Financial Mathematics

Soham Gokhale,
SIT Pune
 Rate of Interest
• Economic gain from the use of money gives money “time value”. Interest
can be seen as the rental amount charged by financial institutions for the use
of money. The rate of gain received from an investment is called as the rate
of interest or the rate of capital growth.
• Interest can be calculated in two ways: simple interest or compound
interest. Simple interest is calculated on the principal, or original, amount of
a loan. Compound interest is calculated on the principal amount and the
accumulated interest of previous periods, and thus can be regarded as
“interest on interest.”
• There can be a big difference in the amount of interest payable on a loan if
interest is calculated on a compound basis rather than on a simple basis. On
the positive side, the magic of compounding can work to your advantage
when it comes to your investments and can be a potent factor in wealth
creation.
• While simple interest and compound interest are basic financial concepts,
becoming thoroughly familiar with them may help you make more informed
decisions when taking out a loan or investing. Cumulative interest can also
help you choose one bond investment over another.
• Interest and principle both become due only at the end of the time period.
 KEY TAKEAWAYS
• Interest can refer to the cost of borrowing money (in the form of interest charged
on a loan) or to the rate paid for money on deposit.
• In the case of a loan, simple interest is only charged on the original principal
amount.
• Simple interest is calculated by multiplying the loan principal by the interest rate and
then by the term of a loan.
• Compound interest multiplies savings or debt at an accelerated rate.
• Compound interest is interest calculated on both the initial principal and all of the
previously accumulated interest.
 Simple Interest Formula

The formula for calculating simple interest is:

𝑆𝑖𝑚𝑝𝑙𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃 × 𝑟 × 𝑛
where: P = Principal, r = Interest rate, n = Term of the loan.
 Compound Interest Formula

The formula for calculating compound interest in a year is:

𝑟 𝑛𝑡
𝐴 =𝑃 1+
𝑛
where: A = Final amount, P = Initial principal balance, r = Interest rate,
n = Number of times interest applied per time period,
t = Number of time periods elapsed.
 Continuously Compounded Interest
• The continuous compound interest formula is used to determine the interest earned on
an account that is constantly compounded, necessarily leading to an infinite amount of
compounding periods. The effect of compounding is earning interest on investment,
or at times paying interest on a debt that is reinvested to earn additional money that
would not have been gained based on the principal balance alone.
• By earning interest on prior interest, one can earn at an exponential rate. The
continuous compounding formula takes this effect of compounding to the furthest
limit. Instead of compounding interest on a monthly, quarterly, or annual basis,
continuous compounding will efficiently reinvest gains perpetually.
 Formula for Continuously Compounded
Interest:
• 𝐴 = 𝑃 ∗ 𝑒 𝑟𝑡
Where r is the rate of interest, P is the principal amount and t is the time
period.
 Example:
• An amount of Rs. 2340.00 is deposited in a bank paying an annual interest
rate of 3.1%, compounded continuously. Find the balance after 3 years.
• Solution: Given : 𝑃 = 2340, 𝑟 = 0.031, 𝑡 = 3. Therefore,
𝑟𝑡
𝐴=𝑃∗𝑒 = 2340 ∗ 𝑒 0.031∗3 = 2568.06
Therefore, the balance after 3 years is Rs. 2568.06.
 Question (Exercise)
• Similar to Continuously Compounded interest, can we talk about
Continuous Simple Interest?
• Which is better, Discretely Compounded Interest or Continuously
Compounded Interest?
• The key difference between simple and compound interest lies in how
interest is calculated and added to the principal. Simple interest remains
constant, while compound interest grows exponentially due to the interest-
on-interest effect.
 Cash flow
• Cash flow can be seen as the amount of cash and cash equivalent assets such
as securities, that a business generates (or spends) over a period of time.
• It basically is the money that goes in and out of a business.
• Companies with positive cash flows indicates money coming in.
• A negative cash flow indicates money going out.
• Net cash flow can be seen as the difference between the net income and the
net spending.
 Cash flow Diagram
• A Cash Flow Diagram is a diagrammatic representation of cash transactions
or transactions in terms of receipts and reimbursements at different
(discrete) time values.
Example
 Multiple Stream of Cash Flows
• A single principal sum of money invested today for several periods will
realise into a higher future sum due its compounding effect, and so does a
multiple stream of cash flows. A future stream of cash flows can also be
discounted to determine its value in a present period. Broadly, a multiple
stream of cash flows may occur in an even stream or in an uneven stream.
 Uniform series
• The same amount is given/received at every time period.
• For example, repayment of a loan taken from a bank.
 Linear Gradient Series
• A cash flow wherein the flow changes with a fixed amount every time
interval (every month, every year, etc.)
• For example, a person starts saving Rs. 10000 per year. With every year, the
person adds the increment of Rs. 500 to the savings. Therefore, the first year
contribution will be Rs. 10000. The second year would be Rs. 10500, the
third year would be Rs. 11000 and so on.
Example
 Geometric Gradient Series
• This is similar to the linear case, with the difference that the increment may
not be constant.
• For example, the landlord decides that the rent for a certain apartment will
increase by 10% every year. If the person is paying Rs. 100 as the rent this
year, the next year the rent will be Rs. 110 (100+10). The third year would
see the rent as Rs. 121 (110+11), and so on.
Example
 Irregular Series
• Where there is no linear/geometric pattern as such.
• Compound Interest : total amount of principal and interest in future
(or future value) less the principal amount at present, called present
value (PV). PV is the current worth of a future sum of money or stream
of cash flows given a specified rate of return.
• A stream of cash flows that is made in an equal size and at a regular interval is
known as annuity. However, a stream of cash flows may also occur irregularly
and in different sizes, and therefore the computations of PV or FV will involve
more than a single formula. A series of equal cash payments that comes in at the
same point in time when the compounding period occurs is known a simple
annuity. In contrast, in a general annuity the annuity payments occur more
frequent than interest is compounded or the interest compounding occurs more
frequent than annuity payments are made. In short, there is a mismatch of
occurrence frequency between annuity made and interest compounded.
• The term “annuity” originally referred to annual payments (hence the name),
but it is now also used for payments with any frequency. Annuities appear in
many situations: for instance, interest payments on an investment can be
considered as an annuity. An important application is the schedule of
payments to pay a loan.
• An annuity with a fixed number of payments is called an annuity certain,
while an annuity whose number of payments depend on some other event
(such as a life annuity) is a contingent annuity. Valuing contingent annuities
requires the use of probabilities and this will not be covered in this course.
• We will only look at annuities certain, which will be called as annuities.
• Simple annuity comes in four different forms as follows: -
• a) Ordinary annuity – annuity payment made at the end of each compounding
period;
• b) Annuity due –a series of equal cash payments made at the beginning of each
compounding period;
• c) Deferred annuity – a series of equal cash payments may also occur later a lapse
of compounding periods;
• d) Perpetuity– a series of equal payments occurs forever (for lifetime).
• The analysis of annuities depends on the following formula for a geometric
progression
𝑛+1 𝑛
2 3 𝑛 𝑘
𝑟 −1
1+ 𝑟 +𝑟 + 𝑟 + …+ 𝑟 = ෍ 𝑟 =
𝑘=0 𝑟−1
 Example:
At the end of every year, you put $100 in a savings account which pays 5%
interest. You do this for eight years. How much do you have at the end (just
after your last payment)?
 Solution
The first payment is done at the end of the first year and the last payment is
done at the end of the eighth year. Thus, the first payment accumulates interest
for seven years, so it grows to
1 + 0.05 7 ∗ 100 = 140.71
dollars.
The second payment accumulates interest for six years, so it grows to
1 + 0.05 6 ∗ 100 = 134.01.
and so on, until the last payment which does not accumulate any interest.
The accumulated value of the payments is therefore
1.057 ∗ 100 + 1.056 ∗ 100 + … + 1.05 ∗ 100 + 1 ∗ 100
7

