Financial Mathematics. Unit 1.

Fundamentals

UNIT 1: FUNDAMENTALS

1.1 Introduction
In any financial transaction, someone (lender) lends a sum of money to someone else
(borrower) for a specific period of time. The party that receives the money must pay
back the sum of money originally borrowed together with a reward paid for the use of
money. In this sense, interest may be defined as the compensation that the borrower of
capital pays to a lender of capital for its use.
A financial transaction can be defined as a non-simultaneous exchange of amounts of
money between two parties in accordance with a given interest rule mutually agreed.
The party that lays out the first amount of money is called the lender, and the party that
receives the first amount of money is called the borrower.
The lender, who makes the initial payment (and possibly other payments in the future),
will receive one or more sums of money in return. Thus, there are two types of cash
flows associated with a financial transaction. Cash outflows are payments made, outlays
or expenditures. Cash inflows are receipts, incomes or revenues. We will consider that
the party who lays out the cash flow stream that includes the first payment lends funds
to the other party, who borrows those funds and agrees to lay out money to meet his/her
interest and principal repayment obligations.
The fee charged for the use of money is called the interest. It can be defined as the
amount measured in the monetary units of a currency that must be paid for the use of
money borrowed from another for a given period of time. Therefore, it can be
considered as the cost of borrowed money.
The amount paid will depend on both the sum of money originally borrowed, called the
principal, and the period of time, or the term, of the loan.
Any interest transaction can be described by the rate of interest, which is the ratio,
usually in per cent, of the interest charged to the principal in one time unit. Note that a
rate of interest always refers to a given time measurement period.
Example 1: Suppose that a sum of money is deposited in a bank for a term of 1 year. The amount you get
at the end of the period is given by the amount originally deposited together with the interest due. If you
deposited EUR 1,000 at an annual interest rate of 10%, the final accumulated value amounts to:

Accumulated value

= Principal + Interest
= 1,000 + 0.11,000
= 1,000 (1+0.1)
= 1,100

One of the key ideas in Finance is that money has time value because of the
opportunities for investing money at some interest rate. In other words, an amount of
money invested today for a given term increases, or accumulates value, as a
consequence of the (positive) interest. From the point of view of the other party, also the
debt increases, for the same reason.

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Financial Mathematics. Unit 1. Fundamentals

Hence, one of the most important facts of the financial mathematics is that it deals with
dated values. In other words, in a financial transaction involving money due on
different dates, every sum of money should have an attached date, the date on which it
falls due. Formally, we can define a dated amount of money as a pair (C;t), which
stands for a given amount of money, C, payable at a certain time t. We will usually
prefer the compact notation Ct, so the later is the one that will be used in the lectures.
Therefore, every transaction involving money and time must consider the time value of
money. In order to compare or add different pieces of money we must place the monies
at the same point in time, called the focal date. This will require us to move money on
the time line, either forward into the future or backward into the past. Important
formulas have been developed to move money so it can be compared or added. We will
give particular attention to those formulas in this unit.

1.2. Financial rules

Interest must be paid for the use of money for a certain period of time. How can it be
calculated?
There are two rules or criteria (that is, two formulae) to calculate the interest, commonly
found in practice. The simple interest rule, mainly used in short-term transactions, and
the compound interest rule. In brief, simple interest is calculated (and paid) only on the
original principal, and compound interest is interest calculated on the original principal
plus accrued interest.
There are also other financial transactions that are conceived as the prepayment of an
amount due on a later date. Obviously, an amount, called the discount, is calculated
over the final amount that must be paid on the due date and deducted from it. How do
we calculate this amount? In this case we use the simple discount rule.
In practice, the simple interest rule is only used in short-term transactions while the
compound interest rule is used in both short and long term transactions. The simple
discount rule is only used in a single financial transaction called discounting of
commercial paper. Therefore, the interest rules, and especially the compound interest
rule, regulate virtually all financial transactions. In this first unit both the simple interest
rule and the simple discount rule are analyzed. The following unites will focus on the
compound interest rule.
1.2.1 Simple interest
Under a simple interest rule, the principal accumulates interest proportional to the total
time of the transaction. So, after n units of time, the total interest due is in times the
principal, where i is the (simple) interest rate per time unit. In other words, the principal
produces interest equal to i times the original amount every unit of time.
Terminology and notation:
C0: the principal. It is due on date t0, say, the present time.

