CM-1 Financial Mathematics

Institute & Faculty of Actuaries, UK

An Introduction to Effective Interest &

Discount Rates
version 1.1 March 2020

Siddharaj Panchal
Introduction to Effective Interest & Discount Rates
It’s often argued that lending is the oldest profession in the world. Even before money
was invented. We have evidences of farmers loaning seeds to other farmers and, in
return, receive more seeds after the harvest. They also used to loan out cattle and
receive the cattle (principal) and its progeny (interest) in return.

The idea of interest, that you’re forgoing something now and getting more of the same
in return after a certain period of time, is as old as civilization.

Figure 1: Hammurabi’s Code carved on a black stone stele (pillar).

Hammurabi, the sixth king of the Babylonian dynasty, ruled central Mesopotamia
from c. 1894 to 1595 B.C. He’s remembered for his code, considered one of the
earliest legal documents available in history, called the Code of Hammurabi. The
seven-foot five inch monument set out 282 laws which governed the city.

A merchant may collect interest of thirty-three and one-third per cent on

a loan of grain, and twenty per cent interest may be charged on a loan of
silver.
- Law 88 of Hammurabi’s code.

Think about it - back in 1700 BC, no computers, no internet, no paper money, you’re
loaning out money at 33 13 % interest .

Framework : Lenders & Borrowers

In a transaction involving lending/borrowing of any sort, there are primarily two
parties - lender & borrower. The lender lends money/things (principal) and the
borrower pays back principal with something extra (interest) to reflect the credit
risk and time value of money. Credit Risk is the risk of default. The borrower may
not be able to return the principal or interest (or both) in part or full. Time value of

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money implies opportunity cost. The lender could have harvested the seeds himself
and gotten a better (or worse) return.

Simply put, a dollar in your hand today is worth more than a dollar you will receive
in the future. This is because a dollar in hand today can be invested to turn into more
money in the future. In CM-1, you’ll be working extensively with time value of money.
Interest is also considered as a form of rent.You pay monthly rentals to your landlord
for using his space . Similarly, you pay rent to use someone else’s capital. Say, you
deposit $100 in a bank for a year. The banks pays you rent for the amount lent, say
$5, at the end of the period. Your account balance becomes $105 at the end of the
year. Alternatively, you borrow $100 from a bank, the bank charges you rent of $5,
and you pay $105 at the end of the year.

amount $100 $105

time 0 1

An alternative arrangement could be - you borrow $95 today and pay $100 at the end
of the year. The rent, of $5, is paid in advance i.e. at the beginning of the year.

Amount Function
Let’s define a couple of variables.
P = Principal Amount.
n = length of time in years. Let A(n) denote the accumulated value of the principal +
interest at any time n. Note: A(n) is a function. By definition, A(0) = P . Accumulated
value at time 0 is nothing but the principal amount.

Effective Rate of Interest

Let in be the rate of interest for the period n − 1 to n. Since n is measured in years, in
is the annual rate of interest. The rate of interest paid once during the period n − 1
to n is called Effective Rate of Interest.

amount P P (1 + i)

time 0 1
n=1

To arrive at a generalized formula let’s replace the amounts [P & P (1+i)] with [A(n−1)
& A(n)] and times [0 & 1] to [n − 1 & n].

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amount A(n − 1) A(n)

time (n − 1) (n)

A(n) = (1 + in )A(n − 1)

Solving for in ,

A(n)
∴ (1 + in ) =
A(n − 1)
A(n)
∴ in = −1
A(n − 1)
A(n) − A(n − 1)
∴ in =
A(n − 1)

Keep in mind,

1. interest amount, by definition, is credited once per time period. Continuing with
the earlier example,if you deposit $ 100 for a year, on 1.1.2020, the interest
credit of $5 happens on 31.12.2020. Throughout the year, value of the deposit
remains $100.

2. the rate of interest is expressed as a % of the amount at the beginning of the

year. Note the denominator. It’s A(n − 1). Correspondingly, Discount Rate is
expressed as a % of the amount at the end of the year.

