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Chapter 5 Typing Practice

Chapter 5 discusses effective and nominal rates of interest and discount, highlighting how effective rates indicate interest paid at the end or beginning of a period, while nominal rates are used when interest is paid more frequently. It defines nominal rates of interest convertible pthly and explains how to annualize a pthly effective interest rate. The chapter emphasizes the importance of recognizing the compounding effect when converting between nominal and effective rates.

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2 views1 page

Chapter 5 Typing Practice

Chapter 5 discusses effective and nominal rates of interest and discount, highlighting how effective rates indicate interest paid at the end or beginning of a period, while nominal rates are used when interest is paid more frequently. It defines nominal rates of interest convertible pthly and explains how to annualize a pthly effective interest rate. The chapter emphasizes the importance of recognizing the compounding effect when converting between nominal and effective rates.

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pritshah617
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 5 typing practice

Recall from Chapter 4 that ‘effective’ rates of interest and discount have interest paid once per
measurement period, either at the end of the period or at the beginning of the period.

The effective annual rate of interest tells us the amount of interest to be paid at the ned of each year.
The effective annual rate of discount tells us the amount of interest to be paid at the start of each
year.

‘Nominal’ is used when interest is paid more (or less) frequently than once per measurement
period.

The example we gave in the previous chapter was that bank accounts sometimes use nominal rates.
They might quote the annual interest rate (and so the time unit or measurement period is one year),
but interest might actually be added at the end of each month (so interest is paid more frequently
that once per unit year).

1.1 Nominal rates of interest

We denote the nominal rate of interest payable p times per period by i ( p ). This is also
referred to as the rate of interest convertible pthly or compounded pythly.

Therefore, working in years, i (12 ) is referred to as a nominal rate of interest convertible monthly
and i (4 ) as a nominal interest rate convertible quarterly, etc.

A nominal rate of interest per period, payable pthly, i ( p ), is defined to be a rate of interest of
i ( p )/p applied for each pth of a period. For example, a nominal rate of interest of 6% pa
convertible quarterly means an interest rate of 6/4 = 1.5% per quarter.

Essentially what we are doing is ‘annualising’ a pthly effective interest rate. That is, we are
converting a non-annual rate by multiplying. For example, suppose interest is 3% effective per
half-year. We could annualise this rate by doubling it, which would give 6% pa. However, this is
clearly not the correct annual effective rate as it has ignored the effect of compounding. The
true effective annual rate is 1.032 -1 = 6.09% pa. We call 6% a nominal rate and give the period
it actually refers to. Dividing by p gives us the correct pthly effective rate. So, in this case, we
would say that the nominal rate of interest is 6% pa convertible half-yearly and we denote this
by i (2 )

Hence, by definition, i ( p ) is equivalent to a pthly effective rate of interest of i ( p )/p.

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