CH3 PDF

Chapter 3
Basic Annuities
Stephen G. Kellison
(edited by Gunardi)
October 6, 2008
Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

3.1 Introduction
Definition of An Annuity
a series of payments made at equal intervals of time (annually
or otherwise)
payments made for certain for a fixed period of time are called
an annuity-certain
the payment frequency and the interest conversion period are
equal (this will change in Chapter 4)
the payments are level (this will also change in Chapter 4)

3.2 Annuity-Immediate
Definition
payments of 1 are made at the end of every year for n years. The
present value is denoted by an| .

3.2 Annuity-Immediate
Definition
payments of 1 are made at the end of every year for n years. The
present value is denoted by an| .
The present value of an annuity-immediate is

1 − νn
an| = . (1)
i

2.3 DETERMINING TIME PERIODS
The purpose of this section is to discuss the various possible

methods to determine the time period of an investment.


Three methods are commonly encountered:

the first method is to use the exact number of days for the
period of investment and to use 365 days in a year (Appendix
II),



II),
the second method assumes that each calendar month has 30
days and that the entire calendar year has 360 days,



II),
the second method assumes that each calendar month has 30
days and that the entire calendar year has 360 days,
the third method is a hybrid and uses the exact number of
days for the period of investment, but uses 360 days in a year.

The first method
The first method is to use the exact number of days for the period
of investment and to use 365 days in a year (Appendix II).

The first method
The first method is to use the exact number of days for the period
of investment and to use 365 days in a year (Appendix II).
Simple interest computed on this basis is sometimes called exact

simple interest and is often denoted by ”actual/actual”. Appendix
II contains a table numbering the days of the year, which facilitates
counting the number of days between two given dates.

The second method
The second method assumes that each calendar month has 30 days
and that the entire calendar year has 360 days.

The second method
The second method assumes that each calendar month has 30 days
and that the entire calendar year has 360 days.
Simple interest computed on this basis is sometimes called ordinary

simple interest and is often denoted by ”30/360”. Appendix II
cannot be used for calculation on this basis. The formula for
computing the number of days between two given dates is
360(Y2 − Y1 ) + 30(M2 − M1 ) + (D2 − D1 ) (2)

The third method
The third method is a hybrid and uses the exact number of days
for the period of investment, but uses 360 days in a year.

The third method
The third method is a hybrid and uses the exact number of days
for the period of investment, but uses 360 days in a year.
Simple interest computed on this basis is sometimes called

Banker’s Rule and is often denoted by ”actual/360”.

Example 2.3, (1)
Find the amount of interest that 2000 deposited on June 17 will

earn, if the money is withdrawn on September 10 in the same year
and if the rate of interest is 0.08, on the following bases: (1) exact
simple interest (actual/actual).

Example 2.3, (1)

and if the rate of interest is 0.08, on the following bases: (1) exact
simple interest (actual/actual).
The answer:
Given k = 2000, i = 0.08, I1 =?
Based on Appendix II, June 17 is day 168, September 10 is day 253
The actual number of days is 253 − 168 = 85,
Exact simple interest=i*(85/365)
85
I1 = k ∗ i ∗
365
85
= 2000 ∗ 0.08 ∗ = 37.26 (3)
365

Example 2.3, (2)

and if the rate of interest is 0.08, on the following bases: (2)
ordinary simple interest (30/360).

Example 2.3, (2)

and if the rate of interest is 0.08, on the following bases: (2)
ordinary simple interest (30/360).
The answer:
Given k = 2000, i = 0.08, I1 =?
Y1 = Y2 , M1 = 6, M2 = 9, D1 = 17, D2 = 10
The actual number of days is
360∗(Y2 −Y1 )+30∗(M2 −M1 )+(D2 −D1 ) = 0+30∗3+(−7) = 83,
ordinary simple interest=i*(83/360)
83
I1 = k ∗ i ∗
360
83
= 1000 ∗ 0.08 ∗ = 36.89 (4)
360
Example 2.3, (3)

and if the rate of interest is 0.08, on the following bases: (3) The
Banker’s Rule (actual/360).

