Interest Rate Quotes and

Adjustment
1. Learn to adjust different interest rate quotes to a consistent discount
rate

Comparing rates that are quoted differently

You need to borrow $15,000 for a new car, which loan should you choose?

A. BankTwo offers 9% p.a. Annual Percentage Rate (APR) with quarterly

payments.

B. WhichBank offers nominal rate of 8.95% p.a. with monthly payments.

C.AnotherNewZombie Bank offers 9.25% Effective Annual Rate (EAR) with

monthly payments.

D.EastPac Bank offers a rate of 0.75% per month.

E. NewApeBank offers 8.9% APR with fortnightly payments.

APR: Annual Percentage Rates

1. The Annual Percentage Rate (APR) indicates the amount of simple

interest

earned in one year.

2. Simple interest is the amount of interest earned without the effect of

compounding.

For example, on an $100 investment you earn $3 interest at the end of June

and December. Assuming no compounding, what is the amount of interest

you

earned?

• You earn 3% every half year, and thus 6$ pa APR. We ignore the interest on
interest you would have earned in December ($3 × 3% = $0.09).

3 . Using APR as a Discount Rate

• The interest rate needs to be consistent with the cash flow interval(time)
e.g. monthly interest rate with monthly cash flows.

• The APR itself cannot be used directly as a discount rate unless we have
yearly cash flows. So, we use:

Interest Rate per Compounding Period = APR/ k periods/year

• Use this with TVOM formula, you effectively captures the compounding
effect e.g.

FV = $1 * (1+r month )^12. Does it look like 1+ EAR = (1+ APR/k )^k

EAR: Effective Annual Rate

1. The Effective Annual Rate (EAR) indicates the total amount of interest
that

will be earned at the end of the year.

2. Compounding is included in EAR.

3. EAR is the equivalent of the annually compounded rate.

For example, on an $100 investment you earn $3 interest at the end of June
and

December. Assuming compounding, what is the amount of interest you

earned?

• Regard the previous slide, we need to add the $0.09 interest on interest,

thus your EAR is 6.09%.

• (1.03)2 − 1 = 6.09%

4. Using EAR as a Discount Rate

• We could also ask: What if we know the EAR of an investment, how can we
calculate the discount rate per period?

• General Equation for Discount Rate Period Conversion

Equivalent n – period discount rate

Equiv R = r per = ( 1+ EAR )^( 1/n) -1

• n is the number of compounding periods in a year.

E.g. What is the semi-annual discount rate to have an EAR of 5%?

- (1+ 5%)^1/2 +1= 2.0247 = 2.47% => It means that if you earn 2.47%
every six months, you would earn 5% for the entire year (EAR).

- With quarterly: (1+ 5%)^1/4 +1 = 1.23%

Conversion between APR and EAR

• Converting quoted APR to EAR and vice versa is easy!

• m = 2, 4, 12 for half-yearly, quarterly or monthly...

1+ r = (1+ y/m)^m

(Where r is EAR and y is APR of compounding period m)

Example:

Compounding Interval Effective Annual Rate

Annual (1+0.06/1)1-1=6%
Semiannual (1+0.06/2)2-1=6.09%
Monthly (1+0.06/12)12-1=6.1678%
Weekly (1+0.06/52)52-1=6.1800%
Daily (1+0.06/365)365-1=6.1831%

• A 6% APR with continuous compounding results in an EAR of 6.1837%.

• The EAR increases with the frequency of compounding.

Continuous compounding is compounding every instant. When m gets

very large, EAR approaches its limit.

EXAMPLE:

1. Suppose an investment pays interest quarterly with the interest rate

quoted as an effective annual rate (EAR) of 9%.  If you have no money in
the bank today, how much will you need to save at the end of each quarter
to accumulate $25,000 in 5 years? -> n= 20

C = FV(annuity) / (1/r x ((1+r)^n -1))

(Where r is r per Equiv R)

- r per = 0.02178 = 2.17% per quarter

- C = $1.010.825 per quarter

2. A firm is considering purchasing or leasing a luxury automobile for the

CEO. The vehicle is expected to last 3 years. You can buy the car for $65,000
up front, or you can lease it for $1,800 per month for 36 months. The firm
can borrow at an interest rate of 8% p.a. with quarterly compounding. Should
you purchase the vehicle outright or pay $1,800 per month?

- interest rate of 8% p.a. with 4 compounding period=> interest rate per(1)

compounding period = 8%/4

- 1+ EAR = (1+ 8%/4)^4 = 1.082432 -> r= 0.66227%

- PV = C x (1- (1+r)^-N)/r = 1,800 x ( 1- (1 +0.66227%)^-36)/r = $57,486 <

65,000

=> choose the latter option

3. Between a return of 12% EAR or 12% APR with monthly payments, which
one would you choose?

- 1+ EAR2 = (1 + APR/k)^k

- EAR2 = 12.68% > EAR1=12% => choose the latter one

Application: Loan Payments

• Payments are made at a set interval, typically monthly.

• Each payment made includes the interest on the loan plus some part of the
loan balance. • All payments are equal and the loan is fully repaid with the
final repayment.

Amount Borrowed = PV ( Loan Payments)

Example:

- Consider a $30,000 car loan with 60 equal monthly payments, computed

using a 6.75% APR with monthly compounding.

