MATH1510

Financial Mathematics I

Jitse Niesen
University of Leeds

January – May 2012

Description of the module

This is the description of the module as it appears in the module catalogue.

Objectives
Introduction to mathematical modelling of financial and insurance markets with
particular emphasis on the time-value of money and interest rates. Introduction
to simple financial instruments. This module covers a major part of the Faculty
and Institute of Actuaries CT1 syllabus (Financial Mathematics, core technical).

Learning outcomes
On completion of this module, students should be able to understand the time
value of money and to calculate interest rates and discount factors. They should
be able to apply these concepts to the pricing of simple, fixed-income financial
instruments and the assessment of investment projects.

Syllabus
• Interest rates. Simple interest rates. Present value of a single future
payment. Discount factors.

• Effective and nominal interest rates. Real and money interest rates. Com-
pound interest rates. Relation between the time periods for compound
interest rates and the discount factor.

• Compound interest functions. Annuities and perpetuities.

• Loans.

• Introduction to fixed-income instruments. Generalized cashflow model.

• Net present value of a sequence of cashflows. Equation of value. Internal

rate of return. Investment project appraisal.

• Examples of cashflow patterns and their present values.

• Elementary compound interest problems.

MATH1510 i
Reading list
These lecture notes are based on the following books:
1. Samuel A. Broverman, Mathematics of Investment and Credit, 4th ed.,
ACTEX Publications, 2008. ISBN 978-1-56698-657-1.

2. The Faculty of Actuaries and Institute of Actuaries, Subject CT1: Finan-

cial Mathematics, Core Technical. Core reading for the 2009 examinations.
3. Stephen G. Kellison, The Theory of Interest, 3rd ed., McGraw-Hill, 2009.
ISBN 978-007-127627-6.

4. John McCutcheon and William F. Scott, An Introduction to the Mathe-

matics of Finance, Elsevier Butterworth-Heinemann, 1986. ISBN 0-7506-
0092-6.
5. Petr Zima and Robert L. Brown, Mathematics of Finance, 2nd ed., Schaum’s
Outline Series, McGraw-Hill, 1996. ISBN 0-07-008203.

The syllabus for the MATH1510 module is based on Units 1–9 and Unit 11 of
book 2. The remainder forms the basis of MATH2510 (Financial Mathemat-
ics II). The book 2 describes the first exam that you need to pass to become an
accredited actuary in the UK. It is written in a concise and perhaps dry style.
These lecture notes are largely based on Book 4. Book 5 contains many exer-
cises, but does not go quite as deep. Book 3 is written from a U.S. perspective, so
the terminology is slightly different, but it has some good explanations. Book 1
is written by a professor from a U.S./Canadian background and is particularly
good in making connections to applications.
All these books are useful for consolidating the course material. They allow
you to gain background knowledge and to try your hand at further exercises.
However, the lecture notes cover the entire syllabus of the module.

ii MATH1510
Chapter 1

The time value of money

Interest is the compensation one gets for lending a certain asset. For instance,
suppose that you put some money on a bank account for a year. Then, the bank
can do whatever it wants with that money for a year. To reward you for that,
it pays you some interest.
The asset being lent out is called the capital. Usually, both the capital and
the interest is expressed in money. However, that is not necessary. For instance,
a farmer may lend his tractor to a neighbour, and get 10% of the grain harvested
in return. In this course, the capital is always expressed in money, and in that
case it is also called the principal.

1.1 Simple interest

Interest is the reward for lending the capital to somebody for a period of time.
There are various methods for computing the interest. As the name implies,
simple interest is easy to understand, and that is the main reason why we talk
about it here. The idea behind simple interest is that the amount of interest
is the product of three quantities: the rate of interest, the principal, and the
period of time. However, as we will see at the end of this section, simple interest
suffers from a major problem. For this reason, its use in practice is limited.
Definition 1.1.1 (Simple interest). The interest earned on a capital C lent
over a period n at a rate i is niC.
Example 1.1.2. How much interest do you get if you put 1000 pounds for two
years in a savings acount that pays simple interest at a rate of 9% per annum?
And if you leave it in the account for only half ar year?
Answer. If you leave it for two years, you get

2 · 0.09 · 1000 = 180

pounds in interest. If you leave it for only half a year, then you get 12 ·0.09·1000 =
45 pounds.
As this example shows, the rate of interest is usually quoted as a percentage;
9% corresponds to a factor of 0.09. Furthermore, you have to be careful that
the rate of interest is quoted using the same time unit as the period. In this

MATH1510 1
example, the period is measured in years, and the interest rate is quoted per
annum (“per annum” is Latin for “per year”). These are the units that are used
most often. In Section 1.5 we will consider other possibilities.

