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

1

## 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

2

## 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

3

## 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

4

## 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)

5

## Nominal interest rate

### Also refers to the rate of interest received before taking into account effects of inflation

6

## 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%.

7

## 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.

8

## Compound interest

### Interest not only bad on principle but on the amount of accumulated unpaid interest. Pays interest on interest; simple does not

9

## 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)

10

## 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

11