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Chapter 4
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Section 4.1
NOMINAL & EFFECTIVE RATES
Review Simple Interest and
Compound Interest (from Chapter
1)
Compound Interest –
Interest computed on Interest
For a given interest period
The time standard for interest
computations – One Year
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…
periods in a year.
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r=
(interest rate per period)(No. of Periods)
Examples Follow…..
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Example:
“12 per cent compounded monthly”
Pick this statement apart:
12% is the nominal rate
“compounded monthly” conveys the
frequency of the compounding
throughout the year
This example: 12 compounding periods
within a year.
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Nominal Rates:
Format: “r% per time period, t”
Ex: 5% per 6-months”
Effective Interest Rates:
Format: “r% per time period, compounded
‘m’ times a year.
‘m’ denotes or infers the number of times
per year that interest is compounded.
Ex: 18% per year, compounded monthly
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i effective per CP
equals…
r%/time period t
m compounding periods/t
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4.1 Example:
Given:
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0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75%
1 2 3 4 5 6 7 8 9 10 11 12
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Section 4.2
Effective Annual Interest Rates
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$F=$P(1+i)1
0 1
$P = $1.00
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$F=$P(1+i)1
01 2 3 4 5 m 1
$P = $1.00
4.2 Rewriting….
F = P + P(ia)
Now, the rate i per CP must be
compounded through all “m”
periods to obtain F1
Rewrite as:
F = P + P(ia) = P(1 + ia)
F = P( 1 + i )m
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1 + ia = (1+i)m (1)
ia = (1 + i )m – 1 (2)
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EAIR = (1 + 0.08/4)4 – 1
EAIR = (1.02)4 – 1 = 0.0824 = 8.24%/year
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Section 4.3
Payment Period (PP)
Recall:
CP is the “compounding period”
PP is now introduced:
PP is the “payment period”
Why “CP” and “PP”?
Often the frequency of depositing
funds or making payments does not
coincide with the frequency of
compounding.
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4.3 Comparisons:
Example 4.4
Three different interest charging plans.
Payments are made on a loan every 6
months. Three interest plans are
presented:
1. 9% per year, c.q. (compounded quarterly).
2. 3% per quarter, compounded quarterly.
3. 8.8% per year, c.m. (compounded monthly)
Payment Payment
Payment Payment
4.3 Plan 2
“r” = 8.8%
“m” = 12
Payments are twice a year
6-month nominal rate = 0.088/2
=4.4%/6-months (“r” = 0.044)
EIR6-months = (1 + 0.044/6)6 – 1
Equals (1.0073)6 – 1= 4.48%/ 6-months
Equals (1 + 0.088/12)12 – 1 = 9.16%/year
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2 6.09% 12.55%
3 4.48% 9.16%
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Section 4.4
Equivalence: Comparing PP to CP
Reality:
PP and CP’s do not always match up;
May have monthly cash flows but…
Compounding period different that monthly.
Savings Accounts – for example;
Monthly deposits with,
Quarterly interest earned or paid;
They don’t match!
Make them match! (by adjusting the
interest period to match the payment period.)
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Section 4.5
Single Amounts: CP >= CP
Example:
“r” = 15%, c.m. (compounded monthly)
Let P = $1500.00
Find F at t = 2 years.
15% c.m. = 0.15/12 = 0.0125 =
1.25%/month.
n = 2 years OR 24 months
Work in months or in years
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4.5 Example 2.
F 10 = ?
Consider
r = 12%/yr, c.s.a.
0 1 2 3 4 5 6 7 8 9 10
$1,000 $1,500
$3,000
4.5 Example 2.
F 10 = ?
Renumber the time line
r = 12%/yr, c.s.a.
0 2 4 6 8 10 12 14 16 18 20
$1,000 $1,500
$3,000
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4.5 Example 2.
F 20 = ?
Compound Forward
r = 12%/yr, c.s.a.
0 2 4 6 8 10 12 14 16 18 20
$1,000 $1,500
$3,000
$1,500(F/P,6%,8) = $11,634
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0 1 2 3 4 5 6 7 8 9 10
$1,000 $1,500
$3,000
Section 4.6
Series Analysis – PP >= CP
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Consider:
0 1 2 3 4 5 6 7
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Section 4.7
Single Amounts/Series with PP <
CP
This situation is different than the last.
Here, PP is less than the compounding
period (CP).
Raises questions?
Issue of interperiod compounding
An example follows.
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$120
$90
$45
0 1 2 3 4 5 6 7 8 9 10 11
12
$75 $50
$150 $100
$200
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r =12%/yr. c.q.
$120
$90
$45
CP-1 CP-2 CP-3 CP-4
0 1 2 3 4 5 6 7 8 9 10 11
12
$75 $50
$150 $100
$200
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$90
$45
CP-1
The $200 is at the end of
0 1 2 3 4 5 6 7 8 9 10 11
12 month 2 and will it earn
$150 $75interest
$100 for one month $50to go
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$90 $90
$45
0 1 2 3 4 5 6 7 8 9 10 11
12
$75 $50 $50
$150 $100
$175
$200 $200
$90
0 1 2 3 4 5 6 7 8 9 10 11
12
$150 $50
$175
$200
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Section 4.8
Continuous Compounding
Recall:
EAIR = i = (1 + r/m)m – 1
What happens if we let m approach
infinity?
That means an infinite number of
compounding periods within a year or,
The time between compounding
approaches “0”.
We will see that a limiting value will be
approached for a given value of “r”
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r m
i = (1 + ) −1
m
Now, examine the impact of letting “m” approach
infinity.
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r
m
r m r r
−1
(1 + ) − 1 = 1 +
m m
Note – the term in brackets has the exponent
changed but all is still the same….
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m
r r
lim 1 + = e,
m →∞
m
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Summarizing…….
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4.8 Derivation of Continuous
Compounding
The EAIR when interest is compounded continuously is then:
EAIR = er – 1
Where “r” is the nominal rate of
interest compounded continuously.
This is the max. interest rate for any
value of “r” compounded
continuously.
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r = ln(1 + i )
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4.8 Example
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4.8 Example
To start: er – 1 = 0.15
Solve for “r” ………
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4.8 Example
er – 1 = 0.15
er = 1.15
ln(er) = ln(1.15)
r = ln(1.15) = 0.1398 = 13.98%
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r = ln(1 + i )
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Section 4.9
Interest Rates that vary over
time
In practice – interest rates do not stay
the same over time unless by
contractual obligation.
There can exist “variation” of interest
rates over time – quite normal!
If required, how do you handle that
situation?
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0 1 2 3 4
(P/F,7%,1)
(P/F,7%,2)
(P/F,9%,3)
(P/F,10%,4)
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P0 =:
1. $7000(P/F,7%,1)
2. $7000(P/F,7%,1)(P/F,7%,1)
3. $35000(P/F,9%,1)(P/F,7%,1)2
4. $25000(P/F,10%,1)(P/F,9%,1)(P/F,7%,1)2
Equals: $172,816 at t = 0…
Work backwards one period at a
time until you get to “0”.
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0 8% 1 9% 2 10% 3 11% 4
P0 = $10,000(P/F,8%,1)(P/F,9%,1)(P/F,10%,1)(P/F,11%,1)
= $10,000(0.9259)(0.9174)(0.9091)(0.9009)
= $10,000(0.6957) = $6,957
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Chapter 4 Summary
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