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Tutorial 01 [FEN9X00]
Financial Economics
College of Business and Economics (CBE)
School of Economics (SOE)
Auckland Park Campus
September 2017
Lecturer: Mr Sutene Mwambi
Coordinator: Prof JM Mwamba
2 PV Discrete Cashflows
2.1 Problem 1: PV of Discrete Cashflows
Recall, given a sequence c = (cj , tj )1jm of payments cj at time tj and a time t < tj j, we can write
the joint discounted value at time t of all payments as:
1
Definition 2.1 (Discounting value: Discrete Time).
m
X m
X
Dvalt (c) = c1 t1 t + c2 t2 t + + cm tm t = cj tj t = cj (1 + i)(tj t)
j=1 j=1
Thus, we have:
m
X m
X
Dvalt (c) = cj (tj t) = cj e(tj t)
j=1 j=1
1
= (1+i) denote the discount factor.
(A) A businessman is owed the following amounts: R1,000 on 1 January 2013, R2,500 on 1 January
2014, and R3,000 on 1 July 2014. Assuming an effective rate of interest of 6.18 per annum, find
the value of these payments on
(a) 1 January 2011,
Solution.
1000 2500 3000
PV = + +
(1 + i)2 (1 + i)3 (1 + i)3.5
1000 2500 3000
= 2
+ 3
+ = R5407.41
(1 + 0.0618) (1 + 0.0618) (1 + 0.0618)3.5
14
F V = R5407.41(1 + i) 12 = R5798.66
(B) Assuming a constant force of interest of 6% per annum, find the value of these payments on (a) 1
January 2011, (b) 1 March 2012.
Solution. Note that i = e 1 therefore the an effective rate of interest of 6.18% is equivalent to
a 6% force of interest
2
More generally, suppose that t > t0 and that an investor wishes to deposit C at time t0 for
withdrawal at time t. Suppose further that n > 1 and that the investor wishes to receive interest
on his deposit at the n equally spaced times The total interest income payable between times t0
and t will then be
n1
X
I(t) = C hih (t0 + jh).
j=0
(a) How much interest will we get at the end of the fifth year?
The interest at the end of the fifth year will be
.
(b) If the interest is paid at the end of each year, how much will these payments be?
The yearly interest payment is
300 0.08 = 24
.
(c) How much will the interest payments be if they are paid monthly?
(12)
First we need to determine i 12 which is
i(12)
= (1.08)1/12 1Sothemonthlyinterestpaymentsare300(1.08)1/12 1 = 1.93
12
(B) A deposit of 400 is made on January 1 for 5 years in an account earning 6% interest a year (i.e it
is an effective rate of interest). Assume the interest is paid continuously.
(a) What is the annual rate of the interest payment?
0
Recall, (t) = AA(t)
(t)
and if the accumulation amount is based on the compound interest
t
(1 = i) , then it it easy to show that (t) = ln(1 + i)
.
(b) What is the total amount of the interest payment?
.
(c) What is the interest paid in one month?
1
(400) = 12(23.31) = 1.94
12
.
3
3 Cashflow Valuation: Discrete and Continuous
3.1 Problem 1: Cashflow Valuation
An individual makes an investment of R4m per annum in the first year, R6m per annum in the second
year and R8m per annum in the third year. The investments are made continuously throughout each
year. Calculate the accumulated value of the investments at the end of the third year at a rate of
interest of 4% per annum effective.
Solution. Recall, The present value (PV) at (time 0) of the continuous rate of payment
(t) : (0, t) R is
Z t Z t Z u
P V () = (u)(u)du = (u) exp (s) ds du (1)
0 0 0
where (t) denotes the present value (time 0) of the amount 1 at time t for t 0.
For a constant interest rate i, equation (1) simplifies to
Z t u
(u)
P V () = du (2)
0 1+i
The accumulated value A(t) at (time t) of the continuous rate of payment (t) : (0, t) R is
Z t Z t Z t
(u)
A(t, ) = (u) du = (u) exp s (s) ds du (3)
0 (t) 0 u
where (t) denotes the present value (time 0) of the amount 1 at time t for t 0.
For a constant interest rate i, equation (3) simplifies to
Z t
P V () = (u)(1 + i)tu du (4)
0
4
(b) Suppose the force of interest is constant and corresponds to the effective annual interest rate i.
Express A(t) in terms of i and .
Z t
A(t) = A(0)(1 + i)t + (1 + i)ts (s) ds
0
Calculate the accumulated value at time t = 12 of a continuous payment stream of R100 per annum
payable from time t = 0 to time t = 6.
