Chapter 3

Nominal and Effective

Interest Rates
 Chapter 3 – Nominal & Effective Interest

TOPICS
PURPOSE
Recognize nominal and
effective rates
Perform calculations for Effective interest rates
interest rates and Payment period (PP) and
cash flows that occur on compounding period (CP)
a time basis Single amounts with PP ≥
other than yearly CP
Series with PP ≥ CP
Single and series with
PP < CP
 Nominal and Effective Rate Statements
Nominal rates
• Interest rate per time period without regard
to compounding frequency
• Some nominal statements:
• 8% per year compounded monthly
• 2% per month compounded weekly
• 8% per year compounded quarterly
• 5% per quarter compounded monthly
Effective rates
• Interest rate is compounded more
frequently than once per year
• Some statements indicating an effective
rate:
• 15% per year
• effective 8.3% per year compounded monthly
• 2% per month compounded monthly
• effective 1% per week compounded
continuously
 Effective Interest Rate Formula

• i = effective rate per some stated period, e.g., quarterly,

annually
• r = nominal rate for same time period
• m = frequency of compounding per same time period
Sec 3.2 – Effective Interest Rate
Time
Compounding Period for period m must
frequency effective i for r equal
Annual annual year 1
Semi-annual annual year 2
Quarterly annual year 4
Monthly annual year 12
Daily annual year 365
Monthly semi-annual 6 months 6
Weekly quarterly quarter 12
 Sec 3.2 – Effective Interest Rate
Example: Find i per year, if m = 4 for
quarterly compounding, and
r = 12% per year

r m
Effective i = (1+ ) − 1
m
Stated period for i is YEAR

i = (1 + 0.12/4)4 - 1 = 12.55%
 Sec 3.2 – Nominal and Effective Rates
Nominal Effective
r m
r = rate/period × periods
Effective i = (1+ ) −1
m

Example: Rate is 1.5% per month. Determine Example: Credit card rate is 1.5% per month
nominal rate per quarter, year, and over 2 compounded monthly. Determine effective
years rate per quarter and per year
Period is quarter:
Qtr: r = 1.5 × 3 mth = 4.5% r = 1.5 × 3 mth = 4.5%
m=3
Year: r = 1.5 ×12 mth = 18% i = (1 + 0.045/3)3 – 1 = 4.57% per quarter
= 4.5 × 4 qtr = 18%
Period is year: r = 18% m = 12
2 yrs: r =1.5 × 24 mth = 36%
= 18 × 2 yrs = 36% i = (1 + 0.18/12)12 - 1) = 19.6% per year
 Example
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 yearly and semiannually?

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Solution
 Effective Interest Rate
When compounding period shortens so much that it approaches to zero;
number of compounding approaches to infinity
As m → ∞, continuous compounding is approached
effective i = (℮r – 1)

Example: r = 14% per year compounded continuously

i = (℮ 0.14 - 1) = 15.03% per year

 Payment Periods (PP) and Compounding Periods (CP)

• PP – how often cash flows occur

• CP – how often interest in compounded
• If PP = CP, no problem concerning effective i rate

Examples where effective i is involved:

Monthly deposit, quarterly compounding (PP < CP)
Semi-annual payment, monthly compounding (PP > CP)
 Example
A company deposits money each month into an account that pays
nominal interest rate of 6% per year, compounded semi annually.

Solution:

• PP: 1 month
• CP: 6 month
• r= 6%

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 Example
A person deposits money into a savings account once in each year, that
compounds quarterly with a nominal interest of 10% per year.
Solution:
• PP: one year
• CP: 3 months (quarter)
• r : 10% per year

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Payment Periods (PP)and Compounding Periods (CP)
Initial things to observe about cash flows
1. Compare length of PP with CP
PP = CP PP > CP PP < CP
2. Determine types of cash flows present
• Only single amounts (P and F)
• Series (A, G, g)
3. Determine correct effective i and n (same time unit on both)

Remember: An effective i rate must be used in all factors

 Equivalence with Single Amounts
If only P and F cash flows are present, equivalence relations are
P = F(P/F, effective i per period, # of periods) [1]
F = P(F/P, effective i per period, # of periods) [2]

