Notes PDF

MAF 101 Mathematics of Finance
Victor Gumbo - PhD, CBiiPro
UNIVERSITY OF BOTSWANA
Academic Year 2018/19, Mon/Wed 248/011 and Thur

248/012, 0800 - 0900
Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Chapter 1: Interest Rate Measurement: Present Value
Definition
If the rate of interest for a period is i, the present value of an amount of
1 1
1 due one period from now is 1+i . The factor 1+i is often denoted ν in
actuarial notation and is called a present value factor or discount
factor.

Compound Accumulation
Let A(0) be present value; A(t) be the future value at time t and i be
the interest rate.
Accumulation under compound interest is then given by
A(t)
A(t) = A(0)(1 + i)t =⇒ A(0) = = A(t)ν t
(1 + i)t
The letter ν is pronounced “nu”.

Example
Mercy wants to invest a sufficient amount in a fund in order that the
accumulated value will be P1 million on her retirement in 25 years.
Mercy considers two options. She can invest in Equity Mutual Fund
(EMF), which invests in the stock market. EMF has averaged an annual
compound rate of return of 19.5% since its inception 30 years ago,
although its annual growth has been as low as 2% and as high as 38%.
The EMF provides no guarantees as to its future performance. Mercy’s
other option is to invest in a zero-coupon bond with a guaranteed
effective annual rate of interest of 11.5% until its maturity date in 25
years.
(a) What amount must Mercy invest if she chooses EMF and assumes
that the average annual growth rate will continue for another 25 years?
(b) What amount must she invest if she opts for the zero coupon bond
investment?
(c) What minimum effective annual rate is needed over the 25 years in
order for an investment of P25 000 to accumulate to Mercy’s target of
one million Pula?
(d) How many years are needed for Mercy to reach P1 000 000 if she
invests the amount found in part (a) in the zero-coupon bond?
Equation of Value
I Equations of value are a useful technique for solving financial

problems involving discounting and accumulating.
I Normally equations of value equate the present value of cash inflows
to the present value of cash outflows.
I Usual problems involve determining the yield earned on an
investment, the number of years it takes to accumulate a certain
amount of money to a specified target amount at a specified rate of
interest, the amount of money that needs to be invested to achieve
a specified target amount, and the accumulated amount over a
given period at a specified rate of interest.
I The last two cases are simple discounting and accumulation
problems, which we have already covered.
I The solution equation in item (d) in the previous example is an
equation of value.

Nominal Rates of Interest
Definition
A nominal annual rate of interest compounded or convertible m times per
year refers to an interest compounding period of m1 years.
quoted nominal annual interest rate
interest rate for m1 = m

Effective Annual Rate of Interest
Definition
Definition 1.8a: Effective Annual Rate of Interest
In terms of an accumulated amount function A(t), the general definition
of the effective annual rate of interest from time t = 0 to time t = 1 is
A(1) − A(0)
i= (1)
A(0)
It measures the growth on the basis of the initially invested amount.

Effective Annual Rate of Discount
Definition
Definition 1.8b: Effective Annual Rate of Discount
In terms of an accumulated amount function A(t), the general definition
of the effective annual rate of discount from time t = 0 to time t = 1 is
A(1) − A(0)
d= (2)
A(1)
It measures growth on the basis of the year-end accumulated amount.

Equivalence between Discount and Interest Rates
A(1) − A(0) 1
i = =⇒ A(0) = A(1)
A(0) 1+i
A(1) − A(0)
d = =⇒ A(0) = A(1)(1 − d)
A(1)
i d
d = and i =
1+i 1−d
The last two are called equivalent rates of discount and interest,
respectively.

Nominal Annual Rates of Interest/Discount
Definition
A nominal annual rate of discount compounded or convertible m times
per year refers to a discount compounding period of m1 years.
quoted nominal annual discount rate
discount rate for m1 = m
If d is the equivalent effective annual rate of discount and d (m) the

equivalent nominal annual discount, then the following relationship holds:
m
d (m)

1−d = 1− (3)
m
m
d (m)

=⇒ d = 1− 1− (4)
m

Nominal Annual Rates of Interest/Discount
Definition
A nominal annual rate of discount compounded or convertible m times
per year refers to a discount compounding period of m1 years.
quoted nominal annual discount rate
discount rate for m1 = m
If i is the effective annual interest rate and i (m) the equivalent nominal
annual interest, then the following relationship holds:
m
i (m)

i +1 = 1+ (5)
m
m
i (m)

i = 1+ −1 (6)
m

Example
Example
Assume an effective annual rate of interest i = 0.10. Find the equivalent
nominal annual interest rates i (m) and the equivalent nominal annual
discount rates d (m) for m = 1, 2, 3, 4, 6, 9, 12.

Example
Example
When a credit card has a 24% nominal annual interest rate, you do not
only pay 24% on the balance. Rather, that 24% is broken down into 12
monthly interest charges on the average balance over a 30 day billing
cycle. So, one pays an effective annual rate of ....(0.2682).

Example
Example
Which is better:
(a) 15.25% nominal annual interest rate compounded semi-annually, or
(b) 15% compounded monthly?
Solution:
(a) m = 2, i (m) = 15.25%, find ieff . Ans: 0.1583
(b) m = 12, i (m) = 15%, find ieff . Ans: 0.1608

More on Discount Rates
Sometimes, interest is paid up front: Receive A(0) up front, pay back

A(1) > A(0).
Consider the example
A(0) = 900
A(1) = 1000
A(1) − A(0)
d =
A(1)
1000 − 900
=
1000
= 0.10
Essentially, the discount rate is the forward price of a dollar (or any other
unit of currency) in the interest rate market with no carrying cost or
dividends (coupons) paid out.

The Force of Interest
Skip

Inflation
• Inflation is defined as a sustained increase in the general level of prices

for goods and services in a country, and is measured as an annual
percentage change.
• Under conditions of inflation, the prices of things rise over time. Put
differently, as inflation rises, every dollar you own buys a smaller
percentage of a good or service.
• When prices rise, and alternatively when the value of money falls you
have inflation.

