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Chapter 2
Chapter 2
Annuities
1. Basic Annuities
1.1 Introduction
Annuity: A series of payments made at equal intervals of time.
Examples: House rents, mortgage payments, installment payments on
automobiles, and interest payments on money invested.
1.2. Annuity-immediate
Annuity-immediate: An annuity under which payments of 1 are made at the
end of each period for n periods.
an|: The present value of the annuity at one period before the first payment is
made.
an| = v + v 2 + + v n1 + v n
1 vn
1 vn
=v
= v
1v
iv
1 vn
=
i
sn|: The accumulated value of the annuity at n periods just after the last
payment is made.
sn| = 1 + (1 + i) + + (1 + i)n2 + (1 + i)n1
=
(1 + i)n 1
i
3
1
1
=
+i
an| sn|
This relationship can be derived as follows:
1
i
+i =
+i
n
sn|
(1 + i) 1
=
=
i
i + i(1 + i)n i
=
(1 + i)n 1
1 vn
1
an|
4
Example 1 Find the present value of an annuity which pays $500 at end of
each half-year for 20 years if the rate of interest is 9% convertible semiannually.
The answer is
500a40|.045 = 500(18.4016) = $9200.80.
Example 2 If a person invests $1000 at 8% per annum convertible quarterly,
how much can be withdraw at end of every quarter to use up the fund exactly
at the end of 10 years.
Let R be the amount of each withdrawal. The equation of value at the date
of investment is
Ra40|0.02 = 1000.
Thus, we have
1000
1000
R=
=
= $36.56.
a40|0.02 27.3555
5
Example 3 Compare the total amount of interest that would be paid on a $1000
loan over 10-year period, if the effective rate of interest is 9% per annum, under
the following three repayment methods: (1) The entire loan plus accumulated
interest is paid in one lump-sum at end of 10 years. (2) Interest is paid each
each year as accrued and the principal is repaid at the end of 10 years. (3) The
loan is repaid by level payments over the 10-years.
(1) The accumulated value of the loan at the end of 10 years is
1000(1.09)10 = $2367.36.
Thus the total amount of interest paid is equal to
$2367.36 1000.00 = $1367.36.
(2)Each year the loan earns interest of 1000(.09) = $90, so that the total
amount of interest paid is equal to
10 90 = $900.00.
6
(3) Let the level payment be R. An equation of value for R at the inception of
the loan is
Ra10| = 1000
which gives
1000
1000
=
= $155.82.
R=
a10|
6.417658
1.3. Annuity-Due
Annuity-Due The payments are made at the beginning of the period.
The present value of the annuity a
n|:
2
a
n| = 1 + v + v + + v
n1
1 vn 1 vn 1 vn
=
=
=
1v
iv
d
Relationship between a
n| ,
sn|
n
sn| = a
n|(1 + i)
and
1
1
=
+d
a
n| sn|
Relationship between a
n|, sn| and an| and sn|
a
n| = an|(1 + i) and sn| = sn|(1 + i)
a
n| = 1 + an1|
1000
1000
1000
=
=
= $59.21
s11|
1.07s11| (1.07)(15.7836)
10
11
Accumulated values more than one period after the last payment date
In general, the accumulated value of an n-period annuity, m periods after
the last payment date, is
sn|(1 + i)m = sn+m| sm|.
Current values between the first and last payment dates
In general, the current value of an n-period annuity immediately after the
mth payment has been made (m < n) is
an|(1 + i)m = v nmsn| = sm| + anm|.
12
1.5. Perpetuities
A perpetuity is an annuity whose payments continue forever, i.e. the term of
the annuity is not finite.
a| The present value of a perpetuity-immediate
a| = v + v 2 + v 3 +
v
v
=
=
1 v iv
1
=
i
provide v < 1, which will be the case if i > 0.
Alternatively we have
a| = lim an|
n
1 vn 1
= lim
=
n
i
i
since lim v n = 0.
n
13
1
=
d
It should be noted that accumulated values for perpetuities do not exist, since
the payments continue forever.
Example 5 A leaves an estate of $100,000. Interest on the estate is paid
to beneficiary B for the first 10 years, to beneficiary C for the second 10
years, and to charity D thereafter. Find the relative shares of B, C, and D in
the estate, if it assumed the estate will earn a 7% annual effective rate of interest.
The value of Bs share is
7000a10| = 7000(7.0236) = $49, 165
to the nearest dollar.
14
1
10.5940) = $25, 842
.07
1 v n+k 1 v n + v n v n+k
=
=
i
i
k
(1 + i) 1
= an| + v n+k
.
i
17
18
an|
n(n + 1)
n(n + 1)(n + 2) 2
=n
i+
i + ,
2!
3!
2
1
1
n+1
n 1 2
=
1+
i+
i +
an| n
2
12
20
21
1 (1 + i)n
i=
k
where k = an|. The rate converge of iteration formula is quite slow.
Newton-Raphson iteration
n
1 (1 + is) kis
is+1 = is 1 +
1 (1 + is)n1{1 + is(n + 1)}
It does have a very rapid rate of convergence.
22
=
1+
i
k an| n
2
which gives
2(n k)
.
k(n + 1)
Analogous results can be derived for accumulated value. Here we let sn|i = k.
is+1
= is 1 +
(1 + is) 1 kis
(1 + is)n1{1 is(n 1)} 1
.3514 + 0
= .0223
.3514 + .4108
We will next illustrate iteration. For a starting value we could use the value
derived by linear interpolation, i.e. j0 = .0223. However, we will instead apply
formula above to obtain
2(20 16)
= .0238.
