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406 views44 pagesCM2 - Booklet 2
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© © All Rights Reserved
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Available Formats
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/ 44
Subject CM2
Revision Notes
For the 2021 exams
Stochastic models of
investment return
Booklet 2
covering
Chapter 5 Stochastic models of
investment returns
The Actuarial Education Company PAST EXAM QUESTIONS
This section contains all of the past exam questions from 2010 to 2018, plus
those from the 2019 Paper A exams, relating to the topics covered in this
booklet.
Solutions are given later in this booklet. These give enough information for
you to check your answer, including working, and also show you what an
adequate examination answer should look like. Further information may be
available in the Examiners’ Report, ASET or Course Notes.
We first provide you with a cross reference grid that indicates the main
subject areas of each exam question. You can use this. if you wish, to
select the questions that relate just to those aspects of the topic that you
may be particularly interested in reviewing.
Alternatively, you can choose to ignore the grid, and instead attempt each
question without having any clues as to its content.
© IFE: 2021 Examinations Page 13 Cross reference grid
Qn ae Proot aa) Lognormal | Attempted
1 v v v
2 vw (“)
3 v
4 v v ¥
5 vw
6 v
7 vw v
8 v v
9 v
10 v v v
11 v 7
42 7 v v
13 v 7)
14 v
15 v
16 v v
17 v v
18 ve v
Page 14
© IFE: 2021 Examinations Subject CT1, April 2010, Question 6
The annual returns, i , on a fund are independent and identically distributed.
Each year, the distribution of 14+/ is lognormal with parameters 1 = 0.05
and o? = 0.004 , where i denotes the annual retum on the fund.
() 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]
Subject CT1, September 2010, Question 3
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 retum per annum. [6]
Subject CT1, April 2011, Question 10
The annual rates of return from a particular investment, Investment A, are
independently and identically distributed. Each year, the distribution of
(1+), where i, is the rate of interest earned in year t , is lognormal with
parameters y and o*.
The mean and standard deviation of i, are 0.06 and 0.03 respectively.
(i) Calculate ys and o?. (5)
An insurance company has liabilities of £15m to meet in one year’s 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.
© IFE: 2021 Examinations Page 15 (ji) Calculate, to two decimal places, the probability that the insurance
company will be unable to meet its liabilities if:
(a) allassets are invested in Investment B.
(b) 75% of assets are invested in Investment A and 25% of assets are
invested in Investment B. [6]
(iii) Calculate the variance of return from each of the portfolios in (ii)(a) and
Go). 3]
[Total 14]
Subject CT1, April 2012, Question 7
The annual yields from a fund are independent and identically distributed.
Each year, the distribution of 1+/ is log-normal with parameters. = 0.05
and o? = 0.004, where i denotes the annual yield on the fund.
() 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
(i) 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]
Subject CT1, September 2012, Question 7
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.
(Calculate the amount the individual should invest if he calculates the
investment using the expected annual interest rate in each ten year
period. [2]
(i) Calculate the expected value of the investment in excess of £200,000 if
the amount calculated in part (i) is invested. feo)
Page 16 © IFE: 2021 Examinations (iii) Calculate the range of the accumulated amount of the investment
assuming the amount calculated in part (i) is invested 2)
[Total 7]
Subject CT1, April 2013, Question 6
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.
() Calculate the mean accumulation at the end of 15 years. 2)
(i) Calculate the standard deviation of the accumulation at the end of 15
years. 5)
(ii) 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]
Subject CT1, September 2013, Question 7
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 f, i; .
has a mean value of 5.5% per annum effective and a standard deviation of
4% per annum effective. (1+ i,) 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.] 19]
© IFE: 2021 Examinations Page 17 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 per annum effective.
(i) Explain the arguments for and against the director's suggestion. [3]
[Total 12]
Subject CT1, April 2014, Question 12
An investor is considering investing £18,000 for a period of 12 years. Let i,
be the effective rate of interest in the fth year, t<12. Assume, for t< 12,
that /, has mean value of 0.08 and standard deviation 0.05 and that 1+, is
independently and lognormally distributed.
(i) Determine the distribution of S,. where S, is the accumulation of £1
over t years. [5]
At the end of the 12 years the investor intends to use the accumulated
amount of the investment to purchase a 12-year annuity certain paying:
£4,000 per annum monthly in advance during the first four years;
£5,000 per annum quarterly in advance during the second four years;
£6,000 per annum continuously during the final four years.
The effective rate of interest will be 7% per annum in years 13 to 18, and 9%
per annum in years 19 to 24, where the years are counted from the start of
the initial investment.
(ii) Calculate the probability that the investor will meet the objective. 12]
[Total 17]
Subject CT1, September 2014, Question 2
A\life insurance company is issuing a single premium policy which will pay
‘out £200,000 in 20 years’ time. The interest rate the company will earn on
the invested fund throughout the 20 years will be 4% per annum effective
with probability 0.25 or 7% per annum effective with probability 0.75. The
insurance company uses the expected annual interest rate to determine the
premium.
