Interest Rate Concepts

Question 1

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.

Answer 1

“effective interest rate”

Computed as: Dollar cost of borrowing/Net proceeds of borrowing.

Question 2

The percentage rate of interest can change over the life of the related debt instrument is the ___ ___ ___.

Answer 2

variable interest rate

Question 3

Interest computed on the principal only; there is no compounding in the interest computation (i.e., no interest paid on interest) is called ___ ___.

Answer 3

Define “simple interest”.

Question 4

The percentage rate of interest does not change over the life of the loan or parts of that life

Answer 4

fixed interest rate

Question 5

Define “interest”.

Answer 5

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.

Question 6

Interest computed not only on the principal but also on any accumulated unpaid interest (i.e., interest is paid on interest) is termed ___ ____.

Answer 6

compound interest

Question 7

Define “stated rate (of interest)” (also used interchangeably as “nominal rate” or “quoted rate”).

Answer 7

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.

Question 8

Define “annual percentage rate (APR)”.

Answer 8

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.

Question 9

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.

Answer 9

fixed

Question 10

The percentage rate of interest can change over the life of the loan or part of that life is called the ___. rate of interest.

Answer 10

variable

Question 11

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.

Answer 11

market interest

Question 12

The market rate of interest is also known as the ___ rate of interest.

Answer 12

prevailing

Question 13

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…??

Answer 13

general economic conditions, expected inflation, the particular market, general type of instrument, government monetary policy, and similar macro-characteristics

Question 14

Within a given market, the rate of interest for specific instruments will depend on such factors as….?

Answer 14

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.

Question 15

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 …?

Answer 15

real risk-free; premiums; inflation, risk of default, length and amount of the instrument, its marketability, and special covenants and features, if any.

Question 16

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.

Answer 16

real risk-free (inflation-free)

Question 17

Why is the real risk-free rate considered a “real” rate?

Answer 17

Because no inflation is expected, the rate is considered a “real” rate (i.e., the rate with - or after - zero inflation).

Question 18

The rate of return on __ ___ ___ __ ___ assuming no inflation is commonly considered as the risk-free rate.

Answer 18

short-term U.S. Treasury securities

Question 19

The risk-free rate of return changes over time as ___ ___ change.

Answer 19

economic conditions

Question 20

The ___ ___ ____ compensates for the adverse effects of expected inflation on the security.

Answer 20

inflation risk premium

Question 21

The ___ ___ ____ is based on the average expected inflation rate over the life of the security.

Answer 21

inflation risk premium

Question 22

The higher the expected inflation rate, the ____ the nominal interest rate.

Answer 22

higher

Question 23

The market price of U.S. Treasury Bills would be the sum of the ___ ___ ___ ___ of interest (which assumes no ___) plus the___ ___ ___.

Answer 23

real risk-free rate; inflation; inflation risk premium

Question 24

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.

Answer 24

default risk premium

Question 25

The greater the perceived default risk, the ___ the nominal interest rate.

Answer 25

higher

Question 26

U.S. Treasury securities are assumed to have no ___ ___ and, therefore, have the lowest interest rates for comparable taxable securities in the U.S.

Answer 26

default risk

Question 27

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 ___ ___.

Answer 27

default premium

Question 28

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.

Answer 28

maturity premium

Question 29

The value of outstanding fixed-rate instruments changes _____ with changes in the market rate of interest.

Answer 29

inversely

Question 30

if over time the market rate of interest increases, the market value of outstanding comparable instruments will ____.

Answer 30

decline

Question 31

___ ___ ___is the risk associated with a change in the market interest rate

Answer 31

interest rate risk

Question 32

All long-term fixed-rate instruments, including U.S. Treasury securities, are subject to the interest rate risk and call for a ____ ___.

Answer 32

maturity premium.

Question 33

The longer the time to maturity, the____ the maturity premium.

Answer 33

higher

Question 34

The ____ ____ compensates for the fact that some securities cannot be converted to cash on short notice at approximate fair market value.

Answer 34

liquidity premium (also called the marketability premium)

Question 35

The liquidity premium is also called the ____ premium.

Answer 35

marketability

Question 36

The greater the perceived liquidity of a security, the ___ the liquidity premium.

Answer 36

lower

Question 37

Securities of the U.S. Treasury and those of financially strong corporations that are widely traded in active markets carry little or no____ ____.

Answer 37

liquidity premium

Question 38

Less liquid securities of small entities are likely to carry a relatively significant ___ ___.

Answer 38

liquidity premium.

Question 39

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.

Answer 39

convertibility, call feature, security provided

Question 40

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 ____.

Answer 40

compounding.

Question 41

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.

Answer 41

stated interest rate (also called the nominal or quoted interest rate)

Question 42

The ___ ___ of interest on a bond is the stated rate of interest for that bond

Answer 42

coupon rate

Question 43

___ ___ ____- 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.

Answer 43

Real interest rate

Question 44

The ___ ____rate of interest is the annualized rate for a loan that is for less than a full year.

Answer 44

annual percentage

Question 45

Compound interest and ___ ___ of __ result in the same values.

Answer 45

future value of $1.00

Question 46

The __ ___ ____ is determined as the full cost of a loan divided by the net cash proceeds

Answer 46

effective interest rate

Question 47

In the U.S., retail interest rates have to be expressed as an____ ____ ____ (___).

Answer 47

annual percentage rate (APR).

Question 48

The market rate of interest on a one-year U.S. Treasury bill would be the ___ ___ rate plus the ___ premium

Answer 48

risk-free; inflation