Principles of Money-Time Relationships

(Part II)
Nominal and Effective Interest Rates
(1/4)

• In our previous examples, we

considered the interest period, or the
time between compounding, as one
year
• However, very often, the interest period is
less than one year
• It has been customary to quote interest
rates on an annual basis, followed by the
compounding period if different from one
year in length
Nominal and Effective Interest Rates
(2/4)

• Ex: A 6% per interest period for a time

period of six months is equivalent to saying
12% compounded semiannually
• The 12% in the case above is what we call the
nominal interest rate, which is represented as
r
• The actual or exact rate of interest earned on the
principal amount during one year is known as the
effective interest rate, which is represented as
i
• Effective interest rates are always expressed on an
annual basis
Nominal and Effective Interest Rates
(3/4)

• The relationship between nominal and

effective interest rates is given by the
equation:

i  1  r / M   1
K

where M is the number of compounding

periods per year; and K is the number
of compounding periods per fixed time
interval separating cash flows
Nominal and Effective Interest Rates
(4/4)

EXAMPLE: A credit card company

charges an interest rate of 1.375% per
month on the unpaid balance of all
accounts. The annual interest rate,
they claim, is 16.5%. What is the
effective interest rate of interest per
year being charged by the company?
Interest Problems with Compounding
More Often Than Once per Year (1/4)

Suppose that a lump-sum amount is

invested for 10-years at a nominal
interest rate of 6% compounded
quarterly. How much is it worth at the
end of the tenth year?

F  PF / P,1.5%, 40   $181.40

F  PF / P,6.14%,10   $181.40
Interest Problems with Compounding
More Often Than Once per Year (2/4)

NOTE: The formulas for uniform and

gradient series can be used as long as
there is a cash flow at the end of
each interest period
Interest Problems with Compounding
More Often Than Once per Year (3/4)

Suppose that one has a bank loan for

P10,000 which is to be repaid in equal
end-of-month installments for five
years with nominal interest rate of
12% compounded monthly. What is
the amount of each payment?

A  PhP10,000 A / P,1%,60  PhP222

Interest Problems with Compounding
More Often Than Once per Year (4/4)

Certain operating savings are expected to be 0 at the

end of the first six months, to be PhP1,000 at the
end of the second six months, and to increase by
PhP1,000 at the end of each six-month period
thereafter for a total of four years. It is desired to
find the equivalent uniform amount, A, at the end of
each of the eight 6-month periods if the nominal
interest rate is 20% compounded semiannually.

A  PhP1,000 A / G,10%,8  PhP 3,004.50

Interest Problems with Cash Flows Less
Often Than Compounding Periods (1/2)

Suppose that there exists a series of 10 end-

of-year receipts of PhP10,000 each, and it is
desired to compute their equivalent worth as
of the end of the tenth year if the nominal
interest rate is 12% compounded quarterly.

F  10,000 A / F ,3%, 4F / A,3%, 40

 PhP180,208.87
F  10,000F / A,12.55%,10 
 PhP180,221.71
Interest Problems with Cash Flows Less
Often Than Compounding Periods (2/2)

Determine the present value of the cash flow

diagram below given that the nominal
interest rate is 15% compounded monthly:

P  1,000P / A,3.8%,8
 PhP 6,788.70
Continuous Compounding (1/2)

• To be competitive in the financial market , or

to entice potential depositors, some financial
institutions offer frequent 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
Continuous Compounding (2/2)

• For continuous compounding, compute

i=e r/K –1

Where K is the number of time periods

per year at which you want to find the
effective interest rate of