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Module 3 Lecture Note 1 Converting Nominal Rate To Effective Rate. Comparison of Two Rates

This document discusses converting nominal interest rates to effective rates and comparing interest rates. It provides formulas for converting rates compounded annually, semi-annually, quarterly, and monthly. Examples show that 12% compounded semi-annually equals 12.36% annually, and 12% compounded monthly equals 12.68% annually. The document also finds that a 6.31% nominal rate compounded semi-annually equals a 6.5% effective rate. When comparing rates, higher compounding periods and rates provide better returns for investors.

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99 views4 pages

Module 3 Lecture Note 1 Converting Nominal Rate To Effective Rate. Comparison of Two Rates

This document discusses converting nominal interest rates to effective rates and comparing interest rates. It provides formulas for converting rates compounded annually, semi-annually, quarterly, and monthly. Examples show that 12% compounded semi-annually equals 12.36% annually, and 12% compounded monthly equals 12.68% annually. The document also finds that a 6.31% nominal rate compounded semi-annually equals a 6.5% effective rate. When comparing rates, higher compounding periods and rates provide better returns for investors.

Uploaded by

Gian Luigi Katigbak
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

Module 3 Lecture Note 1

Converting nominal rate to effective rate.


Comparison of two rates.

Nominal rate is the rate of interest in a compounded period while effective rate is the rate of
interest annually without compounding.

Two annual rates of interest with different conversion periods are said to be equivalent if they
earn same compound interest for the same time. When interest is compounded more than
once a year, the given rate is called nominal rate. The effective rate is the rate that, when
compounded annually, produces the same compound amount each year as the nominal rate “j”
compounded “m” times a year. (source: Mathematics of Investment by Ong and San Gabriel page 39)

Formula for converting nominal rate to effective rate.


U = (1 + j/m)m – 1
U represents the effective rate

1. Find the effective rate equivalent to 12% compounded


a. annually
Given :
j = 12% or .12
m = annually or 1
Solution:
U = (1 + j/m)m – 1
U = (1 + .12/1)1 – 1
U = (1.12)1 – 1
U = 1.12 – 1
U = .12
It means that when the interest is compounded annually is the same as effective rate.

b. semi-annually
Given :
j = 12% or .12
m = semi-annually or 2
Solution:
U = (1 + j/m)m – 1
U = (1 + .12/2)2 – 1
U = (1.06)2 – 1
U = 1.1236 – 1
U = .1236 or 12.36%
It means that 12% interest compounded semi-annually (every 6 months) is the same as 12.36%
interest annually.
c. quarterly
Given :
j = 12% or .12
m = quarterly or 4
Solution:
U = (1 + j/m)m – 1
U = (1 + .12/4)4 – 1
U = (1 .03)4 – 1
U = 1.12550881 – 1
U = .12550881 or 12.55%
It means that 12% interest compounded quarterly (every 3 months) is the same as 12.55%
interest annually.

d. monthly
Given :
j = 12% or .12
m = monthly or 12
Solution:
U = (1 + j/m)m – 1
U = (1 + .12/12)12– 1
U = (1.01)12 – 1
U = 1.12682503 – 1
U = .12682503 or 12.68%
It means that 12% interest compounded quarterly (every month) is the same as 12.68% interest
annually.

2. What nominal rate, converted semi-annually, is equivalent to 6 ½% effective rate?


Given :
U = 6 ½% or 6.5% or .065
m = monthly or 12
j=?

Solution:
U = (1 + j/m)m – 1
-(1+j/m)m = -1 - U
(1 + j/m)m = 1 + U (after multiplying both sides of the equation by -1)
(1 + j/12)12 = 1 + .065
1 + j/12 = (1 + .065) 1/12 (after removing the parentheses and the exponential value of m)
1 + j/12 = (1.065)1/12
1 + j/12 = 1.005261694
j/12 = 1.005261694 – 1 (transpose +1 in the left side to the right side of the equation becomes -1)
j/12 = .005261694
j = .005261694 x 12 (multiplying both sides of 12 to remove the denominator in the left side)
j = .063140328 or .0631 or 6.31%

Comparison of two rates

1. Which is better: 9% (m=2) or 9% (m=4)?


Given:
j = 9% or .09
m1 = 2
m2 = 4

Solution
U1 = (1 + j/m)m – 1
U1 = (1 + 09/2)2- 1
U1 = (1.045)2 - 1
U1 = 1.092025 – 1
U1 = .092025 or 9.20%

U2 = (1 + .09/4)4 – 1
U2 = (1.0225)4 - 1
U2 = 1.093083319 - 1
U2 = .093083319 or 9.31%

If it is investment, it is better to invest at m = 4 because it will earn 9.31% interest. But if you are
going to borrow money, it is better to borrow money at m=2 because you will pay 9.20%
interest only compare to m=4.

2. Which is better to invest money at 7% converted quarterly or at 7 ½% converted semi-


annually?

Given:
j1 = 7% or .07
m1 = quarterly or 4
j2 = 7 ½% or 7.5% or .075
m2 = semi-annually or 2

Solution
U1 = (1 + j/m)m – 1
U1 = (1 + .07/4)4 -1
U1 = (1.0175)4 - 1
U1 = 1.071859031 - 1
U1 = .071859031 or 7.19%
U1 = (1 + j/m)m – 1
U2 = (1 + .075/2)2 – 1
U2 = (1.0375)2 - 1
U2 = 1.07640625 - 1
U2 = .07640625 or 7.64%

So, it is better to invest at 7.5% converted semi-annually because it will give you better returns.

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