When compounding occurs more than once per year, will the annual effective interest rate be higher...

When compounding occurs more than once per year, will the annual effective interest rate be higher or lower than the nominal rate? Use an example to demonstrate your explanation.

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Expert Solution

When compounding occurs more than once per year, effective annual rate EAR/APY is higher than the nominal rate due to compounding. The more often compounding occurs, the higher the effective interest rate. This occurs because nominal rate does not take into account compounding period but effective interest rate takes the compounding period into account and interest is earned more frequently.

Effective annual rate=(1+nominal rate/compounding periods per year)^compounding periods per year-1

We see in the below table that for all compounding frequencies and rates, effective annual rate is higher than nominal rate. Stated rate is another name for nominal rate. The columns show the effective rate if frequency were semiannual, quarterly, monthly, or daily.

jeff jeffy answered 1 year ago

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