Effective Annual Yield

When you go to a bank inquiring about the deposit rates, the rates specified by the bank can be expressed in two ways: nominal interest rate and the effective annual rate (also called effective annual yield).

The difference between the two is that the nominal rate does not take compounding into consideration, while the effective annual yield does.

Consider an investment of $100 at a nominal rate of 10% compounded monthly.

The future value of the investment will be:

The effective yield will be the absolute increase as a percentage of the principal invested.

Therefore, the effective annual yield will be:

Since the effective yield considers compounding effect, it will always be greater than nominal yield.

The effective yield can be calculated using the following formula:

Why Calculate Effective Annual Yield?

Effective yield is useful when you are considering various investment options where the interest rates are expressed at different compounding rates. In such a situation, you can convert all the rates into effective annual yields and then make an informed decision.

For example, assume that you have a choice between investing in Bond A offering a nominal interest rate of 5% compounded semi-annually, and another Bond B offering a nominal interest rate of 4.9% compounded monthly. Since the compounding periods are different, a direct comparison is difficult. Therefore, will calculate the effective annual yields for both the bonds:

We can see that the effective yield for Bond B is higher, so, that’s a better investment.

The nominal interest is also known as Annual Percentage Rate (APR). The Effective Annual Yield is also known as Annual Percentage Yield (APY).

You may find these interesting

Price-Yield Relationship
This short video demonstrates the relationship between the bond price and yield. If the price goes u...
Understanding Yield Curve
The yield curve refers to the relationship between the interest rates and the time to maturity of a ...
Current Yield of a Bond
**Current Yield** The current yield of a bond measures the returns an investor can expect if he hol...
Finance Train Premium
Accelerate your finance career with cutting-edge data skills.
Join Finance Train Premium for unlimited access to a growing library of ebooks, projects and code examples covering financial modeling, data analysis, data science, machine learning, algorithmic trading strategies, and more applied to real-world finance scenarios.
I WANT TO JOIN
JOIN 30,000 DATA PROFESSIONALS

Free Guides - Getting Started with R and Python

Enter your name and email address below and we will email you the guides for R programming and Python.

Saylient AI Logo

Accelerate your finance career with cutting-edge data skills.

Join Finance Train Premium for unlimited access to a growing library of ebooks, projects and code examples covering financial modeling, data analysis, data science, machine learning, algorithmic trading strategies, and more applied to real-world finance scenarios.