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Mathematics in Finance

1. Lender or creditor − a person or an institution who invests money or makes the fund
available
2. Borrower or debtor − a person or an institution who owes the money or avails the funds
from the lender
3. Origin or loan date − the date on which the money is received by the borrower
4. Repayment or maturity date − the date on which the money borrowed or loan is to be
completely repaid
5. Time or term (t) − the amount of time (usually in years) the money is borrowed or
invested; length of time between the origin and maturity dates
6. Principal (P) − the amount of money borrowed or invested on the origin date
7. Rate (r) − annual rate, usually in percent, charged by the lender, or rate of increase of
the investment
8. Interest (I) − the amount paid or earned for the use of money
9. Simple Interest (Is) − Interest is computed on the principal and then added to it
10. Compound Interest (Ic) − Interest is computed on the principal and also on the
accumulated past interests
11. Maturity value or future value (F) − the amount of money, after t years, that the lender
receives from the borrower on the maturity date

I s = Prt

where Is = simple interest P = principal


r = rate t = term of time, in years

Example 1.1
1. A bank offers 0.25% annual simple interest rate for a particular deposit. How much interest
will be earned if ₱1 M is deposited in this savings account for 1 year?
2. How much interest is charged when ₱50,000 is borrowed for 9 months at an annual simple
interest of 10%?
3. When invested at an annual interest rate of 7%, a deposit earned ₱11,200 of simple
interest in two years. How much money was originally invested?
4. If an entrepreneur applies for a loan amounting to ₱50,000 in a bank, the simple interest of
which is ₱7,500 for 3 years, what is the interest rate being
charged?
5. How long will a principal earn an interest equal to half of it at 5% simple interest?

Maturity (Future) Value

F = P + I = P + Prt = P(1 + rt)

where F = maturity (future value) Is = simple interest


P = principal r = rate t = term of time, in years

Example 1.2
1. Find the maturity value if ₱1M is deposited in a bank at an simple interest rate of 0.25%
after (a) 1 year and (b) 5 years?
2. What are the amounts of interest and maturity value of a loan for ₱150,000 at 6.5% simple
interest for 3 years?
3. At what simple interest rate per annum will ₱25,000 accumulate to
₱33,000 years in 5 years?
4. Donald borrowed ₱5,000 at 5% annual simple interest rate. If he decided to pay after 1
year and 3 months, how much should he pay by then?

COMPOUND INTEREST

Compound Interest − a type of interest which results from the periodic addition of simple
interest to the principal.

• Interest is compounded over a period of time.


• Interest is added to the original principal to become the new principal for the next
interest period.

This type of interest often applies to savings accounts, loans and credit cards.

For example, if ₱10,000 is invested in a bank that pays 1.25% compounded annually, it will
earn an interest of ₱125 after a year.

This amount will then be added to the principal. If the amount (principal plus interest)
remains invested for another year, the interest for the second year is computed based on
the new amount and not on the original principal.

This process is repeated in the succeeding periods (yearly, in this case) until the end of the
term. The total interest earned for the entire term is called the compound interest. The sum
of the original principal and compound interest is called the compound amount. It is
denoted by F and is also the accumulated value.

In the previous example, a depositor wants to determine the amount of investment at the
end of 4 years.

The compound amount (𝐹) at the end of 4 years is Php10,509.45. •The total compound
interest is given by 𝐼𝑐 = 𝐹−𝑃 = 509.45.

The process illustrated in the table is not convenient to use when the term of investment is
long and when the investment is compounded more than once in a year.

F = P (1 + i)n Ic = F − P = P[(1 + i)n - 1]

where F = maturity or future value


Ic = compound interest
P = principal or present value
i = interest rate per period
n = number of interest periods

Example 1.3 Compound Interest


1. Find the maturity value and the compound interest if ₱10,000 is compounded annually at
an interest rate of 2% in 5 years.
2. Suppose your father deposited in your bank account an amount of ₱10,000 at an annual
interest rate of 0.5% compounded yearly when you graduate from kindergarten and did
not get the amount until you finish Grade 12. How much will you have in your bank after
12 years?
3. What is the present value of ₱50,000 due in 7 years if money is worth 10% compounded
annually?
4. How much money should a student place in a time deposit in a bank that pays 1.1%
compounded annually so that he will have ₱200,000 in 6 years?
5. In a certain bank, Angel invested ₱88,000 in a time deposit that pays 0.5% compound
interest in a year. How long (in years) will it take for the deposit to have a maturity value of
₱90,000?

