Financial Mathematics

Lesson 7

Prof. María Jesús Segovia Vargas

1. Definitions
2. Classification
3. Valuation of Simple Annuities of C euros
(constant)
1. Ordinary annuity
2. Annuity due
3. Perpetuities
4. Deferred annuity
5. Forborne annuity
4. Annuities where payments vary (variable)
1. Geometric progression
2. Arithmetic progression
5. Fractional annuities
6. Continuous annuities

2
ROBERT BROWN, STEVE KOPP,
PETR ZIMA: Mathematics of
Finance. Mc Graw Hill.

Chapter 3 and 4

3
There are many situations where people make regular deposits into an account or regular payments on
a loan, or regular withdrawals from a fund. If the deposits, payments or withdrawals are made at equal
intervals of time and are the same amount (or change according to a given schedule) each period, we
end up with what is referred to as an annuity.

You have already studied annuities when studying the Net Present Value. In this case you have regular
cashflows.

Therefore, an annuity is a sequence of periodic payments, usually equal, made at equal intervals of
time, [t0,tn], therefore the payments are repeated regularly in time and are of the same amount or
change according to a given schedule.

The time between successive payments of an annuity is called the payment Interval.

The time from the beginning of the first payment interval to the end of the last payment interval is the
term of an annuity.

4
Graphical Representation: We display an annuity on a time diagram

Remember:

• The intervals have to be consecutive.

• Each capital is associated to a time interval, therefore, we have:

Time interval (t0, t1) →associated capital C1

Time interval (t1, t2) →associated capital C2

….

Time interval (tn-1, t n) →associated capital Cn

Elements of an annuity

- The sums of money (financial capitals) are called the terms (termino) of the
annuity.
- The date of the first payment is the origin of the annuity.
- The date of the last payment is the end of the annuity.
- The time from the beginning of the first payment interval to the end of the last
payment interval is called the term of an annuity. It is the lifespan or the
duration of the annuity. It is denoted by n. Therefore we have: n intervals, n
periods, n sums of moneys.
- Each interval is a period in the annuity.

5
1.- If the term of an annuity is fixed it is called an annuity certain, otherwise it is
contingent annuity (for example, life annuity, its payments are qualified by given
conditions which usually have random character)

2.- When its periodic payments are made at the end of each payment interval, the
annuity is called an ordinary annuity or immediate annuity (i.e. the payments are
made in arrears).

If the payments are made at the beginning of each payment interval, the annuity is
called an annuity due.(i.e. the payments are made in advance).

3.- A temporary annuity: its payments have a limited duration (by a contract, e.g. a 20-
year annuity).

In a perpetuity annuity (perpetuities) there is no contractual limit of duration (e.g.

dividends of a common stock).

4.- A deferred annuity is an annuity whose first payment is due at some later date. So,
in a deferred annuity its payments begin not in the first period but after several
periods of a fixed deferment. Therefore, the annuity is valued before its origin.

In a forborne annuity, the accumulated value is calculated k-periods later after the nth
payment. Therefore, it is valued after its end.

5.- If the time intervals are finite, the annuity is discrete. If the time intervals are
infinitesimal, the annuity is continuous.

6.-When the payment interval and interest compounding period coincide, the annuity
is called a simple annuity; otherwise it is a general annuity.

7-An annuity is constant if the sums of money or payments are equal. Otherwise it is
variable.

6.- The payments of an annuity can be annual (annual annuity), monthly (monthly
annuity), similarly quarterly annuity, daily annuity, etc.

6
 Present value of an annuity (PV) or discounted value:

It is a price of a given system of payments if we price it by means of the interest rate at

the present time t=0 (beginning of the term).

Future value or accumulated value of an annuity: it is the price of a given system of

payments if we price it by means of the interest rate at a given future time t=n. (at the
end of the term)

In the general case (Cs and is vary each period), we can use any financial law to value
the annuity.

The financial value would be:

n
F  ts , p 
V   C s
s 1 F  t , p 
S

Therefore, it is the financial sum of all the payments of the annuity at point α (any
point in time). Remember that the financial sum is a financial capital.

7
Normally, the financial value is calculated at the origin or at the end:

•t0- the origin of the annuity. This is the present value or discounted value:
n
F  ts , p 
V0  C
s 1
s
F  t0 , p 
S

•tn- the end of the annuity. This is the future value or the accumulated value:
n
F  ts , p 
Vn  C
s 1
s
F  tn , p 
S

Vα, V0 and Vn are financial sums, and are therefore equivalent financial capitals but
valued at different points in time.

