FM Module 1

Financial Mathematics
ACTL2111/5102 Financial Mathematics
Eric Cheung
UNSW Sydney
Risk and Actuarial Studies, UNSW Business School
Module 1: Time Value of Money and Valuation of Cash Flows
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Plan

Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
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Cash Flow Models
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Cash Flow Models
Cash flow models
A cash flow is a series of payments (inflows or outflows) over a

period of time.
A mathematical projection of the payments involved in a financial
transaction is referred to as a cash flow model.
Cash flows are characterised by their:

I nature: inflow or outflow
I amount
I timing
I probability (if contingent)
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Cash Flow Models
Comparing cash flows

We want to compare different sets of cash flows:
I why?
I compare 2 securities or investments
I compare scenario for a given product (product development,
profit testing, solvency)
I compare potential new products (product development)
I etc. . .
I how?
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Cash Flow Models
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Cash Flow Models
Procedure:
I make the cash flow clear; draw a time diagram
I choose any point in time
I now: present value, sometimes NPV (Net Present Value)
I in the future: accumulated value
I in the middle...
I should be convenient: all are equivalent!
I ”bring back or forth” all cash flows to the point of time you
have chosen
I add them up
I compare!
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Cash Flow Models
You want to buy a television from Bling Bee’s on 31/12/2009 that

is worth $3000. The super mega deal (yeahh) is that you can take
the television now and need only to pay $1000 on 31/12/2011 and
$2000 on 31/12/2012. Their advertisement campaign is ”No
interest, no deposit until 2011!”.
But you are smart (of course, you are an actuary), and you know
that if Bling Bee invests $1000 now, this investment will be worth
$1100 in one year, $1210 in two years and $1331 in three years.
Taking this information into account, what discount can you
reasonably get from Bling Bee?
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Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Time value of money
How much would you pay to buy a security that is guaranteed to

give you $100 in 1 year’s time?
What if there was a chance of default?
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Time is money!
Interest is a mathematical tool to embody

I the time preference of agents in the economy
usually, agents are impatient (interest is positive)
I risk (interest is raised to include a risk premium)
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Mathematical model
Consider an amount of money invested for a period of time.
I A(0): principal = the amount of money initially invested
I t: the length of time for which the amount has been invested
I A(t): amount function or accumulated amount function
I this is the accumulated amount of money at time t
corresponding to A(0)
Assuming these are two equivalent cash flows at two different
point in time, how can we link them using interest?
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Accumulation function
Let a(t) be the accumulation function:
I a(t) the accumulated value at time t of an original investment
of 1 made at time 0
I it is a scaled version of A(t) with a(0) = 1 and can thus be
studied independently of the amounts that are invested
I it represents the way in which money accumulates with the
passage of time
We have
A(t + k) a(t + k)
= ,
A(t) a(t)
which means
a(t + k)
A(t + k) = A(t) .
a(t)
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Effective Interest
In mathematical terms, the effective interest It,k accumulated

between t and t + k (for a period k from time t) is
It,k = A(t + k) − A(t),
and then the effective rate of interest it,k for this same period is
A(t + k) − A(t) a(t + k) − a(t)

it,k = = . (1.1)
A(t) a(t)
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Homogeneity in time
When the effective rate of interest is the same for all t, then we
have
a(t + k) a(k)
= = a(k)
a(t) a(0)
⇐⇒ A(t + k) = A(t)a(k)
and moreover
a(t + k) − a(t)
it,k = = a(k) − 1.
a(t)
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Forms of interest
I a(t) is modeled with the help of interest

I effective rate of interest is always defined as in (1.1)
I however, interest can be expressed in many different ways,
depending on the situation (mainly conventions)
I each way has a different set of assumption
I each definition may lead to different forms for a(t)
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Assumptions about interest

