Financial Mathematics

Financial Mathematics
By

Peter Brusov, Tatiana Filatova

and Natali Orekhova
Financial Mathematics

By Peter Brusov, Tatiana Filatova and Natali Orekhova

This book first published 2023

Cambridge Scholars Publishing

Lady Stephenson Library, Newcastle upon Tyne, NE6 2PA, UK

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

Copyright © 2023 by Peter Brusov, Tatiana Filatova and Natali Orekhova

All rights for this book reserved. No part of this book may be reproduced,
stored in a retrieval system, or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording or otherwise, without
the prior permission of the copyright owner.

ISBN (10): 1-5275-0721-1

ISBN (13): 978-1-5275-0721-0
 TABLE OF CONTENTS

PREFACE ................................................................................................ x

ABSTRACT ............................................................................................ xi

INTRODUCTION .................................................................................... 1

CHAPTER 1. THE THEORY OF INTEREST ........................................ 3

1.1. Simple interest ........................................................................... 4
1.2. Compound interest ..................................................................... 5
1.3. Multiple interest accrual............................................................. 7
1.4. Continuous interest accrual ........................................................ 8
1.5. Equivalence of interest rates in the compound interest scheme.. 10
1.6. Comparison of accruals at simple and complex interest rates .. 13
1.7. Discounting and interest deduction .......................................... 14
1.7.1. Comparison of discounting at complex and simple
discount rates.................................................................. 16
1.7.2. Effective discount rate.................................................... 17
1.8. Multiplying and discounting multipliers .................................. 19
1.9. “Rule of 70” ............................................................................. 20
1.9.1. Compound interest ......................................................... 20
1.10. Generalization of “Rule of 70”............................................... 21
1.10.1. Simple interest ............................................................. 21
1.10.2. Continuous interest...................................................... 21
1.10.3. Multiple interest accrual .............................................. 22
1.11. Capital increase by an arbitrary number of times ................... 23
1.12. The impact of inflation on the interest rate ............................ 25
1.12.1. Fisher’s formula .......................................................... 25
1.12.2. Inflation rate for several periods ................................. 27
1.12.3. Synergistic effect ......................................................... 28
1.13. Effective interest rate ............................................................. 30
1.13.1. Simple and compound interest .................................... 31
1.13.2. Multiple interest accrual .............................................. 31
1.13.3. Adjustment for inflation .............................................. 34
1.13.4. Adjustment for taxes ................................................... 34
1.13.5. Equivalence of different interest rates ......................... 36
vi Table of Contents

1.14. Internal rate of return ............................................................. 38

1.14.1. The concept of internal rate of return .......................... 38
1.14.2. Internal rate of return of typical investment flows ...... 42
1.14.3. Internal rate of return of cash flows with
alternating positive and negative payments ................ 46
1.15. Currency transactions ............................................................. 49
1.15.1. Deposits with and without currency conversion ........... 49
1.15.2. Dual-currency basket .................................................... 54
Control questions and tasks ..................................................... 56

CHAPTER 2. FINANCIAL FLOWS, ANNUITIES ................................. 59

2.1. Financial flows (cash flows) .................................................... 59
2.2. Current, future and present values of the cash flow ................. 60
2.3. The average time of cash flow ................................................. 62
2.4. Continuous cash flows ............................................................. 63
2.4.1 Accrued and present value of continuous cash flows ..... 63
2.4.2. Linearly changing cash flow ......................................... 66
2.4.3. Exponentially changing cash flow ................................ 66
2.5. Regular cash flows ................................................................... 67
2.5.1. Ordinary annuity ............................................................ 67
2.5.2. Coefficients of present and future values of annuities .. 68
2.5.3. Calculation of annuity parameters .................................. 75
2.5.4. Perpetual, term and continuous annuities ....................... 78
2.5.5. p-term annuity ................................................................ 79
2.5.6. Other types of annuities ................................................. 89
2.5.7. Arithmetic and geometric annuities ............................... 94
2.5.8. Comparison of cash flows and annuities ...................... 100
2.5.9. Annuity conversion ...................................................... 102
Control questions and tasks.................................................... 108

CHAPTER 3. PROFITABILITY AND RISK OF FINANCIAL

OPERATION .......................................................................................... 113
3.1. Revenue and yield of financial transaction ............................ 113
3.1.1. Yield for several periods .............................................. 113
3.1.2. Synergetic effect........................................................... 116
3.2. Risk of financial transaction .................................................. 117
3.2.1. Quantitative risk assessment of financial transaction ... 119
3.3. Role of even and normal distributions ................................... 122
3.3.1. Role of even distribution ............................................. 122
3.3.2. The highlighted role of the normal distribution ............ 123
3.4. Correlation of financial transactions ...................................... 124
 Financial Mathematics vii

3.5. Other risk measures................................................................ 127

3.5.1. Value at Risk ................................................................ 128
3.6. Types of financial risks .......................................................... 130
3.7. Methods of reducing the risk of financial transactions .......... 131
3.7.1. Diversification .............................................................. 131
3.7.2. Hedging ........................................................................ 135
3.8. Financial transactions in the conditions of uncertainty .......... 136
3.8.1. Impact and risk matrices .............................................. 136
3.8.2. Decision-making in conditions of complete
uncertainty.................................................................... 137
3.9. Decision-making in conditions of partial uncertainty ............ 139
3.9.1. The rule of maximizing the average expected income .. 139
3.9.2. The rule of minimizing the average expected risk ....... 140
3.9.3. Optimal (Pareto) financial transaction ......................... 141
3.9.4. Laplace's rule of equal opportunity .............................. 143
Control questions and tasks ................................................... 143

