STUDY UNIT 1:
Interest rates
1
Study unit outcomes
After completing this study unit, you should be able to:
• Write down and apply the definitions of effective, nominal and simple interest.
• Write down and apply the definition of compounded interest.
• Use EXCEL to calculate the future value on any investment using any of the above-
mentioned interest calculations.
• Calculate the effective interest rate, given the nominal interest rate.
• Calculate the effective interest rate, given the initial and final amount.
2
Introduction to interest rates
Interest refers to the money that you must pay for borrowing money that does not belong to
you.
VS
Borrower Paying interest amount
Lender/Investor Receiving interest amount
3
Simple interest versus compound
interest
Simple interest
Interest is calculated using the original investment amount only.
Compound interest
Interest is calculated using the sum of the original investment amount and the interest earned during
the previous period.
4
Calculating simple interest
An investor deposits R100 into an account that earns interest at a simple rate of 10% per year. Determine the future
value (accumulated value) in the account at the end of a four-year period.
100 +10 +10 +10 +10
NOTE:
• Interest payments do not earn any
0
1 2 3 4 interest.
• Interest is calculated on the original
capital amount each time.
𝒕 𝟎 𝟏 𝟐 𝟑 𝟒
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏
100 110 120 130 140
𝒂𝒄𝒄𝒐𝒖𝒏𝒕
5
Derive formula – simple interest
100 +10 +10 +10 +10 +𝑖𝐶
𝐶 +𝑖𝐶 +𝑖𝐶 +𝑖𝐶 +𝑖𝐶
…
3 𝑛-1
0
1 2 3 4 0
1 2 𝑛
𝒕 𝟎 𝟏 𝟐 𝟑 𝒏
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏
𝑪 𝐶 + 𝑖𝐶 = 𝑪(𝟏 + 𝒊) 𝐶 + 𝑖𝐶 + 𝑖𝐶 = 𝑪(𝟏 + 𝟐𝒊) 𝐶 + 𝑖𝐶 + 𝑖𝐶 + 𝑖𝐶 = 𝑪(𝟏 + 𝟑𝒊) 𝐶 + 𝑖𝐶 + 𝑖𝐶 + 𝑖𝐶 + ⋯ + 𝑖𝐶 = 𝑪(𝟏 + 𝒏𝒊)
𝒂𝒄𝒄𝒐𝒖𝒏𝒕
∴ 𝑭𝑽 = 𝑪 + 𝒏𝒊𝑪
= 𝑪 𝟏 + 𝒏𝒊
Where
𝑭𝑽: Future value (accumulated value).
𝑪 = 𝑷𝑽: Initial investment amount.
𝒊: Simple interest rate per period.
𝒏: Total number of periods
6
Important definitions for compound
interest
Effective annual interest rate:
The amount of interest earned on a single investment at the end of the year, shown as a fraction of
the initial amount.
interest earned FVyear end − PVyear start
=
PVyear start PVyear start
Effective periodic interest rate:
The amount of interest earned on a single investment at the end of the period, shown as a fraction of
the initial amount.
interest earned FV period end − PV period start
=
PV period start PV period start
Nominal interest rate:
The effective periodic interest rate multiply by the number of periods in a year.
7
Calculating compounded interest
An investor deposits R100 into an account that earns compound interest at a rate of 10% per
year. Determine the future value (accumulated value) in the account at the end of a four-year
period.
100 +10 +11 +12.1 +13.31
NOTE:
• Interest payments earn interest.
0
4
• It is the practice of calculating interest
1 2 3
periodically and adding it to the existing
principle before each subsequent interest
calculation is made.
𝒕 𝟎 𝟏 𝟐 𝟑 𝟒
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏
100 110 121 133.1 146.41
𝒂𝒄𝒄𝒐𝒖𝒏𝒕
8
Derive formula – compounded interest
An investor deposits R𝐶 into an account that earns 𝑖% interest annually. Determine the future value (accumulated
value ) in the account at the end of a n-year period.
100 +10 +11 +12.1 +13.31 𝐶 +𝑖𝐶 + 𝐶 + 𝑖𝐶 𝑖 +C 1 + 𝑖 2 𝑖 +𝐶(1 + 𝑖)𝑛−1 𝑖
…
3 𝑛-1 𝑛
0 0
1 2 3 4 1 2
𝒕 𝟎 𝟏 𝟐 3 𝑛−1 𝒏
𝐶 1+𝑖 +𝐶 1+𝑖 𝑖 = 𝐶(1 + 𝑖)2 +𝑖𝐶(1 + 𝑖)2
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏 𝐶 + 𝑖𝐶 𝑪(𝟏 + 𝒊)𝒏
𝑪 = 𝐶 1+𝑖 1+𝑖 = 𝐶 1+𝑖 2 1+𝑖 𝑪(𝟏 + 𝒊)𝒏−𝟏
𝒂𝒄𝒄𝒐𝒖𝒏𝒕 = 𝑪(𝟏 + 𝒊)
= 𝑪(𝟏 + 𝒊)𝟐 = 𝑪(𝟏 + 𝒊)𝟑
∴ 𝑭𝑽 = 𝑪(𝟏 + 𝒊)𝒏
Where
𝑭𝑽: Future value (accumulated value).