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Financial Mathematics. Unit 1. Fundamentals

I : the (simple) interest. It is due and payable at the end of the transaction term, tn, where
tn > t0.
n = tn t0. Term of the transaction. It is a non-negative number that indicates the
number (including fractions) of time units (or measurement periods) in which time is
measured.
i: the (simple) interest rate per time unit (per measurement period). Remember that the
rate of interest refers to the same time unit used to measure the term. We will take it to
be greater than zero.
Cn = C0 + I : the future value or accumulated value. It is the sum of principal and
interest. It is due at time tn.
In general:
I = C0 i n
And the amount to be received at the end of the term is given by:
C n = C 0 + I = C 0 + C 0 i n = C 0 (1 + i n )
The future value (simple interest) factor (1 + i n ) is frequently called an accumulation
factor at simple interest, and the process of calculating C n from C 0 via the above
equation is called accumulation at simple interest. Accordingly, the future value C n is
also called the accumulated value of C 0 , or the maturity value of C 0 , or simply the
final amount.
Example 2: Suppose that a single deposit of EUR 1,000 for 3 years is made in a bank which pays simple
interest at the rate of 4% per annum. Find the interest earned, and the amount finally withdrawn from the
bank.

Fractions of the time unit of reference. Usually, the parameter i is an interest rate
expressed in annual basis, and accordingly the term n must be expressed in years. When
the time is given in semesters, then n = (number of semesters / 2); when the time is
given in months, then n = (number of months / 12); and when the time is given in days,
then n = (number of days / 365). In general, we can write
k

C n = C 0 1 + i
m

where we have divided one year in m smaller periods (m is a positive integer), each of a
fraction 1/m of a year in length (m = 2 semesters, m = 4 quarters, m = 12 months, m =
365 days, ) and k is the number of such smaller periods included between times t0 and
tn. That is, the proportional rule holds for fractional terms (n k m ) .

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Example 3. Suppose that EUR 5,000 is deposited in a bank which pays simple interest at an annual rate
of 4%. Which will be the final amount withdrawn if the money is deposited for a period of 180 days? And
for a period of 3 months?

1.2.2 Simple discount

Some short-term (loan) transactions are conceived as the prepayment of an amount due
on a later date. Accordingly, in practice such loans are referred to by their maturity
value. Also, the charge for the use of money is based on the final amount rather than on
the present value. An amount, called the discount, is calculated over the final amount
that must be paid on the due date and deducted from it; the borrower receives the
difference.
Example 4: During the period for filing the annual individual income tax statement, many financial
institutions act as tax refund discounters. They offer cash to the taxpayer, who will sign over to them the
full income tax refund when it is returned by the Agencia Tributaria (Revenue Agency). The cash offered
is less than the full refund. It is the discounted value of the full refund.

A common practice is to calculate the so-called simple discount at a discount rate,

also called bank discount, or commercial discount. In this case, the amount to be
deducted is proportional to the size of the maturity value and the length of the discount
period.
Example 5: An employee asks for the advance of his Christmas bonus, which amounts to EUR1,000 due
in two months time, to his employer. The employer agrees to pay him the Christmas bonus beforehand, at
a discount rate of 0.50% per month. This means that the employee receives the discounted value, or
proceeds, of EUR1,000 given by

Discounted value

= Final amount Discount

= 1,000 (1,000 0.005 2)
= 1,000 [1 (0.005 2)]
= 990

Terminology and notation:

Cn : the final amount on which the discount is made, or maturity value. It is due on
date tn.
D: the (simple) discount, or bank discount. It is due and payable at the beginning of the
discount period, t0 < tn.
n = tn t0 : term of the transaction, or discount period. It is a non-negative number that
indicates the number (including fractions) of time units (or measurement periods) in
which time is measured.
d: the (simple) rate of discount per time unit. Remember that the rate of discount refers
to the same time unit used to measure the discount period. We will take it to be positive.
C0 = Cn D : the present value. It is due at time t0.
In general:

D = Cn d n

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Financial Mathematics. Unit 1. Fundamentals

and the amount received at the start is given by

C 0 = C n D = C n C n d n = C n [1 d n]
The present value factor [1 d n] is frequently called as discount factor at simple
discount, and the process of calculating the present value C0 from Cn via the above
equation is called discounting at simple discount. Accordingly, C0 is also called the
discounted value of Cn, or the present value of Cn, or simply the proceeds.
Fractions of the time unit of reference. Usually, the parameter d is an annual discount
rate, and accordingly the term n must be expressed in years. When the time is given in
semesters, then n = (number of semesters / 2); when the time is given in months, then n
= (number of months / 12); and when the time is given in days, then n = (number of
days / 365). In general,
C 0 = C n [1 d k / m]
where we have divided one year in m smaller periods (m is a positive integer), each of a
fraction 1/m of a year in length (m = 2 semesters, m = 4 quarters, m = 12 months, m =
365 days, ) and k is the number of such smaller periods included between times t0 and
tn .

Example 6: Find the present value at annual 6% simple discount of EUR6,000 due in 90 days. In 6
months?

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