Lecture 6.

1 Mathematics of Finance (1):

Compound interests
• In these three lectures, we shall model selected topics in finance that deal with the time value
of money, such as investments, loans, and so on.
The compound interest whereby the interest earned by an invested amount of money (or
principal) is reinvested so that it too earns interest. That is, the interest is converted (or
compounded) into principal and hence there is “interest on interest”.

• 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.

Examples:
1. Suppose $1,000 is invested for 10 years at 6% compounded annually.
a. Find the compound amount.
b. Find the compound interest.
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%
a. compounded semiannually?
b. compounded quarterly?
c. Which account should we choose?

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.

4. How long will it take for $500 to amount to $700 if it is invested at 8% compounded
quarterly?

• 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.
m
æ iquoted ö
Effective annual rate = çç1 + ÷÷ - 1
è m ø
Example
5. Determine the effective annual rates for the deposits in example 2, part (a) and (b).

Answers to Examples

Example 1
1
a. $1790.85
b. $790.85

Example 2

a. $4537.77
b. $4551.67
c. The account with interest rate of 6% compounded quarterly.

Example 3

The nominal rate of interest is 9.19%.

Example 4

4.25 years

Example 5

a. 6.09%
b. 6.14%

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Lecture 6.2 Mathematics of Finance (2):
Present value
• Suppose that $100 is deposited in a savings account that pays 6% compounded annually.
Then at the end of 1 year the account is worth
$100(1 + 6% ) = $106
We say that the compounded amount $106 is the future value of the $100, and $100 is the
present value of the $106. The principal is often referred to as the present value, and the
compound amount is called the future value, since it is realized at a future date.

• The present value (P) of a compounded amount S due n years in the future is the amount, if it
were on hand today, would grow to equal the future amount.
Sn
P=
(1 + i ) n
The process of determining the present value of a cash flow is called discounting.

Example 1 (Present value)

Determine the present value of a $500 due in 10 years at a 6 percent discount rate compounded
annually.

Example 2 (Application of present value)

Ms. Choy wishes to have $90,000 2 years from now in order to buy the car she has her eye on.
What amount of money does she need to invest today at an interest rate of 6% p.a. compounded
quarterly in order to attain her goal?

Example 3 (Present value of an uneven cash flows)

Mr. Wong needs the following amounts available at the end of each of the coming three years.
How much must Mr. Wong save now in order to meet his needs? The appropriate interest rate is
8 percent p.a. compounded annually.

Year Amount needed

1 $100
2 400
3 300

Example 4 (Application of present value)

Mr. Chan has a debt of $550 due in 4 years and $550 due in 5 years. He decides to set aside a
single amount of money now to repay these two debts. Find how much must he set aside if an
interest rate of 10% compounded quarterly is assumed.

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Example 5 (Present value of an uneven cash flows)
Mr. Lei wishes to have the following amounts available at the end of each of the coming four
years to cover his son’s tuition fee.
End of Year Amount needed
1 $20,000
2 22,000
3 23,000
4 24,000
Given that the interest rate is 4% p.a. compounded quarterly, how much must Mr. Lei invest now
in order to meet the above expenses?

Answers to Examples

Example 1

$279.2

Example 2

$79,894

Example 3

$673.68

Example 4

$706.14

Example 5

$80,415.28

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Lecture 6.3 Mathematics of Finance (3)
Annuities; Target Deposits
• An annuity is a series of equal payments made at fixed intervals for a specified number of
periods. The payment is denoted by a.
1. If the payments come at the end of each period, then the annuity is called an ordinary
annuity.
2. If the payments come at the beginning of each period, then the annuity is called an
annuity due.

