Interest Rates and Risks

Money grows as time passes the idea that money that is available at the present time is
the concept that a sum of worth more than the same amount in the future, due to
money is worth more now its potential earning capacity. It holds that provided
than the same sum will be at money can earn interest, any amount of money is worth
a future date due to more the sooner it is received. Money has a time value
its earnings potential in the attached to it. In simpler terms, it would be safe to say
interim. A sum of money in that a dollar was worth more yesterday than today and a
the hand has greater value dollar today is worth more than a dollar tomorrow. -
than the same sum to be paid [Link]
in the future. - Investopedia uction-what-is-time-value-of-money
Interest the compensation that a borrower of
capital pays to a lender for its use.

Determinants:
Classical Theory of Interest (Smith) ‐ rate of interest is determined by two forces:
the supply of savings, derived mainly from households, and the demand for
investment capital, coming mainly from the business sector.
Liquidity Preference Theory of Interest (Keynes) ‐ suggests that an investor should
demand a higher interest rate or premium on securities with long‐term
maturities that carry greater risk because, all other factors being equal,
investors prefer cash or other highly liquid holdings.
Time Preference Theory of Interest* (Fisher) ‐ argues that people prefer to spend
today and save for later, so that interest rates will always be positive ‐ meaning
that a dollar today is more valuable than one in the future.
* also known as Agio Theory of Interest or Austrian Theory of Interest Theory of Interest
Interest the compensation that a borrower of
capital pays to a lender for its use.

Determinants:
Loanable Funds Theory of Interest ‐ argues that the risk‐free interest rate is
determined by the interplay of two forces: the demand for credit (loanable
funds) by domestic businesses, consumers, and governments, as well as
foreign borrowers; and the supply of loanable funds from domestic savings,
dishoarding of money balances, money creation by the banking system, as
well as foreign lending.
Rational Expectation Theory of Interest ‐ posits that individuals base their
decisions on human rationality, information available to them, and their past
experiences. Economists use the rational expectations theory to explain
anticipated economic factors, such as inflation rates and interest rates.
Theory of Interest
Interest the compensation that a borrower of
capital pays to a lender for its use.

Nominal Interest Rate ‐ the rate of interest before adjustment for inflation;
‐ the interest rates "as stated" without adjustment for the full effect of compounding.
Real Interest Rate(Fisher Effect) ‐ interest rate that has been adjusted to remove the effects of inflation to
reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.
Effective Interest Rate (EIR) [Annual Effective Interest Rate] ‐ interest rate restated from the nominal
interest rate and expressed as the equivalent interest rate if compounded [annually].
Pure Interest Rate* ‐ rate refers to the interest rate that emerges in a loanable funds market which is
characterized by absolute certainty and perfect competition. A zero degree of risk and a perfectly
competitive environment theoretically leads to a pure yield.
Market Interest Rate**(CAPM) – risk‐free rate plus market risk premium.

* also known as risk‐free interest rate; ** also considered as expected return Time Value of Money
Risk an uncertain event or condition that, if it occurs, has an
effect on business operations and/or objectives.
A future event (or series of events) with a probability of
occurrence and the potential for loss or impact on objectives
that can either be positive or negative.
Standard deviation
an indicator of market volatility and thus of risk.
measures total risk (diversifiable risk + market risk) for a security, ∑ 𝑥𝑖 𝜇
while beta measures the degree of market (non-diversifiable) risk. 𝜎
𝑁
a measure of how dispersed the data is in relation to the mean.
Coefficient of Variation
a statistical measure of the dispersion of data points in a data
series around the mean. The coefficient of variation represents 𝜎
the ratio of the standard deviation to the mean, and it is a useful 𝐶𝑉
𝜇
statistic for comparing the degree of variation from one data
series to another, even if the means are drastically different from
one another.
Risk
Beta (ß)
measure the volatility of an individual stock compared to the systematic risk of
the entire market. In statistical terms, beta represents the slope of the line
through a regression of data points. In finance, each of these data points
represents an individual stock's returns against those of the market as a whole.
calculated by dividing the product of the covariance of the security's returns and
the market's returns by the variance of the market's returns over a specified
period.
Capital Asset Pricing Model (CAPM)
A model based on the proposition that any stock’s required rate of return is equal to the risk-
free rate of return plus a risk premium that reflects only the risk remaining after diversification.
(Fundamentals of Financial Management, Brigham)

𝐸 𝑅 Capital Asset Expected Return

Beta Coefficient, 𝛽
A metric that shows the extent to which a given stock’s returns
move up and down with the stock market. Beta thus measures
market risk.
Term Structure of Interest Rates
• Bonds of different maturities typically have different interest rates.
• Typically, bonds of longer maturity pay higher yields over their
lifetime.
• Segmented Market Theory: Long‐term bonds have greater interest
rate risk and less liquidity. This explains why long‐term bonds have
greater yields on average.
• commonly known as the yield curve, depicts the interest rates of
similar quality bonds at different maturities.
Methods of Computing Interest
Simple Interest Method ‐ interest paid on a sum (loan or investment) over a set time period at a set rate
without assuming reinvestment.
Computation for Simple Interest follows the formula:

Where: p = principal; r = rate; t = time

Compound Interest Method ‐ assumes that the interest earned is automatically reinvested. The word
compound refers to the process of interest being reinvested to earn additional interest. With compound
interest, the total investment of principal and interest earned to date is kept invested at all times.

Computation for Compound Interest follows the formula:

or
Where: p = principal; i = nominal annual interest rate in percentage terms; n =
number of compounding periods
Interest
Computing Interest as applied
Add‐on Rate
Discount Rate
Annual Percentage Rate
Fixed Rate
Variable Rate
Prime Rate
Simple Rate
Compound Rate

Interest
References:
• [Link]
• The Theory of Interest by Stephen G. Kellison
• The Economics of Money, Banking, and Financial Markets by Frederic S. Mishkin
• Money and Capital Markets by Peter S. Rose and Milton H. Marquis