Example 2.3, (3)

and if the rate of interest is 0.08, on the following bases: (3) The
Banker’s Rule (actual/360).
The answer:
Given k = 2000, i = 0.08, I1 =?
Based on Appendix II, June 17 is day 168, September 10 is day 253
The actual number of days is 253 − 168 = 85,
The banker’s Rule=i*(85/360)
85
I1 = k ∗ i ∗
360
85
= 1000 ∗ 0.08 ∗ = 37.78 (5)
360

2.4 THE BASIC PROBLEM
The interest problem involves four basic quantities:

The principal originally invested (present value),


The length of the invested period,


The rate of interest,


The rate of interest,
The accumulated value of the principal at the end of the
investment period.

2.5 EQUATION VALUE
It is a fundamental principle in the theory of interest that the value

of an amount of money at any given time depends upon the time
elapsed since the money was paid in the past or upon the time
which will elapse in the future before it is paid. This principle is
often characterized as the recognition of the time value of money.

2.5 EQUATION VALUE
It is a fundamental principle in the theory of interest that the value

of an amount of money at any given time depends upon the time
elapsed since the money was paid in the past or upon the time
which will elapse in the future before it is paid. This principle is
often characterized as the recognition of the time value of money.
As a consequence of the above principle, it is obvious that two or

more amounts of money payable at different points in time cannot
be compared until all the amounts are accumulated of discounted
to a common date. This common date is called the comparison
date, and the equation which accumulates or discounts each
payment to the comparison date is called the equation value.

Example 2.4, (1)
In return for a promise to receive 600 at the end of 8 years, a

person agrees to pay 100 at once, 200 at the end of 5 years, and to
make a further payment at the end of 10 years. Find the payment
at the end of 10 years if the nominal rate interest is 0.08
convertible semiannually.

Example 2.4, (1)

The answer:
Given P0 = 100, P5 = 200, P10 = X , R8 = 600, n = 10, m =
2, i (m) = 0.08, X =?
If the comparison date is the end of 10th year, then
i (m) m
a(1) = 1 + i = (1 + ) = (1.04)2 . (6)
m

Example 2.4, (1)
The equation is
P0 ∗ a(1)10 + P5 ∗ a(1)5 + P10 = R8 ∗ a(1)2

100 ∗ (1.04)20 + 200 ∗ (1.04)10 + X = 600 ∗ (1.04)4
100 ∗ (2.19112) + 200 ∗ (1.48024) + X = 600 ∗ (1.16986)
515.16 + X = 701.92
X = 701.92 − 515.16
= 186.76 (7)

Example 2.4, (2)


Example 2.4, (2)

The answer:
Given P0 = 100, P5 = 200, P10 = X , R8 = 600, n = 10, m =
2, i (m) = 0.08, X =?
If the comparison date is the present time, then
i (m) −m
a−1 (1) = (1 + i)−1 = (1 + ) = (1.04)−2 . (8)
m

Example 2.4, (2)
The equation is
P0 + P5 ∗ a−1 (1)5 + P10 ∗ a−1 (1)10 = R8 ∗ a−1 (1)8

100 + 200 ∗ (1.04)−10 + X ∗ (1.04)−20 = 600 ∗ (1.04)−16
100 + 200 ∗ (0.67556) + X ∗ (0.45639) = 600 ∗ (0.53391)
235, 112 + X ∗ (0.45639) = 320.346
320.346 − 235.112
X =
0.45639
= 186.76 (9)

2.6 UNKNOWN TIME
In this section we consider the situation in which the length of the

investment period is the unknown.

2.6 UNKNOWN TIME

The methods:
Logarithmic function,

2.6 UNKNOWN TIME

The methods:
Linear interpolation in the interest table,

2.6 UNKNOWN TIME

The methods:
The method of equated time.

Example 2.5, (1)
Find the length of time necessary for 1000 to accumulate to 1500

if invested at 0.06 per annum compounded semiannually: (1) by
use of logarithms, and (2) by interpolating in the interest table.

