FINANCIAL

MATHEMATICS
Lecturer: Pham Thi Hong Tham
thamtkt@neu.edu.vn

MFE - NCT - NEU

PTHT FM MFE - NCT - NEU 1 / 55

Course Materials

Required textbooks:
1 A Basic Course in the Theory of Interest and Derivatives
Markets: A preparation for the Actuarial Exam FM/2 (Marcel
B.Finan)
2 Financial Mathematics for Actuaries (Wai-Sum Chan, Yiu-Kuen
Tse)
Recommended texts and other readings:
1 ASM Study Manual for exam FM (2017)
2 Actex SOA exam FM Study Manual (2017)

PTHT FM MFE - NCT - NEU 2 / 55

Course Information

Number of credits: 3.
Number of lessons: 45
Course grades:
Attendance and participation: 10%.
Midterm 1: 20%.
Midterm 2: 20%.
Final exam: 50%.
Students are required to attend at least 80% number of lessons.

PTHT FM MFE - NCT - NEU 3 / 55

Contents of course

Lecture 1: Time Value of Money

Lecture 2: Cash flows and Annuities
Lecture 3: Loans
Lecture 4: Spot rates, Forward rates
Lecture 5: Bond
Lecture 6: Bond management
Lecture 7: Stochastic processes

PTHT FM MFE - NCT - NEU 4 / 55

 Lecture 1
Time Value of Money

PTHT FM MFE - NCT - NEU 5 / 55

Table of Contents

1 Accumulation and Amount function

2 Simple Interest and Compound Interest
3 Nominal Rate of Interest
4 Effective Rate of Interest
5 Generalized nominal rate of interest ih (t)
6 Rates of discount
7 Force of interest
8 Present and Future value

PTHT FM MFE - NCT - NEU 6 / 55

Time Value of Money
Money has a time value: receiving a dollar today has a greater
value than receiving one dollar a year from now.
The money invested in financial transactions will be referred to
as the principal, denoted by P.
The amount it has grown to will be called the accumulated
amount, denoted by A.
The difference I = A − P is the amount of interest earned during
the period of investment

PTHT FM MFE - NCT - NEU 7 / 55

Example

Example
You deposit 1000$ into a savings account. One year later, the
account has accumulated to 1050$.
1 What is the principal in this investment?
2 What is the interest earned?
3 What is the annual interest rate?
Solution:
1 The principal is 1000$
2 The interest earned is 1050 – 1000 = 50$
3 The annual interest rate is 50/1000 = 5%

PTHT FM MFE - NCT - NEU 8 / 55

Accumulation and Amount function

PTHT FM MFE - NCT - NEU 9 / 55

Accumulated function

We denote A(t) as the accumulated amount at time t, called

the amount function.
The initial principal P is then A(0).
For the special case of an initial principal of $1, we denote the
accumulated amount at time t by a(t), called the
accumulation function.

Example
Suppose that A(t) = at 2 + 10b. If you invest X at time 0, you
receive $500 at time 4, and $1000 at time 10. Find the amount of
the original investment, X .

Answer: X = $404.76

PTHT FM MFE - NCT - NEU 10 / 55

Accumulation function
Accumulation functions are assumed to possess the following
properties:
a(0) = 1
a(t) is increasing
a(t) is a continuous function in t.

Example
Show that a(t) = t 2 + 2t + 1, where t ≥ 0, satisfies the three
properties of an accumulation function.

Solution:
a(0) = 1
a(t) is continuous function
a′ (t) = 2t + 2 > 0. Thus, a(t) is increasing
PTHT FM MFE - NCT - NEU 11 / 55
Interest

The interest incurred from time t to time t + 1 is

I (t) = A(t + 1) − A(t)

In general, the amount of interest earned on an original

investment $K of between time t and s > t is

I ([t, s]) = A(s) − A(t) = K (a(s) − a(t))

Example
Consider the amount function A(t) = t 2 + 2t + 1. Find I (t) in terms
of t.
Solution: We have I (t) = A(t + 1) − A(t) = 2t + 1.

PTHT FM MFE - NCT - NEU 12 / 55

Simple Interest and Compound Interest

PTHT FM MFE - NCT - NEU 13 / 55

Simple Interest

For the simple interest method, the interest earned over a period
of time is proportional to the length of the period.
The interest incurred from time 0 to time t, for a principal of $1,
is r × t, where r is the constant of proportion called the rate of
interest.
The accumulation function for the simple-interest method is

a(t) = 1 + rt, A(t) = A(0)(1 + rt)

The most commonly used base is the year, in which case the
term annual rate of interest is used.

