EC - Lec 08

Nominal and Effective Interest Rates

Many financial transactions require that interest be compounded more often than once a year (semiannually, quarterly, monthly, daily etc). In such situations, there are two expressions for the interest rate. 1. The nominal interest rate, r, is expressed on an annual basis: this is the rate that is normally quoted when describing an interest bearing transaction. 2. The effective interest rate, i, is the rate that corresponds to the actual interest period. The effective interest rate is obtained by dividing the nominal interest rate by m, the number of interest periods per year. i=r/m
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Nominal Interest Rates

The term nominal means in name only In other words, it is not the real interest rate!

We need a way to convert a nominal interest rate to the true effective interest rate that will actually apply!
Mathematically, we can define the nominal interest rate r as:

r = (effective interest rate/period) (# of periods)

So the effective interest rate can be computed as:

effective interest rate/period = r/(# of periods)

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Effective Interest Rates

An effective interest rate is a true, periodic interest rate: That applies for a stated period of time

It is conventional to use a year as the standard period of time:

So, we would like to be able to convert a nominal interest rate to an effective annual interest rate

Examples
1.5% per month effective interest rate:
Is the same as (1.5%) (12) = 18% nominal interest rate per year

1% per week effective interest rate:

Is the same as (1%) (52) = 52% nominal interest rate per year
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Problem:
A bank claims to pay interest to its depositors at the rate of 6% per year compounded quarterly. What are the nominal and effective interest rates? Solution:

a) The nominal interest rate is r=6%

b) Since there are four interest periods per year the effective interest rate is i=r/m i = 6% / 4 = 1.5% per quarter
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Comparison of Nominal and Effective Interest Rates

It has become customary to quote interest rates on an annual basis, followed by a compounding period if different from one year in length. For example, if the interest rate is 6% per interest period and the interest period is six months, it is customary to speak of this rate as 12% compounded semiannually.

Here the annual rate of interest is known as the nominal rate, 12 % in this case. But the actual annual rate on the principle is not 12% but some thing greater, because compounding occur twice during the year. 6

Consequently, the frequency at which nominal interest rate is compounded each year can have a pronounced effect on the dollar amount of total interest earned. For instant, consider a principal amount of $1000 to be invested for three years at 12% compounded semiannually. The interest earned during the first six months would be $1000 * (0.12/2) = $60. Total principal and interest at the beginning of the second six-month period is P+Pi= $1000 + $60=$1060
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The interest earned during the second six months would be $1060*(0.12/2) = $63.60 The total interest earned during the year is $60.00 + 63.60 = $123.60 Finally, the effective annual interest rate for the entire year is ($123.60 / $1000) * 100 = 12.36%

If this process is repeated for years two and three, the accumulated amount of interest can be plotted as in fig.
Suppose that the same $1000 had been invested at 12% compounded monthly, which is 1% per month. The accumulated interest over three years that results from monthly compounding is shown in fig.
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Effective Annual Interest Rate

Example: 12% annual rate, compounded monthly Pick this statement apart: 12% is the nominal interest rate Compounded monthly tells us the number of compounding periods in a year (12)

The effective interest rate per month is 1%:

We would like to be able to convert this to an effective annual interest rate
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Effective Annual Interest Rate

The effective annual interest rate i for a nominal interest rate r compounded m times per year is:

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

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Monthly Compounding Example

Given:

r = 9% per year, compounded monthly

Compounding is monthly, so there are m = 12 compounding periods in a year

Effective monthly rate: 0.09/12 = 0.0075 = 0.75%/month Effective annual rate: (1 + 0.0075)12 1 = 0.0938 = 9.38%/year
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Example (continued)
r = 9% is the nominal rate

Compounded monthly means m = 12

The effective monthly rate is 0.75%/month

The effective annual rate is 9.38% per year

0.75% 1 0.75% 2 0.75% 3 0.75% 4 0.75% 5 0.75% 6 0.75% 7 0.75% 8 0.75% 9 0.75% 10 0.75% 11 0.75% 12

One year duration (12 months)

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Quarterly Compounding Example

Given r = 9% per year, compounded quarterly
Quarter 1 Quarter 2 Quarter 3 Quarter 4

What is the effective rate?

0.09/4 = 0.0225 = 2.25%/quarter is the

effective quarterly rate

(1 + .0225)4 1 = 0.0930 = 9.30%/year is

the effective annual rate
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Weekly Compounding Example

Given r = 9% per year, compounded weekly:

Assume 52 weeks per year

The effective weekly rate is (0.09/52) = 0.00173 = 0.173%/week The effective annual rate is (1 + 0.00173)52 1 = 0.0940 = 9.40%/week
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Comparison
The effective annual interest rate is always greater than the nominal interest rate: You are earning (paying) interest on your interest The difference is greater with more frequent compounding: If compounded quarterly, we get 9.30%/year If compounded monthly, we get 9.38%/year If compounded weekly, we get 9.40%/year What if we compound infinitely often?
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Effective Interest Rate per Payment Period (i)

i [1 r / CK ] 1
C

C = number of interest periods per payment period K = number of payment periods per year CK = total number of interest periods per year, or M r/K = nominal interest rate per payment period
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Case 0: 8% compounded quarterly

Payment Period = Quarter Interest Period = Quarterly
1st Q

2nd Q
1 interest period

3rd Q

4th Q

Given r = 8%, K = 4 payments per year C = 1 interest period per quarter M = 4 interest periods per year

i [1 r / CK ]C 1 [1 0.08 / (1)( 4)]1 1 2.000% per quarter

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Case 1: 8% compounded monthly

Payment Period = Quarter Interest Period = Monthly
1st Q

2nd Q
3 interest periods Given r = 8%,

3rd Q

4th Q

K = 4 payments per year C = 3 interest periods per quarter M = 12 interest periods per year

i [1 r / CK ]C 1 [1 0.08 / (3)( 4)]3 1 2.013% per quarter

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Case 2: 8% compounded weekly

Payment Period = Quarter Interest Period = Weekly
1st Q

2nd Q
13 interest periods Given r = 8%,

3rd Q

4th Q

K = 4 payments per year C = 13 interest periods per quarter M = 52 interest periods per year

i [1 r / CK ]C 1 [1 0.08 / (13)( 4)]13 1 2.0186% per quarter

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Effective Interest Rate per Payment Period with Continuous Compounding

i [1 r / CK ] 1
C

where CK = number of compounding periods per year continuous compounding => C

i lim[(1 r / CK ) 1]
C

(e )

r 1/ K

1
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Case 3: 8% compounded continuously

Payment Period = Quarter Interest Period = Continuously
1st Q

2nd Q
interest periods Given r = 8%,

3rd Q

4th Q

K = 4 payments per year

i er / K 1 e 0.02 1 2.0201% per quarter

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Summary: Effective interest rate per quarter

Case 0
8% compounded quarterly Payments occur quarterly

Case 1
8% compounded monthly Payments occur quarterly

Case 2
8% compounded weekly Payments occur quarterly

Case 3
8% compounded continuously Payments occur quarterly

2.000% per quarter

2.013% per quarter

2.0186% per quarter

2.0201% per quarter

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Which One to Use: r or i

Some problems state only the nominal interest rate: The nominal interest rate is frequently stated for loans The effective interest rate is always the one used in: Published interest tables time-value-of-money formulas Spreadsheet functions Remember: Always use the effective interest rate in solving problems (Either annual or per period)
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