Types of interest rates • Actuarial Forums

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October 12, 2017 at 1:07 pm #22725
Mayank Goyal
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~~~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~Nominal Interest Rate[/color][/font]~~[/font][/size]~~~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~The [/font][font=Source Sans Pro,serif]~~nominal interest rate[/url] is conceptually the simplest type of interest rate. It is quite simply the stated interest rate of a given bond or loan. This type of interest rate is referred to as the [/color]coupon rate[/url]~~fixed income investments[/url]~~issuer[/url]~~bondholders[/url].[/font]~~~~~~~~[/font][/size]~~

~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~The nominal interest rate is, in essence, the actual monetary price that borrowers pay to lenders to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them.[/font][/font]

~~~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~Real Interest Rate[/color][/font]~~[/font][/size]~~~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~The [/font][font=Source Sans Pro,serif]~~real interest rate[/url] is slightly more complex than the nominal rate but still fairly simple. The nominal interest rate doesn’t tell the whole story because [/color]inflation[/url]~~lender[/url]~~~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~The real interest rate is so named because it states the “real” rate that the lender or investor receives after~~~~ ~~[/font]~~~~[font=Source Sans Pro,serif]~~inflation is factored in[/url]; that is, the interest rate that exceeds the inflation rate. If a bond that compounds annually has a 6% [/color]nominal yield[/url] and the inflation rate is 4%, then the real rate of interest is only 2%.[/font][/font][/size] ~~[font=Times New Roman,serif]~~~~[font=Source Sans Pro,serif]~~Nominal interest rate [/font]~~[font=Tahoma,sans-serif]~~–[/font]~~[font=Calibri,sans-serif]~~ Inflation = Real interest rate[/font][/font]~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~Several economic stipulations can be derived from this formula that lenders, borrowers, and investors can use to make more informed financial decisions.[/font][/font]

~~[font=Calibri,sans-serif][font=Source Sans Pro,serif]~~Real interest rates can not only be positive or negative but can also be higher or lower than nominal rates. Nominal interest rates will exceed real rates when the inflation rate is a positive number (as it usually is). But real rates can also exceed nominal rates during [/color][/font]~~[font=Source Sans Pro,serif]~~deflation[/font][/url]~~[font=Source Sans Pro,serif]~~periods.[/font][/font][/size]

~~[font=Calibri,sans-serif][font=Source Sans Pro,serif]~~A hypothesis maintains that the inflation rate moves in tandem with nominal interest rates over time, which means that real interest rates become stable over longer time periods. Investors with longer [/color][/font]~~[font=Source Sans Pro,serif]~~time horizons[/font][/url]~~[font=Source Sans Pro,serif]~~ may, therefore, be able to more accurately assess their investment returns on an inflation-adjusted basis.[/font][/font][/size]

~~~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~Effective Interest Rate[/color][/font]~~[/font][/size] ~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~One other type of interest rate that investors and borrowers should know is called the effective rate, which [/font]~~[font=Source Sans Pro,serif]~~takes the power of compounding into account[/url].[/font][/font] ~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~For example, if a bond pays 6% on an annual basis and compounds semiannually, then an investor who invests $1,000 in this bond will receive $30 of interest after the first 6 months ($1,000 x .03), and $30.90 of interest after the next 6 months ($1,030 x .03). The investor received a total of $60.90 for the year, which means that while the nominal rate was 6%, the effective rate was 6.09%.[/font][/font] ~~[font=Times New Roman,serif][font=Source Sans Pro,serif]~~Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific period[/font][/font]

Real interest rates can not only be positive or negative but can also be higher or lower than nominal rates. Nominal interest rates will exceed real rates when the inflation rate is a positive number (as it usually is). But real rates can also exceed nominal rates during [/color][/size]deflation[/url]periods.

A hypothesis maintains that the inflation rate moves in tandem with nominal interest rates over time, which means that real interest rates become stable over longer time periods. Investors with longer [/color][/size]time horizons[/url] may, therefore, be able to more accurately assess their investment returns on an inflation-adjusted basis.

~~Effective Interest Rate[/color][/size]~~One other type of interest rate that investors and borrowers should know is called the effective rate, which takes the power of compounding into account[/url].

For example, if a bond pays 6% on an annual basis and compounds semiannually, then an investor who invests $1,000 in this bond will receive $30 of interest after the first 6 months ($1,000 x .03), and $30.90 of interest after the next 6 months ($1,030 x .03). The investor received a total of $60.90 for the year, which means that while the nominal rate was 6%, the effective rate was 6.09%.

Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific period. Note that the rules pertaining to how the [/color]AER[/url]~~annual percentage rate[/url] (APR).[/size]~~