MATHEMATICS OF FINANCE

Financial mathematics is the application of mathematical methods to the solution of problems in finance. Many people are in the dark when it comes to applying math to practical problem solving. This section will show you how to do the math required to figure out a home mortgage, automobile loan, the present value of an annuity, to compare investment alternatives, and much more. This section contains formulas, definitions and some examples regarding: 1. Simple interest 2. Compound interest 3. Annuity 4. Amortization

MATHEMATICS OF FINANCE
Simple Interest

167

1. Simple Interest
Interest is the fee paid for the use of someone elses money. Simple interest is interest paid only on the amount deposited and not on past interest. The formula for simple interest is

I = P-r-t
where

I= interest P = principal r = interest rate in percent / year t = time in years

Example:
Find the simple interest for $1500 at 8% for 2 years.

Solution: P= $1,500, r= 8% = 0.08, and t= 2 years

I = Per. t= (1500)(0.08)(2) = 240 or $240

a) Future value If P dollars are deposited at interest rate r for t years, the money earns interest. When this interest is added to the initial deposit deposit, the total amount in the account is

A = P+ I = P+ P t r = p(1+ rt)
This amount is called the hture value or maturity value.

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MATHEMATICS OF FINANCE
Compound Interest

Example:
Find the maturity value of $10,000 at 8% for 6 months.

Solution: P= $10,000, r= 8% = 0.08, t= 6/12 = 0.5 years

The maturity value is

A=6 1+ rt)= 10,000[1+0.08(0.5)] = 10400, or

$10,400

2. Compound Interest
Simple interest is normally used for loans or investment of a year or less. For longer periods, compound interest is used. The compound amount at the end of t years is given by the compound interest formula,

A=F(+iY
where

i = interest rate per compounding period ( i = - )

r m

n = number of conversion periods for t years

(n= mt)
A = compound amount at the end of n conversion
period

P = principal r = nominal interest per year m = number of conversion periods per year t = term (number of years)

MATHEMATICS OF FINANCE Compound Interest

169

Example: Suppose $15,000 is deposited at 8% and compounded annually for 5 years. Find the compound amount. Solution:

P= $15,000, r= 8% = 0.08, m = 1, n = 5

A = p(l+i)" =1500 1 +

(?)I5

= 15000 [1.0815

= 22039.92, or $22,039.92

a) Continuous compound interest The compound amount A for a deposit of P a t interest rate rper year compounded continuously for tyears is given by

A = Perf
where

P = principal r = annual interest rate compounded continuously t = time in years A = compound amount at the end of t years. e = 2.7182818
b) Effective rate The effective rate is the simple interest rate that would produce the same accumulated amount in one year as the nominal rate compounded m times a year. The formula for effective rate of interest is

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MATHEMATICS OF FINANCE
Compound Interest

I , =

where
&ff

1+-

-1

= effective rate

of interest

r = nominal interest rate per year m = number of conversion periods per year
Example:
Find the effective rate of interest corresponding to a nominal rate of 8% compounded quarterly.

Solution: r= 8% = 0.08, m = 4 ,then

so the corresponding effective rate on this case is 8.243%per year. c) Present value with compound interest The principal P, is often referred to as the present value, and the accumulated value A, is called the future value since it is realized at a future date. The present value is given by

MATHEMATICS OF FINANCE
Annuity

171

p=Example:

A (1 + i>"

= A(1+ i)-"

How much money should be deposited in a bank paying interest at the rate of 3% per year compounding monthly so that at the end of 5 years the accumulated amount will be $15,000?

Solution:
Here:
0 0 0

nominal interest per year r = 3% = 0.03, number of conversion per year m = 12, interest rate per compounding period i = 0.03/12 = 0.0025, number of conversion periods for t years n = (5)(12) = 60, accumulated amount A = 15,000

P = A(1+ i)-" = 15,000(1+0.0025)-60 P= 12,913.03,or $12,913

3. Annuities An annuity is a sequence of payments made at regular time intervals. This is the typical situation in finding the relationship between the amount of money loaned and the size of the payments.

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MATHEMATICS OF FINANCE
Annuity

a) Present value of annuity The present value P of an annuity of n payments of R dollars each, paid at the end of each investment period into an account that earns interest at the rate of i per period, is

where

P = present value of annuity R = regular payment per month n = number of conversion periods for t years
i = annual interest rate

Example:
What size loan could Bob get if he can afford to pay $1,000 per month for 30 years at 5% annual interest?

Solution:
Here: R= 1,000, i = 0.05/12 = 0.00416, n = (12)(30) = 360.

1- (1 + i)-"

P=.[ P= 186579.61,or
$186,576.61

1- (1 + 0.00416)-360 ]=1000[ 0.00416

MATHEMATICS OF FINANCE
Annuity

173

Under these terms, Bob would end up paying a total of $360,000, so the total interest paid would be $360,000 - $186,579,61 = $173,420.39. b) Future value of an annuity The future value S of an annuity of n payments of R dollars each, paid at the end of each investment period into an account that earns interest at the rate of i per period, is

Example:
Let us consider the future value of $1,000 paid at the end of each month into an account paying 8% annual interest for 30 years. How much will accumulate?

Solution:
This is a future value calculation with R =1,000, n = 360, and i =0.05/12 = 0.00416. This account will accumulate as follows:

s={

(1 + i)" - 1 (1 + 0.00416)360 -1 ]=1000[ 0.00416

S = 831028.59,or $831,028.59
Note: This is much larger than the sum of the payments,
since many of those payments are earning interest for many years.

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MATHEMATICS OF FINANCE
Amortization

4. Amortization of Loans
The periodic payment Ra on a loan of P dollars to be amortized over n periods with interest charge at the rate of i per period is

R,
Example:

P i
1- (1 + i)-"

Bob borrowed $120,000 from a bank to buy the house. The bank charges interest at a rate of 5% per year. Bob has agreed to repay the loan in equal monthly installments over 30 years. How much should each payment be if the loan is to be amortized at the end of the time?

Solution:
This is a periodic payment calculation with P= 120,000, i=0.05/12 = 0.00416, and n = (30)(12) = 360

R,

P i
1- (1 + i)-n

(120000)(0.004 16) = 643.88 1- (1.00416)-360

or $643.88.

5. Sinking Fund Payment The Sinking Fund calculation is used to calculate the periodic payments that will accumulate by a specific future date to a specified future value,

MATHEMATICS OF FINANCE
Amortization

175

so that investors can be certain that the funds will be available at maturity. The periodic payment R required to accumulate a sum of Sdollars over n periods, with interest charged at the rate or i per period, is

where S= the future value i = annual interest rate n = number of conversion periods for tyears