CHAPTER 4. PORTFOLIO ANALYSIS ............................................... 145

4.1. The yield of the security and portfolio ................................... 145
4.2. A portfolio of two securities .................................................. 148
4.2.1. Necessary information from probability theory ........... 148
4.2.2. The case of complete correlation.................................. 151
4.2.3. The case of complete anticorrelation............................ 153
4.2.4. Independent securities .................................................. 155
4.2.5. Three independent securities ........................................ 157
4.2.6. Zero-risk security ......................................................... 161
4.2.7. Fixed Efficiency Portfolio ............................................ 163
4.2.8. Portfolio of a given risk................................................ 166
4.3. Portfolios of n-papers. Markowitz Portfolios ......................... 168
4.3.1. Minimum risk portfolio with a given efficiency .......... 168
4.3.2. Minimum boundary and its properties ......................... 172
4.3.3. Markovitz portfolio of minimal risk with an efficiency
not less than the specified one ..................................... 177
4.3.4. Minimum risk portfolio ................................................ 178
4.3.5. Portfolio of maximum efficiency from all risk portfolios
no more than the specified one .................................... 181
4.4. Tobin’s portfolios................................................................... 183
4.4.1. Tobin’s portfolio of minimal risk from all portfolios
of a given efficiency .................................................... 184
4.4.2. Portfolio of maximum efficiency from all risk portfolios
no more than the specified ........................................... 192
viii Table of Contents

4.5. Optimal non-negative portfolios ............................................ 194

4.5.1. The Kuhn—Tucker Theorem ....................................... 194
4.5.2. The profitability of a non-negative portfolio ................ 195
4.5.3. Non-negative portfolio of two securities ...................... 198
4.5.4. Examples of non-negative portfolios of three
independent securities .................................................. 200
4.5.5. Maximum risk portfolio with non-negative
components .................................................................. 206
4.5.6. Maximum efficiency portfolio with non-negative
components .................................................................. 207
4.5.7. Minimum risk portfolio with non-negative components... 207
4.5.8. Portfolio diversification ............................................... 208
Control questions and tasks ................................................... 210

CHAPTER 5. BONDS ............................................................................ 213

5.1. Basic concepts ........................................................................ 213
5.2. Current value of the bond....................................................... 214
5.3. Current yield and yield to maturity ........................................ 215
5.3.1. Current yield of the bond ............................................. 215
5.3.2. Yield to maturity .......................................................... 216
5.4. Dependence of the yield to maturity of the bond on the
parameters .............................................................................. 219
5.5. Additional characteristics of the bond .................................... 225
5.5.1. Average time of income receipt ................................... 225
5.5.2. Bond duration ............................................................... 229
5.5.3. Duration properties....................................................... 231
5.5.4. Bond bulge ................................................................... 239
5.6. Bond portfolio immunization ................................................. 240
5.7. Bond portfolio ........................................................................ 244
5.7.1. Bond portfolio yield ..................................................... 244
5.7.2. Average term of receipt of income of the bond
portfolio........................................................................ 245
5.7.3. Duration of the bond portfolio and its convexity ......... 246
Control questions and tasks ................................................... 248

CHAPTER 6. CAPITAL STRUCTURE: MODIGLIANI-MILLER

THEORY (MM THEORY) ..................................................................... 251
6.1. Modigliani-Miller theory without taxes ................................. 251
6.2. Modigliani-Miller theory with taxes ...................................... 255
6.3. Main assumptions of Modigliani-Miller theory ..................... 259

Tasks ............................................................................................. 262

 Financial Mathematics ix

CHAPTER 7. CAPITAL STRUCTURE THEORY: BRUSOV-

FILATOVA-OREKHOVA THEORY (BFO THEORY) ........................ 264
7.1 Companies with arbitrary age: the Brusov-Filatova-Orekhova
equation .................................................................................. 265

LITERATURE ........................................................................................ 278

 PREFACE

In the education of financiers and economists in all universities of the

world, an important role belongs to mathematical disciplines. Among
these disciplines, financial mathematics occupies a very serious place,
because it is the base for disciplines such as corporate finance, financial
management, investment, taxation, business valuation, ratings, etc.

This textbook is intended for both undergraduate and post-graduate

students studying the course “Financial Mathematics”.

It differs from other textbooks in a detailed and accessible presentation

with the derivation and proof of all statements and theorems and a much
broader consideration of the issues raised.

In each chapter of the textbook, detailed practical examples are given, and
at the end of each chapter, questions and tasks are given to control the
degree of assimilation of the material and consolidation of what has been
studied.
 ABSTRACT

This textbook contains information on financial mathematics, knowledge

of which is necessary not only for every financier, but also for any
competent economist of a wide profile (and especially for financial
analysts). It consists of seven chapters: “Interest theory”, “Financial
flows and rents”, “Profitability and risk of financial transactions”,
“Portfolio analysis”, “Bonds”, “Capital structure: Modigliani-Miller
theory” and “Capital structure: Brusov-Filatova-Orekhova theory”. Each
chapter contains many detailed practical examples, and at the end of
each chapter questions and tasks for revision are given.

For undergraduate and graduate students of all financial and economic

fields and profiles, including “Finance and Credit”, “Accounting and
Auditing”, “Taxes and Taxation”, “World Economy”, etc. It will be useful
for specialists of all financial and economic specialties (and especially for
financial analysts) and for everyone who wants to master quantitative
methods in finance and economics.
 INTRODUCTION

In the education of financiers and economists in all universities of the

world, an important role belongs to mathematical disciplines. Among
these disciplines, financial mathematics occupies a very serious place,
because it is the base for disciplines such as corporate finance, financial
management, investment, taxation, business valuation, ratings, etc.

