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Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA MA – FIA FMA › Effective rate
Hi I don’t understand how to solve questions that say to interest is compounded quarterly. How do I find the effective rate for it? Also could you please elaborate on the concept of effective rate, I watched the lectures but I still don’t understand. Is it the actual annual rate after compounding?
How would I calculate the annual rate with the 1+R=(1+r)^12 if interest compounds quarterly?
If interest is compounded quarterly, then if the quarterly interest is r and the annual effective rate is R, then:
1+R = (1+r)^4
(We multiply by 1+r each quarter to add on the interest. It is to the power 4 because there are 4 quarters in a year and so we need to add interest 4 times).
Why do we compound the interest rate? Isn’t it the principal value that’s compounded by adding interest and then calculating interest on the new principal. This is what I’m having trouble understanding.
If you invest $100 at interest of 2% every three months, then after 3 months you will have 100 x 1.02 = $102.
It is then the 102 then earns interest for another 3 months, and so after six months it will become 102 x 1.02 = 104.04 (which is the same as 100 x 1.02^2).
And so on.
Please do watch the lecture again 🙂