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Financial Mathematics: Interest Rates Explained

The document outlines key concepts in financial mathematics, focusing on nominal and effective interest rates, discount rates, and the time value of money. It explains the relationships between these rates and provides formulas for calculating simple and compound interest. Additionally, it includes examples for converting between effective rates and calculating accumulated values.

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harveywanje
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7 views3 pages

Financial Mathematics: Interest Rates Explained

The document outlines key concepts in financial mathematics, focusing on nominal and effective interest rates, discount rates, and the time value of money. It explains the relationships between these rates and provides formulas for calculating simple and compound interest. Additionally, it includes examples for converting between effective rates and calculating accumulated values.

Uploaded by

harveywanje
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

FINANCIAL MATHEMATICS – CLEAN NOTES

1. NOMINAL RATE OF INTEREST

Two types of interest rates arise in time value of money problems:

(i) Nominal Rate, i(s)

- Rate of interest per unit time (e.g., per year).

- Does not depend on the actual length of interest conversion periods.

- Also called the quoted or stated annual rate.

The nominal rate i(s) gives the interest per unit time.

2. EFFECTIVE RATE OF INTEREST

This is the actual rate earned over a specific interest period.

Definition:

If a sum C invested at time t0 grows to C(1 + i(h)) at time t0 + h,

then i(h) is the effective rate for period h.

If h = 1 → annual effective rate.

3. DISCOUNT RATE

Discount rate d is defined as:

d = (Amount of interest or discount) / (Amount at beginning of period)

Discounted value:

C(1 - d)

Relationships:

i = d / (1 - d)

d = i / (1 + i)
4. RELATIONSHIP BETWEEN NOMINAL & EFFECTIVE RATES

(1 + i(h)) = (1 + i(s))^(h/s)

If nominal rate i_nom is compounded m times per year:

i_eff = (1 + i_nom/m)^m - 1

5. TIME VALUE OF MONEY

Simple Interest:

C(t) = C(1 + it)

Compound Interest:

C(t) = C(1 + i)^t

6. CONVERTING BETWEEN EFFECTIVE RATES

Example:

Annual vs Monthly:

(1 + i_year) = (1 + i_month)^12

7. EXAMPLES

Example 1:

Find monthly rate equivalent to 10% annual effective rate:

1.10 = (1 + i)^12

Example 2:

Amount grows to 100(1+i)^2 in 2 years.

Solve (1 + i)^2 = something to find semi-annual effective rate.

8. ACCUMULATED VALUE EXAMPLE

Value of Ksh 100 at 10% per annum effective:

100(1.10) = 110
9. CAPITAL & INTEREST CONCEPTS

- Capital/Principal: amount invested/borrowed.

- Interest: payment for use of money.

- Discount: interest deducted in advance.

- Appraisal techniques used for evaluating projects.

10. LOAN EXAMPLE

A company borrows and repays after 6 months with interest.

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