ct12010 2013

Faculty of Actuaries
Institute of Actuaries
EXAMINATION
27 April 2010 (am)
Subject CT1 Financial Mathematics

Core Technical
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1.
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
3.
Mark allocations are shown in brackets.
4.
Attempt all 11 questions, beginning your answer to each question on a separate sheet.
5.
Candidates should show calculations where this is appropriate.
Graph paper is NOT required for this paper.
AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
CT1 A2010
(i)
Explain the difference

(a)
(b)
between options and futures

between call options and put options
[4]
A security is priced at 60. Coupons are paid half-yearly. The next coupon is due in
two months time and will be 2.80. The risk-free force of interest is 6% per annum.
(ii)
Calculate the forward price an investor should agree to pay for the security in
three months time assuming no arbitrage.
[3]
[Total 7]
In January 2008, the government of a country issued an index-linked bond with a term
of two years. Coupons were payable half-yearly in arrear, and the annual nominal
coupon rate was 4%. Interest and capital payments were indexed by reference to the
value of an inflation index with a time lag of six months.
A tax-exempt investor purchased 100,000 nominal at issue and held it to redemption.
The issue price was 98 per 100 nominal.
The inflation index was as follows:
Date
Inflation Index
July 2007
January 2008
July 2008
January 2009
July 2009
110.5
112.1
115.7
119.1
123.2
(i)
Calculate the investors cashflows from this investment and state the month
when each cashflow occurs.
[3]
(ii)
Calculate the annual effective money yield obtained by the investor to the
nearest 0.1% per annum.
[3]
[Total 6]
CT1 A20102
A company issues ordinary shares to an investor who is subject to income tax at 20%.
Under the terms of the ordinary share issue, the investor is to purchase 1,000,000
shares at a purchase price of 45p each on 1 January 2011.
No dividend is expected to be paid for 2 years. The first dividend payable on
1 January 2013 is expected to be 5p per share. Dividends will then be paid every 6
months in perpetuity. The two dividend payments in any calendar year are expected
to be the same, but the dividend payment is expected to increase at the end of each
year at a rate of 3% per annum compound.
Calculate the net present value of the investment on 1 January 2011 at an effective
rate of interest of 8% per annum.
[5]
An investor is considering purchasing a fixed interest bond at issue which pays halfyearly coupons at a rate of 6% per annum. The bond will be redeemed at 105 per
100 nominal in 10 years time. The investor is subject to income tax at 20% and
capital gains tax at 25%.
The inflation rate is assumed to be constant at 2.8571% per annum.
Calculate the price per 100 nominal if the investor is to obtain a net real yield of 5%
per annum.
[7]
Let ft denote the one-year forward rate of interest over the year from time t to time
( t + 1) .
The current forward rates in the market are:
time, t
one-year forward rate, ft
4.4% p.a.
4.7% p.a.
4.9% p.a.
5.0% p.a.
A fixed-interest security pays coupons annually in arrear at the rate of 7% per annum
and is redeemable at par in exactly four years.
(i)
Calculate the price per 100 nominal of the security assuming no arbitrage. [3]
(ii)
Calculate the gross redemption yield of the security.
(iii)
Explain, without doing any further calculations, how your answer to part (ii)
would change if the annual coupon rate on the security were 9% per annum
(rather than 7% per annum).
[2]
[Total 8]
CT1 A20103
[3]
PLEASE TURN OVER
The annual returns, i, on a fund are independent and identically distributed. Each
year, the distribution of 1 + i is lognormal with parameters = 0.05 and 2 = 0.004,
where i denotes the annual return on the fund.
(i)
Calculate the expected accumulation in 25 years time if 3,000 is invested in

the fund at the beginning of each of the next 25 years.
[5]
(ii)
Calculate the probability that the accumulation of a single investment of 1

will be greater than its expected value 20 years later.
[5]
[Total 10]
A pension fund has to pay out benefits at the end of each of the next 40 years. The
benefits payable at the end of the first year total 1 million. Thereafter, the benefits
are expected to increase at a fixed rate of 3.8835% per annum compound.
(i)
Calculate the discounted mean term of the liabilities using a rate of interest of
7% per annum effective.
[5]
The pension fund can invest in both coupon-paying and zero-coupon bonds with a
range of terms to redemption. The longest-dated bond currently available in the
market is a zero-coupon bond redeemed in exactly 15 years.
(ii)
Explain why it will not be possible to immunise this pension fund against
small changes in the rate of interest.
[2]
(iii)
Describe the other practical problems for an institutional investor who is

attempting to implement an immunisation strategy.
[3]
[Total 10]
A loan is repayable by annual instalments paid in arrear for 20 years. The first
instalment is 4,650 and each subsequent instalment is 150 greater than the previous
instalment.
Calculate the following, using an interest rate of 9% per annum effective:
(i)
(ii)
(iii)
(iv)
the amount of the original loan

the capital repayment in the tenth instalment
the interest element in the last instalment
the total interest paid over the whole 20 years
CT1 A20104
[3]
[4]
[2]
[2]
[Total 11]
A company is undertaking a new project. The project requires an investment of 5m

at the outset, followed by 3m three months later.
It is expected that the investment will provide income over a 15 year period starting
from the beginning of the third year. Net income from the project will be received
continuously at a rate of 1.7m per annum. At the end of this 15 year period there
will be no further income from the investment.
Calculate at an effective rate of interest of 10% per annum:
(i)
(ii)
the net present value of the project

the discounted payback period
[3]
[4]
A bank has offered to loan the funds required to the company at an effective rate of
interest of 10% per annum. Funds will be drawn from the bank when required and the
loan can be repaid at any time. Once the loan is paid off, the company can earn
interest on funds from the venture at an effective rate of interest of 7% per annum.
(iii)
10
Calculate the accumulated profit at the end of the 17 years.
[4]
[Total 11]
A pension funds assets were invested with two fund managers.

On 1 January 2007 Manager A was given 120,000 and Manager B was given
100,000. A further 10,000 was invested with each manager on 1 January 2008 and
again on 1 January 2009.
The values of the funds were:
Manager A
Manager B
31 December 2007
31 December 2008
31 December 2009
130,000
140,000
135,000
145,000
180,000
150,000
(i)
Calculate the time-weighted rates of return earned by Manager A and Manager

B over the period 1 January 2007 to 31 December 2009.
[4]
(ii)
Show that the money-weighted rate of return earned by Manager A over the
period 1 January 2007 to 31 December 2009 is approximately 9.4% per
annum.
[2]
(iii)
Explain, without performing further calculations, whether the money-weighted

rate of return earned by Manager B over the period 1 January 2007 to
31 December 2009 was higher than, lower than or equal to that earned by
Manager A.
[3]
(iv)
Discuss the relative performance of the two fund managers.
CT1 A20105
[3]
[Total 12]
PLEASE TURN OVER
11
The force of interest (t) is a function of time and at any time t, measured in years, is
given by the formula
0.04 +0.02t
(t ) =
0.05
0t <5
.
5t
(i)
Derive and simplify as far as possible expressions for v(t), where for v(t) is the
present value of a unit sum of money due at time t.
[5]
(ii)
(a)
Calculate the present value of 1000 due at the end of 17 years.
(b)
Calculate the rate of interest per annum convertible monthly implied

by the transaction in part (ii)(a).
[4]
A continuous payment stream is received at a rate of 10e0.01t units per annum between
t = 6 and t = 10.
(iii)
Calculate the present value of the payment stream.
END OF PAPER
CT1 A20106
[4]
[Total 13]
EXAMINERS REPORT
April 2010 Examinations

Core Technical
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
R D Muckart
Chairman of the Board of Examiners
July 2010
Subject CT1 (Financial Mathematics Core Technical) April 2010 Examiners Report
Comments
Please note that different answers may be obtained to those shown in these solutions
depending on whether figures obtained from tables or from calculators are used in the
calculations but candidates are not penalised for this. However, candidates may be penalised
where excessive rounding has been used or where insufficient working is shown.
Well-prepared candidates scored well across the whole paper and the examiners were
pleased with the general standard of answers. However, questions that required an element
of explanation or analysis were less well answered than those which just involved
calculation. The comments below concentrate on areas where candidates could have
improved their performance.
Q2.
A common error was to divide the nominal payments by the increase in the index factor
(rather than multiplying).
Q3.
Many candidates made calculation errors in this question but may have scored more marks if
their working had been clearer.
Q6.
Many candidates assumed that the accumulation in part (i) was for a single payment.
Q7.
The calculation was often performed well. In part (ii), many explanations were unclear and
some candidates seemed confused between DMT and convexity although a correct
explanation could involve either of these concepts.
Q9.
A common error was to assume that income only started after three years rather than
starting from the beginning of the third year.
Q10.
This question was answered well but examiners were surprised by the large number of
candidates who used interpolation or other trial and error methods in part (ii) when the
answer had been given in the question. The examiners recommend that students pay attention
to the details given in the solutions to parts (iii) and (iv). For such questions, candidates
should be looking critically at the figures given/calculated and making points specific to the
scenario rather than just making general statements taken from the Core Reading.
Page 2
(i)
(a)
Options holder has the right but not the obligation to trade
Futures both parties have agreed to the trade and are obliged to do so.
(b)
Call Option right but not the obligation to BUY specified asset at
specified price at specified future date.
Put Option right but not the obligation to SELL specified asset at
specified price at specified future date.
0.06 312
(ii)
K = 60e
(i)
Cash flows:
2.80e
Issue price:
0.06 112
0.98 100, 000
= 98,000
0.02 100, 000
112.1
= 2,028.96
110.5
Jan 09
0.02 100, 000
115.7
= 2,094.12
110.5
July 09
0.02 100, 000
119.1
= 2,155.66
110.5
Jan 10
0.02 100, 000
123.2
= 2,229.86
110.5
Jan 08
Interest payments: July 08
Capital redeemed: Jan 10

(ii)
= 60.90678 2.81404 = 58.09
100, 000
123.2
110.5
= 111,493.21
Equation of value is:

1
11
98000 = 2028.96v 2 + 2094.12v + 2155.66v 2 + 2229.86v 2 + 111493.21v 2

At 11%, RHS = 97955.85 98000
Page 3
Purchase price = 0.45 1,000,000 = 450,000

21
31
41
PV of dividends = 50000 (1 0.2 ) v 2 + v 2 + 1.03 v3 + v 2 + 1.032 v 4 + v 2 +
21
= 40000 v 2 + v 2 1 + 1.03v + 1.032 v 2 +
@ 8%
1
= 40000 1.68231
= 1, 453,516
1 1.03 1.08
NPV = 1,453,516 450,000 = 1,003,516
Let i = money yield
1 + i = 1.0285714 1.05 = 1.08 i = 8% p.a.

2
Check whether CGT is payable: compare i ( ) with (1 t ) g
(1 t ) g = 0.8
6
= 0.04571
105
2
2
From tables, i ( ) = 7.8461% i( ) > (1 t ) g
CGT is payable
( 2)
10
+ 105v10 0.25(105 P)v10 @ 8%
( 2)
10
+ 0.75 105v10
P = 0.8 6a
0.8 6a
1 0.25v10
4.8 1.019615 6.7101 + 78.75 0.46319
1 0.25 0.46319
= 78.39
Page 4
(i)
Let P denote the current price (per 100 nominal) of the security.
Then, we have:
P=
7
7
7
107
+
+
+
= 108.0872
1.044 1.044 1.047 1.044 1.047 1.049 1.044 1.047 1.049 1.05
(ii)
The gross redemption yield, i , is given by:
108.09 = 7 a4i % + 100 vi4%

Then, we have:
i = 5%
RHS = 107.0919
108.0872 108.9688
i 0.045 + ( 0.05 0.045 )
= 0.0473
i = 4.5% RHS = 108.9688
107.0919 108.9688
(iii)
The gross redemption yield represents a weighted average of the forward rates
at each duration, weighted by the cash flow received at that time.
Thus, increasing the coupon rate will increase the weight applied to the cash
flows at the early durations and, as the forward rates are lower at early
durations, the gross redemption yield on a security with a higher coupon rate
will be lower than above.
Note to markers: no marks for simply plugging 9% pa in, and providing no
explanation for result.
(i)
E (1 + i ) = e
+ 1 2 2
=e
0.05+ 1 2 0.004
= 1.0533757
E [i ] = 0.0533757 since E (1 + i ) = 1 + E ( i )
Let A be the accumulation at the end of 25 years of 3,000 paid annually in
advance for 25 years.
Page 5
Then E [ A] = 3000 S 25 at rate j = 0.0533757
((1 + j ) 1) (1 + j )
= 3000
25
(1.0533757
= 3000
25
) 1.0533757
0.0533757
= 158, 036.43
(ii)
Let the accumulation be S20

S20 has a log-normal distribution with parameters 20 and 202
E [ S 20 ] = e
20+ 1 2202
{or (1 + j ) }
20
= exp ( 20 0.05 + 10 0.004 )

= e1.04 = 2.829217
In S20 ~ N 20, 202
In S20 ~ N (1, 0.08)
Pr ( S20 > 2.829217 ) = Pr (1n S20 > 1n 2.829217 )

1n 2.829217-1
= Pr >
where
0.08
= Pr ( Z > 0.14 ) = 1 ( 0.14 )

= 1 0.55567
= 0.44433 i.e. 44.4%
Page 6
N ( 0,1)
(i)
DMT of liabilities is given by:

2
39
2
3
40
1 1 v7% + 2 (1.038835 ) v7%
+ 3 (1.038835 ) v7%
+ + 40 (1.038835 ) v7%
2
39
2
3
40
1 v7% + (1.038835 ) v7%
+ (1.038835 ) v7%
+ + (1.038835 ) v7%
2
3
40
(1.038835 )1 1.038835 + 2 1.038835 + 3 1.038835 + + 40 1.038835

1.07
1.07
1.07
1.07
=
2
3
40
(1.038835 )1 1.038835 + 1.038835 + 1.038835 + + 1.038835

1.07
1.07 1.07 1.07
vi* + 2 vi2* + 3 vi3* + + 40 vi40

*
vi* + vi2* + vi3* + + vi40
*
( Ia )i
40
i*
a40
where vi*
1
1+ i
1.038835
1.07
0.07 0.038835
i* =
1 =
= 0.03 .
1.07
1.038835
1.038835
Hence, DMT of liabilities is:
( Ia )3%
40
3%
a40
384.8647
= 16.65 years
23.1148
(Alternative method for DMT formula

DMT =
v(1 + 2 gv + 3g 2v 2 + " + 40 g 39v39 )

v(1 + gv + g 2v 2 + " + g 39v39 )
v( Ia)3%
40
3%
va40
( Ia)3%
40
3%
a40
( Ia )3%
40
3%
a40
where g = 1.038835 .)
(ii)
Even if the fund manager invested entirely in the 15-year zero-coupon bond,
the DMT of the assets will be only 15 years (and, indeed, any other portfolio
of securities will result in a lower DMT).
Thus, it is not possible to satisfy the second condition required for
immunisation (i.e. DMT of assets = DMT of liabilities).
Hence, the fund cannot be immunised against small changes in the rate of
interest.
Page 7
(iii)
(i)
The other problems with implementing an immunisation strategy in practice

include:
the approach requires a continuous re-structuring of the asset portfolio to

ensure that the volatility of the assets remains equal to that of the liabilities
over time
for most institutional investors, the amounts and timings of the cash flows
in respect of the liabilities are unlikely to be known with certainty
institutional investor is only immunised for small changes in the rate of

interest
the yield curve is unlikely to be flat at all durations
changes in the term structure of interest rates will not necessarily be in the
form of a parallel shift in the curve (e.g. the shape of the curve can also
change from time to time)
Loan = 4500a20 + 150 ( Ia )20 at 9%

Loan = 4500 9.1285 + 150 70.9055
= 41, 078.25 + 10, 635.83 = 51, 714.08
(ii)
Loan o/s after 9th year = ( 4500 + 1350 ) a11 + 150 ( Ia )11 at 9%
Loan o/s = 5,850 6.8052 + 150 35.0533
= 39,810.42 + 5258.00 = 45, 068.42
Repayment = 6000 45, 068.42 0.09 = 1, 943.84

(Alternative solution to (ii)
(ii)
= 5,850 6.8052 + 150 35.0533 = 45, 068.42 as before
= 6, 000 6.4177 + 150 30.7904 = 43,124.76
Repayment = 45, 068.42 43,124.76 = 1,943.66 )
Page 8
(iii)
Last instalment = 4650 + 19 150 = 7500

Loan o/s = 7500a1 = 7500v
Interest = 7500 0.91743 0.09 = 619.27
(iv)
1
Total payments = 20 4650 + 19 20 150
2
= 93, 000 + 28,500 = 121,500
Total interest = 121,500 51,714.08 = 69,785.92
(i)
NPV = 5 3v
+ 1.7a15 v 2 @10%
i
NPV = 5 3 0.976454 + 1.7 0.82645 a15 @10%
= 5 2.929362 + 1.404965 1.049206 7.6061

= 7.929362 + 11.21213458
= 3.282772575
NPV = 3.283m
(ii)
DPP is t + 2 such that

1
1.7 at v 2 = 5 + 3v 4 1.474097708at = 7.929362 @10%

1 1.1t
= 5.379129 1 1.1t = 0.5379129
0.1
0.4620871 = 1.1t 1n 0.4620871 = t 1n 1.1
t = 8.100
DPP = 10.1 years
Page 9
(iii)
Accumulated profit 17 years from start of project:

= 1.7 s6.9 7%
(1.07
= 1.7
(1.07
= 1.7
6.9
6.9
) @ 7%
0.067659
= 1.7 8.79346
= 14.95m
10
(i)
The values of the funds before and after the cash injections are:
1 January 2007
31 December 2007
31 December 2008
31 December 2009
Manager A
Manager B
120,000
130,000
135,000
180,000
100,000
140,000
145,000
150,000
140,000
145,000
150,000
155,000
Thus, TWRR for Manager A is given by:
(1 + i )3 =
130 135 180
i = 0.0905 or 9.05%
120 140 145
And, TWRR for Manager B is given by:
(1 + i )3 =
(ii)
140 145 150
i = 0.0941 or 9.41%
100 150 155
MWRR for Manager A is given by:
120 (1 + i ) + 10 (1 i ) + 10 (1 + i ) = 180
3
Then, putting i = 0.094 gives LHS = 180.03 which is close enough to 180.
(iii)
Both funds increased by 50% over the three year period and received the same
cashflows at the same times.
Since the initial amount in fund B was lower, the cash inflows received
represent a larger proportion of fund B and hence the money weighted return
earned by fund B over the period will be lower, particularly since the returns
were negative for the 2nd and 3rd years.
Page 10
[Could also note that for fund B:
100 (1 + i ) + 10 (1 i ) + 10 (1 + i ) = 150
3
So by a proportional argument 120 (1 + i ) + 12 (1 i ) + 12 (1 + i ) = 180

3
which when compared with the equation for fund A in (ii) clearly shows that
the return for B is lower.]
(iv)
The money weighted rate of return is higher for fund A, whilst the time
weighted return is higher for fund B.
When comparing the performance of investment managers, the time weighted
rate of return is generally better because it ignores the effects of cash inflows
or outflows being made which are beyond the managers control.
In this case, Manager As best performance is in the final year, when the fund
was at its largest, whilst Manager Bs best performance was in the first year,
where his fund was at its lowest.
Overall, it may be argued that Manager B has performed slightly better than
Manager A since Manager B achieved the higher time weighted return.
11
(i)
t <5
v (t ) = e
( 0.04+ 0.02 s )ds

t
0
=e
=e
0.04 s + 0.01s 2
0.04t +0.01t 2
t 5
v (t ) =
{ (0.04+0.02s )ds+ 0.05ds}

e
5
0
= v ( 5) e
t
5
0.05( t 5 )
= e0.45 e
0.05( t 5)
0.05t +0.2]
=e [
Page 11
(ii)
0.0517 + 0.2]
PV = 1, 000e [
= e 1.05
(a)
= 349.94
204
i (12 )
= 349.94
1000 1 +
12
(b)
12
i ( ) = 6.1924%
(iii)
PV =
10 0.45 [ 0.05t 0.25]

e
e
10e0.01t dt
6
= 10e0.2
10 0.04t
e
dt
6
10
= 10e
0.2
e0.04t
0.04 6
= 8.18733 2.90769
= 23.806
(Alternative Solution to (iii)
Accumulated value at time t = 10
10
10
= 10e0.01t exp 0.05ds dt
t
6
10
= 10e0.01t exp [ 0.05s ]t dt

6
10
10
10
= 10e0.01t e0.50.05t dt = 10e0.50.04t dt

6
0.50.04t 10
10e
=
0.04
= 276.293 + 324.233 = 47.940

6
Present value = v (10 ) 47.940 = 0.63763e[0.05100.25] 47.940 = 23.806
END OF EXAMINERS REPORT
Page 12
EXAMINATION
7 October 2010 (am)

Core Technical
1.
booklet.
2.
supervisor.
3.
4.
5.

question paper.
CT1 S2010
A bond pays coupons in perpetuity on 1 June and 1 December each year. The annual
coupon rate is 3.5% per annum. An investor purchases a quantity of this bond on 20
August 2009.
Calculate the price per 100 nominal to provide the investor with an effective rate of
return per annum of 10%.
[3]
A bond is redeemed at 110 per 100 nominal in exactly four years time. It pays
coupons of 4% per annum half-yearly in arrear and the next coupon is due in exactly
six months time. The current price is 110 per 100 nominal.
(i)
(ii)
(a)
Calculate the gross rate of return per annum convertible half-yearly

from the bond.
(b)
Calculate the gross effective rate of return per annum from the bond.
[2]
Calculate the net effective rate of return per annum from the bond for an
investor who pays income tax at 25%.
[2]
[Total 4]
The annual rates of return from an asset are independently and identically distributed.
The expected accumulation after 20 years of 1 invested in this asset is 2 and the
standard deviation of the accumulation is 0.60.
(a)
Calculate the expected effective rate of return per annum from the asset,
showing all the steps in your working.
(b)
Calculate the variance of the effective rate of return per annum.

