Actuarial Science - An Elementary Manual
By Ninian Glen
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Actuarial Science - An Elementary Manual - Ninian Glen
PART I.
INTEREST AND ANNUITIES-CERTAIN.
PART I.
INTEREST AND ANNUITIES-CERTAIN.
CHAPTER I.
INTEREST.
ACCUMULATION AT SIMPLE AND COMPOUND INTEREST. PRESENT VALUES AND DISCOUNT.
Simple and Compound Interest.
THERE are two methods of calculating interest.
(1) It may be charged upon the original loan or principal only. This is known as Simple Interest.
(2) The principal and accrued interest may be accumulated at periodical intervals, and interest charged on the amount. This is Compound Interest as generally understood.
Simple Interest, while very common in commercial transactions, is practically never employed in actuarial calculations. It is an illogical process, and leads to unsatisfactory results. Indeed, the true and logical idea of interest is not even Compound Interest as we have above defined it, but rather a momently growth of the principal under the operation of interest. It is in this direction that the more recent developments of Actuarial Science are tending, but the idea can only be worked out with the help of the higher mathematics.
In dealing with Compound Interest, as above defined, much will evidently depend on the periods at which principal and interest are accumulated. This may take place once a year, once every six months, once every three months, or even at more frequent intervals. If, for instance, we are working with a nominal rate of interest of say 5 per cent. per annum, it is obvious that while 5 per cent. will be the actual rate of interest earned, if principal and interest be compounded once a year, the actual or effective rate of interest will not be 5 per cent., but something higher, if the accumulation take place half-yearly or quarterly. In point of fact, if the conversion be made quarterly, a nominal annual rate of 5 per cent. is equivalent to an actual or effective rate of 5·095 per cent. The exact relations that exist between the nominal and effective rates of interest will shortly be explained.
We now proceed to illustrate the different problems that arise in connection with interest; and, to obtain general expressions, let—
Accumulation at Simple Interest.
First, and briefly, in the case of Simple Interest:—The interest on £1 for one year being i, the interest on any sum, P, will be iP, and for n years niP. We have, therefore,
S (the accumulated amount) = P (the principal) + the interest upon it, that is
S = P + niP = P(1 + ni),
so that, given P, i, and n, S can at once be found.
If S, i, and n be given, to find P we transpose the above equation, thus
Similarly, to find n and i, we have
Thus, given any three of the quantities, P, S, n, and i, we can at once find the fourth.
It is not necessary to go further into the question of Simple Interest, as it is of comparatively little importance.
Accumulation at Compound Interest.
Let us now consider the same problems in Compound Interest—accumulating principal and interest once a year.
The amount to which 1 will accumulate in one year under the operation of interest is manifestly (1 + i), and we start the second year with this as principal, so that at the end of the second year we have (1 + i)(1 + i) or (1 + i)². We start the third year with (1 + i)² as principal, and at the end of the year it will have accumulated to (1 + i)²(1 + i) or (1 + i)³. The amount, therefore, to which 1 will accumulate in n years (to put the case generally) is (1 + i)n.
Having thus ascertained the amount to which 1 will accumulate, the amount to which any other principal, say P, will accumulate is found by simple multiplication, and calling this amount S, we obtain the general formula applicable in all cases,
S = P(1 + i)n.
If S, i, and n be given, and it be desired to find P—transposing the above equation
Again, if P, S, and i, be given, to find n, we have, as above,
Lastly, given S, P, and n to find i—
Nominal and Effective Rates of Interest.
In arriving at the above formulae, we have proceeded on the assumption that interest is accumulated with the principal only once a year; let us now see in what way these formulae are affected by the more frequent accumulation of principal and interest. This brings us to consider the relation between the nominal and effective rates of interest, to which reference has already been made.
Let us suppose that j is the nominal annual rate of interest, and that it is added to the principal m times in the year.
By reasoning similar to that already employed, it is evident that the original 1 invested will have accumulated at the end of the first mth part of the year to ; at the end of the second mth part to ; at the end of the third mth part to , and at the end of the year to . Deducting from this the 1 originally invested, we have, as the interest realised in the year , which is the effective rate corresponding to the nominal rate j. If, therefore, the effective rate of interest be denoted by i, we have
Conversely, to find the nominal rate of interest in terms of the effective rate—transposing the above equation
The numerical difference between the nominal and effective rates of interest will be seen from the following tables, which are based upon the above formulae. Table I. gives the effective rates corresponding to given nominal rates, and Table II. the nominal rates corresponding to given effective rates.
Accumulation at Compound Interest convertible m times a year.
Let us now turn to the expressions already found for S, P, i, and n. If the given rate of interest be the effective rate, the formulae of course need no alteration; but if j, the nominal rate of interest be given, and if the interest be converted m times a year, we must alter the formulae as follows:—
There is a pitfall into which beginners are very apt to stumble in putting these formulae into practice, to which it may be well to refer. The rate of interest is usually stated at so much per cent., but it must be remembered that i represents the interest on 1, not on 100. If, therefore, the rate be say four per cent., i is not 4 but ·04. This is a very simple matter, but nevertheless it is one about which the beginner is very apt to go wrong.
Summary of Results.
We may now summarize the results we have found as follows:—