Actuarial Mathematics

DISCRETE RANDOM VARIABLE

 A random variable is called a discrete random
variable if its set of possible outcomes is countable.
The probability mass function (PMF) is a function that
describes the probability distribution of a discrete random
variable.
Mathematically, the PMF can be represented as:

f (x)=P (X =x)
Where: f (x) is the probability mass function
P( X=x) is the probability that the random
variable X takes on the value x
x is a possible outcome of the random variable
X
The PMF must satisfy the following properties:

1. f ( x ) ≥ 0 ,
2. ∑ f ( x )=1 ,
x
3. P ( X=x ) =f ( x )

The cumulative distribution function (CDF) of a

discrete probability distribution is calculated using the
following formula:

F (x)=P (X ≤ x )=ΣP (X=k )for all k ≤ x ,∨¿

F ( x )=P ( X ≤ x )=∑ f (t), for−∞ < x <∞

t<x

Where:

F (x) is the cumulative distribution function (CDF)

P( X ≤ x) is the probability that the random variable X
takes on a value less than or equal to x
P( X=k ) is the probability that the random variable X
takes on the value k
 Σ denotes the summation over all possible values of k
that are less than or equal to x

For example, consider a discrete probability distribution

with the following probability mass function:

x P(x) F(x)
1 0.2 0.2
3 0.3 0.5
3 0.5 1.0

To calculate the CDF, we would use the following

calculations:
F (1)=P(X ≤ 1)=P (X=1)=0.2
F (2)=P(X ≤ 2)=P (X =1)+ P( X=2)=0.2+0.3=0.5
F (3)=P(X ≤ 3)=P(X =1)+ P ( X=2)+ P( X=3)=0.2+ 0.3+0.5=1

Mean and Variance of a Discrete Probability

Distribution
Mean (Expected Value)
The mean, also known as the expected value E(X), of a
discrete probability distribution is calculated using the
following formula:
μ=E (X )=∑ xP (x)
Where:
- μ is the mean (expected value)
- E( X ) is the expected value of the random variable X
- x is a possible outcome of the random variable X
- P(x ) is the probability of the outcome x
- ∑ denotes the sum over all possible outcomes

Variance
The variance of a discrete probability distribution is
calculated using the following formula:
2 2
σ =Var (X )=∑ ( x −μ ) P ( x )
 2
σ 2=Var (X )=E (X 2 )−( E ( X ) )
Where:
- σ 2 is the variance
-Var ( X) is the variance of the random variable X
- x is a possible outcome of the random variable X
- μ is the mean (expected value)
- P(x ) is the probability of the outcome x
-∑ denotes the sum over all possible outcomes

Standard Deviation
The standard deviation is the square root of the variance:
σ =√ σ 2

CONTINUOUS RANDOM VARIABLE

 When a random variable can take on values on a
continuous scale, it is called a continuous random
variable.

The function f (x) is a probability density function (pdf)

for the continuous random variable X, defined over the set
of real numbers, if

1. f ( x ) ≥ 0 , for all x ∈ R .
∞
2. ∫ f ( x ) dx=1
−∞
b
3. P ( a< X <b ) =∫ f ( x ) dx .
a

The cumulative distribution function F (x) of a

continuous random variable X is defined as:
x
F ( x )=P ( X ≤ x )=∫ f ( t ) dt , for −∞ < x <∞ .
−∞

Where:
F (x) is the cumulative distribution function (CDF)
P( X ≤ x) is the probability that the random variable X takes
on a value less than or equal to x
f (t) is the probability density function (PDF) of X

The CDF has the following properties:

1. F (−∞)=0
2. F(∞)=1
3. F(x ) is non-decreasing
4. F ( x) is right-continuous
5. P (X > x )=1−F (x )
6. P(X =x)=¿ 0 (since X is continuous)

Mean and Variance of a Discrete Probability

Distribution
x
Mean: μ=E (X )= ∫ xf (x )dx
−∞

x
σ 2=E(X )−( E ( X ) ) = ∫ x f ( x ) dx−μ
2 2 2 2
Variance:
−∞

Discrete Probability Distribution related to Actuarial

Mathematics
Bernoulli Trials are a sequence of independent and
identically distributed (i.i.d.) random experiments, each
with exactly two possible outcomes:
1. Success (often denoted as 1 or "yes")
2. Failure (often denoted as 0 or "no")

The probability of success, denoted as p, remains constant

for each trial. The probability of failure is then 1− p .

