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22 views31 pages

Chapter 3 Part1 Stu

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diectran.2210
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© © All Rights Reserved
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MATHEMATICS

FOR BUSINESS
Chapter 3
Mathematics of
Finance
Le Ngoc Anh Khoa, MSc.
Outlines

● Percentages
● Compound interest
● Geometric series
● Investment appraisal
3.1 Percentages
3.1.1 Percentages

Example:
An investment rises from
$2500 to $3375. Express the
Increase as a percentage of
the original.

 The rise in the value of the


investment is
3375 − 2500 = 875
As a fraction of the original this is
875/2500 = 0.35
This is the same as 35 hundredths,
so the percentage rise is 35%.
 In order to calculate the final value all we have to do is to
multiply by the scale factor.
𝐍𝐞𝐰 𝐯𝐚𝐥𝐮𝐞
 Scale factor =
𝐎𝐥𝐝 𝐯𝐚𝐥𝐮𝐞
Example:
(a) If the annual rate of inflation is 4%, find the price of a good at
the end of a year if its price at the beginning of the year is $25.

 The scale factor is


4
1+ = 1.04
100
We are trying to find the price after the increase, so we multiply
to get
25 × 1.04 = $26
(b) Express the rise from 950 to 1007 as a
percentage (scale factor & percentage of rising)
● A)
● B)
● C)
 To compute the overall percentage change over an entire period,
we simply multiply all the scale factors together on each
corresponding individual period. That aslo calls overall scale.

● Example:
 If share prices rise by 32% during the first half of the year and rise
by a further 10% during the second half, the overall percentage
change during the year can be calculated by
 (1+32%) x (1+10%) = 1.452

 If the price of a good rises by 5% in a year but then is reduced by


30% in a sale, the overall percentage change in the price is
 (1+5%) x (1-30%) = 0.735
a)
b)
c)
3.1.2 Index number
 An index number is an economic data figure reflecting price or
quantity compared with a standard or base value.

 Index number = Scale factor from base year x 100


 The base value is usually 100

 Index numbers enable us to identify trends and relationships in


data which are often given in the form of a time series.

 Time series is simply a series of data points ordered in time.


Example
The table below shows the values of household spending (in billions of
dollars) during a 5-year period.

 If 2011 is taken as the base year, the index number of 2011 is 100 and
the index number of the year 2012 is 723.7/697.2 × 100 = 103.8,
which means the value household spending in 2012 is 103.8 % of its
value in 2011. In other words, the household spending increased by 3.8 %
during 2012.
 The remaining other index numbers are calculated
in a similar way and are shown in Table 3.2.
 There are two other index numbers called Paasche index and
Laspeyres index which are to measure the variation of a bundle
of goods over time.

 Passche index (Current-weight Index) is an index number for


groups of data weighted by the quantities used in the current
year.

 Laspeyres index (Base-weight Index) is an index number for


groups of data which are weighted by the quantities used in the
base year.
Example
Table 3.6 below shows the number of each type bought in 2014 together with
the unit prices of each item in 2014 and 2015.

 The Laspeyres index as the base year of 2014 is :

10𝑥20+23𝑥35+5𝑥10
x 100 = 124.1
8𝑥20+18𝑥35+6𝑥10
If the quantities bought in 2015 are those shown in Table 3.7
then the Passche index in 2015 is

17𝑥10+38𝑥23+12𝑥5
x 100 = 129.9
20𝑥8+35𝑥18+10𝑥6
3.1.3 Inflation

• Inflation means that the general level of prices is going up, the opposite of
deflation. More money will need to be paid for goods (like a loaf of bread) and
services (like getting a haircut at the hairdresser's)

• Nominal data are the original, raw data such as those listed in tables in the
previous subsection.

• Real data are the values that have been adjusted to take inflation into account
Example
The table 3.8 shows the price (in thousands of dollars) of an average house in a certain
town during a 5-year period. The price quoted is the value of the house at the end of each
year.
Use the annual rates of inflation given in Table 3.9 to adjust the prices to those prevailing at
the end of 1991 and compare the rise in both the nominal and real values of house prices
during this period?
 Remember that 1991 is chosen as the base year. The real value of the
house:
93,000
At the end of 1992: = 86,835
1+7.1%

100,000
At the end of 1993: = 90,213
1+7.1% (1+3.5%)

100,006
At the end of 1994: = 93,476
1+7.1% (1+3.5%)(1+2.3%)

At the end of 1990: 72,000 x (1+10.7%) = 79,704


The table below shows the nominal values and adjusted values rounded to
the nearest thousand for comparison after taking inflation into account.
3.2 Compound Interest
At the end of this section you should be able to:
Understand the difference between simple and
compound interest.
Calculate the future value of a principal under
annual compounding.
Calculate the future value of a principal under
continuous compounding.
Determine the annual percentage rate of interest
given a nominal rate of interest.
3.2.1 Simple Interest
 Simple Interest: The interest
which is paid direct to the
investor instead of being added
to the original amount.

 Formula: S = P(1+n*r)

with n is the number of periods


you save the money
Example

If you save P = $500 into a bank account


and earn r% = 10% interest (per year) with S = P(1 + nr/100)
simple interest, then the amount of money = 500(1+5*10/100) = 750
after 5 years?
3.2.2 Compound Interest

 Compound Interest: The interest which is added on to the initial


investment, so that this will itself gain interest in subsequent
time periods.

 Formula:
S = P(1+r)n
Example
S = P(1 + r/100)n = 500(1+10/100)5 = 805,255

 Calculate the interest in:


If you save P = $500 into a bank account  Year 1 = 500 x 10% = 50
and earn r% = 10% interest (per year)  Year 2 = (500+50) x 10% = 55
compound yearly, then the amount of money  Year 3 = (500+50+55) x 10% = 60.5
after 5 years?  Year 4 = (500+50+55+60.5) x 10% =
66.55
 Year 5 = (500+50+55+60.5+66.55)x10%
= 72.205
 General formula for compound interest
𝒓
S = P(1 + )nk
𝒌
With:

k=1 : annually k=2 : semmi-annualy k=4 : quarterly

k=52 : weekly k=365 : daily k=12 : monthly

• Continuous compounding: The limiting value when


interest is compounded with ever-increasing frequency.

 Formula:
S = Pern
Example
𝑟 9%
(a) S = P(1 + )nk = 7000(1 + )8*1
𝑘 1
A principal, $7000, is invested at 9% = 13 947.94
interest for 8 years. Determine its
future value if the interest is 9% 8*2
compounded: (b) S = 7000(1 + ) = 14 156.59
2
(a) annually (b) semi-annually 9% 8*12
(c) monthly (d) continuously (c) S = 7000(1 + ) = 14 342.45
12

(d) S = Pern = 7000 x e9%*8 = 14 381.03


● A)
● B)
● C)
● D)
● E)
● F)
Annual percentage rate (APR) is Annual percentage rate (APR) is
the rate of interest, which when the annualized interest rate on a
compounded annually, loan or investment which does
produces the same yield as the take into account for the effect
nominal of interest. of compounding.

Annual equivalent rate (AER) is Formula:


𝒓
used when applied to savings. APR (AER) = (1 + )k – 1
𝒌
Example

Determine the annual percentage


rate of interest if the nominal rate is
12% com-pounded quarterly.

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