Table of Contents

Studying the effect of negative interest rates, continuous compounding and inflation in
compound interest calculation...................................................................................................2
(1)Definitions and Terminologies.................................................................................................2
(2)The Theory of Value of Money................................................................................................3
(3)The main differences between simple interest and compound interest.....................................4
(4)The important of Mathematical of finance (or financial mathematics) and its applications ....5
(5)The main business and economic application of compound interest .......................................6
5.1.Generating Profits....................................................................................................6
5.2.Ensuring Pension Payments.....................................................................................6
5.3.Calculation............................................................................................................... 6
(6)The main business and economic application of annuities.......................................................6
(7)The effect of negative rates .....................................................................................................7
(8)In 1980 the CPI was 86.1 and in 1987 it was 118.7. Both values are relative to 1982-84=100.
Find the annual compounded rate of change of the CPI and of the value of the dollar.................8
(9)References 9
 Studying the effect of negative interest rates, continuous
compounding and inflation in compound interest
calculation
(1)Definitions and Terminologies: -
A. Interest: is the charge for the privilege of borrowing money, typically expressed as
annual percentage rate (APR). Interest can also refer to the amount of ownership a
stockholder has in a company, usually expressed as a percentage.[1]
B. The principle of a loan: is the amount which is actually given as the loan from the
lender of the money to its borrower and it is the amount on which the interest is charged by
the lender of the money from the borrower for the use of its money.[1]
C. Compounding frequencies: is how often the interest is added to the principal of a
loan each year. The greater the compounding frequency is, the more money the lender will
make from the loan.[2]
D. Effective interest rate (EIR): is the interest rate on a loan or financial product restated
from the nominal interest rate and expressed as the equivalent interest rate if compound
interest was payable annually in arrears.[1]
E. Nominal rate [4]: is refers to the interest rate before taking inflation into account.
Nominal can also refer to the advertised or stated interest rate on a loan, without taking
into account any fees or compounding of interest. The nominal rate formula can be
calculated as:
r = m × [ (1 + i)1/m - 1]
F. An annuity: is a contract between you and an insurance company in which you make a
lump-sum payment or series of payments and, in return, receive regular disbursements,
beginning either immediately or at some point in the future. [3]
G. An ordinary annuity: is a series of equal payments made at the end of consecutive
periods over a fixed length of time. While the payments in an ordinary annuity can be
made as frequently as every week, in practice, they are generally made monthly, quarterly,
semi-annually, or annually. [3]
H. Annuity due: is an annuity whose payment is due immediately at the beginning of each
period. A common example of an annuity due payment is rent, as landlords often require
payment upon the start of a new month as opposed to collecting it after the renter has
enjoyed the benefits of the apartment for an entire month. [3]
I. Deferred annuity: is a contract with an insurance company that promises to pay the
owner a regular income, or a lump sum, at some future date. Investors often use deferred
annuities to supplement their other retirement income, such as Social Security. Deferred
annuities differ from immediate annuities, which begin making payments right away. [3]
J. Perpetuity [4]: is a security that pays for an infinite amount of time. In finance, perpetuity
is a constant stream of identical cash flows with no end. The formula to calculate the
present value of a perpetuity, or security with perpetual cash flows, and the concept of a

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 perpetuity is also used in a number of financial theories, such as in the dividend discount
model (DDM).
K. Annuity certain: is an investment that provides a series of payments for a set period to a
person or the person's beneficiary or estate. It is an investment in retirement income
offered by insurance companies. [3]
L. Contingent annuitant: is someone designated by an annuitant to receive the
annuitant’s payments when they pass away. When an annuity has a contingent annuitant. [3]
M. Amortization: is an accounting technique used to periodically lower the book value of a
loan or intangible asset over a set period of time. The term "Amortization" can refer to two
situations. First, amortization is used in the process of paying off debt through regular
principal and interest payments over time. [4]
(2) The Theory of Value of Money [5]: -
Value of money is a term that is necessary to be understood to get acquainted with the
theories of money. In economics, different economists have defined the term value of money
differently. Some of the economists explained value of money as the value of gold and silver in
terms of their weight and fineness.
Other has defined the value of money as the value of Indian currency against foreign
currencies.
On the other hand, few economists have associated the term value of money with the
internal purchasing power of a nation. However, logically, value of money is associated with its
purchasing power, which refers to the quantity of goods and services that can be purchased
with a unit of money. The values of money and price levels in a country are inversely
proportional to each other. For example, when the price level in a country is high, the value of
money is low and vice-versa.
The three main approaches are used for the monetary analysis of a country, which
are as follows:
a. Quantity Velocity Approach/Cash Transaction Approach/Freidman’s Restatement
b. Cash Balances Approach
c. Income-Expenditure Approach

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 (3) The main differences between simple interest and compound
interest [6]: -
An Overview: Interest is the cost of borrowing money, where the borrower pays a fee to the
lender for the loan. The interest, typically expressed as a percentage, can be either simple or
compounded. Simple interest is based on the principal amount of a loan or deposit. In contrast,
compound interest is based on the principal amount and the interest that accumulates on it in every
period. Simple interest is calculated only on the principal amount of a loan or deposit, so it is easier to
determine than compound interest.

