Financial Mathemati CS: Ghulam Nabi

Financial Mathemati cs
By
Ghulam Nabi
§1b. Why Do We Need a Force of Interest?
• Let’s begin with an easy concept that you already
understand from Section 1a(i): The effective rate
of interest is simply the amount of interest earned
during a period divided by the amount invested at
the beginning of that period.
• Consider the following four funds:
• The four curves going from time 0 to time 1 show
how each of the funds grows during the first year.
• As you can see, in this example the amount in the
fund is the same at the beginning and the end of
the year for all four funds.
• But they certainly grow quite differently at any
moment of time during the year.
• Question: What can you say about the effective
rate of interest for the four funds in this year?
• Answer: The effective rate of interest is the same
for all four funds.
• You can see that the amount of interest earned in
the year is the same for all of the funds (i.e., the
increase in each fund over the year is the same).
• Also, the investment at time 0 for each fund is the
same.
• So by definition, the effective rate of interest is
the same for all four.
• This shows that the effective rate of interest is all
we need to know if we are only interested in how
much interest is earned on a fund over the entire
year, but gives us absolutely no information about
how the fund grows at any moment during the
year.
• In theoretical work, and in practical applications
of the theory, we may need to know the rate of
growth of a fund at any moment of time. That’s
what the force of interest is.
§1c. Defining the Force of Interest
• Suppose $1.00 is invested at time 0 and grows
according to the following graph:
• It’s plain that this fund is not growing at a constant

rate.
• Suppose we want to measure how fast it’s growing
at some time t, as indicated on the graph.
• The first thing that comes to mind is the derivative
of a(t).
• A high derivative—a relatively steep curve—tells
us that the fund is increasing by a relatively large
amount near time t.
• A low derivative—a relatively flat curve—tells us
that the fund is increasing by a relatively small
amount near time t.
• But is the derivative, in itself, a good measure of
the rate of growth, as opposed to the amount of
growth?
• The answer is “no.”
• To understand this, let’s consider a second fund along with the first:
• Suppose the derivatives of the two a(t) functions are the same at
time t.
• Suppose the amount in fund #2 is double the amount in fund #1 at
time t.
• Are the two funds growing at the same rate at that time?
• To put the question in practical terms, suppose
you are a manager of a fund with a billion dollars
of assets at time t.
• You have to “park” the billion dollars for a very
short period of time—say for 30 seconds, or
roughly a millionth of a year.
• Where would you park your money?
• Fund #1
• Fund #2
• It makes no difference
• If you said “fund #1,” you were right.
• The reason is that both funds earn about the same amount
of interest in the thirty-second period but fund #1 earns that
amount of interest on only half the investment as fund #2.
• A little more detail: The derivative, or slope, is the same for
both funds at time t.
• This means that for a very small change in t, the two funds
increase by about the same amount.
• In other words, both funds earn about the same amount of
interest in the 30-second period after time t.
• But fund #1 earns that interest on only half the investment
as fund #2 does.
• So fund #1 is growing at about twice the rate of fund #2 at
time t.
• (If bank #1 offers to pay you $5 in interest in one
year on a deposit of $100 and bank #2 also offers
to pay $5 in interest but on a $200 deposit, you
would have no problem in concluding that bank
#1’s effective annual rate of growth is twice that
of bank #2. The same principle applies to a rate of
growth at a point in time.)
• Our conclusion is that to get a rate of growth that
makes sense—one that truly tells us how fast a
fund is growing at any point in time—we must
divide the derivative, or slope, by the amount in
the fund.
• The
rate of growth at a point in time is called the
“force of interest.” If we let stand for the force of
interest at time t, we have:
• Note 1: a(t) (the accumulation function) starts

with 1 at time 0. A(t) (the amount function) starts
with k at time 0, so A(t) = k a(t). So can also be
defined as:
since the k’s cancel when you substitute A(t) = ka(t).

• Note 2: A force of discount could also be defined
as minus the derivative of the discount function
( 1/a(t) ) divided by the discount function. (The
minus sign is used because ( 1/a(t) ) is normally a
decreasing function of t, so it has a negative
derivative. We want the definition to produce a
positive rate when a fund is growing.) However,
this turns out to be equal to the force of interest.
This is not too surprising, since we are measuring
rate of growth in the limit, i.e., at a moment of
time.
• EXAMPLE 1
• You are given the following facts about a fund:
(i) The amount in the fund at the end of 10 years is $2,000
(ii) The amount of interest earned in the period from 10 years to 10.001 years is $.08
• Determine the approximate force of interest at time 10.

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Financial Mathemati cs

• It’s plain that this fund is not growing at a constant

• Note 1: a(t) (the accumulation function) starts

since the k’s cancel when you substitute A(t) = ka(t).

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