10 FM 1 TN 4pp

Financial Mathematics
Plan
Module 1: Time Value of Money and Valuation of Cash Flows
Cash Flow Models
A Mathematical Model of Interest
Simple and Compound Interest
Discount Interest
Nominal Interest
Force of Interest
Real and Money Interest
Relation between Cash Flow, Interest and Present Value
Annuities: Introduction
Term Annuities
Non-Level Annuities
Continuous Annuities
Relations and Recursive Formulas between Annuities
Benjamin Avanzi1
1 University of New South Wales
Actuarial Studies, Australian School of Business
b.avanzi@unsw.edu.au
Module 1 Topic Notes
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Cash Flow Models
Cash flow models
Cash Flow Models
Comparing cash flows

We want to compare different sets of cash flows:
I why?
A cash flow is a series of payments (inflows or outflows) over a

period of time.
A mathematical projection of the payments involved in a financial
transaction is referred to as a cash flow model.
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Cash flows are characterised by their:
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nature: inflow or outflow
amount
timing
probability (if contingent)
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compare 2 securities or investments

compare scenarii for a given product (product development,
profit testing, solvency)
compare potential new products (product development)
etc. . .
how?
Cash Flow Models
Cash Flow Models
Procedure:
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make the cash flow clear; draw a time diagram

choose any point in time
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now: present value, sometimes NPV (Net Present Value)

in the future: accumulated value
in the middle...
should be convenient: all are equivalent!
"bring back or forth" all cash flows to the point of time you
have chosen
add them up
compare!
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Cash Flow Models
Time value of money

You want to buy a television from Bling Bees on 31/12/2009 that
is worth $3000. The super mega deal (yeahh) is that you can take
the television now and need only to pay $1000 on 31/12/2011 and
$2000 on 31/12/2012. Their advertisement campaign is "No
interest, no deposit until 2011!".
But you are smart (of course, you are an actuary), and you know
that if Bling Bee invests $1000 now, this investment will be worth
$1100 in one year, $1210 in two years and $1331 in three years.
Taking this information into account, what discount can you
reasonably get from Bling Bee?
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How much would you pay to buy a security that is guaranteed to

give you $100 in 1 years time?
What if there was a chance of default?
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Mathematical model
Consider an amount of money invested for a period of time.
Time is money!
the time preference of agents in the economy

usually, agents are impatient (interest is positive)
risk (interest is raised to include a risk premium)
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A(0): principal = the amount of money initially invested
t: the length of time for which the amount has been invested
A(t): amount function or accumulated amount function
Interest is a mathematical tool to embody

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this is the accumulated amount of money at time t

corresponding to A(0)
Assuming these are two equivalent cash flows at two different point
in time, how can we link them using interest?
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Accumulation function
Effective Interest
Let a(t) be the accumulation function:

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a(t) the accumulated value at time t of an original investment

of 1 made at time 0
it is a scaled version of A(t) with a(0) = 1 and can thus be

studied independently of the amounts that are invested
it represents the way in which money accumulates with the

passage of time
We have
It,k = A(t + k) A(t),

and then the effective rate of interest it,k for this same period is
a(t + k)
A(t + k)
=
,
A(t)
a(t)
which means
A(t + k) = A(t)
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In mathematical terms, the effective interest It,k accumulated

between t and t + k (for a period k from t) is
it,k =
a(t + k)
.
a(t)
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A(t + k) A(t)
a(t + k) a(t)
=
.
A(t)
a(t)
(1)
Homogeneity in time
Forms of interest
When the effective rate of interest is the same for all t, then we
have
a(t + k)
a(k)
=
= a(k)
a(t)
a(0)
A(t + k) = A(t)a(k)
it,k
=
=
A(t + k) A(t)
A(t + k)
=
1
A(t)
A(t)
a(t + k) a(t)
= a(k) 1.
a(t)
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a(t) is modeled with the help of interest
effective interest is always defined as in (1)
however, interest can be expressed in many different ways,

depending on the situation (mainly conventions)
each way has a different set of assumption
each definition may lead to different forms for a(t)
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Assumptions about interest
1. how much interest is paid?