[6]
A six-month forward contract was issued on 1 April 2009 on a share with a price of
700p at that date. It was known that a dividend of 20p per share would be paid on
1 May 2009. The one-month spot, risk-free rate of interest at the time of issue was
5% per annum effective and the forward rate of interest from 1 May to 30 September
was 3% per annum effective.
(i)
Calculate the forward price at issue, assuming no arbitrage, explaining your

working.
[3]
It has been suggested that the forward price cannot be calculated without making a
judgement about the expected price of the share when the forward contract matures.
(ii)
Explain why this statement is not correct.
(iii)
Comment on whether the method used in part (i) would still be valid if it was
not known with certainty that the dividend due on 1 May 2009 would be paid.
[1]
[Total 6]
CT1 S20102
[2]
(a)
(b)
Describe the characteristics of Eurobonds.

Describe the characteristics of convertible bonds.
[6]
On 1 January 2001 the government of a particular country bought 200 million shares
in a particular bank for a total price of 2,000 million. The shares paid no dividends
for three years. On 30 June 2004 the shares paid dividends of 10 pence per share. On
31 December 2004, they paid dividends of 20 pence per share. Each year, until the
end of 2009, the dividend payable every 30 June rose by 10% per annum compound
and the dividend payable every 31 December rose by 10% per annum compound. On
1 January 2010, the shares were sold for their market price of 3,500 million.
(i)
Calculate the net present value on 1 January 2001 of the governments

investment in the bank at a rate of interest of 8% per annum effective.
[5]
(ii)
Calculate the accumulated profit from the governments investment in the

bank on the date the shares are sold using a rate of interest of 8% per annum
effective.
[1]
[Total 6]
(i)
State the three conditions that are necessary for a fund to be immunised from
small, uniform changes in the rate of interest.
[2]
(ii)
A pension fund has liabilities of 10m to meet at the end of each of the next
ten years. It is able to invest in two zero-coupon bonds with a term to
redemption of three years and 12 years respectively. The rate of interest is 4%
per annum effective.
Calculate:
(iii)
(a)
the present value of the liabilities of the pension fund
(b)
the duration of the liabilities of the pension fund
(c)
the nominal amount that should be invested in the zero-coupon bonds

to ensure that the present values and durations of the assets and
liabilities is the same
[7]
One year later, just before the pension payment then due, the rate of interest is
5% per annum effective.
(a)
Determine whether the duration of the assets and the liabilities are still
equal.
(b)
Comment on the practical usefulness of the theory of immunisation in

the context of the above result.
[6]
[Total 15]
CT1 S20103
PLEASE TURN OVER
The force of interest, (t), is a function of time and at any time t, measured in years, is
0.05 + 0.001t
(t ) =
0.05
(i)
Derive and simplify as far as possible expressions for v(t), where v(t) is the
[5]
(ii)
(a)
Calculate the present value of 100 due at the end of 25 years.
(b)
Calculate the rate of discount per annum convertible quarterly implied

by the transaction in part (ii)(a).
[4]
(iii)
0 t 20
t > 20
A continuous payment stream is received at rate 30e0.015t units per annum

between t = 20 and t = 25. Calculate the accumulated value of the payment
stream at time t = 25.
[4]
[Total 13]
The government of a particular country has just issued three bonds with terms to
redemption of exactly one, two and three years respectively. Each bond is redeemed
at par and pays coupons of 8% annually in arrear. The annual effective gross
redemption yields from the one, two and three year bonds are 4%, 3% and 3%
respectively.
(i)
Calculate the one-year, two-year and three-year spot rates of interest at the
date of issue.
[8]
(ii)
Calculate all possible forward rates of interest from the above spot rates of
interest.
[4]
An index of retail prices has a current value of 100.

(iii)
Calculate the expected level of the retail prices index in one year, two years
and three years time if the expected real spot rates of interest are 2% per
annum effective for all terms.
[5]
(iv)
Calculate the expected rate of inflation per annum in each of the next three
years.
[2]
[Total 19]
CT1 S20104
10
On 1 April 2003 a company issued securities that paid no interest and that were to be
redeemed for 70 after five years. The issue price of the securities was 64. The
securities were traded in the market and the market prices at various different dates
are shown in the table below.
(i)
Date
Market price
of securities ()
1 April 2003
1 April 2004
1 April 2005
1 April 2006
1 April 2007
1 April 2008
64
65
60
65
68
70
Explain why the price of the securities might have fallen between 1 April 2004
and 1 April 2005.
[1]
Two investors bought the securities at various dates. Investor X bought 100 securities
on 1 April 2003 and 1,000 securities on 1 April 2005. Investor Y bought 100
securities every year on 1 April from 2003 to 2007 inclusive. Both investors held the
securities until maturity.
(ii)
Construct a table showing the nominal amount of the securities held and the
market value of the holdings for X and Y on 1 April each year, just before any
purchases of securities.
[5]
(iii)
(a)
Calculate the effective money weighted rate of return per annum for X
for the period from 1 April 2003 to 1 April 2008.
(b)
Calculate the effective time weighted rate of return per annum for X
[6]
(iv)
(v)
(a)
Determine whether the effective money weighted rate of return for Y is

lower or higher than that for X for the period from 1 April 2003 to
1 April 2008.
(b)
Determine the effective time weighted rate of return per annum for Y
[7]
Discuss the relationship between the different rates of return that have been
calculated.
[3]
[Total 22]
END OF PAPER
CT1 S20105
INSTITUTE AND FACULTY OF ACTUARIES
EXAMINERS REPORT
September 2010 Examinations

Core Technical
Introduction
T J Birse
December 2010
Institute and Faculty of Actuaries
Subject CT1 (Financial Mathematics Core Technical) September 2010 Examiners Report
Comments
Please note that different answers may be obtained from those shown in these solutions
where excessive rounding has been used or where insufficient working is shown. Candidates
also lose marks for not showing their working in a methodical manner which the examiner
can follow. This can particularly affect candidates on the pass/fail borderline when the
examiners have to make a judgement as to whether they can be sure that the candidate has
communicated a sufficient command of the syllabus to be awarded a pass.
The general standard of answers was noticeably lower than in previous sessions and there
were a significant number of very ill-prepared candidates. As in previous exams, questions
that required an element of explanation or analysis were less well answered than those which
just involved calculation.
Comments on individual questions, where relevant, can be found after the solution to each
question. These comments concentrate on areas where candidates could have improved their
performance.
Page 2
Working in half years:

The present value of the security on 1st June would have been
20 August is 80 days later so the present value is
Hence the price per 100 nominal is
(i)
(a)
3.5
2
i( )
80
3.5
(1 + i ) 365
2)
(
i
80
3.5
(1.1) 365 = 36.611
0.097618
Gross rate of return convertible half yearly is simply 4/110 = 0.03636

or 3.636%.
2
(b)
(ii)
0.03636
Gross effective rate of return is 1 +
1 = 0.03669 or 3.669%
2
The net effective rate of return per half year is 0.75
0.03636
= 0.013635 .
2
The net effective rate of return per annum is therefore:
(1.013635)2 1 = 0.02746 or 2.746%.

A common error was to divide the nominal payments by the increase in the index factor
(rather than multiplying).
(a)
Let S20 be the accumulation of the unit investment after 20 years:

E ( S20 ) = E (1 + i1 )(1 + i2 ) (1 + i20 )
E ( S 20 ) = E [1 + i1 ] E [1 + i2 ] E [1 + i20 ] as {it } are independent
E [it ] = j
j=2
E ( S 20 ) = (1 + j )
20
20
=2
1 = 3.5265%
Page 3
(b)
The variance of the effective rate of return per annum is s 2 where
Var [ Sn ] = (1 + j ) + s 2
2
20
s = 0.62 + (1 + j )
= 0.62 + 22
20
20
(1 + j )
40
1
10
= 0.004628
20
(1 + j )
= 0.62
Many candidates made calculation errors in this question but may have scored more marks if
their working had been clearer.
(i)
Assuming no arbitrage, buying the share is the same as buying the forward
except that the cash does not have to be paid today and a dividend will be
payable from the share.
Therefore, price of forward is:
700 (1.05 )
1
12
(1.03) 12 20 (1.03) 12
5
= 711.562 20.248 = 691.314
(ii)
The no arbitrage assumption means that we can compare the forward with the
asset from which the forward is derived and for which we know the market
price. As such we can calculate the price of the forward from this, without
knowing the expected price at the time of settlement. [It could also be
mentioned that the market price of the underlying asset does, of course,
already incorporate expectations].
(iii)
If it was not known with certainty that the dividend would be received we
could not use a risk-free interest rate to link the cash flows involved with the
purchase of the forward with all the cash flows from the underlying asset.
(a)
Eurobonds
Page 4
Medium-to-long-term borrowing.
Pay regular coupon payments and a capital payment at maturity.
Issued by large corporations, governments or supranational organisations.
Yields to maturity depend on the risk of the issuer.
Issued and traded internationally (not in core reading).
Often have novel features.
Usually unsecured
Issued in any currency
Normally large issue size
Free from regulation of any one government
(b)
Convertible Securities
Generally unsecured loan stocks.

Can be converted into ordinary shares of the issuing company.
Pay interest/coupons until conversion.
Provide levels of income between that of fixed-interest securities and equities.
Risk characteristics vary as the final date for convertibility approaches.
Generally less volatility than in the underlying share price before conversion.
Combine lower risk of debt securities with the potential for gains from
equity investment.
Security and marketability depend upon issuer
Generally provide higher income than ordinary shares and lower income than
conventional loan stock or preference shares
(i)
Net present value (all figures in m)
= 2, 000 + 0.1 200 v3 v 0.5 + 1.1v1.5 + 1.12 v 2.5 + + 1.15 v5.5
+0.2 200 v3 v + 1.1v 2 + 1.12 v3 + + 1.15 v 6 + 3,500v9

at 8% per annum effective.
)(
= 2, 000 +
200
2
3
6
0.1v 2.5 + 0.2v3 1.1v + (1.1v ) + (1.1v ) + + (1.1v ) + 3,500v9
1.1
= 2, 000 +
200
0.1v 2.5 + 0.2v3 a6' + 3,500v9
1.1
where the annuity is evaluated at a rate of
0.08 0.1
= 1.818% per annum
1 + 0.1
effective.
a6'
1 (1 0.018181)
0.018181
= 6.4011
and so net present value is

2, 000 +
(ii)
200
0.11.082.5 + 0.2 1.083 6.4011 + 3,500 1.089 = 31.66m
1.1
Accumulated profit at the time of sale is 31.66 1.089 = 63.30m
Many candidates assumed that the accumulation in part (i) was for a single payment.
Page 5
(i)
The present value of the assets is equal to the present value of the liabilities.
The duration of the assets is equal to the duration of the liabilities.
The spread of the asset terms around the duration is greater than that for the
liability terms (or, equivalently, convexity of assets is greater).
(ii)
(a)
Present value of liabilities (in m)

= 10a10 at 4% = 10 8.1109 = 81.109
(b)
Duration is equal to
(c)
Let the amounts to be invested in the two zero coupon bonds be X and
Y.
10 ( Ia )10
10a10
at 4% =
Xv3 + Yv12 = 81.109
41.9922
= 5.1773 years
8.1109
(1)
3 Xv3 + 12Yv12 = 419.922 (2)

(2) less 3 times (1) gives:
9Yv12 = 176.595
Y =
176.595
= 31.415m
9 0.62460
Substituting back into (1) gives:

X=
(iii)
(a)
(81.109 31.415 0.62460 ) =

0.88900
69.164m
In one year, the present value of the liabilities is:

10 + 10a9 at 5% = 10 + 10 7.1078 = 81.078
Numerator of duration is 10 0 + 10 ( Ia )9 = 332.347

Duration of liabilities is therefore
332.347
= 4.0991 years
81.078
Present value of assets is:

69.164 v 2 + 31.415 v11 = 69.164 0.90703 + 31.415 0.58468
= 81.101
Page 6
Duration of assets will be:

2 69.164 v 2 + 11 31.415 v11
81.101
=
(b)
2 69.164 0.90703 + 11 31.415 0.58468

= 4.0383 years
81.101
One of the problems of immunisation is that there is a need to

continually adjust portfolios. In this example, a change in the interest
rate means that a portfolio that has a present value and duration equal
to that of the liabilities at the outset does not have a present value and
duration equal to that of the liabilities one year later.
The calculation was often performed well. In part (ii), many explanations were unclear and
some candidates seemed confused between DMT and convexity although a correct
explanation could involve either of these concepts.
(i)
t 20 :
t
v ( t ) = exp 0.05 + 0.001sds
0
t

0.001s 2
= exp 0.05s +

2

0
= e 0.05t 0.0005t
t > 20 :
20
t
v ( t ) = exp ( s ) ds + 0.05ds
20
= v ( 20 ) exp [ 0.05s ] 20
t
= e1.2e10.05t = e 0.20.05t
(ii)
(a)
PV = 100v ( 25 ) = 100e 0.20.0525

= 100e1.45 = 23.46
Page 7
425
d ( 4)
= 100v ( 25 ) = 23.46
100 1
(b)
1
4
d ( ) = 4 1 0.2346 100 = 0.05758
(iii)
PV =
25
20 30e
= 30e
0.015t (0.2+0.05t )
0.2
25 0.065t
e
dt
20
(i)
30e 0.2 0.065t 25

e
=
20
0.065
30e 0.2 1.625 1.3

e
e
= 28.575
0.065
Accumulated value =
dt
28.575
= 28.575e0.2+ 0.0525 = 28.575e1.45 = 121.82
v ( 25 )
The one-year spot rate of interest is simply 4% per annum effective.

For two-year spot rate of interest
First we need to find the price of the security, P:
P = 8a2 + 100v 2 at 3% per annum effective.
a2 = 1.91347 v 2 = 0.942596
P = 8 1.91347 + 100 0.942596 = 109.5673
Let the t-year spot rate of interest be it.

We already know that i1 = 4%. i2 is such that:
109.56736 =
(1 + i2 )
8
108
+
1.04
(1 + i2 )2
= 0.943287
i2 = 0.029623 or 2.9623%.
Page 8
For three-year spot rate of interest we need to find the price of the security P:
P = 8a3 + 100v3 at 3% per annum effective.
a3 = 2.8286 v3 = 0.91514
P = 8 2.8286 + 100 0.91514 = 114.1428
i3 is such that:
114.1428 =
108
(1 + i3 )
8
8
108
+
+
2
1.04
(1.029623) (1 + i3 )3
= 114.1428 15.23860 = 98.9042
i3 = 0.02976 or 2.976%.
(ii)
The one year forward rate of interest beginning at the present time is clearly
4%.
The forward rate for one year beginning in one year is f1,1 such that:
1.04 (1 + f1,1 ) = 1.0296232 f1,1 = 0.01935 = 1.935%.
The forward rate for one year beginning in two years is f 2,1 such that:
1.0296232 (1 + f 2,1 ) = 1.029763 f 2,1 = 0.03003 = 3.003%.
The forward rate for two years beginning in one year is f1,2 such that:
1.029763 = 1.04 (1 + f1,2 )
f1,2 = 0.02468 = 2.468%
Page 9
(iii)
Let the t-year spot rate of inflation be et
(1 + it )t
(1 + et )t
For each term
(1 + e1 ) =
= 1.02 (1 + et )
t
1 + it
=
1.02
1.04
e1 = 1.96%
1.02
and so the value of the retail price index after one year would be 101.96
(1 + e2 )
1.029623
=
e2 = 0.943%
1.02
and so the value of the retail price index after two years would be
100 (1.00943) = 101.90
2
(1 + e3 )
1.02976
=
e3 = 0.9569%
1.02
and so the value of the retail price index after three years would be
100 (1.009569 ) = 102.90
3
(iv)
The spot rates of inflation or the price index values could be used.
Clearly the expected rate of inflation in the first year is 1.96%.
The expected rate of inflation in the second year is:
101.90 101.96
= 0.06%.
101.96
The expected rate of inflation in the third year is:
102.90 101.90
= 0.98%
101.90
A common error was to assume that income only started after three years rather than
starting from the beginning of the third year.
Page 10
10
(i)
The price of the securities might have fallen because interest rates have risen
or because their risk has increased (for example credit risk).
(ii)
Date
Market
price of
securities
()
1 April 2003
1 April 2004
1 April 2005
1 April 2006
1 April 2007
1 April 2008
(iii)
(a)
No of
securities
held
before
purchases
Market
value of
holdings
before
purchases
()
No of
securities
held
before
purchases
Market
value of
holdings
before
purchases
()
100
100
1,100
1,100
1,100
6,500
6,000
71,500
74,800
77,000
100
200
300
400
500
6,500
12,000
19,500
27,200
35,000
64
65
60
65
68
70
Money weighted rate of return is i where:

6, 400 (1 + i ) + 60, 000 (1 + i ) = 77, 000
5
try i = 5% LHS = 77,625.70

try i = 4% LHS = 75,278.42
interpolation implies that
i = 0.05 0.01
77, 625.70 77, 000

= 4.73%
77, 625.70 75, 278.42
(Note true answer is 4.736%)

(b)
Time weighted rate of return is i where using figures in above table:
(1 + i )5 =
6, 000
77, 000
= 1.09375.
6, 400 6, 000 + 60, 000
i = 1.808%
Page 11
(iv)
(a)
Money weighted rate of return is i where:
6, 400 (1 + i ) + 6,500 (1 + i ) + 6, 000 (1 + i ) + 6,500 (1 + i ) + 6,800 (1 + i )

5
= 35,000
Put in i = 4.73%; LHS = 37,026.95
Therefore the money weighted rate of return for Y is less to make LHS
less.
(b)
Time weighted rate of return for Y uses the figures in the above table:
(1 + i )5 =
6,500
12, 000
19,500
27, 200
35, 000
6, 400 6,500 + 6,500 12, 000 + 6, 000 19,500 + 6,500 27, 200 + 6,800
= 1.09375.
i = 1.808%
(Student may reason that the TWRRs are the same and can be derived
from the security prices in which case, time would be saved.)
(v)
The money weighted rate of return was higher for X than for Y because there
was a much greater amount invested when the fund was performing well than
when it was performing badly.
The money weighted rate of return for X (and probably for Y) was more than
the time weighted rate of return because the latter measures the rate of return
that would be achieved by having one unit of money in the fund from the
outset for five years: both X and Y has less in the fund in the years it
performed badly.
This question was answered well but examiners were surprised by the large number of
candidates who used interpolation or other trial and error methods in part (ii) when the
answer had been given in the question. The examiners recommend that students pay attention
to the details given in the solutions to parts (iii) and (iv). For such questions, candidates
should be looking critically at the figures given/calculated and making points specific to the
scenario rather than just making general statements taken from the Core Reading.
Page 12
EXAMINATION
19 April 2011 (am)

Core Technical
1.
booklet.
2.
supervisor.
3.
4.
5.

question paper.
CT1 A2011
0.04 + 0.003t 2
(t ) =
0.01 + 0.03t
for 0 < t 5
for 5 < t
(i)
Calculate the amount to which 1,000 will have accumulated at t = 7 if it is

invested at t = 3.
[4]
(ii)
Calculate the constant rate of discount per annum, convertible monthly, which
would lead to the same accumulation as that in (i) being obtained.
[3]
[Total 7]
A one-year forward contract on a stock is entered into on 1 January 2011 when the
stock price is 68 and the risk-free force of interest is 14% per annum. The stock is
expected to pay an annual dividend of 2.50 with the next dividend due in eight
months time.
On 1 April 2011, the price of the stock is 71 and the risk-free force of interest is 12%
per annum. The dividend expectation is unchanged.
Calculate the value of the contract to the holder of the long forward position on
1 April 2011.
[6]
An investment trust bought 1,000 shares at 135 each on 1 July 2005. The trust
received dividends on its holding on 30 June each year that it held the shares.
The rate of dividend per share was as given in the table below:
30 June
in year
Rate of dividend per

share ()
Retail price
index
2005
2006
2007
2008
2009
2010
7.9
8.4
8.8
9.4
10.1
121.4
125.6
131.8
138.7
145.3
155.2
On 1 July 2010, the investment trust sold its entire holding of the shares at a price of
151 per share.
(i)
Using the retail price index values shown in the table, calculate the real rate of
return per annum effective achieved by the trust on its investment.
[6]
(ii)
Explain, without doing any further calculations, how your answer to (i) would
alter (if at all) if the retail price index for 30 June 2008 had been greater than
138.7 (with all other index values unchanged).
[2]
[Total 8]
CT1 A20112
The n-year spot rate of interest yn , is given by:

yn = 0.03 +
n
1000
for n = 1, 2, 3 and 4
(i)
Calculate the implied one-year and two-year forward rates applicable at time
t = 2.
[3]
(ii)
Calculate, assuming no arbitrage:

(a)
The price at time t = 0 per 100 nominal of a bond which pays annual
coupons of 4% in arrear and is redeemed at 115% after 3 years.
(b)
The 3-year par yield.

