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Lecture 6 Mathematics of Finance

Topics to be discussed:

Simple Interest, Compound interest and

Continuous Compound of Interest

Present and Future Value

Annuities

Amortization and Sinking Funds

Arithmetic and Geometric Progression

Ref: Tan, Chapter 4

1

Learning Outcomes

After this lecture, students should be able to:

Solve problems involving simple, compound,

continuous compounding of interest rate and compute

the effective rate of interest

Compute the present value for compound interest

Use logarithms to solve problems in finance

Calculate the amount , present value and future value

of an annuity

Calculate the amount of loan and monthly mortgage

payments and interest rate from monthly payments

Calculate loans or sinking funds amortized

over n period.

Find terms and compute partial sum of arithmetic

progression and geometric progression

2

Simple Interest

Simple interest Interest that is

computed on the original principal only

If I denotes the interest on a principal P

(in dollars) at an interest rate of r per year

for t years, then we have I = Prt

The accumulated amount A, the sum of

th principal

the

i i l and

d iinterest

t

t after

ft t years, iis

A = P + I = P + Prt = P(1 + rt)

A bank pays simple interest rate of 8% per

year for deposits. If a customer deposits

$1000 ffor 3 years, what

h t iis th

the ttotal

t l amountt off

deposit at the end of 3 years? What is the

interest earned in that period of time?

P = 1000, r =0.08, t = 3

Total amount of deposit at the end of 3 years

is A = P(1 + rt) = 1000[1 + (0.08)(3)]

(0 08)(3)]=$1240

$1240.

The interest earned over the 3-year period is

given by I = Prt=1000(0.08)(3) = $240

An amount of $2000 is invested in a 10year trust

t t ffund

d th

thatt pays 6% annuall simple

i l

interest. What is the total amount of the

trust fund at the end of 10 years.

The total amount of the trust fund at the end

of 10 years is given by

A = P(1 + rt) = 2000[1 + (0.06)(10)] = $3200

Compound Interest

Earned interest that is periodically added to the principal

and thereafter itself earns interest at the same rate is

called compound interest

Example:

E

l $1000 iis d

deposited

it d iin a b

bank

k ffor a tterm off 3

years, earning interest rate of 8% per year compounded

annually. P = 1000, r = 0.08

The accumulated amount at the end of first year is A1 =

P(1 + rt) = 1000[1 + 0.08(1)] = $1080

At the end of the second year, the accumulated amount

is A2=P(1

P(1 + rt) = A1(1+rt) = 1000[1+0.08(1)][1+0.08(1)]

1000[1+0 08(1)][1+0 08(1)]

=1000(1.08)2 = $1166.40

The accumulated amount A3 at the end of the third year

is A3 = P(1 + rt) = A2(1 + rt) = 1000[1 + 0.08]3 = $1259.71

6

Compound Interest

If P dollars is invested over a term of t years, earning

interest at the rate of r per year compounded annually,

then the accumulated amount is A = P(1

( + r))t

Interest may be compounded more than once a year.

The interval of time between successive interest

calculation is called the conversion period

If interest at a nominal rate of r per year is compounded

m times a year on a principal of P dollars, then the

simple interest rate per conversion period is

r

m

7

A = P(1 + i)n

Where i r , n=mt

n=mt, and

m

A = Accumulated amount at the end of n

conversion periods

P = Principal

r = Nominal interest rate per year

m = Number of conversion periods per year

t = Term (number of years)

Find the accumulated amount after 3

years if $1000 is invested at 8% per year

compounded:

(a) annually,

(b) semiannually,

(c) quarterly,

(d) monthly and

(e) daily.

9

Interest

(a) P = 1000, r = 0.08, m = 1. Thus i = r=0.08 and

n = 3. A = 1000(1 + 0.08)3 = $1259.71

(b) P = 1000,

1000 r = 0

0.08,

08 m = 2

2. Th

Thus

si=0

0.08/2

08/2 and n

0.08 6

= 3(2) = 6. A = 1000(1 + 2 ) = $1265.32

(c) P = 1000, r = 0.08, m = 4. Thus i = 0.08/4 and n

= 3(4) = 12. A = 1000(1 + 0.408 )12 = $1268.24

(d) P = 1000, r = 0.08, m = 12. Thus i = 0.08/12

and n = 3(12)

( ) = 36. A = 1000(1

( + 012.08 )36 = $

$1270.24

(e) P = 1000, r = 0.08, m = 365. Thus i = 0.08/365

and n = 3(365) = 1095.