Example 2.5, (1)
Find the length of time necessary for 1000 to accumulate to 1500

if invested at 0.06 per annum compounded semiannually: (1) by
use of logarithms, and (2) by interpolating in the interest table.
The answer:
Given k = 1000, A(n) = 1500, m = 2, i (m) = 0.06
n =?
i (2) n∗m
A(n) = k ∗ a(n) = k ∗ (1 + )
2
1500 = 1000 ∗ (1.03)n∗2
1.5 = (1.03)2n (10)

Example 2.5, (2)
The answer:
(1) Using logarithms
2n ∗ loge 1.03 = loge 1.5
loge 1.5
n =
2 ∗ loge 1.03
0.405465
= = 6.859 (11)
2 ∗ 0.020550
(2) by interpolating in the interest table.
From the interest tables, a(13) = (1.03)13 = 1.46853
and a(14) = (1.03)14 = 1.51259, so that 13 < n0 < 14. Performing
a linear interpolation
a(n0 ) − a(13)
n0 = 13 +
a(14) − a(13)
1.5 − 1.46853
2 ∗ n = 13 + = 13.714
1.51259 − 1.46853
n = 6.857 (12)
The exact method (1)
Several payments made at various points in time are to be replaced

by one payment numerically equal to the sum of the other
payments. The problem is to find the point in time at which the
one payment should be made such that it is equivalent in value to
the payments made separately.


Let amounts s1 , s2 , ..., sn be paid at times t1 , t2 , ..., tn respectively.

The fundamental equation of value is:
(s1 + s2 + ... + sn )ν t = s1 ν t1 + s2 ν t2 + ... + sn ν tn (13)


Let amounts s1 , s2 , ..., sn be paid at times t1 , t2 , ..., tn respectively.

The fundamental equation of value is:
(s1 + s2 + ... + sn )ν t = s1 ν t1 + s2 ν t2 + ... + sn ν tn (13)
The problem is to find time t.

Pn tk
k=1 sk ν
loge P n
s
k=1 k
t = . (14)
loge ν

The method of equated time (1)
As first approximation, t is often calculated as a weighted average

of the various times payment, where the weights are the various
paid, i.e.
s1 t1 + s2 t2 + ... + sn tn
t =
s + s2 + ... + sn
Pn 1
sk t k
= Pk=1n . (15)
k=1 sk
This approximation is denoted by t and is called using the method

of equated time.

The value of t is always greater than the true value of t(t > t), or,
the present value using the method of equated time is smaller than
the true present value (ν t < ν t ).

The value of t is always greater than the true value of t(t > t), or,
the present value using the method of equated time is smaller than
the true present value (ν t < ν t ).
The proof:
Pn tk
t k=1 sk ν
ν = P n
k=1 sk
Pn
k=1 sk tk
n
= νt
P
s
> ν k=1 k (16)

Example 2.6(1)
Payments of 100, 200, and 500 are due at the ends of years 2, 3,
and 8, respectively. Assuming an effective rate of interest of 0.05
per annum, find the point in time which a payment of 800 would
be equivalent: (1) by the method of equated time, and (2) by an
exact method.

Example 2.6(1)
Payments of 100, 200, and 500 are due at the ends of years 2, 3,
and 8, respectively. Assuming an effective rate of interest of 0.05
per annum, find the point in time which a payment of 800 would
be equivalent: (1) by the method of equated time, and (2) by an
exact method.
The answer:
Given
s1 = 100, t1 = 2, s2 = 200, t2 = 3, s3 = 500, t3 = 8, i = 0.05, t =?
(1) by the method of equated time:
s1 t 1 + s2 t 2 + s3 t 3
t =
s1 + s2 + s3
100 ∗ 2 + 200 ∗ 3 + 500 ∗ 8
= =6 (17)
100 + 2000 + 300

Example 2.6(2)
The answer:
Given
s1 = 100, t1 = 2, s2 = 200, t2 = 3, s3 = 500, t3 = 8, i = 0.05, t =?
(2) by an exact method:
ν = (1 + i)−1 = 1.05−1 = 0.952380952
P3 tk
k=1 sk ν
loge P 3
s
k=1 k
t =
loge ν
loge 0.75236 −0.28454
= = = 5.832 (18)
loge 0.952381 −0.04879

2.7 UNKNOWN RATE OF INTEREST
In this section we consider the situation in which the rate of

interest is the unknown. The problems involving the determination
of an unknown rate of interest are widely encountered in practice,
since it is often necessary to compute the rate of return involved in
a particular transaction. We consider four methods to use in
determining an unknown rate of interest.


