1 Time Value of Money (10-15%, B1)

• Interest theory deals with the time value of money.

• Interest is defined as the payment by one party (the borrower) for the use of an asset

that belongs to another party (the lender) over a period of time. This asset is also

known as , or the .

• Of course, because you will have to pay back the capital in the future you will want to

put it to good use, and to earn a return on capital or yield.

• Five ways to express interest: , ,

, , and .

1.1 Interest and interest rate

Interest: The amount of interest earned from time t to time t + s is where

AVt is the accumulated value at time t.

Interest rate: The annual interest rate i in effect from time t to time t + 1 is

where t is measured in years.

If you deposit $1,000 into a bank account. One year later, the account has accumulated to

$1,050. This amount consists of $1,000, representing the initial deposit or capital, and $50,

representing the interest earned on the deposit over the year. In this example, AV0 = $1, 000,

AV1 = $1, 050, the amount of interest earned is and the interest rate

for the year is

1.2 Simple interest and compound interest

Simple interest: When money is invested in an account paying simple interest, interest

is only earned on the . Interest is not earned on the that has

previously accrued.

Accumulated value: If $X is invested in an account that pays simple interest at a rate of i

per year, then the accumulated value of the investment after t years is .

Example 1.1. Alex invests $5,000 into a bank account earning 5% simple interest.

a) How much does he have in the account after seven years?

b) How much interest is earned between four and five (the fifth year)?

c) What was the interest rate earned between years 4 and 5?

Solution.

Compound interest: When money is deposited into an account paying compound interest,

interest is earned on the initial deposit, and .

Accumulated value: If $X is invested in an account that pays compound interest at a

rate of i per year, then the accumulated value of the investment after t years is

Example 1.2. Alex deposits $5,000 into a bank account earning 5% compound interest per

year.

a) How much does he have in the account after seven years?

b) How much interest is earned between four and five (the fifth year)?

c) What was the effective interest rate earned between years 4 and 5?

Solution.

Example 1.3. (simple interest vs compound interest)

a) Simple Interest: If you deposit 100 in a bank at 6% interest, your capital will earn $6.00

at year-end, and you will have $106. If you choose to leave your money on deposit, another

$6.00 will accrue by year-end 2, so now you will have $112.00.

b) Compound Interest: By leaving your $6.00 on deposit at year-end 1, you will accrue

“interest on the interest” by year-end 2. In addition to the $6.00 that you earn in year

2 from your capital (also called principal), you will earn 0.06 × $6.00 or $0.36. So in the

compound case you will have $112.36, vs. $112 in the simple interest case at the end of year

2.

Simple $100 $106.00 $112.00

Compound $100 $106.00 $112.36

| | |

Time 0 1 2

1.3 Accumulation factor and accumulation function

Accumulation (value) factor: The amount to which an initial investment of $1 grows by

time t ≥ 0, denoted by AVFt or a(t). It is for the simple interest and

for the compound interest.

Accumulation (value, or amount) function: The amount to which an initial investment

of A(0) grows by time t, denoted by AVt or A(t). It is for simple

interest and for compound interest.

Note that A(t) = A(0) × a(t).

Future value: When a payment is accumulated to a future point in time, its future value

is calculated, taking into account any interest that will be earned during the investment

period.

Example 1.4.

a) A savings account offers simple interest of 10%. How long does it take to double your

principal?

b) Repeat the same calculation but assume compound interest.

Solution.

a) After n year, the simple interest accumulated value factor is

So n = 10. In the general case, the number of years is n = 1/i.

b) After n year, the compound interest accumulated value factor is

So n = ln 2/ ln(1.1) = 7.2725. In the general case, n = ln 2/ ln(1 + i).

1.4 Present value and discount factor

Not only can we determine the accumulated value of investments at a future point in time,

but we can also find the value now, at time 0, of a payment to be made in the future, taking

into account any interest that will be earned during the investment period. This is known

as the present value of a future payment.

Present value: Assuming an annual compound interest rate of i, the present value of a

payment $X to be made in t years is .

Present value factor: The one-year present value factor, which is also known as the one-

year discount factor, is .

Under compound interest, the present value of a payment of $1 to be made in t years is the

compound interest present value factor: .

Under simple interest, the present value of a payment of $1 to be made in t years is the

simple interest present value factor: .

