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Borrowing with discount rate d

● If you borrow $1,000 at annual effect discount


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

● If how much would you need to borrow at


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%

Compounding frequency (discount) Effective interest rate (nominal


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)