@ Calculate the premium. [2]
Page 18 © IFE: 2021 Examinations 10
ail
(ii) Calculate the expected profit made by the insurance company at the
end of the policy. [2]
[Total 4]
Subject CT1, April 2015, Question 12
In any year, the yield on investments with an insurance company has
mean j and standard deviation s_and is independent of the yields in all
previous years.
() Derive formutae for the mean and variance of the accumulated value
after n years of a single investment of 1 at time 0 with the insurance
company. 5]
Each year the value of (1+ i,), where i, is the rate of interest earned in the
t’ year, is lognormally distributed. The rate of interest has a mean value of
0.04 and standard deviation of 0.12 in all years.
(ii) (@) Calculate the parameters 1 and o® for the lognormal distribution
of (144).
(b) Calculate the probability that an investor receives a rate of retum
between 6% and 8% in any year. 18]
(ii) Explain whether your answer to part (i) (b) looks reasonable. 2]
[Total 15]
Subject CT1, April 2016, Question 8
An individual is planning to purchase £100,000 nominal of a bond on 1 June
2016 which will be redeemable at 110% on 1 June 2020. The bond will pay
coupons of 3% per annum at the end of each year.
The individual wishes to invest the coupon payments on deposit until the
bond is redeemed. It is assumed that, in any year, there is a 55% probability
that the rate of interest will be 6% per annum effective and a 45% probability
that it will be 5.5% per annum effective. It is also assumed that the rate of
interest in any one year is independent of that in any other year.
(i) Derive the necessary formula to determine the mean value of the total
accumulated investment on 1 June 2020. [4
© IFE: 2021 Examinations Page 19 12
13
(i) Calculate the mean value of the total accumulated investment on 1 June
2020. 2]
[Total 6]
Subject CT1, September 2016, Question 9
An insurance company has just written single premium contracts that require
it to make payments to policyholders of £10,000,000 in five years’ time. The
total single premiums paid by policyholders amounted to £8,000,000.
The insurance company is to invest the premiums in assets that have an
uncertain return. The return from these assets in year t , i, . is independent
of the returns in all previous years with a mean value of 5.5% per annum
effective and a standard deviation of 4% per annum effective. (1+ i) is
lognormally distributed
() Calculate, deriving all necessary formulae, the mean and standard
deviation of the accumulation of the premiums over the five-year period.
{9}
A director of the company is concerned about the possibility of a
considerable loss from the investment in the assets suggested in part (i).
Instead, the director suggests investing in fixed interest securities with a
guaranteed return of 4% per annum effective.
(i) Set out the arguments for and against the director's position. (3)
[Total 12}
Subject CT1, April 2017, Question 10
An individual aged exactly 65 intends to retire in five years’ time and receive
an annuity-certain. The annuity will be payable monthly in advance and will
cease after 20 years. The annuity will increase at each anniversary of the
commencement of payment at the rate of 3% per annum.
‘The individual would like the initial level of annuity to be £20,000 per annum.
The price of the annuity will be the present value of the payments on the
date it commences using an interest rate of 7% per annum effective.
(Calculate the price of the annuity. [4]
In order to purchase the annuity described in part (i), the individual invests
£200,000 on his 65th birthday in a particular fund.
Page 20 © IFE: 2021 Examinations 14
15
The investment return on the fund in any given year is independent of
returns in all other years and the annual retum is:
* 4% with a probability of 60%
* 7% with a probability of 40%.
(i) Calculate, showing all workings, the expected accumulation of the
investment at the time of retirement. [3]
(iii) Calculate, showing all workings, the standard deviation of the
investment at the time of retirement. 14)
(iv) Determine the probability that the individual will have sufficient funds to
purchase the annuity. 3]
[Total 14]
Subject CT1, September 2017, Question 5
An individual invests £100 in an asset. The expected accumulation of this
asset after 20 years is £200 and the standard deviation of the accumulation
after 20 years is £50
() Calculate the expected effective rate of return per annum. )
(i) Calculate the standard deviation of the effective rate of return per
annum. (4)
[Total 5}
Subject CT1, April 2018, Question 4
The annual investment return achieved by an insurance company in year t
is i.
Returns in successive years are assumed to be independent and:
In(1+i,) ~ N(z,02), where j= 0.08 and o =0.15
The insurance company has a liability of €800,000 payable at the end of
year 10.
The company wishes to invest an amount now so that there is a 95%
probability that the accumulated amount at the end of year 10 will be
sufficient to meet this liability.
()) Calculate the amount of money that the insurance company should
invest. (5)
© IFE: 2021 Examinations Page 21 16
17
(i) Explain, without doing any further calculations, how your answer to part
(@ would change if each of the following occurs separately, with all other
parameters as in part (i)
(a) The value of 1 is increased to 0.1.
