Module 3: Nominal and

Effective Interest Rates

Outline Module 3

• Interest Rates
• Interest Rates Statements
• Compounding and Payment Periods
• PP = CP
• PP > CP
• PP < CP
Interest Rates

• In reality, loan agreements or cash flows sometimes require that

the interest be paid not in a yearly basis, but more frequently,
such as each half-year (semiannual), each quarter, monthly, or any
other period shorter than a year.
• When the period of compounding is more than once a year, then
two terms of interest are to be considered:
• Nominal interest rate
• Effective interest rate
• The concept of these two interest rates similar to the concept of
simple and compound interests.
• Nominal interest rate is an interest rate that does not include any
consideration of compounding. (Format: r% per time period t)
• Effective interest rate is the actual rate that applies for a stated period of
time. The compounding of interest during the time period of the
corresponding nominal rate is accounted for by the effective interest
rate. (Format: r% per time period t, compounded m-ly)
Interest Rates

• Nominal interest rate:

m
r = interest rate per period rx number
 of periods
i = 1 +  −1
• Effective interest rate:  m 

where: i = effective interest rate per period

r = nominal interest rate per period
m = number of compounding periods
• Term of compounding periods:
• Semiannually, m=2 → 6 months
• Quarterly, m=4 → 3 months
• Monthly, m = 12 → 1 month
• Weekly, m = 52 → 1 week
• Daily, m = 365 → 1 day
• Continuously, m=∞ →
Examples

• Nominal rate of 1.5% per month is the same as each the following
rates:
• ? per year
• ? per 2-year period
• ? per semiannual period
• ? per quarter
• ? per week
• Effective rates:
• 9% per year, compounded quarterly.
• Nominal rate: 9% per year.
• Compounding period: Quarter, m = 4
• Effective rate per compounding period: 2.25%
• Effective rate per year?
• ? per year, compounded monthly.
• ? per 6-month, compounded weekly.
Examples

• Nominal rate of 1.5% per month is the same as each the following
rates:
• 18% per year
• 36% per 2-year period
• 9% per semiannual period
• 4.5% per quarter
• 0.346% per week
• Effective rates:
• 9% per year, compounded quarterly.
• Nominal rate: 9% per year.
• Compounding period: Quarter, m = 4
• Effective rate per compounding period: 2.25%
• Effective rate per year?
• 9% per year, compounded monthly.
• 4.5% per 6-month, compounded weekly.
Effective Annual Interest Rates

• Year is used for the time period t, and compounding period can be

i = (1 + i ) − 1
any time unit less than 1 year. m
a

• ia = effective interest rate per year

• i = effective interest rate per compounding period (CP) = r/m
• r = nominal interest rate per year
• m = number of compounding periods per year
 Interest Rates Statements
interest rate statement
i = 12% per year
i = 1% per month
i = 8% per year,
compounded monthly
i = 4% per quarter,
compounded monthly
i = effective 10% per year,
compounded monthly
i = effective 6% per
quarter,
i = effective 1% per month,
compounded daily
interpretation comment
i = effective 12% per year When non compounding period is
compounded yearly given, interest rate is an effective rate,
i = effective 1% per month with compounding period assume to
be equal to stated time period
compounded monthly
i = nominal 8% per year When compounding period is given
compounded monthly without stating whether the interest
rate is nominal or effective, it is
i = nominal 4% per 3 months assumed to nominal. Compounding
compounded monthly period is as stated
i = effective 10% per year
compounded monthly If interest rate is stated as an effective
rate, the it is an effective rate. If
i = effective 6% per 3 months
compounding period is not given,
compounded quarterly
compounding period is assumed to
i = effective 1% per month coincide with state time period
compounded daily Source: Blank & Tarquin
Exercise 1

• Visteon, a spin-off company of Ford Motor Company, supplies major

automobile components to auto manufacturers worldwide and is
Ford’s largest supplier. An engineer is on a Visteon committee to
evaluate bids for new-generation coordinate-measuring machinery to
be directly linked to the automated manufacturing of high-precision
components. Three vendor bids include the interest rates:
• Bid #1: 9% per year, compounded quarterly
• Bid #2: 3% per quarter, compounded quarterly
• Bid #3: 8.8% per year, compounded monthly
• Visteon will make payments on a semiannual basis only. The engineer
is confuses about the effective interest rates – what they are annually
and over the payment period of 6-month
• Effective rate for each bid on the basis of semiannual payment?
• Effective annual rates for each bid?
Compounding and Payment Periods

• There are 3 situations:

1. The compounding periods and the occurrence of
payment coincide (PP = CP)
2. The compounding periods occur more frequently
than the payments (PP > CP)
3. The compounding periods occur less frequently than
the payments (PP < CP)
• It is essential that the compounding period and
payment period on the same time basis, and that
the interest rate be adjusted accordingly.
PP = CP (1)

• Assume payment of Rp. 300 million occurred semiannually

at the end of each 6 month period for 3 years at nominal
rate of 12% per year, compounded semiannually.
• What isP the equivalent present amount?
300 300 300 300 300 300