Inflation
• The value of a dollar (or any unit of money) is expressed in terms of its
purchasing power, which is the amount of real, tangible goods or actual
services that money can buy at a moment in time.
• When inflation goes up, there is a decline in the purchasing power of
money. For example, if the inflation rate is 2% annually, then
theoretically a P1 pack of sweets will cost P1.02 in a year. After
inflation, your dollar does not go as far as it did in the past.

Inflation
• Inflation is also a concern to investors, since changes in inflation and

interest rates affect various asset types in different ways. This is an
especially important issue for people living on a fixed income, such as
retirees.
• The impact of inflation on your portfolio depends on the type of
securities you hold. If you invest only in stocks, worrying about inflation
shouldn’t keep you up at night since historically stocks have been quite
good hedges against inflation.

Real Rate of Interest
We are interested in analyzing the relationship between interest and

inflation in terms of the measurement of return on investments.
The real rate of interest refers to inflation-adjusted return on an
investment.

Real rate of Interest
Definition
Definition 1.12: Real Rate of Return
With annual interest rate i and annual inflation rate r , the real rate of
interest for the year is
value of amount of real return (yr-end dollars)

ireal =
value of invested amount (yr-end dollars)
i −r
= (7)
1+r

Example
Find the real rate of interest for an investor who invests P1 000 for a year
when the money market yield is 5% and inflation is 3%.

Hyperinflation
Definition
Definition: Hyperinflation
Hyperinflation occurs when a country experiences very high and usually
accelerating rates of inflation, rapidly eroding the real value of the local
currency, and causing the population to minimize their holdings of local
money.

Key Factors Influencing Inflation/Interest rates
• Economic growth rate vs underlying trend rate

• Spare capacity
• Wage inflation
• Unemployment
• Commodity prices
• Exchange Rate
• House prices
• Consumer confidence

House prices
How do house prices affect inflation?

Increasing money supply causes inflation and house prices to increase.
Increases in interest rates causes house prices to increase.

Chapter 2: Valuation of Annuities
Many financial transactions involve a series of periodic payments such as:

• Loan repayment
• Annual interest payment
• Dividend payment, etc
When such happens, it is possible to simplify the valuation of the series
by applying algebraic methods.

Chapter 2: Valuation of Annuities
Objectives:
• Calculate the present and future value of an ordinary annuity and of an
annuity due.
• Calculate the amount of interest earned in an ordinary annuity.
• Calculate the total contributions to an ordinary annuity.
• Calculate monthly payments that will produce a given future value.

Geometric Sequence
A geometric sequence is a sequence such that any element after the

first is obtained by multiplying the preceding element by a constant called
the common ratio which is denoted by r. The common ratio (r ) is
obtained by dividing any term by the preceding term, i.e.,
a, ar , ar 2 , ar 3 , · · · , ar n−1 ...
ar ar 2 ar 3 ar n
r= = = 2 = · · · = n−1
a ar ar ar

Geometric Series
In mathematics, a geometric series is a series with a constant ratio

between successive terms. For example, the series
1 1 1 1
2 + 4 + 8 + 16 + · · ·
is geometric, because each successive term can be obtained by
multiplying the previous term by 1/2.

Sum of a geometric series
For r 6= 1, the finite geometric series sum of the first “n” terms of a
geometric series is n
Pn−1
a + ar + ar 2 + ar 3 + · · · + ar n−1 = k=0 ar k = a 1−r1−r ,
where a is the first term of the series, and r is the common ratio. We can
derive this formula as follows:
s = a + ar + ar 2 + ar 3 + · · · + ar n−1 ,
rs = ar + ar 2 + ar 3 + ar 4 + · · · + ar n ,
s − rs = a − ar n ,
s(1 − r ) = a(1 − r n ),
n
so, s = a 1−r
1−r (if r 6= 1). As n goes to infinity, the absolute value of
r must be less than one for the series to converge. The sum then
becomes P∞ a
a + ar + ar 2 + ar 3 + ar 4 + · · · = k=0 ar k = 1−r , for |r | < 1.
When a = 1, this can be simplified to
1
1 + r + r 2 + r 3 + · · · = 1−r .
Finding the nth term in a GP
Example
Write down the 8th term in the GP 1,3,9,....
Solution:
Note that an = ar n−1
Ans: a8 = 2187

Finding the number of terms in a GP
Example
Find the number of terms in the GP 6, 12, 24,...,1536.
Ans: n = 9

Finding the sum a GP
Example
Find the sum of the geometric series −2, 12 , − 81 , · · · , − 37268
1
52429
Ans: n = 9, S9 = 60536

Annuity Basics
I An annuity is a stream of equal, evenly spaced cash flows.

I The simplest annuity is an annuity certain, which consists of equal
cash flows of known amount paid at regular intervals (level),
either at the beginning or at the end of each period.
I When the first payment occurs at the end of the current
period, the annuity is an immediate ordinary annuity certain (or
simply ordinary annuity).
I When the first payment occurs at the start of the current period
(i.e. now), the annuity is an immediate annuity due certain (or
simply annuity due).

The Present Value of an Ordinary Annuity
An Ordinary annuity is an annuity where the regular payment is made

at the end of the successive time periods.
A loan from a bank is an example of an annuity with a present value and
repayments for the term of the loan. In other words, the banks gives you
the lump now (at present) and the repayments are made in periodic
payments after this.

Present Value of an Ordinary Annuity
Each repayment must be changed to its present value PV. Doing this and
then considering the sum of the series, the sum of the series is
1 − (1 + r )−n
A=R (8)
r
where A is the present value of an ordinary annuity, R is the amount of
each payment, r is the rate per period (payment) and n is the number of
periods (payments). An ordinary annuity is an annuity where the
payment is made at the end of the payment period.
In the foregoing, we shall use actuarial notation as follows:

Present Value of an Annuity-Immediate
Let an|i denote the present value of the annuity, which is sometimes
denoted as an| when the rate of interest is understood.
As the present value of the jth payment is v j , where v = 1/(1 + i) is the
discount factor, the present value of the annuity is the sum of a
geometric progression

Present Value of an Annuity-Immediate
The present value of an annuity is the sum of the present values of each
payment.
an| = v + v2 + v3 + · · · + vn
1 − vn

= v
1−v
1 − vn
=
i
1 − (1 + i)−n
= (9)
i
If the annuity is of level payments of P, the present value of the annuity
is Pan| .

