Mathematics of Finance

Simple interest
Notations
p – interest rate per conversion period (in percent)
t – time in units that correspond to the rate, moment
K
0
– opening capital, original principal, present value
K
t
– amount, capital at the moment t
Z
t
– simple interest earned in the term t
i – interest rate: i =
p
100
T – number of days
• The most frequently period considered is the year, but a half-year, quarter,
month etc. can be used either. The number of days per year or month differs
from country to country. Usual usances are
30
360
,
act
360
,
act
act
, where act means
the actual number of days. In what follows, in all formulas containing the
quantity T the underlying period is the year with 360 days, each month
having 30 days (i. e., the first usance is used).
Basic interest formulas
T = 30 · (m
2
−m
1
) +d
2
−d
1
– number of days for which interest is
paid; m
1
, m
2
– months; d
1
, d
2
– days
Z
t
= K
0
·
p
100
· t = K
0
· i · t – simple interest
Z
T
=
K
0
· i · T
360
=
K
0
· p · T
100 · 360
– simple interest on a day basis
K
0
=
100 · Z
t
p · t
=
Z
t
i · t
– capital (at t = 0)
p =
100 · Z
t
K
0
· t
– interest rate (in percent)
i =
Z
t
K
0
· t
– interest rate
t =
100 · Z
t
K
0
· p
=
Z
t
K
0
· i
– term, time

B. Luderer et al., Mathematical Formulas for Economists, 4th ed.,
DOI 10.1007/978-3-642-04079-5_6, © Springer-Verlag Berlin Heidelberg 2010
32 Mathematics of Finance
Capital at the moment t
K
t
= K
0
(1 +i · t) = K
0
_
1 +i ·
T
360
_
– amount, capital at the mo-
ment t
K
0
=
K
t
1 +i · t
=
K
t
1 +i ·
T
360
– present value
i =
K
n
−K
0
K
0
· t
= 360 ·
K
n
−K
0
K
0
· T
– interest rate
t =
K
n
−K
0
K
0
· i
– term, time
T = 360 ·
K
n
−K
0
K
0
· i
– number of days for which
interest is paid
Periodical payments
• Dividing the original period into mparts of length
1
m
and assuming periodi-
cal payments of size r at the beginning (annuity due) and at the end (ordinary
annuity), respectively, of each payment interval, the following amount results:
R = r
_
m+
m+ 1
2
· i
_
– annuity due
R = r
_
m+
m− 1
2
· i
_
– ordinary annuity
Especially m = 12 (monthly payments and annual interest):
R = r(12 + 6, 5i) – annuity due; R = r(12 + 5, 5i) – ordinary annuity
Different methods for computing interest
Let t
i
= D
i
M
i
Y
i
be day, month and year of the i-th date (i = 1: begin, i = 2:
end); let t = t
2
− t
1
describe the actual number of days between begin and
end; let T
i
denote the number of days in the ’broken’ year i; basis i = 365
oder 366.
method formula
30/360 t = [360 · (Y
2
−Y
1
) + 30 · (M
2
−M
1
) +D
2
−D
1
] /360
act/360 t = (t
2
−t
1
)/360
act/act t =
T
1
basis 1
+Y
2
−Y
1
− 1 +
T
2
basis 2


If the term considered lies within one year, only the first summand remains.
Compound interest 33
Compound interest
When considering several conversion periods, one speaks about compound
interest if interest earned is added to the capital (usually at the end of every
conversion period) and yields again interest.
Notations
p – rate of interest (in percent) per period
n – number of conversion periods
K
0
– opening capital, present value
K
n
– capital after n periods, amount, final value
i – (nominal) interest rate per conversion period: i =
p
100
q – accumulation factor (for 1 period): q = 1 +i
q
n
– accumulation factor (for n periods)
m – number of parts of the period
d – discount factor
i
m
,
ˆ
i
m
– interest rates belonging to each of the m parts of the period
δ – intensity of interest
Conversion table of basic quantities
p i q d δ
p p 100i 100(q − 1) 100
d
1 −d
100(e
δ
− 1)
i
p
100
i q − 1
d
1 −d
e
δ
− 1
q 1 +
p
100
1 +i q
1
1 −d
e
δ
d
p
100 +p
i
1 +i
q − 1
q
d 1 − e
−δ
δ ln
_
1 +
p
100
_
ln(1 +i) ln q ln
_
1
1 −d
_
δ
34 Mathematics of Finance
Basic formulas
K
n
= K
0
· (1 +i)
n
= K
0
· q
n
– compound amount formula
K
0
=
K
n
(1 +i)
n
=
K
n
q
n
– present value at compound interest,
amount at time t = 0
p = 100
_
n
_
K
n
K
0
− 1
_
– rate of interest (in percent)
n =
log K
n
− log K
0
log q
– term, time
n ≈
69
p
– approximate formula for the time
within which a capital doubles
K
n
= K
0
· q
1
· q
2
· . . . · q
n
– final value under changing rates of in-
terest p
j
, j =1, . . . , n (with q
j
=
p
j
100
)
p
r
=100
_
1+i
1+r
−1
_
≈100(i−r) – real rate of interest considering a rate
of inflation r
Mixed, partly simple and partly compound interest
K
t
= K
0
(1 +it
1
)(1 +i)
N
(1 +it
2
) – capital after time t
• Here N denotes the integral number of conversion periods, and t
1
, t
2
are
the lengths of parts of the conversion period where simple interest is paid.
• To simplify calculations, in mathematics of finance usually the compound
amount formula with noninteger exponent is used instead of the formula of
mixed interest, i. e. K
t
= K
0
(1 +i)
t
, where t = t
1
+N +t
2
.
Anticipative interest (discount)
In this case the rate of interest is determined as part of the final value (◮
discount factor p. 33).
d =
K
1
−K
0
K
1
=
K
t
−K
0
K
t
· t
– (discount) rate of interest under antici-
patice compounding
K
n
=
K
0
(1 −d)
n
– final value
K
0
= K
n
(1 −d)
n
– present value
Compound interest 35
More frequently compounding
K
n,m
= K
0
·
_
1 +
i
m
_
n·m
– amount after n years when interest
rate is converted m times per year
i
m
=
i
m
– relative rate per period
ˆ
i
m
=
m