[6]
[Total 9]
A loan of nominal amount 100,000 was issued on 1 April 2011 bearing interest
payable half-yearly in arrear at a rate of 6% per annum. The loan is to be redeemed
with a capital payment of 105 per 100 nominal on any coupon date between 20 and
25 years after the date of issue, inclusive, with the date of redemption being at the
option of the borrower.
An investor who is liable to income tax at 20% and capital gains tax of 35% wishes to
purchase the entire loan on 1 June 2011 at a price which ensures that the investor
achieves a net effective yield of at least 5% per annum.
(i)
Determine whether the investor would make a capital gain if the investment is
held until redemption.
[3]
(ii)
Explain how your answer to (i) influences the assumptions made in calculating
the price the investor should pay.
[2]
(iii)
Calculate the maximum price the investor should pay.
CT1 A20113
[5]
[Total 10]
PLEASE TURN OVER
The value of the assets held by a pension fund on 1 January 2010 was 10 million.
On 30 April 2010, the value of the assets had fallen to 8.5 million. On 1 May 2010,
the fund received a contribution payment of 7.5 million and paid out 2 million in
benefits. On 31 December 2010, the value of the fund was 17.1 million.
(i)
Calculate the annual effective money-weighted rate of return (MWRR) for

2010.
[3]
(ii)
Calculate the annual effective time-weighted rate of return (TWRR) for 2010.
[3]
(iii)
Explain why the MWRR is higher than the TWRR for 2010.
[2]
The fund managers bonus for 2010 is based on the return achieved by the fund over
the year.
(iv)
State, with reasons, which of the two rates of return calculated above would be
more appropriate for this purpose.
[2]
[Total 10]
A loan of 60,000 was granted on 1 July 1998.

The loan is repayable by an annuity payable quarterly in arrear for 20 years. The
amount of the quarterly repayment increases by 100 after every four years. The
repayments were calculated using a rate of interest of 8% per annum convertible
quarterly.
(i)
Show that the initial quarterly repayment is 1,370.41.
[5]
(ii)
Calculate the amount of capital repaid that was included in the payment made
on 1 January 1999.
[3]
(iii)
Calculate the amount of capital outstanding after the quarterly repayment due
[4]
on 1 July 2011 has been made.
[Total 12]
A company has liabilities of 10 million due in three years time and 20 million due
in six years time. The investment manager for the company is able to buy zerocoupon bonds for whatever term he requires and has adequate monies at his disposal.
(i)
Explain whether it is possible for the investment manager to immunise the

fund against small changes in the rate of interest by purchasing a single zerocoupon bond.
[2]
The investment manager decides to purchase two zero-coupon bonds, one for a term
of four years and the other for a term of 20 years. The current interest rate is 4% per
annum effective.
(ii)
Calculate the amount that must be invested in each bond in order that the
company is immunised against small changes in the rate of interest. You
should demonstrate that all three Redington conditions are met.
[10]
[Total 12]
CT1 A20114
A company is considering investing in a project. The project requires an initial

investment of three payments, each of 105,000. The first is due at the start of the
project, the second six months later, and the third payment is due one year after the
start of the project.
After 15 years, it is assumed that a major refurbishment of the infrastructure will be
required, costing 200,000.
The project is expected to provide a continuous income stream as follows:
20,000 in the second year

23,000 in the third year
26,000 in the fourth year
29,000 in the fifth year
Thereafter the continuous income stream is expected to increase by 3% per annum

(compound) at the start of each year. The income stream is expected to cease at the
end of the 30th year from the start of the project.
10
(i)
Show that the net present value of the project at a rate of interest of 8% per
annum effective is 4,000 (to the nearest 1,000).
[7]
(ii)
Calculate the discounted payback period for the project, assuming a rate of
interest of 8% per annum effective.
[5]
[Total 12]
The annual rates of return from a particular investment, Investment A, are

independently and identically distributed. Each year, the distribution of (1 + it ) , where
it is the rate of interest earned in year t , is log-normal with parameters and 2 .
The mean and standard deviation of it are 0.06 and 0.03 respectively.
(i)
Calculate and 2 .
[5]
An insurance company has liabilities of 15m to meet in one years time. It currently
has assets of 14m. Assets can either be invested in Investment A, described above,
or in Investment B which has a guaranteed return of 4% per annum effective.
(ii)
(iii)
Calculate, to two decimal places, the probability that the insurance company
will be unable to meet its liabilities if:
(a)
All assets are invested in Investment B.
(b)
75% of assets are invested in Investment A and 25% of assets are

invested in Investment B.
[6]
Calculate the variance of return from each of the portfolios in (ii)(a) and
(ii)(b).
[3]
[Total 14]
END OF PAPER
CT1 A20115
EXAMINERS REPORT
April 2011 examinations

Core Technical
Introduction
T J Birse
July 2011
Subject CT1 (Financial Mathematics Core Technical) Examiners Report, April 2011
General comments
The general performance was slightly worse than in April 2010 but well-prepared candidates
scored well across the whole paper. As in previous diets, questions that required an element
of explanation or analysis, such as Q3(ii) and Q6(iii) were less well answered than those that
just involved calculation. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Where no comment is made the
question was generally answered well by most candidates.
Page 2
3 ( s ) ds
7
We want 1000e
(i)
5 0.04+ 0.003s 2 ds + 7 ( 0.01+ 0.03s )ds
= 1000 e 3
2
3
3 ( 0.04 + 0.003s ) ds = 0.04s + 0.001 s 3
where
= 0.325 0.147 = 0.178

7
0.03 2
and ( 0.01 + 0.03s ) ds = 0.01s +

s
5
2
5
7
= 0.805 0.425 = 0.380
accumulation at t = 7 is
1000e(
0.178+ 0.380 )
= 1000e0.558 = 1, 747.17
412
d (12 )
1747.17 1
= 1000
12
(ii)
12
d ( ) = 0.138692
Forward price of the contract is K 0 = ( S0 I ) eT = ( 68 I ) e0.141

where I is the present value of income during the term of the contract = 2.5e
K 0 = 68 2.5e
0.14 812
)e
0.14
0.14 812
= 75.59919
Forward price a new contract issued at time r (3 months) is

T r
0.12 912
K = S I * e ( ) = 71 I e
r
(where I * is the present value of income during the term of the contract)
= 2.5e
0.12 512
K 0.25 = 71 2.5e 0.05 e0.09 = 75.08435
Page 3
T r
Value of original contract = ( K r K 0 ) e ( )
= ( 75.08435 75.59919 ) e
0.12912
= 0.47053 = 47.053 p
Many candidates failed to incorporate the change in the value of . Another common error
was in counting the number of months.
(i)
135, 000 = 7,900
+9, 400
121.4
121.4 2
121.4 3
. + 8, 400
+ 8,800
125.6
131.8
138.7
121.4 4
121.4 5
+ (10,100 + 151, 000 )
v
145.3
155.2
at i % where i = real yield

Approx yield:
135, 000 = (7635.828 + 7737.178 + 7702.379 + 7853.820 + 126015.077) 5
3.1% p.a.
Try i = 3%, RHS = 137434.955

Try i = 3.5%, RHS = 134492.919
i = 0.035 0.005
135000 134492.919
137434.955 134492.919
= 0.03414 (i.e. 3.4% p.a.)

(ii)
The term:
8,800
121.4
RPI (June 2008)
would have a lower value (i.e. the dividend paid on 30 June 2008 would have
a lower value when expressed in June 2005 money units). The real yield
would therefore be lower than 3.4% p.a.
The most common error on this question was incorrect use of the indices, e.g. many
candidates inverted them. Several candidates also had difficulty in setting up the equation of
Page 4
value. The examiners noted that a large number of final answers were given to excessive
levels of accuracy given the approximate methods used.
(i)
We can find forward rates f2,1 and f2,2 from:
(1 + y3 )3 = (1 + y2 )2 (1 + f 2,1 )
and
(1 + y4 )4 = (1 + y2 )2 (1 + f 2,2 )
(1.033) = (1.032 ) (1 + f 2,1 )

3
f 2,1 = 3.50029 % p.a.

and (1.034 ) = (1.032 ) (1 + f 2,2 )
4
f 2,2 = 3.60039 % p.a.

(ii)
(a)
Price per 100 nominal
+ v2
4 v
+ v3
3.3%
3.2%
3.1%
) + 115 v
3.3%
= 4 ( 0.969932 + 0.938946 + 0.907192 ) + 115 0.907192
= 115.59
(b)
Let yc3 = 3 year par yield
1 = yc3 v
3.1%
+ v2
3.2%
+ v3
3.3%
)+ v
3.3%
1 = yc3 ( 0.969932 + 0.938946 + 0.907192 ) + 0.907192
yc3 = 0.032957
i.e. 3.2957% p.a.
Page 5
(i)
2
i( 2)
1 +
= 1.05 i ( 2 ) = 4.939% (or use tables)
g (1 t1 ) =
0.06
0.80 = 0.0457
1.05
2
So i ( ) > g (1 t1 ) there is a capital gain on the contract
(ii)
Since there is a capital gain, the loan is least valuable to the investor if the
repayment is made by the borrower at the latest possible date. Hence, we
assume redemption occurs 25 years after issue in order to calculate the
minimum yield achieved.
(iii)
If A is the price per 100 of loan:
A = 100 0.06 0.80 a
( 2)
25
(1.05)12 + (105 0.35 (105 A) ) v

2
2410
12
at 5%
= 4.8 1.012348 14.0939 (1.05 )12 + (105 0.35 (105 A ) ) 0.29771

2
Hence A =
69.0452 + 20.3187
= 99.759
1 0.35 0.29771
Price of loan = 99,759

The majority of this question was well-answered but most candidates struggled with the two
month adjustment. This adjustment needs to be directly incorporated into the equation of
value. Calculating the price first without adjustment and then multiplying by (1+i)1/6 will lead
to the wrong answer.
(i)
MWRR is given by:

10.0 (1 + i ) + 5.5 (1 + i )
8
12
= 17.1
Try 11%, LHS = 16.996

Try 12%, LHS = 17.132
MMRR = 0.11 + 0.01
Page 6
17.1 16.996
= 11.8%p.a.
17.132 16.996
(ii)
TWRR is given by:

8.5
17.1
= 1 + i i = 3.821%p.a.
10.0 8.5 + 5.5
(iii)
MWRR is higher since fund received a large (net) cash flow at a favourable
time (i.e. just before the investment returns increased).
(iv)
TWRR is more appropriate. Cash flows into and out of the fund are outside
the control of the fund manager, and should not influence the level of bonus
payable. TWRR is not distorted by amount and/or timing of cash flows
whereas MWRR is.
The calculations in parts (i) and (ii) were generally well done but parts (iii) and (iv) were
poorly answered (or not answered at all) even by many of the stronger candidates. In (iii) for
example, candidates were expected to comment on the timing of the cashflows for this
particular year.
(i)
Let initial quarterly amount be X . Work in time units of one quarter. The
effective rate of interest per time unit is
0.08
= 0.02 (i.e.2% per quarter)
4
So
60, 000 = X a80 + 100v16 a64 + 100v32 a48 + 100v 48 a32 + 100v 64 a16 at 2%
2%
=
(where a64
1 v 64
= 35.921415)
0.02
= 39.7445 X + 2, 616.695465 + 1, 627.606705 + 907.1436682 + 382.3097071
X=
60, 000 5,533.756

39.7445
= 1,370.41 per quarter

(ii)
Interest paid at the end of the first quarter (i.e. on 1 October 1998) is
60, 000 0.02 = 1, 200
Hence, capital repaid on 1 October 1998 is
1370.41 1200 = 170.41
Page 7
Therefore, interest paid on 1 January 1999 is
( 60000 170.41) 0.02 = 1196.59

capital repaid on 1 January 1999 is
1370.41 1196.59 = 173.82
(iii)
Loan outstanding at 1 July 2011 (after repayment of instalment)

= 1670.41 a12 + 1770.41 12 a16 at 2%
= 1670.4110.5753 + 1770.41 0.78849 13.5777
= 36,619
Candidates found this to be the most challenging question on the paper. The easiest method
was to work in quarters with an effective rate of 2% per quarter. Where candidates worked
using a year as the time period the most common error was to allow for an increase to
payments of 100 pa when the increases were 400pa when they occurred. In part (i), the
examiners were disappointed to see many attempts with incorrect and/or insufficient working
end with the numerical answer that had been given in the question. A candidate who claims
to have obtained a correct answer after making obvious errors in the working is not
demonstrating the required level of skill and judgement and, indeed, is behaving
unprofessionally.
Part (iii) was very poorly answered with surprisingly few candidates recognising the
remaining loan was simply the present value of the last 28 payments.
(i)
No, because the spread (convexity) of the liabilities would always be greater
than the spread (convexity) of the assets then the 3rd Redington condition
would never be satisfied.
(ii)
Work in millions
Let proceeds from four-year bond = X
Let proceeds from 20-year bond = Y
Require PV Assets = PV Liabilities
X 4 + Y 20 = 103 + 20 6
(1)
Require DMT Assets = DMT Liabilities

4 X 4 + 20Y 20 = 303 + 120 6
Page 8
(2)
(2) 4 (1)
16Y20 = 406 103
Y =
40 6 103
16 20
31.61258 8.88996
= 3.11175m
7.30219
From (1):
X=
103 + 20 6 Y 20
4
8.88996 + 15.80629 1.42016

= 27.22973m
0.8548042
Soamounttobeinvestedin4yearbondis
X4=23.27609m
And amount to be invested in 20-year bond is
Y20 = 1.42016m
Require Convexity of Assets > Convexity of Liabilities
20 X 6 + 420Y 22 > 1205 + 8408
LHS = 981.869 > 712.411 = RHS
Therefore condition is satisfied and so above strategy will immunise company
against small changes in interest rates.
Or state that spread of assets (t = 4 to t = 20) is greater than spread of
liabilities (t = 3 to t = 6).
Part (i) was poorly answered. In part (ii) many candidates correctly derived X and Y as the
proceeds from the two bonds. However, only the better candidates recognised that the
amounts to be invested (as required by the question) were therefore Xv4 and Yv20.
(i)
PV of outgo (000s)
1
105 1 + v 2 + v + 200v15 = 366.31
at 8%
Page 9
PV of income
20v + 23v 2 + 26v3 + 29v 4
a1
2
24
+ 29v51.03 1 + (1.03v ) + (1.03v ) + ... + (1.03v )
1 (1.03)25 v 25
2
3
4
5
= a1 20v + 23v + 26v + 29v + 29v 1.03

1 1.03v
PV of income
= a1 {80.193 + 20.329 14.996} = 370.61
So NPV is 4.30 (=4,300)
(ii)
The NPV is very small. It is considerably less than the PV of the final years
income 29 (1.03) a1 v 29 = 6.272 ; therefore the DPP must fall in the

25
final year.
We know the DPP exists as the NPV > 0.
So DPP is 29 + r where
1 (1.03)24 v 24
366.31 = a1 80.193 + 20.329
1
1.03
+29 1.0325 v 29 ar
at 8%
366.31 = 364.335 + 6.5169ar

ar = 0.3031
v r = 0.97668 r = 0.307
So the DPP is 29.31.
This question tended to separate out the stronger and weaker candidates. The most common
errors in part (i) were discounting for an extra year, not including the one-year annuity
factor and incorrectly calculating the geometric progression. Many candidates also lost
marks through poorly presented or illegible methods that were therefore difficult for the
examiners to follow. Part (ii) was poorly attempted with few candidates completing the
question.
Page 10
10
(i)
E (1 + it ) = 1.06
Var (1 + it ) = 0.032 = 0.0009
+ 2
2
1.06 = e
2+2 )
(
0.0009 = e
(1)
e 1
2
(2)
( 2 ) = 0.0009 = e2 1
(1)2 (1.06 )2
0.0009
= Ln
+ 1
(1.06 )2
= 0.000800676
( and = 0.0282962 )
0.000800676
+
1.06 = e
= Ln (1.06 )
0.000800676
2
= 0.0578686
(ii)
(a)
Working in m. Assets would accumulate to 14 1.04 = 14.56 < 15

Probability = 1.00
(b)
The guaranteed portion of the fund would accumulate to

0.25 14 1.04 = 3.64.
Page 11
non-guaranteed portion needs to accumulate to
15 3.64 = 11.36
we require probability that
( 0.75 14 ) (1 + it ) < 11.36

= Pr (1 + it ) < 1.081905
= Pr ( ln (1 + it ) < ln 1.081905 )
ln (1 + it ) 0.0578686 ln1.081905 0.0578686
= Pr
<
0.0282962
0.0282962
= Pr ( Z < 0.7370169 ) where Z N ( 0,1) .

= 0.77
(iii)
(a)
Return is fixed (= 4% p.a.) variance of return = 0
(b)
Return from portfolio = 0.25 0.04 + 0.75 it
Variance of return = 0.752Var ( it )

= 0.752 0.0009 = 0.00050625
[In monetary terms the variance of return for (iii)(b) will be
( 14m )2 0.00050625 = 299, 225m
which is equivalent to a standard
deviation of 315,000]
This question was generally well answered by those candidates who had left enough time to
fully attempt the question. In part (i) the common errors were equating the mean to 0.06
instead of 1.06 and using 0.03 as the variance instead of 0.032. Part (ii) was also well
answered although many candidates quoted the probability of meeting liabilities when the
probability of not meeting the liabilities was asked for. Part (iii) a) was answered well by the
candidates who attempted it, while part b) was not answered well. In part (iii) answers given
in terms of the annual return and in terms of the monetary amounts were both fully
acceptable.
Page 12
EXAMINATION
27 September 2011 (am)

Core Technical
1.
booklet.
2.
supervisor.
3.
4.
5.

question paper.
CT1 S2011
A 91-day treasury bill is issued by the government at a simple rate of discount of 8%

per annum.
Calculate the annual effective rate of return obtained by an investor who purchases
the bill at issue.
[3]
State the characteristics of index-linked government bonds.
[3]
An individual intends to retire on his 65th birthday in exactly four years time. The
government will pay a pension to the individual from age 68 of 5,000 per annum
monthly in advance. The individual would like to purchase an annuity certain so that
his income, including the government pension, is 8,000 per annum paid monthly in
advance from age 65 until his 78th birthday. He is to purchase the annuity by a series
of payments made over four years quarterly in advance starting immediately.
Calculate the quarterly payments the individual has to make if the present value of
these payments is equal to the present value of the annuity he wishes to purchase at a
rate of interest of 5% per annum effective. Mortality should be ignored.
[6]
A pension fund makes the following investments (m):

1 January 2009
1.5
1 July 2009
6.0
1 January 2010
4.0
The rates of return earned on money invested in the fund were as follows:
1 January 2009 to
30 June 2009
1%
1 July 2009 to
31 December 2009
2%
1 January 2010 to
31 December 2010
5%
Assume that 1 January to 30 June and 1 July to 31 December are precise half-year
periods.
(i)
Calculate the time-weighted rate of return per annum effective over the two
years from 1 January 2009 to 31 December 2010.
[3]
(ii)
Calculate the money-weighted rate of return per annum effective over the two
years from 1 January 2009 to 31 December 2010.
[3]
[Total 6]
CT1 S20112
A nine-month forward contract is issued on 1 March 2011 on a stock with a price of

9.56 per share at that date. Dividends of 20 pence per share are expected on both
1 April 2011 and 1 October 2011.
(i)
Calculate the forward price, assuming a risk-free rate of interest of 3% per

annum effective and no arbitrage.
[4]
(ii)
(a)
Explain why the expected price of the share in nine months time is not
needed to calculate the forward price.
(b)
Explain why the price of an option would be explicitly dependent on

the variance of the share price but the price of a forward would not be.
[4]
[Total 8]
a + bt where a and b are constants. An amount of 45 invested at time t = 0
accumulates to 55 at time t = 5 and 120 at time t = 10.
(i)
Calculate the values of a and b.
[5]
(ii)
Calculate the constant force of interest per annum that would give rise to the
same accumulation from time t = 0 to time t = 10.
[2]
[Total 7]
An investment manager is considering investing in the ordinary shares of a particular

company.
The current price of the shares is 12 pence per share. It is highly unlikely that the
share will pay any dividends in the next five years. However, the investment manager
expects the company to pay a dividend of 2 pence per share in exactly six years time,
2.5 pence per share in exactly seven years time, with annual dividends increasing
thereafter by 1% per annum in perpetuity.
In five years time, the investment manager expects to sell the shares. The sale price
is expected to be equal to the present value of the expected dividends from the share at
that time at a rate of interest of 8% per annum effective.
(i)
(ii)
(iii)
Calculate the effective gross rate of return per annum the investment manager
will obtain if he buys the share and then sells it at the expected price in five
years time.
[6]
Calculate the net effective rate of return per annum the investment manager
will obtain if he buys the share today and then sells it at the expected price in
five years time if capital gains tax is payable at 25% on any capital gains. [3]
Calculate the net effective real rate of return per annum the investment
manager will obtain if he buys the share and then sells it at the expected price
in five years time if capital gains tax is payable at 25% on any capital gains
and inflation is 4% per annum effective. There is no indexation allowance. [3]
[Total 12]
CT1 S20113
PLEASE TURN OVER
(i)
State the conditions that are necessary for an insurance company to be

immunised from small, uniform changes in the rate of interest.
[2]
An insurance company has liabilities to pay 100m annually in arrear for the next 40
years. In order to meet these liabilities, the insurance company can invest in zero
coupon bonds with terms to redemption of five years and 40 years.
(ii)
(a)
Calculate the present value of the liabilities at a rate of interest of 4%

(b)
Calculate the duration of the liabilities at a rate of interest of 4% per

annum effective.
[5]
(iii)
Calculate the nominal amount of each bond that the fund needs to hold so that
the first two conditions for immunisation are met at a rate of interest of 4% per
annum effective.
[5]
(iv)
(a)
Estimate, using your calculations in (ii) (b), the revised present value
of the liabilities if there were a reduction in interest rates by 1.5% per
annum effective.
(b)
Calculate the present value of the liabilities at a rate of interest of 2.5%

(c)
Comment on your results to (iv) (a) and (iv) (b).
(i)
[6]
[Total 18]
Describe the information that an investor can obtain from the following yield
curves for government bonds:
(a)
(b)
(c)
A forward rate yield curve.