This textbook is intended for both undergraduate and post-graduate

students studying the course “Financial Mathematics”. It differs from other
textbooks in its detailed and accessible presentation with derivation and
proofs of all statements and a much broader consideration of the issues
raised. So, for example, if in all standard textbooks the “Rule of 70” (the
term for doubling the deposit at a given interest rate) is given only for the
case of compound interest, then this textbook considers an analogue of
“the rule 70” for the case of simple interest, the so-called “rule 100” and
moreover the cases of increasing the deposit an arbitrary number of times
for all types of interest rates: complex, simple, continuous and with
multiple accruals of interest.

In the chapter “Portfolio Analysis”, much attention is paid to the portfolio

of two securities, the theory of which was developed by the authors
specifically for this textbook. Mastering this simple Portfolio theory
prepares students to study the more general portfolio theories of
Markowitz and Tobin. Such a detailed and consistent presentation is aimed
at the student’s conscious, creative assimilation of the course program so
that they have the opportunity to independently solve a wide variety of
tasks and problems arising in practice.

In each chapter of the textbook, detailed practical examples are given, and
at the end of each chapter, questions and tasks are given to control the
degree of assimilation of the material and consolidation of what has been
studied.
2 Introduction

The textbook is written using a competence-based approach based on the

lectures given by the authors for more than 15 years at the Financial
University under the Government of the Russian Federation (Moscow).

The authors are enthusiasts of the introduction of mathematical methods in

economics and finance. The understanding that finance is essentially a
quantitative science, and quantitative methods play a crucial role in the
training of financiers and economists of all profiles, is increasingly
spreading among the specialists responsible for their training. An example
of this understanding is the introduction at the Financial University under
the Government of the Russian Federation on the initiative of the authors
of the course “Financial Mathematics” as a mandatory bachelor’s degree
for students of all directions and profiles, which was an important step
towards the integration of national financial and economic education into
the global one, where the mathematical component of financial disciplines
reaches 70% or more. Such extensive teaching of financial mathematics
has led to the use of the knowledge gained during the study in the
development of many special disciplines and ultimately to an
improvement in the quality of education received by graduates.

The authors are planning to publish “Tasks on Financial Mathematics”, the

use of which together with this textbook will allow the reader to creatively
and firmly master this course.

The authors also plan to publish the second part of the textbook, intended
for master’s students and including not general, but special questions for
each specific master’s program. It sets out issues such as the cost and
structure of capital, the company’s dividend policy, leasing and others for
the “Financial Management” program, issues such as repayment of long-
term loans, VaR and its application in banking and others for the “Banking
industry” program, investments, modern models for evaluating the
effectiveness of investment projects, financial markets and derivative
financial instruments for the “Financial Markets” program, etc.
 CHAPTER 1

THE THEORY OF INTEREST

Interest can be defined as compensation paid by the borrower to the lender

for the use of capital. Therefore, interest can be considered as a rent that
the borrower pays to the lender to compensate for losses from the latter's
non–use of capital during the loan. In general, capital and interest do not
necessarily represent the same commodity. However, we will consider
capital and interest expressed in the same terms — in terms of money.

So, the lender provides the borrower with a certain amount of money; after
the deadline, the borrower must repay the accrued amount equal to the
amount of debt plus interest.

Effective interest rate is the amount paid to the borrower (investor) at the
end of the accrual period for each unit amount borrowed (invested) at the
beginning of the period.

Denoting the increased value of the unit amount at time 𝑡𝑡 through 𝑎𝑎𝑡𝑡 , the
interest rate through 𝑖𝑖, and the increased value of the full amount through
𝑆𝑆𝑡𝑡 , we have for the first accrual period
(1+𝑖𝑖) 𝑎𝑎1 −𝑎𝑎0 𝑆𝑆1 −𝑆𝑆0
𝑖𝑖1 = = = , (1.1)
1 𝑎𝑎0 𝑆𝑆0

for the 𝑛𝑛–th accrual period

𝑎𝑎𝑛𝑛 −𝑎𝑎𝑛𝑛−1 𝑆𝑆𝑛𝑛 −𝑆𝑆𝑛𝑛−1
𝑖𝑖𝑛𝑛 = = . (1.2)
𝑎𝑎𝑛𝑛−1 𝑆𝑆𝑛𝑛−1

From this formula it can be seen that the effective interest rate can change
(and is changing) depending on the number of the accrual period, but, as
will be shown below, in the very important and widely used case of
compound interest, the effective interest rate for all accrual periods
remains constant, i.e. for all 𝑛𝑛 ≥ 1.
4 Chapter 1

1.1. Simple interest

Let 𝑆𝑆0 be the initial amount of debt, 𝑖𝑖 be the interest rate. In the simple
interest scheme, 𝑆𝑆0 will increase by 𝑖𝑖𝑖𝑖0 by the end of a single accrual
period (usually a year), and the accrued amount of 𝑆𝑆1 will be equal to

𝑆𝑆1 = 𝑆𝑆0 + 𝑖𝑖𝑆𝑆0 = 𝑆𝑆0 (1 + 𝑖𝑖). (1.3)

By the end of the second accrual period, the initial amount of debt 𝑆𝑆0 will
increase by another 𝑖𝑖𝑆𝑆0 and the accrued amount will become

𝑆𝑆2 = 𝑆𝑆1 + 𝑖𝑖𝑖𝑖 = 𝑆𝑆0 (1 + 2𝑖𝑖). (1.4)

By the end of the 𝑛𝑛–th accrual interval, the accrued amount will be

𝑆𝑆𝑛𝑛 = 𝑆𝑆0 (1 + 𝑛𝑛𝑖𝑖). (1.5)

This formula is called the simple interest formula. The multiplier (1 +

𝑛𝑛𝑛𝑛) is called the accrual coefficient (multiplier), and the value of 𝑛𝑛𝑛𝑛 is
the interest rate for time 𝑛𝑛.

