Financial Institutions

and markets
Annuities
Prof. Dr. Alain Praet
 Ch. 2: Annuities
2.1. Definition(s) and examples
2.2. Accumulated value
2.3. Present value
2.4. Special cases and more spicy stuff
2.5. Naughty stuff
2.6. Exercises

2
 Annuities (2)
 In chapter 1.: general time-value-of-money
(TVM) problems.
 Limitation: the time required to write down or
enter (and solve) the equation with the help of
the calculator

3
 2.1. Definition(s) and examples
 An annuity is a sequence of cash flows, made at
equal intervals of time.
 The payment interval (or period) is the time
between (any two) successive payments.
 Payment dates are the times at which cash flows
in the annuity are exchanged.
 An annuity is called constant when all payments
are equal.
 An annuity is called simple when the payment
interval and interest compounding period are
equal. 4
 Definition(s) and examples (2)
 A constant annuity looks like this:
K K K ... K
time
1 2 3 ... n

 We will see in 2.1.2. and 2.1.3. that the value

of a constant annuity at an arbitrary moment
in time can be obtained by working out the
Rule of Rules for this special case.
5
 Definition(s) and examples (3)
 Annuities do occur in real life:
 If parents save a fixed sum of money each month for
their children, the set of savings actually takes the
form of a constant annuity.
 When you borrow money to pay off your car, you
actually pay an equal sum each month for a fixed
number of months, so your payments take the form of
an annuity.
 The coupons paid out periodically on lots of bond
issues form a constant annuity.
 ... 6
 2.2. Accumulated value
 Accumulated value (seminal example): Kiki
dreams of marrying in a Jean Paul Gaultier dress.
To that end she will save a sum K each year for
the next n years, the first deposit being made
exactly one year from now. What will the balance
of her savings account be right after the n–th
deposit?
 You can only solve this problem if you know what
annual rate r Kiki earns on her savings account.
7
 Accumulated value (2)
 You can say that the final or accumulated value
FV right after the n-th payment, is equivalent to
the whole annuity on that day. In order to find
FV we apply the Rule of Rules to the following
diagram: V
FV
K K K ... K
time
1 2 3 ... n
rRRR is given8
is given
 Accumulated value (3)
 It can be shown that
(1  r )  1
n
FV  K   K  s n r
r
 The factor s in the preceding expression (“s at n
angle r”) is called the accumulated or final value
factor for n payments at rate r.
 In fact the above expression describes a relation
between four quantities (FV, K, r and n). If any
three are given, you 9can find the fourth.
 Accumulated value (4)
 Example 1 (FV unknown): Keiko deposits 50,000
JPY every three months into a savings account
that accumulates interest at 0.75% per quarter.
How much money is in her account just after the
deposit on November 1, 2027, if the first deposit
was made on November 1, 2023?
 How many deposits are made?

10
 Accumulated value (5)
 Example 1: Solution with explicit formula
(1  r0.25 )  1
n
FV  K   K  snr0.2 5
r0.25
1.0075  1 17
FV  50000 
0.0075
FV  50000 18.05
FV  902963.7011
 Accumulated value (6)
 Example 1: Solution with calculator

12
 Accumulated value (7)
 Warnings concerning the use of the calculator:
 Use the right settings
 I% must be given as a percentage (for us usually between
0 and 30), not as a number between 0 and 0.3.
 Make sure the setting P/Y and C/Y are at 1 and PMT is at
END
 Don’t forget to execute the computation by
pressing ALPHA ENTER
 Please check all results with your intuition,
especially:
 The sign differences between ins and outs
 13 outs
Relative size of ins and
 Accumulated value (8)
 Example 2 (K unknown): Josip the carpenter
estimates that he will need to replace his
swimming pool 10 years from now at a cost of
56,000 HRK. How much must he set aside each
year (starting exactly one year from now) to
provide that money if he earns interest at an
annual rate r = 5.5%?

14
 Accumulated value (9)
 Example 2: Solution with explicit formula

(1  r )  1
n
FV  K   K  s n r
r

15
 Accumulated value (10)
 Example 2: Solution with calculator

16
 Accumulated value (11)
 Example 3 (n unknown): A fund of 80,000 SEK is
to be accumulated by semi-annual payments of
2,000 SEK. If the fund accumulates interest at
r0.5 = 3.15%, find
 the number of full deposits required
 and the actual amount accumulated right after the
final deposit ?
 We don’t really expect the number of deposits to
be an integer number, so we anticipate some
kind of extra argument.
17
 Accumulated value (12)
 Example 3: Solution with explicit formula

18
 Accumulated value (13)
 Example 3: Solution with calculator

 Don’ forget the supplementary question!

