Interest rates may be quoted for days, months, years, or any convenient interval. For example banks may quote a savings rate of 12%, compounded quarterly rather than 2% per quarter. The rate of interest the investor actually realises as a result of compounding is known as the effective interest rate or effective annual rate.
EAR represents the annual rate of return actually being earned after adjustments has been made for different compounding periods.
EAR may be defined in formula as:
Periodic rate = stated annual rate/m
m = number of compounding periods per year
The computation of EAR is necessary when comparing investments that have different compounding periods. It allows for an equal basis for comparison.
Using a stated rate of 6%, compute the EARs for various compounding periods.
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