Video

Lecture

Time value of Money:

Interest rates
FINANCIAL MANAGEMENT
Fábio Soares Santos
Financial Management | Time Value of Money: Interest rates

Interest rates
COMPOUNDING EFFECT
Without compounding With compounding

Calculating the
Stated annual rate Effective annual rate
annual rate
from rate for SAR = m x rm EAR = (1+rm)m-1
the period m

PERIODICITY
Calculating the
rate for the Proportional rate Equivalent rate
period m from SAR
the annual
rm = rm= (1+EAR)1/m-1
m
rate

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Financial Management | Time Value of Money: Interest rates

Interest rates: Examples

Example Example Example
A bank is offering you a deposit A bank offered you a 5% annual Which one yields a better annual
that pays 1% per month. What is rate for one deposit with quarterly return with compounding? (1)
your annual return? payments, but you do not Deposit with SAR of 6% and weekly
remember whether it is an effective compounding or (2) Deposit with
If there is no compounding during annual rate or stated annual rate. SAR of 6.05% and semi-annual
the year, then: What is the quarterly return you compounding?
would get in each scenario? Deposit (1)
SAR =12 x 1% = 12%
6%
If 5% is stated annual rate, then: rs = =0.115%
If there is compounding every 5% 52
EAR =(1+0.115%)52-1
month during the year, then: rQ = =1.25%
4 =6.18%
EAR = (1+1%)12-1=12.68% If 5% is effective annual rate, Deposit (2)
then: 6.05%
rs = =3.025%
rQ= (1+5%)1/4-1=1.23% 2
EAR =(1+3.025%) 2-1
=6.14%

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Financial Management | Time Value of Money: Interest rates

Key takeaways

01 When looking for interest rates, we will find different notions depending on the compounding effect and
on the time period they refer to

02 We have the Stated Annual Rates and Effective Annual Rates and both types can be converted into other
period rates through the calculation of proportional and equivalent rates, respectively

03 To be able to proper use them in our calculations and interpret their value, we need to understand the
technicalities around them