Mathematics of Finance

INTRODUCTORY MATHEMATICAL ANALYSIS
For Business, Economics, and the Life and Social Sciences
Chapter 5
Mathematics of Finance
2007 Pearson Education Asia

0. Review of Algebra
1. Applications and More Algebra
2. Functions and Graphs
3. Lines, Parabolas, and Systems
4. Exponential and Logarithmic Functions
5. Mathematics of Finance
6. Matrix Algebra
7. Linear Programming
8. Introduction to Probability and Statistics

9. Additional Topics in Probability
10. Limits and Continuity
11. Differentiation
12. Additional Differentiation Topics
13. Curve Sketching
14. Integration
15. Methods and Applications of Integration
16. Continuous Random Variables
17. Multivariable Calculus

Chapter 5: Mathematics of Finance
Chapter Objectives
• To solve interest problems which require
logarithms.
• To solve problems involving the time value of
money.
• To solve problems with interest is compounded
continuously.
• To introduce the notions of ordinary annuities
and annuities due.
• To learn how to amortize a loan and set up an
amortization schedule.
Chapter Outline
5.1) Compound Interest

5.2) Present Value
5.3) Interest Compounded Continuously
5.4) Annuities
5.5) Amortization of Loans

5.1 Compound Interest

• Compound amount S at the end of n interest
periods at the periodic rate of r is as
S  P 1  r 
n
Example 1 – Compound Interest

Suppose that $500 amounted to $588.38 in a
savings account after three years. If interest was
compounded semiannually, find the nominal rate of
interest, compounded semiannually, that was
earned by the money.

Solution:
There are 2 × 3 = 6 interest periods.
5001  r   588.38
6
1  r 6  588.38
500
588.38
1 r 6
500
588.38
r 6  1  0.0275
500
The semiannual rate was 2.75%, so the nominal

rate was 5.5 % compounded semiannually.


How long will it take for $600 to amount to $900 at an
annual rate of 6% compounded quarterly?
Solution:
The periodic rate is r = 0.06/4 = 0.015.
900  6001.015 
n
1.015 n  1.5
ln1.015   ln1.5
n
n ln1.015  ln1.5
ln1.5
n  27.233
ln1.015
It will take 27.233
4
 6.8083  6 years, 9 21 months .

Effective Rate
• The effective rate re for a year is given by
n
 r
re  1    1
 n
Example 5 – Effective Rate

To what amount will $12,000 accumulate in 15 years
if it is invested at an effective rate of 5%?
Solution:S  12,0001.05   $24,947.14
15

Example 7 – Comparing Interest Rates

If an investor has a choice of investing money at 6%
1
compounded daily or 6 % compounded quarterly,
8
which is the better choice?
Solution:
Respective effective rates of interest are
365
 0.06 
re  1    1  6.18% and
 365 
4
 0.06125 
re  1    1  6.27%
 4 
The 2nd choice gives a higher effective rate.

5.2 Present Value

• P that must be invested at r for n interest periods
so that the present value, S is given by
P  S 1  r 
n
Example 1 – Present Value

Find the present value of $1000 due after three
years if the interest rate is 9% compounded
monthly.
Solution:
For interest rate, r  0.09 / 12  0.0075.
Principle value is P  10001.0075   $764.15 .
36

5.2 Present Value
Example 3 – Equation of Value

A debt of $3000 due six years from now is instead
to be paid off by three payments:
• $500 now,
• $1500 in three years, and
• a final payment at the end of five years.
What would this payment be if an interest rate of
6% compounded annually is assumed?

5.2 Present Value
Solution:
The equation of value is
x  10001.02   6001.02 
8 20
 $1257 .27

5.2 Present Value
Net Present Value

Net Present Value NPV   Sum of present values - Initial investment
Example 5 – Net Present Value

You can invest $20,000 in a business that guarantees
you cash flows at the end of years 2, 3, and 5 as
indicated in the table. Year Cash Flow
2 $10,000
3 8000
5 6000
Assume an interest rate of 7% compounded annually

and find the net present value of the cash flows.

