Interest Rate Concepts Flashcards
The annual interest rate implicit in the relationship between the net proceeds of a borrowing (or other arrangement) and the dollar cost of the borrowing (or other arrangement) is called the ___ interest rate.
“effective interest rate”
Computed as: Dollar cost of borrowing/Net proceeds of borrowing.
The percentage rate of interest can change over the life of the related debt instrument is the ___ ___ ___.
variable interest rate
Interest computed on the principal only; there is no compounding in the interest computation (i.e., no interest paid on interest) is called ___ ___.
Define “simple interest”.
The percentage rate of interest does not change over the life of the loan or parts of that life
fixed interest rate
Define “interest”.
Cost of the use of money. Expressed as a percentage rate, almost always as an annual percentage rate, applied to the principal to determine dollar amount.
Interest computed not only on the principal but also on any accumulated unpaid interest (i.e., interest is paid on interest) is termed ___ ____.
compound interest
Define “stated rate (of interest)” (also used interchangeably as “nominal rate” or “quoted rate”).
The annual rate of interest specified in a debt instrument or other contract/agreement; it does not take into account the compound effects of payment frequency.
Define “annual percentage rate (APR)”.
The annualized effective interest rate (without compounding) on loans that are for a fraction of a year. In effect, the effective interest rate for a portion of a year is “grossed up” to an annual rate.
Computed as the effective interest rate for the fraction of a year multiplied by the number of such fractions in a whole year.
Basis of interest rate disclosure in U.S.
The percentage rate of interest does not change over the life of the loan or parts of that life is called the ____ rate of interest.
fixed
The percentage rate of interest can change over the life of the loan or part of that life is called the ___. rate of interest.
variable
The ___ ___ of interest is the prevailing rate of interest paid on interest-bearing investments or charged on interest-bearing borrowings as determined by the supply and demand for funds in the market.
market interest
The market rate of interest is also known as the ___ rate of interest.
prevailing
The market rate of interest (i.e., the prevailing rate of interest) can be different in different markets and change over time, depending on such factors as…??
general economic conditions, expected inflation, the particular market, general type of instrument, government monetary policy, and similar macro-characteristics
Within a given market, the rate of interest for specific instruments will depend on such factors as….?
a. Credit rating of the issuer.
b. Duration (length) of the instrument.
c. Amount of the instrument.
d. Liquidity (or marketability) of the instrument.
e. Special covenants and features, if any.
Generally, the nominal (or quoted) interest rate for a security is composed of a __ __ ___ rate of interest, plus ___ that reflect market, entity and instrument risks and characteristics, including …?
real risk-free; premiums; inflation, risk of default, length and amount of the instrument, its marketability, and special covenants and features, if any.
The __ ___ ___ (___ ____) rate of interest constitutes the interest rate that would occur if there are no risks associated with the instrument and inflation is expected to be zero.
real risk-free (inflation-free)
Why is the real risk-free rate considered a “real” rate?
Because no inflation is expected, the rate is considered a “real” rate (i.e., the rate with - or after - zero inflation).
The rate of return on __ ___ ___ __ ___ assuming no inflation is commonly considered as the risk-free rate.
short-term U.S. Treasury securities
The risk-free rate of return changes over time as ___ ___ change.
economic conditions
The ___ ___ ____ compensates for the adverse effects of expected inflation on the security.
inflation risk premium
The ___ ___ ____ is based on the average expected inflation rate over the life of the security.
inflation risk premium
The higher the expected inflation rate, the ____ the nominal interest rate.
higher
The market price of U.S. Treasury Bills would be the sum of the ___ ___ ___ ___ of interest (which assumes no ___) plus the___ ___ ___.
real risk-free rate; inflation; inflation risk premium
The ___ ___ ___ compensates for the possibility that the issuer of debt will not pay interest and/or principal at the contracted time and/or in the contracted amount.
default risk premium
The greater the perceived default risk, the ___ the nominal interest rate.
higher
U.S. Treasury securities are assumed to have no ___ ___ and, therefore, have the lowest interest rates for comparable taxable securities in the U.S.
default risk
The difference between the quoted interest rate on a U.S. T-bond and on a corporate bond with similar amount, maturity, liquidity, tax and other features will be the amount of the ___ ___.
default premium
The ____ ____ compensates for the risk that longer-term fixed-rate instruments will decline in value as a result of an increase in the market rate of interest.
maturity premium
The value of outstanding fixed-rate instruments changes _____ with changes in the market rate of interest.
inversely
if over time the market rate of interest increases, the market value of outstanding comparable instruments will ____.
decline
___ ___ ___is the risk associated with a change in the market interest rate
interest rate risk
All long-term fixed-rate instruments, including U.S. Treasury securities, are subject to the interest rate risk and call for a ____ ___.
maturity premium.
The longer the time to maturity, the____ the maturity premium.
higher
The ____ ____ compensates for the fact that some securities cannot be converted to cash on short notice at approximate fair market value.
liquidity premium (also called the marketability premium)
The liquidity premium is also called the ____ premium.
marketability
The greater the perceived liquidity of a security, the ___ the liquidity premium.
lower
Securities of the U.S. Treasury and those of financially strong corporations that are widely traded in active markets carry little or no____ ____.
liquidity premium
Less liquid securities of small entities are likely to carry a relatively significant ___ ___.
liquidity premium.
Special premiums or discounts may attach to a particular instrument related to such factors as ___, ___ ___, ___ ___ and other factors. The factors and the related premium/discount will depend on terms of the specific instrument.
convertibility, call feature, security provided
While an interest rate states the cost of the use of money, not all statements of interest rate are comparable and this is primarily due to the effects of ____.
compounding.
The ____ ____ ___ is the annual rate specified in the loan agreement or comparable contract; it does not take into account the compounding effects of frequency of payments or the effects of inflation.
stated interest rate (also called the nominal or quoted interest rate)
The ___ ___ of interest on a bond is the stated rate of interest for that bond
coupon rate
___ ___ ____- as contrasted with nominal interest rate, refers to the rate of interest after taking into account the effects of inflation on the value of funds.
Real interest rate
The ___ ____rate of interest is the annualized rate for a loan that is for less than a full year.
annual percentage
Compound interest and ___ ___ of __ result in the same values.
future value of $1.00
The __ ___ ____ is determined as the full cost of a loan divided by the net cash proceeds
effective interest rate
In the U.S., retail interest rates have to be expressed as an____ ____ ____ (___).
annual percentage rate (APR).
The market rate of interest on a one-year U.S. Treasury bill would be the ___ ___ rate plus the ___ premium
risk-free; inflation
