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Understanding Equivalent Interest Rates

Equivalent interest rates produce the same future value even if the rates are compounded at different frequencies. For example, a 10% rate compounded quarterly is equivalent to a 10.125% rate compounded semi-annually. Equivalent rates have different numerical values but the same overall effect. The effective annual rate takes into account compounding frequency, while the equivalent rate considers different compounding periods that produce the same future value. Formulas are provided to calculate the equivalent rate for a given effective rate and compounding frequency.

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89 views5 pages

Understanding Equivalent Interest Rates

Equivalent interest rates produce the same future value even if the rates are compounded at different frequencies. For example, a 10% rate compounded quarterly is equivalent to a 10.125% rate compounded semi-annually. Equivalent rates have different numerical values but the same overall effect. The effective annual rate takes into account compounding frequency, while the equivalent rate considers different compounding periods that produce the same future value. Formulas are provided to calculate the equivalent rate for a given effective rate and compounding frequency.

Uploaded by

Larry Noces
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
  • Equivalent Interest Rates Introduction
  • Formula for Equivalent Interest Rates
  • Calculation Examples of Interest Rates

Equivalent interest rates

Equivalent interest rates are interest rates that produce the same future value
after one year,
For example:
10% compounded quarterly and 10.125% compounded semi-annually are
equivalent nominal interest rates. If you calculate the future value of P100 invested
at either rate for one year, you will obtain P110.38.
You can see that equivalent interest rates have different numerical values
but produce the same effect.
The term “equivalent rates” carries with it the same concept as “effective
rates” but takes into account interest rates that are compounded more than once
per year. Note that “effective rates” refer to interest rates that are
compounded annually.

𝒋𝒎 𝒎
r + 1 = (𝟏 + )
𝒎

If m is greater than 1 so that interest is convertible more frequently than once


a year, interest itself earns interest within the year, and the effective rate of interest
j exceeds the nominal rate of interest, j𝑚 .

As p increases so that intervals between additional interest become smaller


and smaller, the margin between j and j𝑚 ) widens at a decreasing rate, tending to
a limit which corresponds to interest being continuously compounded.

In this case (for which m is infinite), the resultant annual convertible rate of
interest is referred to as the force of interest and is given the symbol.
The equivalent rate of interest per annum is given by

𝒆𝜹 = 1 + r
Where

𝟏 𝒎
𝒆 = 𝒍𝒊𝒎𝒎 → ∞ (𝟏 + ) = 1+r
𝒎

Example:

If the effective annual rate of interest is 6%, what is


(a) the annual rate of interest convertible half-yearly?
(b) the force of interest?
Given:
r = 6% or 0.06
m = semi-annually = 2

Required: 𝑗𝑚 = 𝑗2 =?
Soln:

(a) Let the annual rate of interest convertible half-yearly be 𝑗2


𝑗𝑚 𝑚
r + 1 = (1 + )
𝑚
𝑗2 2
0.06 + 1 = (1 + )
2
𝑗2 2
1.06 = (1 + )
2
𝑗2 2
√1.06 = √(1 + 2
)
𝑗2
1.02956301 = 1 +
2
𝑗2
1.02956301-1 =
2
𝑗2
0.02956301 =
2

Therefore: 𝑗2 = 0.05912602 𝑜𝑟 5.91%

(b) Let the force of interest be 𝛿. Then,


r = 6% or 0.06
Required: 𝛿 = ?
Soln:
𝑒𝛿 = 1 + r
𝑒 𝛿 = 1 + 0.06
𝑒 𝛿 = 1.06
𝑙𝑜𝑔𝑒 𝛿 = log(1.06)
𝑙𝑜𝑔𝑒 𝛿 log(1.06)
= note: e = 2.718281828 . . .
𝑙𝑜𝑔𝑒 𝑙𝑜𝑔𝑒

𝛿 = 0.05826891 𝑜𝑟 5.83%
Example:
To be equivalent to 15% compounded quarterly, what must be the nominal rate
with monthly compounding?
Given: Soln:
𝑗 𝑚
j = 15% or 0.15 r = (1 + ) –1
𝑚
.15 4
m = Compounding frequency: quarterly = 4 = (1 + ) –1
4

Required: = (1.0375)4 – 1
Nominal rate (annual): r = ? = 0.15865041 or 15.87%

Thus the annual nominal rate is 15.87% but we are asked to solve for the nominal
rate with monthly compounding.

Given:
m = Compounding frequency: monthly = 12
r = 15.87% or 0.1587
Required:

Nominal rate (compounding monthly) = 𝑗12

Soln:
𝑗𝑚 𝑚
r + 1 = (1 + )
𝑚
𝑗12 12
0.1587 + 1 = (1 + )
12
𝑗12 12
1.1587 = (1 + )
12

12 12 𝑗12 12
√ 1.1587 = √(1 + 12
)
𝑗12
1.01235053 = 1 +
12
𝑗12
1.01235053 – 1 =
12
𝑗12
0.01235053 =
12

𝑗12 = 0.01235053 x 12
𝑗12 = 0.01235053 x 12
𝑗12 = 0.14820636 or 14.82%

Hence, the 14.82% compounded monthly is equivalent to 15% compounded


quarterly.

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