Nominal and effective interest rates

Nominal and effective interest rates

I In all engineering economy relations developed thus far, the

interest rate has been a constant, annual value.
I For a substantial percentage of projects evaluated in
practice, the interest rate is compounded more frequently
than once a year.
I Frequencies such as semiannually, quarterly, and monthly
are common.
Example

I You placed $100 in a savings account for one year at an

interest rate of 1% per month.
I Calculate the amount of interest and annual interest rate.
I F = P (1 + i)n = 100 × 1.0112 = $112.68
I The interest earned is 112.68 − 100 = $12.68
I The annual interest rate is 12.68/100 = 12.68%.
I We say that the effective annual interest rate is 12.68%
I Or, the interest rate is 12% per year, compounded monthly.
I That is, the effective annual interest that corresponds to a
12% nominal annual interest, compounded monthly is
12.68%.
Nominal interest rate

I A nominal interest rate is an interest rate that does not

include any consideration of compounding.
I Means ‘in name only’, ‘not the true, effective rate.’
I e.g. 12% per year, compounded monthly
I 12% is NOT the true effective rate (per year)
I 12% represents the nominal rate
I Nominal interest rate is commonly referred to as ‘APR’
(annual percentage rate).
Nominal interest rate

I e.g. the interest rate of 1.5% per month is the same as each
of the following nominal rates.
Effective interest rate
I Effective interest rate is the actual rate that applies for a
stated period of time.
I It takes into account the compounding effect of interest.
I Effective interest is stated in the following form:
I r (per year), compounded every CP .
I It involves two parameters:
I The annual nominal rate r
I The compounding period, CP , the time where interest
applies; e.g.:
I Daily compounding, CP = 1 day = 1/365 year.
I Weekly compounding, CP = 1 week =1/52 year.
I Monthly compounding, CP = 1 month = 1/12 year.
I Quarterly compounding, CP = 3 months = 1/4 year.
I Semiannual compounding, CP = 6 months = 1/2 year.
Effective interest rate
I The effective rate is called APY (annual percentage yield).
I APY ≥ APR
I Effective rates are commonly expressed on an annual basis
as an effective annual rate; however, any time basis may be
used.
I If the CP is not mentioned, it is understood to be the same
as the time period mentioned with the interest rate.
I e.g. i = 10% per year, then CP = 1 year, and this is the
effective rate per year.
I e.g. i = effective 1.5% per month compounded monthly,
then CP = 1 month, and this is the effective rate per
month (terms effective and compounded monthly are
redundant here)
I All interest formulas, factors, and tabulated values use an
effective interest rate.
Effective interest rate

I In general:
I Compounding frequency (m = 1/CP ) is the number of
times that compounding occurs within the interest period.
I In previous chapters, all interest rates had an interest
period and CP values of 1 year, so the compounding
frequency was always m = 1.
I This made them all effective rates, because the interest
period and compounding period were the same.
Computing the effective interest rate

I Note that the effective interest rate per CP is r/m, where

m = 1/CP , with CP given in fraction of a year, is the
number of times interest is compounded per year.
I e.g., with monthly compounding, m = 12, and a nominal
rate of 12% translates into an effective monthly rate of 1% .
I With semiannual compounding, m = 2, and a nominal rate
of 12% translates into an effective semiannual rate of 6% .
I Then, $1 is equivalent to (1 + r/m)m after 1 year.
I The effective annual rate is such that
(1 + ia )1 = (1 + r/m)m , i.e.:
 r m
I Effective annual rate: ia = 1 + −1
m
I Effective rate per CP : i = r/m = (1 + ia )1/m − 1
Computing the effective interest rate

I Effective rate per time period t1 : i1

I Effective rate per time period t2 : i2
I i2 = (1 + i1 )m − 1
I m: number of times compounding occurs within period t2 .

