Lecture 1: Interest Accumulation

Lecturer: Trần Minh Hoàng

Financial Mathematics

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Table of Contents

1 Accumulation Function and Amount Function

2 Simple and Compound Interest

3 Frequency of compounding

4 Annual Effective Rate of Interest

5 Generalized nominal rate of interest ih (t)

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 Accumulation Function and Amount Function

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Basic terminologies

Many financial transactions involve lending and borrowing.

The sum of money borrowed is called the principal.
To compensate the lender for the loss of use of the principal during the loan
period the borrower pays the lender an amount of interest.
At the end of the loan period the borrower pays the lender the accumulated
amount, which is equal to the sum of the principal plus interest.

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Accumulated function a(t)

We denote A(t) as the accumulated amount at time t, called the amount

function.
Hence, A(0) is the initial principal and

I (t) = A(t + 1) − A(t)

is the interest incurred from time t to time t + 1.

For the special case of an initial principal of $1, we denote the accumulated
amount at time t by a(t).

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 Simple and Compound Interest

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Simple and Compound Interest

There are many ways to calculate interest.

The two most common methods are the simple interest method and the
compound interest method.

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Simple interest

For the simple interest method, the interest earned over a period of time is
proportional to the length of the period.
The interest incurred from time 0 to time t, for a principal of $1, is r × t,
where r is the constant of proportion called the rate of interest.
The accumulation function for the simple-interest method is

a(t) = 1 + rt, A(t) = A(0)(1 + rt). (1)

The rate of interest may be quoted for any period of time (such as a month
or a year). However, the most commonly used base is the year, in which case
the term annual rate of interest is used.

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Example: simple interest

Example
a) $550 is deposited at 4.6% simple interest for five years. What is the
accumulated amount at the end of this period?
b) At what rate of simple interest will $550 accumulate to $645 in three years?

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Compound interest

For the compound-interest method, the accumulated amount over a period of

time is the principal for the next period.
Thus, a principal of 1 unit accumulates to (1 + r ) units at the end of the
year, which becomes the principal for the second year.
Continuing this process, the accumulation function becomes

a(t) = (1 + r )t , A(t) = A(0)(1 + r )t for t = 0, 1, 2, ... (2)

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Compound interest continued

For the compound-interest method the accumulated amount at the end of a

year becomes the principal for the following year, whereas the principal does
not change for simple interest over the loan period.
The formula for the accumulation function only works for integral values of t
whereas the same formula for simple interest works for all positive value of t.

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Compound versus Simple interest

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Examples: compound interest

Example
a) $550 is deposited at 4.6% compound interest per annum for five years. What
is the accumulated amount at the end of this period?
b) At what rate of compound interest per annum will $550 accumulate to $645
in three years?
c) You have $500 on deposit earning 8.2% annual compound interest. How long
will it be before your account balance is $856?

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Examples: compound interest

Example
$500 is deposited in an account earning annual compound interest of 5.7%. At the
end of two years the accumulated amount is transferred to an account which pays
an unknown annual compound interest. At the end of three additional years the
account shows a balance of $600. What was the rate of annual compound interest
during the final three years?

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Example: compound interest

Example
An investment is earning compound interest. If $100 invested in year 2
accumulates to $105 by year 4, how much will $500 invested in year 5 be worth in
year 10?

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Example: compound interest

Example
Smith deposits $1000 into an account on 1/1/2005. The account credits interest
at 5% per annum at every 31/12. Smith withdraws $200 on 1/1/2007, deposits
$100 on 1/1/2008 and withdraws $250 on 1/1/2010. What is the balance of the
account just after interest is credited on 31/12/2011 ?

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 Frequency of compounding

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Frequency of compounding

The the frequency of compounding is the number of times interest

payments are made annually.
We say that the nominal rate of interest is i (p) convertible p times per
annum if the interest is paid every 1/p of a year at the rate of i/p.
Starting at $1, after t years, the accumulated account grows to
tp
i (p)

a(t) = 1+ . (3)
p

In cases when the loan period is not a multiple of the compound period, we
adopt the convention that (3) can be used even when tp is not a whole
number.

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Example:

Example
$1,000 is deposited into a savings account that pays 3% interest with monthly
compounding. What is the accumulated amount after two and a half years? What
is the amount of interest earned over this period?

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Example:

Example
What is the accumulated amount for a principal of $100 after 25 months if the
nominal rate of interest is 4% compounded quarterly?

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Continuous Compounding

At the same nominal rate of interest r , the more frequent the interest is paid,
the faster the accumulated amount grows. Indeed, if p > q then
 p  q
r r
1+ > 1+
p q

When the number of interest payments per annum approaches infinity, the
accumulated amount tends to a finite number
 p
r
lim 1 + = exp(r ).
p→∞ p

We call the compounding scheme over infinitely small period of time

continuous compounding.
Daily compounding is very close to continuous compounding.

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Continuous Compounding

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 Annual Effective Rate of Interest

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Annual effective rate of interest

Definition
The annual effective rate of interest at time t, denoted by i(t), is the ratio of the
amount of interest earned in a year, from time t to time t + 1, to the accumulated
amount at the beginning of the year (i.e., at time t).

A(t + 1) − A(t) a(t + 1) − a(t)

i(t) = = . (4)
A(t) a(t)

Corollary
A(t + 1) = A(t)(1 + i(t)).

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Simple interest

Proposition
The annual effective rate of interest of simple interest rate r is given by
r
i(t) = .
1 + rt

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Annual effective rate of simple interest versus time

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Compound interest

Proposition
The annual effective rate of interest of compound interest rate r is given by

i(t) = r .

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Compound interest

Proposition
The annual effective rate of interest of nominal rate of interest of i (p) convertible
p times per annum
p
i (p)

i(t) = 1 + − 1.
p

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Example

Example
Consider two investment schemes A and B. Scheme A offers 12% interest with
annual compounding. Scheme B offers 11.5% interest with monthly compounding.
Calculate the effective rates of interest of the two investments. Which scheme
would you choose?

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Example
Suppose i(t) = 0.05 + 0.001t for t = 0, 1, .., 4. What is the accumulation of
$10,000 at these rates of interest over the period t = 0 to t = 5?

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 Generalized nominal rate of interest ih (t)

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Generalized nominal rate of interest ih (t)

Definition
Let h > 0, the generalized nominal rate of interest ih (t) is defined as

1 a(t + h) − a(t)
ih (t) = × .
h a(t)

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ih (t) - continued

This is the annualized effective rate of interest between time t and t + h.

Equivalently, $1 at time t will grow to $1 + hih (t) at time t + h.
The nominal rate of interest i (p) for compound interest convertible p times
per year is a special case of ih (t) with h = 1/p and interest is constant over
time.

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Example: ih (t)

Example
We are given the nominal interest rates i0.4 (0) = 0.05, i0.6 (0.4) = 0.06,
i0.5 (1) = 0.04. What is the accumulation of $1 from time 0 to 1.5?

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Homework

Textbook questions:
Chapter 1: 1,3,4,6,7,12,13,17,22,23,25,29.

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