1 +i − 1 – equivalent rate per period
i
eff
= (1 +i
m
)
m
− 1 – effective rate of interest per year
p
eff
= 100
_
(1 +
p
100m
)
m
− 1
_
– effective rate of interest per year (in
percent)
• Instead of one year one can take any other period as the original one.
• Compounding interest m times per year with the equivalent rate per
period
ˆ
i
m
leads to the same final value as compounding once per year with
the nominal rate i; compounding interest m times per year with the relative
rate per period i
m
leads to that (greater) final value, which results when
compounding once per year with the effective rate i
eff
.
Continuous compounding
K
n,∞
= K
0
· e
i·n
– amount at continuous compounding
δ = ln(1 +i) – intensity of interest (equivalent to the interest
rate i)
i = e
δ
− 1 – nominal rate (equivalent to the intensity δ)
Average date of payment
Problem: At which date of pay-
ment t
m
equivalently the total debt
K
1
+K
2
+. . . +K
k
has to be payed?
-
K
k
K
2
K
1
t
1 0
t
2
. . .
t
k
liabilities to pay
simple interest:
t
m
=
K
1
+K
2
+. . . +K
k
−K
0
i
, where K
0
=
K
1
1 +it
1
+. . . +
K
k
1 +it
k
compound interest:
t
m
=
ln(K
1
+. . . + K
k
) − ln K
0
ln q
, where K
0
=
K
1
q
t
1
+. . . +
K
k
q
t
k
continuous compounding:
t
m
=
ln(K
1
+. . . + K
k
) − ln K
0
δ
, where K
0
= K
1
e
−δt
1
+. . .+K
k
e
−δt
k
36 Mathematics of Finance
Annuities
Notations
p – rate of interest
n – term, number of payment intervals or rent periods
R – periodic rent, size of each payment
q – accumulation factor: q = 1 +
p
100
Basic formulas
Basic assumption: Conversion and rent periods are equal to each other.
F
due
n
= R · q ·
q
n
− 1
q − 1
– amount of an annuity due, final value
P
due
n
=
R
q
n−1
·
q
n
− 1
q − 1
– present value of an annuity due
F
ord
n
= R ·
q
n
− 1
q − 1
– amount of an ordinary annuity, final value
P
ord
n
=
R
q
n
·
q
n
− 1
q − 1
– present value of an ordinary annuity
P
due

=
Rq
q − 1
– present value of a perpetuity, payments at
the beginning of each period
P
ord

