CHAPTER THREE
3. Sequences, Series and Mathematics of Finance
3.1. Sequences and Series
3.1.1. Arithmetic sequences and series
An arithmetic sequence is a sequence in which each term after the first, a1, is equal to the sum of
the preceding term and the common difference, d. The terms of the sequence can be represented
as follows.
a 1 , a1 +d , a1 +2 d , .. .
To find the next term in an arithmetic sequence, first find the common difference by subtracting
any term from its succeeding term. Then add the common difference to the last term to find the
next term in the sequence.
The nth term of an arithmetic sequence can be found by using a formula if the first term and the
common difference are known. This type of formula is called a recursive formula. This means
that each succeeding term is formulated from one or more previous terms.
first term a1 a -11
second term a2 a+d -11 + 1(4) = -7
third term a3 a + 2d -11 + 2(4) = -3
fourth term a4 a + 3d -11 + 3(4) = 1
fifth term a5 a + 4d -11 + 4(4) = 5
nth term an a + (n-1)d -11 + (n - 1)4
The nth term of an arithmetic sequence with first term a1 and common difference d is given by the
following formula.
a n=a1 +(n−1 )d
Notice that the preceding formula has four variables: an, a1, n, and d. If any three of these are
known, the fourth can be found. By definition, the n th term is also equal to an-1 + d, where an-1
is the (n-1)th term. That is, a n=a1 +(n−1 )d .
Example 3.1: Find the 68th term in the sequence 16, 7, -2,…
1
First find the common difference.
7−16=− 9 − 2−7=−9
The common difference is -9. Then, use the formula for nth term of an arithmetic sequence.
a n=a1 +(n−1 )d
a 68=16+(68−1 )(−9 ) n=68 , a1 =16 , and d =−9
= −587
An arithmetic series is the indicated sum of the terms of an arithmetic sequence. The lists below
show some examples of arithmetic sequences and their corresponding arithmetic series.
Arithmetic sequence Arithmetic series
3 , 8 , 13 , 18 , 23 3+8+13+18+ 23
1 1
2 4
, , 0 ,− ,−
1
4
1
2
1 1
+ +0+ −
2 4
1
4
+ −
1
2 ( )( )
a 1 , a2 , a3 , a4 ,. . ., a n a 1 +a 2 +a 3 +a 4 + .. .+a n
The symbol
Sn is used to represent the sum of the first n terms of the series. To develop a
S
formula for n for an arithmetic series, a series can be written in two ways and added term by
S
term, as shown below. The second equation for n given below is obtained by reversing the
order of the terms in the series.
Sn= a1 + (a1+d)+(a1+2d)+. .+(an−2d)+(an−d)+ an ¿ 2S = (a +a )+(a +a )+(a +a )+. .+(a +2d)+(a +d)+ a ¿ n(a1+an)
n 1n 1n 1n 1 1 1
Sn= an +(an−d)+(an−2d)+. .+(a1+2d)+(a1+d)+ a1 ¿ 2S =n a +a There are ntermsin theseries,all ofwhich are (a +a )¿ ¿¿Therefore,Sn= 2 ¿¿
n ( 1 n) 1n
¿
The sum of the first n terms of an arithmetic series is given by the following formula.
n
Sn = ( a1 + an )
2
Example 3.2: Find the sum of 27 terms in the series -14 – 8 – 2 - …. + 142
2
n
Sn = (a1 +an )
2
27
S27= (−14+142 ) n=27 , a1 −14 , and a 27=142
2
=1728
When the value of the last term, an, is not known, you can still determine the sum of the series.
Using the formula for an arithmetic sequence, you can derive another formula for the sum of an
arithmetic series.
n
Sn = ( a1 + an )
2
n
Sn = [ a1 +( a1 +( n−1) d ] an =a 1 +( n−1 )d
2
n
Sn = [ 2 a 1 +( n−1) d ]
2
Example 3.3
Celeste Bay will be a freshman at the University of Kentucky in the fall. Starting one month
from today, she plans to withdraw $10 from her savings account, and then increase her
withdrawal by $10 each week so that she can purchase items for college. If her account has a
balance of $1200 today, how long will it take her to empty her savings account?
Let
Sn = the amount of money that is currently in the savings account, $1200.
Let a 1= the first withdrawal of $10. In this example, d = 10.
We want to find n, the number of weeks that it will take to empty the savings account.
