LESSON 2 – EQUIVALENT INTEREST RATES

1 IN THE CASE OF THE SIMPLE INTEREST RATE

As we have mentioned, in general terms, the interest rates given are annual interest
rates. When the operation time includes fractions of years, we need to determine the
corresponding interest rate, named the equivalent interest rate. In the framework of
the simple interest, this will be proportional to the annual interest rate given.

Let us suppose we invest a quantity of capital (PV) during twelve months at a monthly
interest rate (i’) that should produce the same interests as that same capital invested
during a year at an annual interest rate (i). If this requisite is fulfilled, the rates i’ and i
will be equivalent. Then, using the formula of the simple interest we obtain:

PV × i’ × 12 (months) = PV× i = interest return during a year

So, simplifying we obtain that:

i’ × 12 = i

Thus, the monthly interest rate equals the twelfth part of the annual interest rate. In
general terms, we obtain:

 i = i’ × k

Being “k” the number of sub-periods in a year.

2 IN THE CASE OF THE COMPOUND INTEREST

In the case of the compound interest rate, with the same logic, we want to obtain the
same amount of final capital (FV) if we invest the same initial amount (PV), which means

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the same profitability, using the formula for the compound interest rate. Then, we will
obtain the following equality:

PV (1 + i) = PV (1 +i’)12

(1 + i) = (1 +i’)12

= (1 +i’)

- 1= i’

And, in general terms:

-1

Where “k” is the number of sub-periods within a year. In this case, i’ is an interest rate
equivalent to an annual interest rate i. It is not the proportional interest rate used many
times by moneylenders to calculate the month or quarter maturity date of a loan. Now,
if from this formula we want to work out the value of i, we will obtain the following:

i’k = (1 +i) -1k

i’k + 1k = (1 +i)

i’k + 1k -1 = i

(i’ + 1)k -1 = i

i = (1 + i’) k – 1

Consequently, using this last formula we can calculate the annual interest rate
equivalent to a rate i’ referred to a period different from a year. This formula is what we
call the formula of the A.E.R. (Annual Equivalent Rate) or EFF (Annual effective rate)

3 DIFFERENT COMPOUNDING PERIODS

When we have a rate that is not an annual rate, in the case of the compound interest
rate, what happens is that we can invest the interest that we are earning before the year
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end. For example, if the rate is a monthly interest rate, we can invest the interest that
we have earn during the first month in the following months and that is the reason why
we can earn more money with a compound interest rate than with a simple interest
rate, that invest only the initial amount of money in every period.

Till now we have supposed interests were compounded annually, it means that if I
placed 100 euros in a bank deposit at an annual 5% interest rate I obtained 105 euros at
the end of that year and I only could recover and invest my 5 euros’ earnings at the end
of that year. But we can agree a higher frequency for the capitalization of interests. For
example, we can agree to get the interests my money is generating every quarter,
month, week, day, or any other period. If I can get the interests my money is generating
every month what we have is a monthly interest rate (i’). However, the interests are
usually express in nominal annual terms. That means that in many problems the text is
not going to say that the rate is a 1% monthly, instead you will read that the interest is
a nominal 12% compounded monthly. Please, bear in mind that in this case the rate is
the nominal (12%) divided by the number of compounding periods, it is 12 in the case
of months, because there are 12 months in a year, it is 12%/12= 1%, because after one
month we can invest the interest that we have already earn in the following months.
Then, the rate that is not an annual rate (i’) is always equal to the nominal rate divided
by the number of compounding periods, it is:

𝑖
𝑖 =
𝑘

Let us see what is going to happen then trough an example: Imagine you can invest your
100 euros in five different banks that offer a 12% interest rate, but with different
compounding periods. The first bank compounds interest annually, the second semi-
annually, the third quarterly, the fourth monthly and the fifth daily. Now we are going
to calculate the amount of money we will get at the end of the year in every case.

In the case of the first bank we already know what is going to happen because it is the
kind of calculations we have been doing previously. We just need to use the compound
interest rate formula as follows:

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 FV n = PV × (1 + i) n  FV= 100× (1 + 0,12)1 = 112€

In the case of the second bank the interest is 12%, like in the case of the first bank but
with a difference, in this case interest is compounded semiannually. Which means that
after six months we are going to receive the interests that my money is generating and
then I will have the opportunity to reinvest them. Then, after six months I will receive
half of the annual interest rate, it is, a 6% (Note that a 12% compounded semiannually
is equivalent to a 6% semiannual interest rate, which is actually more than an annual
12%). Then we are going to do our calculations considering that the interest rate is 6%
and the number of periods is two, because there are two semiannual periods in a year:

FV= 100× (1 + 0,06)2 = 112, 36€

Or,

.
FV = 100 × (1 + ) =112, 36€

As we can see we earn some more money, 36-euro cents. This is because I have had the
possibility of reinvesting the interest generated during the first six months. We can also
calculate the money that we will have at the end of the year calculating the EFF rate first
and then using the compound interest rate formula considering years. In this case we
must do two different operations:

i = (1 + i’) k – 1 = (1+0.06) 2 – 1 = 0,1236

FV= 100× (1 + 0,1236)1 = 112, 36€

And, as you can see, the result is the same.

