Mathematics of FinancePYQ May 25Question 4318 of 507
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Relationship between annual nominal rate of interest and annual effective rate of interest, if frequency of compounding is greater than one

Options

AEffective rate < Nominal rate
BEffective rate > Nominal rate
CEffective rate = Nominal rate
DEffective rate = 0.9 times Nominal rate
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Correct Answer

Option bEffective rate > Nominal rate

All Options:

  • AEffective rate < Nominal rate
  • BEffective rate > Nominal rate
  • CEffective rate = Nominal rate
  • DEffective rate = 0.9 times Nominal rate

Detailed Solution & Explanation

Let the nominal rate of interest per annum be r\displaystyle r, and the frequency of compounding per year be m\displaystyle m.
The effective annual rate of interest (E\displaystyle E) is given by the formula:
E=(1+rm)m1E = \left(1 + \frac{r}{m}\right)^m - 1
If the frequency of compounding is greater than one (m>1\displaystyle m > 1), and the nominal interest rate is positive (r>0\displaystyle r > 0), then according to the binomial expansion or Bernoulli's inequality, we have:
(1+rm)m>1+m(rm)=1+r\left(1 + \frac{r}{m}\right)^m > 1 + m\left(\frac{r}{m}\right) = 1 + r
Subtracting 1\displaystyle 1 from both sides, we get:
E>rE > r
Therefore, the effective rate of interest is always greater than the nominal rate of interest when compounding is done more than once a year (e.g., semi-annually, quarterly, monthly, etc.).
Hence, **Option B** is the correct answer.

About This Chapter: Mathematics of Finance

Paper

Paper 3: Quantitative Aptitude

Weightage

12-16 Marks

Key Topics

Simple & Compound Interest, Annuity, Perpetuity

The most important mathematical chapter in the entire syllabus. It covers Simple Interest (SI), Compound Interest (CI), Nominal vs Effective rates, Present and Future Value, Annuities (Ordinary and Due), Sinking Funds, and Perpetuities. The concepts learned here are applied heavily in CA Intermediate and Final.

View Official ICAI Syllabus

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