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Chapter 5

# Chapter 5 - 1 Chapter5 Interest Rates PattyRobertson 2...

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Principles of Finance – FIN 3100 Chapter 5  – Interest Rates 1 Patty Robertson May not be

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Agenda Discuss how interest rates are quoted, and  compute the effective annual rate (EAR). Explain the real rate of interest and the effect of  inflation on nominal interest rates. Summarize the two major premiums that  differentiate interest rates. 2
Abbreviations 3

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More Abbreviations 4
Interest Rates Borrowing money costs money. Sometimes convention influences rate quotation; sometimes it  is governed. Sometimes, those extending credit deliberately mislead  borrowers. Understanding how rates are quoted, and how to convert  them for financial analysis, is critical. 5

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Compounding Periods In Chapter 3, we acknowledged that not all  interest is compounded  annually. It could be compounded daily, weekly, monthly,  quarterly, or semi-annually. We can use our formulas, but they require some  modification. We need to adjust the compounding periods ( t ). But, the  r  and the  t  must match. 6
Interest Rates In Financial Analysis Is 10% compounded semi-annually the same  thing as 10% compounded annually?  Which  would you rather have? 10% compounded semi-annually is 10% / 2 =  5% paid every six months. \$1,000(1.1) = \$1,100.00 \$1,000(1.05)2 = \$1,102.50   10.25%  [(\$1,102.50-\$1,000) / \$1,000] 7

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Interest Rates In Financial Analysis To be comparable, rates must be converted to  effective rates . The interest rate that is expressed as if it were  compounded once per year. It is the true rate of interest. EAR of 10% compounded annually = 10% EAR of 10% compounded semi-annually =  8
Interest Rates In Financial Analysis The relationship between a  quoted  rate, such  as an  annual percentage rate (APR),  and the  effective annual rate (EAR)  is:   EAR = (1 + Quoted rate /m ) m    1 where m  is the number of times during the year  the money is compounded (the number of payments during the year). 9 EAR = 1 + APR m m ( 29 - 1

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Which Would You Choose? 1. 16% compounded annually? 2. 15.5% compounded quarterly? 3. 15% compounded daily? 10
Which Would You Choose? 1. 16% compounded annually? EAR = 16% 2. 15.5% compounded quarterly? EAR = [1 + (.155/4)]4 – 1 = 16.42% 11

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Which Would You Choose? Before we looked at 15.5% compounded  quarterly… The EAR = 16.42% 15.5% compounded quarterly = 16.42%  compounded annually (1 + .155/4)4 = (1 + .1642) Assume you invest \$1,000: \$1,000(1 + .155/4)4 = \$1,164.24 12
Making Sense of Quoted Rates The highest  quoted  rate is not necessarily the best rate.

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Chapter 5 - 1 Chapter5 Interest Rates PattyRobertson 2...

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