A spot rate yield curve.
A gross redemption yield curve.
[6]
An investor is using the information from a government bond spot yield curve to
calculate the present value of a corporate eurobond with a term to redemption of
exactly five years. The investor will value each payment that is due from the bond at a
rate of interest equal to j = i + 0.01 + 0.001t where:
t is the time in years at which the payment is due
i is the annual t-year effective spot rate of interest from the government bond spot
yield curve and i = 0.02t for t 5
The eurobond pays annual coupons of 10% of the nominal amount of the bond and is
redeemed at par.
(ii)
Calculate the present value of the eurobond.
[6]
(iii)
Calculate the gross redemption yield from the eurobond.
[3]
CT1 S20114
(iv)
10
Explain why the investor might use such a formula for j to determine the
interest rates at which to value the payments from the corporate eurobond. [3]
[Total 18]
A countrys football association is considering whether to bid to host the World Cup
in 2026. Several countries aspiring to host the World Cup will be making bids.
Regardless of whether the bid is successful, the association will incur various costs.
For two years, starting on 1 January 2012, the association will incur costs at a rate of
2m per annum, assumed to be paid continuously, to prepare the bid.
If the football association is successful, the following costs will be incurred from
1 January 2016 until 31 December 2025:
One stadium will be built each year for ten years. The first stadium will be built in
2016 and is expected to cost 200m; the stadium built in 2017 is expected to cost
210m; and so on, with the cost of each stadium rising by 5% each year. The costs
of building each stadium are assumed to be incurred halfway through the relevant
year.
Administration costs at a rate of 100m per annum will be incurred, payable

monthly in advance from 1 January 2025 until 31 December 2026.
Revenues from television, ticket receipts, advertising and so on are expected to be

3,300m and are assumed to be received continuously throughout 2026.
(i)
Explain why the payback period is not a good indicator of whether this project
is worthwhile.
[3]
The football association decides to judge whether to go ahead with the bid by
calculating the net present value of the costs and revenues from a successful bid on
1 January 2012 at a rate of interest of 4% per annum effective.
(ii)
Determine whether the association should make the bid.
[13]
The football association is discussing how it might factor into its calculations the fact
that it is not certain to win the right to host the World Cup because other countries are
also bidding.
(iii)
Explain how you might adjust the above calculations if the probability of
winning the right to host the World Cup is 0.1 and whether this adjustment
would make it more likely or less likely that the bid will go ahead.
[3]
[Total 19]
END OF PAPER
CT1 S20115
EXAMINERS REPORT
September 2011 examinations

Core Technical
Purpose of Examiners Reports

The Examiners Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners are not required to examine the content of Core Reading. Notwithstanding that,
the questions set, and the following comments, will generally be based on Core Reading.
For numerical questions the Examiners preferred approach to the solution is reproduced in
this report. Other valid approaches are always given appropriate credit; where there is a
commonly used alternative approach, this is also noted in the report. For essay-style
questions, and particularly the open-ended questions in the later subjects, this report contains
all the points for which the Examiners awarded marks. This is much more than a model
solution it would be impossible to write down all the points in the report in the time allowed
for the question.
T J Birse
December 2011
Subject CT1 (Financial Mathematics Core Technical) Examiners Report, September 2011
General comments on Subject CT1

CT1 provides a grounding in financial mathematics and its simple applications. It introduces
compound interest, the time value of money and discounted cashflow techniques which are
fundamental building blocks for most actuarial work.
Comments on the September 2011 paper
The general performance was considerably better than in September 2010 and also slightly
better than in April 2011. Well-prepared candidates scored well across the whole paper.
As in previous diets, questions that required an element of explanation or analysis, such as
Q5(ii) and Q9(iv) were less well answered than those that just involved calculation. Marginal
candidates should note that it is important to explain and show understanding of the concepts
and not just mechanically go through calculations. The comments that follow the questions
concentrate on areas where candidates could have improved their performance. Where no
comment is made the question was generally answered well by most candidates.
91 0.08 = 1 + i
(1 365
) ( )
0.980055 = (1 + i )
91
91
365
365
1 + i = 1.08416 i = 8.416%
Issued by the government

Pay regular interest
Redeemable at a given redemption date
Normally liquid/marketable
More or less risk-free relative to inflation
Low expected return
Low default risk
Coupon and capital payments linked to an index of prices
with a time lag.
This type of bookwork question is common in CT1 exam papers. As such, it was disappointing
that only about one-sixth of candidates obtained full marks here (which could be achieved by
listing six distinct features).
Let the annual rate of payment = X

( 4)
Present value of the payments = Xa
4
Present value of the payments needed from the annuity is:

(12 )
(12 )
8, 000a v 4 + 3, 000a v 7
3
10
( 4)
(12 )
(12 )
Xa = 8, 000a v 4 + 3, 000a v 7
4
a3 = 2.7232
10
4
d( )
= 1.031059
a4 = 3.5460 a10 = 7.7217
i
d
(4)
a4 = 8, 000
12
d( )
= 1.026881 v 4 = 0.82270 v 7 = 0.71068
i
i
a v 4 + 3, 000
a v7
12 ) 3
12 ) 10
(
(
d
d
X 1.031059 3.5460 = 8, 000 1.026881 2.7232 0.82270

+3, 000 1.026881 7.7217 0.71068
3.65614 X = 18, 404.80 + 16.905.51
Page 3
X = 9, 657.81
Quarterly payment is: 2,414.45.

Many candidates struggled to allow correctly for the Government pension. In some cases,
candidates would have scored more marks if they had explained their methodology and their
workings more clearly.
(i)
The fund value on 30 June 2009 will be:

1.5 1.01 = 1.515
The fund value on 31 December 2009 will be:
(1.5 1.01 + 6 ) 1.02 = 7.6653

The fund value on 31 December 2010 will be:
(1.5 1.01 + 6 ) 1.02 + 4 1.05 = 12.2486
TWRR is i such that:
1.515 7.6653 12.2486

2
= (1 + i ) = 1.0817
1.5
7.515 11.6653
i = 4.005%
(This can also be calculated directly from the rates of return for which no
marks would be lost).
(ii)
The equation of value is:

1.5 (1 + i ) + 6.0 (1 + i )
2
Try i = 4%
11 2
+ 4 (1 + i ) = 12.2486
LHS = 12.146
Try i = 4.5% LHS = 12.22754

Try i = 5%
Page 4
LHS = 12.3094
Interpolate:
i = 0.045 +
12.2486 12.22754
0.005
12.3094 12.22754
= 0.04629 or 4.63%
A common error was to assume that the 1% and 2% rates of return were annualised figures
rather than returns over a six-month period.
(i)
Forward price is accumulated value of the share less the accumulated value of
the expected dividends:
F = 9.56 (1.03)
12
0.2 (1.03)
8
12
0.2 (1.03)
12
= 9.7743 0.20398 0.20099

= 9.3693
(ii)
(a)
Although the share will be bought in nine months, it is not necessary to

take into account the expected share price. The current share price
already makes an allowance for expected movements in the price and
the investor is simply buying an instrument that is (more or less)
identical to the underlying share but with deferred payment. As such,
under given assumptions, the forward can be priced from the underlying
share.
(b)
An option does not have to be exercised. As such, movements in the

share price in one direction will benefit the holder whereas movements
in the other direction will not harm him. The more volatile is the
underlying share price, the more potential there is for gain for the
holder of the option (with limited risk of loss), compared with holding
the underlying share. This is not the case for a forward which has to be
exercised.
Part (i) was well-answered but part (ii) was very poorly answered. The examiners anticipated
that many candidates would find part (ii)(b) challenging but it was pleasing to see some of
the strongest candidates give some well-reasoned explanations for this part.
Page 5
( a +bt )dt
= 55
45e 0
5
(i)
10
45e 0
( a +bt )dt
= 120
(1)
(2)
From (1)
5
bt 2
45exp at +
= 55
2
0
55
ln = 5a + 12.5b = 0.2007
45
(1a)
From (2)
10
bt 2
45exp at +
= 120
2
120
ln
= 10a + 50b = 0.98083
45
From (1a)
10a = 0.4014 25b
(2a)
Substituting into (2a)

0.4014 + 25b = 0.98083
b =
0.98083 0.4014
= 0.02318
25
Substituting into (1a)

5a + 12.5 0.02318 = 0.2007
a =
(ii)
0.2007 12.5 0.0231772

= 0.01781
5
45e10 = 120
120
120
e10 =
;10 = ln
= 0.98083
45
45
= 0.09808 or 9.808 %
Page 6
(i)
Expected price of the shares in five years is:

X = 2v + 2.5v 2 + 2.5 1.01 v3 + 2.5 1.012 v 4 + ...
= 2v + 2.5v 2 + 2.5v 2 1.01v + 1.012 v 2 + ....
1.01v + 1.012 v 2 + ... at 8% =

where i ' =
1
i'
1.08
1 = 0.069307
1.01
X = 2 0.92593 + 2.5 0.85734 +
2.5 0.85734
0.069307
= 3.9952 + 30.9254 = 34.9206

Equation of value for the investor is:
12 (1 + i ) = 34.9206
5
i = 0.23817 or 23.817%
(ii)
12 (1 + i ) = 34.9206 ( 34.9206 12 ) 0.25

5
where i is the net rate of return.

12 (1 + i ) = 29.1905
5
i = 0.1946 or 19.46%
(iii)
The cash flow received in nominal terms is still the same: 29.190495
The equation of value expressed in real terms is:
12 =
29.1905
(1 + f )
v5 where f = 0.04
12 (1.04 )
v =
5
29.1905
v = 0.50016
= 0.50016
= 0.87061
i = 14.86%
Page 7
(i)
The present value of the assets is equal to the present value of the liabilities at
the starting rate of interest.
The duration /discounted mean term/volatility of the assets is equal to that of
the liabilities.
The convexity of the assets (or the spread of the timings of the asset
cashflows) around the discounted mean term is greater than that of the liabilities.
(ii)
(a)
PV of liabilities is: 100m a40 at 4%

= 100m19.7928
= 1,979.28m
(b)
The duration of the liabilities is:

t = 40
100t vt /
t = 40
t =1
100vt
(working in m)
t =1
t = 40
=
(iii)
100 t vt
t =1
1,979.28
100 ( a )40
1,979.28
at 4%
100 306.3231
= 15.4765 years
1,979.28
Let x = nominal amount of five-year bond

y = nominal amount of 40-year bond.
working in m
1,979.28 = xv5 + yv 40
(1)
30, 632.31 = 5 xv5 + 40 yv 40
(2)
multiply equation (1) by 5.

9,896.4 = 5 xv5 + 5 yv 40
(1a)
subtract (1a) from (2) to give

20735.91 = 35yv 40
20, 735.91
35 v 40
Page 8
=y
with v 40 = 0.20829
y = 2,844.38
Substitute into (1) to give:
1,979.28 = Xv5 + 2,844.38 0.20829
v5 = 0.82193
1,979.28 2,844.38 0.20829
= x = 1, 687.28
0.82193
Therefore 1,687.28m nominal of the five-year bond and 2,844.38m nominal
of the 40-year bond should be purchased.
(iv)
(a)
The duration of the liabilities is 15.4765

Therefore the volatility of the liabilities is
15.4765
=14.88125%
1.04
The value of the liabilities would therefore change by:

1.5 0.1488125 1,979.28m = 441.81m
and the revised present value of the liabilities will be 2,421.09m.
(b)
PV of liabilities is: 100m a40 at 2.5%

1 1.02540
= 100m 0.025
= 2,510.28m.
(c)
The PV of liabilities has increased by 531m. This is significantly

greater than that estimated in (iv) (a). This estimation will be less valid
for large changes in interest rates as in this case.
The first three parts were generally well-answered but, in part (iv), the examiners were
surprised that so few candidates were able to use the duration to estimate the change in the
value of the liability.
Page 9
(i)
(a)
The theoretical rate of return that could be achieved over a given time
period in the future from investment in government bonds today.
(b)
The theoretical rate of return that could be achieved between the

current time and a given future time from investment in government
bonds.
(c)
The gross redemption yield that could be theoretically achieved by

investing in government bonds of different terms to redemption. The
yield curve represents a statistical average gross redemption yield.
(ii)
Time
1
2
3
4
5
Government
bond yield
0.02
0.04
0.06
0.08
0.1
Valuation rate
of interest
0.031
0.052
0.073
0.094
0.115
P.V factor
0.96993
0.90358
0.80947
0.69812
0.58026
PV = 10 ( 0.96993 + 0.90358 + 0.80947 + 0.69812 + 0.58026 ) + 100 0.58026
= 97.6396.
(iii)
GRY is such that: 97.6396 = 10a5 + 100v5
Try 11% a5 = 3.69590 v5 = 0.59345 RHS = 96.30397

Try 10% a5 = 3.7908 v5 = 0.62092 RHS = 100
[calculation not necessary]
Interpolate to find i:
i=
97.6396 96.30397
0.01 + 0.11
100 96.30397
i = 0.10639 or 10.64%
(iv)
It is reasonable for the investor to price a corporate bond with reference to the
rates of return from government bonds which may be (more or less) risk free.
A risk premium will then need to be added.
It is also not unreasonable that this risk premium rises with term as the
uncertainty regarding credit risk rises.
This question proved to be the most difficult on the paper. The examiners had anticipated that
some candidates would have difficulty with part (i) but it was disappointing to see the number
of candidates who were unable to give even a basic description of a spot rate and a forward
rate. Part (iv) was also very poorly answered and whilst it had been anticipated that only the
Page 10
strongest candidates would make all the relevant points, the examiners were surprised at how
many candidates failed to score any marks on this part.
10
(i)
The payback period measures the earliest time at which the project breaks
even but takes no account either of interest on borrowings or on cash flows
received after the payback period. It is therefore a poor measure of ultimate
profitability.
(ii)
The present value of preparation costs is (in m):

2a2 @ 4% per annum effective.
i
= 2. .a2
i
= 1.019869 a2 = 1.8861
= 2 1.019869 1.8861 = 3.847
The present value the stadium building costs is (in m):

200v
4 12
+ 200 1.05v
200v
4 12
(1 + 1.05v + 1.05 v
= 200v
5 12
+ 200 1.052 v
2 2
4 12
6 12
13 12
+ ... + 200 1.059 v
+ ... + 1.059 v9
1 1.0510 v10
1 1.05v
with v = 0.96154 v10 = 0.67556 1.0510 = 1.62889 v
4 12
= 0.83820
1 1.62889 0.67556
= 200 0.83820
1 1.05 0.96154
= 1, 750.837
Present value of admin. costs is (m):
(12 )
100a v13
2
with
@ 4%
i
= 1.021537 v13 = 0.60057 a2 = 1.8861
12 )
(
d
= 100 1.021537 1.8861 0.60057
= 115.714
Page 11
Present value of revenue (m):

3,300a1 v14
with
i
= 1.019869 a1 = 0.9615 v14 = 0.57748
= 3,300 1.019869 0.9615 0.57748

= 1,868.781
NPV = 1,868.781 115.714 1,750.837 3.847 = 1.617m.
Therefore should not make a bid.
(iii)
One way of dealing with this would be to multiply the NPV of all the revenues
and costs that are only received if the bid is won by 0.1.
The costs of preparing the bid would be incurred for certain and therefore not
multiplied by 0.1. This adjustment would make it less likely the bid will go
ahead because the only certain item is a cost.
This question contained a potential ambiguity regarding the timing of the administration
costs. Although the examiners felt that the approach given in the model solution was the most
logical, candidates who assumed that the administration costs were only payable during
2025 were given full credit. This question was answered well and it was very pleasing to see
that (a) candidates managed their time efficiently and so left enough time to make a good
attempt at the question with the most marks and (b) candidates who made calculation errors
still clearly explained their method and so were able to pick up significant marks for their
working.
Page 12
EXAMINATION
24 April 2012 (am)

Core Technical
1.
booklet.
2.
supervisor.
3.
4.
5.