DISCRETE PROBABILITY DISTRIBUTIONS

1) BINOMIAL DISTRIBUTION

The binomial distribution is a discrete probability

distribution that models the number of successes in a fixed
number of independent trials of a binary experiment (an
experiment with two possible outcomes: success or failure).

variable 𝑋 representing the number of successes in 𝑛 trials

The probability mass function (PMF) of a binomial random

is given by:

()
P( X=k )= n p q
k
k n−k

Where:
X is the random variable representing the number of

𝑘 is the number of successes (k =0 , 1 ,2 , ... ,n)

successes

𝑝 is the probability of success ¿)

n is the number of trials

𝑞 is the probability of failure (q=1− p)

( nk) is the number of combinations of n items taken k at a

time, or nCk
Mean and Variance:
μ=np
σ ²=npq
Example:
Imagine an insurance company that offers health
insurance policies. They are interested in modeling the
number of policyholders who file a claim in a year. The
company has 10 policyholders, and based on historical
data, the probability that a policyholder files a claim in a
year is 0.20.
1) Find the probability that exactly 2 policyholders
file a claim.
2) Find the mean and variance of the distribution.

2) POISSON DISTRIBUTION
The Poisson distribution is a discrete probability
distribution that models the number of events occurring in a
fixed interval of time or space, where these events occur
independently and at a constant average rate.

Probability Mass Function (PMF)

The probability mass function (PMF) of the Poisson
distribution is:
−λ k
( ) e −λ
P X=k =
k!
where:
X is the random variable representing the number of events
k is the number of events (k =0 , 1 ,2 , ...)
e is the base of the natural logarithm (approximately 2.718)
λ is the average rate of events (also known as the expected
value)

Mean and Variance

The mean (μ) and variance (σ²) of the Poisson distribution
are both equal to λ:
μ= λ
σ ²=λ

Example: Number of Car Accidents per Year

A car insurance company wants to model the number
of accidents per year for a group of drivers. Based on
historical data, they find that the average number of
accidents per year is 2.5. Calculate:
1) the probability of more than 2 accidents occurring
2) the probability of three to five accidents occurring
3) mean and variance of the distribution
3) GEOMETRIC DISTRIBUTION
The geometric distribution is a discrete probability
distribution that models the number of trials until the first
success, where each trial is independent and has a constant
probability of success.

Probability Mass Function (PMF):

The PMF of the geometric distribution is:
k−1 k−1
P( X=k )= (1−p ) ∙ p= p ∙ q

Mean and Variance:

The mean (μ) and variance (σ²) of the geometric distribution
are:
1
μ=
p
2 1−p q
σ = 2 = 2
p p

Example: Number of Policies until First Claim

An insurance company wants to model the number of
policies sold until the first claim is filed. Based on historical

a policy is 0.05. Determine 𝑃(𝑋=5), the mean, and

data, they find that the probability of a claim being filed on

variance of the distribution.

4) NEGATIVE BINOMIAL
The negative binomial probability distribution is a
discrete distribution that models the number of failures until
a specified number of successes occurs in a sequences of
independent Bernoulli trials.
Probability Mass Function (PMF)

( )
P ( X=x ) = k−1 ∗p ∗( 1− p )
r−1
r k−r

Where:
X is the random variable representing the number of trials
until r successes occur
K is the number of trials
R is the number of successes
P is the probability of success

Mean and Variance

r
Mean: E ( X )=
p
r (1− p)
Variance: Var ( x )=
p2

Example 1: Problem with Quality Control

A manufacturing company produces light bulbs, and the
quality control team wants to model the number of
defective bulbs produced until they find 5 non-defectives
bulbs. The probability of producing a non-defective bulb is
0.8. find the probability that it takes exactly 7 trials to
produce 5 non-defective bulbs and calculate the mean and
variance of the distribution.

Example 2: Application to Insurance

XYZ is an insurance company that offers a policy covering
damages due to natural disasters. The company wants to
model the number of years until they have to pay out for 3
major disasters. Historical data shows the probability of a
major disaster occurring in a given year is 0.12. Due to
climate change, this probability is expected to increase by
5% every 2 years. Find the probability that it takes exactly
10 years for the company to pay out for 3 major disasters
and calculate the mean and variance of the distribution.

