Lec4-Nominal-Effective Rates-Plus Audio

Nominal Rate of Interest
 Nominal interest rate definition:

An interest rate that does not include any
consideration of compounding
For example, 8% per year is a nominal rate

A nominal rate is represented by r.
Nominal and effective interest rates.
• A nominal rate of 12%, compounded monthly,
means an interest of 1% (12%/12) would accrue
each month
However , the actual or effective rate is greater than

12% since compounding occurs more than once
per year
Effective Interest Rate
Definition:
The effective interest rate is the actual rate
that applies for a stated period of time.
All interest formulas, factors, tabulated

values, must have the effective interest rate
to properly account for the time value of
money
• The more frequent the compounding the greater

the effective interest.
• The effective rate is represented by i.

Important terminology
 Time Period – The period over which the interest is
expressed (always stated).
 Ex: “1% per year , or 5% per month”
 Compounding Period (CP) – The shortest time unit
over which interest is charged or earned.
 Ex: “8% per year, compounded monthly, semiannually, …”
 Compounding Frequency – The number of times m
that compounding occurs within time period t.
 Ex: “10% per year , compounded monthly” has m = 12
 Ex: “10% per year, compounded quarterly” has m = 4
One Year is segmented into: 365 days, 52 weeks, 12 months

One quarter is: 3 months with 4 quarters/year
Example
• 6% per year , compounded weekly:
• Interest period= 1 year
• Compounding period CP=1 week
• Compounding frequency m= 52
Example: consider a principal amount of $1000 to
be invested for 3 years at a nominal interest rate
of 12% compounded semiannually
• Interest earned during the 1st six month is: $1000
x 6%= $60
• Total principle and interest= $1000 + $60= $1060
• Interest earned during the 2nd six month is:
$1060 x 6%= $63.60
Example: consider a principal amount of $1000 to
be invested for 3 years at a nominal interest rate
of 12% compounded semiannually
• Total interest earned during the year is:
$60+ $63.60 = $123.60
• Effective annual interest rate for the whole year is

$123.60 X 100 = 12.36%
$1000
The effect of more frequent
compounding can be easily
determined.
Let r be the nominal annual interest rate and m the
number of compounding periods per year. We can
find, i, the effective interest by using the formula
below.
r m
Effective i = (1+ )  1
m
Example: Calculating the Effective Rate
• Interest is 8% per year, compounded quarterly

• What is the effective annual interest rate?
• Nominal rate r = 0.08, m = 4
Effective i = (1 + 0.08/4)4 – 1
= (1.02)4 – 1
= 0.0824 or 8.24%/year
Finding effective interest rates.
For an 18% nominal rate, compounded quarterly, the

effective interest is.
For a 7% nominal rate, compounded monthly, the

effective interest is.
Equivalence Relation:
Single Amounts
When dealing with single amount cash flow, to determine P or

F using P = F(P/F,i,n) or F = P(F/P,i,n)
there are two equivalent methods to determine i and n in the

factors.
Single Amounts
Method 1. For the effective interest rate, i, in the factor:

 Determine i over the CP using i= r/m
For the total number of periods, n, in the

factor:
 Determine the number of CP between
occurrence of P and F values using
n = (m)(number of payment periods)
Single Amounts
Method 2.
 Find the effective interest rate for the time period of the
nominal rate using effective i formula
r m
Effective i = (1+ )  1
m
 Set n to the number of periods in the nominal rate statement
Equivalence Relations
Example:
• Suppose that a $100 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 10th year?
Solution : 1st method
• There are four compounding periods per year, or
a total of 4x10=40 interest periods. The interest
rate per interest period is i= r/m = 6% /4=1.5%.
• When the values are used in Equation
• F=P(F/P,1.5%,40)=$100(1.015)^40
=$100(1.814)=$181.40.
• Solution 2nd method :
• Alternatively, the effective interest rate from
Equation
r m
Effective i = (1+ ) 1
m
i= (1+(0.06/4))^4 - 1
= (1.015)^4 – 1
= 1.0614 -1 = 0.614= 6.14%
F=P(F/P,6.14%,10)=$100.00(1.0614)^10=$181.4
Exercise:
• If the principal is $500 and the interest rate is
6% compounded semiannually for the first five
years and 8% compounded quarterly for the
next six years, what is the amount at the end of
the 11th year?
Exercise
Solution using method1
• P=$500 • F5 = P5= $671 , F11?
• i=6% compounded • i=8% compounded
semi-annually quarterly
• N= 5years • N=6 years
• F 5=? • F11 =p(1+i)^n
• i=r/m=6%/2=3% • i=r/m=8%/4=2%
• N=5x2=10 • N=6x4=24
• F5=500(1.03)^10=$671 • F11=671(1.02)^24=
=$1080
Solution using method 2
• Ieff=(1+r/m)^m -1 • Ieff=(1+r/m)^m -1
= (1+0.06/2)^2 -1 = (1+0.08/4)^4 -1
= 0.0609 = 0.824
N=5 years N=6 years
F5 =P(F/P,ieff,5) F11= p5(1+ieff)^n
= P(1+ieff)^n F11 =672( 1.824)^6
F5 =500(1.0609)^5=672 = $1080
Equivalence Relations:
uniform Series or gradients
 When cash flows involve a series (A, or G)
similarly
 Calculate the effective i per payment period

 Apply the correct n for the total number of
payments periods. (method1)
uniform Series
• Example : suppose that one has a bank loan
for $10,000, which is to be repaid in equal –
end- of month installments for 5 years with a
nominal interest rate of 12% compounded
monthly. What is the amount of each
payment?
uniform Series
Solution :
• Number of installment payments = 5x12=60
• Interest rate per month= r/m=12%/12=1%
• A = P(A/P,1%,60)= $10,000 (0.0222)= $222

gradients
Example:
Certain operating savings are expected to be 0 at
the end of the 1st six month, and to be $1000
at the end of the 2nd six month, and to
increase by $1000 at the end of each six
month for a total of 4 years. Find A if nominal
interest rate is 20% compounded
semiannually.
gradients
• Solution:
• Number of installment payments = 4x2=8
• Interest rate per month=r/m= 20%/2=10%
• A = G(A/G,10%,8)= $1000 (3.0045)= $3,004.5

Solution
• F-3= $4,000 (F/P, 4.06%,1) + $5000
= $4,000(1.0406) + $5000 = $9,162.4
• F-2= $9,162.4 (F/P, 3.42%,1) +$6000= $15,475.75
• F-1= $15,475.75 (F/P, 5.23%,1) +$7000= $23,285.13
• F-0= $23,285.13 (F/P, 6.03%,1)= $24,689.22
(F0=P0)
A= $24,689.22 (A/P,5%,20)
= $24,689.22( 0.0802)
= $1,980.08

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Nominal Rate of Interest

 Nominal interest rate definition:

For example, 8% per year is a nominal rate

However , the actual or effective rate is greater than

All interest formulas, factors, tabulated

• The more frequent the compounding the greater

• The effective rate is represented by i.

One Year is segmented into: 365 days, 52 weeks, 12 months

• Effective annual interest rate for the whole year is

• Interest is 8% per year, compounded quarterly

For an 18% nominal rate, compounded quarterly, the

For a 7% nominal rate, compounded monthly, the

When dealing with single amount cash flow, to determine P or

there are two equivalent methods to determine i and n in the

Method 1. For the effective interest rate, i, in the factor:

For the total number of periods, n, in the

• When the values are used in Equation

 Calculate the effective i per payment period

• A = P(A/P,1%,60)= $10,000 (0.0222)= $222

• A = G(A/G,10%,8)= $1000 (3.0045)= $3,004.5

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