Final answer:
The true cost of borrowing is the effective annual rate (EAR), which accounts for compounding's effect on the loan. Real interest rates factor in inflation or deflation, affecting borrowing costs, and bond pricing relates to future expected payments' present value.
Step-by-step explanation:
The true cost of borrowing is best represented by the effective annual rate (EAR). This rate takes into consideration the effects of compounding, which means it accurately reflects the actual cost paid on a loan after including how often interest is applied to the balance. In contrast, the annual percentage rate (APR) might not include the impact of frequent compounding throughout the year, and the quoted interest rate may be the stated rate without accounting for compounding or fees. The periodic rate is the interest rate for a specific period but does not give a yearly cost comparison.
Exploring further, real interest rates are calculated by subtracting the rate of inflation from the nominal interest rate. For example, if the nominal interest rate is 7% and the inflation rate is 3%, then the real interest rate is 4%.
In cases of deflation, where there is a decrease in the general price level, the real interest rate could be even higher than the nominal rate, such as in the case where a nominal rate of 7% paired with a deflation rate of 2% would result in a real interest rate of 9%. These rates are crucial to understanding the true cost of borrowing, as they reflect the actual earning or paying potential after inflation or deflation is taken into account.
When considering investments like bonds, the actual rate of return includes both the interest paid and any capital gains realized, and is the total return received by the investor. The price of a bond is based on the present value of its future expected payments, which also relates to the concepts of interest rates and the cost of borrowing.