effective interest rate

Examples of effective interest rate in the following topics:

• Calculating Values for Different Durations of Compounding Periods

  • Sometimes, the units of the number of periods does not match the units in the interest rate.
  • But suppose you want to convert the interest rate into an annual rate.
  • The effective annual rate (EAR) is a measurement of how much interest actually accrues per year if it compounds more than once per year.
  • Solving for the EAR and then using that number as the effective interest rate in present and future value (PV/FV) calculations is demonstrated here.
  • The effective annual rate for interest that compounds more than once per year.

• Comparing Interest Rates

  • It provides an annual interest rate that accounts for compounded interest during the year.
  • The Fisher Equation is a simple way of determining the real interest rate, or the interest rate accrued after accounting for inflation.
  • To find the real interest rate, simply subtract the expected inflation rate from the nominal interest rate.
  • The nominal interest rate is approximately the sum of the real interest rate and inflation.
  • Discuss the differences between effective interest rates, real interest rates, and cost of capital

• The Fisher Effect

  • We only discussed nominal interest rates.
  • Investors and savers are concerned about the real interest rate because the real interest rate reflects the true cost of borrowing.
  • The Fisher Effect relates nominal and real interest rates and we define the notation as:
  • We show the Fisher Effect Equation in Equation 1.
  • We can use the bond market to show the Fisher Effect.

• International Fisher Effect

  • The Fisher Effect relates the nominal interest rate to the rate of inflation and real interest rate.
  • The International Fisher Effect relates the real interest rate to a nominal interest rate in a foreign country.
  • The International Fisher Effect lets analysts and economists solve for equilibrium exchange rates.
  • For example, the domestic interest rate for United States is id = 3% while the foreign interest rate for Japan equals if = 12%.
  • If an investment period is 90 days, subsequently, we use the International Fisher Effect to predict the exchange rate changes.

• Interest Rate Levels

  • An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender.
  • An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender.
  • Most central banks around the world assume and expect that lowering interest rates (expansionary monetary policies) would produce the effect of increasing investments and consumptions.
  • The adjustment of interest rates and their impact on aggregate demand dampen the expansionary effect of the increased government spending.
  • The effective federal funds rate in the U.S. charted over more than half a century.

• Comparing Price Risk and Reinvestment Risk

  • Price risk and reinvestment risk both represent the uncertainty associated with the effects of changes in market interest rates.
  • When the market interest rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate.
  • To sum up, price risk and interest rates are positively correlated.
  • Reinvestment risk and interest rates are inversely correlated.
  • The former is positively correlated to interest rates, while reinvestment risk is inversely correlated to fluctuations in interest rates.

• Term Structure of Interest Rates

  • Second, interest rates move together, so the yield curve normally shifts upward or downward as the interest rates change.
  • If you decide to hold a two-year bond, the interest rate must be 10% because the interest rate will be 9% for the first year, and you believe interest rates will increase to 11% for the second year.
  • However, investors add a term premium, so the yield curve has a positive slope because the term premium is high enough to cancel the effect of changing interest rates.
  • Unfortunately, the world's economy still feels the lingering effects of the Great Recession in 2014.
  • Term Structure of Interest Rates for U.S.

• Drivers of Market Interest Rates

  • A market interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender in the market.
  • In a free market there will be a positive interest rate.
  • If the inflationary expectation goes up, then so does the market interest rate and vice versa.
  • Different investments effectively compete for funds, boosting the market interest rate up.
  • The greater the risk is, the higher the market interest rate will get.

• Factors External to the Firm

  • Factors such as corporate tax rate, interest rate fluctuation, and conditions of the economy and markets are external factors of the WACC.
  • Another external factor in determining WACC is changing interest rates.
  • It is in charge of moderating long-term interest rates.
  • Therefore, the Fed tries to align the effective federal funds rate with the targeted rate by adding or subtracting from the money supply through open market operations.
  • This moderating of interest rates affects a company's WACC because of the importance of the risk-free rate in calculating cost of capital.

• The Interest Rate Risk

  • Interest rates became volatile during the 1980s, forcing banks to become more concerned with interest-rate risk.
  • If the interest-rate sensitive liabilities exceed the interest-rate sensitive assets, then rising interest rates cause banks' profits to plummet, while falling interest rates cause banks' profits to increase.
  • If the interest-rate sensitive liabilities are less than interest-rate sensitive assets, subsequently, increasing interest rates cause banks' profits to soar, while declining interest rates cause banks' profits to plummet.
  • If the interest-rate sensitive liabilities equal the interest-rate sensitive assets, then fluctuating interest rates do not affect bank profits.
  • If the interest rate rises, subsequently, the banks increase the interest rate on the loans.