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    Nominal and Effective Interest Rate

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    Ridho Wahyu
    The document discusses nominal and effective interest rates. It provides examples to illustrate the difference between nominal and effective rates. A nominal rate is compounded more than once per year, while an effective rate produces the same interest as the nominal rate when compounded annually. Formulas are provided to calculate effective interest rates from nominal rates based on the compounding frequency. Sample problems demonstrate applying the concepts and formulas to calculate future values, present values, and effective interest rates.

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    Nominal and Effective Interest Rate

    Uploaded by

    Ridho Wahyu
    77 views12 pages
    The document discusses nominal and effective interest rates. It provides examples to illustrate the difference between nominal and effective rates. A nominal rate is compounded more than once per year, while an effective rate produces the same interest as the nominal rate when compounded annually. Formulas are provided to calculate effective interest rates from nominal rates based on the compounding frequency. Sample problems demonstrate applying the concepts and formulas to calculate future values, present values, and effective interest rates.

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    The document discusses nominal and effective interest rates. It provides examples to illustrate the difference between nominal and effective rates. A nominal rate is compounded more than once per year, while an effective rate produces the same interest as the nominal rate when compounded annually. Formulas are provided to calculate effective interest rates from nominal rates based on the compounding frequency. Sample problems demonstrate applying the concepts and formulas to calculate future values, present values, and effective interest rates.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    77 views12 pages

    Nominal and Effective Interest Rate

    Uploaded by

    Ridho Wahyu
    The document discusses nominal and effective interest rates. It provides examples to illustrate the difference between nominal and effective rates. A nominal rate is compounded more than once per year, while an effective rate produces the same interest as the nominal rate when compounded annually. Formulas are provided to calculate effective interest rates from nominal rates based on the compounding frequency. Sample problems demonstrate applying the concepts and formulas to calculate future values, present values, and effective interest rates.

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    NOMINAL AND EFFECTIVE

    INTEREST RATE
    NOMINAL RATE AND EFFECTIVE RATE OF INTEREST

    NOMINAL RATE

    Is called when the interest is compounded more than


    once a year

    EFFECTIVE RATE

    Is the rate that, when the compounded annually,


    produces the same amount each year as the nominal
    rate (i) compounded (m) times a year
    Example:
    Two annual rates of interest with different conversion periods
    are said to be equivalent if they earn the same compound interest for
    the same time. For instance, in one year, the compound interest of
    P10.00 invested:

    a. At 12% compounded semi-annually:

    F = 10 ( 1 + 0.06 )² = P11.236

    b. At 12.36% compounded annually:

    F = 10 ( 1 + 0.1236 ) = P11.236

    Then: 12% is a nominal rate


    12.36% is an effective rate
    Formula:

    F = P( 1 + i ) n Where: m = compounding period


    F = P( 1 + j/m) mn n/t = year

    F1 = P( 1 + i ) – effective rate at the end of 1 year

    F2 = P (1 + j / m )m – nominal rate ( i ) compounded ( m ) times a year

    Since the two compounds are equal: F1 = F2 , then

    P (1 + i ) = P (1 + j / m) m

    (1 + i ) = (1 + j / m) m

    i = (1 + j / m) m - 1

    Note: If the nominal rate is compounded annually, then i = j


    Various ( i ) and ( n ) Values for single-amount equations
    using r = 12% per year, compounded monthly

    Effective Interest Rate, i Units for n

    1% per month Months

    3.03% per quarter Quarters

    6.15% per 6 months Semi-annual periods

    12.68% per year Years

    26.97% per 2 years 2-year periods

    Interest rate is used for I, that is (1.01)3 – 1 = 3.03%, then the n time unit I 4 quarters,
    Alternatively , it is always correct to determine the effective i per payment period.
    Sample problems:
    1.

    Given:
    P = P 2000
    j = 11% compounded quarterly
    t = 5 years
    m=4
    n=mxt
    Required:
    F=?

    Solution:
    F= P (1 + j / m )n

    = 2000(1 + 0.11)/4) 4x5

    = 2000(1 + 0.11/4) 20

    = P 3440.87
    2.

    Given:
    F = P 5000
    j = 12% compounded semi-annually
    t = 8 years
    m=2
    n=mxt
    Required:
    P=?

    Solution:
    F= P (1 + j / m )n

    P = F/(1 + j/m) n

    P = 5000/(1 + 0.12/2) 2 x 8

    P = P 1968.23
    3.

    Given:
    P = P 2000
    j = 11% compounded quarterly
    t = 5 years
    m=4
    n=mxt
    Required:
    F=?

    Solution:
    F= P (1 + j / m )n

    = 2000(1 + 0.11)/4) 4x5

    = 2000(1 + 0.11/4) 20

    = P 3440.87
    4.

    Find the effective rate equivalent to 12% compounded semi- annually.

    Given:
    j = 12%
    m=2

    Required:
    Er = ?

    Solution:
    Er = (1 + j / m )m – 1

    = (1 + 0.12/ 2 ) 2 – 1

    = 0.1236 or 12.36%
    25.
    A student deposits P 1,500 in a 9% account today. He intends to deposit
    another P 3,000 at the end of two years. He plans to purchase in five years his
    favorite shoes worth P 5,000. Calculate the money that will be left in his account
    one year after the purchase.

    Given:
    P = 1,500
    j=9%
    n1 = 2 years, n2 = 3 years, n3 = 1years

    Solution:

    a. F = P( 1 + i ) n1

    = 1,500 ( 1 + 0.009) 2

    = 1,782.15

    = 1,782.15 + 3,000(deposit at the end of 2years)

    = P 4,782.15
    b. F = P( 1 + i ) n2

    = 4,782.15 ( 1 + 0.009) 3

    = 6,193.02 – balance after 5 years

    = 6,193.02 - 5,000(shoes worth)

    = P 1,193.02

    c. F = P( 1 + i ) n3
    = 1,193.02 ( 1 + 0.009) 1

    = P 1,300.39 (money left after one year after the purchase)

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