3.1.Simple Interest
Simple interest is calculated using the following formula:
Simple Interest=P×r×n
Where:
P=Principal amount r=Annual interest rate n=Term of loan, in years
Generally, simple interest paid or received over a certain period is a fixed percentage of the
principal amount that was borrowed or lent. For example, say a student obtains a simple-interest loan to
pay one year of college tuition, which costs $18,000, and the annual interest rate on the loan is 6%. The
student repays the loan over three years. The amount of simple interest paid is: $3,240=$18,000×0.06×3
and the total amount paid is: $21,240=$18,000+$3,240

3.2.Compound Interest
Compound interest accrues and is added to the accumulated interest of previous periods; it
includes interest on interest, in other words. The formula for compound interest is:
Compound Interest=P×(1+r) t−P
Where:
P=Principal amount r=Annual interest rate t=Number of years interest is applied
It is calculated by multiplying the principal amount by one plus the annual interest rate raised to
the number of compound periods, and then minus the reduction in the principal for that year. With
compound interest, borrowers must pay interest on the interest as well as the principal.
Compound interest is a percentage of the principal amount including all previously-accrued
interest. In other words, each interest-accruing period, the amount of interest added to the principal is
calculated based on the principal plus the interest added in the previous period.
Compound interest is the most common form of interest you will see. It is used, for example,
when you take out a line of credit. It is also used to calculate the interest your money accrues if you set
up an interest-bearing account.

Simple Interest Compound Interest

is always the same amount since it is a percentage amount will be different every accrual period
of the principle since it is a percentage of the principal plus
interest earned or accrued to date.

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The principal remains the same with simple the compounded interest is added to the principal,
interest. increasing the principal amount.

better for purchases such as car loans since the better for investing or saving since your funds
cost of the loan is static will grow quicker.

(4) The important of Mathematical of finance (or financial mathematics)

and its applications [7]: -
4.1.The Importance:
Mathematics is backbone of Finance. For any calculation like, Ratio Analysis, finance
budget, cash budget, u should know systemic formula. Without proper mathematics knowledge
that is not possible. When you look at all the top math and engineering talent that’s ended up
working in high-frequency trading or hedge funds, there’s no accident there. The ability to
express aspects of dynamical systems mathematically or algorithmically has made some people
into billionaires. I shudder to think the kind of market manipulations that would be possible by
using deep learning algorithms on Google search info and leveraging that against market
changes. I’m sure someone is already doing it.
Mathematics, is the moving force behind critical business thinking, value creation,
pricing and structuring decisions in almost any business. Mathematics manifests itself more
obviously in Finance but it is the warp and weft of modern economic language and grammar.
So, at an overall level, it is invaluable to be fluently numerate at the minimum when handling
the finance function. But it behooves to be mathematically competent in decision sciences to
build business and funding structures.

4.2.The Application:

There are three main applications:

4.2.1. Differential Game Method
In the modern financial theory, mathematics in the field of finance is another
important application is analyzed in option pricing and investment decision using
differential game method, and the application of this aspect has made re-markable
achievements. Because the whole law of financial market does not accord with the
hypothesis of steady state, the abnormal fluctuation of securities will lead to abnormal
change in the process of abnormal fluctuation, and this kind of change will not obey the
Brown motion.

4.2.2. Capital Asset Pricing Model (CAPM)

Markowitz (Markowitz, 1952) the dispersion of investment portfolio theory and
efficiency for the first time as a means of rigorous mathematical tools to show a method for
risk averse investors how to construct the optimal portfolio of risky assets in many. It
should be said that this theory has a strong sense of normative, which tells investors how to
make investment choices.

4.2.3. Stochastic Optimal Control Theory

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 In the mathematical application of the current financial theory, another important
application field is the use of mathematics to solve the stochastic problems in financial
problems.

