Topic 4(a) Interest rates

Measuring Interest Rates:

Forward & Options contracts prices are based on the concept continuous compounding & also is used in bank deposits, loans etc. We know, Compounding value A Sum of principle P Carrying an interest r per annum No. of years n is given by A=P(1+r)n

Ex: a sum of Rs.1000 compounded at 10% for 2 years becomes A = 1000 ( 1 + 0.1)2 = Rs.1210 Suppose compounding was done twice a year, the amount at the end of the year will;

Period I half II half III half IV half

Principal 1000 1050 1102.5 1156.625

Interest Amt. at the end 1000 x 0.05 = 50 1050 1050 x 0.05 = 52.5 1102.50 1102.5 x 0.05 = 55.125 1157.6254 1157.625 x 0.05 = 57.881 1215.51

If the frequency of compounding is increased say quarterly, monthly.. Etc. Compounding Amount Quarterly 1218.40 Monthly 1220.39 Weekly 1221.17 Daily 1221.37 In general mn r A P1 m where m is the number of compounding pa.

Discounting:

Discounting is opposite to the compounding; Discounting is needed when some money to be received in future is to be expressed in terms of the present time Time Value of Money.

A P = ----------(1+r)n
or P = A ( 1 + r ) n

(1+r)n is referred as present value factor and for

continuous compounding involved the pv factor will be e-rn.

Continuous Compounding:
If the compounding per annum increases more and more, the compounding may be thought to be continuously, may be shown as; A = Pern Where, e is the mathematical constant value of 2.7183 ex value can be get from the table which is equal to the product of n & r.

Continuous Compounding ..contd

For most practical purposes, continuous compounding can be thought of as being equivalent to daily compounding. Continuously compounded interest rates are used in pricing derivatives. Rc is a rate of interest with continuous compounding Rm is the equivalent rate with compounding m times per annum.

Determination of Rm and Rc:

Rc = equilent rate when continuous compounding is done. Rm Rc = m ln ( 1 + ----- ) m Rm = rate of interest when m compounding are done. Rm = m ( eRc/m - 1)
Here ln is the natural algorithm, if y = ln x x = ey

Ex: Interest rate is quoted as 12% p.a. with quarterly compounding. This means Rm =12% & m=4. The equivalent rate with continuous compounding would be Rm Rc = m ln ( 1 + ----- ) m = 4 ln ( 1 + 0.12 / 4 ) = 11.82%

Ex: A lender gives a loan on which he quotes the interest rate as 15% p.a. with continuous compounding, and that interest is actually paid quarterly. Where m=4 and Rc=15% Calculate the equivalent rate if compounding was done quarterly. Rm = m ( eRc/m - 1) = 4 ( e 0.15/4 - 1) = 15.285%
This means that on a $1,000 loan, interest payments of $ 28.50 would be required each quarter.

Future Value & Present Value Annuity: (1+r)n - 1 FVIFAn = P ---------------r (1+r)n - 1 PVIFAn = A ---------------r (1+r)n

Zero Rates:
The n-year zero-coupon interest rate is the rate of interest earned on an investment that starts today and lasts for n years. All the interest and principal is realized at the end of n years. Suppose a 5-year zero rate with continuous compounding is quoted as 5% per annum. This means $100, if invested for 5 years, grows to 100 x e 0.05 x 5 = $ 128.40