Though we can use any financial law to value the annuity, normally we are going to use
compound interest.

If we value with L(t,p)=(1+ir)(p-t) where the variable interest rates are r=1,2,3,…,n in all
periods.

Note that the rates are different in each period!!!

n r
For example, in this case the present value is:
 Cr  1  ih 
1
V0 
r 1 h 1

8
All the annuities we are going to study are CERTAIN.

Classical annuity calculus produces explicit formulas for PV and FV of annuities if one
assumes that:

• the interest rate i over one payment (=interest) period remains the same for all
payments periods, i.e., it=i for all t.

• and the payments are equal or they change following a given schedule.

First we are going to study the case for equal payments (CONSTANT ANNUITY).

9
3.1. Ordinary annuity with Periodic Payments (C) and Interest Rate (i): L(t,p)=(1+i)(p-t)

 Present value of an ordinary simple annuity,V0

Note that in the time diagram the payments are situated at the end of each time
interval (ordinary annuity)

We are going to develop a general formula for the discounted value for an ordinary
simple annuity using the sum of a geometric progression.

Let us consider an ordinary simple annuity of n payments of Є1. Let us denote the
discounted value of this annuity an i (read “a angle n at i”). This symbol is the discounted
value of n payments of Є1 using as focal date one period before the first payment.

• a means present value

• n means number of terms

• i is the interest rate

10
We display an ordinary annuity on a time diagram:

1 1 1 1

a 1 2 n-1 n

To obtain an i we calculate the financial sum (an equation of value /financial equivalence) at
the beginning of the term (0), accumulating each Є1 payment to the date of one period before
the first payment:

an i  (1  i ) 1  (1  i ) 2  (1  i ) 3  ...  (1  i )  ( n 1)  (1  i )  n

Remember (1+i)-1 is the discount factor with compound interest

The value of an i can be found as the sum of a geometric progression of n terms whose first
term is (1  i ) 1 and whose common ratio is r= (1  i ) 1 . We obtain:

(1  i ) 1  (1  i )  n (1  i ) 1 (1  i ) 1[1  (1  i )  n ]
an i  
1  (1  i ) 1 1  (1  i ) 1
1 i
if we multiply by , we get
1 i
1  (1  i )  n
an i 
i

Note that the symbol an i is the discounted or present value of the n payments of Є1 using
the date one interest period before the first payment is due as the focal date.

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The factor an i is called the discount factor for n payments or the discounted value of 1
monetary unit ($1, Є1) per period.

If we wish to determine the discounted value of n payments of C euros or dollars (monetary

units), we simply multiply C by an i . Thus the basic formula for the discounted value V0 of an
ordinary annuity is:

n r

V0   C 1  i   C 1  i   1  i   ...  1  i   
1 2 n

r 1
 
 1  i  1  1  i  1 1  i   n  1  1  i   n 
C C   C an i
 
1
 1  1  i   i 

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  Future value of an ordinary simple annuity V n

We are going to value the set of payments at the end of the term.

To develop a general formula we will use the sum of a geometric progression.

Let us consider an ordinary simple annuity of n payments of Є1. Let us denote the
discounted value of this annuity sn i (read “s angle n at i”). This symbol is the
accumulated value of n payments of Є1 using as focal date the nth payment.

We display an ordinary annuity on a time diagram:

1 1 1 1

1 2 n-1 n
S

To obtain sn i we calculate the financial sum (write an equation of value/financial equivalence)

at the end of the term, accumulating each Є1 payment to the date of the last payment:

13
• s means future value

• n means number of terms

• i is the interest rate

sn i  1  1(1  i )1  1(1  i ) 2  1(1  i )3  ...  1(1  i ) ( n  2)  1(1  i )

n 1

Remember (1+i) is the accumulation factor with compound interest.

The value of sn i can be found as the sum of a geometric progression of n terms whose first
term is 1 and whose common ratio is r=(1+i). We obtain:

(1  i ) n 1 (1  i )  1 (1  i ) n  1
sn i  
(1  i )  1 i

(1  i ) n  1
The factor sn i 
i

is called an accumulation factor for n payments, or the accumulated value of Є1 per

period.

