Module 3: Nominal and Effective

Interest Rates
SI-4251 Ekonomi Teknik
Rani G K Pradoto, Ph.D.
Outline Module 3
 Interest Rates
 Interest Rates Statements
 Compounding and Payment Periods
 PP = CP
 PP > CP
 PP < CP

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Interest Rates
 In reality, loan agreements or cash flows sometimes require
that the interest be paid not in a yearly basis, but more
frequently, such as each half-year (semiannual), each quarter,
monthly, or any other period shorter than a year.
 When the period of compounding is more than once a year,
then two terms of interest are to be considered:
 Nominal interest rate
 Effective interest rate
 The concept of these two interest rates similar to the concept
of simple and compound interests.
 Nominal interest rate is an interest rate that does not include any
consideration of compounding. (Format: r% per time period t)
 Effective interest rate is the actual rate that applies for a stated
period of time. The compounding of interest during the time period of
the corresponding nominal rate is accounted for by the effective
interest rate. (Format: r% per time period t, compounded m-ly)

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Interest Rates
 Nominal interest rate:
r = interest rate per period x number of periods
 Effective interest rate: m
 r 
i  1   1
 m
where: i = effective interest rate per period
r = nominal interest rate per period
m = number of compounding periods
r/m = effective rate per compounding period

 Term of compounding periods:

 Semiannually, m = 2  6 months
 Quarterly, m = 4  3 months
 Monthly, m = 12  1 month
 Weekly, m = 52  1 week
 Daily, m = 365  1 day


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Examples
 Nominal rate of 1.5% per month is the same as each the
following rates:
 18% per year
 36% per 2-year period
 9% per semiannual period
 4.5% per quarter

 Effective rates:
 9% per year, compounded quarterly.
 Nominal rate: 9% per year.
 Compounding period: Quarter, m = 4
 Effective rate per compounding period: 2.25%
 Effective rate per year?
 Effective rate per six-month?
 9% per year, compounded monthly.
 4.5% per 6-month, compounded weekly.

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Effective Annual Interest Rates
 Year is used for the time period t, and compounding
period can be any time unit less than 1 year.

ia  1  i   1
m

 ia = effective interest rate per year

 i = effective interest rate per compounding period
(CP) = r/m
 r = nominal interest rate per year
 m = number of compounding periods per year

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 Interest Rates Statements
interest rate
interpretation comment
statement
i = effective 12% per year When non compounding period is
i = 12% per year
compounded yearly given, interest rate is an effective
rate, with compounding period
i = effective 1% per month assume to be equal to stated time
i = 1% per month
compounded monthly period
i = 8% per year, i = nominal 8% per year When compounding period is given
compounded monthly compounded monthly without stating whether the
i = nominal 4% per 3 interest rate is nominal or effective,
i = 4% per quarter, it is assumed to nominal.
months compounded
compounded monthly Compounding period is as stated
monthly
i = effective 10% per
i = effective 10% per year
year, compounded
compounded monthly If interest rate is stated as an
monthly
effective rate, the it is an effective
i = effective 6% per 3
i = effective 6% per rate. If compounding period is not
months compounded
quarter, given, compounding period is
quarterly
assumed to coincide with state
i = effective 1% per time period
i = effective 1% per month
month, compounded
compounded daily Source: Blank & Tarquin
daily
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Exercise 1
 The different bank loan rates for three separates
electric generation equipment project are listed
below. Determine the effective rate on the basis of
the compounding period for each quote
 (a) 9% per year, compounded quarterly
 (b) 9% per year, compounded monthly
 (c) 4.5% per 6 months, compounded weekly.

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Exercise 1

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Compounding and Payment Periods
 There are 3 situations:
1. The compounding periods and the occurrence of
payment coincide (PP = CP)
2. The compounding periods occur more frequently
than the payments (PP > CP)
3. The compounding periods occur less frequently
than the payments (PP < CP)
 It is essential that the compounding period and
payment period on the same time basis, and
that the interest rate be adjusted accordingly.

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PP = CP (1)
 Assume payment of Rp. 300 million occurred
semiannually at the end of each 6 month period for 3
years at nominal rate of 12% per year, compounded
semiannually.
 What is the equivalent present amount?
P
300 300 300 300 300 300

0 1 2 3
1 year

i = 12% / 2 periods = 6% per semiannual period(CP and PP as the basis)

n = (3 years) ( 2 periods per year) = 6 periods
P = A (P/A, i, n) = 300 (P/A, 6, 6) = 300 (4.9173) = Rp 1.475,190,000.-

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PP = CP (2)
 A student is taking Rp. 30 million loan from a bank and to be paid
back in 48 equal monthly installment of Rp. 750.000,- over the next 4
years.
 Calculate the effective and nominal rate of interest (per year) for that
loan if the interest is compounded monthly.

