QF1100 Week 2

▶ Simple Interest and Compound Interest

▶ Frequency of Compounding

▶ Equivalent Interest Rates

▶ Continuous Compounding

▶ Future value and Present Value

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Simple Interest and Compound Interest
Let r be the annual rate of interest.

Simple Interest:

a(t) = a(t − 1) + a(0) × r ⇒ a(t) = a(0) × (1 + rt)

t 0 1 2 ··· n
a(t) a(0) a(0) + ra(0) a(0) + 2ra(0) · · · a(0) + nra(0)
Arithmetic sequence: the initial term a(0) and the common difference
ra(0).

Compound Interest:

a(t) = a(t − 1) + a(t − 1) × r ⇒ a(t) = a(0) × (1 + r)t

t 0 1 2 ··· n
a(t) a(0) a(0)(1 + r) a(0)(1 + r)2 · · · a(0)(1 + r)n
Geometric sequence: the scale factor a(0) and the common ratio
1 + r.
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Fixed-income securities
Fixed-income securities are financial instruments that traded in
well-developed markets and promise a fixed (that is, definite) income
to the holder over a span of time.

Example
▶ Savings Deposits: DBS Fixed Deposits, POSB MySavings
Account, etc.
▶ Government Securities: U.S. Treasury bills/bonds/notes,
Singapore Saving bonds.
▶ Other bonds: Municipal bonds, Corporate bonds.
▶ Mortgages
▶ Annuities: pension.

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Bonds
▶ Governments or corporations can borrow money by issuing bonds
to investors. An bond is an obligation by the bond issuer to pay
money to the bond holder according to rules specified at the time
the bond is issued.
▶ A bond pays a specific amount, its face value or, equivalently,
its par value at the date of maturity.
▶ Coupon rate (for coupon-paying bonds): the bond’s interest
payments, as a percentage of the par value, to be made to
investors at regular intervals during the term of the loan.
▶ Most bonds pay periodic coupon payments: the number of
coupon payments per year, the total number of coupon
payments.

Example.
A 10-year, 9% coupon bond with a face value of $1000 will have a
coupon of $90 per year.
Assume that coupon payments are made every 6 months and paying
one-half of the coupon amount. Then the coupon payment would be
$45.
At the date of maturity, the total interests are $45 × 2 × 10 = $900. 4/25
Exercise (SSB)
I plan to buy $1000 SBFEB24. If I hold the bond to maturity, how
much earnings I will get?

The interest rates are given as follows:

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Example (More general)

Suppose the annual rate of interest of

▶ over the time interval [0, t1 ] is r1 ,
▶ over the time interval [t1 , t1 + t2 ] is r2 , . . . . . .,
▶ over the time interval
[t1 + t2 + . . . + tn−1 , t1 + t2 + . . . + tn−1 + tn ] is rn .
Find a(t1 + t2 + . . . + tn−1 + tn ) if
(i) simple interest is paid
(ii) compound interest is paid.

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Solution
Solution of (i). Note that
a(t1 + t2 + . . . + tn−1 + tn )
=a(t1 + t2 + . . . + tn−1 ) + tn rn a(0)
=a(t1 + t2 + . . . + tn−2 ) + tn−1 rn−1 a(0) + tn rn a(0)
···
=a(0) + t1 r1 a(0) + t2 r2 a(0) + · · · + tn−1 rn−1 a(0) + tn rn a(0)
Xn
=a(0)(1 + ti ri ).
i=1

Solution of (ii). Note that

a(t1 + t2 + . . . + tn−1 + tn ) = a(t1 + t2 + . . . + tn−1 )(1 + rn )tn
By induction, we have
a(t1 + t2 + . . . + tn−1 + tn )
=a(0) × (1 + r1 )t1 × (1 + r2 )t2 × · · · × (1 + rn )tn
n
Y
=a(0) (1 + ri )ti .
i=1 7/25
Frequency of Compounding
When an interest of r = r(p) is paid p times a year (or equivalently,
r(p) is convertible pthly or r(p) is compounded p times a year),
we call p the frequency of compounding and r(p) the nominal
rate of interest.
1
The interest to be paid over one period (of length year for
p
r(p)
instance), is .
p
r(p)
 
Effectively, $1 invested at time t = 0 will grow to 1 + over a
p
period of length p1 , so that the accumulated amount after one year is
 (p)
p
a(1) = a( pp ) = 1 + r p .