Thus, the sequence of incremented sums 𝑆𝑆1 , 𝑆𝑆2 , . . . , 𝑆𝑆𝑛𝑛 is an arithmetic

progression with the initial term 𝑆𝑆0 and the difference 𝑖𝑖𝑖𝑖0 .

The interest for 𝑛𝑛 years can be represented as

𝐼𝐼𝑛𝑛 = 𝑆𝑆0 𝑖𝑖𝑖𝑖. (1.6)

Effective interest rate in the simple interest scheme

𝑎𝑎𝑛𝑛 −𝑎𝑎𝑛𝑛−1 𝑆𝑆𝑛𝑛 −𝑆𝑆𝑛𝑛−1 (1+𝑖𝑖𝑖𝑖)−(1+𝑖𝑖(𝑛𝑛−1)) 𝑖𝑖
𝑖𝑖𝑛𝑛 = = = = (1.7)
𝑎𝑎𝑛𝑛−1 𝑆𝑆𝑛𝑛−1 1+𝑖𝑖(𝑛𝑛−1) 1+𝑖𝑖(𝑛𝑛−1)

decreases with the growth of 𝑛𝑛.

If different interest rates 𝑖𝑖1 , 𝑖𝑖2 , . . . , 𝑖𝑖𝑚𝑚 are set at different intervals of
interest accrual 𝑛𝑛1 , 𝑛𝑛2 , . . . , 𝑛𝑛𝑚𝑚 , then the accrued amount 𝑆𝑆𝑛𝑛 for the time
𝑛𝑛1 + 𝑛𝑛2 + . . . + 𝑛𝑛𝑚𝑚 will be equal to

𝑆𝑆𝑛𝑛 = 𝑆𝑆0 (1 + ∑𝑚𝑚

𝑘𝑘=1 𝑛𝑛𝑘𝑘 𝑖𝑖𝑘𝑘 ). (1.8)
 The Theory of Interest 5

The time of repayment of the loan may not be specified exactly, but may
be a variable (for example, in the case of a cumulative deposit on
demand). Then the formula of simple interest takes the following form:

𝑆𝑆𝑡𝑡 = 𝑆𝑆0 (1 + 𝑖𝑖(𝑡𝑡 − 𝑡𝑡0 )), (1.9)

where 𝑡𝑡0 — the moment when the loan was issued;

𝑡𝑡 — the moment of repayment of the debt with interest.

According to the formula (1.9), the accumulated sum is a linear function of

time. The graph of this function on the “time—money” coordinate plane is
a ray with a starting point (𝑡𝑡0 , 𝑆𝑆0 ) and an angular coefficient 𝑆𝑆0 𝑖𝑖.
Obviously,

𝑆𝑆𝑡𝑡 ′ = 𝑆𝑆0 𝑖𝑖. (1.10)

1.2. Compound interest

With the accrual of compound interest, reinvestment, or capitalization of
the interest received occurs; thus, at the rate 𝑖𝑖, each subsequent accrued
amount increases by a part 𝑖𝑖 of the previous amount, which takes into
account the interest accrued in previous periods.

In the 𝑆𝑆0 compound interest scheme, by the end of a single interval,

accruals will increase by 𝑖𝑖𝑖𝑖0 , and the accrued amount of 𝑆𝑆1 will be equal
to

𝑆𝑆1 = 𝑆𝑆0 + 𝑖𝑖𝑆𝑆0 = 𝑆𝑆0 (1 + 𝑖𝑖). (1.11)

By the end of the second period, 𝑆𝑆1 accruals will increase by 𝑖𝑖𝑆𝑆1 and the
accrued amount will become

𝑆𝑆2 = 𝑆𝑆1 + 𝑖𝑖𝑆𝑆1 = 𝑆𝑆1 (1 + 𝑖𝑖) = 𝑆𝑆0 (1 + 𝑖𝑖)2 . (1.12)

By the end of the 𝑛𝑛–th accrual interval, the accrued amount will be

𝑆𝑆𝑛𝑛 = 𝑆𝑆0 (1 + 𝑖𝑖)𝑛𝑛 . (1.13)

6 Chapter 1

The formula (1.13) is called the compound interest formula. Thus, the
sequence of incremented sums 𝑆𝑆1 , 𝑆𝑆2 , . . . , 𝑆𝑆𝑛𝑛 is a geometric progression
with the initial term 𝑆𝑆0 and the denominator of the progression
𝑞𝑞 = (1 + 𝑖𝑖).

Effective interest rate in the compound interest scheme for the 𝑛𝑛–th
accrual period

𝑎𝑎𝑛𝑛 −𝑎𝑎𝑛𝑛−1 𝑆𝑆𝑛𝑛 −𝑆𝑆𝑛𝑛−1 (1+𝑖𝑖)𝑛𝑛 −(1+𝑖𝑖)𝑛𝑛−1

𝑖𝑖𝑛𝑛 = = = = 𝑖𝑖. (1.14)
𝑎𝑎𝑛𝑛−1 𝑆𝑆𝑛𝑛−1 (1+𝑖𝑖)𝑛𝑛−1

does not depend on 𝑛𝑛 and is equal to the nominal one.

The increased sum 𝑆𝑆𝑛𝑛 is proportional to the initial sum 𝑆𝑆0 . The
proportionality coefficient (1 + 𝑖𝑖)𝑛𝑛 is called the multiplicative factor.

