QABE Lecture 2

Time Value of Money

School of Economics, UNSW

2011

Contents
1 Introduction 1

2 Types of Interest 1
2.1 Option 1: Simple Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.1.1 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.1.2 Working it out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 Option 2: Compound Interest . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2.1 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2.2 Working it out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.3 Option 3: Continuously Compounded Interest . . . . . . . . . . . . . . . . 4
2.3.1 The exponential constant . . . . . . . . . . . . . . . . . . . . . . . 4
2.3.2 Working it out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

3 Present Value 6

1 Introduction
This week we begin a section of the course looking at the time value of money. Put
simply, the maths that we need when dealing with money. The reason we need to
develop an understanding of money mathematics (as opposed to, say, just ‘numbers-
mathematics’) is that numbers representing money, have the special property that they
are actually representing value. The trouble is, as opposed to (say) the number ‘3’ which
represents the same information yesterday, today, and tomorrow, if we were talking about
‘3 dollars’ of some currency, we would have to be very careful about when the number
was quoted – that is, the value of the representation (‘3 dollars’) is defined in part by
the time that it is quoted. Three dollars today wouldn’t get you even a couple of cans
of Coke, three dollars twenty years ago would have obtained you three cans of coke.
An obvious question is, why does money have this peculiar ‘time-value’ property?
For now, it is enough to raise it as a question. We start our inquiry into the realm of
time-value-of-money by looking at the different ways that interest can be calculated.
That is, the value of a deposit (some sum of money) can grow over time in the bank’s
hands. Part of this is to do with simple time-value considerations, and part of it has to
do with various investments the bank has made. More on this later!

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ECON 1202/ECON 2291: QABE School
c of Economics, UNSW

Agenda

1. Simple interest

2. Compound interest

3. Continuous compounding

4. Present value

2 Types of Interest

The Problem
We’re going O/S in 2 years and we need to make as much money as possible before
then through the bank as we don’t have any time for work (we’re studying). We only
have $1500 currently, but the trip will cost $3,200.

The parameters:

• Money in the hand: 1500

• Time available: 2 years

• Three banking options:

1. Option 1: Simple Interest

2. Option 2: Compound Interest
3. Option 3: Continuously Compounded Interest

2.1 Option 1: Simple Interest

2.1.1 Terminology

Definition | Principle, Savings, Rate & Interest KZB 1.1

• The amount of money I have at the beginning (to be invested) is called the
principle, or P ;

• The value of the money after some time of investment, is the final
value, or S;

• The rate at which value is added in a time period is the interest rate,
or r;

• The total value gained due to time-value-of-money – is the interest, or

I due to me.

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ECON 1202/ECON 2291: QABE School
c of Economics, UNSW

So in our case, we have,

P S r I
$1,500 $3,200 (our aim) t.b.d. t.b.d.
Note: On S, P and A There is no real reason why the final value is given the pro-numeral S
– my best guess is that is to do with ‘savings’ (i.e. the amount that is in the account after
some time), but this is pretty tenuous. In any case, it is the convention of the financial
maths texts (both KZB and HPW use S for the final, or saved, value), so we’ll use it
here.
For the initial value, when we are just doing investment calculations, generally we talk
about the Principal P being invested. However, when we are dealing with annuities
(later), we talk about the present-value of the Annuity A (not P ). In this course, we’ll try
to follow the texts as best as possible: P for Principal, S for Savings (or future value), and
A for present-value of an Annuity.

2.1.2 Working it out

Simple Interest

Definition | Simple Interest

Simple interest is used when the interest is calculated once at the end of the
term, that is,
I = P rt (1)
where t is the time-period of the calculation.

Example: Simple Interest

Suppose we invest (as in our case), P = $1500, r = 5%p.a and t = 2yrs. How
much interest (calculated simply) would we gain? What would be the final
value of our investment?

Example: Reverse simple interest

With the same interest rate as in the previous example, how many years would
it take to gain our target ($3,200)?

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ECON 1202/ECON 2291: QABE School
c of Economics, UNSW

2.2 Option 2: Compound Interest

2.2.1 Terminology KZB 2.1,
Compound Interest HPW
5.1
Suppose that instead of I being paid once at the end of the investment period,
the calculation (and payment) of I is made periodically within the period: such a
scenario is that of compound interest.

Definition | Compound Interest

Let P be the original value of the investment, then after n interest periods,
at periodic rate of interest r, the final value of the investment will be,

S = P (1 + r)n (2)

Nominal rate vs. periodic rate Be careful of the terminology here

– if the nominal interest rate is 5% (that is, per annum), but
the interest is to be compounded quarterly, then r in (2) is actually
0.05/4 = 0.0125 (since the calculation period is quarterly).

Example: Compound Interest

Find the final value of a $1000 investment, invested for 5 years at the nominal
rate of 8% compounded quarterly.

2.2.2 Working it out

Example: Option 2: reverse compound interest

Returning to our problem, how long would it take to obtain $3,200 with an
initial investment of $1,500, if interest is compounded every two months at
a nominal rate of 5%?

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ECON 1202/ECON 2291: QABE School
c of Economics, UNSW

2.3 Option 3: Continuously Compounded Interest

2.3.1 The exponential constant HPW
Clearly, it is better to have interest compounded – that is, calculated and added in more 10.3;
KZB
than once a year. However, what would happen if we asked for compounding to take App. D
place every week? every day? every second? continuously??!!!

• Suppose we have our normal compound formula,

S = P (1 + r)n

• However, to be clear about it, let’s define ra to be the annual rate of interest (the
nominal rate), and k to be the number of times a year compounding will
occur, and t to be the number of years,
 ra kt
S =P 1+
k

• Now, what we are interested in, is making k approach ∞... (continuous compound-
ing), that is,
 ra kt
S = lim P 1 +
k→∞ k
  r t
ra  rka a
= P lim 1 +
k→∞ k

ra
• Let x = k for simplicity, meaning the limit is now x → 0
 
1 ra t
S = P lim (1 + x) x
x→0

 1

• But notice that the limit is actually e limx→0(1 + x) x , that is,

S = P era t

2.3.2 Working it out

Continuously compounded interest
Which leads to the following definition,

Definition | Continuously compounded interest

If the initial investment is P and the final value of the investment is S, then
under continuous compounding at an annual interest rate of r for t years,

S = P ert (3)

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ECON 1202/ECON 2291: QABE School
c of Economics, UNSW

Example: Option 3: Continuous compounding

With P = $1500 and r = 0.05, after two years, what will be the value of the
investment under continuous compounding?

Example: for the record...

With continuous compounding, initial investment of $1,500 and annual
interest rate of 0.05, how long would it take to obtain a total investment of
$3,200?

2.4 Summary
To summarize...
5000
S = P ert  nt
4000 S = P 1 + nr

3000
S($)
2000 S = P + P rt

1000

0
0 1 2 3 4 5
t(years)

3 Present Value
The principle, P , can be thought of as the present value of a future value S. A simple
reorganisation of our equations for the future value of P yields the following.

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ECON 1202/ECON 2291: QABE School
c of Economics, UNSW

Definition | Present Value (periodic)

To obtain a compound amount of value S which has been maturing at the
periodic rate of r for n periods, one needs to invest the starting amount, or
principle,
P = S(1 + r)−n (4)
otherwise called the present value of S.

Definition | Present Value (continuous)

To obtain a compound amount of value S which has been maturing continuously
at the nominal rate of r for t years, one needs to invest the starting amount, or
principle,
P = Se−rt (5)
otherwise called the present value of S.

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