Question

Mona Persian is considering a new investment fund with a semiannual interest rate of 2.5%. Any money she invests would have to be left in it for at least five years if she wanted to withdraw it without a penalty.a)What is the nominal interest rate?b)What is the effective annual interest rate?c)If Mona deposits $10,000 in the fund now, how much should it be worth in five years?

Answer 1

Answer with explanation:

Part (a). The nominal rate of interest is the required return that takes the implications of inflation rate. This means that the investor would desire the return that compensates for the risk associated with the investment and additional return that compensates inflation rate:

Investor Required return = Required return for the risk + return to compensate inflation in economy

This required return is also known as Money rate of return and is calculated by using Fisher formula:

(1+n) = (1+r)*(1+i)

Where i is inflation, r is real return that compensates risk associated with the investment and n is nominal rate of return.

Part (b). Effective annual interest rate is the return percentage that the lender earns after one year of lending. This also means that effective interest rate is the return that lender actually earns after one year of investment.

Part (c). The compounding formula would be used to calculate the future value of the investment after five years. Compounding formula is as under:

Future Value = Present Value * (1+r)^n

Where n is the number of years, r is the required return on the deposit.

Putting values in the above equation, we have:

Future Value = $10000 * (1+0.025)^5years = $11314

The net worth of Mona would increase from $10000 to $11,314 in five year duration if the investment is made today.