Remark.
(i) We write the superscript (p) for r(p) to indicate the frequency of
compounding p.
(ii) We can drop the superscript (p) when p = 1.
(iii) p = 2, 4 and 12 correspond to semi-annual, quarterly and
monthly compounding respectively 8/25
Example (Frequency of Compounding)
Suppose a(t) is the accumulation function and r(p) the interest rate
compounded
  p times
 ayear.

1 2 3
Find a ,a ,a , and a(1).
p p p

Solution.
r(p)
   
1
a =a(0) × 1 + ;
p p
2
r(p)
  
2
a =a(0) × 1 + ;
p p
p
r(p)

a(1) =a(0) × 1 + .
p
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Example
At what nominal rate convertible monthly will money be doubled in 5
years?

Solution. Since the nominal rate is convertible monthly, the frequency

of compounding is 12, i.e., p = 12. Thus
" 12 #5
r(12)
a(5) = a(0) 1 + .
12
The accumulation amount is doubled, meaning
" 12 #5
r(12)
a(5) = 2a(0) ⇐⇒ 1+ = 2.
12

Solve for r(12) :

r(12) 1 1
1+ = 2 60 ⇒ r(12) = 12(2 60 − 1) ≈ 0.139.
12 10/25
Cash flow stream
Consider a cash flow stream:
(x0 , x1 , . . . , xn ),
(possibly a series of deposits and withdrawals).

Remark
▶ It is on a fixed time cycle for compounding (for example,
monthly, yearly).
▶ The initial cash flow is x0 .
▶ Cash flows occur at the end of each period (the length of the
time cycle).
▶ There are n periods.
We can construct a cash flow diagram for (x0 , x1 , . . . , xn ) as follows:

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Cash flow of the bond
▶ F : the face value of a bond
▶ c%: the coupon rate
▶ m: the number of coupon payments per year
▶ n: the total number of coupon payments

c% c% c%
(−F , F × ,F × ,...,F × + F)
| m m {z m }
n: total number of coupon payments

The cash flow is the following: a(0) = −1000

6m 12m 18m 24m 30m 36m 42m 48m 54m 60m
13.60 13.60 13.60 13.60 13.60 13.60 13.60 13.60 13.60 13.60
66m 72m 78m 84m 90m 96m 102m 108m 114m 120m
13.60 13.60 13.60 13.60 14.95 14.95 15.45 15.45 15.45 15.45 + 103
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Effective Annual Interest Rate
The effective annual interest rate, denoted by re , is given by
p
r(p)

1 + re = 1+
p

The corresponding accumulation function is

pt
r(p)

t
a(t) = (1 + re ) = 1+ , t = 1, 2, 3, . . .
p

Fact: For p ≥ 1, the effective annual interest rate is always greater

than the nominal rate r(p) . That is, for any positive integer p,
p
r(p)

re = 1+ − 1 ≥ r(p)
p

Bernoulli inequality: If x > 0, then (1 + x)n ≥ 1 + nx for any positive

integer n.
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Exercise
A sum of $8000 is deposited in an account that pays 12% nominal
interest compounded daily.
After how many days will the accumulated amount exceed $12, 000?
(Assume that 1 year = 365 days).
Solution.
1. Find p. That is, what is the frequency of compounding?

2. Solve for t such that a(t) > 12000.

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Exercise
Use Fixed Deposits Rates to answer the following questions. Assume
that the rates are effective annual rates.
1. I would like to place $1000 to a 12-months fixed deposit in 3.2%
p.a. What will the accumulated value be after one year?

2. If I place $1000 to a 6-months fixed deposit in 2.9% p.a. and

renew it once, what will the accumulated value be after one year?

3. What is the nominal rate above?

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Equivalent Interest Rates
Two nominal interest rates are said to be equivalent if and only if
they yield same accumulation amount over a year. Hence, the
nominal rates r(p) and r(q) are equivalent if and only if
!p !q
r(p) r(q)
1+ = 1+ .
p q
Example Find the nominal rate convertible monthly that is
equivalent to a 4% nominal rate convertible quarterly.

Solution. Let r(12) be the nominal rate convertible monthly and

r(4) = 4% be the nominal rate convertible quarterly. Since they are
equivalent, we have
12  4  4
r(12) r(4)

4%
1+ = 1+ = 1+ .
12 4 4
Solve for r(12) :
r(12) 4
1+ = 1.01 12
12
4
⇐⇒ r(12) = 12(1.01 12 − 1) ≈ 0.0399 = 3.99%.
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Exercise
1. Find, to the significant figure, the effective annual rate of interest
equivalent to 18% compounded monthly.

