FMF L1 4S PDF

Lecture 1: Interest Accumulation and Time Value
of Money
Lecturer: Phạm Thị Hồng Thắm
Foundations of Mathematical Finance
PTHT Lecture 1 FMF 1 / 62

Table of Contents
1 Accumulation Function and Amount Function
2 Simple and Compound Interest
3 Frequency of compounding
4 Annual Effective Rate of Interest
5 Generalized nominal rate of interest ih (t)
6 Rates of discount
7 Force of interest
8 Present and Future Values

Accumulation Function and Amount Function

Basic terminologies
Many financial transactions involve lending and borrowing.

The sum of money borrowed is called the principal.
To compensate the lender for the loss of use of the principal during
the loan period the borrower pays the lender an amount of interest.
At the end of the loan period the borrower pays the lender the
accumulated amount, which is equal to the sum of the principal
plus interest.

Accumulated function a(t)
We denote A(t) as the accumulated amount at time t, called the

amount function.
Hence, A(0) is the initial principal and
I (t) = A(t + 1) − A(t)
is the interest incurred from time t to time t + 1.

For the special case of an initial principal of $1, we denote the
accumulated amount at time t by a(t).

Simple and Compound Interest

Simple and Compound Interest
There are many ways to calculate interest.

The two most common methods are the simple interest method and
the compound interest method.

Simple interest
For the simple interest method, the interest earned over a period of
time is proportional to the length of the period.
The interest incurred from time 0 to time t, for a principal of $1, is
r × t, where r is the constant of proportion called the rate of
interest.
The accumulation function for the simple-interest method is
a(t) = 1 + rt, A(t) = A(0)(1 + rt). (1)
The rate of interest may be quoted for any period of time (such as a
month or a year). However, the most commonly used base is the year,
in which case the term annual rate of interest is used.

Example: simple interest
Example
a) $550 is deposited at 4.6% simple interest for five years. What is the
accumulated amount at the end of this period?
b) At what rate of simple interest will $550 accumulate to $645 in three
years?

Compound interest
For the compound-interest method, the accumulated amount over a

period of time is the principal for the next period.
Thus, a principal of 1 unit accumulates to (1 + r ) units at the end of
the year, which becomes the principal for the second year.
Continuing this process, the accumulation function becomes
a(t) = (1 + r )t , A(t) = A(0)(1 + r )t for t = 0, 1, 2, ... (2)

Compound interest (continued)
For the compound-interest method the accumulated amount at the

end of a year becomes the principal for the following year, whereas
the principal does not change for simple interest over the loan period.
The formula for the accumulation function only works for integral
values of t whereas the same formula for simple interest works for all
positive value of t.

Compound versus Simple interest
FM_Hoang/Compound_Simple.png

Examples: compound interest
Example
a) $550 is deposited at 4.6% compound interest per annum for five
years. What is the accumulated amount at the end of this period?
b) At what rate of compound interest per annum will $550 accumulate
to $645 in three years?
c) You have $500 on deposit earning 8.2% annual compound interest.
How long will it be before your account balance is $856?

Examples: compound interest
Example
$500 is deposited in an account earning annual compound interest of
5.7%. At the end of two years the accumulated amount is transferred to
an account which pays an unknown annual compound interest. At the end
of three additional years the account shows a balance of $600. What was
the rate of annual compound interest during the final three years?

Example: compound interest
Example
An investment is earning compound interest. If $100 invested in year 2
accumulates to $105 by year 4, how much will $500 invested in year 5 be
worth in year 10?

Example: compound interest
Example
Smith deposits $1000 into an account on 1/1/2005. The account credits
interest at 5% per annum at every 31/12. Smith withdraws $200 on
1/1/2007, deposits $100 on 1/1/2008 and withdraws $250 on 1/1/2010.
What is the balance of the account just after interest is credited on
31/12/2011 ?

