102 Session 1

(p)
switch from i to d (p)

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 Jargon:
interest rates
Suppose you lend someone (e.g. your bank) £100 and they
promise to pay you £110 in a year’s time.

By convention, we could call £10 of the money returned “interest”

and £100 of the money returned “capital” or “principal”.
The annual interest rate would be 10 / 100 = 10% .
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 Jargon:
discount rates (1)
The bank might have described this deal a different way. It might say
it “sold you a bond” for £110, which you “bought” for only £100.

By convention, we could say that you “paid” £10 less than the
“face value” of the bond (ie you paid £100 = £110 - 10).
So we could say you got a £10 “discount”, an annual rate of 10 / 110 = 9%

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 Jargon:
discount rates (2)
Something pays 100,
but price has been knocked down
from 100 to 95 95 100

d (discount rate) = 5 (the discount) / 100 5

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 Jargon:
interest & discount rates
i (Interest rate) = interest / START

d (discount rate) = interest / END start end

interest

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 Jargon:
interest convertible quarterly
Would you rather get interest sooner or later?

Interest may be described as “convertible quarterly”.

Ie if you lend a bank £100 for 10% pa “convertible quarterly”, it will pay you
(for that £100) £10 interest in four chunks:
£2.50 after 3 months, 6 months, 9 months, 12 months.

So, after 3 months, you have £2.50 interest plus your £100 principal.
So your original £100 has “grown” to £102.50, or by a factor of 1.025.

So if you reinvest the whole lot on the same terms (ie if you reinvest the interest)
your £100 grows to 100 * 1.025 x 1.025 x 1.025 x 1.025 = 110.38
by then end of the year, a total growth of 10.38%.

So by convention, we say 10% pa convertible quarterly ( denoted i(4) )

is equivalent to a 10.38% “annual effective” rate ( denoted i ).
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Specimen 11. Just calculate i

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Specimen 11. Just calculate i
on deposit account

Deposit account pays ……. / 2 = ……% each six months

So every six months, deposit account grows by factor of …….
So in a year, deposit account grows by factor of ………………….
So annual effective rate of return on deposit account is ………..

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Specimen 11. Just calculate i
on deposit account

Deposit account pays 4% / 2 = 2% each six months

So every six months, deposit account grows by factor of 1.02. So
in a year, deposit account grows by factor of 1.02 * 1.02 = 1.0404
So annual effective rate of return on deposit account is 4.04%

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April 2000 3. Just calculate i

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April 2000 3. Just calculate i

Account pays …. / 12 = …….% each month

So every month, account grows by factor of …..….
So in a year, account grows by factor of ………………..….
So annual effective rate of return on account is ………..

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April 2000 3. Just calculate i

1 1.05833 1.05833^2 1.05833^12

Account pays 7% / 12 = 0.58333% each month

So every month, account grows by factor of 1.0058333
So in a year, account grows by factor of 1.005833^12 = 1.0723
So annual effective rate of return on account is 7.23%

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Sep 2002 3. Just calculate i

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Sep 2002 3 (i). Just calculate i

Account pays ……. each month

So every month, account grows by factor of …….
So in a year, account grows by factor of ……………..….
So annual effective rate of return on account is ………..

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Sep 2002 3 (i). Just calculate i

1 1.005 1.005^2 1.005^12

Account pays 0.5% each month

So every month, account grows by factor of 1.005
So in a year, account grows by factor of 1.005^12 = 1.0617.
So annual effective rate of return on account is 6.17%.

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Sep 2002 3 (ii). Just calculate i

Account pays 6% pa so 2 * ….. = ……. every two years

So every year account grows by factor f so that f * f = …….
So in a year, account grows by factor of ……………………...
So annual effective rate of return on account is ………..

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Sep 2002 3 (ii). Just calculate i

Account pays 6% pa so 2 * 6% = 12% every two years

So every year account grows by factor f so that f * f = 1.12
So in a year, account grows by factor of √1.12 = 1.0583
So annual effective rate of return on account is 5.83%

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April 2000 3(i)

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 April 2000 3(i)

Every month, account grows by factor of ……. (we’ve done it already)

So in six months, account pays …………...…..… per £1 invested.
So account pays 2 * …… per £1 invested per year = …….
So annual rate of interest convertible half yearly is ……..

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 April 2000 3(i)

1 1.05833 1.05833^6

Every month, account grows by factor of 1.05833

So in six months, account pays 1.05833^6 = 1.0355 per £1 invested.
So account pays 2 * 3.55% per £1 invested per year = 7.10%
So annual rate of interest convertible half yearly is 7.10%

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April 2000 3(i)

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Sep 2002 3

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 Sep 2002 3 (i)

Every month, account grows by factor of …….

