Financial mathematics Emilio Flores Ballesteros

Chapter 1

What is financial mathematics

and what are its elements?

• What is financial mathematics, what disciplines is it related

to and what is its importance?
• What is the time value of money and what is its
importance?
• What are the elements of financial mathematics?
• What are nominal and effective rates for?
• What is the difference between interest and discount?
• What are annuities and amortizations?
• What are the investment evaluation criteria?

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Financial mathematics Emilio Flores Ballesteros

ELEMENTS OF MATHEMATICS
FINANCIAL
CONCEPTUAL SCHEME

COMPETENCES TO ACHIEVE
CONCEPTUAL PROCEDURAL ATTITUDINAL

Explains the methods of Analyzes the methodologies

Promotes in the company
transferring money over for transferring money over
the application of financial
time and the generation of time and applies them to the
mathematics methods to
financial and commercial daily lives of people and
support decision making
information companies.

KEY CONCEPTS
Financial mathematics, time value of money, nominal rates, effective rates, interest,

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simple interest, compound interest, discount, rational discount, bank discount,

commercial discount, annuities due, early and deferred, amortization, investment
evaluation criteria.

1. ELEMENTS OF FINANCIAL MATHEMATICS

1.1 Financial mathematics concept

José Villalobos (2012, pp. 92, 93) states that financial mathematics is a very important
area of applied mathematics, through which the existing elements and methods are
analyzed for the transfer over time in the most real way possible, of the capitals that
participate in the financial and commercial operations that allow making decisions
about investments.

Financial mathematics is related to accounting, since it is based on reasoned

information generated by accounting records, for the preparation of financial
information such as the analysis of costs and evaluation of investment projects
formulated in an institution.

Financial mathematics is also a support instrument in political science, since its

methodologies are applied in the study and resolution of economic problems of society
through public investment projects. Financial mathematics serves as support and
facilitates investment decision-making, budgeting and economic adjustments.

Financial mathematics concept Financial Mathematics and other

disciplines

Financial mathematics is applied in the daily life of people and entities as a tool that
generates information for making financial decisions, for which it is important to use
the appropriate methods in the calculations and avoid errors that may affect the
economy of the companies. people and companies. For this reason, the study of
financial mathematics allows students the knowledge inherent to the variations in the
value of money over time.

Financial mathematics is used to determine a series of financial market factors that

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affect the presence of capital and money, a basic resource of economic activity, capital
that moves over time and is measured at different times.

Financial mathematics is related to disciplines such as: accounting, finance, law,

economics, political science, industrial engineering, computer science and sociology.

Financial Mathematics and Accounting

Financial mathematics is related to accounting, because it is a tool that processes the
recorded information of the activities carried out by an entity, to generate information
at specific times, which allows making decisions inherent to the investments and costs
made.

Financial Mathematics and Finance

Financial mathematics is closely linked to finance, since finance optimizes the use of
assets and financing, for which they apply methods of value of money in
time with the purpose of evaluating the
assets financial or securities that include bonuses,
Actions; as well as the
loans granted by financial institutions.

Financial Mathematics and Economics

Financial mathematics is related to economics, because through these tools the market
segments where businesses can achieve greater economic benefits are analyzed and
identified.

Financial Mathematics and Law

Financial mathematics and law are linked because their methods serve as a basis for
the regulation of sales, regulating financial instruments, guarantees, insurance,
brokerage and shipping of goods. In addition, they are used in the legal support of
purchase and sale contracts, mortgages and loans.

Financial mathematics and political science

Financial mathematics is related to political science, because its instruments are used
by government institutions to solve society's problems. Financial mathematics is the
support in the evaluation of public investments, negotiations, budgets and economic
adjustments; that help make decisions for the benefit of the population.

Financial mathematics and Industrial Engineering

Financial mathematics is applied in industrial engineering for the measurement and
monitoring of production processes, through the costing of the means of production and
the depreciation of the fixed plant assets used.

