Chapter 4 Nominal and Effective Interest Rates

Chapter 4 Nominal and Effective Interest Rates

INEN 303 Sergiy Butenko Industrial & Systems Engineering Texas A&M University
Chapter 4 Nominal and Effective Interest Rates

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Nominal and Effective Interest Rates Comparing Payment Period and Compounding Period Lengths (PP vs. CP) Interest Periods Equal to Payment Periods Interest Periods Smaller than Payment Periods Interest Periods Larger than Payment Periods Interest Rates That Vary over Time
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Nominal and Effective Interest Rates

Nominal and Effective Interest Rates

Generally interest can be quoted in more than one way:

1.

Quotation using a Nominal Interest Rate (or APR - the Annual Percentage Rate)

2.

Quoting an Effective Interest Rate (or APY the Annual Percentage Yield)

Interest may be computed (compounded): Annually One time a year (at the end) Every 6 months 2 times a year (semi-annual) Every quarter 4 times a year (quarterly) Every Month 12 times a year (monthly) Every Day 365 times a year (daily) Continuous infinite number of compounding periods in a year.
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Chapter 4 Nominal and Effective Interest Rates

Terminology
Payment Period, Tp - Length of time during which cash flows are not recognized except as end of period cash flows. Compounding Period (CP or interest period), Tc Length of time between compounding operations. Interest Rate Period, T - Interest rates are stated as % per time period. T is the time period. Compounding frequency, m - the number of times that compounding occurs within the time period T.
Chapter 4 Nominal and Effective Interest Rates

Nominal Interest Rate

Nominal Interest Rate (r) - rate at which money grows, %/T, without considering compounding. It can be stated for any time period: 1 year, 6 months, quarter, month, week, day, etc.

To find equivalent nominal rate r for any other time period: r = interest rate per period * number of periods
Chapter 4 Nominal and Effective Interest Rates

Nominal Interest Rate

For example, if the nominal interest rate, r, were: r = 1.5% per month, the nominal rate would also be: r = 0.05% per day, if 30 days/mo. r = 4.5% per quarter r = 9% semiannually r = 18% per year

Effective Interest Rate

Effective Interest Rate (i) - rate at which money grows, %/T, considering compounding. It is usually expressed on an annual basis (ia), but any time basis can be used. Effective Interest Rate, i, equals the nominal interest rate, r, if the interest rate period T and the compounding period CP are equal.

Chapter 4 Nominal and Effective Interest Rates

Chapter 4 Nominal and Effective Interest Rates

Nominal Rates:

All the interest formulas, factors, tabulated values, and spreadsheet relations must have the effective interest rate to properly account for the time value of money (effect of compounding). Effective rate has the compounding frequency attached to the nominal rate statement.
Chapter 4 Nominal and Effective Interest Rates

Format: r % per time period T Ex: 5% per 6-months (r = 5%, T = 6 months)

Effective Interest Rates:

Format: r % per time period T, compounded m times in time period T. m denotes the number of times per T that interest is compounded. Ex: 18% per year, compounded monthly (r = 18%, T = 1 year, CP = 1 month, m = 12)

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Example C4.1: What is the CP, m, and effective rate per CP if

a)

Effective rate per CP =

r% per T m per T

b)

r = 9% per year, compounded quarterly r = 15% per month, compounded daily

Solution CP a) quarter b) day m 4 30 Effective rate per CP 9%/4 = 2.25% 15%/30 = 0.5%

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Chapter 4 Nominal and Effective Interest Rates

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Example C4.2: Given r = 9% per year compounded monthly, find the Effective Monthly Rate (effective rate per CP). Solution: m = 12 compounding periods within a year (T). Effective Monthly Rate (effective rate per CP): 0.09/12 = 0.0075 = 0.75%/month

Example C4.3: Statement: 4.5% per 6 months compounded weekly. Find the effective weekly rate (effective rate per CP). Solution: Nominal Rate r = 4.5%. T = 6 months. m = 26 weeks per 6 months T effective weekly rate is: 0.045/26 = 0.00173 = 0.173% per week

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Chapter 4 Nominal and Effective Interest Rates

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Varying Statements of Interest Rates

Varying Statements of Interest Rates

Only the interest rate is stated 8%

Effective Rate is directly stated Effective rate is 8.243% per year, compounded quarterly; No nominal rate given; Compounding frequency m = 4; No need to calculate the true effective rate! It is already given: 8.243% per year!

per year.

