TUTORIAL SOLUTIONS WEEK 2

Question 1
$2,500 is invested. Find the accumulated value of the investment 10 years after it is made for
each of the following rates.
(a) 4% annual simple interest
(b) 4% effective annual compound interest
(c) 2% effective 6-month compound interest
(d) 1% effective 3-month compound interest

Solution
(a)
i = 4% annual simple interest
n = 10 years
2500(1  ni )  2500(1  (10)(0.04))  3500

(b)
i = 4% effective annual compound interest
n = 10 years
2500(1  i ) n  2500(1  0.04)10  3700.61

(c)
i = 2% effective 6-month interest rate.
n = 10 years, or 20 6-month periods.
2500(1  i ) n  2500(1  0.02) 20  3714.87

(d)
i = 1% effective 3-month interest rate.
n = 10 years, or 40 3-month periods.
2500(1  i ) n  2500(1  0.01) 40  3722.16

NOTE: An alternative, yet more labour intensive way of solving (c) and (d) could involve
finding an equivalent effective annual interest rate and compounding this for 10 years.

For example, for part (c), 2% is the 6-month effective interest rate, so an equivalent effective
annual interest rate is: i  1.02 2  1  0.0404

The accumulated value is then:

2500(1  0.0404)10  3714.87

(a) In Excel, calculate the accumulated value of $100 under each of the following situations /
scenarios (note: Do use Excel to do these calculations, as most subsequent tutorials will
have additional Excel-based work – best to practice and start using Excel as soon as you
can)

STAT2032/6046 – Financial Mathematics 1

 Annual effective interest rate, i
Years invested -2% 0% 2% 4% 6% 10%
2
5
10
20
30

See the worked solutions in ‘Week 2 - Tutorial Solution.xls’.

Question 2
If the effective 3-month compound interest rate is -3%, what is the accumulated value after 1
year of an initial investment of $1?

Solution
Negative rates are treated the same as positive rates.

i = 3-month compound interest rate of –3%.

n = 1 year, or four 3-month periods.

(1  i ) n  (1  0.03) 4  0.8853

Question 3
It is known that the present value of $864 due in two years is $600. Find the accumulated
value of $2000 invested at the same rate of compound interest for three years.

Solution
First we need to find the effective annual rate of interest i :

864v 2  600  864  600(1  i ) 2  i  0.2

Therefore, the accumulated value of $2000 invested for three years is:

2000(1  i )3  2000(1.2)3  3456

Question 4
What is the present value of 1000 due in 10 years if the effective annual interest rate is 6%
for each of the first 3 years, 7% for the next 4 years, and 9% for the final 3 years ?

Solution
We can solve this by discounting the 1000 back 3 years at 9%, then discounting this value
back 4 years at 7%, and finally discounting this amount back to the present at 6%:

The discounted value at t=7 is 1,000 v 03.09 

STAT2032/6046 – Financial Mathematics 2

The discounted value at t=3 is 1,000 v 03.09 v 04.07 

The present value at t=0 is, therefore,

   
1,000 v 03.09 v 04.07 v 03.06  1000 (1.09) 3 (1.07 ) 4 (1.06) 3 = 494.62

Question 5
Smith needs to borrow $5,000 for one year.

Under one scenario (A) he is offered a loan at an effective annual rate of 5%. In other words,
he has to pay interest of 5, 000  0.05  250 at the end of the year.

Under another scenario (B) , he is offered a loan of $10,000 at a lower effective annual rate of
interest denoted by i . If he borrows the $10,000, he can invest the excess $5,000 for one year
at 3%. In other words, at the end of the year he will have to pay interest of (10, 000  i ) , but
he receives interest of 5000  0.03  150 .

How low must the rate on the $10,000 loan (scenario B) be in order for Smith to prefer it to
the $5,000 loan (scenario A)?

Solution
We are comparing two scenarios, so the first thing to do is write down the details of both.

Scenario A
Loan amount borrowed = $5,000
Duration of loan = 1 yr
Annual interest rate on borrowed loan = 5%

Scenario B
Loan amount borrowed= 10,000
Duration of loan= 1 yr
Annual interest rate on borrowed loan = i (unknown)
Loan amount invested = 5,000
Duration of investment = 1 yr
Annual interest rate for investment = 3%

The question being asked is: How low must be the rate on the $10,000 loan in order for Smith
to prefer it to the $5,000 loan? In order for Smith to prefer the $10,000 loan, the net interest
paid by Smith should be lower than the net interest paid if he chose the $5,000 loan. We,
therefore, need to find the net interest for each scenario.

Scenario A
Interest paid by Smith at the end of the year = 5,000(0.05) = 250

Scenario B
Interest paid by Smith at the end of the year = 10,000( i )
Interest earned by Smith at the end of the year = 5,000(0.03) = 150
Net interest paid by Smith at the end of the year = 10,000( i ) - 150

STAT2032/6046 – Financial Mathematics 3

Therefore, Smith will prefer the $10,000 loan if the net interest paid by Smith under Scenario
B is less than the net interest paid by Smith under Scenario A, or

10,000( i ) - 150 < 250

Solving for i ,

i < 4%

If i =4% then both scenarios are equally appealing. If i is less than 4% Scenario B is
preferred.

