© May 2024 | IJIRT | Volume 10 Issue 12 | ISSN: 2349-6002

Financial Mathematics in Daily Life

MRINAL SHARMA1, SATPAL PANIKA2
1, 2
Kalinga University Raipur

Abstract— Financial mathematics plays a crucial role in Financial mathematics is not just a theoretical subject
our daily lives, helping us make informed decisions about confined to academic institutions. It has a wide range
our finances and plan for the future. This paper explores of practical applications that can empower individuals
the vielfältigen applications of financial mathematics in
from all walks of life to make informed financial
real-world scenarios, empowering individuals to navigate
decisions and achieve their financial goals. Here are a
the world of personal finance with confidence and
understanding. Financial mathematics is the application few examples of how financial mathematics is used in
of mathematical and statistical methods to financial real-world scenarios:
problems. It provides a framework for understanding and
managing financial risk, and for making informed Time Value of Money: Financial mathematics
decisions about financial investments. Financial incorporates the concept of time value of money,
mathematics is used by a wide range of professionals in the which states that a sum of money today is worth more
financial industry, including portfolio managers, traders, than the same amount in the future due to its potential
risk managers, and financial analysts. Financial
earning capacity. Common time value of money
mathematics draws on a variety of mathematical
calculations include present value, future value,
disciplines, including probability theory, statistics,
calculus, and optimization. It enables practitioners to annuities, and perpetuities.
quantify financial risks, price financial instruments, and
develop trading strategies. Financial mathematics is also Interest Rates and Rates of Return: Understanding
used to develop and implement risk management interest rates, rates of return, and their impact on
frameworks for financial institutions. In recent years, investment growth or borrowing costs is essential in
financial mathematics has become increasingly important financial mathematics. It involves calculations of
due to the growing complexity of financial markets and the compound interest, annual percentage rates (APR),
increasing availability of financial data. Financial
effective interest rates, and yield to maturity.
mathematics is now used to model a wide range of financial
instruments, including stocks, bonds, derivatives, and
commodities. It is also used to develop and implement Discounted Cash Flows: Financial mathematics uses
trading strategies, and to manage financial risk. Financial discounted cash flow analysis to evaluate the present
mathematics is a challenging and rewarding field that value of future cash flows, investment returns, and
offers a wide range of career opportunities. Financial project profitability. This technique is commonly
mathematicians are in high demand in the financial applied in capital budgeting, investment appraisal, and
industry, and they can earn substantial salaries. If you are valuation of financial assets.
interested in a career in financial mathematics, you should
have a strong foundation in mathematics and statistics.
Risk and Return Analysis: Financial mathematics
You should also be able to think critically and solve
helps assess and manage investment risk by
problems creatively.
quantifying risk metrics, such as standard deviation,
beta, Sharpe ratio, and Value at Risk (VaR). These
I. INTRODUCTION
measures provide insights into the relationship
between risk and potential returns in investment
From managing personal budgets to investing for
portfolios.
retirement, financial mathematics provides the tools
and techniques to optimize our financial well-being.
Portfolio Optimization: Portfolio theory in financial
This paper delves into the practical applications of
mathematics focuses on optimizing asset allocation to
financial mathematics, making complex concepts
achieve the desired risk-return trade-off. Techniques
accessible and relatable to individuals from all walks
like Modern Portfolio Theory (MPT) and Capital
of life.

