Compounding Frequencies

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Unformatted text preview: can solve for the Effective Annual Rate (EAR) that would give the investor the same return. Bank A: rYr = 12% – After one year: you have – \$1*(1+rYr)=\$1(1+0.12) = \$1.12 = \$1(1+rYr) – So we found that rYr = rYr= EAR (to state the obvious) If interest is compounded once per year, the stated rate is the EAR. Example: What is the effective annual interest rate (EAR) that yields the same return as Bank C s offer of 3% compounded quarterly? a) 12% b) 12.36% c) 12.48% d) 12.55% e) None of the above Correct answer is d) How Interest Rates are Annualized - Interest rates are normally quoted on an annual basis. - So how should one annualize interest rates that are compounded more than once per year? – One could calculate the corresponding effective annual rate (EAR) as we did above or – One could just multiply the effective periodic rate by the number of compounding periods per year. - For a variety of reasons, including tradition, government legislation, and attempts to mislead borrowers, these rates are typically annualized by multiplying them by the number of compounding periods per year. - These artificially created annual rates are called nominal rates, or quoted rates, or stated rates. - This is how Annual Percentage Rates (APRs) are calculated (by law) – Said differently, APRs are nominal rates! – We usually call them nominal interest rates compounded m 12 times per year, or im. (note: book uses ‘q’ instead of ‘i’)...
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## This document was uploaded on 03/17/2014 for the course COMM 298 at University of British Columbia.

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