Calculating the Annual Percentage Yield (APY) And Continuous Compounding

Note: This page is best printed in landscape and in colour.

Introduction

In calculating the Annual Percentage Yield (APY) over the course of one year, it is usual to take a nominal interest rate and derive the effective interest rate for a given number of compounding periods. When the number of compounding periods per year is one then the effective interest rate is identical to the nominal interest rate. When the number of compounding periods is infinite then you have continuous compounding, and the effective interest rate is maximised for the same nominal interest rate. For a discussion on the distinction between APY and exponential growth see my article What Is Exponential Growth? for more.

In the tables below I have represented a broad range of positive nominal interest rates (Table1 and Table 2) and negative nominal interest rates (Table 3 and Table 4). In each table, I have calculated the number of compounding periods per year, month, week, day, hour, minute and second. That is, the number of years, months, weeks, days, hours, minutes or seconds in one year.

The results are not the effective interest rates, nor the Annual Percentage Yield (APY), but rather what I call the exponential factor. The formula used is:

F = (1 + (p/C)) ^C

F = Exponential Factor
C = number of compounding periods
p = percentage (e.g. 1% = 1/100)

Example:

Nominal Interest Rate = 1%
Number of Compounding Periods = 12

F= (1+(0.01/12)) ¹² = (1 + 0.0008333333) ¹²  = 1.0008333333 ¹²  = 1.0100459609

Annual Percentage Yield

To calculate the APY, simply subtract 1 from exponential factors listed in the tables below. Or, use the formula:

APY = (1 + (p/C)) ^C - 1

APY = Annual Percentage Yield
C = number of compounding periods
p = percentage (e.g. 1% = 1/100)

Example:

Nominal Interest Rate = 1%
Number of Compounding Periods = 12

APY= (1+(0.01/12)) ¹² - 1 = (1 + 0.0008333333) ¹²  - 1 = 1.0008333333 ¹²  - 1 = 1.0100459609 - 1 =

0.0100459609

Effective Interest Rate

This is another name for Annual Percentage Yield. 

What is the exponential factor?

Essentially, the exponential factor is the factor by which a population or investment would grow for a given effective interest rate. 

The reason why I refer to this factor as the exponential factor is because it is directly linked the number e. In fact, as will be demonstrated, for any given Nominal Interest Rate the limit to the exponential factor is represented by e (represented by the MS Excel function Exp) to the power of that Nominal Interest Rate.

Positive Rates

Table 1: Calculating the Exponential Factor for the given compounding periods  for Nominal Interest Rates 1% to 7%. For any combination of Nominal Interest Rate and compounding periods, the limit to the exponential factor is represented by e (represented by the MS Excel function Exp) to the power of that Nominal Interest Rate.

Table 2: Calculating the Exponential Factor for the given compounding periods for Nominal Interest Rates 10%, 50%, 100%, 200%, 250%, 500% and 1000%. For any combination of Nominal Interest Rate and compounding periods, the limit to the exponential factor  is represented by e (represented by the MS Excel function Exp) to the power of that Nominal Interest Rate.

For a nominal growth rate of 100%, e (represented here by the MS Excel function exp(1)) is defined as the limit to the exponential factor (and hence the effective interest rate) for an infinite number of compounding periods. Thus, as the number of compounding periods increases, so the nominal 100% interest rate approaches the limit e. 

Negative Rates

Table 3: Calculating the Exponential Factor for the given compounding periods for negative Nominal Interest Rates 1% to 7%. For any combination of Nominal Interest Rate and compounding periods, the limit to the exponential factor  is represented by e (represented by the MS Excel function Exp) to the power of that Nominal Interest Rate.

Table 4: Calculating the Exponential Factor for the given compounding periods for negative Nominal Interest Rates 10%, 50%, 100%, 200%, 250%, 500% and 1000%. For any combination of Nominal Interest Rate and compounding periods, the limit to the exponential factor  is represented by e (represented by the MS Excel function Exp) to the power of that Nominal Interest Rate.

Only 1 Compounding Period

When the number of compounding periods for the year is 1, clearly the exponential factor is easily derived simply by adding the nominal interest rate to 1. 

However, this should not be confused with simple interest which gives precisely the same result when restricted to just one year's growth. As explored in my article Linear Growth versus Exponential Growth (and Couttsian Growth), once we extend the growth period beyond just one year the difference between compound interest and simple interest becomes starkly obvious. 

Conclusion

Clearly, the more frequent the compounding periods, the closer we get to the limit (imposed by e) to the effective interest rate. Continuous compounding is yet another example of the direct and binding link between compound growth and exponential growth. The two are intrinsically linked, as explored in my article Compound Growth versus Exponential Growth (and Couttsian Growth). 

The fact is that anything that grows via compound interest grows exponentially. That includes money earned in the form of investments, or owed in the form of loans. It also includes all living creatures, all of which are alive today as the result of a replication event, and the majority of which are individually or jointly capable of a replication event.

Back to Top

Send email to exponentialist@optusnet.com.au with questions or comments about this web site.
Copyright © 2005 David A. Coutts

Last modified: 05 January, 2011