19
 Accumulated value (14)
 Example 3: In order to compute how much is
really saved after 26 deposits, we consider the
problem as an “FV unknown” problem:

26
1.0315 −1
𝐹𝑉=2,000⋅
0.0315
20
 Accumulated value (15)
 All of this can be done with the magic
machine as well:

So either you have to save an extra 1285.55 SEK the

last time or …
21
 Accumulated value (16)
 … you increase each of the 26 deposits a bit:

𝐹𝑉=𝐾⋅¿¿ 22
 Accumulated value (17)
 Example 3: Solution with calculator:

23
 Accumulated value (18)
 Example 4 (r unknown): Teginbek really wants
that swimming pool promised to him at a cost of
58,825 EUR provided he can come up with that
amount at the end of one year. He now already
has 50,000 EUR. Teginbek believes he can save
650 EUR for 12 consecutive months, the first
time in one month. What monthly rate must
Teginbek earn on his savings in order to get him
the amount required for the swimming pool right
after the twelfth deposit?
24
 Accumulated value (19)
 Example 4: Solution with explicit formula


𝐹𝑉=𝐾⋅¿¿
No further (analytical) steps possible -> the
machine offers you (and Teginbek) the TVM-
Solver! 25
 Accumulated value (20)
 Example 4: Solution with calculator

26
 2.3. Present value
 Present value (seminal example): Ruby wants to
borrow some money today in order to pay for a
house she bought. She wants to pay back this
loan by paying equal installments of size K for
the next n years, the first payment being exactly
one year away. How much can her banker afford
to lend her today?
 You can only solve this problem by assuming that
the banker targets some real rate of return on
this loan, say r (annual
27
basis!)
 Present value (2)
 You can say that the loan PV granted one year
before the first installment, is equivalent to the
whole annuity on that day. In order to find PV
we apply the Rule of Rules to the following
diagram:
PVV
K K K ... K
time
0 1 2 3 ... n
RRR is given
r is given 28
 Present value (3)
 It can be shown that:
n
1  (1  r )
PV  K   K  anr
r
 The factor a in the preceding expression (“a at n
angle r”) is called the present value factor or
discount factor for n payments at rate r.
 The above expression describes a relation
between four quantities (PV, K, r and n). If any
three are given, you29can find the fourth.
 Present value (4)
 Example 1 (PV unknown): Mwenzi buys a new
car by paying down 12,500,000 ZMK and after
that 2,250,000 ZMK a month for three years
(starting in one month). What was the cash price
of the car, if the interest rate on the loan is r1/12
=1.5%?
 How many deposits are made?

30
 Present value (5)
 Example 1: Solution with explicit formula
n
1  (1  r1/12 )
PV  K   K  anr1 / 1 2
r1/12
36
1  1.015
PV  2,250,000 
0.015
PV  2,250,000  27.66068431
PV  62,236,540
 The total value of the
31 car is 74,736,540 ZMK.
 Present value (6)
 Example 1: Solution with calculator

32
 Present value (7)
 Example 2 (K unknown): A television set worth
$780 may be purchased by paying $80 down and
the balance in monthly installments for two
years. Find the monthly installment if the dealer
charges 1.25% per month and the first
installment is due in one month.
 How many installments are paid?

33
 Present value (8)
 Example 2: Solution with explicit formula
n
1  (1  r1/ 12 )
PV  K   K  anr1 / 1 2
r1/12

34
 Present value (9)
 Example 2: Solution with calculator

35
 Present value (10)
 Example 3 (n unknown): A debt of $4,000 bears
interest at r0.5 =6%? It is to be repaid be semi-
annual payments of $400, the first one at the
end of six months. Find
 the number of full payments needed
 and the balance right after the final payment.

36
 Present value (11)
 Example 3: Solution with explicit formula

𝑃𝑉=𝐾⋅1−¿¿ 37
 Present value (12)
 Example 3: Solution with calculator

 Don’ forget the supplementary

38 question!
 Present value (13)
 Example 3: Try to find how much debt is left
right after the 15th installment:
 Compute the discounted value of the 15 installments
(i.e. an “PV unknown” problem)
 Subtract this from the original debt
 This yields the present value of the remaining debt
 Now bring this amount forward 15 semesters.