Effective rate of Discount

Let dn be the amount of discount charged for the period (n − 1) to n.

A(n) − A(n − 1)
dn =
A(n)

Effective rate of Discount is a measure of interest wherein interest is paid at the

beginning of the period. Say a bank lends you $100 for a year at 5% p.a. rate of
discount. As a borrower, you pay $5, the amount of discount, at the beginning for the
year. Effectively, you get $95 as loan and you pay back $100. The bank is charging
the interest in advance.

Say A & B borrow $100 at the rate of 5% p.a. interest & discount rate respectively.
What is the difference between both scenarios?

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amount 100 A 105
time 0 1

A gets use the full amount ($100) at the beginning of the year and pays the rent ($5)at
the end of the year.

amount 95 B 100
time 0 1

B pays rent ($5) at the beginning of the year. Meaning, he gets to use $95 for year
and pays back $100.

If you’re thinking that interest & discount scenarios are one and the same - think
again. They’re not. An effective rate of interest is not the same as an effective rate
of discount. But they’re definitely related to each other.

How i & d are connected ?

Say, $1 is loaned at discount rate d. The original principal paid to the borrower is
$(1 − d). d is the interest amount charged for the period.

amount (1 − d) 1
time 0 1

A(n)−A(n−1)
Recall, i = A(n−1)
. Plugging the above values, we get

1 − (1 − d)
i=
(1 − d)

d
i=
(1 − d)

Solving for d,
i
d=
(1 + i)

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If you’re familiar with v, defined as v = (1+i)
then d can be written as d = iv.

This relationship sets the foundation of your work in CM-1 and will help you [or haunt
you ] for the rest of your days .

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Reach Out
Found any math errors ? Got some feedback ? Shoot me a mail with the subject line
Review : [Article Name] at panchalsiddharaj[at]gmail[dot]com.

Thanks for reading. Have another awesome day .

References
[1] History.edu

[2] Wikipedia : Code of Hammurabi

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How to use this document
This document is for students for appearing actuarial exams from Institute & Faculty
of Actuaries (IFoA), UK and affiliated institutes. This document is not intended to
replace the study material issued by Acted but to serve as an additional source material
to concretize understanding of concepts presented in the core material. Wherever
possible, we’ve chosen reference material and re-arranged ideas to ensure a higher
levels understanding of the core material.

Actuarial exams are not just about regurgitating material from the CMP but more so
about application of concepts and building higher order skill sets. In the new syllabus,
exam questions are classified as,

1. Knowledge (demonstration of ideas)

2. Application (apply principles (of a topic) in a given scenario)

3. Higher Order(perform deeper analysis, form judgments, compare & contrast)

In CM-1, the approximate split of exam questions is 15% (Knowledge), 70% (Applica-
tion) and 15% (Higher Order).
In a typical exam paper, the Knowledge questions are basic theory and conceptual ques-
tions. Most of them are easy to deal with and are low hanging fruits.
Application & Higher Order skills are taken care of in the rest of the paper. More often
than not, examiners plant stinkers in these questions to knock you off center. It’s
awful being stuck in a particular question which then affects remaining exam perfor-
mance. It’s in these stinkers examiners are testing whether you’ve built secondary and
tertiary skills or not. The core idea being - you’re not only tested on what you know
but also on what you can do with what you know.

As a student, it is imperative that your overall study plan and preparation takes into
account building these skills. The overall outline of prepping for an exam is,

1. the first or second reading of Acted’s Combined Materials Pack (CMP) takes
care of Knowledge.

2. Solving Question Bank, Assignment X series, past exam questions build Appli-
cation & Higher Order skill sets.

Your first reading of the CMP gets you familiar with the topic. Get a feel of the
concepts covered. And your second reading should be this document. It’s designed
to fill in the gaps in understanding and provide conceptual clarity. And the next step
is to start playing with questions.You work your way through the basic questions at
the end of each chapter in the CMP and move on to exam-style questions.

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You may find exam-style questions to be intimidating at first. It’s perfectly alright.
It’s only via practice you’ll become comfortable with the uncomfortable.

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