Question 6
Jones invests $100,000 in a 180-day short term investment at a bank, based on simple interest
at an annual rate of 7.5%. After 120 days, interest rates have risen to 9% and Jones would
like to redeem the certificate early and reinvest in a 60-day certificate at the higher rate.

In order for there to be no advantage in redeeming early and reinvesting at the higher rate,
what early redemption penalty P should the bank charge at the time of early redemption?

Hint: You can approach this question by equating the accumulated value of two scenarios and
solving for P .
A) Jones invests $100,000 for 180 days at 7.5% simple interest per annum.
B) Jones invests $100,000 for 120 days at 7.5% simple interest per annum and then
redeems the accumulated amount. Upon redemption he pays a penalty of P . He then
reinvests the balance at 9% simple interest per annum for 60 days.

Solution
We want to find the level of early redemption penalty that the bank should charge so that
there is no advantage in an investor redeeming early and reinvesting.

First, list the particulars of the investment. Under the first scenario (A), we assume that Jones
does not redeem. Under the second scenario (B), we assume that Jones redeems and reinvests
at a higher rate, and in doing so, is subject to an early redemption penalty.

Scenario A
Amount invested = 100,000
Duration = 180 days
Interest rate = 7.5% simple annual rate

Scenario B
Amount invested = 100,000
Duration = 180 days
Interest rate = 7.5% simple annual rate for first 120 days, then balance reinvested at 9% for
the subsequent 60 days.
Redemption penalty = P (unknown)

STAT2032/6046 – Financial Mathematics 4

We want to find P such that the two scenarios produce identical results. We can do this by
calculating the accumulated amounts at the end of the 180 days:

  180  
Accumulated amount for Scenario A = 100,0001  0.075    103,698.63
  365  

To calculate the accumulated amount for Scenario B, first find the accumulated amount after
120 days:
  120  
= 100,0001  0.075   = 102,465.80
  365  
Before this amount is reinvested, the redemption penalty (P) is subtracted. The balance is
then reinvested with simple interest of 9% for 60 days. The total accumulated amount for
Scenario B is then:

  60  
= 102,465.80  P 1  0.09    102,465.80  P 1.014795
  365  

Equating these two amounts and solving for P, we get:

102,465.80  P 1.014795  103,698.63

102,465.80  P   102,186.80
P  278.93

Question 7
(a) Show that at an effective annual compound interest rate of i , the amount of interest
earned in successive years on an investment of 1 grows by a factor of (1  i ) and these
amounts are i , (1  i)i , (1  i) 2 i , …, (1  i ) n 1 i for the first, second, third, …, nth year,
respectively.
(b) Using the fact that the amount of interest earned from time 0 to time n is (1  i) n  1 ,
derive a formula for the sum 1  (1  i )  (1  i ) 2  ...  (1  i ) n 1 .

Solution
(a) The amount at time 0 is 1, so following the notation of week 1 lectures, let S(0) = 1.

Interest in the first year is S (0)  i  i , so the accumulated value at the end of the first year is
S (1)  S (0)  i  1  i .
Interest in the second year is S (1)  i  (1  i )  i , so the accumulated value at the end of the
second year is S (2)  S (1)  S (1)  i  (1  i )  (1  i )  i  (1  i ) 2 .
Interest in the third year is S (2)  i  (1  i ) 2  i , so the accumulated value at the end of the third
year is S (3)  S (2)  S (2)  i  (1  i ) 2  (1  i ) 2  i  (1  i )3 .

It follows that interest in the nth year is S (n  1)  i  (1  i ) n 1  i

(b)

STAT2032/6046 – Financial Mathematics 5

The total interest earned from time 0 to time n is (1  i) n  1 . This follows from the fact that
the total interest component is simply the accumulated value (1  i )n minus the principal 1.

From part (a), we also know that the total interest earned from time 0 to time n is
i  (1  i )  i  (1  i ) 2  i  (1  i )3  i  ...  (1  i ) n 1  i

This can be written as:

i 1  (1  i )  (1  i ) 2  (1  i )3  ...  (1  i ) n 1 

Therefore, i 1  (1  i )  (1  i ) 2  (1  i )3  ...  (1  i ) n 1  = (1  i) n  1

(1  i ) n  1
and, 1  (1  i )  (1  i ) 2  (1  i )3  ...  (1  i ) n 1 =
i

Past Exam Question – 2005 Final Exam Q1(d)

At a certain rate of compound interest, 1 will increase to 2 in a years, and 4 will increase to
20 in b years. If 6 will increase to 15 in n years, show that n = b - a. (3 marks)

Solution
log(2)
11  i   2  a 
a

log 1  i 
log(5)
4(1  i )b  20  b 
log 1  i 
log(15 / 6)
6(1  i ) n  15  n 
log 1  i 
log(5 / 2) log(5)  log(2)
n   ba
log 1  i  log 1  i 

STAT2032/6046 – Financial Mathematics 6