Module 3: Nominal and Effective

Interest Rates
SI-4251 Ekonomi Teknik
Muhamad Abduh, Ph.D.
Outline Module 3
 Interest Rates
 Interest Rates Statements
 Compounding and Payment Periods
 PP = CP
 PP > CP
 PP < CP

2 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Interest Rates
 In reality, loan agreements or cash flows sometimes
require that the interest be paid not in a yearly basis,
but more frequently, such as each half-year
(semiannual), each quarter, monthly, or any other
period shorter than a year.
 When the period of compounding is more than once a
year, then two terms of interest are to be considered:
 Nominal interest rate
 Effective interest rate
 The concept of these two interest rates similar to the
concept of simple and compound interests.
 Nominal interest rateis an interest rate that does not
include any consideration of compounding. (Format: r% per
time period t)
 Effective interest rate is the actual rate that applies for a
stated period of time. The compounding of interest during the
time period of the corresponding nominal rate is accounted for
by the effective interest rate. (Format: r% per time period t,
compounded m-ly)
3 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Interest Rates
 Nominal interest rate:
r = interest rate per period x number of periods
 Effective interest rate:

where: i = effective interest rate per period

r = nominal interest rate per period
m= number of compounding periods

 Term of compounding periods:

 Semiannually, m=2 6 months
 Quarterly, m = 4 3 months
 Monthly, m = 12 1 month
 Weekly, m = 52 1 week
 Daily, m = 365 1 day
 Continuously, m = ∞

4 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Examples
 Nominal rate of 1.5% per month is the same as
each the following rates:
 18% per year
 36% per 2-year period
 9% per semiannual period
 4.5% per quarter
 0.346% per week
 Effective rates:
 9% per year, compounded quarterly.
 Nominal rate: 9% per year.
 Compounding period: Quarter, m = 4
 Effective rate per compounding period: 2.25%
 Effective rate per year?
 9% per year, compounded monthly.
 4.5% per 6-month, compounded weekly.

5 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Effective Annual Interest Rates
 Year is used for the time period t, and
compounding period can be any time unit less
than 1 year.

 ia= effective interest rate per year

 i = effective interest rate per compounding
period (CP) = r/m
 r = nominal interest rate per year
 m = number of compounding periods per year

6 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Interest Rates Statements

Source: Blank &

Tarquin
7 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Exercise 1
 Visteon, a spin-off company of Ford Motor
Company, supplies major automobile components
to auto manufacturers worldwide and is Ford’s
largest supplier. An engineer is on a Visteon
committee to evaluate bids for new-generation
coordinate-measuring machinery to be directly
linked to the automated manufacturing of high-
precision components. Three vendor bids include
the interest rates:
 Bid #1: 9% per year, compounded quarterly
 Bid #2: 3% per quarter, compounded quarterly
 Bid #3: 8.8% per year, compounded monthly
 Visteon will make payments on a semiannual basis
only. The engineer is confuses about the effective
interest rates – what they are annually and over
the payment period of 6-month
 Effective rate for each bid on the basis of
8 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Compounding and Payment Periods
 There are 3 situations:
1. The compounding periods and the occurrence
of payment coincide (PP = CP)
2. The compounding periods occur more
frequently than the payments (PP > CP)
3. The compounding periods occur less
frequently than the payments (PP < CP)
 It is essential that the compounding period
and payment period on the same time
basis, and that the interest rate be
adjusted accordingly.

9 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

PP = CP (1)
 Assume payment of Rp. 300 million occurred
semiannually at the end of each 6 month period for
3 years at nominal rate of 12% per year,
compounded semiannually.
 What is the equivalent present amount?
P
30 30 30 30 30 30
0 0 0 0 0 0

0 1 2 3
1
year
i = 12% / 2 periods = 6% per semiannual period
n = (3 years) ( 2 periods per year) = 6 periods
P = A (P/A, i, n) = 300 (P/A, 6, 6) = 300 (4.9173) = Rp
1.475,190,000.-
10 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
PP = CP (2)
 A student is taking Rp. 30 million loan from a bank and to be
paid back in 48 equal monthly installment of Rp. 750.000,-
over the next 4 years.
 Calculate the effective and nominal rate of interest (per year)
forPthat
= loan
30M A=
750K

0 1 2 3 4
1 2 4 6 8
year

Rp. 30M = Rp. 750K (P/A, i, 48) (P/A, i, 48) = 40

From interest table with interpolation effective rate i ~0.5% per month
Nominal interest rate, r = (0.5% per month) x (12 month) = 6% per year
Effective annual interest rate, ia = (1+r/m)m – 1 = (1+6%/12)12 – 1 = 7.96%
per
11 year SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
PP > CP
 Suppose you deposit Rp100 M in a bank at each end of year
for the next three years. The bank will pay interest at the
rate of 8% per year compounded quarterly.
 How much will you receive from the bank at the end of the
third year?

