Continuous compound interest exploration

Natalia Filipowicz
 I. Introduction

Albert Einstein once said “Compound interest is the 8th wonder of the world. He who
understands it, earns it… he who… doesn’t pays it.” In this investigation I will focus on
exploring compound interest and in particular continuous compound interest. Which “In theory,
continuously compounded interest means that an account balance is constantly earning interest,
as well as refeeding that interest back into the balance so that it, too, earns interest.” (Investopia
“Continuous Compounding”). I chose this topic because I believe it is of great importance that
continuous compound interest is properly understood. It is a significant tool that is used in
everyday life, majority of times in adulthood. I hope that by the end of this investigation
whoever reads it will understand how important it is and how banks (very often) use it to earn
more money from their customer. In the end both sides what to get the best deal possible.
My question for this investigation is whether or not there is a limit to the future value.
Furthermore, I wonder whether there is difference between compounding the interest by second
and millisecond. The aim of this investigation is to investigate the final value of an investment
for various values of n and allow n to get extremely large.

II. Finding the best future value for compound interest formula

For the first step of this investigation I will use the compound interest formula. My independent
variable will be how often the interest is compounded and the dependent variable will be the
future value it correlates to. To ensure my data is as reliable as possible I will keep all other
factors the same (the interest rate, the previous value and the number of years).

Key Terms:
PV/𝑈0 = previous value
FV/𝑈𝑛 = future value
r = number of times interest is compounded
i = interest rate per compounding period
n = number of periods
Interest rate = 6%
Number of years = 4

𝒊
The compound interest formula: FV = 𝑷𝑽(𝟏 + 𝒓)𝒏𝒕

PV How often r i/r 1+i/r (𝟏 + 𝐢/𝐫)(𝟒𝐫) 𝐂𝐧 = 𝟏𝟎𝟎𝟎 ∗ (𝟏 + 𝐢)(𝟒𝐫)

the interest In $
is
compounded
annually 1 0.06 1.06 1.26247696 1262.47696
1000
1000 twice a 2 0.03 1.03 1.266770081 1266.770081
year
1000 quarterly 4 0.015 1.015 1.268985548 1268.985548
1000 monthly 12 0.005 1.005 1.270489161 1270.489161
1000 daily 365 0.000164384 1.000164384 1.271224077 1271.224077
1000 by the 8760 6.84932E-06 1.000006849 1.271248105 1271.248105
hour
1000 by the 525600 1.14155E-07 1.000000114 1.271249133 1271.249133
minute
1000 by the 31536000 1.90259E-09 1.000000001902590 1.271249132 1271.249132
second
1000 by the 31536000000 1.90259E-12 1.000000000001900 1.271231616 1271.231616
millisecond

Since it is not as important to see all the numbers after decimal in interest over rate, I decided
to use approximation, for all the data to fit in the table.
To achieve such results appropriate technology was used. I have used excel and later checked
my results with the TI-84 Plus C Silver Edition calculator, making sure that they are correct.

Graphical representation of future value

1272

1271

1270

1269
Future value of the initial investment in $

1268

1267

1266

1265

1264

1263

1262
0 2 4 6 8 10 12
Number of compounding periods per year

Figure 1 Graph representing the correlation between the future value vs how often the interest was compounded.

The more frequently you compound the interest, the bigger future value there is. The increase
is rapid at the beginning and slows down as the interest is compounded more frequently. There
is even a decrease in the last two rows (from second to millisecond), rather than increase. The
graph helps in representing the rather unexpected result. Which suggests that there is a limit to
the future value that can be achieved.

The conclusion is rather straightforward. The future value increases in change rapidly at first,
when the interest is compounded annually, twice a year, quarterly and monthly. The increase
is around 2 units (approximately). However, after monthly the interest increase slows down;
and is hardly visible at first sight. The increase is there, but overall it does not make that big of
a difference. Furthermore, considering that the interest would need to be compounded every
second or millisecond it in my opinion is simply not worth it. There will be a limit to which
the interest will be compounded. It does not matter how many times you compound the interest
there will be a limit. Which through calculations was found. The future value will not be larger
than the limit, and therefore at one point it doesn’t matter how often the interest is compounded
since the change in the future value will be insignificant for the customer. Taking that into
consideration and the results that I have achieved in my opinion the best opinion is when the
interest is compounded monthly. It is possible and would not be as much of struggle to
compound the interest monthly (rather than daily) and the future value is still significantly large.
It is clear that there is an increase in future value as the number of how often the interest is
compounded increases. Furthermore, is it clear that there is a limit to the future value that can
be achieved through that, clearly shown when the future value of interest compounded by
millisecond is smaller than when it is compounded by second. It may be that if the interest is
compounded more often the future value will start decreasing even more. However, this
investigation was very limited. I was not able to research that in detail and perhaps even if the
interest is compounded in such way in real life situation, or how is it possible that if the interest
is compounded more the future value is smaller? For now I decided to finding the limit for the
future value, since that would be more helpful for my investigation.

