Interest
Rates
HAZEL JADE E. VILLAMAR
CBA – CLSU
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Types of Interest Rates
Nominal Interest Rate
❖ Stated or Coupon Rate
❖ Used to compute interest payment
received by investors from debt
securities.
Annual Percentage Rate (APR)
❖ Annualized rate including fees, but
excluding compounding effects.
❖ Cost of source of financing that
considers simple interest.
❖ APR = I/(P x T)
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Types of Interest Rates
Effective Interest Rate
❖ Discount Rate
❖ The actual annual rate paid or earned,
accounting for compounding.
❖ Used to compute the present value
factors.
Annual Percentage Yield (APY)
❖ Cost of source of fund that considers
the effect of compounding.
❖ APY = (1 + ((i/m)^m) – 1)
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Components of the Nominal Interest Rate
The nominal interest rate is not a single figure but a composite of several
premiums compensating the lender for various risks and factors.
Real Risk- Inflation Liquidity
Free Rate Premium Premium
Maturity Risk Premium Default Risk Premium
Understanding these components is crucial for accurately assessing the true cost of borrowing or the real return on an investment.
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Components of the Nominal Interest Rate
The nominal interest rate is not a single figure but a composite of several premiums compensating the lender for various risks and factors.
Real Risk-Free Rate Inflation Premium Liquidity Premium
Actual yield of risk- Compensation for the Added return for
free debt security expected loss of assets that are difficult
assuming there is no purchasing power over or slow to convert to
expected inflation the investment period. cash.
Maturity Risk Premium Default Risk Premium
Compensation for the increased Return required to offset the
interest rate risk associated with risk that the borrower may fail
longer-term investments. to make payments.
Understanding these components is crucial for accurately assessing the true cost of borrowing or the real return on an investment.
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Risk-Free Interest Rate (Rf)
❖Used in CAPM
❖Real Risk-Free Rate +
Inflation Premium
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Inflation Premium (IP)
The Inflation Premium is the
additional return required by
investors to offset the expected
erosion of purchasing power due to
inflation over the investment period.
If inflation is expected to be 3% over the
next year, the nominal interest rate must
rise by approximately 3% to ensure the
investor maintains their real return.
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Risk Premiums: Liquidity, Maturity, and Default
These three premiums account for specific risks inherent in different
financial instruments and investment horizons.
Liquidity Highly liquid assets Example:
(like government Corporate bonds
Premium (LP) bonds) have a low often require a higher
This premium LP, while less liquidity premium
compensates investors frequently traded compared to highly
for holding assets that assets (like traded government
cannot be quickly corporate bonds or bonds due to lower
converted to cash. real estate) demand trading volumes and
a higher LP. market depth.
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Risk Premiums: Liquidity, Maturity, and Default
These three premiums account for specific risks inherent in different
financial instruments and investment horizons.
Maturity Risk Example:
Premium (MRP) The longer the A 10-year bond
maturity, the typically offers a
The MRP compensates greater the higher yield than a
investors for the potential for price 1-year bond to
increased sensitivity of fluctuation, thus compensate for the
long-term debt to requiring a higher extended exposure to
changes in interest premium. interest rate risk.
rates.
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Risk Premiums: Liquidity, Maturity, and Default
These three premiums account for specific risks inherent in different
financial instruments and investment horizons.
Default Risk Example:
Premium (DRP) "Junk bonds" (low
credit rating) carry a
This premium is
The DRP is the significantly higher
directly related to
compensation for the DRP than highly-rated
the borrower's
risk that the borrower government
creditworthiness.
will default on interest securities, reflecting
or principal payments. their greater
probability of default.
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Interest Rate Calculations in Practice
The table below illustrates how different compounding frequencies
impact the effective rate across various financial products.
Bank Savings (monthly 5% 5.12%
compound)
Credit Card (monthly 18% 19.56%
compound)
Treasury Bill (no
3% 3%
compounding)
Note that for the Treasury Bill, since there is typically no compounding, the
Nominal Rate, APR, and Effective Rate are all identical. For the credit card, the
difference between the APR (which often excludes compounding) and the
Effective Rate (which includes it) highlights the true annual cost of borrowing.
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