Solution:
Let X be the random variable representing the number of
years until the company has to pay out for 3 major
disasters.

Parameters
r = 3 (number of successes: major disasters)
p1=0.12 (initial probability of a major disaster for years 1
and 2)
p2= p1∗1.05=0.126 (probability of a major disaster for years 3
and 4)
p3= p2∗1.05=0.1323 (probability of a major disaster for years
5 and 6)
p4 = p3∗1.05=0.138915 (probability of a major disaster for
years 7 and 8)
p5= p 4∗1.05=0.14586075 (probability of a major disaster for
years 9 and 10)

n
−1
pn= p 1∗( 1.05 )
2 (probability of a major disaster after n
years)
4
Since p10= p1∗( 1.05 ) =0.14586075

To calculate 𝑃(𝑋 = 10), we need to find the probability of a

Probability Mass Function (PMF)

major disaster occurring each year and then apply the PMF.

3−1( )
P( X=10)= 10−1 ∗0.14586075 ∗( 0.85413925 ) =0.0371
3 10−3

Mean
Since the probability of a major disaster increases over
time, the actual mean will be lower. To calculate the actual
mean, we need to use the formula for the mean of a
Negative Binomial distribution with a time-varying
probability:
r
E ( X )=
pμ
This simplification assumes that:
 - The probability increases by 5% every 2 years.
- The increase in probability is compounded

- p μ is the average probability for 10 years.

continuously.

p 1+ p2 + p3 + p 4+ p 5
p μ= =0.1326
5
3
E ( X =10 )= =22.62
0.1326
Variance
To calculate the actual variance, we need to use the
formula for the variance of a Negative Binomial distribution
with a time-varying probability:
r ( 1− p μ )
Var ( X )= 2
pμ

3 ( 1−0.1326 )
Var ( X )= =147.9972
0.13262
Therefore, the probability that it takes exactly 10 years for
the company to have to pay out for 3 major disasters is
approximately 0.1326. The mean number of years until the
company has to pay out for 3 major disasters is
approximately 22.62, and the variance is approximately
147.9972.

5) HYPERGEOMETRIC
The hypergeometric distribution is a discrete probability
distribution that models the number of successes (or "good"
items) obtained from a fixed number of trials (or "draws")
without replacement from a finite population. The
distribution is characterized by three parameters:
N: The total number of items in the population.
K: The number of "good" or "success" items in the
population.
n: The number of trials or draws without
replacement.

The probability mass function (PMF) of the hypergeometric

distribution is given by:
 P ( X=k )=
( k ) ( n−k )
K ∗ N −K

( Nn )
Where:
k is the number of successes of a sample (0 ≤ k ≤ n)
K is the number of successes of a population
N is the number of items in the population
n is the sample size

The mean and variance of the hypergeometric distribution

are:

n∗K
Mean: E ( X )=
N
n∗K∗( N−K )∗(N−n)
Variance: Var ( x )= 2
N (N −1)

Example: Problem on Finance

Century Holdings' manager has a portfolio of 20 stocks, of
which 8 are from the technology sector. If she randomly
selects 5 stocks from the portfolio for further analysis, what
is the probability that exactly 2 are from the technology
sector? Also, find the mean and variance of the number of
technology stocks selected.

6) LOGARITHMIC DISTRIBUTION
The logarithmic distribution, also known as the log-series
distribution, is a discrete probability distribution that
models the number of occurrences of an event.
The logarithmic distribution is characterized by a:
▪ large number of zero or low-frequency events
▪ small number of high-frequency events
▪ long tail (right skewed), indicating a high degree of
variability
Probability Mass Function (PMF): The PMF of the logarithmic
distribution is given by:
k
−α
P ( X=k )= for k =1, 2 , 3 , …
k ∙ ln ( 1−α )

𝑋 is the random variable

where:

𝑘 is the number of events (𝑘 = 1,2,3,…)

𝛼 is the parameter (0 < 𝛼 < 1)

2. Mean and Variance: The mean and variance of the

logarithmic distribution are:
−α
E ( X )=
(1−α)∗ln ( 1−α )
−α∗[ α +ln ( 1−α ) ]
Var ( X )= 2
[ ( 1−α )∗ln ( 1−α ) ]
Example: Model Distribution of Rare Claims
Suppose an actuary wants to model the number of rare
claims (e.g. natural disasters, major accidents) received by
an insurance company in a year. The actuary assumes that

parameter 𝛼=0.05.
the number of claims follows a logarithmic distribution with

Find:
a ¿ P ( X >3 ) b ¿ E (X )c ¿ V ar (X )

