Question

Distinguish the differences among the following interest rates for bonds payable: yield rate, nominal rate, stated rate, market rate, and effective rate. Please give an example of each rate applied to actual practice.

Answer 1

1) Nominal/ Stated rate: It is the actual monetary price borrower pays lenders to use their money. It is also known as coupon rate as traditionally stamped on coupons redeemed by bond holders. It is pure Simple Interest and no compounding takes place. Nominal rate is always less than Effective Interest rate.

2) Effective Rate: Effective rate takes the concept of compounding which can be weekly, monthly, or annually.

Suppose Nominal rate is 6% and compounded monthly equivalent to 6.17% of Effective rate. As it can be found from r= (1+i/n)ⁿ -1 where i= nominal rate and n= number of compounding periods per year.

3) Market rate: Bonds nominal rate of interest will not change for the life while Market rate constantly changes due to global event like inflation. When Market rate increases, Inflation occurs and hence Bond investors demand to earn more Interest rates. When market rate decreases it shows down market and causes Purchasing power also decreases so risk of owning bonds decreases. For eg: If nominal rate is 9% of $ 100000 bonds, earns $ 4500 for 6 months. But suppose market rate falls to 8% earning $ 4000 so risk of owning bonds takes place.

4) Yield rate: Annual return on investment is known as yield. It depends on purchase price and interest rate also known as coupn rate. Coupon rate is fixed all the life of bond while changes in interest rate, demand of bond, time duration of bond , credit quality affects Yield rate. Higher price paid for bond, yield is lower and vice versa.