MA3269 1314S1 Chapter 1

AY2013-14 Sem1 MA3269 Chapter 1
NG Wee Seng
Email: matnws@nus.edu.sg
Tel: 65164673

1
MA3269 Mathematical Finance I
Chapter 1
Theory of Interest

1.1 Interest

Accumulation Function
When a principal of 1 dollar is deposited in an interest-paying account at time t = 0, it
earns some interest over the time interval [0, t]. The accumulated value of 1 dollar at
time t, denoted by a(t), is known as the accumulation function.

Simple and Compound Interest
Let 0 > t denote time in number of years. Let r be the annual rate of interest.

Based on the simple-interest method of calculating interest,
rt t a + =1 ) ( .
If the compound-interest method is used,
t
r t a ) 1 ( ) ( + = .
Otherwise stated otherwise, we shall assume compound interest is used throughout the
course.
Example 1.1.1
Investor A puts $1,000 in a three-year time deposit account that pays simple interest at an
annual rate of 1.8%. Investor B invests an equal amount of money in a three-year
insurance savings plan that guarantees a fixed interest rate of 1% for the first year, 1.5%
for the second year and r% for the third year. Interests are compounded annually. Find
the value of r for which both investors will get the same amount of money when their
savings plan matures.
Solution


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2
Frequency of Compounding
When an interest of r = r
(p)
is paid p times a year (or equivalently, r
(p)
is convertible pthly
or r
(p)
is compounded p times a year), we call p the frequency of compounding.
The interest to be paid over one period, is
p
r
p) (
. Effectively, $1 invested at time t = 0 will
grow to
|
|
.
|
\
|
+
p
r
p) (
1 over a period of length
p
1
, so the accumulated amount after one year
is
p
p
p
r
|
|
.
|
\
|
+
) (
1 .
Remarks
(i) We write the superscript (p) for r
(p)
to indicate the frequency of compounding p.
(ii) We can drop the superscript (p) when p = 1.
(iii) p = 2, 4 and 12 correspond to semi-annual, quarterly and monthly compoundng
respectively.

Example 1.1.2
At what nominal rate convertible quarterly would $10,000 accumulate to $16,000 in six
years? For this interest rate, calculate the accumulation value if monthly compounding is
used.
Solution


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3
Nominal Rate and Effective Rate
The annual interest rate r
(p)
is called the nominal rate of interest. The effective annual
interest rate
e
r is given by
e
r + 1 =
p
p
p
r
|
|
.
|
\
|
+
) (
1
It can be shown that for 1 > p , the effective annual interest rate is always greater than the
nominal rate
) ( p
r . That is, for any positive integer p,
) (
) (
1 1 :
p
p
p
e
r
p
r
r >
|
|
.
|
\
|
+ =
The corresponding accumulation function is
= ) (t a ( ) = +
t
e
r 1
pt
p
p
r
|
|
.
|
\
|
+
) (
1 .

Equivalent Interest Rates
Two interest rates are said to be equivalent if and only if they yield same accumulation
function (and hence the same effective annual rate of interest).
The nominal rates
) ( p
r and
) (q
r are equivalent if and only if
q
q
p
p
q
r
p
r
|
|
.
|
\
|
+ =
|
|
.
|
\
|
+
) ( ) (
1 1
Example 1.1.3
Find the nominal rate convertible monthly that is equivalent to a 4% nominal rate
convertible quarterly.
Solution


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Tel: 65164673

4
Continuous Compounding
We say that interest is compounded continuously when the frequency of compounding
tends to infinity. Let
) (
r denote the nominal rate of interest under continuous
compounding. Then,
( )
( )
= + =

r p
p
r
p
e a ) 1 ( lim ) 1 ( .
The number
( )
r is known as the continuously compounded rate of interest.
The corresponding accumulation function is
= ) (t a
( )
t r
e

.

