Financial Terms Compound interest

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# Definition of Compound interest

## Compound interest

interest paid on previously earned interest as well as on the principal.

## Compound Interest

interest paid on principal and on interest earned in previous
periods

## compound interest

a method of determining interest in which interest that was earned in prior periods is added to the original investment so that, in each successive period, interest is earned on both principal and interest

## compound interest

interest earned on interest.

## Compound Interest

interest earned on an investment at periodic intervals and added to principal and previous interest earned. Each time new interest earned is calculated it is on a combined total of principal and previous interest earned. Essentially, interest is paid on top of interest.

# Related Terms:

## Effective annual yield

Annualized interest rate on a security computed using compound interest techniques.

## Interest on interest

interest earned on reinvestment of each interest payment on money invested.
See: compound interest.

## Simple interest

interest calculated only on the initial investment. Related:compound interest.

## Future value

The value that a sum of money (the present value) earning
compound interest will have in the future.

## effective annual interest rate

interest rate that is annualized using compound interest.

## Interest Factor

Numbers found in compound interest and annuity tables. Usually called the FVIF or PVIF.

## fractional interest discount

the combined discounts for lack of control and marketability. g the constant growth rate in cash flows or net income used in the ADF, Gordon model, or present value factor.

## Accrued interest

The accumulated coupon interest earned but not yet paid to the seller of a bond by the
buyer (unless the bond is in default).

## Amortizing interest rate swap

Swap in which the principal or national amount rises (falls) as interest rates
rise (decline).

## Base interest rate

Related: Benchmark interest rate.

## Benchmark interest rate

Also called the base interest rate, it is the minimum interest rate investors will
demand for investing in a non-Treasury security. It is also tied to the yield to maturity offered on a
comparable-maturity Treasury security that was most recently issued ("on-the-run").

## Best-interests-of-creditors test

The requirement that a claim holder voting against a plan of reorganization
must receive at least as much as he would have if the debtor were liquidated.

## Capitalized interest

interest that is not immediately expensed, but rather is considered as an asset and is then
amortized through the income statement over time.

## Cash flow after interest and taxes

Net income plus depreciation.

## Compound option

Option on an option.

## Compounding

The process of accumulating the time value of money forward in time. For example, interest
earned in one period earns additional interest during each subsequent time period.

## Compounding frequency

The number of compounding periods in a year. For example, quarterly
compounding has a compounding frequency of 4.

## Compounding period

The length of the time period (for example, a quarter in the case of quarterly
compounding) that elapses before interest compounds.

## Continuous compounding

The process of accumulating the time value of money forward in time on a
continuous, or instantaneous, basis. interest is earned continuously, and at each instant, the interest that
accrues immediately begins earning interest on itself.

## Covered interest arbitrage

A portfolio manager invests dollars in an instrument denominated in a foreign
currency and hedges his resulting foreign exchange risk by selling the proceeds of the investment forward for
dollars.

## Discrete compounding

compounding the time value of money for discrete time intervals.

## Earnings before interest and taxes (EBIT)

A financial measure defined as revenues less cost of goods sold
and selling, general, and administrative expenses. In other words, operating and non-operating profit before
the deduction of interest and income taxes.

## Effective annual interest rate

An annual measure of the time value of money that fully reflects the effects of
compounding.

## Equilibrium rate of interest

The interest rate that clears the market. Also called the market-clearing interest
rate.

## Forward interest rate

interest rate fixed today on a loan to be made at some future date.

## Gross interest

interest earned before taxes are deducted.

## Interest

The price paid for borrowing money. It is expressed as a percentage rate over a period of time and
reflects the rate of exchange of present consumption for future consumption. Also, a share or title in property.

## Interest coverage ratio

The ratio of the earnings before interest and taxes to the annual interest expense. This
ratio measures a firm's ability to pay interest.

## Interest coverage test

A debt limitation that prohibits the issuance of additional long-term debt if the issuer's
interest coverage would, as a result of the issue, fall below some specified minimum.

## Interest equalization tax

Tax on foreign investment by residents of the U.S. which was abolished in 1974.