1)
1)
2) EXPONENTIAL DISTRIBUTION
The exponential probability distribution, also known as the
exponential distribution or negative exponential
distribution, is a continuous probability distribution that
describes the time between events in a Poisson process.
Probability Density Function (PDF):
−λx
f ( x )= λ e for x ≥ 0
Cumulative Distribution Function (CDF):
− λx
F ( x )=1−e for x ≥ 0
1 1
Mean: Variance: 2
λ λ
Example Problem:
The time between arrivals of customers at a store is
exponentially distributed with a mean of 5 minutes.
Find the probability that:
(a) A customer arrives within 2 minutes.
(b) A customer arrives between 2 and 5 minutes.
(c) A customer arrives after 5 minutes.

Given: Mean (μ) = 5 minutes

1
Since the mean of an exponential distribution is , we can
λ
find the value of λ:
1 1
λ= = =0.2
μ 5
The cumulative distribution function (CDF) of the exponential distribution
is:
− λx
F ( x )=1−e

(a) Probability that a customer arrives within 2 minutes:

−0.2 ( 2)
P ( x ≤ 2 )=F ( 2 )=1−e =0.3297

(b) Probability that a customer arrives between 2 and 5

minutes:
P(2< x ≤5)=F (5)−F (2)
¿ ( 1−e ) −( 1−e−0.2 (2) )
−0.2 ( 5 )

¿ ( 1−e−1) −( 1−e−0.4 )=0.3024

(c) Probability that a customer arrives after 5 minutes:

P(x >5)=1−F (5)=1−( 1−e−0.2 ( 5) ) =0.3679

3) WEIBULL DISTIBUTION (more on failure times)

It is a two-parameter distribution, with parameters k (shape) determining

the slope and λ (scale) determining the spread or dispersion of the
distribution. The value of k can be:
k =1 reduces to an Exponential Distribution
k < 1 Decreasing hazard rate (early failures)
k > 1 Increasing hazard rate (wear-out failures)
while ¿ 0 larger values indicate longer lifetimes

Probability Density Function (PDF):

x k−1 −( ❑X )
k

f ( x )=( )( )
k
∗
❑ ❑
∗e for x ≥ 0

x is the variable
k is the shape parameter
is the scale parameter
e is the base of the natural logarithm (approximately 2.718)

Cumulative Distribution Function (CDF):

 ( Xλ )
k
−
F ( x )=1−e for x ≥ 0

Mean and Variance:

( 1k )
E ( X )=¿ Γ 1+

[ 2k 1k ]
Var ( X )=❑ Γ (1+ )−( Γ (1+ ))
2
2

where Γ is the gamma function.

Note that:

( 1+ z ) !
Γ ( 1+ z )=z ∙ Γ ( z )= =z !
1+ z
Γ ( ba )= ba ( ab )! for ab >1 where b ≠0
Example:
A manufacturer tests the lifetime of a new type of light

with a shape parameter 𝑘 = 1.5 and a scale parameter 𝜆 =

bulb. The lifetime (in hours) follows a Weibull distribution

2000.

1. Find the probability that a randomly selected light bulb

will last more than 3000 hours.
2. Calculate the mean and variance of the light bulb's
lifetime.

Solution: Substituting k = 1.5 and λ = 2000 into the CDF,

we get:
(2000 )
1.5
x
−
F (x)=1−e for x ≥ 0

We can find the probability that the light bulb lasts for more than 3000
hours:

P(x >3000)=1−F (3000)

¿ 1−( 1−e ) =0.1592
1.5
− ( 1.5 )
Therefore, the probability that the light bulb will last for
more than 3000 hours is approximately 15.92%.