Example: Find equivalent F in 10 years if P is $1000 now. Assume r = 12% per

year compounded semi-annually.
- PP = year and CP = 6 months; period is 6 months
- Only single amount cash flows
- Use relation [2] above to find F
F = 1000(F/P, 6% semi-annually, 20 periods)
= 1000(3.2071) = $3207
 Example
• Sherry expects to deposit $1000 now, $3000 4 years from now, and $1500
6 years from now and earn at a rate of 12% per year compounded semi-
annually through a company-sponsored savings plan. What amount can
she withdraw 10 years from now?Assume interest rate of 12% per year,
compounded semiannually.
Solution
Solution
 Equivalence with Series

Three types
• Type 1 pp=cp
• Type 2 pp>cp
• Type 3 pp<cp

When pp=cp and pp>cp

• Count number of payments. This is n
• Determine effective i over same time period as n
• Use these i and n values in factors

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 Equivalence with Series and PP ≥ CP
• Count number of payments. This is n
• Determine effective i over same time period as n
• Use these i and n values in factors

Example: $75 per month for 3 years at 12% per year compounded monthly
PP = CP = month
n = 36 months
effective i = 1% per month
Relation: F = A(F/A,1%,36)
 Equivalence with Series and PP ≥ CP
• Count number of payments. This is n
• Determine effective i over same time period as n
• Use these i and n values in factors

Example: $5000 per quarter for 6 years at 12% per year compounded
monthly
PP = quarter and CP = month → PP > CP
n = 24 quarters
i = 1% per month or 3% per quarter
m = 3 CP per quarter
effective i per quarter = (1 + 0.03/3)3 – 1 = 3.03%

Relation: F = A(F/A,3.03%,24)
 CH-5..Equivalence calculations involving PP>=CP
Examples of n and i Values Where PP = CP or PP > CP
(1) (2) (3) (4)
Cash-flow Sequence Interest Rate What to Find; What is Standard Notation
Given

$500 semi-annually for 5 8% per year compounded Find P; given A P= 500(P/A,4%,10)

years Semi-annually
$75 monthly for 3 years 12% per year compounded Find F; given A
F = 75 (F/A,1%,36)
monthly
$180 quarterly for 15 years 5% per quarter Find F; given A
F = 180 (F/A,5%,60)

$25 per month increase for 1% per month Find P; given G

P = 25 (P/G,1%,48)
4 years

$5000 per quarter for 6 1% per month Find P; given A

A = 5000 (P/A,3.03%,24)
years

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 Example- Equivalence with Series and PP ≥ CP

Boeing has purchased composite wing fixtures for the assembly of its
new Dreamliner Commercial airliner. Assume this 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 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 semi-annual A value if capital funds
are evaluated at 8% per year compounded semi-annually.
Solution
 Sec 3.5 – Equivalence with Series and PP ≥ CP

• First step: Find P for n = 10 annual payments

• Period is year
• CP = 6 months; PP = year; PP > CP
• Effective i per year = (1 + 0.08/2)2 – 1 = 8.16%
Relation: P = 3M + 200,000(P/A,8.16%,10) = $4,332,400
Second step: Find A for n = 20 semi-annual amounts
• Period is six months
• CP = 6 months; PP = 6 months; PP = CP
• Effective i per 6 months = 8%/2 = 4%
Relation: A = 4,332,400(A/P,4%,20) = $318,778
 Equivalence with Series and PP < CP
Example:
deposits monthly (PP) with interest compounded semi-annually (CP)
Result: PP < CP

Usually, interest is not paid on interperiod deposits

For equivalence computations: Cash flows are ‘moved’ to match CP time

period
 Equivalence with Series and PP < CP
Move cash flows not at end of a compounding period:
 Deposits ( minus cash flows) - to end of period
 Withdrawals (plus cash flows) - to beginning of same period (which is the
end of last period)

Example (next slide):

move monthly deposits to match quarterly compounding.
Now, PP = CP = quarter
 Find P, F or A using effective i per quarter
 Equivalence with Series and PP < CP
Moving cash flows turns top cash flow diagram into bottom

Qtr 1 Qtr 2 Qtr 3 Qtr4

Future value of all cash flows (i=3% per quarter)

F=-150(F/P,3%,4)-200(F/P,3%,3)-(175-90)(F/P,3%,2)
+165(F/P,3%,1) – 50

F= – 150(1.12551) – 200(1.09273) – 85(1.0609) + 165(1.03) – 50

F= – 357599