Topic 2. Payment, Annuity Streams

2 Basic Definitions Let us call the sequence (range) of payments and inflows arranged for different time moments a payment stream. The payment stream whose elements are positive values and time intervals between two consequent payments are constant are called a financial contract or annuity irrespectively of the purpose, destination and origin of these payments. In practice, financial operations, as a rule, stipulate payments and cash inflows interspaced in time. The annuity is described through the following parameters: Annuity component – the value of each separate payment. Annuity interval – time interval between payments. Annuity term – time from the beginning of the annuity till the end of its last period (interval). Interest rate – the rate used for accumulation or discounting of payments of which the annuity is composed.

3 Annuity Types An annuity is called annual if its period equals one year. An annuity is called p -due, if its period is less than a year and the number of annual payments is p. These annuities are discrete since their payments are coordinated with discrete time points. There are continuous annuities when the payment stream is characterized with the continuous function. Annuities may be constant and variable. An annuity is constant if all its payments are equal and do not change in time. If the amounts of payment depend on time, the annuity is variable. The annuity is certain (terminating) if the number of payments is finite; otherwise the annuity is called indefinite or perpetual. Annuities may be immediate or postponed (deferred). The term of immediate annuities starts from the moment of contract conclusion. If the annuity is postponed, then the starting date of payments is moved aside for a certain time. If payments are made at the end of a period, then such an annuity is called ordinary or annuity-immediate. If payments are made at the beginning of a period, then such an annuity is called annuity-due.

4 Generalized Characteristics of Payment Streams The accumulated sum of a payment stream is the sum of all the successive payments with their calculated interest by the end of the annuity. The present value of a payment stream is the sum of all the payments discounted for a certain time point that coincides with the beginning of the payment stream or that predicts it.

5 Accumulated Sum of Annual Annuity. Annuity-Immediate S – accumulated sum of annuity; R – amount of individual payment; i – interest rate in form of a decimal fraction; n – annuity term in years. Compound accumulation rate 0

6 Accumulated Sum of Annual Annuity. Continued a 1 – first member of a sequence; q – denominator of a sequence.

7 Annuity-Due 0 Compound accumulation rate

8 Simple rate 0 Accumulated Sum of Annual Annuity. Annuity-Immediate

9 Accumulated Sum of Annual Annuity. Annuity-Due Simple rate 0

10 Accumulated Sum of Annual Annuity with Interest Calculation m Times a Year Annuity-Immediate

11 Annuity-Due Accumulated Sum of Annual Annuity with Interest Calculation m Times a Year

12 Accumulated Sum of p -Due Annuity. Annuity-Immediate The amount of payment is R/р, the interval between payments equals 1/р, the number of payments equals np.

13 Accumulated Sum of p -Due Annuity. Annuity-Due

14 Accumulated Sum of p -Due Annuity with Interest Calculation m Times a Year Annuity-immediate

15 Accumulated Sum of p -Due Annuity with Interest Calculation m Times a Year Annuity-Due

16 Present Value of Ordinary Annuity. Annuity-Immediate The present value is the sum of all the discounted members of a payment stream at the starting or its preceding time point. The term present discounted value is sometimes used instead of the term present value. Compound discount rate

17 Present Value of Ordinary Annuity. Annuity-Due Compound discount rate

18 Present Value of Ordinary Annuity. Annuity-Immediate Simple discount rate

19 Present Value of Ordinary Annuity. Annuity-Due Simple discount rate

20 Present Value of Annual Annuity with Interest Calculation m Times a Year Let us replace the discount factorin the obtained formula for the present value of the annual annuity with the factor

21 Present Value of p –Due Annuity ( m=1 ). Annuity-Immediate. The interval between payments with such an annuity equals 1/p, the amount of payment is R/p.

22 Present Value of p –Due Annuity ( m=1 ). Annuity-Due

23 Present Value of p –Due Annuity with Interest Calculation m Times a Year Annuity-immediate Annuity-Due if p=m, then

24 Relation between Accumulated and Present Values of Annuity Let А be the present value of the annual annuity at the beginning of the term with interest calculation once a year, and S be the accumulated sum of this annuity. where Let us display that a following relation exists: Proof: Hence,

25 Determining Annuity Parameters 1. Determining the amount of payment 2. Determining annuity term If the accumulated sum is given, then If the present value is given, then If the accumulated sum is given, then If the present value is given, then the term equals

26 Determining interest rate If the accumulated sum of annuity is known, then in order to determine the rate, the equation below should be solved with respect to If the present annuity value is known, then in order to determine the rate, the equation below should be solved with respect to

27 Annuity Conversions Simple types of conversion 1. Annuity buyout – a replacement of the annuity with a lump sum payment. It follows from the principle of financial equivalency that in this case, instead of the annuity, its present value is paid. 2. Payment by instalments – a replacement of a lump sum payment with an annuity. Compound types of conversion Converting the annuity means changing the conditions of the financial contract that stipulates payment of this annuity. Compound types of conversion include the replacement of one annuity with another that means changing annuity parameters. It follows from the conditions of financial equivalency that at such a replacement, the present values of these annuities must be equal. In other words, if А1 is the present value of the annuity to be replaced, А2 is the present value of the replacing annuity at the same time point, then the following condition must be observed: А1=А2.

28 Examples of Conversion Let there be an annual immediate annuity with the parameters of If this annuity is replaced with another one with the parameters of The equivalency equation is as follows: It is possible to determine one of the parameters of the replacing annuity with this equation