Chapter 5 Interest Rates Borrowing money costs money. If you borrow money from a bank, you will be charged an amount over the initial loan (principal) in the form of interest. If you invest your money ina bond, the company issuing the bond is borrowing money from you. You will, in effect, charge the com- Pany an amount over the initial price of the bond in the form of coupon Payments (interest). These interest rates fluctuate over time. Depending on your role—borrower or lender—interest rate changes can be good news or bad news. Rising interest rates are good for those lending money because they receive more interest on their principal, but they are not as good for those borrowing money because it costs more to borrow. Falling rates are good for borrowers because they pay less for the funds they are borrowing, but they are not as good for lenders be- cause they make less money on the loan. Recall that the variables in the lump-sum time value of money equations are n (number of periods), r (interest rate), PV (present value), and FV (future value), with the additional variable in the annuity equations of PMT (payment). In this chapter, we take the time value of ‘money equations for lump-sum payments and annuities and zoom in on r, the interest rate variable. We'll examine the actual borrowing rates for money, how discount and investment rates are determined, and how to apply the rates in the equation, An understanding of interest rates is yet another key tool for the finance manager and the prudent investor or borrower. In future chap- ters, your understanding of how interest rates work will help you de- velop hurdle rates for company projects, the appropriate cost of capital fora firm, and the optimal capital structure for a firm. For now, we start with the basics.Chapter 5 + Interest Rates 5.1 How Interest Rates Are Quoted: Annual and Periodic Interest Rates ‘To begin our discussion of how interest rates are quoted and why interest rates sometimes referred to as the “price to rent money,” let’s look at a simple example. When you deposit money in a certificate of deposit (CD) at a bank, the bank is technically borrowing or renting money from you with a promise to repay that money with interest, Let’s assume that you purchase a CD for $500 with a prom- nual percentage rate (APR) of 5%. The annual percentage rate (APR) is the yearly rate earned by investing or charged for borrowing; here, itis 5%. Although the 5% interest rate is quoted on an annual basis, interest is, in fact, often paid quarterly, monthly, or even daily. The period in which interest is applied or the frequency of times interest is added to an account cach year is called the compounding period or compounding periods per year (C/Y). To avoid some confusion and make the equations in this chapter more readable, we will let 1m represent the number of compounding periods per year (C/Y = 1). For example, if the number of compounding periods per year is twelve (monthly compound- ing), we will have mi = 12s if itis quarterly compounding, we will have m = 45 ised a and so on, So, what happens to the $500 CD with an annual percentage rate of 5% if itis compounded on an annual, quarterly, monthly, or even daily basis? If an interest rate on a loan or investment compounds more than once a year, we must convert the annual percentage rate (APR) into a periodic interest rate so that compounding can be taken into account, To determine the interest paid each compounding pe- riod, we take the advertised annual percentage rate and divide it by the number of compounding periods per year to get the appropriate periodic interest rate. The periodic rates for annual compounding, quarterly compounding, monthly com- pounding, and daily compounding are illustrated in Table 5.1 and are derived from the equation — . ee m 5.1 / periodic interest rate, r ‘We can now examine more closély'the effect of compounding on our $500 investment on an annual, quarterly, monthly, or daily basis in terms of the annual interest at the end of the first year. With annual compounding, we know we will receive $25.00 interest at the end of the year: $500 X 5% = $25.00. When com- pounding occurs on a more frequent basis, however, the bank applies the periodic interest rate each period to the balance in the account. The more compounding pe- riods per year, the more interest earned or paid each year. For example, with quar- terly compounding each quarter, you receive 1.25% interest on the new balance each quarter and over the year you will receive $25.47, as illustrated in Table 5.2. TABLE 5.1 Periodic Interest Rates | Period Annually z 1 5.0% ‘Quarterly 5.0% 4 1.25% Monthly 5.0% 2 0.4167% 365 0.013699% Daily5.1 + How Interest Rates Are Quoted: Annual and Periodic Interest Rates % TABLE 5.2 $500 CD with 5% APR, Compounded Quarterly at 125% Coan Eee Cees eeu) outset 11-3731 $500.00 $500.00 x 0.0125 = $6.25 $506.25. [an-60 $506.25 $506.25 x 0.0125 = $6.33. $512.58 [seo | ssias8 | ss12sex 00125 - seat as | 101-1231 $518.99 $518.99 x 0.0125=$6.48 | $525.47 The extra 47 cents is interest on interest, and so you have effectively earned 5.094% on your CD ($25.47/$500.00 = 0.05094). Whereas the 5.0% advertised interest on the account is the annual percentage rate (APR), the 5.094% is the ef- fective annual rate. In other words, the effective annual rate (EAR) is the rate of interest actually paid or earned per year and depends on the number of com pounding periods. Some calculators will automatically calculate EARS from APRs as the com- pounding periods vary, but the conversion is quite straightforward to do yourself: (ee= (1p 1] the number of compounding periods per year. It is important to always convert APRs to EARs so that you know your true return or cost of money. Our CD example has four different compounding periods, so we have four dif- where ni ferent EARs: / With annual compounding: 0.05! . BAR =(1+—>) —1= 5.00% With quarterly compounding: EAR = (: + 298) — 1 = 5.094% With monthly compounding: 0.05)? FAR=(1+—~) - With