INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2016

Subject CT1 – Financial Mathematics

Core Technical

Introduction

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 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.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in 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.

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.

Luke Hatter
Chair of the Board of Examiners
December 2016

 Institute and Faculty of Actuaries

 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

A. General comments on the aims of this subject and how it is marked

1. 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.

2. 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 lose
marks where excessive rounding has been used or where insufficient working is shown.

B. General comments on student performance in this diet of the

examination

1. 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. The examiners look most closely at the
performance of the candidates close to the pass mark and the comments therefore often
relate to those candidates.

2. Performance was very slightly weaker when compared with most recent diets. As in
previous diets, the non-numerical questions were often answered poorly by marginal
candidates.

C. Pass Mark

The Pass Mark for this exam was 60.

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

Solutions

Q1 (i) eδ 4 = 1.0125  δ = 4 × ln1.0125 = 0.0496901 = 4.969% [1]

(ii) 1 + i = 1.01254  i = 0.0509453 = 5.095% [1]

(iii) From (i) (though could be done in other ways)

 d (12 ) 
1 −  = e−δ 12 = e−0.0041408 = 0.9958677  d (12 ) = 0.049587 = 4.959%
 12 
 
[2]
[Total 4]

This was generally answered well although many candidates ignored the
specific rounding instructions or rounded incorrectly.

Q2 Various approaches (e.g. effective interest period can be changed etc.).

Work in quarters. Interest rate per quarter = 0.5%. Rate of payment per quarter = 25.
Number of quarters = 48.

i
PV = 25a( ) = 25
3
a [2]
48
d ( 3) 48

3
( −1
)
d ( ) = 3 1 − 1.005 3 = 0.0049834, a48 = 42.5803 [1]

Therefore, PV = 25 × (0.005/0.0049834) × 42.5803 = €1,068.05 [1]

[Total 4]

Generally well answered

Q3 A loan repayable by a series of payments at fixed times set in advance.

Typically issued by banks and building societies

Typically long-term …
…e,g. used to fund house purchase
…and secured against the property

Each payment contains an element to pay interest on the loan with the remainder
being used to repay capital

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

In its simplest form, the interest rate will be fixed …

….and the payments will be of fixed equal amounts.

The interest payment portion of the repayments will fall over time…
… and the capital payments will rise over time.

Risk that borrower defaults on loan

Complications might be added such as (i) allowing the loan to be repaid early or (ii)
allowing the interest rate to vary
[½ mark for each point]
[Max 3]
[Total 3]

Despite being a bookwork question, this was the worst answered question on
the paper. It was not necessary to make all the above points for full marks.

Q4 (i) X = (112 + 23) × 1.1 = £148.5m [1]

(ii) TWRR is found from

148.5 160
(1 + i )2 = = 0.91906  i = −0.04132 = −4.132% [3]
135 148.5 + 43
[Total 4]

A significant number of marginal candidates failed to answer part (i) correctly.

Q5 Let original price of zero coupon bond = P

P = 100v80 at 2.5%

 P = 100 × 0.13870 = 13.87 [2]

Equation of value for the purchaser:

13.87eδt = 80 [1]

ln ( 80 13.67 ) ln 5.7678
t= t = = 36.506 years [1]
δ 0.048

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

0.506 years is 185 days. There are 181 days to the end of June. Default is therefore
on 4 July 2011. [1]
[Total 5]

This question was answered poorly with many candidates not able to
formulate separate equations of value for:

• the original terms to determine the issue price.

• the revised terms to determine the date of default.

Q6 (i) Simple rate of return is (100 – 96)/96 = 0.041666 [1]

Expressed as an annual rate, this is: 0.041666 × (365/182) = 8.3562% [1]

(ii) Let the time in years = t

(97.5 – 96)/96 = 0.035t [1]

t = (97.5 – 96)/(0.035 × 96) = 0.44643 years = 163 days [1]

(iii) Equation of value for the second investor:

97.5(1 + i)(182–163)/365 = 100 [1]

365
19 100  100  19
(1 + i ) 365
= i=  − 1 = 62.640% [1]
97.5  97.5 
[Total 6]

Parts (i) and (ii) were very well answered. In part (iii), some candidates
continued to assume a simple rate of return was required. Alternative
answers to part (iii) based on different rounding of the answer in part (ii) were
given full credit.