C = (r x PV)/ (1-(1+r)^-N) = $590.5 ( monthly payment)

- One can compute the outstanding loan balance by calculating the present
value of the remaining loan payments. After making 12 payments on the
loan, what is your remaining balance( remaining PV after 12 payments)?
+ PVremained= C x ( 1-(1+r)^-N)/r = 590.5 x (1- (1 + 6.75%/12)^-(60-12))/r
= $24,779.245

+ The principal paid (tiền gốc đã trả ) = original principal – remaining

balance = 30,000-24,779.245= $5,220.755

+ The interest paid ( tiền lãi đã trả )= total amount paid – principal paid

+ Total amount paid = monthly payment x 12 =$7,086

=> interest paid = $1,865.245

Real and Nominal Rates

• Nominal Interest Rate ( lãi xuất danh nghĩa) : The rates quotes by financial
institutions and used for discounting or compounding cash flows.

• Real Interest Rate (rr ): The rate of growth of your real purchasing power,
after adjusting for inflation.

Growth in Purchasing Power = 1+ rr = (1+ r)/(1+i) = Growth of Money/

Growth of Prices

rr = (1+r) / (1+i) -1 = (r-i) / ( 1+i) ≈ r – i

example:

• On 31 Dec 2010, the shortest Australian Government bond rate was 5.09%.

• Inflation was 3.1% in Australia in 2011.

• What is the real interest rate implied by these figures?

-> rr = 1.9302% ≈ 𝑟 – 𝑖 = 1.99%

Inflation and Nominal Rates in Australia
Interest Rates Affect Firm Incentives

• Consider an investment that requires an initial investment of $10 million

and generates a cash flow of $3 million per year for four years. If the interest
rate is 5%, the investment has an NPV of:

Opportunity Cost of Capital

1. The discount rate used to evaluate the cashflows is known as the cost
of capital or the opportunity cost of capital.

2. It is the best available expected return offered in the market on an

investment of comparable risk and term to the cash flow being discounted.

For a risk-free project, what is the discount rate that should be used? -> Use
the U.S. Treasury

For a risky project, should the discount rate be higher or lower than the US
Treasury rate? Higher to compensate for the additional risk

What are Yield Curves?

  A yield curve is a graph that illustrates the relationship between yields(
lợi suất) and maturities ( kì hạn) of fixed income securities( chứng
khoán).

1. Term Structure: the relationship between between the investment term

(maturity) and the interest rate.

2. The yield curve for US Treasury securities is considered a market

benchmark( tiêu chuẩn thị trường)

Example:

The Short End and the Long End of the Yield Curve

1. The short end of the yield curve is determined by monetary policy. The
Federal Open Market Committee (FOMC) sets a target for the federal funds
rate( lãi suất quỹ liên bang) (the overnight rate at which banks trade funds
parked with the Federal Reserve).

2. The long end of the yield curve is driven by the pricing of long-dated
US Treasuries. (1) Inflation expectations, (2) Risk premia ( phần bù rủi ro )and
(3) Investor preferences all play a role in shaping the long rate.

Normal Yield Curves

1. Investors expect the economy to grow in the future

2. Stronger growth to lead to higher inflation and higher interest rates

3. Central banks easing monetary policy

Inverted Yield Curves

1. Investors expect the economy to slow or decline in the future

2. Slower growth may lead to lower inflation and lower interest rates for all
maturities

3. Typically indicates that central banks are tightening monetary policy,

limiting the money supply and making credit less available

Tutorial 3 Questions
Question 1

If you were offered a return of 12% EAR or 12% APR with monthly payments,
which one

would you choose?

-> Choose the latter one

Question 2

Convert 10% APR with quarterly payments into its EAR.

->1+ EAR = (1+ APR/k)^k -> EAR = 10.38%

Question 3

(a) Consider a $30,000 car loan with 60 equal monthly payments, computed
using a

6.75% APR with monthly compounding. Work out the monthly payment
(basically

the coupon of the annuity).

-> Monthly payment = C = $590.5

(b) After making 12 repayments on the loan above, use the present value
formula to

work out the remaining balance of the loan.

-> PV= $24,779.4

Question 4

(a) If the yield curve is positively sloping, such that the yield to maturity of
long dated

zero-coupon bonds are higher than the yield to maturity of short dated
treasury bills,

what does this imply about investor expectations of future interest rates?

-> A positively sloping yield curve typically implies that investors expect
interest rates to rise in the future. When investors anticipate higher future
interest rates, they demand higher yields for long-term bonds to compensate
for the risk of rising rates.
(b) If the yield curved inverted, what does this mean about the yield to
maturity of short

maturity bonds vs. long maturity bonds? Furthermore, what does this mean
about

the state of the economy?

-> - The yield to maturity of short-maturity bonds is higher than that of long-
maturity bonds.

- State of the Economy:

- Economic Recession: An inverted yield curve is often seen as a predictor

of an economic recession. Investors expect that interest rates will fall in the
future due to declining economic activity.

- Monetary Policy: Central banks might lower interest rates to stimulate the
economy in anticipation of or during a recession, leading to higher short-
term yields compared to long-term yields.

Question 5

You buy an apartment in Brisbane for $1,200,000. 50% of this is funded by a

20 year

mortgage. The bank charges you 4% APR compounded monthly. You pay
exactly the

monthly instalment suggested by the bank. After 5 years, you sell your
apartment for

$1,400,000 and repay any outstanding debt you have with the bank. How
much are you left

with?

->

- Initial down payment= $600,000

- the mortgage amount = $600,000

The monthly payment on the mortgage: C = $3,635.88

The remaining balance of the mortgage: PV = $491,542.7

=> left with = 1,400,000-491,542.7= $908,457.3