daily compounding: xs ) — 1 = 5,12675% 5.162% tar = (1+ 365 When the compounding is annual, the EAR and APR are the same, 50, on occasion, an APR is the actual cost of money. Now, with these different EARs, we can determine the ending balance of the $500 for each of the different compounding periods; When borrowing or investing money, itis important to see Quarterly compounding = $500 x (1 + 0.05094) = $525.47 Monthly compounding = $500 X (1 + 0.051162) = $525.58 Daily compounding $500 X (I + 0.0512675) = $525.63 the interest rate clearly, that is, to understand how it differs from the stated annual percentage rate (APR).The rate of Interest actually paid or earned per year is known as the effective annual rate (EAR) or the annual percentage yield (APY) and will usually be higher than the APR because ‘compounding is involved,Chapter 5 + Interest Rates quarterly compounding investment with a “Thus, the effective annual rate for a 5.1162% for monthly compounding, and stated APR of 5.0% is really 5.094%, 5,12675% for daily compounding, Savings Act (1991) requires banks to advertise their rates on ind savings accounts as annual percentage yields (APY). (APY) and EAR are two different terms for the same of interest actually paid or earned per the Truth in Lending Act (1968) investments such as Cl ‘The annual percentage yield quoting convention of interest rates: the rate year. When quoting rates on loans, however, requires the bank to state the rate as an APR, effectively understating the true cost of the loan when interest is computed more often than once a year. So, when you g0 10 ‘ bank, you will be quoted the interest rate atthe higher EAR when you are ihvest- ing and atthe lower APR when you are borrowing. Today, many banks Sate both Re APR and the EAR on a loan. If, however, you are borrowing from a bank and you only receive an APR interest quote of 8% for your loan but are required to pay monthly, you can easily compute the true cost of borrowing the money as - 2 car = (1+ 228) - = (1+ 2%) — 1 = 8.30%. 12 How does this new understanding of compounding the time value of money equation from the previous chay straightforward: r, the interest rate used in the equation, is a periodic rate {r — APRIm), which takes compounding into account; and nis the number of periods or the number of compounding periods per year times the number of years (n= years Xm). "As we continue our discussion of interest rates, be aware of some technology {ssues, Some calculators and spreadsheets want the periodic rate, others want the annual rate, When you are using a calculator that has a TVM key of I/Y, for inter- est per year, it wants the annual percentage rate. Some calculators use the symbol io for the interest rate and want the periodic interest rate. The Excel spreadsheet wants the periodic rate. So, we will either enter APR for calculators with the IY notation or APR/m for calculators with the i% notation or our spreadsheet. and interest rates fit into ters? The answer is 5.2. Effect of Compounding Periods on the Time Value of Money Equations When interest rates are stated or given for loan repayments, itis assumed they are annual percentage rates unless specifically stated otherwise. These APRs must be converted to the appropriate periodic rates when compounding is more frequent than once a year. Therefore, the tables of future value and present value interest factors in Appendixes 1 through 4 provide answers for the periodic rates (annually, quarterly, monthly, daily, and so on) and the total number of periods over the length of the loan or investment. Let’ look at the effect of the payments on a mortgage when we shift from annual payments to monthly payments and the application of our three different methods with the TVM equations. Mortgage payments Problem ABC Printing Company has just signed on the dotted line to buy a building worth $200,000 to house its operations. ABC Printing paid $10,000 down and must finance (borrow) the remaining $190,000. The bank will loan the\ 5.2 + Effect of Compounding Periods on the Time Value of Money Equations 15 firm money at 8% APR, but ABC has an monthly payments on the loan, Both ule. What are the annuity pay, option to make annual payments or options have a thirty-year payment sched- rents under the two different plans? Solution MetHop 1: Using the equation For the annual payment plan, apply equation 4.8 and use the 89% APR as the interest rate, the $190,000 as the present value of the loan, and thirty as the number of periods. The APR is the EAR because the compounding periods per year are one. So, 7 $190,000 $190,000 par = —$10,000_ _ $190,000 16,877.21 _ 1 11.2579 ~ § (a + 0.08) 0.08 (with the payment rounded to the nearest cent) IfABC selects the monthly payment plan over the next thirty years, we must convert the 8.0% APR to the monthly interest rate: APR 0.08 _ 2 0.08 _ 9.9 7 5 066666 or 5% Also, the number of periods must reflect the number of payments that ABC will make on the loan over the next thirty years: n= number of years Xm 30 X 12 = 360 Using the payment form of the equations, we have , $190,000 $190,000 PMT 1 136.2835 ~ $1394.15 (+ 0.006666)", 0.006666 Notice that the monthly payment is not one-twelfth of the annual payment (12 x $1394.15 = $16,729.80 < $16,877.21). By increasing the number of payments per year, the total cash outflow is reduced. eeeeeeses»Seeneeeees5gkgesgSs»MNiU| So we can now see how the correct interest rate, rin equation 5.1 is the peri- odic'rate, Its the APR of:8% for annual payments and the APR divided by m— 89/12, or 3%—for the monthly payments. Let’s look at the TVM keys in the cal- culator to incorporate this same adjustment. As just noted, on many calculators the TVM key for interest is IY, which stands for interest per year, or the APR rate. Other calculators ask for i%, which is the periodic interest rate. For example, the ‘Texas Instrument BAII Plus calculator will require you to set the number of com- pounding periods per year and thus will automatically