MATH2511_L1_ver5

MATH2511 Fundamental of Actuarial Mathematics
Lecture Note 1
Basic Interest Theory
1 MATH2511 Fundamentals of Actuarial Mathematics

Lecture Note 1: Basic Interest Theory
What is interest?
Roughly speaking, interest is an amount charged to a borrower for the use
of lender’s money over a period of time. It plays an important role in many
financial transactions in reality.
• Mortgage – Buyer of a property borrows money (usually 60~90% of
the property price) from a bank and the buyer repays the loan
(principal and interest) every month for 20~30 years.
• Deposit – A person deposits money in a saving account offered by the
bank and the bank, as a borrower, pays interest to the person
periodically (usually every month or every 6 months).
• Bond investment – An investor (lender) buys bond issued by
government or company (borrower) which pays a series of coupon
payments and a final payment at maturity date. These payments
contain the capital invested plus additional interest.
In lender’s point of view, the value of money invested is changing with
respect to time due to the additional interest received. Thus, the interest is
often coined as the time value of money.
How to measure interest? Some basic terminologies
The simplest type of interest problem can be described as follows:
At the current time, an amount of money 𝑃 (also called Principal) is
invested in some investment schemes such as saving account or
investment fund for a period of time 𝑇 (called investment period).
(*Remark: In most the cases, time 𝑇 is measured in years. In general, 𝑇 can
be measured by different units (say days, months etc.). The unit that
measures time is called measurement period.)
At time 𝑇, the account
An amount 𝑃 value changes due to the
(Principal) is interest payments.
invested
Series of interest payments

𝑃
Time 𝑇
Time 0
(End date)
(Start date)
Amount function
When time goes by, the money in the account grows due to the additional
interest paid from the investment scheme. We define amount function
𝐴(𝑡) as the value of the account at time 𝑡. Here, 𝐴(𝑡) can be interpreted as
future value of the capital 𝑃 at time 𝑡.
• Note: 𝐴(0) = 𝑃.
Interest and interest rate
Given the principal 𝑃 (initial investment) and suppose that the money grow
to 𝐴(𝑇) after 𝑇 years, then the surplus 𝐴(𝑇) − 𝐴(0) = 𝐴(𝑇) − 𝑃 is called
interest earned over the period [0, 𝑇] and is denoted by 𝐼.
It is natural that the interest earned depends on the amount of principal.
To examine the interest earned by the investment scheme in precisely, we
define interest rate (or effective interest rate) over the period [0, 𝑇],
denoted by 𝑖, to be the amount of interest earned per unit investment.
𝐼 𝐴(𝑇) − 𝐴(0)
𝑖= = .
𝑃 𝐴(0)
Remark
• It is clear that the interest rate 𝑖 defined above is sensitive to the time
interval [0, 𝑇]. When evaluating/comparing the performance of an
investment, 𝑇 is taken to be 1 year (i.e. [0, 1]) and the resulting
interest rate is called annual (effective) interest rate.
Example 1 (A quick example)
An amount of $4000 is invested in an investment fund now. It is given that
the account balance after 12 months (from now) is $4085.
What is the interest rate over the past 12 months?
☺Solution
By taking 𝐴(0) = 4000 and 𝐴(1) = 4085 (since 1 year = 12 months). The
annual interest rate is found to be
𝐴(1) − 𝐴(0) 4085 − 4000
𝑖= = = 2.125%.
𝐴(0) 4000

Accumulation function
Although the amount function 𝐴(𝑡) can describe the growth of the capital
invested in an investment scheme, it may not be an accurate indicator
since the function value depends on the size of the principal 𝐴(0) = 𝑃.
To rule out the effect of the principal invested, we define an accumulation
function, denoted by 𝑎(𝑡), as
𝐴(𝑡)
𝑎(𝑡) =
𝐴(0)
Since 𝑎(0) = 1, 𝑎(𝑡) can be interpreted as the growth the evolution of
unit investment (made at time 0) over time.
Remark
Intuitively, one would evaluate 𝐴(𝑡) by considering the account balance of
the investment account. Since the interest is paid periodically, the resulting
accumulation function is likely to be piecewise continuous function.

Example 2
Mary invests $120 in another fund. It is known that the fund pays two
interests with amounts $6 and $8 after 6 months and 12 months
respectively. Write down the amount function 𝐴(𝑡) and accumulation
function 𝑎(𝑡).
☺Solution
We first determine the account balance of the fund.
1st interest is paid,
Two interests are
the account balance
No interest paid so far. paid, the account
is $126
The account balance balance is $134
remains to be $120
$6 $8
time
0.5 1
(6 months) (12 months)

The amount function and accumulation function are given by
120 𝑖𝑓 0 ≤ 𝑡 < 0.5
𝐴(𝑡) = {126 𝑖𝑓 0.5 ≤ 𝑡 < 1 𝑎𝑛𝑑
134 𝑖𝑓 𝑡 ≥ 1
1 𝑖𝑓 0 ≤ 𝑡 < 0.5
𝐴(𝑡)
𝑎(𝑡) = = {1.05 𝑖𝑓 0.5 ≤ 𝑡 < 1.
𝐴(0)
1.1167 𝑖𝑓 𝑡 ≥ 1
Remark of Example 2
One can observe from Example 2 that the accumulation function 𝑎(𝑡) is
not necessarily to be continuous. The following figure shows the plot of
𝑎(𝑡) in Example 2. 𝑎(𝑡) There is an upward
1.1167 jump on 𝒂(𝒕) at
interest payment date
1.05
1
𝑡
0 0.5 1
Example 3 (Intermediate investment and multiple cashflows)
It is given that the accumulation function of an investment fund is 𝑎(𝑡) =
𝑡 2
(1 + 100) , 𝑡 ≥ 0.
(a) Peter invests $100 in the fund at time 0, how much will he get after
3 years (at time 3)?
(b) Suppose that Peter invests another $120 in the same fund at time 1
(not time 0), how much will he get in total after 2 years (at time 3)?
☺Solution:
(a) It suffices to find the value of 𝐴(3). Using the definition of 𝑎(𝑡) and
taking 𝑡 = 3, we have
3 2
𝐴(3) = 100𝑎(3) = (1 + ) = 106.09.
100
(b) According to the definition of 𝑎(𝑡), we note that investing $1 at
1
time 1 is equivalent to investing $ at time 0.
𝑎(1)

So it follows from the definition of 𝑎(𝑡), the investor should get
1 𝑎(3)
$(
𝑎(1)
) 𝑎(3) =
𝑎(1)
at time 3 if he invests $1 in the fund at time 1.
Using the fact, the total amount in Peter’s account at time 3 is
𝑎(3)
𝑇𝑜𝑡𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 = $100 × 𝑎(3) + $120 ×
𝑎(1)
3 2
(1 + 100)
= $106.09 + $120 × 2 ≈ $230.8895.
1
(1 + 100)
Remark of Example 3 (An useful fact)
In general, if an amount of 𝑃 is deposited at some time 𝑡1 ≥ 0 in a fund
(launched at time 0) which the accumulation function is 𝑎(𝑡), then the
amount value of 𝑃 at some future time 𝑡2 (> 𝑡1) can be expressed as
𝑎(𝑡2 )
𝑃× .
𝑎(𝑡1 )
𝑎(𝑡2 )
Here, the quotient is called accumulation factor or growth factor over
𝑎(𝑡1 )
the time interval [𝑡1 , 𝑡2 ].
Example 4 (Another example of multiple cashflows)
It is given that the accumulation function of an investment fund is 𝑎(𝑡) =
1 + 𝑟𝑡 2 , where 𝑡 ≥ 0 and 𝑟 is a constant. You are given that
• It is known that $150 can be obtained at 𝑡 = 4 if an amount of $120 is
invested in the fund at 𝑡 = 3.
Suppose that Mary deposits $100 in the fund at time 0, 1, 2 respectively.
How much does Mary get at time 4?
☺Solution
From the remark of Example 3, we obtain
𝑎(4) 1 + 16𝑟 1
120 = 150 ⇒ 120 = 150 ⇒ 𝑟 = .
𝑎(3) 1 + 9𝑟 19
One can treat the whole investment as three separate investments: Invest
$100 at time 𝑖 and receive money at time 4, where 𝑖 = 0,1,2. Then the
amount received in the entire investment is
2 2
𝑎(4) 1 + 16𝑟 𝑟=1/19
𝐴𝑚𝑜𝑢𝑛𝑡 = ∑ 100 = ∑ 100 2
⏞ 511.3844.
≈
𝑎(𝑖) 1+𝑖 𝑟
𝑖=0 𝑖=0
How to calculate the interest? Simple interest and Compound interest
Simple interest
If a principal of $1 is invested in an investment scheme at time 0 for a
period of 𝑇, then the interest rate earned over the period [0, 𝑇] is directly
proportional to the length of the period. More precisely, we let 𝑖 be annual
interest rate, then the interest rate earned per unit principal is 𝑖𝑇.
Invest $1 Interest 𝑎(𝑡) = 1 + 𝑖𝑡 Get $𝟏 + 𝒊𝑻
earned
= 𝑖𝑡
Time
0 𝑡 𝑇
Under simple interest, the accumulation function 𝑎(𝑡) can be described as
𝑎(𝑡) = 1 + 𝑖𝑡, 𝑡 ≥ 0.
Remark about simple interest
In practice, simple interest is used in calculating interest involved in short-
term financial transaction such as short-term personal loan (e.g. flat rate
loan) or some fixed-term deposit (usually no intermediate deposit).
Example 5
Michael deposits $1500 in a saving account paying simple interest. Two
years later, Michael closes the account and withdraw all amount from the
account. He immediately deposits the whole amount in a new saving
account offering the same rate. Assuming the annual interest rate is 3%,
find the amount value of the saving account at the end of 5th year.
☺Solution:
We first calculate the account balance at the end of 2nd year. The
accumulation function 𝑎(𝑡) is given by 𝑎(𝑡) = 1 + 0.03𝑡. So the amount
function at the end of 2nd year (denoted by 𝐴(2)) is given by
𝐴(2) = 𝐴(0)𝑎(2) = 1500(1 + 0.03(2)) = 1590.
Since the account is closed and the balance $1590 is treated as principal in
a new saving account for three more years, so the amount function at the
end of 5th year (denoted by 𝐴(5)) will be calculated as
𝐴(5) = 𝐴(2)𝑎𝑛𝑒𝑤 (3) = 1590(1 + 0.03(3)) = 1733.1.
(Note that 1733.1 > 1500𝑎(5) = 1500(1 + 0.03(5)) = 1725.)
Remark: Date conventions under simple interest
An accurate measurement of investment period 𝑡 is crucial in calculating
the interest payment under simple interest. In this section, we examine
three different ways to measure the length of investment period.
(*Here, we assume that 𝑡 is measured in years)
Method 1: Exact simple interest
In this method, we first count the exact number of days between start-
date and end-date of the investment. We denote this number by 𝑁, then 𝑡
is calculated by
𝑁
𝑡= .
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
The denominator is taken to be either 365 (for non-leap year) or 366 (for
leap-year).

