Chapter 23: Financial math

Chapter 23: Interest rate

Interest is the fixed amount that we pay over and above of our initial borrowed amount. Interest can be
viewed as price of using borrowed money or cost of fund. Although interest is not liked by most value based
as well as secular philosophers it is the fact that interest is used almost everywhere in financial sector. So we
would like to pay small attention to its treatise.
First we try to address the rationale behind charging interest. Interest can be considered as a compensation
for holding consumption. We can consume all that we have today or we can save a portion of our resources
until next period when we can consume them. If we prefer to do that then we can let someone else to use
that resources for a specified period, obviously in that case the resources will not be available to us for use
until the specified period. If that happens then from economic argument we are entitled to have some
reward. The extra benefit that we expect to get from this transaction is commonly known as interest. This
can be seen as a reward for suspending consumption.
Apart from compensation for suspending consumption we can think of at least another rationale behind
charging interest. When we lend out our resources we face some risk. Without going into much details we
can argue for at least two different kinds of risks. The first one is default risk. The person who borrowed
money can very well tell at the end of the period that she is not going to pay that back. She may be simply
unwilling to pay back due to her evil intension or she made some bad investment and does not have the
capability to pay back. It is possible to sue against the borrower and if the lending contract is properly
designed then we can expect to have our money back. But certainly that includes cost and hassle. Besides
there is always a risk that the borrower will declare herself bankrupt and in that case law will protect the
borrower.
The other type of risk is known as inflation risk. Inflation is defined as the decrease in purchasing power of
money. Prices normally change with time and if prices of the goods that we generally consume increase
during the lending period then actually we would be worse off when paid back, because we can buy less at
higher price. To cover risks like these we expect to have little bit more than what we have lent out. Interest
is a simple solution of this problem.
Normally interest is charged proportional to the original amount that has been lent out. That proportion is
known as rate of interest.
Vocabulary of interest
Interest rate related problems normally have four variables,
ƒ Principle amount, P : The amount of money that has been borrowed from the lender
ƒ Final amount, A : The amount that is due at the end of the period
ƒ Interest rate, i : Prevailing rate of interest, normally expressed with an associated period
ƒ Time, t : Duration of the loan
Normally in interest related problem three of these four variables are given
Types of interest rates:
Interest is broadly of two types:

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Interest

Simple Interest Compound Interest

Continuous compounding Non Continuous

This classification is based on the way the interest is charged on principle. Simple interest scheme is the case
when interest is charged only on principle years after years and the value of investment increases in a simple
linear way. On the other hand if we let our accrued interest to get converted as principle at regular interval
then we not only get interest on principle amount but also on previously accrued interest. If this scheme is
followed while calculating interest then that is known as compound interest. Compound interest is the most
common type of interest and practiced in commercial purposes. While simple interest scheme s followed in
case of personal (non commercially administered) loan.
Compounding of interest can be of two types depending upon how frequently they are accrued interest is
converted into principle (this process is known as compounding). The first one is continuous compounding
where interest earned at every fraction of a second is converted into principle and used in the calculation of
interest. But when this process is done at certain interval then that is known as non continuous
compounding. Non continuous compounding can be yearly, half yearly, quarterly, daily, hourly and so on.
Yearly compounding is the most popular form of compounding.
We have three formulas to solve problem related to interest rates:

ƒ Simple interest: A = P (1 + it )

ƒ Continuous compounding: A = Pe it , here e is the base of natural logarithm

nt
⎛ i⎞
ƒ Non continuous compounding: A = P⎜1 + ⎟ , here n is a factor depending upon the frequency
⎝ n⎠
of compounding. n is the number of times the money is compounded within a period of interest
rate. That is if our interest rate is expressed yearly and compounding is done monthly then we
compound 12 times in a year and our factor n is 12.however if the interest rate is expressed half
yearly and compounding is done monthly then we compound 6 times in half year and our n factor
is 6. Similarly time in this expression is expressed in terms of the period of interest rate.
Present and future value:
The concept of interest rate is closely related with the concept of present value and future value of money.
We have introduced the concept of lending and in that process we argued that money today is not same as
the money tomorrow. In other words there is time value of money. Normally we expect our money to grow
with time, which implicitly means interest rate is positive1.

1
In some cases in the history we experienced negative interest rate that is people borrow money and pay
beck less than what they borrowed.

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Present value of a future cash amount is the amount which when deposited in a safe investment today will
produce equal amount of the future cash amount. Similarly future value of a current cash amount is the
amount at which the current cash will grow when that is invested in a safe investment.
Example 1: Suppose your local stock index is now at 7900 . It was 800 exactly 15 years ago. What was the
annualized rate of return in this 15 year horizon?