P = 30M
A = 750K

0 12 24 36 48
1 year
(CP and PP as the basis)
Rp. 30M = Rp. 750K (P/A, i, 48)  (P/A, i, 48) = 40
From interest table with interpolation  effective rate i ~ 0.5% per month
Nominal interest rate per year, r = (0.5% per month) x (12 month) = 6% per year
Effective annual interest rate, ia = (1+r/m)m – 1 = (1+6%/12)12 – 1 =
6.17% per year
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PP > CP
 Suppose you deposit Rp 100 M in a bank at each end of year for the
next three years. The bank will pay interest at the rate of 8% per
year compounded quarterly.
 How much will you receive from the bank at the end of the third
year?
Method-1:
effective interest rate per CP, i = r/m=8%/ (4 quarters)/1 = 2% per quarter
F = 100M (F/P, 2, 8) + 100M (F/P, 2, 4) + 100M (F/P, 2, 0) (CP as the basis)
= 100M (1.174 + 1.083 + 1) = 325.7M

Method-2: Use also

effective annual interest rate, ia = (1 + r/m)m -1 = (1 + 8%/4)4 – 1 = 8.24% this for
series of
F = 100M (F/A, 8.24, 3) = 100M (3.257) = 325.7M Payments

(nominal period as the basis)

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PP < CP (version 1)
 Usually, no interest is paid for funds deposited during an interest period
 Funds deposited during an interest period begin earning interest for the following interest period.
 Deposit and/or withdrawal made during an interest period are placed at the end of the period within
which the transaction occur. W2
W1 W1 W1

0 1 2 3 4 5 6 7 8 9 10 11 12 month
Compounded quarterly
D3
D2 D2
W2
D1 3 W1

0 1 2 3 4
month
It becomes PP =CP
D3
2 D2
D1
Cash flow involving interest compounding quarterly
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PP < CP (version 2)
 Usually, no interest is paid for funds deposited during an interest period
 Deposit made during an interest period are placed at the end of the period within which the
transaction occur and withdrawal made during an interest period are placed at the beginning of the
period.
W2
W1 W1 W1

0 1 2 3 4 5 6 7 8 9 10 11 12
Compounded quarterly
D3
D2 D2

D1 W2
3 W1

0 1 2 3 4
It becomes PP =CP

2 D2 D3

D1
Cash flow involving interest compounding quarterly
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PP < CP (version 3)
 Sometimes, interest is paid for funds deposited during an interest period

W2
W1 W1 W1

0 1 2 3 4 5 6 7 8 9 10 11 12

D3
D2 D2

D1 Cash flow involving interest compounding quarterly

 Cash flow diagram remains the same.
 Use effective interest rate per payment periods (PP). The value of m is less than
1.

 Example: For weekly cash flow, compounding quarterly, nominal

interest rate is 12% per year. Effective weekly i% = (1+0.03)1/13-1=
0.228%

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example

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Effective Interest Rate for Continuous
Compounding
 If we allow compounding to occur more and more
frequently, the compounding period becomes shorter
and shorter. Then m, the number of compounding
periods per payment period, increase. As m
approach infinity (compounded continuously) , the
effective interest rate is: r
i  e 1

 Where: e = 2.71828….

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Interest Rates that Vary Over Time
 Real-world interest rates vary from year to year.
 Example:
70,000 70,000 P=?
P=? A A A A A=?
35,000
25,000

0 1 2 3 4
i = 7% i = 7% i = 9% i = 10%
per year per year per year per year

P = [70(P/A, 7%,2) + 35(P/F,7%,2)(P/F,9%,1) + 25(P/F,7%,2)(P/F,9%,1)(P/F,10%,1) ]1000

= 172,816
A = 172,816 / [(P/A, 7%,2) + (P/F,7%,2)(P/F,9%,1) + (P/F,7%,2)(P/F,9%,1)(P/F,10%,1) ]
= 51,777

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Homework #3
1. What uniform annual amount would you have to deposit for 5 year to
have an equivalent present-investment sum of Rp. 100M at an interest
rate of 1.5 % per month compounded continuously?
2. A student borrowed Rp. 8.5M from a bank to buy a computer with an
agreement to repay Rp 250K at the end of the month of each of the first
2 years and Rp. 3.5M at the end of the second year. Determine the rate
of interest (effective monthly, nominal, and effective annually) that
makes the receipts and disbursement equal?
3. A cash flow at 1.5% per month interest compounded semiannually
consists of:
 single receipt of Rp. 23.5M at the first day of the month;
 four equal receipts of Rp. 3.50M starting from the end of the third
month;
 two equal disbursements of Rp 2.75M each at the end of the fourth
and fifth month;
 single payment of Rp 19.75M at the end of seventh month.
Calculate the net cash flow at the end of the year (version 1).

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Homework #3
4. Visteon, a spin-off company of Ford Motor Company, supplies
major automobile components to auto manufacturers worldwide
and is Ford’s largest supplier. An engineer is on a Visteon
committee to evaluate bids for new-generation coordinate-
measuring machinery to be directly linked to the automated
manufacturing of high-precision components. Three vendor bids
include the interest rates:
 Bid #1: 9% per year, compounded quarterly
 Bid #2: 3% per quarter, compounded quarterly
 Bid #3: 8.8% per year, compounded monthly
 Visteon will make payments on a semiannual basis only. The
engineer is confuses about the effective interest rates – what
they are annually and over the payment period of 6-month
 Effective rate for each bid on the basis of semiannual
payment?
 Effective annual rates for each bid?

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