FOF Topic 3 Financial Mathematics

FIN1FOF
FUNDAMENTALS OF
FINANCE
Topic 3: Financial
Mathematics
Topic Overview
3.4 Perpetuities and annuities
3.5 Solving for other variables
3.6 Interest rates
La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 2

3.4.3 PRESENT VALUE OF AN ANNUITY
 An annuity is similar to a perpetuity, in that
it is a constant stream of equal cash flows,
except that it only occurs for a fixed period
of time
0 1 2 3 4
C C C C
 Once again, note that the first cash flow
occurs at the end of the first period of the
annuity
 It would be quite possible to calculate the
present value of an annuity by repeatedly
using the formula for the present value of a
single cash flow, and then summing the
present value of each cash flow; i.e.
C1 C2 Cn
PV    ...  (4.3)
 1 r   1 r  2
 1 r 
n
but it can be shown that this can be

simplified to a single formula
 The formula for the present value of an
annuity is:
1 1 
PV  C   1   (4.5)
 
  1 r 
n
r

where C = the constant cash flow (with
the first cash flow occurring one
period in the future)
r = the interest rate per period
n = the number of periods
Lecture Example 3.17
You have just won a “$30 million” lottery. You
can choose to receive $1 million per year for the
next 30 years (with the first payment in a year’s
time) or $12 million up-front. You can invest
your money at 8% p.a. Which do you prefer?
A $1 million per year (first payment in 1 year)
B $12 million up-front

1 1 
PV  C   1  
r   1 r  n 
 
1  1 
 1,000,000  1  
0.08   1.08  30 
 
 $11,257,783
B $12 million up-front is preferable
You have just won the lottery from Lecture
Example 2.17. You can choose to receive $1
million per year for the next 30 years (with the
first payment today) or $12 million up-front.
(Your rate is still 8% p.a.) Which do you prefer?
A $1 million per year (first payment today)
B $12 million up-front

 The “$1 million per year” option consists of a
single cash flow of $1 million today, plus a 29-
year annuity (because the first cash flow of
this annuity occurs one period in the future),
and we can calculate the answer accordingly
 This is a common situation in finance, and is
referred to as an annuity due, whereas the
annuity formula we use (with the first cash
flow in one period) is for an ordinary annuity
1  1 
PV  $1 m  1    $1 m
0.08   1.08  
29
 
 $11,158,406  $1,000,000
 $12,158,406
A $1 million per year for 30 years (first

payment today) is preferable to $12 million
3.4.4 FUTURE VALUE OF AN ANNUITY
 The formula for the future value of an annuity
(the value of the cash flow stream at the end
of the annuity) is:
1
FV  C   1  r   1
r
n
  (4.6)
where C = the constant cash flow (first

cash flow one period in the future)
r = the interest rate per period
n = the number of periods
You are 25 years old, and have decided to
make annual end-of-year deposits of $12,000
into a bank account paying 12% p.a. How
much will you have when you retire at age 65?
1
FV  C   1  r   1
r
n
 
 12,000 
1
0.12
 1.12   1  $9,205,097
40
 
Redo Lecture Example 2.19, but now you will
save $12,000 per year via monthly deposits into
an account paying 12% p.a. compounding
monthly. How much will you have at age 65?
Adjust for monthly pmts: r = 12% / 12 = 1%
C = $12,000 / 12 = $1000 n = 40 × 12 = 480
FV  1,000 
1
0.01
 1.01  1  $11,764,773
480
 
3.5.1 REARRANGING FORMULAS
 If you have a formula with one unknown
variable, and that variable only appears
once, rearranging the formula should allow
you to solve for that variable
 E.g. we can derive Formula 3.2 from 3.1:
FV  PV   1  r 
n
Substituting PV for C
FV
 PV  Dividing both sides of
 1 r 
n the equation by (1 + r)n

3.5.2 SOLVING FOR THE RATE OF RETURN
An investment will cost you $1000 and will
return $2000 in 5 years. What is the annual
rate of return?
1/ n
 FV 
FV  PV  1  r 
n
\ r 
 PV 

