Basic Theory of Interest

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Basic Theory of Interest

Topics This class: Principal and interest Present and future value Internal rate of return Ranking dierent investments
Kay Giesecke
Principal and interest

Time is money Simple interest: If A is an amount (principal) left in an account at simple interest r per year, the total value after n years is A(1 + rn) Linear growth Compound interest: If the interest r paid on the account is compounded yearly, then the interest earns interest and the total value after n years is A(1 + r)n Geometric growth
Kay Giesecke

Discrete vs. continuous compounding More generally, if a year is divided into a xed number m of equally spaced periods (quarters, months, days etc.) and the interest paid at annual rate r is compounded every period, then the account value after k periods is r Vm (k) = A 1 + m
k
If compounding becomes more and more frequent, in the continuous compounding limit m we get for the account value after a year (= m periods)
m
lim Vm (m) = A lim
r 1+ m
= Aer
Kay Giesecke

Arbitrary length of time After t years, the account has grown to V (t) = lim Vm (mt) = A lim
m m
r 1+ m
mt
= Aert
That is, the account value grows exponentially with time
Kay Giesecke

Nominal vs. eective rate per annum The basic annual rate r is called the nominal rate The eect of compounding is highlighted by stating an eective rate, dened as the number r that satises r 1+r = 1+ m for discrete compounding and 1 + r = er for continuous compounding The eective rate is the equivalent annual simple rate of interest that would produce the same result after 1 year without compounding
Kay Giesecke m

A ccount Value (7% Nom inal Interest Per A nnum )
4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Years

Simple Interest Annual Compounding Continuous Compounding
Kay Giesecke

Topics Principal and interest This class: Present and future value Internal rate of return Ranking dierent investments
Kay Giesecke
Present and future value

Investments A cash ow is a monetary ow x R that occurs at a given, xed time today or in the future Negative: payment that must be made (e.g. initial deposit) Positive: payment that is received (e.g. interest payments) A cash ow stream is a collection (x1 , x2 , . . . , xn ) of cash ows xi that occur at times i An investment is dened in terms of its cash ow stream
Kay Giesecke

No uncertainty We begin by assuming that all relevant quantities are deterministic: we are always certain about their values Timing and size of cash ows Interest rate While this limits the applicability of our results, it eliminates the need to deal with the signicant consequences of uncertainty Later in this course we will relax this assumption and consider stochastic cash ows, i.e. cash ows whose timing is certain but whose size is uncertain (i.e., a random variable)
Kay Giesecke
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Examples A zero coupon bond issued by the US government No default risk A coupon bond issued by the US government A portfolio of zero coupon bonds (arbitrage!) Accrued interest A share of stock issued by a corporation is not an example, because dividends are uncertain in practice!
Kay Giesecke
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Kay Giesecke
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The ideal bank Applies the same rate of interest to both loans and deposits Applies the same rate of interest to any size of principal Does not charge service or transaction fees Does not default on its obligations The constant ideal bank Is an ideal bank Has an interest rate that is independent of the length of time for which it applies Compounds interest according to xed rules
Kay Giesecke
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Future value Fix a time cycle for compounding and let a period be the length of this cycle Suppose that cash ows xi occur initially and at the end of each period i = 1, 2, . . . , n, forming a stream (x0 , x1 , . . . , xn ) If these cash ows are deposited in a constant ideal bank paying a nominal per-period rate r, then at the end of n periods these cash ows will have grown to F V = x0 (1 + r)n + x1 (1 + r)n1 + . . . + xn This is the future value of the cash ow stream (x0 , x1 , . . . , xn ) The accumulation factor (1 + r)i describes the growth of 1 dollar over i periods from now
Kay Giesecke
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Present value We are interested in todays value of the cash ow stream (x0 , x1 , . . . , xn ) If the cash ows could be deposited in a constant ideal bank paying a nominal rate r, then they have a value today of x1 xn P V = x0 + + + 1+r (1 + r)n This is the present value of the cash ow stream (x0 , x1 , . . . , xn ) Present value and future value of a stream are related via FV PV = (1 + r)n
Kay Giesecke
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Discounting The process of evaluating future cash ows as an equivalent present value is also known as discounting The factor di by which a cash ow xi that occurs at the end of period i/time ti must be discounted is called the discount factor Discrete compounding at m equally spaced intervals per year 1 and nominal annual rate r: di = (1+r/m)i Continuous compounding at nominal annual rate r: di = erti The present value formula for a stream (x0 , x1 , . . . , xn ) is then
n
PV =
i=0
xi di
(1)
Note the dependence on the compounding cycle and r!

Kay Giesecke
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Equivalence of cash streams Theorem. The cash streams x = (x0 , x1 , . . . , xn ) and y = (y0 , y1 , . . . , yn ) are equivalent for a constant ideal bank with interest rate r if and only if the PVs of the two streams, evaluated at r, are equal. Corollary. When a constant ideal bank is available, then the PV completely characterizes a cash ow stream. The stream can be transformed in a number of ways but the PV remains the same. The bottom line: We can use the PV as a criterion to compare dierent cash streams, i.e., investments.
Kay Giesecke
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Equivalence of cash streams Proof of Theorem. Let P Vx be the PV of stream x = (x0 , x1 , . . . , xn ) and P Vy be the PV of stream y = (y0 , y1 , . . . , yn ). A constant ideal bank can be used to transform x into the equivalent stream (P Vx , 0, . . . , 0) and y into the equivalent stream (P Vy , 0, . . . , 0). These new streams are equivalent if and only if P Vx = P Vy (here we need the assumption of a constant ideal bank). It follows that the two original streams are equivalent if and only if the PVs are equal.
Kay Giesecke
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Topics Principal and interest Present and future value This class: Internal rate of return Ranking dierent investments
Kay Giesecke
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Internal rate of return