Present Value of an Ordinary Annuity (Annuity-Immediate)
Example
Calculate the present value of an annuity-immediate of amount P100
paid annually for 5 years at the rate of interest of 9%.

Example
Example
A man borrows a loan of P20,000 to purchase a car at annual rate of
interest of 6%. He will pay back the loan through monthly installments
over 5 years, with the first installment to be made one month after the
release of the loan. What is the monthly installment he needs to pay?
See Excel

Exercises
1. Mr. and Mrs. Thuto wish to have an annuity for when their
daughter goes to university. They wish to invest into an annuity
that will pay their daughter P1000 per month for 4 years. What is
the present value of the annuity given that current interest rates are
8% p.a? Ans: P40 961.91
2. Katlego borrows P20 000 to buy a car. He wishes to make monthly
payments for 4 years. The interest rate he is charged is 10.5% p.a.
What is the size of each monthly payment? Ans: P512.07

More Exercises
For each of the following situations, find the present value of the ordinary
annuity described.
1. P2000 per month for 5 years at a rate of 6% compounded monthly.
Ans: 103 451.12
2. P5500 per quarter for 6 21 years at 5.6% compounded quarterly. Ans:
119 174.14
3. P150 per month for 3 years at 8% compounded semi-annually. Ans:
4 717.92
4. Kabo wants to invest a lump sum of money now to cover a monthly
commitment of P100 over 5 years. If the lump sum is invested at
7.5% compounded monthly, what amount will Joe invest? Ans: 4
990.53
5. Leratos car insurance company charges a monthly premium of
P41.50. What is the present value of two years premiums if the rate
of inflation is 0.3% per month? Ans: 959.60

And More Exercises
For each of the following situations, find the periodic payment necessary
for the annuity given the present value.
1. P25 000 to fund 4 years of monthly payments at a rate of 5.25%.
Ans: 578.57
2. A public servant retires with P325 000 in superannuation. He is
offered an annuity for the next 15 years where he will receive
monthly payments. If the interest rate is 8% compounded monthly,
determine the size of the monthly payment. Ans: 3105.87
3. The executor of a will has to distribute an inheritance of P28 000 to
a sole beneficiary in equal monthly payments over 4 years while the
beneficiary undertakes university study. How much will each
monthly payment be? (assume an interest rate of 7.5%). Ans:
677.01
4. If an annuity is purchased for P50 000, how much will each
quarterly payment be over 10 years if the rate of interest is 5%
compounded quarterly. Ans: 1596.07

The Future Value formula of an Ordinary Annuity
• Where regular payments are made with a lump sum at the end, the
lump sum at the end is called the Future Value of an annuity.
• A good example of this is a saving scheme where regular payments are
made to build to a lump sum at the end of a period of time.
• In business, this is called a sinking fund. It is used to save for the
future replacement of major capital items.

The future value of an ordinary annuity is the value of all payments at

the end of the term. It is given by the equation:
(1 + r )n − 1
S =R (10)
r
where S is the future value of the ordinary annuity, R is the periodic
payment, r is the interest rate per period and n is the number of
payments.

In Actuarial notation, the symbol sn|i denotes the accumulated value, at

time of (and including) the final payment of a series of n payments of 1
each made at equally spaced intervals of time, where the rate of interest
per payment period is i:
sn|i = (1 + i)n−1 + (1 + i)n−2 + · · · + (1 + i) + 1

n−1
X
= (1 + i)t
t=0
(1 + i)n − 1
= (11)
i

Notes:
(a) The number of payments in the series, n, is called the term of the
annuity or the frequency;
(b) The payments are of equal amount;
(c) The payments are made at equal time intervals with the same
frequency as the interest is compounded;
(d) The accumulated value is found at the time of and including the final
payment;
(e) The series of payments is referred to as an annuity-immediate;
(f) If there is no possibility of confusion, the subscript i is omitted;
(g) If the annuity is of level payments of P, the future value of the
annuity is Psn|i .

Example
Calculate the future value of an annuity-immediate of amount P100 paid

annually for 5 years at the rate of interest of 9%. Plot the accumulated
value as a function of the number of annuity payments.

Example
A man wants to save P100,000 to pay for his son’s education in 10 years’
time. An education fund requires the investors to deposit equal
installments annually at the end of each year. If interest of 7.5% is paid,
how much does the man need to save each year in order to meet his
target?

Relationship between an|i and sn|i
Since ν = 1/(1 + i), then ν n = 1/(1 + i)n . Also, since

n −n n
an|i = 1−ν
i = 1−(1+i)
i and sn|i = (1+i)i −1 , clearly
n
(1 + i)n − 1

1
an|i =
1+i i
1 − νn
= ν n · sn|i = (12)
i
=⇒ sn|i = ν −n an|i = (1 + i)n an|i (13)

Annuity Due
• So far, all calculations have been performed with ordinary annuities,

where periodic payments are made at the end of the period.
• An annuity due differs from an ordinary annuity since periodic
payments are made at the beginning of the period.
• Some payments such as house rents and insurance premiums are paid
at the beginning of the period before the service is provided.
• If the payment is made at the beginning of the period, each payment
will be subject to an extra months interest when compared to ordinary
annuities.

Annuity Due
A simple modification to the ordinary annuity formulae gives: (Try it at

home)
PRESENT VALUE OF AN ANNUITY DUE
AD = (1 + r )A0
1 − (1 + r )−n
= R(1 + r ) (14)
r
FUTURE VALUE OF AN ANNUITY DUE
SD = (1 + r )S0
(1 + r )n − 1
= R(1 + r ) (15)
r

Annuity Due Example
Example
A company wishes to deposit an amount of money into an account at the
beginning of each year for the next 5 years to purchase a new machine
costing $50000. How much will each yearly payment be if the current
interest rate is 7.2% p.a?

Annuity Due Example
Example
Joe pays $250 rent per week at the beginning of each week. He is
considering paying a whole years rent in advance; given the interest rate
is 5.2% p.a. How much is this amount?

