Effective Annual Interest Rate Using Compound Interest

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.

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Compensating balance required = 4%*100000=4000
Interest foregone ...