Lecture Notes on Theory of Interest/Financial Mathematics

By
Dr. Ajijola, L.A.
1. The measurement of interest
1.1. Introduction
Interest may be defined as the compensation that a borrower of capital pays to lender of capital
for its use. Thus, interest can be viewed as a form of rent that the borrower pays to the lender to
compensate for the loss of use of capital by the lender while it is loaded to the borrower. In
theory, capital and interest need not be expressed in terms of the same commodity.
1.2. The accumulation and amount functions
The principal is the amount of money initially borrowed. The principal can also be defined as
the initial of money (capita) invested. This money accumulates over time. The difference
between the initial amount and the amount returned at the end of the period is called interest.
Accumulate value: The total amount received after a period of time;
Amount of Interest: The difference between the accumulated value and the principle.
Measurement period: The unit in which time is measured.
1.2.1. - Basics
The accumulation function, 𝒂(𝒕): The function gives the accumulated value at time 𝑡 ≥ 0 of
an original investment of 1. That is, it describes the accumulated value at time 𝑡 of initial
investment of 1.
Properties of the accumulation function:
(1) 𝑎(0) = 1
(2) 𝑎(𝑡) is generally increasing function of time.
(3) If interest accrues continuously then 𝑎(𝑡) will be a continuous function.
The amount function, 𝐴(𝑡), gives the accumulated value of an initial investment of 𝑘 at time 𝑡,
OR It is the accumulated value at time 𝑡 ≥ 1 of an original investment of 𝑘, i.e.
𝐴(𝑡) = 𝑘𝑎(𝑡).
It follows that:
𝐴(0) = 𝑘;
and the interest earned during the 𝑛𝑡ℎ period from the date of investment is:
𝐼𝑛 = 𝐴(𝑛) − 𝐴(𝑛 − 1) 𝑓𝑜𝑟 𝑛 = 1, 2,· · ·

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The Effective Rate of Interest
Precise definition: The effective rate of interest 𝑖 is the amount of money that one unit invested
at the beginning of a period will earning during the period, where interest is paid at the end of the
period. The effective rate of interest is also the interest earned in the period divided by the
principal at the beginning of the period.
This definition is equivalent to
𝑖 = 𝑎(1) − 𝑎(0) 𝑜𝑟 𝑎(1) = 1 + 𝑖.
Alternative definition:
(1 + 𝑖) − 1 𝑎(1) − 𝑎(0) 𝐴(1) − 𝐴(0) 𝐼1
𝑖 = = = =
1 𝑎(0) 𝐴(0) 𝐴(0)
Let 𝑖𝑛 be the effective rate of interest during the 𝑛𝑡ℎ period from the date of investment. Then we
have
𝐴(𝑛) − 𝐴(𝑛 − 1) 𝐼1
𝑖𝑛 = = , 𝑛 > 1.
𝐴(𝑛 − 1) 𝐴(𝑛 − 1)
• The use of the word “effective” is not intuitively clear.
• The effective rate of interest is often expressed as a percentage, e.g. 𝑖 = 8% 𝑜𝑟 0.08.
• The amount of principal remains constant throughout the period.
• The effective rate of interest is a measure in which interest is paid at end of period.
Example 1
Consider the accumulation function
𝑎(𝑡) = (0.05)𝑡 2 + 1.
(a) Find the value of 𝑖𝑛 at 𝑛 = 1,2 𝑎𝑛𝑑 3.
(b) If N100 is invested, how much interest will be earned over three periods?
1.3. Simple Interest and Compound Interest
Simple Interest: The accruing of interest according to the following pattern is called simple
interest.
𝑎(𝑡) = 1 + 𝑖𝑡 𝑓𝑜𝑟 𝑖𝑛𝑡𝑒𝑔𝑟𝑎𝑙 𝑡 ≥ 0.
Let 𝑖 be the rate of simple interest and let 𝑖𝑛 be the effective rate of interest for the 𝑛th period.
Then we have
𝑎(𝑛) − 𝑎(𝑛 − 1) [1 + 𝑖𝑛] − [1 + 𝑖(𝑛 − 1)] 1 + 𝑖𝑛 − 1 − 𝑖𝑛 + 𝑖
𝑖𝑛 = = =
𝑎(𝑛 − 1) [1 + 𝑖(𝑛 − 1)] [1 + 𝑖(𝑛 − 1)]

