Universidad Carlos III de Madrid 9/2/2010

Topic 2 Useful tools: financial mathematics

Outline:

Topic 2 SESSION 3
Useful tools:
2.1 Introduction: The time value of money
Financial Mathematics
2.2 Simple and compound interest. Equivalent interest
Copyright of Spanish version from María Gutiérrez
rates.
Translation into English by Francisco Romero

2.3 Present and Future Values.

Universidad Carlos III
Financial Economics 2.4 Annuities

2.5 Loan amortization

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Topic 2 Useful tools: financial mathematics 2.1 Introduction: the time value of money
Learning objectives:
 The value of money depends on the point in time when
the monetary flow (inflow/outflow) takes place.
1. Understand the impact of time in the valuation of
monetary flows.  The value of a future flow is lower than the value of a
2. Understand the concept of interest rate and its present flow.
determinants
3. Calculate present and future values of payment flows. Why?
 Giving up present consumption.
4. Be able to value annuities.
 Giving up alternative investment opportunities.
5. Understand the amortization schedule of loans.  Default risk and inflation risk.

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2.1 Introduction: The time value of money 2.1 Introduction: The time value of money
 When you deposit your money in a bank account or lend it If you require an annual interest rate of 8% on a 1-year
for a given period of time, you are exchanging a cash-flow deposit of 100 euros, this implies that:
today for a cash-flow in the future. As compensation for
 You are indifferent between holding €100 today and the
this you need to receive interest.
bank’s “promise” to pay you €108 in one year.
 Interest is the price or reward for giving up capital for a
 The banks’s “promise” to pay you €108 in one year has
certain period of time.
the same value as holding €100 today.
 Interest rate is the price per unit of capital and time.
 €100 euros is the present value of a promise to pay €108
 In a loan a different interest rate is negotiated depending on in one year.
the:
 The €108 promised payment is the future value in one
 Propensity to consume
year’s time of €100 today.
 Return on alternative investment opportunities.
 Expected inflation rate
 Debtor´s default risk.
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2.2 Simple and compound interest. 2.2 Simple and compound interest.
Equivalent interest rates Equivalent interest rates
Assume we invest our savings in a bank deposit according to
Simple interest :
the following conditions: t Capital Interests earned
 Starting date t=0 • At the beginning of each invested at and paid out
 End date t=N period we always have C the beginning during t
 N time units (days, months, quarters, years). invested. of t
C capital invested at t=0

 I total interest
• iC is the interest that
1
2
C
C
iC
iC
 i agreed interest rate (we assume no change during the period of reference). corresponds to each period.
3 C iC
• Total interest during the …
The interest rate depends on whether you have: operation: I=niC N C iC
 Simple interest: interest payments will be received at the end of • Total amount obtained after
each period (and can be used freely). Interest earned only on the N periods:
original C. C+I=C+niC=C(1+in)
 Compound interest: interests will be received at the end of the
operation. Interest earned on interest.
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2.2 Simple and compound interest. 2.2 Simple and compound interest.
Equivalent interest rates Equivalent interest rates
Simple interest for fractional time periods m (i*) is
A €1,000 bank deposit for 2 years at a 5% a year simple equivalent to a simple annual rate (i). The total amounts
interest rate is worse for its holder than the same deposit at a paid at the end of the operations are the same. => i*=i/m
7% year simple interest rate.
(m=2 semester, m=4 quarter, m=12 month, …)
¿What happens if the offer is 0.5% a month simple interest
rate?
 1. Can you demonstrate that i*=i/m ?

 2. What is the simple interest per month equivalent to a 5%

a year simple interest rate?

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2.2 Simple and compound interest. 2.2 Simple and compound interest.
Equivalent interest rates Equivalent interest rates
Compound interest for fractional time periods (im) is equivalent to the
Compound interest: compound annual rate (i). The total amounts paid at the end of the
t Capital Interests earned operations are the same. => im=(1+i)1/m -1
invested at during t
• Total investment grows at the the • i= (1+im)m -1 is the annual equivalent rate (AER) to a compound
end of each period since interests beginning of
t
interest for fractional time periods im. It is also known as effective rate.
are acummulated.
• Interest rate applies to the
1
2
C
C(1+i)
iC
iC(1+i)
Can you demonstrate that im=(1+i)1/m -1 ?
principal+interests received so far
3 C(1+i)2 iC(1+i)2
• Total interests generated during
…
the lifetime of the loan is C(1+i)N Bank X offers an interest rate of 3% a year compound interest in a 5 year
N C(1+i)N-1 iC(1+i)N-1 deposit, and Bank Y offers an interest rate of 1.5% a semester compound
-C
interest for a 5 year deposit. Which one would you choose? The total
• Total amount to be received by
amounts after 5 years are
the investor is C(1+i)N

