Interest Rates

Question 1

interest rate

Answer 1

A fraction of the principal paid by the borrower to
the lender as “interest”

Question 2

Effective Annual Rate (EAR)

Answer 2

Indicates the total amount of actual interest that will be
earning (paying) at the end of one year.

Question 3

Annual percentage rate (APR)

Answer 3

Amount of simple interest earned in one year.

Question 4

Simple interest

Answer 4

is the amount of interest earned without
the effect of compounding

Question 5

Discount Rate of a Continuously Compounded
A P R

Answer 5

Some investments compound more frequently than daily.
* As we move from daily to hourly to compounding every
second, we approach the limit of continuous
compounding, in which we compound every instant.

Question 6

The Continuously Compounded A P R for an E A R equation

Answer 6

APR = ln(1+EAR)

Question 7

Nominal Interest Rate (𝑰)

Answer 7

The rates quoted by
financial institutions. You earn/pay this with bank
account/loans

Question 8

Real Interest Rate (𝑹)

Answer 8

The rate of growth of your
purchasing power, after adjusting for inflation

Question 9

Inflation (𝝅)

Answer 9

rate of growth of goods/service prices

Question 10

Term Structure

Answer 10

The relationship between the interest rates and loan terms
(maturities)

Question 11

Interest Determination

Answer 11

The Federal Reserve determines very short-term interest
rates through its influence on the federal funds rate,
which is the rate at which banks can borrow cash reserves
on an overnight basis.

Question 12

Interest Rate Expectation Theory

Answer 12

– Argues that the shape of the yield curve is influenced
by interest rate expectations.
– States that current long-term rates can be used to
predict short term rates of future.
– Simplifies the return of one bond as a combination of
the return of other bonds.

Question 13

inverted yield curve

Answer 13

indicates that interest
rates are expected to decline in the future Because interest rates tend to fall in response to an
economic slowdown, an inverted yield curve is often
interpreted as a negative forecast for economic growth

Question 14

Liquidity Preference Theory

Answer 14

– Investors have a general bias towards short-term
securities, which have higher liquidity as
compared to long-term securities, which get one’s
money tied up for a long time.
* Longer maturity means your money will be locked-in
for longer period (less liquid).
* Bonds with longer maturity compensate this
inconvenience (illiquidity) with higher interest rate.
* Less liquidity leads to an increase in yields, while more
liquidity leads to falling yields, thus defining the shape
of upward and downward yield curves.

Question 15

Market Segmentation Theory

Answer 15

– This theory is related to the supply-demand dynamics of a
market.
– Preferences of investors for short term and long term
securities.
– An investor tries to match the maturities of his/her assets
and liabilities. Any mismatch can lead to capital loss or
income loss.
– Securities with varying maturities form a number of
different supply and demand curves which then eventually
inspire the final yield curve.
– Low supply and high demand lead to an increase in
interest rates

Question 16

Preferred Habitat Theory

Answer 16

– This theory states that investor preferences can be
flexible, depending on their risk tolerance level.
– They can choose to invest in securities outside
their general preference also if they are
appropriately compensated for their risk
exposure.

Question 17

Term Structure Theories

Answer 17

1. Interest Rate Expectation Theory
2. Liquidity Preference Theory
3. Market Segmentation Theory
4. Preferred Habitat Theory

Question 18

Interpreting the Term Structure

Answer 18

Yield curve reflects expectations of future
short rates, but also reflects other factors such
as liquidity premiums

The yield curve is a good predictor of the
business cycle
– Long-term rates tend to rise in anticipation of
economic expansion
– Inverted yield curve may indicate that interest
rates are expected to fall and signal a recession

Question 19

pros of term structure

Answer 19

• Knowing how interest rates might change in the future, investors are
  able to make informed decisions.
• Financial organizations have a heavy dependency on the term
  structure of interest rates since it helps in determining rates of lending
  and savings.
• Yield curves give an idea of how overpriced or under-priced the
  securities may be.

Question 20

cons of term structure

Answer 20

• Maturity matching to hedge against yield curve risk is not a
  straightforward task and might not give the desired end results.
• The term structure of interest rates eventually is only a predicted
  estimation that might not always be accurate, but it has hardly ever
  fallen out of place.