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Continuous Compounding
Continuous Compounding Based on the assumption that cash payments occur once per year but compounding is continuous throughout the year.

Review: Future Amount, F

Future Amount or Future Worth F = P(1 + i)n
Where: P = principal i = interest per period (in decimal) n = number of interest periods (1 + i)n = single payment compound amount factor.
PW

0 1 2 3 4

FW

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For m periods of year

Future Amount or Future Worth F = P(1 + i)n
PW

F = P(1 +

mn )

0 1 2 3 4 m

FW

Future Worth of Continuous Compounding

Let x = F = P(1 + i)n F = P(1 + F= F=
mn ) 1 P(1 + )x(NR)n 1 P[(1 + )x](NR)n 1 x )

Thus, F = Pe(NR)n Where: P = principal e = 2.71828 NR = nominal rate n = number of years e(NR)n = continuous compounding amount factor

But lim (1 +

=e

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Present Worth of Continuous Compounding

Present Amount or Present Worth
PW

P=

e(NR)n

0 1 2 3 4 m

FW

Problem #15
Money is deposited in a certain account for which the interest is compounded continuously. If the balance doubles in 6 years, what is the annual percentage rate?

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Solution
F = Pe(NR)n 2P = Pe(NR)6 2 = e6(NR) Take ln on both sides ln 2 = ln e6(NR) ln 2 = 6(NR) ln e ln 2 = 6(NR) NR =
ln 2 6

NR = 0.1155 NR = 11.5524%

ME Board Problem #16

A nominal interest of 3% compounded continuously is given on the account. What is the accumulated amount of Php 10,000 after 10 years?

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Solution
F = Pe(NR)n F = (10,000) e(0.03)10 F = (10,000) e(0.3) F = Php 13,498.5880

Nominal and Effective Rate of Interest

Rate of Interest The cost of borrowing money. Also refers to the amount earned by a unit principal per unit time.

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Two Types of Rate of Interest

Two Types of Rate of Interest 1. Nominal Rate of Interest The basic annual rate of interest. 2. Effective Rate of Interest The actual or the exact rate of interest earned on the principal during a one-year period .

Problem #17
A principal is invested at 5% compounded quarterly.

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Solution
Nominal Rate of Interest = 5% Effective Rate of Interest => 5%, because of the compounding which occur four times a year.

Effective Rate of Interest

Effective Rate of Interest
ER = (1 + i)m 1 or ER = (1 +
m )

Where: m = number of interest period per year i = interest per period NR = nominal rate of interest

Note: NR is the mode of compounding is annually

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Solution
Nominal Rate of Interest = 5% Effective Rate of Interest => 5.0945%, because of the compounding which occur four times a year.

ER = (1 +
ER = (1 +

m ) 1 0.05 4 ) 1 4

ER = 0.0509 ER = 5.0945%

ECE Board Problem #18

What is the effective rate corresponding to 18% compounded daily? Take 1 year is equal to 360 days.

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Solution
ER = (1 + i)m 1 ER = (1 +
0.18 360 ) 360

ER = 0.1971 ER = 19.7163%

ECE Board Problem #19

What nominal rate, compounded semiannually, yields the same amount as 16% compounded quarterly?

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Solution
ER1= ER1 (1 +
4 )2 1 = (1 + )4 2 4 2 0.16 4 (1 + ) = (1 + ) 2 4 (1 + )2 = 1.1698 2 1+ = 1.0816 2 = 0.0816 2
2

NR = 0.1632 NR = 16.32%

ECE Board Problem #20

What rate of interest compounded annually is the same as the rate of interest of 8% compounded quarterly.

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Solution
ER1 = ER1
4

(1 +

i)1

1 = (1 +

4 ) 4

(1 + i) = (1 +

0.08 4 ) 4

(1 + i) = 1.0824 i = 0.0824 i = 8.2432%

ECE Board Problem #21

Find the nominal rate, which if converted quarterly could be used instead of 12% compounded semi-annually?

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Solution
ER1 = ER1
4

But :
2 ) 2

(1 + 1 (1 +

i)4 i)4

1 = (1 + = (1 +

i=

0.12 2 ) 2

0.0295 =

(1 + i)4 = 1.1236 i = 0.0295 i = 2.9563%

Thus, NR = 0.1182 NR = 11.8252%

ECE Board Problem #22

What is the corresponding effective rate of 18% compounded semi-annually?

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Solution
ER = (1 + i)m 1 ER = (1 +
0.18 2 ) 2

ER = 0.1881 ER = 18.81%

ME Board Problem #23

What is the corresponding effective interest rate of 18% compounded quarterly?

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Solution
ER = (1 + i)m 1 ER = (1 +
0.18 4 ) 4

ER = 0.1925 ER = 19.2518%

ME Board Problem #24

Compute the equivalent rate of 6% compounded semi-annually to a rate compounded quarterly.

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Solution
ER quarterly = ER annually (1 + )4 1 = (1 +
4 4 ) 4 0.06 2 ) 2

(1 +

= (1 +

0.06 2 ) 2

i = 0.0595 i = 5.9556%

EE Board Problem #25

A man borrowed Php 100,000 at the interest rate of 12% per annum, compounded quarterly. What is the effective rate?

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Solution
ER = (1 + i)m 1 ER = (1 +
0.12 4 ) 4

ER = 0.1255 ER = 12.5508%

ME Board Problem #26

An interest rate is quoted as being 7.5% compounded quarterly. What is the effective annual interest rate?

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Solution
ER = (1 + i)m 1 ER = (1 +
0.075 4 ) 4

ER = 0.0771 ER = 7.7135%

ME Board Problem #27

A bank pays one percent interest on savings account four times a year. The effective annual interest rate is

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Solution
ER = (1 + i)m 1 ER = (1 + 0.01)4 1 ER = 0.0406 ER = 4.0604%

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