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2.3 Present and Future Values 2.3 Present and Future Values

Compound interest allows us to establish a correspondence Example: for an annual rate of 3%.
between present and future values.  Would you prefer to have €100 today or €107 within two
years?
 V0 today is equivalent to (1+i)NV0 in N periods.
 What is the present value of €10,000 to be received
 V0 is the present value of (1+i)NV0 received in N periods. within one year?

 (1+i)NV0 is the future value in N periods equivalent to  What is the final value of a three year fixed term deposit
investing V0 today. of €13,500, starting today?

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2.3 Present and Future Values 2.3 Present and Future Values
Assume a 4% interest rate. You are indifferent between:
Example: Calculate compound and
(1+i)N is the compound factor, discount factors for 1, 2, 3, 4 and 5 years
 €100 euros today and 104=100(1.04) in 1 year.
 It is the future value in N periods with interest rates of 1%, 2%, 3%, 4% and
of investing €1 today. 5% respectively.

INTEREST 1 2
PERIOD (YEAR)
3 4 5
 €100 euros today and 108.16=100(1.04)2 in 2 years.
compound factors
(1+i)-N is the discount factor, 1% 1.01 1.02 1.03 1.04 1.05
2% 1.02 1.04 1.06 1.08 1.10
 It is the present value of an 3% 1.03 1.06 1.09 1.13 1.16  €104 in 1 year and 108.16=104(1.04) in 2 years.
4% 1.04 1.08 1.12 1.17 1.22
investment that produces €1 in N 5% 1.05 1.10 1.16 1.22 1.28
discount factors
periods. 1% 0.99 0.98 0.97 0.96 0.95  €100 euros in 3 years and 88.90=100(1.04)-3 today.
2% 0.98 0.96 0.94 0.92 0.91
3% 0.97 0.94 0.92 0.89 0.86
4% 0.96 0.92 0.89 0.85 0.82

i is also known as the discount rate. 5% 0.95 0.91 0.86 0.82 0.78
 a €100 annuity for the next 5 years and 445.18 today.

Obviously, time value of money (i>0)  445.18=100(1.04)-1+100(1.04)-2+100(1.04)-3+100(1.04)-4+100(1.04)-5

implies that: (1+i)-N <1< (1+i)N

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2.3 Present and Future Values 2.4 Annuities

To obtain the PV of a stream of payments made at Annuity: stream of equally spaced payments (A0, A1, A2,…AN) increasing over
different dates, compute the PV of each payment and add time at rate f, i.e. At=At-1(1+f), for a limited period of time.
them up. PV of an annuity is:
 This can be too time consuming even when using a V0 = A1 (1 + i) −1 + A2 (1 + i ) −2 + A3 (1 + i) −3 + ... + AN (1 + i ) − N
calculator or a spreadsheet.
V0 = A1 (1 + i) −1 + A1 (1 + f )(1 + i ) −2 + A1 (1 + f ) 2 (1 + i) −3 + ... + A1 (1 + f ) N −1 (1 + i) − N
 But there are special cases for which the PV of a stream
of payments can be easily obtained with simple formulas. [
V0 = A1 (1 + i) −1 1 + (1 + f )(1 + i) −1 + (1 + f ) 2 (1 + i ) −2 + ... + (1 + f ) N −1 (1 + i) −( N −1) ]
 We are dealing with a geometric series: is a series with a constant ratio
between sucessive terms.

 If q= (1+f)(1+i)-1
[
V0 = A1 (1 + i ) −1 1 + q + q 2 + q 3 + ... + q N −1 ]
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2.4 Annuities 2.4 Annuities

Formula to calculate the PV of an annuity:
To compute the sum of N terms of a geometric progression:
S = 1 + q + q 2 + q 3 + ... + q N −1
[
V0 = A1 (1 + i ) −1 1 + q + q 2 + q 3 + ... + q N −1 ]
1− qN
qS = q + q + q + ... + q
2 3 N
V0 = A1 (1 + i ) −1

1− q
S − qS = 1 − g N N
1+ f 
1− 
V0 = A1 (1 + i ) −1  1+ i 
1− q N
1+ f
S= 1−
1− q 1+ i

V0 = A1
[
1 − (1 + f ) N (1 + i ) − N ]
Example: Compute the sum of a geomeric progression with 15 terms, initial i− f
value equal to 1 and a ratio between successive terms of 3/4? What if the Example: compute the PV of an annuity that grows at 3% a year if the first
number of terms is infinite? payment of €1,000 takes place in one year and 10 annual payments will be made
(including the first one); the interest rate is 5% a year.

