Financial Mathematics

Lesson 6

Prof. María Jesús Segovia Vargas

1. Simple Financial Transactions
1. Financial Equivalence (Static Analysis)
2. Mathematical Reserve (Dynamic Analysis)
3. Financial Value of the transaction in τ

2. Analysis of Financial Transactions

1. Commercial Simple Discount
2. Simple Interest
3. Relationship between simple discount and interest
rates, d and i
4. Compound Interest

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A financial transaction is simple if |P|=|R|=1 (that is, each party makes only one
capital contribution). For example, Treasury bills (T-Bills), bank discount are simple
transactions.

Their features are:

Payments: P={(C0,t0)}

Repayments: RP={(Cn,tn)}

We will value them with a financial law F(t,p)

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1.- Financial Equivalence (static study/analysis)

It can be calculated at t0 (at the beginning of the transaction) or at tn (at the end of the
transaction).
 C0 , t0    Cn , tn   C0 F  t0 , p   Cn F  tn , p   V0  Vn

 F  t0 , p 
 0
in t  C  C
F t n , p 
n 0

C0 F  t 0 , p   C n F  t n , p  
in t  C  C F  tn , p 
 n 0 n
F  t0 , p 


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2.- Mathematical Reserve (dynamic study/analysis)

It is calculated at an intermediate point of the transaction, τ.

a) Retrospective method and iterative method (in this kind of transaction they
coincide).

 F  t0 , p 
 R  C0

 F  , p 

b) Prospective method

 F  tn , p 
 R  Cn

 F  , p 

3.- Financial value of the transaction in τ

In this case the new market conditions are reflected in a new financial law F’(t,p)
(different from the original one F(t,p)).


 F '  tn , p 
V  Cn  V  R

 F '  , p 
Vτ can be higher or, on the contrary, lower depending on the relationship between F
and F’.

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 Mathematical Reserve: F(t,p)
 Financial Value: F´(t,p)
Cn

CT

C0

0 T n

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  Simple Financial Operations.
◦ Financial instruments with simple interest.
 Treasury Bills: 3,6 and 12 months
◦ Financial instruments with compound interest.
 Treasury Bills 18 months
◦ Financial instruments with simple discount
 Commercial papers (notes).

Simple financial transactions are normally short-term and they are normally valued
with simple discount, simple interest or compound interest.
The most common ones are:

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 Commercial Simple Discount

In this type of transaction the financial law is a commercial simple

discount law.

A(t,p)=1-d(t-p) with t<p (t is less than p)

Let’s study the finance equivalence in t0 (this is the common practice).

Payments: P={(C0,t0}

Repayments: RP={(Cn,tn}

1 − d(t n − p)
C0 = Cn
1 − d(t 0 − p)

Normally the point p is situated at t 0, that is, at the beginning of the

transaction, therefore if t0=p

C0 = Cn 1 − d t n − t 0 = Cn − Cn (t n − t 0 )

The difference between tn and t0 can be expressed in days, months, etc. It

is denoted by n.

But it is important that the parameter d has to be expressed in the same

time units as the difference between t n and t0, that is, n.

If d is expressed in years and n is expressed in days, we have the following

expression:
n n
C0 = Cn 1 − d = Cn − Cn d = Cn − D
360 360
D is the discount.

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We can use the number of days of the commercial year (360 days) or the exact ones.

This equation is applied in the bank discount, and they are the discounted bills.
Normally, banks refer to C0 as E (cash) and to Cn as N (Face value). Therefore,

(E, t0) and (N,tn)

n n
E= N 1−d =N−N d =N−D
360 360
Commercial simple discount is also applied in T-Bills, promissory notes issued by large
companies.

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Simple interest

The financial law is

L(t,p) =1+i(p-t) p>t (p is greater than t)

Let’s study the finance equivalence in tn (this is the common practice).

(C0,t0)

(Cn,tn)

1 + i(p − t 0 )
Cn = C0
1 + i(p − t n )

Normally point p is situated at t n, that is, at the end of the transaction, therefore if t n=p
we can write the following expression:

Cn = C0 1 + i t n − t 0 = C0 + C0 i t n − t 0 = C0 + I

The difference between tn and t0 can be expressed in days, months, etc. It is denoted
by n.

But it is important that the parameter i has to be expressed in the same time units as
the difference between tn and t0, that is, n.

If i is expressed in years and n is expressed in days, we have the following expression:

n n
Cn = C0 1 + i = C0 + C0 i = C0 + I
360 360
I: Interests

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Relationship between simple discount and interest rates, d and i.

As we have seen, the majority of the transactions are very frequently valued with
simple or compound interest. Even, the simple discount ones are also valued with
simple interest. Therefore, the cost or the yield of the transaction is normally
calculated and expressed using simple/compound interest.

