10 MATHEMATICAL TECHNIQUES IN FINANCE

Alternatively, we can ask how much we need to invest today at the pre-
vailing interest rates to receive unit currency at some future date T:

A × (1 + rT) = 1

In this case, we are setting the future value to 1 and solving for A, the Present
Value, PV(T), of unit currency to be received at T. It is easy to see that

1
PV(T) = = 1∕FV(T)
1 + rT

for simple interest rates. In the above formula, we are using the interest rate
to discount the future unit cash flow to compute its today’s value, and PV(T)
is also known as the Discount Factor, D(T) = PV(T).
For compounding interest rates, we have

1
D(T) =
(1 + r∕m)mT

which for continuously compounded interest rates becomes

D(T) = e−rT

The graph of D(T) versus T is known as the discount factor curve and
is a decreasing (non-increasing) function of T for positive (non-negative)
interest rates. Given a discount factor curve, we compute today’s price of a
series of known cash flows C1 , . . . , CN at futures dates T1 , . . . , Tn , as

∑
N
Ci × D(Ti )
i=1

2.1.4 Yield, Internal Rate of Return

The interest rate of a loan describes the amount and timing of the interest
payments for a loan and is fixed at the inception of a loan, usually reflect-
ing prevailing market interest rates at the time. For a given loan of size
A and interest rate r, one can know with certainty the future interest and
principal cash flows: $100 in, $100(1 + rT) out at T if we use the simple
interest rate r.
On the other hand, given the future cash flows of an investment (FV)
and its today’s value (PV), we can ask for the interest rate r in a cash flow
equivalent loan that would have given us the same cash flows. The interest