Question

1. During the early 1980’s interest rates were much higher. Suppose Bank One offered an APR of 125% with annual compounding on a deposit, while Bank Two offered and APR of 10.90% with monthly compounding. Which would you prefer (all else equal)? Show this with effective annual rates. Please show all work and formulas used!

Answer 1

Bank One offers Annual Interest Rate of 12.5%

Effective Annual Rate for Bank 1 = 12.5%

Bank Two offers APR of 10.9% with monthly compound

Effective Annual Rate = ( 1 + r/n)ⁿ - 1

So Effective Annual Rate for Bank 2 = (1 + (0.109/12))¹² -1

Effective Annual Rate for Bank 2 = 11.46%

So Bank 1 offers higher Interest Rate so we will prefer Bank One.