Note that any moment of time 𝑡𝑡𝑘𝑘 can be taken as a “zero” one. In this case,
the formula (1.13) takes the form:

𝑆𝑆𝑛𝑛 = 𝑆𝑆𝑘𝑘 (1 + 𝑖𝑖 𝑇𝑇 )𝑛𝑛−𝑘𝑘 . (1.15)

где 𝑖𝑖 𝑇𝑇 — the interest rate for period T, constant for all periods.

Assuming 𝑡𝑡 = 𝑛𝑛𝑛𝑛, formula (1.15) can be rewritten as follows:

𝑆𝑆(𝑡𝑡) = 𝑆𝑆0 (1 + 𝑖𝑖 𝑇𝑇 )𝑡𝑡/𝑇𝑇 . (1.16)

Using the formula (1.16), it is possible to calculate the accrued amount at

any time 𝑡𝑡 (not necessarily a multiple of the accrual period 𝑇𝑇. In this case,
it is said that a continuous model of a cumulative account is used in the
compound interest scheme. In the future, unless otherwise specified, this
particular model will be used.

The analogue of formula (1.15) in the continuous model is the following

formula:

𝑆𝑆(𝑡𝑡) = 𝑆𝑆(𝜏𝜏)(1 + 𝑖𝑖 𝑇𝑇 )(𝑡𝑡−𝜏𝜏)/𝑇𝑇 . (1.17)

When interest is accrued once a year (or more generally, if the interest
accrual period coincides with the main time unit), formulas (1.16) and
 The Theory of Interest 7

(1.17) are simplified:

𝑆𝑆(𝑡𝑡) = 𝑆𝑆0 (1 + 𝑖𝑖)𝑡𝑡 ; (1.18)

𝑆𝑆(𝑡𝑡) = 𝑆𝑆(𝜏𝜏)(1 + 𝑖𝑖)𝑡𝑡−𝜏𝜏 , (1.19)

where 𝑖𝑖 — annual interest rate.

The interest for 𝑛𝑛 years can be represented as

𝐼𝐼𝑛𝑛 = 𝑆𝑆0 [(1 + 𝑖𝑖)𝑛𝑛 − 1]. (1.20)

1.3. Multiple interest accrual

If compound interest accrual occurs several times a year (𝑚𝑚) (quarterly,
monthly, etc.), then after 𝑡𝑡 years the accrued amount will become equal to:

а) in the case of simple interest:

𝑖𝑖
𝑆𝑆(𝑡𝑡, 𝑚𝑚) = 𝑆𝑆0 �1 + 𝑚𝑚𝑚𝑚� = 𝑆𝑆0 (1 + 𝑖𝑖𝑖𝑖),
𝑚𝑚

that is, the accrued amount does not depend on the multiplicity of accrual.
This conclusion will be used by us when considering the continuous
accrual of interest in the case of simple interest;

b) in the case of compound interest:

𝑖𝑖 𝑚𝑚𝑚𝑚
𝑆𝑆(𝑡𝑡, 𝑚𝑚) = 𝑆𝑆0 �1 + � . (1.21)
𝑚𝑚

In the next paragraph it will be shown that the effective interest rate in the
compound interest scheme increases with increasing multiplicity of
accrual and reaches a maximum with continuous accrual of interest. At the
same time, the effective interest rate practically reaches saturation at 𝑚𝑚 ≥
6 ÷ 10, i.e. above this multiplicity of accrual, the growth of the effective
interest rate slows down sharply.
8 Chapter 1

1.4. Continuous interest accrual

If the frequency of accrual of compound interest 𝑚𝑚 increases indefinitely,
then there is a continuous accrual of interest. In this case, after 𝑡𝑡 years,
the accumulated amount will be equal to:

а) in the case of simple interest:

𝑖𝑖
𝑆𝑆(𝑡𝑡, ∞) = lim 𝑆𝑆(𝑡𝑡, 𝑚𝑚) = lim 𝑆𝑆0 �1 + 𝑚𝑚𝑚𝑚� = 𝑆𝑆0 (1 + 𝑖𝑖𝑖𝑖),
𝑚𝑚→∞ 𝑚𝑚→∞ 𝑚𝑚

that is, the accrued amount remains the same as with a single interest
charge. This conclusion was made by us in the case of multiple accrual of
interest. Both conclusions are related to the fact that with any multiplicity
of interest accrual, accrual is made on the initial amount in proportion to
the time of the deposit;

b) in the case of compound interest:

𝑖𝑖 𝑚𝑚𝑚𝑚
𝑆𝑆(𝑡𝑡, ∞) = lim 𝑆𝑆(𝑡𝑡, 𝑚𝑚) = lim 𝑆𝑆0 �1 + � =
𝑚𝑚→∞ 𝑚𝑚→∞ 𝑚𝑚

𝑖𝑖 𝑚𝑚𝑚𝑚𝑚𝑚/𝑖𝑖
= lim 𝑆𝑆0 �1 + � = 𝑆𝑆0 𝑒𝑒 𝑖𝑖𝑖𝑖 . (1.22)
𝑚𝑚→∞ 𝑚𝑚

The interest rate 𝑖𝑖 in the formula (1.22) is also called the intensity of the
growth rate and is usually denoted by the letter 𝛿𝛿. With this in mind, this
formula can be written as:

𝑆𝑆(𝑡𝑡) = 𝑆𝑆0 𝑒𝑒 𝛿𝛿𝛿𝛿 . (1.23)

