Introduction to Forex Markets
The term “Forex market” is used very frequently in the media as well as in day to day life. It conjures up an image of a huge historic building somewhere in Canary Wharf or on Wall Street. However, that is not how the Forex market works. This market is unique in many respects and to […]
The Dot Com Bubble of 2001
The new age high tech generation may seem to be immune to market inefficiencies of the past. They may seem to be aware of the true value of everything because of the vast network of information that they are connected to. However, this did not stop them from falling prey to the folly of an […]
Alternative To Salary Caps: Luxury Tax
The effectiveness of salary caps in meeting the stated objectives has always been a topic of debate. There are many experts who believe that there are other alternatives apart from salary tax that can help achieve the same objective. The luxury tax is an alternative system that has been used in various leagues around the […]
Advantages and Disadvantages of High Yield Bonds
In the previous article, we understood about how high-yield bonds have emerged as one of the biggest market segments in the fixed income securities market. However, before an investor decides to commit a part of their portfolio towards high yield bonds, they must be aware of the various types of advantages and disadvantages that these […]
Dollar Yuan Peg
China has become the largest exporter of goods in the world. This has been a remarkable feat achieved by the Chinese given the fact that just a couple of decades back, their economy was in complete shambles. Part of this feat can be attributed to the world class infrastructure that China has built to enable […]
Theoretically there are two types of interest rates, simple and compounding. However, in finance the word interest usually refers to compound interest. Simple interest almost never factors in financial calculations. In all calculations related to present values and future values, compound interest is used. However, as a student of corporate finance, it is essential to know the difference that compounding intervals have on the effective interest rate that is paid on the investment. This article explains the same:
We are all aware of the difference between simple and compound interest. However, just to reiterate, the principal amount never changes in a simple interest calculation. So if $100 are lent for 3 years at 10% simple interest, the interest paid in each of the 3 years would be $10.
But if $100 were lent at 10% for 3 years and compounding happens annually, the interest payments would be $10, $11 and $13.1 for years 1,2 and 3 respectively. This is because at the end of each period the accrued interest gets added to the principal and therefore the interest in the next period is a little bit more.
In case of compound interest 10% compounded annually and 10% compounded semi-annually i.e. twice a year do not means the same thing. Let’s understand this with the help of an example:
Annual Compounding: $100 @10%, Interest = $10
Semi-Annual Compounding: $100 @10%, Interest $5 after 6 months and %5.25 after another 6 months. Hence the total interest would be $10.25 as opposed to $10 on an annual basis.
Rates Increase As Compounding Intervals Grow Smaller:
As we can see from the above example that semi-annual rates give more interest than the annual rates. We can extend this logic further and say that monthly rates will provide more interest as compared to semi-annual rates and weekly rates will provide more interest than monthly rates.
As a thumb rule, we can say that the smaller the compounding intervals, the higher the interest rates will be. As far as investments are concerned, most rates are compounded annually or semi-annually. Smaller compounding frequencies are not used. In common usage, only in the case of credit cards are the rates expressed as monthly compounding interest rates.
Until now, we have considered discrete intervals at which interest was being paid. We could bring the intervals down to hours, minutes or even seconds and yet they will be discrete. Theoretically it is possible that interest be paid continuously over a given period of time. This is not possible in reality. However, continuously compounded interest rates provide some ease in mathematical calculations. It is for this reason that they are often used in finance. Compounded interest rates can be converted into continuously compounded interest rates by multiplying them with — ert
Where:
e = 2.718
r = annually compounded rate of interest
t = number of time periods
Your email address will not be published. Required fields are marked *
