Professional Documents
Culture Documents
Mathematics of Finance
• Compound Interest
• Annuities
• Amortization and Sinking Funds
• Arithmetic and Geometric
Progressions
4.1
Compound Interest
Simple Interest Formulas
• Simple interest is the interest that is
computed on the original principal only.
• If I denotes the interest on a principal P
(in dollars) at an interest rate of r per year
for t years, then we have
I = Prt
• The accumulated amount A, the sum of the
principal and interest after t years is given
by
A = P + I = P + Prt
= P(1 + rt)
and is a linear function of t.
Example
• A bank pays simple interest at the rate of 8% per
year for certain deposits.
• If a customer deposits $1000 and makes no
withdrawals for 3 years, what is the total amount
on deposit at the end of three years?
• What is the interest earned in that period?
Solution
• Using the accumulated amount formula with P =
1000, r = 0.08, and t = 3, we see that the
total amount on deposit at the end of 3 years is
given by
or $1240.
Example
• A bank pays simple interest at the rate of 8% per
year for certain deposits.
• If a customer deposits $1000 and makes no
withdrawals for 3 years, what is the total amount
on deposit at the end of three years?
• What is the interest earned in that period?
Solution
• The interest earned over the three year period is
given by
or $240.
Applied Example: Trust Funds
• An amount of $2000 is invested in a 10-year
trust fund that pays 6% annual simple interest.
• What is the total amount of the trust fund at
the end of 10 years?
Solution
• The total amount is given by
or $3200.
Compound Interest
• Frequently, interest earned is periodically added to the
principal and thereafter earns interest itself at the
same rate. This is called compound interest.
• Suppose $1000 (the principal) is deposited in a bank
for a term of 3 years, earning interest at the rate of 8%
per year compounded annually.
• Using the simple interest formula we see that the
accumulated amount after the first year is
or $1080.
Compound Interest
• To find the accumulated amount A2 at the end
of the second year, we use the simple interest
formula again, this time with P = A1, obtaining:
or approximately $1166.40.
Compound Interest
• We can use the simple interest formula yet
again to find the accumulated amount A3 at
the end of the third year:
or approximately $1259.71.
Compound Interest
• Note that the accumulated amounts at the end of
each year have the following form:
or:
or 2% per period.
Compounding More Than Once a Year
• To find a general formula for the accumulated
amount, we apply
or $1259.71.
Example
Solution
b. Semiannually.
Here, P = 1000, r = 0.08, and m = 2.
Thus, and n = (3)(2) = 6, so
or $1265.32.
Example
Solution
c. Quarterly.
Here, P = 1000, r = 0.08, and m = 4.
Thus, and n = (3)(4) = 12, so
or $1268.24.
Example
Solution
d. Monthly.
Here, P = 1000, r = 0.08, and m = 12.
Thus, and n = (3)(12) = 36, so
or $1270.24.
Example
Solution
e. Daily.
Here, P = 1000, r = 0.08, and m = 365.
Thus, and n = (3)(365) = 1095, so
or $1271.22.
Continuous Compounding of Interest
• One question arises on compound interest:
– What happens to the accumulated amount over
a fixed period of time if the interest is
compounded more and more frequently?
• We’ve seen that the more often interest is
compounded, the larger the accumulated
amount.
• But does the accumulated amount approach
a limit when interest is computed more and
more frequently?
Continuous Compounding of Interest
• Recall that in the compound interest
formula
where
reff = Effective rate of interest
r = Nominal interest rate per year
m = Number of conversion periods per year
Example
• Find the effective rate of interest
corresponding to a nominal rate of 8% per
year compounded
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily
Example
Solution
a. Annually.
Let r = 0.08 and m = 1. Then
or 8%.
Example
Solution
b. Semiannually.
Let r = 0.08 and m = 2. Then
or 8.16%.
Example
Solution
c. Quarterly.
Let r = 0.08 and m = 4. Then
or 8.243%.
Example
Solution
d. Monthly.
Let r = 0.08 and m = 12. Then
or 8.300%.
Example
Solution
e. Daily.
Let r = 0.08 and m = 365. Then
or 8.328%.
Effective Rate Over Several Years
Where and
Examples
• How much money should be deposited in a bank
paying a yearly interest rate of 6% compounded
monthly so that after 3 years the accumulated
amount will be $20,000?
Solution
• Here, A = 20,000, r = 0.06, m = 12, and t = 3.
• Using the present value formula we get
Examples
• Find the present value of $49,158.60 due in 5
years at an interest rate of 10% per year
compounded quarterly.
Solution
• Here, A = 49,158.60, r = 0.1, m = 4, and t = 5.