Annuity Due Exercises
1. Find the future value of an annuity due if $800 is paid into an account
at the beginning of each month for 5 years at a rate of interest of 5%
p.a. compounded monthly.
2. Find the present value of an annuity if the periodic amount is $450
per quarter for 20 years at the rate of 4.5% p.a. compounded quarterly.
3. A company leases office space for a period of 12 months. The
monthly rent of $2500 is paid at the beginning of each month. If the
company is to cover all rents with a single lump sum at the beginning of
the year and invests this at 6.3% p.a. how much will the lump sum be?

Mixed Questions
For the following questions, follow these steps.

1. Read the question thoroughly
2. Decide on the type of annuity: either ordinary annuity, where periodic
payments are made at the end of the period OR annuity due, where
periodic payments are made at the beginning of the period.
3. Decide if the annuity contains a lump sum in the present, the lump
sum is at the beginning of the term of the annuity, OR future, the lump
sum is at the end of the annuity.
4. Select the appropriate formula.

Formulae Table
Ordinary Annuity Annuity Due

)−n −n
Present Value A A= R 1−(1+rrn AD = R(1 + r ) 1−(1+rr
)
(1+r )n −1
Future Value S S= R (1+rr) −1 SD = R(1 + r ) r

Mixed Questions
1. Kevin Tumelo won $820 000 in a lotto game. With this lump sum
he purchases an annuity to give him a monthly income for the next
twenty years. The first payment occurs a month after the start of
the annuity. If the interest rate is 6.8% p.a. compounded monthly,
calculate the amount of each payment. Ans: 6259.38.
2. Sally borrows $10 000 to buy a car. If the interest rate charged is
10.5% p.a. calculate the monthly repayment over the term of the
loan, 5 years. The first payment is made a month after the loan
lump sum is advanced. Ans: 214.94.
3. Ditiro wishes to set aside all his rent for one year. This money will
be put into an account paying 6.6% p.a. compounded monthly and
his rent is $1040 per month. Rent is always paid in advance.
Calculate the amount Ditiro must deposit. Ans: 12111.31.

Mixed Questions
1. From the time Jane and John’s daughter was born, they decided to
save for her university education. Jane and John assume their
daughter will require $1000 per month for her four years of study,
payments being made at the beginning of each month. If Jane and
John save for 18 years, calculate the amount they must save at the
beginning of each month. Assume 6% p.a. interest is compounded
monthly. Hint: there are two annuities here, calculate the lump sum
required to fund the $1000 p.m. allowance first, then the monthly
amount the parents must save. Ans: 42793.22; 109.93.
2. Seabelo Transport Company decide that they must start saving for
a new vehicle in 5 years time. In an account that pays 5.4% p.a.
compounded monthly they deposit a one off payment of $20 000
and $500 at the end of each month. How much will they have at
the end of 5 years? (Hint: treat the two amounts separately, one is
an annuity and the other compound growth). Ans: 26183.43;
34352.36.

Perpetuity-immediate: Present Value
1 n
n 1−( 1+i )
Since an| = 1−v
i = i , as n −→ ∞, (1 + i)n −→ ∞ and
n
1
1+i −→ 0 so that an|i −→ 1i . Generally a∞|i = Xi .
The infinite period annuity that results as n −→ ∞ is called a
perpetuity-immediate.

Example
Example
An amount of P10 000 is to be invested at an effective interest rate of
8%. If “only” the interest is withdrawn from the account but the
principal remains in the account for another year. This is allowed to go
on indefinitely as long as the principal remains.
Put in another way, P10 000 is just the present value at 8% of payments
of P800 at the end of each year, forever: 10000 = 800a∞|0.08

Finding the number of payments (n) in an annuity
Let M be the accumulated value of an annuity-immediate with n level

payments each of J with an interest rate i per period. Then
M = J × (1 + i)n−1 + (1 + i)n−2 + · · · + (1 + i) + 1

(1 + i)n − 1

= J×
i
= J × sn|i
h i
ln 1 + Mi j
=⇒ n = (16)
ln(1 + i)

Finding the number of payments (n) in an annuity
Let L be the present value of an annuity-immediate with n level

payments each of K with an interest rate i per period. Then
L = K × v + v2 + v3 + · · · + vn

1 − vn

= K×
i
Li

ln 1 − K
=⇒ n = (17)
ln v

Notes
• A final payment made to repay a loan that is larger than the regular
payment is referred to as a baloon payment.
• A final payment made to repay a loan that is smaller than the final
regular payment is referred to as a drop payment.
• For both present value and accumulated value of an annuity-due, the
valuation point is one period after the valuation point for the
corresponding annuity-immediate. This leads to the relationships:
än|i = (1 + i)an|i (18)

s̈n|i = (1 + i)sn|i (19)

Chapter 3: Loan Repayment
Objectives:
• Understand different methods of loan repayment.
• Understand the Amortization Loan Repayment Method.

Amortization
I Amortization (or amortisation) is the process of decreasing, or

accounting for, an amount over a period.
I When used in the context of a home purchase, amortization is the
process by which your loan principal decreases over the life of your
loan.
I With each mortgage payment that you make, a portion of your
payment is applied towards reducing your principal and another
portion of your payment is applied towards paying the interest on
the loan.
I Amortization is generally known as depreciation of intangible assets
of a firm.

Amortization schedule
I An amortization schedule is a table detailing each periodic

payment on an amortizing loan (typically a mortgage), as generated
by an amortization calculator.
I Amortization schedules run in chronological order. The first
payment is assumed to take place one full payment period after the
loan was taken out, not on the first day (the amortization date) of
the loan.
I The last payment completely pays off the remainder of the loan.
Often, the last payment will be a slightly different amount than all
earlier payments.

I An amortization schedule reveals the specific monetary amount put

towards interest, as well as the specific amount put towards the
principal balance, with each payment.
I Initially, a large portion of each payment is devoted to interest.
I As the loan matures, larger portions go towards paying down the
principal.