Method 2: Ordinary simple interest
In this method, we assume that there are only 360 days in a year and only
30 days in a month.
Given two dates 𝐷1 /𝑀1 /𝑌1 and 𝐷2 /𝑀2 /𝑌2 , the number of days between the
two dates (denoted by 𝑁) is calculated as follows:
• If 𝐷𝑖 (𝑖 = 1,2) is 31, convert 𝐷𝑖 to 30;
• If 𝑀𝑖 = 2 and 𝐷𝑖 = 28 (non-leap year) or 29 (leap year), convert 𝐷𝑖 to
30.
Then 𝑁 is given by
𝑁 = 360(𝑌2 − 𝑌1 ) + 30(𝑀2 − 𝑀1 ) + (𝐷2 − 𝐷1 ).
The corresponding 𝑡 is computed as
𝑁
𝑡= .
360
Method 3: Banker’s Rule
The method is similar to method 1 except that the number of days in a
year (denominator) is taken to be 360.
Example 6
On 25th November, 2015, Peter deposits $100 in a saving account which
pays simple interest at annual interest rate 5%. He closes the account and
withdraws all money on 31th March, 2016. How much does Peter receive
upon the closure of his account?
☺Solution
We shall calculate the amount using the three methods described above:
Method 1: Exact simple interest
The number of days between two dates is
(5 + 31) + ⏟
𝑁=⏟ (31 + 29 + 31) = 36 + 91 = 127.
𝑖𝑛 2015 𝑖𝑛 2016
36 91
So 𝑡 can be computed as 𝑡 = + = 0.347264. The amount received
365 366
by Peter is given by
𝐴𝑚𝑜𝑢𝑛𝑡 = $100 × (1 + 0.05(0.347264)) = 101.7363.

Method 2: Ordinary simple interest
Since 𝐷2 = 31 for the end date, so it will be converted to 30. Then the
number of days between two given dates is seen to be
𝑁 = 360(2016 − 2015) + 30(3 − 11) + (30 − 25) = 125.
125
Thus 𝑡 is given by 𝑡 = = 0.347222. The corresponding amount
360
received by Peter is
𝐴𝑚𝑜𝑢𝑛𝑡 = $100 × (1 + 0.05(0.347222)) = 101.7361.
Method 3: Banker’s rule

127
Using the result obtained in Method 1, 𝑡 is found to be 𝑡 = ≈
360
0.352778. The corresponding amount received by Peter is
𝐴𝑚𝑜𝑢𝑛𝑡 = $100 × (1 + 0.05(0.352778)) = 101.7639.

Compound Interest
Under compound interest scheme, interest is paid regularly and
periodically. The interest paid over each period (known as interest period)
is calculated based on the account balance in the last interest payment
date instead of the initial principal invested.
Suppose that $1 is invested in the investment scheme and the scheme
pays interest at the end of every interest period. We let 𝑇 be the length of
each interest period and 𝑟 (𝑟 > 0) be the interest rate over an interest
period. Under compound interest, the account will be evolved as follows:
The interest rate earned
over an interest period is 𝒓
Invest $1
𝑟(1) 𝑟(1 + 𝑟) 𝑟(1 + 𝑟)2 𝑟(1 + 𝑟)3 ⋯
Time
0 𝑇 2𝑇 3𝑇 4𝑇 𝑛𝑇
Account
Balance $𝟏 $(𝟏 + 𝒓) $(𝟏 + 𝒓)𝟐 $(𝟏 + 𝒓)𝟑 $(𝟏 + 𝒓)𝟒 $(𝟏 + 𝒓)𝒏

• At time 𝑇, the investor will receive an interest of amount 𝑟(1). After
that, the account balance 1 + 𝑟 will be treated as new principal to
calculate the interest paid at time 2𝑇.
• At time 2𝑇, the investor will receive an interest of amount 𝑟(1 + 𝑟)
and the balance is grown to (1 + 𝑟) + 𝑟(1 + 𝑟) = (1 + 𝑟)2 . After
that, (1 + 𝑟)2 becomes new principal to calculate the interest paid at
time 3𝑇 and so on.
In other words, the interests received at earlier periods will generate extra
interest in future under compound interest scheme.
Under compound interest, the accumulation function 𝑎(𝑡) is seen to be
𝑡=𝑛𝑇 𝑡
𝑎(𝑛𝑇) = (1 + 𝑟 )𝑛 ⏞ 𝑎(𝑡) = (1 +
⇒ 𝑟)𝑇 , 𝑡 = 0, 𝑇, 2𝑇, … … . (𝐴)
Calculation of 𝑟 and compounding frequency

In reality, it is often the case that interest is paid more than once in a year
(for example: daily, monthly, quarterly or semi-annually) under compound
interest. Different from the case of simple interest, the frequency of
compounding (number of interest payments in a year) affects the total
amount of interest received significantly since the interest earned at
earlier time will generate additional interest in future.
Suppose that the interests are paid 𝑚 times regularly per year (at times
1 2 3
, , …), we say the interest is convertible 𝑚𝑡ℎ -ly (or “payable 𝑚𝑡ℎ -ly”,
𝑚 𝑚 𝑚
“compounded 𝑚𝑡ℎ -ly”).
Annual nominal interest rate
In reality, an annual interest rate is quoted in calculating the interest rate
𝑟. This interest rate is called as annual nominal interest rate (denoted by
𝑖 (𝑚) ), which is defined as the interest received by the investor in a year
given that the interest is paid once in the year (at the end of the year). One
has to be careful that the annual nominal interest rate may not indicate
the exact interest received by the investor.
Given 𝑖 (𝑚) , the interest rate 𝑟 over an interest period is calculated as
(𝑚 )
𝑖
𝑟 = 𝑖 (𝑚 ) 𝑇 = .
𝑚
Example 7 (Simple interest v.s. Compound interest)
An amount of $1200 is deposited in a saving account for 3 years. It is given
that the annual nominal interest rate of the saving account is 4%.
(a) If simple interest is applied, find account balance after 3 years.
(b) If compound interest is applied and the interest is paid semi-
annually, find the account balance after 3 years.
☺Solution
(a) Under simple interest scheme, the accumulation function is
𝑎(𝑡) = 1 + 𝑖𝑡 = 1 + 0.04𝑡, 𝑡≥0
Hence, the required account balance is
𝐴(3) = 𝐴(0)𝑎(3) = 1200(1 + 0.04(3)) = 1344.
(b) Under compound interest scheme, the accumulation function is
1
𝑇=
2 0.04 2𝑡 1
𝑎(𝑡) =
⏞ (1 + ) = (1.02)2𝑡 , 𝑡 = 0, , 1, …
2 2
𝐴(3) = 𝐴(0)𝑎(3) = 1200(1.02)2(3) ≈ 1351.395.

Example 8 (Interest payment v.s. Compounding frequency)
Susan deposits $500 in a saving account. It is known that the annual
nominal interest rate is 6% convertible 𝑚-thly, where 𝑚 is positive integer.
Find the amount value after 1 year if
(a) 𝑚 = 2 (i.e. the interest is paid semi-annually)
(b) 𝑚 = 4 (i.e. the interest is paid quarterly)
(c) 𝑚 = 12 (i.e. the interest is paid monthly)
☺Solution
The accumulation function 𝑎(𝑡) is given by
(𝑚) 𝑚𝑡
𝑖 0.06 𝑚𝑡
𝑎(𝑡) = (1 + ) = (1 + ) .
𝑚 𝑚
(a) If 𝑚 = 2, the amount value is 𝐴(1) = 𝑎(1)|𝑚=2 (500) ≈ 530.45.
(b) If 𝑚 = 4, the amount value is 𝐴(1) = 𝑎(1)|𝑚=4 (500) ≈ 530.68.
(c) If 𝑚 = 12, the amount value is 𝐴(1) = 𝑎(1)|𝑚=12 (500) ≈ 530.84.

Remark 1 of Example 8
We observe from the above result that the interest earned increases when
the frequency of compounding 𝑚 increases. In general, one can show that
(𝑚+1)𝑡
𝑖 𝑖 𝑚𝑡
(1 + ) > (1 + ) … … (∗)
⏟ 𝑚+1 ⏟ 𝑚
𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛
(𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑓𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦 𝑚+1) (𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑓𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦 𝑚)
for any positive integer 𝑚. Here, 𝑖 (> 0) denotes the annual nominal
interest rate.
Proof of the inequality (∗)
We consider the quotient
(𝑚+1)𝑡 𝑚𝑡
𝑖 𝑖
(1 + 𝑚 + 1) 1+ 𝑖 𝑡
=( 𝑚 + 1) (1 + )
𝑖 𝑚𝑡 𝑖 𝑚 + 1
(1 + 𝑚) 1+
𝑚

