Brooks FM PPT Ch05 BB

Chapter 5
Interest Rates
Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Learning Objectives
• How interest rates are quoted?

• The effective annual rate on a loan or investment
• Apply the TVM equations
by accounting for the compounding periods
• Amortization tables and the payment change
as the compounding period changes
• The real interest rate and effect of inflation
on nominal interest rates
• Two major premiums that differentiate interest rates:
default premium and maturity premium
• History of U.S. interest rates 5-2
5.1 How Interest Rates Are Quoted:
Annual and Periodic Interest Rates
Annual percentage rate (APR):

Yearly rate earned by investing in assets or charged
for borrowing (the most commonly quoted rate)
Lenders often charge interest on a non-annual basis.
Periodic interest rate (PIR): r = [Tab 5.1]
where m = the number of compounding periods

per year (C/Y)
5-3
The more compounding periods per year,

the more interest earned or paid.
(ex) $500 CD for 1 year with 5% APR
Annual (m=1): PIR = 0.05, Ending balance = $525
Quarterly (m=4): PIR = 0.0125,
Ending balance =
[Tab 5.2]
5-4
Effective annual rate (EAR):
The interest rate actually paid or earned per year

with compounding
Also known as the annual percentage yield (APY).
Given APR and m,

5-5
[Tab 5.2] $500 CD with APR = 0.05
Annual EAR = 0.05000
Quarterly EAR =
Monthly EAR =
Daily EAR =
Ending balance = PV × ( 1 + EAR ) =

5-6
Ex1: Calculating an EAR (or APY)
A bank lends $100,000 for up to 3 years

at an APR of 8.5% (compounded monthly).
If you borrow $100,000 for 1 year,

how much interest will you have paid
and what is the bank's APY?
the EAR for deposits.

※ Banks quotes
the APR for loans.
5-7
5.2 Effect of Compounding Periods
on the TVM Equations
TVM equation requires the periodic rate (r = PIR)
and the number of compounding periods (n),
where n = years × m.
* The interest rate (r) should be consistent with the

frequency of compounding and the number of payments.

5-8
Ex2: Effect of Payment Frequency on Total Payment
Jim needs to borrow $50,000 for a business expansion

project. His bank agrees to lend him the money over a 5-
year term at an APR of 9% and accepts annual, quarterly,
or monthly payments with no change in the APR. Calculate
the periodic payment under each alternative and compare
the total amount paid each year under each option.

5-9
Ex2: Effect of Payment Frequency on Total Payment
Loan = $50,000; Period = 5 years; APR = 9%
Annual: PV = 50000; n=5; I=9; FV=0; P/Y=1; C/Y=1;

CPT PMT =
Quarterly: PV = 50000; n=20; I=9; FV=0; P/Y=4; C/Y=4;

CPT PMT =
Total annual payment =
Monthly: PV = 50000; n=60; I=9; FV=0; P/Y=12; C/Y=12;

CPT PMT =
Total annual payment =
5-10
Ex3: Comparing Annual and Monthly Deposits
Joshua (currently 25 years old) wants to invest money into a

retirement fund so as to have $2,000,000 saved up when he
retires at age 65. If he can earn 12% per year in an equity
fund, calculate the amount of money he would have to invest
in equal annual amounts and alternatively, in equal monthly
amounts.
5-11
Ex3: Comparing Annual and Monthly Deposits
With annual deposits: With monthly deposits:
FV = $2,000,000 FV = $2,000,000
N = 40 (years) N = 12 x 40 = 480 (months)
I/Y = APR = 12% I/Y = APR = 12%
PV = 0 PV = 0
C/Y = 1 C/Y = 12
P/Y = 1 P/Y = 12
PMT = PMT =
5-12
5.3 Consumer Loans
and Amortization Schedules
Interest is charged only

on the outstanding balance of a consumer loan.
Increases in frequency and size of payments

result in reduced interest charges and a quicker payoff.
Amortization schedules help in planning and analysis

of consumer loans.
[Tab 5.3] Monthly Amortization Schedule for $25,000 loan

(6 years at APR = 8%)
5-13
5.3 Consumer Loans
and Amortization Schedules
Ex4: Paying Off a Loan Early!
Kay has just taken out a $200,000, 30-year, 5% mortgage. She

has heard from friends that if she increases the size of her
monthly payment by one-twelfth of the monthly payment, she
will be able to pay off the loan much earlier and save a
bundle on interest costs.
Use the necessary calculations to help convince her
that this is, in fact, true.
5-14
Ex4: Paying Off a Loan Early!
Monthly payment:
PV = $200,000; I/Y = 5; N (= 30 x 12) = 360; FV = 0;

C/Y = 12; P/Y = 12; PMT =
The monthly payment increased by 1/12
 PMT =
PV=$200,000; I/Y=5; C/Y=12; P/Y=12;
N=
5-15
5.4 Nominal and Real Interest Rates
The nominal rate is the rate of interest earned

on a investment such as bank CD or
treasury security.
(Compensation paid for giving up of current

consumption)
Nominal rate (r ): the growth rate of actual dollars
Real rate (r* ): the growth rate of the purchasing power

of the dollars
(adjusted for the erosion of purchasing
power caused by inflation)
5-16
The Fisher Effect shows the relationship between

the real rate (r* ), the inflation rate (h ),
and the nominal interest rate (r ).
(1 + r) = (1 + r*) x (1 + h) → r = r* + h + (r* x h)
Approximately, r = r* + h
The nominal interest rate includes the real interest rate
and the inflation premium.