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2.4 Annuities 2.5 Loan amortization

• This formula is much simpler for some So far we have talked mainly about deposits.
special cases: A1
V0 = A deposit can be seen a loan given to the bank.
 Constant and perpetual i
annuity: Perpetuity
V0 = A1
1 − (1 + i ) − N  In general, a loan is a contract whereby:
i  An agent (borrower or debtor) uses the capital/money that
 Constant annuity: belongs to someone else (lender or creditor) for a certain
period of time. At the end of this period, the agent returns the
• It is also possible to use formulas to VN = V0 (1 + i ) N capital and and interests are paid over the lifetime of the loan.
calculate the FV of an annuity: (1 + i ) N − (1 + f ) N
VN = A1 The capital can also be returned over time.
i− f
Example: Compute the PV of a constant annuity, considering that the first In general, we can differentiate between two types of loans:
payment of €500 takes place in one year, and payments are made for 20 years.  Fixed principal payments
The interest rate is 3%.
 Constant annuities

 Example: mortgages at EURIBOR+spread

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2.5 Loan amortization 2.5 Loan amortization

1. Loans with fixed payments of principal:
principal Year Annuity Interests Principal Total Principal
(constant Amortized pending
payments)
 Each period, the same amount of capital or principal is 0 0 0 0 0 10.000
paid out.
1 2.600 600 2.000 2.000 8.000
2 2.480 480 2.000 4.000 6.000
 Assuming a €10,000 loan with a 6% annual compound
3 2.360 360 2.000 6.000 4.000
interest rate, to be amortized in 5 annual payments.
4 2.240 240 2.000 8.000 2.000
5 2120 120 2.000 10.000 0
 Given fixed principal payments: 10,000/5=2,000€
Step 5:
Step 2
 Then, we start by filling in the payment amount on Principal payment + Interests =
= 2.000 + 600 = 2.600€ Step 4:
Step 1 Step 3

the amortization schedule, as follows. (Principal Pending)*i =

= 10,000 * 0.06 = 600€

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2.5 Loan amortization 2.5 Loan amortization

Loans with constant annuities: We prepare the amortization schedule for this loan with
 In this case, payments are constant, i.e., the amount equivalent to principal
constant annuities:
+ interest payments remain constant..
 We start by filling in the column with the amount of
 First of all, a constant annuity needs to be computed: this is determined by the constant annuity.
equating the PV of the debtor’s payments and the capital lent by the  Then the interest payments (Principal pending * i)
creditor (we can use the formula of the PV of a constant annuity):,
 We compute the principal payment (Constant Annuity
1 − (1 + i ) −T  – Interests)
Initial Capital = C  
 i   Thereafter we obtain the pending amount of Principal
 From the previous example: (Principal pending – Principal payment)
1 − (1 + 0.06) −5   Repeat this process for every year.
10.000 = C    C = 2.374€
 0.06 

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2.5 Loan amortization Readings

Year Annuity Interests Principal Total Principal
payment Amortized pending 1. Grinblatt , M. y S.Titman, “Financial Markets and
0 0 0 0 0 10.000 Corporate Strategy”, McGraw-Hill 2003.
1 2.374 600 1.774 1.774 8.226 TOPIC 9
2 2.374 493.6 1.884,4 3.654,4 6.345,6
3 2.374 380.7 1.993,3 5.647,7 4.352,3
2. Brealey, R., S. Myers y Allen, “Corporate Finance
4 2.374 261.1 2112.9 7.760,6 2.239,4
Principles” 8th edition, Mcgraw-Hill 2006
5 2.374 134 2.240 10.000 0
Step 4:
TOPIC 3
Step 5:
Step 1

Step 2:
Principal Pending (t-1) – Principal Payment
3. Navarro, E. y Nave, J. , “Fundamentos de Matemáticas
(Principal Pending) * i = Financieras”, Antoni Bosch Editor, SA. 2001
= 10.000 * 0.06 = 600€
Step 3:
Annuity - Interests =
TOPICS 1 and 2.
= 2.374 - 600 = 1.774€

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