• Using the present value formula we get
Present Value
with Continuously Compounded Interest
• If we solve the continuous compound interest
formula
A = Pert
for P, we get
P = Ae–rt
• This formula gives the present value in terms
of the future (accumulated) value for the case
of continuous compounding.
Applied Example: Real Estate
Investment
• Blakely Investment Company owns an office building
located in the commercial district of a city.
• As a result of the continued success of an urban renewal
program, local business is enjoying a mini-boom.
• The market value of Blakely’s property is
or $599,837.
Applied Example: Real Estate
Investment
Solution
• Using the present value formula for continuous
compounding
P = Ae–rt
with A = V(t) and r = 0.09, we find that the
present value of the market price of the property
t years from now is
or $600,640.
Applied Example: Real Estate
Investment
Solution
• Using the present value formula for continuous
compounding
P = Ae–rt
with A = V(t) and r = 0.09, we find that the
present value of the market price of the property
t years from now is
or $598,115.
Applied Example: Real Estate
Investment
Solution
• From these results, we see that the present
value of the property’s market price seems to
decrease after a certain period of growth.
• This suggests that there is an optimal time for
the owners to sell.
• You can show that the highest present value
of the property’s market value is $600,779,
and that it occurs at time t ≈ 7.72 years, by
sketching the graph of the function P.
Example: Using Logarithms in Financial
Problems
• How long will it take $10,000 to grow to
$15,000 if the investment earns an interest
rate of 12% per year compounded quarterly?
Solution
• Using the compound interest formula
logbmn = nlogbm
(1 i )n 1 (1 0.01)12 1
S R 100 1268.25
i 0.01
1 (1 i ) n 1 (1 0.01) 36
P R 400 12,043
i 0.01
Annuities
• An annuity is a sequence of payments made at regular
time intervals.
Examples:
1. Regular deposits to a savings account
2. Monthly home mortgage payments
3. Monthly insurance payments
Annuities
1. The terms are given by fixed time intervals(annuity certain).
or $1268.25.
Present Value of an Annuity
or $12,043.
• Therefore, the original cost of the automobile is $16,043
($12,043 plus the $4000 down payment).
• The interest charges paid by Murphy are given by(36)(400) –
12,043 = 2,357or $2,357.
4.3
Amortization and Sinking Funds
Pi (120,000)(0.0075)
R n
360
965.55
1 (1 i ) 1 (1 0.0075)
iS (0.025)(30,000)
R 3434.02
(1 i ) 1 (1 0.025) 1
n 8
Amortization Formula
or $965.55.
Applied Example: Home
Affordability
• The Jacksons have determined that, after
making a down payment, they could afford at
most $2000 for a monthly house payment.
• The bank charges interest at a rate of 7.2% per
year on the unpaid balance, with interest
computations made at the end of each month.
• If the loan is to be amortized in equal monthly
installments over 30 years, what is the
maximum amount that the Jacksons can
borrow from the bank?
Applied Example: Home Affordability
Solution
• We are required to find P, given i = r/m = 0.072/12 =
0.006, n = (30)(12) = 360, and R = 2000.
• We first solve for P in the amortization formula
or $3434.02.
4.4
Arithmetic and Geometric Progressions
Arithmetic Progressions
• An arithmetic progression is a sequence of
numbers in which each term after the first is
obtained by adding a constant d to the
preceding term.
• The constant d is called the common
difference.
• An arithmetic progression is completely
determined if the first term and the common
difference are known.
nth Term of an Arithmetic
Progression
• The nth term of an arithmetic
progression with first term a and
common difference d is given by
an = a + (n – 1)d
Example
or $1,300,000.
Geometric Progressions
• A geometric progression is a sequence of
numbers in which each term after the first is
obtained by multiplying the preceding term by
a constant.
• The constant is called the common ratio.
• A geometric progression is completely
determined if the first term a and the
common ratio r are given.
nth Term of a Geometric
Progression
• The nth term of a geometric
progression with first term a and
common ratio r is given by
Example
• Find the eighth term of a geometric progression whose first
five terms are 162, 54, 18, 6, and 2.
Solution
• The common ratio is found by taking the ratio of any term
other than the first to the preceding term.
• Taking the ratio of the fourth term to the third term, for
example, gives
• Using the nth term formula to find the eighth term gives
Sum of Terms in a Geometric
Progression
• The sum of the first n terms of a
geometric progression with first
term a and common ratio r is given
by
Example
• Find the sum of the first six terms of the
geometric progression 3, 6, 12, 24, …
Solution
• Using the sum of terms formula
or $1, 464,100.
Applied Example: Company Sales
or $6,105,100.
End of
Chapter