.08 1095

A = 1000(1 + 0365

)

= $1271.22

10

The more often interest is compounded, the larger the

accumulated amount will be.

mt

r

n

From the compound interest A P(1 i ) P1

P(e)rt

= Pert. In

this situation, we say that interest is compounded

continuously

The formula of Continuous Compounding of Interest is

A = Pert

where

h

P=P

Principal

i i l

r = Annual interest rate compounded continuously

t = Time in years

A = Accumulated amount at the end of t years.

11

Interest

$1000 is invested at 8% per year compounded

(a) daily (assume 365-day-year)

365 day year) and (b)

continuously.

(a) P = 1000, r=0.08, m = 365, and t = 3. Thus

i=0.08/365 and n=(365)(3)=1095, so that

0.08

A 10001

365

( 365 )( 3)

$1271.22

continuous compound interest rate formula

A = 1000e(0.08)(3) = $1271.25.

12

The interest actually earned on an investment depends

on the frequency with which the interest is compounded.

The stated nominal interest rate of 8% does not reflect

the actual rate at which interest rate is earned.

The effective rate is the simple interest rate that would

produce the same accumulated amount in 1 year as the

nominal rate compounded m times a year. The effective

m

rate is also called the annual yield

r

m

where reff= Effective rate of interest

r = Nominal interest rate per year

m = Number of conversion periods per year

13

Find the effective rate of interest

corresponding to a nominal rate of 8% per

year compounded:

(a) annually

(b) semiannually

(c) quarterly

(d) monthly

(e) daily

14

of Interest

0.08

(b) r = 0

0.08,

08 m = 2

2, reff = (1+

(1 2 )2 -1

1

= (1.04)2 1 = 0.0816

(c) r = 0.08, m = 4, reff = (1+0.08 )4 -1

4

= (1.02)4 1 = 0.0824

0.08

((d)) r = 0.08,, m = 12,, reff = ((1+ 12 )12 -1 = 0.0830

0.08 365

)

365

-1 = 0.0833

15

Present Value

The compounded interest formula expresses the

accumulated amount at the end of n periods when

interest at the rate of r is compounded

p

m times a

year.

The principal is often referred to as the present

value, and the accumulated value A is called the

future value, since it is realized at a future date.

Present Value Formula for Compound Interest:

P = A(1 + i)-nn

where P is the present value, A = accumulated

value, i = r/m, m is the number of conversion

periods per year.

16

How much money should be deposited in a bank

paying interest at the rate of 6% per year

compounded

d d monthly

thl so th

thatt att th

the end

d off 3

years the accumulated amount will be $20,000?

r = 0.06, m = 12, so i = 0.06/12 and n = (3)(12) =

36. Given that A = 20,000

0.06

P 20,0001

12

36

$16.712.90

17

Finance: Example

How long will it take $10,000 to grow to $15000 if

the investment earns an interest rate of 12% per

year compounded

d d quarterly?

t l ?

A = 15000, P = 10000, r = 0.12 and m = 4. We

have 15000 = 10000(1 + 0.412 )4t

15000

(1.03)4t =

= 1.5. Taking logarithms on

10000

both side of the equations,

ln(1.03)4t = ln1.5 4tln1.03 = ln1.5

4t ln 1.5 t ln 1.5 3.43 years

ln 1.03

4 ln 1.03

18

Exercise 6.1(a)

(a) Find the accumulated amount A if the

principal P $1000 is invested at the interest rate

r = 7% for t = 8 years compounded annually

(b) Find the effective rate corresponding to 10%

compounded semiannually.

(c) Find the present value of $40000 due in 4

years at r = 6% per year compounded

semiannually.

19

20

10

Exercise 6.1(b)

(a) To help finance the purchase of a new

house, a family have decided to apply for a

short term loan (a bridge loan) in the amount

off $120,000

$120 000 ffor a tterm off 3 months.

th If the

th

bank charges simple interest rate at the rate

of 10% per year, how much will the family

owe the bank at the end of the term?