Many kinds of amortization exist, including:

I Straight line (linear)
I Declining balance
I Annuity
I Bullet (all at once)
I Increasing balance (negative amortization)

Example
For this example, a loan of P100 000 is being considered over a term of
10 years at an interest rate of 9% p.a. with monthly repayments.
Repayments on loans are made at the end of the month so this is a
ordinary annuity. The lump sum is at the beginning of the annuity so
the present value formula is used.

Solution
The first step is to calculate the repayment amount of the loan.

Given: A = 100000, r = 0.0912 = 0.0075, n = 10 × 12 = 120.
1 − (1 + r )−n
A = R
r
Ar
R =
1 − (1 + r )−n
100000 × 0.0075
=
1 − (1 + 0.0075)−120
= 1266.76
Thus, the monthly repayment for this loan (annuity) is P1266.76 per
month.

Solution
The amount of interest for the first month is 100000 × 0.0075 × 1 = 750,
so the amount of principal paid off the loan during the first month is
P1266.76 -750 = P516.76.
Hence the balance of the loan for the second month is P100 000 -
P516.76 = P99 483.24.

Solution
The amount of interest for the second month is

99483.24 × 0.0075 × 1 = 746.12, so the amount of principal paid off the
loan during the second month is P1266.76 -746.12 = P520.64.
Hence the balance of the loan for the second month is P99 483.24 -
P520.64 = P98 962.60, and this continues until the loan is paid off after
10 years.
Produce an amortization schedule for the first six months of this loan
using the headings: Month, Principal Outstanding at the beginning
of the month, Interest per month, Payment at the end of the
month, Principal paid off outstanding principal, Principal
Outstanding at the end of the month.

Exercises
1. A person amortizes a loan of P30000 for a new car by obtaining a 10

year loan at a rate of 12% with monthly payments. Find
(a) the monthly payment. Ans: 430.41
(b) the total interest charged. Ans: 21649.20
(c) the principal remaining after 4 years. Ans: 22 015.64
(d) the interest paid and the principal paid during the 49th month. Ans:
220.16; 210.15.

Mathematical Definition
Definition
An amortized loan of amount L made at time 0 at periodic interest rate
i and to be repaid by n payments of amounts K1 , K2 , . . . , Kn at times
1, 2, . . . , n (where the payment period corresponds to the interest period)
is based on the equation
L = K1 ν + K2 ν 2 + · · · + Kn ν n . (20)

The outstanding balance (or outstanding principal) just after the first
payment is the unpaid loan balance:
OB1 = L × (1 + i) − K1 (21)
= L − (K1 − L × i) (22)
OB0 × i = I1 represents the interest paid at the end of the first period.
(OBt × i = It+1 )

During the following period this OB will accumulate with interest to

OBt × (1 + i), at which time the t + 1st payment Kt+1 is made, we have:
OBt+1 = OBt × (1 + i) − Kt+1

= OBt − (Kt+1 − OBt × i)
= OBt − (Kt+1 − It+1 )
= OBt − PRt+1 (23)
where PRt+1 stands for principal repaid by the t + 1 payment. Note that
PRt+1 = Kt+1 − It+1

Summary of Components of an Amortization Schedule
Loan Amount L:
Loan amount at interest rate i per period, to be repaid through n
payments Ki , i = 1, 2, . . . , n at the end of n successive periods.
Outstanding Balance just after payment at time t:
OBt is the amount still owed on the loan just after the payment is made.
Interest due in the payment at time t:
It is the interest on the outstanding balance since the previous payment
was made.
Principal repaid in the payment at time t:
PRt is the part of the payment Kt that is applied toward repaying loan
principal.

Example
Example
A borrower takes out a 1-year loan for an amount of P250 000. The loan
is repaid in equal monthly instalments of principal and interest at the end
of each month starting immediately. Calculate the monthly instalment,
assuming that the bank charges interest at 9% p.a. effective and there
are no establishment fees.

Sinking Fund Amortization
Certain loans require periodic payments of interest only, and a single

payment of the full principal amount at the end of the term. In this case,
the interest payments are
I1 = I2 = · · · = In = L × i
and principal payments of
PR1 = PR2 = · · · = PRn−1 = 0 and PRn = L.
The OBs are therefore:
OB0 = L
OB1 = OB0 − PR1 = L
OB2 = OB1 = OB2 = · · · = OBn−1 = L
OBn = OBn−1 − PRn = L − L = 0 (24)

Example
Example
Consider a young couple who want to save for the purchase of a house at
the end of 10 years. If they estimate that they will require a total of
P200 000 for the house, how much should they deposit at the end of
each month in a savings account paying interest at 12% p.a. effective?

Makeham’s Formula
Consider a loan in which the lender receives interest ONLY and the
principal at the end, say after n periods.
The sequence of payments received is Li, Li, Li, . . . , Li, Li + L (n
payments)
Assume the lender wants to sell the loan to some investor. The investor
would obviously want to value the sequence of payments at the time the
loan is purchased.
He can do this by finding the present value at periodic interest rate j.

Makeham’s Formula
The investor will pay the lender an amount equal to the present value of
the payments based on j, not necessarily equal to i.
We say the investor has purchased the right to receive the payments.
This present value is given by:
A = Lνjn + Lian|j
1 − νjn

n
= Lνj + Li
j
i
= Lνjn + L − Lνjn

j
i
= K + (L − K ) (25)
j
where K = Lνjn is the present value of the repayment of principal.
The above formula is called Makeham’s Formula (Makeham, W. M.
(1860). “On the Law of Mortality and the Construction of Annuity
Tables”. J. Inst. Actuaries and Assur. Mag. 8: 301310.)

Example
Example
A loan of P100 000 is to be repaid with 10 annual payments of principal
of P10 000 each, starting one year after the loan is made, plus monthly
interest payments on the outstanding balance. The interest rate is
i (12) = 0.12 Two years after the loan is made (just after the second
principal payment and monthly interest payment) the lender sells the loan
to an investor. Find the price paid by the investor if he values the
remaining payments at a nominal annual rate of interest of 6%
convertible monthly.

