StATS: Compound interest and powers (February 11, 2007)
In some of my mathematical calculations, I end up computing an expression that involves a number very close to one raised to a very large power. This term can often be approximated by an exponential function, but I can never quite remember the relationship. An example involving compound interest may help me remember better in the future.
If you invest an amount of money A for t years at a simple interest rate, i, the amount of money that you earn is
and if you compound the interest n times per year, the amount you earn is
If you let n go to infinity, this term converges to
This formula is well known to people in finance and in mathematics. A nice explanation can be found in the Wikipedia article on compound interest.
As an example of how I would use this, I had an expression of the form
What would this equal for values of s close to zero? Replace s with 1/n to get
This is just like the compound interest formula with A=1, r=1, and t=-1. A purist might quibble that compound interest for a negative amount of time makes no sense, but there is indeed an interpretation for this in a financial context. Even if there were no such interpretation, the mathematical relationship holds anyway.
The limit as n approaches infinity (which is equivalent to the limit as s approaches zero) is
How good is this approximation? The constant e is 2.718 and the ratio 1/e is 0.3679. For s=0.1, you get
For s=0.01, you get
For s=0.001, you get
This page was written by Steve Simon while working at Children's Mercy Hospital. Although I do not hold the copyright for this material, I am reproducing it here as a service, as it is no longer available on the Children's Mercy Hospital website. Need more information? I have a page with general help resources. You can also browse for pages similar to this one at Category: Statistical theory.