Present Value of Annuities Under Random Rates of Interest

By

Abraham Zaks

Technion I.I.T. Haifa ISRAEL

and

University of Haifa , Haifa ISRAEL

Abstract

Some attempts were made to evaluate the future value (FV) of the expected

value and the variance for some classical cash flows (CF). The motivation stemmed

from some recursive formulas. Similar recursive formulas do not hold for the case of

the present value (PV) due to the lack of independence of some random variables .

One can get some estimates for the PV using the results about the FV. We study the

PV and we overcome the difficulty of independence by reversing the order of the CF.

It turns out that we get similar recursive formulas for the PV as for the FV in the

classical cash flows. It turns out to be similar to that used to evaluate the FV.

Furthermore it makes it possible to study the PV of the classical CF directly, and it

may suggest a method to study the PV of other CF as well.

Keywords : Random Rates of Interest; Independent variables; Expected value;

Variance; Annuities; Future value; Present value .

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1. Introduction

We study payments C1 , . . . , Cn made in years ti , i = 1, . . . ,n .

Various classical sets of payments are mentioned in section 4 .

The annuity is due if the payments are made in the beginning of each year , and

if the payments are made at the end of each year we term the annuity as in arrear .

Let the interest in the year ti be ji , and assume that these ji for i = 1, . . .

,n are independent random variables with :

2
E(1+ ji ) = 1+j and Var(1+ ji ) = s for all i , i = 1 , . . . , n . ( 1.1)

We investigate the expected value and the variance of the present value (PV).

Dufresne (1989) and Bedard and Dufresne (2001) study similar PV under a different

set of assumptions. The future value (FV) is discussed in McCutcheon and Scott

(1986), by Zaks (2001) and by Burnecki , Marciniuk and Weron (2003). For a series

of k yearly payments PV(k) denotes the present value at the beginning of the first

year of the payments , and FV(k) denotes the future value at the end of the kth year .

2. Future Value

For the FV of the annuities due , let Sk denote the random value of the FV of an

annuity due of k payments evaluated at the end of k years ,then S = C1(1+ji ) .
1

The following equality holds:

Sk+1 = (Sk +Ck )(1+jk +1 ) for k =1, . . . , n-1 (2.1)

The random variables ( Sk + Ck ) and (1+ jk+1) remain independent for all k. Let :

E(Sk ) = µ k , E(Sk2 ) = mk for k = 1 , . . . , n (2.2)

µ k = FV(k) as in the certain case (2.3)

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and Var( Sk ) = mk - µk2 (2.4)

Detailed evaluation of FV(k) in the various is known , e.g. McCutcheon and

Scott (1986) where specific formulas for E( Sk )= µ k , and for E( Sn )= µ n are given.

One derives the recursive formulas :

µ k+1 = ( µ k + Ck ) (1 +j) for k = 1 , . . . , n (2.5)

and mk+1 = ( mk + 2 µ k Ck + Ck2 ) [(1 + j)2 + s 2 )] for k = 1 , . . . , n (2.6)

that lead to the value Var( Sn ) , via successive iterations.

We will obtain formulas to evaluate Var( Sn ) in the various cases .

In case (1d) it is well known that for all k , k = 1 , . . . , n the following hold :

E( Sk ) = ( 1+ j )k and V a r( Sk ) = [ (1 + j) 2 + s 2 ] k − (1 + j ) 2 k 

and , in the other cases we have :

mk+1 - µk+1
2
=( mk +2µ k Ck + Ck2 )[( 1+ j )2 +s 2 ]-[( µ k + Ck )( 1+ j )] 2

mk+1 -µk+1
2
=[( 1+ j )2 + s 2 ](mk -µk2 )+µk+1
2
s 2 /( 1+ j )2  (2.7)

Set V(k)=Var(Sk )/ [(1+ j)2 + s 2 ] k and µ (k) = µk2 /[( 1+ j )2 +s 2 ] k then:

V(k+1)=V(k)+µ (k+1)s 2 /( 1+ j )2 (2.8)

Set S0 = 0 ,and Var( S0 ) = 0 ,and add (2.8) for k = 1 , . . . , n to get:

V(n) = [s 2 /(1+ j)2 ] ∑ k=1 µ (k)

n
(2.9)

∑ µ (k) in these cases, are given in Zaks (2001). Some

n
Formulas evaluating k=1

errors were noticed and corrected by Burnecki , Marciniuk and Weron (2003)).

For the FV of annuities paid in arrear similar expressions may be derived.

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3. Interlude.

Our next aim is to investigate the PV case . The PV(k) of an annuity is the value

of k annual payments at the beginning of the first year .

A direct approach similar to the one we used for the FV case , seems impossible

since in the recursive formulas for the PV(k) the random variables that arise are not

linearly independent . In section 4 we suggest a different approach to the PV of

annuities. The reader may compare it to that used by Dufresne (1989)). We proceed to

explore the PV in a way similar to the one used for the FV.

At this point we poimt out that estimates for the value of the PV may be easily

derived from the value of FV considerring the quotient of FV by PV.

We observe that the quotient FV(k)/PV(k) satisfies the following equalities :

E[FV(k)/PV(k)]=(1+ j )k and Var[FV(k)/PV(k)]=[( 1+ j )2 +s 2 ] k -( 1+ j )2k

and these values may be used to get estimates for the PV(k) , using the FV(k) .

It is important to observe that the above relations apply to the case of annuities

that consists of a series of k annual payments made during the first k years , and

where FV(k) is their value at the end of the kth year and PV(k) is their value at the

beginning of the first year .

4. Present Value

Denote by di the yearly discount factor for the( n – i + 1 )th year .

