CHAPTER 5

Mathematics of Individual Finance

[Mathematics of Individual Finance Page 1] [Time Value Of Money][Future Values] [More Frequent Compounding] [Effective Annual Interest Rate] [Present Value]
[Annuities] [Present Value Of An Annuity] [Annuities Due] [Future Value Of An Annuity] [Determining Payments] [Bond Valuation]
[Uneven Cash Flows] [Amortization Schedule] [Household Capital Budgeting] [Duration] [Summary] [Discussion Questions]
[Problems]

Effective Annual Interest Rate

When a depository institution compounds rates more than once per year, the effective annual rate will become greater than the stated annual rate. This is demonstrated in Example 5-4.

Example 5-4

In Example 5-3, Tim's money market states an annual percent rate of 3.4% per year. What is its effective annual rate as the result of daily compounding?

Solution 5-4

We can calculate this by taking the future value of $1 compounded for 365 periods at a rate of 3.4%/356 or .009315%. On a financial calculator the answer is [365 N 3.4/356 = %i 1 PV CPT FV] = 1.0345829. Subtracting the 1 and converting the decimal to a percent, we have 3.45629% which is a 5.6 basis point (percent of a percent) improvement in the effective rate over the stated rate.

[Present Value]

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