Question

Which of the following investment opportunities has the lowest effective annual return?

Select one:

a.

An investment, which pays 7% nominal interest rate with annual compounding

b.

An investment, which pays 7% nominal interest rate with monthly compounding

c.

An investment, which pays 6% nominal interest rate with daily compounding

d.

There is not enough information to compute effective annual return (EAR)

Answer 1

A) An investment with 7% annual return with annual compunding has an effective interest rate of ( 1 + 0.07/1)^1 = (1.07) = 7% annualy

B) An investment with 7% nominal return with monthly compunding has an effective interest rate of =

( 1 +0.07/12)^12 = 1.0722

which gives an annual effective interest rate of 7.22%

C) An investment with 6% nominal return with daily compunding has an effective interest rate of =  

( 1 + 0.06/365)^365 =

An investment with 7% nominal return with monthly compunding has an effective interest rate of =

( 1 +0.07/12)^12 = 1.06168 = 6.168%

which gives an annual effective interest rate of 6.168%

D) since there is not any data to calculate effective annual rate cannot be calculated.

Out of the above parts options C has the lowest net effective annual interest rate of 6.186%

An investment with 7% nominal return with monthly compunding has an effective interest rate of =

( 1 +0.07/12)^12 = 1.0722

An investment with 7% nominal return with monthly compunding has an effective interest rate of =

( 1 +0.07/12)^12 = 1.0722

An investment with 7% nominal return with monthly compunding has an effective interest rate of =

( 1 +0.07/12)^12 = 1.0722