Frequency of compounding

Frequency of compounding
The the frequency of compounding is the number of times interest

payments are made annually.
We say that the nominal rate of interest is i (m) convertible m
times per annum if the interest is paid every 1/m of a year at the
rate of i (m) /m.
Starting at $1, after t years, the accumulated account grows to
!tm
i (m)
a(t) = 1 + . (3)
m
In cases when the loan period is not a multiple of the compound

period, we adopt the convention that (3) can be used even when tm
is not a whole number.

Example
Example
$1,000 is deposited into a savings account that pays 3% interest with
monthly compounding. What is the accumulated amount after two and a
half years? What is the amount of interest earned over this period?

Example
Example
What is the accumulated amount for a principal of $100 after 25 months if
the nominal rate of interest is 4% compounded quarterly?

Continuous Compounding
At the same nominal rate of interest r , the more frequent the interest
is paid, the faster the accumulated amount grows. Indeed, if p > q
then
r p r q

1+ > 1+
p q
When the number of interest payments per annum approaches
infinity, the accumulated amount tends to a finite number
r p

lim 1 + = exp(r ).
p→∞ p
We call the compounding scheme over infinitely small period of time

continuous compounding.
Daily compounding is very close to continuous compounding.

Continuous Compounding
FM_Hoang/continuous_compound.png

Annual Effective Rate of Interest

Annual effective rate of interest
Definition
The annual effective rate of interest at time t, denoted by i(t), is the ratio
of the amount of interest earned in a year, from time t − 1 to time t, to
the accumulated amount at the beginning of the year (i.e., at time t).
A(t) − A(t − 1) a(t) − a(t − 1)

i(t) = = . (4)
A(t − 1) a(t − 1)
Corollary
A(t) = A(t − 1)(1 + i(t)).

Simple interest
Proposition
The annual effective rate of interest of simple interest rate r is given by
r
i(t) = .
1 + r (t − 1)

Annual effective rate of simple interest versus time
FM_Hoang/effective_simple.png

Compound interest
Proposition
The annual effective rate of interest of compound interest rate r is given by
i(t) = r .

Compound interest
Proposition
The annual effective rate of interest of nominal rate of interest of i (m)
convertible m times per annum
!m
i (m)
i(t) = 1 + − 1.
m

Example
Example
Consider two investment schemes A and B. Scheme A offers 12% interest
with annual compounding. Scheme B offers 11.5% interest with monthly
compounding. Calculate the effective rates of interest of the two
investments. Which scheme would you choose?

Example
Suppose i(t) = 0.05 + 0.001t for t = 0, 1, .., 4. What is the accumulation
of $10,000 at these rates of interest over the period t = 0 to t = 5?

Generalized nominal rate of interest ih (t)

Generalized nominal rate of interest ih (t)
Definition
Let h > 0, the generalized nominal rate of interest ih (t) is defined as
1 a(t + h) − a(t)
ih (t) = × .
h a(t)

ih (t) - continued
This is the annualized effective rate of interest between time t and

t + h.
Equivalently, $1 at time t will grow to $1 + hih (t) at time t + h.
The nominal rate of interest i (m) for compound interest convertible m
times per year is a special case of ih (t) with h = 1/p and interest is
constant over time.

Example ih (t)
Example
We are given the nominal interest rates i0.4 (0) = 0.05, i0.6 (0.4) = 0.06,
i0.5 (1) = 0.04. What is the accumulation of $1 from time 0 to 1.5?

Homework
Textbook questions:
Chapter 1: 1,3,4,6,7,12,13,17,22,23,25,29.

Rates of discount

Rates of discount
Interest of a loan or investment can be paid either at the end or the

beginning of the period.
For instance, a popular way of raising a short-term loan is to sell a
financial security at a price less than the face value.
Upon the maturity of the loan, the face value is repaid.
For example, a Treasury Bill is a discount instrument.
For a discount security, the shortfall between the sale price and the
face value is called the discount.

Annual effective discount rate
Definition
The effective annual rate of discount is defined as
A(1) − A(0)
d= .
A(1)
Equivalently, d is the interest expressed as a percentage of the

accumulated amount.
A(0) = A(1)(1 − d).