I e.g. given effective monthly rate, find effective annual rate:

I ia = (1 + im )12 − 1
I e.g. given effective annual rate, find effective monthly rate:
I im = (1 + ia )1/12 − 1
I e.g. given effective annual rate, find effective quarterly rate:
I iq = (1 + ia )1/4 − 1
Summary

1. Going from nominal to nominal: scale linearly

I e.g. 9% per year = 4.5% semi-annually
2. Going from nominal to effective: use r/m
I i.e. given r (per year), compounded every CP :
I Effective rate per CP = ief f,CP = r/m
3. Going from effective to effective:
I Effective rate per time period t1 : i1
I Effective rate per time period t2 : i2
I i2 = (1 + i1 )m − 1
I m: number of times compounding occurs within
period t2 .
Example

I Three different bank loan rates for electric generation

equipment are listed below. Determine the effective rate on
the basis of the compounding period for each rate.
I (a) 9% per year, compounded quarterly.
I (b) 9% per year, compounded monthly.
I (c) 4.5% per 6 months, compounded weekly.
Example

I (a) 9% per year, compounded quarterly.

I Effective rate per CP (1 quarter):
iq = r/m = 9%/4 = 2.25%
I (b) 9% per year, compounded monthly.
I Effective rate per CP (1 month):
im = r/m = 9%/12 = 0.75%
I (c) 4.5% per 6 months, compounded weekly.
I Nominal annual rate: r = 4.5 × 2 = 9% per year;
compounded weekly
I Effective rate per CP (1 week): r/m = 9%/52 = 0.173%
I Or directly: iw = 4.5%/26 = 0.173%
Example

I Janice is an engineer with Southwest Airlines. She

purchased Southwest stock for $6.90 per share and sold it
exactly 1 year later for $13.14 per share. She was very
pleased with her investment earnings. Help Janice
understand exactly what she earned in terms of:
I (a) effective annual rate
I (b) effective rate for quarterly compounding
I (c) effective rate for monthly compounding.
I Neglect any commission fees for purchase and selling of
stock and any quarterly dividends paid to stockholders.
Example

I (a) Effective annual rate, ia =?

I F = P (1 + ia )1
13.14
I ia = F/P − 1 = − 1 = 0.9043 (i.e. 90.43%)
6.9
amount of increase per 1 year
I Alternatively, ia = × 100%
original price
13.14 − 6.9
I ia = × 100% = 90.43% per year
6.9
I (b) Effective rate per 1 quarter, iq = (1 + ia )1/4 − 1
I iq = (1 + 0.9043)1/4 − 1 = 0.17472 (i.e. 17.472%)
I (c) Effective rate per 1 month, im = (1 + ia )1/12 − 1
I im = (1.9043)1/12 − 1 = 0.05514 (i.e. 5.514%)
I Or: 13.14 = 6.9(F/P, im , 12) = 6.9(1 + im )12
Example
I Tesla Motors manufactures high-performance battery
electric vehicles. An engineer is on a Tesla committee to
evaluate bids for new-generation coordinate-measuring
machinery to be directly linked to the automated
manufacturing of high-precision vehicle components. Three
bids include the interest rates that vendors will charge on
unpaid balances. To get a clear understanding of finance
costs, Tesla management asked the engineer to determine
the effective semiannual and annual interest rates for each
bid. The bids are as follows:
I Bid 1: 9% per year, compounded quarterly
I Bid 2: 3% per quarter, compounded quarterly
I Bid 3: 8.8% per year, compounded monthly
I (a) Determine the effective rate for each bid on the basis of
semiannual periods. (b) What are the effective annual
rates? These are to be a part of the final bid selection.
Example

I Bid 1: 9% per year, compounded quarterly

I Bid 2: 3% per quarter, compounded quarterly
I Bid 3: 8.8% per year, compounded monthly
I (a-b) Bid 1: effective rate per CP (1 quarter),
iq = r/m = 9%/4 = 2.25%
I Effective semiannual rate,
is = (1 + iq )2 − 1 = (1 + 0.0225)2 − 1 = 0.04551 (4.551%)
I Effective annual rate,
ia = (1 + iq )4 − 1 = (1 + 0.0225)4 − 1 = 0.0931 (9.31%)
I Similar procedure for the other bids.
Example

