FM – Lecture # 1: Introduction, Interest Accumulation & Effective

Rates of Interest
By Logen Kanisan, FSA

Today’s Class Topic –

SOA FM Course Objectives
1 (a), (b)
1. Time Value of Money (10-15%)
Learning Objectives
The Candidate will understand and be able to perform calculations relating to
present value, current value, and accumulated value.
Learning Outcomes
The Candidate will be able to:
a) Define and recognize the definitions of the following terms: interest rate (rate of
interest), simple interest, compound interest, accumulation function, future value,
current value, present value, net present value, discount factor, discount rate (rate of
discount), convertible m-thly, nominal rate, effective rate, inflation and real rate of
interest, force of interest, equation of value.
b) Given any three of interest rate, period of time, present value, current value, and
future value, calculate the remaining item using simple or compound interest. Solve
time value of money equations involving variable force of interest.
Introductory Concepts
• Translate verbal descriptions of financial transactions into mathematical
models

• Component in all financial transactions – interest (time value of money)

• Simple Interest & Compound Interest

• Alternative measures of interest rates

o Nominal annual rate of interest
o Rate of discount
o Force of interest

• Important concepts:
o Accumulated value
o Present Value
o Equation of Value

• Interest Rate – typically an annual percentage

• Reinvesting of interest – leads to compound interest

Example 1
The current rate of interest quoted by a bank on its savings account is 9% per
annum (per year), with interest credited annually, Smith opens an account with a
deposit of 1000. Assuming that there are no transactions on the account other than
the annual crediting of interest, determine the account balance just after interest is
credited at the end of 3 years.
Variable Interest
If Interest were variable,

Accumulated value = C (1+ i1)( 1+ i2) ( 1+ i3) …( 1+ in)

Definitions

Annual Effective Rate of Interest

The percentage change in the value of the investment from the beginning to the end
of the year.

𝐴(𝑢 + 1) − 𝐴(𝑢)
𝑖𝑢+1 =
𝐴(𝑢)

Equivalent Rates of Interest

Two rates of interest are said to be equivalent if the result in the same accumulated
values at each point in time.

Example 2

The monthly compounding interest rate is 0.75%. Find the equivalent annual
compounding rate.

Example 3

Smith deposits 1000 into an account on January 1, 2011. The account credits
interest at an annual effective interest rate of 5% every December 31. Smith
withdraws 200 on January 1, 2013, deposits 100 on January 1, 2014, and withdraws
250 on January 1, 2016. What is the balance in the account just after interest is
credited on December 31, 2017?
Definitions

Accumulation Factor

a(t) : accumulated value at time t of an investment of 1 made at time 0.

a(t) is defined as the accumulation factor from time 0 to time t

Accumulated Amount Function

A(t): The accumulated amount for an investment at time t.

A(t) is the accumulated amount function

𝐴(𝑡) = 𝐴(0) ∗ 𝑎(𝑡)

Compound Interest Accumulation

At an effective rate of interest of i per period, the accumulation factor from time 0 to
time t is

𝑎(𝑡) = (1 + 𝑖)𝑡

Simple Interest Accumulation

At a annual simple interest rate I, where t is measured in years,

𝑎(𝑡) = (1 + 𝑖 ∗ 𝑡)

Example 4

On January 31, Smith borrows 5000 from Brown and gives Brown a promissory note.
The note states that the loan will be repaid on April 30 of the same year, with interest
at 12% per annum. On March 1, Brown sells the promissory note to Jones, who pays
Brown a sum of money in return for the right to collect the payment from Smith on
April 30.

Jones pays Brown an amount such that Jones’ yield (interest rate earned) from
March 1 to the maturity date can be stated as an annual rate of interest of 15%.

(a) Determine the amount Smith was to have paid Brown on April 30

(b) Determine the amount that Jones paid to Brown, and the yield rate (interest
rate) Brown earned, quoted on an annual basis. Assume all calculations are
based on simple interest and a 365 day year.

(c) Suppose instead that Jones pays Brown an amount such that Jones’ yield is
12%. Determine the amount that Jones paid.
Example 5 (Past SOA question)

Joe deposits 10 today and another 30 in five years into a fund paying simple interest
of 11% per year.

Tina will make the same two deposits, but the 10 will be deposited n years from
today and the 30 will be deposited 2n years from today. Tina’s deposits earn an
annual effective rate of 9.15%. At the end of 10 years, the accumulated amount of
Tina’s deposits equals the accumulated amount of Joe’s deposits.

Calculate n.
Homework

1) Alex deposits 10,000 into a bank account that pays an annual effective
interest rate of 4%, with interest credited at the end of each year. Determine
the amount in Alex’s account just after interest is credited at the end of the 1st,
2nd, and 3rd years, and also determine the amount of interest that was credited
on each of those dates.

Answers:
1st year balance: 10,400; interest 400
2nd year balance: 10,816; interest 416
3rd year balance: 11, 248.64; interest 432.64

2) 2500 is invested. Find the accumulated value of the investment 10 years after
it is made for each of the following rates:
a. 4% annual simple interest
b. 4% annual effective compound interest
c. 6-month interest rate of 2% compounded every 6 months
d. 3-month interest rate of 1% compounded every 3 months

Answers:

a) 3500
b) 3700.61
c) 3714.87
d) 3722.16

3) Bob puts 10,000 into a bank account that has monthly compounding with
interest credited at the end of each month. The monthly interest rate is 1% for
the first 3 months of the account and after that the monthly interest rate is
0.75%. Find the balance in Bob’s account at the end of 12 months just after
interest has been credited. Find the average compound monthly interest rate
on Bob’s account for the 12 month period.

Answers:
Balance = 11.019.70
Interest rate = 0.812%

4) [SOA question] Carl puts 10,000 into a bank account that pays an annual
effective interest rate of 4% for ten years, with interest credited at the end of
each year. If a withdrawal is made during the first five and one-half years, a
penalty of 5% of the withdrawal is made. Carl withdraws K at the end of each
of years 4, 5, 6, and 7. The balance in the account at the end of year 10 is
10,000. Calculate K.
 Answer:
K = 979.93

5) Smith’s business receives an invoice from a supplier for 1000 with payment
due within 30 days. The terms of payment allow for a discount of 2.5% if the
bill is paid within 7 days. Smith does not have the cash on hand 7 days later,
but decides to borrow the 975 to take advantage of the discount. What is the
largest simple interest rate, as an annual rate, that Smith would be willing to
pay on the loan?

Answer:

𝑖 ≤ 40.69%