• Future value of an ordinary annuity:

Consider an account earning interest at the rate of 6% p.a., compounded annually, and
suppose that $100 is invested at the end of every year for 6 years. The successive balances
are

100(1.06 ) , 100(1.06 ) , 100(1.06 ) , 100(1.06 ) , 100(1.06 ), 100

5 4 3 2

and this is an example of a geometric progression (G.P.):

a, ar , ar 2 , !, ar n -1

RECALL: The sum s of the first n terms of a geometric series is:

s = a + ar + ar 2 + ! + ar n -1 =
(
a 1- rn )
1- r

The same is true of the balances from a number of equal payments, made at regular intervals,
and the total balance is calculated by adding up the terms of the G.P

Thus, the future value of an ordinary annuity can be calculated as:

n -1 a[(1 + i ) n - 1]
S = a + a (1 + i ) + a (1 + i ) + a (1 + i ) + ...... + a (1 + i )
2 3
= .
i

where: a = amount of each equal periodic payment, i = interest rate per compounding period,
n = number of equal periodic payments

Example 1 (Annuities)
Suppose you invest in a target deposit by depositing $2,000 at the end of every year for the next
15 years. If the interest rate is 5.7% compounded annually, how much will you have at the end
of 15 years?

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• Future value of annuity due:
a[(1 + i ) n +1 - 1]
S = a (1 + i ) + a (1 + i ) 2 + a (1 + i ) 3 + ...... + a (1 + i ) n = -a
i

where: a = amount of each equal periodic payment, i = interest rate per compounding period,
n = number of equal periodic payments

Example 2 (Annuities due)

Suppose you invest in a target deposit by depositing $2,000 at the beginning of every year for the
next 15 years. If the interest rate is 5.7% compounded annually, how much will you have at the
end of 15 years?

Example 3 (Target deposits)

As a saving program toward their child’s college education, Mr. Wong decides to deposit $100 at
the end of every month into a bank account paying interest at the rate of 6% per year
compounded monthly. If the saving program began when the child was 6 years old, how much
money would have accumulated by the time the child turns 18?

Example 4 (Target deposits)

Mr. and Mrs. Chan are planning to go to Europe 3 yr from now and have agreed to set aside
$500/month for their trip. If they deposit this money at the beginning of each month into a
savings account paying interest at the rate of 2% compounded monthly, how much money will
be in their travel fund at the end of the third year?

• Present value of an ordinary annuity:

é æ 1 ön ù
C ê1 - ç ÷ ú
C C C C ê è 1 + i ø ûú
ë
P= + + +!+ =
(1 + i )
1
(1 + i ) 2
(1 + i )
3
(1 + i )n i

where: C = amount of each equal periodic payment, i = interest rate per compounding
period, n = number of equal periodic payments

Example 5 (Present value of ordinary annuity)

Suppose you wish to have $500 at the end of each of the next four years. Assuming an interest
rate of 4% compounded annually, how much you need to save now so as to ensure that you get
the $500 in the coming four years?

Example 6 (Present value of ordinary annuity)

Find the present value of an ordinary annuity of $100 per month for 3.5 years at an interest rate
of 6% compounded monthly.

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Example 7 (Present value of ordinary annuity)
Jeff Jones would like to receive payments of $4000 each quarter for 10 years after he retires. The
first withdrawal will be made one quarter after his retirement. Money is worth 8% compounded
quarterly.
a. How much money must he have on deposit at retirement in order to receive these payments?
b. If Jeff will retire in 15 years, what single deposit should he make now so that he will have the
necessary funds at retirement determined in part (a)?
c. How much interest will the single deposit in part (b) earn over the 25 years’ time?

• Present value of annuity due:

é æ 1 ön ù
C (1 + i )ê1 - ç ÷ ú
C C C C ê è 1 + i ø ûú
ë
P=C+ + + +!+ =
(1 + i )
1
(1 + i ) 2
(1 + i )
3
(1 + i )n-1 i

where: C = amount of each equal periodic payment, i = interest rate per compounding
period, n = number of equal periodic payments

Example 8 (Present value of annuity due)

Suppose you wish to have $500 at the beginning of each of the next four years. Assuming an
interest rate of 4% compounded annually, how much you need to save now so as to ensure that
you get the $500 in the coming four years?

Answers to Examples

Example 1 Example 5
$45,502 $1814.95

Example 2 Example 6
$48,095.67 $3779.83

Example 3 Example 7
$21,015.02 a. $109,421.92 ; b. $33349.86 ; c. $126650.14

Example 4 Example 8
$18,565.95 $1887.55