Financial Mathematics II

© Prof. Sunder Ram Korivi, PhD

When to Compound?
• When money is in hand
• Available for investing and reinvesting
• To attain a target amount on a target date
Discounting
And its role in Financial Mathematics
When to Discount?
• Cash to flow in future
• Cash not in hand at Present
• Future Value of cash flows is known or estimated
• Present Value to be derived
• Based on Opportunity Rate of Return
Time Value of Money
Time Preference for Money
• If F = P(1+r)n Here, the Compound Factor is (1+r)n
• Then P = F/(1+r)n Here, the Discount Factor is 1/(1+r)n
• Discounting is the reciprocal of Compounding and vice versa
• In respect of each Future cash flow, its Present Value is derivable
• Based on a given r = Opportunity Rate of Return
• Question: What is a numeraire in economics and financial economics?
Concept
What will you prefer:
• Receiving Re.1 today
• Receiving Re.1 one year later
• Receiving Re.1 two years later
• Receiving Re.1 three years later
• Are these alternatives the same?
• How is money useful as an asset?
Concept
• Receiving Re.1 each year for 3 years
• Suppose Re.1 can be invested to compound @ 10%
• Suppose Re.1 can be invested to compound @ 11%
• Suppose Re.1 can be invested to compound @ 9%
Exercise #4
• Discount Rs.1,000, Rs.2,000 and Rs.3,000 to be received at the end of
Years 1, 2 and 3 respectively. Assume r to be @10% p.a.
• Recalculate, based on assumed r to be 8% p.a. and 12% p.a.,
respectively
Exercise #5
• Discount Rs.1,000 to be received each year at the end of Years 1, 2
and 3 respectively. Assume r to be @10% p.a.
• Recalculate, based on assumed r to be 8% p.a. and 12% p.a.,
respectively
• Is there any difference in the method of calculation?
Exercise #6
Application: Bonds Valuation
• A bond of Face Value Rs.1000, redeemable at the end of 3 years, pays
a coupon interest @ 8% p.a. and is valued by the market at a yield of
10% p.a. Calculate the market price of the bond.
• P = C/(1+r)1 + C/(1+r)2 + C/(1+r)3 + M/(1+r)3
Thank You