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Principles of Money-Time Relationships

The document discusses nominal and effective interest rates, explaining that nominal rates are quoted annually but interest may compound more frequently, like monthly or quarterly. It defines the nominal rate r and effective annual rate i, and provides a formula to calculate i from r and the number of compounding periods M per year. Several examples are provided of calculating interest with compounding more or less frequently than annually. The document also introduces the concept of continuous compounding.

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Michael Quidor
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71 views13 pages

Principles of Money-Time Relationships

The document discusses nominal and effective interest rates, explaining that nominal rates are quoted annually but interest may compound more frequently, like monthly or quarterly. It defines the nominal rate r and effective annual rate i, and provides a formula to calculate i from r and the number of compounding periods M per year. Several examples are provided of calculating interest with compounding more or less frequently than annually. The document also introduces the concept of continuous compounding.

Uploaded by

Michael Quidor
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 PPT, PDF, TXT or read online on Scribd
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Principles of Money-Time Relationships

(Part II)
Nominal and Effective Interest Rates
(1/4)

• In our previous examples, we


considered the interest period, or the
time between compounding, as one
year
• However, very often, the interest period is
less than one year
• It has been customary to quote interest
rates on an annual basis, followed by the
compounding period if different from one
year in length
Nominal and Effective Interest Rates
(2/4)

• Ex: A 6% per interest period for a time


period of six months is equivalent to saying
12% compounded semiannually
• The 12% in the case above is what we call the
nominal interest rate, which is represented as
r
• The actual or exact rate of interest earned on the
principal amount during one year is known as the
effective interest rate, which is represented as
i
• Effective interest rates are always expressed on an
annual basis
Nominal and Effective Interest Rates
(3/4)

• The relationship between nominal and


effective interest rates is given by the
equation:

i  1  r / M   1
K

where M is the number of compounding


periods per year; and K is the number
of compounding periods per fixed time
interval separating cash flows
Nominal and Effective Interest Rates
(4/4)

EXAMPLE: A credit card company


charges an interest rate of 1.375% per
month on the unpaid balance of all
accounts. The annual interest rate,
they claim, is 16.5%. What is the
effective interest rate of interest per
year being charged by the company?
Interest Problems with Compounding
More Often Than Once per Year (1/4)

Suppose that a lump-sum amount is


invested for 10-years at a nominal
interest rate of 6% compounded
quarterly. How much is it worth at the
end of the tenth year?

F  PF / P,1.5%, 40   $181.40


F  PF / P,6.14%,10   $181.40
Interest Problems with Compounding
More Often Than Once per Year (2/4)

NOTE: The formulas for uniform and


gradient series can be used as long as
there is a cash flow at the end of
each interest period
Interest Problems with Compounding
More Often Than Once per Year (3/4)

Suppose that one has a bank loan for


P10,000 which is to be repaid in equal
end-of-month installments for five
years with nominal interest rate of
12% compounded monthly. What is
the amount of each payment?

A  PhP10,000 A / P,1%,60  PhP222


Interest Problems with Compounding
More Often Than Once per Year (4/4)

Certain operating savings are expected to be 0 at the


end of the first six months, to be PhP1,000 at the
end of the second six months, and to increase by
PhP1,000 at the end of each six-month period
thereafter for a total of four years. It is desired to
find the equivalent uniform amount, A, at the end of
each of the eight 6-month periods if the nominal
interest rate is 20% compounded semiannually.

A  PhP1,000 A / G,10%,8  PhP 3,004.50


Interest Problems with Cash Flows Less
Often Than Compounding Periods (1/2)

Suppose that there exists a series of 10 end-


of-year receipts of PhP10,000 each, and it is
desired to compute their equivalent worth as
of the end of the tenth year if the nominal
interest rate is 12% compounded quarterly.

F  10,000 A / F ,3%, 4F / A,3%, 40


 PhP180,208.87
F  10,000F / A,12.55%,10 
 PhP180,221.71
Interest Problems with Cash Flows Less
Often Than Compounding Periods (2/2)

Determine the present value of the cash flow


diagram below given that the nominal
interest rate is 15% compounded monthly:

P  1,000P / A,3.8%,8
 PhP 6,788.70
Continuous Compounding (1/2)

• To be competitive in the financial market , or


to entice potential depositors, some financial
institutions offer frequent compounding
• As the number of compounding periods (M)
becomes very large, the interest rate per
compounding period, (r/M) becomes very
small
• As M approaches infinity and r/M
approaches zero, we approximate the
situation of continuous compounding
Continuous Compounding (2/2)

• For continuous compounding, compute

i=e r/K –1

Where K is the number of time periods


per year at which you want to find the
effective interest rate of

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