III. Finding the limit

If
r = the percentage rate per year
t = number of years
N = number of interest payments per year,

Then
𝑟
𝑖 = 𝑁 and n = Nt
𝑟
This means that the growth formula becomes 𝑈𝑛 = 𝑈0 (1 + 𝑁)𝑁𝑡

Equivalent:
𝑟 𝑁𝑡 1 𝑁
𝑈𝑛 = 𝑈0 (1 + ) → 𝑈𝑛 = 𝑈0 (1 + ) 𝑟 ∗𝑟𝑡
𝑁 𝑁
𝑟
If
𝑁
=𝑎
𝑟
𝑟 1
=
𝑁 𝑁
𝑟 𝑟
Because both numerator and denominator of can be divided by r
𝑁
𝑟 𝑁𝑡𝑟 𝑁
𝑁𝑡 ∗ = = ∗ 𝑟𝑡
𝑟 𝑟 𝑟
1 𝑎 𝑟𝑡
𝑈𝑁 = 𝑈0 [(1 + ) ]
𝑎

a 𝟏
(𝟏 + )𝒂
𝒂
10 2.59374246
100 2.704813829
1000 2.716923932
10 000 2.718145927
 100 000 2.718268237
1000 000 2.718280469
Figure 2 Table representing the change as a value gets larger

Graph representation of (𝟏+𝟏/𝒂)^𝒂

2.74
2.72
2.7
2.68
2.66
2.64
(𝟏+𝟏/𝒂)^𝒂

2.62
2.6
2.58
2.56
2.54
2.52
10 100 1000 10 000 100 000 1000 000

a Figure 3 Graph shows the correlation between a and

To find this information I used excel and then again checked my answer using the TI-84 Plus
C Silver Edition calculator to make sure that they are as accurate as technology allows me to;
although I am limited by it. The answers had to be shortened to two decimal places to fit in the
graph properly. However, the graph is only a representation for the table, and therefore the
table a more reliable source of information. When looking at the table, it is clear that the
numbers are getting more similar to itself. This is represented on the graph in a clearer way.
There is a strong increase at the beginning, the value of a increases by 10 each time, however
1
the value of (1 + 𝑎)𝑎 increases rapidly at first and then slows down. When thinking about it, it
1
((1 + 𝑎)𝑎 ) only increases from 10 to 100 of a and then is fairly similar. N gets very large
because the future value increases, and therefore a also gets very large. However, there is a
limit to it, and as the results from the table and the graph show as a approaches infinity it is
1
approximately 2.718281… Due to the limit of (1 + 𝑎)𝑎 .
1
Lim (1 + 𝑎)𝑎 = 2.718281
as 𝑎 → ∞

IV. Euler number

The number e is a mathematical constant that is the base of the natural logarithm: the unique
number whose natural logarithm is equal to one. It is approximately equal to 2.71828 and is
the limit of ⁿ as n approaches infinity.

𝑒 = 2.718281
 V. Formula for continuous compound interest

𝑒 = 2.718281
r = the annual percentage rate
t = the number of years

𝑈𝑁 = 𝑈0 𝑒 𝑟𝑡

Where:
𝑈0 = the initial amount/ the previous value

By using the formula to fund the amount at which investment of 1000$ for 4 years at a fixed
rate of 6% p.a., will reach if the interest is calculated continuously (instantaneously).

𝑈𝑁 = 1000 ∗ 𝑒 0.06∗4
≈ 1271.25

This investigation showed me that if the number of compounding periods happens very often
there is a limit to its future value. At one point it reaches the same future value (or very similar).
This led me to questioning that limit, and whether or not there is a formula to it, which
eventually was found. Although it took me some time to myself fully understand it once I did
it was rather easy to display for others to understand it as well. This investigation helped me
understand why banks and customer prefer not to do compound the interest so often, it simply
makes very little sense at some point; since the future value is so similar, and for millisecond
it is even smaller. Taking that into consideration in my opinion it makes the most sense to
compound the interest monthly. It shouldn’t be too bothering for the banks and the future value
for the customer is fairly large. If I had a chance of doing this investigation again, I would try
to research the topic more in depth, think of a different way to represent the findings. For
example, by using the logarithmic scale which used for a large range of positive multiples of
some quantity. This would help in representation of my findings in a more specific, clearer
way. Furthermore, I would use my time more efficiently. During the investigation I had some
difficulty with properly using excel, and the first time I did the table I did it by hand rather than
using excel. This costed me time which could be spend on further research for this exploration.
Furthermore, I struggled when understanding how to clearly represent the limit of the future
value. It needed to be easy to understand for the reader, and they should not be confused by the
calculations.
Nevertheless, this investigation was of big help for myself to understand how continuous
compound interest works, and what it is. Furthermore, it helped me understand why does
compound by minutes, seconds and milliseconds does not happen at banks (or isn’t as popular).
Finally, it taught me how banks can try to trick their customers, when presenting their offers
and how big of a difference it is when the interest is compounded annually or monthly.
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2019, https://www.investopedia.com/articles/07/continuously_compound.asp.

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