Submitted by: Submitted by ahpah6
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Category: Other Topics
Date Submitted: 04/28/2011 08:41 AM
In order to do compounding and discounting calculations, the following are required
Value of Cash Flows
Time line
The relevant interest rate
Interest Rates
Interest rates can be quoted either as effective rates (EAR) or annual percentage rates (APR).
To do compounding and discounting calculations, we need the effective rate that corresponds to the timing of the cash flow.
Effective Annual Rate (EAR)
The effective annual rate (EAR) is the total amount of interest that will be earned at the end of one year.
The effective annual rate takes into account the effect of compounding.
For an effective annual rate r, the equivalent n-period discount rate= (1+r) -1
Annual Percentage Rate (APR)
Banks often express their interest rates as annual percentage rates (APR).
The annual percentage rate (APR) is the amount of simple interest earned in one year and does not take into account the effect of compounding.
The APR is typically less than the EAR
The APR itself cannot be used as a discount rate
To work with an APR, you need to know the compounding interval.
An APR of 12% with monthly compounding means an interest rate of 1% per month.
The APR with k compounding periods is a way of quoting the actual interest earned each compounding period.
Interest rate per compounding period =
Where k is the number of compounding periods in one year.
Converting an APR to an EAR
*IF the time period and the compounding period for the APR are the same, you can get the equivalent n-period discount rate by using
There is no need to find the EAR and then find the APR for that period.
What determines interest rates?
Government monetary policy
Expectations of future economic growth
Expected inflation
NOT by decisions made by the RBA
The Nominal Interest rate = The rate quoted by financial institutions and sued for discounting or compounding cash flows
The Real Interest rate = The actual rate of growth of your purchasing power after adjusting for inflation.
Growth...