Chapter 1: Mathematics of Finance

Lecture 1: Compound Interests

By
Assoc.Prof. Mai Duc Thanh

Course Information

Lecturer: Associate Professor Mai

Duc Thanh
E-mail: mdthanh@hcmiu.edu.vn
Mobile phone: 090 888 1652
Textbooks:
1.

2.

Calculus with Applications, Lial,

Greenwell, etc.
Elementary Linear Algebra with
Applications R. Hills.

Assignments

HW assignments will be given during the

semester. These will typically be simple
questions from your textbook. The more
exercise you solve, the better you will
understand the topics.
CW assignments will be given in the
class.
Late assignments will lose 10% of the
total points for each day they are late
and will not be accepted after one week.

Grading

HW&CW Assignments: 20%

Midterm Test: 20%
Final Exam: 60%
Extra marks E from 0-10 are given
for those who solve exercises on the
board. Rule:
Average of HW/CWA + E = Final
HW/CWA

Example

Minh has Average of HW&CWAs = 88

Minh earns 10 extra marks
So, Minh has his/her final HW/CWAs
= 88+10=98

Outline of Chapter 1

Compound Interest

Continuous Money Flow (sec. 8.3, page 476-484)

Compound interest and compound amount (p. 93-96)

Effective Rate and Present Value (p. 121-123)
Total Money Flow
Present Value of Money Flow
Accumulated Amount of Money Flow at Time t

Annuities (sec. 12.2, p. 658-670)

Annuity
Sinking Fund
Present value of an Annuity
Amortization

Textbook: Calculus with Applications, 8th Edition, by Lial, Greenwell,

Ritchey

Compound Interest

Question: How much interest will an

investment earn?
The cost of borrowing money or the
return on an investment is called an
interest
The amount borrowed or invested is
the principal P
The rate of interest r is given as a
percent per year, and t is the time,
measured in years

Simple Interest. Compound Interest

The product of the principal P, rate r, and

time t gives simple interest, I:

I P gr gt

With compound interest, interest is

charged (or paid) on interest as well as on
principal
To find a formula for compound interest,
first suppose that P dollars, the principal,
is deposited at a rate of interest r per year

Compound Interest

The interest earned during the first

year is found using the formula for
simple interest

First-year interest P.r.1 P.r

At the end of one year, the amount

on deposit will be the sum of the
original
and
P principal
P.r P(1
r ) the interest
(1)
earned:

Compound Interest

If the deposit earns compound interest,

the interest earned during the second year
is found from the total amount on deposit
at the end of the first year.
Thus,[the
P(1 interest
r )](r )(1)earned
P(1 during
r )r the (2)
second year is
So the total amount on deposit at the end
of the second year is the sum of amounts 2
P
(1

r
)

P
(1

r
)
r

P
(1

r
)(1

r
)

P
(1

r
)
from (1) and (2) above, or

Compound Interest

In the same way, the total amount on

deposit at the end of three years is

P (1 r )

After t years, the total amount on

deposit, called the compound
amount, is
t

P(1 r )

Example

Lan invests 100.000.000 VND in a

bank with a rate 9% per year when
she enters the 1st year in IU. How
much she will have when she gets a
bachelor degree after 4 years?

Compound Interest

When interest is compounded more than

once a year, the compound interest
formula is adjusted.
If 1 year = m periods, then

t years=mt periods
Interest r per year = interest r/m per period

So in the formular for compound

amount, we replace t by mt and r by r/m

Compound Interest

When interest is compounded more than

once a year, the compound interest formula
is adjusted.
For example, if interest is to be paid quarterly
(four times a year), of the interest rate is
used each time interest is calculated, so the
rate becomes r/4, and the number of
compounding periods in t years becomes 4t
Generalizing this idea gives the following
formula

Compound Amount
If P dollars is invested at a yearly rate of interest
r per year, compounded m times per year for t years,
the compound amount is

r
A P 1
m

tm

dollars

Example 2

Thuy Vy invests 100.000.000 VND in

a bank with a rate 9% per year,
compounded every month, when she
enters the 1st year in IU. How much
she will have when she gets a
bachelor degree after 4 years?

