Mathematics of Finance

Introduction
The Concept of Interest

Associate Professor: Dr.Mohamed Masry

PhD, MA, Sheffield Hallam University, UK.
MBA, BA, AAST, Egypt.
 Interest is Paid by the
1.1 The the reward borrower
for lending for using
Concept of capital. capital.
Interest:
Introduction
Received by Terms are
the lender mutually
for providing agreed
capital. upon.

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 The Concept of Interest

Definition: Key Roles: Purpose of Interest:

Lender’s Perspective: Borrower: Pays interest to Risk Compensation: Covers

Compensation received for access funds (e.g., loans, the risk of borrower default.
providing capital. mortgages). Opportunity Cost: Rewards the
Borrower’s Perspective: Lender: Earns interest for lender for forgoing alternative
Cost paid for using capital. parting with their capital (e.g., uses of the capital.
banks, investors). Time Value of Money: Reflects
that money available now is
more valuable than the same
amount in the future.
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The Concept of Interest

Agreement • Mutually agreed upon by both parties, including

the interest rate, loan duration, and repayment
Terms: structure.

Factors • Borrower’s creditworthiness (risk level).

• Loan duration (longer terms often have higher rates).
Influencing • Economic conditions (e.g., inflation, central bank
Interest Rates: policies).

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Capital and Principal
Capital is the asset being lent.

Capital, in the context of lending, is the monetary asset provided by a lender to

a borrower. This amount is formally termed the Principal.
In finance, capital is often referred to as Principal.

Principal: The initial sum of money lent or invested, excluding interest or

returns.
Monetary Units: Always measured in currency (e.g., $1,000, €5,000, £500).

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Dr.Mohamed Masry

• Lender’s Role: Provides the principal to the

borrower, expecting repayment with interest.
• Borrower’s Role: Receives the principal and
Role in agrees to repay it alongside interest over time.
• Agreement Terms: The principal amount is
Financial mutually agreed upon and documented in loan
Transactions contracts.
Lender Borrower

│ ▲
▼ │
[ Principal] [ + Repayment]
│ │
└─────→ Loan ←─────────┘

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Default Risk

• Definition: The possibility that a borrower fails to repay the principal or

interest.
• Impact: Lenders face potential losses, making risk assessment critical.
• Risk Factors:
• Borrower’s credit score.
• Industry volatility (e.g., oil exploration, startups).
• Economic conditions (e.g., recession, inflation).

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Risk-Return Tradeoff

• Principle: Higher risk demands a higher interest rate.

• Why?: Lenders require compensation for taking on greater uncertainty.
• Example:
• Safe Investment: Government bonds (low risk, ~2% return).
• Risky Investment: Oil exploration (high risk, ~12% return).

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Risk Premium

• Definition: The additional interest charged to offset default risk.

• Calculation:
• Total Interest Rate = Risk-Free Rate + Risk Premium
• Example: Risk-free rate (3%) + Risk premium (5%) = Total rate (8%).
• Purpose: Ensures lenders are compensated for potential losses.

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Practical Example

• Scenario: A tech startup seeks a loan.

• Risk Factors: Unproven market, high competition, uncertain cash flow.
• Interest Rate: 10% (vs. 4% for a stable corporation).
• Outcome: The higher rate protects the lender if the startup fails.

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Inflation and Currency Value
• Impact on Investments:
• Depreciation: If a currency loses value, returns on foreign investments
(when converted back to the investor’s currency) decrease.
Example: A U.S. investor earns 8% on a Eurozone bond, but the euro
depreciates by 5% against the dollar. Real return = 8% – 5% = 3%.
• Appreciation: A stronger currency boosts returns for foreign investors.
Example: A Japanese investor earns 6% on U.S. stocks, and the dollar
appreciates by 4% against the yen. Real return = 6% + 4% = 10%.
• Key Takeaway: Currency movements can amplify or erode returns,
especially in international investments.

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Interest Rates and Inflation Allowance
• Nominal vs. Real Interest Rates:
• Nominal Rate: The stated interest rate (e.g., 7%).
• Real Rate: Adjusted for inflation (e.g., Nominal 7% – Inflation 3% = Real
4%).
• Inflation Premium: Lenders build an inflation allowance into nominal rates
to preserve purchasing power.
Example: If expected inflation is 4%, a lender might set a nominal rate at 9%
to achieve a real return of 5%.

