Compound Interest

An Example

Suppose that you were going to invest

$5000 in an IRA earning interest at an
annual rate of 5.5%
How

would you determine the amount of

interest youve made on your investment after
one year?
i1 5000 0.055 $275

An Example

How much money would you have in your

IRA account?

F1 5000 i1 5000 5000(0.055) 50001 0.055 $5275

How much interest would you get after two

years?
i2 5275 0.055 290.13

An Example

How much money would you have in your

IRA account after two years?

F2 5275 i2 5275 5275 0.055 52751 0.055 50001 0.0551 0.055

What about 10 years?

F10 50001 0.055

10

$8540.72

Compound Interest

Notice that the interest in our account was

paid at regular intervals, in this case every
year, while our money remained in the
account. This is called compounding
annually or one time per year.

Compound Interest

Suppose that instead of collecting interest at the

end of each year, we decided to collect interest
at the end of each quarter, so our interest is paid
four times each year. What would happen to our
investment?
Since our account has an interest rate of 5.5%
annually, we need to adjust this rate so that we
get interest on a quarterly basis. The quarterly
rate is:

5.5 / 4 1.375%

Compound Interest

So for our IRA account of $5000 at the

end of a year looks like:
41

0.055

F1 5000 1
$5280.72
4

After 10 years, we have:

0.055

F10 5000 1

410

$8633.85

Compound Interest Formula

P dollars invested at an annual rate r,

compounded n times per year, has a
value of F dollars after t years.

r
F P 1
n

nt

Think of P as the present value, and F as

the future value of the deposit.

Yield

One may compare investments with

different interest rates and different
frequencies of compounding by looking at
the values of P dollars at the end of one
year, and then computing the annual rates
that would produce these amounts without
compounding.

Yield
Such a rate is called the effective annual
yield, annual percentage yield, or simply
yield.
In our previous example when we
compounded quarterly, after one year we
had:

0.055

F1 5000 1

41

$5280.72

Yield

To find the effective annual yield, y, notice

that we gained $280.72 on interest after a
year compounded quarterly. That interest
represents a gain of 5.61% on $5000:
280.72
y
0.0561
5000

Finding the Yield

To find the effective annual yield, find the

difference between our money after one year
and our initial investment and divided by the
initial investment.
Therefore, interest at an annual rate r,
compounded n times per year has yield y:

r
P 1 P
n
r
n

y
1 1
P
n

More on Yield

There may be times when we need to find the annual

rate that would produce a given yield at a specified
frequency of compounding. In other words, we need to
solve for r :
n

r
y 1
n

r
y 1 1
n

y 11/ n 1 r
n
y 11/ n 1 r
n
1/ n
n y 1 1 r

1
n

Compound Interest Formula

Notice that when we collected our interest more

times during each year, i.e. we compounded
more frequently, the amount of money in our
account was actually greater than if only
collected interest one time a year.
What would happen to our money if we
compounded a really large number of times?

Continuous Compounding

As n increases, approaches a constant value in the

Frequency Worksheet. Heres why:
n=mr

r
P 1
n

nt

1
P 1
m

mrt

1
1
m

rt

As n gets really large, m also becomes really large, and:

1
1
m

2.71828182845905 e

Continuous Compounding

The value of P dollars after t years, when

compounded continuously at an annual
rate r , is

F Pe
On

rt

the calculator use the button

(on TI-83: 2nd + LN )
In Excel, use the function EXP(x )

The effective annual yield, y, for compounding

continuously at an annual interest rate of r is:

Pe P
r
y
e 1
P
r

To find the annual interest rate r if we know the

yield, y, we would have to solve for r in the
above equation. To do this you would use
logarithms:

r ln y 1

Present Values

If we are given the future value, F, the

annual interest rate r, the number of times
compounded per year n, and the length of
time invested t, we may solve the present
value P :

r
P F 1
n

P F e r t

nt

Ratios

Sometimes we are not interested in the percentage that

an investment increases by. Rather, we would like to
know by what factor the investment increased or
decreased. Such factors are computed by find the ratio
of the future value to the present value. This ratio, R, for
continuous compounding is:

F Pe rt
R
e rt
P
P

This allows us to convert the interest rate for a given

period to a ratio of future to present value for the same
period.

Example Ratios

Suppose that in our IRA example, the annual

interest rate of 5.5% is compounded
continuously.
If we wanted to know the weekly rate our
investment would increase, we would simply
have 0.055/52 or 0.00105 or 0.105%. This
would mean that the ratio of the future value to
the present value between consecutive weeks
compounded continuously would be e0.055/52 or
1.00105

Example Ratios

Multiplying by this weekly ratio 52 times yields a

yearly ratio of (e0.055/52)52 = e(0.055/52)52 = e0.055. As we
would expect, this corresponds to the annual rate of
0.055.

The Project

How can compound interest help us price a stock option?

Our annual risk-free rate of 4%, compounded

continuously, gives a weekly risk-free rate of rrf =
0.04/52 0.0007692. The weekly ratio corresponding to
this weekly rate is e0.04/52.

We call Rrf = e0.04/52 1.0007695 the risk-free weekly

ratio for the Walt Disney option.

The Project
Compound interest can help us with option pricing
in a second way. Suppose that we know a
future value F for our 20 week option at the end
of the 20 weeks. We suppose that money will
earn at the risk-free annual interest rate or 4%
compounded continuously. This can be used to
find the present value, P, of the option.

P F e
P F e

rt
0.04
20
52

Preliminary Reports

You will deliver your preliminary report on Monday March 28th, 2005.
Download your teams historical data today and start looking at the
behavior of your companies particular stock.
For the report you want to determine what a reason able price will
be for investors considering buying an option for your teams
particular company and an explanation as to how you determined
that.
The Chicago Board of Options Exchange is a good resource for
understanding how options are priced.
I will need two hard copies of your powerpoint slides.
Because this is a new project, you will need to draft new team
contracts. Those will be collected in class on Wednesday, March
30th, 2005.