Solution
Given:
i (12) = 0.12, i = 0.12/12 = 0.01, j = 1/2%, L1 = L2 = · · · = L8 = 10000
Required: K , L, A
When the loan is sold, 2 x 10000=20000 principal had been paid.
Outstanding balance is L = 80000 and monthly interest payments at 1%
on the outstanding balance.
Therefore the present value of the principal payments is
K = K1 + K2 + · · · + K8
= L1 νj1n + L2 νj2n + L3 νj3n + · · · + L8 νj8n , n = 12
= 10000 ν 12 + ν 24 + ν 36 + · · · + ν 96

12
ν − ν 108

= 10000
1 − ν 12
= 61 687.68

Solution
The price paid by the investor (buyer) is
i
A = K + (L − K )
j
0.01
= 61687.68 + (80000 − 61687.68)
0.005
= 98312.33

Exercises
1. Construct an amortization schedule for the following scenario: A loan

of P1200 is repaid by 6 quarterly payments, interest is 10% compounded
quarterly.
2. Thuso and Thusang take out a mortgage housing loan for P250 000
over 20 years at an interest rate of 8% with monthly payments. Calculate
the size of each repayment.
3. Thuso and Thusang’s interest rate (from question 2) has just been
increased to 9%, by how much will their repayments increase by so they
can still repay the loan after 20 years?
4. A P45 000 mortgage loan for 25 years for home additions is obtained
at a rate of 7.75% repaid in monthly repayments. Find
a). The monthly repayment
b). The principal outstanding at the beginning of the 36th month.
c). The interest in the 36th payment.
d). The principal in the 36th payment.
e). The total interest paid.

More Exercises
5. Caroline and Carol take out a home mortgage loan for P150 000 over
20 years at an interest rate of 6% with monthly payments.
a). Calculate the amount of each monthly repayment.
After 10 years Caroline receives a lump sum payout of P30 000 after
being made redundant from her university position. She decides to pay
this off the principal of the loan. She also decides to shorten the term of
the loan to just 5 more years (15 in total).
b). What will the size of the new repayment be?

Chapter 4: Bond Valuation
Learning Items:
1. Types, features and risks of bond investments
2. Formulas for pricing a bond
3. Construction of bond amortization schedules
4. Pricing a bond between two coupon-payment dates
5. Callable bonds and their pricing approaches
6. Price of a bond under a non-flat term structure

Bond Basic Concepts
I A bond is a contract/certificate of debt in which the issuer

promises to pay the holder a definite sequence of interest payments
for a specified period of time, and to repay the loan at a specified
terminal date (called the maturity or redemption date).
I It is an interest-bearing certificate of public (government) or private
(corporate) indebtedness.
I Visit http://www.bankofbotswana.bw/content/2009103014034-
government-bonds

Bond Basic Concepts
There are many risks involved in investing in bonds, including:

1. Interest-rate risk: Bond investors receive interest payments
periodically before the bond redemption date. Coupon interest payments
are usually constant during the life of the bond. After the investor
purchased the bond, if the prevailing interest rate rises, the price of the
bond will fall as the bond is less attractive. This is called interest-rate
risk.

Bond Basic Concepts
2. Default risk: Default risk is the risk that the bond issuer is unable to
make interest payments and/or redemption repayment. Based on the
bond issuer’s financial strength, bond rating agencies provide a rating (a
measure of the quality and safety) of the bond. Bonds are classified by
rating agencies into two categories: investment-grade bonds (a safer
class) and junk bonds (a riskier class).

Bond Basic Concepts
3. Reinvestment risk: For coupon-paying bonds, investors receive

interest payments periodically before the redemption date. The
reinvestment of these interest payments (sometimes referred to as
interest-on-interest) depends on the prevailing interest-rate level at the
time of reinvestment. Zero-coupon bonds do not have reinvestment
risk.

Bond Basic Concepts
4. Call risk: The issuer of a callable bond has the right to redeem the
bond prior to its maturity date at a preset call price under certain
conditions. These conditions are specified at the bond issue date, and are
known to the investors. The issuer will typically consider calling a bond if
it is paying a higher coupon rate than the current market interest rate.
Callable bonds often carry a call protection provision. It specifies a period
of time during which the bond cannot be called.

Bond Basic Concepts
5. Inflation risk: Inflation risk arises because of the uncertainty in the

real value (i.e., purchasing power) of the cash flows from a bond due to
inflation. Inflation-indexed bonds are popular among investors who do
not wish to bear inflation risk.

Bond Basic Concepts
Other risks in investing in bonds include: market risk, which is the risk
that the bond market as a whole declines; event risk, which arises when
some specific events occur; liquidity risk, which is the risk that investors
may have difficulty finding a counterparty to trade.

Bond Valuation
The following features of a bond are often agreed upon at the issue date.
Face Value: Face value, denoted by F , also known as par or principal
value, is the amount printed on the bond.
Redemption Value: A bond’s redemption value or maturity value,
denoted by C , is the amount that the issuer promises to pay on the
redemption date. In most cases the redemption value is the same as the
face value.
Time to Maturity: Time to Maturity refers to the length of time before
the redemption value is repaid to the investor.
Coupon Rate: The coupon rate, denoted by r , is the rate at which the
bond pays interest on its face value at regular time intervals until the
redemption date.

Bond Valuation
• We only consider the financial mathematics of default-free bonds.

• We denote by n as the number of coupon payment periods from the
date of purchase (or the settlement date) to the maturity date, P as the
purchase price, and i as the market rate of interest (called the yield rate).
• The yield rate reflects the current market conditions, and is determined
by the market forces, giving investors a fair compensation in bearing the
risks of investing in the bond.
• We assume that r and i are measured per coupon-payment period.
Thus, for semiannual coupon bonds, r and i are the rate of interest per
half-year.

