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CHAPTER 2

GROUP 2A
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TEAM MEMBERS
1. NURFARHANA NABILA BINTI NAZRI 1411328
2. MULIANI BINTI MOHAMAD TAHA 1411300
3. SITI SYURIEYATI BINTI MOHD SOFIAN 1412770
4. NUZUL FARZANA BINTI MOHD KAMIZI 1413686
5. SITI NOR AZMAH BINTI MOHD YUSOF 1410566
2.1.1 Time
Value of Money

$ 100 to be received
after one year is worth
less than the same
amount today
Why?

Inflation

Risk and uncertainty

Money due in future cannot be spent right


away
Present Value (PV) & Future
Value (FV)
Formula

SI = P0(r)(t)

SI Simple Interest
P0 Initial Deposit (t=0) / Principal
r Interest rate per annum
t Time in years

Simple interest: Interest is earned only on


the principal amount
Value of investment
Value of investment at time t, can be denoted
by
V (t ) P (1 rt )

If principal P invested at time S, rather than at


t=0, then theVvalue
(t) [at time
1 (t ts will be
- s)r]P
P V(t)

0
s t
t-s
We shall transform any period
expressed in other units (days, week,
months) into a fraction of a year

For example,
a. Daily basis (given n in days)
V ( 365 ) P (1 365 r )
n n

b. Weekly basis
V ( 52n ) P (1 52n (given
r) n in weeks)

c. ( n
12 ) P (1
Monthly basis r(given
V n
12 ) n in
months)
Example 2.1
Consider a deposit of $150 held for 20
days and attracting simple interest at a
rate of 8%. What is the value of the
deposit after 20 days?
Solution:
From the question above, we know
that P = 150
t = and r = 0.08. Thus,
V(t)=P(1+rt)
The Return on Investment
Return on investment commencing at time s
and terminating at time t can t ) Vdenoted
V (be (s) by
K(s, t)
V (s)
In the case of simple interest, V(t)=V(s)[1+r(t-s)]
K(s, t) r (t s )
V (t ) V ( s )
K(s, t)
V ( s)
V ( s )[1 r (t s )] V ( s )

V (s)
V ( s )[1 r (t s )]
1
V (s)
1 r (t s ) 1
r (t s )
Exercises
Exercise 2.1
A sum of $9, 000 paid into a bank
account for two months (61 days) to
attract simple interest will produce $9,
020 at the end of the term. Find the
interest rate r and the return on this
investment.
Solution:
61 61 9020 9000
(1 r ) 9000 9020 K (0, )
365 365 9000
r 0.0133 1.33% 0.0022 0.22%
Exercises
Exercise 2.3
How long will it take for a sum of $800
attracting simple interest to become $830 if
the rate is 9%? Compute the return on this
investment.
Solution:
(1 t 0.09) 800 830 K(0, t)
830 - 800
t 0.4167 years 800
0.0375
0.4167y 365 152.08 days
3.75%
Perpetuity

Perpetuity is sequence of payments

of a fixed amount to be made at


equal time intervals and continuing
indefinitely into the future
Present value of a perpetuity is

C = fixed amount to be made


r = interest rate
Examples of perpetuities

Series of interest payments from a


sum of money invested
permanently at a certain interest
rate
Scholarship paid from an
endowment on a perpetual basis
Dividends paid in respect of
preference shares
2.1.2
PERIODIC
COMPOUND
ING
FORMULAS
Future
value of initial principal P,

Discounted value of V(t),

Present value of V(t) at an intermediate time 0 < t


< T, given the value of V(t),
PROPOSITION 2.1

The future value V(t) increases if any one


of the parameters m, t, r or P increases,
while the others remain unchanged.
Remark 2.1

Fix the terminal value V(t) of an


investment.
It is an immediate consequence of
Proposition 2.1 that the present value
increases if any one of the factors r, t,
m decreases, the other ones
remaining unchanged.
To find the return on a deposit attracting
interest compounded periodically,