PTHT FM MFE - NCT - NEU 14 / 55

Example
a) $550 is deposited at 4.6% simple interest for five years. What is
the accumulated amount at the end of this period?
b) At what rate of simple interest will $550 accumulate to $645 in
three years?

Answer: a) 676.5 b) 5.76%

PTHT FM MFE - NCT - NEU 15 / 55

Compound interest

For the compound-interest method, the accumulated amount

over a period of time is the principal for the next period.
A principal of 1 unit accumulates to (1 + r ) units at the end of
the year, which becomes the principal for the second year.
Continuing this process, the accumulation function becomes

a(t) = (1 + r )t , A(t) = A(0)(1 + r )t ∀ t ≥ 0

PTHT FM MFE - NCT - NEU 16 / 55

Example

Example
a) $550 is deposited at 4.6% compound interest per annum for five
years. What is the accumulated amount at the end of this
period?
b) At what rate of compound interest per annum will $550
accumulate to $645 in three years?
c) You have $500 on deposit earning 8.2% annual compound
interest. How long will it be before your account balance is
$856?
Answer: a)688.6; b)5.75%; c) 6 years

PTHT FM MFE - NCT - NEU 17 / 55

Compound versus Simple interest

PTHT FM MFE - NCT - NEU 18 / 55

 Nominal Rate of Interest

PTHT FM MFE - NCT - NEU 19 / 55

Frequency of compounding

The the frequency of compounding is the number of times

interest payments are made annually.
We say that the nominal rate of interest is i (p) convertible p
times per annum if the interest is paid every 1/p of a year at the
rate of i/p
Monthly: i (12)
Quarterly: i (4)
Semi-annually: i (2)
Starting at $1, after t years, the accumulated account grows to
 tp
i
a(t) = 1 +
p

PTHT FM MFE - NCT - NEU 20 / 55

Example

Example
$1,000 is deposited into a savings account that pays 3% interest with
monthly compounding. What is the accumulated amount after two
and a half years? What is the amount of interest earned over this
period?

Answer: You can do it !

Example
What is the accumulated amount for a principal of $100 after 25
months if the nominal rate of interest is 4% compounded quarterly?

PTHT FM MFE - NCT - NEU 21 / 55

Continuous Compounding
At the same nominal rate of interest r , the more frequent the
interest is paid, the faster the accumulated amount grows.
 p  q
r r
1+ > 1+ if p > q
p q

When the number of interest payments per annum approaches

infinity, the accumulated amount tends to a finite number
 p
r
lim 1 + = er
p→∞ p

We call the compounding scheme over infinitely small period of

time continuous compounding.
Daily compounding is very close to continuous compounding
PTHT FM MFE - NCT - NEU 22 / 55
PTHT FM MFE - NCT - NEU 23 / 55
 Effective Rate of Interest

PTHT FM MFE - NCT - NEU 24 / 55

Annual Effective Rate of Interest

The annual effective rate of interest at time t, denoted by i(t), is the

ratio of the amount of interest earned in a year, from time t to time
t + 1, to the accumulated amount at the beginning of the year (i.e.,
at time t)

A(t + 1) − A(t) a(t + 1) − a(t)

i(t) = =
A(t) a(t)

Then
A(t + 1) = A(t) (1 + i(t))

PTHT FM MFE - NCT - NEU 25 / 55

Annual Effective Rate of Interest

r
Simple interest t(t) = 1+rt
Compound interest i(t) = r
Interest of i (p) convertible p times per annum
p
i (p)

i(t) = 1 + −1
p

PTHT FM MFE - NCT - NEU 26 / 55

Example

Example
Consider two investment schemes A and B. Scheme A offers 12%
interest with annual compounding. Scheme B offers 11.5% interest
with monthly compounding. Calculate the effective rates of interest
of the two investments. Which scheme would you choose?

Answer: Choose B since effective rate of interests are A 12% and B

12.13%

PTHT FM MFE - NCT - NEU 27 / 55

Example

Example
Suppose i(t) = 0.05 + 0.001t for t = 0, 1, . . . , 4. What is the
accumulation of $10,000 at these rates of interest over the period
t = 0 to t = 5?
Answer: Blackboard.

