MATH1510

Financial Mathematics I

Jitse Niesen
University of Leeds

January – May 2012

Description of the module

This is the description of the module as it appears in the module catalogue.

Objectives
Introduction to mathematical modelling of financial and insurance markets with
particular emphasis on the time-value of money and interest rates. Introduction
to simple financial instruments. This module covers a major part of the Faculty
and Institute of Actuaries CT1 syllabus (Financial Mathematics, core technical).

Learning outcomes
On completion of this module, students should be able to understand the time
value of money and to calculate interest rates and discount factors. They should
be able to apply these concepts to the pricing of simple, fixed-income financial
instruments and the assessment of investment projects.

Syllabus
• Interest rates. Simple interest rates. Present value of a single future
payment. Discount factors.

• Effective and nominal interest rates. Real and money interest rates. Com-
pound interest rates. Relation between the time periods for compound
interest rates and the discount factor.

• Compound interest functions. Annuities and perpetuities.

• Loans.

• Introduction to fixed-income instruments. Generalized cashflow model.

• Net present value of a sequence of cashflows. Equation of value. Internal

rate of return. Investment project appraisal.

• Examples of cashflow patterns and their present values.

• Elementary compound interest problems.

MATH1510 i
Reading list
These lecture notes are based on the following books:
1. Samuel A. Broverman, Mathematics of Investment and Credit, 4th ed.,
ACTEX Publications, 2008. ISBN 978-1-56698-657-1.

2. The Faculty of Actuaries and Institute of Actuaries, Subject CT1: Finan-

cial Mathematics, Core Technical. Core reading for the 2009 examinations.
3. Stephen G. Kellison, The Theory of Interest, 3rd ed., McGraw-Hill, 2009.
ISBN 978-007-127627-6.

4. John McCutcheon and William F. Scott, An Introduction to the Mathe-

matics of Finance, Elsevier Butterworth-Heinemann, 1986. ISBN 0-7506-
0092-6.
5. Petr Zima and Robert L. Brown, Mathematics of Finance, 2nd ed., Schaum’s
Outline Series, McGraw-Hill, 1996. ISBN 0-07-008203.

The syllabus for the MATH1510 module is based on Units 1–9 and Unit 11 of
book 2. The remainder forms the basis of MATH2510 (Financial Mathemat-
ics II). The book 2 describes the first exam that you need to pass to become an
accredited actuary in the UK. It is written in a concise and perhaps dry style.
These lecture notes are largely based on Book 4. Book 5 contains many exer-
cises, but does not go quite as deep. Book 3 is written from a U.S. perspective, so
the terminology is slightly different, but it has some good explanations. Book 1
is written by a professor from a U.S./Canadian background and is particularly
good in making connections to applications.
All these books are useful for consolidating the course material. They allow
you to gain background knowledge and to try your hand at further exercises.
However, the lecture notes cover the entire syllabus of the module.

ii MATH1510
Organization for 2011/12

Lecturer Jitse Niesen

E-mail [email protected]
Office Mathematics 8.22f
Telephone 35870 (from outside: 0113 3435870)
Lectures Tuesdays 10:00 – 11:00 in Roger Stevens LT 20
Wednesdays 12:00 – 13:00 in Roger Stevens LT 25
Fridays 14:00 – 15:00 in Roger Stevens LT 17
Example classes Mondays in weeks 3, 5, 7, 9 and 11,
see your personal timetable for time and room.
Tutors Niloufar Abourashchi, Zhidi Du, James Fung, and Tongya
Wang.
Office hours Tuesdays . . . . . . . . (to be determined)
or whenever you find the lecturer and he has time.
Course work There will be five sets of course work. Put your work in
your tutor’s pigeon hole on Level 8 of School of Mathemat-
ics. Due dates are Wednesday 1 February, 15 February,
29 February, 14 March and 25 April.
Late work One mark (out of ten) will be deducted for every day.
Copying Collaboration is allowed (even encouraged), copying not.
See the student handbook for details.
Exam The exam will take place in the period 14 May – 30 May;
exact date and location to be announced.
Assessment The course work counts for 15%, the exam for 85%.
Lecture notes These notes and supporting materials are available in the
Blackboard VLE.

MATH1510 iii
iv MATH1510
Chapter 1

The time value of money

Interest is the compensation one gets for lending a certain asset. For instance,
suppose that you put some money on a bank account for a year. Then, the bank
can do whatever it wants with that money for a year. To reward you for that,
it pays you some interest.
The asset being lent out is called the capital. Usually, both the capital and
the interest is expressed in money. However, that is not necessary. For instance,
a farmer may lend his tractor to a neighbour, and get 10% of the grain harvested
in return. In this course, the capital is always expressed in money, and in that
case it is also called the principal.

1.1 Simple interest

Interest is the reward for lending the capital to somebody for a period of time.
There are various methods for computing the interest. As the name implies,
simple interest is easy to understand, and that is the main reason why we talk
about it here. The idea behind simple interest is that the amount of interest
is the product of three quantities: the rate of interest, the principal, and the
period of time. However, as we will see at the end of this section, simple interest
suffers from a major problem. For this reason, its use in practice is limited.
Definition 1.1.1 (Simple interest). The interest earned on a capital C lent
over a period n at a rate i is niC.
Example 1.1.2. How much interest do you get if you put 1000 pounds for two
years in a savings acount that pays simple interest at a rate of 9% per annum?
And if you leave it in the account for only half ar year?
Answer. If you leave it for two years, you get

2 · 0.09 · 1000 = 180

pounds in interest. If you leave it for only half a year, then you get 12 ·0.09·1000 =
45 pounds.
As this example shows, the rate of interest is usually quoted as a percentage;
9% corresponds to a factor of 0.09. Furthermore, you have to be careful that
the rate of interest is quoted using the same time unit as the period. In this

MATH1510 1
example, the period is measured in years, and the interest rate is quoted per
annum (“per annum” is Latin for “per year”). These are the units that are used
most often. In Section 1.5 we will consider other possibilities.

Example 1.1.3. Suppose you put £1000 in a savings account paying simple
interest at 9% per annum for one year. Then, you withdraw the money with
interest and put it for one year in another account paying simple interest at 9%.
How much do you have in the end?
Answer. In the first year, you would earn 1·0.09·1000 = 90 pounds in interest, so
you have £1090 after one year. In the second year, you earn 1 · 0.09 · 1090 = 98.1
pounds in interest, so you have £1188.10 (= 1090 + 98.1) at the end of the two
years.

Now compare Examples 1.1.2 and 1.1.3. The first example shows that if you
invest £1000 for two years, the capital grows to £1180. But the second example
shows that you can get £1188.10 by switching accounts after a year. Even better
is to open a new account every month.
This inconsistency means that simple interest is not that often used in prac-
tice. Instead, savings accounts in banks pay compound interest, which will be
introduced in the next section. Nevertheless, simple interest is sometimes used,
especially in short-term investments.

Exercises
1. (From the 2010 exam) How many days does it take for £1450 to accumu-
late to £1500 under 4% p.a. simple interest?

2. (From the sample exam) A bank charges simple interest at a rate of 7% p.a.
on a 90-day loan of £1500. Compute the interest.

1.2 Compound interest

Most bank accounts use compound interest. The idea behind compound interest
is that in the second year, you should get interest on the interest you earned in
the first year. In other words, the interest you earn in the first year is combined
with the principal, and in the second year you earn interest on the combined
sum.
What happens with the example from the previous section, where the in-
vestor put £1000 for two years in an account paying 9%, if we consider com-
pound interest? In the first year, the investor would receive £90 interest (9%
of £1000). This would be credited to his account, so he now has £1090. In
the second year, he would get £98.10 interest (9% of £1090) so that he ends
up with £1188.10; this is the same number as we found before. The capital is
multiplied by 1.09 every year: 1.09 · 1000 = 1090 and 1.09 · 1090 = 1188.1.
More generally, the interest over one year is iC, where i denotes the interest
rate and C the capital at the beginning of the year. Thus, at the end of the year,
the capital has grown to C + iC = (1 + i)C. In the second year, the principal
is (1 + i)C and the interest is computed over this amount, so the interest is
i(1 + i)C and the capital has grown to (1 + i)C + i(1 + i)C = (1 + i)2 C. In
the third year, the interest is i(1 + i)2 C and the capital has grown to (1 + i)3 C.

2 MATH1510
This reasoning, which can be made more formal by using complete induction,
leads to the following definition.
Definition 1.2.1 (Compound interest). A capital C lent over a period n at a
rate i grows to (1 + i)n C.
Example 1.2.2. How much do you have after you put 1000 pounds for two
years in a savings acount that pays compound interest at a rate of 9% per
annum? And if you leave it in the account for only half ar year?
Answer. If you leave it in the account for two years, then at the end you have
(1 + 0.09)2 · 1000 = 1188.10,
as we computed above. If you leave it in the account for only half a year, then
at the end you have
√
(1 + 0.09)1/2 · 1000 = 1.09 · 1000 = 1044.03
pounds (rounded to the nearest penny). This is 97p less than the 45 pounds
interest you get if the account would pay simple interest at the same rate (see
Example 1.1.2).
Example 1.2.3. Suppose that a capital of 500 dollars earns 150 dollars of
interest in 6 years. What was the interest rate if compound interest is used?
What if simple interest is used?
Answer. The capital accumulated to $650, so in the case of compound interest
we have to solve the rate i from the equation
(1 + i)6 · 500 = 650 ⇐⇒ (1 + i)6 = 1.3
⇐⇒ 1 + i = 1.31/6 = 1.044698 . . .
⇐⇒ i = 0.044698 . . .
Thus, the interest rate is 4.47%, rounded to the nearest basis point (a basis point
is 0.01%). Note that the computation is the same, regardless of the currency
used.
In the case of simple interest, the equation to solve 6 · i · 500 = 150, so
150
i = 6·500 = 0.05, so the rate is 5%.
Example 1.2.4. How long does it take to double your capital if you put it in
an account paying compound interest at a rate of 7 12 %? What if the account
pays simple interest?
Answer. The question is for what value of n does a capital C accumulate to 2C
if i = 0.075. So we have to solve the equation 1.075n C = 2C. The first step is
to divide by C to get 1.075n = 2. Then take logarithms:
log(2)
log(1.075n ) = log(2) ⇐⇒ n log(1.075) = log(2) ⇐⇒ n = = 9.58 . . .
log(1.075)
So, it takes 9.58 years to double your capital. Note that it does not matter
how much you have at the start: it takes as long for one pound to grow to two
pounds as for a million pounds to grow to two million.
The computation is simpler for simple interest. We have to solve the equation
1
n · 0.075 · C = C, so n = 0.075 = 13 31 , so with simple interest it takes 13 13 years
to double your capital.

MATH1510 3
More generally, if the interest rate is i, then the time required to double your
capital is
log(2)
n= .
log(1 + i)
We can approximate the denominator by log(1 + i) ≈ i for small i; this is
the first term of the Taylor series of log(1 + i) around i = 0 (note that, as is
common in mathematics, “log” denotes the natural logarithm). Thus, we get
n ≈ log(2)
i . If instead of the interest rate i we use the percentage p = 100i, and
we approximate log(2) = 0.693 . . . by 0.72, we get
72
n≈ .
p
This is known as the rule of 72 : To calculate how many years it takes you to
double your money, you divide 72 by the interest rate expressed as a percentage.
Let us return to the above example with a rate of 7 12 %. We have p = 7 12 so we
compute 72/7 12 = 9.6, which is very close to the actual value of n = 9.58 we
computed before.
The rule of 72 can already be found in a Italian book from 1494: Summa de
Arithmetica by Luca Pacioli. The use of the number 72 instead of 69.3 has two
advantages: many numbers divide 72, and it gives a better approximation for
rates above 4% (remember that the Taylor approximation is centered around
i = 0; it turns out that it is slightly too small for rates of 5–10% and using 72
instead of 69.3 compensates for this).
Remember that with simple interest, you could increase the interest you earn
by withdrawing your money from the account halfway. Compound interest has
the desirable property that this does not make a difference. Suppose that you
put your money m years in one account and then n years in another account,
and that both account pay compount interest at a rate i. Then, after the
first m years, your capital has grown to (1 + i)m C. You withdraw that and
put it in another account for n years, after which your capital has grown to
(1 + i)n (1 + i)m C. This is the same as what you would get if you had kept the
capital in the same account for m + n years, because

(1 + i)n (1 + i)m C = (1 + i)m+n C.

This is the reason why compound interest is used so much in practice. Unless
noted otherwise, interest will always refer to compound interest.

Exercises
1. The rate of interest on a certain bank deposit account is 4 21 % per annum
effective. Find the accumulation of £5000 after seven years in this account.

2. (From the sample exam) How long does it take for £900 to accumulate to
£1000 under an interest rate of 4% p.a.?

4 MATH1510
 2.5 2.5

2 2
final capital

final capital
1.5 1.5

1 1

0.5 0.5
simple
compound
0 0
0 2 4 6 8 10 0 5 10 15
time (in years) interest rate (%)

Figure 1.1: Comparison of simple interest and compound interest. The left
figure plots the growth of capital in time at a rate of 9%. The right figure plots
the amount of capital after 5 years for various interest rates.

1.3 Comparing simple and compound interest

Simple interest is defined by the formula “interest = inC.” Thus, in n years the
capital grows from C to C + niC = (1 + ni)C. Simple interest and compound
interest compare as follows:

simple interest: capital after n years = (1 + ni)C

compound interest: capital after n years = (1 + i)n C

These formulas are compared in Figure 1.1. The left plot shows how a principal
of 1 pound grows under interest at 9%. The dashed line is for simple interest and
the solid curve for compound interest. We see that compound interest pays out
more in the long term. A careful comparison shows that for periods less than a
year simple interest pays out more, while compound interest pays out more if the
period is longer than a year. This agrees with what we found before. A capital
of £1000, invested for half a year at 9%, grows to £1045 under simple interest
and to £1044.03 under compound interest, while the same capital invested for
two years grows to £1180 under simple interest and £1188.10 under compound
interest. The difference between compound and simple interest get bigger as
the period gets longer.
This follows from the following algebraic inequalities: if i is positive, then

(1 + i)n < 1 + ni if n < 1,

n
(1 + i) > 1 + ni if n > 1.

These will not be proven here. However, it is easy to see that the formulas
for simple and compound interest give the same results if n = 0 and n = 1.
Now consider the case n = 2. A capital C grows to (1 + 2i)C under simple
interest and to (1 + i)2 C = (1 + 2i + i2 )C under compound interest. We have
(1 + 2i + i2 )C > (1 + 2i)C (because C is positive), so compound interest pays
out more than simple interest.
The right plot in Figure 1.1 shows the final capital after putting a principal
of 1 pound away for five years at varying interest rates. Again, the dashed line
corresponds to simple interest and the solid curve corresponds to compound

MATH1510 5
 lating
accumu

ting
discoun
present value future value
= £1624.24 = £2000.00

t=0 t=5

Figure 1.2: The time value of money: £1624.24 now is equivalent to £2000 in
five years at a rate of 4 14 %.

interest. We see again that compound interest pays out more, as n = 5 is

greater than 1. However, the plot also shows that the difference is smaller if the
interest rate is small.
This can be explained with the theory of Taylor series. A capital C will grow
in n years to (1 + i)n C. The Taylor series of f (i) = (1 + i)n C around i = 0 is

f (0) + f 0 (0)i + 12 f 00 (0)i2 + · · · = C + niC + 21 n(n − 1)i2 C + · · · .

The first two terms are C + niC = (1 + ni)C, which is precisely the formula
for simple interest. Thus, you can use the formula for simple interest as an ap-
proximation for compound interest; this approximation is especially good if the
rate of interest is small. Especially in the past, people often used simple inter-
est instead of compound interest, notwithstanding the inconsistency of simple
interest, to simplify the computations.

1.4 Discounting
The formula for compound interest relates four quantities: the capital C at the
start, the interest rate i, the period n, and the capital at the end. We have seen
how to calculate the interest rate (Example 1.2.3), the period (Example 1.2.4),
and the capital at the end (Example 1.2.2). The one remaining possibility is
covered in the next example.

Example 1.4.1. How much do you need to invest now to get £2000 after five
years if the rate of interest is 4 14 %?
Answer. One pound will accumulate to (1 + 0.0425)5 = 1.2313466 in five years,
so you need to invest 2000/1.2313466 = 1624.24 pounds.

We say that £1624.24 now is equivalent to £2000 in five years at a rate of 4 41 %.

We call £1624.24 the present value and £2000 the future value. When you move
a payment forward in time, it accumulates; when you move it backward, it is
discounted (see Figure 1.2).

6 MATH1510
 discount accumulate
(by one year) (over one year)

d
1+i
1
v

t=0

Figure 1.3: The relation between the interest rate i, the rate of discount d and
the discount factor v.

This shows that money has a time value: the value of money depends on
the time. £2000 now is worth more than £2000 in five years’ time. In financial
mathematics, all payments must have a date attached to them.
More generally, suppose the interest rate is i. How much do you need to
1
invest to get a capital C after one time unit? The answer is 1+i C. The factor

1
v= . (1.1)
1+i
is known as the discount factor. It is the factor with which you have to multiply
a payment to shift it backward by one year (see Figure 1.3). If the interest rate
is 4 41 %, then the discount factor is 1.0425
1
= 0.95923.
Provided the interest rate is not too big, the discount factor is close to one.
Therefore people often use the rate of discount d = 1 − v, usually expressed as a
percentage (compare how the interest rate i is used instead of the “accumulation
factor” 1 + i). In our example, the rate of discount is 0.04077 or 4.077%.
Example 1.4.2. Suppose that the interest rate is 7%. What is the present
value of a payment of e70 in a year’s time?
Answer. The discount factor is v = 1/1.07 = 0.934579, so the present value is
0.934579 · 70 = 65.42 euro (to the nearest cent).
Usually, interest is paid in arrears. If you borrow money for a year, then at the
end of the year you have to pay the money back plus interest. However, there
are also some situations in which the interest is paid in advance. The rate of
discount is useful in these situations, as the following example shows.
Example 1.4.3. Suppose that the interest rate is 7%. If you borrow e1000 for
a year and you have to pay interest at the start of the year, how much do you
have to pay?

MATH1510 7
Answer. If interest were to be paid in arrears, then you would have to pay
0.07 · 1000 = 70 euros at the end of the year. However, you have to pay the
interest one year earlier. As we saw in Example 1.4.2, the equivalent amount is
v · 70 = 65.42 euros.
There is another way to arrive at the answer. At the start of the year, you
get e1000 from the lender but you have to pay interest immediately, so in effect
you get less from the lender. At the end of the year, you pay e1000 back. The
amount you should get at the start of the year should be equivalent to the e1000
you pay at the end of the year. The discount factor is v = 1/1.07 = 0.934579,
so the present value of the e1000 at the end of the year is e934.58. Thus, the
interest you have to pay is e1000 − e934.58 = e65.42.

In terms of the interest rate i = 0.07 and the capital C = 1000, the first method
calculates ivC and the second method calculates C − vC = (1 − v)C = dC.
Both methods yield the same answer, so we arrive at the important relation

d = iv. (1.2)

We can check this relation algebraically. We found before, in equation (1.1),

that the discount factor is
1
v= .
1+i
The rate of discount is
1 i
d=1−v =1− = . (1.3)
1+i 1+i
Comparing these two formulas, we find that indeed d = iv.
We summarize this discussion with a formal definition of the three quantities
d, i and v.

Definition 1.4.4. The rate of interest i is the interest paid at the end of a
time unit divided by the capital at the beginning of the time unit. The rate
of discount d is the interest paid at the beginning of a time unit divided by
the capital at the end of the time unit. The discount factor v is the amount of
money one needs to invest to get one unit of capital after one time unit.

This definition concerns periods of one year (assuming that time is measured in
years). In Example 1.4.1, we found that the present value of a payment of £2000
due in five years is £1624.24, if compound interest is used at a rate of 4 14 %. This
was computed as 2000/(1 + 0.0425)5 . The same method can be used to find the
present value of a payment of C due in n years if compound interest is used at
a rate i. The question is: which amount x accumulates to C in n years? The
formula for compound interest yields that (1 + i)n x = C, so the present value x
is
C
= v n C = (1 − d)n C. (1.4)
(1 + i)n
This is called compound discounting, analogous with compound interest.
There is another method, called simple discounting (analogous to simple
interest) or commercial discounting. This is defined as follows. The present
value of a payment of C due in n years, at a rate of simple discount of d, is
(1 − nd)C.

