ACCUMULATION AND AMOUNT FUNCTIONS

Principal: Amount of money initially invested or borrowed.

Interest: The compensation a borrower pays to a lender for the use of capital ( money ) or the amount
earned on an investment.

On an investment, the interest is the difference between the amount returned at the end of the
investment period and the principal.

For a loan, the interest is the difference between the amount paid back and the principal.

For the moment, we will concentrate on the investment scenario.

Accumulation Function: a( t ) for some time t 0 is the accumulated value at time t of an investment of 1

Properties of a( t )

1. a( 0 ) = 1

2. a( t ) is generally an increasing function of time, t

3. If interest is accrued continuously then a( t ) will be a continuous function.

Amount Function: A( t ) = k [ a( t ) ] is the accumulated amount an initial investment of size k at time t

Clearly, A( 0 ) = k

Let n denote the nth period from the date of investment so n = 1, 2, 3, . . .

The amount of interest earned during the nth period is In = A( n ) - A( n 1 )

Example: An investment of $ 1000 was made and followed for 5 months yielding the following:

t A( t ) a( t ) In
0 1000.00 1.00000 If $ 100 was invested at the end
1 1032.61 1.03261 32.61 of the second month, what would it
2 1041.89 1.04189 9.28 be worth at the end of the third
3 1078.54 1.07854 36.65 month ?
4 1106.44 1.10644 27.90
5 1119.57 1.11957 13.13 How much would $ 500 invested
at t = 1 be worth at t = 4 ?
 EFFECTIVE RATE OF INTEREST

Effective Rate of Interest: the amount an investment of 1 will earn during the period when interest is paid at
the end of the period.

A(1) A(0) I1
i = a( 1 ) - a( 0 ) or equivalently a( 1 ) = 1 + i or equivalently i =
A(0) A(0)

We will always express ( and use in calculations ) i as a decimal value even though some express it as a percent.

7 % interest i = .07

Effective Rate of Interest ( alternate definition ): the amount of interest earned in a period divided by the
principal at the beginning of the period.

A(n) A(n 1) In a(n) a(n 1)

For the nth period, in = or equivalently in =
A(n 1) A(n 1) a(n 1)

Example: Find the effective rate of interest for each month in the previous example

t A( t ) a( t ) In in
0 1000.00 1.00000
1 1032.61 1.03261 32.61
2 1041.89 1.04189 9.28
3 1078.54 1.07854 36.65
4 1106.44 1.10644 27.90
5 1119.57 1.11957 13.13

Example: Suppose a( t ) = ( .05 ) t2 + 1

Find i1

Find an expression for in and use it to find i2 and i3

If $ 100 was invested at the beginning, how much would it be worth after 3 periods ?