Types of interest rates

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Mayank
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12 Oct 2017, 18:37

Nominal Interest RateThe nominal interest rate 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 coupon rate for fixed income investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons that were redeemed by the bondholders.
 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.
 Real Interest RateThe real interest rate is slightly more complex than the nominal rate but still fairly simple. The nominal interest rate doesn’t tell the whole story because inflation reduces the lender's or investor’s purchasing power so that they cannot buy the same amount of goods or services at payoff or maturity with a given amount of money as they can now.The real interest rate is so named because it states the “real” rate that the lender or investor receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate. If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is only 2%. Nominal interest rate Inflation = Real interest rateSeveral economic stipulations can be derived from this formula that lenders, borrowers, and investors can use to make more informed financial decisions. 
  • 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 deflationperiods.
 
  • 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 time horizons may, therefore, be able to more accurately assess their investment returns on an inflation-adjusted basis.
 Effective Interest Rate 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. 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 
  • 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 deflationperiods.
  •  
  • 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 time horizons may, therefore, be able to more accurately assess their investment returns on an inflation-adjusted basis.
Effective Interest RateOne other type of interest rate that investors and borrowers should know is called the effective rate, which takes the power of compounding into account.
 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 AER on a financial product is calculated and advertised are less stringent than for the annual percentage rate (APR).
Mayank Goyal

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