Q7 (i) Present value of dividends, I, is:

(
0.1 v
1
4 +v
1
2 +v
3
4
)
Calculated at i′% when 1 + i′ = 1.042 = 1.0816

So I = 0.1 (1.0816–0.25 + 1.0816–0.5 + 1.0816–0.75) = 0.288499 [2]

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

Hence, forward price, K, is:

K = (1.1 − 0.288499 ) × 1.08160.75 = 0.86068 = 86.068 p [2]

(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. [Could also be said that the price of the
share already takes into account expectations.] [2]
[Total 6]

Part (i) was answered well although some candidates ignored the fact that the
interest rate given was a convertible half-yearly rate. Part (ii) was answered
less well with the arguments of many marginal candidates being very unclear.

Q8 (i) 96 = 4a3 + 100v3 [1]

Try 6% RHS = 94.654 [½]

Try 5% RHS = 97.2768 [½]

Interpolation gives

97.2768 − 96
i ≈ 0.05 + 0.01× = 0.0549 ≈ 5.5% [1]
97.2768 − 94.6540

(ii) Let in = spot rate for term n

104
Then 96 = 104v at i1  1 + i1 =  i1 = 8.333% [1]
96

2 104 104
96 = 4vi1 +104vi22  (1 + i2 ) = =  i2 = 6.145% [2]
96 − 4vi1 96 − 3.69231

(iii) Let the forward rate be f1,1

(1 + i2 )2 = (1 + i1 ) (1 + f1,1 ) [1]

 1.061452 = 1.08333 × (1 + f1,1 )  f1,1 = 0.04000 = 4% [1]

(iv) The three year gross redemption yield is a complex form of weighted average
of the three spot rates. [1]

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

The one-year spot rate is over 8%, the two-year rate is over 6% and the gross
redemption yield is 5.5%. Therefore, the three-year rate must be less than
5.5% if the weighted average is 5.5%. [1]
[Total 10]

Part (i), (ii) and (iii) were generally answered well, although in part (iii) some
candidates were not clear as to the forward rate required by the question.
Part (iv) was very poorly answered. For this part no marks were available for
calculation without explanation.

Q9 (i) Let S n = Accumulated value at time n of £1 invested at time 0

Sn = (1 + i1 )(1 + i2 ) .... (1 + in )

 E [ Sn ] = E (1 + i1 )(1 + i2 ) .... (1 + in ) 

= E (1 + i1 ) . E (1 + i2 ) .... .E (1 + in ) by independence

and E (1 + it ) = 1 + E ( it ) = 1 + j

n
Hence E ( Sn ) = (1 + j )

Now

Var [ Sn ] = E  Sn2  − ( E [ Sn ])
2
 

E  Sn2  = E (1 + i1 ) (1 + i2 ) .... (1 + in ) 

2 2 2
   

= E (1 + i1 )  . E (1 + i2 )  .... .E (1 + in ) 

2 2 2
[1]
     
by independence [½]

and


2
  (  ) ( )
E (1 + it )  = E  1 + 2it + it2  = 1 + 2 E ( it ) + E it2

( ) 2
( )
and Var [it ] = s 2 = E it2 −  E ( it )  = E it2 − j 2

( )
 E it2 = s 2 + j 2 [1]

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

Hence

( )
n
E  Sn2  = 1 + 2 j + j 2 + s 2
 

( )
n 2n
And Var [ Sn ] = 1 + 2 j + j 2 + s 2 − (1 + j ) [1]

Hence mean accumulation = 8, 000, 000E ( S5 ) [½]

5
= 8, 000, 000 (1.055 ) = £10, 455, 680 [1]

Standard deviation of accumulation = 8, 000, 000 Var ( S5 ) [½]

( )
5 10
= 8, 000, 000 1 + 2 × 0.055 + 0.0552 + 0.042 − (1.055 )

= 8, 000, 000 1.7204573 − 1.7081445 = 8, 000, 000 × 0.01231284

= £887, 706 [2]