𝑚 𝑡
𝑖 𝑚 𝑡
1+ 𝑖 𝑚 2
+ 𝑚 + 𝑚𝑖 𝑖
= [( 𝑚 + 1) (1 + )] = [( 2 ) (1 + )]
𝑖 𝑚 + 1 𝑚 + 𝑚 + 𝑚𝑖 + 𝑖 𝑚 + 1
1+
𝑚
𝑚 𝑡
𝑖 𝑖
= [(1 − 2 ) (1 + )]
𝑚 + 𝑚 + 𝑚𝑖 + 𝑖 𝑚+1
𝑚≥1 𝑡
𝑖 𝑖
⏞ [(1 + 𝑚 (−
≥ )) (1 + )]
2
𝑚 + 𝑚 + 𝑚𝑖 + 𝑖 𝑚+1
𝑡
𝑚2 + 𝑚 + 𝑖 𝑚+1+𝑖
= [( 2 )( )]
𝑚 + 𝑚 + 𝑚𝑖 + 𝑖 𝑚+1
𝑡
𝑚3 + 𝑚2 + 𝑚𝑖 + 𝑚2 + 𝑚 + 𝑖 + 𝑚2 𝑖 + 𝑚𝑖 + 𝑖 2
=[ ]
𝑚3 + 𝑚2 + 𝑚𝑖 + 𝑚2 + 𝑚 + 𝑖 + 𝑚2 𝑖 + 𝑚𝑖
𝑡
𝑖2 𝑡
= [1 + 3 ] > 1 = 1.
𝑚 + 𝑚2 + 𝑚𝑖 + 𝑚2 + 𝑚 + 𝑖 + 𝑚2 𝑖 + 𝑚𝑖
So we deduce that
(𝑚+1)𝑡
𝑖 𝑖 𝑚𝑡
(1 + ) > (1 + )
𝑚+1 𝑚
Remark 2 of Example 8: Continuous compounding
According to the result in remark 1, we expect that the interest earned
would be maximized when 𝑚 → ∞. In this case, the interest is paid
continuously. We say the interest is compounded continuously.
Next, we derive the accumulation function under continuous
compounding. We let 𝑖 be the annual nominal interest rate. Using the fact
𝑥 𝑛
that lim (1 + ) = 𝑒 𝑥 , one can establish that
𝑛→∞ 𝑛
𝑡
𝑖 𝑚𝑡 𝑖 𝑚 𝑖 𝑡
𝑎(𝑡)|𝑚→∞ = lim (1 + ) = lim [(1 + ) ] = (𝑒 ) = 𝑒 𝑖𝑡 .
𝑚→∞ 𝑚 𝑚→∞ 𝑚
Why do we need continuous compounding?
In reality, this formula may not be realistic since the interest is paid
discretely instead of continuously. However, we can deduce from
definition of limit that
𝑖 𝑚𝑡
(1 + ) ≈ 𝑒 𝑖𝑡 , 𝑤ℎ𝑒𝑛 𝑚 𝑖𝑠 𝑠𝑢𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡𝑙𝑦 𝑙𝑎𝑟𝑔𝑒
𝑚
Hence. the formula 𝑎(𝑡) = 𝑒 𝑖𝑡 can be a good approximation if the interest
rate is paid very frequently, such as daily (𝑚 = 365 𝑜𝑟 366).
As an example, we consider a scenario that an investor borrows some
money (say 𝑃 = $1000) from a bank which charges interest at annual
nominal interest rate of 5% compounded daily. Assume that the investor
will repay the loan after 1.5 years, we calculate the repayment amount
after 1.5 years.
Suppose that there are 365 days in a year, then the exact repayment
amount after 1.5 years can be computed as
0.05 365(1.5)
1000 × 𝑎(1.5) = 1000 × (1 + ) = 𝟏𝟎𝟕𝟕. 𝟖𝟕𝟗.
365
Suppose that we adopt continuous compounding approximation (i.e.
𝑎(𝑡) ≈ 𝑒 𝑖𝑡 ), then the corresponding amount is computed as
1000 × 𝑎(1.5) ≈ 1000𝑒 0.05(1.5) = 𝟏𝟎𝟕𝟕. 𝟖𝟖𝟒.
We observe that the answers obtained from two approaches are very
close. It confirms that the effectiveness of the approximation method.
Some simple facts about compound interest
• One can easily verify that 𝑎(𝑡) possess the following property:
⏟ (𝑚 + 𝑛)𝑇) = 𝑎⏟(𝑚𝑇) × 𝑎⏟(𝑛𝑇) … … (𝐵).
𝑎(
=(1+𝑟 )𝑚+𝑛 =(1+𝑟 )𝑚 =(1+𝑟 )𝑛
for any non-negative integers 𝑚, 𝑛.
Financially, it means that the investor cannot earn any extra benefit by
reinvesting the capital into a new account at the intermediate time.
• (Simple interest v.s. Compound interest) We let 𝑖 be annual nominal
interest rate. Using binomial theorem, one can show that for any
1 2 3
positive integer 𝑚 ≥ 1 and 𝑡 = , , , ….
𝑚 𝑚 𝑚
𝑖 𝑚𝑡
(1 + ) ≥ 1
⏟+ 𝑖𝑡
⏟ 𝑚 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛
𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 (𝑠𝑖𝑚𝑝𝑙𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡)
𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
( )
𝑐𝑜𝑛𝑣𝑒𝑟𝑡𝑖𝑏𝑙𝑒 𝑚𝑡ℎ 𝑙𝑦
So compound interest scheme can generate more interest than simple

interest scheme.
One technical issue: How to define 𝑎(𝑡) when 𝑡 ≠ 𝑛𝑇?
Similar to the case for simple interest, we would like to define the
accumulation function for all 𝑡 ≥ 0.
Inspired by the property (𝐵) (see p.23), we assume that the function 𝑎(𝑡)
satisfies the following properties:
𝑎(𝑠 + 𝑡) = 𝑎(𝑠)𝑎(𝑡) … … (𝐵),
for any 𝑠, 𝑡 ≥ 0.
Assuming that 𝑎(𝑡) is a differentiable, we can then deduce the following
theorem:
Theorem 1
Suppose that the accumulation function 𝑎(𝑡) satisfies the properties (A),
(B) and is differentiable, then 𝑎(𝑡) takes the following form:
𝑡
𝑎(𝑡) = (1 + 𝑟)𝑇 , 𝑡 ≥ 0,
where 𝑇 denotes the length of an interest period

Proof of Theorem 1
We first derive a governing equation for 𝑎(𝑡) which allows us to solve for 𝑎(𝑡).
By taking 𝑠 = Δ𝑡 in (𝐵), where Δ𝑡 is some positive number, we get
𝑎(𝑡 + Δ𝑡) − 𝑎(𝑡) 𝑎(Δ𝑡) − 1
𝑎(𝑡 + Δ𝑡) = 𝑎(𝑡)𝑎(Δ𝑡) ⇒ = 𝑎(𝑡) ( ).
Δ𝑡 Δ𝑡
𝑓(𝑥+ℎ)−𝑓(𝑥)
By setting Δ𝑡 → 0 and using the definition of derivative 𝑓 ′ (𝑥 ) = lim ,
ℎ→0 ℎ
the above equation can be expressed as
𝑎′ (𝑡) = 𝑎(𝑡)𝑎′ (0).
Using the separating variable technique, one can deduce that
𝑡 𝑡
𝑎′ (𝑡) 𝑑 ln 𝑎 (𝑠 )
= 𝑎′ (0) ⇒ ∫ 𝑑𝑠 = ∫ 𝑎′ (0)𝑑𝑠 ⇒ ln 𝑎(𝑡) − ln
⏟ 𝑎(0) = 𝑎′ (0)𝑡
𝑎(𝑡) 0 𝑑𝑠 0 =0
′ (0)𝑡
⇒ 𝑎(𝑡) = 𝑒 𝑎
To find 𝑎′ (0), we take 𝑡 = 𝑛𝑇 in the above equation and use the fact that 𝑎(𝑛𝑇) =
(1 + 𝑟)𝑛 (see (A)), we deduce that
𝑛 𝑎 ′ (0)𝑛𝑇 ′
1
(1 + 𝑟) = 𝑒
⏟ ⇒ 𝑎 (0) = ln(1 + 𝑟).
𝑇
=𝑎(𝑛𝑇)
𝑡 𝑡 𝑡
ln(1+𝑟) ln(1+𝑟) 𝑇
Hence, we conclude that 𝑎(𝑡) = 𝑒 𝑇 =𝑒 = (1 + 𝑟) .
𝑇

Example 10 (Harder)
Mr. A deposits $350 in a saving account now (at time 0) and the account
pays interest at an annual nominal interest rate of 𝑖 convertible quarterly.
At the same time, Mr. B deposits $400 in another saving account that pays
simple interest at an annual nominal interest rate of 𝑖.
It is given that two accounts earn the same amount of interest during the
first three months of the 5th year. Find the value of 𝑖.
☺Solution
We first calculate the interests earned by each account during the 5th year.
Note that the accumulation functions, denoted by 𝑎𝐴 (𝑡) (Mr. A’s account)
and 𝑎𝐵 (𝑡) (Mr. B’s account) respectively, are known to be
𝑖 4𝑡
𝑎𝐴 (𝑡) = (1 + ) , 𝑎𝐵 (𝑡) = 1 + 𝑖𝑡
4

Interest earned in Mr. A’s account during 5th year can be computed as
𝑖 17 𝑖 16
= 350𝑎𝐴 (4.25) − 350𝑎𝐴 (4) = 350 [(1 + ) − (1 + ) ]
4 4
𝑖 17 𝑖 𝑖 16 𝑖
= 350 (1 + ) [1 + − 1] = 350 (1 + ) .
4 4 4 4
Interest earned in Mr. B’s account during 5th year is found to be
𝑖
( ) ( )
= 400𝑎𝐵 4.25 − 400𝑎𝐵 4 = ⋯ = 400 .
4
Since the amounts of interest earned in the two accounts are the same in
the 5th year, so we have
𝑖 16 𝑖 𝑖 𝑖 16 400
350 (1 + ) = 400 ⇒ (1 + ) =
⏟ 4 4 ⏟ 4 4 350
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑
(𝑀𝑟.𝐴′ 𝑠) (𝑀𝑟.𝐵′ 𝑠)
1
400 16
⇒ 𝑖 = 4 [( ) − 1] ≈ 0.03352 (𝑜𝑟 3.352%).
350
Example 11 (Compound interest with varying interest rate)
Johnson deposits $20000 in a saving account. It is known that the annual nominal
interest rate is 4% convertible semiannually in the first two years, 5% convertible
quarterly in the next three years and 𝑖 convertible quarterly thereafter.
(a) Determine the accumulation function of the saving account.
(b) Suppose that the amount in Johnson’s account will grow to 28168.22 at the
end of 7th year, find the value of 𝑖.
(c) Suppose that Johnson withdraw an amount of $5000 at the end of 4th year,
find the amount in Johnson’s account at the end of 7th year.
☺Solution
(a) Using forward induction, the accumulation function 𝑎(𝑡) can be expressed
as
0.04 2𝑡
(1 + ) 𝑖𝑓 𝑡 < 2
2
( )
0.04 2(2) 0.05 4 𝑡−2
𝑎(𝑡) = (1 + ) (1 + ) 𝑖𝑓 2 ≤ 𝑡 < 5 .
2 4
( )
0.04 2(2) 0.05 4 3 𝑖 4(𝑡−5)
{(1 + 2 ) (1 +
4
) (1 + )
4
𝑖𝑓 𝑡 ≥ 5
(a) Since the amount becomes 28168.22 after 7 years, we have
20000 𝑎(7) = 28168.22
4(7−5)
𝑖
⇒ 20000(1.02)4 (1.0125)12 (1 + ) = 28168.22
4
8
𝑖
⇒ (1 + ) = 1.129055 ⇒ 𝑖 ≈ 0.0575.
4
(b) We first compute the amount value of the account at the end of 4th
year (just before withdraw). It is easy to see that
𝐴(4) = 20000(1.02)4 (1.0125)8 = 23910.63.
After the withdrawal of $5000, the balance is 23910.63 − 5000 =
18910.63 and the amount value at the end of 7th year is given by
8
𝑎(7) 0.0575
18910.63 × = 18910.63(1.0125)4 (1 + )
𝑎(4) 4
≈ 22277.91.

