TOPIC-5-Interest-Rate-and-Its-Role-in-Finance.pdf

INTEREST RATES
AND ITS ROLE IN
FINANCE
BUSINESS FINANCE

CONTENT
01 Definition and Concept of Interest Rates
02
03
04
05
06
Interest Rate and Rate of Return
Interest vs. Discounts
Measurements of Interest Rates
IR and Its Role in Finance
Interest Rate Theory
Determinants of Interest Rates
07

Renz Vane Aguilar
THE TEAM
Meet
Mirasol Calisaan
Kayla Mae Dela Cruz
Jaynica Floranza
Mica Labrador
Alexa Jane Medel

INTEREST RATE
An interest rate refers to the amount charged by a
lender to a borrower for any form of debt given,
generally expressed as a percentage of the
principal.
The asset borrowed can be in the form of cash,
large assets such as vehicle or building, or just
consumer goods. In the case of larger assets, the
interest rate is commonly referred to as the “lease
rate.”

Whenever you borrow money, you are required to pay
that base amount (the principal) back to your lender. In
addition, you will be required to pay your lender the
interest, which is typically an annual percentage of the
principal, set for the loan. These loans come in many
forms. You may encounter them in the form of credit
cards, car loans, mortgages, personal loans and more.
Understanding how the interest terms and repayment
requirements work is important.
How Interest Works
when Borrowing?

When the borrower is considered to be low risk by the
lender, the borrower will usually be charged a lower
interest rate. If the borrower is considered high risk, the
interest rate that they are charged will be higher, which
results in a higher cost loan.
How Interest Works
when Borrowing?
Risk is typically assessed when a lender looks at a
potential borrower's credit score, which is why it's
important to have an excellent one if you want to qualify
for the best loans.

INTEREST RATE AND
RATE OF RETURN
Rate of return refers to a value that indicates
how much return is generated based on the
initial investment made, also called the capital.
This rate is expressed as a percentage and is
based on the capital and the annual return,
which is the amount earned over the course of
a year.
An interest rate, on the other hand, is based on
additional amounts paid on a loan that are not
part of the actual loan repayment itself.

The Basis of Comparison Interest Rate Discount Rate
Meaning
Lenders charge borrowers an
interest rate for using assets.
Discount Rate is the interest
rate the Federal Reserve Banks
charges to the depository
institutions and commercial
banks on its overnight loans
Charged on Individuals/Borrowers
Depository/Institutions/Commerci
al Banks
Rates are decided by Commercial Banks Central Banks
INTEREST VS. DISCOUNTS

The Basis of Comparison Interest Rate Discount Rate
Dependency
Depends on some factors, such
as the Borrower's
creditworthiness, the risk
associated with lending, and the
market interest rate.
The Central Banks determine the
discount rate, independent of
the market rate of interest.
Usage
Determining present value is not
possible with discount rates.
It can be used in determining the
present value of future cash
flows.
Perspective
Based on the Market and focusing
on the Lender's point of view
Focusing on the Investor's Point of
View.
Economies
Affected by Demand and Supply
in supply in the economy.
Not Affected by Demand and
Supply in supply in the economy
INTEREST VS. DISCOUNTS

DIFFERENT
MEASUREMENTS
OF INTEREST

Simple interest is a type of interest that is calculated only on the initial amount
borrowed/invested, without considering any interest charged/earned in previous
periods. It is a fixed percentage of the principal amount that is charged or earned
over a specific period of time.
To compute for Simple Interest:
where:
P= principal (amount borrowed/loaned)
r= rate of interest
t= time of the loan
i= Interest earned
F= Future Value
Simple Interest
Formula:
I = Part
F = P + I

Simple Interest
Steve placed his money
worth P150,000 in an
investment instrument that
earns 6% simple interest
rate per year. How much will
his money be after 4 years?
Example
Principal (P) = 150,000
Interest rate (r)= 6% = 0.06
Time (t) = 4
I = Prt
I = (150 000) (0.06) (4)
I = 36,000
F = P + I
F = 150,000 + 36,000
F = 186,000
Solution:
1. Identify the given from the problem.
2. Compute for the interest (I).
3. Compute for the maturity value (F).
Therefore, Steve will have P186,000 after four years.

