Chapter 3.

Mathematics of Finance

Phan Quang Sang

Department of mathematics

October 12, 2023

[email protected]
Content

1 Percentage

2 Compound interest

3 Geometric series

4 Investment appraisal
Percentage Compound interest Geometric series Investment appraisal

Revision: percentage, scale factor, percentage change

new data
Scale factor =
old data
new data − old data
Percentage change =
old data

Percentage change = Scale factor − 1

Scale factor = 1 + Percentage change

* Remark: overall scale factor and overall percentage change

Examples: page 198, 200, 201, 202

Phan Quang Sang Chapter 3. Mathematics of Finance
Index number
Example:
Data 80 (as base) 120 70
Index ? x y

120
x= × 100 = 150, y = ??
80
Data A (base) B
B
Index 100 A
× 100

Index = scale factor (w.r.t a choseen base time) × 100

Remark:
Data B C B C
then n1
= n2
Index n1 n2
Example: (page 205 ) Table 3.1 shows the values of
household spending (in billions of dollars) during a 5-year
period. Calculate the index numbers when 2011 is taken as
the base year and give a brief interpretation.

For example, the index number of 2012 is

723.7
× 100 = 103.8
697.2

Example: page 205 and find the percentage changes.

* ppp 206
Inflation: nominal data and real data (page 208)

The annual rate of inflation is the average percentage change

in a given selection of goods and services (called consumer
basket), over the previous year.

Nominal data are prevailed at the time.

Real data are the values that have been adjusted to take
inflation into account (with a chosen base year).
Example: (page 208) 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. Compare the rise in both the nominal and real values of
house prices during this period.

* ppp 210
*Key terms: page 210

*HW: Exercise 3.1, page 210-213, Problems 3, 6, 8, 9, 11, 12,

15,

*HW: Exercise 3.1*, page 213-215, Problems 1, 3, 5, 7, 8

Percentage Compound interest Geometric series Investment appraisal

Simple interest and compound interest, page 216

Example, (page 216): Compare interests and the investments

generated at the end of each year if an amount of $500 is
invested for 5 years at 10 % interest simple and compounded
annually.

Phan Quang Sang Chapter 3. Mathematics of Finance

We call:
- The principal, denoted by P, the original sum of money;
- The future value, denoted by S, the final sum of money.

Let r % be the interest rate compounded annually. Then after

t = n years,
S = Pq n , for q = 1 + r %
We note that the scale factor after each year is

q = q = 1 + r%

Example: find the value, in 4 years’ time, of $10 000 invested

at 5% interest compounded annually.
Examples: p. 218, p.220

*ppp 220
Percentage Compound interest Geometric series Investment appraisal

Discrete compounding periodically: Interest can be

compounded discretely at many different time intervals.

Let r % be the compounding interest rate per period, and n is

the number of periods (during times t ). We have also

S = Pq n , for q = 1 + r %

Remark: k = q n is the overall scale factor

Phan Quang Sang Chapter 3. Mathematics of Finance

Percentage Compound interest Geometric series Investment appraisal

Discrete compounding:
Note that the interest rate might be compounded either
annually, or semi-annually, or quarterly, or monthly, or weekly...

For example, if the (nominal) interest rate is 8 % compounded

quarterly, then R% = 8% and the number of compounding
periods per years is m = 4, and the periodic interest rate is
r % = 8%/4 = 2%. Moreover if t = 6 years then the number
of compounding periods is n = tm = 6 × 4 = 24.

In general, if R% be the annual nominal interest rate then

r % = R%/m, n = tm,

m is the number of compounding periods per year.

Example: page 220
Phan Quang Sang Chapter 3. Mathematics of Finance
Percentage Compound interest Geometric series Investment appraisal

Continuous compounding

If the (nominal) interest rate R % is compounded

continuously, then after t year,

S = Pq t , for q = e R%

Prove:
R% mt
S = lim P(1 + ) = P(e R% )t .
m→∞ m
Example: (page 222) A principal of $2000 is invested at 10%
interest compounded continuously. After how many days will
the investment first exceed $2100?

*ppp 223
Phan Quang Sang Chapter 3. Mathematics of Finance
Percentage Compound interest Geometric series Investment appraisal

Annual percentage rate- APR, p.223

The APR (or AER) is the percentage of interest on a loan or a

saving if compound interest accumulates over a year which no
payments are made.
It is used to compare the interest rates between loans (or
savings) with different compounding periods, such as monthly,
quarterly, semi-annually, yearly, or continously..
Example: (page 223) Determine the annual equivalent rate of
interest of a deposit account that has a nominal rate of 6.6 %
compounded monthly.

*HW: Exercise 3.2, page 226-227, Problems 1, 2, 3, 5, 6, 7, 8,

11, 12, 14, 15
*HW: Exercise 3.2* , page 228-227, Problems 1, 3, 4, 6
Phan Quang Sang Chapter 3. Mathematics of Finance
Percentage Compound interest Geometric series Investment appraisal

Geometric progression

Ex: 1, 2, 4, 8, 16, 32,...

