Annuities
Annuity
An annuity is a financial instrument with periodic pay-
ments.
Example
Monthly deposits of $1000 into an interest-earning
account.
Annuities
Annuity
An annuity is a financial instrument with periodic pay-
ments.
Example
Monthly deposits of $1000 into an interest-earning
account.
Pension fund deposits.
Annuities
Annuity
An annuity is a financial instrument with periodic pay-
ments.
Example
Monthly deposits of $1000 into an interest-earning
account.
Pension fund deposits.
Paying a lump sum at retirement and receiving monthly
pension payments for the rest of your life.
Annuities
Annuity
An annuity is a financial instrument with periodic pay-
ments.
Example
Monthly deposits of $1000 into an interest-earning
account.
Pension fund deposits.
Paying a lump sum at retirement and receiving monthly
pension payments for the rest of your life.
Lottery winnings payable over 30 years.
Annuities
Annuity
An annuity is a financial instrument with periodic pay-
ments.
Example
Monthly deposits of $1000 into an interest-earning
account.
Pension fund deposits.
Paying a lump sum at retirement and receiving monthly
pension payments for the rest of your life.
Lottery winnings payable over 30 years.
Mortgages and other such loans.
Annuities: Basic Setup
The most basic annuity has the following assumptions:
Constant payments of C at
n equally spaced intervals
and constant interest rate i.
Annuities: Basic Setup
The most basic annuity has the following assumptions:
Constant payments of C at
n equally spaced intervals
and constant interest rate i.
Question
How much is an annuity worth at various times? For example:
If I can afford monthly payments of $400 for the next 5
years, how much money can I borrow right now to buy a
car?
What should monthly payments be on my mortgage?
If I make monthly deposits of $100 into an education
fund, how much money will be in the account when my
child starts college?
Annuities: Basic Setup
The most basic annuity has the following assumptions:
n constant payments of C at
equally spaced intervals
and constant interest rate i.
Definition
The concise notation for n payments at equally spaced periods
and constant interest rate i (per period) is n i written in the
subscript.
Annuity n i
Two adjectives:
Buy/sell an annuity immediate means the first periodic
payment is at the end of the first period.
Buy/sell an annuity due means the first periodic
payment is at the start of the first period.
Lecture 13 February 15, 2023
Recall from last lecture
Annuities
Annuity immediate and annuity due
What kind of contract is this?
0 1 2 n−1 n n+1
C C C C
Annuity immediate and annuity due
What kind of contract is this?
0 1 2 n−1 n n+1
C C C C
Contract length: n periods.
Start at 0 end at n: annuity immediate.
Start at 1 end at n + 1: annuity due.
Example
For the following annuities, when will the first and last
payments occur?
Purchase Date Annuity Type Frequency
4/1/2023 Annuity Immediate Every 3 months
5/1/2023 Annuity Immediate Yearly
6/1/2023 Annuity Due Every month
7/1/2023 Annuity Due Every 6 months
Annuity immediate and annuity due
Example
At the start of 2023 you buy an annuity immediate with 10
yearly payments of 100, you sign a contract to buy at the start
of 2025 an annuity immediate with 5 payments of 200 every
two years, and another contract to sell an annuity due with 4
payments of 150 every 3 years. What will be the total
cashflows at the start of 2029, 2030, and 2031?
Present Value and Accumulated Value
What kind of contract is this?
0 1 2 n−1 n n+1
C C C C
Time value of annuity
What is the value of this annuity Annuity n i at various
points in time?
Time t Notation for value of Annuity n i at time t
0 an i
1 ä n i
n sn i
n+1 s̈ n i
Pricing an annuity at the end: accumulated value
Pricing an annuity at the end: algebra
s n i = 1 + (1 + i) + (1 + i)2 + · · · + (1 + i)n−1
xk+1 − 1
1 + x + x2 + · · · + xk =
x−1
Pricing an annuity at the end: algebra
s n i = 1 + (1 + i) + (1 + i)2 + · · · + (1 + i)n−1
xk+1 − 1
1 + x + x2 + · · · + xk =
x−1
(1 + i)n−1+1 − 1
sn i =
(1 + i) − 1
Accumulated Value of Annuity Immediate
(1 + i)n − 1
sn i =
i
Lottery winnings
Example
You won the lottery and you received $1000 each year for 30
years. Interest rates are 3%. What is the value of the lottery
winnings at the time of the last payment? What about 10
years later?
