Cashflow Models

Question 1

Describe the characteristics of an interest-only loan

Answer 1

The loan is repayable by a series of interest payments during the term of the loan

followed by repayment of the full capital amount at the end of the term

amount of capital outstanding therefore remain fixed over the term of the loan

if interest rates is fixed, the interest payments will be known in advance and if the interest rate is variable, the interest payments will be unknown at the onset

Question 2

Describe the characteristics of a repayment loan

Answer 2

Loan is repayable by a series of payments, each of which include partial repayment of the loan capital and additional interest amount.

amount of capital therefore reduces over time.

if the interest rate is fixed, so will the repayments

if the interest rates vary, so will the repayments

Question 3

Similarities between an annuity certain and contingent annuity

Answer 3

provide a regular series of payments in return for a single premium (lump sum) paid at the outset.

frequency of payment will be specified as well as the payment amount

Question 4

Difference between annuity certain and contingent annuity

Answer 4

AC = Number of payments is fixed in advance

CA = payments are dependent upon certain events usually the survival of the policyholder hence the number of payments made will not be known in advance

Question 5

Discuss in detail the amounts and timing of the cashflows of an index-linked bond from
the perspective of the issuer

Answer 5

-Initial positive lump sum inflow
* Certain amount and timing.
* A series of regular outflows of coupon payments until redemption. These may be payable
more frequently than annually but are at regularly spaced intervals.
* Coupons linked to an inflation index that is sometimes lagged, e.g. linked to an inflation
index with a 3-month time lag.
* Due to unknown inflation rates, coupons are uncertain in amount.
* The coupons are certain in timing (the issuer knows when payments are made and is not exposed to default risk as they hold the principal)
* The redemption payment is also linked to an inflation index and may be at, below or above par. The amount is uncertain due to inflation.
* Timing of redemption payment is certain unless the bond is redeemable at the option of the investor.