(b) A family is planning to buy a house 4

years from now. Housing expert have

estimated that the cost of a home will

increase at a rate of 5% per year during that

period. If this prediction is true, how much

can the family expect to pay for a house that

currently costs $210,000?

21

22

11

An Annuity

An annuity is a sequence of payments made at

g

time intervals.

regular

The time period in which these payments are

made is called the term of the annuity.

The term can be a fixed time interval (annuity

certain), a time interval that begins at a definite

date but extends indefinitely (perpetuity) or one

that is not fixed in advance (contingent annuity).

An annuity in which the payments are made at

the end of each payment period is called an

ordinary annuity.

23

The future value S of an annuity of n payments

of R dollars each, paid at the end of each

investment period into an accounts that earns

interest at the rate of i per period, is

1 i n 1

S R

24

12

Find the amount of an ordinary annuity of 12

monthly payments of $100 that earn interest at

12% per year compounded monthly.

Since i is the interest rate per period and the

interest is compounded monthly, i = 0.12/12 =

0.01. R = 100, n = 12, we have

100 1.01 1

S

$1268.25

0.01

12

25

One may wish to determine the current value P

of a sequence of equal periodic payments that

will be made over a certain period of time

time. The

amount P is referred to as the present value of

an annuity

The present value P of an annuity of n

payments of R dollars each, paid at the end of

each investment period into an account that

earns interest at the rate of i per period, is

1 (1 i ) n

P R

26

13

Find the present value of an ordinary annuity of 24

payments of $100 each made monthly and earning

i t

interest

t att 9% per year compounded

d d monthly.

thl

R = 100, i = r/m = 0.09/12 = 0.0075, and n=24. So

100 1 1.0075

P

0.0075

24

$2188.91

27

Exercise 6.2(a)

(a) Find the amount (future value) of each ordinary

annuity

(i) $600 per quarter for 9 year at 12% per year

compounded quarterly

(ii) $200 per month for 20 year at 9% per year

compounded monthly

(b) Find the present value of each ordinary annuity

(i) $5000 twice a year for 8 years at 6% per year

compounded semiannually

(ii) $4000 a year for 5 years at 9% per year

compounded yearly

28

14

29

Exercise 6.2(b)

Linda has joined a scheme at her bank. At

th end

the

d off every month,

th December

D

b

through October inclusive, she will make a

deposit of $40 in her account. If the

money earns interest at the rate of 7% per

year compounded monthly, how much will

she have in her account on December 1 of

the following year?

30

15

31

Amortization of Loans

The annuity formulas may be used to answer

questions involving the amortization of

i t ll

installment

t lloans.

Amortization Formula:

The periodic payment R on a loan of P dollars

to be amortized over n periods with interest

charged at the rate of i per period is

Pi

1 (1 i ) n

32

16

A sum of $50,000 is to be repaid over a 5-year

period through equal installments made at the

end

d off each

h year. If an interest

i t

t rate

t off 8% per

year is charged on the unpaid balance and

interest calculations are made at the end of each

year, determine the size of each installment so

that the loan (principal plus interest charges) is

amortized at the end of 5 years.

years

P = 50,000, i = r = 0.08 (m = 1), n = 5, we have

(50,000)(0.08)

R

$12,522.82

1 (1.08) 5

33

Sinking Funds

A sinking fund is an account that is set up for a

specific purpose at some future date. We can

consider the amount to be accumulated by a

specific date in the future as the future value of

an annuity

Sinking Fund Payment:

The periodic payment R required to accumulate

a sum of S dollars over n periods with interest

charged at the rate of i per period is

Si

R

1 i n 1

34

17

The proprietor of a hardware firm has decided to

set up a sinking fund for the purpose of

purchasing a truck in 2 years

years time.

time It is expected

that the truck will cost $30,000. If the fund earns

10% interest per year compounded quarterly,

determine the size of each quarterly installment

the proprietor should pay into the fund.

S = 30,000,

30 000 i = r/m = 0

0.1/4

1/4 = 0

0.025,

025 n = (2)(4)=8

(2)(4)=8.

R

300000.025 $3434.02

1.0258 1

35

Exercise 6.3(a)

(a) Find the periodic payment R required to

amortize a loan of P dollars over t years with

interest earned at the rate of r% per year

compounded m times a year.