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usually expressed as a percentage per year (per annum, p.a.)

amount can depends on the time period (inhomogeneity)
term structure of interest, see module 4
non-constant force of interest
amount is sometimes stochastic
deterministic vs stochastic interest, see module 6
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2. how often is interest paid?

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as a rule, once per compounding period, whose number per

time unit needs to be determined (usually once a year)
simple vs compound interest (time horizon)
nominal vs effective interest (several times a year)
force of interest (continuously)
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3. when is interest paid?

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at the beginning or end of the compounding period

discount interest (beginning)
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Example: Assume John deposits $1000 on his bank account on
01/01/2010 at an effective rate of interest of 5% p.a. At the
following dates:
1. what is the balance of his account?
2. how much would he get if he closed his account?
3. how much interest has he earnt?
4. how much interest has been credited on the account?
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30/06/2010
01/01/2011
30/06/2011
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Simple Interest
Main difference:
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with simple interest: no interest is ever earnt on

interestinterest is not compounded
with compound interest: interest is continuously earnt on

interestinterest is compounded
Accumulation function: for simple interest i,

a(t) = 1 + it,
and the accumulated amount function after a period t is given by
A(t) = A(0) a(t) = A(0) (1 + it).
When to use one or the other?
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What happens within a year (compounding period) is usually

simple interest (short term securities, T-bills, . . . )
Usually, t < 1 (days/360 or 365, or months/12).
However, simple interest is not homogeneous in time
Effective rate of interest is not constant in this case (decreasing):
For cash flows spanning over periods of more than

a year, compound interest is generally used (easier..!)
a(t + k) = (1 + i(t + k))
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6=
(1 + it)(1 + ik) = a(t)a(k)
Numerical Example
Compound Interest
Accumulation function: for compound interest i,
A Bank accepts deposits for terms up to 3 years and pays interest

on maturity. How much interest would it pay on a deposit of
$20,000 for a term of 1 year and 33 days if the interest rate is 5%
p.a. simple?
a(t) = (1 + i)t ,
and the accumulated amount function after a period t is given by
A(t) = A(0) a(t) = A(0) (1 + i)t .
In this case, effective interest is homogeneous:
a(t + k) = (1 + i)t+k
(1 + i)t (1 + i)k = a(t)a(k)
or alternatively
a(t + k)
= (1 + i)k = a(k), t, k 0.
a(t)
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Numerical Example
General questions
1. What happens to the accumulation if i ?
A Bank accepts deposits for terms up to 3 years and pays interest

on maturity. How much interest would it pay on a deposit of
$20,000 for a term of 1 year and 33 days if the interest rate is 5%
p.a. effective?
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i ?
2. What is the amount of interest earned during each unit period

under compound interest? simple interest?
3. What is the effective rate of interest during each unit period
under compound interest? simple interest?
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Discount Interest
Discount Interest
Rate of Discount

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The rate of interest i applies to the principal now, for interest

calculated at t = 1, whereas the rate of discount d applies to the
principal at the end of the period, for interest calculated at t = 0.
In other words, for i:


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we focus on the principal now
we correct this figure by adding interest at the end of the

period
and for d :

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we focus on the principal at the end of the period
we correct this figure by subtracting interest now
Both methods are equivalent, and use of one or the other is

dictated by the situation for convenience.

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Discount Interest
Discount Interest
Simple vs compound discount interest

Remember: i
=
=
Now: d
=
=
a(1) a(0)
a(0)
A(1) A(0)
= a(1) = (1 + i)
A(0)
a(1) a(0)
a(1)
A(1) A(0)
1
= a(1) =
A(1)
1d
Since we want d and i to be equivalent (they are just formulated

differently), we have
1
1+i =
.
1d
For simple interest:
1
a(t) = a(0)
1 dt
and for compound interest:

t
1
a(t) = a(0)
1d
Financial reasoning:
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At rate of compound interest of i% p.a. the discounted value

of an instrument is known. Is the compound rate of discount
that produces an equivalent discounted value higher or lower?
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Discount Interest
Numerical Example
Discount Interest
Relations between Interest and Discount
In the US Treasury Bills are quoted using simple discount on the

