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Note6.1 Mathematics of Finance (1) Compound Interests PDF

This document discusses compound interest and effective annual rates. It begins by introducing the basic compound interest formula where S is the final amount, P is the principal, i is the interest rate, and n is the number of periods. Several examples are provided to demonstrate calculating compound interest over different time periods and interest rates compounded annually, semiannually, and quarterly. The document concludes by defining effective annual rate as the single rate that would produce the same result as the quoted interest rate compounded over multiple periods.

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71 views23 pages

Note6.1 Mathematics of Finance (1) Compound Interests PDF

This document discusses compound interest and effective annual rates. It begins by introducing the basic compound interest formula where S is the final amount, P is the principal, i is the interest rate, and n is the number of periods. Several examples are provided to demonstrate calculating compound interest over different time periods and interest rates compounded annually, semiannually, and quarterly. The document concludes by defining effective annual rate as the single rate that would produce the same result as the quoted interest rate compounded over multiple periods.

Uploaded by

李华夏
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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6.1.

Mathematics of Finance: Compound


Interests
Tony U
University of Macau

Outline

1 Introduction

2 Effective Annual Rate

3 Summary

Introduction

Introduction

Time value of money: Interest earns or inflation accrued over a


given amount of time.
Investment: Dividends
Loan: Interest (Risk free)

-1-

Introduction

In general, the basic formula for the value (or compound amount)
of an investment after n interest periods at the periodic rate of i .
S = P(1 + i )n
gives the compound amount S at the end of t interest periods at
the periodic rate of i .

-2-

Introduction

Example 1
Suppose $1,000 is invested for 10 years at 6% compounded
annually.
a. Find the compound amount.
b. Find the compound interest.

-3-

Introduction

Example 1
Suppose $1,000 is invested for 10 years at 6% compounded
annually.
a. Find the compound amount.
b. Find the compound interest.
Sol.: (a) S = 1000(1 + 6%)10 = 1, 790.85.

-3-

Introduction

Example 1
Suppose $1,000 is invested for 10 years at 6% compounded
annually.
a. Find the compound amount.
b. Find the compound interest.
Sol.: (a) S = 1000(1 + 6%)10 = 1, 790.85.
(b) I = S P = 1790.85 1000 = 790.85.

-3-

Introduction

Example 2

Suppose $3,000 is placed in a savings account. What is the


balance in the account after 7 years, if the money is worth 6% p.a.
a. compounded semiannually?
b. compounded quarterly?
c. Which account should we choose?

-4-

Introduction

(a) compounded semiannually?

-5-

Introduction

(a) compounded semiannually?


Sol.: S = 3000(1 + 3%)14 = 4, 537.77.

-5-

Introduction

(a) compounded semiannually?


Sol.: S = 3000(1 + 3%)14 = 4, 537.77.
(b) compounded quarterly?

-5-

Introduction

(a) compounded semiannually?


Sol.: S = 3000(1 + 3%)14 = 4, 537.77.
(b) compounded quarterly?
Sol.: S = 3000(1 + 1.5%)28 = 4, 551.67.

-5-

Introduction

(a) compounded semiannually?


Sol.: S = 3000(1 + 3%)14 = 4, 537.77.
(b) compounded quarterly?
Sol.: S = 3000(1 + 1.5%)28 = 4, 551.67.
(c) Which account should we choose?

-5-

Introduction

(a) compounded semiannually?


Sol.: S = 3000(1 + 3%)14 = 4, 537.77.
(b) compounded quarterly?
Sol.: S = 3000(1 + 1.5%)28 = 4, 551.67.
(c) Which account should we choose?
Sol.: The account with interest rate of 6% compounded quarterly.

-5-

Introduction

Example 3
Suppose that over a 6-year period, $1,000 accumulated to $1,725
in an investment certificate in which interest was compounded
quarterly. Find the nominal rate of interest, compounded quarterly,
which was earned.

-6-

Introduction

Example 3
Suppose that over a 6-year period, $1,000 accumulated to $1,725
in an investment certificate in which interest was compounded
quarterly. Find the nominal rate of interest, compounded quarterly,
which was earned.
Sol.: Let r be the nominal rate of interest,
1000(1 + r /4)24 = 1725
1 + r /4 = 1.02298
r

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= 9.19%.

Introduction

Example 4

How long will it take for $500 to amount to $700 if it is invested


at 8% p.a. compounded quarterly?

-7-

Introduction

Example 4

How long will it take for $500 to amount to $700 if it is invested


at 8% p.a. compounded quarterly?
Sol.: Let n years be period it will take
500(1 + 0.08/4)4n

= 700

4n ln(1.02) = ln 1.4
n = 4.25(years).

-7-

Effective Annual Rate

Effective Annual Rate

The interest rate that is stated and used to compute the interest
paid per period is called the quoted, or contracted, interest rate
iquoted .
Effective annual rate (EAR) is defined as that rate which would
produce the same compound amount if annual compounding had
been used

iquoted m
EAR = 1 +
1.
m

-8-

Effective Annual Rate

Example 5

Determine the effective annual rates for the deposits in example 2,


part (a) and (b).

-9-

Effective Annual Rate

Example 5

Determine the effective annual rates for the deposits in example 2,


part (a) and (b).
Sol.: (a) EAR = (1 + 6%/2)2 1 = 6.09%.

-9-

Effective Annual Rate

Example 5

Determine the effective annual rates for the deposits in example 2,


part (a) and (b).
Sol.: (a) EAR = (1 + 6%/2)2 1 = 6.09%.
(b) EAR = (1 + 6%/4)4 1 = 6.14%.

-9-

Summary

Summary

Compound interest: S = P(1 + i )n


Effective annual rate: EAR = (1 + iquoted /m)m 1

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