Chapter 1

Course Introduction and Basics of Interest

Theory
Course syllabus
SOA FM exam
Basics of interest theory: interest, accumulation function and discount

Course Introduction and Basics of Interest Theory

Instructor and TAs

Instructor:
Xinyun Chen, xinyun.chen@stonybrook.edu
OH: Tu/Th 2 - 4 -pm, Math Tower B148 - 4
TA team:
Graduate TA TBA
Minha Kim, minha.kim.1@stonybrook.edu OH: Wed 10-12 pm
Tak Wong, tak.wong@stonybrook.edu OH: Wed 1 - 3 pm
David Cheung, tonyisbest@live.cn OH: Fr 10 -12 pm
*TA OH is in Harriman 010

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Course Introduction and Basics of Interest Theory

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Course objective and the FM exam

This course follows the syllabus for Financial Mathematics (FM) Exam of the
Society of Actuaries and prepares students to pass the FM Exam.
SOA FM Exam: 35 multiple-choice questions, 3 hour, closed-book
website: www.soa.org/education/exam-req/edu-exam-fm-detail.aspx

Course Introduction and Basics of Interest Theory

Assessment
Homework (30%)
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Weekly: assigned every Thursday and due back next Friday

Submit your solution with detailed steps

Exams (60%)
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2 in-class midterms in the week of October 29nd and November 4th

Final exam

All exams are close-book. Calculator is allowed.

Writing project (10%): 3-page essay, due before the final exam

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Course Introduction and Basics of Interest Theory

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Course materials
Required textbook: Mathematical Interest Theory by L. Vaaler and J.
Daniel.
Lecture notes/slides
In the last week, we will watch a documentary film Floored about people and
business of the trading floors.
Financial calculator (optional)
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list of calculators accepted by SOA:

www.soa.org/education/exam-req/exam-day-info/edu-calculators.aspx
BA II plus is used in the textbook with detailed instruction. We will NOT
discuss this part in the lecture.
Any scientific calculator is good for this course

Course Introduction and Basics of Interest Theory

Course content
1. Time Value of Money
Chapter 1 and 2
Interest, discount, accumulation function, equation of value
2. Annuities
Chapter 3 and 4
Annuities/cash flows of different types
3. Loan / Chapter 5
4. Bond / Chapter 6
5. Immunization
Chapter 9
Duration, convexity
6. Equity market

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Course Introduction and Basics of Interest Theory

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What is interest?
If an investment amount $ K grows to an amount $ S, then the difference $
S K is interest.
Economic rationale for the charing of interest:
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investment opportunity theory

time preference theory

default risk

Question: Which of the following may fit the definition of interest?

a The amount I owe on my credit card.
b The amount of credit remaining on my credit card.
c The cost of borrowing money for some period of time.
d A fee charged on the money youve earned by the Federal government.

Course Introduction and Basics of Interest Theory

Interest, amount function and accumulation

function
Definitions
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principal K: amount of money invested at time 0

amount function AK (t): balance at time t

accumulation function a(t): amount function for principal 1

Formulas
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Ak (t) = Ka(t)

Examples
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Example 1.3.2, 1.3.3

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Course Introduction and Basics of Interest Theory

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Interest, amount function and accumulation

function
Definitions
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amount of interest earned: growth amount of an investment

effective interest rate i[t1,t2] for the interval [t1, t2] : growth amount of an
investment of $ 1 from t1 to t2

Formulas
a(t2 )a(t1 )
a(t1 )

Ak (t2 )AK (t1 )

AK (t1 )

i[t1,t2] =

in = i[n1,n]

a(n) = a(n 1)(1 + in), therefore a(n) = (1 + i1)(1 + i2)...(1 + in)

Example: Compute and compare i1 and i5 in Example 1.3.2 and 1.3.3

Course Introduction and Basics of Interest Theory

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Simple interest and compound interest

Definitions
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simple/compound interest accumulation function is an accumulation

function of a special form. The corresponding interest rate is called
simple/compound interest rate

Formulas
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simple interest accumulation function: a(t) = 1 + st, s = simple interest

rate
compound interest accumulation function: a(k) = (1 + i)k , i = compound
interest rate
i = a(1) 1, a(k) = a(k 1)(1 + i)

Examples
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Example 1.4.2,1.54,1.5.5, 1.5.7