3
n
Sn = [ 2 a 1 +(n−1)d ]
2
n
1200= [ 2(10)+(n−1 )10 ] S n =1200 , a1 =10 , and d=10
2
2400=n [ 20+(n−1)10 ] Multiple each side by 2 .
2400=n(20+10 n−10) Simplify .
2400=n(10+10 n )
0=10 n2 +10 n−2400
0=n2 +n−240 Divide each side by 10 .
0=(n−15)( n+16) Factor .
n−15=0 or n+16=0
n=15 n=−16 −16 is not possible answer .
Thus, it would take Celeste 15 weeks to empty her account.
3.1.2. Geometric Sequences and Series
The ratio of successive terms in a geometric sequence is a constant called the common ratio,
denoted r.
A geometric sequence is a sequence in which each term after the first, a1, is the product of the
preceding term and the common ratio, r. the terms of the sequence can be represented as follows,
where a1 is nonzero and r is not equal to 1 or 0.
a 1 , a1 r , a1 r 2 ,. ..
The common ratio of a geometric sequence can be found by dividing any term by the preceding
term. Then multiply the last term by the common ratio to find the next term in the sequence.
Example 3.4: Find the next three terms in the geometric sequence 27, 135, 675, …
First find the common ratio.
135÷27=5 675÷135=5
The common ratio is 5.
Then, multiply the third term by 5 to get the forth term, and so on.
675×5=3375 3375×5=16875 16875×5=84375
The next three terms are 3375 , 16875 , and 84 , 375.
As with arithmetic sequences, geometric sequences are also recursive. Successive terms of the
geometric can be expressed as the product of the common ratio the previous terms. Thus, it
4
follows that each term can be expressed as the product of a1 and a power of r. The terms of a
geometric sequence for which a a1 = 3 and r = 4 can be represented as follows.
First term a1 a1 3
Second term a2 a1r 3.41 = 12
third term a3 a1 r2 3.42 = 48
fourth term a4 a1r3 3.43 = 192
fifth term a5 a1r4 3.44 = 768
nth term an a1rn-1 3.4n-1
The nth term of a geometric sequence with first term a1 and common ratio r is given by the
following formula.
a n=a1 r n−1
Example 3.5
1 1
1, , ,...
3 9
Find the 14th term in the sequence
First find the common ratio.
1 1 1 1 1
÷1= ÷ =
3 3 9 3 3
1
3
The common ratio is
Then use the common formula for the nth term of the geometric sequence.
a n= a1 r n−1
a 14=1
3 ( )
1 14 −1
n=14 , a1 =1 , and r=
1
3
¿ ( )
1 13
3
1 1
13
or
3 1 ,594 , 323
5
A geometric series is the indicated sum of the terms of a geometric sequence. The lists below
show some examples of geometric sequences and their corresponding geometric series.
Geometric Sequence Geometric Series
1 ,4 , 16 , 64 , 256 1+4+16+64+256
1 1 1 1 1 1
2 ,1, , , 2+1+ + +
2 4 8 2 4 8
a 1, a2 , a3 , a4 , .. . , an a 1 +a 2+a3 +a 4+...+an
6
To develop a formula for the sum of the series, Sn, write an expression for Sn and for rSn, as
shown below. Then subtract rSn from Sn and solve for Sn.
2 n−2 n−1 n
Sn=a1+a1r+a1r +. .+a1r +a1r ¿ Sn−rSn=a1 ¿ a1−a1r
¿ 2 n−2 n−1 n ¿ n ¿ ¿Sn= Divide each side by 1−r, r≠1.¿
−(rSn= a1r+a1r +.. +a1r +a1r +a1r ¿ Sn(1−r)=a1−a1r Factor ¿ 1−r
The sum of the first n terms of a geometric series is given by the following formula
a1 −a 1 r n
Sn = , r≠1
1−r
Example 3.6:
Find the sum of the first eight terms of the series 3−6+12+. ..
First, find the common ratio.
−6÷3=−2 12÷(−6 )=−2
The common ratio is -2. The find the sum.
a 1−a1 r n
Sn =
1−r
3−3(−2)8
S8 = n=8 , a1 =3 , r=−2
1−(−2)
3−3 (−256 )
=
3
=−255
Thus, the sum of the first eight terms is -255.
Infinite geometric series
If Sn is the sum of n terms of a series, and S is a number such that S > Sn for all n, and S - Sn
approaches zero as n increases without limit, then the sum of the infinite series is S.