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Asset Pricing Model (CAPM) are used to construct Mathematical Concept Practical Application in
diversified portfolios that maximize returns while Financial Mathematics
minimizing risk.
Time Value of Money
Option Pricing and Derivatives: Financial • Calculating the future value of investments and the
mathematics plays a crucial role in pricing options, present value of future cash flows, such as in
derivatives, and complex financial instruments. savings accounts, loans, and retirement planning.
Models like Black-Scholes-Merton model and • For Example Using the **time value of money**
binomial option pricing model are utilized to value to calculate the future value of a retirement savings
options and manage risk in derivative trading. account, taking into account the effects of
compound interest.
Loan Amortization and Debt Management: Financial
mathematics helps individuals and businesses Example of Present Value
calculate loan amortization schedules, analyze debt You are offered the opportunity to receive $10,000 in
repayment strategies, and evaluate the cost of 5 years. However, you would prefer to have the money
borrowing through interest calculations and principal today. You can invest your money at an annual interest
repayments. rate of 5%, compounded annually. The present value
(PV) is the current value of the $10,000 that you will
Insurance Mathematics: Actuarial science and receive in 5 years.
insurance mathematics use mathematical models to
assess risk, determine insurance premiums, and To calculate the present value, we use the formula:
estimate future liabilities for insurance companies. PV = FV / (1 + r)^n
Probability theory, statistics, and financial where:
mathematics are employed to analyze insurance- FV is the future value ($10,000)
related risks. r is the annual interest rate (as a decimal)
n is the number of years (5)
Making Financial Mathematics Accessible Calculation:
While financial mathematics can seem complex at first PV = $10,000 / (1 + 0.05)^5
glance, there are many resources available to make PV = $10,000 / 1.27628
these concepts accessible and relatable to individuals PV = $7,835.26
from all backgrounds. Online courses, books, and
financial literacy programs can provide a step-by-step Interpretation:
introduction to financial mathematics and its practical ● The present value of the $10,000 that you will
applications. receive in 5 years is $7,835.26, assuming the
annual interest rate of 5% remains constant.
By embracing the power of financial mathematics, ● This means that if you invest $7,835.26 today at an
individuals can take control of their financial lives, annual interest rate of 5%, compounded annually,
make informed decisions, and achieve their financial it will grow to $10,000 in 5 years.
goals.
Example of Future Value
Overall, financial mathematics provides quantitative You invest $1,000 in a savings account that offers an
tools and techniques to analyze, model, and solve annual interest rate of 5%, compounded annually. You
complex financial problems, make informed plan to leave the money in the account for 10 years.
decisions, and optimise financial outcomes in a variety * To calculate the future value, we use the formula:
of real-world contexts. It is an essential discipline in
the financial industry, risk management, investment FV = PV * (1 + r)^n
analysis, and strategic financial planning.
* PV is the present value ($1,000)
* r is the annual interest rate (as a decimal)

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* n is the number of years (10) Expected Return = (0.6 * 0.10) + (0.4 * -0.05)
Calculation: Expected Return = 0.06 - 0.02
FV = $1,000 * (1 + 0.05)^10 Expected Return = 0.04 or 4%
FV = $1,000 * 1.62889
FV = $1,628.89 Interpretation:
* The expected return of the stock is 4%. This means
Interpretation: that, on average, the investor can expect to earn a
● After 10 years, your $1,000 investment will have 4% return on their investment if they invest in the
grown to $1,628.89, assuming the annual interest stock.
rate of 5% remains constant. * This information can help the investor make an
● This example demonstrates the effect of compound informed decision about whether or not to invest in
interest, where the interest earned in each year is the stock.
added to the principal, and interest is earned on the
growing balance. Practical application of statistics is to read data and
interpretation of financial practices to be folowed.
Probability and Statistics
• Assessing the risk of financial events, such as the ● Calculus
probability of default on a loan or the likelihood of ○ Optimizing investment portfolios, pricing
a stock price increase, and making decisions under derivatives (financial instruments whose value is
uncertainty. derived from an underlying asset), and modeling
• Using **probability and statistics** to assess the continuous financial processes, such as stock price
risk of a loan applicant defaulting on their loan, fluctuations.
based on factors such as credit history and income. ○ Using **calculus** to optimize an investment
Example Application of Probability in Financial portfolio, by finding the combination of assets that
Mathematics maximizes the expected return for a given level of
An investor is considering investing in a stock. The risk.
stock has a 60% probability of increasing in value by
10% and a 40% probability of decreasing in value by ● Linear Algebra
5%. The investor wants to calculate the expected ○ Solving systems of equations that arise in financial
return of the stock. modeling, such as in risk management and
portfolio optimization.
Definition ○ Using **linear algebra** to solve a system of
Probability: equations that represents the cash flows of a
The probability of an event occurring is the likelihood complex financial transaction, such as a bond
of that event happening. In this case, the issuance.
probability of the stock increasing in value is 60%, ● Optimization
or 0.6, and the probability of the stock decreasing ○ Finding the best possible solutions to financial
in value is 40%, or 0.4. problems, such as determining the optimal asset
Expected Return: allocation for a given risk tolerance and investment
The expected return of an investment is the average horizon.
return that the investor can expect to receive over ○ Using **optimization** to determine the optimal
many trials. It is calculated by multiplying the withdrawal strategy for a retirement account,
probability of each possible outcome by its considering factors such as life expectancy and
corresponding return and then summing the inflation.
results. ○
Calculation of Expected Return: ● Numerical Methods
Expected Return = (Probability of Increase * Return ○ Solving complex financial models that cannot be
on Increase) + (Probability of Decrease * Return solved analytically, such as in Monte Carlo
on Decrease)

