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You are on page 1of 25

Engineering Economics

By Lec. Junaid Arshad

1

Many financial transactions require that interest be compounded more often than once a year (semiannually, quarterly, monthly, daily etc). In such situations, there are two expressions for the interest rate. The nominal interest rate, r, is expressed on an annual basis: this is the rate that is normally quoted when describing an interest bearing transaction. The effective interest rate, i, is the rate that corresponds to the actual interest period. The effective interest rate is obtained by dividing the nominal interest rate by m, the number of interest periods per year. i=r/m

The term nominal means in name only In other words, it is not the real interest rate!

We need a way to convert a nominal interest rate to the true effective interest rate that will actually apply!

Mathematically, we can define the nominal interest rate r as:

3

That

So,

we would like to be able to convert a nominal interest rate to an effective annual interest rate

Examples

Is

the same as (1.5%) (12) = 18% nominal interest rate per year

Is

the same as (1%) (52) = 52% nominal interest rate per year

Problem:

A bank claims to pay interest to its depositors at the rate of 6% per year compounded quarterly. What are the nominal and effective interest rates? Solution: a) The nominal interest rate is r=6% b) Since there are four interest periods per year the effective interest rate is i=r/m i = 6% / 4 = 1.5% per quarter

6

It has become customary to quote interest rates on an annual basis, followed by a compounding period if different from one year in length. For example, if the interest rate is 6% per interest period and the interest period is six months, it is customary to speak of this rate as 12% compounded semiannually. Here the annual rate of interest is known as the nominal rate, 12 % in this case. But the actual annual rate on the principle is not 12% but some thing greater, because compounding occur twice during the year.

7

Consequently, the frequency at which nominal interest rate is compounded each year can have a pronounced effect on the dollar amount of total interest earned. Q. For instant, consider a principal amount of $1000 to be invested for three years at 12% compounded semiannually. The interest earned during the first six months would be $1000 * (0.12/2) = $60. Total principal and interest at the beginning of the second six-month period is P+Pi= $1000 + $60=$1060

8

$1060*(0.12/2) = $63.60 The total interest earned during the year is

Finally, the effective annual interest rate for the entire year is ($123.60 / $1000) * 100 = 12.36% If this process is repeated for years two and three, the accumulated amount of interest can be plotted. Suppose that the same $1000 had been invested at 12% compounded monthly, which is 1% per month.

Example:

12%

12%

Compounded

We

10

The effective annual interest rate i for a nominal interest rate r compounded m times per year is:

i = (1 + r / m)m - 1

11

Given:

Compounding is monthly, so there are m = 12 compounding periods in a year

Effective monthly rate: 0.09/12 = 0.0075 = 0.75%/month Effective annual rate: (1 + 0.0075)12 1 = 0.0938 = 9.38%/year

12

Example (continued)

0.75% 1

Compounded monthly means m = 12 The effective monthly rate is 0.75%/month

0.75% 2 0.75% 3 0.75% 4 0.75% 5 0.75% 6 0.75% 7 0.75% 8 0.75% 9 0.75% 10 0.75% 11 0.75% 12

13

Quarter 1 Quarter 2 Quarter 3 Quarter 4

effective quarterly rate

the effective annual rate

14

Assume

The

effective weekly rate is (0.09/52) = 0.00173 = 0.173%/week effective annual rate is (1 + 0.00173)52 1 = 0.0940 = 9.40%/week

15

The

Comparison

The effective annual interest rate is always greater than the nominal interest rate:

When

m > 1 because

are earning (paying) interest on your interest The difference is greater with more frequent compounding: If compounded quarterly, we get 9.30%/year If compounded monthly, we get 9.38%/year If compounded weekly, we get 9.40%/year What if we compound infinitely often?

You

16

i [1 r / CK ] 1

C

C = number of interest periods per payment period K = number of payment periods per year CK = total number of interest periods per year, or M r/K = nominal interest rate per payment period

17

Payment Period = Quarter Interest Period = Quarterly

1st Q

2nd Q

1 interest period

3rd Q

4th Q

Given r = 8%, K = 4 payments per year C = 1 interest period per quarter M = 4 interest periods per year

18

Payment Period = Quarter Interest Period = Monthly

1st Q

2nd Q

3 interest periods Given r = 8%,

3rd Q

4th Q

K = 4 payments per year C = 3 interest periods per quarter M = 12 interest periods per year

19

Payment Period = Quarter Interest Period = Weekly

1st Q

2nd Q

13 interest periods Given r = 8%,

3rd Q

4th Q

K = 4 payments per year C = 13 interest periods per quarter M = 52 interest periods per year

20

i [1 r / CK ] 1

C

i lim[(1 r / CK ) 1]

C

(e )

r 1/ K

1

21

Payment Period = Quarter Interest Period = Continuously

1st Q

2nd Q

interest periods Given r = 8%,

3rd Q

4th Q

22

Case 0

8% compounded quarterly Payments occur quarterly 2.000% per quarter

Case 1

8% compounded monthly Payments occur quarterly 2.013% per quarter

Case 2

8% compounded weekly Payments occur quarterly 2.0186% per quarter

Case 3

8% compounded continuously Payments occur quarterly 2.0201% per quarter

23

The nominal interest rate is frequently stated for loans Published interest tables time-value-of-money formulas Spreadsheet functions

A piece of paper with rows and columns for recording financial data for use in comparative analysis

Remember:

24

25

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