Principal Finance 235 - Chapter 5 Interest Rate
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Questions and Answers

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.

    False

    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.

    <p>default</p> Signup and view all the answers

    Match the following terms with their definitions:

    <p>Nominal Interest Rate = Rate at which money invested grows Real Interest Rate = Rate at which purchasing power increases Risk Free Rate = Theoretical interest rate with guaranteed returns Maturity Premium = Compensation for waiting time in investment repayment</p> Signup and view all the answers

    If the compounding frequency (m) is 4, what is the periodic interest rate for an APR of 8.5%?

    <p>2.125%</p> Signup and view all the answers

    What is the formula for Simple Interest Rate?

    <p>P * R * T</p> Signup and view all the answers

    Compound interest is only calculated on the principal amount.

    <p>False</p> Signup and view all the answers

    What does APR stand for?

    <p>Annual Percentage Rate</p> Signup and view all the answers

    The formula for Compound Interest Rate is P (1 + R) ______.

    <p>m</p> Signup and view all the answers

    Match the type of interest rate with its description:

    <p>Simple Interest = Interest calculated only on the initial principal. Compound Interest = Interest calculated on both the principal and accumulated interest. Nominal Interest Rate = The stated interest rate without adjustment for inflation. Real Interest Rate = The interest rate adjusted for inflation.</p> Signup and view all the answers

    Which of the following is NOT a type of interest rate?

    <p>Monthly Interest Rate</p> Signup and view all the answers

    Interest rates do not fluctuate over time.

    <p>False</p> Signup and view all the answers

    What impact does inflation have on nominal interest rates?

    <p>It generally increases nominal interest rates.</p> Signup and view all the answers

    The ______ rate reflects the actual earnings on an investment after accounting for compounding.

    <p>Effective Annual Rate</p> Signup and view all the answers

    What is the formula to calculate the Periodic Interest Rate?

    <p>APR / m</p> Signup and view all the answers

    For quarterly compounding, the value of 'm' is 3.

    <p>False</p> Signup and view all the answers

    If the APR is 8% and interest is compounded monthly, what is the Periodic Interest Rate?

    <p>0.67%</p> Signup and view all the answers

    The Effective Annual Rate (EAR) depends on the number of ____________.

    <p>compounding periods</p> Signup and view all the answers

    Match the following compounding frequencies with their respective values of 'm':

    <p>Quarterly = 4 Monthly = 12 Daily = 365 Annually = 1</p> Signup and view all the answers

    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?

    <p>$134,488</p> Signup and view all the answers

    The total interest earned on an initial investment of $500 at 5% annual compounding after one year is $25.

    <p>True</p> Signup and view all the answers

    What is the total interest earned in the periodic compounding example given?

    <p>$25.47</p> Signup and view all the answers

    The effective annual rate (EAR) can be calculated as the total interest earned divided by the ____________.

    <p>initial investment</p> Signup and view all the answers

    Which of the following best describes the Effective Annual Rate (EAR)?

    <p>The true rate of return to the lender</p> Signup and view all the answers

    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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    Chapter 5 Interest Rates 2024 - Finance 235 PDF

    Description

    Explore the fundamentals of interest rates in Chapter 5 of Principal Finance 235. Learn how they are quoted, the differences between simple and compound interest, and how to calculate the effective annual rate. This quiz will also help you understand the implications of interest rates for financial managers.

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