Effective interest rate (EIR)
The effective interest rate, EIR in short, is defined as the actual amount of
interest that $1 invested at the beginning of a period will earn during the
period, with interest being paid at the end of the period.
$1 + interest (EIR)
$1
𝑡1 1 period 𝑡2
Mathematical definition of EIR
Suppose that $1 is invested in a fund at some time 𝑡1 , then the amount will
𝑎(𝑡2 )
grow to at some future time 𝑡2 (> 𝑡1 ). Here, 𝑎(𝑡) denotes the
𝑎(𝑡1 )
accumulation function of the fund.
Therefore, the interest earned over the interval [𝑡1 , 𝑡2 ] is seen to be
𝑎(𝑡2 ) 𝑎(𝑡2 ) − 𝑎(𝑡1 )
𝑖[𝑡1 ,𝑡2] = −1= .
𝑎(𝑡1 ) 𝑎(𝑡1 )
The quantity 𝑖[𝑡1 ,𝑡2] is called effective interest rate over the period [𝑡1 , 𝑡2 ].
In practice, one period is taken to be one year. So the corresponding EIR is
called annual effective interest rate.
We let 𝑎(𝑡) be an accumulation function of an investment scheme, then
the annual effective interest rate during 𝑛𝑡ℎ year, denoted by 𝑖𝑛 , can be
expressed as
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑔𝑎𝑖𝑛𝑒𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑛𝑡ℎ 𝑦𝑒𝑎𝑟
⏞
𝑎(𝑛) − 𝑎(𝑛 − 1)
𝑖𝑛 = .
⏟(𝑛 − 1)
𝑎
𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 (𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑛𝑡ℎ 𝑦𝑒𝑎𝑟)
Remark
Alternatively, one can express the interest rate 𝑖𝑛 in terms of amount
function 𝐴(𝑡). That is,
𝐴(𝑛) 𝐴(𝑛 − 1)
𝑎(𝑛) − 𝑎(𝑛 − 1) 𝐴(0) − 𝐴(0) 𝐴(𝑛) − 𝐴(𝑛 − 1)
𝑖𝑛 = = = .
𝑎(𝑛 − 1) 𝐴(𝑛 − 1) 𝐴(𝑛 − 1)
𝐴(0)

Example 12 (Effective interest rate under simple interest and compound interest)
Annual nominal interest rate of an investment scheme is known to be 𝑖.
(a) Suppose that the investment scheme pays simple interest, find the annual
effective interest rate during 𝑛𝑡ℎ year.
(b) Suppose that the investment scheme pays compounded rate convertible 𝑚-
thly, what is the corresponding annual effective interest rate during 𝑛𝑡ℎ
year.
☺Solution
(a) Recall that the accumulation function for simple interest is 𝑎(𝑡) = 1 + 𝑖𝑡, so
the effective interest rate can be computed as
𝑎(𝑛) − 𝑎(𝑛 − 1) 1 + 𝑖𝑛 − (1 + 𝑖 (𝑛 − 1)) 𝑖
𝑖𝑛 = = = .
𝑎(𝑛 − 1) 1 + 𝑖(𝑛 − 1) 1 + 𝑖(𝑛 − 1)
𝑖 𝑚𝑡
(b) The accumulation function for compounded interest is 𝑎(𝑡) = (1 + 𝑚) ,
then the corresponding effective interest rate is
𝑖 𝑚𝑛 𝑖 𝑚(𝑛−1)
(1 + 𝑚) − (1 + 𝑚) 𝑖 𝑚
𝑖𝑛 = 𝑚(𝑛−1)
= (1 + ) − 1
𝑖 𝑚
(1 + 𝑚)
Additional remarks about EIR
• To define the effective interest rate, we have assumed that there is no
additional deposit and withdraw throughout the period.
• As seen from Example 12, 𝑖𝑛 may not necessarily to be constant. That
is, the effective interest rates at different periods can be different.
Recovering 𝑎(𝑡) from effective interest rate
Given the set of annual effective interest rates 𝑖𝑛 at different years. The
accumulation function 𝑎(𝑡) can be determined to be
𝑎(𝑛) = (1 + 𝑖𝑛 )(1 + 𝑖𝑛−1 ) … (1 + 𝑖1 )𝑎(0).
for any integers 𝑛.
However, we cannot define the value of 𝑎(𝑡) when 𝑡 is not an integer. It is
because the effective interest rate indicates the total amount of interest
earned over a period only and it does not reveal how the interest be paid
(simple interest/ compound interest) within a period.

Example 13
Peter deposits $200 in a saving account at time 0. At the end of 1st year, he
deposits additional $500 in the same account. It is given that
• Account balance at the end of 2nd year is $720.
• Annual effective interest rate (denoted by 𝑖) of the saving account is
constant in these 2 years.
Find the annual effective interest rate of this saving account.
☺Solution
The accumulation function of the saving account can be expressed as
𝑎(𝑛) = (1 + 𝑖 )𝑛 , 𝑛 = 0,1,2.
Using the above information, we can derive the following equation
𝑎(2)
200𝑎(2) + 500 = 720 ⇒ 200(1 + 𝑖 )2 + 500(1 + 𝑖 ) = 720,
𝑎(1)
−500 ± √(500)2 + 4(200)(720)
⇒1+𝑖 = ⇒ 𝑖 ≈ 0.02211.
2(200)
Example 14 (Harder, Problem 2 of midterm exam, 2016 Fall)
Accumulation function of an investment fund is 𝑎(𝑡), 𝑡 ≥ 0. It is given that
• the effective interest rate of the fund during the 1st year is 𝑖1 = 4% and
• the effective interest rate of the fund during the 2nd year is 𝑖2 = 5%.
Mr. A opens an account at time 0 and deposits $250, $250 and $300 into the
fund at time 0, 1 and 1.5 respectively.
Mr. B opens an account at time 0 and deposits $100, $200 and $300 into the
fund at time 0, 0.5 and 1.5 respectively.
Mr. C opens an account at time 0 and deposits $100, $200, $300 and $400 into
the fund at time 0, 0.5, 1 and 1.5 respectively.
It is given that
• The accumulated (future) value of Mr. A’s account at time 2 is $844.5566;
• The interest earned by Mr. B’s account during 2nd year (from time 1 to
time 2) is 24.45268.
Find the accumulated (future) value of Mr. C account at the end of 2nd year.

Solution
The account value of Mr. C’s account at the end of 2nd year can be expressed as
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = 𝐹𝑉 𝑜𝑓 𝑝𝑎𝑠𝑡 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠 𝑎𝑡 𝑡𝑖𝑚𝑒 2
𝑎(2) 𝑎(2) 𝑎(2)
= 100𝑎(2) + 200 + 300 + 400 … … (∗)
𝑎(0.5) 𝑎(1) 𝑎(1.5)
It remains to find the unknowns 𝑎(0.5), 𝑎(1), 𝑎(1.5) and 𝑎(2), we note that
𝑎(0)=1
𝑎(1)−𝑎(0)
• 𝑖1 = 4% ⇒ ⏞ 𝑎(1) = 1.04.
= 0.04 ⇒
𝑎(0)
𝑎 (1)=1.04
𝑎(2)−𝑎 (1)
• 𝑖2 = 5% ⇒ = 0.05 ⏞
⇒ 𝑎(2) = 1.092.
𝑎(1)
• The account value (i.e. future value of past deposits) of Mr. A account at time
2 is $844.5566, this implies
𝑎(2) 𝑎(2)
250𝑎(2) + 250 + 300 = 844.5566
𝑎(1) 𝑎(1.5)
1.092 1.092
( )
⇒ 250 1.092 + 250 + 300 = 844.5566
1.04 𝑎(1.5)
⇒ 𝑎(1.5) = 1.06.

• The interest earned by Mr. B during second year is 24.45268. On the other
hand, we note the change in account value in 2nd year is caused by interest
earned and the deposit made within the 2nd year, so we have
𝑎(2) 𝑎(2) 𝑎(1)
(100𝑎(2) + 200 + 300 ) − (100𝑎(1) + 200 )
⏟ 𝑎 (0.5) 𝑎 (1.5) ⏟ 𝑎 (0.5)
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 2 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 1
(𝑒𝑛𝑑 𝑜𝑓 2𝑛𝑑 𝑦𝑒𝑎𝑟 ) (𝑒𝑛𝑑 𝑜𝑓 1𝑠𝑡 𝑦𝑒𝑎𝑟 )
= 300
⏟ + 24.45268
⏟
𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑
1.092 1.092 1.04
⇒ (100(1.092) + 200 + 300 ) − (100(1.04) + 200 )
𝑎(0.5) 1.06 𝑎(0.5)
= 324.45268.
⇒ 𝑎(0.5) = 1.02.
Therefore, we deduce from equation (*) that
1.092 1.092 1.092
( )
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = 100 1.092 + 200 + 300 + 400
⏟ 1.02 1.04 1.06
𝑎 (2) 𝑎(2) 𝑎 (2)
100𝑎 (2)+200 +300 +400
𝑎 (0.5) 𝑎(1) 𝑎(1.5)
≈ 1050.393.

Example 15
An investment fund pays compound interest at an annual effective interest
rate 𝑖 = 4.5%.
Suppose that an investor invests $1000 in the fund at time 0 and deposits
another $1500 in the same fund after 9 months, find the amount value of
the fund after 2 years.
☺Solution
Assuming the interest is convertible 𝑚-thly, the accumulation function can
𝑚𝑡
𝑖 (𝑚)
be expressed as 𝑎(𝑡) = (1 + 𝑚
) for 𝑡 ≥ 0. Since the annual effective
𝑚
𝑖 (𝑚)
interest rate 𝑖 is governed by 𝑖 = (1 + 𝑚
) − 1, thus the accumulation
function can be rewritten as
𝑎(𝑡) = (1 + 𝑖 )𝑡 = (1.045)𝑡 , 𝑓𝑜𝑟 𝑡 ≥ 0
Hence, the value of the fund after 2 years can be computed as
𝑎(2)
𝑉𝑎𝑙𝑢𝑒 = 1000𝑎(2) + 1500 = 1000(1.045)2 + 1500(1.045)1.25
𝑎(0.75)
≈ 2676.869.
Example 16
The monthly (not annual) effective interest rate of a saving account during 𝑚𝑡ℎ
month is 𝑗, where 𝑗 is constant. Find the annual effective interest rate during 𝑛𝑡ℎ
year.
☺Solution
We first recover the accumulation function for this saving account. According to
the definition of effective interest rate, we have
𝑎(𝑡 + 1/12) − 𝑎(𝑡)
𝑖𝑚 = ⇒ 𝑎(𝑡 + 1/12) = (1 + 𝑗)𝑎(𝑡).
𝑎(𝑡)
For any positive integer 𝑛, the accumulation function at 𝑛𝑡ℎ month is
𝑛 𝑛−1 𝑛−2
𝑎 ( ) = (1 + 𝑗)𝑎 ( ) = (1 + 𝑗)2 𝑎 ( ) = ⋯ = (1 + 𝑗)𝑛
12 12 12
Replace 𝑛/12 by 𝑡, we get
𝑛 2𝑛
𝑎(𝑡) = (1 + 𝑗)12𝑡 , 𝑡 = 0, , , …
12 12
Therefore, the annual effective interest rate, denoted by 𝑖, is found to be
𝑎(𝑛) − 𝑎(𝑛 − 1) (1 + 𝑗)12𝑛 − (1 + 𝑗)12(𝑛−1)
𝑖= = ( )
= (1 + 𝑗)12 − 1.
𝑎(𝑛 − 1) (1 + 𝑗)12 𝑛−1

Application of effective interest rate: Performance evaluation
In practice, the effective interest rate is often used to compare the
performance between several investment schemes that have different
interest payment schemes.
Example 17
There are three investment funds available in a market:
• Fund A: Pays interest at annual nominal interest rate of 12%
convertible quarterly;
• Fund B: Pays interest at annual nominal interest rate of 12.2%
convertible 3-thly (the interest is paid every 4 months)
• Fund C: Pays interest at annual nominal interest rate 12.3%
convertible semi-annually.
Compare the performance of these three funds by finding the annual
effective interest rate of each fund.