## Interest payments

Contractual debt payments based on the coupon rate of interest and the principal amount.

## Interest-only strip (IO)

A security based solely on the interest payments form a pool of mortgages, Treasury
bonds, or other bonds. Once the principal on the mortgages or bonds has been repaid, interest payments stop
and the value of the IO falls to zero.

## Interest rate agreement

An agreement whereby one party, for an upfront premium, agrees to compensate the
other at specific time periods if a designated interest rate (the reference rate) is different from a predetermined
level (the strike rate).

## Interest rate cap

Also called an interest rate ceiling, an interest rate agreement in which payments are made
when the reference rate exceeds the strike rate.

## Interest rate ceiling

Related: interest rate cap.

## Interest rate floor

An interest rate agreement in which payments are made when the reference rate falls
below the strike rate.

## Interest rate on debt

The firm's cost of debt capital.

## Interest rate parity theorem

interest rate differential between two countries is equal to the difference
between the forward foreign exchange rate and the spot rate.

## Interest rate risk

The risk that a security's value changes due to a change in interest rates. For example, a
bond's price drops as interest rates rise. For a depository institution, also called funding risk, the risk that
spread income will suffer because of a change in interest rates.

## Interest rate swap

A binding agreement between counterparties to exchange periodic interest payments on
some predetermined dollar principal, which is called the notional principal amount. For example, one party
will pay fixed and receive variable.

## Interest subsidy

A firm's deduction of the interest payments on its debt from its earnings before it calculates
its tax bill under current tax law.

## Interest tax shield

The reduction in income taxes that results from the tax-deductibility of interest payments.

## Nominal interest rate

The interest rate unadjusted for inflation.

## Open interest

The total number of derivative contracts traded that not yet been liquidated either by an
offsetting derivative transaction or by delivery. Related: liquidation

## Pooling of interests

An accounting method for reporting acquisitions accomplished through the use of equity.
The combined assets of the merged entity are consolidated using book value, as opposed to the purchase
method, which uses market value. The merging entities' financial results are combined as though the two
entities have always been a single entity.

## Rate of interest

The rate, as a proportion of the principal, at which interest is computed.

## Real interest rate

The rate of interest excluding the effect of inflation; that is, the rate that is earned in terms
of constant-purchasing-power dollars. interest rate expressed in terms of real goods, i.e. nominal interest rate

## Realized compound yield

Yield assuming that coupon payments are invested at the going market interest
rate at the time of their receipt and rolled over until the bond matures.

## Short interest

This is the total number of shares of a security that investors have borrowed, then sold in the
hope that the security will fall in value. An investor then buys back the shares and pockets the difference as profit.

## Simple compound growth method

A method of calculating the growth rate by relating the terminal value to
the initial value and assuming a constant percentage annual rate of growth between these two values.

## Spot interest rate

interest rate fixed today on a loan that is made today. Related: forward interest rates.

## Stated annual interest rate

The interest rate expressed as a per annum percentage, by which interest
payment is determined.

## Times-interest-earned ratio

Earnings before interest and tax, divided by interest payments.

## True interest cost

For a security such as commercial paper that is sold on a discount basis, the coupon rate
required to provide an identical return assuming a coupon-bearing instrument of like maturity that pays
interest in arrears.

## Earnings before interest and taxes (EBIT)

The operating profit before deducting interest and tax.

## Earnings before interest, taxes, depreciation and amortization (EBITDA)

The operating profit before deducting interest, tax, depreciation and amortization.

## Interest

The cost of money, received on investments or paid on borrowings.

See EBIT.

## Interest income

Income that a company receives in the form of interest, usually as the result of keeping money in interest-bearing accounts at financial institutions and the lending of money to other companies.

## Interest payable

The amount of interest that is owed but has not been paid at the end of a period.

## earnings before interest and income tax (EBIT)

A measure of profit that
equals sales revenue for the period minus cost-of-goods-sold expense
and all operating expenses—but before deducting interest and income
tax expenses. It is a measure of the operating profit of a business before
considering the cost of its debt capital and income tax.

