Chapter 2 (Part B)

More General Annuities

August 26, 2017

Chapter 2 (Part B): More General Annuities

A. Payment period di↵erent from interest period

1. Payment period is longer than interest period

Illustration 1:

Given that j1 = 1% (e↵ective rate of interest per month)

1 1 1 1 1 ____

d d d d d
òiiiiiiiioii_mn

payment period = 2 months

Interest conversion period = 1 month

Payment period > interest period. It violates the setup of basic annuity in

Part A of the Chapter 2.

Chapter 2 (Part B): More General Annuities

a. interest conversion approach

• We can re-define the interest period such that the payment period is the

same as the new defined interest period.

• We have to convert the given interest rate to the e↵ective interest

rate per new interest period using the equivalence (in Chapter 1-D-3-

e) method.

• The whole setup will be changed back to basic annuity.

Chapter 2 (Part B): More General Annuities

Illustration 1: (cont’d)

• Change the interest period from 1-month to 2-month with the e↵ective

interest rate per 2-month is j2 = 2.01%.

• The new time diagram becomes

i
iiiiiiiiiiiiii.io_

an

l it

i j zmntn
3

Chapter 2 (Part B): More General Annuities

change
the payment pattern
b. algebraic approach

i. annuity-immediate
Illustration 2:
n

New

iiiiexagdexxxxxxxxxxxxiiiiitiisiii.in

N P = Xs3ei
P
Av

X =

s3ei

Orijdqnmgpaymu P a12ei
PV = Xa12ei =

s3ei

rate
interest AV = Xs12ei =
P s12ei

monthly s3ei

Chapter 2 (Part B): More General Annuities

ii. annuity-due

Illustration 3:

iiiiiiiiiiii

PV P = Xa3ei Av
P

X =

a3ei

P a12ei
P V = Xa12ei =

a3ei

P s12ei

AV = Xs12ei =

a3ei

Chapter 2 (Part B): More General Annuities

Example 13: Find the future value 20 years after the first payment is made

of an annuity of which there are 7 payments of $800 each made at two-year

intervals.

(i) The annual e↵ective rate is 6%.

(ii) The nominal rate of interest is 6%, convertible semi-annually.

Chapter 2 (Part B): More General Annuities

Solutions for (i)

Interest Conversion Approach:

8N FV
800
7

ddtltldbi.tl

i hit do
1 + 0.06 = (1 +
16i(1/2)18
)1/2
io

1/2

i(1/2)

j = = 0.1236
1/2

FV = 800s7e0.1236 (1 + 0.1236)4

= $13007.70

Chapter 2 (Part B): More General Annuities

Solutions for (i)

Algebraic Approach:

wao

800
fxdxdxxxxxxxyxqio

iiiiiiii.io
Xs2e0.06 = 800
8

FV = Xs14e0.06 (1.06)8

800s14e0.06

= (1.06)8

s2e0.06

= $13007.70

The answer for part (ii) is $13173.55 (verify it!)

Chapter 2 (Part B): More General Annuities

2. Payment period is shorter than interest period

卡卡卡 龇

lldlllllllllllll 1111

1 1 1 4

6
Remarks:
1 11 1 之 liljl.nl 4
1
A

(i) i is the interest rate per period.

(ii) Usually, we define 1 period = 1 year.

(iii) n periods are involved in the annuity.

(iv) m is the number of payments made within each period.

1
(v) the amount of each payment is m .

(vi) the nominal total (without considering time value of money )

1
is m ⇥ m = $1 per period.

(vii) total number of payments is m ⇥ n.

Chapter 2 (Part B): More General Annuities

a. interest conversion approach qnhrdentpnhcpd

• Similar to Chapter 2 (Part B)-A-1, the interest conversion period is re-

1
defined as m of the original period.