Denoting the nominal rate for compounding p times a year by
( ) p
r , the following
conversion relation holds if the two rates
( ) p
r and
( )
r are equivalent:

) (
) (
1

=
|
|
.
|
\
|
+
r
p
p
e
p
r
( =
e
r + 1 )
It can be shown that for any fixed nominal rate ( ) e , 0 r ,
p
p
r
) 1 ( + , ( ) e , 0 p , is a
strictly increasing function of p. It follows that continuous compounding yields a higher
accumulated value than does compounding p times a year, for any positive integer p.

Mathematically,
p
r
p
r
e
|
|
.
|
\
|
+ > 1 for any r > 0 and for any e p Z
+


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5
Example 1.1.4
An investor makes a deposit today to earn an effective annual return rate of 4% over the
first 3 years, and a nominal rate of 3% compounded monthly for the next 2 years. What
continuously compounded return rate must be earned over the subsequent five years in
order to triple the original investment by the end of ten years?
Solution


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6
1.2 Time Value

Consider a stream of cash flows ( ) ( ) ( ) { }
n n
t c t c t c C , ,..., , , ,
2 2 1 1
= consisting of a series of
payments, with
i
c received at time
i
t , for ,... 3 , 2 , 1 = i , where
j i
t t < for j i < .
If ( ) t a is the accumulation function, then the present value (PV) of this cash flow is
=
n
i i
i
t a
c
1
) (

In particular, if the annual rate of interest is a constant , r the present value (PV) of this
cash flow is
1
) 1 (
n
i
t
i
i
r
c
=
+

We can construct a cash flow diagram for C as follows.

The time value of C at a time t = T is
( ) ( )
T
n
i
t
i T
r
r
c
r
i
+ 1
) + 1 (
= + 1 PV
0 =
.
If T > t
n
, we call the above quantity the future value of the cash flow stream, C.

Notations
For simplicity, we write C as
( )
n
c c c c ,...., , ,
2 1 0
when c
i
is paid at time t = i, i = 0, 1, 2,

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7
Example 1.2.1
Find the future value at t = 7 of the cash flow stream C = (-30, 20, -40, 50) at an effective
annual rate of 3%. Hence, find
(i) the future value of C at 8 = t ,
(ii) the present value of C at t = 0
(iii) the future value of the cash flow stream C
1
= (0, 0, 0, -30, 20, -40, 50) at t = 8
(iv) the present value of the cash flow stream
C
2
= (300, -200, 400, -500, 0 , 0, -300, 200, -400, 500, )
Solution


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Tel: 65164673

8
Example 1.2.2
The present value of the cash flow stream { -2x, x, x, x } is $2893. Taking the effective
annual interest rate to be 5%, determine
(i) the future value of this cash flow stream at time . 5 = t
(ii) the integer x
Solution

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9
Principle of Equivalence
In an environment where the interest rate and its method of accumulation remain the
same over any time period, two cash flows streams are equivalent if and only if they
have the same time value at any point in time.

Example 1.2.3
At a certain interest rate R, the cash flow steams (-20, 10, 10) and (-60, 20, 60) are
equivalent. Find R.
Solution


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Tel: 65164673

10
Equation of Value
Consider the cash flow stream ( ) ( ) ( ) { }
n n
t c t c t c C , ,..., , , ,
2 2 1 1
= . The equation
0 =
) + 1 (
= PV
1 =
n
i
t
i
i
r
c
,
is known as the equation of value.

Internal Rate of Return (IRR)
Any root, r of the equation of value is called the yield, or internal rate of return (IRR),
of the cash flow stream.

Example 1.2.4
Find all the IRRs of an investment project with cash flow stream (-100, 0, 50, 0, 150)
Solution


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Tel: 65164673

11
For 2 > n , we often have to employ numerical methods to estimate r.

Newton Raphson Iterative Method
Let be a root of the equation 0 ) ( = x f , where f is differentiable on an interval
containing o .

Let
0
be an approximation to o .
The tangent line at the point ( ) ) ( ,
0 0
f on the curve ) (x f y = meets the x-axis at
) 0 , (
1
.
1
is a new approximation to o .
It can be shown that

provided ) ( '
n
f o 0 = .

