Lecture 04 - Nominal Rates

# Lecture 04 - Nominal Rates - Nominal and Effective Rates...

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1 Nominal and Effective Rates Lecture 4

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2 Nominal and Effective Rates Suppose you put \$100 in a savings account that earned 5% per year At the end of the year, you’d have your original \$100 and \$5 in interest However, if the bank paid interest more frequently, you’d actually end up with more money as your interest began to compound Suppose the bank paid interest twice a year (2.5% each time) For the second six months, you would be earning money not on \$100, but on \$102.50
3 Effective Interest Rates At the end of the year, you’d have What if the bank paid interest daily (daily compounding)? Finally, what if the bank paid interest every instant (continuously)? Is this even practical? (No, but it’s easy to use) ( 29 06 . 105 \$ 050625 . 1 100 \$ 2 05 . 0 1 100 \$ 2 = = + ( 29 13 . 105 \$ 0512675 . 1 100 \$ 365 05 . 0 1 100 \$ 365 = = +

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4 Continuous Compounding Let’s look at the general formula for compounding and converting between nominal (the 5%) and effective (the 5.12675%) interest rates: Frequency Periods/Year Nominal
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