Question

RBC is offering a one year Term Deposit that pays 8% compounded quarterly. CIBC is offering a 18-month GIC that pays 8.05% compounded semi-annually. Find the effective rate of interest for both investment options. Explain which option would you choose to invest an amount.

Answer 1

Option 1:

Term of Deposit = 1 year

Interest Rate, i = 8%

Compounding per year, n = 4

Effective Rate of Interest

= (1 + i/n)ⁿ - 1

= (1 + 0.08/4)⁴ - 1

= (1 + 0.02)⁴ - 1

= (1.02)⁴ - 1

= 1.08243216 - 1

= 0.08243216

= 8.243216%

Effective Interest Rate = 8.24%

Option 2:

Term of Deposit = 18 months

Interest Rate, i = 8.05%

Compounding per year, n = 2

Effective Rate of Interest

= (1 + i/n)ⁿ - 1

= (1 + 0.0805/2)² - 1

= (1 + 0.04025)² - 1

= (1.04025)² - 1

= 1.0821200625 - 1

= 0.0821200625

= 8.21200625%

Effective Rate of Interest = 8.21%

Effective Rate of Interest:

Investment Option 1: 8.24%

Investment Option 2: 8.21%

Since effective rate of interest in case of Investment Option 1 is greater than that of the Investment Option 2, it is better to invest in Option 1.

Hence, Investment in one year term deposit that pays 8% compounded quarterly should be chosen.