Question

2. Describe in your own words how effective and nominal are used as adjectives to describe interest rates. Explain how to convert between the two, and explain why you might need to use both to analyze a financial situation.

Answer 1

Interest rate quoted is called nominal interest rate. For example a loan bearing 10% interest rate compunded semi annually , here 10% is nominal interest rate while effective rate of inteerst has to be calculated. It can be calculated as below :

[(1+nominal rate/m)^m-] 1

m= no of compounding period

Continuing above example let us calculate effctive rate of return

=[(1+10%/2)^2] - 1

=[(1+5%)^2] -1

=(1.05)^2 - 1

=1.1025-1

=10.25%

In this way nominal interest rate and effective interest rate differs