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Lesson 4

Nominal interest rate refers to the stated annual interest rate without accounting for compounding, while effective interest rate considers compounding periods. For example, a 23% nominal annual interest rate that is compounded monthly will have a higher effective annual interest rate. Continuous compounding uses calculus to compute interest hypothetically at every moment, yielding larger returns than discrete compounding at regular intervals like yearly, monthly, or weekly. The continuous compounding formula uses the natural logarithm and exponent to calculate future value as P×e^rt, where P is principal, r is annual interest rate, and t is time.

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60 views

Lesson 4

Nominal interest rate refers to the stated annual interest rate without accounting for compounding, while effective interest rate considers compounding periods. For example, a 23% nominal annual interest rate that is compounded monthly will have a higher effective annual interest rate. Continuous compounding uses calculus to compute interest hypothetically at every moment, yielding larger returns than discrete compounding at regular intervals like yearly, monthly, or weekly. The continuous compounding formula uses the natural logarithm and exponent to calculate future value as P×e^rt, where P is principal, r is annual interest rate, and t is time.

Uploaded by

Fredmelson Apolo Gaspar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Nominal and Effective Interest Rates

Nominal interest rate is also defined as a stated interest rate. This


interest works according to the simple interest and does not take into
account the compounding periods. Effective interest rate is the one
which caters the compounding periods during a payment plan.

The nominal interest rate is the rate that is advertised by banks, debt
issuers, and investment firms for loans and various investments. It is
the stated interest rate paid or earned to the lender or by investor.
Nominal and Effective Interest Rates
• Nominal Annual Interest Rate Formulas:
Nominal and Effective Interest Rates
Example: Interest on a credit card is quoted as 23% p.a.
compounded monthly. What is the effective annual interest rate?
Nominal and Effective Interest Rates

Example: Interest on a credit card is quoted as 23% p.a. compounded


monthly. What is the effective annual interest rate?
Nominal and Effective Interest Rates

PROBLEM 1:Determine the nominal interest rate compounded quarterly if the effective interest rate
is 9% per annum (correct to two decimal places).
Continuous Compounding and Discrete Cash
Flows
People invest with the expectation of receiving more than what they
invested. That added amount is commonly referred to as interest. Depending
on the investment, interest can compound differently. The most common
way interest accrues is through discrete compounding, which includes simple
and compounding, and continuous compounding.

Discrete compounding and continuous compounding are closely related


terms. Discretely compounded interest is calculated and added to the
principal at specific intervals (e.g., annually, monthly, or weekly). Continuous
compounding uses a natural log-based formula to calculate and add back
accrued interest at the smallest possible intervals.
Continuous Compounding and Discrete Cash
Flows
KEY TAKEAWAYS
• Compounding occurs when interest is paid not only on account balances
but on previously-paid sums of interest.
• This "interest on interest" can lead to increasingly large returns over time,
and has been heralded as the "miracle" or "magic" of compound interest.
• How often interest is paid on interest matters, as the more often it is paid,
the more it will generate over time.
• Discrete compounding refers to payments made on balances at regular
intervals such as weekly, monthly, or yearly.
• Continuous compounding yields the largest net return and computes (using
calculus) interest paid hypothetically at every moment in time.
Continuous Compounding and Discrete Cash
Flows
Discrete Compounding
• If the interest rate is simple (no compounding takes place), then the future
value of any investment can be written as:
FV=P(1+m/r)^mt
where:
FV=Future value
P=Principal
(r/m)=Interest rate
mt=Time period​
Continuous Compounding and Discrete Cash
Flows
Continuous Compounding
• Continuous compounding introduces the concept of the natural
logarithm. This is the constant rate of growth for all naturally growing
processes. It's a figure that developed out of physics.
• The natural log is typically represented by the letter e. To calculate
continuous compounding for an interest-generating contract, the
formula needs to be written as:

FV=P x e^rt
Continuous Compounding and Discrete Cash
Flows
An amount of 2340.00 is deposited in a bank paying an annual interest
rate of 3.1%, compounded continuously. Find the balance after 3 years.
Continuous Compounding and Discrete Cash
Flows
Solution:
Use the continuous compound interest formula,
Given P = 2340
r = (3.1 / 100) = 0.031
t=3
Use the continuous compound interest formula,
A = Pert
Given,
P = 2340
r = 3.1 = (3.1 / 100) = 0.031
t=3
Here: e stands for the Napier’s number, which is approximately 2.7183.
However, one does not have to plug this value in the formula, as the calculator has a built-in key for e. Therefore,
A = 2340 e0.031(3) ≈ 2568.06
So, the balance after 3 years is approximately 2,568.06.

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