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The relationship between the accumulated value and the discount value of an ordinary
simple annuity of n payments of Є1 is the following:

sn i  1  i  an i
n

an i  1  i 
n
sn i

To obtain the accumulated value Vn of an ordinary simple annuity of n payments of ЄC

each, we simply multiply C by sn i
n nr

Vn   C 1  i   C 1  i   1  i   ...  1  i  
n 1 n2 nn

r 1
 
 1  i  n 1 1  i   (1  i ) 0   1  i  n  1 
C C   C sn i
 1  i   1   i 

Note that V0 and Vn are both dated values of the same set of payments and thus they
can be made equivalent to each other using:

𝑉𝑛 = 𝑉0 (1 + 𝑖)𝑛

𝑉0 = 𝑉𝑛 (1 + 𝑖)−𝑛

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Example 1

Calculate the present value or discounted value and the future value of a 10 year
annuity whose term is Є1000. The maturity is situated at the end of each year and is
valued at 6% annual interest rate.

Example 2

Calculate the present value or discounted value of a 10 year annuity whose term is
Є1000 for the first five years and Є500 for the rest of the years. The maturity is
situated at the end of each year and is valued at 6% annual interest rate.

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Annuities with excel
Calculate the next present value of an ordinary simple annuity with C=500 euros,
quarterly payments, nominal interest rate J(4)=4% and lifespan, n=7 quarterly

It can be calculated through Excel financial function.

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3.2. Annuity due

An annuity due is an annuity whose periodic payments are due at the beginning of
each payment interval. The term of an annuity due starts at the time of the first
payment and ends one payment period after the date of the last payment.

The first payment is made immediately (at period 0).

If we value with L(t,p)=(1+ir)(p-t) where the variable interest rates are r=1,2,3,…,n in all
periods.

The present value is:

 ¨ 
n r

 V 0   C1   C r  1  ih 
1

  r 2 h2

The future value:

¨ n n
V f   C  1  i 
r 1
r
hr
h

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  Annuity Due with Periodic Payments (C) and Interest Rate (i): L(t,p)=(1+i) (p-t
 Present value of an Annuity Due

It is easy to recognize an annuity due as “slipped” ordinary annuity, that is, each of
the n payments of C has been moved one period to the left on the time diagram.

Thus we can simply write the formulas for the accumulated value and discounted
value of an annuity due by adjusting the equations of ordinary annuities for one
interest period.

an i  (1  i ) an i

 Future value of an Annuity Due

sn i  (1  i ) sn i

The relations between an annuity due and an ordinary annuity in compound interest
model is (1+i)

Consequently, the financial value of an annuity due is greater than the financial value
of an ordinary annuity because it is nearer the point in which we value:

V  V

Therefore, to obtain the discounted value and the accumulated value, Vo and V f , of
an annuity due of n payments of ЄC each, we simply multiply the previous expressions
by C:
¨  1  1  i   n 
V 0  C an i  C an i (1  i )  C 1  i   i


 
¨  1  i  n  1 
V  C sn  C sn i (1  i )  C 1  i   
f i  i 
 
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Annuity due with excel

 Calculate the Net Present Value (NPV) and future value (FV) of an annuity
due consisting of seven quarterly payments of €500 where nominal interest
rate is 4%

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3.3. Perpetuities: Lifelong annuity with C annual payments and i interest rate

A perpetuity is an annuity whose payments begin on a fixed date and continue forever.

It is meaningless to speak about the accumulated value of a perpetuity since there is

no end to the term of a perpetuity. Only the net present value is meaningful. The
discounted value is well defined as the equivalent dated value of a set of payments at
the beginning of the term of the perpetuity.

a) Ordinary simple perpetuity

The first payment at the end of the first interest period is made with payments
continuing forever.

Therefore, the discounted value of a Є1 ordinary simple perpetuity is:

1
a i  lim an i 
n  i

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To obtain the discounted value V0 of an ordinary simple
perpetuity of n payments of ЄC each, we simply multiply
C by a i

V0  C (1  i ) 1  C (1  i ) 2  C (1  i ) 3  ...  1 
1  1  i  1  1  i n 
  
r n

V0   C 1  i   lim C    C lim   C1
n  n   
r 1 
 i 
 i i
 
 
 C a i

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b) Simple perpetuity due

1  i 
a i  lim an i  lim an i 1  i  
n  n  i

1  i 
a i  a i 1  i  
i

Therefore, to obtain the discounted value V0 of a simple perpetuity due of n payments

of ЄC each, we simply multiply C by a i

C
V0  (1+i)
i

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3.4 Deferred Annuities

It is an annuity with its first payment due some time later than the end of the first interest
period. Therefore, we are going to value at a point in time before the origin of the annuity. The
time interval between the valuation point and the origin of the annuity is called period of
deferment (d). The period of deferment only affects the present value.

