ACTL2111 Module - 1

Financial Mathematics
Jonathan Ziveyi 1
1
UNSW Australia
Risk and Actuarial Studies, UNSW Business School
j.ziveyi@unsw.edu.au
Module 1 Topic Notes
1/90
Plan
Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
2/90
Cash Flow Models
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
3/90
Cash Flow Models
Cash ow models
A cash ow is a series of payments (inows or outows) over a

period of time.
A mathematical projection of the payments involved in a nancial
transaction is referred to as a cash ow model.
Cash ows are characterised by their:
I nature: inow or outow
I amount
I timing
I probability (if contingent)
3/90
Cash Flow Models
Comparing cash ows

We want to compare dierent sets of cash ows:
why?
I
I compare 2 securities or investments
I compare scenarii for a given product (product development,
prot testing, solvency)
I compare potential new products (product development)
I etc. . .
I how?
4/90
Cash Flow Models
5/90
Cash Flow Models
Procedure:
Imake the cash ow clear; draw a time diagram
Ichoose any point in time
I now: present value, sometimes NPV (Net Present Value)
I in the future: accumulated value
I in the middle...
I should be convenient: all are equivalent!
"bring back or forth" all cash ows to the point of time you
have chosen
I
I add them up
I compare!
6/90
Cash Flow Models
You want to buy a television from Bling Bee's on 31/12/2009 that

is worth $3000. The super mega deal (yeahh) is that you can take
the television now and need only to pay $1000 on 31/12/2011 and
$2000 on 31/12/2012. Their advertisement campaign is "No
interest, no deposit until 2011!".
But you are smart (of course, you are an actuary), and you know
that if Bling Bee invests $1000 now, this investment will be worth
$1100 in one year, $1210 in two years and $1331 in three years.
Taking this information into account, what discount can you
reasonably get from Bling Bee?
7/90
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
8/90
Time value of money
How much would you pay to buy a security that is guaranteed to

give you $100 in 1 year's time?
What if there was a chance of default?
8/90
Time is money!
Interest is a mathematical tool to embody

the time preference of agents in the economy
usually, agents are impatient (interest is positive)
I
I risk (interest is raised to include a risk premium)
9/90
Mathematical model
Consider an amount of money invested for a period of time.
IA(0): principal = the amount of money initially invested
It : the length of time for which the amount has been invested
IA(t): amount function or accumulated amount function
I this is the accumulated amount of money at time t
corresponding to A(0)
Assuming these are two equivalent cash ows at two dierent point
in time, how can we link them using interest?
10/90
Accumulation function
Let a(t) be the accumulation function:
a(t) the accumulated value at time t of an original investment
of 1 made at time 0
I
it is a scaled version of A(t) with a(0) = 1 and can thus be

studied independently of the amounts that are invested
I
it represents the way in which money accumulates with the

passage of time
I
We have A(t + k) a(t + k)

= ,
A(t) a(t)
which means a(t + k)
A(t + k) = A(t) .
a(t)
11/90
Eective Interest
In mathematical terms, the eective interest I accumulated

between t and t + k (for a period k from t ) is
t,k
It,k = A(t + k) A(t),
and then the eective rate of interest i for this same period is
t,k
i =
A(t + k) A(t)
t,k
A(t)
=
a(t + k) a(t)
a(t)
. (1.1)
12/90
Homogeneity in time
When the eective rate of interest is the same for all t , then we
have a(t + k) a(k)
a(0)
= = a(k)
a(t)
A(t + k) = A(t)a(k)
it,k =
A(t + k) A(t)
A(t)
=
A(t + k)
A(t)
1
=
a(t + k) a(t)
a(t)
1
= a(k) .
13/90
Forms of interest
I a(t)is modeled with the help of interest

I eective interest is always dened as in (1.1)
however, interest can be expressed in many dierent ways,
depending on the situation (mainly conventions)
I
I each way has a dierent set of assumption

I each denition may lead to dierent forms for a(t)
14/90
Assumptions about interest

