Interest

Examples of Interest in the following topics:

• Multi-Period Investment

  • The first concept of accruing (or earning) interest is called "simple interest. " Simple interest means that you earn interest only on the principal.
  • The second way of accruing interest is called "compound interest. " In this case, interest is paid at the end of each period based on the balance in the account.
  • Compound interest is named as such because the interest compounds: Interest is paid on interest.
  • Compare compound interest to simple interest.
  • You don't earn interest on interest you previously earned.

• 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.

• Times-Interest-Earned Ratio

  • Times Interest Earned ratio (EBIT or EBITDA divided by total interest payable) measures a company's ability to honor its debt payments.
  • Times interest earned (TIE), or interest coverage ratio, is a measure of a company's ability to honor its debt payments.
  • Interest Charges = Traditionally "charges" refers to interest expense found on the income statement.
  • Times Interest Earned or Interest Coverage is a great tool when measuring a company's ability to meet its debt obligations.
  • When the interest coverage ratio is smaller than 1, the company is not generating enough cash from its operations EBIT to meet its interest obligations.

• Calculating Present Value

  • But first, you must determine whether the type of interest is simple or compound interest.
  • If the interest is simple interest, you plug the numbers into the simple interest formula.
  • Simple interest is pretty rare.
  • Simple interest is when interest is only paid on the amount you originally invested (the principal).
  • You don't earn interest on interest you previously earned.

• Comparing Interest Rates

  • Since interest compounds, the amount of interest actually accrued may be different than the nominal amount.
  • It provides an annual interest rate that accounts for compounded interest during the year.
  • 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

• Calculating Future Value

  • But recall that there are two different formulas for the two different types of interest, simple interest and compound interest .
  • Simple interest is when interest is only paid on the amount you originally invested (the principal).
  • You don't earn interest on interest you previously earned.
  • Interest is paid at the total amount in the account, which may include interest earned in previous periods.
  • Distinguish between calculating future value with simple interest and with compound interest

• Macroeconomic Factors Influencing the Interest Rate

  • Taylor explained the rule of determining interest rates using three variables: inflation rate, GDP growth, and the real interest rate.
  • 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 in the market.
  • The interest rates are influenced by macroeconomic factors.
  • In other words, (πt - π*t)is inflation expectations that influence interest rates.
  • If the inflationary expectation goes up, then so does the market interest rate and vice versa.

• Number of Periods

  • The number of periods corresponds to the number of times the interest is accrued.
  • In the case of simple interest the number of periods, t, is multiplied by their interest rate.
  • This makes sense because if you earn $30 of interest in the first period, you also earn $30 of interest in the last period, so the total amount of interest earned is simple t x $30.
  • Simple interest is rarely used in comparison to compound interest .
  • In compound interest, the interest in one period is also paid on all interest accrued in previous periods.

• 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 EAR can be found through the formula in where i is the nominal interest rate and n is the number of times the interest compounds per year (for continuous compounding, see ).
  • You can think of it as 2% interest accruing every quarter, but since the interest compounds, the amount of interest that actually accrues is slightly more than 8%.
  • The effective annual rate for interest that compounds more than once per year.

• Term Structure of Interest Rates

  • Term structure of interest rates is the interest rates differ by maturity if the securities have identical risk, same liquidity, similar information costs, and the same taxes.
  • 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.
  • Interest rate on a long-term bond equals the average of the short-term interest rates expected to occur over the life of the long-term bond.
  • Term Structure of Interest Rates for U.S.