The effective annual rate reflects the impact of

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Unformatted text preview: inal annual rate (i 0.08) when interest is compounded (1) annually (m 1); (2) semiannually (m 2); and (3) quarterly (m 4). Substituting these values into Equation 4.21, we get 1. For annual compounding: EAR 1 0.08 1 1 1 (1 0.08)1 1 1 0.08 1 0.08 8% CHAPTER 4 159 Time Value of Money 2. For semiannual compounding: EAR 1 0.08 2 2 1 (1 0.04)2 1 1.0816 1 0.0816 8.16% 0.02)4 1 1.0824 1 0.0824 8.24% 3. For quarterly compounding: EAR 1 0.08 4 4 1 (1 These values demonstrate two important points: The first is that nominal and effective annual rates are equivalent for annual compounding. The second is that the effective annual rate increases with increasing compounding frequency, up to a limit that occurs with continuous compounding.11 annual percentage rate (APR) The nominal annual rate of interest, found by multiplying the periodic rate by the number of periods in 1 year, that must be disclosed to consumers on credit cards and loans as a result of “truth-in-lending laws.” annual percentage yield (APY) The effective annual rate of interest that must be disclosed to consumers by banks on their saving...
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