I A dot-com company plans to place money in a new venture

capital fund that currently returns 18% per year,
compounded daily. What effective rate is this (a) yearly
and (b) semiannually?
Example

I Effective rate per CP (1 day) =

id = r/m = 18%/365 = 0.0493%
I (a) Effective rate per year =
ia = (1 + id )365 − 1 = (1 + 0.000493)365 − 1 = 19.716%
I (b) Effective rate per semiannual =
is = (1 + ia )1/2 − 1 = (1 + 0.19716)1/2 − 1 = 9.415%
I Alternatively, effective rate per semiannual =
is = (1 + id )182 − 1 = (1 + 0.000493)182 − 1 = 9.415%
Example

I Assume that the stated credit card rate is nominal 15% per
year, compounded monthly. Find P or F over a 2-year
span.
Example

I Effective rate per CP (1 month) =

im = r/m = 15%/12 = 1.25%
I F = P (1 + im )24 =⇒ F/P = (1 + 0.0125)24 = 1.3473
I Alternatively,
ia = (1 + im )12 − 1 = (1 + 0.0125)12 − 1 = 0.16075
I F = P (1 + ia )2 =⇒ F/P = (1 + 0.16075)2 = 1.3473
I Thus, (F/P, 1.25%, 24) = (F/P, 16.075%, 2) = 1.3473
Example
I Over the past 10 years, Gentrack has placed varying sums
of money into a special capital accumulation fund. The
company sells compost produced by garbage-to-compost
plants in the United States and Vietnam. In the figure
below is the cash flow diagram in $1000 units. Find the
amount in the account now (after 10 years) at an interest
rate of 12% per year, compounded semiannually.
Example

I F = 1000(F/P, ia , 10) + 3000(F/P, ia , 6) + 1500(F/P, ia , 4)

I where ia = ?
I Effective rate per CP (semiannual) =
is = r/m = 12%/2 = 6%
I ia = (1 + is )2 − 1 = (1 + 0.06)2 − 1 = 12.36%
I F = 1000(3.2071) + 3000(2.0122) + 1500(1.5938) = $11,634
Example

I Alternatively,
I F = 1000(F/P, 6%, 20) + 3000(F/P, 6%, 6 × 2 = 12) +
1500(F/P, 6%, 4 × 2 = 8)
I F = 1000(3.2071) + 3000(2.0122) + 1500(1.5938) = $11,634
Example

I For the past 7 years, Excelon Energy has paid $500 every 6
months for a software maintenance contract. What is the
equivalent total amount after the last payment, if these
funds are taken from a pool that has been returning 8%
per year, compounded quarterly?
Example

I Set things according to the payment period, PP

(semiannual).
I F = 500(F/A, is , 14)
I Effective rate per CP (1 quarter) =
iq = r/m = 8%/4 = 2%
I is = (1 + iq )2 − 1 = (1 + 0.02)2 − 1 = 0.0404 (i.e. 4.04%)
I F = 500(F/A, 4.04%, 14) = 500(18.3422) = $9171.09
Example
I The Scott and White Health Plan (SWHP) has purchased
a robotized prescription fulfillment system for faster and
more accurate delivery to patients with stable, pill-form
medication for chronic health problems, such as diabetes,
thyroid, and high blood pressure. Assume this high volume
system costs $3 million to install and an estimated
$200,000 per year for all materials, operating, personnel,
and maintenance costs. The expected life is 10 years. An
SWHP biomedical engineer wants to estimate the total
revenue requirement for each 6-month period that is
necessary to recover the investment, interest, and annual
costs. Find this semiannual A value if capital funds are
evaluated at 8% per year, using two different compounding
periods:
I Rate 1: 8% per year, compounded semiannually.
I Rate 2: 8% per year, compounded monthly.
Example