☺Solution
We let 𝑖𝐴 , 𝑖𝐵 and 𝑖𝐶 be the annual effective interest rate of fund A, fund B
and fund C respectively.
Using the result in Example 12(b), we have
4 (4)
𝑖 (4) 𝑖 =0.12 0.12 4
𝑖𝐴 = (1 + ) −1 =⏞ (1 + ) − 1 = 0.125509,
4 4
3 (3) =0.122
𝑖 (3) 𝑖 0.122 3
𝑖𝐵 = (1 + ) −1 =
⏞ (1 + ) − 1 = 0.127029,
3 3
2 (2) =0.123
𝑖 (2) 𝑖 0.123 2
𝑖𝐶 = (1 + ) −1 =
⏞ (1 + ) − 1 = 0.126782.
2 2
Since 𝑖𝐵 > 𝑖𝐶 > 𝑖𝐴 , we conclude that Fund B has the best performance
among 3 available funds and Fund A has the worst performance.

Force of interest
In our current setting, the value of an investment scheme (measured by
𝑎(𝑡)) changes continuously due to interest is earned continuously. We
would like to examine the amount of interest “paid” at every instant.
How to do it?
We consider the time interval between 𝑡 and 𝑡 + Δ𝑡, where Δ𝑡 is a very
small positive constant.
Given the accumulation function 𝑎(𝑡), the effective interest rate over the
time interval [𝑡, 𝑡 + Δ𝑡] is given by
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑔𝑎𝑖𝑛𝑒𝑑 𝑎(𝑡 + Δ𝑡) − 𝑎(𝑡)
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = = .
𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑎(𝑡)
The above indicator is not useful in practice since the interest rate will tend
to 0 if the time increment Δ𝑡 tends to 0.

To obtain a more meaningful indicator, we will “normalize” the interest
rate by dividing the rate by Δ𝑡 and convert the interest rate to the annual
nominal interest rate. That is,
𝑎(𝑡 + Δt) − 𝑎(𝑡)
1 𝑎(𝑡 + Δ𝑡) − 𝑎(𝑡) Δ𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = ( )= .
Δ𝑡 (
𝑎 𝑡 ) 𝑎(𝑡)
By taking Δ𝑡 → 0 and using the definition of derivative, we get
𝑎(𝑡 + Δ𝑡) − 𝑎(𝑡)
lim 𝑎 ′( )
𝑡
Δ𝑡→0 Δ𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = = .
𝑎(𝑡) 𝑎(𝑡)
This interest rate is called (annual) force of interest.
Definition (Force of interest)
We let 𝑎(𝑡) be the accumulation function of an investment scheme. The
force of interest, denoted by 𝛿𝑡 , is a time-dependent quantity defined by
𝑎′ (𝑡)
𝛿𝑡 = .
𝑎(𝑡)
Example 18
(a) If the investment scheme pays simple interest at annual nominal interest
rate of 𝑖, find the force of interest of the scheme.
(b) Suppose that the investment scheme pays the interest at annual nominal
interest rate of 𝑖, convertible 𝑚-thly, what is the corresponding force of
interest?
☺Solution
(a) The accumulation function is given by 𝑎(𝑡) = 1 + 𝑖𝑡. The force of interest is
found to be
𝑎′ (𝑡) 𝑖
𝛿𝑡 = = .
𝑎(𝑡) 1 + 𝑖𝑡
𝑖 𝑚𝑡
(b) The accumulation function is 𝑎(𝑡) = (1 + 𝑚) , so the force of interest can
be computed as
𝑖 𝑚𝑡 𝑖 𝑚
𝑎′ (𝑡) (1 + 𝑚) ln [(1 + 𝑚) ] 𝑖 𝑚
𝛿𝑡 = = = ln [(1 + ) ].
𝑎(𝑡) 𝑖 𝑚𝑡 𝑚
(1 + 𝑚)
𝑑
Here, we have used the fact that 𝑑𝑥 𝑎 𝑥 = 𝑎 𝑥 ln 𝑎 for any 𝑎 > 0.
How to obtain 𝑎(𝑡) from 𝛿𝑡 ?
Given the force of interest 𝛿𝑡 for any 𝑡 ≥ 0, one can obtain the
accumulation function 𝑎(𝑡) as follows:
𝑎′ (𝑡)
We start from the definition of 𝛿𝑡 . That is, 𝛿𝑡 = .
𝑎(𝑡)
By integrating both sides with respect to 𝑡, we have

𝑡 𝑡
𝑎′ (𝑠)
∫ 𝛿𝑠 𝑑𝑠 = ∫ 𝑑𝑠
0 0 𝑎 ( 𝑠 )
𝑡 𝑡
1
⇒ ∫ 𝛿𝑠 𝑑𝑠 = ∫ 𝑑(𝑎(𝑠))
0 0 𝑎(𝑠)
𝑡
⇒ ln 𝑎(𝑡) − ⏟
ln 𝑎(0) = ∫ 𝛿𝑠 𝑑𝑠
=ln 1=0 0
𝑡
∫0 𝛿𝑠 𝑑𝑠
𝑎(𝑡) = 𝑒

Example 19
(a) If 𝛿𝑡 = 𝛿, then the accumulation function 𝑎(𝑡) is given by
𝑡 𝑡
∫0 𝛿𝑠 𝑑𝑠 ∫0 𝛿 𝑑𝑠
𝑎(𝑡) = 𝑒 =𝑒 = 𝑒 𝛿𝑡 .
0.02
(b) If 𝛿𝑡 = 𝑡+1 , then the accumulation function 𝑎(𝑡) is given by
𝑡 𝑡0.02 𝑡
∫0 𝛿𝑠 𝑑𝑠 ∫0 𝑠+1 𝑑𝑠
𝑎(𝑡) = 𝑒 =𝑒 = 𝑒 0.02 ln(𝑠+1)|0 = 𝑒 0.02 ln(𝑡+1) = (1 + 𝑡)0.02 .
Example 20
$1500 is invested in a fund for 4 years and the fund pays interest at constant force
of interest of 𝛿 = 0.06.
(a) Find the amount received by the investors after 4 years.
(b) Find the annual effective interest rate of the fund.
☺Solution
𝑡
∫0 (0.06)𝑑𝑠
The accumulation function is given by 𝑎(𝑡) = 𝑒 = 𝑒 0.06𝑡 .
(a) The amount received after 4 years is 1500𝑎(4) = 1500𝑒 0.06(4) ≈ 1906.874.
(b) The annual effective interest rate (at 𝑛𝑡ℎ year) is given by
𝑎(𝑛) − 𝑎(𝑛 − 1) 𝑒 0.06𝑛 − 𝑒 0.06(𝑛−1)
𝑖𝑛 = = = 𝑒 0.06 − 1 ≈ 0.061837.
𝑎 (𝑛 − 1 ) 𝑒 0.06(𝑛−1)

Example 21 (Harder)
At time 0, an investor deposits $1000 in a saving account that pays interest
at force of interest 𝛿𝑡 , where 𝛿𝑡 is given by
0.03𝑡 𝑖𝑓 0 ≤ 𝑡 < 2
𝛿𝑡 = { .
0.06 𝑖𝑓 𝑡 ≥ 2
(a) Find the total amount of interest earned during 2nd year and 3rd
year.
(b) Find the effective interest rates in 2nd year and 4th year respectively.
☺Solution
(a) Firstly, the amount of interest earned can be expressed as
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = ⏟ 1000 𝑎(3) − ⏟ 1000 𝑎(1) … … (∗)
𝑎𝑚𝑜𝑢𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
(𝑒𝑛𝑑 𝑜𝑓 3𝑟𝑑 𝑦𝑒𝑎𝑟) (𝑒𝑛𝑑 𝑜𝑓 1𝑠𝑡 𝑦𝑒𝑎𝑟 )
Two accumulation functions can be computed as
1 1 0.03𝑠2 1
𝑎(1) = 𝑒 ∫0 𝛿𝑠 𝑑𝑠
=𝑒 ∫0 0.03𝑠 𝑑𝑠
= 𝑒 2 |0 = 𝑒 0.015 .
3 2 3 0.03𝑠 2 2
∫0 𝛿𝑠 𝑑𝑠 ∫0 0.03𝑠 𝑑𝑠+∫2 0.06 𝑑𝑠 |0 +0.06𝑠|32
𝑎(3) = 𝑒 =𝑒 = 𝑒 2 = 𝑒 0.12 .
From equation (∗), we conclude that
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑒𝑐𝑒𝑣𝑖𝑒𝑑 = 1000(𝑒 0.12 − 𝑒 0.015 ) = 112.384.
(b) The annual effective interest rate in 2nd year is given by
𝑎(2) − 𝑎(1)
𝑖2 = .
𝑎(1)
2 2 0.03𝑠2 2
∫0 𝛿𝑠 𝑑𝑠 ∫0 0.03𝑠 𝑑𝑠 |0
Note that 𝑎(2) = 𝑒 =𝑒 =𝑒 = 𝑒 0.06 .
2
Together with the result in (a), we deduce that

𝑒 0.06 − 𝑒 0.015 0.045
𝑖2 = = 𝑒 − 1 ≈ 0.046028.
𝑒 0.015
On the other hand, we note that
4 2 4 0.03𝑠 2 2
∫0 𝛿𝑠 𝑑𝑠 ∫0 0.03𝑠 𝑑𝑠+∫2 0.06 𝑑𝑠 |0 +0.06𝑠|42
𝑎(4) = 𝑒 =𝑒 = 𝑒 2 = 𝑒 0.18 .
Therefore, the annual effective interest rate during 4th year can be
computed as
𝑎(4) − 𝑎(3) 𝑒 0.18 − 𝑒 0.12
𝑖4 = = ≈ 0.061837.
𝑎(3) 𝑒 0.12

