A 3-month CD currently pays a 6% annual interest rate. A 4-month CD also pays a 6% annual interest rate.
(a) What are the effective annual returns (EARs) for the CDs (assuming 12 months, instead 365 days, in a year when compounding)?
(b) Why do these two CDs have the same annual rate but different EARs?
(c) Assuming the rates will remain unchanged for the next 12 months, which investment strategy below gives you a greater return for an investment period of 12 months?
(i) Buy 3M CD at 6% and at maturity reinvest the proceeds in 6% 3M CD three times until the 12M holding period is up (i.e. at maturity, receive the money and invest all the proceeds in a new 3M CD at 6% again; repeat three times).
(ii) Buy 4M CD at 6% and at maturity reinvest the proceeds in 6% 4M CD twice until the 12M holding period is up (i.e. at maturity, receive the money and invest all the proceeds in a new 4M CD at 6% again; repeat twice).