I Rate 1: 8% per year, compounded semiannually

I P = 3,000,000 + 200,000(P/A, ia , 10)
I Effective rate per CP (semiannual),
is = r/m = 8%/2 = 4%
I ia = (1 + is )2 − 1 = (1 + 0.04)2 − 1 = 8.16%
I P = 3,000,000 + 200,000(P/A, 8.16%, 10)
I P = 3,000,000 + 200,000(6.662) = $4,332,400
I Thus, A = 4,332,400(A/P, is , 20) = $318,778
Example

I Alternatively (textbook):
hP i
I P = 3,000,000 + 200,000 20
k=2,4,6,... (P/F, 4%, k)
I P = 3,000,000 + 200,000(6.662) = $4,332,400
I Thus: A = 4,332,400(A/P, 4%, 20) = $318,778
Example

I Rate 2: 8% per year, compounded monthly.

I P = 3,000,000 + 200,000(P/A, ia , 10)
I Effective rate per CP (1 month),
im = r/m = 8%/12 = 0.666%
I ia = (1 + im )12 − 1 = (1 + 0.00666)12 − 1 = 8.299%
I P = 3,000,000 + 200,000(P/A, 8.299%, 10)
I P = 3,000,000 + 200,000(6.6205) = $4,324,080
I Thus, A = 4,324,080(A/P, is , 20)
I is = (1 + im )6 − 1 = (1 + 0.00666)6 − 1 = 4.067%
I Thus, A = 4,324,080(A/P, 4.067%, 20) = $320,064
Example

I Alternatively (textbook):
hP i
I P = 3,000,000 + 200,000 20
k=2,4,6,... (P/F, 4.067%, k)
I P = 3,000,000 + 200,000(6.6205) = $4,324,080
I Thus: A = 4,324,080(A/P, 4.067%, 20) = $320,064
Single amounts and series with PP < CP

I If payment period in cash flows, PP < CP:

I There are two policies: (i) interperiod cash flows earn no
interest, or (ii) they earn compound interest.
I (i) For a no-interperiod-interest policy, negative cash flows
(deposits or payments) are all regarded as made at the end
of the compounding period, and positive cash flows
(receipts or withdrawals) are all regarded as made at the
beginning.
I This effectively forces the cash flows into a PP = CP
situation.
Single amounts and series with PP < CP

I (ii) If PP < CP and interperiod compounding is earned,

then the cash flows are not moved, and the equivalent P ,
F , or A values are determined using the effective interest
rate per payment period.
I e.g. weekly cash flows when the nominal rate is 12% per
year, compounded quarterly.
I Effective rate per CP (1 quarter) =
iq = r/m = 12%/4 = 3%.
I Use effective rate per PP =
iw = (1 + iq )1/13 − 1 = (1.03)1/13 − 1 = 0.228% per week.
Example
I Last year AllStar Venture Capital agreed to invest funds in
Clean Air Now (CAN), a start-up company in Las Vegas
that is an outgrowth of research conducted in mechanical
engineering at the University of Nevada–Las Vegas. The
product is a new filtration system used in the process of
carbon capture and sequestration (CCS) for coal-fired
power plants. The venture fund manager generated the
cash flow diagram shown below in $1000 units from
AllStar’s perspective.
Example

I Included are payments (outflows) to CAN made over the

first year and receipts (inflows) from CAN to AllStar. The
receipts were unexpected this first year; however, the
product has great promise, and advance orders have come
from eastern U.S. plants anxious to become zero-emission
coal-fueled plants. The interest rate is 12% per year,
compounded quarterly, and AllStar uses the
no-interperiod-interest policy. How much is AllStar in the
‘red’ at the end of the year?
Example

I Here PP (1 month) < CP (1 quarter), and no interperiod

compounding is allowed.
I We need to find F = ?
I With no interperiod interest considered, the cash flows are
moved. All negative cash flows are moved to the end of the
respective quarter, and all positive cash flows are moved to
the beginning of the respective quarter.
Example

I The interest rate is 12% per year, compounded quarterly.