Example 1.5. (present value and accumulated value)

a) What is the present value of $20,000 payable in 15 years at 5% per annum compound?

b) What will $5,000 amount accumulate to in 6 years at 5% annually compound?

c) How much will I have to invest to accumulate to $5,000 in 10 years time at 5% compound

interest? Write this problem in actuarial notation.

Solution.

5
1.5 Effective rate of interest

The effective annual rate of interest earned by an investment during

is the percentage change in the value of the investment from the beginning to the end of the

year, without regard to the investment behavior at intermediate points in the year.

We can find the effective rate of interest over any time period. For the period [t, t + 1] the

beginning amount is A(t) and the amount at the end of the period is A(t+1). Interest earned

over the period is A(t + 1) − A(t). The effective rate of interest over the period [t, t + 1] is

Example 1.6. You deposit $100 in a bank with 6% interest. What is the effective rate of

interest over the period [1, 2], assuming

a) Compound interest at 6% and

b) Simple interest at 6%?

Solution.

a) Compound:

No surprise here: if the effective rate is 6% compounded annually, then measuring the

effective annual rate earned over the year has to be 6%!

b) Simple:

Notice that the effective rate of interest in the case of compounded interest is the rate itself;

in the simple interest case it is the equivalent compounded rate.

6
1.6 Convertible m-thly and nominal rates of interest

When compounding is performed more frequently than annually (e.g. monthly or quarterly)

rates are quoted as nominal annual rates and then converted to a periodic rate. For example,

if you earn 10% annually, compounded quarterly, you will earn 2.5% for the first quarter,

then 2.5% multiplied by the 1.025 in the second quarter, and 2.5% multiplied by (1.025)2 in

the third quarter, etc.

1 1.025 (1.025)2 (1.025)3 (1.025)4

| | | | |

0 1/4 2/4 3/4 4/4

• In this case, the nominal rate is i(4) = 10%.

• The periodic rate (compounded quarterly) is i(4)/4 = 2.5%.

• Here, A(0) = 1 and A(1) = (1 + 0.025)4 = 1.103813. The effective rate is defined as

A(1) − A(0) 1.103813 − 1

• If compounding m times a year, then

• The effective rate is higher than the nominal rate when interest is compounded more

frequently than annually.

7
Example 1.7. Assume you earn a monthly rate of 1% compound.

a) What is the annual nominal rate?

b) What is the annual effective rate?

Solution.

8
1.7 Discount and discount rate

For any amount of discount earned over a period, we can also calculate an associated discount

rate. The discount rate in effect for a one-year period is the amount of discount earned over

the year divided by the ending accumulated value.

Discount: The amount of discount earned from time t to time t + s is

Discount rate: The annual discount rate d in effect for the year from time t to time t + 1

is where t is measured in year.

Example:

• Assuming a one-year period at interest of i = 6%, we would need to invest $94.34, which

would attract interest of $5.66 ($94.34∗6%) to add to $100, i.e. $94.34∗(1+6%) = $100.

• The above equation can be written as $94.34 = v $100 where v = 1/(1 + i) is called

the discount factor.

• It can be written as $94.34 = $100(1 − d) as well where d = 5.66% is called the

discount rate.

• The present value amount that we need to hold at 6% to accumulate to $100 is

100(1/1.06) = 94.34.

• The discount rate is d = 1 − 0.9434 or 0.0566. Multiplying by 100, the amount of the

discount in this case is $5.66, which is the amount we can discount the $100 by to

determine the principal required to accumulate to $100 by the end of the period.

9
As with the interest/discount case, the discount rate d, which is applies to a loaded price, is

lower than the corresponding interest rate:

94.34 × (1 + 6%) = 100

94.34 = 100 × (1 − 5.66%)

Note that d = 1 − v = 1 − 1/(1 + i) = i/(1 + i) = iv.

Example 1.8. You invest $400 today. Your investment grows to $500 by the end of the

year.

a) Calculate d.

b) Calculate the effective rate i.

Solution.

10
1.8 Nominal and effective rates of discount

This works the same way as the nominal rate of interest, with one important difference.

