Measurement of Interest - I

MATH 384, Review lecture 1

Andrei Ordine

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In this lecture
Compound interest, simple interest, time measurement conventions, present value, discount factor. Applications: T-bills.

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Interest
Interest = time value of money Virtually all nancial transactions involve interest. Objective of this course is to provide precise mathematical descriptions of nancial transactions. Terminology, formulas, real-world examples.

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Example: Compound interest

Problem 1 Suppose that $100 is deposited into a bank account which earns interest at the effective annual rate of 10%. What is the balance after 3 years?

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Example: Compound interest

Answer:

Table 1: Compound interest

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Example: varying rates

Problem 2 A Bank of Montreal mutual fund has the following effective rates of interest in years 1998 - 2003: Year Rate of interest

Table 2: Investment rates

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Example: varying rates

An investment of $100 is made in the beginning of 1998. What would be the accumulated amount at the end of 2003?

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Example: varying rates

Answer:

(1)

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Compound interest: usage

Compound interest is almost exclusively used for transactions spanning more than 1 year, and for many shorterterm transactions as well.

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Denitions
Consider an investment of an amount of money at interest. Principal: amount initially invested Accumulated value: amount after a period of time Amount of interest: difference between the accumulated value and the principal Measurement period: a unit of time, in most cases a year, sometimes a month, a day, etc.

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Denitions II

Amount function : accumulated value at time of an original investment. For compound interest, we have

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Denitions

Accumulation function : amount function for an original investment of $1. , where is the amount of the original investment . These denitions assume that the fund is only growing through interest, ie., no principal is added or withdrawn.

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Effective rate of interest

The effective rate of interest is the ratio of the amount of interest earned during the measurement period to the accumulated amount at the beginning of the period. Word effective refers to the fact that nominal rates are also used. They will be discussed in the next lecture. Rates of interest are usually shown as a percentage; for example, 10% = 0.1

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Formal denitions
Effective rate of interest during the rst period

(2)

During the th period:

(3)

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Varying rates of interest

Generalizing our last example, we have

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Example: Simple interest

Problem 3 Suppose that a principal of is invested at simple interest of 10% per year. What is the accumulated amount at the end of 3 years?

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Example: Simple interest

Answer:

Table 3: Simple interest

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Example: Simple interest

Problem 4 A Canadian T-Bill with face value $100 is a security which is exchangeable for $100 CAD on the maturity date. Suppose that a T-Bill with face value $100 is issued on 2005.09.08 and matures on 2005.12.15 (there are 98 days between the dates). Given that the price of the T-Bill is $99.27076, nd the annual rate of interest. Assume simple interest.

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Example: Simple interest

Answer:

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Simple interest: usage

Simple interest is occasionally used in short-term transactions. Simple interest can be used to approximate compound interest.

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Simple v Compound interest

and
500 400 300 A 200 100

500 400 300 A 200 100 4 0 100 2 4 6 8 10 t 14

4 0 100

2 4 6 8 10 t

14

Figure 1: Simple interest and compound interest, ,

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Assumption
Amount functions for simple and compound interest are continuous, not stepwise. For example, if an investment of $100 earns simple interest of 10% per annum, paid at the end of each year, then the amount function at time is $105, not $100.

300 250 200 A150 100 50

300 250 200 A150 100 50

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Practical measurement of time

How to measure time (in years) between two dates? Three approximate methods are commonly encountered. In all methods, time # days between two dates # days in a year (4)

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actual/actual
365 days in a year Actual number of days between dates Simple interest calculated on this basis is called exact simple interest, denoted actual/actual. This method is used for Canadian Treasury Bills.

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30/360
360 days in a year Number of days between two dates is

(5)

where is the rst date, is the second date. Simple interest calculated on this basis is called ordinary simple interest, denoted 30/360.

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actual/360
360 days in a year Actual number of days between dates Simple interest calculated on this basis is called Bankers Rule, denoted actual/360. This method is used for U.S. Treasury bills

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Present value
Present value: two equivalent formulations. How much is a promise of a future payment worth now? How much should I invest now to have at a certain point in the future?

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Example: Present Value

How much do I need to invest at the beginning of the year to have $100 at the end of the year, if the annual effective rate of interest is 10%?

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Example: Present Value

Answer:

(6)

Discount factor is

The present value of year is

payable at the end of the

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Example: Present Value

Problem 5 A Canadian T-Bill with face value $100 is a security which is exchangeable for $100 CAD on the maturity date. Suppose that a T-Bill with face value $100 is issued on 2005.09.08 and matures on 2006.03.09 (there are 182 days between the dates). Assuming simple interest, given that the annual rate of interest is 2.810%, nd the price of the security.

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Example: Present value

Answer: 98.61821

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Example: U.S. Treasury Notes

A 2-year U.S. Treasury Note with face value , coupon rate is a promise by the government to pay a coupon of amount (7)

1 year after the issue, and coupon plus the face value (8)

2 years after the issue.

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Example: U.S. Treasury Notes

Problem 6 Suppose that a 2-year Treasury note with face value $1,000, coupon rate 2.75% is sold for $999.09. Find the effective annual rate of interest. Round to 4 digits.

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Example: U.S. Treasury Notes

Solution plan 1. Calculate the two payments (coupon and coupon+face value) 2. Write the present value of each payment 3. The sum of the two present values is the purchase price 4. Solve the equation to nd and then calculate

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Example: U.S. Treasury Notes

Answer: 2.797% Source: [Link] Note: the solution can be found quickly using a nancial calculator.

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Formal denitions
Discount factor:

Recall: is the accumulated amount of an investment of at time 0. Present value of $1 payable at time is

For simple interest:

For compound interest:

For the Treasury note, the price is the sum of present values of the payments from the security.

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Real world
1. Historical rates 2. What and who determines the rates

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Historical Rates
Key rates of interest, last 10 years

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Notes to the historical rates chart

Fed funds rate is the rate at which banks lend their federal reserve deposits overnight. Prime is one of several base rates used by banks to price short-term business loans. Rates of interest depend on the market and timing of the transaction.

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Notes to the historical rates chart

NBER a includes the average prime rate of commercial banks into the list of lagging indicators of the economic cycle.
a

National Bureau of Economic Research

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What and who determines the rates

Rates depend on the economic climate Rates are a lagging indicator of economic cycle Central banks are major players in the money markets. They promote monetary policies using regulation and open-market operations.

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Sources - Canadian rates

[Link]
[Link]

Weekly nancial report - Bank of Canada

[Link]

Bank of Canada rates page

[Link]

Bank of Canada securities auctions:

[Link]

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Sources - U.S. Rates

Selected interest rates
[Link]

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Sources - History
10 year historical interest rates
[Link]

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Sources - Fed Rates vs GDP

[Link] [Link]

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Sources - FED policy tools

Open Market Operations
[Link]

Federal Reserve Banks discount rate

[Link]

Reserve requirements
[Link]

How the Federal Reserve conducts its policy

The Economist: Monopoly power over money (Nov 18th 1999)

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Summary
Reading for the quiz next Tuesday: Chapter 1 (1.1-1.6) of the textbook. There is no homework; practice with the textbook problems. Thank you!

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