We are going to consider that the interest rate is the same for the period of deferment and for
the annuity.

 Firstly, we are going to consider that C=Є1.

a) An ordinary deferred annuity

We display an ordinary deferred annuity on a time diagram:

d C C C C

a 0 1 2 n-1 n

/ an i  1  i 
d d
an i

Note that (1+i)-d is the discount factor with compound interest for d periods

24
b) A deferred annuity due

/ an i  1  i  an i  1  i  1  i  an i  1  i 
d d d  d 1
an i

c) An ordinary simple perpetuity deferred for d periods:

1  i 
d

/ a i  1  i 
d
d
a i 
i
d) Simple perpetuity due deferred for d periods:

1  i 
/ a i  1  i  a i  1  i 
d d d

 Now, the payments are ЄC

Therefore, to obtain the discounted value V0 or V0 of a perpetuity deferred for d

periods of n payments of ЄC each, we simply multiply the previous expressions by C.

25
3.5. Forborne Annuities (mirror image of a deferred annuity)

It has a period of time after the last payment or deposit is made and before the time
when the accumulated value is calculated.

We are going to value the annuity at a point in time after the end of the annuity (that is h
periods after the last payment). This situation only affects the future value or accumulated
value.

We are going to consider that the interest rate is the same for the annuity and for the period
after the last payment.

 Firstly, we are going to consider that C=Є1.

a) An ordinary forborne annuity

We display an ordinary forborne annuity on a time diagram:

C C C C C h

0 1 2 n-1 n n+h
s

/ sn i  1  i  sn i
h
h

26
b) A forborne annuity due

h / sn i  1  i  sn i  1  i 1  i  sn i  1  i 
h h h 1
sn i

 Now, the payments are ЄC

Therefore, to obtain the future value Vn or Vn of a forborne annuity of n payments of

ЄC each, we simply multiply the previous expressions by C.

Note:

• Another way of calculating the future value of a forborne annuity is the following:

h / s n i  s n  h i  sh i
• Another way of calculating the present value of a deferred annuity is the following:

d
/ an i  an  d i  ad i

27
 ORDINARY (€1) DUE(€1) ORDINARY (€C) DUE (€C)

an i  (1  i )an i
MPORARY
1  (1  i )  n
an i  V0  C an i V0  C an i
NNUITY
has a limit)
i
Discount factor for n payments

sn i 
(1  i ) n  1 sn i  (1  i ) sn i Vn  C sn i Vn  C sn i
i
Accumulated factor for n
payments

sn i  1  i  an i
n

RPETUITY

1  i 
has no 1
mit) a i  a i  a i 1  i   C C
i V0  C a i  Vn  C a i  (1  i )
FV meaningless i i i

28
DEFERRED
/ an i  1  i 
d d
TEMPORARY an i Multiply by Multiply Multiply
ANNUITY (1+i) by C by C
It affects PV
DEFERRED
1  i 
d
PERPETUITY Multiply by Multiply Multiply
/ a i  1  i 
d
d
a i  (1+i) by C by C
i

FV meaningless

FORBORNE
h / sn i  1  i  sn i
h
ANNUITY Multiply by Multiply Multiply
(1+i) by C by C
It affects FV

The relations between an annuity due and an ordinary annuity

in compound interest model is (1+i)

The relations between the present value and the future value
of an annuity in compound interest model is (1+i) n

29
4.1 The payments form a geometric progression

First, we consider the annuity payments vary in terms of a common ratio, q>0 and
interest rate (i). That is, each succeeding payment of an annuity increases or decreases
at a constant percentage of the preceding payment. Therefore, the payments will form
a geometric progression. To calculate the present or accumulated value of the
payments, we will employ the formula for the sum of a geometric progression.