1. how much interest is paid?
I usually expressed as a percentage per year (`per annum', `p.a.')
I amount can depends on the time period (inhomogeneity)
term structure of interest, see module 4
non-constant force of interest
I amount is sometimes stochastic
deterministic vs stochastic interest, see module 6
2. how often is interest paid?
I as a rule, once per `compounding period', whose number per
time unit needs to be determined (usually once a year)
I simple vs compound interest (time horizon)
I nominal vs eective interest (several times a year)
force of interest (continuously)
3. when is interest paid?
I
I at the beginning or end of the compounding period

I discount interest (beginning)
15/90
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
16/90

I

16/90

Example: Assume John deposits $1000 on his bank account on
01/01/2010 at an eective rate of interest of 5% p.a. At the
following dates:
1. what is the balance of his account?
2. how much would he get if he closed his account?
3. how much interest has he earnt?
4. how much interest has been credited on the account?
I 30/06/2010
I 01/01/2011
I 30/06/2011
17/90
18/90

Main dierence:
with simple interest: no interest is ever earnt on
interestinterest is not compounded
I
with compound interest: interest is continuously earnt on

interestinterest is compounded
I
When to use one or the other?

What happens within a year (compounding period) is usually
simple interest (short term securities, T-bills, ...)
I
IHowever, simple interest is not homogeneous in time

For cash ows spanning over periods of more than
a year, compound interest is generally used (easier..!)
I
19/90
Simple Interest
Accumulation function: for simple interest i ,
a(t) = 1 + it,
and the accumulated amount function after a period t is given by

A(t) = A(0) a(t) = A(0) (1 + it).
Usually, t < 1 (days/360 or 365, or months/12).

Eective rate of interest is not constant in this case (decreasing):
a(t + k) = (1 + i(t + k)) 6= (1 + it)(1 + ik) = a(t)a(k)
20/90
Numerical Example
A Bank accepts deposits for terms up to 3 years and pays interest
on maturity. How much interest would it pay on a deposit of
$20,000 for a term of 1 year and 33 days if the interest rate is 5%
p.a. simple?
21/90
Compound Interest
Accumulation function: for compound interest i ,
a(t) = (1 + i) , t
and the accumulated amount function after a period t is given by

A(t) = A(0) a(t) = A(0) (1 + i) . t
In this case, eective interest is homogeneous:

a(t + k) = (1 + i) = (1 + i) (1 + i) = a(t)a(k)
t+k t k
or alternatively
= (1 + i) = a(k), t, k 0.
a(t + k) k
a(t)
22/90
Numerical Example
A Bank accepts deposits for terms up to 3 years and pays interest
on maturity. How much interest would it pay on a deposit of
$20,000 for a term of 1 year and 33 days if the interest rate is 5%
p.a. eective?
23/90
General questions
1. What happens to the accumulation if i ? i ?
2. What is the amount of interest earned during each unit period
under compound interest? simple interest?
3. What is the eective rate of interest during each unit period
under compound interest? simple interest?
24/90
Discount Interest
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
25/90
Discount Interest

I

25/90
Discount Interest
Rate of Discount
The rate of interest i applies to the principal now, for interest
calculated at t = 1, whereas the rate of discount d applies to the
principal at the end of the period, for interest calculated at t = 0.
In other words, for i :
I we focus on the principal now
we correct this gure by adding interest at the end of the
period
I
and for d :
I we focus on the principal at the end of the period
I we correct this gure by subtracting interest now
Both methods are equivalent, and use of one or the other is
dictated by the situation for convenience.
26/90
Discount Interest
Remember: 1 0
a( ) a( )
i =
0
a( )
1 0
A( ) A( )
1 1
=
0
A( )
= a( ) = ( + i)
Now: 1 0
a( ) a( )
d =
1
a( )
1 0
A( ) A( )
1 11
=
1
A( )
= a( ) =
d
Financial reasoning:
At rate of compound interest of i% p.a. the discounted value
of an instrument is known. Is the compound rate of discount
I
that produces an equivalent discounted value higher or lower?