Lecture 14 February 17, 2023
One of these two plots is EURUSD in 2015. The other one is
the time series that pays ±$1 for each prime number p with
p ± 1 a multiple of 4. Which one is which?
Recall from last lecture
Annuities
Annuities after the last payment
Accumulated value after the last payment
To find the accumulated value of an annuity after the last
payment you simply multiply by the accumulated factor,
as you would do for any balance.
Annuities after the last payment
Example
On the first of each month of 2022 you deposit $1000, on the
first of each month of 2023 you deposit $2000, and on the
first of each month of 2024 you deposit $3000. How much
money do you have at the end of 2024 if the nominal interest
rate compounded monthly was 5% in 2022, 4% in 2023, and
3% in 2024? (75085.47)
Pricing an annuity at the beginning
Pricing an annuity at the beginning: algebra
an i = ν + ν 2 + · · · + ν n
1 − xk+1
1 + x + x2 + · · · + xk =
1−x
Pricing an annuity at the beginning: algebra
an i = ν + ν 2 + · · · + ν n
1 − xk+1
1 + x + x2 + · · · + xk =
1−x
1 − νn
an i = ν ·
1−ν
Present Value of Annuity Immediate
1 − νn
an i =
i
Pricing annuities: finding the present value
Example
I want to buy a car, and the bank offers me a loan at nominal
interest rate i(12) = 2.3% for a 5-year loan. I can afford to pay
300 per month. How much money can I borrow to buy the
car? (16988.2. In 2021 the average price for used cars was
$28205.)
Pricing annuities: finding the payments
Example
On 2/7/2022 a 30-year fixed mortgage sold near Notre Dame
with a monthly nominal annual interest rate of 3.7%. If you
borrowed $260000 for a house, what are your monthly
payments? (1196.74)
Lecture 15 February 20, 2023
Pricing an annuity at the beginning: algebra take 2
(1 + i)n − 1
sn i =
i
1 − νn
an i =
i
Pricing annuities: finding the interest rate
2.1.17
(i = 7.177% and X = 574.74)
Annuities at other times
What do you need to remember?
If you know the price of an annuity at any time you can
find its value at any other time, using the concept of
time value of money.
(1 + i)n − 1 1 − νn
sn i = an i =
i i
(1 + i)n − 1 1 − νn
s̈ n i = ä n i =
d d
Pricing annuities: finding the number of periods
Example
$10k are borrowed at the present, to be repaid in yearly
installments, beginning with one year from now. The
payments are $500 per year for the first 5 years, and $1000 per
year thereafter. The annual interest rate is 4%. How long until
the debt is repaid? (18 years)
Combining annuities: different levels of payments
2.1.31
(X = 573.36 and Y = 449.94)
Lecture 16 February 22, 2023
Midterm 1: Chapters 1 and 2.1
Lecture 17 February 24, 2023
Recall from last lecture
Annuities
Combining annuities: different interest rates
Example
A 15-year annuity has yearly payments starting now. For the
first 5 years the annual interest rate is 4%, and for the last 10
years it has annual discount rate of d. You make level
payments. What is the implied discount rate d if this annuity
is equivalent to a 10-year annuity immediate with interest rate
3% and level payment rates that are 30% larger than in the
first annuity? (d = 5.49%)
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
i i i i i d d d d d d d d d d
$1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1
0 1 2 3 4 5 6 7 8 9 10
3% 3% 3% 3% 3% 3% 3% 3% 3% 3%
$1.3 $1.3 $1.3 $1.3 $1.3 $1.3 $1.3 $1.3 $1.3 $1.3
Combining annuities: different interest rates
Basic Annuity
Remember that a basic annuity (for which we can use a n i
and s n i ) has 2 assumptions: (a) equal payments, and (b)
equal interest rate.
The first annuity can be realized as a combination of two basic
annuities in two different ways:
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
i i i i i d d d d d d d d d d
$1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
i i i i i d d d d d d d d d d
$1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1
Combining annuities: different interest rates
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
i i i i i d d d d d d d d d d
$1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
i i i i i d d d d d d d d d d
$1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1 $1
Forever annuities
Perpetuity
A perpetuity is an annuity with infinitely many equally
spaces level payments at a fixed interest rate.