(b) The value of or is increased to 0.2.
(c)_ The desired probability of meeting the liability is increased to 99%.
[3]
[Total 8]
Subject CT1, September 2018, Question 6
Ina particular investment fund, i, is the effective rate of retum in the t-th
year. Let S, be the accumulation of £1 invested over a period of n years.
Assume the mean of i, is 0.08, the standard deviation of i, is 0.07 and that
1+ i; is independently and lognormally distributed.
(Determine the distribution of Sj. . (5)
An investor is considering investing £6,000 in the fund for 10 years.
(i) Determine the amount of the accumulated value after 10 years such that
there is a 97.5% probability of the investor actually achieving an amount
greater than this. 3]
[Total 8}
Subject CM2, April 2019, Question 10
Consider a model in which the annual rates of return are independent and
identically distributed. Let the rate of return each year have mean j and
variance s*
Let S, represent the accumulated amount at time t =n of a single premium
of $1 paid at time t= 0.
() Derive algebraically an expression for the mean value of S,, . BI
(i) Derive algebraically an expression for the variance of S,, . Bl
[Total 6]
Page 22 © IFE: 2021 Examinations 18 Subject CM2, September 2019, Question 3
Let the random variable log(1+/,) be normally distributed with mean j. and
variance o”, where i; is the rate of interest for year t.
(i) Explain the distribution and parameters for variable S, = [1{=7(1+i,) for
n>1 including your reasoning. G8
Consider the present value of a payment of 1 due at the end of n years
denoted by:
en(4,:\-1
Vn = Mist (+4)
(ii) Derive the distribution and parameters of V, . [5]
[Total 8]
© IFE: 2021 Examinations Page 23 SOLUTIONS TO PAST EXAM QUESTIONS
Subject CT1, April 2010, Question 6
() Calculate the expected accumulation
Let A, represent the accumulated value at time n of a series of annual
investments, each of amount 1, at the start of each of the next n years.
We have £3,000 invested at the start of each year for the next 25 years, so
the expected value of this is:
E(3,000Ap5) = 3,000E(Aps) = 3,000855 @ /%
where we use the formula for the expected value of A, in which j
represents the mean interest rate over the period. So, / = E(i) .
To find the value of j, we can use the fact that 1+ ~ log N(0.05,0.004) .
Using the formula given on page 14 of the Tables:
E(1 + i) = @9-05+0-5%0.004 _ 4 9533757
Hence:
E(i+i)=1+E()=1+j => j=5.33757%
Therefore:
E(3,000Ap5) = 300053 @5.33757%
4 25 _4)
0533757"5 ~1
=s000l) 00533757 J
1.0533757
= £158,037
(i) Calculate the probability
Let S, represent the accumulated value at time n of an investment of
amount 1 at time 0.
Page 24 © IFE: 2021 Examinations Since 1+ /~ log N(0.05,0.004) , and the annual returns are independent, we
know that:
Spo ~logN(20 x 0.05,20 x 0.004) => InSzo ~ N(1.0.08)
We need to calculate the probability P(S29 > E(Szo)) -
Using the formula given on page 14 of the Tables:
E (Spo) = e1*0-5%0.08 = 91.4
Therefore, we need to calculate:
P (S20 > E (S20)) = P(S20 > e'™)
= PlinSop > in(e**})
= P(In Soo > 1.04)
Since InSzo is a normal random variable, we can standardise it by
subtracting the mean and dividing by the standard deviation. Letting
Z~N(0.1):
1 1)
P(S2o > E(S20)) = p(z> te
=P(Z > 0.1414)
=1-P(Z <0.1414)
=1-0.5562
= 0.444
© IFE: 2021 Examinations Page 25 Subject CT1, September 2010, Question 3
() Calculate the expected rate of return pa
E(S,) = E[(1+ i))(1 + ig)... (14 in))
= E(1+iE(1+ in)... E(1+ in) by independence
= (1+ E(i))(1+ Ei) --- (1+ Elin)
We are told that the interest rates are identically distributed, so they will all
have the same mean j = E(i;). Hence:
E(Sp) = (1+ 1)”
Therefore:
E(Sq9)= (14 j* =2 => puiaia. nee
(i) Calculate the variance of the effective rate of return pa
We have:
var(S2o) = ((1+ /)? +s?) = (1+ /)*° = 0.67
=((1+ j)? +s?) - 2? = 0.67
=> (2452-436 = 5? =4.36% -27 = 0.004628
Subject CT1, April 2011, Question 10
(The parameters of the lognormal distribution
We are given that:
(1+ i) ~ log N(u1.07)
E(i,) = 0.06 => E(t+i,) = 1.06
var (i,) = 0.037 = var (1+ i,) = 0.03?
