Proof that effective annual interest rate increases with compounding period

finance

The effective annual interest rate (EAR) is given by: $1 + EAR = (1+\frac{APR}{k})^k$.

I want to show that this expression is increasing in k for positive k.

Differentiating leads to the key inequality:

$ln(1+\frac{APR}{k}) \geq \frac{APR}{k+APR}$

This inequality can be demonstrated by plotting the functions, but how can it be demonstrated analytically?

Best Answer

Note that in the United Kingdom where we have compound interest, consumer law requires APR and EAR interest rates to mean the same thing (apart perhaps from fees and other non-interest charges). I will use $r$ rather than your APR.

You are asking whether $(1+\frac rk)^k$ is an increasing function of positive $k$ (given fixed and presumably positive $r$)

and have found $f'(k)=(1+\frac rk)^k\left( \log_e(1+\frac rk) - \frac{r}{k+r}\right)$

which, as you note, is positive when $g(k)=\log_e(1+\frac rk) - \frac{r}{k+r} \ge 0$.

You could then say $\lim\limits_{k\to \infty} g(k)=0-0=0$ and $g'(k)=-\frac{r^2}{k(k+r)^2}<0$,

so $g(k)$ is decreasing towards $0$ as $k$ increases,

meaning $g(k)$ is positive for all finite positive $k$ and similarly $f'(k)$ is positive

and thus $f(k)$ is an increasing function of $k$.

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