Remark
Perpetuities are, really, financial fictions. They were
issued in the past, under the name of “consols,” by the
UK (until 2015) and the US (until 1930).
But they are useful mathematical devices that can be
used to value certain financial assets, such as stock
prices, real estate assets, etc.
Pricing Perpetuities
Perpetuityi = Annuity ∞ i
Pricing Perpetuities
Perpetuityi = Annuity ∞ i
1 − νn 1
a ∞ i = lim a n i = lim =
n→∞ n→∞ i i
Pricing Perpetuities
Perpetuityi = Annuity ∞ i
1 − νn 1
a ∞ i = lim a n i = lim =
n→∞ n→∞ i i
Alternatively, we could use the timeline again:
ν 1
a ∞ i = ν + ν 2 + ν 3 + · · · = ν(1 + ν + ν 2 + · · · ) = = .
1−ν i
Pricing Perpetuities
Perpetuityi = Annuity ∞ i
1 − νn 1
a ∞ i = lim a n i = lim =
n→∞ n→∞ i i
Alternatively, we could use the timeline again:
ν 1
a ∞ i = ν + ν 2 + ν 3 + · · · = ν(1 + ν + ν 2 + · · · ) = = .
1−ν i
Remark
This is related (and mathematically identical) to questions
about probability: You throw a pair of dice. How long until
you hit a double 6? The probability to get a double 6 is
1
i = 36 = 16 · 16 . The expected number of tries until you get a
double 6 is then 1i = 36.
Pricing Perpetuities: take 2
0 1 2 3
$1 $1 $1 $1 $1 $1 $1 $1 $1
Write P = a ∞ i , the price of a perpetuity one period before
the first payment.
0 1 2 3
$1 $1 $1 $1 $1 $1 $1 $1 $1
How close are perpetuities to reality?
Example
Pride and Prejudice features 4% perpetuities, and such assets
were widely purchased and traded in Jane Austen’s time.
(Also World War 2 Britain.) Such a perpetuity purchased in
1813 (the year the novel appeared) would have been redeemed
by the UK Parliament in 1923.
How close are perpetuities to reality?
Example
Pride and Prejudice features 4% perpetuities, and such assets
were widely purchased and traded in Jane Austen’s time.
(Also World War 2 Britain.) Such a perpetuity purchased in
1813 (the year the novel appeared) would have been redeemed
by the UK Parliament in 1923. What if in 1923 this
perpetuities had been lost (for example, the UK goverment
might have been bankrupt after World War 1). How close
would the value of this financial asset (a 110-year annuity)
have come to the theoretical value of a perpetuity? (Within
1.34%, within 1% after 118 years.)
Lecture 18 February 27, 2023
Recall from last lecture
Annuities and Perpetuities
Combining perpetuities
Example
A perpetuity pays 1 every January 1 starting in 2023. The
effective annual interest rate will be 2% in odd-numbered
years and 3% in even-numbered years. Find the present value
of the perpetuity on January 1, 2022. (39.92)
2022 2023 2024 2025 2026 2027 2028
3% 2% 3% 2% 3% 2%
$1 $1 $1 $1 $1 $1
Pricing perpetuities before they begin
Example
A sum of $100k is donated to Notre Dame on September 1,
2022, to be added to the endowment in order to finance the
Math Club. Notre Dame invests this sum at an effective
annual interest rate of 5%, in order to provide the Math Club
$10k every September 1 forever, starting as soon as possible.
In what year with the first payment of $10k be made? (2038,
but it could afford to also pay $7892.82 in 2036.)
Recovering annuities from perpetuities
We already saw that
Annuity n i (1, . . . , n) = Annuity ∞ i (1, . . .)−Annuity ∞ i (n+1, . . .)
PVt=0 (Annuity n i (1, . . . , n)) =
PVt=0 (Annuity ∞ i (1, . . .)) =
PVt=0 (Annuity ∞ i (n + 1, . . .)) =
Recovering annuities from perpetuities
We already saw that
Annuity n i (1, . . . , n) = Annuity ∞ i (1, . . .)−Annuity ∞ i (n+1, . . .)
PVt=0 (Annuity n i (1, . . . , n)) =
PVt=0 (Annuity ∞ i (1, . . .)) =
PVt=0 (Annuity ∞ i (n + 1, . . .)) =
1 − νn
an i = a∞ i − ν n a∞ i = .
i
(1 + i)n − 1
sn i = a n i (1 + i)n = .
i
In-class Exercise
Example
You purchase a perpetuity immediate on 1/1/2022 for X.
