Chapter 5

Interest Rates
Ziwei Wang
Wuhan University
Interest Rate Quotes and Adjustments
• Interest rates are usually stated as an annual rate, with speci c payment

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intervals (e.g. monthly, semiannually, or annually.)

• E ective annual rate (EAR) is one way to quote interest rates. It indicates
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the actual amount of interest that will be earned at the end of one year.

• For example, if the interest is paid after two years, with an EAR of 5%, a $100
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investment grows to 100 × (1.05) = 110.25. That is, the interest is $10.25.
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• What if interest is paid semiannually? Since 100 × (1.05) = 102.47, you get
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$2.47 at the end of the 6th month.

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• In general, equivalent n-year interest rate = (1 + EAR) − 1.
这里的n年利率实际上就是HPR
（持有期收益率）
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Interest Rate Quotes and Adjustments
Problem (Example 5.1 in textbook)

Suppose your bank account pays interest monthly with the interest rate quoted
as an e ective annual rate (EAR) of 6%. What amount of interest will you earn
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each month? If you have no money in the bank today, how much will you need
to save at the end of each month to accumulate $100,000 in 10 years?

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Interest Rate Quotes and Adjustments
• Another (more common) way of quoting interest rates is in term of an annual
percentage rate (APR, 年化收益率). It indicates the amount of interest
earned in one year without the e ect of compounding.

• For example, if the interest is paid semiannually with a 5% APR and you
invest $100, you receive an interest of 100 × (1 + 5 % /2) − 100 = 2.5.

• But the actual interest is compounding, so after one year the interest you
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receive is 100 × (1 + 5 % /2) − 100 = 5.0625 > 5.

( k )
k
APR
If there is k compounding periods per year, 1 + EAR = 1 + .
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Continuous Rates
• Suppose the APR is quoted at r.
• Your investment is compounding every in nitesimal instant.
• What is the future value of an investment C today at the end of year t?
rt
• The compounding factor should be e .

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Source: Chase Sapphire credit card terms.

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 Interest Rate Quotes and Adjustments
Problem (Example 5.2 in textbook)

Your rm is purchasing a new telephone system, which will last for four years.
You can purchase the system for an upfront cost of $150,000, or you can lease
the system from the manufacturer for $4000 paid at the end of each month.Your
rm can borrow at an interest rate of 5% APR with semiannual compounding.
Should you purchase the system outright or pay $4000 per month?

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 Application: Loans
• Many loans, such as mortgages (按揭贷款) and car loans, are amortizing
loans (摊销贷款), which means that each month you pay interest on the loan
plus some part of the loan balance.

• Usually, each monthly payment is the same, and the loan is fully repaid with
the nal payment. (等额本息)

• Sometimes, one may choose to repay the same amount of principal each
month, plus the appropriate interest. (等额本⾦)

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Application: Loans

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Application: Loans

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 Determinants of Interest Rates

• In ation.
• The term structure of interest rates.
• Risks.
• Taxes.

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 Term Structure and Yield Curve
• Term: the horizon of the investment or loan
• For example, if Cn denotes the risk-free cash
ow in year n, while rn is the risk-free interest
rate for an n-year term, then its present value is
Cn
PV = .
(1 + rn)n
• The relationship between the investment term
and the interest rate is called the term
structure of interest rates. We can plot this
relationship on a graph called the yield curve.
Source: 招商银⾏

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Term Structure and Yield Curve

Source: 国家⾦融监督管理总局
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Term Structure and Yield Curve

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Term Structure and Yield Curve
• In the US, the Fed (美联储) determines very short-term (overnight) interest
rates through its in uence on the federal funds rate. All other interest rates
are set by equating supply and demand in the market. Readings:

1. How central banks a ect interest rates.

2. 《中国的利率体系与利率市场化改⾰》，易纲

• The most important determinant of the yield curve is investors’ expectations

of future interest rate changes.

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 Term Structure and Yield Curve
• An increasing yield curve indicates that interest rates are expected to rise in
the future.

• A decreasing (inverted) yield curve signals an expected decline in future

interest rates.

Problem (Example 5.6 in textbook)

Suppose the current one-year interest rate is 1%. If it is commonly believed that
the one-year interest rate will be 2% next year and 4% the following year, what
will the interest rates r1, r2, and r3 of the yield curve be today? Is the yield curve
at, increasing, or inverted?

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注意这里的利率都是
有效年利率
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Term Structure and Yield Curve
• An inverted yield curve usually signals recession. Is
it wrong this time? — Podcast: Marketplace.

• https://www.marketplace.org/2023/09/07/inverted-
yield-curve-signals-a-recession-wrong/

• In normal times, investors receive a higher interest

rate from longer-term government debt, which
makes sense — the longer you lock up your
money, the more you want in interest.

• But when investors get a better annualized return

from a three-month loan to Uncle Sam than a 10-
year loan, something is o .

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Term Structure and Yield Curve
• Historically, inverted yield curves have been a pretty reliable indicator that a
recession is likely.

• Basically, bond investors are betting that a recession is coming, which means
the Fed will lower interest rates to juice a recovery.

• Parts of the yield curve started inverting in July 2022, yet the economy is still
humming along. It’s too early to start calling the bond market a liar, said
Menzie Chinn, a professor at the University of Wisconsin-Madison.

• “The lag time between when you get the inversion and when you have the
recession is variable, and so it could be anywhere from six to eight months to
18 months,” he said.

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Term Structure and Yield Curve
• But another possibility is that this economy is just built di erently after three
years of the pandemic, said Scott Ladner with Horizon Investments.

• “We entered this period really from a point of strength,” he said. “Companies
don’t have to borrow money, people don’t have to borrow money. They’re in
the best shape they’ve been in in 40 or 50 years.”

• Ladner added that when he takes a microscope to the yield curve, it’s not
predicting a recession per se — it’s just predicting the Fed getting in ation
back to normal.

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Risks and Interest Rates
• The rate on U.S. Treasuries (美国国库证券) is usually thought of as the “risk-
free interest rate.” However, all other borrowers have some risk of default. For
these loans, the stated interest rate is the maximum amount that investors will
receive.

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 Risks and Interest Rates
• When computing the present value of a cash ow, the right interest rate is the
rate of return available in the market on other investments of comparable risk
and term.

• We call this interest rate the investor’s opportunity cost of capital (or more
simply, the cost of capital), which is the best available expected return
o ered in the market on an investment of comparable risk and term to the
cash ow being discounted.

• We shall discuss more about estimating the cost of capital later in the course.

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