Course Introduction and Basics of Interest Theory

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Discount rate
Definitions
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If an investor lends $K for one period at a discount rate D, the borrower

need to pay $KD to receive $K.
amount of discount = $KD

Formulas
a(t2 )a(t1 )
a(t2 )

effective discount rate d[t1,t2] =

dn =

a(n 1) = a(n)(1 dn) a(n) =

AK (t2 )AK (t1 )

AK (t2 )

a(n)a(n1)
a(n)

Examples
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Example 1.6.5

1
(1d1 )(1d2 )...(1dn )

Course Introduction and Basics of Interest Theory

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Equivalent interest and discount, simple and

compound discount
Definition
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An interest rate and a discount rate are called equivalent if they

correspond to the same accumulation function.

Formulas
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relation between equivalent interest and discount rates:

1 = (1 + i[t1,t2])(1 d[t1,t2])
i
1+i ,

d
1d

d=

simple discount accumulation function: a(t) =

compound discount accumulation function: a(t) = (1 + i)t = (1 d)t

i=

1
(1dt)

Example: Suppose 1, 000d1 = 85, 1, 000d2 = 90, compute 1, 000i[0,2]

Course Introduction and Basics of Interest Theory

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Discount function and present value

Definitions:
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discount function v(t) =

1
a(t)

Present value is a future amount of money that has been discounted to

reflect its current value, as if it existed today...(is) used to make
comparisons between cash flows that dont occur at simultaneous times.
(http://en.wikipedia.org/wiki/Present value)

Formulas:
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discount factor v = 1 d

compound discount function: v(t) = (1 d)t = v t

The present value of $L to be received at time t0 with respect to a(t)

P Va(t)($L at time t0) = $Lv(t0) = $L/a(t0)

Example: Example 1.7.8

Exercise: can you find the compound interest rate to make the two certificate
equally attractive?

Course Introduction and Basics of Interest Theory

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Nominal rates of interest and discount

Definition
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nominal rate is the rate quoted by banks, not equal to the effect rate
i(m): a nominal interest rate that convertible/compounded/payable m
times per year
d(m): a nominal discount rate that convertible/compounded/payable m
times per year
APY (annual percentage yield): the effect compound interest rate

Formulas
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accumulation function with a nominal interest rate i(m):

i(m) t
1
) , with the unit of time =
year
a(t) = (1 +
m
m

relation between APY i and nominal interest rate i(m):

i(m) m
i = (1 +
) 1,
m

i(m) = m[(1 + i) m 1]

Course Introduction and Basics of Interest Theory

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Nominal rates of interest and discount

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relation between the annual compound discount rate d and nominal

discount rate d(m):

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d(m) m
) , d(m) = m[1 (1 d) m ]
d = 1 (1
m
I relation between the nominal rates of interest and discount:

(m)

d(m)
1

d(m)
m

(m)

i(m)
(m)

1 + im

Example: Helen borrows $ 5000 from her credit card account at a nominal
annual interest rate of 20% per year convertible monthly. Two months later,
she pays $1000 back. Four months after the payment she borrows $ 2000.
How much does she owe one year after the loan is taken out?

Course Introduction and Basics of Interest Theory

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Force of interest
Definition
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force of interest at time t: t = limm m

1 )a(t)
a(t+ m
a(t)

Formulas
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relation between force of interest and general accumulation function:

a0(t)
d
t =
= (ln a(t)),
a(t)
dt

a(t) = e

Rt

0 r dr

force of interest for compound interest accumulation function:

a(t) = (1 + i)t t = ln(1 + i)

Examples
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Example 1.12.6
If the annual effective rate i = 8%, calculate i[1,2], d4, and the force of
interest.

Course Introduction and Basics of Interest Theory

Inflation and inflation adjusted rate

Definition
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inflation r: loss of purchase power per dollar

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Course Introduction and Basics of Interest Theory

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Formula
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Inflation rate:

p(t2) p(t1)
p(t1)
For US inflation rate, p is Consumer Price Index published monthly by
Bureau of Labor Statistics.
r[t1,t2] =

inflation adjusted interest rate

j=

ir
1+r

Investment opportunity with nonadjusted interest rate = i. Assume

anticipated inflation = r0 and target inflation-adjusted interest rate = j 0.
Take the investment opportunity if and only if i j 0 + r0 + r0j 0

Examples
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Example 1.14.6