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Unit iv: Mathematics of Finance

Financial Mathematics
B.Com. (Hons.) IV Sem. 4.0 Rates of interest: Simple and compound
University of Delhi 4.1 Rates of interest: Nominal, effective and their
inter-relationships in different compounding
situations.

4.2 Compounding and discounting of a sum using

different types of rates. Applications relating to
Depreciation of assets and Equation of value.
Course Instructor
Dr. B. B. Mohapatra 4.3 Types of annuities: ordinary, due deferred,
Department of Commerce continuous, perpetual. Determination of future
and present values using different types of rates of
Maharaja Agrasen College
interest. Applications relating to Capital
(University of Delhi), Delhi expenditure, Leasing, Valuation of simple loans
and debentures, sinking fund. (excluding general
annuities).

Simple Interest
I = Prt
I = Total Interest Earnings
Simple P = Principal Amount
r = rate of interest per Annum
& t = time in years

Compound Interest Rates

S = The amount i.e. sum of Principal and Interest Earnings

The Amount (S) = Principal (P) + Interest Earnings (I)

S = P + Prt

S = P(1+rt)

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Simple Interest What if we do not withdraw the interest earning

after the end of period, rather we allow it to be
Example 1: Find the simple interest on ₹ 500 for 3 added to the principal, which of course is an
years at 4% per annum as well as find the amount. usual thing.

Example 2: Find the time required for ₹ 2500 to Our interest gets accumulated i.e. it gets
yield ₹ 300 in simple interest at 8% per annum. compounded.

Example 3: At what interest rate will ₹ 300 to For example; suppose you deposit rupees 500 in a
yield ₹ 100 in simple interest in 6 months. bank @5% per annum. What will be the amount
after say 5 years? How much will be the interest
Example 4: What principal will amount to ₹ 645 earnings?
in one and a half year at 5 % per annum simple
interest rate. Lets do it in Excel

We can do it in Excel by writing the Formula This is quite tedious, can we have a formula?
Let us discover it?

Compound Interest
The Difference Suppose our Principal = P
Rate of Interest per Annum = r

The Amount after 1st year will be P + P r = P(1+r)

The Amount after 2nd year will be P(1+r)+ {P(1+r)}r= P(1+r)2

The Amount after 3rd year will be P(1+r)2 +{P(1+r)2 }r= P(1+r)3
……………
……………

The Amount after t years will be P(1+r)t

Thus the compound interest formula is

S = P(1+r)t
S = The Amount After t years

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However, in the compound interest formula; Compound Interest: The Generic Formula

In order to accommodate various forms of non-annual

S = P(1+r)t , compounding the first and foremost condition is that instead of
year we should focus on the number of conversion period in a year
where
r = rate of interest per Annum The conversion period (m) is the number of period by which the
interest paid gets compounded with the principal amount in a year.
t = time in years
For example;

How to calculate the Amount if the interest is Half yearly compounding => every 6 months your interest earnings
compounded on non-annual basis i.e. by half- are added with the principal => 2 conversion periods in a year
yearly, quarterly, monthly, etc. ?
Similarly, quarterly compounding => every 3 months your interest
earnings are added with the principal => 4 conversion periods in a
We need to discover a more generic formula…. year
For this the first and foremost condition is that
Similarly, monthly compounding => every month your interest
instead of years we should consider conversion
earnings are added with the principal => 12 conversion periods in a
period year

Compound Interest:
The Generic Formula Thus, our Generic Compound Interest
Formula [P(1+i)n ] becomes;
S= P(1+i)n
& '(
S = the Amount after n conversion period
!=# $+
P = the principal in period zero or the initial principal amount '
i = r/m (rate of interest per conversion period in a year)
r = rate of interest per annum
Interest Earning = S – P
m = number of conversion periods in a year
n = m*t (total number of conversion periods altogether)

t = time in years

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Table 1: Amount At Compound Interest Rates (The

A Few Examples CVF Table) S=1(1+i)n
Example 5: Find the compounded amount of ₹ 2000 for
4 years at 6% per annum converted (i) Interest Rates (i)
Annually, (ii) Semi annually, (iii) quarterly n
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
and (iv)Monthly.
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100
Example 6: A man borrows ₹ 750 from a money lender
and the bill is renewed after every half year 2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210
at an interest of 21%. Per annum. After 3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331
how many years the amount becomes ₹
7500. (DU B.com. (Hons.) 2007) 4 1.041 1.082 1.126 1.170 1.216 1.2625 1.311 1.360 1.412 1.464
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
Example 7: A sum of money is deposited in a bank
which compounds interest semi annually. 6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772
The amount at the end of the 4 years is ₹ 7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949
6333.85 and the amount becomes 8023.5
at the end of the 8 years. Find the money 8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144
deposited and the interest rates per annum. 9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358
(DU B.com.(Hons.) 2010)
Now Using the FV function in Excel, NPER, 10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594
Rate, PV, finding one given the other 3

