Mathematics of Finance
Mathematics of Finance
Mathematics of Finance
Mathematics II
Maths of Finance
The first step in time value analysis is to set up a time line, which helps in
visualising what is happening in a particular problem.
E.g., consider the diagram below where Present Value (PV) represents a
$100 that is on hand today and Future Value (FV) is the value that will be in
the account on a future date:
Periods 0 5% 1 2 3
|_________|___________|__________|
Cash PV=$100 FV=?
The intervals from 0-3 are time periods such as years or months. Cash flows
are shown directly below the marks, and the relevant interest rate is shown
just above the time line.
Time 0 5% 1 2 3
|__________|__________|__________|
Amount at beginning $100 $105 $110.25 $115.76
of period
Interest earned in the first year is $100(0.05) = $5, so the amount at the end
of year 1 (or t = 1) is:
FV1 = PV + INT
= PV + PV(I)
= PV (1 + I)
= $100(1 + 0.05) = $100(1.05) = $105
The second year starts with $105, interest of 0.05($105) = $5.25 is earned
on the now larger beginning-of-period amount, and end the year with
$110.25. Interest during Year 2 is $5.25 and it is higher than the first year’s
interest as $5(0.05) = $0.25 interest is earned on the first year’s interest.
This is called ‘compounding’ and interest earned on interest is called
‘compound interest’.
This process continues and since the beginning balance is higher in each
successive year, the interest earned each year increases.
Sec 5.1: Mathematics of Finance
Formulas : S :
FV
Interest is compounded
k times a year.
At what nominal rate of interest compounded yearly
will money double in 8 years.
S
Suppose $500 amounted to $588.38 in a savings account after
three years. If interest was compounded semiannually, find the
nominal rate of interest , compounded semiannually, that was
earned by the money.
S
How long will it take $600 to amount to $900 at an annual
rate of 6% compounded quarterly?
S
Effective Interest Rate
S
If an investor has a choice of investing money at 6% compounded daily or 6.5% compounded quarterly, which is the better choice?
Solution:
S=1000; P=?
r=0.09 k=12
kt=3(12)=36
764.15
Example # 2-Single-Payment Trust Fund
The single payment x due now must be such that it would grow and
eventually pay off the debts when they are due. That is, it must equal
the sum of the present values of the future payments.
we have
The equation above shows that the value now of all payments under
one method must equal the value now of all the payments under the
other method.
Equations of Value
3000( Payment)
x(Payment)
7000(Debt)
Qs 2.A debt of $3500 due in 4 years and $5000 due in six years is
to be repaid by a single payment of $1500 now and three equal
payments that are due each consecutive year from now. If the
interest rate is 7% compounded annually, how much are each of
the equal payments?
Let x = Each payment.
Equation of value at year 3 is:
3 8000
5 6000 6000
19542
Assignment 24
2. How many years will it take for a principal of P to double if money is worth
12 % compounded monthly? Give your answer to the nearest month.
6. A debt of $600 due in three years and $800 due in four years is to be repaid by a
single payment two years from now. If the interest rate is 8% compounded
semiannually, how much is the payment?
Assume an interest rate of 4% compounded quarterly. (a) Find the net present value
of the cash flows. (b) Is the investment profitable?