Financial Mathematics and Computer Science

Financial mathematics is related to computing, because its instruments serve to

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automate manual procedures related to the measurement of the company's activities,

with respect to the measurement of sales and investments.

Financial Mathematics and Sociology

Financial mathematics and sociology are linked, because they use their tools to
optimize the performance of companies, which generate greater benefits that
contribute to a better quality of life for society.

1.2 Importance of financial mathematics

Financial mathematics is important because it has a practical application in solving the

problems of daily life of entities, which has to do with economic and financial issues,
since quick decisions must be made regarding the optimization of assets and financing
that has to do with the time value of money. The suitability of investment projects and
banking and stock market operations is evaluated.

Financial mathematics is important in private and public institutions, since their

financial operations are related to decision making regarding the analysis of rates,
interests, times, amounts and balances; For which financial mathematics methods are
applied that allow generating information for the proper management of financial
resources and optimization of performance and profitability.

Importance of financial mathematics Uses of financial mathematics

Financial mathematics plays a very important role in the daily work of people and
organizations, where an analysis of economic and non-economic factors is regularly
carried out, to make decisions inherent to the way of investing or financing money in
different alternatives. Financial mathematics tools allow you to reliably analyze the
different money options in the future to make the most convenient decisions.

In this sense, financial mathematics is a discipline of great application in the world of

private businesses and public institutions, as well as in banking. For this reason, it is a
very important subject in the curricula of professions related to economic and business
sciences, where it is a basic and mandatory subject; so that its graduates have a
practical knowledge of the basic elements of these tools.

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Then, financial mathematics is a set of basic tools that people and entities apply to
solve a variety of financial and commercial problems, related to the value of money
over time, which allows developing basic information that facilitates the of decisions
inherent to the investment and financing of money that compromise future years.

1.3 Concept of the time value of money

The time value of money means that the unit of money varies over time, such that the
unit of money in the present is greater and worth more than the unit of money in the
future. Money in the present is worth more because it has the possibility of being
invested and generating profits or interest over time that increase its value by a
percentage amount.

In the daily activities of people and entities, money plays an important role in their
activities, since products are sold with money and resources are purchased with money.
So, money facilitates the exchange of goods and services between individuals and
companies; a situation that has allowed us to overcome the inconveniences that
formerly occurred in barter.

Money changes its value over time due to the existence of inflation that affects a
country and a diversity of interest rates that exist in the market. Money decreases its
value over time, because if I have 1000 soles today it has a greater value than 1000
soles in five years. The current 1,000 soles increase its value because it can be
invested and earn interest in the next five years. On the other hand, with the current
1000 soles, today I can buy more than with the 1000 soles in five years, due to
inflation that affects the purchasing power of money in the future.

Concept of the time value of money Factors affecting the value of money

So, money has a different value over time, because it is affected by a series of factors
that together generate an interest rate that increases its present value to compensate
for its value in the future. Among the main variables that influence the value of money,
we can mention:

• Inflation, which consists of a general increase in prices, causes money to lose

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purchasing power over time, that is, it devalues.

• The risk incurred when lending or investing since we are not absolutely certain of
recovering the money lent or invested.
• The opportunity that the owner of the money would have to invest it in another
economic activity, protecting it not only from inflation and risk but also with the
possibility of obtaining a profit. Money has a fundamental characteristic, the ability
to generate more money, that is, to generate more value.

1.4 Importance of the time value of money

Moyer, Guigan and Kretlow (2005, pp. 113, 114) indicate that understanding the time
value of money is very important for effective financial management, such that the
person whose job is based on money management must know the time value of
money. The following cases of its application can be considered:

• Financial entities that make loans and financial investments.

• Executives with decisions on financing sources and in the evaluation of alternatives
for investment projects.
• Securities analysts who evaluate the stocks that an organization sells to investors.

• People who face a series of daily financial problems, ranging from managing their
personal credit account to deciding how to finance the purchase of a new home.

The entities and people mentioned frequently use the concept of the time value of
money and must master the basic tools for its practical application; Counting on the
support of a variety of interest tables, financial calculators and Excel functions and
tools, they facilitate the calculation.