To compute for the mean and variance:

( 1k )
E ( X )=¿ Γ 1+

[ k k ]
Var ( X )=❑ Γ (1+ )−( Γ (1+ ))
2
22 1

( 1k )=Γ (1+ 1.51 )=Γ (1+ 23 )=Γ ( 53 )=( 23 )! ≈ 0.9027

Γ 1+

Γ ( 1+ )=Γ (1+
1.5 )
=Γ (1+ )=Γ ( )=( )! ≈ 1.1906
2 2 4 7 4
k 3 3 3

Now we can compute the mean and variance:

E( X )=2000∗0.9027=1805.40 hours
2 2
Var ( X)=2000 [1.1906−( 0.9027 ) ]=1,502,930.84 squared hours

4) GAMMA DISTRIBUTION
The Gamma distribution is a two-parameter family of
distributions, characterized by the shape parameter (k) and
the rate parameter (θ). It is denoted as Gamma ( k , θ ¿ .

Probability Density Function (PDF):

−x
x k−1 e θ
f ( x )= k for x ≥ 0
θ Γ (k )
where x is the random variable, k is the shape parameter, θ
is the scale parameter, and Γ(k) is the Gamma function.

Cumulative Distribution Function (CDF):

−t
x
t k−1 e θ
F ( X )=∫ k dt for x ≥ 0
0 θ Γ (k )

Mean: E ( X )=kθ
2
Variance: Var ( X )=k θ
Example 1:
A call center records the time between incoming calls

follows a Gamma distribution with a shape parameter 𝑘 = 2

during peak hours. The time between calls (in minutes)

and a scale parameter 𝜃 = 3. What is the probability that

the time between two incoming calls is less than 5 minutes?

Solution:
To find the probability that the time between two incoming
calls is less than 5 minutes, we need to calculate the
cumulative distribution function (CDF) of the Gamma

𝑥 = 5.
distribution at

−t −t
5 2−1 3 5 3 5 −t
t e te 1
F ( X )=∫ dt=∫ dt= ∫ t e 3 dt
0
2
3 Γ ( 2) 0 9(1)
9 0
F ( X< 5 )=0.4963
E ( X )=kθ=2 ( 3 )=6
Var ( X )=k θ2=2 ( 32 )=18

EQUATION OF VALUES
Conversion from Nominal to Effective Rate

( )
m
j
w= 1+ −1
m
Conversion from Effective to Nominal Rate

1
j=m×[ ( 1+i )¿ ¿ −1]¿
m

Effective Rate (w) – the effective annual interest rate

Nominal Rate (j) – the nominal annual interest rate
m – the number of compounding periods per year
Conversion from Nominal to another Nominal

j 2 =m2 ¿

i 1 – periodic interest rate for j 1 (same for i 2 ¿

m1 – compounding frequency for j 1 (same for m2 ¿

Future Value of a Compound Amount

n
FV =PV ( 1+ r )
Present Value of a Compound Amount
−n
PV =FV ( 1+ r )
Future Value of an Ordinary Annuity

F V OA =P ( ( 1+r )n−1
r )
Present Value of an Ordinary Annuity

( )
−n
1−( 1+r )
P V OA=F
r

n=mt (frequency of conversion x time in years)

EQUATION OF VALUES
The sum of the present values of future cash flows must
equal the given amount (such as an investment or loan).
This concept is used to ensure that financial transactions
are fair and balanced.
Components:
1. Present Value (PV): the current worth of a future cash
flow. Discounted at an appropriate interest rate.
2. Future Value (FV): the value of a cash flow at a
specific future date.
3. Number of Periods (n): the total number of
compounding period.
To find the [resent value of a series of future cash flows,
you use the formula:
n

