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Financial Mathematics

Copyright 2004. All Worldwide Rights Reserved. See Credits for permissions.

Would you rather receive $1000 today -- or next year? Obviously, you would want the money

today. You could bank the money today and it would be worth more than $1000 next year. The

most basic principle of Finance is that a dollar today is worth more than a dollar in the future.

We will explore the answer to two questions: "What is the value next year of $1000 received

today?" and "What is the value today of $1000 received next year?" The first question asks us to

find the future value of money received now. The second question asks us to find the present

V0 Present Value

Vn Future Value at the end of n periods

n The number of periods.

Nominal interest rate, also called the "annual percentage rate" (APR) or the "stated interest

R

rate"

m The number of compounding periods per year

i Effective periodic interest rate, or effective interest rate per compounding period (i=R/m).

T The number of years; T = n/m

r The effective annual interest rate, also called the true annual interest rate

The effective periodic interest rate, i, equals the nominal interest rate R divided by the number of

1

R

i= (1)

m

The effective (or true) annual interest rate, r, is the annually compounded interest rate which is

m

(

r = (1 + i ) − 1 = 1 + R

m

)

m

−1 (2)

r = eR − 1 (3)

The future value formula is derived by example. Suppose that you have a deposit of $1000 that

1 1000.00 40.00 1040.00 1000 (1.04)

2 1040.00 41.60 1081.60 1000 (1.04)2

3 1081.60 43.26 1124.86 1000 (1.04)3

4 1124.86 44.99 1169.85 1000 (1.04)4

5 1169.85 46.79 1216.64 1000 (1.04)5

6 1216.64 48.67 1265.31 1000 (1.04)6

The formula for future value when interest is compounded annually is straightforward from this

example:

Vn = V 0(1 + R)

n

(4)

2

0.2 Continuous and Discrete Time Compounding

Suppose that another bank offers you the same nominal interest rate of 4%, but offers to

compound the interest every six months. Would you prefer this deal?

The deposit will pay 2% every six months. The following table shows how this investment will

grow:

0.5 1000.00 20.00 1020.00 1000 (1.02)

1.0 1020.00 20.40 1040.40 1000 (1.02)2

1.5 1040.40 20.81 1061.21 1000 (1.02)3

2.0 1061.21 21.22 1082.43 1000 (1.02)4

2.5 1082.43 21.65 1104.08 1000 (1.02)5

3.0 1104.08 22.08 1126.16 1000 (1.02)6

3.5 1126.16 22.52 1148.68 1000 (1.02)7

4.0 1148.68 22.97 1171.65 1000 (1.02)8

4.5 1171.65 23.43 1195.08 1000 (1.02)9

5.0 1195.08 23.90 1218.98 1000 (1.02)10

5.5 1218.98 24.38 1243.36 1000 (1.02)11

6.0 1243.36 24.87 1268.23 1000 (1.02)12

This investment will be worth an extra $0.40 in the first year, and an extra $2.92 at the end of the

sixth year, because of compounding twice per year. From this table, we can also postulate a

generalized formula for future value, when there are m compounding periods per year.

n

⎛ R⎞

Vn = V 0⎜ 1 + ⎟ = V 0(1 + i)

n

(4)

⎝ m ⎠

Vn = V 0e RT (5)

3

While the nominal rate on these deposits remains the same, the effective annual rate changes.

The effective annual rate can be used to compare investments with different compounding

periods.

Example 1

Suppose a bank offers a nominal interest rate of 4% (R = 0.04) on your savings deposit.

The following table illustrates the different effective or true interest rates depending on

how many times the interest is compounded each year.

Annually r = (1+0.04/1)1-1 4.00000%

Semiannually r = (1+0.04/2)2-1 4.04000%

Quarterly r = (1+0.04/4)4-1 4.06040%

Monthly r = (1+0.04/12)12-1 4.07415%

Weekly r = (1+0.04/52)52-1 4.07948%

Daily r = (1+0.04/365)365-1 4.08085%

Hourly r = (1+0.04/8760)8760-1 4.08107%

Continuous r = e0.04 -1 4.08108%

So, the investor will always prefer more compounding periods to less. The continuous

time rate of interest is always higher than the periodic interest rate.

