Department of Mathematics, Statistics and Insurance

The Hang Seng University of Hong Kong

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 Simple Interest
 Compound Interest
 Forward Problem vs. Backward Problem

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 Do you prefer receiving your monthly salary on 1st of
each month or 28th of each month (if you have such
option)?

 If you deposit $10,000 in a bank, how much will you

have after 1 year? Exactly $10,000, more than $10,000
or less than $10,000?

 Is $1 today the same as $1 tomorrow? Why?

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 Principal (P0)
The original amount borrowed/lent/deposited

 Interest (I)
The money that a borrower pays for the use of a lender’s money

 Interest Rate
(i for annual interest rate; r for interest rate per period)
The proportion/percentage of the principal that has to be paid as
interest

 Time Period (n)

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 Chris borrowed $500 from Yammie and agreed to
return her a total of $515 after 1 year.
Write down the (a) principal, (b) the interest, (c) the
(yearly) interest rate and (d) the time period.

(a) P0 = $500
(b) I = $515 – $500 = $15
(c) i = $15 ÷ $500 = 3% per year
(d) n = 1 year

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 There are 2 ways of calculating the interest – simple
interest and compound interest.

 Let’s discuss the simpler one first – simple interest.

 Simple interest - interest (I) is determined by

multiplying the principal (P0), the interest rate (per
time period) (r) and the number of time periods (n).

I = P0 × r × n

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 If Chris deposit $1,000 in ABC bank, which offers an
annual simple interest rate of 5%, how much does she
have after 5 years?

I = P0 × r × n
I = $1,000 × 5% × 5 = $250

Total amount she will have at the end of the 5 years:

P0 + I = $1,000 + $250 = $1,250

 The calculation is quite easy. Can we do it with Excel?

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 (1) Enter the description in Row 1 to make the
spreadsheet easier to understand.
 (2) Put down the information (P0, r, n) provided in the
question.

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 (3) You may define the format of the data as Currency
and adjust its decimal places (if necessary) to make the
spreadsheet easier to understand.

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 (4) Copy the Principal and Interest Rate for Year 2 to
Year 5.
 (5) Input =B2*C2 in Cell D2 to calculate the interest
for Year 1.

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 (6) Copy the formula in Cell D2 and paste it to Cell D3
to D6.

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 (7) Input =B2+D2 in Cell E2 to calculate the final
amount for Year 1.

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 (8) Input =E2+D3 in Cell E3 to calculate the final
amount for Year 2.

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 (9) Copy the formula in Cell E3 and paste it to Cell E4
to E6.

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 (10) Based on this calculation, we get the total amount
at the end of the 5 years is $1,250.

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 Obviously, there are also some other ways to obtain the
correct answer in this question. An example is shown
below:

All roads lead to Rome!

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 Assuming the annual simple interest rate is 5.9%, how
much does Yammie need to deposit to earn a total interest
of $2,000 in 4 months?

There are 2 ways to consider this question:

(1) Per month

We need to consider the interest rate per month and the
number of time period in terms of months (i.e. 4 months)
I = P0 × r × n
$2,000 = P0 × (5.9% ÷12) × 4
P0 = $101,694.92

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(2) Per year
We need to consider the interest rate per year and the
number of time period in terms of years (i.e. 1/3 year)
I = P0 × r × n
$2,000 = P0 × 5.9% × (4 ÷ 12)
P0 = $101,694.92

 The calculation is still easy. Can we do it with Excel?

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 Again, there are many ways to do it. One possibility is
to set up a table as follows:

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 Can we use a spreadsheet and formulas to find the
Principal instead?

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 We can input the formula in Cell D2 to E5. However,
they will be 0 because B2 is an unknown (Excel
considers blank cell as 0).

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 To find the answer, we can use the trial-and-error
method.
 However, it might be hard to find the exact answer.

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 Here, we need to use the Solver Add-in in Excel to
obtain the exact answer

 To install Solver, follow the guideline uploaded on the

course website
AMS1360 How to install the Solver Add-in.pdf

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 (1) Before we can use the Solver, we first need to set up
the spreadsheet with the correct formulas (as in Slide
21).
 (2) Click on Solver (under the Data tab) and a pop-up
window will appear.

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 (3) Input the parameters
Set Target Cell: $D$2 (←What we want to achieve:
the interest per month is targeted at $500)
Equal To Value of 500
By Changing Cells: $B$2 (← What we want to know:
the principal)

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 (4) Click Solve and you will have the answer.

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 We sometimes call this (Example 3) as a Backward
Problem, in which we need to find the missing “input”
(Principal, in this example) based on a given “output”
(Interest).

 Note: Example 2 is a Forward Problem, in which we

have all the “inputs” (Principal, interest rate, number of
time period) and we need to calculate the “output”
(Interest, and thus the Final Amount).

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 Example 4
Chris borrowed $4,200 from Yammie for 6 months at a
simple interest rate of 8.5% per year. How much
interest should Chris pay?
4200
× 8 5 b
.
'

告 [$178.5]
×
=

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 Example 5
Chris plans to spend $50,000 to pursue a Master degree
immediately after completing the 4-year undergraduate
degree. ABC bank offers her a deposit plan with an
annual simple interest rate of 5%. How much should
she deposit in ABC bank at the beginning of Year 1 to
achieve her goal?
[$41,666.67]

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 Compound interest – interest is calculated based on the
accumulated interest and the original principal. In other words,
interest earns interest too.

