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WEB APPENDIX 2A
Continuous Compounding and Discounting

In Chapter 2 we dealt only with situations where interest is added at discrete intervals—
annually, semiannually, monthly, and so forth. In some instances, though, it is possible to
have instantaneous, or continuous, growth. In this appendix, we discuss present value
and future value calculations when the interest rate is compounded continuously.

Continuous Compounding
The relationship between discrete and continuous compounding is illustrated in Figure Continuous
2A-1. Panel a shows the annual compounding case, where interest is added once a year; Compounding
Panel b shows the situation when compounding occurs twice a year; and Panel c shows A situation in
interest being earned continuously. As the graphs show, the more frequent the compound- which interest is
ing period, the larger the final compounded amount because interest is earned on interest added
continuously
more often.
rather than at
Equation 2-1 in the chapter can be applied to any number of compounding periods
discrete points
per year as follows. in time.
INOM MN
More frequent compounding: FVN  PV a 1  b (2A-1)
M
Here, INOM is the stated annual rate, M is the number of periods per year, and N is the
number of years. To illustrate, let PV  $100, I  10%, and N  5. At various compound-
ing periods per year, we obtain the following future values at the end of five years.

0.10 5112
Annual: FV5  $100 a 1  b  $100 11.102 5  $161.05
1
0.10 5122
Semiannual: FV5  $100 a 1  b  $100 11.052 10  $162.89
2
0.10 51122
Monthly: FV5  $100 a 1  b  $100 11.00832 60  $164.53
12
0.10 513652
Daily: FV5  $100 a 1  b  $164.86
365
We could keep going, compounding every hour, every minute, every second, and so on.
At the limit, we could compound every instant, or continuously. The equation for
continuous compounding is as shown below:

FVN  PV 1eIN 2 (2A-2)

Here e is the value 2.7183 . . . . If $100 is invested for five years at 10 percent compounded
continuously, then FV5 is calculated as shown below:1

Continuous: FV5  $1003 e0.10152 4  $100 12.7183 . . . 2 0.5

 $164.87

1Calculators with exponential functions can be used to evaluate Equation 2A-2. For example, with an HP-10BII
you would type .5, then press the ex key to get 1.6487, and then multiply by $100 to get $164.87.

2A-1
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2A-2 Web Appendix 2A Continuous Compounding and Discounting

FIGURE 2A-1 Annual, Semiannual, and Continuous Compounding: Future Value

with I  25%
a. Annual Compounding b. Semiannual Compounding c. Continuous Compounding
Dollars Dollars Dollars

4 4 4 Interest
Interest Earned
Interest Earned $3.2473 $3.4903
3 Earned $3.0518 3 3

2 2 2

1 1 1

0 1 2 3 4 5 0 1 2 3 4 5 0 1 2 3 4 5
Years Years Years

Continuous Discounting
Equation 2A-2 can be transformed into Equation 2A-3 and used to determine present val-
ues under continuous discounting:

 FVN 1eIN 2
FVN
PV  IN
(2A-3)
e
Thus, if $1,649 is due in 10 years, and if the appropriate continuous discount rate, I, is 5
percent, then the present value of this future payment is $1,000:

$1,649 $1,649
PV    $1,000
12.7183 . . . 2 0.5
1.649

PROBLEMS

2A-1 FV continuous compounding If you receive $15,000 today and can invest it at a 6 per-
cent annual rate compounded continuously, what will be your ending value after
15 years?
2A-2 PV continuous compounding In 7 years, you are scheduled to receive money from a
trust established for you by your grandparents. When the trust matures there will be
$200,000 in the account. If the account earns 9 percent compounded continuously, how
much is in the account today?
2A-3 FV continuous compounding Bank A offers a nominal annual interest rate of 7 percent
compounded daily while Bank B offers continuous compounding at a 6.9 percent nomi-
nal annual rate. If you deposit $1,000 with each bank, what will be the difference in the
two bank account balances after 2 years?
2A-4 Continuous compounding You have the choice of placing your savings in an account
paying 10.25 percent compounded annually, an account paying 10.0 percent com-
pounded semiannually, or an account paying 9.8 percent compounded continuously. To
maximize your return, which would you choose?
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Web Appendix 2A Continuous Compounding and Discounting 2A-3

2A-5 Continuous compounding You have $11,572.28 in an account that has been paying an
annual rate of 9 percent, compounded continuously. If you deposited some funds
15 years ago, how much was your original deposit?
2A-6 Continuous compounding For a 10-year deposit, what annual rate payable semiannu-
ally will produce the same effective rate as 3 percent compounded continuously?
2A-7 Payment and continuous compounding You place $2,000 in an account that pays 8 per-
cent interest compounded continuously. You plan to hold the account exactly 3 years. At
the same time, in another account you deposit money that earns 9 percent compounded
semiannually. If the accounts are to have the same amount at the end of the 3 years, how
much of an initial deposit do you need to make now in the account that pays 9 percent
interest compounded semiannually?
2A-8 Continuous compounded interest rate In order to purchase your first home 6 years
from today, you need a down payment of $40,000. You currently have $20,000 to invest.
To achieve your goal, what nominal interest rate, compounded continuously, must you
earn on this investment?