Question

Explain what effective annual rate or annual percentage yield means

Answer 1

Effective annual rate or EAR is actual rate at which the cash flow will occur to a loan or an investment. It takes in account the compounding effect of the percentage quoted by banks or financial institutions.

The rate quoted by banks are generally in form for APR. They don’t quote the rate which an investor is effectively going to pay or receive.

Example - We can derive EAR from APR as shown in below working:

An investment $100 @ 10% of APR for 1 year. Compounded quarterly will work out EAR = 10.38%

EAR = (1 + APR/Compounding frequency)^(Compounding frequency x Year) - 1

EAR = (1 + 10%/4)^(4 x 1) - 1

EAR = 10.38%

This happens because the earned interest rate is reinvested in investment at per quarter.