Example 1.1.3. Suppose you put £1000 in a savings account paying simple
interest at 9% per annum for one year. Then, you withdraw the money with
interest and put it for one year in another account paying simple interest at 9%.
How much do you have in the end?
Answer. In the first year, you would earn 1·0.09·1000 = 90 pounds in interest, so
you have £1090 after one year. In the second year, you earn 1 · 0.09 · 1090 = 98.1
pounds in interest, so you have £1188.10 (= 1090 + 98.1) at the end of the two
years.

Now compare Examples 1.1.2 and 1.1.3. The first example shows that if you
invest £1000 for two years, the capital grows to £1180. But the second example
shows that you can get £1188.10 by switching accounts after a year. Even better
is to open a new account every month.
This inconsistency means that simple interest is not that often used in prac-
tice. Instead, savings accounts in banks pay compound interest, which will be
introduced in the next section. Nevertheless, simple interest is sometimes used,
especially in short-term investments.

Exercises
1. (From the 2010 exam) How many days does it take for £1450 to accumu-
late to £1500 under 4% p.a. simple interest?

2. (From the sample exam) A bank charges simple interest at a rate of 7% p.a.
on a 90-day loan of £1500. Compute the interest.

1.2 Compound interest

Most bank accounts use compound interest. The idea behind compound interest
is that in the second year, you should get interest on the interest you earned in
the first year. In other words, the interest you earn in the first year is combined
with the principal, and in the second year you earn interest on the combined
sum.
What happens with the example from the previous section, where the in-
vestor put £1000 for two years in an account paying 9%, if we consider com-
pound interest? In the first year, the investor would receive £90 interest (9%
of £1000). This would be credited to his account, so he now has £1090. In
the second year, he would get £98.10 interest (9% of £1090) so that he ends
up with £1188.10; this is the same number as we found before. The capital is
multiplied by 1.09 every year: 1.09 · 1000 = 1090 and 1.09 · 1090 = 1188.1.
More generally, the interest over one year is iC, where i denotes the interest
rate and C the capital at the beginning of the year. Thus, at the end of the year,
the capital has grown to C + iC = (1 + i)C. In the second year, the principal
is (1 + i)C and the interest is computed over this amount, so the interest is
i(1 + i)C and the capital has grown to (1 + i)C + i(1 + i)C = (1 + i)2 C. In
the third year, the interest is i(1 + i)2 C and the capital has grown to (1 + i)3 C.

2 MATH1510
This reasoning, which can be made more formal by using complete induction,
leads to the following definition.
Definition 1.2.1 (Compound interest). A capital C lent over a period n at a
rate i grows to (1 + i)n C.
Example 1.2.2. How much do you have after you put 1000 pounds for two
years in a savings acount that pays compound interest at a rate of 9% per
annum? And if you leave it in the account for only half ar year?
Answer. If you leave it in the account for two years, then at the end you have
(1 + 0.09)2 · 1000 = 1188.10,
as we computed above. If you leave it in the account for only half a year, then
at the end you have
√
(1 + 0.09)1/2 · 1000 = 1.09 · 1000 = 1044.03
pounds (rounded to the nearest penny). This is 97p less than the 45 pounds
interest you get if the account would pay simple interest at the same rate (see
Example 1.1.2).
Example 1.2.3. Suppose that a capital of 500 dollars earns 150 dollars of
interest in 6 years. What was the interest rate if compound interest is used?
What if simple interest is used?
Answer. The capital accumulated to $650, so in the case of compound interest
we have to solve the rate i from the equation
(1 + i)6 · 500 = 650 ⇐⇒ (1 + i)6 = 1.3
⇐⇒ 1 + i = 1.31/6 = 1.044698 . . .
⇐⇒ i = 0.044698 . . .
Thus, the interest rate is 4.47%, rounded to the nearest basis point (a basis point
is 0.01%). Note that the computation is the same, regardless of the currency
used.
In the case of simple interest, the equation to solve 6 · i · 500 = 150, so
150
i = 6·500 = 0.05, so the rate is 5%.
Example 1.2.4. How long does it take to double your capital if you put it in
an account paying compound interest at a rate of 7 12 %? What if the account
pays simple interest?
Answer. The question is for what value of n does a capital C accumulate to 2C
if i = 0.075. So we have to solve the equation 1.075n C = 2C. The first step is
to divide by C to get 1.075n = 2. Then take logarithms:
log(2)
log(1.075n ) = log(2) ⇐⇒ n log(1.075) = log(2) ⇐⇒ n = = 9.58 . . .
log(1.075)
So, it takes 9.58 years to double your capital. Note that it does not matter
how much you have at the start: it takes as long for one pound to grow to two
pounds as for a million pounds to grow to two million.
The computation is simpler for simple interest. We have to solve the equation
1
n · 0.075 · C = C, so n = 0.075 = 13 31 , so with simple interest it takes 13 13 years
to double your capital.

