LEARNING OUTCOMES

1. Make calculations for varying interest rates

2. Understand interest rate statements
3. Use formula for effective interest rates
4. Determine interest rate for any time period
5. Determine payment period (PP) and compounding
period (CP) for equivalence calculations
6. Make calculations for single cash flows
7. Make calculations for series and gradient cash flows
with PP ≥ CP
8. Use interest rate formula for continuous compounding

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Varying Rates
When interest rates vary over time, use the interest rates
associated with their respective time periods to find P

Example: Find the present worth of $2500 deposits in years 1 through 8 if the
interest rate
For the isflow
cash 7%shown
per year
below,for
find the firstworth
the future five(inyears
year 7)and
at i = 10% per
10% per year thereafter.
year.

Solution: P = 2,500(P/A,7%,5) + 2,500(P/A,10%,3)(P/F,7%,5)

= $14,683

An equivalent annual worth value can be obtained by replacing each cash flow
amount with ‘A’ and setting the equation equal to the calculated P value

14,683 = A(P/A,7%,5) + A(P/A,10%,3)(P/F,7%,5)

A = $2500 per year
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 Interest Rate Statements
The terms ‘nominal’ and ‘effective’ enter into consideration
when the interest period is less than one year.

New time-based definitions to understand and remember

Interest period (t) – period of time over which interest is expressed. For example,
1% per month.
Compounding period (CP) – Shortest time unit over which interest is charged or earned.
For example,10% per year compounded monthly.

Compounding frequency (m) – Number of times compounding occurs within the interest
period t. For example, at i = 10% per year, compounded
monthly, interest would be compounded 12 times during the
one year interest period.
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Understanding Interest Rate Terminology

A nominal interest rate (r) is obtained by multiplying an interest rate that is
expressed over a short time period by the number of compounding periods in a
longer time period: That is:
r = interest rate per period x number of compounding periods
Example: If i = 1% per month, nominal rate per year is
r = (1)(12) = 12% per year

Effective interest rates (i) take compounding into account (effective rates can
be obtained from nominal rates via a formula to be discussed later).

IMPORTANT: Nominal interest rates are essentially simple interest rates. Therefore,
they can never be used in interest formulas.
Effective rates must always be used hereafter in all interest formulas.

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More About Interest Rate Terminology
There are 3 general ways to express interest rates as shown below

Sample Interest Rate Statements Comment

i = 2% per month When no compounding period
(1)
i = 12% per year is given, rate is effective

i = 10% per year, comp’d semiannually When compounding period is given

(2)
i = 3% per quarter, comp’d monthly and it is not the same as interest
period, it is nominal

i = effective 9.4%/year, comp’d semiannually When compounding period is given

(3) and rate is specified as effective,
i = effective 4% per quarter, comp’d monthly
rate is effective over stated period

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Effective Interest Rates

Nominal rates can be converted into effective rates
for any time period via the following equation:

i = (1 + r / m)m – 1
where i = effective interest rate for any time period
r = nominal rate for same time period as i
m = no. of times interest is comp’d in period specified for i

Example: For an interest rate of 1.2% per month CP monthly, determine

the nominal and effective rates (a) per quarter, and (b) per year
Solution: (a) Nominal r / quarter = (1.2)(3) = 3.6% per quarter CP monthly
Effective i / quarter = (1 + 0.036/3)3 – 1 = 3.64% per quarter

(b) Nominal i /year = (1.2)(12) = 14.4% per year CP monthly

Effective i / year = (1 + 0.144 / 12)12 – 1 = 15.39% per year
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Example

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 Equivalence Relations: PP and CP
New definition: Payment Period (PP) – Length of time between cash flows
In the diagram below, the compounding period (CP) is semiannual and the payment period (PP) is monthly

$1000

Similarly, for the diagram below, the CP is quarterly and the payment period (PP) is semiannual
F=?
i = 10% per year, compounded quarterly
0 1 2 3 4 5 Years
0 1 2 3 4 5 6 7 8 9 10 Semi-annual periods

A = $8000
Semi-annual PP
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Single Amounts with PP > CP

For problems involving single amounts, the payment period (PP) is usually
longer than the compounding period (CP). For these problems, there are an infinite
number of i and n combinations that can be used, with only two restrictions:
(1) The i must be an effective interest rate, and
(2) The time units on n must be the same as those of i
(i.e., if i is a rate per quarter, then n is the number of quarters between P and F)

There are two equally correct ways to determine i and n

Method 1: Determine effective interest rate over the compounding period CP, and
set n equal to the number of compounding periods between P and F

Method 2: Determine the effective interest rate for any time period t, and
set n equal to the total number of those same time periods.

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 Example: Single Amounts with PP ≥ CP
How much money will be in an account in 5 years if $10,000 is deposited
now at an interest rate of 1% per month CP monthly? Use three different
interest periods: (a) monthly, (b) quarterly , and (c) yearly.