## times interest earned

A ratio that tests the ability of a business to make
interest payments on its debt, which is calculated by dividing annual
earnings before interest and income tax by the interest expense for the
year. There is no particular rule for this ratio, such as 3 or 4 times, but
obviously the ratio should be higher than 1.

## Accrued Interest

The amount of interest accumulated on a debt security between
interest paying dates

## Continuous Compounding

The process of continuously adding interest to a principal plus
interest amount and calculating the resulting compound amount

## Discrete Compounding

The process of adding interest to a principal plus interest amount
and calculating the resulting compound amount at specific
intervals, such as monthly or annually

## Effective Interest Rate

The rate of interest actually earned on an investment. It is
calculated as the ratio of the total amount of interest actually
earned for one year divided by the amount of the principal.

## Nominal Interest Rate

The rate of interest quoted, or stated, to be paid on a security

## Real Interest Rate

The rate of interest paid on an investment adjusted for inflation

## Simple Interest

interest paid only on the principal; calculated by multiplying the
interest rate by the principal

## Times Interest Earned Ratio

A measure of how well a company is able to meet its interest
payments based on the cash generated by its operations. It is
calculated by dividing the earnings before interest and taxes by the
total interest charges incurred by the firm.

## compounding period

the time between each interest computation

## simple interest

a method of determining interest in which interest is earned only on the original investment (or principal) amount

## Interest

The cost of funds loaned to an entity. It can also refer to the equity ownership
of an investor in a business entity.

## Pooling of interests

An method for accounting for a business combination. When used, the expenses of the combination are charged against income at once, and the net
income of the acquired company is added to the full-year reported results of the acquiring company.

## interest rate parity

Theory that forward premium equals interest rate differential.

## interest tax shield

Tax savings resulting from deductibility of interest payments.

## nominal interest rate

Rate at which money invested grows.

## real interest rate

Rate at which the purchasing power of an investment increases.

## simple interest

interest earned only on the original investment; no interest is earned on interest.

## Interest Rate Differential

The interest rate on our financial assets minus the interest rate on a foreign country's financial assets.

## Interest Rate, Nominal

Payment for the use of borrowed funds, measured as a percentage per year of these funds.

## Interest Rate Parity

Theory that real interest rates are approximately the same across countries except for a risk premium.

## Interest Rate, Real

Nominal interest rate less expected inflation.

## Money Rate of Interest

See interest rate, nominal.

## Real Rate of Interest

See interest rate, real.

## Term Structure of Interest Rates

Relationship among interest rates on bonds with different terms to maturity.

## Capitalized Interest

interest incurred during the construction period on monies invested in
assets under construction that is added to the cost of the assets.

## Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

An earningsbased measure that, for many, serves as a surrogate for cash flow. Actually consists of working
capital provided by operations before interest and taxes.

## Insurable Interest

In England in the 1700's it was popular to bet on the date of death of certain prominent public figures. Anyone could buy life insurance on another's life, even without their consent. Unfortunately, some died before it was their time, dispatched prematurely in order that the life insurance proceeds could be collected. In 1774, English Parliament passed a law which restricted the right to be a beneficiary on a life insurance contract to those who would suffer an economic loss when the life insured died. The law also provided that a person has an unlimited insurable interest in his own life. It is still a legal stipulation that an insurance contract is not valid unless insurable interest exists at the time the policy is issued. Life Insurance companies will not, however, issue unlimited amounts of coverage to an individual. The amount of life insurance which will be approved has to approximate the loss caused by the death of the individual and must not result in a windfall for the beneficiary.

## Accrued Interest

The amount of interest owing but not paid.

## Fixed Interest Rate

A rate that does not fluctuate with general market conditions.

## Floating Interest Rate

A rate that fluctuates with general market condition.

## Interest

A charge for the use of money supplied by a lender.

## Interest Rate

Cost of using money, expressed as a rate per period of time, usually one year.

## Interest Rate Risk

Possibility that interest rates will rise during the term of a loan thereby increasing the annual cost of borrowing.

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