Example
Example
Smith borrows $1000 for one year at 10% per annum with interest payable
in advance.
The interest of this loan is
1000 × 10% = $100.
Since it is payable in advance. Smith has to pay back $100 the moment he
receives the $1000 loan. That means he receives $900 today but will pay
back $1000 one year from today. The equivalent effective interest rate is
1000 − 900
i= = 0.1111 = 11.11%.
900
The 10% is referred to as the effective discount rate.

Relationship between discount rate and interest rate
Proposition
Let i and d be the equivalent annual effective interest and discount rates
respectively. Then
(1 + i)(1 − d) = 1.
Or equivalently,
i d
d= , i= .
1+i 1−d
Chứng minh.
Note that A(1) = A(0)(1 + i). Then
A(1) − A(0) A(0)(1 + i) − A(0)

d= =
A(1) A(0)(1 + i)
1+i −1 i
= = .
1+i 1+i

Nominal rate of discount convertible m times per
year
We denote the nominal rate of discount, which is the discount quoted

in annual term for the 1/m year instrument, by d (m) .
That means the accumulated amount is discounted m times per year
and each time the effective discount rate is d (m) /m.
!m
d (m)
A(0) = A(1) 1 − .
m

Relationship between i (m) and d (m)
Proposition
Let i and d be the annual effective interest and discount rates respectively.
Let i (m) and d (m) be the equivalent nominal interest and discount rates
convertible m times per year. Then
! !
i (m) d (m)
1+ 1− = 1.
m m
Or equivalently,
mi (m) md (m)
d (m) = , i (m) = .
m + mi (m) 1 − md (m)

Example
Example
The discount rate of a 3-month Treasury Bill is 6% per annum. What is
the annual effective rate of interest? What is the accumulated value of 1
in 2 years?

Example
Example
Calculate the nominal rate of discount convertible monthly that is
equivalent to a nominal rate of interest of 18.9% per year convertible
monthly.

Example
Example
Jeff deposits $10 into a fund today and $20 fifteen years later.
Interest is credited at a nominal discount rate of d compounded
quarterly for the first 10 years, and at a nominal interest rate of 6%
compounded semiannually thereafter.
The accumulated balance in the fund at the end of 30 years is $100.
Calculate d.

Force of interest

Force of interest
Definition
For an investment that grows according to the accumulation function a(t),
the force of interest δ(t) is defined as
a′ (t)
δ(t) = .
a(t)

Accumulation amount from force of interest
Proposition
Z t
A(t) = A(0) exp δ(s)ds
0

Force of interest & generalized nominal rate of
interest
Proposition
Z t+h
1
lim ih (t) = δ(t), & ih (t) = exp δ(s)ds −1
h→0 h t

Example
Example
Suppose δ(t) = 0.05 + 0.01t for t > 0. What is i0.5 (1)?

Force of interest - compound interest
Proposition
For compound interest at annual effective interest rate i, the force of
interest is given by
δ(t) = ln(1 + i).

Force of interest - simple interest
Proposition
For simple interest i per annum, the force of interest is given by
i
δ(t) = .
1 + it

Example
Example
A fund accumulates at a simple-interest rate of 5%. Another fund
accumulates at a compound-interest rate of 4%, payable yearly. When will
the force of interest be the same for the two funds? After this time, which
fund will have a higher force of interest?

Example
Example
Suppose δ(t) = 0.08 + 0.005t. Calculate the accumulated amount after 5
years of an investment of $1000 made at
a) time 0,
b) time 2.

Example
Example
Bruce deposits $100 into a bank account. His account is credited
interest at a nominal rate of interest of 4% convertible semiannually.
At the same time, Peter deposits $100 into a separate account.
Peter’s account is credited interest at a force of interest of δ.
After 7.25 years, the value of each account is the same. Calculate δ.

