As a level 3 candidate, I am ashamed to ask this question. What interest rate would you use to calculate the NPV of an annuity (eg. 3-months rate, Fed discount rate, Fed funds rate)?
I am ashamed for you
Ok. So tell me!
I’d probably use the YTM of a treasury security that is roughly the same maturity as the length of the annuity. If you are buying the annuity, you might tack on a credit risk premium because the payer might not pay up as promised.
As a LIII candidate, you shoudl use several rates (10yr treasure, 3 month bill, investment-grade bond yield, preferrable the same rateing as the annuity issuer). Then run an distrubtuion table for different rate scenario, see the max. and min NPV of your/your client’s annuity; factor that with client’s current income, then you will know if you are buying a suitable annuity for you/your client.
Is this a trick question? If you give FlyByNightInvestments $1m in return for a stream of payments, the NPV is $1m. (Well, less a 1-3% commission haircut.) If that isn’t the NPV then the annuity is mispriced. Or do you mean: your client, Wendy Gullible, wants $50k/year for up to 20 years. If that’s the situation: You can’t calculate the price of an annuity like this, you have to pick up the phone and call a few vendors to get offers. (The typical annuity, of the type appearing in an IPS, is loaded with optionality and mortality assumptions; it’s way too complicated for L3 CFAs to price.)* *apologies for nounizing “CFA”