EFFECTIVE ANNUAL INTEREST RATE

Self Test Questions

1.How do we compute the effective annual interest rate

The formula and calculations are as follows:

1.Effective annual interest rate = (1 + (nominal rate / number of compounding periods))

^ (number of compounding periods) - 1.

2.For investment A, this would be: 10.47% = (1 + (10% / 12)) ^ 12 - 1.

3.And for investment B, it would be: 10.36% = (1 + (10.1% / 2)) ^ 2 - 1.

2.Will the effective annual rate increase as the frequency of compounding increase?

increasing the number of compounding periods makes the effective annual interest rate
increase as time goes by. ... Increasing the number of compounding periods increases
the effective annual rate as compared to the nominal rate.

Exercise 9

Effective = [1 + R/M]ᵐ- 1

EAR =