Define d(m) as the nominal rate of discount, compounded m-thly. Then

Note that

Example 1.9. (d ⇔ d(m) )

(a) Find the effective rate of discount corresponding to a nominal rate of 7.5%, convertible

3 times per year.

(b) Find the nominal discount rate convertible monthly corresponding to an annual effective

(discount) rate of 6%.

Solution.

11
1.9 Force of interest

For an investment that grows according to accumulated amount function A(t), the force of

interest at time t, is defined to be

which is the relative instantaneous rate of growth per unit amount invested at time t.

Force of interest and accumulation factor: Since

d a′(t)
ln[a(t)] = = δ(t)
dt a(t)
!t
we have 0
δ(s)ds = ln[a(s)]|t0 = ln[a(t)] − ln[a(0)] = ln[a(t)]. Thus

This last expression allows us to calculate the accumulated value in which δ(t) varies with

time.

Accumulated value factor from t1 to t2: The accumulated value at time t2 of a deposit

of $1 at time t1 is .

Present value factor from t2 to t1 : The present value at time t1 of a payment of $1 at

time t2 is .

12
Example 1.10. A person invested $1,000 in a fund at time 0. The force of interest at time

t is given by δt = 0.02(3 + 2t). Determine the accumulated value of the investment two years

from now.

Solution.

Constant force of interest: For the constant force of interest model we have δ(t) = δ for

all t ≥ 0. Thus

a′(t) δeδt
Check: δ(t) = = δt = δ.
a(t) e

If the interest is compounded m-thly a year, the nominal rate of interest i(m) can be calculate

from
#m
i(m)
"
1+ = 1 + i.
m

Assume that the effective rate is i = 6%. Than

i(2) = 5.9126% if compounded semi-annually,

i(4) = 5.8695% if compounded quarterly,

i(12) = 5.8411% if compounded monthly,

i(365) = 5.8274% if compounded daily, and

i(∞) = 5.8269% (see below) if compounded continuously.

13
If the interest is compounded continuously, we can let m → ∞ to get
#m
i(m)
"
1 + i = lim 1+
m→∞ m

%n
Note that limn→∞ 1 + nr = er .
$

We define the constant force of interest δ = limm→∞ i(m). We have 1 + i = eδ and thus

and

Example 1.11. A deposit of $500 is invested today. The constant force of interest is 6%

per year.

a) Determine the accumulated value of the investment 5 years from today.

b) Determine the equivalent compound rate of interest earned over the period.

Solution.

14
1.10 Inflation and real rate of interest

The inflation-adjusted return is the measure of return that takes into account the time

period’s inflation rate. Inflation-adjusted return reveals the return on an investment after

removing the effects of inflation. Removing the effects of inflation from the return of an

investment allows the investor to see the true earning potential of the security without

external economic forces. (source: Investopedia)

The real rate of interest refers to the inflation-adjusted return on an investment. With

annual interest rate i and annual inflation rate r, the real rate of interest for the year is

Example 1.12. Assume an investor purchases a stock on Jan. 1 of a given year for $50,000.

At the end of the year, on Dec. 31, the investor sells the stock for $55,000. At the beginning

of the year, the Consumer Price Index (CPI) was at 700. On Dec. 31, the CPI was at a level

of 721. Determine the inflation-adjusted return.

Solutions.
55, 000 − 50, 000
The annual investment return is i = = 10%. The annual inflation rate is
50, 000
721 − 700
r= = 3%. The the inflation-adjusted return the year is
700

15
Exercises - Time Value of Money (1)
Exercise 1. How much should you deposit in your College fund now to have $80,000 in 18

years at 6% interest?

Exercise 2. You deposit $1,000 now in a fund earning 5.75%.

a. What will it be worth in 5 years?

b. How long will it take to double your money?

Exercise 3. How much should you deposit in a bank account earning 5% annually to be

able to withdraw $1,000 in 2 years and 2,000 in 4 years?

Exercise 4. You deposit $5,000 in an account earning 5% compounded semi-annually for 2

years and 7%, compounded quarterly thereafter.

a. What is the account value after 7 years?

b. What is the equivalent annual rate, compounded annually?

Exercise 5. You deposit $5,000 in an account that earns 5% compounded annually in years

1 and 2, and thereafter at a continuous rate δt = 2/(t + 1). What is the value of the account

after 5 years?