2. Find, to the significant figure, the nominal rate convertible

quarterly that is equivalent to 8% nominal rate convertible
semi-annually.

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Continuous Compounding
We say that interest is compounded continuously when the
frequency of compounding tends to infinity.

Let r(∞) denote the nominal rate of interest under continuous

compounding. Then,
p
r(∞)

(∞)
a(1) = lim 1+ = er ,
p→∞ p
where e ≈ 2.718 is the Euler number.
The number r(∞) is known as the continuously compounded rate
of interest.

Figure: Graph of f (x) = (1 + x1 )x

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Continuous Compounding
The accumulation function of continuous compounding is
(∞) (∞)
a(t) = [er ]t = er t
, t ≥ 0.

The two rates r(p) and r(∞) are equivalent if

p
r(p)

(∞)
1+ = er = 1 + re .
p

Example
An investor makes a deposit today to earn an effective annual return
rate of 4% over the first 3 years, and a nominal rate of 3%
compounded monthly for the next 2 years. What continuously
compounded return rate must be earned over the subsequent five years
in order to triple the original investment by the end of ten years?

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Solution

Solution

The first 3 years : a(3) = a(0)(1 + 4%)3 ,

" 12 #2
3%
The next 2 years : a(5) = a(3) 1 +
12
h i5
The subsequent five years : a(10) = a(5) er(∞) .

Thus
" 12 #2 h i5
3 3%
a(10) = a(0)(1 + 4%) 1+ er(∞) = 3a(0)
12
⇒e5r(∞) = 3 × 1.04−3 × 1.0025−24
⇒r(∞) = 18.42%.

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Investment selection
Cycle Problem: Automobile purchase
▶ Car A costs $20,000, Maintenance cost of $1,000 per year, a
useful mileage life 4 years;
▶ Car B costs $30,000, Maintenance cost of $2,000 per year, a
useful mileage life 6 years;
Assumption: No salvage value, interest rate is 10%, a planning period
of 12 years.

Question: Which car should you buy?

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Present value
Question: Suppose that you have to pay your tuition in exactly 1
year, say $100. If the current annual interest rate is r, how much
money you need now?

We say that $100 has a present value of $100/(1 + r), or the present
value of $100 is $100/(1 + r).

Let r be the annual rate, compounded at the end of each year.

Suppose that a cash payment of amount A will be received at the end
of the n-th period.
Then the present value PV of a payment of A to be received n
periods in the future is
A
A = P V × (1 + r)n ⇒ P V = .
(1 + r)n

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Future value of a stream
Given a cash flow stream (x0 , x1 , ..., xn ) and an annual rate r,
Future value of a stream:
n
X
F V = x0 (1 + r)n + x1 (1 + r)n−1 + · · · + xn = xk (1 + r)n−k .
k=0

Example. Consider the cash flow stream (−2, 1, 1, 1) when the periods
are years and the annual rate is 10%. The future value is

F V = −2 × (1.1)3 + 1 × (1.1)2 + 1 × 1.1 + 1 = 0.648.

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Present value of a stream
Present value of a stream:
n
x1 x2 xn X
P V = x0 + + 2
+ ··· + n
= xk (1 + r)−k .
1 + r (1 + r) (1 + r)
k=0

For example, the present value of x0 is x0 ; The present value of x1 is

x1 xn
1+r ; The present value of xn is (1+r)n .

Example. Consider the cash flow stream (−2, 1, 1, 1) when the periods
are years and the annual rate is 10%. The present value is
1 1 1
P V = −2 + + 2
+ = 0.487
1.1 (1.1) (1.1)3
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Reading material  x
1  r x
Suppose r > 0. Find lim 1+ and lim 1+ .
x→∞ x x→∞ x
Solution.
x
Let f (x) = 1 + x1 . Then ln f (x) = x ln(1 + x1 ).
Using L’Hôpital Rule,

1 ln(1 + x1 )
lim ln f (x) = lim x ln(1 + ) = lim 1
x→∞ x→∞ x x→∞
x
ln(1 + t) 1
= lim+ let t =
t→0 t x
1
1+t
= lim+ by L’Hôpital Rule
t→0 1
=1.
 x
1
Then lim 1+ = e1 . And
x→∞ x
" x/r #r
 r x 1
lim 1 + = lim 1+ = er .
x→∞ x x→∞ x/r
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