8 MATH1510
 Simple discounting is not the same as simple interest. The present value of
a payment of C due in n years, at a rate of simple interest of i, is the amount x
that accumulates to C over n years. Simple interest is defined by C = (1 + ni)x,
so the present value is x = (1 + ni)−1 C.

Example 1.4.5. What is the present value of £6000 due in a month assum-
ing 8% p.a. simple discount? What is the corresponding rate of (compound)
discount? And the rate of (compound) interest? And the rate of simple interest?
1 1
Answer. One month is 12 year, so the present value of is (1 − 12 · 0.08) · 6000 =
5960 pounds. We can compute the rate of (compound) discount d from the
formula “present value = (1 − d)n C”:

5960 = (1 − d)1/12 · 6000 =⇒ (1 − d)1/12 = 5960

6000 = 0.993333
12
=⇒ 1 − d = 0.993333 = 0.922869
=⇒ d = 0.077131.

Thus, the rate of discount is 7.71%. The rate of (compound) interest i follows
from
1
= 1 − d = 0.922869 =⇒ 1 + i = 1.083577
1+i
so the rate of (compound) interest is 8.36%. Finally, to find the rate of simple
1
interest, solve 5960 = (1 + 12 i)−1 6000 to get i = 0.080537, so the rate of simple
interest is 8.05%.

One important application for simple discount is U.S. Treasury Bills. However,
it is used even less in practice than simple interest.

Exercises
1. In return for a loan of £100 a borrower agrees to repay £110 after seven
months.

(a) Find the rate of interest per annum.

(b) Find the rate of discount per annum.
(c) Shortly after receiving the loan the borrower requests that he be
allowed to repay the loan by a payment of £50 on the original set-
tlement date and a second payment six months after this date. As-
suming that the lender agrees to the request and that the calculation
is made on the original interest basis, find the amount of the second
payment under the revised transaction.

2. The commercial rate of discount per annum is 18% (this means that simple
discount is applied with a rate of 18%).

(a) We borrow a certain amount. The loan is settled by a payment of

£1000 after three months. Compute the amount borrowed and the
effective annual rate of discount.
(b) Now the loan is settled by a payment of £1000 after nine months.
Answer the same question.

MATH1510 9
1.5 Interest payable monthly, quarterly, etc.
Up to now, we assumed that interest is paid once a year. In practice interest is
often paid more frequently, for instance quarterly (four times a year). This is
straightforward if the interest rate is also quoted per quarter, as the following
example shows.

Example 1.5.1. Suppose that you save £1000 in an account that pays 2%
interest every quarter. How much do you have in one year, if the interest is paid
in the same account?
Answer. We can use the formula for compound interest in Definition 1.2.1,
which says that a capital C accumulates to (1 + i)n C over a period n, if the
rate is i. The rate i = 0.02 is measured in quarters, so we also have to measure
the period n in quarters. One year is four quarters, so the capital accumulates
to 1.024 · 1000 = 1082.43 pounds.

However, interest rates are usually not quoted per quarter even if interest is paid
quarterly. The rate is usually quoted per annum (p.a.). In the above example,
with 2% per quarter, the interest rate would be quoted as 8% p.a. payable
quarterly. This rate is called the nominal interest rate payable quarterly. You
may also see the words “convertible” or “compounded” instead of “payable”.
It may seem more logical to quote the rate as 8.243%. After all, we computed
that £1000 accumulates to £1082.43 in a year. The rate of 8.243% is called the
effective interest rate. It often appears in advertisements in the U.K. as the
Annual Equivalent Rate (AER). The effective interest rate corresponds to the
interest rate i as defined in Definition 1.4.4: the interest paid at the end of a
time unit divided by the capital at the beginning of the time unit.

Definition 1.5.2. The interest conversion period is the period between two
successive interest payments. Denote the quotient of the time unit and the
interest conversion period by p. Let i[p] denote the interest rate per conversion
period. The nominal interest rate, denoted i(p) , is then p times i[p] .

Common values for p include p = 365 (interest payable daily) and p = 12

(interest payable monthly). The term “interest payable pthly” is used if we
do not want to specify the conversion period. In the example, the interest
conversion period is a quarter and the time unit is a year, so p = 4. The
interest rate per quarter is 2%, meaning that i[4] = 0.02, so the nominal interest
rate is i(4) = 4 · 0.02 = 0.08 or 8%, and the effective interest rate is i = 0.08243.
To compute the effective interest rate from the nominal interest rate i(p) ,
remember that the interest rate per conversion period is i[p] = i(p) /p. There
are p conversion periods in a time unit. Thus, by the formula for compound
interest, a capital C accumulates to (1 + i[p] )p C = (1 + i(p) /p)p C in a time
unit. However, if the effective interest rate is i, then a capital C accumulates
to (1 + i)C in a time unit. Thus, a nominal interest rate i(p) payable pthly is
equivalent to an effective interest rate i if
p
i(p)

1+i= 1+ . (1.5)
p

10 MATH1510
Example 1.5.3. Suppose that an account offers a nominal interest rate of 8%
p.a. payable quarterly. What is the AER? What if the nominal rate is the same,
but interest is payable monthly? Weekly? Daily?
Answer. For interest payable quarterly, we put p = 4 and i(4) = 0.08 in (1.5) to
find  4
0.08
1+i= 1+ = 1.08243,
4
so the AER is 8.243%. This is the example we considered above. In the other
cases, we find:
 12
0.08
monthly (p = 12) : 1 + i = 1 + = 1.08300
12
 52
0.08
weekly (p = 52) : 1+i= 1+ = 1.08322
52
 365
0.08
daily (p = 365) : 1+i= 1+ = 1.08328
365
So, the AER is 8.300% for interest payable monthly, 8.322% for interest payable
weekly, and 8.328% for interest payable daily.
It looks like the numbers converge to some limit as the conversion period
gets shorter. This idea will be taken up at the end of the module.
There is an alternative but equivalent definition of the symbol i(p) , which leads
naturally to the valuation of annuities described in the next chapter. In Exam-
ple 1.5.1, we assumed that the interest is paid in the account so that it generates
more interest. If this is not the case, but you use the interest for other purposes,
then the amount in the account will remain constant at £1000. You will get
£20 interest after each quarter. This is equivalent to receiving £82.43 at the
end of the year, given an (effective) interest rate of 8.243% p.a., as the following
computation shows:
• £20 at the end of the first quarter is equivalent to 1.082433/4 · 20 = 21.22
pounds at the end of the year.
• £20 at the end of the second quarter is equivalent to 1.082431/2 ·20 = 20.81
pounds at the end of the year.
• £20 at the end of the third quarter is equivalent to 1.082431/4 · 20 = 20.40
pounds at the end of the year.
Thus, £20 at the end of each quarter is equivalent to 21.22 + 20.81 + 20.40 +
20.00 = 82.43 pounds at the end of the year.
More generally, a capital of 1 generates i(p) /p interest per conversion period.
We can either leave the interest in the account, in which case the capital accu-
mulates to 1 + i = (1 + i(p) /p)p at the end of the year, as we computed above,
so we get a payment of i at the end of the year. Or we can take the interest as
soon as it is paid, so we get p payments of i(p) /p each at times p1 , p2 , . . . , 1. The
payment of i(p) /p at time kp is equivalent to

i(p)
(1 + i)(p−k)/p
p

MATH1510 11
at the end of the year, because it needs to be shifted p − k periods forward.
Thus, the series of p payments is equivalent to
p
X i(p)
(1 + i)(p−k)/p
p
k=1

at the end of the year. If we make the substitution n = p − k, we get

p p−1
X i(p) X i(p)
(1 + i)(p−k)/p .= (1 + i)n/p .
p n=0
p
k=1

This sum can be evaluated with the following formula for a geometric sum:
n
X rn+1 − 1
1 + r + r2 + · · · + rn = rk = . (1.6)
r−1
k=0

Thus, we find that the series of p payments is equivalent to

p−1
p
X
n/p i
(p) (1 + i)1/p − 1 i(p)
(1 + i) =
n=0
p (1 + i)1/p − 1 p
i i(p)
=  =i
1+ i(p)
p −1 p

at the end of the year, where in the last line we used that 1+i = (1+i(p) /p)p , as
stated in (1.5). Thus, a series of p payments of i(p) /p each at times p1 , p2 , . . . , 1
is equivalent to a payment of i at time 1.
This is illustrated in Figure 1.4, which shows four equivalent ways to pay
interest on a principal of 1. The top two rows show that a payment of d now
is equivalent to a payment of i in a year’s time. Indeed, the present value
of the latter payment is iv, and in Section 1.4 we found that iv = d. The
discussion in the preceding paragraph shows that a total payment of i(p) in
p equal installments, one at the end of every period of 1/p year.
A similar discussion can be had for discounting instead of accumulating
interest. A rate of discount of 2% compounded quarterly gives rise to a nominal
rate of discount of 8% per annum. However, the present value of a payment
of C due in one year is (1 − 0.02)4 C = 0.9224C, see (1.4). Thus, the effective
rate of discount is d = 0.0776 or 7.76%.
Definition 1.5.4. The nominal rate of discount compounded pthly, denoted d(p) ,
is p times the rate of discount per conversion period.
A similar computation as the one leading to (1.5) yields that
p
d(p)

1−d= 1− . (1.7)
p
In Section 1.4, we concluded that the rate of discount arises in two situations:
when computing the present value of a payment and when interest is paid in
advance. Indeed, if the principal at the end of a time unit is 1 and interest is
paid in advance, then the interest is d by Definition 1.4.4. Analogously to the

12 MATH1510
 i

t=0 t=1

t=0 t=1

i(p)
p

t = 0 1/p 2/p ... t=1

d(p)
p

t = 0 1/p 2/p ... t=1

Figure 1.4: The following four situations are equivalent: A payment of i at

the end of the year, a payment of d at the beginning of the year, a series of p
payments of i(p) /p each at the end of every 1/p of a year, and a series of p
payments of d(p) /p each at the beginning of every 1/p of a year.

discussion under (1.5), it can be shown that if interest is paid pthly in advance,
then the total interest is d(p) . In other words, p payments of d(p) /p each at the
beginning of every period of 1/p time unit is equivalent to one payment of d at
the beginning of the time unit. This follows from the computation
p−1
p
X
k/p d
(p) (1 − d)1/p − 1 d(p) d d(p)
(1 − d) = =   = d.
k=0
p (1 − d)1/p − 1 p 1 − dp − 1 p
(p)

This is illustrated in the fourth row of Figure 4.1.

Example 1.5.5 (Kellison, p. 22). Compare the following three loans: a loan
charging an annual effective rate of 9%, a loan charging 8 43 % compounded quar-
terly, and a loan charging 8 12 % payable in advance and convertible monthly.
Answer. We will convert all rates to annual effective rates. For the second loan,
we use (1.5) with p = 4 and i(4) = 0.0875 to get 1+i = (1+i(p) /p)p = 1.0904, so
the annual effective rate is 9.04%. For the third loan, we use (1.7) with p = 12
and d(12) = 0.085 to get 1 − d = (1 − d(p) /p)p = 0.91823. Then, we use (1.1)
and (1.3) to deduce that 1 + i = v1 = 1−d
1
= 1.0890, so the annual effective rate
is 8.90%. Thus, the third loan has the most favourable interest rate.
Consider again the equivalent payments in Figure 1.4. A payment of i at the
end of the year is equivalent to a payment of d at the start of the year. However,

MATH1510 13
a payment made later is worth less than a payment made earlier. It follows that
i has to be bigger than d. Similarly, the p payments of i(p) /p each in the third
row are done before the end of the year, with the exception of the last payment.
Thus i(p) has to be smaller than i. Continuing this reasoning, we find that the
discount and interest rates are ordered as followed.

d < d(2) < d(3) < d(4) < · · · < i(4) < i(3) < i(2) < i.

Exercises
1. Express i(m) in terms of d(`) , ` and m. Hence find i(12) when d(4) =
0.057847.
2. (From the 2010 exam) How many days does it take for £1450 to accumu-
late to £1500 under an interest rate of 4% p.a. convertible monthly?
3. (From the sample exam) Compute the nominal interest rate per annum
payable monthly that is equivalent to the simple interest rate of 7% p.a.
over a period of three months.

14 MATH1510
Chapter 2

Annuities and loans

An annuity is a sequence of payments with fixed frequency. The term “annuity”

originally referred to annual payments (hence the name), but it is now also used
for payments with any frequency. Annuities appear in many situations; for
instance, interest payments on an investment can be considered as an annuity.
An important application is the schedule of payments to pay off a loan.
The word “annuity” refers in everyday language usually to a life annuity. A
life annuity pays out an income at regular intervals until you die. Thus, the
number of payments that a life annuity makes is not known. An annuity with a
fixed number of payments is called an annuity certain, while an annuity whose
number of payments depend on some other event (such as a life annuity) is a
contingent annuity. Valuing contingent annuities requires the use of probabil-
ities and this will not be covered in this module. These notes only looks at
annuities certain, which will be called “annuity” for short.

2.1 Annuities immediate

The analysis of annuities relies on the formula for geometric sums:
n
X rn+1 − 1
1 + r + r2 + · · · + rn = rk = . (2.1)
r−1
k=0

This formula appeared already in Section 1.5, where it was used to relate nom-
inal interest rates to effective interest rates. In fact, the basic computations for
annuities are similar to the one we did in Section 1.5. It is illustrated in the
following example.

Example 2.1.1. At the end of every year, you put £100 in a savings account
which pays 5% interest. You do this for eight years. How much do you have at
the end (just after your last payment)?
Answer. The first payment is done at the end of the first year and the last
payment is done at the end of the eighth year. Thus, the first payment ac-
cumulates interest for seven years, so it grows to (1 + 0.05)7 · 100 = 140.71
pounds. The second payment accumulates interest for six years, so it grows to
1.056 · 100 = 134.01 pounds. And so on, until the last payment which does not

MATH1510 15
 1

t=0 1 2 ... t=n

an sn

Figure 2.1: The present and accumulated value of an annuity immediate.

accumulate any interest. The accumulated value of the eight payments is

1.057 · 100 + 1.056 · 100 + · · · + 100

  7
X
= 100 1 + · · · + 1.056 + 1.057 = 100 1.05k .
k=0

This sum can be evaluated with the formula for a geometric sum. Substitute
r = 1.05 and n = 7 in (2.1) to get
7
X 1.058 − 1
1.05k = = 9.5491.
1.05 − 1
k=0

Thus, the accumulated value of the eight payments is £954.91.

In the above example, we computed the accumulated value of an annuity. More
precisely, we considered an annuity with payments made at the end of every
year. Such an annuity is called an annuity immediate (the term is unfortunate
because it does not seem to be related to its meaning).
Definition 2.1.2. An annuity immediate is a regular series of payments at the
end of every period. Consider an annuity immediate paying one unit of capital
at the end of every period for n periods. The accumulated value of this annuity
at the end of the nth period is denoted sn .
The accumulated value depends on the interest rate i, but the rate is usually
only implicit in the symbol sn . If it is necessary to mention the rate explicitly,
the symbol sn i is used.
Let us derive a formula for sn . The situation is depicted in Figure 2.1. The
annuity consists of payments of 1 at t = 1, 2, . . . , n and we wish to compute
the accumulated value at t = n. The accumulated value of the first payment is
(1 + i)n−1 , the accumulated value of the second payment is (1 + i)n−2 , and so
on till the last payment which has accumulated value 1. Thus, the accumulated
values of all payments together is
n−1
X
n−1 n−2
(1 + i) + (1 + i) + ··· + 1 = (1 + i)k .
k=0

The formula for a geometric sum, cf. (2.1), yields

n−1
X (1 + i)n − 1 (1 + i)n − 1
(1 + i)k = = .
(1 + i) − 1 i
k=0

16 MATH1510
We arrive at the following formula for the accumulated value of an annuity
immediate:
(1 + i)n − 1
sn = . (2.2)
i
This formula is not valid if i = 0. In that case, there is no interest, so the
accumulated value of the annuities is just the sum of the payments: sn = n.
The accumulated value is the value of the annuity at t = n. We may also
be interested in the value at t = 0, the present value of the annuity. This is
denoted by an , as shown in Figure 2.1.

Definition 2.1.3. Consider an annuity immediate paying one unit of capital

at the end of every period for n periods. The value of this annuity at the start
of the first period is denoted an .

A formula for an can be derived as above. The first payment is made after a
1
year, so its present value is the discount factor v = 1+i . The present value of
2
the second value is v , and so on till the last payment which has a present value
of v n . Thus, the present value of all payments together is
n−1
X
v + v 2 + · · · + v n = v(1 + v + · + v n−1 ) = v vk .
k=0

Now, use the formula for a geometric sum:

n−1
X vn − 1 v
v vk = v = (1 − v n ).
v−1 1−v
k=0

v 1
The fraction 1−v can be simplified if we use the relation v = 1+i :

1
v 1 1
= 1+i1 = = .
1−v 1 − 1+i (1 + i) − 1 i

By combining these results, we arrive at the following formula for the present
value of an annuity immediate:
1 − vn
an = . (2.3)
i
Similar to equation (2.2) for sn , the equation for an is not valid for i = 0, in
which case an = n.
There is a simple relation between the present value an and the accumulated
value sn . They are value of the same sequence of payments, but evaluated at
different times: an is the value at t = 0 and sn is the value at t = n (see
Figure 2.1). Thus, an equals sn discounted by n years:

an = v n sn . (2.4)

This relation is easily checked. According to (2.2), the right-hand side evaluates
to
1+i n


(1 + i)n − 1 − vn 1 − vn
v n sn = v n = v = = an ,
i i i

MATH1510 17
 1
where the last-but-one equality follows from v = 1+i and the last equality
from (2.3). This proves (2.4).
One important application of annuities is the repayment of loans. This is
illustrated in the following example.

Example 2.1.4. A loan of e2500 at a rate of 6 12 % is paid off in ten years,

by paying ten equal installments at the end of every year. How much is each
installment?
Answer. Suppose that each installment is x euros. Then the loan is paid off by
a 10-year annuity immediate. The present value of this annuity is xa10 at 6 12 %.
i
We compute v = 1+i = 0.938967 and

1 − v 10 1 − 0.93896710
a10 = = = 7.188830.
i 0.065
The present value should be equal to e2500, so the size of each installment is
x = 2500/a10 = 347.7617 euros. Rounded to the nearest cent, this is e347.76.

Every installment in the above example is used to both pay interest and pay
back a part of the loan. This is studied in more detail in Section 2.6. Another
possibility is to only pay interest every year, and to pay back the principal at
the end. If the principal is one unit of capital which is borrowed for n years,
then the borrower pays i at the end of every year and 1 at the end of the n years.
The payments of i form an annuity with present value ian . The present value
of the payment of 1 at the end of n years is v n . These payments are equivalent
to the payment of the one unit of capital borrowed at the start. Thus, we find

1 = ian + v n .

This gives another way to derive formula (2.3). Similarly, if we compare the
payments at t = n, we find

(1 + i)n = isn + 1,

and (2.2) follows.

Exercises
1. On 15 November in each of the years 1964 to 1979 inclusive an investor
deposited £500 in a special bank savings account. On 15 November 1983
the investor withdrew his savings. Given that over the entire period the
bank used an annual interest rate of 7% for its special savings accounts,
find the sum withdrawn by the investor.

2. A savings plan provides that in return for n annual premiums of £X

(payable annually in advance), an investor will receive m annual payments
of £Y , the first such payments being made one payments after payment
of the last premium.

(a) Show that the equation of value can be written as either

Y an+m − (X + Y )an = 0, or as (X + Y )sm − Xsn+m = 0.

18 MATH1510
 1

t=0 1 2 ... t=n

än s̈n

Figure 2.2: The present and accumulated value of an annuity due.

(b) Suppose that X = 1000, Y = 2000, n = 10 and m = 10. Find the

yield per annum on this transaction.

(c) Suppose that X = 1000, Y = 2000, and n = 10. For what values of
m is the annual yield on the transaction between 8% and 10%?

(d) Suppose that X = 1000, Y = 2000, and m = 20. For what values of
n is the annual yield on the transaction between 8% and 10%?

2.2 Annuities due and perpetuities

The previous section considered annuities immediate, in which the payments
are made in arrears (that is, at the end of the year). Another possibility is to
make the payments at advance. Annuities that pay at the start of each year are
called annuities due.

Definition 2.2.1. An annuity due is a regular series of payments at the begin-

ning of every period. Consider an annuity immediate paying one unit of capital
at the beginning of every period for n periods. The value of this annuity at the
start of the first period is denoted än , and the accumulated value at the end of
the nth period is denoted s̈n .