15 years ago the situation was FV15 = 7900 , PV0 = 800 , n = 15

1
⎡ FV ⎤ 15
r = ⎢ 15 ⎥ − 1
⎣ PV0 ⎦
⇒ r = 16.4937%
Example 2: Find out the doubling time of your investment at 10% interest rate

A = 2 p , r = 10%

2 p = p(1 + 0.1) ⇒ 2 = 1.1t ⇒ t =

ln 2
⇒ t = 7.273 years
t

ln 1.1
Graphical view:
Interval of compounding is an interesting issue, and the value of the investment grows to a different value
when we have different interval for compounding. The lowest return comes in case of simple interest where
there is no compounding. The highest return comes in case of continuous compounding. Shorter the
compounding interval larger is the value of investment. Below we have tabular and graphical comparison
of 1 taka invested according to different compounding scheme at 10% yearly interest rate
Time Simple Yearly Half Monthly Daily Continuous
yearly
0 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
1 1.1000 1.1000 1.1025 1.1047 1.1052 1.1052
5 1.5000 1.6105 1.6289 1.6453 1.6486 1.6487
10 2.0000 2.5937 2.6533 2.7070 2.7179 2.7183
15 2.5000 4.1772 4.3219 4.4539 4.4808 4.4817
20 3.0000 6.7275 7.0400 7.3281 7.3870 7.3891
25 3.5000 10.8347 11.4674 12.0569 12.1783 12.1825
30 4.0000 17.4494 18.6792 19.8374 20.0772 20.0855
35 4.5000 28.1024 30.4264 32.6387 33.0994 33.1155
40 5.0000 45.2593 49.5614 53.7007 54.5678 54.5982
45 5.5000 72.8905 80.7304 88.3542 89.9609 90.0171
Graph:

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Chapter 23: Financial math

100

90

80

70 Simple
60 Yearly
Half yearly
50
Monthly
40 Daily
30 Continuous
20

10

0
0 1 5 10 15 20 25 30 35 40 45

Annuity problems:
So far we have analyzed the case where we paid or received one single transaction at a certain instant of time
and ten reversed the payment at some future date. This technically can be considered as a single payment
structure. Apart from this single payment structure we can have annuity payments. If a payment structure is
such that there is a fixed amount of cash inflow or outflow at fixed intervals for a specified period of time
then that is called an annuity.
Examples of annuity problems:
ƒ Mortgage payments: In mortgage payments we take loan of certain amount and after that we pay
equal month amount to amortize the mortgage.
ƒ Pension account: In pension account we deposit equal amount of money for a certain period of time
and then we withdraw a large sum at the end of the period.
Present value and future value concept can be extended for annuity as well. If we have an annuity that pays
us a constant stream of cash for next few periods and we are interested to fix the price of that cash flow then
we need to find out the present value of the annuity. In the following section we will try to find
relationships that connect present and future value of an annuity and its determining parameters.
Present value of an annuity:
Present value of an annuity is the amount which if paid now will make us indifferent between the annuity
and the amount. If we have a cash flow structure is like below then we can calculate preset value of this
annuity by calculating present value of each of these small payments using appropriate discount rate, and
adding them together. Calculation is given below.

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a a a a a a a a a a
Here a is the fixed payment that is to be paid for next n time periods and P is the amount of loan taken at
the current period. Relevant interest rate is i . Conceptually summation of present value of all these small

payments should be equal to P , mathematically,

⎡ a a a a ⎤
P=⎢ + + + LLL +
⎣ (1 + i ) (1 + i )
2
(1 + i )3
(1 + i )n ⎥⎦
⎛ a ⎞⎡ 1 1 1 ⎤
⇒ P = ⎜⎜ ⎟⎟ ⎢1 + + + LLL +
⎝ (1 + i ) ⎠ ⎣ (1 + i ) (1 + i )
2
(1 + i )n−1 ⎥⎦
⎧ 1 ⎫
⎪ 1− ⎪
⎛ a ⎞⎪ (1 + i )n ⎪
⇒ P = ⎜⎜ ⎟⎟⎨ ⎬
⎝ (1 + i ) ⎠⎪ 1 − 1 ⎪
⎪⎩ (1 + i ) ⎪⎭

⇒P=
{
a (1 + i ) − 1
n
}
(1 + i ) n
i

P (1 + i ) i
n
⇒a=
{
(1 + i )n − 1 }
Future value of an annuity:
Future value of an annuity is the amount which when paid at the end of n period will make us indifferent
between the annuity and that payment. Future value of an annuity can be calculated by summing up future
values of individual small payments discount to the future rate using proper interest rate. Derivation is given
below:

a a a a a a a a a a
Here a is the fixed deposit that we have to make for next n time periods and A is the amount of payment
that we will get at the end of nth period. Conceptually summation of future value of all these small payments
should be equal to A , mathematically,