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 𝑖
=
[1 + 𝑖(𝑛 − 1)]
for integral 𝑛 ≥ 1. This is a decreasing function of 𝑛.
Why is it decreasing?
Answer: The same amount of interest is credited to the account for each period. Since the
amount in the account is increasing, the effective rate is
𝑖 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡
=
𝑎(𝑛 − 1) 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑖𝑛𝑔 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛
which will be a decreasing function. Simple interest can be extended to partial periods by letting
𝑎(𝑡) = 1 + 𝑖𝑡 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑡 ≥ 0:
This extension is justified when interest will be paid for partial periods and accumulation
increments have an additive nature.
Example 2
An account is receiving 6% simple interest. If N100 is invested, how long must it remain
invested until the account contains N200? How much will be in the account in 10 years?
1.4. Compound Interest
The word “Compound” refers to the process of interest being reinvested to earn additional
interest. The theory of compound interest handles the problem by assuming that interest earned is
automatically reinvested. That is, with compound interest, all interest earned in previous periods
is reinvested to earn interest in subsequent periods.
𝑎(1) = (1 + 𝑖)𝑎(0) = (1 + 𝑖)
𝑎(2) = (1 + 𝑖)𝑎(1) = (1 + 𝑖)2
𝑎(3) = (1 + 𝑖)𝑎(2) = (1 + 𝑖)3 𝑒𝑡𝑐.
Extending this to include partial periods produces
𝑎(𝑡) = (1 + 𝑖)𝑡 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑡 ≥ 0.
We will see shortly that this accumulation function is also justified in terms of a multiplicative
property of the accumulation function,
𝑎(𝑡 + 𝑠) = 𝑎(𝑡)𝑎(𝑠) 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑡 ≥ 0 𝑎𝑛𝑑 𝑠 ≥ 0.
The effective interest rate for the 𝑛th period is
𝑎(𝑛) − 𝑎(𝑛 − 1) (1 + 𝑖)𝑛 − (1 + 𝑖)𝑛−1
𝑖𝑛 = = =1+𝑖−1=𝑖
𝑎(𝑛 − 1) (1 + 𝑖)𝑛−1

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Thus, the effective interest rate is the same in every period.
For Simple Interest, the accumulation increment
𝑎(𝑡 + 𝑠) − 𝑎(𝑡) 𝑑𝑜𝑒𝑠 𝑛𝑜𝑡 𝑑𝑒𝑝𝑒𝑛𝑑 𝑜𝑛 𝑡
For Compound Interest, the relative growth
𝑎(𝑡 + 𝑠) − 𝑎(𝑡)
𝑎(𝑡) does not depend on 𝑡.
Difference between simple and compound interest:
• Same results over one measurement period. Over a longer period, compound interest
produces a larger accumulated value than simple interest while the opposite is true over a
shorter period.
• Under simple interest, it is the absolute amount of growth that is constant over equal
periods of time, while under compound interest, it is the relative rate of growth that is
constant.
• Compound interest is used almost exclusively for financial transaction covering a period
of one year or more and is often used for shorter term transaction as well. Simple interest
is occasionally used for short-term transaction and as an approximation for compound
interest over fractional periods.
Example 3
An account is receiving 6% compound interest. How long must N100 be invested for the account
to contain N200? How much will be in the account after 10 years?
Example 4
A 35-year-old investor deposits N25,000 in an account earning 5% compound interest until
retirement at age 65. What is the value of the account at retirement?
Example 5
Find the accumulated value of N2000 invest for four years, if the rate of simple interest and
compound rate is 8% annum respectively.
1.5. Present Value
Accumulation Factor
An asset of one grows to
𝑎(1) = (1 + 𝑖)1
at the end of one period. So (1 + 𝑖) is called the accumulation factor.

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Therefore, an Accumulation factor 𝟏 + 𝒊 accumulates the value of an investment at the
beginning of a period to its value at end of the period.
Discount Factor
What would you need to invest today to achieve a value of one after one interest period?
𝑎(1) = 1 = (1 + 𝑖)( 𝑤ℎ𝑎𝑡 𝑣𝑎𝑙𝑢𝑒? )
Solving this equation for the unknown value yields
1
𝜈 =
(1 + 𝑖)
1
The value 𝜈 is called the discount factor. That is 𝜈 = (1 + 𝑖) discounts the value of an investment
at end of a period to its value at the beginning of the period. If you are going to receive an asset
of 𝑘 at the end of one period, its present value is
𝑘
𝑘𝜈 =
(1 + 𝑖)
Discount Function 𝒂−𝟏 (𝒕)
When set to be in correspondence with one another, accumulation and discounting are reciprocal
processes, i.e., the discount function and the accumulation function satisfy
𝑎(𝑡) · 𝑎−1 (𝑡) = 1;
that is,
1
𝑎 −1 (𝑡) =
𝑎(𝑡)
So, under simple interest
𝑎(𝑡) = (1 + 𝑖𝑡)
1
𝑎 −1 (𝑡) = = (1 + 𝑖𝑡)−1
(1 + 𝑖𝑡)
Under compound interest
𝑎(𝑡) = (1 + 𝑖)𝑡
1
𝑎−1 (𝑡) = = (1 + 𝑖)−𝑡 = 𝑣 𝑡
(1 + 𝑖)𝑡
Accumulating and discounting are opposite processes. The term (1 + 𝑖)𝑡 is said to be the
accumulated value of 1 at the end of 𝑡 period. The term 𝑣 𝑡 is said to present value of 1 to be paid
at the end of 𝑡 periods.

