Corporate Finance 003: Yield and Term Structure

Terminology of Rates

It is pretty confusing if you are unsure of the terms used when quoting interest rates. Here is a simple introduction based on U.S. examples.

The Rate or APR or Annual Percentage Rate is the simple interest earned without compounding in a year. It is therefore not accurate and quoted for convenience. However, many bank products sold commercially are quoted in terms of APR.

The APY or Annual Percentage Yield or EAR or Effective Annual Rate is the actual amount of interest accumulated in a year, taking into effect compounding.

Therefore to calculate actual values using compounding or discounting, we need to use EAR. However, APR is usually quoted instead, therefore we would need to calculate the EAR using the following formula before finding the actual value:

EAR = [ 1+ (APR / k) ]^k  – 1
EAR = ( 1+ i)^k  – 1

k is the number of compounding period within a year. i is the periodic interest rate.


Term Structure

Term Structure is the relation between the investment term and the interest rate. A Yield Curve is a graph representing that relation. The yield typically differs between different maturity terms. The curve conveys the market expectation of interest rates movement in future. If the yields of longer maturity loans are higher, then the market is expecting interest rate to move higher in the future.

Spot Rate (on the Spot) is the interest rate for a loan made today. The rate can be derived from the yield curve using

 

(Reference: Coursera Wharton Online Introduction to Corporate Finance)

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