Bond Valuation
• The price of a bond is the sum of the present values of all coupon
payments plus the present value of the redemption value due at maturity.
• We assume that a coupon has just been paid, and we are interested in
pricing the bond after this payment. (Illustration of the cash-flow pattern
of a typical coupon bond)
• We shall assume that the term structure is flat, so that cash flows at all
times are discounted at the same yield rate i.
• Thus, the fair price P of the bond is given by the following basic price
formula:

Bond Valuation

1 1 1 1 1
P = C· + Fr · + + + ...
(1 + i)n (1 + i) (1 + i)2 (1 + i)3 (1 + i)n
n
= C νi + Fran|i (26)
= C + (Fr − Ci)an|i using the identity νin = 1 − ian|i (27)
= F νin + Fran|i , if C = F (28)
r
= F νin + (F − F νin ) (29)
i
r
= K + (F − K ) , K = F νin , [Makeham’s Formula for Bonds] (30)
i
where the interest and annuity functions are calculated at the yield rate i.

Example
Example
Example: The following shows the results of a government bond auction:
Type of Bond: Government bond
Issue Date: February 15, 2010
Maturity Date: February 15, 2040
Coupon Rate: 4.500% payable semiannually
Yield Rate: 4.530% convertible semiannually
Assume that the redemption value of the bond is the same as the face
value, which is P100. Find the price of the bond.

Solution
This is a 30-year bond and we can use the basic price formula with
F = 100, C = 100, r = 0.045 2 = 0.0225, i = 0.0453
2 = 0.02265, n = 60,
to calculate the price of the bond, which is
P = Cvin + Fran|i
= 100(1.02265)60 + 2.25a60|0.02265
= 99.51

Bond Amortization
• Equation (21) is called the premium/discount formula because
P −C = (Fr − Ci)an|i (31)
represents the bond premium (when it is positive) or the bond discount

(when it is negative).
• In other words, if the selling price of a bond is larger than its
redemption value, the bond is said to be traded at a premium of value
P −C = (Fr − Ci)an|i
• On the other hand, if the selling price of a bond is less than its
redemption value, the bond is said to be traded at a discount of amount
C −P = (Ci − Fr )an|i

Bond Amortization
• In most cases the redemption value is the same as the face value
(i.e.,C = F ), so that the bond is traded at
Premium : P − F = F (r − i)an|i , if r > i,

Par : P − F = 0, if r = i,
Discount : F − P = F (i − r )an|i , if i > r .

Bond Amortization
From P − C = (Fr − Ci)an|i , we obtain
Premium : P − C = C (g − i)an|i , if g > i,

Discount : C − P = C (i − g )an|i , if i > g
where g = (Fr )/C is called a modified coupon rate.

A general bond amortization schedule is given in next Table.

Bond Amortization - Effective Int Method
Half Cpn Eff Amort Book

year Pymnt Int Amnt Value
Earned
0 P = C + C (g −
1 Cg i[C + C (g − i)an|i ] C (g − i)v n C + C (g − i)an−
2 Cg i[C + C (g − i)an−1|i ] C (g − i)v n−1 C + C (g − i)an−
3 Cg i[C + C (g − i)an−2|i ] C (g − i)v n−2 C + C (g − i)an−
.. .. .. .. ..
. . . . .
t Cg i[C + C (g − i)an−t+1|i ] C (g − i)v n−t+1 C + C (g − i)an−
.. .. .. .. ..
. . . . .
n Cg i[C + C (g − i)a1|i ] C (g − i)v 1 C + C (g − i)a0|
Total nCg nCg − C (g − i)an|i C (g − i)an|i

Example
Example
Find the price of a P1,000 face value 15-year bond with redemption value
of P1,080 and coupon rate of 4.32% payable semiannually. The bond is
bought to yield 5.00% convertible semiannually. Show the first 5 entries
of its bond amortization schedule.

Solution
The details of the computation are as follows: (2.333% has been rounded
to 2% for purposes of easy illustration)
The modified coupon rate is g = Fr /C = 2% per half-year period.
Coupon payment is Cg = 1, 080(0.02) = 21.60, and it is the same as
Fr = 1, 000(0.0216) = 21.60, where r = 0.0432/2 = 2.16% per half-year
period.

Solution
Using the bond price formula, we have
P = C + (Fr − Ci)an|i
= 1, 080 + (21.6 − 27.0)a30|0.025
= 966.98.

Solution

Earned
0 966.98
1 21.60 24.17 -2.57 969.55
2 21.60 24.24 -2.64 972.19
3 21.60 24.30 -2.70 974.89
4 21.60 24.37 -2.77 977.67
.. .. .. .. ..
. . . . .
30 21.60 26.87 -5.27 1080.00

Valuation between Coupon-Payment Dates
I The pricing formulas discussed are applicable to a bond at its issue

date or at a date immediately after a coupon payment.
I Bond transactions may occur any time before maturity.
I We now consider the pricing formula of a bond traded between
coupon-payment dates.
I In practice the market price of a bond is stated as a percentage
(e.g., 90.125, or 90.125%) of its face value, which is called the
quoted price (or the clean price).

I When a bond is purchased between the coupon-payment dates,

interest is earned by the seller of the bond from the last
coupon-payment date, which is referred to as the accrued interest.
I The purchaser of the bond has to pay the accrued interest to the
seller since the seller will not be entitled to any amount of the next
coupon payment.
I The accrued interest is added to the quoted price to determine the
purchase price (also called the dirty price or the invoice price),
i.e.,
Purchase price = quoted price + accrued interest.

I Let us denote k as the time immediately after the kth coupon

payment.
I We consider a bond traded in between two coupon-payment dates
(say, between time k and k + 1) at time k + t, where t measures
the length of time since the last coupon payment as a fraction of
the time between k and k + 1.
I While there are different market practices in defining t, we adopt
the actual/actual day count convention and define t as
Number of days since time k

t= (32)
Number of days between k and k + 1
so that 0 < t < 1.

I We denote the bond price at time k and k + 1 by Pk and Pk+1

respectively.
I These prices are the bond values after the coupon payments. For an
investor who purchased the bond after the coupon payment at time
k and held it till time k + 1, the value of her investment in the
period is illustrated.
I If the yield rate remains unchanged from time k to k + 1, we have
the following relationship
Pk+t = Pk (1 + i)t
= (Pk+1 + Fr )(1 + i)−(1−t) , (33)
where i is the yield rate in the coupon-payment period.