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High Inflation and Capital Preservation
• Risk: High inflation erodes the real value of repaid capital.
Example: A loan of $10,000 at 5% interest over 1 year with 10% inflation:
• Nominal Repayment=$10,000+($10,000×5%)=$10,500
• The real value of money after accounting for inflation can be calculated
using the following formula:
• Real Value = Nominal Repayment / (1 + Inflation Rate)
• Real Value = $10,500 / (1 + 0.10)=$9,545
• The lender receives $10,500 nominally, but due to 10% inflation, this
amount only has the purchasing power of $9,545 in today’s dollars.
• Loss in Purchasing Power:
• $10,000 (original principal)−$9,545 (real value)=$455 loss.

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 Key Takeaways
▪ Real vs. Nominal:
1. Nominal returns are the "face value" of money.
2. Real returns account for inflation and reflect true purchasing power.
• Formula for Real Return:
Real Interest Rate=Nominal Interest Rate−Inflation rate
In the original example: 5%−10%=−5% (a negative real return).
• Hyperinflation Response:
In economies with extreme inflation (e.g., Zimbabwe, Venezuela, Egypt),
central banks may set rates >20% to:
1.Preserve lenders’ capital.
2.Discourage excessive borrowing.
3.Stabilize currency value.

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Simple Interest

• Interest is calculated only on the original principal.

• No compounding: Interest is computed solely on the initial amount (e.g.,
£100 earns interest on £100 every year).
• Interest earned does not earn further interest.
• Earned interest remains separate from the principal.
• Common for short-term investments.
• Examples: Short-term bonds, car loans, or savings accounts with fixed
terms.

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 Formula

• Total Amount (A) = C × (1 + n ⋅ i)

• Where:
• C = Initial Capital (Principal)
• i = Annual Interest Rate (expressed as a decimal, e.g., 9% = 0.09)
• n = Number of Years
• Interest Earned:
• Interest = n × i × C

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Example
• Deposit £100 at an annual simple interest rate of 9%.
➢ At the end of 1 year:
• A=100×(1+1×0.09)=£109
• Interest=n*i*C=1*0.09*100=£9

➢At the end of 2 years:

• A=100×(1+2×0.09)=£118
• Interest=n*i*C=2*0.09*100=£18

Year 0: £100 → Year 1: £109 → Year 2: £118

+£9 +£9

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Dr.Mohamed Masry

Compound interest rate

• Interest earns interest.
• Unlike simple interest, compound interest grows exponentially
because earned interest is reinvested.
• Example: Year 1 interest is added to the principal, and Year 2 interest
is calculated on the updated total.
• Interest credited is added to the principal.
• The principal grows each period as interest is reinvested.
• Formula snippet: New Principal = Old Principal + Interest

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The formula for compound interest
• The formula for compound interest is:
A=C×(1+i)ⁿ
• Where:
• A = Accumulated Amount
• C= Initial Principal
• i= Annual Interest Rate
• n = Number of Years.

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 Simple Interest and Compound Interest side-by-side, starting from Year 1, using
a 10% annual interest rate on an initial principal of £100.

Starting Starting Accumulated

Simple Accumulated Compound
Principal Principal Amount
year Interest Amount (Simple Interest
(Simple (Compound (Compound
Earned Interest) Earned
Interest) Interest) Interest)

0 £100.00 £0.00 £100.00 £100.00 £0.00 £100.00

1 £100.00 £10.00 £110.00 £100.00 £10.00 £110.00

2 £100.00 £10.00 £120.00 £110.00 £11.00 £121.00

3 £100.00 £10.00 £130.00 £121.00 £12.10 £133.10

4 £100.00 £10.00 £140.00 £133.10 £13.31 £146.41

5 £100.00 £10.00 £150.00 £146.41 £14.64 £161.05

 Simple Vs Compound interest rate
Simple Compound SIMPLE INTEREST VS COMPOUND
Year
Interest (£) Interest (£) INTERSEST 259.37
0 100 100

accumalated amount
235.79

1 110 110 214.36

200
2 120 121
194.87 190
177.16 180
170
3 130 133.1 146.41
161.05
150
160
140
4 140 146.41
133.1
130
121
120
110
5 150 161.05 100

6 160 177.16
7 170 194.87
10
8 180 214.36 4 5 6 7 8 9
0 1 2 3
1 2 3 4 5 6 7 8 9 10 11
9 190 235.79 Years
10 200 259.37 Year
Compound Interest (£)
Simple Interest (£)

