What is the formula for calculating the Annual Equivalent Rate (AER)?

The Annual Equivalent Rate (AER) is a critical measure used to express the effective interest rate on an investment or loan on an annual basis, taking into account the effects of compounding. The formula provided as the correct choice, (1+r)^(12/n) - 1, reflects a common approach to calculating AER when you have nominal interest rates that are compounded more frequently than annually.

In this formula:

• r represents the nominal interest rate expressed as a decimal.

• n indicates the number of compounding periods per year.

• The term (1 + r) captures the growth due to the interest earned.

• Raising this to the power of (12/n) effectively annualizes the growth, as it adjusts for the frequency of compounding. By subtracting 1, you isolate the interest component, thus providing the AER as a decimal.

This formula is particularly useful because it enables the comparison of different financial products that may have varying compounding intervals. Understanding the AER helps investors and borrowers make more informed decisions about the true cost of loans or the actual return on investments.

In contrast, other choices either relate to different types of calculations or do not specifically address annualized rates with compounding taken into account. The option that