AMS 318 Notes

Instructor: Tyler Mayer

12/8/2015

1 The Growth of Money

1.1 What is interest?
Def 1.1: interest - money paid regularly at a particular rate for the use of money lent, or for
delaying the repayment of a debt.

1. An investor loans money to another entity (invests) with the hopes of financial gains.
2. He invests $K at time T0 and it grows to $S at timeT1 .
3. $R = $S $K is the interest paid.

1.2 Accumulation and Amount Functions

Def 1.2: principal - the initial amount of money $K the investor loans to the borrower at time T0
Def 1.3: amount function (for principal $k) - Ak (t) : R+ R to be the balance (as viewed from
the investors pocket) of the loan at time t.
Def 1.4: accumulation function - a(t) : R+ R the amount of accumulation (or gain for the
investor) at time t per dollar invested at time 0.

1. Fact: a(t) = A$1 (t).

2. It is mostly the case that A$k (t) = k A$1 (t) = k a(t). (unless dealing with a tiered interest
model)
3. For example: suppose that for for every dollar you invest at T = 0 you gain $0.10 each year
for the life time of the loan. a(t) = 1 + (0.10)t, Ak (t) = k + kt(0.10).
4. To see when this is not the case: consider a tiered interest function. If your account has $250
or less you gain interest at a linear rate of 10% per year, otherwise you gain interest at a
linear rate of 8% per year. a(t) depends on t AND the balance of your account. Therefore
Ak (t) 6= k a(t)t
Problem 1.1: Suppose that $1000 invested at t = 0 gains $250 paid continuously per year
for 3 years. What is the equation of A1000 (t)?
Problem 1.2: What is the amount function for 1000 invested at time 0 which gains 250 per
year in interest payable at the end of each year for 3 years?

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 5. Note: accumulation and ammount functions are RIGHT CONTINUOUS FUNCTIONS: limxa+ f (x) =
f (a).
Def 1.5: effective interest rate over the interval [t1 , t2 ] - Expresses the amount of interest
paid/earned over an interval [t1 , t2 ] as a percentage of the initial balance of the loan at t1 .
Denote it as i[t1 , t2 ]

a(t2 ) a(t1 )
i[t1 , t2 ] =
a(t1 )

6. If Ak (t) 6= ka(t) then the investor considers his effective interest rate over the interval [t1 , t2 ]
to be :
Ak (t2 ) Ak (t1 )
i[t1 , t2 ] =
Ak (t1 )

7. Denote in = a(n)a(n1)
a(n1) to be the effective rate over the nth interval [n 1, n] where n is any
positive integer.
8. Note: if we rearrange the above we get a(n) = a(n 1)(1 + in ) Therefore in represents the
interest rate earned by an investor during the nth period in which the investment is governed
by the accumulation function a(t). ( effective interest rates can be different for all n even for
the same a(t).)

1.3 Simple Interest / Linear Accumulation Functions

1. Suppose that your accumulation function is linear: a(t) = 1 + s t meaning that for every
dollar you invest at t = 0 you will gain $s for each year it is invested.
Problem 1.3: A loans B 4000 dollars and B agrees that they will repay A with 6000 in 2
years. What is the corresponding simple interest rate?
Problem 1.4: Frederick lends his brother Francisco 4000 for 4 years at 5% simple interest.
The brothers agreed that Francisco could pay off the loan as early as he wishes at the same
simple interest rate of 5%.
a) calculate how much Francisco would pay if he repaid the loan at the end of years 1,2
b) b) Calculate the annual effective interest rates over 2 years in the case that Francisco
decided to pay his brother off at the end of the 2nd year.
Problem 1.5: The monthly simple interest rate is 5% what is the yearly simple interest rate?
s
2. Note: for simple interest at interest rate s in = 1+sns n 1 which is a monotonically
decreasing sequence in n meaning that the effective interest you gain each period is monoton-
ically increasing.
3. If you realized this you may find it smart to close out your account after 1 year and immediately
re-open it to gain the interest rate i1 every year.

1.4 Compound Interest (usual case)

1. Simple interest has a strictly decreasing effective rate over each period.

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 2. Consider opening a bank account with simple interest: it may serve you better to close out
and re-open it at the beginning of each period.
3. Want accumulation function for which the effective interest rate over a period is independent
of the period itself.