• For example, if

Payment period is 1-month

Interest period is 1-year (say, 6% e↵ective per annum)

• We can re-define the basic time unit as one-month and the monthly

e↵ective rate can be computed as:

i(12) 12

1 + 0.06 = (1 + )
12

i(12)

j = = 0.00486755
12

• Therefore, we now have monthly payments and monthly e↵ective interest

rate and we may use the basic annuity techniques to solve the problem.

10

Chapter 2 (Part B): More General Annuities

b. algebraic approach

In this section, we only consider the interest conversion period to be one year.

i. annuity-immediate

The present and accumulated values of the annuity-immediate are denoted

as a(m) and s(m) , respectively.

e
n i e
n i

六点 站站

llldlldldlllldl l llll
4

留i 1 h 1 i i n
a a(m)
器
2 1
v m + v m + · · · + vn n

= +v
s
m
n ei m"

1
#
1 v (1 v ) n

=
m

m 1 vm

1 vn

a(m) =
e
n i i(m)

11

Chapter 2 (Part B): More General Annuities

Similarly, we can show that

1 h i
s(m)
1 1

= 1 + (1 + i) m + · · · + (1 + i)n m
n ei m

(1 + i)n 1

s(m) =

e
n i i(m)

12

Chapter 2 (Part B): More General Annuities

ii. annuity-due

Remember that we assume the interest conversion period is one year.

tim none ⼀⼀
站六

lllddldddddldlldl ⼀⼈
ldl

ò I 4
nà

幾 5留
The present and accumulated values of the annuity-due are denoted as ä(m)

e n i

and s̈(m) , respectively.

von
n ei

1 h i
ä(m)
1 2 1

= 1 + v m + v m + · · · + vn m
n ei m

1 1 vn
= 1

m 1 vm

1 vn
ä(m) =

n ei d(m)

13

Chapter 2 (Part B): More General Annuities

Similarly, we can show that

(1 + i)n 1

s̈(m) =

e
n i d(m)

Remarks: (Comparison with Basic Annuity)

(1 + i)n 1 (1 + i)n 1
s(m) = s n ei =

n ei i(m) i

(1 + i)n 1 (1 + i)n 1
s̈(m) = s̈nei =

n ei d(m) d

1 vn 1 vn

a(m) = a n ei =
n ei i(m) i

1 vn 1 vn

ä(m) = änei =
e
n i d(m) d

14

Chapter 2 (Part B): More General Annuities

Remarks: (Immediate vs Due)

(1 + i) m a(m) = ä(m)
1

(1 + i) anei = änei e
n i e
n i

Class Exercises: Derive the relationships between (i) snei and s̈nei ;

and (ii) s(m) and s̈(m) using time diagrams

e
n i e
n i

It not
per year

Remarks: (Meaning of the symbol) Get it

pesatvstutwe

dneufnediate

zhunberufsubperidlnehnt.la
myean
i

to eftedhe interest rate

men
pay

Pabnuniwdpeyeayeainonndtdperwdeg.br 15

Opamnth 年咧


Chapter 2 (Part B): More General Annuities

Example 14: Find the present value of a ten-year annuity which pays $500

at the end of each month for the first 4 years and $2,000 at the end of each

quarter for the last 6 years. The annual e↵ective interest rate is 7%.

Solutions

Interest conversion approach

2000 _nnn

zooi
t.hn
tuipǒ

Since i = 0.07, j1 = i(12) /12 = 0.005654145 and j2 = i(4) /4 = 0.017058525.

iiiitiiiijyfgncanmep

PV = 500a48ej1 + 2000a24ej2 (1 + 0.07) 4

= 20967.34 + 29843.84

= $50, 811.18

16

partly algebraic approach

Chapter 2 (Part B): More General Annuities

Solutions
difficult to foundde
cd

Algebraic approach to

but easy

PV = (500 ⇥ 12)a(12) + (2000 ⇥ 4)a(4) (1 + 0.07) 4

e 4 0.07 e 6 0.07

1 1.07 4 1 1.07 6
4

= 6000 + 8000 (1.07)

i(12) i(4)

= 20967.34 + 29843.84

= $50, 811.18

Remarks

Both approaches should give you the same answer.