In the third bank, where the interest is compounded quarterly, we are going to receive
the payment of interests every three months, as there are three months four times in a
year. Then, we calculate as follows:

VF= 100× (1 + 0,03)4 = 112, 55€

Or,

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 .
FV = 100 × (1 + ) =112, 55€

As in the previous case, it is possible to calculate first the EFF rate for a quarterly interest
of 3% and then use years to do calculations. As you can see, benefit grows if period of
capitalization is shorter.

In the case of the fourth bank the period of capitalization is the month, then:

VF= 100× (1 + 0,01)12 = 112, 68€

Or,

.
FV = 100 × (1 + ) =112, 68€

As in previous cases it is possible to calculate first the effective rate of a 1% monthly and
then use years to do calculations.

In the case of the fifth bank, the interest rate is 12%, but with daily capitalization. It
means that interests are compounded daily. We can use calendar years, considering 365
days per year, or commercial years, considering 360 days per year. If we consider
commercial years, the daily interest rate would be 1/360, it is, 0.0333333%. Then we
calculate as follows:

VF= 100× (1 + 0,000333333)360 = 112, 75€

Or,

, ×
VF = 100× 1 + = 112,75€

Then, the general formula to calculate the future value of an amount of money in the
case compounding periods different from the year is as follows:

×
i
FV = PV× 1 +
k

Where “inominal” is the annual nominal interest rate. This rate is equivalent to the annual
rate (A.E.R. or EFF) if the period of capitalization is one year. And “k” is the number of

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time that a period, different from a year, is contained in one year. It is easy to see that
if “k” is one, then the formula is the one we studied first for the calculation of the future
value.

We can also use this formula to calculate the present value instead of the future value.

We know that the compounding period of interest rate can be agreed, as mentioned
above, and the shorter the compounding period, the greater the profitability. In fact, it
could be agreed that the interests are compounded every infinitely small fraction of
time, what is called compounded continuously. In this case, the number of periods that
fit in a year, "k", tends to infinity. If this happens, we must see what happens when
×
1+ tends to infinity, because if "k" tends to infinity, all this term tends to infinity.

To do this we need only solve the following limit:

×
i
lim 1 + = e
→ k

Where "e" is a mathematical number that has infinite decimals, and whose approximate
value is 2.71828. Thus, the formula for calculating the future value would be as follows:

FV= PV×e

4 INFLATION AND REAL RATES

Inflation usually reduce the annual effective rate (EFF) and their impact should not be
ignored.

Inflation changes the purchasing power of money and so behaves like interest but in
reverse. For example, if inflation in one year is 10%, then €100 worth of goods at the
beginning of the year costs €110 at the end. Thus, if the annual inflation rate is “inf”
(expressed as a decimal), then €100 at the beginning of the year purchases 100/(1+ inf)
at the end.

Then, if we keep our €100 under the mattress, and inflation rate “inf” is constant, after
n year the purchasing power of our money is reduce to:

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 PV 1
FV = = PV
(1 + inf) 1 + inf

Now imagine that we keep our money in an account at an annual effective rate “EFF”. If
the inflation rate “inf” is constant, then after n years, the purchasing power of our
money is:

(1 + EFF) 1 + EFF
FV = PV = PV
(1 + inf) 1 + inf

Then:

 If inf>EFF, then FV is a decreasing sequence. Thus, as time goes by, our money
buys less and less.
 If EFF> inf, then FV is an increasing sequence. Thus, as time goes by, our
money buys more and more.

Then, we can introduce the concept of real rate of interest “ireal”, which is the annual
interest rate at which our money grows when interest is compounded annually adjusted
for inflation.

Thus,

FV = PV(1 + i )

And

(1 + EFF)
(1 + i ) =
(1 + inf)

(1 + EFF) (1 + EFF) 1(1 + inf) 1 + EFF − 1 − inf EFF − inf

i = −1= − = =
(1 + inf) (1 + inf) (1 + inf) 1 + inf 1 + inf

Thus, we can say that if annual inflation rate is inf, then the real rate of interest, ireal, that
corresponds to an annual effective rate of EFF, is

EFF − inf
i =
1 + inf
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Solving for EFF gives

EFF = inf + i + inf ∙ i

A rule of thumb use to estimate the real interest rate is ireal ≈ EFF – inf. But this estimate
is always too high during times of inflation and too low during times of deflation.

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