Financial Terms
Interest Rate

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Definition of Interest Rate

Interest Rate Image 1

Interest Rate

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

Interest Rate

rate charged or paid for the use of money, normally expressed as a percentage

Related Terms:

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").

Effective annual interest rate

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

effective annual interest rate

interest rate that is annualized using compound interest.

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.

Interest Rate Image 2

Fixed Interest Rate

A rate that does not fluctuate with general market conditions.

Floating Interest Rate

A rate that fluctuates with general market condition.

Forward interest rate

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

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 Differential

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

Interest rate floor

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

Interest Rate, Nominal

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

Interest Rate Image 3

Interest rate on debt

The firm's cost of debt capital.

interest rate parity

Theory that forward premium equals interest rate differential.

Interest Rate Parity

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

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, Real

Nominal interest rate less expected inflation.

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 Risk

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

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.

Nominal interest rate

The interest rate unadjusted for inflation.

Nominal Interest Rate

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

nominal interest rate

rate at which money invested grows.

Interest Rate Image 4

Nominal Interest Rate

The contracted, or stated, interest rate, undeflated for price level changes.

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
adjusted for inflation.

Real Interest Rate

The rate of interest paid on an investment adjusted for inflation

real interest rate

rate at which the purchasing power of an investment increases.

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.

Term Structure of Interest Rates

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

tiered interest rate

A pre-set scale of interest which is based on the premise that higher sums of money earn higher rates of interest.

Equilibrium rate of interest

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

Money Rate of Interest

See interest rate, nominal.

Rate of interest

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

Real Rate of Interest

See interest rate, real.

annual percentage rate (APR)

interest rate that is annualized using simple interest.


Adjustable rate mortgage. A mortgage that features predetermined adjustments of the loan interest rate
at regular intervals based on an established index. The interest rate is adjusted at each interval to a rate
equivalent to the index value plus a predetermined spread, or margin, over the index, usually subject to perinterval
and to life-of-loan interest rate and/or payment rate caps.

Asset swap

An interest rate swap used to alter the cash flow characteristics of an institution's assets so as to
provide a better match with its iabilities.

Average maturity

The average time to maturity of securities held by a mutual fund. Changes in interest rates
have greater impact on funds with longer average life.

Basis point

In the bond market, the smallest measure used for quoting yields is a basis point. Each percentage
point of yield in bonds equals 100 basis points. Basis points also are used for interest rates. An interest rate of
5% is 50 basis points greater than an interest rate of 4.5%.

Black-Scholes model

The first complete mathematical model for pricing
options, developed by Fischer Black and Myron Scholes. It examines market
price, strike price, volatility, time to expiration, and interest rates. It is limited
to only certain kinds of options.

Black-Scholes option-pricing model

A model for pricing call options based on arbitrage arguments that uses
the stock price, the exercise price, the risk-free interest rate, the time to expiration, and the standard deviation
of the stock return.


A system that monitors and evaluates the performance of a fixed-income portfolio , as well as the
individual securities held in the portfolio. BONDPAR decomposes the return into those elements beyond the
manager's control--such as the interest rate environment and client-imposed duration policy constraints--and
those that the management process contributes to, such as interest rate management, sector/quality allocations,
and individual bond selection.

Book Returns

Book yield is the investment income earned in a year on a portfolio of assets purchased over a number of years and at different interest rates, divided by the book value of those assets.

Call money rate

Also called the broker loan rate , the interest rate that banks charge brokers to finance
margin loans to investors. The broker charges the investor the call money rate plus a service charge.


An upper limit on the interest rate on a floating-rate note.


An upper and lower limit on the interest rate on a floating-rate note.


interest-rate option that guarantees that the rate on a floating-rate
loan will not exceed a certain upper level nor fall below a lower level. It is
designed to protect an investor against wide fluctuations in interest rates.

Convertible Debenture

Are debt instruments that are convertible into common or preferred shares, take secondary or no security against assets, have flexible terms of repayment and charge fixed or floating interest rates.

Cost of funds

interest rate associated with borrowing money.


The parties to an interest rate swap.

Coupon rate

The nominal interest rate that the issuer promises to pay the
buyer of a bond.

Credit Rationing

Restriction of loans by lenders so that not all borrowers willing to pay the current interest rate are able to obtain loans.

Crediting rate

The interest rate offered on an investment type insurance policy.

Delivery options

The options available to the seller of an interest rate futures contract, including the quality
option, the timing option, and the wild card option. Delivery options make the buyer uncertain of which
Treasury Bond will be delivered or when it will be delivered.

Discount rate

The interest rate that the Federal Reserve charges a bank to borrow funds when a bank is
temporarily short of funds. Collateral is necessary to borrow, and such borrowing is quite limited because the
Fed views it as a privilege to be used to meet short-term liquidity needs, and not a device to increase earnings.

discount rate

interest rate used to compute present values of future cash flows.

Discount Rate

The interest rate at which the Fed is prepared to loan reserves to commercial banks.

Discounted payback period rule

An investment decision rule in which the cash flows are discounted at an
interest rate and the payback rule is applied on these discounted cash flows.

Dollar-weighted rate of return

Also called the internal rate of return, the interest rate that will make the
present value of the cash flows from all the subperiods in the evaluation period plus the terminal market value
of the portfolio equal to the initial market value of the portfolio.

Drop lock

An arrangement whereby the interest rate on a floating rate note or preferred stock becomes fixed
if it falls to a specified level.


A common gauge of the price sensitivity of an asset or portfolio to a change in interest rates.


