FMF Lecture1

Download as pdf or txt
Download as pdf or txt
You are on page 1of 66

Lecture 1: Interest Accumulation and Time Value

of Money

Lecturer: Phạm Thị Hồng Thắm

Foundations of Mathematical Finance

PTHT Lecture 1 FMF 1 / 35


Table of Contents

1 Accumulation Function and Amount Function

2 Simple and Compound Interest

3 Frequency of compounding

4 Annual Effective Rate of Interest

5 Generalized nominal rate of interest ih (t)

PTHT Lecture 1 FMF 2 / 35


Accumulation Function and Amount Function

PTHT Lecture 1 FMF 3 / 35


Basic terminologies

PTHT Lecture 1 FMF 4 / 35


Basic terminologies

Many financial transactions involve lending and borrowing.

PTHT Lecture 1 FMF 4 / 35


Basic terminologies

Many financial transactions involve lending and borrowing.


The sum of money borrowed is called the principal.

PTHT Lecture 1 FMF 4 / 35


Basic terminologies

Many financial transactions involve lending and borrowing.


The sum of money borrowed is called the principal.
To compensate the lender for the loss of use of the principal during
the loan period the borrower pays the lender an amount of interest.

PTHT Lecture 1 FMF 4 / 35


Basic terminologies

Many financial transactions involve lending and borrowing.


The sum of money borrowed is called the principal.
To compensate the lender for the loss of use of the principal during
the loan period the borrower pays the lender an amount of interest.
At the end of the loan period the borrower pays the lender the
accumulated amount, which is equal to the sum of the principal
plus interest.

PTHT Lecture 1 FMF 4 / 35


Accumulated function a(t)

PTHT Lecture 1 FMF 5 / 35


Accumulated function a(t)

We denote A(t) as the accumulated amount at time t, called the


amount function.

PTHT Lecture 1 FMF 5 / 35


Accumulated function a(t)

We denote A(t) as the accumulated amount at time t, called the


amount function.
Hence, A(0) is the initial principal and

I (t) = A(t + 1) − A(t)

is the interest incurred from time t to time t + 1.

PTHT Lecture 1 FMF 5 / 35


Accumulated function a(t)

We denote A(t) as the accumulated amount at time t, called the


amount function.
Hence, A(0) is the initial principal and

I (t) = A(t + 1) − A(t)

is the interest incurred from time t to time t + 1.


For the special case of an initial principal of $1, we denote the
accumulated amount at time t by a(t).

PTHT Lecture 1 FMF 5 / 35


Simple and Compound Interest

PTHT Lecture 1 FMF 6 / 35


Simple and Compound Interest

PTHT Lecture 1 FMF 7 / 35


Simple and Compound Interest

There are many ways to calculate interest.

PTHT Lecture 1 FMF 7 / 35


Simple and Compound Interest

There are many ways to calculate interest.


The two most common methods are the simple interest method and
the compound interest method.

PTHT Lecture 1 FMF 7 / 35


Simple interest

PTHT Lecture 1 FMF 8 / 35


Simple interest

For the simple interest method, the interest earned over a period of
time is proportional to the length of the period.

PTHT Lecture 1 FMF 8 / 35


Simple interest

For the simple interest method, the interest earned over a period of
time is proportional to the length of the period.
The interest incurred from time 0 to time t, for a principal of $1, is
r × t, where r is the constant of proportion called the rate of
interest.

PTHT Lecture 1 FMF 8 / 35


Simple interest

For the simple interest method, the interest earned over a period of
time is proportional to the length of the period.
The interest incurred from time 0 to time t, for a principal of $1, is
r × t, where r is the constant of proportion called the rate of
interest.
The accumulation function for the simple-interest method is

a(t) = 1 + rt, A(t) = A(0)(1 + rt). (1)

PTHT Lecture 1 FMF 8 / 35


Simple interest

For the simple interest method, the interest earned over a period of
time is proportional to the length of the period.
The interest incurred from time 0 to time t, for a principal of $1, is
r × t, where r is the constant of proportion called the rate of
interest.
The accumulation function for the simple-interest method is

a(t) = 1 + rt, A(t) = A(0)(1 + rt). (1)

The rate of interest may be quoted for any period of time (such as a
month or a year). However, the most commonly used base is the year,
in which case the term annual rate of interest is used.

PTHT Lecture 1 FMF 8 / 35


Example: simple interest

Example
a) $550 is deposited at 4.6% simple interest for five years. What is the
accumulated amount at the end of this period?
b) At what rate of simple interest will $550 accumulate to $645 in three
years?

PTHT Lecture 1 FMF 9 / 35


Compound interest

PTHT Lecture 1 FMF 10 / 35


Compound interest

For the compound-interest method, the accumulated amount over a


period of time is the principal for the next period.

PTHT Lecture 1 FMF 10 / 35


Compound interest

For the compound-interest method, the accumulated amount over a


period of time is the principal for the next period.
Thus, a principal of 1 unit accumulates to (1 + r ) units at the end of
the year, which becomes the principal for the second year.