1. how much interest is paid?
I usually expressed as a percentage per year (‘per annum’, ‘p.a.’)
I amount can depends on the time period (inhomogeneity)
→ term structure of interest, see module 4
→ non-constant force of interest
I amount is sometimes stochastic
→ deterministic vs stochastic interest, see module 6
2. how often is interest paid?
I as a rule, once per ‘compounding period’, whose number per
time unit needs to be determined (usually once a year)
I → simple vs compound interest (time horizon)
I → nominal vs effective interest (several times a year)
I → force of interest (continuously)
3. when is interest paid?
I at the beginning or end of the compounding period
I → discount interest (beginning)
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Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Example: Assume John deposits $1000 on his bank account on
01/01/2010 at an effective rate of interest of 5% p.a. At the
following dates:
1. what is the balance of his account?
2. how much would he get if he closed his account?
3. how much interest has he earned?
4. how much interest has been credited on the account?
I 30/06/2010
I 01/01/2011
I 30/06/2011
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Main difference:
I with simple interest: no interest is ever earned on
interest—interest is not compounded
I with compound interest: interest is continuously earned on
interest—interest is compounded
When to use one or the other?
I What happens within a year (compounding period) is usually
simple interest (short term securities, T-bills, . . . )
I However, simple interest is not homogeneous in time
I For cash flows spanning over periods of more than
a year, compound interest is generally used (easier..!)
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Simple Interest
Accumulation function: for simple interest i,
a(t) = 1 + it,
and the accumulated amount function after a period t is given by
A(t) = A(0) · a(t) = A(0) · (1 + it).
Usually, t < 1 (days/360 or 365, or months/12).
Effective rate of interest is not constant in this case (decreasing):
a(t + k) = 1 + i(t + k) 6= (1 + it)(1 + ik) = a(t)a(k)
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Numerical Example
A Bank accepts deposits for terms up to 3 years and pays interest
on maturity. How much interest would it pay on a deposit of
$20,000 for a term of 1 year and 33 days if the interest rate is 5%
p.a. simple?
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Compound Interest
Accumulation function: for compound interest i,
a(t) = (1 + i)t ,
and the accumulated amount function after a period t is given by
A(t) = A(0) · a(t) = A(0) · (1 + i)t .
In this case, effective interest is homogeneous:
a(t + k) = (1 + i)t+k = (1 + i)t (1 + i)k = a(t)a(k)
or alternatively
a(t + k)
= (1 + i)k = a(k), t, k ≥ 0.
a(t)
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Numerical Example
A Bank accepts deposits for terms up to 3 years and pays interest
on maturity. How much interest would it pay on a deposit of
$20,000 for a term of 1 year and 33 days if the interest rate is 5%
p.a. effective?
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General questions
1. What happens to the accumulation if i ↑? i ↓?
2. What is the amount of interest earned during each unit period
under compound interest? simple interest?
3. What is the effective rate of interest during each unit period
under compound interest? simple interest?
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Discount Interest
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Discount Interest

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Discount Interest
Rate of Discount
The rate of interest i applies to the principal now, for interest
calculated at t = 1, whereas the rate of discount d applies to the
principal at the end of the period, for interest calculated at t = 0.
In other words, for i:
I we focus on the principal now
I we correct this figure by adding interest at the end of the
period
and for d:
I we focus on the principal at the end of the period
I we correct this figure by subtracting interest now
Both methods are equivalent, and use of one or the other is
dictated by the situation for convenience.
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Discount Interest
a(1) − a(0)
Remember: i =
a(0)
A(1) − A(0)
= =⇒ a(1) = 1 + i
A(0)
a(1) − a(0)
Now: d =
a(1)
A(1) − A(0) 1
= =⇒ a(1) =
A(1) 1−d
Since we want d and i to be equivalent (they are just formulated

differently), we have
1
1+i = .
1−d
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Discount Interest
Simple vs compound discount interest
For simple discount:

1
a(t) =
1 − dt
and for compound discount:
t
1
a(t) =
1−d
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Discount Interest
Numerical Example
In the US Treasury Bills are quoted using ‘simple discount’ on the
basis of a 360 day year.
Consider a US T-Bill with a face value of 500,000 and maturity in
180 days time. Suppose that this is sold to yield 6% p.a (simple
discount). What are the proceeds of the sale?
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Discount Interest
Relations between Interest and Discount
i is the effective rate of interest, d is the effective rate of discount

and v = 1/a(1) is the discount factor.
Show these are correct as an exercise and use financial reasoning.
d
i =
1−d
i
d =
1+i
d = iv
d = 1−v
i −d = id
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Discount Interest
Intuition behind d = 1 − v ?
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Discount Interest
Intuition behind i − d = id?
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Nominal Interest
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Nominal Interest