=
R
q − 1
– present value of a perpetuity, interest used
as earned
n=
1
log q
· log
_
F
ord
n
·
q − 1
R
+ 1
_
=
1
log q
· log
R
R −P
ord
n
(q − 1)
– term
Factors describing the amount of 1 per period
due ordinary
amount of 1
per period
¨ s
n|
= q ·
q
n
− 1
q − 1
s
n|
=
q
n
− 1
q − 1
present worth
of 1 per period
¨ a
n|
=
q
n
− 1
q
n−1
(q − 1)
a
n|
=
q
n
− 1
q
n
(q − 1)
Conversion period > rent period
If m periodic payments (rents) are made per conversion period, then in the
above formulas the payments R are to be understood as R = r
_
m+
m+1
2
· i
_
(annuities due) and R = r
_
m+
m−1
2
· i
_
(ordinary annuities), resp. These
amounts R arise at the end of the conversion period, so with respect to R
one always has to use formulas belonging to ordinary annuities.
Annuities 37
Basic quantities
a
n|
– present value of 1 per period (ordinary annuity)
¨ a
n|
– present value of 1 per period (annuity due)
s
n|
– final value (amount) of 1 per period (ordinary annuity)
¨ s
n|
– final value (amount) of 1 per period (annuity due)
a
∞|
– present value of 1 per period (perpetuity, interest used as earned)
¨ a
∞|
– present value of 1 per period (perpetuity, payments at the begin-
ning of each period)
Factors for amount and present value
a
n|
=
1
q
+
1
q
2
+
1
q
3
+. . . +
1
q
n
=
q
n
− 1
q
n
(q − 1)
¨ a
n|
= 1 +
1
q
+
1
q
2
+. . . +
1
q
n−1
=
q
n
− 1
q
n−1
(q − 1)
s
n|
= 1 +q +q
2
+. . . +q
n−1
=
q
n
− 1
q − 1
¨ s
n|
= q +q
2
+q
3
+. . . +q
n
= q ·
q
n
− 1
q − 1
a
∞|
=
1
q
+
1
q
2
+
1
q
3
+. . . =
1
q − 1
¨ a
∞|
= 1 +
1
q
+
1
q
2
+. . . =
q
q − 1
Conversion table
a
n|
¨ a
n|
s
n|
¨ s
n|
q
n
a
n|
a
n|
¨ a
n|
q
s
n|
1 +is
n|
¨ s
n|
q(1 + d¨ s
n|
)
q
n
− 1
q
n
i
¨ a
n|
qa
n|
¨ a
n|
qs
n|
1 +is
n|
¨ s
n|
1 +d¨ s
n|
q
n
− 1
q
n
d
s
n|
a
n|
1 −ia
n|
¨ a
n|
q(1 −d¨ a
n|
)
s
n|
¨ s
n|
q
q
n
− 1
i
¨ s
n|
qa
n|
1 −ia
n|
¨ a
n|
1 −d¨ a
n|
qs
n|
¨ s
n|
q
n
− 1
d
q
n
1
1 −ia
n|
1
1 −d¨ a
n|
1 +is
n|
1 +d¨ s
n|
q
n
38 Mathematics of Finance
Dynamic annuities
Arithmetically increasing dynamic annuity
Cash flows (increases proportional to the rent R with factor δ):
-
n n−1
. . .
1 0
R(1+(n−1)δ) R(1 +δ) R
-
n 1 0
R R(1+δ) R(1+(n−1)δ)
2
. . .
F
due
n
=
Rq
q − 1
_
q
n
− 1 +δ
_
q
n
− 1
q − 1
−n
__
P
due
n
=
R
q
n−1
(q − 1)
_
q
n
− 1 +δ
_
q
n
− 1
q − 1
−n
__
F
ord
n
=
R
q − 1
_
q
n
− 1 +δ
_
q
n
− 1
q − 1
−n
__
P
ord
n
=
R
q
n
(q − 1)
_
q
n
− 1 +δ
_
q
n
− 1
q − 1
−n
__
P
due

=
Rq
q − 1
_
1 +
δ
q − 1
_
, P
ord

=
R
q − 1
_
1 +
δ
q − 1
_
Geometrically increasing dynamic annuity
-
0 1 2 n n−1
Rb
n−1
R
. . .
Rb Rb
2
-
0 1 2
. . .
n
Rb
n−1
Rb R
The constant quotient b = 1 +
s
100
of succeeding terms is characterized by
the rate of increase s.
F
due
n
= Rq ·
q
n
−b
n
q −b
, b = q; F
due
n
= Rnq
n
, b = q
P
due
n
=
R
q
n−1
·
q
n
−b
n
q −b
, b = q; P
due
n
= Rn, b = q
F
ord
n
= R ·
q
n
−b
n
q −b
, b = q; F
ord
n
= Rnq
n−1
, b = q
P
ord
n
=
R
q
n
·
q
n
−b
n
q −b
, b = q; P
ord
n
=
Rn
q
, b = q
P
due

=
Rq
q −b
, b < q; P
ord

=
R
q −b
, b < q
Amortization calculus 39
Amortization calculus
Notations
p – interest rate (in percent)
n – number of repayment periods
i – interest rate: i =
p
100
q – accumulation factor: q = 1 +i
S
0
– loan, original debt
S
k
– outstanding principal after k periods
T
k
– payoff in the k-th period
Z
k
– interest in the k-th period
A
k
– total payment in the k-th period
Kinds of amortization
• Constant payoffs: repayments constant: T
k
= T =
S
0
n
, interest decreasing
• Constant annuities: total payments constant: A
k
= A = const, interest
decreasing, payoffs increasing
• Amortization of a debt due at the end of the payback period: A
k
= S
0
· i,
k = 1, . . . , n − 1; A
n
= S
0
· (1 +i)
• In an amortization schedule all relevant quantities (interest, payoffs, total
payment, outstanding principal, etc.) are clearly arranged in a table.
Basic formula for the total payment
A
k
= T
k
+Z
k
– total payment (annuity) consisting of payoff
and interest
Constant payoffs (conversion period = payment period)
T
k
=
S
0
n
– payoff in the k-th period
Z
k
= S
0
·
_
1 −
k − 1
n
_
i – interest in the k-th period
A
k
=
S
0
n
[1 − (n −k + 1)i] – total payment in the k-th period
S
k
= S
0
·
_
1 −
k
n
_
– outstanding principal after k periods
P =
S
0
i
n
_
(n + 1)a
n|