a) Ordinary annuity

 Present value

n
  n 1
V0   Cq  1  i   c 1  i   cq 1  i   ....  cq n  2 1  i   cq n 1 1  i 
r 1 r 1 2 n

r 1

c 1  i   cq n 1 1  i  q 1  i 
1 n 1


1  q 1  i 
1

n
 q 
1  
1  q n 1  i 
n

V0  A C , q  n  1 i 
i C C
1 i  q 1 i  q

30
 Future Value

1  i 
n
n
 qn
Vn   Cq  r 1
1  i   S C , q  n i  1  i  A C , q n i
nr n
C
r 1 1 i  q

31
 Future Value

1  i 
n
n
 qn
Vn   Cq  r 1
1  i   S  C , q  n i  1  i  A C , q  n i
nr n
C
r 1 1 i  q

32
 Specific case: (1+i)=q

In this specific case, we will obtain an indeterminate form.

To solve it we can apply L´Hopital. Another possibility is to discount (if we are

calculating the present value) or to accumulate (if we are calculating the future value)
each financial capital.

 Present value

  q 
n
   q 
n

 1      1    
V0  lim  C 1 i  C  1 i  
q  1 i   1 i  q  lim 1  i  q
q  1 i   
   
   
L´ Hopital

C n 1  i 
1
  A C , 1 i  n i
 
 Future Value:

 1  i  n  q n   1  i  n  q n 
  Cn 1  i  
n 1
Vn  lim  C   C lim 
q  (1 i )  1 i  q  q  (1 i )   Applied
   1 i  q  L´ Hopital
 1  i 
n
 S C ,1 i   n i A C ,1 i   n i

33
b). Ordinary Perpetuities where payments vary in terms of a common ratio, q>0 and
interest rate (i).

Only the net present value is meaningful.

  q 
n
   q n 
  1     1   
  1 i  C   1 i  
V0   Cq  r 1
1  i   lim A c ,q n i  lim  C
r

r 1 n  n  1 i  q  lim
n   1  i  q 
   
   
to solve it  1  i  q
1
 C  A C ,q  i
1 i   q 1 i  q
Therefore,

1
A c ,q  
1 i  q

34
c). Annuity due where payments vary in terms of a common ratio, q>0 and interest
rate (i).

Remember that the relationship between the ordinary annuity and the annuity due is
(1+i). Therefore the present and future values are:

A c , q  n i  1  i  A c , q  n i

S c , q  n i  1  i  S c , q  n i  1  i  A c , q n i
n

Specific case: (1+i)=q

A c ,1 i   n i  1  i  A c ,1 i   n i  C n

S  c ,1 i   n i  1  i  A c ,1 i   n i  C n 1  i 
n n

d). Perpetuity due where payments vary in terms of a common ratio, q>0 and interest
rate (i).

C 1  i 
A c , q   i  lim A c , q  n i  lim 1  i  A c , q  n i  1  i  A c , q   i 
n 
n 
n  1 i  q
remember q 1  i 
In annuities where payments vary, they can also be deferred annuities or forborne
annuities.

35
4.2. Payments vary in arithmetic progression, (d )and interest rate, (i)

Now, we will consider that the payments vary in arithmetic progression, that is,
annuities where payments increase and decrease every period by a constant amount.

We consider that:

•i: the interest rate is constant

• d: (common difference) can be positive (in this case payments increase) or negative
(in this case the payments will decrease). In this last case, we have to make sure the
𝐶
last term is positive(C+(n-1)d>0⇒d> − 𝑛 −1

a) Ordinary annuity where payments vary in arithmetic progression(d )and interest

rate, (i)
Vn
 Present value
V0

We are not going to study the mathematical proof to obtain this formula

 
n
V0    c   r  1 d  1  i 
r

r 1

d   1  1  i    dn 1  i   n 
n

 c    
 i   i  
  i 

36
 d dn
V0  A c ,d ) n i  (C  )an i  1  i 
n
  i i

 Future value

 
n
Vn    c   r  1 d  1  i 
nr

r 1

  1  i   1   dn 
n
 d
 c     
 i  i   i 


Therefore:

d dn
Vn  S c , d n i  (1  i ) n A c ,d n i  (C  ) sn i 
i i

37
b)Ordinary Perpetuity (n→∞)where payments vary in arithmetic progression, d, and
interest rate (i).

Only the present value is meaningful.


