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Unformatted text preview: Nominal and Effective Interest Rates Understanding Money Management Nominal and Effective Interest Rates Equivalence Calculations using Effective Interest Rates Debt Management Focus 1. If payments occur more frequently than annual, how do you calculate economic equivalence? 2. If interest period is other than annual, how do you calculate economic equivalence? 3. How are commercial loans structured? 4. How should you manage your debt ? Nominal Versus Effective Interest Rates Nominal Interest Rate : Interest rate quoted based on an annual period Effective Interest Rate : Actual interest earned or paid in a year or some other time period 18% Compounded Monthly Nominal interest rate Annual percentage rate (APR) Interest period 18% Compounded Monthly What It Really Means ? Interest rate per month ( i ) = 18%/12 = 1.5% Number of interest periods per year ( N ) = 12 In words , Bank will charge 1.5% interest each month on your unpaid balance, if you borrowed money You will earn 1.5% interest each month on your remaining balance, if you deposited money 18% compounded monthly Question : Suppose that you invest $1 for 1 year at 18% compounded monthly. How much interest would you earn? Solution : = + = + = a i i F 12 12 ) 015 . 1 ( 1 $ ) 1 ( 1 $ = $1.1956 0.1956 or 19.56% = 1.5% 18% Effective Annual Interest Rate (Yield) r = nominal interest rate per year i a = effective annual interest rate M = number of interest periods per year 1 ) / 1 ( + = M a M r i : 1.5% 18% 18% compounded monthly or 1.5% per month for 12 months = 19.56 % compounded annually Practice Problem...
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This note was uploaded on 04/03/2012 for the course ENGINEERIN 12 taught by Professor Who during the Spring '09 term at Kadir Has Üniversitesi.
 Spring '09
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