MATH 1003 Calculus and Linear Algebra (Lecture 2)

Albert Ku

HKUST Mathematics Department

Albert Ku (HKUST) MATH 1003 1 / 17

Outline

1 Compound Interest

2 Annual Percentage Yield

Albert Ku (HKUST) MATH 1003 2 / 17

 Compound Interest

Compound Interest

Example
If $1,000 is deposited at annual interest rate 10% and the bank provides
interest
(a) annually;
(b) semiannually;
(c) quarterly;
(d) monthly.
What is the amount of money in the bank after 4 years?

Albert Ku (HKUST) MATH 1003 3 / 17

 Compound Interest

Solution for (a)

Amount of money in the bank at the end of the 1st year:

1000(1 + 0.1)

Amount of money in the bank at the end of the 2nd year:

1000(1 + 0.1)(1 + 0.1) = 1000(1 + 0.1)2

Amount of money in the bank at the end of the 3rd year:

1000(1 + 0.1)2 (1 + 0.1) = 1000(1 + 0.1)3

Amount of money in the bank at the end of the 4th year:

1000(1 + 0.1)3 (1 + 0.1) = 1000(1 + 0.1)4 = $1464.1

Albert Ku (HKUST) MATH 1003 4 / 17

 Compound Interest

Solution for (b)

The computation is similar to the solution for (a). But now the period of
providing interest is half year. Therefore, we have the following:
Amount of money in the bank at the end of the 1st half-year:
0.1
1000(1 + )
2
Amount of money in the bank at the end of the 2nd half-year:
0.1 0.1 0.1 2
1000(1 + )(1 + ) = 1000(1 + )
2 2 2
······
Amount of money in the bank at the end of the 8th half-year:
0.1 8
1000(1 + ) = $1477.5
2

Albert Ku (HKUST) MATH 1003 5 / 17

 Compound Interest

Solutions for (c) and (d)

By similar computation, we obtain the following results:

For (c), the amount of money in the bank at the end of the 4th year is

0.1 16
1000(1 + ) = $1484.5
4
For (d), the amount of money in the bank at the end of the 4th year is

0.1 48
1000(1 + ) = $1489.4
12

Albert Ku (HKUST) MATH 1003 6 / 17

 Compound Interest

Compound Interest

The previous example is

Theorem
Let the annual interest rate be r . Let P be the principal (present value). If
the bank provides interest m times per year, then after t years, the amount
(future value), A, is given by
 r mt
A=P 1+ .
m

Remark
When the number of compounding periods in a year (m) is getting larger
and larger, the limiting situation is the so-called continuous compounding.
We will learn more about it later.

Albert Ku (HKUST) MATH 1003 7 / 17

 Compound Interest

Finding Present Value

Example
How much should you invest now at 10% compounded quarterly to have
$8,000 toward the purchase of a car in 5 years?

Solution
Let P be the amount of investment. Then we have
0.1 20
P(1 + ) = 8000
4

⇒ P = $4882.2
A remark: This can be viewed as the present value of $8,000 after 5 years.

Albert Ku (HKUST) MATH 1003 8 / 17

 Compound Interest

Computing Growth Time

Example
How long will it take $10,000 to grow to $12,000 if it is invested at 9%
compounded monthly?

Solution
Let n be the number of months needed for $10,000 to grow to $12,000.
Then we have
0.09 n
12000 = 10000(1 + )
12

⇒ 1.2 = (1.0075)n

Albert Ku (HKUST) MATH 1003 9 / 17

 Compound Interest

To solve an equation with an unknown in the power, we need to use the

“logarithm”:
ln 1.2 = ln(1.0075)n

ln 1.2 = n ln(1.0075)

ln 1.2
⇒n= = 24.4
ln 1.0075
Therefore, it will take 25 months for $10,000 to grow to $12,000.

Albert Ku (HKUST) MATH 1003 10 / 17

 Compound Interest

Zero Coupon Bond

Example
A zero coupon bond is a bond that is sold now at a discount and will pay
its face value at some time in the future when it matures. That is, no
interest payment are made. A zero coupon bond with a face value of
$30,000 matures in 15 years. What should the bond be sold for now if its
rate of return is to be 4% compounded annually?

Remark
A zero coupon bond cannot be sold at the price equal to its face value
because no one is willing to pay $30,000 for getting the same amount after
15 years. Therefore, the “right price” for this zero coupon bond is the
present value of $30,000 that one receives 15 years from now.

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 Compound Interest

Solution

Let P be the present value of the zero coupon bond. Then we have

30000 = P(1 + 0.04)15

⇒ P = $16657.9

Albert Ku (HKUST) MATH 1003 12 / 17

 Compound Interest

Finding Interest Rate

Example
A $10000 investment in a particular growth-oriented mutual fund over a
recent 10-year period would have grown to $128000. What annual
nominal rate would produce the same growth if interest were compounded
annually?

Let r be the annual nominal rate of the mutual fund. Then we have

128000 = 10000(1 + r )10

√
10
12.8 = 1 + r

⇒ r = 0.29 = 29%

Albert Ku (HKUST) MATH 1003 13 / 17

 Annual Percentage Yield

Annual Percentage Yield

Definition
If a principal is invested at the annual rate r compounded m times a year,
then the amount after 1 years is A = P(1 + mr )m . The simple interest rate
that will produce the same amount A in 1 year is called the annual
percentage yield (APY).

Theorem
Formula for APY:
r m
APY = (1 + ) −1
m
The APY is also referred to as the effective rate or the true interest rate.

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 Annual Percentage Yield

Comparison of Different Investments

APY is useful when you want to compare different investment/loan

schemes.
Example
Three banks offer 1-year certificates of deposit (CD):
(a) Lion bank pays 3.97% compounded daily
(b) Chatter bank pays 3.95% compounded monthly
(c) Asian bank pays 3.98% compounded quarterly
Find APY for each of these banks and determine which bank offers the
greatest return.

Albert Ku (HKUST) MATH 1003 15 / 17

 Annual Percentage Yield

Solution

(a) APY for Lion bank is

0.0397 360
 
1+ − 1 = 4.05%
360

(b) APY for Chatter bank is

0.0395 12
 
1+ − 1 = 4.02%
12

(c) APY for Asian bank is

0.0398 4
 
1+ − 1 = 4.04%
4

Therefore, the CD of Lion bank has the greatest return.

Albert Ku (HKUST) MATH 1003 16 / 17
 Annual Percentage Yield

More Example

Example
A savings and loan wants to offer a CD with a monthly compounding rate
that has an APY of 7.2%. What annual nominal rate compounded
monthly should they use?

Solution
Let r be the annual nominal rate. Then we have
 r 12
0.072 = 1 + −1
12

⇒ r = 0.0697 = 6.97%

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