basis of a 360 day year.
Consider a US T-Bill with a face value of 500,000 and maturity in
180 days time. Suppose that this is sold to yield 6%p.a (simple
discount). What are the proceeds of the sale?
i is the effective rate of interest, d is the effective rate of discount

and v = 1/a(1) is the discount factor.
Show these are correct as an exercise and use financial reasoning.
d
1d
i
=
1+i
= iv
= 1v
i
d
i d
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= id
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Discount Interest
Discount Interest
Intuition behind d = 1 v ?
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Intuition behind i d = id ?
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Nominal Interest
Nominal Interest
Nominal Interest Rate

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usually the compounding period is one year

nominal interest rates are interest rates
Example of securities for which nominal rates are relevant:

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that are still expressed as % p.a.

but that have several (m) compounding periods per year
Some bonds pay interest yearly, some semi-annually and some
quarterly
Home loans usually charge interest monthly
Some bank accounts pay interest daily
Notation: i (m) nominal interest rate, payable mthly

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Nominal Interest
Nominal Interest
Nominal vs effective rates
Relationship to i, the effective interest rate
With nominal interest rates, the rate

In general, for rate i per annum
i (m)
m
!m
i (m)
(1 + i) =
1+
m
h
i
i (m) = m (1 + i)1/m 1
is an effective rate of interest for a period of 1/m years.

Reminder:
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1. the effective (actual amount of) interest earned and
2. the principal at the beginning of the period (for interest) or at
the end of the period (for discount).
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i (m) , m > 1, is not an effective rate of interest
i is the effective rate of interest for a year, equivalent to i (m)
<
i (m) >i
??
Can you use your financial reasoning to convince yourself which is

correct?
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Nominal Interest
Nominal Interest
Numerical Example
Nominal Discount Rates
A product offers interest at 8% p.a., payable quarterly. What is the

effective annual rate of interest implied?
Interest is converted m times per year (period)
Notation: d (m) nominal discount rate converted mthly
Relationship to d the effective rate of discount

!m
1
d (m)
= (1 d ) = 1
a(1)
m
Note that the nominal discount rate increases as the frequency

of conversion increases.
d < d (2) < d (4) . . .
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Nominal Interest
Nominal Interest
Exercise
Show that d (m) = i (m) vi
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Numerical Example
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Find the accumulated amount of $100 invested for 15 years if

i (4) = .08 for the first 5 years, d = .07 for the second 5 years and
d (2) = .06 for the last five years.
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Force of Interest
Force of Interest
Force of Interest

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Consider

lim

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!m
lim 1 + m
i (m)
m
i ()
= 1+i
+
2!
i ()
= e
or e ,
2
()

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i (m)
1+
m
m (m 1)
2!
i ()
+
3!
i (m)
!2
+ ...
3
+ ...
where is called the force of interest, or continuously compounding

rate of interest.

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Force of Interest
Force of Interest
Force of Discount
We have
Similarly, consider
1
lim
d (m)
m
lim 1 m
= 1d
= e
1 d = e d
!m
()
d ()
and 1 + i = e i
Now
1d =v =
d (m)
m
d ()
+
2!
2
m (m 1)
2!
d ()
3!
d (m)
m
!2
()
1
.
1+i
Thus,
...
i () = d ()
and, in general,
3
+ ...
d < . . . < d (m) < . . . < d () = = i () < . . . < i (m) < . . . < i.
where d () is the force of discount.

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()
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Force of Interest
Force of Interest
Force of interest that varies with time

Taking the limit, as 4t 0,
Let
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A(0) be the principal invested at time 0
interest be paid continuously at a rate (t) at time t
(t) =
We seek an expression for A(t).
Interest paid over a small interval t is
A(t + t) A(t) A(t)(t)t

=
and thus
(t)
A(t + 4t) A(t)

A(t) 4t
d
1
A(t)
A(t) dt
A0 (t)
A(t)
d
ln A(t).
dt
lim
4t0
A(t + 4t) A(t)

.
A(t)4t
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Force of Interest
Force of Interest
Integrating both sides over [0, t],

Zt
(s)ds =
Numerical Example
Force of interest at time 0 is 0.04, and increases uniformly to 0.06
after 5 years. Find the amount after 5 years of an investment of $1.
ln A(s)|t0
s=0
= ln A(t) ln A(0)
A(t)
.
= ln
A(0)
Thus we have
Z
A(t) = A(0) exp

(s)ds
and
Z
a(t) = exp
For affine (t), the integral in exponential can be simplified:

(s)ds .
k
a(t + k)
= e 2 [(t)+(t+k)]
a(t)
Note that interest is homogeneous iif (t) , t 0.