I We decompose Pk+t into two components. In common practice, the

simple-interest method is used to calculate the accrued interest at
time k + t, denoted by Ik+t .
I Using the simple-interest formula, we have
Ik+t = t(Fr ). (34)
The book value (quoted price) at time t, denoted by Bk+t , is then

given by
Bk+t = Pk+t − Ik+t . (35)

Example
Example
The following shows the information of a government bond traded in the
secondary market.
Type of Bond: Government bond
Issue Date: June 15, 2005
Date of Purchase: June 15, 2009
Maturity Date: June 15, 2020
Coupon Rate: 4.2% payable semiannually
Yield Rate: 4.0% convertible semiannually
Assume that the coupon dates for this government bond are June 15 and
December 15 of each year. On August 18, 2009, an investor purchased
the bond to yield 3.8% convertible semiannually. Find the purchase price,
accrued interest and the quoted price of the bond at the date of
purchase, based on a face value of 100.

Solution
We have i = 0.038/2 = 1.9%, so that the values of Pk and Pk+1 are
Pk = 2.1a22|0.019 + 100(1.019)−22 = 103.5690

Pk+1 = 2.1a21|0.019 + 100(1.019)−21 = 103.4368.
The number of days between June 15, 2009 and August 18, 2009 is 64
and the number of days between the two coupon dates in 2009 is 183.
Therefore t = 64/183. Hence,
64
Pk+t = Pk (1 + i)t = 103.5690(1.019) 183 = 104.2529

Solution
Or equivalently,
−119
Pk+t = v 1−t (Pk+1 + Fr ) = (1.019) 183 (103.4368 + 2.1) = 104.2529
The accrued interest is
Ik+t = t(Fr ) = 0.7344,
and the quoted price (book value) is:
Bk+t = Pk+t − Ik+t = 104.2529 − 0.7344 = 103.5185.

Excel Function
The Excel function PRICE can be used to compute the quoted price of a
bond between coupon-payment dates. Its specification is as follows:
Excel function: PRICE(smt,mty,crt,yld,rdv,frq,basis)
smt = settlement date
mty = maturity date
crt = coupon rate of interest per annum
yld = annual yield rate
rdv = redemption value per 100 face value
frq = number of coupon payments per year
basis = day count, 30/360 if omitted (or set to 0) and actual/actual if
set to 1
Output = quoted price of bond at settlement date per 100 face value
The default for the input basis is the 30/360 convention. Under this
convention, every month has 30 days and every year has 360 days.

Callable Bonds
I Callable bonds are bonds that can be redeemed by the issuer prior
to the bond’s maturity date.
I Investors whose bonds are called are paid a specified call price,
which was fixed at the issue date of the bond.
I The call price may be the bond’s face value, or it may be a price
somewhat higher. The difference between the call price and the face
value is called the call premium.
I If a bond is called between coupon dates, the issuer must pay the
investor accrued interest in addition to the call price.
I Investors of callable bonds often require a higher yield to
compensate for the call risk as compared to non-callable bonds.

Callable Bonds
I Some callable bonds offer a call protection period. The issuer is

not allowed to call the bond before the ending date of the
protection period. The first call date is the date after which the
bond is fully callable.
I Theoretically, there is an optimal call date for the issuer to
maximize the call benefit.
I However, in addition to the call benefit, there are many other
factors (such as transaction costs, possible negative impact on the
company’s reputation and competition, etc.) affecting the decision
of the issuer to make a call. Therefore, it is difficult to predict when
the issuer will call.

Callable Bonds
I Here we consider a defensive pricing approach for the investor.

Under this approach, an investor assumes that the issuer will call
the bond at a date which will maximize the call benefit.
I If a callable bond is traded at a discount and the call price is fixed
at the bond’s redemption value, the optimal call date for the issuer
is at maturity.
I On the other hand, if a callable bond is traded at a premium and
the call price is fixed at the bond’s redemption value, the optimal
call date for the issuer is the first call date.

Callable Bonds
I In general, when the call price is not a constant but varies in a

prefixed relation with the possible call dates, it is not easy to
determine the issuer’s optimal call date.
I In this situation, we can apply the strategy in which the investor
pays the lowest price among the prices calculated by assuming all
possible call dates.

Example
Example
As an illustrative example, we consider a P1,000 face value (same as the
redemption value) 3-year bond with semiannual coupons at the rate of
5% per annum. The current required rate of return i for the bond is 4%
convertible semiannually. Assume that the bond is callable and the first
call date is the date immediately after the 4th coupon payment. Find the
price of the bond for the yield to be at least 4% compounded
semiannually.

Example
The price of the bond is

P = (1, 000 × 0.025)a6|0.02 + 1, 000(1.02)−6 = 1, 028.01, and the
premium is P28.01.
In each half-year period a P25 coupon payment is received. This amount
is larger than the interest earned at the yield rate based on the book
value, which is 1, 028.01 × 0.02 = 20.56 for the first half-year.

Solution

Earned
0 1028.01
1 25.00 20.56 4.44 1023.57
2 25.00 20.47 4.53 1019.04
3 25.00 20.38 4.62 1014.42
4 25.00 20.29 4.71 1009.71
5 25.00 20.19 4.81 1004.90
6 25.00 20.10 4.90 1000.00
Total 150.00 121.99 28.01

Solution
Treating the first call date as the maturity date of the bond, the price of
the bond is 25a4|0.02 + 1, 000(1.02)−4 = 1, 019.04. The prices of the
bond assuming other possible call dates, namely, after the 5th and 6th
coupon payments, are, respectively,
25a5|0.02 + 1, 000(1.02)−5 = 1, 023.57,
and
25a6|0.02 + 1, 000(1.02)−6 = 1, 028.01.
Thus, the price of the bond is the lowest among all possible values, i.e.,
P1,019.04.

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MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro

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Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

• Economic growth rate vs underlying trend rate

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

How do house prices affect inflation?

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Many financial transactions involve a series of periodic payments such as:

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

A geometric sequence is a sequence such that any element after the

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

In mathematics, a geometric series is a series with a constant ratio

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

I An annuity is a stream of equal, evenly spaced cash flows.

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

An Ordinary annuity is an annuity where the regular payment is made

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance

Victor Gumbo - PhD, CBiiPro MAF 101 Mathematics of Finance