[
A = a(1 + i ) + a(1 + i )
n n −1
+ a(1 + i )
n−2
+ a(1 + i )
n −3
+ LLL + a(1 + i ) + a (1 + i )
2
]
⇒ A = a (1 + i )(1 + i )[ n −1
+ (1 + i )
n−2
+ (1 + i )
n −3
+ LLL + (1 + i ) + 1 ]

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Chapter 23: Financial math

⎧1 − (1 + i )n ⎫
⇒ A = a (1 + i )⎨ ⎬
⎩ 1 − (1 + i ) ⎭
⎧ (1 + i )n − 1⎫
⇒ A = a(1 + i )⎨ ⎬
⎩ i ⎭
Example 1:
Suppose we take a loan from our local bank of 100,000 taka and we are supposed to pay back the whole

amount along with any accrued interest by 30 equal monthly payments. The bank will charge us interest at a
rate of 15% per year. Find out our monthly payments.
Solution:
This is an annuity problem where we have to find the annuity payments that have present value
of 100,000 taka. The problem is straight forward with only problem with the maturity of interest rate.

Interest rate is yearly but our payment is monthly. We have to convert interest rate into effective monthly

interest rate (im ) . There are two ways to do that, right way and wrong way:

Right way Wrong way

A = P(1 + im ) ⇒ 1.15 = 1.00(1 + im )

nt 12*1
0.15
im = ⇒ im = 0.0125
⇒ im = 0.011714 12

While the wrong way is easier, it is wrong. Normally, banks and other NGOs normally charge interest in
this fashion. The rest of the problem is easy. Following the right way we can find the monthly payment,

P(1 + i ) i
n
a=
{(1 + i )n − 1 }
100,000 * (1 + 0.011714) * 0.011714
30
⇒a=
{
(1 + 0.011714)30 − 1 }
⇒ a = 3972.55
Following wrong way we can also find our monthly payment

P (1 + i ) i
n
a=
{(1 + i ) − 1}
n

100,000 * (1 + 0.0125) * 0.0125

30
⇒a=
{(1 + 0.0125) 30
−1 }
⇒ a = 4017.85
So following wrong way we will pay 45.3 3taka per month more.
Example 2:
In the above problem suppose as a good customer advantage we do not have to pay anything for first five
months and then we have to pay the whole amount including interest within 25 equal monthly payments, a)
find out our monthly payment b) find out the amount of interest and principle paid in first installment c) in
last installment

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Solution:
Important to notice that during our payment holiday our total payable amount will continue to increase at
the given interest rate, so when we will start our payment then principle will be more than 100,000. To be
specific it will be

P = 100,000 * (1 + 0.011714 ) ⇒ P = 105,995.80 So our monthly payment will be

5

P(1 + i ) i
n
a=
{(1 + i ) − 1}
n

105,995.80 * (1 + 0.011714) * 0.011714

25
⇒a=
{(1 + 0.011714) 25
−1 }
⇒ a = 4915.52
Interest portion of this payment is, 1241.64(= 105,995.80 * 0.011714 ) , the rest 3673.88 taka is

principle.
For the last payment we have (1 + 0.011714) * P = 4915.52 ⇒ P = 4858.60 and interest 56.91 taka.

We can solve this problem using difference equation, the difference equation governing the system will be

Pn +1 = 1.011714 * Pn − a with P0 = 105,995.80 , the corresponding functional form will be

n⎧ ⎫
Pn = (1.011714 ) ⎨105,995.80 +
a a
⎬−
⎩ − 0.011714 ⎭ − 0.011714
25 ⎧ ⎫
⇒ P25 = 0 ⇒ 0 = (1.011714 ) ⎨105,995.80 −
a a
⎬+
⎩ 0.011714 ⎭ 0.011714
⇒ a = 4915.52
Important to notice that the system is not a converging one as the coefficient of the lagged term is greater
than 1.0. It is a uniform diverging series however, we see that the series comes back to zero as our constant
term is negative so each time we are reducing the value of the variable by some fixed amount. That’s how we
control the growth of the system.
Interest
Time period Principle Left paid Principle paid
0 105995.83
1 102321.95 1241.64 3673.88
2 98605.02 1198.60 3716.92
3 94844.56 1155.06 3760.46
4 91040.05 1111.01 3804.51
5 87190.98 1066.44 3849.08
6 83296.81 1021.36 3894.16
7 79357.03 975.74 3939.78
8 75371.10 929.59 3985.93
9 71338.48 882.90 4032.62

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Chapter 23: Financial math

10 67258.61 835.66 4079.86

11 63130.96 787.87 4127.65
12 58954.96 739.52 4176.00
13 54730.04 690.60 4224.92
14 50455.62 641.11 4274.41
15 46131.14 591.04 4324.48
16 41756.00 540.38 4375.14
17 37329.61 489.13 4426.39
18 32851.37 437.28 4478.24
19 28320.67 384.82 4530.70
20 23736.90 331.75 4583.77
21 19099.43 278.05 4637.47
22 14407.64 223.73 4691.79
23 9660.90 168.77 4746.75
24 4858.54 113.17 4802.35
25 -0.06 56.91 4858.61
Example 3:
Find the present and future values of a constant cash stream of 1,000 taka per year for next 15 years,

assuming interest rate of 6% per year compounded monthly.