Some additional examples (for self-reading)
Example 22 (Modified from #1 of sample questions of Exam FM of SOA)
John deposits $85 into a saving account which is credited interest at an
annual nominal interest rate of 𝑖 convertible quarterly.
On the other hand, Michael deposits $90 into another saving account
which is credited interest at an annual force of interest of 3%.
It is known that the values of two accounts are the same after 6.5 years.
Calculate 𝑖.
☺Solution
The first step is to find the values of these two accounts after 6.5 years.
For John’s account, the accumulation function is given by
𝑖 4𝑡
𝑎(𝑡) = (1 + ) .
4

So the value of John’s account after 6.5 years is seen to be
𝑖 26
𝐴(6.5) = 𝐴(0)𝑎(6.5) = 85 (1 + ) … … (∗).
4
On the other hand, the accumulation function of Michael’s account is
𝑡 𝑡
∫0 𝛿𝑠 𝑑𝑠 ∫0 0.03 𝑑𝑠
𝑎(𝑡) = 𝑒 =𝑒 = 𝑒 0.03𝑡 .
So the value of Peter’s account after 6.5 years is seen to be
𝐴(6.5) = 𝐴(0)𝑎(6.5) = 90𝑒 0.03(6.5) = 90𝑒 0.195 … … (∗∗).
Since the values of two accounts are the same after 6.5 years, so we have
𝑖 26
85 (1 + ) = 90𝑒 0.195
4
1
90 0.195 26
⇒ 𝑖 = 4 [( 𝑒 ) − 1] ≈ 0.038982.
85

Example 23 (Modified from #27 of sample questions of Exam FM of SOA)
Ms. A and Ms. B each open up new saving accounts at time 0. Ms. A
deposits $90 into her saving account and Ms. B deposits $120 into her
account. It is also given that
• Each saving account earns the same annual effective interest rate 𝑖
(assumed to be constant).
• The amount of interest earned in Ms. A account during 6th year is 𝑋
and the amount of interest earned in Ms. B account during 10th year is
2𝑋.
Calculate the value of 𝑋.
☺Solution
The accumulation function of the saving account can be expressed as
𝑎(𝑛) = (1 + 𝑖𝑛 )(1 + 𝑖𝑛−1 ) … (1 + 𝑖1 )𝑎(0) = (1 + 𝑖 )𝑛 .

Note that the amount of interest earned by Ms. A account during 6th year
is 𝑋, so we have
90𝑎(6) − 90𝑎(5) = 𝑋 ⇒ 90(1 + 𝑖 )6 − 90(1 + 𝑖 )5 = 𝑋
⇒ 90(1 + 𝑖 )5 𝑖 = 𝑋 … … . (∗)
On the other hand, the amount of interest earned by Ms. B account during
10th year is 2𝑋, so we have
120𝑎(10) − 120𝑎 (9) = 2𝑋 ⇒ 120(1 + 𝑖 )10 − 120(1 + 𝑖 )9 = 2𝑋
⇒ 120(1 + 𝑖 )9 𝑖 = 2𝑋 … … (∗∗)
Substitute (∗) into (∗∗), we obtain
120(1 + 𝑖 )9 𝑖 = 2[90(1 + 𝑖 )5 𝑖 ] ⇒ (1 + 𝑖 )4 = 1.5
⇒ 𝑖 ≈ 0.106682.
Hence, we deduce from equation (∗) that
𝑋 = 90(1 + 0.106682)5 (0.106682) ≈ 15.9385.

Example 24
Eric makes deposits of $80 at time 0, $𝐴 at the end of year 1 and, $3𝐴 at the end of
year 2 in an investment fund. It is given that the fund grows at a force of interest of
𝑡+1
𝛿𝑡 = 100, 𝑡 ≥ 0.
It is given that the total amount of interest earned between end of year 3 and end
of year 5 is 2𝐴. Find the value of 𝐴.
☺Solution
First, the accumulation function of the fund is found to be
𝑡
𝑡 𝑡 𝑠+1 1 𝑠2 𝑡2 𝑡
∫0 𝛿𝑠 𝑑𝑠 ∫0 𝑑𝑠 ( +𝑠) +
100 2
𝑎(𝑡) = 𝑒 =𝑒 100=𝑒 =
0 𝑒 200 100 .
Next, we derive the governing equation for 𝐴. Using the given information, we
have
𝑎(5) 𝑎(5) 𝑎(3) 𝑎(3)
(80𝑎(5) + 𝐴 + 3𝐴 ) − (80𝑎(3) + 𝐴 + 3𝐴 ) = 2𝐴
⏟ 𝑎 (1) 𝑎 (2) ⏟ 𝑎 (1) 𝑎 (2)
𝑎𝑚𝑜𝑢𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
𝑒𝑛𝑑 𝑜𝑓 5𝑡ℎ 𝑦𝑒𝑎𝑟 𝑒𝑛𝑑 𝑜𝑓 3𝑟𝑑 𝑦𝑒𝑎𝑟
⇒ 80𝑒 0.175 + 𝐴𝑒 0.16 + 3𝐴𝑒 0.135 − (80𝑒 0.075 + 𝐴𝑒 0.06 + 3𝐴𝑒 0.035 ) = 2𝐴
80𝑒 0.175 − 80𝑒 0.075
⇒𝐴= ≈ 5.807578.
2 − 𝑒 0.16 − 3𝑒 0.135 + 𝑒 0.06 + 3𝑒 0.035
Present values and discount functions
Suppose that an amount of 𝑃 is invested in a fund, then the amount will
grow to 𝑃𝑎(𝑡) after 𝑡 years, where 𝑎(𝑡) denotes accumulation function of
the fund. In other words, we can say that the amount 𝑃 “worth” 𝑃𝑎(𝑡) at
time 𝑡. So the amount 𝑃𝑎(𝑡) is called future value of 𝑃 at time 𝑡.
Previously, we have discussed how to find future value of an investment
made at present. In this section, we would like to ask the reverse question.
“Suppose that there is a payment of 𝐾 at some future time 𝑡, what is the
value of this payment at present?”
In fact, the above question is equivalent to
“How much does the investor need to pay at present (time 0) in order to
receive a payment of 𝐾 at time 𝑡?”
Given the accumulation function 𝑎(𝑡), we observe that the investor needs
𝐾 𝐾
to pay at present so that he/she can receive 𝑎(𝑡) = 𝐾 at time 𝑡.
𝑎(𝑡) 𝑎(𝑡)
𝐾
The quantity is called present value of 𝐾 to be paid at time 𝑡.
𝑎(𝑡)
Example 25
It is given that the annual nominal interest rate is 4% convertible
semiannually. Find the present value of an amount $800 to be paid at the
end of 2.5 years.
☺Solution
The accumulation function 𝑎(𝑡) is given by
𝑚𝑡
𝑖 (𝑚 ) 0.04 2𝑡
𝑎(𝑡) = (1 + ) = (1 + ) .
𝑚 2
Then the present value of $800 can be computed as
800 800
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = = = 800(0.905731) = 724.5846.
𝑎(2.5) (1.02)2(2.5)
Remark
Apparently, the present value is obtained by multiplying exact amount of
the payment by a discounted factor (highlighted in red).
1
In general, the factor is called discounted function which represents
𝑎(𝑡)
the amount that needs to be invested today in order to get $1 at time 𝑡.
Example 26
You are given two sets of payments:
Set A: $130 is paid at the end of 1st year and $170 is paid at the end of 3rd
year.
Set B: $150 is paid at the end of 2nd year and $180 is paid at the end of 3rd
year.
Suppose that the present value of each of the two sets of payments is the
same and the annual effective interest rate is 𝑖 (> 0), find the value of 𝑖.
☺Solution
Note that the accumulation function is seen to be 𝑎(𝑛) = (1 + 𝑖 )𝑛 , 𝑛 =
0,1,2, …. Then we can derive the following equations for 𝑖:
130 170 150 180
+ = + ⇒ 130(1 + 𝑖 )2 − 150(1 + 𝑖 ) − 10 = 0,
𝑎(1) 𝑎(3) 𝑎(2) 𝑎(3)
150 ± √(−150)2 + 4(130)(10)
⇒1+𝑖 = ⇒ 𝑖 ≈ 0.217051.
2(130)
Effective discount rate
We have seen from previous examples that the value of a future payment
is discounted when it is “brought” to the earlier time.
We consider time interval [𝑡1 , 𝑡2 ]. Suppose that an amount of $1 is paid at
𝑎(𝑡1 )
time 𝑡2 , then the present value of this $1 at time 𝑡1 is seen to be .
𝑎(𝑡2 )
𝑎(𝑡1 )
Then the amount of discount over the time interval is 1 − ( ) =
𝑎 𝑡2
𝑎(𝑡2 )−𝑎(𝑡1 )
and this quantity is called effective discount rate (or effective
𝑎(𝑡2 )
rate of discount) and is denoted by 𝑑[𝑡1 ,𝑡2 ] .
In practice, 𝑡1 is taken to be beginning of 𝑛𝑡ℎ year (time 𝑛 − 1) and 𝑡2 is
taken to be end of 𝑛𝑡ℎ year (time 𝑛). The corresponding discount rate is
called annual effective discount rate, denoted by 𝑑𝑛 . That is,
𝑎(𝑛) − 𝑎(𝑛 − 1)
𝑑𝑛 = .
𝑎(𝑛)

