Scribd
Upload
96 views8 pages

Nominal and Effective Interest Rates: Engineering Economy

economy for engineers

Uploaded by

Hoong
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
96 views8 pages

Nominal and Effective Interest Rates: Engineering Economy

economy for engineers

Uploaded by

Hoong
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 8

Chapter 4

Nominal and
Effective Interest
Rates

Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

© 2012 by McGraw-Hill All Rights Reserved


4-1
LEARNING OUTCOMES
1. Understand interest rate statements
2. Use formula for effective interest rates
3. Determine interest rate for any time period

© 2012 by McGraw-Hill All Rights Reserved


4-2
Interest Rate Statements
The terms ‘nominal’ and ‘effective’ enter into consideration
when the interest period is less than one year.

New time-based definitions to understand and remember

Interest period (t) – period of time over which interest is expressed. For example,
1% per month.
Compounding period (CP) – Shortest time unit over which interest is charged or earned.
For example,10% per year compounded monthly.

Compounding frequency (m) – Number of times compounding occurs within the interest
period t. For example, at i = 10% per year, compounded
monthly, interest would be compounded 12 times during the
one year interest period.
© 2012 by McGraw-Hill All Rights Reserved
4-3
Understanding Interest Rate Terminology
A nominal interest rate (r) is obtained by multiplying an interest rate that is
expressed over a short time period by the number of compounding periods in a
longer time period: That is:
r = interest rate per period x number of compounding periods
Example: If i = 1% per month, nominal rate per year is
r = (1)(12) = 12% per year)

Effective interest rates (i) take compounding into account (effective rates
can be obtained from nominal rates via a formula to be discussed later).

IMPORTANT: Nominal interest rates are essentially simple interest rates. Therefore,
they can never be used in interest formulas.
Effective rates must always be used hereafter in all interest formulas.

© 2012 by McGraw-Hill All Rights Reserved


4-4
More About Interest Rate Terminology
There are 3 general ways to express interest rates as shown below

Sample Interest Rate Statements Comment


i = 2% per month When no compounding period
(1)
i = 12% per year is given, rate is effective

i = 10% per year, comp’d semiannually When compounding period is given


(2)
i = 3% per quarter, comp’d monthly and it is not the same as interest
period, it is nominal

i = effective 9.4%/year, comp’d semiannually When compounding period is given


(3) and rate is specified as effective,
i = effective 4% per quarter, comp’d monthly
rate is effective over stated period

© 2012 by McGraw-Hill All Rights Reserved


4-5
Effective Annual Interest Rates
Nominal rates are converted into effective annual rates via the equation:

ia = (1 + i)m – 1
where ia = effective annual interest rate
i = effective rate for one compounding period
m = number times interest is compounded per year

Example: For a nominal interest rate of 12% per year, determine the nominal
and effective rates per year for (a) quarterly, and (b) monthly compounding

Solution: (a) Nominal r / year = 12% per year


Nominal r / quarter = 12/4 = 3.0% per quarter
Effective i / year = (1 + 0.03)4 – 1 = 12.55% per year
(b) Nominal r /month = 12/12 = 1.0% per year
Effective i / year = (1 + 0.01)12 – 1 = 12.68% per year
© 2012 by McGraw-Hill All Rights Reserved
4-6
Effective Interest Rates
Nominal rates can be converted into effective rates
for any time period via the following equation:

i = (1 + r / m)m – 1
where i = effective interest rate for any time period
r = nominal rate for same time period as i
m = no. times interest is comp’d in period specified for i
Spreadsheet function is = EFFECT(r%,m) where r = nominal rate per period specified for i

Example: For an interest rate of 1.2% per month, determine the nominal
and effective rates (a) per quarter, and (b) per year
Solution: (a) Nominal r / quarter = (1.2)(3) = 3.6% per quarter
Effective i / quarter = (1 + 0.036/3)3 – 1 = 3.64% per quarter

(b) Nominal i /year = (1.2)(12) = 14.4% per year


Effective i / year = (1 + 0.144 / 12)12 – 1 = 15.39% per year
© 2012 by McGraw-Hill All Rights Reserved
4-7
Assignment # 4

4.58
4.59
4.60
4.61
4.62
Due date:27/3/13.

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved


1-8

You might also like