The expected life of a fixed-income security considering its coupon
yield, interest payments, maturity, and call features. As market interest rates
rise, the duration of a financial instrument decreases. See Macaulay duration.

Effective annual yield

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

Effective date

In an interest rate swap, the date the swap begins accruing interest.

Effective duration

The duration calculated using the approximate duration formula for a bond with an
embedded option, reflecting the expected change in the cash flow caused by the option. Measures the
responsiveness of a bond's price taking into account the expected cash flows will change as interest rates
change due to the embedded option.

Effective margin (EM)

Used with SAT performance measures, the amount equaling the net earned spread, or
margin, of income on the assets in excess of financing costs for a given interest rate and prepayment rate

Equity swap

A swap in which the cash flows that are exchanged are based on the total return on some stock
market index and an interest rate (either a fixed rate or a floating rate). Related: interest rate swap.

Expectations hypothesis theories

Theories of the term structure of interest rates which include the pure
expectations theory, the liquidity theory of the term structure, and the preferred habitat theory. These theories
hold that each forward rate equals the expected future interest rate for the relevant period. These three theories
differ, however, on whether other factors also affect forward rates, and how.
Expectations theory of forward exchange rates A theory of foreign exchange rates that holds that the
expected future spot foreign exchange rate t periods in the future equals the current t-period forward exchange

Federal funds rate

This is the interest rate that banks with excess reserves at a Federal Reserve district bank
charge other banks that need overnight loans. The Fed Funds rate, as it is called, often points to the direction
of U.S. interest rates.

Federal Funds Rate

The interest rate at which banks lend deposits at the Federal Reserve to one another overnight.

Federal Reserve (the Fed)

The central bank in the United States, responsible for setting interest rates.

financial leverage

The equity (ownership) capital of a business can serve
as the basis for securing debt capital (borrowing money). In this way, a
business increases the total capital available to invest in its assets and
can make more sales and more profit. The strategy is to earn operating
profit, or earnings before interest and income tax (EBIT), on the capital
supplied from debt that is more than the interest paid on the debt capital.
A financial leverage gain equals the EBIT earned on debt capital
minus the interest on the debt. A financial leverage gain augments earnings
on equity capital. A business must earn a rate of return on its assets
(ROA) that is greater than the interest rate on its debt to make a financial
leverage gain. If the spread between its ROA and interest rate is unfavorable,
a business suffers a financial leverage loss.

Fisher effect

A theory that nominal interest rates in two or more countries should be equal to the required real
rate of return to investors plus compensation for the expected amount of inflation in each country.

Fixed Rate Loan

Loan for a fixed period of time with a fixed interest rate for the life of the loan.

Fixed-rate payer

In an interest rate swap the counterparty who pays a fixed rate, usually in exchange for a
floating-rate payment.

Floating-rate contract

A guaranteed investment contract where the credit rating is tied to some variable
("floating") interest rate benchmark, such as a specific-maturity Treasury yield.

Floating-rate note (FRN)

Note whose interest payment varies with short-term interest rates.

Floating-rate payer

In an interest rate swap, the counterparty who pays a rate based on a reference rate,
usually in exchange for a fixed-rate payment

Floating-rate preferred

Preferred stock paying dividends that vary with short-term interest rates.

floating-rate security

Security paying dividends or interest that vary with short-term interest rates.


interest-rate option that guarantees that the rate on a floating-rate
loan will not fall below a certain level.
Forward curve
The curve of forward interest rates vs. maturity dates for bonds.

Forward rate

A projection of future interest rates calculated from either the spot rates or the yield curve.

Forward rate

The future interest rate of a bond inferred from the term
structure, especially from the yield curve of zero-coupon bonds, calculated from
the growth factor of an investment in a zero held until maturity.

Forward rate agreement (FRA)

Agreement to borrow or lend at a specified future date at an interest rate
that is fixed today.

Fundamental analysis

Security analysis that seeks to detect misvalued securities by an analysis of the firm's
business prospects. Research analysis often focuses on earnings, dividend prospects, expectations for future
interest rates, and risk evaluation of the firm.

Funding risk

Related: interest rate risk

future value

the amount to which one or more sums of
money invested at a specified interest rate will grow over
a specified number of time periods

Future Value

The amount to which a payment or series of payments will grow by a given future date when compounded by a given interest rate. FVIF future value interest factor.


Mortgage-backed securities (MBS) on which registered holders receive an aggregate principal and
interest payment from a central paying agent on all of their certificates. Principal and interest payments are
disbursed on the 20th day of the month. GNMA-II MBS are backed by multiple-issuer pools or custom pools
(one issuer but different interest rates that may vary within one percentage point). Multiple-issuer pools are
known as "Jumbos." Jumbo pools are generally longer and offer certain mortgages that are more
geographically diverse than single-issuer pools. Jumbo pool mortgage interest rates may vary within one
percentage point.

Guaranteed insurance contract

A contract promising a stated nominal interest rate over some specific time
period, usually several years.

Hedged portfolio

A portfolio consisting of the long position in the stock and the short position in the call
option, so as to be riskless and produce a return that equals the risk-free interest rate.

Hot money

Money that moves across country borders in response to interest rate differences and that moves
away when the interest rate differential disappears.

Inflation uncertainty

The fact that future inflation rates are not known. It is a possible contributing factor to
the makeup of the term structure of interest rates.

Intermarket sector

spread The spread between the interest rate offered in two sectors of the bond market for
issues of the same maturity.







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