Present value 

   c   r  1 d  1  i 
r
V0 
r 1

 d   1  1  i 
n
  dn 1  i   n   d 1
 lim   c       c   
n   i      

i   i  i  i 
Therefore
 d 1
A c , d   i   c    
 i  i 
c) Annuity due where payments vary in arithmetic progression(d )and interest rate, (i)

V0  A c , d ) n i  A c , d ) n i (1  i )
   
Vn  S S (1  i )  A c , d ) n i (1  i ) n  A c , d ) n i (1  i )(1  i ) n
 c ,d ) n i   c,d ) n i     

d)Perpetuity due (n→∞)where payments vary in arithmetic progression, d, and

interest rate (i).

d 1  i 
A c , d  i  (1  i ) A c , d  i  (C  )
i i

38
Geometric Progression q>0

ORDINARY (€C) DUE (€C)

TEMPORARY
1  q n 1  i 
n
ANNUITY Multiply by (1+i)
V0  A C , q  n i C 
(n has a 1 i  q
limit)  q 
n
A c , q  n i  1  i  A c , q  n i
1  
C 1 i 
1 i  q

1  i 
n
 qn
S c , q  n i  1  i  S c , q  n i  1  i  A c , q  n i
n
Vn  C  S C , q n i 
1 i  q
 1  i  A C , q  n i
n

Specific case: (1+i)=q

Specific case: (1+i)=q
A c ,1 i   n i  1  i  A c ,1 i   n i  C n
1
A C , 1 i n i  C n 1  i 
    S  c ,1 i   n i  1  i  A c ,1 i   n i  C n 1  i 
n n

Vn  Cn 1  i 
n 1

 1  i 
n
 S C ,1 i   n i A C ,1 i   n i

PERPETUITY Condition (1+i)>q Condition (1+i)>q

(n has no V0  A 1 C 1  i 
 c , q 
C A c , q  i  1  i  A c , q   i 
1 i  q 1 i  q
limit)

39
Arithmetic Progression d >0 or d<0 (if d<0 check that the last term is positive)

ORDINARY (€C) DUE (€C)

TEMPORA
RY Multiply by (1+i)
ANNUITY
(n has a
limit) d dn
V0  A c ,d ) n i  (C  )an i  1  i 
n V0  A c , d ) n i  A c , d ) n i (1  i )
     
i i

Vn  S c , d ) n i  S c , d ) n i (1  i )
   
Vn  S c , d  n i  (1  i ) A c ,d n i 
n

d dn
 (C  ) s n i 
i i

PERPETUI A c ,d  i  (1  i ) A c ,d  i 
TY
 d 1
(n has no V0  A c , d  i   c     d 1  i 
limit)  i  i   (C  )
i i

40
•In annuities where payments vary, they can also be deferred annuities or forborne
annuities.

•If the annuity varies but it does not follow a schedule, we have to discount or
accumulate each financial capital individually.

Example 1

Calculate the income earned by a worker for the last five years taking into account
that the first year he earned Є12,000 and in the consecutive years, his income grew at
a 3% cumulative rate per year. The annual interest rate is 5%.

Do the exercise again but now consider that the annual interest rate is 3%.

If the interest rate is 2% and the income is going to be earned for the rest of his life,
can you calculate the present value of his income? And the future value?

Example 2

The sales of MJSV Corporation are Є500,000 this year (at the end of the year). It is
expected that the sales will increase by Є50.000 a year for the next three years.
Determine the discounted value of the sales for the next three years if the annual
interest rate is 5%.

41
On most of the occasions, times, we have assumed that periodic payments have been
made on the same dates as the interest is compounded. This is not always the case. In
fact, in some annuities payments are made more or less frequently than interest is
compounded. Such a series of payments is called a general annuity

Therefore, we will now consider the case where the payment period differs from the
interest-conversion period but the payments are constant (c).

a) First method: “Change of rate” approach

One way to solve general annuity problems is to replace the given interest rate by an
equivalent rate for which the interest compounding period is the same as the payment
period. This way, the general annuity problems are transformed into simple annuity
problems, therefore no new theory is required.

Example 1: Find the present value of an annuity-due of Є200 per quarter for 2 years, if
interest is compounded monthly at the nominal rate of 8%.

42
b) Second method: It is possible to derive algebraic formulas to compute the present
and future values of annuities for which the period of installment is different from the
period of compounding.