This perpetuity pays every 1/1 as follows: if the year is a
multiple of 3, it pays 3; if the year is a multiple of 3 plus 1, it
pays 5; if the year is a multiple of 3 plus 2, it pays 7.
What was the price X of this annuity if the interest rate
is 10%?
What about if interest rates are 5% in even years, and
10% in odd years?
Lecture 19 March 1, 2023
Annuities payable multiple times per period
m-thly payable annuity
An m-thly payable annuity is an annuity lasting n years
and paying m1 each period of m1 years.
Remark
An n-year annuity and an n-year m-thly payable annuity have
the same time length and the same total cash paid, but of
course the values of these two cashflows will be different.
an i sn i
(m) (m)
an i sn i
Pricing m-thly payable annuities
Pricing m-thly payable annuities
How did we approach questions like this previously? We
computed the per-period interest j and reinterpreted the
n-year annuity as an mn-period annuity:
(m) 1
Annuity n i = Annuity mn j .
m
You could do
(m) 1 (m) 1
an i = a mn j sn i = s mn j
m m
Pricing m-thly payable perpetuities
Instead, let’s work out m-thly payable perpetuities:
(m) 1
Annuity ∞ i = Annuity ∞ j
m
(m) 1
a∞ i = a∞ j
m
m
i(m)
m
1 + i = (1 + j) = 1 +
m
Pricing m-thly payable perpetuities
Instead, let’s work out m-thly payable perpetuities:
(m) 1
Annuity ∞ i = Annuity ∞ j
m
(m) 1
a∞ i = a∞ j
m
m
i(m)
m
1 + i = (1 + j) = 1 +
m
(m) i
a∞ i = a∞ i ×
i(m)
(m) i
Annuity ∞ i = Annuity ∞ i ×
i(m)
Pricing annuities vs m-thly payable annuities
Annuity n i = Annuityyear>0
∞i − Annuityyear>n
∞i
(m) (m),year>0 (m),year>n
Annuity n i = Annuity ∞ i − Annuity ∞ i
so we conclude that
(m) i
Annuity n i = Annuity n i ×
i(m)
(m) i (m) i
an i = an i × sn i = sn i ×
i(m) i(m)
Exercise
2.2.16 Payments of 25 are made every 2 months from June 1,
2003 to April 1, 2009 inclusive. Find the value of the series
1 2 months before the first payment at an annual effective
interest rate of i = 0.06 (755.83),
2 10 months before the first payment at a nominal annual
rate of i(3) = 0.06 (724.08),
3 2 months after the final payment at a nominal annual
rate d(2) = 0.06 (1092.02), and
4 1 year after the final payment at annual force of interest
δ = 0.06 (1144.57).
4/03 4/09
2 1 3 4
Exercise
2.2.15
(i = 7.72% and X = 39.83)
Lecture 20 March 3, 2023
Apple Dividends
Recall from last lecture
Annuities and Perpetuities
Continuously paying annuities
Recall from the chapter on nominal interest rates the idea of a
continuous nominal interest rate i(∞) , which we reinterpretted
as force of interest.
m
i(m)
(∞)
1+i= 1+ = ei = eδ
m
δ = i(∞) = ln(1 + i)
a(t) = (1 + i)t = eδt
Continuous Annuities
A continuous annuity is an annuity of the form
(m)
Annuity n i as m → ∞. It pays continuously for a total
of 1 per period.
Pricing continuous annuities
The present value and accumulated value of a continuously
paying annuity are
(∞) (m)
ā n i = “a n i ” = lim a n i
m→∞
(∞) (m)
s̄ n i = “s n i ” = lim s n i
m→∞
Pricing continuous annuities
The present value and accumulated value of a continuously
paying annuity are
(∞) (m)
ā n i = “a n i ” = lim a n i
m→∞
(∞) (m)
s̄ n i = “s n i ” = lim s n i
m→∞
In other words
i
ā n i = a n i
δ
i
s̄ n i = sn i
δ
Pricing continuous annuities with force of interest
How to price continuous annuities if the interest rate is not
constant? I.e., with variable force of interest?
Z n Z n
1
ā n i = dt s̄ n i = a(t, n)dt
0 a(0, t) 0
Pricing continuous annuities with force of interest
How to price continuous annuities if the interest rate is not
constant? I.e., with variable force of interest?