Define i = i1 = i2 = ...ij = a(1) 1.

Claim: for all non-negative integers k a(k) = (1 + i)k
Proof: By induction. Base case k = 1 trivial.
Suppose by induction this is true k < K
k1
Consider i = iK a(K)a(K1)
a(K1) = a(K)(1+i)
(1+i)k1
a(k) = (1 + i)(1 + i)K1
In general this is true for all k 0 not just integers.

Def 1.6: compound interest- an accumulation function with constant effective interest rates over
all intervals: a(t) = (1 + i)t
Intuitively money gains interest at rate i which is also invested into the account to be accrued
upon.
Problem 1.6: Cyril invests 12000 in a bank which gives 5% compounded interest. How long
should he leave his money in the bank if he is looking to have 15000 with no other investments or
withdraws?
Problem 1.7: Aicha deposits 8000 in a savings which pays:
4% annual effective compound interest for the first 2 years
5% annual effective compound interest for the next 3 years
and 6% annual effective compound interest for the the remainder.
How much will she have if she withdraws the account in 9 years?
Problem 1.8: Paulo has 5000 he wants to invest it in a savings account at which pays compounded
interest at annual effective interest rate 15%. How long does he need to leave his money in the
bank until it amounts to 8000?

1.5 Interest in Advance / The Effective Discount Rate

Suppose when you borrow money the interest is due before the money is released.
Def 1.7: Discount rate- is the rate of interest the borrower must pay (ahead of time) in order to
receive the use of $K.
For example: suppose that an investor lends $K for one basic period at discount rate D then
the borrower must pay $k D to receive the use of $k for the time period. Therefore instead of
having the use of an extra $k for the period he has use of k kD = (1 D)k. The amount $kD is
called the amount of discount on the loan.

Problem 1.9: Freddie borrows $1000 at discount rate 10%. How much extra money does he
actually have the use of?
Problem 1.10: Suppose you need the use of an extra 1000 for this period. An investor is willing
to lend you money at discount rate d how much do you need to ask to borrow so you have the use
of an extra 1000.

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Def 1.8: Effective discount rate- (over an interval [t1 , t2 ]) the amount of interest paid/earned over
the interval [t1 , t2 ] as a percentage of the final balance of the loan (at t2 ). Note the subtle difference
between effective interest rate
a(t2 ) a(t1 )
d[t1 ,t2 ] =
a(t2 )
When n is a positive integer we write

a(tn ) a(tn1 )
dn = a(n 1) = a(n)(1 dn )
a(tn )

compare this with:

a(tn ) a(tn1 )
in = a(n) = a(n 1)(1 + in )
a(tn1 )
Def 1.9: equivalence- an interest rate in and a discount rate dn are said to be equivalent iff for
each dollar invested at time t1 , the two rates provide the same accumulated value at time t2 . More
generally two specifications of an investment?s growth are said to be equivalent iff they correspond
to the same accumulation function.

Focus on a loan lasting from time T1 to T2. If the loan was for $L with effective interest rate
i[t1 ,t2 ] then the borrower walks away with $L and must repay L (1 + i[t1 ,t2 ] ) at time T2.
On the other hand if the loan is made with effective discount rate d[t1 ,t2 ] and its repayment at
time T2 is to be L (1 + i[t1 ,t2 ] ), then the borrower walked away with L (1 + i[t1 ,t2 ] ) (1 d[t1 ,t2 ] )
of the loaners money at time T1. Therefore the two rates are equivalent iff:

L (1 + i[t1 ,t2 ] ) (1 d[t1 ,t2 ] ) = L

(1 + i[t1 ,t2 ] ) (1 d[t1 ,t2 ] ) = 1

In general, for any positive integer n:
dn
in =
1 dn
in
dn =
1 + in
KNOW THIS!
Problem 1.11: Suppose that an account is governed by compound interest at annual effective
interest rate 8%. Find an expression for dn the discount rate for the n-th period.

