able to
achieve an accumulation of 1.18.

How can we check this ?

We can check this by finding the limit as m approaches infinity of f (m ) :

m
 0.16 
lim f ( m)  lim 1    e  1.1735
0.16
m  m 
 m 
Therefore, no matter how many times per annum compounding takes place, a nominal rate of
16% cannot accumulate to an effective rate of greater than 17.35%.

Question 4
Nominal interest can be defined even if m is not an integer. The algebraic definition
m
 i(m) 
1  i  1   is still valid. Suppose a bank advertises a nominal rate of 10% per annum
 m 
convertible every 45 days on short-term deposits. Find m and the equivalent effective annual
rate of interest.

Solution
m is the number of compounding periods per year. Since we are dealing with a term of 45
365
days, the number of 45-day terms in a year is m   8.1111 .
45

If the nominal rate is 10% convertible every 45 days then i ( m )  i ( 365 / 45 )  10% .
m
 i ( m) 
The equivalent effective annual rate of interest can be found by i  1    1 :
 m 
365 / 45
 0.10 
i  1    1  0.104495 .
 365 / 45 

STAT2032/6046 – Financial Mathematics 3

Question 5 (a)
The nominal rate of interest i ( m ) can be defined for values of m  1 . Algebraically the
m
 i(m) 
definition follows the relationship in the equation 1  i   1  
 m 

If i  0.10 , find the equivalent i (0.5) , i (0.25) , i (0.1) , and i (0.01) . Rank the values in increasing
size, and compare with the relationship i ( m )  i for m  1 .

Solution

i ( m )  m 1  i   1
1/ m

(i) compounding every 2 years
i ( 0 .5 )

 0.5 1  0.10 
1 / 0 .5

 1  0.105

(ii) compounding every 4 years

i ( 0.25 )

 0.25 1  0.10 
1 / 0.25

 1  0.116025

(iii) compounding every 10 years


i ( 0.1)  0.1 1  0.10 
1 / 0. 1

 1  0.159374

(iv) compounding every 100 years

i ( 0.01)

 0.01 1  0.10 
1 / 0.01

 1  137 .796

Recall that when m  1 the equivalent effective annual rate of interest is greater than nominal
rates: i  i ( 2 )  i ( 3)  ...   .

When m  1 the equivalent effective annual rate of interest is less than nominal rates:
i  i ( 0.5)  i ( 0.25 )  i ( 0.1)  i ( 0.01)

Question 5 (b)
Find the equivalent effective annual rate i if (i) i ( 0.5 )  0.10 , (ii) i (0.25)  0.10 , (iii)
i (0.1)  0.10 , and (iv) i (0.01)  0.10 .

Solution
m
 i (m) 
i  1    1
 m 
0 .5
 0.10 
(i) i  1    1  0.0954
 0 .5 
0.25
 0.10 
(ii) i  1    1  0.0878
 0.25 
0 .1
 0.10 
(iii) i  1    1  0.0718
 0 .1 

STAT2032/6046 – Financial Mathematics 4

 0.01
 0.10 
(iv) i  1    1  0.0243
 0.01 

Question 6
If the effective rate of interest is 10% per annum, calculate (a) d and (b) d (12) .

Solution
i 0.1
(a) d    0.090909
1  i 1.1

(b) d (12 )  12 1  1  d 
1 / 12
 
 12 1  1  i 
1 / 12
 
 12 1  1.1
1 / 12

 0.094933

Question 7
Find the accumulated value of $100 at the end of two years if:
(a) the nominal annual rate of interest is 6% convertible quarterly.
(b) the nominal annual rate of discount is 4% convertible monthly.
(c) the nominal annual rate of discount is 6% convertible once every four years.

Solution
(a) m  4, t  2
tm
 i (m) 
8
 0.06 
S (t )  S (0)1    S ( 2)  1001    112.6493
 m   4 
(b) m  12, t  2
 tm 24
 d (m)   0.04 
S (t )  S (0)1    S ( 2)  1001    108.3432
 m   12 
1
(c) m  , t  2
4
2
tm 
 d ( m)   0.06  4
S (t )  S (0)1    S (2)  1001    114.7079
 m   (1 / 4) 

Question 8
An investment of $1,000 accumulates to $1,360.86 at the end of 5 years. If the force of
interest is  during the first year and 1.5 in each subsequent year, find the equivalent
effective annual interest rate in the second year.

Solution
The accumulated value of $1,000 after 1 year at a force of interest of  is 1000e .
The accumulated value of this amount after an additional 4 years at a force of interest of 1.5
is:
1000e e1.5 e1.5 e1.5 e1.5  1000e e    1000e7
4 1.5

Therefore,
1000e 7  1360.86
Solving for  :

STAT2032/6046 – Financial Mathematics 5

 1  1360.86 
  ln    0.044017
7  1000 

The effective annual interest rate in the first year is:

e  (1  i )  i  e  1  4.5%

The effective annual interest rate in the second year is:

e1.5  (1  i )  i  e1.5  1  6.8253%

STAT2032/6046 – Financial Mathematics 6

Question 9
Smith forecasts that interest rates will rise over a 5-year period according to a force of interest
0.025t
function given by  t  0.08  for 0  t  5 .
t 1
(a) According to this scheme, what is the average annual compound effective rate for the 5-
year period?
(b) What is the present value at t=2 of $1,000 due at t=4?

 t 
Hint:   dt  t  ln(t  1)
 t 1

Solution
(a) From lectures we know that the accumulation at time n of an amount 1 is given by:
n 
S (n)  exp    t dt 
0 
Under compound interest at an annual effective rate of i this is also equal to (1  i ) n .

Therefore, for a 5-year period:

5  5 0.025t  
(1  i )  exp    t dt   exp    0.08 
5
dt 
0  0 t 1  
Evaluate the integral. Note that:
 t 
  t  1 dt  t  ln(t  1)
Therefore,
 0.025t 
5

0  0.08  t  1 dt   0.08t  0.025  t   0.025ln  t  1  0

5

 0.08(5)  0.025  5   0.025ln  6 

 0.480206

5 0.025t  
 exp    0.08  dt   1.616407
0 t 1  
 i  1.6164071/ 5  1  0.1008

(b) The present value at time 0 of an amount S ( n ) due at time n is:

 n 
S (0)  S ( n)  exp    t dt 
 0 
The present value at time 2 of $1,000 due at time 4 is :
 4 0.025t  
S (2)  1000  exp     0.08  dt 
 2  t  1  
 1000  exp  0.08(4)  0.025  4  ln  5    0.08(2)  0.025  2  ln  3    821

STAT2032/6046 – Financial Mathematics 7

Question 10
The present value of K payable after 2 years is $960. If the force of interest is cut in half the
present value becomes $1,200. Find K.

What is the present value if the effective annual discount rate is cut in half?

Solution
The present value of K payable after 2 years is:
960  Ke 2
The present value of K payable after 2 years if the force of interest is cut in half is:

2
1200  Ke 2
 Ke 

2
1200  1200 
 e    e2   
K  K 
2
2  1200  12002
960  Ke K   K   1500
 K  960

In terms of the effective discount rate, we can write: e   (1  d ) .

When K=1500,
1200
e   (1  d )   0.8  d  0.2
1500
Therefore, if we halve the discount rate ( d  0.1) , the PV of 1500 payable after 2 years is:
2
 d
PV  K  1    1500(1  0.1) 2  1215
 2

STAT2032/6046 – Financial Mathematics 8