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simulations used for risk assessment and option ○ Look for areas where you can cut back on
pricing unnecessary expenses.
○ Using **numerical methods** to simulate the ○ Consider increasing your income by taking on a
behavior of a stock price over time, taking into side hustle or negotiating a raise at work.
account historical data and market conditions, to ● Review and Revise:
assess the risk and potential return of an ○ Regularly review your budget and make
investments adjustments as needed.
○ Your budget should be a living document that
1. Budgeting and Financial Planning: reflects your changing financial situation and
goals.
* Creating realistic budgets based on income and
expenses **Tips for Creating a Realistic Budget:**

A budget is a financial plan that outlines your income * Be honest with yourself about your income and
and expenses over a specific period, typically a expenses.
month. Creating a realistic budget is crucial for * Set realistic financial goals.
managing your finances effectively and achieving * Don't be afraid to adjust your budget as needed.
your financial goals. Here are the steps involved in * Use budgeting tools and resources to make the
creating a realistic budget based on your income process easier.
and expenses: * Seek professional help if you are struggling to create
or stick to a budget.
● Track Your Income and Expenses Remember, creating a realistic budget is an ongoing
○ For a few weeks or even a month, track all of your process. It takes time and effort to develop a budget
income and expenses, no matter how small. that works for you and helps you achieve your
○ * Use a budgeting app, spreadsheet, or simply a financial goals.
notebook to record your transactions. * Forecasting future cash flows and identifying
○ * Categorize your expenses into fixed expenses potential shortfalls
(e.g., rent, car payment, insurance) and variable * Determining optimal savings rates and debt
expenses (e.g., groceries, entertainment, dining repayment strategies
out).
● Calculate Your Net Income: 2. Loans and Mortgages:
○ Subtract your total expenses from your total
income. * Calculating monthly payments, interest rates, and
○ This will give you your net income, which is the loan terms
amount of money you have left over after paying Calculating Monthly Payments
all your expenses.
● Set Financial Goals: Monthly Payment = (Loan Amount * Annual
○ Determine your short-term and long-term financial Percentage Rate / 12) / (1 - (1 + Annual Percentage
goals. Rate / 12)^(-Number of Months))
○ This could include saving for a down payment on
a house, paying off debt, or retiring early. Example:
● Allocate Your Income: For a loan of \$10,000 with an APR of 5%, a loan term
○ Start by allocating funds to your fixed expenses. of 60 months:
○ Then, allocate money to your savings goals. Monthly Payment = (10000 * 0.05 / 12) / (1 - (1 + 0.05
○ Finally, allocate the remaining funds to your / 12)^(-60))
variable expenses. Monthly Payment = \$182.53
● Adjust Your Spending: Calculating Interest Rates
○ If your expenses exceed your income, you will Formula:
need to adjust your spending.

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Annual Percentage Rate = (Monthly Payment * 12 / ● Variable-rate loans have an interest rate that can
(Loan Amount)) - 1 / ((1 / (1 + Monthly Payment fluctuate with market conditions.
* 12/ Loan Amount)^Number of Months)) - 1) ● Choose a loan type that aligns with your financial
Example: goals and risk tolerance.
For a loan of \$5,000 with a monthly payment of 5. Lender Reputation:
\$100, a loan term of 36 months: ● Research the reputation and customer reviews of
Annual Percentage Rate = (100 * 12 / 5000) - 1 / ((1 / different lenders.
(1 + 100 * 12/ 5000)^36)) - 1) Choose a lender that is reputable and offers good
Annual Percentage Rate = 0.05 or 5% customer service.
Calculating Loan Terms Choosing the Most Suitable Loan Option
Formula: Once you have compared different loan options,
Number of Months = -log(1 - (Monthly Payment * consider your individual financial situation to
Loan Amount) / (Annual Percentage Rate * Loan choose the most suitable one:
Amount)) / (log(1 + Annual Percentage Rate / 12)) Income and Expenses: Ensure that the monthly loan
payments fit comfortably within your budget.
Example: Credit Score:A higher credit score typically qualifies
For a loan of \$20,000 with a monthly payment of you for lower interest rates.
\$250, an APR of 6%: Debt-to-Income Ratio: Lenders consider your debt-to-
Number of Months = -log(1 - (250 * 20000) / (0.06 * income ratio (DTI) to determine your ability to
20000)) / (log(1 + 0.06 / 12)) repay the loan. Keep your DTI below 36% for best
Number of Months = 84 or 7 years results.
Loan Purpose: Different loans have different purposes,
Comparing different loan options and choosing the such as home mortgages, auto loans, or personal
most suitable one loans. Choose a loan that is specifically designed
Comparing Different Loan Options for your needs.
Example:
To compare different loan options and choose the most Suppose you are comparing two loan options for a
suitable one, consider the following factors: \$10,000 personal loan:
1. Interest Rate: Loan A: 6% APR, 3-year term, \$200 origination fee
● The lower the interest rate, the less you will pay in Loan B:5% APR, 5-year term, \$100 origination fee
interest over the life of the loan. Calculations:
● Compare the annual percentage rate (APR) of Loan A:
different loans, which includes both the interest Monthly payment: \$312.39
rate and any fees. Total interest: \$674.01
2. Loan Term: Total cost (including fees): \$10,874.01
● A shorter loan term means higher monthly Loan B:
payments but lower total interest paid. Monthly payment: \$215.43
● A longer loan term means lower monthly payments Total interest: \$1,077.16
but higher total interest paid. Total cost (including fees): \$11,177.16
● Choose a loan term that you can comfortably Based on these calculations, Loan A has a lower
afford. monthly payment but higher total cost due to the
3. Loan Fees: shorter loan term and higher origination fee. Loan
● Some loans have origination fees, closing costs, or B has a higher monthly payment but lower total
other fees. cost due to the longer loan term and lower
● Factor these fees into your comparison to origination fee.
determine the true cost of the loan. Depending on your financial situation, you may
4. Loan Type: choose Loan A for the lower monthly payments or
● Fixed-rate loans have an interest rate that remains Loan B for the lower total cost.
the same throughout the loan term.

