Interest Rate

The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR).

Types of Interest Rates

Nominal Interest Rate

The actual rate of interest charged by the supplier of funds and paid by the demander. OR The interest rate on an investment or loan without adjusting for inflation. The nominal interest rate is simply the interest rate stated on the loan or investment agreement.

Real Interest Rate

The real interest rate is the nominal rate

of interest minus inflation.

Real Interest Rate= Nominal Interest Rate - Inflation Rate

Reasons for Interest Rate change

Political short-term gain

Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on interest rates.

Deferred consumption
When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.

Inflationary expectations
Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.

Risks of investment
There is always a risk that the borrower will go bankrupt, abscond, die, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.

Liquidity preference People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize.

Term Structure of Interest Rate

The relationship between interest rate or rate of return and the time to Maturity.

Yield Curve
The yield curve is a curve showing several yields or interest rates across different contract lengths (2 month, 2 year, 20 year, etc...) for a similar debt contract.

Types of Yield Curve

Normal yield curve

The yield curve has usually been "normal" meaning that yields rise as maturity lengthens (i.e., the slope of the yield curve is positive). This positive slope reflects investor expectations for the economy to grow in the future and, importantly, for this growth to be associated with a greater expectation that inflation will rise in the future rather than fall.

Flat yield curve

The flat yield curve is observed when all maturities have similar yields, whereas a humped curve results when short-term and long-term yields are equal and medium-term yields are higher than those of the short-term and long-term.

Flat Yield Curve

BONDS

Long term debt instrument used by business and government to raise large sums of money generally from a diverse group of lenders.

Types of Bonds

Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years.

Convertible Bonds
A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for common shares of the issuer at some fixed ratio during a particular period. As bonds, they have some characteristics of fixed income securities. Their conversion feature also gives them features of equity securities.

High Yield OR "Junk" Bonds

These are usually purchased for speculative purposes. Junk bonds typically offer interest rates three to four percentage points higher than safer government issues. Bond rated 'BB' or lower because of its high default risk.

Zero-Coupon Bonds
This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let's say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you'd be paying $600 today for a bond that will be worth $1,000 in 10 years.

Floating Rate Bond

Bond whose interest amount fluctuates in step with the market interest rates, or some other external measure. Price of floating rate bonds remains relatively stable because neither a capital gain nor a capital loss occurs as market interest rates go up or down.

Extendible Notes/Bonds

Notes whose maturity can be lengthened at the option of the issuer.

Bond Quotations
Information on bonds, stocks and other securities, including current price data and statistics on recent price behavior that are available on Internet and in Stock Markets.

Bond Characteristics

Secured Bonds
Also known as asset-backed bonds, they are issued using specific properties or assets as collateral. These bonds have a high degree of safety since the bondholders have the right to sell the pledged property in case of default.

Unsecured Bonds
Also known as debenture bonds, they are backed solely by the general creditworthiness of the issuer. Regular corporate bonds are an example of unsecured bonds.

General Features of Bond Issue

Conversion Feature
A feature of convertible bonds that allows bondholders to change each bond into a stated number of shares of common stock.

Call Feature
A feature included in nearly all corporate bond issues that gives the issuer the opportunity to repurchase bonds at a stated call price prior to maturity

What is Call Price?

The stated price at which a bond may be repurchased, by use of a call feature prior to maturity.

International Bond Issues

Foreign Bond

A bond issued in host countrys financial market in the host countrys currency, by a foreign borrower.