Page 26 © IFE: 2021 Examinations Using the Tables:
E(1+i,) =e” =1.06 (
var(t+i) =e" ( 27 4
Substituting (1) into (2):
1.06"(e°* -'| = 0.03" =|
+1
2
| 0.03
1.067
Substituting into (1):
e/*H(0.000800676) _ 4 og
=> w=! 06 - 3-(0. 000800676) = 0.0578686
So, (1+ i,) ~ log N(0.0578686,0.000800676) .
(ia) probability that liabilities will not be met if all assets are in
The
Investment B
£14m would accumulate to 14(1.04) = £14.56m by the end of the year, so
the company will not be able to meet its liabilities of £15m. The probability
that the company will not meet its liabilities is 1.
(i)(®) ‘The probability that liabilities will not be met if 75% of assets
are in Investment A and 25% are in Investment B
The £14m will be split into £10.5m in Investment A and £3.5m in
Investment B.
The £3.5m in Investment B will accumulate to 3.5 x 1.04 = £3.64m .
In order to accumulate to £15m in total, the assets in Investment A will need
to accumulate to 15-3.64 = £11.36m.
© IFE: 2021 Examinations Page 27 The accumulation factor can therefore be found as:
10.5(1+i,) = 11.36
(+i) = 1.0819
We want the probability that the liabilities are not met, so we want:
P[(1+i) < 1.0819]
Since (1+ i,) ~ log N(u,07) , then:
(1
In(t+4)~NGno2) and Z= HH _ yg.
Therefore:
in1.0819-0 0578686)
0000800676
=P(Z<0.737)
= 0.769
Plt+4) < 1.0819]=P(z <
So the probability that the liabilities will not be met is 0.77 to two decimal
places.
(ii) The variance of the returns from the portfolios
‘The portfolio in (ii)(a) is made up entirely of Investment B. This asset has a
fixed return of 4%, so there is no variation in the return, ie the variance of the
return = 0.
The return on the portfolio in (ji)(b) will be a weighted average of the returns
from Investment A and Investment B, je:
0.75%, + 0.25 x 0.04
‘The variance of the return will be:
var[0.75i; + 0.25 x 0.04 ] = 0.75? var (i,) = 0.75? x 0.03? = 000050625
Page 28 © IFE: 2021 Examinations Subject CT1, April 2012, Question 7
() The expected accumulation of an annual investment
We are given that:
(1+) ~ log N( = 0.05,0? = 0.004)
where / is the annual yield on the fund.
E(5,000A29) = 5,000E (Azo) = 5, 00055514,
where j= E(i).
Using the Tables:
ywrdo® _ ,0.05+1(0,004) _
E(i+i)=e’ e = 1.0533757
=> j=E€(i)=0.0533757
Therefore:
E(5,000A29) 7 5,0008519 5 33757%
1.05337577° -1
4-1.05337577"
= 5,000 x 36.0998
= £180,499
= 5,000 x
(i) The probability that Sjo is greater than its expected value
(S29) = (1+ j)*° = 1.0533757"° = 2.829217
Using the information in the question:
Spo ~logN(20 41,2007)
~logN(20 x 0.05, 20 x 0.004)
~logN(1,0.08)
© IFE: 2021 Examinations Page 29 The required probability is:
P(Sg9 > 2.829217) = P(In Sop > In2.829217)
(, | In2.829217 - 1)
=P|Z>———————
(4° Joos
1.04-1)
=P|Z = P(Z > 0.14142)
(=> pg) = Peover
=1-0(0.14142)
= 0.44377
Subject CT1, September 2012, Question 7
The distribution for the interest rates in each of the ten year periods is:
i 4% 6%
Probability 03 07
() Amount to be invested
The mean of the annual interest rate in each of the ten year periods is:
Eli) = 0.04 x 0.3 + 0.06 x 0.7 = 0.054
We need to discount for 20 years using this rate to get the amount to invest:
200,000
ogano ~ £09.858.26
(i) Expected value in excess of £200,000
After the 20 year period the amount in part (i) will accumulate to one of three
values:
69, 858.26(1.04)?°, 69,858.26(1.06)?°, or 69,858.26(1.04)'9(1.06)"?
We can calculate the probabilities of each of these possibilities using the
distribution of interest rates shown earlier:
& 69,858.26(1.04)*° | 69,858.26(1.06)"° | 69,858.26(1.04)'9(1.06)'°
” = 153,068.06 = 224,044.91 = 185,186.71
Probability | 0.3 x 0.3 = 0.09 0.7x0.7=0.49 2x0.3x0.7=0.42
Page 30 © IFE: 2021 Examinations We can then calculate the expectation from first principles:
153,068.06 x 0.09 + 224,044.91 x 0.49 + 185,186.71 x 0.42 = 201,336.55
So the expected value in excess of £200,000 is £1,336.55.