Here the trick is the cash flow occurs once per year, interest rate given is yearly interest rate but the interest
is compounded annually. So we need to convert our monthly interest rate to effective yearly interest arte and
the treat the whole problem as an annual annuity problem.
(Note: Here we have to think that the formula that we are going to use requires that the cash flow has to be
in every period so we need to adjust the definition of period as it suits the type of the problem. Her we will
convert the monthly compounding to effective yearly rate and that will give us the required solution)

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Concept check:
1. What is the difference between simple and compound interest
2. Explain the term continuously compounding.
3. Show that expression for non continuous compounding transform into the expression for
continuous compounding as number of compounding per unit of time increases unboundedly
4.
Problems to solve:
1. An amount of 25000 is deposited in a bank that pays interest at the rate of 7% compounded
annually. What is the total amount on deposit at the end of 6 year? Assuming there are no deposits
and withdrawals during those 6 years. What is the total interest earned during that period of time?

2. The properties of the Coachmen Inn secured two loans from the union bank: one for $8000 due in
3 years and one for $15000 due in 6 year, both at an interest rate of 10% compounded
semiannually. The bank allowed the two loans to be consolidated into one loan payable in 5 year at
the same interest rate. How much the business has to pay the bank at the end of 5 year?

(Ans: 23329.49 )
3. Zoe purchased a house in 1996 for $80000 and sold it at 2000 to make a net profit of $28000 .
Find the effective annual interest rate for this 4 years.
4. Having received a large inheritance a child’s parents wish to establish a trust for the child’s college
education. If 7 years from now they need an estimated $70000 how much should they set aside in

trust now, if they invest the money at 10.5% compounded a) annually b) continuously
5. Michael, who is now 50 years old is employed by a firm that guarantees him a pension of
$40000 per year at age 65 . What is the present value of his first year’s pension if inflation over the
next 15 year is a) 6% b) 8% c) 12%

6. Omar’s current salary is 35000 taka. How much will he need to earn 10 years from now in order to
retain his current purchasing power is the rate of inflation over the period is 6% yearly. Assume
that the inflation is continuously compounded.
7. A metropolitan utility company expects the consumption of electricity to increase by 8% per year
during the next decade, due mainly to expected population increase. If consumption does increase at
this rate find the amount by which the utility company will have to increase its generating capacity
in order to meet the area’s need at the end of the decade.
8. The Sotos plan to secure a loan of $160000 to purchase a house. They are considering a

conventional 30 year home mortgage at 9% per year on the unpaid balance. Write an expression of

their unpaid balance B ( x ) . Here x is the number of payments made. Find B ′(180 ) and B (180 ) and

interpret them verbally.

9. “Loan free Bangladesh”, a national NGO is working among rural poor and extending loans to their
members. To help their members they have the convenient weekly repayment system. Their

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members are required to pay 5 taka per week for every 1000 taka they borrow as interest. They
argue that they charge their members simple interest and for members’ convenience distribute the
interest over 52 equal weekly payments. Following their logic calculate their yearly interest rate.
Using your knowledge of compound interest rate find out the fallacy of their argument and the
actual interest rate that they are charging. (033)
10. Mr. Hat-ti-ma-tim secured two loans from the Hazabarol bank ltd, one for 80,000 due in 3 years

and one for 150,000 due in 6 year, both at an interest rate of 10% compounded semiannually. The

bank allowed the two loans to be consolidated into one loan payable in 5 year at same interest

structure. How much Mr. Tim has to pay the bank at the end of 5 year? (053, 051)

11. The properties of the Coachmen Inn secured two loans from the union bank: one for $8000 due in
3 years and one for $15000 due in 6 year, both at an interest rate of 10% compounded
semiannually. The bank allowed the two loans to be consolidated into one loan payable in 5 year at

the same interest rate. How much the business has to pay the bank at the end of 5 year?
12. How long it will take for an investment to grow threefold at an interest rate of 5% following
continuous compounding
13. Suppose at time t = 0 you borrow 1,00,000 taka at the fixed interest rate r = 7.00% per year. You

are supposed to repay the loan in 25 equal payments; the first one is due at the end of 6th year. You
do not make any payment on first five years. So, after t = 30 years, the mortgage is fully paid off.
How much is the yearly repayment2? How much of your first installment is interest and how much
is principal?

2
Caution!!! this is not the problem that you have in problem set

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