Procedure
1. Set
0
o sufficiently close to o . (Use the Intermediate Value Theorem)

2. Compute
) ( '
) (
1
n
n
n n
f
f
o
o
o o =
+
for n = 1, 2, , until the desired degree of
accuracy is reached.

) ( '
) (

0
0
0 1
f
f
=

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Tel: 65164673

12
Example 1.2.5
Find the IRR of the cash flow stream (-2, 1, ,1 ,1) to 4 decimal places.
Solution


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Tel: 65164673

13
1.3 Annuities

Annuities Immediate and Annuities Due

An annuity is a series of payments made at regular intervals.

An annuity-due is one for which payments are made at the beginning of each period.

An annuity immediate (ordinary annuity/ annuity in arrears) is one in which payments
are made at the end of each period.

Perpetual Annuity (Perpetuity)
A perpetuity is an annuity whose payments continue forever (that is, ) n .

Example 1.3.1
Find the accumulated value of a 5-year annuity of $1000 per year, if the first payment is
made at the end of the first year and interest is a nominal 4% compounded quarterly.
Hence, find the present value (at t = 0) of this same annuity.
Solution


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Tel: 65164673

14
Example 1.3.2
A man wants to accumulate a sum of at least $200,000 by the end of 10 years. He plans
to deposit $x yearly into an account that pays 5% interest compounded annually, for the
first 10 years, and $ 2x yearly into the same account for the next 10 years. He intends to
make the first deposit at the beginning of year 1. Find the least value of x.


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Tel: 65164673

15
Example 1.3.3 (Annuities with varying payments)
The first payment of $100 of a 10-year annuity is made at the beginning of the first year.
Every subsequent payment increases by 10%. Assuming an annual interest rate of 5%,
calculate the present value of this annuity.
Redo this problem if the first payment is made at the end of the third year.
Solution

Example 1.3.4 (Perpetuity)
A perpetual annuity begins its annual payment of $A at time N t = . The present value of
this perpetual annuity is P and the continuously compounded rate of interest is r. Express
N in terms of A, P and r.
Solution


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Tel: 65164673

16
1.4 Loans
Loans are normally repaid by a series of installment payments made at periodic intervals.
The size of each installment can be determined using a present-value analysis.
Specifically, if we let L be the amount of L taken at time t = 0 and let
( ) ( ) ( ) { }
n n
t c t c t c C , ,..., , , ,
2 2 1 1
= be the series of repayments, then
L = the present value of C

Example 1.4.1
If you borrow $1000 for a term of 4 years at an annual interest rate of 5% and wish to
completely pay off the loan by equal installments, with the first payment made at the end
of the first year, how much should you pay per year?
Solution


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Tel: 65164673

17
We can also compute the balance of the loan at any point in time.
The loan balance
Balalnce
L
m
immediately after the
th
m installment has been paid is the time
value at m t = of the remaining ( ) m n installment payments.

Example 1.4.2
A loan is being repaid with 20 annual payments of $1000, with payment made at the end
of each year. Immediately after the fifth payment has been made, the borrower wishes to
pay an additional $2000 and then repay the balance over 12 years by annual installment
of $x. If the effective annual interest rate is 9%, find x.
Solution


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Tel: 65164673

18
We now turn to problems in which the number of payments n is to be determined given
the loan amount L , the stream of repayments, assumed to be an annual repayment of the
same amount, A and the interest rates. Quite often, the value of n is not an integer. In this
case, the loan will be repaid with [n] ( [n] is the greatest integer less than or equal to n)
full payments of A plus a final payment, B made at some time T > [n], where B is
determined from the equation
L = present value of ( )

payments
,...., ,
n
A A A + present of { } ) , ( T B

Example 1.4.3.
A loan of $10,000 is to be repaid by annual installments of $1000. The effective interest
rate is 4.5% per annum. Determine the total number of payments to be made and the
amount of the last payment, given that the last payment will be made
(i) together with the last installment payment of $1000
(ii) one year after the last installment payment of $1000
Solution

END OF CHAPTER ONE
Money never made a fool of anybody;
it only shows them up. Elbert Hubbard

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