STUDY UNIT 1:

Interest rates

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 Study unit outcomes
After completing this study unit you should be able to:
• Write down and apply the definitions of effective, nominal and simple interest.
• Write down and apply the definition of compounded interest.
• Use EXCEL to calculate the future value on any investment using any of the above
mentioned interest calculations.
• Calculate the effective interest rate, given the nominal interest rate.
• Calculate the effective interest rate, given the initial and final amount.

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 Introduction to interest rates
Interest refers to the money that you have to pay for borrowing money that does not belong
to you.

VS

Borrower Paying interest amount

Investor Receiving interest amount

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 Simple interest versus compound
interest
Simple interest
Interest is calculated using the original investment amount only.

Compound interest
Interest is calculated using the sum of the original investment amount and the interest earned during
the previous period.

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 Calculating simple interest
An investor deposits R100 into an account that earns interest at a simple rate of 10% per year. Determine the future
value (accumulated value) in the account at the end of a four-year period.

100 +10 +10 +10 +10

NOTE:
• Interest payments do not earn any
0
1 2 3 4 interest.
• Interest is calculated on the original
capital amount each time.

𝒕 𝟎 𝟏 𝟐 𝟑 𝟒
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏
100 110 120 130 140
𝒂𝒄𝒄𝒐𝒖𝒏𝒕

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 Derive formula – simple interest
100 +10 +10 +10 +10 +𝑖𝐶 +𝑖𝐶
𝐶 +𝑖𝐶 +𝑖𝐶

3
0
1 2 3 4 0
1 2 𝑛

𝒕 𝟎 𝟏 𝟐 𝟑 𝒏

𝑻𝒐𝒕𝒂𝒍 𝒊𝒏
𝑪 𝐶 + 𝑖𝐶 = 𝑪(𝟏 + 𝒊) 𝐶 + 𝑖𝐶 + 𝑖𝐶 = 𝑪(𝟏 + 𝟐𝒊) 𝐶 + 𝑖𝐶 + 𝑖𝐶 + 𝑖𝐶 = 𝑪(𝟏 + 𝟑𝒊) 𝐶 + 𝑖𝐶 + 𝑖𝐶 + 𝑖𝐶 + ⋯ + 𝑖𝐶 = 𝑪(𝟏 + 𝒏𝒊)
𝒂𝒄𝒄𝒐𝒖𝒏𝒕

∴ 𝑭𝑽 = 𝑪 + 𝒏𝒊𝑪
= 𝑪 𝟏 + 𝒏𝒊
Where

𝑭𝑽: Future value (accumulated value).

𝑪 = 𝑷𝑽: Initial investment amount.
𝒊: Simple interest rate per period.
𝒏: Total number of periods

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 Important definitions for compound
interest
Effective annual interest rate:
The amount of interest earned on a single investment at the end of the year, shown as a fraction of
the initial amount.
interest earned FVyear end − PVyear start
=
PVyear start PVyear start

Effective periodic interest rate:

The amount of interest earned on a single investment at the end of the period, shown as a fraction of
the initial amount.
interest earned FV period end − PV period start
=
PV period start PV period start
Nominal interest rate:
The effective periodic interest rate multiply by the number of periods in a year.

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 Calculating compounded interest
An investor deposits R100 into an account that earns compound interest at a rate of 10% per
year. Determine the future value (accumulated value) in the account at the end of a four-year
period.

100 +10 +11 +12.1 +13.31

NOTE:
• Interest payments earn interest.
0
4
• It is the practice of calculating interest
1 2 3
periodically and adding it to the existing
principle before each subsequent interest
calculation is made.
𝒕 𝟎 𝟏 𝟐 𝟑 𝟒
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏
100 110 121 133.1 146.41
𝒂𝒄𝒄𝒐𝒖𝒏𝒕

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 Derive formula – compounded interest
100 +10 +11 +12.1 +13.31 𝐶 +𝑖𝐶 𝐶 1+𝑖 +𝐶 1+𝑖 𝑖 … 𝐶(1 + 𝑖)𝑛

𝑛
0 0
1 2 3 4 1 2 …

𝒕 𝟎 𝟏 𝟐 3 𝒏

𝐶 1+𝑖 +𝐶 1+𝑖 𝑖 = 𝐶(1 + 𝑖)2 +𝑖𝐶(1 + 𝑖)2 𝑪(𝟏 + 𝒊)𝒏

𝑻𝒐𝒕𝒂𝒍 𝒊𝒏 𝐶 + 𝑖𝐶
𝑪 = 𝐶 1+𝑖 1+𝑖 = 𝐶 1+𝑖 2 1+𝑖
𝒂𝒄𝒄𝒐𝒖𝒏𝒕 = 𝑪(𝟏 + 𝒊)
= 𝑪(𝟏 + 𝒊)𝟐 = 𝑪(𝟏 + 𝒊)𝟑

∴ 𝑭𝑽 = 𝑪(𝟏 + 𝒊)𝒏
Where

𝑭𝑽: Future value (accumulated value).

