Engineering Economics & Management
(MS490)
Chapter 4
Nominal and Effective Interest Rates
Muhammad Ullah
Assistant Professor
Department of Management Sciences GIKI
Recap
• Single-Payment
[Compounding]
[Discounting]
• Uniform Series /Annuities If ,
and
----- sinking fund factor
----- Uniform Series Compound Amount Factor
Nominal and effective interest rates
• We learned that the primary difference between simple
interest and compound interest is that compound interest
includes interest on the interest earned in the previous
period, while simple interest does not.
• Here we discuss nominal and effective interest rates,
which have the same basic relationship.
• The concepts of nominal and effective must be used when
interest is compounded more than once each year.
3
Nominal interest rates
• A nominal interest rate r is an interest rate that
does not account for compounding.
By definition:
r = interest rate per time period x number of periods
4
Nominal interest rates
• A nominal rate may be calculated for any time period
longer than the time period stated.
For example, the interest rate of 1.5% per month is the same
as each of the following nominal rates.
These nominal rates are calculated in the same way that simple rates, that is, interest
rate times number of periods. 5
Compounding period (CP)
• After the nominal rate has been calculated, the
compounding period (CP) must be included in the interest
rate statement.
• As an illustration, consider the nominal rate of 1.5% per
month.
– If we define the CP as 1 month, the nominal rate statement is
18% per year, compounded monthly, or 4.5% per quarter,
compounded monthly.
• Now we can consider an effective interest rate
6
Effective interest rate
• An effective interest rate i is a rate wherein the compounding
of interest is taken into account.
• Effective rates are commonly expressed on an annual basis as an
effective annual rate; however, any time basis may be used.
• Interest rate statement:
– 10% per year, compounded monthly, or 12% per year, compounded
weekly.
– If the CP is not mentioned, it is understood to be the same as the
time period mentioned with the interest rate.
o For example, an interest rate of “1.5% per month” means that interest
is compounded each month; that is, CP is 1 month
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Effective Interest Rate per CP (Periodic
Interest Rate)
Example: Assume per year, compounded monthly. Then;
per month compounded monthly.
Effective Annual Interest Rate
Suppose represent the Effective Annual
Interest Rate.
-----(1)
Assume
We also know that;
Similarly
Where is the effective interest rate per
compounding period.
Example # 1
For a nominal interest rate of 12% per Nominal rates are
year, determine the nominal and converted into effective
annual rates via the
effective rates per year for (a) quarterly,
equation:
and (b) monthly compounding
Solution:
(a)
effective annual interest
rate
effective rate for one
compounding period
number times interest is
compounded per year
(b)
Example # 2
Nominal rates can be
For an interest rate of 1.2% per converted into effective
month, determine the nominal and rates
for any time period via
effective rates (a) per quarter, and the following equation:
(b) per year
Solution:
(a)
effective annual interest
rate for any period
nominal rate for the
same period as
number times interest is
compounded in period
(b) specified for
Problem # 4.10
The Second National Bank of Fullertum advertises an APR of
14% compounded monthly for student loans. Determine the
APY.
Solution:
APR: Annual Percentage Rate => it is Nominal Rate
APY: Annual Percentage Yield => it is Effective Rate
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Problem # 4.11
For an effective annual rate of 15.87% compounded quarterly,
determine;
(a) the effective quarterly rate and
(b) the nominal annual rate.
Solution:
(a) Use Equation [4.4]:
(b)
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Thank You
Any Questions?
Email:
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