Financial Mathematics

Lesson 8

Prof. María Jesús Segovia Vargas

1. Definitions
2. Static and dynamic study
3. Particular cases

2
When a sum of money will be needed at some future date, a good practice is to
accumulate systematically a fund that will equal the sum desired at the time it is
needed. Money accumulated in this way is called a sinking fund. Therefore, It is a
financial transaction used to accumulate an amount of money via periodic deposits.
Features: It is a compound financial transaction

◦ Payments: (a1 , t 0 ), (a2 , t1 ),....., (an , t n1 )

◦ Repayment: (Cn ,tn )

◦ The transaction schedule is the following. Note that the first payment is
normally made immediately (at point 0) Therefore, it is an annuity due.

a1 a2 a3 a4 as +1 an Cn
|--------|--------|--------|----------------|--------|--------|
t0 t1 t2 .... t3 .... ts .... tn-1 tn

As we can see this is the most general case, that is, the payments are different.

3
2.1. Static study

(Cn, tn ) is the financial capital in t n which verifies the equation of equivalence between
payments and the repayment of the transaction. This equivalence is calculated at the
end because it is easier but it is possible to calculate it at the beginning of the
transaction.
n n
◦ If the effective rates are variable: Cn   a  (1  i
r 1
r
hr
h )

◦ If the effective rate is constant:

n
Cn  ar 1
r (1  i ) n  ( r 1)
2.2. Dynamic study

Cs, the mathematical reserve of the sinking fund at ts, shows the amount of money
accumulated up to ts. It is calculated via the left hand side mathematical reserve.

The easiest way of calculating the reserve is using the retrospective method.
Therefore:

◦ If the effective rates are variable: s s

C s   ar  (1  ih )
r 1 hr

◦ If the effective rates are constant : is =i

s
C 
s  a
r 1
r (1  i ) s  ( r 1)
4
 ◦ The mathematical reserve in two consecutive time periods establishes
the following relationship:

Cs  (Cs1  as )(1  is )

Cs  Cs1  as  (Cs1  as )is   s  as  I s

If we analyze the last formula, we can study the features of a sinking fund:

 ∆s, (Increase in fund) which indicates an increase in the capital of the fund in
two consecutive periods
Cs  Cs1   s

 as: It is the periodic deposit (regular payment)

 Is, Interest income in the interval (ts-1,ts)

I s  (Cs1  as )is

5
Consequently:  s  as  I s

Besides, these three variables verify the following relationships:

◦ The arithmetical sum of all the increases in fund is equal to the

accumulated amount (Cn) at tn.
n
Cn    h
h 1
◦ The arithmetical sum of increases in fund up to ts, is equal to the
accumulated amount at this moment (accumulated balance in the fund)
, that is, the mathematical reserve at ts:
s
C    h

s
h 1

◦ The outstanding principal, (the amount awaiting constitution) is

calculated as the difference between :

Cn  C s  M s
n
Ms  
h  s 1
h 6
Graph of sinking fund schedule

7
The interest rates are constant, therefore is  i s

3.1.- Constant and periodic deposits, a,

a a a a a a Cn
|--------|--------|--------|----------------|--------|--------|
t0 t1 t2 .... t3 .... ts .... tn-1 tn

◦ Financial Equivalence: The future value at tn.

..
C n  a S n i
◦ Accumulated balance in the fund (amount in fund): Mathematical
reserve using retrospective method (the calculations are easier).
..
Cs  a S s i

8
 ◦ Calculating the mathematical reserve for two consecutive periods
(iterative method) , we see that the increase in fund growth forms a
geometric progression rate and the common ratio of this progression is
(1+i). Let´s see it:

C s  (C s 1  a )(1  i )
C s 1  (C s  a )(1  i )

If we calculate the difference between both equations, we will obtain:

Cs 1  Cs  (Cs  Cs 1 )(1  i )   s 1   s (1  i )  1 (1  i ) s

and 1  a (1  i )

9
Example 1

Mr. Smith wants to save € 100,000 over the next 10 years. How much money must be
deposited at the beginning of each year if the interest rate is i=10%?

Sinking fund schedule

10
3.2.- Constant Increase in fund

 s   s

In this case we have the following relationships

◦ Accumulated amount at tn:

n
C n    h  n
h 1

◦ Accumulated balance in fund at ts. Accumulated amount at ts

(mathematical reserve)

s
Cs    h  s 
h 1

◦ The outstanding principal, (the amount awaiting constitution) is:

n
Ms  
h  h 1
h  n  s 
11
 ◦ When the increases in fund are constant and the interest rates are
constant too, the deposits vary in arithmetical progression of common
difference i

1 i
that is, i
a s  a s 1 
1 i

Let´s see it:

Cs 1  Cs  (Cs  Cs 1 )(1  i )  (as 1  as )(1  i )

As the increases in fund are constant:

  (1  i )  (as 1  as )(1  i )

Then i i
as 1  as   a1  s
1 i 1 i


and a1 
1 i

12
Example 2: Solve example 1 but in this case we will consider that the increases in fund
are constant rather than the deposits.

Sinking fund schedule with constant increase in fund

Is as A Cs Ms
0
1 909.091 9.090.909 10.000.000 10.000.000 90.000.000
2 1.818.182 8.181.818 10.000.000 20.000.000 80.000.000
3 2.727.273 7.272.727 10.000.000 30.000.000 70.000.000
4 3.636.364 6.363.636 10.000.000 40.000.000 60.000.000
5 4.545.455 5.454.545 10.000.000 50.000.000 50.000.000
6 5.454.545 4.545.455 10.000.000 60.000.000 40.000.000
7 6.363.636 3.636.364 10.000.000 70.000.000 30.000.000
8 7.272.727 2.727.273 10.000.000 80.000.000 20.000.000
9 8.181.818 1.818.182 10.000.000 90.000.000 10.000.000
10 9.090.909 909.091 10.000.000 100.000.000 0

razon progresion -909.090,91

13