Remark about effective discount rate
• Given the set of annual effective discount rate 𝑑𝑛 , the accumulation
function 𝑎(𝑛) can be expressed as
𝑎(𝑚) = (1 − 𝑑𝑚+1 )(1 − 𝑑𝑚+2 ) … (1 − 𝑑𝑛 )𝑎(𝑛),
or
𝑎(𝑛) = [(1 − 𝑑𝑚+1 )(1 − 𝑑𝑚+2 ) … (1 − 𝑑𝑛 )]−1 𝑎(𝑚)
for any non-negative integer 𝑚 ≤ 𝑛.
• (Relationship between 𝑑𝑛 and 𝑖𝑛 )
We let 𝑖𝑛 be the effective interest rate at the 𝑛𝑡ℎ year. One can
establish that
𝑎(𝑡2 ) − 𝑎(𝑡1 ) 𝑎(𝑡2 ) − 𝑎(𝑡1 ) 𝑎(𝑡2 ) 1
𝑖[𝑡1 ,𝑡2] = = ( ) = 𝑑[𝑡1 ,𝑡2 ] ( )
𝑎(𝑡1 ) 𝑎(𝑡2 ) 𝑎(𝑡1 ) 𝑎(𝑡1 )/𝑎(𝑡2 )
1 𝑑[𝑡1 ,𝑡2 ]
= 𝑑[𝑡1 ,𝑡2] ( )=
1 − 𝑑[𝑡1 ,𝑡2 ] 1 − 𝑑[𝑡1 ,𝑡2 ]
By taking 𝑡1 = 𝑛 − 1 and 𝑡2 = 𝑛, we have
𝑑𝑛
𝑖𝑛 = .
1 − 𝑑𝑛
Example 27
(a) It is given that the annual nominal interest rate is 𝑖 convertible 𝑚-thly, find
the annual effective discount rate during 𝑛𝑡ℎ year.
(b) It is given that the present value of an amount of $3300 to be paid after 2
years is $3000. The annual effective discount rate is known to be 𝑑𝑛 = 𝑑.
Calculate the value of 𝑑.
☺Solution
(a) The corresponding accumulation function 𝑎(𝑡) is known to be
𝑖 𝑚𝑡
𝑎(𝑡) = (1 + ) , 𝑡 ≥ 0.
𝑚
Then the annual effective discount rate during 𝑛𝑡ℎ year is
𝑎(𝑛) − 𝑎(𝑛 − 1) 𝑖 −𝑚
𝑑𝑛 = = ⋯ = 1 − (1 + ) .
𝑎(𝑛) 𝑚
(b) The accumulation function 𝑎(𝑡) at time 2 (end of 2nd year) is
𝑎 (0) = 𝑎(2)(1 − 𝑑 )2 ⇒ 𝑎(2) = (1 − 𝑑 )−2 .
Using the given information, we can deduce that
3300 3000
3000 = ⇒ (1 − 𝑑 )2 = ⇒ 𝑑 ≈ 0.04654.
𝑎(2) 3300

Effective discount rate as interest in advance
We consider a scenario that a person borrows an amount of 𝐾 from the
bank at time 𝑡1 and repays the loan at some future time 𝑡2 . There are two
possible settlement methods:
Method 1: Repays the amount 𝐾 and the interest together at time 𝑡2 . This
repayment is usually adopted in personal loan or mortgage loan offered by
bank.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐾
𝑡1 𝑡2
𝐾
Cash flow diagram of borrower
𝑎(𝑡2 ) 𝑎(𝑡2 )−𝑎(𝑡1 )

The interest repaid is 𝐾 −𝐾 = 𝐾( ) = 𝐾𝑖[𝑡1 ,𝑡2 ] , where
𝑎(𝑡1 ) 𝑎(𝑡1 )
𝑖[𝑡1 ,𝑡2] is the effective interest rate over the period [𝑡1 , 𝑡2 ].

Method 2: Pay the interest now and repays the amount 𝐾 at time 𝑡2 . (The
idea is similar to the case that you need to pay the rent first before renting
a hotel room.). This type of loan is called discounted loan.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐾
𝑡1 𝑡2
𝐾
Cash flow diagram of borrower
The amount of interest charged, denoted by 𝐼, can be found by considering

𝑎(𝑡2 ) 𝑎(𝑡2 ) − 𝑎(𝑡1 )
(𝐾 − 𝐼) (
⏟ ) = 𝐾 ⇒ 𝐼 = 𝐾( ) = 𝐾𝑑[𝑡1 ,𝑡2] .
𝑢𝑛𝑝𝑎𝑖𝑑
𝑎 (𝑡1 ) 𝑎 (𝑡2 )
𝑏𝑎𝑙𝑎𝑛𝑐𝑒
𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡1
Hence, 𝑑[𝑡1 ,𝑡2] can be interpreted as the amount of interest paid by

borrower in advance in order to borrow $1. In practice, discount rate
(interest rate) is often quoted if the loan is settled through this method.
Example 28
Peter borrows 𝑋 for 3 years at an annual effective discount rate of 5%.
Suppose that the amount of interest paid in advance is $656.075, calculate
the value of 𝑋.
☺Solution
By considering the present value of all cash flows (inflows and outflows) at
time 0, we have
𝑋
+ 656.075 = 𝑋 ⏟ … … (1).
𝑎(3)
⏟ 𝑖𝑛𝑓𝑙𝑜𝑤
𝑜𝑢𝑡𝑓𝑙𝑜𝑤
The accumulation function 𝑎(𝑡) at time 3 can be computed as

𝑎(3) = (1 − 0.05)−3 𝑎(0) = 0.95−3 … … (2)
By substituting (2) into (1), we obtain
𝑋(0.95)3 + 656.075 = 𝑋 ⇒ 𝑋 = 4600.

Simple discount and compound discount
When a person borrows some money from the bank and the person needs
to pay the interest in advance in order to receive the money borrowed, the
discount rate (instead of interest rate) is useful in calculating the amount
of interest paid in advance.
There are two different ways to calculate such interest: Simple discount
and compound discount (similar to simple interest and compound
interest).
Simple discount
The definition is just an analogous to the definition of simple interest.
Under simple discount, a fixed amount of discount 𝑑 per period (usually
taken as 1 year) is applied for each $1 borrowed. In other words, it
discounts $1 to be paid at time 𝑡 in the following way.
$(1 − 𝑡𝑑) ⋯ $(1 − 2𝑑) $(1 − 𝑑) $1

Time
0 ⋯ 𝑡−2 𝑡−1 𝑡
Accumulation function under simple discount
We let 𝑎(𝑡) be the accumulation function. Since $1 will be received at time
𝑡 if an amount of (1 − 𝑡𝑑) is deposited at time 0, thus we have
1 1
𝑎(𝑡) = , 𝑓𝑜𝑟 0 ≤ 𝑡 < .
1 − 𝑡𝑑 𝑑
1
(*Remark: We require 𝑡 < to avoid the denominator becomes 0 or
𝑑
negative.)
Effective rate of discount under simple discount
Using the definition, we can calculate the effective rate of discount at 𝑛𝑡ℎ
year. That is,
𝑎(𝑛) − 𝑎(𝑛 − 1) 𝑑 1
𝑑𝑛 = =⋯= , 𝑛< .
𝑎(𝑛) 1 − 𝑑 (𝑛 − 1) 𝑑
One can show, by simple algebra, that
𝑑2
𝑑𝑛+1 − 𝑑𝑛 = ⋯ = > 0 ⇒ 𝑑𝑛+1 > 𝑑𝑛 .
(1 − 𝑛𝑑 )(1 − (𝑛 − 1)𝑑 )
Example 29
A 𝑛-year discounted loan of $5,000 is offered to James at time 0. The loan
charges interest at an annual simple discount rate of 5.2%.
Suppose James accepts the loan and he receives an amount of $3,115 at
time 0 (after the deduction of interest payment), find the value of 𝑛.
☺Solution
Firstly, the accumulation function 𝑎(𝑡) of the loan is given by
1 1
( )
𝑎 𝑡 = , 𝑓𝑜𝑟 0 ≤ 𝑡 < .
1 − 0.052𝑡 0.052
The effective discount rate over 𝑛 years is found to be
𝑎(𝑛) − 𝑎(0) 1
𝑑[0,𝑛] = =1− = 0.052𝑛.
𝑎(𝑛) 1
1 − 0.052𝑛
Since the amount of interest paid at time 0 is 5000 − 3115 = 1885, so
1885 = 5000𝑑[0,𝑛] ⇒ 1885 = 5000(0.052𝑛)
⇒ 𝑛 ≈ 7.25 (𝑦𝑒𝑎𝑟𝑠).
Compound discount
It is a concept parallel to compound interest. Under compound discount,
the amount of discount in each discount period is not fixed and is a fixed
proportion (denoted by 𝑑 ′ ) of the amount value at the end of the discount
period.
More precisely, the scheme discounts $1 to be paid at time 𝑡 as follows:
(1 − 𝑑′ ) − 𝑑 ′ (1 − 𝑑′ )
𝑡
(1 − 𝑑 ′ )𝑇
⋯ = (1 − 𝑑′ )2 1 − 𝑑′ 1
Time
0 ⋯ 𝑡 − 2𝑇 𝑡−𝑇 𝑡
Similar to compound interest, the value of 𝑑 ′ depends on frequency of

discount. Assume that there are 𝑚 discount periods in a year, we let 𝑑 (𝑚)
denote the annual nominal discount rate convertible (or compounded/
payable) m-thly, then 𝑇 = 1/𝑚 and 𝑑 ′ is computed as
(𝑚)
𝑑
𝑑′ = .
𝑚
Accumulation function under compound discount
We let 𝑎(𝑡) be the accumulation function. Since $1 will be received at time
𝑡 if an amount of (1 − 𝑑 ′ )𝑡 is deposited at time 0, thus we have
(𝑚) −𝑚𝑡
1 𝑑
𝑎(𝑡) = = (1 − ) , 𝑡≥0
(1 − 𝑑 ′ )𝑡/𝑇 𝑚
Effective rate of discount under compound discount

Using the definition, we can calculate the effective rate of discount at 𝑛𝑡ℎ
year. That is,
𝑚
𝑎(𝑛) − 𝑎(𝑛 − 1) 𝑑 (𝑚)
𝑑𝑛 = = ⋯ = 1 − (1 − ) .
(
𝑎 𝑛 ) 𝑚
Similar to the case for compound interest, the effect rate of discount is
constant over different periods.

Example 30
Bank ABC offers a personal loan with an annual nominal discount rate of
3.6% convertible monthly.
Find the annual effective interest rate of the loan.
☺Solution
We first compute the annual effective discount rate 𝑑𝑛 of the loan. By
taking 𝑚 = 12 and 𝑑 (𝑚) = 0.036, we get
(𝑚) 𝑚
𝑑 0.036 12
𝑑𝑛 = 1 − (1 − ) = 1 − (1 − ) ≈ 0.035412.
𝑚 12
Using the relationship between 𝑑𝑛 and 𝑖𝑛 , one can deduce that
𝑑𝑛 0.035412
𝑖𝑛 = = ≈ 0.036712.
1 − 𝑑𝑛 1 − 0.035412
Remark
Alternatively, one can derive the accumulation function 𝑎(𝑡) and compute
𝑎(𝑛)−𝑎(𝑛−1)
𝑖𝑛 using 𝑖𝑛 = . Make sure that you get the right denominator.
𝑎(𝑛−1)
Example 31
Linda wishes to get $21,050 now to pay her tuition fee of coming semester.
She qualifies a 1.5 year discounted loan of amount 𝑋. It is given that the
annual nominal discount rate of the loan is 5.4% convertible monthly. Find
the value of 𝑋.
☺Solution
−12𝑡
𝑑 (12)
The accumulation function of the loan is given by 𝑎(𝑡) = (1 − ) =
12
0.054 −12𝑡
(1 − ) = (0.9955)−12𝑡 . The effective discount rate over a period
12
of 1.5 year is seen to be
𝑎(1.5) − 𝑎(0)
𝑑[0,1.5] = = 0.077975.
𝑎(1.5)
Note that the amount of interest paid in advance is 𝐼 = 𝑋 − 21050.
Together with the fact that 𝐼 = 𝑑[0,1.5] 𝑋 = 0.077975𝑋, we have
𝑋 − 21050 = 0.077975𝑋 ⇒ 𝑋 = 22830.18.

