Module 3: Nominal and Effective

Interest Rates
SI-4251 Ekonomi Teknik
 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 m
 r 
• Effective interest rate: i  1   1
 m 

where: i = effective interest rate per period

r = nominal interest rate per period
m = number of compounding periods

• 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
• Continuously, m=∞ 

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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
– 0.346% per week
• 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?
– 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 
m
1
• 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 statement interpretation comment

i = 12% per year i = effective 12% per year When non compounding period is
compounded yearly given, interest rate is an effective rate,
i = effective 1% per month with compounding period assume to
i = 1% per month compounded monthly be equal to stated time period

i = 8% per year, i = nominal 8% per year When compounding period is given

compounded monthly compounded monthly without stating whether the interest
rate is nominal or effective, it is
i = 4% per quarter, i = nominal 4% per 3 months assumed to nominal. Compounding
compounded monthly compounded monthly period is as stated

i = effective 10% per year, i = effective 10% per year

compounded monthly compounded monthly If interest rate is stated as an effective
i = effective 6% per i = effective 6% per 3 months rate, the it is an effective rate. If
quarter, compounded quarterly compounding period is not given,
compounding period is assumed to
i = effective 1% per month, i = effective 1% per month coincide with state time period
compounded daily compounded daily
Source: Blank & Tarquin

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 Exercise 1
• 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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 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

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
P = 30M
A = 750K

0 12 24 36 48
1 year

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, 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 = 7.96% 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 = 8%/ (4 quarters) = 2% per quarter

F = 100M (F/P, 2, 8) + 100M (F/P, 2, 4) + 100M (F/P, 2, 0)
= 100M (1.174 + 1.083 + 1) = 325.7M
Method-2:
effective annual interest rate, ia = (1 + r/m)m -1 = (1 + 8%/4)4 – 1 = 8.24%
F = 100M (F/A, 8.24, 3) = 100M (3.257) = 325.7M

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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

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

D3
D2 D2
W2
D1 3 W1

0 1 2 3 4
It becomes PP =CP D3
2 D2
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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 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:

i  e 1 r

• Where: e = 2.71828….
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Interest Rates that Vary Over Time
• Real-world interest rates vary from year to
year. 70,000 70,000 P=?
A=?
• Example: P=? 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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 Exercise 2
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 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% 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
• Do problems 4.13, 4.15, 4.21, 4.23, 4.33, 4.43,
4.50, 4.54 in Blank and Tarquin, Edition 6th.

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