DIFFERENCE EQUATIONS

VS
DIFFERENTIAL EQUATIONS
ELEMENTS OF FINANCE
AN APPLICATION
 INTEREST AND CAPITAL GROWTH

• SUPPOSE WE INVEST P FOR N YEARS AT A CONSTANT ANNUAL INTEREST RATE R.

• IF WE LET YT BE THE CAPITAL AT THE END OF THE TTH YEAR, WE HAVE Y0 = P AND THE
RECURRENCE
yt = (1+ r)yt-1
WHAT IS THE GENERAL FORM OF THE SOLUTION?

IN PARTICULAR, THE CAPITAL C AFTER N YEARS WILL BE EXPRESSED AS:

 WHAT IS THE INVERSE OF CAPITAL GROWTH FUNCTION?

• IF WE WANT TO ENSURE THE FINAL CAPITAL C, SO WE SHOULD KNOW WHAT THE PRINCIPAL
P SHOULD BE.
 EXAMPLE

IF I AM OFFERED A GIFT OF EITHER PHP 6,000 NOW OR PHP 10,000 IN SEVEN YEARS TIME,
WHICH SHOULD I ACCEPT, GIVEN THE FIXED INTEREST RATE OF 8%.
 INCOME GENERATION

• AS AN ALTERNATIVE TO CAPITAL GROWTH, PEOPLE OFTEN INVEST THEIR MONEY TO PROVIDE

A REGULAR INCOME, OFTEN KNOWN AS AN ANNUITY.
• SUPPOSE WE INVEST P, AND WITHDRAW AN AMOUNT I AT THE END OF EACH YEAR FOR N
YEARS, AT WHICH TIME THE CAPITAL IS USED UP. WHAT INCOME CAN BE GENERATED FROM
THE PRINCIPAL P, OR (MATHEMATICALLY SPEAKING), WHAT IS I AS A FUNCTION OF P?
• WHAT IS THE RECURRENCE EQUATION? yt = (1+ r)yt-1 - I

• WHAT IS THE GENERAL EQUATION?

• IN ORDER TO DETERMINE I AS A FUNCTION OF P, WE MUST USE THE CONDITION THAT
NOTHING IS LEFT AFTER N YEARS, THAT IS, YN=0.

• SO, WHAT PRINCIPAL P IS REQUIRED TO PROVIDE AN ANNUAL INCOME I FOR THE NEXT N
YEARS?
 EXAMPLE

• WHAT IS THE PRESENT VALUE OF N ANNUITY GENERATING PHP 10,000 A YEAR FOR THE NEXT
SEVEN YEARS, GIVEN THE FIXED INTEREST RATE OF 8%?
 EXERCISE

• SUPPOSE THAT YOU HAVE WON A COMPETITION IN A NATIONAL NEWSPAPER

AND YOU CAN CHOOSE EITHER TO RECEIVE A LUMP SUM OF PHP 100,000
NOW, OR A PAYMENT OF PHP 20,000 AT THE END OF EACH YEAR FOR THE
NEXT SEVEN YEARS. WHICH PRIZE SHOULD YOU CHOOSE, ASSUMING THAT
THE HIGHEST INTEREST RATE YOU CAN OBTAIN IS A CONSTANT 7 OVER THE
SEVEN YEAR PERIOD?
 INTERVAL OF COMPOUNDING

• AN AMOUNT OF PHP 100,000 IS INVESTED AND ATTRACTS INTERESET AT A RATE EQUIVALENT

TO 10% PER ANNUM. FIND THE TOTAL AFTER ONE YEAR IF THE INTEREST IS COMPOUNDED
a) ANNUALLY;
b) QUARTERLY;
c) MONTHLY;
d) DAILY.

HOW ABOUT AFTER 6 MONTHS?

 EXERCISE
• IF 80,000PHP IS DEPOSITED AT 12 1/3 % FOR 6 YEARS, WHAT
WILL BE THE COMPOUND AMOUNT AND INTEREST IF INTEREST
IS COMPOUNDED …
① ANNUALLY?
② MONTHLY?
③ SEMI-ANNUALLY?

• ON MAY 6, 2009, DIANNE BORROWED 6,000PHP AND

PROMISED TO PAY THE PRINCIPAL AND INTEREST AT 16%
COMPOUNDED QUARTERLY ON AUGUST 6, 2016. HOW
MUCH WILL SHE REPAY THEN?
 EXERCISE

SUPPOSE YOU HAVE WON A COMPETITION AND THAT YOU ARE GIVEN THE CHOICE BETWEEN
PHP 180,000 NOW OR PHP 10,000 AT THE START OF EACH YEAR, FOR THE REST OF YOUR LIFE.
ASSUME THAT THE BANK HAS A CONSTANT INTEREST RATE OF 6% AND THAT YOU CURRENTLY
HAVE NO DEBTS. WHICH OPTION SHOULD YOU CHOOSE IF YOU THINK YOU WILL LIVE
(a) UNTIL 65;
(b) (B) UNTIL 100;
(c) (C) FOREVER?
(d) NOTE: IGNORE (A) IF YOU ARE OVER 65.
 FOR DIFFERENCE EQUATIONS, WE LOOK AT THE DYNAMIC OF, SAY, ECONOMY, USING WHAT ARE KNOW AS
DISCRETE-TIME MODELS.

HOWEVER, WE MAY ALSO CONSIDER SOME GIVEN TIME-PERIOD, SAY, ONE YEAR; AND INSTEAD OF CONSIDERING A
SEQUENCE OF VALUES TAKEN OVER SUCCESSIVE CALENDAR YEARS, WE LOOK AT THE VALUES TAKEN OVER THE PERIOD
OF ONE YEAR IMMEDIATELY PRECEDING TIME T, WHERE T IS A CONTINUOUSLY VARYING PARAMETER. HERE, WE LOOK AT
CONTINUOUS-TIME MODELS.
 EXAMPLE

• SUPPOSE THE CONSUMPTION C AND INCOME Y ARE LINKED BY

THE EQUATION:
C = AY + B
THIS WILL IMPLY THAT THE RATE OF CHANGE OF C WITH RESPECT TO
TIME IS:
 DEFINITION

DIFFERENTIAL EQUATIONS ARE EQUATIONS THAT INVOLVE DERIVATIVES.

EXAMPLES