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Compound

interes

Compound Interest
Suppose that instead of collecting interest

at the end of each year, we decided to


collect interest at the end of each quarter,
so our interest is paid four times each year.
What would happen to our investment?
Since our account has an interest rate of
5.5% annually, we need to adjust this rate
so that we get interest on a quarterly
basis. The quarterly rate is:

5.5 / 4 1.375%

Compound Interest
So for our IRA account of $5000 at the end of

a year looks like:

F1 5000

0.055
1

41

$5280.72

After 10 years, we have:


0.055

F10 5000 1

410

$8633.85

Compound Interest Formula


P dollars invested at an annual rate r,
compounded n times per year, has a value
of F dollars after t years.
nt

r
F P 1
n

Think of P as the present value, and F as


the future value of the deposit.

Compound Interest
Formula
Notice that when we collected our

interest more times during each year,


i.e. we compounded more frequently,
the amount of money in our account
was actually greater than if only
collected interest one time a year.
What would happen to our money if we
compounded a really large number of
times?

Continuous Compounding
As n increases, approaches a constant value
in the Frequency Worksheet. Heres why:
r

P 1
n

nt

P 1
m

mrt

1
P 1
m

rt

As n gets really large, m also becomes really


large, and:

1
1
m

2.71828182845905 e

Continuous Compounding
The value of P dollars after t years,
when compounded continuously at an
annual rate r , is
rt

F Pe

On the calculator use the button


(on TI-83: 2nd + LN )
In Excel, use the function EXP(x )

Yield
The effective annual yield, y, for

compounding continuously at an annual


r
interest rate ofP r eis:
P
y
er 1
P
To find the annual interest rate r if
we know the yield, y, we would have
to solve for r in the above equation.
To do this you would use logarithms:

r ln y 1

Present Values
If we are given the future value, F, the

annual interest rate r, the number of


times compounded per year n, and the
length of time invested t, we may solve
the present value P :
nt
r

P F 1
n

P F e r t

Ratios
Sometimes we are not interested in the

percentage that an investment increases by.


Rather, we would like to know by what factor the
investment increased or decreased. Such factors
are computed by find the ratio of the future value
to the present value. This ratio, R, for continuous
compounding is:
F Pe rt

e rt

This allows us to convert the interest rate for a

given period to a ratio of future to present value


for the same period.

Example Ratios
Suppose that in our IRA example, the

annual interest rate of 5.5% is


compounded continuously.
If we wanted to know the weekly rate
our investment would increase, we
would simply have 0.055/52 or 0.00105
or 0.105%. This would mean that the
ratio of the future value to the present
value between consecutive weeks
compounded continuously would be
e0.055/52 or 1.00105

Example Ratios
Multiplying by this weekly ratio 52 times yields a

yearly ratio of (e0.055/52)52 = e(0.055/52)52 = e0.055. As


we would expect, this corresponds to the annual
rate of 0.055.

THANK YOU ^_^