Question

8. An investor has the choice to compound an investment with a stated 5% annual return either: annually, quarterly, or continuously. The effective annual rate (EAR) is highest with _ compounding and lowest with compounding. A. annual ; quarterly B. quarterly ; annual C. continuous ; annual D. annual ; continuous

Answer 1

Annually:

EAR=[(1+APR/m)^m]-1
where m=compounding periods

=[(1+0.05/1]^1]-1

=5%

Quarterly:

EAR=[(1+APR/m)^m]-1
where m=compounding periods

=[(1+0.05/4)^4]-1

=5.09%(Approx)

Continuous:

EAR=(e)^APR-1

where e=2.71828

=[(2.71828)^0.05]-1

=5.13%(Approx)

Hence the EAR is highest with continuous compounding and lowest with annual compounding