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Nominal vs Effective Interest Rates

The document discusses nominal and effective interest rates. It provides examples to illustrate the difference between nominal and effective rates. A nominal rate is compounded more than once per year, while an effective rate produces the same interest as the nominal rate when compounded annually. Formulas are provided to calculate effective interest rates from nominal rates based on the compounding frequency. Sample problems demonstrate applying the concepts and formulas to calculate future values, present values, and effective interest rates.

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Ridho Wahyu
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54 views12 pages

Nominal vs Effective Interest Rates

The document discusses nominal and effective interest rates. It provides examples to illustrate the difference between nominal and effective rates. A nominal rate is compounded more than once per year, while an effective rate produces the same interest as the nominal rate when compounded annually. Formulas are provided to calculate effective interest rates from nominal rates based on the compounding frequency. Sample problems demonstrate applying the concepts and formulas to calculate future values, present values, and effective interest rates.

Uploaded by

Ridho Wahyu
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

NOMINAL AND EFFECTIVE

INTEREST RATE
NOMINAL RATE AND EFFECTIVE RATE OF INTEREST

NOMINAL RATE

Is called when the interest is compounded more than


once a year

EFFECTIVE RATE

Is the rate that, when the compounded annually,


produces the same amount each year as the nominal
rate (i) compounded (m) times a year
Example:
Two annual rates of interest with different conversion periods
are said to be equivalent if they earn the same compound interest for
the same time. For instance, in one year, the compound interest of
P10.00 invested:

a. At 12% compounded semi-annually:

F = 10 ( 1 + 0.06 )² = P11.236

b. At 12.36% compounded annually:

F = 10 ( 1 + 0.1236 ) = P11.236

Then: 12% is a nominal rate


12.36% is an effective rate
Formula:

F = P( 1 + i ) n Where: m = compounding period


F = P( 1 + j/m) mn n/t = year

F1 = P( 1 + i ) – effective rate at the end of 1 year

F2 = P (1 + j / m )m – nominal rate ( i ) compounded ( m ) times a year

Since the two compounds are equal: F1 = F2 , then

P (1 + i ) = P (1 + j / m) m

(1 + i ) = (1 + j / m) m

i = (1 + j / m) m - 1

Note: If the nominal rate is compounded annually, then i = j


Various ( i ) and ( n ) Values for single-amount equations
using r = 12% per year, compounded monthly

Effective Interest Rate, i Units for n

1% per month Months

3.03% per quarter Quarters

6.15% per 6 months Semi-annual periods

12.68% per year Years

26.97% per 2 years 2-year periods

Interest rate is used for I, that is (1.01)3 – 1 = 3.03%, then the n time unit I 4 quarters,
Alternatively , it is always correct to determine the effective i per payment period.
Sample problems:
1.

Given:
P = P 2000
j = 11% compounded quarterly
t = 5 years
m=4
n=mxt
Required:
F=?

Solution:
F= P (1 + j / m )n

= 2000(1 + 0.11)/4) 4x5

= 2000(1 + 0.11/4) 20

= P 3440.87
2.

Given:
F = P 5000
j = 12% compounded semi-annually
t = 8 years
m=2
n=mxt
Required:
P=?

Solution:
F= P (1 + j / m )n

P = F/(1 + j/m) n

P = 5000/(1 + 0.12/2) 2 x 8

P = P 1968.23
3.

Given:
P = P 2000
j = 11% compounded quarterly
t = 5 years
m=4
n=mxt
Required:
F=?

Solution:
F= P (1 + j / m )n

= 2000(1 + 0.11)/4) 4x5

= 2000(1 + 0.11/4) 20

= P 3440.87
4.

Find the effective rate equivalent to 12% compounded semi- annually.

Given:
j = 12%
m=2

Required:
Er = ?

Solution:
Er = (1 + j / m )m – 1

= (1 + 0.12/ 2 ) 2 – 1

= 0.1236 or 12.36%
25.
A student deposits P 1,500 in a 9% account today. He intends to deposit
another P 3,000 at the end of two years. He plans to purchase in five years his
favorite shoes worth P 5,000. Calculate the money that will be left in his account
one year after the purchase.

Given:
P = 1,500
j=9%
n1 = 2 years, n2 = 3 years, n3 = 1years

Solution:

a. F = P( 1 + i ) n1

= 1,500 ( 1 + 0.009) 2

= 1,782.15

= 1,782.15 + 3,000(deposit at the end of 2years)

= P 4,782.15
b. F = P( 1 + i ) n2

= 4,782.15 ( 1 + 0.009) 3

= 6,193.02 – balance after 5 years

= 6,193.02 - 5,000(shoes worth)

= P 1,193.02

c. F = P( 1 + i ) n3
= 1,193.02 ( 1 + 0.009) 1

= P 1,300.39 (money left after one year after the purchase)

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