2. Nominal and effective interest rate
Nominal means, “in name only”,
not the real rate in this case.
A Nominal Interest Rate,
is an interest Rate that does not include any consideration of
compound interest
r = (interest rate per period) (No. of Periods)
In common industrial practice, the length of the discrete interest period is assumed to be
1 year and the fixed interest rate i is based on 1 year.
There are cases where other time units are employed. Even though the actual interest
period is not 1 year, the interest rate is often expressed on an annual basis.
3. Examples – Nominal Interest Rates
• 1.5% per month for 24 months
– Same as: (1.5%)(24) = 36% per 24 months
• 1.5% per month for 12 months
– Same as (1.5%)(12 months) = 18%/year
• 1.5% per month for 6 months
–Same as: (1.5%)(6 months) = 9%/6 months or semi-annual
Period
• 1% per week for 1 year
–Same as: (1%)(52 weeks) = 52% per year
4. A nominal rate (so quoted) do not reference the frequency
of compounding. They all have the format “ r% per time period”
• Nominal rates can be misleading
• We need an alternative way to quote interest rates....
• The true Effective Interest Rate is then applied
The Effective Interest Rate (EIR)
• It is a rate that applies for a stated period of time
• It is conventional to use the year as the time standard
• So, the EIR is often referred to as the Effective Annual Interest
Rate (EAIR)
5. Nominal Rates:– Format: “r% per time period, t”
– Ex: 5% per 6-months”
• Effective Interest Rates:– Format: “r% per time period,
compounded ‘m’times a year.– ‘m’ denotes or infers the number
of times per year that interest is compounded.
– Ex: 18% per year, compounded monthly
The Differences
• The Effective interest Rate per compounding
period, CP is:
𝑖 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑝𝑒𝑟 𝐶𝑃 =
𝑟% / 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡
𝑚 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠/𝑡
6. Deriving the EAIR
Invest $1 of principal at time t = 0 at interest rate i per year
.$P = $1.00
$F=$P(1+ia)
1One year later, F = P(1+ia)1
Assume the one year is now divided into “m” compounding
periods.
Replace “i” with “ia” since m now > 1
10. Two similar expressions for F
•F = P(1 + ia);
•F = P( 1 + i )m
•Equate the two expressions;
Solving ‘ia’ in terms of ‘I’
11. Continuous Compounding
What happens if we let m approach infinity?
–That means an infinite number of compounding periods within a year or,
–The time between compounding approaches “0”.
–We will see that a limiting value will be approached for a given value of “r”
13. To find the equivalent nominal rate given the EAIR
when interest is compounded continuously, apply:
14. Problem Statement
An investor requires an effective return of at least 15% per year.
• What is the minimum annual nominal rate that is acceptable if
interest on his investment is compounded
continuously?
A rate of 13.98% per year, cc. generates the same as 15% true
effective annual rate.
Solution
To start: er– 1 = 0.15
15. Following books were used in preparation of notes
Blank, L., Tarquin. A. 2005. Engineering Economy. 6th Edition, McGraw-Hill.
Eschenbach, T. G. 2003. Engineering Economy”, 2nd Edition, Oxford University Press
Riggs, J. L., Bedworth, D. D., Randhawa, S. U. 1996. Engineering Economics”, 4th Edition, Tata McGraw-Hill.
Riggs, J. L., West. T. M. 1986. Essentials of Engineering Economics”, 2nd Edition, McGraw-Hill.
Peter, M. S., Timmerhaus, K. D. 1991. Plant Design and Economics for Chemical Engineers. 4th Edition, McGraw-Hill.
Editor's Notes
Now, examine the impact of letting “m” approach
infinity.