1
q
n
_
q
q
n
−1
(q−1)
2

n
q−1
__
– present value of all
interest payments
40 Mathematics of Finance
Constant annuities (conversion period = payment period)
A = S
0
·
q
n
(q − 1)
q
n
− 1
– (total) payment, annuity
S
0
=
A(q
n
− 1)
q
n
(q − 1)
– original debt
T
k
= T
1
q
k−1
= (A −S
0
· i)q
k−1
– payoff, repayment
S
k
= S
0
q
k
−A
q
k
−1
q − 1
= S
0
−T
1
q
k
−1
q − 1
– outstanding principal
Z
k
= S
0
i −T
1
(q
k−1
−1) = A −T
1
q
k−1
– interest
n =
1
log q
_
log A − log(A −S
0
i)
¸
– length of payback period,
period of full repayment
More frequently payments
In every period m constant annuities A
(m)
are payed.
A
(m)
=
A
m+
m−1
2
i
– payment at the end of each period
A
(m)
=
A
m+
m+1
2
i
– payment at the beginning of each period
Especially: Monthly payments, conversion period = 1 year (m = 12)
A
mon
=
A
12 + 5, 5i
– payment at the end of every month
A
mon
=
A
12 + 6, 5i
– payment at the beginning of every month
Amortization with agio
In an amortization with additional agio (redemption premium) of α percent
on the payoff the quantity T
k
has to be replaced by
ˆ
T
k
= T
k
·
_
1 +
α
100
_
=
T
k
· f
α
. When considering amortization by constant annuities with included
agio, the quantities S
α
= S
0
· f
α
(fictitious debt), i
α
=
i
f
α
(fictitious rate of
interest) and q
α
= 1 +i
α
, resp., are to be used in the above formulas.
Price calculus 41
Price calculus
Notations
P – price, quotation (in percent)
K
nom
– nominal capital or value
K
real
– real capital, market value
n – (remaining) term, payback period
p, p
eff
– nominal (effective, resp.) rate of interest
b
n,nom
; b
n,real
– present worth of 1 per period (ordinary annuity)
a = C − 100 – agio for price above par
d = 100 −C – disagio for price below par
R – return at the end of the payback period
q
eff
= 1 +
p
eff
100
– accumulation factor (effective interest rate)
Price formulas
P = 100 ·
K
real
K
nom
– price as quotient of real and
nominal capital
P = 100 ·
b
n,real
b
n,nom
= 100 ·
n

k=1
1
q
k
eff
n

k=1
1
q
k
– price of a debt repayed by
constant annuities
P =
100
n
_
n ·
p
p
eff
+b
n,real
_
1 −
p
p
eff
__
– price of a debt repayed by
constant payoffs
P =
1
q
n
eff
·
_
p ·
q
n
eff
− 1
q
eff
− 1
+R
_
– price of a debt due at the
end of the payback period
P = 100 · p · (p
eff
)
−1
– price of a perpetuity
p
s
=
100
C
_
p −
a
n
_
=
100
C
_
p +
d
n
_
– simple yield-to-maturity;
= approximate effective interest rate of a debt due at the end of the
payback period (price above and below par, resp.)
• Securities, shares (or stocks) are evaluated at the market by the price.
For given price C in general the effective rate of interest (yield-to-maturity,
redemption yield) can be obtained from the above equations by solving (ap-
proximately) a polynomial equation of higher degree (◮ p. 44).
42 Mathematics of Finance
Investment analysis
Multi-period capital budgeting techniques (discounted cash flow methods) are
methods for estimating investment profitability. The most known are: capital
(or net present) value method, method of internal rate of return, annuity
method. Future income and expenses are prognostic values.
Notations
I
k
– income at moment k
E
k
– expenses, investments at moment k
C
k
– net income, cash flow at moment k: C
k
= I
k
−E
k
K
I
– present value of income
K
E
– present value of expenses
C – net present value, capital value of the investment
n – number of periods
p – conventional (or minimum acceptable) rate of interest
q – accumulation factor: q = 1 +
p
100
Capital value method
K
I
=
n

k=0
I
k
q
k
– present value of income; sum of all present
values of future income
K
E
=
n

k=0
E
k
q
k
– present value of expenses; sum of all present
values of future expenses
C =
n

k=0
C
k
q
k
= K
I
−K
E
– capital value of net income, net present value
• For C = 0 the investment corresponds to the given conventional rate of
interest p, for C > 0 its maturity yield is higher. If several possibilities of
investments are for selection, then that with the highest net present value is
preferred.
Method of internal rate of return
The internal rate of return (yield-to-maturity) is that quantity for which the
net present value of the investment is equal to zero. If several investments
are possible, then that with the highest internal rate of return is chosen.
Annuity method
F
A
=
q
n
· (q − 1)
q
n
− 1
– annuity (or capital recovery) factor
A
I
= K
I
· F
A
– income annuity
A = K
E
· F
A
– expenses annuity
A
P
= A
I
−A – net income (profit) annuity
• For A
I
= A the maturity yield of the investment is equal to p, for A
I
> A
the maturity yield is higher than the conventional rate of interest p.
Depreciations 43
Depreciations
Depreciations describe the reduction in value of capital goods or items of
equipment. The difference between original value (cost price, production
costs) and depreciation yields the book-value.
n – term of utilization (in years)
A – original value
w
k
– depreciation (write-down) in the k-th year
R
k
– book-value after k years (R
n
– remainder, final value)
Linear (straight-line) depreciation
w
k
= w =
A −R
n
n
– annual depreciation
R
k
= A −k · w – book-value after k years
Arithmetically degressive depreciation (reduction by d each year)
w
k
= w
1
− (k − 1) · d – depreciation in the k-th year
d = 2 ·
nw
1
− (A −R
n
)
n(n − 1)
– amount of reduction
Sum-of-the-years digits method (as a special case): w
n
= d
w
k
= (n −k + 1) · d – depreciation in the k-th year
d =
2 · (A −R
n
)
n(n + 1)
– amount of reduction
Geometrically degressive (double-declining balance) depreciation
(reduction by s percent of the last year’s book value in each year)
R
k
= A ·
_
1 −
s
100
_
k
– book-value after k years
s = 100 ·
_
1 −
n
_
R
n
A
_
– rate of depreciation
w
k
= A·
s
100
·
_
1 −
s
100
_
k−1
– depreciation in the k-th year
Transition from degressive to linear depreciation
Under the assumption R
n
= 0 it makes sense to write down geometrically
degressive until the year ⌈k⌉ with k = n + 1 −
100
s
and after that to write
down linearly.
44 Mathematics of Finance
Numerical methods for the determination of zeros
Task: Find a zero x

