8 MATHEMATICAL TECHNIQUES IN FINANCE

The above case is an example of a noncompounding interest rate.

Another way of getting compensated is by compounded interest where the
investor earns compound or interest on interest. For example, for a 2-year
deposit at the same interest rate of r = 4% per annum, but compounded
annually, the 1-year future value of $100 is $104, and the 2-year future
value is $104 × (1 + 4%) = $108.16:

$100 × (1 + 4%)2 = $108.16

Out of the $8.16 in interest, $8 is the interest for two years, $4 for each year,
and the extra $0.16 is due to the compounding effect: receiving interest on
interest.
In general, the Future Value FV of loan A at an interest rate of r per
annum, compounded m times a year for N whole compounding periods is
( )
r N
FV = A × 1 + (2.2)
m
For example, if m = 1, we have annual compounding FV = A × (1 + r)N ,
and N is the number of years until loan maturity T. If m = 2, we have
semi-annual compounding FV = A × (1 + r∕2)N , and N = 2 × T is the num-
ber of whole semiannual periods until loan maturity T years from now (see
Table 2.1). The term r∕m is known as the periodic interest rate.

2.1.1 Fractional Periods

The compound interest Formula 2.2 can be generalized to incorporate loan
durations that are not a whole number of compounding periods away. Let T
be the number of years—including fractions of years—between the invest-
ment date. We can generalize Formula 2.2 to
( )
r m×T
FV = A × 1 + (2.3)
m
TABLE 2.1 Future Value of $100,000 for a 2 year (T = 2) loan with r = 4% per
annum.

Number of Periodic Future

Compoundings Periods Interest Value
Per Year (m) (N = T × m) Rate (r∕m) FV(T) Interest

0=Simple $108,000 $8,000

1=Annual 2 4% $108,160 $8,160
2=Semiannual 4 2% $108,243.22 $8,243.22
4=Quarterly 8 1% $108,285.67 $8,285.67
12=Monthly 24 4%/12 $108,314.30 $8,314.30
365=Daily 2 × 365 4%/365 $108,328.23 $8,328.23
∞=Continuous ∞ $108,328.71 $8,328.71