1.6 Discount Functions, and the Time Value of Money

Notice that in a world where earning of interest is possible a payment of $K now is worth more
than an identical payment of $K t time units from now. This is because you could invest that same
$K today and have AK (t) dollars t unit in the future.

$1
Note that if the growth of money is proportional to the amount invested then a(t) invested now
will grow to $1 t units in the future.

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Def 1.10: Discount function - v(t) to be the amount of money you must invest at time t = 0 to
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receive $1 t units in the future. v(t) = a(t) .
Why? Notice that:
1
AX (t) = 1 = Xa(t) X =
a(t)
We are just solving our interest function for the future dollar amount as known and the present
investment amount as an unknown.
Problem 1.12: Suppose that the growth of money over the next 5 years is governed by simple
interest at 5%. (remember that with simple interest it does you better to close and re-open your
account at the beginning of each year, which is why we created compounding interest.) How much
would you have to invest now to have a balance of $23K at the end of 3 years.
You can think of the discount function v(t) as a function which multiplied by a value gives its
Present value. Ie. I want to know what the present value of $23,000 t years in the future is today.
Problem 1.13: You will invest money in 2 years from now to obtain 23,000 5 years from now.
How much should you invest after two years to have 23,000 at the end of 5 years (again assuming
simple interest at 5%)?
Note the anomaly: If I want 23,000 after 3 years I should invest 20,000 now however, if I want
23,000 after 3 years but I am not starting to invest until time t = 2 (life of investment is still 3
years) I have to invest more.
Why is this?
The interest function is defined as giving the value of $1 invested at time 0, t units in the future.
Therefore if your investment does not begin at time 0 but at time 2 (lets say) you would actually
need to define a new interest function which gives the value of $1 at time t + 2 t 0. However, we
dont have the ability to calculate this new function right now, all we are given is the information
about a function governing an investment started at time 0.
Therefore what is the general approach to solving questions like this?
Problem 1.14: Suppose we begin our story at time t0 = 0. I want $K at time t2 . What is the
value X that I should invest at time t1 to achieve my goal such that t0 t1 t2 ?
Def 1.11: Present value - P Va(t) (L, t) (with respect to an accumulation function a(t)) is a function
which gives the present value of $L t units in the future.
P Va(t) (L, t) = Lv(t)
Problem 1.15: What is the present value of $1200 to be paid 5 years in the future if
1. money grows according to simple interest at 5% /year?
2. money grows according to compound interest at annual effective interest rate of 5%?
Problem 1.16: Suppose Helga has two certificates of deposits (CD?s) available to her. Option A
can be purchased today for $1000 and is redeemable for $1,250 at the end of two years. Option B
can be purchased today for $1000 and is redeemable for $1,300 at the end of 3 years. Assume that
money grows according to compound interest at annual effective interest rate 5%. Which option
should she choose?
The previous problem compared two investments based on their NPV (this just tells you the price
i.e which one is cheaper viewed using money at t = 0). Another way to compare two investments
is to see what the coresponding effective interest rate each investment gives you.

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Problem 1.17: Helga has 1000 to invest 2-year CD A would grow to $1250, while 3-year CD
B would grow to $1300. Find the annual effective (compound) interest rate afforded by each
investment.
This tells us that per dollar invested your return in asset A is higher than your return in asset
B.
Problem 1.18: Project A requires an investment of 10,000 at t=0 and an additional investment
of 5,000 at t=1, it returns 2,000 at t=3, and 6000 at t=4,5,6. Project B requires an investment of
6,000 at t=0 and returns 3,500 at t=1, and 5,000 at an unknown time. The NPV of both projects
are equal using compound interest at annual effective interest rate of 4% find the unknown time of
the second return in project B.

1.7 Simple Discount

When a loan is negotiated a fixed amount of discount D per basic unit of time is agreed upon.
Thus for each $1 borrowed over [0, t] the borrower walks away with 1 1 t D dollars at t = 0
For a loan of $K the borrower walks away with k k t D. The borrower walks away with 1
dollar if k = (1 tD)1 a(t) = (1 tD)1

the discount function v(t) = a(t)1 = (1 dt).

the simple discount accumulation function at rate d: a(t) = (1 dt)1 .
Correspondingly the simple discount amount function for k dollars invested at time 0 with
k
simple discount rate d is Ak (t) = 1dt .

