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Lecture 4A - PDM CPM and Barchart - Part 1

The document discusses nominal and effective interest rates, explaining how to calculate them based on the compounding period and interest period. It provides examples of calculating interest rates expressed as monthly, quarterly, and annual rates. The document also covers topics like single amounts, series cash flows, cash flow diagrams, and continuous compounding.

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24 views19 pages

Lecture 4A - PDM CPM and Barchart - Part 1

The document discusses nominal and effective interest rates, explaining how to calculate them based on the compounding period and interest period. It provides examples of calculating interest rates expressed as monthly, quarterly, and annual rates. The document also covers topics like single amounts, series cash flows, cash flow diagrams, and continuous compounding.

Uploaded by

Mm
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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ENGINEERING ECONOMICS Lecture 4 – nominal and

effective interest rate

1
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.
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.
More About Interest Rate Terminology
There are 3 general ways to express interest rates as shown below
Sample Interest Rate Statements Comment
(1) i = 1% per month i = When no compounding period is given, rate is
12% per year effective

(2) i = 10% per year, comp’d semiannually When compounding period is given and it is not the
i = 3% per quarter, comp’d monthly same as interest period, it is nominal

(3) i = effective 9.4%/year, comp’d semiannually When compounding period is given and rate is
i = effective 4% per quarter, comp’d monthly specified as effective, rate is effective over stated
period
EFFECTIVE ANNUAL INTEREST RATES
Nominal rates are converted into effective annual rates via the
equation:

ia = (1 + i)m – 1

Where, ia = effective annual interest rate


i = effective rate for one compounding period
m = number times interest is compounded per year
EXAMPLE
For a nominal interest rate of 12% per year, determine the nominal
and effective rates per year for (a) quarterly, and (b) monthly
compounding

Solution: (a) Nominal r / year = 12% per year


Nominal r / quarter = 12/4 = 3.0% per quarter
Effective i / year = (1 + 0.03)4 – 1 = 12.55% per year
(b) Nominal r /month = 12/12 = 1.0% per month
Effective i / year = (1 + 0.01)12 – 1 = 12.68% per year
EFFECTIVE INTEREST RATES
Nominal rates can be converted into effective rates for any time
period via the following equation:

ieff = (1 + r/m)m – 1

Where, i = effective interest rate for any time period (t)


r = nominal rate for same time period (t) as i
m = number of compounding period with an interest period (t)
EXAMPLE
For an interest rate of 1.2% per month, 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


Effective i / quarter = (1 + 0.036/3)3 – 1 = 3.64% per quarter
(b) Nominal i /year = (1.2)(12) = 14.4% per year
Effective i / year = (1 + 0.144 / 12)12 – 1 = 15.39% per year
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
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)
SINGLE AMOUNTS WITH PP > CP
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.
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? Use three different interest rates: (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 have
effective i per month
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 have
effective i per quarter 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
i and n must always have
years same time units
effective i per year
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


EXAMPLE
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
Series with PP < CP
Two policies are available:
➢(1) inter-period cash flows earn no interest (most common)
➢(2) inter-period cash flows earn compound interest.

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

policy (2), cash flows are not moved and equivalent P, F, and A values
are determined using the effective interest rate per payment period
Note: The condition of PP < CP with no inter-period interest is the only situation
in which the actual cash flow diagram is changed
EXAMPLE
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 Positive F=?
F=? 75 150 Cash
75 75 75

from to 0 1 2 3 4 5 6 7 8 9 10 21 24
0 1 2 3 4 5 6 7 8 9 10 23 24
Months
this this
1 2 3 7 8 Quarters
100 300 300 300 300 300
Negative
Cash
CONTINUOUS COMPOUNDING
When the interest 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
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
SEE YOU NEXT WEEK

19

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