6
lim S n=S
n→∞
The formula for the sum of the first n terms of a geometric series can be written as follows.
a1 −a 1 r n
Sn = , r≠1
1−r
Suppose n→ ∞ ; that is, the number of terms increases without limit. If |r|>1 , r n increases
without limit as n→ ∞ . However, when |r|<1 , r approaches 0 as n→ ∞ . Then, Sn approaches
n
a1
the value 1−r . The series is convergent if |r|<1 and divergent if |r|>1 . If r = 1, the test provide
no information.
The sum, S, of an infinite geometric series for which |r|<1 is given by the following formula.
a1
Sn =
1−r
1 1 1
+ + +. ..
Example 2.22: Find the sum of the series 25 250 2500
1 1 a
a 1= and r= Sn = 1
In the series, 25 10 . Since |r|<1 , 1−r .
1
a1 25 2
Sn = = =
1−r 1 45
1−
10
2
45
The sum of the series is
7
3.2. Simple and compound interests, Present value,
Annuities
3.2.1. Simple and compound interests
Time is money. If you borrow money you have to pay interest on it. If you invest money in a
deposit account you expect to earn interest on it. From an investor’s viewpoint the interest rate
can be looked on as the ‘opportunity cost of capital’. If a sum of money is tied up in a project for
a year then the investor loses the interest that could have been earned by investing the money
elsewhere, perhaps by putting it in a deposit account.
Simple interest is the interest that accrues on a given sum in a set time period. It is not reinvested
along with the original capital. The amount of interest earned on a given investment each time
period will be the same (if interest rates do not change) as the total amount of capital invested
remains unaltered
Compound interest is interest which is added to the original investment every time it accrues.
The interest added in one time period will itself earn interest in the following time period. The
total value of an investment will therefore grow over time.
Suppose that an individual wishes to invest a sum of £10,000 over a period of three years and
that the annual rate of interest is 5%. After one year, the interest on the investment amounts to
5% of £10,000, which is £500. If the investment is subject to simple interest, then the return on
the investment would be £500 per year for each subsequent year. The total amount of interest
earned over the five-year period in this case is 5 × £500 = £2,500. However, most financial
investment products use compound interest as a means of enticing their customers not to
withdraw the interest earned after the first and subsequent years from the accumulated value of
their investment. When interest is compounded annually, the amount of interest earned in the
second year is 5% of £10,500, which is the sum of the initial investment (£10,000) and the first
year’s interest (£500). The interest earned in the second year is therefore £525 and so the value
of the investment at the end of the second year is £10,500 + £525 = £11,025. Finally, at the end
of the third year the investment is worth £11,025 plus 5% of £11,025 interest giving a total of
£11,576.25.
There is a formula that can be used to determine the future value of an investment. Let P0 denote
the value of the initial investment. This is sometimes known as the principal. Let Pt denote the
value of the investment after t years. If the interest on the principal is compounded annually, at
an interest rate r (written as a decimal or fraction), then after one year the investment is worth
P1=P0+rP0=P0 (1+r)........................................................................................(1)
Similarly, after the second year the investment is worth
8
P2 =P1 +rP 1 =P 1 (1+r )........................................................................................(2)
Substituting equation (1) in to equation (2) we have
P2 =[ P0 (1+r) ] (1+r )=Po (1+r )2 . . .. .. . .. .. . .. .. . .. .. . .. .. .. . .. .. . .. .. . .. .. . .. .. . .. .. . .. .. .. . .. .. . .. .. . ..(3 )
t
In general, one can show that Pt =P o (1+r ) ........................................................(4)
Now suppose that the interest is compounded semi-annually (six monthly intervals). In this case,
(4) would have to be modified to
r
Pt =P o(1+ )2t ..............................................................................................................(5)
2
Similarly, one can show that if interest is added monthly, the value of the investment after t years
is
r
Pt =P o(1+ )12t .............................................................................................................(6)
12
If this argument is continued and interest is compounded n times a year, then we have the
formula
r
Pt =P o(1+ )nt ..............................................................................................................(7)
n
If n is very large then we are approaching the situation in which interest is added continuously
(at every instant of time) instead of at discrete moments in time. If we make the substitution m =
n/r in (7), then we have
( ) ..............................................................................................................(8)
mrt
1
Pt =P o 1+
m
[ m]
m rt
P =P ( 1+ ) ..........................................................................................................(9)
1
t o
Note that
( ) →m as m→∞
m
1
1+
m
If we allow m →∞ in (8) (which is equivalent to allowing n →∞ in (7) since r is held constant),
then we obtain the formula for the continuous compounding of interest:
9
P(t )=P o e rt ......................................................................................................................(10)
In this formula, t need no longer be a positive integer. It can take any positive value. For negative
growth rates, such as depreciation or deflation, the same formulae apply but with t or r negative.