Derivation of the equation,


V (t ) V ( s )
K(s, t)
V ( s)
r
V ( s )[1 ](t s ) m V ( s )
m
V ( s)
r
V ( s )[(1 ) (t s ) m 1]
m
V ( s)
r
(1 ) (t s ) m 1
m
particular,
In
,
which provides a simple way of computing
the interest rate given the return.
Remark 2.2

return on a deposit subject to


The
periodic compounding is not additive.
Take, for simplicity, m=1. Then
,
,
clearly .
2.1.3
STREAMS
OF
PAYMENTS
Annuity : a sequence of finitely
many payments of a fixed amount
due at equal time intervals.
Suppose that payments of an
amount C are to be made once a
year for n years, the first one due a
year hence.
Assuming that annual compounding
applies, we can compute the
present value of such a stream of
payments.
Compute the PV of all payments and add
them up to get,
PV C (1 r ) 1 C (1 r ) 2 C (1 r ) 3 ....... C (1 r ) n .

Amortized Loan : A loan with scheduled


periodic payments (usually equal
installment) of both principal and interest.
This is opposed to loans with interest-only
payment features.
Perpetuity : an infinite sequence of
payments of a fixed amount C occurring at
the end of each year.
Exercise 2.14
How much can you borrow if the interest
rate is 18%, you can afford to pay $10,
000 at the end of each year, and you
want to clear the loan in 10 years?

44941
Exercise 2.15
Suppose that you deposit $1, 200 at the
end of each year for 40 years, subject to
annual compounding at a constant rate
of 5%. Find the balance after 40 years.

20591
2.1.4
CONTINUOU
S
COMPOUND
ING
The continuous compounding formula is used
to determine the interest earned on an account
that is constantly compounded, essentially
leading to an infinite amount of compounding
periods.
The continuous compounding formula takes
this effect of compounding to the furthest limit.
Instead of compounding interest on an
monthly, quarterly, or annual basis, continuous
compounding will effectively reinvest gains
perpetually.
How the Continuous
Compounding Formula is derived
From the periodic compounding formula,
mt
r
V (t ) lim 1 P.
m
m
As m goes to infinity, we get
V (t ) e tr P,
where
m
r
lim 1 e, is the base of natural logarithms.
m m
Proposition 2.2
Continuous compounding produces higher
future value than the periodic compounding
with any frequency m, given the same initial
principle P and interest rate r.

ert > (1+)tm = []rt


Logarithmic return
k(s,t) = ln
since V(t) = , then
= ln
= ln
= rt rs
= r(t s) r=
The logarithmic return is
additive,
k(s,t) + k(t,u) = k(s,u)

Proving:
+ ln
= ln
= ln
= k(s,u)
2.1.5 HOW TO
COMPARE
COMPOUNDIN
G METHODS
More frequent compounding will produce
a higher future value than less frequent
compounding if the interest rates and the
initial principal are the same.
Growth Factor
DEFINITION 2.1
Two compounding methods are
equivalent if the corresponding
growths factor over a period of one
year are the same.
Example 2.6
Semi-annual compounding at 10% is
equivalent to annual compounding at 10.25%.
2 1
0.1 0.1025
1 1.1025 1
2 1

Monthly compounding at 9% over 1 year is


equivalent to annual compounding at 9.38%.
12 1
0.09 0.0938
1 1.0938 1
12 1
Exercise 2.24
Find the rate for continuous compounding
equivalent to monthly compounding at 12%.

mt
r
e 1
rt

m
12
0.12
e 1
r

12
r 0.1194
Exercise 2.25
Find the frequency of periodic compounding at
20% to be equivalent to annual compounding
at 21%.
m 1
0.2 0.21
1 1
m 1
m 2.0
Effective Rate
For a given compounding method with
interest rate r, the effective rate is one
that gives the same growth factor over a
one year period under annual
compounding.
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