The amount by which an
investment will grow over a given
number of time periods including the
accumulation of interest.
Compounding is less frequently used
than discounting in investment
analysis. Discounting and
compounding represent the basic
methods to determine the time value
of money.
Compounding involves three
different types of calculations;
discounting involves another three.
In combination, they are referred to
as the six functions of a dollar .
Compounding can involve:
Compounding a single amount
into the future, e.g., interest
on a loan that compounds monthly
but is not due until the end of
the term;
Compounding a stream of
equal payments, e.g., investment
of equal amounts over a
specified period of time at a
given rate of interest; and
Compounding of a stream of
equal payments to create a
future amount (e.g., payments
necessary to produce a given
future value). This form of
compounding is often referred to
by financial institutions as a
sinking fund.
Compounding is most frequently
encountered from a lender’s
perspective when calculating yield
in relation to loans advanced to
borrowers, determining the value of
an annuity, or establishing the
periodic payments required to
produce a specified annuity.
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