Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

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What is the general term for compound interest that is not continuously compounded?

Simple compounding
Discrete compounding
Linear compounding
Negative compounding

The correct answer is: Discrete compounding

The correct answer, discrete compounding, refers to the method of calculating interest on an investment or loan based on a set interval, such as annually, semi-annually, quarterly, or monthly. This means that interest is calculated and added to the principal at these defined intervals, rather than being compounded continuously over time. In discrete compounding, each interest calculation is independent, and the accumulated interest does not continuously contribute to the principal throughout the time period. This approach contrasts with continuous compounding, where the interest is compounded at every possible moment, effectively leading to a faster accumulation of interest than discrete compounding. Understanding discrete compounding is important for evaluating different investment strategies and financial products, as it affects the overall returns in measurable ways depending on the frequency at which interest is compounded. This enhances a fundamental grasp of time value of money concepts, which are crucial in finance and investment analysis.