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Nominal Interest
Nominal Interest Rate
I usually the compounding period is one year

I nominal interest rates are interest rates
I that are still expressed as % p.a.
I but that have several (m) compounding periods per year
I Example of securities for which nominal rates are relevant:
I Some bonds pay interest yearly, some semi-annually and some
quarterly
I Home loans usually charge interest monthly
I Some bank accounts pay interest daily
I Notation: i (m) = nominal interest rate payable mthly
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Nominal Interest
Nominal vs effective rates

With nominal interest rates, the rate
i (m)
m
is an effective rate of interest for a period of 1/m years.
Reminder:
I the effective rate of interest for a period is the ratio between
1. the actual amount of interest earned and
2. the principal at the beginning of the period (for interest) or at
the end of the period (for discount).
I i (m) (for m > 1) is not an effective rate of interest
I i is the effective rate of interest for a year, equivalent to i (m)
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Nominal Interest
Relationship to i, the effective interest rate
In general, for rate i per annum

!m
i (m)
(1 + i) = 1+
m
h i
i (m) = m (1 + i)1/m − 1
<
i (m) >i ??
Can you use your financial reasoning to convince yourself which is
correct?
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Nominal Interest
Numerical Example
A product offers interest at 8% p.a., payable quarterly. What is the
effective annual rate of interest implied?
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Nominal Interest
Nominal Discount Rates
I Interest is converted m times per year (period)

I Notation: d (m) = nominal discount rate converted mthly
I Relationship to d the effective rate of discount
!m
1 d (m)
=1−d = 1−
a(1) m
I Note that the nominal discount rate increases as the

frequency of conversion increases.
d < d (2) < d (3) . . .
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Nominal Interest
Exercise
1
Show that d (m) = i (m) vi m
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Nominal Interest
Numerical Example
Find the accumulated amount of $100 invested for 15 years if
i (4) = .08 for the first 5 years, d = .07 for the second 5 years and
d (2) = .06 for the last 5 years.
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Force of Interest
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Force of Interest

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Force of Interest
Force of Interest
Consider
!m
i (m)
lim 1+
m→∞ m
 !2 
i (m) m (m − 1) i (m)
= lim 1 + m · + + ...
m→∞ m 2! m
2 3
(∞) i (∞) i (∞)
= 1+i + + + ...
2! 3!
i (∞) δ
= e or e ,
where δ is called the force of interest, or continuously

compounding rate of interest.
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Force of Interest
Force of Discount
Similarly, consider
!m
d (m)
lim 1−
m→∞ m
 !2 
d (m) m (m − 1) d (m)
= lim 1 − m · + − ...
m→∞ m 2! m
2 3
(∞) d (∞) d (∞)
= 1−d + − + ...
2! 3!
(∞)
= e −d ,
where d (∞) is the force of discount.

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Force of Interest
We have
(∞) (∞)
1 − d = e −d and 1 + i = e i .
Now
1
1−d =v = .
1+i
Thus,
i (∞) = d (∞) ≡ δ
and, in general,
d < . . . < d (m) < . . . < d (∞) = δ = i (∞) < . . . < i (m) < . . . < i.
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Force of Interest
Force of interest that varies with time
Let
I A(0) be the principal invested at time 0
I interest be paid continuously at a rate δ (t) at time t
We seek an expression for A(t).
Interest paid over a small interval ∆t is
A(t + ∆t) − A(t) ≈ A(t)δ(t)∆t
and thus
A(t + 4t) − A(t)
δ(t) ≈ .
A(t)4t
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Force of Interest
Taking the limit, as 4t → 0,
A(t + 4t) − A(t)

δ(t) = lim
4t→0 A(t) · 4t
1 d
= · A(t)
A(t) dt
A0 (t)
=
A(t)
d
= ln A(t).
dt
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Force of Interest
Integrating both sides over [0, t],
Zt
δ(s)ds = ln A(s)|t0
s=0
= ln A(t) − ln A(0)
A(t)
= ln .
A(0)
Thus we have Z t
A(t) = A(0) exp δ(s)ds
0
and Z t
a(t) = exp δ(s)ds .
0
Note that interest is homogeneous iif δ(t) ≡ δ, t ≥ 0.