Z n Z n
1
ā n i = dt s̄ n i = a(t, n)dt
a(0, t)
Z0 n Z0 n
= (1 + i)−t dt = (1 + i)n−t dt
0 0
Pricing continuous annuities with force of interest
How to price continuous annuities if the interest rate is not
constant? I.e., with variable force of interest?
Z n Z n
1
ā n i = dt s̄ n i = a(t, n)dt
a(0, t)
Z0 n Z0 n
= (1 + i)−t dt = (1 + i)n−t dt
0 0
With force of interest the only thing that changes is the
accumulated factor: remembering that
Z t2 Z t2
d
ln a(t1 , t2 ) = ln a(t)dt = δt dt.
t1 dt t1
Exercise
2.2.18 Find the present value at time t = 0 of an 10-year
continuous annuity based on force of interest
0.2
δt = 0.1 + .
1 + e0.2t
Annuities where the payments change over time
Our basic annuities had 3 assumptions: (a) equally spaced
payments (b) constant interest rate i and (c) equal level of
payments 1.
1 1 1 ... 1
i i i i i
0 1 2 3 n
Three important alternatives keep assumptions (a) and (b),
but relax (c):
Geometric annuities with constant growth rate r
1 1+r (1 + r)2 ... (1 + r)n−1
i i i i i
0 1 2 3 n
Example
The Powerball Lottery allows one to cash the winnings as a
lump sum payable immediately OR as a 30-year geometric
annuity due with r = 5%.
Annuities where the payments change over time
Increasing/decreasing arithmetic annuities
(Ia) n i (Is) n i
1 2 3 ... n
i i i i i
0 1 2 3 n
n n−1 n−2 ... 1
(Da) n i (Ds) n i
Example
Say every year, starting now, you invest $10 into an account
which earns 10% but which does not cumulate interest. You
withdraw the interest earn and reinvest it into an account at
5%.
10 10 10 10 ... 10
10% 10% 10% 10% 10%
0 1 2 3 n
5% 5% 5% 5% 5%
1 2 3 ... n
Pricing geometric annuities
Present value
Growth rate r, interest rate i, n periods:
n
one period before 1 1+r
PV = 1−
first payment i−r 1+i
1 1+r (1 + r)2 ... (1 + r)n−1
i i i i i
0 1 2 3 n
Pricing geometric annuities
Future value
Growth rate r, interest rate i, n periods:
time of the 1
FV = ((1 + i)n − (1 + r)n )
last payment i−r
1 1+r (1 + r)2 ... (1 + r)n−1
i i i i i
0 1 2 3 n
Lecture 21 March 6, 2023
Annuities with varying payments
Present value
Growth rate r, interest rate i, n periods:
n
one period before 1 1+r
PV = 1−
first payment i−r 1+i
1 1+r (1 + r)2 ... (1 + r)n−1
i i i i i
0 1 2 3 n
Pricing geometric annuities: using inflation
1 1+r (1 + r)2 ... (1 + r)n−1
i i i i i
0 1 2 3 n
Payments that grow at a rate of r per period is equiva-
lent to equal payments but at an inflation rate of r, the
i−r
inflation-adjusted interest being .
1+r
1 i−r 1 i−r 1 i−r
... i−r 1
i 1+r 1+r 1+r 1+r
0 1 2 3 n
Example
You win $10m at the Powerball. You either cash it in one
lump sum or as a 30-year geometric annuity due with growth
5% (that pays a total of $10m).
1 What are the amounts of the first and last payments?
(150514.35 and 619537.48)
Example
You win $10m at the Powerball. You either cash it in one
lump sum or as a 30-year geometric annuity due with growth
5% (that pays a total of $10m).
1 What are the amounts of the first and last payments?
(150514.35 and 619537.48)
2 The tax rate is 55% for payments above 1m, and 20% for
payments below 1m. The interest rate is 3%. Which
option has the larger present value? (4.5m vs 4.7m)
Annual growth rate with monthly payments
2.3.1
(24671 the first year, i = 6.1677%, PV = 419242)
Dividend Discount Model for Stock Prices
DDM
The Dividend Discount Model for pricing a stock posits
that the price of the stock equals the present value of all
future dividend payments.