Continuous Compounding
Compound Interest Formula: Lets have a Relook , &-
! = lim ) * +
&→( &
& , &-
=) lim * + &
'(
!=# $+ &→(
' &/, ,-
,
What is this m? Recall = ) lim * +
&→( &
m is the number of conversion periods in a year, ,
/0- = 1 and as m → ∞, 8 → 0
&
which is nothing but a finite number like 1, 2, 4 ,-
⇒ ) lim * + 1 */1
or 12
1→;
⇒ lim * + 1 */1 =e
(i.e. Interest is compounded discretely)
1→;
>
(e s approximate value is 2.71828)
What if this m becomes infinite? (i.e. interest is Thus
! = ) 0,-
compounded continuously) Given, the P, r and t, using the above formula we can calculate
S, given the 01, table or value to us.
What will be S when m→ ∞

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Lets Solve an Example

The Formula
A person deposits ₹ 5000 in a bank which pays an
interest of 11% per annum compounded
continuously. How much amount will be in the
Thus if it is Discrete Compounding account after 10 years.

& '( We can solve this question by Applying the Formula:

!=# $+
' " = $ %&'
.--(-))
" = ())) *. ,-.*.
But if it is Continuous Compounding then we can solve it by taking log on both the sides and
using the log and antilog tables.
&(
! = #) We can do it in excel by writing the Formula

Dynamic Compounding
Dynamic Compounding An Example
Mr X deposited ₹ 10,000 in a bank for 3 years
offering interest rate at the rate of 6% p.a.
So far we have known compounded half yearly during first year, at the
(a) Discrete compounding rate of 12% p.a. compounded quarterly during
(b) Continuous compounding the second year and 10 % p.a. compounded
continuously during the third year. Find his
balance after 3 years.
we can also have a combination of (a) Solution:
and (b) i.e. S after 1 st yr = #$, $$$ # +
.$( )(#)
)
) # 6 #
. $( . #)
S after 2 years: #$, $$$ # + #+
) 6
(C) Dynamic Compounding [(a) + (b)] 7 89:;< = >;8<?: { #$, $$$ # +
.$( ) #
#+
.#) 6 #
]( ). A#B)B) .#$(#)
) 6

We can do it in excel by writing the Formula

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The more you compound the more you get ……..

Play it in Excel to see it
Let us think (intuitively)à Who will make both the amount (S and S) equal ?

in case of discrete compounding In case of discrete compounding

given the principal P, interest rate, r per annum, given the principal P, interest rate, r per annum, the interest
earning is compounded m times in a year and at the end of the
the interest earning is compounded m times in a year your initial P becomes S and
year and at the end of the year your initial P & '(
'( !=# $+
becomes S and ! = # $ +
& '
'
Now suppose that instead of this m times compounding in an year,
you received the same amount ! at the end of the year on the basis
But in case of simple interest rate of simple interest rate, what would be the rate of interest?
given the same principal P and the same interest Answer
rate, r per annum, the interest earning is Let us assume that rate of interest would be )*
added/compounded just once i.e. at the end of the ! = P 1 + )* (Recall the Simple Interest Rate Formula)
- .
year and your amount becomes S; => P 1 + )* = P 1 +
.
!=P 1++ - .
)* = 1 + . -1
which one would you prefer, S or S? We can do it in excel by writing the Formula or use the inbuilt Function (effective)

The !" The effective rate of Interest ("# ) and the Continuous
Compounding
As we have seen in case of continuous compounding
given the principal P, interest rate, r per annum, the
Note that this #$ is such an annual interest earning is compounded infinite times in a year
rate of interest who at the end of and at the end of the year your initial P becomes S and
% = ' () ( as % = ' ()* and t =1)
the year, even on the basis of Now suppose, you received the same amount % at the end of the
simple interest, gives same year on the basis of simple interest rate, what would be the rate of
interest?
amount, as given by m times Answer
Let us assume that rate of interest would be "#
compounding in a year. % = P 1 + "# (Recall the Simple Interest Rate Formula)
=> P 1 + "# = ' ()
"# = . / - 1
Hence this #$ is called the effective This "# is called the effective rate of Interest in case of
rate of Interest continuous compounding
We can do it in excel by writing the Formula

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Recap
FORCE OF INTEREST So far we have discussed the followings;
In case of continuous compounding, given the nominal r (the 1. Simple Interest Rate (I = Prt)
2. Compound Interest Rate [S = P{1+r/m}mt]
interest rate per annum), we can find re (the effective rate of (using CVF table i.e. the Table A1 we
interest per annum). Now suppose we are given re, and are constructed in Spreadsheet)
asked to find out r taking the continuous compounding into 3. Interest Compounded Continuously (S = Pert)
4. Dynamic Compounding: Compounding at
account. That r will be called the FORCE OF INTEREST.
Changing Rates
Alternatively, the nominal rate r, compounded continuously 5(a). Effective Rate of Interest re = {1+(r/m)}m-1
and equivalent to a given effective rate of interest is called (in case of finite compounding in a year)
5(b). Effective Rate of Interest re = er-1 (in case
the FORCE OF INTEREST. of continuous compounding in a year)
For Example: re= 8% 6. Force of Interest
We have done it Manually, by writing or by using
8% = er-1
in built formula in excel.
r = 7.69% is the FORCE OF INTEREST

Thank you