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Discounting PDF
Discounting PDF
Discounting PDF
Discrete compounding
Continuous compounding
Imagine now that compounding occurs n time a year. By continuous compounding, we then mean that interest is compounded instantaneously, i.e.
n +. Thus, if someone has X dollars to invest currently at an annual interest rate r with compounding n times a year, the amount of money
received at the end of t years would be V = X (1 + r/n)n t . Thus the appropriate discount formula for finding the present value P Vt of a future amount
V when discounting occurs n time per year is:
V
P Vt =
n t
1 + nr
Lemma 1 We have:
1 s
1+
=e
s+
s
lim
(2)
Proof. Let us first remind the LHpital rule. Suppose that f and g
are continuous and dierentiable functions, on an open interval containing
x = a, except possibly at x = a, and that
lim f (x) = + and lim g(x) = +
xa
Then, if limxa
f 0 (x)
g 0 (x)
xa
1 s
= lim (1 + w)1/w
lim 1 +
s+
w0
s
Now let us introduce a dependent variable
y = (1 + w)1/w
If we take the logarithm of both sides of (3), we have:
i
h
log y = log (1 + w)1/w
=
1
log (1 + w)
w
log (1 + w)
w
Thus,
log (1 + w)
w0
w
w0
(3)
1 s
= lim (1 + w)1/w = e
lim 1 +
s+
w0
s
Lemma 2 We have:
r n t
= ert
1+
n+
n
lim
r n t
1+
n+
n
lim
First, introduce a new variable s n/r. Then r/n = 1/s and n = s r. Upon
substituting these values for r/n and n into the formula above, and noting
that as n + so does s +, we have:
r t
1 srt
1 s
r n t
1+
= lim 1 +
= lim
lim 1 +
n+
s+
s+
n
s
s
Ignoring for a moment the term r t, we see from Lemma 1 that:
1 s
lim 1 +
=e
s+
s
It follows that
r t
1 s
lim
1+
= ert
s+
s