Compound interest is the interest on savings calculated on both the initial principal and
the accumulated interest from previous periods.
Compound Interest
It is the interest due computed every conversion period and added to the principal and
thereafter earns interest; the sum which represents the increase in the original
principal at the end of the term
Compound interest can be computed by:
1. Direct Method
2. Fundamental Method

Compound Interest
Fundamental Method
To compute for Compound Interest (Fundamental Formula)
Formula:
F = P ( 1 + i )
i = j/m
n = (m)(t)
n
where:
F = Compound Amount or Maturity Value
P = Principal
i = Interest rate per conversion period
m = Conversion Period
j = Nominal Rate
n = Total number of conversion periods for the whole term
t = Time or Term

The Effective Annual Interest Rate (EAR)
is the interest rate that is adjusted for
compounding over a given period. Simply
put, the effective annual interest rate is
the rate of interest that an investor can
earn (or pay) in a year after taking into
consideration compounding.
Effective Annual Rate
To compute for Effective Annual Rate:
Formula:
EAR = ( 1 + i/n ) - 1
The effective annual interest rate is also
known as the Effective Interest Rate (EIR),
Annual Equivalent Rate (AER), or Effective
Rate.
Where:
i = Stated Annual Interest Rate
n = Number of compounding periods
n

Effective Annual Rate
A credit card company
charges 21% interest per
year, compounded monthly.
What effective Annual
interest rate does the
company charges?
Example
i = 21% = (0.21)
n = 12 (months per year)
EAR = ( 1 + i/n ) - 1
= ( 1 + 0.21/12 )¹² - 1
= 0.2314 or 23.14%
Solution:
1. Identify the given from the problem.
2. Compute for the Effective Annual Rate
n

Yield to Maturity
Yield to Maturity (YTM) is the annual percentage return that an investor can
expect by keeping a bond or other fixed income product until maturity.
The internal rate of return (IRR) associated with purchasing and holding a bond to
maturity is denoted by YTM.
It is an important financial concept since it allows investors to evaluate the returns
on various assets.

Yield to Maturity
It represents the entire return an investor can expect if they keep a bond to
maturity, taking into account the purchase price, coupon rate, and length to
maturity.
Based on current market conditions, investors use yield to maturity to decide
whether a bond is overvalued or undervalued. If a bond's yield to maturity is higher
than current market interest rates, the bond is likely undervalued, and investors
may be able to buy it for less than its true value.

Yield to Maturity
Components of the YTM Equation
This is determined by the bond's coupon rate, which is the proportion of the face
value that the bond pays in interest each year.
Annual Coupon Payment
Face Value
This refers to the bond's nominal or par value, which is the amount the bond will be
worth when it matures.

Yield to Maturity
Components of the YTM Equation
This is the amount that the investor pays to buy the bond.
Purchase Price
Number of Years Until Maturity
This is the remaining time until the bond reaches its maturity date

Real Risk-Free rate of Interest
The real risk-free interest rate is the return on investment that takes inflation into
account and is considered risk-free.
It is the theoretical rate of return on a risk-free investment that an investor can
expect to earn.
This ratio is frequently used as an indicator to assess investment profitability,
adjusting for the effect of inflation on purchasing power returns.
It is the minimum rate of return required for an investor to accept a certain level
of risk.

Nominal or Quoted Risk- Free
Rate of Interest
This refers to the interest rate that is not adjusted for inflation.
This is the quoted or advertised interest rate on the loan or investment without
taking into account the effects of inflation.
It represents the net rate of return on an investment without credit risk.
It also determines the real rate of return requires adjusting the risk-free rate for
inflation, which adequately measures the rate of return based on purchasing
power.

Interest is essentially a charge to the borrower for the use of an asset. Assets
borrowed can include cash, consumer goods, vehicles, and property. Because of
this, an interest rate can be thought of as the "cost of money" - higher interest
rates make borrowing the same amount of money more expensive.
The rate of interest measures the percentage reward a lender receives for
deferring the consumption of resources until a future date. Correspondingly, it
measures the price a borrower pays to have resources now.
IR AND ITS ROLE IN FINANCE

01
INTEREST RATE THEORY
Classical
The classical theory argues that the rate of interest is
determined by two forces:
Demand for Investment capital
- derived mainly from households
Supply of Savings
- coming mainly from the business sector.

