Sec 5.

1: Mathematics of Finance
kt
r
Formulas : S=P 1+
k ( ) : Interest is compounded k times a year.
S=P e rt : Interest is Compounded Continuously

1. Suppose $500 amounted to $588.38 in a savings account after

three years. If interest was compounded semiannually, find the
nominal rate of interest , compounded semiannually, that was
earned by the money.

kt
r
( )
S=P 1+
k
6
r
500 (1+ ) =588.38
2
1
r 588.38
1+ =(
500 )
6
2
r =0.055∨5.5 %

2. At what nominal rate of interest compounded yearly will money

double in 8 years.

t
S=P ( 1+r )
8
2 P=P ( 1+ r )
1
8
1+r=2
r =1.0905−1=0.0905∨9.05 %
 3. How long will it take $600 to amount to $900 at an annual rate of
6% compounded quarterly?
kt
r
( )
S=P 1+
k
4t
0.06
900=600 ( 1+
4 )
4t
1.5= (1.015 )

ln ( 1.5 ) =ln ( ( 1.015 )4 t )

ln 1.5=4 t ln ( 1.015 )
t=6.8083 years .

Effective Interest Rate:

This is the simple annual interest rate. If interest is
compounded at the nominal rate r , the effective
interest rate is the simple annual interest rate r that
yields the same amount of interest after 1 year.

If interest is compounded k times a year and r is the

annual interest rate then
r k
( )
r e = 1+
k
−1

If interest is compounded CONTINUOUSLY and r is the

annual interest rate then
r e =er −1

4. What effective rate is equivalent to a nominal interest rate of 6%

compounded
A) semiannually.

r k 0.06 2
( )
r e = 1+ −1= 1+
k 2 ( )
−1=0.0609=6.09 %
 b) Continuously
r e =er −1=e 0.06−1=¿

5. How many years will it take money to double at an effective

interest rate of r?

t
S=P ( 1+r )
t
2 P=P ( 1+ r )
t
2= (1+r )
t
ln 2=ln ( 1+ r ) ¿
ln 2=tln ( 1+r )
t=ln 2/ ln ( 1+r )

6. If an investor has a choice of investing money at 6% compounded

daily or 6.5% compounded quarterly, which is the better choice?

We compute the effective interest rate for both investments and see
which is larger.
For daily compounding,
r k 365
0.06
( )
r e = 1+
k (
−1= 1+
365 ) −1=0.0618∨6.18 %

For quarterly compounding,

r k 0.065 4
( )
r e = 1+
k (
−1= 1+
4 )
−1=6.27 %

So the quarterly compounding is the better option !

5.2 Present value:

The principal P that must be invested at the periodic rate of r for kt interest periods
so that the compound amount is S is given by
−kt
r
( )
P=S 1+
k

And is called the present value of S.

Example1 –present value

Find the present value of $1000 due after three years if the interest rate is
9%compounded monthly.
Solution:
S=1000; P=?
r/k=.09/12=0.0075
kt=3(12)=36
P=S ( 1+r /k )−kt

P=1000 ¿ ¿764.15

Example 2-Single-Payment Trust Fund

A trust fund for a child’s education is being set-up by a single payment so that at
the end of 15 years there will be $50,000. If the fund earns interest at the rate of
7% compounded semiannually, how much money should be paid into the fund?
Solution:
S=50,000
R=0.07 , k =2, t =15
−kt
r
( )
P= S 1+
k
 =50000 ( 1.035 )−30 ≈ 17,813.92

How long will it take $5000 to grow to $7000 in an investment earning interest at an annual
rate of 6% if compounding is
a. Quarterly

b. Compounded continuously

Additonal Question: Equations of Value

1. A debt of $3500 due in 4 years and $4000 due in six years is to be repaid by a single payment of
$1500 now and two equal payments that are due each consecutive year from now. If the interest
rate is 7% compounded annually, how much are each of the equal payments?