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- Inside the Vault - Spring 2011
- CAT Arithmetic
- 102 Session 2
- financial_guide
- inflation.doc
- Business Finance Solution
- CI intro
- Ekonomi Teknik
- Ch 03 - Addtnl Sensitivity
- This Fortress Built by Nature for Herself
- utang
- Chapter 3 - Combining Factors
- PR1107
- JULY 10, 2019 LESSON INTEREST RATE.pptx
- AD, LRAS, SRAS (Slope and Shifts)
- New Monetary Policy by State Bank of Pakistan
- Banking
- 1M3286 Fin
- Shares Investment Analysis
- Econ

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rate 5% for one year. You receive $950 at the

beginning of the year.

discount rate 5%, to equal a one year loan of

$100 borrowed at interest?

Discount rate example

● You need $100 today. Let X be the amount

borrowed at 5% discount rate.

● 100 = X(1-.05)

● X=105.26

● If the annual effective discount rate is 5% then

borrowing $105.26 at the discount rate gives

the same money now as borrowing $100 at an

interest rate of 5.26%

Nominal rate of discount

● d(m) is the nominal rate of discount

● d(m)/m is discount rate of one mth of a period

● (1-d(m)/m)m=1-d

● d = 1-(1-d(m)/m)m

Example

● You take a loan of $100 at a nominal annual

rate of discount of 18% convertible

semiannually for one year.

● How much do you receive at time 0?

● How much do you pay at the end of one year?

● What is the effective rate of discount?

● Equivalent effective rate of interest?

● Equivalent nominal annual rate of interest

convertible semiannually?

Example

● When borrowing at a discount rate you pay the

interest in advance so you don't receive the full

amount of the loan.

● There are m = 2 periods.

● d(2) = .18 is the nominal annual discount rate

● X = 100(1- d(2)/2)2=82.81

Example

● What do you pay at the end of the year?

Example

● What do you pay at the end of the year?

● You pay the amount of the loan. You already

paid the interest at the beginning of the year, so

all you need to pay is the principal.

Example

● What is the effective rate of discount?

Example

● What is the effective rate of discount?

● d = 1 - (1-.18/2)2 = .1719

● 17.19%

● Notice the effective rate of discount is smaller

than the nominal rate of discount. As you break

● The more you break up the period, the smaller

the effective rate of discount is.

Example

● What is the effective annual rate of interest?

Example

● What is the effective annual rate of interest?

● i = d/(1-d)

● .1719/(1 - .1719) =.20758

● 20.76%

Example

● What is the nominal annual rate of interest

compounded semiannually?

● (1+i(2)/2)2 = 1.20758

● 19.78% nominal rate

Notice!

Compounding frequency (interest) Effective interest rate (nominal 5%)

Compounded semiannually 5.0625%

Compounded monthly 5.1162%

Compounded daily 5.1267%

discount 5%)

Compounded semiannually 5.194%

Compounded monthly 5.1381

Compounded daily 5.1275%

Continuously compounding interest

● Continue the process we saw in the previous

tables to its extreme and compound interest

continuously. I.e. you get credited interest

immediately and immediately begin earning

interest on it.

● Making a continuous process allows for cleaner

mathematical analysis.

Continously compounding interest

● For a nominal annual interest rate i. The

effective interest rate is (1+i/m)m.

● What happens has m goes to infinity?

Continously compounding interest

● For a nominal annual interest rate i. The

effective interest rate is (1+i/m)m.

● What happens has m goes to infinity?

● limm -> infinity(1+i/m)m = ei

Continously compounding interest

● You can do the same thing for discount rate.

● For a nominal annual discount rate d. The

effective discount rate is (1-d/m)m.

● What happens has m goes to infinity?

Continously compounding interest

● You can do the same thing for discount rate.

● For a nominal annual discount rate d. The

effective discount rate is (1-d/m)m.

● What happens has m goes to infinity?

● limm -> infinity(1-d/m)m = e-d

Continously compounding interest

● You can do the same thing for discount rate.

● For a nominal annual discount rate d. The

effective discount rate is (1-d/m)m.

● What happens has m goes to infinity?

● limm -> infinity(1-d/m)m = e-d

● This is equivalent to having a nominal interest

rate d that is continuously compounded!

● A = e-d B is the same as A ed = B.

Force of interest

● The instantaneous interest rate.

Force of interest

● The instantaneous interest rate.

● If we have an accumulated amount function

A(t), then the amount is increasing by A'(t) at

time t.

Force of interest

● The instantaneous interest rate.

● If we have an accumulated amount function

A(t), then the amount is increasing by A'(t) at

time t.

● To calculate interest rate though, we need to

divide that by the amount. So we get

instantaneous interest rate A'(t)/A(t)

Force of interest

● δt is the symbol used for force of interest at time

t

● δt = A'(t)/A(t)

Force of interest: compound interest

● For continously compounding interest we have

A(t) = eit.

Force of interest: compound interest

● For continously compounding interest we have

A(t) = A(0) eit.

● So δt = A'(t)/A(t) = ieit/eit= i

● It's constant. For continuously compounding

interest the force of interest is the same as the

nominal interest rate.

Force of interest: simple interest

● δt=A'(t)/A(t)

● A(t) = (1 + it)A(0)

● A'(t) = i A(0)

● δt =A'(t)/A(t) = i/(1+it)

Example: Force of Interest

● You earn a force of interest δt=t on an initial

investment of $1,000. What is the accumulated

amount function for this investment?

Example: Force of Interest

● You earn a force of interest δt=t on an initial

investment of $1,000. What is the accumulated

amount function for this investment?

● A'(t)/A(t) = t. We can integrate both sides.

● ln(A(t)) - ln(A(0)) = t2/2

Example: Force of Interest

● You earn a force of interest δt=t on an initial

investment of $1,000. What is the accumulated

amount function for this investment?

● A'(t)/A(t) = t. We can integrate both sides.

● ln(A(t)) - ln(A(0)) = t2/2

● A(t)/A(0) = et^2/2

● A(t)= A(0) et^2/2

Example: force of interest

● You have an investment that has an

accumulation factor of a(t) = 1 +.02t2. What is

the force of interest?

● Note that since A(t) = A(0)a(t), we have

● δt = A'(t)/A(t) =a'(t)/a(t)

● δt=.04t/(1+.02t2)

Real rate of interest

● Takes into account inflation

● If an interest rate is lower than inflation rate

than the value of your investment is dropping.

● If they are equal, then your investment is

maintaining the same value.

● If an interest rate is higher than inflation then

your investment is increasing invalue.

Simple Approximation

● If r is the rate of inflation you may see i - r be

given as the real rate of interest. This is an

approximation that works reasonably well if the

rate of inflation is small.

● How do you calculate the rate you want

precisely?

Real rate of interest

● If you earn interest rate i and invest one dollar

then in one year you have 1+i dollars.

Real rate of interest

● If you earn interest rate i and invest one dollar

then in one year you have 1+i dollars.

● However, if a good you want to buy costs 1

dollar today, then it will cost 1+r dollars in one

year.

Real rate of interest

● If you earn interest rate i and invest one dollar

then in one year you have 1+i dollars.

● However, if a good you want to buy costs 1

dollar today, then it will cost 1+r dollars in one

year.

● So in terms of how much you can buy, you will

be able to buy (1+i)/(1+r).

● Originally you could buy 1.

Real rate of interest cont'd

● So the amount you can buy has changed by

(1+i)/(1+r) - 1 = (i-r)/(1+r)

and this is called the real rate of interest.

● You can see why i-r is a decent approximation

when r is small.

Examples:

● Draw a cash flow diagram for the following

transaction: You make annual payments of

$1000 for 5 years. 5 years after you stop

making payments you begin receiving $300

payments for 20 years.

Examples

● Setup an equation of value for the previous

problem so that you could solve for the interest

rate you receive for the transaction.

Examples

● You are quoted a 10% annual interest rate

compounding quarterly. You borrow $100 and

pay if off after two years. How much do you

have to pay? What is the effective annual

interest rate?

Examples

● You are quoted a 10% annual interest rate

compounding quarterly. You borrow $100 and

pay if off after two years. How much do you

have to pay? What is the effective annual

interest rate?

● 100(1.025)8=121.84

● (121.84/100).5 =1.1038

● 10.38% effective annual interest rate

Examples

● For the previous problem, if you are given the

opportunity to borrow at a 10% annual discount

rate compounding quarterly, would you do it

instead?

● What is the effective annual discount rate?

Examples

● For the previous problem, if you are given the

opportunity to borrow at a 10% annual discount

rate compounding quarterly, would you do it

instead?

● What is the effective annual discount rate?

● 1-(.975)4=.0963

● 9.63% effective discount rate

● 10.65% effective interest

Examples

● If an account has accumulated amount A(t) =

100(1+t+t2), what is the force of interest for this

account?

Examples

● If an account has accumulated amount A(t) =

100(1+t+t2), what is the force of interest for this

account?

● A'(t) = 100(1+2t)

● A'(t)/A(t) = (1+2t)/(1+t+t2)

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