Question

Which of the following statement(s) is/are most likely to be true?

I. If you were borrowing funds from a bank, and the quoted interest rate was 8% p.a., you

would be better off if the bank used quarterly compounding rather than daily compounding.

II. If you were depositing funds at a bank and the quoted interest rate was 8% p.a., with interest

compounded daily, you would be better off if the bank used a 360-day basis rather than a

365-day basis for compounding the interest rate.

a) I only.

b) II only.

c) Both I and II.

Answer 1

Answer: [a] I only
Explanation:
I] For borrowing the effective annual rate should
be lower.
For instance, consider an interest rate of 12%
per annum.
EAR with quarterly compounding = (1+0.12/4)^4-1 =	12.55%
EAR with daily compounding = (1+0.12/365)^365-1 =	12.75%
As EAR with quarterly compounding is lower, one would
be better of with it while borrowing.
II] With 12%, daily compounding--Days--365/360:
EAR with daily compounding for 365 days count = (1+0.12/365)^365-1 =	12.74746%
EAR with daily compounding for 360 days count = (1+0.12/360)^360-1 =	12.74743%
The EAR is marginally higher for 365 days count and
hence it is beneficial for depositing.
CONCLUSION:
So statement I alone is correct