Advanced Topics

Abstract

Let us begin with a story. Some years ago, banks came up with a new concept for fixed deposits. The concept was to give interest on interest. This was called ‘compound interest’. Before this concept, the interest was calculated only on the principal – and the approach was called ‘simple interest’. One may call them ‘simple interest model’ and ‘compound interest model’. As you can see, these are two different concepts underlying the computation of the maturity amount. In the simple interest model, there is only one source of interest, i.e. the principal, whereas in the compound interest model, there are two sources of interest: the principal as well as the interest earned periodically.