5-17
Ex5: Calculating nominal & real interest rates
Jill has $100 and is tempted to buy 10 T-shirts, with each one
costing $10. However, she realizes that if she saves the money
in a bank account, she should be able to buy 11 T-shirts.
If the cost of the T-shirt increases by the rate of inflation, i.e.,

by 4%, how much would her nominal and real rates of return
have to be?
5-18
Ex5: Calculating nominal & real interest rates
r* = (FV/PV)1/n – 1 = (11 shirts/10 shirts)1/1 – 1 =
Price of a shirt next year = $10 x (1.04) =

Cost of 11 shirts next year =
PV = $100; n = 1; I/Y = r = (FV/PV) – 1 =
r = r* + h + (r* x h) =

5-19
5.5 Risk-Free Rate and Premiums
⑴ Default premium (dp): Compensation for the risk

associated with varying types of
collateral & frequency of default
* Risk-free rate on the U.S. Treasury bill
⑵ Maturity premium (mp): Compensation for additional

waiting time
[Tab 5.4]
Risk
Variety of interest rates ⇐ of investment or loan
Length
5-20
5.5 Risk-Free Rate and Premiums
The rate of return on all other riskier investments would

have to include a default and maturity premium
r = ( r* + h ) + dp + mp
(Ex) 30-year corporate bond yield > 30-year T-bond yield
(due to the higher default risk on corporate bonds)

5-21
5.6 A Brief History of Interest Rates
The four components of interest rates vary over time.

(r = r* + h + dp + mp)
[Fig 5.2] Inflation in the U.S. (1950-1999)
[Fig 5.3] 3-month T-bill rate in the U.S. (1950-1999)
Data shows the average values over 1950-1999 as:
r = 5.23%, h = 4.05% ⇒ r* =
[Tab 5.5] Bond yields (1953-1999)

5-22

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Chapter 5

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• How interest rates are quoted?

Annual percentage rate (APR):

Lenders often charge interest on a non-annual basis.

Periodic interest rate (PIR): r = [Tab 5.1]

where m = the number of compounding periods

The more compounding periods per year,

(ex) $500 CD for 1 year with 5% APR

Annual (m=1): PIR = 0.05, Ending balance = $525

Quarterly (m=4): PIR = 0.0125,

Effective annual rate (EAR):

The interest rate actually paid or earned per year

Also known as the annual percentage yield (APY).

Given APR and m,

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

[Tab 5.2] $500 CD with APR = 0.05

Annual EAR = 0.05000

Ending balance = PV × ( 1 + EAR ) =

Ex1: Calculating an EAR (or APY)

A bank lends $100,000 for up to 3 years

If you borrow $100,000 for 1 year,

the EAR for deposits.

TVM equation requires the periodic rate (r = PIR)

and the number of compounding periods (n),

* The interest rate (r) should be consistent with the

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Ex2: Effect of Payment Frequency on Total Payment

Jim needs to borrow $50,000 for a business expansion

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Loan = $50,000; Period = 5 years; APR = 9%

Annual: PV = 50000; n=5; I=9; FV=0; P/Y=1; C/Y=1;

Quarterly: PV = 50000; n=20; I=9; FV=0; P/Y=4; C/Y=4;

Monthly: PV = 50000; n=60; I=9; FV=0; P/Y=12; C/Y=12;

Ex3: Comparing Annual and Monthly Deposits

Joshua (currently 25 years old) wants to invest money into a

With annual deposits: With monthly deposits:

Interest is charged only

Increases in frequency and size of payments

Amortization schedules help in planning and analysis

[Tab 5.3] Monthly Amortization Schedule for $25,000 loan

Ex4: Paying Off a Loan Early!

Kay has just taken out a $200,000, 30-year, 5% mortgage. She

PV = $200,000; I/Y = 5; N (= 30 x 12) = 360; FV = 0;

The monthly payment increased by 1/12

PV=$200,000; I/Y=5; C/Y=12; P/Y=12;

The nominal rate is the rate of interest earned

(Compensation paid for giving up of current

Nominal rate (r ): the growth rate of actual dollars

Real rate (r* ): the growth rate of the purchasing power

The Fisher Effect shows the relationship between

The nominal interest rate includes the real interest rate

and the inflation premium.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Ex5: Calculating nominal & real interest rates

If the cost of the T-shirt increases by the rate of inflation, i.e.,

Ex5: Calculating nominal & real interest rates

r* = (FV/PV)1/n – 1 = (11 shirts/10 shirts)1/1 – 1 =

Price of a shirt next year = $10 x (1.04) =

PV = $100; n = 1; I/Y = r = (FV/PV) – 1 =

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

⑴ Default premium (dp): Compensation for the risk

* Risk-free rate on the U.S. Treasury bill