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Financial Mathematics

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Libeeth B. Guevarra

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Department of Mathematics and Natural Sciences

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Many people have long-term financial goals and limited means with which
to accomplish them. Your goal might be:
to save 500,000 over the next ten years for the down payment on a

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home,
to save 3,000,000 over the next eighteen years to finance your new
baby’s college education,

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to save 10,000,000 over the next forty years for your retirement.

It seems incredible, but each of these goals can be achieved by saving only
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3,000 a month (if interest rates are favorable)! All you need to do is start
an annuity.
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Annuity

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An annuity is simply a sequence of equal, regular payments into an

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account in which each payment receives compound interest.
Because most annuities involve relatively small periodic payments,

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they are affordable for the average person.
Over longer periods of time, the payments themselves start to amount
to a significant sum, but it is really the power of compound
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interest that makes annuities so amazing.
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There are different kinds of annuity:

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Immediate Annuity
Fixed Annuity
Fixed Indexed Annuity

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Variable Annuity

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The future value FV of an ordinary annuity with payment size pymt, a

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periodic rate i, and a term of n payment is:

(1 + i)n − 1

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FV (ord) = pymt
i

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Using an Annuity to save for retirement
Example

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Louis and Lanie decided that they should start saving for retirement

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through an ordinary annuity. They arranged to have 500 taken out of each
of Louis monthly pay, which will earn 8.75% interest. Louis just had his

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thirtieth birthday, and his ordinary annuity will come to term when he is
65.
1 What is the future value of the annuity?
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What is Louis’ contribution and the interest portion?
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Math031 - Mathematics in the Modern World 6

Answer:
This is an ordinary annuity, with pymt=500, i = 8.75%
12 =
0.0875
12 , n=35

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years •12 months/year = 420 monthly payments.

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a)

(1 + i)n − 1
FV (ord) = pymt

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i
(1 + 0.0875
12 )
420 − 1
= 500 0.0875
12
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≈ 1, 381, 350
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b) The principal part of this 1,381,349.90 is Louis’ contribution, and the

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rest is interest. Louis’ contribution is 420 of 500 each = 210,000. The

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interest portion is 1,381,350 - 210,000 = 1,171,350 The interest portion is
almost six times as large as Louis’ contribution!

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The magnitude of the earnings illustrates the amazing power of annuities
and the effect of compound interest over a long period of time.
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Stocks, bonds, and mutual funds

When owners of a company want to raise money, generally to expand

their business, they may decide to sell part of the company to

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investors. An investor who purchases a part of the company is said to

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own stock in the company.
Stock is measured in shares; a share of stock in a company is a

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certificate that indicates partial ownership in the company. The
owners of the certificates are called stockholders or shareholders. As
owners, the stockholders share in the profits or losses of the
corporation. U
A company may distribute profits to its shareholders in the form of
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dividends. A dividend is usually expressed as a per-share amount—for
example, 80 per share.

Math031 - Mathematics in the Modern World 9

 When a corporation issues stock, it is selling part of the company to
the stock-holders.

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When it issues a bond, the corporation is borrowing money from the
bondholders; a bondholder lends money to a corporation.
Corporations, the government agencies, states, and cities all issue

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bonds. These entities need money to operate.
The price paid for the bond is the face value. The issuer promises to
repay the bondholder on a particular day, called the maturity date, at
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a given rate of interest, called the coupon.
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An investment trust is a company whose assets are stocks and bonds. The

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purpose of these companies is not to manufacture a product but to
purchase stocks and bonds with the hope that their value will increase. A

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mutual fund is an example of an investment trust.

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When investors purchase shares in a mutual fund, they are adding their

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money to a pool along with many other investors. The investments within
a mutual fund are called the fund’s portfolio. The investors in a mutual
fund share the fund’s profits or losses from the investments in the

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portfolio.

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An advantage of owning shares of a mutual fund is that your money is

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managed by full-time professionals whose job it is to research and evaluate

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stocks; you own stocks with- out having to choose which individual stocks
to buy or to decide when to sell them. Another advantage is that by
owning shares in the fund, you have purchased shares of stock in many

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different companies. This diversification helps to reduce some of the risks
of investing.

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