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Problem Set #2
Compounding Frequency and Discounted Cash Flows
1.
Fixed income investments can be compounded over various periods. The most
common periodic choices are annual, semiannual, and continuous. Suppose you
have $100,000 to invest, and banks
A
,
S
, and
C
offer you the same 8% stated
interest rate on your money, but
A
compounds annually,
S
compounds
semiannually, and
C
compounds continuously.
a. Calculate the future value of your money after 5, 10, and 20 years of compound
interest at each of the three banks.
b. What are the three banks
effective
annual rates of interest? Which bank gives
the best deal (assuming risk is constant among them)?
c. Suppose a fourth bank, Bank
M
, compounds monthly. What
stated
annual rate
does
M
have to offer you to make you indifferent between investing at Bank
M
and the best offer you have from the other three banks? Does your answer depend
on your time horizon (5, 10, or 20 years)?
Solutions:
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 Fall '08
 YONG
 Compounding

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