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Force of Interest
Numerical Example
Force of interest at time 0 is 0.04, and increases uniformly to 0.06
after 5 years. Find the amount after 5 years of an investment of $1.
For affine δ (t), the integral in exponential can be simplified:
a(t + k) k
= e 2 [δ(t)+δ(t+k)]
a(t)
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Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Inflation
When comparing cash flows, time has to be accounted for
1. because of the time preference of agents in the economy (risk
free interest)
2. because there is a risk of default (risk premium)
3. because the value of money changes over time:
inflation/deflation
Inflation:
I Inflation (deflation) is characterized by rising (falling) prices,
or by falling (rising) value of money.
I A common way of measuring inflation is the change in
Consumer Price Index (CPI) which itself measures the annual
rate of change in a specified ”basket” of consumer items.
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Notation
Let
I i p.a. be the money interest rate
I r p.a. be the real interest rate
I p(t) be the price index (with p(0) = 1)
I π p.a. be the inflation rate
What relationships can be established among i, r , p(t) and π?
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Main relations
We have
a(0) = 1 and a(1) = 1 + i.
and
p(0) = 1 and p(1) = 1 + π
Thus, the value of accumulation at today’s prices at time 1 is
given by
a(1) 1+i
= .
p(1) 1+π
Now, define
1+i i −π
1+r = ⇐⇒ r = .
1+π 1+π
Caution: this holds only for effective rates!
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How to deal with inflation

Inflation is introduced in calculations either by
1. considering the cash flow at its date’s $ (nominal value) and
use ‘money’ interest rates:
t
1
A(0) = A(t) ·
1+i
2. or adapting the amounts of cash flows to today’s dollars (real

value) and use a (modified) ‘real’ interest rate:
t
A(t) 1
A(0) = ·
(1 + π)t 1+r
Both methods are equivalent.

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Example
An investor will receive an asset in 10 years time with face value

$100,000. Given a nominal (money) interest rate of 9% p.a.,
quarterly compounding, and an expected inflation rate of 5% p.a.,
(also quarterly compounding), what should you pay now:
Asset 1 if the payment on the asset will not change, failing to increase
in line with inflation
Asset 2 if the asset maintains its real value (an inflation indexed bond)
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To determine the price, we must be consistent. Either we work

with
I Method 1: the nominal value, and discount with the money
interest rate, or
I Method 2: the real value, and discount with the real interest
rate.
The effective real quarterly rate is
.09/4 − .05/4
= 0.9876543%
1 + .05/4
Thus, r (4) = 3.9506% and r = 4.0095%.
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Asset 1
Method 1:
100, 000
PV = 40
1 + .09
4
= 41, 064.58
Method 2:
100, 000
Real value = 40 = 60, 841.33
1 + .05
4
60, 841.33
PV = = 41, 064.57
(1.00987654)40
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Asset 2
Method 1:
40
100, 000 1 + .05
4
PV =
.09 40

1+ 4
= 67, 494.53
Method 2:
100, 000
PV =
(1.00987654)40
= 67, 494.54
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Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Our fundamental problem
Three inter-related (sets) of values:

I a set of cash flows (inflows and outflows, timing, probability)
I interest and its assumptions
I a present value / accumulated value
(for a security: the price / value at maturity)
Learning outcome:
Understand the relation between a present value, a set of
cash flows and interest, be able to determine one in
function of the others in a variety of situations, as well as
understand the interest rate risk (duration, immunisation)
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Practical examples
I Find the price of a security: determine an initial cash flow

such that the NPV is 0, given interest and a set of cash flows
I Find the yield of a security or a project: determine the rate of
interest such that the NPV is 0 (IRR), given a set of cash
flows
I Find the minimum return on the reserves that is necessary to
ensure all current life annuities can be paid until the end,
given the current level of mortality (pensions)
I ...
Note
I If the NPV is 0, we have then an equation of value
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Examples of Common Financial Instruments
I Cash on deposit - term deposits, cash management trusts

