Review: The arithmetic of interest rates

Prof. Dr. Paolo Vanini

Miret Padovani
Financial Engineering I - M.A.S. Finance
ETH Zurich & University of Zurich
Fall term 2008
The following is a quick review of computing interest rates, a topic we pre-
sume students to be familiar with from their undergrad studies. An interesting
educational paper is the Chicago Feds ABCs of interest rates.
1 Present versus future value
An investor prefers to receive a xed amount of money today, rather than receive
an equal amount in the future, all else being equal. This concept is known as the
time value of money. In particular, if the investor receives the payment today,
he can earn interest on the money until a specied future date.
The present value (PV) is the value of a notional amount at current time t
0
.
The future value (FV) is the value of the same amount at a future time T. The
relationship between the two values is
PV = [discount factor] FV.
Denote by D
t0
(T) the discount factor, which gives the value at time t
0
of $1
at time T. Note that D
t0
(T) is unique: it expresses the relationship between
$1 for certain in the future and its value today. Interest rates, on the other
hand, are not unique. An interest rate is nothing more than a mathematical
relationship that maps a present value to a future value or vice versa. There
are numerous interest rates specications that can convert D
t0
(T) into $1 at T,
or vice versa.
2 Simple versus compound interest
Simple interest is interest paid only on the principal or the amount originally
borrowed, and not on the interest owed on the loan. Compound interest is
interest calculated not only on the principal or the amount originally borrowed,
but also on the interest that has accrued at the time of the calculation.
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Table 1: Eect of simple versus compound interest
With simple interest With compound interest
(in CHF) (in CHF)
Loan amount 100 100
Amount owed after 1 year 110 110 (=100+0.1*100)
Amount owed after 2 years 120 121 (=110+0.1*110)
Amount owed after 3 years 130 133.10 (=121+0.1*121)
Table 2: Eect of the compounding frequency on the value of CHF100.00 at the
end of 1 year with an annual interest rate of 10%
Compounding frequency V
T
(in CHF)
Annually (n = 1) 110.00
Semiannually (n = 2) 110.25
Quarterly (n = 4) 110.38
Monthly (n = 12) 110.47
Weekly (n = 52) 110.51
Daily (n = 365) 110.52
Table 1 shows how the amount owed on a three-year loan at an interest rate
of 10% would dier depending on whether simple interest or compound interest
is charged.
3 Discrete versus continuous compounding
Denote the PV of the notional amount by V
t0
and its FV by V
T
. Denote also
by r the annual interest rate at which this amount is invested for T years. If
the amount is compounded once per year, then
V
T
= V
t0
(1 +r)
T
.
If the rate is compounded n times per year, then
V
T
= V
t0

1 +
r
n

nT
.
Table 2 illustrates the eect of the compounding frequency when computing
future values.
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MARKET RATES
*Libor rates come from BBA (see www.bba.org.uk) and are fixed at 11am UK time. Other data sources:
US $, Euro & Cds: dealers; SDR int rate: IMF; EONIA: ECB; EURONIA & SONIA: WMBA. L A 7 days notice: Tradition (UK).
Over Change One Three Six One
night Day Week Month month months months year
US$ Libor* 5.03125 -1.406 +2.901 -0.320 3.03000 3.06250 3.25250 3.22500
Euro Libor* 4.42500 +0.008 +0.121 +0.583 4.53750 4.97375 5.20000 5.35875
Libor* 5.29375 -1.500 +0.243 -0.036 5.58500 5.87125 6.02000 6.09063
Swiss Fr Libor* 3.08333 +0.083 +1.083 +0.963 2.35000 2.75833 2.88500 3.16500
Yen Libor* 0.80625 -0.138 +0.264 +0.160 0.75875 0.90375 0.99250 1.16625
Canada Libor* 4.64167 -0.192 +1.628 +0.392 3.55333 3.64667 3.74167 3.96000
Euro Euribor - - - - 4.54 4.97 5.20 5.36
Sterling CDs - - - - 5.42 5.65 5.99 6.15
US$ CDs - - - - 3.40 3.55 3.55 3.70
Euro CDs - - - - 4.490 4.960 5.180 5.365
US o`night repo 0.63 -0.500 -2.995 -4.640
Fed Funds eff 1.98 -0.660 +0.020 -3.320
US 3m Bills 0.55 -0.295 -1.080 -4.365
SDR int rate 2.85 -0.090 -1.240
EONIA 4.22 -0.249 -0.087 +0.386
EURONIA - - - -
SONIA - - - -
LA 7 Day Notice 5.30-5.25
Sep 17
Over One One Three Six One
night Week month months months year
Interbank 5.50-4.50 6.00-5.50 5.60-5.50 5.90-5.80 6.00-5.90 6.10-6.00
Figure 1: Money rates on September 17, 2008.
As the compounding frequency tends to innity, we move from discrete to
continuous compounding. With continuous compounding, the FV is given by
V
T
= V
t0
e
rT
,
where e
x
is the exponential function. Discounting a FV means
V
t0
= V
T
e
rT
.
4 Types of interest rates
There are several types of interest rates that are regularly quoted. Figure 3 gives
a snapshot of money rates quoted on September 17, 2008. The main dierence
among interest rates depends on the creditworthiness of the borrower of funds:
the higher the default risk of the borrower, the higher the interest rate that is
promised to the lender.
For simple denitions of the dierent rates, check out the Federal Reserves
Web glossary. Money rates are published daily on markets.ft.com.
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5 Test your knowledge
1. An interest rate is quoted at 14% per year with quarterly compounding.
What is the equivalent rate with (i) continuous compounding and (ii)
annual compounding?
2. What rate of interest with continuous compounding is equivalent to 15%
per year with monthly compounding?
3. A deposit account pays 12% per year with continuous compounding, but
interest is paid quarterly. How much interest will be paid each quarter on
a $10,000 deposit?
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