Unit 1.

Fundamentals

Amparo Nagore García

Office: 5E07
[email protected]
Contents
1.- Introduction
 Financial Transaction. Examples
 Time value of money
 Interest & discount
 Financial Transaction. Formal concept

2.- Interest rules: Simple interest and simple discount

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Financial Transaction. Examples
 Example of a loan from the bank to a household

Lends a sum of money

for a specific period of
time Borrower
Lender (i.e.
(i.e bank) household)
Pay back: borrowed money +
Interest (compensation paid
for the use of money)

 2 types of cashflows in any financial transaction:

1) Cash outflows: payments and expenditures

2) Cash inflows: receipts, incomes or revenues

Why does
Why doesthe
theborrower
borrowerpaypay back
back the the interest,
interest apart apart from
from the the borrowed?
money money
borrowed? Amparo Nagore García - Universidad de Valencia 3
Key principle in finance: preference for liquidity

Principle of underestimation of future

needs or preference for liquidity
The value of one euro today is higher than the value of one euro tomorrow
==> Money has time value
In other words, the consumer prefers to consume an economic good today
rather than in the future

There is a price for delaying the availability of the capital: Interest

Or
For anticipating the availability of the capital: Discount
4
Amparo Nagore García - Universidad de Valencia
Time value of money
 As the money has time value, every sum of money involved in a financial
transaction should have an attached date (the date on which it is due).
 Formally, a dated amount of money (dated value) is expressed as a pair:(C;t) or C
 Graphically, we represent (C1,t1); (C2,t2):

 Which Ct is preferred between the following options and why?

1) (100, 29/01/2023) or (1000, 29/01/2023)
Wooclap
2) (100, 29/01/2023) or (100; 29/01/2033)
3) (100, 29/01/2023) or (150; 29/01/2025)

 In order to compare different pieces of money, we will have to place the

monies at the same point in time (called the focal date) using specific
formulas [Recall the computation of the total distance from metres,
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kilometres..]
Interest & Discount
 Interest
 is the compensation that the borrower of capital pays to a lender of capital for its use
 is the amount measured in monetary units that must be paid for the use of money Cn
borrowed for a given period of time I

 Amount of interest depends on: Co

Principal (Co); Period of time(tn-to); interest rate (i)

Example
10,816
We invest 10,000€ today in a fixed term I
deposit, after 2 years we will receive 10,000
10,816€, so the intereset earned is 816€
(=10,816-10,000).
0 2

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Example of the discount of a commercial paper (story telling)

2023
3

NATIONAL BANK

The bank is the owner and in

August it will receive 1,000 €
1,000€ What happens
with the treasury
Bill?
1,000€- 2
2023
Discount
NATIONAL BANK

January 2023 August

2023

Amparo Nagore García - Universidad de Valencia

 Interest & Discount
 Discount
 Short term loans, that consists of selling a financial security at a Price lower than the face value. Upon the
maturity of the loan the face value is repaid
Cn
D
 Some financial transactions have interest paid or deducted up-front. i.e Treasury Bills
Co

 The discount is the difference between the sale price (Cn) and the face value (C0)

 The discount is the amount measured in monetary units that must be paid for the prepayment of an amount due
on a later date

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Financial Transaction. Concept
 Concept of financial transaction:
 Non-simultaneous exchange of amounts of money between two parties in
accordance with a given interest rule mutually agreed

 How do we identify the role of each party (who is the

lender/borrower)?
Makes the initial
payment (and Lends a sum of money Receive the first
possibly other for a specific period of amount of money
payments) time
Lender Borrower
Pay back:
money borrowed + Interest

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Financial Transaction. Practice Wooclap
Trabajo individual
Valencia, February 4 2023 dentro del Aula

Mrs. Smith lends to Mr. Soler 10.000 EUROS today:

In turns, Mrs Smith will receive one of the following cash flows, corresponding to two offers:
a) (11,000€; June 4, 2023)
b) (12,000 €, February 4, 2024)

1- Indicate who is the lender and the borrower

2.- Write down the dated values paid by the borrower and by the lender

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Financial Transaction. Interest rules
 How can interests be calculated?
Using specific rules or criteria (formulas) that mirror the principle of
preferences for liquidity

The most common interest rules are:

- The simple interest rule Used in short-term transactions (shorter than
one year)
- The compound interest rule Used in short-term and long-term
transactions (Unit 2)

- The discount rule discounting of commercial paper

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2.- The interest rule: Simple interest rule. Terminology and Notation
Cn
 The sum of money borrowed is called principal I
Co
(Co) borrower compensates the lender by paying
 The
interests (I)

 The term of the transaction is the number of time units in which time is

measured n=tn-t0 (i.e, number of months, days)

 The interest rate per time unit (i) is the ratio (usually in per cent) of the
interest charged to the principal in one time unit

 At the end of the period (tn), the borrower pays the lender the accumulated

amount or the future value (Cn=C0+I), which is equal the sum of principal
plus interest. It might be called also: the final amount or the maturity value
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 2.1.- The interest rules: Simple interest rule
Cn
 Mainly used in short-term transactions Same
I
time unit
 The interest is proportional to the principal and the total Co
time of the transaction: I C0 i n
 The accumulated value of Co to be received at the end of the term (Cn) is
𝐶 𝑛 by:
given =𝐶 0 + 𝐼 =𝐶 0 +𝐶 0 ⋅ 𝑖 ⋅𝑛𝐶;𝑛 =𝐶 0 ⋅ ( 1+𝑖 ⋅ 𝑛 ) 𝐶 0 ≈ 𝐶 𝑛
If Co=1, then
Is the accumulation factor at simple interest Cn=(1+i*n)=>
accumulated amount of
 If “i” is an annual interest rate & the time of the transaction (n) is notin
one unit borrowed given
t0
in years,
we need to express time in years. How? Rule of three
 k
Cn C0  1  i   For instance, the investment is 5 months
 m
Where: 12 months ------------------ 1 year
K: number of smaller periods included between t0 and tn
(months, semesters…) 5 months ------------------- X years
m: fraction in which the year is divided measured as k, X=5*1/12 13

i.e. how many “semesters” in the year? m=2; Amparo Nagore García - Universidad de Valencia
2.1.- The interest rules: Simple interest rule. Exercises. Basic questions
1.3.- What would be the value, calculated with the simple interest rule, that
would be received at the end of the period if an amount of €10,000 is invested
in a deposit in a financial institution for 3 years at an annual interest rate of
5%?

1.4.- What would be the interest, calculated with the simple interest rule, that
would be received at the end of the period if an amount of €10,000 was
deposited in a financial institution for 3 years at an annual interest rate of 5%?

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2.1.- The interest rules: Simple interest rule. Exercises. Basic questions
1.6.- Indicate the minimum amount to be invested over a period of nine
months in order to obtain interest of 50 euros, if the financial institution
where the operation is carried out applies an annual interest rate of 0.75%
working with simple capitalisation.

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2.1.- The interest rules: Simple interest rule. Exercises. Basic questions
1.7.- Indicate the minimum amount that will have to be invested over a period
of 9 months in order to obtain a final amount of 3,000 euros, if the financial
institution where the operation is carried out applies an annual interest rate of
0.75% working with simple capitalisation.

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 2.1.- The interest rules: Simple interest rule. Exercises. Basic questions
1.9.- Indicate the minimum annual interest rate at which a capital of 2,000
euros must be invested in order to obtain interest of 85 euros after 6 months,
if the financial institution works with simple capitalisation .

1.12.- Indicate how long it will be necessary to have a capital of €1,000

invested in a financial institution that capitalises at an annual interest rate of
3.5% in simple capitalisation in order to have a final accumulated amount
equal to or greater than €1,200.

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2.- Simple Interest rule. Advanced Questions
1.19.- What would be the capital, calculated in simple capitalisation, that
would be received at the end of the period if it were capitalised:
(a) €1,000 for 3 months at 6% per annum.
(b)€5,000 for 3 months at 0.5% per month.
(c) €10,000 over 3 months at 1.5% per quarter.
(d)With the results obtained, indicate which investment is more appropriate.

18
2.2- Dicount interest rule
 Discount interest rules are used for discounting of commercial paper; i.e
Treasury Bills.