question paper.
CT1 A2012
In a particular bond market, n -year spot rates can be approximated by the function
0.06 0.02e0.1n .
(i)
Calculate the gross redemption yield for a 3-year bond which pays coupons of
3% annually in arrear, and is redeemed at par. Show all workings.
[6]
(ii)
Calculate the 4-year par yield.
[3]
[Total 9]
The value of the assets held by an investment fund on 1 January 2011 was 2.3
million.
On 30 April 2011, the value of the assets had risen to 2.9 million and, on 1 May
2011, there was a net cash inflow to the fund of 1.5 million. On 31 December 2011,
the value of the assets was 4.2 million.
(i)
[2]
(ii)
Calculate, to the nearer 0.1%, the annual effective money-weighted rate of

return (MWRR) for 2011.
[4]
(iii)
Explain why the TWRR is significantly higher than the MWRR for 2011. [2]
[Total 8]
A company has borrowed 500,000 from a bank. The loan is to be repaid by level
instalments, payable annually in arrear for ten years from the date the loan is made.
The annual instalments are calculated at an effective rate of interest of 9% per annum.
(i)
Calculate:
(a)
the amount of the level annual instalments.
(b)
the total amount of interest which will be paid over the ten-year term.
[3]
At the beginning of the eighth year, immediately after the seventh instalment has been
made, the company asks for the loan to be rescheduled over a further four years from
that date. The bank agrees to do this on condition that the rate of interest is increased
to an effective rate of 12% per annum for the term of the rescheduled instalments and
that repayments are made quarterly in arrear.
(ii)
CT1 A20122
(a)
Calculate the amount of the new quarterly instalment.
(b)
Calculate the interest content of the second quarterly instalment of the

rescheduled loan repayments.
[5]
[Total 8]
(i)
Explain what is meant by the no arbitrage assumption in financial

mathematics.
[2]
An investor entered into a long forward contract for a security four years ago and the
contract is due to mature in five years time. The price of the security was 7.20 four
years ago and is now 10.45. The risk-free rate of interest can be assumed to be 2.5%
per annum effective throughout the nine-year period.
(ii)
Calculate, assuming no arbitrage, the value of the contract now if the security
will pay dividends of 1.20 annually in arrear until maturity of the contract.
[3]
(iii)
Calculate, assuming no arbitrage, the value of the contract now if the security
has paid and will continue to pay annually in arrear a dividend equal to 3% of
the market price of the security at the time of payment.
[3]
[Total 8]
An investor is considering two projects, Project A and Project B. Project A involves

the investment of 1,309,500 in a retail outlet. Rent is received quarterly in arrear for
25 years, at an initial rate of 100,000 per annum. It is assumed that the rent will
increase at a rate of 5% per annum compound, but with increases taking place every
five years. Maintenance and other expenses are incurred quarterly in arrear, at a rate
of 12,000 per annum. The retail outlet reverts to its original owner after 25 years for
no payment.
Project B involves the purchase of an office building for 1,000,000. The rent is to be
received quarterly in advance at an initial rate of 85,000 per annum. It is assumed
that the rent will increase to 90,000 per annum after 20 years. There are no
maintenance or other expenses. After 25 years the property reverts to its original
owner for no payment.
(i)
Show that the internal rate of return for project A is 9% per annum effective.
[5]
(ii)
Calculate the annual effective internal rate of return for Project B. Show your
working.
[4]
(iii)
Discuss the extent to which the answers to parts (i) and (ii) above will
influence the investors decision over which project to choose.
[3]
[Total 12]
CT1 A20123
PLEASE TURN OVER
A fixed-interest bond pays annual coupons of 5% per annum in arrear on 1 March

each year and is redeemed at par on 1 March 2025.
On 1 March 2007, immediately after the payment of the coupon then due, the gross
redemption yield was 3.158% per annum effective.
(i)
Calculate the price of the bond per 100 nominal on 1 March 2007.
[3]
On 1 March 2012, immediately after the payment of the coupon then due, the gross
redemption yield on the bond was 5% per annum.
(ii)
State the new price of the bond per 100 nominal on 1 March 2012.
[1]
A tax-free investor purchased the bond on 1 March 2007, immediately after payment
of the coupon then due, and sold the bond on 1 March 2012, immediately after
payment of the coupon then due.
(iii)
Calculate the gross annual rate of return achieved by the investor over this
period.
[2]
(iv)
Explain, without doing any further calculations, how your answer to part (iii)
would change if the bond were due to be redeemed on 1 March 2035 (rather
than 1 March 2025). You may assume that the gross redemption yield at both
the date of purchase and the date of sale remains the same as in parts (i) and
(ii) above.
[3]
[Total 9]
The annual yields from a fund are independent and identically distributed. Each year,
the distribution of 1 + i is log-normal with parameters = 0.05 and 2 = 0.004, where
i denotes the annual yield on the fund.
(i)
Calculate the expected accumulation in 20 years time of an annual investment

in the fund of 5,000 at the beginning of each of the next 20 years.
[5]
(ii)
Calculate the probability that the accumulation of a single investment of 1

made now will be greater than its expected value in 20 years time.
[5]
[Total 10]
CT1 A20124
The force of interest, (t), at time t is given by:

0.04 + 0.003t 2
( t ) = 0.01 + 0.03t
0.02
for 0 < t 5
for 5 < t 8
for t > 8
(i)
Calculate the present value (at time t = 0) of an investment of 1,000 due at

time t = 10.
[4]
(ii)
Calculate the constant rate of discount per annum convertible quarterly, which
would lead to the same present value as that in part (i) being obtained.
[2]
(iii)
Calculate the present value (at time t = 0) of a continuous payment stream

[4]
payable at the rate of 100e 0.01t from time t = 10 to t = 18.
[Total 10]
An ordinary share pays dividends on each 31 December. A dividend of 35p per share
was paid on 31 December 2011. The dividend growth is expected to be 3% in 2012,
and a further 5% in 2013. Thereafter, dividends are expected to grow at 6% per
annum compound in perpetuity.
(i)
Calculate the present value of the dividend stream described above at a rate of
interest of 8% per annum effective for an investor holding 100 shares on
1 January 2012.
[4]
An investor buys 100 shares for 17.20 each on 1 January 2012. He expects to sell
the shares for 18 on 1 January 2015.
(ii)
Calculate the investors expected real rate of return.

You should assume that dividends grow as expected and use the following
values of the inflation index:
Year:
2012
2013
2014
2015
Inflation index
at start of year:
110.0
112.3
113.2
113.8
[5]
[Total 9]
CT1 A20125
PLEASE TURN OVER
10
A company has the following liabilities:
annuity payments of 200,000 per annum to be paid annually in arrear for the next
20 years
a lump sum of 300,000 to be paid in 15 years
The company wishes to invest in two fixed-interest securities in order to immunise its
liabilities.
Security A has a coupon rate of 9% per annum and a term to redemption of 12 years.
Security B has a coupon rate of 4% per annum and a term to redemption of 30 years.
Both securities are redeemable at par and pay coupons annually in arrear. The rate of
interest is 8% per annum effective.
(i)
Calculate the present value of the liabilities.
[3]
(ii)
Calculate the discounted mean term of the liabilities.
[4]
(iii)
Calculate the nominal amount of each security that should be purchased so

that Redingtons first two conditions for immunisation against small changes
in the rate of interest are satisfied for this company.
[8]
(iv)
Describe the further calculations that will be necessary to determine whether

the company is immunised against small changes in the rate of interest.
[2]
[Total 17]
END OF PAPER
CT1 A20126
EXAMINERS REPORT

Core Technical
Introduction
candidates, both those who are sitting the examination for the first time and who are using
past papers as a revision aid, and also those who have previously failed the subject. The
Examiners are charged by Council with examining the published syllabus. Although
Examiners have access to the Core Reading, which is designed to interpret the syllabus, the
Examiners are not required to examine the content of Core Reading. Notwithstanding that,
the questions set, and the following comments, will generally be based on Core Reading.
this report. Other valid approaches are always given appropriate credit; where there is a
commonly used alternative approach, this is also noted in the report. For essay-style
questions, and particularly the open-ended questions in the later subjects, this report contains
all the points for which the Examiners awarded marks. This is much more than a model
solution it would be impossible to write down all the points in the report in the time allowed
for the question.
T J Birse
July 2012
Subject CT1 (Financial Mathematics) April 2012 Examiners Report

Comments on the April 2012 paper
The general performance was broadly similar to the previous two exams. Well-prepared
candidates scored well across the whole paper. As in previous diets, questions that required
an element of explanation or analysis, such as Q2(iii), Q5(iii) and Q6(iv) were less well
answered than those that just involved calculation. Marginal candidates should note that it is
important to explain and show understanding of the concepts and not just mechanically go
through calculations. The comments that follow the questions concentrate on areas where
candidates could have improved their performance. Where no comment is made the question
was generally answered well by most candidates.
Page 2
(i)
Price, P, of 100 nominal stock is:
P = 3v y1 + 3v 2y2 + 103v3y3
where
y1 = 0.041903
y2 = 0.043625
y3 = 0.045184
P = 95.845
And gross redemption yield, i%, solves:
95.845 = 3a3 + 100v3 at i %

Try
4% RHS = 97.225
5% RHS = 94.554
i = 0.04 + 0.01
97.225 95.845
97.225 94.554
= 0.0452
i.e. 4.5% p.a.
(ii)
y1, y2 and y3 as above. y4 = 0.046594
1 = ( yc4 ) v y1 + v 2y2 + v3y3 + vY44 + v 4y4

1 = yc4 3.587225 + 0.8334644
yc4 = 0.04642 i.e. 4.642% p.a.
(i)
TWRR, i , is given by:

2.9
4.2
= 1 + i i = 0.204 or 20.4% p.a.

2.3 2.9 + 1.5
(ii)
MWRR, i , is given by:

2.3 (1 + i ) + 1.5 (1 + i )
8
12
= 4.2
Page 3
Then, we have:
i = 12% LHS = 4.1937
4.2 4.1937
i = 0.12 + ( 0.13 0.12 )
i = 13% LHS = 4.2263

4.2263 4.1937
= 0.122
or 12.2% p.a.
(iii)
The MWRR is lower as fund performs better before the cash inflow than after.
Then, as the fund is larger after the cash inflow on 1 May 2011, the effect of
the poor investment performance after this date is more significant in the
calculation of the MWRR.
The calculations were performed well but the quality of the explanations in part (iii) was
often poor. This type of explanation is commonly asked for in CT1 exams. To get full marks,
candidates should address the specific situation given in the question rather than just repeat
the bookwork.
(i)
Let R = annual repayment

9%
500, 000 = R a10
= R 6.4177
R = 77, 910.04
and total interest = 10 77,910.04 500, 000

= 279,100
(ii)
(a)
Capital outstanding at beginning of 8th year is:
77910.04 a39% = 77909.53 2.5313

= 197, 213.28
Let R be new payment per annum then

( 4)
4
R a
= R 1.043938 3.0373 = 197, 213.28
R = 62,196.62
and quarterly payment is 15,549.16
Page 4
(b)
Interest content of 2nd quarterly payment is:
33
4
15549.16 1 v12%
= 5383.41
[Or
Capital in 1st quarterly payment is
15549.16 197213.28 1.12 4 1 = 9,881.77
So capital outstanding after 1st quarterly payment
= 197213.28 9881.77 = 187331.51

Interest in next payment is
1
187331.51 1.12 4 1 = 5383.41 ]
Generally answered well but a number of candidates made errors in calculating the
remaining term in part (ii)
(i)
The no arbitrage assumption means that neither of the following applies:

(a)
an investor can make a deal that would give her or him an immediate
profit, with no risk of future loss;
nor
(b)
(ii)
an investor can make a deal that has zero initial cost, no risk of future
loss, and a non-zero probability of a future profit.
The current value of the forward price of the old contract is:
7.20 (1.025 ) 1.20 a
4
2 12 %
whereas the current value of the forward price of a new contract is:
10.45 1.20 a
2 12 %
Hence, current value of old forward contract is:
10.45 7.20 (1.025 ) = 2.5025

4
Page 5
(iii)
The current value of the forward price of the old contract is:
7.20 (1.025 ) (1.03)

4
= 6.0911
whereas the current value of the forward price of a new contract is:
10.45 (1.03)
= 9.0143
current value of old forward contract is:
9.0143 6.0911 = 2.9232

This was the most poorly answered question on the paper but well-prepared candidates still
scored full marks. Some candidates in part (ii) assumed that the dividend income was
received during the lifetime of the forward contract. Whilst the examiners did not believe that
such an approach was justified, candidates who assumed this alternative treatment of the
income were not penalised. It was very clear that the poor performance on the question was
not as result of this alternative interpretation.
(i)
The equation of value is:
( ( ) + (1.05) v
4
5
1309.5 = 100 a
( 4)
5
( 4)
5
+ + (1.05 ) v 20 a
20
) 12a( )
4
25
Rearranging:
25
( 4 ) 1 (1.05v )
( 4)
1309.5 = 100a
12a
5
5
25
1 (1.05v )
At 9%, RHS is:

1.05 25
1

1.09
100 1.033144 3.8897

12 1.033144 9.8226
5
1.05
1

1.09
0.607292
= 401.8570
121.7779
0.170505
= 1309.53 IRR is 9% p.a.
Page 6
(ii)
For Project B the equation of value is

( 4)
20
1000 = 85a
Roughly 1000
At
( 4)
5
+ v 20 90a
85a25 i
7%
7% RHS is 1039.05
= 85 1.043380 10.5940 + 0.25842 1.043380 4.1002 90
8% RHS is 956.78
= 85 1.049519 9.8181 + 0.21455 1.049519 3.9927 90
i
(iii)
7.5% p.a.
Project A is more attractive since it has the higher IRR. However, the investor
will also need to take into account other factors such as:
the outlay is much higher for Project A than Project B
the interest rate at which the investor might need to borrow at to finance a
project since it will affect the net present values and discounted payback
periods of the projects
the risks for each project that the rents and expenses will not be those
assumed in the calculations.
In part (i) candidates were asked to demonstrate that the internal rate of return was a given
value. In such questions, candidates should set up the equation of value and clearly show
each stage of their algebra and their calculations (including the evaluation of all factors that
make up the equation). Many candidates claimed that they had shown the correct answer
despite obvious errors and/or insufficient working. Candidates who tried to create a
proof where the arguments didnt follow logically gained few marks. In this type of
question, if you cant complete a proof, it is better to show how far you have got and be open
about being unable to proceed further. This will generally gain more intermediate markst.
Part (ii) was answered well but in part (iii) few candidates came up with any of the other
factors that should be considered.
Page 7
(i)
Price per 100 nominal is given by:

1 v18
3.158%
18
3.158%
P = 5 a18
+ 100v18
=
+ 100v3.158% = 125.00
3.158%
0.03158
(ii)
As coupons are payable annually and the gross redemption yield is equal to
the annual coupon rate, the new price per 100 nominal is 100.
i.e. P
(iii)
5%
= 5a13
+ 100v13
5%
1 v13
5%
= 5
0.05
13
+ 100v5% = 100.00
Equation of value is:
125.00 = 5a5 + 100v5 i = 0%

Thus, the investor makes a return of 0% per annum over the period.
(iv)
Longer-dated bonds are more volatile.

Thus, as a result of the rise in gross redemption yields from 3.158% per annum
on 1 March 2007 to 5% on 1 March 2012, the fall in the price of the bond
would be greater.
Thus, as the income received over the period would be unchanged, the overall
return achieved would be reduced (as a result of the greater fall in the capital
value).
[In fact, the price on 1 March 2007 would have been 133.91 per 100
nominal falling to 100 per 100 nominal on 1 March 2012.
i.e. in this case, we need to find i such that 133.91 = 5a5 + 100V 5 i < 0% .]
The first three parts were generally well-answered although relatively few candidates noticed
that parts (ii) and (iii) could be answered quickly and consequently many candidates made
avoidable calculation errors.
(i)
E (1 + i ) = e
=e
+ 1 2 2
0.05+ 1 20.004
= 1.0533757
E [i ] = 0.0533757 since E (1 + i ) = 1 + E ( i )
Page 8
Let A be the accumulation of 5000 at the end of 20 years

then E [ A] = 5000 s20 at rate j = 0.0533757
(1 + j ) 1)
(
= 5000
(1 + j )
20
(1.0533757
= 5000
20
) 1.0533757
0.0533757
= 180,499
(ii)
Let the accumulation be S20

S20 has a log-normal distribution with parameters 20 and 202
E [ S20 ] = e
20+ 12 202
{or (1 + j ) }
20
= exp ( 20 0.05 + 10 0.004 )

= e1.04
= 2.829217
ln S20 N 20, 202
i.e. ln S20 N (1, 0.08)
P S20 > e1.04 = P ( ln S20 > 1.04 )

1.04 1
= P Z >
where
0.08
Z N ( 0,1)
= P ( Z > 0.14 ) = 1 ( 0.14 )
= 1 0.56 = 0.44
Questions regarding annual investments are comparatively rarely asked on this topic and
students seemed to struggle with part (i). Part (ii) was answered better in general than
equivalent questions in previous exams.
Page 9
(i)
for t > 8
v ( t ) = exp
5
0
0.04 + 0.003t 2 dt + 0.01 + 0.03tdt + 0.02dt
5
8
t
= exp 0.04t + 0.001t 3 + 0.01t + 0.015t 2 + [ 0.02t ]8
0
5
}
}
= exp 0.2 + 0.125 + 0.01 3 + 0.015 82 52 + 0.02t 0.02 8
= exp {0.325 + 0.615 + 0.02t 0.16}

0.78+ 0.02t )
=e (
Hence PV of 1,000 due at t = 10 is:
1000 exp ( 0.78 + 0.02 10 ) = 375.31
(ii)
d ( 4)
1000 1
410
= 375.31
40
d ( 4)
375.31
1
=
4
1000
4
d( )
375.31 140
= 4 1
1000
= 0.09681
(iii)
18
PV = ( t ) v ( t ) dt
10
18
0.78+ 0.02t )
= 100e0.01t e (
10
18
= 100e0.78 e0.01t dt
10
= 100e
Page 10
0.01t 18
0.01 10
0.78 e
100 0.78 0.1 0.18

e
e
e
0.01
= 318.90
Parts (i) and (ii) were answered well. Some candidates made errors in part (iii) by not
discounting the payment stream back to time 0.
9
(i)
PV = 100 0.35 1.03v + 1.03 1.05v 2 + 1.03 1.05 1.06v3 + 1.03 1.05 1.062 v 4 +
1.03 1.05 1.06v3

= 35 1.03v + 1.03 1.05v 2 +
@ 8%
1.06
v
1.03 1.03 1.05 1.03 1.05 1.06 1.08

= 35
+
+
0.02
1.082
1.083
1.08
= 35 ( 0.95370 + 0.92721 + 49.14223)
= 1785.81
(ii)
Real rate of return is i such that:
110
110 2
110 3
110 3
1720 = 35 1.03
v + 1.03 1.05
v + 1.03 1.05 1.06
v + 1800
v
112.3
113.2
113.8
113.8
= 35 1.0089047v + 1.050928v 2 + 1.108110v3 + 1739.894552v3

= 35.3116645v + 36.78248v 2 + 1778.678402v3
For initial estimate, assume all income received at end of 3 years:

1720 1850.77v3
v 0.9758696 i 2.4727
Try i = 2.5%, RHS = 1721.14 1720
so i = 2.5%
Most candidates made a good attempt at part (i) although slight errors in setting up the
equation and/or in the calculation were common. Many candidates struggled with setting up
the required equation in part (ii).
Page 11
10
(i)
Working in 000s
PVL = 200a20 + 300v15 @ 8%

= 200 9.818147 + 300 0.315242
= 2058.20199
i.e. 2,058,201.99
(ii)
DMTL =
=
200v + 200 2v 2 + 200 3v3 +
+ 200 20v 20 + 300 15v15
200a20 + 300v15
200 ( Ia )20 + 300 15v15
@ 8%
2058.20199
200 78.9079 + 300 15 0.31524
=
2058.20199
17200.175
=
= 8.3569 years
2058.20199
(iii)
Redingtons first two conditions are:

PVL = PVA
DMTL = DMTA
Let the nominal amount in securities A and B be X and Y respectively.
) (
PVA = PVL X 0.09a12 + v12 + Y 0.04a30 + v30 = 2058201.99 @ 8%

X ( 0.09 7.5361 + 0.39711) + Y ( 0.04 11.2578 + 0.09938 )
1.075361X + 0.549689Y = 2058201.99
2058201.99 0.549689Y
X=
1.075361
DMTA = DMTL
) (
X 0.09 ( Ia )12 + 12v12 + Y 0.04 ( Ia )30 + 30v30

2058201.99
X 0.09 ( Ia )12 + 12v
12
) + Y ( 0.04 ( Ia )
30
) = 8.3569
+ 30v30 = 17200175 @ 8%
X ( 0.09 42.17 + 12 0.39711) + Y ( 0.04 114.7136 + 30 0.09938 ) = 17200175

8.56066 X + 7.56986Y = 17200175
8.56066
( 2058201.99 0.549689Y ) + 7.56986Y = 17200175
1.075361
3.19394Y = 815370.9
Y = 255287, X = 1783470
Page 12
Hence company should purchase 1,783,470 nominal of security A and

255,287 nominal of security B for Redingtons first two conditions to be
satisfied.
(iv)
Redingtons third condition is that the convexity of the asset cash flow series
is greater than the convexity of the liability cash flow series. Therefore the
convexities of the asset cash flows and the liability cash flows will need to be
calculated and compared.
Generally well answered but candidates workings in part (iii) were often unclear which
made it difficult for examiners to award marks when calculation errors had been made.
Page 13
EXAMINATION
3 October 2012 (am)

Core Technical
1.
booklet.
2.
supervisor.
3.
4.
5.

question paper.
CT1 S2012
An investor is considering two investments. One is a 91-day deposit which pays a

rate of interest of 4% per annum effective. The second is a treasury bill.
Calculate the annual simple rate of discount from the treasury bill if both investments
are to provide the same effective rate of return.
[3]
The nominal rate of discount per annum convertible quarterly is 8%.

