Topic 5 - The principles of financial mathematics, indices, data and regression

Question 1

How is Simple Interest calculated?

Answer 1

Most basic of interest calculations. £100 at 10% = £10

Simple Interest = Principle x Rate x Time

Question 2

Whatis future value and how is it calculated?

Answer 2

Allows for quick calculation of compounding interest over multiple periods.

• Future Value = Present Value . (1 + interest) to power of time period
• I.e for £100 at 5% over 5 years = £100 x (1 + 0.05) 5 = £127.63.

Question 3

**&Whatis present value and how is it calculated?

Answer 3

Allows to work out current value based on a real or expected future value.

Present Value = Future Value divided by (1 + interest rate) X Power of periods

£102,414.40 / (1 + 1.2%)- = 1.012% to power of two

Question 4

Define the Net Present Value?

Define Internal Rate of Return?

Answer 4

Net Present Value tells us if a project will be profitable. Use cashflow and gains and then divide by the discount rate (internal rate of return). If greater than 0 then project should be accepted.

Internal Rate of Return tells us at what rate the NPV becomes zero.

• A.K.A - Money Weighted Return
• Each investment has Net Present Value - breakeven point
• I.e cost of project 10%. Investor needs return above 10%
• Most commonly used for measuring fund performance over period that includes deposits and withdrawals.
• Drawbacks to measure is that it is time-consuming

Question 5

Explain what indices are and how they work?

Answer 5

• Index number provides relative value to base value.
• I.e RPI measures number against base number -prices last year
• Series of index numbers are known as indices
• Gives a quick reference point to performance