Interest rates, Financial Management

Interest Rates

The payment borrowers make for the use of the funds that they borrow and the payment that lenders demand for the use of the funds they lend (termed interest) which is expressed as a percentage of the principal (loan amount). This percentage is known as interest rate. Interest rates typically are expressed in overall percentages and basis points. A basis point is one hundredth of a percentage point. There are basically four main parts to market interest rates:

  • The risk (or default) premium
  • The maturity premium
  • An inflation premium
  • The "real" rate

The risk premium is identifying that several classes of borrowers have greater or lesser risk by default. Interest rates are higher for riskier borrowers because they are lowest for the U.S. Treasury, which is considered as a "risk-free" borrower.  The difference in interest rate among any other borrower and the U.S. Treasury for the similar maturity is called a quality spread.  The maturity premium reflects the fact that, in general, a longer loan will have a higher interest rate compare to a shorter loan of the similar quality. The yield curve shows the change in interest rates as maturities are extended for a given class of loans. The inflation premium is identifying that inflation may erode the purchasing power of the funds lent. Therefore, interest includes compensation for the inflation expected over the length of the loan. The remaining part of interest rates reflects the real rate of interest that must be paid to induce the lender to forego the use of the funds. (Note that this is not simply the interest rate less present inflation, but rather interest rates less the average expected inflation over the length of the loan. Subtracting the present inflation rate gives an inflation-adjusted interest rate. Often, since the future interest rates will be assumed to conform to an average of past rates and lenders use some such average as a proxy for expected inflation.)

Posted Date: 10/17/2012 2:43:50 AM | Location : United States







Related Discussions:- Interest rates, Assignment Help, Ask Question on Interest rates, Get Answer, Expert's Help, Interest rates Discussions

Write discussion on Interest rates
Your posts are moderated
Related Questions
Financial Leverage In accounting and finance, the amount of long lasting debt that an organization has in relation to its equity the longer the ratio, the larger the lever

There are three parts to this question. Please answer all parts. The Chicken Company, a company with headquarters in Switzerland, has a receivable of one million euro, which it wil

a) Talk about in brief the various GAAPs that are mandatory to be followed. b) What are the several components of total cost.

Collar A collar can be established by holding a share, along with purchasing a protective put and writing a covered call, where both options at out-of-money.. For Example

Discounted Pay Back Period (DPBP) : The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis.  Discounted pa

It better to buy shares of a company or its assets? The choice among buying shares of a company and buying its assets depends mostly on the fiscal differences and on the possib

1. How would you judge the potential profit of Bajaj Electronics on the first year of sales to Booth Plastics and give your views to increase the profit?

How does the market determine the fair value of a bond? The bond’s fair value is the present value of the bond's coupon interest payments plus the present value of the face value

Compound options are usually cheaper than vanilla options and we know that there are four main types of compound options: a call on a call; a put on a call; a call on a put; a put

Discuss how a business might limit agency problem between management and creditors