convert to the appropriate periodic rate during the calculation. The second function above 1/Y is payments per year (P/Y). When we shift to monthly payments, you enter the second fun tion and set P/Y equal to 12. Then hit the down arrow key, and the C/Y varChapter 5 + Interest Rates (compounding periods per year) sill display. Set this variable to 12. The caleula tor is now in a monthly mode for the problem. Switch Periods per Year and Compounding per Year Monthly Pv ano) MY) Displays P/Y. 12, enter) wy no) WY) 4) Displays CIV. 12, Eten) Notice that the N is no longer 30, but 360, reflecting the number of payments for the home loan (N = 30 % 12 = 360), When the calculator performs the func- tion of finding the monthly payment, it automatically takes the APR entered in the IY key and divides it by the C/Y value, thereby converting to the monthly rate before calculating the monthly payment. Mode: P/IY = 12and C/Y = 12 Input 360 80 190,000? 0 ~ ©@8 8 @ @ cer 1,394.15 You can also let the I/Y key be the periodic rate in the problem by leaving the P/Y and CIY variables set at 1. If P/Y and C/Y are set to 1, the interest rate is the APR/m rate, or 8.0%/12. = 0.6667%. You must always be consistent (between the C/Y setting and the 1/Y input) Mode: P/Y = Land CIY = 1 Input 360 0.6667 — 190,000 ? 0 ky Y Oo a @ PT 1,394.15, Whether you use C/Y = 12 or C/Y = 1 isa personal choice, but it may de- pend on your calculator. Some calculators only allow the second style and use the symbol i% for the TVM interest key rate. This result is the periodic interest rate— the monthly rate of 3% in this problem. Of course, you can also use a spreadsheet. You will note that the spreadsheet uses the periodic interest rate, not the annual percentage rate: [Bo [fx [=PMT(B1,B2,B3,B4,B5) Use the PMT function fo find the monthly payment for a mort ment for a mortga 19f $190,000 over thirty years with an annual interest rate of 85 Rate 0,006666667 Nper 360 Pv ($190,000.00) ty 0 T Type 0 T [Pmt $1,394.15 T5.2 + Effect of Compounding Periods on the Time Value of Money Equations u7 Itis important to reiterate that the interest rate r used in the time value of money equations from Chapters 3 and 4is the periodic interest rate. Advertised rates are annual percentage rates. Therefore, to use the equations or determine the actual cost to rent money, itis essential to know the number of compounding periods per year. Remember that rand n must agree in terms of periods in the equa- tion. For example, if you are making monthly payments, you need a monthly peri- odic rate for rand the number of months over the life of the loan for m. Our mortgage problem is very similar to a future value problem with an an- nuity. Again, the periodic rate is used and the number of periods reflects the number of annuity payments. To illustrate how it works, le’s return to the mil- lionaire problem from Chapter 4, but we will now have Denise save money on a monthly basis in Example 5.2 instead of the annual savings plan. ZEEE SMW Monthly versus annual savings for retirement Problem How much does Denise need to save each period to become a million- aire by age sixty-five? Let’s assume Denise is now thirty-five years old and thus has thirty years for saving toward her one-million-dollar goal. She anticipates an APR of 9% on her investments. How much does she need to save if she puts money away annually? How much does she need to save if she puts money away monthly? Solution MeTHoD I: Using the formula For the annual annuity payments, Denise will make thirty end-of-year pay- ments at 99 APR. To reach $1,000,000, she will need to save aeeeev. —£ __ $1,000,000 ___ $1,000,000 PMT = Te yr ye (+ 0.09) — 1 136.3075 en 0.09 If she puts money away monthly, we must convert the 99 APR to the ‘monthly periodic rate of 0.0075 (0.09/12) and increase the number of pay- ments to 360 (30 X 12). The monthly savings requirement is $7,336.35 FV $1,000,000 $1,000,000 rs] 18307435 7 9946-23 PMT = T= 1 (1+ 0.0075) — 1 1830.7435 r 0.0075 the monthly annuity is not one-twelfth of the annual annuity 13 X 12 = $6,554.76 < $7,336.35). AS noted earlier, this example for Denise when she increases the Again, ($546.2: shows compounding interest at wor! number of payments per year. MerHop 2: Using a calculator ‘On the TVM keys for the monthly savings plan, we have Mode: P/Y = 12and C/Y = 12 Input 3609.0 0 ? 1,000,000 ky 4 Yo 9 ov) © 546.23 cPr118. Chapter 5+ Interest METHOD 3: Using the spreadsheet Nper 360 Pv yl { | Fv $1,000,000.00 _ ‘Type Y _ Pmt ($546.23) 5.3 Consumer Loans and Amortization Schedules ‘Twice so far in this chapter we have seen that the monthly payment is not one- twelfth of the annual payment. Why? The increasing of the compounding periods per year and thus the increasing of payments to more than once a year require us to revisit the typical consumer or business loan. By looking through the amortiza- tion window, we will also see what happens when you increase the number of payments during the year for a loan repayment. Recall the example we used in Chapter 4 for paying off a business loan of $25,000 over a six-year period with an 8% annual percentage rate. The $5,407.88 ordinary an- nuity was an annual payment, but for most loans, payments are monthly. If this loan ‘were converted to monthly payments and monthly compounding of interest, what would the monthly payments be and what would the amortization schedule look like? The known variables are the present value of $25,000, the number of years at six, and the annual percentage rate of 8%. The compounding periods are twelve per year, so the two variables of change are r and n: number of years X compounding periods per year = 6 X 12 = 72 0.08 2 " APR m 8 2 0.006667 eae $25,000 1 FF + naa 0.006666 ee $438.33 | 57.0345 ” Solving for the payment variable, we get monthly payments of $438,33, _ Table 5.3 shows an abbreviated amortization schedule that accounts for the switch to monthly payments. The monthly payments are made at the end of each month, so the interest is