39
 Present value (14)
 Of course, you can also just pay a bit extra
each semester:

40
 Present value (15)
 All of this can be done with the magic
machine as well:

41
 Present value (16)
 Example 4 (r unknown): A dealer sells an article
for $600. He will allow you to buy it for $240,
with the balance to be paid in 12 monthly
installments of $30 each, the first one at the end
of one month from the purchase date. If you pay
cash, you can get the article for $540.
 What is the interest rate r
1/12 paid by a purchaser who
uses the installment plan?
 What annual effective rate is being charged on the
installment plan? 42
 Present value (17)
 Example 4: Solution with explicit formula
n
1  (1  r1/12 )
PV  K   K  anr1 / 1 2
r1/12
12
1  (1  r1/12 )
300  30 
r1/12
 No further steps possible -> the machine
offers you the TVM-Solver!
43
 Present value (18)
 Example 4: Solution with calculator

44
 2.4. Perpetuity
= when you receive a constant cash flow till infinity

PV =

Suppose you own an oil well that generates an annual

cashflow of € 100 miljoen. What is the value of the oil well
now if you expect an annual rate of return of 5%?

2020-21 45
 Perpetuity with constant growth
= when you receive a constant cash flow till
infinity that grows with an annual growth rate g

PV =

 Suppose the cash flows of the oil well increase each year
with 2%. What is the value now of the oil well?

2020-21 46
  What is the value of a perpetuity with an annual cash
flow of € 1 with a first cash flow in year 1?

 What is the value of a perpetuity with an annual cash

flow of € 1 with a first cash flow in year 6?

 What is the value of the cash flows if you receive the

first perpetuity and you have to pay the second one?

2020-21 47
 2.5. Special cases and more
spicy stuff
 Keep this one in mind.
 Two major complications when dealing with
annuities in realistic circumstances are:
 The value of an annuity is required on a date different
from t = 0 (so the present value doesn’t help us out)
and different from t = n (so the accumulated value
doesn’t help us out either).
 More than one annuity is involved.
 The second type of complication must be solved
on the spot (see below),
48 the first one can be
solved in general.
 Special cases and more spicy
stuff (2)
 Please be aware of the fact that the complication
is a complication. Above, we derived and used
two formulas with an interpretation that is very
strict.
 The accumulated value formula gives you the
value of the annuity on the final payment date
(and including the final payment).
 The present value formula yields the value of the
annuity exactly one period before the first
payment date. 49
 Special cases and more spicy
stuff (3)
 In a diagram (accumulated value, rate of
return per period (=payment interval) is r):
K K K ... K
time
1 2 3 ... n
The equality sign here
means “can and =
should be replaced (1  r ) n  1
by” FV  K 
r
time
50
n
 Special cases and more spicy
stuff (4)
 In a diagram (present value, rate of return
per period (=payment interval) is r):
K K K ... K
time
1 2 3 ... n
The equality sign here
n
= means “can and
1  (1  r ) should be replaced
PV  K  by”
r
time
51
0
 Special cases and more spicy
stuff (5)
Now suppose you want the value of an annuity
on an arbitrary moment T, then you observe
that, either you shift “forward” starting from the
PV ... :
1  (1  r )  n
PV  K 
r
time
0 =
1  (1  r )  n
V (T )  K   (1  r ) T

52
r
time
T
 Special cases and more spicy
stuff (6)
 ... or you shift “backward” starting from the FV:

(1  r ) n  1
FV  K 
r
time
n
=
(1  r ) n  1
V (T )  K   (1  r )T  n
r
time
T
53
 Special cases and more spicy
stuff (7)
 Observe that both formulas for V(T) are in fact
equivalent (because FV = PV x (1+r)n ), so you
choose the one that fits your problem best (or
saves time).
 Starting from this new, more general expression,
we can again treat the classical problems
corresponding to the given 5-parameter formula
(i.e. give me four, I’ll compute the fifth one).
 We will only treat a couple of examples.
54
 Special cases and more spicy
stuff (8)
 Example 1: Assume your required rate of return
is r0.25 = 1.75%. In return for 24 trimestrial
payments of €1,750, the first one 5 months from
now, how much do you pay today?

 You need the formula (which one?) but first ...

 ... you draw the diagram.