So in a quarter, account grows by factor of ………………...….
So every quarter, accounts pays ……..…… per £1 invested.
So account pays 4 * …… per £1 invested per year = …….
So annual rate of interest convertible quarterly is ……..
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 Sep 2002 3 (i)

1 1.005 1.005^2 1.005^3

Every month, account grows by factor of 1.005

So in a quarter, account grows by factor of 1.005^3 = 1.01508
So every quarter, accounts pays 1.508% per £1 invested.
So account pays 4 * 1.508% per £1 invested per year = 6.03%
So annual rate of interest convertible quarterly is 6.03%
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Sep 2002 3

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 Sep 2002 3 (ii)

Account pays 2 * ….. = ……. every 2 years

There are ….. quarters in two years.
…
So every quarter account grows by factor f so that f^…. = …….
So in a quarter account pays ……..…… per £1 invested.
So account pays 4 * …… per £1 invested per year = …….
So annual rate of interest convertible quarterly is …….. 31
 Sep 2002 3 (ii)

Account pays 2 * 6% = 12% every 2 years

There are 8 quarters in two years.
…
So every quarter account grows by factor f so that f^8 = 1.12
So in a quarter account pays 1.12^(1/8) – 1 = 1.427% per £1 invested.
So account pays 4 * 1.427% per £1 invested per year = 5.71%
So annual rate of interest convertible quarterly is 5.71% 32
Sep 2002 3 (ii)

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Sep 2003 1

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 Sep 2003 1

Discount rate per 90 days is …… % * 90/365 = …..……

So to get 1 in 90 days you must pay 1 - …….. = ………. now.
Ie any investment grows by factor of 1 / ….… = ……. per 90 days.
So it grows by …….. ^ (1/90) = …….... each day, and grows by
factor of ….…..^365 = ………. each year.
So effective annual rate of interest is ……..
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 Sep 2003 1

0.98521 1

Discount rate per 90 days is 6% * 90/365 = 1.479%

So to get 1 in 90 days you must pay 1 – 1.479% = 0.98521 now.
Ie investment grows by factor of 1 / 0.98521 = 1.01501 per 90 days.
So it grows by 1.01501 ^ (1/90) = 1.0001656 each day, and grows
by factor of 1.0001656^365 = 1.0623 each year.
So effective annual rate of interest is 6.23%
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Sep 2003 1

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Sep 2000 2

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 Sep 2000 2

Discount rate per 90 days is …… % * 90/365 = …..……

So to get 1 in 90 days you must pay 1 - …….. = ………. now.
Ie any investment grows by factor of 1 / ….… = ……. per 90 days.
So it grows by …….. ^ (1/90) = …….... each day, and grows by
factor of ….…..^(365/2) = ………. each half year.
So in six months, account pays ……..…… per £1 invested.
So account pays 2 * …… per £1 invested per year = …….
So annual rate of interest convertible half yearly is …….. 39
 Sep 2000 2

0.9877 1

Discount rate per 90 days is 5% * 90/365 = 1.233%

So to get 1 in 90 days you must pay 1 – 1.233% = 0.9877 now.
Ie investment grows by factor of 1 / 0.9877= 1.01248 per 90 days.
So it grows by 1.01248^ (1/90) = 1.000138 each day, and grows by
factor of 1.000138 (365/2) = 1.02547 each half year.
So in six months, account pays 2.547% per £1 invested.
So account pays 2 * 2.547% per £1 invested per year = 5.095%.
So annual rate of interest convertible half yearly is 5.095% 40
Sep 2000 2

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Apr 2001 3(i)

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 Apr 2001 3(i)

Discount rate per quarter is …… % / 4 = …..……

So to get 1 in a quarter you must pay 1 - …….. = ………. now.
Ie any investment grows by factor of 1 / ….… = ……. per quarter.
There are …... quarters in half-a-year.
So each half-year investment grows by ……..^2 = ……….
So in six months, account pays ……..…… per £1 invested.
So account pays 2 * …… per £1 invested per year = …….
So annual rate of interest convertible half yearly is …….. 43
 Apr 2001 3(i)

0.98 1

Discount rate per quarter is 8% / 4 = 2%.

So to get 1 in a quarter you must pay 1 – 2% = 0.98 now.
Ie any investment grows by factor of 1 / 0.98 = 1.020408 per
quarter.
There are 2 quarters in half-a-year.
So each half-year investment grows by 1.020408^2 = 1.04123
So in six months, account pays 4.123% per £1 invested.
So account pays 2 * 4.123% per £1 invested per year = 8.247% 44
So annual rate of interest convertible half yearly is 8.247%
Apr 2001 3(i)

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Sep 2001 1

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 Sep 2001 1

This bill grows by ……… per year.

So it grows by factor of ……… ^(91/365) = ………. per 91 days.
So to have 1 after 91 days you need
1 / ……… = ………. now.
Ie you must pay 1 - …….% now to get 1 after 91 days.
ie discount rate per 91 days is ……..%
So discount rate per 365 days is ……. * 365/91 = …….% 47
 Sep 2001 1

0.98791 1

This bill grows by 1.05 per year.

