CHAPTER 1

Introduction

1.1 THE CONCEPT OF INTEREST CONTENTS

Interest may be regarded as a reward paid by one person or organization (the 1.1 The Concept of
borrower) for the use of an asset, referred to as capital, belonging to Interest ..........1
another person or organization (the lender). The precise conditions of any 1.2 Simple
transaction will be mutually agreed. For example, after a stated period of time, Interest ..........2
the capital may be returned to the lender with the interest due. Alternatively, 1.3 Compound
several interest payments may be made before the borrower finally returns the Interest ..........4
asset.
1.4 Some Practical
Capital and interest need not be measured in terms of the same commodity, but Illustrations ...6
throughout this book, which relates primarily to problems of a financial nature, Summary ..............9
we shall assume that both are measured in the monetary units of a given currency.
When expressed in monetary terms, capital is also referred to as principal.
If there is some risk of default (i.e., loss of capital or non-payment of interest),
a lender would expect to be paid a higher rate of interest than would otherwise
be the case; this additional interest is known as the risk premium. The additional
interest in such a situation may be considered as a further reward for the
lender’s acceptance of the increased risk. For example, a person who uses his
money to finance the drilling for oil in a previously unexplored region would
expect a relatively high return on his investment if the drilling is successful, but
might have to accept the loss of his capital if no oil were to be found. A further
factor that may influence the rate of interest on any transaction is an allowance
for the possible depreciation or appreciation in the value of the currency in
which the transaction is carried out. This factor is obviously very important in
times of high inflation.
It is convenient to describe the operation of interest within the familiar context
of a savings account, held in a bank, building society, or other similar orga-
nization. An investor who had opened such an account some time ago with an
initial deposit of £100, and who had made no other payments to or from the
account, would expect to withdraw more than £100 if he were now to close the
account. Suppose, for example, that he receives £106 on closing his account. 1
An Introduction to the Mathematics of Finance. http://dx.doi.org/10.1016/B978-0-08-098240-3.00001-1
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2 CHAPTER 1: Introduction

This sum may be regarded as consisting of £100 as the return of the initial
deposit and £6 as interest. The interest is a payment by the bank to the investor
for the use of his capital over the duration of the account.
The most elementary concept is that of simple interest. This naturally leads to
the idea of compound interest, which is much more commonly found in
practice in relation to all but short-term investments. Both concepts are easily
described within the framework of a savings account, as described in the
following sections.

1.2 SIMPLE INTEREST

Suppose that an investor opens a savings account, which pays simple interest at
the rate of 9% per annum, with a single deposit of £100. The account will be
credited with £9 of interest for each complete year the money remains on
deposit. If the account is closed after 1 year, the investor will receive £109; if the
account is closed after 2 years, he will receive £118, and so on. This may be
summarized more generally as follows.
If an amount C is deposited in an account that pays simple interest at the rate of
i per annum and the account is closed after n years (there being no intervening
payments to or from the account), then the amount paid to the investor when
the account is closed will be
Cð1 þ niÞ (1.2.1)
This payment consists of a return of the initial deposit C, together with interest
of amount
niC (1.2.2)
In our discussion so far, we have implicitly assumed that, in each of these last
two expressions, n is an integer. However, the normal commercial practice in
relation to fractional periods of a year is to pay interest on a pro rata basis, so
that Eqs 1.2.1 and 1.2.2 may be considered as applying for all non-negative
values of n.
Note that if the annual rate of interest is 12%, then i ¼ 0.12 per annum; if the
annual rate of interest is 9%, then i ¼ 0.09 per annum; and so on.
Note that in the solution to Example 1.2.1, we have assumed that 6 months
and 10 months are periods of 1/2 and 10/12 of 1 year, respectively. For
accounts of duration less than 1 year, it is usual to allow for the actual
number of days an account is held, so, for example, two 6-month periods are
not necessarily regarded as being of equal length. In this case Eq. 1.2.1
becomes
 1.2 Simple Interest 3

EXAMPLE 1.2.1
Suppose that £860 is deposited in a savings account that 1 in Eq. 1.2.1 with C ¼ 860 and i ¼ 0.05375, we obtain the
pays simple interest at the rate of 5:375% per annum. answers
Assuming that there are no subsequent payments to or
(a) £883.11,
from the account, find the amount finally withdrawn if the
(b) £898.52,
account is closed after
(c) £906.23.
(a) 6 months,
In each case we have given the answer to two decimal places
(b) 10 months,
of one pound, rounded down. This is quite common in
(c) 1 year.
commercial practice.
Solution
The interest rate is given as a per annum value; therefore, n
must be measured in years. By letting n ¼ 6/12, 10/12, and