The number e

Begin with the formula for compound interest

r
1
m

tm

Suppose that: a lucky investment produces

annual interest of 100%, so that r=1. P=1,

t=1

Compound amount:
m

1
1
m

e 2.718281828 as m

Ex: m=360, then A= 2.7145

Continuous Compounding

In economics, the formula for continuous

compounding is a good example of an
exponential growth function
Let m be the number of times annually that
interest is compounded.
Compound
mt amount:
tm

r
A P 1
m

1
P 1

(m / r )

1
1

(m / r )

m/ r

rt

Pe rt

as m

Recall: Exponential Growth and

Decay

Let

y Ce

kt

where C, k are constant.

Then, if k>0, we say y has
exponential growth
If k<0, y has exponential decay

Continuous Compounding

When m tends to infinity, we say that

the interest is compounded
continuously

If a deposit of P dollars at a rate of interest

r compounded continuously for t years, the
compound amount is
A Pe

rt

dollars

Example 1

Ngoc Ha invests a bonus of $9000 at

6% annual interest compounded
semi-annually for 4 years. How much
interest will she earn?
Solution.
We use the formula for compound
amount withtm P=9000, r=6%,
42 m=2,
r
0.06

t=4A P 1 9000 1
=11,400

Example 2

Assuming continuous compounding,

if the inflation rate averaged 6% per
year for 5 years, how much would a
$1 item cost at the end of the 5
years?
Solution. We use the formula for
rt
.065
0.3with P=1,
continuous
compounding
A Pe 1.e
e 1.35
r=.06, t=5

Effective rate: Example

We could use a calculator to see that

the compound amount for $1 at 8%
interest per year compound
semiannually is 1(1+0.08/2)2x1
=(1(1.04)2 = 1.0816 (USD)
The actual increase of $0.0816 is
8.16%, not 8% (with interest
compounded annually)!
8% is called the nominal or stated
interest rate

Effective Rate for Compound

Interest

We use r for stated rate and use rE

for effective rate
Definition. If r is the annual stated
rate of interest and m is the number
of compounding periods per year, the
effective rate of interest, sometimes
called annual yield, mis

r
rE 1 1
m

Effective rate for Continuous

Compounding

With continuous compounding, $1 at

1(.08)
8% for 1 year
becomes
(1)e
1.0833
So the increase is 8.33% rather than
8% . That is:
A stated interest rate of 8% produces
an effective rate of 8.33%
Definition. If interest is compounded
r
continuously at an annual
stated
rate
rE e 1
of r, the effective rate of interest is

Example 3
Find the effective rate corresponding to each
stated rate
a) 6% compounded quarterly
b) 6% compounded continuously
Solution. a) Using the formula, we get

(1 0.06 / 4) 1 (1.015) 1 0.0614

4

So, the effective rate is 6.14%

b) The formula for continuous compounding
gives
e.06 -1 =0.0618. So the effective rate is 6.18%

Present Value

The formula for interest compounded m times a

tm
A

P
(1

r
/
m
)
year
has five variables: A, P, r,
m, and t
If the values of any four are known, then the
value of the fifth can be found
In particular, if A, the amount of money we
wish to end up with, is given as well as r, m,
and t, then P can be found
P is the amount that should be deposited today
to produce A dollars in t years. The amount P is
called the present value of A dollars

Finding Present Value

So, the present value for an interest

rate r compounded m times per year
for t years is r tm

P A 1
m

And the present value for an interest

rate r compounded
rt continuously for t
years is P Ae

Example

Messi has a balloon payment of

$100,000 due in 3 years. What is the
present value of that amount if the
money earns interest at 12%
annually?
Solution.
31
3
P 100000 1 0.12 / 1
71,178.02

100000 / 1.12

Example 2

Find the interest rate that will cause

$5000 to row to $7250 in 4 years if
the money is compounded
continuously.
Solution.
1 A
1 7250

rt

A Pe r ln ln
0.093
t P
4 5000

The required interest rate is 9.3%

Exercises
Find the interest earned on $10,000
invested for 5 years at 6% interest
compounded as follows:
1. Annually
2. Semi-annually
3. Quarterly
4. Monthly

Ex 2
A company must pay a $750,000
settlement in 10 years.
a) What amount must be deposited now at
8% compounded semiannually to have
enough money for the settlement?
b) How much interest will be earned?
c) Suppose the company can deposit only
$250,000 now. Compounded semianually.
How much more will be needed in 10
years?

Ex 2

A company must pay a $750,000

settlement in 10 years.
d) Suppose the company can deposit
only $250,000 now at interest rate 8%
compounded quarterly. After 5 years the
company will have the possibility to get
an amount of money that could give
interest at the same rate compounded
quarterly. What is this amount of money
to get the above $750,000?