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More generally, if the interest rate is i, then the time required to double your
capital is
log(2)
n= .
log(1 + i)
We can approximate the denominator by log(1 + i) ≈ i for small i; this is
the first term of the Taylor series of log(1 + i) around i = 0 (note that, as is
common in mathematics, “log” denotes the natural logarithm). Thus, we get
n ≈ log(2)
i . If instead of the interest rate i we use the percentage p = 100i, and
we approximate log(2) = 0.693 . . . by 0.72, we get
72
n≈ .
p
This is known as the rule of 72 : To calculate how many years it takes you to
double your money, you divide 72 by the interest rate expressed as a percentage.
Let us return to the above example with a rate of 7 12 %. We have p = 7 12 so we
compute 72/7 12 = 9.6, which is very close to the actual value of n = 9.58 we
computed before.
The rule of 72 can already be found in a Italian book from 1494: Summa de
Arithmetica by Luca Pacioli. The use of the number 72 instead of 69.3 has two
advantages: many numbers divide 72, and it gives a better approximation for
rates above 4% (remember that the Taylor approximation is centered around
i = 0; it turns out that it is slightly too small for rates of 5–10% and using 72
instead of 69.3 compensates for this).
Remember that with simple interest, you could increase the interest you earn
by withdrawing your money from the account halfway. Compound interest has
the desirable property that this does not make a difference. Suppose that you
put your money m years in one account and then n years in another account,
and that both account pay compount interest at a rate i. Then, after the
first m years, your capital has grown to (1 + i)m C. You withdraw that and
put it in another account for n years, after which your capital has grown to
(1 + i)n (1 + i)m C. This is the same as what you would get if you had kept the
capital in the same account for m + n years, because

(1 + i)n (1 + i)m C = (1 + i)m+n C.

This is the reason why compound interest is used so much in practice. Unless
noted otherwise, interest will always refer to compound interest.

Exercises
1. The rate of interest on a certain bank deposit account is 4 21 % per annum
effective. Find the accumulation of £5000 after seven years in this account.

2. (From the sample exam) How long does it take for £900 to accumulate to
£1000 under an interest rate of 4% p.a.?

4 MATH1510
 2.5 2.5

2 2
final capital

final capital
1.5 1.5

1 1

0.5 0.5
simple
compound
0 0
0 2 4 6 8 10 0 5 10 15
time (in years) interest rate (%)

Figure 1.1: Comparison of simple interest and compound interest. The left
figure plots the growth of capital in time at a rate of 9%. The right figure plots
the amount of capital after 5 years for various interest rates.

1.3 Comparing simple and compound interest

Simple interest is defined by the formula “interest = inC.” Thus, in n years the
capital grows from C to C + niC = (1 + ni)C. Simple interest and compound
interest compare as follows:

simple interest: capital after n years = (1 + ni)C

compound interest: capital after n years = (1 + i)n C

These formulas are compared in Figure 1.1. The left plot shows how a principal
of 1 pound grows under interest at 9%. The dashed line is for simple interest and
the solid curve for compound interest. We see that compound interest pays out
more in the long term. A careful comparison shows that for periods less than a
year simple interest pays out more, while compound interest pays out more if the
period is longer than a year. This agrees with what we found before. A capital
of £1000, invested for half a year at 9%, grows to £1045 under simple interest
and to £1044.03 under compound interest, while the same capital invested for
two years grows to £1180 under simple interest and £1188.10 under compound
interest. The difference between compound and simple interest get bigger as
the period gets longer.
This follows from the following algebraic inequalities: if i is positive, then

(1 + i)n < 1 + ni if n < 1,

n
(1 + i) > 1 + ni if n > 1.

