Question

upon retirement came across the following investment regimes;

a) 12% p.a compounded annually

b) 11% p.a compounded quarterly

c) 10% p.a. compounded monthly

d) 9.85% p.a compounded continuously

 

advise

i) As a rational lender which one would you choose?                        (3 marks)

ii) As a rational borrower which of the regimes would you choose?             (3 marks)

Answer 1

With compound interest, the rate at which interest accrues depends on the frequency of compounding, such that compounding interest semiannually would accrue more interest than compounding annually.

As a rational lender which one would you choose?

As a rational lender, aiming to earn a higher interest on the money lent to a borrower, I would choose 9.85% p.a compounded continuously. In this regime the money lent continuously earns interest, refeeds the interest into the balance then the interest itself earns more interest.

As a rational borrower which of the regimes would you choose?

As a rational borrower seeking to minimize the interest I will have to pay to the lender, I would choose 12% p.a compounded annually. Here the frequency of compounding will be less than any other regime listed above and hence low interest will accrue.