55
 Special cases and more spicy
stuff (9)
 Example 1: Diagram
1750 1750 1750 ... 1750
time
-2/3 0 1 2 3 ... 24
=now
 And first reduction
1750  a240.0175
time
-2/3 0 1 ... 24
=now 56
 Special cases and more spicy
stuff (10)
 Example 1: Further reduction using the
“forward” formula from slide 49

1750  a240.0175 1.01752 / 3

time
-2/3 0 1 ... 24
=now

57
 Special cases and more spicy
stuff (11)
 Example 1: Solution
2 / 3
1750  a240.0175 1.0175
 24
1  1.0175 2 / 3
 1750  1.0175
0.0175
 1750 19.46068...  0.98850...
 33664.58
58
 Special cases and more spicy
stuff (12)
 Remember the second complication, the “more
than one annuity” problem?
 Example 2: Guanyin opens a savings account by
depositing 1,500 HKD on October 29, 2008. She
makes monthly deposits of 150 HKD for 5 years,
starting November 29, 2008. Starting November
29, 2013, she makes withdrawals of 300 HKD per
month for 3 years. If r1/12 = 0.5%, what is the
balance on Guanyin’s account right after the last
withdrawal? 59
 Special cases and more spicy
stuff (13)
 Example 2: Diagram

1500 150 150 150 ... 150

time
0 1 2 3 ... 60
-300 -300 -300 -300 ... -300
time
61 62 63 64 ... 96
rr1/12
= =0,5%
0.5
60
 Special cases and more spicy
stuff (14)
 Example 2: Simplified diagram

1500
1500 150  s600.005  300  s360.005
time
0 ... 60 ... 96

 Do you understand how this diagram has been

constructed?
 Do you understand?
61
 Special cases and more spicy
stuff (15)
 Example 2: Explicit solution. The balance on
Guanyin’s account per October 29, 2016, is the
sum of three terms: The value of the initial 1,500
HKD, the value of the 60 deposits of 150 HKD
and the value of the 36 withdrawals of 300 HKD,
i.e.

1500 1.00596  150  s600.005 1.00536  300  s360.005

62
 Special cases and more spicy
stuff (16)
 Example 2: Numerical solution

63
 Special cases and more spicy
stuff (17)
 Example 3: Joao wants to save money for his
son’s university education. To that end, he will
save 500 BRL per semester, starting nine months
from now. The last deposit will be made 17 years
and 9 months from now. Joao hopes to be able
to give his son ten semestrial allowances of
12,000 BRL per semester, the first one will be
paid 18 years from now. What rate of return
must Joao obtain in order to realise this
intention? 64
 Special cases and more spicy
stuff (18)
 Example 3: Diagram

500 500 500 ... 500

time
0 0,5 1,5 2,5 3,5 ... 35,5
-12k -12k -12k -12k ... -12k
time
36 37 38 39 ... 45
r=?
65
 Special cases and more spicy
stuff (19)
 Example 3: Simplification of the diagram

500  a35r  12000 s10 r

time
0 0,5 ... 45
=
500  a35r  (1  r ) 0.5  12000 s10 r
time
0 0,5 1,5 ... 45
66
 Special cases and more spicy
stuff (20)
 Example 3: Explicit equation for the unknown
rate of return.
0.5 45
500  a35r  (1  r )  12000  s10r  (1  r )
 Solution with Math Solver

67
 2.5. Naughty stuff
 Up until now, when dealing with annuities, we
have been fairly mild in the problem
description: the consistency condition with
respect to compounding periodicity and
measurement of time intervals was
“automatically” fullfilled in all examples.
 In general however, realistic problem settings
tend to be less mild. When annuities are
studied for which this consistency problem
does show up, we speak of general annuities.
68
 Naughty stuff (2)
 Example: Miranda buys a car worth €12,250. She
pays down €2,000 and agrees to pay €500 at the
end of each month for as long as necessary. Find
the number of full payments required and the
additional payment going with the last full one if
interest is at r0.5 = 3.625%.
 Careful, don’t get confused!
 Payments are monthly, so we first compute the
monthly interest rate equivalent to r0.5 = 3.625%.
 Then only can we continue
69
the solution.
 Naughty stuff (3)
 There are six months in one half year so
1
(1  r1/12 ) 6  1  r0.5  r1/12  (1  r0.5 )  1
6

1
(1  r1/12 ) 6  1.03625  r1/12  (1.03625)  1  0.005952...
6

 Then compute the solution with the calculator

70