5.2 Present Value
Example 5 – Net Present Value
Solution:
NPV  10,0001.07   80001.07   60001.07  20,000
2 3 5
 $457.31

5.3 Interest Compounded Continuously

Compound Amount under Continuous Interest
• The compound amount S is defined as
kt
 r
S  P 1  
 k
Example 1 – Compound Amount

If $100 is invested at an annual rate of 5%
compounded continuously, find the compound
amount at the end of
a. 1 year.
S  Pe rt  100e 0.05 1  $105.13
b. 5 years.
S  100e 0.05 5   100e 0.25  $128.40
Effective Rate under Continuous Interest

• Effective rate with annual r compounded
r
continuously is er  e 1 .
Present Value under Continuous Interest

• Present value P at the end of t years at an
annual r compounded continuously is P  Se  rt .

Example 3 – Trust Fund

A trust fund is being set up by a single payment so
that at the end of 20 years there will be $25,000 in
the fund. If interest compounded continuously at an
annual rate of 7%, how much money should be paid
into the fund initially?
Solution:
We want the present value of $25,000 due in 20
years.
P  Se  rt  25,000e  0.07 20 
 25,000e 1.4  $6165

5.4 Annuities
Sequences and Geometric Series
• A geometric sequence with first term a and
common ratio r is defined as
a, ar , ar 2 , ar 3 ,..., ar n 1 where a  0
Example 1 – Geometric Sequences
a. The geometric sequence with a = 3, common
ratio 1/2 , and n = 5 is
2 3 4
 1  1  1  1
3, 3 , 3  , 3  , 3 
2 2 2 2

5.4 Annuities
Example 1 – Geometric Sequences
b. Geometric sequence with a = 1, r = 0.1, and

n = 4.
1, 0.1, 0.01, 0.001
c. Geometric sequence with a = Pe−kI , r = e−kI ,

n = d.  kI 2 kI  dkI
Pe , Pe ,..., Pe
Sum of Geometric Series

• The sum of a geometric series of n terms, with
first term a, is given by
n 1
s   ar i 
a 1  
r n

for r  1
i 0 1 r
5.4 Annuities
Example 3 – Sum of Geometric Series

2 6
1  1  1
Find the sum of the geometric series: 2  2 
1      ...   
2
Solution: For a = 1, r = 1/2, and n = 7
  1 7 
11    
s

a 1 r n   2 
  
127
128

127
1 r 1 1
64
1 2
2
Present Value of an Annuity
• The present value of an annuity (A) is the sum
of the present values of all the payments.
A  R 1  r   R 1  r   ...  R 1  r 
1 2 n

5.4 Annuities
Example 5 – Present Value of Annuity

Find the present value of an annuity of $100 per
1
month for 3 years at an interest rate of 6%
2
compounded monthly.
Solution:
1
For R = 100, r = 0.06/12 = 0.005, n = ( 3 )(12) = 42
2
A  100a __
42 0.005
From Appendix B, a  37.798300.

__
42 0.005
Hence,
A  10037.798300   $3779.83

5.4 Annuities
Example 7 – Periodic Payment of Annuity

If $10,000 is used to purchase an annuity consisting
of equal payments at the end of each year for the
next four years and the interest rate is 6%
compounded annually, find the amount of each
payment.
Solution:
For A= $10,000, n = 4, r = 0.06,
10,000  Ra__
4 0.06
A 10,000 10,000
R    $2885.91
a__ a__ 3.465106
n r 4 0.06

5.4 Annuities
Amount of an Annuity
• The amount S of ordinary annuity of R for n
periods at r per period is
S R
1 r   1
n
r
Example 9 – Amount of Annuity
Find S consisting of payments of $50 at the end of
every 3 months for 3 years at 6% compounded
quarterly. Also, find the compound interest.
Solution: For R=50, n=4(3)=12, r=0.06/4=0.015,

