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EGR2302-Engineering Economics
Al Akhawayn University
EGR2302-Engineering Economics
Al Akhawayn University
Section 4.1
NOMINAL & EFFECTIVE RATES
Compound Interest
Interest computed on Interest
For a given interest period
EGR2302-Engineering Economics
Al Akhawayn University
EGR2302-Engineering Economics
Al Akhawayn University
EGR2302-Engineering Economics
Al Akhawayn University
EGR2302-Engineering Economics
Al Akhawayn University
You will see there are two ways to quote an interest rate:
1. Quote the Nominal rate
2. Quote the true, effective rate.
EGR2302-Engineering Economics
Al Akhawayn University
Examples Follow..
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Al Akhawayn University
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Given:
4.1 Example:
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Qtr. 1
Qtr. 2
Qtr. 3
Qtr. 4
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Al Akhawayn University
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Qtr. 2
Qtr. 3
Qtr. 4
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Qtr. 2:2.25%
Qtr. 3:2.25%
Qtr. 4:2.25%
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0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75% 0.75%
1
10
11
12
23
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Al Akhawayn University
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Al Akhawayn University
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per year.
Note:
No information on the frequency of
compounding.
Must assume it is for one year!
m is assumed to equal 1.
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Section 4.2
Effective Annual Interest Rates
Here, we show how to calculate true, effective,
annual interest rates.
We assume the year is the standard of measure for
time.
The year can be comprised of various numbers of
compounding periods (within the year).
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Al Akhawayn University
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Al Akhawayn University
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Al Akhawayn University
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Al Akhawayn University
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$F=$P(1+ia)1
0
$P = $1.00
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$P = $1.00
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4.2 Rewriting.
F = P + P(ia)
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Al Akhawayn University
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F = P(1 + ia);
F = P( 1 + i )m;
Solve ia in terms of i.
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Al Akhawayn University
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1 + ia = (1+i)m
(1)
ia = (1 + i )m 1
(2)
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Al Akhawayn University
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EAIR = (1 + r/m)m - 1.
(3)
(4)
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EAIR = (1 + 0.08/4)4 1
EAIR = (1.02)4 1 = 0.0824 = 8.24%/year
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Al Akhawayn University
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m = 2 (semiannual compounding)
EAIR = (1 + 0.18/2)2 1 = 18.810%
m = 4 (quarterly compounding)
EAIR = (1 + 0.18/4)4 1 = 19.252%
m = 12 ( monthly compounding)
EAIR = ( 1 + 0.18/12)12 1 = 19.562%
m = 52 ( weekly compounding)
EAIR = (1 + 0.18/52)52 1 = 19.684%
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Al Akhawayn University
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No. of
Comp. Per.
1
2
4
6
12
52
365
8760
525600
31536000
EAIR
(Decimal)
0.1200000
0.1236000
0.1255088
0.1261624
0.1268250
0.1273410
0.1274746
0.1274959
0.1274968
0.1274969
EAIR
(per cent)
12.00000%
12.36000%
12.55088%
12.61624%
12.68250%
12.73410%
12.74746%
12.74959%
12.74968%
12.74969%
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Al Akhawayn University
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PP is now introduced:
PP is the payment period
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Al Akhawayn University
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4.3 Comparisons:
Example 4.4
2.
3.
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CP-1
CP-2
CP-3
Payment Period 1
CP-4
Payment Period 2
Payment
Payment
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Al Akhawayn University
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CP-1
CP-2
CP-3
Payment Period 1
CP-4
Payment Period 2
Payment
Payment
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4.3 Plan 2
3% per quarter, c.q.
Effective=3%/quarter
Find the EIR for 6-months
Calculate:
For a 6-month effective interest rate (1.03)2 1 = 0.0609 = 6.09% per 6-months
Or, for a 1 year effective interest rate (1.03)4 1 = 12.55%/year
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Al Akhawayn University
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r = 8.8%
m = 12
6-months
EIR12-months = (1 + 0.088/12)12 1 = 9.16%/year
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Al Akhawayn University
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6-month
1-year
4.55%
9.31%
6.09%
12.55%
4.48%
9.16%
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Al Akhawayn University
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Al Akhawayn University
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Section 4.4:
Equivalence: Comparing PP to CP
Reality:
PP and CPs do not always match up;
May have monthly cash flows but
Compounding period different than monthly.
Make them match! (by adjusting the interest period to match the
payment period.)
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Al Akhawayn University
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Situations
Situation
PP = CP
PP > CP
PP < CP
Text Reference
Sections 4.5 and 4.6
Sections 4.5 and 4.6
Section 4.7
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Al Akhawayn University
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Section 4.5
Single Amounts: PP >= CP
Example1:
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Al Akhawayn University
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4.5 Example 2.