EXAMPLE 1.2.2
 
30
Calculate the price of a 30-day £2,000 treasury bill issued £2; 000 1   0:05 ¼ £1; 991:78
365
by the government at a simple rate of discount of 5% per
annum. The investor has received interest of £8.22 under this
Solution transaction.
By issuing the treasury bill, the government is borrowing an
amount equal to the price of the bill. In return, it pays £2,000
after 30 days. The price is given by

 
mi
C 1þ (1.2.3)
365
where m is the duration of the account, measured in days, and i is the annual
rate of interest.
The essential feature of simple interest, as expressed algebraically by Eq. 1.2.1,
is that interest, once credited to an account, does not itself earn further interest.
This leads to inconsistencies that are avoided by the application of compound
interest theory, as discussed in Section 1.3.
As a result of these inconsistencies, simple interest has limited practical use, and
this book will, necessarily, focus on compound interest. However, an impor-
tant commercial application of simple interest is simple discount, which is
commonly used for short-term loan transactions, i.e., up to 1 year. Under
4 CHAPTER 1: Introduction

simple discount, the amount lent is determined by subtracting a discount from

the amount due at the later date. If a lender bases his short-term transactions on
a simple rate of discount d, then, in return for a repayment of X after a period t
(typically t < 1), he will lend X(1  td) at the start of the period. In this situa-
tion, d is also known as a rate of commercial discount.

1.3 COMPOUND INTEREST

Suppose now that a certain type of savings account pays simple interest at the
rate of i per annum. Suppose further that this rate is guaranteed to apply
throughout the next 2 years and that accounts may be opened and closed at any
time. Consider an investor who opens an account at the present time (t ¼ 0)
with an initial deposit of C. The investor may close this account after 1 year
(t ¼ 1), at which time he will withdraw C(1 þ i) (see Eq. 1.2.1). He may then
place this sum on deposit in a new account and close this second account after
one further year (t ¼ 2). When this latter account is closed, the sum withdrawn
(again see Eq. 1.2.1) will be

½Cð1 þ iÞ  ð1 þ iÞ ¼ Cð1 þ iÞ2 ¼ Cð1 þ 2i þ i2 Þ

If, however, the investor chooses not to switch accounts after 1 year and leaves his
money in the original account, on closing this account after 2 years, he will receive
C(1 þ 2i). Therefore, simply by switching accounts in the middle of the 2-year
period, the investor will receive an additional amount i2C at the end of the
period. This extra payment is, of course, equal to i(iC) and arises as interest paid
(at t ¼ 2) on the interest credited to the original account at the end of the first year.
From a practical viewpoint, it would be difficult to prevent an investor
switching accounts in the manner described here (or with even greater
frequency). Furthermore, the investor, having closed his second account after
1 year, could then deposit the entire amount withdrawn in yet another account.
Any bank would find it administratively very inconvenient to have to keep
opening and closing accounts in the manner just described. Moreover, on
closing one account, the investor might choose to deposit his money elsewhere.
Therefore, partly to encourage long-term investment and partly for other
practical reasons, it is common commercial practice (at least in relation to
investments of duration greater than 1 year) to pay compound interest on
savings accounts. Moreover, the concepts of compound interest are used in
the assessment and evaluation of investments as discussed throughout this
book.
The essential feature of compound interest is that interest itself earns interest. The
operation of compound interest may be described as follows: consider
a savings account, which pays compound interest at rate i per annum, into
 1.3 Compound Interest 5

which is placed an initial deposit C at time t ¼ 0. (We assume that there are no
further payments to or from the account.) If the account is closed after 1 year
(t ¼ 1) the investor will receive C(1 þ i). More generally, let An be the amount
that will be received by the investor if he closes the account after n years (t ¼ n).
It is clear that A1 ¼ C(1 þ i). By definition, the amount received by the investor
on closing the account at the end of any year is equal to the amount he would
have received if he had closed the account 1 year previously plus further interest
of i times this amount. The interest credited to the account up to the start of the
final year itself earns interest (at rate i per annum) over the final year. Expressed
algebraically, this definition becomes
Anþ1 ¼ An þ iAn

or
Anþ1 ¼ ð1 þ iÞAn n1 (1.3.1)