(iii) Range of accumulated values
We can get the range of values straight from the solution to part (ii):
224,044.91 - 153,068.06 = £70,976.85
Subject CT1, April 2013, Question 6
() Mean accumulation
The mean interest rate in each year is:
J = Eli) = 0.05 x 0.2 + 0.07 x0.6 + 0.09 x 0.2= 0.07
‘So, the mean of the accumulation of £10,000 for 15 years is:
E(10,000S;5) = 10, 000E(S;5) = 10,000 x (1+ j)"> = 10,000 x 1.07"
= £27,590.32
(i) Standard deviation
First we need the variance, s*, of the annual yield:
E(i?) = 0.05? x 0.2 +0.07? x 06 + 0.09" x 0.2 = 0.00506
= s? = 0.00506 - (0.07)? = 0.00016
© IFE: 2021 Examinations Page 31 So the variance of the accumulation of £10,000 for 15 years is:
var(10,000S,.) = 10,000? var(S,5)
@ 10,008 (1 pr +s)? (1+ i*|
5
= 10,0007 [[+07 + 0.00016)" ~107*|
1,597, 283.16
= 10,000"[(1.14506)"* “1 07 |
So the standard deviation of the accumulation is:
sd(10,000S,5) = 1597, 283.16 = £1,263.84
(i)(@) Different yields
If the yields had been 6%, 7% and 8%, the value of j would still have been
7%, So the mean accumulation would be the same. However, the individual
yield values are less spread out, so the standard deviation of the
accumulation would be reduced.
(iii(b) Shorter term
If the term had been 13 years instead of 15, the mean accumulation would
be reduced, since the investment has a shorter time in which to grow. The
standard deviation of the accumulation would also have been reduced, since
the spread of possible outcomes would be narrower if the term of the
investment is shorter.
Subject CT1, September 2013, Question 7
(i) Mean and standard deviation of the accumulation
Let i, denote the yield in year k. The accumulation after 5 years of a unit
‘sum of money invested at time 0 is given by:
Ss = (1414) (1+i2)~-(1+)
Page 32 © IFE: 2021 Examinations The expected value of this accumulation is:
E(Sg) = E[(1+4)(1+ ig)... (14+ ig)]
= E(1+)E(1+ ip)... E(1+ is) by independence
= (1+ E(i) 1+ Eliz) -.- (14 Elis)
We are told that E(i,) = 0.055 . Hence:
E(Sg) = 1.055°
But here there is an investment of £7.85m not a unit sum of money, so:
E(7.85S,) = 7.85E (S,) = 7.85(1.055)° = 10.260 , ie £10,260,000 (5 SF)
The variance of the accumulation after 5 years of a unit sum of money
invested at time 0 is:
var (Ss) = E(S2)~[E (Ss)
The second moment can be written as:
(S32) = elt +i)? (14%)? (1 +i) |
= elt +i) Je [+ ia)? je [0 +n) | by independence
We can simplify this using the variance
var (1+ ig) = E(1+ ig)? -[EM+ig) > E+ ig)? = var(t+ig) +[EC+ iF
So:
(82) = [var(1+ i) +[e(t+ inf | [var(t+is) +[c(1+is)} |
= [var(i) +(1+(4))* || var(i) +(1+€0) |
© IFE: 2021 Examinations Page 33 We are told that E(/;) = 0.055 and var(i;) = 0.047. Hence:
E(S2)-[0 04? +1058? f°
= var(Ss) =[0.047 +1 oss? -[1 oss®
But here there is an investment of £7.85m not a unit sum of money, so:
var(7.85Ss) = 7.857 var(Ss)
= 7.852 {oo + 1.0857)" -(1 085)"°)
= 0.75875
So the standard deviation is J0.75875 = 0.87106, ie £871,100 (4 SF).
Alternatively, we could use the lognormal distribution to calculate the mean
and standard deviation of the accumulation.
(i) Director's suggestion
If there was a guaranteed return of 4% then the accumulated value would
be
7.85(1.04)° = 9.5507, ie £9,551,000 (4 SF).
This is less than the insurance company has to pay out (£10m) so therefore
there is definitely going to be a loss.
However, even though the expected accumulation under the strategy in part
() is higher than the payout, that value is not guaranteed. The standard
deviation of just under £900,000 means that the accumulation could be
much higher than the mean (of £10.26m) but it could also be much lower
leading to a higher loss than investing in the fixed-interest securities.
Page 34 © IFE: 2021 Examinations Subject CT1, April 2014, Question 12
() Distribution of S,
Si2 is given by:
Siz = (14/4) xx (1442)
Taking logs:
log $12 = log(1+i4) +----+10g(1+ 12)
Each of these factors of log(1+i,) has a normal distribution with
parameters, say, 4. and o?.
Since E(i,) = 0.08, we have E(1+ i;) = 1.08. Hence:
eva" 4.08 (1)
Since var (1+ i,) = var(/,) = 0.05? we have:
ed [ew - ‘|= 0.05? 2)
Squaring Equation (1), and substituting into Equation (2), we get:
1.08"| e”* -1]= 0.05"
0.05?
