1. 3. Compounding Interest The process where interest earns interest is
called compounding interest.
There are two types of compounding interest:
Discrete compounding
Continuous compounding
12/7/2018
Asitha Kodippili, Ph.D

2. 3.1a) Discrete Compounding
is the computation of interest at fixed intervals
and addition of that interest to successive principals
at the end of those fixed intervals.
The fixed interval for computing interest is called the
computation period.
The frequency of compounding (compounding frequency)
Is determined by dividing the length of the year by the fixed
interval.
12/7/2018
Asitha Kodippili, Ph.D

3. 3.1a) … Notations effective annual interest rate(%).
number of compounding periods per year
nominal rate of interest
interest rate per period (periodic interest rate)
number of years
total number of periods
Example : Annual interest rate of 8% compounded quarterly
(or nominal rate of 8% convertible quarterly).
12/7/2018
Asitha Kodippili, Ph.D

4. 3.1a) … From the definition of equivalency we have
Because each side of the equation gives the
accumulated value of 1 invested for a year.
Therefore effective annual interest rate:
12/7/2018
Asitha Kodippili, Ph.D

5. 3.1a) … Q1
An amount of money is invested for 5 years at a nominal rate of 6% convertible semiannually. Determine
Compounding frequency
the periodic interest rate
the number of periods
effective annual interest rate
12/7/2018
Asitha Kodippili, Ph.D

6. 3.1b) Continuous compounding
In continuous compounding interest is computed and added to the previous balance on continuing basis. However, actual addition of the interest occurs at discrete intervals.
12/7/2018
Asitha Kodippili, Ph.D