Mathematics of Finance

Simple and Compound Interest,

Effective Rate of Interest and
Present Value
 Interest
Simple Interest
Let:
p = Principal amount
r =Interest rate per year
t = number of years

The accumulated amount A after t years:

A = p + prt = p ( 1 + rt)
Graphing the straight line segment:
A(t) = p + prt ; t ≥ 0
 Sample Problem 1:
What are the interest and the total accumulated
amount after 10 years on a deposit of 2000 pesos at a
simple interest rate of 1% per year?

Solution:
The accumulated amount : A = p + prt
The interest paid: I = prt

where p = 2000, r = 1/100 = 0.01 and t = 10

A = 2000 + 2000(1/100)(10) = 2000 + 200 = 2200

I = prt = 200 pesos

 Graphing the straight line:
A(t) = 2000 + 2000(0.01)t ; t ≥ 0
 Compound Interest
Let:
p = Principal amount
r =Interest rate per year
t = number of years

The accumulated amount A1 after 1 year:

A1 = p + pr(1) = p (1 + r)

The accumulated amount A2 after 2 years:

A2 = A1 + A1 r(1) = A1 (1 + r) = p(1 + r) (1 + r)= p(1 + r)2

 The accumulated amount A3 after 3 years:

A3 = A2 + A2 r(1) = A2 (1 + r) = p(1 + r)2 (1 + r)=p (1 + r)3

The accumulated amount A after 4 years:

A4 = A3 + A3 r(1) = A3 (1 + r) = p(1 + r)3 (1 + r)= p(1 + r)4

Therefore, the accumulated amount after t years:

At = p(1 + r)t
 Sample Problem 2:
What are the interest and the total accumulated
amount after 2 years on a deposit of 2000 pesos at a
compound interest rate of 10% per year?

Solution:
The accumulated amount: A = p(1+ r)t
The interest paid: I=A–p

where, p = 2000, r = 10/100 = 1 /10 = 0.1 and t = 2

A = 2000[1 + (1/10)]2 = 2420 pesos

The interest paid = 2420 – 2000 = 420 pesos

 Interest compounded m times a year
Let:
p = Principal amount
r = Interest rate per year
m = number of times a year the interest is compounded

Conversion period = the period of time between successive

interest calculations

The interest rate per conversion period = i = r / m

t = the number of years (term)
n = Number of periods in t years = mt
 Interest compounded m times a year
The accumulated amount A1 after 1 period:
A1 = p + pi = p (1 + i)

The accumulated amount A2 after 2 periods:

A2 = A1 + A1 i = A1 (1 + i) = p(1 + i) (1 + i)= p(1 + i)2

The accumulated amount A3 after 3 periods:

A3 = A2 + A2 i = A2 (1 + i) = p(1 + i)2 (1 + i)=p (1 + i)3

The accumulated amount A after 4 periods:

A4 = A3 + A3 i = A3 (1 + i) = p(1 + i)3 (1 + i)= p(1 + i)4
 Therefore, the accumulated amount after n
periods:

An = p(1 + i)n = p (1+i)mt = p (1 + r/m )mt

Where,
p = the principal
r = the interest per year
m = the number of times (periods) in a year the
interest is
compounded
 Sample Problem 3:
What is the total accumulated amount after 3 years on a
deposit of 1000 pesos at interest rate of 10% per year
compounded:

1. semiannually ( 2 periods in a year)

2. quarterly ( 4 periods in a year )
3. monthly ( 12 periods in a year)
4. daily ( 365 periods in a year)
5. every 4 months ( 3 periods in a year )
6. every two months ( 6 periods in a year )
7. annually
Solution:
In all of these cases, we use the formula:
An = p(1 + i)n = p (1+i)mt = p (1 + r/m )mt

1. semiannually ( 2 periods in a year)

A = 1000[1 + (0.1)/2 ]2(3) = 1340.10

2. quarterly ( 4 periods in a year )

A = 1000[1 + (0.1)/4 ]4(3) = 1344.89
Solution:

3. monthly ( 12 periods in a year)

A = 1000[1 + (0.1)/12 ]12(3) = 1348.18

4. daily ( 365 periods in a year)

A = 1000[1 + (0.1)/365 ]365(3) = 1349.80

5. every 4 months ( 3 periods in a year )

A = 1000[1 + (0.1)/3 ]3(3) = 1343.27
Solution:

6. every two months ( 6 periods in a year )

A = 1000[1 + (0.1)/6 ]6(3) = 1346.53

7. annually ( 1 periods in a year )

A = 1000[1 + 0.1 ]3= 1331.00
 Continuous Compounding of Interest
“ If the interest is compounded more and more frequently”

We have:
A = p (1 + r/m )mt
= p (1 + r/m )\(m/r) rt
= p [1 + (1/u)]u(rt) , by letting m/r = u and so r/m = 1/u

= p [1 + (1/u)]u(rt) = p [[1 + (1/u)]u](rt)

Notice that u →0 as m→∞ and so [[1 + (1/u)]u → e

And thus, p [[1 + (1/u)]u](rt) → p ert

 Continuous Compounding of Interest
“ If the interest is compounded more and more frequently”

Therefore, the amount accumulated if the interest is

compounded continuously is:

A = p ert

where:
p is the principal
r is the interest rate
t is the term ( number of years)
 Sample Problem 4:
What is the total accumulated amount after 3 years
on a deposit of1000 pesos at interest rate of 10%
compounded continuously?

Solution:

The amount accumulated: A = p ert

where p=1000, r = 0.1 and t = 3.

Thus,

A = 1000 e(0.1)(3) = 1349.86 pesos

 Effective Rate of Interest
( the annual percentage yield)
We let:
p(1+ reff ) = p[1+ (r/m)]m

Where,
r = the nominal yearly interest rate
m= the number of conversion periods per year

1+ reff = [1+ (r/m)]m

reff = [1+ (r/m)]m - 1

 Sample Problem 5:

What’s the effective rate if the rate if the nominal rate

of interest is 10% per year compounded:
1. quarterly
2. monthly
3. annually

Solution:

We use the formula: reff = [1 + (r/m)]m – 1

where r = 10/100 = 1/10 = 0.1

Solution:

1. quarterly → m = 4
reff = [1 + (0.1)/4)]4 – 1 = 0.1038 = 10.38%

2. monthly→ m = 12
reff = [1 + (0.1)/12)]12 – 1 = 0.1047 = 10.47%

3. annually → m = 1
reff = [1 + (0.1)/1)]1– 1 = 0.1 = the nominal interest
 Present Value

What’s the principal (present value) that should be

deposited in a bank paying an Interest at a rate of r
compounded m times a Year such that at the end
of t years the accumulated amount will be A.

We had A = p [ 1 +(r/m) ]mt

p = A / [ 1 +(r/m) ] mt

p = A [ 1 +(r/m) ] - mt
 Sample Problem 6:
What’s the principal (present value) that should be
deposited in a bank paying an interest at a rate of 10%
compounded 3 times a year such that at the end of 4
years the accumulated amount will be 5000 pesos?

Solution:

p = A [ 1 +(r/m) ] - mt

where A=5000, r =10/100=1/10= 0.1, m=3, t=4

p = 5000 [ 1 +(0.1)/3 ] –3(4) = 3372.53 pesos