applied for the entire month on the outstanding balance. Monthly interest is equal to interest expense for the month = Siting principal balance x 0.08 125.3 + Consumer Loans and Amortization Schedules TABLE 5.3 Abbreviated Monthly Amortization Schedule for $25,000 Loan, Six Years at 8% Annual Percentage Rate ed Interest. | Principal | Ending Se a Terie eee matte 1 | s2600000 | s4ae.a3 s74778.4 seaaae | $490.00 s24t58 6 ‘$24, "$438.33 ‘$275.30 $24,179.56 a | s24.7066 | saae.a9 “senna | s23.00048 | 5 | seage24s | sasaza | stso35 | sa7ese | s23.003.48 S| sees | sasasa | sisza | sasoae | sza3i2.t 7 3 8 $23,342.61 | $436.33 | $196.62 | $282.71 | $23,059.90 $23,059.90 | $436.33 | sisa73_| $284.60 | $22,775.30 $22,775.30 | $436.33 | sisiea | szeeaa | $22,488.81 10__| _sezasse1 | sase33 | stao.es | $288.40 | $22,200.40 W $22,200.40 | $430.33 | $148.00 | $290.33 | $21,910.07 2 sz1gi.07 | sases3 | sia607 | $292.26 | $21,61781 | 23 | sigse5es | sasea3 | sizast | sstaaz | sia.z7182 24 $18,271.42 $438.33 $121.81 s31652 | $17,954.91 n_ | $579 | 43264 | $ 43552 7m | $ 43552 | $sasea2 | $ 290 | s43552 | $ 000 [Not Values have been rounded tothe nearest cent, The las payments $0.09 higher to cover the shortfall when the actual payments are rounded to the nearest cent. The abbreviated amortization schedule illustrates that each month less and less of the payment is applied to interest and more and more is applied to the principal. This schedule should make sense because each month we have less money borrowed (lower principal amount) than the month before, so the inter- est expense is lower with a constant APR of 8% on the loan. How does that com- pare with the annual annuity for this loan in which the annual payment was $5,407.88 ‘The total interest for the first year on the monthly payment schedule is $1,877.77 (adding up the twelve months of interest), but under the annual pay- ‘ment, the first year’s interest is $2,000 ($25,000 0.08). The average principal over the first year of the monthly loan repayment is $23,472.14 (using the monthly beginning balances) versus the $25,000 when paying off the loan with an annual payment. Therefore, the interest expense is lower for the monthly repayment plan ($23,472.14 X 0,08) versus the annual payment ($25,000 X 0.08). Over the life of the loan, the total interest expense for the monthly loan is $6,559.76, whereas the total interest payment for the annual loan is $7,447.28. The difference reflects the reduction of the principal each month versus the annual reduction of the principal; hence, the monthly payment is not one-twelfth the annual payment, ‘The average annual principal and thus the interest cost are lower the more fre- quent the payment, Reducing principal ata faster pace reduces the overall interest paid on aloan. {An interesting sidenote to these increased payments per year is what happens when you pay more than the required annuity payment. For example, you may 920 Chapter 5 + Interest Rates hear about making one extra payment a year (thirteen payments instead of twelve) on a home mortgage loan. The extra portion of the payment goes to the | principal. The amazing thing with an extra payment above the required annuity is, that it can significantly reduce the number of payments needed to pay off the loan. Let’s examine the case where you add “one extra payment” per year to a mortgage. For simplicity, we will add this extra payment equally across the twelve monthly payments. ewig Extra payment on a mortgage Problem Assume you just bought a new home and now have a mortgage. ‘The amount of the principal is $250,000, the loan is at 8% APR, and the monthly payments are spread out over thirty years. Your lender states that you may want to add an extra payment each year to the loan to reduce maturity of the loan and save money. First, what is the loan payment? Second, if you add an extra payment per year, how soon will the loan be paid off? What is the dif. ference in the total cash payments? Solution METHOD 2: Using a calculator The monthly payment is Mode: P/Y = 12 and C/y = 12 Input — 360. 8.0 250,000 £ 0 vy O8 © @ a 2» CPT 1,834.41 Je will now add this extra annual payment of $1,834.41 by splitting it evenly across the twelve payments: $1,834.41/12. The result is $120 87, but we will adda slightly lesser amount of $149.22 each month to the current pay- iment. (We have picked the amount of $149.22 so that the number of years is a whole number when we solve for how long it will take to Pay off the loan at the higher payments.) We now make monthly payments ¢f $1,983.63. We solve forthe number of payments it will take to pay off the loan, ‘METHOD 2: Using a calculator Mode: PY = 12and CY = 12 Input t 8.0 250,000 —1,983,63 0 we YO Y wy wy CPT 276.0 So, with an extra $149.22 in each three years (276 months/12 = 23 years This extra payment saves you the last seven years on eighty-four pay- ‘ments at $1,834.41 (for a total of $154,090, 44). The 090.44), total extra cash for the first 276 months is $41,184.72 (276 x $149.22), fora netseviege et5.3 + Consumer Loans and Amortization Schedules 21 Another twist to interest rates that we hear about with consumer loans concerns car loans. Have you ever seen a tel- evision ad that makes a big fuss about car loans for 0% fi- nancing or no payments for a full year? Are these commer- cials just alot of hot air or can you really borrow money for free? If you were to read the fine print, the 0% financing or the “no payments for a year” clause comes with a provision that you must pay off the loan within a specific period of time, say, the first two years for the 0% financing loan or one year for the “no payments for a year” loan. If you cannot ful- fill these requirements, you will have to pay at the annual percentage rate stated for the entire loan period, Let’s look at this scenario more closely. Can you borrow money for free? Problem Let's take a $25,000 loan over six years at 8% APR once again, but this time we'll assume it is for a car loan that offers 0% financing