Chartered Institute of Stockbrokers (CISI) Professional Practice Exam

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How is the effective annual interest rate calculated?

  1. By multiplying the annual rate by the frequency it is charged

  2. By dividing the annual rate by the frequency it is charged and then compounding it

  3. By adding the nominal rate to the inflation rate

  4. By multiplying the nominal rate by the number of years

The correct answer is: By dividing the annual rate by the frequency it is charged and then compounding it

The effective annual interest rate is calculated by taking the nominal interest rate and adjusting it based on the frequency of compounding within a year. This means that if interest is compounded more frequently than annually, you must account for this additional growth by dividing the nominal rate by the number of compounding periods per year. Then, you compound that result over the number of periods to find the equivalent rate that reflects the true cost of borrowing or the true yield on an investment over a year. This approach captures the effects of compounding, which can significantly increase the total interest earned or owed compared to simply using the nominal rate. Therefore, calculating the effective annual interest rate in this manner provides a more accurate picture of the interest being charged or earned over time, accounting for how often interest is applied to the principal.

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