Since, by definition, A1 ¼ C(1 þ i), Eq.1.3.1 implies that, for n ¼ 1, 2, . . . ,

An ¼ Cð1 þ iÞn (1.3.2)
Therefore, if the investor closes the account after n years, he will receive
Cð1 þ iÞn (1.3.3)
This payment consists of a return of the initial deposit C, together with accu-
mulated interest (i.e., interest which, if n > 1, has itself earned further interest)
of amount
C½ð1 þ iÞn  1 (1.3.4)
In our discussion so far, we have assumed that in both these last expressions n is
an integer. However, in Chapter 2 we will widen the discussion and show that,
under very general conditions, Eqs 1.3.3 and 1.3.4 remain valid for all non-
negative values of n.
Since

½Cð1 þ iÞt1 ð1 þ iÞt2 ¼ Cð1 þ iÞt1 þt2

an investor who is able to switch his money between two accounts, both of
which pay compound interest at the same rate, is not able to profit by such
action. This is in contrast with the somewhat anomalous situation, described at
the beginning of this section, which may occur if simple interest is paid.
Equations 1.3.3 and 1.3.4 should be compared with the corresponding
expressions under the operation of simple interest (i.e., Eqs 1.2.1 and 1.2.2). If
interest compounds (i.e., earns further interest), the effect on the accumulation of
an account can be very significant, especially if the duration of the account or
6 CHAPTER 1: Introduction

EXAMPLE 1.3.1
Suppose that £100 is deposited in a savings account.
Construct a table to show the accumulated amount of the
account after 5, 10, 20, and 40 years on the assumption
that compound interest is paid at the rate of
(a) 4% per annum,
(b) 8% per annum.
Give also the corresponding figures on the assumption that
only simple interest is paid at the same rate.
Solution
From Eqs 1.2.1 and 1.3.3 we obtain the following values. The
reader should verify the figures by direct calculation and also
by the use of standard compound interest tables.

Annual Rate of Interest 4% Annual Rate of Interest 8%

Term
(Years) Simple Compound Simple Compound
5 £120 £121.67 £140 £146.93
10 £140 £148.02 £180 £215.89
20 £180 £219.11 £260 £466.10
40 £260 £480.10 £420 £2,172.45

the rate of interest is great. This is revisited mathematically in Section 2.1, but is
illustrated by Example 1.3.1.
Note that in Example 1.3.1, compound interest over 40 years at 8% per annum
accumulates to more than five times the amount of the corresponding account
with simple interest. The exponential growth of money under compound
interest and its linear growth under simple interest are illustrated in Figure 1.3.1
for the case when i ¼ 0.08.
As we have already indicated, compound interest is used in the assessment and
evaluation of investments. In the final section of this chapter, we describe
briefly several kinds of situations that can typically arise in practice. The
analyses of these types of problems are among those discussed later in this
book.

1.4 SOME PRACTICAL ILLUSTRATIONS

As a simple illustration, consider an investor who is offered a contract with
a financial institution that provides £22,500 at the end of 10 years in return for
a single payment of £10,000 now. If the investor is willing to tie up this amount
of capital for 10 years, the decision as to whether or not he enters into the
contract will depend upon the alternative investments available. For example, if
the investor can obtain elsewhere a guaranteed compound rate of interest for
the next 10 years of 10% per annum, then he should not enter into the contract
 1.4 Some Practical Illustrations 7

FIGURE 1.3.1
Accumulation of £100 with interest at 8% per annum

as, from Eq. 1.3.3, £10,000  (1 þ 10%)10¼ £25,937.42, which is greater than
£22,500.
However, if he can obtain this rate of interest with certainty only for the next 6
years, in deciding whether or not to enter into the contract, he will have to make
a judgment about the rates of interest he is likely to be able to obtain over the
4-year period commencing 6 years from now. (Note that in these illustrations
we ignore further possible complications, such as the effect of taxation or the
reliability of the company offering the contract.)
Similar considerations would apply in relation to a contract which offered to
provide a specified lump sum at the end of a given period in return for the
payment of a series of premiums of stated (and often constant) amount at regular
intervals throughout the period. Would an investor favorably consider a contract
that provides £3,500 tax free at the end of 10 years in return for ten annual
premiums, each of £200, payable at the start of each year? This question can be
answered by considering the growth of each individual premium to the end of
8 CHAPTER 1: Introduction