1.087
= o? alog( t+ }=o00er41
‘Substituting back into Equation (1), we find that:
= 11.08 - % x 0.002141 = 0.075891
© IFE: 2021 Examinations Page 35 log Sj» is the sum of twelve independent N(xz,02) random variables. So
logS\z has a N (12,1207) distribution, and hence S,2 is lognormal with
parameters 12,1 = 0.910686 and 120? = 0.025693.
(i) Probability of meeting the objective
£4,000 pa £5,000 pa £6,000 pa
monthly in advance. quarterly in advance continuously
4 4 | 4 4 4 4
t T t t t t t
12, 4 16 18 20 22 24
gS
Mpa % pa
We first need the present value at time 12 of the annuity payments made
subsequent to time 12. These are given by:
Pv = 4.00084) + 5,000v4, (a, + veua). | +6,000V9,v 2094
= 4,000 x 3.514316 + 5,000 x 1.074 {1 886450 + 1.077 x 1.856995 |
+6,000 x 1.07% «1.097? x 3.383414
= 38,825.52
So we now want the probability that 18,000S,, will exceed this value:
Ps. > 38.825,62) = P(S,2 > 2.15697)
= P (log N(0.910686, 0.025693) > 2.15697)
= P(N(0.910686, 0.025693) > log 2.15697)
log 2.15697 - 0.910686 |
0.025693
= P(N(0,1) > -0.88578)
= P(won>
Since the standard normal is symmetrical about zero we have:
P(Z > -0.88578) = P(Z < 0.88578) = 0.81213
So the probability of meeting the objective is about 81%.
Page 36 © IFE: 2021 Examinations 10
Subject CT1, September 2014 Question 2
(i) Premium
The expected annual interest rate is:
E(i) = 0.04 x 0.25 + 0.07 x 0.75 = 0.0625
‘So we use an interest rate of 6.25% to calculate the premium.
The equation of value is:
P = 200,000 x 1.0625-*° = £59,490.99
(ii), Expected profit
The accumulated profit will take one of two values. It may be:
Profit; = 59,490.99 x 1.0479 - 200, 000 = -£69, 647.92
with probability 0.25.
Alternatively, the accumulated profit may be:
Profit, = 59,490.99 x 1.077° ~ 200, 000 = +£30,211.36
with probability 0.75.
So the expected value of the accumulated profit is:
(Prof) = 0.25 x -£69, 647.92 + 0.75 x £30, 211.36 = £5, 246.54
Subject CT1, April 2015, Question 12
() Mean and variance
Let i, denote the yield in year k. Then E(i,) = j and var(i,) = s?. The
accumulation after n years of a single investment of 1 at time 0 is given by:
Sp = (1+ 4) (14 i2) (14+ in)
© IFE: 2021 Examinations Page 37 The expected value of this accumulation is:
E(S,) = E[(1+4) (1+ 2) (1449) ]
=E(1+i)E(1+i.)---E(1+/,) by independence
=[1+E(4))[1+ EG) ]---[1+ E0,)]
=(1+J)(1+/)--(1+/)
=(1+/)"
The variance of the accumulation after n years of a single investment of 1
at time 0 is:
var (S,) - €(S3)-[€(S,)P
The second moment can be written as:
E(s2) = E[(t+i)? (14%)? (tin)? |
=e [(t+4) Je [(1e) | -e[(0+in) | by independence
=[var(t+i) +[EC+ iy) |~[var(t+ in) +[e0+inF |
[var(i)+[1+€ (4) | var()«[1+€ (mF |
[s? +(t+4)? }-[s? +(1 +i
7 [s? +(14 yy
var (Sp) -[2 sea], -(14)"
Page 38 © IFE: 2021 Examinations (ii)(@)__ Lognormat parameters
Here we have E(i,) =0.04, and var(i,)=0.12?. So E(1+i,)=1.04 and
var (1+ i,) = 0.127.
Using the formulae for the mean and variance of the lognormal distribution,
we obtain:
en4e* 4.04 and: e+"
( *-1)=0.122
‘Squaring the first of these equations, and substituting into the second
equation, we get:
1.04? -1)=0.127
Rearranging:
2
oz of (222) } = 0.013226
‘Substituting back to find « , we obtain:
y= 10g 1.04- %o? = 0.032608
(i)(b) Probability
We now want the probability that i, lies between 0.06 and 0.08:
P(0.06 < i, < 0.08) = P(1.06 < 1+i, < 1.08)
=P(t 06
SS
0 1 2 nim “19: 20 Time (years)
The price of the annuity, P, is the present value of its cashflows on the date
it commences, so:
4)
P= 20,000 (ai) + (1.03vat?) ++-+4(1.03)!9v
= 20,0008{/7)(1 + (1.03)v +---+(1.03)'°v'*)
The summation in brackets forms a geometric progression of 20 terms, with
first term 1 and common ratio (1.03)v . So:
1-((1.03)v)"°
1=(1.03)v
14 (1.03)v +---+(1.03)"8v'9 = =14.264880
© IFE: 2021 Examinations Page 45 To calculate P , we also need to calculate the annuity:
Putting these values together gives:
P= 20,0008") (1+ (1.03)v +--+ (1 -03)'°v'9)
= 20,000(0.969649)(14.264880)
= £276,639
So, the price of the annuity is £276,639.