The four methods:



The four methods:

Algebraic technique,


The four methods:



The four methods:

successive approximation or iteration.

Example 2.7
At what interest rate convertible quarterly would 1000 accumulate

to 1600 in six years?

Example 2.7
At what interest rate convertible quarterly would 1000 accumulate

to 1600 in six years?
The answer:
Given k = 1000, n = 6, A(6) = 1600, m = 4, i (m) =?
i (m) mn
A(n) = ka(n) = k(1 + )
m
i (4) 4∗6
A(6) = 1000(1 + )
4
i (4) 24
1600 = 1000 ∗ (1 + )
4
i (4) = 4 ∗ [(1.6)1/24 − 1] = 4 ∗ 0.019776 = 0.0791 (19)

Example 2.8(1)
At what effective rate of interest will the present value of 2000 at

the end of two years and 3000 at the end of four years be equal to
4000?

Example 2.8(1)
At what effective rate of interest will the present value of 2000 at

the end of two years and 3000 at the end of four years be equal to
4000?
The answer:
Given k = 4000, A(2) = 2000, A(4) = 3000, i =?
An equation of value is
k = A(2) ∗ a−1 (2) + A(4) ∗ a−1 (4)

4000 = 2000 ∗ ν 2 + 3000 ∗ ν 4 (20)
which can be written as
3 ∗ ν4 + 2 ∗ ν2 − 4 = 0 (21)

Example 2.8(2)
which can be written as
3 ∗ ν4 + 2 ∗ ν2 − 4 = 0 (22)
This equation can be solved as a quadratic in ν 2 , which gives

p
2 −2 + 22 − 4 ∗ 3 ∗ (−4)
ν =
√ 2∗3
−2 + 52
= = 0.868517
6
1
(1 + i)2 = = 1.151388
0.868517
√
i = 1.151388 − 1 = 0.0730 (23)

CH3 PDF

Uploaded by

Copyright:

Available Formats

You might also like

CH3 PDF

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH3 PDF

Uploaded by

Copyright:

Available Formats

Chapter 3

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The present value of an annuity-immediate is

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The purpose of this section is to discuss the various possible

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The purpose of this section is to discuss the various possible

Three methods are commonly encountered:

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The purpose of this section is to discuss the various possible

Three methods are commonly encountered:

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The purpose of this section is to discuss the various possible

Three methods are commonly encountered:

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Simple interest computed on this basis is sometimes called exact

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Simple interest computed on this basis is sometimes called ordinary

360(Y2 − Y1 ) + 30(M2 − M1 ) + (D2 − D1 ) (2)

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Simple interest computed on this basis is sometimes called

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Find the amount of interest that 2000 deposited on June 17 will

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Find the amount of interest that 2000 deposited on June 17 will

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Find the amount of interest that 2000 deposited on June 17 will

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Find the amount of interest that 2000 deposited on June 17 will

Find the amount of interest that 2000 deposited on June 17 will

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

Find the amount of interest that 2000 deposited on June 17 will

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The interest problem involves four basic quantities:

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The interest problem involves four basic quantities:

The principal originally invested (present value),

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The interest problem involves four basic quantities:

The principal originally invested (present value),

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The interest problem involves four basic quantities:

The principal originally invested (present value),

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

The interest problem involves four basic quantities:

The principal originally invested (present value),

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

It is a fundamental principle in the theory of interest that the value

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities

It is a fundamental principle in the theory of interest that the value

As a consequence of the above principle, it is obvious that two or

Stephen G. Kellison (edited by Gunardi) Chapter 3Basic Annuities