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Module 1 - Time value of money (cont.)

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Module 1 - Time value of money (cont.)

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thaongan8225
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© © All Rights Reserved
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CHAPTER 1 (cont.

)
TIME VALUE OF MONEY

CHAPTER 1 (cont.) 1/8


Force of interest
Why Do We Need a Force of Interest?

- The interest rate for the unit interval [t, t + 1]:


A(t + 1) − A(t)
A(t)
→ If the interest varies a lot, the annual effective rate may not be helpful
for determining how money grows on short intervals containing t.
CHAPTER 1 (cont.) 2/8
Force of interest
In high-frequency trading, where every second is critical, investors must
evaluate the expected value of their investments or funds in small time
increments.
→ need to know the rate of growth of an investment at any moment of
time t.
1
Look at the interval [t, t + m ], where m is positive integer.
1
The effective interest for the interval with length m is
1 1
A(t + m) − A(t) a(t + m ) − a(t)
=
A(t) a(t)

→ The annual nominal interest rate


1
a(t + m) − a(t)
m×
a(t)

When 1/m → 0 : · · ·
CHAPTER 1 (cont.) 3/8
Force of interest

The instantaneous rate, which is obtained when 1/m is infinitesimally


small, is
a′ (t)
δt =
a(t)
is the force of interest at time t.
force of interest = the nominal rate of interest payable continuously
Exercise Suppose a(t) = (t + 1)2 . Determine the force of interest.

Exercise You are given:


• a(t) = Kt2 + Lt + M, for 0 ≤ t ≤ 2
• A(0) = 100; A(1) = 110; A(2) = 136
Determine the force of interest at time t = 12 .

CHAPTER 1 (cont.) 4/8


Force of interest

Finding a(t) from δt

d ln a(t)
δt =
dt
Z k k
→ δt dt = ln a(t) = ln a(k) − ln a(0) = ln a(k)
0 0
Z k 
→ a(k) = exp δt dt
0
3
Exercise Suppose δt = 1−3t . Find the corresponding accumulation
function a(t).
2
Exercise You are given δt = 1+t . A payment of 300 at the end of 3 years
and 500 at the end of 6 years has the same present value as the payment
of 200 at the end of 2 years and X at the end of 5 years. Calculate X.

CHAPTER 1 (cont.) 5/8


Force of interest

The accumulation factor for a period from time t1 to t2


Consider a payment of 1 at a future time t1 . The future value of this
payment at time t2 > t1 is
Z t2 
1 a(t2 )
× a(t2 ) = = exp δt dt
a(t1 )) a(t1 ) t1

Exercise Ernie makes deposits of 100 at time 0, and X at time 3. The


t2
fund grows at a force of interest δt = 100 , t > 0. The amount of interest
earned from time 3 to time 6 is X. Calculate X.

Exercise Deposits of 100 are made to an account today and one year
from today. The annual force of interest at time t in years for this
account is: δt = 0.03 + 0.005t, 0 ≤ t ≤ 3. Calculate the account balance
two years from today.

CHAPTER 1 (cont.) 6/8


Force of interest

Constant force of interest


For the compound-interest method:

a′ (t) = (1 + i)t ln(1 + i) → δ(t) = ln(1 + i) = δ

δ m
 
1 + i = lim 1 + = eδ
m−∞ m
a(n) = enδ
Consider a payment of 1 at a future time t1 . The future value of this
payment at time t2 > t1 is

a(t2 )
= e(t2 −t1 )δ
a(t1 )

CHAPTER 1 (cont.) 7/8


Force of interest
Exercise Bruce deposits 100 into a bank account. His account is credited
interest at a nominal rate of interest of 4% convertible semi-annually. At
the same time, Peter deposits 100 into a separate account. Peter’s
account is credited interest at a force of interest of δ. After 7.25 years,
the value of each account is the same. Calculate δ.
Exercise Two deposits are made into an account: 100 at time 0, and 300
twelve years later. For the first 8 years interest are credited at a nominal
annual rate of 6% convertible quarterly. For the next 8 years the account
accumulates at a force of interest δ. At the end of 16 years the account
balance is 656. Find δ.
Exercise An investment has interest
( calculated according to the
0.02t, 0≤t≤3
following force of interest: δt =
0.045 3<t
A customer invests 1 at time t = 0. What is the equivalent annual
effective interest rate is earned over the first four-year period?
CHAPTER 1 (cont.) 8/8

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