K K(1 + r) ... K(1 + r)n−1 ...
i i i i i
0 1 2 n
P
If r < i: n
1 − 1+r
1+i K
P = lim K = .
n→∞ i−r i−r
Apple Stock Prices
Apple Stock Prices
Split-adjusted dividends for Apple:
Apple Stock Prices
Fiscal Year May Aug Nov Feb
2014-15 0.47 0.47 0.47 0.47
2015-16 0.52 0.52 0.52 0.52
2016-17 0.57 0.57 0.57 0.57
2017-18 0.63 0.63 0.63 0.63
2018-19 0.73 0.73 0.73 0.73
2019-20 0.77 0.77 0.77 0.77
2020-21 0.82 0.82 0.82 0.82
2021-22 0.88 0.88 0.88 0.88
2022-23 0.92 0.92 0.92 0.92
Apple Stock Prices
Fiscal Year May Aug Nov Feb
2014-15 0.47 0.47 0.47 0.47
2015-16 0.52 0.52 0.52 0.52
2016-17 0.57 0.57 0.57 0.57
2017-18 0.63 0.63 0.63 0.63
2018-19 0.73 0.73 0.73 0.73
2019-20 0.77 0.77 0.77 0.77
2020-21 0.82 0.82 0.82 0.82
2021-22 0.88 0.88 0.88 0.88
2022-23 0.92 0.92 0.92 0.92
0.92
(1 + r)8 = r = 8.76%
0.47
Kq = next quarterly dividend = 0.92(1 + r) = 1.
Lecture 22 March 8, 2023
Dividend Discount Model
K
P =
i−r
K K(1 + r) ... K(1 + r)n−1 ...
i i i i i
0 1 2 n
P
Apple Dividends
0.88 0.88 0.88 0.88 0.92 0.92 0.92 0.92 X X X X X2 X2 X2 X2 X3 X 3 X3 X 3
−2 −1 0 1 2 3
2/16/23
Apple Stock Prices
Fiscal Year May Aug Nov Feb
2014-15 0.47 0.47 0.47 0.47
2015-16 0.52 0.52 0.52 0.52
2016-17 0.57 0.57 0.57 0.57
2017-18 0.63 0.63 0.63 0.63
2018-19 0.73 0.73 0.73 0.73
2019-20 0.77 0.77 0.77 0.77
2020-21 0.82 0.82 0.82 0.82
2021-22 0.88 0.88 0.88 0.88
2022-23 0.92 0.92 0.92 0.92
0.92
(1 + r)8 = r = 8.76%
0.47
Kq = next quarterly dividend = 0.92(1 + r) = 1.
Apple Stock Prices on Feb 16, 2023
K
P =
i−r
What is K here? It should be the next yearly dividend so
(4)
K = 4Kq s 1 i
But what about the interest rate i?
Apple Stock Prices on Feb 16, 2023
K
P =
i−r
What is K here? It should be the next yearly dividend so
(4)
K = 4Kq s 1 i
But what about the interest rate i? Say we use i = 10%.
Then
(4)
K = 4Kq s 1 i = 4.147
and so
K 4.147
Apple Stock Price = = = 334.43.
i−r 10% − 8.76%
At the time of the last dividend payment, Apple sold for
153.71. Clearly something is wrong.
Apple Stock Prices on Feb 16, 2023
K
P =
i−r
What is K here? It should be the next yearly dividend so
(4)
K = 4Kq s 1 i
Maybe we used the wrong i.
i = 4.75%(e.g., US Discount Rate in 3/2023)
K is the next yearly dividend, in our model:
(4)
K = 4Kq s 1 i = 4.07056.
So we get the price
K 4.07056
Apple Stock Price = = = −101.51.
i−r 4.75% − 8.76%
Apple Stock Prices on Feb 16, 2023
K
P =
i−r
Implied Interest Rate
Instead, we’ll compute a value for the interest rate i which
makes the stock price equal to the DDM price. This is
the implied interest rate from DDM.
Apple stock price is 153.71 on 2/16/2023:
(4)
K 4s 1 i
= 153.71 = 153.71.
i−r i−r
i = Implied Interest Rate = 9.43%.
Pricing arithmetic annuities
(Ia) n i (Is) n i
1 2 3 ... n
i i i i i
0 1 2 3 n
Increasing Arithmetic Annuities
ä n i − nν n
(Ia) n i =
i
Portfolio:
Buy an IAnnuity n i at time 0,
Sell an IAnnuity n i at time 1.