Consequently, it is necessary to compare simple discount rate (d) with simple interest
rate (i) in order to establish a relationship between them.

We have already studied these equations:

n
Cn = C0 1 + i
360
n
C0 = Cn 1 − d
360

Therefore, we have two financial capitals valued with simple and discount interest and
in both cases the transaction has the same lifespan (n).

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Therefore we can solve this equation simple:
n n
C0 = C0 1 + i 1−d
360 360
Where:

𝑑 𝑖
𝑖= 𝑑=
𝑑𝑛 𝑖𝑛
1 − 360 1 + 360

These relationships allow us to compare the cost or the yield of a transaction

expressed with a parameter d (simple discount) by expressing it in simple interest.

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 Average interest rate calculation:
The return calculation is the following one:

 T-Bills with t≤ 376 days

QUOTATION ( 1 + t * i / 360) =N

where:
Quotation: purchase prize
t: number of days from the issue date to the maturity date,
i: interest rate
N: face vale. It is 1.000 €. If we want to express the prize
in percentage, it is necessary to put 100 €

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 T-Bills with t >376 days (18 months).

t
QUOTATION (1  i ) 360 N

360
 N  t
i  1
 quot . 

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Resultados de la última subasta de Letras a 12 meses

Fecha de la subasta: 17/09/2013

Maturity
Fecha de vencimiento: 19/09/2014 Date

Importe en millones de Euros

LETRAS A 12 MESES
Fecha de liquidación 20/09/2013 Account date
Nominal solicitado 5.764,09
Nominal adjudicado 3.120,28
Nominal adjudicado (2ª vuelta) 636,41
Precio mínimo aceptado 98,614
Tipo de interés marginal 1,390
Precio medio 98,637 Average Prize
Tipo de interés medio 1,367 Average interest rate
Adjudicado al marginal 405,00
1er precio no admitido 98,610
Volumen peticiones a ese precio 80,00
Peticiones no competitivas 65,28
Efectivo solicitado 5.680,85
Efectivo adjudicado 3.077,51
Efectivo adjudicado (2ª vuelta) 627,73
Porcentaje de prorrateo
Ratio de cobertura 1,85

Anterior tipo marginal 1,278

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 Average interest rate calculation:
◦ Account date of the auction:20.09.2013
◦ Maturity date:19.09.2014
◦ Number of days: 364 days
◦ Average Prize: 98,637
364
98.637 (1  i )  100  i  1.367%
360

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Resultados de la última subasta de Letras del Tesoro a 18 meses

Fecha de la subasta: 11 de diciembre de 2012

Fecha de vencimiento: 20 de junio de 2014

Importe en millones de Euros

LETRAS A 18 MESES

Fecha de liquidación 14-dic-12

Nominal solicitado 4.058,82

Nominal adjudicado 1.504,89

Nominal adjudicado (2ª vuelta) 318,55

Precio mínimo aceptado 95,721

Tipo de interés marginal 2,888

Precio medio 95,879

Tipo de interés medio 2,778

Adjudicado al marginal 200,00

1er precio no admitido 95,718

Volumen peticiones a ese precio 2,50

Peticiones no competitivas 115,79

Efectivo solicitado 3.873,23

Efectivo adjudicado 1.442,29

Efectivo adjudicado (2ª vuelta) 305,42

Porcentaje de prorrateo

Ratio de cobertura 2,70

Anterior tipo marginal 3,077

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 Average interest rate calculus:

◦ Account date of the auction:14.12.2012

◦ Maturity date: 20.06.2014
◦ Number of days: 553 days
◦ Average Prize: 95.879
553

95.879 (1  i ) 360
 100  i  2.778%

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Compound Interest

It is the most common way to value financial transactions. Normally, it is used for long-
term transactions but it is also used for the short -term ones.

The financial law is:

L(t,p)=(1+i)p-t p>t (p is greater than t)

The financial equivalence between two capitals (C0,t0) and (C n,tn) at tn is:

(1 + 𝑖)𝑝 −𝑡0
𝐶𝑛 = 𝐶0 𝑝−𝑡
= 𝐶0 (1 + 𝑖)(𝑡𝑛 − 𝑡0 )
(1 + 𝑖) 𝑛

𝐶0 = 𝐶𝑛 (1 + 𝑖)−(𝑡𝑛 − 𝑡0 )

As we have seen the last expressions do not depend on point p, this is the reason why
compound interest is the most common financial law in practice.

The calculation of the financial reserve Rτ is the same by using prospective or

retrospective method because it does not depend on p.

𝑅𝜏 = 𝐶0 (1 + 𝑖)(𝜏 − 𝑡0 ) = 𝐶𝑛 (1 + 𝑖)−(𝑡𝑛 − 𝜏)

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