Solution. p(t) = 100 and
Z t
PV = (u)(u) du
0
Z 6 Z t
= 100 (u) du where (t) = exp (u) du
0 0
Z 6 Z t
Hence,P V = 100 exp 0.06 du dt
0 0
Z 6
= 100 exp[0.06t] dt
0
= 100[1 e0.36 ]/0.06
PV
A(12) =
(12)
Z 12 Z 12 Z 6 Z 12
= P V exp (u) du where (u) du = 0.06 du + 0, 05 + 0, 0002u2 d
0 0 0 6
0.36
= 100[1 e ]/0.06 exp(0.760800) = 1078.281485
Calculate the accumulated value at time t = 15 of a continuous payment stream of R50 per annum
payable from time t = 0 to time t = 8.
5
3.5 Problem 5 : Cashflow Valuation
The force of interest t is:
(
0, 04 if 0 < t 5;
0, 01(t2 t) if 5 < t.
(i) Calculate the present value of a unit sum of money due at time t = 10.
Solution.
Z 10
(t) = exp (t) dt
0
Z 5 Z 10
= exp 0, 04 dt + exp 0, 01(t2 t) dt
0 5
15.25
= exp 0.2 + = 0.0645
6
(ii) Calculate the effective rate of interest over the period t = 9 to t = 10.
Solution.
Z 10
(9)
(1 + i) = A(9, 10) = = exp 0, 01(t2 t)dt = 2.244
(10) 9
Hencei = 1.244
(iii) In terms of t, determine an expression for (t), the present value of a unit sum of money due
during the period 0 < t 5.
Solution.
Z t
(t) = exp 0.04 ds = e0.04t
0
(iv) Calculate the present value of a payment stream paid continuously for the period 0 < t 5, where
the rate of payment, (t), at time t is e0,04t .
Solution.
Z t Z t Z t
PV = (u)(u) du where (t) = exp (s) ds Hence(t) = exp 0.04 ds = e0.04t T heref or
0 0 0
Z 5
= 1 dt = 5
0
4 Force of Interest
4.1 Problem 6: Deriving t from a(t)
1 12 13
Suppose A(t) = (1.05) 2 (1.04) 3 (1.03) 6 . Find t
d A0 (t)
Solution. Recall, t = dt ln [A(t)] equivalently t = A(t)
d h t t2 t3
i
t = ln (1.05) 2 (1.04) 3 (1.03) 6
dt
t2 t3
d t
= ln(1.05) + ln(1.04) + ln(1.03)
dt 2 3 6
2
1 2t t
= ln(1.05) + ln(1.04) + ln(1.03)
2 3 2
t2
h 1 2t
i
= ln (1.05) 2 + (1.04) 3 + (1.03) 2
6
4.2 Problem 7: Deriving a(t) from t
Measuring time in years from the present, suppose that t = 0.06 0.9t for all t. Find a simple
expression for t , and hence find the discounted present value of R100 due in 3.5 years time.
Rt
Solution. Recall, (t) = e 0
r dr
Z t Z t
r dr = 0.06 0.9r dr
0 0
= .06 ln(0.9t 1)
t
(t) = e0.06[ln(0.9 1)]
3.5
Hence, the present value of R100 due in 3.5 years time is, by: (3.5) = e0.06[ln(0.9 1)]
Z t Z t
3
r dr = dr = ln [1 3r]
0 0 1 3r
1
= ln [1 3t]
1
Rt
a(t) = e 0
r dr
= eln[13t] = (1 3t)1
(a) According to this scheme, what is the average annual compound effective rate for the 5-year period?
R t R 1
Solution. Hint: t+1 dt = 1 t+1 dt
Z n
n
(1 + i) = exp t dt
0
Z 5
0.025t
(1 + i)5 = exp 0.08 + dt
0 t+1
5
= exp [0.08t + 0.025(t ln(t + 1)]0 = 1.6164
i = 1.61641/5 1 = 10.08
(b) What are the equivalent effective annual rates for each of years 1, 2, 3, 4, and, 5
Solution.
7
Table 1: Add caption
Rn Rn 1/n i
n 0
t dt A(tn ) = exp[ 0
t dt] i = A(n) 1 A(n) A(n 1) ief f = A(n)
Solution. By definition, the present value at time 0 of an investment amount A(n) due at time n
is given by: Z n
A(0) = A(n)exp t dt
0
Therefore, the present value at time 2 of A(4) due in time 4 is given as:
Z 4
A(2) = 1000 exp t dt
2
Z 4
0.025t
= 1000 exp 0.08 + dt
2 t+1
= 1000 exp(0.197229359) = R821.0023071
(d) A debt of R10 000 bearing interest of 14% per annum, to be paid half-yearly, must be discharged
by the sinking fund method. If the sinking fund earns interest at a rate of 12% per annum
compounded quarterly, and the debt is to be discharged after five years, determine the size of the
quarterly deposits. What is the total yearly cost of the debt?