02
Loanable Funds
Loanable funds is the sum total of all the money people and entities in
an economy have decided to save and lend out to borrowers as an
investment rather than use for personal consumption.
This view argues that the risk-free interest rate is determined by the
interplay of two forces:
Demand for Loanable Funds
Supply of Loanable Funds

03
Liquidity Preference
The liquidity preference (or cash balances) theory of interest rates is a
short-term theory that was developed for explaining near-term changes
in interest rates, and hence, is more relevant for policymakers.
According to the theory, the rate of interest is the payment to money
(cash balances) holders for the use of their scarce resource (liquidity), by
those who demand liquidity (i.e. money or cash balances).

04
Rational Expectations
The rational expectations theory builds on a growing body of research
evidence that the money and capital markets are highly efficient in
digesting new information that affects interest rates and security
prices.

DETERMINANTS OF
INTEREST RATES

INFLATION
EXPECTATION
Simply put inflation expectations are the rates
at which investors, businesses, and consumer
anticipate future price increases. They are
important because of expectations of inflation
Influence it in real terms.

MONETARY
POLICY
Is the collection of measures used to manage its
total money supply and promote economic
expansion. Interest rate adjustments and
modifications to bank reserve requirements are
examples of monetary policy tactics. One way to
categorize monetary policy is as contradictionary
or expansionary.

BUSINESS
CYCLE
A business cycle is a series of swings in the
GDP that revenue around its img- term pace of
natural growth. It clarifies the fluctuations in
economic activity that an economy goes
through the time.

GOVERNMENT
BUDGET DEFICITS
A budget depicit occurs when money going
out (spending) exceeds money aming in
(revenue) during the defined period.

REFERENCES
Banton, C. (2023, March 28). Interest Rates: Different Types and What They Mean to Borrowers. Investopedia.
Retrieved December 12, 2023, from https://www.investopedia.com/terms/i/interestrate.asp
Banton, C. (2023, March 28). Interest Rates: Different Types and What They Mean to Borrowers. Investopedia.
Retrieved December 12, 2023, from
https://www.investopedia.com/terms/i/interestrate.asp#:~:text=Interest%20is%20essentially%20a%20charge,
amount%20of%20money%20more%20expensive
Borad, S. B. (2022, June 13). Nominal Risk-Free Rate – All You Need to Know. eFinanceManagement. Retrieved
December 12, 2023, from https://efinancemanagement.com/international-financial-management/nominal-risk-
free-rate
Classical Theory of Interest 7f2558125 Dd2e6b7a9b8ab5715890 D1e - CLASSICAL THEORY OF INTEREST
The - Studocu. (n.d.). Studocu. Retrieved December 12, 2023, from
https://www.studocu.com/in/document/mahatma-gandhi-university/economics/classical-theory-of-interest-
7f2558125-dd2e6b7a9b8ab5715890-d1e/26714897
Cussen, M. P. (2023, July 27). Interest Rates Explained: Nominal, Real, and Effective. Investopedia. Retrieved
December 12, 2023, from https://www.investopedia.com/articles/investing/082113/understanding-interest-
rates-nominal-real-and-effective.asp

REFERENCES
Hoel, R. (2023, September 1). What Is Interest? Definition, How It Works and Examples. Bankrate. Retrieved
December 12, 2023, from https://www.bankrate.com/banking/savings/what-is-interest/#how-interest-works-
when-borrowing
Napoletano, E. (2022, June 28). The Risk-Free Rate. Forbes Advisor. Retrieved December 12, 2023, from
https://www.forbes.com/advisor/investing/risk-free-rate
Simple Interest - Definition, Formula, Examples. (n.d.). Cuemath. Retrieved December 12, 2023, from
https://www.cuemath.com/commercial-math/simple-interest/
Tardi, C. (2023, September 19). Rational Expectations Theory Definition and How It Works. Investopedia.
Retrieved December 12, 2023, from https://www.investopedia.com/terms/r/rationaltheoryofexpectations.asp
Team, C. (2023, November 1). Effective Annual Interest Rate. Corporate Finance Institute. Retrieved December
12, 2023, from https://corporatefinanceinstitute.com/resources/commercial-lending/effective-annual-
interest-rate-ear/
Team, C. (2023, November 11). Interest Rate. Corporate Finance Institute. Retrieved December 12, 2023, from
https://corporatefinanceinstitute.com/resources/commercial-lending/interest-rate/

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