For a given cash stream (x0 , x1 , . . . , xn ) over n equally spaced periods and corresponding compounding cycle with nominal rate n xi r, the PV is i=0 (1+r)i We now turn the PV procedure around: Denition. Let (x0 , x1 , . . . , xn ) be some cash stream. The internal rate of return (IRR) is the number r that satises the equation 0 = x0 + x1 x2 xn + + ... + (1 + r) (1 + r)2 (1 + r)n
Equivalently, this is a number r satisfying c = 1/(1 + r), where c satises the polynomial equation 0 = x0 + x1 c + x2 c2 + . . . + xn cn (2)
Kay Giesecke
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The IRR is entirely based on the cash stream itself: it is dened without reference to the external nancial world (e.g. a pertaining nominal rate) It is the nominal interest rate that an ideal bank would have to apply in order to generate the cash stream from an initial balance of 0
Kay Giesecke
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Equation (2) is a polynomial equation of degree n with real coecients It has n roots, which may be real or complex (this is the Fundamental Theorem of Algebra) If a + ib is a complex root, then so is its conjugate a ib This may lead to an ill-posed IRR problem What if there are several roots? How do we pick a specic one? How do we treat complex roots?
Kay Giesecke
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Existence and uniqueness of real solutions to (2) Descartes Rule. The number of positive roots of a polynomial equation with real coecients is equal to the number of changes of sign in the list of coecients, or is less than this number by a multiple of 2. Theorem. If the cash stream (x0 , x1 , . . . , xn ) has x0 < 0 and xi 0 for all i = 1, 2, . . . , n, with at least one term being strictly positive, then there is a unique positive root to (2). If in addition
n i=0
xi > 0, then the corresponding IRR is positive.
Kay Giesecke
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Existence and uniqueness of real solutions to (2) Proof. Let f (c) denote the polynomial. We have f (0) = x0 < 0. Since there is at least one strictly positive coecient, f is strictly increasing to . Since f is continuous, there is a unique real c , which is positive, for which f (c ) = 0. The corresponding IRR is given by
n 1 c
1. It is positive if
f (1) =
i=0
xi > 0
since then c < 1.
Kay Giesecke
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Finding real roots of f (c): Newtons method This is an iterative method, in which the polynomial f (c) is locally approximated by a line tangent Suppose f (c) satises the conditions of the previous theorem. For an initial guess c0 we calculate recursively ci+1 f (ci ) , = ci f (ci ) i = 0, 1, 2, . . . ,
(since f is strictly increasing, f > 0) We have limi ci = c for c the root of f
Kay Giesecke
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Finding real roots of f (c): Newtons method
Kay Giesecke
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Topics Principal and interest Present and future value Internal rate of return This class: Ranking dierent investments
Kay Giesecke
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Evaluation criteria
Ranking dierent investments Net present value (NPV) = PV of benets minus the PV of the cost associated with an investment: the greater the better (if > 0) Can be broken up into components: PV of a sum of cash ows is equal to the sum of the PVs of the individual cash ows No ambiguity Does depend on the interest rate, which is not always easily dened in practice (this rate is really the benchmark) IRR: the greater the better (if > r) Cannot be broken up into pieces Potential ambiguity Does only depend on cash ows
Kay Giesecke
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Evaluation criteria
Example: when to cut a tree Two alternatives Cut early with cash stream (1, 2) Cut late with cash stream (1, 0, 3) Fill in the gaps and decide: Cut Early NPV (r = 10%) IRR ? ? Cut Late ? ?
Kay Giesecke
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Evaluation criteria
Example: when to cut a tree Two alternatives Cut early with cash stream (1, 2) Cut late with cash stream (1, 0, 3) The two criteria are in conict: Cut Early NPV (r = 10%) IRR What do we do now? 0.82 1.00 Cut Late 1.48 3 1 0.73
Kay Giesecke
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Evaluation criteria
Equalizing the horizon Suppose we can repeat the investment for a total of 6 years; this gives cash streams of equal length: Cut early with cash stream (1, 1, 1, 1, 1, 1, 2) Cut late with cash stream (1, 0, 2, 0, 2, 0, 3) Now the two criteria lead to consistent decisions: Cut Early NPV (r = 10%) IRR 3.92 1.00 Cut Late 3.71 3 1 0.73
Kay Giesecke
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Evaluation criteria
Conclusions Overall, most theorists but not all practitioners would decide according to the NPV, so we would choose to cut late in the original setting However, we need to put the investment into perspective If the investment can be repeated over a longer horizon, then we are better o choosing the alternative with the higher IRR to get the greatest growth of capital, and cut early We see that if we equalize the investment horizon and compare the sequences of investments, both criteria lead to consistent decisions
Kay Giesecke
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Evaluation criteria
Taxes If there is a uniform tax rate for revenues and expenses, then the ranking implied by our criteria does not change The NPV of an individual investment changes by a factor of one minus the tax rate The IRR of an individual investment does not change Beware of depreciation in the calculation of cash ows
Kay Giesecke

Basic Theory of Interest

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Basic Theory of Interest

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