F 10 = ?
Consider
r = 12%/yr, c.s.a.
0
$1,000
10
$1,500
$3,000
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4.5 Example 2.
F 10 = ?
$1,000
10
12
14
16
18
20
$1,500
$3,000
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4.5 Example 2.
F 20 = ?
Compound Forward
r = 12%/yr, c.s.a.
0
$1,000
10
12
14
16
18
20
$1,500
$3,000
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4.5 Example 2.
Let n count years.
F 10 = ?
Compound Forward
r = 12%/yr, c.s.a.
0
$1,000
10
$1,500
$3,000
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Section 4.6
Series Analysis PP >= CP
Find the effective i per payment period.
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Al Akhawayn University
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F7 = ??
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r = 20%, c.q.
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This is Wrong!
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Al Akhawayn University
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Section 4.7
Single Amounts/Series with PP < CP
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$75
$150
$100
10
11
12
$50
$200
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Al Akhawayn University
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r =12%/yr. c.q.
$120
$90
$45
CP-1
CP-2
2
$75
$150
CP-3
6
$100
CP-4
9
10
11
12
$50
$200
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$150
$200
12
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Al Akhawayn University
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Revised CF Diagram
$90
$90
$45
5
$75
$150
$200 $200
$100
10
11
12
$50
$50
$175
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Revised CF Diagram
$90
10
11
12
$50
$150
$200
$175
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Al Akhawayn University
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r =12%/yr. c.q.
$120
$90
$45
CP-1
CP-2
2
$75
$150
CP-3
6
$100
CP-4
9
10
11
12
$50
$200
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r =12%/yr. c.q.
$120
$90
$45
CP-1
0
CP-2
2
$75
$150
CP-3
6
$100
CP-4
9
10
11
12
$50
$200
80
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Al Akhawayn University
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Section 4.8
Continuous Compounding
Recall:
EAIR = i = (1 + r/m)m 1
What happens if we let m approach infinity?
That means an infinite number of compounding
periods within a year or,
The time between compounding approaches 0.
We will see that a limiting value will be approached
for a given value of r
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Al Akhawayn University
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r m
i = (1 + ) 1
m
Now, examine the impact of letting m approach
infinity.
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Al Akhawayn University
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r m
r
(1 + ) 1 = 1 +
m
m
m
r
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Al Akhawayn University
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Specifically:
1
lim 1 + = e = 2.71828
h
h
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Al Akhawayn University
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m
r
lim 1 + = e,
m
m
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Al Akhawayn University
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So that:
i = lim 1 +
m
m
m
r
1 = e r 1.
Summarizing.
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Al Akhawayn University
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Example:
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r = ln(1 + i )
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4.8 Example
Given r = 18% per year, cc, find:
A. the effective monthly rate
B. the effective annual rate
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Al Akhawayn University
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4.8 Example
To start: er 1 = 0.15
Solve for r
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Al Akhawayn University
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er 1 = 0.15
4.8 Example
er = 1.15
ln(er) = ln(1.15)
r = ln(1.15) = 0.1398 = 13.98%
A rate of 13.98% per year, cc. generates the same
as 15% true effective annual rate.
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Al Akhawayn University
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Section 4.9
Interest Rates that vary over time
In practice interest rates do not stay the same over
time unless by contractual obligation.
There can exist variation of interest rates over time
quite normal!
If required, how do you handle that situation?
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Al Akhawayn University
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$70,000
$35,000
7%
0
(P/F,7%,1)
7%
1
9%
2
$25,000
10%
(P/F,7%,2)
(P/F,9%,3)
(P/F,10%,4)
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P = F1(P/F.i1,1) + F2(P/F,i1)(P/F,i2) +
+ Fn(P/F,i1)(P/F,i2)(P/F,i3)(P/F,in,1)
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P0 =:
1.
$7000(P/F,7%,1)
2.
$7000(P/F,7%,1)(P/F,7%,1)
3.
$35000(P/F,9%,1)(P/F,7%,1)2
4.
$25000(P/F,10%,1)(P/F,9%,1)(P/F,7%,1)2
Equals: $172,816 at t = 0
Work backwards one period at a
time until you get to 0.
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Al Akhawayn University
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8%
9%
10%
11%
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Al Akhawayn University
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Chapter 4 Summary
Many applications use and apply nominal and effective
compounding
Given a nominal rate must get the interest rate to
match the frequency of the payments.
Apply the effective interest rate per payment period.
PP >= CP (adjusting the interest period to match the payment period)
PP < CP (Consider inter-period compounding or not?)
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Al Akhawayn University
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Al Akhawayn University
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