for the first two years of the Joan or 8% financing over six years. What are your pay- ment choices to ensure you pay no interest on the loan? ‘Can you get fre ride on your car loan with a O% interest rate? Solution Iedepends on whether you can pay off the whole loan ina Payment iasthod) short period of time, often two years (There always a catch) Make twenty-four equal monthly payments over the first two years so that the entire loan is paid in full at the end of the second year. With a 0% in. terest rate, you simply divide the car loan principal by the number of pay- ments, twenty-four: $25,000 payment $1,041.67 Payment method 2 ‘A more likely scenario is that you will elect to make the payments over the first two years as though you were going to pay the loan off over the six- year period. Typically, a loan payment schedule is set with the assumption that the loan will be paid off over the entire six years. The 8% APR is used to determine the monthly payments. The monthly payment will be $438.33 at the 8% APR. Using a calculat Mode: P/Y = 12andC/Y = 12 Input 72 8.0 25,000 2 ° ky 4) YW 9) oa) yy cPT 438.33 ‘Then, at the end of the second year, you will pay a balloon payment on the re- maining balance to pay off the car loan. How big a balloon payment will be necessary to pay off the loan so as to incur no interest?122 Chapter 5 + Interest Rates One way to determine the final balloon payment isto realize that all your monthly payments can be applied to the original principal. You have paid twenty-four payments of $438.33, or a total so far of $10,519.92. Therefore, your balloon payment is balloon payment = $25,000.00 ~ $10,519.92 = $14,480.08 ar roreanirrcies So, can you borrow money for free? In Example 5.4, the answer is yes if you are willing to make the loan period last just two years and can either pay off the balloon balance of $14,480.08 at the end of the second year following twenty-four equal payments of $438.33 or increase your monthly payments to $1,041.67. For many people, those are big if, and they usually end up making the $438.33 monthly payment for the six years. 5.4 Nominal and Real Interest Rates ‘The interest rates we are using in the introductory chapters are also known as nominal interest rates. As we shall see shortly, nominal interest rates are made up of two primary components, inflation and the real interest rate. The real interest rate is the reward for waiting; we will talk more about it as we progress through this section. The nominal rate is the percentage change in the actual dollars that you receive on your investment. The real rate is the percentage change in the pur- chasing power of those dollars; with inflation, they buy less. Let’s see how these rates work. Assume you are willing to postpone the consumption of $500 today to buy a 7% certificate of deposit (CD) at your local bank with the $500. Holding the CD for one year provides you with a 7% return. This return for postponing consump- tion implies that at the end of the year you should be able to buy more goods or services than the $500 would have purchased at the start of the year; you would have $535 for spending, As we all know, however, the prices of goods and services tend to increase over time because of inflation. Inflation will eat away at some of the benefit of the extra $35, so the 7% return should be sufficient both to cover inflation and provide some reward for waiting, Therefore, the first major compo- nent of the nominal rate is inflation, and the second is the real rate or reward for waiting, foregoing the use of the money today: nominal rate = real rate + expected inflation 53 ZEEE Nominal and real interest rates Problem Marco Corso of Corso del Tempo Books is seeking to expand his rare book collection. He has $1,000 to spend on these books today. Each year, rare books increase in price at a 4% rate (inflation). Marco believes that if he invests his money for one year, he should be able to buy twenty-one books for what twenty books would cost today. In other words, his reward for waiting one year should be the ability to buy one additional book for each twenty he could buy today. ‘What interest rate will Marco need to find in nominal terms to overcome the effects of inflation and still realize his reward for waiting?5.4 + Nominal and Real Interest Rates 123, Solution The real rate of interest or reward is the i rare books Marco wants to purchase in one ° in on | revra = (2)"" =f PV, | where FV is the number of books he wants to purchase at the end of the year, PV's the number of books he: time between the two year). So, ease in the number of an currently purchase, and 1 is the waiting purchase options in years (and for this example is one ay real rate = ( — -1=005 ae (8) oo As discussed, the nominal interest rate is the real rate plus anticipated in- flation. The assumed inflation rate is 4% on rare books, so the rate necessary to compensate for waiting and cover inflation is nominal interest rate = 5% + 4% = 9% ‘Marco will need to find a nominal interest rate of 9% to meet his reward for waiting objective. We will see, however, that this simple addition of inflation and the real rate will leave him a litle short in trying to buy the twenty-one books at the end of the year. So let's continue with the example and see why he comes up short. SS ‘What effect do inflation and the reward for waiting have on the price of books and Marco's choice to postpone buying rare books for one year? Assume the aver- age rare book costs $50 today. With his current $1,000, Marco could buy twenty books today. If he waits one year, how much will he need to buy twenty-one books? Each book will increase in price to $52.00 if we apply our anticipated inflation rate of 4%: FV = PVX (1 +7)" price at end of year for a single book = $50 X 1.04! $52.00 buy twenty-ong books at the new price will cost $1,092.00 (21 $52.00). Therefore, Marco must earn $92 on his invested $1,000 (investment earnings of 9.2%) for the year to cover both inflation and his required