17

Chapter 2 (Part B): More General Annuities

iii. perpetuities

If payments continue forever, i.e. n ! 1, the present value of perpetuity-

immediate is

a(m) = lim a(m)

e
1 i n!1 en i

a(m) =
e
1 i i(m)

and the present value of perpetuity-due is

ä(m) =

1 ie d(m)

18

Chapter 2 (Part B): More General Annuities

c. continuous annuity

• A continuous annuity is an annuity whose payments are made continu-

ously, i.e. frequency of payment tends to infinite, or m ! 1.

• The present value of continuous annuity is denoted as ānei .

ānei = lim a(m)

m!1 en i

=
1 vn
lim
m!1 i(m)
ādi ⼆

1 vn

ānei =

• The future value of continuous annuity is denoted as s̄nei .

osktuǚ

(1 + i)n 1
s̄nei =

5 i dont
19

exist


first 4 year

Chapter 2 (Part B): More General Annuities

Example 15: A sum of $20,000 is used to buy a four-year deferred

perpetuity-due which pays $M every quarter forever. If the annual e↵ective

wpgǚizowo

rate of interest is 8%, find M .

Solutions

Algebraic approach

m M

t TTTTTTT

iiii.it d(4) 4 (4)

__ year

1 + i = (1 ) ) d = 0.076225392

20000 = (4 ⇥ M )ä(4)e (1 + 0.08) 4

1 0.08

4M 4
= (1.08)

0.076225392

M = $518.52

20

Chapter 2 (Part B): More General Annuities

B. Basic Varying Annuities

Now, we remove the restriction that annuity has level payments.

We first consider the following two types of payment patterns:

— arithmetic progression (AP);

— geometric progression (GP).

1. Payments varying in AP

Consider an annuity-immediate with a term of n periods in which payments

begin at P and increase by Q per period thereafter.

ptln

ptza ptko

DQiidl.pt

21

2 3 4
h
⼀

Chapter 2 (Part B): More General Annuities

Determine the present value of an AP annuity-immediate, P VI

P VI = P v + (P + Q)v 2 + · · · + [P + Q(n 1)]v n

= P v + P v2 + · · · + P vn +

Qv 2 + 2Qv 3 + · · · + (n 1)Qv n

= S1 + S2

where

S1 = P (v + v 2 + · · · + v n )

= P anei

22

Chapter 2 (Part B): More General Annuities

and

S2 = Qv 2 + 2Qv 3 + · · · + (n 1)Qv n (1)

(1 + i)S2 = Qv + 2Qv 2 + · · · + (n 1)Qv n 1

(2)

equation (2) minus equation (1):

iS2 = Qv + Qv 2 + · · · + Qv n 1
(n 1)Qv n

= Q(v + v 2 + · · · + v n ) nQv n

= Qanei Qnv n


a n ei nv n

S2 = Q

Therefore,

a n ei nv n
P VI = P anei + Q

23

Chapter 2 (Part B): More General Annuities

Remarks: Present values (P V ) or Accumulated value (AV ) for both Imme-

diate (I) and Due (D) situations of AP annuities can be obtained from the

P VI value.

PMQPtZQ n

ptlnnalld
nL

2iiiiiii.mg

Py A Vz
Class Exercise: Illustrate the following identities by time diagrams.

AVI = P VI (1 + i)n

P VD = P VI (1 + i)

Abuer

AVD = P VI (1 + i)n+1

24

Chapter 2 (Part B): More General Annuities

Example 16: An annuity-due has eight quarterly payments of $3, $7, $11,

$15, $19, $23, $27, $31, respectively. Given that the annual nominal interest

rate is 6.5%, compounded monthly, find the present value of this annuity.

Solutions

3 7 11 151923 22 31
Ǘǐtǐǎǐii

This is AP with P = 3, Q = 4 and n = 8.

The e↵ective rate per quarter j = 0.016338179.