1
1/ n 1/5
 FV   2000 
r   1    1  14.87%
 PV   1000 
3.5.3 SOLVING FOR THE ANNUITY CASH FLOW
You take out a $250,000 mortgage loan,
repayable over 20 years at an interest rate of
12% p.a., compounding monthly. What is the
monthly repayment?
We first adjust for r = 12% / 12 = 1%

monthly payments: n = 20 × 12 = 240
This problem is easily solved using a financial
calculator, but can solved using Formula 4.5
3.5.3 SOLVING FOR THE ANNUITY CASH FLOW
1 1 
C
PV
PV  C   1   \
  1 r 
  1 
n
r 1
 1 
  1 r 
r  n


250,000
C (4.9)
1  1 
1 240   $2752.72
0.01   1.01 
 
3.6 Interest rates
3.6.1 ANNUAL PERCENTAGE RATE (APR)
 Interest rates can be quoted in different ways,
and we need to know how to interpret them
and convert between them
 So far we have mainly concentrated on the
interest rate per compounding period – the
discount rate (r) used in most TVM formulas
 Banks usually quote an annual interest rate
(the APR, or Annual Percentage Rate), and
they should also tell you how often interest is
compounded
3.6 Interest rates
3.6.2 INTEREST RATE PER COMPOUNDING PERIOD
 As we seen, to find the interest rate per
compounding period, we divide the APR by
the number of compounding periods per year
 The formula for finding the interest rate per
compounding period is:
APR
r 
m
where m = the number of compounding
periods per year
3.6 Interest rates
3.6.3 EFFECTIVE ANNUAL RATE (EAR)
 The problem with the APR is that it ignores
the effect of compounding
 For example, consider 10% p.a. compounded
annually
these interest rate quotes:
10% p.a. compounded
 They are clearly different quarterly
quotes, but they have the 10% p.a. compounded
same APR (10%) daily
 This makes comparisons between rates with

different compounding periods difficult
3.6 Interest rates
 If you need to compare alternative financing
arrangements, the best method is to convert
the quoted rate, or APR, to an Effective
Annual Rate (EAR)
 The EAR tells you how much you are
effectively paying or receiving, taking into
account the effect of compounding
 The EAR is the annually-compounded APR
that would leave you in the same position in
terms of interest paid or received
3.6 Interest rates
 The formula for Effective Annual Rate is:
m
 APR 
EAR   1   1 (5.3)
 m 
where EAR = The Effective Annual Rate

APR = The Annual Percentage Rate
m = the number of compounding
periods per year

3.6 Interest rates
Would you prefer to borrow at 10% compounded
annually or 9.7% p.a. compounded quarterly?
m
10%
AEAR compounded
APR  annually
 1 1  
 m 
B 9.7% compounded
4 quarterly
 0.097 
C   1  between
Indifferent  the
1  two
10.06%
 4 
A 10% compounded annually is preferable
3.6 Interest rates
3.6.5 REAL AND NOMINAL INTEREST RATES
 So far we have restricted our discussion to the
nominal interest rate, which is the quoted or
observable interest rate paid or received
 Because we normally experience inflation,
which reduces the purchasing power of dollars
over time, the nominal interest rate does not
represent the increase in purchasing power
from an investment
 The rate that measures the increase in
purchasing power is the real interest rate
3.6 Interest rates
 The relationship between the nominal and
real interest rate is as follows:
1  rn   1  rr   1  π 
rn  rr  π
where rn = nominal interest rate
rr = real interest rate
π = the expected inflation rate
 The second formula above is a convenient
approximation when interest rates are low
3.6 Interest rates
If the nominal rate is 12% and the expected
inflation rate is 3%, what is the approximate real
interest rate? What is the exact real interest rate?
rr  rn  π  12%  3%  9%
1  rn   1  rr   1  π 
1  rn 1.12
 rr  1  1  8.74%
1 π 1.03
3.6 Interest rates
3.6.6 THE TERM STRUCTURE OF INTEREST RATES
 Until now we have treated “the interest rate”
as a single variable, but interest rates usually
vary across different financial assets
 Interest rates may reflect different variables,
such as credit risk, but the most important
variable is the term to maturity
 The relationship between interest rates and
term to maturity – the pattern of different rates
applying to different maturities – is referred to
as the term structure of interest rates
3.6 Interest rates
 The term structure of interest rates can be
represented graphically, via a yield curve
Interest rate The yield curve
shows the interest
rate, or yield, that
is currently
available for
otherwise identical
Maturity
securities with
different maturities
Short-term Medium-term Long-term

