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INTERESTRATECONVERSION

Summary
1. Vocabulary...............................................................................................................................1
2. Rateequivalence.....................................................................................................................1
3. Exercise....................................................................................................................................4

1. Vocabulary
Interestdates:dateswheninterestisreceived;
Interestperiod:timeintervalbetweentwointerestdates;
Periodicinterestrate:realinterestrateperinterestperiod;
Capitalization:addinginteresttothecapital;
Nominalinterestrate:Thisrate,calculatedonanannualbasis,isusedtodetermine
the periodic interest rate. Generally, this is the rate that is published. It should
always be accompanied by the type of capitalization. For example, a rate of "8%
capitalizedbiannually"meansthattheinterestperiodishalfyearly,andtheperiodic
%
interest rate (biannual) is 4 %. The nominal interest rate does not
correspondtotheeffectiveannualinterestrate,unlessthecapitalizationisannual;
Effectiveinterestrate:effectiveannualinterestrate.

2. Equivalence of interest rates

Imaginethefollowingsituation:abankoffersyouaneffectiveannualinterestof6%;a
bank offers you a periodic interest rate of 1,5% per quarter. How would you
determinewhichbankoffersthebestyield?Tocomparetwointerestrates,youneedto
beabletoevaluatethemduringthesameperiod.Forexample,wecanfindtheannual
interest rate equivalent to a quarterly interest rate of 1,5% and verify if it is greater
than 6%. This conversion must be done respecting the value of an investment that
wouldbeaccumulatedatagiveninterestrate.

Definition
Tworatesaresaidtobeequivalentif,forthesameinitialinvestmentandoverthe
sametimeinterval(onefullyear,forexample),thefinalvalueoftheinvestment,
calculatedwiththetwointerestrates,isequal.

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ConsideracasewherewedepositanamountV0inabankofferingaquarterlyinterest
rate .Attheendoftheyear,i.e.4quarters,thevalueoftheinvestmentwillbe:

Now,supposethatanotherbankoffersanannualinterestrate .Attheendofone
fullyear,thevalueoftheinvestmentwillbe:

1 .

Accordingtothedefinition,therates and areequivalentif

1 1

1 1

Notethattheinitialinvestmentvalueisofnoimportance.Thisrelationallowsustopass
fromaquarterlyinterestratetoanequivalentannualinterestrateorviceversa.

Example1

A bank offers you an (effective) annual interest rate of 6%; the bank offers an
interestrateof1,5%perquarter.Whichofthesetwobanksoffersthebestreturn?

Solution
Bank offersaquarterlyrateof1,5%.Theequivalentannualinterestrate(oreffective
rate)forthisinterestratecanbeobtainedbytherelation

1 i 1 i
1,015 1 i
i 1,015 1 0,06136355
Bank , therefore offers a better return (with (effective) annual interest rate of
6,136355%)thanbank .

Alternativesolution
Bank offersaneffectiveinterestrateof6%.Thequarterlyequivalentisalsoobtained
fromtherelation:

1 i 1 i
1 i 1 0,06 1,06
1 i 1,06
1 i 1,06
i 1,06 1 0,014673846 i. e 1,4673846 %
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Thisrateisinferiortothequarterlyinterestrateofferedbybank andwearriveatthe
sameconclusion.

Thereasoningwejustmadeappliestoallinterestrateconversions.Aperiodicinterest
ratecanalwaysbeconvertedgiventhattherateequivalencerelationisrespected:

Interestrateequivalencerelation

1 1 1 1

We must make sure this relation is satisfied so that the accumulated value of a 1$
investment,capitalandinterest,isthesameattheendofonefullyearnomatterwhich
methodofcapitalizationisused.

Example2

Whatisthemonthlyequivalentinterestratetoaquarterlyinterestrateof2,5%?

Solution
We want to find knowing that 2,5 %. According to the relation of rate
equivalence,theequality
1 1

mustbesatisfied. needstobeisolated:

1 1
1 1 2,5%
1 1,025
1 1,025
1 1,025
1,025 1
0,8265%

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Example3

What is the monthly interest rate equivalent to an annual rate of 8%, capitalized
quarterly?

Solution
First,youneedtointerprettherateof8%asbeingnominalsinceitisaccompaniedbya
capitalizationperiod.Arateof8%,capitalizedquarterly,representsinrealityabiannual
%
rateof4%( 4 %,semesters/year),ifwelettheinterestcapitalize.Wetherefore
need to find knowing that 4 %. According to the relation of rate
equivalence,theidentity
1 1

Mustbesatisfied. needstobeisolated:

1 1 4%
1 1,04
1 1,04
1 1,04
1,04 1
0,6558%

3. Exercise

Givenanannualinterestrateof15%.Findtheperiodicrates , , thatare
equivalent.

(Answers:7,23805%;3,55581%;1,17149%)

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