MATHEMATICS OF

FINANCE
Financial mathematics is the application of mathematical
methods to the solution of problems in finance.
Many people are in the dark when it comes to applying
math to practical problem solving. This section will
show you how to do the math required to figure out a
home mortgage, automobile loan, the present value of an
annuity, to compare investment alternatives, and much
more.
This section contains formulas, definitions and some
examples regarding:
1. Simple interest
2. Compound interest
3. Annuity
4. Amortization
 MATHEMATICS OF FINANCE 167
Simple Interest

1. Simple Interest
Interest is the fee paid for the use of someone else’s
money. Simple interest is interest paid only on the
amount deposited and not on past interest.
The formula for simple interest is

I = P-r-t
where
I= interest
P = principal
r = interest rate in percent / year
t = time in years

Example:
Find the simple interest for $1500 at 8% for 2 years.

Solution:
P= $1,500, r= 8% = 0.08, and t= 2 years
I = Per.
t= (1500)(0.08)(2) = 240 or $240
a) Future value
If P dollars are deposited at interest rate r for t years, the
money earns interest. When this interest is added to the
initial deposit deposit, the total amount in the account is

A = P+ I = P+ Ptr = p(1+ rt)

This amount is called the hture value or maturity value.
168 MATHEMATICS OF FINANCE
Compound Interest

Example:
Find the maturity value of $10,000 at 8% for 6 months.

Solution:
P= $10,000, r= 8% = 0.08, t= 6/12 = 0.5 years

The maturity value is

1+ rt)= 10,000[1+0.08(0.5)] = 10400, or
A=6
$10,400

2. Compound Interest
Simple interest is normally used for loans or investment
of a year or less. For longer periods, compound interest
is used.
The compound amount at the end of t years is given by
the compound interest formula,

A=F(+iY
where
r
i = interest rate per compounding period ( i = - )
m
n = number of conversion periods for t years
(n= mt)
A = compound amount at the end of n conversion
period
P = principal
r = nominal interest per year
m = number of conversion periods per year
t = term (number of years)
 MATHEMATICS OF FINANCE 169
Compound Interest

Example:
Suppose $15,000 is deposited at 8% and compounded
annually for 5 years. Find the compound amount.

Solution:
P= $15,000, r= 8% = 0.08, m = 1, n = 5

A = p(l+i)" =1500 1 + [ (?)I5 = 15000 [1.0815

= 22039.92, or $22,039.92

a) Continuous compound interest

The compound amount A for a deposit of P a t interest
rate rper year compounded continuously for tyears is
given by
A = Perf
where
P = principal
r = annual interest rate compounded continuously
t = time in years
A = compound amount at the end of t years.
e = 2.7182818

b) Effective rate
The effective rate is the simple interest rate that would
produce the same accumulated amount in one year as the
nominal rate compounded m times a year.

The formula for effective rate of interest is

170 MATHEMATICS OF FINANCE
Compound Interest

where
I-,=
( 1+-
3 -1

&ff= effective rate of interest

r = nominal interest rate per year
m = number of conversion periods per year

Example:
Find the effective rate of interest corresponding to a
nominal rate of 8% compounded quarterly.

Solution:
r= 8% = 0.08, m = 4 ,then

so the corresponding effective rate on this case is

8.243%per year.

c) Present value with compound interest

The principal P, 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. The present value is
given by
 MATHEMATICS OF FINANCE 171
Annuity

p=- A
= A(1+ i)-"
(1 + i>"

Example:
How much money should be deposited in a bank paying
interest at the rate of 3% per year compounding monthly
so that at the end of 5 years the accumulated amount will
be $15,000?

Solution:
Here:
0 nominal interest per year r = 3% = 0.03,
0 number of conversion per year m = 12,
0 interest rate per compounding period i = 0.03/12
= 0.0025,
0 number of conversion periods for t years n =
(5)(12) = 60,
accumulated amount A = 15,000

P = A(1+ i)-" = 15,000(1+0.0025)-60

P= 12,913.03,or $12,913

3. Annuities
An annuity is a sequence of payments made at regular
time intervals. This is the typical situation in finding the
relationship between the amount of money loaned and
the size of the payments.
172 MATHEMATICS OF FINANCE
Annuity

a) Present value of 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

where
P = present value of annuity
R = regular payment per month
n = number of conversion periods for t years
i = annual interest rate

Example:
What size loan could Bob get if he can afford to pay
$1,000 per month for 30 years at 5% annual interest?

Solution:
Here: R= 1,000, i = 0.05/12 = 0.00416, n = (12)(30) =
360.

1- (1 + i)-" 1- (1 + 0.00416)-360
P=.[ ]=1000[ 0.00416

P= 186579.61,or
$186,576.61
 MATHEMATICS OF FINANCE 173
Annuity

Under these terms, Bob would end up paying a total of

$360,000, so the total interest paid would be
$360,000 - $186,579,61 = $173,420.39.

b) Future value of an annuity

The future value S 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

Example:
Let us consider the future value of $1,000 paid at the end
of each month into an account paying 8% annual interest
for 30 years. How much will accumulate?

Solution:
This is a future value calculation with R =1,000,
n = 360, and i =0.05/12 = 0.00416. This account
will accumulate as follows:
(1 + i)" - 1 (1 + 0.00416)360-1
s={ ]=1000[ 0.00416
S = 831028.59,or $831,028.59

Note: This is much larger than the sum of the payments,

since many of those payments are earning interest for
many years.
174 MATHEMATICS OF FINANCE
Amortization

4. Amortization of Loans
The periodic payment Ra on a loan of P dollars to be
amortized over n periods with interest charge at the rate
of i per period is
Pi
R, =
1- (1 + i)-"
Example:
Bob borrowed $120,000 from a bank to buy the house.
The bank charges interest at a rate of 5% per year. Bob
has agreed to repay the loan in equal monthly
installments over 30 years. How much should each
payment be if the loan is to be amortized at the end of
the time?

Solution:
This is a periodic payment calculation with
P= 120,000, i=0.05/12 = 0.00416, and
n = (30)(12) = 360

Pi - (120000)(0.004 16)
R, = - = 643.88
1- (1 + i)-n 1- (1.00416)-360

or $643.88.

5. Sinking Fund Payment

The Sinking Fund calculation is used to calculate
the periodic payments that will accumulate by a
specific future date to a specified future value,
 MATHEMATICS OF FINANCE 175
Amortization

so that investors can be certain that the funds will be

available at maturity.
The periodic payment R required to accumulate a sum of
Sdollars over n periods, with interest charged at the rate
or i per period, is

where
S= the future value
i = annual interest rate
n = number of conversion periods for tyears