Inflation and purchasing power
Roughly speaking, inflation is defined as a continued increases in prices of
general goods and services in a country. The existence of inflation
(Increase in prices of goods) weakens the value (purchasing power) of a
currency since less goods/services can be purchased using the same
amount of money. Therefore, investors are concerned about inflation
when they choose their investment plan.
Mathematical definition of inflation rate
We let 𝑝(𝑡) be the price level function. We define the inflation rate over
the time interval [𝑡1 , 𝑡2 ], denoted by 𝑟[𝑡1 ,𝑡2] , to be the percentage change
of the price level over the period [𝑡1 , 𝑡2 ]. That is,
𝑝(𝑡2 ) − 𝑝(𝑡1 )
𝑟[𝑡1 ,𝑡2] = .
𝑝(𝑡1 )
If 𝑟[𝑡1 ,𝑡2] > 0, this indicates an inflation over the period [𝑡1 , 𝑡2 ]. If 𝑟[𝑡1 ,𝑡2 ] <
0, this indicates a deflation over the period.

How inflation weakens purchasing power?
We consider the following scenarios: Sunny has $1000 currently and the
price of a good is $50.
1000
Currently, Sunny’s wealth can purchase = 20 units of goods. This is
50
the purchasing power of Sunny’s current wealth.
Suppose that Sunny’s wealth is deposited in a saving account which earns
interest at annual effective interest rate of 4% for 1 years, then Sunny’s
wealth will grow to $1000 × (1 + 0.04) = 1040 after 1 year.
• If there is no inflation and the price remains to be $50 after 1 year,
1040
Sunny’s wealth can purchase = 20.8 units of goods.
50
• If the inflation rate is 3% and the price becomes $51.5 after 1 year,
1040
51.5
• If the inflation rate is 8% and the price becomes $54 after 1 year,
1040
54

Real rate of interest
To define the real interest rate, we consider the following scenario: An
investor owns $𝑢 now and current price of a unit of good is $𝑔. Then the
𝑢
investor’s wealth can purchase of the goods.
𝑔
We let 𝑖 and 𝑟 be the effective interest rate and inflation rate over a period
respectively. After a period, the money owned by the investor grows to
(1 + 𝑖 )𝑢 and the price of the good becomes (1 + 𝑟)𝑔. Then the money
(1+𝑖)𝑢
owned by the investor can purchase ( units of goods.
1+𝑟 )𝑔
If we denote 𝑖𝑟𝑒𝑎𝑙 be the percentage change of the purchasing power over

the period, then 𝑖𝑟𝑒𝑎𝑙 can be expressed as
(1 + 𝑖 )𝑢 𝑢
− 𝑖−𝑟
(1 + 𝑟)𝑔 𝑔
𝑖𝑟𝑒𝑎𝑙 = 𝑢 = .
1+𝑟
𝑔
This quantity is called real rate of interest.

Remark
1. According to the definition, real rate of interest 𝑖𝑟𝑒𝑎𝑙 measures the
growth of the purchasing power but NOT the growth of the amount
value. Hence, one should use 𝑖𝑟𝑒𝑎𝑙 when analyzing the problems
related to purchase power and use 𝑖 (ordinary interest rate) when
analyzing the problems involving the amount value of the investment.
2. In reality, the inflation rate 𝑟 is measured by the change in Consumer

Price Index, which is calculated based on a basket of specified
consumer items (food, electricity, gas, water, transport, entertainment
etc.) consumed by a general household.
3. When there is inflation, the investors will demand a higher return for
their investment and the lender will charge a higher rate to the
borrower in order to compensate the loss due to inflation. As a result,
the interest rate will increase (see Example 33).

Example 32
Johnson deposits $12,000 in a saving account at the beginning of 2016. The
account pays interest at an annual nominal interest rate of 4% convertible
quarterly. It is forecasted that annual effective inflation rate in 2016 is
4.2%. Calculate the percentage loss, if any, of the purchasing power of
$12,000 invested.
☺Solution
We shall calculate the annual real rate of interest in 2016. Firstly, the
accumulation function of the saving account is given by 𝑎(𝑡) =
0.04 4𝑡
(1 + ) = (1.01)4𝑡 . So the annual effective interest rate is given by
4
𝑎(𝑛) − 𝑎(𝑛 − 1) (1.01)4𝑛 − (1.01)4𝑛−4 4
𝑖= = = ( 1.01) − 1 = 0.040604.
𝑎(𝑛 − 1) (1.01)4𝑛−4
Hence, the real rate of interest is found to be
𝑖 − 𝑟 0.040604 − 0.042
𝑖𝑟𝑒𝑎𝑙 = = = −0.00134.
1+𝑟 1 + 0.042
So the percentage loss in the purchasing power is 0.134%.
Example 33
Mr. A wishes to invest his wealth into a fund for 3 years. His goal is to
increase the purchasing power of his wealth by at least 5% after 3 years. It
is given that
• the annual effective interest rate of the fund is 𝑖;
• The annual inflation rate is 𝑟.
(a) Suppose that 𝑟 = 0 (no inflation), find the minimum value of 𝑖 such
that Mr. A goals can be achieved.
(b) Suppose that 𝑟 = 3.5%, find the minimum value of 𝑖 such that Mr. A
goals can be achieved.
☺Solution
We let 𝑖𝑟𝑒𝑎𝑙 be the real rate of interest over the 3-year period and it
follows that
𝑖[0,3] − 𝑟[0,3]
𝑖𝑟𝑒𝑎𝑙 = .
1 + 𝑟[0,3]
Using the definition, we get 𝑖[0,3] = (1 + 𝑖 )3 − 1 and 𝑟[0,3] = (1 + 𝑟)3 − 1.
(a) When there is no inflation, we have 𝑟 = 0 or 𝑟[0,3] = 0.
In order to achieve the investment goal, 𝑖 must satisfy
𝑖[0,3] − 𝑟[0,3] (1 + 𝑖 )3 − 1
𝑖𝑟𝑒𝑎𝑙 = ≥ 0.05 ⇒ ≥ 0.05
1 + 𝑟[0,3] 1
⇒ 𝑖 ≥ 0.016396
(b) When 𝑟 = 3.5%, then 𝑖 must satisfy

(1 + 𝑖 )3 − 1 − [(1.035)3 − 1]
𝑖𝑟𝑒𝑎𝑙 = 3
≥ 0.05
1 + [(1.035) − 1]
⇒ 𝑖 ≥ 0.05197.
Remark of Example 33
Under the existence of inflation, investors will demand a higher return (or
higher interest rate) of an investment since they are more interested in
growth in their purchasing power instead of amount growth in their
wealth.

Example 34 (A bit harder)
It is forecasted that the 6-month inflation rate is 2.3% over first half of
2017 and 1.9% over second half of 2017. An investor invests his wealth
0.1
into a fund which pays interest at an annual force of interest of 𝛿𝑡 = at
1+𝑡
the beginning of 2017. Compute the real rate of interest over 2017.
☺Solution
Firstly, the accumulation function of the fund is
𝑡 𝑡 0.1
∫0 𝛿𝑠 𝑑𝑠 ∫0 1+𝑠𝑑𝑠
𝑎(𝑡) = 𝑒 =𝑒 = 𝑒 0.1 ln(1+𝑡) = (1 + 𝑡)0.1 .
Then the effective interest rate over 2017, denoted by 𝑖, is seen to be
𝑎(1) − 𝑎(0) 1.071773 − 1
𝑖= = = 0.071773.
(
𝑎 0) 1
We let 𝑝(0) be the price function at the beginning of 2017, 𝑝(1) be the
price function at the end of 2017 and 𝑟 be the effective inflation rate over
2017.

Using the definition of inflation rate, we have
𝑝(1) 𝑝(0.5)
𝑝(1) = ( )( ) 𝑝(0) = (1 + 𝑟𝑠𝑒𝑐𝑜𝑛𝑑 )(1 + 𝑟𝑓𝑖𝑟𝑠𝑡 )𝑝(0)
(
𝑝 0.5) (
𝑝 0)
= (1 + 0.019)(1 + 0.023)𝑝(0) = 1.042437 𝑝(0).
So we have
𝑝(1) − 𝑝(0) 1.042437 − 1
𝑟= = = 0.042437.
𝑝(0) 1
Hence, the real rate of interest over 2017 can be computed as
𝑖 − 𝑟 0.071773 − 0.042437
𝑖𝑟𝑒𝑎𝑙 = = = 0.028142.
1+𝑟 1 + 0.042437


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MATH2511 Fundamental of Actuarial Mathematics

Basic Interest Theory

1 MATH2511 Fundamentals of Actuarial Mathematics

Series of interest payments

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Method 3: Banker’s rule

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Calculation of 𝑟 and compounding frequency

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So compound interest scheme can generate more interest than simple

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By integrating both sides with respect to 𝑡, we have

49 MATH2511 Fundamentals of Actuarial Mathematics

50 MATH2511 Fundamentals of Actuarial Mathematics

Together with the result in (a), we deduce that

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𝑎(𝑡2 ) 𝑎(𝑡2 )−𝑎(𝑡1 )

64 MATH2511 Fundamentals of Actuarial Mathematics

The amount of interest charged, denoted by 𝐼, can be found by considering

Hence, 𝑑[𝑡1 ,𝑡2] can be interpreted as the amount of interest paid by

The accumulation function 𝑎(𝑡) at time 3 can be computed as

66 MATH2511 Fundamentals of Actuarial Mathematics

$(1 − 𝑡𝑑) ⋯ $(1 − 2𝑑) $(1 − 𝑑) $1

Similar to compound interest, the value of 𝑑 ′ depends on frequency of

Effective rate of discount under compound discount

71 MATH2511 Fundamentals of Actuarial Mathematics

73 MATH2511 Fundamentals of Actuarial Mathematics

74 MATH2511 Fundamentals of Actuarial Mathematics

75 MATH2511 Fundamentals of Actuarial Mathematics

If we denote 𝑖𝑟𝑒𝑎𝑙 be the percentage change of the purchasing power over

76 MATH2511 Fundamentals of Actuarial Mathematics

2. In reality, the inflation rate 𝑟 is measured by the change in Consumer

77 MATH2511 Fundamentals of Actuarial Mathematics

(b) When 𝑟 = 3.5%, then 𝑖 must satisfy

80 MATH2511 Fundamentals of Actuarial Mathematics

81 MATH2511 Fundamentals of Actuarial Mathematics

82 MATH2511 Fundamentals of Actuarial Mathematics

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