Chapter 5: Interest Rates

Question 1

Effective Annual Rate (EAR)

Answer 1

• the total amount of interest that will be earned at the end of one year
• the actual rate paid (or received) after accounting for compounding that occurs during the year
• considers the effect of compounding

Question 2

Annual Percentage Rate (APR)

Answer 2

• indicates the amount of interest earned in one year without the effect of compounding
• the annual rate that is quoted by law
• period rate times the number of periods per year
• indicates the amount of simple interest earned in one year

Question 3

Continuous Compounding

Answer 3

the compounding of interest every instant (an infinite number of times per year)

Question 4

Nominal Interest Rate

Answer 4

interest rate quoted by banks and other financial institutions that indicate the rate at which money will grow if invested for a certain period of time

Question 5

Term Structure

Answer 5

the relationship between the investment term and the interest rate

Question 6

Yield Curve

Answer 6

a plot of bond yields as a function of the bonds’ maturity date

Question 7

Overnight Rate

Answer 7

• the overnight loan rate charged by banks with excess reserves at the Bank of Canada (called federal funds) to banks that need additional funds to meet reserve requirements.
• the federal funds rate is influenced by the Bank of Canada’s monetary policy, and itself influences other interest rates in the market

Question 8

After-tax Interest Rate

Answer 8

reflects the amount of interest an investor can keep after taxes have been deducted

Question 9

Opportunity Cost of Capital

Answer 9

is the best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted

Question 10

Period Rate

Answer 10

• = APR / number of periods per year (implied effective rate per compounding period)
• NEVER divide the effective rate by the number of periods per year – it will NOT give you the period rate

Question 11

Things To Remember

Answer 11

• you ALWAYS need to make sure that the interest rate and the time period match
• if you are looking at annual periods, you need an annual rate
• if you are looking at monthly periods, you need a monthly rate
• if you have an APR based on monthly compounding, you have to use monthly periods for lump sums, or adjust the interest rate appropriately if you have payments other than monthly

Question 12

Converting APR to EAR

Answer 12

1. Convert the APR to its implied effective interest rate, r, per compounding period
2. Convert the implied effective interest rate per compounding period, r, into the EAR
   * EFFECT function in excel

Question 13

Real Interest Rate

Answer 13

the rate of growth of purchasing power after adjusting for inflation

Question 14

Spot Rate of Interest

Answer 14

current interest rate for different terms to maturity determined from default-free zero coupon bond yields