1.4. Interest Rates

Question 1

What is the Effective Annual Rate? (EAR)

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Answer 1

• indicates the actual amount of interest in percent that will be earned at the end of one year, i.e. reference always per annum (p.a.)
• adjust discount rate to match the time period of the cash flows
• adjustment is necessary to apply present and future value formulas incl. perpetuity or annuity formulas

Question 2

Annual Percentage Rate (APR)

Answer 2

• simple interest earned in one year, i.e. amount of interest earned without the effect of compounding

Question 3

When working with APRs we must…

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Answer 3

• divide the APR by the number of compounding periods per year to determine the actual interest rate per compounding period
• then, if the cash flows occur at a different interval than the compounding period, we compute the appropriate discount rate by compounding

Question 4

Discount Rates and Loans

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Answer 4

• to calculate a loan payment, we equate the outstanding loan balance with the present value of the loan payments using the discount rate from the quoted interest rate of the loan, and then solve for the loan payment
• many loans such as mortages and vehicle loans are amortizing loans with annuity payments

Question 5

The Yield Curve and Discount Rates

Answer 5

interest rates typically depend on the horizon (=term) of investment/ loan

Question 6

Term Structure

Answer 6

relationship between investment term and interest rate

Question 7

Yield Curve

Answer 7

graph of relationship between investment term and interest rate

Question 8

Risk-free Interest Rates

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Answer 8

• all other borrowers have some risk of default
• for these loans, the stated interest rate is the maximum amount that investors will receive
• investors may receive less if the company has financial difficulties and is unable to fully repay the loan
• compensate for risk -> investors demand a higher interest rate than the rate on risk- free investments
• !! when discounting future cash flows, it is important to use a discount rate that matches both the horizon and the risk of the cash flows | the right discount rate for a cash flow is the rate of return available in the market on other investments of comparable risk and term