9/13/2022

Interest Rates

 Interest rate quotes and adjustments

– Effective annual rate (EAR)
– Annual percentage rate (APR)

 Factors affecting interest rates

J. Zhou
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Interest Rate Quotes and Adjustments

 The Effective Annual Rate (EAR)

– Indicates the total amount of interest that will be earned at the end
of one year
• Also referred to as the effective annual yield (EAY) or annual
percentage yield (APY)

– Considers the effect of compounding

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Effective Annual Rate

• Adjusting the Effective Annual Rate to an Effective Rate over
different time periods
• For example, EAR = 5%
Investment Value in 1 year Value in 2 years

$1 $1×(1+r) = $1.05 $1×(1+r)2 = $1.1025

– Effective interest rate for one year: (1+r)-1=5%

– Effective interest rate for two years: (1+r)2 -1=10.25%

Equivalent n-Period Effective Rate  (1  r )n  1

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Effective n-Period Interest Rate

Equivalent n-Period Effective Rate  (1  r )n  1

• Find the equivalent effective interest rate for a period

shorter than one year: e.g., six months

(1+0.05)0.5 − 1 = 1.0247 − 1 = .0247 = 2.47%

• Earning a 5% return annually is not the same as earning

2.50% every six months.
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Example: Valuing Monthly Cash Flows

Problem
Suppose your bank account pays interest monthly with an EAR of 6%.
What interest rate will you earn 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?
Solution
Effective monthly interest rate: (1.06)1/12 − 1 = 0.4868% per month
Given an interest rate of 0.4868% per month, we must determine the
amount C of the monthly payment that will have a future value of
$100,000 in 10 years.
We can use the annuity formula (120 payments):
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Example: Valuing Monthly Cash Flows

1
FV (annuity) = C 
r
 (1  r )n  1

we can solve for the payment, C, using the equivalent

monthly interest rate, r = 0.4868%, and n = 120 months
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Example: Valuing Monthly Cash Flows

FV (annuity) $100, 000

C   $615.47 per month
1 1
 (1  r ) –1
n
 (1.004868) –1
120

r 0.004868 

We can also compute this result using the spreadsheet:

or a financial calculator:
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Annual Percentage Rates

1. The effective annual rate (EAR)

2. The annual percentage rate (APR)
 APR indicates the amount of simple interest earned in one
year. It does not consider the effect of compounding.

 E.g., a 6% APR with monthly compounding

→ it implies effective monthly rate of 6%/12=0.5%

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Annual Percentage Rates

 APR is the amount of interest earned without the effect of

compounding (in last example, APR is 6%).

If consider compounding: (1+0.005)12 = 1.061678

it means the actual (effective) interest rate is about 6.17% per year

 The APR does not reflect the true amount earned over one year;
the APR itself cannot be used as a discount rate and it is not an
effective annual rate (EAR).
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Convert APR to EAR

• Step 1: Convert the APR to its implied effective interest rate,

r, per compounding period.

APR
r
k compounding periods per year
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Convert APR to EAR

• Step 2: Convert the implied effective interest rate per

compounding period, r, into the EAR.

1  EAR  1  r 
k

– Steps 1 and 2 can be combined and represented by:

k
 APR 
1  EAR  1  
 k 
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Convert APR to EAR

• Converting an APR to an EAR

k
 APR 
1  EAR  1  
 k 

• The EAR increases with the frequency of compounding.

– Continuous compounding is compounding every instant.
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Convert APR to EAR

• A 6% APR with continuous compounding results in an EAR of

approximately 6.1837%.
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Example 1

• Problem
– A firm is considering purchasing or leasing a luxury automobile
for the CEO. The vehicle is expected to last 3 years. You can
buy the car for $65,000 up front , or you can pay $1,800 per
month for 36 months when leasing. The firm can borrow at an
interest rate of 8% APR with quarterly compounding.

Should you purchase the vehicle outright or pay $1,800 per

month?
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Example 1
• Solution
– The first step is to compute the discount rate that corresponds
to monthly compounding. How?
– a). convert an 8% APR compounded quarterly to EAR
– b). convert EAR to a monthly discount rate

4 1
 .08 
1    1.082432  1.082432  1  0.66227% per month
12

 4 
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Example 1
• Solution
– Given a monthly discount rate of 0.66227%, the present value
of the 36 monthly payments can be computed:

1  1 
PV  $1,800   1  36 
 $57, 486
0.0066227  1.0066227 

− This is $65,000 − $57,486 = $7,514 lower than the cost of

purchasing the vehicle, so it is better to lease the vehicle
rather than buy it.
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Example 2: Computing Loan Payments

 Loan Payments
– Payments are made at a set interval, typically monthly

– Each payment made includes the interest on the loan plus

some part of the loan balance

– All payments are equal and the loan is fully repaid with the final
payment
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Example 2
• Computing Loan Payments
– Consider a $30,000 car loan with 60 equal monthly payments.
Find the loan payments using a 6.75% APR with monthly
compounding.
 6.75% APR with monthly compounding corresponds to a
one-month discount rate of 6.75% / 12 = 0.5625%.