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 (5) The main business and economic application of compound interest [8]: -
5.1.Generating Profits
Compound interest opens doors to sources of profits for a company. For example, businesses
can please investors by earning them higher profits than expected. Financial managers are
expected to give dividends to investors. If these dividends are accumulated, or more precisely
compounded, and reinvested in the business, higher dividends may be payable the next year.
5.2.Ensuring Pension Payments
Various companies seek assistance of investment accounts to pay pensions. Typically,
employers exclude a fixed amount of their employees’ salaries and contribute it to their pension
fund. The amount accumulates for years until the employees reach retirement age, when the
entire amount is provided as pension. Businesses use the money in pension funds to invest in
financial instruments that pay guaranteed return rates.
5.3.Calculation
Compound interest is one of two ways to calculate interest -- the other is simple interest. While
simple interest calculates interest on the initial principal only, compound interest lets you enjoy
higher returns by paying you interest on the principal amount plus the interest you previously
earned.
(6) The main business and economic application of annuities: -
Annuities are used mainly to supplement more traditional sources of retirement income such as
Social Security and pension plans. Common features include:

6.1.Tax-deferred growth
You will pay no income taxes on the earnings from your annuity investments until you begin
making withdrawals or receiving periodic payments. Note that withdrawals prior to age 59½
may be subject to an additional 10% tax.
6.2.Unlimited contributions
Generally speaking, there is no limit to the amount of after-tax money you can put into an
annuity, regardless of your income level or sources of income.
6.3.Choice of investment options
Fixed annuities offer a stated rate of return for a specified period of time. Variable annuities
include a variety of investment options, such as stocks, bonds, and money market instruments,
that fluctuate with market conditions.

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(7) The effect of negative rates [9]: -
Examples:
1- Find the Present value of $750 due in 9 years if money is worth 5.2% compounded
semiannually.
Solution:
Substituting S=750, i=0.26, and n=16 in formula (11), we have
P=750(1.026)-16
Taking the logarithm of both sides, we obtain
Log P= Log 750 – 16 Log (1.026)
Log 750 = 2.875061263
16 Log (1.026) = 16 x 0.11147= 0.178352
Log P=2.875061263-0.178352
Log P= 2.696709263
Looking up the antilog of 2.696709263, we have:
P=10 2.696709263=$ 497.40

2- How many years will it take $220 to amount to $560 at 4.4%?

Solution:
Substituting S=560, P=220, and i=0.44 in formula (9), we have

560= 220(1.044) n
From which
560
(1.044)n=
220
Taking the logarithm of both sides, we obtain
n Log (1.044) = Log 560 – Log 220
log 560−log 220 2.748188027−2.342422681
n= = =21.699 years
log 1.044 0.18700

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(8) In 1980 the CPI was 86.1 and in 1987 it was 118.7. Both values are
relative to 1982-84=100. Find the annual compounded rate of
change of the CPI and of the value of the dollar. [9]
Solution:
Substituting the CPI values in formula (9), we have
86.1 (1+i) 7 = 118.7
118.7
(1+i) 7 =
86.1
Taking logarithms of both sides, we obtain
7 Log (1+i) = Log 118.7 – Log 86.1
2.074450719−1.935003151
log ( 1+i )= =0.019921
7
1+i = 100.019921
1+i = 1.046938284

To determine the annual percentage change in the value of the dollar, we first obtain the value
of dollar as explained above.

Year Consumer Price Index Value of the dollar

1975 86.1 $1.6

1982 118.7 $1.1

Substituting in formula (9), we have

1.6 (1+i) 7 = 1.1
7 Log (1+i) = Log (1.1) – Log (1.6)
¿
Log (1+i) = 0.0413927−0.20419 ¿ 7

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(9) References
[1] Roberts, Peter W. "The profit orientation of microfinance institutions and effective interest
rates." World Development 41 (2013): 120-131.
[2] Pircher, Michael, et al. "Speckle reduction in optical coherence tomography by frequency
compounding." Journal of biomedical optics 8.3 (2003): 565-570.
[3] Zelman, William N., et al. Financial management of health care organizations: an
introduction to fundamental tools, concepts, and applications. John Wiley & Sons, 2009.
[4] Hadzic, Ilija, and Dusan Suvakovic. "High-speed serial transceiver with sub-nominal rate
operating mode." U.S. Patent No. 7,672,416. 2 Mar. 2010.
[5] Moseley, Fred, ed. Marx’s theory of money: modern appraisals. Springer, 2004.
[6] Hubbard, Edward, Percival Matthews, and Anya Samek. "Using online compound interest
tools to improve financial literacy." The Journal of Economic Education 47.2 (2016): 106-120.
[7] Rosenthal, Joachim, and David S. Gilliam, eds. Mathematical systems theory in biology,
communications, computation and finance. Vol. 134. Springer Science & Business Media, 2012.
[8] Affolder, Natasha. "Awarding Compound Interest in International Arbitration." American
Review of International Arbitration 12.1 (2001): 45.
[9] University Book,2020,pp:174-182.

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