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Interest Rate Conversion PDF

This document discusses interest rate conversions between periodic and annual rates. It defines key terms like nominal rate, effective rate, and interest periods. It then presents the rate equivalence relationship that must be satisfied to convert between rates: the accumulated value after one year must be the same. Examples show how to calculate equivalent quarterly, monthly, and biannual rates from given annual or periodic rates using the rate equivalence relationship.

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Hay Jirenyaa
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54 views4 pages

Interest Rate Conversion PDF

This document discusses interest rate conversions between periodic and annual rates. It defines key terms like nominal rate, effective rate, and interest periods. It then presents the rate equivalence relationship that must be satisfied to convert between rates: the accumulated value after one year must be the same. Examples show how to calculate equivalent quarterly, monthly, and biannual rates from given annual or periodic rates using the rate equivalence relationship.

Uploaded by

Hay Jirenyaa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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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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