The term

n

⎛ R⎞

Mn = ⎜1 + ⎟ (6)

⎝ m⎠

M n = e RT (7)

4

for continuous compounding, is sometimes referred to as the money multiplier. As the name

implies, the money multiplier measures the factor by which your money multiplies in the future,

given a nominal rate R and a maturity of n periods. Often, the return on investment depends upon

the length of time the money is tied up. Consider a schedule of bank interest rates. The 1-5 year

1 Year 8.150 1.0815000

2 Years 8.200 1.1707240

3 Years 8.350 1.2719989

4 Years 8.400 1.3807566

5 Years 8.500 1.5036567

10 Years 9.000 2.3673637

15 Years 9.000 3.6424824

20 Years 9.000 5.6055107

30 Years 9.000 13.267678

Note that the money market multiplier increases exponentially with longer time to maturity.

The Present Value formula can be derived from the formula for the future value. Suppose that

we know the future value (Vn) of an investment. The present value of that investment (V0) is

n

⎛ R⎞

Vn = V 0⎜ 1 + ⎟ (8)

⎝ m⎠

Divide both sides by the money multiplier to get the present value:

−n

⎛ R⎞

V0 = Vn⎜ 1 + ⎟ (9)

⎝ m⎠

5

For continuous compounding, we have the following formula:

V 0 = Vne − RT (10)

Example 2

If you wish to provide $200,000 for your newborn's college education, how much should

you invest now if the interest rate is 8% compounded annually? That is, what is the

present value of $200,000 in 18 year's time at 8%?

Vo = Vn (1 + R m)

−n

= $200,000(1.08)

−18

= $50,049.81 (11)

The formula for finding the present value of a single cash flow can be used to find the

present value of a set of cash flows by finding the value of each separate flow, and adding

them all together.

An annuity is a stream of cash flows that are equally spaced in time and of equal amount. An

example is a $250,000 mortgage at 9% per year, or 9%/12 = .75% per month, that is paid off

with a 180 month annuity of $2,535.67. We will show how to calculate the present value of an

annuity and how to determine the size of an annuity that is necessary to pay off a certain present

T The number of years in annuity. Note T = n/m

n The total number of periods (n = mT)

R Annual Percentage Rate (APR) or the "stated interest rate"

a Amount of the annuity payment

An Present value of n period annuity of a dollars

6

Let Z be the present value of $1 at the end of one period. Often Z is referred to as a discount

factor. From the formula for the present value of a single cash flow, we know that:

1

Z=

⎛ R⎞

⎜1 + ⎟

⎝ m⎠

This value is used to find the present value of an annuity. The present value of an n period

a ⋅ Z ⋅ (1 − Z n )

An = (12)

1− Z

Some people prefer another form of the formula. Recall that i = R/m. If we substitute (1+i)-1 for

1 − (1 + i )

−n

An = a ⋅ (13)

i

Note that if the number of payments becomes infinite, then the present value of the annuity

simplifies:

a a

A∞ = = (14)

⎛ R⎞ i

⎜ ⎟

⎝ m⎠

7

An example of an annuity with an infinite number of constant payments is the British consol

bond. It pays a coupon at the end of each year and never matures. These bonds are called

perpetuities. It is not legal to issue bonds which are perpetuities in the United States.

