Rates, Yields, Bond Math 9

For example, the future value of A = $100,000 in 9 months (T = 0.75) for

a semiannual (m = 2) compounded interest rate of 4% per annum is
( )2×0.75
4%
FV = $1,000, 000 × 1 + = $103, 014.95
2

while the future value of A = $100,000 in 3 months (T = 0.25) for a semi-

annual compounded interest rate of 4% per annum is
( )2×0.25
4%
FV = $100,000 × 1 + = $100, 995.05
2

The first case’s interest of $3,014.95 is for 1.5 semiannual compounding

periods, and exceeds the simple interest of $3,000 = $100,000 × 4% × 3∕12
due to compounding, while the second case is for a half (semiannual) com-
pounding period.
Similarly, for noncompounding simple rates, we can let T be a frac-
tion of a year. For example, the future value of A = $100,000 in 2 months
(T = 2∕12) at the simple interest rate of 4% p.a. is
( )
2
FV = $1,000, 000 × 1 + 4% × = $100, 666.67
12

2.1.2 Continuous Compounding

As we compound more often, in the limit we reach continuous compounding
and Formula 2.3 becomes
( )
r m×T
FV = lim A × 1 + = A × erT
m→∞ m

While seldom used in real-world loans and deposits, continuously com-

pounded interest rates provide an easy way to derive analytical formulas
when interest rates are not the primary object of study, for example in
investment analysis or option pricing for equities.

2.1.3 Discount Factor, PV, FV

Given an interest rate r for a time horizon T, let FV(T) be the future value
of unit (A = 1) currency. For a simple (noncompounding) interest rate r,
we have
FV(T) = 1 + rT (2.4)

and for any given initial amount A, its future value is then simply A × FV(T).