The intensity of the growth rate 𝛿𝛿 is characterized by the relative increase

in the accrued amount over an infinitesimal period of time

𝑆𝑆(𝑡𝑡) = 𝑆𝑆0 ∙ 𝑒𝑒 𝛿𝛿𝛿𝛿 ∙ 𝛿𝛿 = 𝑆𝑆(𝑡𝑡) ∙ 𝛿𝛿, (1.24)

or
𝑑𝑑𝑑𝑑(𝑡𝑡)
= 𝛿𝛿 ∙ 𝑑𝑑𝑑𝑑. (1.25)
𝑆𝑆(𝑡𝑡)
 The Theory of Interest 9

If the intensity of the growth rate depends on time, then S(t) can be
obtained as a solution of the differential equation (1.25). Finding the
integral of both parts (1.25), we get
𝑡𝑡
ln 𝑆𝑆(𝑡𝑡) − ln 𝑆𝑆0 = ∫0 𝛿𝛿 𝑑𝑑𝑑𝑑. (1.26)

It means that
𝑡𝑡
𝑆𝑆(𝑡𝑡) = 𝑆𝑆0 𝑒𝑒 ∫0 𝛿𝛿 𝑑𝑑𝑑𝑑 . (1.26)

Example 1.1. The bank has a deposit of 1000 $ at 10% per annum under
the compound interest scheme. Find the amount of the deposit in three
years when interest is accrued 1, 4, 6, 12 times a year and in the case of
continuous interest accrual.

By the formula (1.21) we have

𝑆𝑆3/1 = 1000(1 + 0.1)3 = $1,331,

0.1 3∙4
𝑆𝑆3/4 = 1000 �1 + � = $1,344.9,
4
0.1 3∙6
𝑆𝑆3/6 = 1000 �1 + � = $1,346.5,
6
0.1 3∙12
𝑆𝑆3/12 = 1000 �1 + � = $1,348.2.
12

In the case of continuous accrual of interest, the formula (1.22) must be

used

𝑆𝑆3/∞ = 1000𝑒𝑒 0.1∙3 = $1,349.6. (1.27)

Interest for three years amounted to ($):

— with a single accrual of interest — 331;

— with a four–time accrual — 344.9;
— with a six–time accrual — 346.5;
— at twelve–time accrual —348.2;
— with continuous accrual— 349.6.
10 Chapter 1

We come to the conclusion that the accrued amount, as well as the amount
of interest money, in the compound interest scheme increases with
increasing multiplicity of accrual and reaches a maximum with continuous
accrual of interest. Moreover, the growth rate of both values decreases
with an increase in the multiplicity of accrual. (For proof of these facts,
see paragraph 1.13.)

Example 1.2. An amount of $3,000 was put on the bank deposit on March
10 at 15% per annum under the compound interest scheme. What amount
will the depositor receive on October 22?

We use the formula (1.13) for the accrual according to the scheme of
compound interest:

𝑆𝑆𝑛𝑛 = 𝑆𝑆0 (1 + 𝑖𝑖)𝑛𝑛

Duration of the financial transaction (in fractions of the period)

𝑡𝑡 20 + 30 ∙ 6 + 22
𝑛𝑛 = = = 0.608
𝑇𝑇 365

(it is assumed that there are 30 days in a month, 365 in a year), so we have

𝑆𝑆𝑛𝑛 = 𝑆𝑆0 (1 + 𝑖𝑖)𝑛𝑛 = 3,000(1 + 0.15)0.608 = $3,266.07.

So, on October 22, the depositor will receive $3,266.07.

1.5. Equivalence of interest rates in the compound

interest scheme
Let's consider interest rates, using which a model of the percentage growth
of the accrual in the compound interest scheme can be described.

If the accrual rate i for the accrual period T is specified, then

𝑡𝑡
𝑆𝑆𝑡𝑡 = 𝑆𝑆0 (1 + 𝑖𝑖)𝑇𝑇 . (1.28)

If the annual rate j and the multiplicity of accrual (during the year) p are
specified, then
 The Theory of Interest 11

𝑆𝑆𝑡𝑡 = 𝑆𝑆0 (1 + 𝑗𝑗/𝑝𝑝)𝑝𝑝𝑝𝑝 . (1.29)

In this case, it is said that j is the nominal rate.

With continuous accrual of interest

𝑆𝑆𝑡𝑡 = 𝑆𝑆0 𝑒𝑒 𝛿𝛿𝛿𝛿 . (1.30)

And the intensity of the growth rate 𝛿𝛿 is also called the continuous
nominal rate.

Finally, if the effective rate 𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 is specified, the accrued amount is

determined by the formula
𝑡𝑡
𝑆𝑆𝑡𝑡 = 𝑆𝑆0 �1 + 𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 � . (1.31)

Formulas (1.28)—(1.31) have the form:

𝑆𝑆𝑡𝑡 = 𝑆𝑆0 𝑎𝑎𝑡𝑡 . (1.32)

where a —the corresponding (normalized) accrual coefficient.

In each case, a is obtained as an annual accrual factor.

Rates are called equivalent if they have the same growth coefficients. This
means that with the same initial amount, the amounts accumulated by any
point in time t at equivalent rates are the same.

The growth coefficient 𝑎𝑎 and the effective 𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 rate are related by a simple
ratio

𝑎𝑎 = 1 + 𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 (1.33)

With this in mind, we can say that the rates are equivalent if the effective
rates equivalent to them coincide.

