MATH2040 Financial Mathematics

Homework (1) Solutions

Variable Force of Interest Questions: Solutions

Session 2007/08:

Q110 (i). The closing balance of the account is, in units of £ thousands,
   
1 3
A = 5 u(0, 1) − u ,1 −u ,1 ,
4 4
Rt
δ(w) dw
where u(s, t) = e s . We have
Z Z 1 Z Z (  2 )
1 1 1
2 1 (0.05 + 0.07) 1
δ(t) dt = δ(t) dt + δ(t) dt = × + 0.07 − 0.04 t − dt,
0 0 1
2
2 2 1
2
2

that is,
Z  " 3 #1
1
0.04 1 1 19
δ(t) dt = 0.03 + 0.07 t − t− = 0.03 + = = 0.063333333,
0 3 2 1
30 300
2

Z 1 Z 1 Z 1
2 1 (0.06 + 0.07) 1 13 1 119
δ(t) dt = δ(t) dt + δ(t) dt = × + = + = = 0.049583333,
1
4
1
4
1
2
4 2 30 800 30 2400
and
Z Z (  2 ) "  3 #1
1 1
1 0.04 1 7 1 1
δ(t) dt = 0.07 − 0.04 t − dt = 0.07 t − t− = − + ,
3
4
3
4
2 3 2 3
400 600 4800
4

that is, Z 1
77
δ(t) dt = = 0.016041666.
3
4
4800
Thus,
19
u(0, 1) = e 300 = 1.065381907,
 
1 119
u , 1 = e 2400 = 1.050833158,
4
and  
3 77
u , 1 = e 4800 = 1.016171025.
4

The closing balance of the account is therefore

A = 5 × 1.065381907 − 1.050833158 − 1.016171025 = 3.259905352 or £3,259.91.

10 (ii). We have
 

!  
1 3 1
1 u 4, 4 −1 u 4 , 1
1.050833158
i1 = 1 =2 3 −1 = 2× − 1 = 0.068221061 or 6.8221061%,
2 4 2 u 4, 1
1.016171025

and
 

!  
3 1 − v 14 , 34 v 1
4 , 1
1.016171025
d1 = 1 =2 1− 3 = 2× 1 − = 0.065970763 or 6.5970763%.
2 4 2 v 4, 1
1.050833158

1
 Session 2006/07:

Q210 (i). Use one year as the time unit. The graph of δ(t) for 0 ≤ t ≤ 3 is as follows:
.
....
δ(t) .........
........

0.08
0.07
0.06
0.05 .........
..........
......... ..
...........................................................................................
.. .. .................
..................
..................
......... .. .. .. .. ......
0.04 . .
........
...
.. ..
...
.
....... ...
.
.. .
.
.
.
..
.
.
..
.
.
..
.. ...
...
...
. . . . . . ..
....
0.03 ...
..
...
..
...
..
...
..
...
..
..
..
0.02 ..
..
..
..
..
..
..
..
..
..
..
..
.. .. .. .. .. ..
0.01 ..
..
..
..
..
..
..
..
..
..
..
..
.
.. .. .. .. .. .. ....................................................
1 3 5 t
0 2 1 2 2 2 3

10 (ii). The accumulated value of the fund at the end of the 3-year period is
     
1 3 5
A = 3 u(0, 3) + u ,3 +u ,3 +u ,3 .
2 2 2
R3 R3 R3 R3
δ(t) dt 1

1 δ(t) dt 3

3 δ(t) dt 5

5 δ(t) dt
We require u(0, 3) = e 0 , u 2, 3 = e 2 , u 2, 3 = e 2 , and u 2 , 3 = e 2 .
Taking advantage of the piecewise linear nature of δ(t), the integrals may be easily evaluated using the
trapezium rule to give
Z 3
(0.03 + 0.05) (0.05 + 0.04)
δ(t) dt = 1 × + 1 × 0.05 + 1 × = 0.135,
0 2 2
Z 3
1 (0.04 + 0.05) (0.05 + 0.04)
δ(t) dt = × + 1 × 0.05 + 1 × = 0.1175,
1
2
2 2 2
Z 3
1 (0.05 + 0.04)
δ(t) dt = × 0.05 + 1 × = 0.07,
3
2
2 2
and Z 3
1 (0.045 + 0.04)
δ(t) dt = × = 0.02125.
5
2
2 2
Thus,  
1
u(0, 3) = e0.135 = 1.144536784 u , 3 = e0.1175 = 1.12468163
2
   
3 5
u , 3 = e0.07 = 1.072508181 u , 3 = e0.02125 = 1.021477389,
2 2
and so
A = 3 × 1.144536784 + 1.12468163 + 1.072508181 + 1.021477389 = 6.652277552.

10 (iii). Let i be the yield per annum, which is the money-weighted rate of return per annum. The
equation of value at time t = 3 is
5 3 1
3 (1 + i)3 + (1 + i) 2 + (1 + i) 2 + (1 + i) 2 = 6.652277552,

which may be rewritten as

Since
f (0.046) = −0.00741486591