1 A Primer on the Time Value of Money
All of us have either paid and/or received interest at some point in our lives. Those of us who have taken educational, housing, or automobile loans have paid interest to the lending institution. On the other hand, those of us who have deposited funds with a bank in the form of a savings account or a time deposit have received interest. The same holds true for people who have bought bonds or debentures.
Interest may be defined as the compensation paid by the borrower of capital to the lender, for permitting him to use his funds. An economist would define interest as the rent paid by the borrower of capital to the lender, to compensate him for the loss of the opportunity to use the funds when it is on loan. After all when we decide not to live in an apartment or house owned by us, we typically let it out to a tenant. The tenant will pay us a monthly rental because as long as he is occupying our property, we are deprived of an opportunity to use it ourselves. The same principle is involved when it comes to a loan of funds. The difference is that the compensation in the case of property is termed as rent, whereas when it comes to capital, we term it as interest.
Nominal and Effective Rates of Interest
The quoted rate of interest per period is called the nominal rate of interest. The nominal rate is usually quoted on a per annum basis. The effective rate of interest may be defined as the interest that a unit of currency invested at the beginning of a year would have earned by the end of the year. Quite obviously the effective rate will be equal to the quoted or nominal rate if interest is compounded once per annum. However, if the interest is compounded more ...