P1 = P0 × (1 + r)
P2 = P1 × (1 + r)
.
.
.

A recursive relationship: Pt = Pt-1 × (1 + r)

And the final amount (at time = n) is Pn = P0 × (1 + r)n

 In real life, compound interest is commonly used in financial

markets. Most financing agreements, such as mortgage, are based
on the concept of compound interest.

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 If Yammie deposits $1,000 in ABC bank, which offers
her an annual interest rate of 5%, compounded annually,
how much does she have after 5 years? Compare this
result with Chris in Example 2 (Slide 7).

Pn = P0 × (1 + r)n
P5 = $1,000 × (1 + 5%)5 = $1,276.28

 $1,276.28 vs. $1,250

 Yammie has more than Chris after 5 years.

 Can we do it with Excel?

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 (1) Put down the information (P0, i, n) provided in the
question. (Note: i = r in this example)
 (2) Input =B1 in Cell C6 as the starting principal.

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 (3) Input =C6*(1+$B$2) in Cell C7 to calculate the
balance at the end of Year 1
P1 = P0 × (1 + r)

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 (4) Copy the formula of Cell C7 and paste it to Cell C8
to C11.

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 (5) Based on this calculation, we get the total amount at
the end of the 5 years is $1,276.28.

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 Again, there are some other ways to obtain the correct
answer. An example is shown below:

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 In Example 6, interest is compounded annually.

 However, there are other compounding frequencies, for

instance, quarterly, monthly, weekly, daily, or even
hourly, etc.

 Compounding frequency is the number of times per

year the accumulated interest is calculated.

 Question: Is it better to have a higher compounding

frequency, given all other factors are the same?

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 If Yammie deposits $1,000 in DEF bank, which offers
an annual interest rate of 5%, compounded monthly,
how much does she have after 5 years?

 Note: This is the exact same situation as Example 6

except the compounding frequency.

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 (1) Put down the information (P0, i, r, n) provided in the
question. (Note: r = i ÷ 12 in this example)
 (2) Input =B1 in Cell C7 as the starting principal.

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 (3) Input =C7*(1+$B$3) in Cell C8 to calculate the
balance at the end of Year 1

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 (4) Copy the formula of Cell C8 and paste it to Cell C9 to
C67.
 (5) The total amount at the end of the 5 years is $1,283.36.

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 If Yammie deposits $1,000 in GHJ bank, which offers
an annual interest rate of 5%, compounded daily
(assume 365 days per year), how much does she have
after 5 years? Compare this result with Example 6 and
7 (Slide 31 and 38).
[$1,284.00]

 Note: This is the exact same situation as Example 6

except the compounding frequency.

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 Comparison between Example 6, 7 and 8

Bank Compounding Frequency Balance at the end of Year 5

ABC Bank Annually $1,276.28

DEF Bank Monthly $1,283.36

GHJ Bank Daily $1,284.00

 Given all other factors are the same, compounding more

frequently will lead to higher balance.

 Question: If we keep on increasing the compounding frequency,

will the balance increase indefinitely (i.e. goes to infinity)?

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 Consider a deposit of $1 with an annual interest rate of
100%, how much does it worth after 1 year if interest is
(a) compounded yearly?
(b) compounded monthly?
(c) compounded daily?
(d) compounded hourly?
(e) compounded every minute?
(f) compounded every second? (Note: 31,536,000 rows are
required, which exceeds the limit of rows in Excel)

Note: Assume there are 365 days per year

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 The spreadsheets for (a) to (f) are basically the same. We
may add Row 5 and 6 and change Cell B3 and B4 into a
formula to make the spreadsheet more automated.
 Below is the spreadsheet for (d) compounded hourly:

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 Answer
(a) $2.00
(b) $2.61303529
(c) $2.71456748
(d) $2.71812669
(e) $2.71827924
(f) $2.71828178

 As the compounding frequency increases, the balance after

1 year increases.

 But it seems like there is a limit, where 2.71828 ≈ e

(e is a mathematical constant, which is the base of the
natural logarithm).

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 As the compounding frequency increases, we call it
continuous compounding. And the balance at time t can
be calculated by
Pt = P0 × e rt

 Note: Here, we will skip the proof, which involves calculus, because it is
not the focus of this course.

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 Examples 6 to 9 are forward problems. We are asked to
find the balance at time t with the given principal,
interest rate and time period.

 Could there be backward problems?

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 Chris deposited $50,000 into ABC bank 3 years ago
and did not do any transaction afterwards. Somehow
she forgot the interest rate offered by the bank. But
after 3 years (now), Chris finds that her total balance is
$51,500. What is the annual interest rate if interest is
(a) compounded yearly?
(b) compounded monthly?
(c) compounded daily?

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 This is a backward problem, so we need to use Solver
to find the annual interest rate.
 (1) Set up the spreadsheet with correct formulas

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 (2) Input the parameters in Solver
Set Target Cell: $C$12 (←What we want to achieve:
the final amount is $51,500)
Equal To Value of 51500
By Changing Cells: $B$2 (← What we want to know:
the annual interest rate)

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 (3) Click Solve and you will have the answer.

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 Repeat the same procedure for compounded monthly.

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 Repeat the same procedure for compounded daily.

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 The annual interest rates are 0.9902% compounded
yearly, 0.9857% compounded monthly and 0.9853%
compounded daily.

 As a customer, you need to be aware of these 3

different values will, in fact, generate the same amount
after 3 years.

 Think on the other side

If you were the bank, which interest rate will you show
on your advertisement?

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