The situation is illustrated in Figure 2.2, which should be compared to the

corresponding figure for annuities immediate. Both an and än are measured at
t = 0, while sn and s̈n are both measured at t = n. The present value of an
annuity immediate (an ) is measured one period before the first payment, while
the present value of an annuity due (än ) is measured at the first payment. On
the other hand, the accumulated value of an annuity immediate (sn ) is at the
last payment, while the accumulated value of an annuity due (s̈n ) is measured
one period after the last payment.
We can easily derive formulas for än and s̈n . One method is to sum a
geometric series. An annuity due consists of payments at t = 0, t = 1, . . . ,
t = n − 1, so its value at t = 0 is

n−1
X 1 − vn 1 − vn
än = 1 + v + · · · + v n−1 = vk = = . (2.5)
1−v d
k=0

MATH1510 19
The value at t = n is
n
X
s̈n = (1 + i)n + (1 + i)n−1 + · · · + (1 + i) = (1 + i)k
k=1 (2.6)
(1 + i)n − 1 1+i
(1 + i)n − 1
= (1 + i) = (1 + i)n − 1 = .
(1 + i) − 1 i d
If we compare these formulas with the formulas for an and sn , given in (2.3)
and (2.2), we see that they are identical except that the denominator is d instead
of i. In other words,
i i
än = an = (1 + i)an and s̈n = sn = (1 + i)sn .
d d
There a simple explanation for this. An annuity due is an annuity immediate
with all payments shifted one time period in the past (compare Figures 2.1
and 2.2). Thus, the value of an annuity due at t = 0 equals the value of an
annuity immediate at t = 1. We know that an annuity immediate is worth an
at t = 0, so its value at t = 1 is (1 + i)an and this has to equal än . Similarly,
s̈n is not only the value of an annuity due at t = n but also the value of an
annuity immediate at t = n + 1. Annuities immediate and annuities due refer
to the same sequence of payments evaluated at different times.
There is another relationship between annuities immediate and annuities
due. An annuity immediate over n years has payments at t = 1, . . . , t = n and
an annuity due over n + 1 years has payments at t = 0, t = 1, . . . , t = n. Thus,
the difference is a single payment at t = 0. It follows that

än+1 = an + 1. (2.7)

Similarly, sn+1 is the value at t = n + 1 of a series of n + 1 payments at

times t = 1, . . . , n + 1, which is the same as the value at t = n of a series of
n + 1 payments at t = 0, . . . , n. On the other hand, s̈n is the value at t = n of
a series of n payments at t = 0, . . . , n − 1. The difference is a single payment at
t = n, so
sn+1 = s̈n + 1. (2.8)
The relations (2.7) and (2.8) can be checked algebraically by substituting (2.2),
(2.3), (2.5) and (2.6) in them.
There is an alternative method to derive the formulas for än and s̈n , anal-
ogous to the discussion at the end of the previous section. Consider a loan of
one unit of capital over n years, and suppose that the borrower pays interest in
advance and repays the principal after n years. As discussed in Section 1.4, the
interest over one unit of capital is d if paid in advance, so the borrower pays
an annuity due of size d over n years and a single payment of 1 after n years.
These payments should be equivalent to the one unit of capital borrowed at the
start. By evaluating this equivalence at t = 0 and t = n, respectively, we find
that
1 = dän + v n and (1 + i)n = ds̈n + 1,
and the formulas (2.5) and (2.6) follow immediately.
As a final example, we consider perpetuities, which are annuities continuing
perpetually. Consols, which are a kind of British government bonds, and certain
preferred stock can be modelled as perpetuities.

20 MATH1510
Definition 2.2.2. A perpetuity immediate is an annuity immediate contin-
uing indefinitely. Its present value (one period before the first payment) is
denoted a∞ . A perpetuity due is an annuity due continuing indefinitely. Its
present value (at the time of the first payment) is denoted ä∞ .
There is no symbol for the accumulated value of a perpetuity, because it would
be infinite. It is not immediately obvious that the present value is finite, because
it is the present value of an infinite sequence of payments.
P∞ However, using the
1
formula for the sum of an infinite geometric sequence ( k=0 rk = 1−r ), we find
that
∞
X 1 1
ä∞ = vk = =
1−v d
k=0
and
∞ ∞
X X v 1
a∞ = vk = v vk = = .
1−v i
k=1 k=0
Alternatively, we can use a∞ = limn→∞ an and ä∞ = limn→∞ än in combina-
tion with the formulas for an and än . This method gives the same result.
Example 2.2.3. You want to endow a fund which pays out a scholarship of
£1000 every year in perpetuity. The first scholarship will be paid out in five
years’ time. Assuming an interest rate of 7%, how much do you need to pay
into the fund?
Answer. The fund makes payments of £1000 at t = 5, 6, 7, . . ., and we wish to
compute the present value of these payments at t = 0. These payments form a
perpetuity, so the value at t = 5 is ä∞ . We need to discount by five years to
find the value at t = 0:
v5 0.9345795
v 5 ä∞ = = = 10.89850.
d 0.0654206
Thus, the fund should be set up with a contribution of £10898.50.
Alternatively, imagine that the fund would be making annual payments
starting immediately. Then the present value at t = 0 would be 1000ä∞ .
However, we added imaginary payments at t = 0, 1, 2, 3, 4; the value at t = 0 of
these imaginary payments is 1000ä5 . Thus, the value at t = 0 of the payments
at t = 5, 6, 7, . . . is
1 1 − v5
1000ä∞ − 1000ä5 = 1000 · − 1000 ·
d d
= 15285.71 − 4387.21 = 10898.50,
as we found before. This alternative method is not faster in this example, but
it illustrates a reasoning which is useful in many situations.
An annuity which starts paying in the future is called a deferred annuity. The
perpetuity in the above example has its first payment in five years’ time, so
it can be considered as a perpetuity due deferred by five years. The actuarial
symbol for the present value of such a perpetuity is 5 |ä∞ . Alternatively, we can
consider the example as a perpetuity immediate deferred by four years, whose
present value is denoted by 4 |a∞ . Generally, the present value of an annuities
over n years deferred by m years is given
m |an = v m an and m |än = v m än .

MATH1510 21
Exercises
1. A loan of £2400 is to be repaid by 20 equal annual instalments. The rate
of interest for the transaction is 10% per annum. Fiund the amount of
each annual repayment, assuming that payments are made (a) in arrear
and (b) in advance.

2.3 Unknown interest rate

In Sections 2.1 and 2.2 we derived the present and accumulated values of annu-
ities with given period n and interest rate i. In Section 2.7, we studied how to
find n. The topic of the current section is the determination of the rate i.
Example 2.3.1 (McCutcheon & Scott, p. 48). A loan of £5000 is repaid by
15 annual payments of £500, with the first payment due in a year. What is the
interest rate?
Answer. The repayments form an annuity. The value of this annuity at the
time of the loan, which is one year before the first payment, is 500a15 . This
has to equal the principal, so we have to solve 500a15 = 5000 or a15 = 0.1.
Formula (2.3) for an yields
15 !
1 − v 15

1 1
a15 = = 1− ,
i i 1+i

so the equation that we have to solve is

 15 !
1 1
1− = 10. (2.9)
i 1+i

The solution of this equation is i = 0.055565, so the rate is 5.56%.

The above example is formulated in terms of a loan, but it can also be formulated
from the view of the lender. The lender pays £5000 and gets 15 annual payments
of £500 in return. The interest rate implied by the transaction is called the yield
or the (internal) rate of return of the transaction. It is an important concept
when analysing possible investments. Obviously, an investor wants to get high
yield on his investment. We will return to this in Chapter 3.
Example 2.3.1 raises the question: how can we solve equations like (2.9)?
It cannot be solved algebraically, so we have to use some numerical method to
find an approximation to the solution. We present several methods here. Con-
ceptually the simplest method is to consider a table like the following, perhaps
by consulting a book of actuarial tables.
i 0 0.01 0.02 0.03 0.04 0.05
a15 15.0000 13.8651 12.8493 11.9379 11.1184 10.3797

i 0.06 0.07 0.08 0.09 0.10 0.11

a15 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909
This shows that a15 = 10 for some value of i between 0.05 and 0.06, so the
interest rate lies between 5% and 6%. The table also shows that the present

22 MATH1510
 14

12
an
10

i
0 0.04 0.08

Figure 2.3: A plot of the present value of a 15-year annuity against the interest
rate i (cf. Example 2.3.1). This shows that the solution of (2.9) lies between
i = 0.05 and i = 0.06.

10.3797

10.0376 10
9.9547
9.8729

9.7122
an
i
0.06 0.065 0.07

Figure 2.4: An illustration of the bisection method.

value a15 decreases as the rate i increases (you should be able to understand
this from first principles).
If we would like a more accurate approximation, we can apply the bisection
method. This method takes the midpoint, which is here 5 21 %. We compute
a15 at 5 21 %, which turns out to be 10.0376. On the other hand, a15 at 6% is
9.7122, so rate at which a15 = 10 lies between 5 12 % and 6%. Another step of
the bisection method takes i = 5 34 %; at this rate a15 = 9.8729, so the rate we
are looking for lies between 5 12 % and 5 34 %. At the next step, we compute a15
at 5 58 %, which turns out to be 9.9547, so we know that i should be between
5 21 % and 5 58 %. As illustrated in Figure 2.4, the bisection method allows us to
slowly zoom in on the solution.
Another possibility is to use linear interpolation. Again, we use that a15
at 5% equals 10.3797, and that a15 at 6% equals 9.7122. In other words, we know
two points on the graph depicted in Figure 2.3, namely (x1 , y1 ) = (0.05, 10.3797)

MATH1510 23
 y1

y∗

y2

x1 x∗ x2

Figure 2.5: The method of linear interpolation takes two known points (x1 , y1 )
and (x2 , y2 ) on the graph and considers the line between them (the dashed
line in the figure). This line approximates the graph and is used to find an
approximation x∗ to the x-value corresponding to y∗ .

and (x2 , y2 ) = (0.06, 9.7122). The method of linear interpolation approximates

the graph by a straight line between (x1 , y1 ) and (x2 , y2 ), as illustrated in Fig-
ure 2.5. The equation of this line is
y2 − y1
y − y1 = (x − x1 ) .
x2 − x1
In the current example, we wish to find the value of x which corresponds to
y = 10. If we denote the given value of y by y∗ , then the unknown value of x∗
is given by
x2 − x1
x∗ = x1 + (y∗ − y1 ) . (2.10)
y2 − y1
In the situation considered here, this evaluates to
0.06 − 0.05
0.05 + (10 − 10.3797) · = 0.055689.
9.7122 − 10.3797
This brings us in one step close to the solution. As with the bisection method,
we can repeat this process to get more accurate approximations of the solution.
Some people may know Newton’s method, also known as the Newton–Raphson
method. This method is usually given for equations of the form f (x) = 0. We
can write (2.9) in this form by taking
 15 !
1 1
f (x) = 1− − 10.
i 1+i

Newton’s method start from only one value of x, say x∗ . It states that if x∗ is
a good approximation to the solution, then
f (x∗ )
x∗∗ = x∗ −
f 0 (x∗ )
is an even better one. The disadvantage of Newton’s method is that you have
to differentiate the function in the equation. We will not consider this method
any further.

24 MATH1510
 All these methods are quite cumbersome to use by hand, so people commonly
use some kind of machine to solve equations like these. Some graphical calcu-
lators allow you to solve equations numerically. Financial calculators generally
have an option to find the interest rate of an annuity, given the number of pay-
ments, the size of every payment, and the present or accumulated value. There
are also computer programs that can assist you with these computations. For
example, in Excel the command RATE(15,500,-5000) computes the unknown
rate in Example 2.3.1.

Exercises
1. A borrower agrees to repay a loan of £3000 by 15 annual repayments of
£500, the first repayment being due after five years. Find the annual yield
for this transaction.

2. (From the sample exam) A loan of £50,000 is repaid by annual payments

of £4000 in arrear over a period of 20 years. Write down the equation of
value and use linear interpolation with trial values of i = 0.04 and i = 0.07
to approximate the effective rate of interest per annum.

2.4 Annuities payable monthly, etc.

Up to now all annuities involved annual payments. However, other frequencies
commonly arise in practice. The same theory as developed above apply to
annuities with other frequencies.
Example 2.1.1 shows that the accumulated value of a sequence of eight an-
nual payments of £100 at the time of the last payment is £954.91, if the rate of
interest is 5% per annum. The result remains valid if we change the time unit.
The same computation shows that the accumulated value of a sequence of eight
monthly payments of £100 at the time of the last payment is £954.91, if the
rate of interest is 5% per month.
Interest rates per month are not used very often. As explained in Section 1.5,
a rate of 5% per month corresponds to a nominal rate i(12) of 60% per year
payable monthly (computed as 60 = 5 × 12). It also corresponds to an effective
rate i of 79.59% per year, because (1.05)12 = 1.7959. Thus, the accumulated
value of a sequence of eight monthly payments of £100 at the time of the last
payment is £954.91, if the (effective) rate of interest is 79.59% p.a.
The preceding two paragraphs illustrate the basic idea of this section. The
remainder elaborates on this and gives some definitions.

Definition 2.4.1. An annuity immediate payable pthly is a regular series of

payments at the end of every period of 1/p time unit. Consider such an annuity
lasting for n time units (so there are np payments), where every payment is
1/p unit of capital (so the total payment is n units). The present value of this
(p)
annuity at the start of the first period is denoted an , and the accumulated
(p)
value at the end of the npth period is denoted sn .

The present and accumulated value of an annuity immediate payable pthly on

the basis of an interest rate i per time unit can be calculated using several

MATH1510 25
methods. Three methods will be presented here. All these methods use the
nominal interest rate i(p) payable pthly, which is related to i by (1.5):
p
i(p)

1+i= 1+ .
p

The first method is the one used at the start of the section, in which a new time
unit is introduced which equals the time between two payments (i.e., 1/p old
time units). The rate i per old time unit corresponds to a rate of j = i(p) /p per
new time unit, and the annuity payable pthly becomes a standard annuity over
np (new) time units, with one payment of 1/p per (new) time unit. The future
value of this annuity is p1 snp j , which can be evaluated using (2.2):
(p)
np

(p) 1 (1 + j)np − 1 1 + ip −1 (1 + i)n − 1

sn i = p snp j = = (p)
= .
jp i i(p)
To compute the present value of the annuity over np time units, with one pay-
ment of 1/p per time unit, use (2.3) while bearing in mind that the discount
factor in new time units is 1/(1 + j):

1 np i(p) −np


(p) 1
1− 1+j ) 1− 1+ p 1 − (1 + i)−n 1 − vn
an i = p anp j = = = = (p) .
jp i(p) i (p) i
The second method computes the present and accumulated value of annuities
payable pthly from first principles using formula (2.1) for the sum of a geometric
sequence. This is the same method used to derive formulas (2.2) and (2.3). The
(p)
symbol an denotes the present value at t = 0 of np payments of 1/p each. The
first payment is at time t = 1/p, so its present value is (1/p) · v 1/p ; the second
payment is at time t = 2/p, so its present value is (1/p) · v 2/p ; and so on till the
last payment which is at time t = n, so its present value is (1/p) · v n . The sum
of the present values is:
np
(p) 1  1/p 1
 1X
an = v + v 2/p + · · · + v n− p + v n = v k/p
p p
k=1
v 1/p 1 − (v 1/p )np 1 1 − vn 1 − vn
= · 1/p
= · 1/p
= (p) .
p 1−v p (1 + i) − 1 i

Similarly, the accumulated value is computed as

(p) 1 1 2

sn = (1 + i)n− p + (1 + i)n− p + · · · + (1 + i)1/p + 1
p
np−1
1 X 1 ((1 + i)1/p )np − 1 (1 + i)n − 1
= (1 + i)k/p = · = .
p
k=0
p (1 + i) − 1 i(p)

The third method compares an annuity payable pthly to an annuity payable

annually over the same period. In one year, an annuity payable pthly consists
of p payments (at the end of every period of 1/p year) and an annuity payable
annually consists of one payment at the end of the year. If p payments are i(p) /p
each and the annual payment is i, then these payments are equivalent, as was

26 MATH1510
found in Section 1.5 (see Figure 4.1). Thus, an annuity with pthly payments
of i(p) /p is equivalent to an annuity with annual payments of i, so their present
and accumulated values are the same:
(p) (p)
ian = i(p) an and isn = i(p) sn .

All three methods leads to the same conclusion:

(p) 1 − vn (p) (1 + i)n − 1
an = and sn = . (2.11)
i(p) i(p)
The formulas for annuities payable pthly are the same as the formulas for stan-
dard annuities (that is, annuities payable annually), except that the formulas for
annuities payable pthly have the nominal interest rate i(p) in the denominator
instead of i.
A similar story holds for annuities due. An annuity due payable pthly is a
sequence of payments at t = 0, 1/p, . . . , n−(1/p), whereas an annuity immediate
payable pthly is a sequence of payments at t = 1/p, 2/p, . . . , n. Thus, they
represent the same sequence of payments, but shifted by one period of 1/p
time unit. The present value of an annuity due payable pthly at t = 0 is
(p) (p)
denoted by än , and the accumulated value at t = n is denoted by s̈n . The
corresponding expressions are

(p) 1 − vn (p) (1 + i)n − 1

än = and s̈n = . (2.12)
d(p) d(p)
The difference with the formulas (2.11) for annuities immediate is again only in
the denominator: i(p) is replaced by d(p) .
The above discussion tacitly assumed that p is an integer, but in fact the
results are also valid for fractional values of p. This is illustrated in the following
example.
Example 2.4.2. Consider an annuity of payments of £1000 at the end of every
second year. What is the present value of this annuity if it runs for ten years
and the interest rate is 7%?
Answer. The present value can be found from first principles by summing a
geometric sequence. We have i = 0.07 so v = 1/1.07 = 0.934579, so the present
value is

1000v 2 + 1000v 4 + 1000v 6 + 1000v 8 + 1000v 10

5
X 1 − (v 2 )5
= 1000 v 2k = 1000v 2 · = 3393.03 pounds.
1 − v2
k=1

Alternatively, we can use (2.11) with p = 1/2, because there is one payment per
two years. We compute i(1/2) from (1.5),
1/2
i(1/2)

1 
1+i= 1+ =⇒ i(1/2) = (1 + i)2 − 1 = 0.07245,
1/2 2
and thus
(1/2) 1 − v 10
a10 = = 6.786069.
i(1/2)

MATH1510 27
 (p)
Remember that an is the present value of an annuity paying 1/p units of capital
(1/2)
every 1/p years for a period of n years, so a10 = 6.786069 is the present value
of an annuity paying two units of capital every two years for a period of 10 years.
Thus, the present value of the annuity in the question is 500·6.786069 = 3393.03
pounds. This is the same as we found from first principles.

Exercises
1. (From the 2010 exam)

(a) A savings plan requires you to make payments of £250 each at the
end of every month for a year. The bank will then make six equal
monthly payments to you, with its first payment due one month after
the last payment you make to the bank. Compute the size of each
monthly payment made by the bank, assuming a nominal interest
rate of 4% p.a. payable monthly.
(b) The situation is the same as in question (a): you make payments
of £250 each at the end of every month for a year, and the rate is
4% p.a. payable monthly. However, now the bank will make equal
annual payments to you in perpetuity, with the first payment due
three years after the last payment you make to the bank. Compute
the size of the annual payments.

2. (From the sample exam) A 20-year loan of £50,000 is repaid as follows.

The borrower pays only interest on the loan, annually in arrear at a rate
of 5.5% per annum. The borrower will take out a separate savings pol-
icy which involves making monthly payments in advance such that the
proceeds will be sufficient to repay the loan at the end of its term. The
payments into the savings policy accumulate at a rate of interest of 4%
per annum effective.
Compute the monthly payments into the savings account which ensures
that it contains £50,000 after 20 years, and write down the equation of
value for the effective rate of interest on the loan if it is repaid using this
arrangement.

3. (From the CT1 exam, Sept ’08) A bank offers two repayment alternatives
for a loan that is to be repaid over ten years. The first requires the
borrower to pay £1,200 per annum quarterly in advance and the second
requires the borrower to make payments at an annual rate of £1,260 every
second year in arrears. Determine which terms would provide the best deal
for the borrower at a rate of interest of 4% per annum effective.

2.5 Varying annuities

The annuities studied in the preceding sections are all level annuities, meaning
that all payments are equal. This section studies annuities in which the size of
the payments changes. In simple cases, these can be studied by splitting the
varying annuities in a sum of level annuities, as the following example shows.