P VD = P VI (1 + j)

a8ej 8v 8

= (3a8ej + 4 )(1 + j)
j

= (22.3274 + 101.6625)(1.016338179)

= $126.02

25

make sureAP

it

Chapter 2 (Part B): More General Annuities

Special cases

a. increasing annuity with (P = 1, Q = 1)

1 2 3
ndtl.org

Substitute (P = 1,
i
Q = 1) into the general formula j 弊

a n ei nv n
(Ia)nei = anei +

änei nv n

(Ia)nei =

Furthermore,

(Is)nei = (Ia)nei (1 + i)n

s̈nei n

(Is)nei =

26

Chapter 2 (Part B): More General Annuities

b. decreasing annuity with (P = n, Q= 1)

i i i

i i i i a n ei nv n
i
(Da)nei = nanei

n a n ei
(Da)nei =

Furthermore,

(Ds)nei = (Da)nei (1 + i)n

n(1 + i)n s n ei

(Ds)nei =

27

Chapter 2 (Part B): More General Annuities

Remarks:

For annuity-due, we just need to change i in the denominator to d, i.e.

änei nv n

(Iä)nei =

s̈nei n

(Is̈)nei =
d

n a n ei
(Dä)nei =

n(1 + i)n s n ei

(Ds̈)nei =

28

Chapter 2 (Part B): More General Annuities

c. varing perpetuities

PVof perpetuity-immediate varying in AP

⇢ ✓ ◆
anei nv n

= lim P anei + Q
n!1 i

n o Qn o

= P lim anei + lim a lim nv n

n!1 i n!1 nei n!1

✓ ◆ 

1 Q 1

= P + 0
i i i

P Q

= + 2
i i

Class Exercises: (i) Draw a time diagram and provide verbal interpretation of

the above expression. (ii) What about perpetuity-due with payments varying

in AP ? Hint: Note that P VD (1) = P VI (1) ⇥ (1 + i)

29

Chapter 2 (Part B): More General Annuities

2. Payment varying in GP

j it'll tk

iiii.in

PV of annuity-immediate varying in GP

= v + v 2 (1 + k) + v 3 (1 + k)2 + · · · + v n (1 + k)n 1

1 1

= v[1 + v(1 + k) + · · · + v n (1 + k)n ]

✓ ◆n

1 1+k

1+i

TIPS ihad

= v ✓ ◆
1+k

1 1+i

1
✓
1+k
1+i
◆n inflation GIG

P VI =
i k protein 30

rind

Chapter 2 (Part B): More General Annuities

Questions

• What about annuity-due varying in GP?

• What about perpetuity varying in GP?

• What if i = k? or i < k?

can be fond
品
31
Chapter 2 (Part B): More General Annuities

Example 17: Annual deposits are made into a fund at the beginning of each
year for 10 years. The first 4 deposits are $5,000 each and deposits increase
by 5% per year thereafter. If the fund earns 6.5% per annum payable monthly,
find the accumulated value at the end of 14 years after the first deposit.
5ovu CI.nl

f touch0576
50W___5000
t.lt I 5 wait
iiiL.iodo
Since i(12) = 0.065, i = 0.066971852.
6 it dio ⼈ 以
AV = 5000s4ei (1 + i) 11
+ 5250
1
i
( 1+0.05
1+i
0.05
)6
(1 + i)11 不
= 45090.18 + 57888.71

= $102, 978.89

32
 ㄟ 100 名
Chapter 2 (Part B): More General Annuities

3. Other Payment Patterns

Given the e↵ective interest rate is 1% per month, find the present value of
the following cash flows:
iiiiiiǘ

0 1 2 3 4 5 6
e↵ective rate per 3-month period is j = 0.030301; e↵ective interest rate per
year is i = 0.12682503.
( )
a6ei 6(1 + i) 6
P V = s4ej 100a6ei + 20
i
= $2, 415.56

Class Exercise: Solve the above question using an alternative formulation.

Make sure that you got the same answer as above. (Hint.....)
33