1.8 Compound Discount

We considered the case when in was the same n. Now suppose we require dn = d n
identity:
1
1+i=
1d
d
i=
1d
As a consequence: some helpful formulas..

d = iv

v = 1 d d = 1 v.
Problem 1.19: The AEIR = 5% find the equivalent AEDR.
Problem 1.20: is it better to borrow money at AEIR 5.1% or AEDR 4.9%?
The accumulation function a(t) = (1 d)t is called the compound discount accumulation
function at effective discount rate d. it gives the value at time t of $1 invested at at t = 0 under
effective discount rate d. This means that at time 0 if you borrow K at discount and agree to repay
it at time n you walk away with k(1 d)n of the lenders money at t = 0 and repay k at time n.
Problem 1.21: Ezra wants to borrow money at annual compound discount rate 8% to buy a piano
for 3000. He wishes to repay the loan with a payment in 5 years. How much must he ask to borrow?

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1.9 Nominal Rates of Interest and Discount
If 1 dollar is borrowed at time 0 with AEIR i then a(t) = (1 + i)t . Meaning that the interest gained
for leaving $1 for t units of time is [(1 + i)t 1]
We say that [(1 + i)t 1] is the effective interest rate over a period of length t.
As many banks usually do, interest can be awarded more than once per year (monthly e.g).
They will advertise a nominal, meaning in name only, rate of interest i(m) compounded m times
per year. It is called in name only because they are not actually paying you the nominal rate i(m) ,
(m)
m times per year, they are actually only paying you i m , m times per year.
Def 1.12: Nominal interest rate- (compounded m times per year) i(m) the bank pays
i(m)
= [(1 + i)1/m 1]
m
per m-th of a year.
i(m) = m[(1 + i)1/m 1]
m
i(m)

i= 1+ 1
m
KNOW THIS!
Problem 1.22: Eric deposits 100 into a savings account at time 0 which pays interest at a nominal
rate of i compounded semiannually.
Mike deposits 200 into a different savings acount at time 0, which pays simple interest at an annual
rate of i.
Eric and Mike earn the same amount of interest during the last 6 months of the 8th year.
calculate i
Def 1.13: Annual Percent Yield - (APY)
m
i(m)

i= 1+ 1
m
Also called Annual Effective Yield.
Problem 1.23: A bank offers 4% nominal interest compounded quarterly. What is the APY?
Problem 1.24: Suppose interest is paid every 2 years. The effective interest rate for a 2 year
period is 14%. Find the nominal interest rate compounded biennially and the AEIR.
Def 1.14: Nominal discount rate - d(m) (compounded m times per year) means that the bank
(m)
offers d m discount each m-th of a year.
m
d(m)

1d= 1
m
d(m) = m[1 (1 d)1/m ]
We can now show: m  m
d(m) i(m)

1 1+ =1
m m
Problem 1.25: A bank offers nominal discount rate 4.8% compounded monthly. Find the AEIR
and AEDR.

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1.10 Inflation
Def 1.15: Inflation - refers to the loss of purchasing power of money.
We will define inflation analogously to the effective interest rate but we will use another function
p(t)
Def 1.16: p(t) - price level function.
p(t2 )p(t1 )
Consider an interval [t1 , t2 ]. Let r[t1 ,t2 ] = p(t1 ) be the inflation rate over the interval [t1 , t2 ].
The exact definition of p(t) is unclear but most economists believe or use the price index.
Suppose Michael has $D now and can purchase u units of some good. Each dollar has D/u
units of purchasing power. Suppose the inflation rate over 1 period is r. Then in 1 unit of time the
same u units of goods would cost D(1 + r).
u
Now each dollar only buys D(1+r) units of a good 1 time unit in the future. However, had Michael
have invested his $D for 1 unit of time he would have D(1 + i) at time t = 1 and he could then
u
buy [(1 + i)D] (1+r)D units of goods. Therefore Michaels purchasing power changed from u units
1+i
at t = 0 to 1+r u units at t = 1.
Def 1.17: inflation adjusted interest rate - (also called real rate) j

1+i
j|1 + j = .
1+r
ir
j=
1+r