Exercise 6. Suppose an initial investment of $100 grows according to the accumulated

amount function A(t) = (100)(1 + 0.01 t).

a. Find the effective rate of interest earned during the 5th year, ie i5.

b. Find the effective discount rate during the 5th year, ie d5 .

c. Find the force of interest δt .

d. Find the equivalent effect rate of interest compounded annually during the first five years.

Exercise 7. Let in = 0.1t for t = 1, 2, 3, 4 be the effective rate of interest earned in year t.

Find a(4) and the effective annual rate of interest earned during the first 4 years.
Exercise 8. An investment fund has a force of interest δt = 0.2 t. Find the amount of money

to be invested in the fund at time t = 1 in order to have $10,000 at time t = 2.

Exercise 9. An investor puts 100 into a fund paying an effective rate of discount of 20%

for the first 2 years and a force of interest δt = 2t/(t2 + 8), 2 ≤ t ≤ 4, for the next 2 years.

At the end of 4 years the amount in the account is the same as it would have been if he had

put 100 into an account paying interest at a nominal rate compounded quarterly. Calculate

i(4).

Exercise 10. John has $10,000 to invest at time t = 0, and two possible ways to invest it.
0.08
Investment A has a force of interest equal to at time t.
1 + 0.08t
Investment B provides a 5% effective annual interest rate.

John can invest any portion of her principal in either investment A or B, and can transfer

any portion of her money between the two investments at any time. What is the maximum

amount John can accumulate by time t = 20?

2
Solution 1. We are to discount the future value of $80,000 for 18 years with i = .06. The

present value is the amount of money you should deposit today.

PV = $80, 000 v 18 = $80, 000 (1.06)−18 = 28, 027.50

Solution 2. a. The accumulated value after 5 years is AV5 = 1000(1.0575)5 = $1, 322.52.

b. You will double your money when the accumulated value reaches $2,000. Solve n such

that 1000(1.0575)n = 2000. We have n = ln(2)/ ln(1.0575) = 12.398.

Solution 3. The present value at time 0 of the withdrawals is PV = 1000v 2 + 2000v 4 =

907.03 + 1, 645.40 = $2, 552.43. So the deposit amount is $2,552.43.

Solution 4. a. FV = 5000[(1 + 0.05/2)4 (1 + 0.07/4)20 ] = $7, 808.25

b. 5000(1 + i)7 = 7808.25 gives i = .06575.

Solution 5. The future value is

R5 2
dt
(5, 000)(1.05)2 e 2 t+1 = (5, 512.50)e(2)[ln(5+1)−ln(2+1)] = (5, 512.50)(4) = $22, 050

A(5) − A(4) (100)(1.05 − 1.04)

d. By the end of year 5, the fund has grown to 105. Let i be the equivalent annual effect

rate, compounded annually. Than (100)(1 + i)5 = 105 and i = (1.05)1/5 − 1 = 0.0098.

Solution 7. First calculate a(4) = (1.1)(1.2)(1.3)(1.4) = 2.4024. Then solve i from (1+i)4 =

2.4024 to get i = 0.245.

R2 R2
δt dt 0.2tdt
Solution 8. (X)e 1 = (X)e 1 = (X)e0.3 = 10, 000. Thus X = (10, 000)e−.3 =

$7, 408.18

3
R4 2t
2 t2 +8 dt
Solution 9. First calculate the accumulated value at t = 4: AV4 = (100)(1−0.2)−2 e =
2 +8)|4
(156.25)eln(t 2 = (156.25)(2) = 312.50. Then calculate the nominal rate from i(4) from

(100)(1 + i(4)/4)16 = 312.50 to get i(4) = .295.

Solution 10. Investment A provides a decreasing force of interest from δ0 = .08 to δ20 =

.08/(1+(.08)(20)) = .03077. Invest B provides a constant force of interest ln(1.05) = 0.04879.

John should invest in A until the force of interest decreases to 0.04879 and then switch to

B. To find this point in time, solve .08/(1 + (.08)(t)) = 0.04879 to get t = 8. So John

should invest in A for the first 8 years and then switch to B for the rest of 12 years. The
R8 .08
accumulated value is (10, 000)e 0 1+.08t dt (1.05)12 = (10, 000)(1.64)(1.05)12 = $29, 453.