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Chapter 1 – The Time Value of Money

In any financial transaction, there are two


parties:

The lender and the borrower

Consider the following transaction:


Person A lends money to person B

• person A is called the “lender” or


“investor”
• person B is called the “borrower” or
“debtor”

• the debtor must pay back the original


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

S = accumulated or future value of P

Thus, S−P=I

In this chapter, we will study the various


methods by which interest is calculated and
paid
Accumulation and Amount Functions
(section 1.1)

Consider a financial transaction in which an


investor deposits $1 in an account or fund
(in this case, P = 1)

• we wish to determine how much money


the investor will receive after a certain
period of time
• this amount is called the accumulated
value or future value

(I) Definition – Accumulation Function

a(t) = accumulated value at time t ≥ 0 of an


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added or withdrawn during the term, so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

(II) Definition – Amount Function

If we assume an original principal of P


(instead of 1), then we can define an amount
function with the following properties:

1. A(0) = P

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

3. A(t) is an increasing function of t (as


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.

(a) What are the value of b, c and d?


(b) How much interest is earned in period 6?
Solution to 1.1.1
The Effective Rate of Interest

We define,

i = effective rate of interest


= 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

Effective Rate of Interest in the nth year

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)

As you can see, the effective rate of interest


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)

However, there are two functions that are


used most often in the financial world

These two functions represent two different


types of interest calculation:

1. Simple Interest (section 1.3)

2. Compound Interest (section 1.4)


Simple Interest (section 1.3)

Interest is calculated only on the original


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

That means the interest earned is the same


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

A(t) = A(0)[1 + it] = P[1 + it]

Notes

1. The term (1 + it ) is called the


accumulation factor at simple interest

2. The process of calculating A(t) from P is


called accumulation at simple interest
Note About Time
The value of t must be given in years

If time is given as something other than


years, make the following adjustments to t:

1. If time is given in months, then

number of months
t=
12

2. If time is given in days, then

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)]

Under simple interest, we see that the


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?

Solution to 1.3.6 (Try this one on your own)


Compound Interest (section 1.4)

The interest earned at the end of any given


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

A(t) = A(0)(1 + i ) t = P(1 + i ) t

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

Effective Rate of Interest


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?

Solution (Try this one on your own!)