Answer to Question 1:

You have a choice of receiving $500 today or $520 two years from now. By choosing the $500 today you are giving up interest at the rate of

1. just under 2 percent.

2. 4 percent.

3. 2 percent.

4. just over 2 percent.

Choose the correct option.

Choice 1 is correct.

A sum A0 today will grow to A1 = A0 (1 + r)2 in two years. Letting A0 equal $500 and A1 = $520, we have

$520 = $500 (1 + r)2

or

$520/$500 = 1.04 = (1 + r)2.

Taking the square root of 1.04 we obtain 1 + r = 1.0198 from whence r = .0198. This is 1.98 percent.

If you picked 4 percent as the answer you probably discounted the $520 back only one year instead of two years. Loose thinking might have led you to pick 2 percent on the grounds that the $520 is discounted two years and 2 percent is half of 4 percent. This is wrong because interest is compounded for the two years, not added.

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