3.6 Interest rates
 Yield curves can take on a variety of shapes.
Commonly observed shapes include:
Interest rate
An upward
sloping yield
curve is referred
to as “normal”
because it is the
most commonly
Maturity observed shape
Positive or “normal”
3.6 Interest rates
Interest rate
When there is
little or no
difference
between short-
and long-term
rates, the yield
Maturity curve is referred
to as flat
Flat
3.6 Interest rates
Interest rate
A downward
sloping yield
curve is referred
to as “inverse”
because it is the
opposite of a
Maturity “normal” curve
Negative or “inverse”
3.6 Interest rates
Interest rate
A humped yield
curve, or other
non-standard
shape, usually
occurs when
there are varying
Maturity expectations
about future rates
Humped
3.6 Interest rates
3.6.7 INTEREST RATE DETERMINATION
 Interest rates are set by the RBA, which uses
the cash rate to implement monetary policy
Monetary policy Cash rate

The main tool used to The rate charged on
influence economic growth, overnight loans between
inflation and unemployment financial institutions
 The cash rate is a very short term rate, but

as a result of market forces, changes in the
cash rate flow on to longer-term rates
3.6 Interest rates
 Long-term rates, and therefore the term
structure of interest rates and the shape of
the yield curve, are largely determined by
investor expectations regarding future
interest rates
 This is based on the assumption that capital
markets are perfect and that investors are
indifferent between investments with
differing maturities – they will always choose
the investment providing the highest return
3.6 Interest rates
3.28 A
If short-term rates and long-term rates are equal
(say, 5% p.a.) but you expect short-term rates to
go up in the future (to 6%), would
you would
you prefer…
A series of successive
single long-term
B
A
short-term
investment? investments
A series
You could thenof“roll
successive
over” your short-term
B
short-term
investments andinvestments?
get higher rates in the future

3.6 Interest rates
2.28 B
If you (and everyone else as smart as you)
prefers to invest short-term rather than long-
term, but there are still people who want to
borrow long-term, what will happen to long-term
interest rates?
ALong-term
Increaserates would increase until they are
B Decrease
high enough to attract investors, at which point
short-term
C Remain investments
the same do not provide higher
returns
3.6 Interest rates
 As a result of this process, we would expect
current long-term rates to be the geometric
average of expected future short-term rates
 If this were not the case, arbitrage
opportunities would exist – arbitrageurs
could borrow at the point on the yield curve
where rates are lowest and invest where
they are highest, and the resulting market
forces would restore an equilibrium in which
the above prediction holds
3.6 Interest rates
 The question then is…
Why is an upward- Is it reasonable to assume
sloping yield curve that, most of the time,
considered investors expect interest rates
“normal”? to up rather than down?
 Probably not
As a result, those
In addition to investor wanting to borrow
expectations, something else long-term have to
is causing them to prefer offer higher rates to
short-term investments attract investors
3.6 Interest rates
 The reason is that long-term investments are
riskier than short-term investments
 Small changes in interest rates cause a
much greater change in the value of a long-
term investment than a short-term
investment
 Because of this preference for short-term
investments, yields on long-term
investments will be somewhat higher than
the predicted yield based on purely on
expectations
3.6 Interest rates
 This phenomenon results in higher yields
for long-term securities, but has little effect
on short term securities
Observed
Interest rate
yield curve
“Pure expectations” yield curve
Maturity

3.6 Interest rates
 The “upward bias” to what would otherwise be
a flat yield curve may help to explain why an
upward sloping yield is most commonly seen
Interest rate
Observed
yield curve
“Pure expectations” yield curve
Maturity

3.6 Interest rates
 This hypothesis does not preclude an inverse
yield curve, but predicts that the yield curve
will be flatter (less negative) as a result
Interest rate
Observed yield curve
“Pure
expectations”
yield curve
Maturity

Topic 3 Appendices
Appendix 3.1 Detailed reading guide
Appendix 3.2 Further study and
Assessment
Appendix 3.3 Financial calculator
guide
Appendix 3.4 General calculator guide

Appendix 3.1
DETAILED READING GUIDE
Chapter Sections Pages
3 3.1, 3.3 and 3.4 65 – 68, 73 – 83
Not examinable: Section 3.2.
4 All 90 – 111
Not examinable: “Solving for the discount rate of an annuity”
and “Solving for the number of periods” (pp. 111 –115).
5 All 127 – 148
Not examinable: “Present value of a cash flow stream using a
term structure of discount rates” and “The yield curve and the
economy” (pp. 142 – 143).
*Note that Section 5.4 is not specifically covered in the Topic 2
lecture slides but is prescribed reading for later topics.