Example 3.7
Suppose that the sum of $100 is invested at an annual rate of interest of 10%. Calculate the value
of the investment in five years’ time if the interest is compounded (a) annually, (b) semiannually,
(c) continuously.
Solution
1. We apply the formula (4) with P0 = $100, r = 10% = 0.1and t =5. Inserting these values
into the formula gives
P5 =100(1+0 . 10)5 =$ 161. 05
2. We apply the formula (5) with P0 = $100, r = 10% = 0.1and t =5. Inserting these values
into the formula gives
0 .10 2×5
P5 =100(1+ ) =100 (1. 05 )10=$ 162. 89
2
3. We apply the formula (10) with P0 = $100, r = 10% = 0.1and t =5. Inserting these values
into the formula gives
S=100 e0 . 10×5 =100 e 0. 5 =$ 164 . 87
Example 3.8
The value of an asset, currently priced at $250,000, is expected to increase by 12% a year.
1. Find its value in ten years’ time.
2. After how many years will it be worth at least 1.25 million dollars?
Solution
1. We use the formula (10) with P0 = $250, 000, r = 12% = 0.12, and t = 10. Inserting these
values into the formula yields
P10=250 , 000(1+0 .12)10
250 , 000(1 .12 )10
¿ $776 , 462 .05
Therefore, after 10 years the asset will be worth $776,462.05.
10
2. In this part of the question, we use the formula (4) again but this time we know Pt =
1,250,000 and we need to determine the value of t. We need to find the value of t for
which
1,250 ,000=250 ,000(1+0.12)t
5=(1.12)t
Take natural logarithms of both sides:
ln 5=ln(1 .12 )t =t ln1 . 12
ln 5
Therefore , t= =14 . 20
ln 1 .12
So after 15 years, the asset will be worth at least 1.25 million dollars.
3.2.2. Present value
Discounting is the process of determining the today’s or present value of some amount in the
past or in the future. Why would you be interested in present values?
An important economic application of sequences is the determination of the present value of a
sum of money to be received at some point in the future. This computation is the inverse of
determining how much money one would have in the future up on investing a certain amount
now. The following formula, which determines the present value PVt of amount V to be received
t periods from now when the interest rate is r per period and compounding occurs at the end of
each period:
V
PV t =
(1+r )t
t
Notice that for r >0 the denominator of (1+r ) becomes larger as t becomes larger, and thus t
PV
, gets smaller. In other words, receiving a certain sum in the future has a lower PV the longer one
has to wait for the payment. This is natural since the further in the future one receives the fixed
amount V, the less one would need to invest now to replicate that future payment. For this reason
1
economists refers to the discounting of future benefits and the value (1+r ) is referred to as the
discount rate, or discount factor. Moreover, (1 + r) t grows without bound as t →∞ , and so
PV t →0 as t →∞ .
Example 3.9: Compute the PV of $500 to be received in one year’s time given the interest rate
of 8%.
11
V V 500 500
PV 1 = = = = =$ 462. 96
(1+r)1 (1+r ) 1+0. 08 1. 08
Example 3.10: Compute the PV of receiving $1 million at the end of each of the next three years
given the interest rate of 12%.
$ 1000000
=$ 892 , 857 . 14
PV of $1 million at the end of the 1st year = 1 . 12
$ 1000000
2
=$ 797 , 193 . 88
nd
PV of $1 million at the end of the 2 year = ( 1. 12 )
$ 1000000
3
=$ 711 ,780 . 25
rd
PV of $1 million at the end of the 3 year = ( 1. 12 )
Total =$2,401,831.27
So the PV of the sum of these three annual payments of $1million is =$2,401,831.27
Example 3.11
Determine the present value of $25,000 to be received in the future in the following situations. In
each case assume that the annual interest rate is 8%.
