APS 502

Theory of Interest
Lecture 2, Jan. 21, 2021

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 Principal and Interest

Simple Interest
Interest
Compound Interest

Effective Interest Rate

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 Principal and Interest

• Principal: Amount invested

• Interest: “Rent” paid on investment
• Example: You invest $1 for 1 year at 8%. After 1
year you receive $1.08.

$1.08 = $1.00 + $0.08

principal interest

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 Principal and Interest

• In general, if
– A : Principal
– r : interest rate per period

• After 1 period, you receive

– A(1+r)
A A(1+r)

0 1 time

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 Principal and Interest

• A = principal
• Ar = interest earned on principal for one period
• In previous example, A = $1.00 and r = 0.08 = 8%
and so Ar = 0.08 or 8 cents.

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 Principal and Interest

• Interest over multiple periods depends on the

compounding rule used.
• Two Rules
– Simple
– Compound

A ???

0 10 time

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 Principal and Interest

Simple Interest
Interest
Compound Interest

Effective Interest Rate

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 Simple Interest

• Simple Interest
– Interest is proportional to the time invested.

Time: Value:
0 A A(1+r) A(1+nr)
A
1 A+Ar=A(1+r)
2 A+A(2r)=A(1+2r)
0 1 n time
n A(1+nr) Money grows linearly

Simple interest is not used often in practice.

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 Example

• What amount will be owed in 5 years if $5000 is

borrowed now at 10% per year simple interest?

Let V = Final value, A = Principal, r = interest rate:

V = A(1 + r (time)) = $5000(1 + 0.1(5)) = $7500

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 Principal and Interest

Simple Interest
Interest
Compound Interest

Effective Interest Rate

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 Compound Interest

• Compound Interest
– Interest on Interest.

Time: Value:
0 A A(1+r) A(1+r)n
A
1 A(1+r)
2 A(1+r)(1+r)=A(1+r)2
0 1 n time
n A(1+r)n Money grows geometrically

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 Compound Interest
• Example:
You deposit $100 at 7% interest compounded yearly.
How much do you have after 10 years?

V = A(1 + r ) n = 100(1 + 0.07)10 = 196.72

The rule of 72:

Rule of – Money invested at r% per year doubles in
Thumb approximately 72/r years.

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 Nominal Interest Rate

• Compounding at m periods per year.

– Many banks compound more often than yearly.
– Convention: Rates are quoted yearly but only the fraction
of interest corresponding to the compounding period is
applied over each compounding period.
– When rates are quoted this way, this rate is known as the
nominal interest rate.
r/m r/m r/m r/m

0 1
m periods
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 Nominal Interest Rate

• At r% compounded m periods per year for k

periods would cause money to grow by the factor
(1+r/m)k

• Ex: one year: (1+r/m)m

r/m r/m r/m r/m

0 1
m periods
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 Nominal Interest Example

• Example: Invest $10 at 8% compounded quarterly

for 3 quarters.

$10(1 + 0.08 / 4) 3 = $10.61

r/m r/m r/m r/m

0 1
m periods
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 Continuous Compound Interest
• Continuous Compounding
– Take the limit of m periods per year as m approaches
infinity.
– After 1 year: (1+r/m)m
– Limit as m approaches infinity: lim (1 + mr ) m = e r
m →

r/m r/m r/m r/m

0 1
m periods
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 Continuous Compound Interest
• Continuous Compounding
– More generally, let t be an arbitrary time measured in
years.
– If there are m periods per year, in time t (measured in
years) there are k = tm periods.
– So, (1+r/m)k = (1+r/m)tm approaches ert

r/m r/m r/m r/m

0 1
m periods
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 Continuous Compound Interest
• Continuous Compounding
– Money invested at interest rate r compounded
continuously for time t grows by ert.
– Example: Let A=$100, r=9% compounded
continuously. After 1.5 years, your investment has
grown to:
V = 100e( 0.09)(1.5) = $114.45

r/m r/m r/m r/m

0 1
m periods
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 Compound Interest Summary
r is the nominal interest rate quoted:

Yearly for k years: (1 + r) k

k
 r
m periods per year for k periods: 1 + 
 m

Continuously for time t: e rt

r/m r/m r/m r/m

0 1
m periods
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 Principal and Interest

Simple Interest
Interest
Compound Interest

Effective Interest Rate

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 Effective Interest Rate
• Interest rates are usually quoted as nominal rates.
• However, how much you pay depends on the
number of compounding periods.
• When we compute an equivalent rate with a single
compounding period over the time interval of
interest, we refer to this as the effective rate.

r/m r/m r/m r/m

0 1
m periods
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 Relationship between Nominal and
Effective Rate
Nominal yearly rate: rnom

m compounding periods
Effective rate per compounding period: r=rnom/m
Effective yearly rate:
1 + reff = (1 + rnom m
m ) reff = (1 + ) −1
rnom m
m

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 Calculation of Effective Rate
• Example: What is the effective yearly rate of 8%
compounded quarterly?

reff = (1 + 0.08 4 ) 4 − 1 = 8.24%

r/m r/m r/m r/m

0 1
m periods
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 A Credit Card Example

Nominal Calculations Effective Calculations

(0.02986%)(365) = 10.900% (1.0002986) 365 − 1 = 11.514%

(0.05477%)(365) = 19.990% (1.0005477) 365 − 1 = 22.121%
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Problems

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Nominal and Effective Interest Rates

What is the yearly effective interest rate corresponding to:

a) 8% compounded monthly?

b) 5% compounded semi-annually?

c) 10% compounded continuously?

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Nominal and Effective Interest Rates
Convert
a) 3% compounded quarterly to the nominal rate
compounded monthly.

b) 6% compounded semi-annually to the nominal rate

compounded continuously.

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Nominal and Effective Interest Rates
Given a choice of the following interest rates, which would
you choose and why?
a) 10% compounded continuously.
b) 10.3% compounded monthly.
c) 10.5% compounded quarterly.
d) 10.6% compounded yearly.

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Appendix

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 APR vs. APY

• Required by Truth in Lending Act (1968)

• APR = Annual Percentage Rate
– The nominal annual rate of interest including all fees
and charges.
• APY = Annual Percentage Yield
– The effective annual rate of interest including all fees
and charges.
• APR and APY can be used to compare loans with
different terms.

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Commonly referred to Interest Rates

Discount Rate – The rate at which member banks may

borrow short term funds directly from a federal reserve bank.

Federal Funds Rate – The rate that banks charge each other
for the use of federal funds.

Prime Rate – The interest rate that commercial banks charge

their most creditworthy borrowers.

LIBOR – London Inter-Bank Offer Rate: The interest rate

that the banks charge each other for loans (usually in
Eurodollars).

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