Price the portfolio in two different ways to find Ia n i .
Exercise
2.3.14
(n = 19)
Exercise
2.3.14
(n = 19)
77.1 = ν(Ia) n−1 i + na ∞ i ν n
ä n−1 i − (n − 1)ν n−1 nν n
=ν +
i i
1 − ν n−1
1 n n
= ν − (n − 1)ν + nν
i 1−ν
ν
77.1 = (1 − ν n )
i(1 − ν)
Lecture 23 March 10, 2023
US Government budget and GDP
([Link])
Exercise: takes 2 and 3
2.3.14
(n = 19)
77.1 = ν(Ia) n i + na ∞ i ν n+1
77.1 = na ∞ i − (Da) n i
Pricing Decreasing Arithmetic Annuities
(Ia) n i (Is) n i
1 2 3 ... n
i i i i i
0 1 2 3 n
n n−1 n−2 ... 1
(Da) n i (Ds) n i
I Annuity n i +D Annuity n i = (n + 1) Annuity n i
(Ia) n i + (Da) n i = (n + 1)a n i
Recalling that
ä n i − nν n
(Ia) n i =
i
Pricing Decreasing Arithmetic Annuities
(Ia) n i (Is) n i
1 2 3 ... n
i i i i i
0 1 2 3 n
n n−1 n−2 ... 1
(Da) n i (Ds) n i
I Annuity n i +D Annuity n i = (n + 1) Annuity n i
(Ia) n i + (Da) n i = (n + 1)a n i
Recalling that
ä n i − nν n
(Ia) n i =
i
ä ∞ 1 1
(Ia) ∞ i = = + 2.
i i i
Continuous annuities with nonlevel payments
We already discussed continuous annuities with nonlevel
interest rates (i.e., with nonlevel force of interest).
Continuous Annuities
Suppose an annuity pays h(t) at time t between 0 ≤ t ≤
n. Then Z n
1
PVt=0 = h(t) dt,
0 a(t)
where a(t) = eδt if δ is constant.
1 Level annuity has h(t) = K constant.
2 Geometric annuity has h(t) = K(1 + r)t .
3 Increasing (resp. descreasing) arithmetic annuity has
h(t) = Kt (resp. h(t) = K(n − t)).
Pricing continuous annuities
Continuous annuity price
Z n
h(t)
PVt=0 = dt.
0 a(t)
Geometric annuities h(t) = (1 + r)t , a(t) = eδt
Z n Z n
t −δt
PVt=0 = (1 + r) e dt = (eln(1+r) )t e−δt dt
0 0
Pricing continuous annuities
Continuous annuity price
Z n
h(t)
PVt=0 = dt.
0 a(t)
Geometric annuities h(t) = (1 + r)t , a(t) = eδt
Z n Z n
t −δt
PVt=0 = (1 + r) e dt = (eln(1+r) )t e−δt dt
0 0
Z n n(ln(1+r)−δ)
e −1
= et(ln(1+r)−δ) dt =
0 ln(1 + r) − δ
Pricing continuous annuities
Continuous annuity price
Z n
h(t)
PVt=0 = dt.
0 a(t)
Geometric annuities h(t) = (1 + r)t , a(t) = eδt
Z n Z n
t −δt
PVt=0 = (1 + r) e dt = (eln(1+r) )t e−δt dt
0 0
Z n n(ln(1+r)−δ)
e −1
= et(ln(1+r)−δ) dt =
0 ln(1 + r) − δ
1+r 1+r
n
en ln 1+i − 1 1+i
−1
= 1+r = 1+r
ln 1+i ln 1+i
Pricing continuous annuities
Continuous annuity price
Z n
h(t)
PVt=0 = dt.
0 a(t)
Increasing arithmetic annuities h(t) = t, a(t) = eδt
Z n Z n −δt
−δt e
PVt=0 = te dt = td
0 0 −δ
−δt
Z n −δt
e e
=t |n0 − dt
−δ 0 −δ
−δt −δt
e n e
=t |0 − |n0
−δ δ2
1 ne−δn e−δn
= 2− − 2
δ δ δ
Exercise
A financial instrument consists of an initial payment of 100
and then a continuous annuity that pays at the level
h(t) = 20 + 5t + 1.03t , with force of interest δ = 5%. How
much is accumulated in the account after 10 years?