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Basics and Applications of Finance (File - 6) - Compressed

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15 views3 pages

Basics and Applications of Finance (File - 6) - Compressed

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Chandni garg
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BASICS OF FINANCE

Nominal and Effective Rates of Interest

An interest rate takes two forms:

1)Nominal interest rate: The nominal interest rate does not take into account the compounding
period. It is the rate of interest before adjustment for inflation. An interest rate is called nominal if
the frequency of compounding is not similar to the basic time unit (generally a year). For example,
if the nominal interest rate offered on a three-year deposit is 4% and the inflation rate over this
period is 3%, the investor’s real rate of return is 1%. The nominal rate is the stated rate associated
with a loan

2)Effective interest rate: The effective interest rate does take the compounding period into
account and thus is a more accurate measure of interest charges. The effective interest rate is
always calculated as if compounded annually. With other periods of time than the year -
like month, week, or day - the interest rate may be called effective interest rate. The consumer pays
an effective rate that varies based on fees and the effect of compounding.

The effective rate is calculated in the following way,

1) When the nominal rate is converted n times in a year,

𝒓 𝐧
Effective rate, (re ) = (𝟏 + 𝒏)

where r is the effective rate, i the nominal rate (as a decimal, e.g. 12% = 0.12), and n the number
of compounding periods per year (for example, 12 for monthly compounding).

2) When the nominal rate is compounded continuously,

Effective rate, (re ) = er – 1

When the nominal rate is compounded continuously and reaches almost ∞, at such a stage
effective rate is called force of interest. The force of interest is less than the annual effective
interest rate, but more than the annual effective discount rate.

Example 33: Effective rate a Money lender charges "interest at the rate of 5 paisa per rupee per
month, payable in advance. What effective rate of interest does he charge per annum?
Solution: 5 paise interest on 95 paisa in advance
5 1
 Interest per month = =
95 19
12 12
 1  20 
 re = (1 + r) − 1 = 1 +  − 1 =   − 1
12

 19   19 
12
 20 
 1 + re =  
 19 
Taking logarithm both sides, we obtain
 Log(1 + re) = 12(log 20 − log 19) = 12(1.3010 − 1.2788)
 log(1 + re) = 0.2664  1 + re = AL(0.2664)
1 + re = 1.847  re = 0.847
 Effective rate of interest, re = 84.7%

Example 34: Calculate force of interest corresponding to the effective rate of interest of 6%.
Solution: re = 6% = 0.06
re= er − 1
0.06 = er − 1 or er = 1 + 0.06 = 1.06
r log e = log(1.06) = 0.0253
0.0253 0.0253`
r= = = 0.0583 = 5.83%
log e 0.4343
Thus, the force of interest corresponding to the effective rate of interest of 6% is 5.83%.

Example 35: Find the effective interest rate equivalent to the nominal interest rate 6%
compounded quarterly.
Solution: Normal rate of interest (r) = 6% = 0.06
Since interest is compounded quarterly, m = 4
m 4
 r   0.06 
re = 1 +  − 1 = 1 +  −1
 m  4 
= (1.015)4 − 1 = 1.06136 − 1 = 0.06136
 re = 6.14 (approx.)

Example 36: A bank pays 6% p.a. compounded quarterly. If ₹8,000 is placed in savings account
and the quarterly interest is left in the account, how much money is in the account after three years?
What is the effective rate of interest?
Solution: Given P = ₹8,000, r = @ p.a. = 0.06
t = 3 years quarterly, M=4
We know, that
mt 48
 r   0.06 
A = P 1 +  = 8, 000 1 + 
 m  4 
= 8,000(1 + 0.015)12 = 8,000(1.015)12
= 8,000  1.1956 = ₹9,564.80
m
 r 
 Effective rate (re ) = 1 +  − 1
 m
4
 0.06 
= 1 +  − 1 = (1.015) − 1
4

 4 
= 1.06136 − 1 = 0.06136 = 6.14% (approx.)

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