I Notes: Treasury notes, promissory notes, bank bills
I Equities - also known as shares, equity shares or common
stock
I Bonds: Coupon Bonds, Zero Coupon Bonds (‘ZCB’),
Government bonds
I Annuities: annuities-certain, life annuities
I Insurance applications: Term life insurance, Endowment
insurance
See Broverman and Sherris for the main definitions and examples.
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Determine a PV in function of cash flows and interest
Recall that the (one-period) discount factor is
1 1 d
v= = =1−d = .
a(1) 1+i i
If interest is homogeneous with time (which is the usual

assumption), then powers of the discount factor can be used to
discount all cash flows. This is because the (time-0) PV of $1
payable at time t is equal to
1 1
= = vt.
a(t) (1 + i)t
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Numerical Examples
Example 1
Consider a Coupon bond which pays $6 at times 1 and 2, and an
additional $100 at time 2. Find the Present Value of this bond at
8% p.a. effective interest.
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Numerical Examples
Example 2
In Australia, Short term Government securities such as Treasury
Notes and Treasury Bonds (less than 6 months to maturity) are
priced using simple interest and a 365 day convention.
Consider a Treasury-note with a face value of 500,000 and
maturity in 180 days time. Suppose that this is sold at a yield
(interest rate) of 6% p.a. What are the proceeds of the sale?
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Determine interest in function of a PV and cash flows
If there are more than 2 cash flows, it is generally impossible to

solve for interest analytically.
In that case, several approaches are possible:

I use a financial calculator
I use a computer (R, Goal Seek in Excel, etc. . . )
I use a numerical method (e.g. Newton-Raphson)
(the method to be used in mid-term exam and final exam)
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Newton-Raphson method (a recursive numerical method)

(see, e.g. http://en.wikipedia.org/wiki/Newton’s method)
f (in ) f (in )
f 0 (in ) ≈ =⇒ in+1 = in − 0
in − in+1 f (in )
1. determine f (i) such that f (i) = 0

2. determine f 0 (i)
3. choose initial value i0
4. perform recursions
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Numerical Example
A Bond pays $100 in 1.5 years. Coupon payments of $5 are
payable times 0.5, 1, and 1.5
1. Find the Price of the Bond if the yield is i (2) = 6%.
2. Suppose the Price of the Bond is 107.14. Find the Yield
implied by this price.
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Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Notation
(p)
m| äx:n i
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Perpetuity
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Numerical example
A foundation has $100,000,000. Instead of spending the entire
amount immediately on charity, it plans make investment to
generate annual payments that last forever. Assuming a long term
net return on investments of 5% p.a., how much money can be
used on charity every year?
Determine the annual payment if it is made (1) in arrears or (2) in
advance.
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Term Annuities
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Term Annuities
Annuity-immediate (paid in arrears)
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Term Annuities
Numerical example
A Bond pays $100 at time 3. Coupon payments of $5 are payable
at times 1, 2, and 3.
1. Find the Price of the Bond if the effective yield is i = 5%.
2. What is the Price if the effective yield is 6%?
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Term Annuities
Annuity-due (paid in advance)
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Term Annuities
Numerical example
A Bond pays $100 at time 2. Coupon payments of $5 are payable
times 0, 1, and 2. (i.e. the first payment occurs immediately after
purchase).
1. Find the Price of the Bond if the effective yield is i = 6%.
2. What is the Price if the effective yield is 5%?
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Term Annuities
Deferred annuity
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Term Annuities
Numerical example
Consider a Bond pays $100 at time 6. Coupon payments of $5 are
payable times 4, 5, and 6. How much would you be willing to pay
to purchase the bond today? Assume i = 6%.
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Term Annuities
Payments more frequent than a year
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Term Annuities
Alternative method
Alternatively, find the effective pthly rate of interest,
i (p)
j = (1 + i)1/p − 1 = .
p
Then
(p) 1
an i = anp j
p
where j = (1 + i)1/p − 1.
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Term Annuities
Numerical example
Payments of 10 made at end of each month for next 5 years.
Calculate their present value at (i) 8% p.a. effective, and (ii) 8%
p.a. convertible half-yearly.
There are at least two ways to do these questions:
1. work according to cash flows and change i
2. work according to i (p) and change cash flows
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Non-Level Annuities
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
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Non-Level Annuities
Increasing annuity (arithmetic progression)
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Non-Level Annuities
Numerical example
Value the following set of cashflows at 10% p.a.: A payment of$10
at time 1, $20 at time 2, $30 at time 3, $40 at time 4. What is the
present value at time t = 0?
What is the present value at time t = 1?
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Non-Level Annuities
Increasing annuity (arithmetic progression): general case
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Non-Level Annuities
Numerical example
Value the following series of payments at 10% p.a.:
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Non-Level Annuities
Increasing annuity (geometric progression)
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Non-Level Annuities
Numerical example
You can invest in a bond that pays coupons that grow with
inflation. The coupon received at the end of the first year is
$25,000, and each annual payment will increase, with inflation, at
rate 2.5% p.a. There are 10 annual payments and the bond
matures in 10 years with a face value of $400,000 (not indexed to
inflation). What is the price of the bond at a valuation interest
rate of 8% p.a.?
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Non-Level Annuities
Increasing annuity with p payments per annum
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Non-Level Annuities
Numerical example
Determine the present value of a 10 year annuity with half-yearly
payments in arrears at rate 2 p.a. in the first year, 4 p.a. in the
second year, . . . , 20 p.a. in the 10th year. Use a 10% p.a.
convertible half-yearly compound interest rate.
85/87
Non-Level Annuities
Decreasing annuity
86/87
Non-Level Annuities
Numerical example
Value the following set of payments at 10% p.a: $40 at time 1,
$30 at time 2, $20 at time 3, $10 at time 4.
87/87