Example 3

Now we will return to the example of the $250,000 mortgage. Suppose you borrow

$250,000 and repay over 15 years. The interest rate is 9% annually and payments are

made monthly. The effective periodic rate of interest is 9%/12=.75% per month. Let us

solve for the monthly payment a that is needed to pay off the mortgage. From our

formula for the present value of the annuity, we know:

a ⋅ Z ⋅ (1 − Z n )

An =

1− Z

The strategy will be to substitute in for all the variables that we know (An, n, Z) and solve

for the one variable that we do not know (a). First, we know that the present value must

be $250,000. Second, calculate Z, the one period discount factor:

Since n = 180,

( )

A180 = $250,000 = a 0.9925558(1 − 0.9925558180 ) / (1 − 0.9925558) = a ( 98.59319)

Example 4

Now let's consider another example. This will highlight the idea of an amortization

schedule. Suppose that $1000 is borrowed. The loan will be repaid in 5 equal annual

8

payments (each includes interest and principal). The interest rate is 10% per annum. First,

compute the one period discount factor:

Z = 1 / 110

. = 0.9091

( )

A5 = 1000 = a 0.9091(1 − 0.90915 ) (1 − 0.9091) = a ( 3.791)

Solve for a

1 1000.00 100.00 263.80 163.80 836.20

2 836.20 83.62 263.80 180.18 656.02

3 656.02 65.60 263.80 198.20 457.82

4 457.82 45.78 263.80 218.02 239.80

5 239.80 23.98 263.80 239.82 000.00

This example illustrates the accounting implications of using an annuity. Note that there

is a 2-cent rounding error.

It is often useful to know how much principal remains on a loan. Many mortgages, for example,

allow the homeowner to pay off the mortgage at any time. An amortization schedule, like the one

above, can be used to construct the remaining principal at any time. With a thirty-year mortgage,

there are 360 payments. Constructing an amortization schedule can be tedious, although tools

like Excel make the task easier. An easier way to find the remaining principal is to use the

9

Example 5

A 30-year, $200,000.00 mortgage at a nominal rate of 8% will require monthly payments

of $1,467.53. After ten years, the homeowner sells the house. How much must she pay

the bank in order to pay off the mortgage?

After ten years, there will still be 20 years of payments left. That means that there are 240

monthly periods. The following table shows the values needed to calculate the remaining

principal:

Z = 1/1.006667% = 0.9933775 One period discount factor.

a = $1,467.53. Monthly Payment

n = 240 Number of remaining payments.

Plugging these numbers into the formula, we find that the remaining principal is equal to:

Note that this value could be either more or less than the present value of the remaining

cash flows. If, for example, mortgage rates went up to 9%, then the present value of the

cash flows would be less than the value of the remaining principal.

It is sometimes useful to know the future value of an annuity. For example, if we are putting

$100 per month into a vacation fund at 6% per year, compounded monthly, we would want to

We already know how to find the present value, An of that annuity at 6% per year. We could

multiply that present value by the money multiplier (1+6%/12)12 to find the future value.

10

(1 + i ) n − 1

FV ( An ) = An ⋅ (1 + i) = a ⋅

n

(15)

i

Example 6

We can use this formula to determine the future value of the vacation fund described

above. a is equal to $100, i is 6%/12 and n is 12 periods. The future value is equal to:

(1 + 0.005)12 − 1 1.0616778 − 1

100 ⋅ = 100 ⋅ = $1,23356

.

0.005 0.005

Summary of Formulas

R

i=

m

m

(

r = (1 + i ) − 1 = 1 + R

m

)m

−1

r = eR -1

Future Value

Vn = V 0(1 + R)

n

11

Future Value for Continuous Compounding

Vn = V 0e RT

Money Multiplier

n

⎛ R⎞

Mn = ⎜1 + ⎟

⎝ m⎠

M n = e RT

−n

⎛ R⎞

V0 = Vn⎜ 1 + ⎟

⎝ m⎠

V 0 = Vne − RT

1

Z=

⎛ R⎞

⎜1 + ⎟

⎝ m⎠

a ⋅ Z ⋅ (1 − Z n )

An =

1− Z

12

1 − (1 + i )

−n

An = a ⋅

i

a a

A∞ = =

⎛ R⎞ i

⎜ ⎟

⎝ m⎠

(1 + i ) n − 1

FV ( An ) = An ⋅ (1 + i) = a ⋅

n

Acknowledgement:

The lecture note has benefited from previous versions of BA350 taught by Tom Smith and Bob Whaley.

13

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