FMF Lecture1
FMF Lecture1
FMF Lecture1
of Money
3 Frequency of compounding
For the simple interest method, the interest earned over a period of
time is proportional to the length of the period.
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.
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
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
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.
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?
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?
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?
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?
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 ?
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?
Example
What is the accumulated amount for a principal of $100 after 25 months if
the nominal rate of interest is 4% compounded quarterly?
r p
lim 1 + = exp(r ).
p→∞ p
r p
lim 1 + = exp(r ).
p→∞ p
r p
lim 1 + = exp(r ).
p→∞ p
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).
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).
Corollary
A(t + 1) = A(t)(1 + i(t)).
Proposition
The annual effective rate of interest of simple interest rate r is given by
r
i(t) = .
1 + rt
Proposition
The annual effective rate of interest of compound interest rate r is given by
i(t) = r .
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
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?
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)
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?
Textbook questions:
Chapter 1: 1,3,4,6,7,12,13,17,22,23,25,29.