AM41110 Theory of Interest 2.

Review:

1. Which of the following skills/knowledge adds value to Actuarial Work?

 Effective Communication
 Knowledge of Trends and the Economy
 Simplifying Complex Problems
 Data Handling
 All of the Above

2. Why is accuracy important in “predicting” the future?

 It can minimize business losses

 It can minimize business gains
 It can minimize growth opportunities

3. Can we accurately predict the future?

 Yes, because of technology

 No, but we can make approximations of it

4. Which of the following is not a Core Principle in Finance?

 Time Value of Money

 Risk and Reward Trade-off
 Cashflows are a Source of Value
 Markets are a Source of Value

5. It is the type of interest that is earned on the original investment plus all the interest earned on the
interest accumulated over time

 Simple Interest
 Compound Interest

6. It is the type of interest that is earned on the original investment only

 Simple Interest
 Compound Interest

7. Compound Interest is greater than Simple Interest over time.

 True
 False
Lesson 1: The Time Value of Money

What are the different types of Interest Rates?

Finance is the study of how people and businesses evaluate investments and raise capital to fund them?

- gov’t raised funds from private citizens through retail treasury bonds (RTB) to curb the effect of
the lockdown

Three Basics Questions Addressed by the Study of Finance:

1. What long term investments should the firm undertake? (ex. money, time, job position, skills)
2. How should the firm raise money to fund these investments? (ex. salary; from skills/knowledge)
3. How can the firm best manage its cash flows as they arise in its day-to-day operations? (ex.
nourish smart spending/saving)

#1 The first principle of Finance is Money Has a Time Value. A saying goes, “A dollar today is worth
more than a dollar tomorrow.”, what makes this statement true and what will make it false?

- we must align ourselves with investments that surpass the performance of the economy

- The money the lender is investing is changing value with time due to the interest being added.
For that reason, interest is sometimes referred to as the time value of money. A dollar will only
be worth more than a dollar tomorrow if money is grown at a rate that surpasses economic
conditions tomorrow.

#2 Based on what you watched, take a guess in completing this statement: Interest Rates are
determined based on D__ and S__.

- Demand and Supply. An increase in the demand for money or credit (of banks) will raise
interest rates, while a decrease in the demand for credit will decrease them.

- ex. Last year, no one was borrowing money from banks. If banks are unable to receive enough
profits from quarterly payments, they will have to raise interest rates to make up for it.

#3 The 2nd principle of Finance is “There is risk-return trade-off”, in other words any additional risk will
be compensated in return. Based on the videos, how does risk affect interest rates?

- This applies in stocks. There are companies whose balance sheets and cash flows aren’t
constant, making them a high-risk but highly capitalized company. In risks, we consider volatility.
If you can’t predict it, the risk is high. Higher risk, higher reward.

- Comparative example:

 Bonds - fixed income instrument that represents a loan made by an investor to a

borrower. Recently, the PH government sold bonds to private citizens to raise money for
COVID efforts. The government receives money from citizens with a promise to pay
them interest in fixed periods (usually quarterly)
o Note: Fixed income refers to those types of investment security that pay
investors fixed interest
 o Bonds are slightly riskier and more liquid than time deposits (ex. Premyo bonds
@ 1.25%)
 Time deposits – a time deposit is an interest-bearing bank account that has a date of
maturity. The depositer is required to keep the money in the bank until its maturity.

Interest rates are win-win

 Someone doesn’t need money right now, but will get the interest as a fee for loaning the
money/taking the risk of default.
o Collaterals reduce risk of default. Better credit standing/history = better interest rates
 You need money right now, but you think that you will grow that money in a year.

1. The principal originally invested (PV)

2. Length of investment period (n)
3. The rate of interest (i)
4. The accumulated value of the principal (AV)

Interest is an amount charged to a borrower for the use of the lender’s money over a period of time.

The accumulation function a (t) is the rate by which the principal had accumulated over an investment
period (similar to interest rates).

 a ( 0 )=1
 a (t) is a generally increasing function
 interest is generally continuous

The amount function A(t ) represents the accumulated value of a principal at time t

k ⋅a ( t=t ) A ( t )
a ( t )= =
k ⋅ a(t=0) A ( 0 )
Sample problem:

It is known that the accumulation function a (t) is of the form a ( t )=b ⋅ ( 1.1 )t + c t 2; where b and c are
constants to be determined.

If $100 invested at time t=0 accumulates to $170 at time t=3; find the accumulated value at time t=12 of
$100 invested at time t=1.

Given:

A ( 0 ) =$ 100
A ( 3 )=$ 170
Find A(1,12)

Solution:

A ( 3 ) 170
a (3)= = =1.7
A ( 0 ) 100
3 2
a ( 3 ) =b ⋅ ( 1.1 ) + c ( 3 ) =1.7
0 2
a ( 0 )=b ( 1.1 ) +c ( 0 ) =1
b=1 ; c=0.041
1 2
a ( 1 )=1 ( 1.1 ) + 0.041 ( 1 ) =1 .14 1
12 2
a ( 1 2 )=1 ( 1.1 ) +0.041 ( 12 ) =9.042
a ( 12 ) 9.042
A ( 1,12 )= A ( 0 ) ⋅ =$ 100 ⋅ =$ 792.50
a ( 1) 1.141

Interest earned and Interest rates:

Let n is a positive integer, the time interval is n−1≤ t ≤ n

Interest earned I n= A ( n ) −A (n−1)

*unless specified, assume that interest are effective interest rates

The effective interest rate i n is the amount of interest in one period divided by the principal at the
beginning of the period.
 A ( n )− A (n−1) In
i n= =
A (n−1) A (n−1)