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explain interest rates

Time value of money is measured by interest rate.
‘Cost (price) of money’
Interest rate is always expressed as a % per annum (p.a.), unless specified.
$ Interest Amount = Principal × Interest Rate × Interest Period Duration
Suppose Sam borrowed $10,000 at 5% p.a. for one year.
In one year, he has to pay $10,000 × 0.05 (per annum) × 1 (year) = $500 as interest, as well as $10,000 principal repayment.
% (5%) is for presentation, while decimals (0.05) are for calculation.
Always convert % to decimals in this topic!


explain real v normal interest rates

Nominal interest rate
Interest rate observed in the market contains ‘real interest rate’ and ‘inflation rate’.
Real interest rate
the basic interest rate in a world of no inflation
Pure time value of money
Rate of inflation
Annual percentage rate of change in the price level, usually measured by the consumer price index (CPI).
It reflects the tendency of prices to increase over time.
Higher expected inflation implies greater interest rate required by lenders to compensate for the loss in terms of purchasing power.


explain the fisher effect and real interest rates

A simple formula, ‘Fisher Effect’ to convert nominal interest rates into real rates:

Real interest rate = nominal interest rate − inflation


The real interest rate affects three private-sector components of spending

Net exports


There is a negative relationship between real interest rates and private expenditure.

Higher (Lower) interest rate will discourage (encourage) private consumption.

Investment is more sensitive to real interest rate as real interest rate influences long-term borrowing to purchase durable capital goods.

Higher (lower) interest rate will make A$ appreciate (depreciate), which decrease (increase) net exports.


explain the RBA and interest rates

Reserve Bank of Australia (RBA) monitors nominal interest rates by targeting the overnight cash interest rates.
In low inflation environments, any decision by the RBA to change the nominal interest rates in the short run will lead to changes in real interest rates.
e.g. if the nominal cash rate is 2.5% and inflation is 1.9%, real interest rate is 0.6%.
if the cash rate increases to 2.75%, inflation would remain unchanged in the short term, so real interest rate would be 0.85%.
By targeting the overnight cash rate, the RBA can affect other interest rates quite quickly.
Longer term interest rates track the overnight cash rate closely


explain simple interst

Simple interest
Principal is constant across the life of borrowing/lending contract.
Usually applied onto short-term borrowing/lending contract (within 1 year)


explain compound interest

Interest is accrued onto the principal at the end of each interest interval

Principal is ‘growing’ across the life of borrowing/lending contract.

In other words, there will be ‘interest on interest’.

Usually applied onto long-term borrowing/lending contract (over 1 year

Typically applied to long term interest arrangement, such as bond, mortgage.
FV with compound interest: compounding


explain nominal interest rate

the standard practice for expressing interest rates, e.g. 10% per annum
the nominal interest rate does not provide a true indication of the ‘effective’ interest rate when we compare interest rate arrangements with different compounding frequency.
Which term deposit account is better? Let’s assume $10,000 principal (PV) and 1 year time to maturity


explain effective annual rate

We need to know how much interest rate the arrangement implies, effectively
Effective interest rate provides a ‘standardized’ measurement of interest rate, after considering different compounding frequency.
‘Equivalent’ interest rate if compounded annually
12% p.a. compound monthly is indifferent from ? % p.a. compound annually.


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