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Lesson 6 of 15 : Continuous Compounding 3 4 b 6
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Learning Outcomes
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calculate and interpret the effective annual rate, given the stated annual interest rate and the frequency
B Search of compounding Low

calculate the solution for time value of money problems with different frequencies of compounding
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The preceding discussion on compounding periods illustrates discrete compounding, which credits interest
after a discrete amount of time has elapsed. If the number of compounding periods per year becomes
Category
infinite, then interest is said to compound continuously. If we want to use the future value formula with
Interest Rates, Present Value,
continuous compounding, we need to find the limiting value of the future value factor for m → ∞ (infinitely and Future Value
many compounding periods per year) in Equation 3. The expression for the future value of a sum in N years
with continuous compounding is r Related Questions:
Practice questions related to
FV N = PVers N 4
this topic
The term
ers N is the transcendental number e ≈ 2.7182818 raised to the power rsN. Most financial calculators have the
function ex.

EXAMPLE 6

The Future Value of a Lump Sum with Continuous Compounding

Suppose a $10,000 investment will earn 8 percent compounded continuously for two years. We can
compute the future value with Equation 4 as follows:

PV = $10,000
rs = 8% = 0.08
N=2
FV N = PVers N
= $10,000e0.08(2)
= $10,000 (1.173511)
= $11,735.11

With the same interest rate but using continuous compounding, the $10,000 investment will grow to
$11,735.11 in two years, compared with $11,716.59 using quarterly compounding as shown in Example
4.

Exhibit 3 shows how a stated annual interest rate of 8 percent generates different ending dollar amounts
with annual, semiannual, quarterly, monthly, daily, and continuous compounding for an initial investment of
$1 (carried out to six decimal places).

As Exhibit 3 shows, all six cases have the same stated annual interest rate of 8 percent; they have different
ending dollar amounts, however, because of differences in the frequency of compounding. With annual
compounding, the ending amount is $1.08. More frequent compounding results in larger ending amounts.
The ending dollar amount with continuous compounding is the maximum amount that can be earned with a
stated annual rate of 8 percent.

Exhibit 3: The Effect of Compounding Frequency on Future Value

Frequency rs/m mN Future Value of $1

Annual 8%/1 = 8% 1×1=1 $1.00(1.08) = $1.08

Semiannual 8%/2 = 4% 2×1=2 $1.00(1.04)2 = $1.081600

Quarterly 8%/4 = 2% 4×1=4 $1.00(1.02)4 = $1.082432

Monthly 8%/12 = 0.6667% 12 × 1 = 12 $1.00(1.006667)12 = $1.083000

Daily 8%/365 = 0.0219% 365 × 1 = 365 $1.00(1.000219)365 = $1.083278

Continuous $1.00e0.08(1) = $1.083287

Exhibit 3 also shows that a $1 investment earning 8.16 percent compounded annually grows to the same
future value at the end of one year as a $1 investment earning 8 percent compounded semiannually. This
result leads us to a distinction between the stated annual interest rate and the effective annual rate (EAR).6
For an 8 percent stated annual interest rate with semiannual compounding, the EAR is 8.16 percent.

Stated and Effective Rates

The stated annual interest rate does not give a future value directly, so we need a formula for the EAR. With
an annual interest rate of 8 percent compounded semiannually, we receive a periodic rate of 4 percent.
During the course of a year, an investment of $1 would grow to $1(1.04)2 = $1.0816, as illustrated in Exhibit
3. The interest earned on the $1 investment is $0.0816 and represents an effective annual rate of interest of
8.16 percent. The effective annual rate is calculated as follows:

EAR = (1 + Periodic interest rate)m – 1 5

The periodic interest rate is the stated annual interest rate divided by m, where m is the number of
compounding periods in one year. Using our previous example, we can solve for EAR as follows: (1.04)2 − 1
= 8.16 percent.

