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Interest rates and Present value

Analysis

27.01.2020

1 Present Value
If an amount D is deposited for one year in a bank for interest rate r,
amount receivable after one year is D(1 + r).
If D1 is the amount receivable after one year, the present value is
D1 (1 + r)−1 .

If from an investment yielding compound interest of r, one withdraws


amounts a1 , a2 , ..., an in the first, second year etc., then the present
value,
P V = Σn1 ai αi
where α = (1 + r)−1 .
Effective Interest Rate:

2 Continously compunded and continously vary-


ing interest rates
Continuous compounding:
If annual interest rate is r and interest calculated every quarter, the
effective annual interest rate is (1 + r/4)4 − 1 which greater than r.
If interest is calculated and compunded n times in a year, then the
effective annual interest rate is (1 + r/n)n − 1 which tends to er − 1 for
large n.

1
If D is the principal, the amount repaid at the end of t years at annual
interest rate r the continously compounded, is Dert . t need not be an
integer, but a length of time measured in terms years.

Continously varying interest rate

If the annual interest rate is r, and the principal is D, the repayable


amount for a small length ∆ year is Der∆ which is approximately equal
to D(1 + r∆) because the other terms of ∆ are negligible in the expan-
sion of er∆ .

Let the annual interest rate at time t be r(t) instead of a constant r.

By the same logic above, for a cumulative amount of D(s) of deposit


due for receipt at time s, the accumulated amount after a length of
small interval h is:

D(s + h) = D(s)(1 + r(s)h) which, when rewritten becomes,


D(s+h)−D(S)
h
/D(S) = r(s). Taking h− > 0 we get

(D′ (s)/D(s)) = r(s) which, by solving differential equation, yields


∫t
r(s)ds
D(t) = D(0)e 0

r(s) is ∫called the spot interest rate. The average of spot interest is
t
r = 1t e 0 r(s)ds (Note that r is not the average of r(s), but the average
of the repayable for 1 unit principlal, at t for the period [0, t]).

If P is the accumulated proceed receivable after time t where the spot


interest rate is r(s), then the
∫t
1. P V (t) = P e− 0 r(s)ds

The notation P (t) stands for ∫the present value of the amount 1 to be
t
received at time t. P (t) = e− 0 r(s)ds
∫t
r(t) = (1/t) 0 r(s)ds is called yield curve.

Question:
A bank pays a nominal interest rate of 6 percent continuously compounded.
If 100 is initially deposited, how much interest will be earned after
30 days, 60 days and 120 days?
Question:
Show that r(t) = −P ′ (t)/P (t)

2
Question:
Show that if r(t) is a non-decreasing function of t, then so is r(t).
Question:
What is the value of the continously compounded nominal interest rate r if
the present value of 104 to be received after 1 year is the same as the present
value of 110 to be received after 2 years ?
Question:
For an initial investment of 100, an investor is to receive the amounts 8, 16, 110
at the end of the following three periods. Is the rate of return above 11 per-
cent ?

Question:
Let bi ≥ 0 and ci ≥ 0, i = 1, 2, ..., n be flows of income in the first,
second,..., and nth year in two investment schemes. Let Bi = Σi1 bj and
Ci = Σi1 cj . Let Bi = Σi1 Bj and Ci = Σi1 Cj . Show that the PV of the
a′ series is greater than the PV of the b′ series for any interest rate r

(1) if Bi ≥ Ci , i = 1, 2, ..., n

(2) if Bi ≥ Ci , i = 1, 2, ...n − 1 and Bn ≥ Cn .

Answer:

Let r be the interest rate and α = (1 + r)−1 . Then

Σn1 bi αi = Σn1 (Bi − Bi−1 )αi ....................................(1)


= Σn1 Bi αi − αΣn−1
1 Bi αi .................2).
= Σn−1
1 Bi αi (1 − α) + Bn αn .................(3)
= Σn−1
1 (B i − B i−1 )αi (1 − α) + Bn αn ..........(4)
= Σn−1
1 B i αi (1 − α) − Σn−2
1 B i αi (1 − α) + Bn αn ...........(5)
= Σn−2
1 B i αi (1 − α)2 + B n−1 αn−1 (1 − α) + Bn αn .................(6)
Similar equalities as above hold when b,B and B are replaced with c,C and C

Σn1 ci αi = Σn1 (Ci − Ci−1 )αi ....................................(7)


= Σn1 Ci αi − αΣn−1
1 Ci αi ................(8).
= Σn−1
1 Ci αi (1 − α) + Cn αn .................(9)
= Σn−1
1 (C i − C i−1 )αi (1 − α) + Cn αn ..........(10)
= Σn−1
1 C i αi (1 − α) − Σn−2
1 C i αi (1 − α) + Cn αn ...........(11)
= Σn−2
1 C i αi (1 − α)2 + C n−1 αn−1 (1 − α) + Cn αn .................(12)

3
When Bn ≥ Cn , and B n ≥ C n , we see that

Σn−2
1 B i αi (1 − α)2 + B n−1 αn−1 (1 − α) + Bn αn ≥ Σ1n−2 C i αi (1 − α)2 + C n−1 αn−1 (1 − α) + Cn αn
which is same as that Σn1 bi αi ≥ Σn1 ci αi
proving Part (2). Part (1) of the proposition follows by considering
Σn1 bi αi = Σn−1
1 Bi αi (1 − α) + Bn αn and
Σn1 ci αi = Σn−1
1 Ci αi (1 − α) + Cn αn
by virtue of the inequality,
Σn−1
1 Bi αi (1 − α) + Bn αn ≥ Σn−1
1 Ci αi (1 − α) + Cn αn

Question:
Consider the two cash flow streams, where each will return the ith payment
after i years:
100, 140, 131 and 90, 160, 120
Is it possible to tell which cash flow stream is preferable ?

3 Rate of Return
Let P (r) = −a + Σn1 bi (1 + r)−i
If r∗ is a root of the above equation, r∗ is the rate of return or internal rate
of return which yields PV equal to a. We look for r∗ ≥ −1,
or else the solution is inadmissible
P (−1) = ∞ and P (∞) = −a. Therefore, there exists a root in (−1, ∞).
P (0) ≥ 0 if Σbi ≥ a in which case r∗ is positive.
P (0) ≤ 0 if Σbi ≤ a
The curve P (r) crosses the X-axis at a point left of 0 when Σbi ≤ a, and so
r∗ is negative
P (r) crosses the X-axis on the right of 0 when Σbi ≥ a, and in this case r∗
is positive.
Example:
For initial investment of 100, an investment yields returns of Xi for periods
i = 1, 2, where Xi′ s are independent Normal r.v’s with mean 60 and variance
25. What is the probability the rate of return of this investment is greater
than 10 percent ?
P (r) = X1 (1+r)−1 +X2 (1+r)−2 . If r ≥ 0.11 then P (0.11) ≥ 0 which implies
that
X1 /1.11 + X2 /(1.11)2 ≥ 100.
The LHS of this inequality is a Normal r.v (say,X). We have to find P (X >
100).

4
Question:
Find the rate of return from an investment that, for an initial payment of
100, yields returns 60 at the end of the first two periods.