28 MATH1510
Example 2.5.1. An annuity pays e50 at the end of every month for two years,
and e60 at the end of every month for the next three years. Compute the
present value of this annuity on the basis of an interest rate of 7% p.a.
Answer. This annuity can be considered as the sum of two annuities: one of e50
per month running for the first two years, and one of e60 per month running
(12)
for the next three years. The present value of the first annuity is 600a2 euros
(12)
(remember that an is the present value of an annuity paying 1/12 at the end
of every month). The value of the second annuity one month before its first
(12)
payment is 720a3 , which we need to discount by two years. Thus, the present
value of the annuity in the question is

(12) (12) 1 − v2 2 1−v

3
600a2 + 720v 2 a3 = 600 · + 720v · .
i(12) i(12)
The interest rate is i = 0.07, so the discount factor is v = 1/1.07 = 0.934579
and the nominal interest rate is i(12) = 12(1.071/12 − 1) = 0.0678497, so

1 − v2 2 1−v
3
600 · + 720v · = 1119.19 + 1702.67 = 2821.86.
i(12) i(12)
Thus, the present value of the annuity in the question is e2821.86.
Alternatively, the annuity can be considered as the difference between an
annuity of e60 per month running for five years and an annuity of e10 per
month running for the first two years. This argument shows that the present
value of the annuity in the question is
(12) (12)
720a5 − 120a2 = 3045.70 − 223.84 = 2821.86.

Unsurprisingly, this is the same answer as we found before.

More complicated examples of varying annuities require a return to first prin-

ciples. Let us consider a varying annuity immediate running over n time units,
and denote the amount paid at the end of the kth time unit by Pk . The present
value of this annuity, one time unit before the first payment, is given by
n
X
Pk v k ,
k=1

and its accumulated value at the time of the last payment is given by
n
X
Pk (1 + i)n−i .
k=1

For a level annuity, all the Pk are equal, and we arrive at the formulas for an
and sn . The next example considers an annuity whose payments increase geo-
metrically.

Example 2.5.2. An annuity immediate pays £1000 at the end of the first year.
The payment increases by 3% per year to compensate for inflation. What is the
present value of this annuity on the basis of a rate of 7%, if it runs for 20 years?

MATH1510 29
Answer. The annuity pays £1000 at the end of the first year, £1030 at the end
of the second year, and so on. The payment at the end of year k is given by
Pk = 1000 · (1.03)k−1 . Thus, the present value is

20 20
X 1000 X
1000 · (1.03)k−1 · v k = (1.03v)k
1.03
k=1 k=1
20
!
1000 X
k
= (1.03v) − 1
1.03
k=0
1000 1 − (1.03v)21
 
= −1
1.03 1 − 1.03v
1000
= (14.731613 − 1) = 13331.66.
1.03
So the present value of the annuity is £13,331.66.

The case of an annuity whose payments increase in an arithmetic progression is

important enough to have its own symbol.

Definition 2.5.3. The present value of an increasing annuity immediate which

pays 1 at t = 1, 2 at t = 2, and so on until a final payment of n at t = n, is
denoted by (Ia)n . The present value of an increasing annuity due which pays
1 at t = 0, 2 at t = 1, and so on until a final payment of n at t = n − 1, is
denoted by (Iä)n .

Expressions for (Ia)n and (Iä)n can be derived as follows. Consider first the
increasing annuity immediate. The first payment of 1 at t = 1 has present
value v, the second payment of 2 at t = 2 has present value 2v 2 , et cetera, so
n
X
(Ia)n = v + 2v 2 + 3v 3 + · · · + nv n = kv k . (2.13)
k=1

For the increasing annuity due, the first payment of 1 at t = 0 has present
value 1, the second payment of 2 at t = 2 has present value 2v, et cetera, so
n
X
(Iä)n = 1 + 2v + 3v 2 + · · · + nv n−1 = kv k−1 . (2.14)
k=1

The annuity due is the same sequence of payments as the annuity immediate,
but one year earlier. Thus, we have (Ia)n = v(Iä)n , as is already obvious
from (2.13) and (2.14) above.
Now consider the difference between the annuity due and the annuity im-
mediate. At time t = 0, the annuity due pays out 1 and the annuity immediate
pays out nothing. At time t = 1, the annuity due pays out 2 and the annuity
immediate pays out 1. The annuity due pays out 1 more than the annuity im-
mediate at t = 0, 1, . . . , n − 1. At the other hand, the annuity immediate pays
out n at t = n and the annuity due pays out nothing. Thus,

(Iä)n − (Ia)n = än − nv n .

30 MATH1510
This can also be found by subtracting (2.13) from (2.14). Now use that (Ia)n =
v(Iä)n , as we found above:
1 än − nv n än − nv n
(Ia)n − (Ia)n = än − nv n =⇒ (Ia)n = 1 = .
v −1
v i

This can be written as än = i(Ia)n + nv n , an equation with an interesting (but

perhaps challenging) interpretation. Consider a transaction, in which one unit
of capital is lent every year. The interest is i in the first year, 2i in the second
year, and so on. At the end of n years, the amount borrowed is n, which is then
paid back. The equation än = i(Ia)n + nv n expresses that the payments done
by the lender are equivalent to the payments by the borrower.
The formula for (Ia)n can be used to find the value of annuities with pay-
ments in an arithmetic progression. For instance, consider an annuity paying
£1000 at the end of the first year, £950 at the end of the second year, £900 at
the end of the third year, and so on, with the payment decreasing by £50 ever
year. The last payment is £500 at the end of the eleventh year. The present
value of this annuity is 1050a11 − 50(Ia)11 .

Exercises
1. An annuity is payable in arrear for 20 years. The first payment is of
amount £8000 and the amount of each subsequence payment decreases by
£300 each year. Find the present value of the annuity on the basis of an
interest rate of 5% per annum.
2. An annuity is payable half-yearly for six years, the first half-yearly pay-
ment of amount £1800 being due after two years. The amount of sub-
sequent payments decreases by £30 every half-year. On the basis of an
interest rate of 5% per half-year, find the present value of the annuity.
3. ((From the 2010 exam) An annuity pays out on 1 January in every year,
from 1 January 2011 up to (and including) 1 January 2030. The annuity
pays £1000 in odd years (2011, 2013, 2015, etc.) and £2000 in even years
(2012, 2014, 2016, etc.). Compute the present value of this annuity on 1
January 2011 on the basis on an interest rate of 6% p.a.
4. (From the sample exam) An individual wishes to receive an annuity which
is payable monthly in arrears for 15 years. The annuity is to commence
in exactly 10 years at an initial rate of £12,000 per annum. The pay-
ments increase at each anniversary by 3% per annum (so the first twelve
payments are £1000, the next twelve payments are £1030, and so on).
Compute the amount needed to purchase this annuity now assuming an
interest rate of 6% per annum effective.
5. (From the CT1 exam, Sept ’09) A member of a pensions savings scheme
invests £1,200 per annum in monthly instalments, in advance, for 20 years
from his 25th birthday. From the age of 45, the member increases his in-
vestment to £2,400 per annum. At each birthday thereafter the annual
rate of investment is further increased by £100 per annum. The invest-
ments continue to be made monthly in advance for 20 years until the
individuals 65th birthday.

MATH1510 31
 (a) Calculate the accumulation of the investment at the age of 65 using
a rate of interest of 6% per annum effective.
(b) At the age of 65, the scheme member uses his accumulated investment
to purchase an annuity with a term of 20 years to be paid half-yearly
in arrear. At this time the interest rate is 5% per annum convertible
half-yearly. Calculate the annual rate of payment of the annuity.

2.6 Loans
Example 2.1.4 considered the repayment of a loan by a level annuity. The
repayment of loans is an important application of annuities, which is studied
further in this section.

Example 2.6.1 (Continuation of Example 2.1.4). We computed that a loan

of e2500 at 6 12 % interest can be repaid by ten installments of e347.76, each
being paid at the end of the year. What is the remaining balance of the loan
after six years?
Answer. There are two methods to handle questions like this. The first method
considers the payments in the first six years. This is called the retrospective
method, because it looks back to payments already made. The second method
considers the payments in the last four years. This is called the prospective
method, because it looks forward to payments that have not been made yet.
Obviously, both methods should give the same answer, and you should pick the
method that seems more convenient.
The retrospective method uses that the remaining balance is the value of
the original loan after six years minus the accumulated value of the payments
that have already been made. The borrower has made six payments of e347.76
each at the end of the year. The accumulated value of these payments is

347.76 · s6 = 347.76 · 7.063728 = 2456.48.

The value of the loan after six years is

2500 · (1 + i)6 = 2500 · 1.459142 = 3647.86,

so the remaining balance of the loan is 3647.86 − 2456.48 = 1191.38 euros.

The prospective method uses that the remaining balance equals the present
value of the remaining payments. The borrower still has to make four payments
of e347.76. We need the present value of these payments six years after the start
of the loan. This is one year before the first of the four remaining payments is
due, so the present value of the four remaining payments is

347.76 · a4 = 347.76 · 3.425799 = 1191.36

euros. Thus, the remaining balance of the loan after six years is e1191.36.
The results found by the retrospective and prospective methods differ by
two cents. The difference is caused because at the end of Example 2.1.4, the
value of 347.7617 . . . was rounded to 347.76. The prospective and retrospective
method would have given the same result if we had used the exact value.

32 MATH1510
 Interest Principal Outstanding
Year Payment paid repaid balance
0 — — — 2500.00
1 347.76 162.50 185.26 2314.74
2 347.76 150.46 197.30 2117.44
3 347.76 137.63 210.13 1907.31
4 347.76 123.98 223.78 1683.53
5 347.76 109.43 238.33 1445.20
6 347.76 93.94 253.82 1191.38
7 347.76 77.44 270.32 921.06
8 347.76 59.87 287.89 633.17
9 347.76 41.16 306.60 326.57
10 347.76 21.23 326.53 0.04

Table 2.1: Loan schedule for a loan of e2500 which is repaid by 10 annual
payments of e347.76.

The outstanding balance at the end of every year can be computed with either
the retrospective method or the prospective method. The results are summa-
rized in Table 2.1. This table is read as follows. At the end of the first year, the
borrower pays e347.76. Part of this payment is interest on the loan. The interest
part is 0.065 · 2500 = 162.50 euros. The remainder, 347.76 − 162.50 = 185.26 eu-
ros, is used to repay the loan, so the remaining balance is 2500−185.26 = 2314.74
euros. In the second year, the payment of e347.76 consist of e150.46 interest
on the outstanding balance of e2314.74 and e197.30 repayment of the loan,
and so on.
According to the table, the loan is not fully repaid after 10 years, but there
is an outstanding balance of four cents. The reason for this is that the table
assumes that the annual payment is 347.76 euros, instead of the exact value of
347.7617 . . . euros that was computed in Example 2.1.4. Had we used the exact
value, then the loan would be exactly repaid after ten years. In practice, the
final payment is often adjusted so that the loan is fully repaid. In our example,
that would mean that the final payment is e347.80 instead of e347.76.
A table such as Table 2.1, is known as a loan schedule or amortization
schedule. It shows the interest component of every payment, which is useful
if the interest component is taxed differently from the repayment component.
It also shows the outstanding balance after every payment. The outstanding
balance is used if the terms of the loan changes, as shown in the forthcoming
Example 2.6.2.
Loan schedules can be computed quite easily. Consider a loan over n years
with an annual payment of P , so amount borrowed is P an . At the end of
year k, there are n − k further payments to be done, so the outstanding balance
is P an−k , by the prospective method. Thus, the next payment (at the end of
year k + 1) has an interest component of iP an−k = (1 − v n−k )P . The rest of
the payment, namely v n−k P , is used to repay the loan.
Example 2.6.2. A mortgage of £120,000 is repaid over 20 years by equal
monthly payments. How much is every payment on the basis of an effective
interest rate of 5.89% p.a.? Suppose that the rate increases by one percent

MATH1510 33
point after eleven years. Compute the revised monthly payment.
Answer. The rate of i = 0.0589 corresponds to a nominal rate payable monthly
of  
i(12) = 12 (1 + i)1/12 − 1 = 0.05736732.

If every monthly payment is 1/12, then the present value of all the monthly
payments is
(12) 1 − v 20 1 − 1.0589−20
a20 = (12) = = 11.882249.
i 0.05736732
Thus, the monthly repayment required to pay off the mortgage of £120,000 is

120000 1
(12)
· = 841.59 pounds.
a20 12

Now consider the situation after eleven years. There are nine years of payments
remaining. The present value of these payments is
(12)
841.59 · 12 · a9 = 841.49 · 11 · 7.016967 = 70864.91

pounds, so by the prospective method the outstanding balance is £70,864.91.

It may seem surprising that less than half the loan is repaid in the first eleven
years, but at the start of the loan most of the payments are used to pay the
interest. The bulk of the loan is repaid in the second half.
To compute the revised monthly payment after the rate increase, we compute
the revised nominal rate as
 
i(12) = 12 (1.0689)1/12 − 1 = 0.06681541.

There are nine years of monthly payments left, in which £70,864.91 needs to be
repaid, so the revised monthly payment is

70864.91 1 70864.91 1
(12)
· = · = 874.87.
a9 12 6.750054 12

Thus, the rate increase causes the monthly payment to be increased from
£841.59 to £874.87.

Exercises
1. (From the 2010 exam) A four-year loan of £5000 is repaid by equal annual
payments at the end of each year. Compute the annual payment on the
basis of an interest rate of 6% p.a. and draw up a loan schedule, showing
the interest component of every payment and the outstanding balance.

2. (From the CT1 exam, April ’08) A mortgage company offers the following
two deals to customers for twenty-five year mortgages.

(a) A mortgage of £100,000 is offered with level repayments of £7,095.25

made annually in arrear. There are no arrangement or exit fees.

34 MATH1510
 (b) A mortgage of £100,000 is offered whereby a monthly payment in
advance is calculated such that the customer pays an effective rate
of return of 4% per annum ignoring arrangement and exit fees. In
addition the customer also has to pay an arrangement fee of £6,000
at the beginning of the mortgage and an exit fee of £5,000 at the end
of the twenty-five year term of the mortgage.
Compare the annual effective rates of return paid by customers on the two
products.
3. (From the CT1 exam, April ’09) A loan is to be repaid by an annuity
payable annually in arrear. The annuity starts at a rate of £300 per
annum and increases each year by £30 per annum. The annuity is to be
paid for 20 years. Repayments are calculated using a rate of interest of
7% per annum effective.
Calculate:
(a) The amount of the loan.
(b) The capital outstanding immediately after the 5th payment has been
made.
(c) The capital and interest components of the final payment.

2.7 Annuities over non-integer periods

It is fairly easy to compute the number n of payments of an annuity given
its present or accumulated value, as the following example shows. However, the
result is usually not an integer. This section explains how to interpret fractional
periods.
Example 2.7.1. A loan of $10000 is repaid by annual payments of $1000 each
at the end of the year. How long does it take to repay the loan on the basis of
an interest rate of 6% p.a.?
Answer. The annual payments form an annuity immediate. Its present value
is 1000an . This should equal the amount borrowed, so we have to solve an = 10
for n. Using (2.3), we find:
1 − vn
an = 10 =⇒ = 10
i
=⇒ v n = 1 − 10i
log(1 − 10i)
=⇒ n = = 15.725,
log(v)
so the solution is n = 15.725.
How should we to interpret the result n = 15.725? What does it mean to
have an annuity over 15.725 years? One possibility is that the borrower should
make 15 payments of $1000 at t = 1, . . . , 15, and one final payment at time
t = 15.725 (after 15 years and 265 days). The present value of the 15 payments
of $1000 is 1000a15 = 9712.25 dollars, so after these payments $287.75 of the
loan is still outstanding. Thus, the final payment at t = 15.725 should be

MATH1510 35
(1 + i)15.725 · 287.75 = 718.38 dollars. The loan is repaid by 15 payments
of $1000, paid annually in arrears, and a final payment of $718.38, paid after
15 years and 265 days.
This interpretation is possible but not used very often in practice, because
it is more convenient for both parties to have all payments at regular times.
Usually, either the payment at t = 15 is increased so that the entire loan is
repaid at that time, or a payment is added at t = 16 to repay the remainder of
the loan. In the first case, the borrower has to pay (1 + i)15 · 287.75 = 689.61
dollars extra at t = 15, so the loan is repaid by 14 payments of $1000 at
t = 1, . . . , 14 and a final payment of $1689.61. The payment of $1689.61 at the
end is called the balloon payment. In the second case, the borrower has to make
an additional payment of (1 + i)16 · 287.75 = 730.99 dollars at t = 16, so the
loan is repaid by 15 payments of $1000 at t = 1, . . . , 15 and a final payment
of $730.99 at t = 16. The payment of $730.99 at the end is called the drop
payment. In conclusion, we found three possible interpretations of the annuity
over 15.725 years, that resulted in the situation of Example 2.7.1:
• The borrower pays $1000 at t = 1, . . . , 14 and $1689.61 at t = 15.
• The borrower pays $1000 at t = 1, . . . , 15 and $718.38 at t = 15.725.

• The borrower pays $1000 at t = 1, . . . , 15 and $730.99 at t = 16.

In all these three cases, the present value of the payments at t = 0 is $10000.
These notes use the convention that an annuity over 15.725 years is inter-
preted by one of the three sequences of payments listed above, whose present
value is 1000a15.725 . In other words, we define annuities over n years, where n
is not an integer, such that the formulas (2.3) for the present value and (2.2) for
the accumulated value remain valid. This definition is not generally accepted.
Other writers define an annuity immediate of $1000 over 15.725 years as 15 pay-
ments of $1000 at t = 1, . . . , 15 and a final payment of $725 at t = 15.725. This
may seem more normal, but in that interpretation formulas (2.3) and (2.2) are
no longer valid.

Exercises
1. (From the 2010 exam) A loan of $1000 is repaid by payments of $100 at
the end of each quarter, and a smaller final payment made one quarter
after the last regular payment (a drop payment). The interest rate is
10% p.a. as long as the outstanding balance is greater than $500 and
8% p.a. afterwards.
(a) Compute the outstanding balance after one year.
(b) Which payment causes the outstanding balance to drop below $500?
(c) How long does it take to pay off the loan?
(d) Compute the final payment.

36 MATH1510
Chapter 3

Cash flows

In Chapter 1 we looked at how the value of single payments changes in time.

Chapter 2 discussed annuities, regular sequences of payments. The topic of this
chapter is irregular sequences of payments, called cash flows.
The chapter starts with an analysis of cash flows and in particular with
the computation of their rate of return or yield. This can be used to appraise
different investment projects and to value bonds and other securities. The
last sections discusses how to incorporate practical matters like inflation and
taxation in the theoretical framework.

3.1 Cash flows and their value

Varying annuities were discussed in Section 2.5, where we considered a sequence
of payments done at times t = 1, 2, . . . , n, with the amount paid at time t = k
denoted by Pk . This chapter generalizes the situation even further by dropping
the assumption that the payments are done at regular intervals. Instead, we
consider at sequence of payments of size Pk done at time t = tk . Such a sequence
is called a cash flow.

Example 3.1.1. Consider a contractor building a house. Suppose that he buys

the ground at a certain time for £15,000. A month later, he pays his workers
in advance, for a total of £30,000. The building materials cost £25,000, to be
paid one quarter after the purchase of the ground. These payments constitute
a cash flow, with (measuring time in years) P1 = 15000, t1 = 0, P2 = 30000,
1
t2 = 12 , P3 = 25000 and t3 = 14 .
The payments could also be considered as a varying annuity payable monthly,
with a payment of zero after two months. However, the pattern of payments
here is so irregular that it is more natural to consider it as a cash flow.

The example only considers money flowing out. We can consider money flowing
in as a separate cash flow. It is easier however to combine money flowing in
and money flowing out in one cash flow with positive and negative payments.
The convention is to take money flowing in as positive and money flowing out
as negative. Such a cash flow is called a net cash flow.

MATH1510 37
Example 3.1.2 (Continuation of Example 3.1.1). Suppose that it takes the
contractor nine months to build the house. When it is finished, he sells it for
£75,000. The net cash flow is as given in the following table.

k tk Pk
1 0 −15000
1
2 12 −30000
1
3 4 −25000
3
4 4 +75000

The value of a cash flow at a time t∗ is computed as followed. Payment k is

done at time tk , so it accumulates interest for t∗ − tk time units (this number
may be negative, but that does not matter). Thus, the value of payment k at
time t∗ is (1 + i)t∗ −tk Pk . Summing over all payments yields that the value of
the entire cash flow at time t∗ is given by
X
(1 + i)t∗ −tk Pk . (3.1)
k

Of particular importance is the case where t∗ is zero. The value of the net cash
flow at t = 0 is called the net present value (NPV).

