Compounding effect: Difference between revisions

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imported>Doug Williamson
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imported>Doug Williamson
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The additional growth or additional interest, resulting from the compounding effects of - for example - interest on interest.
The additional growth or additional interest, resulting from the compounding effects of - for example - interest on interest.
For example, interest quoted at 6% per annum, compounded annually, for two years maturity, means that the interest accumulated after two years is:
For example, interest quoted at 6% per annum, compounded annually, for two years maturity, means that the interest accumulated after two years is:


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= 12.36% for the two year period.
= 12.36% for the two year period.


Without the additional interest on interest, the total interest would have been simply 6% per annum x 2 years = 12.00%.
 
So the compounding effect of interest on interest here = 12.36% - 12.00% = 0.36% over the two year period (= 6% x 6%).
Without the additional interest on interest, the total interest would have been simply  
 
6% per annum x 2 years  
 
= 12.00%.
 
 
So the compounding effect of interest on interest here  
 
= 12.36% - 12.00%  
 
= 0.36% over the two year period (= 6% x 6%).
 


When both the number of periods and the rate of growth/interest are low, compounding effects are relatively small.
When both the number of periods and the rate of growth/interest are low, compounding effects are relatively small.
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* [[Continuously compounded rate of return]]
* [[Continuously compounded rate of return]]


[[Category:Interest_Rate_Risk]]
[[Category:Manage_risks]]

Revision as of 14:06, 20 September 2014

The additional growth or additional interest, resulting from the compounding effects of - for example - interest on interest.


For example, interest quoted at 6% per annum, compounded annually, for two years maturity, means that the interest accumulated after two years is:

= [1.06 x 1.06] - 1

= 12.36% for the two year period.


Without the additional interest on interest, the total interest would have been simply

6% per annum x 2 years

= 12.00%.


So the compounding effect of interest on interest here

= 12.36% - 12.00%

= 0.36% over the two year period (= 6% x 6%).


When both the number of periods and the rate of growth/interest are low, compounding effects are relatively small. When either the number of periods or the rate of growth/interest - or both - are greater, compounding effects become very much larger.


See also