= 100 1.057 + 1.056 + … + 1.05 + 1 = 100 ෍ 1.05𝑘

𝑘=0
Using the geometric sum formula, we have
7 8
𝑘
1.05 −1
෍ 1.05 = = 9.5491.
1.05 − 1
𝑘=0
Therefore, the accumulated value of the payments is $954.91
 A general formula:
• The sum accumulated at the end of an annuity consisting of payments of 1
at 𝑡 = 1,2, … , 𝑛 is
 Time value of Money
• We have studied rate of interest and certain types of calculations. But why
do banks charge/offer interest?
• Money has value, which is a function of time.
• Economic gain from the use of money is what gives money its time value.
 Single Payment Compound Amount Factor
(P/F, i,n)
• A factor, when multiplied with the Present Value (PV), gives you the Future
Value (FV).
• For example, if we invest an amount P now, at a rate of compound interest i,
the value of this amount after n years will be
𝐴 = 𝑃 1 + 𝑖 𝑛.
 Equal Payment Series Compound Amount
Factor (F/A, i,n)
• Suppose that you are depositing an amount A every year, compounded yearly
at the rate i.
• This factor, when multiplied with the equal annual amount A gives the
Future Value/ Compound Amount.
1+𝑖 𝑛 −1
• Factor is given by 𝑖
.
 Future Value
• For example, the Future Value (FV) of an ordinary annuity is the sum of all
regular equal payments and the compounded interest accumulated at the end
of the last period. The FV in this case is determined as follows:
𝟏+𝒊 𝒏 −𝟏
• 𝑭𝑽 = 𝑷𝑴𝑻 ∗ 𝒊
,
Where PMT=annuity payment at the end of each period.
 Example:
• Consider an equal yearly sum of $1,200 deposited regularly for 5 years in a
savings account that pays 5% p.a. compounded annually. What is the future
value?
• Solution: The annuity is paid at the end of each year in which there is a
total of 5 annuities paid.
 Present Value
• The Present Value (PV) of an ordinary annuity is the sum of all regular
equal payments discounted at a certain rate of interest at the end of each
time period. It is determined as follows:
1− 1+𝑖 −𝑛
• 𝑃𝑉 = 𝑃𝑀𝑇 ∗ 𝑖
 Example:
• Consider an equal yearly sum of $1, 200 deposited regularly for 5 years in a
savings account that pays 5% p.a. compounded annually.
• The annuity is paid at the end of each year in which there is a total of 5
annuities paid.
 Annuity Payment (PMT)
• The amount of annuity payment can also be determined given that its
present value or future value is known. Suppose a present value of $5,195 is
discounted at a rate of 5% p.a. compounded annually over a 5-year period.
What is the annual regular payment made?
• Annuities can also be viewed from a borrowing perspective. Assume that a
loan sum of $50,000 compounded monthly at 12% p.a. for 10 years, what is
its monthly payment then?
 Annuity Due
• Annuity due is the same as ordinary annuity with a slight different in the
timing of the payments made. The annuity payments are made at the
beginning of each compounding period.
• The computations of present value and future value therefore have to take
into consideration the earlier occurrence of annuity, i.e. at the front end of
compounding periods.
 Example:
• An annuity payment of $1,200 is made annually for 5 years with an interest
rate of 5% p.a.
• In determining the present value, we consider one (1) annuity payment is
made in the present and four (4) made in the future periods.
1−0.05−4
• 𝑃𝑉𝐼𝐹𝐴5%,4 = 0.05
+ 1 = 3.546 + 1 = 3.546.
• 1 is added because an annuity payment is made at the beginning of the
period.
• In determining the future value (FV) of an ordinary annuity, if 5 equal
payments made in 5 years, we consider n = 5 because the annuities occur at
the end of each compounding period. But in the case of annuity due, we
consider n = 6 as the annuities occur at the beginning of each
compounding period. Therefore
1−0.056
• 𝐹𝑉𝐼𝐹𝐴5%,6 = 0.05
− 1 = 5.8019.
• 1 is subtracted because there is no annuity payment at the beginning of
period 6.
 Economic equivalence
• At times, you may need to know how to cumulatively tackle different
transactions that are taking place and also compare them with other types of
cash flows, alternatives, etc.
• Suppose there are two banks that are offering you a loan. In such cases, you
need to know how to compare these two offers. For studying these things
you need to have the understanding of the equivalence economic
equivalence.
• Two things are said to be equivalent if they have the same effect.
• For comparing two separate situations, the parameters to be evaluated need
to be placed on an equivalent basis.
• For finding equivalence in economic calculations, the elements that are
generally involved are:
a. Amount of the sums
b. Times of occurrence of the sums
c. Interest rate
 Example:
Consider the following rewards:
Reward 1: Get Rs. 50,000 now
Reward 2: Get Rs. 8000 per year for the next 10 years (first payment given at
the end of the first year)
Assuming a 12% rate of interest on deposits/loans, which option is better for
you?
Portfolios