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The properties of a discount function are:
1
1. 𝑎−1 (0) = 𝑎(0) = 1
1
2. 𝑎−1 (1) = (1 + 𝑖) = (1 + 𝑖)−1 = 𝑣
3. 𝑎−1 (𝑡) is typically a decreasing function of 𝑡.
Example 6
Two sets of grandparents of a new-born agreed to invest immediately to fund N20,000 per year
for four years of college at age 18 for the child. Grandparents A agreed to cover the first two
years of college with grandparents B covering the last two years. The account has an effective
rate of 6% per annum. What should each of the grandparents contribute to the fund today to meet
this need?
Example 7
Find the amount which must be invested at a rate of simple interest of 9% per annum in order to
accumulate N1000 at end of three years. Rework the example above using compound interest
instead of simple interest.
The Effective Rate of Discount
Numerical illustration 1:
If A goes to a bank and borrow N100 for one year at an effective rate of interest of 6%, then the
bank will give A N100. At the end of the year, A will repay the bank the original loan of N100,
plus interest N6 or a total of N106.
However, if A borrows N100 for one year at an effective rate of discount of 6%. then the bank
will collect its interest of 6% in advance and will give A only N94. At end of the year, A will
repay N100.
In the case of an effective rate of interest, the 6% is taken as a percentage of the balance at the
beginning of the year, while in the case of an effective rate of discount, the 6% is taken as
percentage of the balance at the end of the year.
Numerical illustration 2:
Which would you rather have:
Case A: $100 Today? Or
Case B: Receive $100 two years from today?
The answer is clear - you would prefer to have the money NOW! Money in your possession
today is more valuable to you (today) than the same amount of money received in the future. So,
what value should you place on this $100 you will receive in two years? You value it as though it

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is the amount that you would need to invest today to have $100 in two years. Therefore, its value
is

1 2
$100𝜈 2 = $100 ( )
1+𝑖
So, this future payment is viewed relative to some interest rate 𝑖.
Time Value of Money:
The present value of a future payment is discounted according to some interest rate 𝑖. In order to
be compared, all payments must be viewed from the same time point and therefore must be
accumulated or discounted to that time point via an interest rate 𝑖.
Definition of the effective rate of discount: The effective rate of discount d is the ratio of the
amount of interest (sometimes called the “amount of discount” or just “discount”) earned during
the period to the amount invested at end of the period.
• The phrases amount of discount and amount of interest can be used interchangeably in
situations involving rates of discount.
• The definition does not use the word “principal”, since the definition of principal refers to
the amount invest at the beginning of the period and not at the end of the period.
The key distinction between the effective rate of interest and the effective rate of discount can be
summarized as follows:
(a) Interest-paid at end of the period on the balance at the beginning of the period.
(b) Discount-paid at the beginning of the period on the balance at the end of the period.
Effective rates 𝑑𝑛 of discount over any particular measurement period:
𝐴(𝑛) − 𝐴(𝑛 − 1) 𝐼𝑛
𝑑𝑛 = = 𝑓𝑜𝑟 𝑖𝑛𝑡𝑒𝑔𝑟𝑎𝑙 𝑛 ≥ 1
𝐴(𝑛) 𝐴𝑛
In other words
The effective rate of interest, 𝑖, satisfies:
𝐴(0) + 𝑖𝐴(0) = 𝐴(1) 𝑜𝑟
𝐴(1) − 𝐴(0) 𝑎(1) − 𝑎(0)
𝑖 = =
𝐴(0) 𝑎(0)
Likewise, the effective rate of discount, 𝑑, satisfies:
𝐴(1) − 𝑑𝐴(1) = 𝐴(0) 𝑜𝑟
𝐴(1) − 𝐴(0) 𝑎(1) − 𝑎(0)
𝑑 = =
𝐴(1) 𝑎(1)

