Compounding

• Interest may be credited/charged more often than annually

– Bank accounts: Daily
– Loans/leases: Monthly
– Bonds: Semi-annually
• For the same quoted interest rate, the effective annual rate (EAR) may
differ
– The EAR converts all interest compounding intervals into an annual rate so that they can be
compared
o
. 𝑟
1 + 𝐸𝐴𝑅 = 1 +
𝑘
o
𝑟
𝐸𝐴𝑅 = 1 + −1
𝑘
r=annual interest rate
k=number of periods per year
10% Compounded Annually, Semi-Annually,
Quarterly, and Monthly
Compounding for 1 year

𝑟 >q4
1+ Daily
365

𝑟 .=
.
𝑒p 1 + 𝐸𝐴𝑅 1+
12

Continuous Monthly

𝑟 =
1+
2
Semi-Annual
APR vs EAR
• Two way of quoting per-period interest rate 𝑟:
r
– EAR = 1 + 𝑟 , 𝑁 = number of periods per year
– APR = 𝑁×𝑟
• Example:
– CD uses semi-annual compounding, quoted as APY
– Mortgage uses monthly compounding, quoted as APR
Example

• Fixed rate mortgage calculation in the U.S.

– 20% down payment, and borrow the rest from bank using property as collateral
– Pay a fixed monthly payment for the life of the mortgage
– Have the option to prepay

• Suppose that you bought a house for $500,000 with $100,000 down
payment and financed the rest with a thirty-year fixed rate mortgage at
4.273% APR compounded monthly
• What is your monthly payment and what is the Effective Annual Rate you
are paying?

31
Example
• Fixed rate mortgage calculation in the U.S.
– 20% down payment, and borrow the rest from bank using property as collateral
– Pay a fixed monthly payment for the life of the mortgage
– Have the option to prepay

• Suppose that you bought a house for $500,000 with $100,000 down payment and financed the rest
with a thirty-year fixed rate mortgage at 4.273% APR compounded monthly
• This is really an annuity problem (PV = $400,000), with an extra interest compounding piece. We
will use r as a rate per period (4.273% / 12) for 360 periods

1 1 1 1
𝑃𝑉 𝐴 = 𝐴 − = $400𝑘 = 𝐴 −
𝑟 𝑟(1 + 𝑟)C .04273 .04273 .04273 >q0
12 1 +
12 12
𝐴 = $1,973.15

o .=
𝑟 .04273
𝐸𝐴𝑅 = 1 + −1 = 1+ − 1 = 4.358%
𝑘 12
32
Amortization Schedule
Remaining
T (month) Principal Interest Sum
Principal
1 548.82 1,424.33 1,973.15 399,451.18
2 550.77 1,422.38 1,973.15 398,900.41
3 552.73 1,420.42 1,973.15 398,347.68
… … … … …
120 837.78 1,135.37 1,973.15 318,012.93
121 840.76 1,132.39 1,973.15 317,172.18
… … … … …
240 1,283.43 689.72 1,973.15 192,412.90
241 1,288.00 685.15 1,973.15 191,124.91
… … … … …
359 1,959.17 13.98 1,973.15 1,966.15
360 1,966.15 7.00 1,973.15 0.00
33
Example

• Bank of America advertises a 12 month CD with an APY (EAR) of 0.07%

• What is this as an APR, with semi-annual compounding?

𝐴𝑃𝑅 o
𝐸𝐴𝑅 = 1 + −1
𝑘
𝐴𝑃𝑅 =
. 0007 = 1 + −1
2
𝐴𝑃𝑅 = 0.069987754%

34
Nominal vs Real CFs
• Inflation is 4% per year. You expect to receive $1.04 in one year, what is
this CF really worth next year?
• The inflation adjusted, or real value of $1.04 in a year is, where i is the
inflation rate:

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐶𝐹 $ 1.04
𝑅𝑒𝑎𝑙 𝐶𝐹 $ = = = $1.00
1+𝑖 $ 1 + .04

• Nominal cash flows are expressed in actual-dollar cash flows

• Real cash flows are express in constant purchasing power
36
 Annual Inflation Rates
(last 8 years, data up to 7/2016)
43%
38%
33%
2009
28% 2010
23% 2011
2012
18% 2013
13% 2014
2015
8%
2016
3%
-2%

37
Nominal vs Real Rate of Return

• Nominal rates of return are the prevailing market rates

• Real rates of return are the inflation adjusted rates
• $1.00 invested at a 6% interest rate grows to $1.06 next year. However, if
inflation is 4% per year, then the real rate of return is:

.2p{|}~{•€ .2.0q
𝑟pxyz = − 1 = .2.0R − 1 =1.9%
.2•

𝑟pxyz ≈ 𝑟ƒ„…•ƒyz − 𝑖
38
Example
• Sales are $1mm this year and are expected to have a real growth of 2% next year. Inflation is
expected to be 4%. The appropriate nominal discount rate is 5%. What is the present value of next
year’s sales revenue?
• We must be consistent in how we compare cash flows: compare nominal with nominal and real with
real
• Generally, we discount nominal values, therefore we must grow the $1mm by a nominal growth rate,
so that we can then discount it by the nominal 5% discount rate

.2†{|}~{•€ .2†{|}~{•€
𝑔pxyz = − 1 ⇒ .02 = −1 ⇒ 𝑔𝑛𝑜𝑚𝑖𝑛𝑎𝑙 = 6.08%
.2• .2.0R

.
Next year’s sales = $1𝑚𝑚 ∗ 1 + .0608 = $1.0608𝑚𝑚

𝐶𝐹C $1.0608𝑚𝑚
𝑃𝑉 𝐶𝐹C = C = . = $1.0103𝑚𝑚
(1 + 𝑟) (1 + .05) 39