Financial institutions like to advertise the interest rates their products return to investors. Most ads list an annual percentage rate, which you can use to calculate the yearly return using the compound interest formula. Some ads, however, list an annual percentage yield, which is the net return and not the actual interest rate applied to the investment.
- [Instructor] Financial institutions like to advertise the interest rates that their products return to investors. Most ads list an annual percentage rate, which you can use to calculate the yearly return using the compound interest formula. Some ads, however, list an annual percentage yield, which is the net return and not the actual interest rate applied to the investment. When comparing two or more investment opportunities, you must make sure that all of the investment's terms are expressed using the same type of interest rate. Either APR or APY.
In this movie, I will show you how to convert between those two types of rates, nominal and effective. My sample file is NominalAndEffective_01_05 and you can find it in the chapter one folder of your exercise files collection. In this workbook I have the data that I need to calculate both annual percentage rate given APY and annual percentage yield given APR. We'll start on the left with the nominal rate and what I want to do is calculate the annual percentage rate or APR given the APY here in cell B5.
To do that I will use the NOMINAL function. So I'll click in cell B8. Type an equals sign and then type nominal. When I do, I see that I need to input the effective rate and the number of periods per year. The effective rate is the APY, that's in cell B5. So I'll go ahead and click that cell. Then a comma. And then the number of periods per year. I'm assuming monthly compounding, so that would be 12.
So I'll click cell B6. Type your right parenthesis and press enter. And when I do, I see that the annual percentage rate that equates to an annual percentage yield of 5% is 4.89 and if I were evaluating an investment, I would see that my APR of 4.89 given a principal of $20 million and a term of 10 years, would return a future value of $32,234,973.
Now let's take a look at the effective rate or the APY given an APR. I'll click in cell E8. Type an equals sign and I want to use the EFFECTIVE function, so that is effect and I need the nominal rate, which is the APR. That's here in cell E5, then the comma and the number of periods is 12 and that's in E6. Type a right parenthesis, press enter.
And I see that the annual percentage yield for a 5% APR is 5.12%. And if I look for the terms of my investment, I see that, in fact, the APR of 5% returns about $340,000 more than a similar investment with a 5% APY. Every fraction of a percentage point of interest makes a big difference in the value of a loan or investment. Especially when the amounts are in the millions of dollars.
You should use the NOMINAL and EFFECT functions to ensure the interest rates of the investments you're considering are expressed using consistent terms.
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- Analyzing loans, payments, and interest
- Calculating depreciation
- Determining values and rates of return
- Calculating bond coupon dates and security durations
- Calculating security prices and yields
- Calculating prices and yields of securities with odd periods
- Analyzing simulation results