S  50 __  5013.041211  $652.06
12 0.015
Compund Interest  652.06  1250   $52.06

5.4 Annuities
Example 11 – Sinking Fund

A sinking fund is a fund into which periodic
payments are made in order to satisfy a future
obligation. A machine costing $7000 is replaced at
the end of 8 years, at which time it will have a salvage
value of $700. A sinking fund is set up. The amount in
the fund at the end of 8 years is to be the difference
between the replacement cost and the salvage value.
If equal payments are placed in the fund at the end of
each quarter and the fund earns 8% compounded
quarterly, what should each payment be?

5.4 Annuities
Example 11 – Sinking Fund
Solution:
Amount needed after 8 years = 7000 − 700 = $6300.
For n = 4(8) = 32, r = 0.08/4 = 0.02, and S = 6300,
the periodic payment R of an annuity is
6300  Rs ____
32 0.02
S 6300
R   $142 .45
s ____ s ____
n r 32 0.02

5.5 Amortization of Loans

Amortization Formulas

Example 1 – Amortizing a Loan

A person amortizes a loan of $170,000 by obtaining
a 20-year mortgage at 7.5% compounded monthly.
Find
a.monthly payment,
b.total interest charges, and
c.principal remaining after five years.

Example 1 – Amortizing a Loan
Solution:
a. Monthly payment:
 0.00625 
R  170,000   $1369.51
 240 
 1  0.00625 
b. Total interest charge:
2401369.51  170,000  $158,682.40
c. Principal value:
 1  0.00625 180 
1369.51   $147,733.74

 0 . 00625 

Mathematics of Finance

Uploaded by

Copyright:

Available Formats

You might also like

Mathematics of Finance

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Mathematics of Finance

Uploaded by

Copyright:

Available Formats

INTRODUCTORY MATHEMATICAL ANALYSIS

For Business, Economics, and the Life and Social Sciences

2007 Pearson Education Asia

2007 Pearson Education Asia

2007 Pearson Education Asia

5.1) Compound Interest

2007 Pearson Education Asia

5.1 Compound Interest

Example 1 – Compound Interest

2007 Pearson Education Asia

The semiannual rate was 2.75%, so the nominal

2007 Pearson Education Asia

Example 3 – Compound Interest

2007 Pearson Education Asia

Example 5 – Effective Rate

2007 Pearson Education Asia

Example 7 – Comparing Interest Rates

The 2nd choice gives a higher effective rate.

5.2 Present Value

Example 1 – Present Value

2007 Pearson Education Asia

Example 3 – Equation of Value

2007 Pearson Education Asia

2007 Pearson Education Asia

Net Present Value

Example 5 – Net Present Value

Assume an interest rate of 7% compounded annually

2007 Pearson Education Asia

2007 Pearson Education Asia

5.3 Interest Compounded Continuously

Example 1 – Compound Amount

Effective Rate under Continuous Interest

Present Value under Continuous Interest

2007 Pearson Education Asia

Example 3 – Trust Fund

2007 Pearson Education Asia

2007 Pearson Education Asia

b. Geometric sequence with a = 1, r = 0.1, and

c. Geometric sequence with a = Pe−kI , r = e−kI ,

Sum of Geometric Series

Example 3 – Sum of Geometric Series

2007 Pearson Education Asia

Example 5 – Present Value of Annuity

From Appendix B, a  37.798300.

2007 Pearson Education Asia

Example 7 – Periodic Payment of Annuity

2007 Pearson Education Asia

Solution: For R=50, n=4(3)=12, r=0.06/4=0.015,

Compund Interest  652.06  1250   $52.06

Example 11 – Sinking Fund

2007 Pearson Education Asia

2007 Pearson Education Asia

5.5 Amortization of Loans

2007 Pearson Education Asia

Example 1 – Amortizing a Loan

2007 Pearson Education Asia

2007 Pearson Education Asia