∑ of P V '
s=∑ F V i ( 1+r )i
−t

i=1

Example:
1. A college student has an investment that promises to
pay P10,000 at the end of each year for the next 3
years, and the interest rate is 5%. The present value of
these future payments would be calculated as follows:
−1 −2 −3
PV =10000 ( 1.05 ) +10000 ( 1.05 ) +10000 ( 1.05 ) =27232.48
2. An actuary calculates the expected present value of a
life insurance policy that pays P1,000,000 upon the
policyholder’s death within the next year. If the
probability of the policyholder’s death within that year is
0.01 (1%), and the interest rate is 5%, the expected
present value would be:
−1
EPV =1,000,000 ×0.01 × ( 1.05 ) =P 9,523.81
Problem 1:
A company invests P10,000 for 2 years at an annual
interest rate of 6%. There is a 20% chance that the interest
rate will increase to 7% in the third year. What is the
equivalent value of this investment at the end of 3 years,
considering the probability of the interest rate increase?
Solution: a) Compute equivalent value without the increase
n 2
FV =PV ( 1+ r ) =10000 ( 1+0.06 ) =11,236
b) Compute equivalent value with the increased rate on the
third year
2 1
FV =10000 ( 1.06 ) ( 1+0.07 ) =12,022.52
c) Compute for the expected value using probability
EPV =0.80 ( 11,236 ) +0.20 ( 12,022.52 )=11,393.304
Problem 2:
A person borrows P5,000 for 5 years at an annual interest
rate of 8%. There is a 30% chance that the borrower will
default on the loan after 3 years, resulting in a loss of 20%
of the principal amount. What is the equivalent value of this
loan at the end of 3 years, considering the probability of
default?
Solution: a) Compute equivalent value at the end of 3 years
without default
3
FV =5,000 ( 1+0.08 ) =6,298.56
b) Compute for the value considering the default (loss of
20% in principal amount))
FV =5,000−( 0.2× 5,000 )=5,000 ( 0.08 )=4,000
c) Compute for the expected using the probability
EFV =6,298.56 ( 0.70 )+ 4,000 ( 0.30 )=5,608.992

Problem 3:
A savings account earns an annual interest rate of 4%
compounded semiannually. There is a 10% chance that the
interest rate will decrease to 3% after 5 years. If ₱8,000 is
deposited into the account, what is the equivalent value of
this deposit after 10 years, considering the probability of
the interest rate decrease?
Solution: a) Compute equivalent value without decrease

( )
2 ( 10 )
0.04
FV =8,000 1+ =11,887.58
2
b) Compute value with the decreased rate

( ) ( )
2 (5 ) 2 ( 5)
0.04 0.03
FV =8,000 1+ × 1+ =11, 317.54
2 2
c) Compute for the expected value

EFV =0.10 ( 11,317.64 ) +0.90 ( 11,887.58 )=11,830.58

Problem 4:
An insurance company issues a 2-year term life insurance
policy to a person aged 30. The policy pays a death benefit
of ₱200,000 if the insured dies within the next 2 years. The
probability of the insured dying within the next year is
0.005, and the probability of the insured surviving the first
year and then dying in the second year is 0.0045. The
interest rate is 6% per annum. Calculate the expected
present value of the death benefit.

Given: P ( q 1) =0.005
Prob. of surviving the 1st year and then dying in the 2nd
year = 0.0045
Death benefit = 200,000
r = 0.06
Year PV px EPV
(x)
1 −1 0.005 188,679.25(0.00
200,000 ( 1+0.06 ) =188,679.25
5) = 943.40
2 −2 0.004 177,999.29(0.00
200,000 ( 1+0.06 ) =177,999.29
5 45) = 801.00
Total P 1,744.40
Therefore, the expected present value of the death benefit
is 1744.40

Problem 5:
A person invests ₱20,000 in a mutual fund that earns an
average annual return of 10%. There is a 20% chance that
the fund will experience a downturn, resulting in a -5%
return for the next 2 years. What is the equivalent value of
this investment after 15 years, considering the probability
of the downturn?
Given: PV = 20,000r = 10% = 0.10 t = 15
Downturn, resulting in -5% return for the next years.
a) Compute for equivalent value without downturn
15
FV =20,000 ( 1+0.10 ) =83,544.96
b) Compute FV with downturn
Annual return for the first 2 years: -5%
Annual return for the remaining 13 years: 10%
2
FV =20,000 ( 1−0.05 ) =18,050
13
FV =18050 ( 1+0.10 ) =62,313.50
c) Calculate expected value
FV =0.80 ( 83,544.96 ) +0.20 ( 62,313.50 )=79,298.67

Problem 6:
A company offers a lease agreement for a piece of
equipment with annual payments of ₱5,000 for 5 years.
There is a 15% chance that the lessee will terminate the
lease after 3 years, resulting in a penalty of 10% of the
remaining lease payments. What is the equivalent value of
the lease agreement at the beginning of the lease term,
considering the probability of termination?
Given:
Annual Payments = 5,000
Lease term = 5 years
Probability of termination = 0.15
Penalty = 10% of remaining lease payments
a) Calculate the remaining lease payments if the lessee
terminates the lease after 3 years
Remaining Payments → 5000× 2=10,000
Penalty → 10000 ×0.10=1,000
b) Calculate expected present value of the lease
agreements
S1: No termination
Total payments=5000 ×5=25,000
S2: with termination after 3 years
Total Payments=( Annual payments × 3 ) + Penalty=5,000 ( 3 ) +1,000=16,00
c) Calculate expected present value
EPV =25,000 ( 0.85 ) +16,000 ( 0.15 )=23,650