(i) P = 5000, r = 4, t = 3, m = 4

(ii) P = 25000, r = 3, t = 12, m = 4

(b) Find the periodic payment R required to

accumulate a sum S dollars over t years with

interest earned at the rate of r% per year

compounded m times a year.

(i) S = 20,000, r = 4, t = 6, m = 2

(ii) S = 100,000, r = 4.5, t = 20, m = 6

36

18

37

A sum of $100,000 is to be repaid over a 10year period through equal installments made at

the end of each year. If an interest rate of 10%

per year is charged on the unpaid balance and

interest calculations are made at the end of each

year, determine the size of each installments so

that the loan (p

(principal

p p

plus interest charges)

g ) is

amortized at the end of 10 year.

38

19

39

Arithmetic Progressions

An arithmetic progression is a sequence of

numbers in which each term after the first is

obtained

bt i d b

by adding

ddi a constant

t t d tto th

the

preceding term. The constant d is called the

common difference.

If a1, a2 a3, , an, is an arithmetic progression

with the first term a and common difference d,

then a1 = a, a2 = a + d,

a3 = a2 + d = a + d + d = a + 2d

a4 = a3 + d = a + 2d + d = a + 3d

an = an-1 + d = a + (n - 1)d (nth term)

40

20

Progression

The sum of the first n terms of an arithmetic

progression with first term a and common

n

difference d is given by

Sn

2a n 1d

the arithmetic progression 2, 7, 12, 17, 22,

Letting

g a = 2, d = 5 and n = 20, we have

S20 = 20 [2(2) + (19)(5)] = 990

41

Applied Example

A company had sales of $200,000 in its

first year of operation. If the sales

increased by $30

$30,000

000 per year thereafter

thereafter,

find Madisons sales in the fifth year and

its total sales over the first 5 years of

operation.

a = 200,000, d = 30,000, n = 5

a5 = 200,000

200 000 + (5 - 1)30,000

1)30 000 = $320

$320,000

000

S5 = (5/2) [2(200,000) + (5 - 1)30,000]

= $1,300,000

42

21

Geometric Progressions

A geometric progression is a sequence of

numbers in which each term after the first is

obtained

bt i d b

by multiplying

lti l i th

the preceding

di tterm b

by a

constant r. The constant r is called the common

ratio.

If a1, a2, a3, , an, is a geometric progression

with the first term a and common ratio r, then

a1 = a,

a2 = a1r = ar,

a4 = a3r = ar3

a3 = a2r = ar2

an = an-1r = arn-1 (nth term)

43

Progression

The sum of the first n terms of a geometric

progression with first term a and common

ratio r is given by

n

a 11 rr if r 1

Sn

if r = 1

na

Example: Find the sum of the first six terms

of the g

geometric p

progression

g

3, 6, 12, 24

a = 3, r = 6/3 = 2, n = 6

S6 = 3(1 26) = 189

1-2

44

22

Applied Example

A company had sales of $1 million in its

first year of operations. If sales

i

increased

db

by 10% per year thereafter,

th

ft

find the companys sales in the fifth year

and its total sales over the first 5 years

of operation.

a = 1,000,000, r = 1.1, n = 5

a5 = 1,000,000(1.1)4 = $1,464,100

S5 = 1,000,000 [1 (1.1)5] = $6,105,100

1 1.1

45

Exercise 6.4(a)

(a) Find the first five terms of the arithmetic

progression whose 4th and 11th terms are 30 and

107 respectively.

(b) Find the sum of the first 15 terms of the

arithmetic progression: 4, 11, 18,

(c) A tourist wish to go from the airport to his

hotel, which is 25 miles away. The taxi rate is

$1.00 for the first mile and $0.60 for each

additional

dditi

l mile.

il Th

The airport

i

t lilimousine

i also

l goes

to his hotel and charges a flat rate of $7.50.

How much money will the tourist save by taking

the airport limousine?

46

23

47

48

24

Exercise 6.4(b)

(a) For the geometric progression 4, 8, 16,

32 , find

32,

fi d th

the 7th term

t

and

d th

the sum off the

th

first seven terms.

(b) It has been projected that the

population of a certain city will increase by

8% each of the next 5 years. If the current

population is 200,000, what is the

expected population in 5 years?

49

50

25

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