An interest rate is the amount charged by a lender, to a borrower, of capital funds (i.e. money). The rate is expressed as an annual percentage of the principal, or amount borrowed. There are three "interest rate" models discussed in this course:
1. TREASURY YIELD CURVE:
This is a two dimensional graphic model printed daily in the
Wall Street Journal that shows the relationship between "interest rates" (on the vertical axis)
and "time to maturity" on the horizontal axis. Note: Time to maturity is the length of time
between the present and the time that the instrument becomes "due". Rates vary among different instruments
according to the instrument's time to maturity (generally a higher rate for a
longer maturity). This is NOT the same as saying that rates change through time.
And although rates DO change through time (on an hourly/daily basis), the
Treasury Yield curve does NOT show rates changing through time.
2. DECOMPOSITION OF INTEREST RATES:
This model shows the five major components that
are considered in the setting of rates. The total rate is made up of:
2.1 The "real" rate: (k*) Pure gain to lender, not tied to any real or perceived cost.
2.2 Inflation Premium (IP): Compensation for the effects of inflation
2.3 Default Risk Premium (DRP): Compensation for probability of default
2.4 Liquidity Premium: (LP)Compensation for lack of liquidity in an instrument
2.5 Maturity Risk Premium: (MRP) Compensation for lending for long periods
3. MAJOR TYPES:
There are three major interest rates that a student should be aware of
and know where to find the daily listing (in the WSJ)
3.1 Fed Discount Rate: The charge on loans to depository institutions by the
NY Federal Reserve Banks (6.25% 2Feb07)
3.2 Federal Funds Rate: Reserves traded among commercial banks for overnight use in amounts of $1 million or more.
A "target rate" is set by the Fed, but the actual rates paid by institutions is set by auction.
(5.25% 2 Feb07)
3.3 Prime Rate: The base rate on corporate loans posted by at least 75% of the nations 30 largest banks.
(8.25% 2Feb07)
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Below are some definitions from Wikipedia:
A depository institution is a financial institution in United States, such as a savings bank, that is legally allowed to accept monetary deposits from consumers. Federal depository institutions are regulated by the Federal Deposit Insurance Corporation (FDIC). An example of a non-depository institution might be a mortgage bank. While licensed to lend, they cannot accept deposits.
A commercial bank is a type of financial intermediary and a type of bank. Commercial bank has two possible meanings:
This is what people normally call a "bank". The term "commercial" was used to distinguish it from an investment bank. Since the two types of banks no longer have to be separate companies, some have used the term "commercial bank" to refer to banks which focus mainly on companies. In some English-speaking countries outside North America, the term "trading bank" was and is used to denote a commercial bank.(After the great depression, the U.S. Congress required that banks only engage in banking activities, whereas investment banks were limited to capital markets activities. This seperation is no longer mandatory.)