The concept of EAR extends to continuous compounding. Suppose we have a rate of 8 percent
compounded continuously. We can find the EAR in the same way as above by finding the appropriate future
value factor. In this case, a $1 investment would grow to $1e0.08(1.0) = $1.0833. The interest earned for one
year represents an effective annual rate of 8.33 percent and is larger than the 8.16 percent EAR with
semiannual compounding because interest is compounded more frequently. With continuous compounding,
we can solve for the effective annual rate as follows:

EAR = ers − 1 6

We can reverse the formulas for EAR with discrete and continuous compounding to find a periodic rate that
corresponds to a particular effective annual rate. Suppose we want to find the appropriate periodic rate for a
given effective annual rate of 8.16 percent with semiannual compounding. We can use Equation 5 to find the
periodic rate:

0.0816 = (1 + Periodic rate) 2 − 1

1.0816 = (1 + Periodic rate) 2
(1.0816)1/2 − 1 = Periodic rate
(1.04) − 1 = Periodic rate
4%= Periodic rate

To calculate the continuously compounded rate (the stated annual interest rate with continuous
compounding) corresponding to an effective annual rate of 8.33 percent, we find the interest rate that
satisfies Equation 6:

0.0833 = ers − 1
1.0833 = ers

To solve this equation, we take the natural logarithm of both sides. (Recall that the natural log of
ers is ln
ers = rs .) Therefore, ln 1.0833 = rs, resulting in rs = 8 percent. We see that a stated annual rate of 8 percent
with continuous compounding is equivalent to an EAR of 8.33 percent.

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Discussion

Keep getting error 1 with BA II when I use e with 10,000 example. Anyone know why?
WC

Created a month ago by William Conn 1 reply | Last Activity: 12 days ago
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NC Hello William,
Here's the solution

1. Input (0.08) * 2 which would give you 0.16

2. Now with 0.16 ==> Press 2nd key + ex key on your financial calculator which would result in 1.1735
3. Now as per the formula = FVn = 10000*(1.1735) = 11,735.108

Hope that helps!!!

Nitish Chaulkar replied 12 days ago

What does r_s means?

KL

Created 18 days ago by Keng Lam Wong 1 reply | Last Activity: 18 days ago
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How to take the natural logarithm of both sides. (Recall that the natural log of ers is ln ers=rs) with calculator? at the last phrase.
MM

Created a month ago by MOHAMED MOHAMED ABDOU ELTABEI ELSHAZLI 0 replies | Last Activity: a month ago
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Can someone explain how to calculate all this in financial calculator.. Finding it difficult to do it financial calculator
ND

Created 2 months ago by Nitin Dhyani 1 reply | Last Activity: 2 months ago
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Use Texas: E6: 0.16,2nd,LN,*,10000

WC

Created 2 months ago by Wenjing Chen 0 replies | Last Activity: 2 months ago
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How does one determine when to use EAR vs APR? I understand the general concept... but when given a question what is the indicator, to use APR (or stated 'r') vs EAR?
JP

Created 7 months ago by Jay Patel 2 replies | Last Activity: 4 months ago
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The related practice question did not show how did they came up with m=365. Trying to solve the equation needs advanced math background which not everyone may have at
AS
this point....by substituting in EAR=(1+Periodic Int. Rate)m -1, we get 0.0408=(1+0.04/m)m-1
By moving -1 to the other hand side of the equation will give us 1.0408 = (m+0.04/m)m.....this will leave us with the dillema of how to solve for m in this equation, unless we
should make an educated guess of the value of m and keep trying until we get the right answer.

Created 4 months ago by Amgad Sherif Nassif 2 replies | Last Activity: 4 months ago
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Anyone know ho to do TVM continuous compounding on a TI BAII Plus?

CC

Created 9 months ago by Cooper Carter 5 replies | Last Activity: 6 months ago
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In equation 6 how will we find natural logarithm? and how did this 8% derived after solving eqn of 8.33%?
RJ

Created 10 months ago by Rohan Jain 3 replies | Last Activity: 9 months ago
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