Your bank offers you a £100,000 line of credit with an interest rate of 2.5% per quarter.The loan agreement also requires that 4% of the unused portion of the credit line be deposited in a non-
Interest bearing account as a compensating balance.Your short-term investments are paying 1.25%
Per quarter.What is your effective annual interest rate on this arrangement if you do not borrow any
Money on this credit line during the year? Assume that both the funds you borrow and the funds
You invest use compound interest.

Question

Quizplus · Accepted Answer

The effective annual interest rate is calculated by considering the opportunity cost of the compensating balance. The compensating balance is 4% of £100,000, which is £4,000. This amount could have been invested at 1.25% per quarter, compounded quarterly. The opportunity cost is calculated as: (1 + 0.0125)^4 - 1 = 0.0509 or 5.09%.

Your Bank Offers You a £100,000 Line of Credit with an Interest