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By extension, during the 𝑛𝑡ℎ period, the effective rate of discount is:
𝐴(𝑛) − 𝐴(𝑛 − 1) 𝑎(𝑛) − 𝑎(𝑛 − 1)
𝑑𝑛 = = 𝑛 ≥ 1
𝐴(𝑛) 𝑎(𝑛)
Compound discount: If we have compound interest, in which case the effective rate of interest
is constant, then the effective rate of discount is also constant. These situations are referred to as
compound discount.
When do the two rates 𝒊 and 𝒅 correspond the the same movement of assets in opposite
directions (equivalent in this sense)?
Concept of equivalency: Two rates of interest or discount are said to be equivalent if a given
amount of principal invested for the same length of time at each of the rates produces the same
accumulated value.
(1 + 𝑖)𝐴(0) = 𝐴(1) 𝑎𝑛𝑑
(1 − 𝑑)𝐴(1) = 𝐴(0) 𝑜𝑟
(1 + 𝑖)(1 − 𝑑) = 1.
Solving this equation for 𝑑 yields:
𝑖
𝑑 = = 𝑖𝑣
(1 + 𝑖)
and solving it for 𝑖 yields:
𝑑
𝑖 = .
(1 − 𝑑)
:
This shows that
1
1 − 𝑑 = = 𝑣,
(1 + 𝑖)
𝑑 = 1 − 𝜈 𝑜𝑟
𝜈 + 𝑑 = 1.
In addition,
𝑑 = 𝑖𝜈 = 𝑖(1 − 𝑑) 𝑜𝑟
𝑖 − 𝑑 = 𝑖𝑑 > 0.
For compound discount,
𝑑(𝑡) = 𝜈 𝑡 = (1 − 𝑑)𝑡 .

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Clearly
𝑑(𝑡)𝑎(𝑡) = 𝜈 𝑡 (1 + 𝑖)𝑡 = 1 𝑜𝑟
1
𝑑(𝑡) = = [𝑎(𝑡)]−1
𝑎(𝑡)
For simple discount:
1
𝑑(𝑡) = (1 − 𝑑𝑡)𝑓𝑜𝑟 0 < 𝑡 < .
𝑑
• A constant rate of simple discount implies an increasing effective rate of discount (and
interest).
• Simple and compound discount produce the same result over one measurement period.
Over a longer period, simple discount produces a smaller present value than compound
discount, while the opposite is true over a shorter period.
• Simple discount is used only for short-term transactions and as an approximation for
compound discount over fractional periods.
Example 8
Rework Example 7 using simple and compound discount instead of simple and compound
interest.
Nominal Rates of Interest and Discount
Effective: used for the rates of interest and discount in which interest is paid once per
measurement period.
Nominal: Rates of interest and discount in which interest is paid more frequently than once per
measurement period.
Nominal Rates
Interest is quoted in terms of an annual rate, but frequently is compounded over shorter intervals.
For example, an 8% interest rate when compounded quarterly means 2% percent interest is
added to the principal at the end of each quarter thus the effective annual rate 𝑖 is determined by:

0.08 4
(1 + 𝑖) = (1 + ) 𝑜𝑟 𝑖 = 0.0824.
4
which is larger than 8%.
In this example, 8% is the nominal annual rate (APR) and 8.24% is the effective annual rate
(APY).

In general, suppose a nominal annual rate of 𝑖 (𝑚) is compounded over 𝑚 equal segments of the
year. Then the effective annual interest rate 𝑖 is determined by

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 𝑚 𝑚
𝑖 (𝑚) 𝑖 (𝑚)
(1 + 𝑖) = (1 + ) 𝑜𝑟 𝑖 = (1 + ) −1
𝑚 𝑚

Moreover, we can find the nominal annual rate which achieves a fixed effective annual rate via
1
𝑖 (𝑚) = 𝑚 [(1 + 𝑖)𝑚 − 1].

The accumulation function in this setting is

𝑚𝑡
𝑖 (𝑚)
𝑎(𝑡) = (1 + ) .
𝑚

Suppose𝑖 (𝑚) does not depend on m, that is the nominal level stays the same, no matter how many
times the account is compounded. Call this value 𝑖 (1) . In calculus we learned that
𝑚
𝑖 (1) (1)
lim (1 + ) = 𝑒𝑖
𝑚→∞ 𝑚

As 𝑚 → ∞, the account is said to be compounded continuously.

When 𝑚 → ∞, and 𝑖 (𝑚) = 𝑖 (1) for all 𝑚 (i.e. the nominal rate does not change as 𝑚 changes),
the effective annual rate is
(1)
𝑖 = 𝑒𝑖 − 1 𝑎𝑛𝑑 𝑖 (1) = 𝑙𝑛(1 + 𝑖)

where 𝑖 (1) is the nominal annual interest rate.

Example: Compound a fixed 5% nominal rate (𝑖 (1) = 0.05 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑚).
Period 𝒎 𝒊 (effective rate)
Annually 1 0.05
Semi-annually 2 0.050625
Quarterly 4 0.050945
Monthly 12 0.051162
Daily 365 0.051267
Continuously →∞ 0.051271

In a similar fashion, discounting can also be applied 𝑚 times each period. If 𝑑 (𝑚) denotes the
nominal discount rate in a complete period, the effective discount rate for a complete period
when convertible m times per period is:
𝑚 𝑚
𝑑 (𝑚) 𝑑 (𝑚)
(1 − 𝑑) = (1 − ) 𝑜𝑟 𝑑 = 1 − (1 − )
𝑚 𝑚

or we can solve the relationship for

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 1 1
𝑑(𝑚) = 𝑚 [1 − (1 − 𝑑)𝑚 ] = 𝑚 [1 − 𝑣 𝑚 ].

