Definition of Interest Rate

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

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
compounding.

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 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.

Nominal interest rate

The interest rate unadjusted for inflation.

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.

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.

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

effective annual interest rate

interest rate that is annualized using compound interest.

interest rate parity

Theory that forward premium equals interest rate differential.

nominal interest rate

rate at which money invested grows.

real interest rate

rate at which the purchasing power of an investment increases.

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.

Term Structure of Interest Rates

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

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 Rate Risk

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

Nominal Interest Rate

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

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
rate.

Rate of interest

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

Money Rate of Interest

See interest rate, nominal.

Real Rate of Interest

See interest rate, real.

ARM

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 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.

BONDPAR

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.

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.

Cap

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

Collar

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

Cost of funds

interest rate associated with borrowing money.

Counterparties

The parties to an interest rate swap.

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.

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.

Duration

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

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
scenario.

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
rate.

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.

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 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.

Forward rate

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

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

GNMA-II

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.

International Fisher effect

States that the interest rate differential between two countries should be an
unbiased predictor of the future change in the spot rate.

Intramarket sector spread

The spread between two issues of the same maturity within a market sector. For
instance, the difference in interest rates offered for five-year industrial corporate bonds and five-year utility
corporate bonds.

Inverse floating rate note

A variable rate security whose coupon rate increases as a benchmark interest rate declines.

Irrational call option

The implied call imbedded in the MBS. Identified as irrational because the call is
sometimes not exercised when it is in the money (interest rates are below the threshold to refinance).
Sometimes exercised when not in the money (home sold without regard to the relative level of interest rates).

Liability swap

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

LIBOR

The London Interbank Offered rate; the rate of interest that major international banks in London
charge each other for borrowings. Many variable interest rates in the U.S. are based on spreads off of LIBOR.
There are many different LIBOR tenors.

Liquidity preference hypothesis

The argument that greater liquidity is valuable, all else equal. Also, the
theory that the forward rate exceeds expected future interest rates.

Liquidity premium

Forward rate minus expected future short-term interest rate.

Liquidity theory of the term structure

A biased expectations theory that asserts that the implied forward
rates will not be a pure estimate of the market's expectations of future interest rates because they embody a
liquidity premium.

Loan value

The amount a policyholder may borrow against a whole life insurance policy at the interest rate
specified in the policy.

Maturity

For a bond, the date on which the principal is required to be repaid. In an interest rate swap, the
date that the swap stops accruing interest.

Mismatch bond

Floating rate note whose interest rate is reset at more frequent intervals than the rollover
period (e.g. a note whose payments are set quarterly on the basis of the one-year interest rate).

Monetary policy

Actions taken by the Board of Governors of the Federal Reserve System to influence the
money supply or interest rates.

Money market demand account

An account that pays interest based on short-term interest rates.

Mortgage duration

A modification of standard duration to account for the impact on duration of MBSs of
changes in prepayment speed resulting from changes in interest rates. Two factors are employed: one that
reflects the impact of changes in prepayment speed or price.

Mortgage rate

The interest rate on a mortgage loan.

Multiperiod immunization

A portfolio strategy in which a portfolio is created that will be capable of
satisfying more than one predetermined future liability regardless if interest rates change.

Negative duration

A situation in which the price of the MBS moves in the same direction as interest rates.

Nominal

In name only. Differences in compounding cause the nominal rate to differ from the effective
interest rate. Inflation causes the purchasing power of money to differ from one time to another.

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