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Lecture 4
Varying interest
Solution of problems in interest

Varying Effective Rate of Interest

where ik denote the effective rate of interest during the kth period
from the date of investment and t>=1 is positive integer

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Varying Force of Interest

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A summary

Solution of problems in interest

An interest problem involves four basic variables :
original amount(s) invested
length of investment period(s)
rate (or force) of interest (or discount)
accumulated value(s) at the end of the investment period.
if you have 3 of the above variables, then you can solve for the unknown
4th variable.
An interest problem can be viewed from two perspectives, since it involves
a financial transaction between two parties: the borrower and the lender.
From either perspective, the problem is essentially the same; however, the
wording of a problem may be different depending upon the point of view.
For example: paid / credited
Obtaining Numerical Results : using a calculator or an interest table
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Equations of value
Recognition of time value of money.
This reflects the effect of interest, but not the effect of inflation which
reduces the purchasing power of money over time. Inflation-adjusted
calculations will be discussed in our later lectures.
Considering time value of money, two or more amounts of money
payable at different points in time cannot be compared until all the
amounts are accumulated or discounted to a common date.
This common date is called the comparison date (or the focus point),
and the equation which accumulates or discounts each payment to the
comparison date is called equation of value.
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Time diagram
One device which is often helpful in the solution of equations of value
is the time diagram.
It helps to draw out a time line and plot the payments and
withdrawals accordingly
Payments in one direction are placed on the top of the diagram and
payments in the other direction are placed on the bottom of the
diagram.

The comparison date is denoted by an arrow.

Under the compund interest case, the choice of the comparison date
makes no difference in the answer obtained.
Thus there is a different equation of value for each comparison date,
but they all produce the same answer!
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Example: A $600 payment is due in 8 years; the alternative is to

receive $100 now, $200 in 5 years and $X in 10 years. If i = 8%, find $X,
such that the value of both options is equal.

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Unknown time
Single Payment
the easiest approach is to use logarithms
Example: How long does it take money to double at i = 6%?

if logarithms are not available, then use an interest table and

perform a linear interpolation
(1.06)n = 2
From interest table (1.06)11 = 1.89830 and (1.06)12 = 2.01220

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Rule of 72 for doubling a single payment

Rule of 114 for tripling a single payment

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How long does it take money to double

at a given rate of interest?
Rate of interest Rule of 72 Exact Value
Relative Error
i%
0.72/i n=ln(2)/ln(1+i) Absolute Error/Exact Value
35,00
23,45
17,67
14,21
11,90
10,24
9,01
8,04
7,27
6,64
6,12
5,67
5,29
4,96
4,67
4,41
4,19
3,98
3,80

0,03
0,02
0,02
0,01
0,01
0,00
0,00
0,01
0,01
0,01
0,02
0,02
0,03
0,03
0,04
0,04
0,04
0,05
0,05

increasing

36,00
24,00
18,00
14,40
12,00
10,29
9,00
8,00
7,20
6,55
6,00
5,54
5,14
4,80
4,50
4,24
4,00
3,79
3,60

increasing

2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
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19
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An Approximate Approach For Multiple Payments

let St represent a payment made at time t such that

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This approximation of t is always greater than the true value of t, which means
that the present value using the method of equated time is smaller than the true
present value.
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Unknown rate of interest

There are 4 general methods to use in determining an unknown rate
of interest.
The first is to solve the equation of value for i directly using a
calculator with exponential and logarithmic functions .This will work
well in situations where there are few payments, and the equation of
value can be easily reduced.
The second is to solve the equation of value for i directly by algebraic
techniques. An equation of value with integral exponents on all the
terms can be written as an nth degree polynomial in i. This method is
generally practical for only small values of n.
The third method is to use linear interpolation in the interest tables.
The fourth is successive approximation, or iteration. This seems
impractical for use on exams, especially with modern calculators.
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Example: At what effective interest rate will an investment of $100

immediately and $500 4 years from now accumulate to $1000 10
years from now?

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Determining time periods

Simple interest is computed using the exact number of days for
the period of investment and 365 as the number of days in a year.
This is called exact simple interest, and is denoted by
actual/actual.
The second method assumes that each month has 30 days, and
that the entire year has 360 days. Simple interest computed on
this method is called ordinary simple interest, and is denoted by
30/360.
The third method is a hybrid. It uses the exact number of days for
the period of investment, but uses 360 days per year. Simple
interest on this basis is called the bankers rule, and is denoted by
actual/360.
The Bankers Rule is always more favorable to a lender than exact
simple interest, and is usually more favorable to a lender than
ordinary simple interest, but there are exceptions to that.
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It is assumed, unless stated otherwise, that in counting days,

interest is not credited for both the date of deposit and the
date of withdrawal, but for only one of these days.
Not all practical problems involve the counting of days, many
transactions are on a monthly, quarterly, semiannual, or
annual basis. In these cases, the above counting methods are
not required.
In summary
(i) exact simple interest approach: count actual number of days
where one year equals 365 days
(ii) ordinary simple interest approach: one month equals 30 days;
total number of days between D2,M2, Y2 and D1,M1, Y1 is
360(Y2 Y1) + 30(M2 M1) + (D2 D1)
(2.5)
(iii) Bankers Rule: count actual number of days where one year
equals 360 day
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Reference: KELLISON, S. G., 1991, The Theory of Interest, Irwin Inc., USA., Chapter 1.10, Chapter 2

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