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i) Nominal, Effective and Equivalent Rate

Two annual
rates of interest with different conversion periods are said to be
equivalent if they earn the same compound amount for the same time.
For instance, in one year, the compound amount of 10 invested
a) at 12% compounded semi-annually is 10 = = 11.236
b) At 12.36% compounded annually is 10 (1+ 0.1236) = 11.236

Notice that 12% compounded semi-annually is equivalent to 12.36% compound


annually

When interest is compounded more than once a year, the given rate is called t
nominal rate. The effective rate is the rate that, when compounded annually,
produces the same compound amount each year as the nominal rate j compou
m times a year. In example above, 12% is a nominal rate while 12.36% is an eff
rate.

Derivation of formula:

Let the effective


rate be denoted by w. To compute w, let a principal P be inve

at these two investment rates. The amount of P at the effective rate w at the
of one year is

The amount of P in one year, at the nominal rate j compounded m times a ye


Since the two compound amount are equal (= ), then by substitution,
=
= , solving for w
= -1
and j can be expressed in terms of w as
Note that if the nominal rate j is compounded annually, then w = j.

Example 1: Find the effective rate equivalent to 12% compounded quarterly.

Example 2: What nominal rate compounded semi-annually is equivalent to in


at 8% effective rate?

Example 3: What rate compounded quarterly is equivalent to 14% compound


semi-annually?
Example 4: Comparison of Two Rates
Which is better, to invest money at 6 % compounded monthly or 6.5%
compounded semi-annually?
(Hint: To compare two rates of interest is to compare their effective rates)

Example1: Find the effective rate equivalent to 12% compounded quarterly.


Solution:
Given: j = 12% = 0.12
m=4
w=?
= -1
=
=
=
=

-1
-1
0.1255088
12.55%

Thus, investing at 12.55% compounded annually is equivalent to investing at 1


compounded quarterly.

Example 2: What nominal rate compounded semi-annually is equivalent to inv


at 8% effective rate?
Solution:
Given: w = 8% = 0.08
m=2
j=?
=
1 + 0.08 = , take square root both sides or power of .
1.0392305 =
0.0392305 =
j = 2(0.0392305)
j = 0.078461
j = 7.85%

Example 3: What rate compounded quarterly is equivalent to 14% compounde


semi-annually?
Derivation:

Solution:
Given: = 14% = 0.14
=2
=
=?
=
=4
=
=
=
=4
=4
=4
= 4(0.034408)
= 0.1376321
= 13.76%
Thus, investing at 13.76% compounded quarterly is equivalent to investing at
compounded semi-annually.

Example
4: Comparison of Two Rates
Which is better, to invest money at 6 % compounded monthly or 6.5%
compounded semi-annually?
(Hint: To compare two rates of interest is to compare their effective rates
Solution:
Given: = 6% = 0.06
= 12
=2
=?
=?
= -1
= -1
= -1
= -1
= 0.0616778

= 6.5% = 0.065

= 0.0660563

Since is greater than , then it is better to invest at 6.5% compounded


Semi-annually than to invest at 6% compounded monthly.

Problem Set:
1. Find the effective rate equivalent to 12% compounded
a) annually
b) semi-annually
c) quarterly
d) monthly
2. What nominal rate, converted semi-annually, is equivalent to 6.5% effective
3. What rate compounded monthly will yield the effective rate 7%?
4. Find the rate compounded semi-annually that is equivalent to 15% compoun
monthly.
5. What simple interest rate is equivalent to 12% compounded quarterly in a 3
transaction?
6. What nominal rate converted semi-annually is equivalent to 9% simple inter
a 5-year transaction?
7. Which investment is better: 9% (m=2) or 9% (m=4)?
8. BDO bank offers 6% (m=4) on savings account while BPI bank offers 6.5% (m
If you are a depositor, in which bank would you prefer to put your money?
9. Which investment yields a higher interest: 8% effective rate or 7.5% compo
semi-annually?

Reference Book:
1) Mathematics of Investment
by Victoria C. Naval, N.B. Gorospe, et., al.
2) Fundamentals of Investment Mathematics
by Presentacion Gabriel and Anita C. Ong
Assignment:
Pages: 36
Items: 2, 11, 12, and 14
Book: Mathematics of Investment
by Victoria C. Naval, N.B. Gorospe, et., al.

ii) Continuous Compounding

Interest may also be converted very frequently; weekly, daily, or hourly. Wh


happens when interest is converted very frequently, or the frequency of conv
becomes infinite? The table below gives the amounts for converted interest a
nominal rate of 7%, at different frequencies in one year.
The value of 100 at the End of One Year as m Becomes Infinite
Nominal Rate
(j):
7% converted