(16)(20)
We first illustrate the first iteration method. We obtain the following results
j0 = .02380
j1 = .02345
j2 = .02319
j3 = .02298
j4 = .02283
j5 = .02270
j6 = .02261
j7 = .02253
j8 = .02283
j9 = .02243
j10 = .02239
j11 = .02237
j12 = .02234
j13 = .02233
j14 = .02231
j15 = .02230
We stop after 15 cycles, since the iteration is converging so slowly. Here we just
want to demonstrate the care which must be taken in practice to use iteration
methods with a reasonable rate of convergence.
25
26
t
n Y
X
(1 + is)1
t=1 s=1
The second patter would be compute present values using rate ik for the
payment made at time k over all k periods. In this case the present value
becomes
an| = (1 + i1)1 + (1 + i2)2 + . . . + (1 + in)n
=
n
X
(1 + it)t.
t=1
27
n Y
t
X
(1 + ins+1)
t=1 s=1
n
X
(1 + int+1)t.
t=1
28
30
n
X
1
=
a(t)
t=1
sn| =
n1
X
t=0
n
X
a(n)
1
= a(n)
.
a(t)
a(t)
t=1
(1)
The above formula does not produce correct results in all case. For example,
suppose we wish to find the accumulated value of an n-period annuity-immediate
in which each payment is invested at a simple interest from the day of payment
until the end of the n periods. The accumulated value of such an annuity would
be
1 + (1 + i) + (1 + 2i) + + [1 + (n 1)i]
.
31
sn| =
n1
X
a(t)
(2)
t=0
which will produce the correct answer for the above simple interest example.
By the formula above, we can find another expression for an|
an| =
n1
X
t=0
n1
a(t)
1 X
=
a(t).
a(n) a(n) t=0
It is not surprising that formulas above for an| produce different answers
unless compound interest is involved.
32
Example 10 Compare the value of s6|.1 at 10% interest (1) assuming compound
interest, (2) using formula (1), and (3) using formula (2).
1. Using compound interest at 10%
s6| = 7.72.
2. From formula (1)
1
1
1
s6| = 1.6
+
+ +
= 7.23.
1.1 1.2
1.6
34
35
36
37
v +v
2k
+ + v
n k
k
=
=
v k v n+k
1 vk
an|
1 vn
=
1
(1 + i)
sk|
an|
sn|
(1 + i)n =
sk|
sk|
Annuity-due
1 v n an|
1 + v + v + + v
=
=
1 vk
ak|
an|
sn|
n
(1 + i) =
ak|
ak|
k
2k
nk
38
Other considerations
1. Perpetuity payable is less frequent than interest
The present value of perpetuity-immediate is is1 .
k|
1
iak| .
39
s36|.035
s2|.035
= 1000(1.035)36
or
70.0076
= $10.09.
2.0350
The total final payment would thus be $110.09.
R = 1000(3.45027) 100
40
1 vn
1 vn
.
1 1 =
(m)
i
m((1 + i) m )
=
(m)
an| (1
(1 + i)n 1
+ i) =
.
(m)
i
n
41
(m)
(m)
Write an| and sn| in terms of an| and sn| with an adjustment factor
(m)
an| =
(m)
sn|
an|
(m)
i
i
i(m)
sn|
Annuity-due
(m)
1
a
n| : the present value of an annuity which pays m
at the beginning of each
mth of an interest conversion period for a total of n interest conversion periods.
(m)
a
n|
(m)
sn|
(m)
a
n| (1
1 vn
= (m)
d
n
(1
+
i)
1
n
+ i) =
d(m)
42
(m)
(m)
Write a
n| and sn| in terms of an| and sn| with an adjustment factor
(m)
a
n| =
(m)
sn|
(m)
a
n|
an|
(m)
d
i
sn|
d(m)
(m)
1 (m)
i
i
i
i
= (1 + i) m an| = 1 +
an|
a
=
+
n|
(m)
(m)
m i
m
i
i
i
(m)
sn|
sn| = (m) +
m
i
43
Other Consider
a| =
,
(m)
i
(m)
and a
| =
1
d(m)
44
Example 4 Payments of $400 per month are made over a ten-year period.
Find expression for: (1) the present value of these payments two years prior
to the first payment, and (2) the accumulated value three years after the final
payment. Use symbols based on an effective rate of interest.
1) The answer is
12
12
4800v 2a
12
=
4800(
a
).
10|
12|
2|
2) The answer is
3
12
12
4800s12
(1
+
i)
=
4800(s
s
).
10|
13|
3|
45
vt n 1 vn
a
n| =
|0 =
.
v dt =
loge v
0
1 vn 1 vn
(m)
a
n| = lim an| = lim
=
.
m
m i(m)
1 vn 1 vn
(m)
=
a
n| = lim a
= lim
.
m d(m)
m n|
i
a
n| = an| = s1|an|.
Z n
n
(1
+
i)
1
i
(m)
(m)
t
sn| =
(1 + i) dt =
= sn| = s1|sn| = lim sn| = lim sn|
m
m
0
Z
46
47
48
Special cases
Increasing annuity P = 1 and Q = 1
(Ia)n|
n+1| (n + 1)v n a
an| nv n a
n| (n)v n
= an| +
=
=
i
i
i
(Is)n|
sn| n sn+1| (n + 1)
= (Ia)n|(1 + i) =
=
i
i
n
n
n(1
+
i)
sn|
n
= (Da)n|(1 + i) =
.
i
n
1+k
1
1+i
2
n
n1
v + v (1 + k) + + v (1 + k)
= v
1+k
1 1+i
n
1 1+k
1+i
=
.
ik
50
51
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