(i)
Calculate the equivalent force of interest.
[1]
(ii)
Calculate the equivalent effective rate of interest per annum.
[1]
(iii)
Calculate the equivalent nominal rate of discount per annum convertible

monthly.
[2]
[Total 4]
An investment fund is valued at 120m on 1 January 2010 and at 140m on 1 January

2011. Immediately after the valuation on 1 January 2011, 200m is paid into the
fund. On 1 July 2012, the value of the fund is 600m.
(i)
Calculate the annual effective time-weighted rate of return over the two-and-a
half year period.
[3]
(ii)
Explain why the money-weighted rate of return would be higher than the timeweighted rate of return.
[2]
[Total 5]
A ten-month forward contract was issued on 1 September 2012 for a share with a
price of 10 at that date. Dividends of 1 per share are expected on 1 December
2012, 1 March 2013 and 1 June 2013.
(i)
Calculate the forward price assuming a risk-free rate of interest of 8% per

annum convertible half-yearly and no arbitrage.
[4]
(ii)
Explain why it is not necessary to use the expected price of the share at the
time the forward matures in the calculation of the forward price.
[2]
[Total 6]
CT1 S20122
(i)
State the characteristics of a Eurobond
[4]
(ii)
(a)
State the characteristics of a certificate of deposit.
(b)
Two certificates of deposit issued by a given bank are being traded. A

one-month certificate of deposit provides a rate of return of 12 per cent
per annum convertible monthly. A two-month certificate of deposit
provides a rate of return of 24 per cent per annum convertible monthly.
Calculate the forward rate of interest per annum convertible monthly in
the second month, assuming no arbitrage.
[4]
[Total 8]
A loan is to be repaid by an increasing annuity. The first repayment will be 200 and
the repayments will increase by 100 per annum. Repayments will be made annually
in arrear for ten years. The repayments are calculated using a rate of interest of 6%
(i)
Calculate the amount of the loan
(ii)
(a)
(b)
[2]
Calculate the interest component of the seventh repayment.

Calculate the capital component of the seventh repayment.
[4]
(iii)
Immediately after the seventh repayment, the borrower asks to have the
original term of the loan extended to fifteen years and wishes to repay the
outstanding loan using level annual repayments. The lender agrees but
changes the interest rate at the time of the alteration to 8% per annum
effective.
Calculate the revised annual repayment.
CT1 S20123
[3]
[Total 9]
PLEASE TURN OVER
An individual wishes to make an investment that will pay out 200,000 in twenty
years time. The interest rate he will earn on the invested funds in the first ten years
will be either 4% per annum with probability of 0.3 or 6% per annum with probability
0.7. The interest rate he will earn on the invested funds in the second ten years will
also be either 4% per annum with probability of 0.3 or 6% per annum with probability
0.7. However, the interest rate in the second ten year period will be independent of
that in the first ten year period.
(i)
Calculate the amount the individual should invest if he calculates the

investment using the expected annual interest rate in each ten year period. [2]
(ii)
Calculate the expected value of the investment in excess of 200,000 if the

amount calculated in part (i) is invested.
[3]
(iii)
Calculate the range of the accumulated amount of the investment assuming the
amount calculated in part (i) is invested.
[2]
[Total 7]
0.03 + 0.01t for 0 t 9
(t ) =
for 9 < t
0.06
(i)
Derive, and simplify as far as possible, expressions for (t) where (t) is the
[5]
(ii)
(a)
Calculate the present value of 5,000 due at the end of 15 years.
(b)
Calculate the constant force of interest implied by the transaction in

part (a).
[4]
A continuous payment stream is received at rate 100e 0.02t units per annum between
t = 11 and t = 15.
(iii)
CT1 S20124
Calculate the present value of the payment stream.
[4]
[Total 13]
(i)
Describe three theories that have been put forward to explain the shape of the
yield curve.
[7]
The government of a particular country has just issued five bonds with terms to
redemption of one, two, three, four and five years respectively. The bonds are
redeemed at par and have coupon rates of 4% per annum payable annually in arrear.
(ii)
Calculate the duration of the one-year, three-year and five-year bonds at a

gross redemption yield of 5% per annum effective.
[6]
(iii)
Explain why a five-year bond with a coupon rate of 8% per annum would have
a lower duration than a five-year bond with a coupon rate of 4% per annum.
[2]
Four years after issue, immediately after the coupon payment then due the
government is anticipating problems servicing its remaining debt. The government
offers two options to the holders of the bond with an original term of five years:
Option 1: the bond is repaid at 79% of its nominal value at the scheduled time with no
final coupon payment being paid.
Option 2: the redemption of the bond is deferred for seven years from the original
redemption date and the coupon rate reduced to 1% per annum for the remainder of
the existing term and the whole of the extended term.
Assume the bonds were issued at a price of 95 per 100 nominal.
(iv)
Calculate the effective rate of return per annum from Options 1 and 2 over the
total life of the bond and determine which would provide the higher rate of
return.
[6]
(v)
Suggest two other considerations that bond holders may wish to take into
account when deciding which options to accept.
[2]
[Total 23]
CT1 S20125
PLEASE TURN OVER
10
Two investment projects are being considered.

(i)
Explain why comparing the two discounted payback periods or comparing the
two payback periods are not generally appropriate ways to choose between
two investment projects.
[3]
The two projects each involve an initial investment of 3m. The incoming cash flows
from the two projects are as follows:
Project A
In the first year, Project A generates cash flows of 0.5m. In the second year it will
generate cash flows of 0.55m. The cash flows generated by the project will continue
to increase by 10% per annum until the end of the sixth year and will then cease.
Assume that all cash flows are received in the middle of the year.
Project B
Project B generates cash flows of 0.64m per annum for six years. Assume that all
cash flows are received continuously throughout the year.
(ii)
(a)
Calculate the payback period from Project B.
(b)
Calculate the discounted payback period from Project B at a rate of

interest of 4% per annum effective.
[5]
(iii)
Show that there is at least one cross-over point for Projects A and B between
0% per annum effective and 4% per annum effective where the cross-over
point is defined as the rate of interest at which the net present value of the two
projects is equal.
[6]
(iv)
Calculate the duration of the incoming cash flows from Projects A and B at a
rate of interest of 4% per annum effective.
[6]
(v)
Explain why the net present value of Project A appears to fall more rapidly
than the net present value of Project B as the rate of interest increases.
[2]
[Total 22]
END OF PAPER
CT1 S20126
EXAMINERS REPORT

Core Technical
Introduction
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.
The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.
D C Bowie
December 2012
Subject CT1 (Financial Mathematics) September 2012 Examiners Report

The general performance was of a lower standard compared with the previous two exams.
Well-prepared candidates scored well across the whole paper. As in previous diets, questions
that required an element of explanation or analysis, such as Q3(ii), Q4(ii) and Q9(iii) were
less well answered than those that just involved calculation. This is an area to which
attention should be paid. Candidates should note that it is important to explain and show
understanding of the concepts and not just mechanically go through calculations. At the
other end of the spectrum, there was a difficulty for many candidates when it came to
answering questions involving introductory ideas.
The comments that follow the questions concentrate on areas where candidates could have
improved their performance. Where no comment is made the question was generally
answered well by most candidates.
Page 2
Let d be the annual simple rate of discount.

The discounted value of 100 in the deposit account would be x such that:
x = 100(1.04)91/365 = 99.0269
to provide the same effective rate of return a treasury bill that pays 100 must have a
91
price of 99.0269 and 100 1

d = 99.0269
365
91
99.0269
d =
= 0.990269
365
100
d = (1-0.990269)
365
=0.03903
91
Many candidates scored full marks on this question but many others failed to score any
marks at all. Some candidates incorrectly used (1-nd) as an accumulation factor
/4
0.08
= 0.98 = 0.080811
4
= 1
(i)
(ii)
0.08
(1 + i)1 = 1
= 0.92237 i = 0.084166
4
(iii)
d (12)
1
12
12
0.08
(12)
= 1
= 0.080539
= 0.92237 d
4
A lot of marginal candidates scored very badly on this question even though it was covering
an introductory part of the syllabus.
(i)
(1 + i )2.5 =
140
600
= 2.05882
120 140 + 200
1 + i = 1.33490
i = 33.49% p.a. effective.
(ii)
The money weighted rate of return weights performance according to the

amount of money in the fund. The fund was performing better after it had
been given the large injection of money on 1/1/2011.
Page 3
Part (i) was answered well. The type of explanation asked for in part (ii) is commonly asked
for in CT1 exams. To get full marks, candidates should address the specific situation given in
the question rather than just repeat the bookwork.
(i)
Present value of dividends, I, is:
I= v
+v
+v
Calculated at i% when (1 + i ') = (1.04)2 = 1.0816

1
So I = 1.0816 4 + 1.0816
= 2.88499
12
+ 1.0816
34
Hence, forward price, F, is:

10
F = (10 2.88499)(1 + i)
12
at 8.16%
= (10 2.88499 ) 1.0816
10
Page 4
12
= 7.5956
(ii)
The price of the forward can be determined from the price of the share (for
which it is a close substitute). The forward is like the share but with delayed
settlement and without dividends.
(i)
The characteristics of a Eurobond are:

Medium- or long-term borrowing
Unsecured
Regular coupon payments
Redeemed at par
Issued and traded internationally/not in the jurisdiction of any one country
Can be denominated in any currency (e.g. not the currency of issuer)
Tend to be issued by large companies, governments or supra-national
organisations
Yields depend on issue size and issuer (or marketability and risk)
Issue characteristics may vary market free to allow innovation
(ii)
(a)
The characteristics of a certificate of deposit are:

Tradable certificate issued by banks stating that money has been
deposited
Terms to maturity between one and six months
Interest payable on maturity/issued at a discount
Security and marketability will depend on issuing bank
Active secondary market
(b)
Answer is i such that (1.01)
12
12
i( ) = 36.119%
(i)
12
i (12 )
24
1 +
= (1.02 ) giving
12
Amount of loan is:
100( Ia)10 + 100a10 at 6% p.a.

= 100 36.9624 + 100 7.3601
= 3696.24 + 736.01 = 4,432.25
(ii)
(a)
the o/s loan after sixth instalment is:
100( Ia)4 + 700 a4

=100 8.4106 + 700 3.4651 = 841.06 + 2425.57 = 3,266.64
The interest component is therefore:
0.06 3266.64 = 196.00
(b)
The capital component =

800-196.00 = 604.00
(iii)
The capital remaining after the seventh instalment is

3266.64 604.00 = 2662.64
Let the new instalment = X
Xa8 = 2, 662.64 at 8%
a8 = 5.7466; X = 2,662.64/5.7466 = 463.34
(i)
Expected annual interest rate in both ten-year periods =

0.04 0.3 + 0.06 0.7 = 0.054 or 5.4%
Amount of the investment would be X such that:
X (1.054)20 = 200,000
X = 69,858.26
Page 5
(ii)
Expected accumulation factors in both ten-year periods are:

0.3 (1.04)10 + 0.7(1.06)10 = 1.697667
The accumulation factors in each ten-year period are independent.
Therefore the expected accumulation is:
69,858.26 1.697667 1.697667
= 201,336.55
Therefore the value of investment over and above 200,000 = 1,336.55.
(iii)
The extreme outcomes for the investment are:

69,858.26 1.0420 = 153,068.06
69,858.26 1.0620 = 224,044.91.
Therefore the range is: 70,976.85
Many candidates struggled with this question and seemed to have difficulty particularly with
part (ii). Part (iii) was also badly answered even though part (ii) was not needed to answer
part (iii).
(i)
t9
t
v(t ) = e
(0.03+0.01 s ) ds
0
0.01s 2 t
0.03s +
0
=e
0.03t +0.005t 2
=e
t>9
V (t )
t
9
( s ) ds + 0.06 ds
9
= e 0
= V (9).e0.06(t 9)
= e0.675 .e0.06(t 9)
= e(0.135+0.06t )
Page 6
(ii)
PV = 5, 000 e(0.135+0.0615)
(a)
= 5, 000 e1.035
= 1, 776.13
1,776.13 e15 = 5,000
(b)
e15 = 2.81511
15 = ln 2.81511
=
ln 2.81511
= 0.0690
15
(iii)
15
P.V . =
(0.135+ 0.06t )
100 e0.02t dt
11
15
= 100 e0.1350.08t dt
11
15
= 100 e
0.135
e0.08t
0.08 11
= 100 e0.135 (5.18479 3.76493)

= 124.055
Generally answered well but some candidates lost marks in part (i) by not deriving the
discount factor for t < 9.
(i)
Expectations theory: yields on short and long-term bonds are determined by

expectations of future interest rates as it is assumed that a long-term bond is a
substitute for a series of short-term bonds.
[If interest rates are expected to rise (fall) long-term bonds will have higher
(lower) yields that short-term bonds.]
Liquidity preference: it is assumed that investors have an inherent preference
for short-term bonds because interest-rate sensitivity is lower. As such, (there
is an upward bias on the expectations-based yield curve) and longer-term
bonds will offer a higher expected return than implied by expectations theory
on its own. N.B. the part in brackets is not in core reading.
Market segmentation: bonds of different terms to redemption are attractive to
different investors with different liabilities.
Page 7
The supply of bonds of different terms to redemption will depend on the

strategy of the relevant issuer. The term structure is determined by the
interaction of supply and demand in each term-to-redemption segment.
(ii)
Duration =
tCt t = 4 ( Ia)n + 100n vn

Ct t 4 an + 100 n
For n = 1 to 5. Clearly duration on one-year bond is one year.

Term
( Ia)n
100n
3
5
5.3580
12.5664
86.384
78.353
an
n100n
2.7232 259.152
4.3295 391.765
4( Ia ) n
21.432
50.2656
Duration of three-year bond:

21.432 + 259.152
= 2.884 years
4 2.7232 + 86.384
Duration of five-year bond:

50.2656 + 391.765
= 4.620 years
4 4.3295 + 78.353
(iii)
The duration of a bond is the average time of the cashflows weighted by

present value. The coupon payments of the 8% coupon bond will be a higher
proportion of the total proceeds than for the 4% coupon bond. Thus, a greater
proportion of the total proceeds of the 8% coupon bond will be received
before the end of the term. The average time of the cashflows will be shorter
and hence the duration will be lower.
(iv)
Option 1
The equation of value would be:
95 = 4a4 + 795
The rate of return is zero (incoming and outgoing cash flows are equal).
Option 2
The equation of value would be:
95 = 4a4 + 4 a8 + 10012
i = 2.5%
Page 8
RHS = 4 3.762 + 0.90595 7.1701 + 100 0.74356

= 15.0479 + 6.4958 + 74.3556 = 95.8993
i = 3%
RHS = 4 3.7171 + 0.88849 7.0197 + 100 0.70138
= 14.8684 + 6.2369 + 70.1380
= 91.2433
By interpolation:
95.8998 95
i = 0.005
+ 0.025
95.8998 91.2433
= 0.025966 or 2.6% per annum effective.

Hence Option 2 would provide the higher rate of return
(v)
Two of the following:
Option 2 creates a higher duration bond which might not be suitable for
the investor
.e.g. alternative investments may be available in the longer term
The credit risk over the longer duration may be greater
The inflation risk over the longer duration may be greater
There may be tax implications because of the differing capital and income
combinations.
the institution could reinvest the proceeds from option 1 at whatever rate
of return prevails.
Part (i) was often poorly answered even though this was bookwork and candidates also
struggled with part (ii). In part (ii) it is important to include the correct units for the
duration (in this case, years). Most candidates made a good attempt at part (iv) even if some
made calculation errors (e.g. in the calculation of the outstanding term of the bond under
Option 2). Marginal candidates scored badly on parts (iii) and (v).
10
(i)
The payback period simply looks at the time when the total incoming cash
flows are greater than the total outgoing cash flows. It takes no account of
interest at all.
Though the discounted payback period takes account of interest that would
have to be paid on loans, it only looks at when loans used to finance outgoing
cash flows would be repaid and not at the overall profitability of the projects.
(ii)
(a)
Outgoing cash flow = 3m

In m, at time t, total incoming cash flows are 0.64t
Page 9
We need t such that 3 = 0.64t

t=3
(b)
0.64
= 4.6875 years
Present value of incoming cash flows at time t is:

1 t
0.64at = 0.64

where = 0.039221
Require t such that:

1 t
=3
0.64
0.039221
1 - t = 0.183848
= 0.816152
t
t ln = ln 0.816152
t =
ln 0.816152
ln
=
(iii)
0.203155
= 5.1798 years
0.039221
Crossover point is the rate of interest at which the n.p.v. of the two projects is
equal. As the present value of the cash outflows for both projects is the same
at all rates of interest, the crossover point is the rate of interest at which the
present value of the cash inflows from both projects is equal.
P.V of cash inflows from Project B = 0.64a6
P.V of cash inflows from Project A =
0.5
+ 1.1 0.5 1 + " + 1.15 0.5
1 1.16 6
= 0.5
1 1.1
1
Therefore require i such that:

6 6
1 1 1.1
0.64 a6 0.5 2
=0
1 1.1
Page 10
5 12
Let i = 4%
a6 = 5.2421 i = 1.019869
= 0.98058
= 0.96154
6 = 0.79031
1.16 = 1.77156
1 1.77156 0.79031
LHS = 0.64 5.2421 1.019869 0.5 0.98058
1 1.1 0.96154
= 3.4216 0.49029 6.93490 = 3.4216 3.4001
= 0.0215
Let i = 0%
1 1.77156
= 3.84 - 3.8578 = -0.0178
LHS = 0.64 6 0.5
1 1.1
Given that NPV of Project A is greater than that of project B at 0% per annum
effective and the reverse is true at 4% per annum effective, the NPV of the two
projects must be equal at some point between 0% and 4%.
(iv)
Project A
Duration is:
1
2 0.5(0.5 + 1.11.5 + 1.12 2.5 2 + 1.13 3.53 + 1.14 4.5 4 + 1.15 5.5 5 )
0.49029 6.93490
Term in brackets is
0.5 + 1.58654 + 2.79678 + 4.14139 + 5.63183 + 7.28047 = 21.93702.
Duration =
0.98059 0.5 21.93702

= 3.163 years
0.49029 6.93490
Project B
6
0.64 t t dt
Duration is :
0
6
0.64 t dt
( Ia )6
a6
(
=
a6 6 6
i
a6
Page 11
(1.019869 5.2421 6 0.79031)
0.039221
1.019869 5.2421
15.41000
= 2.882 years
5.3462
(v)
Project A has a longer duration and therefore the present value of its incoming
cash flows is more sensitive to changes in the rate of interest. As such, when
the interest rate rises, the present value of incoming cash flows falls more
rapidly than for Project B.
Most candidates could calculate the discounted payback period but struggled with the
undiscounted equivalent. As in Q9, the units should be included within the answer. The
working of many candidates in part (iii) was often unclear even when the formulae were
correctly derived. In part (iv) many candidates incorrectly thought the duration should be
( Ia )6
for Project B.
a6
Page 12
EXAMINATION
15 April 2013 (pm)

Core Technical
1.
booklet.
2.
supervisor.
3.
4.
5.

question paper.
CT1 A2013
The value of the assets held by an investment fund on 1 January 2012 was 1.3
million.
On 30 September 2012, the value of the assets was 1.9 million.
On 1 October 2012, there was a net cash outflow from the fund of 0.9 million.
On 31 December 2012, the value of the assets was 0.8 million.
(i)
[2]
(ii)
Calculate the annual effective money-weighted rate of return (MWRR) for

2012 to the nearest 1%.
[3]
(iii)
Explain why the MWRR is significantly higher than the TWRR.
(i)
Explain the main difference:

(a)
(b)
[2]
[Total 7]
between options and futures.

between call options and put options.
[4]
(ii)
A one-year forward contract is issued on 1 April 2013 on a share with a price

at that date of 10.50. Dividends of 1.10 per share are expected on 30
September 2013 and 31 March 2014. On 1 April 2013, the 6-month risk-free
spot rate of interest is 4.5% per annum convertible half-yearly and the
12-month risk-free spot rate of interest is 5% per annum convertible halfyearly.
Calculate the forward price at issue, stating any further assumptions made. [4]
[Total 8]
Three bonds each paying annual coupons in arrear of 6% and redeemable at 103 per
100 nominal reach their redemption dates in exactly one, two and three years time,
respectively. The price of each bond is 97 per 100 nominal.
(i)
Calculate the gross redemption yield of the 3-year bond.
(ii)
Calculate the one-year and two-year spot rates implied by the information
given.
[3]
[Total 6]
CT1 A20132
[3]
An investor is interested in purchasing shares in a particular company.

The company pays annual dividends, and a dividend payment of 30 pence per share
has just been made.
Future dividends are expected to grow at the rate of 5% per annum compound.
(i)
Calculate the maximum price per share that the investor should pay to give an
effective return of 9% per annum.
[4]
(ii)
Without doing any further calculations, explain whether the maximum price
paid will be higher, lower or the same if:
(a)
after consulting the managers of the company, the investor increases

his estimate of the rate of growth of future dividends to 6% per annum.
(b)
as a result of a government announcement, the general level of future

price inflation in the economy is now expected to be 2% per annum
higher than previously assumed.
(c)
general economic uncertainty means that, whilst the investor still

estimates future dividends will grow at 5% per annum, he is now much
less sure about the accuracy of this assumption.
You should consider the effect of each change separately.
[6]
[Total 10]
The force of interest per unit time at time t, (t), is given by:
0.1 0.005t for t < 6
(t ) =
for t 6
0.07
(i)
Calculate the total accumulation at time 10 of an investment of 100 made at

time 0 and a further investment of 50 made at time 7.
[4]
(ii)
Calculate the present value at time 0 of a continuous payment stream at the

rate 50e0.05t per unit time received between time 12 and time 15.
[5]
[Total 9]
CT1 A20133
PLEASE TURN OVER
A cash sum of 10,000 is invested in a fund and held for 15 years. The yield on the
investment in any year will be 5% with probability 0.2, 7% with probability 0.6 and
9% with probability 0.2, and is independent of the yield in any other year.
(i)
Calculate the mean accumulation at the end of 15 years.
[2]
(ii)
Calculate the standard deviation of the accumulation at the end of 15 years. [5]
(iii)
Without carrying out any further calculations, explain how your answers to
parts (i) and (ii) would change (if at all) if:
(a)
the yields had been 6%, 7% and 8% instead of 5%, 7%, and 9% per
annum, respectively.
(b)
the investment had been held for 13 years instead of 15 years.