27/90
Discount Interest
Simple vs compound discount interest
Since we want d and i to be equivalent (they are just formulated

dierently), we have
1 + i = 1 1 d .
For simple interest: 1
a(t) = a(0)
1 dt
and for compound interest:
a(t) = a(0)

1 t
1d
28/90
Discount Interest
Numerical Example
In the US Treasury Bills are quoted using `simple discount' on the
basis of a 360 day year.
Consider a US T-Bill with a face value of 500,000 and maturity in
180 days time. Suppose that this is sold to yield 6%p.a (simple
discount). What are the proceeds of the sale?
29/90
Discount Interest
Relations between Interest and Discount

iis the eective rate of interest, d is the eective rate of discount
and v = 1/a(1) is the discount factor.
Show these are correct as an exercise and use nancial reasoning.
d
i =
1 d
i
d =
1 +i
d = iv
d = 1v
i d = id
30/90
Discount Interest
Intuition behind d = 1 v ?
31/90
Discount Interest
Intuition behind i d = id ?
32/90
Nominal Interest
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
33/90
Nominal Interest

I

33/90
Nominal Interest
Nominal Interest Rate
I usually the compounding period is one year

I nominal interest rates are interest rates
I that are still expressed as % p.a.
but that have several (m) compounding periods per year
Example of securities for which nominal rates are relevant:
I
I
I Some bonds pay interest yearly, some semi-annually and some
quarterly
I Home loans usually charge interest monthly
I Some bank accounts pay interest daily
I Notation: i nominal interest rate, payable mthly
(m)
34/90
Nominal Interest
Nominal vs eective rates

With nominal interest rates, the rate
i (m)
m
is an eective rate of interest for a period of 1/m years.
Reminder:
I the eective rate of interest for a period is the ratio between
1. the eective (actual amount of) interest earned and
2. the principal at the beginning of the period (for interest) or at
the end of the period (for discount).
I , 1, is not an eective rate of interest
i (m) m >
I i is the eective rate of interest for a year, equivalent to i (m)
35/90
Nominal Interest
Relationship to i , the eective interest rate
In general, for rate i per annum

!m
1
( + i) = 1 +
i (m)
m
1 1
h i
i (m) = m ( + i)1/m
?? <
i (m) >i
Can you use your nancial reasoning to convince yourself which is
correct?
36/90
Nominal Interest
Numerical Example
A product oers interest at 8% p.a., payable quarterly. What is the
eective annual rate of interest implied?
37/90
Nominal Interest
Nominal Discount Rates
I Interest is converted m times per year (period)

I Notation: d nominal discount rate converted mthly
(m)
I Relationship to d the eective rate of discount

1 = (1 d) = 1 d m
!
(m)
a(1) m
Note that the nominal discount rate increases as the frequency

of conversion increases.
I
d < d (2) < d (4) . . .
38/90
Nominal Interest
Exercise
Show that d (m)
1
= i (m) vi m
39/90
Nominal Interest
Numerical Example
Find the accumulated amount of $100 invested for 15 years if
i = .08 for the rst 5 years, d = .07 for the second 5 years and
(4)
d = .06 for the last ve years.

(2)
40/90
Force of Interest
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
41/90
Force of Interest

I

41/90
Force of Interest
Force of Interest
Consider
m
lim 1 + m
!
i (m)
lim 1 + m
!2
i (m) m (m ) i (m)
=
m m
+
!2 m
+ ...
1+i
2 3
i () i ()
2 3
()
= + + + ...
! !
= ei or()
e ,
where is called the force of interest, or continuously compounding

rate of interest.
42/90
Force of Interest
Force of Discount
Similarly, consider
!m
lim 1
m

d (m)
m
lim 1
!2
(m) m (m ) d (m)
m d
=
m m
+
! 2 m
...
1d
2 3
d () d ()
2 3
()
= + + ...
! !
()
= e d ,
where d is the force of discount.