It is not difficult to specify the ratios that ensure the equivalence of rates of
various types.
12 Chapter 1

If j is the annual rate at the multiplicity of accrual p, then it is equivalent to

the rate 𝑖𝑖𝑖𝑖 = 𝑖𝑖1/𝑝𝑝 = 𝑗𝑗/𝑝𝑝 for the period 𝑇𝑇 = 1/𝑝𝑝. The equivalent
effective rate is determined by the formula

𝑗𝑗 𝑝𝑝
𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 = �1 + � − 1, (1.34)
𝑝𝑝

or

𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 = (1 + 𝑖𝑖 𝑇𝑇 )1/𝑇𝑇 − 1. (1.35)

Accordingly,
1
𝑗𝑗 = 𝑝𝑝 ��1 + 𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 �𝑝𝑝 − 1� ; (1.36)

𝑇𝑇
𝑖𝑖 𝑇𝑇 = �1 + 𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 � − 1. (1.37)

With continuous accrual of interest, we get:

𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 = 𝑒𝑒 𝛿𝛿 − 1, (1.38)

𝛿𝛿 = ln�1 + 𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒 �. (1.39)

iT and iT interest rates with accrual periods T1 and T2, respectively, are
equivalent if
1 1
�1 + 𝑖𝑖 𝑇𝑇1 �𝑇𝑇1 = �1 + 𝑖𝑖 𝑇𝑇2 �𝑇𝑇2 . (1.40)

If different interest rates i1, i2, …, im are set at different intervals of interest
accrual n1, n2, …, nm, then the accumulated amount Sn for the time n1 + n2
+ … + nm will be equal to

𝑆𝑆𝑛𝑛 = 𝑆𝑆0 (1 + 𝑖𝑖1 )𝑛𝑛1 (1 + 𝑖𝑖2 )𝑛𝑛2 … (1 + 𝑖𝑖𝑚𝑚 )𝑛𝑛𝑚𝑚 = 𝑆𝑆0 ∏𝑚𝑚
𝑘𝑘=1(1 + 𝑖𝑖𝑘𝑘 ) . (1.41)
𝑛𝑛𝑘𝑘
 The Theory of Interest 13

1.6. Comparison of accruals at simple and compound

interest rates
At the same interest rate, the increase according to the simple interest
scheme is more advantageous for an accrual period of less than a year. For
an accrual period of more than a year, it is more advantageous to be
accrued according to the compound interest scheme (Fig. 1.1). For proof,
it is sufficient to show that

𝑓𝑓(𝑡𝑡) = (1 + 𝑖𝑖)𝑡𝑡 < 𝑔𝑔(𝑡𝑡) = 1 + 𝑡𝑡𝑡𝑡, 𝑖𝑖𝑖𝑖 0 < 𝑡𝑡 < 1;

𝑓𝑓(𝑡𝑡) = (1 + 𝑖𝑖)𝑡𝑡 > 𝑔𝑔(𝑡𝑡) = 1 + 𝑡𝑡𝑡𝑡, 𝑖𝑖𝑖𝑖 𝑡𝑡 > 1

For the second order derivative of the function f(t)we have f''(t) = =ln2(1+
i)(1 + i)t >0, therefore, f(t) is a convex down function at t > 0, and g(t) = 1
+ it is a chord to f(t), since the equation f(t) = g(t) or (1 +i)t = 1 + + ti has
two solutions: t = 0 and t = 1. Hence (1 + i)t < 1 +ti if 0 < t < 1, and (1 + i)t
> 1 + ti if t >1.

Figure 1.1. Accrual at simple (I) and complex (II) interest rates
14 Chapter 1

Important notice 1

When interest is calculated once a year, simple interest is more effective

than compound interest with a deposit term of up to one year, and
compound interest is more effective with a deposit term of more than one
year. This can be seen from Fig.1.1.

Does this condition change with multiple accrual percent and if it changes,
then how. We leave readers to verify the following: with multiple accrual
interest, simple interest is more effective than compound interest before
the first accrual of interest. By other words at monthly accrual of interest,
simple interest is more effective than compound interest during the first
month; at quarterly accrual of interest, simple interest is more effective
than compound interest during the first quarter; when interest is accrual
semi–annually, simple interest is more effective than compound interest
during the first half of the year, and so on.

Important notice 2

Concerning the continuous interest, they are more effective than simple or
compound interest for any term of the deposit.

1.7. Discounting and interest deduction

Discounting and interest deduction are in a certain sense the reverse of
interest accrual. There are mathematical discounting and bank accounting.

Mathematical discounting allows you to find out what initial amount 𝑆𝑆0
needs to be invested in order to receive, after 𝑡𝑡 years, the amount 𝑆𝑆𝑡𝑡 when
interest is accrued on 𝑆𝑆0 at the rate 𝑖𝑖.

In the case of simple interest

𝑆𝑆𝑜𝑜 = 𝑆𝑆𝑡𝑡 /(1 + 𝑡𝑡𝑡𝑡). (1.42)

In the case of compound interest

𝑆𝑆𝑜𝑜 = 𝑆𝑆𝑡𝑡 /(1 + 𝑖𝑖)𝑡𝑡 . (1.43)

 The Theory of Interest 15

In the case of continuous accrual of interest

𝑆𝑆𝑜𝑜 = 𝑆𝑆𝑡𝑡 /e𝛿𝛿𝛿𝛿 . (1.43)

The value 𝑆𝑆0 is called the present value of the value 𝑆𝑆𝑡𝑡 . The values 𝑖𝑖 and
𝛿𝛿, which were previously called interest rates, now mean discount rates.

Bank accounting is the purchase by a bank of monetary obligations at a

price less than the nominal amount specified in them.

An example of monetary obligations is a promissory note — a

promissory note containing an obligation to pay a certain amount of
money (nominal value) within a certain period.

In the case of a bank purchase of a bill, they say that the latter is taken into
account, and the amount is paid to the client

𝑆𝑆𝑛𝑛 = 𝑆𝑆𝑜𝑜 − 𝐼𝐼𝑛𝑛 (1.45)

where S0 — nominal amount of the promissory note;

Sn — the purchase price of the promissory note by the bank for n years
before maturity;

In — discount, or the bank's income (interest money).

𝐼𝐼1 = 𝑆𝑆𝑜𝑜 𝑑𝑑. (1.46)

where d — discount rate (as a rule, through d we will further denote the
discount rate).