Example 3.1.3 (Continuation of Example 3.1.2). The net present value of the
cash flow in Example 3.1.2 is

(−15000) · (1 + i)0 + (−30000) · (1 + i)−1/12

+ (−25000) · (1 + i)−1/4 + 75000 · (1 + i)−3/4 . (3.2)

If the interest rate is 6%, then this is

−15000 − 29854.68 − 24638.46 + 71792.96 = 2299.82

so the net present value is £2299.82. The fact that it is positive means the
project will be profitable for the contractor, if he can borrow the money at 6%.

Exercises
1. (From the 2010 exam) An investor is considering two projects:

(a) The first project requires an investment of e10,000 now. In return,

the investor will receive six annual payments of e2100, the first of
which will be done one year after the investment.
(b) The second project also requires an investment of e10,000 now, but
it requires a further investment of e2500 one year later. In return,
the investor will be paid e8500 in four years’ time and another e8500
in seven years’ time.

Compute the net present values of both investments, on the basis of an

interest rate of 4%. Which is the better investment based on this compu-
tation?

38 MATH1510
 2. (From the CT1 exam, April ’09) A pension fund purchased an office block
nine months ago for £5 million.
The pension fund will spend a further £900,000 on refurbishment in two
months time.
A company has agreed to occupy the office block six months from now.
The lease agreement states that the company will rent the office block for
fifteen years and will then purchase the property at the end of the fifteen
year rental period for £6 million.
It is further agreed that rents will be paid quarterly in advance and will
be increased every three years at the rate of 4% per annum compound.
The initial rent has been set at £800,000 per annum with the first rental
payment due immediately on the date of occupation.
Calculate, as at the date of purchase of the office block, the net present
value of the project to the pension fund assuming an effective rate of
interest of 8% per annum.
3. (From the CT1 exam, Sept ’08) An insurance company is considering two
possible investment options.
The first investment option involves setting up a branch in a foreign coun-
try. This will involve an immediate outlay of £0.25m, followed by invest-
ments of £0.1m at the end of one year, £0.2m at the end of two years,
£0.3m at the end of three years and so on until a final investment is made
of £1m in ten years time. The investment will provide annual payments
of £0.5m for twenty years with the first payment at the end of the eighth
year. There will be an additional incoming cash flow of £5m at the end
of the 27th year.
The second investment option involves the purchase of 1 million shares in
a bank at a price of £4.20 per share. The shares are expected to provide
a dividend of 21p per share in exactly one year, 22.05p per share in two
years and so on, increasing by 5% per annum compound. The shares are
expected to be sold at the end of ten years, just after a dividend has been
paid, for £5.64 per share.
Determine which of the options has the higher net present value at a rate
of interest of 7% per annum effective.

3.2 The internal rate of return

The net present value of a cash flow is given by (3.1). It clearly depends on the
interest rate i. For instance, the net present value for the construction project
in Example 3.1.3 is given by (3.2). The net present value for different interest
rates is in the following table.
i = 0 : −15000.00 − 30000.00 − 25000.00 + 75000.00 = 5000.00
i = 0.05 : −15000.00 − 29878.27 − 24696.91 + 72305.16 = 2729.97
i = 0.10 : −15000.00 − 29762.67 − 24411.35 + 69825.93 = 651.91
i = 0.15 : −15000.00 − 29652.62 − 24141.57 + 67536.40 = −1257.80
i = 0.20 : −15000.00 − 29547.64 − 23886.07 + 65414.70 = −3019.01

MATH1510 39
 5000

4000

3000

2000
NPV
1000

−1000

−2000
0 0.05 0.1 0.15 0.2
i

Figure 3.1: The net present value for the project in Example 3.1.3 plotted
against the interest rate.

Figure 3.1 shows how the net present value depends on the interest rate. We
see that the net present value is the highest when i = 0 and decreases as the
interest rate increases. Of particular interest is the rate at which the net present
value is zero, that is, the value of i∗ for which

−15000 − 40000(1 + i∗ )−1/12 − 25000(1 + i∗ )−1/4 + 75000(1 + i∗ )−3/4 = 0.

This equation is called the equation of value (for the interest rate), and the
rate i∗ is called the yield of the transaction. It is also known as the internal rate
of return (IRR); these terms will be used interchangeably here. If the contractor
can borrow money for a rate lower than the internal rate of return, he will make
a profit. If not, he will make a loss. The figure suggests that for this project,
the yield is around 11% or 12% p.a.

Definition 3.2.1. Let NPV(i) denote the net present value of a cash flow as
a function of the interest rate i. The equation “NPV(i) = 0” is the equation of
value for this transaction. The yield or internal rate of return is the value of i
which solves this equation.

If the total expenses equal the total income, the investor receives no return,
and the yield is zero. If the expenses exceed the income, the yield is negative.
We will assume that the yield is always larger than −1, as it is hard to give a
meaning to yields smaller than −1.
The above definition uses the net value of the cash flow at time t = 0. In
fact, the time t∗ at which the cash flow is valued does not make a difference: if
the present value at t = 0 is zero for some value of i, then the value at any time
will be zero for that value of i. A smart choice of the time t∗ at which the cash
flow is valued may however simplify the computations.
In Section 2.3, we studied how to compute the interest rate for an annuity.
The internal rate of return as defined here is a generalization to cash flows.

40 MATH1510
As for annuities, the yield of a transaction can in general not be computed
analytically, but the iterative methods discussed in Section 2.3 can be applied.
Linear interpolation is often a fast way to compute the yield approximately.
Example 3.2.2 (Continuation of Example 3.1.3). In Example 3.1.3 we com-
puted that the net present value for the construction project is £2299.82 if the
interest rate is 6%. If i = 0 then the net present value is £5000. The formula
for linear interpolation is given in (2.10), which we reproduce here:
x2 − x1
x∗ = x1 + (y∗ − y1 ) .
y2 − y1
Substitution of x1 = 0, y1 = 5000, x2 = 0.06, y2 = 2299.82 and y∗ = 0 results
in
0.06
x∗ = −5000 = 0.1111.
2299.82 − 5000
Thus, linear interpolation yields an approximate yield of 11.11%. The net
present value at this rate is given by (3.2):

−15000.00 − 29737.78 − 24350.15 + 69302.10 = 214.17.

For another iteration of linear interpolation, we substitute the values x1 = 0.06,

y1 = 2299.82, x2 = 0.1111, y2 = 214.17 and y∗ = 0 in the formula for linear
interpolation, yielding
0.1111 − 0.06
x∗ = 0.06 − 2299.82 · = 0.1163
214.17 − 2299.82
The yield is thus approximately 11.63%. This is already very close to the exact
value for the yield, which is 11.66% (rounded to the nearest basis point).
The internal rate of return is often used to compare different transactions. For
an investor or lender, who puts up some money at the start and receives money
later, a higher yield indicates a more favorable transaction. For a borrower,
who receives some money at the start of the transaction and has to pay money
back later, lower yields are better. However, the internal rate of return is not
always the correct measure. The next section, which is about the appraisal of
investments, discusses some issues with use of the internal rate of return for this
purpose.
A more fundamental issue is that a transaction may not necessarily have a
rate of return, or it may have multiple rate of returns. For example, consider a
project in which you receive £1000 at time t = 0 and £1155 at t = 2, in return
for which you have to pay £2150 at t = 1. As noted just under Definition 3.2.1,
we may choose any time t∗ to value the cash flow. We choose t∗ = 2; the value
of the cash flow at that time is

1000(1 + i)2 − 2150(1 + i) + 1155. (3.3)

To find the yield, we need to solve 1000(1 + i)2 − 2150(1 + i) + 1155 = 0. This
is a quadratic equation in 1 + i and its solution is
√
2150 ± 21502 − 4 · 1000 · 1155 2150 ± 50
1+i= = ,
2000 2000

MATH1510 41
 Pn
P`+1
···
t1 t`
t
t∗ t`+1 tn
···
P1
P`

Figure 3.2: If all expenses are incurred before the earnings are due, then the
internal rate of return is uniquely defined.

so i = 0.10 and i = 0.05. Thus, the transaction has a yield of 5% and also
of 10%. The concept of a yield is not useful in this situation.
The problem is that the net value of the cash flow, given by (3.3), is a
quadratic function which crosses the x-axis twice. In contrast, the net value (3.2)
of the construction project, plotted in Figure 3.1, is a decreasing function and
crosses the x-axis only once, and thus the yield is well defined. The reason is that
in the construction project, the income (positive payments) is after the expenses
(negative payments). If the interest rate increases, the effect of discounting in-
creases. However, the income is affected more by this than the expenses, because
the income is due after the expenses. Thus, the value of the income decreases
more rapidly than the value of the expenses if the interest rate increases. This
explains why the net value decreases as the interest rate increases.
More formally, suppose that there are n payments. The payments are in
chronological order, meaning that t1 < . . . < tn . Assume that the first ` pay-
ments (with 1 ≤ ` < n) are negative and the rest are positive, as illustrated in
Figure 3.2. The value of the cash flow at time t∗ is
n
X
V (i) = P1 (1 + i)t∗ −t1 + · · · + Pn (1 + i)t∗ −tn = Pk (1 + i)t∗ −tk . (3.4)
k=1

We wish to prove that this is a decreasing function, so we compute the derivative

with respect to i:
n
X
V 0 (i) = Pk (t∗ − tk )(1 + i)t∗ −tk −1 . (3.5)
k=1

We now make a smart choice for t∗ : we choose it so that all expenses are due
before t∗ and all earnings are due after t∗ . In other words, t∗ is between t` (the
last expense) and t`+1 (the first income). Now, if k ≤ ` then tk < t∗ and thus
t∗ − tk > 0. Furthermore, the first ` payments are negative, so if k < ` then
Pk < 0. In combination with our assumption that i > −1, we conclude that

if k ≤ ` then Pk (t∗ − tk )(1 + i)t∗ −tk −1 < 0.

On the other hand, if k ≥ ` + 1, then t∗ − tk < 0 and Pk > 0, so

if k ≥ ` + 1 then Pk (t∗ − tk )(1 + i)t∗ −tk −1 < 0.

42 MATH1510
This mean that all terms in the sum in (3.5) are negative, Thus, V 0 (i) < 0; the
net value is a decreasing function with respect to the interest rate. This means
that the graph of V (i) can cross the x-axis at most once, so the internal rate of
return is unique.
This does not show that the graph of V (i) does in fact cross the x-axis. For
that, we compute the value of the cash flow in the limits i ↓ −1 and i → +∞.
In the limit i ↓ −1 (that is, i approaches −1 from above), 1 + i is small but
positive. We have
(
a +∞, if a < 0;
lim (1 + i) =
i↓−1 0, if a > 0.

The kth term in the sum (3.4) for V (i) is Pk (1 + i)t∗ −tk . First consider the case
k ≤ `. The exponent t∗ − tk is positive if k ≤ `, so Pk (1 + i)t∗ −tk → 0 as i ↓ −1.
In the case k ≥ ` + 1, the exponent t∗ − tk is negative, and Pk is positive, so
Pk (1 + i)t∗ −tk → +∞ as i ↓ −1. Adding all terms, we find that V (i) → +∞ in
the limit i ↓ −1.
Next, consider the limit i → ∞. Now we have
(
a 0, if a < 0;
lim (1 + i) =
i→∞ +∞, if a > 0.

Thus, Pk (1 + i)t∗ −tk → −∞ if k ≤ ` and Pk (1 + i)t∗ −tk → 0 if k ≥ ` + 1. We

find that

lim V (i) = +∞ and lim V (i) = −∞.

i↓−1 i→∞

Since V (i) goes from +∞ to −∞, there must be an i ∈ (−1, ∞) for which
V (i) = 0. Thus, the internal rate of return exists and is unique.
The above discussion shows that a cash flow where all expenses are incurred
before the earnings are due has a well-defined yield. The same is true in the
reverse situation, where all earnings are due before the expenses are incurred,
as happens for instance when borrowing money. The proof is very similar.
There is another situation in which the yield is well-defined, namely, if all
cumulative payments before a certain time t∗ are negative and all cumulative
payments afterwards are positive (or the other way around, with all cumulative
payments before t∗ positive and all after t∗ negative). The kth cumulative
payment Ck is the sum of the first k payments:

k
X
Ck = Pj . (3.6)
j=1

Thus, Ck is the total amount the investor has received at the time of the kth
payment. If there is one and only one time at which the cumulative cash flow
changes sign, then there is only one positive value of i for which the net value
of the cash flow is zero. We will not prove this result in these lecture notes.

MATH1510 43
Example 3.2.3. A cash flow with payments −5, 3, −1, 7, −1 and 3 after 0,
2, 3, 7, 8 and 10 years, respectively, has cumulative payments as shown in the
table below:

k tk Pk Ck
1 0 −5 −5
2 2 3 −2
3 3 −1 −3
4 7 7 4
5 8 −1 3
6 10 3 6

Even though the negative and positive payments are interleaved, all negative Ck
are before the positive Ck . After seven years, at the time of the fourth payment,
the cumulative cash flow changes from negative to positive (as explained in the
next section, this time is called the payback period ). Thus the yield of this cash
flow is well defined. A computation as in Example 3.2.2 shows that the yield is
approximately 13.55% p.a.
The two situations discussed above (payments change sign only once, and cu-
mulative payments change sign only once) cover many cash flows occurring in
practice. The internal rate of return of a investment project is usually well
defined.

3.3 Investment project appraisal

Section 3.1 defined the net present value of a cash flow, while Section 3.2 dis-
cussed the internal rate of return. Both quantities are often used to evaluate
and compare investments and other projects. Project with higher net present
values and yields are more profitable to invest in.
If, as in many investments, there is a period of outlays followed by a period
of profits, then the net present value is a decreasing function of the interest rate.
The net present value is positive, and thus the project profitable, if the investor
can borrow and lend money at a rate smaller than the internal rate of return.
Thus, a project with a higher yield has more chance to be profitable.
This does not mean, however, that a project with a higher yield will always
be more profitable than a project with a lower yield. It is the project with the
higher net value for a given interest rate that is the most profitable.
Example 3.3.1 (McCutcheon & Scott, p. 92). An investor is contemplating two
investment projects. Project A requires an initial payment of £10000, in return
for which the investor will receive £250 at the end of every quarter for 15 years.
Project B requires an initial payment of £11000. In return, the investor will
be paid £605 at the end of every year for 18 years and the initial payment of
£11000 will be repaid at the end.
Both projects have one outlay at the start, and payments to the investor
afterwards, so they both have a well-defined internal rate of return. The net
present value for Project A is given by
(4)
NPVA (i) = −10000 + 1000a15 .

44 MATH1510
 4000

3000

B
2000 A
NPV

1000

−1000

−2000
0.03 0.04 0.05 0.06 0.07
i

Figure 3.3: The net present values of the two projects in Example 3.3.1.

(4)
The yield is found by solving NPVA (i) = 0, or a15 = 10, resulting in a yield
of (approximately) 5.88% p.a. On the other hand, the net present value for
Project B is
NPVB (i) = −11000 + 605a18 + 11000v 18 .
The internal rate of return for Project B is 5.5% p.a.
The net present values of both projects are plotted in Figure 3.3. This
shows that if the interest rate is low enough, Project B is more profitable than
Project A, even though it has a lower yield. The rate at which the graph cross,
that is, the rate i at which NPVA (i) = NPVB (i), is called the cross-over rate.
In this example, the cross-over rate is approximately 5.11%.
If the investor can borrow money for a lower rate than the cross-over rate,
he will make a larger profit on Project B than on Project A. For instance, if
the investor may lend or borrow money at 4%, then the profit on Project A is
NPVA (0.04) = 1283.81, while the profit on Project B is NPVB (0.04) = 2088.82.

Another quantity that is sometimes used to evaluate investment projects is

the payback period. This is the answer to the simple but compelling question:
“When do I get my money back?” The payback period is the first time t∗ , such
that all payments up to that time added together are positive. In terms of the
cumulative payments Ck defined in (3.6), if j is the smallest integer such that
Cj > 0, then the payback period is tj .
A disadvantage of the payback period is that it does not take the time value
of money into account. This leads to a more sophisticated measure, called
the discounted payback period (DPP). Given an interest rate i, the discounted
payback period is the first time t∗ , such that the value of all payments up to
that time is positive. In other words, if the cumulative discounted payments are
defined by
Xk
C̃k = v t j Pj , (3.7)
j=1

MATH1510 45
and j is the smallest integer such that C̃j > 0, then the payback period is tj .
The discounted payback period is the period that investors have to wait to
get their money back if they borrow the money that they invest in the project
against a rate i.

Example 3.3.2 (Continuation of Example 3.2.3). Consider the same project

as before, with payments −5, 3, −1, 7, −1 and 3 at times 0, 2, 3, 7, 8 and 10,
respectively. We compute the discounted payments using a rate of 8% and 12%.

i = 0.08 i = 0.12
k tk Pk Ck v t k Pk Ck0 v tk Pk Ck0
1 0 −5 −5 −5.00 −5.00 −5.00 −5.00
2 2 +3 −2 +2.57 −2.43 +2.39 −2.61
3 3 −1 −3 −0.79 −3.22 −0.71 −3.32
4 7 +7 +4 +4.08 +0.86 +3.17 −0.15
5 8 −1 +3 −0.54 +0.32 −0.40 −0.56
6 10 +3 +6 +1.39 +1.71 +0.97 +0.41

As explained in Example 3.2.3, the fourth cumulative payment is the first one
that is positive, thus the payback period is the time of the fourth payment,
which is t = 7. This does not change if all payments are discounted at a rate
of 8%; the discounted payback period is still seven years. However, if a rate
of 12% is used, then the discounted payback period is 10 years.
The table also shows that the net present value a rate of 8% is 1.71. This
is the profit the investor makes (valued at t = 0) assuming that the investor
borrows the money he invests in the project, and that he can both borrow and
deposit money at an interest rate of 8%. However, this assumption is not very
realistic: banks generally pay less interest on a deposit than they charge on a
loan. This leads us to consider variable interest rates later in the module, in
Chapter 4.

As the example shows, the discounted payback period computed on the basis
of an interest rate of 8% measures how long it takes before the investor recoups
his investment, if he borrows the money against a rate of 8%. The accumulated
value of the project does not only depend on the rate against which the investor
can borrow money, but also on the rate at which the profits can be reinvested
(the reinvestment rate). The definition of the internal rate of return (IRR)
assumes that these rates are equal. This assumption is not always valid. When
it is not valid, it is dangerous to compare different investment projects using
the internal rate of return, especially when the interest rate fluctuate widely or
the investment periods are very different.
We end this section on the appraisal of investment projects by acknowledging
that nothing is certain in life except death and taxes. Investment may not make
the returns that we expect them to made. A borrower may default on a loan.
These risks are difficult to estimate and handle, but taking them properly into
account is of great importance. An easy way to compensate for the risk of
default is to demand a higher interest rate or a higher yield on a transaction
(a risk premium), but then the question becomes how high the risk premium
should be. More sophisticated methods use the theory of probability. This will
be treated in Financial Mathematics II and other modules.

46 MATH1510
3.4 Investment funds
An investment fund is a collective scheme which pools and invests money from
multiple parties. The pool of money administered by the fund changes over time.
This complicates the assessment of the performance of an investment fund. The
value of the fund changes not only due to the performance of its investments,
but also due to additional investments or withdrawals by its members.
The following example shows that the internal rate of return can be used to
assess the performance of an investment fund.
Example 3.4.1. Consider an investment fund that starts out with £100,000.
After one year, this has increased to £105,000. The investors deposit an addi-
tional £50,000 to the funds, so the total sum administered is now £155,000. The
second years turns out to be very profitable: the value of the funds increases
to £195,000. At this time, the investors withdraw £60,000, leaving £135,000
in the funds. Unfortunately, the investments go sour in the third year, and the
value of the funds decreases to £125,000. What is the yield achieved by the
investment fund over these three years?
Answer. If the fund would be wound up, the fund would have to pay £125,000
back to the investors. Thus, the cash flow is +100 (measured in thousands
of pounds) at t = 0 (measured in years), +50 at t = 1, −60 at t = 2 and
−125 at t = 3. The equation of value at t = 0 is
100 + 50(1 + i)−1 − 60(1 + i)−2 − 125(1 + i)−3 = 0. (3.8)
The solution of this equation is i = 0.0937, so the yield rate is 9.37%.
5
The fund manager in the example achieved a return of 100 = 5% in the first
40 10
year, 155 = 25.81% in the second year, and − 135 = −7.41% in the third year.
If you invest money against these rates, the yield over three years is
   1/3
5 40 10
1+ 1+ 1− − 1 = (1.223118)1/3 − 1 = 0.0694,
100 155 135
or 6.94%. The yield rate of 9.37% that was computed in the example is consid-
erably higher because that computation gives more weight to periods in which
more money is invested in the funds. In the example, the second year has the
most money in the funds, so that year has more influence on the yield rate than
the first and last year. Coincidentally, the funds performed considerably better
in the second year than in the first and last year. This explains why the yield
rate is so high.
Because the internal rate of return gives more weight to periods in which
more money is invested in the funds, it is often called the money-weighted rate
of return in this context. Yet another name is the dollar-weighted rate of return,
though this is obviously not appropriate for British funds. In contrast, the rate
of 6.94% is called the time-weighted rate of return. The time-weighted rate
of return is a fairer measure of the performance of a fund manager, because
it eliminates the effect of investors depositing or withdrawing money from the
funds. However, the money-weighted computation is a valid measure of the
actual investment results achieved.
The formal definitions of the money-weighted rate of return and the time-
weighted rate of return are as follows.