PTHT Lecture 1 FMF 10 / 35


Compound interest

For the compound-interest method, the accumulated amount over a


period of time is the principal for the next period.
Thus, a principal of 1 unit accumulates to (1 + r ) units at the end of
the year, which becomes the principal for the second year.
Continuing this process, the accumulation function becomes

a(t) = (1 + r )t , A(t) = A(0)(1 + r )t for t = 0, 1, 2, ... (2)

PTHT Lecture 1 FMF 10 / 35


Compound interest (continued)

PTHT Lecture 1 FMF 11 / 35


Compound interest (continued)

For the compound-interest method the accumulated amount at the


end of a year becomes the principal for the following year, whereas
the principal does not change for simple interest over the loan period.

PTHT Lecture 1 FMF 11 / 35


Compound interest (continued)

For the compound-interest method the accumulated amount at the


end of a year becomes the principal for the following year, whereas
the principal does not change for simple interest over the loan period.
The formula for the accumulation function only works for integral
values of t whereas the same formula for simple interest works for all
positive value of t.

PTHT Lecture 1 FMF 11 / 35


Compound versus Simple interest

PTHT Lecture 1 FMF 12 / 35


Examples: compound interest

Example
a) $550 is deposited at 4.6% compound interest per annum for five
years. What is the accumulated amount at the end of this period?
b) At what rate of compound interest per annum will $550 accumulate
to $645 in three years?
c) You have $500 on deposit earning 8.2% annual compound interest.
How long will it be before your account balance is $856?

PTHT Lecture 1 FMF 13 / 35


Examples: compound interest

Example
$500 is deposited in an account earning annual compound interest of
5.7%. At the end of two years the accumulated amount is transferred to
an account which pays an unknown annual compound interest. At the end
of three additional years the account shows a balance of $600. What was
the rate of annual compound interest during the final three years?

PTHT Lecture 1 FMF 14 / 35


Example: compound interest

Example
An investment is earning compound interest. If $100 invested in year 2
accumulates to $105 by year 4, how much will $500 invested in year 5 be
worth in year 10?

PTHT Lecture 1 FMF 15 / 35


Example: compound interest

Example
Smith deposits $1000 into an account on 1/1/2005. The account credits
interest at 5% per annum at every 31/12. Smith withdraws $200 on
1/1/2007, deposits $100 on 1/1/2008 and withdraws $250 on 1/1/2010.
What is the balance of the account just after interest is credited on
31/12/2011 ?

PTHT Lecture 1 FMF 16 / 35


Frequency of compounding

PTHT Lecture 1 FMF 17 / 35


Frequency of compounding

PTHT Lecture 1 FMF 18 / 35


Frequency of compounding

The the frequency of compounding is the number of times interest


payments are made annually.

PTHT Lecture 1 FMF 18 / 35


Frequency of compounding

The the frequency of compounding is the number of times interest


payments are made annually.
We say that the nominal rate of interest is i (p) convertible p times
per annum if the interest is paid every 1/p of a year at the rate of
i (p) /p.

PTHT Lecture 1 FMF 18 / 35


Frequency of compounding

The the frequency of compounding is the number of times interest


payments are made annually.
We say that the nominal rate of interest is i (p) convertible p times
per annum if the interest is paid every 1/p of a year at the rate of
i (p) /p.
Starting at $1, after t years, the accumulated account grows to
!tp
i (p)
a(t) = 1 + . (3)
p

PTHT Lecture 1 FMF 18 / 35


Frequency of compounding

The the frequency of compounding is the number of times interest


payments are made annually.
We say that the nominal rate of interest is i (p) convertible p times
per annum if the interest is paid every 1/p of a year at the rate of
i (p) /p.
Starting at $1, after t years, the accumulated account grows to
!tp
i (p)
a(t) = 1 + . (3)
p

In cases when the loan period is not a multiple of the compound


period, we adopt the convention that (3) can be used even when tp is
not a whole number.

PTHT Lecture 1 FMF 18 / 35


Example

Example
$1,000 is deposited into a savings account that pays 3% interest with
monthly compounding. What is the accumulated amount after two and a
half years? What is the amount of interest earned over this period?

PTHT Lecture 1 FMF 19 / 35


Example

Example
What is the accumulated amount for a principal of $100 after 25 months if
the nominal rate of interest is 4% compounded quarterly?

PTHT Lecture 1 FMF 20 / 35


Continuous Compounding

PTHT Lecture 1 FMF 21 / 35


Continuous Compounding
At the same nominal rate of interest r , the more frequent the interest
is paid, the faster the accumulated amount grows. Indeed, if p > q
then
r p r q
   
1+ > 1+
p q

PTHT Lecture 1 FMF 21 / 35


Continuous Compounding
At the same nominal rate of interest r , the more frequent the interest
is paid, the faster the accumulated amount grows. Indeed, if p > q
then
r p r q
   
1+ > 1+
p q

When the number of interest payments per annum approaches


infinity, the accumulated amount tends to a finite number

r p
 
lim 1 + = exp(r ).
p→∞ p

PTHT Lecture 1 FMF 21 / 35


Continuous Compounding
At the same nominal rate of interest r , the more frequent the interest
is paid, the faster the accumulated amount grows. Indeed, if p > q
then
r p r q
   
1+ > 1+
p q

When the number of interest payments per annum approaches


infinity, the accumulated amount tends to a finite number

r p
 
lim 1 + = exp(r ).
p→∞ p

We call the compounding scheme over infinitely small period of time


continuous compounding.

