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1. Introduction
Chapter 4
Nominal and Effective
Interest Rates
How much
you going to
pay after 1
year ?
Rate is 15% per year but compounding is daily so the rate at per day is 0.15/365 =
0.000411 per day or 0.0411% per day
Days
1
Amount ($)
1000
Interest earned
Amount x r =0.411
1000.411
1000.411
0.411169
1000. 82269
1000. 82269
0.411169
1001.233507
--------
------
------
1161.338553
0.47731
1161.815863
365
1161.815863 . But
this is around 16.81%
rate rather than
15% stated
If compounding
period is less than a
year . We face
such situation!!!
3/24/2015
Previous Learning
denoted by (r)
does not include any consideration of
the compounding of
interest(frequency)
It is given as: r = interest rate per
period x number of compounding
periods
Interest Rate:
important terminologies
New time-based definitions to understand and remember
Interest period (t) period of time over which interest is expressed.
For example, 1% per month.
Compounding period (CP) The time unit over which interest is charged or earned.
For example,10% per year, here CP is a year.
Compounding frequency (m) Number of times compounding occurs within the
interest period t.
For example, at i = 10% per year, compounded monthly, interest would be
compounded 12 times during the one year interest period.
IMPORTANT: Compounding
Period and Interest Rate
Some times, Compounding period is not mentioned in
Interest statement
For example, an interest rate of 1.5% per month
..It means that interest is compounded each
month; i.e., Compounding Period is 1 month.
REMEMBER: If the Compounding Period is not
mentioned it is understood to be the same as the time
period mentioned with the interest rate.
Calculating Effective
Interest Rate
Effective interest rate per compounding
period can be calculated as follows:
=
3/24/2015
Example: Calculating
Effective Interest rates per CP
Example:
Three different bank loan rates for electric
generation equipment are listed below.
Determine the effective rate on the basis of the
compounding period for each rate
(a) 9% per year, compounded quarterly
(b) 9% per year, compounded monthly
(c) 4.5% per 6 months, compounded weekly
Class Practice:
2 minute
For a nominal interest rate of 12% per year, determine the nominal and effective
rates per year for
(a) quarterly, and
ia = (1 + i)m 1
(b) monthly compounding
where
ia = effective annual interest rate
i = effective rate for one compounding
period (r/m)
m = number times interest is compounded
per year
= (1 + ) 1
where
= (1 +
) 1
Class Practice:
3 minutes
Example
Solution:
Nominal rates are converted into Effective Annual Interest Rates (EAIR)
via the equation:
= (1 +
) 1
= (1 + ) 1
3/24/2015
Economic Equivalence:
From Chapter 1
1
$100 now
CP
6 months
10
11
12
Months
PP = CP
PP < CP
Solution:
P = $100, r = 15%, m = 12
EIR /month = 15/12 = 1.25%
n = 2 years or 24 months
F = P(F/P, i, n)
F = P(F/P, 0.0125, 24)
F = 100(F/P, 0.0125, 24)
F = $134.74
Length of Time
Case I:
When PP>CP for Single Amount
for P/F or F/P
F = 100(1.3474)
Involves Single
Amount
(P and F Only)
P/F , F/P
PP > CP
PP
1 month
F = 100(1.3474)
Alternative Method
i = (1 + r/m)m 1
= (1+0.15/12)12 1
= 16.076%
F = P(F/P, i, n)
F = P(F/P, 16.076%, 2)
F = 100(1.3456)
F = $134.56
Interpolation
needed
P/F, F/P
Involves Gradient
Series (A, G, or g)
Case I:
When PP>CP for Single
Amount for P/F or F/P
Step 1: Identify the number of compounding
periods (M) per year
Step 2: Compute the effective interest rate per
payment period (i)
i = r/M
Step 3: Determine the total number of payment
periods (n)
Step 4: Use the SPPWF or SPCAF with i and N above
3/24/2015
Solution:
CP = Quarter
PP > CP
Effective rate (i) per 6 months = (1+r/m)m -1
i= (1+0.04/2)2 1 => 4.04%
each PP
amount get
compounded
twice
F = A(F/A, i, n)
PP = 6 months
etc.
10
11
12
Months
PP
1 month
Two policies:
1. Inter-period cash flows
earn no interest (most
common)
positive cash flows are
moved to beginning of the
interest period (no
interest earned) in which
they occur and negative
cash flows are moved to
the end of the interest
period (no interest paid)
3/24/2015
Solution:
Positive Cash flows (inflows) at the start
of CP period
10
11
12
F = 1000[-150(F/P, 3%, 4)-200(F/P, 3%, 3) +(180-175 )(F/P, 3%, 2)+ 165(F/P, 3%, 1)-50]
Months
PP
1 month
Two policies:
1. Inter-period cash flows
earn no interest (most
common)
positive cash flows are
moved to beginning of the
interest period (no
interest earned) in which
they occur and negative
cash flows are moved to
the end of the interest
period (no interest paid)
3/24/2015
Solution:
Positive Cash flows (inflows) at the start
of CP period
F = 1000[-150(F/P, 3%, 4)-200(F/P, 3%, 3) +(180-175 )(F/P, 3%, 2)+ 165(F/P, 3%, 1)-50]
F = $ (-262111) Investment after one year
Continuous Compounding
If we allow compounding to occur more and more frequently, the
compounding period becomes shorter and shorter and m , the
number of compounding periods per payment period, increases.
Continuous compounding is present when the duration of the
compounding period (CP), becomes infinitely small and, the
number of times interest is compounded per period (m), becomes
infinite.
Example: Continuous
Compounding
Example: If a person deposits $500 into an account every 3 months
at an interest rate of 6% per year, compounded continuously, how
much will be in the account at the end of 5 years?
Solution:
F = 500(F/A,1.51%,20) = $11,573
Practice:
$70,000
i=7%
$35,000
i=7%
i=9%
$25,000
i=10%
Year
0
P=?
3/24/2015
P=?
i=10%
i=14%
Year
1 2 3
i=14%
4 5
Year
Year
0 1 2
3 4
5 6 7
A=?
P = 100(P/A, 10%, 5) + 150 (P/A, 14%, 3) (P/F, 10%, 5)
= 100(3.7908) + 160(2.3216)(0.6209)
= $609.72
$160
THANK YOU