FM2010 Topic 1b Interest rate and loans [Compatibility Mode]

# FM2010 Topic 1b Interest rate and loans [Compatibility...

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Interest Rate & 2-1 Effective Rate of return

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Classifications of interest rates square6 Nominal rate (I NOM ) – also called the quoted or state rate. An annual rate that ignores compounding effects. I is stated in contracts. Periods must also be 2-2 square6 NOM given, e.g. 8% Quarterly or 8% Daily interest. square6 Periodic rate (I PER ) – amount of interest charged each period, e.g. monthly or quarterly. square6 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 square6 Effective (or equivalent) annual rate (EAR = EFF%) – the annual rate of interest actually being earned, accounting for compounding. EFF% for 10% semiannual investment 2-3 square6 EFF% = ( 1 + I NOM / M ) M - 1 = ( 1 + 0.10 / 2 ) 2 – 1 = 10.25% square6 Should be indifferent between receiving 10.25% annual interest and receiving 10% interest, compounded semiannually.

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Why is it important to consider effective rates of return? square6 Investments with different compounding intervals provide different effective returns. square6 To compare investments with different compounding intervals, you must look at their effective returns (EFF% or EAR). 2-4 square6 See how the effective return varies between investments with the same nominal rate, but different compounding intervals.
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