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Flashcards in Finance - Interest Rate Concepts Deck (11):

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:
Time, or
× R
T, or
× .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



ompound interest and future value of $1.00 result in the same values.

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