The discount function is

𝑚𝑡
𝑑 (𝑚)
𝑑(𝑡) = (1 − ) 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑡 > 0:
𝑚

When the nominal discount rate is the same for all 𝑚, i.e. 𝑑 (𝑚) = 𝑑 (1) , and 𝑚 → ∞ (the
discounts are convertible continuously), the effective rate of discount per period is
(1)
𝑑 = 1 − 𝑒 −𝑑
Also note that for the effective rates of interest and discount to match, that is
𝑎(𝑡)𝑑(𝑡) = 1
Then
𝑚𝑡 −𝑝𝑡
𝑖 (𝑚) 𝑑 (𝑝)
(1 + ) = (1 − )
𝑚 𝑝

𝑖 (𝑚) 𝑑 (𝑝) 𝑖 (𝑚) 𝑑 (𝑝)

− = ×
𝑚 𝑝 𝑚 𝑝
even when interest is compounded 𝑚𝑡ℎ𝑙𝑦 per period and discount is convertible 𝑝𝑡ℎ𝑙𝑦 per
period.
Example 9
Find the accumulated value of N500 at the end of three years
(a) if the nominal rate of interest is 5% convertible semi-annually.
(b) (b) if the nominal rate of discount is 7% convertible every two years.
Example 10
Find the present value of N5000 to be paid at the end of 25 months at a discount of 8%
convertible quarterly.
(a) Assume compound discount throughout.
(b) Assume compound discount for whole periods and simple discount for fractional periods.

Example 11
Find the accumulated value of N500 invested for five years at 8% annum convertible quarterly.
Example 12

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Find the present value of N1000 to be paid at end of six years at 6% per annum payable in
advance and convertible semi-annually.
Example 13
Find the nominal rate of interest convertible quarterly which is equivalent to a nominal rate of
discount of 6% per annum convertible monthly.
Forces of Interest and Discount
Earlier we described the effective rate of interest for the 𝑛th period to be
𝐴(𝑛) − 𝐴(𝑛 − 1) 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝑚𝑜𝑢𝑛𝑡 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
= .
𝐴(𝑛 − 1) 𝐴𝑚𝑜𝑢𝑛𝑡 𝑒𝑛𝑡𝑒𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
representing the relative growth in the amount during that period. As we ignore the discrete
period boundaries and focus on the amount function 𝐴(𝑡) at all 𝑡 > 0, it is natural to describe
the relative growth in this amount function at time 𝑡 with
𝐴′ (𝑡)
,
𝐴(𝑡)
the instantaneous rate of change in the amount function relative to its current size.
Definition: The force of interest 𝛿𝑡 at time 𝑡 > 0 is
𝐴(𝑡 + ℎ) − 𝐴(𝑡) 𝐴′ (𝑡) 𝑎′ (𝑡)
𝛿𝑡 = lim = = .
ℎ→0 ℎ𝐴(𝑡) 𝐴(𝑡) 𝑎(𝑡)
Examples
Simple Interest:
1
𝑎(𝑡) = 1 + 𝑖𝑡 𝛿𝑡 = (𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑖𝑛𝑔 𝑖𝑛 𝑡)
1 + 𝑖𝑡
Compound Interest:
𝑎(𝑡) = (1 + 𝑖)𝑡 𝛿𝑡 = 𝑙𝑛(1 + 𝑖) (𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑖𝑛 𝑡)
For Example:
(0.1)𝑡
𝑎(𝑡) = (0.05)𝑡 2 + 1 𝛿𝑡 =
(0.05)𝑡 2 + 1
Note that
𝐴′ (𝑡) 𝑑 𝑑
𝛿𝑡 = = 𝑙𝑛(𝐴(𝑡)) = 𝑙𝑛(𝑎(𝑡))
𝐴(𝑡) 𝑑𝑡 𝑑𝑡
Replacing 𝑡 with 𝑟 and integrating yields

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 𝑡 𝑡
𝑑 𝑡
∫ 𝛿𝑟 𝑑𝑟 = ∫ 𝑙𝑛(𝐴(𝑟))𝑑𝑟 = 𝑙𝑛(𝐴(𝑟))|0
0 0 𝑑𝑡
𝐴(𝑡)
𝑙𝑛(𝐴(𝑡)) − 𝑙𝑛(𝐴(0)) = 𝑙𝑛 ( )
𝐴(0)