MATH1510 47
Definition 3.4.2. Let Vk with k = 0, 1, . . . , n denote the value of an investment
fund at time tk , where the times are ordered such that t0 < t1 < . . . < tn . Let
ck with k = 1, 2, . . . , n1 denote the new cash deposited into the fund at time tk
(if ck < 0 then cash is withdrawn). The value Vk is measured just before the
new cash is deposited or withdrawn. The money-weighted rate of return is the
rate i which satisfies

V0 (1 + i)tn −t0 + c1 (1 + i)tn −t1

+ c2 (1 + i)tn −t2 + · · · + cn−1 (1 + i)tn −tn−1 = Vn . (3.9)

The time-weighted rate of return is the rate i which satisfies

V1 V2 V3 Vn
(1 + i)tn −t0 = · · ··· . (3.10)
V0 V1 + c1 V2 + c2 Vn−1 + cn−1
Example 3.4.3 (Continuation of Example 3.4.1). In the situation of Exam-
ple 3.4.1, the value of the fund is V0 = 100000, V1 = 105000, V2 = 155000 and
V3 = 125000 at times t0 = 0, t1 = 1, t2 = 2 and t3 = 3, respectively. The flow
of new money is given by c1 = 50000 and c2 = −60000. Thus, equation (3.9)
for the money-weighted rate of return gives

100000(1 + i)3 + 50000(1 + i)2 − 60000(1 + i) = 125000.

This is equivalent to equation (3.10) which we found before; the money-weighted

rate of return is 9.37%.
Equation (3.10) for the time-weighted rate of return gives
105000 195000 125000
(1 + i)3 = · · .
100000 105000 + 50000 195000 − 60000
The solution of this equation is i = 0.0694, so the time-weighted rate of return
is 6.94%, as we found before.
The linked internal rate of return is another measure that is sometimes used.
It is a variant of the time-weighted rate of return which approximates the flow
of new money into and out of the funds. We will not be considering the linked
internal rate of return in this module.

Exercises
1. (From the CT1 exam, April ’09) A fund had a value of £150,000 on 1
July 2006. A net cash flow of £30,000 was received on 1 July 2007 and a
further net cash flow of £40,000 was received on 1 July 2008. The fund
had a value of £175,000 on 30 June 2007 and a value of £225,000 on 30
June 2008. The value of the fund on 1 January 2009 was £280,000.
(a) Calculate the time-weighted rate of return per annum earned on the
fund between 1 July 2006 and 1 January 2009.
(b) Calculate the money-weighted rate of return per annum earned on
the fund between 1 July 2006 and 1 January 2009.
(c) Explain why the time-weighted rate of return is more appropriate
than the money-weighted rate of return when comparing the perfor-
mance of two investment managers over the same period of time.

48 MATH1510
 2. (From the CT1 exam, Sept ’08) An investor had savings totalling £41,000
in an account on 1 January 2006. He invested a further £12,000 in this
account on 1 August 2006. The total value of the account was £45,000 on
31 July 2006 and was £72,000 on 31 December 2007.
Assuming that the investor made no further deposits or withdrawals in
relation to this account, calculate the annual effective time-weighted rate
of return for the period 1 January 2006 to 31 December 2007.

3.5 Bonds
A bond is a certificate of indebtedness issued by a borrower. It promises to pay
a certain amount of money at a specified date (or several amounts at several
dates). If a company or government agency wants to borrow money, it can go
to a bank or it can issue bonds and sell these to investors. Bonds are usually
issued for a round value such as £100 in the U.K. and $1000 in the U.S.; this is
called the face value of the bond.
Most bonds specify when the loan is paid back. This is called the maturity
date, and the period between the issue of the bond and its maturity is the term
of the bond. The amount paid to the investor at the maturity date is called the
redemption value of the bond. The redemption value usually equals the face
value; in this case the bond is said to be redeemed at par. We will assume in
this module that all bonds are redeemed at par.
Many bonds also pay interest on the loan in addition to repaying it at matu-
rity. These interest payments are called coupons. The coupons are computed by
multiplying an interest rate specified on the bond (the coupon rate) by the face
value. Thus, a bond with a coupon rate of 8% and a face value of £100 would
pay coupons of £8 if the coupons are paid annually. Typically, coupons are
payable semi-annually and the nominal rate is quoted, so a bond with coupons
of 8% payable semi-annually pays coupons of £4 every half year.
Governments usually have to raise large sums of money and they do this by
issuing bonds. Bonds issued by the U.K. government are known as gilts. Bonds
issued by the U.S. governments are called Treasury notes if the term is relatively
long, and Treasury bills (or T-bills) if the term is relatively short.
A fundamental computation is to compute the price an investor has to pay
for a bond to achieve a certain yield. The basic rule is that the price of the
bond must be equal to the present value of the coupons plus the present value
of the redemption value, where the present values are computed using the given
yield rate.

Example 3.5.1. Find the price of a five-year bond with a face value of £100
and coupons at 8% p.a. payable semi-annually. The bond is redeemable at par
and bought to yield 5%.
Answer. The investor will receive half-yearly payments of £4 for five years.
(2)
We use time units of a year. The present value of these payments is 8a5
(2)
(remember that an is the present value of semi-annual payments of a half ).
Additionally, the investor will receive £100 at maturity; the present value of
this payment is 100v 5 . Here, the yield rate is given as i = 0.05, so v = 0.952381
and i(2) = 0.0493901. We compute the present value of both the coupons and

MATH1510 49
the redemption value using i = 0.05 (the given yield rate) as
(2) 1 − v5
8a5 + 100v 5 = 8 · + 100v 5 = 8 · 4.382935 + 100 · 0.783526
i(2)
= 35.0635 + 78.3526 = 113.4161.
So, the price of the bond is £113.42.
We can also use time units of half a year. The yield rate of 5% p.a. is
equivalent to a rate of 2.4695% per half-year, so the discount factor is v =
1/1.024695 = 0.975900. The present value of the coupons and the payment at
maturity is now computed as
1 − v 10
4a10 + 100v 10 = 4 · + 100v 10 = 4 · 8.765870 + 100 · 0.783526
i
= 35.0635 + 78.3526 = 113.4161,
which is of course the same as we found using time units of a year.
The same reasoning shows that the price to be paid to achieve a yield of i for a
bond with a face value of F and coupons payable half-yearly at a rate of D per
annum, redeemable at par in n years, is
(2)
F Dan + F v n at a rate of i. (3.11)
The coupon rate of D p.a. payable semi-annually corresponds to an effective
annual rate of (1 + 12 D)2 − 1; this is formula (1.5) relating nominal and effective
interest rates. For the bond in Example 3.5.1, the coupon rate is 8% p.a. payable
semi-annually, which corresponds to an effective rate of 8.16% p.a. If the yield
rate equals the effective coupon rate, meaning that i = (1 + 12 D)2 − 1, then
i(2) = D and thus the price of the bond is
(2)
F Dan + F v n = F (1 − v n ) + F v n = F.
Thus, if the yield rate equals the coupon rate, the price of a bond equals the face
value. In this case, the bond is said to sell at par. If the yield rate i decreases,
the present value of the coupons and the redemption value increase. Thus, the
price of the bond is higher than the face value if the coupon rate is higher than
the yield rate. This is the case in Example 3.5.1. We say that the bond sells at
a premium (the buyer of the bond has to pay a premium above the face value
and gets higher coupons in return). In the opposite situation, where the coupon
rate is lower than the yield rate and the price of the bond is lower than the face
value, the bond is said to sell at a discount. This is yet another meaning of the
word “discount” in financial mathematics.
The relationship between the price and the yield of a bond can also be
understood algebraically, starting from equation (3.11) for the price of a bond.
The theory of annuities treated in Chapter 2, specifically equation (2.11), implies
that
(2)
v n = 1 − i(2) an ,
so we can rewrite the formula for the price as
 
(2) (2) (2)
price = F Dan + F v n = F Dan + F 1 − i(2) an
 
(2)
= F + F D − i(2) an (3.12)
| {z }
premium/discount

50 MATH1510
This is called the premium/discount formula, because it gives the price as a sum
of the face value and the premium or discount. In the situation of Example 3.5.1,
we have
 
(2)
premium = F D − i(2) an = 100 · (0.08 − 0.0493901) · 4.382935 = 13.416,

which corresponds to the price of £113.42 that we found before.

The premium/discount formula shows immediately that if the yield equals
the coupon rate (both expressed as nominal rates), the price of the bond equals
the face value. If the coupon rate is higher than the yield (D > i(2) ), then
the bond trades at a premium, and if the coupon rate is lower than the yield
(D < i(2) ), then the bond trades as a premium. If the yield increases, then i(2)
increases and thus the price of the bond decreases.
A consequence of the inverse relationship between the price and the yield of
a bond is that the bonds become cheaper if the interest rate (or more precisely,
the expected interest rate in the future) increases. This is the main source of
fluctuations in the bond market.
Example 3.5.1 above shows how to compute the price of a bond given the
yield rate. The opposite computation, where the yield rate is to be found given
the price, can be performed as explained in Section 3.2: write down the equation
of value and solve it for the rate i. Usually, we can find only an approximate
solution, using techniques like linear interpolation.
Example 3.5.2. A bond with a face value of £100 and coupons at 8% p.a.
payable semi-annually is redeemable in five years at par. Find the yield if the
bond is bought for £119.25.
Answer. This is the same bond as in Example 3.5.1. The price of the bond
should equal the present value of the semi-annual coupons of £4 each plus the
present value of the £100 paid at maturity:
(2)
8a5 + 100v 5 = 119.25.
Writing everything in terms of the rate i, this becomes
1 − (1 + i)−5
8· + 100(1 + i)−5 = 119.25.
2((1 + i)1/2 − 1)
The solution of this equation is i = 0.0377774 so the yield is 3.78%.
Unfortunately, this solution cannot be found analytically. We can find find
an approximate solution for the yield rate using linear interpolation if we know
the bond price for two yield rates. In Example 3.5.1, we found that if the yield
is 5% p.a., the bond costs £113.42. Furthermore, we know that the price of the
bond equals the face value if the yield rate equals the coupon rates. Here, the
coupon rate is 8% p.a. payable semi-annually, which corresponds to an effective
rate of (1 + 0.08/2)2 − 1 = 0.0816 or 8.16% p.a. Thus, we use the formula for
linear interpolation
x2 − x1
x∗ = x1 + (y∗ − y1 ) .
y2 − y1
with x1 = 0.05, y1 = 113.42, x2 = 0.0816, y2 = 100 and y∗ = 119.25. We find
x∗ = 0.03627, so the approximate yield of the bond is 3.63%. This is fairly close
to the exact solution of 3.78%. Another round of interpolation would allow us
to come even closer to the exact solution.

MATH1510 51
 16

14

12

10
yield (%)
8

0
70 80 90 100 110 120 130 140
price

Figure 3.4: The relation between the price and the yield of a five-year bond with
a face value of £100 and coupons at 8% p.a. payable semi-annually (as treated
in the examples in this section). If the price increases, the yield decreases, and
vice versa.

As illustrated in the example, the yield of a bond that is trading at a premium

(that is, the price is higher than the face value) is lower than the coupon rate.
The relation between yield and price is shown in Figure 3.4.
A source of confusion is the difference between effective and nominal rates.
The coupon rate is always quoted as a nominal rate, convertible with the same
frequency as the coupon payments. The yield rate of 3.78% computed in the
above example is an effective rate. The corresponding nominal rate is

2 (1 + 0.0378)1/2 − 1 = 0.0374 or 3.74%.

When comparing two rates, you should make sure they both are both effective
rates or that they both are nominal rates convertible with the same frequency.
Thus, in the premium/discount formula, equation (3.12), the coupon rate and
yield are both nominal rates. Bond yields in the financial press are usually
quoted using nominal rates. This is appropriate when comparing different bonds
because (almost) all bonds pay coupons with the same frequency. However,
when comparing bond yields with yields on other investments, the bond yield
has to be converted to an effective annual rate.
Another source of confusion is that people sometimes consider another yield
rate called the interest yield. This is the yield computed on the basis of only the
interest payments, while ignoring the redemption value. The interest yield of the
bond in Example 3.5.2, which has a coupon rate of 8% and trades at £119.25,
is 8/119.25 = 0.0671 or 6.71%. This rate is the nominal rate p.a. convertible
semi-annually; the effective rate is 6.82%. The interest yield is also known as
the flat yield. The yield that we considered in the rest of this section, which
does take the redemption value into account, is sometimes called the redemption
yield or the yield to maturity if it is necessary to distinguish it from the interest

52 MATH1510
 8
140

6
130

yield (%)
price

120 4

110 2

100 0
0 5 10 15 20 0 5 10 15 20
term to redemption term to redemption

Figure 3.5: The relation between the redemption term and the price and yield
of a bond. Consider a bound with a face value of £100 and a coupon rate of 8%
payable semi-annually, whose redemption term varies. The left plot shows the
price of the bond if it is bought to yield 5%, as in Example 3.5.1. The right plot
shows the yield of the bond if it is bought for £119.25, as in Example 3.5.2.

yield.
If a bond is trading at a premium then the investor will receive less money
at maturity than he paid for the bond, so he will suffer a loss at maturity.
Thus, the redemption yield is lower than the interest yield for bonds trading
at a premium. On the other hand, the coupon rate is higher than the interest
yield for bonds trading at a premium: the interest yield is the coupon payments
divided by the price of the bond, while the coupon rate is the coupon payments
divided by the face value, and the price is higher than the face value because
the bond trades at a premium. This is the case in Example 3.5.2, where the
bond has a redemption yield of 3.74%, an interest yield of 6.71%, and a coupon
rate of 8% (all quoted as nominal rates). Conversely, the redemption yield is
higher than the interest yield which is higher than the coupon rate when the
bond is trading at a discount.
The difference between the redemption yield and the interest yield depends
on the term to redemption. If it takes very long before the bond matures,
then the present value of the profit or loss for the investor at maturity is small,
because it is discounted for a very long time. Thus, the difference between
the redemption yield and the interest yield decreases as the redemption term
increases. In the limit n → ∞, the bond never matures (so the coupons form a
perpetuity), and the redemption and interest yields are the same.
If a bond is trading at a premium, then the redemption yield is lower than
the interest yield. Since the redemption yield approaches the interest yield
as the redemption term increases, and the interest yield stays constant, the
redemption yield must increase. This is shown in the right plot of Figure 3.5,
which illustrate the influence of the redemption term on the yield of the bond
in Example 3.5.2, which is trading at a premium. In the opposite situation, the
bond is trading at a discount, the redemption yield is higher than the interest
yield, and the redemption yield decreases as the redemption term increases.
The effect of the term to redemption on the price can be seen from for-

MATH1510 53
mula (3.11) for the price of a bond, which we rewrite as

1 − vn
 
(2) FD D
price = F Dan + F v = F D (2) + F v n = (2) + F
n
1 − (2) vn .
i i i

In the limit n → ∞, the second term goes to zero, so the price of the bond
approaches F D/i(2) . We also know that the price equals the face value F if the
bond matures immediately (n = 0). The price of the bond converges to the face
value as the maturity date is approached; this is known as the pull to par.
If i(2) < D, the yield is lower than the coupon rate so the bond is trading at
a discount. In this case, the price is lower than the face value, and the above
formula for the price shows that price increases monotonically as the redemption
rate increases if the yield is held constant. This is illustrated in the left plot of
Figure 3.5. In the opposite situation, where the bond is trading at a discount,
the price decreases as the redemption rate increases if the yield is held constant.

Zero-coupon bonds, as the name indicates, are bonds that do not pay out any
coupons. The bond holder does receives a payment (the redemption value) when
the bond matures, but he does not receive any interest payments. Zero-coupon
bonds are used when the term of the bond is short. For instance, U.S. Treasure
bills are zero-coupon bonds. Zero-coupon bonds with longer terms are created
by brokers, who take a bond with non-zero coupons and sell the redemption
payment and the coupon payments separately.
Zero-coupon bond are easy to analyse, because the bond holder receives
only one payment. The price of a zero-coupon bond is simply the redemption
payment at maturity, discounted to the present time. A bond with face value F
maturing in n years costs F v n . This agrees with (3.11) if considering a zero-
coupon bond as a bond with coupon rate D = 0. Thus, zero-coupon bonds
always trade at a discount and the price of a zero-coupon bond increases over
time as the bond approaches maturity.
It is also easy to compute the yield of a zero-coupon bond. Consider for
example a zero-coupon bond with a face value of £100 which matures in one
year. If this bond is bought for £95, then the equation of value at the time of
purchase is 95 = (1 + i)−1 · 100. The yield is found by solving this equation:
i = 100
95 − 1 = 0.05263, so the yield is 5.26%.
Normal bonds, for which the coupon and redemption payments are fixed,
are called vanilla bonds. There are also more exotic bonds, where the payments
are not fixed beforehand. For example, the coupons and redemption value of
an index-linked bond change according to the inflation index. These bonds
are discussed in the next section. Another example are bonds with no fixed
redemption date; instead, the terms of the bond specify that the borrower may
redeem the bond when he wants, as long as it is redeemed between two specified
date. In the past, the U.K. government issued many of these bonds with optional
redemption rates. They are slowly disappearing from the market as they reach
maturity. One of the remaining issues is 12% Exchequer stock 2013–2017, which
pays 12% interest and has to be redeemed by the government between 2013
and 2017. Undated gilts, which may be redeemed by the government in any year
of its choosing, also exist. The only issue that is actively traded is the 3 12 % War
Loan, which was issued by the U.K. government to finance World War I. Since
3 12 % is historically a very low rate, it is considered unlikely that the government

54 MATH1510
will redeem this gilt, instead choosing to make coupon payments forever. These
bonds are therefore usually modelled as a perpetuity (see Section 2.2).
Bond are fixed-income securities: the payments of the bonds are specified
beforehand (at least, for vanilla bonds). However, there is still a risk of default,
which means that the borrower fails to make the promised payments. The
risk of default is considered very low for bonds issued by the U.K. and U.S.
governments. However, it does happen that national government default on
their bonds. Argentina defaulted on parts of its debt in 2002. The risk of
default is bigger for bonds issued by companies because the companies may go
bankrupt. Investors want to be compensated for this risk and thus companies
have to offer higher interest rates when issuing bonds. Bonds with significant
risk of default are called junk bonds or high-yield bonds. The valuation of bonds
in the presence of a default risk requires probability theory and is thus outside
the scope of this module.
The techniques in this module can also be used for the valuation of other
investment like shares and real-estate property. The buyer of an equity share in a
company becomes owner of a part of the company. This allows the shareholder
to share in the profits in the company in the form of dividends paid by the
company to its shareholder. Usually shareholders also have a say in the running
of the company. If a company goes bankrupt, creditors such as bondholders
are paid before owners such as shareholders. The owner of real-estate property
derives a regular income from it in the form of rent. Both these cash flows
can be valued with the techniques discussed in this module. However, the
income derived from equity shares and real-estate property is subject to many
uncertainties, and it may be best to use a more sophisticated model reflecting
these risks.

Exercises
1. (From the 2010 exam)

(a) A bond with a redemption value of e100 pays coupons of e1.50

semi-annually, with the first coupon due in half a year. The bond
will mature in ten years’ time. It is currently selling for e95.25. Show
that the yield to maturity is 3.6% p.a.
(b) A zero-coupon bond is redeemable for e100 in twelve years’ time. Its
yield to maturity is also 3.6%. Compute its current price.