Alternative Solution

(1+it) ~ lognormal (µ,σ2)

ln(1 + it ) ~ N (μ, σ2 )

ln(1 + it )5 = ln(1 + it ) + ln(1 + it ) +  + ln(1 + it ) ~ N (5μ,5σ2 )

Given assumption that they are independent and identically distributed

∴ (1 + it )5 ~ lognormal (5μ,5σ2 ) [2]

 σ2 
E (1 + it ) = exp  μ +  = 1.055 [1]
 2 


Var(1 + it ) = exp(2μ + σ2 )  exp(σ2 ) − 1 = 0.042 [1]

 

0.042
1.055 2  ( )
= exp σ2 − 1  σ2 = 0.0014365

[1]

 0.0014360 
exp  μ +  = 1.055 
 2 

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Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

0.0014365
μ = ln1.055 − = 0.052823 [1]
2

5µ = 0.264113

5σ2 = 0.0071825.

Let S5 be the accumulation of one unit after five years:

 5σ 2   0.0071825 
E ( S5 ) = exp  5 × μ +  = exp  0.264113 + 
 2   2 


=1.30696 [½]

 ( )
Var( S5 ) = exp(2 × 5μ + 5σ 2 )  exp 5σ 2 − 1


= exp(2 × 0.264113 + 0.0071825) . (exp 0.0071825 –1)

= exp 0.53541 (exp 0.0071825 – 1)

= 0.01231284 [½]

Mean value of the accumulation of premiums is

8,000,000 × 1.30696 = £10,455,680. [1]

Standard deviation of the accumulated value of the premiums is

8,000,000 × 0.0123128490.5 = £887,706 [1]

(ii) If the company invested in fixed-interest securities, it would obtain a

guaranteed accumulation of £8,000,000 * (1.04)5 = £9,733,223. In one sense,
there is a 100% probability that a loss will be made and therefore the policy is
unwise. [1]

The “risky” investment strategy leads to an expected profit. [1]

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

On the other hand, the standard deviation of the accumulation from the risky
investment strategy will be higher than investing in the fixed-interest
securities. 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. [1]
[Total 12]

Many candidates either ignored the requirement in part (i) to derive the
necessary formulae or had difficulty in performing the derivation often trying to
combine the two methods above without success. Part (ii) was better
answered than the other explanation questions on the paper.

Q10 (i) The payback period simply tells an investor when the total cash inflows from
the investment have exceeded the total cash outflows. This tells the investor
nothing about the overall profitability of the project. [2]

(ii) The present value of outgoing cash flows at a rate of return of 6% per annum
effective is as follows (in £m):

(
a3 + 0.05 a13 − a3 )
= 1.06 × 2.6730 + 0.05(8.8527 – 2.6730) = 3.14238 [2]

The present value of the incoming cash flows is as follows (in £m):

(
= 0.495v3a(12) 1 + 1.01v + 1.012 v 2 + ... + 1.019 v9
1 )
= 0.495v3
d
d
(12 ) (
1 + 1.01v + 1.012 v 2 + ... + 1.019 v9 )
= 0.495 × 0.83962 × 0.973784 × (1 – 1.0110/1.0610) / (1 – 1.01/1.06)

= 0.404716 × 8.12352 = 3.2877 [3½]

NPV of cash flows at 6% = 3.2877 – 3.1424 = £0.1453m = £145,300 [1]

The project has a positive NPV at 6% and therefore an IRR higher than 6%
and the first criteria is met. [½]

By the end of the 10th year, the total outgoing cash flows will have been:
£3,000,000 plus 7 × £50,000 or £3,350,000. [1]

Total incoming cash flows are:

495,000 × (1 + 1.01 + 1.012 +...+ 1.016) (i.e. rate of payment of £495,000

rising by 1% per year for seven years). [1]

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

Geometric progression with common ratio 1.01 and seven terms

= 495,000(1 – 1.017)/(1 – 1.01) = £3,570,700 [1]

This is greater than total outgoing cash flows and therefore second criterion is
met. [½]

There is clearly a positive cash flow in the fifth year as the incoming cash
flows will be greater than £495,000 and the outgoing cash flows will be
£50,000. [1]

Therefore final criterion is met. [½]

[Total 14]

This was the worst answered of the longer questions. The examiners strongly
recommend that candidates take a systematic approach to the question and
e.g. derive the PVs of the outgo and income separately. Marginal candidates
would have benefited from showing their intermediate working in greater
depth and/or with greater clarity, explaining all steps.