()
43/90
Force of Interest
We have
1d =e d ()
and 1 + i = e i ()
.
Now
1 d = v = 1 +1 i .
Thus,
i () = d ()
and, in general,
d < . . . < d (m) < . . . < d () = = i () < . . . < i (m) < . . . < i.
44/90
Force of Interest
Force of interest that varies with time

Let
I 0 be the principal invested at time 0
A( )
Iinterest be paid continuously at a rate (t) at time t
We seek an expression for A(t).
Interest paid over a small interval t is
A(t + t) A(t) A(t)(t)t
and thus A(t + 4t) A(t)

(t) .
A(t)4t
45/90
Force of Interest
Taking the limit, as 4t 0,

(t) = lim
A(t + 4t) A(t)
A(t) 4t
1
4t0
d
= A(t)
A(t) dt
A0 (t)
=
A(t)
=
d
dt
ln A(t).
46/90
Force of Interest
Integrating both sides over [0, t],

Zt
(s)ds = ln A(s)| t
0
ln A(t) ln A(0)
s=0
=
= ln A(
A(t)
0) .
Thus we have
0 exp
Z t
A(t) = A( ) (s)ds
and
0
exp (s)ds .
Z t
a(t) =
Note that interest is homogeneous iif (t) , t 0.

0
47/90
Force of Interest
Numerical Example
Force of interest at time 0 is 0.04, and increases uniformly to 0.06
after 5 years. Find the amount after 5 years of an investment of $1.
For ane (t), the integral in exponential can be simplied:

a(t + k) k
= e [(t)+(t+k)]
2
a(t)
48/90
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
49/90
Ination
When comparing cash ows, time has to be accounted
1. because of the time preference of agents in the economy (risk
free interest)
2. because there is a risk of default (risk premium)
3. because the value of money changes over time:
ination/deation
Ination:
Ination (deation) is characterized by rising (falling) prices, or
by falling (rising) value of money.
I
A common way of measuring ination is the change in

Consumer Price Index (CPI) which itself measures the annual
I
rate of change in a specied "basket" of consumer items.

49/90
Notation
Let
I p.a. be the money interest rate
i%
r % p.a. be the real interest rate
I
p(t) be the price index (with P(0) = 1)

I
% p.a. be the ination rate

I
What relationships can be established among i , r , P(t) and ?
50/90
Main relations
We have
0 1 and a(1) = 1 + i.
a( ) =
and
0 1 and p(1) = 1 +
p( ) =
Thus, the value of accumulation at today's prices is given by
a(1) 1+i .
p(1) 1+
=
Now, dene
1 + r = 11 ++ i r = 1i + .
Caution: this holds only for eective rates!
51/90
How to deal with ination

Ination is introduced in calculations either by
1. considering the cash ow at its date's $ (nominal value) and
use `money' interest rates:
A(0) = A(t)

1 t
1+i
2. or adapting the amounts of cash ows to today's dollars (real
value) and use a (modied) `real' interest rate:
A(0) =
A(t)

1 t
(1 + ) 1+r
t
Both methods are equivalent.

52/90
Example
An investor will receive an asset in 10 years time with face value

$100,000. Given a nominal (money) interest rate of 9% p.a.,
quarterly compounding, and an expected ination rate of 5% p.a.,
(also quarterly compounding), what should you pay now:
Asset 1 if the payment on the asset will not change, failing to increase
in line with ination
Asset 2 if the asset maintains its real value (an ination indexed bond)
53/90
To determine the price, we must be consistent. Either we work with

Method 1: the nominal value, and discount with the money
interest rate, or
I
Method 2: the real value, and discount with the real interest
rate.
I
The eective real quarterly rate is

.09/4 .05/4
1 + .05/4 = 0.9876543%
Thus, r = 3.9506% and r = 4.0095%.
(4)
54/90
Asset 1
Method 1:
100, 000
PV =
1+ .09 40
41, 064.58
4
Method 2:
Real value = 1100+ , 000 = 60, 841.33
.05 40
60, 841.33 = 41, 064.57

4
(1.00987654)
PV = 40
55/90
Asset 2
Method 1:
100000 1 + .05
40
1+
4
PV = 40
.09
67494.53
4
Method 2:
100, 000
(1.00987654)
PV = 40
= 67, 494.54
56/90
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
57/90
Our fundamental problem
Three inter-related (sets) of values:

Ia set of cash ows (inows and outows, timing, probability)
Iinterest and its assumptions
a present value / accumulated value
(for a security: the price / value at maturity)
I
Learning outcome A3:

Understand the relation between a present value, a set of
cash ows and interest, be able to determine one in
function of the others in a variety of situations, as well as
understand the interest rate risk (duration, immunisation)
57/90
Practical examples
Find the price of a security: determine an initial cash ow such

that the NPV is 0, given interest and a set of cash ows
I
Find the yield of a security or a project: determine the rate of

interest such that the NPV is 0 (IRR), given a set of cash ows
I
Find the minimum return on the reserves that is necessary to

ensure all current life annuities can be paid until the end, given
I
the current level of mortality (pensions)

I ...
Note
I If the NPV is 0, we have then an equation of value
58/90
Examples of Common Financial Instruments
ICash on deposit - term deposits, cash management trusts

INotes: Treasury notes, promissory notes, bank bills
IEquities - also known as shares, equity shares or common stock
Bonds: Coupon Bonds, Zero Coupon Bonds (`ZCB'),
Government bonds
I
IAnnuities: annuities-certain, life annuities

Insurance applications: Term life insurance, Endowment
insurance
I
See Broverman and Sherris for the main denitions and examples.
59/90
Determine a PV in function of cash ows and interest

The present value PV of an amount A(t) accumulated at time t is
given by
A(t)
A(t) = PV a(t) PV = .
a(t)
The present value or discount factor is then
1 = 1
a(1) 1+i
v=
= 1d
= d/i
Powers of the discount factor can be used to discount all cash ows
if interest is homogeneous with time
(which is the usual assumption)
60/90
Numerical Examples
Example 1
Consider a Coupon bond which pays $6 at times 1 and 2, and an
additional $100 at time 2. Find the Present Value of this bond at
8% p.a. eective interest.
61/90
Numerical Examples
Example 2
In Australia, Short term Government securities such as Treasury
Notes and Treasury Bonds (less than 6 months to maturity) are
priced using simple interest and a 365 day convention.
Consider a Treasury-note with a face value of 500,000 and maturity
in 180 days time. Suppose that this is sold at a yield (interest rate)
of 6%p.a. What are the proceeds of the sale?
62/90
Determine interest in function of a PV and cash ows
If there are more than 2 cash ows, it is generally impossible to

solve for interest analytically.
In that case, several approaches are possible:
I use a nancial calculator
I use a computer (R, Goal Seek in Excel, etc...)
use a numerical method (e.g. Newton-Raphson)
(the method to be used in quizzes and in the nal exam)
I
63/90
Newton-Raphson method (a recursive numerical method)

(see, e.g. http://en.wikipedia.org/wiki/Newton's_method)
f (in ) f (in )
f 0 (in ) = in+1 = in 0
in in+1 f (in )
1. determine f (i) such that f (i ) = 0
2. determine f (i) 0
3. choose initial value i

4. perform recursions
0
64/90
Numerical Example
A Bond pays $100 in 1.5 years. Coupon payments of $5 are payable
times 0.5, 1, and 1.5
1. Find the Price of the Bond if the yield is i = 6%. (2)
2. Suppose the Price of the Bond is 107.14. Find the Yield

implied by this price.
65/90
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
66/90
Notation
(p)
m| ax:n i
66/90
Our main tool to value annuities-certain: the perpetuity
67/90
Numerical example
A foundation has $100,000,000. Assuming a long term net return
on investments of 5% p.a., how much money can it use every year
without decreasing the capital?
Determine the annual payment if it is made in arrears or in
advance, and in the two situations:
1. the capital should not decrease in nominal terms
2. the capital should not decrease in real terms
Assume a long term ination rate of 3% p.a.
68/90
Numerical example
69/90
Term Annuities
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
70/90
Term Annuities
Annuity-immediate (paid in arrears)
70/90
Term Annuities
Numerical example
A Bond pays $100 at time 3. Coupon payments of $5 are payable
at times 1, 2, and 3
1. Find the Price of the Bond if the eective yield is i = 5%.
2. What is the Price if the eective yield is 6%?
71/90
Term Annuities
Annuity-due (paid in advance)
72/90
Term Annuities
Numerical example
A Bond pays $100 at time 2. Coupon payments of $5 are payable
times 0, 1, and 2. (i.e. the rst payment occurs immediately after
purchase).
1. Find the Price of the Bond if the eective yield is i = 6%.
2. What is the Price if the eective yield is 5%?
73/90
Term Annuities
Deferred annuity
74/90
Term Annuities
Numerical example
Consider a Bond pays $100 at time 6. Coupon payments of $5 are
payable times 4, 5, and 6. How much would you be willing to pay
to purchase the bond today? Assume i = 6%.
75/90
Term Annuities
Payments more frequent than a year
76/90
Term Annuities
77/90
Term Annuities
Alternative method
Alternatively, nd the eective pthly rate of interest,