 Short-term loans that consists of selling a financial security at a Price less

than the face value. Upon the maturity of the loan the face value is repaid

 In other words, these transactions are conceived as the prepayment of an

amount due on a later date
Cn
 The cost for the prepayment is called discount (the amount D
C0
to be deducted) and is the difference between Cn and C0

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 2.2.- Discount interest rule (cont.)
Notation:

• Cn final amount on which the discount is made, or maturity value. It is due on date
tn
• D: the (simple) discount. It is due and payable at the beginning of the discount
period
• n=tn-t0 : the term of the transaction or discount period.
It is the number of time units in which time is measured (i.e, Cn
number of months, days…) D
C0
• d: the (simple) rate of discount per time unit. The rate of
discount refers to the same time unit used to measure the
discount period
• C0 = Cn – D: the present value. It is due at time t0.

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2.2.- Discount interest rule (cont.)
 Discount interest rule: Cn
 The discount is proportional to the size of the maturity
D
D C d n
value and the length of the discount period
n C0
 The amount received at the start is given by:
Discount factor at simple
C 0 C n  D C n  C n d n C n [1  d n] discount

 C0 is obtained by discounting Cn at simple discount

Same time unit
C0 Cn [1  d n] Cn [1  d k / m] Where:
21

K: number of smaller periods

included between t0 and tn (months,
If d is an annual discount rate, n must be semesters…)
expressed in years m: fraction in which the year is
divided,
i.e. how many “semesters” in the
year? m=2;
Amparo Nagore García - Universidad de Valencia
Discount interest rule. Basic and advanced Questions
1.13 What would be the discount on a capital of €3,000 if its availability were brought
forward by 3 months and the discount rate were 3% per annum?

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Discount interest rule. Basic and advanced Questions
1.15 Find the present value corresponding to a future value of €9,000 at
annual 3% simple discount if
a) The term of the transaction is 18 months.
b) The term of the transaction is 30 days.
c) The term of the transaction is 1 year.

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Conceptual map Unit 1
Principle of underestimation of future needs or
preference for liquidity
Base of
Financial Transaction

When is paid the What is Which parties Interest rules or

compensation? exchanged? participate? criteria
Type of transaction

Short & long Discounting

The compensation is called Short term comercial pape
term

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Concepts Unit 1
 Financial transaction

 Principle of the preferences for liquidity

 Lender

 Borrower

 Interest

 Discount

 Simple discount rule

 Simple interest rule

Know how to do
 Draw the time-diagram

 Find the principal, the accumulated amount, interest, disount, term…. Using the simple
interest rule and discount interest rule

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Degree in International Business. 2022-2023

Unit 1. Fundamentals

Amparo Nagore García

Office: 5E07
[email protected]
Conceptual map Unit 1
Principle of underestimation of future needs or
preference for liquidity
Base of
Financial Transaction

When is paid the What is Which parties Interest rules or

compensation? exchanged? participate? criteria
Type of transaction

Maturity t0
Short term Short & long Discounting
The compensation is called term comercial pape
Lender Borrower Compound Simple
Interest Discount Dated values (C,t) Simple interest
interest discount

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 Thanls for
your attention
Financial Transaction. Practice
Valencia, February 4 2023 Trabajo individual
dentro del Aula
Mrs. Smith lends to Mr. Soler 10.000 EUROS today:
In turns, Mrs Smith will receive one of the following cash flows, corresponding to two offers:
a) (11,000€; June 4, 2023)
b) (12,000 €, February 4, 2024)

1- Indicate who is the lender and the borrower

2.- Write down the dated values paid by the borrower and by the lender
3.- Which is the value of the annual interest rate in the two cases assuming simple interest rule?

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 Simple interest rule. Example
Example 1.2: Suppose that a single deposit of EUR 1,000 for 3 years is made in a bank that
pays simple interest at the rate of 4% per annum. Find the interest earned, and the amount
finally withdrawn from the bank.

Example 1.3. Suppose that EUR 5,000 is deposited in a bank that pays simple interest at
an annual rate of 4%. Which will be the final amount withdrawn if the money is deposited for
a period of 180 days? And for a period of 3 months?

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Homework in couples: Review of some concepts (Concepts unit 1)
1) Define the concept of financial transaction

2) Name the agents that participate in a financial transaction and their functions. How can you identify who is the lender?