𝑪 = 𝑷𝑽: Initial investment amount.
𝒊: compound interest rate per period.
𝒏: Total number of periods

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 Calculating effective periodic interest
Effective interest rate
An investor deposits R100 into an account that earns 5% 𝑭𝑽 = 𝑪(𝟏 + 𝒓)𝒏𝒑 𝑭𝑽 = 𝑪(𝟏 + 𝒊)𝒏
interest semi-annually. Determine the future value
Effective periodic interest rate Effective annual interest rate
(accumulated value ) in the account at the end of a two-
𝒊(𝒑) 𝟏𝟐𝟏, 𝟓𝟓𝟎𝟔
year period. 𝒓 = 𝟓% 𝒑𝒆𝒓 𝒉𝒂𝒍𝒇 𝒚𝒆𝒂𝒓 = 𝒊= − 𝟏 = 𝟏𝟎, 𝟐𝟓%
𝒑 𝟏𝟎𝟎

100 +5 +5.25 +5.5125 +5.7881 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕

𝒆𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 =
𝑷𝑽
Effective 2 year interest rate
0
0.5 1 1.5 2 𝟏𝟐𝟏. 𝟓𝟓𝟎𝟔 − 𝟏𝟎𝟎
= 𝟐𝟏, 𝟓𝟓%
𝟏𝟎𝟎

𝒕 𝟎 𝟎. 𝟓 𝟏 𝟏. 𝟓 𝟐 NB: Effective interest rate is always used in calculations.

𝑻𝒐𝒕𝒂𝒍 𝒊𝒏
Nominal interest rate
100 105 110.25 115.7625 121.5506 Nominal interest is a quoted rate (implicit per year).Interest
𝒂𝒄𝒄𝒐𝒖𝒏𝒕
is earned more often than once per year.

𝒊(𝒑) 𝒏𝑝
Nominal interest rate
𝑭𝑽 = 𝑪(𝟏 + ) 𝒊 (𝟐)
= 𝟓% + 𝟓% = 𝟏𝟎% per year
𝒑

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Relationship between different interest
rate forms.

Simple interest Effective annual interest Nominal interest

(𝑝) (𝑝) 𝑝𝑛
𝑖 𝑖
(1 + 𝑖𝑛) = 1 + 𝑖 𝑛 = (1 + )𝑝𝑛 = 1 +
𝑝 𝑝

Effective periodic interest

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 Examples
Convert an effective monthly interest rate of 1% to an equivalent effective quarterly interest rate.

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 Examples
Convert an effective annual interest rate of 14% to an equivalent nominal interest rate, compounded daily
(assume there are 365 days in a year).

i (365) = 13.1052%

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 In EXCEL or any other programming
language
Create a template for converting any interest rate form to any other interest rate form.
Use the Exercises in the following slides to test your answers.

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 Exercise 1
(i) Convert 9% pa effectively to:

a) a nominal interest rate, converted daily. (8.6188%)

b) an effective weekly interest rate. (0.1659%)

c) a simple quarterly interest rate. (2.25%)

(ii) Use the answer found in (i) and show that it converts to 9% pa effectively.

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 Exercise 2
(i) Convert 7% pa, compounded monthly to:

a) a nominal interest rate compounded quarterly. (7.0409%)

b) an effective semi-annual interest rate. (3.5514%)

c) a simple annual interest rate. (7.2290%)

d)an effective monthly interest rate. (0.5833%)

(ii) Use the answer found in (i) and show that it converts 7% pa, compounded monthly.

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 Exercise 3
(i) Convert a 0.05% simple daily interest rate

a) an effective annual interest rate. (18.25%)

b) an nominal interest rate convertible monthly. (16.8807%)

c) an effective quarterly interest rate. (4.2798%)

(ii) Use the answer found in (i) and show that it converts to 0.05% simple daily interest rate.

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 To do
• Read Study unit 1 of the study guide.
• You will now be able to do Problem 1.1 – 1.4 from the study guide.
• Assignment 1 – due one week from today
• Do Tutorial 1 before the Tutorial class

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