Candidates who assumed that the repayments continued for 11 years, rather
than 10, were not penalised.

Q11 (i) Duration =  tCt vt  Ct vt

t t

 3   10 
  4 × 0.04 × tv  +   5 × 0.04 × tv  + 4 ×1× 3v + 5 ×1×10v
t t 3 10

=  t =1   t =1 
 3   10 
  4 × 0.04 × v  +   5 × 0.04 × v  + 4 ×1× v + 5 ×1× v
t t 3 10

 t =1   t =1 

0.16 ( Ia )3 + 0.20 ( Ia )10 + 12v3 + 50v10

= [4]
0.16a3 + 0.20a10 + 4v3 + 5v10

Therefore, duration

0.16 × 5.2422 + 0.20 × 36.9624 + 12 × 0.83962 + 50 × 0.55839 46.2264

= =
0.16 × 2.6730 + 0.20 × 7.3601 + 4 × 0.83962 + 5 × 0.55839 8.05015

= 5.742 years [3]

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

1
(ii) Present value of new portfolio per unit nominal = [1]
i

d 1
  1
Volatility of new portfolio per unit nominal = − di  i  = [1]
1 i
i

Duration of new portfolio, applying equation above is

1 + i 1.06
volatility × (1 + i ) = =
i 0.06

= 17.666 years [2]

(iii) Present value of existing bonds:

= £8.05013bn [½]

Let the nominal amount of new bonds issued = X

0.05 X
Present value of new bonds = 0.05 Xa∞ =
0.06

0.05 X
 = 0.8 × 8.05013  X = £7.728bn
0.06
[1½]
[Total 13]

In part (i), many candidates incorrectly calculated DMTs separately for the two
bonds which simplified the question and did not produce the DMT of the
whole portfolio. Part (ii) was poorly answered with many candidates not
recognising the relationship between DMT and volatility. It is also important in
such questions to state the time units in the final answer. Part (iii) did seem to
act as a differentiator between candidates, with the strongest candidates able
to proceed clearly through the question.

Q12 (i) 50 = 100v ( 20 )

 10   20 
where v ( 20 ) = exp  −  0.03dt  exp  −  at dt  [3]
   
 0   10 

20
10  at 2 
= exp [ −0.03t ]0
exp  − 
 2 10

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Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

= e−0.3e−150 a = e−0.3−150a = 0.5 [1]

ln 2 − 0.3
a= = 0.0026210 [1]
150

(ii) 40 = 100v ( 28)

 28 
where v ( 28 ) = v ( 20 ) exp  −  bt dt  [1]
 
 20 

28
 −bt 2 
= −0.5exp  
 2  20

= 0.5e−192b = 0.4 [2]

− ln 0.8
b= = 0.0011622 [1]
192

(iii) Equivalent annual effective rate of discount can be found from:

28 28
100 (1 − d ) = 40  (1 − d ) = 0.4 [1]

 d = 0.032195 = 3.220% [1]

7 7 7
(iv) (a) We require:  ρ ( t ) v ( t ) dt =  e −0.04t −0.03t
e dt =  e−0.07t dt [1½]
3 3 3

e −0.07t  7
=  [1]
 −0.07  3

= −8.751806 + 11.579775 = 2.827969 [1½]

(b) The present value of the payment stream 2.827969 = X a7 − a3 ( )

where X is the continuous payment stream using δ = 0.03. [2]

2.827969 2.827969
X= =
a7 − a3  1 − e−0.03×7   1 − e−0.03×3 
  −  
 0.03   0.03 

2.827969
= = 0.82092 [2]
6.31386 − 2.86896
[Total 19]

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 Subject CT1 (Financial Mathematics Core Technical) – September 2016 – Examiners’ Report

This was well answered apart from part (iv)(b). It was pleasing to see many
candidates using good exam technique to leave enough time for this question
which proved to be more straightforward than the other longer questions.

END OF EXAMINERS’ REPORT

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