True or False: The effective annual rate of return considers the effect of compounding while the nominal rate does not.A.TrueB.False

Answer

A. True

Explanation

The effective annual rate (EAR) of return accounts for the effects of compounding over a specific period, reflecting the true economic benefit of an investment. It provides a more accurate representation of the potential earnings by factoring in how often interest is applied to the principal. In contrast, the nominal rate of return does not take compounding into consideration; it merely reflects the stated interest rate without adjustment for the frequency of compounding periods within a year.

For example, if a nominal rate is 12% per year compounded quarterly, the EAR would be higher than 12% because the interest earned in each quarter will itself earn interest in subsequent quarters. As a result, the higher the frequency of compounding, the greater the difference between the nominal and effective rates. Thus, the statement is true.