(i) Expected accumulation
The £200,000 will be invested for 5 years (from age 65 to age 70, when the
proceeds will be used to fund the annuity purchase).
Let S; denote the accumulated value at time 5 of an investment of 1 made
at time 0 and let i, denote the interest rate in year t , with E(i,)=j. Then:
Sy = (14:4) (14 ig)(1+i5)(14i4)(14 is)
Taking expectations:
E (Ss) =E[ (1+ i4)(1+in)(1+%3)(1+ ig)(1445)]
=E(1+i)E(1+ig)E(1+i3)E (1+ ig)E(1+i5)
since returns in each year are independent. This simplifies to:
E (Sg) =[1+E(4)][1+ lia) ][1+ Elia) ][1+ Eig) [1+ Etis)] = (14)
Now.
[= Ej) = 0.6 x0.04 + 0.4 x0.07 = 0.052
Page 46 © IFE: 2021 Examinations ‘So the expected accumulation of the investment is:
E (200,000Ss ) = 200,000 (S;) = 200,000 1.052° = £257,697
(iii) Standard deviation
To calculate the standard deviation of the investment, we can first calculate
the variance using the formula:
var (Ss ) = E(S3)~(E(Ss))*
Now:
£(s2)= E[(t+)* (1+ ia) (1+) (t (1446) |
P E[(r+ay Je [ty JEL (+e Y Je[(r+ia)? Je [rey]
since returns in each year are independent.
Looking at each individual term in the product, we have:
E[(+ |= E [14 2), +i? ]=1+ 260) +E?)
where E(i,) = /=0.052.
Now:
E(i?) = 0.6 x 0.04? +0.4x 0.077 = 0.00292
E| (14 i)° |= 1+ 2E(,) +E?) = 142% 0.052 + 0.00292 = 1.10692
It 't. t
© IFE: 2021 Examinations Page 47 Therefore, the variance of S, is:
var(Ss)=€(S2)-(E(Ss))"
1.10692)° -(1.0828)°
= 000162076
So the standard deviation of the investment is:
fvar (200,008, ) = 200,000 [var (Ss)
= 200,000 /0.00162076
= £8,051.74
(iv) Probability
If the interest rate is 7% in each of the five years, the initial investment of
£200,000 will accumulate to:
200,000 x 1.075 = £280,510
which exceeds the purchase price of the annuity of £276,639.
If the interest rate is 7% in four of the years, and 4% in the other year, the
initial investment of £200,000 will accumulate to:
200,000 x 1.074 1.04 = £272,646
which is less than the purchase price of the annuity.
So the individual will have enough to purchase the annuity only if the interest
rate is 7% in each of the 5 years, which has probability:
0.4° =0.01024
Page 48 © IFE: 2021 Examinations 14 Subject CT1, September 2017, Question 5
() Expected effective annual rate of return
We are given that:
100(1+ j)*° = 200
Solving this equation, we find that:
j= 2"? 4=0.03526
The expected effective rate of return per annum is 3.526% pa.
(ii) Standard deviation of the effective rate of return
The variance of the accumulated value of an investment of £100 for 20 years
will be:
2 | (44 2 +82)” — (14; le 502
100° (+4) +8 ) (1+) |=50
So we have the equation (using the value j= 0.03526 from part (i):
100" (1.035002 +87)" -(1 03626}""] = 50?
Rearranging this equation:
[=
jv20
oe? (10320) ~(1.03526”) = 0.0032537
So the standard deviation of the rate of retum is /0.0032537 = 0.05704 , or
5.704% pa.
© IFE: 2021 Examinations Page 49 15 Subject CT1, April 2018, Question 4
() Investment to meet liability with 95% probability
Let S,, denote the accumulation at time n of an initial investment of 1 at
time 0.
Then we have:
10
=[]0+h)
tat
which implies that:
10
In(S1o) = SIn(1+ i) ~ N10, 1007)
tsi
Let x be the amount initially invested by the company, then we require:
P(xSjo > 800,000) = 0.95
> a( ce ee 0.95
n( sono0e
104
> rjmon>— a Ed =0.95
xe
n( 200200) 6m
> = 0.05
Cel
w( 02000). uae
= yeroe
~~ fi0x015
=> x =800,000exp(1.6449 x/10 «0.15 -0.8) = 784,351
So the company should invest approximately €784, 360.