These will not be proven here. However, it is easy to see that the formulas
for simple and compound interest give the same results if n = 0 and n = 1.
Now consider the case n = 2. A capital C grows to (1 + 2i)C under simple
interest and to (1 + i)2 C = (1 + 2i + i2 )C under compound interest. We have
(1 + 2i + i2 )C > (1 + 2i)C (because C is positive), so compound interest pays
out more than simple interest.
The right plot in Figure 1.1 shows the final capital after putting a principal
of 1 pound away for five years at varying interest rates. Again, the dashed line
corresponds to simple interest and the solid curve corresponds to compound

MATH1510 5
 lating
accumu

ting
discoun
present value future value
= £1624.24 = £2000.00

t=0 t=5

Figure 1.2: The time value of money: £1624.24 now is equivalent to £2000 in
five years at a rate of 4 14 %.

interest. We see again that compound interest pays out more, as n = 5 is

greater than 1. However, the plot also shows that the difference is smaller if the
interest rate is small.
This can be explained with the theory of Taylor series. A capital C will grow
in n years to (1 + i)n C. The Taylor series of f (i) = (1 + i)n C around i = 0 is

f (0) + f 0 (0)i + 12 f 00 (0)i2 + · · · = C + niC + 21 n(n − 1)i2 C + · · · .

The first two terms are C + niC = (1 + ni)C, which is precisely the formula
for simple interest. Thus, you can use the formula for simple interest as an ap-
proximation for compound interest; this approximation is especially good if the
rate of interest is small. Especially in the past, people often used simple inter-
est instead of compound interest, notwithstanding the inconsistency of simple
interest, to simplify the computations.

1.4 Discounting
The formula for compound interest relates four quantities: the capital C at the
start, the interest rate i, the period n, and the capital at the end. We have seen
how to calculate the interest rate (Example 1.2.3), the period (Example 1.2.4),
and the capital at the end (Example 1.2.2). The one remaining possibility is
covered in the next example.

Example 1.4.1. How much do you need to invest now to get £2000 after five
years if the rate of interest is 4 14 %?
Answer. One pound will accumulate to (1 + 0.0425)5 = 1.2313466 in five years,
so you need to invest 2000/1.2313466 = 1624.24 pounds.

We say that £1624.24 now is equivalent to £2000 in five years at a rate of 4 41 %.

We call £1624.24 the present value and £2000 the future value. When you move
a payment forward in time, it accumulates; when you move it backward, it is
discounted (see Figure 1.2).

6 MATH1510
 discount accumulate
(by one year) (over one year)

d
1+i
1
v

t=0

Figure 1.3: The relation between the interest rate i, the rate of discount d and
the discount factor v.

This shows that money has a time value: the value of money depends on
the time. £2000 now is worth more than £2000 in five years’ time. In financial
mathematics, all payments must have a date attached to them.
More generally, suppose the interest rate is i. How much do you need to
1
invest to get a capital C after one time unit? The answer is 1+i C. The factor

1
v= . (1.1)
1+i
is known as the discount factor. It is the factor with which you have to multiply
a payment to shift it backward by one year (see Figure 1.3). If the interest rate
is 4 41 %, then the discount factor is 1.0425
1
= 0.95923.
Provided the interest rate is not too big, the discount factor is close to one.
Therefore people often use the rate of discount d = 1 − v, usually expressed as a
percentage (compare how the interest rate i is used instead of the “accumulation
factor” 1 + i). In our example, the rate of discount is 0.04077 or 4.077%.
Example 1.4.2. Suppose that the interest rate is 7%. What is the present
value of a payment of e70 in a year’s time?
Answer. The discount factor is v = 1/1.07 = 0.934579, so the present value is
0.934579 · 70 = 65.42 euro (to the nearest cent).
Usually, interest is paid in arrears. If you borrow money for a year, then at the
end of the year you have to pay the money back plus interest. However, there
are also some situations in which the interest is paid in advance. The rate of
discount is useful in these situations, as the following example shows.
Example 1.4.3. Suppose that the interest rate is 7%. If you borrow e1000 for
a year and you have to pay interest at the start of the year, how much do you
have to pay?