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Inflation
Notation
When comparing cash flows, time has to be accounted

1. because of the time preference of agents in the economy (risk
free interest)
Let
2. because there is a risk of default (risk premium)

3. because the value of money changes over time:
inflation/deflation
Inflation:
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Inflation (deflation) is characterized by rising (falling) prices, or

by falling (rising) value of money.
i% p.a. be the money interest rate
r % p.a. be the real interest rate
p(t) be the price index (with P(0) = 1)
% p.a. be the inflation rate
What relationships can be established among i, r , P(t) and ?
A common way of measuring inflation is the change in

Consumer Price Index (CPI) which itself measures the annual
rate of change in a specified "basket" of consumer items.
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Main relations
How to deal with inflation
We have
Inflation is introduced in calculations either by

a(0) = 1 and a(1) = 1 + i.
1. considering the cash flow at its dates $ (nominal value) and

use money interest rates:
t

1
A(0) = A(t)
1+i
and
p(0) = 1 and p(1) = 1 +
Thus, the value of accumulation at todays prices is given by
a(1)
1+i
=
.
p(1)
1+
2. or adapting the amounts of cash flows to todays dollars (real

value) and use a (modified) real interest rate:
Now, define
A(t)
A(0) =
(1 + )t
1+i
i
r =
.
1+
1+
Caution: this holds only for effective rates!
1+r =
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Both methods are equivalent.

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1
1+r
t
Example
To determine the price, we must be consistent. Either we work with
An investor will receive an asset in 10 years time with face value
$100,000. Given a nominal (money) interest rate of 9% p.a.,
quarterly compounding, and an expected inflation rate of 5% p.a.,
(also quarterly compounding), what should you pay now:
Method 1: the nominal value, and discount with the money

interest rate, or
Method 2: the real value, and discount with the real interest
rate.
The effective real quarterly rate is
Asset 1 if the payment on the asset will not change, failing to increase
in line with inflation
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= 0.9876543%
1 + .05/4
Asset 2 if the asset maintains its real value (an inflation indexed bond)
Thus, r (4) = 3.9506% and r = 4.0095%.
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Asset 1
Asset 2
Method 1:
Method 1:
PV
100, 000
=
40
1 + .09
4
= 41, 064.58
PV
100 000 1 + .05

4
=

.09 40
1+ 4
= 67 494.53
40
Method 2:
Method 2:
100, 000
Real value =
40 = 60, 841.33
1 + .05
4
PV =
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60, 841.33
(1.00987654)40
PV
= 41, 064.57
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100, 000
(1.00987654)40
= 67, 494.54
Our fundamental problem
Practical examples
Three inter-related (sets) of values:
Find the price of a security: determine an initial cash flow such

that the NPV is 0, given interest and a set of cash flows
a set of cash flows (inflows and outflows, timing, probability)
interest and its assumptions
a present value / accumulated value

(for a security: the price / value at maturity)
Find the yield of a security or a project: determine the rate of

interest such that the NPV is 0 (IRR), given a set of cash flows
Find the minimum return on the reserves that is necessary to

ensure all current life annuities can be paid until the end, given
the current level of mortality (pensions)
...
Learning outcome A3:

Understand the relation between a present value, a set of
cash flows and interest, be able to determine one in
function of the others in a variety of situations, as well as
understand the interest rate risk (duration, immunisation)
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Note
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If the NPV is 0, we have then an equation of value
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Examples of Common Financial Instruments
Determine a PV in function of cash flows and interest
Cash on deposit - term deposits, cash management trusts
Notes: Treasury notes, promissory notes, bank bills
The present value PV of an amount A(t) accumulated at time t is

given by
A(t)
A(t) = PV a(t) PV =
.
a(t)
Equities - also known as shares, equity shares or common stock
The present value or discount factor is then
Bonds: Coupon Bonds, Zero Coupon Bonds (ZCB),

Government bonds
Annuities: annuities-certain, life annuities
Insurance applications: Term life insurance, Endowment

insurance
v=
1
1+i
= 1d
=
= d /i
Powers of the discount factor can be used to discount all cash flows
if interest is homogeneous with time
(which is the usual assumption)
See Broverman and Sherris for the main definitions and examples.
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1
a(1)
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Numerical Examples
Numerical Examples
Example 1
Consider a Coupon bond which pays $6 at times 1 and 2, and an
additional $100 at time 2. Find the Present Value of this bond at
8% p.a. effective interest.
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Example 2
In Australia, Short term Government securities such as Treasury
Notes and Treasury Bonds (less than 6 months to maturity) are
priced using simple interest and a 365 day convention.
Consider a Treasury-note with a face value of 500,000 and maturity
in 180 days time. Suppose that this is sold at a yield (interest rate)
of 6%p.a. What are the proceeds of the sale?
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Determine interest in function of a PV and cash flows
Newton-Raphson method (a recursive numerical method)

(see, e.g. http://en.wikipedia.org/wiki/Newtons_method)
If there are more than 2 cash flows, it is generally impossible to

solve for interest analytically.
f 0 (in ) =
1. determine f (i) such that f (i ) = 0
In that case, several approaches are possible:
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use a financial calculator
use a computer (R, Goal Seek in Excel, etc. . . )
use a numerical method (e.g. Newton-Raphson)

(the method to be used in quizzes and in the final exam)
f (in )
f (in )
in+1 = in 0
in in+1
f (in )
2. determine f 0 (i)
3. choose initial value i0
4. perform recursions
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Numerical Example
Notation
A Bond pays $100 in 1.5 years. Coupon payments of $5 are payable

times 0.5, 1, and 1.5
1. Find the Price of the Bond if the yield is i (2) = 6%.
2. Suppose the Price of the Bond is 107.14. Find the Yield
implied by this price.
(p)
ax:n i
m|
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Our main tool to value annuities-certain: the perpetuity
Numerical example
A foundation has $100,000,000. Assuming a long term net return
on investments of 5% p.a., how much money can it use every year
without decreasing the capital?
Determine the annual payment if it is made in arrears or in
advance, and in the two situations:
1. the capital should not decrease in nominal terms
2. the capital should not decrease in real terms
Assume a long term inflation rate of 3% p.a.
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Numerical example
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Term Annuities
Annuity-immediate (paid in arrears)
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Term Annuities
Numerical example
Term Annuities
Annuity-due (paid in advance)
A Bond pays $100 at time 3. Coupon payments of $5 are payable

at times 1, 2, and 3
1. Find the Price of the Bond if the effective yield is i = 5%.
2. What is the Price if the effective yield is 6%?
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Term Annuities
Numerical example
Term Annuities
Deferred annuity
A Bond pays $100 at time 2. Coupon payments of $5 are payable

times 0, 1, and 2. (i.e. the first payment occurs immediately after
purchase).
1. Find the Price of the Bond if the effective yield is i = 6%.
2. What is the Price if the effective yield is 5%?
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Term Annuities
Numerical example
Term Annuities
Payments more frequent than a year
Consider a Bond pays $100 at time 6. Coupon payments of $5 are

payable times 4, 5, and 6. How much would you be willing to pay
to purchase the bond today? Assume i = 6%.
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Term Annuities
Term Annuities
Alternative method
Alternatively, find the effective pthly rate of interest,

j = (1 + i)1/p 1 =
Then
(p)
an i =
1
anp j
p
where j = (1 + i)1/p 1.
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Term Annuities
Numerical example
Term Annuities
Numerical example
Payments of 10 made at end of each month for next 5 years.