Page 50 © IFE: 2021 Examinations 16
(i)(a)_ Consequence of increasing the mean
Increasing the value of y will increase the expected annual investment
return and so the amount required at time 0 (to meet the liability with
probability 95%) will decrease.
(l(b) Consequence of increasing the standard deviation
Increasing the value of o will increase the volatility of the annual investment
return, which implies that the amount required at time 0 (to meet the liability
with probability 95%) will increase.
(i)(©)_ Consequence of increasing the probability
If the probability of meeting the liability is increased from 95% to 99%, then
the risk of not meeting the liability must be reduced. This can only be
achieved by investing a greater amount now.
Subject CT1, September 2018, Question 6
(i) Distribution of accumulation
We need to find the parameters of the lognormal distribution of 1+ i, given
that E[/,]=0.08 and Var(i,)= 0.077. Let 1+i, ~logN(u,0*), then from
page 14 in the Tables we have:
27 < E114 ig] = 14 Eli] = 1.08
and:
ernre? (e" ) Var(1+i,) = 0.072
Combining these two equations gives:
1.08? (°* -1)- 0.07?
2 0.07?
=> 7 =log| 1+ = 0.0041922
a 1.087
© IFE: 2021 Examinations Page 51 Substituting this result into the first equation gives:
elt 4010041922 _ 4 og
=> r= log(1.08)-4«0.0041922 = 0.074865
40 10
Now Sig = [] (1+ ix) and so log(Sjg) = ¥ log(1+i,)- Since the returns i,
ket ket
are independent, this means that Sj, is lognormally distributed with
parameters 10 and 100”. Therefore we have:
Stq ~ log N(10y,1007)
~ log N(0.74865,0.041922)
(i) Minimum accumulated amount with 97.5% confidence
Let X denote an amount such that we can be 97.5% confident of the
accumulated fund after ten years actually exceeding it. Then we need to
find X such that:
P(6,000Sy9 > X) = 97.5%
=> Pllog(S,o) > log(X / 6,000) = 97.5%
= P(N(0.74865,0.041922) > log(X / 6000)) = 97.5%
log(X / 6,000)-0.74865
=> PIN(O.1)>
( oe (0.041922
}-975%
From page 162 of the Tables, P(N(0,1) > -1.96) = 97.5% , therefore:
log(X / 6,000) - 0.74865 _
0.041922
-1.96
=> X =6,000xexp(-1.96 x (0.041922 + 0.74865) = 8,491.81
So the required amount is approximately £8,492.
Page 52 © IFE: 2021 Examinations 17
18
Subject CM2, April 2019, Question 10
() Expression for mean
See Core Reading paragraph 10.
(i) Expression for variance
See Core Reading paragraphs 11 and 12.
Subject CM2, September 2019, Question 3
()_ Distribution and parameters of S,,
See Core Reading paragraph 20.
(i) Distribution and parameters of V,
From the question we have
far tayo! = (FAA y+ i)
=> log(V,)= —log(1+ i) -log(1+i2)—...—log(1+ in)
Since, for each value of t, log(1+ i;)is normally distributed with mean. and
variance o”, each term on the right-hand side of the above equation is
independent and normally distributed with mean -, and variance o?
So, log(V,) is normally distributed with mean -ny and variance na? .
Therefore, V,, has a lognormal distribution with parameters -ny and no®.
© IFE: 2021 Examinations Page 53 FACTSHEET
This factsheet summarises the main methods, formulae and information
required for tackling questions on the topics in this booklet.
Stochastic interest rate models
A stochastic interest rate model provides information about the distribution of
financial outcomes. This distribution can be used to find best estimates and
probabilities
The varying interest rate model and the fixed interest rate model provide
formulae for the mean and variance of the accumulated amount of a fund or
the present value of a future payment.
Varying interest rate model (single premium):
E(S,)= (1+ /)" var(S,) = [(1+ j)? +87)" -(1+ j)?”
Fixed interest rate model (single premium):
(Sp) = El(1+i)"] var(Sn) = El(1+/)?"]- (E+) )?
For the varying interest rate model, the variance and higher moments of the
accumulated amount of a series of payments can be calculated using
recursive formulae.
Varying interest rate model (annual premium)
E(A,) = 5 at rate j
Recursive formulae for E(A,) :
E(Ag)=0
and:
EA) = (1+ J+ EA (kK =12.....9)
Page 54 © IFE: 2021 Examinations Recursive formulae for var( Ap) :
(AS) =0
and:
E(AR) = [1+ J)? +87I1 + 2E (Ag 1) + ECAR (k= 1.2.42)
Then:
var(A,) = E(As)-[E(A,)I?
For the fixed interest rate model with annual premiums, calculate the mean
and variance directly from the definitions.
The lognormal distribution can be used to model the annual growth rate.
This allows probabilities to be determined in terms of the distribution function
of the normal distribution.
The lognormal model formulae for the varying interest rate model are:
Sp ~log (nui, no?)
Hence:
P(S,