j = (1 + i) 1 =
i (p)
/p
1
.
p
Then 1 (p)
an i = anp j
p
where j = (1 + i) 1/p 1.
78/90
Term Annuities
Numerical example
Payments of 10 made at end of each month for next 5 years.
Calculate their present value at (i) 8% p.a. eective, and (ii) 8%
p.a. convertible half-yearly.
There are at least two ways to do these questions:
1. work according to cash ows and change i
2. work according to i and change cash ows
(p)
79/90
Term Annuities
Numerical example
80/90
Non-Level Annuities
Plan

Cash Flow Models
Discount Interest
Nominal Interest
Force of Interest
Term Annuities
Non-Level Annuities
81/90
Non-Level Annuities
Increasing annuity (arithmetic progression)
81/90
Non-Level Annuities
Numerical example
Value the following set of cashows at 10% p.a.: A payment of$10
at time 1, $20 at time 2, $30 at time 3, $40 at time 4. What is the
present value at time t = 0?
What is the present value at time t = 1?
82/90
Non-Level Annuities
Increasing annuity (arithmetic progression): general case
83/90
Non-Level Annuities
Numerical example
Value the following series of payments at 10% p.a.:
84/90
Non-Level Annuities
Increasing annuity (geometric progression)
85/90
Non-Level Annuities
Numerical example
You can invest in a bond that pays coupons that grow with
ination. The coupon received at the end of the rst year is
$25,000, and each annual payment will increase, with ination, at
rate 2.5% p.a. There are 10 annual payments and the bond
matures in 10 years with a face value of $400,000 (not indexed to
ination). What is the price of the bond at a valuation interest rate
of 8%p.a.?
86/90
Non-Level Annuities
Increasing annuity with p payments per annum
87/90
Non-Level Annuities
Numerical example
Determine the present value of a 10 year annuity with half-yearly
payments in arrears at rate 2 p.a. in the rst year, 4 p.a. in the
second year, ..., 20 p.a. in the 10th year. Use a 10% p.a.
convertible half-yearly compound interest rate.
88/90
Non-Level Annuities
Decreasing annuity
89/90
Non-Level Annuities
Numerical example
Value the following set of payments at 10% p.a: $40 at time 1, $30
at time 2, $20 at time 3, $10 at time 4.
90/90

ACTL2111 Module - 1

Uploaded by

Copyright:

Available Formats

ACTL2111 Module - 1

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

ACTL2111 Module - 1

Uploaded by

Copyright:

Available Formats

Financial Mathematics

Risk and Actuarial Studies, UNSW Business School

Module 1 Topic Notes

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models

Cash ow models

A cash ow is a series of payments (inows or outows) over a

Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models

Comparing cash ows

Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models

Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models

Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models

You want to buy a television from Bling Bee's on 31/12/2009 that

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

Time value of money

How much would you pay to buy a security that is guaranteed to

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

Interest is a mathematical tool to embody

I risk (interest is raised to include a risk premium)

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

it is a scaled version of A(t) with a(0) = 1 and can thus be

it represents the way in which money accumulates with the

We have A(t + k) a(t + k)

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

In mathematical terms, the eective interest I accumulated

It,k = A(t + k) A(t),

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

I a(t)is modeled with the help of interest

I each way has a dierent set of assumption

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

Assumptions about interest

I at the beginning or end of the compounding period

Module 1: Time Value of Money and Valuation of Cash Flows

Simple and Compound Interest

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

Simple and Compound Interest

Cash ow models

A cash ow is a series of payments (inows or outows) over a

Comparing cash ows

In mathematical terms, the eective interest I accumulated

I each way has a dierent set of assumption

In this case, eective interest is homogeneous:

Nominal vs eective rates

Relationship to i , the eective interest rate

I Relationship to d the eective rate of discount

d = .06 for the last ve years.