Thus
𝑡 𝐴(𝑡) 𝑎(𝑡)
𝑒 ∫0 𝛿𝑟 𝑑𝑟 = = = 𝑎(𝑡)
𝐴(0) 𝑎(0)
Also
𝑡 𝑡
∫ 𝐴(𝑟)𝛿𝑟 𝑑𝑟 = ∫ 𝐴′ (𝑟)𝑑𝑟 = 𝐴(𝑟)|𝑡0 = 𝐴(𝑡) − 𝐴(0)
0 0

A Constant Force of Interest means

𝛿𝑡 = 𝛿 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑡 > 0
In this case
𝑡
∫ 𝛿𝑟 𝑑𝑟 = 𝛿𝑟|𝑡0 = 𝛿𝑡
0

and

𝑎(𝑡) = 𝑒 𝛿𝑡 .
Since

𝑎(1) = 1 + 𝑖 = 𝑒 𝛿 ,
𝛿 = 𝑙𝑛(1 + 𝑖),
where 𝑖 is the effective rate of interest and 𝛿 is the nominal rate of interest when interest is
compounded continuously?
So, when a problem is described as having a constant force of interest,
𝑎(𝑡) = 𝑒 𝛿𝑡 = (1 + 𝑖)𝑡 𝑎𝑛𝑑 𝛿 = 𝑙𝑛(1 + 𝑖)
where 𝑖 is the effective interest rate, 𝛿 is the nominal interest rate and there is continuous
compounding of interest.
Force of Discount
The force of discount is defined as
𝑑 ′ (𝑡)
𝛿𝑡′ =− ,
𝑑(𝑡)

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where the minus sign is included because 𝑑′ (𝑡) is typically negative.
Because 𝑑(𝑡) = [𝑎(𝑡)]−1,
𝑑 ′ (𝑡)
− [𝑎(𝑡)]−1 [𝑎(𝑡)]−2 𝑎′ (𝑡)
𝑑(𝑡)
𝛿𝑡′ = = ,
[𝑎(𝑡)]−1 [𝑎(𝑡)]−1
𝑎′ (𝑡)
= 𝛿𝑡
𝑎(𝑡)
So, we dropped the prime, because these two are the same quantity.
Also note that
𝑡
𝑑(𝑡) = [𝑎(𝑡)] − 1 = 𝑒 − ∫0 𝛿𝑟 𝑑𝑟
A constant force of discount means the same thing as a constant force of interest, i.e.

𝑑(𝑡) = [𝑎(𝑡)]−1 = 𝑒 −𝛿𝑡

where 𝛿 = 𝑙𝑛(1 + 𝑖) = − 𝑙𝑛(1 − 𝑑), for 𝑖 the effective rate of interest and 𝑑 the effective
rate of discount.
In addition
𝑚 𝑝
𝑖 (𝑚) 𝑑 (𝑝)
[1 + ] = 1 + 𝑖 = 𝑣 −1 = (1 − 𝑑)−1 = [1 − ] = 𝑒𝛿
𝑚 𝑝
𝛿
𝑖 (𝑚) = 𝑚 [𝑒 𝑚 − 1]

By series expansion

(𝑚) 𝛿 1 𝛿 2 1 𝛿 3
𝑖 = 𝑚[ + [ ] + [ ] +⋯]
𝑚 2! 𝑚 3! 𝑚

and let 𝑚 → ∞ we have

lim 𝑖 (𝑚) = 𝛿
𝑚→∞

Similarly, we also have

lim 𝑑 (𝑚) = 𝛿
𝑚→∞

Example 14
What is the account balance after two years when a N500 deposit is made in an account with
𝛿𝑡 = (0.02) + (0.03)𝑡 2 ?

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Example 15

You are given 𝛿𝑡 = 2⁄(𝑡 − 1) 𝑓𝑜𝑟 2 ≤ 𝑡 ≤ 10. For any one-year interval between 𝑛 and
𝑛 + 1, with 𝑛 = 2,· · · ,9, calculate the equivalent 𝑑 (2) .
Example 16
A fund earns interest at a force of interest of 𝛿𝑡 = 𝑘𝑡. A deposit of 100 at time 0 will grow to
250 at the end of five years. Find 𝑘.
Example 17
Find the accumulated value of N1000 invested for ten years if the force of interest is 5%.
Varying Interest (Discount)
For many investments the interest rates vary from one period to the next, where the periods are
of fixed and equal length. The compound accumulation function over n periods is then
𝑛

𝑎(𝑛) = (1 + 𝑖1 )(1 + 𝑖2 ) · · · (1 + 𝑖𝑛 ) = ∏(1 + 𝑖𝑗 ),

𝑗=1

where 𝑖𝑗 is the effective interest rate for the 𝑗 𝑡ℎ interest period. In similar fashion, if the discount
rates vary from period to period, the discount function over n periods is
𝑛
−1 (𝑛)
𝑎 = 𝑑(𝑛) = (1 − 𝑑1 )(1 − 𝑑2 ) · · · (1 − 𝑑𝑛 ) = ∏(1 − 𝑑𝑗 ),
𝑗=1

where 𝑑𝑗 is the effective rate of discount during the 𝑗 𝑡ℎ period.