Appendix 3.2
FURTHER STUDY & ASSESSMENT
FIN1FOF Workbook
Questions 31 – 90 (pages 13 to 29 inclusive)
Textbook Questions/Problems (Berk 2nd edition)
Chapter 3 – Problems 1-3, 9-11, 13-22
Chapter 4 – Review Questions 2-7
– Problems 3-15, 18-28, 30, 32, 34
Chapter 5 – Review Questions 5-9
– Problems 2-3, 5, 10-12, 26-27, 30

Appendix 3.2
FURTHER STUDY & ASSESSMENT
MyFinanceLab
Tutorial 2
Tutorial 3
Tutorial Quiz 2 (Tutorial 3)
Tutorial Quiz 3 (Tutorial 4)
Mid-semester Test
Final Examination
Appendix 3.3
FINANCIAL CALCULATOR GUIDE
Although not required for this subject, many
students find a financial calculator easier to use
in many situations instead of formulas, or use it
to double check the results from using formulas
The following slides demonstrate how to solve
selected Lecture Examples from Topic 2 using a
financial calculator
Buttons shown are for the Texas Instruments
BAII Plus, although others are similar

Appendix 3.3
There are five TVM (time value of money)
buttons on a financial calculator:
N I/Y PV PMT FV
For TVM calculations, you input four of the

variables and ask the calculator to compute the
value of the fifth variable
In many situations, you only need three input
variables, so the fourth can be set to zero or
you can clear all TVM values before you begin
Appendix 3.3
Lecture Example 3.5
What is the future value of $1000 invested for 4
years at an interest rate of 8% p.a.?
2ND FV This first step clears all TVM values from previous entires
4 N The next three steps input the number of periods, the

interest rate per period and the present value, respectively
8 I/Y
1 0 0 0 PV The last step computes the future

value, which appears as a negative number (if
CPT FV the present value is positive, the future value is
negative, and vice versa)
Appendix 3.3
Lecture Example 3.7
What is the present value of $4000 to be
received in 7 years if the interest rate is 5% p.a.?
2ND FV For the remaining examples shown in this appendix,

it is assumed that you will clear all TVM values using
7 N this step, or else explicitly enter 0 for the variable
not being used. For example, instead of …
5 I/Y 2ND FV
you could enter…
4 0 0 0 FV
0 PMT
CPT PV In this example and get the same result.

Appendix 3.3
Lecture Example 3.8
What is the future value of $1000 invested for 4
years at an interest rate of 8% p.a., if interest is
compounded semi-annually?
8 N If interest compounds more than once per year, we

need to work out r (in this case, 4%) and n (8 years)
4 I/Y and enter the problem as if it was 4% p.a. for 8 years
1 0 0 0 PV
CPT FV

Appendix 3.3
What is the present value of $1 million per year
for the next 30 years (with the first payment in a
year’s time), if the interest rate is 8% p.a.?
3 0 N In this case the payment has been entered in

millions of dollars, so the answer will be in millions
of dollars ($11.26). To get the answer in dollars,
8 I/Y
you can enter the payment as 1000000, or
multiply the answer by 1 million.
1 PMT
For Lecture Example 2.18, enter the number of
CPT PV payments as 29 and then add $1 m to the answer.
Appendix 3.3
You are 25 years old, and have decided to save
$12,000 per year by making monthly deposits
into an account paying 12% p.a. compounding
monthly. How much will you have at age 65?
4 8 0 N Due to monthly
compounding, we are
1 I/Y entering the problem as if
it was $1000 per year at
1 0 0 0 PMT 1% p.a. for 480 years.
The answer is the same.
CPT FV