I Effective rate per CP (1 quarter), iq = r/m = 12%/4 = 3%
I In $1000 units:
I F = −150(F/P, 3%, 4) − 200(F/P, 3%, 3) + (−175 +
180)(F/P, 3%, 2) + 165(F/P, 3%, 1) − 50 = $ − 262.111
Effective interest rate for continuous compounding

I If the compounding period, CP , is too small, CP → 0, the

number of compounding times gets too large, m → ∞.
I This situation is known as ‘continuous compounding’
I Under continuous compounding, the rate of growth of an
investment over a time t expressed in years, i.e., the F/P
factor, is:
I F = P (1 + ia )t = P (1 + r/m)mt
I F/P = limm→∞ (1 + r/m)mt = ert
I Similarly, under continuous compounding, the effective
annual rate is:
I ia = er − 1 (since as m → ∞, (1 + r/m)m − 1 → er − 1)
Effective interest rate for continuous compounding

I Continuous compounding is often assumed in quantitative

finance as it simplifies the analysis.
I For some business activities, cash flows occur throughout
the day. Examples of costs are energy and water costs,
inventory costs, and labor costs.
I A realistic model for these activities is to increase the
frequency of the cash flows to become continuous.
I In these cases, the economic analysis can be performed for
continuous cash flows.
Addendum

I We used the fact that: limn→∞ (1 + 1/n)n = e

I Therefore, er = limn→∞ (1 + 1/n)nr
I er = limm→∞ (1 + 1/(m/r))m = limm→∞ (1 + r/m)m

I But why is limn→∞ (1 + 1/n)n = e?

I Sometimes this is taken to be the definition of e, but we’ll
take e to be the base of the natural logarithm.
Addendum

I For a positive number x the natural logarithm of x is

defined as the integral:
Rx1
I ln(x) = dt
1 t
I e is the unique real number such that ln(e) = 1
Re1
I i.e. 1 = dt
1 t
I Let t be any number in an interval [1, 1 + n1 ]
I Then we have:
1 1
I ≤ ≤1
1 t
1+
n
Addendum
1 1 1
1 1
R 1+ n
R 1+ n
R 1+ n
I dt ≤ dt ≤ 1dt
1 1 1 t 1
1+
n
1 1 1
I ≤ ln 1 + ≤
n+1 n n
1 1 1
I e n+1 ≤ 1 + ≤ e n
n
I For the left inequality, we get:
1 n+1 1 n
   
e
I e≤ 1+ =⇒ ≤ 1+
n 1 n
1+
n
I For the right inequality, we get:
1 n
 
I 1+ ≤e
n
Addendum

1 n
 
e
I i.e. ≤ 1+ ≤e
1 n
1+
n  n
e 1
I limn→∞ ≤ limn→∞ 1+ ≤ limn→∞ e
1 n
1+
n
1 n
 
I e ≤ limn→∞ 1 + ≤e
n
1 n
 
I limn→∞ 1 + =e
n
Example

I (a) For an interest rate of 18% per year, compounded

continuously, calculate the effective monthly and annual
interest rates.
I (b) An investor requires an effective return of at least 15%.
What is the minimum annual nominal rate that is
acceptable for continuous compounding?
Example

I r = 18%
I ia = er − 1 = e0.18 − 1 = 19.722% per year
I im = (1 + ia )1/12 − 1
I im = (1 + 0.19722)1/12 − 1 = 1.5113% per month
I Alternatively, rm = 18%/12 = 1.5% (nominal monthly)
I im = erm − 1 = e0.015 − 1 = 1.5113%
Example

I (b) Effective annnual rate, ia = 0.15

I r =?
I ia = er − 1 =⇒ 0.15 = er − 1
I er = 1.15 =⇒ r = ln(1.15) = 0.13976 (i.e. 13.976%) per
year, compounded continuously.
Example

I Engineers Marci and Suzanne both invest $5000 for 10

years at 10% per year. Compute the future worth for both
individuals if Marci receives annual compounding and
Suzanne receives continuous compounding.
Example