(a) For monthly rate, 1% is effective [n = (5 years)×(12 CP per year = 60]

F = 10,000(F/P,1%,60) = $18,167
months i and n must always
effective i per month have same time units

(b) For a quarterly rate, effective i/quarter = (1 + 0.03/3)3 –1 = 3.03%

F = 10,000(F/P,3.03%,20) = $18,167
quarters i and n must always
effective i per quarter have same time units

(c) For an annual rate, effective i/year = (1 + 0.12/12)12 –1 = 12.683%

F = 10,000(F/P,12.683%,5) = $18,167
years i and n must always
effective i per year have same time units
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Series with PP ≥ CP
For series cash flows, first step is to determine relationship between PP and CP
Determine if PP ≥ CP, or if PP < CP

When PP ≥ CP, the only procedure (2 steps) that can be used is as follows:

(1) First, find effective i per PP

Example: if PP is in quarters, must find effective i/quarter
(2) Second, determine n, the number of A values involved
Example: quarterly payments for 6 years yields n = 4×6 = 24

Note: Procedure when PP < CP is discussed later

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 Example: Series with PP ≥ CP
How much money will be accumulated in 10 years from a deposit
of $500 every 6 months if the interest rate is 1% per month?

Solution: First, find relationship between PP and CP

PP = six months, CP = one month; Therefore, PP > CP

Since PP > CP, find effective i per PP of six months

Step 1. i /6 months = (1 + 0.06/6)6 – 1 = 6.15%

Next, determine n (number of 6-month periods)

Step 2: n = 10(2) = 20 six month periods

Finally, set up equation and solve for F

F = 500(F/A,6.15%,20) = $18,692 (by factor)
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Series with PP < CP

Two policies: (1) interperiod cash flows earn no interest (most common)
(2) interperiod cash flows earn compound interest

For policy (1), positive cash flows are moved to beginning

of the interest period in which they occur
and negative cash flows are moved to the end of the interest period

Note: The condition of PP < CP with no interperiod interest is the only situation
in which the actual cash flow diagram is changed

For policy (2), cash flows are not moved and equivalent P, F, and A values are
determined using the effective interest rate per payment period

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 Example: Series with PP < CP
A person deposits $100 per month into a savings account for 2 years. If
$75 is withdrawn in months 5, 7 and 8 (in addition to the deposits),
construct the cash flow diagram to determine how much will be in the
account after 2 years at i = 6% per year, compounded quarterly. Assume
there is no interperiod interest.

Solution: Since PP < CP with no interperiod interest, the cash flow diagram must be
changed using quarters as the time periods
F=?
F=? 75 150
75 75 75

from to 0 1 2 3 4 5 6 7 8 9 10 21 24 Months
0 1 2 3 4 5 6 7 8 9 10 23 24
this this 1 2 3 7 8 Quarters
100 300 300 300 300 300

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Example: Series with PP < CP

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Example: Series with PP < CP

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Example: Series with PP < CP

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 Series with PP < CP

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Continuous Compounding
When the compounding period is infinitely small, interest is
compounded continuously. Therefore, PP > CP and m increases.

Take limit as m → ∞ to find the effective interest rate equation

i = er – 1
Proof:

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Example: Continuous Compounding
The effective interest rate equation
i = er – 1

For an interest rate of 18% per year, compounded continuously,

calculate the effective monthly and annual interest rates.
Solution:
The nominal monthly rate is r = 18%/12 =1.5%, or 0.015 per month CP continuously
the effective monthly rate is:
i % per month = e r − 1 = e0.015 − 1= 1.511%

The effective annual rate using r =0.18 per year CP continuously is

i % per year = e r − 1= e0.18 − 1 = 19.722%

Example: Continuous Compounding

The effective interest rate equation
i = er – 1

Example: If a person deposits $500 into an account every 3 months

at an interest rate of 6% per year, compounded continuously,
how much will be in the account at the end of 5 years?
Solution: Payment Period: PP = 3 months
Nominal rate per three months: r = 6%/4 = 1.50%
Effective rate per 3 months: i = e0.015 – 1 = 1.51%
F = 500(F/A,1.51%,20) = $11,573

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 Summary of Important Points

Must understand: interest period, compounding period, compounding

frequency, and payment period

Always use effective rates in interest formulas

i = (1 + r / m)m – 1

Interest rates are stated different ways; must know how to get effective rates

Make sure units on i and n are the same

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Important Points (cont’d)

For uniform series with PP ≥ CP, find effective i over PP

For uniform series with PP < CP and no interperiod interest, move

cash flows to match compounding period

For continuous compounding, use i = er – 1 to get effective rate

For the cash flow shown below, find the future worth (in year 7) at i = 10% per year.

For varying rates, use stated i values for respective time periods

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