Appendix 3.3
An investment will cost you $1000 and will
return $2000 in 5 years. What is the annual
rate of return?
5 N Either the present

value or the future
value needs to be
1 0 0 0 PV
entered as a negative
number (using the +/-
2 0 0 0 +/– FV button) – otherwise
you will get an error
CPT I/Y message
Appendix 3.3
What is the monthly repayment on a $250,000
mortgage loan, repayable over 20 years at an
interest rate of 12% p.a., compounding monthly?
2 4 0 N
1 I/Y
2 5 0 0 0 0 PV
CPT PMT

Appendix 3.4
GENERAL CALCULATOR GUIDE
Rounding errors
It is important to avoid rounding errors
whenever possible. Minor rounding errors will
not be penalised in this subject if it is clear that
the correct technique has been used, but major
rounding errors (especially errors so great that
it hard to be sure that the correct technique has
been used) will be penalised.

Appendix 3.4
Rounding errors
The best way to avoid rounding errors is to
never write down an intermediate answer and
then later enter it in your calculator. You should
keep intermediate answers in the calculator.
The following slides show three different ways
to solve Lecture Example 2.23 (using the BAII
Plus, but others are similar), avoiding the
necessity to write down intermediate answers
and therefore avoiding rounding errors.
Appendix 3.4
Algebraic Operating System
Before looking at these examples, it is important
to understand two different ways in which
calculators perform operations:
Chain – Operations are carried out in the
order in which they are entered
AOS – Operations are carried out in the
mathematically correct order (e.g.
multiplication is done before addition)
Appendix 3.4
Scientific calculators use AOS. Simple
calculators, and many financial calculators,
generally use the Chain system. The BAII Plus,
and most advanced financial calculators, can
be set to either.
All of the following examples assume your
calculator is set to use AOS. If your calculator
uses the Chain system you probably need to
use a lot more brackets to get the right answer.
Appendix 3.4
The following is a simple test to determine
which system your calculator uses (or has been
set to use). Enter the following calculation:
1 + 2 × 3 =
If your answer is 9, your calculator uses the

Chain system. If your answer is 7 (which is the
correct answer) your calculator uses AOS.

Appendix 3.4
To set the BAII Plus to AOS, use the following
steps:
2ND .
If you want to change the number of

decimal places, at this point enter
↑ n ENTER
where n in this case is the number of
2ND ENTER
decimal places you want (e.g. 4).
2ND CPT

Appendix 3.4
Lecture Example 2.23 – Using brackets
The calculation becomes 250000/(1/0.01*(1-1/1.01^240))
and is entered as follows. If you are using the
Chain system, you need 250000/(1/0.01*(1-(1/(1.01^240))))
- i.e. you need more brackets.
2 5 0 0 0 0 ÷ (
1 ÷ 0 . 0 1 × (
1 – 1 ÷ 1 . 0 1
yx 2 4 0 ) ) =

Appendix 2.4
Lecture Example 2.23 – Using the memory
If you find brackets tedious, you can minimise them
by storing intermediate answers in the calculator’s
memory. The following steps also reduce the use of
brackets by changing the order of some of the steps.
1 – ( 1 ÷ 1 . 0
1 yx 2 4 0 ) = ÷
0 . 0 1 = STO 1 2
5 0 0 0 0 ÷ RCL 1 =

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FIN1FOF

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 2

but it can be shown that this can be

A $1 million per year (first payment in 1 year)

B $12 million up-front

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 6

A $1 million per year (first payment today)

B $12 million up-front

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 8

A $1 million per year for 30 years (first

where C = the constant cash flow (first

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 14

We first adjust for r = 12% / 12 = 1%

 This makes comparisons between rates with

where EAR = The Effective Annual Rate

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 22

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 28

Monetary policy Cash rate

 The cash rate is a very short term rate, but

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 35

“Pure expectations” yield curve

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 40

“Pure expectations” yield curve

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 41

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 42

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 43

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 44

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 45

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 47

For TVM calculations, you input four of the

4 N The next three steps input the number of periods, the

1 0 0 0 PV The last step computes the future

2ND FV For the remaining examples shown in this appendix,

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 50

8 N If interest compounds more than once per year, we

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 51

3 0 N In this case the payment has been entered in

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 53

5 N Either the present

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 55

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 56

If your answer is 9, your calculator uses the

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 60

If you want to change the number of

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 61

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 62

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 63

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