Definition of Terms

1. Conversion or interest period – time between successive conversions of interest


2. Frequency of conversion (m) – number of conversion periods in one year
3. Nominal rate (j) – annual rate of interest compounded at a given period

Ex. 2% per annum compounded semi-annually or simply 2% compounded semi-annually

4. Rate of interest (i) for each conversion period

j nominal rate
i= =
m frequency of conversion

6. Total number of conversion periods

n = ( no. of conversion periods in one year )( no. of years) = mt

When the term of investment is long and when the investment is compounded more than
once in a year:

Frequency of Conversion

The frequency of conversion (𝑚) is the number of times the investment/loan is compounded
in a year
Nominal Rate Frequency of Interest Rate per One Conversion
(j) Conversion (m) Period (i) = j/m Period
2% compounded
annually 1 0.02/1 = 0.02 1 yr
2% per annum
compounded 2 0.02/2 = 0.01 6 mo
semi-annually
2% per annum
compounded 4 0.02/4 = 0.005 3 mo
quarterly

2% per annum
compounded 12 0.02/2 = 0.00167 1 mo
monthly
2% per annum 0.02/365 =
compounded 365 0.00005479 1 day
daily

Formula

m
 j
r = 1 +  −1
 m

Example 1.4. Convert to effective annual interest rate (r)


1. 2% compounded semi-annually
2. 2% compounded quarterly
3. 2% compounded monthly
4. 2% compounded daily

Future and Present Value (Compounding m times a year)

n −n
F = P (1 + i ) P = F (1 + i )

Example 1.5
1. ₱10,000 is invested in a in a certain investing company that pays
a. 1.25% compounded annually b. 4% compounded semi-annually
c. 12% compounded quarterly d. 20% compounded monthly
d. 30% compounded daily (Use 365 days = 1 yr)
How much will it earn after a 3 years?
2. Find the maturity value and interest, if ₱10,000 is deposited in a bank at 2% compounded
quarterly for 5 years.
3. Cris borrows ₱50,000 and promises to pay the principal and interest at
a. 12% compounded monthly b. 0.5% per month compounded weekly
c. 0.25% per month compounded daily (Use 1 month = 30 days)
How much must he pay after 9 months?
4. Find the present value of ₱50,000 at 12% compounded semi-annually.
5. How much should Kaye set aside and invest in a fund earning 2% compound quarterly if
she needs ₱75,000 in 15 months?
6. Peter is planning to invest ₱100,000. Bank A is offering 5% compounded semi-annually
while Bank B is offering 4.5% compounded monthly. If he plans to invest for 5 years, which
bank should he invest?

Definition of Terms
1. Annuity – a sequence of payments made at equal (fixed) intervals or periods of time
2. Payment interval – the time between successive payments
3. Term of an annuity, n – time between the first payment and last payment interval
4. Regular or periodic payment, A – the amount of equal payments
5. Amount on an annuity (future value, F) – “sum” of future values of all the payments to be
made during the entire term of the annuity
6. Present value of an annuity (P) – “sum” of present values of all the payments to be made
during the entire term of the annuity

Simple (Ordinary) Annuity

A A A

F

P 1 2 3 4 5 n

A simple (ordinary) annuity has the following characteristics:


1. The payments are always made at the end of each interval
2. The interest rate compounds at the same interval as the payment interval
3. The future value of the annuity coincides with the last period of the equal sequence of
Payments

 ( 1 + i )n − 1   1 − (1 + i ) − n 
F = A  P = A 
 i   i 
   

 i   i 
A=F =P 
 ( 1 + i )n − 1   1 − (1 + i ) − n 
   

where A – amount of equal payments


Example 1.6
1. Usano wants to purchase a cellular phone worth ₱50,000. RLM Store offers an installment
plan offering an interest rate of 12% compounded monthly having an down payment ₱
5,000 . How much will be the monthly payment to be made if Usano has to pay in 18
months? What is the future value of the cellular phone in 18 months?
2. Marie decided to save ₱200 at the end of each month. If the bank pays 0.25%
compounded monthly, how much will her money be at the end of
a. 8 months? b. 3 years?
3. What would be the value of a monthly deposit amounting to ₱3,000 at the end of 6
months when interest is 9% compounded monthly?
4. A loan of ₱70,000 with 10% interest compounded semi-annually is to be amortized by
equal semi-annual payments over the next 5 years, the first payment being after 6
months. Calculate the amount of equal semi-annual payments.
5. What is the future worth of an equal quarterly payment series of ₱2,500 for 10 years, if the
interest rate is 9% compounded quarterly?
6. Mr. Gran wants to purchase a cellular phone. He decided to pay monthly for 1 year starting
at the end of the month. How much is the cost of his cellular phone if his monthly payment
is ₱2,500 and interest is at 9% compounded monthly?
6. A loan of ₱50,000 with 10% interest compounded quarterly is to be amortized by equal
quarter payments, the first payment being after 3 months. If the quarter payment is
₱2795.64. How many payments are needed to pay the loan?