of the continuous function f(x); let ε be the accuracy
bound for stopping the iteration process.
Table of values
For chosen values x find the corresponding function values f(x). Then one
obtains a rough survey on the graph of the function and the location of zeros.
Interval bisection
Given x
L
with f(x
L
) < 0 and x
R
with f(x
R
) > 0.
1. Calculate x
M
=
1
2
(x
L
+x
R
) and f(x
M
).
2. If |f(x
M
)| < ε, then stop and take x
M
as an approximation of x

.
3. If f(x
M
) < 0, then set x
L
:= x
M
(x
R
unchanged), if f(x
M
) > 0, then
set x
R
:= x
M
(x
L
unchanged), go to 1.
Method of false position (linear interpolation, regula falsi)
Given x
L
with f(x
L
) < 0 and x
R
with f(x
R
) > 0.
1. Calculate x
S
= x
L

x
R
−x
L
f(x
R
) −f(x
L
)
f(x
L
) and f(x
S
).
2. If |f(x
S
)| < ε, then stop and take x
S
as an approximation of x

.
3. If f(x
S
) < 0, then set x
L
:= x
S
(x
R
unchanged), if f(x
M
) > 0, then set
x
R
:= x
S
(x
L
unchanged), go to 1.
• For f(x
L
) > 0, f(x
R
) < 0 the methods can be adapted in an obvious way.
Newton’s method
Given x
0
∈ U(x

); let the function f be differentiable.
1. Calculate x
k+1
= x
k

f(x
k
)
f

(x
k
)
.
2. If |f(x
k+1
)| < ε, then stop and take x
k+1
as an approximation of x

.
3. Set k := k + 1, go to 1.
• If f

(x
k
) = 0 for some k, then restart the iteration process with another
starting point x
0
.
• Other stopping rule: |x
L
−x
R
| < ε or |x
k+1
−x
k
| < ε.
Descartes’ rule of signs. The number of positive zeros of the polynomial
n

k=0
a
k
x
k
is equal to w or w−2, w−4, . . . , where w is the number of changes
in sign of the coefficients a
k
(not considering zeros).

let t = t2 − t1 describe the actual number of days between begin and end. R = r(12 + 5.32 Mathematics of Finance Capital at the moment t Kt = K0 (1 + i · t) = K0 1 + i · K0 = i= t= Kt Kt = T 1+i·t 1 + i · 360 T 360 – amount. month and year of the i-th date (i = 1: begin. . basis i = 365 oder 366. of each payment interval. time – number of days for which interest is paid Kn − K0 Kn − K0 = 360 · K0 · t K0 · T Kn − K0 K0 · i Kn − K0 K0 · i T = 360 · Periodical payments 1 • Dividing the original period into m parts of length m and assuming periodical payments of size r at the beginning (annuity due) and at the end (ordinary annuity). 5i) – ordinary annuity Different methods for computing interest Let ti = Di Mi Yi be day. capital at the moment t – present value – interest rate – term. i = 2: end). only the first summand remains. 5i) – annuity due. respectively. the following amount results: R =r m+ R =r m+ m+1 ·i 2 – annuity due m−1 ·i – ordinary annuity 2 Especially m = 12 (monthly payments and annual interest): R = r(12 + 6. let Ti denote the number of days in the ’broken’ year i. method 30/360 act/360 act/act ∗ formula t = [360 · (Y2 − Y1 ) + 30 · (M2 − M1 ) + D2 − D1 ] /360 t = (t2 − t1 )/360 t= T1 T2 ∗ + Y2 − Y1 − 1 + basis 1 basis 2 If the term considered lies within one year.

Compound interest 33 Compound interest When considering several conversion periods. final value (nominal) interest rate per conversion period: i = accumulation factor (for 1 period): q = 1 + i accumulation factor (for n periods) number of parts of the period discount factor interest rates belonging to each of the m parts of the period intensity of interest p 100 m d im . amount. Notations p n K0 Kn i q q n – – – – – – – – – – – rate of interest (in percent) per period number of conversion periods opening capital. ˆm i δ Conversion table of basic quantities p p p p 100 1+ p 100 i 100i q 100(q − 1) q−1 q q−1 q ln q ln 100 d d 1−d δ 100(eδ − 1) eδ − 1 eδ 1 − e−δ δ i i d 1−d 1 1−d d 1 1−d q 1+i i 1+i ln(1 + i) d p 100 + p ln 1 + p 100 δ . present value capital after n periods. one speaks about compound interest if interest earned is added to the capital (usually at the end of every conversion period) and yields again interest.

