Two annual rates of interest with different conversion periods are said to be equivalent if they earn the same

amount for the same time. Nominal rate compounded more than once a year. Effective rate - a special case of nominal rate, the frequency of conversion is once a year; m= 1.

r u ! 1   1 m r ! m   u m 1 1
u - effective rate r nominal rate m frequency of conversion in nominal rate

DERIVATION OF THE FORMULA:

Ex. 1 Find the effective rate which is equivalent to a nominal rate 8 % compounded quarterly.
Given: r = 8% = 0.08; m = 4
m 4

r u ! 1   1 m

0.08 ! 1  1 4

! 0 . 0824 ! 8 . 24 %

Ex. 2 What nominal rate compounded monthly is equivalent to an effective rate 9%?
Given: u = 9% = 0.09; m = 12

r ! m   u m 1 1

1 ! 12   0.09

1 12

1

! 0.0865 ! 8.65%

Ex. 3 What rate compounded quarterly is equivalent to 14% compounded semi-annually? m1 m2 1 Additional Formula: 2 2 1 Given: r1 = 14% = 0.14; m1 = 2

r r ! m 1  m

 m2

m2 = 4

; r2 = ?
m1 m2

r1 r2 ! m 2 1  m1

 m2
2

0 . 14 ! 41  2

 4

! 0.1376 ! 13.76

Ex. Which is better, to invest money at 9% compounded semiannually or at 7 % compounded quarterly?

r1 ! 9

! 0.09; r2 ! 7 1 2
r u ! 1   1 m
m

! 0.075

m1 ! 2; m2 ! 4

0.09 u1 ! 1  1 2 0.075 u 2 ! 1  1 4
4

! 0.092025

! 0.077135865

Since u1 is greater than u2 then it is better to invest at 9% compounded semi-annually than 7 % compounded quarterly

Ex. RCBC Bank offers 12 % compounded quarterly for their savings account while Banco de Oro offers 12 % compunded semi-annually. If ypu were a depositor, in which bank would you prefer to invest?

r1 ! 0.1275; r2 ! 0.1225 m1 ! 4; m2 ! 2
0.1275 u1 ! 1  1 4 0.1225 u 2 ! 1  1 2
2 4

! 0.133726668 ! 0.126251562

Since u1 is greater than u2 then it is better to invest at RCBC Bank