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Two annual
rates of interest with different conversion periods are said to be
equivalent if they earn the same compound amount for the same time.
For instance, in one year, the compound amount of 10 invested
a) at 12% compounded semi-annually is 10 = = 11.236
b) At 12.36% compounded annually is 10 (1+ 0.1236) = 11.236
When interest is compounded more than once a year, the given rate is called t
nominal rate. The effective rate is the rate that, when compounded annually,
produces the same compound amount each year as the nominal rate j compou
m times a year. In example above, 12% is a nominal rate while 12.36% is an eff
rate.
Derivation of formula:
at these two investment rates. The amount of P at the effective rate w at the
of one year is
-1
-1
0.1255088
12.55%
Solution:
Given: = 14% = 0.14
=2
=
=?
=
=4
=
=
=
=4
=4
=4
= 4(0.034408)
= 0.1376321
= 13.76%
Thus, investing at 13.76% compounded quarterly is equivalent to investing at
compounded semi-annually.
Example
4: Comparison of Two Rates
Which is better, to invest money at 6 % compounded monthly or 6.5%
compounded semi-annually?
(Hint: To compare two rates of interest is to compare their effective rates
Solution:
Given: = 6% = 0.06
= 12
=2
=?
=?
= -1
= -1
= -1
= -1
= 0.0616778
= 6.5% = 0.065
= 0.0660563
Problem Set:
1. Find the effective rate equivalent to 12% compounded
a) annually
b) semi-annually
c) quarterly
d) monthly
2. What nominal rate, converted semi-annually, is equivalent to 6.5% effective
3. What rate compounded monthly will yield the effective rate 7%?
4. Find the rate compounded semi-annually that is equivalent to 15% compoun
monthly.
5. What simple interest rate is equivalent to 12% compounded quarterly in a 3
transaction?
6. What nominal rate converted semi-annually is equivalent to 9% simple inter
a 5-year transaction?
7. Which investment is better: 9% (m=2) or 9% (m=4)?
8. BDO bank offers 6% (m=4) on savings account while BPI bank offers 6.5% (m
If you are a depositor, in which bank would you prefer to put your money?
9. Which investment yields a higher interest: 8% effective rate or 7.5% compo
semi-annually?
Reference Book:
1) Mathematics of Investment
by Victoria C. Naval, N.B. Gorospe, et., al.
2) Fundamentals of Investment Mathematics
by Presentacion Gabriel and Anita C. Ong
Assignment:
Pages: 36
Items: 2, 11, 12, and 14
Book: Mathematics of Investment
by Victoria C. Naval, N.B. Gorospe, et., al.
Frequency of
Conversion
(m)
annually
semi-annually
quarterly
monthly
weekly
daily
1
2
4
12
52
365
107
107.1225
107.1859
107.22901
107.24576
107.25006
Solving for P, the present value of F due at the end of t years at the nominal r
compounded continuously is
P
The base e is a constant where e = 2.71828 The value of and can be
obtained using a scientific calculator. (see the derivation of these formulas in
book).
Example 1: Find the amount of 200 at the end two years if the interest rate
is 9% compounded: a) semi-annually b) quarterly c) monthly, and d) continu
Example 2: Find the present value of 5,000 due in 5 years at 7% converted
continuously.
Example 3: Find the present value of 750, due in 4 years, at the interest rate
8% converted a) annually, b) quarterly, and c) continuously.
Example 4: Find the accumulated value of 9,000 at the end of 5 years if it is
invested at 9% converted continuously.
Example1: Find the amount of 200 at the end two years if the interest rate
is 9% compounded: a) semi-annually b) quarterly c) monthly, and d) continu
Solution:
The amount at the end of 2 years at
a) 9%, m = 2 is = 200 = 200 = 238.50
b) 9%, m = 4 is F = 200 = 238.97
c) 9%, m = 12 is F = 200 = 239.28
d) 9% continuously is = 200 = 239.44
Example
2: Find the present value of 5,000 due in 5 years at 7% converted
continuously.
Solution:
P
= 5,000
= 5,000 (0.704688)
= 3,523.44