Lecture # 12

Engineering Economics (MS-291)

Chapter 4
Nominal and Effective Interest Rates

Dr. Muhammad Ullah

Assistant Professor
Department of Management Sciences GIKI
Recap
• Single-Payment
[Compounding]
[Discounting]

• Uniform Series /Annuities If ,
and
----- sinking fund factor
----- Uniform Series Compound Amount Factor
Nominal and effective interest rates
• We learned that the primary difference between simple interest and
compound interest is that compound interest includes interest on the
interest earned in the previous period, while simple interest does not.
• Here we discuss nominal and effective interest rates, which have the same
basic relationship.
• The concepts of nominal and effective must be used when interest is
compounded more than once each year.

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Nominal interest rates

• A nominal interest rate r is an interest rate that does not account

for compounding.
By definition:
r = interest rate per time period x number of periods

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 Nominal interest rates
• A nominal rate may be calculated for any time period longer than the time
period stated.
For example, the interest rate of 1.5% per month is the same as each of the
following nominal rates.

These nominal rates are calculated in the same way that simple rates, that is, interest
rate times number of periods. 5
Compounding period (CP)
• After the nominal rate has been calculated, the compounding period (CP)
must be included in the interest rate statement.
• As an illustration, consider the nominal rate of 1.5% per month.
– If we define the CP as 1 month, the nominal rate statement is 18% per year,
compounded monthly, or 4.5% per quarter, compounded monthly.

• Now we can consider an effective interest rate

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Effective interest rate
• An effective interest rate i is a rate wherein the compounding of interest is
taken into account.
• Effective rates are commonly expressed on an annual basis as an effective
annual rate; however, any time basis may be used.
• Interest rate statement:
– 10% per year, compounded monthly, or 12% per year, compounded weekly.
– If the CP is not mentioned, it is understood to be the same as the time period
mentioned with the interest rate.
o For example, an interest rate of “1.5% per month” means that interest is compounded
each month; that is, CP is 1 month
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Effective Interest Rate

Example: Assume per year, compounded monthly. Then;

per month compounded monthly.

 Effective Annual Interest Rate

Suppose represent the Effective Annual Interest

Rate.
-----(1)

Assume

We also know that;

Similarly

Where is the effective interest rate per compounding

period.
 Example # 1
For a nominal interest rate of 12% per year, Nominal rates are converted
determine the nominal and effective rates per into effective annual rates via
the equation:
year for (a) quarterly, and (b) monthly
compounding
Solution:
(a) effective annual interest rate
effective rate for one
compounding period
number times interest is
compounded per year

(b)
 Example # 2

Nominal rates can be converted

For an interest rate of 1.2% per month, into effective rates
determine the nominal and effective rates for any time period via the
following equation:
(a) per quarter, and (b) per year
Solution:
(a)
effective annual interest rate for
any period
nominal rate for the same period
as
number times interest is
compounded in period specified
for
(b)
Problem # 4.10
The Second National Bank of Fullertum advertises an APR of 14%
compounded monthly for student loans. Determine the APY. Show
hand and spreadsheet solutions.

Solution:
APR: Annual Percentage Rate => it is Nominal Rate
APY: Annual Percentage Yield => it is Effective Rate

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Problem # 4.11
For an effective annual rate of 15.87% compounded quarterly, determine;
(a) the effective quarterly rate and
(b) the nominal annual rate.
Solution:
(a) Use Equation [4.4]:

(b)
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 Thank You

Any Questions?
Email: muhammad.ullah@giki.edu.pk