Final answer:
The Annual Percentage Yield (APY) reflects the total amount of interest earned in one year, taking into account the effect of compounding. The formula to calculate it is APY = (1 + r/n)^n - 1, where 'r' is the annual interest rate and 'n' is the number of compounding periods per year. More frequent compounding results in a higher APY.
Step-by-step explanation:
Calculating the Annual Percentage Yield (APY)
The Annual Percentage Yield (APY) reflects the interest rate that is earned at a bank or credit union from a savings account or certificate of deposit (CD). It takes into account the effect of compounding interest, which is the interest on the interest. This means that periodically, the interest that your money earns in an account will in turn earn interest itself.
To calculate the APY, you can use the following formula:
APY = (1 + r/n)^n - 1
Where:
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- r is the annual interest rate (decimal)
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- n is the number of compounding periods per year
For example, if you have a bank account that offers a 2% annual interest rate and the interest is compounded annually (n=1), then the APY is:
APY = (1 + 0.02/1)^1 - 1 = 0.02 or 2% APY
If the interest was compounded monthly (n=12), the APY would be:
APY = (1 + 0.02/12)^12 - 1 = 0.02018 or 2.018% APY
Notice that the APY is slightly higher with more frequent compounding due to the effect of earning interest on interest. In contrast, when considering bonds, the term yield typically refers to the expected return on the investment considering both the interest payments (coupon payments) and any potential difference between the purchase price and the face value if the bond is held to maturity.