PTHT FM MFE - NCT - NEU 28 / 55

Generalized nominal rate of interest ih (t)

PTHT FM MFE - NCT - NEU 29 / 55

Generalized nominal rate of interest ih (t)

Definition
Let h > 0, the generalized nominal rate of interest ih (t) is defined as

1 a(t + h) − a(t)
ih (t) = × .
h a(t)

PTHT FM MFE - NCT - NEU 30 / 55

ih (t) - continued

This is the annualized effective rate of interest between time t

and t + h.
Equivalently, $1 at time t will grow to $1 + hih (t) at time t + h.

Example
We are given the nominal interest rates i0.4 (0) = 0.05,
i0.6 (0.4) = 0.06, i0.5 (1) = 0.04. What is the accumulation of $1 from
time 0 to 1.5?

PTHT FM MFE - NCT - NEU 31 / 55

 Rates of discount

PTHT FM MFE - NCT - NEU 32 / 55

Rates of discount

Interest of a loan or investment can be paid either at the end or

the beginning of the period.
For instance, a popular way of raising a short-term loan is to sell
a financial security at a price less than the face value. Upon the
maturity of the loan, the face value is repaid.
For example, a Treasury Bill, is a short-term financial instrument
that is issued by the US Treasury with maturity periods ranging
from a few days up to 52 weeks (one year).
For a discount security, the shortfall between the sale price and
the face value is called the discount.

PTHT FM MFE - NCT - NEU 33 / 55

Rates of discount

The effective annual rate of discount is defined as

A(1) − A(0)
d=
A(1)

Equivalently, d is the interest expressed as a percentage of the

accumulated amount, i.e,

A(0) = A(1)(1 − d)

PTHT FM MFE - NCT - NEU 34 / 55

Example
Smith borrows $1000 for one year at 10% per annum with interest
payable in advance. Compute the effective rate of interest.

The interest of this loan is

1000 × 10% = $100

Since it is payable in advance. Smith has to pay back $100 the

moment he receives the $1000 loan. That means he receives $900
today but will pay back $1000 one year from today.
The 10% is referred to as the effective discount rate. The equivalent
effective interest rate is
1000 − 900
i= = 0, 1111 = 11, 11%
900

PTHT FM MFE - NCT - NEU 35 / 55

Discount rate and interest rate

Let i and d be the equivalent annual effective interest and discount

rates respectively. Then

(1 + i)(1 − d) = 1

Or equivalently,
i d
d= , i=
1+i 1−d

PTHT FM MFE - NCT - NEU 36 / 55

Rate of discount convertible

We denote the nominal rate of discount, which is the discount

quoted in annual term for the 1/m year instrument, by d (m) .
That means the accumulated amount is discounted m times per
year and each time the effective discount rate is d (m) /m,
m
d (m)

A(0) = A(1) 1 −
m

Then the annual effective rate of discount d is defined by

m
d (m)

1−d = 1−
m

PTHT FM MFE - NCT - NEU 37 / 55

Examples

If annual rate of discount of 8% convertible quarterly is

d (4) = 0.08, then the equivalent annual effective rate of discount
is d = 1 − (1 − 0.08/4)4 = 0.077

If the annual effective rate of discount is d = 6%, then the

equivalent annual√rate of discount convertible semi – annually is
d (2) = 2 × (1 − 1 − d) = 0.060928

PTHT FM MFE - NCT - NEU 38 / 55

i (m) and d (m)

Let i and d be the annual effective interest and discount rates

respectively. Let i (m) be the equivalent nominal interest m times per
year, and d (p) discount rates convertible p times per year. Then
m  p
i (m) d (p)

1+ 1− =1
m p

If m = p,
mi (m) md (m)
d (m) = , i (m)
=
m + i (m) m − d (m)

PTHT FM MFE - NCT - NEU 39 / 55

Example
Find the rate of discount convertible semi-annually that is equivalent
to a nominal rate of interest of 8% convertible monthly.

Solution: −2
0.08 12 d (2)
  
1+ = 1.0830 = 1−
12 2
Then d (2) = 0.0782.

PTHT FM MFE - NCT - NEU 40 / 55

Examples

Example
Calculate the nominal rate of discount convertible monthly that is
equivalent to a nominal rate of interest of 18.9% per year convertible
monthly.

Example
Jeff deposits $10 into a fund today and $20 fifteen years later.
Interest is credited at a nominal discount rate of d compounded
quarterly for the first 10 years, and at a nominal interest rate of 6%
compounded semiannually thereafter.
The accumulated balance in the fund at the end of 30 years is $100.
Calculate d.

