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L4._Compounded_Continuously

The document discusses continuous compounding, where interest is calculated and added to the principal continuously. It provides formulas for calculating future value, present value, number of periods, nominal rate, and effective rate of interest for continuous compounding, along with several example calculations. The key concepts are illustrated through practical examples demonstrating how to apply the formulas in various financial scenarios.

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Satyr Codm
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2 views

L4._Compounded_Continuously

The document discusses continuous compounding, where interest is calculated and added to the principal continuously. It provides formulas for calculating future value, present value, number of periods, nominal rate, and effective rate of interest for continuous compounding, along with several example calculations. The key concepts are illustrated through practical examples demonstrating how to apply the formulas in various financial scenarios.

Uploaded by

Satyr Codm
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
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Lecture on Compounded Continuously

Continuous compounding is a concept where interest is calculated and added to the principal
balance of an investment or loan continuously, effectively at every possible instant. This differs
from traditional compounding methods where interest is typically compounded at discrete
intervals such as annually, semi-annually, quarterly, or monthly.

The Formula for Continuous Compounding


The formula for continuously compounded interest is derived from the exponential function and is
expressed as:

where:

• F is the future value of the investment/loan, including interest.


• P is the principal investment amount (initial deposit or loan amount).
• j is the nominal rate of interest compounded continuously
• n is the time or period the money is invested or borrowed for, in years.
• e is the base of the natural logarithm, approximately equal to 2.71828.

Example Calculations

Future Value Calculation


Example 1: Find the accumulated amount of a deposit amounting to $1,000 if the interest is 5%
compounded continuously for 3 years.

Given: Principal (P): $1,000


Nominal rate of interest (j): 5% (0.05)
Time (n): 3 years

Solution:

Final answer: Future Amount (F) = $1161.83

Example 2: Determine the total amount to be paid after 5 years for $2,000 if the interest is 8%
compounded continuously.

Given: Principal (P): $2,000


Nominal annual interest rate (j): 8% (0.08)
Time (n): 5 years

Solution:

Final Answer: Total amount to be paid is $2983.65

Present Value Calculation


The present value (P) can be calculated by rearranging the continuous compounding formula:

Example 3: A $1,500 deposit is to be withdrawn after 4 years. Determine the amount of money to be
deposited today if the interest is 6% compounded continuously.

Given: Future Value (F): $1,500


Nominal interest rate (j): 6% (0.06)
Time (n): 4 years

Solution:

Final Answer: Total amount to be deposited is $1179.94

Example 4: Determine the equivalent present value of $3,000 if the money is withdrawn 10 years
from now with an interest of 4% compounded continuously.

Given: Future Value (F): $3,000


Nominal interest rate (j): 4% (0.04)
Time (n): 10 years

Solution:

Final Answer: Total amount to be deposited is $2010.96

Number of Periods Calculation


The time period (n) can be calculated by rearranging the continuous compounding formula:

Example 5: Determine the number of periods needed for the amount to grow from $1,000 to $2,500
if the interest is 5% compounded continuously.
Given: Future Value (F): $2,500
Principal (P): $1,000
Nominal interest rate (r): 5% (0.05)

Solution:

Example 6: Determine the number of years for an amount of $2,000 to be $5,000 if the interest rate
is 7% compounded continuously.

Given: Future Value (F): $5,000


Principal (P): $2,000
Nominal interest rate (j): 7% (0.07)

Solution:

Nominal Rate Calculation


The nominal annual interest rate (r) can be calculated by rearranging the continuous compounding
formula:

Example 7: A principal amounting to $1,500 is invested in an account and is withdrawn after 6 years
in the amount of $3,000. Determine the nominal rate of interest if the interest is continuous
compounding.

Given: Future Value (F): $3,000


Principal (P): $1,500
Time (n): 6 years

Solution:
Example 8: $10,000 is withdrawn from an account after 12 years. Determine the nominal rate if the
principal is $4,000.

Given: Future Value (F): $10,000


Principal (P): $4,000
Time (n): 12 years

Solution:

Effective Rate of Interest for Continuous Compounding


The effective rate of interest, also known as the annual equivalent rate (AER) or ie, represents the
actual rate of interest earned or paid on an investment or loan over a period, considering the effects
of compounding. For continuous compounding, the effective rate can be calculated using the
formula:

where ‘e’ is the base of the natural logarithm (approximately equal to 2.71828), and ‘j’ is the
nominal interest rate compounded continuously.

Let's explore this with a few examples:

Example 7: If the nominal interest rate is 5% compounded continuously, find the equivalent
effective rate.

Given: Nominal Rate (j): 5% or 0.05

Solution:

Example 8: Determine the effective rate of interest if the nominal rate is 7% compounded
continuously.

Given: Nominal Rate (j): 7% or 0.07

Solution:
Finding the Equivalent Nominal Rate for Compounding Continuously
To find the equivalent nominal rate for continuous compounding given an effective rate, we can
rearrange the effective rate formula:

Let's consider two additional examples:

Example 9: Find the equivalent nominal rate compounded continuously if the effective rate is 6%.

Given: Effective Rate of Interest (ie): 6%

Solution:

Example 10: The effective rate of interest is 12%. Find the equivalent nominal rate of interest if is
continuous compounding.

Given: Effective Rate of Interest (ie): 12%

Solution:

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