[4]
[Total 11]
An insurance company has liabilities of 6 million due in 8 years time and 11

million due in 15 years time. The assets consist of two zero-coupon bonds, one
paying X in 5 years time and the other paying Y in 20 years time. The current
interest rate is 8% per annum effective. The insurance company wishes to ensure that
it is immunised against small changes in the rate of interest.
(i)
(ii)
CT1 A20134
Determine the values of X and Y such that the first two conditions for
Redingtons immunisation are satisfied.
[8]
Demonstrate that the third condition for Redingtons immunisation is also

satisfied.
[2]
[Total 10]
A car manufacturer is to develop a new model to be produced from 1 January 2016

for six years until 31 December 2021. The development costs will be 19 million on
1 January 2014, 9 million on 1 July 2014 and 5 million on 1 January 2015.
It is assumed that 6,000 cars will be produced each year from 2016 onwards and that
all will be sold.
The production cost per car will be 9,500 during 2016 and will increase by 4% each
year with the first increase occurring in 2017. All production costs are assumed to be
incurred at the beginning of each calendar year.
The sale price of each car will be 12,600 during 2016 and will also increase by 4%
each year with the first increase occurring in 2017. All revenue from sales is assumed
to be received at the end of each calendar year.
(i)
Calculate the discounted payback period at an effective rate of interest of 9%

per annum.
[9]
(ii)
Without doing any further calculations, explain whether the discounted

payback period would be greater than, equal to, or less than the period
calculated in part (i) if the effective rate of interest were substantially less than
9% per annum.
[2]
[Total 11]
A fixed-interest security pays coupons of 8% per annum half yearly on 1 January and
1 July. The security will be redeemed at par on any 1 January from 1 January 2017 to
1 January 2022 inclusive, at the option of the borrower.
An investor purchased a holding of the security on 1 May 2011, at a price which gave
him a net yield of at least 6% per annum effective. The investor pays tax at 30% on
interest income and 25% on capital gains.
On 1 April 2013 the investor sold the holding to a fund which pays no tax at a price to
give the fund a gross yield of at least 7% per annum effective.
(i)
Calculate the price per 100 nominal at which the investor bought the security.
[5]
(ii)
Calculate the price per 100 nominal at which the investor sold the security.
[3]
(iii)
Show that the effective net yield that the investor obtained on the investment
was between 8% and 9% per annum.
[6]
[Total 14]
CT1 A20135
PLEASE TURN OVER
10
A loan is repayable by annual instalments in arrear for 20 years. The initial

instalment is 5,000, with each subsequent instalment decreasing by 200.
The effective rate of interest over the period of the loan is 4% per annum.
(i)
Calculate the amount of the original loan.
[3]
(ii)
Calculate the capital repayment in the 12th instalment.
[3]
After the 12th instalment is paid, the borrower and lender agree to a restructuring of
the debt.
The 200 reduction per year will no longer continue. Instead, future instalments will
remain at the level of the 12th instalment and the remaining term of the debt will be
shortened. The final payment will then be a reduced amount which will clear the
debt.
(iii)
(a)
(b)
(c)
Calculate the remaining term of the revised loan.

Calculate the amount of the final reduced payment.
Calculate the total interest paid during the term of the loan.
[8]
[Total 14]
END OF PAPER
CT1 A20136
EXAMINERS REPORT

Core Technical
Introduction
The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.
D C Bowie
July 2013

Comments on the April 2013 paper
This paper proved to be marginally more challenging than other recent papers and the general
performance was of a slightly lower standard compared with the previous April exams. Wellprepared candidates scored well across the whole paper. As in previous diets, questions that
required an element of explanation or analysis, such as Q1(iii) and Q4(ii) were less well
answered than those that just involved calculation. This is an area to which attention should
be paid. Candidates should note that it is important to explain and show understanding of the
concepts and not just mechanically go through calculations.
Page 2
(i)
TWRR, i , is given by:

1.9
0.8
= 1 + i i = 0.169 or 16.9% p.a.

1.3 1.9 0.9
(ii)
MWRR, i , is given by:

3
1.3 (1 + i ) 0.9 (1 + i )12 = 0.8
Then, we have:
i = 30% LHS = 0.729
0.8 0.729
i 0.3 + ( 0.4 0.3)
= 0.36
i = 40% LHS = 0.841
0.841 0.729
or 36% p.a.
(iii)
MWRR is higher as fund performs much better before the cash outflow than
after. As the fund is smaller after 1 October 2012, the effect of the poor
investment performance is less significant.
The calculations were performed well but the quality of the explanations in part (iii) was
often poor. A common error was to cite the large withdrawal itself as the reason for the
superior MWRR.
(i)
(a)
Options holder has the right but not the obligation to trade.
Futures both parties have agreed to the trade and are obliged to do so.
(b)
Call Option right but not the obligation to BUY specified asset in the
future at specified price.
Put Option right but not the obligation to SELL specified asset in the
future at specified price.
(ii)
Assume no arbitrage.
The present value of the dividends, I , is:
2
= 1.1 ( 0.977995 + 0.951814 )
I = 1.1v2.25% + 1.1v2.5%
= 2.12279
Hence, forward price F = (10.50 2.12279 ) 1.0252
= 8.8013
Page 3
(i)
97 = 6 a3 + 103v3
Try 9%
Try 8%
RHS = 94.723
RHS = 97.227
Interpolation gives
0.08 +
97.227 97
0.01
97.227 94.723
= 0.08091
i.e.
(ii)
8.09% p.a. (exact answer is 8.089%)
Let in = spot rate for term n

Then 97 = 109vi1%
i1 = 12.371% p.a.
97 = 6vi1% + 109vi22%
109 (1 + i2 )
= 97
6
1.12371
i2 = 9.049% p.a.
Part (i) was generally well answered. Some candidates wasted time in (ii) through using
linear interpolation to solve the yield for the one year bond.
(i)
Maximum price payable by investor is given by:

2
P = 0.30 1.05 v9% + 0.30 1.052 v9%
+
2
1.05 1.05 1.05

= 0.30
1
+
+
+
1.09 1.09 1.09
1
1.05
= 0.30
1.05
1.09 1
1.09
Page 4
1.09
1.05
1.05
= 0.30
= 0.30
0.09 0.05
1.09 0.09 0.05
= 7.875
(ii)
(a)
Increasing the expected rate of dividend growth, g , will increase the

maximum price that the investor is prepared to pay to purchase the
share since the dividend income is expected to be higher.
(b)
An increase in the expected rate of future price inflation is likely to

lead to an increase in both the expected rate of dividend growth (as
nominal level of profits should increase in line with inflation) and the
nominal return required from the investment (as the investor is likely
to want to maintain the required real return).
Thus, the maximum price that the investor is prepared to pay will be
(largely) unchanged in fact, it will increase slightly due to (1 + g)
term in numerator.
(c)
If the investor is more uncertain about the rate of future dividend

growth (whilst the expected dividend growth is unchanged), then the
required return, i, is likely to be increased to compensate for the
increased uncertainty.
Thus, the maximum price that the investor is prepared to pay will
reduce.
Part (i) was generally well answered although common errors included adding an extra 30
pence dividend at the start or to assume that the first dividend was payable immediately.
The examiners expected candidates to find part (ii) challenging and this was indeed the case
with very few candidates scoring full marks. In (ii)(b) full marks were awarded for a
reasoned argument that led to a final answer of either an increase or no change in the price.
In general, some credit was given for valid reasoning even if the final conclusion was
incorrect.
(i)
Accumulated value at time 10 is:
10
10
100 exp ( t ) dt + 50 exp ( t ) dt
10
6
10
(
)
= 100 exp 0.1 0.005t dt + 0.07dt + 50 exp 0.07dt
6
0
t =6
t =10
t =10
= 100 exp [ 0.1t 0.0025t 2 ]t =0 + [ 0.07t ]t =6 + 50 exp [ 0.07t ]t =7
Page 5
= 100 exp ([ 0.6 0.09] + 0.28 ) + 50 exp ( 0.21)

= 220.34 + 61.68
= 282.02
(ii)
Present value at time 0 is:

15
( t ) v ( t ) dt
12
15
50e
0.05t
12
exp ( s ) ds dt
t
6
0.05t
( 0.1 0.005s ) ds + 0.07 ds dt
50
e
exp

12
6
0
15
15
s =t
[
0.05t
2 ]s =6 [
50
e
exp
0.1
s
0.0025
s
s =0 + 0.07 s ]s =6 dt
12
15
50e
0.05t
exp ( [ 0.51 + ( 0.07t 0.42 )]) dt
0.05t
e0.090.07t dt
12
15
50e
12
= 50e
0.09
15
e 0.02t dt
12
t =15
= 50e
0.09
e0.02t
0.02 t =12
= 2,500e 0.09 ( e 0.24 e 0.30 )

= 104.67
Page 6
(i)
j = 0.05 0.2 + 0.07 0.6 + 0.09 0.2

= 0.07
mean accumulation = 10,000 (1 + j)15
= 10,000 (1.07)15
= 27,590.32
(ii)
s2 = 0.052 0.2 + 0.072 0.6 + 0.092 0.2 0.072

= 0.00506 0.00490
= 0.00016
Var (accumulation) = 10,0002{(1 + 2j + j2 + s2)15 (1 + j)30}
= 10,0002 {1.1450615 1.0730}
= 1,597,283.16
SD (accumulation) = 1597283.16 = 1, 263.84
(iii)
(a)
By symmetry j = 0.07 (as in (i))

Hence, mean (accumulation) will be the same as in (i) (i.e.
27,590.32).
The spread of the yields around the mean is lower than in (i). Hence,
the standard deviation of the accumulation will be lower than
1,263.84.
(b)
Mean (accumulation) < 27,590.32 since the investment is being

accumulated over a shorter period.
SD (accumulation) < 1,263.84 since investing over a shorter term
than in (i) will lead to a narrower spread of possible accumulated
amounts.
In part (i) some candidates misread the question and assumed the yield was fixed for the
whole ten years rather than varying each year.
Page 7
(i)
Need VA (i ) = VL (i ) with i = 0.08

VL(i) = 6v8 + 11v15
VA(i) = Xv5 + Yv20
Need VA (i ) = VL (i ) with i = 0.08
VL = 48v9 165v16
VA = 5Xv6 20Y v21
Thus we have to solve simultaneous equations:
(a)
(b)
6v8 + 11v15 = Xv5 + Yv20

48v9 165v16 = 5Xv6 20Y v21
Taking 5 times (a) + (1+i) times (b) we get

18v8 110v15 = 15Yv 20
18 (1 + i ) + 110 (1 + i )
12
Y =
15
Y = 13.79688
Substitute back in (a) to get X = 5.50877

Hence the values of the zero-coupon bonds are 5.50877 million and
13.79688 million.
(ii)
We need to check that the third condition is satisfied:

VA = 5 Xv 6 20Yv 21
VA = 30 Xv 7 + 420Yv 22
VA (0.08) = 30 5.50877 1.087 + 420 13.79688 1.0822
= 1162.31
VL = 48 v9 165 v16
VL = 432 v10 + 2640 v17
VL(0.08) = 432 1.0810 + 2640 1.0817
= 913.61
Therefore VA (0.08) > VL(0.08)
Thus the third condition is satisfied.
[Or note that since the assets have terms of 5 years and 20 years and the liabilities
have terms of 8 years and 15 years, the spread of assets around the mean term is
Page 8
greater than that of the liabilities. Hence, the convexity of assets is greater than the
convexity of liabilities].
The best answered question on the paper.
(i)
Work in millions
Let Discounted Payback Period from 1 January 2014 be n.
Then, considering project at the end of year n but before the outgo at the start
of year n + 1
19 9v
5v
6 9.5 v 2 + 1.04v3 + ... + (1.04 )
)
v )0
n 3 n 1
+ 6 12.6 v3 + 1.04v 4 + ... + (1.04 )
n 3 n
Hence, 19 + 8.6204 + 4.5872 75.6v3 57v 2
at 9%
1.04 n2
1
1.09
1.04
1 1.09
1.04 n2
and RHS = 10.4013 21.8 1

1.09
32.2076
1.04
1
Hence,
10.4013 21.8
1.09
1.04
1.09
n2
n 2
0.85796
1.04
( n 2 ) log
log 0.85796
1.09
n2
0.06653
= 3.262
0.02039
n 5.262
But sales are only made at the end of each calendar year.
DPP = 6 years
Page 9
(ii)
The DPP would be shorter using an effective rate of interest less than 9% p.a.
This is because the income (in the form of car sales) does not commence until
a few years have elapsed whereas the bulk of the outgo occurs in the early
years. The effect of discounting means that using a lower rate of interest has a
greater effect on the value of the income than on the value of the outgo
(although both values increase). Hence the DPP becomes shorter.
In part (i), many candidates valued the total outgo for the whole production run and then
attempted to find when the present value of income exceeded this. The working of many
marginal candidates was difficult to follow and it was not clear to the examiners what the
candidates were attempting to do.
(i)
D
0.08
0.7 = 0.056 < i ( 2 ) = 0.059126
(1 t1 ) =
6%
R
1
There is a capital gain and assume redeemed as late as possible.
Let P = Price at 1/5/11 per 100 nominal

4
( 2)
P = 0.7 8 a + 100v11 0.25 (100 P ) v11 (1 + i ) 12
11
P = 5.6 1.014782 7.8869 (1.06 )

P =
12
10 812
+ 75v
10 812
+ 0.25 Pv
45.6985 + 40.2839
10 812
1 0.25v
= 99.319
(ii)
D
( 2)
= 0.08 > i7% = 0.068816
R
Assume redeemed as soon as possible
3
2
Sale Price per 100 nominal = 8 a( ) + 100v 4 (1 + i ) 12
= ( 8 1.017204 3.3872 + 100 0.76290 ) (1.07 )

= 105.625
(iii)
Page 10
CGT is payable of (105.625 99.319 ) 0.25

= 1.5765
3
12
Equation of value:
99.319 = 0.7 4 v
+ 0.7 4 v
8
12
1812
12
+ 0.7 4 v 12 + 0.7 4 v
4
111
( 2)
99.319 = (1 + i ) 12 5.6 a + 104.0485v 12
12
+ (105.625 1.5765 ) v
11112
At 8%, RHS is 1.08

= 100.226
12
At 9% RHS is (1.09 )
11112
5.6 1.019615 1.7833 + 104.0485v
12
11112
5.6 1.022015 1.7591 + 104.0485v
= 98.568
and since 98.568 < 99.319 < 100.226, the net yield is between 8% and 9% p.a.
Many candidates struggled with the four month adjustment in part (i). Common errors
included:
ignoring the adjustment completely.

discounting the present value of payments by four months rather than accumulating.
adjusting the price at the end of the calculations (which does not allow for CGT
correctly).
In part (iii) some candidates wasted time by trying to solve the yield exactly rather than just
show that 8% was too low and 9% too high.
10
(i)
Original amount of loan is:

L = 5, 000v + 4,800v 2 + 4, 600v3 + + 1, 200v 20
= 5, 200 v + v 2 + + v 20 200 v + 2v 2 + + 20v 20
= 5, 200a20 200 ( Ia )20

= 5, 200 13.5903 200 125.1550
= 45, 638.56
(ii)
Amount of 12th instalment is 2,800.

Loan o/s after 11th instalment is given by PV of future repayments:
L11 = 2,800v + 2, 600v 2 + 2, 400v3 + + 1, 200v9
= 3, 000a9 200 ( Ia )9
= 3, 000 7.4353 200 35.2366

= 15, 258.58
Then, interest component of 12th instalment is: 0.04 15, 258.58 = 610.34 .
Page 11
Hence, capital repaid in 12th instalment is 2,800 610.34 = 2,189.66 .

(iii)
(a)
Then, after 12th instalment, loan o/s is

15, 258.58 2,189.66 = 13, 068.92 .
This will be repaid by level instalments of 2,800.

Thus, remaining term of loan is n given by:
13, 068.92 2,800 an4% an4% 4.6675 n = 6

i.e. remaining term is 6 years (i.e. loan is repaid by time 18)
(b)
We need to find reduced final payment, R , such that:

6
13, 068.92 = 2,800 a54% + Rv4%
0.79031R
= 13, 068.92 2,800 4.4518 R = 764.11
(c)
Total amount of interest paid is given by:

5, 000 + 4,800 + 4, 600 + + 2,800 + 5 2,800 + 764.11 45, 638.56
= 15, 925.55
In part (ii) the most common error was to not round n up, i.e. quoting a non-integer number
of years for the revised loan. Part (iii) was answered poorly with candidates often not
correctly allowing for the payments prior to the change in payment schedule.
Page 12
EXAMINATION
23 September 2013 (pm)

Core Technical
1.
booklet.
2.
supervisor.
3.
4.
5.

question paper.
CT1 S2013
The rate of interest is 4.5% per annum effective.

(i)
Calculate:
(a)
(b)
(c)
(d)
the annual effective rate of discount.

the nominal rate of discount per annum convertible monthly.
the nominal rate of interest per annum convertible quarterly.
the effective rate of interest over a five year period.
[5]
(ii)
Explain why your answer to part (i)(b) is higher than your answer to part
(i)(a).
[2]
[Total 7]
A nine-month forward contract is issued on 1 March 2012 on a share with a price of

1.80 at that date. Dividends of 10p per share are expected on 1 September 2012.
Calculate the forward price at issue assuming a risk-free rate of interest of 4% per
annum effective and no arbitrage.
[3]
A fixed-interest security pays coupons of 4% per annum, half-yearly in arrear and will
be redeemed at par in exactly ten years.
(i)
Calculate the price per 100 nominal to provide a gross redemption yield of
3% per annum convertible half-yearly.
[2]
(ii)
Calculate the price, 91 days later, to provide a net redemption yield of 3% per
annum convertible half-yearly if income tax is payable at 25%.
[2]
[Total 4]
Describe the characteristics of the cash flows that are paid and received in respect of:
(i)
(ii)
CT1 S20132
an index-linked security.
an equity.
[2]
[3]
[Total 5]
An investor is considering the purchase of two government bonds, issued by two

countries A and B respectively, both denominated in euro.
Both bonds provide a capital repayment of 100 together with a final coupon payment
of 6 in exactly one year. The investor believes that he will receive both payments
from the bond issued by Country A with certainty. He believes that there are four
possible outcomes for the bond from Country B, shown in the table below.
Outcome
Probability
No coupon or capital payment

Capital payment received, but no coupon payment received
50% of capital payment received, but no coupon payment received
Both coupon and capital payments received in full
0.1
0.2
0.3
0.4
The price of the bond issued by Country A is 101.