So it grows by factor of 1.05^(91/365) = 1.012238 per 91 days.
So to have 1 after 91 days you need
1 / 1.012238 = 0.98791 now.
Ie you must pay 1 – 1.209% now to get 1 after 91 days.
ie discount rate per 91 days is 1.209%
So discount rate per 365 days is 1.209% * 365/91 = 4.849% 48
Sep 2001 1

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Apr 2001 3(ii)

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 Apr 2001 3(ii)

To get 1 in a quarter you must pay 1 - ……./4 = ………. now.

Ie any investment grows by factor of 1 / ….… = ……. per quarter.
There are …... months in a quarter.
So each month investment grows by …….^(1/3) = …….
So to have 1 after a month you need 1/ ………. now.
Ie you need 1 - …… % now to have 1 after a month.
Ie discount rate per month is ……..%
So discount rate pa (convertible monthly) is 12 * ……= …….% 51
 Apr 2001 3(ii)

0.98 1

To get 1 in a quarter you must pay 1 – 8%/4 = 0.98 now.

Ie any investment grows by factor of 1 / 0.98 = 1.02041 per quarter.
There are 3 months in a quarter.
So each month investment grows by 1.02041^(1/3) = 1.00676
So to have 1 after a month you need 1/ 1.00676 = 0.9933 now.
Ie you need 1 – 0.67% % now to have 1 after a month.
Ie discount rate per month is 0.67%
So discount rate pa (convertible monthly) is 12 * 0.67%= 8.05% 52
Apr 2001 3(ii)

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Specimen 11

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 Specimen 11

Deposit account pays ……. / 2 = ……% each six months

So every six months, deposit account grows by factor of …….
Equivalently, in 3 months, deposit account grows by factor of
…….^(3/6) = …………
So to get 1 in 3 months on deposit account (or on Bill) you need to
pay 1 / …….. = ………. = 1 - …… now.
So discount rate per 3 months is …. ie ….. * 4 = ……… % pa 55
 Specimen 11

Deposit account pays 4% / 2 = 2% each six months

So every six months, deposit account grows by factor of 1.02
Equivalently, in 3 months, deposit account grows by factor of
1.02^(3/6) = 1.00995.
So to get 1 in 3 months on deposit account (or on Bill) you need
to pay 1 / 1.00995 = 0.990148 = 1 – 0.9852% now.
Discount rate per 3 months is 0.9852% ie 0.9852% * 4
= 3.941% pa 56
Specimen 11

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April 2000 3(ii)

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 April 2000 3(ii)

Account pays …. / 12 = …….% each month

So every month, account grows by factor of …..….
So to get 1 in a month, you need 1 / ….. = …….. = 1 - ..…% now.
So discount rate per month is ……..% and discount rate pa
convertible monthly is 12 * …….% = ………..%
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 April 2000 3(ii)

0.9942 1

Account pays 7% / 12 = 0.58333% each month

So every month, account grows by factor of 1.005833
So to get 1 in a month, you need 1 / 1.005833 = 0.99420
= 1 -0.58% now.
So discount rate per month is 0.58% and discount rate pa
convertible monthly is 12 * 0.58% = 6.96%
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April 2000 3(ii)

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 Jargon for next session :
“total force of interest” (1)
If i is constant annual effective rate of interest, the accumulated
amount at time t is …………

So we need 1 / ……… now to have 1 at time t

so the present value of 1 payable at time t is …….……

Define δ as ln(1+i). So e δt = (1+i)^…..

δt is the “total force of interest” from time 0 to time t.

So e^(total force of interest) = accumulated amount at time t

And present value of 1 payable at time t is

….. ^-(total force of interest)
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 “total force of interest” (2)

If i is constant annual effective rate of interest, the accumulated

amount at time t is (1+i)^t

So we need 1 / (1+i)^t now to have 1 at time t

so the present value of 1 payable at time t is (1+i)^-t

Define δ as ln(1+i). So e δt = (1+i)^t

δt is the “total force of interest” from time 0 to time t.

So e^(total force of interest) = accumulated amount at time t

And present value of 1 payable at time t is

e ^-(total force of interest)
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 “total force of interest” (3)

E.g. (1) if i = 5%, then δ = ………….

After two years, 1 accumulates to (1 + … )^2 = e^(2 * ….)

= e^ (total force of interest)
E.g. (2) if δ = 20%, then i = ……….
and to pay 1 in three years time you need e^-(total force of interest)
= e^-(3 * …….)
= (1 + ……)^-3

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 “total force of interest” (4)

E.g. (1) if i = 5%, then δ = ln(1.05) = 4.88%

After two years, 1 accumulates to (1.05)^2 = e^(2 * 4.88%)

= e^ (total force of interest)
E.g. (2) if δ = 20%, then i = e^20% -1 = 22.14%
and to pay 1 in three years time you need e^-(total force of interest)
= e^-(3 * 20%)
= (1.2214)^-3

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END of session 1

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