Professional Documents
Culture Documents
Engineering Economics
By Lec. Junaid Arshad
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Many financial transactions require that interest be compounded more often than once a year (semiannually, quarterly, monthly, daily etc). In such situations, there are two expressions for the interest rate. The nominal interest rate, r, is expressed on an annual basis: this is the rate that is normally quoted when describing an interest bearing transaction. The effective interest rate, i, is the rate that corresponds to the actual interest period. The effective interest rate is obtained by dividing the nominal interest rate by m, the number of interest periods per year. i=r/m
We need a way to convert a nominal interest rate to the true effective interest rate that will actually apply!
Mathematically, we can define the nominal interest rate r as:
we would like to be able to convert a nominal interest rate to an effective annual interest rate
Examples
the same as (1.5%) (12) = 18% nominal interest rate per year
the same as (1%) (52) = 52% nominal interest rate per year
Problem:
A bank claims to pay interest to its depositors at the rate of 6% per year compounded quarterly. What are the nominal and effective interest rates? Solution: a) The nominal interest rate is r=6% b) Since there are four interest periods per year the effective interest rate is i=r/m i = 6% / 4 = 1.5% per quarter
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Consequently, the frequency at which nominal interest rate is compounded each year can have a pronounced effect on the dollar amount of total interest earned. Q. For instant, consider a principal amount of $1000 to be invested for three years at 12% compounded semiannually. The interest earned during the first six months would be $1000 * (0.12/2) = $60. Total principal and interest at the beginning of the second six-month period is P+Pi= $1000 + $60=$1060
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Example:
12%
Compounded
i = (1 + r / m)m - 1
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Given:
Effective monthly rate: 0.09/12 = 0.0075 = 0.75%/month Effective annual rate: (1 + 0.0075)12 1 = 0.0938 = 9.38%/year
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Example (continued)
0.75% 1
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The
effective weekly rate is (0.09/52) = 0.00173 = 0.173%/week effective annual rate is (1 + 0.00173)52 1 = 0.0940 = 9.40%/week
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The
Comparison
The effective annual interest rate is always greater than the nominal interest rate:
When
m > 1 because
are earning (paying) interest on your interest The difference is greater with more frequent compounding: If compounded quarterly, we get 9.30%/year If compounded monthly, we get 9.38%/year If compounded weekly, we get 9.40%/year What if we compound infinitely often?
You
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i [1 r / CK ] 1
C
C = number of interest periods per payment period K = number of payment periods per year CK = total number of interest periods per year, or M r/K = nominal interest rate per payment period
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2nd Q
1 interest period
3rd Q
4th Q
Given r = 8%, K = 4 payments per year C = 1 interest period per quarter M = 4 interest periods per year
2nd Q
3 interest periods Given r = 8%,
3rd Q
4th Q
K = 4 payments per year C = 3 interest periods per quarter M = 12 interest periods per year
2nd Q
13 interest periods Given r = 8%,
3rd Q
4th Q
K = 4 payments per year C = 13 interest periods per quarter M = 52 interest periods per year
i [1 r / CK ] 1
C
i lim[(1 r / CK ) 1]
C
(e )
r 1/ K
1
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2nd Q
interest periods Given r = 8%,
3rd Q
4th Q
Case 1
8% compounded monthly Payments occur quarterly 2.013% per quarter
Case 2
8% compounded weekly Payments occur quarterly 2.0186% per quarter
Case 3
8% compounded continuously Payments occur quarterly 2.0201% per quarter
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The nominal interest rate is frequently stated for loans Published interest tables time-value-of-money formulas Spreadsheet functions
A piece of paper with rows and columns for recording financial data for use in comparative analysis
Remember:
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