in mathematics of finance usually the compound amount formula with noninteger exponent is used instead of the formula of mixed interest. e. . t2 are the lengths of parts of the conversion period where simple interest is paid. • To simplify calculations. where t = t1 + N + t2 . amount at time t = 0 – rate of interest (in percent) – term. · qn pr = 100 1+i −1 ≈ 100(i−r) – real rate of interest considering a rate 1+r of inflation r Mixed. 33). i. . Kt = K0 (1 + i)t . d= Kt − K0 K1 − K0 = K1 Kt · t K0 (1 − d)n – (discount) rate of interest under anticipatice compounding – final value – present value Kn = K0 = Kn (1 − d)n . partly simple and partly compound interest Kt = K0 (1 + it1 )(1 + i)N (1 + it2 ) – capital after time t • Here N denotes the integral number of conversion periods. and t1 . time – approximate formula for the time within which a capital doubles – final value under changing rates of inpj terest pj . . . . . Anticipative interest (discount) In this case the rate of interest is determined as part of the final value (◮ discount factor p. j = 1.34 Mathematics of Finance Basic formulas Kn = K0 · (1 + i)n = K0 · q n K0 = Kn Kn = n (1 + i)n q n – compound amount formula – present value at compound interest. n (with qj = 100 ) p = 100 n= Kn −1 K0 log Kn − log K0 log q 69 n≈ p Kn = K0 · q1 · q2 · .

. . .+ . + Kk − K0 + .m = K0 · 1 + im = ˆm = i i m m i n·m m – – amount after n years when interest rate is converted m times per year relative rate per period equivalent rate per period effective rate of interest per year effective rate of interest per year (in percent) √ 1+i−1 p m ) −1 100m – – – ieff = (1 + im )m − 1 peff = 100 (1 + • Instead of one year one can take any other period as the original one. . + t ln q q qk continuous compounding: tm = tm = ln(K1 + . compounding interest m times per year with the relative rate per period im leads to that (greater) final value.Compound interest 35 More frequently compounding Kn. + Kk ) − ln K0 K1 Kk . . . • Compounding interest m times per year with the equivalent rate per period ˆm leads to the same final value as compounding once per year with i the nominal rate i. where K0 = t1 + . + Kk has to be payed? K1 0 t1 K2 t2 .∞ = K0 · ei·n δ = ln(1 + i) i = eδ − 1 – – – amount at continuous compounding intensity of interest (equivalent to the interest rate i) nominal rate (equivalent to the intensity δ) Average date of payment Problem: At which date of payment tm equivalently the total debt K1 + K2 + . . which results when compounding once per year with the effective rate ieff .. Kk tk liabilities to pay simple interest: Kk K1 K1 + K2 + . Continuous compounding Kn. . .+ Kk e−δtk δ . . + Kk ) − ln K0 ... .. . where K0 = tm = i 1 + it1 1 + itk compound interest: ln(K1 + . where K0 = K1 e−δt1 +.

so with respect to R one always has to use formulas belonging to ordinary annuities. . size of each payment p accumulation factor: q = 1 + 100 Basic formulas Basic assumption: Conversion and rent periods are equal to each other. payments at the beginning of each period present value of a perpetuity. due Fn = R · q · qn − 1 q−1 qn − 1 R due Pn = n−1 · q q−1 qn − 1 ord Fn = R · q−1 R qn − 1 ord Pn = n · q q−1 Rq due P∞ = q−1 ord P∞ = – – – – – amount of an annuity due. These 2 amounts R arise at the end of the conversion period. interest used as earned – term R q−1 – n= R 1 ord q − 1 + 1 = 1 · log · log Fn · ord (q − 1) log q R log q R − Pn Factors describing the amount of 1 per period amount of 1 per period present worth of 1 per period due qn − 1 sn | = q · ¨ q−1 an | = ¨ ordinary qn − 1 sn | = q−1 an | = qn − 1 q n−1 (q − 1) qn − 1 q n (q − 1) Conversion period > rent period If m periodic payments (rents) are made per conversion period. resp. final value present value of an annuity due amount of an ordinary annuity.36 Mathematics of Finance Annuities Notations p n R q – – – – rate of interest term. final value present value of an ordinary annuity present value of a perpetuity. number of payment intervals or rent periods periodic rent. then in the above formulas the payments R are to be understood as R = r m + m+1 · i 2 (annuities due) and R = r m + m−1 · i (ordinary annuities).

... + n−1 q q q = = = = = = q n (q qn − 1 − 1) qn − 1 q n−1 (q − 1) qn − 1 q−1 1 + q + q 2 + .Annuities 37 Basic quantities an | an | ¨ sn | sn | ¨ a∞ | a∞ | ¨ – – – – – – present value of 1 per period (ordinary annuity) present value of 1 per period (annuity due) final value (amount) of 1 per period (ordinary annuity) final value (amount) of 1 per period (annuity due) present value of 1 per period (perpetuity. interest used as earned) present value of 1 per period (perpetuity. . . .+ n q q q q 1+ 1 1 1 + 2 + .. q q q 1 1 1 + + 2 + .. + q n−1 q + q2 + q3 + ... payments at the beginning of each period) Factors for amount and present value an | an | ¨ sn | sn | ¨ a∞ | a∞ | ¨ = = = = = = 1 1 1 1 + 2 + 3 + . q q q· qn − 1 q−1 1 q−1 q q−1 sn | ¨ sn | ¨ q(1 + d¨n | ) s sn | ¨ 1 + d¨n | s sn | ¨ q sn | ¨ 1 + d¨n | s qn qn − 1 qn i qn − 1 qn d qn − 1 i qn − 1 d qn Conversion table an | an | an | ¨ sn | sn | ¨ qn an | qan | an | 1 − ian | qan | 1 − ian | 1 1 − ian | an | ¨ an | ¨ q an | ¨ an | ¨ q(1 − d¨n | ) a an | ¨ 1 − d¨n | a 1 1 − d¨n | a sn | sn | 1 + isn | qsn | 1 + isn | sn | qsn | 1 + isn | . + qn 1 1 1 + 2 + 3 + . . .

