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    Lecture 3

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    Hassan -
    Nominal interest rates are stated rates before adjustments for compounding or inflation. Effective interest rates take compounding into account over time periods less than one year. Real interest rates account for inflation by subtracting it from nominal rates to show the purchasing power gained by savers over time.

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    Lecture 3

    Uploaded by

    Hassan -
    77 views9 pages
    Nominal interest rates are stated rates before adjustments for compounding or inflation. Effective interest rates take compounding into account over time periods less than one year. Real interest rates account for inflation by subtracting it from nominal rates to show the purchasing power gained by savers over time.

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    Nominal interest rates are stated rates before adjustments for compounding or inflation. Effective interest rates take compounding into account over time periods less than one year. Real interest rates account for inflation by subtracting it from nominal rates to show the purchasing power gained by savers over time.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    77 views9 pages

    Lecture 3

    Uploaded by

    Hassan -
    Nominal interest rates are stated rates before adjustments for compounding or inflation. Effective interest rates take compounding into account over time periods less than one year. Real interest rates account for inflation by subtracting it from nominal rates to show the purchasing power gained by savers over time.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 9

    Interest Rates

    Nominal, Effective, and Real Interest Rates


    Nominal Interest Rates
    Nominal Interest rate is stated interest rate before any adjustment
    for compounding or Inflation.

    For example when any return on any financial instrument or


    security is announced, say 7% on Treasury Bill, 8% on Special
    national Saving Certificates.

    Nominal, Effective and Real Interest 2


    Effective Interest Rate
    Very often the interest period, or time between successive compounding, is
    less than one year (e.g., daily, weekly, monthly, or quarterly).
    For example, it is customary as “12% compounded semiannually.” Here the
    annual rate of interest is known as the nominal rate, 12% in this case.
    Here, the actual (or effective) annual rate on the investment is not 12%,
    but something greater, because compounding occurs twice during the year.
    The actual or exact rate of interest earned on the principal during one year
    is known as the effective rate.

    Nominal, Effective and Real Interest 3


    Nominal vs. Effective Interest Rate
    n
    F  P (1  r ) Future Value Formula

    F  P (1  i ) mm Future Value formula with compounding


    m effect

    Equating both formulas as Left


    P(1  r )  P(1  i )mn
    n
    Hand Side is equal in both
    m
    (1  r ) n  (1  i ) mn
    m
    (1  r )  (1  i ) m NR m ER=Effective Interest Rate
    m ER  (1 
    m
    ) 1
    NR= Nominal Interest rate

    r  (1  i m
    ) 1
    m
    Nominal, Effective and Real Interest 4
    Example:
    Compute the effective annual interest rate in each of the following situations.
    a) 10% nominal interest, compounded semiannually.
    b) 10% nominal interest, compounded quarterly.
    c) 10% nominal interest, compounded weekly.

    Nominal, Effective and Real Interest 5


    A credit card company charges an interest rate of 1.375% per month
    on the unpaid balance of all accounts. The annual interest rate, they
    claim, is 12(1.375%) = 16.5%. What is the effective rate of interest per
    year being charged by the company?
    R=12*1.375% = 16.5% which is Annual Percent Rate (APR)
    However, for effective rate, the formula will be used:

    Nominal, Effective and Real Interest 6


    Example:
    An APR of 5.875% produces an effective annual interest rate of
    6.04% What is the compounding frequency (M) in this situation?

    Nominal, Effective and Real Interest 7


    Nominal vs. Real Interest Rate
    A real interest rate is an interest rate that has been adjusted to
    remove the effects of inflation.
    The real interest rate reflects the rate of time-preference for current
    goods over future goods.
    It can be described more formally by the Fisher equation.
    (1+i) = (1+r)*(1+inf)
    If the inflation rate and the nominal interest are relatively low, then:
    r = i - inf

    Nominal, Effective and Real Interest 8


    Example:
    National Savings Certificates (NSCs) are offering interest rate
    at 8% whereas inflation rate in Pakistan is expected to be at
    6%. What will be real interest rate for investors who invest in
    NSCs.
    Fisher equation is (1+i) = (1+r)*(1+inf)
    (1+.08)=(1+r)*(1+.06)
    r = 1.887%
    This equation simply tells that real interest rate can be negative as well.

    Nominal, Effective and Real Interest 9

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