𝑪 = 𝑷𝑽: Initial investment amount.
𝒊: compound interest rate per period.
𝒏: Total number of periods
9
Calculating effective periodic interest
Effective interest rate
An investor deposits R100 into an account that earns 5%
𝑭𝑽 = 𝑪(𝟏 + 𝒓)𝒏
interest semi-annually. Determine the future value
(accumulated value ) in the account at the end of a two-
year period. Effective periodic interest rate
𝒊(𝒑)
𝒓=
+5 +5.25 +5.5125 +5.7881 𝒑
100
NB: Effective interest rate is always used in calculations.
Nominal interest rate
0
0.5 1 1.5 2
Nominal interest is a quoted rate (implicit per year).Interest
𝒕 𝟎 𝟎. 𝟓 𝟏 𝟏. 𝟓 𝟐
is earned more often than once per year.
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏 𝒊(𝒑) 𝒏𝑝
100 105 110.25 115.7625 121.5506
𝒂𝒄𝒄𝒐𝒖𝒏𝒕 𝑭𝑽 = 𝑪(𝟏 + )
𝒑
Nominal interest rate
𝒊(𝟐) = 𝟏𝟎%
∴ 𝟓% + 𝟓%
10
Relationship between different interest
rate forms.
Simple interest Effective annual interest Nominal interest
(𝑝) (𝑝) 𝑝𝑛
𝑖 𝑖
(1 + 𝑖𝑛) = 1 + 𝑖 𝑛 = (1 + )𝑝𝑛 = 1 +
𝑝 𝑝
Effective periodic interest
11
Examples
Convert an effective monthly interest rate of 1% to an equivalent effective quarterly interest rate.
12
Examples
Convert an effective annual interest rate of 14% to an equivalent nominal interest rate, compounded daily
(assume there are 365 days in a year).
𝑖 (365) = 13.1052%
13
Examples
The interest over the next 5 years are as follows:
5% pa, compounded monthly for the first 2 years
1,5% simple interest per quarter during year 3
2.5% per quarter effective for the last 2 years.
Determine the equivalent effective annual interest over the 5-year period
12 4
𝑖 𝑖
(1 + 𝑖)5 = (1 + )12(2) (1 + 𝑛𝑖)(1 + )4(2)
12 4
5 5% 12 2 4 2
1+𝑖 = 1 + 12 1 + 4 1,5% 1 + 2.5%
𝑖 =7,3711%
14
In EXCEL or any other programming
language
Create a template for converting any interest rate form to any other interest rate form.
Use the Exercises in the following slides to test your answers.
15
Exercise 1
(i) Convert 9% pa effectively to:
a) a nominal interest rate, converted daily. (8.6188%)
b) an effective weekly interest rate. (0.1659%)
c) a simple quarterly interest rate. (2.25%)
(ii) Use the answer found in (i) and show that it converts to 9% pa effectively.
16
Exercise 2
(i) Convert 7% pa, compounded monthly to:
a) a nominal interest rate compounded quarterly. (7.0409%)
b) an effective semi-annual interest rate. (3.5514%)
c) a simple annual interest rate. (7.2290%)
d)an effective monthly interest rate. (0.5833%)
(ii) Use the answer found in (i) and show that it converts 7% pa, compounded monthly.
17
Exercise 3
(i) Convert a 0.05% simple daily interest rate
a) an effective annual interest rate. (18.25%)
b) an nominal interest rate convertible monthly. (16.8807%)
c) an effective quarterly interest rate. (4.2798%)
(ii) Use the answer found in (i) and show that it converts to 0.05% simple daily interest rate.
18
Exercise 4
For the next four years a bank account will earn interest as follows:
• During the first nine months the effective annual interest rate is 7.12%;
• For the following year and a half, the interest rate is 7.65% per year, compounded half
yearly;
• For the next five quarters the simple interest rate is 2% per quarter and
• For the remaining period the interest rate is 1.92% effective per month.
Determine the effective annual interest rate over the four-year period.
(9.79%)
19
To do
• Read Study unit 1 of the study guide.
• You will now be able to do Problem 1.1 – 1.4 from the study guide.
• Assignment 1 – due along with the test on Assignment 1 (See the planning)
• Do Tutorial 1 before the next Tutorial class
20