Problem 7:
A person wins a lottery prize of ₱1 million, which can be
taken as either a lump sum or an annuity of ₱50,000 per
year for 20 years. There is a 10% chance that the annuity
payments will increase by 2% per year due to inflation.
Which option has the higher equivalent value, considering
the probability of inflation?
Option 1: Lumpsum = 1,000,000
Option 2: Annuity
a) Calculate PV without inflation
PV =50,000 ( 20 ) =1,000,000
b) Calculate PV considering the 2% increase per year
due to inflation
20
PV =50,000 ( 20 ) ( 1+0.02 ) =1,485,947.40
c) Calculate EPV considering the probability of inflation
PV =0.10 ( 148947.40 )+ 0.90 ( 1000000 )=1.048,594 .74
Therefore, OPTION 2 is the better option, with a higher
equivalent value

Problem 8:
A company invests $50,000 that earns 12% for 3 years,
followed by an annual return of 8% for the next 2 years.
There is a 25% chance that the project will experience a
delay, resulting in a 1-year extension of the project
duration. What is the equivalent value of this investment at
the end of 5 years, considering the probability of the delay?
a) Calculate future value without delay
3
F V first 3 years=50,000 ( 1+0.12 ) =70,246.40
2
F V fornext 2 years=70,246.40 ( 1+0.08 ) =81,935.40
b) Calculate the future value with 1 year delay
2 +1
FV =70,246.20 ( 1+0.08 ) =88,490.23
c) Compute for the expected future value considering
probability of delay
EFV =81925.40 ( 0.75 )+ 88490.23 ( 0.25 )=83,574.11

Problem 9:
A person borrows P10,000 for 10 years at an annual interest
rate of 9%. There is a 20% chance that the borrower will
refinance the loan after 5 years, resulting in a new interest
rate of 8% for the remaining 5 years. What is the equivalent
value of this loan at the end of 5 years, considering the
probability of refinancing?
a) Calculate FV without refinancing
5
FV =10,000 ( 1+0.09 ) =15,386.24
b) Calculate FV of loan after 5 years with refinancing
5
FV =15,386.24 ( 1+0.08 ) =22,607.43
c) Calculate expected value considering probability
EFV =0.80 ( 15,386.24 )+ 0.20 ( 22,607.43 )=16,830.48

Problem 10:
A company issues a zero-coupon bond with a face value of
P50,000 and a maturity date in 10 years. There is a 15%
chance that the company will default on the bond, resulting
in a recovery rate of 80% of the face value. What is the
equivalent value of the bond at maturity, considering the
probability of default?
 a) Expected value with no default = 50,000
b) Expected value with default
Recovery rate = 80%
EV =50000 ( 0.80 )=40,000
c) Expected value of the bond considering probability
EV =0.15 ( 40,000 ) +0.85 ( 50,000 )=48,500

Problem 11:
An insurance policy pays a benefit of P100,000 if the
insured dies within the next 2 years. The probability of the
insured dying within the next 2 years is 0.02. What is the
expected present value of the benefit if the interest rate is
4% per annum?
Given:
Benefit = 1000,000
Prob of dying = 0.02
r = 4% = 0.04

Since the insured can die I either of the 2 years, we need to

calculate the present value of the benefit for each year and
then ,multiply it by the probability of dying in that year.
Year 1 2 TOTAL
(x)
qx 0.01 0.01 0.02
−1 −2
EPV PV =100,000 ( 1.04 ) × 0.01=961.54
PV =100,000 ( 1.04 ) 1,886.10
× 0.01=924.56

Problem 12:
A life insurance policy pays a death benefit of P300,000 at
the end of the year of death. The probability of the insured
dying in the first year is 0.01, in the second year is 0.015,
and in the third year is 0.02. What is the expected present
value of the death benefit if the interest rate is 9% per
annum?
Given: Death benefit = 300,000 r = 0.09
Ye 1 2 3 Total
ar
(x)
qx 0.01 0.015 0.02
PV 300,000 ( 1.09 ) =275,229.36
−1 −2
300,000 ( 1.09 ) =252,504
−3
300,000 ( 1.09 ) =231,655.04
EP 2,752.29 3,787.56 4,633.10 11,172.
 V 95
Therefore, the expected present value of the death benefit
is 11, 172.95