3) Define the concept of “interest” and “discount”

4) What is the principle of preference for liquidity?

5) Which are the most common interest rules used in the financial markets and for which type of transactions should we use
each of them?

6) Write down the equation to obtain the accumulated value using the simple interest rule and the equation to obtain the
present value discounting the maturity value at simple discount. Identify the accumulation factor and the discount factor for each
expression.

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Amparo Nagore García - Universidad de Valencia 33
Test Unit 1
Select the right answer:

1) A financial transaction
Is the simultaneous exchange of amounts of money between two parties in accordance with a given
interest rule mutually agreed.
a) Is a non-simultaneous exchange of amounts of money between two parties in which the equivalence
between the principal and the accumulated value with a given interest rule is not satisfied.
b) Is any transaction between financial agents.
c) None of the previous answers is correct.

2) Interest in a financial transaction:

a) is the amount measured in the monetary units that must be paid for the use of money borrowed for
a given period of time.
b) Is the total amount of money that is paid to pay the borrowed money back.
c) It is the profit margin that is added to the cost of the goods to obtain the final price.
d) None of the previous answers is correct.

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Test Unit 1 (Cont.)
3) If we compare two dated values (C1, t1) y (C2, t2):
a) If t1<t2 and C1>C2, then C1 is preferred to C2
b) If t1 <t2 and C1> C2, then C2 is preferred to C1
c) If t1 ≠ t2 and C1 ≠ C2, then definitely both dated values are equivalent based on an interest rule
d) None of the previous answers is correct.

4) In a financial transaction:
The party that receives the first amount of money is called the borrower.
e) The party that receives the first amount of money is called the lender.
f) Cash outflows are receipts, incomes or revenues.
g) None of the previous answers is correct.

5) In a financial transaction where the discount interest rule is used:

a) The compensation for the use of money is called interest.
b) A financial security is sold in t0 at a Price less than the face value.
c) A financial security is sold in t0 at a Price higher than the face value.
d) None of the previous answers is correct.

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Test Unit 1 (Cont.)
6) In a financial transaction in which the discount interest rule is used. Compute the present value if the final amount
is 29000 euros; the term of the transaction is 93 days and the discount rate is 5% annual.
a) 29369.45
b) 28630.55
c) 369.45
d) None of the previous answers is correct.
7) In a financial transaction in which the simple interest rule is used, find how long (in months) will it take to earn
6270.37€ of interest if the principal is 77000 and the annual interest rate is 6.98%.
e) 1.16
f) 14
g) 5
h) None of the previous answers is correct.

8) In a financial transaction in which the simple interest rule is used, find the principal if the final amount is 50000; the
term is 22 months ant the annual interest rate is 4.56%
a) 46552.26
b) 46142.49
c) 3857.5
d) None of the previous answers is correct.

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Test Unit 1 (Cont.)
9) What would be the discount if, using the discount interest rule, we discount 8000 euros at 3% annual discount rate
during 90 days?
a) 7940
b) 70
c) 59.18
d) None of the previous answers is correct.

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6. Referencias bibliográficas
Básicas
 Navarro, E. (2019): Matemáticas de las operaciones financieras. Ediciones Pirámide. Madrid
 Zima, P. and R.L. Brown (1996): Schaum’s outline of theory and practice of Mathematics of Finance,
2nd Edition. McGraw-Hill, New York
Complementarias
 Baquero, M.J. y Maestro, M.L. (2003): Problemas Resueltos de Matemática de las Operaciones Financieras.
Editorial AC. Madrid
 Dalton, B. (2008): Financial products: an introduction using mathematics and Excel, Cambridge University
Press
 De Pablo, A. (1998): Matemáticas de las operaciones financieras, Tomo I, Tercera Edición, Editorial UNED.
Madrid
 De Pablo, A. (1998): Matemáticas de las operaciones financieras, Tomo II, Tercera Edición, Editorial UNED.
Madrid
 Meneu, V., Jordá, M.P. y Barreira, M.T. (1994): Operaciones financieras en el mercado español.Editorial Ariel
Economía. Barcelona

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Contents
1.- Introduction
 Financial Transaction. Examples
 Interest & discount
 Time value of money
 Financial Transaction. Formal concept

2.- Interest rules: Simple interest and simple discount

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