Question

What are the differences between the effective rate of return and a nominal rate of return? In what circumstances can we use these to evaluate different investment opportunities?

Answer 1

Effective rate is also known as Annual equivalent rate. It is used to find out interest earned or paid during the compounding period.

EAR = (1+rate/n )ⁿ -1

Rate = stated rate

n= compounding periods

Assume investment return =4% compounded semiannually

EAR =( 1.02)² -1 = 1.0404 - 1 = 4.04%

It will helpful to find out what is the return on investment if the investment pays semiannually.

Nominal rate of return include the inflation part.

Nominal return = Real return + inflation

If return in investment is 6% and inflation = 2%

Nominal return = 4 +2=6%

Hence the real return = 4%

For the given nominal return the investor needs to find what is the compensation for inflation and what is the real return on investment.