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Sep 24, 2018

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economics

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3 vizualizări28 paginieconomics

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parties:

Person A lends money to person B

“investor”

• person B is called the “borrower” or

“debtor”

amount borrowed (at some point in the

future) along with a fee charged for the

use of the money, called interest

Definitions/Notation

P = principal

= original amount borrowed

= original amount invested

I = interest

= a dollar amount of money

representing a fee or service charge

paid to the lender for the use of

his/her money

Thus, S−P=I

methods by which interest is calculated and

paid

Accumulation and Amount Functions

(section 1.1)

investor deposits $1 in an account or fund

(in this case, P = 1)

the investor will receive after a certain

period of time

• this amount is called the accumulated

value or future value

original investment of $1

Properties of a(t)

1. a(0) = 1

2. a(t) is an increasing function of t (as long

as interest > 0)

3. a(t) is a continuous function (even

though interest payments are often paid

discretely at defined points in time)

Notes

• a(t) = original investment + interest

• t = term of the investment

= time elapsed from date of investment

• time is measured in periods; but most

common period used is YEARS

• We assume (for now) that no principal is

added or withdrawn during the term, so

that any change in the value of the

investment is due strictly to the effect of

interest

(instead of 1), then we can define an amount

function with the following properties:

1. A(0) = P

2. A(t) = P a(t)

long as interest > 0)

4. A(t) is a continuous

Define

In = amount of interest earned in period n

where

In = A(n) − A(n − 1)

Example 1.1.1

You are given that the accumulation function is

a(t) = b(t − 1)2 + ct + d. You are also given that

under this accumulation function, $800 invested

at time 0 accumulates to $920 at time 1 and

$3704 at time 3.

(b) How much interest is earned in period 6?

Solution to 1.1.1

The Effective Rate of Interest

We define,

= amount of money that $1, invested at the

beginning of a period, will earn during the

period, where interest is paid at the end of the

period

Note

The rate of interest is expressed as a

percentage

→ i = 6% means i = 0.06

→ i = 4 ½% means i = 0.045

a (n) − a (n − 1)

in =

a (n − 1)

The above can also be written in terms of

the amount function:

A( n) − A(n − 1) In

in = =

A(n − 1) A(n − 1)

in any period is the ratio of the interest

earned in that period, In, to the amount

invested at the start of the period, A(n−1)

Example 1.2.1

In example 1.1.1, calculate the effective rate of

interest earned in year 1, year 6 and year 10.

Solution to 1.2.1

There are many different functional forms of

the accumulation function, a(t)

used most often in the financial world

types of interest calculation:

Simple Interest (section 1.3)

principal during the whole term of the

investment (or loan), at the stated annual

rate of interest; there is no interest earned on

any interest that is paid

each period:

In = I = P i t

We know that I = S − P

Thus,

S = P+I = P+Pit

= P(1 + it )

In other words:

a(t) = 1 + i t

Notes

accumulation factor at simple interest

called accumulation at simple interest

Note About Time

The value of t must be given in years

years, make the following adjustments to t:

number of months

t=

12

number of days

(a) Exact Interest: t = 365

number of days

(b) Ordinary Interest: t = 360

(also referred to as the Banker’s Rule)

Example 1.3.1

Calculate the future value in 5-years of $5000

invested today, earning simple interest at i = 5%.

Solution to 1.3.1

Example 1.3.2

Using exact and ordinary interest, what will

$15,000 accumulate to over 120 days at a simple

interest rate of i = 7%?

Solution to 1.3.2

Example 1.3.3

How long will it take $1500 to earn $22.50 in

simple interest at i = 9%?

Solution to 1.3.3

Effective Rate of Interest

a (n) − a (n − 1) [1 + in] − [1 + i(n − 1)] i

in = = =

a (n − 1) [1 + i( n − 1)] [1 + i (n − 1)]

effective rate of interest is a decreasing

function of n.

Example 1.3.4

An investment of $600 is earning 6% per year

simple interest. Calculate the effective rate of

interest earned in years 1, 5 and 10.

Solution to 1.3.4

Example 1.3.5

You borrow $1500 on March 13, 2018 and

another $2000 on June 24, 2018. If you are

being charged simple interest at i = 12%, how

much do you need to pay back on September 13,

2018?

Solution to 1.3.5

Example 1.3.6

You deposit $200 today, $300 at the end of 2-

months, $400 at the end of 5-months and $500 at

the end of 8-months. At the end of the year, you

have $1429.75. What rate of simple interest is

assumed?

Compound Interest (section 1.4)

period of time is added to the principal and

it thereafter earns interest

• the interest is said to be “compounded”

End of Interest Accumulated

period Earned Value

In other words:

a(t) = (1 + i ) t

Note

The term (1 + i ) t is called the accumulation

factor

Example 1.4.1

Calculate the future value in 5-years of $5000

invested today, earning compound interest at

i = 5%. Calculate the effective rate of interest

for years 3 and 4.

Solution to 1.4.1

Example 1.4.2

A loan of $2500 is taken out and is due with

interest at 8%. How much is to be paid back in

8-months if

(a) It is a simple interest rate

(b) It is a compound interest rate

Solution to 1.4.2

Comparison of Compound and Simple

Interest

Example 1.4.3

You deposit $3000 today and another $X at the

end of 1.5-years in a fund earning interest at

i = 3.5%. At the end of 6 years, you have

accumulated $5600. What is the value of X?

Solution to 1.4.3

Bonus Example

A deposit of $5000 is made today in a fund

earning compound interest at i. Another deposit

of $8000 is made into the same fund at the end

of 3-years. At the end of 6-years, the fund has

accumulated to $16,000. What is the value of i?

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