CFA Level I · CFA Level I Exam · The Time Value of Money in Finance
A bank quotes a stated annual rate of 6.00% on a deposit. Holding the stated rate constant, which compounding frequency will most likely produce the highest effective annual rate?
Daily compounding gives the highest effective annual rate. With the stated rate held constant, more frequent compounding means interest is credited and earns further interest more often, so the EAR rises as frequency increases, approaching the continuous compounding limit.
- AAnnual compounding
- BMonthly compounding
- CDaily compoundingCorrect
Explanation
For a fixed stated rate, a higher compounding frequency produces a higher effective annual rate because interest is earned on previously credited interest more often. Daily compounding is the most frequent of the three, so it gives the highest EAR (about 6.183% versus 6.168% monthly and 6.00% annual).
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