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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

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:

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

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.

at 8% effective rate?

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: j = 12% = 0.12

m=4

w=?

= -1

=

=

=

=

-1

-1

0.1255088

12.55%

compounded quarterly.

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%

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

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.

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)

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

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

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.

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

Step 1: Find the compound amount at the end of the largest number of who

periods in the given time.

Formula:

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)

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

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.

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