-1
It follows tha: 1- di =( 1+ jn-i+1 ) . Let us denote :

2
E( 1- di )=1- d and Var( 1- di )= z for all i , i = 1 , . . . , n . ( 4.1)

-1
In general the relation 1- d = ( 1+ j ) does not hold .
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The problem that arises , when trying to follow a line of thought similar to the

one used for the FV in the second section , is that the random variables involved are

no longer independent .

To overcome this difficulty we consider the annuity backwards. We will

consider all the above cases with Ck , for k = 1 , . . . , n, and set Dk = Cn-k+1 in each

of the five cases. The annuity we consider is the sequence of payments Dn , . . . , D1 .

In particular , the PV(k) of that annuity is the value in the beginning of the (n-k+1) th

year of the last k yearly payments , Dk , . . . , D1.

The formulas for the values of PV(k) as annuities certain at a fixed yearly rate of

discount ○ are discussed in McCutcheon and Scott (1986). The classical cases are:

(1d) D1 = 1 and Di = 0 for i = 2 , . . . , n PV(k) = (1 – d )k-1

(1a) PV(k) = (1 - d )k
(2d) Di = 1 for i = 1 , . . . , n k
PV(k) = a

(2a) PV(k) = ak

(3d) Di = n-i+1 for i = 1 , . . . , n  k + ( n - k )ak

PV(k) = (Ia)
(3a) PV(k) = (Ia)k + ( n - k )ak
(4d) Di = i for i=1,...,n  k
PV(k) = (Da)

(4a) PV(k) = (Da)k

(5d) Di = (1+r)n-i for i = 1 , . . . , k PV(k) = (1+ r)n-k (Ca)
 kr

(5a) PV(k) = (1+ r)n-k (Ca)kr

k and the PV(k) in (5a) is evaluated as

The PV(k) in (5d) is evaluated as a

ak (1+r)-1 both at the rate of interest f so that (1+f)(1+r) = (1+j) .

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 denote the random value of the PV(k) of an annuity due , of a sequence

Let A k

 = D1 , and
of k yearly payments evaluated at the beginning of the first year ,then A 1

 = A
A  (1- d )+ D (4.2)
k+1 k k+1 k+1 , for k = 1 , . . . , n - 1

 and (1 - dk) for all k and Dk+1 a constant . Let :

with independent random variables A k

 ) = θ
E(A 2 ) = t
and E(A for k = 1 , . . . , n (4.3)
k k k k

Then , for k = 1 , . . . , n the following hold in cases 2 , 3 , 4 , 5 :

 ) = tk - θ 2
θ k = FV(k) as given above and , Var( A (4.4)
k k

The detailed evaluation of PV(k) is known e.g. McCutcheon abd Scott (1986),

 ) = θ .
 ) = θ k , and in particular for E( A
so there are known formulas for E( A k n n

One derives the two recursive formulas :

θ k+1 = θ k (1- d ) + Dk+1 for k = 1 , . . . , n (4.5)

tk+1 = tk [(1- d)2 + z 2 )] + 2θk Dk +1 (1- d)+ Dk+1

2
for k = 1 , . . . , n (4.6)

 ) , and Var( A
that lead to the values of E( A  ) , via successive iterations.
n n

 ) replaces the recursive iterations to evaluate it.

The formula we get for Var( A n

To verify this point one observes that in the case (1d) it is well known that :

 ) = (1 - d)k-1  and Var(A

E(A  )= [(1 - d)2 + z 2 ] k -1 - (1 - d)2(k -1)
k k

and ,in the other cases One can derive the recursive formulas , for k = 1 , . . . , n – 1:

2
tk+1 - θ k+1 = [(1- d)2 + z 2 ](tk - θ k2 ) + θ k2 z 2 (4.7)
 )/[(1- d)2 + z 2 ] k ,and θ (k)= θ 2 /[(1- d)2 + z 2 ] k
Set M(k) = Var(A then :
k k

M(k+1) = M(k) + θ (k)z 2 /[(1- d)2 + z 2 ] (4.8)

and noticing that σ1 = 1 , Var( A

 ) = 0 , and t1 = 1 we obtain a similar equality:
1
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M(n) = [z 2 /[(1- d)2 + z 2 ] ∑ k=1θ (k)

n-1
(4.9)

∑ θ (k) for all cases , except the first one,

n-1
A detailed calculation to evaluate k=1

may be achieved along the details as introduced by Zaks (2001) and Burnecki ,

Marciniuk and Weron (2003) .

A similar approach for the PV of annuities due can be used for that of annuities

in arrear and leads to similar results . Starting by replacing (4.1) with the equalities :

Ak+1 = (Ak + Dk+1 ) (1- d k+1 ) , for k = 1 ,. . . , n - 1 (4.10)

E( Ak ) = σ k , E( Ak2 ) = sk for k = 1 , . . . , n (4.11)

We observe that Ak and (1- d k+1 ) are independent random variables and Dk+1 is

constant for all k.

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References

Bedard D., Dufresne D. (2001) Pension Funding with Moving Average Rates of

Return, Scand. Act. J. 1-17

Burnecki K., Marciniuk A., Weron A. (2003) Annuities Under Random Rates of

Interest – revisited , IME 32 , 457-460

Dufresne D. (1989) Stability of pension systems when rates of return are random ,

IME 8 , 71-76

McCutcheon J. J. , Scott W. F. (1986) An Introduction to the Mathematics of

Finance ,Butterworth/Heinemann, London

Zaks A. (2001) Annuities Under Random Rate of Interest , IME 28 , 1 – 11

Address

Department of Mathematics , Tecnion , I.I.T , Haifa , 32000 , Israel

e-mail : azaks@techunix.technion..ac.il

Fax : +972 4 829 3388

Acknowledgement

This research was supported by the Fund for the Promotion of Research at the

Techhnion

Footnote

In memory of the late Professor Binyamin Schwarz