The Compound Amount of One refers to the value that one dollar (or any single unit of currency) will grow to over a specified period of time when interest is compounded at a specific rate. This concept is fundamental in finance and investment as it helps determine the future value of investments, savings, and deposits.
The Formula
The compound amount \( A \) of one dollar after \( n \) periods at an interest rate \( r \) can be expressed with the formula:
where:
- \( A \) = Compound amount of one dollar.
- \( r \) = Interest rate per period.
- \( n \) = Number of compounding periods.
Illustrated Example
To illustrate, let’s consider a dollar deposited in a bank that offers an 8% annual interest rate with annual compounding.
Year-by-Year Calculation
Starting with $1.00:
-
Year 1:
$$ A_1 = 1 \times (1 + 0.08)^1 = 1.08 $$ -
Year 2:
$$ A_2 = 1 \times (1 + 0.08)^2 = 1.1664 $$ -
Year 3:
$$ A_3 = 1 \times (1 + 0.08)^3 = 1.2597 $$ -
Year 4:
$$ A_4 = 1 \times (1 + 0.08)^4 = 1.3605 $$ -
Year 5:
$$ A_5 = 1 \times (1 + 0.08)^5 = 1.4693 $$
The table below summarizes the balance each year for 5 years:
| Year | Balance ($) |
|---|---|
| 1 | 1.08 |
| 2 | 1.1664 |
| 3 | 1.2597 |
| 4 | 1.3605 |
| 5 | 1.4693 |
(Note: Include a corresponding image illustrating the compound amount growth)
Special Considerations
Different Compounding Periods
Interest can also be compounded more frequently than annually, such as semi-annually, quarterly, monthly, or daily. The formula adapts as follows:
where:
- \( m \) = Number of compounding periods per year.
Continuous Compounding
For continuous compounding, the formula becomes:
where:
- \( e \) is the base of the natural logarithm (approximately 2.71828).
- \( t \) is the time in years.
Historical Context
The concept of compound interest dates back to ancient civilizations, with records indicating usage in Babylonian financial transactions. Modern formalization and widespread use arose in the 17th century, profoundly impacting banking, finance, and investment strategies.
Applicability
The compound amount of one is widely used in various financial contexts, including:
- Investment Planning: Projecting future value of portfolios.
- Savings Accounts: Estimating how much savings will grow.
- Debt Management: Understanding accrual of interest on loans.
- Actuarial Calculations: In insurance and pension fund management.
Related Terms
- Simple Interest: Interest calculated on the principal amount only.
- Present Value: The current worth of a future sum of money.
- Future Value: The value of a current asset at a future date based on an assumed rate of growth.
FAQs
What is the difference between simple and compound interest?
How does the frequency of compounding affect the compound amount?
Can the compound amount of one be applied to any currency?
References
- “Principles of Risk Management and Insurance” by George E. Rejda.
- “Corporate Finance” by Jonathan Berk and Peter DeMarzo.
- Financial and banking records from Babylonian civilization.
Summary
Understanding the compound amount of one is crucial for anyone involved in finance and investment. It illustrates how investments grow over time when interest compounds, providing valuable insights for making informed financial decisions. This concept is not just limited to theoretical applications but has practical implications across various sectors, including banking, insurance, and investment planning.
