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Exercise 7.4 · Q2

Q.Which is the better investment, 3% per year compounded monthly or 3.1% per year compounded quarterly?

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The key is to convert each nominal rate into its Effective Annual Rate (EAR) — the actual annual growth factor. 3% compounded monthly yields an EAR of about 3.042%, while 3.1% compounded quarterly yields an EAR of about 3.136%. The 3.1% quarterly option is better.


Why we compare effective rates, not nominal ones

When interest is compounded more than once a year, the actual growth over a full year is higher than the stated nominal rate. This happens because each compounding period earns interest on the interest already credited. The Effective Annual Rate (EAR) is the single annual rate that would produce the same final amount after one year as the given compounding schedule. Comparing EARs is the only fair way to decide between two investments with different compounding frequencies.

EAR=(1+rn)n−1\text{EAR} = \left(1 + \frac{r}{n}\right)^n - 1

where rr is the nominal annual rate (as a decimal) and nn is the number of compounding periods per year.


Step-by-step comparison

1. Compute the EAR for 3% compounded monthly

  • Nominal rate: r=0.03r = 0.03
  • Compounding periods per year: n=12n = 12
  • Monthly rate: rn=0.0312=0.0025\frac{r}{n} = \frac{0.03}{12} = 0.0025

The growth factor over one year is:

(1+0.0025)12\left(1 + 0.0025\right)^{12}

Now calculate:

(1.0025)12=1.0304159…(1.0025)^{12} = 1.0304159\ldots

Subtract 1 to get the EAR:

EAR=1.0304159−1=0.0304159≈3.042%\text{EAR} = 1.0304159 - 1 = 0.0304159 \approx 3.042\%

So a 3% nominal rate compounded monthly is equivalent to earning about 3.042% once per year.

2. Compute the EAR for 3.1% compounded quarterly

  • Nominal rate: r=0.031r = 0.031
  • Compounding periods per year: n=4n = 4
  • Quarterly rate: rn=0.0314=0.00775\frac{r}{n} = \frac{0.031}{4} = 0.00775

The growth factor over one year is:

(1+0.00775)4\left(1 + 0.00775\right)^{4}

Calculate:

(1.00775)4=1.031363…(1.00775)^4 = 1.031363\ldots

Subtract 1:

EAR=1.031363−1=0.031363≈3.136%\text{EAR} = 1.031363 - 1 = 0.031363 \approx 3.136\%

So a 3.1% nominal rate compounded quarterly is equivalent to about 3.136% per year.

3. Compare the two EARs

InvestmentNominal RateCompoundingEAR
A3%Monthly3.042%
B3.1%Quarterly3.136%

Since 3.136%>3.042%3.136\% > 3.042\%, the second investment yields a higher actual annual return.

Watch out

A common mistake is to compare the nominal rates directly (3% vs 3.1%) and conclude the 3.1% option is better — which happens to be correct here, but only by luck. If the compounding frequencies were reversed (e.g., 3% quarterly vs 3.1% monthly), the nominal comparison would be misleading. Always compute EARs.

Tip

For a quick mental check: the more frequently interest compounds, the larger the EAR for a given nominal rate. Here, the 3.1% option has both a higher nominal rate and less frequent compounding (quarterly vs monthly), so it wins decisively. But don't rely on intuition — do the math.


✓Final answer

The better investment is 3.1% per year compounded quarterly, because its effective annual rate (3.136%) exceeds that of the 3% monthly option (3.042%).

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