Unformatted text preview: d) Never, ever, EVER, use a nominal interest rate to discount or compound cash flows!!!  Never use ‘(1+im)’ for anything and never
ever put ‘im’ into a denominator!  Nominal rates do not reflect the actual cost of lending/borrowing.  The only thing a nominal rate is good for is to compute the corresponding effective periodic rate.  This effective rate can then be used to compute effective rates for different compounding frequencies. What is the nominal interest rate isemi that yields the same return as a monthly interest rate rmo of 1%? – a) 6.00% – b) 12.00% – c) 12.30% – d) 6.15% – e) None of the above – Correct answer is c) Why Stop Here? Taking Compounding to the Limit  We don t have to stop at monthly or daily compounding. Interest rates could be compounded every hour, every second, or every infinitesimally small time interval.  We call this limit ‘continuous compounding.’  So what happens if interest is compounded continuously (or instantaneously) ? Will the EAR explode or will there be an upper limit?  One can show that: – where e is the base of the natural log (e = 2.718281828.....) The natural log is denoted by ‘ln’. Recall that with daily compounding, the effective annual rate that yielded the same return as 12% compounded daily is equal to 12.7475%  So the difference between daily compounding and continuous compounding is relatively small....
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This document was uploaded on 03/17/2014 for the course COMM 298 at University of British Columbia.
 Spring '14

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