PTHT Lecture 1 FMF 21 / 35


Continuous Compounding
At the same nominal rate of interest r , the more frequent the interest
is paid, the faster the accumulated amount grows. Indeed, if p > q
then
r p r q
   
1+ > 1+
p q

When the number of interest payments per annum approaches


infinity, the accumulated amount tends to a finite number

r p
 
lim 1 + = exp(r ).
p→∞ p

We call the compounding scheme over infinitely small period of time


continuous compounding.
Daily compounding is very close to continuous compounding.

PTHT Lecture 1 FMF 21 / 35


Continuous Compounding

PTHT Lecture 1 FMF 22 / 35


Annual Effective Rate of Interest

PTHT Lecture 1 FMF 23 / 35


Annual effective rate of interest

Definition
The annual effective rate of interest at time t, denoted by i(t), is the ratio
of the amount of interest earned in a year, from time t to time t + 1, to
the accumulated amount at the beginning of the year (i.e., at time t).

A(t + 1) − A(t) a(t + 1) − a(t)


i(t) = = . (4)
A(t) a(t)

PTHT Lecture 1 FMF 24 / 35


Annual effective rate of interest

Definition
The annual effective rate of interest at time t, denoted by i(t), is the ratio
of the amount of interest earned in a year, from time t to time t + 1, to
the accumulated amount at the beginning of the year (i.e., at time t).

A(t + 1) − A(t) a(t + 1) − a(t)


i(t) = = . (4)
A(t) a(t)

Corollary
A(t + 1) = A(t)(1 + i(t)).

PTHT Lecture 1 FMF 24 / 35


Simple interest

PTHT Lecture 1 FMF 25 / 35


Simple interest

Proposition
The annual effective rate of interest of simple interest rate r is given by
r
i(t) = .
1 + rt

PTHT Lecture 1 FMF 25 / 35


Annual effective rate of simple interest versus time

PTHT Lecture 1 FMF 26 / 35


Compound interest

Proposition
The annual effective rate of interest of compound interest rate r is given by

i(t) = r .

PTHT Lecture 1 FMF 27 / 35


Compound interest

Proposition
The annual effective rate of interest of nominal rate of interest of i (p)
convertible p times per annum
!p
i (p)
i(t) = 1 + − 1.
p

PTHT Lecture 1 FMF 28 / 35


Example

Example
Consider two investment schemes A and B. Scheme A offers 12% interest
with annual compounding. Scheme B offers 11.5% interest with monthly
compounding. Calculate the effective rates of interest of the two
investments. Which scheme would you choose?

PTHT Lecture 1 FMF 29 / 35


Example
Suppose i(t) = 0.05 + 0.001t for t = 0, 1, .., 4. What is the accumulation
of $10,000 at these rates of interest over the period t = 0 to t = 5?

PTHT Lecture 1 FMF 30 / 35


Generalized nominal rate of interest ih (t)

PTHT Lecture 1 FMF 31 / 35


Generalized nominal rate of interest ih (t)

Definition
Let h > 0, the generalized nominal rate of interest ih (t) is defined as

1 a(t + h) − a(t)
ih (t) = × .
h a(t)

PTHT Lecture 1 FMF 32 / 35


ih (t) - continued

PTHT Lecture 1 FMF 33 / 35


ih (t) - continued

This is the annualized effective rate of interest between time t and


t + h.

PTHT Lecture 1 FMF 33 / 35


ih (t) - continued

This is the annualized effective rate of interest between time t and


t + h.
Equivalently, $1 at time t will grow to $1 + hih (t) at time t + h.

PTHT Lecture 1 FMF 33 / 35


ih (t) - continued

This is the annualized effective rate of interest between time t and


t + h.
Equivalently, $1 at time t will grow to $1 + hih (t) at time t + h.
The nominal rate of interest i (p) for compound interest convertible p
times per year is a special case of ih (t) with h = 1/p and interest is
constant over time.

PTHT Lecture 1 FMF 33 / 35


Example ih (t)

Example
We are given the nominal interest rates i0.4 (0) = 0.05, i0.6 (0.4) = 0.06,
i0.5 (1) = 0.04. What is the accumulation of $1 from time 0 to 1.5?

PTHT Lecture 1 FMF 34 / 35


Homework

Textbook questions:
Chapter 1: 1,3,4,6,7,12,13,17,22,23,25,29.

PTHT Lecture 1 FMF 35 / 35

You might also like