Frequency of
Conversion
(m)

Amount of 100 at the end of 1


year

annually
semi-annually
quarterly
monthly
weekly
daily

1
2
4
12
52
365

107
107.1225
107.1859
107.22901
107.24576
107.25006

Notice in table that as m increases, the compounded amount increases margi


Frequency compounding thus will increase the interest, but only slightly. For
example, 100 earns 7.24 when converted weekly, and 7.25, or a centavo
when converted daily. For this reason, depositors need not be attracted to ban
advertising interest compounded daily unless they have considered other fact

Interest converted very frequently is referred to as being converted continuou


At the nominal rate j compounded continuously, the amount of a principal P
invested for t years is

Solving for P, the present value of F due at the end of t years at the nominal r
compounded continuously is
P
The base e is a constant where e = 2.71828 The value of and can be
obtained using a scientific calculator. (see the derivation of these formulas in
book).

Example 1: Find the amount of 200 at the end two years if the interest rate
is 9% compounded: a) semi-annually b) quarterly c) monthly, and d) continu
Example 2: Find the present value of 5,000 due in 5 years at 7% converted
continuously.

Example 3: Find the present value of 750, due in 4 years, at the interest rate
8% converted a) annually, b) quarterly, and c) continuously.
Example 4: Find the accumulated value of 9,000 at the end of 5 years if it is
invested at 9% converted continuously.

Example 5: Find the accumulated value of 8,700 at the end of 10 years if it ea


effective interest of 7% in the first 3 years and 10% converted continuously
the remaining years.

Example1: Find the amount of 200 at the end two years if the interest rate
is 9% compounded: a) semi-annually b) quarterly c) monthly, and d) continu
Solution:
The amount at the end of 2 years at
a) 9%, m = 2 is = 200 = 200 = 238.50
b) 9%, m = 4 is F = 200 = 238.97
c) 9%, m = 12 is F = 200 = 239.28
d) 9% continuously is = 200 = 239.44

Example
2: Find the present value of 5,000 due in 5 years at 7% converted
continuously.
Solution:
P
= 5,000
= 5,000 (0.704688)
= 3,523.44

iii) Compound

amount at a fraction of a period:

The two steps to solve:


Step 1: Find the compound amount at the end of the largest number of who
periods in the given time.
Formula:

where: i = ; j = nominal rate, m = frequency of conversion


n = mt, t = terms of conversion in years
Step 2: Accumulate the result in step 1 for the remaining time (which is les
a period) at simple interest, nominal rate.
F = P(1 +rt)

Example 1: Find the compound amount if 5,000 is invested for 3 years an


9 months at 12% compounded semi-annually, assuming simple interest ov
the fractional part.

Example 1: Find the compound amount if 5,000 is invested for 3 years and
9 months at 12% compounded semi-annually, assuming simple interest ove
the fractional part.
= ; for 3 years and 6 months
Solution:
= 5,000
Given: P = 5,000
= 7,518.1515
j = 12% = 0.12 (j = r)
m=2
F = (1+ rt)
; for 3 months
j = = 0.06
= 7,518.1515 [1+ 0.12()]
t = 3 years
= 7,743.70 , answer
n = mt = 2() = 7 periods
F =?
Time Diagram:
I =0.06
r =0.12
n=7
t = 3 months
5,000
0

1
2
3
3
3 years and 9 months

Example 2: Find the compound amount if 6,800 is invested at 12% compou


quarterly for 4 years and 5 months.
iv) Present value at a fraction of a period:
The two steps to solve:

Step 1: Increase the number of whole periods by one. Using this new period,
discount F. This means we have to add a few months to complete the fract
part to one period.
Step 2: Accumulate the result in Step 1 at simple interest, at nominal rate, fo
number of months added in Step 1.

Example 1: Find the present value of 1,000 due in 3 years and 4 months at
compounded quarterly.

Example 1: Find the present value of 1,000 due in 3 years and 4 months at 1
compounded quarterly.
= F ; for 3 years and 6 months
Solution:
=1,000
Given: F = 1,000
= 683.99728
j = 11% = 0.11 (j = r)
m=4
P = (1 + rt) ; for 2 months
i = = 0.0275
= 683.99728[1 + 0.11()]
t = 3 years
= 696.54 , answer
n = mt = 4(3 ) = 13 periods
P=?
Time Diagram:
i = 0.0275
n = 14
P

1,000

0
1
2
3
r = 0.11
t = 2 months
3 years and 4 months

3 4

Example 2: Find the present value of 1,400 pesos due in 3 years and 8 mont
if money is worth 10% compounded semi-annually.
Assignment:
Page: 42
Items : 2 and 6
Book: Mathematics of Investment
by: Victoria C. Naval, et., al.