2. (From the CT1 exam, Sept ’08) Three bonds, paying annual coupons in
arrears of 6%, are redeemable at £105 per £100 nominal and reach their
redemption dates in exactly one, two and three years time respectively.
The price of each of the bonds is £103 per £100 nominal. Calculate the
gross redemption yield of the three-year bond.

3. (From the CT1 exam, Sept ’09) A 182-day government bill, redeemable
at £100, was purchased for £96 at the time of issue and was later sold
to another investor for £97.89 (a goverment bill is a zero-coupon bond).
The rate of return received by the initial purchaser was 5% per annum
effective.

MATH1510 55
 (a) Calculate the length of time in days for which the initial purchaser
held the bill.
(b) Calculate the annual simple rate of return achieved by the second
investor.

3.6 Inflation
Inflation is a general increase in prices over time. Inflation decreases the pur-
chasing power of money: you can buy less for £1000 in 2010 than you could
buy for £1000 in 2000. It is one of the reasons that you receive interest when
depositing money on the bank: you need to be compensated for the loss of
purchasing power of the money that you deposit.

Example 3.6.1. The interest rate is 6% and the rate of inflation is 4%. This
means that if you deposit £100, you will have £106 one year later. However,
products that would cost £100 when you deposited the money, now cost £104.
If we say that the 100 pounds you deposited had a purchasing power of 1, then
the purchasing power of the 106 pounds you have after a year is 106/104 =
1.01923. Thus, the interest rate after taking the effects of inflation into account
is 1.923% p.a.

The rate of 1.923% in the example is called the real rate of interest. The actual
interest rate of 6% is called the nominal rate of interest. The word “nominal”
has a very different meaning in this context than in Section 1.5, when we dis-
cussed interest payable with different frequencies (as in the nominal rate payable
monthly).
The nominal rate of interest is the rate of interest that we discussed in this
module and that we denoted by i. In this section, we denote the real rate of
interest by i0 and the rate of inflation by r. These rates are related by

1 + i = (1 + i0 )(1 + r). (3.13)

The nominal rate of interest combines the real rate of interest with the effect of
inflation. In the example, we have 1.06 = 1.01923 · 1.04.
When computing the real rate of interest, as we did in Example 3.6.1, we
need to solve (3.13) for i0 :

1+i i−r
1 + i0 = , so i0 = .
1+r 1+r
Substituting the values from the example in this formula, we get
0.06 − 0.04
i0 = = 0.01923.
1 + 0.04
If we multiply out the right-hand side of (3.13), we find 1 + i = 1 + i0 + r + i0 r,
which simplifies to
i = i0 + r + i0 r.
The term i0 r is often ignored in practice, because it is small and the rate of
inflation is not accurately known. This leads to the approximation i ≈ i0 + r. In

56 MATH1510
the example where the nominal rate of interest is 6% and the rate of inflation
is 4%, this would yield a real rate of interest of 2% instead of 1.923%.
Inflation is usually measured with the help of a price index. A price index
is a weighted average of prices of several goods and services. Usually the price
index is normalized so that it equals 100 in a specific year. The National Office
of Statistics in the U.K. computes the Retail Price Index (RPI), which is nor-
malized to be 100 in 1987. It reached 200 points in 2006. The U.S. equivalent is
the Consumer Price Index (CPI), computed by the Bureau of Labor Statistics.
The inflation rate over a particular year equals the increase in the price index
over that year divided by the price index at the start of the year.
Just as the real rate of interest is the nominal rate of interest adjusted for
inflation, the real rate of return (or real yield ) is the nominal rate of return
adjusted for inflation. If the rate of inflation is constant, then we can use
formula (3.13) to compute the real rate of return from the nominal rate of return.
For instance, if the rate of inflation is constant and equal to 4% p.a., and the
nominal rate of return is 6% p.a., then the real rate of return is 1.923% p.a.
The computation of the real rate of return of an investment is more com-
plicated if the rate of inflation is not constant. Recall that the (nominal) value
at time t∗ of a payment P due at time t is P (1 + i)t∗ −t . Thus, the equation of
value for an investment consisting of payments Pk due at times tk is
X
Pk (1 + i)t∗ −tk = 0,
k

and the value of i that solves this equation is the (nominal) yield. However, the
payment of P due at time t equals P/Q(t) in real terms, where Q(t) denotes
the value of the price index at time t; the payment can buy P/Q(t) units of the
index. Thus, the equation of value in real terms is
X Pk
(1 + i0 )t∗ −tk = 0, (3.14)
Q(tk )
k

and the real rate of return is the value of i0 that solves this equation.
The procedure is illustrated in the following example.
Example 3.6.2 (After McCutcheon & Scott, p. 180). A bank lends £1000
in January 2005 against 5% interest. The borrower pays £50 in interest for
four years, and repays the loan in January 2009. The RPI for January 2005,
2006, 2007, 2008 and 2009 is 188.9, 193.4, 201.6, 209.8, and 210.1, respectively.
Compute the real rate of return.
Answer. The equation of value in real terms is found by substituting the date
into (3.14), yielding
1000 50 50 50 1050
− (1 + i0 )4 + (1 + i0 )3 + (1 + i0 )2 + (1 + i0 ) + = 0.
188.9 193.4 201.6 209.8 210.1
Here, we chose the end of the loan (January 2009) for t∗ . We can find the real
yield approximately with linear interpolation.
The rate of inflation is approximately 3% p.a., so let’s try i0 = 0.02 as initial
guess. The left-hand side of the equation of value in real terms evaluates to

−5.7302 + 0.2744 + 0.2580 + 0.2431 + 4.9976 = 0.0429.

MATH1510 57
This is slightly above zero. We then try i0 = 0.03; the left-hand side is now

−5.9582 + 0.2825 + 0.2631 + 0.2455 + 4.9976 = −0.1695.

This shows that the real yield is between 2% and 3%. Linear interpolation yields
the approximation

0.0429 − 0
0.02 + (0.02 − 0.03) · = 0.02202.
0.0429 − (−0.1695)

The real yield is thus approximately 2.2% p.a.

Index-linked bonds are bonds whose coupons and maturity value depends on
a price index. For instance, the 1 18 % Index-linked Treasury Gilt 2037 pays
coupons at a rate which lies 1 81 % above inflation, as measured by the RPI.
The payments at maturity is also corrected for inflation. This 30-year gilt was
issued by the U.K. Treasury in 2007. An analogous index-linked bond in the
U.S. market is the Treasury Inflation-Protected Security (abbreviated TIPS).
Index-linked bonds are attractive for investors, especially for parties who
have future obligations which rise in line with inflation, because they guarantee
a certain real rate of return, independent of the inflation rate. The investor is
thus shielded against the effects of inflation.
The coupons of an index-linked bond are computed as follows. Let Q(t) be
the relevant price index at time t, and consider a £100 bond with coupon rate D
paid semi-annually issued at time t0 . Then the coupon payment at time t is

D Q(t)
100 . (3.15)
2 Q(t0 )

This has the same purchasing power as a payment of 100 D 2 at time t0 when
the bond was issued. The maturity value of the bond is also linked to the price
index. If the bond matures at time tm , then it pays out 100Q(tm )/Q(t0 ) at
maturity.
The meaning of “the relevant price index at time t” is a bit subtle in practice.
It takes some time for the National Office of Statistics to compute the RPI,
and thus the RPI for a given month, say March, is only known some time
afterwards, say in the middle of April. Thus, it is not possible to compute
and pay the coupons of an index-linked bond in March on the basis of the RPI
of March. For this reason, the coupons and maturity value of an index-linked
bond are usually linked to the value of some price index several months ago.
The 1 18 % Index-linked Treasury Gilt 2037 mentioned above is linked to the RPI
with a time-lag of three months.

Example 3.6.3. An index-linked bond with an annual coupon rate of 1%

payable semi-annually is issued in April 2005. The coupons are paid on April
and October of every year. The bond has a face value of £100 and matures
at par in April 2008. The bond is linked to the RPI with a time-lag of three
months. The relevant values of the RPI are given in the following table:

Month Jan ’05 Jul ’05 Jan ’06 Jul ’06 Jan ’07 Jul ’07 Jan ’08
RPI 188.9 192.2 193.4 198.5 201.6 206.1 209.8

58 MATH1510
An investor buys the bond at the issue date for £101.20. What are the coupons
and maturity payments that the investor receives? Compute the nominal rate
of return.
Answer. The bond is issued in April 2005. The relevant price index at that
time is the RPI three month before the issue date, which is January 2005, so
Q(t0 ) = 188.9. The first coupon date is October 2005. This coupon is linked to
the RPI in July 2005: 192.2. Equation (3.15) for the coupon payments tells us
that the first coupon is
0.01 192.2
100 · · = 0.5087.
2 188.9
Similarly, we compute that the second coupon in April 2006 is 0.5·193.4/188.9 =
0.5119. The other four coupons are 0.5254, 0.5336, 0.5455 and 0.5553. Finally,
the payment at maturity in April 2008 is 100 · 209.8/188.9 = 111.0641.
To compute the nominal rate of return, we write down the equation of value
(in nominal terms, that is, in pounds). The investor pays 101.20 and receives six
coupon payments and the maturity payment, leading to the following equation
at value:

101.20 = 0.5087(1 + i)−1/2 + 0.5119(1 + i)−1 + 0.5254(1 + i)−3/2

+ 0.5336(1 + i)−2 + 0.5455(1 + i)−5/2 + (0.5553 + 111.0641)(1 + i)−3 .
To approximate the nominal rate of return, we evaluate the right-hand side at
the trial values of i = 0 and i = 0.05 and use linear interpolation to approximate
the value of i for which the right-hand side equals 101.20. If i = 0, the right-
hand side evaluates to 114.2446, and if i = 0.05, it evaluates to 98.8602. The
formula for linear interpolation is
101.20 − 114.2446
0 + (0.05 − 0) · = 0.0424,
98.8602 − 114.2446
so the nominal rate of return is approximately 4.2% p.a.
If we want compute the real rate of return for the bond in the example, we
write down the equation of value in real terms, as illustrated in (3.14). How-
ever, the coupon at time t is defined to have the same purchasing power as
£0.50 in April 2005, when the bond was issued; see (3.15) (we are ignoring the
three-month time lag here for the sake of illustration). Similarly, the maturity
payment is defined to have the same purchasing power as £100 when the bond
was issued. Thus, the equation of value in real terms is

101.20 = 0.5(1 + i0 )−1/2 + 0.5(1 + i0 )−1 + 0.5(1 + i0 )−3/2

+ 0.5(1 + i0 )−2 + 0.5(1 + i0 )−5/2 + 100.5(1 + i0 )−3 .
The solution of this is i0 = 0.0060, so the real rate of return is 0.6% p.a. As
expected, the price index does not appear in the equation of value in real terms;
the real rate of return of an index-linked bond does not depend on the inflation
rate (in practice, there is a small dependance because of the time lag). On the
other hand, the nominal rate of return does depend on the inflation rate because
the coupon and maturity payments depend on the price index. The situation is
opposite with a normal bond, which is not linked to a price index. For a normal
bond, the nominal rate of return is independent of the inflation, but the real
rate of return is not.

MATH1510 59
Exercises
1. (From the CT1 exam, Sept ’08) A 91-day government bill is purchased for
£95 at the time of issue and is redeemed at the maturity date for £100
(a government bill is a zero-coupon bond). Over the 91 days, an index of
consumer prices rises from 220 to 222. Calculate the effective real rate of
return per annum.

2. (From the CT1 exam, Sept ’09) An investor bought a number of shares
at 78 pence each on 31 December 2005. She received dividends on her
holding on 31 December 2006, 2007 and 2008. The rate of dividend per
share is given in the table below:

Date Rate of dividend per share Retail price index

31.12.2005 — 147.7
31.12.2006 4.1 pence 153.4
31.12.2007 4.6 pence 158.6
31.12.2008 5.1 pence 165.1

On 31 December 2008, she sold her shares at a price of 93 pence per

share. Calculate, using the retail price index values shown in the table,
the effective annual real rate of return achieved by the investor

3.7 Taxes
In the previous section we discussed the difference between nominal and real
rates of return. The latter compensate for the effect of inflation. We end this
module with a discussion of the effects of taxation.
In the presence of taxes, we need to distinguised between gross and net
income. Gross income is the income before taxes, and net income is what is left
after you have paid the taxes. The rate of return computed using gross income
is known as the gross rate of return (or gross yield), while the rate of return
computed using net income is the (surprise, surprise . . . ) net rate of return (or net
yield).
The rules and laws around taxes are extremely complicated and far beyond
the scope of this module. We will satisfy ourselves with a simple example
featuring income tax and capital gains tax. Income tax is levied on income such
as wages and interest. Capital gains tax is a tax levied on the profit one makes
because the value of some asset increases. In the context of bonds, income tax
is levied on coupon payments, and capital gains tax is levied on the difference
between the price at which you sell a bond and the price at which you buy
a bond. If the bond is held until maturity, capital gains tax is levied on the
difference between the maturity value and the purchase price.

Example 3.7.1. A bond with a face value of £100 and coupons at 4% p.a.
payable semi-annually is redeemable in five years at par. Suppose the bought
for £91.22 by an investor who is subject to income tax at 40% on the coupons
and capital gains tax at 18% on the profit on redemption. Compute the gross
and net yield on this transaction.

60 MATH1510
Answer. The investor receives ten coupons of £2 each on which he has to pay
40% income tax, so he pays £0.80 of every coupon in tax and receives a net
payment of £1.20. At maturity, the investor makes a profit of 100−91.22 = 8.78
pounds, which is taxed at 18%. Thus, he has to pay £1.58 capital gains tax.
At maturity, the investor receives a net payment of 100 − 1.58 = 98.42 pounds.
The equation of value for the gross yield is
(2) (2)
price = F Dan + F v n or 91.22 = 4a5 + 100v 5 .

If i(2) = D = 0.04, corresponding to an effective interest rate of i = (1.02)2 −1 =

0.0404, then the bond trades at par and costs £100. In fact, the bond sells
for £91.22, so it is trading at a discount, which means that the gross yield is
higher than that. We try i = 0.1; the price corresponding to this yield is
(2)
F Dan + F v n (at 10%) = 15.5332 + 62.0921 = 77.6253.

Linear interpolation suggests that the gross yield is approximately

91.22 − 100
0.0404 + (0.1 − 0.0404) · = 0.06379.
77.6253 − 100
To compute the net yield we need to write down the equation of value with
net payments. After tax, the investor receives coupons of £1.20 and £98.42 at
maturity. Thus, the equation of value for the net yield is
(2)
91.22 = 1.20 · 2a5 + 98.42 v 5 .

We guess trial values of i = 0.03 and i = 0.06 for the net yield:
(2)
at 3%: 1.20 · 2a5 + 98.42 v 5 = 11.0731 + 84.8980 = 95.9710,
(2)
at 6%: 1.20 · 2a5 + 98.42 v 5 = 10.2591 + 73.5451 = 83.8042.

Another round of linear interpolation suggests that the net yield is approxi-
mately
91.22 − 95.9710
0.03 + (0.06 − 0.03) · = 0.04171.
83.8042 − 95.9710
Thus, we arrive at a net yield of 4.2% p.a. In contrast, we found that the
investor makes a gross yield of 6.4% p.a.

Exercises
1. (From the 2010 exam) A bond with a redemption value of e100 pays
coupons of e1.50 semi-annually, with the first coupon due in half a year.
The bond will mature in ten years’ time. It is currently selling for e95.25.
An investor, who is subject to income tax at 40% on the coupons and
capital gains tax at 18% on the profit on redemption, buys some of these
bonds. The investor wants to know the net yield on this transaction.
Write down the equation of value and use linear interpolation with trial
values of i = 0.02 and i = 0.03 to find the approximate net yield.

MATH1510 61
 2. (From the sample exam) A bond with a face value of £100 has just been
issued. The bond pays half-yearly coupons of 5% per annum (payable
semi-annually) in arrear and is redeemable at par 20 years after issue.
(a) Without any computations, explain why an investor who wants to
achieve a (gross) yield of 6% p.a. should pay less than £100 for the
bond.
(b) Assume that the investor pays tax at a rate of 20% on income and
is not subject to capital gains tax. Calculate the price to provide an
investor with a net redemption yield of 6% per annum.
(c) Write down the equation of value for the annual effective gross re-
demption yield of this bond assuming the price calculated in ques-
tion (b) is paid, and use linear interpolation with trial values of 5%
and 6% to compute the gross redemption yield.
(d) Determine the real annual effective gross redemption yield on this
bond if the rate of inflation is constant over the twenty years at 3%
per annum.
3. (From the CT1 exam, Sept ’08) A tax advisor is assisting a client in
choosing between three types of investment. The client pays tax at 40%
on income and 40% on capital gains.
Investment A requires the investment of £1m and provides an income of
£0.1m per year in arrears for ten years. Income tax is deducted at source.
At the end of the ten years, the investment of £1m is returned.
In Investment B, the initial sum of £1m accumulates at the rate of 10%
per annum compound for ten years. At the end of the ten years, the accu-
mulated value of the investment is returned to the investor after deduction
of capital gains tax.
Investment C is identical to Investment B except that the initial sum
is deemed, for tax purposes, to have increased in line with the index of
consumer prices between the date of the investment and the end of the
ten-year period. The index of consumer prices is expected to increase by
4% per annum compound over the period.

(a) Calculate the net rate of return expected from each of the invest-
ments.
(b) Explain why the expected rate of return is higher for Investment
C than for Investment B and is higher for Investment B than for
Investment A.

4. (From the CT1 exam, April ’09) A loan pays coupons of 11% per annum
quarterly on 1 January, 1 April, 1 July and 1 October each year. The
loan will be redeemed at 115% on any 1 January from 1 January 2015 to
1 January 2020 inclusive, at the option of the borrower. In addition to
the redemption proceeds, the coupon then due is also paid.
An investor purchased a holding of the loan on 1 January 2005, immedi-
ately after the payment of the coupon then due, at a price which gave him
a net redemption yield of at least 8% per annum effective. The investor
pays tax at 30% on income and 25% on capital gains.

62 MATH1510
 On 1 January 2008 the investor sold the holding, immediately after the
payment of the coupon then due, to a fund which pays no tax. The sale
price gave the fund a gross redemption yield of at least 9% per annum
effective.
Calculate the following:
(a) The price per £100 nominal at which the investor bought the loan.
(b) The price per £100 nominal at which the investor sold the loan.
(c) The net yield per annum convertible quarterly that was actually ob-
tained by the investor during the period of ownership of the loan.

MATH1510 63
64 MATH1510
Chapter 4

Payment streams and

variable interest rates

In this chapter we consider two extensions of the theory. Firstly, we look at

payment streams. A payment stream is a payment that occurs continuously,
just like the stream of water out of a tap. We model this as the limit of the fol-
lowing sequence: annual payments, monthly payments, weekly payments, daily
payments, hourly payments, payments every minute, payments every second,
et cetera. Mathematically speaking, we are taking the limit p → ∞.
Secondly, we look at variable interest rates. In combination with continuous
payment streams, this give us the most general framework for cash flows. This
is used in second- and third-year finance modules to price complicated financial
instruments like options.