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Financial Mathematics

ACTL2111/5102 Financial Mathematics

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

Cash flow models

A cash flow is a series of payments (inflows or outflows) over a

Cash flows are characterised by their:

Comparing cash flows

You want to buy a television from Bling Bee’s on 31/12/2009 that

Module 1: Time Value of Money and Valuation of Cash Flows

Time value of money

How much would you pay to buy a security that is guaranteed to

What if there was a chance of default?

Interest is a mathematical tool to embody

In mathematical terms, the effective interest It,k accumulated

It,k = A(t + k) − A(t),

A(t + k) − A(t) a(t + k) − a(t)

I a(t) is modeled with the help of interest

Assumptions about interest

Module 1: Time Value of Money and Valuation of Cash Flows

Assumptions about interest

Simple and Compound Interest

Simple and Compound Interest

and the accumulated amount function after a period t is given by

A(t) = A(0) · a(t) = A(0) · (1 + it).

Usually, t < 1 (days/360 or 365, or months/12).

Effective rate of interest is not constant in this case (decreasing):

a(t + k) = 1 + i(t + k) 6= (1 + it)(1 + ik) = a(t)a(k)

and the accumulated amount function after a period t is given by

A(t) = A(0) · a(t) = A(0) · (1 + i)t .

In this case, effective interest is homogeneous:

a(t + k) = (1 + i)t+k = (1 + i)t (1 + i)k = a(t)a(k)

Module 1: Time Value of Money and Valuation of Cash Flows

Assumptions about interest

Since we want d and i to be equivalent (they are just formulated

Simple vs compound discount interest

For simple discount:

Relations between Interest and Discount

i is the effective rate of interest, d is the effective rate of discount

Intuition behind i − d = id?

Module 1: Time Value of Money and Valuation of Cash Flows

Assumptions about interest

Nominal Interest Rate

I usually the compounding period is one year

Nominal vs effective rates

Relationship to i, the effective interest rate

In general, for rate i per annum

Nominal Discount Rates

I Interest is converted m times per year (period)

I Note that the nominal discount rate increases as the

d < d (2) < d (3) . . .

Module 1: Time Value of Money and Valuation of Cash Flows

Assumptions about interest

where δ is called the force of interest, or continuously

where d (∞) is the force of discount.

Force of interest that varies with time

Interest paid over a small interval ∆t is

A(t + ∆t) − A(t) ≈ A(t)δ(t)∆t

Taking the limit, as 4t → 0,

A(t + 4t) − A(t)

Integrating both sides over [0, t],

Note that interest is homogeneous iif δ(t) ≡ δ, t ≥ 0.