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