q−b b = q. . b = q. ... b = q Rn . Rnq n−1 . q R . b < q. due P∞ = Rq q−1 R q−1 1+ δ q−1 Geometrically increasing dynamic annuity R 0 Rb 1 Rb2 2 Rbn−1 . Rbn−1 n The constant quotient b = 1 + the rate of increase s.38 Mathematics of Finance Dynamic annuities Arithmetically increasing dynamic annuity Cash flows (increases proportional to the rent R with factor δ): R R(1 + δ) R(1+(n−1)δ) 0 qn − 1 −n q−1 R R(1+δ) R(1+(n−1)δ) - 0 1 .. Rn. n−1 n 1 2 . qn q−b Rq .. q−b q n − bn . due Fn due Pn ord Fn ord Pn due P∞ of succeeding terms is characterized by = Rq · = R q n − bn . due Fn due Pn ord Fn ord Pn ord P∞ = = = = = Rnq n . q−b b=q b<q . b = q. n due = Fn due = Pn ord Fn ord Pn Rq qn − 1 + δ q−1 R q n−1 (q − 1) qn − 1 + δ qn − 1 −n q−1 = = R qn − 1 + δ q−1 q n (q qn − 1 −n q−1 qn − 1 −n q−1 ord P∞ = R qn − 1 + δ − 1) 1+ δ q−1 . q−b · b = q. q−b q n − bn . n−1 n s 100 0 R 1 Rb 2 .. b=q b=q q n−1 = R· = = R q n − bn · ..

. k = 1. interest decreasing n • Constant annuities: total payments constant: Ak = A = const.Amortization calculus 39 Amortization calculus Notations p n i q S0 Sk Tk Zk Ak – – – – – – – – – interest rate (in percent) number of repayment periods p interest rate: i = 100 accumulation factor: q = 1 + i loan. . n − 1. total payment. . outstanding principal. An = S0 · (1 + i) • In an amortization schedule all relevant quantities (interest. interest decreasing. etc. payoffs increasing • Amortization of a debt due at the end of the payback period : Ak = S0 · i.) are clearly arranged in a table. • Constant payoffs: repayments constant: Tk = T = Basic formula for the total payment Ak = Tk + Zk – total payment (annuity) consisting of payoff and interest Kinds of amortization Constant payoffs (conversion period = payment period) Tk = S0 n k−1 n i – – – – q payoff in the k-th period interest in the k-th period total payment in the k-th period outstanding principal after k periods – present value of all interest payments Z k = S0 · 1 − Ak = S0 [1 − (n − k + 1)i] n k n Sk = S0 · 1 − P = 1 S0 i (n + 1)an | − n n q q n −1 n − (q−1)2 q−1 . original debt outstanding principal after k periods payoff in the k-th period interest in the k-th period total payment in the k-th period S0 . . payoffs.

the quantities Sα = S0 · fα (fictitious debt). resp.. conversion period = 1 year (m = 12) Amon = Amon = A 12 + 5. . are to be used in the above formulas. 5i – payment at the end of every month – payment at the beginning of every month Amortization with agio In an amortization with additional agio (redemption premium) of α percent α ˆ = on the payoff the quantity Tk has to be replaced by Tk = Tk · 1 + 100 Tk · fα . repayment – outstanding principal – interest – length of payback period. annuity – original debt – payoff. iα = fα interest) and qα = 1 + iα .40 Mathematics of Finance Constant annuities (conversion period = payment period) A = S0 · S0 = q n (q − 1) qn − 1 – (total) payment. When considering amortization by constant annuities with included i (fictitious rate of agio. period of full repayment A(q n − 1) q n (q − 1) Tk = T1 q k−1 = (A − S0 · i)q k−1 Sk = S0 q k −A q k −1 q k −1 = S0 −T1 q−1 q−1 Zk = S0 i − T1 (q k−1 −1) = A − T1 q k−1 n= 1 log A − log(A − S0 i) log q More frequently payments In every period m constant annuities A(m) are payed. 5i A 12 + 6. A(m) = A(m) = A m + m−1 i 2 A m + m+1 i 2 – payment at the end of each period – payment at the beginning of each period Especially: Monthly payments.

payback period nominal (effective.nom – price of a debt repayed by constant annuities P = p p 100 n· + bn. shares (or stocks) are evaluated at the market by the price.real a = C − 100 d = 100 − C R p eff qeff = 1 + 100 – – – – – – – – – price.) • Securities. 44).nom . redemption yield) can be obtained from the above equations by solving (approximately) a polynomial equation of higher degree (◮ p. resp.Price calculus 41 Price calculus Notations P Knom Kreal n p. bn. peff bn. market value (remaining) term.real = 100 · P = 100 · bn.real 1 − n peff peff qn − 1 · p · eff +R qeff − 1 eff 1 – price of a debt repayed by constant payoffs – price of a debt due at the end of the payback period – price of a perpetuity P = qn P = 100 · p · (peff )−1 ps = a 100 100 p− = C n C p+ d n – simple yield-to-maturity. . = approximate effective interest rate of a debt due at the end of the payback period (price above and below par. quotation (in percent) nominal capital or value real capital.) rate of interest present worth of 1 per period (ordinary annuity) agio for price above par disagio for price below par return at the end of the payback period – accumulation factor (effective interest rate) Price formulas P = 100 · Kreal Knom n 1 k qeff 1 qk – price as quotient of real and nominal capital k=1 n k=1 bn. resp. For given price C in general the effective rate of interest (yield-to-maturity.

