CH.5 - Interest Rates
Interest rate determination
- Attract investors: If interest rates are expected to rise, long-term interest rates will tend to be higher than short-term rates - Attract borrowers: If interest rates are expected to fall, long-term rates will tend to be lower than short-term rates
Amortizing loan
A loan on which the borrower makes monthly payments that include interest on the loan plus some part of loan balance
Yield curve
A plot of yield bonds as a function of the bonds' maturity date
Outstanding balance
Also called outstanding principal - This is equal to the present value of the remaining future loans payments
Inverted yield curve
Characteristics: Decreasing - Indicates an expected decline in future interest rates - Long-term rates lower than short-term rates - Often negative forecast for economic growth
Steep yield curve
Characteristics: Increasing - Indicates that interest rates will rise in the future - Long-term rates much higher than short-term rates
Normal yield curve
Characteristics: Moderately upward sloping - Investors almost always believed that interest rates were going to rise in the future - Long term interest rates normally to be higher than short-term rates - Long-term loans are riskier than short-term loans
Determinants of interest rate
Include: (1) Inflation vs. nominal rates (2) Yield curve & discount rates (3) Federal funds rate
Determinants of yield curve
Include: (1) Investors' expectations for future interest rates (2) Certain "risk premiums" that investors require to hold long-term bonds
Annual percentage rate (APR)
Indicates the amount of interest earned in one year without the effect of compounding
Simple interest
Interest earned without the effect of compounding
Effective annual rate (EAR)
Or Annual Percentage Yield (APY) - The total amount of interest that will be earned at the end of one year
Opportunity cost of capital
The best available expected return offered in the market on an investment of comparable risk and the term to the cash flow being discounted - Cost of capital comes from Investors giving up opportunity to invest elsewhere - Cost of making specific investment
Risk-free interest rate
The interest rate at which money can be borrowed or lent without risk over a given period
Federal funds rate
The overnight loan rate charged by banks with excess reserves at a Federal Reserve bank to banks that need additional funds to meet reserve requirements - The Federal Reserve determines very short-term interest rates through its influence on the federal funds rate
Nominal rates
The rate at which your money will grow if invested for a certain period - Interest rates quoted by banks/other financial institutions - Tends to be high when inflation is high - Low when inflation is low
Real inflation rate
The rate of growth of your purchasing power, after adjusting for inflation - Can be negative (if inflation rate exceeds the nominal rate)
Term structure
The relationship between the investment term and the interest rate
Federal reserve
This organization will: (1) Raise interest rates to moderate investment and combat inflation - Reduce investment if economy is "overheating" and inflation rate is on the rise (2) Lower interest rate to stimulate investment if economy is slowing
Investment & interest rate policy
When the costs of an investment precede the benefits, an increase in interest rate will make the investment less attractive