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* Understanding the impact of amortization and Calculating returns, risks, and portfolio diversification
refinancing Calculating Returns
1. Total Return:
3. Investments: Return on investment (ROI) = (Current Value - Initial
Investment) / Initial Investment
Evaluating Investment Opportunities Using Time 2. Annualized Return:
Value of Money (TVM) Concepts If the investment period is less than one year:
TVM concepts help determine the present value and Annualized Return = (1 + Total Return)^(365 / Days
future value of money, which is crucial for evaluating Held) - 1
investment opportunities. Here's how to use TVM: If the investment period is greater than one year:
Annualized Return = (Ending Value / Beginning
Value)^(1 / Number of Years) - 1
1. Determine the Time Value of Money: Calculating Risks
Present Value (PV): The current value of a future sum 1. Standard Deviation:
of money. Measures the volatility of an investment's returns.
Future Value (FV): The value of a current sum of A higher standard deviation indicates higher risk.
money at a future date, considering interest earned. 2. Abeta:
2. Calculate the Present Value of Future Cash Flows: Measures the volatility of an investment relative to the
Use the formula: PV = FV / (1 + r)^n overall market.
Where: Abeta of 1 indicates the investment moves in line with
r = annual interest rate (as a decimal) the market.
n = number of years Abeta greater than 1 indicates the investment is more
3. Calculate the Future Value of Present Investments: volatile than the market.
Use the formula: FV = PV * (1 + r)^n 3. Sharpe Ratio:
4. Evaluate Investment Opportunities: Measures the excess return (return above the risk-free
Net Present Value (NPV):The difference between the rate) per unit of risk.
present value of future cash inflows and outflows. A A higher Sharpe ratio indicates a better risk-adjusted
positive NPV indicates a profitable investment. return.
Internal Rate of Return (IRR): The discount rate that Portfolio Diversification
makes the NPV equal to zero. A higher IRR indicates Diversification is a risk management strategy that
a more profitable investment. involves spreading investments across different asset
Example: classes, industries, and geographic regions. The goal
Suppose you are considering investing in a project that is to reduce overall portfolio risk by minimizing the
will generate the following cash flows: impact of any single investment's performance.
Year 0: -$10,000 (initial investment) Benefits of Diversification:
Year 1: $5,000 Reduces portfolio volatility
Year 2: $6,000 Improves risk-adjusted returns
Year 3: $7,000 Provides downside protection
Assuming an annual interest rate of 5%, let's evaluate Methods of Diversification:
the investment using NPV: Asset Allocation: Dividing investments among
PV of Cash Flows: different asset classes, such as stocks, bonds, and real
Year 1: $5,000 / (1 + 0.05)^1 = $4,761.90 estate.
Year 2: $6,000 / (1 + 0.05)^2 = $5,334.93 Industry Diversification:Investing in companies from
Year 3: $7,000 / (1 + 0.05)^3 = $5,786.63 various industries to reduce exposure to industry-
NPV: specific risks.
NPV = -$10,000 + $4,761.90 + $5,334.93 + $5,786.63 Geographic Diversification: Investing in companies
NPV = $5,883.56 from different countries to reduce exposure to country-
Since the NPV is positive, this investment is specific risks.
considered profitable. Example:

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Suppose you have a portfolio with the following Financial Security: Helps individuals plan for the
investments: future, reduce risks, and achieve financial stability.
Stock A: 50% Informed Decision-Making:Provides a framework for
Stock B: 25% evaluating financial options and choosing the best
Stock C: 25% course of action.
The standard deviations of the individual stocks are: Reduced Financial Stress: Empowers individuals to
Stock A: 15% manage their finances effectively, reducing stress and
Stock B: 10% anxiety.
Stock C: 8% Improved Financial Well-being: Contributes to overall
The correlation coefficients between the stocks are: financial well-being by optimizing financial resources
Stock A and Stock B: 0.5 and achieving long-term financial goals.
Stock A and Stock C: 0.3
Stock B and Stock C: 0.2 Conclusion
Using the formula for portfolio standard deviation:
Portfolio Standard Deviation = √[(0.5² x 0.15²) + Financial mathematics is not just a subject taught in
(0.25² x 0.1²) + (0.25² x 0.08²) + (2 x0.5 x 0.25 x 0.15 textbooks. It is a practical and empowering tool that
x 10%) + (2 x 0.5 x 0.25 x 0.08 x 3%) + (2 x 0.25 x can revolutionize our relationship with money. By
0.25 x 0.1 x 8%)] embracing the concepts of financial mathematics,
Portfolio Standard Deviation = √[0.0563 + 0.0156 + individuals can unlock their financial potential, secure
0.0064 + 0.0150 + 0.0048 + 0.0040] their financial future, and achieve greater financial
Portfolio Standard Deviation = 0.1192 or 11.92% well-being.
By diversifying your portfolio, you have reduced the
overall risk, as measured by the portfolio standard *Textbooks:*
deviation, to 11.92%, which is lower than the standard
deviations of the individual stocks. ● Financial Mathematics: A Comprehensive
Making informed decisions about stocks, bonds, and Treatment by Robert L. McDonald
mutual funds ● Mathematics for Finance: An Introduction to
4. Retirement Planning: Financial Engineering by Marek Capinski and
Determining retirement savings goals and timelines Ekkehard Kopp
Choosing appropriate retirement accounts (e.g., ● Financial Calculus: An Introduction to Derivative
401(k), IRA) Pricing by Martin Baxter and Andrew Rennie
Estimating retirement income needs and creating a ● Introduction to Quantitative Finance by Keith Hull
sustainable withdrawal strategy ● Financial Risk Management: Models and
5. Insurance: Techniques by John C. Hull
Assessing risk and determining appropriate insurance
coverage *Online Resources:*
Calculating insurance premiums and deductibles
Evaluating the financial impact of potential events ● [The Mathematical Association of America's
(e.g., accidents, illnesses) Committee on Undergraduate Statistics
6. Taxes: (CAUSE)](https://www.causeweb.org/)
Understanding tax brackets and deductions ● [The Society for Industrial and Applied
Optimizing tax strategies to reduce tax liability Mathematics (SIAM)](https://www.siam.org/)
Planning for tax-efficient investments and retirement ● [The American Statistical Association
income (ASA)](https://www.amstat.org/)
Benefits of Financial Mathematics Literacy ● [The Royal Statistical Society
(RSS)](https://www.rss.org.uk/)
Empowerment:Enables individuals to take control of ● [The International Statistical Institute
their financial lives and make informed decisions. (ISI)](https://www.isi-web.org/)
*Research Papers:*

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● [A survey of financial
mathematics](https://arxiv.org/abs/2103.02684)
● [Financial mathematics: A review of the literature]
(https://www.sciencedirect.com/science/article/ab
s/pii/S037847541930294X)
● [Ten trends in financial
mathematics](https://arxiv.org/abs/2103.02774)

*Other Resources:*

● [Financial
Mathematics](https://en.wikipedia.org/wiki/Finan
cial_mathematics) on Wikipedia
● [Financial Mathematics]
(https://www.investopedia.com/terms/f/financial
mathematics.asp) on Investopedia
● [Financial
Mathematics](https://www.khanacademy.org/mat
h/ap-statistics-
a/x2eef969c74e0d802:probability/x2eef969c74e0
d802:financial-math/v/expected-value-of-a-
lottery-ticket) on Khan Academy

*MOOCs:*

● [Financial
Mathematics](https://www.coursera.org/specializ
ations/financial-mathematics) on Coursera
● [Mathematics for
Finance](https://www.edx.org/course/mathematic
s-for-finance) on edX
● [Financial
Mathematics](https://www.udacity.com/school-
of-business/degree/financial-analyst-nanodegree--
nd059) on Udacity

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