Example 18
A bank recently advertised a variable interest rate CD that earns 1.6% APR for the first six
months, 1.8% for the second six months, 2.0% for the third and 2.2% for the fourth. What is the
effective annual interest rate for the CD?
Example 19
Find the accumulated value of N1000 at the end of 15 years if the effective rate of interest is 5%
1
for first 5 year, 4 2 % for the second 5 years, and 4% for the third 5 years.

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PREPARED BY DR AJIJOLA, L.A. 16
Chapter 2: Solution of problems in interest
2.1. Introduction
This Chapter discusses general principles to be followed in the solution of problem interest. The
purpose of this chapter is to develop a systematic approach by which the basic principles from
Chapter 1 can be applied to more complex financial transaction.
2.2. Obtaining Numerical Results
Naturally, in practice work, actual numerical answers are usually desired, and the purpose of this
section is to discuss the various the various possible methods of obtains such answer.
• Direct calculation by Personal computers, inexpensive pocket calculators with
exponential and logarithmic functions.
• Compound interest tables Use of the compound interest tables is a convenient approach if
required values appear in the tables.
Direct calculation by hand. This may require the us e of series expansions. Here are two
examples: One example would be to evaluate (1 + 𝑖)𝑘 using the binomial expansion theorem.
𝑘(𝑘 − 1) 2 𝑘(𝑘 − 1)(𝑘 − 2) 3
(1 + 𝑖)𝑘 = 1 + 𝑘𝑖 + 𝑖 + 𝑖 …,
2! 3!
A second example would be to evaluate 𝑒 𝑘𝛿 as

𝑘𝛿
(𝑘𝛿)2 2 (𝑘𝛿)3 3
𝑒 = 1 + 𝑘𝛿 + 𝑖 + 𝑖 …,
2! 3!
It should be emphasized that using series expansions for calculation purposes is cumbersome and
should be unnecessary except in unusual circumstances.
One method of crediting interest
• Using compound interest for integral periods of time.
• Using simple interest for any fractional period.
• Using first two terms of the binomial expansion assuming 0 < 𝑘 < 1.
• Such method is commonly encountered in practice.
Simple interest for a final fractional period is equivalent to performing a linear interpolation
between (1 + 𝑖)𝑛 and (1 + 𝑖)𝑛+1
(1 + 𝑖)𝑛+𝑘 ≈ (1 − 𝑘)(1 + 𝑖)𝑛 + 𝑘(1 + 𝑖)𝑛+1
= (1 + 𝑖)𝑛 (1 + 𝑘𝑖)
Analogous fashion for simple discount over the final fractional period by linear
interpolation
𝑣 𝑛+𝑘 = (1 − 𝑑)𝑛+𝑘 ≈ (1 − 𝑘)(1 − 𝑑)𝑛 + 𝑘 (1 − 𝑑)𝑛+1

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 = (1 − 𝑑)𝑛 (1 − 𝑘𝑑).
Example 2.1. Find the accumulated value of N5000 at the end of 30 years and 4 months at 6% er
annum convertible semi-annually:
(1) assuming compound interest throughout, and
(2) assuming simple interest during the final fractional period.
2.3. Determining Time periods
Although there would appear to be no ambiguity in this process, different methods of counting
the days in a period of investment have arisen in practice.
Three methods are commonly encountered.
1. Using exact number of days for the period of investment and to use 365 days in a year.
2. Assuming each calendar month has 30 days and the entire calendar year has 360 days.
Formula for computing the number of days between two given days is
360(𝑌2 – 𝑌1 ) + 30(𝑀2 – 𝑀1 ) + (𝐷2 – 𝐷1 )
3. A hybrid method, uses exact number of days for period of investment, but uses 360 days
in a year.
For simple interest, those method are called
1. Exact simple interest, “actal/actal”.
2. Ordinary simple interest, “30/360”
3. Banker’s rule, “actual/360”
Banker’s Rule is more favourable to a lender than is ordinary interest. A further complication
arises in a leap year. In most cases, Feb. 29 is counted a day and the year has 366 days. The three
commonly encountered calculation bases also are used for calculations on a compound interest
basis. It is assumed, unless stated otherwise, that in counting days interest is not credited for both
the date of deposit and the date of withdrawal, but for only one of these two dates. Many
financial transactions are handled on a monthly, quarterly, semi-annual or annual basis.
Example 2.2. Find the amount of interest that N2000 deposited on June 17 will earn, if the
money is withdrawn on September 10 in the same year and if the rate of interest is 8%, on the
following bases: (1) exact simple interest, (2) ordinary simple interest, (3) the Banker’s Rule.
2.4. The Basic Problem
• The principal originally invested.
• The length of the investment period.
• The rate of interest.
• The accumulated value of the principle at the end of the investment period.
IF any three of these quantities are known, then the fourth quantity can be determined.
The following observations may prove helpful in the solution of problems interest

