Section 3.

2 Compound interest
Annual Percentage Yield

MATH 1003 Calculus and Linear Algebra

(Lecture 2)

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Compound Interest: definition

Reinvestment matters!

If at the end of a payment period (for an investment), the interest

earned is reinvested, then the interest earned in the previous period
will earn interest in the next payment period, just as the original
principal.
Interest earned (or paid) on interest reinvested is called compound
interest.

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

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?

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Solution for (a)

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

1000(1 + 0.1)

I 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

I 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

I 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

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

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

0.1
1000(1 + )
2
I 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
I
I Amount of money in the bank at the end of the 8th half-year:
0.1 8
1000(1 + ) = $1477.5
2
MATH 1003 Calculus and Linear Algebra (Lecture 2)
 Section 3.2 Compound interest
Annual Percentage Yield

Solutions for (c) and (d)

By similar computation, we obtain the following results:

I 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
I 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

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

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

The total interest earned is

 r mt
I =P 1+ P.
m
Check that I > Prt.

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Compound Interest

Observation
Given a fixed annual interest rate, the more times compounded in a
certain period, the more profit a certain amount deposit can make

Example

Period 3 months 6 months 1 year

Interest rate 2.4 p.a. 2.5 p.a. 2.7 p.a.

The annual interest rate generally varies for different periods.

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Example 1 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?

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Example 1 Finding Present Value

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.

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Example 2 Computing Growth Time

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

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Example 2 Computing Growth Time

Solution part 1
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

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Example 2 Computing Growth Time

Solution part 2
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.

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Example 3 Finding Interest (Inflation) Rate (Self-Study)

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 was
compounded annually?

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Example 3 Finding Interest (Inflation) Rate (Self-Study)

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 was
compounded annually?

Solution
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%

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Compound Interest
Recall that
Theorem
Let r be the (annual nominal) interest rate, (compound) interest
paid m times per year. Let P be the principal (present value).
Then after t years, the amount (future value), A, is given by

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Compound Interest
Recall that
Theorem
Let r be the (annual nominal) interest rate, (compound) interest
paid m times per year. Let P be the principal (present value).
Then after t years, the amount (future value), A, is given by
 r mt
A=P 1+ .
m

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Compound Interest
Recall that
Theorem
Let r be the (annual nominal) interest rate, (compound) interest
paid m times per year. Let P be the principal (present value).
Then after t years, the amount (future value), A, is given by
 r mt
A=P 1+ .
m

Remark
I m = 2: compounded semiannually;
I m = 4: compounded quarterly;
I m = 12: compounded monthly;

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Compound Interest

Remark
 r mt
A=P 1+ .
m

I m = 365: compounded daily;

I m = 365 24 60 = 525, 600: compounded every minute;
I m = 5, 256, 000: compounded every 10th of a minute;
I m , i.e., m gets larger and larger, then what?
If m , interest is called compounded continuously, we have

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Continuous Compound Interest

Definition
As the number m of compounding periods per year increases
without bound, the compounded amount approaches a limiting
value. This value is given by the following formula:
 r mt
lim P 1 + = Pe rt
m m
A = Pe rt ,

where A is the compounded amount and e 2.71828.

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Continuous Compound Interest

Example
What amount will an account have after 10 years if $1500 is
invested at an annual rate of 6.75% compounded continuously?

Solution

A = 1500e 0.067510 = $2946.05.

Remark
This amount is only 18 cents more than the amount you receive by
daily compounding.

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
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.
remark
r and m are both determined by a financial institution.
MATH 1003 Calculus and Linear Algebra (Lecture 2)
 Section 3.2 Compound interest
Annual Percentage Yield

Example 4 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.

MATH 1003 Calculus and Linear Algebra (Lecture 2)

 Section 3.2 Compound interest
Annual Percentage Yield

Example 4 Comparison of Different Investments

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.
MATH 1003 Calculus and Linear Algebra (Lecture 2)
 Section 3.2 Compound interest
Annual Percentage Yield

Example 5 Find the Annual Nominal Rate (Optional)

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%

MATH 1003 Calculus and Linear Algebra (Lecture 2)