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Lecture 4

Varying interest Solution of problems in interest

Varying Effective Rate of Interest where i k denote the effective rate of interest during the kth period from the date of investment and t>=1 is positive integer  2

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Varying Force of Interest   3    4

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A summary 7

Solution of problems in interest

An interest problem involves four basic variables :

original amount(s) invested

length of investment period(s)

rate (or force) of interest (or discount)

accumulated value(s) at the end of the investment period. if you have 3 of the above variables, then you can solve for the unknown 4th variable.

An interest problem can be viewed from two perspectives, since it involves a financial transaction between two parties: the borrower and the lender.

From either perspective, the problem is essentially the same; however, the wording of a problem may be different depending upon the point of view. For example: paid / credited

Obtaining Numerical Results : using a calculator or an interest table

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Equations of value

Recognition of time value of money.

This reflects the effect of interest, but not the effect of inflation which reduces the purchasing power of money over time. Inflation-adjusted calculations will be discussed in our later lectures.

Considering time value of money, two or more amounts of money payable at different points in time cannot be compared until all the amounts are accumulated or discounted to a common date.

This common date is called the «comparison date» (or the «focus point»), and the equation which accumulates or discounts each payment to the comparison date is called «equation of value».

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Time diagram

One device which is often helpful in the solution of equations of value is the time diagram.

It helps to draw out a time line and plot the payments and withdrawals accordingly

Payments in one direction are placed on the top of the diagram and payments in the other direction are placed on the bottom of the diagram. The comparison date is denoted by an arrow.

Under the compund interest case, the choice of the comparison date makes no difference in the answer obtained.

Thus there is a different equation of value for each comparison date, but they all produce the same answer!

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Example: A \$600 payment is due in 8 years; the alternative is to receive \$100 now, \$200 in 5 years and \$X in 10 years. If i = 8%, find \$X, such that the value of both options is equal.  11      12

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Unknown time

Single Payment

the easiest approach is to use logarithms

Example: How long does it take money to double at i = 6%?

if logarithms are not available, then use an interest table and perform a linear interpolation (1.06) n = 2 From interest table (1.06) 11 = 1.89830 and (1.06) 12 = 2.01220

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Rule of 72 for doubling a single payment  Rule of 114 for tripling a single payment 16

18.03.2015 How long does it take money to double at a given rate of interest?
Rate of interest Rule of 72
Exact Value
Relative Error
i%
0.72/i
n=ln(2)/ln(1+i) Absolute Error/Exact Value
2
36,00
35,00
0,03
3
24,00
23,45
0,02
4
18,00
17,67
0,02
5
14,40
14,21
0,01
6
12,00
11,90
0,01
7
10,29
10,24
0,00
8
9,00
9,01
0,00
9
8,00
8,04
0,01
10
7,20
7,27
0,01
11
6,55
6,64
0,01
12
6,00
6,12
0,02
13
5,54
5,67
0,02
14
5,14
5,29
0,03
15
4,80
4,96
0,03
16
4,50
4,67
0,04
17
4,24
4,41
0,04
18
4,00
4,19
0,04
19
3,79
3,98
0,05
20
3,60
3,80
0,05
→←
increasing
increasing

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An Approximate Approach For Multiple Payments

let S t represent a payment made at time t such that      18

18.03.2015 This approximation of t is always greater than the true value of t, which means that the present value using the method of equated time is smaller than the true present value.

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Unknown rate of interest

There are 4 general methods to use in determining an unknown rate of interest.

The first is to solve the equation of value for i directly using a calculator with exponential and logarithmic functions .This will work well in situations where there are few payments, and the equation of value can be easily reduced.

The second is to solve the equation of value for i directly by algebraic techniques. An equation of value with integral exponents on all the terms can be written as an nth degree polynomial in i. This method is generally practical for only small values of n.

The third method is to use linear interpolation in the interest tables.

The fourth is successive approximation, or iteration. This seems impractical for use on exams, especially with modern calculators.

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Example: At what effective interest rate will an investment of \$100 immediately and \$500 4 years from now accumulate to \$1000 10 years from now?

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Determining time periods

Simple interest is computed using the exact number of days for the period of investment and 365 as the number of days in a year. This is called exact simple interest, and is denoted by “actual/actual.”

The second method assumes that each month has 30 days, and that the entire year has 360 days. Simple interest computed on this method is called ordinary simple interest, and is denoted by

“30/360.”

The third method is a hybrid. It uses the exact number of days for the period of investment, but uses 360 days per year. Simple interest on this basis is called the bankers rule, and is denoted by

actual/360.”

The Banker’s Rule is always more favorable to a lender than exact simple interest, and is usually more favorable to a lender than ordinary simple interest, but there are exceptions to that.

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It is assumed, unless stated otherwise, that in counting days, interest is not credited for both the date of deposit and the date of withdrawal, but for only one of these days.

Not all practical problems involve the counting of days, many transactions are on a monthly, quarterly, semiannual, or annual basis. In these cases, the above counting methods are not required.

In summary

(i) exact simple interest approach: count actual number of days

where one year equals 365 days

(ii) ordinary simple interest approach: one month equals 30 days; total number of days between D2,M2, Y2 and D1,M1, Y1 is

(2.5)

(iii) Banker’s Rule: count actual number of days where one year equals 360 day

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360(Y2 − Y1) + 30(M2 −M1) + (D2 − D1) 28

18.03.2015  Reference: KELLISON, S. G., 1991, The Theory of Interest, Irwin Inc., USA., Chapter 1.10, Chapter 2

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