the 10-year term under a particular rate of compound interest available to him
elsewhere and comparing the resulting value to £3,500. However, a more elegant
approach is related to the concept of annuities as introduced in Chapter 3.
As a further example, consider a business venture, requiring an initial outlay of
£500,000, which will provide a return of £550,000 after 5 years and £480,000
after a further 3 years (both these sums are paid free of tax). An investor with
£500,000 of spare cash might compare this opportunity with other available
investments of a similar term. An investor who had no spare cash might
consider financing the venture by borrowing the initial outlay from a bank.
Whether or not he should do so depends upon the rate of interest charged for
the loan. If the rate charged is more than a particular “critical” value, it will not
be profitable to finance the investment in this way.
Another practical illustration of compound interest is provided by mortgage
loans, i.e., loans that are made for the specific purpose of buying property which
then acts as security for the loan. Suppose, for example, that a person wishes to
borrow £200,000 for the purchase of a house with the intention of repaying the
loan by regular periodic payments of a fixed amount over 25 years. What
should be the amount of each regular repayment? Obviously, this amount will
depend on both the rate of interest charged by the lender and the precise
frequency of the repayments (monthly, half-yearly, annually, etc.). It should
also be noted that, under modern conditions in the UK, most lenders would be
unwilling to quote a fixed rate of interest for such a long period. During the
course of such a loan, the rate of interest might well be revised several times
(according to market conditions), and on each revision there would be a cor-
responding change in either the amount of the borrower’s regular repayment or
in the outstanding term of the loan. Compound interest techniques enable the
revised amount of the repayment or the new outstanding term to be found in
such cases. Loan repayments are considered in detail in Chapter 5.
One of the most important applications of compound interest lies in the
analysis and evaluation of investments, particularly fixed-interest securities. For
example, assume that any one of the following series of payments may be
purchased for £1,000 by an investor who is not liable to tax:
(i) Income of £120 per annum payable in arrears at yearly intervals for
8 years, together with a payment of £1,000 at the end of 8 years;
(ii) Income of £90 per annum payable in arrears at yearly intervals for 8 years,
together with a payment of £1,300 at the end of 8 years;
(iii) A series of eight payments, each of amount £180, payable annually in
arrears.
The first two of the preceding may be considered as typical fixed-interest
securities. The third is generally known as a level annuity (or, more precisely,
 Summary 9

a level annuity certain, as the payment timings and amounts are known in
advance), payable for 8 years, in this case. In an obvious sense, the yield (or
return) on the first investment is 12% per annum. Each year the investor
receives an income of 12% of his outlay until such time as this outlay is repaid.
However, it is less clear what is meant by the yield on the second or third
investments. For the second investment, the annual income is 9% of the
purchase price, but the final payment after 8 years exceeds the purchase price.
Intuitively, therefore, one would consider the second investment as providing
a yield greater than 9% per annum. How much greater? Does the yield on the
second investment exceed that on the first? Furthermore, what is the yield on
the third investment? Is the investment with the highest yield likely to be the
most profitable? The appraisal of investment and project opportunities is
considered in Chapter 6 and fixed-interest investments in particular are
considered in detail in Chapters 7 and 8.
In addition to considering the theoretical analysis and numerous practical
applications of compound interest, this book provides an introduction to
derivative pricing in Chapters 10 and 11. In particular, we will demonstrate that
compound interest plays a crucial role at the very heart of modern financial
mathematics. Furthermore, despite this book having a clear focus on deter-
ministic techniques, we end with a description of stochastic modeling techniques
in Chapter 12.

SUMMARY
n Interest is the reward paid by the borrower for the use of money, referred to
as capital or principal, belonging to the lender.
n Under the action of simple interest, interest is paid only on the principal
amount and previously earned interest does not earn interest itself. A
principal amount of C invested under simple interest at a rate of i per
annum for n years will accumulate to
Cð1 þ inÞ

n Under the action of compound interest, interest is paid on previously earned

interest. A principal amount of C invested under compound interest at a rate
of i per annum for years will accumulate to
Cð1 þ iÞn
n Compound interest is used in practice for all but very short-term
investments.