Question

Given an Annual Percentage Rate (APR), the _________ frequent the compounding periods, the __________ the Effective Annual Rate (EAR).

		less, higher
		The relationship cannot be determined.
		more, lower
		more, higher

Answer 1

Given an Annual Percentage Rate (APR), the more frequent the compounding periods, the higher the Effective Annual Rate (EAR). This is because when we compound it more often, the interest earned in compounding in a small period will also be earning interest now. For e.g. if we compare an yearly compounding loan and a monthly compounding loan with the same APR, we see that the yearly loan will earn interest at the year end while the monthly loan will earn interest each month. Hence, the monthly interest earned in the first month will also start earning interest in the following months. That's the reason why compounding is called the "eighth wonder of the world".