Calculate their present value at (i) 8% p.a. effective, and (ii) 8%
p.a. convertible half-yearly.
There are at least two ways to do these questions:
1. work according to cash flows and change i
2. work according to i (p) and change cash flows
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i (p)
.
p
Non-Level Annuities
Increasing annuity (arithmetic progression)
Non-Level Annuities
Numerical example
Value the following set of cashflows at 10% p.a.: A payment of$10
at time 1, $20 at time 2, $30 at time 3, $40 at time 4. What is the
present value at time t = 0?
What is the present value at time t = 1?
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Non-Level Annuities
Increasing annuity (arithmetic progression): general case
Non-Level Annuities
Numerical example
Value the following series of payments at 10% p.a.:
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Non-Level Annuities
Increasing annuity (geometric progression)
Non-Level Annuities
Numerical example
You can invest in a bond that pays coupons that grow with
inflation. The coupon received at the end of the first year is
$25,000, and each annual payment will increase, with inflation, at
rate 2.5% p.a. There are 10 annual payments and the bond
matures in 10 years with a face value of $400,000 (not indexed to
inflation). What is the price of the bond at a valuation interest rate
of 8%p.a.?
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Non-Level Annuities
Increasing annuity with p payments per annum
Non-Level Annuities
Numerical example
Determine the present value of a 10 year annuity with half-yearly
payments in arrears at rate 2 p.a. in the first year, 4 p.a. in the
second year, . . . , 20 p.a. in the 10th year. Use a 10% p.a.
convertible half-yearly compound interest rate.
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Non-Level Annuities
Non-Level Annuities
Decreasing annuity
Numerical example
Value the following set of payments at 10% p.a: $40 at time 1, $30
at time 2, $20 at time 3, $10 at time 4.
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Continuous annuity
Remember: a(t) = e
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Rt
0
(s)ds
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Increasing continuous annuity (discrete increments)
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Increasing continuous annuity (continuously increasing)
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Relations and recursive formulas
Concatenate two present values:
Concatenate two accumulated values:
an+k = ak + v k an
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sn+k = sk (1 + i)n + sn
96/99
Recursive formula for the present value:
Recursive formula for the accumulated value:
an+1 = v (1 + an )
97/99
98/99

Another interpretation of the formula for an :
1 = i an + v n
99/99
sn+1 = 1 + (1 + i)sn

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Financial Mathematics

Module 1 Topic Notes

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models

Cash flow models

Cash Flow Models

Comparing cash flows

A cash flow is a series of payments (inflows or outflows) over a

Cash flows are characterised by their:

nature: inflow or outflow

probability (if contingent)

compare 2 securities or investments

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models

Cash Flow Models

make the cash flow clear; draw a time diagram

now: present value, sometimes NPV (Net Present Value)

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

Cash Flow Models

A Mathematical Model of Interest

Time value of money

How much would you pay to buy a security that is guaranteed to

What if there was a chance of default?

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

A Mathematical Model of Interest

the time preference of agents in the economy

risk (interest is raised to include a risk premium)

A(0): principal = the amount of money initially invested

Interest is a mathematical tool to embody

this is the accumulated amount of money at time t

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

A Mathematical Model of Interest

Let a(t) be the accumulation function:

a(t) the accumulated value at time t of an original investment

it is a scaled version of A(t) with a(0) = 1 and can thus be

it represents the way in which money accumulates with the

It,k = A(t + k) A(t),

In mathematical terms, the effective interest It,k accumulated

Module 1: Time Value of Money and Valuation of Cash Flows

Module 1: Time Value of Money and Valuation of Cash Flows

A Mathematical Model of Interest

A Mathematical Model of Interest

a(t) is modeled with the help of interest

effective interest is always defined as in (1)

however, interest can be expressed in many different ways,

each way has a different set of assumption

each definition may lead to different forms for a(t)

A Mathematical Model of Interest

Assumptions about interest

Simple and Compound Interest

Assumptions about interest

1. how much interest is paid?

1. how much interest is paid?

usually expressed as a percentage per year (per annum, p.a.)

2. how often is interest paid?

usually expressed as a percentage per year (per annum, p.a.)