i. Payment is received at the end of one year’s time given annual compounding
ii. Payment is received at the end of 20 year’s time given annual compounding
iii. Payment is received at the end of one year’s time given quarterly compounding (i.e.,
every three months)
iv. Payment is received at the end of 20 year’s time given quarterly compounding
v. Payment is received at the end of one year’s time given continuous compounding
vi. Payment is received at the end of 20 year’s time given continuous compounding
Solution
Using the formulas
V
PV t =
[ ]
nt
r
1+( )
n For discrete compounding
−rt
PV t =Ve
for continuous compounding
we get
12
25 , 000 25000
PV 1 = = =$ 23 ,148 . 15
i. 1+0 . 08 1 .08
25 , 000 25000
PV 20 = 20
= =$ 5 , 363. 70
ii. (1+0. 08 ) ( 1. 08 )20
25 , 000 25 , 000
PV 1 = = =$ 23 , 096 .14
[1+( 0 . 08 4 )]
4
( 1 . 02)4
iii.
25 , 000 25 , 000
PV 20 = = =$ 5 ,127 . 74
[ 1+( 0 . 08 4 )]
80
( 1 . 02)80
iv.
−0 . 08
v. PV 1 =25 , 000 e =$ 25 , 000(0 . 9231163 )=$ 23 , 077 .91
−1 . 6
vi. PV 20 =25 , 000 e =$ 25 ,000 (0. 2018965 )=$ 5 , 047 . 41
As the applications above indicate, computing the present value streams of payments or periodic
payments can be quite tedious. These computations, however, are essentials to banks and other
financial institutions that need to determine the equivalence of streams of payments to a fixed
current amount.
3.2.3. Annuities
Many times individuals become concerned that their estate or assets will be used up or dissipated
prior to their death, leaving nothing to live on. Also as we age the burden of management of our
assets and especially investments in securities become difficult, if not impossible. An annuity
can help alleviate these problems and concerns. Hence, an annuity is a contract or agreement on
the part of another person or company to pay another person (the annuitant) a fixed sum at
periodic intervals usually for as long as the person lives or for a specified term of years. Then, an
annuity is an insurance contract, and this contract is created when an individual makes a payment
(or a series of payments) called premium. In return for this premium, the insurer guarantees
periodic payments back to the individual, either beginning immediately or at some future date.
As a result, the most important reason for purchasing an annuity is, therefore, to ensure the
annuitant an “income” for the rest of his or her lifetime without the burdens and risks of
management.
Types of Annuities:
Generally, there are two (2) types of annuities, commercial annuities and private annuities.
Commercial Annuities: These annuities are sold by companies, primarily insurance companies.
The annuity may be purchased for a single premium, in which case the annuity payments
frequently commence immediately or the annuity payments may deferred to commence at some
13
future date. Many times we see the date on which the annuitant reaches age 65 as a beginning
date. The annuity may also be purchased where the purchaser pays a monthly or other periodic
premium. In that case the annuity payments usually commence at a future date.
Private Annuities: the term “private annuity” by itself generally refers to an annuity (a payment
in cash of a sum certain at least annually) for the lifetime of the annuitant by a purchaser of the
property who does not otherwise issue annuities. The private annuity is contract between the
annuitant and someone other than an insurance company or entity regularly engaged in the
business of issuing annuity contracts. The most typical situation where a private annuity is used
is when an elderly family member transfers assets to a younger family member who makes an
unsecured promise to pay a lifetime annuity to the elderly family member.
Example 3.12: An annuity will pay $8,000 at the end of each year for 5 successive years, the
first payment being 12 months from the initial purchase date. What is the maximum price any
rational investor would pay for such an annuity if the opportunity cost of capital is 10%?
Solution
The maximum purchase price will be the PV of the stream of returns, using 10% as the discount
rate. Therefore (in $):
8000 8000 8000 8000 8000
PV = + + + +
1 . 1 (1. 1)2 (1 .1 )3 (1. 1)4 (1. 1)5 This is a geometric series with five terms. The
8000
first term a is 1 .1 (not 8,000).
1
The constant ratio r is 1. 1 Therefore
PV =
8000
a (1−r n ) 1. 1
=
[ ( )]
1−
1 5
1 .1
1−r 1
1−
1 .1
8000 ( 1−0 . 6209211) 8000(0 . 3790789)
= =
1 1. 1−1
1. 1(1− )
1 .1
3032 .6312
= =$ 30326 .31
0 .1
14