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Unformatted text preview: ual rate of interest
actually paid or earned. Both businesses and investors need to make objective comparisons of loan costs
or investment returns over different compounding periods. In order to put interest rates on a common basis, to allow comparison, we distinguish between nominal and effective annual rates. The nominal, or stated, annual rate is the contractual annual rate of interest charged by a lender or promised by a borrower. The
effective, or true, annual rate (EAR) is the annual rate of interest actually paid or
earned. The effective annual rate reflects the impact of compounding frequency,
whereas the nominal annual rate does not.
Using the notation introduced earlier, we can calculate the effective annual
rate, EAR, by substituting values for the nominal annual rate, i, and the compounding frequency, m, into Equation 4.21:
EAR 1 im
m 1 (4.21) We can apply this equation using data from preceding examples.
EXAMPLE Fred Moreno wishes to find the effective annual rate associated with an 8% nom...
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