reward for waiting: mr , wy" 1 trater = (22) — nominal interest rater = (FV (22 ) an $1,000 9.2% (ne component ofthe nomial intrest rte isthe exp Notice that the required nominal rates slighty greater than fuser ae luton ae ee eek ee es the simple addition of the expected inflation rate of 49% and Garcia Drices for goods and services isrsing—takes a bite out of the real rate of 5%. purchasing power of money. meChapter + Interest Rates We can write the true relationship between the nominal interest rate and the real rate and expected inflation as Q+n=Q+r)x (+h) 5.4 or \r=G+ ex (Ltn 5.5 where r is the nominal interest rate, r* is the real interest rate, and his inflation. This relationship is called the Fisher effect, after economist Irving Fisher. ‘The Fisher effect is the relationship between three items: the nominal rate, the real rate, and inflation. Equation 5.5 can be restated as per tht xm 5.6 This new equation tells us that the true nominal rate is actually made up of three components: the real rate, the inflation rate, and the product of the real rate and inflation. Looking back at Example 5.5, we find that the required nominal rate and the three components are 9.2% = 5% + 4% + (5% X 4%) The product of the real rate and the inflation rate can be thought of as the additional compensation needed because the interest earned during the year is also subject to inflation or a loss of purchasing power at the end of the year. This, product can be quite small, even though in this example it is 0.2%. Therefore, it is very common to approximate the nominal rate as simply the real rate plus inflation: approximate nominal interest rate = real rate + inflation or rth 5.7 To be accurate about the nominal rate, however, all three pieces need to be used: true nominal interest rate = real rate + inflation + (real rate X inflation) or mths (exh) Again, we want to emphasize that almost all financial rates are quoted in nominal terms. 5.5 Risk-Free Rate and Premiums We have looked at two important concepts in regard to interest rates: the concept of annual rates and periodic rates, and the concept of real rates and nominal rates. ‘When you visit any financial institution, however, you will see many different ad. vertised rates. For example, a visit to the Web site of a local credit union revealed a number of borrowing rates and investing rates as shown in Table 5.4, Why are these nominal rates different? Why does the credit union charge you one rate when you borrow for a house and another rate when you borrow for car or boat? When you get a credit card, why isthe rate so much higher than the Fate you get when you borrow for a house or car or boat? Also, why is the bank5.5 + Risk-Free Rate and Premiums 125 TABLE 54 Advertised Borrowing and investing Rates ata Credit Union, january 22, 2007 RE ce rowing Investing Real estate 30-year fixed 6.50% 90t0 181 days | 2.50% Real estate 15-year fixed 6.02% 1e2t0364aays | 4.00% [ew auto toan 718% 1210 24months | 4.15% Usod auto loan 728% 24%0.36 months | 4.20% New boat or AV loan 750% 361048 months | 425% | Used boat or AV loan 850% 481060 months | 4.30% Visa Rewards creditcard | 14.as% Over 5 years 4.35% Vis Value credit cara 175% | [ willing to pay you more the longer you leave your money in a certificate of deposit? These differences can generally be explained by two factors: 1. The level of risk of the investment or loan 2. The length of the investment or loan ‘The two major components of the interest rate that cause rates to vary across different investment opportunities or loans relate to these two factors. They are, respectively, the default premium (which relates to risk) and the maturity premium (which relates to time), Let's examine the default premium first. Looking back at the loan rates, we see that the house loan rate (thirty-year fixed loan) is 6.50%, the loan rate for a new car is 7.14%, and the borrowing rate for a Visa Rewards card is 14.45%. One rea- son these rates vary is that the default rates or potential losses due to default are different for these different kinds of loans. For the home loan, the collateral (the house) is an asset that will increase in value over time (in general); with a car loan, the collateral (the car) decreases in value over time. If the borrower cannot pay back the loan and must default, the lender can take the asset to cover the loan. With a house, the potential loss due to default is less because the growing value of the asset should be sufficient to cover the outstanding balance (principal) of the loan. For the car, however, the decreas- ing value of the collateral may not be sufficient to pay off the remaining balance of the loan with a default. A personal credit card essentially has no collateral, so the potential loss is even higher if the customer defaults on his or her credit card payments. The default premium is therefore that portion of a borrowing rate that compensates the lender for the higher risk associated with varying types of, collateral. ‘Another part of the default premium has to do with the frequency of default by the borrower. Some investments or loans have a higher frequency of default than others. The frequency of default on a home loan is much lower than the fre- quency of default on a credit card. In the investment world, the frequency of bankruptcy (a default) for a high-tech start-up company is higher than for a blue- chip company, so we see higher borrowing rates for start-ups than for mature companies. Is there a base rate that has no potential for default? The answer is yes, the risk-free rate. We will build the different rates for loans and investments from this rate. A risk-free rate is a theoretical interest rate at which an investor is guaranteed126 Chapter 5 + tntetest Rates tearm the subseribed rate and at which the borrower will never defaults in other words, itis the rate of return for an investment with zero risk. We typically think the US.