0 1 2 3
1 year

i = 12% / 2 periods = 6% per semiannual period

n = (3 years) ( 2 periods per year) = 6 periods
P = A (P/A, i, n) = 300 (P/A, 6, 6) = 300 (4.9173) = Rp 1.475,190,000.-
PP = CP (2)

• A student is taking Rp. 30 million loan from a bank and to be paid back in
48 equal monthly installment of Rp. 750.000,- over the next 4 years.
• Calculate
P = 30M the effective and nominal rate of interest (per year) for that
loan A = 750K

0 12 24 36 48
1 year

Rp. 30M = Rp. 750K (P/A, i, 48) → (P/A, i, 48) = 40

From interest table with interpolation → effective rate i ~ 0.5% per month
Nominal interest rate, r = (0.5% per month) x (12 month) = 6% per year
Effective annual interest rate, ia = (1+r/m)m – 1 = (1+6%/12)12 – 1 = 7.96% per year
3-27
PP > CP

• Suppose you deposit Rp 100 M in a bank at each end of year for the next
three years. The bank will pay interest at the rate of 8% per year
compounded quarterly.
• How much will you receive from the bank at the end of the third year?
Method-1:

effective interest rate per CP, i = 8%/ (4 quarters) = 2% per quarter

F = 100M (F/P, 2, 8) + 100M (F/P, 2, 4) + 100M (F/P, 2, 0)
= 100M (1.174 + 1.083 + 1) = 325.7M

Method-2:
effective annual interest rate, ia = (1 + r/m)m -1 = (1 + 8%/4)4 – 1 = 8.24%
F = 100M (F/A, 8.24, 3) = 100M (3.257) = 325.7M
 PP < CP (version 1)

• Usually, no interest is paid for funds deposited during an interest period

• Funds deposited during an interest period begin earning interest for W2
the following interest period.
W1 W1 W1
• Deposit and/or withdrawal made during an interest period are placed at the end of the period within
which the transaction occur.

0 1 2 3 4 5 6 7 8 9 10 11 12 month

D3
D2 D2
W2
D1 3 W1

0 1 2 3 4
month
It becomes PP =CP D3
2 D2
D1
Cash flow involving interest compounding quarterly
 PP < CP (version 2)

• Usually, no interest is paid for funds deposited during an interest period

• Deposit made during an interest period are placed at the end of the period within which the transaction
W2beginning of the period.
occur and withdrawal made during an interest period are placed at the
W1 W1 W1

0 1 2 3 4 5 6 7 8 9 10 11 12

D3
D2 D2
W2
D1 3 W1

0 1 2 3 4
It becomes PP =CP D3
2 D2
D1
Cash flow involving interest compounding quarterly
PP < CP (version 3)

• Sometimes, interest W1
is paid
W1 for
W2
W1 funds deposited during an interest period

0 1 2 3 4 5 6 7 8 9 10 11 12

D3
D2 D2

D1 Cash flow involving interest compounding quarterly

• Cash flow diagram remains the same.

• Use effective interest rate per payment periods (PP). The value of m is less than
1.

• Example: For weekly cash flow, compounding quarterly, nominal interest

rate is 12% per year. Effective weekly i% = (1+0.03)1/13-1= 0.228%
Effective Interest Rate for Continuous
Compounding
• If we allow compounding to occur more and more frequently, the
compounding period becomes shorter and shorter. Then m, the
number of compounding periods per payment period, increase. As m
approach infinity (compounded continuously) , the effective interest
rate is:

i = e −1 r

• Where: e = 2.71828….
 Interest Rates that Vary Over Time

• Real-world interest rates vary from year to year.

• Example: 70,000 70,000 P=?
P=? A A A A A=?
35,000
25,000

0 1 2 3 4
i = 7% i = 7% i = 9% i = 10%
per year per year per year per year

P = [70(P/A, 7%,2) + 35(P/F,7%,2)(P/F,9%,1) + 25(P/F,7%,2)(P/F,9%,1)(P/F,10%,1) ]1000

= 172,816
A = 172,816 / [(P/A, 7%,2) + (P/F,7%,2)(P/F,9%,1) + (P/F,7%,2)(P/F,9%,1)(P/F,10%,1) ]
= 51,777
Exercise 2

1. What uniform annual amount would you have to deposit for 5 year to have
an equivalent present-investment sum of Rp. 100M at an interest rate of
1.5 % per month compounded continuously?
2. A student borrowed Rp. 8.5M from a bank buy a computer with an
agreement to repay Rp 250K at the end of the month of each of the first 2
years and Rp. 3.5M at the end of the second year. Determine the rate of
interest (effective monthly, nominal, and effective annually) that makes the
receipts and disbursement equal?
3. A cash flow at 1.5% interest compounded semiannually consists of:
• single receipt of Rp. 23.5M at the first day of the month;
• four equal receipts of Rp. 3.50M starting from the end of the third
month;
• two equal disbursements of Rp 2.75M each at the end of the fourth and
fifth month;
• single payment of Rp 19.75M at the end of seventh month.
Calculate the net cash flow at the end of the year (version 1).