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Compounding Techniques
Compounding is a technique used in the treasury markets to calculate the future value of an investment or loan. It involves reinvesting the interest earned on an investment or adding interest charges to a loan’s principal balance, resulting in the interest earning interest. There are several compounding techniques used in the treasury markets, including:
Simple interest: Simple interest is calculated on the principal amount of an investment or loan. The interest earned or charged does not earn interest on itself.
Annual compounding: Annual compounding is the most common compounding technique used in the treasury markets. Interest is added to the principal balance at the end of each year, and the interest earned in the following year is based on the new balance.
Semi-annual compounding: Semi-annual compounding involves adding interest to the principal balance twice a year, resulting in more frequent compounding than annual compounding.
Quarterly compounding: Quarterly compounding involves adding interest to the principal balance four times a year, resulting in even more frequent compounding than semi-annual compounding.
Monthly compounding: Monthly compounding involves adding interest to the principal balance 12 times a year, resulting in even more frequent compounding than quarterly compounding.
Daily compounding: Daily compounding is the most frequent compounding technique used in the treasury markets. Interest is added to the principal balance every day, resulting in the highest potential returns but also the highest risk.
Usually financial problems involve cash flows occurring at different points of time. These cash flows have to be bought to the same point of time for the purpose of comparison and aggregation. Thus we use the tools of compounding and discounting primarily for the purpose of valuing of securities, analyzing projects, choosing right financial instruments, setting loan amortization schedule etc.
The compounding techniques are used to find out the future value (FV) of present money. It is the similar to the concept of compound interest, where the interest earned in a previous year is reinvested at the current rate of interest for the remaining period. Thus, the accumulated amount at the end of a period becomes the principal amount for calculating the interest for the next period.
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