Question

When comparing two investments with the same effective rate, one with a 4-year term and semi-annual compounding and one with a 2-year term and quarterly compounding, the nominal rate of the 4-year term instrument is ____ the nominal rate of the 2-year term instrument.

   A.   the same as

    B.   lower than

    C.   higher than

Answer 1

Correct answer is C. - higher than

The nominal rate of the 4-year term instrument will be higher than the nominal rate of the 2-year term instrument to get the same effective rate.

The basic difference between Nominal and effective rate is that the nominal rate does not take into account the effect of compounding whereas the effective rate considers the effect of compounding.

More the no. of compounding more will be the effective rate as interest is earned on interest also when there is compounding. More the no. of times compounding is done more the times interest will be earned on previous earned interest.

As in question it is given that the two investment options have same effective rate, but in 2-year term investment option there are more no. of compounding (it is quarterly compounded) where as 4-year term investment is semi-annual compounded.

If the nominal rate of both the options were same, the effective rate of 2 year investment option would be more than the 4 year investment option as there are more no. of compounding in that. Here, to get the same effective rate, the nominal rate of the investment which has less no. of compounding will have to be more than the other.

Hope it helps!