(i)
Calculate the price of the bond issued by Country B to give the same expected
return as that for the bond issued by Country A.
[3]
(ii)
Calculate the gross redemption yield from the bond issued by Country B
assuming that the price is as calculated in part (i).
(iii)
[1]
Explain why the investor might require a higher expected return from the bond
issued by Country B than from the bond issued by Country A.
[2]
[Total 6]
A pension fund is considering investing in a major infrastructure project. The fund

has been asked to make an investment of 2m for a 1% share in revenues from
building a road. No other costs will be incurred by the pension fund. The following
revenues are expected to arise from the project:
In the first year, 40,000 vehicles a day will use the road, each paying a toll of 1.
In the second year, 50,000 vehicles a day will use the road, each paying a toll of
1.10.
In the third year, both the number of vehicles using the road and the level of tolls will
rise by 1% from their level in the second year. They will both continue to rise by 1%
per annum compound until the end of the 20th year.
At the end of the 20th year, it is assumed that the road has no value as it will have to
be completely rebuilt.
You should assume that all revenue is received continuously throughout the year and
that there are 365 days in all years.
Calculate the net present value of the investment in the road at a rate of interest of 8%
[10]
CT1 S20133
PLEASE TURN OVER
An insurance company has just written contracts that require it to make payments to
policyholders of 10 million in five years time. The total premiums paid by
policyholders at the outset of the contracts amounted to 7.85 million. The insurance
company is to invest the premiums in assets that have an uncertain return. The return
from these assets in year t, it, has a mean value of 5.5% per annum effective and a
standard deviation of 4% per annum effective. (1+it) is independently and
lognormally distributed.
(i)
Calculate the mean and standard deviation of the accumulation of the

premiums over the five-year period. You should derive all necessary formulae.
[Note: You are not required to derive the formulae for the mean and variance
of a lognormal distribution.]
[9]
A director of the insurance company is concerned about the possibility of a

considerable loss from the investment strategy suggested in part (i). He therefore
suggests investing in fixed-interest securities with a guaranteed return of 4 per cent
(ii)
Explain the arguments for and against the directors suggestion.
[3]
[Total 12]
Mrs Jones invests a sum of money for her retirement which is expected to be in 20
years time. The money is invested in a zero coupon bond which provides a return of
5% per annum effective. At retirement, the individual requires sufficient money to
purchase an annuity certain of 10,000 per annum for 25 years. The annuity will be
paid monthly in arrear and the purchase price will be calculated at a rate of interest of
4% per annum convertible half-yearly.
(i)
Calculate the sum of money the individual needs to invest at the beginning of
the 20-year period.
[5]
The index of retail prices has a value of 143 at the beginning of the 20-year period and
340 at the end of the 20-year period.
(ii)
Calculate the annual effective real return the individual would obtain from the
zero coupon bond.
[2]
The government introduces a capital gains tax on zero coupon bonds of 25 per cent of
the nominal capital gain.
(iii)
Calculate the net annual effective real return to the investor over the 20-year
period before the annuity commences.
[3]
(iv)
Explain why the investor has achieved a negative real rate of return despite
capital gains tax only being a tax on the profits from an investment.
[2]
[Total 12]
CT1 S20134
A bank makes a loan to be repaid by instalments paid annually in arrear. The first
instalment is 400, the second is 380 with the payments reducing by 20 per annum
until the end of the 15th year, after which there are no further repayments. The rate of
interest charged is 4% per annum effective.
(i)
Calculate the amount of the loan.
[3]
(ii)
Calculate the capital and interest components of the first payment.
[2]
At the beginning of the ninth year, the borrower can no longer make the scheduled
repayments. The bank agrees to reduce the capital by 50 per cent of the loan
outstanding after the eighth repayment. The bank requires that the remaining capital
is repaid by a 10-year annuity paid annually in arrear, increasing by 2 per annum.
The bank changes the rate of interest to 8% per annum effective.
(iii)
10
Calculate the first repayment under the revised loan.
[5]
[Total 10]
given by the formula:
(t) = 0.05 + 0.002t
Calculate the accumulated value of a unit sum of money:
(i)
(a)
(b)
(c)
accumulated from time t = 0 to time t = 7.

[5]
(ii)
Calculate, using your results from part (i) or otherwise:

(a)
the seven-year spot rate of interest per annum from time t = 0 to time
t = 7.
(b)
the six-year spot rate of interest per annum from time t = 0 to time
t = 6.
(c)
f6,1 where f6,1 is the one-year forward rate of interest per annum from
time t = 6.
[3]
(iii)
Explain why your answer to part (ii)(c) is higher than your answer to part
(ii)(a).
[2]
(iv)
Calculate the present value of an annuity that is paid continuously at a rate of

2
30e0.01t +0.001t units per annum from t = 3 to t = 10.
CT1 S20135
[5]
[Total 15]
PLEASE TURN OVER
11
A pension fund has liabilities to meet annuities payable in arrear for 40 years at a rate
of 10 million per annum.
The fund is invested in two fixed-interest securities. The first security pays annual
coupons of 5% and is redeemed at par in exactly ten years time. The second security
pays annual coupons of 10% and is redeemed at par in exactly five years time. The
present value of the assets in the pension fund is equal to the present value of the
liabilities of the fund and exactly half the assets are invested in each security. All
assets and liabilities are valued at a rate of interest of 4% per annum effective.
(i)
Calculate the present value of the liabilities of the fund.
(ii)
Calculate the nominal amount held of each security purchased by the pension
fund.
[6]
(iii)
Calculate the duration of the liabilities of the pension fund.
[3]
(iv)
Calculate the duration of the assets of the pension fund.
[4]
(v)
Without further calculations, explain whether the pension fund will make a
profit or loss if interest rates fall uniformly by 1.5% per annum effective. [2]
[Total 16]
END OF PAPER
CT1 S20136
[1]
EXAMINERS REPORT

Core Technical
Introduction
The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.
D C Bowie
December 2013

This paper proved to have some questions where the vast majority of candidates scored well
and others where many candidates found challenging. Well-prepared candidates scored well
across the whole paper. As in previous diets, questions that required an element of
explanation or analysis, such as Q1(ii), Q8(iv), Q10(iii) and Q11(v) were less well answered
than those that just involved calculation. This is an area to which attention should be paid.
Candidates should note that it is important to explain and show understanding of the concepts
and not just mechanically go through calculations.
Page 2
(i)
(a) =
d
(b)
0.045
= 0.043062
= 4.3062%
1.045
(1.045)
(1 d (12)12 ) =
1
12
d (12)
=0.99634
12
d (12) =
0.043936 or 4.3936%
4
(c)
i (4)
1.045
1 +
=
4
i (4)
1.011065
1 +
=
i
(d)
(4)
=
0.044260 or 4.4260%
1.0455 = 1.24618
five-yearly effective rate is 24.618%

(ii)
The answer to (i)(b) is bigger than the answer to (i)(a) because the rate of
discount convertible monthly is applied each month to a smaller (already
discounted) sum of money. As such, in order to achieve the same total amount
of discounting the rate has to be slightly more than one twelfth of the annual
rate of discount. [An answer relating to the concept of interest payable in
advance would also be acceptable].
The calculations were performed well but the quality of the explanations in part (ii) was often
(1 )
1 )
i 5
(
5
.
poor. A common error in (i)(d) was to state the answer as i rather than
1 5
Present value of dividend = 0.11.040.5 =

0.09806
1.75275
Value of forward is (1.8 0.09806 ) 1.040.75 =
Page 3
(i)
Work in half years.

P = 2a20 + 100v 20 @1 1 2 %
= 2 17.1686+100 0.74247
= 108.584
(ii)
P = (2 0.75a20 + 100v 20 )(1.015)
91
182.5
= (20.7517.1686+1000.74247) (1.015)
= 100.7452
91
182.5
Part (i) was answered well although some candidates assumed an annual effective rate of
3%. In part (ii) many candidates did not deal with the 91 days elapsed duration discounting
instead of accumulating the 10-year bond price and/or assuming that 91 days equated to a
quarter of a year.
(i)
The investor pays a purchase price at outset.

The investor receives a series of coupon payments and a capital payment at
maturity
The coupon and capital payments are linked to an index of prices (possibly
with a time lag)
[Time lag does not have to be mentioned].
(ii)
The investor pays a purchase price at outset

Shareholders are paid dividends. These are not fixed but declared out of
profits.
Dividends may be expected to increase over time .
.but may cease if the company fails.
There is a high degree of uncertainty with regard to future cash flows.
No maturity date
Would receive a sale price on the sale of the shares
Generally poorly answered with many candidates just writing down all characteristics they
knew about these assets rather than concentrating on the cashflows. Many candidates
omitted mention of the initial purchase price in each part.
Page 4
(i)
The return from the bonds issued by Country A is:
106
1 =0.049505
101
The expected cash flows from the bonds from Country B are:
0.1 0 + 0.2 100 + 0.3 50 + 0.4 106 = 77.4
The price to provide the same expected return is P such that:
=
P
(ii)
77.4
= 73.749
1.049505
The gross redemption yield from the bond is such that:

73.749 (1 + i ) =
106
i =43.731%
(iii)
The risk is higher for Country Bs bond. Although the gross redemption yield
is such that the expected returns are equal, the investor may want a higher
expected return to compensate for the higher risk.
Many candidates had trouble with part (ii) not recognising that the gross redemption yield
calculation will not include any allowance for default.
Divide the number of cars by 100 to obtain the share due to the pension fund
PV of income = 365 400 a1 +365 500 a1 v 1.1 1 + 1.012 v + 1.014 v 2 + ...... + 1.0136 v18
1 1.0138 v19
i
i
= 365 400 a1 + 365 500 a1 v 1.1
1 1.012 v
= 365 400 1.039487 0.92593
1 1.45953 0.23171
+365 500 1.039487 0.92593 0.92593 1.1
1 1.0201 0.92593
= 140,523 + 178,907 11.93247

= 140,523 + 2,134,801 = 2,275,324 so NPV = 275,324
Candidates made a variety of errors in this question often ignoring one or more parts of the
scenario (e.g. pension funds 1% share of the project, the fact that daily vehicle numbers
were given in the question, 1% increases in both vehicle numbers and tolls from the second
year). Nevertheless, candidates who set out their workings clearly and logically often scored
the majority of the available marks.
Page 5
(i)
(1 + it) ~ lognormal (, 2)
ln(1 + it ) ~ N (, 2 )
5
ln (1 + it ) = ln(1 + it ) + ln(1 + it ) + L + ln(1 + it )

t =1
~ N (5,52 ) by independence
5
(1 + it ) ~ lognormal (5,52 )
t =1
2
E (1 +=
it ) exp + =
1.055
Var(1 +=
it ) exp(2 + 2 ) exp(2 ) =
1 0.042
( )
0.042
2
=
exp 2 1
=
0.0014365
2
1.055
0.0014360
=
exp +
1.055
2
=
ln1.055
0.0014365
= 0.052823
2
5 = 0.264113
52 = 0.007182.
Let S5 be the accumulation of one unit after five years:
E ( S5 )
52
0.007182
= exp =
5 +
exp 0.264113 +
2
2
= 1.30696
( )
Var( S5 ) = exp(2 5 + 52 ) exp 52 1
= exp(2 0.264113 + 0.007182).(exp 0.007182 1)
Page 6
= exp 0.53541 (exp 0.007182 1)

= 0.012313
Mean value of the accumulation of premiums is
7,850,000 1.30696 = 10,259,636.
Standard deviation of the accumulated value of the premiums is
7,850, 000 0.012313 =
871, 061
Alternatively:
Let it be the (random) rate of interest in year t . Let S5 be the accumulation of a
single investment of 1 unit after five years:
E ( S5 ) = E (1 + i1 )(1 + i2 ) K (1 + i5 )
E ( S5 ) = E [1 + i1 ] E [1 + i2 ]K E [1 + i5 ] as {it } are independent
E [it ]
= 0.055
E ( S5 ) = (1.055 ) = 1.30696
5
( )
2
E S52 = E (1 + i1 )(1 + i2 ) K (1 + i5 )
=
E (1 + i1 ) E (1 + i2 ) K E (1 + i5 ) (using independence)
2
) (
) (
= E 1 + 2i1 + i12 E 1 + 2i2 + i22 K E 1 + 2i5 + i52
= 1 + 2 0.055 + 0.042 + 0.0552
as E ii2 =V [it ] + E [it ] =0.042 + 0.0552

2
Var [ S5 ] = 1 + 2 0.055 + 0.042 + 0.0552
(1.055 )
10
=
1.1146255 (1.055
=
) 0.0123128
10
Page 7
Mean value of the accumulation of premiums is

7,850,000 1.30696 = 10,259,636.
Standard deviation of the accumulated value of the premiums is
7,850, 000 0.012313 =
871, 061
(ii)
If the company invested in fixed-interest securities, it would obtain a

guaranteed accumulation of 7,850,000 (1.04)5 = 9,550,725. In one sense,
there is a 100% probability that a loss will be made and therefore the policy is
unwise. The risky investment strategy leads to an expected profit. On the
other hand, the standard deviation of the accumulation from the risky
investment strategy is 871,061. Whilst there is a chance of an even greater
profit from this strategy, there is also a chance of a more considerable loss
than from investing in fixed-interest securities.
A poorly answered questions with many candidates not including enough derivation of the
required results in part (i). Some candidates mixed their answers between the two methods
given above e.g. they calculated and 2 for the log normal route, then used these in the
alternative method for the mean and variance of it. Other candidates just used 0.055 and
.042 as their values of and 2 .
(i)
Purchase price of the annuity (working in half-years)

5, 000a (6) calculated at i = 2%
50
= 5, 000
i
i
(6)
a50
i = 0.02
i(6) = 0.019835
a50 = 31.4236
Purchase price = 5, 000
0.02
31.4236
0.019835
= 158,422
Page 8
Individual needs to invest X such that: (working in years)

X 1.0520 = 158,422
1.0520 = 2.653297
=
X
(ii)
158, 422
= 59, 708
2.653297
Real return is j such that:
=
59, 708
(i + j ) 20 =
158, 422 143
(1 + j ) 20 340
158, 422 143
59, 708 340
=1.11595
j = 0.550%
(iii)
The amount of the capital gain is:

158,422 59,708 = 98,714
Tax = 0.25 98,714 = 24,679
Proceeds of investment = 133,744
Net real return is j such that:
=
59, 708
(1 + j ) 20 =
133, 744 143
(1 + j ) 20 340
133, 744 143
59, 708 340
= 0.942106
j = 0.2977%
(iv)
The capital gains taxed has taxed the nominal gain, part of which is merely to
compensate the investor for inflation. The tax has therefore reduced the real
value of the investors capital and led to a negative real return.
Parts (i) and (ii) were generally answered well but many candidates struggled with the
calculation of the capital gain in part (iii) not recognising that this would be based on money
values.
Page 9
(i)
PV is:
400v + 380v 2 + 360v3 + L + 120v5
420 a15 20 ( Ia )15
@ 4%
= 420 11.1184 - 20 80.8539

= 4,669.728 1,617.078 = 3,052.65.
(ii)
Interest component:
= 0.04 3,052.65 = 122.106
Capital component = 400 122.106
= 277.894
(iii)
Seven repayments remain and the PV of the remaining payments is:
240v + 220v 2 + L + 120 v 7

260 a7 20 ( Ia )7
@ 4%
= 260 6.0021 20 23.0678 = 1, 099.19
The loan is written down to: 0.5 1,099.19

= 549.595
The present value of the new repayment is:
( X 2 ) a10
549.595=
=
X 2
+ 2( Ia )10
@8%
( X 2 ) 6.7101 + 2 32.6869
549.595 2 32.6869
= 72.163
6.7101
X =
74.16
The best answered question on the paper although some candidates, when calculating the
outstanding loan in part (iii), stated that the repayment in year 8 was 420. Some candidates
also used the incorrect formula Xa10 + 2( Ia )10 for the repayment in part (iv).
Page 10
7
10
(i)
(a)
0.05+0.002t dt
e0
0.002t 2 7
0.05t +
e
0
= exp [ 0.05 7 ] +
0.002 49
2
= exp (0.399) = 1.490331

6
0.05+0.002t dt
(b)
0.00236
0.056+
2
e
= exp (0.336) = 1.399339
(ii)
(c)
1.490331
= 1.06503
1.399339
(a)
Let spot rate = i7

(1 + i7 )7 =
1.490334
i7 =
5.8656% p.a. effective
(b)
(1 + i6 )6 =
1.39934
i6 =
5.7598% p.a. effective
(c)
(iii)
From (i) (c) 6.503% per annum effective.
The forward rate is the rate of interest in the seventh year. The spot rate, in
effect, is the rate of interest per annum averaged over the seven years (a form
of geometric average). As the force of interest is rising the rate of interest in
the seventh year must be higher than the rate averaged over the full seven year
period.
Page 11
t
(iv)
v(t ) = e
0.05+ 0.002 s ds
0
0.002 s 2 t
0.05 s +
2
= e
0
= e0.05t 0.001t
We require
10
(t )v(t )dt
3
10
30 e 0.01t
e0.001t
.e0.05t .e 0.001t dt
2
10
30 e0.06t dt
3
30 0.06t 10
e
3
0.06
30 0.6 0.18
e
e
0.06
= 500(0.548812 0.83527)
=143.229
The calculations were well-done but only the best candidates clearly explained their
reasoning in part (iii).
11
(i)
Present value of liabilities annuity
10 a40 at 4%
a40 = 19.7928
= 10 19.7928 = 197.928m
(ii)
Call 10 year security security A and five year security security B.

We need to calculate the PV of 100 nominal for each of security A and
security B
Page 12
P.V of 100 nominal of A is:
5a10 + 100v10 @4%

=
a10 8.1109
=
v10 0.67556
PV = 58.1109 + 67.556 = 108.1105
P.V of 100 nominal of B is:
10 a5 + 100v5 @ 4%
=
a5 4.4518
=
v5 0.82193
PV = 44.518 + 82.193 = 126.711
98.964m, is invested in each security.
98,964, 000
100 per 100 nominal of A is bought.
108.1105
= 91,539,674 nominal
98,964, 000
100 per 100 nominal of B is bought
126.711
= 78,102,138 nominal
[other ways of expressing units are okay, but marks will be deducted if units
are not correct]
(iii)
Duration of the liabilities

tct vt
=
ct vt
40
Numerator = 10 t vt
(in m)
t =1
= 10( Ia ) 40 =
10 306.3231 =
3063.231 at 4% p.a. effective
Duration = 3063.231/197.928 = 15.48 years
Page 13
(iv)
Numerator of duration is:
(5( Ia )10 + 10 100 v10 ) 915,396.74

+(10( Ia )5 + 5 100 v5 ) 781, 021.38
Following the same reasoning as for the calculation of the duration of the
annuity payments, adding the capital repayment and multiplying by the
number of units of 100 nominal bought.
( Ia )10 = 41.9922
v10 = 0.67556
( Ia )5 = 13.0065
v5 = 0.82193
= (5 41.9922 + 10 100 0.67556) 915,396.74
+(10 13.0065 + 5 100 0.82193) 781, 021.38
= 810, 603, 000 + 422,554, 000
= 1, 233,157, 000
Duration = 1,233,157,000/197,928,000
= 6.23 years
(v)
The duration (and therefore the volatility) is greater for the liabilities than for
the assets. As a result, when interest rates fall, the present value of the
liabilities will rise by more than the present value of the assets and so a loss
will be made.
Many candidates wrongly assumed that the same nominal amounts were bought of each asset
rather than each asset amount having the same present value. This assumption made the
calculations in part (ii) somewhat easier and the marks awarded in this part took this into
account. Part (iii) was answered well. The explanations in part (v) were often poorly stated
although time pressures at the end of the paper may have contributed to this.
Page 14

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Faculty of Actuaries

Subject CT1 Financial Mathematics

Mark allocations are shown in brackets.

Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Explain the difference

between options and futures

Calculate the gross redemption yield of the security.

PLEASE TURN OVER

Calculate the expected accumulation in 25 years time if 3,000 is invested in

Calculate the probability that the accumulation of a single investment of 1

Describe the other practical problems for an institutional investor who is

the amount of the original loan

A company is undertaking a new project. The project requires an investment of 5m

the net present value of the project

Calculate the accumulated profit at the end of the 17 years.

A pension funds assets were invested with two fund managers.

Calculate the time-weighted rates of return earned by Manager A and Manager

Explain, without performing further calculations, whether the money-weighted

Discuss the relative performance of the two fund managers.

PLEASE TURN OVER

Calculate the present value of 1000 due at the end of 17 years.

Calculate the rate of interest per annum convertible monthly implied

Calculate the present value of the payment stream.

Subject CT1 Financial Mathematics

0.98 100, 000

0.02 100, 000

0.02 100, 000

0.02 100, 000

0.02 100, 000

Interest payments: July 08

Capital redeemed: Jan 10

= 60.90678 2.81404 = 58.09

Equation of value is:

98000 = 2028.96v 2 + 2094.12v + 2155.66v 2 + 2229.86v 2 + 111493.21v 2

Purchase price = 0.45 1,000,000 = 450,000

PV of dividends = 50000 (1 0.2 ) v 2 + v 2 + 1.03 v3 + v 2 + 1.032 v 4 + v 2 +

Let i = money yield

1 + i = 1.0285714 1.05 = 1.08 i = 8% p.a.

+ 105v10 0.25(105 P)v10 @ 8%

The gross redemption yield, i , is given by:

108.09 = 7 a4i % + 100 vi4%

Let the accumulation be S20

= exp ( 20 0.05 + 10 0.004 )

In S20 ~ N 20, 202

In S20 ~ N (1, 0.08)

Pr ( S20 > 2.829217 ) = Pr (1n S20 > 1n 2.829217 )

= Pr ( Z > 0.14 ) = 1 ( 0.14 )

DMT of liabilities is given by:

(1.038835 )1 1.038835 + 2 1.038835 + 3 1.038835 + + 40 1.038835

(1.038835 )1 1.038835 + 1.038835 + 1.038835 + + 1.038835

vi* + 2 vi2* + 3 vi3* + + 40 vi40

Hence, DMT of liabilities is:

(Alternative method for DMT formula

v(1 + 2 gv + 3g 2v 2 + " + 40 g 39v39 )

The other problems with implementing an immunisation strategy in practice

the approach requires a continuous re-structuring of the asset portfolio to

institutional investor is only immunised for small changes in the rate of