Finance - Interest Rate Concepts Flashcards
Key concept of interest; risk
The greater the perceived risk in an investment or other undertaking, the greater the expected rate of return, or interest rate
Types of interest rates
Fixed rate - rate of interest does not change over the life of the loan
Variable - Rate of interest can change over the life f the loan
Variable to fixed rate or fixe to variable - Charge one type for a portion of life and then change to another
Market interest rate definition
Rate of interest paid on interest bearing investments or charged on interest bearing borrowings determined b supply and demand of funds in the market
Stated interest rate
(Nominal or quoted) is the annual rate specified in the loan agreement or comparable contract; no compounding effects or effects of inflation
(Effective interest rate can be higher because of interest paid X times during year, but stated rate is coupon rate)
Nominal interest rate
Also refers to the rate of interest received before taking into account effects of inflation
Real interest rate
Rate of interest after taking into account the effects of inflation
RIR = Nominal Interest Rate - Inflation Rate
Assume a one-year investment instrument that pays a stated (nominal) rate of interest of 8%. During the year inflation is 3%. The real interest rate (RIR) is:
RIR = 8% − 3% = 5%
Therefore, while the nominal interest rate is 8%, because of inflation the real interest rate is 5%.
Simple interest
Interest computed on the original principal only; no compounding of interest
Assume a two-year, $2,000 note that provides for 6% simple interest with principal and interest to be paid at the end of the two-year period. The basic interest expression provides: Interest = Principal × Rate × Time, or = P × R × T, or = $2,000 × .06 × 2 years = $240 Thus, at the end of the second year the borrower would repay $2,000 principal + $240 interest = $2,240.
Compound interest
Interest not only bad on principle but on the amount of accumulated unpaid interest. Pays interest on interest; simple does not
Effective interest
Annual interest rate implicit in relationship between net proceeds from loan and the dollar cost of loan
Assume the facts above, which were a two-year, $2,000 note with 6% interest. We saw that if the contract provided for simple interest, the dollar amount of interest was:
I = P × R × T = $2,000 × .06 × 2 = $240
The effective rate (EI) is 6%, which can be shown as the relationship between the cost ($240) and the proceeds ($2,000), or:
EI = ($240/$2,000)/2 years
EI = .12/2 = .06
Assume the contract provides the same terms, except that the note will be discounted. In that case, the proceeds are:
$2,000 − $240 = $1,760
The effective rate of interest (EI) is now:
EI = ($240/$1,760)/2 years EI = 0.1364/2 = 0.0682 = 6.82%
There was a question with compensating balance; subtract it (ex - 20% compensating balance on 500k = 400k available for use)
Annual percentage rate
APR is the annualized effective interest rate without compounding in the loans that are for a fraction of the year; computed as effective interest rate for the fraction of a year x number of time fractions in a year
APR = (interest (cost)/principal) x 1/time fraction of the year
ddd
ompound interest and future value of $1.00 result in the same values.