The discount rate can be simple and complex, depending on which scheme
is used — simple or compound interest. In the case of simple interest, the
sequence of amounts remaining after the discount {Sn} forms a decreasing
arithmetic progression with a common term Sn = S0(1 – nd) equal to the
amount that the client will receive n years before repayment.

In the case of compound interest, the sequence of amounts remaining after

the discount {Sn} forms a decreasing geometric progression with a
common term Sn = S0(1 – d)n equal to the amount that the client will
16 Chapter 1

receive n years before repayment.

1.7.1. Comparison of discounting at complex and simple

discounting rates

For the bank, the discounting situation is the inverse of the accrual. For
example, if the accounting period is less than one year, it is more
profitable for the bank to discount at a complex discount rate (Figure 1.2)
(the accrual — at a simple one (Figure 1.1)), and if the accounting period
is more than one year — at a simple discount rate (Figure 1.2) (the accrual
— at a complex one (see Figure 1.1)).

For proof, it is sufficient to show that

𝑓𝑓(𝑡𝑡) = (1 + 𝑑𝑑)𝑡𝑡 < 𝑔𝑔(𝑡𝑡) = 1 − 𝑡𝑡𝑡𝑡, 𝑖𝑖𝑖𝑖 0 < 𝑡𝑡 < 1;

𝑓𝑓(𝑡𝑡) = (1 + 𝑑𝑑)𝑡𝑡 > 𝑔𝑔(𝑡𝑡) = 1 − 𝑡𝑡𝑡𝑡, 𝑖𝑖𝑖𝑖 𝑡𝑡 > 1

For the second derivative of the function f(t) we have f "(t) = ln2(1–d)• •(1
– d)t > 0, hence f(t) is a convex down function at t > 0, and g(t) = 1–id is a
chord to f(t), since the equation f(t) = g(t) or (1 – d)t = 1 – dt has two
solutions: t = 0 and t = 1. Hence, (1 – d)t < 1 – dt if 0 < t < 1, and
(1 – d)t > 1 – dt if t >1.
 The Theory of Interest 17

Figure 1.2. Discounting at simple (I) and complex (II) interest rates

1.7.2. Effective discount rate

Let 𝑑𝑑𝑒𝑒𝑒𝑒𝑒𝑒 be the annual (effective) discount rate (discount rate) with a
multiplicity of accrual m. The equivalent effective discount rate is
determined based on the equivalence principle

𝑛𝑛 𝑑𝑑 𝑛𝑛∙𝑚𝑚
𝑆𝑆𝑜𝑜 �1 − 𝑑𝑑𝑒𝑒𝑒𝑒𝑒𝑒 � = 𝑆𝑆𝑜𝑜 �1 − � , (1.47)
𝑚𝑚

hence

𝑑𝑑 𝑚𝑚
1 − 𝑑𝑑𝑒𝑒𝑒𝑒𝑒𝑒 = �1 − � , (1.48)
𝑚𝑚

or

𝑑𝑑 𝑚𝑚
𝑑𝑑𝑒𝑒𝑒𝑒𝑒𝑒 = 1 − �1 − � , (1.49)
𝑚𝑚
18 Chapter 1

Inversely, the discount rate d is expressed in terms of the effective

discount rate 𝑑𝑑𝑒𝑒𝑒𝑒𝑒𝑒 :

𝑑𝑑 = 𝑚𝑚�1 − 𝑚𝑚�1 − 𝑑𝑑𝑒𝑒𝑒𝑒𝑒𝑒 �. (1.50)

The discount rate d and the interest rate i lead to the same result over a
period of time t if

𝑆𝑆0 (1 + 𝑖𝑖𝑖𝑖) = 𝑆𝑆𝑡𝑡 and 𝑆𝑆0 = 𝑆𝑆𝑡𝑡 (1– 𝑑𝑑𝑑𝑑), (1.51)

(1 + 𝑖𝑖𝑖𝑖)(1 – 𝑑𝑑𝑑𝑑) = 1. (1.52)

The last equality can be transformed as follows:

𝑖𝑖 𝑑𝑑
𝑑𝑑 = ; 𝑖𝑖 = . (1.53)
1+𝑖𝑖𝑖𝑖 1 –𝑑𝑑𝑑𝑑

We can also write down the relationship between the nominal rates of
increment and discounting

𝑖𝑖 𝑚𝑚 𝑑𝑑 −𝑝𝑝
�1 + 𝑚𝑚� = �1 − 𝑝𝑝� , (1.54)

since both parts of the equation are equal to (1 + i).

If m = p, we have

𝑖𝑖 𝑚𝑚 𝑑𝑑 −𝑚𝑚
�1 + 𝑚𝑚� = �1 − 𝑚𝑚� , (1.55)

hence
𝑖𝑖 𝑑𝑑 𝑖𝑖 𝑑𝑑
− = ∙ . (1.56)
𝑚𝑚 𝑚𝑚 𝑚𝑚 𝑚𝑚

If different discount rates i1, i2, …, im are set at different discount intervals
n1, n2, …, nm, then Sn for the time n1 + n2 + … + nm will be equal to

𝑆𝑆𝑛𝑛 = 𝑆𝑆0 (1 + 𝑖𝑖1 )−𝑛𝑛1 (1 + 𝑖𝑖2 )−𝑛𝑛2 … (1 + 𝑖𝑖𝑚𝑚 )−𝑛𝑛𝑚𝑚 =

= 𝑆𝑆0 ∏𝑚𝑚
𝑘𝑘=1(1 + 𝑖𝑖𝑘𝑘 )
−𝑛𝑛𝑘𝑘
, (1.57)