Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

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What does the concept of discrete compounding imply?

Interest is applied continuously
Interest is applied at regular intervals
Interest is ignored
Interest changes based on investment type

The correct answer is: Interest is applied at regular intervals

The concept of discrete compounding refers to the process where interest is calculated and added to the principal amount at specific, regular intervals, such as annually, semi-annually, quarterly, or monthly. This means that the interest earned during one period does not earn interest until the next compounding period, which is a key characteristic of discrete compounding. The application of interest at regular intervals contrasts with continuous compounding, where interest is calculated and added to the account balance at every possible moment. Because discrete compounding allows for clear intervals for interest calculation, it can provide a clear understanding of how much interest will be accrued over time, depending on the frequency of the compounding periods. Understanding this concept is crucial for evaluating various investment vehicles and financial products that utilize different compounding methods.