MATH 1009: Basic Mathematics for Business and Economics

Chapter 3 The Mathematics of Finance

Study Guide

This is the final pre-calculus chapter before we start the main dish of the course, calculus.
Unlike Chapters 1 and 2, this chapter focuses on applications more than mathematical concepts.
Essentially the only new mathematical tool needed is geometric series (which is not so new
since you should have learned that in secondary school), while we will also revisit the number
e introduced in Chapter 2.

Section 3.1 of the textbook consists of a review on percentages. You are expected to know
the mathematics well, so this section will not be covered in the lecture videos. Some applications
of percentages have also been mentioned in the textbook, and they are straightforward so you
should be able to understand them well with your background in economics without much
difficulty — except perhaps that you may not remember the meanings of the terms Lasperyres
index and Paasche index — and it is not necessary to remember these names in this course
anyway. You should take a quick look at this section of the textbook to ensure that you indeed
know the mathematics well.

3A. Interest problems

This section deals with various compound interest problems, and it is based mainly on
Section 3.2 of the textbook. There are two main things to learn in this section:

ˆ The concept of continuous compounding — a particular example (a principal of $1, an

interest rate of 100% per annum and a period of 1 year) was mentioned in Chapter 2 in
introducing the number e. Here we look at the more general case where these parameters
could change.

ˆ The concept of annualised percentage rate (APR) — with so many different ways to
quote interest rates in real life, the APR provides a common ground for comparison. It
should be noted that you may see different definitions of the APR in other courses. The
definition adopted in this course agrees with that used in our textbook, and also agrees
with the one adopted by the Hong Kong Bank Association.

3B. Geometric series

In this part we review the mathematics of geometric series which you should have learned
in secondary school. The materials can be found in Section 3.3 of the textbook, and the
summation notation is discussed in ‘Formal Mathematics’ at the end of Chapter 3.

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 You should try to relate the sum to infinity of a geometric series with the concept of limits
introduced in Chapter 2. Basically as you keep adding terms of a geometric sequence the
accumulated sum will get closer and closer to the sum to infinity provided that the series is
convergent. Hence the sum to infinity can be considered as a limit. You should also be able to
determine whether a geometric series is convergent based on the common ratio.

3C. Topics in financial mathematics (I)

In this part we study more advanced problems involving interest rates in financial mathe-
matics, some of which require the mathematical tool of geometric series to solve. The central
notion is the time value of money, which leads to the concepts of present value and future value
of a sum of money.

The problems in this part mainly come from Section 3.3 of the textbook, although the
textbook introduces the concept of future value in Section 3.2 and that of future value in
Section 3.4.

3D. Topics in financial mathematics (II)

In this part we mainly study investment appraisal problems, and the materials are based
largely on Section 3.4 of the textbook. We introduce the notion of internal rate of return
(IRR) which, having essentially the same meaning as the APR, provides a common ground for
comparing different investment projects. It should be noted that solving for the APR or IRR
often involves an equation of high degree, which is generally beyond the level of this course.
We can however solve these equations with the help of computers.