then that with the highest net present value is preferred. method of internal rate of return. for C > 0 its maturity yield is higher. . net present value k k=0 q n • For C = 0 the investment corresponds to the given conventional rate of interest p. If several possibilities of investments are for selection. then that with the highest internal rate of return is chosen. capital value of the investment number of periods conventional (or minimum acceptable) rate of interest p accumulation factor: q = 1 + 100 Capital value method KI = Ik – present value of income. sum of all present k k=0 q values of future expenses n C k C= = KI −KE – capital value of net income. Method of internal rate of return The internal rate of return (yield-to-maturity) is that quantity for which the net present value of the investment is equal to zero. Annuity method FA = q n · (q − 1) qn − 1 AI = KI · FA A = KE · FA AP = AI − A – – – – annuity (or capital recovery) factor income annuity expenses annuity net income (profit) annuity • For AI = A the maturity yield of the investment is equal to p. The most known are: capital (or net present) value method. cash flow at moment k: Ck = Ik − Ek present value of income present value of expenses net present value. If several investments are possible. for AI > A the maturity yield is higher than the conventional rate of interest p. sum of all present k k=0 q values of future income n E k KE = – present value of expenses. Notations Ik Ek Ck KI KE C n p q – – – – – – – – – income at moment k expenses. annuity method.42 Mathematics of Finance Investment analysis Multi-period capital budgeting techniques (discounted cash flow methods) are methods for estimating investment profitability. investments at moment k net income. Future income and expenses are prognostic values.

n A wk Rk – – – – term of utilization (in years) original value depreciation (write-down) in the k-th year book-value after k years (Rn – remainder. final value) Linear (straight-line) depreciation wk = w = A − Rn n Rk = A − k · w – – annual depreciation book-value after k years Arithmetically degressive depreciation (reduction by d each year) wk = w1 − (k − 1) · d nw1 − (A − Rn ) d=2· n(n − 1) wk = (n − k + 1) · d 2 · (A − Rn ) d= n(n + 1) – – depreciation in the k-th year amount of reduction Sum-of-the-years digits method (as a special case): wn = d – – depreciation in the k-th year amount of reduction Geometrically degressive (double-declining balance) depreciation (reduction by s percent of the last year’s book value in each year) Rk = A · 1 − s = 100 · wk = A · 1− s 100 n k – – k−1 book-value after k years rate of depreciation depreciation in the k-th year Rn A s s · 1− 100 100 – Transition from degressive to linear depreciation Under the assumption Rn = 0 it makes sense to write down geometrically degressive until the year ⌈k⌉ with k = n + 1 − 100 and after that to write s down linearly. The difference between original value (cost price.Depreciations 43 Depreciations Depreciations describe the reduction in value of capital goods or items of equipment. production costs) and depreciation yields the book-value. .

Method of false position (linear interpolation. f (xR ) − f (xL ) 3. regula falsi) Given xL with f (xL ) < 0 and xR with f (xR ) > 0. . . If f (xM ) < 0. then set xL := xS (xR unchanged). then stop and take xM as an approximation of x∗ . then set xR := xM (xL unchanged). Calculate xM = 1 (xL + xR ) and f (xM ). • If f ′ (xk ) = 0 for some k. Descartes’ rule of signs. if f (xM ) > 0. then set xL := xM (xR unchanged). let the function f be differentiable. Calculate xS = xL − xR − xL f (xL ) and f (xS ). . then stop and take xk+1 as an approximation of x∗ . go to 1. w − 4.44 Mathematics of Finance Numerical methods for the determination of zeros Task: Find a zero x∗ of the continuous function f (x). Newton’s method Given x0 ∈ U (x∗ ). 2. then set xR := xS (xL unchanged). If |f (xM )| < ε. if f (xM ) > 0. then restart the iteration process with another starting point x0 . let ε be the accuracy bound for stopping the iteration process. then stop and take xS as an approximation of x∗ . Table of values For chosen values x find the corresponding function values f (x). • Other stopping rule: |xL − xR | < ε or |xk+1 − xk | < ε. 3. If |f (xS )| < ε. Set k := k + 1. The number of positive zeros of the polynomial n k=0 ak xk is equal to w or w − 2. where w is the number of changes in sign of the coefficients ak (not considering zeros). f (xk ) . go to 1. . If f (xS ) < 0. Then one obtains a rough survey on the graph of the function and the location of zeros. • For f (xL ) > 0. go to 1. f ′ (xk ) 2. . f (xR ) < 0 the methods can be adapted in an obvious way. If |f (xk+1 )| < ε. 1. 1. Interval bisection Given xL with f (xL ) < 0 and xR with f (xR ) > 0. 1. 2 2. Calculate xk+1 = xk − 3.