‘Treasury bill asa risk-free investment. That is, we assign avery low probabibity of default to the US. Treasury and thus assume that all Treasury bills fell be pad in full at maturity and have a zero default premium (dp = 0) 58 Treasury bill interest rate = 1y made up of two components, the real rate plus Treasury bill rate as Again, this stated risk-free rat inflation, so we can write the U. yar + inf 59 where isthe risk-free interest rate, isthe real rate of interest, and infs the rate of inflation, ‘What happens when we add the element of default to an interest rate? Let’ re- turn to our rare book buyer, Marco Corso. It was assumed that if he invested his $1,000 at 9.2%, he was sure to receive a yield of 9.2% at the end of the year. This guaranteed return by the bank would mean that Marco had assumed no default risk and thus was a risk-free nominal interest rate, but what if the bank were un- able to pay the full 9.2% at the end of the year? Then, Marco would be short of the needed funds to purchase his twenty-one rare books. Thus, Marco, like all in- vestors, would also need to receive some extra compensation in the form of a higher yield or interest rate for this potential default on the part of the bank. The higher the potential default, the greater the risk assumed by the investor and hence the higher the yield required. In Marco's case, the default risk will be based on the financial stability of the bank offering the 9.2% interest rate. We add this default premium to determine the nominal interest rate for a specific investment or loan, posed of the real rate, inflation, and a default premium (dp): no soit r=r+ inf + dp } 5.10 The default premium compensates the investor for the additional risk taken on by the investor that the loan will not be repaid in full. Interest rates can now be thought of in two dimensions: an inflation dimen- sion and a default dimension. These two dimensions are illustrated in Figure 5.1. Maturity Premiums If you look back at the loan rates in Table 5.4 on a house for a fifteen-year loan versus a thirty-year loan (6.02% versus 6.50%) or the different rates on the Real to nominal: add inflation | Real Nominal 1 ere Risk-free rt yee +f Ris tee (reasurybit) |g, | add | default ror +inf+ dp FIGURES. Inteestrate (annua percentage dimensions.55 + Risk-Free Rate and Premiums available certificates of deposit (from 2.5% to 4.35%), you can see that the shorter the period, the lower the rate. That is, if you invest money for a short petiod—say you buya six-month CD—you will not receive as high an interest rate as if you bought a CD with a longer maturity period. This difference in rates as the bor- rowing time or investment horizon increases is due to the maturity prentium of the investments, In the cases of the house mortgages and the CDs, remember that we are look ing at different time horizons, with everything else held constant. In the case of the mortgage, itis the same house, the same lender, and the same borrower with the same capability for repaying the loan, but with two different choices: one loan for fifteen years and another for thirty years. In the case of the CD, itis the same credit union and the same investor, but seven different maturity dates for the dif- ferent CDs. How does extending the time horizon affect the interest rate? To answer this question, we need to ask two additional fundamental questions about borrowing. and lending money: 1, When you borrow money, when is the optimal time for you to pay back the money? 2. When you loan money, how quickly do you want to be repaid? When we borrow money, we would like to wait as long as possible to pay back the loan, When we loan money, we want to be repaid as quickly as possible. Therefore, borrowers want to borrow in the long term and lenders want to lend in the short term. In other words, we have different maturity preferences between borrowers and lenders. How do these different time horizons play out in the real world? How does a lending institution encourage you to take a shorter period on your mortgage when your incentive might be to stretch it out to the full time horizon of the loan? It of- fers a lower rate on the shorter-period loan. How does the institution encourage you to invest your money in longer-term CDs when your incentive might be to cash in as soon as possible? It offers higher rates on longer-term CDs. By offering lower borrowing rates for shorter maturities, the lender (the institution) entices the borrower (you, the mortgagee) to shorten the loan period. Conversely, by offer- ing higher investment rates for longer maturities, the borrower (the lending insti- tution) entices the lender (you, the CD buyer) to lengthen the investment period, _The maturity premium (mp), then, represents that portion of the nominal interest rate that compensates the investor for the additional waiting time or the ender for the additional time it takes to receive repayment in full. In general, the longer the period of the investment, the greater the extra reward an investor de- mands; the longer the loan, the greater the risk of nonpayment and thus the higher the interest rate the lender demands. ‘We have now added another dimension to the nominal interest rate so that our nominal advertised interest rate reflects the real rate, inflation, the default Premium, and the maturity premium: r= 9 + inf + dp + mp 3al At this point, let’s review the most important points about interest rates you have learned so far in this chapter. ™ Itis standard to use the nominal annual percentage rate (APR) as the basic quoted rate for interest. The annual percentage rate remains the bellwether interest rate. 127128, Inflation rate Chapter 5 + Interest Rates = The effective annual rate (EAR) is the rate that provides the best information on the actual cost of a loan for borrowers or yield on an investment for investors. = The periodic interest rate (semiannual, quarterly, monthly, or daily rate) is the rate used in the time value of money equations. = The components (real rate, inflation, default premiums, and maturity premi- tums) determine