EXAMPLE

FUTURE VALURE WITH DISCRETE (ANNUAL) COMPOUNDING

On May 1, 2000 (t = 0) an investor deposits $500 into a certificate of deposit that pays an annually
compounded nominal (market) interest rate of 5%. Assume further that the investor plans to make
no additional deposits. How much will the certificate of deposit be worth on April 30,2005 (t=5).It is
often useful to visualize such problems with a cash flow diagram. Figure 12.1 presents the cash flow
diagram for this problem.

FUTURE VALUE WITH DISCRETE (MORE FREQUENT) COMPOUNDING

Consider, again, the example above that the certificate of deposit pays 5%,which is compounded
semi-annually .To begin with, the student should note that the number of compounding periods has
been doubled from 5 to 10. Since compounding will occur every 6 months instead of every 12
months, the periodic interest rate is now 2.5% semiannually instead of 5% per year.