I i = 10% per year (i.e. assume compounded yearly)

I Marci, annual compounding:
I Effective rate per CP (1 year), ia = r/m = 10%/1 = 10%
I F = 5000(F/P, 10%, 10) = 5000(2.5937) = $12,969
I Suzanne, continuous compounding:
I ia = er − 1 = e0.1 − 1 = 10.517%
I F = 5000(F/P, 10.517%, 10) = 5000(2.7183) = $13,591
Interest rates that vary over time

I In practice, interest rates may vary from one period to the

other.
I In particular, it is often expected that the interest rate will
increase with time.
I If the interest rates in periods, 1, ..., n are i1 , ..., in , then,
the future worth after n periods, F , of aQpresent amount P
is: F = P (1 + i1 )(1 + i2 )...(1 + in ) = P nt=1 (1 + it )
I The rates i1 , ..., in are known as short rates.
I The short rate it represents the expected 1-year rate after t
years.
Example

I CE, Inc., leases large earth tunneling equipment. The net

profit from the equipment for each of the last 4 years has
been decreasing, as shown below. Also shown are the
annual rates of return on invested capital. The return has
been increasing.
I Determine the present worth P and equivalent uniform
series A of the net profit series. Take the annual variation
of rates of return into account.
Example

I In $1000 units:
I P = 70(P/A, 7%, 2) + 35(P/F, 9%, 1)(P/F, 7%, 2) +
25(P/F, 10%, 1)(P/F, 9%, 1)(P/F, 7%, 2)
I P = 70(1.8080) + 35(0.8013) + 25(0.7284) = $172.816
Example

I Equivalent annual series A = ?

I P = $172.816 ≡
A(P/A, 7%, 2) + A(P/F, 9%, 1)(P/F, 7%, 2) +
A(P/F, 10%, 1)(P/F, 9%, 1)(P/F, 7%, 2)
I $172.816 ≡ A(1.8080) + A(0.8013) + A(0.7284)
I A = $51.777 per year.
Bonds

I Bonds represent the major source that governments and

companies use to obtain debt financing.
I A bond is an obligation by the bond issuer to pay money
to the bond holder (buyer).
I A bond pays its face value or par value at its maturity date.
In addition, bonds usually pay periodic coupon payments.
Usually, coupon payments are made every 6 months.
I The coupon amount is described in percent of face value.
I For example, a 10% coupon with a face value of $1000 will
pay $100 coupon per year. If payment is semiannual, the
coupon payment will be $50.
Bonds

I Usually coupon rates are close to the prevailing interest

rate.
I A bond can be traded freely in the market place. Its price
varies continuously.
I A bond’s yield to maturity is the interest rate at which the
PV of coupon and face value payments are equal to the
bond price. This is always quoted on an annual basis.
I Yield to maturity (YTM) is actually the internal rate of
return (IRR) of the bond (Chapter 7).
Bonds

I Consider a bond with a price of P and a face value F ,

making m coupon payments per year of C/m (with a total
of n payments over entire period).
I The YTM is the value of λ such that:
F Pn C/m
I P = + k=1
(1 + λ/m)n [1 + (λ/m)]k
I This formula assumes that the interest is compounded
every payment period.
I Upon simplification (geometric series),
 
F C 1
I P = + 1−
(1 + λ/m)n λ [1 + (λ/m)]n
C
I Alternatively, P = F (P/F, λ/m, n) + (P/A, λ/m, n)
m
Example

I What is the price of a 10% (coupon, paid semiannually),

30-year US Treasury bond with yield 4%? Assume a face
value of 100. (Bond prices are typically quoted as
percentage of face value)
Example

I F = 100, C = 0.1 × 100 = $10, and m = 2,

I λ = 4%, and n = 30 × 2 = 60 (total number of payments).
 
F C 1
I P = + 1−
(1 + λ/m)n λ [1 + (λ/m)]n
 
100 10 1
I P = + 1 − = $204.28
(1 + 0.04/2)60 0.04 [1 + (0.04/2)]60