the rate for individual loans or investments, 5.6 A Brief History of Interest Rates and Inflation in the United States The four major components of interest rates vary over time. Thus, nominal inter- est rates vary across the same investment or loan over time. For example, interest rates change daily on mortgage and car loans, government bonds, corporate bonds, and other financial assets. During the early 1980s, interest rates on home mortgages were as high as 16%. Today, rates are around 5%, back to some of the all-time-low rates. How much do interest rates vary over time, and to what extent do the swings in the interest rate components of inflation, default premiums, and ‘maturity premiums contribute to the variation in interest rates? By looking at his- torical interest rates, we can get a feel for the variation in the components (how much they move from period to period) and the range of the components (what the highest rates are and what the lowest rates are). First and probably easiest to understand is that inflation varies over time. One year’s inflation rate may be 3%; another year’s inflation rate may be 15%. To ap- preciate the variation in inflation, we can look at historical U.S. inflation rates in Figure 5.2. Toiillustrate how much a nominal rate composed of just inflation and the real rate can vary over time, we can examine the historical interest rates on the three- month U.S. treasury bill from 1950 to 1999 as depicted in Figure 5.3. This invest- ‘ment instrument is assumed to have a zero default premium and has the shortest maturity of the U.S. Treasury bills; thus, it has no maturity premium. The year-to- year differences are attributed only to changes in the real rate and inflation, FIGURE 5.2 _ Inflation Rates in the United States, 1950-19995.6 + A Brief History of Interest Rates and Inflation in the United States 129 Interest rate Year FIGURES3 Interest Rates forthe Three-Month Treasury Bil 1950-1999 Because Figure 5.2 and Figure 5.3 present data over the same time period, from 1950 to 1999, can we combine the information in the two graphs to estimate the change in the real rate from year to year? There are a few problems with such a simple approach to estimating the real rate of interest, First, the yields are based on expected inflation, and Figure 5.2 shows actual inflation (historically meas- tured). So, we actually have a nonsynchronous set of observations. We can get an average real rate if we assume that expected inflation and actual inflation are on average the same when we look over a relatively long period of time. Figures 5.2 and 5.3 show that the risk-free rate (using the three-month US. ‘Treasury bill) in the United States has varied from slightly under 1% to a high of nearly 15% in the early 1980s. Inflation has varied from a low of negative 196 toa high of slightly over 139%. The average rate for the three-month Treasury bill from 1950 to 1999 has been 5.23%, and the average inflation rate during this same pe- riod has been 4.05%. Using a simple approximation we can say that the average real interest rate from 1950 to 1999 has been 1.18%: nominal rate = real rate + inflation 5.23% = real rate + 4.05% real rate = 5.23% ~ 4.05% = 1.18% Other interest rate data provide insight into the magnitude of the default pre- ‘ium and the maturity premium, Table 5.5 shows the average and the standard TABLES. Yields on Treasury Bills, Treasury Bonds, and AAA Corporate Bonds, 1953-1999 co ec) Average 5.23% 6.64% 713% ‘Standard deviation 2.98% 2.86% 295% Source St. Louis Federal Reserve.130 Chapter 5 + Interest Rates Ks istorical yields on the Treasury bill, the twenty-year Treasury poet a Tee AA, A Goa bonds (the bonds with the lowest defaul, Taweeen 4 rough estimate of the default premium for the fifty-year time pe, od between the top-rated corporate bonds and U.S. government bonds. If we 4s, sume the AAA corporate bonds have the same maturity as that of the Treasury bonds, the average difference over this period (1953 to 1999) is 0.49% 7 13% ~ 6.649%) We can get a rough estimate of the maturity premium between the three-month Treasury bill and the twenty-year Treasury bond as well. The maturity premium jg 1.41% when using the average yields (6.64% — 5.23%). So, if we want an idea of the average size of the four components of the nomi. nal interest rate in the market for a fifty-year period for twenty-year, AAA corpo. rate bonds we have Inflation at 4.05% Real rate at 1.18% Default premium of 0.49% (for AAA over government bonds) Maturity premium at 1.28% (for twenty-year maturity differences) Although this approach to estimating the size of the components is very simple, we do get an idea of their relative contribution. And, of course, the default premi- ums and maturity premiums will vary as we look at investments with more or less risk and longer or shorter maturities. To review this chapter, see the Summary Card at the end of the text. Key Terms annual percentage rate (APR), p.112 fisher effect, p. 124 annual percentage yield (APY), p. 114 maturity premium, p. 127 compounding period, p. 112 nominal interest rate, p. 122 compounding periods periodic interest rate, p. 112 per year (C/Y), p. 112 teal interest rate, p. 122 default premium (dp), p. 125 reward for waiting, p. 122 effective annual rate (EAR), p- 113 risk-free rate, p. 125 Questions 1. Why does it make sense to say that the interest rate is the price to rent money? 2. Which of the following statements is true? Give all correct answers. a. effective annual rate > annual percentage rate . effective annual rate = annual percentage rate effective annual rate < annual percentage rate 3. When you increase the number of payments Per period, why does the total cash payments times the number of payments in the period not, equal the orig- inal single payment for the period? (In other words, why does twelve times monthly payment on a loan with a positive interest rate not equal the required annual payment on the same loan amount with the same interest sate?)