Effective annual yield

Definition

Effective annual yield (EAY) is the real annual return on an investment, taking into account the effect of compounding interest. It provides a more accurate measure of financial performance than nominal interest rates.

5 Must Know Facts For Your Next Test

1. EAY accounts for the frequency of compounding within a year.
2. It is always higher than or equal to the nominal interest rate when interest is compounded more than once a year.
3. The formula to calculate EAY is (1 + i/n)^n - 1, where i is the nominal rate and n is the number of compounding periods per year.
4. EAY allows investors to compare different financial products with varying compounding intervals.
5. Understanding EAY helps in making better financial decisions by showing the true earning potential of investments.

Review Questions

• What does EAY take into account that nominal interest rates do not?
• Why is EAY typically higher than nominal interest rates when compounded frequently?
• How can you calculate EAY from a given nominal rate and compounding frequency?

Related terms

Compound Interest: Interest calculated on both the initial principal and the accumulated interest from previous periods.

Nominal Interest Rate: The stated interest rate of an investment or loan, without taking into account compounding.

Annual Percentage Rate (APR): The yearly cost of funds expressed as a percentage, which does not take compounding into account.