No information on the frequency of compounding; Must assume it is for one year! Assume that 8% per year is a true, effective annual rate!

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Chapter 4 Nominal and Effective Interest Rates

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Effective Interest Rate, i, equals the nominal interest rate, r, if the interest rate period T and the compounding period CP are equal. Effective rate per payment period = (1 + r/m)m 1

Example C4.4: What is the future worth of $100 after 1 year if a bank pays 12% interest per year compounded semiannually? Solution: First find effective interest rate per year r = 12% per year (nominal); T = 1 year; CP = 6 months; m = 2; payment period PP = 1 year Effective rate per payment period = (1 + r/m)m 1 i per year = (1 + 0.12/2)2 1 = 0.1236 = 12.36% F = $100 (1+0.1236) = $112.36
Chapter 4 Nominal and Effective Interest Rates

r = nominal interest rate per payment period m = number of compounding periods per payment period

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Example C4.5: A bank pays a 12% per year compounded semiannually. What is the effective interest rate for a) 6 mo.? b) 12 mo? c) 24 mo.? Solution: a) Compounding period CP is 6 mo. The nominal interest is 12% per year, so the nominal interest rate per 6 mo is 6%. The effective interest rate per 6 mo. is also 6% since the compounding period equals to the interest rate period (6 mo.).

Formally: r = 12% / year CP = 6 months i/6 months = r/6months = 12% / 2 = 6% b) What is the effective interest rate for 12 mo.? r/12 months = 0.12 (given); m = 2 i/12 months = (1 + .12/2)2 1 = 12.4% c) What is the effective interest for 24 mo.? i = (1+.24/4)4 - 1 = 26.2 %

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Chapter 4 Nominal and Effective Interest Rates

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Example C4.6: The nominal rate is 1% per month and compounding occurs monthly, what is the effective rate for 12 months. Solution: r must be in %/PP for PP=12 months. r = 12 % m = #CPs in 1PP m = 1 year / 1 month = 12

Terminology
Payment Period, Tp - Length of time during which cash flows are not recognized except as end of period cash flows. Compounding Period (CP or interest period), Tc Length of time between compounding operations. Interest Rate Period, T - Interest rates are stated as % per time period. T is the time period. Compounding frequency, m - the number of times that compounding occurs within the time period of T.
Chapter 4 Nominal and Effective Interest Rates

i = (1 +

.12 12 ) 1 = 1.1268- 1 = 12.68% 12

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Comparing payment period and compounding period lengths (PP vs. CP)
Often the frequency of cash flows doesnt equal the frequency of interest compounding. To correctly perform any equivalence computation, it is essential that the payment period and compounding period be placed on the same time basis, and that the interest rate and the number of periods be adjusted accordingly.

Example C4.9: An engineer plans to borrow $3,000 from his company credit union, to be paid in 24 equal monthly installments. The credit union charges interest at the rate of 1% per month on the unpaid balance. How much money must the engineer repay each month?

Solution:
Here both the payment and compound periods are equal to one month. Therefore, A = P(A/P, 1%, 24) = $3,000 (0.04707) = $141.21.