MATH1510 7
Answer. If interest were to be paid in arrears, then you would have to pay
0.07 · 1000 = 70 euros at the end of the year. However, you have to pay the
interest one year earlier. As we saw in Example 1.4.2, the equivalent amount is
v · 70 = 65.42 euros.
There is another way to arrive at the answer. At the start of the year, you
get e1000 from the lender but you have to pay interest immediately, so in effect
you get less from the lender. At the end of the year, you pay e1000 back. The
amount you should get at the start of the year should be equivalent to the e1000
you pay at the end of the year. The discount factor is v = 1/1.07 = 0.934579,
so the present value of the e1000 at the end of the year is e934.58. Thus, the
interest you have to pay is e1000 − e934.58 = e65.42.

In terms of the interest rate i = 0.07 and the capital C = 1000, the first method
calculates ivC and the second method calculates C − vC = (1 − v)C = dC.
Both methods yield the same answer, so we arrive at the important relation

d = iv. (1.2)

We can check this relation algebraically. We found before, in equation (1.1),

that the discount factor is
1
v= .
1+i
The rate of discount is
1 i
d=1−v =1− = . (1.3)
1+i 1+i
Comparing these two formulas, we find that indeed d = iv.
We summarize this discussion with a formal definition of the three quantities
d, i and v.

Definition 1.4.4. The rate of interest i is the interest paid at the end of a
time unit divided by the capital at the beginning of the time unit. The rate
of discount d is the interest paid at the beginning of a time unit divided by
the capital at the end of the time unit. The discount factor v is the amount of
money one needs to invest to get one unit of capital after one time unit.

This definition concerns periods of one year (assuming that time is measured in
years). In Example 1.4.1, we found that the present value of a payment of £2000
due in five years is £1624.24, if compound interest is used at a rate of 4 14 %. This
was computed as 2000/(1 + 0.0425)5 . The same method can be used to find the
present value of a payment of C due in n years if compound interest is used at
a rate i. The question is: which amount x accumulates to C in n years? The
formula for compound interest yields that (1 + i)n x = C, so the present value x
is
C
= v n C = (1 − d)n C. (1.4)
(1 + i)n
This is called compound discounting, analogous with compound interest.
There is another method, called simple discounting (analogous to simple
interest) or commercial discounting. This is defined as follows. The present
value of a payment of C due in n years, at a rate of simple discount of d, is
(1 − nd)C.

8 MATH1510
 Simple discounting is not the same as simple interest. The present value of
a payment of C due in n years, at a rate of simple interest of i, is the amount x
that accumulates to C over n years. Simple interest is defined by C = (1 + ni)x,
so the present value is x = (1 + ni)−1 C.

Example 1.4.5. What is the present value of £6000 due in a month assum-
ing 8% p.a. simple discount? What is the corresponding rate of (compound)
discount? And the rate of (compound) interest? And the rate of simple interest?
1 1
Answer. One month is 12 year, so the present value of is (1 − 12 · 0.08) · 6000 =
5960 pounds. We can compute the rate of (compound) discount d from the
formula “present value = (1 − d)n C”:

5960 = (1 − d)1/12 · 6000 =⇒ (1 − d)1/12 = 5960

6000 = 0.993333
12
=⇒ 1 − d = 0.993333 = 0.922869
=⇒ d = 0.077131.

Thus, the rate of discount is 7.71%. The rate of (compound) interest i follows
from
1
= 1 − d = 0.922869 =⇒ 1 + i = 1.083577
1+i
so the rate of (compound) interest is 8.36%. Finally, to find the rate of simple
1
interest, solve 5960 = (1 + 12 i)−1 6000 to get i = 0.080537, so the rate of simple
interest is 8.05%.

One important application for simple discount is U.S. Treasury Bills. However,
it is used even less in practice than simple interest.

Exercises
1. In return for a loan of £100 a borrower agrees to repay £110 after seven
months.

(a) Find the rate of interest per annum.

(b) Find the rate of discount per annum.
(c) Shortly after receiving the loan the borrower requests that he be
allowed to repay the loan by a payment of £50 on the original set-
tlement date and a second payment six months after this date. As-
suming that the lender agrees to the request and that the calculation
is made on the original interest basis, find the amount of the second
payment under the revised transaction.

2. The commercial rate of discount per annum is 18% (this means that simple
discount is applied with a rate of 18%).

(a) We borrow a certain amount. The loan is settled by a payment of

£1000 after three months. Compute the amount borrowed and the
effective annual rate of discount.
(b) Now the loan is settled by a payment of £1000 after nine months.
Answer the same question.

MATH1510 9