Understanding interest rate

18 important questions on Understanding interest rate

Explain the concept of the present value?

a dollar paid one year from now is worth less than a dollar paid today

What is a simple loan?

the lender provides the borrower with money (principal), that must be repaid at maturity date + additional payments.

How is the simple interest rate calculated?

Simple interest rate (i)= payment for interest / principal
e.g. 10/100= 0.10= 10% ßinterest
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What is discounting the future and how is it calculated?

calculating today's value of dollars received in the future.
PV= CF / (1 + i) ^ n
(with PV as present future and CF as future cash flow, PV also the principal)

What are the four types of market instruments?

1. simple loan
2. fixed-payment loan
3. coupon bond
4. discount bond or zero-coupon bond

What is a fixed-payment loan?

Lender provides the borrower with funds, where the borrower can make payments each month until the fund is paid back. E.g. payment of intuition fee paid per month.

What is a coupon bond?

Pays the owner of the bond a fixed interest payment until the face value or par value is paid back

What is a coupon bond rate?

the percentage of what you pay back each month of the whole amount

What is a discount bond?

Is bought at a discount (below face value) and the face value is repaid at the maturity date. Does not make any interest payment and just pays off the face value.

What is yield to maturity?

the interest rate that is the same as the present value of cashflow payments received from a debt instrument with its today value.

How is the yield to maturity calculated on a simple loan?

PV= CF/ (1+ i) ^ n
100=110/ (1 + i) ^n
(1+ i)100= 110
(1+i) = 110/100
I = 1.10 - 1 = 0.10 = 10%

How can a fixed-payment loan be calculated?

this is the answer

How can a coupon bond be calculated?

This is the answer

What are three interesting facts about coupon bonds?

  1. When the coupon is priced at its face value, the yield to maturity equals the coupon rate
  2. The price of a coupon bond and the yield to maturity are negatively related.
  3. The yield to maturity is greater than the coupon bond rate when the bond price is below its face value.

What is a consol or perpetuity bond?

continuous bond with no maturity date and no repayment, but pay coupon payments forever.

How can the YTM be calculated on a discount bond?

I = F – P / P
F= face value of the discount bond, P = current price of the discount bond

What is the rate of return?

a measurement of how well a person does by holding a bond or any other security.  And is defined as the payments of the owner + the change in value (for what the bond is sold minus what the bond is bought for), expressed as a part of its purchase price.

Name the 5 facts that are true about bonds

- interest rate goes up --> the bond price goes down
- longer maturity --> larger price changes
- longer maturity --> lower rate of return
- longer maturity --> higher risk
- rate of return can be become negative

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