Method-
1:
effective interest rate per CP, i = 8%/ (4 quarters) = 2% per quarter
F = 100M (F/P, 2, 8) + 100M (F/P, 2, 4) + 100M (F/P, 2, 0)
= 100M (1.174 + 1.083 + 1) = 325.7M

Method-
2:
effective annual interest rate, ia = (1 + r/m)m -1 = (1 + 8%/4)4 – 1 =
8.24%
F = 100M (F/A, 8.24, 3) = 100M (3.257) = 325.7M
12 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
PP < CP (version 1)
 Usually, no interest is paid for funds deposited during an interest period
 Funds deposited during an interest period begin earning interest for the following
interest period.
 Deposit and/or withdrawal made during an interest period are placed at the end of the
W
period within which the transaction
W W W occur. 2
1 1 1

0 1 2 3 4 5 6 7 8 9 1 1 1 mont
0 1 2 h
D
D D 3
2 2 W
D 3
2
1 W1

0 1 2 3 4
mont
h
It becomes PP D
=CP 2 3
D2
D
1 Cash flow involving interest compounding
quarterly
13 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
PP < CP (version 2)
 Usually, no interest is paid for funds deposited during an interest period
 Deposit made during an interest period are placed at the end of the period within which
the transaction occur and withdrawal made during an interest period are placed at the
beginning of the period.
W
W W W 2
1 1 1

0 1 2 3 4 5 6 7 8 9 1 1 1
0 1 2
D
D D 3
2 2 W
D 3
2
1 W1

0 1 2 3 4
It becomes PP D
=CP 2 3
D2
D
1 Cash flow involving interest compounding
14 quarterly SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
PP < CP (version 3)
 Sometimes, interest is paid for funds deposited during an
interest period
W
W W W 2
1 1 1

0 1 2 3 4 5 6 7 8 9 1 1 1
0 1 2
D
D D 3
2 2
D Cash flow involving interest compounding
1 quarterly

 Cash flow diagram remains the same.

 Use effective interest rate per payment periods (PP). The value of m
is less than 1.

 Example: For weekly cash flow, compounding quarterly,

nominal interest rate is 12% per year. Effective weekly i% =
15 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Effective Interest Rate for Continuous
Compounding
 If we allow compounding to occur more and
more frequently, the compounding period
becomes shorter and shorter. Then m, the
number of compounding periods per payment
period, increase. As m approach infinity
(compounded continuously) , the effective
interest rate is:

 Where: e = 2.71828….

16 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Interest Rates that Vary Over Time
 Real-world interest rates vary from year to
year.
 Example:
70,0 70,0 P
00 00 =?
P A A A A
=?
35,0
25,0
A
00
00

0 1 2 3 4
i = 7% i = 7% i = 9% i=
per per per 10%
year year year per
P = [70(P/A, 7%,2) + 35(P/F,7%,2)(P/F,9%,1) +
25(P/F,7%,2)(P/F,9%,1)(P/F,10%,1) ]1000
= 172,816
A = 172,816 / [(P/A, 7%,2) + (P/F,7%,2)(P/F,9%,1) +
(P/F,7%,2)(P/F,9%,1)(P/F,10%,1) ]
17 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Exercise 2
1. What uniform annual amount would you have to deposit for 5
year to have an equivalent present-investment sum of Rp. 100M
at an interest rate of 1.5 % per month compounded
continuously?
2. A student borrowed Rp. 8.5M from a bank buy a computer with
an agreement to repay Rp 250K at the end of the month of each
of the first 2 years and Rp. 3.5M at the end of the second year.
Determine the rate of interest (effective monthly, nominal, and
effective annually) that makes the receipts and disbursement
equal?
3. A cash flow at 1.5% interest compounded semiannually consists
of:
 single receipt of Rp. 23.5M at the first day of the month;
 four equal receipts of Rp. 3.50M starting from the end of the
third month;
 two equal disbursements of Rp 2.75M each at the end of the
fourth and fifth month;
 single payment of Rp 19.75M at the end of seventh month.
18 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Homework #3
 Do problems 4.13, 4.15, 4.21, 4.23, 4.33, 4.43,
4.50, 4.54 in Blank and Tarquin, Edition 6th.

19 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.