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Compound and Continuous Interest

Compound Continuous Interest

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Angelo Cabral
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19 views30 pages

Compound and Continuous Interest

Compound Continuous Interest

Uploaded by

Angelo Cabral
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Compound Interest

Compound Interest

Exponential functions occur in


calculating compound interest.

• Suppose an amount of money P, called


the principal, is invested at an interest rate i
per time period.

• Then, after one time period, the interest is Pi,


and the amount F of money is:
F = P + Pi
= P(1 + i)
Compound Interest

If the interest is reinvested, the new principal


is P(1 + i), and the amount after another time
period is:
F = P(1 + i)(1 + i) = P(1 + i)2

• Similarly, after a third time period,


the amount is:
F = P(1 + i)3
Compound Interest

In general, after k periods,


the amount is:
F = P(1 + i)k

• Notice that this is an exponential function


with base 1 + i.
Compound Interest

If the annual interest rate is r and interest is


compounded n times per year.

Then, in each time period, the interest rate


is i = r/n, and there are nt time periods
in t years.

• This leads to the following formula


for the amount after t years.
Compound Interest

Compound interest is calculated by


the formula

where:
• F(t) = amount after t years
• P = principal
• r = interest rate per year
• n = number of times interest is compounded
per year
• t = number of years
Ex. 1 — Calculating Compound Interest

A sum of $1000 is invested at an interest rate


of 12% per year.

Find the amounts in the account after 3 years


if interest is compounded:
• Annually
• Semiannually
• Quarterly
• Monthly
• Daily
Ex. 1 — Calculating Compound Interest

We use the compound interest formula


with: P = $1000, r = 0.12, t = 3
Ex. 1 — Calculating Compound Interest

We use the compound interest formula


with: P = $1000, r = 0.12, t = 3
Ex. 2 — Calculating the Annual Percentage Yield

Find the annual percentage yield for an


investment that earns interest at a rate
of 6% per year, compounded daily.
Ex. 2 — Calculating the Annual Percentage Yield

After one year, a principal P will grow to the


amount

•The formula for simple interest is


F = P(1 + rt)
Ex. 2 — Calculating the Annual Percentage Yield

Comparing, we see that 1 + r(1) = 1.06183,


so r = 0.06183. Thus the annual percentage
yield is 6.183%.
Continuously Compounded
Interest
Compound Interest

We saw that the interest paid increases as


the number of compounding periods n
increases.

• Let’s see what happens as n increases


indefinitely.
Compound Interest

If we let m = n/r, then


Compound Interest

Recall that, as m becomes large, the


quantity (1 + 1/m)m approaches
the number e.

• Thus, the amount approaches F = Pert.

• This expression gives the amount when


the interest is compounded at “every instant.”
Continuously Compounded Interest

Continuously compounded interest is


calculated by
F(t) = Pert
where:
• F(t) = amount after t years
• P = principal
• r = interest rate per year
• t = number of years
Ex. 4—Calculating Continuously Compounded Interest

Find the amount after 3 years if $1000


is invested at an interest rate of 12%
per year, compounded continuously.
Ex. 4—Calculating Continuously Compounded Interest

We use the formula for continuously


compounded interest with:
P = $1000, r = 0.12, t = 3

• Thus,
A(3) = 1000e(0.12)3 = 1000e0.36

= $1433.33
Compound Interest
Types of Interest

If a principal P is invested at an interest rate r


for a period of t years, the future amount F of
the investment is given by:
Compound Interest

We can use logarithms to determine


the time it takes for the principal
to increase to a given amount.
Ex. 5—Finding Term for an Investment to Double

A sum of $5000 is invested at an interest


rate of 5% per year.

Find the time required for the money to


double if the interest is compounded
according to the following method.
(a) Semiannually
(b) Continuously
Ex. 5—Semiannually Example (a)

We use the formula for compound interest


with

P = $5000, F(t) = $10,000, r = 0.05, n = 2

and solve the resulting exponential equation


for t.
Ex. 5—Semiannually Example (a)
2t
 0.05 
5000  1 +  = 10000
 2 
(1.025 )
2t
=2
log 1.025 = log2
2t

2t log 1.025 = log2 (Law 3)


log2
t=  14.04
2log1.025

• The money will double in 14.04 years.


Ex. 5—Continuously Example (b)

We use the formula for continuously


compounded interest with

P = $5000, A(t) = $10,000, r = 0.05

and solve the resulting exponential equation


for t.
E.g. 5—Continuously Example (b)

5000e 0.05 t
= 10,000
e 0.05 t
=2
ln e = ln2
0.05 t

0.05t = ln2
ln2
t=  13.86
0.05

• The money will double in 13.86 years.


Ex. 6—Time Required to Grow an Investment

A sum of $1000 is invested at an interest rate


of 4% per year.

Find the time required for the amount to


grow to $4000 if interest is compounded
continuously.
Ex. 6—Time Required to Grow an Investment

We use the formula for continuously


compounded interest with

P = $1000, F(t) = $4000, r = 0.04

and solve the resulting exponential equation


for t.
Ex. 6—Time Required to Grow an Investment

1000e 0.04 t
= 4000
e =4
0.04 t

0.04t = ln 4
ln 4
t=  34.66
0.04

• The amount will be $4000 in about


34 years and 8 months.

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