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Unformatted text preview: Interest Rate & 21 Effective Rate of return Classifications of interest rates s Nominal rate (I NOM ) also called the quoted or state rate. An annual rate that ignores compounding effects. 22 s I NOM is stated in contracts. Periods must also be given, e.g. 8% Quarterly or 8% Daily interest. s Periodic rate (I PER ) amount of interest charged each period, e.g. monthly or quarterly. s I PER = I NOM / M, where M is the number of compounding periods per year. M = 4 for quarterly and M = 12 for monthly compounding. Classifications of interest rates s Effective (or equivalent) annual rate (EAR = EFF%) the annual rate of interest actually being earned, accounting for compounding. 23 s EFF% for 10% semiannual investment EFF% = ( 1 + I NOM / M ) M 1 = ( 1 + 0.10 / 2 ) 2 1 = 10.25% s Should be indifferent between receiving 10.25% annual interest and receiving 10% interest, compounded semiannually. Why is it important to consider effective rates of return? s Investments with different compounding intervals provide different effective returns. s To compare investments with different compounding intervals, you must look at their ffective returns (EFF% or EAR)....
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 Spring '10
 on9
 Compounding, Interest, Interest Rate

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