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Section 5.2
Introduction
Re-investing your interest income from an investment makes your money grow faster over time! This is what compound interest does. Compound interest uses the same information as simple interest, but what is new is the frequency of compounding n. n=1 annual, n=2 semi-annual, n=4 quarterly, n=12 monthly, n=52 weekly, n=365 daily.
Example
Suppose you invest $32,000 into a certificate of deposit that has an annual interest rate of 5.2% compounded annually for 3 years. ANSWER: Use the compound interest formula. F = 32000(1+.052/4)(4)(3) = 32000(1.013)12 = $37,364.86
Annual Yield
To compare different savings plans, you need to have a common basis for making the comparisons. The annual yield of a compound interest investment is the simple interest rate that has the same future value the compound rate would have in one year.
Derivation of yield
Future Value Compound = Future value simple P(1 + r/n)nt = P(1 + yt) Since this computation is done for 1 year, we set t = 1. P(1+ r/n)n = P(1 + y) Since P appears on both side, we divide by P and P disappears. (1 + r/n)n = 1 + y, now solve for y by subtracting 1 from both sides. The formula for yield is y = (1 + r/n)n 1.