Problem 13:
An ordinary annuity pays P100,000 per annum for 3 years.
The probability that the annuitant survives to the end of
each year is as follows:
Year 1: 0.98
Year 2: 0.97
Year 3: 0.96
What is the expected preset value of the ordinary annuity if
the interest rate is 5% per annum?
Year (x) 1 2 3
Px 0.98 0.97 0.96
PV −1
100,000 ( 1.05 ) =95,238.10
−2
100,000 ( 1.05 ) =90,702.95
−3
100,000 ( 1.05 ) =86,383.7
EPV 93,333.34 87,981.86 82,928.41
Total 264,243.61

Problem 14:
An ordinary annuity pays ₱50,000 per annum for 4 years.
The probability that the annuitant survives to the end of
each year is constant at 0.95. The interest rate is 6% per
annum. What is the expected present value of the ordinary
annuity?
Given:
Annual Payment (R) = 50,000
n=4
i = 0.06
Using the formula for present value of ordinary annuity:

[ ] [ ]
−n −4
1−( 1+ i ) 1−( 1+0.06 )
A=R =50,000 =173,255.28
i 0.06
Compute for th expected present value considering the
probability of survival of the annuitant.
EPV =0.95 ( 173,255.28 ) =164,592.52
Discrete
Distributi PMF P( X=x) Mean (μ) Variance (σ ¿¿ 2)¿
on
x 1−x
Bernoulli p q p p(1−p)

Binomial ( nk) p qk n −k
np npq

−λ k
e λ
Poisson λ λ
k!

k−1 1 q
Geometric pq 2
p p
Negative
Binomial ( )
k−1 pr q k−r
r−1
r
p
r (1− p )
p
2

Hypergeo ( Kk )( Nn−k
−K
) nK nK ( N −K ) ( N−n )

( NN )
metric N N 2 ( N −1 )

Logarithmi −α
k
−α −α [ α + ln ( 1−α ) ]
c kln(1−α ) ( 1−α ) ln(1−α ) 2
( 1−α ) ( ln (1−α ) )
2

Continuous
Distributio PDF CDF
n

{
0 , x< a
1 F (x)= x−a
Uniform f ( x )= ,a≤x ≤b
b−a b−a
1 , x> b

−λx − λx
Exponential f ( x )= λ e F ( x )=1−e
 ( )
k
k−1 − X
( Xλ )
( )( )
k

f ( x )= k x
λ −
Weibull e
λ λ F ( x )=1−e
−x −t
k−1 θ x k−1 θ
x e t e
Gamma f ( x )= k
F ( x )=∫ k
dt
θ Γ (k ) 0 θ Γ(k)

OUTER MEASURES
Examples of Measure

LEBESGUE MEASURABLE SETS

We also want m to have these properties.
1. The measure of an interval is equal to its length.
2. The measure is translation invariant.

3. The measure must be σ -additive.

But there exists no such m! Hence, we reconstruct our

steps to define m as follows
THM: The outer measure of an interval is equal to its length
THM:
1. Finite subadditivity of m* follows from its σ -
subadditivity. (PROVE)
2. Every countable set has an outer measure of zero.
3. Every interval of the form (a, b), where a< b, is
countable.

THM:
¿
1. The outer measure m is translation invariant
2. The outer measure is homogenous.
APPROXIMATION OF MEASURABLE SETS

Proof:
LEBESGUE MEASURABLE FUNCTIONS
We devote this section to the study of Lebesgue
measurable functions in order to lay the foundation for the
study of the Lebesgue integral. Lal continuous functions on
a measurable domain are measurable, as well as all
monotone and step functions on closed and bounded
interval. Linear combinations of measurable functions are
measurable. The pointwise limit of a sequence of
measurable functions is measurable. We establish results
regarding the approximation of measurable functions by
simple functions and by the continuous functions.
Proof:

Definition:
A property is said to hold almost everywhere if the set of
points for which the property fails to hold is a set of
measure zero.

Theorem:
If f is measurable function and f =g almost everywhere,
then g is measurable.

Proof: