Basic Ideas of Financial Mathematics

1 Percentage
The word “percent” simply means “out of 100”. Thus if you have 55% in a test, it means you
obtained 55 marks out of a possible 100. This means you obtained
55
th’s
100
of the marks available. So if the test is actually marked out of 40, then you have
55 55
of 40 = × 40 = 22 marks.
100 100
Thus, if we have R58.00, then 8% of that amount is
8
R 58 × = R 4.64
100
Similarly, 120% of R 300 is
120
R 300 × = R 360.
100

2 Compound Interest
Suppose you invest R400 in a bank. The bank then pays you interest on your investment. Let
us suppose the rate of interest is 8% per annum. (“per annum” is just another way of saying
“for each year”.) This means you earn interest of
8
R 400 × = R 32.00
100
The total amount you now have is

R 400 + R 32 = R 432.

It is important to understand that the bank pays you 8% of whatever you have in your account.
So, if you leave the money in the bank for another year, the bank now calculates the interest
on R432. You then earn interest for the second year of
8
R 432 × = R 34.56.
100
Your account now holds the amount you had at the start of the second year plus the new
interest earned, that is
R 432.00 + R 34.56 = R 466.56.
This process is known as calculating compound interest.
More generally, suppose we invest a sum P , known as the principal at an interest rate i
per annum. In the first year, the interest is I1 = P i, so the amount is

S1 = P + I1 = P + P i = P (1 + i).

We now calculate the interest for the second year on the new amount S1 . This is

I2 = S1 i = P (1 + i)i = P i + P i2

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and the new amount is

S2 = S1 + I2 = P (1 + i) + P (1 + i)i = P (1 + i)(1 + i) = P (1 + i)2 .

Continuing in this way, the amount after n years is

Sn = P (1 + i)n

Example 2.1

Find the amount if R800 is invested for 7 years at 6% per annum.

Solution
6
Here P = 800, n = 7 and i = = 0.06. Thus
100
S7 = 800(1 + 0.06)7 = 1202.90

(where the calculation has been rounded to the nearest cent).

Example 2.2

If R200 is invested at 8% per annum, how long will it take for the amount to become
worth R350?

Solution

Here P = 200, i = 0.08 and we wish the amount to be R350. Thus

350 = 200(1.08)n .

It follows that
350
1.08n = = 1.75.
200
Taking logs (to any base) gives

log 1.75 = log(1.08)n = n log 1.08

using elementary properties of logs. Hence

log 1.75 0.243308
n= = ≈ 7.27 years.
log 1.08 0.033424
The figures given are logs to the base 10, but the base is actually irrelevant.
Note that no rounding should be done until the calculation has been completed

3 Effective Interest Rate

Now suppose you were offered either an interest rate of 10% compounded once per year or an
interest rate of 5% compounded every 6 months. Which would be the better? Or does it make
no difference? Let us see.

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 Suppose then we have R1000. If the interest is compounded annually at 10%, then it is easy
to see that the amount after 1 year is
R1100.
However, if we compound twice a year at 5% we have

1000(1 + 0.05)2 = 1102.50

which is more.
More generally, if the bank offers an interest rate of i compounded k times per year, then
the amount accrued after one year on a principal P is
³ i ´k
P 1+ .
k

Example 3.1

Suppose R1000 is invested at 6% per annum, compounded monthly. Find the amount
after 1 year.

Solution

Since there are 12 months in a year, we obtain

³ 0.06 ´12
1000 1 + = R 1061.68.
12

In the previous example, we see that the interest rate is effectively 6.168%. We say that
the effective interest rate is 6.168%, while the original interest rate of 6% is known as the
nominal interest rate.

Example 3.2

Suppose a bank offers a nominal interest rate of 9%, which is compounded quarterly.
(a) What is the effective interest rate?
(b) If R500 is invested, what will the amount be after 5 years?

Solution

(a) To obtain the effective interest rate, it is easiest to see what happens to an investment
of R100. Since there are 4 quarters in a year, the amount is
³ 0.09 ´4
100 1 + = 109.31,
4
so the effective interest rate is 9.31%.
(b) Over a period of 5 years there are 20 quarters, so the amount is
³ 0.09 ´20
500 1 + ≈ 780.25.
4

We can ask the question the other way around, that is, if we are given the effective interest
rate, can we find the nominal rate?

Example 3.3

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 Suppose a principal P is invested at an effective rate of 7% compounded 6 times per year.
What is the nominal interest rate?

Solution

Let the nominal interest rate be x. We know the amount after 1 year is P (1 + 0.07). So
³ x ´6
P (1 + 0.07) = P 1 + .
6
x
This gives 1 + = 1.071/6 and so x = 0.6804, that is a nominal interest rate of 6.804%
6

4 Continuous Interest
Now suppose we start with an investment of R100 at a nominal rate of 10%. Let us calculate
the interest rate if interest is compounded
(a) monthly (b) weekly (c) daily (d) hourly (e) every minute

(a) There are 12 months in a year, so we obtain

³ 0.10 ´12
100 1 + =≈ 110.47.
12
The effective interest rate is thus 10.47%.
(b) There are 52 weeks in a year, so now we have
³ 0.10 ´52
100 1 + = 110.5065.
52
The effective interest rate is thus 10.5065%.
(c) Since there are 365 days in a year, we have
³ 0.10 ´365
100 1 + = 110.5156
365
with an effective interest rate of 10.5156%
(d) There are 24 hours in a day, so there are 24 × 365 = 8760 hours in a year. The amount
is then ³ 0.10 ´8760
100 1 + = 110.5170
8760
and the effective interest rate is 10.5170%
(e) Since there are 60 minutes in each hour there are 60 × 8760 = 525 600 minutes in a year.
The same computation gives an effective interest of 10.5171%

Now consider the effective interest rates we obtained:

10.47, 10.5065, 10.5156, 10.5170, 10.5171

Clearly the numbers are increasing as the number of periods increases, but they are getting
bigger more and more slowly.
So suppose we have n periods, where n is any very large number. Then the amount is
³ 0.10 ´n
100 1 + .
n

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If we now let n → ∞, we obtain
³ 0.1 ´n
lim 100 1 + .
n→∞ n
We now use the fact that ³ x ´n
lim 1 + = ex .
n→∞ n
Setting x = 0.10, the amount is
100e0.10 = 110.5171
The effective interest rate is then 10.5171. This is known as the continuous rate of interest.
In general, if the nominal rate of interest is i, then the continuous rate of interest is ei . To
put it another way, if a principal P is invested at nominal interest rate i, then after 1 year the
amount is
S1 = P ei .
After 2 years it will be
S2 = S1 ei = P (ei )2 = P e2i
and after n years it is
P eni .

Example 4.1

R100 000 is invested for 3 years. If the nominal rate of interest is 6% what will the amount
be if interest is compounded
(a) annually (b) quarterly (c) continuously

Solution

(a) In this case we have

100000(1 + 0.06)3 = 119 101.60.
(b) Compounding quarterly we have 12 periods, and so the amount is
³ 0.06 ´12
100000 1 + = 119 561.80.
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(b) Continuous compounding gives
100000(e0.06 )3 = 10000e0.18 = 119 721.70

5 Future and Present Values

If we invest a principal P at an interest rate i over n periods, then, as we have seen, the amount
is
S = P (1 + i)n .
This is the amount the investment will be worth in n periods of time, and is therefore also
known as the future value of P . We emphasize

The future value of an investment P is the amount it will be worth

after n time periods taking into account interest earned

Now suppose, instead we wish to find how much money P V , we must have in the bank now
in order for our investment, at interest rate i, to be worth P after n time periods. We must
have
P V (1 + i)n = P.

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Thus
P
PV = = P (1 + i)−n .
(1 + i)n
This is known as the present value or discounted value of P .
One can think of it this way. Suppose you have to make a payment P , which must be made
n time in the future. The present value of P is the money you need to deposit in the bank now
in order to have enough money to pay the amount P after n time periods, taking into account
interest earned. Again we emphasize

The present value of P due in n time periods is the amount that needs to be
deposited now in order to amount to P after n time periods

Example 5.1

Find the present value of R1000 due in 5 years time at an interest rate of 8% per annum

Solution

Let the present value be P V . Then the amount at 8% over 5 years is

P V (1 + 0.08)5

We want this to be equal to R1000, so

P V (1 + 0.08)5 = 1000,

that is
1000
PV = = 1000 × 1.08−5 = R 680.58
(1.08)5

Example 5.2

Mr Mkhize wishes to ensure that there will be enough money in the bank in 18 years time
to send his new-born daughter to UKZN. Taking into account inflation, he estimates that
the fees then will be R1 000 000. Assuming an interest rate of 10%, how much must he
deposit in the bank now?

Solution

Let the amount he must deposit be P V . Then

P V (1 + 0.10)18 = 1 000 000,

and so
1 000 000
PV = = 1 000 000 × 1.1−18 = R179 858.80
1.1018
Note that this is far less than the one million he pays at the end. However, he may not have
that much money right now. One way around his problem is to make a regular sequence of
smaller payments into a special account, so that the payments plus their interest will eventually
amount to the million he needs. We shall see how this operates in a little while.

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6 Geometric Series
A series of the form
Sn = a + ar + ar2 + ar3 + · · · + arn−1 (1)
is known as a geometric series. Note that each term is r times the previous one. Hence r
is known as the common ratio. The number of terms is n. Note that the right-hand side of
(1) has n terms (not n − 1), since we must also count the first term, which does not contain r.
Thus
a + ar + ar2 + ar3
has 4 terms, not 3. Count them!
Our main concern here is to find a formula for the sum of a geometric series. Let then

Sn = a + ar + ar2 + ar3 + · · · + arn−1 . (2)

Multiplying by r gives

rSn = ar + ar2 + ar3 + · · · + arn−1 + arn . (3)

On subtracting (2) from (3), we have

rSn − Sn = arn − ar,

that is
Sn (r − 1) = a(rn − 1)
and so, provided r 6= 1,

a(rn − 1) a(1 − rn )
Sn = = , r 6= 1 (4)
(r − 1) (1 − r)

7 Annuities
Fundamentally an annuity is a sequence of equal payments made over equally spaced time
intervals. Working with annuities is just like working with future and present values. The only
difference is that we make a succession of deposits or a succession of payments.

Corresponding to future value, we consider how much money will be accrued, in-
cluding interest, if we make regular deposits into a bank.

Corresponding to present value, we ask how much money we need to have in the
bank now, taking into account interest, in order to make a sequence of regular
payments in the future.

We consider two basic examples.

Example 7.1

Suppose I invest R1000 at the end of every year for 5 years. If the interest rate is 8%,
how much will my investment be worth after 5 years?

Solution

In order to see what is happening, it is a good idea to draw a simple diagram.

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 Deposit R1000 R1000 R1000 R1000 R1000

Year 1 2 3 4 5

Figure 1

Figure 1 shows the payments and when they are deposited.

Now consider the first payment. It remains in the bank for 4 years. The accumulated amount
(i.e. its future value) is therefore

1000 × (1 + 0.08)4 .

The next deposit is in the bank for 3 years and is worth

1000 × (1.08)3 .

Continuing in this way, the other 3 deposits are worth

1000 × (1.08)2 , 1000 × (1.08)1 and 1000.

Notice that the last payment accrues no interest, as it is made at the end of the fifth year.
The total is therefore

1000 × (1.08)4 + 1000 × (1.08)3 + 1000 × (1.08)2 + 1000 × (1.08)1 + 1000

Writing this is the reverse order gives an amount of

1000 + 1000 × (1.08) + 1000 × (1.08)2 + 1000 × (1.08)3 + 1000 × (1.08)4 .

This is a geometric series. So using (4), where a = 1000, r = 1.08 and n = 5 (since there
are 5 terms in the series), the amount is

1000(1.085 − 1) 1000(1.085 − 1)
S= = . (5)
1.08 − 1 0.08
A calculation shows that
S = R 5866.60
Now let us

Now let us introduce some terminology.

• The payment interval is the time between payments (in the case above, 1 year),
• The term is the length of time from the beginning to the end (in the case above, 5 years),
• The annual rent is the amount paid per year (in the case above R 1000),

• An annuity is an ordinary annuity if payments are made at the end of each time period,
as is the case above. If they are made at the beginning, it is a due annuity.
• The amount is the total of all the payments made plus their interest, that is the future
value of all deposits.

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 Now let us reconsider (5) and see if we can derive a general formula. Let the annual rent be
P . In the case above P = 1000. Let the term be n. In the case above n = 5. Let the interest
rate per time interval be i. In the case above i = 0.08. Then using exactly the same argument,
the amount is ¡ ¢
P (1 + i)n − 1
S= .
i
In the case that P = 1 we obtain
(1 + i)n − 1
S= .
i
Of course S depends on n and i, so we write the amount as

(1 + i)n − 1
snei = (6)
i

For our second example consider the following situation.

Example 7.2

Mr Mkhize needs to make regular payments at the end of each month in order to pay for
his furniture. How much money does he need to have in the bank now in order to pay
for his furniture if the monthly payments are R 200 for 2 years at a nominal interest rate
of 15% compounded monthly?

Solution

Again it is a good idea to draw a diagram.

Now

Payment ? 200 200 200 ··· 200 200

Month 1 2 3 ··· 23 24

Figure 2

Now we need to ensure that there is enough money in the bank now to be able to make the
payments, taking into account the interest earned. Thus we need to find the sum of all the
present values.
0.15
Note that the interest rate is = 0.0125 (since it is compounded monthly) over 24 months.
12
Let the money deposited initially be P V . The first payment is R200. The money, P V1 to
make this earns interest for 1 month. So

P V1 (1 + 0.0125) = 200

that is
200
P V1 = = 200(1.0125)−1 .
1.0125
The second payment is again R200, but remains in Mr Mkhize’s account for 2 months. The
money, P V2 is then given by
P V2 (1 + 0.0125)2 = 200
so
200
P V2 = = 200(1.0125)−2 .
1.0125

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 Continuing in this way, we arrive at the 24th payment, which earns interest for 24 months,
given a total present value of

PV = P V1 + P V2 + · · · + P V24
= 200(1.0125)−1 + 200(1.0125)−2 + · · · + 200(1.0125)−24
= 200(1.0125)−1 (1 + (1.0125)−1 + (1.0125)−2 + · · · + (1.0125)−23 .

Again we have a geometric series in which a = 1, r = (1.0125)−1 and n = 24.

Using (4), the total present value is
¡ ¢ ¡ ¢
1 − ((1.0125)−1 )24 −1 1 − (1.0125)
−24
P V = 200(1.0125)−1 = 200(1.0125) .
1 − (1.0125)−1 1 − (1.0125)−1

To clean up this somewhat messy expression, multiply the numerator and denominator by
1.0125. We obtain
¡ ¢ ¡ ¢
1 − (1.0125)−24 1 − (1 + 0.0125)−24
P V = 200 = 200 . (7)
1.0125 − 1 0.0125
A calculation shows that
P V = 4124.85.

We emphasize again, this is the quantity of money needed in the bank now in order to
affect 24 payments in the future. It is simply the sum of all the present values of the payments,
and is therefore called the present value of the annuity.
Again it is fairly easy to see what the general formula is for the present value of an annuity.
Suppose the payments are p (in the example above p = 200, the interest rate is i (in the case
above i = 0.0125) and the number of payments is n (in the case above n = 24). Then, using
just the same argument,
1 − (1 + i)−n
PV = p × .
i
In the case that p = 1, P V depends on n and i, so we write the present value as

1 − (1 + i)−n
anei = (8)
i

Example 7.3

What is the amount for an investment of R 5000 where payments are made quarterly over
5 years at a nominal interest rate of 6% compounded quarterly?

Solution

Here we are being asked to find the future value. We have 20 periods (since there are 5 years
0.06
each with 4 quarters), and the interest rate is since we are compounding quarterly. Thus
4
0.06
n = 20 and i = = 0.015
4
So, by (6)
(1 + 0.015)20 − 1
S = 5000 × snei = 5000 × = R 115 618.34
0.015

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Example 7.4

Find the present value of an annuity, where payments of R 10 000 are to be paid at the
end of every year for 7 years at an interest rate of 12.5%.

Solution

Now we are being asked to find the present value. Here n = 7 and i = 0.125, so by (8),

(1 − (1 + 0.125)7 )
P V = 10000 × anei = 10000 × = R 44923.01
0.125

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