Your bank offers you a £70,000 line of credit with an interest rate of 2.75% per quarter.The loan agreement also requires that 5% 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 ½ of
1% per month.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 compensating balance requirement. Since you do not borrow any money, the compensating balance is 5% of £70,000, which is £3,500. The opportunity cost of this compensating balance is the interest you could have earned by investing it, which is 0.5% per month compounded monthly. The effective annual rate is calculated by considering this opportunity cost, leading to an effective annual rate of approximately 6.17%.

Your Bank Offers You a £70,000 Line of Credit with an Interest