PTHT FM MFE - NCT - NEU 41 / 55

 Force of interest

PTHT FM MFE - NCT - NEU 42 / 55

Force of interest

All four funds have the same amount at the beginning and the
end of the year.
The effective rate of interest give us absolutely no information
about how the fund grows at any moment during the year.
Need to know the rate of growth of a fund at any moment of
time.
PTHT FM MFE - NCT - NEU 43 / 55
Force of interest
When interest is compounded continuously, we call the interest rate a
force of interest (or the rate of growth at a point in time). We let
δ(t) stand for the force of interest at time t,

A′ (t) a′ (t)
δ(t) = =
A(t) a(t)

Example
You are given that a′ (t) = 3t 2 + 2t + 1. Determine the force of
interest at t = 5.
Z
Solution: a(t) = (3t 2 + 2t + 1)dt = t 3 + t 2 + t + c. Since
a′ (5)
a(0) = 1, c = 1. So we have δ(5) = a(5)
= 55.13%.

PTHT FM MFE - NCT - NEU 44 / 55

Accumulation/Amount from force of interest

Accumulation function a(t)

Rt
δ(s)ds
a(t) = e 0

Amount function A(t):

Rt
δ(s)ds
A(t) = A(0)e 0

PTHT FM MFE - NCT - NEU 45 / 55

Example

Example
$100 is invested at a force of interest δ(t) = t 22t+1 . Determine the
amount of interest earned in the 5-th year.
R 
t
Solution: a(t) = exp 0 s 22s+1 ds = t 2 + 1. The interest earned in
the 5-th year is

100[a(5) − a(4)] = 100(26 − 7) = 900

PTHT FM MFE - NCT - NEU 46 / 55

Force of interest

For compound interest at annual effective interest rate i, the

force of interest is
δ(t) = ln(1 + i)
For simple interest r per annum, the force of interest is given by
r
δ(t) =
1 + rt

PTHT FM MFE - NCT - NEU 47 / 55

Example
A fund accumulates at a simple-interest rate of 5%. Another fund
accumulates at a compound-interest rate of 4%, payable yearly.
When will the force of interest be the same for the two funds? After
this time, which fund will have a higher force of interest?

Solution
0.05
= ln(1.04)
1 + 0.05t
i.e.,
0.05 − ln(1.04)
t= = 5.4967
0.05ln(1.04)

PTHT FM MFE - NCT - NEU 48 / 55

 Present and Future value

PTHT FM MFE - NCT - NEU 49 / 55

Present and Future Values

The present value of $1 at time t is the amount of money needed

to set aside at time 0 so that it will accumulate to $1 at time t.
The future value at time t of $1 invested at time 0 is the amount
of money accumulated at time t from $1 invested at time 0.
The present and future values depend on the rate of interest.

PTHT FM MFE - NCT - NEU 50 / 55

Constant interest rate

Suppose interest is fixed and compounded annually at i per

annum. Then $1 invested today will grow to $(1+i) in one year.
The factor (1 + i) is called the accumulation factor.
Let v = (1 + i)−1 be the discount factor.
The future value of $1 after t years from now is a(t) = (1 + i)t .
The present value of $1 at time t is v (t) = v t .

PTHT FM MFE - NCT - NEU 51 / 55

Example

Example
Find the sum of the present values of two payments of $100 each to
be paid at the end of year 4 and 9, if interest is compounded
semiannually at the nominal rate of 8% per year.

Solution: the effective rate of interest is (1.04)2 − 1 = 0.0816.

1 1
We have v (4) = 1.08216 4 = 0.7307 and v (9) = 1.08269 = 0.4936. The

sum of present value is

100(0.7307 + 0.4936) = $122.43

PTHT FM MFE - NCT - NEU 52 / 55

Varying interest rate

Suppose we are given the force of interest δ(t).

Then the present value of $1 at time t is
Rt
v (t) = e − 0 δ(s)ds

The future value of $1 at time t is given by

Rt
δ(s)ds
a(t) = e 0

PTHT FM MFE - NCT - NEU 53 / 55

Example

Example
Suppose v (t) = 0.98 − 0.3t for t = 1, 2, 3, 4. Let Ct = 1000 − 200t
for t = 0, . . . , 4 where Ct is a payment at time t. Find the present
value of this stream of payments.

PTHT FM MFE - NCT - NEU 54 / 55

Homework

Textbook questions:
Chapter 1: 5,9,10,11,15,18,19,20,21,28,30,36,39,40.

PTHT FM MFE - NCT - NEU 55 / 55