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Instructor: E. N. Papadakis

**Handout #1 Introduction to the theory of interetst and time value of money
**

Money has time value, that is, ¿1 in hand today is more valuable than ¿1 to be received one year hence. The purpose of this section is to examine the basic aspects of the theory of interest. A thorough understanding of the concepts discussed here is essential. Suppose an amount X (principle) is invested at interest rate r per year and this interest is compounded annually. After one year, the amount (value) in the account will be V (1) = X + rX = X (1 + r), and this total amount will earn interest the second year. Thus, after n years the amount will be V (n) = X (1 + r)n . The factor (1 + r)n is sometimes called the accumulation factor. If interest is compounded daily 365n r . In this last context the after the same n years the amount will be X 1 + 365 interest rate r is called the nominal annual rate of interest. The eective annual rate of interest is the amount of money that one unit invested at the beginning of the year will earn during the year, when the amount earned is paid at the end of the year. In the daily compounding example the ef365n r fective annual rate of interest is 1 + 365 − 1. This is the rate of interest which compounded annually would provide the same return. When the time period is not specied, both nominal and eective interest rates are assumed to be annual rates. Also, the terminology `convertible daily' is sometimes used instead of `compounded daily.' This serves as a reminder that at the end of a conversion period (compounding period) the interest that has just been earned is treated as principal for the subsequent period. 1

Two dierent investment schemes with two dierent nominal annual rates of interest may in fact be equivalent. Here m = 1 so the requirement for equivalence is that eδ = (1 + r) ⇔ δ = ln (1 + r) p Interest rates are not always the same throughout time. Find the force of interest which is equivalent to r% compounded annually. The force of interest is extremely important from a theoretical standpoint and also provides some useful quick approximations. Some notation is needed to discuss these situations conveniently. compounded daily. to provide an equivalent investment? Solution 1. Consider the situation in which ¿1 is invested at time 0 in an account which pays interest at a constant force of interest δ . and this corresponds to the notion of instantaneous compounding of interest. Solution 2.05 12 1+ r 365 365t 12t and respectively. p Situations in which interest is compounded more often than annually will arise frequently. What is the amount X(t) in the account at time t? What is the relationship between X (t) and X(t)? More generally. Under the assumption that 2 . suppose the force of interest at time t is δ(t). At any time t in years the amount in the two banks is given by 1 + 0. If interest is compounded n times per year the amount after t nt r years is given by 1 + n . may have equal dollar value at any xed date in the future. Denote by r (m) the nominal annual interest rate compounded m times per year which is equivalent to the interest rate r compounded annually. In theoretical studies such scenarios are usually modelled by allowing the force of interest to depend on time. Example 1. What interest rate does Bank B have to pay. Example 2. This possibility is illustrated by means of an example. Suppose you have the opportunity to invest ¿1 in Bank A which pays 5% interest compounded monthly. This means that 1+ r (m) m m =1+r An important abstraction of the idea of compound interest is the idea of continuous compounding. Here δ is called the force of interest. that is. In this context denote by δ the rate of instantaneous compounding which is equivalent to interest rate r. Letting n → ∞ in this expression produces eit . It is now an easy exercise to nd the nominal interest rate r which makes these two functions equal.

Suppose you were given the following choice. This quantity is called the present value of X . What relationship between r. Example 3. how much should be deposited today in order to achieve this objective? It is readily seen that the amount required is X (1 + r)−n . The present value is ¿2000(1 + 0. Under the assumption of an interest rate of 5%. the most favorable option is readily apparent. the eective annual rate of discount is the amount of discount paid at the beginning of a year when the amount invested at the end of the year is a unit amount. we solve this dierential equation and nd an explicit formula for X(t) in terms of δ(t) alone: X (t) = X (0) e ´t 0 δ(s)ds where X(0) represents the initial fund (principle). at time period 1. Suppose the annual interest rate is 5%. the payment of ¿2000 in ten years can be replaced by a payment of ¿1227. Thus the payment of ¿2000 can be moved through time using the idea of present value. 3 . the payment of interest of r at the end of the period is equivalent to the payment of d at the beginning of the period. Such a payment at the beginning of a period is called a discount. In other words δ (s) is taken by substituting s in place of t in the δ (t) formula. A positive power of v is used to move an amount backward in time. a negative power of v is used to move an amount forward in time. Suppose the objective is to have an amount X .83 p The notion of present value is used to move payments of money through time in order to simplify the analysis of a complex sequence of payments. at time period 0. What is the present value of a payment of ¿2000 payable 10 years from now? Solution 3. t denotes the maturity period as usual and s is used in place of t inside the integral. If money can be invested at interest rate r. and d.05)−10 = ¿1227. The notation vr is used if the value of r needs to be specied. n years hence.Notice too that a payment amount can be easily moved either forward or backward in time. The converse of the problem of nding the amount after n years at compound interest is as follows. In the simple case of the last example the important idea is this. You may either receive ¿1227. The advantage of moving amounts of money through time is that once all amounts are paid at the same point in time.83 today.83 today or you may receive ¿2000 ten years from now.X (t) = δ(t)X(t). If you can earn 5% on your money (compounded annually) you should be indierent between these two choices. The factor (1 + r)−n is often called the discount factor and is denoted by v . In an interest payment setting. must hold for a discount payment to be equivalent to the interest payment? The relationship is d = rv follows by moving the interest payment back in time to the equivalent payment of rv at time 0. Formally.

a euro amount payable at one time can be exchanged for an equivalent euro amount payable at another time by multiplying the original euro amount by an appropriate power of v . since the computations are easier than with compound interest. If an amount X is deposited at interest rate r per period for t time units and earns simple interst. The most important facts are the following: [1] Once an interest rate is specied. [2] The ve sided equality above allows interest rates to be expressed relative to a convenient time scale for computation. Simple interest is often used over short time intervals.The notation and the relationships thus far are summarized in the string of ve sided equality: r (m) 1+r = 1+ m m d (m) = 1− m −m = v −1 = eδ Another notion that is sometimes used is that of simple interest. the amount at the end of the period is X (1 + rt). 4 . These two ideas will be used repeatedly in what follows.

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