Ex: a, aq, aq 2 , aq 3 , ... (q is the geometric ratio)

Geometric series: for a ∈ R and q ̸= 1, the sum of the n first

terms of a geometric progression is
 n 
2 n−1 q −1 un+1 − u1
a + aq + aq + ... + aq =a =
q−1 q−1

Example: evaluate the geometric series

500(1.1) + 500(1.1)2 + 500(1.1)3 + ... + 500(1.1)25

* ppp 231
Phan Quang Sang Chapter 3. Mathematics of Finance
Applications of geometric series: savings and loans

Savings: discussion about sinking fund

Send equal amounts to save into a bank account periodically
(ex: at the same time each year or month) and assume that
the interest rate does not change.

Suppose that an equal amount a is saved at the beginning at

each period, and the constant interest rate per period is r %,
then total savings after n periods is
 n 
2 n q −1
TS = aq + aq + ... + aq = aq ,
q−1

for q := 1 + r %.
Example: (page 233) A person saves $100 in a bank account
at the beginning of each month. The bank offers a return of
12% compounded monthly.
(a) Determine the total amount saved after 12 months.
(b) After how many months does the amount saved first
exceed $2000?

*ppp 234
Loans: discussion about repayment for a loan by installments

Example: A person borrows a loan of $1000 at 8% interest

compounded monthly. If the person repays an amount of $100
at the end of each month. Find the debt owed (the
outstanding debt) at the end of 3-rd month.

Let the original loan L, the equal periodically installments a at

the end of each period, and the periodic interest rate r %.
Let q := 1 + r %. The debt owed at the end of n−th period is

DO = Lq n − a + aq + aq 2 + ... + aq n−1


 n 
n q −1
= Lq − a
q−1
The debt is paid off if the periodically repayments are
qn − 1
a = Lq n ÷
q−1
Example: (page 235) Determine the monthly repayments
needed to repay a $100 000 loan which is paid back over 25
years when the interest rate is 8% compounded annually.
Example: (page 235) Determine the monthly repayments
needed to repay a $100 000 loan which is paid back over 25
years when the interest rate is 8% compounded annually.

L = $100000, r % = 8% ⇒ q = 1.08, n = 25

*ppp 236
*Key terms: page 238

*HW: Exercise 3.3, page 238-239, Problems 2, 3, 4, 6, 7

*HW: Exercise 3.3*, page 239-240, Problems 3, 4, 5

Percentage Compound interest Geometric series Investment appraisal

Discounting, p.241:
Example: Nam plans to buy a new car for $50,000 in 3 years.
If the bank offers an interest rate of 6.5 %, how much does he
invest in the bank now to have enough money to buy a car
after 3 years?

The present value for a single future value is given by:

P = Sq −n ,

(1) discrete compounding: q = 1 + r %, n is the number of

periods.
(2) continuous compounding: q = e R% , n = t is the number
of years.
Phan Quang Sang Chapter 3. Mathematics of Finance
Example, p.242: find the present value of $1000 in 4 years’s
time if the discount rate is 10% compounded:

(a) semi-annually;

(b) continuously.
Appraising an investment project: 2 methods

(1) Net present value (NPV), page 242

NPV = the present value of revenue − the present value of costs

NPV = P − P0
If NPV > 0 then the project is profitable.

(2) Internal rate of return (IRR), page 243

This is an annual rate which, when applied to the initial
outlay, yields the same return as the project after the same
number of years: P = P0 .

The investment is considered worthwhile provided the IRR

exceeds the market rate.
Example, p.243: A project requiring an initial outlay of $15
000 is guaranteed to produce a return of $20 000 in 3 years?
time. Use the
(a) net present value
(b) internal rate of return
methods to decide whether this investment is worthwhile if the
prevailing market rate is 5% compounded annually. Would
your decision be affected if the interest rate were 12%?

*ppp.244

Example p.245 and ppp.246

Calculating the present value of an annuity
An annuity is a sequence of regular equal payments

Let q := 1 + r %, the Present value of annuity (payments are

made at the end of time periods) is

Sq −n−1 − Sq −1
Sq −1 + Sq −2 + ... + Sq −n =
q −1 − 1

q −n − 1 S
= Sq −1 × = (1 − q −n )
q −1 − 1 q−1
Example: (page 246) Suppose that the interest rate is 7%
compounded annually. Find the present value of an annuity
which give a regular income of $10 000 at the end of each year

(a) for the next 10 years;

(b) for many years (or in perpetuity / forever).

*ppp 246

Examples: p.248, p.249, p.252

Key terms: page 253

*HW: Exercise 3.4*, page 253- problems 2, 4, 6, 8, 10

THANK YOU VERY MUCH!