Cases of application of the value of Topics related to the value of money

money

In financial administration, the time value of money is very useful in itself, and is also
important in the development of the following topics:

• The valuation of stocks, bonds and other assets

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• Capital budget and analysis of investment projects

• Cost of capital and capital structure
• Working capital management: short-term assets and liabilities
• Financial lease analysis

Finally, many of the decisions managers frequently encounter involve a series of cash
flows that pay out over time. To make informed decisions, the manager needs to have
a working knowledge of the time value of money.

1.5 The interest

The interest on borrowing money or compensation for the use or deprivation of use of
money is the profit or income produced by capital. Hugo Palacios (2006, page 15)
indicates that interest is the payment made for the use of the money of others or third
parties received as a loan, or it is the charge received for the temporary transfer of
one's own money to third parties .

Moyer, Guigan and Kretlow (2005, pp. 114, 115) state that interest is the amount of
money earned that is obtained as a return, as a consequence of having lost the
opportunity to consume it, make an alternative investment or lend the money. The
interest rate is a percentage that the borrower pays to the lender or borrower to
compensate for lost investment or consumption opportunities.

DEFINITION OF INTEREST
Variation of the amount due to interest

Interest is an economic magnitude expressed in absolute values , obtained at the end

of a period, multiplying the interest rate by the amount of capital or principal received
or transferred as a loan. For example, for a capital of 100 CU at an annual interest rate
of 20%, it becomes 120 CU in one year, because the interest generated is equal to
20% (100 CU) = 20 CU. The 20 um serve to compensate for the alternate use of the
principal, the risks incurred by the loan, the inflation generated in the loan period and
the profit from the service on the money lent.

Interest is generated by interest rates, which represent the value of money in the
financial market . When there is a large amount of money in the financial market,

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interest rates go down; Otherwise, when money is scarce, interest rates rise.

1.6 Elements of financial mathematics

Financial mathematics includes a series of options for solving the various financial
problems that arise in the business world, which allow entrepreneurs and any person to
carry out financial calculations in order to make an investment or financing decision.
based on a rate of profitability. Financial mathematics includes the following aspects:

• Nominal, effective, proportional and equivalent rates

• Simple interest and compound interest
• The rational, banking and commercial discount
• Past due, early and deferred annuities
• Loan repayment systems
• Investment project evaluation criteria

a. Nominal and effective rates

It includes the study of nominal and proportional rates, as well as effective and
equivalent rates; in the form of overdue rates and advance rates; As a basis for the
calculation, the nominal and effective rates are studied, as well as the method to
convert nominal rates into effective rates, convert effective rates into nominal rates,
and convert effective rates of one term into effective rates of another term.

Nominal rates and effective Overdue fees and advance fees

Nominalrates
rate Effective rate Overdue rate
Advance rate

b. Simple interest and compound interest

Simple interest is the payment in the case of credits or collection in the case of
investments, which is obtained on the principal. The amount of simple interest is equal
to the product of the principal times the rate for each period multiplied by the number
of periods. An account is under a simple interest regime if it produces a single

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capitalization of interest at the end of the agreed time horizon. For example, this simple
interest rate can be monthly and the account horizon can be semiannual.

Definition of Simple Definition of compound

Interest interest

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Moyer, Guigan and Kretlow (2005, pp. 116, 117) point out that compound interest is a
succession of simple interest operations, in which the final amount of each of them
constitutes the principal of the following operation. Compound interest is given
when the capital accrues interest generated by an effective interest rate, which in turn
may be a function of a nominal interest rate that capitalizes every certain period of
time.

c. Rational, banking and commercial discount

The rational discount made to the nominal value of a security that matures in the
future, which is its respective interest deducted in advance, calculated with the nominal
or effective interest rate due on the true amount, receives the discount; This amount
constitutes the present value of the security. In this way, the rational discount
calculated on the nominal value of the security and the interest due calculated on its
respective present value during the same period, with the same rate, produce the same
results; establishing the identity: discount equal to interest.