Consider there be m payments for an immediate annuity occurring at time 1/m, 2/m, ·
· ·, 1, 1+1/m, · · ·, 2, · · ·, n, and let i be the effective rate of interest per interest-
conversion period. Thus, there are m·n payments over n interest-conversion periods.

Interest periods: n

0 1 2 3 4 s-1 s n
i i i i

Payments: n periods * m payments each period. Therefore C=c*m

This is the time diagram for one period:

c c c c c

S-1 i S

In this case, we are not going “to change the rate”, therefore we will use i, the annual
interest rate. In this case the payments will be: c·m. Therefore we need to use the
formula developed for “fractional annuities”:

43
Given an ordinary annuity with the following features:
c: C/m: payment
n: period of compounding
m: number of payments
n*m: total number of periods

 
r

    1  i   
nxm
C C
V0   1  i m
1 m 2 m  ( mxn )
 1 im  ...  1  i
r 1 m m

C

 1 im   1  i  1  i 
1 m 1 m  ( mxn )

 

 C 1  1  i m   ( mxn )


1  1  i  m 1 m
  m  i 

C i 1  1  i     
m ( n ) ( n )
m
i 1 1 i
  C
mi im  J (m) i Notation: 𝑖𝑚 = 𝑖 𝑚
 
 5.1.Ordinary Fractional Annuity
 Therefore the relationship between an
ordinary fractional annuity (constant, variable
following a geometric or an arithmetic
progression) and the corresponding ordinary
annuity is:
i
J (m)
 Given an annuity due with the following features:
c: C/m: payment
n: period of compounding
m: number of payments
n*m: total number of periods

 
( nxm ) 1 r

V0  
C

1 im  C
 1 1 im    1  i 
1 m 2

 ...  1  i 
m  (( mxn ) 1)

r 0 m m

C 1 1 i
 
m 1

1 i  
m  (( mxn ) 1) 
C 1  1  i m
 
 
 ( mxn )


m  1 1 i m 1
   m  i m

1  1  i  
m ( n )    ( n )
m 1 1 i
   
m
Ci i
 1 im C 1 i
 
m
mi i J (m) i
 
Notation: 𝑖𝑚 = 𝑖 𝑚
 5.2. Fractional Annuity Due
 Therefore the relationship between a
fractional annuity due (constant, variable
following a geometric or an arithmetic
progression) and the corresponding annuity
due is: i
1  im 
J (m)
Therefore:

•ordinary annuity

i i
a (m)
ni
 an i  V0  c m a (m)
ni
 cm an i
j( m ) j( m )
i i
s (m)
ni
 sn i  Vn  c m s (m)
ni
 cm sn i
j( m ) j( m )
•annuity due
1 1
i i i
a (m)
ni
 an i  (1  i ) m
an i  V0  c m a (m)
ni
 (1  i ) m
c m an i
j( m ) j( m ) j( m )
sn( mi )  (1  i ) n an( mi )  Vn  c m (1  i ) n an( mi )

Note: Be careful!!!: (1+i)1/m

48
Example 3: Solve example 1 using the formulas we have already seen.

On the other hand, we are going to consider that the payments vary and
they form a geometric progression.
Remember that n, i and q have to refer to the same time units. But,
sometimes q is an annual magnitude and c is not an annual payment. In
this case we have to use the following expression:

i
A (m)
( c m ,q ) n i
 A( c m ,q ) n i
jm

Example 4
A worker earns 600 euros per month. This amount will grow at a 3%
cumulative rate per year for the next three years. Determine the present
value of his salary taking into account that the annual interest rate is 5%.

49
Suppose the annuities are paid continuously (i.e., daily) then m→∞.To calculate these
annuities, we will use the fractional annuities.
We denote the present value of this continuous annuity by an i (C=1):

i
an i  an i


ρ=Ln(1+i) That is, the instant rate of compound interest.

To obtain this formula we have calculated the limit of a fractional annuity when n
tends to infinity. As we can see, we have replaced the nominal rate (jm) in the
fractional annuity with the instant rate in the continuous annuity.

We can calculate the future value or we can consider that the payments vary and form
a geometric progression. In this last case, we will have the following expression:

i1  q n (1  i )  n
A( c , q ) n i  C
 1 i  q

In a continuous annuity, there is no difference between an ordinary annuity and an annuity

due.

50
Example
If the interest rate is 14%, determine the
present value of a 500 euro daily annuity with
a duration of five years.

51