P 30,000
C    $590.50
1  1  1  1 
1  1 
r (1  r)n  0.005625  (1  0.005625)60 

 Also, try a financial calculator

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Example 2

• Computing the Outstanding Loan Balance

– One can compute the outstanding loan balance by calculating
the present value of the remaining loan payments after certain
number of payments
– In this example: a $30,000 car loan with 60 equal monthly
payments. Interest rate is 6.75% APR with monthly
compounding. If the monthly loan payment is $590.50, what is
the outstanding loan balance after 25 payments?
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Practice Questions

• Suppose the interest rate is 8% APR with monthly compounding.

What is the present value of an annuity that pays $100 every six
months for five years?
(hint: we need to find the effective interest rate for 6-month)
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Practice Questions

• Many academic institutions offer a sabbatical policy. Assume that

every seven years a professor is given a year free of teaching and
other administrative responsibilities at full pay. For a professor
earning $70,000 per year who works for a total of 42 years, what
is the present value at the beginning of her career of the amount
she will earn while on sabbatical if the interest rate is 6% (EAR)?
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Intermission

22
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Interest Rates
 Interest is the price a borrower must pay to the lender to
obtain the use of money for a period of time
 Interest rate: an exchange rate across time
 Types of interest rate
– Overnight rate
– Prime rate
– Treasury bill rate
– Treasury bond rate
– Corporate bond rate
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Factors Affecting Interest Rates

 Inflation

 Horizon of the loan

 Riskiness of the loan

 Tax policy
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Factor 1: Inflation

• Real vs. Nominal Interest Rates

– Nominal Interest Rate: The rates quoted by financial
institutions; the rate at which your money will grow if invested
for a certain period
• used for discounting or compounding cash flows

– Real Interest Rate: The rate of growth of your purchasing

power, after adjusting for inflation
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Real vs. Normal Interest Rates

• Let nominal interest rate be r and inflation rate be i

1  r Growth of Money
Growth in Purchasing Power  1  rr  
1  i Growth of Prices

• The Real Interest Rate

r i
rr   r i
1 i
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Example
 Problem
– In the year 2006, the average 1-year Treasury Bills rate was about
4.93% and the rate of inflation was about 2.58%.
– What was the real interest rate in 2006?

 Solution
– The real interest rate in 2006 was:
 (4.93% − 2.58%) ÷ (1.0258) = 2.29%
– Which is approximately equal to the difference between
the nominal rate and inflation: 4.93% − 2.58% = 2.35%
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Canadian Interest Rates and Inflation Rates,

January 1960–December 2016
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Interest Rate and NPV

• An increase in (nominal) interest rates will typically reduce
the NPV of an investment.
– Consider an investment that requires an initial investment of $10
million and generates a cash flow of $3 million per year for four
years. If the interest rate is 5%, the investment has an NPV of:

$3 $3 $3 $3
NPV  $10      $0.638 million
1.05 1.052 1.053 1.054
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Interest Rate and NPV

• If the (nominal) interest rate rises to 9%, the NPV becomes

negative and the investment is no longer profitable:

$3 $3 $3 $3
NPV  $10      $0.281 million
1.09 1.092 1.093 1.094
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Factor 2: Horizon of the Loan

• Term: the horizon of an investment or loan

• Term Structure: The relationship between the investment

term and the interest rate

• Yield Curve: A graph of the term structure

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Term Structure of Risk-Free Canadian Interest Rates,

January 2004, 2008, 2009, 2010, 2016
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The Yield Curve and Discount Rates

• The yield curve shows the spot rates of interest available

(at a point in time) from investing in securities with different
terms to maturity
– They are the EAR for different investment horizon

• The term structure can be used to compute the present and

future values of a risk-free cash flow over different investment
horizons
– Note: we need to match the term of cash flow and term of the spot rate
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The Yield Curve and Discount Rates

• From Figure 5.2, we see that $100 invested for one year at
the 1-year interest rate (r1) in January 2004 would grow to a
future value at the end of one year:
$100 × 1.025875 = $102.59

• $100 invested for 10 years at the 10-year interest rate (r10)

in January 2004 would be:
$100 × (1.048969)10 = $161.30
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The Yield Curve and Discount Rates

• Present Value of a cash flow that occurs in n years

Cn
PV0 
(1  rn ) n

• Present Value of a cash flow stream using a term structure

of discount rates
n
C1 C2 Cn Ct
PV0  
(1  r1 )1 (1  r2 ) 2
    
(1  rn ) n t 1 (1  rt )t
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Example
• Problem
– Compute the present value of a risk-free three-year annuity
of $500 per year, given the following yield curve:

Term (Years) Rate

1 5.06%
2 4.88%
3 4.79%

Note: rates on yield curves are EAR. How to interpret a rate, such as 4.88%, in
the table? It means: standing today, if you invest for a period of 2 years, you will
earn an effective rate of 4.88% every year.
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Example
• Solution
– Each cash flow must be discounted by the corresponding
interest rate:
$500 $500 $500
PV   
1.0506 1.04882 1.04793

PV  $475.92  $454.55  434.52  $1,364.99

Note: we cannot use the annuity formula here because the

discount rates differ for each cash flow.
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What Accounts for the Shape of the Yield Curve?