Case 1. PP = CP In this case all the results obtained in Chapter 2 are correct.
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Chapter 4 Nominal and Effective Interest Rates

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Case 2. PP > CP
Method 1: Determine the effective interest rate over the given compounding period, and treat each payment separately. i.e. change the time unit of the cash flow diagram to CP Method 2: Calculate an effective interest rate for the payment period and then proceed as when the interest period and payment period coincide. i.e. retain the time unit as imposed by the cash flows for the cash flow diagram

Example C4.10: An engineer deposits $1,000 in a savings account at the end of each year. If the bank pays interest at the rate of 6% per year, compounded quarterly, how much money will be accumulated in the account after 5 years?

i per PP = ?
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Example C4.10, Solution Method 1: m = 4; n = 5; mn = 20; r = 0.06; PP = 1 year; CP = 1 quarter; i per CP is i = r/m = 0.06/4 = 0.015 F = 1,000(F/P,1.5%,16) + 1,000(F/P,1.5%,12) + 1,000(F/P,1.5%,8) + 1,000(F/P,1.5%,4) + 1,000 = $5,652.50.

Method 2:
i = (1 + r/m)m 1 = (1 + 0.06/4)4 1 = 0.06136 (effective interest rate per year). F = $1,000(F/A, 6.136%, 5). Note that there are no tables for i = 6.136%. Using the formula, we get
) F = A[ (1+ii) 1 ] = $1,000 (1+ 00..06136 06136
n 5

= $5,652.40
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Chapter 4 Nominal and Effective Interest Rates

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Chapter 4 Nominal and Effective Interest Rates

Example C4.11:
A deposit of $3000 is made after 3 years and $5000 after 5 years, what is the value of the account after 10 years if the interest rate is 12% per year compounded semiannually?

Solution: PP = 1 year > CP = year

Method 1 i per CP = .12/2 = .06 F = 3000 (F/P,6%,14) + 5000 (F/P,6%,10) = 3000 (2.2609) + 5000 (1.7908) = 15,736.70 Method 2 i = (1 + (.12/2))2 1 = 12.36% per year F = 3000 (F/P,12.36%,7) + 5000 (F/P,12.36%,5) = 15,736.70

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Chapter 4 Nominal and Effective Interest Rates

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Example C4.12: $100 is deposited each quarter for 5 years. What is the future value of the account if interest is 12% per year compounded monthly.

Solution: PP = 1 quarter; CP = 1 month Nominal rate per month is .12/12 = .01 which is also the effective interest rate The effective interest per quarter is: i = (1+ .03/3)3 - 1 = .0303
F = $100 (F/A, .0303, 20) = $2695.76

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Chapter 4 Nominal and Effective Interest Rates

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Interest Periods Smaller than Payment Periods

CP > PP
Case 1 Interest is earned only by those payments that have been deposited or invested for the entire interest period (CP). This is the usual mode of operation of banks and lending institutions. The following rules are applied: 1. All deposits made during an interest period are moved to the end of the interest period. 2. All withdrawals made during an interest period are moved to the beginning of the interest period. 3. Proceed as in the case where interest periods and payment periods coincide.

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Chapter 4 Nominal and Effective Interest Rates

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CP > PP
Case 2 Any amount of money that is deposited between compounding times earns compound interest. Number of CPs per PP is now less than 1. Use the effective rate formula to find effective rate. Use that rate assuming compounding occurs at that rate every PP. Example: PP=1 week; CP=1 quarter; r=3% per quarter. Effective weekly i%=(1.03)1/13-1.
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Effective Interest Rate for Continuous Compounding

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Interest Rates That Vary over Time

Example C4.13: How much money would be accumulated in 5 years with an initial deposit of $10,000, if the account earned interest at 12% per year for the first 3 years and at 15% per year for the last 2 years? Solution: F = $10,000(F/P,12%,3)(F/P,15%,2) = $10,000(1.4049)(1.3225) = $18,579.80
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Example 4.16: Year 1 2 3 4 Net Profit 70k 70k 35k 25k Annual Rate 7% 7% 9% 10% Given above cash flow and corresponding interest, find its present worth

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Solution: P = 70k(P/A,7%,2) + 35k(P/F,9%,1)(P/F,7%,2) + 25k(P/F,10%,1)(P/F,9%,1)(P/F,7%,2) = $172,816

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