Present and Future Values

Present and Future Values
The present value of $1 at time t is the amount of money needed to

set aside at time 0 so that it will accumulate to $1 at time t.
The future value at time t of 1 invested at time 0 is the amount of
money accumulated at time t from 1 invested at time 0.
The present and future values depend on the force of interest.

Constant interest rate
Suppose interest is fixed and compounded annually at i per annum.

Then $1 invested today will grow to $(1+i) in one year.
The factor (1 + i) is called the accumulation factor.
Let v = (1 + i)−1 be the discount factor.
The future value of $1 t years from now is (1 + i)t .
The present value of $1 at time t is v t .

Example
Example
Find the sum of the present values of two payments of $100 each to be
paid at the end of year 4 and 9, if interest is compounded semiannually at
the nominal rate of 8% per year.

Varying interest rate
Suppose we are given the force of interest δ(t).

Then the present value of $1 at time t is given by
Z t
v (t) = exp − δ(s)ds .
0
The future value of $1 at time t is given by

Z t
v (t)−1 = exp δ(s)ds .
0

Example
Example
Suppose v (t) = 0.98 − 0.3t for t = 1, 2, 3, 4.
Let Ct = 1000 − 200t for t = 0, 1, 2, .., 4 where Ct is a payment at
time t.
Find the present value of this stream of payments.

Homework
Textbook questions:
Chapter 1: 5,9,10,11,15,18,19,20,21,28,30,36,39,40.

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Lecture 1: Interest Accumulation and Time Value

Lecturer: Phạm Thị Hồng Thắm

Foundations of Mathematical Finance

PTHT Lecture 1 FMF 1 / 62

1 Accumulation Function and Amount Function

2 Simple and Compound Interest

4 Annual Effective Rate of Interest

5 Generalized nominal rate of interest ih (t)

8 Present and Future Values

PTHT Lecture 1 FMF 2 / 62

PTHT Lecture 1 FMF 3 / 62

Many financial transactions involve lending and borrowing.

PTHT Lecture 1 FMF 4 / 62

We denote A(t) as the accumulated amount at time t, called the

I (t) = A(t + 1) − A(t)

is the interest incurred from time t to time t + 1.

PTHT Lecture 1 FMF 5 / 62

PTHT Lecture 1 FMF 6 / 62

There are many ways to calculate interest.

PTHT Lecture 1 FMF 7 / 62

a(t) = 1 + rt, A(t) = A(0)(1 + rt). (1)

PTHT Lecture 1 FMF 8 / 62

PTHT Lecture 1 FMF 9 / 62

For the compound-interest method, the accumulated amount over a

a(t) = (1 + r )t , A(t) = A(0)(1 + r )t for t = 0, 1, 2, ... (2)

PTHT Lecture 1 FMF 10 / 62

For the compound-interest method the accumulated amount at the

PTHT Lecture 1 FMF 11 / 62

PTHT Lecture 1 FMF 12 / 62

PTHT Lecture 1 FMF 13 / 62

PTHT Lecture 1 FMF 14 / 62

PTHT Lecture 1 FMF 15 / 62

PTHT Lecture 1 FMF 16 / 62

PTHT Lecture 1 FMF 17 / 62

The the frequency of compounding is the number of times interest

In cases when the loan period is not a multiple of the compound

PTHT Lecture 1 FMF 18 / 62

PTHT Lecture 1 FMF 19 / 62

PTHT Lecture 1 FMF 20 / 62

We call the compounding scheme over infinitely small period of time

PTHT Lecture 1 FMF 21 / 62

PTHT Lecture 1 FMF 22 / 62

PTHT Lecture 1 FMF 23 / 62

A(t) − A(t − 1) a(t) − a(t − 1)

PTHT Lecture 1 FMF 24 / 62

PTHT Lecture 1 FMF 25 / 62

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PTHT Lecture 1 FMF 27 / 62

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This is the annualized effective rate of interest between time t and

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PTHT Lecture 1 FMF 34 / 62

PTHT Lecture 1 FMF 35 / 62

PTHT Lecture 1 FMF 36 / 62

Interest of a loan or investment can be paid either at the end or the