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Aspect Simple Interest Compound Interest
Growth
Linear Exponential
Pattern

Principal Fixed Increases periodically

Short-term Long-term investments (e.g.,

Best For
loans/investments stocks)

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 Inconsistencies of Simple Interest
1.Year 1: Close account, withdraw £109.
1. Simple interest earned in Year 1:
2. Interest=100×0.09=£9⇒Total=£109Interest=100×0.09=£9⇒Total=£109
2.Re-deposit £109, close after Year 2:
1. Simple interest earned in Year 2:
2. Interest=109×0.09=£9.81⇒Total=£118.81Interest=109×0.09=£9.81⇒Total=£
118.81
• By withdrawing and re-depositing, you gain an extra £0.81 (£118.81 vs. £118).
• Why?
• Resetting the principal after Year 1 allows you to earn interest on the new
principal (£109), mimicking compound interest.

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Practical Applications
• What is the difference between simple interest and
compound interest?
• Suppose you have $500 to invest and you believe that you
can earn 8% per year over the next 15 years.
• How much would you have at the end of 15 years
using compound interest?
• How much would you have using simple interest?

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 Answer
• Principal (C): $500
• Annual Interest Rate (i): 8% = 0.08
• Time (n): 15 years
1. Compound Interest Calculation
• Using the compound interest formula:
A=C×(1+i)ⁿ
• A=500×(1+0.08) 15 =1586.08
2. Simple Interest Calculation
A=C×(1+n*i)
• A=500×(1+15×0.08)=1100
• Difference:1586.08−1100=486.08
• Conclusion: For long-term investments, compound interest is significantly more powerful,
as it allows your money to grow faster over time!

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Practical Applications
• Investment Contract Example
• Offer Details
• Offer: Receive £22,500 in 10 years in exchange for £10,000
now.
• Alternative Option
• Alternative: Invest the £10,000 elsewhere at 10%
compound interest.

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 Answer
1. Compound Interest Calculation(Alternative option)
• Using the compound interest formula:
A=C×(1+i)ⁿ
• A=10000×(1+0.10) 10 =£25,937.42
2. Compare with the Contract Offer
• Contract Offer: £22,500 in 10 years.
• Alternative Investment: £25,937.42 in 10 years.
• Difference:25,937.42−22,500=£3,437.42
• Decision
• Do not enter the contract. The alternative investment at 10% compound interest yields £3,437.42
more than the contract offer.
• Conclusion:
• The alternative investment at 10% compound interest is the better choice, providing £25,937.42 after
10 years compared to the contract's £22,500. Always analyze opportunities carefully!

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 Practical Applications
• Sarah needs to borrow £5,000 to purchase a used car. She is comparing two loan offers
from different lenders:
• Loan Offer A: Simple Interest
• Loan Amount: £5,000
• Interest Rate: 8% per annum simple interest
• Loan Term: 3 years
• Loan Offer B: Compound Interest
• Loan Amount: £5,000
• Interest Rate: 8% per annum compounded annually
• Loan Term: 3 years
• Questions:
1.For each loan offer (A and B), calculate the total interest Sarah will pay over the 3-year
loan term.
2.For each loan offer, calculate the total amount Sarah will repay (principal + interest) at
the end of 3 years.
3.Which loan offer (A or B) is financially more advantageous for Sarah, and why?

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Answer
• Loan Offer A: Simple Interest
• Formula for Simple Interest: Interest = Principal * Rate * Time=A=C×(1+n*i)
• Interest = £5,000 * 0.08 * 3= £1,200
• Total Interest Paid under Simple Interest: £1,200
• Loan Offer B: Compound Interest
• A=C×(1+i)ⁿ =5000×(1+0.08) 3 =£6,298.56
• Total Interest Paid = Accumulated Amount - Principal = £6,298.56 - £5,000= £1,298.56
• Total Interest Paid under Compound Interest: £1,298.56
• Loan Offer A: Simple Interest
• Total Repayment = Principal + Total Interest=£5,000 + £1,200= £6,200
• Loan Offer B: Compound Interest
• Total Repayment = Accumulated Amount (calculated above)
• Total Repayment for Loan B: £6,298.56
• Loan Offer A (Simple Interest) is financially more advantageous for Sarah.
• By choosing Loan Offer A, Sarah will pay £98.56 less in interest over the 3-year loan term
compared to Loan Offer B.
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