 Pure expectation theory

 Market segmentation theory
 Liquidity preference (liquidity premium) theory
– Investors require compensation for the added risk of longer
period (price uncertainty)
– It predicts that yield curves usually slope upward
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Expectation Theory
• The shape of the yield curve is influenced by interest rate
expectations
• It predicts that the interest rate on a long-term bond will
roughly equal an average of the short-term interest rates that
people expect to occur over the life of the long-term bond
– An increasing (steep) yield curve generally indicates that
interest rates are expected to rise in the future.
 The yield curve tends to be increasing as the economy comes
out of a recession and interest rates are expected to rise.
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Expectation Theory

• The shape of the yield curve is influenced by interest rate

expectations
– A decreasing (inverted) yield curve indicates that interest
rates are expected to decline in the future.
 Because interest rates tend to fall in response to an economic
slowdown, an inverted yield curve is often interpreted as a
negative view for economic growth.
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Example
• Nest, we use an example to look at the relationship between
short-term interest rates and a longer-term interest rate
• Problem
– Suppose the current one-year interest rate is 3%. If it is known
with certainty that the one-year interest rate will be 2% next
year and 1% the following year,

• What will the interest rates r1, r2, and r3 (i.e., the current 1-
year, 2-year, and 3-year rate) of the yield curve be today?

• Is the yield curve flat, increasing, or inverted?

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Example

• Solution
– We are told already that the one-year rate r1 = 3%.

– To find r2, we know that if we invest $1 for one year at the

current one-year rate and then reinvest next year at the new
one-year rate, after two years we will earn:

$1 1.03  1.02   $1.0506

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Example

• Solution
– We should earn the same payoff if we invest for two years at
the current two-year rate r2:

$1 (1  r2 ) 2  $1.0506
– Otherwise, there would be an arbitrage opportunity
– Solving for r2, we find that:

r2  1.0506   1  2.499%
12
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Example
• Solution
– Similarly, investing for three years at the one-year rates should
have the same payoff as investing at the current three-year rate:

1.03  1.02   1.01  1.0611  (1  r3 )3

We can solve for
r3  1.0611  1  1.997%.
13

Therefore, the current yield curve has r1 = 3%,

r2  2.499%, and r3  1.997%
→The yield curve is decreasing as a result of the anticipated
lower interest rates in the future.
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Factor 3: Risk and Interest Rates

 Government of Canada treasury bills are considered “risk-

free.”

 All other (private) borrowers have some risk of default, so

investors require a higher expected rate of return.
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Interest Rates on Five-Year Loans for Various

Borrowers, January 26, 2017
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Discounting Risky Cash Flows

 Suppose the Canadian government owes your firm $1000, to be paid in
five years.
Present value of this cash flow:
PV0  $1000  (1.01278)5  $938.48

 Suppose instead Sherritt owes your firm $1000, to be paid in five years.
Present value of this cash flow:
PV0  $1000  (1.11829)5  $571.78

Note the substantially lower present value in this case, due to the risk of default.
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Factor 4: Tax Policy

• Taxes reduce the amount of interest an investor can keep,

and we refer to this reduced amount as the after-tax
interest rate:

After-Tax Interest Rate

r  (  r )  r (1   )

where is the tax rate on interest income

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The Opportunity Cost of Capital

• Opportunity Cost of Capital: refers to the discount rate that

would be used in determining the present value of future
cash flows and eventually deciding whether a project (an
investment) is worth undertaking or not

– Also referred to as Cost of Capital

– It is the best available expected return offered in the market on

an investment of comparable risk and term
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Question?
Which of the following statements is false?

A) The yield curve changes over time.

B) The formulas for computing present values of annuities and
perpetuities cannot be used in situations in which cash flows need to
be discounted at different rates.
C) We can use the term structure to compute the present and future
values of a risk-free cash flow over different investment horizons.
D) The yield curve tends to be inverted as the economy comes out of a
recession.
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Question?
Suppose the term structure of interest rates is shown below:
Term 1 year 2 years 3 years 5 years 10 years 20 years

Rate
5.00% 4.80% 4.60% 4.50% 4.25% 4.15%
(EAR)

(1) After examining the yield curve, what predictions do you have
about interest rates in the future? About future economic growth
and the overall state of the economy?
(2) What is the NPV of an investment that costs $2,500 today and
pays $1,000 certain at the end of one, three, and five years ?