Question

1. Simple versus compound interest

Financial contracts involving investments, mortgages, loans, and so on are based on either a fixed or a variable interest rate. Assume that fixed interest rates are used throughout this question.

Sheila plans to loan $1,000 to her friend, who will pay a simple interest rate of 9% every year for the loan. If no payments are made and no further borrowing occurs between them for 5 years, then how much money will Sheila’s friend owe her?

$1,098.10

$1,538.62

$1,450.00

$190.00

Now, assume that Sheila’s friend volunteers to pay compound interest instead of simple interest for her loan. If interest is accrued at 9% compounded annually, all other things being equal, how much money will Sheila’s friend owe her in 5 years?

$1,450.00

$138.48

$1,538.62

$1,090.00

Sheila has another investment option in the market that pays 9% nominal interest, but it’s compounded quarterly. Keeping everything else constant, how much money will Sheila have in 5 years if she invests $1,000 in this fund?

$190.00

$153.09

$1,560.51

$1,093.08

Answer 1

a. The amount is computed as shown below:

= $ 1,000 + $ 1,000 x 0.09 x 5 years

= $ 1,450

So the correct answer is option of $ 1,450

b. The amount is computed as shown below:

= $ 1,000 ( 1.09 )⁵

= $ 1,538.62 Approximately

So the correct answer is option of $ 1,538.62

c. The amount is computed as shown below:

= $ 1,000 ( 1 + 0.09 / 4 )^{4 x 5}

= $ 1,560.51 Approximately

So the correct answer is option of $ 1,560.51

Feel free to ask in case of any query relating to this question