Peer to Peer (P2P) Business Model
The internet has enabled the functioning of various new types of business models. The peer-to-peer business model is one such business model which has recently come into existence. Companies such as Outdoorsy and BlaBlaCar have transformed the way in which individuals and small businesses interact with one another. LinkedIn is one of the biggest names […]
The War on Cash
Governments all over the world are fighting a war on cash. It is a known fact that the governments do not like cash. However, what is not clearly known is the reason behind it. What is it that makes governments all over the world unanimously abhor cash and pass legislation to control or even curb […]
An Overview of Contracts and Why They are Important to Business and Society
Contracts govern all transactions whether they are between firms or between firms and private individuals. Indeed, in most of the developed world, any transaction or commercial exchange is usually not undertaken without a contract. This trend is also catching up in the developing world where contracts are increasingly becoming the norm. The importance of contracts […]
Market-Based Vs Bank-Based Financial Systems
Commercial banks do make some money by providing services such as transaction processing and payroll processing to their clients. However, to a large extent commercial banks make money by making loans to corporations. Interest income is the predominant source of income for banks around the world. Now, this puts commercial banks in direct competition with […]
What are Demergers: Its Pros and Cons
Mergers and acquisitions are often used by conglomerates to create value. However, in some cases, demergers have also been effectively used. While the workings of mergers and acquisitions are well known to many people, demerger is still considered somewhat of a mystery. In this article, we will have a closer look at what a demerger […]
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 *
