2. Example

Suppose you have an investment of EUR 100'000 that pays an annual return of 8% over the next 5 years, payable with semi-annual interest payments of 4% at the end of every 6 months. What will be the future value of the investment in 5 years?

   

The basic challenge is that the above investment proposal treats time inconsistently: The investment horizon is expressed in years (5 years) whereas the return frequency is expressed in half-years. To compute future values, we have to make sure that we measure time in a consistent way. We can do so in two ways:

 

  1. We can express the interest rate as an Effective Annual Rate
  2. Or we can measure the investment periods in half-years instead of years.

 

The following sections introduce these two approaches. They also show that, when correctly implemented, both approaches yield the same result.