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 • Assessing the tools that will be available in performing the financial calculations, such as
interest tables, pocket calculators, personal computers.
• The length of the investment period is measured in time units.
• An interest problem can be viewed from two perspectives, from borrower and lender.
• In practice applications involving interest the terminology can become confusing.
Equations of Value
Fundamental Principle, Recognition of the Time value of money: The value of an amount of
money at any given point in time depends upon the time elapsed since the money was paid in the
past or upon time which will elapse in the future before it paid.
Recognition of the time value of money reflects the effect of interest, but not the effect of
inflation which reduces the purchasing power of money over time.
Two or more amount of money payable at a different point in time cannot be compared until all
the amount are accumulated or discounted to a common date (Comparison Date), and the
equation which accumulates or discounts each payment to the comparison date is called the
equation of value.
Example 2.4. In return for a promise to receive N600 at the end of 8 years, a person agrees to
pay N100 at once, N200 at end of 5 years and to make a further payment at end of 10 years. Find
the payment at end of 10 years if the nominal rate of interest is 8% convertible semi-annually.
Unknown Time
Let amount 𝑠1 , 𝑠2 , . . . , 𝑠𝑛 be paid at times 𝑡1 , 𝑡2 , . . . , 𝑡𝑛 respectively. The problem is to find time 𝑡
such that 𝑠1 , 𝑠2 , . . . , 𝑠𝑛 paid at time t is equivalent to the payments of 𝑠1 , 𝑠2 , . . . , 𝑠𝑛 made
separately.
The fundamental equation of value is
(𝑠1 + 𝑠2 +. . . +𝑠𝑛 )𝑣 𝑡 = 𝑠1 𝑣 𝑡1 + 𝑠2 𝑣 𝑡2 + · · · +𝑠𝑛 𝑣 𝑡𝑛
A first approximation, the method of equated time
𝑠1 𝑡1 + 𝑠2 𝑡2 +. . . , +𝑠𝑛 𝑡𝑛
𝑡̅ =
𝑠1 + 𝑠2 +. . . +𝑠𝑛
It is possible to prove that the value of 𝑡̅ is always great than the true value of 𝑡.
Another interesting question often asked is how long it takes money to double at a given rate of
interest.
(1 + 𝑖)𝑛 = 2 𝑜𝑟 𝑛𝑙𝑜𝑔𝑒 (1 + 𝑖) = 𝑙𝑜𝑔𝑒 2.
Then we have
𝑙𝑜𝑔𝑒 2 0.6931 𝑖
𝑛 = = ×
𝑙𝑜𝑔𝑒 (1 + 𝑖) 𝑖 𝑙𝑜𝑔𝑒 (1 + 𝑖)

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Rule of 72
The last factor above equation evaluated for 𝑖 = 8% is 1.0395.
Thus, we have
0.6931 0.72
𝑛 ≈ (1.0395) =
𝑖 𝑖
Table 2: Length of Time It Takes Money Double
Rate of interest Rule of 72 Exact value
4% 18 17.67
6% 12 11.90
8% 9 9.01
10% 7.2 7.27
12% 6 6.12
18% 4 4.19

Example 2.5. Find the length of time necessary for N1000 to accumulate to N1500 if invested at
6% per annum compounded semi-annually: (1) by use of logarithms, and (2) by interpolating in
the interest tables.
Example 2.6. Payments of N100, N200, and N500 are due at the ends of years 2,3 and 8,
respectively. Assuming an effective rate of interest of 5% per annum, find the point in time at
which a payment of N800 would be equivalent: (1) by the method of equated time, and (2) by an
exact method.
Unknown rate of Interest
Four methods to use in determining an unknown rate of interest
• Solve equation of value for 𝑖 directly using a calculator with exponential and logarithmic
function.
• Solve equation of value for 𝑖 by algebraic techniques.
• Use linear interpolation in the interest tables.
• Successive approximation or iteration.
Example 2.7 At what interest rate convertible quarterly would N1000 accumulate to N1600 in
six years.
Example 2.8. At what effective rate of interest rate will the present value of N2000 at the end of
two years and N3000 at the end of four years be equal to N4000.
Example 2.9. At what interest rate convertible semi-annually would an investment of N1000
immediately and N2000 3 years from now accumulate to $5000 10 years from now.

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