4.1 The force of interest

A long time ago, in Example 1.5.3, we computed that a nominal rate of 8% p.a.
payable quarterly corresponds to an effective rate of 8.243% p.a. As shown in
Figure 1.4, this means that a series of four payments of 2 each at the end of every
quarter is equivalent to a single payment of 8.243 at the end of the year. The
8
other results in Example 1.5.3 show that a series of twelve payments of 12 = 23
each at the end of every month is equivalent to a single payment of 8.300 at
8
the end of the year, that a series of 52 payments of 52 each at the end of every
week is equivalent to a single payment of 8.322 at the end of the year, and
8
that a series of 365 payments of 365 each at the end of every day equivalent to
a single payment of 8.328 at the end of the year. More generally, a series of
p payments of i(p) /p each at the end of every period of 1/p year equivalent to a
single payment of
p
i(p)

i= 1+ − 1.
p
at the end of the year. As the conversion period gets shorter, p gets larger,
and it looks like the effective rate tends to a limiting value. In the limit, the
interest is paid continuously. Although this is essentially a theoretical concept,

MATH1510 65
it is important both for conceptual reasons and as an approximation for when
the conversion period is short.
To study this limit, we fix the effective interest rate i and let p go to infinity.
Remember that the nominal rate i(p) is given by
 
i(p) = p (1 + i)1/p − 1 . (4.1)

We want to compute the limit of this quantity as p → ∞. To this end, we

introduce h = 1/p, the length of the period between two interest payments (p is
the number of interest payments per year). Substituting this in (4.1), we find
1 
i(1/h) = (1 + i)1/h − 1 .
h
If p goes to infinity, then h = 1/p goes to zero, so the limit we want to compute
is
(1 + i)1/h − 1
lim i(p) = lim i(1/h) = lim .
p→∞ h→0 h→0 h
Now comes the smart bit. Recall the definition of the derivative of a function f
at a point x0 :
df
(x0 ) = lim f (x0 + h) − f (x0 )h.
dx h→0
x
If we take f (x) = (1 + i) and x0 = 0, then we get precisely the limit we want
to compute! Turning this around, we find that

(1 + i)1/h − 1 d
lim i(p) = lim i(1/h) = lim = (1 + i)x |x=0 .
p→∞ h→0 h→0 h dx
You can get the same result with l’Hôpital’s rule for limits, if you know that.
However the result is arrived at, we now have to find the derivative of f (x) =
(1+i)x . To differentiate this function, rewrite it as f (x) = ex log(1+i) , so f 0 (x) =
log(1 + i) · ex log(1+i) = log(1 + i)(1 + i)x and f 0 (0) = log(1 + i). Thus,
d
lim i(p) = (1 + i)x |x=0 = log(1 + i).
p→∞ dx

We may refer to limp→∞ i(p) as the nominal rate payable continuously, but in
practice another term is used to refer to this quantity.
Definition 4.1.1. The force of interest, denoted δ, is the limit of the nominal
interest rate i(p) as p → ∞.
The computation above gives us the relation between the force of interest δ and
effective interest rate i:
δ = log(1 + i). (4.2)
We can also write this relation as i = eδ − 1. If we put δ = 0.08 in here, as in
Example 1.5.3, we get i = e0.08 − 1 = 0.083287. Indeed, the AERs in the answer
tend to a limiting rate of 8.2387%.
As a side note, if we take the limit p → ∞ in (1.5), we get
 p
δ
1 + i = lim 1 + ,
p→∞ p

66 MATH1510
 i

t=0 t=1

t=0 t=1

i(p)
p

t = 0 1/p 2/p ... t=1

d(p)
p

t = 0 1/p 2/p ... t=1

δ
t=0 t=1

Figure 4.1: The following five situations are equivalent: A payment of i at the
end of the year, a payment of d at the beginning of the year, a series of p
payments of i(p) /p each at the end of every 1/p of a year, a series of p payments
of d(p) /p each at the beginning of every 1/p of a year, and a continuous payment
for one year at rate δ per year. This extends Figure 1.4, in which only the first
four situations were given.

and above we found that 1 + i = eδ . We thus arrive at

 p
δ
lim 1 + = eδ .
p→∞ p
This is one of the standard limits.
We have now defined five standard symbols: i, d, i(p) , d(p) and δ. A con-
cise summary of their definitions is given in Figure 4.1. The figure shows five
equivalent ways to pay interest on a principal of 1. The first four rows have
already been explained in the previous section. The last row shows a contin-
uous payment stream, lasting one time unit, with rate δ per time unit. The
equivalence of these payments lead to the following algebraic relations, which
follow from (1.3), (1.5), (1.7) and (4.2):
i = eδ − 1, i(p) = p eδ/p − 1 ,


(4.3)
−δ (p) −δ/p


d=1−e , d =p 1−e . (4.4)

MATH1510 67
Assuming that the interest rate is positive, the rates are ordered as

d < d(2) < d(3) < · · · < δ < · · · < i(3) < i(2) < i.

Exercises
1. Given that δ = 0.08, find the values of i, d, and v.
2. Given that d = 0.08, find the values of v, i, and δ.
3. Given that i = 0.08, find the values of v, d, and δ.
4. Given that v = 0.95, find the values of d, i, and δ.

4.2 Annuities paid continuously

The concept of a continuous payment stream can also be applied to annuities.
An annuity paid continuously is a payment stream with a constant rate that
lasts for a specified period of time. As with the other annuities, we are interested
in the present and accumulated value of annuties paid continuously.
Definition 4.2.1. Consider a payment stream lasting for n time units with a
rate of one unit of capital per time unit. The present value of this stream at
the start (t = 0) is denoted by ān and the future value at the end (t = n) is
denoted by s̄n .
(p) (p)
Formulas for ān and s̄n are derived by taking the limits of an and sn as
p → ∞:
(p) 1 − vn 1 − vn
ān = lim an = lim = ,
p→∞ p→∞ i(p) δ
(4.5)
(p) (1 + i)n − 1 (1 + i)n − 1
s̄n = lim sn = lim (p)
= ,
p→∞ p→∞ i δ
where the final equality follows from δ = limp→∞ i(p) , see Definition 4.1.1.
The formulas for ān and s̄n differ from those for an and sn only in that
the formulas for annuities payable continuously have the force of interest δ in
the denominator, whereas the formulas for standard annuities have the interest
rate i in the denominator. The reason for this is that in one year, an annuity
payable continuously consists of a payment stream over the entire year and
a standard annuity consists of a single payment at the end of the year. If
the payment stream has rate δ and the payment at the end of the year is i,
then these payments are equivalent, as was found in the previous section (see
Figure 4.1). Thus, an annuity immediate with annual payments of i is equivalent
to an annuity payable continuously with rate δ, so ian = δān and isn = δs̄n .
There is no need to distinguish between annuities immediate and annuities
due for annuities payable continuously. Indeed, an annuity due payable pthly
is the same as an annuity immediate payable pthly moved forward in time
by 1/p time units. As p → ∞, the annuity payable pthly becomes an annuity
payable continuously and the time shift tends to zero. Algebraically, this follows
from limp→∞ i(p) = limp→∞ d(p) = δ.
As an illustration, let us continue Example 3.1.3 in which we looked at a
constructor that is building a house.

68 MATH1510
Example 4.2.2 (Continuation of Example 3.1.3). As before, the contractor has
to pay £15,000 at t = 0 to purchase the land and £25,000 at t = 14 to purchase
the materials. The house is also still sold for £75,000 at t = 34 . The difference
1
is that the £30,000 salary for the workers is not paid at once (at t = 12 ), but
continously from the time the ground is purchased (at t = 0) until the house is
sold (at t = 34 ).
This continous payment forms an annuity paid continuously lasting for three
quarters of a year. The salary is £30,000 over three quarters, so the rate
is 40,000 pounds per year. Thus the present value of the workers’ salary is
40000ā3/4 . Using equation (4.5), we find that

1 − v 3/4 1 − (1 + i)−3/4
ā3/4 = = .
δ log(1 + i)
Thus, the net present value of the whole project is
1 − (1 + i)−3/4
−15000 − 40000 · − 25000(1 + i)−1/4 + 75000(1 + i)−3/4 . (4.6)
log(1 + i)
If the interest rate is 6%, then this is

−15000 − 29353.92 − 24638.46 + 71792.96 = 2800.58.

This is higher than the net present value for the situation before in Exam-
1
ple 3.1.3, where the workers were paid at t = 12 . There, we found that the net
present value was £2299.82. Loosely speaking, the payments to the workers are
later on average when they are paid continuously from t = 0 to t = 34 than when
1
they are paid at once at t = 12 . Thus, these payments are discounted by more
when the workers are paid continuously, and this causes the net present value
to increase from £2299.82 to £2800.58.

Exercises
1. (From the CT1 exam, April ’08; quite difficult) An investor is considering
investing in a capital project.
The project requires an outlay of £500,000 at outset and further payments
at the end of each of the first 5 years, the first payment being £100,000
and each successive payment increasing by £10,000.
The project is expected to provide a continuous income at a rate of £80,000
in the first year, £83,200 in the second year and so on, with income in-
creasing each year by 4per annum compound. The income is received for
25 years.
It is assumed that, at the end of 15 years, a further investment of £300,000
will be required and that the project can be sold to another investor for
£700,000 at the end of 25 years.
(a) Calculate the net present value of the project at a rate of interest of
11% per annum effective.
(b) Without doing any further calculations, explain how the net present
value would alter if the interest rate had been greater than 11% per
annum effective.

MATH1510 69
4.3 Variable interest rates
All the discussion up to now assumes that the interest rate stays constant.
However, this is not a realistic assumption. In this section we consider situations
in which the interest rate varies.
We start with a simple example.
Example 4.3.1. Suppose you invest 2000 dollars in an account that pays 4%
interest in the first year, 5% in the second year, and 6% in the third year. How
much do you have at the end of the third year?
Answer. You have (1 + 0.04) · 2000 = 2080 dollars after the first year, (1 + 0.05) ·
2080 = 2184 dollars after the second year, and (1 + 0.06) · 2184 = 2315.04 dollars
after the third year.
The following computation is not valid: the average rate is 5%, and $2000 at
5% over three years accumulates to (1 + 0.05)3 · 2000 = 2315.25 dollars. Indeed,
though the result is close to the correct answer, it is not the same.
We now consider a general model which covers the above example, but also
simple and compound interest with constant rate. The central quantity in this
model is the accumulation factor.
Definition 4.3.2. The accumulation factor A(t1 , t2 ) is the amount that one
unit of principal at time t1 accumulates to at time t2 .
In Example 4.3.1, a principal of $2000 at time t = 0 accumulates to $2080 at
time t = 1, so the accumulation factor over this period is A(0, 1) = 2080
2000 = 1.04,
corresponding to an interest rate of 4%. Similarly, A(0, 3) = 2315.04
2000 = 1.15752.
Two examples are particularly important. The accumulation factor for sim-
ple interest with constant rate i is given by

A(t1 , t2 ) = 1 + i(t2 − t1 ). (4.7)

The accumulation factor for compound interest with constant rate i is given by

A(t1 , t2 ) = (1 + i)t2 −t1 . (4.8)

As we discussed at the end of Section 1.1, simple interest is not consistent in

that you receive less interest if you put money in an account for two years than
if you put money in one account for a year and then take it out with interest
and put it in another account for a year. On the other hand, you get the same
amount if compound interest is used. We say that the principle of consistency
holds with compound interest.
Definition 4.3.3. An accumulation function A satisfies the principle of con-
sistency if the equation A(t1 , t2 ) A(t2 , t3 ) = A(t1 , t3 ) holds for all values of t1 ,
t2 , and t3 .
For instance, with compound interest we have:

A(t1 , t2 ) A(t2 , t3 ) = (1 + i)t2 −t1 (1 + i)t3 −t2 = (1 + i)t3 −t1 ,

and

A(t1 , t3 ) = (1 + i)t3 −t1 ,

70 MATH1510
so A(t1 , t2 )A(t2 , t3 ) = A(t1 , t3 ) for all t1 , t2 , and t3 . On the other hand, with
simple interest we have:



A(t1 , t2 ) A(t2 , t3 ) = 1 + (t2 − t1 )i 1 + (t3 − t2 )i
= 1 + (t3 − t1 )i + (t3 − t2 )(t2 − t1 )i2 ,

and

A(t1 , t3 ) = 1 + (t3 − t1 )i,

which are not equal in general, so simple interest does not satisfy the principle
of consistency. Unless stated otherwise, we assume that A satisfies the principle
of consistency.
We proceed to generalize the definitions of the quantities i, i(p) , δ, v, d
and d(p) from the previous sections to arbitrary accumulation functions. One
unit of capital at time t accumulates to A(t, t + 1) in one time period. Thus,
the effective interest rate per unit time under the accumulation function A is
given by
i(t) = A(t, t + 1) − 1.
In general, the effective interest rate depends on the time t. In Example 4.3.1,
we have i(0) = 0.04, i(1) = 0.05 and i(2) = 0.06. Given the principle of
consistency, the accumulation function over a whole number n of time periods
can be expressed in terms of the interest rates:

A(0, n) = A(0, 1) A(1, 2) A(2, 3) . . . A(n − 1, n)

(4.9)
= 1 + i(0) 1 + i(1) 1 + i(2) · · · 1 + i(n − 1)

The nominal interest rate per unit time for a term h is the effective interest rate
over the term h divided by the length of the term:
A(t, t + h) − 1
ih (t) = .
h
This is related to nominal rate payable pthly, i(p) , as defined in Definition 1.5.2,
by i(p) = i1/p . Furthermore, we have i = i1 = i(1) .
The force of interest is found by taking the limit as h → 0:
A(t, t + h) − 1
δ(t) = lim ih (t) = lim .
h→0 h→0 h
The accumulation function associated to compound interest is given in (4.8),
A(t1 , t2 ) = (1 + i)t2 −t1 , so

(1 + i)h − 1 d
 d 
δ(t) = lim = (1 + i)t  = et log(1+i) 

h→0 h  dt t=0 dt t=0
t log(1+i)
=e log(1 + i) = log(1 + i),

t=0

where we used the definition of derivatives to evaluate the limit. This is another
derivation for the relation δ = log(1+i) which we found before in Equation (4.2).
The relations (4.3) and (4.4) at the end of Section 4.1 may be understood more
easily in this context.

MATH1510 71
 We can now model the situation of Example 4.3.1, where the interest rate
was 4% in the first year, 5% in the second year, and 6% in the third year, more
rigorously as: 
log(1.04), if t ∈ [0, 1),

δ(t) = log(1.05), if t ∈ [1, 2),

log(1.06), if t ∈ [2, 3).


It can be argued that the force of interest should be considered as the funda-
mental quantity. Suppose that the principle of consistency holds and that A is
a differentiable function. Define f (t) = A(0, t). Then,
A(t, t + h) − 1
δ(t) = lim
h→0 h
1 A(0, t) A(t, t + h) − A(0, t)
= lim
A(0, t) h→0 h
1 A(0, t + h) − A(0, t)
= lim
A(0, t) h→0 h
1 f (t + h) − f (t)
= lim
f (t) h→0 h
0
f (t)
= ,
f (t)
where we used the principle of consistency on the third line. Thus, f satisfies
the differential equation f 0 (t) = δ(f )f (t). Furthermore, f (0) = A(0, 0) = 1 by
the consistency principle. The solution of this differential equation is
Z t 
f (t) = exp δ(τ ) dτ .
0

A(0,t2 )
We can find A(t1 , t2 ) by noting that A(t1 , t2 ) = A(t1 , 0) A(0, t2 ) = A(0,t1 ) by
the consistency principle, and thus
f (t2 )
A(t1 , t2 ) =
f (t1 )
R 
t
exp 0 2 δ(τ ) dτ
= R
t

exp 0 1 δ(τ ) dτ
Z t2 Z t1 
= exp δ(τ ) dτ − δ(τ ) dτ
0 0
Z t2 
= exp δ(τ ) dτ .
t1

Thus, the accumulation function can be found in terms of the force of interest:
Z t2 
A(t1 , t2 ) = exp δ(τ ) dτ . (4.10)
t1

This can be seen as a continuous version of (4.9). The effective rate of interest
and the nominal rate of interest are both defined in terms of A. In a sense, the
force of interest can be seen as the most fundamental quantity.

72 MATH1510
Example 4.3.4. Stoodley’s formula for the force of interest is
s
δ(t) = p + ,
1 + rest
where p, r and s are constants. What is the accumulation factor A(0, t)?
Answer. Applying (4.10) yields
Z t 
s
A(0, t) = exp p+ dτ
0 1 + resτ
Z t
rsest

= exp p+s− dτ
1 + resτ
h 0 it 
sτ
= exp (p + s)τ − log(1 + re )
0

= exp (p + s)t − log(1 + rest ) + log(1 + r)

1+r
= e(p+s)t .
1 + rest
Stoodley’s formula is sometimes used to model gradually increasing or decreas-
ing interest rates, because the integral can be evaluated exactly.

Exercises
1. The effective rate of interest per annum on a certain building society
account is at present 7% but in two years’ time it will be reduced to 6%.
Find the accumulation in five years’ time of £4000 in this account.
2. (From the 2010 exam)
(a) A capital of £100 at time t = 0 grows to £110 at t = 2, while a capital
of £100 at t = 2 grows to £120 at t = 5. Assume that the principle
of consistency holds. Compute the accumulated value at t = 5 of
a payment of £50 at t = 0, showing clearly where the principle of
consistency is used.
(b) Assume in addition to the data in question (a) that the force of
interest varies according to δ(t) = a + bt. Show that a ≈ 0.0424076
and that b ≈ 0.0052475.
(c) Compute the present value at t = 0 of a payment of £500 due at
t = 3, assuming that the force of interest varies as in question (b).
(d) An annuity pays £75 at t = 1, t = 2 and t = 3. Compute its
present value at t = 0, assuming that the force of interest varies as
in question (b).
3. (From the CT1 exam, September ’08) The force of interest, δ(t), is a
function of time and at any time t, measured in years, is given by the
formula: (
0.05 + 0.02t, for 0 ≤ t ≤ 5;
δ(t) =
0.15, for t > 5.
(a) Calculate the present value of 1,000 due at the end of 12 years.
(b) Calculate the annual effective rate of discount implied by the trans-
action in (a).

MATH1510 73
4.4 Cash flows in full generality
In Section 3.1 we looked at cash flows, irregular sequences of payments. The
main formula from that section is (3.1): the value at tim t∗ of a cash flow
consisting of payments Pk at time tk is
X
(1 + i)t∗ −tk Pk .
k

We may also incorporate continuous payment streams in the framework. Fur-

thermore, the rate of the stream may vary. Say that the rate is given by ρ(t).
As before, a positive ρ indicates income and a negative ρ indicates expenditure.
Now consider the period between time t and t + ∆t, with ∆t small. In this
period, the payment stream pays approximately (∆t) · ρ(t), because the rate is
the amount paid divided by the length of the period. The value of this payment
at time t∗ is approximately (1 + i)t∗ −t · (∆t) · ρ(t). If we sum up the values
of all these payments and then take the limit ∆t → 0, we get the integral of
(1 + i)t∗ −t ρ(t). Thus, we find that the value of varying payment stream at
time t∗ equals Z ∞
(1 + i)t∗ −t ρ(t) dt. (4.11)
−∞

We will not concern ourselves with convergence issues.

A special case is annuities payable continuously. Definition 4.2.1 states that
ān denotes the value at time t = 0 of a payment stream with rate 1 lasting
from t = 0 to t = n. This can be brought in the framework considered here by
defining the rate ρ(t) as
(
1, if 0 < t ≤ n;
ρ(t) =
0, if t ≤ 0 or t > n.

Then, ān is the present value at t∗ = 0 of the payment stream with rate ρ(t).
Substituting this in (4.11) yields
Z ∞ Z n Z n
ān = (1 + i)−t ρ(t) dt = (1 + i)−t dt = e−t log(1+i) dt
−∞ 0 0
n n
(1 + i)−t
 
1
= − e−t log(1+i) = −
log(1 + i) 0 log(1 + i) 0
(1 + i)0 (1 + i)−n 1 − (1 + i)−n 1 − vn
= − = = .
log(1 + i) log(1 + i) log(1 + i) δ

This is the same expression for ān as we found earlier in Section 4.2.1.
Some situations combine discrete and continuous cash flows. Suppose that
there are (discrete) payments of Pk at time tk , and also a continuous payment
stream with rate ρ(t). The value of the combined cash flow at time t = t∗ is
X Z ∞
(1 + i)t∗ −tk Pk + (1 + i)t∗ −t ρ(t) dt. (4.12)
k −∞

This is a combination of (3.1) and (4.11). A further generalization is that the

interest rate may also vary. This was analyzed in the previous section, where

74 MATH1510
we introduced the accumulation function A(t1 , t2 ). The value of the combined
discrete/continuous cash flow in this setting is
Z ∞
Pk A(tk , t∗ ) + ρ(t)A(t, t∗ ) dt.
−∞

Compound interest with a constant interest rate i has accumulation function

A(t1 , t2 ) = (1 + i)t2 −t1 , and substitution of this in the formula above re-
trieves (4.12).

Exercises
1. (From the CT1 exam, April ’08) The force of interest, δ(t), is a function
of time and at any time t, measured in years, is given by the formula:

0.06,
 0 ≤ t ≤ 4;
δ(t) = 0.10 − 0.01t 4 < t ≤ 7;

0.01t − 0.04 7 < t.


(a) Calculate the value at time t = 5 of £1,000 due for payment at time
t = 10.
(b) Calculate the constant rate of interest per annum convertible monthly
which leads to the same result as in (a) being obtained.
(c) Calculate the accumulated amount at time t = 12 of a payment
stream, paid continuously from time t = 0 to t = 4, under which the
rate of payment at time t is ρ(t) = 100e0.02t .

Success with the exam!!!

MATH1510 75