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
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)
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.
Way better than my lecturer explained it. Kudos!