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In this lecture
Compound interest, simple interest, time measurement conventions, present value, discount factor. Applications: T-bills.
Interest
Interest = time value of money Virtually all nancial transactions involve interest. Objective of this course is to provide precise mathematical descriptions of nancial transactions. Terminology, formulas, real-world examples.
(1)
Denitions
Consider an investment of an amount of money at interest. Principal: amount initially invested Accumulated value: amount after a period of time Amount of interest: difference between the accumulated value and the principal Measurement period: a unit of time, in most cases a year, sometimes a month, a day, etc.
Denitions II
Amount function : accumulated value at time of an original investment. For compound interest, we have
Denitions
Accumulation function : amount function for an original investment of $1. , where is the amount of the original investment . These denitions assume that the fund is only growing through interest, ie., no principal is added or withdrawn.
Formal denitions
Effective rate of interest during the rst period
(2)
(3)
and
500 400 300 A 200 100
4 0 100
2 4 6 8 10 t
14
Assumption
Amount functions for simple and compound interest are continuous, not stepwise. For example, if an investment of $100 earns simple interest of 10% per annum, paid at the end of each year, then the amount function at time is $105, not $100.
actual/actual
365 days in a year Actual number of days between dates Simple interest calculated on this basis is called exact simple interest, denoted actual/actual. This method is used for Canadian Treasury Bills.
30/360
360 days in a year Number of days between two dates is
(5)
where is the rst date, is the second date. Simple interest calculated on this basis is called ordinary simple interest, denoted 30/360.
actual/360
360 days in a year Actual number of days between dates Simple interest calculated on this basis is called Bankers Rule, denoted actual/360. This method is used for U.S. Treasury bills
Present value
Present value: two equivalent formulations. How much is a promise of a future payment worth now? How much should I invest now to have at a certain point in the future?
(6)
Discount factor is
1 year after the issue, and coupon plus the face value (8)
Formal denitions
Discount factor:
Recall: is the accumulated amount of an investment of at time 0. Present value of $1 payable at time is
For the Treasury note, the price is the sum of present values of the payments from the security.
Real world
1. Historical rates 2. What and who determines the rates
Historical Rates
Key rates of interest, last 10 years
Sources - History
10 year historical interest rates
http://www.bankrate.com/gookeyword/news/fed/fedchart.asp
Reserve requirements
http://www.federalreserve.gov/monetarypolicy/reservereq.htm
Summary
Reading for the quiz next Tuesday: Chapter 1 (1.1-1.6) of the textbook. There is no homework; practice with the textbook problems. Thank you!