The bank discount made to the face value of a security maturing in the future is the
interest deducted in advance, calculated with the advance discount rate (d) on the face
value of the security; The result of subtracting the discount amount from the face value
is the net value. The net value of a security is less than the present value calculated at
a mature rate i equal to the advanced rate d; Therefore in this case: bank discount is
greater than the interest due.

Definition of Discount Discount classification

Discount
classes

Discount system Discount system

banking non-banking

Discount Discount Discount

rational banking commerci
al
Discount Discount Discount
simple simple unitary
Compoun Compoun Discount
d discount d discount successiv
e
The commercial discount occurs when a discount rate (d) is applied to the sales price
(PV) of a certain product on said value, to obtain a discounted price PR. If, for example,
in a store a product has a sales price of 100 soles and a 20% discount is applied, which
is 20, the reduced price is 80 soles. The commercial discount can be unitary or
successive.

d. Past due, early and deferred annuities

Zvi Bodie and Robert Merton (2003, pp. 118-120) state that an annuity is the set of
income for flow effect of effective, whether income or expenses in
effective, which are carried out in the temporal horizon or in a perpetual horizon, which
consider periods of rate, periods of income and the amounts of rent. The

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Annuities can be classified as simple, general and improper or variable.

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Simple annuities are characterized because the rate periods, income periods and
income amounts are uniform. General annuities are those where the income period
does not coincide with the capitalization period and there may be several rate periods
per income period, or several income periods per rate period.
Definition of an annuity Annuity Classification

Expired or ordinary annuities are those whose income begins at the end of each income
period. Early annuities and contributions are those where the income begins at the
beginning of the income period. Deferred annuities are those where the income begins
after a certain number of income periods, a period in which the initial capital is
capitalized.

e. Loan amortization

Zvi Bodie and Robert Merton (2003, pp. 124, 125) point out that the amortization of
Loan is the process of gradually paying off the principal of a debt over its life. Home
mortgage loans and car loans are paid in equal periodic installments. Part of each
payment is to pay the principal or capital and the other part to cover the interest. After
each payment, the outstanding balance is reduced, interest decreases, and the
principal payment increases.
Definition of amortization Types of loan repayment

Amortization is the financial process through which a debt or obligation and the interest
it generates are progressively extinguished through periodic or partial payments, which
can be initiated jointly with the cash received from the loan (anticipated flow), at the
expiration of each payment period (due flow) or after a certain originally agreed period
(deferred flow).

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There are various loan repayment systems, among which we have: French system or
uniform installments, German system or uniform principal installment, arithmetically
and geometrically variable installments. There are also personalized amortization
systems under the form of financial equivalence.

f. Criteria for evaluating projects

They are long-term financial indicators used in the evaluation of investment projects,
which, combined with the projected financial statements, the cost of money over time
and the residual value, serve as a basis for making decisions about capital investments.

Moyer, Guigan and Kretlow (2005, pp. 307, 308) state that these indicators have
virtues and defects, and in the evaluation and selection of investment projects four
criteria are usually followed. Net present value – NPV, cost-benefit index – CB, internal
rate of return – IRR and capital recovery period – PR.

Interpretation of NPV Interpretation of the

IRR
NPV > 0 NPV = 0 NPV < 0 TIR > COK IRR = COK IRR < COK

It is accepted the The It rejects the The The project It rejects the
project project project project is is project
accepted postponed
The net present value of a capital investment project is defined as the present value of
a series of net cash flows during the “n” period of the project's life, less the project's
net investment. The IRR is the discount rate that equates the present value of the net
cash flows during the life of the project with the net investment of the project. This is
the discount rate that makes the NPV of a project equal to zero.

The benefit-cost ratio is the return on net cash flows with respect to the initial
investment. The benefit-cost coefficient is calculated directly by dividing the sum of the
NPV plus the investment by said investment in present time. The capital payback period
is the time required for a project's cumulative cash inflows or net cash flows to equal
the initial cash outlay or net investment. It is about determining the time necessary for
the NPV of the investment to be equal to zero.

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