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Econ Module03

The document discusses two types of interest rates: nominal and effective, explaining how nominal rates do not account for compounding, while effective rates do. It includes examples of calculating effective interest rates for various compounding frequencies and provides formulas for discrete and continuous compounding. Additionally, it covers amortization, detailing the process of spreading loan payments over time and the necessary components for calculating effective interest rates.

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Econ Module03

The document discusses two types of interest rates: nominal and effective, explaining how nominal rates do not account for compounding, while effective rates do. It includes examples of calculating effective interest rates for various compounding frequencies and provides formulas for discrete and continuous compounding. Additionally, it covers amortization, detailing the process of spreading loan payments over time and the necessary components for calculating effective interest rates.

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22104548
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© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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INTEREST RATES

01 MODULE 03
Two common types of interest quotation

NOMINAL INTEREST RATE EXAMPLES


• An interest rate that does not
include any consideration of
compounding.
• If the bank states 8% per year,
compounded monthly.
• 8% is NOT the true effective
rate (per year).
• 8% represents the nominal
rate.
Two common types of interest quotation
COMMON COMPOUNDING
EFFECTIVE INTEREST RATE FREQUENCIES
• is the actual rate that applies
for a stated period of time.
• the compounding interest
during the time period of the
corresponding nominal rate is
accounted for by the effective
interest rate.
Effective Rates of Interes
• For an interest rate of 1.2% per month, determine the nominal and
effective rates?
• What are the interest rates
• Per Quarter?
• Per Year?
Effective Rates of Interest
• $5,000 in invested at a Interest rate of 15% per year compounded
quarterly. • What is the quarterly interest rates?
• What is the effective annual interest rate?
• What is the value of the investment after 6 quarters?
• What is the value of the investment after 2 years?
Given :
P = $5,000
i = 15%
N(6 Quarters) = 6
N(2 Years) = 6
DISCRETE, CONTINUOUS
COMPOUNDING
02 MODULE 03
“COMPOUND INTEREST IS THE
EIGHT WONDER OF THE
WORLD. HE WHO
UNDERSTANDS IT, EARNS IT.
HE WHO DOESN’T, PAYS IT.”
ALBERT EINSTEIN
DISCRETE COMPOUNDING
• If cash flow transaction occurs quarterly but interest is
compounded monthly, we may wish to calculate the effective
rate of interest on a quarterly basis.
𝑟 𝐶
• 𝑖 = (1 + ) −1
𝑀
• Where:
M = the number of interest periods per year
C = the number of interest period per payment period
K = the number of payment periods per year.
Note : M = CK
CONTINUOUS COMPOUNDING

• As the number of compounding periods (M) becomes very


large, the interest rate per compounding period (r/M) becomes
very small.
• As M approaches infinity and r/M approaches zero, we
approximate the situation of continuous compounding
EXAMPLE
Suppose that you make quarterly deposits into a savings account that
earns 8% interest compounded monthly. Compute for the effective rate
of interest per quarter.

Given:
R= 8%
C = 3 interest periods per quarter
K = 4 quarterly payments per year
M = 12 interests period per year.

Asked: Find i per quarter = ?


EXAMPLE
What is the effective annual interest rate for a nominal interest rate
of 12% compounded continuously?

Given:
𝑖 = 12%
𝐶𝑜𝑚𝑝𝑢𝑛𝑑𝑒𝑑 𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑠𝑙𝑦
𝑖𝑎 = 𝑒 0.12 − 1 = 12.7497
SEATWORK
• Find the effective interest rate per quarter at a nominal rate of 8%
compounded

a. Weekly
b. Daily
c. Continuous
EXAMPLE
• Suppose you want to buy a car. The gross price of the price
inclusive of all charges is $22,678.95. You can afford to have a
downpayment of $2,678.95 so the net amount of $20,000 is to
be financed.
• what would be the monthly amortization?
• After the 25th payment, you want to pay off the remaining loan
in a lump-sum amount. What is the lump-sum?
• Interest Rate = 8.5% per year, K = 12 payments per year, N =
48 months, and C = 1, M = 12.
FORMULAS
AMORTIZATION
03 MODULE 03
AMORTIZATION
• Is an accounting term that refers to the
process of allocating the cost of an
intangible asset over a period of time. It
also refers to the repayment of loan
principal over time.
• is the process of spreading out a loan
into a series of fixed payments over time.
You'll be paying off the loan's interest
and principal in different amounts each
month, although your total payment
remains equal each period.
COMPONENTS OF AN AMORTIZATION
1. Identify the number of compounding periods per year (M), the
number of payment periods per year (K), and the number of
interest periods per payment period (C)
2. Compute for the effective rate of interest per payment period.
For Discrete Compounding
𝐼 = (1 + 𝑟/𝑀)𝐶 − 1
For Continuous Compounding
𝐼 = 𝑒 𝑟/𝐾 − 1
3. Find the total number of payment periods
N = K* (number of years)
4. Use I & N in the appropriate formulas
EXAMPLE
Suppose you make equal quarterly deposits of $1,000 into a fund
that pays interest at a rate of 12% compounded monthly. Find the
balance at the end of year 3.

Given:
A = $1,000
r = 12%
M = 12 compounding periods per year
N = 12 quarters
FORMULAS
DISCRETE COMPOUNDING
04 MODULE 03
SAMPLE
• Assuming a nominal rate of 24%, compounded QUARTERLY. What
does this mean?
• It means, your money will compound EVERY quarter of the year. If the
nominal rate is 24%, divide it by 4 quarters in 1 year.
• It means, every QUARTER, it will compound at an interest of 6% (24%/4).
• So, its effective interest is 6% per Quarter or in a year in compounds
quarterly.

24 4
𝐸𝑅 = (1 + ) = 26.25% (𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒)
4
WHAT HAPPENS?
• If the money is compounded quarterly and you are paying
monthly? What should you do?
• Both Quarterly compounding and Monthly compounding should
have the same Effective rate of interest. Right?
• So, since you know that the money is compounded Quarterly with
6% per quarter. What should be it’s equivalent monthly interest
rate?
((1 + 𝑖𝑚 )3 − 1 = ((1 + 𝑖𝑞 )1 − 1 [eq. 01]
• Eq. 1 tells you that monthly ER compounded 3 times is equivalent
to quarterly rate compounded 1 times.
WHAT HAPPENS?
WHAT HAPPENS?

In other terms, it should have


the same ER as a monthly rate. It
means;

(1 +2%)3 −1 = 6.12%

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