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Questions and Answers
What is the formula for calculating the Effective Annual Rate (EAR)?
What is the formula for calculating the Effective Annual Rate (EAR)?
- EAR = APR * m
- EAR = (1 + Periodic Interest Rate)^m - 1 (correct)
- EAR = (APR / m)
- EAR = (1 + APR)^m - 1
The Real Interest Rate is calculated by adding the expected inflation rate to the nominal interest rate.
The Real Interest Rate is calculated by adding the expected inflation rate to the nominal interest rate.
False (B)
How much total interest expense will accumulate after 1 year on a loan of $100,000 at an APR of 8.5%?
How much total interest expense will accumulate after 1 year on a loan of $100,000 at an APR of 8.5%?
$8,839.09
The portion of the nominal interest rate that compensates for the risk of borrower default is called the ______ premium.
The portion of the nominal interest rate that compensates for the risk of borrower default is called the ______ premium.
Match the following terms with their definitions:
Match the following terms with their definitions:
If the compounding frequency (m) is 4, what is the periodic interest rate for an APR of 8.5%?
If the compounding frequency (m) is 4, what is the periodic interest rate for an APR of 8.5%?
What is the formula for Simple Interest Rate?
What is the formula for Simple Interest Rate?
Compound interest is only calculated on the principal amount.
Compound interest is only calculated on the principal amount.
What does APR stand for?
What does APR stand for?
The formula for Compound Interest Rate is P (1 + R) ______.
The formula for Compound Interest Rate is P (1 + R) ______.
Match the type of interest rate with its description:
Match the type of interest rate with its description:
Which of the following is NOT a type of interest rate?
Which of the following is NOT a type of interest rate?
Interest rates do not fluctuate over time.
Interest rates do not fluctuate over time.
What impact does inflation have on nominal interest rates?
What impact does inflation have on nominal interest rates?
The ______ rate reflects the actual earnings on an investment after accounting for compounding.
The ______ rate reflects the actual earnings on an investment after accounting for compounding.
What is the formula to calculate the Periodic Interest Rate?
What is the formula to calculate the Periodic Interest Rate?
For quarterly compounding, the value of 'm' is 3.
For quarterly compounding, the value of 'm' is 3.
If the APR is 8% and interest is compounded monthly, what is the Periodic Interest Rate?
If the APR is 8% and interest is compounded monthly, what is the Periodic Interest Rate?
The Effective Annual Rate (EAR) depends on the number of ____________.
The Effective Annual Rate (EAR) depends on the number of ____________.
Match the following compounding frequencies with their respective values of 'm':
Match the following compounding frequencies with their respective values of 'm':
Based on the example, what is the future value (FV) of a loan of $100,000 at an APR of 10% compounded quarterly after 3 years?
Based on the example, what is the future value (FV) of a loan of $100,000 at an APR of 10% compounded quarterly after 3 years?
The total interest earned on an initial investment of $500 at 5% annual compounding after one year is $25.
The total interest earned on an initial investment of $500 at 5% annual compounding after one year is $25.
What is the total interest earned in the periodic compounding example given?
What is the total interest earned in the periodic compounding example given?
The effective annual rate (EAR) can be calculated as the total interest earned divided by the ____________.
The effective annual rate (EAR) can be calculated as the total interest earned divided by the ____________.
Which of the following best describes the Effective Annual Rate (EAR)?
Which of the following best describes the Effective Annual Rate (EAR)?
Flashcards
Simple Interest
Simple Interest
Interest calculated only on the principal amount, each year.
Compound Interest
Compound Interest
Interest calculated on the principal and accumulated interest.
Annual Percentage Rate (APR)
Annual Percentage Rate (APR)
Yearly interest rate for investment/loan.
Periodic Interest Rate
Periodic Interest Rate
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Effective Annual Rate (EAR)
Effective Annual Rate (EAR)
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Risk-Free Rate
Risk-Free Rate
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Interest Rate
Interest Rate
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Principal
Principal
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Compounding Period
Compounding Period
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Nominal Interest Rate
Nominal Interest Rate
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Real Interest Rate
Real Interest Rate
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Default Premium
Default Premium
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Maturity Premium
Maturity Premium
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APR
APR
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Quarterly Compounding
Quarterly Compounding
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Daily Compounding
Daily Compounding
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Calculating Periodic Interest
Calculating Periodic Interest
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Calculating Future Value with Periodic Interest
Calculating Future Value with Periodic Interest
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Study Notes
Principal Finance 235 (2024) - Chapter 5 Interest Rate
- Interest rates are quoted in various ways
- Interest rate is fundamentally the cost of borrowing money.
- Interest rates change over time
- Interest rates are crucial tools for financial managers.
- Learning outcomes of chapter 5 include discussing how interest rates are quoted, calculating the annual and periodic interest rate, computing the effective annual rate (EAR), explaining the real rate of interest, and its inflation on nominal rates, and explaining the risk-free rate
Types of Interest Rates
- Simple Interest: interest calculated only on the principal amount. Formula: Simple Interest = PRT (P = Principal, R = Rate, T = Time)
- Compound Interest: interest calculated on the principal and previously accumulated interest
- Annual Percentage Rate (APR): Yearly percentage rate of earning interest or fee for borrowing.
- Effective Annual Rate (EAR): The true rate of return to the lender or cost of borrowing to the borrower. It's calculated based on the APR and compounding periods. Calculation: EAR = (1 + Periodic Interest Rate)^m – 1
How Financial Institutions Quote Interest Rates
- Lenders often charge interest on non-annual bases (semi-annually, quarterly, monthly, or daily)
- Compounding period per year: Frequency of times interest is added to an account.
- Periodic Interest Rate: APR divided by the number of compounding periods in a year (m) Formula: r = APR/m
Effective Annual Rate (EAR)
- EAR is the true rate of return or cost of borrowing, expressed on an annual basis.
- EAR depends on the number of compounding periods.
- Formula EAR = (1 + Periodic Interest Rate)^m – 1
Nominal and Real Interest Rates
- Nominal Interest Rate: Rate at which an investment grows, includes expected inflation. Formula: Nominal rate = Real rate + expected inflation.
- Real Interest Rate: Rate at which purchasing power of an investment increases. Formula: Real rate = Nominal rate - expected inflation.
- Inflation: Rate at which prices increase over time.
Risk-Free Rate
- Theoretical interest rate guaranteeing an investor's expected return and where the borrower never defaults
- Characteristics of a risk-free rate include very clean customers, reliable securities, and safe investment.
Default Premium
- Portion of interest rate compensating for risk associated with the borrower defaulting.
- Associated with chance of default and unsafe investment
Maturity Premium
- Portion of nominal interest rate compensating an investor for waiting time until repayment.
Yield Curve
- Shows the relationship between interest rates and the maturity date of a financial instrument.
- Possible shapes include downward-sloping and upward-sloping yield curves.
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